United States: United States v. Stein: DOJ Policy Threatening Companies with Indictment Based Upon Advancement of Employee Legal Fees Ruled Unconstitutional

On June 27, 2006, Judge Lewis Kaplan of the U.S. District Court for the Southern District of New York ruled that certain guidelines set forth in the Justice Department’s so-called Thompson Memorandum violated the constitutional rights of 16 former partners and employees of the accounting firm KPMG who, along with the firm, were accused of selling fraudulent tax shelters in what has been described as the largest tax fraud case in U.S. history.¹ At issue were guidelines issued in 2003 by former U.S. Deputy Attorney General Larry D. Thompson stating that, in reaching a determination of corporate wrongdoing, prosecutors can interpret a company’s willingness to advance legal fees to its employees during a criminal investigation as a sign of lack of cooperation. The Court held that such guidelines violated the KPMG partners’ and employees’ Fifth Amendment right to a fair trial and Sixth Amendment right to legal representation.

On January 20, 2003, then-Deputy Attorney General Larry D. Thompson distributed to all United States Attorneys a memorandum entitled "Principles of Federal Prosecution of Business Organizations" (the "Thompson Memo"). The Thompson Memo, which is binding on all federal prosecutors, set out nine factors that should be considered in deciding whether to charge a corporation with wrongdoing. One such factor is: "the corporation’s timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation of its agents, including, if necessary, the waiver of corporate attorney-client and work product protection …"² Section VI of the Thompson Memo elaborated on what was meant by "cooperation". The general principle was that "[in] gauging the extent of the corporation’s cooperation, the prosecutor may consider the corporation’s willingness to identify the culprits within the corporation, including senior executives; to make witnesses available; to disclose the complete results of its internal investigation; and to waive attorney- client and work-product privileges."³ The Thompson Memo then set out several paragraphs of commentary, the most germane of which states:

According to the Thompson Memo, a corporation's compliance with governing law which requires it to pay the legal fees of officers under investigation should not be considered a failure to cooperate.⁵

Until it came under investigation in early 2004, KPMG, like most corporations and other businesses, had a long-standing policy of advancing and paying the legal defense costs and expenses of partners and employees for litigation arising out of work done for the business. However, as a result of the government’s position that advancing or paying legal fees and expenses is akin to protecting culpable personnel, KPMG, in order to avoid criminal indictment, limited the payment of legal fees and expenses to a maximum of $400,000, and conditioned the payment of such fees on an employee’s or partner’s cooperation with the government’s investigation. In January 2006, the KPMG employees challenged their indictments on the grounds that the government had interfered improperly with the advancement of attorneys’ fees by KPMG in violation of their constitutional and other rights.

The Court began its opinion in the KPMG Case by stating three principles of American law: (1) everyone accused of a crime in the U.S. is entitled to a fundamentally fair trial (a central meaning of the Due Process clause of the Constitution); (2) everyone charged with a crime is entitled to the assistance of a lawyer (at the heart of the Sixth Amendment); and (3) an employer often must reimburse an employee for legal expenses or advance such expenses when the employee is charged with a crime or sued as a result of doing his or her job.⁶ While the third principle - the defense cost principle - "does not remotely approach Miranda warnings in popular culture," it is "very much a part of American life" and is "as much a part of the bargain between employer and employee as salary or wages."⁷ The Court agreed with the KPMG employees who alleged that KPMG had refused to pay their legal costs because the government pressured the company: "KPMG refused to pay because the government held the proverbial gun to its head. Had that pressure not been brought to bear, KPMG would have paid these defendants’ legal expenses."⁸ "Those who commit crimes – regardless of whether they wear white or blue collars – must be brought to justice. The government, however, has let its zeal get in the way of its judgment. It has violated the Constitution it is sworn to defend."⁹

The Court made four findings of fact. First, the Thompson Memo caused KPMG to consider departing from its long-standing policy of paying legal fees and expenses of its personnel in all cases and investigations even before it first met with the U.S. Attorney’s Office ("USAO"). Second, the USAO did not give KPMG the comfort it sought and, instead, consistent with Department of Justice ("DOJ") policy, reinforced the threat inherent in the Thompson Memo. Third, the government conducted itself in a manner that evidenced a desire to minimize the involvement of defense attorneys. Fourth, KPMG’s decision to cut off all payments of legal fees and expenses to anyone who was indicted and to limit and to condition such payments prior to indictment upon cooperation with the government was the direct consequence of the pressure applied by the Thompson Memo and the USAO.¹⁰

The Court traced the history of the payment of legal expenses by employers back to the nineteenth century. The Court noted that, under the applicable Delaware statute, KPMG had the authority to indemnify its employees and in other jurisdictions it might be required to do so.¹¹ While the Court declined to decide whether the defendants in fact had contractual and other legal rights to indemnification and advancement of defense costs, the opinion suggests that KPMG’s uniform past practice of reimbursing and advancing legal fees could give rise to an implied in fact contract obligating the company to do so.¹²

The Court rejected the DOJ’s assertion that the Thompson Memo merely contains guidelines prosecutors should consider in evaluating whether a corporation is cooperating with an investigation. "Few if any competent defense lawyers would advise a corporate client at risk of indictment that it should feel free to advance legal fees to individuals in the face of the language of the Thompson Memorandum itself[,]" the Court wrote.¹³

The Court concluded that, under the Due Process Clause of the Fifth Amendment, the KPMG employees had a fundamental right to fairness in the criminal process.¹⁴ Strict scrutiny was, therefore, employed to determine whether the government’s infringement of the defendants’ right was narrowly tailored to serve a compelling state interest. The Court found that the government’s coercion infringed upon the defendants’ constitutional right because it limited the means lawfully available to them to present an adequate defense in a complex case involving finance and accounting, such as the case at hand.¹⁵ The Court elaborated on what the state’s interests in the portion of the Thompson Memo at issue purportedly were: (1) to facilitate just charging decisions concerning business entities by focusing on a consideration pertinent to gauging degrees of cooperation; (2) to strengthen the government’s ability to investigate and prosecute corporate crime by encouraging companies to pressure their employees to aid the government; and (3) to punish those whom prosecutors deem culpable.¹⁶ After rejecting the third rationale as an abuse of power rather than a legitimate governmental interest, the Court concluded that the government’s actions were not narrowly tailored because the Thompson Memo did not take the payment of legal expenses into account in making charging decisions only where such payments were part of a broader scheme to obstruct the government investigation. ¹⁷ Rather, the Thompson Memo’s policies reached situations even where a corporation was fully cooperating.

The Court noted that, under the Sixth Amendment, the right to counsel typically attaches at the initiation of adversarial proceedings.¹⁸ However, in the KPMG Case, even though the Thompson Memo and the USAO’s actions were part of an effort to limit defendants’ access to funds for their defense pre-indictment, the Court determined that the Thompson Memo was adopted and the USAO acted in circumstances in which that result was known to be exceptionally likely.¹⁹ Therefore, this conduct, unless justified, violated the KPMG employees’ Sixth Amendment rights.²⁰ The Court concluded that the government’s interference with the employees’ Sixth Amendment rights was unjustified because the benefits of the policy did not outweigh the heavy costs of undermining the adversarial system.²¹ Finally, the Court concluded that the defendants in this case did not have to make a particularized showing of prejudice because the considerations supporting a presumption of prejudice were present – governmental interference with the resources that a defendant has or legally may obtain fundamentally altered the structure of the adversary process, and this infringement of a defendant’s rights was susceptible of cure before trial.²²

The Thompson Memo has been generally viewed as a means to pressure companies into avoiding indictment by cooperating with the government during a criminal investigation. An indictment of a company could deal a fatal blow to its business, as it did to accounting firm Arthur Andersen in 2002. A public company is at far greater risk of serious harm from the negative publicity resulting from a criminal indictment. Loss of investor confidence and reputational damage in such case can be irrecoverable.

The ruling in the KPMG Case is the first major criticism from the bench of tactics that federal prosecutors have adopted since the wave of corporate scandals that erupted after the collapse of Enron. It is unclear what the long-term implications of the decision will be, and it remains to be seen whether the DOJ will appeal the ruling.

The ruling may cause federal prosecutors to reassess the tactics of applying pressure on a company under criminal investigation with respect to curtailing payment of legal fees and expenses, although the USAO for the Southern District of New York has expressed its disappointment in the ruling and affirmed its belief that the actions of the government in the KPMG Case were entirely consistent with appropriate DOJ policy.²³

Although the Stein decision is only a District Court opinion, the decision should carry weight outside the Southern District of New York and affect prosecutorial policy nationwide. A significant number of white-collar criminal cases are tried in the Southern District of New York, and its opinions tend to be influential.

In light of the decision, companies should review their corporate bylaws, policies and practices regarding the advancement and indemnification of legal expenses to ensure that they have their intended consequences – either providing for mandatory indemnification and advancement or providing that such indemnification and advancement is discretionary in certain circumstances. As the Thompson Memo and the decision in the KPMG Case make clear, a company’s policy may still be a factor in how the government evaluates a company’s cooperation with an investigation. In any event, the decision should provide support for companies involved in a governmental investigation to assert the legitimacy of their indemnification and advancement provisions without fear that the payment of such fees and expenses will necessarily be deemed to be indicative of an unwillingness to cooperate.

It is possible that the strong criticism of the fees guidelines in the KPMG Case will heighten the skepticism with which courts view other aspects of the Thompson Memo. Perhaps even more controversial than the fees guidelines is the provision in the Thompson Memo that encourages companies to waive attorney-client privilege so that they can share information with federal prosecutors. That provision has been modified somewhat by the October 21, 2005 Memorandum to all United States Attorneys from DOJ Acting Deputy Attorney General Robert D. McCallum, Jr. (the "McCallum Memo"). The McCallum Memo directs every U.S. Attorney Office to develop a written waiver review process "[t]o ensure that federal prosecutors exercise appropriate prosecutorial discretion under the principles of the Thompson Memorandum."²⁴

The KPMG ruling could bolster the challenge to what the Association of Corporate Counsel and other business groups have called a "culture of waiver" that has evolved as a result of the Thompson Memo.²⁵ Under this culture, the government has often come to expect that a company under criminal investigation will waive its attorney-client privilege in order to demonstrate its cooperation with federal prosecutors. This aspect of the Thompson Memo has come under Congressional scrutiny. In March 2006, during a House Judiciary subcommittee hearing, a number of members reportedly voiced concern to Mr. McCallum about the Thompson Memo's erosion of the attorney-client privilege and work-product protection.²⁶ In addition, more recently, the president of the American Bar Association and the chief executive officer of the U.S. Chamber of Commerce reportedly met with Senate Judiciary Committee Chairman Arlen Specter, R-Pa., to request a hearing on the policy and its impact.²⁷ Mr. Specter reportedly expressed concern about the issue and an interest in holding a hearing.²⁸

Pillsbury Winthrop Shaw Pittman’s Corporate & Securities and Corporate Investigations & White Collar Defense practice teams monitor developments in corporate investigations. If you wish to obtain more details on the KPMG Case and its implications, or to develop strategies to address potential corporate investigations, please contact the Pillsbury lawyer with whom you work or one of the attorneys listed.

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