Vanguard: Lawyer-turned-whistleblower 'betrayed' fund giant

Vanguard Group, the Malvern mutual fund giant, has responded to a New York whistleblower lawsuit by former Vanguard tax lawyer David Danon with accusations of betrayal, theft and ethics violations the company says should bar him or his lawyers from bringing the complaint.

The company also offers a defense of Vanguard's "unique" legal structure, noting company officials have testified about its practices before Congress, and widely publicized its arrangements since its founding by John C. Bogle 40 years ago.

In documents made public after New York state court Judge Joan A. Madden declined Vanguard requests to keep them sealed away, the $3 trillion-asset company argues Danon "grossly betrayed" his former employer, violated confidentiality agreements and broke state bar association ethics rules when he illegally "stole hundred of privileged and confidential documents" related to Vanguard's income tax and financial arrangements.

Danon has argued that the harm that Vanguard is doing other U.S. taxpayers -- his suit estimates the company's unpaid taxes at over $1 billion -- justifies his actions under whistleblower protection rules.

But Vanguard says federal courts have thrown out similar lawsuits. Vanguard cited an action against Quest Diagnostics Inc. by Mark Bibi, a former lawyer for a Quest predecessor who accused the medical-testing company of paying kickbacks to insurers who sent it federally-funded Medicare and Medicaid patients. A federal court in New York dismissed the suit in 2011 and disqualified Bibi and his lawyers from suing again because he had based it on information he obtained as the company's lawyer, Vanguard said in its memo.

Danon's lawsuit, according to Vanguard, "is a brazen attempt by an in-house attorney to obtain a bounty [of up to 30% of any Vanguard settlement with tax collectors] as a whistleblower by suing his client with respect to the very issues on which he provided legal advice" to Vanguard, the company argued in a memo filed by a team of attorney from the New York corporate law firm Jones Day. The team is led by Heidi Wendel, a former head of the Civil Frauds Unit for the U.S. Attorney's Office in Manhattan.

"The ethics rules governing attorneys do not permit attorneys to sue their own clients," Vanguard adds. "Nor may attorneys disclose their clients' confidential information in lawsuits against their clients. These principles are fundamental to the attorney-client relationship," and Danon's reversal is "a gross violation of the confidence Vanguard reposed in him." The suit also argues that "permitting lawyers to sue their own clients would make a farce of the attorney-client relationship" and "destroy the very underpinnings of the legal system" which depend on candid discussion of confidential information.

Danon "improperly accessed hundreds of privileged and confidential" Vanguard documents, sent them to a personal email account in early 2013, and declined to give them back, after he was told he would have to look for another job, Vanguard says. The company says he wasn't fired in retaliation for Danon's lawsuit. Vanguard doesn't say why Danon was terminated.

In its response Vanguard also defends its corporate structure, which both the company and Danon in court papers have called "unique."

The Vanguard Group Inc. management company is owned by Vanguard's mutual funds, which pay the company for services. Danon's suit alleges the company lowballs the price of its services, ensuring it shows little profit and owes little federal income tax. With lower tax costs, Vanguard can afford to charge lower fees and lure business away from rival investment companies.

Danon argues this violates Section 482 of the Internal Revenue Code, which requires companies to pay their own affilates the same market prices they would have to pay to buy those services from an outside firm, rather than providing them more cheaply "at cost."

But Vanguard says its practices benefit clients and are fully-disclosed and time-honored; and that Vanguard officials' past testimony in Congressional hearings about its structure should protect it from suits under whistleblower rules.

Also, Vanguard argues that the IRS, not tax lawyers like Danon, determine how Internal Revenue Code Section 482 and similar state tax rules applies to individual taxpayers like Vanguard. "Only if the IRS" or a state such as New York "were to exercise their authority" over inter-company payments and set payment levels higher than what Vanguard uses, could Vanguard be credibly accused of knowingly underpricing its services or underpaying its taxes, according to the memo. Vanguard doesn't say whether or how the IRS may have explicitly approved its unique arrangements.

Danon's lawyer, Stephen Sorensen, said he reads Vanguard's reply as an admission that tax code Section 482 and inter-company payment pricing rules apply to Vanguard.  Even as it tries to get the case thrown out because of Danon's past role as a company lawyer, Sorensen says he finds it significant that Vanguard also felt it had to address the merits of Danon's charges, however broadly.

"Vanguard's approach here is to shoot the messenger," Sorenson told me. In its memo, he adds, "Vanguard recognizes that the SEC letter that approved its structure provides no help on the tax front... Vanguard could not take that position that its at-cost pricing fit within the limited exception [the IRS allows] for accounting and administrative functions, because that would be like poking the IRS with a stick in the eye. Vanguard is looking for mercy from the IRS and so does not want to take any position on Section 482 that will put it crosswise with the IRS."

In filing its memo, Vanguard attached a copy of founder John C. Bogle's initial letter to the SEC reviewing the company's structure at the time of its founding. The document describes the early 1970s mutual fund business as an industry in rapid decline, plagued by high fees, poor results, manager conflicts of interest, and a lack of investor trust. Bogle presented Vanguard's fund-owned and at-cost structure as a way to regain public trust and convince Americans to start buying mutual funds again.

Danon has until Nov. 17 to respond to Vanguard's memo.