Fictitious, Non-Existing, and Imaginary Friends: Bank Liability for Cheque Fraud

The Supreme Court of Canada recently released its decision in Teva Canada Ltd. V TD Canada Trust, 2017 SCC 51 [Teva]. In it, the divided court found TD Canada Trust and Bank of Nova Scotia liable to Teva Canada Limited for $5.4 million dollars because of a cheque fraud carried out by a rogue Teva employee.

Teva highlights the unfortunate scenario in which two innocent parties are left to fight over which one will be left holding the bag after a multi-million dollar fraud is uncovered.

Under the Canadian bills of exchange system, where a bank cashes a forged cheque it may be held liable for doing so, regardless of whether it was negligent. In doing so, the bank is said to have “converted”, or wrongfully interfered with, the goods of another. A bank’s only real defence in these situations is to avail itself of a narrow statutory protection known as the “fictitious payee” defence, under the Bills of Exchange Act.[1]

The “fictitious payee” defence holds that where the payee of a cheque is “fictitious or non-existing”, the cheque may be treated as “payable to bearer”. A payable to bearer cheque means that anyone who presents the cheque to the bank is entitled to the funds. As such, where a bank delivers funds to a payee with a payable to bearer cheque, it will not be liable for conversion, because it has not wrongfully interfered with the goods of another.

The Fraudulent Scheme

In Teva, a rouge employee drafted false cheque requisition forms for business entities with similar or identical names to those of Teva’s legitimate customers. Based on the fraudulent forms, Teva’s accounts payable department issued cheques in the amounts owing, and mechanically applied the requisite signatures.

The fraudulent cheques were payable to six payees, two of whom had names that were similar to existing Teva customer names, and the other four were names of existing Teva customers.

The rogue employee then registered sole proprietorships under the names of the payees and opened multiple bank accounts to deposit the fraudulent cheques. In total, the rogue employee deposited 63 cheques, amounting to $5.4 million dollars stolen from Teva.

Teva discovered the fraud in 2006, fired the rogue employee, and commenced an action against the collecting banks for conversion.

Conversion

The tort of conversion involves the wrongful interference with the goods of another. Conversion is a strict liability tort, which means that any negligence on the part of the banks, or Teva, is irrelevant. Where a bank pays out on a forged cheque, it will be liable for conversion.

The question is such instances is not who is more at fault? Rather, which of two innocent parties should bear the loss occasioned by the fraud?

Given that the banks in Teva dealt with the forged cheques under the direction of the rogue employee – an unauthorized person – and made the proceeds of the cheques available to the rogue employee, the banks were prima facie liable for conversion.

Bills of Exchange Act

To avoid liability for conversion, banks can attempt to bring themselves within the fictitious payee defence under section 20(5) of the Act. Section 20(5) states:

Fictitious payee

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

A cheque that is “payable to bearer” is one that can be negotiated by simple delivery to the bank – a signature is not required. Whether there is a legitimate or forged signature is irrelevant to a bearer cheque as a bank becomes the lawful holder of it simply through delivery.

Given that the Act doesn’t define a “fictitious” or “non-existing” payee, these terms have been interpreted by the courts. In Teva, the majority of the court reviewed previous jurisprudence and defined such payees as follows:

FICITIOUS PAYEE: a payee is fictitious when the drawer does not intend to pay the payee, meaning the payee’s name is inserted by way of pretence only.

NON-EXISTING PAYEE: a payee will be non-existing where the payee lacks an established relationship with the drawer, and the drawer could not reasonably have mistaken the payee to be one with which it has an established relationship.[2]

The Fight Below

At trial, Justice Whitaker found that there was a rational basis for concluding the fraudulent cheques were payable to existing clients, and that the payees could plausibly be real entities and customers of Teva. As such, Justice Whitaker held that the payees were neither fictitious nor non-existing and found the banks liable to Teva for conversion.

The Court of Appeal overruled Justice Whitaker’s decision, classifying two of the payees as non-existing, and the remaining four as fictitious, allowing the banks to avail themselves of the fictitious payee defence under the Act. The banks could therefore treat the cheques as payable to bearer, Teva’s action for conversion failed, and Teva was left liable for the fraud.

The Final Say

At issue before the Supreme Court was whether the six payees on the fraudulent cheques could be classified as fictitious or non-existing. Ultimately, the court split 5:4 in favour of overturning the Court of Appeal’s ruling, finding the banks liable for conversion, and unable to bring themselves within the fictitious payee defence.

Justice Abella, writing for the majority of the court, set out the two-step framework for what a bank must prove to demonstrate that a payee is fictitious or non-existing:

STEP ONE: Does the drawer (i.e. Teva) intend to pay the payee?

  • If the bank proves that the drawer lacked such intent, the payee is fictitious, the analysis is over, and the drawer is liable. 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.

STEP TWO: Is the payee either (i) a legitimate payee of the drawer; or (ii) a payee who could reasonably be mistaken for a legitimate payee of the drawer?

  • If neither of these is satisfied, then the payee does not exist, and the drawer is liable. If either is satisfied, then the payee exists, and the bank is liable.

The majority found there was a rational basis for concluding that the cheques were payable to existing clients and the payees could plausibly be understood to be real entities and customers of Teva. Consequently, the payees were neither fictitious nor non-existing, and the banks were liable for conversion.

In arriving at its decision, the court commented on the policy rationales that support apportioning liability this way. The court held that banks are well-situated to handle the losses arising from fraudulent cheques as they can distribute those losses amongst many users. Whereas, in the case of individuals or small businesses, where they fall prey to a fraud the results may be much more catastrophic.

The court also noted that banks are more significant beneficiaries of the bills of exchange system and it is therefore appropriate, in certain situations, that they bear risks and losses associated with that system.

Although the majority’s decision in Teva aligns with its previous jurisprudence, the conflicting decisions at trial and the Court of Appeal, along with the split decision at the Supreme Court, evidences the strain the courts have with allocating liability under the Act.

As the majority noted, it is up to parliament to amend the Act where it feels necessary. However, given the Act’s history and the steady course with which it has prevailed, attempts to alter or update its provisions will likely be met with criticism due to inserting uncertainty into the established bills of exchange system.

The Supreme Court’s decision in Teva is relevant for businesses small and large. When faced with a fraud committed by a rogue employee, businesses will seek recovery from those with the means to pay. However, recovery may not be simple. In the face of fraud, retaining experienced legal counsel will ensure the protection of your business and provide necessary guidance during turbulent times.

By: David Cassin

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[1] RSC 1985, c B-4, s 20(5) [Act].

[2] The court in Teva gave the example of a cheque made out to “Snow White” as one that is made out to a non-existing payee and thus payable to bearer (see Teva at para 57).

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