E.F. Hutton slippery slope into criminal actions: short version

The E.F. Hutton case demonstrates how the actions and culture in an organization can deteriorate into criminal behavior and end in demolishing the organization. The following is a short version of a case study by Mark Fagan and Tamar Frankel. Background materials include Tamar's book Trust and Honesty, America's Business Culture at a Crossroad (2006). The full version and the discussions uptodate are contained in the attachment.

The case raises issues for practicing lawyers and businesspersons. How could the failure of E.F.Hutton be avoided? What can we learn from this story?

© Mark Fagan and Tamar Frankel

In the 1970's E.F. Hutton was an enormously successful brokerage firm (1980s revenues of $1.1 billion and profits of $82 million). The firm was innovative, aggressive, and decentralized. Its philosophy was: Win at any cost and focus entirely on profits.

In 1975 the law that required fixed 1% brokerage fees at the New York Stock Exchange was eliminated. "No frills" brokers appeared with whom E.F. Hutton could not compete in its existing structure. Hutton's branch offices sought other income sources, and found it in cash management. The firm deposited customers' checks at local banks to speed the availability of funds, and brought excess cash balances into a central bank location(s). The managers began using geographically dispersed banks to "play the float," earning interest on checks that were still in the clearing process. Gains could be substantial. Increasing Hutton's daily cash balance by $10 million on annually could produce $1.8 million in interest income at the December 1980 interest rate. This method blossomed into check kiting: "a method whereby a depositor . . . utilizes the time required for checks to clear to obtain an unauthorized loan without any interest charge." Check kiting is illegal in the U.S. and can carry fines up to $1 million and 30 years in prison.

Hutton's check kiting scheme was discovered when a small bank noted that the deposited checks were written by Hutton to Hutton drawn on two Pennsylvania banks, and learned that Hutton had insufficient funds to cover the checks in those banks. The discovery led to a vigorous investigation. At first Hutton "dragged its feet." Then it dumped 7 million documents at the prosecutor's office. But the investigation continued. The financial community and the press were shocked. The House Subcommittee on Crime took up the issue. On May 2, 1985 E.F. Hutton pled guilty to 2000 counts of mail and wire fraud and agreed to pay a fine of $2 million, compensate the government $750,000 for its investigation expenses, and make restitution to the banks it defrauded.

Yet, during that period Hutton's stock price barely moved. Senior management took steps to regain its footing. An internal investigation concluded that Hutton had inadequate internal controls and a loose management structure that permitted employees to overdraft at will. The CFO and the general counsel, three regional managers, and six branch managers were held responsible.

Hutton hired the chief administrative officer at Merrill Lynch to improve Hutton's operations. But it was too little, too late. The board and CEO were slow to act, and Hutton's combative style prompted more House hearings. The financial impact of the plea bargain was trivial for this billion dollar company. But the loss of reputation for integrity was so great that the company never regained its own financial viability. In December 1987, the company was sold to Shearson in a fire sale for marginally more than book value.

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