US seeks to extend False Claims Act reach in $1 billion lawsuit against Bank of America

Since 2010, federal prosecutors in Manhattan have waged war against what they term “reckless lending.” They have brought civil fraud suits against five major residential mortgage lenders and recovered $493 million in three 2012 settlements alone.

Now, the same prosecutors in the Southern District of New York have opened a new front in the battle with mortgage fraud. On October 24, they filed a suit in Manhattan federal court charging Bank of America with fraudulent lending practices. The lawsuit seeks at least $1 billion in damages from the second-largest financial institution in the United States.

It is the first civil fraud suit by federal prosecutors connected to loans that had been sold to Fannie Mae and Freddie Mac, the two mortgage giants that owned or guaranteed about half of the nation’s $12 trillion mortgage market before the 2008 financial collapse.

The groundbreaking lawsuit also deploys a novel and untested use of the False Claims Act (FCA). The law, which dates back to the Civil War, allows the US government to sue for treble damages for the losses it sustains as a result of any “false or fraudulent claim for payment.” Over time, the FCA has evolved into one of the government’s most potent weapons against fraud.

“The False Claims Act has been used to fight mortgage fraud for decades,” says Adam Feinberg, an attorney at Miller & Chevalier, in Washington, DC, who has litigated several such cases. “But we’ve seen an explosion of these fraud suits recently because there are so many federal dollars in the mortgage market.”

“What’s very new in the Bank of America case is the application of the FCA to Fannie and Freddie Mac,” he added. “There’s a very big difference between [suits based on] federally-insured loans and stretching the FCA to Fannie and Freddie. These aren’t necessarily federal agencies that received government funding in any traditional sense. That raises the bigger issue of what qualifies for a FCA case.”

Suit says Bank of America’s ‘Hustle’ is grounds for FCA charges

2009 amendments to the FCA made the law applicable not only to fraudulent claims made directly to US agencies, but also to contractors and private sector entities that receive federal funds to “advance a government interest.”

The five prior mortgage fraud cases filed in Manhattan were all brought under the False Claims Act. Those cases all alleged that the accused mortgage lenders committed fraud on the government by misrepresenting risky mortgages that they submitted for insurance by the Federal Housing Administration (FHA).

In the latest case, the complaint focuses instead on loans that originated at Countrywide Financial, which Bank of America acquired in 2008. The complaint says Countrywide systemically processed thousands of risky loans “at high speed and without quality checkpoints” in a process it calls “High Speed Swim Lane,” or “Hustle.”

Bank of America sold these “fraudulent and otherwise defective” loans to Fannie and Freddie Mac for bundling into mortgage-backed securities. When thousands of these mortgages defaulted after the US housing market collapsed in late 2008, the stock prices of Fannie and Freddie Mac crumbled, causing them billions in losses. Although the loans were not government-insured, the lawsuit alleges that the sale to Fannie and Freddie is sufficient grounds for an FCA case.

Allegations of systemic lending abuses

The 46-page complaint focuses on the period from 2007 to 2009, when it says that Countrywide, and later Bank of America, was the largest mortgage provider to Fannie and Freddie Mac. Loans sold to Fannie and Freddie are obligated to adhere to certain documentation, quality control and underwriting standards, but the complaint accuses Countrywide of producing a high volume of risky mortgages with little compliance with the required standards.

Prosecutors accuse Countrywide of operating under the motto, “loans move forward, never backward” and using unqualified and poorly trained mortgage processing staff. When reviews in 2008 discovered that 40% of the mortgages were defective, compared to the industry standard of about 5%, Countrywide allegedly offered bonuses to employees who doctored their rates. The lender also failed to report the abnormally high defect rate, as required by Fannie and Freddie Mac.

Bank of America is also accused of resisting government efforts to force it to buy back faulty mortgages, an allegation the bank called “simply not true” in a statement released late last month.

US may face uphill battle in extending False Claims Act

Prosecutors face legal hurdles in applying FCA charges to Bank of America. The US justifies its FCA case by stating in the complaint that Treasury funds were provided to Fannie and Freddie Mac “to advance a government interest… specifically, to prevent disruptions in the availability of mortgage finance.”

Before the US Federal Housing Finance Agency assumed control of Fannie and Freddie Mac in September 2008, they were shareholder-owned, for-profit corporations. The takeover of Fannie and Freddie was a purchase of their stock with federal funds, which totaled $183 billion by late 2011.

The law that extended the FCA to enterprises like Fannie and Freddie Mac, the Fraud Enforcement and Recovery Act, was not enacted until May 2009. This has led some observers to question the FCA’s application in this case, and led to speculation that Bank of America may have grounds to fend off the suit.

“I would be extremely surprised if Bank of America did not vigorously challenge the case,” said a former prosecutor with the Southern District of New York. “It’s very unlikely the bank would be sued for this amount on a novel legal theory and just write a check for $1 billion.”

Once-obscure law now serves as potent US fraud weapon

Even if the government falls short in its bid to bring FCA charges, it may still ensnare Bank of America for alleged violations of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). That law allows government prosecutors to sue for civil penalties when they believe individual or entity has violated certain criminal laws, including wire and bank fraud.

The complaint charges Bank of America with violating FIRREA from 2006 to 2010 based on allegations the bank “originated loans in violation of [Fannie and Freddie’s] guidelines, concealed the Hustle and resulting defect rates… and sold loans… while knowingly… misrepresenting that they complied with the guidelines.”

Penalties for violating FIRREA can be steep, up to $1 million per violation, with authorization for the court to award more in damages if the loss from the fraud is higher. Most significantly, the law does not require the government to be the victim of the fraud, giving FIRREA an even further reach than the FCA.

“You don’t need to prove a fraud on the government to have a FIRREA case,” says Ryan Morrison, an associate with Greene, a firm specializing in FCA cases in Boston. “When Bank of America sent documents through the mail or electronically to [Fannie and Freddie] regarding these allegedly misrepresented loans, that could be fraud on a financial institution and enough to establish FIRREA violations.”

Once rarely used, FIRREA charges have appeared with increasing frequency in mortgage fraud cases. Over the past two years, US prosecutors in the Civil Frauds section of the Southern District of New York have wielded FIRREA as their legal weapon of choice.

In February 2012, CitiMortgage, the mortgage lending branch of Citigroup, settled with the US government for $158 million in penalties after Southern District prosecutors brought a civil suit that included FIRREA charges. Prosecutors are currently pursuing two other mortgage fraud suits, against Wells Fargo and Allied Home Mortgage Corp., that also allege violations of FIRREA.

Whistleblowers emerge as potent resource in mortgage fraud cases

The Bank of America suit also spotlights the rising prevalence of whistleblower claims in financial crimes cases, particularly in the recent spate of mortgage fraud suits. The False Claims Act is the oldest and most frequently used whistleblower program in the US.

In the Bank of America case, former Countrywide vice president Eric O’Donnell originally filed suit against the bank before federal prosecutors assumed responsibility for the case. Under the FCA, O’Donnell remained anonymous until the government decided to intervene. If the government prevails, O’Donnell is entitled to receive between 15% and 30% of recovery awarded in the case.

The FCA allows whistleblowers, known as “relators,” to file suits on behalf of the government. The government may review the case before deciding to bring charges, or “intervene.” If the government declines to pursue the FCA case, the whistleblower can still pursue the case on their own.

By this process, which allows the government to weed out weaker cases, the US has achieved a highly successful record in FCA suits. “Once the government decides to intervene in an FCA suit, 98% of cases end in settlement,” says Morrison.

Big payouts to tipsters may encourage other cases

If O’Donnell receives payment, he won’t be the only whistleblower to earn a hefty award in a mortgage fraud case. In a settlement with CitiMortgage announced earlier this year, a whistleblower received $32 million. The $25 billion settlement reached by the Justice Department with five large US mortgage servicers over fraudulent foreclosure practices in March 2012 included $46 million for whistleblowers in the cases.

The huge payments may encourage others to step forward, and the US government is actively courting mortgage fraud whistleblowers through its online tipster site StopFraud.gov. This means that any company or institution should be closely examining its claims processes to ensure compliance with the FCA, says Feinberg.

“There’s no liability under the FCA until you submit a claim to the government,” Feinberg says. “One of the things a company can do is conduct pre-claim review. They could mess up a loan approval, for example, but save themselves by conducting a later review.”

“This is something institutions need to watch closely,” Feinberg continues. “People are highly incentivized to file FCA actions, whether or not there is fraud.”