Written by Chip Phinney and Josh Browning
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.