(Article from Securities Law Alert, May 2016)
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On May 23, 2016, the Second Circuit considered the question of when a breach of contract can “also support a claim for fraud[.]” United States v. Countrywide Home Loans, 2016 WL 2956743 (2016) (Wesley, J.). The Second Circuit held that “where allegedly fraudulent misrepresentations are promises made in a contract, a party claiming fraud must prove fraudulent intent at the time of contract execution; evidence of a subsequent, willful breach cannot sustain the claim.”
Based on these principles, the Second Circuit reversed a district court decision imposing civil penalties in excess of $1.2 billion on Countrywide Home Loans, Countrywide Bank, and Bank of America (collectively, “Countrywide”) for allegedly violating federal mail and wire fraud statutes by selling low-quality mortgages to the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) in breach of the terms of Countrywide’s contracts with Fannie Mae and Freddie Mac. The Second Circuit held the Government “failed to meet its burden” to prove a “scheme to defraud” because it “presented no proof at trial that any [loan] quality guarantee was made with fraudulent intent at the time of contract execution.”
Background
Countrywide entered into contracts pursuant to which it agreed to sell mortgages of a certain quality level to Fannie Mae and Freddie Mac. According to the Government, Countrywide instead sold subpar loans under these contracts and allegedly intended to defraud Fannie Mae and Freddie Mac. The Government brought suit under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), which establishes civil penalties for violating or conspiring to violate the federal mail and wire fraud statutes in a manner that affects a federally insured financial institution.
During trial before a jury, “[t]he Government adduced no evidence and made no claim that Countrywide had fraudulent intent during the negotiation or execution” of the contracts at issue. The jury returned a verdict in favor of the Government. The district court subsequently imposed civil penalties of $1.27 billion against Countrywide, as well as $1 million in penalties against the COO of the Countrywide division that originated the loans in question.
The district court “concluded that the federal fraud statutes do not incorporate the common-law principle that actions brought in fraud cannot be premised solely upon evidence of contractual breaches —or, in the alternative, that the scheme alleged here fell into one of the recognized exceptions to this principle for actions premised on contractual breaches that nonetheless can sustain an action for fraud.”
Defendants appealed, arguing “that the conduct alleged and proven by the Government [was], at most, a series of intentional breaches of contract.”
Second Circuit Holds a Contractual Breach Can Only Support a Fraud Claim If the Defendant Had No Intent to Perform at the Time of Contract Execution
The Second Circuit began its analysis with the text of the federal mail and wire fraud statutes, and found the “gravamen” of these offenses is “a scheme to defraud.” Under Supreme Court precedent, the court explained that “statutes employing common-law terms[,]” such as the phrase “scheme to defraud,” “are presumed, ‘unless the statute otherwise dictates, . . . to incorporate the established meaning of” those terms.’” Id. (quoting Nationwide Mut. Ins. v. Darden, 503 U.S. 318 (1992)).
The Second Circuit agreed with defendants that “the common law does not permit a fraud claim based solely on a contractual breach.” However, the court also recognized that “a contractual relationship between the parties does not wholly remove a party’s conduct from the scope of fraud.” Rather, fraud in the context of a contractual relationship “turns on . . . when the representations were made and the intent of the promisor at that time.” The Second Circuit held “a contractual promise can only support a claim for fraud upon proof of fraudulent intent not to perform the promise at the time of contract execution.” The court emphasized that without proof of contemporaneous fraudulent intent, “a subsequent breach of that promise—even where willful and intentional—cannot in itself transform the promise into a fraud.”
The Second Circuit “deem[ed] the common law’s contemporaneous fraudulent intent principle incorporated into the federal mail and wire fraud statutes.” The court reasoned that “[w]hat gives a scheme its fraudulent nature is” whether the scheme was “designed to induce reliance on a known misrepresentation.” The Second Circuit held that “[o]nly if a contractual promise is made with no intent ever to perform it can the promise itself constitute a fraudulent misrepresentation” for purposes of the mail and wire fraud statutes.
Second Circuit Holds the Government Failed to Prove Fraud as a Matter of Law
Applying these principles to the case before it, the Second Circuit held the Government’s evidence insufficient as a matter of law to prove fraud. The court noted that “[t]he Government did not prove—in fact, did not attempt to prove—that at the time the contracts were executed Countrywide never intended to perform its promise of investment quality.” The court further observed that the Government did not “prove that Countrywide made any later misrepresentations—i.e., ones not contained in the contracts — as to which fraudulent intent could be found.” The court explained that “[t]he only representations alleged to be false were guarantees of future quality made in contracts as to which no proof of contemporaneous fraudulent intent was introduced at trial.”
Because “the Government’s proof show[ed] only post-contractual intentional breach of the [contractual] representations,” the Second Circuit held “the jury had no legally sufficient basis on which to conclude that the misrepresentations alleged were made with contemporaneous fraudulent intent” as required under the federal mail and wire fraud statutes. The Second Circuit therefore reversed the district court’s judgment.