Gift cards and money laundering: The gift that keeps on taking

Gift cards are the perfect solutions for birthdays and holidays. Unfortunately, they're also becoming the perfect tool for money launderers and they're not interested in giving. Here are the facts for fraud examiners who need to know about the newest scam. 

When Grandma doesn't know what to get for little Susie's birthday it's a quick trip to just about any store you can think of or a simple walk over to the computer to purchase a gift card. The result is that Susie (and anyone else who Grandma wants to give a card to) can now get whatever she wants and she's happy. And the amount Grandma puts on the card is whatever she can afford depending on how many brothers, sisters, sons, daughters, nieces, nephews, and grandchildren she has. It's the perfect gift - what could be simpler and easier to give and use?

The problem is that gift cards might be a little too easy to use. Consider the potentially sinister side. According to Jeffery Ross, a senior adviser with the U.S. Department of the Treasury's Office of Terrorist Financing and Financial Crime, terrorists and money launderers might find it easier to escape detection by using gift and other prepaid cards.

Ross says that criminals are increasingly using the cards, some of which are bought with "digital currency" via the Internet, to avoid leaving financial fingerprints. The Department of the Treasury is considering new regulations to help monitor the $163 billion (U.S.) stored-value industry, which includes gift, long-distance, transit, payroll, and money cards redeemable at automated teller machines.¹  

While casinos and banks are among the most established means for laundering, money launderers are increasingly turning to such methods as online payment services and gift cards to move their illicit funds because they provide anonymity.²  

The scheme is so new that there's a dearth of known case histories.

CLOSED- AND OPEN-SYSTEM GIFT CARDS
Gift cards are frequently referred to as closed-system or closed-loop cards because they can only be used at the retailers that issue them. Besides retailing, other types of uses for closed-system cards include phone, vending, and even payroll cards.

Open-system cards (such as those affiliated with VISA or MasterCard) can be used at most retailers and many of them are useable as ATM cards where anyone can withdraw the card's monetary value from practically anyplace in the world. These open-system cards are sometimes referred to as prepaid cards, which can act like credit cards but, in reality, are more like debit cards. Generally speaking, a cardholder's credit line depends on how much money he transfers to the card; cards can be purchased online through any number of financial institutions that carry a VISA or MasterCard or through American Express.

Because many of these closed- and open-system cards can be reloaded online or at checkout counters, they're the perfect instrument for organized crime, drug dealers, money launderers, and even for financing terrorist activity.

The U.S. Drug Enforcement Administration, Immigration and Customs Enforcement, and the Internal Revenue Service - Criminal Investigation have all found pre-paid cards that were used in conjunction with bulk cash smuggling.³ 

Drug dealers load cash onto pre-paid, open-system cards and send the cards to their drug suppliers outside the country. The suppliers then use the cards to withdraw money from local ATMs.⁴ 

Of the two, the open-system cards have drawn most of the attention from the banking industry, the Department of Treasury, Department of Homeland Security, and the FBI. However, many financial institutions are now updating the information they gather to abide with anti-money laundering laws made tougher by the USA PATRIOT Act passed in the wake of 9/11 and the increasing pressure from industry regulators and auditors. For example, banks have been working at automating, tracking, and logging the electronic cross-checking of non-customer names against government blacklists. Because of this increased attention, fraudsters are now using more of the common closed-system gift cards.

GIFT CARDS FOR EVERYBODY
Gift givers can buy the closed-system cards almost anywhere - in retail stores, restaurants, grocery stores, movie theatres, and even coffee shops. The National Retail Federation estimates that gift card sales just during the 2005 Christmas season reached more than $18.5 billion, up from $17.3 billion in 2004. And it doesn't stop there. Gift card usage is expanding rapidly beyond the customary winter celebrations to other special events and occasions like Valentine's Day, Mother's Day, birthdays, weddings, and anniversaries. In some cases, love may have nothing to do with it; gift cards can also be used as incentives and awards from appreciative employers. So it's no longer unusual to see someone purchase a number of gift cards at one time for substantial amounts.

According to Deloitte & Touche's second annual Post-Holiday Gift Card Survey of more than 17,000 people, more than two-thirds of U.S. shoppers were expected to buy nearly five cards on average last year.⁵ The survey also found that 7.1 percent still hadn't used between three and nine gift cards they received during last year's holiday season and that more than half of those will never be fully redeemed. In December 2005, Home Depot had given up on customers redeeming some $49 million in gift cards sold between 1998 and 2001. The home improvement chain actually recognized a gain from gift card "breakage" for the first time ever in a quarterly filing with the Securities and Exchange Commission. Breakage is the balance remaining on gift cards that a retailer can claim when the cards expire, are lost or are unused for a lengthy period (www.bizjournals.com/atlanta/stories/2005/06/13/story3.html).

Best Buy estimates $29 million in gift cards sold over a 10-year period that had never been used and probably never would. Cards are mislaid and forgotten or shoppers will spend $22 and not remember to use the last $3. It adds up to a pile of money in an area where accounting rules seem vague. That's why some retailers have decided that once the cards have expired or estimated that they will never be used (breakage), they will designate them as "new-found income." It's no surprise that retailers gladly encourage gift card sales because they not only attract new customers but the larger the gift, the more consumers will be obligated to purchase or, better yet, the more they ultimately won't be redeemed.

VEHICLE OF CHOICE
With encouragement from retailers and the consumers' enthusiasm, individuals and businesses often purchase large numbers of cards and it doesn't raise red flags. But a fraudster can place several thousand dollars on a retail gift card and not have to deal with a currency transaction report - such as he would at a bank - and it wouldn't be recorded on a suspicious activity report. In fact, fraudsters often will divert attention by breaking a large-dollar amount into a number of smaller amounts (a method of laundering sometimes referred to as smurfing).

Open-system cardholders generally aren't obligated to have bank accounts. The banks handling the money that flows through the gift cards are required only to conduct customer due diligence and customer identification procedures on the independent firms that manage the cards and not the individual cardholders.⁶ 

Fraudsters also stay under the radar by purchasing a number of cards from several different retailers at different locations over various periods of time. Transporting the cards is easy. Conceivably, a wallet or purse could inconspicuously hold as many as 25 or more cards totaling a value of close to $100,000! A small package of 200 cards sent through the mail or in a small carry-on suitcase could hold as much as $1 million or more. The fraudster knows that moving funds from one country to another in any type of currency with an assortment of recognizable retail gift cards for supposedly promotional or gift-giving purposes is less suspicious than traveling with a briefcase stuffed with VISA cards.

CONVERTING CARDS BACK TO CASH
Fraudsters can sell or auction throughout the world thousands of gift cards on SwapaGift.com, CardAvenue.com, and even eBay. They sell the cards at a slight discount but it isn't much different than bringing large amounts of cash into a casino, buying chips, gambling for a short time, and then cashing out with one or more cashier's checks to hide the scheme.

Also, anyone can visit an online card company and purchase thousands of professional-looking gift cards - say, for a supposed nursery store - with innocuous toy balloons and animal figures printed on them. A fraudster then could conceivably open a series of stores in several worldwide locations with the sole purpose of using them as fronts for transferring value from one country to another. Even better yet, the stores could simply be global Internet sites that have no physical existence and are virtually untraceable.

This isn't only a problem for your local retail store; it's a mission for the enforcement agencies throughout the world. This is a serious money laundering problem that has criminal and terrorist implications on a worldwide scale. The PATRIOT Act is only designed to fight money laundering and terrorist financing through U.S. financial institutions. The 9/11 hijackers were eventually identified by their bank accounts, card signatures, and wire transfers. But if they had covered their expenses using some form of prepaid cards, there wouldn't have been any identity clues.

WORLDWIDE LEGISLATION?
Gift cards might be a wonderful idea for Grandma if she doesn't know what to buy for little Susie's birthday. But they represent a clever and stealthy vehicle for financing terrorist activities or other types of criminal behavior without the least bit of suspicion. Once again the bad guys are one step ahead of the rest of us, and until worldwide legislation is passed to monitor and control these closed-systems cards there seems to be little to stop these illegal financing activities.

APPLICATIONS FOR FRAUD EXAMINERS
This fraud is so new that law enforcement is still devising ways to catch the crooks and legislators haven't begun to formulate regulations. Closed-loop gift cards can't be traced back to individuals so fraudsters for now have free reign with the ubiquitous pieces of plastic. All fraud examiners need to stay aware of developments and some need to help create detection methods. That would surely be a gift to all of us.

1. "Terror Warning on Gift Cards." The Toronto Star, business section. March 16, 2006.  
2. Hoffman, Claire. "New Methods Reported for Money Laundering." Los Angeles Times, business section. Jan. 12, 2006. 
3. U.S. Money Laundering Threat Assessment. Dec. 2005. Page 21. www.treas.gov/offices/ enforcement/pdf/mlta.pdf. 
4. Ibid, page 21. 
5. www.retailleaders.org/new/resources/POSTHOLIDAY%20Gift%20Card%20PR %20FINAL%202-10-05.pdf #search=%22Deloitte%20Survey%20on%20Cards%22
6. Ibid, page 22. 

[Some source links referenced in this article are no longer available. — Ed.]

Ron Marden, Ph.D., Educator Associate, is a professor of accounting at Appalachian State University in Boone, N.C. His e-mail address is: mardenre@appstate.edu.

Randy Edwards, Ph.D., is dean of the Walker College of Business at Appalachian State University in Boone, N.C. His e-mail address is: edwardsrk.appstate.edu.

Carol Johnson, Ph.D., Educator Associate, is an associate professor of accounting at Oklahoma State University in Stillwater.