The states, led by Massachusetts, tried to oust KPMG in April as MCI was preparing to exit bankruptcy protection. The states cited a controversial tax plan that the accounting firm designed for MCI, then known as WorldCom Inc., and said KPMG could not audit its own tax work.

"Any argument by the states that they have pursued the disqualification of KPMG to protect the public interest 'rings hollow' in light of the fact that the very conflict they allege warrants disqualification was known to them for no less than 10 months before they decided to file [the motion]," wrote Judge Arthur Gonzalez of the U.S. Bankruptcy Court for the Southern District of New York.

Throughout the dispute, KPMG and MCI maintained that the tax plan is legitimate. And even though the company exited Chapter 11 protection in April, the disqualification motion still carried serious consequences for the Ashburn, Va.-based telecom.

States have submitted about $2.75 billion in tax claims against MCI's bankruptcy estate, and disqualification of the company's adviser and auditor would have strengthened their hand in negotiations.

A ruling in favor of the states' position also could have put MCI in the tenuous position of having to find a new auditor in a post-Sarbanes-Oxley world in which Chinese walls are now supposed to exist regarding what services such firms can and can't provide.

"There are nonaudit services that auditors were providing that they cannot provide today," said one attorney not involved in the case, Morton Pierce of Dewey Ballantine LLP. "Many companies have adopted a policy that they will not use their auditor for any non-audit services.

"Given how few major firms are left, any given company probably has some nonaudit relationships with one or more of the other firms," Pierce added. "It can be a large problem."

Gonzalez's ruling helps KPMG immediately. The states had argued that KPMG should have to sacrifice all its fees during the bankruptcy case, which totaled well more than $140 million.

Even though the disqualification motion was denied, the dispute over the tax plan still simmers.

In the 37-page memorandum that accompanied his ruling, Gonzalez noted that the tax issue could figure in litigation over claims that the states have against MCI that still need to be resolved.

The Securities and Exchange Commission has requested documents related to the tax work, though the agency hasn't indicated that it will take any action. SEC lawyers could not be reached Wednesday for comment.

Charles Mulford, a professor of accounting at Georgia Institute of Technology, said the tax plan raises complex issues.

"Where I question any kind of shelter, whether it's state or federal, is when it is created simply for tax avoidance and it has no real economic basis," he said. "That's when questions should be raised."

The tax plan has been a lightning-rod issue in the MCI case for more than a year. Creditors who were dissatisfied with their recoveries under MCI's reorganization plan attacked the system in April 2003. In various motions, the dissenting creditors labeled the scheme a sham, arguing that it did nothing more than shift MCI's income from states with high taxes to those with more favorable policies.

To resolve the dispute, MCI increased recoveries to the dissenting creditors, who in return dropped their objections to the company's reorganization.

The tax minimization plan surfaced again in January, however, when Richard Thornburgh, the former U.S. attorney general who served as MCI's bankruptcy examiner, criticized KPMG at length in his final report.

"WorldCom likely avoided paying hundreds of millions of dollars in state taxes in 1998-2001," Thornburgh wrote. "The cornerstone of this program, which was designed by KPMG Peat Marwick LLP, was the classification of the 'foresight of top management' as an intangible asset, which the parent company could license to the subsidiaries in return for massive royalty charges."

In his order on Wednesday, Gonzalez called the states "dilatory" for waiting until the eve of MCI's exit from bankruptcy to protest.

"The grounds on which the Disqualification Motion are based have been ripe since April 2003 and [been] open and notorious since May 2003," Gonzalez wrote. "It was only after the States decided that such a motion would advance their particular interests that they filed the Disqualification Motion."

The next tussle between the states and MCI will concern the 35 boxes of documents and five compact disks related to the KPMG matter that the company provided the SEC.

Gonzalez previously denied the states access to the documents during discovery for the disqualification motion, but the taxing authorities are trying another approach.

The states have argued that the boxes are "judicial documents" that Gonzalez relied upon to reach his decision and should therefore be unsealed. A hearing on that motion is set for July 27.

-- Chris Nolter