How Bank of America Could Fight a Government Lawsuit

Legal minutiae may give Bank of America a basis to fight the claims in a recent Justice Department lawsuit.

The Justice Department filed a lawsuit last week seeking at least $1 billion in penalties against Bank of America for troubled loans sold to the mortgage finance giants Fannie Mae and Freddie Mac. The government complaint focuses on a program to push out mortgages implemented by Countrywide Financial, which Bank of America acquired in July 2008.

The program, referred to as the “High-Speed Swim Lane” or “the hustle,” was designed to get mortgages approved by dropping a number of credit quality protections to speed up the approval process. The program began in 2007 after the subprime mortgage market collapsed, and Countrywide tried to prop up its loan volume by concentrating on higher quality mortgages that met the underwriting requirements of Fannie and Freddie.

According to the complaint, Countrywide did not disclose that “the hustle” el iminated many checks on the quality of the borrowers when it sold the loans to Fannie and Freddie. The Justice Department accuses Bank of America of continuing the program after it acquired Countrywide, and claims the bank has improperly fought taking back defaulted loans that should not have been sold to Fannie and Freddie.

The complaint relies on two statutes in seeking penalties: the False Claims Act and the Financial Institutions Reform, Recovery and Enforcement Act.

The False Claims Act dates to the Civil War, when it was enacted to combat defective products supplied to the Union army. The law now allows a penalty of up to $11,000 and triple the amount of damages sustained by the government for submission of any “false or fraudulent claim for payment.”

An important aspect of the act is that private individuals can serve as whistle-blowers by suing on behalf of the government in what is known as a qui tam action. A former vice president of Country wide initially filed the suit against Bank of America, and if the case is successful he would be eligible to receive up to 30 percent of the government's recovery.

The Financial Institutions Reform, Recovery and Enforcement Act is of much more recent vintage, having been adopted in 1989 during the savings and loan crises. It allows the government to recover civil penalties of up to $1 million for each violation of the federal mail and wire fraud statutes when it affects a federally insured financial institution.

One potential problem the Justice Department faces is proving that Countrywide's sales of the mortgages to Fannie and Freddie constituted the submission of a “claim” to “an officer, employee or agent of the United States.” The statute requires that the recipient of the claim be an instrumentality of the federal government, which is very much an open question.

Fannie and Freddie operated as for-profit enterprises until they were put into cons ervatorship overseen by the Federal Housing Finance Agency in September 2008. While they were “government sponsored enterprises” created by Congress and subject to extensive regulatory oversight, they looked like any other private company with shares listed on the New York Stock Exchange.

The Justice Department's complaint provides details of a few questionable mortgages sold by Countrywide as examples of the types of transactions that constituted fraudulent claims under the False Claims Act. The problem is that these transactions took place in 2007, before the federal takeover of the two companies.

The financial crisis hit around the time Bank of America took control of Countrywide. As a result, Bank of America could argue that the statute does not apply to any sales to Fannie and Freddie before they were bailed out, and before then the law is uncertain concerning their status as instruments of the federal government.

In Lebron v. National Railroad Pas senger Corp., the Supreme Court found that Amtrak was an instrument of the federal government. The court found that it was created “by special law, for the furtherance of governmental objectives, and retains for itself permanent authority to appoint a majority of the directors of that corporation.”

Like Amtrak, Congress created Fannie and Freddie, and they serve an important government purpose in maintaining the mortgage market. But shareholders elected a majority of the directors before the 2008 government takeover, and ownership of their shares was in private hands, with no direct federal control of the companies.

Bank of America can point to a 1996 decision by the United States Court of Appeals for the Ninth Circuit in American Bankers Mortgage Corporation v. Federal Home Loan Mortgage Corporation to support an argument that the two companies are not government instruments.

In that case, a mortgage company sued Freddie Mac for violating its due proce ss rights when it transferred loan servicing contracts to â€" of all companies â€" Countrywide Financial because of violations of Freddie's guidelines. The appellate court rejected the claim that Freddie Mac was an arm of the federal government because shareholders elected 13 of its 18 directors and the government had far less control over its operations than it exercised at Amtrak.

But there are also cases that have found the two companies to be government instruments for determining whether they are subject to state and local taxation or come under federal securities laws. The Justice Department is sure to point to these in support of its position that the False Claims Act applies to Fannie and Freddie.

Bank of America can also challenge the claim for penalties under the Financial Institutions Reform, Recovery and Enforcement Act by arguing that Countrywide's conduct falls outside the statute.

The Justice Department complaint asserts that the troubled loa ns caused substantial losses at Fannie and Freddie, which in turn led to losses at a number of banks that bought securities sold by the two companies. This is essentially a trickle-down theory: Countrywide's fraud prompted losses at Fannie and Freddie that then spread to other federally insured financial institutions.

That is a very broad reading of what constitutes “affecting,” and arguably means that any mail or wire fraud at a company whose shares are owned by a federally insured financial institution could trigger liability for civil penalties under the Financial Institutions Reform, Recovery and Enforcement Act. Determining whether a financial institution has been affected usually requires some direct impact on a bank and not just that the fraud rippled through the financial system.

An article for DealBook by Ben Protess described the many legal claims against Bank of America from its Countrywide acquisition that might cost it as much as $40 billion. T he bank has already paid $2.5 billion to Fannie and Freddie for problematic loans Countrywide sold to them, and the latest lawsuit tries to pile on more penalties for those transactions.

Bank of America can point to requirements for pursuing a case under both statutes to try to get the complaint dismissed and keep its costs down. Other banks that sold bad mortgages to Fannie and Freddie will certainly be watching closely to see whether they might face similar claims in the future.