Alan L Tyree

Fraud by design

Alan L Tyree*

1  The problem

You work for a company or a public authority. You have authority to write cheques for certain purposes, perhaps even an authority to invest funds on behalf of your employer.

You wish to embezzle a significant amount of money.

Not a problem, you think.

2  The wrong way #1

The first and most obvious thing is to write a cheque to yourself. A moment’s thought shows that this is not a very good solution. First, you might find it difficult to find a second signatory for the cheque, although the newspapers show us each day that company directors and employees do some rather extraordinary things.

The second problem with this solution is that the payments show up very quickly in the company accounts, calling for an explanation. Again, there are some dramatic examples of accounts that are not inspected for years, but it would be unwise to count on this.

The third problem with this solution is that you will have to deposit the cheque into an account. At this point, the vigilant bank teller will begin to ask questions about why you are depositing a cheque from your employer.

3  The wrong way #2

A better solution is to write a cheque to a third party. To cover your accounting tracks, the payee should be a trade creditor or some other entity to which your employer might be expected to write cheques. You should study the cases on conversion of cheques to pick up pointers.

The main problem with this method of embezzlement is to get the funds into an account which you control. Forged indorsements have worked, but if the cheques are marked “account payee only” then you will again be facing questions from the teller. A clever way is to form a company with a name similar to that of the legitimate payee and trust that the deposits will go through: see, for example, Dairy Containers Ltd v NZI Bank Ltd [1995] 2 NZLR 30.

This method of embezzlement is likely to be too limiting. Except in very unusual circumstances, the amount of money that will be paid to legitimate third parties will be limited by the normal expectations of business.

4  Getting it right

Fortunately, the banks and brokers have designed a system to solve your problem. The system is explained in NIML Limited v MAN Financial Australia Limited [2004] VSC 449 and it is convenient to refer to the facts of that case to describe the system.

NIML handled the funds of various superannuation funds. The company maintained a current account with a Sydney branch of Westpac. The company secretary, SB, was authorised to draw cheques and to make investments on behalf of NIML. Two signatures were required to operated the account, and SB was one of the persons authorised to sign cheques.

MFA was a futures broker and foreign exchange dealer. It maintained a current account with a Melbourne branch of Westpac. It was “client segregated account” as required by s 1209 of the Corporations Law then in force. Clients paid money into the account for trading purposes. However, clients could also direct MFA to make third party payments of any funds in excess of those used for trading. From the client’s point of view, the account could function as a current account.

The feature of the account that makes it attractive for our hypothetical white collar criminal also made it attractive to SB. MFA could not accept cash, but would often require margin calls to be met quickly. It solved this problem by providing account details to clients and authorising Westpac to accept deposits of cheques made payable to MFA.

Finally, Westpac account statements did not identify the depositors or specify the client account to which the amounts should be credited. MFA relied entirely on their clients to identify deposits.

It almost goes without saying that SB opened a trading account with MFA. He deposited NIML cheques to the MFA account and then advised MFA that the sums were for his personal client trading account. In less than 14 months, he misappropriated over $2.5 million.

NIML sued both MFA and Westpac, losing in the first instance. The appeal was concerned primarily with the question of conversion. The Court of Appeal held that Westpac was not liable, but that MFA was.

This note considers only the question of conversion by the bank.

4.1  The court of appeal

The Court of Appeal decision in favour of the bank was based on the following propositions:

Since the system sanctioned by the Court of Appeal is so obviously open to abuse, it is hoped that the decision is wrong. This note challenges the chain of reasoning outlined above.

4.2  Paying/collecting bank

At one time there was confusion about the defences available to a bank when the bank acted as both drawee and collecting institution. Section 60 of the Bills of Exchange Act 1882 (UK) deems a bill to have been paid in due course in certain circumstances. Early cases held that this section also provided a defence for the bank against an action in conversion: see Bissell & Co v Fox Bros & Co (1884) 51 LT 663; Capital and Counties Bank Ltd v Gordon [1903] AC 240.

This was expressly rejected by the UK Court of Appeal in Carpenters Co v British Mutual Banking Co Ltd [1938] 1 KB 511. After careful consideration of the above cases, the Court of Appeal held that a bank could still be liable in its character as collecting bank even though it had a statutory or common law defence in its role as paying bank.

In other words, where an institution acts as both a paying and a collecting institution, its liability must be analysed both as a paying institution and as a collecting one. This decision has never been seriously challenged.

Not only has there been no challenge to the Carpenters case, the ratio of the decision was adopted explicitly when drafting the Cheques Act 1986: see para 437 of the Explanatory Memorandum.

Weaver and Craigie point out (at para [9.6820]) that:

The provisions of the Cheques Act 1986, including ss 92, 93 and 94(2), all refer simply to payment to “a financial institution” upon the unspoken assumption that, so long as reference is made to payment to a “financial institution” rather than to “another financial institution”, it is beyond argument that a drawee institution which pays a cheque which was deposited with itself as collecting institution will fall within the relevant sections.

In spite of all this, the Victorian Court of Appeal decided that the NIML case was one “in which it would be artificial to draw a distinction between a bank’s authority as paying bank and its authority as collecting bank.”

It justified this only by reference to the decision of the Privy Council in Universal Guarantee Pty Ltd v National Bank of Australasia Ltd [1965] NSWR 342; [1965] 2 All ER 98 where, in the circumstances of the case, it was said that “any analysis of the obligations of the Bank as a ’paying’ or ’collecting’ Bank is unrealistic and entirely out of place, as is any allegation of tortious neglect.”

But the Universal Guarantee case concerned only a bank and its customer where cheques drawn by the customer were deposited back into the customer’s account. That is certainly a very specialised and unusual circumstance and far removed from the situation in NIML where there were not only two accounts involved, but the accounts were held at different branches.

4.3  Authority to deposit

The Court of Appeal said (at para 26)

Speaking generally, where a cheque is drawn in favour of a named payee and the bank on which the cheque is drawn is also the bank of the named payee, and the drawer deposits the cheque with that bank for credit to the account of the named payee, the drawer will not be heard to complain if the bank credits the proceeds of the cheque to the account of the named payee. The drawer’s request to credit the proceeds to the account of the named payee estops the drawer from contending that the bank has dealt with the cheque otherwise than in accordance with the rights of the drawer.

There are any number of cases which show that this is a questionable proposition. Most importantly, it overlooks the cases where it was held that the bank may have a duty, as paying bank, to examine and question a valid mandate: see, for example, Selangor United Rubber Estates Ltd v Cradock (No 3) [1968] 1 WLR 1555 and the Court of Appeal decision in Lipkin Gorman v Karpanale Ltd [1989] 1 WLR 1340 (this aspect of the decision was not considered in the House of Lords: Lipkin Gorman v Karpanale Ltd [1991] 2 AC 548.) For a discussion of this duty, see Alan L Tyree, Liability of a Bank which Follows its Customer’s Mandate, (1992) 3 JBFLP 40

In any case, in the present instance it was not the drawer of the cheque (NIML) which deposited it, it was SB. The Court met this problem by extending the rule, holding that an authority to draw cheques implies an authority to deposit the cheque to the account of the named payee: at para 27.

This is a startling proposition, in effect declaring that anyone who has an authority to write cheques may deposit the amount in the account of a payee. It flies in the face of Rekstin v Severo Sibirsko Gosudarstvennoe Akcionernoe Obschestvo Komseverputj [1933] 1 KB 47 as explained in Momm v Barclays Bank International [1977] QB 79. It implies that the bank is an agent of the customer for the purposes of receiving gifts: see R S T Chorley, The Law of Banking, 6th ed, 1974 Sweet & Maxwell at 71, Weaver and Craigie, The law relating to banker and customer in Australia, 3rd ed, 2003 Thomson Lawbook Co para [9.970] and Alan L Tyree, Deposits by strangers, (2003) 14 JBFLP 42.

4.4  Reliance

Apparent or ostensible authority is a form of estoppel. As such, the party claiming the estoppel must show that they relied on the apparent authority: see Freeman and Lockyer v Buckhurst Park Properties (Mangal) Ltd [1964] 2 QB 480 and Lloyd’s Bank plc v Independent Insurance Co Ltd [2000] QB 110.

Westpac did not rely on the apparent authority of SB to deposit cheques even if, contrary to the discussion above, SB had such apparent authority. Westpac would accept cheques payable to the MFA account from anyone, not because of some supposed apparent authority, but because of the actual authority granted by MFA.

4.5  Section 95

If any of the above is correct, then the proper approach to the problem is to consider the bank’s role as collecting bank as distinct from its role as paying bank.

There is little doubt that the bank converted the cheque. SB converted the cheque the moment that he decided to use it for his own improper purposes. The bank assisted him by collecting the cheque for the account of the payee.

The question then becomes: Does the bank have a defence under s 95 of the Cheques Act 1986? That is, has it collected the cheque in good faith and without negligence?

On the plus side: the bank was (probably) acting in accord with current banking practice, there was nothing on the face of the cheque to raise suspicion, the bank knew that SB had responsibilities for investing company funds.

On the minus side: the bank knew that the funds were being deposited in an account where many people had a beneficial interest. Caution would dictate that some inquiry be made.

On balance, the Court would probably have found that the bank had established the s 95 defence. The advantage would be that the issues would have been clearly discussed in a framework that has history and authority to recommend it.

4.6  Other considerations

These broker accounts are clearly an invitation to fraud, and it is hard to see why they are necessary. Brokers use them primarily because it was thought that the arrangement absolved them from making the identity checks required by the Financial Transaction Reports Act 1988 (“FTRA”).

The validity of this belief is in doubt given that ASIC received advice from the Solicitor General that cash management trusts with the same general structure were “facilities” for collecting cheques. The SG’s advice never explained how it was possible for a payee to “collect” a cheque on behalf of the drawer. “Collection” is a term usually used to describe the action of obtaining payment for the account of the payee.

This does not mean that the FTRA is irrelevant. A “signatory” to an account is:

the person, or one of the persons, on whose instructions (whether required to be in writing or not and whether required to be signed or not) the cash dealer conducts transactions in relation to the account.

This clearly identifies any depositor to the broker account as a signatory. As such, the bank is required to perform the identity checks as required by the Act: see Alan L Tyree, CMTs revisited, (2002) 13 JBFLP 36 for a discussion of the problem.

Consultant; formerly Landerer Professor of Information Technology and Law, University of Sydney. The views expressed are my own and do not necessarily reflect the views of any other person or organisation.