US Department of Justice v KPMG: Document Shows “Too Few To Fail” Was Opening PremiseBy Francine • Apr 19th, 2014 • Category: Attorney-Client Privilege, PCAOB, Pure Content, Regulators, Laws, Standards, Regulations, Sarbanes-Oxley, SEC, The Case Against The Auditors
What makes the Big Four global audit firms so arrogant? What is it that makes the firms feel indestructible, impermeable, immune from serious scrutiny? You might think the implosion of Arthur Andersen in 2001 would have scared the daylights out of firms’ leadership and the regulators who are supposed to monitor them.
But it took the KPMG tax shelter scandal in 2005 to bring regulators to the uncomfortable realization there is no contingency plan. The audit firms will continue to push the envelope on legality, ethics and self-interest with impunity even with a new regulator, the PCAOB, in town. We can no longer depend on “professional” disdain for reputation risk to promote self-policing within the firms and within the accounting profession.
The Roman satirist Juvenal asked, “Sed, quis custodiet ipsos custodes?”
But who guards the guardians?
No one, it seems.
The viability of another firm may be threatened even if the US, UK and EU try their damnedest not to be the ones to cause it. No regulator is willing to sue or sanction a global audit firm if the enforcement means the firm will legally, or practically, become unable to continue to perform its legally mandated primary business, audit. The US Department of Justice guaranteed that moral hazard with its choice to not criminally prosecute KPMG.
A reader alerted me to a very interesting KPMG tax shelter era document, available publicly on a major media website, that had not yet been cited or quoted from in any media reports, that I am aware of. Back in 2007, several news outlets recounted some of the intrigue during the negotiations between KPMG and the Department of Justice that led to its guilty plea for tax fraud, $456 million fine, and deferred prosecution agreement. The new insight came from documents, mostly notes of KPMG’s Skadden Arps attorney Joseph Barloon, filed in the lawsuits against 13 KPMG executives accused of developing and leading the schemes.
(The documents that were quoted in the later stories in 2007 were not linked to, and seem to be from a slightly earlier stage in the negotiations than the one below. Here is the document I have in original PDF form, modified only for my bolding of important passages. The document that resides on the major media site includes additional documents that are not being discussed here today. A call on April 17 to Joseph Barloon at Skadden Arps for comment has not yet been returned.)
The necessity in 2005 to make a decision that could cause another audit firm’s demise came much too soon after the messy dissolution of Arthur Andersen in 2001. I’ve written previously that when Attorney General Alberto Gonzales decided not to criminally prosecute KPMG he effectively established the “too few to fail” doctrine for the major public accounting firms that is in effect today: (This is a quote from a Bloomberg report at that time linked to in my post.)
As for indicting KPMG, Comey told the firm’s representatives at the June 13 meeting that he had already consulted with Attorney General Alberto Gonzales about the case.
Comey said he was “struck by the scope of the wrongdoing,” according to the internal documents. He also expressed concern that audit firms after the Andersen case might believe they were immune from prosecution.
“Does the notion of corporate criminal liability mean anything for the Big 4?” Comey asked.
About two weeks after meeting with Comey, the KPMG legal team met in New York with Kelley and his aides and got the good news: Comey and Gonzales decided against an indictment of the firm, the papers show…details of the deal that would be announced at a Gonzales news conference on Aug. 29, 2005, at the Justice Department’s Washington headquarters.
The resolution, Gonzales said, “reflects the reality that the conviction of an organization can affect innocent workers and others associated with the organization, and can even have an impact on the national economy.”
Most accounts of KPMG’s negotiations with the Department of Justice focus on a key date, June 13, 2005, when new US chairman Tim Flynn, stepping up after the sudden death of Gene O’Kelly, changed KPMG’s tune. Then reports skip to “two weeks later” as the day when Comey told KPMG that the firm would not be indicted.
He took over as chairman just three days before a meeting with Justice Department officials set for Monday, June 13.
At 7 a.m. the Saturday before, executives huddled in the Washington offices of law firm Skadden, Arps, Slate, Meagher &Flom. Among those there to plot strategy were Mr. Flynn, new deputy chairman John Veihmeyer, and a former federal judge who’d recently joined KPMG, Sven Holmes. KPMG still hadn’t made a final decision on whether to admit wrongdoing, or, if so, what form an admission would take.
One adviser, Mr. Flynn recalls, warned that an admission, once made, couldn’t be rescinded. Others raised the risk of civil liability. But Mr. Holmes says he told Mr. Flynn bold action was called for, because “you only get one chance to make a first impression in a meeting like this.”
All were aware Arthur Andersen had faced a similar decision in 2002. Andersen later had its conviction overturned — in one sense, a vindication of its defiance. It was a Pyrrhic victory, as by then, partners and clients had fled and Andersen was out of business.
“I think we have to just admit wrongdoing and accept responsibility,” Mr. Flynn says he finally told the KPMG group. The firm agreed that, as an executive with no direct involvement in the shelter sales, Mr. Flynn was the right person to deliver the message. Though he was on the management committee when KPMG was selling shelters, Mr. Flynn was at human resources during much of the period and was never a tax partner.
On Monday morning, he attended the meeting with the Justice officials and — sharply changing KPMG‘s position — admitted it had sold shelters that helped people evade taxes. Justice officials basically just listened.
Later that week, after a Wall Street Journal report that the Justice Department was weighing an indictment, KPMG issued a statement taking “full responsibility” for “unlawful conduct by former KPMG partners” in offering tax services. Not long afterward, Justice Department lawyers let the KPMG side know they were willing to discuss a settlement.
The document below tells us, however, that two weeks later, June 27, the DOJ still would not agree to all of KPMG’s terms, including promising not to criminally charge the firm. The document does clearly show that the decision to prevent KPMG from “going under” had already been made. But key details were still being discussed. KPMG and its Skadden Arps attorneys led by Robert Bennett, were still trying to help the DOJ understand how not to screw it up again.
Notes to the document:
- Barloon is referring in the first paragraph to Deputy Attorney General James Comey and Attorney General Alberto Gonzales.
- The largest public accounting firms in the US do not publish audited financial statements. There is no publicly available financial information about the firms except what the firms themselves now publish at the global level. (UK Big Four firms do produce financial statements that are prepared under IFRS and audited.)
- The payment was to be a combination of disgorgement of fees, something to make up for what clients did not pay “but for” KPMG, and IRS penalties as a “promoter”.
- Which tax functions are essential to do an audit are debateable. That’s especially true since the few SOx prohibitions on tax services by auditors for audit clients were vague, subject to interpretation and not yet tested by courts.
- DOJ intended for the monitor, Richard Breeden, to have the power to terminate people but not I’m not sure he ever got it and pretty sure he would have never used it.
- What interest or jurisdiction the PCAOB, an audit regulator, and the SEC, focused on issuers, would have in this case is not clear. But KPMG wanted to make sure any firm-level disciplinary action by either was off the table.
- KPMG was ready to pay the price for staying in business but tried to negotiate the price and wanted credit for lost profits from shedding problematic tax businesses.
- KPMG had leverage as long as DOJ still agreed the firm must be saved. KPMG came to the negotiating table as nearly an equal who could dictate terms because the firm believed, and convinced the DOJ, KPMG was in best position to judge the impact of proposed terms. What’s surprising is the lack of awareness exhibited by DOJ personnel on the importance of KPMG avoiding the AA problem, a criminal indictment. An indictment alone is a death knell for a public accounting firm. “It would kill us” was repeated over and over. KPMG, from a position of advantage, tells DOJ’s Kelley that an obstruction of justice charge would be a deal breaker.
- However, KPMG admits it did obstruct justice. Judge Sven Erik Holmes, who KPMG hired to provide support in its negotiations, admits that KPMG “obstructed”. He’d been telling client Audit Committees that the firm’s failure to produce documents was “intentional”.
- Why would an obstruction charge be so serious over and above the significant legal obstacle of state by state public accounting firm de-licensing of an indicted firm? An obstruction charge reminds us of AA and Enron and shredding. It’s a criminal charge and says to clients the firm has an ethics problem. It’s a criminal enterprise. There’s no return, reputation-wise. A tax fraud charge, on the other hand, is limited to that practice and specific people.
- KPMG was desperate to have the issue perceived as a “tax only” problem. There is actually a specific reference to the danger of being viewed by the public and clients as a “criminal enterprise.”
- At one point KPMG’s attorney says it would be acceptable to admit obstruction in a statement of facts but only in reference to people who were already gone. Here he is referring to Global Tax Vice Chairman Jeff Stein. Stein was “retired” by the firm in January 2004 after initially leading the discussions, and refusing to fully cooperate, with law enforcement under prior Chairman Gene O’Kelly.
- KPMG gives a figure for lost profit from giving up the tax activities under discussion but it seems low. And when it says which services are required to service audit clients it includes valuation. Valuation services are prohibited by Sarbanes-Oxley Act of 2002 from being provided to audit clients by their auditor.
- KPMG, as auditor of the Department of Justice and the US Treasury/IRS, was concerned about debarment, a ban from working for the government. The ‘no debarment” deal was cut because, as Kelley said, DOJ had no choice. KPMG was not debarred and continued unabated with all Fed government contracts. Later, after the crisis, KPMG would continue as auditor of Citigroup even after US owned almost all of the bank and could have forced a change.
- Judge Holmes comments about his discussions with Audit Committees are telling. It was a form over substance strategy. According to Holmes, audit committees, rather than looking out for shareholders, were aligned with KPMG’s desire to keep the audit engagements as auditors in spite of a tax fraud charge. They were hoping there’d be no obstruction charge. A criminal indictment would force their hands and mean potential liability for directors if they didn’t immediately dump KPMG.
- In spite of DOJ David Kelley’s hard-guy tone, the final deferred prosecution agreement ran until December 2006, a little more than a year after the August 2005 agreement was signed. There was an extension clause but a judge dismissed the charges in January 2007. Monitor Richard Breeden served for three years.
- The government insisted it was first in line to get its money from KPMG before any private plaintiffs, especially if the charges and pleas were construed to make “victims” of KPMG’s shelter promotion out to be co-conspirators instead. That’s what eventually happened.
Attorney Work Product Privileged & Confidential Settlement Discussion
June 27, 2005
FROM: Joseph L. Barloon
Re: June 27. 2005 Meeting with U.S.Attomey
On June 27,2005, Robert S.Bennett, Armando Gomez, and Joseph L. Barloon of Skadden, Arps, Slate, Meagher & Flom LLP and Judge Sven Erik Holmes and Joseph I. Loonan of KPMG LLP (“KPMG” or”the Firm”) met with United States Attorney David Kelley, Celeste Koeleveld, and prosecutors Shirah Neiman, Stan Okula, and Justin Weddle of the Southern District. Treasury agent Rich Kando also attended the meeting, which began at approximately 9:30 a.m. and lasted until approximately 10:30 a.m. 
Agreement Terms Outlined by Kelley
Kelley opened the meeting by telling us that the Deputy Attorney General, in consultation with the Attorney General, had determined that he would like the Southern District to try to work out a deferred prosecution agreement with KPMG, but had not ruled out filing charges against KPMG. Kelley emphasized however, that the Deputy Attorney General had not ruled out filing charges against KPMG. He added that he was assuming that we wanted to take this step forward and that he wanted the negotiations to move forward quickly.
With regard to specific terms of any deferred prosecution agreement, Kelley related the following:
- Duration: Kelley told us that the term of any deferred prosecution agreement should be five years, with a statute of limitations waiver of six years.
- Admissions: Kelley told us that he envisioned that KPMG would agree to a statement “along the lines of what we have been pushing.” Kelley told us that his Office had drafted a statement of facts, but indicated that it required some “tinkering” before he could share that document with us. He indicated that there would be very little flexibility for revision once he provided the statement to us and that he did not want to get” bogged down” with wordsmithing the statement.
- Monetary Payments: In terms of fines and restitution, Kelley envisioned a lump sum payment with additional amounts paid over the duration of the agreement. He did not want to get into specifics regarding financial payments, and told us that he wanted to review the Firm’s financial statements at a separate meeting so that he could “figure out what is fair and appropriate” for KPMG to pay.
He told us that his determination as to an appropriate monetary amount would not be made with reference to settlement amounts in other matters. He identified four components of the payment: (i) the amount of fees received by KPMG for FLIP, OPIS; BIJPS, and SOS transactions, including the Greenberg transactions; (ii) gross unrecoverable tax that would have been recovered “but for KPMG’s obstruction”; (iii )interest on taxes due and owing to the government as a result of the shelter losses, less any interest collected by the IRS; and (iv) the promoter penalty applicable to KPMG.
- Tax Practice Restrictions: With regard to limitations on KPMG’s tax practice, Kelley told us that a resolution ” along the lines of my proposal” would be acceptable. He said that he knew we “wanted a broader tax practice,” and indicated that he would allow KPMG to retain “what’s essential to the audit function.
- Monitor: Kelley told us that he wanted a monitor for the five-year term of the agreement He said that it was not his role to determine who “needed to go” at the Finn, and he wanted to structure the monitor’s duties and authority to allow him to effect personnel actions in some fashion.
- Cooperation: KPMG would have to agree to continue to cooperate with the investigation as part of any resolution.
- SEC/PCAOB: Kelley affirmed that any settlement would be conditioned on an agreement from the Securities and Exchange Commission (“SEC”) and the Public Company Oversight Board (“PCAOB”) to take no disciplinary action against KPMG and he said that we could try to “get some type of language” from those regulators that would support KPMG.
Discussion of Proposed Terms
Bennett began his response by telling Kelley that we had read his position as indicating that he “didn’t want to put KPMG under,” which we appreciated. Nevertheless, Bennett told Kelley, the terms and conditions of any agreement with the government would be crucial to the Firm’s survival: KPMG “can die by indictment or we can die by deferred prosecution.”
Bennett added that KPMG understood that it would have to pay “a lot” and that there would be “a lot of pain.” He stated that KPMG was hopeful that it could reach an agreement but KPMG would not agree to any resolution that would “put it under.”
Bennett noted that he perceived the Deputy Attorney General as wanting to vindicate the interests of justice with regard to tax fraud and obstruction. He said, though, that such an outcome has to be done in away that would not destroy KPMG. At this point, Neiman asked for an example. Bennett said that, based on our discussion, we would not have a problem with “obstruction-type language” in the statement of facts, but that K.PMG would not want an obstruction component in the charge itself. Such a charge “would kill us. Bennett stated that we would like the U.S. Attorney’s Office to consider not filing a charge at all. Instead, the charge could be attached to the agreement and “held in abeyance”.
If we’re not successful at convincing you to do that,” he said, then we would need to discuss what the exact charge would be. Obstruction was a problem because “it’s the kind of charge that could kill us.” Bennett also stated that the amount of money to be paid by KPMG was another example where a term of the deferred prosecution agreement could destroy the Firm.
Bennett said that he did not want the statement that KPMG could not agree to certain terms in an agreement to be perceived as a threat. Rather, he simply wanted to make sure that Kelley could not assume that “any deferred prosecution agreement would be preferable to an indictment” The benefit of an indictment is that it ”at least gives you time to unwind.” Depending on the terms, however, a deferred prosecution agreement could cause the immediate destruction of the Firm.
Kelley asked Bennett to address the impact of filing a charge based on tax fraud versus filing a charge based on obstruction. Bennett responded that KPMG “could probably survive” a tax fraud charge but that an obstruction charge” would Kill us.” He noted that the charge filed in the AmSouth deferred prosecution agreement did not include an obstruction component although the statement of facts in that agreement set forth the necessary factual predicate for an obstruction charge.
Kelley asked whether the AmSouth agreement had included a statute of limitations waiver on obstruction charges. Bennett replied that it had not but suggested that such a provision could be included in an agreement.
At this point, Judge Holmes spoke about his recent discussions with audit committees and lawyers advising audit committees of KPMG clients. He noted that clients have been consulting whether continuing to retain KPMG would be in violation of committee members’ standard of care. He said that KPMG was “in extremis.” The Firm was forecasting that it would suffer a significant drop in revenue with the filing of charges relating to the “evasion of taxes.” He said that he told audit committees that there were elements of obstruction in the case. He told them that there was an “intentional failure to produce documents.”
The clients understood that fact but they made it clear that “if you have capital ‘0’ Obstruction” in the charge then they may not be able to continue to retain KPMG.
Neiman asked why they viewed an obstruction charge as so much worse than the tax fraud charges. Holmes responded that clients viewed an obstruction charge as involving something “at the heart of the system.”
Holmes indicated that it was important that this problem be viewed as a tax problem.
He said that KPMG’s proposal to restrict its tax practice would entail lost annual profits of $62million, but that shedding those businesses “makes it clear that this was a tax problem.”
He said that the inclusion of an obstruction charge in the agreement would cause audit committees to view the entire firm as a “criminal enterprise.
Neiman asked why the obstruction charge would have such an impact given that the underlying facts would in any event be described in the statement of facts. Bennett responded that “some obstruction-type language could be part of [an allocution] if it can be focused on people who are gone.”
Bennett stated that if there is language in the statement relating to obstruction but no obstruction charge, then KPMG would at least have a chance at convincing the audit committees to stay with KPMG. Holmes added that, if both sides had a mutual goal of permitting the survival of KPMG, then they would need to put themselves in the position of audit committees, who had an obligation to consider whether continuing to retain KPMG was in violation of the standard of care for a committee member. At this point Kelley cut off further discussion, stating, “I get the gist.
Discussion of Changes to the Tax Practice and the Remaining Audit Function
We then provided an overview of the ways in which KPMG proposed to restructure its tax practice. We noted that KPMG had given a lot of thought to the different ways to “shrink the tax practice.” Kelley said that he thought that he was probably thinking of more expansive changes than we had in mind. We responded that KPMG was “willing to give up lucrative, profitable business” in an effort to shed everything that was not necessary to maintain the audit practice. The businesses that we felt we had to keep did not necessarily make money but they were necessary in order for KPMG to continue to be able to perform the services for audit clients. For example, Loonan noted that partners in federal tax are involved deeply in the review of client financial statements. He added that the SEC and PCAOB have reminded audit firms that they need to work with client tax professionals throughout the year in order to ensure a quality audit
We added that we had engaged in a great deal of internal and external consultation in determining which parts of the tax practice were necessary to the audit practice. The Firm had asked audit clients, such as Pfizer, what capabilities KPMG needed to retain in the tax area to be able to conduct sophisticated audits.
We had been informed that certain practices, such as mergers and acquisitions, federal tax, valuations, and international taxation, were necessary to support the audit function.
Neiman said that she was still confused as to what tax service KPMG would continue to offer. Kelley cutoff further discussion on this issue and asked for a presentation within the next day or two regarding the tax segments that KPMG proposed to retain.
Holmes reiterated that KPMG’s proposed restrictions on its tax practice would have a significant financial impact on KPMG because the restrictions would cause KPMG to lose $62million annually in lost profit. Accordingly, the tax practice restrictions had to be viewed as a” penalty component.” He asked Kelley to keep that in mind when considering the other components of a resolution.
Holmes added that he had asked Ellen Zimiles, who was a former prosecutor and who headed up KPMG’s anti-money laundering practice, to work with him and KPMG’s financial personnel over the weekend in order to determine KPMG’s ability to pay. He said that he would like her to participate in any follow- up discussions relating to KPMG’s financial statements. He said that he wanted to make sure that we were completely open with the government and that the government believed that it could trust KPMG.
Discussion Relating to Suspension/Debarment
Bennett said that KPMG would like the Department of Justice (“DOJ”) as part of the resolution to issue a statement affirming that it would continue to use the Firm as its auditor. Kelley responded by saying that he did not think DOJ had much of a choice but to continue with its contract with KPMG. He added that, if DOI says nothing to the contrary, then KPMG’s continued role as DOJ auditor would be a signal to the marketplace. Loonan said that KPMG wanted to get an agreement from General Services Administration (“GSA’ that the fact the Firm had entered into a deferred prosecution agreement would not prevent it from being deemed “presently responsible” for purposes of federal contracting.
Kelley responded that there were so many agencies that he did not think KPMG could get all of the assurances it was seeking prior to entering into an agreement. Loonan said that the key was having GSA onboard. He suggested expediting GSA’s time frame for consideration of the issue. Kelley indicated that he would ”hear it out as it unfolds.” Holmes added, “We just want to front-run it a little bit. Kelley replied by saying that he would let us know if we could go ahead and have discussions with GSA.
Length of Agreement
Holmes raised concerns about the proposed length of the agreement. Holmes noted that all previous deferred prosecution agreements were three years in duration or less and stated that a five-year agreement would be unprecedented.
Holmes stated that audit committees wanted KPMG to get this investigation behind it, and that such a long agreement, during which time KPMG would be subject to a monitor, would make it more difficult to view the problem as a “past problem” and not a present problem.
Holmes reiterated that previous deferred prosecution agreements were much shorter than five years. Kelley responded, half-jokingly, that” you guys are really bad,” and asked what tern we had in mind. Holmes said that an appropriate term would be two years from the end of the fiscal year. Kelly responded, “Two years is not going to happen.” Holmes responded that, if KPMG couldn’t get things into shape by the end of two years, then, “We should be indicted.”
Neiman said that it “takes along time to change culture,” adding that, in the case of Consolidated Edison, it took nearly seven years to change the culture. Holmes said that he viewed his own charge as including changing KPMG’s culture. Neiman responded that the issue was not Holmes; rather, the issue was that there were 20,000 employees at KPMG and it was necessary to have a long-term agreement with a monitor to ensure that the culture among the 20,000 employees changed.
Kelley stated” Let’s say I cut it [the duration] back. What about having a clause [in the deferred prosecution agreement] that would make it extendable?” We indicated that such an arrangement might be acceptable .
Loonan told Kelley that he wanted to ensure that the resolution would be” global” in that it would resolve the IRS audit as well as the government investigation. Nieman disagreed and stated that we would have to work out any promoter penalty with the lRS. We said that we had always understood that this was to be a global resolution. We added that the IRS told us that it had given the SDNY the information needed to determine the promoter penalty and that we had not yet received that information. Kelly seemed impatient with this discussion and said that he would get back to us on the issues of the “obstruction language “and the “term of the agreement” He asked us to provide him with more detail on the tax practice proposal and scheduled a meeting for the following day to discuss KPMG’s financial statements. He made it clear that he planned to participate in the discussion of KPMG’s financial condition.
After scheduling a follow-up meeting we briefly discussed a proposed settlement of civil litigation. Bennett noted that the total amount of payments KPMG would be making to resolve the tax shelter issues had to include civil litigation payments. Bennett added that KPMG’s insurance companies have informed the Firm that payments for civil shelter claims would not be covered under the terms of its policies.
Holmes also addressed the Firm’s attempt to settle the civil suits as part of a class action. He noted that KPMG and Milberg Weiss were working with two retired judges to 1ryto reach a settlement. He said he understood that Kelley’s office had expressed concern about a proposed resolution of the civil litigation. He said he did not think that there was anything wrong with attempting to negotiate such a settlement, and that any objections to the settlement could be adequately addressed during a fairness hearing.
He added that the government could participate in the fairness hearing in order to ensure that the plaintiffs will have met all of their obligations to the government. Neiman asserted that “the IRS needs to be made whole before the people [plaintiffs] need to be made whole.” Holmes indicated that KPMG could not simply ignore the civil litigation: “This is like rent. We have to pay it.” Weddle added that KPMG’s obligation to pay the government should take precedence over any payment to civil claimants who were “co-conspirators.”
Neiman said,” The bottom line is that the government needs to be paid back. If you have to move out of your posh headquarters, then so be it.” Holmes ended discussion of this topic by noting that any payment to civil plaintiffs would not occur until 2006.
 This memorandum serves to reflect my thoughts, recollections, impressions, conclusions and opinions concerning this meeting, in connection with a grand jury investigation of KPMG LLP. It is not a verbatim recitation of the meeting. This memorandum also serves to communicate certain facts and mental impressions to KPMG in connection with the provision of legal advice. Accordingly, this memorandum and its contents are protected from discovery by virtue of the attorney-client and work product privileges. In addition, as this meeting was a settlement discussion, this memorandum and all statements included herein are inadmissible pursuant to Federal Rule of Criminal Procedure ll(f) and Federal Rule of Evidence 410.