Potential Criminal Liability for Subprime Lending Practices

What is ABC Bank's exposure? Could ABC Bank be criminally liable? Could Larry? Here are some of the enforcement statutes prosecutors and regulators could use to pursue ABC Bank:

Wire Fraud/Mail Fraud

(18 U.S.C. ” 1341, 1343.) Federal prosecutors may take the position that ABC Bank committed fraud, or conspired to do so, when it sold mortgages based on inflated appraisals to the MBS trusts that purchased the loans for the benefit of purchasers of MBSs. To prove its case, prosecutors would need to identify specific, allegedly fraudulent statements by ABC Bank and demonstrate that purchasers relied on those statements when purchasing a particular MBS. In its defense to prosecution on this theory, ABC Bank would need to master all the evidence about the disclosures it made when it sold the mortgages, particularly with respect to valuation. ABC Bank might also argue that its appraisals were reasonable in light of the market conditions at the time. Finally, ABC Bank would likely argue that it never intended to defraud anyone and therefore lacked the necessary scienter for a wire fraud or mail fraud violation.

Securities Fraud

(” 10(b) and 32 of the Securities Exchange Act of 1934.) Because MBSs are securities, ABC Bank may also face criminal prosecution under the 1934 Act. As with wire fraud and mail fraud claims, ABC Bank's disclosures to purchasers would be critical to its defense. Moreover, the adequacy of disclosures made with respect to MBSs issued in 2006 will be measured against the more rigorous standards of SEC Regulation AB (2004), which require sponsors of asset-backed securities, including MBSs, to disclose asset pool information, including delinquency and loss data.

New York's Martin Act

If ABC Bank sold the mortgages in New York, it may have exposure under state law. The Martin Act, N.Y. Gen. Bus. Law ' 353, is especially powerful because it allows the state's Attorney General to establish fraud without proving an intent to defraud or reliance, and its scope is not limited to transactions between a buyer and a seller. ABC Bank could be prosecuted simply by virtue of having sold MBSs on the financial markets in New York State. Other state attorneys general may invoke state securities laws since, like the Martin Act, they may not be subject to some of the limitations imposed by Congress and the Supreme Court with respect to federal securities laws. For example, some state securities laws may provide for longer statutes of limitations, more liberal pleading requirements, or less stringent reliance doctrines, including a greater willingness to apply 'fraud on the market' theories.

Bank Fraud

(18 U.S.C. ' 1344.) This statute prohibits knowingly executing or attempting to execute a scheme or artifice to defraud a financial institution. If the purchasers of ABC Bank's mortgages were also financial institutions, which includes federally chartered and federally insured institutions and their holding companies, ABC Bank may face charges under ' 1344.

The Continuing Financial Crimes Enterprise Act

(18 USC ' 225 (CFCEA)). This statute prohibits organizing, managing, or supervising a continuing financial crimes enterprise, defined as at least four persons acting in concert over a 24-month period to commit a series of specifically enumerated crimes affecting a financial institution. The enumerated statutes include mail fraud, wire fraud, misapplication by bank officer (18 U.S.C. ' 656), and making a false statement on a federal credit application (18 U.S.C. ' 1014). Potential liability will lie so long as the defendant received $5 million or more in gross receipts from the enterprise over any 24-month period. Thus, if Larry and his staff originated four or more subprime loans over a 24-month period that resulted in gross receipts of $5 million or more, and those loans are found to be fraudulent, both Larry and ABC bank could be liable for violating the CFCEA.

Most of the prosecutions under the bank statutes that constitute predicate violations under the CFCEA involved bank officers that engaged in self-dealing. Prosecution of ABC Bank and its employees would be a novel application of those statutes. This potential enforcement theory could expose Larry Lender and ABC Bank to liability even if neither received a direct pecuniary benefit, and even if the victim did not suffer an actual monetary loss. Notably, a false statement under ' 1014 does not even need to be material. Possible defenses include whether Larry Lender and ABC Bank had the requisite intent to injure or defraud, and whether their actions amount to 'misapplication,' punishable under ' 656, or simple 'maladministration,' which is punishable under neither ' 656 nor the CFCEA.

Conclusion

In light of the complex and opaque nature of the subprime mortgage market, government investigators are probing the valuation and disclosure decisions made by market participants at multiple levels. It is not yet clear what charges prosecutors will assert to prove fraud claims against dishonest subprime market participants. However, given the wide array of prosecutorial tools available, it seems likely that, once these investigations mature, indictments and enforcement actions will follow. All participants in the subprime mortgage industry need to assess their exposure and get control of their documents and e-discovery before the regulators, federal and state prosecutors, and Congress arrive with the next round of examinations and audits, subpoenas and search warrants.

Mark D. Seltzer ([email protected]) and David M. Ryan ([email protected]) are partners in the Government Investigations and White Collar Criminal Defense group of Nixon Peabody LLP. Seltzer is a former federal prosecutor for 13 years both in Miami as an Assistant United States Attorney and in Boston as Director of the New England Bank Fraud Task Force of the U.S. Department of Justice.

ABC Bank is a publicly traded lender specializing in consumer loans to first-time homebuyers in the southeastern United States. For the past three years, ABC Bank has posted record revenues from its operations in central Florida's hot real estate market. In 2005, ABC Bank decided to focus its efforts on new-loan origination. The bank's strategy was to originate consumer real-estate mortgages, quickly package them together and sell them on the financial markets. ABC Bank then used the proceeds to originate new loans. Most of the bank's employees spent their time originating new mortgages. Most other administrative functions, including appraisals, were handled by outside vendors.

Larry Lender heads ABC Bank's loan department in Midcity, FL. Larry has lived in Midcity all of his life and knows the real-estate market well. In 2006, Larry began noticing loans coming through for his approval based on appraisals that he suspected, even in the context of a hot real-estate market, were unrealistically high. Larry also knew, however, that ABC Bank would hold these mortgages only for a few weeks before packaging them into mortgage-backed securities ('MBSs') and selling them on the financial markets through an investment bank. The investment bank often repackaged some of the MBS into collateralized debt obligations ('CDOs'), which are debt securities backed by portfolios of other debt securities. Larry therefore viewed the risks to ABC Bank as minimal and approved the loans. He had many discussions with the bank's loan department heads in other cities in Florida, and understood that they were doing the same thing, as was most of ABC Bank's competition. Larry received a bonus at the end of the year based largely upon his loan volume. Since 2006, Larry's annual bonuses have dwarfed his salary.

In 2008, Midcity's real-estate market began declining steeply, and Larry learned that an unexpectedly large percentage of the loans he had originated were in default. He also learned from his supervisors that ABC Bank was having trouble raising new funds to lend because it could no longer turn its existing mortgages into MBSs and sell them on the financial markets. Shortly thereafter, ABC Bank received a broad SEC subpoena and, subsequently, a grand jury subpoena concerning its lending practices.

What is ABC Bank's exposure? Could ABC Bank be criminally liable? Could Larry? Here are some of the enforcement statutes prosecutors and regulators could use to pursue ABC Bank:

Wire Fraud/Mail Fraud

(18 U.S.C. ” 1341, 1343.) Federal prosecutors may take the position that ABC Bank committed fraud, or conspired to do so, when it sold mortgages based on inflated appraisals to the MBS trusts that purchased the loans for the benefit of purchasers of MBSs. To prove its case, prosecutors would need to identify specific, allegedly fraudulent statements by ABC Bank and demonstrate that purchasers relied on those statements when purchasing a particular MBS. In its defense to prosecution on this theory, ABC Bank would need to master all the evidence about the disclosures it made when it sold the mortgages, particularly with respect to valuation. ABC Bank might also argue that its appraisals were reasonable in light of the market conditions at the time. Finally, ABC Bank would likely argue that it never intended to defraud anyone and therefore lacked the necessary scienter for a wire fraud or mail fraud violation.

Securities Fraud

(” 10(b) and 32 of the Securities Exchange Act of 1934.) Because MBSs are securities, ABC Bank may also face criminal prosecution under the 1934 Act. As with wire fraud and mail fraud claims, ABC Bank's disclosures to purchasers would be critical to its defense. Moreover, the adequacy of disclosures made with respect to MBSs issued in 2006 will be measured against the more rigorous standards of SEC Regulation AB (2004), which require sponsors of asset-backed securities, including MBSs, to disclose asset pool information, including delinquency and loss data.

New York's Martin Act

If ABC Bank sold the mortgages in New York, it may have exposure under state law. The Martin Act, N.Y. Gen. Bus. Law ' 353, is especially powerful because it allows the state's Attorney General to establish fraud without proving an intent to defraud or reliance, and its scope is not limited to transactions between a buyer and a seller. ABC Bank could be prosecuted simply by virtue of having sold MBSs on the financial markets in New York State. Other state attorneys general may invoke state securities laws since, like the Martin Act, they may not be subject to some of the limitations imposed by Congress and the Supreme Court with respect to federal securities laws. For example, some state securities laws may provide for longer statutes of limitations, more liberal pleading requirements, or less stringent reliance doctrines, including a greater willingness to apply 'fraud on the market' theories.

Bank Fraud

(18 U.S.C. ' 1344.) This statute prohibits knowingly executing or attempting to execute a scheme or artifice to defraud a financial institution. If the purchasers of ABC Bank's mortgages were also financial institutions, which includes federally chartered and federally insured institutions and their holding companies, ABC Bank may face charges under ' 1344.

The Continuing Financial Crimes Enterprise Act

(18 USC ' 225 (CFCEA)). This statute prohibits organizing, managing, or supervising a continuing financial crimes enterprise, defined as at least four persons acting in concert over a 24-month period to commit a series of specifically enumerated crimes affecting a financial institution. The enumerated statutes include mail fraud, wire fraud, misapplication by bank officer (18 U.S.C. ' 656), and making a false statement on a federal credit application (18 U.S.C. ' 1014). Potential liability will lie so long as the defendant received $5 million or more in gross receipts from the enterprise over any 24-month period. Thus, if Larry and his staff originated four or more subprime loans over a 24-month period that resulted in gross receipts of $5 million or more, and those loans are found to be fraudulent, both Larry and ABC bank could be liable for violating the CFCEA.

Most of the prosecutions under the bank statutes that constitute predicate violations under the CFCEA involved bank officers that engaged in self-dealing. Prosecution of ABC Bank and its employees would be a novel application of those statutes. This potential enforcement theory could expose Larry Lender and ABC Bank to liability even if neither received a direct pecuniary benefit, and even if the victim did not suffer an actual monetary loss. Notably, a false statement under ' 1014 does not even need to be material. Possible defenses include whether Larry Lender and ABC Bank had the requisite intent to injure or defraud, and whether their actions amount to 'misapplication,' punishable under ' 656, or simple 'maladministration,' which is punishable under neither ' 656 nor the CFCEA.

Conclusion

In light of the complex and opaque nature of the subprime mortgage market, government investigators are probing the valuation and disclosure decisions made by market participants at multiple levels. It is not yet clear what charges prosecutors will assert to prove fraud claims against dishonest subprime market participants. However, given the wide array of prosecutorial tools available, it seems likely that, once these investigations mature, indictments and enforcement actions will follow. All participants in the subprime mortgage industry need to assess their exposure and get control of their documents and e-discovery before the regulators, federal and state prosecutors, and Congress arrive with the next round of examinations and audits, subpoenas and search warrants.

Mark D. Seltzer ([email protected]) and David M. Ryan ([email protected]) are partners in the Government Investigations and White Collar Criminal Defense group of Nixon Peabody LLP. Seltzer is a former federal prosecutor for 13 years both in Miami as an Assistant United States Attorney and in Boston as Director of the New England Bank Fraud Task Force of the U.S. Department of Justice.