The U.S. District Court for the District of Delaware recently interpreted the work product privilege in a manner favorable to taxpayers, ruling that documents can be prepared “in anticipation of litigation” even if created during the planning stages of a transaction. 

On October 25, 2013, the U.S. District Court for the District of Delaware issued an order in United States v. Veolia Environnement North America Operations, Inc., Civ. No. 13-mc-03-LPS (D. Del. 2013), interpreting the applicability of various claimed privileges, including the work product privilege, to a group of documents withheld in response to summonses issued by the Internal Revenue Service in connection with an audit of a $4.5 billion worthless stock deduction.  The district court did not make a specific holding with respect to any of the particular documents, but it did make various findings designed to assist the parties in resolving the discovery dispute.  While the district court sided with the government in rejecting the taxpayer’s privilege claim over certain documents provided to its experts, the district court agreed with the taxpayer on the primary dispute over the applicability of the work product privilege to other documents prepared during the planning stages of the transaction that triggered the claimed deduction. 

Background

Work Product Doctrine

Federal Rule of Civil Procedure 26(b)(1) lays out the general scope of discovery: “[p]arties may obtain discovery regarding any nonprivileged matter that is relevant to any party’s claim or defense.”  One exception to that disclosure requirement is the work product privilege (also known as the work product doctrine).  Designed “to preserve a zone of privacy in which a lawyer can prepare and develop legal theories and strategy with an eye toward litigation, free from unnecessary intrusion by his adversaries,” United States v. Adlman, 134 F.3d 1194, 1196 (2d Cir. 1998), the doctrine was first recognized by the Supreme Court in Hickman v. Taylor, 329 U.S. 495 (1947).  The Supreme Court observed that, to properly prepare a client’s case, a lawyer must be able to “assemble information, sift what he considers to be the relevant from the irrelevant facts, prepare his legal theories and plan his strategy without undue and needless interference.”

The work product doctrine as articulated in Hickman was partially codified in the Federal Rules.  In its current form, Rule 26(b)(3) ordinarily protects from discovery “documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party or its representative.”  Thus, unless the opposing party can show a substantial need for the materials and cannot obtain their substantial equivalent without undue hardship, materials—whenever created—that are “prepared in anticipation of litigation or for trial” are protected by the work product privilege.

Assuming the party issuing a summons makes out a prima facie case to obtain enforcement of it, seeUnited States v. Powell, 379 U.S. 48, 57-58 (1964), the party asserting work product protection carries the burden of demonstrating that it was justified in asserting the privilege, see, e.g., Conoco, Inc. v. U.S. Dept. of Justice, 687 F.2d 724, 730 (3d Cir. 1982), which includes showing that the materials at issue were prepared in anticipation of litigation.  To meet that burden, courts have required the proponent asserting the privilege to satisfy both a subjective and objective test.  See, e.g., United States v. Roxworthy, 457 F.3d 590, 593 (6th Cir. 2006).  Not only must a party “have had a subjective belief that litigation was a real possibility,” but also “that belief must have been objectively reasonable.”  Id. (quoting In re Sealed Case, 146 F.3d 881, 884 (D.C. Cir. 1998)); accordMartin v. Bally’s Park Place Hotel & Casino, 983 F.2d 1252, 1260 (3d Cir. 1993).

For the most part, federal appellate courts agree on the test to determine whether a document was created in “anticipation of litigation.”  Most circuits have adopted the “because of” test—that is, asking whether a document was “prepared or obtained because of the prospect of litigation.”  Adlman, 134 F.3d at 1202; accordUnited States v. Deloitte LLP, 610 F.3d 129, 137 (D.C. Cir 2010); Roxworthy, 457 F.3d at 593; In re Grand Jury Subpeona, 357 F.3d 900, 907 (9th Cir. 2004); Maine v. U.S. Dept. of Interior, 298 F.3d 60, 68 (1st Cir. 2002), Nat’l Union Fire Ins. Co. of Pittsburgh v. Murray Sheet Metal Co., 967 F.2d 980, 984 (4th Cir. 1992); Simon v. G.D. Searle & Co., 816 F.2d 397, 401 (8th Cir. 1987); Binks Mfg. Co. v. Nat’l Presto Indus. Inc., 709 F.2d 1109, 1118-19 (7th Cir. 1983); In re Grand Jury Proceedings, 604 F.2d 798, 803 (3d Cir. 1979).  The outlier is the U.S. Court of Appeals for the Fifth Circuit, which protects only documents prepared with the “primary motivating purpose” of existing or anticipated litigation.  United States v. El Paso Co., 682 F.2d 530, 542 (5th Cir. 1982).  In adopting the “because of” standard, many courts have quoted the formulation used by Wright & Miller’s Federal Practice and Procedure treatise: “[T]he test should be whether in light of the document and factual situation in the particular case, the document can fairly be said to have been prepared or obtained because of the prospect of litigation.”  See, e.g.,In re Grand Jury Proceedings, 604 F.2d at 803.

While courts generally agree upon the test, the challenge they often face is “to determine how to apply [it] to the complex facts of” each case.  See United States v. Chevron Texaco Corp., 241 F. Supp. 2d 1065, 1070 (N.D. Cal. 2002).  Indeed, there is no bright-line rule to determine whether—or when—a document was created because of the prospect of litigation.  “It is clear that documents prepared in the ordinary course of business, or pursuant to public requirements unrelated to litigation, or for other nonlitigation purposes, are not covered by the work product privilege.”  Roxworthy, 457 F.3d at 593 (citing Fed. R. Civ. P. 26(b)(3) advisory committee’s notes (1970)).  It is not unusual, however, for a document to be created for more than one purpose.  To that end, material generated in anticipation of litigation will not lose its protected status simply because it was also used in the ordinary course of business.  Deloitte, 610 F.3d at 138.  In other words, “a document created because of anticipated litigation … does not lose work-product protection merely because it is intended to assist in the making of a business decision influenced by the likely outcome of the anticipated litigation.”  Adlman, 134 F.3d at 1195.  Rather, “[w]here a document was created because of anticipated litigation, and would not have been prepared in substantially similar form but for the prospect of that litigation, it falls within Rule 26(b)(3).”  Id.

Attorney-Expert Communications

The Federal Rules also require disclosure of all “facts or data considered by” an expert witness retained or employed to provide expert testimony in connection with forming opinions that the expert will express.  Fed. R. Civ. P. 26(a)(2)(B)(ii).   In 2010, however, Rule 26 was amended “to address concerns about expert discovery.”  See Fed. R. Civ. P. 26 advisory committee’s notes (2010).  One of those changes included generally protecting “communications between the party’s attorney and any [expert] witness required to provide a report under Rule 26(a)(2)(B) regardless of the form of the communications … .”  Fed. R. Civ. P. 26(b)(4)(C).  That addition was “designed to protect counsel’s work product and ensure that lawyers may interact with retained experts without fear of exposing those communications to searching discovery.”  Fed. R. Civ. P. 26(b)(4) advisory committee’s notes (2010).  That broad protection, however, was limited by three exceptions where discovery would still be permitted: “communications [that]: (i) relate to compensation for the expert’s study or testimony; (ii) identify facts or data that the party’s attorney provided and that the expert considered in forming the opinions to be expressed; [and] (iii) identify assumptions that the party’s attorney provided and that the expert relied on in forming the opinions to be expressed.”  Fed. R. Civ. P. 26(b)(4)(C).  The scope of the second of those exceptions was at issue in Veolia.

Veolia

In April 1999, the taxpayer, a U.S. holding company owned by a subsidiary of French conglomerate Vivendi S.A., purchased Water Application & Solutions Corporation (WASCO) for $8.2 billion.  By 2006, however, the taxpayer concluded that WASCO’s stock was worthless.  It then retained legal advisors and tax experts to advise on how it could claim a deduction for a worthless security in an affiliated corporation under Internal Revenue Code § 165(g)(3).  That advice led the taxpayer to convert WASCO to a Delaware LLC in December 2006. 

Before doing so, the taxpayer took a number of steps “to best prepare” its case.  In March 2006, the taxpayer retained outside counsel to obtain a private letter ruling from the IRS interpreting IRC § 165(g).  And in the fall of 2006, the taxpayer hired two valuation firms to evaluate and produce written reports on WASCO’s insolvency.  In February 2007, when it was already under IRS audit for its 2004 and 2005 returns, the taxpayer enrolled in the IRS’s then newly established Pre-Filing Agreement (PFA) program to attempt to resolve, before its 2006 return was filed, the worthless stock deduction.  In April 2007, the taxpayer hired a third valuation firm to produce an independent valuation of WASCO’s stock.  The taxpayer then provided the IRS with the final version of that expert’s report as well as one of the two valuation reports it procured in 2006 to support its claim regarding the worthlessness of WASCO’s stock.

In December 2008, the IRS issued summonses for a variety of documents in the taxpayer’s possession.  While the taxpayer produced hundreds of thousands of pages in response to IRS requests, it withheld 361 documents and portions of 45 documents.  The taxpayer asserted that the withheld documents were covered by either (or a combination of) the (1) work product privilege; (2) attorney-client privilege; or (3) tax practitioner privilege.  Specifically, it claimed work product protection for documents created in or after March 2006 in connection with the worthless stock deduction.

Anticipation of Litigation

Most importantly, the district court sided with the taxpayer regarding the work product protection dispute.  Applying the two-part inquiry from the Third Circuit’s decision in Martin, the court found that the taxpayer had “met its burden to prove that it anticipated litigation at least as early as March 2006”—going back to the transaction’s planning stages.  The court first found that the taxpayer subjectively anticipated litigation.  When the taxpayer sought the valuation reports and retained outside counsel to obtain a PLR in 2006, it did so “because of the prospect of litigation with the IRS, believing that an IRS audit was probable.”  That was also the reason why the taxpayer participated in the PFA program.  Furthermore, the court pointed to two reasons why that subjective expectation of litigation was objectively reasonable.  It noted both “the sheer size” of the $4.5 billion deduction, as well as the fact that the taxpayer was already under audit for its 2004 and 2005 returns.  Interestingly, the court also went out of its way in a footnote to highlight that the government did not appear to dispute the notion that “anticipation of an audit satisfies the requirement of anticipation of litigation.”

While the court did not make specific findings as to particular documents that could be “fairly said” to be created in anticipation of litigation, it did cite to four of the withheld documents it reviewed as support for its decision to side with the taxpayer on the work product privilege dispute.  First, it cited to a memo from the taxpayer’s counsel that not only indicated that the taxpayer expected the IRS to scrutinize the transaction but also remarked on the importance that one of the independent valuation reports would play in potential litigation.  It then mentioned a communication between the taxpayer, outside counsel and its consultant that indicated that the valuation reports were a foundational part of the strategy to resist an IRS audit.  Finally, it pointed to a pair of documents—one providing a summary of potential WASCO transactions and another providing facts and legal advice required for the PLR—that corroborated the taxpayer’s narrative that from early 2006, in anticipation of an IRS dispute, it took steps to bolster its legal position that the conversion was proper.

The court then addressed the government’s contention that the disputed documents created in connection with the WASCO conversion and the worthless stock deduction should not be protected because they were the types of transactions that the taxpayer took in the ordinary course of business.  The court effectively dismissed that assertion as irrelevant.  Even assuming that assertion was true, the court said that fact would not “deprive the Taxpayer of the opportunity to meet its burden to show that it anticipated litigation would arise from” the WASCO transactions.  And, as detailed above, the court determined the taxpayer had met that burden.  “Importantly,” the court found, “there is no evidence that the specific transaction at issue … was undertaken for any purpose other than to enable [the] Taxpayer to recognize a $4.5 billion loss on its tax return and then litigate with the IRS over the legitimacy of that deduction.”

Materials Relied on by Experts

The district court then turned to the dispute over discoverability of certain materials relied on by the taxpayer’s experts.  While the taxpayer had provided the government with documents containing facts and data the taxpayer itself had given to its valuation experts, it had withheld documents containing information those experts received from entities other than the taxpayer.  The government argued that, under Rule 26(b)(4)(C), the taxpayer must disclose all facts and data provided to the experts.

The court agreed with the government, noting that Rule 26(b)(4)(C) only protects communications between a “party’s attorney” and “expert witnesses.”  It does not protect facts and data provided to an expert by sources other than the “party’s attorney.”  According to the court, this was a “logical result.”  Because one of the exceptions to protection from disclosure of attorney-expert communications is facts and data provided by the party’s attorney to the expert, “there is no reason” that such communications from someone other than the party’s attorney should be protected from disclosure.  Thus, the court ordered the taxpayer to produce materials containing facts or data considered by the valuation experts, even if such information was provided by someone other than the taxpayer or its attorneys.

Remaining Issues

In response to the summonses, the taxpayer had claimed two other privileges—the attorney-client privilege and tax practitioner privilege—with respect to documents that the taxpayer said related to “legal and tax analysis of complicated provisions of the [Internal Revenue] Code.”  The court decided it could not yet resolve the taxpayer’s claim of those two privileges over such documents.  Instead, based on the two rulings detailed above, the court asked for the parties’ assistance in determining which documents, if any, remained in dispute for purposes of evaluating the application of those two privileges. 

Finally, the court quickly rejected the government’s contention that the taxpayer waived any applicable privilege by widely sharing some of the withheld materials among employees of the taxpayer and related entities.  The court was “persuaded” by the taxpayer’s argument that the taxpayer shared common interests with the affiliated entities and “the presence of the individuals participating in the communications was necessary for obtaining or acting upon the legal or tax advice sought.”

Conclusion

It is well-established that “[p]rudent parties anticipate litigation and begin preparation prior to the time suit is formally commenced.”  See, e.g., In re Grand Jury Proceedings, 604 F.2d at 803 (quoting Wright & Miller’s treatise).  While the likelihood of litigation increases once an audit has begun, there is no set event that must be triggered before a taxpayer can claim work-product protection.  Veolia reaffirmed that principle, as the court’s order will likely lead to work product protection for many of the contested documents generated during the planning stages of the transaction.