Beware Of A Potential New Duty Of Care For Investment Fund Managers – Six Takeaways From Wright V. Horizons – Finance and Banking – Canada – Mondaq News Alerts

A recent decision of the Ontario Court of Appeal (COA), Wright v. Horizons ETFS Management (Canada)
Inc. (Horizons), has been the subject of much
discussion in the investment funds and asset management
industry.  The COA decision opens the door to potentially
establishing a novel common law duty of care for investment fund
managers. It also held that investors in exchange-traded funds
(ETFs) can launch claims of misrepresentations in a prospectus
using the “primary market” civil liability regime under
Section 130 of the Securities Act (Ontario)
(Securities Act).  This is noteworthy because
investors typically do not know whether or not they purchase units
of ETFs in the primary or secondary market when they make purchases
over a stock exchange.

The matters considered in Horizons raise many
complicated issues for debate.  This bulletin highlights key
facts of the proceedings thus far and outlines six takeaways for
the industry to consider as we wait for further developments.
  

A BRIEF OVERVIEW OF THE CASE

The Horizons Fund

Horizons involved a highly complex ETF (the Horizons
Fund), designed to provide inverse exposure to stock market
volatility (as represented by the daily performance of the S&P
500® VIX Short-Term Futures Index).  Its investment
strategy involved daily rebalancing and, like many ETFs, was
passively managed.  Depending on market volatility, the cost
of rebalancing could erase gains accrued over months or years in
one trading day. The prospectus of the Horizons Fund explicitly
cautioned that investors should monitor their investment on a daily
basis and that a substantial portion of all money invested in the
fund could be lost. On February 5, 2018, the Horizons Fund lost
over 81% of its value overnight and investors who bought units on
that day purchased those units at inflated prices.  The
Horizons Fund never recovered and was subsequently terminated. In
the press release announcing the termination, Horizons ETFs
Management (Canada) Inc. (the Manager) stated that it did not want
to offer a product that had the “potential to lose the
majority of an investor’s capital in such a short period of
time” and that the fund “no longer offer[ed] an
acceptable risk/reward trade-off for investors”.

The Claims – Negligence and
Misrepresentations

A class action was commenced by a representative investor,
Wright, in the Horizons Fund. Wright had sold his units of the
Horizons Fund on February 6, 2018 and lost approximately $210,000
in doing so. Wright claimed common law negligence and
misrepresentations in a prospectus under the “primary
market” civil liability regime under Section 130 of the
Securities Act . It is important to note that neither
the lower court nor the COA decision evaluated the merits of the
allegations, but, rather, both considered certification of the
class action.  

Wright’s statement of claim outlined:

• A Negligence Claim – alleging
  the Manager breached its duty of care in its creation, marketing,
  and management of the Horizons Fund.
• A Misrepresentations Claim –
  alleging the Manager failed to fully and adequately disclose the
  risks of the Horizons Fund’s investment strategy, along with
  its valuation methods, including that the intra-day trading value
  could be inaccurate and that its value could drop precipitously
  after the close of the trading day.

Specifically, the negligence claim alleged that the Manager
breached its duty of care by:

• designing and developing a fund it
  knew or ought to have known was excessively complex, risky, and
  “doomed to fail”;
• offering and promoting the Horizons
  Fund to retail investors knowing it contained structural design
  flaws, including exposure to risk of catastrophic losses, and
  lacked a coherent investment thesis, offering unreasonable
  risk/reward trade-offs to investors;
• failing to adequately explain the
  nature and extent of the risks involved in investing in the
  Horizons Fund; and
• failing to exercise its powers as
  manager to mitigate risks and losses to investors.

Purchases of ETF Securities – The Primary Market
versus the Secondary Market

Units of ETFs can only be purchased by an investor over a stock
exchange through brokers and dealers, and not directly from the
issuer.  An investor’s purchase of ETF securities on a
stock exchange are purchases of either:

• treasury securities subscribed for
  the first time through a broker or dealer through a continuous
  distribution agreement, constituting “primary market”
  purchases (termed “creation units” in Horizons);
  or
• ETF securities that have already been
  in circulation (either from a broker’s or dealer’s
  inventory of units or from other holders through a broker or
  dealer), constituting “secondary market”
  purchases. 

Both types of ETF securities exist on the relevant stock
exchange and, as the Ontario Superior Court of Justice pointed out,
are comingled. The COA noted that it was not clear, on the evidence
before the court, whether the manager, dealers, or any other person
was able to distinguish between sales of “creation units”
and previously issued units of the Horizons Fund. 

The Ontario Superior Court of Justice Decision

In hearing the case, the Honourable Justice Perell of the
Ontario Superior Court of Justice dismissed the motion for
certification of the class action and Wright’s claim.

Specifically:

• On the negligence claim, the lower
  court held that no cause of action in negligence could be made as
  the Manager had met its undertaking to investors in offering a
  financial product that performed in accordance with its disclosure
  documents, and, in any event, policy reasons discouraged further
  extending the Manager’s duty of care as argued by the
  plaintiff.
• On the misrepresentations claim, the
  lower court held that the action could not proceed using the
  “primary market” civil liability regime under Section 130
  of the Securities Act  because the Horizons Fund was
  offered over a stock exchange (the secondary market), and not
  directly to investors (the primary market). Instead, the claim
  should have been made using the “secondary market” civil
  liability regime under Section 138.3 of the Securities
  Act.

Claims under Section 130 of the Securities Act are
advantageous to claims under Section 138.3 of the Securities
Act, as the latter type of claim requires permission to
proceed, is capped on recoverable damages, and the losing party in
the proceeding will be responsible for the costs of the other
party.

The Court of Appeal Decision

The COA granted the appeal, in part, holding that the lower
court erred in concluding that the claim disclosed no reasonable
cause of action, and remanded the case back to the lower court for
a decision with respect to the remaining certification factors.

In rendering its decision, the COA assumed all allegations of
fact pleaded to be true.

The COA’s legal analysis of the negligence claim is complex.
The negligence claim was for pure economic loss.  This is
different from negligence claims involving physical harm or damage
to property.  In fact, there is debate in the legal community
on whether or not claims for pure economic loss should be permitted
(for reasons outside the scope of this bulletin). 

In brief, there are two parts to the legal analysis for claims
for pure economic loss:

1. The court must determine if the claim
   fits within or is analogous to a previously recognized duty of
   care.
2. If the answer to the first inquiry is
   no, the court must be convinced to recognize a novel prima
   facie duty of care and, if so recognized, the court must then
   evaluate whether there are policy reasons that would negate the
   imposition of the duty of care (including evaluating other remedies
   available or whether unlimited liability would be created for an
   unlimited class).

The COA found that it was not plain and obvious that the
negligence claim was doomed to fail with respect to both parts of
the analysis as outlined above. The court held that the negligence
claim in Horizons could fit within a recognized duty of
care: negligent performance of a service. It went further to state
that even if it was incorrect, a novel prima facie duty of
care for the negligent performance of a service could be
recognized, and it was not “plain and obvious” that such
duty should be negated by policy considerations. 

In finding that a novel prima facie duty of care could
be recognized, the COA focused on the Manager’s statutory duty
to act honestly, in good faith, and in the best interests of the
investment fund and to exercise the degree of care and diligence
that a prudent person would exercise in the circumstances. 
The COA pointed to the Manager’s failure to provide full
disclosure of the risks and/or the fact that the Horizons Fund was
doomed to fail, coupled with its failure to develop a viable
strategy for the Horizons Fund, as potential breaches of this duty
of care.  

On the misrepresentations claim, the COA disagreed with the
lower court that all members of the class should be considered
secondary market purchasers and held that some members could have
purchased “creation units”.  However, the statement
of claim did not contain all the necessary pleadings required to
properly bring an action under Section 130 of the Securities
Act and, therefore, the plaintiff was granted leave to amend
the statement of claim accordingly. 

SIX TAKEAWAYS

1. This Was Not a Consideration of the Merits of the
Case

As mentioned above, the COA did not opine on the merits
of the case, and, therefore, the application of the COA’s
findings to the development of the law is currently unknown. 
The test required to be met on a certification proceeding for a
class action has a low threshold. The COA’s decision only
considered whether the claim could be proven, assuming all facts
pleaded were true, and whether it was “plain and obvious”
that the claim could not succeed; in other words, whether there was
a radical defect with the claim.

Accordingly, a prima facie duty of care for investment
fund managers has not been established by the COA decision; rather,
the door is now open for such a duty of care to be
established.  Notably, an evaluation of the merits of the case
may find that overriding policy reasons should negate establishing
this prima facie duty of care. Therefore, we must wait for
further jurisprudence on this matter to see if this novel duty of
care is indeed established and the practical effect of
that.    

2. Disclosure is Important 

Irrespective of what happens with these proceedings, disclosure
always has been, and will remain, important. In addition to
ensuring that a fund’s disclosure documents are detailed,
comprehensive, and avoid boilerplate language, the following points
raised in Horizons can be considered when reviewing
disclosure documents, particularly for complex funds:

• Are the valuation methodologies for
  the calculation of the fund’s net asset value atypical and do
  they require additional and specific disclosure?
• Does the fund’s design and
  trading strategy present unique or unusual risks that may not be
  expected or understood by an “average” retail investor
  and should be explicitly disclosed?
• Is the fund only appropriate for
  certain investors who can understand or appreciate a complicated
  trading strategy, and, if so, how can this be clearly communicated
  in the fund’s disclosure documents?   
• Is there a disparity in the way gains
  and losses are experienced by the fund (e.g., incremental gains
  versus rapid losses)?  Can the fund’s value significantly
  drop in a short period of time and are the risks adequately
  disclosed?  Do investors have a reasonable opportunity to exit
  the fund?  

It is interesting to note that the disclosure documents of the
Horizons Fund explicitly referenced unusual, specific risks
applicable to the fund. These risks included a warning to investors
that, historically, the index had experienced significant one day
increases on days when equity markets had large negative returns
which, if repeated, could cause the fund to suffer substantial
losses.  The prospectus further contained disclosure that the
use of derivatives could quickly lead to large losses as well as
large gains, which losses could “sharply” reduce the
value of the fund. There was a statement that the fund was
“intended for use in daily or short-term trading strategies by
sophisticated investors”.  The statement of claim alleged
the fund’s disclosure was inadequate.  As noted above,
until there is a hearing on the merits, it is unknown whether the
courts would agree, but, in the meantime, fund managers may wish to
review and potentially enhance their funds’ disclosure
documents with these allegations in mind.

3. Warning – Disclosure May Not Be
Enough 

Perhaps the most notable finding of the COA is the suggestion
that an investment fund manager’s duty of care may require
“more” than just creating and managing an investment fund
that operates and performs exactly as described in its disclosure
documents.  Creating a fund that is not suitable for
“any” investors because it has a “design flaw”
rendering it “doomed to fail” is described by the COA as
potentially constituting a breach of a fund manager’s duty of
care.  It seems unlikely that the majority of investment funds
would be considered to have a “design flaw” rendering
them “doomed to fail”.  However, the question
remains: are there other types of “design flaws” that
could constitute a breach of this duty of care?

Even more importantly, the COA’s decision opens the door to
the possibility that “perfect” disclosure is not
enough.  Depending on how the jurisprudence on this develops,
fund managers may wish to make an assessment of the
“designs” of their funds,
including:

• How does the fund perform under a
  variety of market conditions and what factors impact
  performance?
• Will only sophisticated investors
  understand the fund’s performance variables?
• Does the fund present an
  “acceptable risk/reward trade-off for investors”?
• Does the fund have inherent risks
  that could render it unsuitable for “all” investors and
  open to allegations that it is “doomed to fail”?
• Are the investment strategies of the
  fund too complex or do they present risks rendering the fund
  unsuitable for passive management?

Unfortunately, how to practically and meaningfully address the
results of any such assessment is difficult, especially until the
jurisprudence further develops.   

4. Reconsider what Passive Management Means

The plaintiff alleged in Horizons that the Manager had
a positive duty to take action in response to declining and
volatile markets, despite the fact that the Horizons Fund, like
many ETFs, was passively managed. If this allegation is ultimately
accepted, fund managers and possibly portfolio managers could face
potential liability for failing to take positive action to mitigate
losses in certain conditions. Practically, this may mean a manager
may have to call the stock exchange to halt trading in certain
circumstances or take steps to actively manage the investments of
an ETF.  This could fundamentally shift how passive funds are
managed.  Consider how such an obligation could impact
management of passive funds during extreme circumstances, such as
the COVID-19 pandemic.  Managers of passive funds will likely
want to keep careful watch on how this issue develops.

5. The Primary Market vs. the Secondary
Market  

The misrepresentations claim in Horizons focused on
whether the claim could proceed using the “primary
market” civil liability regime under Section 130 of the
Securities Act relating to sales of ETF securities. 
As outlined above, the type of claim a potential plaintiff can
pursue hinges on the type of ETF securities purchased, which is
problematic because investors typically do not know what type of
ETF securities they have purchased.

Horizons is significant because the COA found that,
despite this difficulty, Section 130 of the Securities Act
can apply to purchases of ETF securities. It will likely be
challenging to show whether an investor purchased “creation
units” as opposed to units already existing in the secondary
marketplace and to address the fact that not all investors who wish
to participate in the class action may have purchased
“creation units”.  The COA noted that these
determinations would be addressed in the course of the litigation,
but not much guidance was given outside of
that.   

Aside from the potential of increasing the number and types of
future misrepresentations class actions that may be commenced
against ETFs, the Horizons decision raises practical
considerations that industry participants may wish to consider
further.  For example, is there a practical way of identifying
purchases as being on the primary or secondary market?  If so,
can or should investors have any control over how purchases are
made?  If given the choice, an investor would likely wish to
purchase on the primary market for the reasons noted above.

6. Suitability May be Worth a Thought (Not Just for
Dealers)

Another complex allegation in Horizons was that the
Manager was liable for creating a fund that was not suitable for
“any” investor.  If accepted, this could be taken to
mean that fund managers have some type of suitability obligation to
investors.  The imposition of such an obligation, if
ultimately affirmed, could have significant implications for the
industry, and could raise a number of difficult questions:

• How would such an obligation be
  limited?  Would liability only be imposed if a fund manager
  created a fund that is not suitable for “any”
  investor? 
• How would such an obligation of the
  fund manager complement or supplement other registrants’
  suitability obligations?
• If a fund’s disclosure documents
  clearly disclose that the fund is only suitable for a certain type
  of investor, who would be responsible if an investor that does not
  meet the disclosed qualifications ends up investing in the
  fund?  What steps could industry participants take to mitigate
  these potential risks?
• Would saddling registrants with new
  suitability assessments paralyze the creation of innovative
  products? Could this result in investors having less choice in
  selecting financial products in the future?

These takeaways aim to highlight the potential far-reaching
implications this decision could have on the industry.  Not
only could investment fund managers be subject to new duties,
obligations, and potential liabilities, these changes could impact
how investment fund managers create products, interact with other
industry participants, and seek to fulfil investor
expectations.  Unfortunately, at this point, Horizons
raises more questions than it answers.  However, the Manager
appears to be pursuing an application for leave to appeal this case
to the Supreme Court of Canada, so more clarity may be provided in
the future.

The foregoing provides only an overview and does not
constitute legal advice. Readers are cautioned against making any
decisions based on this material alone. Rather, specific legal
advice should be obtained.

© McMillan LLP 2020

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