Tax cases make bad work product law: the discoverability of litigation risk assessments after United States v. Textron.

• Author: Kling, Jacob A.

In United States v. Textron, Inc., (1) the United States Court of Appeals for the First Circuit, in a rehearing en banc, held that tax accrual work papers prepared by a corporation's lawyers in order to calculate tax reserves for financial reporting purposes are not protected by the work product doctrine. (2) The majority reasoned that tax accrual work papers are not created in anticipation of litigation, but rather in the ordinary course of business pursuant to the securities laws, (3) and suggested that documents that are not "prepared for use in possible litigation" are beyond the scope of work product protection. (4) The court also emphasized that permitting discovery of tax accrual work papers "serves the legitimate, and important, function of detecting and disallowing abusive tax shelters." (5)

This Comment argues that Textron's "use in possible litigation" standard is inconsistent with precedent and, moreover, is normatively undesirable. In particular, it may deter companies, public and nonpublic, from voluntarily preparing litigation risk assessments that estimate the company's contingent liabilities for the benefit of third parties, including potential acquirers or investors, and thereby impede socially efficient business transactions, while at the same time diminishing the accuracy of public companies' financial statements. Moreover, the principle objections to work product protection--including its potential to deprive the court of relevant information, to lead to the duplication of efforts in trial preparation, and to encourage overinvestment in the stakes-dividing function of litigation (6)--are largely inapplicable to quantitative litigation risk analyses outside of the tax context. Although the first two of these objections may apply to tax accrual work papers given their usefulness in combating tax evasion, the negative economic effects of permitting discovery of litigation risk analyses, including tax work papers, suggest that work product protection is desirable on balance. Because the discoverability of litigation risk assessments is likely to interfere with the efficient functioning of the capital markets and the market for corporate control, the Supreme Court should grant Textron's petition for certiorari and affirm their protected status.

1. TEXTRON'S NEW STANDARD

   The dispute in Textron began when the IRS brought an action in federal court to enforce a summons demanding that Textron produce its tax accrual work papers to facilitate the IRS's investigation of several transactions in which the company had been involved. Tax accrual work papers are documents prepared by a company's lawyers that identify potential "soft spots" on the company's tax return, estimate the probability that the company's position will be sustained, and use that estimate to recommend an amount that should be reserved as contingent tax liabilities on the company's financial statements. (7) Publicly traded corporations like Textron are required under the federal securities laws to have audited financial statements that comply with generally accepted accounting principles (GAAP), (8) according to which companies must report certain loss contingencies in their financial statements, including potential tax liabilities. (9) Tax accrual work papers form the basis for the auditor's evaluation of the sufficiency of the company's tax reserves. (10)

   The majority in Textron held that the preparation of Textron's work papers was statutorily mandated and that the documents were thus created not in anticipation of litigation but rather in the ordinary course of business in order to prepare financial statements and obtain a clean audit report. (11) As a doctrinal matter, this reasoning is problematic. The circuits have adopted two distinct tests to determine whether a dual-purpose document that is prepared in expectation of litigation but also for a business purpose is entitled to work product protection under Federal Rule of Civil Procedure 26(b)(3). The Fifth Circuit applies a primary motivating purpose test under which a document qualifies for work product protection only if "the primary motivating purpose behind the creation of the document was to aid in possible future litigation." (12) Based on this primary purpose test, the Fifth Circuit, the only circuit to specifically address the status of tax accrual work papers prior to Textron, also concluded that they are not work product because their primary purpose is "to back up a figure on a financial balance sheet" rather than to assist in litigation. (13)

   However, a majority of circuits, including the First Circuit, have rejected the Fifth Circuit's "primary motivating purpose" test, instead interpreting the work product doctrine to cover documents prepared "because of" the prospect of litigation even if the documents were also prepared for a business purpose. In United States v. Adlman, (14) a decision later followed by the First Circuit in Maine v. United States Department of the Interior., (15) the Second Circuit rejected the Fifth Circuit's primary motivating purpose test in favor of a "because of" test and held that a memorandum analyzing likely IRS challenges to a proposed reorganization and predicting the outcome of resulting litigation qualified as work product under the latter test. The court interpreted the work product doctrine to protect dual purpose documents prepared in anticipation of litigation but also "to inform a business decision influenced by the prospects of the litigation" (16) provided that the documents "would not have been prepared in substantially similar form but for the prospect of that litigation." (17) Although neither Adlman nor Maine dealt specifically with tax accrual work papers, such work papers would seem to merit protection under the "because of" test since they would not need to be prepared but for the possibility of litigation with the IRS. (18)

   In the face of these contrary precedents, the majority in Textron appears to have crafted a new standard limiting work product protection to documents prepared for use in litigation. The court repeatedly emphasized that the work product privilege is "aimed centrally at protecting the litigation process" (19) and that the focus of the doctrine has been on "materials prepared for use in litigation." (20) Tax accrual work papers, the court reasoned, cannot be said to be prepared "for use in possible litigation" (21) since they would not assist Textron in litigating against the IRS. (22) As Judge Torruella pointed out in dissent, however, this narrow interpretation of the work product doctrine was expressly rejected in Adlman on the theory that Rule 26(b)(3) protects both documents "prepared ... for trial" and those prepared "in anticipation of litigation," and an interpretation requiring...