Blowing the Whistle on the Bank Got Easier

A series of “sensational congressional investigations” in the 1860s led to the disclosure that the United States had been bilked by war time contractors who charged for nonexistent or worthless goods, billed exorbitant prices for goods delivered and generally stole from the country in supplying the necessities for fighting the Civil War1. The result was the passage of the False Claims Act (“FCA”),2 which imposes significant civil and criminal penalties on those who defraud the government. Since passage of the FCA in 1863, Congress has repeatedly amended the law, but the FCA has always targeted those who present or directly induce false or fraudulent claims for payment by the United States.

The FCA permits persons who are not affiliated with the government to file actions against federal contractors or those receiving federal funds alleging a violation of the law and to receive a portion (up to 30%) of any damages they recover on the government’s behalf. Such persons are commonly referred to as “whistleblowers.”

Two such whistleblowers, Paul Bishop and Robert Kraus, sought damages for the United States under the FCA from Wells Fargo in connection with improper activities allegedly engaged in by Wachovia and World Savings Bank. Both banks were acquired by Wells Fargo along with their assets and liabilities.

Kraus claimed that Wachovia hid loans from internal and regulatory review by moving them from the bank’s balance sheet to an entity account for which insiders at the bank had a colorful name, the “Black Box.” Kraus claimed the Black Box contained $6,000,000,000 in loans and other assets, amounting to almost 13% of Wachovia’s total equity. Wachovia, Kraus contended, deceived federal entities, including the Federal Reserve, when the bank sought financial support as a result of the Great Recession. According to Bishop, World Savings also made misleading statements about the quality of the loans in its portfolio.

Both Kraus and Bishop claimed that the banks had misrepresented their financial health and defrauded the government by falsely certifying that they were in compliance with various banking regulations when they borrowed at favorable rates from the Federal Reserve’s discount window. What their claims did not allege was that the banks had violated any explicit precondition for the loans.

In a decision affirming the trial court’s dismissal of the case, the United States Court of Appeals for the Second Circuit found that nothing Kraus and Bishop alleged directly addressed any preconditions the Fed places on loans at its discount window. Instead, what they charged was general regulatory non-compliance, which the FCA was not designed to police.

The Court therefore rejected all of the legal theories the two advanced, including one known as the “implied false certification” theory of liability. That theory, which courts had dealt with in various ways over the years, treats the request that the government make a payment as a claimant’s implied certification of compliance with statutes, regulations and contract requirements that the government would consider a material condition of payment. Failure to disclose a violation of such a requirement, the theory goes, is a misrepresentation that renders the claim false or fraudulent and therefore actionable under the FCA.3

In a brief order, the United States Supreme Court reversed the Second Circuit4. The Court directed reconsideration in light of a decision it reached in June 2016, Universal Health Serv., Inc. v. United States ex rel. Escobar. In that matter, the Supreme Court found that a Medicaid provider, a mental health facility, was liable under the FCA because it had received payment from the government for services provided by unlicensed, unqualified and unsupervised personnel. While those things were not an explicit precondition of reimbursement, failure to disclose them constituted fraud. The Court found that, had the government known of the deficiencies, which were violations of Medicaid regulations, it would not have paid for the treatment, which led to the death of a teenage beneficiary of the Medicaid program. The qualifications were a requirement material to the decision to make the payment, and the provider was guilty of an “implied false certification.”

So what happens next in Wells Fargo’s case? Assuming Kraus and Bishop prove their allegations, the issue will be whether the Federal Reserve would have viewed the discount window loan application differently if the banks had disclosed that they lacked controls, and were undercapitalized and in generally worse financial condition than appeared from the application. In other words, were those circumstances material to the decision to make the loan? It’s a good bet the Fed would not have made the loan, or at least not at such favorable rates.

The consequences for Wells Fargo are serious. The theory of damages in the case is that Wells Fargo should repay the government the difference between the low rate of interest the acquired banks paid at the Fed’s discount window and the rate they would have paid had the banks not misrepresented their financial condition. On billions of dollars of loans over a number of years, this adds up. As the late Senator Everett Dirksen said, “A billion here, a billion there, and pretty soon you’re talking real money.”

Endnotes

1 United States v. McNinch, 356 U.S. 595, 599 (1958).

2 31 U.S.C. §3729 et seq.

3 Bishop v. Wells Fargo & Company, Wells Fargo Bank, N.A., 823 F.3rd 35 (2nd Cir. 2016).

4 Bishop v. Wells Fargo and Company, 85 U.S.L.W. 3389 (February 21, 2017).

5 579 U.S 136 S.Ct. 1989.