Introduction

Federal judges in the U.S. District Court, Southern District of New York are making the Financial Institutions Reform Enforcement and Recovery Act of 1989 (FIRREA)1 required re-reading for banking attorneys. In an opinion released this week, Judge Rakoff joined his colleague, Judge Lewis Kaplan, in endorsing the claims the United States Department of Justice (DOJ) is pursuing with provisions of the 1989 reform law in the aftermath of the late 2007 and 2008 meltdown in the housing and secondary mortgage market and other financial markets.

In this case, the court denied motions to dismiss FIRREA claims against Bank of America and Countrywide and adopted the novel principle Judge Kaplan accepted in April that FIRREA’s required proof of fraud “affecting a federally insured financial institution” can be met even when the alleged perpetrator of the fraud was the same financial institution that was affected by the fraud.2 Judge Rakoff also confirmed 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 The loan underwriting, oversight, and quality review risk equations have thus tilted further in the government’s favor.

Background

DOJ is using the federal courts in the Southern District of New York as a testing ground for its rarely seen application of FIRREA’s civil enforcement tools. Congress created this civil penalty after the 1980s savings and loan debacle to supplement criminal bank fraud tools. It augments the civil False Claims Act (FCA) where there is no federal insurance or loan guarantee, as required for a government claim under that statute. U.S. Attorney Preet Bharara is leading FIRREA’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 US$1 million per violation, and its 10-year statute of limitations. Earlier this year, Judge Lewis Kaplan also refused to dismiss a FIRREA 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 HUD-insured loans.5

The Opinion

Dealing direct blows to several defense arguments, the Judge Rakoff held that: (1) even though the primary impact of the alleged fraud was on Fannie Mae and Freddie Mac, which are not federally insured financial institutions, FIRREA can reach fraud affecting a federally insured financial institution that itself allegedly committed the fraud; (2) federal mail and wire fraud statutes reach not only false factual statements, but also reach false promises, or breach of contract; (3) 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 program was designed to reduce processing from a high of 60 days to 10-15 days by eliminating certain stages of review, which in turn affected loan quality. The program 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 4-5%.

The court took time to summarize allegations about the impact this program had on Fannie Mae, Freddie Mac, and the banks who invested in them. The Countrywide and Bank of America loans allegedly caused more than a billion dollars 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 on the perception that these shares were safe. Many of those banks then failed, leading to an alleged loss of US$2.3 billion to the FDIC insurance fund.

  1. Affecting a federally insured financial institution — “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). Judge Rakoff swept away “unconvincing,” but “clever” legislative history and policy arguments to turn to a simple Webster’s dictionary definition of “affect” and the unambiguous language of FIRREA which he said he could not ignore. The court said 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

  1. Affecting a federally insured financial institution — “Derivative theory”

The court expressly did not decide whether derivative fraud — that did not directly or immediately affect a federally insured financial institution — supports a FIRREA 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. But the judge noted with approval the defense 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

  1. Pleading predicate offenses of mail and wire fraud

The court rejected the defense 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 defense argument that the allegedly fraudulent statements to Fannie Mae and Freddie Mac were breaches of contract, not separate evidence of fraud. Judge 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 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 FIRREA 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.

  1. FIRREA scienter

Judge Rakoff rejected individual defendant’s argument that the complaint failed sufficiently to allege her intent to defraud under FIRREA, citing allegations specific to that defendant, beyond conduct of other executives and beyond internal concealment of loan problems.

  1. 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.

Conclusion

Judge Rakoff’s opinion does not change the compliance or regulatory risks attendant to lending and secondary marketing of loans. It underscores their importance in loan underwriting review, due diligence, and loan quality and risk assessments. But it squarely supports the government’s efforts to use civil penalties where even a bank’s own financial losses provide an element of the cause of action against it. It will remain for future challengers of this statute to bring arguments under different facts that this reach extends too far.