Investors Battle Fidelity in Court Over Tax-Break Deal

In the final days of 2017, Malcolm and Emily Fairbairn thought they had everything ready to cushion the income-tax hit from more than $200 million in hedge-fund income. They prepared a large charitable donation, using their relationship with Fidelity Investments and a booming energy stock to maximize their tax deduction.It didn’t go as they had hoped. Now, the Fairbairns and Fidelity’s charitable arm are facing off in a contentious federal court trial. The Fairbairns say Fidelity Charitable lured them into making the donation with statements about how and when the stock would be sold, then violated those promises and botched the transaction. Fidelity denied making such promises and says its trading was appropriate.

The case puts a spotlight on so-called donor-advised funds managed by firms including Fidelity, the Vanguard Group and

Charles Schwab Corp.

Donor-advised funds held $121.4 billion as of 2018, according to the National Philanthropic Trust.

For investment firms, the funds can help attract and keep high-net-worth clients. Donors get tax deductions when they give cash or securities. Investments then grow tax-free and get distributed to operating charities on donors’ recommendations, functioning almost like a charitable checking account.

The hitch: Although donors can make those recommendations and funds usually heed that advice, donors must cede legal control over the assets to get the tax break. That tension sits at the center of the Fairbairn case.

The Fairbairns were racing to finish the donation in 2017 for a tax deduction. They authorized a donation of 1.9 million shares of

Energous Corp.

to Fidelity Charitable on Dec. 28, then worked to ensure the stock got to Fidelity.

The timing seemed ideal: The price of Energous had jumped that week after it won government approval for its wireless-charging technology.

On Dec. 29, Fidelity sold those shares—nearly 10% of the company—in 154 minutes as the price dropped to $19.45 from a closing high of $31.57. The Fairbairns contend that Fidelity’s quick selling flooded the market and drove down the price.

The Fairbairns at one point had $61 million in stock but ended up with a $52 million tax deduction and $44 million in the account for directing donations to charities, including Lyme disease research. Those amounts were less than they had expected, and they may seek compensation for the tax deduction and replenishment of their donor account.

The virtual trial began this week in federal court in northern California and resumes Monday; it is focused on whether Fidelity broke promises and handled the stock sale negligently. If Fidelity is found liable, a subsequent phase would determine potential remedies for the Fairbairns.

Mr. Fairbairn testified that he knew Fidelity Charitable owned the stock once the donation and deduction were complete in 2017 and could sell it. But he said he was told the sale would happen in 2018 and that he could offer advice to Fidelity Charitable on the selling strategy. As the price fell on Dec. 29, he wondered who had sold so much Energous stock—only to learn in January that it was Fidelity Charitable selling the shares they had given.

“I was upset and angry,” Mr. Fairbairn told the court. “Normally, I don’t get upset very often. It’s only when I feel like I’ve been lied to.”

Under cross-examination, the Fairbairns acknowledged that promises about the timing and manner of the stock sales weren’t written.

Donor-advised funds are increasingly popular, and Fidelity Charitable is a giant in the field. In the year ended June 30, 2019, it had almost 127,000 accounts, collected $8.6 billion, donated $6.1 billion and held $31 billion.

For donors managing millions but not billions, the funds can be more attractive and efficient than private foundations, which have stricter rules requiring annual payouts.

But charitable aims sometimes conflict with the investment firms’ profit motives.

Messages displayed during the trial showed Fidelity employees offering discounted fees to attract the Fairbairns’ donation to Fidelity Charitable instead of a similar fund at

JPMorgan Chase

& Co. Justin Kunz, who managed Fidelity’s relationship with the Fairbairns, defended his use of terms like “win the business” in internal emails to describe his discussions with the couple.

At times, Mr. Kunz in testimony described his role as facilitating donors’ charitable endeavors, showing how Fidelity ’s financial-services professionals could help with the Fairbairns’ complex assets. At other times, he described a competition against JPMorgan.

The Fairbairn case shows how commercially sponsored funds differentiate themselves by emphasizing how they can handle the assets wealthy people have, said Brian Mittendorf, an accounting professor at Ohio State University who isn’t involved in the case.

“Being a sponsor of a donor-advised fund is somewhat of a commodity,” he said in an interview. “If Fidelity won’t take my funds, I can certainly find someone who will. Customer service becomes a big deal.”

The Fairbairns say they were won over by Mr. Kunz’s promises of a “gentle” stock sale designed in a sophisticated way to avoid hurting the share price. That can be a challenge with such a large chunk of a smaller stock like Energous.

Their lawyers displayed messages between Fidelity employees speculating that Mr. Kunz had been too loose-lipped.

“I know that I didn’t make any of those promises that they’re alleging,” Mr. Kunz testified.

Funds typically follow donors’ recommendations for giving money to charities, but they don’t have to. Technically, once the Fairbairns donated their stock, they no longer owned it and had no legal control over the subsequent sale.

“Just like you can’t keep your cake after you’ve eaten it, you can’t keep control of what a charity does with assets after you’ve given them away,” David Marcus a lawyer with WilmerHale, which is representing Fidelity Charitable, said in his opening argument.

The Fairbairns pointed to internal Fidelity messages to support their argument that the stock sale was mishandled. One Dec. 29 message described the result of the selling as “ugly.” A January 2018 email from Mr. Kunz described the trade as “botched,” though he testified he was parroting Mr. Fairbairn’s description.

Mr. Fairbairn said any trader at his firm, Ascend Capital, would have been fired for putting so much supply of a single stock in the market at once.

“This literally, when I looked at this, was the worst-executed trade that I have seen,” he said.

Fidelity Charitable says its selling didn’t cause the Dec. 29 price decline. The stock has never regained its late-2017 highs and closed Friday at $2.55.

“Unlike the Fairbairns’ hedge fund, Fidelity Charitable doesn’t make bets on stock. The charity takes a conservative approach,” Mr. Marcus said. “They’re blaming Fidelity for not timing the market perfectly.”

Write to Richard Rubin at richard.rubin@wsj.com

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