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Nov 22, 2017

Teva Canada, Cheque Fraud and Risk Allocation for Collecting Banks

By Timothy Jones

In a fiercely-contested, 5-4 split decision, the Supreme Court of Canada ruled that a company victimized by employee cheque fraud can recover its $5.5-million loss from the banks that deposited the fraudulent cheques.

We discussed the facts of this case (Teva Canada Ltd v TD Canada Trust, 2017 SCC 51) (“Teva”), as well as the legal and business issues at stake, in the December 2016 issue of our Collateral Matters newsletter.

In that article, we wrote that “the core policy question… is whether non-negligent banks should be penalized for the negligence and/or fraud of drawers [the issuers of the cheques] simply because the banks have a greater capacity to absorb the costs.” The Supreme Court’s majority opinion in Teva answered this question with a yes.

The majority reaffirmed the existing test for whether a bank has defences to conversion actions under s. 20(5) of the Bills of Exchange Act, R.S.C. 1985, c. B. 4. This section gives banks a defence if they negotiate cheques which were issued to fictitious or non-existing payees.

The majority confirmed that the question of whether a payee is “fictitious” will turn on whether the drawer has a subjective intention to pay the payee, and the question of whether a payee is “non-existing” depends on, in most cases, whether the drawer could have reasonably mistaken the payee for an existing payee (for example, a payee with a similar name to an existing creditor would not be a “non-existing” payee, but a payee named “Snow White” would be considered non-existing).

Judges, academics and practitioners have criticized this test fiercely for over four decades. They consider it unrealistic, unpredictable and unfair to collecting banks.  The difficulty is twofold: for one, the test is complex and frequently misunderstood; for another, and more importantly, certain of the test’s variables are impossible for the bank to ascertain at the time it negotiates a cheque since it generally will not have knowledge of who the drawer’s legitimate payees are, or what the directing mind of the drawer was thinking when it authorized the cheque.

The Teva dissent reiterated these critiques, complaining that under the current test, “collecting banks [are] required to conduct an investigation into subjective factors to determine the validity of every cheque” or else assume the risk of having to repay the value of the negotiated cheque to the drawer over a decade later, as occurred in the Teva result.

The dissenting judges stress the values of commercial efficacy, finality and certainty, arguing that “the focus placed on subjective intentions and the existence of reasonable beliefs in the mind of the drawer brings uncertainty to Canada’s negotiable instrument and payment system.” The dissenting judges prefer an allocation of risk that incentivizes “upstream” monitoring of cheque fraud (i.e. through the drawer’s financial controls) rather than “downstream” monitoring (i.e. placing an onus on collecting banks to verify whether the payee was legitimate). Certainly, the finance departments of large corporations like Teva are in a better position to ascertain whether a cheque’s payee is a legitimate recipient of a payment than a collecting bank that has no client relationship with the corporation.

By contrast, the majority opinion took the position that the existing test had “served the commercial world for over 40 years without significant complaint from that world.” (There was apparently no evidence before the court of the burdens that cheque fraud places on banks, nor how the costs of cheque fraud are distributed across the costs of banking for customers, including the small businesses that the majority opinion highlighted the importance of protecting). The majority opinion also stressed the fact that the banks are the main beneficiaries of the bills of exchange system, so an interpretation of the Bills of Exchange Act that exposes them to costs is not unfair from a policy perspective.

Although most financial services professionals will probably prefer the reasoning in the dissenting opinion, tort law purists will appreciate the majority opinion, since in an action under the tort of conversion, “upstream” monitoring is irrelevant. Conversion is a “strict liability” tort, which, legally speaking, means that negligence or other faults on the part of a cheque’s issuer will make no difference to the result.

However, the news that the doctrinal purity of tort law has been maintained will provide little comfort to Canadian collecting banks. To the extent that the policy results of the existing jurisprudence are unfair or commercially punitive to innocent collecting banks, the majority in Teva held, it is the responsibility of Parliament rather than the courts to intervene.

The United States has already made this type of legislative intervention. Under §3-420 of the Uniform Commercial Code , drawers are statute-barred from bringing actions in conversion against the collecting bank. Recovery for cheque fraud is typically dealt with between the drawer and its own bank, not the collecting bank, and the relative degree of negligence of each party is considered. This arguably places the risk of cheque fraud on the shoulders of the participants most capable of monitoring it.

Canadian deposit-taking institutions, on the other hand, do not have the benefit of such a legal environment. The sting is particularly harsh in Ontario, where several decisions that made great efforts to distinguish or avoid this test have now effectively been criticized, if not completely overruled, by Teva. After decades of debate, the law of fictitious and non-existing payees is now settled, and it continues to expose collecting banks to serious, long-term risks arising from fraudulently-issued cheques.

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