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One of the most important cases facing general counsel, their accountants and outside lawyers has been percolating through Texas. The suit raises questions about the scope of the so-called auditor privilege: whether records turned over to auditors, including sensitive legal documents, are for the auditor’s eyes only, or whether they can be subpoenaed by third parties. It didn’t look like a particularly consequential case at the outset. It began as a dispute between two companies over a construction contract. In 2002, AES Wolf Hollow L.P. commissioned The Shaw Group Inc. to build an electric power plant in Texas for $99 million. But things got ugly, and Shaw eventually sued AES for nonpayment. In turn, AES said that since Shaw was suing for lost profits and damages, it had a right to see the company’s financials. So AES subpoenaed the accounting firm Ernst & Young LLP for Shaw’s auditing records. Granbury, Texas-based AES made the request even though Shaw and its auditor are located in Louisiana, where state law provides for an iron-clad auditor-client privilege. This became more than just an aggressive fishing expedition in May 2005, when the trial judge made a surprising call. Sitting in Hood County, Texas, state court, Judge Ralph Walton Jr. ordered Ernst & Young to comply with the discovery request, even though Texas has a similar law recognizing auditor-client privilege. But before Ernst & Young could turn over the papers, Shaw and the auditors appealed the issue to the Texas Supreme Court, saying that everything AES needed was in its public filings with the U.S. Securities and Exchange Commission (SEC). A March surprise In March, to the surprise of many in-house counsel following the case, the court upheld AES’ right to see the auditor’s records. Because of the case’s significance, Shaw sought a rehearing, but on April 28 the state high court denied the motion. (Shaw’s lawyers declined to comment for this story.) In its petition for rehearing, Shaw listed a number of arguments why its auditing records shouldn’t be turned over: All its significant communications took place with the Ernst & Young office in Louisiana, and both the company and the auditors relied on that state’s auditor privilege when they shared information. Most importantly, the free flow of information between a business and its auditor must be protected from discovery in order to assure complete and accurate financial reporting. The ruling, Shaw argues, will undermine that candor. And, the petition says, breaking the privilege could conceivably discourage companies from doing business in Texas in the future, for fear that audit records (which usually include documents that are considered attorney-client privileged) “would be subject to discovery in litigation in Texas, even if such communications did not take place in Texas.” Shaw isn’t alone in worrying about the decision’s implications. The Washington-based Association of Corporate Counsel (ACC), the American Bar Association’s task force on attorney-client privilege, which has a subcommittee on auditor privilege, as well as many in-house lawyers across the country are closely following the case. This is a galvanizing issue for them, because under new Sarbanes-Oxley Act regulations, auditors must ask for more information than ever. To vouch for a company’s economic health, they may even request documents, such as internal investigation reports and legal opinions, that have been marked “attorney-client privileged.” When this happens, company lawyers face an incredibly difficult decision: Should they hand over this sensitive information when auditors ask for it, and take the chance that it will be given to a third party? Or should they refuse the auditor’s requests even though the accounting firm might then withhold its opinion letter certifying that the company had a clean audit? Little help from courts In-house counsel aren’t finding a lot of answers from federal courts or state laws. Karen Corallo, a partner in Akin Gump Strauss Hauer & Feld’s Dallas office who represented Ernst & Young in the Shaw case, notes that federal courts are split on the audit-privilege issue, and that 34 states provide for varying degrees of privilege. Louisiana and a handful of other states have statutes that appear absolute, with no exemptions. But other state laws contain what Corallo calls “gaping-hole exceptions.” For example, in some states, simply requesting audit records from the other side is enough to break the auditor-client privilege. Other states require a legal showing of need or hardship to overcome the privilege. “If you leave it up to each individual court case, it’s as good as no privilege at all,” Corallo said. However, some experts following this issue say that lawyers should stop complaining. One critic, business law professor Thomas Morgan of George Washington University Law School in Washington, believes that companies and both their inside and outside counsel need to face the reality of post-Enron times. “Frankly,” Morgan said, “lawyers have got to catch up with the fact that we are in a world where it’s in the best interest of their client to be comfortable with producing a clean audit. Companies and lawyers are kidding themselves if they think they are helping by failing to turn [sensitive information] over.” Subpoenaing auditors’ records as part of the discovery process is not new; it’s a common tactic in shareholder and derivative suits. What is new is the depth and breadth of auditors’ demands in today’s environment-and that’s what has general counsel worried. The Sarbanes-Oxley Act of 2002 created additional standards for auditors of public companies, as well as a new oversight agency, the Public Company Account Oversight Board. The board, composed of a chairman and four members (all but one of them lawyers) appointed by the SEC, has been phasing in its new rules over the past two years. The rules require the 1,611 registered auditing firms to examine their clients in a host of new areas, including liabilities and contingency/litigation reserves, ongoing and threatened litigation, enforcement matters and claims, results of internal investigations and compliance audits, and sometimes even legal advice provided about regulatory and transactional matters. In addition, beginning in January, auditors have had to certify and report on a company’s internal financial controls, including identifying any high-risk legal areas that could adversely affect a company’s finances. That’s not information that most GCs care to share with third parties. But corporate counsel are fighting back and forging alliances to keep cases like Shaw from becoming the general rule. Coming up with a coherent legal theory and implementation strategy, though, isn’t easy. Even among their own members, advocacy groups like the ABA task force haven’t been able to craft a unified solution. The various groups do agree, however, that finding a way to strengthen the auditor-client privilege is critical. C. Lee Cusenbary Jr., general counsel of Mission Pharmacal Co. in San Antonio, who joined ACC’s amicus brief, siding with Shaw in the dispute, said his company recently “relied on [the audit] privilege in sharing all our information with Ernst & Young [in its annual audit]. Now all that means nothing?” For ACC, this isn’t just a fight about auditor privilege, it’s also about the explosive issue of attorney-client privilege, which the in-house counsel group and other bar associations are fighting on additional fronts. ACC underscored this point in its amicus brief, which it filed in January on behalf of its 1,380 corporate counsel members in Texas. ACC argued that forcing a company to give up auditing records by its very nature violates attorney-client privilege, because so much of what an auditor now seeks includes documents that are protected by this privilege.

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