Court of Appeal opens door for negligence claims against investment funds
In its recent securities class action decision in Wright v. Horizons ETFS Management (Canada) Inc., 2020 ONCA 337, the Court of Appeal for Ontario certified a common law negligence claim for pure economic loss alongside statutory claims for primary and secondary market misrepresentation under the Ontario Securities Act (the “Act”). In doing so, the Court of Appeal signalled a potential expansion of negligence claims for pure economic loss for creators and managers of investment products.
The defendant Horizons ETFS Management (Canada) Inc. (“Horizons”) created and managed an exchange traded fund (the “Fund”), which sought to provide inverse exposure to stock market volatility. The prospectus described the Fund as “highly speculative” and “involv[ing] a high degree of risk”.
Horizons distributed all units in the Fund to a designated broker or dealer. When investors purchased units from a designated broker or dealer, they did not know whether they were receiving units on the primary market, or units from the broker’s or dealer’s inventory on the stock exchange (i.e. the secondary market).
On February 5, 2018, the value of the Fund dropped dramatically after having grown significantly over the prior two years. The Fund lost almost 90% of its total value overnight and investors lost nearly $40 million. In April of 2018, Horizons announced it would be closing the Fund because it no longer offered an acceptable risk/reward trade-off for its investors.
The plaintiff, an investor in the Fund, brought a claim pursuant to the Class Proceedings Act, 1992 on behalf of the Fund’s investors alleging common law negligence and the statutory cause of action for primary market misrepresentation under section 130 of the Act.
The certification motion
In the underlying decision, the motions judge refused to certify the class action on the grounds that the pleadings failed to disclose a cause of action.
With respect to the negligence claim, as it was a claim for pure economic loss, it had to either fit into one of the five recognized categories of recovery, or a new category had to be created. The two potentially applicable existing categories were: (i) negligent supply of a shoddy good, or (ii) negligent performance of a service.
The motions judge held that it did not fall into the “negligent supply of shoddy goods” category, which had been narrowly defined to involve only products with the prospect of causing physical harm. He further held it did not fit into “negligent performance of a service”. There was no precedent for a negligence claim for pure economic loss relating to financial products. Further, allowing such a claim would create “unprecedented and new duties of care” for investment fund managers, particularly where (as here) the fund managers did not undertake to protect investors from a risk of losing their investment. To the contrary, they had warned the investment was highly speculative and high risk. The motions judge also declined to create a new category. In doing so he held that:
[e]xtending a duty of care for pure economic loss to the creator of an index tracking ETF would: (a) deter useful economic activity where the parties are best left to allocate risks through the autonomy of contract, insurance, and due diligence; (b) encourage a multiplicity of inappropriate lawsuits; (c) arguably disturb the balance between statutory and common law actions envisioned by the legislator; and (e) introduce the courts to a significant regulatory function when existing causes of action, the regulators, and the marketplace already provide remedies
The motions judge also found that the plaintiff, as an investor, did not have a cause of action for primary market misrepresentation pursuant to section 130, because from an investor’s perspective, exchange traded funds are tied to the secondary market, and an investor would have no visibility into whether it had purchased originating, primary market units. Accordingly, the claim should have been brought pursuant to the secondary market cause of action under section 138.3. He made his order without prejudice to the plaintiff commencing a secondary market class action.
Court of Appeal finds that pleadings disclose cause of action in negligence
The Court of Appeal allowed the appeal in part on the basis that the statement of claim disclosed a reasonable cause of action in negligence. The Court further held that while there was no reasonable cause of action under section 130 as pleaded, that cause of action would be available to the plaintiff if it amended the pleadings to allege that he purchased on the primary market.
On the negligence claim, the Court agreed that it did not fit into the category of negligent supply of shoddy goods.
However, with respect to the claim of negligent performance of a service, the Court of Appeal held that, on a reading of the statement of claim (the facts of which had to be accepted as true for purposes of certification), “investors were not given sufficient information about the nature and extent of the risks and possible rewards to enable them to make an informed decision as to whether to invest, nor were they told that there was a design flaw and that the investment was doomed to fail.” The Court of Appeal therefore determined that the plaintiff’s claim could fall within a recognized duty of care, and that it was not clear that the claim disclosed no reasonable cause of action in negligence.
The Court of Appeal also considered whether there was a novel claim for breach of duty of care. The Court disagreed with the motions judge in finding that Horizons’ undertaking was broader in scope than the motions judge found. Specifically, the Court found that Horizons undertook to its investors to act honestly, in good faith and in the best interests of the investment fund and exercise the degree of care and diligence that a prudent person would exercise in the circumstances. The Court determined that, if the pleadings were assumed to be true, “Horizons created a Fund that was not suitable for any investors because [a] design flaw rendered it doomed to fail” and that “[t]he failure to provide full disclosure of the risks and/or the fact that the product was doomed to fail and the Fund manager’s failure to develop a viable strategy for the Fund might constitute a breach of a prima facie duty of care and/or a breach of the fund managers’ statutory duties”. The Court therefore appeared willing to find, if necessary, that there existed a new category of negligence for pure economic loss.
Though the Court’s findings were for the purposes of certification, and not on the merits, they may signal a willingness to expand negligence claims for pure economic loss to the creators and managers of investment products. This would represent a significant expansion of the causes of action available in such circumstances, which until now have sounded in statutory and common law negligent misrepresentation actions and contract.
Creators and managers of funds should be mindful of the Court’s statements, which suggest that a novel prima facie duty of care may be found where there is a failure to provide full disclosure as to the risks of investing in a financial product, and, further, where fund managers fail to develop a viable structure for their product.