Who Bears the Risk of Cheque Fraud? The SCC Weighs In


The Supreme Court has recently found two banks liable in conversion for a $5.5 million cheque fraud carried out by a former employee of a major pharmaceutical company. The decision stands as the Court’s most recent consideration of the “fictitious or non-existent” payee defence to the tort of conversion under the Bills of Exchange Act.

The decision is important for its conclusion as to which innocent party bears the risk of loss from a fraudulent cheque cashing scheme in situations where both the drawer of the cheque and the collecting bank are victims to the fraud.

Background

On October 27, 2017 the Supreme Court of Canada released its decision in Teva Canada Ltd. v TD Canada Trust, 2017 SCC 51. This decision involved Teva Canada Ltd., (“Teva”), a large pharmaceutical company, that was subject to a multimillion dollar fraud by its own finance manager.

Cheque Fraud Scheme

The fraudulent scheme that Teva’s employee devised involved drafting false cheque requisition forms. Based on these forms, Teva’s accounts payable department issued the cheques and mechanically applied the requisite signatures. Over a period of four years, the employee deposited 63 fraudulent cheques into accounts at TD Canada Trust (“TD Canada”) and the Bank of Nova Scotia (“Scotiabank”).

The fraudulent cheques were made payable to payees with six different names. Four of these names were the names of legitimate Teva customers or service providers. The remaining two were fictional names the employee created which were similar to the names of existing customers. In all instances, there was no legitimate debt owed by Teva.

The employee had registered business names for all of these payees as sole proprietorships and opened bank accounts for them, depositing fraudulent cheques totaling $5,482,249 into these accounts. The employee eventually removed the funds.

At the time of the fraud, Teva believed that each cheque was related to a legitimate obligation to a supplier customer for services provided. The employee was not authorized to possess or use the cheques for personal use, and the fictitious account holders were not intended by Teva to be payees of the cheques.

Teva discovered the fraud in 2006, and the fraudulent employee was fired. Teva then commenced action in 2007 against several banks, including TD Canada and Scotiabank, alleging that they were liable in conversion as a result of negotiating the fraudulent cheques.

Tort of Conversion and Defence Under the Bills of Exchange Act

The tort of conversion involves the wrongful interference with the goods of another.

If a cheque is made payable to a specific payee, then it is ordinarily “payable to order”—meaning that the bank may only negotiate the cheque if it is both delivered and validly endorsed. Where a cheque payable to order has a forged or missing endorsement, and the collecting bank pays out on the cheque, it will be liable for conversion.

Given that the tort is one of strict liability, it is irrelevant whether negligence on the part of the bank or contributory negligence by the person on whose account a cheque is drawn (the “drawer”) can be established.

However, a statutory defence is provided under the Bills of Exchange Act (the “Act”), and a bank can avoid liability for conversion by applying section 20(5) which states:

(5) Where the payee is a fictitious or non-existing person, the bill may be treated as payable to bearer

If a cheque is payable to bearer, the cheque may be negotiated by simple delivery to the bank without a valid endorsement. Since the presence or absence of a legitimate or forged endorsement is irrelevant to a bearer cheque, anyone may negotiate the cheque.

Section 20(5) thus offers a defence to conversion by making the impugned cheque payable to bearer if cheques are made out to “fictitious or non-existing” payees.

For the purposes of TD Canada and Scotiabank, this meant that if the cheques drafted by Teva’s employee were found to be payable to either a fictitious or non-existent payee, then the banks would not be liable for conversion. However, if the payees were not found to be fictitious or non-existent, the banks would be liable for conversion as a result of the fact that they negotiated the cheques in favour of the fraudster without the required endorsements.

History of Claim

Teva moved for summary judgment on the claims in 2013, at which point only the claims against TD Canada and Scotiabank remained. At the Ontario Superior Court, the motions judge had ruled in favour of Teva, finding the banks liable in conversion. It was held that the payees were not fictitious or non-existing within the meaning of section 20(5) of the Act, as it could be concluded that the cheques were apparently made to existing clients and the payees could be understood to be real entities and customers of Teva.

The banks appealed to the Ontario Court of Appeal, which overturned the decision of the motions judge. The Court of Appeal found that the two payees whose names were invented were “non-existing” within the meaning of section 20(5). The Court also concluded that the four payees with names identical to existing customers of Teva were fictitious. As a result, the cheques were found to fall within the statutory defence of s. 20(5) and the banks were therefore not liable for conversion.

Teva then appealed to the Supreme Court of Canada. Although other defences had previously been raised by the banks, at issue before the Court was whether the payees were fictitious within the meaning of section 20(5) of the Act.

The Supreme Court’s Decision

Justice Abella, writing for the majority, began her analysis by engaging in a historical review of the tort of conversion and the defence contained in section 20(5) of the Act. The Court then provided a two-step analysis for how a bank must prove a payee is fictitious or non-existing under section 20(5).

The first step is the subjective “fictitious payee inquiry,” which asks whether the drawer intends to pay the payee.

If the bank can show that the drawer lacked such intent, then the payee is fictitious, and the analysis ends with the result that the drawer is liable and the bank is not. If the bank does not prove that the drawer lacked such intent, then the payee is not fictitious, and the analysis proceeds to step two.

The Supreme Court held that a specific intention to pay the payee may be presumed or attributed, in accordance with the realities of the cheque-issuing process in many large corporations, where “a specific intention by the guiding mind(s) of the corporation is not directed to each individual cheque.” Thus where cheques are drawn mechanically without any directing mind forming an intention to pay, the drawer will benefit from a presumed intent to pay its cheques.

The second step under section 20(5) is the objective “non-existing payee inquiry,” which considers the legitimacy of the payee.

This step asks if the payee is either (1) a legitimate payee of the drawer; or (2) a payee who could reasonably be mistaken for a legitimate payee of the drawer. If either can be established, then the payee does not meet the requirements of being “non-existent” for the purpose of section 20(5) and the bank is liable. If neither of these is satisfied, then the payee is not said to exist and the drawer is liable.

According to Justice Abella, this approach to determining whether a payee is fictitious or non-existent was consistent with the bulk of existing law on the area. Although criticism of such law was recognized, Justice Abella noted that compelling reasons to overrule the Supreme Court’s prior decisions did not exist in this case.

This approach to determining fictitious or non-existent persons was held to be further supported by public policy considerations regarding the allocation of risk.

The Court noted that banks are “well-situated to handle the losses arising from fraudulent cheques, allowing those losses to be distributed among users, rather than by potentially bankrupting individuals or small businesses which are the victims of fraud.” The Supreme Court thus found it appropriate for banks to bear the risks and losses associated with the bills of exchange system.

Turning to the claim by Teva, the Court recognized that the banks in this instance were prima facie liable for conversion, as the banks had dealt with the cheques “under the direction of one not authorized” and then made “the proceeds available to someone other than the person rightfully entitled to possession.” In order to avoid liability, the banks would have to establish a defence under section 20(5) and meet the two-step test enunciated by the majority to establish that the payees were fictitious or non-existing.

In allowing the appeal and restoring the motions judge’s decision, Justice Abella held that Teva was not complicit in the fraud, and although only four of the names used were those of existing customers, the other two names used were very similar to names of Teva’s real customers. Justice Abella upheld the reasoning of the motions judge that there was a “rational basis for concluding that cheques were apparently made payable to existing clients” and that “the payees could plausibly be understood to be entities and customers of the plaintiffs.” As a result, the majority found that the payees were not fictitious or non-existing under section 20(5), and that the banks were therefore liable in conversion.

It should be noted that such a decision was reached despite the fact that Teva had an express policy requiring specific approval for the cheques issued to the payees, which was not followed in regard to the fraudulent cheques.

The employee at issue did not have authority to requisition the cheques or approve the payments for which the cheques were requisitioned. Although it knew that the employee did not have authority to approve payments, Teva’s accounts payable department nevertheless issued the cheques.

Decision of the Dissent

The dissenting judges, Justices Côté and Rowe, would have dismissed the appeal and overturned previous jurisprudence in the area. The dissent suggested that a more simplified and objective approach to the interpretation of s. 20(5) be adopted.

According to the dissent, a payee is “fictitious” where the payee is not entitled to the proceeds of the cheque because there is not a real underlying transaction or debt. A payee is “non-existent” where the payee does not in fact exist at the time the instrument is drawn, regardless of the knowledge or belief of the drawer. Such an approach serves as a marked departure from previous judicial authority, as even if a payee is found to be an existing person, it must be asked whether the payee is nevertheless fictitious given the absence of a real transaction between the drawer and the payee.

According to Justices Côté and Rowe a purely objective approach would better reflect the meaning of section 20(5) and the purpose of the Act. The dissent further held that such an approach would also properly allocate the risk of losses from cheque fraud to the drawer, who is in the best position to detect and prevent such fraud.

Applying this approach, the dissent found that the payees created by the employee were non-existent under section 20(5). Although the four other payees were real entities, Justices Côté and Rowe found these payees to be fictitious as there was no real transaction between these payees and Teva. Therefore, the dissent would not have held the banks liable for conversion.

Conclusion

The Supreme Court’s decision in Teva clarifies the statutory defence to conversion under section 20(5) of the Bills of Exchange Act and the two-step approach to be used in establishing this defence.

The decision has important ramifications in regard to the allocation of risk for fraudulent cheque schemes. Simply, there is a greater risk of cheque fraud being allocated to the banks which collect fraudulent cheques, given that it may be more difficult for the banks to rely on the defence that a payee is “fictitious” or “non-existent.”

Teva confirms that a payee will only be fictitious if the drawer did not intend to make payment to the payee, and a payee will not be found to be “non-existent” if the payee is a legitimate payee or could reasonably have been mistaken by the drawer for a legitimate payee. A specific intention to pay a payee is also presumed or attributed to a large corporation with a mechanical and/or computerized cheque-issuing process, even where the corporation’s cheque-issuing policy is not followed. Thus the effect of Teva is to narrow the application of the fictitious/non-existing payee defence.

As a result, a fraudster may be able to draft cheques to payees which are current payees of the drawer or who are confusingly similar, and a collecting bank is likely unable to avail itself of the defence under section 20(5).

Banks may therefore need to implement more rigorous controls for negotiating cheques in order to avoid liability for conversion. Ultimately, allocating the risk of liability to banks may result in greater costs for banking customers.

Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.

William E.J. Skelly is counsel for MLT Aikins LLP in Vancouver. He maintains a corporate and commercial law practice with a focus on insolvency law, corporate and commercial lending and real estate, and is recognized for restructuring national and international companies. 

Chase Salembier is currently an articling student at MLT Aikins LLP in Regina. He is a recent graduate of the University of Alberta, Faculty of Law.