Chastened KPMG Got By Tax-Shelter Crisis;
Boss of Just Three Days Admitted Firm's Sins, Fought to Keep
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
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
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
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.
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
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
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
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.
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
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
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