Banks and mortgage lenders be forewarned: federal prosecutors can use your internal quality-control reports to support fraud allegations.

Wells Fargo's quality-control procedures will take center stage in a closely watched case that could go to trial this summer, in which federal prosecutors have accused the nation's largest mortgage lender of "shoddy underwriting" of government-insured loans.

Prosecutors allege that Wells engaged in more than 10 years of "reckless" origination and underwriting of Federal Housing Administration loans. The case hinges on the knowledge that Wells' executives obtained from their own review processes.

Focusing on the quality control is a way for the government to allege knowledge by bank executives without necessarily showing examples of outright fraud, some lawyers said. There is concern in the industry that quality-control programs, even strong ones, will make banks vulnerable in court.

"Many times originators didn't have a QC program or had weak ones, and the fact that Wells Fargo had one and caught weak loans is an interesting one," said Patricia McCoy, a professor at Boston College Law School who specializes in banking law. "That raises a question of whether we want to penalize a quality-control program for catching things."

Wells' reports show that executives knew some loans were of poor quality but did nothing about it, the lawsuit alleges. Wells failed to report the errors or change its practices because of pressure to fund more loans, the suit claims.

Attempts at a settlement broke down last year. Wells has been the lone big bank holdout willing to go to trial over allegations it violated the False Claims Act, a Civil War-era law that allows the government to collect triple damages for fraud against the government. The violations stem from essentially another era of mortgage lending, dating back to 2001, before far more rigorous quality-control requirements were put in place.

If Wells deliberately ignored its own quality-control reports, there could be potential liability, McCoy said.

"They don't have to specifically intend to defraud the government for violating the False Claims Act," McCoy said. "If they knew the truth and deliberately ignored it, they can be held liable."

However, Wells clearly believes the government "is overzealous in pursuing this broad of an action," said Allen H. Jones, a managing director at RiskSpan, a mortgage data and analytics firm.

"The outcome of this litigation will be telling for the industry because Wells has dug in," said Jones, who managed Bank of America's FHA business from 2005 to 2009.

Last year the government added a Wells executive in charge of quality control, Kurt Lofrano, as a defendant to the lawsuit, which was originally filed in 2012. Lofrano was responsible for reporting loans with material defects to the Department of Housing and Urban Development, which oversees the FHA.

Lofrano, Wells' former head of quality control, still works at the bank, according to the company. Lofrano's attorney, Meredith Kotler, a partner at Cleary‎ Gottlieb, declined to comment for this story.

The lawsuit alleges that from May 2001 to October 2005, Wells claimed more than 100,000 loans met HUD's guidelines when it knew a substantial number, up to 50% in 2002 alone, did not.

Theoretically lenders are required to indemnify FHA for loans that have mistakes or are defective, essentially self-insuring the loan so taxpayers are not on the hook for potential losses. In this case, HUD paid insurance claims on thousands of defaulted loans that it later found had significant material violations, the lawsuit alleges.

Federal prosecutors have gone further, claiming Lofrano engaged in a "fraudulent scheme," of violating HUD's self-reporting requirements and concealing its practices. Specifically Lofrano failed to report 6,320 loans that had material defects to HUD, the lawsuit said. Before 2005, Wells did not self-report a single bad loan, the suit said.

From 2002 to 2010, "Wells internally identified 6,558 loans that it was required to self-report. .. but self-reported only 238 loans," the suit states.

A number of other large banks have settled similar cases, but Wells spokesman Tom Goyda said the $1.7 trillion-asset San Francisco bank had not reached a settlement "despite good-faith efforts to work with the federal government on a possible resolution of the complaint."

"We will move forward with presenting our case in support of our prudent and responsible FHA lending practices, which have produced high-quality FHA loans with delinquency rates that are half the industry average," Goyda said.

Some lawyers have suggested that even a well-functioning quality-control process can be used by federal prosecutors as evidence of fraud.

"Quality-control results appear to be the 'red flags' that the government seeks to rely upon to demonstrate fraudulent intent," Richard Strassberg, a partner at the law firm Goodwin Procter, wrote in a New York Law Journal article last year. "Allegations that Wells Fargo failed to report bad loans detected in its quality-control reviews shows that even much narrower failures can attract Justice Department interest."

Strassberg, who is co-chair of Goodwin Procter's securities litigation and white collar defense group, is a former head of the major crimes unit in the U.S. Attorney's Office for the Southern District of New York. That office, headed by Preet Bharara, filed the original complaint against Wells in 2012. The government's claims also include a breach of fiduciary duty, gross negligence and negligence.

"Now a jury will have to weigh the facts to determine the bank's liability and the scope of the damages it must pay," Bharara said in a press release when the case was originally filed.

The stakes in such cases are high.

Last year, JPMorgan Chase paid $614 million to settle claims it improperly approved FHA and Veterans Affairs loans. After that settlement, JPMorgan CEO Jamie Dimon told analysts in an often-repeated comment: "The real question for me is should we be in the FHA business at all."

Bharara and the Justice Department have settled civil fraud cases against Bank of America for $1.8 billion, Deutsche Bank's MortgageIT unit for $202.3 million, CitiMortgage for $158 million, SunTrust for $418 million and Flagstar Bank for $132.8 million.

Each of the settlements involved the lender's admission that they submitted what are called "false annual certifications" to HUD.

In the Wells case, the government alleges Wells falsely certified that "tens of thousands of loans were eligible for FHA insurance," when a substantial number "did not comply with HUD requirements, contained an unacceptable level of risk and [were] ineligible for HUD insurance."

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