There may be trouble brewing in Bogle-land
Fans of Jack Bogle, the legendary Vanguard Group founder, may be in for an unwelcome surprise: The mutual fund giant is facing claims that it doesn't charge enough for its management services.
Yes, you read that correctly. According to legal and regulatory claims from former Vanguard employee David Danon, the fund company's famously low fees are allegedly the result of an illegal tax strategy.
The potential fallout, according to a tax expert who is working with Danon, is a bill from the IRS for back taxes of up to $34.6 billion and, for Vanguard investors, the specter of much higher fees. The typical expense ratio for Vanguard funds, which now stands at an ultralow 0.18 percent, could more than quadruple to as high as 0.82 percent, according to the tax expert's assessment.
Vanguard, for the uninitiated, is the second-largest fund management company in America following BlackRock (BLK). It has gained more than $3 trillion in assets under management and 20 million investors, thanks to Bogle's pioneering philosophy of passive investing through index funds and Vanguard's low fees, which the firm promotes as 82 percent lower than the industry average.
But Danon claims those low fees are allegedly the result of avoiding taxes from what he asserts is an illegal pricing method that stems from Vanguard's unusual corporate structure, which is more investment co-operative than traditional investment company.
"From day one, Jack Bogle and the folks who ran Vanguard after him have pointed to Wall Street's greed as the reason why other companies can't bring the costs down to Vanguard's level," said Daniel Wiener, editor of The Independent Adviser for Vanguard Investors. "But it could be that Vanguard's (co-operative-like) structure may have been a structure that is not allowed by the tax law."
If Danon's succeeds in his claims -- a big "if," given that Vanguard Group vigorously denies his contentions -- "it will damage their reputation tremendously," Wiener added.
Danon also stands to reap more than $10 billion because the law allows a successful tax whistleblower to collect as much as 30 percent of whatever the IRS collects.
He may seem like an unlikely whistleblower: a graduate of Fordham law school who went on to work at prominent New York law firms Sullivan & Cromwell and Cleary Gottlieb. After joining Vanguard as a tax attorney in 2008, Danon noticed that the company handled its international funds differently than its U.S. funds, said attorney Stephen Sorensen of law firm Thomas Alexander & Forrester, who represents Danon.
The overseas funds were pricing their services at what tax law calls "arm's length," which is required when affiliates of the same company conduct business dealings with each other, Sorensen said. Under the tax law, transactions between affiliates or a corporation and its shareholders can't be brokered at rock-bottom prices because it can allow those companies to sidestep taxes.
"He said, 'Why is Vanguard not doing that domestically?' That's when he started asking questions, and that led to him getting terminated," Sorensen said.
His claims have been lodged with several authorities, including the IRS, the Securities & Exchange Commission and state regulators in New York, California, Massachusetts and Texas, Sorensen said. In the two years since he first filed his claims, there have been some steps forward -- and backward -- for Danon.
New York state officials dismissed the claim, although Sorensen said the decision is under appeal. In Texas, Vanguard agreed to pay what Bloomberg News reported was "several million dollars" in back taxes because of Danon's complaint. (A copy of the settlement agreement between Texas and Vanguard reviewed by CBS MoneyWatch had the amount of the penalties redacted.) And in California, an investigator from the California Franchise Tax Board contacted Sorensen in October to request more information, Sorensen said. The California Franchise Tax Board declined to comment.
Vanguard spokesman John Woerth said Danon's claims "are without merit."
"We are confident that we are not under investigation in California," he wrote in an email. He said the company wasn't aware of any actions in any other state or jurisdiction related to Danon's allegations.
Others say Danon's argument has some meat. Vanguard could be on the hook for $34.6 billion in past-due federal taxes from 2007 to 2014, according to a report prepared for the plaintiffs in September by Reuven Avi-Yonah, a University of Michigan tax law professor. Avi-Yonah, who has also taught tax law at Harvard and consulted for groups ranging from the U.N. to the U.S. Treasury, is working with Danon on the case.
While the heart of Danon's allegations are complex, the situation spins out of the unusual way Vanguard was structured when it was founded in the 1970s. Bogle wanted the company to be set up differently than other fund management firms because he believed many fund managers had an inherent conflict of interest between making profits for their company shareholders versus their fund investors.
That prompted him to ask for permission from the SEC to create a new structure for his firm. Vanguard's investors own the firm's funds, and those funds own Vanguard, as opposed to rivals such as Fidelity Investments, which are owned by third-party shareholders. Vanguard describes itself as remaining "unique in the industry" because of that structure.
Vanguard charges for the advisory services it provides to its mutual funds, but it prices them "at cost," which is a feature the company promotes in its marketing literature. Danon contends that's not allowed under U.S. tax law, given that both federal and state tax laws require affiliated companies to negotiate "arm's length" prices -- meaning the same amount two unaffiliated companies would charge each other.
"If the IRS were to pursue the matter, it will prevail in court on the issue of whether Vanguard should have charged its affiliated funds an arm's length advisory fee based on industry comparables," wrote Avi-Yonah.
If Vanguard were charging an "arm's length" advisory fee to its funds, the fee would be pegged between 0.71 percent to 0.82 percent of each fund's net asset value, according to his calculations. The taxes on that much greater income would amount to about $34.6 billion from 2007 to 2014 alone, he added.
As for hardcore fans of Bogle and Vanguard, who call themselves Bogleheads, most aren't concerned, said Independent Adviser editor Wiener. He himself has money invested in Vanguard funds and hasn't made any changes in allocation because of the tax complaint. "With any acolyte, it's pretty hard to shift their belief system once they've drunk the Kool-Aid," he said.
At Bogleheads.org, a forum devoted to Bogle's philosophy, followers are attentive to the case but not necessarily concerned it will mean higher fees or taxes. "Vanguard has been open about their organizational structure for decades," one member of the forum pointed out.
Others, like Wiener, are viewing the case as potentially expensive for Vanguard. "I don't believe even if Vanguard is found guilty of some tax crime that this will knock them out of the running," he said. "They will not be able to call themselves the low-cost provider any longer. They may be one of the low-cost providers."
It could take two or three more years for the case to work its way through the IRS, Sorensen estimates. He believes the states will wait to see how the case plays out with the nation's tax authority. Vanguard could also settle, he added.
While Danon could collect as much as 30 percent of what the IRS collects, Sorensen said his client isn't in this for the money. "He believes what they are doing is wrong," Sorensen said, adding Danon is not currently employed. "It's a tough life. I wouldn't advise anyone to be a whistleblower unless they are prepared for it."