Did Fidelity cheat its own client out of millions of dollars?

As Peter Deutsch sat in his spacious lakeside getaway in upstate New York one steamy July morning, the last thing on his mind was relaxing. The wealthy wine merchant was on a risky mission. He'd decided to buy control of a troubled Chinese company and then float a rescue plan. To do that, he'd have to snap up at least 5 million shares of its thinly traded stock in a matter of days. It was either that or kiss goodbye the $40 million he'd already invested. With the waters of Lake George gently lapping onto his property, Mr. Deutsch turned to his iPad, opened his brokerage account, and tapped “buy.” Bingo. He picked up a few thousand shares. He tapped “buy” again. Nothing. Figuring it was a glitch, he reached for the phone. “What's going on, guys?” he recalls asking one of his reps at Fidelity Investments. “I'm putting through important trades here.” The rep, he says, didn't have a clue. Mr. Deutsch says his unease turned to shock later that day when he fielded a call from a Fidelity employee he'd never spoken with before. Mr. Deutsch remembers the man informing him that Fidelity was “uncomfortable” with his purchases of China Medical Technologies, a Beijing-based maker of cancer-treatment devices. Effective immediately, the man told Mr. Deutsch, he could no longer buy the stock. And with that, a hefty slice of his family's net worth was toast. The impasse with Fidelity in the summer of 2012 took Mr. Deutsch by surprise. The previous year, Fidelity Family Office Services, a unit of the second-largest mutual fund group in the U.S., had sent a sales team to woo Mr. Deutsch with tales of the bespoke services FFOS lavished on its ultrawealthy clients. Here he was, less than a year later, and he couldn't even make a trade. For Mr. Deutsch, 53, discovering the real reasons behind Fidelity's change of heart has become a consuming passion, along with fighting to be made whole again. The battle, details of which emerge in part from internal company e-mails and sworn testimony, which were all filed in federal court, has stretched from industry arbitration to the U.S. Department of the Treasury. Among the things Mr. Deutsch learned, according to papers he filed in the U.S. District Court for the Southern District of New York: While he was trying to gain control of China Medical, he had a formidable rival — Fidelity, the very firm whose family office he says had promised him seamless trade execution and conflict-free service. Fidelity, he alleges, was secretly buying the stock so aggressively that it drove up the price of China Medical's shares at a time when the brokerage was supposed to be helping him build his stake. What's more, he says, even as FFOS was making nice, another part of Fidelity was using his shares against his wishes for its benefit — and then it stopped him from trading to cover up its own misdeeds. Mr. Deutsch is seeking as much as $400 million to $500 million in damages from Fidelity in arbitration before the Financial Industry Regulatory Authority. The amount is what Deutsch claims he could have earned if Fidelity hadn't prevented him from reaching his goal of a 66% stake in a company he'd already poured tens of millions of dollars into. Fidelity is contesting the claims. The firm says it prevented Mr. Deutsch from trading out of concern he was trying to illegally manipulate China Medical shares, according to documents entered into court and people familiar with the company's views. Fidelity took the case to federal court last year in an attempt to hold onto documents it said were protected by the Bank Secrecy Act; Mr. Deutsch had sought the paperwork to use in the Finra arbitration. The court battle ended last September after the judge ordered Fidelity to turn most of the documents over to Mr. Deutsch. As of early April, the arbitration is ongoing. “While it's our practice not to discuss ongoing litigation, we strongly and completely refute the assertions made by the plaintiffs in this matter,” says Fidelity spokesman Adam Banker. “This suit is entirely without merit, and we are vigorously defending against it.” To some Fidelity executives, however, the blowup between Mr. Deutsch and the company didn't come as a shock. David Whitlock, a senior Fidelity compliance official, saw trouble ahead when he learned, two days after the fact, that the firm had cut Mr. Deutsch off. “It won't surprise me if this ends up a nice big legal mess involving them, his adviser, the company, the SEC, and the firm for the next few years,” he wrote to colleagues in an e-mail that was filed in court. CAUTIONARY TALE The Deutsch-Fidelity saga is a cautionary tale. It shines a harsh light on the perils clients can face as financial behemoths seek to manage competing interests within their own ranks. And it underscores the risks that countless investors, drawn to the allure of all things Chinese, take while pursuing opportunities in its quickly growing economy. Mr. Deutsch's investment in China Medical might have sunk to zero no matter how his brokerage had behaved. The affair also raises questions about the methods Fidelity used to build a sizable business lending out shares its clients own outright — a practice known as “fully paid lending.” Mr. Deutsch claims he was a victim of inappropriate share lending. For its part, Fidelity, the largest player in the fully paid share-lending business, says it didn't lend out Mr. Deutsch's shares under its fully paid lending program but rather under the authority it says it has to lend shares out of a client's margin account, according to people familiar with the company's views. “We have strong and thorough control and compliance processes in place for all aspects of our business, including securities lending,” says Fidelity's Banker. “Clients who choose to open a margin account sign margin agreements that consent to securities lending.” The athletically built Mr. Deutsch grew up in the suburbs north of Manhattan. Mathematically inclined from an early age, he attended Franklin & Marshall College in Pennsylvania, where the 6-foot-3 power forward led the basketball team in scoring for two seasons. After graduating in 1984 with a degree in accounting, he joined the wine-importing business his father, Bill, also an accountant, had set up in their home in 1981. Together they mounted an assault on wine snobbery, building Deutsch Family Wine & Spirits into one of the country's largest importers over the next two decades. In the process they introduced Americans to Beaujolais Nouveau from France and for a time turned Australia's Yellow Tail, with its memorable kangaroo label, into the top-selling imported wine in the U.S. The business, now headquartered in White Plains, N.Y., provided Peter, a divorced father of three, with the means to indulge his appetite for investing. He's a guarded man in some ways; he's loath to say much about his lake home, for example. But he's not shy about his appetite for aggressive investments. Mr. Deutsch's path to Fidelity began with Tom Steffanci Jr., the wine company's president, who introduced him to AER Advisors of North Hampton, N.H. The firm, run by the husband-and-wife team of David and Carol O'Leary, originally came to the Deutsches to discuss currency-risk hedging for the wine business. David, a chartered financial analyst, had worked at Fidelity until 1994, when he left and set up Alpha Equity Research, which provided investment research to his old employer and others. It eventually evolved into investment adviser AER. Peter Deutsch became a client and fan. He even did some investing on his own using AER's trading models. With them, he bet millions, buying Direxion triple-leveraged and inverse ETFs via a Fidelity brokerage account he'd had since 2000. By late 2011 he'd pocketed more than $60 million, according to him and David O'Leary. Mr. Deutsch says his investment activity caught the eye of a Fidelity representative, who connected him with FFOS. In October 2011, FFOS sent half a dozen employees to meet with Mr. Deutsch near his Connecticut home. As part of Fidelity, FFOS can offer a range of big-bank services, such as securities research and trust management. “One of their missions is to leverage the technology and resources of Fidelity,” says Greg Kushner, founder of Beverly Hills-based Lido Consulting, which manages and advises family offices. “They've used it to build a pretty substantial mix of clients across the country.” And yet, FFOS, the brainchild of Fidelity founder Ned Johnson, is a far cry from the private-banking world of walnut paneling and bone china. Located in Boston's trendy Seaport district, the division has a distinct startup vibe; it's a world apart from Fidelity's headquarters downtown, a few blocks away. A promotional video on YouTube shows employees celebrating excellence on the job by tossing toy fish to one another. A tieless Jeff Bezanson, vice president of Relationship Management, who became Mr. Deutsch's rep, says in the video that when on the phone, customers relish the blast of a bullhorn the sales staff uses to mark “a good client experience.” (Fidelity declined to make Mr. Bezanson or other employees available.) As Mr. Deutsch recalls, FFOS offered to welcome him and his money into what was then an elite constellation of 300 families worth a total of $30 billion. An FFOS brochure says it provides clients with the chance to network with other “families of wealth” and enjoy “a conflict-free client service model in which we put our clients' interests first.” The pitch, Mr. Deutsch says, aligned nicely with the way he and his father had done business with winemaking families around the world. “I left Fidelity that day feeling like I'd found a new family partner,” says Mr. Deutsch, whose family eventually had at least $155 million at the firm. Mr. Deutsch would need all the goodwill and advice he could get. At about the time FFOS was wooing Mr. Deutsch, Mr. O'Leary — who remained his investment adviser — got him interested in a new strategy. The wild China boom that, among other things, brought hundreds of Chinese stock listings to the U.S. had also led to a spate of outright frauds. Investors fled the sector. Valuations plummeted. Still, Mr. O'Leary believed quality stocks had gotten crushed along with junk ones. He compiled a list of a dozen beaten-down companies, some trading for as little as one times earnings, that an investor could ride back to health. Mr. O'Leary dubbed his strategy China Gold. CHINA MEDICAL Among the most promising-looking nuggets was China Medical. After all, General Electric had owned 20% of the firm when UBS took it public on Nasdaq in 2005. In August 2011, Mr. O'Leary wrote investors that China Medical stood apart from “Chinese frauds.” It was blessed with a first-tier auditor, PwC, and not sullied by insider selling. Within months, however, it became clear China Medical had its own problems. That December it defaulted on a bond-interest payment. Also in December, Glaucus Research Group, a California-based short seller, issued a report saying it believed the company had “defrauded investors,” in part by using sham acquisitions to “embezzle” tens of millions of dollars. Mr. Deutsch and Mr. O'Leary say they took a hard look at the Glaucus report as well as a point-by-point response from China Medical's management. (Glaucus says it stands by its research.) The two men remained confident the stock would ultimately be proven worth $30 per share, roughly 10 times its recent trading range. Its business apparently remained robust, and the $200 million in cash on its balance sheet was double its market value. Others saw value, too. In January 2012, Barclays recommended that investors “overweight” the stock. It described China Medical as “one of our top picks” and “a premium domestic player in the protected China medical diagnostics space, with a 70 percent potential upside.” Mr. Deutsch decided to continue accumulating shares. In 2010 two Chinese health-care companies, BMP Sunstone and Tongjitang Chinese Medicines, had gone private at significant premiums. If Mr. Deutsch was right that China Medical shares had a fair market value of $30, the whole company could bring in close to $1 billion in an outright sale. Not everybody agreed. John Hempton, an Australian short seller, says he cautioned the Deutsches in a letter back in September 2011 that AER might be leading them astray, only to hear from a lawyer. “I got back, via overnight international courier at a cost of about $300, a letter threatening to sue me” if he contacted the Deutsches again, Mr. Hempton says. Then, in February 2012, Nasdaq stopped trading China Medical, which moved to OTC Link ATS. OTC Link doesn't have listing requirements, and, as opposed to trading listed stocks, investors often must pay for OTC shares in cash — and in full. At the time China Medical started trading on OTC Link, Bill and Peter Deutsch owned 4.4 million shares, representing a 13 percent stake in the company. Fidelity soon identified Mr. Deutsch as a promising supplier of shares for its fully paid lending business. On March 5, five days after China Medical moved to OTC, Amanda Topping of FFOS e-mailed Mr. O'Leary with an offer: “Fully Paid Lending Opportunity—CMEDY,” the subject line said, referencing China Medical's ticker. Topping inquired if Peter Deutsch would be interested in letting Fidelity loan out his shares. Securities lending is a $22 billion global business, according to Finadium, a consultancy. It entails brokerages borrowing securities from clients' accounts and lending them out, for a fee, to short sellers. At least some of Mr. Deutsch's China Medical shares qualified as “fully paid.” Topping's e-mail said Fidelity was willing to pay the Deutsches the equivalent of more than 7% annually to borrow shares. O'Leary rang Deutsch, who said he didn't like the idea of arming short sellers. “I asked David, 'Why would it be in my interest to lend out the stock?'  ” Mr. Deutsch recalls. “He said, 'It wouldn't be.'  ” An hour after receiving Topping's e-mail, Mr. O'Leary replied, according to an e-mail entered in court: “Client is not interested in lending stock. Thx.” What Mr. Deutsch was interested in was finding a buyer to take China Medical private. By June 12, 2012, he and his father, Bill, now 79, had increased their holdings to 11.9 million shares, or 37% of the company. That day, AER made a filing on their behalf that the U.S. Securities and Exchange Commission periodically requires of owners of 5% or more of a stock. It served notice that the Deutsches “may suggest or take a position with respect to potential changes in the operations or strategy of the Issuer, such as disposing of one or more businesses or assets.” (The timing of when the Deutsches took their activist position was amended in a later filing.) As Carol O'Leary was preparing the filing, she says, she was surprised to discover that short sellers had managed to borrow 5 million shares of China Medical. The brokerages had to be getting them from somewhere, and she suspected they'd come from the Deutsches. But AER had already told Fidelity the Deutsches weren't interested in lending their shares. “Had Fidelity gone ahead anyway?” Mr. O'Leary wondered. She says she e-mailed Mark Driscoll, AER's rep at Fidelity Institutional Wealth Services, on June 12, the same day AER made the SEC filing: “I would like to know how much of our CMEDY stock has been lent out to short sellers.” Ms. Driscoll, usually quick to respond, she says, replied several hours later that he wasn't at liberty to discuss China Medical. As it turns out, Fidelity was already in a bind over the stock, according to court documents. Its predicament was that, in preparation for AER's SEC filing, Mr. Deutsch had moved a large block of shares from a personal account with a large margin balance to an AER-run account with a small margin balance. Mr. Deutsch's transfer had slashed Fidelity's calculation of what it was permitted to lend from his margin account by more than 70%, company records entered in court indicate. Fidelity suddenly had 1.25 million more of Deutsch's shares on loan than SEC regulations permitted. If it didn't get them back fast, it would run afoul of regulations meant to prevent naked short selling. On June 13, Fidelity's lending desk began sending other firms “recall” notices indicating it wanted back 1.8 million shares. By the 15th, it had received only 377,000. That same day, Ugyen Sass, a Fidelity Capital Markets vice president involved in securities lending, cautioned a compliance colleague that the firm had supplied 30% of all China Medical shares on loan, an e-mail entered in court says. Since its recall effort had largely failed, it would now have to go into the open market and buy 1.2 million shares. The process was likely to be “disruptive,” meaning it could send the price skyrocketing, according to an e-mail and testimony entered in court. WARNING SIGNS Also that day, China Medical's creditors warned in court in the Cayman Islands, where the company was incorporated, that they intended to force it into liquidation within a month if they didn't get paid. Mr. Deutsch says he believed his best bet was to buy a controlling 66% stake and then find a buyer whose offer provided creditors with more than they were likely to get in bankruptcy court. But even if Mr. Deutsch raised his stake to 66%, Mr. O'Leary warned him, he wouldn't be able to vote any shares that Fidelity had loaned out. To be safe, he advised Mr. Deutsch to move his shares to a cash account, where lending is forbidden. On the morning of the following Monday, June 18, Mr. Deutsch told Fidelity to move his shares. That afternoon, FFOS's Topping called and confirmed what Carol O'Leary had suspected: Fidelity's lending desk was lending out Mr. Deutsch's shares, a call transcript entered into federal court indicates; Topping made no mention of possible repurchases. Over the next seven days, as Mr. Deutsch was trying to gain control of China Medical, his own brokerage — unbeknown to him — was competing against him, buying just shy of the 1.2 million shares Fidelity's Mr. Sass had predicted it would need, according to company records entered into court. Between June 18, the day before Fidelity began repurchasing shares in the open market, and June 27, China Medical's price nearly tripled, to $12, trading records compiled by Bloomberg show. Two days later, the SEC imposed a two-week halt on trading due to concerns about the accuracy of China Medical's financial statements and the status of its officers and directors. Mr. Deutsch didn't know it in the days leading up to the reality-check moment at his lake house, but his personal investment world had changed dramatically. Fidelity Capital Markets officials had kept not only Mr. Deutsch but also FFOS in the dark about the brokerage's role in creating the share price spike that immediately preceded the June 29 trading halt, according to e-mail and testimony of Fidelity executives entered into court. As far as he knew, Mr. Deutsch remained one of the company's most valued customers. Indeed, that very week, FFOS wined and dined him and other clients aboard a luxury yacht in Newport, R.I., as they watched the America's Cup World Series sailing competition, an event sponsored by Fidelity Investments. Mr. Deutsch remembers FFOS's Mr. Bezanson telling him on the yacht how his family-office colleagues had broken into a standing ovation to celebrate his gains when China Medical spiked above $10. Mr. Bezanson's team hadn't been told that their parent company had contributed to the price spike just as Mr. Deutsch was trying to amass shares as cheaply as possible, according to sworn testimony and a July 2, 2012, e-mail that surfaced in the court case. Brian Losier, a Fidelity capital markets executive, e-mailed Sass in the share-lending unit, saying Fidelity hadn't told FFOS of the China Medical stock repurchases while they were under way, nor had it informed clients. “Deutsche [sic]/AER,” the e-mail states, was “active in the name [meaning China Medical] while we were buying in so didn't want to broadcast buyin impact.” On June 27, the same day the brokerage ended its buy-ins and China Medical's stock peaked, David Richardson, a Fidelity compliance official, e-mailed a colleague the results of a trading review. He said his research was prompted by an e-mail from Mr. Sass a dozen days earlier warning of “unusual activity.” Mr. Richardson noted that Fidelity's purchase of 1.2 million shares “contributed to the short squeeze.” He also wrote that market rumors about what was behind the aggressive buying by AER and Mr. Deutsch ran the gamut, from “allegedly artificial stock inflation” to tax planning. The following day, Fidelity circulated an internal report among compliance, market surveillance, and anti-money-laundering executives. Written by Christopher Janes, a senior risk manager, it noted that “at this time, there appears to be a legitimate reason for the client's trading. The customer has not sold, and it would not benefit him to drive up the price while he is continuing to purchase shares.” (Janes later changed his view in light of additional information, a person familiar with the matter says.) A few Fidelity executives said in e-mails that the firm should reach out to Mr. Deutsch. Instead, it held a call with David O'Leary on July 10, while China Medical trading was still halted, documents reviewed by Bloomberg indicate. Mr. O'Leary explained his China Gold strategy and his view that the firm was worth $30 per share, according to Mr. O'Leary and records of the conversation. “Peter Deutsch—did not want shorts to borrow the stock. Moved all from margin to cash,” Fidelity call notes reviewed by Bloomberg say. Mr. O'Leary says he had no inkling then that Fidelity was concerned about Mr. Deutsch's trading or about to cut them off. Likewise, Mr. Deutsch says Fidelity gave him no indication that it had any such concerns until Monday, July 16, the day China Medical resumed trading — and Mr. Deutsch tapped the “buy” button on his iPad and got zilch. He says Fidelity, which at least one employee believed may still have needed 300,000 shares itself, did tell him he could sell. Exactly what actions, if any, Fidelity may have taken at the time against Mr. Deutsch or AER remain unclear. Fidelity court filings state that it is barred by law from confirming or denying whether it filed a Suspicious Activity Report with Treasury flagging Mr. Deutsch or anyone else. AER did ultimately receive four SEC subpoenas and an on-site audit by New Hampshire securities officials. Regulators took no further action against AER. Mr. O'Leary is closing his firm but continues to talk frequently with Mr. Deutsch about investing. Shortly after Fidelity stopped him from trading China Medical shares, Mr. Deutsch initiated his Finra arbitration. Almost two years later, on July 8, 2014, Fidelity sought during arbitration to protect its documents under the Bank Secrecy Act. (Fidelity went to federal court in 2015 seeking the same protection because it takes seriously a law that helps “protect against money laundering, tax evasion and other illegal financial activity,” according to spokesman Banker.) A month later, in August 2014, China Medical filed for bankruptcy protection in Manhattan, listing $426 million in senior convertible debt. Efforts to reach the company in China were unsuccessful. Mr. Deutsch himself is undaunted. While he's moved his brokerage account from Fidelity to Charles Schwab, his keenness for aggressive investing remains intact. So does his willingness to live with the consequences if his investments blow up, he says. But he staunchly rejects the notion that China Medical was a bad bet, and he's spending a small fortune to prove Fidelity is at fault. Reflecting on everything he should have known but didn't during his pursuit of China Gold, Mr. Deutsch ruefully remembers a scene in the FFOS fish-tossing video. At one point, the camera settles on FFOS President Ed Orazem, who says, “The most incredible things happen when you're not looking.”