In a case with important implications for companies that utilize legal analysis in establishing reserves for their financial statements, the United States Court of Appeals for the First Circuit recently decided that tax accrual work papers incorporating counsel’s views of the possibility – and likely outcome – of disputes with the IRS are subject to work-product protection. However, the court also decided that the work-product protection could be waived if a company’s legal analysis was incorporated into the work papers of its outside auditor.
United States v. Textron Inc., No. 07-2631, 2009 WL 136752 (1st Cir. Jan. 21, 2009), involved workpapers prepared by Textron for the purpose of determining a reserve for additional tax liability should certain debatable positions taken on its tax returns be disallowed. Textron’s tax counsel prepared the workpapers by analyzing the positions the company had taken on its tax returns, estimating a percentage likelihood that the position would not prevail if challenged by the IRS, and then multiplying the percentage by the tax benefit claimed to establish the reserves. Textron shared the workpapers with its auditor, Ernst & Young, in the course of Ernst & Young’s regular audit of the company. (Ernst & Young did not retain a copy of the workpapers.) The IRS, after identifying potential tax shelter transactions, subpoenaed Textron’s workpapers. When Textron refused to comply, the IRS sued to enforce the subpoena.
A divided panel of the First Circuit first held that the workpapers were entitled to work-product protection, even though no specific litigation was imminent when they were prepared and even though the workpapers indisputably were prepared in the regular course of business to comply with public company reporting and securities obligations. The court held that, under applicable First Circuit law (based, in turn, on the Second Circuit’s opinion in United States v. Adlman, 134 F.3d 1194 (2d Cir. 1998)), the appropriate test for determining whether the work-product doctrine applied was whether the workpapers “can be fairly said to have been prepared or obtained because of the prospect of litigation.” The panel first determined that disputes with the IRS constituted “litigation,” and then found that the workpapers were created “in anticipation of litigation” because their purpose was to analyze potential litigation so as to establish a reserve “in anticipation of disputes with the IRS.” The court also rejected the IRS’s argument that the business or regulatory purpose of the workpapers defeated work-product protection, noting that “dual purpose” documents created “because of the prospect of litigation” were protected even if they were also prepared for a business purpose. (The dissenting opinion argued that work-product protection did not extend to documents prepared in the ordinary course of business or that would have been created irrespective of litigation, and embraced the Fifth Circuit’s reasoning in United States v. El Paso Co., 682 F.2d 530 (5th Cir. 1982), which, utilizing the minority view that work-product protection applied only to documents whose “primary purpose” was anticipation of litigation, held that tax accrual work papers were only a “means to a business end” and therefore were not protected.)
Public companies can take heart from the court’s finding that the tax workpapers were protected from disclosure by the work-product doctrine. Under the court’s analysis, other legal analyses of potential litigation undertaken for purposes of establishing a reserve should be similarly protected. However, what the court giveth in the first three-quarters of its opinion may have been taken away in its analysis of a possible waiver.
Although the court held that Textron had not waived work-product protection merely by providing its workpapers to Ernst & Young – the court found that an independent auditor’s relationship with its client is cooperative rather than adversarial – it nonetheless concluded that a waiver would exist if Ernst & Young’s own workpapers disclosed Textron’s analysis. Noting that “disclosure to a conduit to a potential adversary” waives work-product protection, the court held that if Ernst & Young’s workpapers – themselves potentially discoverable – disclosed Textron’s counsel’s analysis, work-product protection would be waived. (Because the district court did not address this issue, the First Circuit panel remanded the matter for development of the factual record as to whether the auditor’s workpapers disclosed Textron’s analysis.)
The importance of the Textron decision extends beyond tax accrual workpapers. The court’s analysis would apply equally to litigation reserves, contingent liability reserves, or any other reserves that involved legal analysis of potential regulatory disputes or potential litigation. Although companies necessarily have to disclose a certain amount of information concerning such reserves to their outside auditors, they and their auditors must work together to ensure that legal analysis subject to work-product protection is either not revealed in full to the auditor, or that the auditor does not reveal the analysis in its own workpapers. (The auditor may, of course, reveal the amount of the reserve and its own conclusions as to the appropriateness of the reserve.) Otherwise, litigation adversaries will find an easy path to the impressions, conclusions, opinions, or theories of a company’s legal counsel, both through access to the auditor’s workpapers and, by asserting a waiver, through the company’s own workpapers.