Important takeaways for fund managers from recent market-timing decision
There are many important takeaways for investment fund managers from the Ontario Superior Court’s recent trial decision in Fischer, a case in which two fund managers were found liable for failing to take reasonable steps to identify and deter “time zone arbitrage”. While the plaintiffs’ specific allegations concerning “market timing” trading practices are unlikely to repeat themselves in practice, the broader takeaways from this decision have significant implications for investment fund managers and their internal compliance and risk management teams.
The Fischer class action was commenced against five investment fund managers that settled with the Ontario Securities Commission (OSC) following its investigation into “market timing” trading practices. The OSC investigation resulted in the five fund managers, including both defendants, entering into settlement agreements in which they paid over $200 million to their respective funds.
The plaintiffs in Fischer were unitholders in certain funds of the two defendant managers between 1998/9 and 2003. They alleged that the managers failed to prevent and in fact facilitated so-called “market timing” trading practices that allowed hedge funds to frequently trade in and out of the funds, resulting in dilution of the returns of long-term investors. The trial judge agreed, holding:
…There was ample evidence before me to demonstrate that the standard of care during the Class Period required the defendants to be aware of the dangers of frequent trading in and out of their funds and take reasonable steps to prevent it. The harm that frequent trading causes to long-term unitholders has been known for decades. Mutual fund prospectuses (including those of [the defendants]) warned that frequent trading caused harm to funds and could result in fees of up to 2% being charged to frequent traders. It was generally agreed that a 2% fee would have stopped switching or frequent trading immediately. Despite the contents of their prospectuses, the defendants not only failed to take steps to prevent frequent trading or charge the fees set out in their prospectuses when it occurred, they facilitated frequent trading by entering into “Switch Agreements” which allowed certain investors to switch in and out of funds for a fee of only 0.2%.
A manager is not expected to act perfectly: It must act with “care, diligence, and skill of a reasonably prudent person in the circumstances” and based on prevailing standards. It’s conduct will not be judged in hindsight.
A manager must take “reasonable steps” to prevent harm: A manager’s duty to implement preventative steps is triggered by “the potential for harm” to investors. The Court found that the managers failed to implement policies and procedures to detect and monitor frequent trading activity even though they ought to have known it was harmful to investors.
In the context of this case, the Court held that the managers owed a duty to prevent and prohibit frequent trading and were “required to foresee” the harm such trading could cause to long-term unitholders – i.e., that frequent trading could have a dilutive impact on unitholders.
A manager need not have actual knowledge of harm to act: The Court found the managers did not know that dilution was occurring in the funds from frequent trading. There was no finding that such trading caused harms to the funds from higher transaction and administrative costs or a need to hold a higher level of cash, thereby causing a cash drag on performance.
The Court therefore focussed on whether “someone in the defendant’s position ought to have foreseen the harm” arising from time zone arbitrage. In finding ‘yes’, the Court relied on, among other things:
- the prospectuses of the defendants’ funds reserving the manager’s right to charge a penalty fee for frequent trading. The Court found that the “overall thrust” of the prospectuses was that short-term trading “is undesirable and is not wanted”.
- articles from other jurisdictions and the “popular press” to find that “the articles do suggest that concepts of time zone arbitrage, frequent trading and dilution were more broadly known and less arcane than the defendants make out” – even though there was no evidence that time zone arbitrage was a known trading strategy in Canada.
- the prospectuses of funds manufactured by other managers, holding that they “demonstrate that the standard of care during the Class Period required mutual funds to be aware of the risk of frequent short-term trading. The prospectuses also demonstrate that harm from frequent short-term trading was foreseeable.”
- the OSC report on its probe noting that many other managers took steps to detect and prohibit frequent trading. The Court held that the OSC’s report provided further evidence that the defendants failed to live up to the industry’s standard of care.
A manager must investigate unusual activity and conduct analysis to support decision-making: The Court found that the managers failed to recognize the unusual nature of the hedge fund making frequent trades in a retail mutual fund and took no steps to investigate why that was occurring. Executives from one of the defendants testified that they believed that the limitations and switch fees set out in the Switch Agreements adequately compensated the funds for any potential costs arising from the frequent trading activity. The Court concluded that there was “no proper analysis” supporting this conclusion, the Switch Agreements were “entered into based on a gut feeling that markets were a random walk”, and had the required analysis been conducted, the managers “would have seen a profitable strategy that, at a very minimum, posed serious risk of dilution to long-term unitholders.”
The Court held that at a minimum, the managers should have “tested their gut reaction” and “both defendants had an easy mechanism of analysing the past trading history of the frequent traders by reviewing their account statements with only a few keystrokes”.
A manager may have a duty to review unusual trading by investors: The Court agreed with the managers that they had no duty to understand the personal investment strategy of each investor since investors purchase mutual fund units through a dealer/investment advisor, not directly from the manager. As such, a manager is not obliged to satisfy itself that each investor “shares the fund manager’s philosophy and objective”.
In this case, the Court found that the managers did not need to know the precise motivations of the hedge fund investors to intervene because the managers would have seen “large switches in and out of a fund in short order” and the compliance department had sufficient information to investigate.
A manager should keep contemporaneous records of such analysis: A senior executive at a manager testified that some analysis was conducted of the cost of the activities proposed in the Switch Agreements before the first one was signed. However, the written work-product had been lost. The Court placed little weight on the oral evidence because the witness did not remember any details of the analysis. The Court also noted that no analysis was conducted after the Switch Agreements were entered into.
A manager’s reliance on legal advice must be substantiated: The Court placed no weight on the managers’ argument that they relied on legal advice relating to the legitimacy of the Switch Agreements because the managers did not disclose the substance of the legal advice they received.
A manager must have general knowledge about its peers’ practices: The Court held that one of the managers had a “blinkered view of its duties to protect clients” because a senior executive testified that it was beyond the scope of his duties to make inquiries with other fund managers to see how they were dealing with frequent traders. The Court disagreed, noting that the manager and its employees were members of various industry organizations and “one might reasonably expect” the senior executive “to have contacts with whom he could raise issues.”
The business judgment rule will only apply to informed and reasonable decisions: In keeping with well-established law, the Court held that the business judgment rule would not assist a manager defend a claim alleging a statutory breach. That said, the Court was willing to apply deference to a manager’s business decisions if such decisions were taken “carefully by persons knowledgeable in the business”, “on an informed basis”, and after “an appropriate degree of prudence and diligence was exercised”.
In this case, the Court held that the managers had not demonstrated that they acted on an informed or reasonable basis. The Court also noted that the business decision at issue was not taken for the benefit of the funds or investors (such as an investment decision) and it was “more focused on growing their business”.
A prospectus will be read generously in favour of investors: The Court held that the prospectuses of the defendants’ funds had to be “read purposively” as “consumer protection documents” that are “not intended to be parsed by investors the way a court might deconstruct language of the income tax act before imposing a significant liability on a taxpayer”. The Court did not want to “search them for every possible technical out that might be available to the defendants.”
The Court found that the “overall thrust” in the prospectuses was that short-term trading is “frowned upon” and that such representations “clearly send a directional message to retail investors” that the fund would utilize strategies that “maximized capital returns for long-term investors”. The Court made such inferences even though the prospectuses did not (a) expressly state that frequent trading practices would be discouraged or prevented, and (b) distinguish between the interests of short-term and long-term investors.
Disclosure to investors must be clear: A manager argued that it had disclosed short-term trading to investors because the annual reports for each fund appended financial statements that indicated the volume of trading in each fund’s units. With such information, investors could determine the extent of frequent trading in the fund. The Court did not accept that such information amounted to disclosure of frequent trading in the funds, reasoning:
The funds were aimed at retail investors. The purpose of disclosure is to bring information home primarily to that retail investor audience. It is unrealistic to expect retail investors to parse through notes to financial statements and infer from the number of units traded that the fund permits frequent trading which dilutes the value of the units of long-term investors. Disclosure must be made in a way that makes clear to the reader the risks involved. Burying information in cryptic footnotes to financial statements does not amount to disclosure to retail investors
Absence of regulatory requirement not determinative of scope of manager’s duty: The Court rejected the managers’ argument that there was no regulatory requirement in Canada with respect to frequent trading. While such regulatory controls existed in the past, they were removed and a policy recommendation to reintroduce them was not implemented. In contrast, the U.S. Securities and Exchange Commission had rules to address short-term trading and dilution governing mutual funds since 1968. The Court reasoned that “[i]t may well be that a regulator believes it preferable for market participants to have a degree of flexibility and be regulated by common-law duties rather than absolute rules”.
 Fischer v. IG Investment, 2023 ONSC 915.