Sharing Information With Auditors Could Increase Risk Of Waiving Privileges

In a post-Sarbanes-Oxley world it might seem that a company can never disclose too much to its auditors. Unfortunately, caution must be exercised when sharing information with auditors to avoid waiving legal privileges.

Courts have long recognized that when accountants are retained to assist attorneys in providing legal advice to clients (e.g., by helping to interpret accounting principles), disclosure of privileged communications to those accountants does not waive the attorney-client or work product privileges. Conversely, such privileges generally are not applicable to material shared with accountants for business rather than legal purposes.

The nature of the work performed by accountants is central to the question of whether the work would be considered privileged because accounting firms today often perform different types of services for their corporate clients.

In First Federal Savings Bank of Hegewisch v. United States, 55 Fed. Cl. 263, 2003 U.S. Claims LEXIS 23 (Fed. Ct. Cl. Feb. 12, 2003), unredacted board minutes that included discussions between board members and counsel had been disclosed to the same accounting firm on two separate occasions – first in the course of an internal investigation directed by outside counsel relating to fraud by a former executive, and later in the course of an annual audit.

The court concluded that the first disclosure did not waive the attorney-client privilege because the accountants’ role involved assisting legal counsel in the investigation, but the second disclosure did waive the privilege because the accountants’ work merely assisted an ordinary business purpose.

While the vast majority of privileged documents that a large corporation accumulates has no bearing on an auditor’s work, in some circumstances otherwise privileged material could be necessary for outside auditors to render opinions on financial statements. This is especially true where a company faces the risks of high stakes litigation where the adequacy of reserves may be at issue for purposes of rendering an opinion on financial statements. (See Statement of Financial Accounting Standards No. 5.)

In these circumstances, courts have wrestled with whether audit response letters and supporting material disclosed to outside auditors will be protected by the work product doctrine as against other third parties.

Case Law

Not surprisingly, in recent years courts have been influenced by the major corporate scandals in addressing these questions of privilege.

For example, in Medinol, Ltd. v. Boston Scientific Corp., 214 F.R.D. 113, 114 (S.D.N.Y. 2002), a public company claimed privilege under the work product doctrine over the minutes of a special litigation committee that had been made available to its outside auditor.

The court adopted an adversarial view of the client-auditor relationship and found that such disclosures waived any privilege, noting that in the course of rendering an opinion on financial statements, an auditor "must come to his own understanding of reasonableness" because "[t]he auditor’s review supports the auditor’s independent opinion about the fairness of the company’s financial reports, not the audited company’s litigation interests" and that it had "become crystal clear in the face of the many accounting scandals that have arisen as of late, in order for auditors to properly do their job, they must not share common interests with the company they audit." (emphasis in original).

Audit letters and supporting materials also were recently discussed at length in In re Raytheon Sec. Litig., 218 F.R.D. 354 (D. Mass. 2003), where plaintiffs sought to compel such materials from auditor and corporate client co-defendants. Regarding the audit letters, the court first noted that other courts around the country have interpreted differently the requirement that documents qualifying for work product protection be prepared "in the anticipation of litigation."

Those courts requiring advancement of litigation to be the "primary purpose" for the creation of a work product protected document have not recognized audit letters as qualifying for the privilege. See e.g., Indep. Petrochemical Corp. v. Aetna Cas. & Sur. Co., 117 F.R.D. 292, 298 (D.D.C. 1987); McEwen v. Digitran Sys., Inc., 155 F.R.D. 678, 684 (D. Utah 1994).

Those courts adopting a "because of litigation" test have upheld the protection. See, e.g., Tronitech, Inc. v. NCR Corp., 108 F.R.D. 655, 656 (S.D. Ind. 1985); In re Grand Jury Proceedings, 601 F.2d 162, 171 (5th Cir. 1979).

Middle Ground

The court in Raytheon attempted to strike a middle ground, concluding that "[t]o the extent the information in these letters must be disclosed in the public financial statements of the company being audited, it is not entitled to work product protection even under the broader ‘because of litigation’ definition of the privilege."

The judge ordered that the documents be produced for in camera review, as well as affidavits supporting the accounting and legal requirements for the treatment of pending or anticipated litigation in financial statements.

The Raytheon court also further held off until in camera review the determination of whether work protection for other supporting materials shared with the audit team had been waived by disclosure to potential adversaries. Without deciding the issue, the court noted that nothing suggested that "materials disclosed to an independent auditor are likely to be disclosed to the company’s adversaries except to the extent that the securities laws and/or accounting standard mandated public disclosure."

Given the tension between fulfilling disclosure requirements and the legitimate interests in keeping litigation strategy private, courts will likely continue to refine their approach and hopefully set clearer ground rules.

In the meantime, in-house counsel should keep close watch on what privileged materials might be disclosed during the audit process and try to determine what (if any) of such privileged material are essential to the audit. To the extent that material that is privileged but extraneous to the audit can legitimately be withheld or redacted beforehand, corporate clients may be in better position to avoid the specter of a privilege waiver down the road in litigation.

James H. Rotondo, chairman of the litigation section of Day, Berry & Howard LLP, represents a broad range of clients in product liability, negligence, commercial, and insurance coverage litigation. He can be reached at (860) 275-0197 or [email protected]. Stephen B. Hudak III, an associate at Day, Berry & Howard LLP practicing in the firm’s insurance and torts litigation Department, can be reached at (860) 275-0474.