Justice scales and gavel by books

Almost 20 years since harmful market-timing trading in mutual funds was first exposed by U.S. authorities, an Ontario court has found that fund managers breached their duties to investors when they failed to prevent market-timing trading by allowing hedge funds to use their funds to engage in the practice.

In the fall of 2003, New York’s attorney general brought the first enforcement action alleging that mutual fund companies were allowing hedge funds to use their funds in arbitrage trading that harmed long-term investors in those same mutual funds. That discovery led to a series of regulatory investigations and enforcement actions in both the U.S. and Canada.

Later, a class action was filed against the five major fund managers that had reached settlements with the Ontario Securities Commission over the practice — IG Investment Management Ltd., CI Mutual Funds Inc., Franklin Templeton Investments Corp., AGF Funds Inc. and AIC Ltd. Three of those five firms have since settled.

This week, Ontario’s Superior Court of Justice ruled that the other two, CI Mutual Funds and AIC, breached their duty of care to prevent market timing in their funds.

“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 decision said.

The harm that frequent trading causes long-term unitholders “has been known for decades,” it added.

While the mutual funds’ prospectuses warned about the harm from frequent trading and threatened 2% fees to prevent it, “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%,” the court noted.

According to the court’s ruling, the firms argued they weren’t aware that the frequent traders were engaged in “time zone arbitrage.”

However, the court found that the specific form of market timing didn’t matter — it was the frequent trading that harmed long-term investors.

“Had the defendants taken steps to prevent or prohibit frequent trading, they would have prevented time zone arbitrage as well,” it said.

At the same time, the court ruled that while the fund firms were negligent, they did not breach their fiduciary duties to investors.

“I do not find that their negligence rises to a breach of honesty or good faith,” the court said in its decision.

“The defendants may have acted with considerable hubris in thinking that their own ‘knowledge’ of the market was superior to that of experienced, sophisticated hedge funds. They acted with a lack of knowledge that fell below the standards of care in failing to recognize the dangers of frequent short-term trading. They acted with carelessness in failing to understand what the frequent traders were telling them. They acted negligently in failing to examine past or current trading records to test their random walk thesis, but I am not persuaded that they acted in breach of their fiduciary duties,” it said.

Based on the finding that the companies breached their duties of care, however, the court directed the case to proceed to a trial to determine investors’ damages.