Banks Security Interests in Checking Accounts and Check-kiting Schemes

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Oct 2002

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This article discusses how courts typically view the security interest Article 4 of
the Uniform Commercial Code (UCC) grants to banks extending credit for checks
deposited in furtherance of a check-kiting scheme. It also examines Article 4's
interplay with the Bankruptcy Code when the check-kiter enters bankruptcy and whether
the 2001 revisions of <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. Article 9</a> alter this interplay. In most
scenarios, the first bank to discover a check-kiting scheme and halt withdrawals from
an account while accepting deposits to that account will be protected, but the
unsuspecting bank will not. Article 9's recent revisions do not alter this
conclusion.

<h3>Check-kiting Schemes</h3>

Check kiting is "[t]he illegal practice of writing a check against a bank account with
insufficient funds to cover the check, in the hope that the funds from a previously
deposited check will reach the account before the bank debits the amount of the
outstanding check." Black's Law Dictionary, 231 (Seventh ed. 1999). In
other words, a check kite is "a type of check fraud by which the malefactor uses
at least two accounts at separate banks and covers overdrafts on one bank by writing
overdrafts on the other bank." The Law of Bank Deposits, Collections and Credit
Cards, §9.01, at 9-1 (rev. ed. 2001).

For example, as explained in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. United States, 458 U.S. 279,
281 n.2 (1982)</a>), a check-kiter opens an account at Bank A with some
small amount of cash. The check kiter then writes a check on his Bank A account
for, say, $50,000 and uses that check to open an account at Bank B.
Before Bank B presents the $50,000 check to Bank A for payment, Bank B
extends credit to the check-kiter, allowing him or her to immediately write a
$50,000 (or more or less) check on the Bank B account and present it to
Bank A. Bank A immediately credits the Bank A account and pays the
$50,000 check when Bank B presents it to Bank A. By repeating a scheme
like the above, a check-kiter can use substantial amounts of money interest-free
which, in most cases, will end in the scheme falling apart and leaving depositary
banks holding the empty bag. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

Check-kiting is possible because the banking system is set up so that a bank
receiving a check does not get paid on it immediately; the bank forwards a deposited
check to a clearinghouse for payment. The clearing-house then forwards the check to
the bank on whose account the check was drawn, which has until midnight on the date
of presentment to pay or dishonor the check. This payment process typically takes a
day or two, and a customer can take advantage of this time (the "float") to use
other peoples' money. The "provisional credit" extended during the float period results
in a positive ledger balance for the account and a negative provisional collected
balance. "The extension of provisional credit to bank customers is common...and is
encouraged by Federal Reserve Regulation CC, which implements the <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Funds
Availability Act of 1987." See Pereira v. Summit Bank, 44 UCC Rep. Serv.
2d 806, 2001 WL 563730 at *4 (S.D.N.Y. 2001)</a> (citing 12
U.S.C.A. §§4001 et seq. (West 1989 and 2000 Supp.); 12
C.F.R. pt. 229 (2000)).

<h3>A Bank's Security Interest in Account Used in Check-kiting Scheme</h3>

Check-kiting schemes often result in the check-kiter being criminally prosecuted
or going bankrupt. In the bankrupt situation, the trustee often pursues payments
received by a bank in the form of checks deposited into a debtor's account as
preference payments. In such situations, banking law, as governed by Article 4,
meets the <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Code, 11 U.S.C. §101</a> et seq. Section 210 of
Article 4 provides that:

<blockquote>
(a) A collecting bank has a security interest in an item and any accompanying
documents or the proceeds of either:

<blockquote>
(1) in case of an item deposited in an account, to the extent to
which credit given for the item has been withdrawn or applied;
</blockquote>
* * *
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. §4-210(a)(1)</a>. Pursuant to this provision, courts have consistently
held that when a bank extends provisional credit to a customer, Article 4 grants
a security interest to the bank in checks deposited with that bank.<a href="#1" name="1a">1</a> Such cases fall
in line with the position enunciated in The Law of Bank Deposits, Collections and
Credit Cards: "Since the system of bank deposits under the UCC almost encourages
kiting—and loss by one of the banks—the courts should be very leery of crafting rules
that fail to leave the loss where it is when the kite comes crashing down." §9.04
at 9-15 (rev. ed. 2001).

Courts examining check-kiting also seem to follow the suggested approach that "[t]he
bank that comes out whole is usually the first to discover the kite." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; §9.01. at 9-1</a>. Although it has been proposed that a check-kiting loss should
be apportioned between banks caught in the scheme, see, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…, Stephanie
A., "Check Kiting: The Inadequacy of the Uniform Commercial Code," 1986 Duke
L.J. 728 (1986)</a>, this position has not been adopted.

<h3>Case Studies</h3>

To understand how courts apply §210 of Article 4 (§4-210) in check-kiting
situations, we will examine two cases. The first, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Laws, 98 F.3d
1047 (8th Cir. 1996)</a>, is a 1996 Eighth Circuit case that illustrates
the basic application of §4-210. The second is an unpublished opinion from the
Southern District of New York that provides additional detail as to how a court is
likely to approach §4-210 in a check-kiting situation. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 44 UCC
Rep. Serv. 2d 806 (S.D.N.Y. 2001)</a>.

In the Eighth Circuit case, a bank extended provisional credits to a customer/
depositor, who used such credits to run up a negative provisional collected funds
balance of about $4 million. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Laws, 98 F.3d 1047</a>. At that point,
the bank notified the customer that it would no longer pay on the customer's
uncollected deposits. The customer then borrowed $4 million from another bank and
wire-transferred it to the first bank to cover the negative provisional collected funds
balance there. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1048-49</a>. A few months later, the customer ended up
in bankruptcy.

The Eighth Circuit examined whether the $4 million payment to the first bank was
a preference payment. The court concluded that the customer's "antecedent debt" (his
negative collected funds balance) was fully secured "and therefore the $4 million
transfer did not improve the bank's position." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1052</a>. The court recognized
that Missouri law (adopting <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. §4-210</a>) granted the bank a security
interest in checks "to the extent to which credit given for the [check] has been
withdrawn or applied." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; (citing Mo. Rev. State §400.4-210(a)(1)).
The debt evidenced by the negative $4 million provisional collected funds balance was
thus secured by the checks deposited with the bank and by the provisional clearinghouse
credits. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1052</a>. Through the bank's collection and final settlement of the
debt (that is, when the bank received the $4 million deposit), the bank realized
its security interests in the checks. Accordingly, the bank did not improve its fully
secured position, and no preference payment existed.

<blockquote>
Because the bank's security interest in the check and its proceeds [were]
released when the provisional credit was repaid...the estate was not depleted
and no preferential transfer occurred. Whether a provisional credit is construed
as a loan secured by the check, or simply as too "provisional" to be treated
as debt for bankruptcy purposes, it cannot properly serve as the basis for
preference liability.
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1052</a> (citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Frigitemp, 34 B.R. at 1015-16</a>). In
so holding, the court rejected the trustee's argument that kited checks are worthless,
stating that "deposited checks in an ongoing kite are not worthless, though some may
be dishonored if the kite collapses." Id. at 1052.

More recently, in Pereira, the Southern District of New York discussed whether
payments received by United Jersey Bank (UJB) during a check-kiting scheme run by
a payroll administration company (Payroll) were preferential payments in the bankruptcy
context. Payroll's business was to receive money from its customers through its
customers' deposits into a Payroll bank account (one such account being with UJB),
then, prior to each payday, organize the currency at Payday's premises and deliver
the currency to various locations to cash payroll checks of Payroll's customers'
employees. Id. at *2. Like a typical bank, UJB extended provisional credits prior
to collecting on checks, including checks deposited in Payroll's UJB account. Payroll,
through its kiting scheme, used checks drawn on National Westminster Bank New Jersey
(NatWest) to cover the negative provisional collected funds balance at UJB and used
UJB checks to cover the negative provisional collected funds balance at NatWest. After
a while, NatWest discovered the kite and dishonored and returned $20.9 million of
checks written on Payroll's NatWest account that were deposited with UJB and presented
to NatWest through the clearinghouse. Id. at *5-*7.

<blockquote><blockquote>
<hr>
<big><center>
These cases and the others cited above demonstrate the importance of a bank promptly recognizing a check-kiting scheme and being the first bank to halt withdrawals from the respective account.
</center></big>
<hr>

</blockquote></blockquote>

When UJB discovered the kite (through NatWest's dishonor of $20.9 million of
checks), UJB halted currency withdrawals from Payroll's UJB account and notified
NatWest of UJB's loss, but was stuck with the approximately $21 million in
overdraft liability. NatWest responded by wiring the $1.57 million in Payroll's
NatWest account to UJB. Also subsequent to UJB halting withdrawals from Payroll's
UJB account, Payroll customers, unaware of any impropriety, deposited $15.5
million into Payroll's account for Payroll to use to administer its customers'
payrolls. Id. at *6-*7.

Payroll then entered bankruptcy. During the proceedings, the trustee alleged that
UJB received preferential payments of about $17 million by receiving checks deposited
in Payroll's UJB account by third parties (that is, by NatWest and Payroll
customers). Id. at 10. The court focused on the last requirement of a
preferential transfer: whether UJB received more than it would have if Payroll
liquidated under chapter 7. The court found that UJB's security interest attached when
UJB extended provisional credit to Payroll (based on kited checks) when it paid
in-clearing checks drawn on the UJB account and deposited at NatWest. Thus, "UJB
gave credit to Payroll's deposited checks and became secured for its negative uncollected
funds exposure under [§4-210]." Id. at *15. The court found UJB's security
interest to total $20.9 million, the amount of checks deposited with UJB that
NatWest dishonored. Id. at *15.

Thus, "UJB had the right to liquidate its security interest in the kited checks"
and did so by applying the $1.57 million payment received from NatWest. By such
application, the court found that UJB received no more than it would have in a
liquidation. Id. at *15. The court also found that UJB had the right as a
secured creditor to liquidate its secured interest in the kited checks by accepting the
$15.5 million in wire transfers and deposits from Payroll's customers. The court
reasoned that had UJB returned the transfers and deposits to Payroll's customers, the
estate would not benefit; UJB would have a much larger secured claim, and Payroll's
customers would have smaller claims against Payroll. Id. at *15-16. That
Payroll's customers were not in the practice of extending credit to Payroll, but
forwarded its own money to Payroll's UJB account so Payroll could administer the
funds, did not fit into the equation.

These cases and the others cited above demonstrate the importance of a bank promptly
recognizing a check-kiting scheme and being the first bank to halt withdrawals from
the respective account. A bank's receipt of deposits to an account can be applied
to the security interest granted by the bank's extension of provisional credit on that
account.

<h3>Effect of Article 9 Revision</h3>

Section 210 of Article 4 also provides that a security interest granted to a
bank for extending credit (such as provisional credits) are subject to Article 9,
but (1) no security agreement is necessary to make the security interest enforceable
(§9-203(1)(a)), (2) no filing is required to perfect the security interest
and (3) the security interest has priority over conflicting perfected security
interests in the item, accompanying documents or proceeds. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=….
§4-210((3)</a>. Where pre-revised Article 9 deferred to common law to determine
priority of "deposit accounts," revised Article 9 (RA9) includes deposit accounts
within its scope. "Deposit account" means "a demand, time, savings, passbook or
similar account maintained with a bank." RA9 §102. While slightly modified, RA9
§203 still governs attachment and enforceability of security interests. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; That
section specifically provides that "subsection (b) is subject to §4-210 on the
security interest of a collecting bank..." RA9 §203(c). Given that a security
interest granted by §4-210 "has priority over conflicting security interests in the
item, accompanying documents or proceeds," <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. §4-210(a)</a>, it appears that
a bank is always safe.

But RA9's new perfection rules for deposit accounts may lead to a different
result. Perfection of deposit accounts is achieved through control pursuant to RA9
§§312 and 314, and priority of conflicting security interests in deposit accounts
are governed by RA9 §327. The requirements for control of a deposit account are
set forth in RA9 §104, which provides that a bank is afforded automatic perfection
(through control) in a deposit account the bank maintains. RA9 §104(a)(1)
and ct. 3. However, "under subsection (a)(2), a secured party may obtain
control by obtaining the bank's authenticated agreement that it will comply with the
secured party's instructions without further consent by the debtor." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… §104 ct.
3</a>. In such a situation, could the authenticated agreement granting control over the
deposit account waive the bank's security interest in extended provisional credit granted
by <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. §4-210</a>? Not likely, given the wording of that section and RA9
§203(c), but it may well depend on the language of the authenticated agreement.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Cannon, 237 F.3d 716 (6th Cir. 2001)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Laws v. United Mo. Bank of Kansas City,
98 F.3d 1047 (8th Cir. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Frigitemp Corp., 34 B.R. 1000 (Bankr. S.D.N.Y. 1983)</a>, aff'd.,

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.2d 230 (2d Cir. 1985)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 44 U.C.C. Rep. Serv. 2d 806</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Summitt Fin. Serv's. Inc.,
240 B.R. 105 (Bankr. N.D. Ga. 1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Brown, 33 U.C.C. Rep. 2d 181 (Bankr. W.D. Tenn.
1997)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Consolidated Pioneer Mtg. Entities, 211 B.R. 704 (S.D. Cal. 1997)</a>, aff'd. in part and rev'd. in
part, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 342 (9th Cir. 1999)</a>. <a href="#1a">Return to article</a>

Journal Authors

Deborah L. Thorne

Kurt A. Winiecki

Journal Date

Tuesday, October 1, 2002 - 12:00

Bankruptcy Rule

2002