The Pitfalls and Prospects of Bank Prosecutions

The savings and loan (S&L) crisis of the 1980s and 1990s was one of the worst financial disasters in United States history ' up to that date. Over 550 savings and loan institutions failed between 1980 and 1988 alone, with total failures ultimately costing $160 billion to resolve. The “S&L debacle” resulted in the well-publicized fraud prosecution of Charles Keating of the American Continental Corporation and the Lincoln Savings and Loan Association, among many others. It also led to the 1989 enactment of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA).

The FIRREA legislation provides that the FDIC, when it takes over a failed bank, assumes the legal claims that the failed bank held, including claims for mismanagement by the bank's former officers or directors. While FIRREA requires gross negligence by an officer as the standard of liability, it also allows directors and officers to be held personally liable under a lower standard of conduct, such as simple negligence, where state law employs this standard. Atherton v. FDIC, 519 U.S. 213, 216 (1997).

Using this authority, the FDIC has brought civil enforcement actions stemming from the recent financial crisis. Among the most notable is the action against executives of IndyMac Bancorp for $300 million in damages. In its massive 300-page complaint, the FDIC brought 68 separate negligence and breach of duty claims against former officers at IndyMac's Homebuilder Division.

The Securities and Exchange Commission (SEC) is also investigating subprime mortgage banking. It reached a settlement against three former officers of Countrywide Financial, including Countrywide's founder and former CEO Angelo Mozilo for the alleged: 1) failure to disclose Countrywide's significant credit risk; 2) misrepresentation of the quality of Countrywide's loan portfolio; and 3) defendant Mozilo's illegal insider trading of Countrywide stock. The settlement included the largest financial penalty ever paid by a senior executive of a public company in an SEC settlement with Mozilo agreeing to pay a $22.5 million penalty, and to disgorge $45 million, among other sanctions. Recently, it was reported that the federal criminal investigation against the former CEO of Countrywide Financial has been closed after two years of inquiry. N.Y. Times, Feb. 19, 2011.

The Obstacles to Criminal Prosecutions

Despite the serious and extensive allegations set forth in the IndyMac and Countrywide civil enforcement actions, criminal prosecutions, especially against bank officers or directors, have not been initiated in the majority of bank failures. One readily apparent reason is that civil actions brought by the FDIC and the SEC have a lower burden of proof than the “beyond a reasonable doubt” criminal standard. The federal bank fraud statute requires intent to knowingly execute a scheme or artifice to defraud a financial institution, or to obtain the money or assets of a financial institution for a conviction. 18 U.S.C. ' 1344. Similarly, a showing of bank embezzlement and “willful misapplication” of bank funds by bank employees requires that the funds be “disbursed from the bank under a false pretense designed to deceive bank officials.” 18 U.S.C A. 656; United States v. Wolfswinkel, 44 F.3d 782, 786 (9th Cir. 1995). Thus, proof that may be sufficient for civil enforcement actions is not enough for criminal cases.

A more serious hurdle is the complex and volatile economic conditions that affected the overall housing market. The inability to predict the sudden downturn in the real estate market could form the basis of a strong defense to claims of intentional misconduct, similar to the unsuccessful prosecution in United States v. Cioffi and Tannin. Indictment, U.S. v. Cioffi, No. 08-CR-00415 (E.D.N.Y. June 18, 2008). There, two former fund managers of Bear Stearns were acquitted of fraud charges for encouraging investment in hedge funds heavily composed of subprime mortgage investments. According to the government's theory, the Bear Stearns managers believed the subprime market was about to collapse, at the same time the managers were advising investors to continue investing in the funds for their own profit. A defense theme, reflected in the fund managers' e-mails, was that the managers' advice was not fraudulent because the managers were conflicted about the state of the market. Further, investors lost money when lenders stopped extending credit, causing the collapse of the subprime market. Thus, without some component of personal profit or intentional misrepresentation by an officer or board member, a large upsurge in criminal cases from the bank failures remains problematic.

While the factors that led to the dramatic market conditions may be a hurdle to bringing prosecutions, recent sentencing decisions regarding mortgage fraud reflect that market conditions will not affect the loss calculation for sentencing for those prosecutions that are brought. In U.S. v. Turk, the Second Circuit ruled that the loss calculated for sentencing purposes could not be offset by a decline in real estate values. United States v. Turk, 626 F.3d 743, 751 (2d Cir. 2010). The Turk court explicitly departed from its approach in criminal securities fraud cases, which is that changed market conditions may to be considered in sentencing when calculating the loss caused by an individual's conduct. See, e.g., U.S. v. Rutkoske, 506 F.3d 170, 179 (2d Cir. 2007). A defendant potentially would not be responsible for the portion of loss in a security attributable to market decline. Id. In a strongly worded opinion, the Turk decision, however, emphasized that “loans” and “stocks” are different because stock ownership carries “the assumption of upside benefit and downside risk, while a loan is merely the exchange of money for a promise to repay, with no assumption of upside benefit.” U.S. v. Turk, 626 F.3d at 751. Thus, the loss for the mortgage loan principal will not be offset by a decrease in the value of the property caused by market factors that may have precipitated the bank failure.

Bank Failures and Attorney-Client Privilege

The announcement of more bank failures and investigations requires a careful consideration of the status of the attorney-client privilege once the FDIC becomes the failed bank's receiver or transfers the failed bank's assets. For closed banks, directors and officers may not be able to invoke the attorney-client privilege for discussions related to problematic loans or oversight at a failed bank. In Commodity Futures Trading Commission v. Weintraub, 471 U.S. 343, 349, 354 (1985), the Supreme Court ruled that a bankruptcy trustee, rather than a debtor corporation's directors, holds the corporation's attorney-client privilege. Thus, it is the trustee and not the directors or officers of the debtor corporation that holds the power to waive the attorney-client privilege with respect to communications, including pre-bankruptcy, between the corporation and its counsel. This principle has been extended to the waiver of the attorney-client privilege in criminal prosecutions as well. U.S. v. Shapiro, No. 06-CR-357, 2007 WL 2914218, at *6 (S.D.N.Y. Oct. 1, 2007) (citing Weintraub for the proposition that a company's receiver has the authority to waive the attorney-client privilege for communications made to the company's counsel by a former executive).

When the FDIC has taken over a failed bank, courts have analogized the FDIC to the bankruptcy trustee in Weintraub. Accordingly, the FDIC becomes the holder of the privilege and may waive the attorney-client privilege on behalf of the failed entity. FDIC v. Cherry, Bekaert & Holland, 1989 U.S. Dist. LEXIS 16846, at *8-9 (M.D. Fla. 1989). Similarly, “when control of a corporation passes to new management, the authority to assert and waive the corporation's attorney-client privilege passes as well.” Commodity Futures Trading Commission v. Weintraub, 471 U.S. at 349. If control of a failed bank passes to a new financial institution, it would hold the attorney-client privilege of the failed bank. Further, the new holder of the attorney-client privilege may seek to disqualify the bank's former counsel from representing parties in litigation against it going forward. See FDIC v. Cherry, 1989 U.S. Dist. LEXIS 15872, at *14; FDIC v. Ellis, 1985 U.S. Dist. LEXIS 23861, at **6-7.

However, in at least two cases, the FDIC has been treated instead as a liquidator or an asset purchaser, rather than as a bankruptcy-type trustee or receiver, and has not been allowed to assert the attorney-client privilege of the failed bank. FDIC v. McAtee, 1988 U.S. Dist. LEXIS 15872, at *5-6 (D. Kan. 1988); FDIC v. Amundson, et al., 682 F. Supp. 981, 986-987 (D. Minn. 1988). McAtee reasoned that the FDIC should not obtain the attorney-client privilege because the bank no longer existed, and a simple transfer of assets from one entity to another does not normally transfer the attorney-client privilege. McAtee, 1988 U.S. Dist. LEXIS 15872 at *5. Under this approach, since the failed bank no longer exists, its attorney-client privilege will not pass with the sale of its assets either to the FDIC or to another financial institution. Thus, evaluating who holds the attorney-client privilege of a failed bank and how the information may be divulged is an important component of a defense strategy.

Conclusion

Although the “traditional” prosecutions of bank officers similar to those of the 1990s may not emerge, that does not spell the end for investigations arising out of the bank failures. The SEC and other agencies continue to investigate the role of credit rating agencies and banks in the subprime lending debacle. Possible misrepresentations in public offerings of mortgage backed securities remain an area of investigative scrutiny. Further, recent news articles have reported on new inquiries by the DOJ, SEC, and regulators on practices in mortgage securitization. Yet, the difficulty and uncertainty of separating merely bad business decisions and the impact of unpredictable economic market factors from intentional bad conduct will likely result in greater emphasis on civil enforcement actions against officers and directors, such as the recently reported actions against Washington Mutual, rather than criminal prosecutions.

Jonathan S. Feld ([email protected]), a member of this newsletter's Board of Editors, is a partner at Katten Muchin Rosenman LLP, where he focuses on civil and criminal enforcement matters. Blake C. Goebel is an associate in the firm's Litigation Department.

The past two years have seen the largest number of bank failures in recent U.S. history, with 157 in 2010 alone, as a result of the collapse of the housing and subprime mortgage markets (as of Dec. 22, 2010, FDIC Failed Bank List, http://www.fdic.gov/bank/individual/failed/banklist.html). These failures led to the Federal Deposit Insurance Corporation's (FDIC) November 2010 announcement of 50 criminal investigations into the activities of former executives, directors and employees of failed banks. Jean Eaglesham, U.S. Sets Fifty Bank Probes, Wall St. J., Nov. 17, 2010. The DOJ Criminal Division also has announced the creation of its Money Laundering and Bank Integrity Unit, which reiterated that financial crimes, and financial institution matters, remain top priorities.

Notwithstanding these announcements, other considerations suggest that a dramatic increase in criminal prosecutions of financial institution directors and officers is not likely.

Banking Prosecutions and FIRREA

The savings and loan (S&L) crisis of the 1980s and 1990s was one of the worst financial disasters in United States history ' up to that date. Over 550 savings and loan institutions failed between 1980 and 1988 alone, with total failures ultimately costing $160 billion to resolve. The “S&L debacle” resulted in the well-publicized fraud prosecution of Charles Keating of the American Continental Corporation and the Lincoln Savings and Loan Association, among many others. It also led to the 1989 enactment of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA).

The FIRREA legislation provides that the FDIC, when it takes over a failed bank, assumes the legal claims that the failed bank held, including claims for mismanagement by the bank's former officers or directors. While FIRREA requires gross negligence by an officer as the standard of liability, it also allows directors and officers to be held personally liable under a lower standard of conduct, such as simple negligence, where state law employs this standard. Atherton v. FDIC , 519 U.S. 213, 216 (1997).

Using this authority, the FDIC has brought civil enforcement actions stemming from the recent financial crisis. Among the most notable is the action against executives of IndyMac Bancorp for $300 million in damages. In its massive 300-page complaint, the FDIC brought 68 separate negligence and breach of duty claims against former officers at IndyMac's Homebuilder Division.

The Securities and Exchange Commission (SEC) is also investigating subprime mortgage banking. It reached a settlement against three former officers of Countrywide Financial, including Countrywide's founder and former CEO Angelo Mozilo for the alleged: 1) failure to disclose Countrywide's significant credit risk; 2) misrepresentation of the quality of Countrywide's loan portfolio; and 3) defendant Mozilo's illegal insider trading of Countrywide stock. The settlement included the largest financial penalty ever paid by a senior executive of a public company in an SEC settlement with Mozilo agreeing to pay a $22.5 million penalty, and to disgorge $45 million, among other sanctions. Recently, it was reported that the federal criminal investigation against the former CEO of Countrywide Financial has been closed after two years of inquiry. N.Y. Times, Feb. 19, 2011.

The Obstacles to Criminal Prosecutions

Despite the serious and extensive allegations set forth in the IndyMac and Countrywide civil enforcement actions, criminal prosecutions, especially against bank officers or directors, have not been initiated in the majority of bank failures. One readily apparent reason is that civil actions brought by the FDIC and the SEC have a lower burden of proof than the “beyond a reasonable doubt” criminal standard. The federal bank fraud statute requires intent to knowingly execute a scheme or artifice to defraud a financial institution, or to obtain the money or assets of a financial institution for a conviction. 18 U.S.C. ' 1344. Similarly, a showing of bank embezzlement and “willful misapplication” of bank funds by bank employees requires that the funds be “disbursed from the bank under a false pretense designed to deceive bank officials.” 18 U.S.C A. 656; United States v. Wolfswinkel , 44 F.3d 782, 786 (9th Cir. 1995). Thus, proof that may be sufficient for civil enforcement actions is not enough for criminal cases.

A more serious hurdle is the complex and volatile economic conditions that affected the overall housing market. The inability to predict the sudden downturn in the real estate market could form the basis of a strong defense to claims of intentional misconduct, similar to the unsuccessful prosecution in United States v. Cioffi and Tannin. Indictment, U.S. v. Cioffi, No. 08-CR-00415 (E.D.N.Y. June 18, 2008). There, two former fund managers of Bear Stearns were acquitted of fraud charges for encouraging investment in hedge funds heavily composed of subprime mortgage investments. According to the government's theory, the Bear Stearns managers believed the subprime market was about to collapse, at the same time the managers were advising investors to continue investing in the funds for their own profit. A defense theme, reflected in the fund managers' e-mails, was that the managers' advice was not fraudulent because the managers were conflicted about the state of the market. Further, investors lost money when lenders stopped extending credit, causing the collapse of the subprime market. Thus, without some component of personal profit or intentional misrepresentation by an officer or board member, a large upsurge in criminal cases from the bank failures remains problematic.

While the factors that led to the dramatic market conditions may be a hurdle to bringing prosecutions, recent sentencing decisions regarding mortgage fraud reflect that market conditions will not affect the loss calculation for sentencing for those prosecutions that are brought. In U.S. v. Turk, the Second Circuit ruled that the loss calculated for sentencing purposes could not be offset by a decline in real estate values. United States v. Turk , 626 F.3d 743, 751 (2d Cir. 2010). The Turk court explicitly departed from its approach in criminal securities fraud cases, which is that changed market conditions may to be considered in sentencing when calculating the loss caused by an individual's conduct. See, e.g., U.S. v. Rutkoske , 506 F.3d 170, 179 (2d Cir. 2007). A defendant potentially would not be responsible for the portion of loss in a security attributable to market decline. Id. In a strongly worded opinion, the Turk decision, however, emphasized that “loans” and “stocks” are different because stock ownership carries “the assumption of upside benefit and downside risk, while a loan is merely the exchange of money for a promise to repay, with no assumption of upside benefit.” U.S. v. Turk , 626 F.3d at 751. Thus, the loss for the mortgage loan principal will not be offset by a decrease in the value of the property caused by market factors that may have precipitated the bank failure.

Bank Failures and Attorney-Client Privilege

The announcement of more bank failures and investigations requires a careful consideration of the status of the attorney-client privilege once the FDIC becomes the failed bank's receiver or transfers the failed bank's assets. For closed banks, directors and officers may not be able to invoke the attorney-client privilege for discussions related to problematic loans or oversight at a failed bank. In Commodity Futures Trading Commission v. Weintraub , 471 U.S. 343, 349, 354 (1985), the Supreme Court ruled that a bankruptcy trustee, rather than a debtor corporation's directors, holds the corporation's attorney-client privilege. Thus, it is the trustee and not the directors or officers of the debtor corporation that holds the power to waive the attorney-client privilege with respect to communications, including pre-bankruptcy, between the corporation and its counsel. This principle has been extended to the waiver of the attorney-client privilege in criminal prosecutions as well. U.S. v. Shapiro, No. 06-CR-357, 2007 WL 2914218, at *6 (S.D.N.Y. Oct. 1, 2007) (citing Weintraub for the proposition that a company's receiver has the authority to waive the attorney-client privilege for communications made to the company's counsel by a former executive).

When the FDIC has taken over a failed bank, courts have analogized the FDIC to the bankruptcy trustee in Weintraub. Accordingly, the FDIC becomes the holder of the privilege and may waive the attorney-client privilege on behalf of the failed entity. FDIC v. Cherry, Bekaert & Holland, 1989 U.S. Dist. LEXIS 16846, at *8-9 (M.D. Fla. 1989). Similarly, “when control of a corporation passes to new management, the authority to assert and waive the corporation's attorney-client privilege passes as well.” Commodity Futures Trading Commission v. Weintraub , 471 U.S. at 349. If control of a failed bank passes to a new financial institution, it would hold the attorney-client privilege of the failed bank. Further, the new holder of the attorney-client privilege may seek to disqualify the bank's former counsel from representing parties in litigation against it going forward. See FDIC v. Cherry, 1989 U.S. Dist. LEXIS 15872, at *14; FDIC v. Ellis, 1985 U.S. Dist. LEXIS 23861, at **6-7.

However, in at least two cases, the FDIC has been treated instead as a liquidator or an asset purchaser, rather than as a bankruptcy-type trustee or receiver, and has not been allowed to assert the attorney-client privilege of the failed bank. FDIC v. McAtee, 1988 U.S. Dist. LEXIS 15872, at *5-6 (D. Kan. 1988); FDIC v. Amundson, et al., 682 F. Supp. 981, 986-987 (D. Minn. 1988). McAtee reasoned that the FDIC should not obtain the attorney-client privilege because the bank no longer existed, and a simple transfer of assets from one entity to another does not normally transfer the attorney-client privilege. McAtee, 1988 U.S. Dist. LEXIS 15872 at *5. Under this approach, since the failed bank no longer exists, its attorney-client privilege will not pass with the sale of its assets either to the FDIC or to another financial institution. Thus, evaluating who holds the attorney-client privilege of a failed bank and how the information may be divulged is an important component of a defense strategy.

Conclusion

Although the “traditional” prosecutions of bank officers similar to those of the 1990s may not emerge, that does not spell the end for investigations arising out of the bank failures. The SEC and other agencies continue to investigate the role of credit rating agencies and banks in the subprime lending debacle. Possible misrepresentations in public offerings of mortgage backed securities remain an area of investigative scrutiny. Further, recent news articles have reported on new inquiries by the DOJ, SEC, and regulators on practices in mortgage securitization. Yet, the difficulty and uncertainty of separating merely bad business decisions and the impact of unpredictable economic market factors from intentional bad conduct will likely result in greater emphasis on civil enforcement actions against officers and directors, such as the recently reported actions against Washington Mutual, rather than criminal prosecutions.

Jonathan S. Feld ([email protected]), a member of this newsletter's Board of Editors, is a partner at Katten Muchin Rosenman LLP, where he focuses on civil and criminal enforcement matters. Blake C. Goebel is an associate in the firm's Litigation Department.