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It was a festive day for Sven Erik Holmes. Family, friends and colleagues surrounded him in the Tulsa federal courthouse last March as his official portrait was unveiled. It was the last day on the job for Holmes, who was retiring as chief federal judge for the Northern District of Oklahoma, after 10 years on the bench. Five months later, Holmes was back in a federal court, without his robes and under drastically different circumstances. This time, the U.S. Attorney in Manhattan looked on as Holmes, now the chief legal officer for KPMG, signed a document to keep his company from being criminally prosecuted. Afterward Holmes remembers someone quipping: “It used to be the full force of the U.S. government behind your signature. Now it’s on top of your signature.” The deal was a lifesaver for the New York-based auditing firm, which is caught up in what the government calls “the largest ever tax shelter fraud.” The document allowed KPMG to enter a so-called deferred prosecution agreement: The feds agreed to defer prosecuting KPMG on one count of conspiracy to defraud the Internal Revenue Service until Dec. 31, 2006. If the accounting firm adheres to the terms, the charge will be dropped. Holmes describes the deal as KPMG’s last resort, adding, “Society has a very real interest in [punishing] this kind of wrongful conduct.” As part of the agreement, KPMG had to admit to a lengthy list of illegal actions — from creating and selling shady tax shelters that saved wealthy clients millions in taxes, to trying to cover up the scheme by lying under oath. And it had to pay $456 million in penalties. The tax shelters, with names like FLIP (Foreign Leveraged Investment Program), OPIS (Offshore Portfolio Investment Strategy), BLIPS (Bond Linked Issue Premium Structure) and SOS (Short Option Strategy), funneled money through foreign accounts to create phony investment losses. All told, the firm’s clients dodged at least $2.5 billion in taxes, according to court documents. The auditing firm also agreed to curtail its tax business, including ceasing its private client tax service. And it promised to institute an array of ethics and compliance reforms, under the auspices of former Securities and Exchange Commission chair and corporate cleanup monitor Richard Breeden. Among them: setting up a hot line for whistleblowing employees to reach Holmes’ office. With the firm on probation, any hint that it is trying to hide something from the IRS in the next year could make the government pursue the charge. Holmes had nothing to do with the criminal behavior — he wasn’t around when KPMG was selling the shelters from 1997 to 2002. But he has everything to do with the company’s hopes of changing its image as an arrogant and deceitful rogue that raked in $128 million in ill-gotten profits while thumbing its nose at the law. With his sterling reputation — as a partner at Williams & Connolly in Washington, D.C., he was known to “fire” corporate clients rather than defend behavior he saw as unethical — and his sober, judicial demeanor, he’s exactly the kind of top lawyer a firm like KPMG needs right now. According to corporate law professor Deborah DeMott of Duke University, it’s especially important for companies to turn to someone with a reputation for honesty and credibility when they’re under the gun from regulators. Holmes’ appointment as chief legal officer over the company’s general counsel Claudia Taft, she says, “signals the market and the regulators” that the company is ready to change its culture and practices. (Taft, who remains GC at KPMG, according to a spokesperson, declined to comment for this story.) So how did Holmes go from sitting in judgment on felons to seeking mercy for a wayward corporation? For the 54-year-old, the summer of 2004 brought a midlife yearning for something new after a “comfortable” decade as a federal judge. A Clinton appointee, he knew there was little chance he’d be elevated to a higher court during the Bush administration. “I wasn’t bored or tired,” Holmes says, but he and his wife kept discussing “what-ifs” about the rest of their lives. They had moved to Tulsa 10 years earlier from Washington, D.C., when their children were 4 and 8, so the girls could grow up in Oklahoma near their grandparents. But their daughters were now teenagers, and the grandparents had passed away. Holmes and his wife thought the timing might be right to return to the East Coast. So he began exploring if there might be “something unique and challenging” for him beyond the bench. At that same time, KPMG was fighting for its life against then-U.S. Attorney David Kelley in New York. Kelley had convened a grand jury and seemed determined to indict the company as much for its cover-up tactics as for its tax shelters. The government had easily settled previous tax shelter cases with other auditing firms for much smaller fines. In 2003, for instance, Ernst & Young paid a paltry $15 million to settle. But KPMG had infuriated officials by hiding documents, defying federal investigators and lying to the IRS, U.S. senators and a federal court. The Justice Department action wasn’t the only case dogging KPMG that summer. It was fighting civil charges filed in 2003 by the SEC, accusing the firm of helping Xerox Corp. cook its books to cover up a $3 billion gap between its finances and its reported income. The SEC was also investigating whether KPMG audit failures allowed Gemstar-TV Guide International Inc., to misstate and inflate its revenue. And in California, in a civil suit that’s still pending, KPMG compounded its troubles by angering the trial judge. That case involved a $50 million accounting malpractice allegation by a client, Targus Group International Inc., an Anaheim, Calif.-based supplier of laptop computer cases and accessories. When KPMG hid documents and misled the court, the state judge imposed sanctions on the company. KPMG denies the malpractice allegations. Targus lawyer Michael Avenatti, an associate at Greene Broillet & Wheeler in Santa Monica, Calif., says KPMG’s abuse of discovery was so bad that the judge allowed him to depose GC Taft. Her deposition is sealed, but Avenatti describes her answers as “evasive.” In fact, discovery abuse in the Justice Department’s case probably riled federal prosecutors even more than the illegal tax shelters. When the IRS tried repeatedly in early 2004 to shake loose material on the shelters, KPMG lawyers claimed that many of the records were protected by attorney-client privilege — a claim the U.S. attorney later called a “sham.” So the IRS went to court to force KPMG to submit its documents. In May 2004, D.C. federal district court Chief Judge Thomas Hogan agreed with the IRS. He ordered KPMG to turn over the documents. In a footnote, Hogan wrote: “The court hesitates to consider the judicial resources that have been wasted as a result of these improper claims.” KPMG’s senior managers knew they were in trouble. They had begun to clean house by firing three employees involved in the tax shelters, but they needed something more: a white knight to face the feds — and burnish the company’s image. They sent the headhunters on a quest. Late that summer, Holmes was contacted by one of his former law partners at Williams & Connolly. A KPMG headhunter, who was nervous about approaching a sitting judge, asked the colleague to contact Holmes. The judge was intrigued. So was KPMG Chairman and CEO Eugene O’Kelly when he heard of Holmes’ interest. KPMG wanted to bring in someone with Holmes’ reputation for legal rigor and unimpeachable ethics. One former law clerk, Jeffrey Faucette, recalls that his boss was detail-oriented and “absolutely dedicated to getting it right.” Faucette now directs the litigation department at Howard Rice Nemerovski Canady Falk & Rabkin in San Francisco. (KPMG is not a client.) The judge had other attractive qualities. Holmes is politically connected. He worked for David Boren, a Democrat, when Boren was governor of Oklahoma and later a U.S. senator. And he’s used to dealing with sensitive public matters. Holmes also served as general counsel and staff director for the U.S. Senate Select Committee on Intelligence, and on a congressional committee investigating the Iran-Contra links in the 1980s. He’s media-savvy, too. It runs in the family — his wife is Lois Romano, a veteran reporter for The Washington Post, and their older daughter just entered journalism school at Northwestern University. In Tulsa, Holmes was known for taking the press on site visits during trials, such as to a toxic waste dump. KPMG courted Holmes through the fall of 2004. The first-generation American son of Norwegian immigrants, Holmes hit it off with KPMG’s O’Kelly, a first-generation Irish-American. (O’Kelly stepped down in ill health in June 2005 and died three months later of cancer at 53.) Holmes says he did not negotiate specific hiring points with O’Kelly, but sought broad assurances about putting the necessary legal and ethical changes in place. O’Kelly assured Holmes that KPMG already was cooperating with the federal investigation and was following the tenets of the so-called Thompson memo. The memo was written in 2003 by then-Deputy Attorney General Larry Thompson (now GC of Pepsi Co. Inc.) to spell out what a corporation must do to win a deferred prosecution agreement. If KPMG could not completely avoid being prosecuted, then it wanted a deferred prosecution agreement — the trend in dozens of recent corporate cases, including those involving American International Group Inc., Monsanto Co., Computer Associates International Inc., Merrill Lynch & Co. Inc. and Bristol-Myers Squibb Co. Holmes knew accepting the job would mean putting his reputation on the line, as well as giving up a secure, lifetime appointment to the bench. It didn’t hurt that KPMG offered him many times his $160,000-plus salary as a judge, but those who know Holmes insist that he wasn’t motivated by the lure of a big paycheck. What was important to Holmes was O’Kelly’s promise that the new chief legal officer would have the “standing and authority” to clean up KPMG and make it an ethical model for corporate America. Holmes believed O’Kelly was sincere. Touching his chest for emphasis, Holmes says, “In the end, you go with what you believe, and with the people you believe in.” So KPMG announced Holmes’ hiring in January 2005. His duties include overseeing ethics and compliance, directing the office of general counsel and its 25 lawyers and acting as counsel to the chairman, the management committee and the board of directors. Holmes says, “It doesn’t get more challenging than this. Everything interesting in law, public policy and business whirls around these issues.” By the time Holmes came on board in March, KPMG had already begun to resolve its legal problems. It settled the Gemstar case with the SEC by paying $10 million to shareholders and accepting a censure. And in April it reached a settlement with the SEC on the Xerox case; KPMG agreed to pay $22.5 million and accept a censure. The accounting firm was cooperating with the Justice Department as well. O’Kelly had hired a new team of outside lawyers, headed by Robert Bennett, the Washington superlawyer. Bennett, a partner at Skadden, Arps, Slate, Meagher & Flom, had served as special counsel to the U.S. Senate Select Committee on Ethics in several major investigations. Yet, all KPMG’s efforts came too little and too late to placate the U.S. Attorney. Observers say Kelley was determined to indict the company and send a message to corporate America: Don’t fool with the feds. KPMG feared that an indictment would kill the company and its 18,000 jobs, much as the Enron-related criminal charges had mortally wounded accounting giant Arthur Andersen. Just four days after starting his new job in March, Holmes sat down with the prosecutor. Kelley says that while Holmes came in the midst of negotiations, “he was a quick study.” Kelley was also impressed with how Holmes worked with Bennett. “Judge Holmes is not afraid to have a strong outside counsel, [and] he wants your honest opinion,” Kelley explains. “I think KPMG is fortunate to have him there.” Holmes struck an easy rapport with Kelley because they shared the same views about the wrongdoing and the wrongdoers. Holmes agreed with the prosecutor that indictments were necessary. The only question was of whom. Holmes, trying to dissuade Kelley from indicting the firm itself, told the prosecutor that companies hold a special place in society, and that you harm innocent people when you indict a business rather than individual wrongdoers. Holmes jokes that he and the U.S. Attorney agreed on almost everything — “except indicting the company.” By June, however, KPMG’s efforts seemed doomed. Kelley was ready to indict. But Holmes and his legal team had one more chance. Holmes recalls, “In my last meeting with David Kelley, I talked about meeting with the Department of Justice in Washington,” and Kelley agreed to set up a meeting with his boss, Deputy Attorney General James Comey. Holmes says he appreciates that Kelley “availed us that opportunity … and didn’t take the final resolution — indictment — upon himself.” According to Holmes, the turning point came at a June 13 summit in Washington with Kelley and Comey. (Comey has since become general counsel at Lockheed Martin Corp.) Representing KPMG were Holmes and Bennett, along with KPMG’s new chairman and CEO, Timothy Flynn, and deputy chairman, John Veihmeyer. At the meeting, Bennett defended KPMG and emphasized its months-long efforts to cooperate with the government. CEO Flynn described the dire results of any criminal indictment — clients fleeing, the firm folding, thousands of employees laid off. He stressed that the Big Five accounting firms had already shrunk to four with Andersen’s closing, and now could go to three. Holmes assured Comey of the company’s plans for an overhauled ethics and compliance program. Shortly afterward, Kelley relented and agreed to work with KPMG on the deferred prosecution agreement. Kelley won’t discuss his change of heart except to say, “I was part of the discussions that came up with that decision.” Sources believe that Comey, who did not return calls for comment, ordered him to do it. With great relief, KPMG’s legal team began negotiating the settlement. Kelley made tough demands, insisting that KPMG admit to all aspects of the wrongdoing. The negotiations ran all summer, with Bennett doing most of the direct haggling with Kelley. However, “We couldn’t have gotten the result we got,” Bennett says, if it weren’t for Flynn’s and Holmes’ leadership pushing the negotiations along and reassuring Kelley of KPMG’s commitment to cultural change. Finally, on Aug. 26, the KPMG board accepted the agreement, and Sven Erik Holmes signed his name to a waiver of indictment and the deferred prosecution agreement. At the same time, eight former KPMG employees were indicted, along with an outside lawyer, R.J. Ruble, formerly a tax partner at Sidley Austin Brown & Wood’s New York office. The government said more indictments will follow. Remarking on the agreement, U.S. Attorney General Alberto Gonzales appeared to echo KPMG’s argument. Gonzales cited “the reality that the conviction of an organization can affect innocent workers and others associated with the organization, and can even have an impact on the national economy.” Shortly after the settlement, Kelley, as previously planned, left the Justice Department to become a senior litigation partner at Cahill Gordon & Reindel in New York. He says he’s satisfied with the accord: “At the end of the day, I think the agreement was a very just outcome.” Part two of Holmes’ job has just begun. Already promoted to executive vice-chairman, Holmes now reports directly to CEO Flynn. Engaging, witty and openly idealistic, the former judge talks about his plans for the firm as he eats lunch informally with his staff. He peppers his conversation with asides about family, baseball (he’s a devoted Boston Red Sox fan) and the law. Holmes inherited a problem-plagued legal department, as well as a slew of civil suits filed by tax shelter clients who are seeking hundreds of millions of dollars in damages. (Some of those suits were settled for $195 million in September.) But his main challenge now is overseeing the changes promised in the agreement. They include implementing a permanent compliance and ethics program that will identify high-risk practice areas as well as reportable incidents. Specifically, the agreement requires that the program punish employees who violate laws and standards and reward those who report the violators. The program must also include a hot line to Holmes’ office to report any noncompliance. Holmes has hired Williams & Connolly to do a risk-assessment study to pinpoint the areas with the most potential for violations. He is also working closely with Breeden, who started as a court-appointed monitor in September, according to the terms of the settlement. Equally important as the policies and procedures, Holmes says, is trying to bring better communications to KPMG. He wants to make sure that when partners have legal questions, as some did during the tax shelter days, that they are addressed by an in-house lawyer who has the authority to give an answer. He also wants to make sure that when the company asserts attorney-client privilege in the future, it will be for a good cause and not a “sham,” as it was against the IRS. Holmes sums up his expectations: “What you want is a system that aspires to get it right. That’s the test of a firm — do they live in the aspiration? That’s all you can ask.”

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