Editors Note: Amalie L. Tuffin is a member of the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.

RESEARCH TRIANGLE PARK, N.C. – Last August the U.S. Justice Department entered into a deferred prosecution agreement with KPMG LLP related to its sale of certain tax shelters (See the article at www.localtechwire.com/article.cfm?u=12222 ).

As part of this agreement, KPMG agreed to pay a fine of $456 million and as well as to significant restrictions on its practice in certain areas and oversignt of its practice. In addition, KMPG promised to fully cooperate with the IRS, the Justice Department and other law enforcement authorities in their investigation and prosecution of other parties implicated in the tax shelter sales. KPMG entered into the agreement so that the firm itself would not be indicted on criminal charges, it being widely understood that such an indictment would likely mean the end of the firm.

Former KPMG Partners, Employees Face Criminal Trials

At the same time that KPMG entered into the deferred prosecution agreement, eight of its former partners and employees were indicted, including people who worked at the highest levels within KPMG, such as its former deputy chairman, a former vice chairman, and two former heads of the firm’s National Tax Practice. Further indictments followed and there are now 16 individuals facing trial related to the tax shelters that were sold, most being former partners and employees of KPMG. The defendants in these cases are each likely to incur legal fees in the hundreds of thousands if not millions of dollars.

In many cases where an employee, and especially a very senior employee or officer of a business, is required to pay legal fees resulting from activities undertaken as a result of his activities as an employee, it is the employer rather than the individual who pays the legal fees. Judge Kaplan, the judge hearing the case against the KPMG defendants, noted in the decision that is the subject of this article that “an employer often must reimburse an employee for legal expenses when the employee is sued, or even charged with a crime, as a result of doing his or her job. Indeed, the employer must often advance legal expenses to an employee up front, although the employee sometimes must pay the employer back if the employee has been guilty of wrongdoing.”

Judge Kaplan further noted that “Persons in jobs big and small, private and public, rely on [this principle] every day. Bus drivers sued for accidents, cops sued for allegedly wrongful arrests, nurses named in malpractice cases, news reporters sued in libel cases, and corporate chieftains embroiled in securities litigation generally have similar rights to have their employers pay their legal expenses if they are sued as a result of doing their jobs. This right is as much a part of the bargain between employer and employee as salary or wages.”

KPMG historically has indemnified its partners and employees for legal fees for lawsuits related to their work at KPMG, “regardless of cost and regardless of whether its personnel were charged with crimes,” according to Judge Kaplan. In at least one recent case, such fees exceeded $20 million. In the tax shelter case, however, KPMG agreed to reimburse employees for legal fees only if they cooperated with the government “promptly, completely and truthfully” and that reimbursement for such fees would cease if the employee were indicted. KPMG also instituted a cap on reimbursement of $400,000 per employee.

Why did KPMG change its historical practice in this way? And why does it matter to employees of other companies?

Government Pressured KPMG Not To Pay Legal Fees

The KPMG defendants claimed, in the words of Judge Kaplan, that KPMG refused to advance defense costs “because the government pressured KPMG to cut them off. The government, they say, thus violated their rights and threatens their right to a fair trial.” Judge Kaplan agreed with the defendants’ claims, stating “KPMG refused to pay because the government held the proverbial gun to its head. Had that pressure not been brought to bear, KMPG would have paid these defendants’ legal expenses.” Furthermore, Judge Kaplan ruled that in applying this pressure the government “lets its zeal get in the way of its judgment. It has violated the Constitution it is sworn to defend.”

The gun that Judge Kaplan referred to is a document issued by then-Deputy Attorney General Larry D. Thompson on January 20, 2003 called “Principles of Federal Prosecution of Business Organizations”. Federal prosecutors are bound by the principles set forth in this document, known as the Thompson Memorandum, in deciding whether to indict a corporation or other business entity. One of the guiding principles in this decision is the prosecution’s analysis of whether the corporation willingly cooperates with the investigation of its agents (i.e., employees). The Thompson Memorandum sets forth many indicia of cooperation; the one at issue in the KPMG decision is whether the corporation is advancing attorneys fees for its employees. Advancing such fees, unless required to do so by law, is considered a sign that the corporation is not fully cooperating with the government.

The KPMG defendants convincingly argued to the judge that the U.S. attorneys negotiating KPMG’s deferred prosecution agreement led KPMG to believe that the government would not enter into the agreement if KPMG was advancing attorneys’ fees for its employees. According to the opinion, the government also urged KPMG to suggest to its employees that they cooperate with the government without benefit of their own counsel. Judge Kaplan, in a sometimes scathing opinion, held that the government’s conduct violated the defendants’ constitutional rights to a fundamentally fair trial under the Due Process Clause of the Constitution and the right to be represented by counsel under the Sixth Amendment to the Constitution. (In fact, Judge Kaplan’s opinion was so critical of the prosecuting attorneys that the Manhattan U.S. Attorney has sent the judge an eight-page letter requesting that he revise his opinion to remove references to the names of specific prosecutors and certain statements regarding the conduct of the prosecutors.)

The judge also ruled that the government’s conduct interfered with the defendants’ legitimate expectation, arising from their employment with KPMG, that KPMG would advance their defense costs. Potential remedies for the government’s violation range from reimbursement of attorneys’ fees, to refusal to admit certain items of evidence obtained while defendants were denied proper counsel at trial, to dismissal of the charges. The judge has not yet ruled on the appropriate remedy, but has indicated that the defendants are free to sue KPMG to obtain payment of their fees. The judge has also suggested that the prosecution consider advising KPMG to pay the fees in order to avoid more drastic remedies.

Judge Kaplan’s Decision Has Important Ramifications

The importance of Judge Kaplan’s decision reaches far beyond the KPMG trial. In case after case, the government has used the Thompson Memorandum, including its proscription against advancing attorneys’ fees, to pressure companies into cooperating in investigations against their employees in order to avoid indictment of the company itself, with the consequent risk to the livelihood of all of the company’s employees and stakeholders. In case after case, companies have waived the attorney-client privilege, refused to advance attorneys’ fees, or taken other actions that could harm some of its employees in order to avoid a risk to the firm as a whole. Companies that have failed to cooperate to the fullest extent demanded by the government, such as the Milberg Weiss law firm, have found themselves indicted. This isn’t to say that in some cases companies don’t deserve to be indicted — some of them do — but at the same time the government should not use its prosecutorial power to bully firms into waiving legal rights.

The KMPG decision, filled with stern language affirming the duty of the government’s lawyers to uphold the Constitution and dismay about the overreaching tactics of the government in the KPMG case, may help to encourage prosecutors to be more careful about how they wield their powers.

Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Amalie L. Tuffin concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, taxation and securities matters. Questions or comments can be sent to atuffin@d2vlaw.com