ETF class action proceeds, raising bigger issues

The deadline is looming for investors to opt out of a class action lawsuit over an inverse ETF product, a case that raised a broader policy issue for ETF investors.

Last year, the Ontario Superior Court of Justice certified a proposed class action against Horizons ETFs Management (Canada) Inc. alleging that an inverse ETF product was poorly designed.

The court initially denied certification, but that decision was partly overturned on appeal. Both sides appealed that ruling to the Supreme Court of Canada, which declined to review the appeal court’s decision.

Ultimately, the lower court certified a claim of negligence against Horizons stemming from the design of its BetaPro S&P 500 VIX Short-Term Futures Daily Inverse ETF (HVI). The fund saw its value plunge by almost 90% in February 2018 amid a spike in market volatility.

The court certified the lawsuit’s proposed claim alleging that Horizons was negligent in designing a product for retail investors that was based on a complex institutional trading strategy.

Those allegations have not been proven. ​ Investors who are covered by the lawsuit — those who owned the fund on Feb. 5, 2018 — have until July 4 to opt out of the proceeding.

The case has raised a broader issue with the regulation of ETFs.

As it certified the negligence claim, the court also rejected a claim for misrepresentation in the ETF’s prospectus disclosure. The court said the case exposed a problem with bringing misrepresentation claims against ETF providers, which “leaves the law about the Ontario Securities Act’s statutory causes of action about the distribution of ETFs in a problematic and uncertain state.”

In particular, the court found that, while there could be a claim against an ETF issuer for alleged misrepresentation in its disclosure to investors, it’s not possible to identify whether investors acquired newly issued “creation” units of an ETF (relying on prospectus disclosure) or units that were already trading in the secondary market.

“The paradox is that for purchasers of ETFs, it cannot be determined whether or not their ETF unit is a creation unit,” the court said. This makes it impossible to determine the group of investors with common issues.

The Ontario Superior Court of Justice noted that the Court of Appeal effectively ruled ETFs are a hybrid, with “creation” units and non-creation units falling under different parts of the existing securities law. As a result, a claim for misrepresentation can’t be brought as a class action, the court ruled.

“The problem for the regulation of ETFs is that this paradox is not confined to the immediate case,” the court noted. “The class members must thus rely on a common law negligence claim which takes the matter outside the Ontario Securities Act. This is a problem worth the attention of the Ontario Securities Commission or the legislature.”

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.