Understanding attorneys' responses to auditors' inquiries.

Over time, attorneys have pointed to three reasons to limit their involvement in the audit process:

* Concern the attorney's response to an auditor's inquiry may constitute a waiver of the attorney-client privilege.

* Concern an erroneous response may subject attorneys to potential lawsuits.

* Concern their responses will be disclosed to opposing counsel in client litigation.

PRIVILEGED

COMMUNICATION

Communication between an attorney and a client seeking legal advice is privileged (the communication receives protection from disclosure during litigation). This is intended to encourage prompt and frank attorney-client communication. Society benefits when clients act on timely legal advice. Naturally, no privilege attaches to a communication in which a future fraud or other such crime is discussed.

The attorney-client privilege is waived when an otherwise privileged communication is disclosed by the attorney to a third party. The law implicitly recognizes the benefit of protecting the communication disappears when the information is made public. Many lawyers fear their response to an audit inquiry may be a waiver of attorney--client privilege. Why? An audit response may be the equivalent of revealing confidential information to third parties.

Do attorneys have reason to be concerned? Research for this article uncovered no court in which an attorney's response to an audit inquiry was held to be a waiver of privilege. This means potential waivers are not a valid reason to curtail attorneys' involvement in the audit process.

The accounting and legal professions have dealt with this involvement in separate policy statements. Statement on Auditing Standards no. 12, Inquiry of a Client's Lawyer Concerning Litigation, Claims and Assessments, and the American Bar Association's Statement of Policy Regarding Responses to Auditor's Requests for Information, reflect the professions' attempts to reach a compromise. The absence of court cases finding a waiver of attorney-client privilege may be a sign the compromise is working.

ABA GUIDELINES 

Under the ABA statement, an attorney may not provide information about unasserted claims unless the client specifically identifies such a claim and asks the attorney to comment on it. Unasserted claims arise when events have occurred that may give rise to legal liability but no litigation has actually been initiated or threatened or settlement proposed.

For example, a company might manufacture a product that injures consumers over time. This is an unasserted claim until the injuries are discovered and legal action initiated.

The attorney, however, is free to comment on pending litigation without the client's specific request. The ABA statement assumes a response on such litigation is not likely to be a waiver of privilege. However, a response regarding an unasserted claim could be a waiver.

Why are unasserted claims treated differently? An attorney's knowledge and evaluation of such claims probably result from confidential client communication. In the previous example, for instance, an attorney can advise a client about product liability only after the client has communicated relevant facts.

In contrast, legal conclusions related to pending or threatened litigation come from a variety of scources, including depositions and the attorney's own research. Therefore, an audit response evaluating such legal action is not a waiver of privilege.

There is a general belief in the legal profession that the benefits of protecting attorney-client communications outweigh any adverse consequences when attorneys are not required to disclose their knowledge of unasserted claims that often cannot be revealed by other audit procedures. This is demonstrated by Tew v. Arky, Freed, Stearns, Watson, Greer, Weaver & Harris, P.A. (655 F.Supp 1573, S.D. Fla. 1987).

TEW CASE

In Tew, the receiver for the bankrupt ESM Group brought an action against a law firm. The heart of the action was the law firm's failure to reveal ESM's financial problems in response to an inquiry by the company's auditors. An attorney at Arky, Freed allegedly knew of the problems because of a meeting he attended before ESM's collapse. However, the attorney did not attend the meeting to represent ESM but, rather, to consult another individual on a personal matter.

The court categorized the legal problems resulting from ESM's financial condition as an unasserted claim or assessment because stock purchasers did not know at the time of the audit inquiry of the fraud and had not initiated legal proceedings to recover damages. The court found the law firm was not liable because the auditor's request neither identified ESM's financial problems nor requested the law firm to comment on those problems.

The Tew opinion justifies the decision based on the benefits of protecting attorney-client communication. However, this is a spurious argument; others apparently attended the meeting, meaning no confidential attorney-client communication occurred.

Tew also ignores the fact the legal profession recognizes exceptions to the confidential attorney-client relationship when a future crime is involved. A future crime could have been involved since ESM still appeared to be engaged in fraudulent financial reporting at the time of the auditing inquiry response. Such reporting would have been a violation of securities law.

Tew also demonstrated another facet of attorneys' responses to audit inquiries of concern to the legal profession--potential liability for an erroneous response. Most attorneys do not have an overall knowledge of their clients' affairs sufficient to render a complete response to a broad audit inquiry. Attorneys also may have information suggesting potential legal problems received in a non-legal capacity, for example, as a member of the board of directors. The legal profession fears a "clean" response from one lawyer may be misconstrued as meaning no legal problems exist. Such a misinterpretation could encourage someone to sue the responding attorney.

ERRONEOUS RESPONSES

The ABA statement attempts to curtail erroneous responses to auditor's inquiries by limiting the responses' scope to matters on which the attention. The attorney's response is not expected to include all known and unknown legal problems the client may face. This makes an accurate response more likely because it is limited to matters the attorney has considered carefully.

The ABA statement also attempts to curtail erroneous responses by not requiring attorneys to consider facts that come to their attention while acting in another capacity, such as a director. This is not meant to protect the attorney-client privilege. Any such communications would not qualify because they are not made to obtain legal advice.

In Tew, the court relied on the fact the Arky, Freed attorney attended the ill-fated meeting to represent an individual, not ESM. The court implied the information obtained at the meeting need not have been disclosed in the attorney's response because that response was obtained in another capacity.

This reasoning is arguably beyond the spirit of the ABA statement's limitations. The information was received in a legal capacity and should have been carefully considered by the firm in formulating its response to the audit inquiry. In fact, the law firm did not claim it had failed to devote substantive attention to ESM's financial problems.

Tew should be viewed as a case with a right decision for the wrong reasons. Other audit procedures were available to disclose the financial statement fraud. Therefore, the ABA statement, which limits the scope of attorneys' responses in cases of unasserted claims, should not be blamed for the audit failure. Research for this article found no cases that held an attorney liable for an erroneous response. Again, this suggests further limits on attorneys' involvement in the audit process are unnecessary.

WORK PRODUCT DOCTRINE

Attorneys also are concerned about the possible disclosure of an audit response to an opposing party in litigation via discovery procedures (the various methods in civil procedure rules that require parties to give information and documents to other parties). However, there is no need for an attorney to divulge any information that falls within a recognized privilege.

A reading of the cases shows few disputes about the discovery of an attorney's response to an auditor's inquiry. The attorney-client privilege does not shield a response to an audit inquiry because it is made to a third party, the auditor. However, another privilege, the work product doctrine, arguably does protect an audit inquiry response.

What constitutes an attorney's work product? An attorney's legal research on possible client defenses would qualify, as would interviews of potential witnesses if the attorney's notes also contained an evaluation of the legal impact of the testimony.

While exceptions to the work product doctrine exist, the opposing party may not seek to learn the mental impressions, conclusions or opinions of an attorney through discovery. The purpose of the doctrine is to promote effective courtroom representation by safeguarding the fruits of an attorney's trial preparations from discovery.

To respond to an audit inquiry, an attorney may have to disclose opinions about the probability and possible range of a loss. Protecting an attorney's mental impressions and opinions furthers the purpose of the work product doctrine. It allows an attorney to prepare the case free from an opponent's interference. Work product protection also allows the financial reporting process to function more smoothly, providing benefits to society as a whole.

LIMIT ATTORNEY

INVOLVEMENT IN THE

AUDIT PROCESS?

Case law does not seem to support suggestions to limit attorneys' involvement in the audit process. The paucity of reported cases shows widespread problems have not occurred. Fears of waiver of the attorney-client privilege and civil or criminal liability are unfounded based on limitations in the ABA statement. The better argument is an attorney's response is privileged under the work product doctrine. As such, attorneys should feel free to provide candid responses to auditors' inquiries in the future, making the auditor's work much easier.