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Overturned 'Hustle' Case Clouds Government Enforcement - Benjamin K. McComas and Brendan P. Brady

Benjamin K. McComas and Brendan P. Brady
New Coordinates
Summer 2016

The Second Circuit Court of Appeals recently overturned the most notable civil penalty judgment achieved by the government in the wake of the financial crisis, overturning a case widely known as the “Hustle.” United States ex. rel. Edward O’Donnell v. Countrywide Home Loans, Inc. had been prosecuted by the Justice Department in the Southern District of New York and initially resulted in a $1.3 billion judgment against Bank of America. The impact of the bank’s successful appeal on the financial services industry could be quite profound, as the government decides how to pursue other enforcement actions and as financial institutions decide when to settle and when to fight.

2012-2014: Government Sues, Jury Finds Fraud, and Judge Imposes High Penalty
The Hustle case was considered groundbreaking litigation founded on the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), which allows courts to assess civil penalties against financial institutions that violate certain criminal provisions. Enacted in the wake of the savings and loan crisis, FIRREA had largely lay dormant for decades until the most recent financial crisis. The statute, which was designed to protect financial institutions from fraud and other criminal activity, has since been used as the basis to negotiate billions of dollars in settlements from financial institutions.

In the Hustle case, the bank did not reach a settlement with the government, setting the matter up as the test case for FIRREA enforcement. The Justice Department filed an action against the bank as Countrywide’s new owner, citing a Countrywide pilot loan origination program called the “High-Speed Swim Lane” or “HSSL.” The HSSL program was designed to speed up delivery of loans to Fannie Mae and Freddie Mac (the government-sponsored enterprises, or GSEs) and thus increase market share. The government used the HSSL abbreviation to brand the program “the Hustle” in pleadings and sought to portray it as a swindle against the GSEs.

The bank presented evidence at trial that the loans were of high quality, but the program was terminated after only a few months because of a significant number of technical delivery errors. Ultimately, the jury found the bank liable for fraud, and District Judge Jed Rakoff used what was considered the most punitive damages methodology available to arrive at a $1.3 billion civil penalty.

2014-2016: Bank Appeals and Court Rejects Fraud Claim

Although the District Court decision was seen as a serious setback, and likely encouraged other entities to settle similar claims, the bank pursued an appeal based on multiple arguments. Observers believed that the bank’s best hope on appeal centered on an attack of the “self-affecting harm” doctrine. FIRREA was designed to protect financial institutions, and because the GSEs were the counterparty to the underlying transaction (rather than the financial institutions), the Justice Department argued that Countrywide had actually harmed itself by committing fraud and phone/wiretapping violations against the GSEs. This concept of “self-affecting harm” represented an aggressive interpretation of FIRREA’s purpose and was an essential element of Judge Rakoff’s award.

Also challenged was the methodology used to calculate damages. Judge Rakoff had used a “gross” calculation method, basing damages off of the total size of the transaction, while the bank argued that FIRREA mandated a “net” calculation method focused solely on the allegedly misbegotten profits from the transaction.

The Second Circuit’s May 2016 opinion, however, overturned the jury decision without opining on these critical arguments. Instead, the court of appeals determined that, as a matter of law, Countrywide had not engaged in fraud and therefore that no underlying activity had even opened the door to a civil penalty under FIRREA. In short, the government had failed to prove that Countrywide, when entering into contract with the GSEs, had intended to deliver “bad loans.” This finding indicated that any “bad loans” that were delivered resulted only in a simple breach of contract. The bank had already settled breach of contract claims with the GSEs, and additional damages were unwarranted under FIRREA.

Although the decision seems straightforward, using only a basic analysis of the elements of fraud, it has much wider implications. Future government enforcement actions may face tighter public scrutiny and defendants who are less willing to settle quietly.

Future Enforcement Actions Are Unpredictable
The major question resulting from the Second Circuit’s decision is whether the Justice Department will be deterred from pursing further actions under FIRREA. The government has used FIRREA as a major tool against financial institutions this decade. In fact, the Justice Department has achieved settlements ranging from $10 million to at least $4 billion over just the last three years. The 10-year statute of limitations available under FIRREA makes it an attractive leverage point for the government as it is longer than other statutes, but a sense of urgency now exists if the government wishes to hold parties responsible for harm caused during the financial crisis.

The Justice Department has been silent since the ruling was handed down in late May, but it is possible that the government will put less weight in FIRREA claims when seeking settlements. Of course, this depends on the corollary response from financial institutions, as they reassess their willingness to fund the defense of claims that suddenly seem more vulnerable. Significant litigation costs can be incurred in fighting FIRREA claims, which might force some lenders to settle. However, the Second Circuit decision should instill confidence in lenders involved in or facing litigation—suggesting that they needn’t acquiesce to multi-billion dollar settlements, as had continued in the months leading up to the Hustle decision.

Ultimately, one of the most important measures of the bank’s victory will be gauged by its impact on the enforcement environment. As previously indicated, the appeals court left untouched the important issues of the “self-affecting harm” theory and how FIRREA damages are calculated. Because the outcome of any future cases involving these key issues is unpredictable, FIRREA actions have an unpredictable future.

FCA Implications Emerge
Just as important is the potential impact on False Claims Act (FCA) cases. Reliance on FIRREA has been a fallback plan for the government when the favored FCA is unavailable. Specifically, Federal Housing Administration (FHA) lenders have faced industry-changing litigation from the Justice Department based on the FCA. Most major banks have withdrawn from the FHA space entirely, which not only cuts off a steady flow of loan production but also serves to limit credit access to many first-time and middle-class homebuyers. For instance, JPMorgan Chase originated just 340 FHA loans in the second quarter of 2015 compared to 19,111 such loans in the second quarter of 2013.

The FCA imposes liability “on any person who knowingly presents, or causes to be presented, a false or fraudulent claim for payment or approval” or “knowingly makes, uses, or causes to be made or used, a false record or statement material to a false or fraudulent claim.” In order to qualify for FHA insurance, lenders are required to certify both that their quality control procedures comply with all relevant Department of Housing and Urban Development (HUD) regulations and that every loan eligible for FHA insurance complies with those same rules. If a lender fails to comply with HUD regulations in seeking FHA insurance for loans it has made, this may give rise to a cause for FCA litigation by the government. Unlike FIRREA, the government is not required to plead fraud under the FCA. Rather, it is sufficient that a claim is false rather than false and fraudulent.

As such, litigation under the FCA is not substantively impacted by the Hustle decision. However, the notion that a lender can stand against the federal government and ultimately be vindicated may encourage more financial institutions to eschew quick settlements. If this change in the enforcement environment occurs, it could signal a final, cathartic rush of litigation that is necessary for clearing the air in the wake of the financial crisis and giving a fresh restart to residential mortgage lending

The Hustle outcome alone will not give lenders the confidence to step back into FHA lending. However, Bank of America’s decision to fight allegations of fraud may provide the only blueprint for establishing clear standards under the FCA and may also provide more lenders the confidence to step forward and carry the banner.

Lenders who have remained involved in, or are considering a return to, FHA lending should be heartened by the Second Circuit’s decision in the Hustle case. FCA litigation currently appears to be an insurmountable barrier to a profitable, long-term relationship with the government, but the recent decision provides both an example of success and an opportunity for the environment to be recalibrated.

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