Senator Elizabeth Warren Versus Paul Krugman on Too Big to Fail

By Pam Martens and Russ Martens: August 19, 2014

Senator Elizabeth Warren Questioning Janet Yellen During Senate Hearing on July 15, 2014

Senator Elizabeth Warren Questioning Janet Yellen During Senate Hearing on July 15, 2014

Two weeks ago, Paul Krugman used some expensive media real estate to write a propaganda piece on the unsupportable proposition that the Dodd-Frank financial reform legislation passed in 2010 is “a success story” and that its bank wind-down program known as Ordinary Liquidation Authority has put an end to “bailing out the bankers.”

Wall Street On Parade took Krugman to task over this fanciful ode to accomplishments by the President the day after his piece ran in the New York Times’ opinion pages and suggested he do proper research on this subject before opining in the future. That was the morning of August 5.

By late in the afternoon of August 5, Krugman had a reality smack-down on his Dodd-Frank success fairy tale by two Federal regulators. Every major media outlet was running with the news that eleven of the biggest banks in the country, including the mega Wall Street banks, had just had their wind-down plans (known as living wills) rejected by the Federal Reserve and FDIC for not being credible or rational. The eleven banks are: Bank of America, Bank of New York Mellon, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street and UBS.

New York Times Columnist, Paul Krugman

New York Times Columnist, Paul Krugman

Yesterday, Krugman’s Dodd-Frank fantasy lost further credibility when Senator Elizabeth Warren released a letter that she and eleven of her Congressional colleagues had sent to the Federal Reserve, warning that one of its Dodd-Frank proposed rules “invites the same sort of backdoor bailout we witnessed five years ago.”

To refresh any forgetful minds at the Fed over its unprecedented hubris in connecting a giant feeding tube to Wall Street during the last financial crisis, the Senators and Congressional Reps wrote:

“During the financial crisis, the Board invoked its emergency lending authority for the first time in 75 years. The scope of the Board’s program was staggering. Between 2007 and 2009, the Board’s emergency lending facilities provided over $23 trillion in loans to large domestic and foreign financial institutions.

“These loans were another bailout in all but name. Of the nearly $9 trillion the Board provided through its largest facility – the Primary Dealer Credit Facility – over two-thirds went to just three institutions: Citigroup, Merrill Lynch, and Morgan Stanley. Those institutions and others had access to the Board’s credit facilities for an average of 22 months. And the interest rates the Board offered were typically very low – in many cases, under 1%.”

Think about this for a moment. Citigroup was insolvent during the crisis – as Federal insiders have now acknowledged in books and media interviews. In an efficient market system, Citigroup would not have been able to borrow at all, much less at a rate for a AAA-borrower of less than 1 percent. The Federal Reserve is forbidden from making loans to insolvent institutions – but it did it anyway.

Contrast the Fed’s largess to serial miscreants like Citigroup against homeowners at the time whose credit was flawed but they had a job and were still paying their bills. If these homeowners could have received funds at a borrowing rate of less than 1 percent, they could have paid off all of their high-interest rate debt, saved their homes from foreclosure, and started out on fresh footing.

Why does the U.S. financial infrastructure only play Fairy Godmother to criminally inclined banks?

Senator Warren and her colleagues clearly smell the possibility of another Citigroup-type situation occurring again. In the letter, they request that the Fed adopt a broader definition of insolvent “so that the Board could not use its emergency lending program to save an institution that is on the verge of bankruptcy.”

The twelve members of the Senate and House who sent this sternly worded letter to the Fed have solid cause for worry.  On July 31 of this year, Edward J. Kane, Professor of Finance at Boston College, testified before the Senate Banking Subcommittee on Financial Institutions and Consumer Protection that the stock of Bank of America and Citigroup “would have been declared worthless long ago if market participants were not convinced that authorities are afraid to force them to resolve their weaknesses.”

In his testimony, Kane called it “shameful” for government officials to suggest that bank bailouts were good deals for taxpayers, stating: “On balance, the bailouts transferred wealth and economic opportunity from ordinary taxpayers to much higher-income stakeholders in TBTF [too-big-to-fail] firms. Ordinary citizens understand that this is unfair and officials that deny the unfairness undermine confidence in the integrity of economic policymaking going forward.”

The letter from Senator Warren and her colleagues together with Professor Kane’s testimony are like a fresh breeze and the first glimpse of sunshine after being trapped in an underground tunnel of darkness for six years.

In addition to Senator Warren, the letter was signed by the following: Senators Sherrod Brown (D-Ohio), Mark Begich (D-Alaska), Mazie Hirono (D-Hawaii), and Edward Markey (D-Mass.), and Representatives Walter Jones, Jr. (R-Calif.), Stephen Lynch (D-Mass.), Michael McCaul (R-Texas), Gwen Moore (D-Wis.), Keith Ellison (D-Minn.), Leonard Lance (R-N.J.), and Tom Cotton (R-Ark.).

The letter ends with this: “If the Board’s emergency lending authority is left unchecked, it can once again be used to provide massive bailouts to large financial institutions without any congressional action.” (Read the full text of the letter here.)

36,000 Madoff Victims Have Not Received a Dime in Restitution; 1,129 Fully Reimbursed

By Pam Martens: August 18, 2014

Bernard Madoff Outside Federal Court in Manhattan in 2008

Bernard Madoff Outside Federal Court in Manhattan in 2008

On May 5, 2014, Irving Picard, the court-appointed trustee in charge of finding and distributing Madoff’s swindled funds to investors released this statement in a press release announcing the fourth interim distribution of funds to victims: “…1,129 accounts will be fully satisfied following the fourth interim distribution. All allowed claims totaling $925,000 or less will be fully satisfied after the distribution.”

Just eight days later, Richard Breeden, the Special Master that’s working on behalf of the U.S. Department of Justice to distribute a separate pool of funds to Madoff’s victims reported that more than 36,000 claimants have filed documents with his office indicating that they haven’t yet received a dime of restitution. Yes, 36,000 people from all over the globe.

That’s bad enough but the story goes downhill from there. Almost six years from the date that Bernard Madoff turned himself in as the largest Ponzi fraudster in the history of finance, the U.S. Department of Justice is still scratching its head over just how much money Madoff actually ripped off from investors and puzzling over how to divvy up its inadequate pot of money.

We know for certain that the Justice Department was stunned to learn that 36,000 claimants said they hadn’t received a dime because in a November 18, 2013 press release, Breeden indicated that he was going to begin accepting claims from “approximately 11,000 investors whose assets came into Madoff Securities indirectly through feeder funds, investment partnerships, bank commingled funds, family trusts or other pooled investment accounts. As a result, we expect approximately 12,000 direct and indirect investors will be eligible for a recovery…” Instead of receiving 11,000 claim forms, Breeden received 51,700 with 36,000 of those reporting zero restitution.

The Justice Department’s idea was to help Madoff’s victims who weren’t eligible under the pool of funds administered by the court-appointed trustee, Irving Picard. The Securities Investor Protection Act, which governs Picard’s distributions, requires that the customer must have held a direct account in his/her own name at a broker-dealer that was a member of SIPC (Securities Investor Protection Corporation) to be eligible to make a claim when the firm fails. Because many of Madoff’s victims gave their money to hedge funds, banks and funds of funds who co-mingled the money with many other investors and then placed the money with Madoff under the fund’s name, those investors to a large degree have seen little restitution.

One primary reason their claims have been denied by Picard revolves around the decision, upheld by the court, to return only original principal deposited – not fictitious profits shown on the statement. Since there was not going to be adequate funds to pay fictitious profits, this seemed like a good idea at the time. The problems emerged when a pooled fund account was deemed – on a total account basis – to have withdrawn more principal than deposited; even when thousands of investors in the fund may have never withdrawn a dime, if the fund account as a whole had withdrawn more principal than it had deposited on behalf of all investors, the claim was denied as it was deemed a net winner.

Picard had previously approved $2.9 billion in claims of Tremont-managed funds which held accounts with Madoff’s broker-dealer. (Picard had also reached a settlement with Tremont where it agreed to pay approximately $1 billion because Picard believed it had ignored warnings that Madoff might be running a Ponzi scheme.) Approximately $1.2 billion of that claim has been distributed by Picard but it’s sitting in an escrow agent account due to court challenges by some Tremont investors.

Breeden, working on behalf of the Justice Department, has adopted a different formula for making distributions. For investors whose money was held by a hedge fund, bank, feeder fund or co-mingled family account, it will look at the individual’s claim solely, not whether the account collectively had withdrawn more principal than it had deposited. Unfortunately, there is not going to be enough money to make people anywhere near whole.

The monies the Justice Department has to distribute came from forfeitures of persons involved in the Madoff fraud. Right now, Breedon has only $4 billion to dispurse. The Justice Department would have had a pot of $9 billion in total funds but it previously turned over $5 billion of what it had collected to the Madoff bankruptcy estate to be used to pay creditors.

According to the May 13, 2014 press release from Breeden, this is the breakdown of claims received: “Based on preliminary review, approximately 77.5% of claims were submitted by individuals reporting losses of up to $500,000, while approximately 9.5% of claimants reported losing from $500,000 to $1 million. Approximately 13% of victims reported losses in excess of $1 million.”

Applying those percentages to just the 36,000 claimants who have not received any funds thus far, and using the low end calculation of the dollar losses, the Justice Department is looking at a ballpark of $16 billion in claims for just those who have yet to receive a dime of restitution – four times what it has on hand.

Equally disturbing, Breeden indicated on May 13 that his office had received “more than 43,500 claims from individuals who did not file a claim” with Picard and said the claims came from 119 countries.

If you add the 43,500 claims received by Breeden from brand new filers together with the 16,519 claims previously filed with Picard, we are looking at 60,019 people stating that they were victims of Madoff’s fraud. Of that 60,019, there are 36,000 people who have not received a dime; 1,129 who have been made completely whole by Picard up to an amount of $925,000. And out of the 60,019, almost six years after Madoff turned himself in, only 2,518 claims have been approved for payment.

When the news of the Madoff fraud first gained media attention around the world in December of 2008, there was widespread criticism of the structural failure of the U.S. financial regulatory system, particularly the SEC – which had not only ignored detailed, written warnings from professionals like Harry Markopolos and others that Madoff was running a Ponzi scheme but the SEC had actually closed investigations into Madoff’s operations and then shredded the evidence it had collected.

The only consistent message here is that the U.S. financial regulatory structure is just as bad at delivering fraud restitution as it is at detecting fraud.

It’s time for another Senate Committee to begin to function like Carl Levin’s Permanent Subcommittee on Investigations (already buried under exponentially accelerating Wall Street fraud investigations) and hold new hearings on the Madoff fraud.

Key questions for this hearing are as follows: why did it take over five years to learn that 36,000 Madoff claimants have not received a dime of restitution. Why was JPMorgan Chase, which was charged with two felonies for aiding and abetting the Madoff fraud, given a deferred prosecution agreement and allowed to settle for chump change. It was agreed by both the Justice Department and Picard that JPMorgan Chase (and/or its predecessor banks) stood at the very center of the fraud as Madoff’s key business bank for more than 20 years watching hundreds of billions of dollars being washed between accounts. And yet, this is what JPMorgan paid in settlement funds: $1.7 billion to the U.S. Justice Department to compensate victims of the fraud; another $543 million to Picard’s trustee fund to compensate victims; and a $350 million fine to the regulator of national banks, the Office of the Comptroller of the Currency.

That settlement with JPMorgan came on January 7, 2014.  The Justice Department did not release the news revealing that it had a paltry pot of money to pay claims reaching somewhere between $16 billion and $40 billion until four months after that settlement with JPMorgan.

And finally, there is the matter of the Justice Department quashing the subpoena by one of JPMorgan’s regulators who had demanded information from inside JPMorgan on what its employees knew about the Madoff fraud.

When the highest law enforcement in the land quashes a subpoena from a Federal regulator while deferring felony prosecutions and settling on the cheap with a serial miscreant – leaving tens of thousands of Madoff victims destitute for six years – the public and defrauded investors around the world need answers.

To do anything less sends a chilling message around the globe that the U.S. is not a safe place to invest.

Citadel’s Dark Pool: SEC Draws a Dark Curtain Around Its Operations

By Pam Martens and Russ Martens: August 14, 2014

Ken Griffin, Owner of Hedge Fund Citadel, Giving a Speech at the Economic Club of Chicago

Ken Griffin, Owner of Hedge Fund Citadel, Giving a Speech at the Economic Club of Chicago in May, 2013

In response to a Freedom of Information Act (FOIA) request from Wall Street On Parade seeking information on how Citadel’s dark pool, Apogee, operates, the Securities and Exchange Commission responded in a letter dated August 12, 2014 that “we have determined to withhold records responsive to your request….”

Dark pools are the unregulated stock exchanges currently under scrutiny for potentially illegal market rigging activities. We were not asking for trade secrets or results of examinations. We simply wanted basic information on how the Apogee dark pool operates in the marketplace. Mary Jo White, Chair of the SEC, has promised greater transparency by her agency, and yet, this very basic level of information was denied.

Other dark pools like Liquidnet, Credit Suisse Crossfinder, and even the mighty Goldman Sachs’ dark pool, Sigma-X, have released their Form ATS describing the operations of their dark pools. What’s so secretive about how Citadel operates that it needs the SEC to run interference for it?

Citadel demands public scrutiny because it has been fined and/or sanctioned for market misconduct 26 times according to Financial Industry Regulatory Authority (FINRA) records. To put that number in perspective, if an individual broker had 26 violations on his public record he would have a very difficult time getting hired by a reputable firm. (Bad brokers with long histories of misconduct do sometimes get hired, unfortunately, because disciplinary records are expunged from the public record as part of settlement agreements.)

On June 25, 2014, Citadel Securities LLC, the owner of Apogee, was fined a total of $800,000 by its various regulators for serious trading misconduct. Citadel paid the fines in the typical manner, without admitting or denying the charges. This is what the New York Stock Exchange said Citadel had done:

“The firm sent multiple, periodic bursts of order messages, at 10,000 orders per second, to the exchanges. This excessive messaging activity, which involved hundreds of thousands of orders for more than 19 million shares, occurred two to three times per day.”

In addition, according to the York Stock Exchange, Citadel “erroneously sold short, on a proprietary basis, 2.75 million shares of an entity causing the share price of the entity to fall by 77 percent during an eleven minute period.”

In another instance, according to the New York Stock Exchange, Citadel’s trading resulted in “an immediate increase in the price of the security of 132 percent.”

On January 9, 2014, the New York Stock Exchange charged Citadel Securities LLC with engaging in wash sales 502,243 times using its computer algorithms. A wash sale is where the buyer and the seller are the same entity and no change in beneficial ownership occurs. (Wash sales are illegal because they can manipulate stock prices up or down. They played a major role in the rigged stock market that crashed in 1929.) Citadel paid a $115,000 fine for these 502,243 violations and walked away.

As Wall Street On Parade reported on July 28 of this year, instead of cracking down on wash sales, Wall Street’s regulators have instead watered down the rules governing this virulent form of market manipulation.

Despite the seriousness of the market violations that Citadel has committed – 26 times – no prosecution has occurred and no one has gone to jail. But if you take something from Citadel, and are young employees lacking Citadel billionaire-owner Ken Griffin’s money to hire legions of top tier law firms, you will be hounded by relentless prosecutors and very likely end up with a long prison term. (See Appellate Court Finds Misconduct by SEC and U.S. Prosecutors in Squawk Box Case; Overturns Convictions)

According to this story at Bloomberg News, Sahil Uppal and Yihao Pu, both 26 years old, have been charged by the Justice Department in connection with the removal of computer code from Citadel. According to Bloomberg, Uppal faces 10 years in prison.

The case against Uppal and Pu is all the more interesting because theft of computer code charges were thrown out by a Federal appeals court in December 2010 in a case involving Sergey Aleynikov, a gifted former programmer at Goldman Sachs.

The Aleynikov prosecution was so egregious that bestselling author, Michael Lewis, covered the case in his book, Flash Boys, about the market manipulations of dark pools and high frequency traders. Aleynikov had been working for Goldman Sachs when he received an offer to move to a hedge fund and build a system from scratch.

That was 2009. Over the past five years, Aleynikov has been arrested and jailed by the U.S. Attorney’s office in Manhattan, had his conviction overturned by the Second Circuit Appeals Court, arrested again by the Manhattan District Attorney Cyrus Vance, and now faces more prosecution over the same set of facts: namely, that he took computer code that belonged to Goldman Sachs.

The case was so devoid of statutory support that on the very same day that Kevin Marino, Aleynikov’s lawyer, gave his oral arguments to the Appeals Court, “the judges ordered Serge released, on the grounds that the laws he stood accused of breaking did not actually apply to his case,” Lewis wrote. Aleynikov had already been in prison for a year.

The Second Circuit Appeals Court ruled that Aleynikov had neither taken a tangible good from Goldman nor had he stolen a product involved in interstate commerce – noting that at oral argument the government “was unable to identify a single product that affects interstate commerce.”

Aleynikov awaits trial in New York State court.


See SEC Response to FOIA Request for Information on Citadel’s Dark Pool, Apogee

How High Up Did the Madoff Fraud Go at JPMorgan?

By Pam Martens and Russ Martens: August 13, 2014

JPMadoff BookHelen Davis Chaitman is a nationally recognized litigator and author of The Law of Lender Liability. And she is two other things as well – a Bernie Madoff victim who lost a large part of her life savings to his Ponzi scheme and the tenacious lawyer who represented other victims of his fraud in district and appellate courts. 

Now, together with attorney Lance Gotthoffer, Chaitman has written a book titled JPMadoff: The Unholy Alliance Between America’s Biggest Bank and America’s Biggest Crook. The book is being made available to readers on a new web site which will provide a chapter each month. The first chapter is currently available and Chaitman says that the second chapter, to be posted on September 12, will detail what JPMorgan knew and when it knew it. 

The web site also provides a quick means of contacting your legislator in Washington to urge Congress toact in the interests of the American people, not in the interests of the financial institutions that are rich enough to make significant contributions.”

Helen Davis Chaitman

Helen Davis Chaitman

It is universally agreed among these authors, the prosecutors and the trustee for the Madoff victims’ fund that JPMorgan Chase (or its predecessor banks) stood at the center of the fraud as Madoff’s commercial bank for more than 20 years. It’s the lack of criminal prosecutions against the JPMorgan wrongdoers that has incensed these attorneys to launch the book and web site.

The authors explain their position in the book’s foreward:

“Madoff could not have stolen $64.8 billion of other people’s money without the complicity of a major financial institution. Madoff was able to get by with a three-person accounting firm working out of a store front in a shopping center in Rockland County, New York. But make no mistake about it. Madoff needed the imprimatur and facilities of a major bank. And JPMorgan Chase stepped up to the plate. Why would the bank do this? Shall we follow the money? Do you have any idea how much money JPMorgan Chase was able to make off the Madoff account? Did you know that Madoff maintained huge balances in his JPMorgan Chase account, reaching $4 billion or more from 2006 on. And do you think the folks at JPMorgan Chase know how to make money off other people’s money? You bet they do.

“The facts — which we lay out in this book — compel the conclusion that senior officers of JPMorgan Chase knew that Madoff was misappropriating customer funds and knew who all the victims were. There were 12 people who worked for Madoff who knew about Madoff’s embezzlement of money belonging to innocent investors. Outside of Madoff’s offices, nobody knew — for 20 years. Nobody, that is, except the people at JPMorgan Chase who were responsible to monitor the activities in Madoff’s account. They saw that, from 1986 to December 2008, Madoff deposited into his JPMorgan Chase account approximately $150 billion of funds — from upstate New York union pension funds, from charities, from corporate pension plans, from individual I.R.A. accounts. Bank officers knew that Madoff was an SEC-regulated broker who was retained by his customers to purchase securities for them. Yet, they saw no transactions in Madoff’s account indicating that he was purchasing securities for his customers. Instead, billions of dollars went to Madoff’s co-conspirators, or were wired overseas.”

Under the author section, Chaitman provides more detail on why she feels JPMorgan got off so easily:

“The most glaring example of the corruption of American values by the financial services industry is the government’s recent refusal to prosecute any individual at JPMorgan Chase for providing banking services to Bernard Madoff for almost 20 years with knowledge that he was dishonest. The prosecutor was Preet Bharara, formerly chief counsel to Senator Schumer who has enjoyed, over the years, a flow of political contributions from the entire Madoff family and from JPMorgan Chase.”

In January of this year, Wall Street On Parade completed months of research into court filings that detailed JPMorgan’s involvement in the Madoff fraud. Our conclusion was that there was not just a Ponzi scheme taking place but a series of frauds that sprang from the original fraud in a Russian nesting doll form of structure. (Read the full article.)

Lance Gotthoffer

Lance Gotthoffer

One of the most damning pieces of evidence suggesting that JPMorgan prolonged the Madoff fraud, allowing him to suck in more innocent victims, was a report from the trustee for the Madoff victim fund, Irving Picard, that JPMorgan Chase used unaudited financial statements to make $145 million in loans to Madoff’s business. Lawyers for the Trustee write further that from November 2005 through January 18, 2006, JPMorgan Chase loaned $145 million to Madoff’s business at a time when the bank was on “notice of fraudulent activity” in Madoff’s business account and when, in fact, Madoff’s business was insolvent. The reason for the JPMorgan Chase loans resulted from the fact that Madoff’s business account was “reaching dangerously low levels of liquidity, and the Ponzi scheme was at risk of collapsing.”

You will note as you read the background information on the Chaitman-Gotthoffer web site that the attorneys refer to a “$64.8 billion” Madoff fraud, not the $17.5 billion figure used by Madoff Trustee, Irving Picard, and major business media.

The dramatic difference in the two numbers is that Picard is using the figure for the amount of original principal he believes to have been invested with Madoff. Chaitman and Gotthoffer are using the gross amount Madoff showed on his client statements as his customers’ account balances.

The $64.8 billion figure is a valid calculation for this reason: money has a time value. Some investors started with Madoff as far back as 30 years ago. If they had placed those funds in something as simple as a savings account or a Treasury bill, they would have compounded and grown significantly. To call it a $17.5 billion fraud ignores 30 years of compound interest or legitimate stock market returns that could have been achieved had Madoff actually invested the money.

The media’s willingness to reduce the fraud to the $17.5 billion figure may have something to do with putting the best face possible on the recoveries for victims. To date, Picard has recovered $9.825 billion and made distributions of $5.259 billion. Richard Breeden, the Special Master for the U.S. Department of Justice, is administering another Madoff victim fund consisting of $4 billion in forfeited assets recovered from persons involved in the fraud. That brings the total current recoveries to $13.825 billion – which doesn’t sound too bad versus a $17.5 billion fraud but would represent only 21 percent of the statement value of $64.8 billion.

Chaitman and Gotthoffer provide another salient point in their book foreward, writing:

“It is almost six years since Madoff confessed and yet, Madoff has never testified under oath; no one from JPMorgan Chase has testified under oath…The big question is whether Americans are going to continue to tolerate criminal conduct in its financial institutions. We know the government will; the question is whether the American people will.”

This new web site, with its quick link to communicate with your members of the House and Senate, is a hopeful message that Americans are starting to fight back.

Meet the Tax Lawyer Whistleblower Who’s Taking a Wrecking Ball to John Bogle’s Legendary Career at Vanguard

By Pam Martens and Russ Martens: August 12, 2014

John Bogle, Founder of the Vanguard Group

John Bogle, Founder of the Vanguard Group

Tax lawyers do not typically blow the whistle on their corporate employers because that law degree cost them (or their parents) a serious amount of money; the degree will result in outsized lifetime earnings; and, most importantly, because it is career suicide. Even when the tax lawyer may believe there is fraud that would trump the attorney-client privilege, whistle blowing in a court of law against one’s employer is a rarity for a tax lawyer.

So one must seriously ask what would motivate David Danon, a 1998 magna cum laude graduate of Fordham University School of Law who proceeded to work at top tier corporate law firms (where he obviously saw a lot of questionable tax deals) to blow the whistle on the gold standard of the mutual fund industry, the Vanguard Group, Inc. In making his claims, Danon is also besmirching the reputation of Wall Street legend, John Bogle, who founded Vanguard and has served as its top spokesperson for the past 40 years.

In his whistleblowing lawsuit, unsealed last month in New York State Supreme Court, Danon names only Vanguard Group, Inc. and two subsidiaries as defendants. But by calling the company a major tax cheat, Danon is challenging the reputation of Bogle and the company’s Big Four accounting firm, PricewaterhouseCoopers (PwC).

Danon went to work for Vanguard in Pennsylvania in August 2008, according to his LinkedIn profile. He continued to work there for the next 4 years and 11 months until June 2013. The month prior to his departure, on May 8, 2013, Danon filed his 40-page, sealed whistleblower lawsuit, making breathtaking claims against his employer, such as the following:

“Vanguard has operated as an illegal tax shelter for nearly forty years, providing services to the Funds at prices designed to avoid federal and state income tax, sheltering hundreds of millions of dollars of income annually, avoiding approximately $1 billion of U.S. federal income tax and at least $20 million of New York tax over the last ten years.”

By claiming that Vanguard has been running an illegal tax shelter for 40 years, Danon is aiming his slings and arrows right at the armor of its founder. Bogle started Vanguard in 1974; served as its CEO until 1996; and as Senior Chairman and Director until 2000. Bogle is still affiliated with the company as President of Vanguard’s Bogle Financial Markets Research Center.

One specific charge that Danon makes in his complaint may be tough to prove as a devious effort to dodge taxes. Danon states:

“Vanguard violates Section 211(5) and Section 482 by providing services to the Funds at artificially low, ‘at-cost’ prices. As a result, Vanguard shows little or no profit and pays little or no federal or state income tax despite managing Funds with nearly $2 trillion in assets.”

This at-cost pricing is so transparent at Vanguard that John Bogle explained it in testimony he gave to the U.S. Senate on November 3, 2003 when he was invited to lecture his industry on “Trading Practices and Abuses that Harm Investors.” In his written testimony submitted to the Senate, Bogle wrote:

“Vanguard was created as a mutual organization, with its member mutual funds as the sole owners of the management company, Vanguard Group, Inc.  The company operates the funds on an ‘at-cost’ basis.  Essentially, we treat our clients — the fund shareholders — as our owners, simply because they are our owners.  We are the industry’s only mutual, mutual fund enterprise…”

This certainly makes what Vanguard was doing all these decades look pretty much like an open book that Congress and the IRS and PricewaterhouseCoopers understood to be legitimate. Vanguard even has a full page with graphs explaining further its structure and how it benefits the average investor in its mutual funds. One section explains:

“The typical fund management company is owned by third parties, either public or private stockholders, not by the funds it serves. These fund management companies have to charge fund investors fees that are high enough to generate profits for the companies’ owners. In contrast, the Vanguard funds own the management company known as Vanguard—a unique arrangement that eliminates conflicting loyalties. Under its agreement with the funds, Vanguard must operate ‘at-cost’— it can charge the funds only enough to cover its cost of operations. No wonder Vanguard’s average fund expense ratio in 2013 was 0.19%, less than one-fifth that of the 1.08% industry average. That means Vanguard fund investors keep more of any returns their funds earn.”

Bogle is no slouch when it comes to accounting. This is an excerpt from testimony he gave to the Public Company Accounting Oversight Board on March 21, 2012:

“I’m pleased to have this opportunity to comment on my general views on auditor independence and specific views on audit firm rotation. I have been an observer of and participant in auditing issues throughout my 60-year career, most recently as one of four independent members of the Independence Standards Board (from 1997 to 2001, when it ceased operations), appointed by SEC Chairman Arthur Levitt, where we worked with the four CEOs of the major accounting firms to establish more rigorous standards for assuring that our public accountants remained truly independent of the firms that retain them for attestation services…”

In that same testimony, Bogle notes that two of his books, Don’t Count On It! and The Battle for the Soul of Capitalism deal with significant accounting issues.

At the risk of a very bad pun, it is simply mind-Bogleing that John Bogle or PricewaterhouseCoopers would not have gotten an all-clear letter from the IRS on this structure at some point over the past four decades.

The takeaway for investors is this: high mutual fund fees are already gobbling up your hopes to ever retire in comfort. As Frontline’s Martin Smith exposed in April of last year, if you’re receiving the typical long-term return of 7 percent on your 401(k) plan and your fees are 2 percent, almost two-thirds of your account will go to Wall Street over the course of your career. If Vanguard, the low-cost mutual fund provider is forced to restructure itself and incur higher operating expenses and taxes, the small investor loses.

Against that backdrop, it should also be noted that David Danon, should he prevail in his lawsuit, would be entitled to collect a portion of the back taxes owed by Vanguard. 


See Vanguard Complaint Filed by David Danon for the full text of the lawsuit.