Justice's Bank of America suit failed the basic contracts test

If I promise to sell you a 2016 BMW and deliver my 2006 Yugo instead, you can sue me for breach. If my breach is "intentional," you might even get extra damages. But although I have done you a wrong, I have not committed a fraud -- not unless I planned to stick you with the Yugo all along.

Every first-year law student is familiar with this fundamental rule of contracts. The fact that the Justice Department chose to ignore it is crucial to understanding Monday's decision by the U.S. Court of Appeals for the Second Circuit to overturn a $1.27 billion judgment against Bank of America related to alleged wrongdoing by Countrywide Home Loans.

A little background.

In 2007, following the implosion of the subprime market, Countrywide decided to reconstitute its subprime lending division into a prime lending division, with the goal of reselling mortgages to Fannie Mae and Freddie Mac. The lender subsequently entered into contracts with both government-sponsored enterprises. The contract with Fannie Mae promised that each of the mortgages sold would be an "Acceptable Investment." The contract with Freddie Mac promised that each would "have the characteristics of an investment quality mortgage."

In both cases, Countrywide offered its promise as of the date the loans were transferred.

The government subsequently brought suit under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, or Firrea, contending that Countrywide had delivered mortgages of lower quality than promised. It was this lawsuit that resulted in the $1.27 billion damages award.

But the government's theory had a problem, one that the Second Circuit had no trouble spotting. The section of Firrea under which the lawsuit proceeded applies only if the defendant has violated the wire fraud or mail fraud statutes. To commit wire fraud or mail fraud, one must commit fraud. And that's where the case fell apart.

Fraud cannot be committed by accident. It requires an intentional and material misrepresentation at the time that the contract is entered into. In other words, to win its suit, the Justice Department would have had to demonstrate that Countrywide, when it signed the agreements with Fannie Mae and Freddie Mac, was already scheming to deliver nonconforming mortgages. Alas, wrote the Second Circuit, no such showing was made: "The Government did not prove -- in fact, did not attempt to prove -- that at the time the contracts were executed Countrywide never intended to perform its promise of investment quality."

The government's argument, in effect, was that if Countrywide at any point knowingly delivered a mortgage that did not meet the contractual standard, it was committing a fraud. Such a principle would upend contract law as it has been taught for generations. The only misrepresentations to which the government pointed were the promises in the contract.

But unless Countrywide knew at the time it made those promises that the mortgages in question would be of less-than-investment quality, it at worst committed not a fraud but a breach. The difference matters.

Fraud has special pleading rules -- rules the government here did not even try to meet. Oliver Wendell Holmes argued in "The Common Law" that fraud has traditionally been treated differently from breach because deceit implies a greater moral failing than mere failure to keep one's word. Contemporary legal theorists say that fraud in the making of agreements drives up the cost of contracting because each party must take precautions against the possibility that the other is lying.

Thus whether one believes in a moral or an economic justification for contract law, the solution is to punish fraud more harshly than ordinary breaches. Possibly the Justice Department could have won a lawsuit for ordinary breach. But it's not likely to have obtained a billion-dollar verdict. The Second Circuit was right to reverse the trial court. Fraud, to be fraud, must occur at the time the promise is made.

Otherwise every lawsuit for breach would potentially be a lawsuit for fraud. Pretty much everybody is mad at the big banks. But the Justice Department, in its zeal to snare one, can't rewrite the fundamental principles of contract.

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Stephen L. Carter is the William Nelson Cromwell Professor of Law at Yale, where he has taught since 1982. Among his courses are law and religion, the ethics of war, contracts, evidence, and professional responsibility. His most recent book is The Violence of Peace: America’s Wars in the Age of Obama (2011). He is an author and Bloomberg View columnist.