by Michael Rowe, Thomas Swigert | Dorsey & Whitney LLP June 1, 2016
When does a breach of contract amount to fraud? Last week the Second Circuit answered this question and reversed a $1.27 billion judgment against Bank of America and a $1 million judgment against a former executive for their alleged violations of the Financial Institutions Reform, Recovery, and Enforcement Act (“FIRREA”). United States ex rel. O’Donnell v. Countrywide Home Loans, Inc., et al., Nos. 15-496 & 15-499 (2d Cir. May 23, 2016). In the wake of the 2008 financial crisis, the Department of Justice has increasingly used the civil provisions in FIRREA as a tool to penalize those whom the government believes have defrauded financial institutions. Specifically, § 951 imposes civil penalties for violations of the federal mail- and wire-fraud statutes that “affect a federally insured financial institution.” 12 U.S.C. § 1833a(c)(2). In O’Donnell, the Court found that a knowing and even an intentional breach of a contract does not equal fraud absent a contemporaneous statement made with the intent to commit fraud. Thus, even though the jury found that Countrywide Home Loans (later purchased by Bank of America) intentionally sold bad loans under its contract, Countrywide was not liable for fraud under FIRREA. This ruling makes the government’s ability to penalize what it perceives to be financial wrongdoing more difficult going forward.
At trial, the government alleged that Countrywide knowingly failed to deliver loans to Fannie Mae and Freddie Mac in conformance with its contract. Among other things, the contract required Countrywide to make representations regarding the quality of the loans “as of” the date the loans were sold to Fannie and Freddie. At final argument, the government contended that (i) the sold loans were bad; (ii) Countrywide knew the loans were bad; and (iii) Countrywide misrepresented the quality of the loans to defraud Fannie and Freddie. The jury agreed, and the district court (Judge Rakoff) imposed a $1.27 billion fine against Bank of America.
The Second Circuit reversed, and found that the government “failed to prove the necessary FIRREA prerequisite—i.e., a violation of (or conspiracy to violate) § 1341 or § 1343,” the mail- and wire-fraud statutes. O’Donnell, Nos. 15-496 & 15-499, at 9. Before the court reached the sufficiency of the government’s evidence, it framed the central legal dispute as whether a breach of contract can ever constitute a fraud—the predicate for FIRREA civil penalties. In answering that question, the court turned to longstanding common-law principles to establish the meaning of the federal fraud statutes. Id. at 12. The court then found that “the common law does not permit a fraud claim based solely on contractual breach; [and] at the same time, a contractual relationship between the parties does not wholly remove a party’s conduct from the scope of fraud.” Id. at 14. Instead, common-law fraud depends on “when the representations were made and the intent of the promisor at that time.” Id. In other words, a statement becomes fraudulent “only if made with the contemporaneous intent to defraud.” Id.
Turning to the government’s evidence, the court found that it was insufficient as a matter of law to prove fraud. That is, “[t]he government did not prove—in fact, did not attempt to prove—that at the time the contracts were executed Countrywide never intended to perform its promise of investment quality.” Id. at 23. The government also failed to prove or offer evidence that any post-contract representations were made with fraudulent intent to induce Fannie and Freddie into buying its mortgages. Id. at 25. At best, the government’s evidence established an intentional breach of contract; falling well short of fraud.
The court was careful to note it reviewed the government’s evidence only in relation to the charged theory. And here, the jury was instructed “only as to a theory of fraud through an affirmative misstatement, i.e., a statement that was either ‘an outright lie’ or partially true but ‘omitted information necessary to correct a false impression.’” Id. at 23. Importantly, the court did not address whether “silence without any affirmative statement while under a duty to disclose material information, can constitute fraud under the federal statutes.” Id. at 24.
The immediate effect of O’Donnell is that the Justice Department must now re-think its increasing reliance on FIRREA as an enforcement mechanism for claims involving contracts with financial institutions. It will surely be more difficult for the government to prove that a party executed the initial contract with fraudulent intent. And to the extent the government continues to bring FIRREA cases in the context of a contract, O’Donnell leaves open several important questions. First, the court declined to consider the viability of the government’s “self-affecting” theory of liability—that is, whether liability can be imposed when the only institution “affected” by the wrongdoing is the alleged bad actor. The court also declined to consider how a court should calculate pecuniary gain or loss to impose civil penalties under 12 U.S.C. 1833a(b)(3).