The KPMG Tax Shelter Case and the Right Against Self-Incrimination

In Stein, the Second Circuit held that the government, acting in coordination with and through KPMG, violated the defendants' rights to counsel under the Sixth Amendment. At issue were the government's charging guidelines set forth in a 2003 policy statement, known as the “Thompson Memorandum” because it was issued by then-Deputy Attorney General Larry D. Thompson. It instructed prosecutors deciding whether to indict a corporation to consider the company's cooperation as measured by (among other factors) willingness to advance legal fees to employees suspected by the government of wrongdoing. The Thompson Memorandum has since undergone two revisions, each by subsequent Deputy Attorneys General. Each revision softened some of the policies scrutinized in the KPMG case. For example, under the current charging policies, prosecutors are no longer directed to consider the advancement of legal fees as a metric of corporate cooperation. (See the article by Arkin, Pope and Prinz on the new DOJ guidelines, this issue.)

The mitigating revisions to the Thompson Memorandum have made it unlikely that another case like KPMG will emerge in similar form. Commentators have described the case as a “perfect storm” in which zealous post-Enron corporate charging policies collided with an accounting partnership which ' unlike many corporations ' was not legally bound to advance legal fees. For this reason, Stein's Sixth Amendment holding may have little impact on future cases. But that may not be true for an issue the appellate court did not reach ' whether an employee's right against self-incrimination is violated when a corporation threatens to terminate an employee unless he cooperates with an internal investigation that is conducted in coordination with the government.

The Right Against Self-Incrimination

The Self-Incrimination Clause of the Fifth Amendment states that no person “shall be compelled in any criminal case to be a witness against himself.” A statement taken in a criminal investigation violates the clause only if it is both compelled and brought to bear by a state actor. In Garrity v. New Jersey, 385 U.S. 493 (1967), both conditions were met. The Supreme Court held that the right against self-incrimination, as applied to New Jersey through the Fourteenth Amendment, precluded the state's Attorney General from compelling police officers to testify about an alleged traffic ticket-fixing scheme, where the officers were told that if they did not testify, they would be subject to removal from their positions. The forced choice between “self-incrimination and job forfeiture,” the Court explained, was the “antithesis of free choice to speak out or to remain silent.”

But Garrity was a public employee. In contrast, employees of private companies like KPMG have had little success in asserting that their Fifth Amendment rights were violated when their private-sector employers order them to cooperate with the government or lose their jobs. The decision in Stein, however, may have strengthened their hand. Judge Kaplan found that statements by a KPMG employee were unconstitutionally coerced because he was threatened with loss of both his job and the advancement of legal fees if he did not cooperate with the government. A second employee was coerced by KPMG, according to Judge Kaplan, not because the firm threatened to fire him, but because it conditioned advancement of his legal fees on his cooperation with investigators. Judge Kaplan equated KPMG's acts with those of coercive government action because KPMG was acting under the threat of indictment, and because the government had actively encouraged KPMG's actions. In both cases, the employees succumbed to coercion ' which the district court considered “beyond the bounds of appropriate government action” ' to waive their Fifth Amendment rights.

One of the issues the Second Circuit considered in Stein was whether KPMG's refusal to advance legal fees could be considered government action and thus a potential violation of the Sixth Amendment. At the time KPMG was making advancement decisions and threatening employees with termination if they failed to cooperate, the firm was operating under a deferred prosecution agreement, which required it to assist the government in its investigation. Judge Jacobs, writing for the panel on the Sixth Amendment, explained that state action was established in Stein as a matter of law “because the government forced KPMG to adopt its constricted Fees Policy.” So powerful was the threat of indictment hanging over KPMG that it “was easily sufficient to convert [the government's] adversary into [the government's] agent.” The panel, however, also found that government action could be ascribed to KPMG's actions on two other grounds. It agreed with Judge Kaplan that the government offered KPMG “significant encouragement” to change its fee policies ' a carrot to complement the stick of possible indictment ' and also that KPMG was a “willful participant in joint activity” with the government. Under prevailing case law, any of the three findings ' that KMPG was coerced by the government, that KPMG was significantly encouraged by the government, or that KMPG was a willful participant in coordination with the government ' is sufficient to find state action. While prosecutors are less likely to wield the stick now that DOJ policy has been restated in the Filip Memorandum, the Stein decision leaves the door open for employees to argue that government carrots are sufficient to find state action.

Although the government in Stein fought the idea that KPMG was its agent, sometimes it has itself relied on the agency principle that underlies the Second Circuit analysis in Stein. In the Computer Associates case, the government alleged that members of the private bar who were conducting an internal investigation were surrogate government investigators so that employees could be charged with violations of 18 U.S.C. ' 1001, which prohibits false statements in matters within the jurisdiction of the federal government. The Computer Associates employees were charged with lying to the government without ever having spoken to them, as one commentator said. Employees at Rite Aid met a similar fate. The government's position in Computer Associates and Rite Aid was that a lie to corporate counsel was a lie to the government. Although the statements in those cases were admitted, the agency analysis in KPMG should make it more difficult for the government to resist an employee's claim that his employer (and its legal counsel) acted as de facto state actors when conducting an internal investigation in coordination with the government.

Although couched in terms of the Sixth Amendment, the Second Circuit's decision has clear implications for those claiming violations of their Fifth Amendment rights when told by their employers to cooperate or clean out their desks. Although direct government coercion will be less common insofar as line prosecutors heed the new guidelines set forth in the Filip Memorandum, the Stein panel's willingness to look at the underlying incentives created by the policy should make it easier for employees to claim that their employer was acting with “significant encouragement” from the government and that powerful legal incentives motivated their employer to coerce their testimony.

Nonetheless, companies may continue to condition the advancement of legal fees on cooperation with government investigators in order to curry favor with the regulators, even though there is no specific government threat of indictment if they fail to do so. Post-Stein, cooperation remains a critical component of the government's corporate charging policies. The incentives for companies to demonstrate their cooperation to government regulators by delivering their employees to the government remain in place. A company also faces powerful incentives under the U.S. Sentencing Guidelines to cooperate with a government investigation and, in particular, to demonstrate an effective disciplinary program. These legal forces remain largely untouched by revisions in the Filip Memorandum and will likely continue to confront employees with the choice of losing their job or incriminating themselves.

In Stein, the Second Circuit rejected the government's view of two precedents ' D.L. Cromwell Investments, Inc. v. NASD Regulation, Inc., 279 F.3d 155 (2d Cir. 2002) and United States v. Solomon, 509 F.2d 863 (2d Cir. 1975) ' in which private actors engaged in cooperative, parallel investigations with the government. In both, the court explained, there was “no state action because the private actors had independent regulatory interests and motives” for conducting parallel investigations. KPMG's actions, the panel wrote, were different, because its investigation was compelled by the Thompson Memorandum and the prosecutors involved in the case. The court's willingness to distinguish cases in which companies make truly independent decisions to conduct internal investigations from those in which the government coerces a company to investigate on the government's behalf is a development in the law that should also aid employees in making stronger Fifth Amendment claims.

Conclusion

At the time this article went to press, the government had not indicated whether it would seek en banc review of the panel's decision or a writ of certiorari from the Supreme Court. If the Second Circuit's decision stands, it will likely require the government, employers, and defense counsel to consider its implications for internal investigations in conjunction with government regulators. The Stein affirmance makes it easier for defense counsel to ask important questions about whether internal investigations can be considered compelled state action in violation of the constitutional prescription against self-incrimination.

Laurence A. Urgenson ([email protected]), Chairman of this newsletter's Board of Editors, is a Partner at Kirkland & Ellis LLP. He has served as Acting Deputy Assistant General, Chief of the Fraud Section, Executive Director of the Economic Crime Council in the Criminal Division of the Department of Justice, and as Chief Assistant U.S. Attorney in the Eastern District of New York. Jason P. Hernandez ([email protected]) is an Associate at the firm, teaches sentencing at The George Washington University School of Law, and is the Associate Editor of this newsletter.

In a much anticipated opinion, the Second Circuit has affirmed the dismissal of an indictment against 13 former partners and employees of the accounting firm KPMG, who were charged with creating fraudulent tax shelters. United States v. Stein, — F.3d –, 2008 WL 3982104 (2d Cir. Aug. 28, 2008). The appeals court agreed with District Judge Lewis Kaplan that prosecutors' coercive tactics designed to induce KPMG's refusal to pay for the defendants' legal fees constituted a violation of their Sixth Amendment right to counsel. In addition, Judge Kaplan had found that some of the defendants' Fifth Amendment rights against self-incrimination were violated when KPMG employees were told that if they did not answer the government's questions, their employment would be terminated and/or that the firm would cease advancing legal fees to them.

The Second Circuit did not reach the Fifth Amendment question, but we do here. We conclude that Stein strengthens the argument of employees that their Fifth Amendment rights have been violated when they are coerced by their employers ' acting as agents of the government ' to cooperate with government investigations.

DOJ Policies on Charging Corporations

In Stein, the Second Circuit held that the government, acting in coordination with and through KPMG, violated the defendants' rights to counsel under the Sixth Amendment. At issue were the government's charging guidelines set forth in a 2003 policy statement, known as the “Thompson Memorandum” because it was issued by then-Deputy Attorney General Larry D. Thompson. It instructed prosecutors deciding whether to indict a corporation to consider the company's cooperation as measured by (among other factors) willingness to advance legal fees to employees suspected by the government of wrongdoing. The Thompson Memorandum has since undergone two revisions, each by subsequent Deputy Attorneys General. Each revision softened some of the policies scrutinized in the KPMG case. For example, under the current charging policies, prosecutors are no longer directed to consider the advancement of legal fees as a metric of corporate cooperation. (See the article by Arkin, Pope and Prinz on the new DOJ guidelines, this issue.)

The mitigating revisions to the Thompson Memorandum have made it unlikely that another case like KPMG will emerge in similar form. Commentators have described the case as a “perfect storm” in which zealous post-Enron corporate charging policies collided with an accounting partnership which ' unlike many corporations ' was not legally bound to advance legal fees. For this reason, Stein's Sixth Amendment holding may have little impact on future cases. But that may not be true for an issue the appellate court did not reach ' whether an employee's right against self-incrimination is violated when a corporation threatens to terminate an employee unless he cooperates with an internal investigation that is conducted in coordination with the government.

The Right Against Self-Incrimination

The Self-Incrimination Clause of the Fifth Amendment states that no person “shall be compelled in any criminal case to be a witness against himself.” A statement taken in a criminal investigation violates the clause only if it is both compelled and brought to bear by a state actor. In Garrity v. New Jersey , 385 U.S. 493 (1967), both conditions were met. The Supreme Court held that the right against self-incrimination, as applied to New Jersey through the Fourteenth Amendment, precluded the state's Attorney General from compelling police officers to testify about an alleged traffic ticket-fixing scheme, where the officers were told that if they did not testify, they would be subject to removal from their positions. The forced choice between “self-incrimination and job forfeiture,” the Court explained, was the “antithesis of free choice to speak out or to remain silent.”

But Garrity was a public employee. In contrast, employees of private companies like KPMG have had little success in asserting that their Fifth Amendment rights were violated when their private-sector employers order them to cooperate with the government or lose their jobs. The decision in Stein, however, may have strengthened their hand. Judge Kaplan found that statements by a KPMG employee were unconstitutionally coerced because he was threatened with loss of both his job and the advancement of legal fees if he did not cooperate with the government. A second employee was coerced by KPMG, according to Judge Kaplan, not because the firm threatened to fire him, but because it conditioned advancement of his legal fees on his cooperation with investigators. Judge Kaplan equated KPMG's acts with those of coercive government action because KPMG was acting under the threat of indictment, and because the government had actively encouraged KPMG's actions. In both cases, the employees succumbed to coercion ' which the district court considered “beyond the bounds of appropriate government action” ' to waive their Fifth Amendment rights.

One of the issues the Second Circuit considered in Stein was whether KPMG's refusal to advance legal fees could be considered government action and thus a potential violation of the Sixth Amendment. At the time KPMG was making advancement decisions and threatening employees with termination if they failed to cooperate, the firm was operating under a deferred prosecution agreement, which required it to assist the government in its investigation. Judge Jacobs, writing for the panel on the Sixth Amendment, explained that state action was established in Stein as a matter of law “because the government forced KPMG to adopt its constricted Fees Policy.” So powerful was the threat of indictment hanging over KPMG that it “was easily sufficient to convert [the government's] adversary into [the government's] agent.” The panel, however, also found that government action could be ascribed to KPMG's actions on two other grounds. It agreed with Judge Kaplan that the government offered KPMG “significant encouragement” to change its fee policies ' a carrot to complement the stick of possible indictment ' and also that KPMG was a “willful participant in joint activity” with the government. Under prevailing case law, any of the three findings ' that KMPG was coerced by the government, that KPMG was significantly encouraged by the government, or that KMPG was a willful participant in coordination with the government ' is sufficient to find state action. While prosecutors are less likely to wield the stick now that DOJ policy has been restated in the Filip Memorandum, the Stein decision leaves the door open for employees to argue that government carrots are sufficient to find state action.

Although the government in Stein fought the idea that KPMG was its agent, sometimes it has itself relied on the agency principle that underlies the Second Circuit analysis in Stein. In the Computer Associates case, the government alleged that members of the private bar who were conducting an internal investigation were surrogate government investigators so that employees could be charged with violations of 18 U.S.C. ' 1001, which prohibits false statements in matters within the jurisdiction of the federal government. The Computer Associates employees were charged with lying to the government without ever having spoken to them, as one commentator said. Employees at Rite Aid met a similar fate. The government's position in Computer Associates and Rite Aid was that a lie to corporate counsel was a lie to the government. Although the statements in those cases were admitted, the agency analysis in KPMG should make it more difficult for the government to resist an employee's claim that his employer (and its legal counsel) acted as de facto state actors when conducting an internal investigation in coordination with the government.

Although couched in terms of the Sixth Amendment, the Second Circuit's decision has clear implications for those claiming violations of their Fifth Amendment rights when told by their employers to cooperate or clean out their desks. Although direct government coercion will be less common insofar as line prosecutors heed the new guidelines set forth in the Filip Memorandum, the Stein panel's willingness to look at the underlying incentives created by the policy should make it easier for employees to claim that their employer was acting with “significant encouragement” from the government and that powerful legal incentives motivated their employer to coerce their testimony.

Nonetheless, companies may continue to condition the advancement of legal fees on cooperation with government investigators in order to curry favor with the regulators, even though there is no specific government threat of indictment if they fail to do so. Post-Stein, cooperation remains a critical component of the government's corporate charging policies. The incentives for companies to demonstrate their cooperation to government regulators by delivering their employees to the government remain in place. A company also faces powerful incentives under the U.S. Sentencing Guidelines to cooperate with a government investigation and, in particular, to demonstrate an effective disciplinary program. These legal forces remain largely untouched by revisions in the Filip Memorandum and will likely continue to confront employees with the choice of losing their job or incriminating themselves.

In Stein , the Second Circuit rejected the government's view of two precedents ' D.L. Cromwell Investments, Inc. v. NASD Regulation, Inc. , 279 F.3d 155 (2d Cir. 2002) and United States v. Solomon , 509 F.2d 863 (2d Cir. 1975) ' in which private actors engaged in cooperative, parallel investigations with the government. In both, the court explained, there was “no state action because the private actors had independent regulatory interests and motives” for conducting parallel investigations. KPMG's actions, the panel wrote, were different, because its investigation was compelled by the Thompson Memorandum and the prosecutors involved in the case. The court's willingness to distinguish cases in which companies make truly independent decisions to conduct internal investigations from those in which the government coerces a company to investigate on the government's behalf is a development in the law that should also aid employees in making stronger Fifth Amendment claims.

Conclusion

At the time this article went to press, the government had not indicated whether it would seek en banc review of the panel's decision or a writ of certiorari from the Supreme Court. If the Second Circuit's decision stands, it will likely require the government, employers, and defense counsel to consider its implications for internal investigations in conjunction with government regulators. The Stein affirmance makes it easier for defense counsel to ask important questions about whether internal investigations can be considered compelled state action in violation of the constitutional prescription against self-incrimination.

Laurence A. Urgenson ([email protected]), Chairman of this newsletter's Board of Editors, is a Partner at Kirkland & Ellis LLP. He has served as Acting Deputy Assistant General, Chief of the Fraud Section, Executive Director of the Economic Crime Council in the Criminal Division of the Department of Justice, and as Chief Assistant U.S. Attorney in the Eastern District of New York. Jason P. Hernandez ([email protected]) is an Associate at the firm, teaches sentencing at The George Washington University School of Law, and is the Associate Editor of this newsletter.