First Circuit’s Textron Ruling Raises New Concerns About Vitality of Work-Product Doctrine

First Circuit’s Textron Ruling Raises New Concerns About Vitality of Work-Product Doctrine

 
In August 2009, the First Circuit en banc ruled on the applicability of the work-product doctrine to shield tax accrual work papers from an IRS summons. United States v. Textron, Inc., 577 F.3d 21 (1st Cir. 2009). In a decision widely criticized in the accounting industry and by others such as the Association of Corporate Counsel of America (ACCA), the court held that work-product protection did not apply. In the context of internal corporate investigations, Textron raises new concerns about discovery by government authorities of counsels’ assessments of liabilities that might arise from possible misconduct discovered by businesses in the course of operations.
 
Background
 
In 2001, Textron participated in nine sale-in, lease-out (SILO) transactions, which the IRS considers to be abusive "listed transactions." Textron’s in-house tax attorneys analyzed the company’s tax positions, and its in-house audit personnel, in consultation with counsel, prepared tax accrual work papers. The work papers included a spreadsheet listing the issues, percentage estimates of the hazards of litigation, and established a tax reserve. Textron disclosed the tax accrual work papers to its external auditors, Ernst & Young (E&Y), with the understanding that they were confidential. It did not allow E&Y to retain copies.
 
The IRS commenced an audit of Textron and became aware of the SILO transactions. Under IRS policy, the Service (1) seeks tax accrual work papers specifically related to a taxpayer’s participation in a listed transaction if the taxpayer engaged in a single listed transaction and properly disclosed its participation; and (2) seeks all tax accrual work papers if the taxpayer engaged in multiple listed transactions or in a single listed transaction that was not properly disclosed. Because Textron engaged in nine SILOs, the IRS issued summonses for all of Textron’s tax accrual work papers for 2001. Textron declined to produce them, claiming work-product protection, and the IRS moved to enforce the summons.
 
The district court found for Textron, agreeing with the defense that the disclosure was not a waiver of the work-product doctrine as defined by Fed. R. Civ. P. 26(b)(3). According to the district court, only disclosures inconsistent with the adversary system are deemed waivers of the work-product protection. Typically, this means disclosure to an adversary, which E&Y was not. Applying the First Circuit’s "because of litigation" test, the lower court concluded the tax accrual work papers qualified for the doctrine’s protection because of the prospect of litigation, even if the documents also had a dual business purpose. Maine v. United States Dep’t of the Interior, 298 F.3d 60, 68 (1st Cir. 2002).
 
On appeal to the First Circuit, the IRS argued that the presence of a business or regulatory purpose defeated work-product protection. The IRS claimed that the tax accrual work papers were not prepared because of litigation since they were created to evaluate uncertain tax positions for financial accounting purposes. The First Circuit initially rejected this IRS argument and affirmed the district court’s holding that documents could be protected even though there was a dual purpose. After all, as the panel noted, they would not have been prepared for financial accounting purposes if there had been no prospect of litigation with the IRS. This decision was vacated, however, and the case was heard en banc by the First Circuit.
 
En Banc Ruling in Textron
 
In its en banc opinion, the First Circuit vacated the panel’s ruling. The First Circuit held that the work papers were not protected pursuant to the work-product doctrine under the First Circuit’s established "because of litigation" test. The court rejected the argument that providing the IRS with the company’s evaluation of its legal position was unfair, observing that that "tax collection is not a game" and that under-reporting of corporate taxes "is likely endemic." The court ultimately found the work-product doctrine is aimed at protecting work done for litigation, not in preparing financial statements. Since Textron’s work papers were to support financial filings and gain auditor approval, the IRS had rightful access.
 
For the dissent, the majority’s decision was out of step with both circuit precedent and the plain language Rule 26. See e.g., United States v. Adlman, 134 F.3d 1194, 1198-99 (2d Cir. 1998) (holding that a memorandum discussing various legal issues relating to taxation and predicting the outcome of possible litigation prepared in connection with the sale of a subsidiary could qualify as work product). Chiding the majority for favoritism toward the IRS, the dissent complained that "the scope of the work-product doctrine should not depend on what party is asserting it." Perhaps most importantly, however, the dissent noted that "under the majority’s rule one party in a litigation will be able to discover an opposing party’s analysis of the business risks of the instant litigation, including the amount of money set aside in a litigation reserve fund, created in accordance with similar requirements as Textron’s tax reserve fund."
 
Analysis
 
In Textron, the First Circuit applied its "because of litigation" test narrowly in defining the reach of work-product protection under Rule 26 in connection with audit work papers. Textron follows the Fifth Circuit’s similar ruling many years ago in United States v. El Paso Co., 682 F.2d 530, 542 (5th Cir. 1982), cert. denied, 466 U.S. 944 (1984) (finding tax accrual work papers are only protected by the work-product doctrine if the documents are "primarily motivated to assist in future litigation"). After Textron, there is arguably little difference other than nomenclature between the First Circuit’s "because of litigation" test and the Fifth Circuit’s old "primary purpose" standard.
 
The Textron en banc ruling should be carefully considered by counsel when consulting with auditors regarding possible loss contingencies. Work papers reflecting statements of counsel and the resulting establishment of a specific reserve in connection with a possible specific claim may not be protected under the work-product doctrine and may constitute highly damaging admissions of a party opponent under F.R.E. 801 admissible in court. The problems with allowing adversaries to discover such matters in connection with litigation and to admit resulting evidence at trial are so obvious as to need no elaboration. It seems hard to argue with ACCA’s position that Textron fails to recognize that greater protection, not less, is needed to support candid attorney-client communications and to cabin discovery by adversaries of attorney work-product.
 
To the extent that Textron reflects the First Circuit’s view that work-product is entitled to less protection when law enforcement interests are engaged, Textron is a particularly ominous decision for lawyers, accountants and their clients in defending regulatory proceedings and criminal cases. Counsel conducting internal corporate investigations of possible misconduct are urged to review and consider Textron, as well as the Financial Accounting Services Board’s proposed changes to Financial Accounting Standards Statement 5 relating to financial statement reporting of loss contingencies, before consulting company’s management and the company’s audit personnel regarding the results of their inquiries.
 
With any luck, neither Textron’s reasoning nor result will be adopted in other circuits. In the absence of any relief from Textron, the best approach for affected parties is to be mindful of the record they may have to present in support of future claims of work-product protection. Accordingly, both in-house and outside counsel involved in internal investigations, as well as those involved in considering possible loss contingencies, should take measures to document and support that their work was done "in anticipation of litigation" under Rule 26.
 
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