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NARROW ESCAPE:  How a Chastened KPMG Got By Tax-Shelter Crisis;
Boss of Just Three Days Admitted Firm's Sins, Fought to Keep Clients
By David Reilly
The Wall Street Journal
Thursday, February 15, 2007

Timothy Flynn, a top executive at KPMG LLP, was driving to a nephew's graduation in May 2005 when he got a phone call from the chairman:  The firm faced imminent criminal indictment over tax shelters it used to sell.

Then a different sort of shock. One week later, the chairman, Eugene O'Kelly, learned he had a brain tumor that left him just months to live.  Mr. Flynn, a down-to-earth accountant who once led KPMG's human-resources department, was suddenly thrust into its top job, where he faced an urgent task:  to somehow persuade the government not to indict.  He knew that criminal charges against the firm would probably kill it, as they did Arthur Andersen after the Enron scandal.

Mr. Flynn took a gamble.  KPMG had for years stoutly denied any impropriety, calling its tax advice legal.  But days after taking the helm, Mr. Flynn met with Justice Department officials and acknowledged that KPMG had engaged in wrongdoing.

He got no promises in return, and the admission could have sunk the firm.  Instead, it provided flexibility to the prosecutors, who were aware that the collapse of one of only four remaining accounting giants could harm the financial markets.  Two months later, the government gave KPMG a deferred-prosecution deal, holding off indicting if KPMG paid a $456 million penalty and met other conditions.

KPMG now is emerging from what some at the firm call a near-death experience.  Last month a judge, satisfied with the firm's reforms so far, dismissed the deferred criminal charge.  Mr. Flynn has put in place stronger controls, and a former federal judge now oversees KPMG's ethics and compliance efforts.  Mr. Flynn also banned a type of incentive pay that many believe helped fuel the sale of improper tax shelters.  For the most part, he has managed to retain partners and clients.  In November, he was able to report that the firm's revenue had grown 2% in the fiscal year ended Sept. 30.

KPMG isn't out of the woods.  It still faces lawsuits from tax-shelter clients.  And though the firm hasn't been indicted, some of its former executives have, and their trial in September could cast the firm in a harsh light.  Defense attorneys plan to argue that the shelters had approval from top management.  KPMG says, "There's no evidence whatsoever to suggest that the management committee was aware that there was fraudulent conduct involved in the sale of tax shelters."

A government-appointed monitor of KPMG gives Mr. Flynn a vote of confidence.  He has proved to be "the right person at the right time," says the monitor, Richard Breeden, a former chairman of the Securities and Exchange Commission.

Mr. Flynn grew up in a tightknit family with six children in the Minneapolis suburb of Bloomington.  An Eagle Scout and high-school wrestler, he attended the nearby College of St. Thomas, his father's alma mater, and, along with two brothers, followed his father into accounting.

In 1979 he took a $13,700-a-year job in the local office of Peat Marwick & Co., a predecessor of KPMG, eventually impressing superiors with his technical accounting skills and management knack.  Frequently described by those who meet him as earnest, Mr. Flynn, says former SEC Chairman Arthur Levitt, is like "the parish priest who became pope."

Test of Skills

A test of his skills came in 2002.  As Arthur Andersen was imploding after an obstruction-of-justice indictment, accounting firms rushed to snap up its clients and partners.  KPMG initially fell behind in this scramble.  Mr. Flynn and Jack Taylor, then vice chairmen of KPMG's audit business, refocused the effort.  First, they made a priority of signing up Andersen partners, figuring clients would follow their auditors.  Then, dividing the country between them, they spent the next three months on the road, meeting with about 1,000 Andersen partners in all.

One, Dan Doherty, recalls the approach.  While executives from other accounting firms simply left messages at his home, he says, Mr. Flynn took the time to talk to his wife and showed a "clear empathy for the circumstance we were in."  It "wasn't just this mad rush of recruiting .... I never felt I was in the back of the line," he says.

Mr. Doherty joined KPMG.  In all, about 200 Andersen partners did.  KPMG snagged 395 Andersen clients, second only to Ernst & Young's haul, according to research firm AuditAnalytics Inc.

But soon, KPMG had troubles of its own.  The once-staid accounting world had changed, with big firms using their audit relationships with companies to pitch more-lucrative services.  Among them were tax shelters:  elaborate sets of financial transactions designed to shield income from taxation.

For example, some shelters created paper losses on foreign currencies, which wealthy individuals who bought the shelters could use to offset taxable gains -- despite having never really put any money at risk.  KPMG developed a sophisticated marketing operation, including a cold-call center in Fort Wayne, Ind., to push its tax products, according to a 2003 Senate report.

As the Internal Revenue Service stepped up probes of such shelters early in this decade, KPMG's accounting-firm rivals stopped offering them and settled with the government.  KPMG sold shelters longer than others and insisted there was nothing wrong with its products, a stance that angered the IRS, the Justice Department and some senators.

Shifting Strategy

KPMG began to shift strategy in early 2004.  Under Justice Department investigation, it forced out people who worked on the shelters and started to work toward a resolution with the government.  But as the process dragged on, in late May 2005 the U.S. attorney in Manhattan sent KPMG a letter saying an indictment was imminent.

Then came the shock of Mr. O'Kelly's tumor.  He stepped down, and the firm promoted Mr. Flynn, now 50 years old.  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.

Now KPMG had to fight to retain clients.  Executives took to the road for long stretches.  Mr. Veihmeyer's wife sent clothes to him by courier as he traveled.  Over the summer of 2005, Messrs. Flynn and Holmes contacted more than 100 audit clients.

One was General Electric Co., KPMG's biggest audit client and one that paid it more than $109 million in fees that year, according to AuditAnalytics.  Mr. Flynn met with GE directors.  According to a person who attended, his message amounted to: "There's some stuff here, it's really ugly, it happened, and here's what we're going to try to do with this situation."

GE stuck with KPMG.  A spokesman for GE says it is "pleased that KPMG and its leadership have aggressively addressed the compliance issues raised in the government's tax case."

KPMG was lucky in one way.  Midsummer is late in the year for big companies to make auditor switches, because it can take months to negotiate terms of an audit engagement.

Clients weren't the only concern.  Many KPMG partners were angry.  Any exodus of partners would make it harder to keep audit clients.

Then in early August, a memo purporting to be from unnamed current and former KPMG board members circulated.  Saying Mr. Flynn lacked "backbone," it blasted management for admitting wrongdoing and abandoning partners involved.  "While the leadership may believe the path to pursue is the survival of the firm at all costs, we don't," the memo said.  "The actions being taken will probably result in the demise of the firm anyway."

Mr. Flynn says the memo was "hurtful" and its claims were "lies."  To calm partners, he personally reached out to hundreds of them, often singling out younger ones.  Michael R. Gervasio, a young tax partner in Chicago, says he was impressed as much by Mr. Flynn's persistence as by what he said.  Mr. Flynn phoned eight times over two days before finally connecting with Mr. Gervasio at home at 10 one night.  "We really want you to stay," Mr. Gervasio recalls being told.  He did.

Later that month, August 2005, KPMG won a new lease on life:  The Justice Department announced a deferred-prosecution agreement.  Besides the $456 million penalty, it required KPMG to stop selling prepackaged tax products, stop doing tax returns for most individuals, shed its benefits and compensation practice, and submit to federal monitoring through September 2008.

Special Meeting

Mr. Flynn called a special meeting of partners.  Such sessions typically were staged.  This time, Messrs. Flynn and Mr. Veihmeyer set up computer kiosks so people could submit questions anonymously.

"Why should we trust you guys now?" asked one question at the meeting in Dallas, which had drawn nearly all of the then-1,607 partners.  Others asked why the penalty shouldn't be paid just by tax partners.  Mr. Flynn said they all had to "sink or swim" together, and a big fine was the price they must pay to "get their firm back."

The firm says that from June 1 to Sept. 30, 2005, just 18 partners left, excluding normal retirements and some forced out because of the tax shelters.  One thing that helped keep people aboard was a post-Enron boom in auditing.  Auditors now had to do more and take more responsibility -- and they demanded bigger fees to do it.

KPMG also kept most of its clients.  From June 2005 through the end of the year, it lost just three companies with stock-market values above $1 billion, according to AuditAnalytics.

Mr. Flynn set about changing how the firm was run.  He scrapped an incentive-pay system blamed for encouraging partners to push the tax shelters.

In a two-day January 2006 board meeting, he urged directors to rethink KPMG's governance, and they crafted 14 changes.  The head of legal and compliance, currently former Judge Holmes, is now one of the firm's top four executives.  The chairman and deputy chairman no longer sit on the nominating committee, limiting their ability to fill the board with their allies.  The board now has a lead director who is a counterweight to the chairman.

Mr. Breeden, the monitor, says KPMG has developed a good governance system, "but it needs more seasoning to be sure that it works as well in practice as it should in theory."

Although KPMG reached a $154 million settlement with investors it sold tax shelters to, it still faces suits from several dozen investors who opted out of the settlement. It has been quietly settling some of these.

KPMG remains in a wrangle over its refusal to pay legal fees for former executives who were indicted.  In that and other cases, lawyers opposing KPMG say it is a sharp-elbowed litigator, as antagonistic as ever.  Michael Avenatti, who represents tax-shelter investors suing KPMG, says, "They interpret court orders in the narrowest sense and to the utmost extreme to benefit their positions."  KPMG says it defends itself "as appropriate and in a professional manner."

One former critic is impressed with changes at KPMG.  Former SEC Chairman Levitt once called KPMG a "rogue operation."  Mr. Levitt, who has offered informal counsel to Mr. Flynn, says that the chairman "stepped into a troubled situation and by sheer strength of personality and character saved that firm from destruction."

Write to David Reilly at david.reilly@wsj.com

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