Alison Frankel

There’s a good reason the exchange of information in civil litigation is called discovery. If you want an example of the kind of powerful facts shareholders can obtain once they’re finally allowed to take depositions from securities class-action defendants – and remember, they only get there after surviving defense motions to dismiss – look no further than the motion for summary judgment that plaintiffs’ lawyers filed Sunday against Bank of America in the securities class action over the Merrill Lynch merger. There’s nothing like a former CEO’s admission that insiders withheld dire predictions from shareholders to boost the class’s case.

Shareholder lawyers always knew they’d have more information than usual in the securities litigation against BofA, which allegedly failed to warn investors about Merrill Lynch’s precarious finances before shareholders approved the Merrill merger in the fall of 2008. When plaintiffs’ lawyers first filed lead counsel motions in the spring of 2009, the Securities and Exchange Commission, the New York Attorney General, the North Carolina AG and even Congress were all already poking at the Merrill merger. They were focused on whether BofA adequately disclosed the billions of dollars it had agreed to set aside for bonuses to Merrill executives, in addition to the bank’s communications with shareholders about Merrill’s mounting losses in the last quarter of 2008.

Just weeks after Denny Chin (then a federal district judge in Manhattan, now on the 2nd Circuit Court of Appeals) appointed lead counsel – Bernstein Litowitz Berger & Grossmann; Kaplan Fox & Kilsheimer; and Kessler Topaz Meltzer & Check – the SEC announced a settlement with BofA for disclosure violations. And when U.S. Senior District Judge Jed Rakoff rejected the SEC’s initial settlement and demanded more information about BofA’s disclosure decisions, plaintiffs’ lawyers in the class action pounced. In October 2009, they asked Chin to order the defendants to give them whatever BofA, Merrill and bank officials were turning over to regulators and congressional investigators. In November 2009, Chin granted the motion. Whatever documents the defendants were producing to anyone else, he said, they also had to turn over to shareholders.

That’s a lot more than plaintiffs usually get in the early stages of securities class actions. As you know, when Congress revised the law governing private securities litigation in 1995, it imposed an automatic discovery stay: Shareholders aren’t permitted to conduct any depositions or demand any documents from defendants until they’ve survived a defense motion to dismiss their case. Given that Congress simultaneously set the bar for alleging fraud very high, that discovery stay means lots of securities class actions have died before plaintiffs’ lawyers even got a chance to uncover what defendants really knew.

In the BofA case, shareholders’ lawyers took full advantage of Chin’s directive. Their first and second amended complaints, each weighing in at more than 150 pages, cited, for instance, memos and notes from BofA’s counsel at Wachtell, Lipton, Rosen & Katz, which had advised the bank on the Merrill merger. That material had been produced to Rakoff in the SEC case (or to Congress), so plaintiffs’ lawyers in the securities class action were able to get their hands on Wachtell’s advice on what to tell shareholders about those infamous Merrill bonuses, as well as Merrill’s escalating losses. It was juicy stuff, and in August 2010 U.S. District Judge Kevin Castel, who took over the case from Chin, found that most of the shareholders’ allegations included enough factual specificity to survive the defendants’ motions to dismiss.

Securities class action lawyers have short attention spans. It was only last week, after all, that JPMorgan Chase and its $2 billion (and counting) loss on its credit default swap hedge was the topic of the moment. Plaintiffs’ lawyers and their institutional clients were figuring out whether they bought the bank’s shares in the one-month period between CEO Jamie Dimon telling analysts that the hedge was a “tempest in a teapot” and Dimon disclosing the initial $2 billion loss. But after an initial flurry of filings and press releases about the JPMorgan case, this week has brought no additional complaints against the bank – even as the impact of JPMorgan’s hedge ripples through credit markets and regulatory debate.

Instead, the securities class action bar has scurried this week to grab a piece of what will undoubtedly become known as In re: Facebook IPO Securities Litigation. On Tuesday Alistair Barr of Reuters reported that Morgan Stanley, the lead underwriter for Facebook’s initial public offering, told favored clients that the bank’s Internet analyst was cutting his revenue forecast for the company. Almost as soon as plaintiffs’ firms could cut and paste Barr’s story into a complaint, the shareholder class actions began piling up. By Thursday evening, at least eight suits against Facebook and its underwriters had been filed in federal court in Manhattan and San Francisco. Some big-name plaintiff firms were among the early filers, including Hagens Berman Sobol Shapiro, Girard Gibbs, Wolf Haldenstein Adler Freeman & Herz and (inevitably) Robbins Geller Rudman & Dowd.

Neither the JPMorgan nor the Facebook IPO case is a slam-dunk, by any means. Despite increasing concern about the risk of JPMorgan’s $100 billion CDS bet – and its alleged failure to disclose that risk – shareholders won’t have an easy time proving that they bought JPMorgan shares because they relied on Dimon’s “tempest in a teapot” remark. In the Facebook IPO case, meanwhile, underwriters will argue that Facebook’s uncertain revenue prospects were adequately disclosed in the IPO offering materials, and whatever additional information was conveyed to favored clients was permissible oral communication under rules the Securities and Exchange Commission adopted in 2005.

AIG’s $6 billion in mortgage-backed securities claims against Countrywide survived a near-death experience late Wednesday, when U.S. District Judge Mariana Pfaelzer of Los Angeles issued her ruling on Countrywide’s statute of limitations defense. In a 25-page opinion, Pfaelzer tossed AIG’s federal securities claims, as well as some fraud and negligent misrepresentation claims by AIG subsidiaries. But AIG said in an email statement that the ruling leaves alive “more than 98 percent of the recovery it seeks.” For a plaintiff that feared the worst – as AIG most certainly did, thanks to a silver bullet Pfaelzer handed to Countrywide in February – the judge’s ruling is a stunning reprieve.

Here’s why. Pfaelzer has not been a particularly good friend to investors in Countrywide mortgage-backed securities, particularly when it comes to the statute of limitations on their claims. In a ruling last August, Pfaelzer said that MBS investors were on notice of potential federal securities claims against Countrywide as of Feb. 14, 2008. Given the three-year time limit on those federal claims – and Pfaelzer’s role overseeing all Countrywide MBS litigation in federal court – her ruling meant that any Countrywide investor who hadn’t filed a complaint by Feb. 14, 2011, or who didn’t have a tolling agreement was too late.

Countrywide MBS plaintiffs had an alternative route to recovery, though, through fraud and negligent misrepresentation claims under state laws, some of which have less restrictive time limits. New York, for instance, has particularly generous laws, giving plaintiffs up to six years to file fraud cases. So the New York-based insurer AIG didn’t completely despair when its Countrywide MBS claims were severed from its $10 billion suit against Bank of America and transferred to Pfaelzer in Los Angeles. (AIG doesn’t think any part of its MBS case belongs in federal court, but that’s another story.) The insurer had to expect that in Pfaelzer’s court its federal securities case wouldn’t survive Countrywide’s statute of limitations defense. But it also had reason to be confident that its New York state fraud claims would be fine.

Sometime in the next few days of testimony in the prosecution of former Goldman Sachs director Rajat Gupta, U.S. Senior District Judge Jed Rakoff will probably take a moment to give jurors what he has described in previous trials as a “heads-up.” Rakoff will offer the jury a preliminary instruction on what insider trading is. If you think that’s an easy task, you should look at the proposed instructions the government and defense counsel from Kramer Levin Naftalis & Frankel submitted to Rakoff this week. The two sides agree that Rakoff should use phrases like “material non-public information,” but beyond that they’re each trying to use the preliminary instruction to sway jurors.

The nine-page proposal from prosecutors Reed Brodsky and Richard Tarlowe (which includes transcripts of Rakoff’s instructions in two previous insider-trading cases) asks the judge to tell the jury that corporate directors have a “legal duty not to disclose to anyone outside the company financial or other confidential information about the company that the company has not yet made public or authorized to be made public.”

That’s straightforward enough, but prosecutors went on to suggest how Rakoff should describe the link between insider trading and securities fraud. “In connection with this charge, the government must show that Mr. Gupta anticipated some kind of benefit, directly or indirectly, however modest, from providing (Raj) Rajaratnam with the inside information,” prosecutors proposed Rakoff tell jurors. “Examples of a benefit include Mr. Gupta giving the information to Rajaratnam as a gift, giving the information to maintain a good relationship with a frequent business partner, or giving the information to receive money in exchange.”

In March, when the U.S. Supreme Court ruled unanimously that Prometheus Laboratories was not entitled to a patent on a diagnostic process because it’s a law of nature, On the Case (and many others) predicted the justices would subsequently call for reconsideration of Myriad Genetics’ patents on breast cancer genes, since genes are, of course, also natural phenomena. Within a week we were all proven right. But the second case the Supreme Court has remanded to the Federal Circuit Court of Appeals in light of the Mayo ruling – which involves a patent on viewing copyrighted content on the Internet – suggests the justices want greater scrutiny of a wide array of patents, not just biotech IP.

Mayo addressed Section 101 of the Patent Act, which holds that “laws of nature, natural phenomena, and abstract ideas” are not patentable. That seems simple, but in interpretation it’s not. If patent seekers can show their invention involves a unique application of an abstract idea or law of nature, they’re entitled to a patent, so analysis of Section 101 patentability has focused on what constitutes an application. In Mayo, the justices unanimously agreed that a diagnostic test based on how patients respond to autoimmune drugs is not a patentable process under Section 101. But the cases the Supreme Court cited to reach that conclusion involved patents far removed from the human body: a process for molding rubber and a process for monitoring the catalytic conversion of hydrocarbons. Both processes relied on math and science formulas, which aren’t patentable. The rubber molding system, however, transformed a non-patentable law of nature into a patentable process, while the alarm system for catalytic converters did not.

That reasoning leaves plenty of room for cases that have nothing to do with diagnostic procedures to be re-evaluated under Section 101. “The basic analysis the Supreme Court lays out isn’t limited by subject matter,” said Gregory Garre of Latham & Watkins, who represents an online game company called WildTangent in the case the Supreme Court remanded to the Federal Circuit on Monday. WildTangent was one of three defendants sued by a company called Ultramercial, which holds a patent on a process for distributing copyrighted material on the Internet. Hulu and YouTube settled out of the patent infringement litigation in federal court in Los Angeles. But WildTangent continued, through both U.S. District Judge Gary Klausner‘s finding that Ultramercial’s patent was impermissibly abstract and the Federal Circuit’s restoration of the case last September. A three-judge appellate panel headed by Chief Judge Randall Rader held that Ultramercial’s patent – which calls for online viewers to watch an ad before being permitted access to copyrighted content – was not excluded by Section 101 because it described “the application of an abstract idea to a ‘new and useful end,’” which the Federal Circuit said was “the type of invention that the Supreme Court has described as deserving of patent protection.”

It’s been relatively easy for district courts to figure out how to apply the U.S. Supreme Court’s 2010 ruling in Morrison v. National Australia Bank in securities cases – unless the defendant is a U.S.-listed company, shareholders are pretty much out of luck in U.S. courts. Post-Morrison racketeering litigation has no such conveniently bright lines. The Racketeer Influenced and Corrupt Organizations Act doesn’t explicitly mention that it applies to overseas conduct, so under Morrison judges must presume it does not. But they’ve struggled to define exactly what constitutes overseas racketeering as opposed to domestic racketeering with an international component.

After all, as U.S. District Judge Lewis Kaplan of federal court in Manhattan noted in a ruling last week, RICO was originally intended to combat international organized crime rings. Kaplan is presiding over Chevron’s RICO case against the U.S. lawyers and experts who helped Ecuadoreans obtain an $18 billion judgment against the oil company. His ruling cites the Southern District’s famous Pizza Connection prosecution, which involved Mafia drug trafficking between Sicily and New York, as a RICO paradigm. “To say that Congress did not intend RICO to apply unless the enterprise in question was purely domestic would be unsupportable,” Kaplan wrote.

But on the other hand, he said, courts have concluded since Morrison that RICO cases involving mainly foreign plaintiffs, foreign defendants and foreign conduct are not viable in U.S. courts. The 2nd Circuit Court of Appeals ruled first, in a case called Norex Petroleum v. Access Industries. U.S. Senior District Judge Jed Rakoff subsequently reached the same result in Cedeno v. Intech (affirmed by the 2nd Circuit in a summary order). Kaplan also cited several other rulings in which courts have focused on “the domestic or foreign character of the alleged RICO enterprise” – mostly, whether defendants are “foreign” – to decide whether cases are barred by Morrison.

There’s a peculiarity in U.S. copyright law that must drive painters and sculptors nuts. When writers, composers, photographers, and filmmakers obtain copyrights, they’re entitled to royalties every time their work is sold. Not painters or sculptors. Under the U.S. Copyright Act (in contrast to many copyright regimes in Europe), once a piece of art is sold, all rights to the physical work belong to the buyer. No matter how much the art appreciates in value, artists aren’t due a penny when the work is resold. All of the profits belong to sellers, not to creators.

There is only one exception to that rule in the United States: the 1977 California Resale Royalties Act, a so-called droit de suite law that grants artists a continuing interest in their work when it changes hands. The law holds that anytime a work is resold in California, or is resold by a California owner anywhere else in the world, the seller’s agent must pay 5 percent of any sale price over $1,000 to the original artist. The artist must only be a U.S. citizen or California resident to qualify for the California resale royalty.

California is the only state in the country that has such a law. New York has considered droit de suite legislation on more than one occasion but has never enacted resale royalties for artists. Similarly, Congress has declined to include resale royalties for artists every time it has reconsidered the copyright statute.

The key detail in the two securities-fraud complaints filed so far against JPMorgan Chase isn’t that CEO Jamie Dimon told analysts that news reports about the bank’s risky credit default swap position were a “tempest in a teapot.” Even though that’s the statement both complaints pinpoint as best evidence so far of the bank’s alleged deception, to understand the shape this litigation is likely to take, you have to check out the class period both complaints (here and here) assert. It’s unusually short for a securities class action, beginning on Apr. 13 – when Dimon made the fateful “tempest” comment – and ending on May 10, the day the bank disclosed losses of $2 billion in CDS trades, with more to come.

Under the rules the U.S. Supreme Court established in its 1975 opinion in Blue Chip Stamps v. Manor Drug Stores, only investors who bought or sold JPMorgan shares within that window can be part of the class suing for fraud. Shareholders who bought the bank’s stock before Dimon’s comment on Apr. 13 are not in the suit as it’s currently framed, even if they subsequently lost millions after the May 10 disclosure. So before JPMorgan shareholders can file a suit and make a bid to be named lead plaintiff in the class action, they have to be sure they bought in that one-month window. (The law permits claims by sellers as well, but as a practical matter, it’s much harder for them to show that they suffered losses tied to the alleged fraud.)

That’s one reason the first complaints against JPMorgan weren’t by the large institutional investors that typically end up as lead plaintiffs. Pension and healthcare funds have to figure out when they purchased the bank’s shares and what their losses in the class period were. They buy and sell all the time, but one veteran shareholder class-action lawyer told me the short window will limit the universe of institutional investors with large losses. He also said that many institutional investors have made significant gains in JPMorgan investments in the last couple of years and may be reluctant to sue the bank.

On Monday, a three-judge panel of the Court of Appeals for the D.C. Circuit refused to stay a lower-court ruling that requires corporations, unions and non-profits engaged in a certain form of campaign-related advertising to disclose their donors. In a 2-to-1 decision, the appeals court held that there’s no irreparable harm in waiting for a full appellate record to decide whether U.S. District Judge Amy Berman Jackson was correct in ruling that the Federal Election Commission may not curtail disclosure requirements Congress specified. In fact, D.C. Circuit Judges Judith Rogers and Thomas Griffith said the public’s interest is in disclosure, rather than secrecy.

On its most basic level, the ruling means that groups like the U.S. Chamber of Commerce, Crossroads GPS, Americans for Prosperity and other non-profits that run a particular kind of election-related advocacy ad must reveal who is giving them money. (The case doesn’t affect political action committees, which have their own set of rules.) “This is a very important victory in the battle to end secret contributions being funneled into federal elections,” said Democracy 21 President Fred Wertheimer, who was co-counsel for the plaintiff in the underlying case, Representative Chris Van Hollen, a Maryland Democrat. “This case represents the first major breakthrough in the effort to restore for the public the disclosure of contributors who are secretly providing massive amounts to influence federal elections,” Wertheimer said in a statement. (Here’s an excellent overview of the case from the L.A. Times.)

But here’s the thing: The D.C. Circuit’s ruling may have the entirely unintended effect of pushing more money from politically active non-profits into television and radio ads that directly call on voters to support (or vote against) particular candidates. According to both election law professor (and blogger) Rick Hasen of the University of California at Irvine and Hispanic Leadership Fund counsel Jason Torchinsky of Holtzman Vogel Josefiak, there’s now a peculiar distinction between the ads at issue in the Van Hollen case – so-called electioneering communications that talk about particular candidates but stop short of recommending a vote for or against them – and “indirect expenditures,” in which groups run ads specifically urging you to vote for or against a candidate. The Van Hollen suit didn’t address indirect expenditures, so, according to Hasen, if non-profit groups want to keep their donor lists secret, they may switch their spending to ads that contain express advocacy.

Remember the children’s game Telephone? One kid whispers something in another kid’s ear, the second kid turns around and whispers what she heard to the next child, and so on down the line. At the end, the last one to receive the whispered message says aloud what she heard, the kid at the start of the chain announces the original phrase, and everyone laughs because the message was inevitably mangled as it was passed along. That’s why courts have a rule barring hearsay. Witnesses can testify about conversations they participated in, but they can’t generally tell jurors what they heard secondhand about discussions they weren’t directly involved in, because hearsay isn’t considered sufficiently reliable.

The same principle applies when prosecutors obtain wiretap evidence of phone conversations. Obviously, wiretaps provide a record of direct conversations. But when one person on a recorded phone call tells another about a conversation he had with someone else, is that evidence or hearsay?

For Rajat Gupta, the former McKinsey chief and Goldman Sachs director accused of passing tips to convicted inside-trader Raj Rajaratnam, the hearsay rule could well be the difference between acquittal and a long prison sentence. As I’ve previously reported, prosecutors from the U.S. Attorney’s office in Manhattan are relying on tapes of three conversations between Rajaratnam and his colleagues at the Galleon Group hedge fund to link Rajaratnam’s illegal trades with tips he allegedly received from Gupta. The government conceded in a brief filed earlier this month that those tapes are the best evidence it has – in a case in which there’s no proof Gupta profited from his alleged insider trading – that Gupta actually passed confidential information to the hedge fund billionaire. Without Rajaratnam’s fleeting recorded references to tips about Goldman Sachs, the government’s case against Gupta is all inference, requiring jurors to draw lines between phone records and Rajaratnam trades.