United States: Massachusetts Supreme Judicial Court Takes Expansive View Of Investment Advisor's Liability Under Blue Sky Law In Hays V. Ellrich

Last Updated: June 17 2015
Article by Chip Phinney

Last week, the Massachusetts Supreme Judicial Court (SJC) handed down Hays v. Ellrich, a decision with important implications for the investor advising community. The case is significant for two reasons. First, even though the defendant advisor did not earn a commission or any other direct compensation for the plaintiff's investment in a hedge fund, the SJC held the advisor liable as a "seller" under the Massachusetts Uniform Securities Act, M.G.L. c. 110A, § 410(a)(2). Second, despite extensive risk factor language in the hedge fund prospectus and many other "storm warnings," the SJC held that the statute of limitations on the plaintiff's Massachusetts Securities Act claim was not triggered until she had actual knowledge that this investment was unsuitable for her.

The plaintiff, Hays, was an unsophisticated investor who had relied on the defendants, Ellrich and his company Morgan Financial Advisors (MFA), to advise her since 1993. In 2000, Ellrich became the investment advisor for a new hedge fund, Convergent Market Funds, and he stopped offering advisory services to individual clients such as Hays. At Ellrich's invitation, Hays then transferred all of the funds she had previously invested through him to Convergent, with disastrous results—the fund failed in 2003 and Hays lost her entire investment. She then sued Ellrich and MFA under the Massachusetts Securities Act, among other claims, alleging that Ellrich did not adequately discuss with her the risks of a hedge fund or whether it would be a suitable investment. After a jury-waived trial, the trial judge found in favor of the plaintiff and awarded her judgment for the amount of her original investment, plus interest.

On appeal, the defendants argued they were not "sellers" of securities under M.G.L. c. 110A, § 410(a)(2). Under this statute (following cases interpreting its federal analogue, Section 12(a)(2) of the Securities Act of 1933), a person who successfully solicits a purchase motivated in part by a desire to serve his own financial interests, or those of the securities owner, will be deemed a seller. In this case, however, Ellrich did not receive any commission or other compensation for Hays' investment in Convergent. Moreover, the rate he earned as Convergent's advisor (1.25% of total assets) was less than the rate he had previously earned for advising Hays directly (1.75% of her retirement funds), so that effectively he earned less from Hays' investment. The SJC nevertheless upheld the trial court's conclusion that defendants were "sellers" of securities, because Ellrich was motivated at least in part by the potential for a long-term increase in his investment advisory fees if he could raise the funds necessary to launch Convergent. Writing for the Court, Chief Justice Gants stated that "we agree with the 'many courts [that] have taken a more expansive view of financial gain that includes increased compensation tied to share price or company performance'" – or, it appears, the prospect of raising additional assets to manage.

The defendants also argued on appeal that the plaintiff's Massachusetts Securities Act claim, filed in 2006, was barred by the applicable four-year statute of limitations because the Convergent prospectus had put the plaintiff on "inquiry notice" as of December 2000 that it was an unsuitable investment for her.  In making this argument, the defendants cited an earlier SJC decision, Marram v. Kobrick Offshore Fund, Ltd., 442 Mass. 43 (2004), where the Court had noted that "[t]he plaintiff is on inquiry notice from the time a reasonable investor would have noticed something was 'amiss,' e.g., when he obtained a prospectus."  Id. at 54, n.20 (citing Kennedy v. Josephthal & Co., 814 F.2d 789, 802-803 (1st Cir. 1987)).  The SJC distinguished Marram, however, on the ground that in that case the defendant who solicited the plaintiff to invest in his hedge fund did not owe the plaintiff a fiduciary duty.  By contrast, the SJC said, Ellrich owed Hays a fiduciary duty as her investment advisor both when she invested in Convergent and thereafter, since he did not adequately explain that he would no longer be considering her individual needs in making investment decisions for Convergent.

In light of this fiduciary relationship, the SJC applied an "actual knowledge" test to determine when the statute of limitations should begin to run, rather than the "inquiry notice" standard. The Court held that

"where an investment advisor owes a fiduciary duty of disclosure to his or her client and violates the [Massachusetts Securities Act] by misleading the client regarding the suitability of an investment, Massachusetts law deems it fraudulent concealment for the fiduciary to fail to reveal to the client that the investment was not suitable, and the limitations clock begins to run only when the client has actual knowledge of the unsuitability of the investment."

The Court concluded that neither the risk warnings in the Convergent prospectus, nor a subsequent 17 percent drop in the value of her Convergent investment in the first five months of 2001, were sufficient to give rise to such actual knowledge for the plaintiff. The SJC ruled that the plaintiff's claim was timely because she did not gain this actual knowledge until September 2003, when she learned that she had lost her entire investment in Convergent.

In adopting this "actual knowledge" test to determine when the limitations period began to run on the plaintiff's Massachusetts Securities Act claim, the SJC declined to follow federal securities cases addressing fraudulent concealment. The Court noted that even where the plaintiff investor is unsophisticated and has a fiduciary relationship with the defendant advisor, federal courts have asked whether there were sufficient "storm warnings" to alert a reasonable person to the possibility that the securities transaction involved misleading statements or omissions, and whether the plaintiff actually exercised reasonable diligence in light of those storm warnings. Instead, the SJC concluded that the "actual knowledge" standard is more appropriate where there is a fiduciary relationship between the investor and the advisor. The Court observed that unsophisticated investors may not recognize storm warnings in an investment prospectus, and expecting them to make an independent inquiry into the fiduciary's trustworthiness would be contrary to the relationship of trust in a fiduciary relationship. Notwithstanding the fact that the Massachusetts Securities Act directs courts to coordinate its interpretation with federal law, see M.G.L. c. 110A, § 415, the SJC further concluded that the generous limitations period provided in the Massachusetts Securities Act, in contrast with the stricter time limits for bringing a claim under Section 12(a)(2) of the federal Securities Act of 1933, indicates that the Massachusetts legislature did not expect them to be treated exactly the same.

Although the facts of Hays v. Ellrich are somewhat unusual, the case offers important warnings for investment advisors. First, even the prospect of future indirect compensation may render advisors liable as "sellers" under the Massachusetts Securities Act when they solicit an investment. Second, even extensive risk factor language and other warnings in a prospectus or substantial losses in the investment may be insufficient to start the statute of limitations clock on a Massachusetts Securities Act claim, if the investor is relying on the advisor and the advisor fails to provide relevant information in a way that the investor can understand.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Chip Phinney
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions