Lessons from TDAM’s victory in rare securities class action trial
It is exceptionally rare for class actions to proceed to trial in Canada. There are many reasons why most certified class actions settle in advance of trial, even when a defendant believes the allegations lack merit. This trend is especially true for financial services defendants. Despite the foregoing, TD Asset Management (“TDAM”) chose to contest allegations that it caused over $1 billion in damages by engaging in deceptive conduct known as “closet indexing” in one of its flagship mutual funds. TDAM’s total victory at trial offers lessons that are germane to class action and financial services litigation.
In Turpin v. TD Asset Management, 2022 BCSC 1083, the BC Supreme Court handed a resounding victory to TDAM, finding that the TD Canadian Equity Fund (the “CEF”) was not a “closet index fund”, as the plaintiff had alleged. To our knowledge, the Turpin case is the first decision in which a court has considered how trust duties function in the context of a mutual fund trust, one of the most common investment vehicles through which Canadians participate in the financial markets. It is also the first merits decision in a series of “closet indexing” class actions that have been initiated against several Canadian investment fund managers (“IFMs”) affiliated with large banks. While the cases against other IFMs remain at the certification stage, TDAM consented to certification, resulting in a narrower set of common issues and pleadings and a relatively quick trial.
The central issue in Turpin was the plaintiff’s allegation that, instead of using active management (i.e., research, discretion and expertise) to select equities for the CEF, TDAM employed a “closet indexing” strategy that was designed to closely track or replicate the returns of the CEF’s benchmark index, the S&P/TSX Composite Total Return Index (the “Benchmark”). The plaintiff also advanced a novel damages theory, seeking a “rebate” of the difference between the management fees charged for the CEF and the management fees that could have been charged for a product that tracks the performance of the Benchmark (i.e., a Canadian equity index fund or ETF). Given the size of the CEF and the ten year Class Period, the plaintiff sought more than $1.3 billion in damages.
Conceptually, the plaintiff’s allegations were based on academic literature that attempts to identify potential “closet indexers” through the use of various statistical metrics that purport to measure the degree of similarity between an investment fund and its benchmark. Legally, the plaintiff’s allegations were grounded in the law of trust and, in particular, in the duties owed by a trustee and manager of a mutual fund trust (TDAM, in this case) to the beneficiaries of that trust (the unitholders of the CEF). Among other things, the plaintiff alleged that TDAM had failed to disclose the true investment strategy employed by the CEF and had failed to advise unitholders that the returns of the CEF were likely to track or replicate the Benchmark.
In its defence, TDAM marshalled extensive fact and expert evidence about all aspects of the CEF’s management and oversight during the Class Period. A wide range of TDAM fact witnesses testified, including (to name only a few) the CEO and ultimate designated person, lead portfolio manager and personnel from the fundamental research, risk and compliance groups. Among other things, this evidence and contemporaneous records showed that the CEF’s portfolio manager used research, analysis and expertise to select equities for the CEF and, further, that the holdings and performance of the CEF diverged from that of the Benchmark during the Class Period. In fact, the CEF significantly outperformed the Benchmark (by more than 2%) for several 12- and 3-month periods during the Class Period.
After nine weeks of trial, Justice Funt ruled in favour of TDAM on all certified common issues, finding that the CEF was actively managed throughout the Class Period and that the plaintiff’s closet indexing allegations were unfounded. Justice Funt addressed a number of issues that are germane to class action and financial services litigation, including the following:
- In BC, the pleadings strictly constrain the scope and interpretation of the common issues. Common Issue #1 was whether TDAM had employed the “closet indexing strategy” during the Class Period. The notice of civil claim set out a definition of “closet indexing strategy” that TDAM argued required intentional or deceitful conduct on behalf of the portfolio manager. At trial, the plaintiff tried to expand the scope of “closet indexing strategy” so that it would capture non-deceitful conduct. The court rejected the plaintiff’s attempt to broaden the scope of Common Issue #1, finding that the pleaded definition of “closet indexing strategy” required intentional conduct and noting that “cases should not be decided on grounds not raised” (para. 439). Justice Funt noted, out of an abundance of caution, that given the facts before him, he would have ruled in TDAM’s favour even on a broader definition of “closet indexing” (para. 440).
- Quantitative metrics are not determinative of “closet indexing”. The court held that statistical metrics, which played a central role in the plaintiff’s case, are of limited utility in definitively determining whether an investment fund is a “closet indexer”. At most, quantitative statistics can be used as a “screening tool” that must be supplemented by a more rigorous qualitative analysis (paras. 137-155).
- The duties of mutual fund trustees must be interpreted in context. The court accepted TDAM’s argument that mutual fund trusts are commercial trusts that operate “within a highly regulated securities law environment designed to protect investors” (para. 87). The court also accepted TDAM’s argument that this unique context must be taken into account when courts interpret the duties of mutual fund trustees. In particular, mutual fund trustees owe duties to unitholders as a whole, not to any particular unitholder (para. 397).
- The court’s jurisdiction to supervise trusts should be exercised with restraint. Where a plaintiff has failed to establish wrongdoing on behalf of a mutual fund trustee, the court has no basis to exercise its discretion to supervise the trust. The court’s supervisory rule does not include using hindsight to second-guess the bona fide investment decisions made by professional portfolio managers (paras. 151, 408).
A McCarthy Tétrault team of Jill Yates, Shane D’Souza, Kevan Hanowski, Jennifer Choi, and Heather Mallabone acted for TDAM.