At the conclusion of a liability trial before the Ontario Superior Court of Justice in this class action commenced 17 years ago[1], two Canadian mutual fund managers were found negligent for having failed to prevent certain hedge funds from engaging in “time zone arbitrage”, a type of trading strategy employed by short term traders characterized by short-term or frequent trading in and out of mutual funds that are invested heavily or exclusively in shares trading on stock exchanges in different time zones.
The class action was commenced in 2006, following an OSC investigation into so-called “market timing” trading practices. This resulted in five mutual fund managers entering into settlement agreements with the OSC in 2004 pursuant to which they agreed to pay a total of in excess of $200 million to their respective unit holders. Two of those fund managers were the defendants in this action. The other three fund managers settled the class action prior to the liability trial.
The Mutual Fund Managers Were Negligent in Failing to Prevent Frequent Trading in the Funds
Justice Koehnen determined that there was ample evidence that the standard of care of a “reasonably prudent manager” required the defendant fund managers to be aware of the dangers of frequent trading in and out of their funds and to take reasonable steps to prevent it. The harm that frequent trading causes to long-term unitholders had been known for decades, as evidenced by a 2005 report on the results of the OSC’s probe into market timing and disclosures made in various mutual fund prospectuses (including those of the defendants) that warned that frequent trading causes harm to funds and could result in fees of up to 2% being charged to frequent traders. However, instead of taking steps to prevent frequent trading, the defendants actually facilitated the practice by entering into “Switch Agreements” which allowed certain investors, typically hedge funds, to switch in and out of the funds for a fee of only 0.2%. It was generally agreed that had the defendants charged those investors a 2% fee the practice would have stopped.
The Court was not persuaded by the defendants’ argument that they were not aware that the hedge fund investors were engaging in “time zone arbitrage” at the time. This trading strategy targets mutual funds whose holdings are heavily weighted in shares trading on stock exchanges in different time zones. In brief, market timers take advantage of the pricing methodology for mutual funds and different market closing times, and earn a risk-free profit by pulling out their money from a particular fund before it can be actually invested into any securities. Even though this specific practice was not well known at the time, the defendants were found to have known that “market timers” were engaged in frequent, short term trading. It is the frequent short-term trading that caused the harm, not the time zone arbitrage strategy underlying it. Had the defendants met their duty of taking steps to prevent or prohibit frequent trading, they would have prevented time zone arbitrage as well.
The Court rejected the defendants’ argument that they could only be found liable if a reasonable Canadian mutual fund manager would have foreseen that certain investors were employing a time zone arbitrage strategy causing harm to investors. Even if time zone arbitrage was not a widely known harm, frequent short term trading was and damage from it was reasonably foreseeable. It was sufficient that the harm suffered was of a type that was reasonably foreseeable.
Breach of Fiduciary Duty Requires More than Negligence
However, the Court found that the defendants were not liable for breach of fiduciary duty. “There is no fiduciary duty to “never make a mistake”, and a trustee’s negligence cannot be turned into a breach of fiduciary duty”. When determining whether a fiduciary has breached his duty, the court will focus on the fiduciary’s subjective motivation and whether he acted in good faith. In this case the Court was not satisfied that the defendants had acted dishonestly, in bad faith or acted consciously against the best interests of the class members.
Other Notable Findings:
Importance of the Pleadings
A preliminary issue was whether the allegations of negligence and breach of fiduciary duty extended beyond time zone arbitrage. The plaintiffs argued that liability for all forms of frequent trading was in issue. The certified common issues related to whether the defendants had breached duties to prevent “market timing” activities in their funds, and “market timing” was not defined in the order.
The Court rejected this contention, finding that “the scope of an action is defined by the pleadings”. The Amended Statement of Claim referred only to time zone arbitrage, not other forms of frequent trading: “…it would be unfair to the defendants to extend the scope of the inquiry 19 years after the end of the Class Period and after the conclusion of the liability trial when other forms of frequent trading were not put in issue in the statement of claim.”
Establishing the Standard of Care
Among other evidence, the Court admitted and relied upon for the truth of its contents an OSC report on its probe into mutual fund trading practices published in 2005 which was tendered as evidence of the standard of care applicable to mutual fund managers at the time. It established that other mutual funds had prohibited frequent trading. The Court found that it was admissible both under the public records exception to hearsay and the principled approach to hearsay. With respect to the latter, the necessity criterion was met because it was unsigned and the author unknown. It also bore numerous indicia of reliability. It was the result of a lengthy investigation by a regulatory body and “had the attention of the highest levels of the OSC and the mutual fund industry in Canada”.
The defendants’ prospectuses, “read purposively”, also were relied upon: “The overall thrust of the message delivered in the prospectuses is that short-term trading is frowned upon, is undesirable and not wanted. Having set that message out clearly in their prospectuses, the defendants then went out and took proactive steps to design a program that permitted short-term trading”.
No Role for the Business Judgment Rule
The Court also determined that the business judgment rule had no application in the circumstances of the case. While the defendants claimed to have acted upon legal advice, the legal advice was not produced. “Unproduced advice that no one recalls cannot anchor a business judgment defence”. The financial advice relied upon by one of the defendants was unhelpful to its position and should have led it to prohibit frequent trading.
The statutory context, in particular, section 116 of the Securities Act which requires every investment fund manager to exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in the circumstances, also influenced the Court’s rejection of the availability of a business judgment defence. Other financial advisers have been held liable for lack of diligence in carrying out their mandates. Further, the business judgment rule is aimed at permitting businesses to engage in certain high risk activities without liability, such as a decision to make a particular investment for the benefit of the business and its owners. However, “permitting frequent trading was not a risk-taking decision that the defendants made for the benefit of the mutual funds or their unitholders”.
Takeaways. A key takeaway is that courts will not give too narrow a reading of the harm that must be reasonably foreseeable in the negligence analysis. Here, the harm – in the form of dilution in value — was caused by the frequent, short-term nature of the trades, not the specific time zone arbitrage strategy that the defendants permitted. The harm was well known, as evidenced by the content of the defendants’ own prospectuses, and it was a breach of the standard of care not the protect against it.
The fact that the defendants were operating in a heavily regulated industry, subject to a statutory standard of care and required to publish “consumer protection documents” in the form of prospectuses also appears to have influenced the courts’ assessment of the defendants’ overall conduct:
“ If the defendants were not aware of dilutive harm, the consequences of that ignorance lie on them. If they were not aware of time zone arbitrage, the consequences of that should also lie on them. They entered into agreements that knowingly contravened the directional thrust of their prospectuses. If they did so on a theory that was wrong, that was a risk they took. In doing so they miscalculated the risks even though they were clearly aware of the risk of frequent short-term trading. Willingly incurring a risk by miscalculating the degree of danger is a form of negligence. As between the innocent long-term unitholders who played no role in the frequent trading and the defendants who held themselves out as experts and facilitated the frequent trading, the risk of miscalculation and loss must fall on the defendants.”
[1] Certification of the proceeding as a class action was finally affirmed by the Supreme Court of Canada in AIC Limited v. Fischer, 2013 SCC 69.
