When are banks liable for not spotting fraud?

March 2022 | EXPERT BRIEFING | FRAUD & CORRUPTION

financierworldwide.com

Banks are often in the firing line for civil claims alleging that they knew about, turned a blind eye to or, alternatively, had a duty to spot the dishonest behaviour of someone else. The reasons for this are obvious: fraudsters themselves rarely make good targets for damages claims. They may have spent all the proceeds of their illicit activity (perhaps on addictions such as gambling) or perhaps, as with a Ponzi scheme, the money was only ever illusory. With modern crimes like cyber fraud, the perpetrators could be anywhere in the world. Even if the defrauded victim could track them down, a claim may be impossible to enforce.

Banks are, on the other hand, attractive defendants for civil damages claims. They are subject to professional standards, owe duties to their customers and clients, cannot flee the jurisdiction and have deep pockets. For these reasons, a judgment against a bank would normally be easy to enforce. Financial services firms may also be more willing to settle claims to avoid adverse publicity and potential reputational damage.

But how can someone be held liable to pay damages for another person’s fraud? In effect, there are three ways. The first is a situation where the defendant has negligently failed to perform its professional duties in a situation where, absent such failure, the fraud would have come to light. This is potentially an issue that may arise, for example, in the world of auditing. The second type of liability is as an accessory. In civil cases this is framed as dishonest assistance in a breach of trust or breach of fiduciary duty. The third type of liability arises from an implied duty on banks to spot whether a customer’s orders are dishonestly given.

In order to spot dishonesty, you first have to be able to recognise it. However, it is almost impossible to define. The UK Supreme Court has said that that dishonesty “like the elephant… is characterised more by recognition when encountered than by description”.

In criminal cases, whether the defendant’s conduct is dishonest is a point for the jury. In civil cases, the judge decides. But even judicial views on what crosses the line in individual cases clearly do differ. An investment bank brought a claim against its customer for payment of several hundred million dollars under a series of complex swap transactions. The High Court refused to allow the claim because the judge found that the bank’s employees had been aware that the customer’s third-party financial advisers had, in breach of fiduciary duty, not been acting in the customer’s best interests. Unbeknown to the bank’s employees, the scale of the financial advisers’ wrongdoing extended to paying a bribe to the customer’s managing director in return for receiving disproportionate advice fees. The judge ruled that the bank was liable for this bribe, so that the swap transactions were overturned, despite the bank’s staff not knowing about it. On appeal, two of the three judges upheld the decision, but the third judge rejected this approach, saying that: “it is impracticable and unreal to introduce into commercial transactions the moral standards of the vicarage”.

One of the factors that means frauds can go undetected for some time is the drip, drip effect. While some commercial frauds are scams from the outset, in other cases the wrongdoer is initially engaged in some legitimate business practice but perhaps starts to ‘borrow’ money from the business that they cannot repay or ‘improves’ the accounts to hide trading losses from investors or secure a bank loan. Certainly a red flag for further investigation is any situation where particular assets are constantly revalued upwards, with no obvious reason for the value to have increased significantly.

This type of activity has been a feature of a number of hedge fund frauds, of which Weavering Capital is a good example. Weavering’s investment manager covered up the fund’s failure to make any actual profits by entering into sham swap transactions with another fund under his control, but one which had no real significant assets of its own. Consequently, when investors asked to withdraw their money following the financial crash, the valuation of the Weavering fund was found to be illusory with virtually all the fund’s supposed $600m assets comprising the worthless swaps.

Many fraudulent schemes involve the use of banking facilities because, the emergence of blockchain cryptocurrencies aside, most money transfers and trading still have to be done through banks. Banks and their employees are, therefore, in a position that may enable them to spot and block or report suspected fraud. Indeed, the Proceeds of Crime Act imposes specific obligations on regulated firms to report suspicious financial activities to the National Crime Agency.

But what about civil liability for failing to spot potentially fraudulent behaviour? Sometimes a failure to ask questions about a potentially suspicious transaction or trading strategy is considered so improbable that it is possible for the court to infer it was deliberate. The person assisting the fraudster in effect prefers to remain ‘blind’ so that they can say they did not know about the fraud. However, it has been established is numerous high-profile cases that such deliberate ‘blindness’ does not offer a defence.

To bring this kind of claim against someone who is an accessory to, but not the perpetrator of, the fraud in question, it is normally necessary to be able to establish some motivation for the defendant to have closed their eyes to the wrongdoing. In the case of banks, this might be inferred where a bank employee stands to get a bonus, promotion or other reward if the suspicious transaction completes.

A recent example of this is a claim brought against a bank for dishonest assistance by the liquidators of a company that had been set up by its directors as part of a scheme to trade carbon credits in order to make fraudulent VAT claims. The judge held that, although the bank’s traders were not fundamentally dishonest men, in not asking the counterparty about its business model or how it obtained such a large volume of carbon credits to trade, the traders had made a deliberate, and therefore dishonest, decision not to enquire because they were motivated by the desire to continue the profitable trading. However, this case has now been remitted for a retrial by the Court of Appeal.

For banks there is the particular problem of the civil liability imposed on them for failing to spot fraud negligently (as opposed to deliberately), first established in a case known as Quincecare. As a result, an implied term of the contract between a bank and its customer is that the bank owes a duty of care not to execute the customer’s order if it knows the order to be dishonestly given, or shuts its eyes to obvious dishonesty, or acts recklessly in failing to make inquiries.

This doctrine, which remains somewhat controversial, was recently considered again in a case in which a bank was held liable for not preventing an individual, Mr Al Sanea, who was both the sole shareholder and chairman of the bank’s customer, Singularis, from making fraudulent transfers of Singularis’ assets. After having instructed the bank to make payments totalling approximately $204.5m to third parties out of monies held in Singularis’ account, Mr Al Sanea then put it into liquidation, leaving it unable to meet the demands of its creditors. The company’s liquidators sought damages from the bank amounting to the value of the misappropriations made by Mr Al Sanea from the company’s bank account.

The court found that the bank’s employees had acted honestly but concluded that – although this was not a case of deliberate blindness – any reasonable banker would have realised that there were many obvious, even glaring, signs that Mr Al Sanea was perpetrating a fraud on Singularis and therefore held the bank liable in negligence for failing to prevent the fraud. The judgment was upheld on appeal.

However, the court has recently clarified that the Quincecare doctrine does not extend to a duty to have in place policies and procedures for detecting potential authorised push payment fraud and to protect customers from the consequences of such fraud where the payment instructions were valid and not of themselves fraudulently given. Quincecare duty only extends to instructions fraudulently given by the customer’s own agent, not fraud perpetrated against the customer by third parties. Given the scale of authorised push payment fraud and leaving aside any agreement to reimburse customers under the Contingent Reimbursement Model Code, the court’s ruling will come as a relief to the banking sector.

Susan Rosser is a partner at Mayer Brown International LLP. She can be contacted on +44 (0)20 3130 3358 or by email: srosser@mayerbrown.com.

Susan Rosser

Mayer Brown International LLP