Three Felonies a Day
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Cooperation, in short, involved the company’s doing virtually anything and everything asked of it by prosecutors. While some details of the so-called Thompson Memorandum were modified in subsequent years, largely as a result of criticism by judges, legal scholars, civil libertarians, and industry representatives, the heart of this approach remains.21
KPMG, if it could be persuaded to switch rather than fight, would be able to supply a crucially important legal element to the DOJ’s intended prosecution of the individual targets. The weakest part of the government’s case was the underlying issue of whether the shelters were so clearly fraudulent that the individuals must have believed, indeed known, that they were phony. For one thing, consider the requirement that certain tax shelters have to be registered with the IRS. The indictment alleged that the defendants had criminally failed to register the shelters. Yet there was documented evidence, later revealed, that there had been considerable disagreement within the IRS itself as to whether these tax shelters had to be registered. The non-registration was an important part of the government’s criminal case, since its theory was that the tax partners failed to register the shelters for fear that the IRS would instantly declare them fraudulent and disallow the deductions for each affected tax filer. If in fact there was no registration requirement for these particular shelters, or the defendants genuinely believed such, this theory of demonstrable criminal intent goes out the window.22
Furthermore, there was a real question as to whether the shelters themselves might have presented a legitimate, or at least a sufficient, question so that a jury could find “reasonable doubt” and acquit. This was demonstrated later when, on July 20, 2006, a federal judge in the Eastern District of Texas ruled preliminarily in a civil tax case brought two years earlier that one of the shelters (the BLIPS) was valid because the government could not retroactively change the way it dealt with such issues. The lawsuit was brought by two Texas lawyers who had made a fortune in anti-tobacco litigation, used the shelter, were denied large deductions, and, in accordance with proper procedure, sued the IRS for a determination of the shelter’s legitimacy. They won the preliminary round and were heading for a full trial. This was widely considered a serious setback for the government’s assault on these shelters. After all, even if this finding were later reversed on appeal,23 the case demonstrated that at least one federal judge thought the taxpayers’ position on the shelter device was reasonable. Could this be the foundation upon which criminal tax conspiracies are fairly built?
Given the potential weakness at the heart of the DOJ’s intended criminal case (the issue of the legality of the shelters), the government arrived at a strategy for strengthening this aspect of its case for presentation to the jury. Part of the deal it made with KPMG, once the partnership changed law firms and began to negotiate a cooperation agreement, was that the firm would admit that the tax shelters it had so eagerly and profitably promoted over several years were in fact a fraud. This and other obligations by both the government and its new ally KPMG were spelled out in great detail in a remarkable “deferred prosecution agreement” negotiated between the DOJ and KPMG’s new lawyer, Robert S. Bennett of the Washington office of the mega-firm Skadden, Arps, Slate, Meagher & Flom.
Bennett had substantial, and lucrative, experience in negotiating such deals for other corporate clients. As Laurie P. Cohen reported in The Wall Street Journal,24 Bennett a year earlier had negotiated a corporate rescue deal for HealthSouth with Birmingham, Alabama, U.S. Attorney Alice Martin.25 A triumphant Bennett told Jonathan Weil of the WSJ that he was now “confident under the new leadership that KPMG will not only survive but will flourish.”26
The deferred prosecution agreement between the government and KPMG, dated August 26, 2005, provided that KPMG would admit to the facts and conclusions set out in a comprehensive government memorandum detailing how and why the shelters were fraudulent, and that the tax partners and others knew it. KPMG agreed to cooperate with the government “fully and actively.” The firm agreed to do its best “to make available its recent and former partners and employees to provide information and/or testimony as requested by” the government. It would waive all privileges, including the attorney-client privilege, thus giving the government full access to all records and memoranda, including interviews between its employees and the company’s lawyers. The firm even agreed to take on a government-approved monitor to make sure it complied with the settlement agreement and followed recommended business practices.
KPMG also agreed, in a breathtaking stipulation, that it, its employees, and even its lawyers would not “make any statement, in litigation or otherwise, contradicting the Statement of Facts or its representations in this Agreement.” In other words, the partnership making the agreement had to warrant that a host of individuals financially dependent on it would not stray off the reservation. These witnesses had agreed to sing, and even to the extent some might already have “composed,” they were not to deviate from the agreed storyline. Indeed, the agreement, recognizing that some individual employees of the partnership might at some point go off-script, included an Orwellian provision that if the DOJ decided that some statement contradicted the official version in the Statement of Facts and the settlement agreement, the DOJ would give the company notice and it would have 48 hours to issue a “repudiation” of any such “contradictory statement.”
If KPMG complied with all terms of the settlement agreement, the criminal charges would be dismissed rather than brought forward. The DOJ retained sole discretion to determine whether KPMG had at any point violated its cooperation agreement. The agreement contained within it KPMG’s “deferred” guilty plea to the criminal charge, and if at any point through the end of 2006 the company violated (in the government’s eyes) the agreement, its guilty plea would move from “deferred” to active status. The company would then stand indicted, subject instantly to the unraveling that destroyed Arthur Andersen.
Rather than having to prove to the jury that the shelters were in fact illegal, the DOJ took this short cut. KPMG’s agreement to help the government in this fashion would enable the DOJ to turn a very shaky prosecution into a truly dangerous one for the individual defendants. And it was all made possible not primarily by the truth, not by the facts, and not by the law governing tax shelters, but rather by the enormous leverage that the DOJ held in determining whether the firm would live or die.
The deferred prosecution agreement was signed August 26, 2005. The indictment of eight former partners of KPMG as well as one of the lawyers who advised the company on the propriety of the shelters was made public a mere three days later. In reporting on the indictment of the individuals as well as the terms of the company’s deferred prosecution agreement, Floyd Norris, in a “news analysis” in The New York Times, noted that a once “proud and confident” accounting behemoth that had a reputation for being “certain of its own righteousness” had been unceremoniously “brought to heel.” Early in the investigation, Norris explained, KPMG had taken the position that neither the SEC, IRS, nor DOJ could control how it conducted its business. “It viewed accounting as a self-regulated profession that should not face government control.” Under “new leadership” and with new legal counsel, the firm had “been forced to grovel, as it realized that its continued existence might be in question if the Justice Department chose to file criminal charges against it.”27
Norris’s analysis in the Times was rather typical of the approach taken by much of the news media in reporting the KPMG struggle. It did not seriously question the danger to liberty when the government could get a party to “grovel” under these circumstances. Furthermore, the analysis nowhere questioned the veracity of the firm’s sudden admission of fraud in the face of the potent weapon wielded by the DOJ. It failed to take into account the charges made by the defendants’ lawyers, reported in the accompanying news article:KPMG’s statements in court were the product of extreme duress and are not worth the paper they are printed on,’ said Robert H. H
otz, Jr., of the firm Akin Gump Strauss Hauer & Feld, representing one of the indictees. Robert S. Fink, one of the leading tax litigators in the country, representing another former KPMG partner, told the press that ‘the government is attempting to criminalize the type of tax planning that tax professionals engage in on a daily basis.’ He suggested that ‘if the government wants to put an end to these types of transactions, the proper response is for Congress to change the law, not to scare professionals away with indictments.
Perhaps these statements were viewed by a skeptical press corps as standard for lawyers trying to defend their indicted clients in the court of public opinion. However, another way of viewing the matter is that the lawyers were trying, probably in vain, to touch upon issues fundamental to the fairness and accuracy of the prosecution.
The indictment charged a single over-arching conspiracy to design and market, and conceal from the IRS, phony tax shelters. The conspiracy charge was broad enough to include, as well, acts to obstruct the operations of the IRS. This was an obvious attempt to try to insulate the indictment from a defense that the shelters themselves were legitimate. Yet notwithstanding the breadth of the indictment and the fact that the government had the newly contrite accounting firm on its side, claiming that everyone knew that the tax shelters were unlawful all along, the ongoing legitimate dispute over this central question obviously continued to gnaw at the prosecutors’ confidence, especially in view of the feisty resolve shown by some of the defendants and their lawyers to fight the charges.
Almost predictably, the DOJ issued a “superseding indictment” on October 17, 2005, adding not only ten additional defendants (for a total of 19), but also 45 new counts (for a total of 46), including charges for obstruction and making false statements to the IRS. These obstruction counts were separate from the conspiracy charge, an apparent further step to rescue at least part of the indictment just in case the defendants were able to demonstrate to a jury that the shelters were sufficiently legitimate to defeat the standard for criminal IRS fraud. The government was taking no chances that the truth might wreck its ability to get a conviction.
The government thus put together a case which, even if wrong on the merits of its fraud claims concerning the tax shelters themselves, would cause the defendants to begin to tumble like dominoes. “It’s a lot like the scene in ‘The Godfather’ where Marlon Brando explains how he’s going to make an offer they can’t refuse,” Joseph Grundfest, a Stanford University professor of business and ethics and former SEC commissioner, told The Wall Street Journal.28 The New York Times quoted E. Lawrence Barcella Jr., a lawyer representing one of the new defendants, as reminding the world that no court had yet determined that the shelters were illegal.29 However, this inconvenient, stubborn fact appeared to matter less and less as the government’s successful, though dubious, strategy unfolded.
In time, various individuals involved in the shelters and named in this or related indictments began to fold, plead guilty, and agree to testify. On March 27, 2006, David Rivkin, a former KPMG partner in San Diego named in the indictment, pleaded guilty and agreed to cooperate. Rivkin stated, in open court during his plea, that he knew the tax returns to be false at the time for some of the firm’s wealthy clients.
Judge Lewis A. Kaplan of the United States District Court for the Southern District of New York (Manhattan), playing out the same dubious scenario enacted in federal courts countless times each day all over the country, solemnly informed Rivkin that his eventual sentence would depend upon the extent of his “cooperation” with prosecutors.30 By December of 2006 there were two additional such guilty pleas by persons not actually charged in the main KPMG indictment—Domenick DeGiorgio who pleaded guilty in August 2005, and Chandler Stuart Moisen in December 2006.31 On September 10, 2007, David Amir Makov pleaded guilty to a single count of conspiracy to engage in tax fraud, and, as part of the morality play, he announced that three of the remaining defendants were likewise involved in committing fraud. Unsurprisingly, Makov agreed that the “sole purpose” of the BLIPS shelter was to generate “paper losses” rather than real economic activity.32
Yet one additional weapon wielded by the government did not sit as well with Judge Kaplan. Based on the terms of the Thompson Memorandum, the prosecutors put pressure on KPMG to withdraw from its earlier agreement to pay the attorneys’ fees for its indicted former partners. One factor prosecutors should take into account when deciding whether a company should be indicted, according to the memo, “is whether the corporation appears to be protecting its culpable employees.”33 (Of course, the process that determines whether an employee is or is not culpable—the trial—requires substantial fees to pay for competent defense attorneys to assist in fairly and correctly making this determination.)
When the defendants complained to Judge Kaplan that their lawyers’ fees were being cut off by KPMG under pressure from the prosecutors to appear to be cooperative, the judge reacted sharply, questioning aloud whether the DOJ violated the defendants’ rights to the effective assistance of legal counsel, a right guaranteed by the Sixth Amendment to all criminal defendants and an essential element in assuring them a fair trial. This was no small gesture. After holding a highly contentious and heavily publicized hearing, Judge Kaplan ruled on June 27, 2006, that the government’s pressure on KPMG was improper and unconstitutional. “KPMG refused to pay because the government held the proverbial gun to its head,” wrote the judge. He postponed the trial in order to allow for litigation between the defendants and KPMG over the payment of fees. The government took an appeal, further postponing the trial. How the issue would eventually be resolved by the higher courts was less telling, perhaps, than Judge Kaplan’s finding that the prosecutors were using their power to try to disable the defendants from defending themselves.34
As the tax shelter criminal conspiracy case unfolded, it became clearer that the government was doing all it could to avoid a fair showdown on the merits of the central issue that started the case—were the tax shelters sufficiently and transparently phony so that those who devised and sold them could be said to have acted criminally, in violation of a clear and known legal obligation? Did the government sufficiently lack faith in its own legal theories so that it wanted to avoid a fair test of those theories, relying instead on pressure tactics to produce pleas of guilty, and coerced witnesses, up and down the line?
Interestingly, while all of this was going on, Congress, in reaction to the Enron and other corporate “scandals,” enacted legislation imposing significant new audit and other obligations on accounting firms. The so-called Sarbanes-Oxley law created the Public Company Accounting Oversight Board (PCAOB) to exercise new and strict supervisory powers over public auditing firms. One duty of the PCAOB was to establish standards for when an accounting firm that performs auditing services for a company could also provide other services and products that might constitute a conflict of interest, such as the sale of tax shelters. Such regulations, of course, if they can be honed with sufficient clarity, would eliminate any question as to whether in the future a firm like KPMG could have acted as it did. However, this attempt at clarifying the law and the obligations of accounting firms going forward did nothing to dim the resolve of the DOJ to punish the former KPMG partners and others for engaging in arguably dubious but not clearly illegal conduct in the past. Meanwhile, a substantial number of careers and lives ended up as wreckage on the shoals of a pioneering prosecution where nobody could reliably draw the line separating criminal from, at worst, questionable and, at best, perfectly lawful (even if aggressive) conduct.
One further provision of the deferred prosecution agreement might under ordinary circumstances raise the eyebrow of a disinterested observer. It turns out that KPMG, in the words of the agreement, “has been involved in an engagement to audit the Department of Justice’s financial statements.” Because KPMG had entered into the deferred prosecution agreement, the DOJ agreed that it would allow the firm to continue as its auditor. Such was the high de
gree of confidence now placed by the government in its erstwhile prey—an auditing firm that the government at one time saw as a veritable house of fraud but which had since seen the light of redemption. The partnership between the DOJ and the accounting firm would continue, both in and out of the prosecutorial arena—profitably for both.
At times, state attorneys general have gone out of their way to act as lone heroes and emulate their federal counterparts, especially if the state law enforcement officers were looking to the prize of higher office. Such an attorney general was New York’s Eliot Spitzer, who, in 2005, very publicly went after “Wall Street” in what turned out to be something of a dog-and-pony show played out on one stage, with the feds operating next door.