SCC misses opportunity to correct the law of fictitious and non-existing payees

Authors: Jordan Deering, Emily McCartney Publication | November 2017

Twenty years after its last look at the issue, the Supreme Court of Canada has once again had the opportunity to determine which innocent party should bear the loss caused by the negotiation of fraudulent corporate cheques – the corporation employing the fraudster, or the bank. In Teva Canada Limited v TD Canada Trust (Teva Canada) a 5-4 majority narrowly reaffirmed the existing interpretation of the false payee defence under s. 20(5) of the Bills of Exchange Act (BEA). This provision provides a defence to banks for the tort of conversion when fraudulent cheques are made out to “fictitious or non-existing” payees. 

Unfortunately, the majority failed to take the opportunity to overturn its previous decision on this issue in Boma Manufacturing Ltd v Canadian Imperial Bank of Commerce, and bring the law in line with modern-day commercial realities by reconsidering the interpretation of a “fictitious” payee. As a result, banks remain the de facto insurers for corporations subject to cheque fraud committed by rogue employees. 



Background

In Teva Canada, a rogue employee of the corporation requisitioned fraudulent cheques from Teva, made out to six payees. Four payees were actual Teva customers to whom no money was owed. The other two payees had names that deviated slightly from those of existing customers. The fraudster registered the business names as sole proprietorships, and opened bank accounts in each name. He then deposited 63 fraudulent cheques, totalling just under $5.5 million.

Teva brought an action against the banks in which the fraudulent cheques were deposited for conversion of the funds. Conversion is a strict liability tort for the wrongful interference with someone else’s property, and contributory negligence may not be invoked as a defence.

The banks defended the conversion claim on the basis of s. 20(5) of the BEA, among other defences. Pursuant to that section, financial institutions are not liable for negotiating cheques made out to “fictitious or non-existing” payees. Such cheques are considered “payable to bearer” – i.e. payable to the person in possession of the cheque rather than the person to whom it is made out (“payable to order”). As such, the bank may negotiate the cheque without liability in conversion, even if the cheque turns out to be fraudulent.

The Supreme Court’s decision: the majority

The appeal to the SCC was limited to one issue: whether the payees of the fraudulent cheques were “fictitious or non-existing” within the meaning of s. 20(5) of the BEA so as to render the fraudulent cheques payable to bearer. In a 5/4 split, the Supreme Court allowed the appeal, finding the payees were not fictitious or non-existing within the meaning of the BEA. The banks were therefore unable to rely on the s. 20(5) defence and were ordered to compensate Teva for the $5.5 million loss caused by Teva’s rogue employee.

The majority decision relied on precedent mandating a subjective interpretation of the s. 20(5) defence of whether a payee is “fictitious” or “non-existent.” In particular, the majority held that determining whether a payee is fictitious requires the court to inquire whether the drawer of the cheque (in this case, Teva) subjectively intended to pay the payee. As the majority stated, “If the drawer did not intend that the payee receive payment, such as in cases of fraud, the drawer should not be able to recover from the bank” (para 51). In that case only, the cheque will be considered “payable to bearer” and the negotiating bank may rely on the “fictitious payee” defence in s. 20(5) of the BEA.

Determining whether a payee is “non-existent” is a factual inquiry, regardless of an intent to pay. According to the majority, a payee is non-existing “when the payee lacks an established relationship with the drawer, unless the drawer could reasonably have mistaken the payee to be one with such a relationship” (para. 56).

The majority concluded that all the payees were either known customers to Teva, or companies whose names could reasonably have been mistaken for Teva’s actual customers. As such, all payees – in the majority’s view – existed, and the banks could not rely on the s. 20(5) defence. The cheques were therefore payable to order (and not to bearer) and the banks were liable in conversion.

While the technical, subjective consideration of what constitutes a “fictitious or non-existent” payee by the majority constitutes a significant portion of the analysis, the majority also based its decision in part on which innocent party was best poised to absorb the loss occasioned by the fraud. The majority found that “[b]anks are well-situated to handle the losses arising from fraudulent cheques, allowing those losses to be distributed among users, rather than potentially bankrupting individuals or small business which are the victims of fraud” (para. 67). Consequently, banks and their users become the unwitting insurers of corporations that may lack adequate, or any, controls for internal fraud. Once the fraudster has absconded with the fraudulent cheques, the corporation can simply look to the bank to recoup its losses, and the bank may not even advance a defence of contributory negligence, given the strict liability nature of the tort of conversion.

The dissent

The strong dissenting opinion held that the subjective intent of the parties involved in creating the cheque had no place in interpreting of s. 20(5) of the BEA. The dissent proposed a “simplified, objective” approach to the false payee defence, in which the court first asks whether the payee in fact existed at the time the instrument was drawn.

If the payee did not exist, endorsement by this person is impossible, and the instrument is payable to bearer. If the payee did exist at the time the instrument was drawn, the court should determine whether the payee is fictitious. According to the dissent, a payee is fictitious where there is no real transaction between the drawer and the payee. A payee can be a real, existing person (as was the case with four of the payees in Teva Canada), but nevertheless be fictitious if the payee is not entitled to the proceeds of the cheque because there is no legitimate underlying transaction between the drawer and the payee. Simply put, “Non-existence depends on whether the payee exists in fact, while fictitiousness depends on whether there is an underlying transaction” (para. 118).

Applying its objective interpretation of s. 20(5) to the facts before it, the dissent concluded that the payees in Teva Canada were all non-existing. Two of the businesses did not exist at the time the cheques were drawn, and the other four companies, though bearing identical names to Teva customers, lacked legitimate underlying transactions with Teva that would have entitled them to the proceeds of the cheques. Under this approach, the banks would have successfully relied on the s. 20(5) defence. The cheques would have been payable to bearer and Teva would have to bear its own loss.

The rationale behind the dissent was not focused on which innocent party had sufficiently “deep pockets” to best bear the loss. Rather, the dissent focused on which innocent party is best placed to prevent the fraud in the first place – the corporation. The corporation can implement policies and fraud detection measures to significantly alleviate the risk of internal fraud. The bank cannot, but is unfairly burdened with the risk of a corporate client’s failure to do so.

Conclusion

Underpinning the majority’s decision is the view that banks are “well-situated to handle the losses arising from fraudulent cheques” (para 67). With respect, however, the majority concluded that the wrong innocent party ought to bear the loss resulting from the employee’s fraud. As set out in the dissent, companies who draw cheques are in the best position to detect fraud or prevent it from happening. Corporate banking clients may otherwise lack incentive to implement policies and procedures to prevent internal cheque fraud, when someone else must bear the loss of failing to do so. With great respect to the majority, the risk of liability should be allocated to the party best able to mitigate the risk of loss, and not the party with the greatest means to bear the loss.

As noted by both the majority and minority decision in Teva Canada, the BEA does not provide any definitions or guidance respecting the meaning of “fictitious or non-existing” under s. 20(5). This language was adopted in Canada in 1890, and has not been amended since. Two narrow majority SCC decisions in the last 20 years have made banks the de facto insurers against corporate fraud based on non-specific language in the BEA,which has not been amended for over 100 years despite major changes and advances in the banking economy. It is time for Parliament to update the injustice created by the SCC’s interpretation of s. 20(5) of the BEA, whether by clearly defining “fictitious on non-existing” or permitting a statutory defence of contributory negligence.


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