by Lee Gesmer | Mar 20, 2013 | Copyright
Last week I published a post on the lawsuit challenging the “first-sale” doctrine in the context of digital files. On Tuesday the Supreme Court issued a decision holding that the first-sale doctrine applies to copies of copyrighted works lawfully made abroad.
To understand the facts of this case picture this scenario.
You are a student in Thailand, and you use English-language textbooks in your studies there. You see that the textbooks are not pirated copies—they are legal copies, authorized for foreign publication. When you come to the United States to continue your education you see the same textbooks are sold at much higher prices. Why not get ahold of some of the books being sold in Thailand and sell them at below-U.S. prices but above Thailand prices? There is money to be made there!
Math student Supap Kirtsaeng recognized this arbitrage opportunity. He asked his family in Thailand to buy copies of foreign edition English language textbooks at Thai book shops and ship them to him in the U.S. He sold the textbooks on EBay, reimbursed his buyers and pocketed the difference. He was successful to the tune of almost a million dollars in sales and $100,000 in profits. However, the fact that Kirtsaeng was undercutting U.S. prices infuriated book publisher John Wiley & Sons, Inc., which sued Kirtsaeng in U.S. District Court in Manhattan, arguing that Kirtsaeng violated its copyright rights by reselling books manufactured and sold abroad. The district court and the Second Circuit agreed with Wiley, and awarded damages that, if upheld, would have cost Kirtsaeng far more than he had earned.
On Tuesday, in a Cinderella victory, the Supreme Court reversed, holding that the “first-sale” doctrine protected Kirtsaeng against Wiley’s claims of copyright infringement.
This case came down to a thorny issue of statutory construction under the first-sale doctrine, which provides that “the owner of a particular copy or 
phonorecord lawfully made under this title . . . is entitled, without the authority of the copyright owner, to sell or otherwise dispose of the possession of that copy or phonorecord.” 17 U. S. C. §109(a). Kirtsaeng claimed that the first-sale doctrine protected him. Wiley argued that the books, printed in Thailand under a license from Wiley, were not made “under this title,” and therefore Kirtsaeng could not lawfully resell them. In other words, Wiley argued that there was a geographical limitation on the first-sale doctrine.
The Court’s opinion (written by Justice Breyer) involves some hair-splitting statutory analysis and a good deal of legislative and historical analysis in support of its conclusion. The bottom line is that a six-Justice majority found Wiley’s geographical limitation argument unsupportable under the statute, and concluded that there is “no basic principle of copyright law that suggests that publishers are especially entitled to . . . charge different prices for the same book in different geographic markets.”*
*The Court also took into consideration the “practical copyright-related harms with which a geographical interpretation would threaten ordinary scholarly, artistic, commercial, and consumer activities.” How would used book stores and libraries (for example) know that they had the right sell or loan books that had originated abroad?
The Court dismissed its 1998 dictum in Quality King v. L’Anza Research International that copies made by a British publisher would not be “lawfully made under this title,” stating, “is the Court having once written dicta calling a tomato a vegetable bound to deny that it is a fruit forever after?”
The implications of a decision legalizing the importation of “gray market” copyrighted works created outside the United States are significant for publishers, but this battle may be far from over. There can be little doubt that the U.S. publishing industry is strategizing over how restrict the importation of copyrighted works in light of this decision. In fact, Justice Kagan wrote a concurring opinion outlining at least one option: since the Supreme Court’s decision interprets a federal statute (the Copyright Act), the law can be amended to prohibit the importation of foreign-manufactured copyrighted works, but to avoid some of the collateral harm that influenced the Court’s decision. However, opposition to such a change in the law is already ready to do battle.*
*See Owners Rights Initiative.
Sellers might also attempt to restrict importation by licensing (rather than selling) their products, a strategy that has been somewhat successful under U.S. law in the case of software. (For a post discussing this issue see here). On this strategy the line between digital and physical goods blurs—for example, even now Amazon uses licensing to /restrict the purchase of territorially licensed e-books from outside the U.S. And, whether a license would be recognized under the laws of foreign countries where the transaction first takes place (and when the transaction is arguably a sale) remains open to question.
Every Supreme Court opinion generates massive press coverage. For a partial collection of articles and posts see this collection at SCOTUS blog. I also recommend Terry Hart’s discussion on Copyhype and Margot Kaminski’s post on Concurring Opinions, both of which contain valuable observations about how Congress and the publishing industry might respond to this decision.
Kirtsaeng v. John Wiley & Sons, Inc.
by Lee Gesmer | Mar 14, 2013 | Copyright
Last week’s New York Times article on digital resales, Imagining a Swap Meet for E-Books and Music, is a reminder that U.S. District Court Judge Richard Sullivan’s decision on the pending cross-motions for summary judgment in Capitol v. Redigi can be expected quite soon. The motions were argued on October 5, 2012 (transcript), and six months is a fairly long time for a judge to decide motions of this sort. (For my earlier blog post on this case see Redigi Case Poses A Novel Copyright Question on the Resale of Digital Audio Files – Is “Digital First Sale” Legal?)
Ever since copyright protection began to be applied to software in the early 1980s the industry has complained that the law lags behind the technology. The Redigi case is another example of this lag. The hearing transcript illustrates the difficulty of applying copyright law to new digital technologies, as the lawyers and the judge stuggle to find an analogy that will help them apply the copyright “first sale” doctrine to the Redigi “forward and delete” system.
The Redigi System. To briefly recap, Redigi can be used to copy (reproduce, migrate, transport, all verbs used by the parties) an iTunes file from a consumer’s computer to a Redigi server (aka the “cloud”), during which process it deletes the file from the owner’s computer. The file, although located on Redigi’s servers, remains accessible only by the original owner until it is purchased by a customer of Redigi, at which point it can be accessed only by the purchaser, who may stream it from the Redigi server or download it to the purchaser’s computer. Either way, the original owner (or more precisely Apple licensee) loses all rights to the file.
The “First Sale” Doctrine. The legality or illegality of this system rests on the court’s interpretation of the copyright statute’s “first sale” doctrine, which states as follows:
Notwithstanding the provisions of section 106 (3), the owner of a particular copy or phonorecord lawfully made under this title, or any person authorized by such owner, is entitled, without the authority of the copyright owner, to sell or otherwise dispose of the possession of that copy or phonorecord. 17 U.S.C. 109(a).
“Phonrecords,” in turn, are defined as:
material objects in which sounds . . . are fixed by any method now known or later developed, and from which the sounds can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device.
It is the “first sale” that allows the purchaser of a copyrighted work—such as a book, record, tape, CD or DVD—to resell that physical copy without violating the rights of the copyright owner. Hence, the existence of (for example) used bookstores, whether brick-and-mortar or online. However, Capitol argues that the first sale doctrine is limited to copyrighted works embodied in physical objects (paper, records, tapes, CDs, DVDs). It does not, Capitol claims, apply to digital files. In the case of Redigi the sale of a digital copy, Capitol argues, involves not the transfer of a “particular copy,” but rather the “reproduction” of the electronic file on the Redigi cloud. And reproduction, Capitol rightly argues, is an exclusive right of the copyright holder which is not protected by the first sale doctrine. By reproducing a copyrighted file on a Redigi server Redigi violates that right.
Redigi responds that the transmission of a digital work that is simultaneously deleted from the sender’s computer is the digital equivalent of giving, lending, or selling a book, consistent with long-standing copyright law under the first sale doctrine. The key factor, it argues, is that the original owner has no further rights (and no access) to the file once it has been sold.
The Summary Judgment Hearing (and the Star Trek Transporter). Judge Sullivan will have to decide which side is correct, and the summary judgment transcript shows how the judge and the parties have struggeled to fit Redigi’s system under the Copyright Act’s first sale doctrine:
Judge Sullivan: I guess [Redigi is] saying it’s not a copy, right? They’re saying that [the actual file] it’s transported from one place to another, . . . I’m not a Trekkie, but I kept thinking it’s the difference from Captain Kirk going from the Enterprise to the planet through that transporter thing, where he’s not duplicated, to the cloning where there’s a good and a bad Captain Kirk where they’re both running around. I think one is a copy and the other is — the other was transported and it’s only one Captain Kirk. (Transcript pp. 9-10).
Redigi’s lawyer (possibly in jest, it’s hard to tell): one of the examples I was thinking of was Willy Wonka. Remember when they put Tommy on the stage. They beamed him, and you saw the particles go across the top and, boom, there he was, miniaturized, but still him in that TV. What’s so hard to believe?*
*Redigi’s lawyer also described the process as “like a train. . . . Redigi grabs the file on the [customer’s local] hard drive and . . . pulls it in a matter of seconds to the cloud hard drive”
Perhaps the best analogy came from Judge Sullivan, where he described Redigi’s process as “if I combined my photocopier and my shredder so that I made a photocopy and the original, instead of coming out of the bin where I can pick it up, goes straight to the shredder. The two don’t exist at the same time, but it seems to me the other one is still a copy.” Redigi objected to this analogy, which is harmful to its position, but was challenged to distinguish it.
Judge Sullivan knows this is an important case: it is the first of its kind, and many eyes are watching. He also knows there is a good chance the losing party will appeal his decision to the Second Circuit Court of Appeals. He made it clear that his job is to apply the copyright statute, not make copyright policy—that would be up to Congress. At the same time, he is obviously struggling with the implications of Capitol’s position. The first sale doctrine has been a mainstay of U.S. copyright law since it was first established by the Supreme Court in 1908, and it seems intuitively unfair that it should not be expanded to encompass digital works.*
*In fact, a recent court ruling on this issue by the Court of Justice of the European Union held that held that a licensor of software made available for download over the Internet may not prevent the resale of perpetual licenses by its licensees. (UsedSoft GmbH v. Oracle International Corp., July 12, 2012), setting up the possibility that U.S. and E.U. law will differ on this issue. Unfortunately, Redigi and other potential resellers do not have the option of escaping more restrictive U.S. laws by moving their businesses to Europe, since the Court of Justice held that the first sale must occur within the European Union.
Nevertheless, under the current statute the Redigi case requires the court to identify the “phonorecord” in which the iTunes files are fixed, and determine whether Redigi is enabling the sale of that phonorecord. Capitol argues that the phonorecord is the hard drive, just as the material object in which the letters of a book are fixed is the printed page.
At the heart of Redigi’s response lies its assumption that the bits themselves are the phonorecord, and that its technology enables the transfer to the Redigi cloud of the specific bits the user downloaded from iTunes. However, although neither party seems to have argued the point,* as a technical matter Redigi seems to have the losing end of this argument. A digital file (such as an MP3 of AAC file) is nothing more than the alteration of the polarities of a magnetic medium (in the case of a hard drive) and the storage of electrons in the case of flash drives. In the case of a hard drive the only thing that is transfered is the set of instructions that set the magnetic polarities; in the case of a flash drive the electrons in the first user’s drive are not physically transferred to the Redigi cloud. Thus, Redigi’s argument that it “migrates” the file seems to have missed the mark as a technical matter. The most reasonable interpretation of the statute leads to the conclusion that the hard drive or flash drive is the “phonorecord” or “material object” in which “sounds are fixed,” and Redigi’s system does not involve the resale of the drives.
*The parties submitted expert affidavits, but they are so heavily redacted that it is impossible to know whether this argument was made. However, during oral argument Capitol’s lawyer stated that he did not “think it’s necessary to delve into the technology.”
While this conclusion will almost certainly leave many people deeply dissatisfied, Judge Sullivan is likely to conclude that a clear application of the law extending the first sale doctrine to digital files must come from Congress, not from the courts. Of course, Congress may take no action on this issue for years (if ever), leaving the legality of resales of digital works in limbo or, if Capitol’s position becomes case law, illegal.
An exchange between the judge and Capitol’s lawyer shows that the first sale doctrine is not a complete dead letter in the context of digital files, at least in theory. During the preliminary injunction hearing a year ago the judge asked Capitol’s lawyer whether the first sale doctrine would permit him to sell his iPod to his law clerk. Capitol responded that this would be permissible. (I discussed this exchange toward the end of my first post on this case). The judge raised this hypothetical again in October, and this time Capitol’s lawyer backed away from it:
Judge Sullivan: . . . last time we were here . . . I asked you if I could sell my iPod to somebody and you said I could.
Capitol’s Lawyer: Yes, and you know, it’s interesting you say that because I would actually have to say that I think that answer probably was not a correct one.
Clearly, Capitol’s lawyer did answer this question incorrectly the first time, at least from the perspective of his client. One can imagine someone who repeatedly copies his 10,000 song iTunes music collection to an iPod or a very inexpensive portable player, and sells the player and the entire collection for 10 cents on the dollar, hypothetically depriving the record industry of $10,000 in revenues with each sale. However, this begs the question of whether the original purchaser could use the first sale doctrine to justify the sale of the original device to which he downloaded these files (perhaps an inexpensive computer). It seems likely that he could under the first sale doctrine, but no court has ruled directly on this issue.
Fair Use Confusion. A surprising amount of the argument in this case seems to have confused principles of fair use with issues associated with first sale. For example, at one point Capitol’s lawyer was asked whether cloud storage alone (without an associated sale) violated the Copyright Act. Capitol’s lawyer, more cautious this time, answered that Capitol didn’t challenge cloud storage in this case. The correct answer seems to be that cloud storage alone (without resale, and without allowing third-party access) is protected by fair use, and Capitol seemed to acknowledge this (describing it as “pure storage”).
Redigi’s lawyer, for his part, improperly interjected issues of fair use when he argued that since a downloaded music file can be moved around on the users hard drive (from one directory to another, for example), it must be permissible for the user to upload the file to the Redigi cloud drive: “why is it okay to move files on my own hard drive and that doesn’t violate the [reproduction right], but to move my file to a cloud does violate reproduction? It doesn’t seem to make sense to me.” However, this argument ignores a basic principle of fair use, specifically that the use be non-commercial. The Redigi system moves the file not for the convenience of the person that downloaded the file from iTunes, but for the commercial purpose of selling it.
A Tactical Error By Redigi Early in the Case. As an aside, it seems unfortunate that Redigi dug itself into a legal hole by admitting, earlier in the case, that the customer’s local file is deleted. If “File A” is deleted, then “File B” must, by logic, be something other than File A (a copy or reproduction), and not the result of a “migration” from the Redigi customer’s hard drive to the Redigi cloud. Capitol argued that this judicial admission was fatal to Redigi’s attempts to describe its process differently at this point in the case, and the judge seemed receptive to Capitol’s argument that this was a binding admission, stating that Redigi “admitted certain acts that are going to be fatal.”
As I noted at the beginning of this post, it’s been six months since summary judgment was argued, and that’s a long time. It’s dangerous to try to interpret a judge’s comments during oral argument, and judges are known to disfavor, during oral argument, the side they ultimately rule for. However, I think that the judge in this case is likely to feel bound by a strict reading of the statute, and to rule in favor of Capitol. We shall know soon.
October 5, 2012 Transcript of Summary Judgment Hearing
by Lee Gesmer | Dec 20, 2012 | Trials
Juror #8: It’s always difficult to keep personal prejudice out of a thing like this. And wherever you run into it, prejudice always obscures the truth. 12 Angry Men
In this business you got fifty ways you’re gonna screw up. If you think of twenty-five of them, then you’re a genius… and you ain’t no genius. Body Heat (“G”-rated version of quote from the movie)
____________________
If you’ve noticed a lawyer with a paranoid, haunted look, and you’re wondering why, the answer may be that the lawyer is thinking, “what I have forgotten? Having a waived something I shouldn’t have?” The last time I wrote about the lawyer’s nightmare of waiver the waiver may have ended up costing Microsoft $300 million. In that case, i4i’s patent suit against Microsoft, Microsoft’s appeal of damages was made more difficult by its failure to move for judgment as a matter of law on the issue. As I said in my post on that case, “trials are a virtual waiver landmine.”
Now, a waiver in Apple v. Samsung may outdo the cost of the waiver in the Microsoft case by $700 million.
In Apple v. Samsung a California federal jury awarded Apple over $1 billion for infringing patent and trade dress rights associated with the Apple iPhone.
Following trial the jury foreperson, Velvin Hogan (pictured above), became a media star, granting generous interviews to the press. Some of what he had to say motivated Samsung to investigate his background, and it didn’t like what it learned. During jury selection the judge asked the prospective jurors “have you or a family member or someone very close to you ever been involved in a lawsuit, either as a plaintiff, a defendant, or as a witness?” Hogan described a 2008 lawsuit in which he had been a defendant, but failed to disclose the fact that he had been sued by Seagate in 1993, and had filed for bankruptcy at least in part as a consequence of that lawsuit.
Since 2011 Samsung has been Seagate’s largest shareholder, owning almost 10% of Seagate’s stock. It follows, Samsung has argued, that Hogan may have been biased against Samsung based on this financial relationship. At the very least, he should have disclosed this lawsuit in response to the judge’s question. Samsung filed a motion for a new trial or an evidentiary hearing to examine Hogan’s conduct during jury deliberations.
No way, the judge ruled this week. Hogan disclosed the fact of his bankruptcy during voir dire (questioning during jury selection). Samsung was able to dig up his bankruptcy case file after trial, and they could have done it during trial. If they had, the bankruptcy filing would have led them to the Seagate case and they could then have moved to disqualify Hogan during trial. Samsung was obligated to act with “reasonable diligence based on information about juror misconduct” in its possession, and it failed to do so. Consequently, Samsung waived its right to seek a new trial, or even an evidentiary hearing into juror misconduct.
What is one to make of all of this?
If given a choice between retrying this case and torture with a medieval thumbscrew Judge Koh might be hard-pressed to chose. This trial consumed enormous resources—of the parties and the court system—and the idea of being forced to retry it based on one errant juror’s failure to disclose a fact that could have been totally irrelevant to the jury’s decision would be anathema to her.
As a legal matter, whether to grant a new trial or an evidentiary hearing is at the discretion of the court, and Judge Koh is unlikely to be reversed on appeal. Not every judge would necessarily rule as she did, but Samsung is almost certainly stuck with her ruling. The fact that the Seagate case against Hogan is almost 20 years old, and that Samsung’s financial relationship with Seagate is so tenuous, makes it extremely unlikely that the Federal Circuit will reverse Judge Koh on this issue.
If Hogan had brought evidence into the juryroom—or if there was reason to believe he was doing independent research into the patents at issue and sharing that with the jury—it might be a whole other story. For example, the Federal Circuit reversed a federal judge in the district where I practice (Massachusetts) for failing to question the jury after learning that a juror had brought a physical object into the jury room during in order to help clarify the evidence. (Atlantic Research Marketing Systems, Inc. v. Troy). However, that case involved conduct brought to the attention of the court during deliberations, not afterwards, as was the case here. And, Hogan didn’t bring any objects (other smart phones?) or information to the deliberations, so this case doesn’t go as far as the Federal Circuit’s ruling in Atlantic Research.
Samsung does seem to have dropped the ball by not investigating Hogan’s bankruptcy filing during trial. Each side of this case was almost certainly heavily staffed, and one attorney or paralegal should have been assigned to investigate each juror. To the extent this wasn’t standard procedure before this case, it is a lesson to trial lawyers that an in-depth background check on each juror is mandatory. Failing to do so is arguably malpractice, unless the case is too small (or client funds too constrained) for a check to be affordable.
In 12 Angry Men one juror, played by Henry Fonda, persuaded 11 jurors to change their view of the evidence. Did Velvin Hogan connect the relationship between Samsung and Seagate and decide to use his place on this jury to retaliate against Seagate for the suit it brought against him 19 years ago? Likely, we will never know. Big money cases and s0-called “trials of the century” like Apple v. Samsung are common, and are quickly forgotten. The lesson this case is most likely to be remembered for years from now is this: research your jurors at the outset of trial as soon as possible. If a juror has a hidden bias or there is some other basis for disqualification and you could have learned it during trial, you risk a post-trial challenge to the verdict based on waiver.
Apple v. Samsung Order re Juror Misconduct (courtesy Groklaw.com)
by Lee Gesmer | Dec 13, 2012 | Contracts, Employment
A lot of people blogged for The Huffington Post for free between 2005 and 2011. But after Huffpost was sold to AOL for $315 million in 2011, they had second thoughts about their generosity. They filed a class action seeking compensation for their work based on claims of unjust enrichment and deceptive business practices, seeking one-third of that money for the bloggers. The trial court, and now the Second Circuit, rejected their claims. As the Second Circuit stated early this week in Tasini v. AOL (2d Cir. Dec. 12, 2012):
Plaintiffs’ basic contention is that they were duped into providing free content for The Huffington Post based upon the representation that their work would be used to provide a public service and would not be supplied or sold to “Big Media.” Had they known that The Huffington Post would use their efforts not solely in support of liberal causes, but, in fact, to make itself desirable as a merger target for a large media corporation, plaintiffs claim they would never have supplied material for The Huffington Post.
The problem with plaintiffs’ argument is that it has no basis in their Amended Complaint. Nowhere in the Amended Complaint do plaintiffs allege that The Huffington Post represented that their work was purely for public service or that The Huffington Post would not subsequently be sold to another company. To the contrary, plaintiffs were perfectly aware that The Huffington Post was a for-profit enterprise, which derived revenues from their ubmissions through advertising. Perhaps most importantly, at all times prior to the merger when they submitted their work to The Huffington Post, plaintiffs understood that they would receive compensation only in the form of exposure and promotion. Indeed, these arrangements have never changed.
The case puts me in mind of the observations of a great American writer:
Tom said to himself that it was not such a hollow world, after all. He had discovered a great law of human action, without knowing it – namely, that in order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to attain. If he had been a great and wise philosopher, like the writer of this book, he would now have comprehended that Work consists of whatever a body is obliged to do, and that Play consists of whatever a body is not obliged to do. And this would help him to understand why constructing artificial flowers or performing on a tread-mill is work, while rolling ten-pins or climbing Mont Blanc is only amusement. There are wealthy gentlemen in England who drive four-horse passenger-coaches twenty or thirty miles on a daily line, in the summer, because the privilege costs them considerable money; but if they were offered wages for the service, that would turn it into work and then they would resign.
In an earlier time, I think Ms. Huffington would rarely have been required to lift a paintbrush.
by Lee Gesmer | Dec 10, 2012 | Contracts, Corporate Law
An interesting “David v. Goliath” jury trial is scheduled to begin in Massachusetts U.S. District Court Judge Patti Saris’s Boston courtroom this week. The case has received a fair amount of press coverage, but not nearly enough in my opinion. (Steven Syre Boston Globe column today, July 2012 NYT article).
The events in Baker v. Goldman Sachs date back to the heady days of the dotcom era. In short, James and Janet Baker (pictured here) spent much of their careers pioneering speech recognition technology which they commercialized under their company Dragon Systems, based in Newton, Massachusetts. The Bakers were legendary in the Massachusetts tech community in the 1990s – home-based technologists who came up with a promising-today, sky-is-the-limit-tomorrow technology.
In 2000 they sold Dragon for almost $600 million to Lernout & Hauspie, a Dutch company. Unfortunately, they were paid fully in Lernout stock, and almost immediately after the sale Lernout was discovered to have been cooking its books. The stock went to zero, and so did the consideration the Bakers received for their company. For the Bakers, this was a business catastrophe of mythical proportions. One day they owned an immensely valuable company that that owned technology they had spent decades developing. The next day they had sold the company in exchange for almost $600 million of Lernout stock. Within a few months, their company was gone and their stock worth nothing.
While several Lernout executives ended up with stiff prison terms in Belgium this was small consolation to the Bakers. Their technology is owned by Nuance, which sells it under the product name “Dragon NaturallySpeaking.” The Bakers’ technology has had steady success under Nuance. Reportedly, it is a component in the Apple iPhone’s Siri product.
Goldman Sachs was the “investment banker” for Dragon’s sale to Lerner, and the question is, why didn’t they discovery that Lernout was a shell game? 
The gist of the Baker’s case is that Goldman (which received $5 million in fees) breached various legal obligations to Dragon by failing to discover that Lerner was “all hat, no cattle.” According to Steven Syre’s column, after Dragon’s salel to Lernout The Wall Street Journal simply called purported L&H customers and discovered they weren’t doing business with Lernout, something the Bakers claim that Goldman should have uncovered as part of its due diligence before the sale. In fact, it appears that Lernout’s Asian business—a significant part of its overall revenues—was a sham. Lernout had fabricated almost $400 million in income.
To make matters worse, the Times article asserts that Goldman assigned a young (20s and 30s) and inexperienced team to handle the deal. The Bakers’ court filings claim that Dragon and the Bakers fell victim to a massive fraud, that there were many “red flags” that Goldman failed to pursue in due diligence, and that had Goldman done the job it promised to do, the sale never would have occurred. In fact, the Bakers claim that Goldman had discovered problems with Lernout on behalf of another client, and failed to disclose these problems, or raise its level of investigation based upon this knowledge.
The full story is complex, and involves many different actors at Dragon, Goldman and various accounting and law firms. The question of who should have discovered Lernout’s fraud involves more finger-pointing than the presto movement in a piano concerto for four-hands. Of course, the Bakers (local scientists with significant bona fides) are far more sympathetic than the Goldman witnesses, many of whom left Goldman shortly after the sale to Lernout closed in June 2000. It remains to be seen whether they can hold their own as trial witnesses. Goldman Sachs’ credibility? Well, the Bakers must hope they draw a jury that reads the business pages.
While in the eyes of a non-lawyer the facts (as alleged) appear to favor the Bakers, Goldman has a number of technical legal defenses, and while it’s had little success with them before Judge Saris, presumably it hopes to prevail on them on appeal. For example, it argues that it was not responsible for the due diligence that would have uncovered the irregularities in Lerner’s sales numbers — Dragon’s accountants were responsible for this task. It claims that Lerner’s fraud was essentially undiscoverable by Goldman. It’s trump card is that the Bakers are caught in a legal catch-22: since Goldman Sachs’ engagement letter was with Dragon (the corporation), the Bakers lack legal standing as individual shareholders. And, since Dragon was merged into Lernout (and therefore for reasons arising out of bankruptcy law had no right to sue), Goldman is immune from liability to Dragon. Since neither the Bakers nor Dragon has standing, Goldman has no liability. Thus far the Bakers have been able to side-step this argument (arguing, for example, that they are third-party beneficiaries to the contract), but this issue remains unresolved, and could prove to be a get-out-of-jail-free card for Goldman.
The parties’ joint pretrial memo, outlining the many legal and factual issues, is linked below.
It is surprising that this case has not yet settled (the vast majority of civil cases—estimated as high as 95%—do). However, cases often settle “on the courthouse steps” or during trial. In fact, the trial judge in this case has been known to require party principals to hold a settlement conference following opening statements at trial. The idea is that once the parties get a look at a real jury, and hear the opposing attorney’s opening statement, they may adjust their expectations and reach a settlement.
If this case doesn’t settle it is almost certain to raise interesting and important investment banking legal issues both during trial, and on appeal to the First Circuit. Presumably, Goldman Sachs has revised its engagement letters.
Update: The jury found against the Bakers at trial.
Baker v. Goldman Joint Pretrial Memo
See also Baker v. Goldman Sachs, 656 F. Supp. 2d 226 (D. Mass. 2009) and an as yet unreported 2012 decision Baker v. Goldman Sachs (D. Mass. October 31, 2012).
