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Vanguard whistleblower's first day in court

Vanguard ready to argue facts, if judge doesn't dismiss

Last Friday Feb. 13, New York Superior Court Judge Joan Madden held a previously-delayed hearing, in Courtroom 351 of Manhattan's state courthouse way downtown, so she could grill lawyers for both sides on Vanguard Group Inc.'s motion to dismiss former Vanguard tax lawyer David Danon's whistleblower lawsuit, which challenges the legal and expense structure the Malvern investment giant has used over its 40-year history.

It was the first time the two sides have faced each other in court since Danon prepared his complaint while still working for Vanguard in 2013. The case was filed under seal; it became public last summer after New York State declined to prosecute it last year -- whether because the Attorney General considers it a weak case, or because the state is leaving an investigation of the facts to the federal government which Danon alleges is Vanguard's main victim, or for some other reason, New York officials wouldn't tell me.

Danon alleges the company has systematically underpaid more than $1 billion in U.S. and state income taxes. Danon has also complained to the IRS and SEC, detailing his claims that Vanguard charges its own mutual funds artificially low management fees so it appears to make little or no profit, reducing its tax liability; and that Vanguard has, separately, built up a $1.5 billion reserve without paying proper taxes or giving investors a share. If New York or the IRS decide Danon is right and oblige Vanguard to pay back taxes, Danon might be able to claim millions of dollars as whistleblower's compensation.

Both sides agree Vanguard, as a private investment management company owned by its affiliated mutual funds, has set up a "unique" structure and pays low income taxes, enabling the company to charge lower fees than its rivals and win business from them. Vanguard's lawyer said Vanguard has "very strong arguments that show Mr. Danon is completely wrong" about tax fraud allegations. 

But before having to explain too much about its internal doings or its tax procedures in a public court proceeding, Vanguard wants the case thrown out: The company says Danon breached attorney-client privilege and New York State legal ethics rules when he used privileged, confidential company documents to make his case, and that this should oblige Madden to toss the complaint. Danon argues he was protected by state and federal whistleblower laws that allow lawyers to bring illegal actions -- crimes, or at least frauds -- to the attention of government authorities.

Danon is represented by Stephen Sorensen of Thomas Alexander & Forrester, Los Angeles. Vanguard's team of lawyers is headed by Heidi Wendel of New York-based Jones Day, a former federal prosecutor. Both are Philadelphia-area natives: Sorensen grew up in Swarthmore (went to Cardinal O'Hara High), Wendel in the Princeton area (she's a Swarthmore College grad.) Several paragraphs in Vanguard's dismissal request and several arguments at Friday's hearing took place privately, because they concern information Vanguard says it has an interest in keeping secret. Here are some highlights from the public part of Friday's hearing:

WENDEL, for Vanguard: "Vanguard moves to dismiss this lawsuit and to disqualify Danon and his counsel" based on "the most egregious possible violation" of his duty to the company, his client, under New York State legal ethics rules: As an in-house lawyer, he used privileged and confidential information to sue his client, for personal gain, and exposed that company information "on the Internet and to the media."

Danon's "only excuse" is that he alleges the New York State False Claims Act protects him as a whistleblower, Wendel told the judge. But New York decided not to prosecute Danon's complaint: Danon is on his own with all his allegations, she added.

"Contrary to Mr. Danon's arguments, he does not get the free pass he sees," Wendel added, citing a federal appeals court's dismissal of another whistleblower complaint by a lawyer for a predecessor of Quest Diagnostics, because he relied on inside legal information the court found was tainted and inadmissible.

JUDGE MADDEN: "Quest. That is the main case you relied on..."
WENDEL said she could also cite earlier federal cases, and some state decisions by Madden herself; adding that the Quest decisions make clear that the False Claims Act does not allow a lawyer like Danon to simply dispense with his legal-ethical obligations. And, "this case involves a much more egregious violation for the ethics duties than the Quest case," since Danon sued his own client.

"And Danon used his employment --"
JUDGE: "-- to take confidential information?"
WENDEL: "He simply sued while still at his desk at Vanguard. There's clearly no way that Mr. Danon can justify that act. He has grossly violated his duty of loyalty under Rule 1.7 of the New York State ethics rules."

JUDGE: "Doesn't he make an argument he's not violating the section because he's not suing on behalf of another person?"
WENDEL: "Section 1.7 (is) a blanket prohibition on suing your own client. Your Honor addressed the extent of that prohibition" in a New York case where Judge Madden disqualified a lawyer for a rent-collection agency from a suing his landlord clients over alleged illegalities, citing that same ethics rule.

Danon's argument, that under the terms of his whistleblower suit it's New York, not him, who is suing Vanguard, "is a specious point" contradicted by the rest of his case. He sued while he was still an employee. And "the case law is that once an attorney has violated Section 1.7, they cannot rescue their case by simply leaving that client's employment and becoming a former employee."

Moving on to New York State legal ethics rule 1.9a, "it cannot be disputed that (Danon) had access to confidential information of Vanguard... (which) is related to this action."

JUDGE: But Danon argues there is "no substantial relationship" between his case and any confidential information he may have learned at Vanguard.
WENDEL: "The case law expressly holds" that it doesn't matter if he worked on information related to the case or not; it's whether he had access to information he might use against his client, that makes Danon's case inadmissible.

As to Danon's claims that his case "may fall within a crime-fraud exception," Danon seems to have "totally misunderstood" the exception relates narrowly to attorney-client privilege, when an attorney is compelled to testify against a former client accused of breaking the law.

And there's no crime involved with this case that could trigger such an exemption: Vanguard's "cost-plus" calculations for the fees it collects from its funds have been public information "for 40 years.... There's nothing here that comes close to criminal conduct."

JUDGE: "You're saying (that Vanguard's) crime was well-known?
WENDEL: "No, your Honor, the conduct was well-known."

JUDGE: "If the acts were well-known, how did (Danon) breach confidentiality?"
WENDEL: "By bringing a complaint that exposes confidential communications... Second, he advertised it on the Internet, he took claims to the media, he made no effort to make only reasonable (disclosure)... That requires dismissal and disqualifications...

"Third, Danon did not take any steps to report up," to his own bosses, Vanguard's alleged tax violations, which Danon says he found. True, Danon says "that he reported something to the head of the tax department, the legal department's tax unit. (But) he provides no specifics. That does not satisfy the ethics rules," which Wendell said woud urge Danon to bring his concerns of illegality to the "highest" person in the company.

Danon's failures to walk the narrow path of legally protected whistleblowing, according to Wendel, "clearly require that this action be dismissed and Mr. Danon and his counsel be disqualified."

Wendel also challenged Danon's application of the False Claims Act to the particular Vanguard information he has used to make his case: Danon, she said, "is claiming to be blowing the whistle on conduct that is well known for 40 years," since Vanguard's founding by John C. Bogle.

JUDGE: "Doesn't that undermine your allegations" with respect to Danon violating confidentiality? ...since "it's already known that this is how Vanguard prices. There's no confidential information" if it's already out there: "How can it be 'known' and 'confidential' at the same time?" 
WENDEL: Any information Danon used that doesn't satisfy the law's "original source rule" violates the ethics rule.

The fact Danon has copied "dozens and dozens" of "some of the most confidential documents of the company" -- a list of which has been given the judge but withheld from the public record -- is another reason Danon's claim "should not be allowed to go forth" and he should be barred from receiving any payment (presumably, in case Vanguard ends up having to pay more tax, which Vanguard says it shouldn't).

"Tax provisions can't be a basis for the False Claims Act, because he is relying on tax provisions that do not provide a directive to the taxpayer." Tax fraud, she said, requires the violation of some IRS or state tax directive to a company. "Here, there is no directive." Internal Revenue Code 482, which governs payments between affiliates, and the equivalent state laws don't provide detailed guidelines that Vanguard can be shown to have violated.

So, without a government tax directive to violate, "it defies any common sense to say a taxpayer could nevertheless be liable to fraud. There's no (tax) directive here that Vanguard could have violated." The IRS and state tax authorities have "discretion" to approve or order particular tax practices; Danon as a Vanguard lawyer is not qualified to say tax law was broken by the company. Therefore, "Vanguard did not knowlingly submit a false claim" for its taxes. And the case should be dismissed.

SORENSON for DANONE: "We are in somewhat unchartered territory" since so few cases under the current New York False Claims Act have been litigated. 

"Vanguard's motion to dismiss should be denied. Vanguard has no defense to its knowing failure to report hundreds of millions of dollars" in income to the state, or to "report and pay tax on its $1.5 billion Contingency Reserve." Danon alleges "fraudulent conduct" by Vanguard -- two frauds, in short, Sorenson said:

First,
Vanguard has violated Treasury Regulation 1.482-9, which governs the pricing of services between affiliated entities for income tax purposes. "They didn't price at arm's length" as Treasury requires. "They violated that directly."
JUDGE: Is the tax code really that specific? And yet the New York Attorney General's Office declined to intervene?
SORENSEN: "At this stage. They could intervene, at any time." At least the state didn't dismiss the case. (That would have needed a judge, Madden pointed out, smiling.)

Second, the "illegal contingency or cookie jar reserve," in which Danon alleges Vanguard has been setting money aside from its funds without paying taxes or giving each fund's shareholders their part of the total.

Danon concluded Vanguard was committing these two major tax frauds in 2012. He filed his whistleblower claims, out of the public record, in 2013. He was terminated later in 2013. The state case became public a year later, in the summer of 2014.

Sorensen quoted New York Attorney General Eric Schneiderman (whose office declined to pursue Danon's case) in a statement he made on the issue: "Tax dodging is not acceptable," and New York "will use every tool in our arsenal" to go after tax cheats and protect other taxpayers.

Sorensen added that Vanguard's defense appears to "admit" that Treasury pricing regulations should apply to the company. At least, Vanguard isn't disproving Danon's arguments: "All they have said is that ethical rules bar it. If Mr. Danon did not violate ethical rules, the claim stands...

"Vanguard did not publicly disclose its tax dodges. Danon is an original source (which would make his actions eligible for whistleblower protection) because his allegations regarding the contingeny reserve and Vanguard's failure to price at arm's length for tax purposes were not known by the State of New York." While Vanguard did advertise its low-cost structure, it never disclosed that "they don't pay taxes" or that the company relies on "tax dodges," Sorensen said.

JUDGE: "If they are in fact tax dodges. You characterized them as such. That speaks of conduct."
SORENSEN: "Yes. Contrary to what the defendant said, it is a false claim to understate your income..."

JUDGE: "Do you find it troubling at all that an attorney is suing his former client, the entity for which he worked?"
SORENSEN: "No, your honor... The ethical rules are made to deter wrongdoing."
JUDGE: The ethics rules require a lawyer to report wrongdoing, if it's of a criminal nature. "Isn't there a distinction between that requirement and bringing a qui tam (for the People) action in which the attorney stands" to get paid?
SORENSEN: "There is a distinction. The qui tam law should encourage" complaints like Danon's.

JUDGE: "Isn't there a tension between confidentiality and privileged communications, and the fact a client should be able to have complete trust in his attorney or her attorney or its attorney, to ensure that confidences will be kept private and privileged?"
SORENSEN: That is the general rule. But there is an exception: Fraudulent or Criminal conduct.
JUDGE: "Not 'Fraudulent'. 'Fraudulent' is removed. The statute says 'Criminal'."
SORENSEN: Disagrees; reviews language in the New York statute, which does reference "a crime" as the threshhold for whistleblower protections. But also reads from the 2013 Second Circuit decision in the Quest case, where the judges wrote: "...to prevent any ongoing fraudulent scheme." The lawyer in Quest, Sorensen says, "could have made limited disclosures" without getting his case thrown out as tainted.

JUDGE: "There's only criminal tax fraud if (the taxpayer) has no discretion?"
SORENSEN: "I don't know."
JUDGE: "Isn't that your case?"
SORENSEN: "In transfer pricing, there's no discretion. (Payments, for example from Vanguard funds to Vanguard Group) must be at arm's length" and priced higher than merely the cost of the services, which is what Vanguard is understood to charge. 
JUDGE: "You hesitated."
SORENSEN: "I thought you were talking about all tax cases. Here, there is no discretion. Vanguard did not have the ability to price at anything other than arm's length...

"Danon satisfied the Quest test. He had probable cause to believe a crime or fraud was being committed. Danon's belief is a question of fact" and thus grounds for trial, not dismissal. Unlike with Quest, "Danon has disclosed a minimal amount of information...

JUDGE: "Doesn't (Danon) have a significant financial interest?"
SORENSON: "Not in this case. His claim would be with New York. He does not get any recovery in this case. He is not a party of interest. He is a relator (whistleblower)... That's why the duty of loyalty (in N.Y. legal ethics code Sections) 1.7 and 1.9 do not apply here. He's not representing a client. He's not a lawyer here. He's not a party. The relator's ultimate claim is not even against the defendants, but against the government, for a share of the reward." (Cites a past N.Y. case involving Beth Israel Hospital.)

"1.7 only applies when an attorney simultaneously represents parties with differing interests. He stopped working at Vanguard before his case proceeded."

JUDGE: Danon filed in May 2013 (before he was fired, effective June).
SORENSEN: "He stopped working at Vanguard before his case proceeded. It did not commence until it was unsealed" (July 2014).
JUDGE: "You're saying the qui tam (date a case commences) is different..."
SORENSEN: "Danon is not representing anyone. The case didn't really proceed until after he left Vanguard. He also did not switch sides. He has no interest in this case; he's a relator; he's not on a side in this case. The burden would be on Vanguard to show it is a substantially related matter. Quest, in the U.S. Second Circuit. makes clear the relator brings suit 'on behalf of the U.S. Government.' Here, the state is not bound by the relator (Danon)."

Also, Danon had "discretion to decide whether to report up" to his Vanguard superiors before he was fired. "The case proceeded long afterwards."

WENDEL: Regarding Danon's claim the case didn't proceed until it was unsealed months after he was fired: "This is unbelievably semantic... (Danon) certainly is an interested party... The court disqualifies attorneys who were not even litigating an action" because they had access to privileged information.

"When an attorney does something adverse to the interests of a client," the case can't proceed. "His actions in this lawsuit are totally adverse to his client... He has disclosed and used the client's confidential information... New York State has declined to intervene... He stands to benefit greatly... This case would not be going forward without Danon...

"Danon does not cite any cases where there has been a criminal charge or criminal conviction" for violation of Internal Revenue Code 482 or similar New York rules. She said again that Danon deserves no reward since Vanguard's behavior has been public. 

The federal courts blew out the Quest whistleblower's case, Wendel said, because the ex-company lawyer who brought the case had disclosed "more information than would be considered reasonably necessary... Switching sides... was a violation of the ethics duties (in Quest) so the relator had to be dismissed and disqualified. The same results should obtain (in Danon's case)..."

JUDGE: "Am I bound by the Quest courts' rulings? By my own decisions? I am not... It's certainly instructive and informative."
WENDEL: "This should be interpreted in line with the federal False Claims Act. Danon also stole large amounts of material that relates to his other tax claims in the case. He has more confidential information in his possession...

"We have very strong arguments that show Mr. Danon is completely wrong about... the contingency reserve and the (tax) nexus claims in this case... Those arguments are fact-based, so we haven't brought them forward on this motion... We consider all his tax fraud claims to be completely specious and we'll make that clear... in subsequent proceedings." (Assuming the case isn't thrown out.)

SORENSEN: "Section 191 of the New York False Claims Act is one area where the New York False Claims Act is significantly different from the federal one... It allows a qui tam plaintiff to take documents that support the claim...

"It's discretion on the part of the IRS to tell you you (paid your taxes) wrong." But, by contrast, Vanguard has "no discretion not to rely on arms-length basis" -- the system Vanguard actually uses -- for calculating affiliate payments, margins and taxes.

WENDEL: "He's wrong. It certainly doesn't say an in-house counsel can steal attorney-client privilege documents from his counsel... The IRS provisions, the SEC provisions, do not say, 'Send us any privileged or confidential documents.'

"There certainly is no basis in the New York False Claims Act permitting him to steal confidential documents."

Judge Madden called both lawyers forward to talk briefly about matters under seal. 
JUDGE: "The motion is submitted. Counsel, thank you."

Sorensen and Wendel each told me they have no timetable for the court's next move. The senior of the several Vanguard people present, before I could greet him, directed me to ask any questions to "John," presumably spokesman John Woerth, who (back in Malvern) reminded me Vanguard does not plan to litigate the case in the press, as it were. It was getting dark, we left.  (Revised and updated 2/19)