The Fraudulent Employee – Who Pays?

Trusted employees are key assets of a business.  No business owner can oversee all aspects of their business all the time.  Trusted employees are needed in all aspects of a business, but particularly in the financial affairs of a business.  Companies frequently give trusted employees the authority to prepare and issue cheques for ordinary course bill payments.  However, who is responsible when an employee abuses this trust and fraudulently issues payments to third parties that have not delivered goods or services to the company?

This edition of The Battlefront looks at a recent court decision regarding a dispute between a company and its bank over who is liable for fraudulently issued cheques.

Bank’s have an obligation to verify identity if Payee exists

In the case of Teva Canada Ltd. v. TD Canada Trust (2017 Supreme Court of Canada), an employee prepared false cheque requisitions for entities with similar or identical names to existing suppliers of the company.  In reliance of these requisitions, the accounting personnel of the company issued payment cheques totaling over $5 million during the course of the fraud.  The rogue employee registered business names, opened bank accounts, deposited and then removed the funds.  When the fraud was discovered, the employee was terminated but the funds could not be recovered.

The company then sued the bank that collected on the fraudulent cheques on the grounds of conversion, i.e. the funds were authorized for specific suppliers of the company but were diverted (i.e. “converted”) to an unauthorized recipient (i.e. the entities set up by the rogue employee).  The bank took the position that since the entities named on the fraudulent cheques did not exist, anyone could cash the cheques without the bank having to confirm the existence of the recipients.

This fact situation hinged on a technical requirement of the law.  The federal Bills of Exchange Act sets out that a cheque made out to “fictitious or non-existing” payees are deemed to be “payable to the bearer”.  A cheque payable to the bearer can be cashed by anyone without the bank being obligated to confirm their identity.  However, a cheque that names a specific recipient does not qualify for this statutory protection and the bank requires an endorsement to cash the cheque, i.e. verify that the entity cashing the cheque was the named recipient.

The issue in this case was whether the payees named on the cheques were “fictitious or non-existing”.

The company was initially successful at trial, but the bank was successful at the Court of Appeal.  The case then went to the Supreme Court of Canada for a final decision.

The Court considered the purpose of bills of exchange system in Canada and pointed out that the banks benefit more from the legal system than the customers writing the cheques.  When considering the balance between an innocent victim of fraud or a sophisticated bank, the Court reasoned that there are certain circumstances when the banks should bear more of the risk of loss associated with the bills of exchange system that generally favours the banks.

The banks are the first gatekeepers of the system.  To benefit from the protections of the system, the burden is on the bank to demonstrate that the payee is fictitious or non-existing before the conduct of the company is considered.  Whether the company was negligent in failing to detect the fraud is irrelevant to this initial burden which rests solely on the bank.

To demonstrate the payee is fictitious or non-existing, the bank must satisfy a two-step framework consisting of a subjective test, and then an objective test.

First, the bank must consider whether the company intended to pay the specific recipient named on the cheque.  If the name on the cheque was clearly fraudulent (for example: “John Doe” or “ABC Company”), then the court may reasonably conclude that the company did not form the intention to pay a specific person.  However, the burden of proof in on the bank to demonstrate this lack of intent.  Absent sufficient evidence, the presumption must be that the company intended the named recipient to receive the funds. 

In this case, the court concluded that the company did intend to pay the payees named on the cheques. 

Second, the bank must then consider whether each payee is either a legitimate payee of the company or could reasonably be mistaken as a legitimate payee of the company.  This objective question focuses on whether a real individual or company exists that could present the cheque for deposit, or whether the payee that could reasonably be mistaken as real.  If the payee exists, then an endorsement could be obtained.  Conversely, a fictitious or non-existing payee could not give an endorsement so none would be required.

In this case, the court pointed out that the name of each payee was exactly the same, or reasonably close, to the name of known suppliers of the company.  These suppliers did exist even though the names on the cheques did not match exactly.  As the named recipients did exist, then the banks had an obligation to confirm the identity of the recipient seeking to deposit the cheques.

Hence, the court concluded that the company had intended to pay the funds to named payees, i.e. the company had only authorized the funds be paid to those recipients named on the cheques.  By not detecting the fraudulent endorsements, the bank had permitted the funds to be delivered to improper parties.  The court found the bank liable for converting the company’s funds.  Any failures by the company in issuing the cheques were irrelevant to the banks’ gatekeeper obligations.

Thoughts to Take Away

Fraud liability may be widespread!  While the rogue employee is always liable for his/her fraud, there may be other participants in market who may also bear liability, regardless of whether they were aware of the fraud or not.  In this case, the banks were unknowingly part of the fraud and failed to fulfil their obligation to verify the identity of the fraudsters.  This resulted in liability.

However, companies should not become complacent in their fraud protection efforts.  This fraud in this case was detected in 2006 but the company did not receive a final court decision until October 2017.  Many companies would not have been able to survive this level of fraud or finance the multiple levels of court to achieve a final decision and reimbursement.

In the unfortunate event that a company has been the subject of an employee fraud, there may be alternative remedies.  A careful examination of the facts and events may determine that other players bear some level of responsibility and liability for not fulfilling their obligations in the legal system.  Just because your employee went rogue may not mean you alone must suffer the consequences.  Remember, fraud prevention is everyone’s concern!


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About The Battlefront

This article contains general information only.  The Battlefront is a brief canvasing of the topic presented and should not be relied upon as professional advice in making any personal or business decisions.  Always consult with a licenced legal professional before making any decisions regarding your own personal or business needs.  The author takes no responsibility to update any of the information presented in this article.  All rights reserved.  © Loopstra Nixon LLP 2017