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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,

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 subpoena.


  A. Overview

  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 California.

  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 Documents

  Section 27 of the Illinois Public Accounting Act*fn18 provides:

"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 audit.*fn19 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 third parties,"*fn21 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 confidential capacity.

  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.


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