On Monday, the Second Circuit Court of Appeals delivered a blow to the Justice Department’s increasing use of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, 12 U.S.C. § 1833a (“FIRREA”), a statute that imposes civil liability—in the form of potentially hefty civil monetary penalties— for certain criminal offenses that affect financial institutions. After the Justice Department secured jury trial verdicts against Countrywide, Bank of America as Countrywide’s successor, and a former Countrywide executive, and after U.S. District Court Judge Jed Rakoff broadly interpreted FIRREA’s civil penalty provision to justify a massive $1.27 billion penalty, the Second Circuit gutted those results, remanded the case, and ordered Judge Rakoff to enter final judgment for the defendants. See United States ex rel. O’Donnell v. Countrywide Home Loans, Inc., No. 15-496, 2016 U.S. App. LEXIS 9365 (2d Cir. May 23, 2016).
In coming to that conclusion, instead of grappling with several difficult and novel legal questions regarding FIRREA’s liability and penalty provisions, the Second Circuit simply determined that the Justice Department failed to establish that the supposedly fraudulent conduct was anything more than an intentional contract breach. This result—coming in an extremely high-profile “Financial Crisis” case involving allegedly “bad” residential mortgages sold to two Government Sponsored Enterprises (“GSEs”), Fannie Mae and Freddie Mac—should force the Justice Department to reconsider its reliance on FIRREA as a civil enforcement tool against financial institutions.
Background of the O’Donnell Case
In a nutshell, the Justice Department’s theory of liability was as follows: (1) Countrywide entered into contracts with the GSEs requiring Countrywide to sell them only investment quality mortgage loans; (2) later, and without notifying the GSEs, Countrywide implemented a mortgage loan origination program—referred to as the High Speed Swim Lane or “HSSL” program—which compromised mortgage loan quality; (3) Countrywide delivered less than investment quality mortgages to the GSEs under the contracts, knowing that the mortgage loans did not satisfy the contract standard; and (4) GSEs suffered losses when they purchased the HSSL program loans.
Although the case essentially began as a False Claims Act (“FCA”) qui tam suit, the FCA claims were dismissed and the Justice Department proceeded to trial alleging only FIRREA violations, claiming mail and wire fraud as the predicate offenses for FIRREA liability. We first described the basic elements of FIRREA in FraudMail Alert No. 13-02-11, Justice Department Brandishes Rarely Used Weapon— FIRREA—in Full-Scale Assault on S&P, and California Joins the Battle with Separate State False Claims Act Complaint (Feb. 11, 2013), and then we further explored the statute in an article, FIRREA Enforcement Trends, in The Review of Banking & Financial Services (Dec. 2015).
Following a multi-week trial, the jury found the defendants liable and, in post-trial proceedings, Judge Rakoff imposed a $1.27 billion FIRREA penalty against the bank and a $1 million FIRREA penalty against the Countrywide executive.
The Second Circuit’s Decision
Bypassing the FIRREA legal questions that raised the most outside interest—including the issues of whether a bank could be liable for conduct that affected the bank itself (the Justice Department’s controversial “self-affecting” theory) and how to calculate “pecuniary gain or loss” for penalty purposes— the Second Circuit reversed on much more basic and fundamental grounds having nothing in particular to do with FIRREA. The court held that the Justice Department had failed to adduce trial evidence sufficient to establish the fraud necessary to support the predicate offenses of mail and wire fraud. In fact, the court found that the trial evidence, at best, established nothing more than an intentional contract breach— i.e., a knowing post-contract execution failure to deliver mortgage loans meeting the quality standards specified in the contract. Under these circumstances, and relying on basic, common law principles, the Second Circuit reaffirmed that:
[A] contractual promise can only support a claim for fraud upon proof of fraudulent intent not to perform the promise at the time of contract execution. Absent such proof, a subsequent breach of that promise—even where willful and intentional—cannot in itself transform the promise into a fraud.
O’Donnell, 2016 U.S. App. LEXIS 9365, at *29. In other words, in order to meet its evidentiary burden, the Justice Department had to prove that Countrywide never intended to deliver investment quality mortgage loans at the time it originally executed the contracts with the GSEs. Not only was there a complete failure to deliver such evidence, but the Second Circuit specifically noted that the Justice Department did not even attempt to establish any such facts. The court also rejected the Justice Department’s contention that the contractual misrepresentations were somehow made “continuously” at each point of sale, finding instead that the plain language of the contract representations did not permit this interpretation. At bottom, the Second Circuit criticized the Justice Department’s theory as one that would contravene a “fundamental common-law requirement” of fraud, “convert every intentional or willful breach of contract in which the mails or wires were used into criminal fraud,” and cause a “dramatic expansion of fraud liability.”1 Id. at *25, 28.
While the Second Circuit’s decision is a welcome stopgap to the Justice Department’s attempts to stretch the contours of FIRREA and FCA liability beyond their statutory limits, the decision leaves key FIRREA questions unanswered. In particular, the Second Circuit avoided being the first federal appeals court to confront the issue of whether a FIRREA cause of action is viable where the only financial institution allegedly “affected” by the fraud is the defendant financial institution itself. The so-called “self-affecting” theory of FIRREA liability thus remains a potential threat to the financial institutions FIRREA originally was designed to protect.
In addition, the Second Circuit did not reach the question of whether a civil penalty under FIRREA should be calculated on a “net” basis—i.e., one that accurately reflects the supposed loss to the victim or gain to the perpetrator—or on a “gross” basis, as Judge Rakoff applied, which distorts and inflates the actual loss or gain. See FraudMail Alert No. 14-08-04, Court’s $1.3 Billion Judgment against Bank of America Signals FIRREA’s Potential Role as a Powerful Substitute for the False Claims Act in Financial Fraud Cases (Aug. 4, 2014).