Timing is everything: mutual fund managers had duty to prevent market timing behaviour

The Ontario Superior Court recently released its decision in Fischer v. IG Investment¹, a relatively rare class action common issues trial decision. The case was against two mutual fund managers in connection with market timing trading. The decision addresses principles of negligence and fiduciary obligations on a class-wide basis, ultimately concluding that the defendants had a duty to take reasonable steps to prevent market timing trade activity in their funds.

What you need to know

• “Market timing” in the context of mutual funds refers to a trading strategy whereby an investor moves money into and out of a mutual fund quickly, attempting to use inefficiencies in the market (such as a delay in market pricing) to generate profit. The Court’s decision found that this type of frequent, short-term trading can harm long-term investors in the fund by diluting the value of their investment.
• The plaintiffs brought a class action on behalf of unitholders who invested in mutual funds managed by the defendants, alleging that they negligently failed to prevent frequent, short-term trading in their funds, thereby diluting class members’ investments. The plaintiffs also alleged the defendants breached fiduciary duties to the class.
• The Court held that the defendants were negligent. They had a duty to take reasonable steps to prevent frequent, short-term trading but failed to do so. However, this negligence did not rise to a breach of the defendants’ fiduciary obligations.
• Subject to any appeal or settlement, the class action will proceed to a trial to determine the amount of damages.

Background: what is “market timing”?

Broadly speaking, “market timing” refers to trading behaviour that is based on anticipated changes in market price over a period of time. While this, in and of itself, is not unlawful, employing trading strategies that are intended to make money off technology or other trading inefficiencies or lapses, as opposed to trading based on fundamentals, can be problematic. In the context of this case, market timing describes arbitrage consisting of frequent, short-term trading, whereby investors move money into and out of a mutual fund quickly to take advantage of market inefficiencies.

The specific type of short-term trading at issue in Fischer was time zone arbitrage. Where mutual funds comprise securities concentrated in a particular market (e.g., Asia), a trader can leverage time zone differences and movements in other markets to profit from a short-term investment with relatively little risk. This is because mutual fund units are generally only priced once per trading day, so that price may lag behind the actual market value of the securities in the fund. A trader using time zone arbitrage seeks to benefit from this stale pricing.

For example, units of a Canadian mutual fund are priced at the end of each trading day in Toronto, but the fund may be heavily invested in the Japanese market. Tokyo is 11 hours ahead of Toronto. If North American markets rally on Monday, the same could be expected to happen in Tokyo on Tuesday, but this would not yet be reflected in the price of the Canadian mutual fund (since Tuesday trading in Tokyo does not begin until after Monday trading closes in Toronto). A market timer can therefore buy a unit of the Canadian mutual fund on Monday at what is effectively a stale-priced discount, wait for the Tokyo market to rally overnight, and then redeem the unit on Tuesday in Toronto.

The trial judge found that this kind of arbitrage can harm long-term unitholders in the fund by diluting the value of their units. Because the market timer puts money in on Monday and withdraws it on Tuesday, there is no time for the mutual fund manager to invest that capital in any securities. The market timer receives a windfall without contributing any value to the fund.

In 2003, the Ontario Securities Commission (OSC) began an investigation into market timing behaviour in Canadian mutual funds—to date the largest investigation in the OSC’s history. This led to five fund managers, including the defendants, paying settlements to the OSC. The class action was then commenced against all five of those fund managers, but the defendants were the only ones that did not settle with the plaintiffs. The trial of the common issues required the Court to determine whether the defendants breached either a duty of care or fiduciary duty to prevent market timing activities in their mutual funds between 1998 and 2003.

The defendants

The bulk of the Court’s analysis focused on whether the defendants were negligent. The defendants conceded that they owed a duty of care to the unitholders of their funds as a whole, so the real question was whether this duty required the defendants to take reasonable steps to prevent frequent, short-term trading activity. The Court concluded that it did, relying both on general knowledge within the mutual fund industry and the defendants’ public disclosure during the class period regarding the potential risks of short-term trading.

The Court observed that the U.S. Securities and Exchange Commission (SEC) had changed rules governing mutual funds as early as 1968 to address stale pricing, short-term trading and dilution. Press articles published around the beginning of the class period discussed time zone arbitrage and what certain mutual funds were doing to discourage it. Mutual fund prospectuses from the same time period explained the potential risks of frequent, short-term trading. And the OSC investigation noted that other mutual fund managers had taken steps to discourage this behaviour, including by charging short-term trading fees. The Court held that this evidence indicated mutual fund managers ought to have been aware of the potential risks stemming from this type of trading behaviour.

The Court found that the defendants fell below the standard of care by not taking reasonable steps to prevent frequent, short-term trading. Among other things, they did not adequately monitor for this type of activity and did not charge higher short-term trading fees that would have stopped it. Instead, the defendants allowed short-term trading by entering into “switch agreements” with certain of their investors, permitting these investors to switch in and out of the defendants’ funds on a short-term basis for a reduced fee.

While the defendants raised several defences, the Court’s conclusions on the following points are noteworthy:

• Foreseeability of a general class of harm, rather than specific harm, is sufficient. The defendants argued that time zone arbitrage was not a sufficiently well-known practice during the class period to justify imposing obligations on mutual fund managers to prevent it. The Court rejected this, concluding it was enough that the defendants knew or ought to have known of the potential risks that could result from frequent, short-term trading in general. Time zone arbitrage was simply one particular strategy that short-term traders used. The defendants had a duty to reasonably prevent all frequent, short-term trading.
• Randomness of markets is no defence but is potentially relevant to damages. The defendants argued that harm to long-term unitholders was not foreseeable because they believed markets were a “random walk” and could not be accurately timed. The Court dismissed this, concluding that, had the defendants more closely monitored the short-term trading in their funds, they would have seen it was a profitable exercise. However, the Court left it open to the defendants to argue at the damages trial that the harm to unitholders from short-term trading when the market rose was cancelled out by the benefit to unitholders when the market declined. Thus, it remains open to the defendants to argue that, liability notwithstanding, the class has suffered no or limited damages.
• The standard of care evolves with time. The Court acknowledged the importance of not viewing historical events (in this case, covering 1998 through 2003) with the benefit of hindsight. The standard of care that the defendants were held to evolved over the years, and it was important to ensure liability was imposed based on the standard as it existed at the appropriate time. Despite this holding, the Court ruled that there was sufficient evidence to conclude mutual fund managers were alert to the dangers of frequent short-term trading, and took steps to prevent it, throughout the class period.
• The Court may take a narrow approach to the application of the business judgment rule. The defendants relied on the business judgment rule as a defence to the claim against them. The Court relied on an earlier decision involving the interaction between the Securities Act and the business judgment rule in holding that the business judgment rule did not assist the defendants in a claim involving a failure to meet a statutory duty of care to investors.

No breach of fiduciary duties

The defendants agreed they had a fiduciary obligation to act in the best interests of their mutual funds as a whole. A fiduciary owes duties of utmost good faith and loyalty to its beneficiaries. This includes a duty to fully disclose any conflicts of interest. The plaintiffs alleged that short-term trading within the defendants’ funds created such a conflict, arguing that the defendants preferred the higher fees that came with such trading over the interests of unitholders and failed to disclose this.

The Court held that the defendants did not breach their fiduciary duties. A fiduciary that fails to meet the standard of care does not automatically breach fiduciary duties simply because they are a fiduciary. There is no fiduciary duty to “never make a mistake”. The Court’s focus must be on the fiduciary’s subjective motivation. Here, while the defendants were held to be negligent, they honestly believed that randomness in the market would cancel out any harm to unitholders.

What’s next?

The Court’s decision on liability concludes that the defendants had a duty to reasonably prevent frequent, short-term trading that could harm the long-term unitholders of their funds, while at the same time confirming the high threshold that must be met to show a breach of fiduciary duty. The applicability of this decision to other market participants remains to be seen, though the Supreme Court of Canada has warned against unduly expanding liability in negligence when dealing with pure economic loss.

Subject to any appeal or settlement, the class action will proceed to a trial to assess the quantum of damages to the class.