The Ontario court of appeal has rejected a bid from two mutual fund companies to have a class-action lawsuit against them shut down.

The firms — CI Mutual Funds Inc. and AIC Ltd., which was acquired by Manulife Financial Corp. in 2009 — claimed that they had already settled a regulatory case for the same conduct that is the subject of the class action. But in a decision handed down late last month, the court found that regardless of whether a firm has already faced a regulatory hearing and paid restitution to the funds’ unitholders, it may still have to answer for its actions in court.

The decision is “a huge step forward for investors,” says retired securities lawyer Glorianne Stromberg, formerly a commissioner with the Ontario Securities Commission. “It brings much-needed clarity to [class actions and regulatory proceedings].”

The case stems from the mutual fund market-timing scandal that came to light in 2003, which culminated in a series of settlements between the OSC and five fund-management companies in late 2004 and early 2005.

These settlements concern allegations that these firms allowed various institutional traders to market-time the firms’ funds, often trading after hours to take advantage of short-term price discrepancies that would occur in the firms’ foreign equities funds. As a result of those settlements, the mutual fund firms agreed to pay more than $200 million to unitholders of the funds that were used by the market-timers.

In 2006, a class-action lawsuit was filed against the five fund firms — I.G. Investment Management Ltd., CI, Franklin Templeton Investments Corp., AGF Funds Inc. and AIC — alleging breach of fiduciary duty and duty of care by the fund firms.

That lawsuit claimed that the losses suffered by unitholders were far greater than the amounts recovered in the settlements with the OSC. An expert affidavit filed by the plaintiffs in the case estimated the harm to unitholders from the market-timing activity in the funds to be worth $760 million. (It allowed that the figure could be as high as $831.9 million or as low as $301.1 million, using other calculation methods.)

Initially, the courts refused to certify that class action. The judge who originally ruled on the motion to certify the case as a class action found that the regulatory hearings had already given the unitholders access to justice, so a followup class-action lawsuit could not proceed, on the basis that the regulatory hearing represented the “preferable procedure.”

The unitholders appealed the ruling; while a decision in that appeal was pending, three of the five companies — AGF, I.G. and Franklin Templeton — settled with the OSC in late 2010, agreeing to pay $3.5 million, $2.8 million and $5 million, respectively, back to the affected funds (before 25% in lawyers’ fees). That left CI and AIC still in litigation.

Then, in January 2011, the Ontario Divisional Court sided with the unitholders, overturning the initial decision and allowing the class action to go ahead. The court found that the initial ruling was flawed, in that the class action is not seeking to recover the $205 million that has already been paid back to unitholders under the OSC settlement; it is seeking damages that the unitholders claim they suffered but weren’t recovered by the OSC.

“It cannot be said that the OSC process is a preferable procedure for recovering damages it failed to recover in the first place,” the Divisional Court’s ruling states, adding that there is no chance the regulator will seek further damages on behalf of the unitholders.

The motion judge treated the OSC’s $200-million recovery as a reasonable settlement of the plaintiffs’ claims, the Divisional Court ruled, but added: “Unless it can be said that the plaintiffs have achieved full or, at the very least, substantially full recovery, they are entitled to maintain this action.”

The Divisional Court calculated that unitholders’ claims against the two remaining defendants in the case go well beyond the amount recovered by the OSC. Using the calculation method put forward by the unitholders’ expert, that court said the unitholders’ claim against CI amounts to $349.3 million (far above the $49.3 million CI paid under the OSC settlement), and the claim against AIC works out to $192.6 million (vs AIC’s OSC settlement of $58.8 million).

Given that the unitholders’ claimed losses go well beyond what was recovered in the OSC settlement, the Divisional Court reversed the original decision and certified the class action.

The fund companies then appealed the Divisional Court’s ruling, again arguing that the dispute had already been resolved by the settlements with the OSC.

However, the Court of Appeal has sided with the unitholders, albeit for reasons different from those given by the Divisional Court judge. The appeal court ruled that the primary consideration in determining whether a class action is the “preferable procedure” is not whether the regulatory settlement was big enough; the critical factor is the regulatory nature of the OSC’s proceedings.

That decision notes that the OSC’s enforcement efforts are focused on protection and prevention, not on securing compensation for harmed investors — even though that’s what the OSC did in this case. As a result, the Court of Appeal said, the “remedial powers available to the OSC … are insufficient to enable it to fully address” the unitholders’ claims.

In addition, the decision points out that OSC proceedings don’t give investors a chance to participate in its hearings. There’s nothing wrong with that, the court stresses — it’s just not the purpose of a regulatory hearing.

Moreover, the Court of Appeal notes in its decision that the settlement agreements signed by the fund companies expressly contemplate that they could face civil lawsuits: “The OSC settlements simply resolved the proceedings taken by the OSC against the defendants. The settlements did not finally resolve the claims of the investors as against the defendants, nor did they purport to do so.”

As a result, the court dismissed the fund companies’ appeal and gave the class action the green light once again.

That decision could yet be appealed as well. But, for now, it appears that agreeing to return money to harmed investors in a regulatory proceeding is no assurance that companies won’t also have to face a civil lawsuit down the line.

Stromberg hopes that one of the effects of the Court of Appeal’s decision will be to speed up the certification of class actions. This decision clarifies that the existence of regulatory proceedings shouldn’t stand in the way of class actions, she says, and class actions shouldn’t be delayed until regulatory proceedings are completed before they can proceed.

From the regulators’ point of view, Stromberg says, the case highlights “how problematic settlements can be, and just how much can or should be … achieved through the settlement process.”

That aggrieved investors don’t have a voice at enforcement hearings of cases in which they are effectively the victims of industry wrongdoing has long been a source of frustration for those investors.

But the Court of Appeal’s ruling confirms that investors can still have their day in court regardless of regulators’ actions. IE