In 1979, E. F. Hutton Group Inc. made a seemingly innocuous change in its annual financial statement, creating a category called "drafts and checks payable."
The phrase "checks payable" is an unusual one, according to several experienced accountants. In preparing financial statements, a company customarily subtracts checks outstanding from cash on hand rather than reporting checks payable separately as a liability, the accountants said.
The change was not explained in Hutton's financial reports that year and in subsequent ones, and neither Hutton nor its accounting firm, Arthur Andersen & Co., would respond to questions about the change, so it isn't clear why it occurred.
But in 1984, a large part of $405 million in "drafts and checks payable" in one Hutton financial report consisted of overdrafts, its comptroller has testified at a congressional hearing.
The overdrafts that year arose from the cash-concentration system introduced in 1978 by the company's brokerage subsidiary, E. F. Hutton & Co., the comptroller said in response to questions at the hearing. The system was designed to increase Hutton's control over the funds deposited in banks by its branches around the country -- and thus to increase the interest Hutton could earn on these deposits.
Out of this system grew the massive overdrafting abuses that led Hutton to plead guilty last May to 2,000 counts of mail and wire fraud.
A leading gadfly in the accounting profession, Abraham J. Briloff, Emanuel Saxe distinguished professor of accountancy at City University of New York, said that the effect of the change was to becloud the overdrafting.
Hutton said it immediately halted illegal overdrafting when it "came to the attention of senior management in early 1982. . . . " In addition to its guilty plea to criminal check-kiting, Hutton is barred by a civil consent decree from certain cash-concentration practices that the Justice Department objected to but did not contend were illegal.
The old description that Hutton had used before 1979 was "drafts payable," a common one in financial reports referring to payments Hutton was obligated to make to others.
In 1979, that heading was changed to "drafts and checks payable," an accounting term that was unknown to several veteran certified public accountants interviewed by The Washington Post. "It's an unusual term. I've never seen the combination before," said Eugene Kent, a CPA consultant with Mason & Co. who has 40 years' accounting experience.
A check of a commercial computer data base with financial reports on more than 4,000 companies from the past five years turned up only three other firms that used the term "drafts and checks payable."
Normally, companies handle outstanding checks the way individuals do, accountants said. It's as if you had $1,000 in your personal checking account and wrote a check for $100.You'd say your new cash balance was $900, the sum shown in your checkbook.
Hutton's practice of putting "checks payable" on the liability side of the ledger "is a fancy way of saying they drew checks for which they didn't have sufficient funds," Kent said.
Arthur Andersen reviewed Hutton's financial statements during this period beginning in 1978 and found each to be "in accordance with generally accepted auditing standards."
Last week, Andersen declined to say why the two-word change was made, what it signified, or why it went unmentioned in the standard explanatory note in financial statements titled "Summary of Accounting Policies."
"Professional ethics prohibit us from discussing client matters," a spokesman said in Chicago. A month earlier, the firm had discussed with reporters a March 1980 memo in which Arthur Anderson officials raised questions about Hutton's cash-management system.
The House Judiciary subcommittee on crime has held three hearings this summer focussed on the Justice Department's handling of the Hutton case. Subcommittee member E. Clay Shaw (R-Fla.), who was an accountant and practiced as an attorney before election to Congress, said in an interview that he will ask Chairman William J. Hughes (D-N.J.) to summon Andersen officials to testify about why they did not disclose the presence of the overdrafts.
"I find it somewhat curious that checks slid over to the liability side" instead of being subtracted from cash, on the asset side, Shaw added. "One of the things I want to know is why [the change to "drafts and checks payable"] was not specifically shown" by Andersen in the opinion it provided each year on Hutton's statement, he said. "That I find very curious."
One example of overdrafting involved United Virginia Bank. Between January and December 1981, Hutton's office in Alexandria deposited $33.5 million in the UVB branch there, while writing checks for $640.8 million, the Justice Department said. This was "well over one-half billion dollars in overdrafts," it added.
Briloff said, "I know of no accounting rule that permits an approved financial statement to reflect an issued check as a liability rather than 'netted' against the cash balance.
"After Hutton's excessive overdrafting began, the subtraction of issued checks from the cash-on-hand entry would presumably have converted 'cash subject to immediate withdrawal' into a negative asset that would have been awkward and embarrassing and a disclosure of the overdrafting," Briloff contended.
Briloff based his contention on Hutton's sharply higher figures for "drafts and checks payable" as opposed to "cash subject to immediate withdrawal," as reported in Hutton's financial statements.
The "drafts payable" figure in 1978 -- the last year this term was used -- was $149.5 million. In the next year's financial statement, the entry under the new term "drafts and checks payable" increased to $266.5 million, while the cash item declined to $23.6 million from $25.4 million.
In 1982, the year that Hutton said the illegal overdrafting was halted, "drafts and checks payable" was $174 million. In 1983, "drafts and checks payable" soared to $445.6 million.
At a June 19 hearing, the subcommittee took testimony from a panel of four Hutton executives. Hughes asked precisely what was encompassed by the $405 million in "drafts and checks payable," the sum listed by Hutton as of last Dec. 31 in a "confidential" broker-dealer report to the SEC.
Hughes asked Hutton comptroller Michael Castellano: "So my question is, once again, a large measure of that $405 million represented overdrafts?"
"Yes, it does," Castellano replied.
Hughes asked if this hadn't made it obvious that something was amiss in "drafts and checks," which he called "a most unusual entry."
"Arthur Andersen has never raised it as an issue," Castellano responded.
A month later, the subcommittee produced an Andersen memo on a March 5, 1980, meeting at which Joel Miller, a partner in the firm, asked Thomas W. Rae, Hutton's general counsel and executive vice president, to "render a written legal opinion stating that Hutton's activities in this [cash-management] area don't present any potential legal problems."
The memo, signed by Andersen's Louis T. Lynn and John Tesoro, continued:
"Mr. Rae declined to render such an opinion, stating that the banks are fully cognizant of Hutton's procedures, that this is an accepted banking practice, and that there is no question as to the propriety of such transaction. . . . Joel Miller then stated that he would discuss the matter with other partners at AA&Co., whose clients include major money center banks to ascertain what the bank's 'point of view' is regarding these questions."
Rae testified at the congressional hearing that, up to the day of the meeting, he had not heard of a complaint about the system "in any way, shape, or form" and that he consequently viewed the request for a written opinion as "an annoyance" and as "an imposition on my time."
Did Anderson ever tell Hutton's shareholders anything "that would in any way imply what was going on in these accounts?" Shaw asked Hutton Group Vice Chairman Thomas P. Lynch. "No, they did not," Lynch said.
Federal court records show that Andersen had provided evidence to the grand jury in Scranton, Pa., that would charge Hutton with the check-kiting that gave it huge illegal interest-free bank loans. In July, the accounting firm objected to an SEC effort to get the evidence for its own investigations. A hearing on the objection was held Aug. 2, but Chief Judge William J. Nealon sealed the record.
Hutton Chairman Robert N. Fomon, in an exchange with Chairman Hughes, acknowledged that no one was overseeing the branch managers who were drawing down excessive sums from Hutton's accounts in local banks. "That is what was wrong with our system," Fomon said.
In the "Legal Proceedings" note in the Hutton Group's 1983 annual report to the SEC, the 37th item -- on the eighth of nine pages of single-spaced listings -- made a disclosure that turned out to be more important than the run-of-the-mill stockholder suits among which it was embedded:
"A federal grand jury . . . is conducting an inquiry into certain cash management practices at EFH . . . While the company cannot predict what, if any, action will result from such inquiry, it believes that its internal cash management policies are consistent with all applicable laws and regulations and are similar to the policies of many other public companies."
Briloff said that the claim about other companies was either "a canard" or "a sad reflection on the financial community generally. If it were true, the Department of Justice should be sending out a dragnet for all the other institutions."
Albert Murray Jr., the assistant U.S. attorney who began the Hutton investigation three years ago, has said -- in court and in a May Washington Post interview -- that bank records he examined indicate that a number of major U.S. companies appear to be using schemes similar to the one Hutton used to cheat banks out of tens of millions of dollars.