It was a deal years in the making, though industry observers say that it didn't have to be.In striking an agreement to escape a potentially fatal criminal indictment for its sale of legally questionable tax shelters from 1996 to 2002, KPMG will pay a $456 million fine to the federal government and essentially spend the next 16 months on probation. The firm has also agreed to close its tax business for high-net-worth individuals within six months.

Experts agreed that it was a reasonable price for the firm to pay, compared to the alternative - an across-the-board prohibition from working with public clients if it were found guilty.

As part of the deferred prosecution agreement, the charges will be dismissed on Dec. 31, 2006, if KPMG lives up to the terms outlined by the U.S. Attorney's Office for the Southern District of New York and the Internal Revenue Service.

The same day the settlement was announced, criminal conspiracy charges were brought in U.S. District Court in Manhattan against eight former KPMG executives and a lawyer who gave his tacit approval to the shelters. Among the indicted are three former heads of KPMG's tax practice, including former deputy chairman Jeffrey Stein, and former vice chairmen Richard Smith and John Lanning.

At press time, prosecutors expected to seek indictments against at least a dozen more individuals involved in the sale of tax shelters, and to levy additional charges, including obstruction of justice and tax evasion. No names were released.

The fine - equal to about 11 percent of KPMG's 2004 revenue, or about four times the amount the firm made from selling the shelters - will be paid in three installments, and KPMG will also have to implement elevated standards for its tax business. Former Securities and Exchange Commission Chairman Richard C. Breeden will independently monitor the firm's compliance over the next three years. Breeden, who owns his own consulting firm, was appointed to act as WorldCom Inc.'s corporate monitor in July 2002, and remains an ex-officio member of WorldCom's board.

"We regret the past tax practices that were the subject of the investigation," said KPMG chairman and chief executive Timothy P. Flynn in a prepared statement. "The resolution of this matter allows KPMG to confidently face the future."

The deal will likely be viewed as a significant victory for Flynn, who succeeded Eugene O'Kelly as chair and CEO of KPMG in early June. Within a week of Flynn taking the reins, KPMG released a statement bluntly acknowledging "unlawful activity" by former partners and setting the stage for a resolution with prosecutors.

John Coffee, a law professor and securities regulation expert at Columbia University who has followed the case, termed the deal a "no-brainer" for both the government and KPMG. "The only thing that mystifies me is how it took so long to reach a settlement," he said. "KPMG wanted to avoid an indictment and has limited leverage. And no one thinks the government really wanted to destroy a second member of the Big Five within a couple of years."

Meanwhile the audit firm received a vote of confidence from the Public Company Accounting Oversight Board, which has, for two years, performed inspections of its audits: "As board members have stated in the past, and based on these inspections, the board remains confident in KPMG's ability to perform high-quality audits of public companies."

Lynn Turner, former chief accountant at the SEC and now managing director of research at independent research firm Glass Lewis & Co., said that once KPMG failed to cooperate with regulators and testified before the Senate, the U.S. Justice Department had little choice but to act. In January 2004, KPMG announced congressional scrutiny into its past shelter activities after a November 2003 report compiled by a Senate subcommittee.

"The firm, under its old leadership had a reputation for fighting with regulators," said Turner, noting settlements reached by PricewaterhouseCoopers and Ernst & Young over their sale of tax shelters in 2002 and 2003, respectively. "I think the current leadership has a different mentality and understands that just doesn't work anymore," he said. "And I think once you saw that old regime and the old legal counsel go by the wayside, a relatively quick settlement was reached."

Four separate tax shelters designed and marketed by KPMG were cited in the criminal indictments. Federal prosecutors have said that the shelters generated billions in false tax losses for hundreds of KPMG's clients, and cost the government more than $1.4 billion in taxes.

A complicated case

In mid-August, a former accountant at bank HVB Group pleaded guilty in the first prosecution arising out of the Senate's tax shelter investigation.

Domenick DeGiorgio pleaded guilty to defrauding the IRS and to charges of wire fraud, tax evasion and conspiracy. Although KPMG was not named by federal prosecutors, the tax shelter that DeGiorgio admitted selling was one of the types created and sold by KPMG.

While the IRS has said that the tax shelters are illegal because they serve no legitimate economic purpose and are done solely to reduce taxes, none of the schemes has yet to be taken to court, and the internal rules used by the IRS to evaluate the shelters are not technically written law. Even with KPMG admitting culpability and DeGiorgio's testimony, the IRS would still have a complicated case to make in court, though the indictments were broad enough to allege that the nine defendants conspired to mislead the IRS by lying about the shelters' details.

Looking ahead, Coffee said that another key was that KPMG totally waived its attorney-client privilege. He expects a number of documents concerning the tax shelters, likely from a number of law firms, to be released and to be a huge aid in proving that the individuals now under indictment were aware of the serious legal questions surrounding the shelters.

Both Coffee and Turner said that the details of the 28-page deferred prosecution agreement were mostly unsurprising.

"The one thing that caught my attention is the requirement to comply with the PCAOB's independence standards. That's the real risky point if there is a misstep," Turner said, mentioning a number of incidents over the past five years in which KPMG was investigated for independence issues.

Turner thinks that there are a number of lessons for the industry, among them that cooperation with regulators pays; that being less than transparent will cost a firm; and that businesses with a poor leadership tone at the top will ultimately see their ability to be compliant diminished throughout their organization. But he said that maybe the biggest takeaway for the entire profession is that firms would benefit from having an outside board of directors, and that independence rules need to be followed.

"If KPMG had that outside board, I don't believe this would have happened," Turner said. "The Napoleonic way of doing business isn't the way to go."

He later added, "When the profession permitted contingency fees and commissions, it was only a matter of time before it was going to be left with a black eye. The rule runs directly counter to what this profession is all about." Turner said that he hopes the settlement will spur the industry to have serious discussions about withdrawing the rule sometime in the next few years.

The next step for KPMG will be resolving a number of lawsuits filed by individual taxpayers, many of whom are facing back taxes and other penalties. Since the start of 2005, KPMG has already paid millions to resolve civil lawsuits brought by businesspeople and wealthy individuals who bought the shelters and are now being scrutinized by the IRS.

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