Latham & Watkins Litigation Department

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1 Number 698 April 24, 2008 Client Alert Latham & Watkins Litigation Department First Circuit Considers Whether Tax Accrual Workpapers Shared with Auditors are Protected Work Product Companies should be entitled to rely on their counsel to perform litigation analyses used to support reserves, and should be able to share those analyses with outside auditors, without fear that the companies will be forced produce possible litigation roadmaps that adversaries can exploit. In connection with its audit of Textron Inc. (Textron), the IRS is seeking the production of documents prepared by Textron s attorneys analyzing potential tax disputes with the IRS. Textron shared the analysis, used to support the company s reserves for contingent tax liabilities, with its outside auditors. On August 28, 2007, in a closely monitored case, the US District Court for the District of Rhode Island ruled against the IRS, holding, inter alia, that the analysis was protected attorney work product. The decision was heralded by proponents of attorney-client protections and was the subject of a prior Latham & Watkins Client Alert. 1 As many anticipated, the IRS appealed to the First Circuit. On April 8, 2008, Latham & Watkins submitted a brief in United States v. Textron Inc. in support of Textron, on behalf of amici curiae the Chamber of Commerce of the United States of America (Chamber) and Association of Corporate Counsel (ACC). The First Circuit s decision could have far-reaching consequences for all public companies financial reporting processes. This Client Alert analyzes many of the important legal and policy issues faced by the First Circuit. Background and the District Court s Decision As the District Court found, the term tax accrual workpapers can mean different things in different contexts, but those at issue in this case constitute a spreadsheet containing: a) lists of items on Textron s tax returns, which, in the opinion of Textron s counsel, involve issues on which the tax laws are unclear, and therefore may be challenged by the IRS; b) estimates by Textron s counsel expressing, in percentage terms, their judgment regarding Textron s changes of prevailing in any litigation over those issues; and c) the dollar amounts reserved to reflect the possibility that Textron might not prevail in such litigation. The documents at issue also include certain backup, including earlier spreadsheets and drafts (collectively, the Workpapers). 2 The Workpapers, however, do not include the factual information and documents underlying Textron s tax positions, e.g., agreements and other documents on which the company s tax positions were based, which have been made available to the IRS in connection with its audit. Latham & Watkins operates as a limited liability partnership worldwide with affiliated limited liability partnerships conducting the practice in the United Kingdom, France and Italy. Under s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue,, NY , Phone: Copyright 2008 Latham & Watkins. All Rights Reserved.

2 The District Court found that Textron created the Workpapers (1) to ensure that Textron was adequately reserved with respect to any potential disputes or litigation that would happen in the future and (2) to satisfy its independent auditor, Ernst & Young (EY), which requested the Workpapers as part of its audit of Textron (and to which Textron showed the Workpapers), that Textron s reserves for contingent liabilities were consistent with Generally Accepted Accounting Principles (GAAP). The IRS commenced its audit after the Workpapers were created. When Textron refused to produce them, the IRS served a summons and brought this action to enforce its summons. The District Court (Senior Judge Ernest C. Torres) held, inter alia, that Textron s Workpapers are attorney work product. The Workpapers were prepared in anticipation of litigation, and thus protected, because they would not have been created but for the fact that Textron anticipated the possibility of litigation with the IRS in the first place. Furthermore, the District Court found that EY was neither Textron s adversary nor a conduit to Textron s adversaries, and thus Judge Torres held that Textron s decision to share the Workpapers with EY did not waive work product protection. Application of the Work Product Doctrine In approaching the issues on appeal, the IRS primary focus is to suggest that the importance of its role in auditing taxpayers necessarily outweighs Textron s interest in preserving work product protection. Because the Workpapers identify the potential soft spots in Textron s tax returns, and Textron s assessment of an uncertain issue s reserve percentage could assist the IRS agents in determining whether to use their limited resources to develop that issue, the IRS argues that the work product doctrine should give way to the IRS audit function. As evidenced by the survey of law in the Chamber and ACC amici brief regarding the attorneyclient privilege and the work product doctrine, however, the IRS important enforcement responsibilities do not per se trump the attorney-client protections. It has been long-recognized that, even though the attorney-client protections necessarily limit discovery in any given context, they are beneficial to our system of jurisprudence. The US Supreme Court, in fact, has confirmed that the IRS subpoena power is subject to the traditional privileges and limitations. 3 Thus, the IRS position is particularly troubling, given that it seems contrary to Justice Jackson s celebrated concurring opinion in the seminal decision announcing the work product doctrine in Hickman v. Taylor: Discovery was hardly intended to allow a learned profession to perform its functions either without wits or upon wits borrowed from an adversary. 4 That is exactly what the IRS intends by seeking the Workpapers. Dual Purpose Documents are Entitled to Work Product Protection In its appeal, the IRS asserts that the Workpapers would have been created in the same form regardless of any potential dispute with the IRS because they supported Textron s reserves, and because EY needed them to conclude its audit and give an unqualified opinion regarding Textron s financial statements (which is required to avoid delisting). Thus, the IRS argues, the Workpapers were not created truly because of anticipated litigation. The IRS relies heavily on the Fifth Circuit s decision in United States v. El Paso Co., denying work product protection to a company s tax accrual workpapers because they were created primarily to support financial statements and satisfy regulatory requirements. 5 The

3 Fifth Circuit, however, is the only Circuit to adopt the primary purpose test. The First Circuit like almost all Circuits applies the because of test, which extends protection so long as a reason for creation of the document is anticipated litigation. As most courts have held, under the because of test, documents created for dual purposes not only litigation but also, e.g., informing a business decision or meeting regulatory requirements are entitled to work product protection. 6 The same reasoning applies to the Workpapers prepared by Textron s attorneys, which assess litigation risk with the IRS and, at the same time, are used to support Textron s reserves. The IRS also fails to understand the nature of the tax reserve analyses contained in the Workpapers in the first place. Textron would have had no reason to create the Workpapers and establish contingent reserves regarding its tax positions if it did not foresee potential disputes with the IRS on those issues. The litigation potential is inherent in the analysis itself. Moreover, given that every Textron tax return is audited by the IRS, and Textron and the IRS have a history of disputes, administrative appeals and even lawsuits in court, the litigation potential in this case is very real. The Issue of Waiver Upon Disclosure to Outside Auditors A work product waiver occurs only with conduct inconsistent with keeping it from an adversary, i.e., disclosure to an adversary or a conduit to adversaries. 7 The IRS argues that independent auditors are watchdogs charged with ensuring the reliability of financial information for the public, and thus that they always are adverse to their audit clients. Moreover, the IRS argues that Textron could not expect EY to maintain the confidentiality of the Workpapers because auditors may be required to produce information and documents to regulators. Thus, the IRS argues, sharing work product with outside auditors constitutes a waiver as a matter of law. Although some courts have seized upon the watchdog description to conclude that a company s disclosure of work product to its independent auditor constitutes a waiver, the recent and overwhelming trend is instead to hold that independent auditors are not sufficiently adversarial to their clients to destroy work product protection. As recognized in Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc., 8 an outside auditor s independence does not make it adverse to its client. Indeed, as the Chamber and ACC argue in their amici brief, even the threat of litigation between an auditor and its client can raise questions, under American Institute of Certified Public Accountants (AICPA) rules, about an auditor s independence. Auditors and clients, in fact, share a common interest a critical predicate in many cases finding no waiver in ensuring the accuracy of the client s financial information. As described in Merrill Lynch: A business and its auditor can and should be aligned insofar as they both seek to prevent, detect, and root out corporate fraud. The same rationale applies to Textron s decision to share the Workpapers with EY. A company s cooperation with its auditors should not be discouraged. Moreover, it is reasonable for companies to expect that their auditors are not mere conduits to adversaries. Indeed, auditors are bound to follow AICPA ET Rule , which states: A member in public practice shall not disclose any confidential client information without the specific consent of the client. In fact, when Congress created the The Public Company Accounting Oversight Board (PCAOB) which is charged with overseeing independent auditors it specifically provided that auditors disclosure of its client documents to

4 that regulator shall be confidential and privileged, and that if the PCAOB shares a document with the SEC or other regulators, it will be without the loss of its status as confidential and privileged. 9 Thus, even Congress has recognized that confidentiality should not be lost when documents are shared with those in important oversight roles. Implications of United States v. Textron Following the District Court s decision, IRS Chief Counsel Donald Korb stated that Textron s victory could be shortlived, and that [a]s far as we re concerned, we re not going to change [IRS policy] as a result of this decision. 10 Thus, the First Circuit s decision could have a significant impact on the IRS policy going forward regarding tax accrual workpapers and on taxpayers own processes for creating and handling their workpapers, but the full extent of that impact may take time to assess. The First Circuit also will be the first federal appeals court with the opportunity to resolve whether disclosure of work product to outside auditors constitutes a waiver. As such, the decision will be closely scrutinized. As the Chamber and ACC argued in their amici brief, each of the per se rules advocated by the IRS first, that documents used to support financial statements or fulfill regulatory requirements never are entitled to work product protection; and second, that disclosure of work product to outside auditors always constitutes a waiver would create perverse catch-22s for public companies. Companies should be entitled to rely on their counsel to perform litigation analyses used to support reserves, and should be able to share those analyses with outside auditors, without fear that the companies will be forced produce possible litigation roadmaps that adversaries can exploit. The result would be to frustrate, rather than advance, many of the purposes of federal securities laws prudent corporate governance, meaningful selfanalysis and public disclosure. * * * If you have any questions about this Client Alert or would like a copy of the Chamber/ACC amici brief, please contact David M. Brodsky, Robert J. Malionek or Adam J. Goldberg in our office. Endnotes 1 See Textron and Workpaper Confidentiality, Latham & Watkins LLP Client Alert No. 625 (Sept. 5, 2007). 2 United States v. Textron Inc., 507 F. Supp. 2d 138, (D.R.I. 2007). 3 United States v. Arthur Young & Co., 465 US 805, 816 (1984) (citations omitted) US 495, 516 (1947) (Jackson, J., concurring). 5 See United States v. El Paso Co., 682 F.2d 530, 542 (5th Cir. 1982). 6 See United States v. Adlman, 134 F.3d at 1194, (explaining policies). 7 See, e.g., United States v. Mass. Inst. of Tech., 129 F.3d 681, 687 (1st Cir. 1997) F.R.D. 441 (S.D.N.Y. 2004) U.S.C Tax Accrual Work Papers Protected by Work-Product, BNA Corporate Counsel Weekly, Sept. 12, Current IRS policy is one of self-restraint, with requests for tax accrual workpapers generally made only in connection with cases involving listed transactions or unusual circumstances, such as a restatement of earnings.

5 If you have any questions about this Client Alert, please contact one of the authors listed below: David M. Brodsky Robert J. Malionek Adam J. Goldberg Or any of the following attorneys listed to the right. Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorneys listed below or the attorney whom you normally consult. A complete list of our Client Alerts can be found on our Web site at If you wish to update your contact details or customize the information you receive from Latham & Watkins, please visit to subscribe to our global client mailings program. Barcelona José Luis Blanco Madrid José Luis Blanco Rome Fabio Coppola Brussels Howard Rosenblatt Milan Fabio Coppola San Diego Bruce P. Shepherd Office locations: Barcelona Brussels Chicago Dubai Frankfurt Hamburg Hong Kong London Los Angeles Madrid Milan Moscow Munich New Jersey Northern Virginia Orange County Paris Rome San Diego San Francisco Shanghai Silicon Valley Singapore Tokyo Washington, D.C. Chicago Robert G. Goldman Frankfurt Hans-Jürgen Lütt Hamburg Götz T. Wiese Hong Kong Joseph A. Bevash London Daniel Friel Los Angeles James D. C. Barrall Laurence J. Stein Moscow Mark M. Banovich Munich Stefan Süss New Jersey David J. McLean Jed W. Brickner David S. Raab Northern Virginia Eric L. Bernthal Orange County David W. Barby Paris Christian Nouel San Francisco Scott R. Haber Shanghai Rowland Cheng Silicon Valley Joseph M. Yaffe Singapore Mark A. Nelson Tokyo Bernard E. Nelson Washington, D.C. Gerald A. Kafka Julian Y. Kim