Canada: Fraud And Misconduct By Financial Intermediaries

By Frank Palmay¹ And Assunta Di Lorenzo²

1. Introduction

Fraud or its synonyms "dishonesty, infidelity, faithlessness, perfidy, unfairness etc..."³ is the direct antithesis of "trust, good faith, fidelity, fiduciary etc..." which are the hallmarks of the relationship between a financial institution and its clients.

The financial intermediary is most often the link between the institution and its client.

The financial intermediary, whether a bank or trust company employee/officer, an insurance or stock broker or an insurance agent, is in a unique position because often he/she is selling products to which the client cannot accurately attach a value and which the client may not fully understand. When this is the case, the client is particularly vulnerable to the actions of the intermediary.

With the growing number of participants and transactions in the financial services industry, it is more important than ever for financial institutions to protect themselves, their clients and their reputations from the effects of fraud or misconduct by the financial intermediaries they employ. Exacerbating the situation is the increasing complexity, speed and volume of financial transactions and the supervisory and monitoring difficulties which they imply.

In Canada, the 2007 CSA Investor Study on "Understanding the Social Impact of Investment Fraud"⁴ revealed that more than one million Canadians, that is one in five Canadians, have reported having been a victim of investment fraud.

White-collar crime costs corporations billions of dollars annually, damages the wealth and health of individual victims, and undermines the integrity of markets through eroding investor confidence. Securities regulators face high consumer expectations regarding the prevention of financial fraud. In response to these expectations, the Autorité des marchés financiers and other Canadian securities regulators have greatly bolstered their efforts in recent years to deter financial crimes.

The Canadian justice system has in the past earned the reputation of being "soft" on investment fraud. However, it now has the tools to "get tough" on investment fraud as a result of the coming into force of recent amendments to the Criminal Code which provide for stiffer penalties for white-collar crimes such as fraud. In the future, more significant consequences or sanctions are expected to be imposed by judges on those who are convicted of fraud.

Implementing an effective prevention and protection program is an important safeguard to protect institutions against the kind of financial, business and reputational cost arising from a conviction or damage to reputation.

2. What Constitutes Fraud?

2.1 Criminal Fraud

The essence of fraud is dishonest deprivation. Section 380 of the Criminal Code makes fraud a criminal offence punishable by up to fourteen years imprisonment. The following individuals are guilty of fraud:

(1) Every one who, by deceit, falsehood or other fraudulent means defrauds the public or any person whether ascertained or not, of any property, money or valuable security.

(2) Every one who, by deceit, falsehood or other fraudulent means with intent to defraud, affects the public market price of stocks, shares, merchandise or anything that is offered for sale to the public.

There are three leading Supreme Court of Canada (SCC) cases that establish the elements of criminal fraud: R. v. Olan (1978), 41 C.C.C. (2d) 145 (S.C.C.); R. v. Théroux (1993), 79 C.C.C. (3d) 449 (S.C.C.); and R. v. Zlatic (1993), 79 C.C.C. (3d) 466 (S.C.C.). The case of Olan expanded the interpretation of the offence of fraud, and indicated that dishonest deprivation must be established to support a conviction of fraud. Actual economic loss is not an essential element to the offence. Zlatic and Theroux clarified what is required for the mens rea element for the offence of fraud. The mens rea element requires proof evidence that the accused's conduct was deliberate and there was knowledge of the relevant facts of the crime.

The Quebec Court of Appeal in Regina v. Lacombe⁵ disallowed an appeal by a stockbroker charged with fraud under section 380 of the Criminal Code. In confirming the guilt of the stock broker, the Quebec Court of Appeal discussed the elements of the offence of fraud.

"Under our present law of fraud, the ultimate burden of proof being on the Crown, there can be no conviction where the trier of fact is left with a reasonable doubt (a) as to the element of deprivation, in the sense of detriment, prejudice or risk of prejudice to the economic interests of the victim; (b) that this deprivation was caused by conduct of the accused which, '...by the ordinary standards of reasonable and honest people...' would be regarded as dishonest, and (c) that the accused acted knowingly and intentionally, in the sense that he was aware his conduct would be ordinarily considered 'dishonest' and would result in 'deprivation'."

The court found that the stockbroker had defrauded his employers by knowingly putting their economic interests at risk for the purpose of recouping the loss he had dishonestly caused in the account of his brother-in-law.

A finding of criminal fraud specifically requires proof of an intent to defraud.

However, the fact that a person does not know "for certain" that an act is "dishonest" or that it creates a risk of deprivation does not necessarily provide a defense against a charge of fraud. Criminal intent for fraud can also be established through proof of "recklessness" or "wilful blindness".

On November 1, 2011, important changes to the Criminal Code came into force following the adoption of Bill C-21 (Standing up for Victims of White Collar Crime Act), which was introduced in response to a number of high-profile fraud cases. One of the most important amendments is the creation of a two-year mandatory minimum sentence for fraud over $1 million minimum under section 380(1) of the Criminal Code. The White Collar Crime Act also makes important changes to the aggravating circumstances that are to be considered at sentencing (such as the magnitude, complexity, duration or degree of planning of the fraud), it allows for a new type of prohibition order (such as banning the offender from working in the financial services industry on a permanent basis) and it allows the courts to consider the "community impact statement" in sentencing.

2.2 Civil Fraud and Misconduct

While it is relatively difficult to get a conviction under section 380 of the Criminal Code, it is much more likely that a financial intermediary engaged in improper conduct will be liable in a civil action and found to have violated the standards of regulatory authorities.

In Common Law Jurisdictions

Financial intermediaries and their employers may be liable to compensate their clients for losses under the tort of deceit or for breach of fiduciary duty or negligent misrepresentation.

The concept of fraud is captured in the civil cause of action of deceit. "In an action of deceit the plaintiff must prove actual fraud. Fraud is proved when it is shown that a false representation has been made knowingly, or without belief in its truth, or recklessly, without caring whether it be true or false."⁶

Unlike in the case of criminal fraud, in the civil action it is not necessary to show that the intermediary intended to defraud. It is sufficient to show that the intermediary made a representation which he knew to be false and that injury ensued. The motivation behind the false representations (i.e., an intent to defraud) is irrelevant.

When a client is suing for losses suffered attributable to alleged misconduct by a financial intermediary, the court will often examine whether a fiduciary relationship existed between the parties. If a fiduciary relationship is found to have existed at the relevant time, the intermediary is obligated:

• to act in the best interests of the client;
• to refrain from placing himself or herself in a position where a client's interests conflict with those of the intermediary;
• not to secretly profit from the relationship with the client; and
• to always place the client's interests above the intermediary's own.

The relationship between a financial intermediary and client is not per se a fiduciary relationship such a relationship must be found. As it is unusual for the parties to have specified a fiduciary relationship by contract the court looks for indicia which include the level of trust, confidence and reliance placed on the intermediary's skill, knowledge and advice present in the relationship.⁷ The less financially sophisticated or the more vulnerable the client, the more likely that trust will be found to have been placed in the financial intermediary. Therefore, the experience and sophistication of the client are also important factors considered by the courts in determining whether or not a fiduciary relationship exists. Forsyth, J described the broker-client relationship to be a spectrum – on one end it was a relationship of full trust and advice, and on the other end, the broker does not provide any advice and acts as an "order-taker" for the client.⁸

The case of Hodgkinson v. Simms,⁹ sets out the relevant factors that must be considered when determining whether a relationship between a broker and client is a fiduciary relationship. La Forest, J summarizes the guidelines to determine whether a fiduciary relationship exists as follows:¹⁰

(1) scope for the exercise of some discretion or power; (2) that power or discretion can be exercised unilaterally so as to effect the beneficiary's legal or practical interests; and, (3) a peculiar vulnerability to the exercise of that discretion or power.

La Forest, J identified the following five interrelated factors to consider, when determining whether a financial intermediary and client are in a fiduciary relationship, (i) vulnerability of the client; (ii) degree of trust and confidence in financial intermediary, (iii) reliance on financial intermediary's judgment, (iv) discretion or power over client's account; and (v) profession rules or codes of conduct to determine the duties of the financial intermediary.¹¹

The client in Ryder v. Osler, Wills, Bickle Ltd.¹² was a widow with no business experience and the stock broker alleged to have breached her fiduciary duties had been entrusted to follow the investment instructions of the widow's children. The Ontario Court of Appeal accepted that whether or not a fiduciary relationship exists depends on the facts of each case. The Court went on to find a fiduciary relationship between the broker and her client based on the fact that the client was unsophisticated as to financial affairs and had placed her complete trust and confidence in the decisions of her broker. As there was a fiduciary relationship between the parties, the Court held that the broker had a duty to advise her client "carefully, fully and honestly and to comply with the instructions concerning investment that had been given to her." By changing the character of the account without instructions and by "churning" (i.e. trading with unjustified frequency) in order to earn substantial commissions, the broker was in clear breach of her fiduciary duty.

Similarly, Kelly Peters & Associates ("KP&A")¹³, a financial counselling business was held liable to its clients for breach of fiduciary duty for failing to make full disclosure of an interest in an investment recommended by the company. The Court found that the long-term relationship between KP&A and the clients involving a high level of confidence placed by the clients in KP&A created a fiduciary relationship with the result being that the clients were awarded the amount they would have had if they had not invested in the condominiums.

In the case of Hunt v. TD Securities Inc.,¹⁴ the court did not find a fiduciary relationship between a stockbroker and his clients. The clients were an elderly couple investing their retirement funds and alleged that their stockbroker sold their shares without their authorization. The clients found out about the sale ten days later, but continued to use the stockbroker for other transactions. The Court of Appeal found that although the stockbroker was in a position to carry out unauthorized sales of shares, that discretion did not create a fiduciary relationship. The stockbroker was not authorized to act on his own, and had not done so, except for the one authorized transaction.

Although the tendency of the courts has been to find that the relationship between client and a financial intermediary is a fiduciary one, even if a fiduciary relationship between an intermediary and client is not found, the client may nevertheless be compensated for the intermediary's misconduct.

By contrast, in the decision of Campbell v. Sherman,¹⁵ the court distinguished the case from Ryder because the victim was a sophisticated investor. The victim in Campbell v. Sherman was a promoter who alleged that the registered stock broker representative wrongfully converted shares into other accounts. The court also found that the relationship between the stock broker and alleged victim was one of a daily working relationship; and it would have been difficult for the stock broker to mislead the alleged victim. The court dismissed the action, finding that the victim was not a beneficial owner of the shares and thus could not claim a loss.

It has long been the case that when a person with special skills undertakes to give advice which he knows will be relied upon, he is under an obligation to do so with care. On occasion a court will find misconduct by a financial intermediary without regard to whether or not the indicia of a fiduciary relationship are present. In Rhoads v. Prudential-Bache Securities Canada Ltd.¹⁶ the British Columbia Court of Appeal found that a stockbroker who had disregarded his client's investment objectives when giving his investment advice was liable. The court stated that brokers represent themselves as professional advisors and therefore must "give careful and objective advice having in mind the goals described by their customers and all the options open."¹⁷

Under Quebec Civil Law

The Quebec`s legal system is based on the Civil Code of Québec ("CCQ"), whereas the systems in the rest of Canada are based on the principle of common law. Individual and class actions in damages against financial intermediaries and their employers are permitted under both systems.

Under Québec civil law, actions may be brought against financial intermediaries and their employers under breach of contract¹⁸ or for extra-contractual liability (comparable to common law tort liability) as a result of the injury caused to the client by reason of their faults.¹⁹ The determination of the type of civil action to choose will depend on the particular facts of each case.

As for the concepts of "fiduciary duty" and "fiduciary obligation", they are used in common law jurisdictions in Canada and in the United States. However, in Québec, the 1994 reform of the CCQ led to the introduction of standards of civil rights similar to fiduciary duty. For example, the contractual rules of mandate impose obligations on financial markets participants that are similar to fiduciary duty. The main obligations are good faith, loyalty and honesty. The nature and the scope of these obligations vary depending on the legal context of the relationship between the market intermediary and the client. The extent of the obligation is proportionate to the relationship between the parties: the more unequal the trustee-beneficiary relationship, the greater the trustee`s obligation.

For example, in Laflamme v. Prudential Bache-Commodities Ltd²⁰, the Supreme Court of Canada found that the relationship between the securities dealer acting as a portfolio manager and his client was governed by the rules of mandate. In discussing the content of the obligations of the portfolio manager, it recognized explicitly the intensification of the obligations of the portfolio manager in light of the vulnerability of the client. The court explained:

This spirit of trust is reflected in the weight of the obligations that rest on the manager, which will be heavier where the mandator is vulnerable, lacks specialized knowledge, is dependent on the mandatary, and where the mandate is important. The corresponding requirements of fair dealing, good faith and diligence on the part of the manager in relation to his client will thus be more stringent.²¹

In the case of Markarian v. CIBC World Markets Inc.²², the Québec Superior Court recognized that many factors can contribute to the high degree of trust and confidence that a client may have in the financial intermediary. The Court also stated that the existence of such a bond of trust involves a correlative reduction, protected by law, in the vigilance expected of the client.

The Markarian case involved a retired Canadian couple of Armenian descent, the Markarians, who had entrusted their assets to a fellow Armenian financial advisor Harry Migirdic, who worked at CIBC World Markets Inc. The Markarians wanted safe, no risk and non-speculative investments, both for themselves and for their company. Over the years, as a result of the fraudulent actions of Migirdic, the couple guaranteed, unbeknownst to them, the trading losses of people they did not know. CIBC World Markets had invoked the guarantees to seize $1.4-million from the Markarians in 2001, leaving almost nothing in their accounts -- even though Migirdic had admitted to CIBC prior to his 2001 termination that the Markarians were the subject of his fraud and that they were totally unaware.

The Markarians had absolute trust in Migirdic because he had been introduced to them by CIBC as an honest and knowledgeable man, because he was Armenian like them and had a "Vice-President" title.

The Court awarded more than $3-million, including $1.5-million in punitive damages, to the Markarians. It also ordered CIBC to reimburse the Markarians' legal fees. The Court called CIBC World Markets' conduct "reprehensible," saying it "cruelly failed" in its duty to protect its clients. The Court held that the defendant CIBC was under a heightened duty to supervise Migirdic because of the latter's past questionable conduct. Further, it noted that civil law mandataries have a duty to act faithfully, honestly and with integrity, and must subordinate their interests to those of their clients.

3. Why Intermediaries Engage in Fraud or Misconduct

Financial intermediaries who engage in fraud or misconduct, are usually motivated by greed or need and act on these motivations when given an opportunity to do so. Because of the nature of the work performed by financial intermediaries and sometimes their clientele, the opportunity and temptation are often present and if the intermediary succumbs, the results are usually unfortunate for the client, the institution and the intermediary. Often the compensation structure established by the financial institution provides an additional impetus for intermediaries to engage in misconduct or fraudulent behaviour.

3.1 Compensation Structure

In Ryder, supra, the stock broker, "churned" the client's account and in doing so was able to earn $124,220 in commissions over an eleven month period. The fact that a broker earns a commission every time a trade is made creates an incentive for the broker to maximise the number of trades on a given account. In addition, some stock brokers receive varying commission rates, depending on the type of securities they trade. This also creates an incentive to alter the character of the account towards those investments which generate higher commission payments. This type of compensation structure can place the interests of the broker and those of his or her client at odds from the outset of the relationship.

To attempt to compensate for this conflict, a stock broker is obligated to disclose the commission and bonus structure in place to clients and to ensure that, in carrying out the instructions of the client, the broker is careful to consider only the best interests of the client.

The compensation package commonly found in the insurance industry can also provide incentives for misconduct by placing the financial interests of the agents potentially in conflict with the interests of the insurance company and the client. Turning to the insurance industry, "rebating" is an illegal practice by which an insurance agent induces a customer to apply for an insurance contract by promising to pay all or a portion of the customer's premiums. As the commissions paid to the agent during the first few years are sometimes greater than the premiums for the same period, the agent can make a profit at the expense of the insurance company. Once the policy has reached the point where the commission payable to the agent is less than the premiums owed by the insured, the agent either cancels the policy or allows it to lapse, depending on the applicable compensation structure. Once again, the insurer employing the insurance agent has established an incentive for the agent to behave improperly through the compensation and commission structure.

Rebating was employed by a Crown Life insurance agent²³ that obtained, for his own benefit, commission payments and bonuses on account of 297 life insurance policies issued to members of the public without payment of consideration or any kind. The agent accomplished this either by reimbursing the person in whose name the policy was issued immediately after paying the premium or by simply paying the premium directly to Crown Life. The commission and bonus structure then in force at Crown Life enabled the agent to pay at least three years worth of premiums out of its compensation and still make a profit. The agent intended to pay the premiums for three years and then allow the policies to lapse.

Another example of a scheme made possible by the commission and bonus structure payable to an insurance agent was the subject of proceedings taken by the province of British Columbia against Don Baxi Agencies lnc.²⁴ An insurance agent employed by North American Life submitted false insurance applications for the purpose of generating commissions. The agent maintained premiums on policies which clients had declined or allowed to lapse, keeping them in force and as a result earning substantial commissions from North American Life to which he was not entitled. The agent was charged with, and pled guilty to, having breached provisions of the Financial Institutions Act.²⁵

The practice of "churning" in the insurance industry, an activity which occurs when an agent induces a policy holder to replace an existing one with one sold by the agent, is also considered misconduct. Churning or "replacement" can be severely disadvantageous to the policy holder and can result in the total loss of insurance coverage, for instance, because of the current health of the insured, imposition of new waiting periods and less favourable terms and returns. Often the insurance agent's motivation is to generate commissions for himself/herself and not the best interest of the client.²⁶ Most jurisdictions have enacted extensive life insurance replacement legislation which prohibits this type of improper activity but nevertheless a number of life insurance companies have experienced agents for whom the temptation of an "easy buck" is too hard to avoid. When a life agent changes insurers, there may be an added incentive to engage in "replacement".

3.2 Vulnerable Clientele

The lack of sophistication and dependency of a financial intermediary's clientele can also present an alluring temptation. New immigrants unfamiliar with the language and financial products are especially vulnerable to unscrupulous financial intermediaries of the same ethnic group. One insurance broker "sold" a number of automobile and home insurance policies to members of his ethnic community and pocketed the premiums without either forwarding the application to any of the insurance companies that he represented nor issuing any policies to the clients. He fielded and dealt with inquiries from the clients who trusted him and relied on his good faith. The scheme came tumbling down when the first major claim arose. Since he represented a number of insurers and issued no policies, no coverage was found and the clients were left out in the cold. The criminal investigation is yet to be concluded.

An insurance salesman was convicted with a strong sentence of four years imprisonment and an order to pay restitution.²⁷ He was charged with 20 charges of fraud, and was found guilty of defrauding vulnerable clients. The court emphasized that the victims trusted and relied on the expertise of the accused. These victims were on the cusp of retirement or already retired, and were convinced to invest their life savings with the insurance salesman. Further, the accused often arranged for the victims to obtain loans to supplement their investments. The decision examines each victim's situation in order "to understand the depth and damage of the ongoing breach of trust."²⁸

3.3 Firm Culture

Another factor which undoubtedly influences whether a financial intermediary is likely to engage in fraud or misconduct is the culture of the firm employing the intermediary. As financial intermediaries often find themselves in situations where opportunities and incentives to engage in misconduct are prevalent, it is imperative that the firm employing them have adequate policies and, equally importantly, an effective and well known procedure for aggressively enforcing internal policies and maintaining a compliance-oriented atmosphere.

If deviations from internal policies, codes of ethics or external standards are felt to be condoned or the perceived "operating norm" and if infractions and misconduct are not expected to be treated with severity in a given institution, there is a greater likelihood that an employee will engage in misconduct or fraud. In a number of situations where financial intermediaries have been fraudulent or dishonest, the transaction could not have been successful if the safeguards and policies in place at the institutions involved had been strictly adhered to and questionable activities reported and dealt with.

Footnotes

1 Frank Palmay – Partner with McMillan LLP, Suite 4400, Brookfield Place 181 Bay Street, Toronto, Ontario M5J 2T3 direct line 416.307.4037, e-mail: frank.palmay@mcmillan.ca.

2 Assunta Di Lorenzo – Partner with McMillan S.E.N.C.R.L., s.r.l., 1000 Sherbrooke Street West Suite 2700 Montréal, Québec Canada H3A 3G4 direct line 514.987.5018; e-mail: assunta.dilorenzo@mcmillan.ca.

3 Black's Law Dictionary quoting from Joiner v. Joiner, Tex.Civ.App., 87 S.W. 2d 903, 914, 915.

4 Innovative Research Group Inc., 2007 CSA Investor Study: Understanding the Social Impact of Investment Fraud, Report prepared by the Canadian Securities Administrators Investor Education Committee, p.4

5 (1990), 60 C.C.C. (3d) 489

6 Derry v. Peek (1899), 14 App. Cas. 337

7 Varcoe v. Sterling (1992), 7 O.R. 204

8 Kent v. May (2001), 298 A.R. 71 at para 51.

9 [1994] 3 S.C.R. 377.

10 Supra note 9 at 30.

11 Hunt v. TD Securities Inc., (2003) 175 O.A.C. 19 at para 40.

12 (1985), 16 D.L.R. (4th) 80

13 Burns et al. v. Kelly Peters & Associates Ltd. et al. (1987), 41 D.L.R. (4th) 577

14 (2003) 175 O.A.C. 19, 36 B.L.R. (3d) 165.

15 Campbell v. Sherman, 2 C.C.L.S. 156.

16 [1992] 2 W.W.R. 630

17 Ibid., at p. 637

18 S. 1458 of the CCQ. For example, a contract of services (s.2100 of the CCQ), application of the rules of mandate (s. 2130 of the CCQ) or application of the rules of administration of the property of others (s. 1299 of the CCQ)

19 S. 1457 of the CCQ (injury to others) or s.1463 of the CCQ (faults of agents and servants).

20 (2000) 1 S.C.R. 638

21 Ibid., para 28

22 (2006) QCCS 3314

23 Crown Life Insurance Co. v. American Home Assurance (1991), 77 D.L.R. (4th) 11

24 Provincial Court of British Columbia, Oct. 7, 1996

25 R.S.B.C. 1996, c. 141.

26 Norwood on Life Insurance Law in Canada, p.45

27 R. v. Wheeler, (2007) 215 Man. R. (2d) 127.

28 Supra note 27 at para 10.

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The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.

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