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Yes, Proof Is Required

Bank of America ATM sign
photo by Mike Mozart

The 2nd U.S. Circuit Court of Appeals stunned the Justice Department this week by holding that, in order to commit fraud, you actually have to set out to defraud somebody.

This sounds pretty basic, but apparently not so to the government lawyers who see both criminal and civil actions as mere opportunities to squeeze money from deep pockets.

In a unanimous ruling, the 2nd Circuit threw out a finding that Bank of America Corp. was liable for mortgage fraud connected to the “Hustle” program run by the former Countrywide Financial Corp. The original case, which resulted in a $1.27 billion penalty for the bank, sharpened the knives for the government’s scalp hunt, about which I have written before.

While the appeals court’s ruling is narrow, it illustrates the ways in which government officials overreached in their efforts to identify and sacrifice any likely scapegoat in the wake of the 2008 financial crisis. Brandon Garrett, a law professor at the University of Virginia, explained to The Wall Street Journal that proving fraud is legally quite difficult, though this didn’t slow Justice down very much.

“Obviously, people don’t normally come out and admit that they know they were selling deceptive products,” he said. “It’s hard to get smoking guns. And now the courts are saying, you need smoking guns at the beginning and end of the deal.”

The federal district judge who set the now-discarded Bank of America penalty was Jed Rakoff, whose penchant for slamming banks with enormous fines previously triggered pushback from the Court of Appeals. Rakoff seems to have mounted a personal crusade in his courtroom to hold financial institutions and their executives accountable for their alleged misdeeds. He rejected a proposed settlement between Citigroup and the Securities and Exchange Commission in 2011 because, in his view, it was not harsh enough. The Court of Appeals for the 2nd Circuit agreed with Citigroup’s argument that Rakoff had overreached in that case, too.

While the details of the Citigroup decision and the Bank of America case are not the same in their particulars, they share a common foundation in a mindset that weights punishment for its own sake more heavily than justice. In its appeal, Bank of America argued that Rakoff’s history raised serious questions about his impartiality. “From beginning to end, what took place in this case was not only unfair, but utterly unprecedented,” the appeal concluded.

At this point, Rakoff ought to be granting motions to recuse himself from similar cases, though I have no reason to believe he will. The appearance of impartiality has not been a high priority for him up to this point. Bank of America has asked that, if the case is retried, it be assigned a judge other than Rakoff, for obvious reasons.

The “Hustle” case centers on a 2012 lawsuit filed by the U.S. attorney’s office of Manhattan. In essence, Countrywide entered into a contract to originate mortgages and then sell them to the federally sponsored entities Fannie Mae and Freddie Mac. As the housing frenzy mounted a decade ago, Countrywide’s lending standards declined, as did those of many lenders in the industry. Some of this trend was due to the fact that Fannie and Freddie wanted more loans made to low-income borrowers, but never mind that.

Many of the lower quality loans blew up amid the housing bust, and Countrywide’s resulting financial troubles resulted in its takeover by Bank of America in 2008. The Justice Department subsequently claimed that the subpar loans represented not merely a breach of contract, but actual fraud.

This argument is something like saying a football player who promises to win the Super Bowl commits fraud when his team ultimately fails to deliver on that promise. Now, if the star quarterback somehow knew that his team would lose, perhaps because he had accepted a bribe from gamblers, the situation would be different. Fans might have been defrauded; the player’s employers certainly were. But in order for this scenario to be fraud, the player had to know at the time he made the promise that he had no intention of delivering on it.

As the 2nd Circuit panel held, the Justice Department produced no evidence that Countrywide entered its contracts with the intent to fail to fulfill them. The most the government managed was to show that Countrywide breached its agreements after the fact. Failure to comply with a contract is only fraud when the party entering the contract never intended to honor it in the first place

In other words, to defraud someone, you have to intend to defraud them. The Court of Appeals wisely stepped in to remind Justice that this is the case, even when the party in question happens to be a bank.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us” and Chapter 4, “The Family Business."

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