BofA Suit: New Look at 'Lincoln Law'

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The correct general position on the financial crisis lawsuits we're now seeing arise from various government agencies is reluctant support. (Read more: Barney Frank Defends JPMorgan Against Bear Stearns Suit)

But at least one of the recent suits has a legal basis that borders on the absurd. Under even the slightest scrutiny, it falls apart faster than Felix Salmon's countenance when he is somehow forced to wear an off-the-rack shirt. (Yes, this is an affectionate inside joke for some.)

The Department of Justice claims that it is entitled to claim treble damages against Bank of America because of mortgages Countrywide sold to Fannie Mae and Freddie Mac. The "treble" part of those damages arise under the False Claims Act, a law which allows prosecutors to multiply fraud claims by 300 percent when the victim is the federal government. (Read more: Federal Prosecutors Sue Bank of America Over Mortgage Program.)

The False Claims Act is sometimes known as the Lincoln Law because it was enacted during the Civil War to crack down on those who tried to perpetrate fraud while selling supplies to the Union army. Under the original law, the government could double the penalties against violators—and half the government's take would be split with whistle-blowers.

The point of the increased damages was to raise the cost of defrauding the government. Willful wrong-doers might be deterred and other companies would take extra precautions to avoid the additional costs.

Later amendments fiddled with the damages formula as well as the potential awards to whistle-blowers. Under an amendment signed by President Ronald Reagan in 1986, treble-damages were introduced.

This obviously raises the potential liability for Bank of America . As Matt Levine of Dealbreaker points out, the potential liability for Countrywide mortgages sold to Fannie and Freddie is not limited to the total value of those mortgages. It's now at least three times that amount. And, really, four times that, since Fannie and Freddie can also sue to recover.

These are nonsense numbers. Bank of America will never be required to fork over anywhere near that much. Even if somehow it were proven that fraud had been a part of every single mortgage Countrywide had ever sold to Fannie and Freddie, the total liability would just put Bank of America out of business. (Note: however scammy Countrywide might seem, it seems unlikely in the extreme that it never managed to non-fraudulently sell a mortgage to the GSEs.)

But apart from this important reality check, the legal basis for employing the False Claims Act is flawed. Fannie and Freddie were known as "government sponsored entities" but they were private companies until the government took them into conservatorship in 2008.

Barney Frank famously declared in 2003 that "There is no guarantee, there is no explicit guarantee, there is no implicit guarantee, there is no wink-and-nod guarantee" of Fannie and Freddie's liabilities.

There is no legal basis for claiming that the acquisition of Fannie and Freddie by the government, and subsequent guarantees of their liabilities, somehow back-dates their status as government entities.

At least, no legal basis of which I am aware, and none that is spelled out in the Department of Justice's complaint against Bank of America.

The ex post facto extension of FCA liability actually seems to work counter to the goals of the law, which are to make it especially costly to defraud the government and to encourage extra-diligence in preventing such fraud. Under the DoJ's theory, any company is potentially an agency of the government, and any fraud a potential violation of the FCA, since any company could eventually be acquired or backed by the government.

As a matter of equitable justice, it seems wrong to foist treble-damages on a company that was never on notice of this potential liability because it believed it was dealing with another private actor. In the case of Bank of America, which acquired Countrywide but never could have expected this novel interpretation of the FCA, this seems to be even more unjust.

It's hard to discern a natural stopping place once we start down this road. If government support of Fannie and Freddie opens their trading partners to treble damages, what about the trading partners of Citigroup and AIG ? What about the trading partners of Bank of America itself? Since Treasury money eventually went into every major bank, is the entire financial system carrying potential treble-damages for any fraud committed between private actors?

I don't think courts will want to go down this path. In fact, I expect that if the Bank of America case were ever litigated, this claim would be thrown out. But that's an unlikely outcome since, most likely, the case will be settled long before a federal court reaches a final decision about this application of the FCA.

(Read more: JPMorgan Took a Bath on Bear Stearns Sale: Dimon)

- by CNBC Senior Editor John Carney


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