By Aruna Viswanatha and Christina Rexrode 

An appeals court dealt the federal government a major setback in its efforts to punish big banks for the financial crisis, overturning a mortgage fraud case against Bank of America Corp. that has framed the Obama administration's legal strategy in pursuing multibillion-dollar settlements with financial institutions.

The court also tossed out a $1-million civil penalty against Rebecca Mairone, a former executive at Countrywide Financial Corp., who was one of the few individuals fined for the financial crisis. The decision suggests there could be new legal hurdles for the administration's efforts to hold corporations and individuals criminally and civilly liable for alleged misdeeds. Last year, a memo from Deputy Attorney General Sally Yates urged prosecutors to more aggressively pursue criminal and civil penalties against corporations and executives, but Monday's ruling suggests the Justice Department may already have overstepped their legal authority in pursuing such cases.

The decision Monday by the Second Circuit Court of Appeals raises the bar for the government to prove fraud, weakening a weapon the Justice Department has used to push Wall Street to agree to big mortgage settlements.

If it stands, the ruling could undermine the remaining government investigations into crisis-era mortgage securities, experts said, including those into European banks Royal Bank of Scotland, UBS AG and others.

And while the ruling won't affect more than $40 billion in mortgage-securities settlements the Justice Department already reached with the biggest U.S.banks -- including J.P. Morgan Chase & Co. and Citigroup Inc. -- it is a symbolic setback for the government's aggressive pursuit of those claims.

Monday's ruling is the latest in a series of high-profile losses by government prosecutors and regulators in recent years, both in their attempts to punish financial crimes and to expand postcrisis regulations. A 2014 case made it more difficult for the government to pursue insider trading cases, forcing prosecutors to drop a dozen cases in the past year and a half. A federal judge in March overturned the federal government's attempt to impose stringent new regulatory oversight on MetLife Inc. because officials had declared the insurance giant as a potential threat to the global financial system.

The appeals court Monday threw out a $1.27 billion penalty against Bank of America over mortgages sold by its Countrywide unit, in what had become known as the "Hustle" case. It revolved around a civil lawsuit that the Manhattan U.S. attorney's office filed against Bank of America in 2012. It alleged that a precrisis Countrywide Financial Corp. program called Hustle had churned out shoddy mortgages with a focus on quantity, not quality, and then misrepresented those loans when selling them to Fannie Mae and Freddie Mac, which had to be propped up by government money in the financial crisis.

The Second Circuit's three-judge panel said the jury's findings that the shoddy loans sold to Fannie Mae and Freddie Mac were below the quality that had been promised might be considered an "intentional breach of contract." But it said those transgressions didn't constitute fraud, overturning a 2013 jury verdict that had been a signature win for government officials widely criticized for bringing few cases tied to the 2008 crisis.

Josh Rosenkranz, who represented Ms. Mairone, said the ruling shows "this case was a massive government overreach from inception," in which prosecutors "tried to take an allegation of garden variety breach of contract and turn it into a fraud with crushing and career-ending penalties."

While the ruling itself is a narrow one, it gets at issues that underpinned the major settlements that banks signed to resolve civil charges that they misrepresented the quality of loans packaged into securities.

The Justice Department pursued the cases by dusting off a little-used law enacted in the wake of the 1980s savings and loan crisis, the Financial Institutions Reform, Recovery and Enforcement Act, or FIRREA, which allows the government to civilly prosecute fraud affecting federally insured financial institutions.

The government could appeal the ruling to either the full appeals court or to the Supreme Court. Representatives of the Justice Department and the U.S. attorney's office in Manhattan, which brought the case, declined to comment.

A Bank of America spokesman said the company is "pleased with the appellate court's decision."

The issue, the court said, turned on the timing of any misstatements and whether at the time they were made, the bank or its employees knew they were false. In this case, the panel said, Countrywide entered into the contract to sell loans to Fannie and Freddie long before the alleged scheme to defraud the housing entities took place.

The judges' decision could encourage other companies to push back against government prosecutions, even though most big financial institutions have generally preferred to settle such disputes rather than go through the public scrutiny of a trial. The case and the favorable verdict for the government helped pave the way for multibillion-dollar settlements with top banks for alleged financial crisis misdeeds under a similar theory.

The Hustle penalty was relatively small compared with other fines paid by the bank, but it was an important anecdote in the government's arsenal in its push for bigger penalties against the banks over related charges. Three weeks after a judge set the Hustle penalty -- which was higher than Bank of America had expected -- the bank agreed to a $16.65 billion mortgage-securities settlement with the Justice Department.

The charges and trial took observers deep inside Countrywide, which is often seen as a central player in the mortgage meltdown. According to the government, the firm accepted borrowers' applications without checking that income levels and other information was reasonable. It awarded bonuses to employees who could make the case that a loan deemed defective by corporate auditors was in fact eligible for sale to Fannie and Freddie, with little regard for whether customers would be able to repay them.

Ed O'Donnell, a former Countrywide executive, was the government's star witness in the trial, testifying that he was ignored when he alerted his bosses to deterioration in the quality of the mortgage loans.

He didn't receive any money from the case since it went under appeal. He did, however, receive nearly $58 million for a separate lawsuit against Bank of America.

Write to Aruna Viswanatha at Aruna.Viswanatha@wsj.com and Christina Rexrode at christina.rexrode@wsj.com

 

(END) Dow Jones Newswires

May 23, 2016 16:10 ET (20:10 GMT)

Copyright (c) 2016 Dow Jones & Company, Inc.
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