Deferred prosecution agreements: implications for corporate tax departments.

• Author: Michel, Scott D.

Tax enforcement is back in vogue. In the past few years, the Internal Revenue Service has dramatically ramped up its compliance functions. The budget for tax enforcement has increased, additional agents are on board, and the tax community is witnessing an increase in examination, tax litigation, and criminal investigation activity. The IRS has become more aggressive in pursuing companies, law firms, and accounting firms through the examination and summons processes. (1) The agency is also coordinating efforts more closely with the Department of Justice and the invigorated Office of Professional Responsibility. Thus, potential consequences are more serious than ever for companies and corporate tax departments that have failed to adhere to the tax laws.

This enhanced focus on tax compliance is, in part, an outgrowth of corporate scandals such as Enron and WorldCom, which led to reforms such as the Sarbanes-Oxley Act of 2002 (2) and several enforcement provisions in the American Jobs Creation Act of 2004. (3) The reform movement has prompted companies to re-examine, strengthen, and enforce internal control mechanisms and similar procedures. Meanwhile, the Department of Justice has vigorously pursued individuals and corporations alleged to operate outside of the law.

Most recently, the government has devoted substantial attention to tax shelter abuses, and the most prominent such case arises from the New York grand jury investigation into shelters promoted by the accounting firm KPMG and others. This investigation remains ongoing, but in recent months it has produced two related events. One is the indictment of 19 individuals, most of them former senior personnel at KPMG. The other was the decision by the Justice Department not to indict KPMG as a firm, as it had done in an Enron-related case involving Arthur Andersen, but instead to enter into, with KPMG, a deferred prosecution agreement (DPA). Pursuant to this DPA, the government filed a criminal charge against the firm and KPMG admitted extensive wrongdoing, but the Justice Department agreed to "defer" prosecution of the case and to dismiss the charge if KPMG pays specified stiff penalties and implements certain new reforms and enhanced standards.

DPAs have been around for many years, and the Justice Department is using deferred prosecution increasingly to dispose of complex corporate criminal investigations. In tax investigations, however, DPAs have been rare, and while the KPMG agreement has many features common to other DPAs, it contains other provisions unique to tax enforcement. Given these developments, both the concept of deferred prosecution and the KPMG agreement itself warrant further examination.

This article focuses on the implications these DPA arrangements may have for corporations and corporate tax executives. After a background discussion concerning corporate criminal matters and the wide latitude given federal prosecutors in dealing with entities, the article discusses (1) the general nature of DPAs and how they work as a matter of process and practice, (2) the specific provisions of the KPMG DPA, and (3) the ways a DPA might affect a company's tax department and its tax officials.

Background

The implications for company tax departments of enhanced law enforcement attention on corporate wrongdoing has been previously discussed in The Tax Executive. (4) In a nutshell, the government technically can prosecute entities as a whole if a director, officer, or employee engages in criminal conduct in the scope of their employment and the entity benefits from such actions. (5) In nearly every corporate criminal investigation, tax or otherwise, where even a single employee has engaged in wrongful conduct, the government can usually amass sufficient evidence to meet this low threshold and, if the prosecutor so chooses, to indict the company as a whole.

Accordingly, in many such investigations, the issue often is not whether the company technically broke the law, but rather whether, in the sound exercise of prosecutorial discretion, the government should charge the company with a crime or dispose of the case by other means. Generally, prosecutors have the option (1) to decline criminal prosecution altogether, (2) to enter into plea negotiations with the company, (3) to pursue a criminal charge against the entity through a trial and either conviction or acquittal, or (4) to enter into a deferred prosecution arrangement. Short of a declination, a DPA is often an acceptable alternative to criminal prosecution, which can lead to devastating results, as occurred the Andersen case.

The Justice Department has published the criteria it uses in evaluating its options in a corporate criminal investigation. (6) In what has become known simply as the "Thompson Memorandum," named after the issuing Deputy Attorney General, the Department outlined the following primary factors:

1. The nature and seriousness of the offense;

2. The pervasiveness of wrongdoing within the corporation;

3. The corporation's history of misconduct;

4. The corporation's timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation;

5. The existence and adequacy of the corporation's compliance program;

6. The corporation's remedial actions, including disciplining or terminating wrongdoers;

7. Collateral consequences;

8. The adequacy of the prosecution of individuals for the corporation's malfeasance; and

9. The adequacy of civil or regulatory remedies against the corporation. (7)

The Thompson Memo explicitly recognizes deferred prosecution as an alternative disposition for corporate criminal investigations. It has also clearly affected both corporate and governmental responses to allegations of criminal wrongdoing--no major corporation caught engaging in accounting or securities fraud has been convicted of a crime since the fall of Andersen in June 2002, (8) and federal prosecutors have entered into twice as many DPAs with major American corporations in the last four years (23 agreements between 2002 to 2005) than they have in the previous 10 years (11, between 1992 to 2001). (9)

KPMG, notwithstanding its admission that the firm promoted a multi-billion criminal tax fraud, apparently presented a strong enough case on these factors to persuade senior Justice Department officials to enter into a DPA rather than pursue a felony conviction of the firm. Aside from the firm's extensive cooperation in the investigation (which provided much of the evidence leading to the indictment of its former personnel), its payment of more than $450 million in fines and penalties, and its implementation of major reforms, a prime rationale for a DPA was undoubtedly the prospect of the firm suffering an Andersen-like fate, with the result that only three major worldwide accounting firms would remain. (10)

What Is a Deferred Prosecution Agreement?

Fundamentally, a DPA is a contract between the government and a defendant, executed contemporaneously with the government's filing of a criminal charge alleging that the defendant has committed one or more federal crimes. Notwithstanding the filing of this charge, the government agrees to "defer" its prosecution of the charge through pre-trial and trial proceedings if the defendant adheres to various obligations outlined in the DPA. If the defendant satisfies the provisions of the DPA, at the conclusion of a specified term the government will move to dismiss the charge, leaving the defendant without a criminal record. In...