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Although WorldCom emerged from bankruptcy more than two months ago as MCI, its legal battles continue in bankruptcy court in the Southern District of New York. In this latest round, 14 states sought to disqualify MCI’s auditors and tax advisers, KPMG, and disgorge tens of millions in fees the accounting firm received during bankruptcy proceedings. The states allege that KPMG advised MCI to implement an illegal tax strategy aimed at evading hundreds of millions of dollars in taxes owed to the states. Bankruptcy Judge Arthur Gonzalez, who also presides over the Enron bankruptcy, soundly rejected the states’ motion, calling the move to disqualify KPMG a “litigation tactic.” The underlying dispute arose from a restructuring strategy KPMG advised MCI to undertake in the late 1990s. One purpose of the effort, according to a January report issued by Bankruptcy Court Examiner Richard Thornburgh, was to minimize state taxes by as much as $350 million. The process involved licenses to MCI’s subsidiaries, which then generated royalty fees in excess of $20 billion. MCI’s subsidiaries deducted the royalty charges, according to the examiner’s report, and the corresponding income was transferred to states with lower tax consequences. Thornburgh strongly criticized KPMG, claiming it “rendered improper tax advice” and “failed to disclose the risks” to MCI. The report concluded that if MCI is found liable for implementing KPMG’s tax restructuring plan, it could sue KPMG to recover its penalties. Upon the release of the report, MCI announced it had no plans to pursue claims against KPMG. In mid-March, the states filed a motion to disqualify KPMG, arguing that it held an adverse interest to MCI and was not acting as a disinterested party — in other words, that it had a conflict of interest as MCI’s auditor. Gonzalez saw the timing of the states’ motion as a ruse. “It was only after the States decided that such a motion would advance their particular interests that they filed the Disqualification Motion,” he wrote. Looking back at the record, the judge found that the states were cognizant of the potential underlying grievances against KPMG as early as April 2003, and at no point did they request the auditor’s removal. The delay in filing the motion, said Gonzalez in In re WorldCom, 02-13533, spoke volumes of the states’ motivation to pressure MCI during settlement discussions by potentially delaying its emergence from Chapter 11 bankruptcy through the eviction of its auditor. Such a removal would force MCI to find a replacement to issue a new audit for its 2003 financial statements, a process that would prolong its status in bankruptcy, the judge said. “[T]he Court finds by filing the Disqualification Motion, the States acted in connection with a litigation strategy that served their own pecuniary interest,” said the judge. “Any argument by the States that they have pursued the disqualification of KPMG to protect the public interest ‘rings hollow’ in light of the fact that the very conflict they allege warrants disqualification was known to them for no less than ten months before they decided to file the Disqualification Motion.” REJECTED ON THE MERITS Despite finding that the states acted with improper motives and were derelict in filing the motion, Gonzalez decided the motion on the merits “because of the seriousness of the allegations and their impact on [MCI] as well as KPMG.” One by one, the judge turned down the states’ positions. The first claim involved MCI’s potential action against KPMG if the telecommunications giant were found liable for implementing an improper tax structure. The states claimed the plausibility of a lawsuit made KPMG’s relationship with MCI untenable, leading it to foster an adverse interest to its client. Such an outcome is “speculative,” held the judge. “An interest is not considered adverse simply because it is possible to conceive of a situation where interests might clash.” The court added that MCI publicly declined to pursue such claims. The court also found no problems with KPMG serving as both MCI’s auditor and tax adviser, finding it to fall within the proper role of an accounting firm. Lastly, the court saw no “appearance of impropriety” in having KPMG continue to serve as MCI’s accountant, despite the examiner’s criticism of its tax advice. The “numerous structural safeguards employed in this case,” said the judge in referring to his role and the roles of the examiner, the Securities and Exchange Commission and a corporate monitor assigned to oversee MCI’s activities, precluded an inference of impropriety and did not justify KPMG’s dismissal as MCI’s accountant. Weil Gotshal & Manges represented MCI. The states were represented by James O’Connor and Jeffrey Ogilvie of the litigation bureau of the Massachusetts Commissioner of Revenue. Greenberg Traurig and McGuireWoods were counsel to KPMG.

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