12   Endgame: KPMG and Jenkens

KPMG

KPMG’s extensive tax shelter operations began to catch the eye of the IRS in 2000. By the end of that year, the agency was aware that the accounting firm had been involved in both OPIS and FLIP shelters. In October 2001, the IRS informed KPMG that it was beginning an audit, and in December it issued an information document request to the firm. KPMG claimed that client confidentiality concerns prevented it from providing the documents described in the request but indicated that the firm would comply with a request for documents set forth in an administrative summons. The IRS issued summonses seeking investor lists and three different sets of documents in January, March, and May of 2002.

KPMG acknowledged that the identity of investors was not privileged but insisted that a large number of documents were protected from disclosure based on attorney-client and statutory accountant-client privileges. The firm was also slow in producing unprivileged documents that were responsive to the summonses. One internal email acknowledged that although lists of some investors in various transactions had been provided to the IRS, “not all client names were turned over for each of [the] solutions.”¹ A partner who read this email, which had been widely distributed, forwarded it to Jeff Stein with a cover note explaining that she was “watching [his] back.” “Given the sensitivity of this situation, should we be putting all this in print?,” she wondered.²

In July 2002 the Department of Justice responded to KPMG’s recalcitrance by filing a motion to enforce the summonses. In an accompanying declaration, the IRS agent in charge of the audit stated that an analysis of only the incomplete investor lists that KPMG had provided with respect to FLIP/OPIS and BLIPS indicated that investors had claimed $5.8 billion in phony losses.³ He estimated the loss in revenue from BLIPS alone to be more than $1.28 billion. The agent also stated that the IRS had received a letter from a confidential source indicating that KPMG was continuing to develop and market dozens of possibly abusive shelters without registering them. “The information developed in this examination thus far,” he stated, “leads me to conclude that KPMG is actively flaunting the statutes and regulations requiring transparency in the development, organization, and marketing of tax shelters.”⁴ The Justice Department petition and exhibits came to 376 pages and provided a detailed account of tax shelter operations inside a major accounting firm.

In the meantime, clients whose transactions were being scrutinized by the IRS were starting to bring litigation against their former advisors. In April 2002, Joseph Jacoboni filed an action alleging that KPMG had defrauded him by claiming that the FLIP shelter it sold him was a legitimate tax technique.⁵ An entrepreneur, Jacoboni had grown a technical support company into a multimillion-dollar business, which he sold for more than $30 million dollars in 1997. When First Union, his long-time bank, saw the size of his gain, it immediately put Jacobini in touch with a tax partner at KPMG, who pitched him FLIP as an investment strategy that would allow him to shield the gains from his sale. Completely in the dark about how the transaction worked but repeatedly assured that it was “bullet-proof,” Jacoboni paid $2.4 million to the firm to do a FLIP deal.⁶ When it became clear that the IRS was going to disallow the tax benefits, Jacoboni, represented by Campbell Killefer and Damon Wright of the Venable law firm in Washington, D.C., sued KPMG and the other advisors on the transaction.

Soon afterward, the Perez brothers, founders of a health care business, brought suit against KPMG in connection with their purchase of FLIP.⁷ The Perez brothers had approached Edmundo Ramirez, a trial lawyer based in McAllen, Texas, to represent them. When Ramirez first talked to tax specialists about the case, they had discouraged him from pursuing it, emphasizing that the case would turn on complex tax questions with no clear answers. Untangling the technical details of FLIP and figuring out their significance for a possible claim against the firm would be a daunting proposition. But as Ramirez thought about the story his clients had told him, he realized that KPMG and the other promoters involved had violated their obligations as trusted advisors to their clients. FLIP’s marketers had failed to look out for the brothers’ interests and misrepresented the legality of the transaction. Consistent with this intuition, Ramirez’s complaint alleged that the accounting firm had committed fraud, malpractice, and breach of its fiduciary duties.

KPMG fought these first lawsuits aggressively, asserting initially that Jacoboni and the Perez brothers had to prove in court that the transaction didn’t work before they could make a claim against the firm. As the cases progressed, the firm shifted to a different defense, contending that by purchasing the shelters their former clients were complicit in any wrongdoing by the firm.

Neither defense strategy ultimately succeeded. Since these were the first shelter lawsuits against KPMG, Ramirez and the Venable lawyers did not know what to expect and decided to collaborate, sharing information, documents, and strategies. The lawyers were particularly effective in using their different professional styles—Killefer and Wright were partners in an East Coast Am Law 100 law firm, while Ramirez was the founding partner of a small firm located just north of the Rio Grande—to obtain key documents and solicit useful admissions during depositions of KPMG witnesses. As discovery progressed, it became evident that FLIP’s developers had worked closely from the outset to develop the strategy and that any claim of independence among them was a sham. It also became clear that internally the firm had had much greater doubts about the shelter’s legality than it had represented to its clients.

Within a year of the first lawsuit, KPMG had been sued in at least eight other cases—a fact reported in a Wall Street Journal article under the headline “Lawsuits over Tax Shelters Suggest a Hard Sell by KPMG.”⁸ Eventually, lawyers representing the firm’s former clients were successful in obtaining favorable settlements on behalf of their clients. KPMG, for its part, was able to avoid the additional negative publicity that would come from a trial.

A Whistleblower

The government’s efforts and private lawsuits received a big boost with the appearance of a second whistleblower at KPMG. Unlike an earlier anonymous informer who provided information to the IRS, Michael Hamersley eventually went public with his charges against KPMG. Even before that point, he played a critical role in helping Congress uncover details about the tax shelter industry.

A 1995 Georgetown law school graduate, Hamersley had come to KPMG after working briefly at Ernst & Young.⁹ After graduation, Hamersley had accepted a position at E&Y instead of a traditional law firm because the accounting firm, with a corporate client base many times the size of a law firm, offered unique opportunities for developing high-level tax expertise. Hamersley had earned an MBA before law school, and E&Y offered him an opportunity to use his business background and develop a highly specialized tax niche. Starting salaries for lawyers at accounting firms, which had once lagged significantly behind those at law firms, were also catching up.

Hamersley joined E&Y’s National Tax Department, specializing in tax issues relating to mergers and acquisitions (M&A). Soon after he started, he began to notice changes in the provision of tax services toward what he calls the “productizing” of tax. In the late 1990s, E&Y, like other major accounting firms, realized that developing standardized tax products could be an effective strategy to serve its many similarly situated clients. To Hamersley, the efficiency gains were obvious. Complex processes, such as analyzing the acquisition costs of a company, benefited from standardization. After a few years, Hamersley moved over to KPMG, where he hoped to do both product and client-based work.

As a junior person in KPMG’s Washington National Tax office, Hamersley was not exposed to the discussions surrounding BLIPS and other tax shelters. He sometimes saw a Tax Product Alert about a new product or heard a description but he assumed that even the most technically aggressive products—that is, those that heavily shaded the law to reach a favorable result—could be implemented legally. It did not occur to Hamersley, who deferred to the expertise of his senior colleagues, that the firm might sign off on transactions with knowledge that material facts related to whether the transactions had economic substance were being omitted, concealed, or misrepresented.¹⁰

In 2000, Hamersley moved to the KPMG Los Angeles field office. He was considered a rising star at the firm and had been offered a promotion to senior management if he relocated. Higher-ups assured him that, if things continued on course, he would be made a partner within two years and would eventually take over the direction of the Los Angeles M&A tax practice.¹¹ Delighted, Hamersley and his wife moved across the country.

In Hamersley’s new workplace, he was regularly exposed to tax shelter activity. He was surrounded by members of the firm’s Stratecon practice, which had been established to develop and market tax strategies to corporate clients. As Hamersley continued to work on client service matters, he began to hear about details of corporate tax shelters being promoted by Stratecon. At first, Hamersley assumed that the aggressive salesmanship was a reflection of the “Wild West” atmosphere of the office. Over time, though, he began to realize that the focus on marketing tax shelters came from the firm’s senior tax leadership.¹²

Client service tax partners in the L.A. office, who were under significant pressure to give Stratecon access to their clients, occasionally showed Hamersley the descriptions and legal opinions on tax products. Hamersley did not hesitate to voice his concerns, even though he was advised on at least one occasion not to be so vocal in his criticisms if he wanted to advance to partner. Over the next two years, he managed to avoid direct involvement in tax products, but—not one to stay quiet—persisted in raising questions about their legality.¹³

Hamersley was especially concerned about the firm’s practice of selling highly aggressive tax shelters to audit clients and allowing them to include the tax benefits on their financial statements. KPMG’s tax shelter promoters would team with audit partners, who received financial bonuses for facilitating sales to their clients. Frequently, audit partners would sign off on the financial statement treatment of the tax shelter based solely on a tax opinion provided by the tax partner who had developed or marketed the transaction. Hamersley was concerned that this practice compromised auditor independence since the audit partner was not relying on an objective evaluation of the tax shelter but on the opinion of the same person who was marketing the product.¹⁴

In 2002, Hamersley, who had always received exceptional performance evaluations, was due for partnership. His game plan was to lie low, make partner, and leave the firm as soon as possible. His wife was pregnant with their first child. That spring, he was asked to become involved in the audit of a Fortune 100 company, a former client of Arthur Andersen that had engaged KPMG to reaudit its financials to shore up investor confidence in the wake of Andersen’s collapse. Hamersley was requested to review several highly aggressive tax strategies that would allow the company to claim a $450 million loss. After studying the transactions, he concluded that the strategies didn’t work. Under audit standards, unless KPMG reached a “should” level of certainty—an opinion that there was at least a 70 percent likelihood that if the IRS challenged the transaction, a court would uphold the tax treatment favored by the taxpayer—the client would have to set aside reserves for a contingent liability. This meant restating its earnings without the tax benefits the aggressive transaction was supposed to produce.

As the client put pressure on KPMG to arrive at a “should” level of certainty, KPMG higher-ups insisted that Hamersley alter his analysis. After Hamersley made clear that his assessment was not going to change, he realized that his future at the firm was at risk. At the same time, he thought that he had extricated himself from the immediate problem of not being able to “get comfortable” with the client’s position. His game plan was to immerse himself in his other work and start looking for an exit strategy.

Other tax partners at KPMG were able to arrive at a “should” level of certainty and signed off on the company’s financial statements in the summer of 2002. Shortly afterward, the partner to whom Hamersley reported asked him to write an opinion supporting the firm’s treatment of the highly aggressive tax strategy. Hamersley protested that he had arrived at a different view and showed the partner a PowerPoint presentation he had created to explain his analysis. According to Hamersley, when the partner saw the presentation, he instructed Hamersley to remove the negative information it contained.¹⁵

In response to Arthur Andersen’s destruction of Enron audit documents, Congress had strengthened the penalties that applied to destroying audit work papers. Hamersley worried that if he followed instructions and altered his memo, he could be subject to criminal prosecution. He consulted with a private attorney and concluded that it was time to contact government officials.¹⁶ After he watched Senator Carl Levin preside over hearings that led up to the enactment of the Sarbanes-Oxley Act, Hamersley decided to contact the staff of the Senate’s Permanent Subcommittee on Investigations (PSI). When KPMG became suspicious that Hamersley was cooperating with the government, it put him on administrative leave, cut off his access to his clients, email, and files, and forbade him from coming to the office.¹⁷ A rumor circulated in the firm that Hamersley was suffering from mental problems. While on leave during the next twelve months, Hamersley helped PSI staff members to understand the various tax strategies KPMG had promoted and to focus the investigation on the most egregious conduct.

Help from the Hill

In October 2003, a year after Hammersley contacted the PSI, he made his first public appearance at Senate Finance Committee hearings on abusive tax shelters. Hamersley testified: “A culture existed [at KPMG] in which intimidation and coercion were often used to foster the abusive tax environment. Tax professionals who ‘played the game’ and fully embraced the promotion of abusive tax shelters were rewarded handsomely. However,” he underscored, “those who were vocal in raising concerns about abusive tax shelters were stifled and reprimanded and their opportunities for advancement were limited.”¹⁸

As it turned out, Hamersley’s testimony at the Finance Committee was a warm-up for the main event. A month later, Senators Norman Coleman and Carl Levin presided over two days of hearings of the Permanent Subcommittee on Investigations on the tax shelter industry. The PSI had been investigating the industry for over a year with Hamersley’s assistance behind the scenes. After collecting thousands of pages of documents and interviewing numerous witnesses, the committee focused on shelters promoted by KPMG while also emphasizing that many other similar shelters were being marketed by major accounting firms, law firms, and investment boutiques.

The PSI heard twenty-one witnesses, six of them from KPMG. Of the KPMG witnesses, only Mark Watson, the tax partner who tried to prevent the firm from approving BLIPS, admitted to any doubt about the validity of any shelter, testifying that he “was never comfortable that BLIPS provided a reasonable opportunity to make a reasonable pre-tax profit.”¹⁹ The other KPMG witnesses, however, presented a unified front, insisting that the firm had not engaged in any wrongdoing. The thrust of their position was that “the tax laws are complicated and often ambiguous and unsettled” and that KPMG’s shelters conformed to the technical requirements of the law during a period marked by a “far different regulatory and marketplace environment.”²⁰ According to its statement, KPMG had now entered a new era in which it was guided not simply by legality but also by “whether any action could in any way risk the reputations of KPMG or our clients.”²¹

Senator Levin was exasperated with KPMG’s responses. At one point he asked Jeffrey Eischeid, the partner who had taken over the tax shelter group in 1999, whether FLIP, OPIS, and BLIPS weren’t “primarily tax-reduction strategies that have financial transactions tied to them to give them a colorable business purpose?”²² Eischeid denied this contention, suggesting that they were “investment strategies” that had “a significant income tax component to them.”²³ Levin then proceeded to quote from several documents, including client presentations by KPMG’s tax shelter team, that explicitly stated that FLIP, OPIS, and BLIPS were tax elimination techniques. Confronted with these documents, Eischeid continued to insist that these were investment strategies that had tax minimization as one “attribute.”²⁴ Pressed to admit that the transactions were intended to eliminate taxes, Eischeid, after a moment of silence, replied that he did not know how to change his answer. “Try an honest answer,” Senator Levin retorted.²⁵ Eischeid subsequently defended his conduct, expressing surprise that his ethics had been questioned.²⁶ Senator Levin did manage to obtain one concession from one of the representatives of KPMG when Richard Smith, the vice chair of Tax Services, acknowledged that the firm encouraged its professionals to design and sell tax products.²⁷

At the close of the hearings, the Permanent Subcommittee on Investigations issued a Minority Staff Report that contained a discussion of the evidence that the committee had collected, a set of proposed findings, and detailed case studies of the BLIPS and SC2 shelter transactions marketed by KPMG.²⁸ The PSI also released thousands of pages of documents it had collected. These provided a detailed window into the activities of KPMG, Brown & Wood, and the financial advisors and banks that worked with them. In the meantime, Hamersley filed a lawsuit against KPMG, contending that the firm had retaliated against him for whistleblowing and defamed him by starting the rumors about his mental health. After the suit was settled, Hamersley joined the California Franchise Board, in a newly created department dedicated to investigating and prosecuting abusive tax shelters.

Cleaning House at KPMG

On November 18, 2003, several thousand KPMG partners were gathered in Orlando, Florida, for their annual meeting. Instead of taking advantage of the warm weather, many stayed inside to follow the PSI hearings being broadcast on C-Span. As they watched, Senators Levin and Coleman demonstrated that FLIP, OPIS, and BLIPS were not, contrary to the firm’s claims, investment strategies, but transactions whose primary purpose was reducing or eliminating taxes. During the questioning, partners in the tax group, including the vice chair of Tax Services, had been exposed as liars—in front of Congress no less. As one KPMG partner described the experience, “It was like watching your own house burn down.”²⁹

A few weeks later, Eugene D. O’Kelly, the chair of KPMG, called a meeting of the firm’s board, at which he announced that the firm was taking “a new direction.” Recognizing that the firm’s very survival was at stake, its highest leaders had decided, finally, to stop defying the government. As one board member noted: “We came to the party late. We drank more, and we stayed longer.”³⁰ At the end of 2003, O’Kelly announced that Jeff Stein, who had been appointed deputy chair for Tax in 2002, was resigning. Jeffrey Eischeid, who had been in charge of Personal Financing Planning’s tax products group, was removed as a partner and put on administrative leave. Richard Smith, vice chair of Tax Services, was reassigned to “unspecified new duties.” Two tax partners believed not to be associated with the firm’s tax shelter group, James Brasher and John Chopack, were appointed to replace, respectively, Smith and Stein.³¹

In early 2004, KPMG began to make systematic efforts to change the focus of its tax services, dismantling the organizational structure devoted to developing and mass marketing generic shelters to individuals and emphasizing the provision of advice tailored to a client’s specific circumstances. It also started to disband the Innovative Strategies and Stratecon groups. Approximately half the members who had been most deeply involved in designing and marketing shelters soon left the firm. To implement more effective controls, the firm created the positions of vice chair for Risk and Regulatory Matters, which reported directly to the firm’s CEO, and partner in charge of Risk and Regulatory Matters for Tax, which reported to the new vice chair. The partner in charge of Risk and Regulatory Matters for Tax was given authority to determine the parameters of acceptable tax services without interference from the business units.³²

KPMG hoped that by cleaning house it would put its difficulties with the government behind it. It was wrong. In February 2004, it received more bad news. A grand jury was investigating its tax shelter activities, raising the specter that the firm would be indicted. The Wall Street Journal reported that thirty former and current employees were subjects of the criminal probe.³³ At around the same time, the IRS listed SC2, the shelter KPMG had aggressively marketed to S corporations through the Stratecon group, as abusive.³⁴ Meanwhile, PBS’s Frontline aired an hour-long exposé on abusive tax shelters, which featured Joseph Jacoboni, one of the firm’s clients who had bought FLIP, and Mike Hamersley, the whistleblower who had appeared before Congress in October.

As publicity mounted, KPMG became increasingly concerned about the prospect of criminal charges. Soon after the PSI hearings in November 2003, KPMG had switched lawyers, dismissing Wilkie Farr and Spalding and King, which had represented the firm in the shelter investigation by the U.S. Department of Justice and before the IRS. KPMG retained Robert Bennett of Skadden, Arps, who had a reputation for helping companies avoid prosecution.³⁵ Represented by Bennett, the firm began to make intense efforts to cooperate with the government.

At the urging of the government, KPMG limited the amount of legal fees that it was willing to cover for partners and employees under investigation. It had been a long-standing practice for KPMG to pay the legal fees of employees in connection with employment-related matters. In 2003, however, the government had adopted a policy, described in a memo written by then Attorney General Larry Thompson, which took into account whether a company paid legal fees in determining whether the company was cooperating fully in an investigation. Consistent with this policy, federal prosecutors in the KPMG matter emphasized that they expected the firm not to pay the fees of employees who failed to cooperate in the investigation. Eager to avoid indictment itself, the firm set a cap of $400,000 on legal fees and made clear that it would immediately cut off fees for employees who asserted their right not to incriminate themselves under the Fifth Amendment, refused to participate in interviews, “failed to be prompt, complete or truthful,” or otherwise failed to cooperate in the investigation.³⁶ The firm also informed employees that it would cease paying legal fees for any employee indicted by the government.³⁷ The decision to limit attorneys’ fees was a significant departure from KPMG’s prior practice and that of most large companies at the time.

In the spring of 2004, KPMG’s board also agreed to waive any claims of privilege and work product the firm had in connection with communications with its inside counsel related to the development and marketing of shelters. The firm’s waiver was an attempt to signal cooperation, but covered only a small portion of the documents sought by the IRS’s summons. KPMG continued to insist that a significant number of documents sought in the enforcement action by the Justice Department were not subject to disclosure because they were privileged communications between the firm and its clients.

In October 2003, a special master appointed by the judge in the Justice Department enforcement action against KPMG had recommended to Judge Thomas F. Hogan that the firm be ordered to disclose most of the documents it was withholding.³⁸ In May 2004 Judge Hogan issued a scathing opinion that invited the Justice Department to charge KPMG with obstruction of justice. In reviewing KPMG’s conduct in response to the government’s enforcement action, Judge Hogan found that the firm was asserting the privilege in bad faith.³⁹ “The Court comes to the inescapable conclusion,” he wrote, “that KPMG has taken steps since the IRS investigation began that have been designed to hide its tax shelter activities.”⁴⁰

Recognizing that such a charge was not to be made lightly, the court went on to catalog each event that cumulatively showed that KPMG was intentionally attempting to avoid its legal obligations to disclose information to the IRS. The court found that KPMG falsely claimed in response to the IRS’s summons that its role in the SOS tax shelter was limited to preparing tax returns, when in fact it was involved in marketing and implementing the shelter. The court also found that KPMG had delayed in providing the names of purchasers of SOS in an attempt to allow the statute of limitations to run on the IRS’s claims against those clients.

The court was “most troubled” by evidence that the firm had incorrectly described documents to support “dubious claims” of privilege.⁴¹ In particular, the firm had characterized a number of emails among members of the tax shelter group as involving particularized advice to individual clients when these documents failed to refer to any specific clients at all. The court also criticized KPMG’s attempt to characterize drafts of Brown & Wood opinion letters and email discussions of the business relationship between the firm and R. J. Ruble as involving legal advice to particular clients. The court characterized the opinion letters as “boilerplate that are almost, if not completely, identical except for date, investor name, investor advisor, and dates and amounts of investment transactions.”⁴² According to the court, there was “little indication that these [were] independent opinion letters that reflect[ed] any sort of legal analysis, reasoned or otherwise. In fact, when examined as a group, the letters appear[ed] to be nothing more than an orchestrated extension of KPMG’s marketing machine.”⁴³

As his opinion suggested, Judge Hogan was deeply disturbed that the firm had invoked the privilege—which is intended to protect confidential information shared between clients and their advisors—in a completely inapposite context, in an effort to mislead the government and the court. Even if the underlying shelters were arguably legitimate, KPMG’s attempts to use the privilege to evade disclosure obligations that would reveal its tax activities exposed it to criminal charges for obstruction of justice.

Over the next few months, KPMG continued its efforts to demonstrate to the government and the public that it had turned over a new leaf. In the summer of 2004, Richard Rosenthal, KPMG’s Chief Financial Officer since 2002, and, earlier, vice chair for Tax Services, left the firm. Known for sending emails in red eighteen-point type that instructed the recipient: “you will do this now,” Rosenthal had been a protégé of Stein’s. During his tenure as vice chair, he had overseen the development and marketing of the firm’s most aggressive tax strategies, including SC2.⁴⁴

Notwithstanding KPMG’s efforts to get beyond its shelter activities, every week seemed to bring a new revelation or inquiry. In August 2004, the PSI released another set of exhibits, which added details about the internal apparatus the firm had developed to design and market tax shelters. In a separate development, South Carolina’s Department of Revenue launched an investigation and was threatening to bring disciplinary action against the partners involved in designing and promoting shelters to customers in that state.

The trouble the firm was facing in connection with its shelter activities was not its only legal difficulty; KPMG was also defending itself in a civil case brought by the Securities and Exchange Commission arising out of a $6.1 billion restatement by Xerox Corp, a firm client.⁴⁵ A few months earlier, the firm had been censured by the SEC for improper professional conduct for its audit of Gemstar. Recognizing that its reputation was eroding, KPMG was anxious to resolve all of its outstanding legal problems as quickly as possible and move on. In early 2005, KPMG hired Sven Erik Holmes, former chief federal judge for the Northern District of Oklahoma and earlier a partner in the Washington firm of Williams & Connolly, to assume the newly created position of vice chair for Legal Affairs. The firm brought in Holmes over Claudia Taft, its highest-ranked internal lawyer, emphasizing that it was seeking to “strengthen its legal function.”⁴⁶

After his arrival, Judge Holmes engaged in another round of house cleaning, firing several more high-level partners who were associated with KPMG’s shelter activity.⁴⁷ Richard Smith, the vice chair for Tax Services from 2002 until his “reassignment” in 2004, was dismissed. David Brockway, who had headed the firm’s Washington National Tax (WNT) office since the summer of 1999, and Michael Burke, a managing partner in the firm’s Los Angeles office in the Statecon group, were asked to leave the firm.⁴⁸

The Specter of Indictment

In the spring of 2005, KPMG was engaged in intense negotiations with government officials to stave off an indictment. During discussions, the firm emphasized that it had put its shelter activities behind it. It also underscored the likely collateral consequences of a prosecution. When Arthur Andersen had been indicted in 2002, its clients, worried that a criminal charge would cast doubt on the integrity of the firm’s audits, had fled, leading to the firm’s rapid collapse. After Andersen’s failure, four major accounting firms remained to audit nearly 80 percent of publicly owned companies.⁴⁹ If KPMG was indicted, the firm emphasized, it would most likely dissolve, leaving only three major accounting firms to audit the biggest corporations. Such an outcome would have very serious implications for the financial markets. A minimum number of accounting firms with the necessary expertise and capacity were required to safeguard the quality and independence of audit services. In essence, the Big Four were “too few” for KPMG to be allowed to fail.⁵⁰ O’Kelly, the firm’s chair, participated directly in discussions with the government to make the case for the importance of allowing the firm to survive. He also appealed to Bill McDonough, head of the newly created Public Company Accounting Oversight Board, and Arthur Levitt, former chair of the SEC. Meanwhile, the firm hired a public relations firm and solicited corporate audit clients to assist it in making the case for its central role in providing audit services.

The government was open to the firm’s appeal. During the spring and into the summer, a vigorous debate was occurring inside the Justice Department about whether to indict the firm. On the one hand, the criminal wrongdoing—which encompassed tax fraud and obstruction of justice—was serious. It permeated the firm’s tax services and had been approved at the highest levels of leadership. No one could argue that the wrongful conduct was a product of the actions of one or two rogue partners, or even—as had been the case with Arthur Andersen and Enron—the actions of an audit team captured by a single powerful client. As a federal prosecutor emphasized during negotiations, in contrast to a situation where a company engages in a corrupt action as part of the provision of a legitimate service, “the very service KPMG was providing was corrupt.”⁵¹

On the other hand, if KPMG was indicted, it would most certainly meet the same fate as Arthur Andersen, which would have negative repercussions that rippled through the business world. The reversal of Andersen’s conviction at the end of May 2005 on the grounds of defective jury instructions provided additional fodder for those arguing against indictment. In the Andersen prosecution, the Justice Department had come in for significant criticism for bringing a case that had resulted in the destruction of an important institution and the loss of tens of thousands of jobs. The Department needed to avoid a similar result.

Shortly after the debates inside the Justice Department were reported in the press, KPMG—in a highly unusual move—publicly conceded that it had engaged in wrongdoing in its tax shelter practice. According to the firm, it “took full responsibility for the unlawful conduct by former KPMG partners” and “deeply regret[ed] that it had occurred.”⁵² As commentators observed, the firm’s public statement of responsibility was a significant admission that former clients would be able to use in lawsuits against it. Despite the statement’s implications for the firm’s posture in civil litigation, the firm was making an eleventh-hour attempt to stave off criminal charges.

The firm’s efforts worked—in a sense. The firm was not indicted, although it did not obtain the ideal outcome it desired—an agreement from the government not to prosecute at all. In late August 2005, KPMG entered into a deferred prosecution agreement, under which the firm could still be prosecuted for its tax shelter activities if it failed to comply with the agreement’s terms.⁵³ The firm consented to the filing of a one-count information charging it with conspiracy to commit tax evasion, which would eventually be dismissed if KPMG adhered to all the terms of the deal. The firm acknowledged assisting individuals in tax evasion, engaging in unlawful and fraudulent conduct, actively concealing shelters, and impeding the IRS—activities that were described in a detailed statement of facts to which the firm admitted. FLIP, OPIS, BLIPS, and SOS generated more than $11 billion in artificial tax losses.⁵⁴ As part of the settlement, KPMG agreed to pay a fine of $456,000,000, which represented $128,000,000 in fees earned from the shelters, $228,000,000 in restitution to the government for taxes that had gone unpaid, and $1,000,000 to settle the IRS’s promoter penalty examination. At the time, the fine was by far the largest in connection with an organization’s participation in the tax shelter market.

KPMG’s agreement with the government contemplated that it would make substantial changes in its tax services. KPMG was required to dismantle its tax practice for high-wealth individuals; in effect, it had to disband the Personal Financial Planning group. It was also obligated to implement a firm-wide compliance program under which its professionals would receive appropriate training, violators of the firm’s ethics standards and policies would be punished, and those who reported wrongdoing would be rewarded. To ensure that KPMG abided by the terms of the agreement, Richard C. Breeden, former chair of the SEC, was appointed to monitor the firm’s operations. He would be involved in overseeing the implementation of the deferred prosecution agreement for a period of three years.

One aspect of the firm’s shelter activity went notably unmentioned in the deferred prosecution agreement. Although the firm was apparently willing during negotiations to acknowledge wrongdoing in connection with SC2, in the end, neither that shelter, the Contested Liability Acceleration Strategy (CLAS), nor the other corporate shelters marketed by the L.A.-based Stratecon group were included. The firm had already disbanded Stratecon, and many of its members had left the firm. The IRS ultimately listed SC2 and CLAS, but, at the time of the settlement discussions, the government may have concluded that promoting corporate shelters was not as egregious as marketing shelters to individuals. Alternatively KPMG may have been more adept at keeping Stratecon’s activities out of public view and protecting the partners who were members of the group.

Prosecuting Partners

In mid-August, when KPMG was finalizing the terms of the deferred prosecution agreement with the government, a lengthy anonymous memo, written by five current and former KPMG board members and three former WNT partners, was sent to KPMG’s partners, the Justice Department, and several news outlets. The memo’s authors decried the fact that KPMG was bowing to government pressure not to pay legal fees for individuals under investigation. In addition, the memo contended that because the tax strategies at issue had not been tested in court they could not be the basis of individual criminal liability. Emphasizing that the tax shelters had been vetted at the highest levels in the firm, the authors noted that some leaders had been fired, while others who had had a hand in approving or marketing questionable tax strategies remained at the firm.⁵⁵

As the memo’s authors further underscored, the firm’s organizational culture and incentive structure had given rise to the firm’s tax shelter activities, not the actions of any one or even several individuals. If the firm was responsible for wrongdoing, then all the tax leaders shared in the blame and it was unfair to single out individuals and leave them exposed to criminal liability. Organizational responsibility was inconsistent with leaving specific partners and employees to fend for themselves.

Among the individuals whom the memo identified as having been involved in tax shelter activities, but spared thus far, were James Brasher and John Chopack, the tax partners appointed a year earlier as vice chairs during the first stage of the firm’s house cleaning. Within a day or so after the anonymous memo was circulated, the Wall Street Journal published a story describing Brasher’s and Chopack’s participation in the sale of tax shelters to corporate clients. As a Midwest managing partner, Brasher had urged area partners and managers to intensify their efforts in selling 401(k)Accel, a corporate shelter identified as abusive by the IRS in 2002. Chopack, for his part, had overseen the sales of CLAS, which the IRS listed in 2003.⁵⁶ A month after the article appeared, the firm announced that it had replaced Brasher and Chopack. Brasher took on other, unspecified, duties, while Chopack planned to retire in early 2006.⁵⁷

By the time the memo appeared in mid-August 2005 word was out that some former KPMG partners and employees would be indicted. Many of the thirty individuals originally identified as subjects of the criminal investigation had rejected KPMG’s offer to pay legal fees conditioned on their cooperation and had retained their own lawyers at significant personal expense. In mid-August, the government obtained its first conviction—although not from a former KPMG employee. Domenick DeGiorgio, a bank executive at HVB, pled guilty to conspiracy and tax fraud in connection with KPMG’s promotion of FLIP and OPIS.⁵⁸ After the plea was announced, it was widely assumed that DeGiorgio would provide testimony against individuals involved in designing and marketing those shelters.

Two weeks later, shortly after KPMG had entered into the deferred prosecution agreement, an indictment was handed down against Jeff Stein, John Lanning, Richard Smith, Jeffrey Eischeid, Philip Wiesner, John Larson, Robert Pfaff, R. J. Ruble, the former partner at Sidley Austin Brown & Wood, and Mark Watson. While the first eight individuals had been deeply involved in the firm’s shelter activities, the charges against Watson came as a surprise. As the technical expert in charge of the firm’s review of BLIPS in 1999, he made repeated attempts to prevent the strategy from gaining approval. When he later testified in front of the Permanent Subcommittee on Investigations in 2003, he was forthright about his doubts. Watson’s indictment contributed to a sense shared among observers that the government was being especially aggressive in its handling of the criminal case.

In mid-October 2004, the government filed a superseding indictment that added counts and defendants. In total, nineteen individuals involved in the design, approval, sale, or implementation of FLIP, OPIS, BLIPS, and SOS were charged, including seventeen former KPMG tax partners and managers. The scope of the indictment also covered the defendants’ attempts to mislead the IRS in the firm’s response to the summons. The case was described as the biggest tax prosecution in history. Notably, as in the case of the deferred prosecution agreement, none of the firm’s corporate tax shelter activities were involved.

Over the next few months, lawyers for the defense pooled information, shared strategies, and filed a slew of motions together and separately that challenged different aspects of the case. In late fall of 2005, Ron DePetris and Marion Bachrach, who represented Wiesner, the former WNT head, came up with the idea of fighting the indictment on the grounds that the government had pressured KPMG into withholding legal fees from the KPMG defendants in violation of their right to counsel. The idea seemed far-fetched. Applicable precedents in the criminal constitutional context define a narrow zone around state action so that the conduct of private entities cannot be easily imputed to the government. Case law also sets a very high bar for finding that a private entity’s actions were involuntary and therefore the direct product of state pressure. The law is well established that the government can make all types of threats to induce defendants to waive their rights without those threats rendering the waiver involuntary.

In the KPMG context, this meant that no matter how much pressure the government put on KPMG to stop advancing fees, ultimately the decision was the firm’s and was not attributable to the state for purposes of finding a violation of the defendants’ right to counsel. Although DePetris and Bachrach’s motion to dismiss was a long shot, the other defense lawyers signed on. Their clients had nothing to lose. One KPMG defendant, David Rivkin, who had been part of the BLIPS sales team, pled guilty, presumably to put the ordeal and expense of defending himself behind him and receiving lenient treatment if his testimony was helpful to the government.

In response to the KPMG defendants’ argument that prosecutors had interfered with their right to counsel, the government’s strategy was to insist that the decision to withhold legal fees had been solely the firm’s, and that the government had not applied pressure on KPMG. In one memorandum, the government represented that the decision “was KPMG’s decision alone” and added, for good measure, that “the defendants have not—and indeed cannot—point to any evidence supporting their spurious claims that the United States ‘coerc[ed]’ or ‘bull[ied]’ KPMG into its making its decision to limit the advancement of fees.” In a sworn statement, Assistant U.S. Attorney Justin Weddle further declared that “we [did] not instruct or request KPMG to change its decision about paying fees, capping the payment of fees, or conditioning of fees on an employee’s or partner’s cooperation.”⁵⁹

When it became clear that the two sides had wholly divergent accounts of the facts, Judge Lewis Kaplan, who was presiding over the case, ordered a hearing. As the testimony and exhibits established conclusively, the government had insisted repeatedly that KPMG not pay the fees of employees and partners who refused to cooperate. Copious amounts of evidence showed that the government had been explicit in its view that the firm’s payment of attorneys’ fees was a factor in the government’s assessment of the extent of its cooperation. The prosecution’s contrary statements, made under oath to the court, were simply false.

Judge Kaplan was incensed. In a lengthy decision issued in late June 2006, he described in detail the government’s successful attempts to prevent KPMG from advancing its employees’ fees and the government’s subsequent efforts to mislead the court. The court held that the government’s actions had interfered with the fairness of the proceedings and had violated the defendants’ right to counsel. Recognizing that dismissing the indictment was an extreme sanction, the court attempted to fashion a remedy short of dismissal under which KPMG would be compelled to advance the defendants’ fees. If the court held that KPMG had a contractual obligation to pay attorneys’ fees, this would also redress KPMG’s wrongful actions against its former employees and allow the case to go forward. Even if KPMG’s actions were the result of government pressure, it was ultimately the firm that had thrown its employees under the bus. When the district court attempted to resolve the question of whether KPMG was contractually required to pay the defendants’ attorneys’ fees, however, the Court of Appeals reversed the decision.⁶⁰ It held that the issue was beyond the district court’s jurisdiction, which was limited to the criminal case. Ultimately, the only remedy available to the court to address the government’s violation of the KPMG defendants’ constitutional rights was dismissal of the indictment involving the thirteen KPMG defendants.⁶¹ In August 2008, the Court of Appeals for the Second Circuit affirmed the district court’s decision.⁶²

Because of the government’s overreaching, the biggest tax prosecution in United States history was reduced to a case against five individuals who had not been the driving force behind the firm’s tax shelter activities. The remaining defendants were Larson and Pfaff, who had left KPMG to form Presidio in 1997; Amir Makov, the partner they brought on; R. J. Ruble, the outside lawyer who provided opinion letters; and a rogue KPMG partner in the L.A. office who had been terminated from the firm before discussions with the government had commenced.

In 2008, after a ten-week trial, Larson, Pfaff, and Ruble were found guilty. Makov, who had pled guilty in August 2007, offered compelling testimony against his former partners at Presidio. The evidence against the fifth defendant was weaker, and the jury acquitted him. Larson, Pfaff, and Ruble unsuccessfully appealed both to the Court of Appeals for the Second Circuit and to the Supreme Court. Larson received a ten-year prison sentence, Pfaff a nearly eight-year sentence, and Ruble a six-and-a-half-year sentence, which they were serving as of 2013.

The prosecution and conviction of individuals in connection with KPMG’s involvement in abusive tax shelters—which was premised on the claim that each individual was aware that the shelters were fraudulent but promoted them anyway—was profoundly at odds with the organizational dimensions of the wrongdoing. At the firm, tax leaders implemented an incentive and reporting structure that valorized tax shelter development and sales. With increased competition in other areas in which accounting firms provide services, KPMG, like other firms, was eager to find a new source of revenue. Tax shelters, which could be sold on a value-added basis, seemed to be the solution. The focus on tax shelters created incentives to work on them. As tax leaders subtly and not so subtly communicated, promotion and career advancement were premised on involvement in the tax shelter work. In contrast, those who declined to work on shelters or raised issues about their propriety were sidelined and suffered negative career repercussions. In addition, the importance assigned tax shelter activity gave it the allure of a cutting-edge practice. For members of the tax shelter team, it must have been exciting to be among a select group chosen to participate.

As the approval process for BLIPS, described in chapter 5, suggests, the highly specialized division of expertise within the tax practice made it difficult for any one professional to grasp the centrality of economic substance in determining whether a shelter would be upheld by a court. Economic substance became a formal requirement like any other and was therefore treated technically. As a consequence, satisfying the requirement became one of technique—searching for some possible scenario in which a taxpayer might have a business reason to engage in the strategy, rather than ascertaining the economic reality that underlay the strategies they were promoting. Once evidence emerged that belied the claim that the strategies had economic substance, the momentum behind bringing the strategies to market made it very difficult to change course.

In addition, the centralized reporting structure of the firm was at odds with the idea that a core professional ideal is independent of individualized, discretionary judgment. The result was that assigning responsibility for any one decision was often difficult. Here too the BLIPS approval process is illuminating. Mark Watson, a junior partner at WNT, was assigned the task of shepherding the product through the approval process. So his judgment as a professional should have been deferred to. The reporting structure, however, made it difficult for Watson to exercise independent judgment. From the very beginning, he was under constant pressure from senior tax leaders to approve the shelters. The blending of business-generating and compliance functions up the reporting ladder to the chair of the tax practice made it impossible to separate questions of professionalism and ethics from the question of profitability. The organizational factors that shaped decision making at the firm made the assignment of responsibility to one or a handful of firm members very difficult.

Jenkens & Gilchrist

In the Crosshairs

When the IRS began to review information gathering disclosed from taxpayers in 2002 in response to the agency’s amnesty offer, the name of Jenkens & Gilchrist began to appear more and more frequently. On May 21, 2002, the IRS issued twenty-two administrative summonses to the firm. The IRS requested documents and records from Jenkens to determine if it had complied with registration and list maintenance requirements with respect to certain listed or potentially abusive transactions. After reviewing its files, Jenkens concluded that 607 of the 700 client files were responsive to the summonses. The firm nevertheless refused to produce any of this material on the grounds that it was protected by the attorney-client privilege.

In the face of this resistance, the government in June 2003 took the highly unusual step of obtaining court permission to serve a John Doe summons on Jenkens to obtain the names of investors who engaged in particular transactions from January 1998 through June 15, 2003.⁶³ The Justice Department, the Treasury Department, and the IRS called a joint press conference to announce “the first-time issuance of a summons for the primary purpose of obtaining the identities of the investors in a technical tax shelter the IRS determined is abusive.”⁶⁴ IRS Chief Counsel B. John Williams told reporters that the IRS would consider seeking John Doe summonses to preserve the statute of limitations for investors. “We will not allow investors and promoters to use stalling tactics to circumvent our compliance efforts,” he emphasized.⁶⁵

According to the IRS, the Jenkens investigation found that the firm’s shelter activities involved, by a “conservative estimate,” $2.4 billion in reported tax losses that should have been reported as taxable gains by 600 taxpayers.⁶⁶ The agency maintained that the attorney-client privilege did not apply to the information sought because the firm was acting as a promoter of the shelters, rather than serving as an attorney to the investors. Jenkens announced that it would not comply with the John Doe summons on the grounds that the privilege applied. “It has long been the law of this country that Americans have a right to consult with an attorney in confidence,” a statement from the firm said, “and only the clients themselves can waive that right.”⁶⁷

Shortly thereafter the Justice Department petitioned the court to enforce five of the twenty-one promoter summonses and the John Doe summons. It pointed out that the Jenkens agreement with taxpayers participating in tax shelters provided that that the taxpayer and the firm “are acting solely as independent contracting parties, and neither party shall be deemed to be the agent or fiduciary of the other.”⁶⁸ The Department emphasized further that even in an attorney-client relationship, the identity of the client is not privileged, except in the rare instance in which revealing the client’s identity is tantamount to disclosing a confidential communication.

On April 20, 2004, the court held that the privilege did not protect the identities of Jenkens & Gilchrist’s clients.⁶⁹ As the court noted, only five days earlier another federal district court in Chicago had reached the same conclusion with respect to Sidley Austin Brown & Wood’s refusal to disclose the names of former clients in response to another John Doe summons by the IRS. On May 13, the court rejected the firm’s other claim that the terms of the summonses were unduly ambiguous and ordered Jenkens to comply.⁷⁰ Four days later, Jenkens turned over a list of investor names to the IRS.

Meanwhile, investor lawsuits and the IRS investigation had begun to take their toll. The firm went from more than 625 lawyers in 2001 to about 460 by early 2004. William Durbin was reelected to a third term as chair of the firm at the beginning of 2004, despite significant opposition from many partners who felt he focused too narrowly on the bottom line. There was considerable unhappiness at his reelection, with some partners threatening to leave if Durbin were not replaced as chairman. Just weeks after his election, Durbin stepped down. “It was time for a change,” he said. “I had initiated a lot of change within the firm that necessarily was resisted, or understandably was resisted by some.”⁷¹ Thomas Cantrill, a veteran partner who had been chair for three and a half years in the 1980s, took over. The exodus continued, however. With the departure of the firm’s employee benefits practice group in the fall of that year, the firm felt it had no choice but to stop returning capital to partners who left.

The most significant investor lawsuit against Jenkens was the Denney consolidated class action in Manhattan. The suit had begun as an action filed against the firm and Ernst & Young in December 2002 by Camferdam and other COBRA investors, and eventually included 1,100 class members who had invested in various shelters. Negotiations began in November 2003 between Jenkens and David Deary, a Dallas lawyer representing the plaintiffs. The two sides negotiated during three separate sessions over the course of several days from December 2003 until early March 2004, with retired Fifth Circuit Judge Robert Parker serving as mediator. The negotiations were conducted against a backdrop of concern that the firm would go under before a settlement could be reached. Complicating matters was the resistance of Jenkens’s primary insurance carrier, Executive Risk Indemnity, Inc., to covering any liability to the plaintiffs. In March 2004, the parties finally agreed to a settlement of $75 million. Jenkens would be responsible for $5.25 million; Daugerdas, Mayer, and Guerin for $6.25 million, and the firm’s insurers would pay the rest.⁷²

After conducting additional informal discovery as part of evaluating the settlement, however, plaintiffs’ counsel insisted on an increase in the settlement amount. In addition, more than one hundred class members indicated their intention to reject the settlement and opt out of the class. This left Jenkens vulnerable to claims that could total tens of millions of dollars because the settlement had been conditioned on the firm providing a release to its insurers of any further responsibility. Jenkens had conditioned the settlement on the participation of all the plaintiffs. The firm threatened to sue its insurers if the firm went under. Eventually, the insurers agreed to provide an additional $25 million to cover any liabilities to plaintiffs who chose to opt out of the class.

In December 2004 the parties reached a final settlement, with Jenkens dropping its condition that all plaintiffs participate. The terms called for payment of $81.55 million to the plaintiff class. Jenkens, Daugerdas, Mayer, and Guerin were responsible for about $11.5 million of this and the firm’s insurers for the rest. About 92 percent of the class members agreed to the terms, leaving some eighty-eight opt-out plaintiffs remaining. The court approved the settlement in February 2005.⁷³ With this litigation resolved, Jenkens chair Cantrill declared, “We are looking forward to putting this matter behind us and moving forward in a positive and successful direction in 2005.”⁷⁴

Cantrill hoped to put an optimistic face on the settlement, but the underlying reality was much bleaker. As the firm’s settlement memo suggested, the sheer number and size of the lawsuits pending against Jenkens “[had] driven the firm to the brink.”⁷⁵ As a result, “J&G’s leaders [had to] spend much of their time addressing substantial and unusual competitive and business pressures on the firm’s lawyers, business, and profits,”⁷⁶ and “[c]ompetitors continued to use the firm’s tax-case problems to try to lure away productive shareholders, associates, and clients.”⁷⁷ In the last two years, the firm had lost over 200 of its 600 lawyers. In March 2005, the firm suffered a significant additional loss with the departure of ninety-one lawyers in its New York office to Troutman Sanders.

The End of the Road

In January 2006 the New York Times reported that the U.S. Attorney’s Office in Manhattan had impaneled a grand jury to investigate Jenkens & Gilchrist’s tax shelter activity.⁷⁸ Leaders of the firm assumed that the focus was on Daugerdas, Mayer, and Guerin, but prosecutors would not rule out the firm as a target. They talked to the firm’s board members and issued subpoenas to reinforce the perception that the firm might be subject to indictment. At the same time, they pushed hard for cooperation from the firm in investigating the individual lawyers. Firm management figured that the Justice Department needed to decide what to do by October 2006 to avoid having the six-year statute of limitations run on claims from 1999. It asked members of the firm to hold on until then because there was likely to be clarity by that point.

By 2006, the firm was down to 144 lawyers, compared to the 600 or so it had had in 2001. Management had done its best to keep the firm together in hopes of surviving but also to protect employees by effecting an orderly dissolution if need be. Firm leaders’ approach to the Justice Department up to that point had been that the Department should not issue an indictment or take any other actions that would bring the entire firm down. Eventually, when prosecutors were unresponsive to requests for more clarity about the status of the investigation, Jenkens management told the government that the firm had no choice but to shut down. A template for an orderly dissolution was the departure of the New York office: when all its lawyers left the firm to join Troutman Sanders, the latter assumed the lease obligation for the office space.

Jenkens management did its best to keep partners from leaving immediately so that the firm could effect an orderly wind-up that involved finding people jobs elsewhere. Management tried to move offices in entire groups so that lease obligations could continue to be met. Firm chair Pat Mitchell told wavering partners that they had an obligation to the employees who had stuck with the firm rather than triggering a chaotic dissolution by jumping ship. “We’re not going to survive,” he emphasized, “but let’s die well.” In relatively short order, Jenkens lawyers in Houston, Los Angeles, Chicago, and San Antonio left for other firms. Eventually, almost a hundred lawyers went to Hunton & Williams, mostly in Dallas but also in Austin. About 95 percent of both lawyers and nonlawyers found jobs. The firm collected about 90 percent of its receivables—a high amount considering that clients knew that the firm was going under.

As negotiations proceeded, the firm brought the IRS in so that it could resolve both outstanding matters with the government. The end came swiftly. On March 29, 2007, the U.S. Attorney’s Office announced that it had entered into a non-prosecution agreement with Jenkens & Gilchrist, under which the firm admitted that it had developed and marketed fraudulent tax shelters and that it had issued fraudulent opinion letters.⁷⁹ As the U.S. Attorney explained, the government’s decision to enter into the agreement was based on these admissions by the firm, as well as the firm’s “inability to continue practicing law as a firm”; its cooperation with the prosecutor’s investigation of the tax shelter activities of the firm and its lawyers; and the firm’s entry into a settlement with the IRS.⁸⁰

According to the statement Jenkens & Gilchrist issued in connection with the agreement,

We believe that certain J&G attorneys developed and marketed fraudulent tax shelters, with fraudulent tax opinions, that wrongly deprived the US Treasury of significant tax revenues. The firm’s tax shelter practice was spearheaded by tax practitioners in J&G’s Chicago office who are no longer with the firm. Those responsible for overseeing the Chicago tax practice placed unwarranted trust in the judgment and integrity of the attorneys principally responsible for that practice, and failed to exercise effective oversight and control over the firm’s tax shelter practice. Our prior support for the opinions adversely affected the efforts of the IRS to assess and collect tax revenues. We deeply regret our involvement in this tax practice, and the serious harm it caused to the United States Treasury.⁸¹

That same day, the IRS announced that it had reached a settlement with Jenkens under which the firm agreed that it was subject to a $76 million penalty due to “the firm’s promotion of abusive and fraudulent tax shelters and violation of the tax law concerning tax shelter registration and maintenance and turnover to the IRS of tax shelter investor lists.”⁸² The agency estimated that 1,400 investors received advice from Jenkens and would owe interest and penalties for underpayment of tax. What had been the fastest growing law firm in the country nine years earlier was now out of business.

At the time of the dissolution, Henry Gilchrest, retired from the firm, was in his late seventies. A courtly southern gentleman, he had founded the firm on traditional values of providing expert advice to long-term clients and had sought to maintain a reputation for professional integrity and high standards. Now the firm that bore his name was associated with one of the biggest tax shelter scandals in U.S. history.

In June 2009, Daugerdas, Mayer, and Guerin were indicted in connection with their tax shelter activities. Former BDO officials Denis Field and Robert Greisman and Deutsche Bank employees Raymond Brubaker and David Parse were also charged.⁸³ The shelters named in the indictment included Treasury Short Sales, Short Options Strategy and others known under the names Swaps and HOMER.

Greisman and Mayer entered guilty pleas a year apart. Both admitted that they knew that the shelters they promoted had no reasonable possibility of making a profit because, among other reasons, the costs and fees for most of the transactions exceeded the potential profit, if any.⁸⁴ As part of his agreement, Mayer forfeited his two residences and more than $10 million.

Mayer was a key witness at the trial of the remaining defendants. He admitted that the opinion letters of Daugerdas’s group all used the same template and falsely described the representations that clients ostensibly made about the reasons for entering into transactions, for engaging in trading activity, for transferring assets to partnerships and other entities, and for closing out the transactions. In addition, no client had ever articulated a nontax reason for participating in a shelter. At the time he was working on the shelters Mayer was aware that they would not be upheld under the tax law. He continued to work on them, he acknowledged, because of the enormous fees they generated. During Mayer’s testimony, the prosecution asked whether Daugerdas had ever discussed his status as a taxpayer. Mayer responded that on several occasions Daugerdas had mentioned that he was briefly a taxpayer for a few years in the early 1990s.⁸⁵

Daugerdas, Guerin, Field, and Parse were found guilty on multiple counts of tax evasion and endeavoring to obstruct and impede the internal revenue laws. Brubaker was acquitted of all the charges against him. The convictions of Daugerdas, Guerin, and Field were vacated a little over a year later on grounds of juror misconduct.⁸⁶ In September 2012 Donna Guerin pled guilty to one count of conspiracy and one count of tax evasion, each of which carried a maximum sentence of five years. She also agreed to forfeit $1.6 million as part of her plea agreement. Daugerdas and Field were retried in the fall of 2013. While Field was acquitted, Daugerdas was convicted on several counts of tax evasion, conspiracy, and mail fraud. As of December 2013, he was awaiting sentencing.

Jenkens & Gilchrist’s is the story of a regional firm with national ambitions, which sought to use Paul Daugerdas to make the leap to premium billing without the need to provide customized high-end legal services. It was an aggressive firm that had grown rapidly by acquiring profitable laterals and it believed that it had learned how to manage the risks associated with them. As long as there was at least colorable legal support for Daugerdas’s tax shelters, Jenkens management saw the decision as involving a business judgment about whether the rewards were worth the risk. The firm concluded they were. A major surge in tax shelter activity boosted the firm’s revenues by a staggering amount and seemed to vindicate that conclusion. That same surge, however, prompted an ambitious enforcement campaign by the government that dramatically raised the stakes and eventually led to the collapse of the firm.

Jenkens & Gilchrist had lawyers responsible for ethics issues who conducted considerable training within the firm. It had a deliberative process in place that allowed opponents of hiring Paul Daugerdas to make their case at the highest level of the firm. It had a policy of requiring a second opinion on firm legal opinions that it adapted for use in monitoring Daugerdas’s tax shelters. These measures reflect the laudable trend in recent years for law firms to establish a more sophisticated “ethical infrastructure,”⁸⁷ but they turned out to be inadequate to address the risks presented by Daugerdas’s tax shelter practice.

The Jenkens story illustrates how organizational culture shapes the deliberations that occur within a firm’s infrastructure. Culture influences whether decisions are framed as involving business risks or ethical choices, the assessment of the nature and magnitude of risks, and the determination of how well the firm can manage the risks that it assumes. Culture also determines the extent to which financial considerations subtly influence deliberation on these issues. Ultimately, at a crucial point in the history of the firm, the Jenkens culture fell short.