Duties not to facilitate fraud
The Wealth Finance Brief - March 2015
- Lending to Individuals
- Execution of Guarantees
- Sovereign Immunity: considerations for lenders
- Duties to not facilitate fraud
- MiFID II: A Summary
- Taking Security Over IP
Fraud and forgery have always been an issue for banks and customers alike in the transfer of money and these days, with the electronic transfer of money, the risks are even greater. This briefing paper explores what duties banks and their customers owe not to facilitate fraud.
What duties apply to banks and their customers to prevent fraud arising in banking transactions?
With the widespread use of mobile and internet banking, there has been an increased focus on the need to mitigate the possibility of fraudulent activity in private banking transactions, with a duty of care placed on both a bank and its customers. Such duty of care has long been in existence, with statute granting certain protections to banks and numerous cases establishing the obligations owed by each party, particularly in relation to the drawing of cheques.
The extent of the duty of care owed by each party however is predominantly dependent on the terms and conditions of the contract governing the bank account. For those banks which have signed up to the Lending Code, there is a requirement that terms are in compliance with them. In addition, both the Financial Conduct Authority's Banking Conduct of Business Rules and the Unfair Terms in Consumer Contracts Regulations ("UTCCRs"), impose a duty of fairness on the bank to its customer who is a consumer. Terms are regarded as unfair if, contrary to the requirement of good faith, they cause a significant imbalance in the parties' rights and obligations to the detriment of the bank's customer. Accordingly, a bank would be unable to exclude their liability by restricting the duty of care owed to their consumer customers. Common law has supported this approach, reiterating that a duty of care exists on both banks and their customers not to facilitate fraud.
To what extent does a bank owe its customer a duty of care not to facilitate fraud?
Banks are expected to comply strictly with their customer's payment orders, issuing corresponding payment orders that precisely match that of their customer's. There are limited circumstances in which a bank is able to refuse a payment order, and in the case that it does, the bank must inform the customer at the earliest opportunity that it is doing so and, where possible, provide an explanation. In Bank of New South Wales v Laing  AC 135 it was held that there was an obligation on a bank to comply with their customer's payment order so long as the account was in credit. Banks are also entitled to reject a payment order where the customer has breached the agreed terms and conditions governing the account, for example by not providing two signatures for a joint account payment, or where making the payment would be considered unlawful.
However, the duty to obey a customer's payment order can conflict with a bank's duty to exercise reasonable care and skill, in protecting its customer from the fraud of agents such as directors and partners in issuing a payment order. A conflict can occur where a bank is provided with what may appear to be an authorised payment order, but in fact was made as a result of fraudulent activity, raising questions as to the extent of the duty of care a bank owes to its customer in confirming the validity of the payment order instruction.
The Payment Services Regulations ("PSRs"), where they apply, address the issue of the misuse of a payment instrument. They direct that a bank will only have the authority to make a payment or debit a customer's account if it can show that consent has been obtained from the customer. The form and procedure for giving consent to the execution of a transaction must be set out in the information given to a customer before a transaction is concluded. If a bank cannot show that consent has been obtained the transaction must be regarded as unauthorised. As a result, if a third party were to gain access to a customer's electronic payment device or were able to bypass it altogether and send payment instructions to a bank, the obligation on the bank to assess whether it had the consent to process the transaction would be dependent on the terms of the contract between the parties.
In situations where incorrect payment instructions are given to a bank as a result of fraud and a bank acts in accordance with those instructions, case law has sought to restrict the liability of a bank. In Tidal Energy Ltd v Bank of Scotland PLC  EWCA Civ 1107 it was held that a customer's bank will not be liable for facilitating the defrauding of its customers, so long as it follows established banking practice. In this particular circumstance, the customer had provided the bank with the correct name but incorrect account number and sort code, having been subject to fraud. The bank complied with the payment order to the fraudulent third party and the payment was withdrawn from the account. It was held that as established banking practice did not require that a bank should match names to account numbers and sort codes, the bank was not under a duty of care to do so.
Standard banking practice requires that in order to confirm a payment instruction, a bank must provide to its customer details of transactions made from their account, including the date of the transaction, the amount of the transaction, the name of the payee or payer and a reference so that the payment can be easily identified. More stringent requirements have been proposed in the form of a Fourth Money Laundering Directive and revised Wire Transfer Regulations.
In the event that there has been a misdirection of payment, the Code of Best Practice ("Code") published by the Payments Council provides guidance on payments made via BACS, CHAPS and Faster Payments. It directs that both the sending and receiving banks would be expected to investigate the misdirected payment in line with the Credit Payment Recovery process and associated timeframes. The receiving bank will also be expected to inform the sending bank of the progress and outcome of any error recovery request. If the receiving bank is not a subscriber to the Code or a payment scheme member it should still follow the recovery framework processes, and seek information from its sponsor scheme member on these. The sending bank, however, may refer it to the Code and request it to contact its customer within two working days.
Difficulties may, however, surface where a bank complies with standard banking practice, but fails to comply with its own internal procedures for the verification of the authority of a payment order. This could be problematic in situations where a bank's internal procedure provides a more rigorous requirement on the bank to verify the payment order, than that set by standard banking practice. On the one hand, it could be considered that so long as the bank complies with standard banking practice there should be no expectation that they meet a higher threshold by complying with their own internal procedure. However, it is likely that a court would not look favourably upon a bank which has failed to comply with its internal procedures, in facilitating fraud on a customer's account, regardless of whether its conduct met standard banking practice. In order to satisfy the duty of care owed to its customer, a bank would be well advised to comply with its internal procedures, in addition to standard banking practice.
To what extent does a customer owe its bank a duty of care not to facilitate fraud?
A customer also owes its bank a duty of care: the duty to refrain from drawing cheques or other payment orders in such a manner as to facilitate fraud or forgery (following the House of Lords' decision in London Joint Stock Bank Ltd v Macmillan  A.C. 777, 789);and the duty to inform the bank of any forgery of a cheque as soon as he becomes aware of it (following the House of Lords' decision in Greenwood v Martins Bank Ltd  AC 51). Whilst these duties were stated in relation to the drawing of cheques, they are applicable to payment orders through all mediums.
The PSRs provide that a bank's customer would be liable for all losses arising from the unauthorised use of a 'payment instrument' if he has intentionally or with 'gross negligence' failed to comply with his statutory obligations, for example by not complying with the terms and conditions of the use of the payment instrument, failing to notify the bank without 'undue delay' (and no later than 13 months after the date of the transaction) of its loss, theft, misappropriation or unauthorised use, or failing to take reasonable steps to keep the personalised security features of the payment instrument safe.
However, the Financial Conduct Authority has indicated that while a customer is obligated under the PSRs to take all reasonable steps to keep the personalised security features of his payment instrument safe, a contractual term which prohibits the customer from writing down or recording a password or PIN in any form goes beyond 'reasonable steps' and may potentially be unfair under the UTCCRs. A term specifying that a customer will be liable for any unauthorised transaction if he records his password or PIN, will be inconsistent with the UTCCRs and is likely to be considered unenforceable. What constitutes reasonable steps will depend on the circumstances, but payment service providers must specify the steps they expect customers to take in their pre-contract disclosure information.
Under the PSRs, the bank bears the burden of proof where a customer's claim that a transaction is unauthorised is rejected. A rejection must be supported by sufficient evidence to prove that the customer is guilty of fraud, gross negligence or intentional breach, and the bank must provide an explanation for the rejection to the customer.
It is worth noting, however, that whilst a customer would be liable for all loses incurred due to his 'gross negligence', if there is no element of culpability on behalf of the customer, the customer could only be liable for the first £50 of the loss.
Both banks and their customers have a duty not to facilitate fraud on the customer's account and care must be taken by both parties to ensure they meet their legal obligations. Where a private bank is dealing with individuals it needs to ensure that it complies with all its internal procedures as well as standard banking practice, otherwise it could find that, in the event of fraud, a court would not allow it to rely on any exclusion of liability clause in its standard terms and conditions.