Seeking alpha readers will have read in the newspapers about the Second Circuit Court of Appeals decision reversing the District Court's judgment against Bank of America (NYSE:BAC) for $1.3 billion. (I will call it the Countrywide Case.) My purpose in this article is to explain what the decision means and, especially, what it does not mean for future cases seeking recoveries from banks for having sold bad loans to Fannie and Freddie or to other purchasers. There are only a few cases pending that arose out of the boom of the 2000s. But banks are still selling securitized loans in offerings that are subject to the Securities Act.
The first point about the Countrywide Case is that it was not brought to compensate for damages that Countrywide (now a BofA subsidiary) may have caused to Fannie and Freddie by selling them bad loans. That was a different case that was settled for a great deal more money and that was never the subject of a court ruling on the merits. The case that was reversed was brought under a provision of FIRREA, the 1989 law that provided the money to resolve the failed S&Ls. In that law, a Congress angry at having finally to admit that obligations of the FSLIC, the insurer of savings and loan deposits, were obligations of the United States, imposed the potential of civil money penalties.
Summary of the case
The provision at issue in the Countrywide Case permits the government to bring an action to impose "civil money penalties" on anyone who has violated the federal mail and wire fraud statutes in a way that affected an insured financial institution. Frankly, civil money penalties have always looked to me like fines for criminal conduct without affording the defendant the protections of the criminal law. I suspect that the Second Circuit judges may have had that sort of thought in the back of their minds as they decided the case.
At the District Court level, the case was tried to a jury, which found that Countrywide had violated the wire fraud statute, and Senior Judge Jed Rakoff, often known in the business as a hanging judge, imposed the $1.3 billion penalty. The appeal was based on the premise that even if Countrywide knew the loans did not meet the requirements of its agreement with Fannie and Freddie and sold them nevertheless, such a breach of contract, even if intentional, does not constitute fraud. The Second Circuit agreed.
The fundamental holding in the case was that the representation made by the defendant that was false as to the loans sold had to have been false when it was made, not only when the loans were sold. Frankly, this is dancing angels on the head of a pin.
The loans in question were sold pursuant to master agreements that governed all loans sold by the defendant Countrywide to Fannie and Freddie. The agreements contained representations that the loans, when sold, would conform to specified requirements. The loans in question did not meet those requirements-that was not disputed on appeal. But the court ruled that when the master agreements were entered into, Countrywide intended to sell loans that met the requirements, and no new representation was made at the time the loans in question were sold. Absent a representation at the time the loans in question were sold, there could be no fraud.
The court could just as easily have construed the master agreement as impliedly being repeated as part of each loan sale. But it did not say that, so that is not the law.
The limited consequences of the decision
The corporate bar will now add boilerplate to the closing documents that will make master agreements entered into, if effect, on each closing. Nothing else needs to change to change the law in cases like this, and the new language is unlikely to affect future conduct.
Those legal niceties, however, are not the most important points to note about this case. The most important points are the differences between this case and the cases that were brought by FHFA on behalf of Fannie and Freddie for securities law violations and the similar securities law cases brought by other plaintiffs, some of which are still pending.
The securities law cases do not require the plaintiffs to prove fraud. Securities Act Section 12(2) provides liability for any person who sells a security "by means of a prospectus or oral communication which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading." It is enough that the statement be misleading. The defendant is allowed to try to prove that he did not know the statement was misleading, but on that issue, the defendant will have the burden of proof. That is a far cry from the need for a plaintiff to prove fraud.
FHFA v. Nomura, decided about a year ago, showed the difference quite clearly. In that case, the District Court held Nomura Securities liable under Securities Act provision quoted above. Judge Denise Cote's opinion is excellent, if readers want to delve further.
The importance of the Nomura case is that it was a companion case to the major cases that were settled by BofA, JPMorgan (NYSE:JPM), Goldman Sachs (NYSE:GS) and others for a total of about $16 billion. Those cases would have been unaffected by the reversal of Judge Rakoff''s and the jury's decision in the Countrywide Case. If Judge Cote is upheld on appeal (the Nomura case is on appeal to the same Second Circuit Court of Appeals), which I believe she will be, then major banks probably would have lost their cases, just like Nomura, and they were wise to settle. I do not think the Countrywide Case will have any bearing on the Court of appeals' approach to the Nomura case.
Some of the newspaper stories have suggested that Judge Rakoff's decision in the Countrywide case caused BofA to settle the FHFA case against BofA for almost $6 billion, since the settlement came about immediately after Rakoff's decision, which might imply that reversal of the District Court's Countrywide decision will make defendants in securities law cases like the FHFA cases less likely to settle. I find that hard to believe because the differences in what must be proved are so great. I am sure BofA's lawyers made that very clear before the FHFA case was settled.
In sum, I like the result in the Countrywide case because the statute on which it was based is an outrageous one. But in thinking about banks' future potential liabilities for sales of securities backed by mortgages or other loans, one should take no comfort from it. FHFA v. Nomura is the key case, and the corporate bar is likely to, in effect, overrule the Second Circuit's Countrywide opinion by changing the boilerplate documentation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.