Check Kiting

Check Kiting is a form of bank fraud that involves illegally exploiting a time gap in the banking system to create a temporary, artificial balance in an account. The person committing the fraud, known as the “kiter,” writes a check from an account that has insufficient funds and deposits it into another account at a different bank. The receiving bank often provisionally credits the account, making the funds available before they have actually been collected from the first bank. The kiter then quickly writes a check from the second account to cover the shortfall in the first, or simply withdraws the cash. This creates a continuous, circular scheme that relies on the banking system's delay—the float time—between a check's deposit and its clearance. While it might sound like a clever trick, check kiting is a serious federal crime that can lead to hefty fines and imprisonment.

Imagine a magician's trick where a ball seems to be in two places at once. Check kiting works on a similar principle, but with money and bank accounts. The entire scheme hinges on the float, which is the period between when you deposit a check and when the bank actually pulls the money from the check writer's account. Let's break it down with a simple example:

• Step 1: A fraudster, let's call him Charlie, has two bank accounts. Account A at Big Bank and Account B at Metro Bank, both with nearly zero balances.
• Step 2: Charlie writes a $5,000 check from Account A (which doesn't have the money) and deposits it into Account B. Metro Bank, seeing the deposit, provisionally credits Account B with $5,000, making the funds available for withdrawal, often within a day.
• Step 3: Before Big Bank can process the check and realize Account A is empty (a process that might take a few days), Charlie withdraws the $5,000 in cash from Account B. He now has real money based on a phantom deposit.
• Step 4: To prevent the first check from bouncing, Charlie must keep the kite “in the air.” He might write another bad check, this time for $5,000 from Account B, and deposit it into Account A to cover the original withdrawal.

This cycle of writing bad checks between accounts creates an unauthorized, interest-free loan and can be maintained for some time. However, banks have sophisticated systems to detect such patterns, and eventually, the kite comes crashing down.

While you probably aren't at risk of unknowingly kiting checks, understanding this type of fraud is crucial for a value investor. It's a massive red flag that can signal deep-seated problems within a company you might be analyzing.

On a corporate level, check kiting is a symptom of either extreme financial desperation or outright accounting fraud. A struggling company might use it to temporarily mask a cash shortfall, pay employees, or fool creditors. Dishonest executives can also use complex kiting schemes to artificially inflate the cash figures on the balance sheet, making the company appear much healthier than it is. As an outside investor, you can't see a company's daily bank transactions. However, you can look for warning signs in their financial reports that hint at cash manipulation:

• Unusual Cash Movements: Scrutinize the Statement of Cash Flows. Are there large, unexplained transfers between different company subsidiaries or a pattern of cash balances that just don't seem to align with the reported net income or operating cash flow?
• “Window Dressing”: Be wary of companies that consistently show a strong cash position only at the end of a reporting period (quarter or year-end). This could suggest they are using short-term tricks to temporarily boost their books.
• Inconsistent Disclosures: If management's discussion of liquidity and cash management seems vague, confusing, or contradictory to the numbers, it's time to dig deeper.

The lesson from check kiting extends to a core tenet of value investing: Cash is king, but only if it's real. Revenue can be recognized early and earnings can be manipulated, but cash is supposed to be the ultimate reality check. Frauds like kiting prove that even cash balances can be faked. This is why savvy investors don't just glance at the cash line on the balance sheet. They analyze the entire Statement of Cash Flows to understand where the cash came from. A healthy company generates a robust and growing stream of cash from its core operations, not from financial trickery or unsustainable borrowing.

One of the most famous cases of corporate check kiting involved the once-prestigious brokerage firm E.F. Hutton. In the early 1980s, the firm systematically and intentionally overdrew accounts at various banks by billions of dollars. By shuffling money between branches and banks, they effectively gave themselves interest-free loans daily. The scheme was uncovered, and in 1985, the company pleaded guilty to 2,000 felony counts of mail and wire fraud, resulting in massive fines and irreparable damage to its reputation.

Popularized by the film “Catch Me If You Can,” Frank Abagnale Jr. was a master forger and fraudster in the 1960s. While his crimes were more varied, a key part of his success was exploiting check float to stay one step ahead of the banks and law enforcement. His story, though romanticized, provides a vivid illustration of how a clever individual could manipulate the vulnerabilities in the banking system of that era.