This is not a common problem, but not unknown. The source of the problem is how the integral fan controller derives voltage levels. For 5V and 12V, the switch just shifts the draw from the PSU, via the 4-pin Molex connector. For 5V, it connects to the 5V line and ground, and for 12V, the 12V line and ground. To get 7V however, they basically "trick" the PSU - there's no 7V line, so it connects the 12V line to the 5V line instead of a ground. I know, it sounds crazy, but it works.
There are several potential (and in your case, realized) problems with this. If the PSU is not high enough quality, it may sense the current intersection as a fault or short and shut down to protect itself. If the switch cannot completely break a connection before making the next, it can a cause a surge that makes your system BSOD or black out. In extreme cases, especially if there are any physical faults in the wiring, connectors, switch or front panel PCB, it can cause a fire. The switch itself is not a particularly high tolerance component - it's only rated at .42 amp.
A short-term solution is to make sure that your desired voltage position is selected before you power up your system, and if you need to change it, power down first, make the switch, then turn it back on. Long-term, you can contact Fractal and report it to their support team. They may offer to send a new switch, but most likely they'll offer to RMA the whole case. A pain in the ass, and there's no guarantee that the next one won't have the same problem.
The alternative is to take the switch out of the equation completely, as you mentioned in your original post. Disconnect the fan leads (I recommend removing them completely by unplugging from the front panel) and running your fans from either an aftermarket fan controller or directly from your motherboard. If you decide to go this route, let me know what motherboard you have and I'll be happy to walk you through the setup.
Good luck!