Full Disclosure

By Thomas Brom
     
      Every once in a while a judge throws the book at the prosecutor, not the defendant. And when that happens in a white-collar case, the defense bar knows how to run with it. In June 2006, U.S. District Judge Lewis A. Kaplan held that federal prosecutors who pressured KPMG to cut off attorneys fees for 19 defendants in a conspiracy and tax-evasion case had violated their constitutional rights to fair trial and effective assistance of counsel. (United States v. Stein, 435 F. Supp. 2d 330.) The prosecutors strongly suggested to KPMG that terminating the advancement of defense expenses to indicted individuals would decrease the risk that the firm itself would be indicted. But the court held that "the KPMG Defendants had at least an expectation that their expenses in defending any claims or charges brought against them by reason of their employment by KPMG would be paid by the firm"?and the law protects such interests against interference.
      The white-collar defense bar loved it. "Although the Stein decision is only a District Court opinion, the decision should carry weight outside the Southern District of New York and affect prosecutorial policy nationwide," wrote Pillsbury Winthrop Shaw Pittman in a July 2006 client alert.
      In fact, the U.S. Department of Justice quickly backed off. In December 2006, Deputy Attorney General Paul J. McNulty issued a new version of the 2003 Thompson Memo, which had provided guidance to U.S. Attorneys regarding factors to consider in deciding whether to charge a corporation with criminal wrongdoing. According to the revised McNulty Memo, prosecutors "generally should not take into account whether a corporation is advancing attorney's fees to employees or agents under investigation and indictment."
      Congress jumped in as well. That month, Senator Arlen Specter (R-Penn.) introduced the Attorney-Client Privilege Protection Act (S 186); the House of Representatives followed with a companion bill (HR 3013) in July 2007. Both would prohibit government lawyers from forcing organizations not to contribute to an employee's legal defense.
      Judge Kaplan wouldn't let it go either, dismissing the government's case against 13 of the KPMG defendants in a fourth published opinion. (Stein IV, 2007 U.S. Dist. LEXIS 52053.) "The government's actions with respect to legal fees were at least deliberately indifferent to the rights of the defendants and others," Kaplan wrote. "In all the 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." Kaplan cited attorney declarations estimating defense costs in the case that ranged from $3.3 million to $24 million per client.
      Not everyone shared Judge Kaplan's outrage. "The Stein opinion is one of the most disproportionate and disingenuous I have come across in my career as a law professor," says Peter Margulies of Roger Williams University School of Law in Providence, Rhode Island. "He ignored the elephant in the room?the admitted conduct of KPMG and some of the defendants. He attempted to retry issues?such as KPMG's duty to reimburse defendants for their legal costs?that the Second Circuit had allocated to the state court. And his reference to conduct that 'shocks the conscience' invokes a case from the 1950s involving the pumping of a defendant's stomach without a warrant. We have a very different situation here?the government did not interfere with a preexisting right."
      Margulies points out?and Judge Kaplan acknowledged in Stein I?that the KPMG partnership agreement and bylaws are silent on indemnification and fee advancement. Kaplan based his opinion on the stipulation that "it had been the longstanding voluntary practice of KPMG to advance and pay legal fees, without a preset cap or condition of cooperation with the government, for counsel for partners, principals, and employees of the firm." (435 F. Supp. 2d at 340.)
      This isn't just nitpicking. Even some proponents of indemnification are uncomfortable with an implied-in-fact contract for unlimited defense costs. "Delaware statutory law permits a company to advance defense expenses under appropriate circumstances," says William D. Johnston, a partner in the Wilmington firm of Young Conaway Stargatt & Taylor. "But corporate bylaws may also provide for discretion, including whether advancement must be repaid or whether officers and directors should be indemnified if found to be liable or convicted of a crime."
      It's the assumed right to a "Cadillac defense" that so agitates Margulies. In a recent article, he cautioned that limitless fee subsidies raise questions of excessive executive compensation, obstruction of justice, and conflicts of interest for outside counsel, "since the defendants' cooperation with the government can jeopardize the interests of the entity paying the bills." (Legal Hazard: Corporate Crime, Advancement of Executives' Defense Costs, and the Federal Courts, 7 u.c. davis bus. l.j. 55 at 60 (2006).)
      Margulies contends that during the New Deal, courts viewed subsidy of legal fees as wasteful and at the expense of shareholders. Quoting from a Depression-era case from New York, he points out that courts formerly rejected fee advancement to corporate directors, favoring "the small and isolated investor who needs adequate opportunity for protection against the managers or the board." (See New York Dock Co. v. McCollum, 173 Misc. 106 at 112 (1939).)
      In the years following the Depression, many states enacted indemnification statutes justified as necessary to attract and retain managers, and to protect directors from frivolous lawsuits. More recently the Supreme Court of Delaware asserted, "Advancement is an especially important corollary to indemnification as an inducement for attracting capable individuals into corporate service." (Homestore, Inc. v. Tafeen, 888 A. 2d 204 at all (2005).)
      Certainly, the carriers of directors and officers (D&O) insurance still monitor defense costs. "D&O insurers are aggressive in trying to contain fee exposure," says David L. Anderson, a former federal prosecutor now in the corporate investigations and white-collar defense group at Pillsbury's San Francisco office. "To limit coverage, they will seek policy rescission, impose caps, look for claw-backs, manage attorney panel lists, and impose stringent billing requirements. But in many criminal investigations, the D&O carriers aren't even involved. Corporations pay the bills directly."
      Anderson supports indemnification and fee advancement. "How else can you defend yourself?" he asks. "The cost of a defense can be a home-wrecking event." But he acknowledges that multimillion dollar attorneys fees "can trigger disclosure in the MD&A [Management Discussion & Analysis section of the proxy statement], and could raise a red flag to investors."
      But Margulies isn't so sure anyone is watching. "Corporate lawyers are hired by corporate managers who benefit from unlimited defense costs," he says. "The Stein case, unfortunately, provides no basis for corporations to assess their costs. Kaplan applies a standard very different from what 99.9 percent of the American people have to live with."
     

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