On August 29, 2005, the Department of Justice announced that KPMG had admitted to criminal wrongdoing and agreed to pay $456 million in fines, restitution and penalties as part of an agreement to defer prosecution of the firm. In addition to the agreement, nine individuals, including six former KPMG partners and the former deputy chairman of the firm, were indicted for what the government characterized as a multibillion-dollar criminal tax fraud conspiracy, the largest criminal tax case ever filed. The government alleged a conspiracy related to the marketing and implementation of fraudulent tax shelters that generated at least $11 billion in phony tax losses and cost the Internal Revenue Service at least $2.5 billion in evaded taxes.
The deferred prosecution agreement provides that prosecution of criminal charges against KPMG would be deferred until December 31, 2006, if the firm meets certain conditions, including the payment of $456 million, admission of liability, cooperation against the firm's former partners, an elimination of certain practice areas and oversight by an outside monitor. If the firm has fully complied with all the terms of the agreement at the end of the deferral period, the government will dismiss the criminal charges.
KPMG now joins the ranks of Bristol-Myers Squibb Company, Computer Associates, WorldCom, AIG, America Online, Monsanto, PNC Financial Services Group and others as a party to a deferred prosecution agreement, thereby avoiding trial and the risk of suffering the fate of Arthur Andersen LLP. The details of the KPMG deferred prosecution agreement give insight into the lengths to which a firm will go to avoid prosecution and to protect its existence.
The Allegations of a Conspiracy to Promote Fraudulent Tax Shelters
The indictment against the former KPMG personnel and the information filed against KPMG outline the government's allegations against KPMG and the individual defendants. The charging documents allege that KPMG, the individual defendants and others deliberately perpetrated a scheme that generated more than $11 billion of phony tax losses. The scheme enabled wealthy KPMG clients to evade billions of dollars in taxes they owed on income and capital gains, and permitted KPMG to earn at least $150 million in fees. The government alleges that, between 1996 and 2003, KPMG, the nine indicted defendants and others conspired to defraud the IRS through illegal tax shelters. The charging documents focus on four tax shelters: FLIP (Foreign Leverage Investment Program), OPIS (Offshore Portfolio Investment Strategy), BLIPS (Bond Linked Issue Premium Structure) and SOS (Short Option Strategy). The charging documents allege that KPMG and the individual defendants concocted tax-shelter transactions - together with false and fraudulent factual scenarios to support them - and targeted them to wealthy individuals who needed a minimum of $10 or $20 million dollars in tax losses so that they would pay fees that were a percentage of the desired tax loss to KPMG, certain law firms and others instead of paying billions of dollars in taxes owed to the government.
To further the scheme, KPMG and the individual defendants allegedly filed false and fraudulent tax returns and claimed phony tax losses. The information and the indictment alleged that top leadership at KPMG made the decision to approve and participate in the shelters and issued opinion letters despite specific warnings from KPMG tax experts at critical junctures throughout the development of the shelters that: (i) the shelters were close to frivolous and would not withstand IRS scrutiny; (ii) the representations required to be made by the wealthy individuals were not credible; and (iii) the consequences of going forward with the shelters - as well as failing to register them - could include criminal investigation, among other things.
The KPMG Deferred Prosecution Agreement
In a letter dated August 29, 2005, from the Department of Justice to KPMG's attorneys, the Department of Justice set forth the agreement that would permit the government to file a one-count information against KPMG charging the firm with participating in a conspiracy to defraud the IRS, commit tax evasion and make and subscribe fraudulent tax returns and that would later be dismissed if KPMG complied with the provisions of the deferred prosecution agreement. The agreement has several notable components.
Acceptance of Responsibility
KPMG agreed to admit that the conduct of certain KPMG tax leaders assisted high net worth U.S. citizens to evade U.S. individual income taxes on billions of dollars in capital gains and ordinary income by developing and promoting fraudulent tax shelters. KPMG admitted that a number of its tax partners engaged in conduct that was unlawful and fraudulent, including: (i) preparing false tax returns; (ii) drafting false proposed factual recitations and representations as a part of the documentation underlying the shelters; (iii) issuing opinions that contained false and fraudulent statements, although the KPMG tax partners and the high net worth individuals knew the statements were false; (iv) actively taking steps to conceal the tax shelters from the IRS; and (v) impeding the IRS by knowingly failing to locate and produce all documents responsive to IRS summonses.
KPMG agreed that it would not make any statement in litigation or otherwise contradicting these admissions. Consistent with that provision, KPMG is allowed to raise defenses or affirmative claims in any civil proceedings brought by private parties as long as in doing so it does not contradict the admissions.
KPMG agreed to pay a total of $456 million to the United States, comprised of a fine representing disgorgement of $128 million of fees; restitution to the IRS of $228 million for actual losses suffered as a result of the running of the statute of limitations because of KPMG's failure to register the shelters, KPMG's failure to disclose its participation in certain fraudulent tax shelters to the IRS in response to summonses and KPMG's misrepresentation to the IRS of its involvement in those transactions; and an IRS penalty of $100 million to settle the IRS promoter's penalty examination of KPMG. KPMG agreed that no portion of the payment was deductible on any federal or state tax or information return. Further, KPMG represented that no portion of the $456 million was covered by insurance. KPMG agreed that, if any portion of the $456 million obligation was ultimately covered by insurance, 50 percent of any such insurance received by the firm would be remitted to the United States.
Permanent Restrictions On and Elevated Standards for KPMG's Tax Practice
KPMG agreed to certain permanent restrictions and elevated standards for its tax practice. The firm agreed to cease its private client tax practice and its compensation and benefits tax practice. KPMG agreed not to develop any prepackaged tax products and not to participate in marketing, implementing or issuing any "covered opinion" with respect to any "listed transaction." Further, the firm agreed not to provide any tax services under any conditions of confidentiality.
With certain limited exceptions, KPMG agreed not to prepare tax returns or provide tax advice of any kind to any individual clients except: (i) individual tax planning and compliance services to individuals who are owners or senior executives of privately held business clients, (ii) individual tax services as part of its international executive services practice and (iii) bank trust outsourcing services where KPMG prepares trust tax returns.
KPMG agreed to comply with minimum opinion thresholds and minimum return position thresholds for its clients on covered opinions and tax returns. For instance, for tax returns for other than principal purpose or listed transactions, the firm agreed that the minimum return position for individuals and other private entities would be "more likely than not" and for large private entities and public companies the return position threshold would be "realistic possibility of success."
KPMG agreed to limit its federal tax controversy representation to public companies, private entities and persons for whom it is permitted to prepare tax returns as set forth above. Further, the firm is not permitted to defend any transaction that is or becomes a listed transaction and is not permitted to defend any transaction with respect to which the firm could not render an opinion or prepare a return in compliance with the standards regarding the minimum thresholds for opinions and return positions.
Cooperation
KPMG agreed to fully and actively cooperate with the government regarding any matter relating to the government's investigation. The firm is required to provide a complete and truthful analysis and a complete and detailed description of the design, marketing and implementation by KPMG of all the transactions subject to the investigation, including where necessary an appropriate and detailed description of representative client transactions. The firm also agreed to waive any attorney-client privilege or work product protection as to any documents or testimony requested by the government related to its investigation, with certain limited exceptions.
Compliance and Ethics Programs
As part of the agreement, KPMG is required to maintain a permanent compliance office and a permanent educational and training program relating to the laws and ethics governing the work of KPMG's partners and employees. The firm's programs are required to pay particular attention to practice areas that pose high risk, including the determinations of whether transactions in which KPMG and its clients are involved constitute "reportable transactions" and whether the appropriate level of opinions and advice set forth in the agreement and all applicable laws have been satisfied. KPMG agreed that all of its professionals and employees will receive appropriate training pursuant to the compliance and ethics program within one year and that such training would occur on a regular basis but in any event no less than annually for the tax practice and no less than every two years for other practices. As part of the compliance and ethics program, the firm is required to ensure that there is an effective program to punish violators and to reward those who report such violations.
Independent Monitor Appointed by the Government
The firm agreed to the appointment of a monitor with the power to review and monitor: KPMG's compliance with the agreement; the maintenance and execution of the compliance and ethics program; the implementation and execution of personnel decisions regarding individuals who engaged in or were responsible for the illegal conduct described in the information and may require any personnel action, including termination, of such individuals; and KPMG's compliance with the restrictions on its tax practice and the operations and decisions of any practice area involved in "reportable" and "listed" transactions. The monitor's authority is to extend for a period of three years from the date the monitor enters duty. The selection of the monitor will be made by the government after consultation with KPMG and with the use of best efforts to select and appoint a mutually acceptable monitor.
No Department of Justice Debarment
KPMG is permitted to continue its engagement to audit the Department of Justice's financial statements. The Department of Justice's debarring officer determined that suspension or debarment of KPMG was not warranted because KPMG had agreed to the terms of the deferred prosecution agreement.
Deferral of Prosecution
In consideration of KPMG's entry into the agreement and its commitments to accept and acknowledge responsibility for its conduct, to cooperate with government, to comply with federal criminal laws and otherwise to comply with all terms of the agreement, the government agrees to recommend to the Court that the prosecution of the firm on the information be deferred for the period through December 31, 2006. If at that date KPMG has complied with all its obligations under the agreement, the government would seek the dismissal without prejudice as to KPMG of the information filed against it.
Principles of Federal Prosecution of Business Organizations
The authority for KPMG's attorneys to secure the deferred prosecution agreement lies in a January 20, 2003, memorandum of then Deputy Attorney General Larry Thompson. In determining whether to charge a business organization, that entity's timely and voluntary disclosure of wrongdoing and its willingness to cooperate with the government in its investigation is an important factor. The memorandum is specific in the character and quality of the prospective defendant-corporation's cooperation and disclosure, and provides a road map for securing a deferred or non-prosecution agreement: (1) identify the culprits, including senior executives; (2) make witnesses available; (3) disclose the results of internal investigations; and (4) waive all privileges, including attorney-client and work product.
Saving the entity is important, but each of these elements presents its own collateral issues: defamation actions by accused executives; uncooperative/worried employee witnesses; competitors/injured parties' use of internal investigations in litigation; and erosion of the attorney client privilege. These considerations are too complex to address in this space and will be the subject of a future Alert.
Any entity considering cooperation with government investigators should tread carefully to stay on the path to avoiding or deferring prosecution. Such non-prosecution or deferral agreements are typically available only when an organization's "timely cooperation appears to be necessary to the public interest and other means of obtaining the desired cooperation are unavailable or would not be effective." Factors supporting declination or deferral of prosecution in addition to the above include whether the organization appears to be protecting culpable employees and agents. Such common arrangements as retaining the employee without sanctions, advancing attorneys' fees, using joint defense agreements and providing the "culprit" with information about the government's investigation may be viewed negatively by a prosecutor.
The lesson to be learned from the KPMG deferred prosecution is that, despite egregious conduct, a way can be found to preserve the entity. Safe passage may be worth the price but is at a significant cost to former friends, partners and ongoing business relationships, as the KPMG agreement requires the firm to provide the government a road map of its former partners' alleged misdeeds in developing, marketing and implementing the alleged fraudulent tax shelters and requires the firm to eliminate certain practice areas.
Should a business entity forego the fight and choose this course, it should do so with an experienced guide, as the road to survival is filled with land mines.
For more information or if you have a question about this Alert, please contact Thomas W. Ostrander or any of the other attorneys of our Tax Practice Group or the attorney in the firm with whom you are regularly in contact.
This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.
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