Bank of America Wins Reversal of FIRREA $1.27B Penalty

by Manatt, Phelps & Phillips, LLP

A breach of contract is insufficient to also support a claim for fraud, the Second Circuit Court of Appeals has ruled, reversing a $1.2 billion verdict against Countrywide Home Loans in the process.

What happened

The U.S. Court of Appeals for the Second Circuit handed Bank of America a victory on May 23, reversing a $1.27 billion penalty imposed on the bank. A jury in the case below imposed that penalty for alleged mortgage fraud arising out of events that took place at Countrywide Financial before it was acquired by the bank. In reversing, the Second Circuit concludes that breach of contract cannot support fraud without a demonstrable intent to defraud at the time of contract formation.

Filed in early 2012, the suit alleged mail and wire fraud based on violations of the federal Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). In 2007, Countrywide sold loans to Fannie Mae and Freddie Mac through Countrywide's so-called "High-Speed Swim Lane" (HSSL) loan program, which allegedly expedited the processing of mortgages but with inadequate risk checks. Pursuant to its contracts with Fannie Mae, Countrywide as the seller of mortgages represented that, "as of the date [of] transfer," the mortgages sold would be an "Acceptable Investment." Likewise, Countrywide similarly represented to Freddie Mac that "all Mortgages sold to Freddie Mac have the characteristics of an investment quality mortgage." These loans, the government claimed, were then sold to Fannie Mae and Freddie Mac, where many then defaulted. Even though HSSL was short-lived, and all of the alleged wrongdoing took place before Bank of America acquired Countrywide, a jury concluded that the bank itself committed fraud.

In reversing the ruling, the Second Circuit answered a core question at issue in many fraud suits, i.e., when may a breach of contract claim also support a claim for fraud? In asserting claims for mail and wire fraud, the government (originally through a qui tam relator, or "whistleblower") argued that Countrywide knew that its sales of poor-quality mortgages to government-sponsored entities (GSEs) were not of the quality promised in their contracts with Fannie and Freddie. The Second Circuit concluded that this is, at most, intentional breach of contract, and not fraud.

The government argued that Countrywide sold loans under these purchase agreements, intending to defraud Fannie and Freddie because it thereafter sold loans to these entities knowing the loans were not investment quality. To support this argument, the government offered evidence of quality problems in the loans approved through the HSSL program. To demonstrate the requisite intent, the government presented evidence that the Key Individuals were informed of the poor quality of HSSL loans by Countrywide employees and internal quality control reports and nonetheless sold them to the GSEs. The government presented no evidence that any of the Key Individuals were involved in the negotiation or execution of these contracts, nor did it present evidence that any of them communicated with either GSE regarding the loans sold; in fact, Defendants elicited testimony from GSE witnesses to the contrary.

The provision of FIRREA under which Defendants were found liable provides for civil penalties against "[w]hoever" violates or conspires to violate, inter alia, the federal mail or wire fraud statutes, see 18 U.S.C. §§ 1341, 1343, in a manner "affecting a federally insured financial institution." 12 U.S.C. § 1833a(a), (c)(2). While this is the first appellate case to consider whether FIRREA even applies to self-affecting conduct, the Second Circuit never reaches this issue. Instead, the court decided the issue on a much simpler point: a defendant cannot commit fraud in a breach of contract case unless the plaintiff proves an intent to defraud at the time of contract formation.

Bank of America argued, as it did below, that the conduct alleged and proven by the government is, at most, a series of intentional breaches of contract. The common law, it argued, does not recognize such conduct as fraud, and as a result, the federal statutes do not either. Because the only representations involved in this case are contained within contracts—to demonstrate fraud, rather than simple breach of contract, under the common law and federal statutes, the government had to prove (and it did not) that Countrywide never intended to perform those contracts at the time of contract execution. By contrast, the government argued that any contractual relationship between the defendant and an alleged fraud victim is "irrelevant," citing as examples decisions in which this court and others recognized a fraud claim where the parties were engaged in a contractual relationship.

The federal mail and wire fraud statutes, in relevant part, impose criminal penalties on "[w]hoever, having devised or intending to devise any scheme or artifice to defraud, or for obtaining money or property by means of false or fraudulent pretenses, representations, or promises[,]" uses the mail, 18 U.S.C. § 1341, or wires, id. § 1343, for such purposes. Thus, the essential elements of these federal fraud crimes are " '(1) a scheme to defraud, (2) money or property as the object of the scheme, and (3) use of the mails or wires to further the scheme.' " The court then noted that statutes employing common-law terms are presumed, "unless the statute otherwise dictates, . . . to incorporate the established meaning of these terms." Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 322 (1992). These statutes require proof—as at common law—that the misrepresentations were material, notwithstanding the fact that a solely "natural reading of the full text" would omit such an element.

The first element—a scheme to defraud—is noticeably absent in a breach of contract case unless that scheme existed at the time the contract was made. As the court put it, "a contractual relationship between the parties does not wholly remove a party's conduct from the scope of fraud. What fraud in these instances turns on, however, is when the representations were made and the intent of the promisor at that time. As explained below, where allegedly fraudulent misrepresentations are promises made in a contract, a party claiming fraud must prove fraudulent intent at the time of contract execution; evidence of a subsequent, willful breach cannot sustain the claim." … "It is emphatically the case—and has been for more than a century—that a representation is fraudulent only if made with the contemporaneous intent to defraud—i.e., the statement was knowingly or recklessly false and made with the intent to induce harmful reliance." In short, because the government failed to prove an intent to defraud at contract formation, there was no violation of the mail and wire fraud statutes.

To read the opinion in United States ex rel. Edward O'Donnell v. Countrywide Home Loans, Inc., click here.

Why it matters

Until this case, there was little or no useful case law to battle plaintiffs who allege fraud arising out of mere intentional breach of contract. This case provides defendants with the necessary ammunition to attack fraud allegations where there is zero evidence that the defendant intended at the time of contracting to defraud the other contracting party.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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