Today we welcome first time guest blogger Ben Bolas. Ben provided significant assistance to me in researching blog posts during the early days of the blog while he was still a student at Villanova. In 2014 he was the tax clinic student of the year. He is now an associate at Dilworth Paxson LLP in Philadelphia where he focuses on tax issues. He writes today on an important issue regarding attorney-client privilege and work product in a high dollar tax case with significant pre-litigation tax planning. Keith
On November 10, 2015, the Second Circuit issued a decision in Schaeffler v US that expanded the boundaries of attorney-client privilege and work product doctrine in the context of tax advice, which was rendered in connection with a complex debt restructuring transaction. Schaeffler reminds us of the importance of maintaining proper procedures and documentation to safeguard attorney-client privilege and work product. The Second Circuit rejected the district court’s holding, severely limiting the application of attorney-client privilege and work product doctrine, and rewarded the taxpayer for careful planning.
In addition to providing guidance regarding attorney-client privilege and work product doctrine, Schaeffler is also noteworthy because it involved a marquee matchup between a high-profile taxpayer, Georg F.W. Schaeffler (“Mr. Schaeffler”), and the IRS. As the opinion described him, Mr. Schaeffler was a resident of Texas and the majority owner of Schaeffler Group, a German automotive and industrial part supplier. However, Mr. Schaeffler also happens to be the richest man in Germany. He is currently the 21st richest billionaire in the world, with a net worth of $26.7 billion, according to Forbes. To put Mr. Schaeffler’s wealth into perspective, Mr. Schaeffler’s net worth is more than double the IRS’s annual operating budget in recent years.
While the issues in Schaeffler began when Mr. Schaeffler and the Schaeffler Group (referred to collectively as “Schaeffler”) attempted to buy a minority interest in a German company, it is worth noting that Schaeffler and the IRS maintain a long-standing and ongoing acquaintance via IRS audit of several of Schaeffler’s prior year tax returns. In light of this history, and considering the magnitude of Schaeffler’s transactions in this case, Schaeffler had good reason to expect additional IRS scrutiny in the form of IRS audit and litigation. In fact, as the Second Circuit determined, Schaeffler was planning on it.read more...
In 2008, due to the nature and timing of a tender offer to buy a minority interest in a German company named Continental AG, Schaeffler purchased many more shares of Continental AG stock than planned. German law prohibited tender offers seeking less than all of a company’s shares, and so Schaeffler needed to set an offering price that would yield the desired number of shares. German law also prohibited withdrawing a tender offer once made. Unfortunately for Schaeffler, the tender offer expired on September 16, 2008, two days after Lehman Brothers collapsed and amidst the height of stock market panic associated with the 2008 economic collapse. Schaeffler quickly became the not-so-proud owner of roughly 90% of Continental AG stock at a cost of €11 billion. Threatened by insolvency stemming from Continental AG stock acquisition-related indebtedness, Schaeffler needed to refinance and restructure debt with several banks that helped finance the tender offer (the “Consortium”).
From the earliest stages of planning, Schaeffler expected IRS audit and litigation in connection with at least some of the refinancing and restructuring, given the magnitude and complexity of the envisioned transactions. Anticipation of IRS scrutiny was further bolstered by the fact that in 2007-2008 the IRS audited Mr. Schaeffler’s amended 2001 and 2004 returns, and in 2009 the IRS audited his 2006, 2007 and 2008 tax returns. In contemplation of refinancing and restructuring €11 billion, Schaeffler described IRS scrutiny as “inevitable.”
In response to ongoing and additional anticipated IRS scrutiny, Schaeffler hired Ernst & Young, and global law firm, Dentons, to advise him on the federal tax implications of the proposed debt refinancing and restructuring transaction with the Consortium. Schaeffler requested and obtained a private letter ruling from the IRS approving the core tax treatment of proposed transactions, and Ernst & Young prepared a 321-page memorandum (“EY Tax Memo”) to analyze and support the refinancing and restructuring plan. The EY Tax Memo and hundreds of other related documents explained in intricate detail the federal tax issues implicated by each step in the proposed transaction, while also setting forth legal strategies and appraisals of the likelihood of success of such strategies in a case or controversy with the IRS.
Schaeffler, Ernst & Young and Dentons worked closely with the Consortium to accomplish the refinancing and restructuring. The Consortium was also concerned about the tax implications of Schaeffler’s refinancing because the tax consequences to Schaeffler would directly impact the assets available for repayment to the Consortium. Schaeffler and the Consortium even conditioned some of the terms of refinancing upon Mr. Schaeffler’s duty to notify the Consortium of IRS audit, and to allow the Consortium to advise Schaeffler on proposed action and response to a tax case or controversy with the IRS. Schaeffler and the Consortium executed an agreement, wherein the parties expressed their desire to “share privileged, protected, and confidential documents and their analyses without waiving those privileges, protections, or the confidentiality of the information.” Thereafter, Schaeffler shared tax advice it received from Ernst & Young and Dentons with the Consortium, including the EY Tax Memo. On July 26, 2012, Schaeffler received notice of IRS audit of Mr. Schaeffler’s personal tax returns and the Schaeffler Group’s tax returns relating to tax years 2009 and 2010.
In response to the IRS’s Information Document Request (“IDR”) in September 2012 requesting documents prepared by Ernst & Young, Schaeffler invoked attorney-client privilege and work product doctrine. Thereafter the IRS issued 86 IDRs and an administrative summons to Ernst & Young to provide all documents created by Ernst & Young, including but not limited to legal opinions, analysis and appraisals, that were provided to parties outside the Schaeffler Group relating to the debt refinancing and restructuring. Ernst & Young responded by filing an action to quash the summons pursuant to 26 U.S.C. § 7609(b)(2).
U.S. District Court (SDNY) (“District Court”)
The District Court held that attorney-client privilege did not apply to the documents that the IRS requested because the Consortium did not have a “common legal interest” in the outcome of a tax dispute between Schaeffler and the IRS, and accordingly, Schaeffler waived attorney-client privilege when it shared the documents with the Consortium. Even though the Consortium had an “enormous stake in the tax consequences of Schaeffler’s refinancing and restructuring” the District Court found that such stake was “an economic one.” Therefore, the court held that the Consortium lacked any legal stake in Schaeffler’s putative action with the IRS, indicating that attorney-client privilege is not meant to apply to a “joint business strategy.”
Work Product Doctrine
While noting that work-product protection was not waived when Schaeffler shared documents with the Consortium, the District Court held that work product protection did not apply in this case because the EY Tax Memo and other documents were never entitled to work product protection. The court’s rationale was that Schaeffler would have sought the same tax advice in connection with the transaction if Schaeffler had no concerns in regard to tax controversy or litigation and that the EY Tax Memo did not “specifically refer to litigation.”
The District Court was not persuaded by characterizations and discussions in the documents concerning risk of litigation with the IRS and chances of success upon such litigation, stating that such characterizations are “of no significance” for purposes of determining whether the document would have been created differently absent anticipated litigation, stating further that Ernst & Young had “an independent responsibility to engage in such legal analysis in order to advise Schaeffler on what transactional steps he should take.”
United States Court of Appeals for the Second Circuit (“Circuit Court”)
The Circuit Court began its analysis by discussing attorney-client privilege, and reviewing when such privilege is waived. While acknowledging the District Court’s premise that “[c]ommunications that are made for purposes of evaluating the commercial wisdom of various options as well as in getting or giving legal advice are not protected[,]” the Circuit Court explained that a client does not waive attorney-client privilege when the client discloses information to another party that is engaged in a “common legal enterprise” (also referred to as “common legal interest”) with the client. The court cited United States v. Schwimmer to support its assertion that such a common legal interest can be found even where there is no ongoing litigation, “where a joint defensive effort or strategy has been decided upon and undertaken by the parties and their respective counsel.”
The Circuit Court held that Schaeffler did not waive attorney-client privilege when it disclosed documents to the Consortium because Schaeffler and the Consortium did share a common legal interest. In concluding that the Consortium’s common interest with Schaeffler was of a sufficient legal character to prevent a waiver by the sharing of those communications, the Circuit Court rejected the District Court’s assertion that the Consortium’s interest was purely economic, stating that the fact that the Consortium had an €11 billion financial interest at stake does not overshadow the legal issues and make them commercial. “A financial interest of a party, no matter how large, does not preclude a court from finding a legal interest shared with another party where the legal aspects materially affect the financial interests.”
The Circuit Court further held that the tax treatment of the refinancing and restructuring, anticipated IRS scrutiny and the potential tax liability stemming therefrom all worked to shape the agreement between Schaeffler and the Consortium, and such considerations reflected a common legal strategy against IRS scrutiny, including tax controversy and litigation. The parties even contractually tied their interests in IRS litigation by exchanging mutual obligations, whereby the Consortium agreed to subordinate debt and extend a line of credit to Schaeffler to allow Schaeffler to pay its tax debt, and in exchange for Schaeffler agreed to notify the Consortium of IRS audit and to consult with the Consortium before Schaeffler paid additional taxes or filed a refund claim.
Work Product Doctrine
The Circuit Court found that the EY Tax Memo and other documents were entitled to receive work product protection because they were prepared in anticipation of litigation, despite the fact that such documents were also intended to assist with the business transactions. The Circuit Court cited United States v. Adlmanas the “governing precedent” in finding that work product doctrine applied, noting the closely-related facts of this case and Adlman,and using Adlman to differentiate when work product doctrine should and should not apply.
The Circuit Court indicated that work product protection would not be appropriate for supporting records and papers that were collected in the ordinary course of business, such as documents collected annually while preparing Schaeffler’s tax returns. Work product protection would be appropriate, however, for documents specifically drafted to address an urgent need to refinance and restructure, and necessarily geared to address the high likelihood of audit and litigation that such refinancing and restructuring created. The Circuit Court explained that the highly-detailed memoranda and litigation-focused analysis indicated preparations above and beyond that which is required to prepare an ordinary tax return or tax document with clear application of law, and that Schaeffler and the Consortium requested the highly-detailed and technical tax advice and memoranda because of the anticipation of litigation.
The Circuit Court concluded that it would have been unrealistic, given the magnitude and complexity of the transaction, to conceive of the refinancing and restructuring transactions without the threat of litigation. If the District Court’s interpretation of Adlman were to apply, tax analysis and opinions created to assist large and highly complex transactions with uncertain tax consequences would never receive work product protection.
While the District Court recognized the concept of a common legal interest, its application of the facts of this case in finding no common legal interest between Schaeffler and the Consortium appeared to be clearly erroneous. Although the summons requested documents exclusively from Ernst & Young, and not documents prepared by the law firm, Dentons, the critical distinction (and error) the District Court made in its analysis of whether Schaeffler waived attorney-client privilege pertained to the conclusion that there was no common legal interest between Schaeffler and the Consortium, only an economic interest. The facts indicated multiple instances where Schaeffler and the Consortium aligned their legal interests, and they did so with an eye toward preserving attorney-client privilege, even executing an agreement entitled “Attorney Client Privilege Agreement” (although not determinative of whether a document is protected by attorney-client privilege, the such a label is relevant, as the Circuit Court explained). More importantly, Schaeffler and the Consortium not only acknowledged the potential for IRS scrutiny, including IRS controversy and litigation, they allocated risk and contractual obligations accordingly (as the Circuit Court described it, “the Consortium’s legal interest is underlined by the extent to which the Consortium essentially insured [Schaeffler].”).
In regard to work product doctrine, the District Court’s decision created the enigmatic result that documents analyzing large and complex transactions with uncertain tax results are less likely to receive work product protection, unless particular litigation is referenced. As the U.S. Chamber of Commerce argued in an amicus curiae brief, if such a decision were allowed to stand, it would have a stifling effect on legal advice rendered in connection to complex litigation, and “lawyers will hesitate to give candid guidance for fear that their work product will later be revealed to opposing counsel.”
Questions still exist pertaining to the precise limits of attorney-client privilege and work product doctrine in the context of tax advice. For instance, if Schaeffler is audited year after year, and if each year Schaeffler engages Ernst & Young to prepare documents in anticipation of audit and litigation, query whether the documents could be considered to be prepared in the ordinary course of business and therefore not entitled to work product protection.
While the contours of attorney-client privilege and work product doctrine relating to tax advice remain to be defined, Schaeffler broadened attorney-client privilege and work product doctrine by lowering the threshold for achieving such protections in instances where attorneys, accountants and other professionals (bankers in this case) have a common legal interest and share documents in anticipation of litigation.