Reactions to Vanguard whistle-blower's allegations

Posted: August 04, 2014

How can low investment fees be a bad thing?

That's what readers were asking one another last week on forums such as Bogleheads.com and other sites linked to stories about Vanguard Group Inc. and David Danon, the Vanguard tax lawyer-turned-whistle-blower.

Danon, a former employee, alleges in his suit in a New York state court that Vanguard wrongly avoided income taxes on a $1.5 billion "contingency reserve" and lowballed the advisory fees it charges its own Vanguard funds so it could avoid U.S. taxes. If so, wasn't that just Vanguard's way of helping investors pay less and save more?

But the federal government is not the only victim, Danon alleges. Vanguard customers are losing, too, he told the Securities and Exchange Commission in a series of letters filed under a federal whistle-blower's law beginning last year.

In its marketing materials, Vanguard calls attention to its "unique" structure as a money-management company owned, not by private investors, but by its own mutual funds. Vanguard says its structure and its tax practices are legal and time-sanctioned, that it has cooperated with the Internal Revenue Service, the SEC, and other agencies, and that its low fees prove it works efficiently for investors' best interests.

But Danon told SEC officials the group's unusual structure leaves investors surprisingly unprotected. Vanguard Group isn't a nonprofit, or a cooperative, or a public company, bound by certain disclosure rules and limits. It's a private corporation run by "a small, insular group of insiders" who can use company funds to finance new business lines or pay themselves millions of dollars a year, "with virtually no oversight," Danon told the SEC.

"No public reporting or oversight ensures that Vanguard acts in the best interests of the Funds," Danon wrote. "Vanguard's management - the perpetuators of the tax avoidance - derives enormous benefits from the secrecy Vanguard's structure provides."

For example, Vanguard isn't obliged to report how much it pays its top managers. Vanguard stopped making that information public in the late 1990s.

Vanguard says its compensation is "competitive relative to the rest of the industry," said Vanguard spokeswoman Linda Wolohan. She said that up to 90 percent of senior executives' pay was based on "the performance of our funds, efficiency of our operations, productivity improvements, and higher levels of service."

Now that Vanguard is the largest mutual fund company, does competitive pay mean its executives collect as much as or more than those at smaller, publicly traded rivals such as Affiliated Management Group, Franklin Resources, or Invesco, whose CEOs collect $10 million to $20 million annually, according to SEC reports?

'Ridiculous'

"The idea that our growth and size means we have the highest compensation in the industry is ridiculous," Wolohan said. She would not disclose executive pay, saying that was a private matter.

Danon accused the company of misleading investors in its marketing materials by not disclosing the risk that the IRS will eventually enforce the law and oblige Vanguard to pay more taxes.

Danon says Vanguard Group is also undervaluing fund investors' share values by underreporting the value of its own private stock, some of which is held by each of the Vanguard funds.

By collecting artificially low management fees, by not fully valuing the group's non-mutual fund businesses (brokerage, advisory, foreign-based funds), and by not counting the contingency reserve, Vanguard shares are on the books at billions less than their potential value, Danon says.

He told the SEC the value of the Vanguard 500 Index Fund's holdings in Vanguard Group Inc. itself could be worth roughly as much as the fund's holdings in Citigroup, one of the nation's largest banks, if they were properly valued.

Terminated

That still could amount to small change compared with Vanguard's $2.5 trillion in total investor assets. "[But] the SEC should not view this misrepresentation as irrelevant ancient history," Danon wrote.

Danon also faults Vanguard's fee policies, which he called contradictory. While charging its American funds only "at-cost fees" for management services, Vanguard charges the same funds "above-cost fees" to fund the contingency reserve, a payment that reduces returns for fund shareholders without giving them corresponding benefits, Danon told the SEC.

In contrast with its low-fee U.S. operations, Vanguard charges its foreign-based funds higher "market-rate" fees, according to Danon, because foreign tax laws demand it. The United States has similar laws, but they aren't enforced in Vanguard's case, Danon alleges.

Danon has also reported on Vanguard to the IRS. He was terminated by Vanguard in 2013, as a result, he says, of his whistle-blowing.

Danon says his decision to "do the right thing" has ended his once-promising career as a corporate tax lawyer - he has let his bar association memberships lapse - and left him scrambling to support his family.


JoeD@phillynews.com

215-854-5194

@PhillyJoeD

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