Tax lawyers, Vanguard-watchers on whistleblower tax case

WEDNESDAY 7/30: Vanguard Group says ex-Vanguard tax lawyer David Danon's whistle-blower case alleging the company's low fees are based on "illegal" tax avoidance is both "without merit" and also "far too complex to get an adequate hearing in the news media. I asked veteran tax lawyers Robert Willens, Stanley Kull (Saul Ewing), Lee Sheppard (Tax Notes), David Shakow (18-year Penn Law professor now advising Danon for a possible cut of his whistleblower's fee). Read highlights in my Vanguard article in today's Philadelphia Inquirer here.

FRIDAY 7/25: Vanguard Group has become the largest mutual fund group, with more than $2 trillion in investments and close to one-fifth of the market, thanks to its low costs and fees. But in a New York whistleblower's lawsuit, David Danon, a former tax lawyer at Vanguard (2008-13), says the company has never received proper Securities and Exchange Commission or Internal Revenue Service approval for the way it moves money between Vanguard's management company and its funds, and challenges: the way Vanguard reduces tax liability by charging only "at cost" not full market prices for services between affiliates; and the tax practices of Vanguard's large cash Contingency Reserve. Danon says Vanguard has used its "illegal" tax advantage to cut fees and boost market share.

Vanguard spokesman John Woerth in a statement says the company denies wrongdoing, affirms the legality of its practices and says it will defend against the suit vigorously. The company is the largest private employer in Chester County, where its Malvern complex houses around 10,000 workers.

More about the case in my Philadelphia Inquirer story here. [ALSO: Read the lawsuit at Paul Caron's Pepperdine U Law School site here.  Investment News, Wall St. Journal and Reuters have also picked up the story. Read what Daniel Wiener of the Independent Adviser for Vanguard Investors newsletter says at the end of this item.]

Danon put his accusations into the lawsuit and filed it under seal before he was obliged to leave Vanguard last year. Danon had his lawyer, Brian Mahany, unseal the case last week after the New York attorney general's office declined to prosecute.  Danon stands to get paid if the New York court ever endorses his charges and finds Vanguard liable for not paying taxes in New York.

If the SEC and IRS were to endorse Danon's allegations, what would they demand from Vanguard? The company's original structure dates back to the 1970s. If it's inadequate, why haven't tax authorities moved to change it in all those years? Is Danon right about the legal and regulatory basis for Vanguard's tax practices? I asked to talk to Vanguard's lawyers and get their side in more detail.

SUNDAY 7/27: Daniel P. Wiener, longtime publisher of the Independent Adviser for Vanguard Investors newsletter, read my story Saturday, ran to read Danon's complaint, and today sent this note to clients:

VANGUARD'S AT-COST STRUCTURE UNDER SEIGE COULD CHANGE INDUSTRY LANDSCAPE

A lawsuit, file on May 8, 2013 and unsealed this week in New York, claims that Vanguard has used its SEC exemptive order allowing it to operate "at cost" to avoid paying "approximately $1 billion of U.S. federal income tax and at least $20 million of New York tax over the last ten years."

Secondary to the "at costs" arguments, the suit also alleges that Vanguard didn't treat a $1.5 billion Contingency Reserve that is funded by each individual mutual fund properly, from a tax perspective.

Filed by a former Associate Counsel and tax attorney who worked for Vanguard for just under five years, the suit makes some pretty major allegations.

Let's start by saying I'm not a tax attorney. I can't debate the merits of the lawsuit or some of the allegations presented in it.

But from a broader perspective, this assault on Vanguard's "at cost" operating principle could, if successfully challenged, have seismic implications for the fund industry and possibly put competitors on a more level playing field with Vanguard as far as costs are concerned...

According to the complaint, Vanguard prices its services to its overseas funds as "a 7.5% cost-plus return." To give a sense of how this might translate to higher costs at home, consider the Vanguard U.S. 500 Stock Index Fund offered to overseas investors http://bit.ly/nonUSfunds .

The fund's investor share class charges a 0.25% operating expense compared to the investor class expense of 0.17% for 500 Index here at home. That's still low, but it's almost 50% higher than what U.S. investors pay. Vanguard's ETF shares currently charge just 0.05% in expenses.

Add on a basis point or two and, while still low, [the cost of the Vanguard fund] would be closer to the [competing] iShares Core S&P 500 ETF's 0.07% expense ratio or SPDR S&P 500 ETF's current 0.0945%.

On the managed front the differences are even more stark. The Vanguard U.S. Opportunities Fund is managed in essentially the same style as the PRIMECAP or Capital Opportunity funds here in the U.S. The all-in expenses for the overseas fund are 0.95% for the investor shares. Investor-share expenses for PRIMECAP and Capital Opportunity are, respectively, 0.45% and 0.48%...

 I believe the crux of the whole complaint as far as its potential impact on the industry lies in [Danon's] allegation that "Vanguard's costs are, however, generally quite consistent with its competitors' costs, with the notable exception of Vanguard's tax costs."

 The fund industry's competitive landscape could change dramatically if Vanguard is forced at some point to raises fees to address costs it has, heretofore avoided consciously or not... [So] the attack on Vanguard's "at cost" expense regime is a serious one and must have competitors in a frenzy debating its merits and potential impact.

All in, whether this lawsuit has merit or not, and whether Vanguard is forced to raise expenses for costs they haven't always accounted for, I believe the company will remain one of the low-cost leaders in the industry. (emphasis added) However, a ruling against the complex would be a huge hit to the firm's reputation as an investor advocate and ethical leader...