CLIENT ALERT. Banking on Fraud: The Expanding Use of the False Claims Act To Target Financial Services Institutions

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1 CLIENT ALERT April 5, 2012 Banking on Fraud: The Expanding Use of the False Claims Act To Target Financial Services Institutions The federal False Claims Act (FCA), 1 a Civil War era federal statute intended to punish the submission of false claims to the United States, has traditionally been employed against participants in the most prominent federal programs, such as health care providers and federal contractors (including defense contractors, construction companies and other federal contractors). In the aftermath of the recent financial crisis, however, federal prosecutors and private whistleblowers utilizing the FCA s powerful damages and penalty provisions (including treble damages, up to $11,000 per claim and attorneys fees) have recently turned their focus to banks, mortgage companies and others in the financial industry. 2 Indeed, many recent FCA lawsuits have been directed at major national lending institutions related to their alleged role in the housing market downturn, predatory lending and even student lending programs. 3 An increasingly aggressive and well-funded whistleblower plaintiffs bar working with disgruntled bank employees and other insiders knowledgeable about financial industry practices has driven the recent influx of FCA cases. 4 1 See 31 USC 3729, et seq. Generally, the False Claims Act imposes liability on persons or organizations that knowingly submit, or cause to be submitted, false claims for government funds, or which uses false statements or records to avoid or conceal an obligation to pay the government. Id. Note that most states have similar statutes as well. 2 Id. 3 See Sam Garcia, Wave of Whistleblower Actions Ahead for Mortgage Firms, Mortgage Daily, March 14, 2012, available at 4 One recent decision suggests that at least some plaintiffs counsel have located willing whistleblowers by searching employment discrimination case filings. See, e.g., Daniel Fisher, Judge Slaps Motley Rice with Fees Over Frivolous Lawsuit, Forbes.com, March 28, 2012, available at In an unusually harsh opinion dismissing a FCA claim against ITT Educational Services, Inc., and sanctioning whistleblowers counsel for nearly $400,000, a federal judge in Indiana commented on the sometimes unscrupulous methods used to identify whistleblowers and seek to extract hefty FCA settlements from regulated companies: The Court easily finds that it was brought for an improper purpose presumably, to extract a large settlement from ITT, which would otherwise be forced to incur massive legal fees. On this point, the Court simply cannot ignore the genesis of this lawsuit. Matusheski brought this lawsuit after trolling public dockets and using a private investigator to cold-call ex-employees of for-profit educational institutions who had sued their former employer. This is as unethical as it is unseemly. Specifically, Model Rule of Professional Conduct 7.3 prohibits lawyers from soliciting professional employment from a prospective client when a significant motive for the lawyer s

2 As federal and state investigations continue into the causes of the recent financial crisis, financial services firms must now attempt to anticipate and take steps to avoid this burgeoning risk of significant exposure. This Client Alert describes recent cases illustrating whistleblowers increasing use of the FCA against financial services companies. Real Estate Lending The federal government has recently intervened in or settled a number of FCA actions related to the mortgage-lending industry. These actions include claims based on loan origination and foreclosure or loan modification fraud. Loan Origination FCA lawsuits related to loan origination often focus on federal programs which guarantee residential loans. FCA cases related to the origination of mortgage loans have included allegations regarding the following fraudulent acts: Inaccuracies on loan applications, including overstated income or assets, overvalued collateral, or falsifying employment information; Fraudulent property appraisals; The use of straw buyers; The use of false or inflated credit reports; Failure to report sellers concessions, thus improperly inflating the sales price; Claiming an intent to occupy property which is to be used as rental property. For example, on February 12, 2012, the United States Attorney for the Eastern District of New York announced that it had entered into a $1 billion settlement with Bank of America and Countrywide Financial. 5 The Department of Justice (DOJ), intervening in an action initiated by a private whistleblower (called a relator under the FCA), alleged that Bank of America and Countrywide defrauded the Federal Housing Administration (FHA) insurance fund by originating loans which failed to meet FHA underwriting standards. Specifically, DOJ alleged that Bank of America and Countrywide had knowingly engaged in a pattern of originating FHA-insured loans to borrowers Bank of America and Countrywide knew were unqualified under the FHA program. In originating the loans, the lenders had certified to the government that certain due diligence measures had been taken to ensure that borrowers met FHA eligibility criteria, and, as a result of that certification, FHA insured the loans, many of which subsequently doing so is the lawyer s pecuniary gain. At its core, this was an opportunistic and attorney-driven lawsuit. See United States ex rel. Leveski v. ITT Educational Services, Inc. (No.07-cv-TWP) (SD Indiana) (March 26, 2012). 5 Press Release, United States Attorney s Office, Eastern District of New York, $1 Billion to be Paid by the Bank of America to the United States (Feb. 9, 2012),

3 defaulted. The FCA complaint also alleged that Bank of America and Countrywide had engaged in a widespread pattern of falsely inflating home appraisals on FHA-backed loans. 6 Similar allegations led to another FCA settlement, this time a $158 million settlement with CitiMortgage, Inc., announced on February 15, The United States Attorney s Office for the Southern District of New York announced that CitiMortgage had agreed to settle a claim under the FCA, filed by a relator in August 2011, 8 alleging that CitiMortgage failed to comply with HUD and FHA underwriting requirements, originated loans for unreviewed applications which subsequently defaulted almost immediately, and that CitiMortgage filed false HUD-FHA certifications claiming eligibility for FHA mortgage insurance. 9 Less than two weeks later, the United States Attorney s Office for the Southern District of New York announced yet another FCA settlement, this time against Flagstar Bank, F.S.B., based on substantially similar allegations. 10 In recent months, FCA lawsuits have also targeted allegedly illegal fees charged on Veterans Administration-guaranteed loans. JP Morgan Chase recently settled a FCA claim for $45 million which alleged it had hidden illegal fees while refinancing home mortgages guaranteed by the VA on behalf of veterans. 11 In order to finance loans guaranteed by the VA, loan servicers must again agree to certain guidelines restricting certain fees that can be charged. Plaintiff alleged the failure to comply with that certification, by charging improper fees, provided the basis for liability under the FCA. Similar claims remain pending against a number of other lenders. 12 In addition to intervening or settling FCA lawsuits initiated by relators, the United States has also initiated many FCA cases against lenders for fraud in the loan origination process. In May 2011, the United States filed a $1 billion FCA complaint against Deutsche Bank AG and MortgageIT, Inc. alleging that those lenders engaged in filing false certifications of compliance with HUD underwriting procedures. 13 The complaint alleged the lenders certified that 39,000 loans qualified to be insured by HUD. At the time of the complaint, the government alleged that it had paid out more than $386 million dollars in insurance claims related to over 6 See Complaint, United States ex rel. Lagow v. Countrywide Financial Corp. et al., Case No. 1:09-cv (E.D.N.Y. Filed May 13, 2009). 7 Press Release, United States Attorney s Office, Southern District of New York, Manhattan U.S. Attorney Files and Simultaneously Settles Fraud Lawsuit Against CitiMortgage, Inc. for Reckless Mortgage Lending Practices (Feb. 15, 2012), 8 See Jonathan Stempel, Citigroup Whistleblower: I Have No Regrets, Reuters, Feb. 17, 2012, available at 9 See Complaint, United States ex rel. Hunt v. Citigroup, Inc. et al., Case No. 11 Civ (S.D.N.Y. Filed Feb. 14, 2012). 10 Press Release, United States Attorney s Office, Southern District of New York, Manhattan U.S. Attorney Sues Flagstar Bank for Fraudulent Mortgage Lending Practices and Settles for $132.8 Million and Other Concessions (Feb. 24, 2012), 11 See Complaint, United States ex rel. Bibby v. Wells Fargo Bank, N.A. et al., Case No. 1:06-CV-0547 (N.D. Ga. Filed June 28, 2011). 12 See JPMorgan Chase Settles Whistleblower Lawsuit Alleging Fraud in Veteran Loans for $45 Million, MarketWatch, March 13, 2012, available at 13 United States v. Deutsche Bank et al., Case No. 11 Civ (S.D.N.Y. Filed May 3, 2011)

4 3,100 mortgages. 14 In addition to traditional claims based on false certification of eligibility with federal requirements, the complaint against Deutsche Bank AG and MortgageIT alleged those lenders falsely certified that they had taken corrective action after prior HUD audits discovered MortgageIT was not reviewing early defaults as it claimed to be doing. As of this writing, this action currently remains pending in the Southern District of New York. Foreclosure Fraud At the other end of the mortgage-lending spectrum, several recent FCA actions have alleged fraudulent acts related to the foreclosure process. These claims have varied widely between claims of fraudulent loan servicing, claims related to foreclosure activities and documents, and claims based on federal loan modification programs. The largest such settlement resulted from a federal-state investigation into the alleged fraudulent foreclosure activities of the five largest mortgage servicing companies in the United States. The DOJ recently announced a $25 billion settlement had been reached with these loan servicers based on allegations they had used robo-signed affidavits in order to foreclose, 15 engaged in deceptive practices related to loan modifications, foreclosed without offering alternatives to foreclosure as required by the FHA and had filed improper documents in federal bankruptcy courts. 16 The government alleged these lenders failed to follow FHA servicing and foreclosure guidelines and submitted false certifications of compliance. Specifically, the government alleged these companies engaged in abuses while servicing loans, including misapplying payments, charging excessive fees, failing to oversee third-party loan servicers, improperly responding to borrower complaints and failing to maintain quality control systems. 17 With regard to foreclosure, the government alleged these lenders failed to follow FHA guidelines meant to provide an opportunity for borrowers to avoid foreclosure and to ensure that the foreclosure of the FHA loan is conducted properly, including with regard to preforeclosure appraisals. By allegedly falsely certifying compliance with FHA regulations, the lending institutions became subject to FCA liability. The government s complaint alleged FCA violations related to FHA insured loans, loans made under the Department of Agriculture s Rural Housing Service Rural Housing Guarantee Program and VA insured loans. 18 In addition to the $25 billion settlement, a separate FCA settlement with Bank of America reportedly stemmed from allegations that Bank of America defrauded the federal Home 14 Id. 15 Robo-signing has received significant national attention, including with the recent revelation that an early robo-signing whistleblower, Lynn Szymoniak, will receive $18 million as a result of the joint federal-state settlement. See How This Foreclosure Victim Just Scored an $18 Million Settlement, Business Insider, March 17, 2012, available at The potential for future robo-signing claims on behalf of the government may be limited, however, as the joint settlement purports to limit future liability for such claims. 16 Press Release, United States Dep t of Justice, Federal Government and State Attorneys General Reach $25 Billion Agreement with Five Largest Mortgage Servicers to Address Mortgage Loan Servicing and Foreclosure Abuses (Feb. 9, 2012), 17 See Complaint, United States et al. v. Bank of America et al., Case No. 1:12-cv (D.D.C. Filed March 12, 2012). 18 Id

5 Affordable Modification Program (HAMP). 19 In the lawsuit, the relator, Gregory Mackler, alleged Bank of America intentionally prevented qualified borrowers from becoming eligible to participate in HAMP. Each participating lender in the HAMP program was required to certify compliance with the requirements of the Servicer Participation Agreement (SPA) it entered into when deciding to participate in the program. 20 The SPA placed various requirements on lenders when deciding whether a borrower is entitled to a HAMP modification. By certifying compliance with HAMP, Bank of America was entitled to certain financial incentives from the federal government, but by limiting the number of modifications granted under the program, Bank of America allegedly avoided taking losses on additional defaulted loans. Student Lending and Higher Education FCA actions against financial firms participating in various government-funded student lending programs have proliferated as well. These federal programs exist to encourage private student lending or to guarantee loans offered by private lenders. A number of FCA lawsuits have been filed alleging that false certifications of compliance were submitted, or claims were made on federal guarantees, for loans which failed to comply with federal guidelines controlling those programs. While not all of these actions have been successful, at a time when student loans have surpassed credit cards as the greatest source of consumer debt in the United States, 21 student lending will continue to provide a fertile ground for future FCA relators. In a recent FCA action in the student lending arena, a former student loan marketer sued his employer and other lenders participating in the Department of Education s FFELP program, claiming various abusive student loan marketing practice, and alleging that the lenders certifications to the government were false. The trial court dismissed the relator s claim, which was subsequently affirmed by the Eighth Circuit Court of Appeals. 22 Specifically, the relator alleged that defendants offered loan advisors prohibited bonuses and commissions, provided prohibited exit-counseling software to schools to solicit borrowers and directed fraudulent advertising at potential borrowers. 23 The complaint alleged these activities made the defendant ineligible to participate in federal lending activities under the FFELP. Thus, the complaint alleged, each claim for an interest subsidy or default reimbursement would constitute a false claim. The district court dismissed the claims, and the Eighth Circuit affirmed, because the allegations in the complaint were not alleged with the particularity required under Rule 9(b) of the Federal Rules of Civil Procedure. The courts found the complaint failed to allege any specific claims were false and further held that the relator failed to establish ineligibility to participate in FFELP because only the Secretary of Education could, consistent with due process, remove an eligible participant. As such, ineligibility was not automatic upon the failure to comply with the applicable regulations. 19 United States ex rel. Mackler v. Bank of America, N.A. et al., Case No. 1:11-cv (E.D.N.Y. Filed July 7, 2011). 20 See HAMP Handbook for Servicers of Non-GSE Mortgages, version 3.4, December 15, 2011, p. 19, available at for an example SPA. 21 See Andrew Chow, America s Burgeoning Student Loan Debt Crisis, Reuters (March 8, 2012), available at 22 U.S. ex rel. Vigil v. Nelnet, Inc., 639 F.3d 791 (8th Cir. 2011). 23 See Complaint, United States ex rel. Vigil v. Nelnet, Inc. et al., Case No. 8:07cv266 (D. Neb. Filed July 11, 2007)

6 A similar FFELP FCA claim against Collegiate Funding Services, Inc., alleging false certifications of student loan defaults, was also dismissed for failure to state a claim. 24 Despite the fact that these particular lawsuits were unsuccessful, 25 the FFELP provides fertile ground for future FCA challenges based on the variety of regulations applicable to lenders that offer federal student loans. 26 For-profit colleges also have been subject to a number of FCA challenges based on their role as student lenders. 27 The United States recently intervened in a FCA lawsuit filed by a relator in the Northern District of Texas against American Commercial College Inc. (ACCI), which operates a chain of for-profit colleges in Texas. 28 The claims against ACCI allege that it falsely certified that it was in compliance with the 90/10 rule, which prohibits colleges and universities from receiving more than 90% of their tuition from federal student aid. A similar false certification FCA lawsuit was filed in the Western District of Pennsylvania by the United States against Education Management Corp (EDMC). 29 The suit alleges EDMC falsely certified that it was in compliance with federal laws prohibiting the payment of incentive-based compensation to admissions recruiters. The University of Phoenix also settled a $67.5 million FCA suit based on incentive-based commissions paid to recruiters. 30 As previously noted, ITT successfully defended FCA actions claiming it submitted false certifications of compliance to the Department of Education. See note 4, supra. As with real estate lending, institutions providing federal student loan services must take steps to ensure they comply with federal regulations relating to their participation in federal loan programs. This includes ensuring that only qualified student borrowers receive loans, that any marketing programs related to loans satisfy federal requirements, and even ensuring that employment practices do not create incentives which might cause employees to take risks which could create FCA liability. As the costs of higher education continue to increase and more 24 See United States ex rel. Jones v. Collegiate Funding Services, Inc., Case No. 3:2007-cv (E.D. Va. Filed May 18, 2007). 25 The relator s suit in Vigil was dismissed by the trial court for failure to plead fraud with specificity. The trial court s dismissal was subsequently upheld by the Eight Circuit in United States ex rel. Vigil v. Nelnet, Inc. et al., 639 F.3d 791 (8th Cir. 2011). 26 See Michael J. Maloney, Virginia District Court Dismisses FCA Case Against Student Lending Companies, FCA Alert, Feb. 8, 2011, available at For additional discussion of student lending and higher education FCA cases see Damages in Education False Claims Act Cases The Tail that Wags the Dog, Gibson, Dunn & Crutcher LLP, Feb. 23, 2010, available at See also Press Release, United States Dep t of Justice, Four Student Aid Lenders Settle False Claims Act Suit for Total of $57.75 Million (Nov. 17, 2010), 27 For further discussion, see Gayland O. Hethcoat II, For-Profits Under Fire: The False Claims Act as a Regulatory Check on the For-Profit Education Sector, 24 LOY. CONSUMER L. REV. 1 (2011). 28 Press Release, United States Dep t of Justice, United States Intervenes in Suit Against American Commercial College Inc. Alleging False Claims Act Violations (Feb. 28, 2012), 29 Press Release, United States Dep t of Justice, U.S. Files Complaint Against Educational Management Corp. Alleging False Claims Act Violations (Aug. 8, 2011), 30 Press Release, United States Dep t of Justice, University of Phoenix Settles False Claims Act Lawsuit for $67.5 Million (Dec. 15, 2009),

7 students become reliant on access to student loans, aggressive whistleblowers attorneys will continue to seek opportunities to assert potentially lucrative FCA cases on the industry. The above sampling of recent FCA actions illustrates a rapidly increasing threat of exposure posed to the financial services industry. To counteract this threat, banks and other lenders should consider proactive actions, including compliance programs and various risk management tools, and in addition should continue to monitor this rapidly developing area of law. Financial services firms, responding to potential FCA actions based on false certifications of compliance, have begun developing or refining compliance mechanisms to ensure the accuracy of all certifications made to the government and taking special care to address complaints and hotline calls from employees or competitors which complain about regulatory non-compliance. Other due diligence and risk management efforts adapted to the lender s particular business lines should be considered in attempting to mitigate potential FCA exposure. Additional Information If you wish to visit with us about our False Claims Act practice, please contact your Kutak Rock LLP attorney or a member of our Financial Services Group or a member of our Government Disputes Practice Group. Firm attorneys have deep experience both in defending FCA claims and in developing compliance systems to help mitigate exposure in this growing area of regulatory enforcement. For more information on our Government Disputes practice and for recent news and alerts, please visit us at Thomas J. Kenny Thomas.Kenny@KutakRock.com Gilbert W. Boyce Gilbert.Boyce@KutakRock.com (202) Paul Gwilt Paul.Gwilt@KutakRock.com Russell C. Atchley Russell.Atchley@KutakRock.com (479) Patrick G. Griffin Patrick.Griffin@KutakRock.com Angela K. Wilson Angela.Wilson@KutakRock.com Juliet A. Cox Juliet.Cox@KutakRock.com (816) Edward G. Warin Edward.Warin@KutakRock.com Edward M. Fox Edward.Fox@KutakRock.com Kutak Rock LLP The Omaha Building 1650 Farnam Street Omaha, NE This Client Alert is a publication of Kutak Rock LLP. This publication is intended to notify our clients and friends of current events and provide general information about government disputes issues. This Client Alert is not intended, nor should it be used, as legal advice, and it does not create an attorney-client relationship. To ensure compliance with requirements imposed by the IRS, we inform you that any federal tax advice contained in this communication should not be used or referred to in the promoting, marketing or recommending of any entity, investment plan or arrangement, and such advice is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties under the Internal Revenue Code. Kutak Rock LLP 2012 All Rights Reserved This communication may be considered advertising in some jurisdictions