In a narrow 5-4 decision, the Supreme Court of Canada has laid out a new formulation of the “fictitious or non-existing payee” defence under section 20(5) of the Bills of Exchange Act (BEA). The underlying dispute involved an employee who took advantage of weak internal compliance mechanisms to draft a number of fraudulent cheques. The employee made the cheques payable to entities the employer dealt with, as well as two non-existent entities with names similar to those of real suppliers. The cheques were then deposited into a number of bank accounts, set up by the employee in the names of these entities. The fraud was not discovered until after the employee had deposited $5,483,249 into the various accounts. The employer ultimately sued the banks in conversion in an attempt to recover the stolen funds.

The banks argued that they were not liable on the basis of a statutory defence under section 20(5) of the BEA, which states that “Where the payee is a fictitious or non-existing person, the bill may be treated as payable to the bearer.” Where a cheque is made out to a fictitious or non-existing person, the bank would be able to pay out to the person cashing the cheque without being held liable for conversion. The Supreme Court’s interpretation of this test narrows the defence significantly, and places increased risk of losses in cheque frauds on financial institutions. Justice Abella’s two step test is set out below:

  1. The subjective fictitious payee inquiry asks whether the drawer intends to pay the payee. Where the payee’s name is inserted by way of pretence the drawer does not intend to pay the payee, and the payee can be said to be fictitious. In this situation, the cheque will be payable to bearer, and the bank can rely on the section 20(5) defence.
  2. 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 payor/drawer, if neither is satisfied, then the payee does not exist, and the payor/drawer is liable. If either is satisfied, then the payee exists, and the bank is liable.

On the facts of the case, the banks could not prove any subjective intention on the part of the drawer, as the employer had not participated in the fraud and the fraud had been structured so as to give the appearance that payments were being made to real suppliers thereby satisfying the second branch of the test.

Justices Côté and Rowe wrote a dissenting judgement advocating a simplified objective approach to s.20(5) of the BEA. Their approach was that where a payee does not exist at the time the cheque is drawn a banks may treat the cheque as payable to the payor/drawer relying on the statutory defence. Where the payee exists but there is no real transaction between the payor/drawer and the payee, the payee would be said to be fictitious and a bank may similarly rely on the defence.  This removes the subjective element from the analysis.  The jurisprudence in the United States approaches this type of cheque fraud in a manner closer to that proposed by the dissenting Justices. While the Uniform Commercial Code allows for a consideration of subjective intent, it focuses on the intention of the individual signing or writing the cheque (and whether the cheque was authorized or unauthorized).  If unauthorized, the bank will not be liable.

Financial institutions should be aware of the increased risks in Canada and consider implementing new measures to identify potential cheque fraud involving fictitious payees.  This decision shifts some of the burden and costs of monitoring fraudulent activity to banks, which are arguably in a worse position to uncover such conduct than an employer.  We can expect this increased burden to slow down the cheque cashing process in Canada, with additional costs passed onto customers.

With thanks to Ben Sakamoto for his assistance writing this article.