When several of KPMG’s top partners were investigated on allegations related to illegal tax shelters in 2004, prosecutors wasted no time implementing a scorched earth strategy–

demanding not only that the company waive privilege, but also that KPMG stop paying legal fees for any accused employees who did not fully “cooperate” with prosecutors.

Under threat of indictment, KPMG complied, cutting off legal defense fees for any accused partner who asserted his Fifth Amendment rights and capping legal fees for those who did cooperate at $400,000. The 16 indicted partners were left to defend themselves with their hands tied.

The aggressive stance prosecutors took in the KPMG case–and KPMG’s reaction to it–are not at all uncommon. Increasingly, prosecutors are using the 2003 Thompson Memo to justify hard-line tactics in their prosecutions of corporate crimes and to pressure companies into not paying legal fees for employees under investigation.

“Since the Thompson Memo came out, we’ve seen a number of corporate counsel decide that they’re no longer going to have any joint defense agreements because prosecutors view that as not cooperating,” said Mike Tuteur, partner at Foley & Lardner in Boston.

Tuteur and other attendees at a recent Martindale-Hubbell Counsel to Counsel Forum in New York titled “Managing Attorney-Client Communication in a Time of Eroding Privilege” discussed ways in which companies can approach defending their valued executives without increasing their risk of prosecution or regulatory action.

Always Be Prepared

While a company’s first instinct may be to comply with DOJ demands to not provide legal counsel for accused employees, that’s not always a desirable option. If management believes a valued employee or executive is being wrongly accused, the company may not want to leave that person to fend for him or herself.

“If someone was wrongly accused or the investigation is going to settle, you’re going to want to continue to work with that person,” said Bruce Ortwine, deputy general manager and general counsel of the Sumitomo Trust & Banking Co. Ltd. “Abandoning employees does not send a particularly good message.”

The key to managing this sticky situation is advance preparation. Several attendees at the forum recommended in-house counsel undertake a careful review of the company’s indemnification policies regarding when the company will defend an accused employee and what triggers will cause the company to stop paying fees. This strategy allows the company to defend a valued employee without raising suspicion among investigators.

“As long as the company’s made a policy choice initially about how it wants to behave and it follows that choice, there’s no sense in which it appears the company is granting a special favor to someone to help him resist providing truthful information,” said Seth Levine, partner at Foley & Lardner.

The second proactive strategy is the creation of a panel of outside attorneys with whom the company does not regularly work to essentially be on-call if the need for separate counsel arises.

This strategy, however, is not without its difficulties. Firms will certainly require the company to pay some kind of retainer to be available for such duties. And top-notch firms may be wary of entering into such arrangements.

“If the employee decides suddenly to assert the Fifth, and the company stops paying for his counsel, the firm may be representing that person pro bono until the end of the case,” Levine said. “It’s very difficult to withdraw at that sensitive point.”

Taking A Stand

In addition to planning ahead and retaining separate outside counsel to represent accused executives, there is one other important weapon many companies will have on their side to fight prosecutor’s demands that they not provide counsel for accused executives–case law that requires organizations to defend their employees under certain circumstances.

In October 2003, for example, the Delaware Chancery Court ruled that Rite-Aid was obligated to continue to pay legal defense fees for its former CFO up until sentencing, despite the fact that he pled guilty to criminal fraud. The court based this decision on the fact that the company’s corporate charter said the company would advance defense fees to its employees who were accused of wrongdoing until a “final disposition” of the case.

“The key thing you can say is, ‘We’re a Delaware company. We have no choice,’” Tuteur said. “That’s what Bergonzi v. Rite Aid established in all of these cases.”

In the event that the company has to confront a prosecutor who still insists that defending an executive is obstructive despite legal obligations to do so, attendees at the forum recommended going up the ladder and fighting back.

“If you have policies in place that established the ground rules, you can at least go to the superior of the prosecutor,” Levine said. “Unless you’re using indemnification to slow down the process, it should be a non-issue.”

Glimmer Of Hope

Some recent activity suggests that fighting back against aggressive prosecutors is becoming a more viable strategy.

In June, Federal District Court Judge Lewis Kaplan issued a scathing ruling that the prosecutor’s tactics in the KPMG case violated employees’ constitutional rights to legal representation.

“Isn’t it ?? 1/2 the position of the U.S. Department of Justice that a company facing possible prosecution hurts its case for a favorable outcome by advancing defense costs to present and former employees[?]” Kaplan said. “ [T]he natural consequence of that is that some corporations in that position will cut off defense costs for individuals, who will ?? 1/2 be deprived of the means of mounting a defense against the indictment.”

Some see this as a sign that companies do not always have to comply with prosecutors’ instructions not to provide counsel for employees.

“The KPMG case shows that the pendulum is swinging back a bit,” said A. Ross Pearlson, partner at Sills Cummis Epstein & Gross in New Jersey. “The Constitutional rights of employees to counsel are being implicated and companies don’t pay legal fees because they don’t want to be indicted.”

Yet despite this support from the bench, the decision of when and how extensively to extend legal defense fees to executives still lands companies and their counsel in a difficult position. At the end of the day, all a company can do is proceed with caution.

“It makes sense that companies fight indictment at all costs,” Pearlson said. “But it’s always a matter of striking a balance.”