Keep Your Friends Close – The Second Circuit Strengthens Common Interest Privilege

January 20, 2016

By: Sara Kropf

The common interest (sometimes called “joint defense”) privilege serves an invaluable strategic role in complex white-collar cases.

It allows the targets of an investigation to work together, without fear that the government will discover their communications or shared work product.

In a complex case, it’s nearly impossible to defend an individual without knowing what other people did. White collar defense work is not for lone wolves.

A recent Second Circuit decision, Schaeffler v. United States, reinforced the parameters of the common interest privilege. The court held that a waiver of attorney-client privilege did not occur when documents prepared for one client were shared with a consortium of banks involved in the client’s complex transaction. The parties shared a common economic interest in the outcome of litigation with the IRS, though only one party was directly involved in the IRS dispute.

The court also held that the work-product doctrine protected the material within the documents, because they were prepared in anticipation of litigation.

A Refresher on the Common Interest Privilege and Work Product Doctrines

When an attorney and client communicate regarding legal advice, those communications are protected by the attorney-client privilege. The privilege can be waived when the communications are shared with third parties. Courts have created an exception to waiver when the third party is part of a “common legal enterprise” with the client.

As the Schaeffler court explained:

Under United States v. Schwimmer, 892 F.2d 237 (2d Cir. 1989), such disclosures remain privileged “where a joint defense effort or strategy has been decided upon and undertaken by the parties and their respective counsel . . . in the course of an ongoing common enterprise . . . [and] multiple clients share a common interest about a legal matter.” The common-interest-rule serves to “protect the confidentiality of communications passing from one party to the attorney for another party where a joint defense effort or strategy has been decided upon and undertaken by the parties and their respective counsel.”

The Schaeffler case revolves around the challenge to a summons issued by the IRS. The tax code specifically protects communications between a client and a “federally authorized tax practitioner.” Section 7525(a)(1) provides:

the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.

According to the Schaeffler, this

“tax practitioner privilege” is, therefore, essentially coterminous with the attorney-client privilege both in scope and in waiver.

Under the work-product doctrine, documents prepared by or for a client in anticipation of litigation are not discoverable, absent extraordinary circumstances. Documents that a client regularly prepares during the ordinary course of business are not considered privileged. Therefore, it is crucial to distinguish between documents prepared in the ordinary course and those prepared in anticipation of litigation.

What Happened in Schaeffler

Georg [not a typo, there is no “e”] Schaeffler is the 80% owner of the ultimate parent of a group of entities called the Schaeffler Group. The Schaeffler Group is an automotive and industrial parts supplier.

Back in early 2008, the Schaeffler Group attempted to acquire a minority interest in Continental AG, a German company, through a tender offer. A tender offer is a public offer to buy all of a company’s shareholders’ shares for a specified price in a specified time frame. In order to finance the offer, the Schaeffler Group executed an eleven-billion euro offer with a consortium of banks.

The Schaeffler Group made the offer on July 30, 2008 with an expiration date of September 16, 2008. German law prohibits the withdrawal of tender offers before the expiration date. This was particularly problematic for the Schaeffler Group because on September 14, 2008, two days before the offer was set to expire, Lehman Brothers declared bankruptcy and the market collapsed.

As a result, more shareholders than anticipated cashed in on the offer and the Schaeffler Group ended up as the owner of 89.9% of Continental’s shares—a teensy bit more than the hoped-for minority interest.

Mr. Schaeffler, along with his company and the banks, were facing huge financial consequences as a result of this transaction. They decided to refinance the loan agreement and reorganize the Schaeffler Group’s corporate structure.

They (meaning the Schaeffler Group and the “Consortium” of banks involved in the deal) hired Dentons US LLP as legal counsel along with Ernst & Young to provide tax guidance. The court explained that they hired these companies

to advise on the federal tax implications of the transactions and possible future litigation with the IRS as they knew an audit and litigation with the IRS were highly likely.

The IRS Summons

Sure enough, the IRS began an audit of the Schaeffler Group. The IRS issued a summons for all of the documents prepared by Ernst & Young, “including but not limited to legal opinions, analysis and appraisals, that were provided to parties outside [appellants], that relate to [the restructuring].”

In response, the Schaeffler Group produced thousands of documents, but also filed a motion to quash on the basis of privilege with regards to memoranda that were prepared in anticipation of litigation that contained detailed information such as the tax consequences of refinancing and restructuring as well as relevant statutes and judicial and administrative holdings.

The IRS argued that (1) privilege was waived by the sharing of the memoranda with the Consortium, and that (2) these documents were not protected by the work-product doctrine because they were not sufficiently prepared in anticipation of litigation.

Mr. Schaeffler and his related companies responded that (1) privilege was not waived as a result of the common-interest privilege exception, and (2) the documents were, in fact, prepared in anticipation of litigation.

What Did the District Court Do?

The district court held that the Consortium and the Schaeffler Group did not have a common legal interest sufficient to prevent waiver of the privilege. Describing the district court’s holding, the court of appeals stated the following:

In the [district] court’s view, the Consortium “lack[ed] . . . any common legal stake in Schaeffler’s putative litigation with the IRS,” because it would not be named as a co-defendant in the anticipated litigation and “only the Consortium’s economic interests,” as opposed to its legal interests, “were in jeopardy.” Therefore, appellants and the Consortium did not have a common legal interest and were not “formulating a common legal strategy.” Accordingly, appellants’ attorney-client privilege had been waived.

The district court also found, after an in camera review, that the documents were not protected by the work-product doctrine. Because the documents did not “discuss[] what actions peculiar to the litigation process [the parties] might take or what settlement strategies might be considered,” they did not fall within the doctrine. In short,

even had [Mr. Shaeffler] not anticipated an audit or litigation with the IRS, he still would have had to obtain the type of legal assistance provided by Ernst & Young to carry out the refinancing and restructuring transactions in an appropriate manner.

The Second Circuit’s Review

The Second Circuit disagreed with the district court and reversed. It held that even though the banks and Mr. Schaeffler/Schaeffler Group were not co-defendants in a case, they were still working together to prevent mutual financial disaster. They did so by undertaking bilateral obligations to ensure that they would receive certain tax treatment after refinancing and restructuring.

The Group and the Consortium could avoid this mutual financial disaster by cooperating in securing a particular tax treatment of a refinancing and restructuring. Securing that treatment would likely involve a legal encounter with the IRS. Both appellants and the Consortium, therefore, had a strong common interest in the outcome of that legal encounter.

The court of appeals also found that the district court missed the boat when it asserted that because the banks had eleven-billion euros at stake, their interest in reviewing the Ernst &bYoung documents was purely commercial. Even though the deal involved a great sum of money, the issue was not solely commercial. Rather, the Consortium’s own interest in avoiding Schaeffler’s insolvency created a common legal interest.

In our view, the fact that the Consortium stood to lose a lot of money (along with appellants) if appellants’ tax arguments failed is not support for the position that no common legal interest existed. To the contrary, it was the interest in avoiding the losses that established a common legal interest. 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 court of appeals also disagreed with the district court’s holding that the documents were not protected by the work-product doctrine.

The court of appeals found that while documents such as those used to prepare annual tax filings wouldn’t be protected here, as they would fall under the “ordinary course of business” category, these memoranda were different. They were specifically geared towards remedying the impending financial crisis and tax audit, and were much more detailed and litigation-focused than something a reasonable businessperson would obtain during the ordinary course of business.

How Can You Help Your Clients Obtain This Same Ruling?

If you are facing this type of situation with a client, keep in mind that there are steps to strengthen the chance that the common interest privilege will apply. For example, the client will need to show that the third party’s commercial interest will be affected by a specific legal outcome. This is a stronger argument if the commercial interest of the third party is substantial, rather than minimal. Plus, the greater involvement of the third party in directing the legal strategy can be helpful, as the Schaeffler court considered the fact that the Consortium was closely involved with Ernst & Young.

This latter step is not without its risks, however. If you are outside of the Second Circuit, it is not clear that Schaeffler‘s holding will apply. In other jurisdictions, if a third party is heavily involved in communications surrounding legal strategy, then your client faces the risk that the privileged will be waived as to this greater number of communications.  

This may be one of the rare times when a written common interest agreement is helpful to prove the existence and scope of the privilege.

Published by Kropf Moseley

Whether you need to take a case to trial, negotiate a resolution without ever setting foot in the courtroom, or navigate a complex public relations problem, we can help. View all posts by Kropf Moseley.