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When federal district court Judge Lewis Kaplan dismissed criminal charges against 13 former KPMG partners indicted in the government's massive tax shelter fraud case, he beamed a bright light on a subject that is usually very private: the cost of defending a complex corporate fraud case. By prodding KPMG to end its longtime practice of advancing employees' legal fees, he concluded, the government had irreversibly damaged the defendants' ability to defend themselves.
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The 19 KPMG defendants struggled with a mountain of discovery, a blizzard of motions, and for most, no way to pay for it all

Julie Triedman

The American Lawyer

November 8, 2007

On July 16, when federal district court Judge Lewis Kaplan dismissed criminal charges against 13 former KPMG partners indicted in the government's massive tax shelter fraud case, he beamed a bright light on a subject that is usually very private: the cost of defending a complex corporate fraud case.

As part of his own fact-finding, Kaplan had asked defense lawyers for their actual and projected costs. His decision to dismiss was rooted in what he found: a growing gap between what defendants were able to pay and what they needed for a full defense. By prodding KPMG to end its longtime practice of advancing employees' legal fees, he concluded, the government had irreversibly damaged the defendants' ability to defend themselves. Eighteen submissions were filed by individual defendants and their counsel; even though most were filed under seal, the judge cited or referred to all of them to varying degrees in that ruling. Twenty-one months into the case, through early July, all the defense firms had spent at least $500,000, and one tab was up to $3.6 million, Kaplan wrote. The defendants, he found, couldn't afford their defense.

Among the unsealed submissions Kaplan noted in his decision was one from Mark Watson, a 40-year-old former KPMG partner, who said in an affidavit that he had run up legal bills of $1.3 million to his lawyers at Kobre & Kim. As of mid-July, he had only been able to pay $300,000: He borrowed $100,000 from his parents; contributed another $120,000 from the sale of his house; and took the rest from savings. Former KPMG partner Carl Hasting, Kaplan noted, was wiped out financially. Hasting, a father of five, had written that his legal bills had topped $1.5 million by January 2007; at the time, he was $95,000 in arrears to his counsel at Litman, Asche & Gioiella.

The judge noted that a third former KPMG partner, Randall Bickham, owed his lawyers at Duane Morris $600,000; he had already paid $850,000, and had just $300,000 in assets left.

Several factors contributed to the enormous bills. Coordinating a defense in a 19-defendant indictment drove up costs, particularly for those lawyers who took the lead in joint efforts. Document production was unusually large and unwieldy, and all of the defense lawyers felt constrained to run their own document reviews.

The demands of the case left many of the KPMG defendants' lawyers torn between their professional duty to provide the best possible legal services and the financial drag of carrying a client in default. Among those who struggled was Michael Kim, a former prosecutor who cofounded a litigation boutique in 2003. In August 2005, Kim agreed to take over the defense of Watson, a bit player in the government's case, from Zuckerman Spaeder, Watson's previous counsel. He did so even though KPMG had just cut off Watson's legal support. Kim believed, as many counsel did prior to indictment, that his client could nearly afford to cover the costs of a case that -- rumor had it -- would involve just a handful of defendants and would last less than a year. "If I had known what this case would become," Kim said in June, "I would have told Mark that I probably could not afford to do this."

The accounts of KPMG lawyers and defendants persuaded Judge Kaplan that a sophisticated white-collar defense has become a multimillion-dollar proposition -- a cost few individuals can bear. Defense costs, Kaplan wrote in a footnote, "are astonishingly large, not in the sense that they are not credible, but for what they say about the cost of justice in our society and about the disparity between those with means and those without."

The government's case revolved around several tax shelter products that KPMG began marketing to its wealthiest clients in 1996. These new-generation shelters allowed clients to skirt taxes by orchestrating transactions posting large paper losses. Those paper losses, in turn, offset taxable capital gains, resulting in tax savings. In 2002 the Internal Revenue Service began auditing four KPMG products that it believed to be illegal.

The shelters were known by their acronyms: BLIPS, FLIP, OPIS and SOS. In early 2004, stymied by KPMG's resistance to its inquiries, the IRS sent the matter to the U.S. Department of Justice for criminal investigation.

At first, the KPMG partners under investigation -- and their lawyers -- fully expected that KPMG would pay their legal bills up front. Most U.S. companies and partnerships habitually advance fees to current and former employees whose alleged crimes occurred in the course of their work. (Fee advancement is distinct from indemnification policies, which, unlike fee advancement policies, are not discretionary. Companies and partnerships typically are obliged through their bylaws to indemnify or reimburse employees for legal bills and other costs stemming from actions taken while they were employed, as long as those actions were taken in good faith.) KPMG didn't have a commitment to advance fees enshrined in its bylaws, but in practice it had done the same: For example, just before the tax shelter case, KPMG had spent more than $20 million defending four former partners charged with fraud by the Securities and Exchange Commission in 2003 in connection with audits of Xerox Corporation. (Three agreed to pay record civil penalties and to permanent injunctions; a fourth agreed to censure.) But the Department of Justice's 2003 Thompson Memo threatened corporate America's reflexive advance payment of legal fees. Making a 1999 advisory issued by his predecessor, Eric Holder, Jr., into official policy, thendeputy attorney general Larry Thompson ordered prosecutors to weigh "whether the corporation appears to be protecting its culpable employees and agents."

A corporation's "promise of support to culpable employees and agents ... through the advancing of attorneys' fees" could be "considered by the prosecutor in weighing the extent and value of a corporation's cooperation."

Strong-armed by prosecutors, KPMG quickly abandoned its employees in order to save itself. Beginning in March 2004, at least 20 KPMG partners under investigation learned of the company's about-face through letters from KPMG's outside lawyers at Skadden, Arps, Slate, Meagher & Flom. Without mentioning any pressure from the government, the letters said that KPMG would only front the fees of those who cooperated, and then only to a maximum of $400,000. Support would cease upon indictment, wrote Skadden's Robert Bennett.

Several large firms subsequently exited the KPMG case, some before indictment, others soon after. Jones Day dropped former KPMG associate general counsel Steven Gremminger, who then tapped Doar Rieck Kaley & Mack, a firm that charged half the hourly rate of Jones Day, he noted in a later filing. Another defendant, former KPMG partner Gregg Ritchie, decided he couldn't afford Cadwalader, Wickersham & Taft; and a third, former KPMG tax partner David Greenberg, parted ways with Arent Fox. Some smaller firms like Zuckerman Spaeder also pulled out for financial reasons.

Meanwhile, KPMG cut a deferred prosecution deal for itself. Admitting to criminal wrongdoing, it agreed to pay $456 million in fines and restitution in late August 2005. The firm admitted that it had concocted and marketed four sham tax shelters since 1996 -- products that, according to the government, generated $11 billion in phony tax losses and cost the U.S. Treasury at least $2.5 billion. KPMG also admitted to hiding incriminating information from the IRS.

The same day that KPMG's deferred prosecution agreement was announced, the government indicted eight former KPMG partners and an outside lawyer on a single conspiracy count. Defense lawyers began to realize the true scope of the case only in mid-October, however, when the government added ten more defendants, bringing the total to 19 -- the highest number ever charged concurrently in any white-collar case that several defense counsel could recall. The new indictment added 43 tax evasion counts and two counts of obstruction of the IRS. (Four tax evasion counts applied only to the outside lawyer, and the obstruction counts applied to just three defendants.) Seventeen of the 19 defendants were former KPMG partners.

The sheer number of defendants made the case exceptionally complex. To keep the case more manageable, the judge required many motions and briefs to be filed jointly on issues of common interest. But coordinating joint defense efforts was immensely time-consuming, according to David Spears of Spears & Imes, who represented former KPMG deputy chairman Jeffrey Stein. Every motion, brief, and affidavit had to be reviewed by every defense lawyer. "It became brutal. It morphed into a nightmare," says Spears. The docket also remained crowded with motions pertaining to individual defendants' cases. In January 2006, for instance, defendants filed 26 distinct motions supported by 1,100 pages of briefs. The docket sheet would grow to more than 1,100 items by the time of dismissal.

A unified front was a strategic necessity. Under the government's conspiracy theory, defendants all faced liability for each of 39 tax evasion counts.

And with all the defendants tried together, "you don't want a circular firing squad," says Akin Gump Strauss Hauer & Feld's Michael Madigan, counsel for former KPMG vice-chair John Lanning.

The sweeping liability cast on bit players was "outrageous," says Ronald DePetris, who defended retired KPMG partner Philip Wiesner. "My client was alleged to have committed one overt act -- approval of the BLIPS template," says DePetris. "But they're holding him responsible for all the tax counts.

So we had to do it all."

But coordinating a concerted defense at times felt like driving a cart with horses going in a dozen different directions. Despite being yoked together, defendants did not share a common background. Some had initially cooperated with investigators; others had not. They had played different roles in the alleged conspiracy, from creating or marketing the tax shelters to providing legal opinions on them. Their job titles ranged from a deputy chairman down to nonequity partner. Defendants worked at several different offices, and two, an outside lawyer, Raymond Ruble, and an Israeli citizen, David Amir Makov, had never worked at KPMG. Most, in fact, had never met all of their codefendants.

Document review ate up even more time and money than coordinating the defense. KPMG was an extremely document-intensive case, with data flowing from banks and the IRS, from videotaped depositions and speeches, from tax returns, and from years of e-mail of all those involved in the transactions.

Document production would ultimately swell past 22 million pages.

Even at a first status hearing in October 2005, defense lawyers complained about the volume of documents. At the time, Assistant U.S. Attorney Justin Weddle told the judge that the government expected to produce a total of 5 million pages in five weeks. But the process, defense counsel said, was a mess. Electronic files were in such bad shape that they could only be searched document by document. "We've been overwhelmed with massive material that is simply not manageable in its present form," asserted Spears at the hearing.

Defense counsel all faced the same monumental task. Unlike plaintiffs counsel in document-intensive class actions, criminal lawyers are uncomfortable relying on someone else's document review, say several KPMG defense counsel. Lawyers discussed sharing the cost -- more than $150,000 -- of establishing a centralized document database, as well as the monthly $50,000 expense of a vendor to cull through and narrow down materials for review.

But they scrapped the idea: No one wanted others to see what had been flagged as important to their client's case.

"There's always the possibility that someone might become a government witness," explains Kim. "It's not like all these defendants are a band of brothers." (In fact, two defendants, David Rivkin and David Amir Makov, eventually pleaded guilty.) In the end, many counsel set up their own review systems. Some used their firms' computers; others paid the five-figure monthly fee to an outside vendor. (Kim estimates that roughly $850,000 of the $1.3 million his firm spent on Watson's case was related to discovery.) Several defendants -- including Watson, a nonlawyer, and Stein, a law school graduate who had never practiced -- wound up reviewing documents themselves. But only a small fraction was ultimately reviewed by anyone, say several counsel. "We were all grossly understaffed," recalls Spears.

At least three small firms had neither the money nor the computer power to handle discovery independently. Counsel to former KPMG partners Carol Warley and Carl Hasting both relied heavily on the few other defense firms willing to share their findings and to point out critical documents. Two firms, Akin Gump and Arguedas, Cassman & Headley, were particularly helpful; Akin Gump's client, John Lanning, "wanted to support his junior partners," says his counsel, Michael Madigan. And half of the fees of the Arguedas firm's client, former KPMG partner Gregg Ritchie, were being reimbursed by his subsequent employer.

The paper documents were a separate nightmare. According to Spears, most had never been scanned into digital form. Among them, he and Kim say, were the only copies of individual tax returns central to the government's tax evasion charges. By mid-2006, as the original trial date approached, only counsel for a few deeper-pocketed defendants had visited the warehouse in Maspeth, New York, where paper documents were stored. Inside were hundreds of boxes, many marked with the toothmarks of rats, piled high on pallets and shrink-wrapped in plastic.

The discovery to-do list didn't end there. Prosecutors provided a list of 68 government witnesses and 110 other individuals that they indicated had "potentially exculpatory information." Prosecutors offered up 2,000 trial exhibits -- 150,000 pages in all.

Kaplan pushed back the trial date, but he continued to demand strict compliance with his filing schedule in the fall of 2006. At a hearing in late September, Russell Gioiella, lawyer for former KPMG partner Carl Hasting, pleaded with the judge to postpone deadlines for defense witness lists. Gioiella, of three-lawyer Litman, Asche & Gioiella, had had the 12 boxes of exhibits shipped to his home so that he could go through them. He was basically on his own, he said, relying on other counsel with greater resources to point potentially exculpatory documents in his direction. "I've tried to figure out every way, and at great personal sort of trauma ... because this is not the way I've ever handled a case, ever, in 25 years of doing this," he complained. At some point, "it becomes ineffective assistance of counsel."

The judge had shown an interest in the defendants' plight as early as March 2006, when he responded favorably to a defense motion for fee relief. Ronald DePetris' motion was initially considered by some defense counsel as a long shot: It challenged whether the government had the constitutional authority it claimed in the Thompson Memo to interfere in corporate policies of advancing legal fees to employees.

On the basis of that motion, Kaplan allowed subpoenas of communications that revealed the pressure that prosecutors had exerted on KPMG. Those communications between KPMG and the government contradicted prosecutors' earlier assertions that no strong-arm tactics had ever been used. Defense lawyers for the KPMG defendants, sensing an opportunity, received permission to file a new motion to dismiss.

On June 26, 2006, the judge issued a scathing 83-page opinion that blasted the government. The prosecutors' tactics, he wrote, represented an injury to the criminal justice system itself.

"While a defendant does not have a constitutional right to the most expensive lawyer or to unlimited defense funds, government interference with those resources that a defendant does have or legally may obtain fundamentally alters the structure of the adversary process," he wrote.

The criticism of the Thompson Memo by a federal district court judge in Manhattan, the traditional center of corporate fraud prosecution, marked a major defeat for the Department of Justice. Legislative action followed: In December 2006 Senator Arlen Specter introduced a bill to ban prosecutors from using certain pressure tactics to get companies to cooperate in white-collar criminal investigations. Five days later, deputy attorney general Paul McNulty issued new guidelines omitting the section advising prosecutors to consider the advancement of legal fees in bringing charges against institutions.

But defense counsel were still struggling with the government's near-ceaseless document production. In March 2007 Kaplan ordered prosecutors to propose a solution. Two weeks later, prosecutors consented to put all discovery materials on a single searchable Web-based database. But for some defendants, the database wouldn't relieve the discovery burden.

"Obviously, no matter how effective the database is, someone will still need to review the documents contained within it," wrote Watson, Kim's client, in an affidavit filed after the government proposed the database.

By then, Kim and several other lawyers for KPMG defendants were fronting their clients' legal costs. Unemployed and with less than $82,000 in assets, Watson no longer attended hearings; he couldn't afford to fly from Florida, where his wife, an entry-level flight attendant, was based.

Former KPMG partner Carl Hasting was also running out of money to pay his legal bills; in February his lawyer, Gioiella of Litman, Asche, had filed a motion to withdraw for nonpayment. The two had been wrangling over a $500,000 retainer, which Gioiella claimed had never been paid. (Gioiella did not return numerous calls and e-mails for comment.) In June 2006 Kaplan denied Gioiella's motion. "Given the fact that Mr. Gioiella undertook this representation," the judge wrote, "knowing that his prospects for full payment were unsecured and inherently somewhat uncertain, the court has a heightened interest in his finishing what he started."

Kaplan offered to make Gioiella court-appointed counsel at $94 an hour, applicable retroactively. Gioiella declined.

In May, pretrial subpoenas brought to light still more evidence of prosecutorial interference in the run-up to the deferred prosecution deal.

That evidence included communications between Skadden and prosecutors showing that, during the government's investigation, KPMG had threatened withdrawal of the $400,000 in legal fee support to former partners if they did not provide voluntary statements, or proffers, to prosecutors.

Kaplan permitted the KPMG defendants to submit a new, updated motion to dismiss. But he remained preoccupied by the issue of legal fees. In July the judge told KPMG defendants that they could submit specifics about how the change in the fee advancement policy had hurt their clients' defense. He invited defense counsel to estimate how much a full defense would cost.

Susan Necheles, of five-lawyer Hafetz & Necheles, told the judge a proper defense for her client Richard Rosenthal, a former KPMG CFO, should cost $1520 million. And Steven Bauer of Latham & Watkins, attorney for former KPMG partner John Larson, estimated a cost of as much as $44 million per defendant, if potential appeals and a retrial were included.

Spears said his client, former KPMG deputy chairman Stein had paid him and cocounsel at Vinson & Elkins $2.4 million. But Spears had estimated that a thorough defense would cost $10 million. Spears asserted he would have mounted a far broader effort if KPMG had been footing the bill. He would have hired an electronic evidence consultant to identify documents requiring attorney review; at least four associates and four legal assistants to review those documents and prepare detailed summaries; a forensic accountant to review and analyze the hundreds of tax returns the government had produced; experts in several arcane areas including foreign exchange futures trading; and finally, two associates and two paralegals to prepare for trial.

Spears had argued that even if Stein used every dollar of his net worth, including selling his Scarsdale, New York, home, he could not come close to paying the cost of that kind of defense. And that shortfall, Spears asserted, "could well mean the difference between conviction and exoneration."

Even at current staffing levels, each month of trial would cost as much as $400,000 or $500,000 per defendant; submissions from various attorneys estimated that an eight-month trial alone would cost their clients $3.24 million apiece.

Prosecutors, who were given the opportunity to comment on the defendants' estimates, chose not to dispute them.

Ultimately, the judge dismissed the case against all but three of the defendants who had worked at KPMG. (Two, John Larson and Robert Pfaff, had left KPMG to set up a small tax shelter boutique, Presidio Advisory Services, in 1997; most of their alleged participation in the questionable tax transactions occurred after they left KPMG. A third, David Greenberg, had waived any claim for legal fees when he left KPMG in 2003.) None of the 13, wrote the judge, "has the resources to defend this case as he or she would have defended it had KPMG been paying the cost, even if he or she liquidated all property owned."

Since the dismissal, the government has pressed on with the case against the three onetime KPMG partners and an outside lawyer; trial was scheduled to begin Oct. 17. (A fifth remaining non-KPMG defendant, David Amir Makov, pleaded guilty to two charges in September.) Lawyers for three of the four facing trial, David Greenberg, John Larson and Robert Pfaff, did not return calls requesting information about how they were covering legal bills.

Defendant Raymond Ruble, a former Sidley Austin attorney, is getting no help on fees from his former firm.

But the case is not over yet for the other 13. The government is appealing Kaplan's dismissal. (Prosecutors would not comment on the appeal; a brief was due in October.) Defense lawyers expect the government to argue that the KPMG defendants' constitutional rights were never violated, since case law has long held that defendants are only entitled to a lawyer -- not an expensive defense. But if the KPMG case shows anything, says Kim, it's that "the law hasn't really kept pace with the real world." In the real world -- or at least in Judge Kaplan's ruling -- due process rights cannot be met by a court-appointed counsel hired as trial approaches. And in a world in which the government pursues arcane financial crimes in still-evolving areas of law, old rules may be insufficient guarantees that defendants will have access to the material they need to defend themselves.

The KPMG debacle is not likely to be repeated on quite the same scale. Many companies and partnerships have incorporated the advancement of legal fees into their bylaws in recent years, say Necheles and others.

Yet there are likely to be other cases in which companies cannot afford to front legal costs -- and small white-collar defense shops will still agree to represent defendants. "People [who] have had to pay their own legal fees," says Necheles, "have always come to firms like ours."

And those firms, say several small-firm defense counsel, understand that they may not always collect what they bill. "Part of being a white-collar defense lawyer is you don't always get 100 percent.," says one. "That's just the way it works."

Most of the time, that is. Smaller firms may have a bigger appetite for risk -- but in KPMG, even they got more risk than they bargained for.