The Second Circuit’s May 23 “mortgage hustle” decision (PDF: 440 KB) corrects a questionable interpretation of the mail and wire fraud statutes.[1]
Countrywide Home Loans – now a subsidiary of Bank of America – entered into contracts to sell mortgages to Fannie Mae and Freddie Mac. The contracts contained representations regarding the quality of the mortgages that would be transferred. Allegedly, the loans didn’t measure up.
Freddie and Fannie might have sought redress on a simple breach of contract theory: Countrywide did not carry through on its promise to supply good quality loans, and as a result the purchasers were entitled to damages. Regrettably, however, the government litigated this action on a different theory. It claimed that the defendants had committed mail and wire fraud by supplying mortgages they knew did not meet the contractual specifications.
In other words, the government used the alchemy of enforcement to convert an ordinary contract action into a claim of fraud – one which, moreover, could be backed by criminal as well as civil sanctions.
The lawsuit played into a compelling political narrative. Prosecutors were under pressure to punish bankers for their role in the financial crisis. Angelo Mozilo, Countrywide’s former chairman, had come to symbolize the abuses and excesses of those years. But, contrary to the expectations of many, the government was never able to indict him.
The present lawsuit shielded prosecutors against the criticism that they had not vigorously pursued the wrongdoers. If Mozilo was going to avoid a prison sentence, at least his underlings could be called to account. It didn’t hurt that employees had nicknamed Countrywide’s mortgage origination business “the Hustle.” Many believed that bankers had hustled the public; the government’s case against Countrywide promised a small measure of redress.
Early results seemed to validate the strategy. A civil jury held the defendants liable on the fraud charges. U.S. Attorney Preet Bharara was swift to claim credit: “In a rush to feed at the trough of easy mortgage money on the eve of the financial crisis, Bank of America purchased Countrywide, thinking it had gobbled up a cash cow. That profit, however, was built on fraud.”
Judge Jed Rakoff, who presided over the case, compounded the defendants’ misery when he imposed a $1.27 billion fine on the corporate defendant and ordered the individual defendant, Rebecca Mairone, to hand over one fifth of her gross income every quarter until the payments reached $1 million. Rakoff’s opinion (PDF: 9.3 MB) imposing these penalties bristled with indignation about the defendants’ “brazen fraud” and “serious misconduct.”[2]
On appeal, the outcome was different.
Even construing the evidence in favor of the government, and even though in this civil action the government was not required to prove its case beyond a reasonable doubt, the Second Circuit held that the verdict could not stand. The reason was straightforward: the government failed to introduce evidence that the defendants had lied to Fannie and Freddie at the time of contract. The government’s evidence went only to whether the defendants intentionally breached the contract after it was made.
The Court of Appeals was right to reject the verdict. Fraud requires an intentional misrepresentation of fact. Breaches of contract, even if intentional, are not misrepresentations of fact.
What is distressing about the government’s decision to press this dubious lawsuit is the dangerous breadth of the underlying legal theory. Breaches of contract become frauds; frauds become crimes; crimes become predicates for RICO actions, and sooner or later ordinary commercial conduct is regulated through the lens of the criminal law.
Our legal system already incorporates an effective set of remedies for breaches of contract. Converting contract breaches into frauds would threaten to disrupt that system of regulation, impose unwarranted liability on innocent parties, and harm the public welfare by undermining incentives for efficient behavior.
The Second Circuit’s opinion appropriately rejected the government’s attempt to criminalize breaches of contract. Possibly, also, the opinion reflects a belief on the part of some jurists that meaningful judicial review is needed in order to counterbalance the awesome powers conferred on prosecutors and regulators in the modern administrative state.
Footnotes
[1] United States ex rel. O’Donnell v. Countrywide Home Loans, Inc., Nos. 15-496-cv(L), 15-499-cv(Con) (2d Cir., May 23, 2016).
[2] United States ex rel. O’Donnell v. Countrywide Home Loans, Inc., No. 12-cv-1422 (JSR) (S.D.N.Y., July 30, 2014).
Geoffrey Parsons Miller is the Stuyvesant Comfort Professor at NYU Law School, co-director of the law school’s Program on Corporate Compliance and Enforcement, and author of “The Law of Governance, Risk Management and Compliance” (Wolters Kluwer 2014).
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