August 21, 2009

The Risks of TARP Funding for the Real Estate Industry: New Programs Bring Challenges in Compliance With Enforcement Regulations

Holland & Knight Alert
Christopher A. Myers

Treasury Department Creating Market for Distressed Assets

Since the Emergency Economic Stabilization Act of 2008 was enacted in October 2008, the federal government has designed a number of programs to create a market for financial assets whose value has fallen so significantly that a functioning market no longer exists. Grouped broadly under the heading of the Troubled Asset Relief Program (TARP), these programs are part of the efforts to assist the financial, insurance, real estate and auto industries, among others. The total combined investment of public and private funds in nearly a dozen TARP programs is expected to reach $3 trillion.

Treasury’s Public-Private Investment Program

Because the current financial crisis stemmed in significant part from mortgage-backed securities and their impact on the real estate industry, several of the TARP programs involve efforts to revitalize the real estate industry and to remove toxic real estate-related assets from the books of financial institutions and insurance companies. One of these programs is the U.S. Treasury Department’s Public-Private Investment Program (PPIP), announced in March 2009. Although the market for toxic real estate assets has thawed little to date, it seems to be only a matter of time before the federal government manages to successfully entice – or, if necessary, force – banks, other financial institutions, and investors to join in PPIP.

PPIP’s original purpose was to use a combination of TARP funds, private investors and loans from the Federal Reserve’s Term Asset Lending Facility (TALF), another TARP program, to purchase troubled legacy real estate loans on banks’ books (legacy loans) and securities backed by loan portfolios (legacy securities).

The Legacy Securities Market

The legacy loans component of PPIP was postponed indefinitely in June 2009 because banks simply refused to sell their toxic assets at prices investors were willing to pay, perhaps due to the banks’ desire to avoid recording losses on the loans.

In July 2009, Treasury selected a number of fund managers in PPIP’s legacy securities program to team with the government to purchase pools of toxic commercial mortgage-backed securities, residential mortgage-backed securities and other mortgage-related securities from banks and other financial institutions.

How well the legacy securities market will function remains uncertain. Banks and other major financial institutions may still be unwilling to sell their assets at a deep discount, which would also frustrate this goal of the program. Or the program could evolve, which could expose early participants to having the rules changed retroactively. Additional concerns include uncertain requirements related to pricing transparency, profitability and executive compensation.

Numerous potential participants have adopted a wait-and-see approach. Ultimately, the federal government likely will establish parameters acceptable to banks, other financial institutions and investors. Confronted with the carrot and stick of federal policy, banks and other financial institutions may be persuaded, if not pressured, to sell legacy securities to investors. No matter how the program evolves, going into business with the government will present new challenges for financial institutions. Because Treasury is committed to making PPIP work, potential participants should make sure they understand the maze of statutes, regulations and contract clauses that will govern the program so that they may design and implement procedures to ensure compliance with the PPIP program requirements.

FERA: New Fraud Enforcement Statute Will Apply to TARP Recipients

On May 20, 2009, President Obama signed into law the Fraud Enforcement and Recovery Act of 2009 (FERA).1 The statute aims to “improve enforcement” of laws that prohibit fraud involving the mortgage, financial institutions, securities, and to facilitate the recovery of federal funds lost to those frauds.

Of particular interest to those considering participating in a TARP-related program are FERA’s provisions that reclassify mortgage lenders as financial institutions and expand federal criminal liability for mortgage fraud, securities fraud, and major fraud against the United States involving TARP funds. Also, specifically related to TARP, Section 2(d) of FERA amends the law to prohibit participating in a scheme with the intention of obtaining money through false or fraudulent representations or promises made “in any grant, contract, subcontract, subsidy, loan, guarantee, insurance, or other form of Federal assistance, including through the Troubled Asset Relief Program, an economic stimulus, recovery or rescue plan provided by the Government, or the Government’s purchase of any troubled asset as defined in the Emergency Economic Stabilization Act of 2008.”2

In addition, FERA amended the civil False Claims Act (FCA) to greatly expand that statute’s reach. Many financial institutions and real estate ventures may be unfamiliar with the FCA, which for decades has been used as the federal government’s principal tool to combat fraud, waste, and abuse in government programs. Until now, the FCA generally did not apply to banks and other privately-funded financial institutions; nor did it apply except in very limited situations to the real estate industry. With the proliferation of efforts to revive the real estate and financial sectors, those industries now are exposed to the potential for FCA liability when they participate in federally-funded programs, including TARP.

FERA and the FCA Significantly Increase Risks to TARP Fund Recipients

Entities that receive or administer federal funding in any form – whether through formal government contracts, subcontracts, grants, sub-grants, or through any of the TARP programs – should be aware of the FCA.3 This Act, first passed in the wake of the Civil War and substantially amended in 1986 and again this year, creates liability for the “knowing” submission of false or fraudulent claims to the United States government. “Knowing” can include both actual knowledge and “reckless disregard” or “deliberate ignorance” of compliance obligations. Violators can be required to pay treble damages plus civil penalties of up to $11,000 for each false claim submitted.

The FCA also permits private citizens with information about the submission of false claims to file an FCA lawsuit on behalf of, and in the name of, the United States. These actions are referred to as qui tam, or “whistleblower” lawsuits, and the person who brings them is permitted by statute to share in any recovery that is obtained for the government. The qui tam provisions supply unhappy or disgruntled employees, vendors and others with very profitable means of seeking revenge against a noncompliant entity. Another potential consequence of violating the FCA is the possibility of being suspended, debarred, or excluded from future participation in government funded programs.

FERA amends and expands the FCA in various ways that increase the risk of investigation and civil enforcement actions for recipients of federal funds, whether through TARP or other government programs. Among other things, FERA makes the following changes to the FCA:

  • It extends liability to persons who “shortchange” the government, i.e., who possess or control money or property used, or to be used, by the government and knowingly deliver less than the full amount, or who falsely certify receipt of property used, or to be used by the government.
  • It eliminates the requirement that the false claim be presented to a representative of the United States government. It provides that false “claims” can include requests for payment or property that are made either to the federal government or to a contractor, grantee, or other recipient of federal funds. Subcontractors, sub-grantees and vendors are now explicitly covered by the Act. This revision allows for the “tracing” of federal funds through state and local government agency grants, as well as other public or even private entities, as long as the funding or some portion of it comes from the federal government and “is to be spent or used on the Government’s behalf or to advance a Government program or interest.” (emphasis added).4
  • It explicitly authorizes the Department of Justice to share information obtained through a civil investigative demand (pre-intervention investigative discovery)5 with a whistleblower, an administrative agency, and/or a state investigative agency for the purposes of advancing or pursuing an FCA matter (this can occur before the defendant is even aware that a lawsuit is pending against it).6
  • It permits state and local authorities to receive pleadings and materials while a whistleblower case is under seal if the state or local government is named as a co-plaintiff with the United States.7
  • It permits the government to add claims to a whistleblower action that would otherwise be barred by the applicable statute of limitations by providing that these additional claims shall be considered to have been filed as of the date of the initial qui tam lawsuit.8
  • It extends anti-retaliation protections for whistleblowers to include contractors and agents.9

A complete discussion of FERA, its changes to the FCA and the anticipated impact on those receiving federal funds can be found in the May 26, 2009 Holland & Knight Compliance Services alert.

With FERA and the FCA changes added to its arsenal, the Department of Justice has vowed to take on mortgage fraud and abuse when government dollars are at stake. In early June, the Justice Department instituted an action against Capmark Finance, alleging Capmark made false statements to obtain federal mortgage insurance when Capmark acquired a group of nursing homes. The complaint alleges that the Department of Housing and Urban Development was forced to pay nearly $26 million dollars when the nursing homes defaulted on their loans. Under the FCA, as strengthened by FERA, the government can recover treble damages, in addition to civil penalties. With such significant amounts of money on the line and Justice’s stated commitment to combat mortgage fraud, the real estate industry can expect similar lawsuits in the future.

Companies Planning to Participate in PPIP Should Be Proactive Against Possible Fraud and Abuse Allegations

Because of the worldwide financial meltdown and the resulting recession, many companies that previously focused on commercial business activities have seen those business lines dry up. They have turned to the large, expansively funded federal recovery and TARP programs. Federal money is, or will be, flowing into those programs, but those seeking to get involved in, or expand their government business need to pay close attention to the extensive strings that are attached. Many new compliance, tracking and reporting obligations have been enacted to prevent and detect improper uses of the federal funds. Significant new criminal, civil and administrative sanctions are available to the government.

As often happens with new government programs enacted to respond to a crisis, there is haste to get the money out the door, and controls are sometimes lacking in the early stages of the program. Later, in hindsight, different federal authorities, often with pressure from Congress, begin to examine how the funds were spent. Even companies that have made good faith efforts to do the right thing and help resolve the crisis often come under investigation for civil or criminal fraud. Simple, honest mistakes made by companies trying to do their best to implement an important government program can be misinterpreted and viewed as fraud by whistleblowers or federal prosecutors. These risks are increased further by the numerous states that have enacted their own False Claims Acts.

The most effective way your company can protect against these risks is to establish internal policies and controls that will allow you to effectively and fully explain how the government’s funds were secured, accounted for and used. Comprehensive compliance and ethics programs, including mandatory disclosure of various forms of wrongdoing, are now required of most government contractors, and those companies receiving TARP funding should anticipate similar requirements. Even if your company already has compliance and ethics programs, you should review your policies to insure that they incorporate legislative and regulatory changes affecting your business and its receipt and use of TARP funds.

If your company is considering participation in PPIP or any other federal program, be proactive in setting up systems and controls to detect and prevent fraud, as well as mistakes that the government might interpret as fraud. In doing so, your company can develop a mutually beneficial business relationship with the government – whereas failing to take compliance and ethics programs and obligations seriously could cause serious, even disastrous, problems down the line.


1 On May 26, 2009, Holland & Knight issued a detailed alert on this landmark anti-fraud bill, “President Obama Signs Landmark Anti-Fraud Bill Into Law.”

2
FERA § 2(d) (amending 18 U.S.C. § 1031(a), which was previously limited to statements and promises made in the context of a federal government contract or subcontract).

3
29 U.S.C. § 3729 et seq.

4
FERA § 4(a)(2).

5
31 U.S.C. § 3733 allows the Department of Justice to issue “civil investigative demands” for documents, responses to written interrogatories, oral testimony, or any combination of these forms of discovery, before commencing an FCA action.

6
FERA § 4(c).

7
Id. § 4(e).

8
Id. § 4(b).

9
Id. § 4(d).

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