Introduction
Background
Opinion
Comment
Introduction
Federal judges in the US District Court for the Southern District of New York, and now a federal jury in that same district, are making the Financial Institutions Reform Enforcement and Recovery Act of 1989 (12 USC §1833(a)) required re-reading for banking attorneys. In recent opinions, Judge Jed S Rakoff and Judge Lewis Kaplan endorsed the claims filed under the act's provisions, a 1989 reform law now being applied by the US Department of Justice to the aftermath of the late 2007 and 2008 meltdown in the housing and secondary mortgage market and other financial markets. In November, a jury found that Bank of America and a lending executive there were liable for civil penalties under the statute.(1)
In their rulings allowing the cases to proceed, the judges accepted a novel principle that fraud "affecting a federally insured financial institution" can be proven under the act even when the alleged perpetrator of the fraud was the same financial institution that was affected by it.(2) Rakoff also confirmed a longstanding precedent that allows a breach of contract to serve as a basis for federal statutory fraud claims even though such claims of false promises cannot meet the test for common law fraud.(3) These decisions, and the jury's November 2013 verdict, show that loan underwriting, oversight and quality review risk equations have tilted precipitously higher.
Background
The Department of Justice is using the federal courts in the Southern District of New York as a testing ground for its rarely seen application of the Financial Institutions Reform Enforcement and Recovery Act's civil enforcement tools. Congress created a new investigative authority and a new civil penalty after the 1980s savings and loan debacle as a supplement to traditional criminal bank fraud tools. The penalty can apply where there is no federal insurance or loan guarantee, and where there is only an affect on a federally insured financial institution from an allegedly fraudulent scheme. The government has applied the act's civil remedy to supplement civil False Claims Act cases brought by whistleblowers who allege losses to the treasury in federally guaranteed lending programs. US attorney Preet Bharara is leading the Financial Institutions Reform Enforcement and Recovery Act's application in the aftermath of the most recent financial crisis. His office is using the statute's authority to issue civil subpoenas in investigations, its civil penalty of up to $1 million per violation, and its 10-year statute of limitations. Earlier this year, Kaplan also refused to dismiss a Financial Institutions Reform Enforcement and Recovery Act case against BNY Mellon alleging fraud in its foreign currency charges.(4) Another case is pending against Wells Fargo alleging fraud in underwriting and quality monitoring of Department of Housing and Urban Development-insured loans.(5)
Dealing direct blows to several defence arguments, Rakoff held that:
- even though the primary impact of the alleged fraud was on Fannie Mae and Freddie Mac, which are not federally insured financial institutions, the Financial Institutions Reform Enforcement and Recovery Act can reach fraud affecting a federally insured financial institution that itself allegedly committed the fraud;
- federal mail and wire fraud statutes reach not only false factual statements, but also reach false promises, or breach of contract; and
- fraudulent intent was adequately pleaded against an executive defendant.
The court recited particular facts that led to its conclusions. Countrywide originated mortgage loans that Bank of America sold to Fannie Mae and Freddie Mac. Each loan sold was required to conform to guides, master contracts, and purchase contracts that set forth underwriting, documentation, quality control, and self-reporting requirements allegedly not met. The complaint alleged that when selling the loans, defendants represented they knew nothing about the mortgage, the property, the mortgagor or his/her credit standing that could cause a lender reasonably to regard the mortgage as an unacceptable investment, cause the mortgage to become delinquent, or adversely affect the mortgages' value or marketability. They further represented that all loan data was true and complete, underwriting conditions were met for loans processed through automated systems, and no fraud or material misrepresentation had been committed. The High Speed Swim Lane (HSSL) loan origination programme was designed to reduce processing from a high of 60 days to between 10 and 15 days by eliminating certain stages of review, which in turn affected loan quality. The programme added turn time bonuses to speed loan approval, removed loan quality as a criterion for compensation, and then offered bonuses for rebutting earlier findings that loans were defective. The one individual defendant is alleged to have moved sub-prime loans into the HSSL despite their higher risk. Internal reports showed material defect rates in one quarter were just under 40%, while the industry standard defect rate was between 4% and 5%.
The court focused on allegations about the impact this programme had on Fannie Mae, Freddie Mac, and the banks who invested in them. The Countrywide and Bank of America loans allegedly caused more than $1 billion in losses, which led to their insolvency. The consequent conservatorship eliminated all preferred shareholders in Fannie Mae and Freddie Mac, a group that included federally insured banks who had concentrated their investments in this preferred stock in the belief that these shares were safe. Many of those banks then failed, leading to an alleged loss of $2.3 billion to the Federal Deposit Insurance Corporation insurance fund.
Affecting federally insured financial institution – the self-affecting theory
The court accepted the government's theory that alleged wrongful conduct by the bank itself affected a federally insured financial institution (the self-affecting theory). Rakoff swept away "unconvincing" but "clever" legislative history and policy arguments in favour of a simple Webster's dictionary definition of 'affect' and the unambiguous language of the Financial Institutions Reform Enforcement and Recovery Act, which he said he could not ignore. The court said that the alleged fraud "had a huge effect" on Bank of America and its shareholders because the bank paid billions to settle repurchase claims made by Fannie and Freddie.(6)
Affecting federally insured financial institution – derivative theory
The court expressly did not decide whether derivative fraud – which does not directly or immediately affect a federally insured financial institution – supports a Financial Institutions Reform Enforcement and Recovery Act claim. It commented that the derivative theory is akin to classic proximate cause principles – that the defendants' actions prompted a substantial and foreseeable chain of events – when so many loans failed, this forced Fannie Mae and Freddie Mac into receivership, which in turn eliminated the preferred securities that were the core reserves of other federally insured banks. However, the judge noted with approval the defence argument that Congress may not have intended such an attenuated impact because it did not add to the state the "direct or indirect" terminology it "typically employs to reach derivative effects".(7)
Pleading predicate offences of mail and wire fraud
The court rejected the defence that the complaint failed to allege the elements of mail and wire fraud: specific statements, a speaker, a time and place where statements were made, and an explanation of why the statements were fraudulent.(8) The court also rejected a second defence argument that the allegedly fraudulent statements to Fannie Mae and Freddie Mac were breaches of contract, not separate evidence of fraud. Rakoff reached back to an 1896 case and a 1909 amendment to the mail fraud statute to instruct that Title 18 mail and wire fraud are not to be judged by the limitations on common law fraud. Even though, in New York, a false promise is not actionable under common law fraud in the same way that a false statement of fact is, this is not the rule under the federal mail and wire fraud statutes. The court cited his own 1980 law review article and said that the mail fraud statute is "untrammeled by such common law limitations".(9) He went on to find that even if New York common law of fraud applied to the federal statutes upon which the Financial Institutions Reform Enforcement and Recovery Act claims are predicated, the claims still survive as exceptions to the common law false promise rule. Citing two state court cases, claims based on false representations of the quality of mortgages made in connection with the sale of those loans are not impermissible as fraud because they were not "duplicative" breach of contract claims.
Financial Institutions Reform Enforcement and Recovery Act scienter
Rakoff rejected the individual lending executive defendant's argument that the complaint failed sufficiently to allege her intent to defraud under the act, citing allegations specific to that defendant, beyond conduct of other executives and beyond internal concealment of loan problems. This allowed the government's proof to proceed at trial, where the jury found her liable.
False Claims Act
The United States conceded that none of its allegations encompassed loans sold to Fannie Mae and Freddie Mac after the effective date of the Fraud Enforcement Recovery Act, which extended the government's reach in the civil False Claims Act. The court dismissed claims under that statute with prejudice, noting that extensive discovery occurred and no further justification exists for allowing a third complaint to be filed by the government.
Comment
The jury verdict for the government following Rakoff's opinion does not change the compliance or regulatory risks attendant to lending and secondary marketing of loans. However, these events underscore the importance of compliance procedures in loan underwriting review, due diligence, and loan quality and risk assessments. And they show that not only will regulators be watching, but so will the Department of Justice and whistleblowers who bring it cases. Where federally guaranteed lending programmes and now even private loans sold on the secondary market show significant losses, the government will use the Financial Institutions Reform Enforcement and Recovery Act's civil penalties to augment the civil False Claims Act theories it used in the past. Future cases with different facts will no doubt bring challenges that the Financial Institutions Reform Enforcement and Recovery Act's reach extended too far in the Southern District of New York.
For further information on this topic please contact Virginia A Gibson at Hogan Lovells US LLP by telephone (+1 267 675 4600), fax (+1 267 675 4601) or email ([email protected]). The Hogan Lovells US LLP website can be accessed at www.hoganlovells.com.
Endnotes
(1) The bank and its former executive await a decision by the court on the scope and amount of the penalty that can be imposed after the jury found them liable.
(2) US v Bank of America, 2013 WL 4437232 (entered August 19 2013, SDNY), at 6-7.
(4) US v Bank of New York Mellon, CV01:11-06969 (April 24 2013, SDNY).
(5) US v Wells Fargo, CV01:12-07527 (SDNY).
