Accounting for Crime

By Reynolds Holding

Accounting, I admit, is not the normal stuff of true-crime drama. But among accused finaglers walking perplike into court, former bean counters at accounting firm KPMG have more cause than most to question White House tactics against financial fraud.

The crime the accountants stand accused of is peddling iffy tax shelters, arcane financial deals that shield income from the IRS. Shelters are O.K. if they serve a true business purpose, and the KPMG gang insisted that its did. Yet over the past four years, the accountants have taken a prosecutorial beating. A Senate subcommittee publicly grilled them. The Justice Department suggested they blab without their lawyers present. KPMG, bending to government pressure, stopped covering its employees' crushing legal bills. And all this happened before any court ruled the tax shelters improper.

It has made the Bush Administration look tough on financial fraud. The accountants seem headed for criminal trials, and KPMG coughed up $456 million to settle separately with the government. Yet just when we're prepared to be impressed, the White House pulls a U-turn.

On Feb. 9, the chief accountant for the Securities and Exchange Commission (SEC) said the agency was considering how to shield accounting firms from civil litigation because--get this--the Administration doesn't want the Big Four firms to become the Big Three. So, on the one hand, the Justice Department is squeezing KPMG and its former employees within an inch of their professional lives. On the other hand, the SEC is pushing for limits on lawsuits that might hurt firms like KPMG. Talk about mixed messages.

Assuming that the White House isn't just confused, its behavior amounts to policing the financial world through criminal prosecutions rather than lawsuits filed by shareholders. Could that work?

Joseph Grundfest, a Stanford Law School professor, attributes a recent drop in shareholder lawsuits to aggressive government enforcement following the Enron fraud. But others say Grundfest discounts more likely causes: a relatively steady stock market and the criminal investigation of the law firm that files most shareholder suits. And even if he's right, a strategy of criminal prosecution is still a bad idea.

Consider KPMG. From 1997 to 2001, the firm sold four types of shelters that helped clients avoid taxes by doing things like putting income temporarily in a tax-exempt entity. The transactions were so complex, it was hard to see a purpose other than skirting taxes. Although the IRS ruled them potentially improper in 2000, experts disagreed about their legality.

In any event, KPMG's reluctance to let regulators inspect backup documents pushed the feds' buttons. By 2004, Justice had launched a criminal investigation. A federal indictment helped kill Enron's auditor, Arthur Andersen, in 2002, so KPMG tried to avoid indictment by doing pretty much whatever the government wanted. That included cutting off the payment of legal fees for indicted employees. The groveling worked for KPMG, which dodged indictment, but not for the 16 indicted employees, who couldn't afford their lawyers. A New York federal judge ruled that they could sue KPMG for their legal bills (KPMG has appealed the ruling) and slammed the prosecution for denying them the right to counsel: "The government ... has let its zeal get in the way of its judgment. It has violated the Constitution it is sworn to defend."

Unfortunately, government "zeal" infects a lot of prosecutions for financial wrongdoing. Threats of prison give prosecutors enormous leverage, says Larry Ribstein, a law professor at the Uni- versity of Illinois, and they don't shy from using it in cases involving "common business practices" like structuring tax shelters, in which "the line between merely wrong and criminal interpretations of the tax code are hazy." And if a crime occurred, "you need to know who up the line had responsibility," he says, "and that is extraordinarily difficult to determine in the context of a large corporation." Especially in a criminal case, in which witnesses can plead the Fifth rather than incriminate themselves with explanations.

In lawsuits, pretrial discovery eases the job of determining what went wrong, who bears responsibility--and how to prevent future misconduct. Besides, the government can file relatively few cases, while private shareholders can sue a swindler whenever they feel wronged. Egregious misconduct may merit jail, but if the Administration is serious about keeping fraud in check, it won't rely on criminal cases to get the message out.

And accounting firms? Sarbanes-Oxley, the 2002 antifraud law, gave them a windfall by putting them in the business of reviewing financial-reporting policies. With the Big Four now making record profits, their story reads more like the rich get richer than true-crime drama.