A U.S. appeals court told the judge overseeing the KPMG tax shelter cause that if he believes federal prosecutors violated the rights of former KPMG employees he should toss the entire case.

Judge Lewis Kaplan, who is overseeing the case in New York, has been outspoken in his belief that prosecutors may have crossed the line in pressuring KPMG to stop paying the legal fees of the 17 former employees of the Big Four firm who are facing conspiracy and tax evasion charges over the sale of legally questionable tax shelters.

But the 2nd U.S. Circuit Court of Appeals said that Kaplan was wrong in encouraging 16 of the people indicted in the case to file civil breach of contract claims against KPMG to force it to pay their legal expenses. (One indictee has already pleaded guilty.) Last summer, Kaplan said that the government violated the constitutional rights of the former KPMG employees by threatening the company with indictment if it continued to pay the fees.

In a footnote, the appeals court disputed whether or not KPMG had a “uniform practice” of paying legal fees for indicted employees -- pointing to a single 1974 trial in which KPMG paid the legal fees of two partners indicted and convicted in a criminal case. The appeals court also noted that most of the former KPMG workers signed fee letters acknowledging that KPMG would not pay post-indictment fees.

The wrangle over legal fees has put a hold on the progress of the criminal case, which sprang from a government investigation of what it described as a tax shelter fraud that helped the wealthy escape $2.5 billion in U.S. taxes. KPMG avoided criminal prosecution by agreeing to cooperate with the government and pay a $456 million fine.

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