K is for Kiting

Anyone remember E.F. Hutton?

The brokerage company was famous for a 1980s ad campaign, “When E.F. Hutton talks… people listen.” E.F. Hutton became famous for something else. It was complicated, it was company-wide, and it went on for three years, until they were found guilty of thousands of counts of fraud involving millions of dollars.

The fraud was for kiting.

A Special Type of Fraud

Check kiting is a type of bank fraud that occurs because banks and merchants extend credit on customer checks, when they don’t know whether the customer has enough funds in the other bank. Criminals could open two bank accounts, then write checks between them, covering each bad check with another bad check.

Up until recently, banks didn’t have computer systems to track customer money. Signature cards were kept on file at branches, and banks had to ship all the checks back and forth to each other. Heck, up until the 1970s, customer accounts were all balanced by hand in a single location. Customers could write bad checks for weeks without the banks catching up with them. Thus, kiting could only exist once checks, or bank drafts, were commonplace, which was the early 20th century.

Yet, though this started back in the 1920s, check kiting schemes still happen, and on a big scale. In October 2018, Texas First Bank and Trust and Ford Credit sued Reagor Dykes, a car company, for a massive check kiting scheme. Dykes settled for $58.7 million and Reagor settled for $54 million.

Robbing Peter to Pay Paul

Kiting rests on two fundamental ideas. The first one relates to using new money to pay old money, a cousin to a Ponzi scheme. Another recent example of this was a political fundraising scheme reported in the Times. Lengthy requests for funds would end with an already-checked box, often in small print, that said the donations might recur monthly or weekly.

Donors eventually complained, and some were issued refunds. But this allowed access to money on a large, temporary basis when the political party needed it, before the election. Money that kept pouring in from new duped donors could be used to give refunds, extending the time that the scheme could continue.

Kiting isn’t always only about checks.

Hutton Floats Down the Drain

Check kiting specifically rests on the key banking idea of float, a risk reduced as checks become replaced by debit cards or ACH transactions. Float refers to the time it takes a bank to recover money from a cashed check. A California bank at its fastest might take three days to send a check to New York. If a customer’s New York account didn’t have enough funds, it would take three days to send it back, buying the bad check writer at least a week.

Or, suppose the paperhanger (bad check writer) involved a third-party, like a retailer. If the kiter was able to cash a check to buy tobacco or gas, then the retailer would probably take a few extra days to get the check to the bank. This is why stores eventually stopped taking checks. The float for them was too long and the losses too high.

If you really want to get this scheme working, you had to think big, like E.F. Hutton did. In the early 1980s, this second-largest brokerage in the U.S. designed a process known as Chaining, which used float to move money between banks. Write a check greater than the local company’s cash account, deposit it in a second bank, then cover your first check with a mirror deposit. Add in three or four banks, and Hutton had phantom money going around in a circle.

Hutton manager Thomas Morley, charged with improving the bank’s cash flow, wrote a positive memo about this approach to Hutton’s president, suggesting that this netted one Hutton office an extra $30,000 a month. In effect, it was an interest-free loan. Morley neglected to mention the illegal part. The CEO passed the memo on and the entire company operated in this manner until a local New York bank questioned the process. By the time the criminal complaint was settled, Hutton was found guilty of 2000 counts of fraud and paid multi-million dollar settlements.

The company value fell, making them vulnerable enough to be bought by Shearson/American Express. After that, they were merged and passed around like an orphaned cousin in an Austen novel. Hutton eventually tried to rebrand themselves, moving from New York to Springfield and calling themselves EFH, but they suspended operations in 2019.

In the end, everybody was talking about them, but no longer listening to them. Except for the feds.

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