The U.S. Court of Appeals in Manhattan has overturned a fraud verdict against Bank of America's Countrywide mortgage business stemming from poor quality mortgages the company sold Fannie Mae and Freddie Mac in 2007 and 2008. According to a
New York Times analysis, the earlier District Court ruling had imposed a civil penalty of US$1.27 billion against the bank and a US$1 million penalty against the former executive who had overseen the mortgage program. This is the only case to go to trial invoking a provision of the U.S. Financial Institutions Reform, Recovery, and Enforcement Act that authorizes civil penalties for fraud violations affecting a financial institution. The Appeals Court ruled that the Justice Department didn't prove "fraudulent intent at the time of contract execution; evidence of subsequent, willful breach cannot sustain the claim."
In the wake of the 2008 subprime mortgage crisis, many billions of dollars in fines and settlements have been paid by financial institutions for fraudulent activity and wrongdoing. But, as this story indicates, Bank of America won't have to pay a US$1.27 billion penalty as a result of a potentially significant Court of Appeals ruling — one that seems to redefine or at least reinterpret what legally constitutes fraud. And the court's decision cannot be appealed further. For auditors, this is a good opportunity to revisit the elements of how
fraud is defined.
Legal definitions of fraud, particularly those relating to criminal forms, vary somewhat from jurisdiction to jurisdiction. Countries such as the U.K. have adopted definitions that are more explicit than in the U.S., where fraud is based on a failure to disclose information within a legally defined relationship, including contractual ones. Perhaps this is something for U.S. lawmakers and regulators to study.
Most U.S. legal discussions of proving fraud in court converge around the need to show that a defendant's actions involve five elements:
- A false statement of a material fact.
- Knowledge on the part of the defendant that the statement is untrue. To be fraudulent, a false statement must be made with intent to deceive the alleged victim. This may be the easiest element to prove, once falsity and materiality are proved, because most materially false statements are designed to mislead.
- Intent on the part of the defendant to deceive the alleged victim, such as depriving the individual of his or her legal rights.
- Justifiable reliance by the alleged victim on the statement. While relying on a patently absurd false statement generally may not give rise to fraud, people who are especially gullible, superstitious, or ignorant — or who are illiterate — may recover damages for fraud if the defendant knew and took advantage of their condition.
- Injury to the alleged victim, leaving him or her in a worse position as a result.
As this story underscores, these elements contain nuances that cannot be easily proved. Two aspects are particularly significant. First, the Appeals Court has interpreted that for fraud to have occurred, there must be a "concurrence of the elements." The misstatement and the intent to defraud must be present
at the same time, so that a subsequent decision to intentionally violate an agreement by supplying an inferior or defective product does not establish that a misstatement took place with the requisite intent at the time the contract was signed. This is a troublingly narrow interpretation. Many fraud cases are of a significant duration, and the intent and actions to commit fraud are not necessarily present at the outset of a given situation, but develop subsequently.
Secondly, although it is true that not all false statements are fraudulent, if a false statement substantially affects a decision to enter into a contract or pursue a certain course of action, there is greater cause for concern about fraud. Would Fannie Mae and Freddie Mac have entered into a contract with Bank of America's Countrywide unit if they knew that the bank would later substitute an inferior, higher risk product? There also is the aspect of the obligation of one of the contracted parties to inform the other of a significant change in the quality of the product that has been contracted for. I have not reviewed the contracts involved in this case, but such requirements are very standard.
Finally, the views of U.S. District Court Judge Jed Rakoff, the presiding judge in the lower court case against Bank of America, are of interest. At a recent Association of Certified Fraud Examiners conference, he told attendees that prosecutors are falling short in pursuing fraud cases. "I am regretfully increasingly convinced that the federal government and the federal system of justice has somewhat retrogressed over the past couple of decades in its prosecution of fraud," Rakoff said, "or at least in its prosecution of fraud when it's perpetrated by people at the highest levels of the financial establishment." Rakoff also noted that the courts have made it more difficult to prosecute fraud cases, "imposing impediments to actions against fraud that are nowhere to be found in the language of the anti-fraud statutes themselves."
What do you think? Please give your views in the Comments section.