NEW YORK—A federal prosecution tactic of pressuring organizations not to pay executives' defense costs in white-collar criminal cases has been dealt a major blow--but not a fatal hit--in the closely watched KPMG L.L.P. tax fraud case, legal experts say.

A New York federal district court judge last week dismissed criminal charges against 13 current and former executives of the huge New York-based accounting firm, because the prosecution tactic of interfering with their defense was unconstitutional.

New York federal district Judge Lewis A. Kaplan had ruled last year that federal prosecutors' actions had violated the executives' due process and other rights, but he gave prosecutors an opportunity to save their case.

But on July 16, Judge Kaplan ruled that there was no other remedy but to dismiss the charges with prejudice, which means the government cannot again indict the executives.

The U.S. Department of Justice late last week asked the 2nd U.S. Circuit Court of Appeals to review the decision.

Corporate governance bylaws often allow organizations to cover the defense costs of employees facing civil lawsuits or criminal prosecution.

In the KPMG case, the defendants faced charges of scheming to create illegal tax shelters that would let rich clients avoid billions of dollars of U.S. taxes. In keeping with its longstanding custom, KPMG intended to cover the legal expenses for 13 executives.

But, according to court papers, prosecutors threatened to "destroy" KPMG by filing a criminal corporate indictment against the firm unless it cut off its indemnification of defense fees. KPMG complied, and prosecutors dropped a conspiracy charge against the firm. KPMG settled out of the case in 2005 by agreeing to pay $456 million and admit it engaged in fraudulent conduct.

In a January 2003 memo to U.S. Attorneys, a deputy U.S. attorney general, Larry D. Thompson, endorsed such prosecutor actions and others designed to weaken defense cases.

But under congressional pressure, another deputy U.S. attorney general, Patrick J. McNulty, told U.S. Attorneys last year in a memo that such measurers should be used only in rare circumstances.

While Judge Kaplan's ruling, if upheld, would not set a national precedent, some legal experts predict it would set the tone nationally for federal prosecutors.

"If you have an attorney general who wants to do the right thing...then I suspect he or she would take this decision seriously and consider whether the tactics in this case or others are appropriate and have to be modified," said former Justice Department prosecutor Harry Rimm, now a policyholder attorney with Anderson Kill & Olick P.C. of New York.

If the 2nd Circuit upholds the ruling, "that would be pretty strong guidance for the Justice Department everywhere," said William G. Passannante, a partner with Anderson Kill.

In addition, the McNulty memo has changed federal prosecution guidelines for future cases, said insurer attorney Dan A. Bailey, a partner with Bailey Cavalieri L.L.C. of Columbus, Ohio.

As a result, companies now can comply with their defense indemnification obligations without increasing the risk of a company indictment, he said.

But not all observers agree.

The McNulty memo left several loopholes that would allow federal prosecutors to pressure other companies in the same way they intimidated KPMG, said Stephanie Martz, director of the white-collar crime division for the National Assn. of Criminal Defense Lawyers in Washington.

For example, the memo does not address situations--like KPMG's--in which the practice of indemnifying defense costs is a longtime custom but has not been adopted as a written policy, Ms. Martz said.

Several lawmakers also contend the McNulty memo does not adequately protect defendants' rights. A House bill, H.R. 3013, introduced July 12, and an earlier Senate bill, S. 186, would bar the tactics that prosecutors used in the KPMG case.

Brokers say that risk managers have an immediate, insurance-based solution to the problem.

Side A difference-in-conditions directors and officers liability insurance would have responded in a case like KPMG's and covered the defense costs without any immediate objection from the insurers, said Steve Shappell, managing director of the legal and claims practice for Aon Financial Services Group in Denver.

But if a company, like KPMG, had no statutory or bylaw impediments to indemnifying the defendants, the insurers likely would later attempt to recover from its policyholder, he said. By reimbursing the insurer, the company essentially would have indemnified the defendants without running afoul of prosecutors, Mr. Shappell said.