Whistleblower Alleges Vanguard Cheated On Taxes, Costing Taxpayers More Than $1 Billion

On May 1, 1975, Princeton graduate John C. Bogle launched an investment company on a bold new idea: it would be owned by its member funds and operated for the benefit of its shareholders. That company, the Vanguard Group, is now one of the world’s largest investment companies with about $3 trillion under management.

Whistleblower David Danon says there’s a good reason for Vanguard’s growth. Danon alleges that the fund company illegal manipulated transfer pricing to keep costs – and taxes – artificially low. Transfer pricing is the term for the sale of goods and services between related companies; since those companies are considered separate entities for legal and tax purposes, those transactions must be priced at “arm’s length,” meaning the price that a willing buyer and a willing seller would pay in a bona fide transaction. When pricing is kept artificially low, or below fair market value for goods and services, it’s considered transfer pricing abuse.

Allegations of transfer pricing abuse at big dollar companies isn’t new – it’s exactly what companies like Apple AAPL -2.24% and Starbucks SBUX +0.26% have been accused of doing. The difference is this case is that it’s all domestic: there aren’t any allegations of income shifting to offshore tax havens.

Vanguard concedes that it charges its own funds at-cost prices for management services: in otherwise, below market pricing. But the company says that they have a legal basis for doing so. Specifically, when the investment company got its start, it asked the Securities and Exchange Commission (SEC) to issue an exemptive order, approving its “joint participation” arrangement (SEC order downloads as a pdf). Danon alleges, however, that the SEC order only allowed the transactions for securities purposes, not for tax purposes. He claims that treatment is a violation of federal and state tax laws, costing taxpayers more than $1 billion. In his suit, Danon notes that “Vanguard’s costs are … generally quite consistent with its competitors’ costs, with the notable exception of Vanguard’s tax costs.”

Those uneven tax costs, Danon alleges, have allowed the company’s growth to outpace those of its competitors.

Danon knows a little something about tax law: he was a tax attorney at Vanguard for nearly five years. Prior to coming to work for the company, he graduated from Fordham University Law School, where he won honors and was a member of law review. Danon went on to work for a number of big name law firms before settling on a job as tax counsel at Vanguard.

While at Vanguard, Danon became aware of the transfer pricing arrangements and had concerns about how it translated to the corporate tax returns.  Although he didn’t work directly on those transfer pricing tax issues, he raised them with the company. The company, he claims, brushed aside his concerns and eventually fired him.

Just before his ouster, Danon filed a whistleblower action, State of New York ex rel David Danon v. Vanguard Group, Inc., No. 100711-13 (Sup. Ct, N.Y. Cnty, May 8, 2013), outlining his concerns. The action was filed under the False Claims Act in New York State. That move was deliberate: Danon is a resident of Pennsylvania and Vanguard is headquartered in Pennsylvania but Pennsylvania doesn’t allow for the kind of action that Danon filed. New York does, the first in the country to do so. And Vanguard clearly does business in New York. That, explained Stephen Sorensen of Thomas, Alexander & Forrester LLP, lead counsel in Danon’s suit, made it a natural venue for the suit.

The suit has been under wraps for a year as a qui tam case meaning that the suit was brought by a third party whistleblower on behalf of the government. In New York, these kinds of actions are filed under seal for a year while the New York Attorney General contemplates whether it might intervene. In this case, the New York Attorney General opted not to intervene and the case was eventually made public. Sorensen remains optimistic, however, noting that the current New York Attorney General, Eric Schneiderman, was the leader, as a state senator, in the 2010 expansion of the False Claims Act to include tax matters.

Whistleblower actions aren’t restricted to state matters so Danon also filed actions with the Internal Revenue Service (IRS) and the SEC.  The IRS and SEC matters will progress according to those agencies’ respect timelines.

The New York state matter has the benefit of a more predictable timeline since it will progress through the state judicial system. As Sorensen explains, the matter first goes to the New York Supreme Court. That might sound odd but in New York, the Supreme Court is the trial court, so it’s the first step and not the final step.

Like any other civil action, the matter is fought on paper long before it sees the inside a courtroom. After the action was filed, Vanguard took actions to stop the suit, including filing a motion to dismiss. The company alleges that since Danon is a former tax attorney for the company, he cannot file suit against them; Sorensen says that they’re saying he was “switching sides.” Vanguard also alleged that Danon improperly used privilege and confidential information to bring the suit.

Sorensen has dismissed those allegations, noting, among other issues that Danon did not work directly on the transfer pricing matters. He also argues that Danon’s actions would fall under the crime fraud exception to the privilege rules. The exception varies among jurisdictions but generally allows that there is no attorney-client privilege if legal services are used to commit or plan to commit a crime or a fraud. I asked Sorensen whether Danon stepped in to stop the fraud before he filed suit. He says that Danon “did attempt to remedy the situation” but that ultimately, “he was terminated as a result of raising his concerns.”

Sorensen expects that the motion will fully briefed by end of year and is hoping for a hearing early next year. After that, it’s up to Judge Joan Madden to deny or grant the motion: Sorensen, of course, thinks that the judge will deny the motion to dismiss. If that happens, the suit will go forward with discovery. Vanguard has promised to fight the suit “vigorously.” That’s right up Sorensen’s alley: he notes that his firm was brought on board because “we go to trial.”

If Danon is successful in his actions, he would stand to collect a percentage of any taxes collected by the State of New York and the IRS. That’s another challenge since even if Danon can prove that Vanguard should have been paying more taxes, in order to be rewarded for his findings, those taxing authorities would actually have to come forward and collect taxes.

Danon currently resides in Chester County, just down the street from his own former employer (and not far from me). I asked Sorensen about Danon’s next career move: he indicated that it was unlikely that Danon will work as a lawyer anytime soon. Danon would, says Sorensen, like to be able to practice again but he says his reputation has been damaged by Vanguard. Vanguard has alleged, among other things, that Danon broke ethics rules by revealing private client information and failing to return client documents.

Sorensen says that those allegations don’t describe Danon at all. Danon is, he says, a “guy of principle, not a disgruntled employee.” Danon, he says, believes in tax fairness. He notes that Vanguard’s competitors, like Blackrock and Templeton, don’t use the same practices. In contrast, he noted, Vanguard’s own transfer pricing practices mean that they don’t have to pay the same amount of tax as their competitors. According to Danon’s complaint, that was the result of a “deliberate ignorance of the truth or falsity of the information or claims submitted” or, in the alternative, a “reckless disregard of the truth.”

That, is what this suit is about, Sorensen says, “The issue is fairness.”