United States District Court, S.D. New York
November 4, 2004.
CATHERINE LEGO, as representative of the shareholders of Tsunami Optics, Inc., et al., Plaintiffs,
STRATOS LIGHTWAVE, INC., Defendant.
The opinion of the court was delivered by: LEWIS KAPLAN, District Judge
The plaintiffs in this action, which is pending in the Northern
District of California, move to compel non-party Ernst & Young
LLP ("E&Y") to comply with a subpoena seeking discovery concerning defendant Stratos Lightwave, Inc.
("Stratos"),*fn1 a client of E&Y's accounting business. The
matter turns on whether and to what extent the Illinois
accountant's privilege applies here.
A. The Parties' Claims
The plaintiffs were founders of and investors in Tsunami
Optics, Inc. ("Tsunami"), a California-based enterprise in the
fiber optics industry. In 2002, Tsunami merged with a Stratos
subsidiary in a transaction in which the securities of Tsunami
were converted into a right to receive securities of Stratos as
well as post-merger payments in Stratos securities in amounts
that were to be a function of the average trading price of
Stratos common stock during a defined period following the
merger. Plaintiffs subsequently commenced this action, claiming
that Stratos has mismanaged the Tsunami subsidiary, and thereby
interfered with the Tsunami shareholders' rights under the merger
agreement, and that Stratos induced plaintiffs to enter into the
transaction by misrepresenting its financial condition.
Stratos in turn counterclaimed. It contends, among other
things, that plaintiffs fraudulently induced it to enter into the
transaction by misrepresenting Tsunami's current and anticipated
financial condition as well as its product development schedules.
The parties rely exclusively on state law for the rules of
decision governing their claims save that one of Stratos' five
claims for relief on its counterclaim is based on Section 10(b)
of the Securities Exchange Act of 1934*fn2 and Rule 10b-5 thereunder.*fn3
B. The Disputed Discovery
E&Y was Stratos' outside auditor. In June 2003, plaintiffs
served on E&Y's New York headquarters a subpoena issued by this
Court which seeks to compel deposition testimony and the
production of a broad variety of documents relating generally to
the parties' agreement, E&Y's activities on behalf of Stratos
such as due diligence on the Tsunami transaction, Stratos'
financial condition, analyses of Tsunami's financial condition,
and other matters.
E&Y objects to the subpoena on the ground that the requested
information is protected from disclosure by the Illinois
accountant's privilege. The plaintiffs counter that privilege
with respect to the subject matter of this subpoena should be
determined in accordance with federal, not state, law and that
even if state law does apply, the Court should apply California
or New York law, neither of which recognizes a privilege for
accountants. They seek an order compelling compliance with the
Federal Rule of Evidence 501 provides that privileges in
federal courts are governed by federal common law except that in
civil cases, "with respect to an element of a claim or defense as
to which State law supplies the rule of decision, the privilege
of a witness [or] person . . . shall be determined in accordance with State law." In a diversity case,
this rule "requires the application of the state law of
privileges, except where the proof is directed to an issue that
is governed by federal law."*fn4
To the extent that the discovery requested in this case is
relevant to the federal counterclaim (or to a defense based on
federal law), or to both federal and state claims, privileges are
determined in accordance with federal law. This rule is
consistent with the established principle that when federal
jurisdiction is based on the existence of a federal question, but
the case includes pendent state law claims arising out of the
same events, federal law governs privileges.*fn5 To the
extent, however, that the discovery requested in this case is
relevant only to state claims and defenses, privilege is
determined by the applicable state law.*fn6
B. Choice of Law
Having determined that state privilege law governs all evidence
sought except that which would be relevant to plaintiffs' defense against Stratos'
federal counterclaim, the next step is to determine the state the
law of which controls.
Under New York's choice of law principles,*fn7 the
governing law is that "`of the jurisdiction which, because of its
relationship or contact with the occurrence or the parties, has
the greatest concern with the specific issue raised in the
litigation.'"*fn8 In this case, the only states that have a
plausible concern with the privilege issue are Illinois and
Stratos' headquarters are in Illinois. All or substantially all
of E&Y's audit work was performed in that state.*fn9
California, on the other hand, is the location of the forum of
the underlying action as well as the plaintiffs' home state and
the state the substantive law of which will govern most of the
claims in this case. Thus, California too has a material interest
in application of its law.
In cases requiring a choice of privilege law, the interest
analysis usually has led New York courts to apply the law of the
jurisdiction in which the assertedly privileged communications were made, which in most of the cases was also the jurisdiction
in which the party that made the communications
resided.*fn10 The most common rationale is that the parties
who made the communications expected that those communications
would remain confidential under the law of that jurisdiction, and
the state has an interest in furthering the policies behind the
privilege at issue.
Two cases have come out differently, but each is
distinguishable. In First Interstate Credit Alliance, Inc. v.
Arthur Andersen & Co.,*fn11 the Appellate Division refused
to apply Maryland's accountant-client privilege to the defendant
accounting firm's Maryland-based audit of a Maryland client that had transacted business with the plaintiff, a New
York corporation. In that case, however, the action contended
that the audit reports were prepared for the purpose of assisting
the client in procuring financing from a New York lender and that
they had been used to perpetrate a fraud. Taking all factors into
account, the court concluded that New York's interest in getting
to the truth concerning the alleged fraud outweighed Maryland's
interest in protecting the accountant-client communications at
issue. In this case, by contrast, there is no suggestion that any
of E&Y's work was undertaken to further a fraud by Stratos.
In Bamco 18 v. Reeves,*fn12 Bamco 18, an investor in a
defendant limited partnership known as Hospitality, sued
Hospitality and several of its principals, including one Reeves,
for fraudulently inducing its investment. It sought production by
Reeves of accountants' documents concerning one of Reeves'
ventures, a Maryland limited partnership known as Laurel. Reeves
resisted, invoking Maryland's accountant-client privilege.
Judge Sweet determined that "the only contact with Maryland is
that a limited partnership [Laurel] from which documents are
sought is located there."*fn13 Moreover, Laurel's general
partner was a New Hampshire corporation and Reeves himself, who
was both the owner of the general partner and himself a limited
partner in Laurel, also was domiciled in New Hampshire. The
accounting firm that prepared the documents was from Boston.
Thus, neither the putative client really Reeves nor the
accountant had any substantial connection to Maryland. The Court
therefore rejected application of the Maryland privilege law. Bamco 18 bears no similarity to this case. Here the
accounting work and the client both were in Illinois, the state
whose law is said to apply.
Accordingly, this Court holds that the accountant's privilege
of Illinois governs this action to the extent that state law
supplies the rule of decision as to privilege.
C. Application of the Illinois Accountant's Privilege
Determination of the extent to which the discovery sought by
plaintiffs is privileged requires two steps. The Court first must
determine what discovery relates to the plaintiffs' defense
against Stratos' federal securities law counterclaim, for the
Illinois privilege does not apply to those requests at all. It
then must decide which of the remaining documents come within the
scope of the Illinois privilege.
1. Documents Relevant to Defense against the Federal Claim
The sole federal counterclaim alleges that the plaintiffs made
misrepresentations during the negotiations that led to the merger
agreements,*fn14 including "false, unrealistic and
unachievable" projections about Tsunami's future
revenues.*fn15 The plaintiffs argue that they can defend
against this claim in several ways, including by arguing "that
Tsunami met the financial benchmarks Plaintiffs set forth in
negotiations" and "that Tsunami came close to meeting those
financial benchmarks but fell short because of interference by
Stratos."*fn16 Thus, documents relating to Tsunami's performance after the acquisition by Stratos would
be relevant to the defense of Stratos' 10b-5 counterclaim. By
contrast, documents concerning only Stratos' overall financial
condition and performance cannot help the plaintiffs defend
against the claim that they made misrepresentations about Tsunami
in the course of negotiations.
Because federal law does not recognize a privilege for
accountants,*fn17 E&Y must comply with the subpoena to the
extent that it demands information about Tsunami after Tsunami
came under Stratos' ownership.
2. Applicability of the Illinois Privilege to the Remaining
Section 27 of the Illinois Public Accounting Act*fn18
"A licensed certified public accountant shall not be
required by any court to divulge information or
evidence which has been obtained by him in his
confidential capacity as a public accountant."
The statute's protection extends at least to an accounting firm's
work papers and to confidential communications between the
accounting firm and the client in connection with an
The statute has been found inapplicable to,
among other things, nonfinancial work such as quality control assessments,*fn20
"documents that have previously been filed
with third parties and any claims or communications received from
and "an accountant's views concerning
matters of financial disclosure."*fn22
There is no real dispute that much of the requested discovery
falls within the scope of Section 27. The plaintiffs have
demanded from E&Y mostly documents that reflect financial
information that Stratos provided to the accounting firm. E&Y has
represented that "[a]ll of the audit workpapers are maintained in
a confidential fashion."*fn23
The plaintiffs do dispute that Section 27 applies to the
minutes of meetings of Stratos' Board of Directors and its
subcommittees.*fn24 The Court agrees; the record of a
meeting does not appear to qualify as information obtained by an accountant in a
Furthermore, certain additional information requested by the
plaintiffs may not be privileged. For example, correspondence
with a third party does not qualify for Section 27 protection.
E&Y must comply with the subpoena insofar as the requested
discovery falls outside the protection of Section 27.
The plaintiffs' motion to compel E&Y to comply with the June
24, 2003 subpoena is granted to the extent that E&Y (a) on or
before November 18, 2004, shall produce the documents described
in Document Requests 2, 9, 11, 12, 13, 16 insofar as those
documents contain information about events after the acquisition
of Tsunami by Stratos, and 17, (b) shall testify, pursuant to the
Rule 30(b)(6) notice of deposition, on such date as may be agreed
upon by the parties or fixed by the Court, with respect to the
subjects described in paragraphs 6, 12, and 13 thereof to the
extent of information about events after the acquisition of
Tsunami by Stratos, and (c) shall produce any other documents
described in the request for documents that do not contain
information that has been obtained by a licensed certified public
accountant in that accountant's confidential capacity. The motion
is denied in all other respects.