Nightmare on Wall Street: JP Morgan and the US Government’s New Legal Stance on Liability For Mortgage Mis-selling

On Friday the 11th of October the CEO of JP Morgan Chase & Co, the largest bank in America[1], announced that $9.2 billion has been set aside in anticipation of ‘volatile’ litigation expenses[2]. The high-charged environment causing JP Morgan’s first quarterly loss in 8 years[3] is a direct consequence of the US government’s growingly aggressive stance on liability for mortgage mis-selling. This article will briefly look at how mortgage securities fraud contributed to the 2007-2008 financial crisis and will then focus on the legal developments which enable the government’s new position.

Background

The selling of mortgage securities was a ‘brisk business for Wall Street’ in the years leading up to the collapse of the market in 2007-2008[4]. Banks and savings and loan associations (S&Ls) pooled loans together and sold ‘pieces of the pool’s cash flow’ to investors, while retaining some ‘servicing’ functions for which they charged considerable fees[5]. In doing so they avoided the long repayment period of loans and SECURED the constant inflow of revenue. This in turn allowed these institutions to expand and benefit from specialization and economies of scale[6].

In what can be regarded as amounting to contractual misrepresentations, investors were led to believe that these transactions had been ‘carefully evaluated’ and would be closely monitored, which in reality was not the case[7]. Further, when the banks and S&Ls became aware of the risks associated with their failure to adequately scrutinize the pooling of loans, they failed to change their practices and as a result, when a great number of mortgagors defaulted causing the value of these securities to fall rapidly, investors incurred monumental losses[8]. On the basis of their contractual misrepresentations these financial institutions can be seen as having committed a line of fraudulent and deceptive acts[9].

In 2008, JP Morgan acquired Bear Stearns, one of the major investment banks involved in the bubble, in light of Bear Stearn’s collapse, at the request of the Federal Reserve[10]. Prior to the acquisition JP Morgan consulted the Securities and Exchange Commission, which confirmed that the company’s post-acquisition liability for Bear Stearns’ misrepresentations would be minimal[11].

The Commission’s statement was not only based on the absence of political willingness to hold rescuers such as JP Morgan accountable, but from a legal perspective, financial fraud claims in securities cases are aslo difficult to underpin. Firstly, there is a multitude of contractual documentation and the slicing of loan pools is complex[12]. Secondly, even if proceedings were brought against integrated players like Bear Stearns, it is difficult to ‘pierce the corporate veil’ and prove a ‘company-wide’ conspiracy to defraud[13]. Thirdly, financial institutions are also able to raise defenses, such as that of ‘honest belief in security value’ and ‘absence of intent to defraud’[14]. Finally, even if the involved institutions are held liable, rescuers’ post-acquisition liability is particularly difficult to establish since no fiduciary or contractual relationship exists between them and the investors, a point which is emphasized in Barclays Bank Plc vs. Bear Stearns[15]. JP Morgan’s acquisition could not therefore be considered risky at the time.

Legal Developments

In November 2009, the Obama administration announced the formation of the Financial Fraud Enforcement Task Force, an amalgamation of federal, state and local authorities headed by the Department of Justice (DoJ), whose aim is to fight fraud. Although its formation was initially regarded as an effort to appease the general public, the Task Force eventually provided the political drive for expanding the scope of liability for financial fraud. This was mainly achieved by employing a rarely-used provision of the Financial Institutions Reform, Recovery and Enforcement Act 1989 (FIRREA).

Under Section 1833a of the FIRREA[16], the US government may bring civil claims for violation of any of the 14 relevant criminal statutes related to financial fraud, on the basis that the government itself has been defrauded[17]. It is thus considered to be a hybrid Act, but it retains a civil burden of proof: the government is not required to demonstrate an intention to defraud but only evidence that a fraud has occurred[18]. Claims depend on ‘whistleblowers’, individuals who report fraud incidents and provide evidence for the claims. In relation to this, the Act permits the Task Force to undertake a one year investigation before bringing proceedings which is a further advantage over other legal routes for recovery[19].

However, the FIRREA did not always pose a threat to financial institutions. Its personal scope is limited to occasions where the alleged fraud ‘affects a federally insured institution’[20]. The threat only began to emerge when a line of cases accepted the Department of Justice’s far-fetched reasoning that defendants may have ‘affected’ themselves.

In United States v Bank of New York Mellon[21] Judge Kaplan used a range of interpretative methods, looking at Congressional intent, FIRREA’s structure, dictionary definitions and case law on other provisions to rule in favour of the US government[22]. In preliminary procedures for United States ex rel. O’ Donnell v Countrywide Financial Corporation[23], a case which is still pending, Judge Rakoff further agreed that ‘self-affecting’ was possible albeit expressing some reservations. Most recently, in United States v Wells Fargo Bank[24] the precedential value of both aforementioned cases was acknowledged and the federal court confirmed that the US government may use FIRREA’s provisions against financial institutions for instances of mortgage mis-selling which lead to the financial crisis.

Of equal importance is that Wells Fargo Bank demonstrates that FIRREA is not the only means now available to the government. Rather, the case suggests that FIRREA can apply in parallel and supplement the False Claims Act (FCA)[25]. The FCA allows the government to bring civil claims and seek exceptionally high damages (penalties of $5,500 to $11,000 per violation as well as treble damages). However, the burden of proof for this statute is higher than that of FIRREA as it demands that the alleged false claim was made ‘knowingly’[26]. In addition, a statute of limitations requires that claims are brought either within six years of the violation or within three years from the date the DOJ knew or should have known of facts material to the claim[27].

Wells Fargo Bank formally accepted the application of the FCA for the first time, accepting therefore that the government’s claims fall within the limitation period and that the burden of proof is not inhibitive. In conjunction with FIRREA’s re-interpreted scope of application this development signals a massive victory for the government which greatly expands the potential breadth of liability of financial institutions for mortgage mis-selling[28].

Nightmare on Wall Street

Armed with these rulings, the Department of Justice has the ability to pressure financial giants such as JP Morgan to enter into billion dollar settlements despite the fact that up to 80% of the alleged fraud incidents can be attributed to their acquirees[29]. On the one hand this appears strange, as it is less than clear whether JP Morgan could be held liable under a FCA-FIRREA claim; the Countrywide Financial Corporation case involving the Bank of America who is similarly situated as JP Morgan, has yet to be decided and leaving the question post-acquisition liability unanswered. On the other hand, the above cases indicate a greatly expanding area of law which could grow to accommodate the US government’s argument that ‘successors-in-interest’[30] should be held accountable. Either way, the threat to major financial institutions can create a financial ‘crisis of confidence’ whose disadvantages would disproportionately exceed the nominal value of legal charges[31]. Naturally, financial institutions will prefer to settle cases to avoid disrupting their market performance.

Commentators may find the effects of the US government’s stance devastating. Such an attempt to hold big banks accountable can be regarded as delayed, but also unfair since the same corporations came to the rescue of the Federal Reserve five years ago upon its request. In addition, any settlement for homeowners will leave investors who also suffered from the financial bubble in a disadvantaged position. Investors may consider this as a prejudicial government stance against big banks capable of creating an unpredictable and potentially harmful business environment. Ultimately it could be seen as perpetuating a systemic crisis it attempts to bring an end to[32].

Nonetheless, the Department of Justice has the democratic mandate and now the legal vehicles to take its efforts to unprecedented levels.

 

Andreas Georgiou 

Commercial Awareness Features Editor 

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[1] Halal Touryalai, ‘America's Biggest Banks, JPMorgan Takes A Bigger Lead Over Bank Of America’ (Forbes, 6 May 2013) <http://www.forbes.com/sites/halahtouryalai/2013/06/05/americas-biggest-banks-jpmorgan-takes-a-bigger-lead-over-bank-of-america/ > accessed 18 October 2013.

[2]  Quoting CEO Jamie Dimon,  Jack Gross ‘JPMorgan Chase Suffers First Quarterly Loss On Dimon’s Watch’ (invests.com, 11 October 2013) <http://invests.com/jpmorgan-chase-suffers-first-quarterly-loss-on-dimons-watch/2013101132059854> accessed 18 October 2013.

[3] Tom Braithwaite and Kara Scannell, ‘Banks shudder at JPMorgan’s legal burden’ Financial Times (London, 13 October 2013) 20.

[4] Danielle Douglas, ‘JP Morgan in talks to settle government cases for $11 billion, source says’ (Washington Post, 25 September 2013) <http://articles.washingtonpost.com/2013-09-25/business/42387103_1_mortgage-securities-jpmorgan-chase-bear-stearns> accessed 18 October 2013.

[5] William V Rapp, ‘The Global Mortgage Crisis Litigation Fallout’ (Leir Centre for Bubble Research, 29 June 2011) <http://www.leirbubblecenter.org/2011/06/global-mortgage-crisis-litigation.html> accessed 18 October 2013.

[6] Ibid.

[7] Press Release, ‘A.G. Schneiderman Sues JPMorgan For Fraudulent Residential Mortgage-Backed Securities Issued By Bear Stearns’ (AG Schneiderman’s Office, 12 October 2012) <http://www.ag.ny.gov/press-release/ag-schneiderman-sues-jpmorgan-fraudulent-residential-mortgage-backed-securities-issued> accessed 18 October 2013.

[8] Ibid.

[9] Ibid.

[10] Douglas (n4).

[11] Financial Times (n3).

[12] Rapp (n5) 6. The complexity makes it hard to identify who is responsible for final loss.

[13] Ibid 22.

[14] Ibid 29

[15] Barclays Bank Plc v Bear Stearns Asset Management Inc No 07 Civ 11400 (LAP) 2008 WL 4499468.

[16] Codified as 12 USC § 1833a.

[17] Section 951(a).

[18] Ibid (e).

[19] Ibid (g)(1).

[20] Ibid (c)(2).

[21] US v Bank of New York Mellon No 11 Civ 6969 (LAK), 2013 US Dist LEXIS 58816 (SDNY Apr 24, 2013).

[22] Benton Campell, William Reckler and Brigid Morris, ‘Expanding FIRREA Liability for Financial Institutions: Southern District of New York Developments’ (Latham & Watkins LLP, 3 September 2013) <http://www.lw.com/thoughtLeadership/> accessed 18 October 2013.

[23] US ex rel O'Donnell v Countrywide Fin Corp No 12 Civ 1422 (JSR) 2013 US Dist LEXIS 117140 (SDNY Aug 16 2013) .

[24] US  v Wells Fargo Bank NA, No 12-7527 (SDNY) (Compl Sept 24, 2013, Am. Compl. Dec. 14, 2012).

[25] 31 USC §§ 3729.

[26] Section 3729 (a)(1) (A).

[27] Confirmed in Wells Fargo Bank (n24).

[28] Benjamin B Klubes & Michelle L Rogers, ‘Another Court Affirms DOJ Financial Fraud Strategy’ (Buckley Sandler LLP, 10 October 2013) <http://www.buckleysandler.com/news-detail/another-court-affirms-doj-financial-fraud-strategy> accessed 18 October 2013.

[29] Douglas (n4).

[30] Financial Times (n3).

[31] Ibid.

[32] Note that the literature is divided on this issue.

Disclaimer: The views expressed are that of the individual author, not those of DUPS or Clifford Chance. All rights are reserved to the original authors of the materials consulted, which are listed in the bibliography above.