Businesses facing the threat of indictment have become increasingly willing to enter deferred prosecution agreements with the government. In a deferred prosecution agreement, a business entity agrees to admit its wrongdoing and enact reform policies in exchange for a promise by the Justice Department not to seek an indictment as long as the business lives up to its agreement.
Though these agreements reduce the risk of criminal liability, two recent decisions from New York’s Commercial Division indicate how deferred prosecution agreements can increase a firm’s exposure to civil liability. In Shalam v. KPMG LLP, No. 112732/05, 2006 N.Y. Misc. LEXIS 2380 (Sup. Ct. Sept. 8, 2006) and Williams v. Sidley Austin Brown & Wood, L.L.P., No. 60080/05, 2006 N.Y. Misc. LEXIS 2581 (Sup. Ct. Sept. 22, 2006), plaintiffs alleged that accounting firm KPMG colluded with the law firm Sidley Austin Brown & Wood, and others, to dupe wealthy investors into participating in tax shelter transactions that they knew would not withstand IRS scrutiny. In both cases, the court found that allegations based on defendants’ admissions from deferred prosecution agreements satisfied the heightened pleading requirements for fraud claims.
As these decisions make clear,a firm threatened with criminal prosecution by the Justice Department faces difficult choices.On the one hand,the firm will feel enormous pressure to enter into a deferred prosecution agreement,to avoid being prosecuted and risking dramatic consequences.On the other hand,if a firm enters into a deferred prosecution agreement,the firm typically must make admissions thatwill increase the firm’s exposure to civil liability.
Shalam v. KPMG LLP
In Shalam, the founder and CEO of Audiovox alleged that in early 2000, partners at KPMG solicited his participation in a tax shelter transaction to offset capital gains realized from the sale of $55 million worth of stock. Shalam v. KPMG LLP, No. 112732/05, 2006 N.Y. Misc. LEXIS (Sup. Ct. Sept. 8, 2006). KPMG and Sidley Austin provided positive tax opinion letters on the transaction. Id. at *10.The IRS disallowed the tax shelter and ordered Shalam to pay back taxes, interest, and penalties. Shalam subsequently filed suit against KPMG, Sidley Austin, and other entities involved in the transaction including Bayerische Hypo-Und Vereinsbank AG and HVB Structured Finance, Inc. (referred to collectively as "HVB"by the court) alleging fraud and other claims. Id. at *11-12. The defendants moved to dismiss.The claims against KPMG and Sidley Austin were stayed because Shalam had participated in a class action against those defendants. Id. at *3.
The court, however, denied HVB’s motion to dismiss. HVB had argued, in part, that Shalam had failed to satisfy the pleading requirement necessary to sustain his fraud allegation. Id. at *2. To satisfy the pleading requirement, Shalam relied in part on admissions of wrongdoing made by HVB in a deferred prosecution agreement. These admissions included a statement that HVB "participated in a number of fraudulent tax shelter transactions devised by others." Id. at *33. Shalam also seized upon portions of the deferred prosecution agreement in which HVB described how it marketed these types of tax shelter schemes. Id. at *33-34.
HVB tried to convince the court that these admissions should not be used by Shalam in his civil action. HVB argued that it had admitted to committing fraud only against the United States, but "not against investors like plaintiff who took full advantage of tax savings generated" by the disallowed transactions. Id. at *35. The court rejected HVB’s argument, refusing to dismiss Shalam’s fraud claim. The court found that the admissions provided a sufficient basis to draw "a solid inference" that HVB both marketed and facilitated the tax transactions in a way that defrauded Shalam. Id. at *36.
Williams v. Sidley Austin Brown & Wood, L.L.P.
Williams provides another recent example of a plaintiff using a deferred prosecution agreement to state a claim for fraud. See Williams v. Sidley Austin Brown & Wood, No. 60080/05, 2006 N.Y. Misc. LEXIS 2581 (Sup. Ct. Sept. 22, 2006). Like Shalam, the plaintiffs in Williams alleged that KPMG, Sidley Austin, and HVB solicited their involvement in a tax shelter transaction that was subsequently disallowed. Id. at *2-3. The plaintiffs sued, alleging fraud and conspiracy to commit fraud. Id. The defendants moved to dismiss on the grounds that the complaint failed to plead fraud with particularity. Id. at *3.
After the motion papers were submitted and oral arguments on the motion were heard, the deferred prosecution agreement became available to the plaintiffs. This was the same deferred prosecution agreement that was at issue in Shalam. The court, unaware of the deferred prosecution agreement, initially granted the motion to dismiss. Nevertheless, when the plaintiffs moved to renew that motion, the court allowed them to amend the complaint by supplementing it with information contained in the deferred prosecution agreement. Id. at *3. The court determined that "all of the documents comprising the deferred prosecution agreement will be considered to the extent that they are relevant to the causes of action alleged by plaintiffs." Id. at *6. With the new information from the deferred prosecution agreement, the court found that the plaintiffs had satisfied the pleading requirement for fraud.
Conclusion
Because admissions contained in deferred prosecution agreements can be used by plaintiffs to plead a civil fraud claim, firms threatened with criminal prosecution must tread carefully.Their first priority, of course, will be to avoid a criminal indictment. Even when successful in that goal, however, if the government insists on a deferred prosecution agreement businesses will likely face an increased exposure to civil liability as a result of admissions made in that agreement.
Recently, the Department of Justice has moderated its guidelines for determining when it will pursue criminal prosecution of a business entity. See "U.S. Department of Justice Moderates Guidelines for Prosecution of Corporate Fraud," Chadbourne & Parke LLP Client Alert at 1-3 (Dec. 2006). Whether these changes lead to fewer investigations and prosecutions of corporations, only time will tell. In the meantime, businesses faced with the threat of criminal prosecution must be mindful that statements made in deferred prosecution agreements can increase a business’s exposure to civil liability.
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