On August 16, 2013, Judge Jed S. Rakoff of the Southern District of New York issued a ruling in in United States v. Countrywide Financial Corp., No. 12 Civ. 1422, that will likely be relevant to any financial institution facing suit or investigation by the government under the Financial Institutions Reform, Recovery and Enforcement Act (“FIRREA”) or the False Claims Act. Ruling on a motion to dismiss filed by Bank of America and Countrywide, Judge Rakoff declines to dismiss the government’s claims under FIRREA, addressing when a FIRREA defendant’s actions have “affected a federally insured financial institution,” and dismisses the government’s claims under the False Claims Act as insufficiently pled.
The case is one of numerous mortgage origination and servicing cases brought by the government in the wake of the financial crisis. It involves allegations by the government that Countrywide used a “High Speed Swim Lane” (“HSSL”) program to speed loan origination on prime loans—and later for loans categorized between prime and subprime—and sold the deficient loans to Fannie Mae and Freddie Mac. The HSSL program allegedly “reduced effective oversight,” removed “toll gates” that were set up to ensure loan quality, and ultimately led to a reported 57% material defect rate in Countrywide’s HSSL loans. (Slip Opinion at 5, 7.) As alleged, Countrywide ultimately sold some of the loans resulting from the HSSL program to Fannie Mae and Freddie Mac, representing that they were investment-quality loans despite both the “defects in the HSSL program” and the loan documentation containing “misrepresent[ations of] the borrowers’ income” and “obvious errors in the appraisal and occupancy status” of the property. (Id. at 9.)
Bank of America and Countrywide argued that the government’s FIRREA allegations did not state a claim because the sale of loans to Fannie Mae and Freddie Mac did not directly “affect a federally insured financial institution”— a statutory requirement for FIRREA claims premised on mail or wire fraud. 12 U.S.C. § 1833a(c)(2). As Fannie Mae and Freddie Mac are not “federally insured financial institutions” under the statute, the government presented two theories for how the alleged behavior affected a federally insured financial institution. First, in its “self-affecting theory,” the government argued that “since Bank of America N.A. is itself a federally insured financial institution, its wrongful conduct (and the conduct of Countrywide imputed to it) ‘affected’ a federally insured financial institution.” (Id. at 11.) Second, in its “derivative effect theory,” the government argued that the losses Fannie Mae and Freddie Mac suffered due to defaulted loans caused them to become insolvent, which ultimately wiped out the investments of Fannie Mae and Freddie Mac shareholders, some of which were federally insured banks.
Judge Rakoff’s opinion denies the motion to dismiss the FIRREA claims, holding that “self-affecting” conduct by a federally insured financial institution is sufficient to state a FIRREA cause of action. In making his ruling, Judge Rakoff is not convinced by the parties’ arguments based on the legislative history of FIRREA or policy considerations. (Id. at 11-12.) Rather, he finds that the self-affecting theory is supported by a “straightforward application of the plain words of the statute.” (Id. at 12.) His opinion states, “The fraud here in question had a huge effect on BofA itself,” and “BofA has paid billions of dollars to settle repurchase claims by Fannie Mae and Freddie Mac made [as] a result of the fraud here alleged.” (Id.) Note that this is not the first time the Southern District of New York has found FIRREA claims sufficient based on the conduct of an institution that affects only itself. See United States v. Bank of New York Mellon, No. 11-civ-6969, 2013 WL 1749418 (S.D.N.Y. Apr. 24, 2013) (Kaplan, J.) (finding the defendant’s alleged conduct “affect[ed] a federally insured financial institution” because it exposed the defendant to a realistic prospect of legal liability and caused it to incur actual losses in the form of attorney’s fees).
The decision declines to rule on the government’s “derivative effects theory,” a theory which could drastically expand the reach of FIRREA. In so declining, Judge Rakoff states potential arguments for and against adopting the theory. In support of the theory, he notes that the government alleged that the effect on the federally insured banks that invested in Fannie Mae and Freddie Mac was “both substantial and foreseeable, the classic components of proximate cause, let alone of mere ‘affect.’” (Slip Opinion at 14.) In opposition to the theory, Judge Rakoff notes that while it is an overstatement to argue that the theory would make FIRREA liability “limitless” or “contrary to case law,” the argument has some force, particularly in light of the fact that “Congress did not include the modifying language ‘directly or indirectly’ that it typically employs to reach derivative effects.” (Id. at 13.)
Turning to the government’s False Claims Act claims, Judge Rakoff dismisses the claims with prejudice, finding that the False Claims Act is not applicable to claims made to Fannie Mae or Freddie Mac prior to May 20, 2009—the date the Fraud Enforcement and Recovery Act of 2009 (“FERA”) amended the False Claims Act, expanding its definition of “claim” to include claims submitted directly to recipients of federal funds. See FERA, Pub. L. No. 111-21, § 4(a)(1)(a). Rakoff holds that, while claims made to Fannie Mae or Freddie Mac were not encompassed by the prior version of the statute, the FERA amendment “arguably extends the FCA to false claims made to Fannie Mae and Freddie Mac,” and is not effective retroactively in this respect. (Slip Opinion at 21.) Notably, the government appears to tacitly agree with this interpretation, limiting certain False Claims Act allegations in its complaint to “loans sold to GSEs in violation of GSE requirements after the effective date of FERA.” (Amended Complaint ¶ 207). As the court finds that the government had not sufficiently pled any False Claims Act claims after May 20, 2009, and the government had already taken “extensive discovery” and filed several amended complaints, Judge Rakoff dismisses its False Claims Act claims with prejudice. (Id. at 23.)
This decision indicates that while courts and the government continue to broadly interpret FIRREA liability, that liability may have its limits. Federally insured financial institutions should continue to be mindful of any statements that could be interpreted as false or activities that could be interpreted as a fraudulent scheme—even where the statements or activities affect only the institution itself—as they could open the institution to allegations of FIRREA violations. Further, the financial industry and companies that deal with the financial industry should be watchful for future rulings or guidance on the validity of the government’s expansive “derivative effect theory.”