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U.S. Finds Fresh Use for Seldom-Used Statute in Subprime Cases

The Justice Department is investigating whether lenders are packaging subprime auto loans without reviewing their quality.


Like a child with a new toy, the U.S. Justice Department is using a powerful civil fraud provision to investigate potential fraud in the marketing of securities backed by risky auto loans.

This opens up a new front for the government to pursue large monetary penalties against companies that package loans made without paying too much attention to whether the borrowers are credit worthy.

General Motors Financial, the lending arm of the carmaker, and the auto finance company Santander Consumer USA disclosed last week that they had received subpoenas from the Justice Department for information about the securitization of subprime loans since 2007.

The subpoenas seek documents related to possible violations of the Financial Institutions Reform, Recovery, and Enforcement Act, better known as Firrea, which is being wielded to great effect these days.

Firrea was adopted in 1989 during the height of the savings and loan crisis when thrifts that were created to make plain-vanilla home mortgages had shifted into risky lending that drove many into insolvency. The primary goal of the statute was to overhaul the banking system by getting rid of the Federal Savings and Loan Insurance Corporation, which had run out of money, and expand the power of regulators to protect against abuses by insiders who often treated savings and loans as their own personal piggy banks.

One little-noticed provision of Firrea was Section 951, now found at 12 U.S.C. § 1833a, which gave the Justice Department the power to pursue criminal violations involving banks by means of a civil lawsuit for penalties. Similar to the Racketeer Influenced and Corrupt Organizations Act, or RICO, it allows a civil case based on proving a crime, with the benefit of applying the lower standard of proof used in those cases rather than showing a violation beyond a reasonable doubt. Unlike RICO, however, only the Justice Department can pursue a Firrea case, not private individuals.

No significant cases were filed under this provision during the savings and loan crisis, and the law remained in obscurity once the banking system recovered. But in 2012, the Justice Department seized on it to bring cases against banks for misconduct in the housing market during the run-up to the financial crisis. Since then, multibillion-dollar settlements have been extracted for shoddy subprime loan underwriting practices and sales of overvalued mortgage-backed securities, along with a lawsuit against Standard & Poor’s for how it rated those offerings.

Firrea is not just a penalty provision, however, because it also authorizes the Justice Department to pursue civil investigations into potential violations. Rather than just using it as a backstop when evidence might be insufficient to support criminal charges, the subpoenas to G.M. Financial and Santander Consumer indicate that the government is using Firrea as a new means to police the financial markets.

Crimes are typically investigated by a grand jury, which can compel the production of evidence and testimony from witnesses. The civil investigatory power is nearly as broad, with the Justice Department authorized to issue subpoenas to “summon witnesses and require the production of any books” or other evidence from any place in the United States. Unlike a grand jury investigation, in which federal prosecutors generally do not call a subject to testify, a civil inquiry can include requiring someone involved in possible misconduct to appear for questioning. A witness can invoke the Fifth Amendment right against self-incrimination in response to questions, but that can be considered as evidence if a civil case is filed and goes to trial.

Just because the Justice Department issues subpoenas as part of a civil investigation does not necessarily preclude a parallel criminal investigation. Any evidence gathered pursuant to Firrea can be shared with criminal prosecutors, unlike the secrecy rule imposed on any material presented to a grand jury. There is a rule of thumb in white-collar cases that if there is any possibility a case could go criminal, defense counsel should assume that it will and protect the client accordingly. So a Firrea investigation can be fraught with danger.

Firrea authorizes an investigation into possible violations of a host of banking laws, along with mail and wire fraud “affecting a federally insured financial institution.” That means the Justice Department can investigate when banks may be the victims of misconduct perpetrated by others. Expanding the statute’s scope even further, judges have also found that fraudulent conduct by a bank itself can be the basis for a Firrea penalty because it was affected by its own misdeeds.

The securitization of subprime auto loans no doubt includes banks as buyers or underwriters, so showing they were affected by any misstatements or omissions in the disclosure of risks associated the securities should not be difficult. Although this area is usually policed by the Securities and Exchange Commission, the subpoenas to G.M. Financial and Santander Consumer indicate that the Justice Department is assuming a greater role in looking at possible violations in the financial markets. So don’t be surprised if other auto lenders disclose that they received subpoenas for information about their loans.

What other types of lending and securitization might the Justice Department start scrutinizing under Firrea? One possible area could be student loans, which surpasses $1 trillion. This is the ultimate form of subprime lending, with no collateral to secure the debt and borrowers with minimal resources to repay in the early years of the loan.

Firrea makes the Justice Department a potential player in a wide range of financial cases involving potential misconduct. The recent decision by Judge Jed S. Rakoff of Federal District Court in Manhattan that gave a broad reading to the amount of the penalty that can be assessed against Bank of America for violations of a subprime mortgage program makes this an even more powerful tool for policing misconduct. So look for the Justice Department to issue more Firrea subpoenas that are sure to shake up the markets.