– Commercial law — Bills of exchange — Fraudulent cheques

On appeal from a judgment of the Ontario Court of Appeal (2016 ONCA 94) setting aside a decision of Whitaker J. (2014 ONSC 828).

T, a pharmaceutical company, was the victim of a fraudulent cheque scheme implemented by one of its employees, M. M’s scheme involved drafting false cheque requisition forms for business entities with similar or identical names to those of T’s real customers, to whom no debt was owed. Based on M’s fraudulent forms, T’s accounts payable department issued the cheques and mechanically applied the requisite signatures. M registered the business names as sole proprietorships and opened bank accounts at several banks. In total, he deposited 63 fraudulent cheques totaling $5,483,249.40 into these accounts and eventually removed the funds.

T filed an action claiming that the collecting banks involved in negotiating the fraudulent cheques are liable for conversion, a strict liability tort. The banks argued that the payees in this case were fictitious or non‑existing and that they were not, as a result, liable for conversion. Under s. 20(5) of the Bills of Exchange Act, it is a defence to the tort of conversion if cheques are made out to “fictitious or non‑existing” payees. The defence operates by rendering the impugned cheque “payable to bearer”, such that mere delivery — without endorsement — effects negotiation. The cheque would otherwise be “payable to order”, require an endorsement, and, without such endorsement, be wrongly converted by the bank.

The motions judge found that the payees were not fictitious or non‑existing within the meaning of s. 20(5); therefore, the banks could not rely on that defence and were ordered to pay T the full amount owing. The Court of Appeal concluded that the motions judge erred in determining that the banks should bear the loss and T’s action for conversion could not succeed.

Held (5-4): The appeal should be allowed and the decision of the motions judge restored.

Per Abella, Moldaver, Karakatsanis, Gascon and Brown JJ: The question at the heart of this case is which innocent party — T or the collecting banks — should bear the loss resulting from fraud? The Bills of Exchange Act should be interpreted in such a way that drawers and banks are exposed to the risks created by the fraudulent use of the system, but the banks are the more significant beneficiaries of the bills of exchange system. It is therefore appropriate, in certain circumstances, for them to bear risks and losses associated with that system. To allocate losses to the drawer for having failed to identify and detect the fraud is inconsistent with the strict liability tort of conversion, which makes any negligence on the part of the drawer or the banks in preventing the fraud irrelevant. The Court has, in multiple decisions, provided a two‑step framework which outlines what a bank must prove to demonstrate that a payee is fictitious or non‑existing. The first step — the subjective fictitious payee inquiry — asks whether the drawer intends to pay the payee. A payee is fictitious when the drawer does not intend to pay the payee, meaning that the payee’s name is inserted by way of pretence only. The underlying rationale behind the fictitious payee rule is that 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. As a result, if the drawer does not intend to pay the payee, the payee will be fictitious, the cheque will be payable to bearer, and the banks will be able to rely on the defence in s. 20(5). In this sense, the fictitious payee analysis is subjective. The Court’s interpretation of fictitious payees as incorporating a subjective standard is deeply rooted in the common law, which s. 20(5) of the Bills of Exchange Act was intended to codify. This approach is also sensitive to commercial realities. Attributing an intention to pay recognizes that, particularly in a large corporation, a specific intention by the guiding mind of the corporation is not directed to each individual cheque. To require such an intention would ignore the realities of the cheque issuing process in many organizations.

If the bank proves that the drawer lacked such intent to pay the payee, then the payee is fictitious 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. The second step — the objective non‑existing payee inquiry — 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 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. Whether a payee is non‑existing is a simple question of fact, not depending on anyone’s intention.

There is no reason to create a new version of this test. In enacting s. 20(5), Parliament intended to codify the common law false payee defence, including subjective considerations. No express language in s. 20(5) ousted these subjective considerations. There are no compelling reasons that the past precedents of the Court were wrongly decided and should be overruled. The fact that there are dissenting opinions on this issue is not a basis for overruling a precedent. Further, there is no evidence that the jurisprudence on fictitious and non‑existing payees reflects unsound public policy on the allocation of risk. 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.

In this case, since M was not lawfully entitled to the cheques, the banks are prima facie liable for conversion. It is accepted that T did not participate in the fraud. It follows that none of the payees were fictitious. Further, all payees were either (1) known customers of T’s; or (2) companies whose names could reasonably have been mistaken for its actual customers, such that all payees existed. Therefore, none of the payees in this case were either fictitious or non‑existing. As a result, the defence in s. 20(5) does not apply and the banks are liable for conversion.

Per McLachlin C.J. and Wagner, Côté and Rowe JJ. (dissenting): A simplified, objective approach to the interpretation of s. 20(5) of the Bills of Exchange Act should be followed. The current focus placed on subjective intentions and the existence of reasonable beliefs in the mind of the drawer brings uncertainty to Canada’s negotiable instruments and payment system. The payees here are fictitious and non‑existing on an objective interpretation of s. 20(5), and therefore, the banks should be entitled to rely on s. 20(5) as a defence to the tort of conversion. The appeal should be dismissed and past precedents from the Court which adopted a subjective approach should be overruled.

Under this proposed approach, the first step in determining whether an instrument ought to be considered as payable to bearer under s. 20(5) of the Act involves determining whether the payee is a non‑existing person. Under an objective approach, a payee will be non‑existing where the payee does not in fact exist at the time the instrument is drawn. The non‑existence of the payee obviously makes endorsement by this person impossible. Thus, such a cheque may be treated as payable to the bearer, providing the banks with a defence to the tort of conversion.

If the payee is an existing person, then a second inquiry is required to determine if the payee is fictitious. A payee will be fictitious where there is no real transaction between the drawer and the payee. By definition, or necessary implication, a payee who is non‑existing is also fictitious (given that there can be no real transaction with a person that does not exist). But a payee who is a real person can nevertheless be fictitious. This is the case where the payee, despite being a real person, is not entitled to the proceeds of the cheque because there is no underlying transaction with the drawer.

This approach does away with all considerations of intent. Where a cheque is drawn to the order of a person who does not in fact exist, or to the order of a person who exists but who is not entitled to the proceeds of the cheque, s. 20(5) will apply, regardless of the intent of the parties involved in the creation of the cheque. It does not matter that such a situation is the result of a deliberate choice, of an innocent mistake by the drawer, or, as is the case here, of fraud committed on the drawer. This approach to s. 20(5) is not novel. Rather, it returns Canadian jurisprudence to the principles underlying the earliest interpretation of s. 20(5).

This interpretation supports the purpose of the bills of exchange system. The principles of negotiability, certainty, and finality are integral to the operation of the Act. To give effect to these principles, the negotiability of a cheque must be determinable on its face. Otherwise, the efficiency created by the bills of exchange system would be undermined as collecting banks would be required to conduct an investigation into subjective factors to determine the validity of every cheque. Rather than requiring a bank to verify subjective intent and drawer belief, it is more congruent with the purpose of the Act to adopt an interpretation that encourages drawers, prior to the drawing of a cheque, to ensure that the cheque is drawn for a real transaction. A bank’s legal position will no longer depend on facts unknown to it.

The policy rationales for this approach are significant. First, the proposed objective approach allocates the risk of losses from cheque fraud to the party in the best position to detect and minimize such fraud: the drawer. Where a drawer is fraudulently induced into drawing a cheque to the order of someone with whom the drawer has no real transaction, the drawer will bear the loss. It matters not whether the fraudster was an employee or a third party, whether the fraudster might be the directing mind, or whether the payee is real. In all such a cases, the banks will be able to successfully avail themselves of the protection granted by s. 20(5) against an action in conversion by the drawer. The drawer is the party in the best position to detect and prevent cheque fraud, since it is able to implement cheque approval policies and fraud detection measures such as audits. By contrast, banks are not in the best position to prevent cheque fraud on the drawer. The second policy rationale for this approach is that it simplifies the analysis to be performed ex post facto by courts to determine whether a payee is non‑existing or fictitious under s. 20(5).

The Court should not continue to apply an interpretation of s. 20(5) that is inconsistent with the purpose of the Act and the principles underlying the bills of exchange system. Although the Court does not lightly depart from its own precedents, there are compelling reasons to do so in this case. Courts have struggled to apply the subjective approach. The proposed objective approach will add much needed predictability to the s. 20(5) analysis and increase certainty. It offers a needed course correction that will return the jurisprudence to a proper interpretation of s. 20(5).

In this case, two payees were invented by M and did not in fact exist. They are therefore non‑existing under s. 20(5). The other four payees are real entities. However, the cheques were for false purchase orders and thus there were no underlying transactions with the payees. Accordingly, all payees in this second group were fictitious under s. 20(5). In the result, the banks were entitled to treat all the cheques as payable to bearer.

Reasons for judgment: Abella J. (Moldaver, Karakatsanis, Gascon and Brown JJ. concurring)

Joint Dissenting Reasons: Côté and Rowe JJ. (McLachlin C.J. and Wagner J. concurring)

Neutral Citation: 2017 SCC 51

Docket Number: 36918