Readers of this journal surely know of the myriad ways in which the federal government is moving to curb, regulate, seize, and supplant the little that was left of the free market when this recent crisis began. So, it will come as no surprise that the Left’s media allies are preparing for the show trials that will cement into America’s historical imagination a new “Herbert Hoover” myth: Under the laissez-faire administration of George W. Bush, capitalists and capitalism destroyed the American economy. Already The New York Times has begun to beat the drums for the guillotine. Last October 18, it ran a story that began: “The Federal Bureau of Investigation is struggling to find enough agents and resources to investigate criminal wrongdoing tied to the country’s economic crisis, according to current and former bureau officials.”
America’s political turn to the Left—perhaps even to a new “Red Decade” of the far, far Left—is a matter of philosophical ideology, about which we cannot do much in the short term. But the second scenario—the persecution of individual businessmen—is a matter of justice, and that is something we can fight for, here and now. So long as enough judges in the upper reaches of the American judicial system retain a sense of fairness, there is some hope that we can block the criminalization of the producer class. But that hope depends, crucially, on the willingness of American business to end its hundred-year record of capitulating to demagogues and to establish an organization that will fight unapologetically for its rights—a business civil liberties union. (See the sidebar commentary: "Business Needs a Civil Liberties Union Now!")
That a Business Civil Liberties Union could be effective was demonstrated by a recent decision from the second circuit court of appeals. This was a decision in the KPMG (Klynveld Peat Marwick Goerdeler) case that I wrote about for the April issue of The New Individualist. (KPMG is one of the “Big Four” accounting firms.) At that time I wrote, all hope in the case rested on a single courageous judge, Lewis Kaplan, who had slapped down the government’s persecution of KPMG’s former employees. A friend of mine, who has been a judge at a very high level, said that although Kaplan was an intelligent man his reasoning would not be likely to persuade the appellate court. But it did. And that is more than a cause for hope; it is cause for optimism.
The case had its roots approximately ten years ago, when KPMG began selling investment strategies that would allow people to reduce their taxes. In order to police such strategies, Congress had, in 1984, defined a tax shelter as an arrangement under which the participant expected to get $2 in tax savings for every $1 invested. (In 1997, it said simply that a tax shelter was investment in which “a significant purpose” was the avoidance of taxation.) New rules also said that those offering such dubious investments had to register them with the Internal Revenue Service (IRS) before making them available to the public, had to maintain a list of people who invested, and had to make the list of investors available to the IRS upon request.
Senators excoriated KPMG for being a business that helped people reduce their taxes.
To implement these rules, the Treasury authorized the IRS to publish a list of tax investment strategies that it considered to be potentially abusive and therefore subject to registration and other rules. When a strategy makes the IRS roster, it said to be “listed.” Part of the reason for “listing” strategies, as the IRS admitted, was to prevent people from offering the defense that they had “substantial authority” for thinking their investment strategy would be accepted. But the listing of a strategy does not by itself make the strategy illegal. If the taxpayer chooses to go ahead with the investment, the IRS can refuse to accept the investment’s loss, and ultimately a court decides whether or not the strategy was legitimate.
In 2000, the IRS heard about investment strategies being offered by KPMG that had not been registered but that someone at IRS thought they might be able to disallow. In August 2001, the IRS announced that the techniques employed by these strategies made “unintended use” of the Tax Code and that the techniques were therefore being listed. In October, Michael Halpert of the IRS began investigating KPMG’s promotion of these strategies and its failure to register them. In December, Halpert demanded that KPMG hand over the client list for these strategies within 10 days and provide other documents within 30 days. Citing its confidentiality rules, KPMG said it could not hand over the documents on the basis of the simple request but it would do so in response to an administrative summons. In late January, a summons was issued and in the next three months KPMG handed over more than half a million pages of documents. It also sent three individuals to provide the IRS with sworn testimony regarding the two investment strategies. But, again citing confidentiality concerns, KPMG refused to hand over various other documents sought by the IRS, and in July 2002, Halpert went to the D.C. federal district court to compel them to do so.
The Inquisition Begins
In 2003, the Senate’s Permanent Subcommittee on Investigations got into the act by holding hearings on the KPMG tax shelters that Halpert was investigating. Accommodatingly, the firm sent several people to present a defense, including its deputy chairman and chief operating officer, Jeffrey Stein; Richard Smith, vice chairman in charge of the tax division; and Jeffrey Eischeid, a partner in the Personal Financial Planning division, Predictably, the men were excoriated and insulted by anti-business Senators. In mid-November, the committee’s minority staff (that is, the Democrats’ staff) issued a report damning KPMG and its products. In summary, the report condemned the firm for (a) acting like a business and soliciting customers, and (b) helping people who wanted to reduce their taxes.
PBS's Frontline helped whip up the lynch mob against tax shelters and KPMG.
Of course, these points were made in the usual breathless language of leftist demagogues. So, the report said that KPMG had “moved from providing one-on-one tax advice in response to tax inquiries to also initiating, designing, and mass marketing tax shelter products.” But isn’t marketing what businesses do? It has been a long time since the guilds of Italy forbade their members to look out of their shop windows lest they gain an unfair advantage by attracting a customer. Then, too, the report said that KPMG’s products were “not to achieve a business or economic purpose, but to reduce or eliminate a client’s U.S. tax liability.” Well, that may not be an economic purpose from a Senator’s standpoint but it sounds like an economic purpose from the individual’s standpoint. In any case, this whole “economic substance” standard is a much disputed test. When the subcommittee’s ranking Democrat, Senator Carl Levin, was asked about what reforms he would like to see, one of the first he mentioned was putting the “economic substance” doctrine into the tax code rather than leaving it as an invention of the courts, some of which enforce it strictly and some of which enforce it hardly at all.
In February 2004, PBS’s Frontline helped to whip up the lynch-mob against tax shelters by airing an hour-long program called “Tax Me If You Can,” focusing on KPMG. The show instructed its audience in the distinction between legitimate deductions and illegitimate ones by observing that legitimate deductions “are deductions sanctioned by Congress, often for social purposes.” Presumably, then, any attempt to use the tax code in order to retain one’s own money for private purposes would be illegitimate. After all, as former IRS Commissioner Charles Rossotti said on the show: “Anything that’s not being paid that should be paid, that’s basically what the honest taxpayer is making up.” What Congress wishes to spend, evidently, is an absolute necessity that must be satisfied somehow.
Naturally enough, KPMG’s chairman and CEO, Eugene O’Kelly, watched this gathering storm with concern. And in January 2004, he employed the law firm of Skadden Arps, and particularly Robert S. Bennett, to save KPMG from destruction. As a first step, the three men whom the company had sent to Congress were thrown overboard. Stein “retired” with a three-year consulting contract; Eischeid was placed on administrative leave; Smith was transferred out of the tax division.
In February, the U.S. Attorney’s Office (USAO) for the Southern District of New York notified Skadden Arps that the IRS had sent to the Justice Department a criminal complaint against KPMG and its employees. The USAO also warned some thirty KPMG employees that a grand jury was looking into their actions.
Such an approach to tax shelters reflected the new persecutorial atmosphere. Ordinarily, as noted above, the IRS would “list” a technique as questionable, and then take to court a taxpayer who used it. There, a judge would rule on the technique’s acceptability. But in the KPMG case, as The Wall Street Journal later editorialized, the IRS attempted “to short-circuit the messy business of proving that a tax shelter is illegal by using the power of prosecution to target the tax advisers directly. . . . The underlying legality of those shelters has never been formally challenged. Yet the government has come down on those accountants and tax lawyers as if they belonged to the mob” (October 6, 2005).
At this point, it is necessary to go back and look at the instruments of coercion that the Justice Department would bring to bear in the KPMG case. In 1999, then-U.S. Deputy Eric Holder –currently President-Elect Barack Obama’s choice for U.S. Attorney General - issued a document called Federal Prosecution of Corporations, which became known as the Holder Memorandum. It offered guidance to prosecutors regarding the factors to be considered in deciding whether to prosecute a corporation. Among the factors was this one: “Whether the corporation appears to be protecting its culpable employees and agents.” But which employees were “culpable” and which were not? Isn’t the rule “innocent until proven guilty”? Not in the case of businessmen and their companies.
The Arthur Andersen case showed that even an innocent firm can be destroyed by prosecution.
In January 2003, the Holder Memorandum was replaced, though not much changed, by the Thompson Memorandum, issued by Deputy Attorney General Larry D. Thompson. But the power of the prosecutorial discretion these documents granted was not yet evident. It soon would be.
In March 2002, Arthur Andersen (then one of the Big Five accounting firms) was indicted for obstructing justice. A Wall Street Journal story noted: “In the 212-year history of the U.S. financial markets, no major financial-services firm has ever survived a criminal indictment. Now, Arthur Andersen LLP will either make history–or be history.” In fact, the firm did a bit of both. Most immediately, with its reputation destroyed by the indictment, Arthur Andersen collapsed and 85,000 people lost their jobs. But in a sense the firm also made history. For in 2005, the Supreme Court threw out the conviction of Arthur Andersen and declared, unanimously, that the jury in the case had been wrongly instructed.
Thus, the historic meaning of Arthur Andersen was this: Merely by indicting a financial-services company, the government could guarantee its collapse. Innocence and guilt were insignificant, because the company could not afford to go to trial. It therefore had no choice but to do what the prosecutors wished. Just that was the position of KPMG when the Justice Department began its case in 2004.
Nevertheless, as the government closed in, KPMG’s CEO, Gene O’Kelly, notified the firm’s partners that any “present or former members of the firm asked to appear will be represented by competent counsel at the firm’s expense.” All of that changed on February 25 when Robert Bennett held a meeting with government prosecutors. Bennett announced that KPMG was determined to save itself, above everything else. When he mentioned the subject of partners’ and employees’ legal fees, the government’s lead attorney said that “misconduct” should not be “rewarded.” Another government attorney warned that if the company did pay partners’ fees, “we’ll look at that under a microscope.”
Under attack by the Justice Dept., KPMG abandoned its employees.
As a result, KPMG abandoned its employees. It told lawyers whom it was paying to represent employees that payments would cease if the employees were charged with crimes. Blackjack firmly in hand, the prosecutors pressed their advantage. They notified KPMG whenever anyone had failed to comply with their demands, and KPMG duly notified the person’s lawyer that the person had ten days to comply—after which legal fees would be terminated. When some people still refused to comply with government demands, the company fired them.
Finally, having ensured that indicted KPMG employees would be all but helpless, prosecutors charged eight of the firm’s former employees, and KPMG cut off their legal expenses. In October 2005, a superseding indictment accused 17 former KPMG employees and 2 outsiders of conspiring to defraud the IRS. With millions of documents and hundreds of depositions at issue, it was reckoned that a defendant would need $20 million to go to trial.
Fortunately, the KPMG defendants did not succumb to the coercion of the government and accept short prison terms in exchange for guilty pleas. Instead, they moved to have the charges against them dismissed, saying that prosecutors had vitiated their rights to a fair trial by forcing KPMG to cut off the money it had promised for their legal bills. In March 2006, the government—unbelievably—declared that it had never objected to KPMG’s paying the defendants’ expenses.
Judge Lewis Kaplan, who was overseeing the case, heard the evidence and didn’t buy the government’s argument for a second. He wrote, in his June decision, that “it had been the longstanding voluntary practice of KPMG to advance and pay legal fees, without a present cap or condition of cooperation with the government, for counsel for partners, principals, and employees of the firm.” Admittedly, this was a private deal between KPMG and its employees. But the government obviously caused the firm to change its practice—and that was not a private matter. On the basis of the Thompson Memorandum, prosecutors forced KPMG to withhold money for legal defense that its employees had a right to expect. “KPMG refused to pay because the government held the proverbial gun to its head.” That, in turn, undermined “the proper function of the adversary process” and violated the defendants’ Sixth Amendment right to the assistance of counsel.
The goal of a prosecutor is justice, Kaplan said, not victory.
Inspiringly, Kaplan lashed out not only at the prosectors’ methods but also at their motives: their barely concealed desire to “nail” the businessmen they were targeting. He chastised the government’s young assistant attorneys, by quoting a 70-year-old Supreme Court decision: A prosecutor, he said, “is the representative not of an ordinary party to a controversy but of a sovereignty whose obligation is govern impartially . . . and whose interest, therefore, in a criminal prosecution is not that it shall win a case, but that justice shall be done.”
When it came to remedying the defendants’ plight, Kaplan’s attempt to have them sue KPMG for their fees was struck down by the second circuit court of appeals, which noted: “Dismissal of an indictment . . . is always an available remedy.” So that was the course Judge Kaplan took. Thirteen of the defendants, he concluded, had been deprived by the government of the ability they would have had to mount an adequate defense. And government attorneys had tried to deceive the Court into believing otherwise. That was intolerable. On July 16, 2007, therefore, Kaplan dismissed all charges against the thirteen.
In the months following Kaplan’s decision, the parties went through the usual maneuverings of an appeal, and in March 2008 the case was argued before a three-judge panel of the second circuit appeals court. Last August, the panel handed down its decision.
Two arguments made by the government are especially worthy of note. First, it said, a defendant’s Sixth Amendment right to counsel in “criminal prosecutions” begins only with “adversarial and judicial criminal proceedings,” typically, an arraignment or indictment. Thus, nothing that the government did prior to the indictment could have interfered with such a right. In response, the appellate court noted that Judge Kaplan had focused his Sixth Amendment reasoning only on KPMG’s actions post-indictment and only on government behavior that affected those actions. But, the court went on: “State action that . . . affected the advancement of legal fees for services rendered post-indictment does implicate defendants’ Sixth Amendment right, regardless of when the conduct took place.” The court then quoted Judge Kaplan and endorsed his analysis: “The fact that events were set in motion prior to indictment with the object of having, or with knowledge that they were likely to have, an unconstitutional effect upon indictment cannot save the government.”
A second line of argument put forward by the government would be laughable if it were not so infuriating. The government contended that the KPMG defendants had a right to hire counsel using their own money, or to have a government-paid lawyer if they could not afford to hire one—but they no right to hire a counsel using “other people’s money.” Whoever drew up the appellate brief for the government had evidently, somewhere in his career, lost sight of the fact that there exist arrangements called voluntary relationships, some of which are contractual. The court, fortunately, had not lost sight of that fact. “It is axiomatic,” it said, “that if defendants had already received fee advances from KPMG, the government could not deliberately interfere with the use of that money to fuel their defenses. And the government concedes that it could not prevent a lawyer from furnishing a defense gratis. . . . And if the Sixth Amendment prohibits the government from interfering with such arrangements, then surely it also prohibits the government from interfering with financial donations by others, such as family members and neighbors—and employers.”
In conclusion, the court wrote: “We hold that KPMG’s adoption and enforcement of a policy under which it conditioned, capped, and ultimately ceased advancing legal fees to defendants followed as a direct consequence of the government’s overwhelming influence, and that KPMG’s conduct therefore amounted to state action. We further hold that the government thus unjustifiably interfered with defendants’ relationship with counsel and their ability to mount a defense.” The persecution was stopped in its tracks.
On October 15, the remaining defendants in the KPMG went on trial in New York City, fortunately in the courtroom of Judge Lewis Kaplan. According to a story in Forbes, Assistant U.S. Attorney John Hillebrecht said the defendants “were motivated by greed, knowing they could make millions of dollars in fees by erasing tens of millions of dollars in taxes their wealthy clients owed between 1997 and 2000.”
Whether the defendants are guilty or not guilty under current law, I do not know. But I do know that greed is not a crime nor even a sin. And I know that the government attorney’s demagogic invocation of greed strongly suggests that this prosecution could easily degenerate into a persecution. One juror has already been dismissed for saying she would “vote guilty from day one” after reading an article about the case. So I shall be watching the KPMG trial as it unfolds.
And I shall be watching other business trials as well. Atlantic magazine blogger Megan McArdle recently said of the finance industry’s collapse: “One of the things that has really surprised me—so far, anyway—is just how little criminal activity we've uncovered during this crisis. . . . But no one wants to hear that.” Indeed. According to The New York Times, two Congressmen have sent a letter to FBI Director Robert Mueller, calling for a more aggressive response, and for tripling the FBI’s financing for financial crimes investigations. The letter, written by Reps. Mark S. Kirk (R-IL) and Chris P. Carney (D-PA) stated in part, “To fix our system and prevent a repeat of the events we now see, we have got to set an example by bringing the full might of federal law enforcement against the people who illegally profited or destroyed companies at the expense of our country.”
The KPMG tax case, as a lingering remnant of the last economic bubble, is a useful reminder of the business prosecutions that likely lie ahead for companies involved in the real-estate bubble. But it is, more importantly, a reminder that businessmen who fight for their rights can sometimes win. The cost of battle is always high, win or lose, and cutting a deal may seem advantageous to the man under fire. But when an individual fails to assert his rights, all Americans lose a part of their freedom. And that is why businessmen should not have to fight their battles alone.