In an unusual, much-discussed, and potentially significant case, the United States Court of Appeals for the Second Circuit held in a 2 to 1 decision that a 58-page memorandum prepared by the taxpayer's accounting firm, Arthur Andersen & Co., could qualify for the work product privilege if certain conditions were met. United States v. Adlman, 134 F.3d 1194 (Feb. 13, 1998).
The Federal work product privilege, which is embodied in Federal Rule of Civil Procedure 26(b)(3), protects against the discovery by an opposing party of documents prepared in anticipation of litigation or for trial by a party or by its representative, including its attorney, consultant, surety or agent, unless the opposing party shows a substantial need for the material and that it is unable to obtain the equivalent of the material by other means without undue hardship. However, even if a showing of undue hardship is made, the court must protect against disclosure of the mental impressions, conclusions, opinions, or legal theories of an attorney or other representative of a party concerning the litigation.
It is clear from the foregoing that the work product privilege is not limited to documents which reflect the mental impressions, conclusions, opinions or theories of an attorney. The privilege extends to documents prepared by a party, or any agent or representative of a party, including the party's accountant, provided that the documents are prepared in anticipation of litigation. Thus, the Second Circuit's opinion does not break new ground in applying the work product privilege to accountants. However, the opinion addresses the less clear question of when a document is prepared in anticipation of litigation.
The memorandum prepared by Arthur Andersen dealt with a proposed merger of the client's subsidiaries which would trigger a large tax loss and give rise to a carryback refund claim. The memorandum detailed the likely IRS challenges to the tax treatment of the proposed merger and to the related tax refund claim that would be filed after the merger. The document contained possible legal theories and strategies for the taxpayer to adopt, recommended preferred methods of structuring the merger transaction, and made predictions about the likely outcome of litigation.
The taxpayer went ahead with the restructuring, claimed the resulting $289 million loss, and carried back the loss, thereby generating a $35 million refund claim.
The IRS sought to obtain a copy of the 58-page memorandum by issuing a summons during an audit of the taxpayer's income tax returns. The IRS argued that the document could not have been prepared in anticipation of litigation because not only was there no pending or threatened litigation, but the business transaction had not even taken place. The taxpayer argued that because of the substantial amounts involved, the nature of the legal issues, the fact that the taxpayer was audited every year and that it would file a substantial refund claim if the transaction occurred, there was a virtual certainty that litigation would ensue if the transactions outlined in the memorandum were effectuated. Therefore, the memorandum should be considered to be have been prepared in anticipation of litigation.
The District Court denied protection from disclosure under the work product doctrine because the primary purpose for the memorandum was to decide whether or not to go through with the multimillion dollar transaction and not to prepare for litigation. The Second Circuit Court of Appeals, however, ruled that a document should not be denied the work product privilege merely because it was prepared to assist in a business decision rather than to assist in the conduct of a specific litigation. The court held that documents should be deemed prepared in anticipation of litigation, and thus be within the scope of the work product privilege, if "in light of the nature of the document and the factual situation in the particular case, the document can fairly be said to have been prepared or obtained because of the prospect of litigation". A document which is created because of the prospect of litigation and which analyzes the likely outcome of that litigation, does not lose work product protection merely because it is created in order to assist the party in making a business decision.
The Second Circuit did not actually determine whether or not the 58-page memorandum was prepared "because of the prospect of litigation". The Circuit Court remanded the case to the District Court to consider whether the document can fairly be said to have been prepared because of the prospect of litigation. The Circuit Court noted that the taxpayer had the prospect of litigation in mind when it directed Arthur Andersen to prepare the memorandum. However, whether the memorandum was prepared because of that expected litigation turns on whether it would have been prepared in substantially similar form irrespective of the expected litigation with the IRS. The Circuit Court instructed the District Court that if substantially the same memorandum would have been prepared in any event as part of the ordinary course of business in undertaking the corporate restructuring, then the memorandum was not prepared because of the expected litigation and it would not be entitled to the work product privilege. On the other hand, if the memorandum would not have been prepared but for the taxpayer's anticipation of litigation with the IRS over the losses generated by the restructuring, then the memorandum is protected by work product privilege.
The dissenting opinion characterized the majority opinion as expanding the work product privilege to protect documents not prepared in anticipation of litigation but instead prepared in order to permit the client to determine whether to undertake a business transaction. The dissent noted that there would be no litigation unless the transaction is undertaken. The dissent also points out that a party is not without means to protect the legal analysis and conclusions from disclosure, since the party could engage an attorney and be protected by the attorney-client privilege.
The majority opinion appears to be saying that it will not deny the work product privilege to the accountant's legal analysis, conclusions and mental impressions simply because there is no actual litigation or even an actual audit of the taxpayer's return. However, it will not grant work product privilege simply because litigation is possible or even likely. The court says the first question to be asked is whether the document was prepared in the ordinary course of business; e.g., is it the usual course of business for the client to seek the advice of its accountants or others in advance with regard to the tax consequences of major transactions? The Court did not give guidance on what constitutes the ordinary course of business in this context. One important fact might be how often in the past an accountant or attorney had been asked by the party to prepare an analysis of the tax consequences of its proposed business transactions.
The client who normally comes to his accountant for analysis of the tax consequences of a proposed business transaction might be hard pressed to justify the work product privilege, since it would be argued that the memorandum was prepared in the ordinary course of business.
If the accountant prepares a memorandum with regards to a transaction that has already occurred, but before the tax return has been prepared, it could be argued that the memorandum was prepared to assist in reporting the transaction on the tax return and not because of anticipated litigation.
In sum, the work product privilege will not automatically apply to an accountant's legal analysis merely because there is a likelihood that the taxpayer will be audited and that litigation with the IRS is likely. The concern expressed by the dissent that the majority opinion will substantially broaden the scope of the work product privilege may well be misplaced.
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