Aug. 28 (Bloomberg) -- A U.S. appeals court upheld a judge's decision to throw out the indictment of 13 former KPMG LLP executives for tax-fraud after finding federal prosecutors violated their constitutional right to legal counsel.

The government ``unjustifiably interfered with defendants' relationship with counsel and their ability to mount a defense, in violation of the Sixth Amendment,'' U.S. Circuit Judge Dennis Jacobs wrote today on behalf of a unanimous three-judge panel of the U.S. Court of Appeals in New York. By threatening to indict KPMG if it paid the legal fees of the former partners and employees, the U.S. infringed their right to have a lawyer.

The ruling came the same day Deputy Attorney General Mark Filip announced guidelines barring prosecutors from demanding firms not pay employee legal fees in federal criminal cases. Previously, companies were urged to turn over confidential legal materials to avoid indictment or to win leniency in plea deals.

The policy switch, disclosed last month in a letter to the Senate Judiciary Committee, is a victory for groups including the U.S. Chamber of Commerce and the American Bar Association that have spent more than three years lobbying for the modifications.

``We're obviously very pleased,'' Craig Margolis, a partner at Vinson & Elkins in Washington and a lawyer for former KPMG Deputy Chairman Jeffrey Stein, said of the ruling. ``We hope today is the end of a long and arduous journey.''

`Extraordinary Advance'

Margolis said the decision and the new rules ``mark today as an extraordinary advance for fairness in the criminal process.''

Rebekah Carmichael, a spokeswoman for U.S. Attorney Michael Garcia in New York, said the office is reviewing the ruling. The government could seek a rehearing by the panel or a larger group of judges, or permission to appeal to the U.S. Supreme Court.

The panel's ruling upheld a July 2007 decision by U.S. District Judge Lewis Kaplan in Manhattan that gutted the largest U.S. criminal tax-shelter prosecution. Kaplan said it was ``intolerable'' that prosecutors threatened to indict New York- based KPMG, which likely would have destroyed the firm, unless it stopped paying legal bills for former executives, including Stein; Richard Smith, KPMG's former vice-chairman of tax services; and former partner John Lanning.

`Complete Affirmance'

``It was a complete affirmance of Judge Kaplan's opinion,'' said John Martin Jr., a former federal judge now with New York's Martin & Obermaier, who represented four of the defendants. ``It means all charges against them are now dropped.''

The case began in 2005 when prosecutors accused 17 former KPMG executives and two other defendants of selling illegal tax shelters from 1996 to 2005, allegedly costing the U.S. Treasury at least $2 billion. One executive pleaded guilty, along with individuals not affiliated with KPMG.

Four of the original 19 defendants are scheduled to go on trial later this year. Charges against New York-based KPMG, the fourth-largest U.S. accounting firm, were dismissed last year after it paid a $456 million fine.

The appeals court said Kaplan's ruling that, were it not for the so-called ``Thompson Memorandum'' and prosecutorial conduct, KPMG would have paid the legal fees, wasn't ``clearly erroneous,'' the standard for reversal. The memo, written in 2003 by then-Deputy U.S. Attorney General Larry Thompson, said prosecutors may consider a company's payment of fees for ``culpable employees and agents'' when deciding whether to indict the company.

2006 Change

After Kaplan's ruling, the Justice Department in December 2006 made it tougher for prosecutors to force companies to refuse payment of employee legal fees.

Kaplan found that the 13 defendants were forced to limit their defenses for economic reasons because KPMG wouldn't pay the fees. KPMG operated in tandem with the government, the appeals court said, so its refusal to pay the fees, which it normally would have paid, amounted to ``state action.''

``The government forced KPMG to adopt its constricted fees policy,'' the court wrote.

The panel said that a prosecutor's statement in court that KPMG may decide whether to advance the fees didn't ``cure'' the constitutional violation, and dropping the charges was the only remedy.

``KPMG was faced with the prospect of indictment; it could be expected to do all it could, assisted by sophisticated counsel, to placate and appease the government,'' Jacobs wrote on behalf of the court.

The appeals panel didn't address Kaplan's finding that the government's actions also violated the defendants' Fifth Amendment right to due process, or fairness.

The case is U.S. v. Stein, 07-3042, 2nd U.S. Circuit Court of Appeals (New York).

To contact the reporter on this story: Thom Weidlich in New York federal court at tweidlich@bloomberg.net.

Last Updated: August 28, 2008 16:26 EDT