Microsoft tax case highlights conflict concerns when U.S. hires private firms

November 24, 2015

(Reuters) – On Monday, U.S. District Judge Ricardo Martinez of Seattle ruled that Microsoft must comply with summonses issued by the Internal Revenue Service in the government’s seven-year investigation of the company’s cost-sharing agreements with affiliates in Puerto Rico and Asia. The decision, which Judge Martinez reiterated late Monday in a followup order responding to post-decision evidence submitted by Microsoft, seems to put an end to the company’s attempt to restrict the role of the IRS’s hired guns from Quinn Emanuel Urquhart & Sullivan.

Microsoft had argued that the IRS summonses were improper because Quinn Emanuel had effectively taken over the case against Microsoft, in violation of statutes barring outside contractors from using power reserved for IRS officials. Judge Martinez said Microsoft’s theory was too speculative. The company didn’t have evidence to prove the summonses had been issued at Quinn Emanuel’s direction or in anticipation of litigation, according to the judge.

But even Judge Martinez expressed qualms about the IRS hiring an outside firm – apparently for the first time – to advise on a potentially enormous case. “The court is troubled by Quinn Emanuel’s level of involvement in this audit,” he wrote. “The idea that the IRS can ‘farm out’ legal assistance to a private law firm is by no means established by prior practice, and this case may lead to further scrutiny by Congress.”

Of course, there’s nothing unusual about a government agency hiring private lawyers to prosecute a case. State attorneys general do it all the time in securities, antitrust and consumer litigation, most famously in the coordinated multistate tobacco onslaught of the 1990s.

The federal government has also made effective use of outside lawyers, including Boies Schiller & Flexner in litigation stemming from the savings and loan crisis and Quinn Emanuel in mortgage-backed-securities litigation on behalf of the Federal Housing Finance Agency. (It’s probably not a coincidence that those are the two firms the IRS talked to about the Microsoft case.) In 2013, Columbia law professor John Coffee even suggested that the Securities and Exchange Commission learn from FHFA’s spectacular MBS success and begin hiring private law firms to handle its biggest, toughest cases.

These public-private hookups are quite controversial, though. State AGs’ use of private law firms is one of the U.S. Chamber of Commerce’s pet causes. Partly because of the attention the Chamber has brought to the potential conflict between government policy concerns and financial incentives for contingency-fee lawyers, at least 20 states have passed laws to regulate how state AGs hire and oversee private firms.

Federal contractors are also regulated, although those regulations generally weren’t drafted with outside law firms in mind. The IRS, for instance, had never brought in private lawyers to work on an investigation before the Microsoft audit, according to testimony in the Microsoft case. The innovation was so novel that the Treasury Department actually adopted a temporary rule in June 2014, allowing private contractors to participate in interviews with witnesses responding to an IRS summons, to be sure Quinn Emanuel could do its job.

The IRS insisted, in its brief seeking to enforce the Microsoft summonses, that Quinn Emanuel’s contract expressly prohibits Quinn lawyers from stepping onto government turf, limiting the firm’s role to legal and investigative counsel. “Importantly, neither providing legal advice nor gathering facts is an inherently governmental function,” the IRS brief said.

Fair enough. But you can understand why Microsoft was so exercised about Quinn Emanuel’s entrance into the case from reading a passage in its brief. At the time the IRS was talking to Quinn about coming aboard in 2014, according to Microsoft’s brief, the law firm was involved in more than 30 active cases adverse to Microsoft. Some of Quinn Emanuel’s biggest clients, such as Samsung, are major Microsoft competitors. Yet according to Microsoft’s brief, the IRS shared confidential tax and financial documents with Quinn Emanuel without ever inquiring about potential conflicts. “No reason to ask,” said IRS official Eli Hoory, the only witness at an evidentiary hearing on the agency’s contract with Quinn.

I certainly don’t mean to imply Quinn Emanuel misused information it obtained from the IRS investigation of Microsoft. There’s nothing in the record that even hints of misuse and I’m sure Quinn implemented the requisite internal procedures to protect Microsoft documents.

Nevertheless, Microsoft’s brief does give defendants another reason to worry about federal agencies hiring private attorneys. Unlike government lawyers, who have only one client, lawyers at big firms have to think about the interests of lots of clients at a time. If agencies want to continue hiring outside legal advisors, they really ought to develop a hiring process to protect themselves from any whiff of a suggestion that the private lawyers are acting to benefit private clients and not necessarily the government.

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