Serpent on the Rock

by Kurt Eichenwald

  Bank account overdrafting came to the rescue. Like every brokerage firm, Hutton needed millions of dollars each day to finance its operations. The idea had started in 1978, with Hutton branches writing perfectly legal checks against funds that had not yet cleared. It took away float from the banks, but those institutions were still paid for their services. Then, in 1980, Hutton pushed the aggressive idea over the line. Rather than just using small overdrafts to recapture float that the banks would have taken, the firm began writing huge, multimillion-dollar overdrafts to create float for Hutton. In effect, Hutton was stealing millions of dollars out of the nation’s banking system.

  Writing bad checks allowed it to borrow a lot of the money interest-free. In 1980 alone, overdrafting its bank accounts helped Hutton cut its bank borrowings to $192 million a day from $383 million a year earlier— a change that would save it tens of millions of dollars in interest payments. And profits from interest earned climbed, too—reaching $95.9 million in 1980, almost double the previous year’s performance.

  With such a performance, Ball aggressively pushed his team to overdraft the bank accounts. Managers who brought in huge sums from overdrafting received big bonuses. Those who did not were admonished. Ball encouraged regional managers to give the slackers Monopoly money, sealed in plastic, along with their regular bonuses to show how much they might have made had they overdrafted their bank accounts more aggressively.

  He used the Ballgrams to egg on managers and account executives, known as AEs, to do more overdrafting. In a May 12, 1981, memo to the firm entitled “Interest,” Ball described a branch that had been earning “a consistent $30,000 per month in interest just by overdrafting of the bank account.” But after changing cashiers, the branch’s interest income from overdrafting dropped to less than $10,000 a month. The conclusion? “A good branch cashier is worth as much as an AE,” he wrote.

  By October 1981, Ball felt compelled to point out to the firm that it was hooked on overdrafting; the sales of securities no longer covered its huge expenses. “Without gigantic interest profits,” he wrote, “the bottom line would have been a dismal one, as I know you are aware.”

  Shortly after he wrote those words, a discovery would be made at a small bank in upstate New York that would obliterate those profits forever. John Lounsbury, the chief auditor of Security New York State Corporation, picked up the telephone in his office in Rochester, New York, on almost the first ring. It was Steve Milne, the control officer at the holding company’s subsidiary, Genessee Country Bank. Lounsbury heard several times a day from staff members he had stationed at the company’s nine banks. But rarely did they sound as concerned as Milne did this day in December 1981.

  “We had an account opened recently by E. F. Hutton,” Milne said. “And we’re just getting burned with activity.”

  Lounsbury couldn’t help but be amused. Bank auditors always keep their eyes open for rapid series of transactions in new accounts. Such fast business was usually a clear sign that some scam artist was trying to write as many bad checks as possible before getting caught. But Lounsbury knew Genessee was a small bank that had not seen much business from brokerage firms. The account from Hutton’s branch in Batavia had been opened only a few days earlier. Perhaps, he suggested gently, Milne was just seeing the results of a good business day at a branch of a prominent brokerage firm.

  “You don’t understand,” Milne replied with deep concern in his voice. “There are millions of dollars of transactions in this account, and they don’t have the money for it.”

  Lounsbury shifted in his seat. It didn’t take much knowledge to realize that a Hutton branch in upstate New York couldn’t be doing that much daily business. “I don’t understand,” he said, and asked for all the details Milne could provide.

  With a little digging, Lounsbury and Milne learned that, except for a few customer checks, almost every transaction in the Hutton account involved checks from United Penn Bank in Wilkes-Barre, Pennsylvania, and another bank in Reading. The latest check was for $8 million, drawn on United Penn. Lounsbury decided to telephone United Penn to see if the check was any good. He explained the situation and asked a banker there if Hutton had good funds to back up its check.

  “Oh, hell,” the banker replied. “This is E. F. Hutton. They never have good funds.”

  The banker said that that account was backed by still another uncollected check that would not clear for days. That check was drawn on a third Hutton account with a New York City bank. Lounsbury hung up the telephone. He knew exactly what he was looking at, and it shocked him: This financial giant was trying to rip off a tiny little local bank. Hutton was passing bad checks from one account to the next in what is known as a pinwheel, creating float for the firm. If some con man had been trying it, the sheriff would be knocking on his door before nightfall.

  Well, the hell with this, Lounsbury thought. He telephoned Milne and told him to bounce the Hutton check. Genessee would not pay any Hutton checks that were not covered by cash on deposit. It took days for Hutton to figure it out, during which time it bounced $22 million worth of checks at Genessee.

  Lounsbury then telephoned the local branch manager of Hutton to demand an explanation. But the manager said that he was simply following orders from New York. His contact, he said, was a regional operations manager with the firm. Lounsbury hung up and immediately telephoned that executive.

  “What are you people doing?” he demanded after describing what he had learned.

  The operations manager sounded panicked. Lounsbury shouldn’t blame him, he said. He was just a middle manager, taking orders from above. “I’m just a pawn in all this,” he said.

  Then the operations manager made a suggestion. To make up for any troubles caused to Genessee, Hutton would wire more than $30 million in cash to the bank. Lounsbury agreed, and the money arrived an hour later. Still, the auditor was angry, and on December 11, he shut down the Hutton account, retaining the $30 million for three months.

  Mulling it over, Lounsbury decided that Hutton was willfully breaking the law in an attempt to defraud the banks. On December 29, he wrote letters to the state and federal banking regulators, the FBI, and the Secret Service describing everything Hutton had done. A few days earlier, United Penn had notified the Federal Deposit Insurance Corporation, a federal banking regulator. As the complaints flowed in, the banking regulators realized they had a potentially significant problem on their hands. They had to investigate.

  By January 1982, the FDIC had examined enough of Hutton’s practices to know something improper was up. “At first glance, it could appear that Hutton was ‘playing the float,’ ” wrote Gerald Korn, an FDIC examiner. “But further investigation revealed evidence of an apparent, deliberate kiting operation almost ‘textbook’ in form.”

  As the regulators fanned out, some of Hutton’s best banking relationships started suffering. John McGillicuddy, the chairman of Manufacturers Hanover, assured the regulators that he was satisfied with his bank’s relationship with Hutton, but shortly after being questioned, his bank imposed new rules restricting Hutton’s cash management business. So Hutton took its money to another bank.

  The time had come, the regulators decided, to confront Hutton.

  Loren Schechter, Hutton’s deputy general counsel, could not imagine what the problem was. In February 1982, state banking regulators called Hutton, asking to meet with representatives of the firm to discuss its banking practices. As far as Schechter was concerned, this meeting would be a nonevent with a lowly bureaucrat, sitting at a government-issued metal desk.

  At six-two and more than two hundred pounds, Schechter had the look of a retired football player and the demeanor of a professional wrestler. A man with thick black hair touched with gray, Schechter had always wanted to be a lawyer. As a child growing up in Queens, New York, he was an avid reader of every Perry Mason mystery and dreamed of courtroom battles. Even though he drifted instead into securities law, he became a legal brawler all the same. In his ten
years as a Hutton lawyer, he chiseled a reputation as one of the biggest defenders of the firm’s actions, even those that pushed close to the line. This time was no different. Although Schechter could not imagine what the regulators wanted, he was sure Hutton had done nothing wrong.

  Schechter arrived at the state banking department’s offices in the World Trade Center in downtown Manhattan on February 10, at 10:00 A.M. Rather than meeting with a single bureaucrat in the bowels of the building, as he had expected, he was taken to the department’s boardroom. There he was confronted by a small battalion of federal and state bank examiners. There were few pleasantries. Ernest Patrikis, deputy general counsel of the New York Federal Reserve, asked Schechter if he knew that Hutton had bounced $22 million in checks at the Genessee Country Bank in LeRoy, New York.

  “I’ve never even heard of LeRoy,” Schechter replied. “Why is this important?”

  Because, Patrikis replied, the $22 million in checks appeared to be part of a larger pinwheel.

  “What’s a pinwheel?” Schechter asked.

  “That’s when you move money for no other purpose than to create float.”

  The regulators said that they had found massive evidence of pinwheeling and overdrafting by Hutton, specifically in its accounts at Manufacturers Hanover and Chemical. They demanded that Hutton look into the matter, and Schechter, shaken by the confrontation, readily agreed.

  After the tense meeting ended, Schechter scurried back to Hutton. He tracked down the firm’s general counsel, Tom Rae, and filled him in on what the regulators had to say. Rae agreed that Schechter would be in charge of the in-house investigation. The lawyers then called an emergency meeting with their accountants from Arthur Andersen. The accountants could not have been surprised: In 1980, five accountants from the firm had warned Hutton executives, including Rae, that the overdrafting policies might not be legal. Those concerns had been dismissed by Rae and others, who said that the banks were fully aware of the nature of the transactions. But if the accountants expected Hutton to switch opinions after hearing from regulators, they were disappointed.

  Rae, with the backing of Schechter and other Hutton executives, again asserted that their banking strategies were perfectly proper. “There’s nothing illegal here,” he said to the accountants, with the agreement of the other Hutton executives. “The banks knew all about it.” No one, Rae concluded, could be defrauded if they walked into a transaction with their eyes open. Besides, the Hutton executives argued, banking regulators had no authority to do anything to a brokerage firm.

  And Genessee, Rae said, would be no problem. The bank wanted to continue doing business with Hutton. It didn’t even want to charge Hutton a penny in interest on the overdrawn balances, he claimed. In truth, Genessee had already shut down Hutton’s accounts months earlier and refused to do any more business with the firm.

  The only thing the firm had to worry about, the executives said, was potential negative publicity if reporters learned of the banking problems. That might hurt Hutton’s image. But no one, they said, could accuse Hutton of participating in illegal conduct.

  Stephen Hammerman, the general counsel of Merrill Lynch, poked his head into the firm’s compliance department. He had been walking down the hallway at Merrill’s headquarters one day in April 1982 when he heard some members of his staff talking urgently about a problem that had developed. It seemed a good time to investigate.

  “What’s going on, guys?” Hammerman said to the lawyers and investigators gathered in the office.

  Over the next few minutes, they told Hammerman of a brokerage account that had been opened at the firm in the name of Traex Corporation. Someone named Franco Della Torre had begun making cash deposits into the account totaling more than $4.9 million. As required under a law designed to deter money laundering, the firm was reporting all cash deposits greater than $10,000 to the government. Still, the compliance team was uncomfortable. Della Torre brought the cash in suitcases from ritzy hotels like the Waldorf and the Parker Meridien. Although the deposits were made at the firm’s headquarters in Manhattan, the account was based in Lugano, Switzerland, and the money was sent there. It had all the earmarks of a crime, probably laundering drug money.

  “What are the size of the bills we’re talking about?” Hammerman asked.

  “Mostly tens and twenties,” said Louis Brown, a member of the firm’s security team.

  “Well, what does this person do for a living?”

  “He said he’s in the real estate business.”

  Hammerman cracked a smile. “That’s a hell of a lot of rent somebody’s paying,” he said.

  Hammerman prided himself on running a tight ship. It didn’t take J. Edgar Hoover to figure out that, whatever this client was up to, Hammerman didn’t want Merrill involved in it.

  “Let’s throw the account out of here,” he said to the group. “Shut it down.”

  Hammerman turned around and continued down the hall, glad to have rid the firm of a potentially devastating problem.

  A few days later, Arnold Phelan, the head of commodities at Hutton, approached Loren Schechter with big news: He had just snagged a major account from Merrill Lynch. It was a big-time company, represented by an Italian named Franco Della Torre. The new client wanted to maintain his account in Lugano, Switzerland, but Della Torre would be making huge cash deposits in New York City. Phelan asked if the setup was acceptable.

  Schechter said he couldn’t see why not. He told Phelan to make sure that all deposits of more than $10,000 were reported, as the law required. Still, Schechter decided it would be better to double-check about this potential new client, so he kicked the matter upstairs to find out what Ball thought. Hutton’s president was delighted—he loved nothing more than hearing about his firm winning a major new account from a competitor. As long as Hutton followed the rules, he didn’t see anything wrong with accepting the money.

  Della Torre began dropping off his suitcases full of cash at Hutton’s front door. Executives with the firm carefully monitored the deposits, making sure that they filled out all of the necessary forms. Over the next few months, Della Torre deposited $15.5 million in small bills at E. F. Hutton.

  The next time bomb for Hutton had been planted. By the time it went off, Hutton would already be the subject of a massive federal criminal investigation for its check-kiting scheme.

  Like the original complaint that came from the tiny Genessee bank, the criminal investigation of Hutton’s check-kiting scheme started in a most unlikely spot. Al Murray was one of the hundreds of young assistant U.S. attorneys who worked for the Justice Department. Murray was an aggressive sort working in the small outpost in Scranton, Pennsylvania, a place that almost never became involved in large-scale securities cases. Still, it would be Murray, the son of a Brooklyn criminal court judge, who would launch the criminal investigation of E. F. Hutton.

  On a day in April 1982, Murray sat at his desk studying a curious FDIC memorandum about Hutton. For some reason, the firm had been overdrafting its bank accounts. The details in the memo sent to criminal investigators in New York and Pennsylvania amazed him. To Murray, Hutton’s banking practices seemed like the stuff of a great criminal case: a firm with a household name involved in huge money transfers that appeared to siphon off cash from the nation’s banking system. Murray decided to dig deeper.

  He subpoenaed the full FDIC report in May. It detailed what happened at Genessee Country Bank and United Penn and laid out other information about the practices Hutton used in its bank overdrafts. Murray also found copies of the letters that Lounsbury, the bank auditor, had sent to the government months before. He contacted John Holland, a postal inspector, and the two started working on the case. Holland decided he should speak with Lounsbury to see if the small-town bank auditor might have some information that could help them.

  So one morning in the spring of 1982, Holland drove across two states, toward the city of Rochester, New York, on the shore of Lake Ontario. Lounsbury was delighted
to hear from somebody in the government. As months of silence had followed his letter-writing campaign, he had just assumed that his complaints had been dropped into some bureaucrat’s garbage can.

  The meeting started with Holland showing Lounsbury the FDIC memo, saying, “I don’t really know what I have here.”

  Lounsbury got up from his desk and walked over to his file cabinet. He had planned ahead and saved every scrap of paper relating to the Hutton transactions. “I’ve got a whole file drawer full of information here that might help you.”

  Over the next two hours, they reviewed the records, with Lounsbury walking Holland through each step slowly. He showed how Hutton had used the system to loot the banks.

  Eventually, Holland concluded, “Based on this, I think these folks have been committing a fraud by using the United States mail. That’s a crime. I think I can get them.”

  Holland returned to Scranton and reported what he had learned to Murray. Lounsbury’s information emboldened them to press on. Grand jury subpoenas were issued to Fomon, Hutton’s chairman, and two other senior Hutton executives. Throughout the top ranks of the brokerage, word spread quickly that a criminal probe of Hutton’s checking practices had begun.

  Despite all his typical public enthusiasm that summer, Ball had his private, undisclosed anguish. Fomon had become more erratic, clinging desperately to power while backing away from critical decisions. With the overdrafting on hold as the firm’s lawyers investigated, Hutton was stumbling and its profits were eroding. The criminal investigation was unnerving the firm’s senior ranks.