Aug. 12 (Bloomberg) -- Richard H. Smith, once charged in the biggest tax fraud ever, owes his lawyers a debt of gratitude for getting him out of what could have been life in prison.

He also owes them $1.3 million, they claim, alleging one of the more outrageous man-stiffs-lawyers stories.

In Smith’s case, it isn’t as if he didn’t have the money. In mediation with his former employer, accounting firm KPMG LLC, Smith was awarded funds meant to go to his lawyers, the attorneys say in a suit they filed against Smith last week.

But did he hand it over? He didn’t, they say.

Contacted by phone in Royce, Virginia, where he lives, he declined to discuss the matter.

To be sure, fee disputes between lawyer and client come with the territory. Last month, Schulte Roth & Zabel sued Dallas-based Highland Capital Management LP, claiming the investment firm owed it $2.8 million. And these things aren’t always so civilized.

A lawyer in West Virginia hired a felon to get a gun and use his special powers of persuasion to squeeze fees out of deadbeat ex-clients, the state supreme court said in lifting his license.

In Smith’s case, “It’s disheartening after working so hard on someone’s behalf and achieving what really was an unprecedented result that gave him his life back,” says Caroline Rule, one of the lawyers at New York’s Kostelanetz & Fink who saved his skin.

Disheartening hardly covers it, when you consider the circumstances.

Fraudulent Tax Shelters

Smith got in trouble over fraudulent tax shelters, the selling of which had become a KPMG specialty, prosecutors said. The accounting firm admitted fraud in a deal that cost it $456 million in fines, restrictions on its tax practice and a promise not to pay lawyers representing its former executives.

This didn’t bode well for Smith. As vice chairman in charge of tax services at KPMG, he oversaw much of the conduct that KPMG admitted was fraudulent.

Smith faced 41 counts of tax evasion, obstructing justice and conspiring to defraud the Internal Revenue Service. The federal indictment was returned in New York City, where some of the nation’s most aggressive prosecutors work.

So lawyers for the accused ex-KPMG managers did what criminal defense lawyers often do, usually to no avail. They claimed the government had violated their clients’ constitutional rights.

Threatening Indictment

They complained to the judge about the U.S. Justice Department’s policy of threatening to indict corporate wrongdoers if they paid the legal expenses of employees suspected in the same misdeeds.

It worked. U.S. District Judge Lewis Kaplan ruled in 2006 that, by pressuring KPMG to stop paying its ex-employees’ lawyers, the government had denied the defendants their constitutional right to counsel.

“This is intolerable in a society that holds itself out to the world as a paragon of justice,” Kaplan wrote in a 64-page opinion the following year, when he dismissed the case against most of the accused.

Voila. In a stroke of a judge’s pen, Smith and a dozen others were set free without ever having to face whatever evidence the prosecutors had on them.

Extraordinary Result

By any reckoning, this was an extraordinary result. A federal appeals court upheld Kaplan’s ruling on the same day that the Justice Department announced it was changing its practice. Not only did Kaplan dislike the policy, so did the American Bar Association, the U.S. Chamber of Commerce and, naturally, the criminal defense bar.

Smith wrote his lawyers to thank them for “all you have done,” according to their suit. During the course of the criminal case he had complimented the firm for its “magic pen” and “great briefs,” the Kostelanetz & Fink complaint against him says.

Still, there was the matter of payment.

By the time Kaplan ruled, lawyers and other staff at K&F had spent more than 7,000 hours handling this complex case, for which it billed Smith $2.9 million. He paid some of it, but not the last $1.3 million, the firm says.

More irksome is that KPMG paid Smith to pay the lawyers, according to K&F. After the Kaplan ruling allowed the accounting firm to do so, it went into mediation with its ex-managers.

Legal Fees

When it was over, KPMG had “agreed to pay substantially all of the legal fees incurred by its former principals and employees, including Smith,” according to the Kostelanetz & Fink complaint.

K&F is still waiting for whatever money KPMG gave Smith to pay his lawyers.

Smith claims he isn’t liable for the debt for a variety of reasons, the lawyers say. He didn’t like a footnote in one of the briefs, and a lawyer was once late to a hearing, the lawsuit relates.

Then there is the old standby, “excessive billing.”

We will never know whether he committed the tax fraud alleged in the dropped indictment. Under the eyes of the law, he is innocent.

But if his lawyers’ claims prove true, Smith, who is himself a lawyer, made off like a bandit.

(Ann Woolner is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Ann Woolner in Atlanta at awoolner@bloomberg.net

Last Updated: August 11, 2009 21:00 EDT