photo by Mike Cumpston

The Court of Appeals for the Second Circuit reversed the District Court’s judgment (SDNY, Rakoff, J.) against Bank of America defendants for actions arising from Countrywide’s infamous “Hustle” mortgage origination program. The case has a lot of interesting aspects to it, not the least of which is that it does away with more than one billion dollar in civil penalties levied against the defendants.

The opinion itself answers the narrow question, when “can a breach of contract also support a claim for fraud?” (2) The Court concluded that “the trial evidence fails to demonstrate the contemporaneous fraudulent intent necessary to prove a scheme to defraud through contractual promises.” (3)

I think the most important aspect of the opinion is how it limits the reach of the Financial Institutions Reform, Recover, and Enforcement Act of 1989 (FIRREA). Courts have have been reading FIRREA very broadly to give the federal government immense power to go after financial institutions accused of wrongdoing.

FIRREA provides for civil penalties for violations of federal mail or wire fraud statutes, but the Court found that there was no fraud at all. It made its point with a hypothetical:

Imagine that two parties—A and B—execute a contract, in which A agrees to provide widgets periodically to B during the five-year term of the agreement. A represents that each delivery of widgets, “as of” the date of delivery, complies with a set of standards identified as “widget specifications” in the contract. At the time of contracting, A intends to fulfill the bargain and provide conforming widgets. Later, after several successful and conforming deliveries to B, A’s production process experiences difficulties, and the quality of A’s widgets falls below the specified standards. Despite knowing the widgets are subpar, A decides to ship these nonconforming widgets to B without saying anything about their quality. When these widgets begin to break down, B complains, alleging that A has not only breached its agreement but also has committed a fraud. B’s fraud theory is that A knowingly and intentionally provided substandard widgets in violation of the contractual promise—a promise A made at the time of contract execution about the quality of widgets at the time of future delivery. Is A’s willful but silent noncompliance a fraud—a knowingly false statement, made with intent to defraud—or is it simply an intentional breach of contract? (10)

This case emphasizes that “a representation is fraudulent only if made with the contemporaneous intent to defraud . . .” (14) While this is not really new law, it is a clear statement as to the limits of FIRREA. This will act as a limit on how the government can deploy this powerful tool as new cases crop up. Unless, of course, the Supreme Court were to reverse it on appeal.

FIRREA Factors for Determining Civil Penalties

Andrew Schilling, Ross Morrison and Michelle Rogers wrote a short article (here, behind a paywall) about a recent case, U.S. v Menendez, No. C.V. 11-06313 (C.D. Cal. Mar. 6., 2013) that sets forth the eight factors that are to govern the determination of civil penalties under FIRREA.  Menendez had defrauded HUD by lying on a form submitted to HUD as to the existence of any “hidden terms or special understandings” relating to the underlying short sale transaction. (3) The court stated that the relevant factors are

  1. the good or bad faith of the defendant and the degree of his or her scienter;
  2. the injury to the public and loss or risk of loss for other persons;
  3. the egregiousness of the violation;
  4. the isolated or repeated nature of the violation;
  5. the defendant’s financial condition and ability to pay;
  6. the criminal fine that could be levied for the conduct;
  7. the amount the defendant sought to profit through the fraud; and
  8. the penalty range available under FIRREA. (10-13)

The case is important because it provides guidance, which has been lacking, to courts as they apply this untested statute to civil fraud cases.  And given that this case arose in the same jurisdiction in which the DoJ sued S&P, alleging violations of FIRREA, this guidance may be particularly useful.  On the other hand, the facts of this case (dealing with one instance of fraud by one individual) are quite different from those that in the other cases that the government has brought pursuant to FIRREA, which typically involve allegations of fraud by large financial institutions.

As a side note, it is interesting that the federal government took full advantage of FIRREA’s ten year statute of limitations as it filed this suit in 2011 for actions that occurred in 2002.