Thursday's ruling came shortly before a U.S. Department of Justice announcement that it has revised its guidelines for the investigation and prosecution of corporate crimes. Among the changes, which are effective immediately, is an explicit statement that prosecutors evaluating a company's cooperativeness are not to consider whether a company has advanced legal fees to employees.
KPMG had advanced such fees to individual employees targeted by the government in its probe of the promotion of illegal tax shelters. Acting under the earlier guidelines set forth by the Justice Department's 2003 Thompson Memorandum, prosecutors informed KPMG that its assisting employees with legal fees would be taken into account in determining whether or not to prosecute the company itself. According to the decision written by Judge Dennis Jacobs, the government's "overwhelming influence" prompted KPMG to impose conditions, then cap the fees and finally terminate them.
Arthur Andersen, KPMG's onetime rival, collapsed in the face of government charges that it participated in accounting fraud at Enron Corp. and companies' fears of a similar fate have given prosecutors enormous leverage in negotiating nonprosecution agreements. KPMG signed such a deal in August 2005, agreeing to pay $456 million in fines and restitution to former tax shelter clients.
But the government's conduct in such negotiations came under sharp attack in the KPMG case. Southern District Judge Lewis Kaplan ruled that prosecutors had violated former KPMG employees' Sixth Amendment right to counsel. He initially invited the 13 individual KPMG defendants to file civil suits against the company for their legal fees. However, the 2nd Circuit ruled that he lacked jurisdiction to hear such actions. Judge Kaplan then concluded that the only way to cure the constitutional violation was to dismiss the indictments entirely.
On Thursday, a 2nd Circuit panel of judges, Jacobs, Wilfred Feinberg and Peter Hall, agreed, affirming Kaplan's dismissal in a 68-page decision. The government "unjustifiably interfered with defendants' relationship with counsel and their ability to mount a defense, in violation of the Sixth Amendment," Judge Jacobs wrote for the unanimous panel in United States v. Stein, 07 cr. 3042.
Prosecutors had argued on appeal that KPMG's actions in suspending its legal-fees assistance to the indicted ex-employees were voluntary on KPMG's part, but the circuit said the government's stance rendered as state action the company's decision.
"KPMG faced ruin by indictment and reasonably believed it must do everything in its power to avoid it," the court said. "The government's threat of indictment was easily sufficient to convert its adversary into its agent. KPMG was not in a position to consider coolly the risk of indictment, weigh the potential significance of the other enumerated factors in the Thompson Memorandum, and decided for itself how to proceed."
The panel also rejected the government's argument that the Sixth Amendment does not apply to third-party assistance with legal expenses. The court pointed out that it was well established that the Sixth Amendment bars the government from interfering in cases where a lawyer elects to represent a defendant for free.
"And if the Sixth Amendment prohibits the government from interfering with such arrangements, then surely it also prohibits the government from interfering with financial donations by others, such as family members and neighbors -- and employers," Jacobs wrote.
Nor did a March 30, 2006 in-court government statement that KPMG was free to "exercise [its] business judgment" on payment of legal fees cure the violation, the circuit concluded. The court said that it was "unrealistic" to expect the company, which had assumed "a supine position" in its negotiations with the government, to reverse course and exercise judgment "as if it had never experienced the government's pressure in the first place."
The Thompson memo, circulated in January 2003 by then-Deputy Attorney General Larry D. Thompson, was replaced in December 2006 by a memo from Thompson's successor, Paul J. McNulty.
The McNulty memo stated that federal prosecutors "generally should not" consider a company's advancement of legal fees to employees in deciding whether or not the company is being cooperative. But the government reserved the right to consider such actions "when the totality of the circumstances show that [the advancement of legal fees] was intended to impede a criminal investigation."
MOST QUALIFIERS DROPPED
The revisions announced Thursday by Deputy Attorney General Mark R. Filip at the New York Stock Exchange drops most qualifiers and simply state that prosecutors should not consider a company's payment of employees' legal fees. The new guidelines also said a company's participation in a joint defense with employees should not be considered in deciding whether the company deserves credit for cooperation.
And, the revised guidelines are designed to address concerns about intrusions on attorney-client privilege in white-collar prosecutions. One major change is that the government will no longer give corporations credit for cooperation based on their waiver of attorney-client or work-product privilege. The disclosure of information will be the only factor considered, Filip said.
"[C]orporations will receive the same credit for disclosing facts that are contained in unprotected materials as they would for disclosing the identical facts contained in protected materials," he said. "The government will assess neither a credit nor a penalty based on whether the disclosed materials are protected by the attorney-client privilege or attorney work product."
Prosecutors also will now be barred from requesting the disclosure of internal communications covered by the attorney-client privilege. Filip used the example of a pharmaceutical sales representative asking in-house counsel whether her marketing practices were lawful.
"Permitting and respecting the need for such attorney-client communications is particularly important, because such dialogue is often a necessary, a typically salutary, part of a company's efforts to obey the law on an ongoing basis," Filip said.
In addition, prosecutors will be barred from awarding companies points for cooperation for firing or disciplining employees.
The changes will not likely salvage the government's KPMG prosecution, which had been touted as one of the largest tax shelter prosecutions ever. Filip on Thursday said it is too soon to discuss the circuit's decision, but Stanley S. Arkin of Arkin Kaplan Rice, the lawyer for defendant Jeffrey Eischeid, the former head of KPMG's personal financial planning group, said a push for review by the full 2nd Circuit or U.S. Supreme Court would send the wrong message.
"A good prosecutor has to be decent in addition to being tough," said Arkin. He described the prosecutors' conduct in the KPMG case as "just vicious" and said the new guidelines suggest the Justice Department had taken the right lessons from the court.
The tax shelter case is continuing against four other individual defendants, including lawyer R.J. Ruble, a former tax partner at Sidley Austin who provide opinion letters stating the tax shelters at issue were legal. Sidley Austin last year agreed to pay $39.4 million as part of a non-prosecution deal in the case.
The government was represented on appeal by Assistant U.S. Attorney Karl Metzner.
The former KPMG employees were represented by several leading white-collar and appellate lawyers, including Arkin, Seth Waxman of Wilmer Cutler Pickering Hale and Dorr and John S. Martin of Martin & Obermaier.
Prosecutors meet with KPMG in connection with an investigation into the company's alleged devising and marketing of fraudulent tax shelters.
August: KPMG enters a deferred prosecution agreement, agreeing to pay $456 million and to cooperate in the prosecution of individuals.
October: The government indicts 19 people in connection with the probe, including 17 ex-employees of KPMG.
January: The defendants file a motion accusing prosecutors of improperly infringing on "their constitutional rights to counsel and a fair trial" by pressuring KPMG to stop paying their legal fees.
March: Ex-KPMG employee David Rivkin pleads guilty to conspiracy and tax evasion.
June 26: Southern District Judge Lewis Kaplan rules that the U.S. Attorney's Office coerced KPMG into refusing to advance legal fees for its ex-employees. He declines to dismiss the indictment, but says the ex-employees can pursue a civil lawsuit against the accounting firm for payment of their legal bills. United States v. Stein, 435 F. Supp. 2d 330.
July 2006: The 16 ex-employees file a civil lawsuit against KPMG to recoup legal fees.
January: The case against KPMG is dismissed.
May: The 2nd U.S. Circuit Court of Appeals rules that Judge Kaplan cannot exercise ancillary jurisdiction over the civil case, although it suggests he could dismiss the indictment if he believes the defendants' rights had been violated, Stein v. KPMP, 486 F.3d 753.
June: The 16 ex-employees file a motion to dismiss the indictment in light of Judge Kaplan's June 2006 decision. Prosecutors later in the month ask the judge to dismiss charges against 12 of the 16 KPMG defendants, saying it is his only option due to his earlier ruling.
July 16: Judge Kaplan dismisses indictments against 13 ex-KPMG employees. The case proceeds against the other three, as well as against the two non-employees, one of whom is R.J. Ruble, a former Sidley Austin tax lawyer, United States v. Stein, 495 F. Supp. 2d 390.
September: A second defendant, former investment advisor David Makov, pleads guilty.
Thursday: The 2nd Circuit upholds the dismissals.