TCS Daily


The Primacy of Contract

By Larry E. Ribstein - July 6, 2006 12:00 AM

On June 26 Judge Lewis Kaplan delivered a stunning blow against government excesses in prosecuting white collar crime. Judge Kaplan's 83-page opinion in U.S. v. Stein is not only a powerful rebuke, but it establishes an important principle for future cases -- that the criminal law must respect the importance of the complex sets of contracts and incentive devices that make firms work.

First some background. The government indicted 16 people who worked for the accounting giant KPMG and a couple of others for allegedly conspiring to make and sell bogus tax shelters. Prodded by prosecutors, KPMG cut off advancement of these defendants' legal fees. Judge Kaplan held a hearing on the KPMG defendants' claim that the government pressure on KPMG was improper.

At the heart of this dispute lies the infamous "Thompson Memorandum." On January 20, 2003, Deputy Attorney General Larry Thompson ordered federal prosecutors to consider, when deciding whether to indict a business entity, the extent of the entity's cooperation in the investigation -- including whether the defendant advanced legal fees to employees, unless advancement was required by governing law.

The government had insisted that KPMG made its own decision on advancement of expenses. This was an astounding claim in light of the Thompson Memorandum; KPMG's knowledge of what had happened to Arthur Andersen; and the pressure the government had exerted on KPMG to limit its payment of defendants' fees. Judge Kaplan found (p. 33):

"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 Memorandum and the USAO [US Attorney's Office]. Absent the Thompson Memorandum and the actions of the USAO, KPMG would have paid the legal fees and expenses of all of its partners and employees both prior to and after indictment, without regard to cost."

In other words, said the court, (p. 2) "KPMG refused to pay because the government held the proverbial gun to its head." Judge Kaplan resoundingly rebuked the government for letting "its zeal get in the way of its judgment. It has violated the Constitution it is sworn to defend" (p. 3).

Judge Kaplan held that this conduct violated the defendants' Fifth Amendment right to a fair trial and Sixth Amendment right to counsel. The court noted that the defendants had an expectation of advancement based on KPMG's past practices, which "arguably" gave rise to an "implied contract" (n. 119) (though the court didn't definitively conclude that all defendants had contractual or other legal rights to indemnification or advancement). As the court said (p. 57):

"The law protects such interests against unjustified and improper interference. Thus, both the expectation and any benefits that would have flowed from that expectation -- the legal fees at issue now -- were, in every material sense, their property, not that of a third party."

The court also concluded that the government's conduct was not justified by its law enforcement interests or by the fact that advancement might indicate obstruction or lack of full cooperation.

In reaching its decision, the court noted the extraordinary burden that the defendants would be subjected to if denied advancement of expenses (p. 48):

"This is by no means a garden-variety criminal case. It has been described as the largest tax fraud case in United States history. The government thus far has produced in discovery, in electronic or paper form, at least 5 million to 6 million pages of documents plus transcripts of 335 depositions and 195 income tax returns. The briefs on pretrial motions passed the 1,000-page mark some time ago. The government expects its case in chief to last three months, while defendants expect theirs to be lengthy as well. To prepare for and try a case of such length requires substantial resources."

The court believed it had only one viable remedy -- use its ancillary jurisdiction to order KPMG to advance defendants' fees. The court invited the defendants to sue KPMG to bring it before the court for this purpose.

One might argue that the court could have dispensed with the whole constitutional part of the opinion and just let the defendants sue KPMG for breach of contract. But the government had already made clear that the defendants' mere contract right to fees would not prevent it from threatening indictment pursuant to the Thompson memo. It is far from clear what either KPMG or the court adjudicating the defendants' rights against KPMG would do in the face of this treat. The defendants needed a constitutional right because their contract rights alone could not stand up to the government's intimidation.

The defendants' contract-like rights are clearly at the heart of Judge Kaplan's decision. The first page of his opinion characterizes advancement and reimbursement of legal expenses as one of "three principles of American law" that are at issue in the case. Judge Kaplan later discusses the history of indemnification and advancement rights in corporate law, noting one court's statement that advancement is "an especially important corollary to indemnification as an inducement for attracting capable individuals into corporate service" (37).

Judge Kaplan noted (p.2) that KPMG's refusal to pay defendants' expenses "would be a private matter between KPMG and its former personnel" if not for the fact that "the government pressured KPMG to cut them off." It is this pressure, said Judge Kaplan, which supports defendants' claim that the government "violated their rights and threatens their right to a fair trial." In other words, the contract matters, even if it gets in the way of prosecution.

It has been suggested that the case may have little effect because firms, prodded by their insurers, might want to clarify that indicted employees are not entitled to fees. But this doesn't lessen the opinion's importance. It is reasonable for firms to balance defense costs and incentives. If the government decides that it has the evidence to support an indictment, this might be the right place for the firm to draw the line on paying for its employees' defense. Courts should no more ignore this contract than they should a defendant's expectations that his fees will be paid. The question, as Judge Kaplan said, is whether the government is trouncing on the contract in order to get a conviction.

This case isn't going to solve all of the problems of corporate criminal liability. The government retains considerable leverage in prosecuting corporations and their employees. This problem is inherent in cases involving common business practices such as the structuring and sale of tax shelters, where the very criminality of the conduct is an extremely complex issue. The problem is compounded in this case by the haziness of the line between merely wrong and criminal interpretations of the tax code. The court must determine whether the tax shelters in this case were illegal rather than simply aggressive and ultimately unsuccessful tax planning that was not sharply distinguishable from what tax advisers do everyday.

The case's complexity is enhanced by the problems of determining how to allocate responsibility within a large organization. As the New York Times reports, the defendants are raising questions about which of them should be responsible for designing the tax shelters, the advice to clients, and the statements to the IRS.

Real relief from undue burdens of criminal prosecution will come only when courts face up to these underlying problems of corporate criminal liability. Judge Kaplan's opinion is important for its recognition that fundamental fairness in a criminal trial may turn on the parties' contract and property rights, as well as on business realities. It is to be hoped other courts will follow the principle Judge Kaplan has established to restore balance in white collar crime cases.

Larry E. Ribstein is Corman Professor of Law at the University of Illinois College of Law.

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2 Comments

Let me see if I get this straight...
Is the gist of the article the assertion that the government should not put "pressure" on one party of an "implied contract" to facilitate prosecution of alleged criminal conduct by the other party to the implied contract?

It never ceases to amaze me the technicalities that judges will raise in order to affect their own personal biases and opinions. My guess is that this judge has a "special" affintity towards these defendants, most of whom seem to share a certain common trait that only those in the know will see....

Just more judicial tyranny ...and special protection for the inner circle.

it's more like
the govt shouldn't try to prevent the defendants from hiring their own attorneys.

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