Whoops, it happened again. This time it was a software glitch that led brokerage Charles Schwab to erroneously transfer US$1.2 million from a former retail client’s account to the customer’s new brokerage account at Fidelity Brokerage Services which has left operations managers at rival brokerages scratching their heads and Schwab forced to go to court.
The cause of operational snafu which occurred in late February was briefly cited in a lawsuit filed by Schwab in Louisiana which lends itself to two questions unrelated to whether the former customer — Kelyn Soldani– will actually give back the funds. The first is how the mistake really happened and the second is how Schwab will prevent a similar scenario from occurring again. Schwab isn’t explaining much. It has asked a district court in the Eastern District of Louisiana court to issue an emergency order preventing Kelyn Spadoni, a Harvey, Louisiana resident from spending the funds until an arbitration hearing is held with the Financial Industry Regulatory Authority (FINRA), the broker-dealer watchdog. The arbitration, required by Spadoni’s account opening agreement with Schwab, might not take place for another two months at the earliest. Schwab filed the lawsuit on March 30.
The case of Schwab’s inflated transfer payment sounds eerily reminiscent of a recent situation involving Citibank which in August 2020 mistakenly sent lenders of Revlon US$900 million, instead of about U$7.8 million in repayment for a loan. In Citibank’s case, as reported by FinOps Report last month, a New York district court judge in February ruled that the recipients who refused to return about US$500 million of the US$900 million can keep the money under an exception to New York law. As a rule of thumb, individuals receiving funds to which they are not entitled must return the funds to the sender. However, that doesn’t apply if the recipient actually thinks it was entitled to the funds. The New York judge sided with several hedge funds that declined to return the money to Citibank on the grounds they believed Revlon had prepaid its loan because Citibank could not have possibly made an operational error. Citibank’s mistake has prompted syndicated loan agent banks — loan administrators– to review their operations and include language in their agreements requiring the return of mistaken payments to lenders.
In its lawsuit filed against Spadoni, Schwab says that the $1.2 million was mistakenly sent to Spadoni’s account at Fidelity on February 23 due to a software upgrade made on February 18 that went awry. The timing of the payment so soon after an upgrade raises the question of whether sufficient testing was done before it went into production. Several operations experts at rival brokerages say that Schwab should have waited for several weeks before allowing the upgrade to be used to ensure that several trial runs could have been done, particularly with so many technology and operations managers working remotely during the pandemic.
According to Schwab’s lawsuit when Schwab caught wind of the error the day after the money hit Spadoni’s account at Fidelity it did contact National Financial Services, a Fidelity affiliate, to retrieve the funds only to be told by NFS that it did not have the money. Schwab re-sent is request on March 24 and was again informed by NFS it didn’t have the money. The lawsuit did not specify where Schwab thinks the money is located, how Spadoni found out it had been transferred to her Fidelity Brokerage account so quickly, or how Schwab discovered the error. In its lawsuit Schwab only says that Spadoni did not respond to repeated telephone calls and emails first from Brett Thompson, an operations specialist in the account transfer department at Schwab, and later from Schwab’s internal legal counsel. One can only presume that Thompson was the one who caught the error. Schwab and Fidelity declined to comment for this article.
Just as important as knowing how the software glitch could have occurred is knowing whether was related to Schwab’s possible use of service from the US Depository Trust & Clearing Corp. (DTCC) called Automated Account Transfer Service (ACATS). FINRA’s rule on customer account transfers– Rule 11870 — suggests that broker-dealer members of FINRA must use the ACATS system for account transfers, but it does allow for some exceptions. Those exceptions are: when the parties are not eligible to participate in ACATS; the customer requests a partial account asset transfer; the securities are not eligible for processing in CNS (the National Securities Clearing Corp.’s continuous net settlement system) and the customer provides alternative instructions in writing. NSCC is the securities clearinghouse subsidiary of DTCC.
Based on Schwab’s own description the Schwab One account which Spadoni opened in late January requires her to have US$1,000 in the account before any trading is done. However, the account can be opened with no money. It could not be determined whether Spadoni opened the account with only US$82.56 or whether she had done any trading and liquidated her shares leaving only US$82.56 in the account before asking for the money to be transferred to Fidelity Brokerage. One can only presume she was not happy with her service at Schwab, because she switched to another broker-dealer after only one month with Schwab.
The language in the court documentation suggests that Schwab relied strictly on its own platform called TOAR– there is no mention of ACATS– but that presumption could not be verified with either Schwab, the DTCC or Fidelity. Operations managers at rival broker-dealers believe that it is likely the ACATS service was not used because funds, rather than securities, were transferred and only a small amount was involved. DTCC did not respond to requests for comment on whether Schwab used the ACATS service or whether using the ACATS platform would have prevented an error of the magnitude of Schwab’s to have occurred.
Based on DTCC’s description of how the ACATS platform works the receiving firm fills out the necessary paperwork to send to the original firm before a transfer of assets is made. The process takes several days to complete. A mistake could occur, say operations experts at several brokerages, if the original firm– the carrying firm– inputs the wrong data into the ACATS platform, but that mistake would likely result in the receiving firm rejecting the transfer. No one would tell FinOps Report whether they had experienced any erroneous customer account transfers using the ACATS platform or any proprietary platform requiring the return of funds to the sender, or carrying firm.
Schwab’s lack of details on how it made the software error in its lawsuit or why an upgrade was needed reads in sharp contrast to the intricate explanation offered by Citibank in explaining its payment mistake. In the case of Citibank’s mistake, as previously reported by FinOps Report, court documentation shows that there was an incorrect data entry by an executive at Wipro, Citibank’s offshore operations provider, which was not caught by Citibank’s Oracle Flexcube platform. An incomplete description of the value of the funds to be wired to lender accounts appearing on the user screen led employees at Wipro and Citibank to conclude that only the intended $7.8 million would be sent to the lenders instead of US$900 million. Citibank has repeatedly blamed the mistake on human error. Presumably, had the data input been completed correctly — according to the manual’s rules — the problem might not have occurred. However, it is equally as likely that had the user screen on the Oracle Flexcube application shown the full amount of US$900 million that would have been wired out of the bank, payment would have been stopped in time.
Schwab’s scant description of its software upgrade glitch leads one to speculate whether the brokerage firm is attempting to cast itself in a more favorable light so it can be reimbursed for the lost funds from its insurance firm should Spadoni not return the money. Brokerages typically buy insurance to compensate for “errors and omissions.” The more details Schwab provides on the software glitch the more it is highlighting its potential culpability in not sufficiently testing the software upgrade or making the upgrade during the COVID-19 pandemic. An insurance firm could decide the mistake does not fall under the category of “errors and omissions.”
Reimbursement by an insurance company might end up being Schwab’s only recourse. “If Ms Spadoni spent the money, skipped town to a jurisdiction with no extradition treaty with the US, or transferred the funds to another bank Schwab will have a hard time getting it back,” says Bill Singer, a New York attorney focused on securities law for broker-dealers. “Should Spadoni refuse to return the funds, it is unclear whether a federal or state prosecutor would file criminal charges. Because Louisiana follows parts of the French Napoleonic Code/Code Civil in addition to the common law followed by other US states, that state always presents unique legal and jurisdictional challenges.”
Recouping US $1.2 million is the tip of the iceberg in Schwab’s problems. The other is the reputational risk. Customers won’t trust that Schwab’s technology works and there are already plenty of complaints on social media channels about Schwab’s website. Even more worrisome for Schwab is whether it will face fines from the Securities and Exchange Commission, FINRA, and other regulators. In October 2013 Knight Capital Americas agreed to pay the SEC a US$12 million penalty based on allegations the firm had violated the SEC’s market access rule in connection with an August 1, 2012 trading incident that disrupted the market. The SEC’s Rule 15c3-5 requires broker-dealers with market access to create and maintain risk management controls, policies, and procedures, to manage operational risks associated with having access to trading securities directly or through alternative trading systems. The infamous “Trading Glitch” was caused by a computer code that was not meant to be used and likely would have been discovered through more robust debugging and Beta protocol prior to use. If a similar software glitch is at the heart of Schwab’s overpayment to Spadoni, regulators may want answers as to what program Schwab claims was used for the transfer at issue, whether it had been properly tested before implementation, whether it was routinely subjected to maintenance and review, and what, if any, steps the firm has taken to prevent an erroneous account transfer in the future. For now, the story of how Schwab mistakenly transferred US$1.2 million to another brokerage firm is another one — like Citibank’s– for the record books during the COVID-19 pandemic.