Hands in the air for questions

Silence is usually golden. But for unitholders trapped in 11 Emerge ETFs for more than eight months last year, the silence from the issuer and regulators has been leaden.

“Hopefully the regulators next time round have a better process, because their timing was questionable for a lot of investors,” said Pat Dunwoody, executive director of the Canadian ETF Association (CETFA).

“Money is such an emotional and sensitive topic, and so when it’s trapped, that is an example where I feel communication needs to be clearer,” said Karl Cheong, an investor and former ETF industry executive in Toronto.

Cheong and Dunwoody acknowledged the regulators were dealing with an unprecedented situation — but like many ETF professionals, they would like the industry to learn from last year’s missteps.

The public was first alerted to a problem on April 6, 2023, when the Ontario Securities Commission (OSC) placed an entire family of ETFs under a cease-trade order (CTO) for the first time. The order occurred after Emerge Canada Inc. missed its deadline to file audited annual financial statements, which happened because BDO LLP, Emerge’s auditor, quit in November 2022 and hadn’t been replaced.

Investment Executive reported a week later that Emerge’s six ARK ETFs were owed more than $2.5 million in receivables from Emerge as of June 30, 2022 — an amount that had grown more than fivefold over the preceding two-and-a-half years.

On May 11, 2023, the OSC suspended Emerge Canada’s registration for capital deficiency, sharing that the receivable had grown to $5.5 million. The OSC also stated that Emerge was likely capital-deficient at some point prior to Sept. 30, 2022, and ordered Emerge to wind down its funds.

That was the last official update from the regulator. JP Vecsi, senior public affairs specialist with the OSC, told Investment Executive about six months into the CTO that it was Emerge Canada’s statutory duty to share further details.

On Monday, Vecsi shared additional context about the scant communications that did come from the firm: “During our oversight of Emerge, we ensured that it kept the funds’ investors informed about the CTO and the subsequent termination of the funds through various means, including press releases, investor letters, requiring it to actively maintain [its] website with a prominent page for investor questions on the wind-up and trading restrictions, as well as monitoring whether it was responding to investor questions,” he said in an email.

Details eventually came from Emerge Canada on Oct. 19, when it announced all 11 ETFs would be terminated by the end of the year and the proceeds returned to unitholders.

The funds were liquidated by Oct. 31, with the proceeds held in cash until the funds were terminated at the end of the year. That meant unitholders missed the spectacular technology run-up that followed: Cathie Wood’s ARK Innovation ETF, upon which the flagship Emerge ETF is based, returned 31.1% in November following three straight months of losses.

Emerge managed to shave more than $800,000 from the receivable between May and December. However, $4.7 million remained outstanding as of Dec. 29. The ETFs were terminated that day and the unitholders became unsecured creditors of Emerge Canada.

On Monday, Vecsi said: “There is an active and ongoing investigation into Emerge Canada, but [we] cannot provide any further details at this time.”

Emerge Canada has not released any further information about the receivable’s status, and a lawyer for the firm did not respond to requests for comment.

Emerge Canada also is the subject of a proposed class action being brought by Kalloghlian Myers LLP in Toronto, alleging that unitholders suffered damages because of Emerge’s misconduct and the CTO. The class action has not been certified.

Searching for answers

Amid last year’s prolonged radio silence, many of Emerge’s unitholders took to Reddit asking when they would regain access to their investments and commiserating about their bad luck. Other investors resorted to giving one-star Google reviews of Emerge Canada’s Toronto location.

As frustration grew, some DIY investors admitted to overexuberance about the Emerge ARK funds’ technology-focused strategies. A more common refrain, and one echoed by the unitholders we spoke to during our reporting, was that investors would stick with the largest ETF providers in future, or stop investing in ETFs altogether.

But Mary Hagerman, senior portfolio manager and investment advisor with Raymond James Ltd. in Montreal, said the Emerge situation was “extremely unfortunate and very exceptional,” and emphasized the importance of doing due diligence on new products in general.

Tiffany Zhang, vice-president of ETFs and financial products research with National Bank Financial in Toronto, said in an email that the situation should not influence how people view Canada’s ETF industry.

“The Emerge case shouldn’t act as a roadblock to innovative ideas being brought forward to the marketplace, and it shouldn’t discourage investors from checking out the unique products put forward by smaller providers,” Zhang said. “ETF issuers big and small are essential parts of the innovation ecosystem.”

Like Hagerman, she stressed that Emerge’s issues were not ETF-specific.

“The cease-trade order and subsequent regulatory action would have happened to any fund company that failed to comply with minimum working capital requirements and annual audited financial statement deadlines,” Zhang said, adding that the OSC’s regulatory action was an example of the system working as intended.

During the CTO, Dunwoody said CETFA’s board discussed the Emerge situation and reached out to non-members to check if they had questions. But she said the association did not hear much from the public.

“I had one phone call from a [DIY Emerge unitholder], and it was to help them interpret their brokerage statement,” Dunwoody said.

Emerge Canada was a CETFA member, and “they were very slow in paying their fees, and so we have changed that process,” Dunwoody said. “We are very diligent now in following up and getting payment sooner than later.”

In addition to that change, Dunwoody said the association has added questions to its membership application forms to learn more about firms before they join, and is developing a list of prohibited activities for members so violators can be quickly removed.

Hidden in plain sight?

Clues to Emerge’s extensive money challenges were available in their ETFs’ financial statements.

Those statements showed that Emerge Canada owed its ARK ETFs $486,442 as of Dec. 31, 2019 — an amount that ballooned more than tenfold to $5.5 million by May 2023. Analysis of similar-sized fund managers and from industry experts showed this to be an unusual and concerning practice.

In May 2023, the OSC revealed the receivable was so large because Emerge’s U.S. sister company, Buffalo, N.Y.–based Emerge Capital Management Inc., owed Emerge Canada millions of dollars. Emerge Canada and Emerge Capital Management are both owned and were founded by Lisa Lake Langley.

Both Emerge Canada and Emerge Capital Management stopped paying employees in December 2022. Some former employees have since commenced legal action for unpaid wages.

Emerge then resorted to borrowing from its employees to stay afloat. Three employees of Emerge Canada lent Emerge Capital Management US$199,763.24 on Jan. 5, 2023, at 25% interest and with the promise that the loan would be converted to equity. Legal action in New York State alleges the outstanding loan is overdue.

Emerge Canada also had trouble paying for its Toronto office space. In November 2023, a default judgment from the Ontario Superior Court of Justice ordered Emerge to pay more $112,000 in arrears and interest to its former landlord.

Dan Hallett, vice-president of research and principal with HighView Financial Group in Oakville, Ont., said regulators will probably be more sensitive to an issuer’s financial state in the future.

Securities regulations dictate that a registered investment fund manager must have at least $100,000 in working capital, a figure the OSC said Emerge probably fell short of prior to Sept. 30, 2022 — six months before the CTO.

“Firms are required to know their excess working capital at all times. This may require a firm to calculate its working capital every day,” the OSC states in a guide to financial filing requirements.

“While I can’t speculate on future process changes, registered investment fund managers are currently required by NI 31-103 to submit their financial statements and calculations of excess working capital to the OSC every three months, and these records are reviewed by a team of financial analysts and accountants,” Vecsi said, replying to a question asking whether the OSC would change its oversight of working capital in response to the Emerge situation.

A firm must notify the OSC as soon as its excess working capital falls below zero, and the amount cannot be less than zero for two consecutive days. The regulator can impose terms and conditions on firms that do not meet their capital requirements.

“The OSC will take further regulatory action on firms that are unable to rectify a capital deficiency on a timely basis, including suspension of their registration,” Vecsi said.

Emerge Canada’s working capital calculations were complicated by the inclusion of two questionable line items: the money it was owed by its U.S. sister firm, as well as 1.5 million DIGau crypto tokens.

The OSC’s guide states that related-party receivables often cannot be easily converted into cash, and should usually be deducted from working capital calculations. Further, the OSC requires fund managers to discount or exclude the value of risky securities, such as cryptoassets.

The OSC’s May 2023 decision said Emerge Canada shouldn’t have included the U.S. receivable or the crypto tokens in its calculations of working capital. However, even before excluding those items, Emerge had an excess working capital deficiency of $1.5 million as of Mar. 31, 2023.

Private companies aren’t required to publicly disclose their working capital, and Hallett doesn’t believe they should have to. However, he said investors can go to the Canadian Securities Administrators’ national registration database to confirm whether a securities issuer has terms and conditions on its registration, for example due to capital deficiency.

Emerge Canada’s financial troubles stemmed in part from its ETFs’ low traction with investors. Canadian investors could purchase the U.S. versions of the ARK ETFs before the Emerge launches, and BMO Global Asset Management began offering versions of three ARK funds in November 2022.

“Although Emerge was the first to market here in Canada, it became very difficult to distinguish [from the U.S. version],” Cheong said. “The notoriety of the [ARK Innovation ETF] made things even more complicated. [In a way], you’re competing against your partners.”

The main fund, the Emerge ARK Global Disruptive Innovation ETF, had roughly $73.3 million in assets under management (AUM) between its Canadian- and U.S.-dollar versions as of April 12, 2023, a few days after the CTO. The next highest was the genomics and biotech fund with less than $13 million, and all the others were below $8 million in AUM.

Canadian manufacturers often consider $20 million to $50 million in AUM as the breakeven point for an ETF.

How to improve due diligence

Hagerman and Hallett said the Emerge situation hasn’t changed their due diligence processes, but it has reminded them of the fundamentals.

Hallett’s process always involves looking at a fund’s financials statements, “but I think it’s raised awareness for everybody of this rare but obviously very important issue,” he said, referring to the presence of a receivable from the fund manager.

He also recommends advisors build a strong due-diligence methodology and then use it repeatedly. “You keep following the same process because that’s how you catch things; that’s how you get more insight into things,” Hallett said.

Hagerman, who wrote a column about assessing new ETFs for Investment Executive in the wake of the Emerge CTO, recommends observing how a fund has performed through a market cycle before investing. “You could get into thematic investing when the theme is doing well,” she said. “But when things go out of favour, there can be outflows, and what happens to the product?”

She also suggests speaking to an issuer’s competitors. “A competitor may have a slanted view,” Hagerman said, “but they also may be further down the due diligence road because they have to explain why their product is better.”

How issuers interact with unitholders is another telltale sign.

“Investors should seek out firms that prioritize transparent and frequent communication,” Cheong said. “Understanding how an investment firm communicates with its investors during both good times and periods of difficulty can provide insights into its management practices and investor relations.”

Read about options for bolstering trust in the Canadian ETF industry.