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KPMG Trial, Pared in Scope, Nears After Stormy Prologue
By Paul Daviess and Chad Bray
The Wall Street Journal
Friday, October 12, 2007


NEW YORK -- It was once billed as the biggest tax-fraud case in U.S. history.  Then a federal judge devastated prosecutors by dismissing charges against 13 out of 19 targets.

But as the landmark case against former executives of accounting giant KPMG heads for trial Oct. 23, more than two years after the initial indictments, the stakes are still high for the government's broad fight against abusive tax shelters.

Three former lower-level KPMG executives and an attorney are all that remain of a case that once included the accounting firm's former vice chairman, Jeffrey Stein.  A federal judge dismissed the charges against 13 individuals in July after finding that federal prosecutors violated their constitutional rights by pressuring KPMG to cut off their legal fees.  Two others have pleaded guilty.

Though the case has been whittled down, the outcome will be closely watched in legal circles, executive suites and accounting offices.

A victory for the government could bolster its broad probe into abusive tax shelters.  An acquittal may cause the government to re-think its strategy in future tax-shelter cases.

Prosecutors initially accused the 19 individuals of selling bogus tax shelters to about 600 wealthy individuals from 1996 to 2002, generating about $2.5 billion of tax savings.  The case got bogged down for more than a year in a widely watched dispute over the legal fees.

The federal judge overseeing the case, Lewis A. Kaplan, challenged the government over pressure tactics that defense attorneys say have been on the rise as part of a broader crackdown on white-collar crime in wake of the Enron collapse.

Judge Kaplan concluded that KPMG refused to pay the legal fees "because the government held the proverbial gun to its head."  The judge accused the prosecutors of being "economical with the truth" in responses regarding the pressure tactics.

After throwing out the charges against the 13 individuals Judge Kaplan said "the responsibility for the dismissal" of the indictment "lies with the government."

A spokeswoman in the U.S. attorney's office for the Southern District of New York, which is handling the case, declined to comment.  Prosecutors previously have denied placing an undue pressure on KPMG and on Oct. 10 filed an appeal of the judge's ruling.

While many legal experts say there is a strong chance the judge may get reversed, the fallout from his landmark ruling continues:  The Justice Department repudiated its guidelines for white-collar prosecutors after Judge Kaplan singled out the government's pressure tactics.  Defense attorneys say federal prosecutors have largely stopped asking companies if they are paying legal fees, avoiding a topic that has become "radioactive," as one lawyer put it.

Defense attorneys for Jamie Olis, who was convicted of fraud and conspiracy in 2003, filed an appeal last week, alleging that federal prosecutors in Houston pressured his former employer, Dynegy Inc., to withhold his legal fees, a move that could lead to similar appeals by others citing the KPMG case.

"With all the backstory going on, a complex tax-shelter case got a lot more complex," said Peter Henning, a professor at Wayne State University Law School in Michigan, who has been following the case.

The Four to Be Tried

Opening arguments are scheduled for Oct. 23 in a trial expected to last three to five months.  The four on trial include former KPMG tax partners Robert Pfaff, John Larson and David Greenberg, and Raymond J. Ruble, a former partner at Sidley Austin LLP.  The government has turned over more than 22 million pages of documents to defense attorneys.  Much of the testimony is expected to be complex and tedious information related to the sale of tax shelters.

Convictions would energize the government's wide-ranging, years-long probe into allegedly abusive tax shelters that has ensnared others, including five current and former executives from Ernst & Young; led to the closing of Jenkens & Gilchrist, a large Dallas law firm, and HVB Group, which reached a deferred-prosecution agreement with prosecutors last year.

Deutsche Bank AG also has come under scrutiny for its role in the sale of the tax shelters.  The bank hasn't been charged but could reach a settlement with the government, according to a person familiar with the matter.

The hurdle for prosecutors is that this is the first attempt to criminalize the tax shelters.  The Internal Revenue Service has long contended that the shelters were improper.  A federal judge overseeing a separate civil case in Texas found that one of the shelters at issue in the KPMG case was a sham that "lacked economic substance."

"The question in the trial is whether or not the government can prove beyond a reasonable doubt that these defendants knew that, in reality, these transactions had no economic substance and were never going to have any economic substance, not withstanding whatever the theoretical potential of the transactions might have been," said Michael N. Levy, a former federal prosecutor and now a white-collar defense attorney at McKee Nelson LLP in Washington.

Prosecutors contend the underlying tax-shelter transactions were bogus investments designed to generate phony capital losses.  In order to conceal the true nature of the tax shelters from the IRS, KPMG or a law firm provided clients with opinion letters containing false and fraudulent representations about the transactions, the government has alleged.

The four shelters at issue were known as Blips, or bond linked issue premium structure;  Flips, or foreign leveraged investment program;  OPIS, or offshore portfolio investment strategy;  and SOS, or short option strategies.  The transactions allegedly generated millions of dollars in fees and income for KPMG and others, the government said.

Messrs. Larson, Pfaff, Greenberg and Ruble have been charged with conspiracy and multiple counts of tax evasion.  They have denied wrongdoing.  Attorneys for Messrs. Larson and Pfaff didn't return calls for comment.  Mr. Greenberg's attorney, Richard Strassberg of Goodwin Procter LLP, said: "We'll be vigorously defending the case."  Mr. Ruble's attorney, Jack Hoffinger, said, "We're proceeding to trial."

The government's case is expected to be bolstered by the guilty plea last month of David Amir Makov, a one-time currency and fixed-income derivatives trader, who said the "sole purpose" of the Blips shelter was to generate "paper losses" and fees.

Mr. Makov, who pleaded guilty to a single count of conspiracy, worked as an investment adviser at Presidio Resources Inc., an investment-advisory firm formed by Messrs. Larson and Pfaff in 1997 after they left KPMG.

Keeping the Jury Awake

The other challenge for the government is to keep its case simple and easy to understand for jurors.  The tax-shelter transactions are complex and difficult to follow.  Look for prosecutors to emphasize the millions of dollars in fees the defendants pocketed in an effort to paint them as greedy, defense attorneys say.

The government removed Justin Weddle, the lead prosecutor on the case, after running into trouble over the legal-fee issue.  Assistant U.S. Attorney John Hillebrecht was added to the trial team last year, but veteran prosecutor Shirah Neiman remains firmly in charge of the legal strategy.

KPMG avoided a criminal indictment that could have put the firm out of business.  Instead, the firm signed a deferred prosecution agreement in which it admitted to the fraudulent sale and marketing of the bogus tax shelters and agreed to pay a $456 million penalty.

Write to Paul Davies at paul.davies@wsj.com and Chad Bray at chad.bray@dowjones.com

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