Tag Archives: Southern District

FIRREA Blanks

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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.

Monday’s Adjudication Roundup

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FHFA Wins on “Actual Knowledge”

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Judge Cote issued an Opinion and Order in Federal Housing Finance Agency v. HSBC North America Holdings Inc., et al. (11-cv-06189 July 25, 2014). The opinion and order granted the FHFA’s motion for partial summary judgment concerning whether Fannie and Freddie knew of the falsity of various representations contained in offering documents for residential mortgage-backed securities (RMBS) issued by the remaining defendants in the case.

I found there to be three notable aspects of this lengthy opinion. First, it provides a detailed exposition of the process by which Fannie and Freddie purchased mortgages from the defendants (who included most of the major Wall Street firms, although many of them have settled out of the case by now). it goes into great length about how loans were underwritten and how originators and aggregators reviewed them as they were evaluated  as potential collateral for RMBS issuances.

Second, it goes into great detail about the discovery battle in a high, high-stakes dispute with very well funded parties. While not of primary interest to readers of this blog, it is amazing to see just how much of a slog discovery can be in a complex matter like this.

Finally, it demonstrates the importance of litigating with common sense in mind. Judge Cote was clearly put off by the inconsistent arguments of the defendants. She writes, with clear frustration,

It bears emphasis that at this late stage — long after the close of fact discovery and as the parties prepare their Pretrial Orders for three of these four cases — Defendants continue to argue both that their representations were true and that underwriting defects, inflated appraisals and borrower fraud were so endemic as to render their representations obviously false to the GSEs. Using the example just given, Goldman Sachs argues both that Fannie Mae knew that the percentage of loans with an LTV ratio below 80% was not 67%, but also that the true figure was, in fact, 67%. (65)