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Why the Law Failed to Punish Wrongdoers in the Financial Crisis

Noah Feldman is a Bloomberg View columnist. He is a professor of constitutional and international law at Harvard University and was a clerk to U.S. Supreme Court Justice David Souter. His books include “Cool War: The Future of Global Competition” and “Divided by God: America’s Church-State Problem -- and What We Should Do About It.”
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Historians of the future will want to know why almost no one went to jail in connection with the collapse of mortgage-backed securities that triggered the 2007-8 financial crisis. Monday’s appeals court decision reversing a $1.2 billion fraud judgment against Bank of America will be an important part of the answer. To put it bluntly, the law failed -- because the law as it existed didn’t properly anticipate or cover the events that occurred.

The decision, by the U.S. Court of Appeals for the Second Circuit, was the result of an appeal by Bank of America from a judgment by federal district court Judge Jed Rakoff, the most outspoken judicial critic of how the legal system responded to the crisis.

Technically, the judgment against Bank of America was civil, not criminal -- but it implicated the criminal fraud laws. The government brought the case under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, known as Firrea. The law, passed in the wake of the savings and loan crisis, allows the government to collect civil penalties if a defendant has violated the federal mail fraud and wire fraud statutes in a way that affects a federally insured financial institution.

In other words, to award damages under Firrea, the court has to find that a defendant violated federal criminal fraud statutes.

The evidence presented to Judge Rakoff related to a subprime loan program with the almost-too-poetic name Hustle, which was operated by Countrywide Home Loans, owned by Bank of America.

When Countrywide sold Hustle mortgages to Fannie Mae and Freddie Mac, it contractually promised those government entities that the mortgages would be investment quality. Then, according to the government, countrywide sold Fannie Mae and Freddie Mac mortgages that it knew were below investment grade.

The government brought suit against Countrywide and Bank of America. For good measure, it added countrywide executive Susan Mairone as a defendant.

In its closing argument before the District Court, the government summarized its position with a simplicity worthy of the film version of a Michael Lewis book: “This case … comes down to a few simple facts,” said the government. “First, the Hustle loans were bad. Second, the defendants knew the Hustle loans were bad. And third, the defendants passed the Hustle loans off as good loans anyway to cheat Fannie and Freddie out of money.”

 Sounds like fraud, doesn’t it? To a layman, the answer would be yes. And Judge Rakoff agreed.

The Second Circuit thought the answer was more complicated. The government presented evidence to show that Countrywide knew that the loans were below grade when it sold them. But it didn’t provide any evidence to show that, when it made the original sales contracts, Countrywide intended to sell the government below-grade mortgages.

That distinction lay at the heart of the opinion by the three-judge appellate panel. The court held unanimously that, to prove fraud, you need to show that the fraudster knowingly and intentionally meant to defraud the other party when it made the contract in the first place.

The court’s reason lay in the common-law origins of the fraud crime. Traditionally, you couldn’t prove the crime of fraud if your only evidence was that the defendant breached a promise made in a contract. Otherwise, every time someone failed to fulfill the terms of the contract, he or she would be potentially criminally liable. After all, every contract is a promise -- so every knowing breach of contract involves a knowing violation of a promise.

The common law as interpreted today actually favors the option of breaching a contract when circumstances have changed -- so long as you’re willing to pay damages. Modern law and economics analysis calls this the theory of “efficient breach”: by paying damages, you leave everyone better off than they would be if the inefficient contract were fulfilled.

To differentiate efficient breach of contract from fraud, the court held, you need the added element that the fraudster intended from the start not to fulfill the contract. On this view, Countrywide and Mairone couldn’t be held liable, because there was no proof that they intended to deliver below-grade mortgages when they made their initial contractual promise.

Right or wrong, the court’s decision says a lot about why there have been almost no successful criminal prosecutions in conjunction with the mortgage crisis. Sure, it might be possible to identify individual mortgage applicants who lied in their application documents, or mortgage brokers who encouraged or tolerated those lies. And technically, those lies might be the basis for fraud charges.

But such charges would reach only the smallest of the small fish. The really important fraud-related stage of the systemic breakdown was when these bad mortgages, made on the basis of incomplete or false information, were packaged into securities. But that packaging wasn’t done with fraudulent intent – just a kind of negligent failure to check on the underlying value. Even willful blindness doesn’t usually add up to fraud, legally speaking.

Similarly, most of what followed, including the varied and many real and synthetic financial products that were created based on these underlying mortgages, involved contracts made by people who had no intent to defraud.

The law is no better than what it’s able to anticipate. And the simple fact is that, just as the markets didn’t foresee the risks of mistakenly assuming the true value of underlying mortgages, so the law wasn’t designed to punish and disincentivize systemic failure.

It’s easy to say that the legal system is stacked in favor of corporate fat cats, and in many ways that can be true. But it’s also important to remember that law is a system of rules that must be set in advance to have the necessary effect. The challenge now should be to make new laws to make sure all this doesn’t happen again.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Feldman at nfeldman7@bloomberg.net

To contact the editor responsible for this story:
Philip Gray at philipgray@bloomberg.net