Articles

I. Background

Check kiting losses have been a difficult issue for financial institution insurers for more than 40 years. Losses resulting from the granting of credit are inherit in the business of banking. Because check kiting is predicated upon the granting of immediate credit on items of deposit, insurers historically contended that insurance should not be available for the resulting loss. Insurers argued that such credit losses were excluded by the loan loss exclusion of the standard form bonds. The courts often did not agree and created coverage by refusing to apply the loan exclusion to check kiting losses.

This ongoing debate resulted in several amendments to the standard forms of the Financial Institution Bond and its predecessor, the Bankers Blanket Bond. By these amendments, the insurers adopted language which the insurers believed would reflect the intent that check kiting losses should be excluded from coverage. By 1986, amendments to the Financial Institution Bond seemed to make it clear that check kiting losses (and losses resulting from the giving of immediate credit on deposit items) were not covered.

The industry has now come full circle. After struggling for 40 years to avoid coverage for check kiting losses, insurers now make coverage available for losses due to check kiting, typically in the form of a “Check Kiting Fraud” rider to the standard bond forms. This paper will discuss kiting, the relevant history of coverage for check kiting losses, the nature of those kiting losses and the currently available coverages.

II. 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. See First Texas Savings Ass’n v. Reliance Ins. Co., 950 F.2d 1171, 1173, n.1 (5^th Cir. 1992); Calcasieu-Marine Nat’l Bank v. American Employer’s Ins. Co., 533 F.2d 290, 294, n. 3 (5^th Cir. 1976), cert. denied, 429 U.S. 922 (1976). 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. See United States v. Frydenlund, 990 F.2d 822 (5^th Cir. 1993).

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.” Howell Hydrocarbons, Inc. v. Adams, 897 F.2d 183, 191 (5^th Cir. 1990); Mitsui Mfgrs. Bank v. Federal Ins. Co., 795 F.2d 827, 830, n. 2 (9^th Cir. 1986); Bay Area Bank v. Fidelity & Deposit Corp. of Maryland, 629 F.Supp. 693, 695, n. 3 (N.D. Cal. 1986); see also, Williams v. United States, 458 U.S. 279 (1982) (“[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. [Citation omitted]. Check kiting necessarily involves two or more accounts.

Ortiz v. San Antonio City Employees Credit Union, 974 S.W.2d 833, 836 (Tex. App.— San Antonio, no writ).

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.

1 Barclay Clark & Barbara Clark, The Law of Bank Deposits, Collections and Credit Cards ¶ 9.01 (rev. ed. 2000) [hereinafter “Clark”]. 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). See Clark, ¶ 9.01.

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. See Clark, ¶ 9.01.

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. Clark, ¶ 9.03; Alta Vista State Bank v. Kobliska, 897 F.2d 930 (8^th Cir. 1990); Citizens Nat’l Bank v. First Nat’l Bank, 347 So. 2d 964 (Miss. 1977). 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. See, Community Bank v. United States Nat’l Bank, 555 P.2d 435 (Or. 1976). 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. Clark, ¶ 9.01. 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. See Clark, ¶ 9.09[3].

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.

III. History of Check Kiting under 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. See J. Knox and S. Baskind, The Loan and Uncollected Funds Exclusion, ABA National Institute on Financial Institution Bonds (1989).

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. See e.g., Calcasieu Marine Nat’l Bank v. American Employers Ins. Co., 533 F.2d 290 (5^th Cir. 1976), cert. denied, 97 S. Ct. 319 (1976).

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. See, Bradley Bank v. Hartford Accident & Indemnity Co., 557 F.Supp. 243, on motion to vacate judgment, 562 F.Supp 241 (W.D. Wis. 1983), aff’d, 737 F.2d 657 (7^th Cir. 1984).

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.

IV. Changing Times: Check Kiting Fraud Coverage

There are companies that offer coverage that is more restricted. See Appendix A. 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.