Just last week, the U.S. District Court for the Southern District of New York ruled that the government had violated the rights of certain partners and employees under the Fifth and Sixth Amendments to the U.S. Constitution by pressuring the accounting firm KPMG LLP to cut off the payment of defense costs for its partners and employees. United States v. Stein et al., No. S1 05 Crim. 0888 (LAK), -- F. Supp.2d --, 2006 WL 1735260 (S.D.N.Y. June 26, 2006). The decision is highly significant for all companies and their employees. The federal government has, in recent years, attempted to use such pressure on corporations as a method for corporations under investigation to show their “cooperation” with the government, and get favorable treatment. The ultimate result, however, is that corporate officers, directors, and employees may lose representation by counsel of their choice, or in some instances, any counsel at all.
The case concerns the Internal Revenue Service’s well-publicized investigation of allegedly fraudulent tax shelters by KPMG. The IRS ultimately referred the matter for potential criminal prosecution to the U.S. Department of Justice, which, in turn, referred it to the United States Attorney’s Office (USAO) for the Southern District of New York. After several of its partners received rather rough treatment while testifying before a Senate subcommittee also looking into the matter, KPMG decided that, to avoid the fate of Arthur Andersen, it needed to “clean house.” After terminating several partners, and as part of that house cleaning, lawyers for KPMG met with federal prosecutors assigned to the case in an attempt to stave off prosecution of the firm.
At that time (early 2004), as many as thirty KPMG partners and employees were notified by the government that they were “subjects” of the federal grand jury investigation of the tax shelters (i.e., not targets who the government sought to prosecute, but persons in whom the government had an interest and who might subsequently become targets). A number, including the defendants in this case, were later indicted. During the initial discussions between KPMG and the prosecutors, the latter asked whether KPMG was paying the legal fees and expenses of its employees under investigation.
The government’s inquiry was based on what has become known as the “Thompson Memorandum” (for U.S. Deputy Attorney General Larry D. Thompson). Formally entitled Federal Prosecution of Business Organizations, this memorandum sets forth, among other things, the factors federal prosecutors must consider in determining whether to criminally charge a corporation. The government’s interpretation of the fourth factor—“ the corporation’s timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation of its agents, including, if necessary, the waiver of corporate attorney-client and work product protection”— became the issue in the case. This factor instructs prosecutors who are assessing a corporation’s cooperation to determine “whether the corporation appears to be protecting its culpable employees and agents,” by, for example, “the advancing of attorney’s fees” to them.
KPMG’s initial response to the government’s inquiry concerning attorneys’ fees was non-committal. The prosecutors continued to raise the attorneys’ fee issue in subsequent communications, however, and KMPG eventually concluded from these repeated inquiries that the government was viewing any payment of employees’ attorneys’ fees by KPMG negatively. Accordingly, KPMG began “cooperating” on the matter of attorneys’ fees. It decided to pay employee attorneys’ fees only in cases where the employee cooperated with the government and then only up to a certain, relatively minimal cap, and if the employee was indicted, KPMG would immediately cease paying fees. Also, at the government’s request, KPMG notified its employees that they could choose to deal with the government without counsel. And whenever the government notified KPMG counsel that a KPMG employee had failed to submit to an interview with the government, KPMG would notify the employee that he or she had ten days to submit or otherwise KPMG would stop the payment of legal fees. As a result of this “cooperation,” KPMG entered into a Deferred Prosecution Agreement with the government, pursuant to which a one-count criminal information against the company would be dismissed if KPMG, in addition to its other obligations (such as paying a $456 million fine), continued its extensive cooperation.
In unusually harsh language directed at the government, the Court found that the “government held the proverbial gun to [KPMG’s] head” by pressuring KPMG to cut off the payment of legal fees and expenses to individuals under investigation or indictment. The Court noted that KPMG had a “long-standing policy” and “unbroken track record” of paying the legal expenses of its partners and employees incurred as a result of their jobs, without regard to cost.
The Court found that the Thompson Memorandum, as implemented by the government here, violated the Due Process Clause of the Fifth Amendment because it denied the defendants the fundamental right to defend themselves using resources that were lawfully available to them, free from governmental interference. The Court also found a violation of the Sixth Amendment right to counsel, in that the government interfered with the defendants’ right to be represented by counsel of their choice. To remedy the violation, Judge Lewis A. Kaplan took the unusual step of directing the Clerk of Court, as ancillary to the criminal proceeding, to open a civil docket number to accommodate the claims of the KPMG defendants against KPMG for reimbursement of defense costs. He strongly urged the government, however, to use its “substantial influence and . . . power” over KPMG to cause KPMG to advance those costs to the defendants without the need for further litigation.
The Court’s ruling is subject to two important corollaries. First, in those situations where a corporation is legally obligated to pay defense fees and costs, its doing so cannot be deemed by the government as a failure to cooperate. Second, and on the other hand, a corporation’s advancement of fees and expenses may be considered as one sign of a lack of cooperation where the corporation does so with the intent to impede or obstruct the government’s investigation.
The Stein case is of vital importance both to corporations and any employees who find themselves under the cloud of a criminal investigation. For corporations, the ruling provides them with impetus to resist governmental pressure to cut off the advancement of legal fees and expenses to their employees. As the Court recognized, corporate entities typically offer to pay employees’ attorneys’ fees where an employee is involved in an investigation as a result of doing his or her job. Doing so helps a corporation to hire and retain competent and honest employees. Stein also may provide legal support for corporations to resist another recently employed government tactic: pressuring corporations to waive the protections of the corporate attorney-client and work product privileges and turn over to the government such communications, including reports of internal investigations. Waiver of these protections is another factor that the government considers in determining corporate “cooperation,” and is currently another hotly debated issue within the legal and corporate community.
For company officers, directors, and employees faced with investigations or indictments involving complex white-collar and regulatory crimes, the advancement of legal fees and expenses is often the difference between an effective and fair defense, and an inadequate defense or, in some instances, no defense at all. The Court noted that substantial resources are needed to defend properly cases, like the alleged tax-shelter frauds at issue in Stein, where a proper defense may require review of millions of pages of documents, and interviews of hundreds of witnesses. Individuals who find themselves, wrongly or otherwise, caught up in corporate scandals should not have to choose between being forced to cooperate with the government, regardless of whether or not that is in their best interest, or being cut off from the payment of legal fees that their corporate employers have obligated themselves to make. Stein may have dealt a death blow to the chilling effect that choice has on a person’s ability to defend him or herself.
Additional related materials:
Court Finds That the Government Improperly Interfered with KPMG'S Advancement of Legal Fees and Expenses...