Old Law Gains New Relevance on Financial Crisis Cases

The Department of Justice is dusting off an old and rarely used financial reform law that's been on the books for more than two decades to pursue cases related to the financial crisis.

The Financial Institutions Reform Recovery and Enforcement Act, enacted in response to the savings-and-loan-crisis of the 1980s, empowers federal prosecutors to seek civil penalties for a wide range of fraud crimes that specifically affect federally insured financial institutions. Such crimes include mail and wire fraud, bank fraud, and false statements made to the government.

Despite its expansive reach, regulators used the statute infrequently as an enforcement mechanism—that is, until the wake of the financial crisis, when the acquittals of several high-profile criminal defendants forced the government to rethink its efforts. “The government is under tremendous pressure to go after companies it believes were major players in the financial crisis,” says Douglas Baruch, a partner with the law firm Fried Frank Harris Shriver & Jacobson. “Government lawyers are reevaluating every tool in their toolboxes to see what they can use to craft a theory of liability.”

Where the government lacks overwhelming evidence to pursue a criminal enforcement action—which has been a major sticking point in many financial crisis-related cases—a FIRREA civil claim may be brought based merely on preponderance of the evidence. In comparison, a criminal case requires proof “beyond a reasonable doubt,” which is a “difficult standard to meet in complex financial cases,” says Andrew Schilling, a partner at law firm BuckleySanders and former chief of the Civil Division at the U.S. Attorney's Office for the Southern District of New York.

In the last few months, FIRREA increasingly has played a central role in several civil fraud lawsuits. “The Justice Department is very focused on mortgage fraud, in particular,” Schilling says. In most cases, FIRREA claims are brought in tandem with actions alleging violation of the False Claims Act.

Whether the Justice Department will prevail with its FIRREA claims is too soon to say. Wells Fargo, Bank of America, and Allied Home Mortgage are just a few mortgage lenders that are currently challenging civil fraud actions that accuse the banks of violating FIRREA. All three banks have filed motions to dismiss, arguing that the government is taking an overly broad reading of the law.

If the government were to prevail in these cases, penalties under FIRREA can reach up to $1 million per violation, or $5 million for continuing violations. Additional civil penalties may be imposed equal to the amount of the gain or loss resulting from the fraud, potentially amounting to billions of dollars. The upside for mortgage lenders is that the penalties are a better alternative to facing a criminal indictment, “which effectively can put a company out of business,” says Jason Jurgens, a partner at law firm Cadwalader.

In one of the first FIRREA claims to result in a settlement, Citigroup agreed to pay $158 million in February 2012 over allegations that its subsidiary CitiMortgage falsely stated that some loans met Federal Housing Administration and Housing and Urban Development agency standards for mortgage eligibility, causing several borrowers to default on their  loans. The case originally stemmed from a whistleblower lawsuit brought under the FCA.

That settlement followed in the same month that the nation's five largest mortgage servicers—including Citigroup—reached a record $25 billion settlement with the Justice Department and 49 states over allegations that included violations of FIRREA.

Extensive Reach

Mortgage lenders are not the only targets of a FIRREA claim. In the first-ever federal enforcement action against a credit rating agency over bond ratings, the Justice Department filed a lawsuit Feb. 4 against credit rating agency Standard & Poor's Financial Services over allegations that it engaged in a scheme to defraud investors in financial products known as Residential Mortgage-Backed Securities and Collateralized Debt Obligations.

“We allege that, by knowingly issuing inflated credit ratings for CDOs, which misrepresented their creditworthiness and understated their risks, S&P misled investors, including many federally insured financial institutions,” Attorney General Eric Holder said in a prepared statement announcing the lawsuit. The government is seeking $5 billion in its civil lawsuit.

Closer coordination between the Justice Department and regulators raises the risk even more that a financial institution will face a FIRREA claim. “What may have been a routine inquiry from regulators in the past may not be routine any longer now that the Justice Department is out there aggressively pursuing these cases and working with regulators,” says Schilling.

“For many of the financial institutions that have received FIRREA subpoenas over the last couple of years, it's been a rude awakening.”

—Douglas Baruch,

Partner,

Fried Frank

That effectively means companies that receive a FIRREA subpoena will want to take it seriously, because that's usually the first indication that a company likely will face a FIRREA civil fraud action.

FIRREA is one of few federal statutes that gives Justice Department civil lawyers direct authority to issue subpoenas and take extensive discovery before filing a lawsuit.  “For many of the financial institutions that have received FIRREA subpoenas over the last couple of years, it's been a rude awakening,” says Baruch.

Because the Justice Department has only recently begun to issue FIRREA subpoenas, a financial institution has no way of knowing whether it's being subpoenaed for possessing information relevant to an investigation of a third party, or whether it is the actual target of the investigation, says Schilling. “The only way to know the answer to that is to ask the government, and they may not tell you,” he says. “Financial institutions need to assume that they may be the focus of the government's investigation and act cautiously.”

Proactive Measures

The target of a FIRREA subpoena will want to conduct an internal investigation to determine the full scope of the problem, advises Jurgens. “Document preservations and collection would also be important,” he says.

The other unique challenge posed by FIRREA is its 10-year statute of limitations, “so it can reach back further than some of the traditional statutes that the government has been using,” says Baruch. The False Claims Act, for example, has a six-year statute of limitations.

ARGUING FIRREA CLAIMS

Below is an excerpt from Allied's Motion to Dismiss claim against the Department of Justice, arguing why the government's FIRREA claims have no basis in law:

Allied Corporation has not violated 18 U.S.C. § 1006, because it only applies to individuals in their capacity as officers of an applicable institution. Since Allied Corporation is neither an individual nor an applicable institution, no viable claim is stated for a violation of 18 U.S.C. §1006 (2011).

To state a claim under 18 U.S.C. § 1006, the Complaint must allege:

(1) That the defendant is an officer or employee of a lending institution organized under the laws of the United States;

(2) That the defendant participated, shared in or received, either directly or indirectly, money, profit or benefit by and through any transaction of such institution;

(3) That the defendant did such act or acts with intent to defraud the association; and

(4) That such act or acts were done knowingly and willfully.

Allied Corporation is the lending institution, not an officer or employee of one. Further, the statute explicitly requires the lending institution to be “authorized or acting under the laws of the United States . . . the accounts of which are insured by the Federal Deposit Insurance Corporation or by the National Credit Union Administration Board . . . .” 18 U.S.C. § 1006. Allied Corporation is not organized under the laws of the United States. Allied Corporation is a state-chartered lending company, which is not, nor is it alleged to be, authorized or organized under the laws of the United States.

Moreover, Allied Corporation is not insured, nor is it alleged to be insured by, either the Federal Deposit Insurance Corporation or the National Credit Union Administration Board. For these reasons alone, the government's allegations fail against Allied Corporation under §1006.

Source: Allied.

That means those in the financial services industry might want to consider modifying their document retention policies in connection with negotiations and analysis of transactions involving financial institutions, says Jurgens.

In light of the government's increasingly aggressive use of FIRREA, financial institutions should also ask themselves “whether their existing compliance programs are sufficient to protect the bank from potential FIRREA exposure, given its relationships with other financial institutions,” says Jurgens. “That requires training and educating employees who have authority to negotiate transactions with financial institutions about FIRREA.”

“The compliance function in the mortgage space is more important than ever,” agrees Schilling.

Those who may be at risk of a FIRREA claim may also want to establish materiality thresholds for transactions involving or affecting financial institutions, advises Jurgens. They may further want to have employees who are responsible for material transactions execute some certification, or testing, to the accuracy of information provided to financial institutions, he says.

The biggest challenge in evaluating the legal risks posed by a FIRREA claim is that “there is no body of case law they can turn to determine what defenses may be viable or not,” says Jurgens. The flip side to that, however, is that “financial institutions and their legal counsel are able to work from a blank slate and develop defenses and arguments without having to worry about earlier precedent that might preclude them from making certain arguments,” he says.

One thing is for certain:  “The next couple of years are going to be very significant in determining the scope and reach of FIRREA, as many financial institutions and other defendants who've been hit with FIRREA civil complaints start to challenge them in court,” says Baruch.

Until the courts define with more clarity the limitations of FIRREA in response to the Justice Department's extensive reach of the law, Schilling says, financial institutions would be well advised to familiarize themselves with the statute and to respond to FIRREA subpoenas cautiously.