Written by Alan Gardner, Jonathan Bell and Douglas Fenton
In Wright v Horizons ETFS Management (Canada) Inc., 2020 ONCA 337, the Court of Appeal for Ontario has opened the door to investor class actions related to exchange-traded funds (ETFs), holding that the creator/manager of an ETF may owe a duty of care in negligence to investors in the creation, marketing and management of the ETF. The Court of Appeal also clarified the doctrinal boundaries between s. 130 of the Ontario Securities Act, R.S.O. 1990 c. S. 5, (which creates a statutory cause of action for misrepresentations in respect of securities purchased in the "primary market") and s. 138.3 of the Securities Act (which creates a separate cause of action for misrepresentations relating to securities purchased in the "secondary market"), holding for the first time that ETF investors in certain circumstances may be entitled to bring a claim under s. 130 of the Securities Act for misrepresentations in a prospectus. Given the proliferation of ETFs and similar products, the Court of Appeal's decision has potentially far-reaching implications for participants in capital markets.
The defendant Horizons ETFS Management Inc. is one of the largest providers of ETFs in the Canadian market. Among its many ETF products, Horizons created and passively managed a complex derivate-based ETF, designed to provide inverse exposure to stock market volatility (the Fund).
The Fund was intended to track the daily performance of the VIX Index and S&P 500 VIX Short-Term Futures Index (the VIX Futures Index), which are measures of expected market volatility. The Fund was designed so that when the VIX Futures Index declined by a certain percentage on a given day, the Fund's net asset value automatically went up by that percentage. Conversely, when the VIX Futures Index increased on a given day, the Fund's net asset value went down by that percentage.
The Fund was a complex—and risky—ETF product. If volatility remained low, the Fund generated income by selling longer-term VIX futures contracts at a premium in relation to nearer term contracts. But if market volatility increased, the price to repurchase VIX futures contracts could increase exponentially. As a consequence, the cost of rebalancing the Fund at the end of each trading day following increased market volatility could erase any gains over months or years, in as little as a single day. One of the prospectuses prepared in connection with the Fund cautioned investors that the Fund was "highly speculative and involved a high degree of risk".
On February 5, 2018, effectively overnight, investors in the Fund lost almost their entire investment. Shortly thereafter, the plaintiff commenced a proposed investor class action, seeking damages for the capital losses experienced by investors in the Fund.
The plaintiff's primary cause of action was a common law negligence claim grounded in an argument that Horizons had allegedly breached a duty of care owed to its investors by, among other things:
- designing and developing the Fund when it knew that the fund was excessively complex and too risky for retail investors;
- offering and promoting the Fund to retail investors knowing it contained "structural flaws", such that it was "doomed to fail";
- failing to properly explain the risks involved in investing in the Fund; and
- offering a product that was fundamentally unsuited to passive management.
The plaintiff also brought a claim under s. 130 of the Securities Act, alleging misrepresentation in a prospectus prepared in connection with the issuance of certain units in the Fund. This was a novel claim: an Ontario court had not previously considered whether an investor in an ETF could maintain a claim for primary market misrepresentation under s. 130 of the Securities Act. The plaintiff likely chose to proceed under s. 130 of the Securities Act—rather than s. 138.3 of the Securities Act, which concerns securities in the "secondary market"—for strategic reasons. Section 138.3 of the Securities Act includes a damages cap of the greater of 5 percent of the issuer's market capitalization or $1 million for a responsible issuer, and a "loser-pays" cost rule. Moreover, a plaintiff who brings a claim under s. 138.3 must first obtain leave of the court to commence an action, unlike a plaintiff who commences an action under s. 130 of the Securities Act. As a result, s. 130 of the Securities Act provides a more attractive cause of action (assuming it is validly pled) and more powerful remedies than s. 138.3 of the Securities Act.
Certification Decision: 2019 ONSC 3827
The certification judge refused to certify the plaintiff's action as a class proceeding on the basis that it was "plain and obvious" that the plaintiff's claim did not disclose a "reasonable cause of action" (i.e., the claim was not tenable at law).
Duty of Care in Negligence?
The parties agreed that the plaintiff's negligence claim—which focused on the allegedly negligent design and management of the Fund—was a claim for pure economic loss. The certification judge rejected that the plaintiff's claim fell within any of the previously recognized categories of duties of care for pure economic loss (including, for example, negligent supply of a "shoddy good" or negligent performance of a service), which required the certification judge to consider whether it was appropriate to recognize a "novel" duty of care.
The certification judge referred to the Supreme Court of Canada's decision in Deloitte & Touché v Livent Inc. (Receiver of), 2017 SCC 63, which directs that, in considering whether to recognize a novel duty of care for pure economic loss, it is relevant to consider (a) whether the parties are in a sufficiently close and direct (or proximate) relationship and whether the harm suffered is reasonably foreseeable, such that a prima facie duty of care exits; and (b) if so, whether there are residual policy considerations that should insulate the defendant from liability.
Ultimately, the certification judge determined that it was not appropriate to recognize a novel duty of care in these circumstances. While the certification judge was prepared to accept that there was a legally "proximate" relationship between Horizons and its investors (on the basis that harm to investors would be a "reasonably foreseeable" consequence of Horizons' negligence), the certification judge found that any resulting duty of care was limited by the narrow scope of Horizons' undertaking. In his view, Horizons had not agreed to guarantee returns, to actively manage the Fund, or to step in to prevent investor loss if things went awry. Rather, Horizons had simply undertaken to put on the market an ETF product that operated as described in the accompanying disclosure documents (which the Fund did). As a result, Horizons could not be held responsible for its investors' losses.
The certification judge also held that there were policy reasons that militated against extending a duty of care for pure economic loss in the manner proposed by the plaintiff. In the Court’s view, imposing a duty to exercise care in the design and management of a passively-managed ETF product would:
- 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
- have the courts take on a significant regulatory function when existing causes of action, the regulators, and the marketplace already provide remedies.
As a result, the certification judge concluded it was "plain and obvious" that the plaintiff/class members' claims in negligence could not succeed.
Primary Market Misrepresentation? Or Secondary Market Misrepresentation?
The certification judge accepted that there "should be a statutory cause of action for misrepresentations in the selling of ETFs, which now represent a substantial and growing share of the investment marketplace." But the novel issue before the certification judge was whether a claim for misrepresentations arising out of the sale of ETFs could be brought under s. 130 of the Securities Act (concerning primary market misrepresentation), or whether a claim only arose under s. 138.3 of the Securities Act (concerning secondary market misrepresentation).
ETFs sit somewhat uneasily within the civil liability regime created by the Securities Act. In this regard, the process by which units in the Fund were distributed to investors was somewhat complex, and differed from "typical" distributions of securities. In the instant case, Horizons distributed all units in the Fund to designated brokers/dealers pursuant to a continuous distribution agreement, with those newly created units referred to as "Creation Units." A broker/dealer would then make the units available for purchase over various stock exchanges. In order to fulfill the retail investors' orders over each stock exchange, the broker/dealer would either sell a unit from its existing inventory, or subscribe for additional Creation Units from Horizons.
Under applicable securities law, the first sale of a Creation Unit to an investor is a "distribution" of a security within the meaning of the Securities Act, which required Horizons and the designated broker/dealer to file a prospectus with the relevant securities regulator. At the same time, Creation Units were comingled with other units in the Fund purchased by the broker/dealer, such that it was impracticable to determine whether a particular re-sale involved Creation Units, units purchased in the secondary market, or both. To obviate this problem, securities regulators provide the designated broker/dealer an exemption from the obligation to deliver a prospectus with each re-sale of a Creation Unit, and instead allows the designated broker/dealer to provide a summary document (referred to as an ETF Facts Document) to first time purchasers of units. Importantly, an investor in the Fund had no way of knowing whether his or her purchase over the stock exchange involved the primary sale of Creation Units or a resale of units in the secondary market.
This raises a problem: were investors in the Fund purchasing units pursuant under a prospectus, such that they could bring a claim under s. 130 of the Securities Act? Or were they purchasing already circulating units in the secondary market? Could one tell?
The certification judge held that the plaintiff had improperly framed his claim under s. 130 of the Securities Act, and could not bring a claim for alleged misrepresentation in the Fund's prospectus. In the certification judge's view, ETFs were fundamentally connected to the "secondary market" because retail investors purchased units from designated broker/dealers that had made the units available for purchase over a stock exchange, and did not purchase the units directly from the issuer. The only connection between ETFs and the primary market was that before an ETF could begin trading on a stock exchange, the ETF manager was required to file a prospectus. However, purchasers of the units, for all practical purposes, were trading in the secondary market.
On this basis, the certification judge held that it was plain and obvious that the plaintiff's claim under s. 130 of the Securities Act could not succeed.
Ontario Court of Appeal: 2020 ONCA 337
On appeal, the Court of Appeal determined that the certification judge had erred in concluding that the plaintiff's claims were "doomed to fail." Writing for a unanimous panel of the Court of Appeal, Thorburn J.A. held that an ETF manager may owe a duty of care in negligence arising out its creation and management of an ETF product and that investors in ETFs could, in some circumstances, bring a claim under s. 130 of the Securities Act.
ETF Manager's May Owe a Duty of Care in Negligence
As a preliminary matter, the Court of Appeal disagreed with the certification judge that it was plain and obvious that the plaintiff's claim did not fall within the previously recognized categories of duty of care for pure economic loss. In its view, it was arguable that Horizons owed its investors a duty of care arising out of the negligent performance of a service, on the theory that Horizons was providing a service in designing and managing the Fund. In this regard, it was arguable that Horizons had negligently designed the Fund and failed to ensure it was an appropriate investment product for retail investors.
More significantly, the Court of Appeal held that the certification judge had erred in concluding that it was plain and obvious that this was an inappropriate case to recognize a novel duty of care requiring ETF managers to exercise reasonable care in the creation and management of ETF products. In particular, the Court of Appeal disagreed with the certification judge that Horizons had only undertaken to "place on the exchange a financial product that operated in accordance with the accompanying financial disclosure." Instead, it was suggested that Horizons had undertaken to its investors to act honestly, in good faith and in the best interests of the investment fund, and to exercise reasonable care and diligence, in accordance with s. 116 of the Securities Act.
The Court of Appeal emphasized that, at this early stage of the proceedings and for the purpose of the certification motion, the allegations in the plaintiff's statement of claim had to be assumed to be true. Since the plaintiff had alleged that Horizons had created a fund that was not suitable for any investor because it was structurally flawed and "doomed" to fail, it was arguable that Horizons had breached a duty of care in the circumstances. Nor was it plain and obvious at this early stage of the litigation that policy considerations ought to negate any such duty of care.
Some ETF Investors Can Bring a Section 130 Primary Market Misrepresentation Claim
The Court of Appeal also disagreed with the certification judge's conclusion that all purchases of ETF units should be treated as secondary market purchases, such that an ETF investor could only bring a claim under s. 138.3 of the Securities Act. In the Court of Appeal's view, an ETF investor could bring a claim under s. 130 of the Securities Act, if the investor had purchased a Creation Unit.
To begin, as the certification judge had recognized, Horizons was required to prepare and file a prospectus in connection with the distribution of the Creation Units to the broker/dealer and in connection with the first-resale of Creation Units to retail investors. While the broker/dealer was not required to deliver a prospectus in connection with each sale of a unit (as the result of the exemption provided by securities regulators) the ETF Facts Document provided by the broker/dealer incorporated by reference information in the relevant prospectuses. As a result, retail investors that purchase Creation Units qualified as purchasers of a security offered by prospectus during a period of distribution, and could therefore maintain a claim under s. 130 of the Securities Act.
In the Court of Appeal's view, the fact that an investor was unable to tell at the time of purchase whether they were purchasing a Creation Unit or a unit in the secondary market should not disentitle purchasers of Creation Units from bringing a claim under s. 130 of the Securities Act. The investors were obviously not responsible for the manner in which the units were distributed and, in the circumstances, it would be unfair to deny purchasers of Creation Units the advantages of proceeding by way of s. 130 of the Securities Act. Importantly in this regard, the Court of Appeal noted that, on the evidence before the court, it was not clear whether Horizons or the broker/dealer could distinguish between sales of Creation Units and other units. While this was a practical issue that would have to be addressed if the litigation were to proceed as a class proceeding, it did not mean the plaintiff's claim was "doomed to fail."
The Court of Appeal recognized that this created a somewhat artificial distinction between purchasers of Creation Units (who could bring a claim under s. 130 of the Securities Act) and purchasers of re-sale units (who could only bring a claim under s. 138.3 of the Securities Act), particularly given that investors could not know whether they were receiving Creation Units or re-sale units at the time of purchase. However, this conclusion was thought to be consistent with the manner in which ETFs were distributed and regulated, as well as the text of s. 130 of the Securities Act.
The Court of Appeal's decision may have significant implications for ETF managers, investors and other capital markets participants:
- The decision suggests that managers of ETFs may face significantly greater potential liability than previously recognized at Canadian law. While it is important to emphasize that the Court of Appeal was dealing with an appeal from a certification decision (and therefore only concluded that it was not "plain and obvious" that the plaintiff's claim would fail), its decision indicates a willingness to expand previously recognized duties of care for pure economic loss to account for the proliferation of ETFs and other index-based securities products. In this regard, an ETF manager may owe a duty of care in negligence to investors to properly design the EFT product and to fully disclose all risks associated with the ETF product. If the ETF manager is found to have breached the duty of care, it could be liable for investors' losses, even when the ETF operates exactly as described in the accompanying disclosure documents.
- In holding that purchasers of Creation Units could maintain a claim under s. 130 of the Securities Act for misrepresentation in a prospectus, while purchasers of re-sale units could only maintain an action under s. 138.3 of the Securities Act, the Court of Appeal adopted an interpretative approach that emphasized the text of the Securities Act and the broader scheme of securities regulation. For example, the Court of Appeal found it significant that securities regulators formally regard the first distribution of Creation Units to retail investors as a "distribution" of securities (which required the ETF manager to file a prospectus), notwithstanding that trading in ETFs might be intuitively thought to be more akin to trading in the secondary market.
- Passively managed ETFs have become widely popular among investors because of their low-fee structures. In light of the Court of Appeal's decision, it remains to be seen whether ETF managers will be able to maintain these low fee structures for all products. As a consequence of the decision, ETF managers may decide they need to actively manage more ETF products, which may require higher fees. ETF managers may also charge higher fees to offset their potential liability for investor losses, either at common law or under the Securities Act.
- ETFs came to prominence as simple, low-cost alternatives to mutual funds, designed to allow retail investors to de-risk their portfolios through broad exposure to particular indexes and industries. But as Wright demonstrates, ETFs have become increasingly complicated and now include complex, derivative-backed securities. Paradoxically, a retail investor may now be able to invest through ETFs in securities they would not be able to purchase directly from broker/dealers (due to the "know your client" and investment suitability obligations that apply to investment trading accounts and investment advisors). In this context, ETF managers need to carefully consider whether certain of their products are appropriate for retail investors and, if not, what they can do to prevent casual investors from purchasing product not commensurate with investors' risk tolerance and degree of sophistication.
- ETF managers should also carefully consider what disclosure must be provided in connection with particular ETF products. The Court of Appeal's decision in Wright emphasizes the importance of providing comprehensive disclosure, including details as to the mechanics of the ETF (for example, how the value of the product calculated at the end of each trading day), key risk factors (for example, exposure to market volatility or irregular trading patterns), and the suitability of the ETF for particular investing audiences (including, for example, whether the product is suitable for retail investors).