Sarbanes-Oxley compliance has outside auditors increasingly asking for privileged information, putting a company’s internal Investigation materials at risk of disclosure.
The waiver of the attorney-client privilege is a complex, legally challenging decision often faced by corporate management in today’s litigious world. Those waiver decisions are usually associated with requests for information made by opposing counsel in a lawsuit, or by government regulators or investigators who want the benefit of the corporate investigation to jump-start their own independent investigation.
However, there is an ever-increasing movement forcing corporations to disclose otherwise privileged materials that is coating not from corporate adversaries, but instead the company’s own auditors.
Determining whether to disclose attorney-client privileged materials learned as a result of an internal investigation to outside auditors has become a modern corporate dilemma faced by both public and private companies. Often, the eventual decision will be dictated by the required services of the auditors and their willingness so remain flexible concerning the methodology and substance of information that may ultimately be released.
Auditing responsibilities
As a result of corporate scandals, vigorous oversight, a thoroughness of effort and self-preservation interests, outside auditors have become increasingly interested in reviewing the underlying documentation — and counsel’s conclusions — associated with the investigation of alleged corporate misconduct. Indeed, the auditor’s role and responsibility has significantly increased in preventing and detecting corporate fraud.
Ensuring truth in financial reporting is not only a laudable goal, but serves a vital public interest. The public has both a need and a right to rely upon a corporation’s financial reporting, and there must be a mechanism in place to ensure accurate reporting. Outside auditing firms play a crucial role in the transparency, accuracy and reliability of corporate financial reporting.
However, as a result of the myopic approach to cleaning up corporate America and providing scrutiny of all things financial, a fundamental process of corporate management – being able to rely upon confidential advice of counsel – has been placed at risk.
In reaction to Enron and the many other instances of corporate financial mismanagement, Congress enacted the Sarbanes-Oxley Act of 2002. SOX necessitates, under sec. 404, that the company publish information in its annual reports concerning the scope and adequacy of its internal control structure and procedures for financial reporting. The company’s auditors must then attest to and report on their assessment to the effectiveness of the internal control structure and procedures for financial reporting.
Auditors have used this regulatory requirement as justification to demand a much broader range of information, and a much more in-depth level of information, including attorney-client privileged material.
More than 30 years ago, the American Bar Association and American Institute of Certified Public Accountants addressed the concern of the release of attorney-client privileged material to auditors relating to “audit letters.” At that time, it was recognized that the need for public confidence in corporate financial statements could be better served by preserving the integrity of the privileged nature of communications between the company and its attorneys, thus encouraging management to seek out, listen to and adhere its actions to the legal advice obtained.
However, companies increasingly have been confronted with requests by auditors for privileged information regarding potential “contingent liabilities.” Auditors often seek further information based on their need to know of any loss contingencies when there is a “reasonable possibility” that a loss may have been incurred. Accordingly, the auditors are interested in what is the loss contingency, what are the possibilities that it will he incurred and, even more so now, what are the attorneys advising on the potential risk and damages based on the information uncovered during the internal investigation.
Attorney-client privilege in jeopardy
In today’s ever-increasingly litigious society, lawsuits are but a moment away from any corporate action.
Certainly, information obtained by counsel in anticipation of litigation — and work product that was produced to assist counsel in providing advice on those matters to corporate management — has as its fundamental characteristic the need for confidentiality. Courts have long recognized that encouraging a corporate client’s candor by protecting the confidentiality of these communications will promote the observance of law and administration of justice.
Companies are increasing their own efforts to investigate potential wrongdoing and to create effective compliance programs that not only deter, but also detect misconduct. As a result of these increased efforts, attorneys are routinely brought in not only to assist in the investigations, but also to offer advice as to what action is appropriate, creating work product and providing advice that is ostensibly confidential.
This confidentiality encourages full and frank communications and assists in the detection and thorough uncovering of misconduct.
Auditors’ requests for this information, however, now place the company’s privileged status of this material at risk. If the privilege is later determined by a court to have been waived through release to the auditors, then this material will likely be available to third parties for their use in litigation against the company or its management. Governmental agencies, shareholders, plaintiff’s counsel and disgruntled former employees now may have access to this formerly privileged information.
Potential ramifications
If an arrangement cannot be met to satisfy the legitimate needs of the auditors while balancing the legitimate needs of the company to maintain its privileges, significant ramifications are at stake. The company faces a Hobson’s choice.
If the company elects to maintain the privilege, it faces the potential of auditors refusing to make the attestation under sec. 404 of SOX, issuing a qualified audit opinion or perhaps providing no opinion at all. This could cause the required financial reporting to be delayed, or potentially allow financial institutions to call due significant loans and result in a public relations outcry.
If the company waives the privilege and releases those materials to the auditors, the company has likely lost the ability to keep its confidential legal advice and the confidential materials that were prepared in anticipation of litigation will now potentially assist its litigation adversaries.
The AICPA’s Code of Professional Conduct states that no confidential client information may be disclosed absent consent of the client. However, this section goes on to allow the disclosure of this confidential information pursuant to a validly issued and enforceable subpoena. Likewise, Minn. Stat. sec. 326A.12 states that information provided by a client shall not he disclosed absent consent of the client or when required to be disclosed in court proceedings.
Thus, these sections provide no practical support for maintaining the confidentiality of privileged material provided to the auditors when sought via legal process by third parties involved in litigation with the client company.
Courts present diverging opinions
What first appeared to be a common breach of contracts case in Texas recently became an omen of things to come on this issue. In Stone & Webster, Inc v. AES Wolf Hollow, AES requested in discovery all of the plaintiffs “financial losses and all charges against profits claimed with respect to the claim].” The plaintiff then responded that “[the answer is contained in [the company’s] May 2003 through current 10Q and 10K filings.”
Even though there were state auditor-client privilege protections in place, the court ordered that the information provided by the plaintiff to its auditors would be discoverable, enableing AES to test the validity of the reported 10Q and 10K filings and to have access to what would otherwise have been privileged.
Texas is not alone in addressing this issue, although the various courts – as expected – are divergent on their conclusions regarding this waiver argument. In Merrill Lynch & Co. v. Allegheny Energy, Inc., the court declined to find a waiver of the attorney-client privilege after internal investigation reports had been provided to Merrill Lynch’s outside auditors for their use in preparing its annual audit and SOX 404 attestation. The court reasoned that finding a waiver would discourage companies from conducting investigations and disclosing those results to auditors.
However, in Medinol, Ltd. v. Boston Scientific and numerous other cases, courts have taken the opposite approach and found that disclosure to auditors results in waivers of the privilege. In Medinol, the court stated that “in order for auditors to properly do their job, they must not share common interests with the company they audit.” It went on to say that in order to perform properly, there must be adversarial tension between the auditor and the company. Additionally, by certifying the financial statements, the court found that the independent auditor assumed a public responsibility that transcended any relationship with the Company
A legal crap shoot
At this time there is very little silver lining to this issue. Proposed legislation regarding the selective waiver doctrine has been limited to production of materials to governmental agencies and remains just that – proposed legislation.
Confidentiality agreements have also been inadequate to protect the privileged nature of the materials, and sec. 105 of SOX – which specifically addresses the protection of privileged status for material provided to the Public Company Accounting Oversight Board – is inapplicable to the company’s own auditor’s requests for information.
The Securities and Exchange Commission has taken an affirmative role in advocating, although unsuccessfully, for the maintenance of privileged status for materials turned over to its investigators by filing amicus briefs when court challenges are received regarding the wavier issue.
In the 8th U.S. Circuit Court of Appeals, there is argument under the Diversified line of cases that selective waiver is appropriate when privileged materials are provided to the government. However, these arguments may be unpersuasive when advocating their applicability to materials provided to auditors.
Additionally, with the emergence of a national, if not global, economy and industry that transcends jurisdictional lines, the limited jurisdictional applicability of Diversified continually narrows with time as Minnesota companies face litigation in venues far from home.
Facing potential litigation in venues all over the court, and with this issue in such a state of legal flux, any determination of whether the release of privileged information to the auditors will constitute a waiver is nothing more than a legal crap shoot. Accordingly, the waiver of privilege over such materials and subject matters released to the auditors should generally be expected, and its appearance in the hands of litigation adversaries assumed.
For any relief on this subject, attention must be brought to this issue through a concerted effort by corporate advocates to address it legislatively on the federal level, so as to eliminate a smorgasbord of state laws and court decisions.
Unfortunately, as a result of the same underlying corporate conduct that produced this problem, Congress is unlikely to be sympathetic to argue the need to withhold certain material from financial auditors, even for necessary and legitimate reasons.
Originally appeared in Minnesota Lawyer, March 2007, Reprinted with permission.
Featured article in Dorsey's Spring 2007 White Collar Crime and Civil Fraud Update.