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, 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. Deutsch’s transfer had slashed Fidelity’s calculation of what it was permitted to lend from his margin account by more than 70 percent, 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 percent 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.
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. Deutsch says he believed his best bet was to buy a controlling 66 percent stake and then find a buyer whose offer provided creditors with more than they were likely to get in bankruptcy court. But even if Deutsch raised his stake to 66 percent, O’Leary warned him, he wouldn’t be able to vote any shares that Fidelity had loaned out. To be safe, he advised Deutsch to move his shares to a cash account, where lending is forbidden. On the morning of the following Monday, June 18, 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 Deutsch’s shares, a call transcript entered into federal court indicates; Topping made no mention of possible repurchases.
Over the next seven days, as 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 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.
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 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, 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. Deutsch remembers FFOS’s 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.
Bezanson’s team hadn’t been told that their parent company had contributed to the price spike just as 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 Sass a dozen days earlier warning of “unusual activity.” 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 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.)