A trial court judge granted Vanguard Group, Inc.’s motion to dismiss a qui tam action filed by its former in-house tax counsel under New York’s False Claims Act, on the basis that the in-house counsel violated the rules of attorney professional conduct in bringing the action. State of New York ex rel David Danon v. Vanguard Group, Inc. et al., No. 100711/13 (N.Y. Sup. Ct., N.Y. Cnty. Nov. 13, 2015). Meanwhile, another New York qui tam action was recently unsealed, alleging that Citigroup wrongly claimed net operating loss deductions on its New York bank tax returns, even though such NOL deductions were related to deductions that were approved by the Internal Revenue Service. State of New York ex rel Eric Rasmusen v. Citigroup, Inc., No. 100175/13 (N.Y. Sup. Ct., N.Y. Cnty. Jan. 24, 2013), removed to federal court, No. 15-cv-7826 (S.D.N.Y.Oct. 2, 2015).

Vanguard Case

Facts. As discussed in the September 2014 issue of New York Tax Insights, David Danon, a New York and Pennsylvania licensed attorney, filed a qui tam action against Vanguard Group, Inc. (“Vanguard”) in 2013. Mr. Danon alleged that Vanguard has “operated as an illegal tax shelter for nearly forty years,” arguing that Vanguard did not file tax returns before 2011, despite having nexus in New York; that, when Vanguard did begin filing returns, it did not follow New York’s shareholder sourcing rules for apportionment; and that Vanguard “violate[d]” Tax Law § 211.5 and Internal Revenue Code § 482 by providing services to related parties—the Vanguard group of mutual funds—at artificially low prices. Mr. Danon also alleged that Vanguard entities conspired to fail to pay required taxes, and that he was retaliated against by being demoted and discharged. Mr. Danon sought damages of 25 to 30 percent of the proceeds of the action or settlement of the claims in his complaint. The New York State Attorney General (“AG”) declined to convert the qui tam action into a civil enforcement action, so Mr. Danon continued to bring the action with the assistance of private counsel.

Vanguard moved to dismiss Mr. Danon’s complaint, arguing, among other things, that: (1) Mr. Danon and his counsel should be disqualified from the action because Danon violated his duty of loyalty and confidentiality to Vanguard under New York’s Rules of Professional Conduct applicable to attorneys (“Attorney Conduct Rules” or “Rules”); (2) Mr. Danon did not make proper retaliation or conspiracy claims; and (3) Vanguard did not knowingly submit a false claim to New York.

The Decision. The trial court dismissed Mr. Danon’s action and disqualified Danon’s counsel from bringing any subsequent related action. The court determined that Mr. Danon violated two Attorney Conduct Rules, Rules 1.6 and 1.9(c), under which “[a] lawyer shall not knowingly reveal confidential information . . . or use such information to the disadvantage of a [current or former] client or for the advantage of the lawyer or a third person.” The court concluded that an exception to those Rules, allowing disclosure of confidential information “to prevent [a] client from committing a crime,” was not applicable.

The court relied on U.S. v. Quest Diagnostics Inc., 734 F.3d 154 (2d Cir. 2013), a case affirming the dismissal of a qui tam action under the federal False Claims Act brought by plaintiff entity with a general partner who was previously in-house general counsel for the defendant, with allegations based on confidential information obtained through the counsel’s previous employment. The court in Quest rejected the argument that counsel did not violate the Attorney Conduct Rules because disclosure was necessary to prevent the commission of a crime, finding that the federal False Claims Act did not preempt attorney conduct rules, and that the plaintiff’s disclosures went beyond what was necessary to prevent any alleged crime of the defendant.

Applying Quest, the court in Vanguard found that, even if Mr. Danon reasonably believed Vanguard intended to continue committing a crime, he had alternate means of preventing the alleged tax violations, including by providing Vanguard documents to the IRS, the Securities and Exchange Commission, and the AG—as Mr. Danon did prior to bringing his action. The court also highlighted allegations by Mr. Danon that were unrelated to an asserted ongoing crime, including alleged tax violations from 1999 and 2004, finding that the disclosures went well beyond those necessary to prevent a crime.

The court also dismissed Mr. Danon’s retaliation claim, finding among other things that Mr. Danon’s internal complaints to Vanguard regarding its tax practices did not constitute “protected activity” under the New York False Claims Act (“New York FCA”). Separately, the court dismissed Mr. Danon’s conspiracy claim on the basis that related entities cannot conspire to violate the New York FCA. However, the court made “no determinations as to the merits, or lack thereof” of Mr. Danon’s allegations in general, and stated that the dismissal would not prevent a New York State agency from pursuing the allegations made by Danon.

Citigroup Case

A recently unsealed qui tam action brought by Indiana University professor Eric Rasmusen alleges that Citigroup failed to pay approximately $800 million in New York bank tax between 2010 and 2012 because the bank improperly deducted NOLs from taxable income “after undergoing ownership changes resulting from the federal government’s purchase and sale” of Citigroup stock.

During the years at issue, New York allowed a bank to deduct NOLs from its taxable income, and such NOL deduction was “presumably” the same as the federal NOL deduction calculated under the IRC, with certain modifications. Former Tax Law § 1453(k-1). IRC § 382 limits a corporation’s ability to use its NOL carry forwards after the corporation experiences an “ownership change.” The policy purpose of § 382 is to prevent NOLs from being used to reduce taxes for corporate shareholders that did not actually bear the corporation’s losses.

According to Mr. Rasmusen, Citigroup had two ownership changes for purposes of § 382, the first in 2008 when the U.S. Treasury purchased equity in Citigroup as part of the Troubled Asset Relief Program, and the other in 2010 when the U.S. Treasury sold its Citigroup equity. The IRS released three Revenue Notices stating that the § 382 limitation would not be triggered by the U.S. Treasury’s purchase and sale of stock, but Rasmusen’s complaint alleges that 2009 federal legislation expressly forbid the “special rules” provided in the Revenue Notices, and that Citigroup wrongfully relied on the Revenue Notices in calculating its federal and New York NOL deductions.

Like in the Vanguard case, the AG declined to convert Mr. Rasmusen’s claim into a civil enforcement action, so he continued to pursue the case in his own name with the assistance of a New York law firm. The complaint was unsealed this year, and Citigroup has filed a notice to remove the case to federal court on the grounds that Mr. Rasmusen’s claims require “resolution of a substantial question of federal law.” In its filing for removal, Citigroup repeatedly highlighted that the Revenue Notices directly contradict Mr. Rasmusen’s “dubious” claims.

Additional Insights

While the Vanguard decision acknowledges that there is no “absolute bar” to an attorney bringing a qui tam action against a client, it also affirms that an attorney who violates New York’s Attorney Conduct Rules in bringing such an action will not be allowed to go forward with (and potentially profit from) attorney-client confidences. Further, the dismissal of Mr. Danon’s wrongful termination action on summary judgement may suggest that the New York courts will be wary towards wrongful termination claims brought by attorneys against their employer-clients in the context of New York FCA actions.

Press reports indicate that Mr. Danon intends to appeal the dismissal of his New York action, and also that he has received a payment in connection with a Texas audit of Vanguard based on information he provided to that state’s taxing authority.

In connection with the Citigroup action, Mr. Rasmusen has stated in published articles that he brought his action against Citigroup under the New York FCA because he could find no way to challenge Citigroup’s federal tax filings or to force the U.S. Treasury to collect taxes that the IRS had decided were not due. The action raises the troubling possibility that the New York FCA could be used to force companies to litigate tax issues that are primarily federal in nature, and to do so in circumstances where the company obtained and adhered to formal federal advice.