By Amanda Maine, J.D.
A hedge fund adviser has filed a petition for a writ of certiorari to the U.S. Supreme Court, urging the reversal of Massachusetts state court holdings finding him liable for securities fraud. The adviser argued that those holdings created conflicts between state and federal laws regarding the fiduciary duty owed to investors in hedge funds and regarding the imposition of seller liability (Ellrich v. Hays, September 8, 2015).
Background. Molly Hays sued Morgan Financial Advisors, Inc. (MFA) and its sole owner and officer, David J. Ellrich, alleging violations of the antifraud provisions of the Massachusetts Uniform Securities Act (MUSA). Hays had worked with Ellrich as her investment adviser since 1993, investing mostly in registered mutual funds. In September 2000, MFA agreed to become an investment adviser to a private hedge fund called Convergent and signed an agreement with Convergent’s General Partner, Emerging Health Capital Partners, LLC (EHCP). Hays, acting on advice from Ellrich, transferred 75 percent of her retirement savings to Convergent. In 2003, Convergent became insolvent due to overstatements by Convergent’s qualified custodian, and Hays lost nearly all of her investment.
The trial judge found in favor of Hays. On appeal, the Massachusetts Supreme Judicial Court rejected Ellrich’s arguments, finding that: (1) Ellrich met MUSA’s definition of a “seller” of securities because he was motivated in part by the potential for personal financial gain, despite not receiving direct financial compensation; and (2) Hays’s claims were not barred by the statute of limitations.
Fiduciary duty. In his petition for a writ of certiorari to the U.S. Supreme Court, Ellrich argued that the Massachusetts court rulings imposed a fiduciary duty on federally-registered investment advisers that conflicts with their fiduciary duties under federal law. Specifically, Ellrich pointed out that the Investment Advisers Act requires that federally-registered investment advisers owe a fiduciary duty only to the hedge fund itself, and not individual shareholders, limited partners, or members of the fund. Ellrich also noted that federal law actually prohibits Ellrich and MFA from owing a fiduciary duty to Hays, observing that an adviser to a hedge fund could give conflicting advice to the fund and to the client. Advice to a fund about to go bankrupt would include taking all efforts to remain solvent, while advice to an investor in that fund would likely be to sell, he explained, citing Goldstein v. SEC (D.C. Cir. 2006).
According to Ellrich, the Massachusetts courts have created an “impossible, catch-22 type of situation” because federally-registered investment advisers now owe simultaneous undivided fiduciary duties to both their hedge fund clients and investors in those hedge funds, which is both legally impermissible and a duty with which the advisers cannot comply. He also claimed the decision was dangerous by setting a precedent where federally-registered advisers who have complied with federal requirements may still be liable for violations of state common law, which is contrary to the intent of Congress and the SEC.
Seller liability. Ellrich’s petition also contended that the Massachusetts courts erroneously imposed seller liability on him in conflict with federal law. Under Investment Advisers Act Section 206(3), an investment adviser will not be deemed to be acting as a broker (seller) when the adviser receives no compensation, other than its advisory fee, for effecting a particular transaction. Ellrich pointed out that he did not receive direct financial compensation as a result of Hays’s decision to invest in Convergent—EHCP solicited the sales of limited partner interests in Convergent, and neither Ellrich nor MFA had any control over EHCP. Without “direct compensation,” Ellrich is not a seller under federal law, he argued. By imposing seller liability on investment advisers who did not receive direct compensation, the Massachusetts courts created a new avenue of seller liability for individuals who “merely assist or participate in” a general partner’s solicitation of investments in a hedge fun, according to Ellrich.
The case is No. 15-300.