The recent decision of the Ontario Court of Appeal in Wright v. Horizons ETFS Management (Canada) Inc. (2020 ONCA 337) is significant for two reasons. First, it recognizes the existence of a duty of care owed by a fund manager to purchasers of units of the fund in relation to the allegedly negligent design of the fund. In addition, it opens the door to potential claims under s. 130 of the Ontario Securities Act against fund managers in relation to misrepresentations in the fund’s prospectus notwithstanding that the funds are sold over a stock exchange.
The proposed class action was commenced on behalf of investors in a complex, derivatives-based exchange-traded fund (the Fund) managed by Horizons ETFS Management (Canada) Inc. (Horizons). The fund, which invested in futures contracts, was meant to provide inverse exposure to stock market volatility.
Units in the fund were distributed by Horizons to brokers and dealers through a continuous distribution agreement. The newly created units were called Creation Units. Units were sold over the stock exchange, and investors did not know if they were purchasing Creation Units or units from inventory that had previously been in circulation on the secondary market.
Prior to trading units of the Fund, Horizons filed a prospectus in which the Fund was described as “highly speculative” and involving a “high degree of risk”.
As a result of the Fund experiencing a dramatic loss of value of over 80% in a single day, the representative plaintiff, Graham Wright (Wright), brought a class action under Ontario’s Class Proceedings Act, 1992. The claim alleged that Horizons was negligent in designing, developing, offering, and promoting the Fund, which was excessively risky and doomed to fail. Second, it asserted a statutory cause of action under s. 130 of the Securities Act based upon alleged misrepresentations in the Fund’s prospectus.
Wright’s motion for certification of the claim as a class action failed as it did not disclose a cause of action (reported at 2019 ONSC 3827). The Motion Judge held that it was plain and obvious that Horizons owed the class no duty of care. Further, the class did not have a cause of action under s. 130 of the Securities Act. Because units of the Fund were bought and sold by brokers and dealers in the secondary market, the action ought to have been brought under s. 138.3 of the Securities Act (which creates a cause of action for misrepresentations for secondary market purchasers), rather than s. 130 (which provides a cause of action in relation to misrepresentations in a prospectus for funds distributed on the primary market).
On appeal, the Ontario Court of Appeal disagreed with the Motion Judge’s conclusion that Horizons did not owe a duty of care to the class, finding that the claim disclosed a duty of care under the recognized category of negligent performance of a service. Specifically, the claim alleged that Horizons created the Fund for investment, earned money from the promotion and management of the Fund, and undertook to provide a financial product that was suitable for investors. The claim further alleged that the Fund was not suitable for some investors, contained an undisclosed design flaw, and was doomed to fail. On the basis of those alleged facts, the claim demonstrated a relationship of proximity between Horizons and the class such that the risk of injury to the class was reasonably foreseeable.
The Court of Appeal held that even if the claim did not fall within the recognized category of negligent performance of a service, the claim nonetheless disclosed a novel claim for breach of the duty of care. According to the Court, Horizons undertook to act honestly, in good faith, and in the best interests of the Fund, and to exercise the degree of care and diligence that a prudent person would exercise in the circumstances, as provided for in s. 116 of the Securities Act. In failing to disclose the alleged design flaw that doomed the Fund to failure, Horizons breached its duty of care and statutory duties under the Securities Act. It was not plain and obvious that any of the usual policy considerations negated the imposition of a duty of care.
The Court of Appeal also disagreed with the basis of the Motion Judge’s determination that it was plain and obvious that the claim was not properly brought under s. 130 of the Securities Act. The Court determined that the sale of Creation Units constitutes a “distribution” as defined in the Securities Act and that Creation Units were therefore primary market units under the Securities Act. Purchasers of Creation Units should be entitled to invoke their rights under s. 130 of the Securities Act to seek redress for misrepresentations made in the Fund’s prospectus.
The fact that Creation Units were commingled with other units trading in the secondary market, making it difficult for class members to determine whether they had received Creation Units or secondary market units, should not deny them the right to seek relief under s. 130. However, the statement of claim, as drafted, did not disclose a cause of action under s. 130 because Wright failed to plead that he purchased one or more Creation Units.
As a result, the appeal was allowed in part. Wright was given leave to amend the statement of claim to plead material facts to support the cause of action under s. 130 of the Securities Act, and the matter was remitted the matter to the Motion Judge for determination as to whether the remaining certification criteria are satisfied.
While the decision makes it possible for a fund purchaser to bring a s. 130 claim in respect to an alleged misrepresentation in a fund prospectus, the decision suggests that simply because a class member does not to know if he or she purchased a unit in the primary offering does not mean that the class member has a cause of action under s. 130. If a class member purchased in the secondary market, a s. 138.3 claim must be pursued, which unlike s. 130 will require leave of the court.