Canada: Coverage For Social Engineering Fraud Takes Its Place Among The Required Coverage For Canadian Business

Last Updated: January 20 2017
Article by David S. Wilson, Christopher McKibbin and Zack Garcia

Insurance for loss resulting from the use of technology to com­mit fraud has existed for decades. Since the 1980s, commercial crime poli­cies have included vari­ous forms of computer fraud and funds transfer fraud coverage. Similar coverage has been avail­able in financial insti­tution bonds since the 1990s.

New forms of fraud have emerged in recent years that do not fit neat­ly into the existing cover­ages. Social engineering fraud is the most signifi­cant of these new frauds, and occurs when an em­ployee of a business is duped by a fraudster into voluntarily part­ing with the assets of the business. Some examples include:

  • Phony Client Scams: The victims or targets of these scams are financial in­stitutions or other entities that handle client funds. The target's employee is induced by email, phone or fax to wire client funds to a "new" account. Verifi­cation procedures are either absent or not followed, and the funds are typi­cally unrecoverable. The target must reimburse its client for the lost funds, and then looks to its crime insurer for indemnity.
  • Vendor Impersonation Scams: The fraudster purports to be a legitimate vendor of the target, and contacts the target's employee to request that the vendor's banking information be changed. The victim wires funds to the "new" account. By the time the le­gitimate vendor follows up with the vic­tim on its outstanding receivables, the funds are gone.
  • Executive Impersonation Scams: The fraudster, posing as the target's "CEO" or other high-ranking executive, con­tacts its finance department using a spoof email or similar-domain email, under the pretext of needing an emer­gency payment relating to a "top secret" acquisition, merger or other situation. The fraudster directs the finance de­partment employee to wire funds to a "special" account. The lost funds are typically unrecoverable, and the victim turns to its crime insurer for indemnity.
  • Law Firm Collection Scams: The fraudster poses as a foreign "client" in a debt collection matter. The "debtor" is in collusion with the "client". As soon as the lawyer demands payment, the "debtor" promptly issues a (counterfeit) cheque payable to the lawyer's trust ac­count. The lawyer is instructed to wire the funds (less his or her fee) to the "cli­ent"—invariably, on an urgent basis. Once the debtor's cheque is returned as counterfeit, the lawyer's trust account is in deficit. Given the limited scope of trust account overdraft coverage under most lawyers' E&O policies, the lawyer often looks to his or her crime insurer for indemnity.

Standard crime insurance policies are not intended to cover social engineering fraud:

  • Computer Fraud insuring agreements typically only indemnify for unau­thorized entries (or "hacks") into an insured's computer system. Social engi­neering incidents typically involve pay­ments initiated by the insured's employ­ee, albeit on the basis of an inaccurate understanding of the facts.
  • Funds Transfer Fraud insuring agree­ments are intended to cover fraudulent transfers caused by a third party direct­ing an insured's financial institution to transfer the insured's funds without the insured's knowledge or consent. Social engineering incidents typically involve payment instructions authorized and voluntarily initiated by the insured's employee and, as such, they usually do not meet the requirements of the insur­ing agreement.
  • Crime policies generally contain exclu­sions for losses resulting from an in­sured's voluntarily parting with money, or for losses resulting from authorized entries into an insured's computer sys­tem.

In response, the first discrete social engineering fraud coverages were intro­duced in Canada in 2014. Unfortunately, some victims of social engineering fraud have not obtained this coverage and, after incurring a loss, seek indemnity under the computer fraud or funds transfer fraud in­suring agreements of their policies.

The October 18, 2016 decision of the U.S. Court of Appeals for the Fifth Cir­cuit, Apache Corporation v. Great Ameri­can Insurance Company,1 is one of the first American appellate decisions to consider coverage for a vendor impersonation scam under "traditional" commercial crime policy wording since the widespread in­troduction of social engineering fraud coverage. In holding that the resulting loss did not trigger indemnity under the computer fraud coverage, the Fifth Circuit adopted the interpretive approach to com­puter fraud coverage taken by most other American courts, such as the Ninth Circuit in Pestmaster Services v. Travelers,2 and ap­plied it in the context of social engineering fraud.

Apache is an oil production company headquartered in Texas and operates in­ternationally. In March 2013, an Apache employee in Scotland received a call from a person claiming to be a representative of Petrofac, a legitimate vendor of Apache. The caller instructed the employ­ee to change the bank account information which Apache had on record for Petrofac. The Apache employee advised that such a change request would not be processed without a formal request on Petrofac let­terhead.

A week later, Apache's accounts pay­able department received an email from a @petrofacltd.com email address. Petrofac's legitimate email domain name is @petro­fac.com. The email advised that Petrofac's bank account details had changed, and in­cluded as an attachment a signed letter on Petrofac letterhead setting out the old and new account numbers and requesting that Apache "use the new account with immedi­ate effect."

An Apache employee called the tele­phone number on the letterhead and con­firmed the authenticity of the change re­quest. A different Apache employee then approved and implemented the change. One week later, Apache began transferring funds for payment of Petrofac's invoices to the new bank account. Within a month, Petrofac advised Apache that it had not received payment of approximately $7 million which Apache had transferred to the new account. Apache recovered some of the funds, but still incurred a net loss of approximately $2.4 million.

Apache maintained a Crime Protection Policy with Great American. The policy does not appear to have included social en­gineering fraud coverage. Apache asserted a claim under its Computer Fraud cover­age, which provided that:

We will pay for loss of, and loss from damage to, money, securities and other property resulting directly from the use of any computer to fraudulently cause a transfer of that property from inside the premises or banking premises:

  1. to a person (other than a messen-ger) outside those premises; or
  2. to a place outside those premises.

In Great American's view, this cover­age applies when an individual improp­erly accesses, or "hacks", into the insured's computer system and fraudulently causes a transfer of funds, either from the in­sured's premises or the insured's bank's premises. Thus, no indemnity was avail­able to Apache because the @petrofacltd. com email did not cause the transfers in issue; the loss was not the direct result of unauthorized computer use, but rather the subsequent acts of Apache's employees.

The Fifth Circuit accepted Great Amer­ican's position. The Court engaged in what it described as a "detailed—but numbing —analysis" of the authorities interpret­ing the Computer Fraud coverage. Chief among these was the Ninth Circuit's recent decision in Pestmaster, in which that Court interpreted the computer fraud coverage to require an unauthorized transfer of funds, rather than simply any transfer which in­volved both a computer and a fraud at some point.

The Court observed that prior courts had generally refused to extend the scope of the computer fraud coverage to situa­tions where the fraudulent transfer is not a direct result of computer use, but rather a result from other events. In concluding that no indemnity was available under the computer fraud coverage, the Court held that:

The email was part of the scheme; but, the email was merely incidental to the occurrence of the authorized transfer of money. To interpret the comput­er-fraud provision as reaching any fraudulent scheme in which an email communication was part of the pro­cess would, as stated in Pestmaster..., convert the computer-fraud provision to one for general fraud...We take ju­dicial notice that, when the policy was issued in 2012, electronic communica­tions were, as they are now, ubiquitous, and even the line between "computer" and "telephone" was already blurred. In short, few—if any—fraudulent schemes would not involve some form of com­puter-facilitated communication. [em­phasis added]

Apache is significant to the insurance industry not only because, like Pestmas­ter, it reaffirms the intended scope of the computer fraud coverage, but also because it reinforces the purpose behind insurers' recent introduction of discrete social engi­neering fraud coverage.

In our view, a Canadian court should reach the same conclusion if it were to con­sider similar facts. As the Court of Appeal for Ontario has held, where there is little or no Canadian authority interpreting lan­guage used in standard-form policies in both Canada and the United States, resort may be had to American authorities to en­sure uniformity in construction in both countries.3

The proliferation of social engineer­ing frauds has created a new exposure for Canadian business. While insurers have responded by creating discrete social engi­neering fraud coverages, Apache serves as a cautionary tale of how a business may be exposed to an uninsured loss in the event that it does not maintain such coverage.

Footnotes

1 Apache Corporation v. Great American Insurance Company, 2016 WL 6090901 (5th Cir.).

2 Pestmaster Services, Inc. v. Travelers Ca­sualty and Surety Company of America, 2016 WL 4056068 (9th Cir.).

3 Halifax Insurance Co. of Canada v. Innopex Ltd. (2004), 72 O.R. (3d) 522 (C.A.) at para. 56, citing Zurich Insur­ance v. 686234 Ontario Ltd. (2002), 62 O.R. (3d) 447 (C.A.) at 461.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
David S. Wilson
Christopher McKibbin
 
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