Taxation & Estate Planning

"Primary Purpose Test" Applied to Work Product of Outside Attorney Conducting Internal Investigation on Behalf of Corporate Client"

By Fox Rothschild

In SEC v. Microtune, Inc. (N.D. Tex. 6/4/09), the District Court for the Northern District of Texas held that documents, notes, memos and other material produced and maintained by a law firm and its agents for the purpose of conducting an internal investigation of alleged improper practices with respect to reporting stock options was discoverable by the SEC through the issuance of its subpoena over the company's claims (motion to quash) of attorney client privilege and the work product doctrine.

The case involved an enforcement action by the Securities and Exchange Commission against the former Chairman and CEO, Bartek, and the former CFO, Richardson, for their role in an alleged backdating scheme involving stock options of Microtune.

In June 2006, Microtune hired outside counsel, Andrews Kurth law firm, to conduct an internal investigation into the company's stock option practices. Such legal counsel hired an outside accounting, Grant Thornton LLP, to assist in its efforts. In February and July 2007, Andrews Kurth presented its findings to the SEC, in the process turning over hundreds of pages of documents and other information gathered during the internal investigation. Approximately one year later, the SEC filed civil charges against Microtune, Bartek and Richardson allegeding the perpetration of a fraudulent stock option backdating scheme that had as its intended effect the improper awarding the defendants and other employees of millions of dollars in undisclosed compensation. Bartek and Richardson caused Microtune to grant backdated options, cancelling those options after the company's stock price dropped precipitously, and subsequently re-granting the same options at a substantially lower exercise price. According to the SEC's complaint, the re-grants were not, as required, accounted for using variable accounting, in part because Richardson and Bartek allegedly concealed the nature of the re-grants from Microtune's outside auditors and others.

There were SEC financial disclosure violations caused by the scheme as the backdated options resulted in the filing of false and misleading financial statements with the SEC. In particular, the SEC alleged that 'Bartek directed others to backdate employment records, including offer letters, to establish falsified start dates and grant dates that preceded the actual dates when the new hires began working for Microtune.' The SEC sought penalties and other relief under Section 304 of the 2002 Sarbanes-Oxley Act, in order to prevent corporate executives to profit from money wrongfully earned while their companies mislead investors with false financial statements. Microtune, without admitting or denying wrongdoing, agreed to a permanent injunction against violations of the antifraud, financial reporting, books and records, internal controls, and proxy provisions of the federal securities laws. The SEC sought injunctive relief, disgorgement of wrongful profits, civil monetary penalties, officer and director bars, and reimbursement of profits from stock sales pursuant to Section 304 of the Sarbanes-Oxley Act against Bartek and Richardson. The company settled its liability out separately with the SEC, which presumably is proceeding against Bartek and Richardson.

Now for the production request made by the SEC. During discovery, the SEC subpoenaed internal investigation documents from Microtune, Andrews Kurth, Grant Thornton, and other law firms that had provided services to Microtune. Microtune moved to quash the subpoena on grounds of attorney-client and work product privileges. The District Court ruled in favor of the SEC in its June 4, 2009 decision. The attorney-client privilege was waived by Microtune's voluntarily disclosing the internal investigation documents to the SEC and others.

The work product argument was also rejected because the evidence did not suggest that litigation concerns were the 'primary motivating purpose' behind the documents' creation. The work product doctrine, sourced from the Supreme Court's decision in Hickman v. Taylor, 329 U.S. 495 (1947) and now settled in FRCP 26(b)(3), holds that the work of preparing for trial demands insulation from opposing counsel's inquiries on a lawyer's research, analysis, legal theories, and mental impressions. The courts have used two tests in determining what is work product, which does not necessarily have to be prepared by a lawyer. The broader test is the 'because of' test, which widens substantially the scope of what is work product. See United States v. Textron Inc. & Subsidiaries, 103 AFTR2d 2009-509, 520-23 (1st Cir. 2009), pending rehearing en banc. The other standard is that announced in the El Paso decision rendered by the 5^th Cir., 682 F2d 530 (5^th Cir. 1982), cert. denied, (1984) which asks if the primary purpose or motivation for engaging in the analysis, here the internal investigation, was in anticipation of litigation. If not, the work product doctrine does not apply. In is obviously of great difference whether the court applies the 'because of……litigation' test versus the 'primary purpose of …..litigation' test.

The decision in Microtune is presumably one of the first cases to extend such an analysis to internal investigation documents such that the documents are not protected unless the primary motivation behind their creation was the anticipation of litigation. This case should stand as a sharp reminder to counsel engaged in internal investigations to earmark that their work, memos, e-mails, power points, etc., are documented as primarily engaged in anticipation of litigation. For further background and analysis see, August, the Attorney-Client Privilege and Work-Product Doctrine in Federal Tax Matters, Business Entities (WG&L), Jul/Aug 2008.

Full post as published by Tax Litigation Blog on July 14, 2009 (boomark / email).