Risk Management

Deferring that Day in Court

Corporate wrongdoers are showing a heightened interest in putting off prosecution.
Helen ShawMarch 24, 2006

Last August, when KPMG entered into a deferred prosecution agreement with the Justice Department, representatives of both parties might well have had the specter of Arthur Andersen on their minds.

For their part, prosecutors were wary of pursuing a full conviction of the firm for selling fraudulent tax shelters. A massive verdict against KPMG could, after all, spawn Andersen-like effects, bringing the company down and leaving thousands jobless and the corporate world with one less major auditor to choose from. While the deferred prosecution agreement (DPA) “requires KPMG to accept responsibility and make amends for its criminal conduct,” U.S. Attorney General Alberto Gonzales said at the time, it still protects “innocent workers and others from the consequences of a conviction.”

Under its DPA, the Big Four firm paid $456 million, and was given until the end of 2006 to boost its control environment. To be sure, by entering into the pact, the accounting heavyweight admitted to wrongdoing. In return, it was given some breathing room to clean up its act and possibly avoid prosecution. (KPMG had not provided a comment as of presstime.)

Andersen, whose troubles arose in the days before DPAs were on offer, felt the effects of its prosecution in non-legal ways. Notably, the firm failed after it was indicted and before a verdict was rendered because clients didn’t want their financial statements or tax returns tainted by the firm’s reputation. “It was the perception that killed Arthur Andersen,” said Bill Smith, director of the national tax office at CBIZ Inc., an accounting and tax services company. For the same reason, KPMG had no option but to accept the agreement and try to avoid prosecution “if it wanted to exist as KPMG.”

Overall, interest in DPAs has grown with the stepped-up focus on nabbing corporate criminals. Since the creation of President Bush’s Corporate Fraud Taskforce in 2002—which snared KPMG—the federal government has focused on enforcement against financial crimes, observers note.

Indeed, the DOJ has entered into an estimated 20 to 25 DPAs since 2002. One of the first DPAs involved Computer Associates International Inc. Once a software-industry darling, CA brokered a deal in 2002 after federal regulators charged some of its top executives with a $3.3 billion fraud in 1998. The company continues to labor under the DPA as it tries to improve itself, according to “Race to Reform,” a story in the January issue of CFO.

An investigation into a company typically starts at an agency like the Internal Revenue Service or the Securities and Exchange Commission. A company charged with criminal conduct faces four possible outcomes: no prosecution, a non-prosecution agreement (in which the prosecutor agrees not to go ahead with a case in exchange for such things as fines and governance changes), a DPA, and full prosecution.

Under a DPA, the DOJ agrees to defer prosecution of the case and dismiss the charges upon completion of satisfactory reforms. Usually those reforms proceed under the watchful gaze of an independent overseer and the pressure of a government-imposed deadline.

Prosecutors usually require companies to reform the conditions that produced the problems in the first place, like the tightening of lax accounting controls or the improvement of poor board oversight, says David Pitofsky, a partner in the New York office of law firm Goodwin Procter and a former federal prosecutor involved in the Computer Associates case. The appointed overseer—usually a former judge, prosecutor, or SEC attorney—presents conclusions on the company’s compliance with the DPA to the court and prosecutors.

Companies do have a choice about whether to accept a DPA, and not all of those under investigation would welcome one. “If a company’s misconduct is severe and its effort to reform meager, the company would be very pleased to be offered a DPA,” says Pitofsky. “But if misconduct was slight and its effort to reform great, it would consider a DPA to be a very unfortunate result.”

To gauge whether a DPA is the right way to go, senior managers should assess what the collateral damage will be—ranging from the financial consequences to the reputational risk—
if indictments are handed down, attorneys advise. Further, executives must consider the expense of defending criminal charges against the company in court and weigh the chances of success against the possibility of penalties.

From the standpoint of preserving a company’s good name, signing on to a DPA can be a boon or a bane. “From a public relations perspective, it shows the company has taken responsibility, cooperated with authorities, and is doing the right thing,” says Michel. “A company that is indicted and faces the prospect of a trial is in a more adversarial position with the government and faces potentially more dangerous consequences.”

On the other hand, an admission of wrongdoing could create reputation problems of its own, as well as the possibility that government entities would terminate contracts with a company, according to Pitofsky.

There are other downsides. The usual one-to-three-year probationary period can prove painful, replete with drops in share price, access to capital markets, and ability to recruit employees and board members, according to Pitofsky. “The black cloud over the company causes a substantial drag,” says Pitofsky,.

On the bright side, however, is the chance for some spring cleaning. Some managements “are finding that it can be difficult to reform a mature company that has problems, and the deferred prosecution agreement gives the company the motivation to clean itself up,” the lawyer observes.