Deloitte Decision Protects Work Product Disclosed to Independent Auditor

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Robin L. Greenhouse, Esq. and Joseph H. Shelby, Esq.
McDermott, Will & Emery LLP, Washington, D.C. and Boston, MA

The D.C. Circuit Court's decision in U.S. v. Deloitte LLP, et. al. questions Textron and rejects government motion to compel work product disclosed to an independent auditor.

On June 29, 2010, the U.S. Court of Appeals for the District of Columbia rejected the Internal Revenue Service's (IRS) positions that work-product protection cannot apply to documents prepared in connection with a financial audit and that work-product protection is waived by disclosure to an independent auditor (U.S. v. Deloitte LLP, et. al., No. 09-5171 (D.C. Cir. 6/29/10)).

This decision is significant because the D.C. Circuit adopted a broad view regarding the application of work-product protection to dual-purpose documents—documents developed in anticipation of litigation, but also used for business purposes.  Writing for the court, Chief Judge Sentelle stated "a document can contain protected work-product material even though it serves multiple purposes." In so holding, the D.C. Circuit cited approvingly to U.S. v. Adlman, 134 F.3d 1194, 1195 (2d Cir. 1998), which held that "a document created because of anticipated litigation, which tends to reveal mental impressions, conclusions or theories concerning litigation, does not lose work-product protection merely because it is intended to assist in the making of a business decision influenced by the likely outcome of the anticipated litigation.

The D.C. Circuit went further than Adlman, however, and found that work-product protection applied to work papers prepared by an independent auditor who had recorded the mental impressions, conclusions or theories of the taxpayer's counsel concerning anticipated litigation. In this regard, the D.C. Circuit found unconvincing the precedent set in the U.S. Court of Appeals for the Fifth Circuit (U.S. v. El Paso Co., 682 F.2d 530 (5th Cir. 1982)) and the U.S. Court of Appeals for the First Circuit (U.S. v. Textron Inc., 577 F.3d 21 (1st Cir. 2009)) (en banc), both of which held tax accrual work papers that are prepared by the taxpayer and that reflect a lawyer's analysis of the likelihood of success in litigation were not prepared in anticipation of litigation because such work papers were created as part of an independent audit.

Equally important is the D.C. Circuit's holding that no waiver had occurred when the taxpayer shared the documents with its independent auditor. This is an issue of first impression at the appellate level. A majority of the district courts addressing the issue have held that no waiver occurs in those circumstances.  However, in the vacated panel decision in Textron (U.S. v. Textron Inc., No. 07-0263 (1st Cir. 1/21/09), vacated (3/24/09)), the First Circuit had held that waiver could occur if work product was reflected in the auditor's work papers, because such work papers are discoverable under Arthur Young(U.S. v. Arthur Young, 465 U.S. 805 (1984)).

In Deloitte, the discovery dispute arose from litigation in the U.S. District Court for the Middle District of Louisiana concerning the tax treatment of two partnerships owned by Dow Chemical Company and two of its wholly owned subsidiaries.  During discovery, the government subpoenaed documents from Deloitte, Dow's auditor. It's important to point out the IRS's "modified policy of restraint" does not apply in tax litigation. The discovery dispute found its way to the U.S. District Court for the District of Columbia because the subpoena sought production in Washington, D.C.

Deloitte produced a number of documents, but refused to produce three that Dow identified as work product. The first document was a draft memorandum prepared by Deloitte summarizing a meeting at which Dow's outside counsel was present and recording the legal analysis from Dow's outside counsel about the possibility of litigation over the partnership. The other two documents at issue were created by Dow's counsel (outside and in-house), but were disclosed to Deloitte so that it could review the adequacy of Dow's contingency reserves.

The district court denied the government's motion to compel without reviewing the three documents in camera.  The district court concluded that the Deloitte memo was work product because its contents recorded the thoughts of Dow's counsel regarding the prospect of litigation. The government did not dispute that the other two Dow documents were work product, but maintained that the disclosure of these documents to Deloitte waived the privilege. The district court held that waiver did not occur because Deloitte was not a potential adversary and nothing suggested that it was unreasonable for Dow to expect Deloitte to maintain confidentiality.

The government appealed to the D.C. Circuit.  With respect to the Deloitte memo, the government argued that work-product protection did not apply to the auditor's recording of the counsel's legal analysis because the function of the document (prepared for use in the audit) rather than its content (the thoughts and opinions of counsel) determines whether a document is prepared in anticipation of litigation. In this regard, the government argued El Paso and Textron demonstrate that, when a document is created as part of an independent audit, its sole function is to facilitate that audit, which means that it was not prepared in anticipation of litigation.

The court rejected the government's "function" test and held that the court should not look solely to a document's function divorced from its contents in determining its status as work product. Moreover, the court found neither El Paso nor Textron convincing. The court explained that "El Paso was decided under the `primary motivating purpose' test, which is more demanding than the "because of" test we employ. Under the more lenient `because of' test, material generated in anticipation of litigation may also be used for ordinary purposes without losing its protected status." Addressing Textron, the court acknowledged that it applied the "because of" test, but found it "distinguishable because it turned on the court's examination of the particular documents at issue. While the court concluded that those documents were not work product, it did not exclude the possibility that other documents prepared during the audit process might warrant work-product protection." The court went on, however, to refer to Judge Torruella's dissenting opinion in Textron as "mak[ing] a strong argument that while the court said it was applying the `because of' test, it actually asked whether the documents were `prepared for use in possible litigation,' a much more exacting standard.

The government also argued that the Deloitte memo was not subject to work-product protection because the protection under Rule 26(b)(3) of the Federal Rules of Civil Procedure only covers tangible documents prepared by a party or its representatives, and Deloitte was neither. While agreeing that Deloitte was not a party or Dow's representative, the court held that the work-product protection in Rule 26(b)(3) was only a partial codification of the Supreme Court's broader articulation of work product in Hickman v. Taylor.  According to the D.C. Circuit, the critical question is not who prepares the document, but whether the document contains work product. The court remanded the Deloitte memo to the district court to determine if it is entirely work product, or whether a partial or redacted version of the document could have been disclosed.

The court next turned to the government's contention that Dow waived the work-product protection by disclosing the Dow documents to Deloitte. Work product is waived only if there has been a voluntary disclosure to an adversary or a conduit to an adversary.  In this regard, the work-product protection is stronger than attorney-client privilege, which is generally waived if disclosed to any third party, whether or not such third party is an adversary or a conduit to an adversary.

The government argued that Deloitte was a potential adversary or a conduit to other adversaries. The court considered and rejected both contentions. In considering whether Deloitte is a potential adversary, the court framed the question as whether Deloitte could be Dow's adversary in the sort of litigation the documents at issue address and not whether Deloitte could be Dow's adversary in any conceivable future litigation. Since the documents prepared by Dow's counsel were prepared in anticipation of litigation with the IRS, not Deloitte, the court held that Deloitte was not a potential adversary. Likewise, the court rejected the contention that Deloitte was a conduit for an adversary. "In short, Deloitte's independent audit obligations do not make it a conduit to Dow's adversaries," the court ruled. "Dow had a reasonable expectation of confidentiality because Deloitte, as an independent auditor, has an obligation to refrain from disclosing confidential information." The court also found the government's reliance on Arthur Young was misplaced since, "the government attempts to discover not an independent auditor's `interpretations of the client's financial statements,' which Arthur Young would permit, but an attorney's thoughts and opinion developed in anticipation of litigation, which the work-product doctrine forbids.

Practice Note

The court recognized "independent auditors have significant leverage over companies whose finances they audit.  An auditor can essentially compel disclosure by refusing to provide an unqualified opinion otherwise." Companies have used several techniques to minimize the risk of waiving work-product protection.  Companies may ask their counsel to orally provide their views regarding the hazards of litigation to the independent auditor. Another approach is for a company to request that their counsel prepare a litigation risk analysis memorandum and provide the independent auditor with access to the memo in a reading room. Under either approach, it is not surprising that the auditor's work papers will document the counsel's views regarding the potential litigation. The court's decision validates these approaches by holding that the independent auditor's description and summary of counsel's views are protected work product.

For more information, in the Tax Management Portfolios, see Schmehl and Fox, 633 T.M., Compelled Production of Documents and Testimony in Tax Examinations,  and in Tax Practice Series, see ¶3850, Examination: Audits, Assessments, Appeals.


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