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The other shoe dropped yesterday in the government’s crippled tax shelter prosecution against former KPMG employees as Southern District Judge Lewis Kaplan dismissed charges against 13 of 16 defendants. It was a decision sought by prosecutors, who want the U.S. Court of Appeals for the Second Circuit to unwind Judge Kaplan’s earlier ruling that the government violated the U.S. Constitution by using its leverage to force the accounting firm to stop paying the legal fees of indicted partners and employees. Judge Kaplan said yesterday in United States v. Stein, 05 Crim. 0888, that he reached the conclusion “only after pursuing every alternative short of dismissal and only with greatest reluctance.” The decision will be published Friday. His decision leaves only three defendants – Robert Pfaff, John Larson and David Greenberg – facing trial on charges of selling what the government claims are illegal tax shelters. Judge Kaplan found in June 2006 that the rights of most of the defendants were violated because KPMG bent over backward to cooperate with prosecutors and avoid indictment by changing its long-standing practice of paying its employees’ legal fees. Despite that ruling, Judge Kaplan put the remedy on hold and invited the defendants to file civil suits seeking payment of their fees by KPMG, which he intended to hear under jurisdiction ancillary to his control of the criminal case. But on May 23, 2007, the Second Circuit rejected the assertion of ancillary jurisdiction and said, more than once, that Judge Kaplan had other remedies for the government’s conduct, particularly dismissal of the indictment ( NYLJ, May 24). With the case back in his court, Judge Kaplan said yesterday that the substantive due process rights of 13 of the defendants, including four who were deprived of counsel of their choice, were violated. He also acknowledged that, “It is reasonably plain that the government’s concession with respect to dismissal, whether so motivated or not, is a prelude to an appeal.” The judge yesterday again explored the government’s use of the Thompson Memorandum, a U.S. Justice Department guide for prosecutors on how to measure cooperation by a company under investigation. Among the factors to be considered in weighing whether to indict an entity is whether or not the entity is paying the fees of employees under investigation or indictment. Judge Kaplan said yesterday that additional evidence has emerged since his ruling last year to show that the Thompson Memorandum, (which has since be superceded at the Justice Department) was used to violate the defendants’ constitutional rights. The most striking example emerged only recently from the 22 million pages of discovery turned over to the defense – a voicemail message sent on Feb. 18, 2004, to all partners from then-KPMG Chief Executive Officer Gene O’Kelly. Mr. O’Kelly, having learned that KPMG was under investigation, said any “present or former members of the firm asked to appear will be represented by competent counsel at the firm’s expense.” Judge Kaplan said, “There was no mention of conditioning KPMG’s payment on cooperation, no mention of any cap on legal expenses, and no mention the firm would stop paying in the event of an indictment.” He said it also was telling that several of the defendants for whom KPMG had stopped paying criminal defense costs were still having their legal fees for civil and regulatory actions picked up by the accounting firm. “Indeed, the fact that KPMG has been paying the civil defense costs on condition that the defendants’ lawyers in those matters be different than their lawyers in the criminal case – a condition that is at war with any consideration of economy or efficiency – demonstrates with astonishing clarity that the different treatment of the criminal case defense costs has been driven from the outset by the fear that the government would view any assistance in defending against the indictment as a black mark against KPMG.” He continued, “KPMG cut off payment of defense costs to anyone who was indicted for one reason and one reason alone – the Thompson Memorandum and the related actions of the [U.S. Attorney's Office]. In their absence, KPMG would have paid every penny.” Government Pressure The judge reiterated his finding that the government improperly coerced KPMG on the fee issue, “was less than candid with the Court in its effort to avoid a hearing on that issue, and improperly used KPMG to coerce proffers from KPMG personnel.” He said there was a violation of substantive due process even if the government did not intentionally set out to do harm. “Their deliberate interference with the defendants’ rights was outrageous and shocking in the constitutional sense because it was fundamentally at odds with two of our most basic constitutional values – the right to counsel and the right to fair criminal proceedings,” he said. Judge Kaplan paused at the end of his opinion to say he respected the “distinguished record” of the Southern District, “which long has been, and continues to be, a model for the nation.” But, he added, “there are limits on the permissible actions of even the best prosecutors.” The government “deliberately or callously prevented many of these defendants from obtaining funds for their defense that they lawfully would have had absent the government’s interference” – and either prevented them from defending the case the way they wanted to or, in some cases, using the lawyer they wanted, the judge said. “This is intolerable in a society that holds itself out to the world as a paragon of justice,” said Judge Kaplan. “The responsibility for the dismissal of the indictment as to 13 defendants lies with the government.” Stanley Arkin of Arkin Kaplan Rice, who represents former KPMG partner Jeffrey Eischeid, said yesterday that “it was about time” the “overreaching” of prosecutors was “checked.” “There is basically an absence of a magisterial or fair-minded approach to investigations and prosecutions,” Mr. Arkin said. “These guys just went way out deep because they are arrogant and unfair.” Mr. Arkin said he is confident the government will lose any appeal. In a statement yesterday, Southern District U.S. Attorney Michael Garcia said that the government “respectfully disagrees with Judge Kaplan as to whether there was any constitutional violation in this case. As is clear from Judge Kaplan’s decision today, the Government has already appealed one ruling (the suppression of proffer statements of two defendants) arising from that finding. That appeal is pending. We will continue to pursue appellate review.” - Mark Hamblett can be reached at [email protected].

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