In the recent Court of Appeal decision in Teva Canada Limited v Bank of Montreal, the Court continued to shift the burden of preventing employee fraud ontp the company defrauded and away from the innocent banks. Similar to its decision in Kayani v Toronto Dominion Bank, which we previously reported on, the Court found itself again tackling the arcane notions of whether the recipient payees of fraudulent cheques should be considered fictitious or non-existing under section 20(5) of the Bills of Exchange Act(“BEA”).In relieving the banks of liability, the Court noted that companies who do not follow their own policies for approving the issuance of their cheques may be liable for any frauds perpetrated on them.

Background to the Fraud

TD Bank and the Bank of Nova Scotia (together the “Collecting Banks”) and the respondent Teva Canada Limited, a generic pharmaceutical manufacturer, were all innocent victims of fraud totalling of over $5M. The fraud was perpetrated by a former employee in Teva’s finance department. Between 2003 and 2006, the employee requisitioned 63 cheques payable to six entities: two entities he invented and four actual customers of Teva. The cheques purported to relate to Teva’s Continuing Education (CE) Program. The CE Program was designed to refund certain amounts to Teva’s customers as an inducement to buy Teva’s products. Teva paid tens of millions of dollars under its CE Program until Ontario banned the practice shortly after the fraud was discovered.

The cheques were issued by Teva’s accounts payable department and given to the employee, even though he had no authority either to requisition cheques or to approve payments to customers, and Teva’s own internal approval policies had been ignored. No signing officer or directing mind of Teva turned their minds to the cheques and no one examined them. The cheques were mechanically processed without proper internal approvals. None of the six entities was owed any money by Teva, and even the cheques written for the four actual customers of Teva were directed to fake bank accounts at one of the Collecting Banks. The employee and several accomplices opened accounts in the names of the six entities and deposited the cheques, which the Collecting Banks negotiated, into these accounts. The fraud was discovered in 2006.

Justice Laskin helpfully set out the banking terminology, which bears repeating here:

  • “Drawer” is the person on whose account a cheque is drawn, in this case Teva;
  • “Drawee” or “Drawing Bank” is the bank on which a cheque is drawn and is directed to pay the cheque, in this case Teva’s bank;
  • “Payee” is the person to whom the cheque is payable;
  • “Bearer” is the person delivering a cheque to a bank;
  • “Collecting Bank” is the bank in which a cheque is [eventually] deposited, in this case Scotiabank and TD.

The Lawsuit

Teva sued the Collecting Banks for damages for conversion for the misappropriation of its property. The tort of conversion is described in the Supreme Court of Canada case of Boma Manufacturing Ltd. v Canadian Imperial Bank of Commerce, and “involves a wrongful interference with the goods of another, such as taking, using or destroying these goods in a manner inconsistent with the owner’s right of possession.” If money is paid to a party that is not entitled to receive the funds, then it has been converted. The tort of conversion is one of strict liability and any alleged negligence by Teva gives the banks no relief. However, the tort of conversion is not an absolute liability tort and section 20(5) of the BEA gives a Collecting Bank a statutory defence to an action for conversion.

Therefore, the Collecting Banks were prima facie liable to Teva for converting them. The Collecting Banks took the position that the cheques were payable to “non-existing or fictitious payees,” and thus under section 20(5) of the BEA, the banks were lawfully entitled to negotiate them. Each party then brought motions for summary judgment, and the motion judge granted Teva judgment in the amount of $5.4 million. On their appeals, the Collecting Banks argued that the motion judge erred in failing to give effect to the banks’ defences.

The principal issues raised by the parties concerned the application of section 20(5) of the BEA that creates statutory defences for the banks in certain circumstances.

Defence available to Banks under the BEA

We have previously reported on the defences available to Banks under section 20(5) of the BEA. Though the language in the BEA is archaic, having been around since at least 1890, it still has application in the world of modern banking.

Section 20(5) provides that “where the payee is a fictitious or non-existing person, the bill may be treated as payable to the "bearer” and no endorsement is needed. If the bill or cheque is treated as payable to the bearer, then the person delivering the cheque or instrument to the bank is entitled to receive the money. That person is deemed to be the rightful payee, regardless of who is actually named on the cheque as the payee or who endorses the cheque or instrument. The bank will ordinarily have no liability in those circumstances for having negotiated the cheque and paying the bearer.

The purpose of section 20(5) is to protect the bank from fraud on the drawer/company, committed by a third party or insider in the drawer’s organization. The loss for the fraud is instead allocated to the drawer/company, who typically is better positioned to discover the fraud or insure against it.

The Supreme Court of Canada considered the issue of when a payee is a non-existing person or fictitious in Boma. The Courtadopted the "Falconbridge propositions," which state that:

  1. If the payee is not the name of any real person known to the drawer, but is merely that of a creature of the imagination, the payee is non-existing, and is probably also fictitious;
  2. If the drawer for some purpose of his own inserts as payee the name of a real person who was not known to him but whom he knows to be dead, the payee is non-existing but is not fictitious;
  3. If the payee is the name of a real person known to the drawer, but the drawer names him as payee by way of pretence, not intending that he should receive payment, the payee is fictitious, but is not non-existing; and,
  4. If the payee is the name of a real person, intended by the drawer to receive payment, the payee is neither fictitious nor non-existing notwithstanding that the drawer has been induced to draw the bill by the fraud of some other person who has falsely represented to the drawer that there is a transaction in respect of which the payee is entitled to the sum mentioned in the bill.

Under the first three propositions, the bank has a full defence. The payee is considered to be either fictitious or non-existing, and as such section 20(5) of the BEA applies. The loss is allocated to the drawer (in this case, Teva) of the cheque or instrument, who is typically in a better position to discover the fraud. Only under the fourth proposition would the bank be found liable, even though the bank is still not at fault. To come under Falconbridge’s fourth proposition, two requirements must be met:

  • Each payee must be a real person, that is, not non-existing;
  • each payee must be intended by the drawer (Teva) to receive payment and thus not fictitious.

The non-existing payee defence was modified by Justice Iacobucci in Boma, who imported the notion of “plausibility” into the question whether a payee is non-existing. The effect of his modification is that even if a payee is, in fact, a creature of the fraudster’s imagination, the payee may still not be considered non-existing if the drawer had a plausible and honest, though mistaken, belief that the payee was a real creditor of the drawer’s business.The notion of “plausibility” limited the availability of the BEA defence for the Collecting Bank. Using logic that only a lawyer could love, the “plausibility” notion states that if the drawer (Teva) of the cheque was honestly mistaken as to the identity of the payee, believing that it was paying a real person that was similar in name to the fictional payee, then that person, while fictional, was “plausibly” real and therefore not “non-existent.”

Subsequently, the Court of Appeal in Rouge Valley Health System v TD Canada Trust reviewed the Falconbridge propositions and noted:

  • the question of whether a payee is fictitious depends upon the intention of the drawer of the cheque or instrument, and
  • the question whether a payee exists is a question of fact independent of anyone’s intention.

a) Clarification of the Plausibility Modification

The facts in Teva required the Court to consider both whether some payees were “non-existence” and whether other payees were “fictitious.”

For the two completely invented payees, the appeal turned on whether or not they were non-existing. Teva argued that because their names were similar to existing customers, they could plausibly have been thought to be real payees, fitting within Boma’s plausibility modification to the non-existing payee defence. 

Justice Laskin disagreed, stating that, for the plausibility doctrine to apply, there needed to be evidence establishing an “honest but mistaken belief” that the drawer intended this “real” entity to receive payment. Justice Laskin stated that, to satisfy Boma’s plausibility modification to the “non-existing” payee defence, Teva had to meet two requirements:

  1. The name of the imaginary payee must be sufficiently similar to the name of one of Teva’s legitimate customers that Teva could plausibly, though mistakenly, maintain it was writing a cheque to a real person, a real creditor of its business; and
  2. At the time each cheque was drawn, Teva had considered the name of the payee on the cheque and, because of the similarity in name, had an honest, though mistaken, belief that the named payee was a real customer or service provider. [Emphasis added.]

In Teva's case, the second part of this test could not have been met as no one in a position of authority at Teva ever looked at any of the requisitions or the cheques. The cheques were mechanically signed by clerks who never turned their minds to the names on the requisitions or the cheques. No officer or other responsible person at Teva considered the identity of the payees on the fraudulent cheques. Therefore, Teva could not have formed an honest, though mistaken belief, that the named payees were legitimate customers or service providers. The Collecting Banks were therefore not liable for having negotiated those cheques for non-existing payees.

b) When the drawer is a corporation, “fictitiousness” depends on the intent of a responsible officer

The four remaining payees were actual customers of Teva’s, and thus real persons. Therefore the Collecting Banks needed to show that they were nonetheless “fictitious” in order to succeed on appeal.

Whether these payees were fictitious depended upon the intention of the creator of the instrument, that is the drawer of the cheque. Justice Laskin noted that, in Boma, Justice Iacobucci said that the relevant intent for determining whether a payee is fictitious is the intent of the drawer itself, not the intent of the actual “creator of the instrument.” Where the drawer is a corporation, it is the intent of its directing mind, or at least the intent of one of its responsible officers, that is determinative.

The Court held that it was Teva’s, or its directing mind’s, intent at the time the cheques were drawn that mattered. To determine this intent, one did not look at the intent of the individual fraudulent employee. In Teva, the cheques to these payees were requested by the fraudster. They were not reviewed or authorized by any of the officers. Therefore, the requisite corporate intent could not be found directly or inferred as none of Teva’s responsible officers scrutinized any of the fraudulent cheques. If the company had followed its own approval policies and mistakenly approved the fraudulent cheques, Justice Laskin explicitly said he would have inferred a corporate intent to pay real creditors for legitimate obligations.

Justice Laskin was careful to point out that it was not Teva’s negligence that made it liable for the fraudulent amounts. Instead it was a “lack of corporate knowledge and therefore the absence of any evidence from which one could reasonably infer it intended to pay real creditors of its business for legitimate debts.”

The Court concluded that Teva had failed to show that it intended the four payees, who were actual customers, to receive the proceeds of the cheques. All of these payees were therefore considered to be fictitious, and the Collecting Banks were entitled to treat all the cheques as payable to bearer. The Collecting Banks were not liable for having negotiated those cheques.

Conclusion

The decision in Teva is fully consistent with the Court of Appeal’s decision in Kayani and allocates risk to the party best positioned to prevent the fraud. Banks should therefore find some comfort in the clarity Justice Laskin provides to the BEA analysis.