The Ontario Court of Appeal recently held that a class action brought on behalf of investors in risky securities discloses a sufficient cause of action to be certified. The decision may open the gates to more securities class actions in Ontario. It also serves as a cautionary tale for fund developers and managers to consider when crafting disclosure documents under the Securities Act.
Wright v Horizons ETFS Management (Canada) Inc. deals with a proposed class action brought on behalf of investors in a complex derivative-based exchange-traded fund (ETF) developed and managed by Horizons. The ETF was available for retail investors to purchase on stock exchanges through authorized brokers and dealers. The disclosure documents stated that the ETF was “highly speculative” and “involv[ed] a high degree of risk.”
On February 5, 2018, the value of the ETF collapsed, eliminating nearly 90% of the assets the fund had accumulated over several years. Investors in the ETF lost almost their entire investment, totaling tens of millions of dollars. The proposed representative plaintiff, Mr. Wright, lost about $210,000 when he sold his units the next day.
Mr. Wright brought an action on behalf of himself and other investors who lost money in the crash.
In June 2019, the certification judge refused to certify the action as a class action, holding that Mr. Wright’s allegations disclosed no reasonable cause of action (Wright v Horizons ETFS Management (Canada) Inc., 2019 ONSC 3827). Recently, the Ontario Court of Appeal reversed the decision and remitted the case back to the certification judge to determine if the remaining certification criteria are met (Wright v Horizons ETFS Management (Canada) Inc., 2020 ONCA 337).
Mr. Wright advanced two main causes of action: the tort of negligent performance of a service, and negligent misrepresentation in a prospectus under the Securities Act. Both of these were risky, as neither has been used to successfully sue on losses in speculative investments in the past. Mr. Wright was ultimately rewarded by the Court of Appeal, which held that both causes of action were viable.
Common Law Claim for Negligence
Mr. Wright’s first argument was that the managers of the ETF breached their common law duty of care by designing and managing the ETF in a way that was excessively complex and contained fundamental design flaws.
The Court of Appeal held that this case was analogous to cases of negligent performance of a service. And, even if it was not, a new duty of care could reasonably be established in this case.
The main issue was the scope of Horizon’s duties to investors. Though the motion judge held that Horizons did not undertake responsibility for any gains or losses investors might realize in purchasing ETF units, the Court of Appeal disagreed. The Court of Appeal held that Horizons undertook 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 as provided for in the Securities Act (see section 116 of the Securities Act).
Mr. Wright’s statement of claim alleged that the ETF was doomed to fail, and was not suitable for any investors because there was no disclosure of this risk. The Court of Appeal held that this could, if proven at trial, constitute a breach of Horizons’ duty of care or its duty under the Securities Act to adequately manage the ETF.
Statutory Claim for Negligent Misrepresentation in a Prospectus
Mr. Wright’s second argument was that the developers and managers of the ETF misrepresented in the prospectus how the ETF operated and the nature of the risks involved, constituting a breach of section 130 of the Securities Act. That section permits investors to start a legal action where a prospectus contains a misrepresentation.
In this case, when investors purchased units of the ETF, they did not know whether the particular units they were buying were new units that had never been sold before – i.e. they were in the primary market and section 130 of the Securities Act governed – or were units their broker/dealer bought from others on the stock exchange – i.e. they were in the secondary market and therefore a different section, section 138.3, of the Securities Act governed.
For plaintiffs, there are clear advantages to bringing a claim for misrepresentations in the primary market rather than the secondary market. Under section 138.3 of the Securities Act, damages for misrepresentations to secondary market purchasers are capped. Further, an action for secondary market misrepresentation requires investors to get leave (permission) of the court to move forward with an action. The threshold to obtain leave to proceed can be a significant hurdle: the plaintiff must show that the case has a reasonable chance of success at trial and do so prior to any documentary or oral discovery of the proposed defendants.
The Court of Appeal held that it was appropriate to distinguish between the two types of units rather than continue with an action that tries to artificially conflate the two. The Court held that any action relating to units that had never been sold before must be brought under section 130 of the Securities Act. Denying holders of such units the right to proceed under section 130 would unfairly deny them the advantages of that section of the legislation.
At the same time, investors who bought ETF units that had previously been purchased by other investors are required to bring an action under section 138.3 of the Securities Act, which deals with secondary market purchasers.
Practical Considerations for Fund Developers and Managers
It is important to remember what this decision does not mean. This was a certification motion, where the question to be answered was whether Mr. Wright’s allegations of wrongdoing are doomed to fail. The Court of Appeal held they are not, and that Mr. Wright should be given a chance to go to trial to try to prove his claim. This does not mean that Horizons has been or will be held liable for a breach of its duty of care to investors, or for a breach of the Securities Act.
But practically speaking, many class actions never go to trial. The risks and costs of a common issues trial are high for defendants, and most class actions settle before a common issues trial is held. Therefore, the practical reality is that certification is an important litmus test for a class proceeding.
Both of the causes of action advanced by Mr. Wright were novel in the context of high-risk securities that took a turn for the worst. The investors’ appetite for risk paid off in the context of the litigation; they can at least now ask the court to certify the action as a class action. This decision’s impact may be wide-ranging and include an increase in securities class actions being brought across Canada, as well as a more conservative approach by fund developers and managers when they create both investment products for Canadian retail investors and the disclosure documents accompanying those products.