In Wright v. Horizons ETFs Management (Canada) Inc. (Horizons), the Ontario Court of Appeal concluded, in the context of a class action certification motion, that investment fund managers may owe a new common law duty of care to investors with respect to the creation, marketing and/or management of an exchange traded investment fund (ETF) (ETFs are securities that are comprised of a basket of securities. Unlike a mutual fund whose units are not traded on an exchange, ETFs trade on exchanges and their prices can fluctuate throughout the trading day.). Further, the Court determined, for the first time in Canadian law, that claims for misrepresentations arising out of the sale of ETFs may be brought under section 130 of the Ontario Securities Act (OSA) (which relates to primary, rather than secondary market misrepresentations).
Horizons ETFs Management Inc. (Horizons) offered what the court described as a highly complex derivative ETF designed to provide inverse exposure to stock market volatility (the Fund). Like many ETFs, the Fund was passively managed.
The Fund’s prospectus, for which the Ontario Securities Commission (OSC) had issued a receipt, included a warning that the units in the Fund were “highly speculative” and “involve a high degree of risk.”
ETFs are unlike other investment funds in the way they are distributed, and the manner of distribution was a key fact in this case. All ETF fund units are acquired by investment dealers from the fund, and sold on to investors through the stock exchanges, at prices dictated by the net asset value of the fund and its market price. When investors purchase units of an ETF, they are either buying newly created fund units—Creation Units—that were distributed pursuant to a prospectus, or units that are in the dealer’s inventory—Inventory Units—but have already been in circulation and trading on an exchange. Investors have no way of knowing whether they have received Creation Units or Inventory Units and thus, whether they have purchased units issued under a prospectus, or units which have been freely traded in the marketplace. The distinction bears on whether investors who sue for damages have a cause of action for prospectus misrepresentation (under section 130 of the OSA) or for misrepresentations in the secondary market (the cause of action under Part XXIII.1 of the OSA).
The events of February 5, 2018
On February 5, 2018 the stock markets experienced significant volatility, which resulted in the Fund sustaining a loss of more than 80% of its value in one day. As a result, investors saw a drastic loss of value in their investments in the Fund.
On April 10, 2018, Horizons announced it was terminating the Fund, on the basis that it no longer offered an acceptable risk/reward trade-off for investors.
Lower Court decision
Graham Wright commenced a proposed class proceeding against Horizons on behalf of investors in the Fund. He brought a motion to certify two causes of action against Horizons: common law negligence and prospectus misrepresentation under section 130 of the OSA. The motion judge assessed whether these causes of action were tenable. He refused certification on the basis that it was plain and obvious that neither claims disclosed a reasonable cause of action.
Wright pleaded that Horizons was negligent in the development, promotion and management of the Fund. The motion judge declined to recognize a novel duty of care in these circumstances. He held that the plaintiff’s claims were not within the scope of Horizons’ undertaking as an ETF provider to operate an ETF product as described in the accompanying disclosure document. Horizon had operated its Fund in accordance with the prospectus. As a result, Horizons could not be held responsible for investors' losses.
The motion judge held that there were policy reasons against extending a duty of care for pure economic loss in these circumstances. For example, this novel duty of care might:
- deter useful economic activity where the parties are best left to allocate risks through the autonomy of contract, insurance, and due diligence;
- encourage a multiplicity of inappropriate lawsuits;
- arguably disturb the balance between statutory and common law securities actions envisioned by the legislator; and
- introduce the courts to a significant regulatory function when existing causes of action, the regulators, and the marketplace already provide remedies.
The judge also found it plain and obvious that Wright had no cause of action for prospectus misrepresentation under section 130 of the OSA. He reasoned that because investors could only purchase ETFs from investment dealers and not from Horizons directly, they would not know if they were purchasing Creation Units (primary market) or Inventory Units (secondary market) such that there was no claim under section 130 of the OSA. As a result of his conclusion that it was plain and obvious that neither the negligence claim nor the section 130 claim could succeed, the motion judge dismissed the action.
Court of Appeal decision
The Court of Appeal overturned the decision of the motion judge and ordered that the case be remanded back to him for a determination of whether the remaining elements of the test for certification could be met.
The Court of Appeal found that Horizons could owe investors a duty of care with respect to the design of the Fund, despite it being structured and sold as a passive index-tracking investment product. It was possible that the plaintiff had a claim of “negligent performance of a service”. Additionally, the Court of Appeal concluded that it may be appropriate to recognize a novel duty of care for investment fund managers. The Court of Appeal held that Horizons’ undertaking to investors could also include a dimension of suitability. On this basis, the Court of Appeal would not foreclose that Horizons could owe a duty of care as alleged by the plaintiff.
The Court of Appeal also found that an ETF investor could bring a claim under section 130 of the OSA if the investor had purchased Creation Units. The fact that an investor was unable to tell at the time of purchase whether they were purchasing a Creation Unit or an Inventory Unit should not, according to the Court of Appeal, disentitle purchasers of Creation Units from bringing a claim under section 130 of the OSA.
Implications of the decision
This decision may have significant legal implications for the certification of class actions claiming investment fund losses.
- A potentially lower bar for class action plaintiffs. The Court of Appeal has indicated that it is willing to be more permissive than some class action motion judges regarding the application of 5(1)(a) of the Class Proceedings Act, 1992, thereby allowing claims to pass the certification test and proceed to testing the merits on a full evidentiary record. In this case, that willingness is demonstrated in the court interpreting and applying established and long-standing statutory (section 130 of the OSA) and common law (negligence) causes of action in a generous way so as to permit the plaintiff to “have his day in court”.
- An injection of the “suitability” standard into common law obligations of ETFs. The Ontario Court of Appeal concluded that it was possible that a passively managed fund could owe a duty to ensure that its product is suitable for investors. It remains to be determined whether this duty is in fact owed, and how courts will expect funds to make such suitability determinations, as the managers of ETFs do not have a direct relationship with investors.
- The possibility of new obligations for passively managed funds. It is unclear whether passively-managed funds may have an obligation to engage in active management in certain circumstances. Whether such an obligation exists, and the circumstances in which courts will expect a passively-management fund to engage in active management, are yet to be determined.
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