BAC Bank of America Corporation

By Aruna Viswanatha, Christina Rexrode and Devlin Barrett 

A federal appeals court on Monday reversed a lower court order that Bank of America Corp. pay a $1.27 billion penalty in connection with mortgages sold by its Countrywide unit., a major blow to the government which had won the high-profile financial crisis case at trial.

The U.S. Court of Appeals for the Second Circuit said it agreed with the bank, which argued the government didn't provide sufficient proof at trial.

The "Hustle" case revolves around a civil lawsuit that the Manhattan U.S. attorney's office filed against Bank of America in 2012. It alleged that a precrisis Countrywide Financial Corp. program called Hustle had churned out shoddy mortgages with a focus on quantity, not quality, and then misrepresented those loans when selling them to Fannie Mae and Freddie Mac, which had to be propped up by government money in the financial crisis.

A jury found Bank of America liable for fraud in the case in 2013.

The appeals panel said the government didn't prove the bank had intended to commit fraud when it signed deals with the housing entities, which it said was necessary in order to sustain the case.

The government "presented no evidence" that the executives involved in the alleged scheme were "involved in the negotiation or execution of these contracts," the panel said.

Spokesmen for the Justice Department and the U.S. Attorney's office in Manhattan didn't immediately comment on the ruling, which also tossed out a $1-million civil penalty against Rebecca Mairone, a former executive at Countrywide Financial Corp.

While her case was a civil trial, it was a rare instance in which a senior official at a major bank was held personally responsible for conduct leading up to the 2008 financial crisis.

"We're very pleased with the way the circuit ruled," said Michael Hefter, one of the lawyers representing Ms. Mairone. "It's a vindication for our trial team and for Ms. Mairone."

In the case the bank had argued that it shouldn't be held accountable for a program that ended before Bank of America bought Countrywide. The bank had also argued that the judge who oversaw the trial had been unfair.

The judges' decision could encourage other companies to push back against government prosecutions, even though most big financial institutions have generally preferred to settle such disputes rather than go through the public scrutiny of a trial. The case, brought under a 1989 law enacted in the wake of the 1980s savings and loan crisis, the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), and the favorable verdict for the government helped pave the way for multi-billion dollar settlements with top banks for alleged financial crisis misdeeds under a similar theory.

The Hustle penalty was relatively small compared to other fines paid by the bank, but it was an important anecdote in the government's arsenal in its push for bigger penalties against the banks over related charges. Three weeks after a judge set the Hustle penalty -- which was higher than Bank of America had expected -- the bank agreed to a $16.65 billion mortgage-securities settlement with the Justice Department.

The charges and trial took observers deep inside Countrywide, which is often seen as a central player in the mortgage meltdown. According to the government, the firm accepted borrowers' applications without checking that income levels and other information was reasonable. It awarded bonuses to employees who could make the case that a loan deemed defective by corporate auditors was in fact eligible for sale to Fannie and Freddie, with little regard for whether customers would be able to repay them.

Ed O'Donnell, a former Countrywide executive, was the government's star witness in the trial, testifying that he was ignored when he alerted his bosses to deterioration in the quality of the mortgage loans.

He didn't receive any money from the case since it went under appeal. He did, however, receive nearly $58 million for a separate lawsuit against Bank of America.

Write to Aruna Viswanatha at Aruna.Viswanatha@wsj.com, Christina Rexrode at christina.rexrode@wsj.com and Devlin Barrett at devlin.barrett@wsj.com

(END) Dow Jones Newswires

May 23, 2016 12:36 ET (16:36 GMT)

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