Jeffrey Stein, et al. v. KPMG, LLP, 486 F.3d  753 (C.A.2 (N.Y.). 2007)

Brief Summary
The Second Circuit held that the district court’s jurisdiction over the underlying criminal case did not give it ancillary jurisdiction over the individual defendants’ claim that, as a result of undue government pressure, the defendants’ former employer had breached its agreement to pay their legal fees.

Complete Summary
This appeal arose from a criminal tax prosecution. The defendants, former partners or employees of the KPMG accounting firm, were charged with devising and marketing fraudulent tax shelters that resulted in a loss to the U.S. Treasury of more than $2 billion. KPMG agreed to pay $456 million in fines and penalties and to cooperate with the government in exchange for avoiding prosecution. Id. at 756.

The Department of Justice had a policy called the “Thompson Memorandum” that set forth standards to be followed by federal prosecutors to determine if criminal prosecutions should be brought against firms as well as their agents, such as partners and employees. One standard included whether a firm voluntarily paid its agents’ legal expenses as a factor in favor of prosecuting the firm. Id. at 756. Prior to the indictments in this case, KPMG paid some of the legal fees for the defendants. In Stein I, 435 F. Supp. 2d 330 (S.D. N.Y. 2006), the district court held that the government violated defendants’ Fifth and Sixth Amendment rights by threatening to prosecute KPMG unless it stopped paying defendants’ legal fees. That ruling was not at issue in the present appeal.

The district court had also sought, however, to take jurisdiction over the defendants’ attorney fee claims against KPMG as an alternative to dismissing the government’s indictment of the defendants. Id. at 380. Following this decision, the defendants sued KPMG, which moved to dismiss the claims against it due to lack of subject matter jurisdiction or, in the alternative, to compel arbitration. The district court denied both motions. Stein II, 452 F. Supp. 2d 230 (S.D.N.Y. 2006).

The key issue in the present appeal was whether the district court had properly exercised ancillary jurisdiction over the fee dispute between the criminal defendants and the non-party, KPMG. Stein at 758. The court declined to address the complex question of appellate jurisdiction, and chose to exercise its mandamus power. The court stated that “[B]ecause the actions of the district court were well outside its subject matter jurisdiction, our resort to mandamus does not in any way expand the potential use of that writ and avoids our unnecessarily addressing complex jurisdictional issues.”  Id. at 759.

The court agreed the most common exercise of ancillary jurisdiction was to resolve fee disputes between a party and its attorney in the litigation, who was an officer of the court. That is a “world away,” the court stated, from using ancillary jurisdiction in a criminal case to address a contract dispute between the defendants and a non-party former employer. Id. at 760. The court stated “when a non-party to the primary proceeding is sought to be joined as a defendant in the ancillary proceeding, the need for the ancillary proceeding and the efficiencies provided by it must be both sufficiently great to outweigh the prejudice to the non-party and to be consistent with the limited jurisdiction of federal courts.” Id. at 760-761. Although the court did not exclude the possibility of a “legitimate ancillary proceeding involving a nonparty to the primary litigation,” it stated that the “requisite compelling circumstances will be rare,” Id. at 761.

The court found the prejudice to KPMG clear and the need for the ancillary proceeding “entirely speculative.” The court stated that the ancillary proceeding would provide a remedy only if KPMG loses, “hardly a foregone conclusion on the present record.” Id. at 762. In a footnote, the court referenced a single instance in which KPMG paid the legal fees of two partners indicted in a 1974 case. The court also noted that as a condition of having pre-indictment legal fees paid by KPMG, most of the defendants signed fee letters acknowledging that KPMG would not pay post-indictment fees. See Stein II, 452 F. Supp.2d 240-41.

The court added that the dismissal of the indictment for Fifth and Sixth Amendment violations was always an available remedy. Even assuming constitutional violations and a contractual obligation by KMPG to pay the attorney fees and costs, however, an ancillary proceeding was not the proper remedy. The court stated “we hold…that the remedies available to the district court in the circumstances presented here did not include the novel exercise of ancillary jurisdiction.” Stein at 763. The court also noted that the parties knew for some time about KPMG’s intent not to pay the fees and took no steps to enforce the alleged contracts until the district court indicated a willingness to exercise jurisdiction over it. Id. at 763.

Subsequent to this decision, the district court judge, Judge Lewis Kaplan, dismissed charges against 13 of the KPMG defendants, including the lead defendant Jeffrey Stein, based on the actions of prosecutors which violated the constitutional rights of the defendants by pressuring KPMG to cut off legal fees despite the employer’s policy to provide the same. The prosecution continues regarding the three remaining defendants. See ___F.Supp.2d___, 2007 WL 2050921 (S.D.N.Y.)

Significance of Case
Unlike state courts, federal courts are courts of limited jurisdiction. Although it sometimes may be tempting for federal judges to extend their reach in order to resolve the whole of a controversy, the Second Circuit made clear that at least on these facts, such temptations are better resisted.

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