Responding to Audit Inquiry Letters Working with Your Client to Provide Full Disclosure While Protecting Sensitive Information
It's "that time of year" again. No, it's not tax season, but rather the time for your client to prepare its audited financial statements and requisite disclosures to the Securities and Exchange Commission (SEC) and/or any other party to which it agreed to provide an annual audit.1 As part of this disclosure, your client has asked its accountant to prepare financial statements and issue an opinion that these statements fairly present the true financial picture. The accountant, in turn, sends you and/or your client an "audit inquiry letter" that asks you to describe any event that may affect your client's financial status, including pending and potential litigation. The most likely next step is for your client to send you a letter that simply requests that you respond. Typically, this would be the extent of your client's involvement in this process because it has confidence that you can accurately describe the matters that you are handling, or have discussed potentially handling.
However, despite a split of authority, many courts hold that the response to the audit inquiry letter waives the attorney-client privilege and/or the work product doctrine. Thus, the response, drafts and underlying documentation could be discoverable by your client's adversary in litigation and/or your client's creditors.2 In order to limit the potentially damaging impact that the disclosure of such sensitive information can have, you need to implore your client to take an active role and work in concert with you to carefully craft a reply that is at once forthcoming and at the same time preserves their rights.
When your client's accountant prepares the financial statements and issues its opinion on them, the accounting firm must comply with, among other things, Statement of Financial Accounting Standards Number Five (FAS 5) and Statement on Auditing Standards Number 12 (SAS 12). FAS 5 establishes standards of financial accounting and reporting for loss contingencies and provides that "one such loss contingency is pending or threatened litigation."3 SAS 12 gives the accounting firm guidance on the procedures that it should consider for identifying litigation, claims and assessments and satisfying itself that the financial accounting and reporting for such matters is in accord with the generally accepted auditing standards.4 SAS 12 requires disclosure of (1) a list that describes and evaluates pending or threatened litigation and (2) a list that evaluates claims that have not yet been asserted.
Given that these statements command the accountant to gather as much information as possible, you and your client should be aware that there is no federal accountant-client privilege as a matter of federal common law and no such privilege under Federal Rule of Evidence 501.5 In fact, the U.S. Supreme Court has expressly disapproved of the so-called accountant-client privilege, stating that "no confidential accountant-client privilege exists under federal law, and no state-created privilege has been recognized in federal cases."6 Most states do not recognize an accountant-client privilege. Thus, without any other applicable privilege, information that is provided to the accountant could be the subject of discovery by a litigation adversary or a creditor.
As a bankruptcy court practitioner, when you prepare your response to the audit inquiry letter, you must comply with the Rules of Professional Conduct enacted in your state and the Federal Rules of Evidence.7 These statutes require you to represent your client zealously and to assert privileges to protect confidential communications.8 You may assert either the attorney-client privilege or the work product doctrine to withhold producing the response and/or underlying documentation used in preparing the response to your client's litigation adversary or creditor who has requested its production. The attorney-client privilege provides that your client has the privilege to refuse to disclose, and to prevent any other person from disclosing, confidential communications between him/her and you that were made to facilitate your rendition of legal services.9 The purpose of this privilege is to encourage "full and frank communication between attorneys and their clients."10 The work product doctrine provides that any notes, working papers, memoranda or similar materials prepared by you in anticipation of litigation generally are protected from discovery.11 While there is sparse pertinent case law, courts have held that the response to an audit inquiry letter may be a waiver of the attorney-client privilege and possibly a waiver of the protections of the work product doctrine.
The courts have used three primary lines of reasoning to support this view. First, the Fourth Circuit reasoned that "if a client communicates information to his attorney with the understanding that the information will be revealed to others, the information, as well as the details underlying the data that was to be published, will not enjoy the privilege."12 Thus, it concluded, the final response to the audit inquiry letter, as well as the underlying drafts, notes and memoranda, were not protected by the attorney-client privilege.13 Second, a Pennsylvania U.S. District Court held that the response was merely a communication of facts of various loss contingencies and not of litigation strategy or the specific nature of the legal services performed, and that the privilege does not extend to facts.14 Third, a Florida bankruptcy court found that the response was intended to be made available to the public because it was used in the preparation of public financial statements, and thus, the privilege was waived.15
Courts are split on whether the response to an audit inquiry letter is a waiver of the protections of the work product doctrine. On one hand, the aforementioned Pennsylvania district court limited its holding by ordering the reduction of the portions of the response that discussed the expected result and probable loss. The court deemed those items to be counsel's mental impressions and legal opinions that would be protected by the work product doctrine.16 The court went further by concluding that the disclosure to the accountant was not a waiver of the work product doctrine because it was not a voluntary disclosure to an adversary.17 Similarly, an Indiana district court found that the doctrine was not waived because the response was prepared only due to the existence of the litigation, as opposed to being prepared in the ordinary course of business.18 The Fourth Circuit drew a distinction between "fact work product" and "opinion work product," and extended the privilege to "opinion work product."19 On the other hand, a District of Columbia district court found a waiver of the doctrine by reasoning that the response to the audit inquiry letter was not prepared for purposes of a trial or with reference to future litigation.20 For support of its position, the court drew on the Advisory Committee Notes to Federal Rule of Civil Procedure 26(b)(3), which provides that "materials assembled in the ordinary course of business, or pursuant to public requirements unrelated to litigation, or for other non-litigation purposes are not under the qualified immunity provided by this subdivision."21
Under either the attorney-client privilege analysis or the work product doctrine analysis, the most extreme ramification of the court finding of a waiver is that it is uncertain whether the waiver results in a "subject matter waiver" or is limited only to the information actually disclosed.22 For instance, where the Second Circuit at one time rejected the concept of a selective waiver of the attorney-client privilege, it later held that disclosure to a third party did not waive the privilege as to the undisclosed portions of the communication.23 In addition, some courts have found a limited waiver when the purpose behind the creation of the communication in question was to cooperate with a government agency.24 Thus, if the court finds that the response to the audit inquiry letter is a waiver of either the attorney-client privilege or the work product doctrine, there is a real risk that the waiver will extend beyond the response to all of the documents regarding the litigation matters described in the response.
ABA and AICPA Guidelines
To address the tension between the accountant's need for information and your need to assert privileges on your client's behalf, the American Bar Association (ABA) approved a Statement of Policy in 1975 and the American Institute of Certified Public Accountants approved a corresponding Statement on Auditing Standards in 1976.25 The Statement of Policy recognized that:
Both the Code of Professional Responsibility and the cases applying the evidentiary privilege recognize that the privilege against disclosure can be knowingly and voluntarily waived by the client. It is equally clear that disclosure to a third party may result in loss of the confidentiality essential to maintain the privilege. Disclosure to a third party of the lawyer-client communication on a particular subject may also destroy the privilege as to other communication on the subject. Thus, the mere disclosure by the lawyer to the outside auditor, with due client consent, of the substance of communications between the lawyer and client may significantly impair the client's ability in other contexts to maintain the confidentiality of such communications.
The Statement of Policy set forth guidelines for responding to an audit inquiry letter that are designed to allow you to protect your client's privilege and at the same time give the accountant the information needed. Some of the methods that the Statement of Policy set forth were to:
- Distinguish between pending, impending (i.e., litigation in which a third party has manifested a present intention to commence) and other contingencies of a legal nature. The ABA reasoned that with respect to the last, it was not in the public interest for you to be required to respond.
- Specify the scope and nature of your firm's engagement, including the dates of commencement and termination of representation. You are not required to investigate and give an opinion on matters on which your firm did not work. Nor are you required to opine on those aspects of a case that were handled by another firm.
- Limit the response to items that are considered individually or collectively "material" to the presentation of the financial statements.26
- Refrain from expressing predictions of the outcome of the litigation except in those relatively few clear cases where it appears that an unfavorable outcome is either "remote" or "probable."27
- Ensure that the accountant understands that the response to its audit inquiry letter is for informational purposes only, cannot be quoted in whole or in part, and is not to be filed with any governmental agency or given to any private entity or person.
- Require you to inform your client of any confidence, secret or evaluation that is to be revealed to the accountant and ensure that your client understand the legal consequences and consent to the disclosure.
Clearly, before the response to the audit inquiry letter is sent to the accountant, your client will want to review and approve the language used. Corresponding to the guidelines set forth in the Statement of Policy above, the following are suggestions of steps that your client can take to minimize the potential exposure from a waiver of the attorney-client privilege and/or work product doctrine:
- Discuss with you which potential litigation is of an imminent nature requiring discussion and which is remote enough that no elaboration is required.
- Ensure that where it utilized more than one law firm in the time period covered by the audit inquiry letter, and each is issuing a response, there is no duplication of the matters included and the discussions of such matters are not contradictory.
- The determination of which matters are financially "material" is a judgment call and should be made jointly by you and your client after significant analysis and discussion of the issues and potential financial impact of the litigation. More often than not, this will be a case-specific analysis where your client will have the best ability to make the decision. The ramifications of a reduced cash flow from funds spent on litigation or the payment of an award extend far beyond the actual dollar amounts. Your client will need to determine the numerous ancillary ramifications of the loss of those dollars, such as lower capital expenditures, research and development, and marketing, that can have a hugely detrimental impact on future sales. Your client will also need to be particularly aware of the timing of the required cash outflows and the impact that they may have on its required purchases of materials or the payment of taxes, insurance, payroll or pension plan contributions.
- In assessing whether an unfavorable outcome is either remote or probable, there is little that your client can do to assist you other than give you as many relevant facts as possible.
- When your client retains an accountant to prepare the audited financial statements, they should include language in the retention agreement stating that the response to the audit inquiry letter cannot be quoted, filed with an agency or be provided to any private entity or persons. Your client should follow this up by confirming oral communications with the accountants who are actually working on the project. In addition, be sure to have your client review the financial statements and opinions of the accountant prior to it being filed to compare it with the response to the audit inquiry letter.
- Encourage your client to ask questions if it does not understand the legal ramifications of a disclosure to the accountant. Let them know that it is entirely appropriate to have the individual steps of your analysis explained to them in addition to the ultimate conclusion. Importantly, help your client set up a protocol that ensures that it does not purposely or inadvertently disclose information concerning pending or potential litigation to the accountant other than the response to the audit inquiry letter. That is just as likely to be deemed a waiver of the attorney-client privilege as is the response itself.
Until the circuit-level federal courts or the U.S. Supreme Court decide the issues conclusively, it is uncertain whether the response to an audit inquiry letter will waive the attorney-client privilege or the work product doctrine. Thus, the best way to preserve your clients' rights is for them to take an active role in the preparation of the response instead of simply handing it off to you. Your client can be an integral component in limiting the items reported, constraining and carefully wording the descriptions of the items that are reported, making clear to the accountant the appropriate and inappropriate uses for the response, and in coordinating the responses of all of their attorneys to ensure that there is no duplication or conflicting discussions. Taking an active role in preparing the response will certainly make "that time of year" more stressful for your client, but that unpleasantness will be considerably less than that which they and you would feel should some sensitive information get into the wrong hands.
1 For instance, the SEC requires all public corporations to file quarterly financial statements and audited annual financial statements that describe their financial status. 15 U.S.C. §78(m). This requirement is satisfied through the filing of an annual 10-K statement and quarterly 10-Q statements. In addition, private companies are often under contractual obligation to provide annual certified financial statements that require an accountant to perform an audit. Most often, this requirement is a condition for a loan and impacts both public and private companies equally. Occasionally, as part of a judgment, the court will order the judgment debtor to provide the judgment creditor with audited financial statements. Return to article
2 Federal Rules of Bankruptcy Procedure 2004 and 7034 provide that "any party in interest" can bring a motion for an order of examination or request for production of documents, which would include creditors of a bankruptcy estate. In fact, courts have held that a creditor is not precluded from taking a Rule 2004 examination just because there is an adversary proceeding pending between it and the debtor when the examination is into issues that are beyond the scope of the adversary proceeding. In re Buick, 174 B.R. 299 (Bankr. D. Colo. 1994); accord In re Blinder, Robinson & Co., 127 B.R. 267 (D. Colo. 1991). Return to article
4 "Inquiry of a Client's Lawyer Concerning Litigation, Claims and Assessments," Statement on Auditing Standards Number Twelve, §§337.01, 337.08, 337.09 (American Institute of Certified Public Accountants 1976). It provides that "a letter of audit inquiry to the client's lawyer is the auditor's primary means of obtaining corroboration of the information furnished by management concerning litigation, claims and assessments." Return to article
5 Matter of International Horizons Inc., 689 F.2d 996, 1003-04 (11th Cir. 1982); Matter of Mori, 1 B.R. 265, 267 (Bankr. S.D. Fla. 1979) (holding that if the accountant-client privilege were allowed in a voluntary bankruptcy proceeding as to information relating to assets, liabilities or income of the debtor, it would severely prejudice creditors and destroy the concepts of full disclosure embodied in the Bankruptcy Code); see, also, Russell, Bankruptcy Evidence Manual, 1997 Ed., §501.4. Return to article
7 See, e.g., American Bar Association Model Rules of Professional Responsibility; American Bar Association Code of Professional Responsibility; American Bar Association Canons of Professional Ethics; California Rules of Professional Conduct (approved by the California Supreme Court August 13, 1992); and California Business and Professions Code §6067 et seq. Return to article
11 Federal Rule of Civil Procedure 26(b)(3); California Code of Civil Procedure §2018; Hickman v. Taylor, 329 U.S. 495, 67 S. Ct. 385, 91 L. Ed. 451 (1947). Return to article
15 Hillsborough Holdings Corp. v. Celotex Corp. (In re Hillsborough Holdings Corp.), 132 B.R. 478, 481 (Bankr. M.D. Fla. 1991) (citing Russell, Bankruptcy Evidence Manual, §501.4). Return to article
17 Id. at 13. A disclosure to a third party does not necessarily waive the work product doctrine protections. Instead, a waiver occurs only if a voluntary disclosure enables an adversary to gain access to the information. If the disclosure is either inadvertent or made to a non-adversary, the court looks to the surrounding circumstances to determine whether the disclosure evidenced a conscious disregard of the possibility that an adversary might obtain the protected materials. See United States v. American Tel. and Tel. Co., 642 F. 2d 1285, 1299 (D.C. Cir. 1980). Return to article
18 Tronitech Inc. v. NCR Corp., 108 F.R.D. 655, 656 (S.D. Ind. 1985). The work product doctrine applies only to materials prepared in the anticipation of litigation and not to materials prepared in the ordinary course of business or otherwise for some purpose not primarily concerned with litigation. See Brinks Mfg. Co. v. National Presto Indus., 709 F. 2d 1109 (7th Cir. 1983). Return to article
19 In re Grand Jury Proceedings, 33 F. 3d at 348-349. The court recognized that both "fact work product" and "opinion work product" were generally protected and could only be the subject of discovery in limited circumstances. It distinguished, though, "fact work product" from "opinion work product." It concluded that "fact work product" could be discovered upon a showing of both a substantial need and an inability to secure the substantial equivalent of the materials by alternate means without undue hardship. However, "opinion work product" was to be even more scrupulously protected as it represents the actual thoughts and impressions of the attorney. Return to article
24 Westinghouse Elec. Corp. v Republic of the Philippines, 951 F.2d 1414, 1424 (3rd Cir. 1991) (holding that a limited waiver does not exist); Diversified Indus. Inc. v. Meredith, 572 F.2d 596 (8th Cir. 1978) (holding that a limited waiver does exist under these circumstances). Return to article
26 Typically, the audit inquiry letter will provide a dollar amount definition of "material." If not, the Commentary to the Statement of Policy directs the attorney to reach an agreement on the definition with the accountant such that the test of materiality is not so low in amount as to result in a disservice to the client and an unreasonable burden on counsel. Return to article
27 In this instance, "remote" means the prospects for the client not succeeding in its defense are judged to be extremely doubtful and the prospects of success by the claimant are judged to be slight. "Probable" means the prospects of the claimant not succeeding are extremely doubtful and the prospects for success by the client in its defense are judged to be slight. Return to article