The federal government has been heavily criticized for not pursuing legal claims against financial institutions and their senior executives in connection with the financial crisis. Attempting to blunt that criticism, in November 2009, the administration established the Financial Fraud Enforcement Task Force to “hold accountable those who helped bring about the last financial crisis as well as those who would attempt to take advantage of the efforts at economic recovery.” The task force, headed by Attorney General Eric Holder, is a coalition of more than 20 federal agencies, 94 U.S. Attorney’s Offices, and state and local partners. Within the task force is the Residential Mortgage Backed Securities (RMBS) Working Group, formed in January 2012 to investigate misconduct related to the origination and securitization of mortgage loans.
The working group has initiated only a handful of actions against financial institutions—United States v. Wells Fargo Bank, N.A., No. 12 Civ. 7527 (S.D.N.Y. filed Oct. 8, 2012); New York v. J.P. Morgan Sec. LLC, Index No. 451556/2012 (N.Y. Sup. Ct. filed Oct. 1, 2012); United States ex rel. O’Donnell v. Countrywide Financial Corp., No. No. 12 Civ. 1422 (S.D.N.Y. filed Sept. 6, 2013) (second amended complaint)—and the prospect of additional actions appears to be dwindling as statutes of limitations run out on securities claims and common-law analogues. But three recent court decisions involving the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), which has a 10-year statute of limitations, potentially breathe new life into the working group’s efforts by adopting a novel application of FIRREA. In this article, we review how prosecutors have employed FIRREA in those cases and the implications for financial institutions as they attempt to manage their financial crisis litigation risk.
Strengthening the Government’s Ability to Protect Federally Insured Financial Institutions
Poor management and fraud—including “poor underwriting and loan administration standards”—caused hundreds of thrift institutions to fail in the 1980s. H.R. Rep. No. 101-54 (1989), 1989 U.S.C.C.A.N. 86, 95. Regulators found poor loan documentation and inadequate credit analysis at 92 percent of failed thrifts, and 88 percent of failed thrifts violated federal regulations requiring thrifts to obtain appraisals for loans secured by real estate. In response, Congress enacted FIRREA to strengthen the civil sanctions and criminal penalties for defrauding or otherwise damaging depository institutions and their depositors. Among its features, FIRREA permits the Attorney General to bring civil actions seeking penalties for violations or conspiracies to violate certain predicate crimes, such as mail and wire fraud. Pub. L. No. 101-73, 103 Stat. 183 (1989). Those crimes are set forth in section 1833a(c) of title 12 of the U.S. Code:
(c) Violations to which penalty is applicable
This section applies to a violation of, or a conspiracy to violate—
(1) section 215, 656, 657, 1005, 1006, 1007, 1014, or 1344 of title 18;
(2) section 287, 1001, 1032, 1341, or 1343 of title 18 affecting a federally insured financial institution; or
(3) section 645(a) of title 15.
The Government Targets Big Banks with an Expanded Theory of FIRREA Liability
The RMBS Working Group, acting through the United States Attorney for the Southern District of New York, has brought civil FIRREA claims against two financial institutions in the wake of the most recent financial crisis. United States ex rel. O’Donnell v. Countrywide Fin. Corp., No. 12-cv-1422 (S.D.N.Y.); United States v. Wells Fargo Bank, N.A., No. 12 Civ. 7527 (S.D.N.Y.). The government alleges that the banks violated Section 1833a, which, as noted, permits civil penalties for mail and wire fraud “affecting a federally insured financial institution.” According to the government, Countrywide engaged in a scheme to defraud Fannie Mae and Freddie Mac by falsely representing that loans originated under a Countrywide program and sold to Fannie Mae and Freddie Mac complied with their loan purchasing guidelines. And Wells Fargo allegedly originated loans that the bank falsely represented qualified for government-sponsored insurance under a program administered by the Housing and Urban Development Department’s Federal Housing Administration (FHA).
However, the government faced a dilemma in attempting to pursue claims under section 1833a because Fannie, Freddie, and the FHA are not federally insured financial institutions that can be “affect[ed]” by violations of the predicate crimes, as is required to establish liability under that section. Attempting to resolve that dilemma, the government advanced a novel interpretation of section 1833a. Specifically, the government argued that the banks’ alleged misconduct affected the banks themselves. This “self-affecting” theory—coupled with FIRREA’s 10-year statute of limitations and civil standard of proof—threatens to expand financial institution liability arising from the financial crisis.
The “self-affecting” theory. The court in Countrywide and Wells Fargo accepted the government’s self-affecting theory under section 1833a. Wells Fargo,No. 12 Civ. 7527, 2013 WL 5312564, at *28–29 (S.D.N.Y. Sept. 24, 2013); Countrywide, No. 12 Civ. 1422, 2013 WL 4437232, at *5–6 (S.D.N.Y. Aug. 16, 2013). The decision in another recent FIRREA action—unrelated to mortgage origination—analyzes the theory at length. United States v. Bank of N.Y. Mellon, No. 11 Civ. 6969, 2013 WL 1749418 (S.D.N.Y. Apr. 24, 2013).
In Bank of New York (BNY), the government alleged, inter alia, that the bank and one of its managing directors engaged in a scheme to defraud certain customers by representing that the bank provided “best execution” for the customers’ foreign exchange trades when, in fact, those trades were executed in a manner that enriched the bank at the customers’ expense. In alleging violations of section 1833a, the government claimed that BNY itself was the federally insured financial institution affected by BNY’s own misconduct. The government alleged that when customers learned about the practice, they sued BNY for potentially billions of dollars in liability and either withdrew their business from BNY or shifted it to less profitable exchange programs.
The bank and the managing director moved to dismiss. They argued that FIRREA’s plain language, structure, and legislative history did not support the government’s self-affecting theory. But the court rejected each argument.
As to the statute’s plain language, defendants argued that “affecting” means
(i) “victimizing,” such that the fraud must be directed at the federally insured financial institution, or (ii) “indirectly harming” the federally insured financial institution, “but only insofar as the alleged harm is caused solely by persons other than the” financial institution. The court rejected both interpretations. Citing Webster’s, it held that “to affect” means “‘to act upon’ as in ‘to produce an effect . . . upon,’ ‘to produce a material influence upon or alteration in,’ or possibly ‘to have a detrimental influence on’”—all of which are broader than “victimizing.” The court also noted that other courts reached a similar conclusion about the breadth of “affecting,” as used in a different FIRREA provision. Id. at *7 (citing United States v. Bouyea,152 F.3d 192 (2d Cir. 1998)). As for liability attaching only when the financial institution is harmed by someone else, the court held that “it would be absurd” if a bank could escape liability when the bank itself participates in a predicate crime.
Turning to the statute’s structure, the defendants argued that the predicate crimes identified in section 1833a(c)(1) and (3) inherently involve financial institutions, and “affecting a federally insured financial institution” was added to 1833a(c)(2) “to ensure that the statute required victimization of [those institutions] in all cases in which the statute created liability.” But the court held that section 1833a(c)(1)’s and (3)’s predicate crimes did not inherently involve federally insured financial institutions, thus undercutting the defendants’ argument. In addition, that those crimes did not inherently involve financial institutions suggested to the court that “Congress . . . was not necessarily concerned only with harm to financial institutions—let alone only their victimization—as it was with the presence of criminal activity in matters meaningfully involving financial institutions, however that activity might affect them.”
The court also held that it could not square the defendants’ interpretation—“affecting” means “victimization of the financial institution”—with certain of the section 1833a(c)(2) predicate crimes. The court noted, for example, that 18 U.S.C. § 287 proscribes the making of false claims against the federal government—a crime in which U.S. taxpayers, not financial institutions, are the victims.
Turning to legislative history, the defendants argued that Congress was concerned “exclusively with shield[ing] institutions from fraud committed at their expense.” Using this history, the court reasoned that Congress was also concerned with fraud committed by financial institution insiders. The court further found that that concern was not limited to insiders’ victimization of their institutions for personal gain; rather, “some of the fraud at issue was . . . due to thrift officers seeking to . . . save [the thrift] without any intent to achieve personal gain.” The court also held that Congress believed the thrifts’ depositors and federal taxpayers were the victims of the savings and loan crisis. Viewed through that lens, FIRREA was enacted to “[e]nsur[e] that taxpayers would not need to bail the industry out again in order to protect the funds of depositors”—a goal achieved not only through “seeking to prevent fraud perpetrated against the financial institutions, but also through deterring or punishing fraud which occurs as a result of insiders’ misguided efforts to benefit their institutions.” In short, the court concluded that the legislative history, along with the plain language and structure of the statute, supported the self-affecting theory.
Was the bank affected? Having accepted the self-affecting theory of FIRREA liability, the BNY court addressed whether the government adequately alleged that the fraud, in fact, affected the bank. The court considered three issues—whether “affecting” encompassed positive, as well as negative, effects; whether a scheme’s profits may negate the scheme’s negative effects; and whether the effects must be direct, and not merely indirect. As to the first issue, the court held that the government adequately alleged the fraud’s negative effects on the bank; therefore, it did not decide whether positive effects alone would suffice. The alleged negative effects included legal fees incurred as a result of, and potential liability arising from, the fraud, as well as lost business and a shift to a less profitable foreign exchange business model. The court also held that it “might not be sufficient to allege only that an institution no longer is receiving the allegedly fraudulent profits” from the scheme. But the government had alleged “more than that here. In particular, one may infer that the [bank], going forward, would have been able to make larger profits [with its former foreign exchange business model] had the alleged fraud never occurred than it will now make with respect to clients under [the new business model].”
As to the second issue, the court held that a scheme’s profits should not be permitted to offset its negative effects because “offsetting the [scheme’s] losses and risks with [its] profits would perversely incentivize financial institutions to participate in frauds in which they expect to earn a benefit, which is behavior that the statute seeks to discourage.” As to the third issue, the court acknowledged that “the alleged negative effects are slightly removed from the underlying alleged scheme insofar as they manifested only when that scheme was revealed, not as it was ongoing.” But that was “no matter,” the court held, because “[t]he touchstone of proximate causation is reasonable foreseeability, and it certainly was reasonably foreseeable that this alleged scheme, if uncovered, would result in these kinds of harms to the Bank.” Consequently, the court concluded that the government had sufficiently alleged that the fraudulent scheme affected the bank.
“Self-affecting” theory accepted in RMBS Working Group actions. On the heels of the BNY decision, two other courts issued orders accepting the “self-affecting” theory and denying motions to dismiss FIRREA claims. In Countrywide, the court concluded that FIRREA’s plain language supported the theory. Citing Webster’s, the court held that “affect” means “to have an effect on,” and it agreed with the government that Bank of America’s misconduct “had a huge effect on BofA itself (not to mention its shareholders),” in that the bank allegedly “has paid billions of dollars to settle repurchase claims by Fannie Mae and Freddie Mac made as a result of the fraud here alleged.” The court in Wells Fargo adopted the plain language reasoning of the courts in Countrywide and BNY, and noted that the fraud affected Wells Fargo itself not only because Wells Fargo was exposed to legal liability but also because the bank had to indemnify the government for more faulty mortgages than it would have if it had not engaged in the alleged fraud. In addition to the self-affecting theory, the government alleged that Bank of America’s conduct derivatively affected other, smaller financial institutions. Specifically, the government alleged that Fannie Mae and Freddie Mac were placed into conservatorship due in part to the defendants’ misconduct, and the conservatorship wiped out the value of Fannie Mae’s and Freddie Mac’s preferred securities, which formed a substantial part of the smaller financial institutions’ core capital. The defendants argued that crediting the derivative theory would allow for limitless FIRREA liability. The court was not unsympathetic and acknowledged that “Congress did not include the modifying language ‘directly or indirectly’ that it typically employs to reach derivative effects.” But the court also acknowledged that, as alleged, the harm to the smaller financial institutions was “both substantial and foreseeable, . . . the classic components of the proximate cause, let alone of mere ‘affect.’” Ultimately, the court did not decide the issue because the self-affecting theory was sufficient to permit the case to move forward.
The BNY, Countrywide, and Wells Fargo decisions are discomforting for those who thought the government was running out of time to prosecute financial institutions for securities claims arising from the financial crisis. FIRREA’s reach arguably is broader than that of section 10(b) of the 1934 Exchange Act; its 10-year statute of limitations is double the statute of limitations for federal criminal fraud or civil securities fraud; and its penalties are not insubstantial: $1 million per violation and $5 million for a continuing violation, and potentially more if the defendant’s gains or the victim’s losses are greater than the penalties. 12 U.S.C. § 1833a(b). Still, FIRREA’s new potential reach is in the early stages of its evolution. All three opinions accepting the self-affecting theory of FIRREA liability were written by judges from the Southern District of New York, and no other district court—let alone a circuit court of appeals—has addressed the issue. But that may soon change. As this article was going to publication, the Countrywide jury concluded that Bank of America and a former Countrywide executive committed fraud. Nate Raymond, “Bank of America Liable for Countrywide Mortgage Fraud,” Reuters, Oct. 23, 2013. The court will consider civil penalties in early 2014. In the meantime, the RMBS Working Group appears to be actively investigating potential claims against numerous other financial institutions. Devlin Barrett, “Justice Department Plans New Crisis-Related Cases,” Wall. St. J., Aug. 20, 2013 (quoting Attorney General Holder: “My message is, anybody who’s inflicted damage on our financial markets should not be of the belief that they are out of the woods because of the passage of time. If any individual or if any institution is banking on waiting things out, they have to think again.”).