Fraud and Prevention

Expanding the Scope and Funding of Fraud Enforcement

Perspectives by James Hamilton
July 29, 2009

The following is an excerpt from Mr. Hamilton's white paper, "Congress Passes First Financial Regulation Reforms of 2009: Expands Scope and Funding of Fraud Enforcement."

Congress passed and cleared for the president's signature its first piece of legislation reforming the oversight of the financial industry following the recent economic upheavals. The Fraud Enforcement and Recovery Act strengthens enforcement of securities and commodities fraud, financial institution fraud involving asset-backed securities, and fraud related to federal assistance and relief programs.

Specifically, the act expands the scope of securities fraud provisions to include commodities and derivatives fraud and extends the prohibition against defrauding the federal government to the Troubled Asset Relief Program and stimulus bill. The legislation provides the Department of Justice with the tools it needs to fight fraud in the use of funds under TARP and the American Recovery and Reinvestment Act.

In addition, the measure authorizes additional appropriations for the SEC and other federal agencies to investigate and prosecute fraud, and creates a Select Commission to examine the causes of the current financial crisis. The legislation also makes several important improvements to existing fraud and money-laundering statutes to strengthen prosecutors' ability to combat this growing wave of fraud.

A main component of the reform is the reinvigoration of federal antifraud measures. FERA is a major step toward holding accountable those who have caused so much damage to the U.S. economy, while at the same time protecting economic recovery efforts from the scourge of fraud.

FERA makes a number of important improvements to antifraud and money laundering statutes. Specifically, the legislation amends the federal securities fraud statute to cover fraudulent schemes involving commodities futures and options, including derivatives involving the mortgage-backed securities that caused such damage to the banking system.

The act authorizes additional appropriations for the SEC to fight financial fraud of $20 million for fiscal years 2010 and 2011. The legislation specifically states that the additional funds are to be used for investigations and enforcement proceedings involving financial institutions. FERA also adds $1 million a year for two years for the salaries and expenses of the SEC's inspector general.

The legislation includes important improvements to federal fraud and money-laundering statutes to strengthen prosecutors' ability to confront fraud in mortgage lending practices, to protect TARP funds, and to cover fraudulent schemes involving commodities futures, options and derivatives, as well as making sure the government can recover ill-gotten proceeds from crime.

The legislation amends the federal securities antifraud statute to cover fraudulent schemes involving commodities futures and options, including derivatives involving the mortgage-backed securities that caused such damage to the financial system. The federal securities antifraud statute was added to the U.S. criminal code by Section 807 of the Sarbanes-Oxley Act, which created a new federal felony for securities fraud with a 25-year penalty.

Section 807 made it easier to prove securities fraud while at the same time increasing the penalty. Before Sarbanes-Oxley, federal prosecutors were forced to resort to a patchwork of technical offenses and regulations that criminalized particular violations of the securities laws, or to treat the cases as generic wire or mail fraud.

Sarbanes-Oxley criminalized any scheme to defraud persons in connection with securities or public companies to obtain their money or property. Importantly, FERA extends the strong provisions of Section 807 to frauds involving commodities, including derivatives, such as options and mortgage-backed securities.

At the height of the subprime lending era, independent mortgage companies made nearly half of the higher-priced, first-lien mortgages. The loans originated by these private mortgage companies were not generally covered by current federal fraud statutes, such as the bank fraud and bank bribery statutes.

Thus, FERA amends the definition of "financial institution" to extend federal fraud laws to mortgage lending businesses that are not directly regulated or insured by the federal government.

These companies were responsible for nearly half the residential mortgage market before the economic collapse, Congress found, and yet they remain largely unregulated and outside the scope of traditional federal fraud statutes. This change will apply the federal fraud laws to private mortgage businesses just as they apply to federally insured and regulated banks.

Expanding the term financial institution to include mortgage lending businesses will also strengthen penalties for mortgage frauds and the civil forfeiture in mortgage fraud cases.

It will also extend the statute of limitations in investigations of mortgage fraud cases to be consistent with bank fraud investigations. The new definition would also provide for enhanced penalties for mail and wire fraud affecting a financial institution, including a mortgage lending business.

James Hamilton is a principal analyst at Wolters Kluwer Law & Business. For more information, visit his blog at http://jimhamiltonblog.blogspot.com.