Can Breach of Contract Also Be Fraud?
Every day, somewhere a business is breaching a contract with another company. The breach may cause significant financial damage to the non-breaching company. The harm and sense of deception may cause the damaged company to believe the breaching company is dishonest and fraudulent. Does that mean that the company that breached the contract also committed fraud?
The question is a real-world issue. It arises in many different contexts and is not just academic. The damages from fraud can be significantly higher than the damages for breach of contract. Millions of dollars can hinge on the answer to that question.
Sometimes even a billion. The Second Circuit Court of Appeals in New York recently issued a major decision widely reported in the media reversing a $1.2 billion fraud judgment against Countrywide Home Loans (now owned by Bank of America) arising from the sale of questionable mortgages by Countrywide to Fannie Mae and Freddie Mac. United States ex rel. O’Donnell v. Countrywide Homes Loans, Inc. (May 23, 2016). Although the media gave almost no attention to the legal issue decided by the Second Circuit, the case hinged on this common issue in business cases: can breach of contract -- even intentional breach of contract -- also constitute fraud?
In the Countrywide case, the answer was No. Countrywide had entered into a contract with Fannie Mae and Freddie Mac to sell “investment quality” mortgages to them. The government alleged that the mortgages Countrywide later sold to Fannie Mae and Freddie Mac under that contract were poor loans and failed to meet the required investment quality. In fact, the government claimed that at the time the mortgages were sold to Fannie Mae and Freddie Mac, Countrywide actually knew the mortgages failed to satisfy the investment-grade requirement (although there was no allegation that Countrywide made contrary representations about the quality of the mortgages at the time they were actually sold).
The Second Circuit held -- even assuming an intentional breach of the contract -- the government neither alleged nor proved any fraud in connection with either the entering into the contract or in the subsequent breach of the contract by Countrywide in the sale of the questionable mortgages.
Yet most business cases involving a breach of contract also allege fraud and misrepresentation. In many cases, where breach of contract exists, fraud and deception also exist.
The interplay between fraud and breach of contract is more complicated than indicated by the result reached in the Countrywide case.
The Countrywide Home Loans case above applied the general rule that, without more, breach of contract -- even intentional breach of contract -- does not amount to fraud. The Second Circuit applied the general rule that, without more, breach of contract -- even intentional breach of contract -- does not amount to fraud.
Yet most breach of contract cases also allege fraud and misrepresentation. The key qualifier to the general rule, and to understanding the Countrywide case itself, is: “without more.”
Most breach cases do involve more. The Second Circuit Countrywide case mentioned some of the circumstances where fraud can be implicated by a breach of contract. The allegation of fraud is so common in breach of contract cases that it is surprising that both the government and the federal district court in Countrywide lost sight of the basic interplay between breach of contract and fraud.
The most common circumstance, and what most cases allege, is that an intentional misrepresentation was made at the time the parties entered into the contract. In the Countrywide case, the government did not allege, and had no evidence of, a misrepresentation at the time the parties entered the contract.
A second circumstance is when there is a duty to speak at the time of performance. For instance, in the Countrywide case, if Countrywide had been required to certify the investment quality of the mortgages each time it sold the mortgages to Fannie Mae and Freddie Mac, a false certification could have led to a claim for fraud. But apparently, no certification was required from Countrywide as part of each sale, and according to the Second Circuit decision, Countrywide made no representations at the time of the sales regarding the quality of the mortgages.
A third circumstance is if, at the time of entering the contract, one of the contracting parties had no intention of actually performing the contract. As the Second Circuit pointed out in Countrywide, the government did not allege such lack of intent, nor did the government offer any evidence of lack of intent at the time of the contracting. This version of fraud is often difficult to prove and the evidence is usually circumstantial. But there are ways to prove it. For example, our Business Litigation Team recently handled a major business case where one of the contracting parties violated the contract within days of entering into the contract. An immediate breach of the contract can be evidence of fraudulent intent at the time of contracting.
The interplay of fraud and breach of contract can also occur in other circumstances. And as illustrated by the Countrywide case, even sophisticated parties such as the U.S. Attorneys’ Office in SDNY and federal district judges get it wrong. The relationship of the two concepts can be complex, and as in most legal claims, much will depend on the specific facts of the case.
Topics: Business Fraud