Check Fraud - What´s “Check Kiting”?

 

Check kiting is generally considered a process whereby a person with a checking account in two banks can create an illusion of money in his account. A check drawn on the first bank is deposited with the second bank. Before the check reaches the first bank for payment, a check drawn on the second bank is deposited to the first bank. If the bank is willing to give immediate credit in the interim, the person can use the bank’s money without first providing collateral and without paying interest. This scheme can go on as long as the person keeps depositing checks in both banks and both banks believe there is money behind the checks.


Another court described check kiting as a scheme designed to separate the bank from its money by tricking it into inflating bank balances and honoring checks drawn against accounts with insufficient funds.


Another more simple definition of check kiting is “the passing of checks between two or more banks to obtain unauthorized credit from each bank during the time it takes the checks to clear.”


“[T]he check kiter can take advantage of the several-day period required for the transmittal, processing, and payment of checks from accounts in different banks.”).


In defining check kiting as a species of fraud consisting of the exchange of checks of approximately the same dates and amounts between two banks for the purpose of obtaining money, one court explained:


It is a process where checks written on one account are continually covered with deposits of checks written on another account, thereby creating positive statement balances and preventing overdrafts but resulting in steadily decreasing deficit in the collective balance in most of the accounts. Check kiting necessarily involves two or more accounts.



Check kiting is a dangerous threat to banks. As one commentator observes:

One of the greatest threats to depository institutions is the check-kiting scheme. The bank left in the overdraft position will usually suffer substantial loss, particularly because the kiting risk is normally not covered by the bank blanket surety bond.


In addition to creating a civil problem for banks, check kiting is a crime prohibited by federal law. 18 U.S.C § 1344. Thus, individuals who perpetrate a check kite are frequently prosecuted and sent to prison. That often does not help the banks that are left with a loss after the check kite collapses.


Banks often unintentionally create the opportunity for a kite by granting immediate credit on depository items. While banks claim that a depositor will not get immediate credit on items deposited for several days, banks frequently give immediate credit to the depositor on those items. Since a kite is a type of fraud by which the kiter uses at least two accounts at different banks, the kiter covers overdrafts on one of the banks by drawing checks on the other bank. In doing so, the kiter creates fictional balances at both banks – that is, balances based on the granting of immediate credit on items of deposit which are, in fact, not represented by real funds. The kiter can do this by taking advantage of the “float” period between the time of deposit and the time of the actual payment by the drawee bank. This opportunity is available to the customer because the banks are willing to grant immediate credit on deposit items and allow withdrawals against uncollected funds, as authorized by UCC Article 4 and Regulation CC (12 C.F.R. pt. 229).


The kite usually continues until one of the two or more banks discovers the kite and returns, unpaid, checks drawn on it (for which the other bank has granted immediate credit upon the deposit thereof). At this point, the kite collapses. Usually, the bank that first discovers the kite will successfully shift the entire loss to the other bank. It does this by remaining silent about its discovery, and while sending the items deposited at it for collection, refuses to pay items drawn on it which were deposited at the other bank. The discovering bank hopes the other bank will not discover the kite in time to return items by the midnight deadline. As one commentator noted, the bank that loses in a kite is the bank that, relying on uncollected deposits, holds checks drawn on it beyond the midnight deadline.


Whether the discovering bank owes duties to the other banks in the kite, such as to inquire further and notify each other of suspicions of kiting, is beyond the scope of this article. The majority rule seems to be that if each bank in a kiting situation is merely trying to protect itself, it has no duty to advise the other bank of its suspicions and the discovering bank can act to protect itself – even if this has the effect of shifting the entire loss to the other bank.


One jurisdiction, however, seems to suggest that the discovering bank may act in bad faith when it stops payment on items drawn on it while at the same time trying to collect items deposited at it. A finding of bad faith may be the basis to impose liability upon the discovery bank.


Check kiting schemes are usually accompanied by certain predictable account activity. There is usually sudden increased activity in the account when the kite begins. There are wild fluctuations in the balances in the involved accounts. There is a steady increase in the amount of deposits. Sometimes the withdrawal and deposits are very similar in amount. Sometimes the withdrawals and deposits are in an identical amount Other warning signs include frequent daily negative balances or overdrafts that are covered in a short time frame, frequent check withdrawals to the same institution, and deposit volume that is inappropriate in relation to the nature of the depositor’s business.


Because of these patterns and warning signs, kite-detection software is available to banks. This software detects the usual patterns of kiting and reflects that suspicious activity in reports designed to be reviewed by bank officers. These reports frequently result in the early detection of check kites and the shifting of loss by the discovering bank to the other involved banks. Unfortunately, many banks still do not use this kite detection software.

History of Check Kiting

Financial Institutions Bonds

Historically, financial institution insurers did not provide insurance for check kiting fraud. Check kiting losses were typically viewed as a “credit risk.” Insurers did not insure against any form of credit risks, particularly those credit risks for which the insured bank was in the best position to prevent by exercising good banking judgment.


When an insured presented a claim for a check kiting loss, the insurer typically asserted that the loss was not covered, most often arguing that it was excluded by the loan exclusion Because the courts were not always receptive to the argument that check kiting losses were the equivalent to loan losses and thereby excluded by the loan loss exclusion, the insurers amended the loan exclusion in an attempt to make it clear that kiting losses were not covered by the bond. The language that first appeared in the bonds was found as an add-on to the loan exclusion (Exclusion (e)) and provided that the loss was not covered if it resulted from “... payments made or withdrawals from any depositor’s account by reason of uncollected items of deposit having been credited by the Insured to such account, unless such payments are made to, or withdrawn by, such depositor or representative of such depositor who is within the office of the Insured at the time of such payment or withdrawal, or unless such loss is covered under Insuring Agreement A.”


Later, with the 1980 revisions to the standard form bond, the language was set forth in a separate exclusion, the Uncollected Funds Exclusion §2(o). Exclusion §2(o) read:


Loss resulting directly or indirectly from payments made or withdrawals from a depositor’s account involving items of deposit which are not finally paid for any reason, including but not limited to Forgery or any other fraud, unless such payments or withdrawals are physically received by such depositor or representative of such depositor who is within the office of the Insured at the time of such payment or withdrawal, or except when covered under Insuring Agreement (A).


An exception to the exclusion, set forth in the above quoted provision, was allowed for coverage of check kiting losses if the depositor or his representative actually came to the office of the bank and was on the premises when the payment or withdrawal was made. To fit within the exception (that is, to be covered), the depositor or his representative was required to physically receive the withdrawal. The physical receipt of the withdrawal could only be accomplished through receipt of cash or its equivalent, such as a cashiers check.


Under this version, the bond recognized a distinction between on-premises kiting (in which the kiter actually enters the bank’s premises and physically receives the proceeds of the kite) and off-premises kiting (in which the kiter perpetrates the kite without coming on premises). The on-premises versus off-premises distinction was predicated on the historical coverage afforded by Insuring Clause B, which had always provided for loss due to fraud committed on premises accompanied by the physical taking of tangible property.


The insurers, however, ultimately concluded that they simply did not want to insure for kiting losses. The exclusion was, thus, modified to delete the on-premises exception to the exclusion. This modification, in 1986, changed Exclusion § 2(o) to read: Loss resulting directly or indirectly from payments made or withdrawals from a depositor’s account involving items of deposit which are not finally paid for any reasons including but not limited to Forgery or any other fraud, except when covered under Insuring Agreement (A).


After the 1986 amendments, no coverage for check kiting losses existed unless those losses involved employee dishonesty and otherwise fell within the scope of Insuring Agreement A. The 1986 amendments clarified the desired intent to exclude losses due to check kiting and the granting of immediate credit on deposit items under all circumstances except when employee dishonesty existed.


A full discussion of the cases dealing with coverage under the earlier versions of the Bond, is beyond the scope of this paper.

Times do change

In this era of a soft insurance market, competitive forces in the marketplace led many insurance companies to now offer coverage for Check Kiting Fraud.


These various endorsements are usually referred to as the Check Kiting Fraud Endorsement or a Fraudulent Deposit endorsement. Set forth in Appendix A are samples of some of the currently available Riders. It must be noted that all opinions and analyses offered in this paper of any sample endorsements reflected in the Appendix A are exclusively the opinions of the authors and do not necessarily reflect the views of any of the companies whose endorsements are included in the Appendix.


The principal elements in the typical form are:


• There is coverage for loss resulting from checks or items of deposit which are not finally paid due to “Check Kiting Fraud” committed against the Insured bank;
• “Check Kiting Fraud” must be perpetrated by a depositor of the Insured as set forth below;
• The depositor’s fraud must involve the establishment of two or more accounts in different institutions, one of which is the Insured;
• The fraud must involve “constant, systematic, back and forth deposits” between two or more accounts utilizing checks of “approximately the same amount” to create the appearance of valid funds in the accounts;
• The fraud must involve checks, deposited with the Insured, “drawn against uncollected funds” which have been deposited in another institution to create the appearance of valid funds in the account at the other institution;
• The deposits must be made with the “clear and obvious intent” to defraud the Insured;
• The Insured must in fact be deceived by such deposits. In addition to the elements of coverage set forth above, the general form also includes a condition precedent to coverage. The Insured’s right of recovery under the Check Kiting Fraud coverage is expressly conditioned upon the Insured, following its discovery of the fraud, stopping payment of any checks drawn on the depositor’s account and returning all checks drawn on the insured which have been drawn against uncollected funds. That is, the insured must act to shift the loss to the other banks involved in the kite. If the foregoing elements and conditions are satisfied, there is coverage for the check kiting loss. Some forms provide separate limits and deductibles for the check kiting coverage.


There are companies that offer coverage that is more restricted. For example, one company offers coverage for “loss resulting directly from a person depositing or exchanging for cash with you a check or draft that is ultimately not paid, providing that:


(a) the person intended to commit a fraud by depositing or exchanging for cash the check or draft; and
(b) you made payment or extended credit against the check or draft.” While this form would apparently afford coverage without proof of an actual kite – which would seem as broader coverage – the form restricts coverage to transactions in which the customer receives “cash” in exchange for the unpaid check. This type of coverage seems to reflect the intent under the earlier forms which recognized coverage only when the fraud was committed on premises accompanied by a taking of tangible property.


Another company’s coverage does not require the continuous and systematic withdrawals between banks, or at least, does not contain that specific language in the coverage clause. Instead, it covers loss that results from an insured bank’s having credited any items of deposit which prove to be uncollectible. There is a requirement that the depositor intend to cause the insured to sustain a loss or to obtain a financial benefit for the depositor. An additional requirement is that the act of granting the immediate credit permitted the fraudulent withdrawals from the account. While this coverage language is different from that of several other companies, the net effect is to effectively limit coverage to a check kiting scenario since the language requires losses resulting from credit being granted that allowed fraudulent withdrawals on items that are uncollectible.

Questions, Comments and Thoughts

To date, there are no reported decisions interpreting the “Check Kiting Fraud” endorsements. Thus, at this time, there is no case authority to provide guidance in interpreting this new coverage. Set forth below are some questions, comments and thoughts about the coverage and how the new coverage might be interpreted along with some issues that might arise in a check kiting situation:


• The general form endorsement contains a very specific definition of kiting and includes, for example, language requiring “constant, systematic, back and forth deposits.” What if the kite involves only a few, very large, checks when it collapses? Will that be sufficient to satisfy the elements of coverage?
• What is “constant” and “systematic”? For example, would large deposits and withdrawals every 5 days be sufficient? Or, does there need to be activity in the account on an almost daily basis? How long does a kiting scheme have to go on to be considered “constant?” It would seem that a kite would not work if the deposits and withdrawals were spaced out on a weekly basis since the kiter would not really be able to play the “float” in the instance, but depending on a bank’s policy in regard to giving immediate credit, such a scenario could be envisioned.
• The general form indicates that the fraud must utilize “checks of approximately the same amount to create the appearance of valid funds.” Some very complex kites involve the deposit of real checks along with the bogus checks. If several institutions are involved, the kiter may use a combination of checks as deposit items. In these situations the deposited checks may not necessarily be in “the same amount.” Is there an intent not to provide coverage in such a case? Or, is coverage afforded if it is clear there is a kite – albeit, in the complex example, a kite that does not necessarily involve items in approximately the same amount?
• The coverage is expressly conditioned on the discovering bank immediately stopping payment on items drawn on it and returning those items. As noted above, there seems to be no violation of any duty owed to the other banks when a discovering bank acts in such a way to protect itself stopping payment on items drawn on it while collecting items from the other bank. What if the discovering bank acts in just such a manner – which is a condition to coverage – and shifts the loss to the other bank, but the other bank imposes liability back upon the discovering bank under some breach-of-duty theory? It is quite common for banks to pursue claims against the other banks involved in the kite. Is there coverage for the loss resulting from the breach of duty?
• The coverage only applies if the customer has the “clear and obvious intent” to defraud. In the ususal kite, fraudulent intent should not be a major issue. But there are very complex kites perpetrated with multiple accounts and legitimate deposits. In these situations, fraudulent intent may not be obvious.
• The coverage also requires that the Insured actually be deceived by the kiter. There are reported instances when banks have allowed “good” customers to repeatedly draw on uncollected funds, deposit items which are not paid and otherwise deal with their accounts in an usual way, usually because the customer has some explanation for the conduct and the bank thinks the customer is wealthy (customer represented that he was “extremely wealthy and that he required special attention to conduct his real estate and securities trading businesses,” such that Bank paid all his checks regardless of his pattern of depositing NSF checks and drawing against uncollected funds.


The resulting loss was excluded by the loan exclusion.) When a bank knowingly allows a customer to draw against uncollected funds without regard to funds in the account, the Insured might not be able to establish that is was in fact deceived by the kiter, and there should be no coverage.


• Since the coverage generally requires that a bank be actually deceived by a kiter, what if the bank had check-kite detection software and ignored all of the reports and the warning signals? Can the bank claim to be deceived when it was receiving internal warnings from its kite detection software but the bank chose to ignore those warnings? Will a finding of actual deceit be based on subjective or objective criteria?
• Coverage generally requires two or more different accounts in two or more different institutions. Can a kite exist in just one institutions? What if the kite is between two subsidiaries or related institutions such as the banking arm of a company and the brokerage entity of a sister company? How will coverage be impacted in that instance?


Since there are no cases to guide insurers yet, insurers will have to rely on common sense interpretations of the check kiting endorsement in making these coverage determinations.


Fortunately, in most kiting situations, the intent to deceive is clear and the fraud is obvious.

Conclusion

With the advent of the “Check Kiting Fraud” endorsement, financial institutions can now purchase coverage for kiting losses that would not otherwise be covered under the current Financial Institution Bond. After 40 years of struggle while insurers tried to exclude check kites from coverage, this direct method of dealing with kiting losses could be much better for all involved. To the extent the risk inherent in kiting (that is, loss due to the granting of immediate credit) is now one for which insurers are willing to indemnify, the cost of that risk can be allocated properly through appropriate premiums, limits and deductibles.

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