Certification partially granted in ETF class action, but uncertainty remains over availability of statutory claims

The recent case of Wright v. Horizons ETFs Management Canada Inc.¹ is the third chapter in a series of decisions relating to whether a class action can be brought against Horizons (a manager of exchange-traded fund products) for negligence and misrepresentation under the Securities Act. The class action was initially denied certification, but this holding was overturned by the Ontario Court for Appeal and remitted back to the Superior Court. This time, the Ontario Superior Court of Justice certified a class action based on a claim of negligence against the fund manager. However, the Court refused to certify a statutory claim under the Securities Act in a decision highlighting a limit to the scope of the statutory scheme relating to continuous disclosure misrepresentation schemes and challenges present in pursuing claims related to exchange-traded funds (ETFs). Based on the operation of the market for ETF funds, investors may find themselves without any statutory remedy where the fund manager has made otherwise actionable misrepresentations about the fund and its units.

What you need to know

• The class action relates to the collapse of an ETF, the units of which lost over 80% of their value in one day.
• This decision was the plaintiff’s second attempt at having this class action certified. In the first instance, certification was denied by the Superior Court, which concluded that the proposed claim did not disclose a reasonable cause of action. The motion judge’s decision was reversed by the Ontario Court of Appeal which remitted the decision back to the motion judge to determine whether the other certification criteria had been met. Our bulletin on the Ontario Court of Appeal’s decision can be found here.
• On reconsideration, the certification judge determined that the plaintiff’s claim for pure economic loss in negligence, while novel, satisfied the criteria for certification. The certification judge concluded that it was not plain and obvious that the plaintiff’s claim that the fund manager had negligently performed a service when structuring the fund could not succeed. This decision was based, in part, on the Court of Appeal’s decision.
• The certification judge declined to certify a claim undersection 130 of the Securities Act because it was impossible to determine whether the securities at issue, the units of the ETF, were sold on the primary or secondary market. Therefore, there was no identifiable class for the statutory cause of action.
• The decision raises interesting questions about the availability of statutory causes of action in relation to claims against ETF fund managers which may pose significant challenges for future securities class actions related to ETFs.

Background facts

Horizons ETFs Management (Canada) Inc. (Horizons) offered an ETF which was designed to offer inverse exposure to stock market volatility (the Fund). The fund held a basket of securities in an investment portfolio which are held in trust for the unitholders of the Fund. Horizons distributed units of the Fund through a designated broker or a dealer. When an investor purchased a unit of the Fund the unit would be delivered from two possible sources: 1) the dealer could sell a previously-issued unit held in the dealer’s inventory of units acquired in the secondary market; or 2) the broker or dealer could subscribe to Horizons for a brand-new unit known as a “Creation Unit” which the dealer would sell to the investor.

Canadian securities regulators generally take the position that the first sale of Creation Units is considered sales on the primary market and would normally be subject to prospectus requirements². However, Creation Units are generally comingled with other ETF units purchased by the broker or dealer in the secondary market. Therefore, it is not practicable to determine whether a particular sale of units to an investor involves units purchased by the dealer on the secondary market, Creation Units, or both. This is because ETF units are not individually identifiable and no one who purchases ETF units over an exchange can determine if they are receiving a Creation Unit or a unit that has been previously in circulation and they are priced the same way.

History of the class action

The class action was commenced in May 2018. The Plaintiff sought, among other things, $38 million in damages due to the capital losses suffered when the Fund collapsed. The plaintiff’s alleged both common law negligence, and a breach of section 130 of the Securities Act which provides a statutory cause of action for prospectus misrepresentation related to the sale of securities on the primary market.

The certification judge initially denied certification on the basis that the statement of claim did not disclose a reasonable cause of action³. The Ontario Court of Appeal reversed this decision and remitted the certification motion back to the certification judge for consideration of the other certification criteria⁴.

The claim in negligence

On the basis of the Court of Appeal’s decision that the plaintiff could have a claim in negligence which would give rise to a novel duty of care the certification judge concluded that the plaintiff had satisfied the cause of action criterion for his negligence claim. However, the certification judge clarified that it may be determined after a trial that no duty of care existed or that the other elements of a negligence claim had not been made out. The negligence claim is based on the allegation that Horizons owed investors a duty of care with respect to the design of the fund despite it being structured and sold as a passive investment product. On the basis of that duty of care, it was possible that the plaintiff had a claim for the negligent performance of a service.

The certification judge also concluded that the other criteria to certify a class action were satisfied with respect to the negligence claim: there was an identifiable class, there were common issues, that a class action was the preferable procedure and that there was a suitable representative plaintiff.

Despite certifying the negligence claim, the certification judge noted the limitations of a class action. The certification judge expressly ruled that this was not an appropriate action for aggregated damages and that even if the plaintiff was ultimately successful in the class action the potential existed that over a thousand individual issues trials would still be needed to determine if an individual class member actually suffered any financial losses from their investments in the Fund. That said, the certification judge concluded that the common issues trial would still substantially advance the claims of the class members and as a result satisfied the preferable procedure requirement.

The statutory claim under the Securities Act

When the Court of Appeal reversed the certification judge’s initial decision that the plaintiff had not disclosed a reasonable cause of action with respect to his claim under section 130 of the Securities Act, it granted him leave to amend the pleading to specify that he was a holder of a Creation Unit. The plaintiff amended the statement accordingly. The certification judge determined that the statement of claim, as amended, disclosed a reasonable cause of action in respect of the section 130 claim.

Despite determining that the claim under section 130 had satisfied the first criterion of the certification analysis, the motion judge concluded that the claim still could not be certified because there was no identifiable class. That is because, importantly and fatally, it is impossible for a purchaser of a Fund unit to prove whether they are receiving a Creation Unit or one acquired by the dealer in the secondary market and sold to the investor. Therefore, it was not possible for a potential class member to determine whether they had a claim under section 130 of the Securities Act. The alternative would be a claim relating to the Fund’s continuous disclosure, but an investor would also find it impossible to prove its units were secondary market units. As noted below, this exposes a lacuna and a limit in the statutory regimes for protecting investors from disclosure misrepresentations.

Key takeaways

• This decision highlights the challenges posed by litigation related to certain securities products—significant in light of the popularity of investments similar to the Fund units.
• In a post-script at the end of the decision, the certification judge commented that the Court of Appeal’s decision which acknowledged that ETFs are governed by both Parts XXIII and XXIII.1 of the Securities Act. This has created an obstacle which could prevent class actions regarding ETFs from proceeding with claims under Securities Act. Since unit purchasers cannot determine whether they are purchasing Creation Units (which would be governed by Part XXIII) or secondary-market non-Creation Units (which would be governed by Part XXIII.1), the purchasers would be unable to determine under which Part to pursue their claim and therefore cannot be a part of an identifiable class under either regime.
• Based on this decision, prospective plaintiffs will face challenges in bringing statutory misrepresentation class actions against ETF fund managers and creators. However, the Court’s post-script in the decision could act as an invitation for further judicial or regulatory intervention in the issue.

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¹2021 ONSC 3120.

²See s. 53 of the Securities Act. Note that under Part 3C of NI 41-101 ETFs are exempted from prospectus disclosure and dealers must instead deliver an ETF facts document to purchasers.

³ 2019 ONSC 3827.

⁴ 2020 ONCA 337.

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