By Daniel Colbert, ACLR Featured Blogger
Lacey Phillips and Erin Hall were two of millions of Americans who received subprime loans from unscrupulous lenders in the years leading up to the financial crisis.[i] In 2006, the couple applied for a loan from a reputable bank and were turned down.[ii] A short time later, they found a mortgage broker – Brian Bowling – who directed them to Fremont Investment & Loan.[iii] There is no indication the couple knew that Bowling had a history of producing fraudulent loan documents or that Fremont was a disreputable institution that would soon face prosecution for its predatory practices.[iv] Fremont specialized in “stated income” loans – known in the industry as “liar’s loans” because they required no proof of the borrower’s income – which it quickly repackaged into mortgage-backed securities and sold, turning a profit despite the high risk of default.[v] Phillips and Hall applied for and received a loan, purchased the house, and soon lost it when they defaulted on the mortgage.[vi]
Phillips and Hall were convicted of violating 18 U.S.C. §1014, which makes it a crime to “knowingly make any false statement . . . for the purpose of influencing in any way the action of” a federally insured bank like Fremont.[vii] The couple had made several false statements on their loan application, including inflating their income and misrepresenting Hall’s job title.[viii] They appealed, arguing that the trial judge erred when she refused to allow the defendants to testify that Bowling had told them they should combine their incomes on the application.[ix] A panel of the Seventh Circuit upheld the decision, with Judge Easterbrook writing for the majority and Judge Posner dissenting.[x] The Seventh Circuit then granted a rehearing en banc, in which Posner carried the day and Easterbrook dissented.[xi]
Posner argued that the defendants’ testimony is pertinent to whether they knowingly made a false statement, and if they did, whether they intended to influence the bank’s behavior.[xii] The couple may have believed, Posner argued, that the application’s blank for “borrower’s income” was asking for the total income from which the loan would be paid, and thus that their combined income was the correct number.[xiii] Further, the couple may have believed that the bank had essentially already approved the loan and that the bank would grant the loan regardless of what was reported on the form.[xiv] Given Fremont’s business model, this belief would have been close to the truth.[xv]
Easterbrook’s dissent notes that even if Phillips and Hall believed the bank would be indifferent to the truth of the loan application’s statements, they were undoubtedly aware – and possibly were told – that a higher reported income was more likely to be approved.[xvi] The bank possibly did not care whether the borrowers could pay the loans back, but it did care whether the debt would be rated high enough to sell.[xvii] Easterbrook thus argued that the defendants did intend to influence the bank’s actions; they knew that without the false representations on the application, the loan would not have been made.
Easterbrook seems to have much of the case law on his side. Courts who had considered the question previously had found that the bank’s awareness of the fraud is “not inconsistent with the intent to influence which a violator of § 1014 must possess.”[xviii] Because the statute does not require that the borrower intend to harm the bank, but only that he intend to influence it, it does not “immunize a party from criminal liability because an officer of the bank was involved in the fraudulent scheme.”[xix] Though one of the effects of the statute is that banks are protected from false statements, its central goal was the vitality of the government’s deposit insurance programs, which is only served if the statute also bans statements that the bank knows are false.[xx]
Easterbrook is also correct to note that Bowling’s testimony would have shown Phillips and Hall knew the bank cared about the income they claimed, even if it didn’t care that it was true.[xxi] Perhaps unsurprisingly, Easterbrook is also concerned about the adverse economic effects of Posner’s decision:
The upshot of my colleagues' contrary conclusion is that crooked brokers such as Bowling can confer on clients a legal entitlement to obtain loans by deceit. That's bad economics as well as bad law. It makes it harder to extirpate liars' loans programs, and it raises the rate of interest that will be charged to honest applicants.[xxii]
Easterbrook seems worried that Posner’s approach will eviscerate the statute and allow borrowers to lie intentionally.
Yet Easterbrook’s logic assumes that the borrowers are crooks, or at least sophisticated financial actors. Posner’s justification, on the other hand, stems from his sympathy for Phillips and Hall, whom he calls “hapless victims” of Bowling and Fremont.[xxiii] In his original dissent, Posner points out that Bowling and Fremont were among the “unscrupulous” actors who helped cause the financial crisis by lending money to “impecunious suckers.”[xxiv] In fact, Bowling had become the subject of a federal investigation and agreed to testify against several of his clients to reduce his prison sentence.[xxv]
Phillips and Hall likely knew, as Easterbrook notes, that the income they reported would matter. What the couple probably did not know is that Fremont was willing to give them a loan they could not afford to pay back. They likely did not know that two years after they took out the loan, their interest rate would increase and they would lose their house, even after working second jobs.[xxvi]
In recent years, prosecutions under § 1014 have “mushroomed” in the wake of the housing and credit collapse.[xxvii] Unfortunately, many of those cases are of a different nature from the frauds that the statute was designed to prevent. Many of the borrowers who made false statements, perhaps like Phillips and Hall, were the victims rather than the perpetrators of fraud. Posner’s approach – allowing the jury to hear evidence that a mortgage broker misled the borrowers – may not fit well with existing precedent, but it offers a way to distinguish fraudsters from their victims.
There are undoubtedly cases in which borrowers have conspired in a scheme to defraud, but there are also many cases in which the borrowers were, in Posner’s words, “hapless victims.”[xxviii] One would hope that prosecutors would consider the sophistication of the borrowers before prosecuting. One former Assistant United States Attorney called it “appalling and embarrassing that any self-respecting U.S. Attorney's Office would prosecute a case” against Phillips and Hall.[xxix] But when an overzealous prosecutor brings a case against borrowers, allowing the jury to consider the possibility that the borrowers were unwitting victims can adapt § 1014 to fit the realities of the subprime market.