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Privilege and Rich German Win Out in Second Circuit

MANHATTAN (CN) - When Germany's richest businessman worked with banks and accountants on a tax strategy to avoid insolvency after the 2008 financial crash, he did not waive his right to attorney-client privilege, the Second Circuit ruled Tuesday.

Though the Internal Revenue Service contends that Georg F. W. Schaeffler waived privilege in sharing the records, the federal appeals court found that Schaeffler and the banking consortium's common legal interest serves to quash the government's subpoena.

Schaeffler, who owns 80 percent of his family's German automotive and industrial parts supplier Schaeffler Group, had borrowed 11 billion euro from the banks in 2008 while attempting to acquire fellow German automaker company Continental AG.

In a stroke of massively bad luck for Schaeffler, however, he executed the deal just two days before the financial recession came into full force with Lehman Brothers announcing its bankruptcy in September 2008.

Continental's stock prices, already on the decline after the company overextended itself acquiring Siemans' auto unit earlier that year, plummeted soon thereafter.

German law blocked Schaeffler from pulling the tender, and he was stuck buying up nearly 90 percent of the company's shares from Continental's bailing stockholders.

Court records show that Schaeffler scrambled to refinance the newly acquired debt and restructure his own company, which also bumped him into a higher tax bracket. To avoid scrutiny by the Internal Revenue Service, Schaeffler enlisted accounting firm Ernst & Young and law firm Dentons US to advise how to prepare for future litigation with tax authorities.

The bank consortium, which stood to lose billions in euros amid a default, suggested that Schaeffler repay his personal liabilities first, then those of his company.

The banks also extended him an additional line of credit for 250 million euro, a deal that clipped Schaeffler's wings and gave the consortium right of refusal over any IRS settlements or tax refunds, as well as his right to sue.

The IRS audited Schaeffler shortly after and issued summons for all documents created by Ernst & Young related to the restructuring, as well as legal opinions and analyses.

Schaeffler complied with much of the summons, turning over thousands of documents, but filed to quash the demand for an E&Y memo that discussed legal opinions on U.S. tax regulations and legal precedents.

Though a federal judge found that Schaeffler had waived both attorney-client and work-product privilege, the Second Circuit reversed Tuesday.

A unanimous three-judge panel found that the E&Y memo was specifically written to address "urgent circumstances" and "necessarily geared to an anticipated audit and subsequent litigation." The fact that billions of euro were at stake did not mean the internal memos were strictly commercial in nature and not legal, according to the ruling.

"A financial interest of a party, no matter how large, does not preclude a court from finding a legal interest hared with another party were the legal aspects materially affect the financial interests," Judge Ralph Winter wrote for the court.

Winter wrote said various parties can share a legal interest even if they are not parties in the same litigation. In this case, the consortium of banks had common-enough interest in keeping Schaeffler Group afloat as to warrant privilege.

"The documents in question were all directed to the tax issues, a legal problem albeit with commercial consequences," Winter wrote. "The consortium's interest was in funding a refinancing that would protect its earlier investment and would itself be repaid, goals dependant on the resolution of legal tax issues."

The ruling avoids a potential side effect on future tax issues involving work-product privilege, Winter wrote. "We note that the district court's holding appears to imply that tax analyses and opinions created to assist in large, complex transactions with uncertain ax consequences can never have work-product protection from IRS subpoenas," the opinion states.

On remand, the District Court must determine if any remaining documents are privileged.

Before its previous ruling against Schaeffler, the lower court had reviewed the E&Y memo behind closed doors and found it unlikely that the accounting firm and the banks would have reacted differently and reworded their legal advice to Schaeffler if they knew a lawsuit was coming.

Schaeffler's interest in Continental has worked out in the long run. In July 2015, the Financial Times valued the Schaeffler family's 46 percent stake in the company at nearly 20 billion euro. Schaeffler has been suggested to be Germany's richest person.

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