Federal appellate judges in New York throw out civil penalty in Bank of America 'Hustle' case

By Aruna Viswanatha and Christina Rexrode 

An appeals court dealt the Obama administration a major setback in its efforts to levy tough fines on corporations and executives, overturning a civil mortgage-fraud case against Bank of America Corp. tied to the financial crisis.

The court on Monday also tossed out a $1 million civil penalty against Rebecca Mairone , a former executive at Countrywide Financial Corp., who was one of the few individuals fined for alleged misdeeds during the crisis.

The ruling by the Second U.S. Circuit Court of Appeals in New York raises the bar for the government to prove fraud against companies and individuals, weakening a weapon the Justice Department has used to push Wall Street to agree to big mortgage settlements.

If it stands, the three-judge panel's unanimous decision could affect the remaining investigations into crisis-era mortgage securities, some observers said, including those into European lenders Royal Bank of Scotland Group PLC and UBS Group AG. The decision also could encourage other firms to push back against prosecutions.

The original verdict in the Bank of America case helped pave the way for the government to reach multibillion-dollar settlements with large banks for alleged financial-crisis misdeeds.

Representatives of the Justice Department and the Manhattan U.S. attorney's office, which brought the case, declined to comment. A Bank of America spokesman said the company is "pleased with the appellate court's decision."

The ruling won't alter the nearly $45 billion in mortgage-securities settlements the Justice Department already has reached with the biggest U.S. banks, including J.P. Morgan Chase & Co. and Citigroup Inc.

The court's decision is the latest in a series of high-profile losses by government prosecutors and regulators, both in their attempts to punish financial crimes and to expand regulations.

A 2014 appeals court ruling made it more difficult for the government to pursue insider-trading cases, forcing prosecutors to drop a dozen actions in the past year and a half. In March, a federal judge overturned the government's attempt to impose stringent new regulatory oversight on MetLife Inc. after officials had declared the insurer a potential threat to the global financial system.

Last year, a memo from Deputy Attorney General Sally Yates urged prosecutors to more aggressively pursue criminal and civil penalties against firms and executives.

The appeals court panel threw out a $1.27 billion penalty against Bank of America over mortgages sold by its Countrywide unit, in what had become known as the "Hustle" case.

It revolved around a civil lawsuit that the U.S. attorney's office in Manhattan filed against Bank of America in 2012. It alleged that a precrisis Countrywide program called Hustle had generated shoddy mortgages and then misrepresented those loans when selling them to Fannie Mae and Freddie Mac, which had to be bailed out by the government during the financial crisis.

The panel said the jury's findings in 2013 that the loans sold to Fannie and Freddie were below the quality that had been promised might be considered an "intentional breach of contract." But it said those transgressions didn't constitute fraud, overturning the jury verdict that had been a signature win for government officials widely criticized for bringing few cases tied to the 2008 crisis.

Josh Rosenkranz, who represented Ms. Mairone, said the ruling shows "this case was a massive government overreach from inception," in which prosecutors "tried to take an allegation of garden variety breach of contract and turn it into a fraud with crushing and career-ending penalties."

The ruling itself is a narrow one, but it raises issues that underpin banks' mortgage settlements in recent years. Those cases resolved civil accusations the banks misrepresented the quality of loans packaged into securities.

"It is challenging to prove fraud," said Brandon Garrett, a University of Virginia law professor who has studied corporate prosecutions. "Obviously, people don't normally come out and admit that they know they were selling deceptive products. 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 government could appeal the ruling to either the full appeals court or Supreme Court.

The Justice Department employed a little-used law enacted in the wake of the 1980s savings-and-loan crisis, the Financial Institutions Reform, Recovery and Enforcement Act, which allows the government to civilly prosecute fraud affecting federally insured financial institutions.

The issue, the court said, turned on the timing of any misstatements and whether at the time they were made, the bank or its employees knew they were false. In this case, the panel said, Countrywide entered into the contract to sell loans to Fannie and Freddie long before the alleged scheme to defraud the housing entities took place.

"Critically, the Government presented no proof at trial that any quality guarantee was made with fraudulent intent at the time of contract execution," the panel said. "In essence, the Government's theory would convert every intentional or willful breach of contract...into criminal fraud."

At a hearing in December, U.S. Appeals Judge Reena Raggi questioned whether the government was stretching the bounds of what constitutes fraud. "What you're asking for is a major change in how we view breach," Judge Raggi said at the hearing.

In 2014, U.S. District Judge Jed Rakoff ruled that the bank should pay a penalty of $1.27 billion, more than the bank had expected. At the time, the bank was in the midst of negotiating a far bigger mortgage-securities settlement with the Justice Department. People close to the matter have said that Judge Rakoff's ruling reinforced for bank executives that the government was going to hold it accountable for misdeeds by Countrywide, which it acquired in 2008.

That night, Bank of America CEO Brian Moynihan agreed to the outlines of a deal on a phone call with Eric Holder, then the attorney general, The Wall Street Journal previously reported. Three weeks later, the $16.65 billion settlement was announced, the biggest ever between the Justice Department and a single company.

The Hustle penalty was relatively small compared with other fines paid by the bank, but it was an important step in the government's efforts to push for bigger penalties against banks over related charges.

The charges and trial took observers deep inside Countrywide, which has been seen as a central player in the mortgage crisis. According to the government, the firm accepted borrowers' applications without checking that income levels and other information were 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 who was the government's star witness in the trial, testified that he was ignored when he alerted his bosses to deterioration in the quality of the mortgage loans.

Write to Aruna Viswanatha at Aruna.Viswanatha@wsj.com and Christina Rexrode at christina.rexrode@wsj.com

 

(END) Dow Jones Newswires

May 24, 2016 02:47 ET (06:47 GMT)

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