Supreme Court's Recent Decision Might Time-Bar Government Litigation Against Banks

| About: Bank of (BAC)
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Large bank stocks have an overhang of uncertainty and fear due to a seemingly endless stream of multi-billion dollar settlements and litigation.

Private corporation lawsuits against banks that began in mid-2011 or later have been dismissed due to a little-known rule called the statute of repose.

A recent, relatively unknown supreme court decision may indicate that current and future government lawsuits should also be dismissed according to the statute of repose.

The supreme court may abruptly end financial crisis-era settlements and litigation, dramatically changing the investment narrative and profitability of the large banks.

For the past several years, large banks including Bank of America (NYSE:BAC), Citigroup (NYSE:C) and JP Morgan (NYSE:JPM) have been threatened with never-ending government lawsuits for tens of billions of dollars. In the past few weeks, the Department of Justice (DOJ) has reportedly asked for another $17 billion from BAC, and another $10 billion from C. These follow last year's $13 billion settlement with JPM. The seemingly endless wave of threatened and actual litigation has introduced a great deal of uncertainty and fear into large bank stocks, and is likely depressing their stock prices.

This article is primarily about the statute of repose, a little known rule which, like the better-known statute of limitations, places limits on when plaintiffs can litigate against a defendant. Allison Frankel has written a good summary of the legal issues on her excellent blog, and my purpose here is mainly to supplement her legal discussion with some investment perspectives.

For most financial litigation, the Securities Act of 1933 sets the statute of repose at three years after the wrongdoing. Since most financial crisis misbehavior happened prior to mid-2008, the statute of repose sets a mid-2011 deadline for filing litigation. That deadline, per the Supreme Court, can not be extended.

This mid-2011 deadline has been enforced in several pieces of litigation between private companies, for example in the ruling Allstate (NYSE:ALL) vs. Bank of America. Private company litigation over the financial crisis that began after mid-2011 has largely been dismissed as time-barred.

The statute of repose applies to government litigation too. However, the government has a special tool in its belt called FIRREA. FIRREA explicitly has an "extender" which gives the government a 10-year statute of limitations on litigation, but is silent on the topic of the statute of repose.

Banks have argued that since congress did not explicitly change the statute of repose, the mid-2011 cut off defined by the Securities Act should remain in force.

So far, most lower courts have ruled against the banks. The courts believe congress "intended to" extend the statute of repose when they explicitly extended the statute of limitations. This has led to a prevailing investment narrative of uncertainty and fear, where banks will need to pay untold billions of dollars in settlements, litigation, and fines.

A recent, largely unknown, Supreme Court decision may flip that narrative. CTS Corp vs. Waldburger deals with an environmental law where congress explicitly extended the statute of limitations, but did not extend the statute of repose. The Supreme Court, reversing a lower court, ruled that the statute of repose was not changed, and therefore, that Waldburger was too late in suing CTS Corp.

In his opinion, Justice Kennedy described the statute of repose as a type of defendant's rights:

Like a discharge in bankruptcy, a statute of repose can be said to provide a fresh start or freedom from liability...[it] embodies the idea that at some point a defendant should be able to put past events behind him.

FIRREA, like the environmental law above, is silent on the topic of statute of repose. There are good arguments both for and against the implicit extension of the statute of repose in FIRREA.

Arguments for the government:

  • Why would Congress extend the statute of limitations if the statute of repose would prevent litigation anyway?
  • Most lower courts have favored the government.

Arguments for the banks:

  • The Supreme Court ruled 7-2 in favor of CTS corporation. Multiple justices would need to find FIRREA sufficiently different in order to shift the verdict against the banks.
  • The Supreme Court may decide that Congress should be taken literally, i.e. that the Supreme Court should try not to guess Congress' intentions beyond what was written into the law.
  • The Supreme Court's discussion of a defendant's rights as a"fresh start" and "freedom from liability" may suggest a reluctance to remove those rights without an explicit law from Congress.

I don't have a strong view which direction the Supreme Court will rule, and would be unsurprised if the verdict went in either direction.

If the Supreme Court decides that FIRREA does not implicitly extend the statute of repose, just about all government litigation and settlements against the banks would abruptly end - just as private company litigation against the banks abruptly ended around mid-2011.

From an investment perspective, I believe a future Supreme Court ruling constitutes a sizeable free option. To me the downside, where the banks suffer from continued and sizeable settlements and litigation, is already priced into bank stocks. But the upside, where the Supreme Court rules for the banks, would mean protection from those lawsuits and the reversal of litigation reserves, creating billions of dollars in unexpected profits. I believe there's substantial upside should the banks win, while the downside is already priced in.

Disclosure: The author is long BAC, C, JPM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.