In the wake of the 2008 financial crisis, the financial services industry has faced an increased risk of exposure to civil liability premised on new theories of fraud pursued under two statutes: the False Claims Act (FCA), 31 U.S.C. § 3729 et seq., and the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), 12 U.S.C. § 1833a. Using these old tools in new ways, the U.S. Department of Justice (DOJ) has extracted historically high settlements of fraud-related claims over the past several years.
For those facing potential exposure to liability under the FCA and FIRREA, understanding these statutes—including recent developments in their application and interpretation—is essential. Perhaps the most significant event of the year so far has been the Supreme Court’s decision in Universal Health Services, Inc. v. United States ex rel. Escobar, 579 U.S. –, 136 S. Ct. 1989 (2016), in which the Court upheld the validity of the implied false certification theory of FCA liability, an oft-used but hotly-contested hook for liability that has been expanding the universe of FCA claims. At the same time, however, the Court clarified the theory in ways that may narrow its reach in future cases. This advisory examines how the FCA and FIRREA have been used to pursue new theories of fraud against the financial services industry and how Escobar and other developments in this area in recent years may affect the industry’s exposure to such claims going forward.
A. Overview of the FCA
The False Claims Act imposes civil liability on any person who "knowingly presents, or causes to be presented, a false or fraudulent claim for payment or approval." Under the statute, a "claim" is broadly defined as "any request or demand . . . for money or property" that is presented to the U.S. Government or to certain recipients of Government funds. FCA claims are brought in the name of the U.S. Government, either by DOJ or a private party (known as a "relator"). Notably, the FCA does not require proof that the defendant acted with a specific intent to defraud. Instead, it is sufficient that the defendant knew the claim was false or acted with "deliberate ignorance" or "reckless disregard" of its truth or falsity. The False Claims Act provides for both treble damages and civil penalties. As the result of recent legislation that took effect on August 1, 2016, the civil penalties under 31 U.S.C. § 3729(a)(1) now range between US$10,781 and US$21,563 per false or fraudulent claim, nearly double the amount that could be recovered previously.
For providers of financial services, the FCA has potential application whenever the services provided involve federal funds. The majority of FCA claims brought against financial institutions to date have involved the origination and servicing of loans insured by the U.S. Department of Housing and Urban Development (HUD) through its component, the Federal Housing Administration (FHA). In these cases, the Government and relators allege that the financial institutions certified to HUD-FHA that the loans were eligible for FHA insurance when in fact the loans did not meet certain HUD program rules and were therefore not eligible. This, in turn, allegedly caused HUD to insure defective loans and then incur losses when HUD paid claims on the loans after they defaulted. The institutions also allegedly failed to self-report to HUD certain loans that they had identified as deficient, as required by HUD program rules. Similar actions have been brought with respect to "reverse" mortgage loans insured by HUD’s Home Equity Conversion Mortgages (HECM) program, as well as loans insured or refinanced by the U.S. Department of Veterans Affairs through its Home Loan Guaranty Program. The FCA’s application, however, has not been limited to the housing market. For example, the statute has been successfully used against financial institutions for false statements and claims made to the ExportImport Bank of the United States (ExIm Bank) to obtain loan guarantees. It was also invoked in a case alleging that banks had falsely represented their financial health to the Federal Reserve in order to borrow money at favorable rates. (As discussed below, that case was later dismissed.) As these examples reflect, the FCA has potential application to a wide range of financial services involving federal funds.
This past June, the Supreme Court issued a landmark decision affecting the scope of FCA liability. The decision, Universal Health Services, Inc. v. United States ex rel. Escobar,addressed a recurring issue in FCA litigation: what constitutes a "false" or "fraudulent" claim. The FCA itself does not define those terms. Generally, courts have categorized claims as either factually false or legally false. A factually false claim involves "an incorrect description of goods or services provided" or "a request for reimbursement for goods or services never provided." In contrast, a "legally" false claim is a claim for reimbursement that includes a "false representation of compliance with a . . . statute or regulation or a prescribed contractual term." Claims premised on legal falsity have been pursued under two theories. Under the express false certification theory, a claim is false when it includes an express (and false) certification of compliance with a statutory, regulatory, or contractual requirement. In contrast, under the implied false certification theory, the mere act of submitting a claim for reimbursement may impliedly certify compliance with such requirements, and thus the failure to comply with those requirements renders the claim "false."
Given the broad range of statutory, regulatory, and contractual requirements that industries which submit claims to the federal Government are subject to, the implied certification theory has the continuing potential to dramatically expand the scope of FCA liability. For this reason, the theory had been the subject of repeated challenges, generating a split in the U.S. Courts of Appeals over its validity.
Further complicating matters, certain courts added even greater nuance to the theory’s application. For example, the U.S. Court of Appeals for the Second Circuit held that the implied certification theory was only applicable when the relevant statutory or regulatory requirement "expressly state[d] the provider must comply in order to be paid." The Second Circuit also drew a distinction between certifying compliance with "conditions of payment" (i.e., "prerequisites to receiving reimbursement"), which could support an FCA claim, and certifying compliance with "conditions of participation" (i.e., requirements to participate in the Government programs that provided reimbursement), which could not.
In Escobar, the Supreme Court upheld the validity of the implied certification theory and shed light on all of the above issues. Although the Court declined to go so far as to hold that "all claims for payment implicitly represent that the billing party is legally entitled to payment,"
it held that where "a defendant makes representations in submitting a claim but omits its violations of statutory, regulatory, or contractual requirements, those omissions can be a basis for liability if they render the defendant’s representations misleading with respect to the goods or services provided." Thus, "the implied false certification theory can, at least in some circumstances, provide a basis for liability."
In upholding the theory, however, the Court also provided clarification regarding its application. First, the Court rejected the position that failing to disclose a violation of a contractual, statutory, or regulatory requirement could only give rise to liability if the Government had expressly designated the requirement as a condition of payment.
On the other hand, the Government’s "decision to expressly identify a provision as a condition of payment is relevant, but not automatically dispositive." Instead, the Court held that the applicability of the implied certification theory turns on "whether the defendant knowingly violated a requirement that the defendant kn[ew] [was] material to the Government’s payment decision."
The Court emphasized the "demanding" nature of the implied certification theory’s materiality requirement.
Specifically, the Court explained that noncompliance must be more than "minor or insubstantial," and that it is not enough for the Government to show that it would have had "the option to decline to pay if it knew of the defendant’s noncompliance." The Government had taken the position in Escobar that the test for materiality is whether the defendant knew the Government "could lawfully withhold payment." In response to questioning at oral argument, the Government took this position to the extreme, arguing that a defendant who contracts with the Government to provide health services, while also agreeing to buy American-made staplers, violates the False Claims Act if it submits a claim for the health services "but fails to disclose its use of foreign staplers"—"irrespective of whether the Government routinely pays claims despite knowing that foreign staplers were used." "Likewise," the Court noted, "if the Government required contractors to aver their compliance with the entire U.S. Code and Code of Federal Regulations," then under the Government’s view "failing to mention noncompliance with any of those requirements would always be material." The Court emphatically rejected the Government’s position, stating that the False Claims Act "does not adopt such an extraordinarily expansive view of liability." As to what type of evidence would be probative of materiality, the Court explained that if the Government "regularly pays a particular type of claim in full despite actual knowledge that certain requirements were violated, and has signaled no change in position, that is strong evidence that the requirements are not material."
While the full impact of Escobar remains to be seen as the case law develops in the lower courts, the decision undoubtedly has significant implications for the financial services industry. As the Second Circuit recently noted—in a pre-Escobar decision in which the court found a bank’s certification of compliance (that it had not violated "any laws or regulations") too broad to support FCA liability—the "universe of potentially applicable laws or regulations is vast . . . . [B]anks are subject to thousands of laws and regulations[.]"
With the viability of the implied false certification theory no longer in question, the financial services industry is likely to face continued (and perhaps increased) exposure to FCA claims based on alleged noncompliance with statutory, regulatory, and contractual requirements. At the same time, the Supreme Court’s refusal to adopt a blanket rule regarding the applicability of the theory, as well as its emphasis on a "demanding" materiality requirement, may provide financial institutions with stronger defenses against such claims.
The Financial Institutions Reform, Recovery, and Enforcement Act
In addition to the FCA, the Government has in recent years pursued large-scale allegations of fraud against financial institutions using FIRREA, a statute passed in the wake of the savings and loan crisis of the 1980s that had largely gone unused since that era. FIRREA allows DOJ to bring civil actions and recover civil penalties for violations of certain delineated criminal statutes, without having to prove culpability beyond a reasonable doubt. Although the Government frequently asserts FIRREA and FCA claims in tandem, in some respects FIRREA has a broader reach than the FCA. Most importantly, FIRREA does not require that the United States have been a victim of the alleged misconduct; the Government need not show that a claim for payment was made to the United States. For several of the criminal predicates listed in FIRREA—including the broad and oft-invoked mail and wire fraud statutes—civil liability is only available where the alleged fraud is one "affecting a federally insured financial institution." In recent years, the Government has asserted FIRREA claims based on these predicates under a "self-affecting" theory of liability, arguing that "a federally insured financial institution may be held civilly liable under [FIRREA] for allegedly engaging in fraudulent conduct ‘affecting’ that same institution." While no federal appellate court has yet addressed this theory, three federal district courts in the Southern District of New York have upheld its validity. Thus, financial institutions may find themselves subject to liability under FIRREA for harm to themselves, where they are alleged to be the cause of such harm. As of August 1, 2016, FIRREA provides for civil penalties that generally do not exceed US$1,893,610. However, for continuing violations, the amount of the penalty could be as much as US$9,468,050. More importantly, where "any person derives pecuniary gain from the violation" or "the violation results in pecuniary loss to a person other than the violator," the penalty may exceed those limits and be imposed up to the amount of the gain or the loss.
Most FIRREA claims against the financial industry to date have involved alleged fraud related to the marketing, structuring, arrangement, underwriting, issuance, and sale of defective residential mortgage backed securities (RMBS) to federally-insured financial institutions. Given FIRREA’s broad reach and the severe impact of the financial crisis, the Government has been highly successful in resolving these claims, generally through global settlements of historic proportion. Also in the mortgage fraud context, the Government has alleged, in a FIRREA case that went to trial, that a financial institution sold poor-quality mortgages to government-sponsored entities in violation of the mail and wire fraud statutes. That case resulted in a jury verdict and substantial civil penalty. (The U.S. Court of Appeals for the Second Circuit reversed the judgment this year, finding that there was insufficient evidence of mail and wire fraud. The Government sought rehearing of the decision, but rehearing was denied.) As mentioned, the Government has also brought claims under FIRREA against financial institutions in connection with FHA-insured loans, in combination with claims under the FCA. While RMBS-related FIRREA claims are becoming less frequent, the financial services industry has likely not seen the end of Government enforcement under this statute. Last year, for example, federal and state governments settled a multi-year suit against a bank alleging that the bank had represented that it was providing "best rates" and "best execution" when pricing foreign exchange trades, while instead giving its clients the worst reported interbank rates of the trading day. Other examples include the Government’s "payment processing" cases, in which the Government alleged that financial institutions violated FIRREA by permitting third-party merchants through payment processors to illegally withdraw funds from their customers’ bank accounts. Given the broad reach of the statute and the Government’s aggressive use of it in recent years, one can assume that DOJ will continue to look for ways to take full advantage of its enforcement powers in the days ahead. The Government’s pursuit of fraud-related claims under the FCA and FIRREA has had a significant impact on the financial services industry. The Supreme Court’s Escobar decision may fuel a continuing surge of FCA claims, now that the validity of the implied false certification theory has been established. Whether those claims will, in fact, be reined in by the Supreme Court’s articulation of a demanding materiality standard remains to be seen. In addition, although FIRREA claims against many major industry members related to RMBS have been resolved, FIRREA remains a powerful tool applicable to a wide range of allegedly fraudulent conduct. Understanding the FCA, FIRREA, and recent developments in their interpretation and application therefore remains essential to members of the financial services industry, who may find themselves caught in the cross-hairs of these statutes in the future.