What the recent history of securities litigation tells us about the future of the capital markets
The past twenty years of securities litigation shed light on what businesses involved in Canada’s capital markets can expect in the future.
Whether the cases involve issuers of securities or dealers and advisers in securities, experience demonstrates that trends in securities litigation are driven by the state of the economy, investment product innovation and related regulatory initiatives.
These key drivers tell us that, in looking to 2021 and beyond, Canadian securities market participants can expect to be subject to claims influenced by the COVID-19 related market turmoil and securities regulators’ ongoing focus on enhanced disclosure and registrant conduct standards. Businesses that view current market conditions through the lens of past litigation and regulatory trends will be better equipped to calibrate their business practices accordingly—as well as respond to the next wave of securities litigation.
Securities litigation then: the dot-com bubble and other cautionary tales
The mid-2000s marked a period of growth in investment loss claims against securities dealers and advisors, and against securities issuers. With the benefit of hindsight, it is evident that the economy and regulatory change both played a key role in this growth.
The early 2000s marked the end of a sustained bull market that had lasted through much of the late 1990s. This time period was defined in part by the bursting of the dot-com bubble, the Bre-X mining stock fraud, and the flattening of equity markets as investors sustained losses associated with these events. Retail investors were introduced to hedge funds that were manufactured in response to market stagnation and investor skittishness. However, some of these hedge funds were marred by high-profile failures resulting in significant losses for investors1.
Court and regulatory response
In reaction to this chain of events, securities regulators took steps to enhance market participant standards. In the late 1990’s, the Allen Committee Report had recommended statutory civil liability for breaches of continuous disclosure allegations and by 2005, regulators across the country had implemented a new framework for this liability. As well, around the turn of the century the TSX/OSC Mining Standards Task Force issued new increased standards (including governance and disclosure) for mining companies. In 2003, IIROC issued enhanced standards for securities analysts and the research reports they issued. All of these regulatory changes were aimed at addressing market misconduct by creating more stringent standards for securities issuers and dealers.
Throughout this period, securities dealers and advisers, as well as issuers and fund manufacturers, saw a spike in investment loss claims. These claims were focused on suitability—claims that investors had been advised to buy securities that were incompatible with their financial circumstances and investment objectives—in a broad range of stocks. The impetus for these claims was both the investment losses and the regulatory changes, which put a spotlight on the conduct of market participants who may have caused or contributed to those losses.
Securities litigation now and into the future: the long shadow of the Great Recession
Through the 2010s to present day, the state of the economy and regulatory priorities both continued to be key drivers of securities litigation. Although investors enjoyed market recovery in the early 2000s, the capital markets were again rocked, this time by the Great Recession of 2007-2009, caused in part by the sub-prime mortgage market collapse in the U.S. One related ill effect in Canada was the gutting of the asset-backed commercial paper market. The market response to the Great Recession has included increased investment product innovation, designed to deliver income to an increasingly significant number of retirees in a sustained low-interest environment.
Court and regulatory response
Significant investor loss eventually brought with it litigation and regulatory enforcement actions, focusing on claims of improper disclosure by issuers, including related to subprime housing exposure2. Faced with a new wave of investor complaints and claims, courts and regulators have taken steps to further enhance market participant standards and make it easier for investors to seek redress.
Whereas in the early days of class actions in Canada, courts tended not to certify proposed investor loss class actions because of the many individual issues that each investor would have to prove in order to succeed, there has been a discernable move toward courts no longer seeing those individual issues as an impediment to certification, in order to grant retail investors with access to a cost-effective way to pursue claims. Though there has been some backlash to this trend (see changes to the Ontario Class Proceedings Act3), it seems to have taken hold in most provinces.
The market turmoil caused by the COVID-19 pandemic is likely to accentuate the pressure on some market participants to account for investor losses.
The enhanced regulatory standards of the 2000s and the response by securities dealers to adopt enhanced technology to assist with assessing suitability and risk-rating securities has helped to reduce the volume of suitability claims for “standard” or well-known asset classes. At the same time, regulators have turned their sights to addressing new areas of the investor-client relationship. For example, there are new regulations focused on the requirement to resolve conflicts in the best interests of investors and on reducing or eliminating certain kinds of compensation paid by investors4.
As in the 2000s, these market factors, investment product innovations and regulatory changes have caused and will likely continue to cause new investor loss litigation5 and related regulatory enforcement action6. The market turmoil caused by the COVID-19 pandemic is likely to accentuate the pressure on at least some market participants to account for investor losses.
What lies ahead for capital markets participants
History has taught us that market turmoil and related investment loss leads to evolution in the approaches of courts and regulators to market participant standards and responsibility for losses. The trend of more stringent standards being imposed by the courts and regulators is clear and likely to continue.
Securities issuers should think carefully about public disclosure of the impacts of the pandemic as we expect the risk of class action litigation has heightened7. Dealers and advisers should reflect on advice for retail investors grappling with financial hardship and market volatility, as both IIROC and the OSC have identified investor protection and the impact of the pandemic as areas of current focus8.
Market participants need to be nimble in adopting to evolving standards. Doing so will help them to defend the litigation and regulatory action which inevitably follows market turmoil.
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1 See for example the regulatory proceedings relating to the collapse of Norshield-related retail hedge funds in which investors lost close to $159 million. Re: Norshield Asset Management, (2010) 33 O.S.C.B. 2139
2 There is always a time lag between the occurrence of significant market events and litigation that is based on investment losses associated with those events.
3 Bill 161, the Smarter and Stronger Justice Act, 2020 makes significant changes to the preferable procedure test under the Class Proceedings Act. Further details about the changes to the Class Proceedings Act can be found here.
4 See for example the Canadian Securities Administrators’ “Client Focused Reforms” to National Instrument 31-103 and other CSA changes which will prohibit the payment of upfront sales commissions to dealers.
5 For example, numerous class actions have been commenced against mutual fund manufacturers in relation to the payment of trailing commissions by investors (e.g. Stenzler v. TD Asset Management, 2020 ONSC 111). The Ontario Court of Appeal also recently overturned the refusal to certify a class action in relation to the collapse of a derivatives-based exchange-traded fund (Wright v. Horizons ETFS Management (Canada) Inc., 2020 ONCA 337)
6 Regulators are increasingly pursuing advisors who recommend unsuitable investments to investors (see, for example, Re Locke, 2020 IIROC 14) and focusing on conflicts of interest (see, for example, for Re: O’Brien, 2020 ABASC 160)
7 More detailed insight and analysis on key disclosure obligations for public companies in light of the COVID-19 pandemic can be found here.
8 The OSC’s study on COVID-19 and the Investor Experience can be found here. The CSA and IIROC’s joint statement on COVID-19’s impact on Canadian equity markets can be found here.
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