The Second Circuit Polices the Contract-Tort Boundary — Greg Klass

Post by Greg Klass

On Monday the Second Circuit released its decision in US ex rel. O’Donnell v. Countrywide Home Loans. This is a major case—in terms of dollar amounts (the trial court had assessed a $1.27 billion penalty against Countrywide), for understanding the law’s ability to deal with the wrongs that caused the subprime mortgage crisis, and with respect to the legal question of where to draw the line between contracts and torts. There’s much more going on in the case than I can summarize here. But here are some initial thoughts on it. Some of them also appear in Dan Fisher’s excellent piece in Forbes.

The legal framework is a little complex, but the basic thrust of the decision is that there was no evidence that Countrywide ever made a false representation to Freddie Mac and Fannie Mae about the quality of the mortgages it was selling. The initial contract of sale promised to deliver “investment quality mortgages,” but that was just a promise. There was no evidence that at the time Countrywide made it the company intended to do anything else—that it committed promissory fraud. It is clear that Countrywide subsequently intentionally breached that promise by delivering lots and lots mortgages that it knew were crap. (If you haven’t seen or read The Big Short, you might be shocked by Judge Rakoff’s post-verdict summary of the bullshit Countrywide trafficked in.) But, according to the Second Circuit, there was no evidence that it ever made any additional representations—after the initial contract to sell—as to the quality of those mortgages. No lie, no fraud.

A few observations:

First, the Second Circuit’s decision was in line with the way courts generally police the contract-tort boundary. Oversimplifying, the general rule is fraud in the inducement (before the contract is formed) is actionable, fraud in the performance (after there’s a contract) is not. And there is no general duty to disclose when you are in breach. Put these two doctrines together, and it was easy for the Second Circuit to shut the door in the plaintiffs’ faces.

Second, these are bad rules. I argued way back in 2007 that misrepresentations about performance should be actionable. (Which just goes to show how much influence that article has had.) And as I think Daniel Markovits and Alan Schwartz’s recent work on the theory of efficient breach shows, the breaching promisor should have a duty to disclose the fact that she is in breach – especially when the promisee is unlikely to discover the breach right away.

Third, the latter point suggests a special irony in the Second Circuit’s passing appeal to “the common law’s tolerance for, even encouragement of, so-called ‘efficient breaches’ that increase overall wealth.” There are two problems here. First, it is never efficient to lie about performance. Second, Countrywide’s breach in this case was not efficient, but opportunistic. They were cheating. Far from creating new value, Countrywide’s breach was part of a pattern of behavior that ended up threatening the entire economy. The Second Circuit’s passing appeal to the theory of efficient breach is an example of that theory run amock. (The published version of this paper on the theory of efficient breach, which makes a similar point, will says something about this case.)

Fourth, the differences between Judge Rakoff, who approved the jury’s verdict against Countrywide, and the Second Circuit exemplify an abiding tension in the law of fraud. This is the tension between the need to clearly define legal wrongs and the worry that in this area of the law, clear ex ante definitions create safe harbors for bad actors. Many common law courts have commented on this fact. For example: “it is part of the equity doctrine of fraud not to define it, lest the craft of men should find ways of committing fraud which might evade such a definition.” Smith v. Harrison, 49 Tenn. (2 Heisk.) 230, 242–43 (1870). Sam Buell has a very good article on the topic. The issue also appeared in Skilling v. United States, where the Supreme Court held that the Constitution required a narrowing construction of “a scheme or artifice to deprive another of the intangible right of honest services” in the federal mail and wire fraud statute. Like the Supreme Court, the Second Circuit here opted for a narrow and more precise definition of what counts as fraud. But Skilling was a criminal case, and turned on due process requirements that apply only to penal statutes. The argument for flexibility is much stronger in civil cases like this one. I think Rakoff had it right in taking a more flexible approach.

Last thought: The case might have come out differently if the plaintiffs had been able to sue under the False Claims Act. Under the doctrine of implied certification (which could soon go away!), a request for payment from the government implicitly represents material compliance with the contract, as well as relevant statutes and regulations, and supports a claim for treble damages and fines. I have argued that this is a pretty good rule, and I think contracts scholars should pay more attention to the FCA. Unfortunately for the plaintiffs in this case, their FCA claims were dismissed early in the litigation. Apparently the FCA didn’t cover Freddie Mac and Fannie Mae until 2009, after the events at issue in the case.


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