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Schwab Sued Over Allegedly Malfunctioning Order System
March 23, 2021
It's not just Robinhood. It's not just GameStop. It's not all the fault of Reddit or social media. To the contrary, Wall Street expanded to a point where its operational capacity doesn't keep pace. In the rush to cut commissions, expand online trading, and cater to those eager to "play" the stock market, brokerage firms are frequently overwhelmed by surges in volume or computer outages. Sure, there are times when it's just the nature of technology. More recently, a finger might even be pointed at COVID. But where are the industry's regulators? Where are the consequences for a lack of planning or a lack of funding or a lack of management? In a recent lawsuit against Schwab, a customer raises many of these issues.
The Amended Complaint
Robert Wright filed a class action against Charles Schwab in state court, but Schwab had the matter removed to the United States District Court for the Northern District of California ("NDCA").Wright was a customer of Schwab and had executed a Schwab One Account brokerage agreement (the "Schwab One Agreement"). NDCA granted Schwab's Motion to Dismiss largely on the determination that there was no viable tort claim because Schwab had no duty independent of the Schwab One Agreement.
Following dismissal, Plaintiff Wright filed an Amended Complaint alleging violations of the unlawful and unfair prongs of California's Unfair Competition Law (the "UCL"), Cal. Bus. & Prof. Code § 17200; and breach of contract and the implied covenant of good faith and fair dealing. Robert Wright, on behalf of himself and all others similarly situated, Plaintiff, v. Charles Schwab & Co., Inc., Defendant (Order Granting in Part and Denying In Part Motion to Dismiss, 20-CV-05281 / March 18, 2021) (the "NDCA Order"). http://brokeandbroker.com/PDF/WrightNDCAOrd210318.pdf
The Ship Sailed And Sailed And Sailed And . . .
As set forth in part in the NDCA Order [Ed: footnotes omitted]:
at pages 2 - 3 of the NDCA OrderThe plaintiff alleges that Schwab's online platform for buying and selling stocks malfunctioned. On April 20, 2020, he tried to close a short position on 6,300 shares of Royal Caribbean stock. Schwab bought the replacement 6,300 shares to close the short position, but it did not close the short position. The plaintiff tried several times (by clicking the "close" link) to close the short position, but each click resulted only in duplicate orders for the purchase of the replacement 6,300 shares and did not close the short position. In total, the plaintiff clicked the close link five times over a 10-minute period, resulting in the purchase of 31,500 shares, purchased long on margin (on loaned funds totaling $1.1 million and carrying interest charges)."Upon realizing that Schwab's system placed him into a $1.1 million long position in Royal Caribbean, Plaintiff informed Schwab that Schwab's system had malfunctioned and that trades were executed inconsistent with his instructions. Schwab did not correct its errors and left . . . [the] short and long positions open, thereby failing to timely execute a securities trade as instructed." "Given the risk of significant financial loss from a $1.1 million margin loan," the plaintiff "attempted to mitigate the damages . . . [from] the system malfunction" and sold the shares after hours at a loss that exceeded $10,000. In addition, Schwab removed the plaintiff's margin buying power for 90 days.The system malfunctioned again on April 22, 2020, when the plaintiff tried unsuccessfully to close a new short position in Royal Caribbean stock, again by clicking the close link. The plaintiff "immediately" contacted Schwab. Schwab's representative said that the system was "getting confused and changing the type" of transaction, which meant that a transaction bought replacement shares but did not close the short position. The representative said that "Schwab was aware of the problem and had been working for several months to correct it." A week later, a "Resolution Manager" from Schwab's Client Advocacy Team told the plaintiff that "due its ongoing system malfunction, Schwab failed to execute Plaintiff's trades as Plaintiff instructed." "Schwab has not fully compensated Plaintiff for his losses."
SIDE BAR: Note "operational capacity" and trading-platform issues set forth in: "A History Of SOES, Daytrading, NASD, NASDAQ, DOJ, SEC, Congress, And Robinhood -- And A Massachusetts Complaint And Another FINRA Fine" (BrokeAndBroker.com Blog / December 17, 2020) http://www.brokeandbroker.com/5595/robinhood-daytrading-massachusetts/
Beyond Our Control
Citing various terms of its Schwab One Agreement, Defendant Schwab responded to the Complaint as follows [Ed: footnotes omitted]:
First, after a customer completes an application, Schwab opens an account and acts as the customer's broker to purchase and sell securities for the account "and on [the customer's] instructions."Second, the agreement defines Schwab's liability for its failure to complete transactions:
If we do not complete a transaction to or from your Account on time or in the correct amount according to our agreement with you, we may be liable for your losses or damages. However, in no event shall Schwab be liable for any special, indirect or consequential damages, even if we have been informed of the possibility of such damages.
There are some exceptions. (There may be other exceptions not specifically mentioned here.) We will not be liable, for instance, if:. . .
- Circumstances beyond our control (such as fire or flood) prevent the transfer, despite reasonable precautions that we have taken.
. . .
- An error in posting an amount or transaction occurs that is beyond our control.
Another section called "Limitations of Liability" also provides that Schwab has no liability for events outside of its direct control.
Schwab, the Information Providers, Information Transmitters, Third-Party Research Providers and any other person involved in transmitting Information will not be liable for any loss that results from a cause over which that entity does not have direct control. Such causes include, but are not limited to: (1) the failure of electronic or mechanical equipment or communication lines: (2) telephone or other interconnect problems; [and] (3) bugs, errors, configuration problems or the incompatibility of computer hardware or software. . . ."
Third, the agreement has two separate (and virtually identical) paragraphs about procedures for order changes or cancellation requests.
Another section has this provision requiring customers to notify Schwab of transaction errors:
You acknowledge that it may not be possible to cancel a market or limit order once you have placed it, and you agree to exercise caution before placing all orders. Any attempt you make to cancel an order is simply a "request to cancel." Schwab processes your request to change or cancel an order on a best-efforts basis only and will not be liable to you if Schwab is unable to change or cancel your order. . . . No change or cancellation of market orders will be accepted through the Electronic Services. . . . If you wish to try to change or cancel your market order, you agree to call a Schwab representative to assist you. Attempting to replace or change a market order through the Electronic Services can result in the execution of duplicate orders, which ultimately are your responsibility. If an order cannot be canceled or changed, you agree that you are bound by the results of the original order you placed.
You also agree to notify us immediately if you:. . .
- Fail to receive a message that an order you initiated through the services has been received or executed.
Fourth, the agreement has a section titled "Risks of Electronic Trading," which states in part:
- Fail to receive an accurate written confirmation of an order or its execution.
- Receive confirmation of an order that you did not place.
at pages 4 - 5 of the NDCA OrderWhen you use the Electronic Services to place a trade order, you acknowledge that your order may not be reviewed by a registered representative before being routed to an exchange for execution and you also will not have the opportunity to ask questions or otherwise interact with a Schwab representative. By placing a trade order through the Electronic Services, you voluntarily agree to assume any added risk that may result from the lack of human review of [the] order in exchange for the reduced commission and potentially greater convenience of electronic trading.
In response to the Amended Complaint, Schwab moved to dismiss the contract and UCL claims, primarily on the grounds that
at Page 7 of the NDCA Order[(1)] it is not liable under the brokerage agreement for system bugs and technical errors, the plaintiff breached the agreement by not notifying Schwab, and there is no standalone claim for breach of the implied covenant of good faith and fair dealing, and (2) there is no unlawful act or unfair practice.20 The court denies the motion to dismiss the contract claim and grants the motion to dismiss the implied-covenant and UCL claims.
4-Part Breach of Contract Test
In considering Schwab's Motion to Dismiss the breach of contract claim, NDCA noted that its test required Plaintiff to demonstrate:
(1) a contract existed; (2) the plaintiff performed his duties or was excused from performing his duties under the contract; (3) the defendant breached the contract; and (4) the plaintiff suffered damages as a result of that breach.
at Page 7 of the NDCA Order
Bugging Out ?
In considering whether Schwab had demonstrated that the trading system errors were so-called bugs beyond its direct control, NDCA found in pertinent part that [Ed: footnotes omitted]:
at Pages 8 - 9 of the NDCA OrderThe disclaimer here bars Schwab's liability for technical errors that are outside its direct control. The plaintiff does not contest that he is bound by the disclaimer and instead contends that the provision does not apply because Schwab had control over the technical errors. This involves a fact issue that the court cannot address at the pleadings stage. It is Schwab's trading platform, after all, and the plaintiff plausibly pleaded Schwab's knowledge of an ongoing problem and its inability to remedy it.Second, Schwab contends that the losses here happened because the plaintiff kept reentering duplicative orders and did not - as required by the brokerage agreement - "call a Schwab representative to assist" him. Moreover, it asserts, the online platform enabled trading without Schwab agents, but it came with identified risks: no review by agents and the potential that changing orders online - in violation of the requirement to call an agent for assistance - could result in duplicate orders.
Sufficiently Pled Breach of Contract
In rejecting Schwab's contentions, NDCA notes that Plaintiff Wright's attempted order entries happened over a "short 10 minutes, and he alleged that he notified Schwab." at page 9 of the NDCA Order. Accordingly, the court dismissed Schwab's Motion to Dismiss as based upon Plaintiff's alleged failure to plead a sufficient breach of contract claim.
Superfluous Implied Covenants Claim
In granting Schwab's Motion to Dismiss as to the alleged breaches of the implied covenants, NDCA found that Plaintiff's claim was "superfluous" because there are express terms set forth in the contract at issue, which the Court allowed to go forward under the breach of contract claim. In essence, Plaintiff was seeking to invoke as "implied" terms that were already expressly set forth in the Schwab One Agreement.
Unfair Competition Not Applicable
As to Plaintiff's UCL claims, Schwab moved to dismiss those citing:
[(1)] the UCL does not apply to securities transactions; (2) a breach-of-contract clam cannot be a predicate for a UCL unlawful claim; and (3) the plaintiff did not plausibly plead an unfair practice. . . .
at Page 11 of the NDCA Order
In granting the dismissal of the UCL claims, NDCA does not discern the requisite "unfair practice," that must be well pled. As the Court characterized Plaintiff's claim, Wright argued that Schwab had not used due care to maintain an error-free platform -- which, at best, would constitute not an unfair practice but negligence, which was not a cause of action in the Complaint.
Bill Singer's Comment
This case highlights issues that are not unique to Schwab but have become common occurrences among brokerage firms that offer so-called discount, online trading. In this age of zero-commission-day-trading, operational capacity is an issue that has stepped to the forefront. Each day, when customers log on to their accounts, they are immediately confronted with warnings about unprecedented trading volume, brokerage employees working remote, and all sorts of indications about why the brokerage firm may not be able to timely execute an order or timely confirm same or timely update your buying power or timely disclose your current positions. Sure, go ahead and trade blindfolded!
Frankly, that's just not acceptable. Worse, Wall Street's regulatory community is all too aware of the operational capacity stresses among the industry's key retail players; however, rather than act decisively, the industry's regulators prefer to fall back to their same old, tired reactions. They issue notices reminding broker-dealers to remain compliant. They post purported consumer warnings about the risks of trading. They produce podcasts and videos. What doesn't come from Wall Street's regulatory community are solutions.
What would some meaningful solutions look like? For starters:
- restrict a firm from opening more retail accounts until it invests sufficient cash and human assets into its trading platform and operational capacity;
- require X number of customer service reps per Y number of customers;
- monitor the delays between a customer phoning a firm's customer service and the time it takes for that call to be handled -- and NOT ending with the time the call is "picked up" but immediately put on further hold;
- monitor the level of traffic coming into a firm's online helpline and chat features to detect growing issues;
- monitor online communities and websites that report about brokerage firm outages;
- require firms to post weekly statistics about the time to answer an average customer request for help or to file a dispute about a trade-related issue;
- promulgate fixed guidelines as to when a delayed response to a customer trading complaint/query is not timely and constitutes conduct inconsistent with just and equitable principles of trade; and
- require firms to fully and timely repay all customer losses related to platform or operational capacity issues.