Forensic, General & Medical
Expert Witnesses

First Circuit Applies New Standard Restricting Work Product Privilege when Information is Used for Financial Reporting


     By Fulcrum Inquiry Damages, Appraisal, Accounting & Economics Expert Witnesses

PhoneCall David Nolte at (213) 787-4100


Expert Witness: Fulcrum Inquiry
The attorney work product doctrine, now codified in Federal Rule of Evidence 26(b)(3), protects from discovery documents prepared "in anticipation of litigation or for trial." In a 3 to 2 decision, the First Circuit determined that only information directly "prepared for" use in litigation is protected from disclosure. Potentially, the ruling affects every public and private company that addresses litigation and/or tax exposures for financial reporting.
The attorney work product doctrine, now codified in Federal Rule of Evidence 26(b)(3), protects from discovery documents prepared "in anticipation of litigation or for trial." Courts apply different tests to interpret this phrase. A minority of courts apply a stringent test under which documents are protected only if they were created for the "primary purpose" of assisting in litigation. In an earlier opinion, the First Circuit adopted the more widely accepted "because of" standard. Under this standard, work product protection occurs if the document was created "because of" the prospect of litigation.

In a 3 to 2 decision, the First Circuit Court (United States v. Textron, Inc., No. 07-2631 (First Circuit, August 13, 2009) (en banc)) overturned both its earlier three-judge ruling and a district court in holding that attorney work product protection from disclosure was available. Under the ruling, only documents and information directly "prepared for" use in litigation is protected from disclosure. See Tax Accrual Work Papers Are Probably Safe from the IRS’s Probing Eyes for a discussion of the underlying trial court decision which the first Circuit initially upheld.

Although the Court’s discussion indicates that this decision pertains to a public company with an outside audit requirement (which is true), the decision equally affects any company (including private companies) who prepare audited or unaudited financial statements in accordance with generally accepted accounting principles. This occurs because FIN 48 requires tax contingency assessments for all financial statements by entities that pay taxes. For more information see The FASB's Gift to the IRS. As explained below, the application of this same rule would also make available non-tax communications and calculations involving the assessment of litigation loss exposures for financial reporting.

The Textron case involves a sales-in, lease-out transaction, or SILO. The First Circuit’s en banc ruling described these transactions as follows:

“SILOs allow tax-exempt or tax-indifferent organizations-for example, a tax-exempt charity or a city-owned transit authority to transfer depreciation and interest deductions, from which they cannot benefit, to other taxpayers who use them to shelter income from tax. Where the only motive of a sale and lease back is tax avoidance, it can be disregarded by the IRS and taxes assessed on the wrongly sheltered income.”

Textron entered into nine of these transactions, which were the subject of an IRS audit. Textron refused to produce to the IRS Textron’s notes and calculations that internally assessed the risks and possible audit outcomes of these tax shelters. The current case addressed whether this refusal to produce on attorney work product grounds was appropriate. The en banc decision framed the issue as follows:

“…[H]ow far work product protection extends turns on a balancing of policy concerns rather than application of abstract logic; here, two circuits have addressed tax accrual work papers in the work product context, but, apart from whatever light is cast by Arthur Young [a Supreme Court 1984 decision which held that tax accrual work papers prepared by an independent auditing firm were not protected from an IRS summons because of an accountant-client privilege or an accountant work product privilege], the Supreme Court has not ruled on the issue before us, namely, one in which a document is not in any way prepared "for" litigation but relates to a subject that might or might not occasion litigation.”

The case establishes a new test of whether something is protected from discovery. Because the documents were not directly prepared for litigation, but instead for a financial reporting purpose, the work product privilege did not prevent their discovery by the IRS. According to the ruling, this result occurs even though the documents explicitly contemplated the possibility of litigation. According to the full First Circuit, the documents must have been prepared “for use” in litigation, and not the more liberal “because of” test. In the Court’s words:

“…the IRS is unquestionably right that the immediate motive of Textron in preparing the tax accrual work papers was to fix the amount of the tax reserve on Textron's books and to obtain a clean financial opinion from its auditor. And Textron may be correct that unless the IRS might dispute an item in the return, no reserve for that item might be necessary, so perhaps some of the items might be litigated. But in saying that Textron wanted to be "adequately reserved," the district judge did not say that the work papers were prepared for use in possible litigation--only that the reserves would cover liabilities that might be determined in litigation. If the judge had made a "for use" finding--which he did not--that finding would have been clearly erroneous.

That the purpose of the work papers was to make book entries, prepare financial statements and obtain a clean audit cannot be disputed. … Textron's testimony differed from that of the IRS expert only in its further assertion that, without the possibility of litigation, no tax reserves or audit papers would have been necessary.”

In deciding what is protectable, the en banc First Circuit relied on a judgmental test lacking clearly-defined parameters. The first Circuit’s guidance is reminiscent of Justice Potter Stewart’s famous but unhelpful description in Jacobellis vs. Ohio 378 U.S. 184 (1964), which described possible obscenity as “I know it when I see it”. In a description with which most tax departments of public corporations would disagree, the First Circuit simply “knows” that calculations addressing tax contingencies is not what is supposed to be protected from IRS disclosure :

“Every lawyer who tries cases knows the touch and feel of materials prepared for a current or possible (i.e., "in anticipation of") law suit. They are the very materials catalogued in Hickman v. Taylor and the English precedent with which the decision began. No one with experience of law suits would talk about tax accrual work papers in those terms. A set of tax reserve figures, calculated for purposes of accurately stating a company's financial figures, has in ordinary parlance only that purpose: to support a financial statement and the independent audit of it.”

Perhaps the reason the First Circuit simply “knows” the right answer is that the decision clearly is a results-oriented ruling intended to fight perceived corporate abuse in not paying taxes. The judges expressed clear sympathy to the IRS’s job. According to the ruling:

“The practical problems confronting the IRS in discovering under-reporting of corporate taxes, which is likely endemic, are serious. … It is because the collection of revenues is essential to government that administrative discovery, along with many other comparatively unusual tools, are furnished to the IRS. …

Textron apparently thinks it is "unfair" for the government to have access to its spreadsheets, but tax collection is not a game. Underpaying taxes threatens the essential public interest in revenue collection. If a blueprint to Textron's possible improper deductions can be found in Textron's files, it is properly available to the government unless privileged. Virtually all discovery against a party aims at securing information that may assist an opponent in uncovering the truth.”

The en banc decision was 3 to 2. The two in the minority wrote a harshly-worded dissent that will certainly be useful to those in other circuits who wish a different result. The dissent said that the majority applied neither the "because of" test previously adopted by the First Circuit in Maine v. United States Department of Interior, 298 F.3d 60 (1st Cir. 2002), nor the more restrictive "primary purpose" test. Instead, the dissenters claim the majority created a third, even more restrictive test under which only documents “prepared for use in litigation” would be non-discoverable. The dissenting opinion also addresses the broad impact that the decision could have if it applied to areas other than tax work papers. The long dissenting opinion concludes:

“In straining to craft a rule favorable to the IRS as a matter of tax law, the majority has thrown the law of work-product protection into disarray. Circuits have already split interpreting the meaning of "anticipation of litigation," between the "primary purpose" and "because of" tests. Now this court has proceeded to further the split by purporting to apply the "because of" test while rejecting that test's protection for dual purpose documents. In reality, the majority applied a new test that requires that documents be actually "prepared for" use in litigation. The time is ripe for the Supreme Court to intervene and set the circuits straight on this issue which is essential to the daily practice of litigators across the country.”

The minority’s claim that this issue affects the “daily practice of litigators across the country” is well founded since this issue is not limited to work product created by or for tax reporting. In a nearly identical situation, all companies must evaluate non-tax contingent liabilities when preparing financial statements in accordance with generally accepted accounting principles. Other than the public policy appeal of desiring to collect taxes, the identical rationale described by the majority's opinion would have litigation opponents discovering litigation analysis whenever the analysis is part of, or used in connection with, the preparation of financial statements (in other words, always!), and not solely for trial team preparation.

ABOUT THE AUTHOR: David Nolte
Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

Copyright Fulcrum Inquiry

More information about Fulcrum Inquiry


While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.
For specific technical or legal advice on the information provided and related topics, please contact the author.

Find an Expert Witness