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Delaware Bankruptcy Court Holds that Federal Privilege Law Incorporates Delaware State Law's Broad Attorney-Client Privilege Rule Protecting Communications with Financial Professionals if the Communication Relates to a Delaware Transaction

May 15, 2018

Fraudulent transfer plaintiffs frequently challenge transactions that they say contributed to the company’s insolvency: leveraged buyouts, cash-out mergers, share redemptions, or other major transactions where the company parts with assets or incurs liabilities. State law (often Delaware law) typically governs these types of transactions, and structuring them usually requires the involvement of attorneys, financial professionals, and sometimes investment bankers. Because state law applies at the time the transaction is negotiated, the parties might assume—reasonably so—that state privilege law will govern communications with their attorneys and financial professionals. But what happens if, years later, a fraudulent transfer plaintiff files suit in federal court and brings claims under federal law? Does state privilege law still apply? The answer matters, because the Delaware attorney-client privilege protects a broader array of communications involving financial professionals than does federal privilege law. Would communications that were privileged when made lose that status years later, or would a federal court honor Delaware’s privilege rule even though federal law typically would not treat the same communications as privileged?

The Delaware Bankruptcy Court recently addressed these questions. In a bench ruling, Judge Gross applied federal privilege law but held that because the communications at issue arose from a merger governed by Delaware law, federal privilege law in this instance would apply the same broad rule that Delaware law would apply to the communications. PAH Litigation Trust v. Water Street Healthcare Partners, L.P., et al. (In re Physiotherapy Holdings, Inc., et al.), Adv. No. 15-51238 (KG) (Bankr. D. Del.) (Apr. 26, 2018 Hr’g Tr.) [D.I. 842]. On the facts of the case, the Court expanded the federal common law of privilege to incorporate the Delaware rule in situations where the communications arise from a Delaware transaction.

The facts of the case are straightforward. A company’s owners sold their shares through a cash-out merger governed by Delaware law. A few years later, the company filed for bankruptcy. The bankruptcy litigation trust sued the former owners, alleging that the payments they received were fraudulent transfers under the Bankruptcy Code and state law. The parties conducted discovery, and the former business owners withheld certain communications with their attorneys and financial advisors on the ground that the communications arose from a Delaware merger and were attorney-client privileged under Delaware’s privilege rule. The litigation trust argued that federal privilege law applied, and that the communications had to be produced under the narrower federal rule.

Delaware’s privilege rule is both clearer and broader than federal law. It starts from the proposition that a third party’s presence in an attorney-client privileged communication generally will break the privilege. But Delaware law recognizes that attorneys and clients may need to communicate with financial professionals to properly give and receive legal advice. Based on this practical reality, a long line of Delaware cases hold that the financial professional’s presence does not break an otherwise attorney-client privileged communication if the parties expected to treat the communication as confidential. See, e.g., Jedwab v. MGM Grand Hotels, Inc., 1986 WL 3426, at *2 (Del. Ch. Mar. 20, 1986); 3Com Corp. v. Diamond II Holdings, Inc., 2010 WL 2280734, at *5–6 (Del. Ch. May 31, 2010).

Federal privilege law is not so clear or broad. Surprisingly, there is no uniformly applied test across the federal courts. Some courts ask whether the financial professional is the “functional equivalent” of a client employee, such that it stands in the same shoes vis-à-vis the lawyer as the client. See, e.g., In re Bieter Co., 16 F.3d 929, 935–40 (8th Cir. 1994). Other courts examine the role that the financial professional plays in the communication, and protect only those communications where the professional “translates” or “interprets” financial material for the lawyer. See, e.g., United States v. Ackert, 169 F.3d 136, 139–40 (2d Cir. 1999). In most cases, federal courts have applied the privilege more narrowly than Delaware state courts, as Delaware courts do not require any assessment of the financial professional’s precise “role” in the communication.

Because of this difference in federal and Delaware state law, parties to a Delaware transaction may find themselves in a predicament if that transaction later is challenged in federal court, as there is no assurance that a federal court would apply Delaware’s privilege law. It is settled law that a federal court will apply federal privilege law to federal causes of action and state privilege law to state causes of action. But if a lawsuit presents both federal and state causes of action and the evidence at issue relates to both, then a federal court will apply federal privilege law across the board. See, e.g., Pearson v. Miller, 211 F.3d 57, 66 (3d Cir. 2000).

This means that any complaint that includes a federal cause of action will by default lead to federal privilege law, a result that puts parties to a Delaware transaction in an untenable position. On the one hand, Delaware law governs the transaction from which the communications arose, and the parties therefore would expect Delaware privilege law to apply at the time that they actually made the communications. But on the other hand, the parties would have no assurance that if they were haled into federal court, the court would honor the Delaware state law privilege. The mere prospect that a plaintiff might one day sue, and that a federal court would not enforce the privilege, would effectively nullify Delaware’s broader privilege rule, for “any State’s promise of confidentiality would have little value if the [client] were aware that the privilege would not be honored in federal court.” Jaffee v. Redmond, 518 U.S. 1, 17–18 (1996).

Parties to a Delaware transaction can now breathe easier in light of the Bankruptcy Court’s recent ruling. The Court began its analysis by noting that federal privilege law is flexible and may recognize an expanded privilege if the privilege is recognized by a state, is supported by a strong state interest, and is not outweighed by a countervailing federal interest. See Pearson, 211 F.3d at 66. Each of these criteria was met in Physiotherapy. First, Delaware recognizes an expanded privilege for attorney-client communications involving financial professionals. Second, Delaware has an “overwhelming” interest in upholding the expectations of parties who avail themselves of Delaware law, including expectations that communications that are privileged when made will stay that way. Third, the Court found no strong countervailing federal policy, such as civil rights concerns, that would weigh in favor of applying the narrower federal privilege. The Court concluded that on the facts of this case, “where a financial professional … is retained for purposes of a transaction and assisted the lawyers with the transaction, communications with the financial professional and communications that financial professional has relating to the transaction are protected by privilege.”

Although several federal courts within the Third Circuit have relied on the same legal framework to expand other types of privileges, this decision appears to be the first to apply that reasoning specifically to the attorney-client privilege as it relates to financial professionals. The ruling recognizes that if parties cannot reasonably predict whether communications will be privileged (because a court later might refuse to honor the privilege), then the privilege would be toothless, resulting in the chilling of transactional attorney-client communications and the frustrating of Delaware law. The ruling thus should provide some comfort to professionals advising on a Delaware transaction that federal courts will honor Delaware’s broader privilege rule for transaction-related legal communications involving financial professionals.