By Order dated July 16, 2007, Judge Kaplan confirmed his previous holding, in connection with KPMG tax shelter litigation, that the government’s interference with KPMG’s payment of the legal fees of its employees and former employees (under the now-superseded Thompson Memo) violated the employee’s constitutional rights.  Based on this finding, Judge Kaplan dismissed the indictment of thirteen of the sixteen KPMG Defendants.  Judge Kaplan wrote that “[t]he Court has reached this conclusion only after pursuing every alternative short of dismissal and only with the greatest reluctance.”


By order dated June 27, 2006, Judge Kaplan found that the government violated the Fifth and Sixth Amendment rights of the KPMG Defendants by causing KPMG to depart from its prior practice of paying the legal expenses of KPMG personnel in cases in which they were sued in consequence of their activities on behalf of the firm.  Implicit in this holding was that KPMG would have paid those expenses, whether legally obligated to do so or not, but for the government’s interference.

The court’s factual findings were based on the following:

(1)   “As a direct result of the threat to the firm inherent in the Thompson Memorandum (guidelines for corporate prosecution), KPMG sought an indication from the U.S. Attorney’s Office that the payment of fees in accordance with its settled practice would not be held against it”;

(2)   “The U.S. Attorney’s Office did not give KPMG the comfort it sought.  To the contrary, it deliberately . . . reinforced the threat inherent in the Thompson Memorandum”; and

(3)   “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 U.S. Attorney’s Office.”

Due Process Considerations

In the July 16, 2007 Order, Judge Kaplan reconsidered whether the government’s actions violated the due process afforded to the KPMG Defendants.  Judge Kaplan noted that, “[t]he question whether deliberately indifferent government conduct is outrageous or shocking depends on the circumstances.”

Judge Kaplan found that the fact that the government had ample time for deliberation, and in fact deliberated, before acting weighed in favor of a showing of “deliberate indifference.”  For example, the Assistant U.S. Attorneys met privately before meeting with KPMG and decided to inquire as to whether KPMG intended to pay legal fees of its personnel.  Judge Kaplan held, “it is entirely likely, and the Court finds, that they [the Assistant U.S. Attorneys] then decided the substance of their intended reaction to KPMG’s possible responses . . . [and] made clear [to KPMG] that any discretionary payment of legal fees by KPMG would be looked at ‘under the microscope’ . . . threats if ever there were any.”

Judge Kaplan concluded that “in all circumstances, this behavior shocks the conscience in the constitutional sense whether prosecutors were merely deliberately indifferent to the KPMG Defendants rights or acted more culpably.”

Appropriate Remedy

Three of the sixteen KPMG Defendants did not establish that KPMG would have paid their defense costs even if the government had left KPMG to its own devices.  Therefore, Judge Kaplan held that these defendants’ constitutional rights were not harmed and dismissal was not warranted. However, with regard to the other thirteen defendants, as to whom KPMG would have paid defense costs but for the governments’ interference, the indictment was dismissed.

Judge Kaplan recognized that prosecutors can and should be aggressive in the pursuit of the public interest, but cautioned that preventing defendants from presenting the defenses they wish to present and depriving defendants of counsel of their choice is “intolerable in a society that holds itself out to the world as a paragon of justice.”

D& O Ramifications

This decision is a positive development for directors and officers, who might otherwise have begun finding it more difficult to obtain indemnification from their companies for legal fees incurred in connection with government investigations (though some of this risk may have already been alleviated by the shifts seen between the Thompson and the McNulty Memoranda).  The issues surrounding D&O indemnification for criminal and regulatory investigations, however, are hardly finally resolved by Judge Kaplan’s ruling.

First, as previously discussed here, the government has not given up on its previously-effective investigatory strategy of forcing company’s to deny indemnification for legal costs of directors and officers under criminal investigation.  Although the government largely conceded the appropriateness of the indictment dismissals given the Court’s prior finding of constitutional violations, prosecutors have already stated that the government will appeal Judge Kaplan’s underlying due process decision (see discussion here).  Among the government’s potential arguments that have been raised in the media has been that the 6th Amendment right to counsel does not require permitting individuals access to the sort of $700/hour lawyers that were at issue in the KPMG partners’ cases.

Second, the Securities and Exchange Commission and New York Attorney General continue to apply similar strategies in their non-criminal investigations.  Judge Kaplan’s decision does nothing to limit the SEC or NYAG’s strategies in non-criminal cases, nor does it impact the use of such strategies in pre-indictment criminal cases, which is when this government tactic has often been used in the past.

Because legal fees and expenses in connection with government investigations often run into the millions of dollars, a company’s ability and willingness to indemnify its directors and officers will likely remain of significant importance in attracting and retaining highly qualified candidates.  As concerns director and officer liability insurance, the decision reinforces the importance of clearly delineating in the policy whether directors and officers will be covered for the costs of governmental investigation, whether directly or upon indemnification by the insured company.