If you are going to originate some shady mortgages, maybe you shouldn’t nickname the program the “hustle.” If you package up the mortgages and sell them as good mortgages, it would seem you are committing fraud. But maybe not.
It may come as no surprise that the company running the “hustle” was Countrywide. According to Countrywide, the High Speed Swim Lane or HSSL (or hustle) was an automated program created to improve loan quality by limiting the number of people who processed loans. According to the government, the Hustle program was meant to churn out home loans, rewarding employees for speed rather than quality and removing financial penalties that employees could incur for making bad loans. In the end Countrywide made $165 million from the program while Fannie Mae and Freddie Mac had net losses of $131 million.
Countrywide had a contract with Fannie Mae and Freddie Mac to sell Acceptable Mortgages. As you might expect, the Hustle mortgages did not all meet the Acceptable Mortgage standard, so it was delivering some sub-standard mortgages under the contract.
The government claims fraud and Countrywide claims that it was merely a breach of contract.
A jury ruled in favor or the government and the judge ordered $1.27 billion in penalties. The Second Circuit overturned that decision and the judgment. It was was merely a breach of contract.
The Second Circuit phrased the question like this:
“B’s Fraud theory is that A knowingly and intentionally provided substandard widgets in violation of the contractual promise—a promise A made at the time of contract execution about the quality of widgets at the time of future delivery. Is A’s willful but silent noncompliance a fraud—a knowingly false statement, made with intent to defraud—or is it simply an intentional breach of contract?”
The law does not permit a fraud claim merely on a contractual breach. Fraud turns on the parties intention when the contractual obligations and representations were made. The party claiming fraud need to prove that the other party had fraudulent intent at the time the party entered into the contract.
So to prove fraud, the government would need to prove that Countrywide did not intent to perform its obligations when it entered into the contract.
[T]he Government has never argued—much less proved at trial—that the contractual representations at issue were executed with contemporaneous intent never to perform, and the trial record contains no evidence that the three Key Individuals—or anyone else—had such fraudulent intent in the contract negotiation or execution. Instead, the Government’s proof shows only post-contractual intentional breach of the representations. Accordingly, the jury had no legally sufficient basis on which to conclude that the misrepresentations alleged were made with contemporaneous fraudulent intent
This is a fairly arcane area. The court agrees with this arcane assessment. I think the decision also hinges on the way the contract was structured. The contract did not call for a restatement of the representations when each mortgage was delivered. Many contracts are structured with the restatement of representations to avoid this arcane treatment.
It does not mean that Countrywide is off the hook. It’s still liable for damages from the contractual breach. It does mean that Countrywide did not commit fraud under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and is not liable for the ensuing civil penalties.
The big loser in this was Ed O’Donnell. He was the whistleblower in this case. He is doing okay. He had already been awarded $58 million as a result of the $16.65 billion that Countrywide paid for the contractual breaches and mortgage securities fraud. I assume he would have been eligible to get a chunk of the $1.27 billion fine in this case.
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