March 12, 2013
Cy Pres Settlements
Testimony by Theodore H. Frank, Adjunct Fellow, Manhattan Institute Center for Legal Policy
Thank you, Mr. Chairman, and members of this Subcommittee, for your kind invitation to testify today about abusive cy pres settlements.
I serve as an Adjunct Fellow at the Manhattan Institute Center for Legal Policy and as President for the Center for Class Action Fairness, but I am not testifying here on their behalf and the views that I am sharing today are my own. My perspective comes from my legal practice running a non-profit public-interest law firm focusing on litigation in class actions on behalf of class members in cases where their courtappointed attorneys have failed to fairly represent their clients' interests. I was elected to the American Law Institute in 2008, and have published and spoken across the country on topics related to class actions.
Background: Class Action Settlements
Class actions were designed to provide injured parties with a more efficient means of accessing justice by aggregating claims for violations of individual rights. Although most successful class action litigation under Rule 23 is resolved in the form of a class settlement, such class settlements frequently provide little or no meaningful compensation to consumers. Indeed, a significant number of consumer class settlements do not provide consumers with any monetary relief whatsoever. This systematic undercompensation is the product of two structural problems in class actions. First, because class attorneys' fees generally come from the same source as the class members' compensation—the defendant—class attorneys settling class claims have a fundamental conflict of interest. Second, to the extent class attorneys exploit that conflict of interest, judges lack the necessary information or incentive to rectify self-dealing in most cases.
The principal reason for the failure of many class settlements to provide meaningful compensation is obvious: class attorneys have incentives to engage in selfdealing during the negotiation of class settlements. Because class members, especially those in a small-claims consumer class action, have small stakes in the case and therefore usually do not closely monitor their attorneys' conduct, class attorneys often are able to obtain high fees without obtaining meaningful compensation for class members.
Indeed, all three branches of government have recognized this economic reality. In enacting the Class Action Fairness Act of 2005, Congress found that "[c]lass members often receive little or no benefit from class actions, and are sometimes harmed, such as where . . . counsel are awarded large fees, while leaving class members with coupons or other awards of little or no value."
Similarly the FTC has recognized that "[e]xcessive class action attorney fee awards represent a substantial source of consumer harm."
Courts also have recognized the harm to consumer welfare caused by the class attorney's conflict of interest: "the negotiator on the plaintiffs' side, that is, the lawyer for the class, is potentially an unreliable agent of his principals" given the possibility that he may trade a small class award for the relatively certainty of a high fee award.
One of the leading ways for self-dealing class counsel to benefit themselves at the expense of the class is through what are called cy pres settlements.
The Problem of Cy Pres Relief.
The idea of cy pres (pronounced "see pray" or "sigh pray," from the French cy pres comme possible—"as near as possible") originated in the trust context, where courts would reinterpret the terms of a charitable trust when literal application of those terms resulted in the dissolution of the trust because of impossibility or illegality. In a classic 19th-century example, a court repurposed a trust that had been created to abolish slavery in the United States to instead provide charity to poor African-Americans. The California Supreme Court endorsed the use of cy pres or "fluid recovery" mechanism in class action settlements in 1986, to distribute proceeds to a "next best" class of consumers, and many other courts have gradually adopted the procedure. Cy pres settlements arise in one of three circumstances:
While original cy pres class action settlements provided that left-over money be distributed to a different set of consumers who may or may not coincide with the class, in recent years, left-over, or specifically earmarked, funds are typically given directly to a third-party charity.
The problem with cy pres is that it exacerbates existing conflicts of interest in the class action settlement context. When a class attorney settles a class action, he or she is not only negotiating class recovery, but is also negotiating his or her own fee. A defendant may be willing to spend a certain amount of money to settle a class action to avoid the expense and risk of litigation, but that money must be divided between the class and their attorneys. Every dollar going to the attorneys does not go to the class, and vice versa. At the same time, a class action settlement must be approved by the court. Attorneys who do not adhere to their fiduciary responsibility to the class have an incentive to exaggerate class recovery to a court to maximize their fees.
The possibility of cy pres awards gives an additional incentive to class action attorneys to breach their fiduciary duties to the class. Every dollar that a class member does not recover can now be spent by the attorney himself to the charity of the attorney's choice. Attorneys essentially get free advertising: witness the existence of websites like "ohiolawyersgiveback.com" where lawyers are using their clients' money to advertise themselves. At best this is unseemly; at worst, it is an unethical breach of the attorneys' fiduciary duty to put the interests of their clients first. If courts permit unfettered cy pres, then attorneys have an incentive to make it difficult for their own putative clients to recover, because then they can maximize the amount of money that goes to charity in the attorneys' names. This hurts class members. For example, in a settlement I successfully challenged in the Third Circuit,15 the parties created substantial burdens, including a five-page claim form with confusing instructions, that successfully deterred class members from making claims on the settlement fund. If my client had not successfully appealed the settlement approval, class members would have received less than $3 million, while the class counsel would have received about $15 million to distribute to its favorite charity, plus another $14 million for itself.
Judge Richard Posner has argued that cy pres is a misnomer in the class action context:
[Cy pres] doctrine is based on the idea that the settlor would have preferred a modest alteration in the terms of the trust to having the corpus revert to his residuary legatees. So there is an indirect benefit to the settlor. In the class action context the reason for appealing to cy pres is to prevent the defendant from walking away from the litigation scot-free because of the infeasibility of distributing the proceeds of the settlement (or the judgment, in the rare case in which a class action goes to judgment) to the class members. There is no indirect benefit to the class from the defendant's giving the money to someone else. In such a case the "cy pres" remedy (badly misnamed, but the alternative term—"fluid recovery"—is no less misleading) is purely punitive.
But sometimes cy pres is less a matter of being punitive and more a matter of disguising the true cost of a settlement to the defendant to maximize the share of the actual recovery received by the plaintiffs' attorneys. If the beneficiary is related to the defendant, or the defendant otherwise benefits from the payout, then the contingent attorneys' fee can be exaggerated by claiming that the value to the class is equal to nominal value of the payment to the beneficiary; the defendant is willing to make a larger nominal contribution to settle the case than the actual cost to the defendant. For example, a California state court settlement of a derivative action against Larry Ellison alleging insider trading settled when Ellison agreed to pay $100 million to a charity chosen by Oracle—even though the billionaire has previously stated that his fortune would go to charity.17 The only real expense to Ellison was the $22 million attorneys' fee. More recently, Facebook settled a suit by establishing a charity run by a Facebook board member, and funding it with $6.5 million dollars; again, the class did not benefit, and the only expense to Facebook was the $3.2 million fee paid to the class attorneys. If the charitable contribution is one that the defendant was making anyway, the effect on the defendant is one of a change of accounting entries rather than any cost to the defendant or benefit to the class aside from the attorneys' fees. While federal courts are starting to crack down on such abuses, they are doing so inconsistently, and parties are still trying to get away with such shenanigans.
Further ethical problems arise if the beneficiary is related to the judge. The New York Times has documented the problem of charities soliciting judges for leftover settlement money. In one notorious case, a judge directed cy pres to an animal-rights group in a class action over a hotel fire. In a mass-tort inventory settlement of fenphen cases in Kentucky, tens of millions of dollars intended for plaintiffs was diverted to a newly created charity, where the judge who approved the settlement and three of the plaintiffs' attorneys sat as board members, each receiving tens of thousands of dollars for their service. The settlement also provided a million dollars to the alma mater of one of the trial lawyers, which then hired the attorney for a $100,000/year noshow job. (Two of the attorneys were eventually convicted, and too few people went to prison over this.)
While this is obviously an extreme case, it does illustrate the ethical problems associated with judges choosing or approving charitable destinations for settlement money. In a settlement I objected to, the parties in a nationwide class action proposed a cy pres award to a local charity where the judge's husband served as a board member; the judge rubber-stamped the proposed settlement over an objection regarding the appropriateness of the cy pres award. The Ninth Circuit reversed on other grounds, but refused to condemn the conflict of interest. This appearance of impropriety damages public perceptions of the fairness of the justice system, and appellate courts should be doing more to police it.
More frequently, if the beneficiary is related to the plaintiffs' attorneys, or the plaintiffs' attorneys otherwise benefit from the payout, the award rewards trial lawyers twice: first by providing cy pres recovery to an organization that supports the agenda or causes of the trial lawyers bringing the case, and then a second time by basing attorneys' fees on the first amount.
In July 2007, a district court judge granted a motion to award $5.1 million of unclaimed antitrust settlement funds to George Washington University to create a "Center for Competition Law" on the grounds that it would "benefit the plaintiff class and similarly situated parties by creating a Center that will help protect them from future antitrust violations and violations of other competition laws." The lead plaintiffs' attorney was a GWU Law alumnus. I represent a client appealing an approval of a settlement of a class action with a national class where over $2 million of cy pres is going to three San Diego universities (including the alma mater of class counsel), class counsel is being paid $8.85 million, but the class will receive only about $225,000 in cash. In another settlement where class counsel was already scheduled to receive $27 million, cy pres was designated to a charity run by the ex-wife of class counsel. Such problems go beyond trial lawyers and civil lawsuits; Richard Epstein has criticized a Bush administration settlement with Bristol-Myers Squibb requiring them to endow a chair of ethics at the District of New Jersey U.S. Attorney's alma mater, Seton Hall Law School.
Certainly, the desire to give money to charity is a good cause. But there are surely more efficient ways to do so than to give carte blanche to plaintiffs' attorneys to direct class members' money and then have them take a 25 to 40 percent commission on the donation. In practice, cy pres "creates the illusion of class compensation" without actually compensating the class. And as Judge Edith Jones has said, "district courts should avoid the legal complications that assuredly arise when judges award surplus settlement funds to charities and civic organizations."
There are several possible responses to the issue of unfettered cy pres awards, which frequently have too little scrutiny from courts, despite the clear conflicts of interest they present between class members and their attorneys. The American Law Institute's Principles of the Law of Aggregate Litigation proposes limiting cy pres to "circumstances in which direct distribution to individual class members is not economically feasible, or where funds remain after class members are given a full opportunity to make a claim." This would imply that a settlement distribution should go to class members who have filed a claim, although some courts have rejected such a solution as a windfall to class members, especially when the number of class members filing claims is small relative to the size of the class. Another possibility is already contemplated by federal law: unclaimed funds escheat to the treasury.
There is still another possible solution. The federal Class Action Fairness Act bases fee awards in coupon settlements on the actual redeemed value of the coupons; if coupons are donated to charity, those coupons cannot be used to calculate a fee award. The same principle should apply when cash is involved; at a minimum, money given to cy pres should not count dollar for dollar like money given to class members. Contingent-fee attorneys should be rewarded only for benefits going directly to the class. Moreover, if a cy pres settlement benefits the attorneys directly or indirectly, that settlement should offset the attorneys' fees. A $1 million cy pres award on behalf of a charity related to class counsel should count as part of the attorneys' fee award, not as a justification for additional attorneys' fees. Such a mechanism would give plaintiffs' attorneys the proper incentive to align their interests with those of the class when devising a settlement: if the settlement does not benefit class members, the attorneys should not be realizing disproportionate benefit. Judge Lee Rosenthal correctly recognized the need to structure incentives ex ante, and discounts cy pres in calculating settlement benefit; this should be standard practice, rather than a rare exception.
At a minimum, the parties should be required to give notice to the class of who the cy pres recipients are, and whether there are relationships between the recipients and the parties, attorneys, and judge. Though this information is plainly material to the fairness of a settlement, courts have generally refused to establish bright-line rules that penalize parties that hide this information from class members.
I welcome your questions.