Investment management company Emerge owes $2.5-million to the funds it oversees

Investment management company Emerge, whose exchange-traded funds were abruptly slapped with a trading halt by regulators last week, owes more than $2.5-million to half a dozen of those funds, a debt that more than doubled in the first half of last year.

The Toronto-based company, which manages about $118-million in assets, owes a total of $2.53-million across six of its Emerge ARK funds, a group of investment funds that are sub-advised by prominent U.S. investor Cathie Wood.

The total amount owed was first disclosed in 2019, the year Emerge entered the Canadian ETF industry with the launch of the ARK funds. At that time, Emerge owed $486,442 to five ETFs. By the end of 2021, the debt had grown to $1.12-million and was spread across six ETFs. Six months later, by June 30, 2022, the figure had jumped 127 per cent to $2.53-million.

The amounts owed to the funds are money that was “pre-paid” to Emerge for managing the ETFs, according to a note in the funds’ 2019 annual financial statements. Emerge said the money was used to cover operating expenses for the funds, a cost that is typically paid directly by a fund manager when first launching an ETF or mutual fund, in order to keep management fees low for investors.

It is unconventional for an investment manager to use money from inside an investment fund to prepay the fund manager. And it is even more unusual for a manager to carry a balance owing, year-over-year, with accrued interest for operating expenses, as Emerge did.

The funds’ financial statements show that over their life, Emerge agreed to cover just under $1-million in fund expenses, an arrangement called “cost absorption.” The total amount Emerge owed back to its funds as of June 30 of last year exceeds the reported absorbed costs. Emerge said in a statement that the remaining funds were used on “allowable expenses,” which the company defined as expenses approved by an auditor.

In 2020, the company began to report that the amounts owed to the funds would accrue interest at a rate of 2.5 per cent annually. There was $39,172 in interest owing, as of June 30, 2022.

“We consider that our practice has benefited unit holders by providing both interest (on the receivable) and a reduced management expense ratio for the duration of our reimbursement of expenses,” Emerge told The Globe and Mail.

”Absorption is not borrowing from the ETFs,” Emerge’s statement said. “The operating expenses absorbed by the manager benefited unitholders, as it reduced the [management expense ratio] and contributed positively to performance. The absorbed expenses do not include payments to sub-advisors, which we pay out of our management fees.”

Opinion: OSC needs to take accountability seriously or risk losing public confidence

While the company has been focused on growing its ARK fund families – it reached more than $336-million in assets in early 2021 – the decline in the broader technology sector has resulted in Emerge’s funds losing about two-thirds of their value.

Last week, the Ontario Securities Commission issued a cease-trade order, or CTO, for all of the Emerge ETFs because the company had failed to file financial statements by a March 31 deadline.

The OSC had never previously taken such an action against a fund family of ETFs, OSC spokesperson JP Vecsi said in an e-mail.

Mr. Vesci said the cease-trade order was issued for an indefinite period of time. When such an order is issued with no expiry date, “it will remain in effect until the decision is revoked by the regulator, when and if the company or individual corrects the deficiencies or meets certain conditions,” he said.

Emerge first said in a mid-December news release that BDO Canada LLP had resigned as the auditor of its funds nearly six weeks earlier. At the time, Emerge said it was “working expeditiously to appoint a successor auditor.”

Emerge revealed Monday that it had yet to hire a replacement for BDO.

Both BDO and Emerge declined to comment on why the relationship ended, but Emerge chief executive officer Lisa Langley told The Globe the decision was “mutual.” In regulatory filings, Emerge and BDO said there were no disputes over accounting issues. Ms. Langley also said the trading halt and the amount owing to the ETFs are unrelated.

The company confirmed that the Emerge funds, and Emerge itself, had three clean audits from BDO for the financial years 2019, 2020 and 2021, including “the treatment of the amounts” owed to the funds for reimbursement of expenses.

Emerge also confirmed that an independent review committee – a group that considers potential conflicts of interest between funds and their managers – had reviewed the company’s expense practices, disclosures and fund performance.

“We do not speak for the independent review committee members, but we confirm we discussed this practice with them,” Emerge said in a statement.

Deborah Fuhr, a managing partner at ETFGI, an independent research and consulting firm based in Britain, said that although she hasn’t previously seen an ETF provider face a trading halt for failure to file financial documents, investors should not extend their concerns to the overall industry.

“While Emerge is a small asset manager relative to the entire Canadian marketplace, this is not a small-player issue,” Ms. Fuhr said. “This is a company-specific issue that could have occurred at a large or small company who is changing service providers.”

The trading halt is a highly uncommon occurrence among exchange-traded funds, said Yves Rebetez, a partner with Credo Consulting Inc., a financial services consulting company.

“Failure to expeditiously address the matter could be a black eye on the Canadian market and the industry, in that a matter specific to regulatory responsibilities of an issuer shouldn’t freeze investors’ monies for unspecified periods of time without clarity and recourse,” Mr. Rebetez said.

“After all, investors chose ETFs for their trading liquidity and transparency, not to find themselves as victims of issues between the regulator and the manager.”

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