Obtaining Immediate Judicial Intervention Upon Discovery of a Check Kite Situation
By Anthony J. Sylvester and Matthew H. Lewis
Many banks are faced, at one time or another, with overdrafts caused by a check kite. Fortunately, in New Jersey, powerful steps can be taken to obtain swift judicial intervention, including an immediate injunction freezing funds associated with the kite and other assets of the kiters. In addition, a bank can and should take immediate steps to establish priority over claims of other creditors of the wrongdoers.
A check kite involves the interchange of checks between two or more accounts, usually at different financial institutions, and the systematic issuance of items drawn on funds made available before deposited items have actually cleared. In a kite’s simplest form, the kiter draws on the available balance in one account to create an available balance in another account – neither of which is comprised of cleared funds – to cover the checks deposited in the first account, and vice versa.
Thus, it appears that the checks are timely covered when, in fact, they are covered with checks drawn on fictional balances. This practice results in “fictional” account balances from which monies can be diverted. Once the kite is detected, the banks involved generally stop paying presented items, resulting in overdrafts for one or more of the banks.
LOCATING AND FREEZING ASSETS
A bank that detects a kite should be able to identify quickly the other accounts involved by reviewing items deposited in and drawn on accounts at the bank. Next, the bank should attempt to obtain an injunction freezing the funds contained in such accounts, as well as other assets of the check kiters. The injunction should apply to the assets of all account holders that can be identified. Further, the bank may be able to obtain the injunction from a court without giving notice to the kiters.
The issuance of such immediate restraints without notice is extraordinary and unusual because of due process concerns. However, it can be done provided the court finds a probability that:
1. the bank will ultimately prove its claims;
2. the bank will suffer immediate and irreparable harm absent the requested relief;
3. a monetary judgment will not be an adequate remedy;
4. the harm to the bank without the injunction would outweigh any harm to the defendants caused by it.
The court may also consider whether public policy favors the relief (Crowe v. DeGioia, 1982). In addition, the bank must demonstrate that “immediate and irreparable damage” would result if notice were given and a hearing conducted (New Jersey Superior Court Rule 4:52-1).
Persuading a court that these criteria have been met, and that extraordinary relief is justified, will depend upon the ability of the bank, through its counsel, to present convincing evidence of the kite and its intentional nature. Whether to grant the relief is within the judge’s discretion. However, a bank victimized by a check kite is well-positioned to provide the requisite evidence through its records and sworn statements from its personnel. The court should also recognize that providing notice to the kiters is likely to defeat the purpose of the injunction – to prevent dissipation of the fruits of their theft and other assets – and that time is of the essence.
The bank should simultaneously file affirmative claims against the kiters, such as claims for fraud and conversion. Since the evidence of the kite usually is relatively clear, there is a substantial likelihood that the bank will be able ultimately to prevail on those claims, and obtain a judgment. In addition, if there are no other banks suffering losses from the kite, the bank may be able to persuade the account holder of any account where funds are held to consent to their remittance to the bank, thereby offsetting the bank’s losses, at least in part.
OBTAINING PRIORITY OVER CREDITORS
If other accounts involved in the kite or other assets of the kiters are identified, the bank should also seek to obtain writs of attachment from the court at the outset of the case. By serving writs of attachment at the initiation of proceedings, a bank can constructively move forward the date of its eventual judgment levy, potentially by months or even years – possibly putting it ahead of other judgment creditors who would have otherwise taken priority. This can be especially important in a kiting situation because the kiters often have run into financial difficulties and may have numerous potential judgment creditors.
Serving a writ of attachment at the initiation of a case, like serving an injunction, freezes specific assets held by whomever is served with the writ. In addition, under New Jersey law, a levy on property subject to the attachment that is ultimately made pursuant to a judgment in the case will “relate back” to the date of issuance of the writ of attachment (Wolfson v. Bonello, N.J. Superior Court, App. Div. 1994; In re Bobilin, Bankruptcy Division 1988). The levy will be deemed to have been made on the date the writ of attachment was served. Since such a judgment usually cannot be obtained for a number of months, at a minimum, this fact can be significant in potential disputes with other judgment creditors.
Such writs are normally issued in actions seeking seizure of specific assets, and certain statutory criteria must be met to support their issuance. In general, writs may issue if the loss resulted from a willful or malicious act, or fraudulently incurred debt, and it appears that the defendant is likely to abscond with the intent to defraud his or her creditors (N.J.S.A. 2A:26-2; 2A:15-41-42; New Jersey Superior Court Rule 4:60-5). Faced with strong evidence of a check kite, there is a strong likelihood that the court will issue the writs with respect to any specific property identified.
In addition, the bank may attempt to assert a “constructive trust” claim with respect to funds that appear to be in accounts at other banks as a result of the kite. A constructive trust is a remedial device employed by a court to transfer property to its rightful owner. Such a claim amounts to an assertion that the victimized bank is the rightful owner of the funds and that anyone else would be unjustly enriched by obtaining them.
Such a claim may be contested by any other banks victimized by the kite. However, if it is established that funds located in identified bank accounts resulted from the kite, this finding can be used to defeat other creditors of the kiters – who were not victims of the kite – who may assert claims to the funds based on either judgments or loan agreements. The reason is that such creditors should only be able to seize assets of the debtors to satisfy their debt. A judicial determination that specific funds represent proceeds of the kite implies that the funds never belonged to the debtors. Thus, the parties from which the funds were stolen – the banks victimized by the kite – should have a claim to the funds that trumps any claim asserted by mere creditors of the kiters.
IN CASE OF A KITE …
In sum, when a loss from a kite is discovered, a bank, in conjunction with its counsel, should take the following steps:
1. identify assets, including positive account balances in other accounts involved in the kite;
2. attempt to freeze the assets through an immediate injunction and also attempt to obtain writs of attachment on holders of the assets;
3. assert an unjust enrichment claim, seeking imposition of a constructive trust, with respect to any funds identified as proceeds of the kite.
The overriding goals are to preserve assets of the wrongdoers to remedy the bank’s injury and establish priority over other potential creditors.
Anthony J. Sylvester is a partner and Matthew H. Lewis is an associate in the Banking Litigation Department of Morristown-based law firm Riker Danzig Scherer Hyland & Perretti LLP. They can be reached at (973) 538-0800 or at firstname.lastname@example.org.