NextCard was an Internet-based issuer of credit cards that marketed solely to its web site, www.nextcard.com. The action alleges that NextCard took substantial risks in issuing credit cards to individuals almost instantly or the Internet, and actually increased its risk because it granted loans to subprime borrowers with credit scores below 660 to increase growth. Ernst & Young was NextCard’s auditor from 1998 into 2002. The action alleges that, because Ernst & Young evaluated NextCard’s financial results throughout the period, it had to know that NextCard was reporting materially false and misleading financial results.

As early as the second quarter of 2000, Ernst & Young allegedly knew that NextCard was improperly classifying credit losses as fraud losses and excluding those losses from the charge operate it was used to establish loan loss allowances. As a result, Ernst & Young allegedly knew that NextCard was understating the charge-off rate and loan loss allowances, and overstating earnings. Ernst & Young's work papers allegedly reflect that as a result of its fiscal year 2000 audit, the law firm knew that NextCard’s charge-off rate as a percentage of managed loans was 4.99%. On the 2000 report on its SEC form 10K, NextCard reported the charge-off rate of 2.62%-- nearly 50% less than what Ernst & Young had to know to be true charge-off rate.

During the Office of the Comptroller of the Currency’s (OCC) 2001 examination of NextBank, N.A., Ernst & Young learned that the OCC had discovered various accounting improprieties, challenged Ernst & Young’s audit and review procedures, and asked the firm to provide certain working papers from its audit of NextCard’s 2000 financial statements and its reviews of NextCard’s first and second quarter 2001 financial results. Rather than produce the working papers that would have shown Ernst & Young’s knowledge that NextCard had reported materially false and misleading financial results, Ernst & Young allegedly destroyed and falsified both hard and electronic copies of the working papers and produced those altered versions to the OCC.

Ernst & Young has effectively admitted to its participation in the fraudulent scheme. Oliver G. Flanagan, an Ernst & Young senior manager on the NextCard engagement, has pled guilty to corruptly obstructing the OCC’s examination of NextBank in violation of federal law and has admitted that he withheld and destroyed responsive documents at the direction of Thomas C. Trauger for the improper purpose of concealing the prior alterations from the OCC. Trauger, the Ernst & Young audit partner on the NextCard engagement, has been arrested and charged with one count of corruptly obstructing the OCC’s examination of NextBank in violation of federal law and one count of knowingly concealing and covering up false entries in certain records and documents related to Ernst & Young’s annual audits and quarterly reviews of NextCard’s financial statements with the intent to impede and obstruct the investigation of NextCard by the SEC. Trauger also admitted to Ernst & Young attorneys that he altered NextCard workpapers. The SEC has instituted two administrative proceedings – one, a currently pending, unsettled proceeding against Trauger and Michael Mullen, an Ernst & Young audit manager on the NextCard engagement, and the other, a separate, settled proceeding against Flanagan.

On February 7, 2002, the OCC placed NextBank, NextCard’s wholly owned banking subsidiary, into receivership and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver after determining that NextBank had experienced a substantial dissipation of assets, earnings and capital through unsafe and unsound practices and that there was no reasonable prospect for NextBank to become adequately capitalized without federal assistance. The failure of NextBank was one of the quickest bank failures in decades and will cost the FDIC between $300 and $350 million, making it the most costly bank failure in 2002. In November 2002, NextCard declared bankruptcy.