In a class action spanning nearly 20 years, Ontario’s Superior Court of Justice has found two mutual fund managers liable for negligence related to “market timing”. Justice Koehnen held in Fisher v. IG Investment that the mutual fund managers failed to take reasonable steps to prevent frequent, short-term trading in their funds that harmed long-term investors. The mutual fund managers did not, however, breach their fiduciary duties. This decision offers important takeaways concerning class proceedings, negligence, and fiduciary principles.
“Market timing” in this case refers to a trading strategy where sophisticated investors make repeated, frequent, and short-term trades in and out of mutual funds. While not unlawful in-itself, market timing can harm other investors by diluting the value of the fund. This case concerned “time zone arbitrage,” a specific type of market timing whereby a trader leverages time-zone differences and movements in other markets for a short-term gain.
Following a US investigation into “market timing” practices in 2003, the Ontario Security Commission (“OSC”) investigated similar practices among mutual fund managers in Ontario. Five fund managers, including the defendants, settled with the OSC and paid over $200 million to their respective funds. After the settlement, representative plaintiffs launched class actions against the five fund managers. All but the two remaining defendants settled the class action claims.
The plaintiffs were unitholders of the two defendants’ mutual funds between 1998/1999 and 2003. The plaintiffs allege that the fund managers were negligent and breached their fiduciary duty by allowing sophisticated investors to engage in market timing activities which diluted the class members’ returns.
The court held that the applicable standard of care was that of a reasonably prudent fund manager. This standard does not demand perfection, but the defendants were required to act with care, diligence, and skill, including taking reasonable steps to prevent harm. A court will not apply the standard with hindsight. Instead, the question is whether the defendants at the time had a duty to prevent market timing activities.
The court found that the fund managers ought to have foreseen the general harm of frequent, short-term trading to long-term unitholders. The defendants’ failure to prevent this harm fell short of their standard of care.
The court did not require the defendants to know the specific harm that would occur as a result of the market timing. Instead, Justice Koehnen relied on various evidence, including media articles from other jurisdictions, to suggest that the dangers of frequent, short-term trading were broadly known at the time. Prospectuses by various mutual funds demonstrated that harm from frequent, short-term trading was foreseeable. The defendants’ own prospectuses at the time revealed that frequent, short-term trading was “undesirable”. Justice Koehnen also relied on the OSC investigation to find that other fund managers took reasonable steps to prevent frequent, short-term trading.
Turning to the specific failures by the defendants, Justice Koehnen held that the defendants, among other things, failed to adequately monitor the frequent trading activity and did not take measures, such as charging higher trading fees, to stop it. Instead, the defendants entered into so-called “switch agreements” with investors, which allowed them to switch in and out of the funds for a reduced fee.
The defendants raised several defenses which were dismissed by the court.
- The defendants advanced the “random walk” theory that market returns are random and cannot be predicted. The court held that the defendants knew or ought to have known the dilutive harms created by frequent, short-term trading.
- The defendants argued that there had been a lack of regulatory action regarding “time-zone arbitrage”. The court noted the limited resources of regulators and held that conduct which has not been specifically prohibited may still not be legally acceptable.
- The defendants relied on the business judgment rule, which is a legal principle that protects the business decisions of officers and directors from court review where the decisions have been made honestly, in good faith and in the best interests of the corporation. The court found the rule did not assist the fund managers in a case involving a breach of a statutory duty of care to investors. Moreover, the defendants did not demonstrate that they acted on a reasonable or informed basis for the benefit of the mutual fund.
The defendants acknowledged that they owed a fiduciary duty to act in the best interests of their mutual funds as a whole. A fiduciary must act with utmost good faith and loyalty and must fully disclose conflicts of interest.
The plaintiffs alleged that the defendants breached their fiduciary duty by failing to disclose a conflict of interest, and by earning increased management fees by allowing frequent, short-term trading despite the general harm to long-term unitholders.
Justice Koehnen rejected this argument, finding that the nature of the fiduciary duty did not mean that the defendants could “never make a mistake”. Mere carelessness does not breach a fiduciary duty. The fund managers conduct was neither dishonest, in bad faith or against the best interests of the plaintiffs. Their negligence did not rise to a breach of fiduciary duty.
- Cautionary Tale: The decision should serve as a cautionary tale for mutual fund managers and others to be diligent in identifying practices that may dilute long-term returns and proactively address them.
- Rare Class Action Trial of Common Issues: Most class proceedings settle before or after the certification motion, and very few proceed to the common issues trial. Justice Koehnen bifurcated liability and damages, determining liability on a class-wide basis but leaving any assessment of damages for another day.
- Enormous Timelines: The underlying investigations into “market timing” occurred 20 years ago. The class action was commenced in 2006. The certification motion was dismissed at first instance in 2010, proceeded through three levels of appeal and was granted by the Supreme Court of Canada in 2013. Several more motions arose at the discovery phase. The common issues trial began in early 2022 and the decision was released in early 2023. Pending appeals of Justice Koehnen’s decision on liability, the court has directed the matter to proceed to a damages trial.