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Class Actions: The New Ethical Frontier

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issue brief

Class Actions: The New Ethical Frontier

November 1, 1996
Legal ReformOther

Controversy keeps mounting over class actions, yet the discussion often seems to take place in a historical vacuum. In particular, it isn’t always realized to what extent shrewd lawyering in recent years has transformed this type of litigation in ways the drafters of Rule 23 never foresaw or intended. Over the past decade or so, the class action bar has taken advantage of gaps in judicial and public oversight to develop entirely new techniques for prosecuting and settling class action suits, techniques that offer unprecedented opportunities for abuse. If the class action device is under attack as never before, one reason may be that it’s being abused as never before.

The “textbook” class action runs as follows. Using a token representative plaintiff to get into court, entrepreneurial lawyers sue a defendant, gain the court’s permission to represent a large class, and negotiate a settlement. Because class counsel is bargaining away class members’ legal rights, in circumstances where the clients are in no position to review their attorneys’ handling of the case, proposed settlements must receive judicial approval as to their fairness, adequacy and reasonableness. The court must also approve the lawyers’ request for attorneys’ fees and costs, which traditionally have been deducted from the "common fund" from which class members get their relief.

The problems with this mechanism are by now familiar.  Lawyers may walk off with millions in fees while class members individually receive pennies on the dollar for alleged harms. One client of mine, in the Greenwich Pharmaceuticals Securities Litigation, received a settlement check for 14 cents—along with four pages of Internal Revenue Service instructions on how to report the payment!

Judges often display little initiative in verifying lawyers’ claims regarding how much time they devoted to the case, who worked on it, and how and to what extent litigation costs were incurred.  Defendants, as a condition of settlement, are required to agree not to contest plaintiff counsel’s representations on these matters.  An overworked judiciary, hoping to clear its docket, too often finds it easier to follow the maxim, "better a bad settlement than a good trial."

Two developments in recent years have drastically transformed the textbook model of a class action settlement.  The first has been the rise of coupon settlements.  Defendants found they could offer settlements consisting not of cash, but of coupons or other discounts, to class members.  Instead of resisting such non-cash settlements, class counsel began to retain valuation experts willing to attach extravagantly high values to the purported benefits of these nonpecuniary settlements.

The result has been a long string of settlements whose terms look favorable to plaintiffs on the surface—but only on the surface. In the Domestic Air Transportation Antitrust Litigation settlement, class members received $25 coupons for discounts on certain flights; in the In re General Motors Corp. Pickup Truck Fuel Tank Products Liability Litigation settlement, class members were offered a $1,000 discount coupon toward the purchase of a new GM vehicle.  In the Toyota Motor Sales USA, Inc. case, class members were offered a $100 discount on the purchase of a new car and a $50 discount off the cost of repairs.  In the Stouffer Frozen Foods Corp., Inc. case, class members were offered 35-cent and 50-cent coupon discounts off the future purchase of Lean Cuisine products. In the recent America Online, Inc. settlement, class members were offered an additional hour’s use of America Online services—though it was estimated that between 60 and 70 percent of class members already didn’t use even the full five hours allotted to them.

But as economists know, the true economic value of a coupon to its recipient, or true economic cost to its issuer, are by no means equivalent to its face value. If it were, the Sunday-paper supplements containing $100 worth of coupons would be as valuable as a $100 bill. Many customers never cash in coupons, and others who do are actually bringing a net profit to the issuer who would not otherwise have gotten their business.

Some coupons come with baffling fine-print conditions attached.  In other cases, defendants appear to offer cash, but payments are made only to claimants found eligible according to complex or even undisclosed formulas, and only after class members furnish what one party or the other considers adequate documentation.  Any money not paid to class members is kept by the defendant company.  In the State Farm Mutual Automobile Insurance Company class action, a client of mine was denied eligibility for several reasons, including her failure to include her home address and social security number, but was accorded no opportunity to correct the omissions. In other situations, coupons may be given out indiscriminately to anyone who claims to be a class member. For example, in the In re Sears Automobile Center Consumer Litigation, anyone who claimed they were a class member, without any verification of class membership, was given a $50 coupon redeemable for the purchase of merchandise sold by Sears.

In these coupon settlements, the parties often provide the judge with purported expert projections, forecasts and guesses as to how many class members will avail themselves of the coupons being offered, the idea again being to legitimate the size of the fee they have negotiated with the defendant. In the State Farm case, the projected value of the settlement ranged from a high of $106 million to a low of $6 million—a remarkably wide range, one might think.  And in many cases, very little money is actually paid out.  In defending their failure to create a common fund in the In re Pentium Processor case, class action lawyers argued that since defendant Intel had placed the entire assets of the corporation at risk in agreeing to settle class members’ claims, rather than placing a fixed sum of money in a common fund, their failure to create a common fund was a benefit to the class.  As of March 1996, a total of 68 claims had been filed against Intel for money damages, and the company had paid out $18,000 to these claimants. Not long ago, in the In re Coordinated Pretrial Proceedings in Petroleum Products Antitrust Litigation, a settlement that established a $10 million settlement fund for business class members’ claims actually paid out a mere $60,000 to class members, reportedly because it was inadequately advertised.

You might expect the attorneys for the class to cry foul at such developments, fighting for broader distribution of money, for more effective advertising and clearer explanations of claim procedures, and for more generous application of eligibility rules. However, once a settlement has been approved and fees paid, neither side has an incentive to direct the court’s attention to the question of whether real payouts are keeping up with the script.  The overwhelming majority of class action settlements do not provide the court or general public with any means of obtaining later data on the number or size of claims made, the proportion of these that are rejected, or the resulting total payout to class members.  In coupon settlements in which class members are offered discounts, it can be even more difficult to determine how many beneficiaries have taken advantage of the offers.

Even more remarkable than the coupon settlement ploy is a technique developed by class action lawyers some time around the early 1990s and typified in such well-known recent cases as Pentium, America Online, and In re Packard Bell Consumer Class Action Litigation.  Traditionally, class counsel had obtained their fees as a deduction from the common fund held in trust for the class, after the opponent had written the settlement check. But what was there to prevent the lawyer from asking for a fee to be paid by the opponent directly?  Hence, a brilliant innovation—the class action fee separately negotiated with, and paid by, the opponent.

It was an idea created out of whole cloth and unknown to previous fee jurisprudence, and it offered several immediate advantages.  To begin with, the separately paid attorneys’ fee did not have to be linked to some set hourly formula or to some fixed percentage of the recovery.  Instead, the amount could depend far more on the discretion of both sides.  In fact the fee negotiations could take place in private, with neither the public nor class members being invited to watch or take part.  And the greatest advantage of all—or so class counsel regularly argue with a straight face—is that this method of attorney compensation, unlike the common fund method, doesn’t reduce the class’s recovery.

This argument simply cannot be taken seriously.  Suppose lawyers for accident victims were discovered to be striking side deals by which they recovered handsome fees from the insurance company after agreement on their clients' recovery.  Would they really get away with assuring ethical inquisitors that, after all, the nice fees were no skin off their clients’ backs; the clients’ settlement would have been the same regardless of the amount of the attorneys’ fee which they had negotiated for themselves?  Wouldn’t clients and bystanders be justified in questioning the implicit trade-off going on in such negotiations: lower settlement sums for higher attorneys’ fees?  It is quite clear that in normal litigation the law would view such arrangements as constituting an impermissible conflict of interest.

To hear the lawyers tell it, there’s no conflict of interest at all in this type of negotiation. The official line is that as soon as the sides sit down to talk settlement, class counsel informs defendants’ counsel that no discussion of attorneys’ fees will take place until after the class’s relief has been agreed on.  However, they also advise defendants’ counsel that any agreement to settle the class’s claims is contingent upon a satisfactory resolution of the attorneys’ fee issue. Class action lawyers routinely file affidavits declaring that neither side breathed a word about the quantum of attorneys’ fees until after the class relief had been agreed on.  The common term of art is that no “discussions” took place, which of course leaves open the possibility of other forms of signaling. These are all matters to take on faith, because neither we, the public, nor members of the class are ever allowed into the negotiating room.

In their presentation to the court seeking approval of the settlement, a prime objective of class counsel is naturally to get the judge to rubber-stamp the separately negotiated attorneys’ fee provision of the settlement. As one who has participated as an objector's counsel to urge greater judicial scrutiny of attorneys’ fees in numerous class action settlements, this writer has heard an endlessly inventive array of entreaties and arguments aimed at trial judges in state and federal courts throughout America:

  1. Your Honor, approve this fee.  It was bargained for by sophisticated and experienced attorneys on both sides. The defendants would not have agreed to pay this amount were it not reasonable.
  2. Your Honor, approve this fee.  We were careful to avoid any conflict of interest that might have arisen had we negotiated our fee and the class’s recovery at the same time.
  3. Your Honor, approve this fee.  The settlement is a package.  You needn’t find each of its provisions reasonable in order to find it reasonable overall.
  4. Your Honor, approve this fee.  So long as you believe the class’s recovery to be fair, adequate and reasonable, then you have sufficiently protected its interests, even if the fee itself may be higher than you would have awarded.
  5. Your Honor, approve this fee.  Remember, no standard has yet been established by which judges review the "separately negotiated" fee, and you need not apply a standard of reasonableness. We urge you instead to adopt a “shock the conscience of the court” standard.  This means you can approve a fee to which we and the defendants have agreed even though it’s higher than the fee you would have found reasonable.
  6. Your Honor, approve this fee.  The judiciary’s time, and in particular your time, is too valuable to be spent examining the details of an attorneys’ fee request. After all, there is no dispute about the fee between the two main parties and you have more important matters to which your attention should be devoted.
  7. Your Honor, approve this fee.  After all, the purpose of litigation is to punish and deter wrongful conduct.  If you reduce the amount of our fee, the defendant will get some of his money back and the deterrent effect of this litigation will be weakened.
  8. Your Honor, approve this fee.  Here is a declaration by a retired judge (whom we’ve hired) who says the fee we’re requesting is reasonable.  Certainly you can rely on the opinion of this distinguished former jurist.
  9. Your Honor, approve this fee.  Should you desire to undertake the exhaustive effort needed to calculate a reasonable attorneys’ fee, you must bear in mind that there simply is no money available to pay a special master or outside expert to assist you.  It is the position of the defendants that any money not paid to class counsel must go back to them and cannot be used for any other purpose.

In all too many cases, trial court judges across America dutifully accept one or more of these rationales in awarding class counsel their fees.  As the trial judge in the Sears case noted in approving a separately negotiated fee whose amount he described as "not unreasonable": "the fee is separately paid by the defendants; whether the defendants pay $3.50 or $50 million in fees is pretty much irrelevant to the [class member] plaintiffs."

The final indignity comes when a disgruntled member of the victimized class tries to appeal the fee ruling to a higher court: class counsel proceed to argue that the lower court judge’s approval of the fee cannot be appealed.  They unashamedly challenge objectors’ standing to get into court, on the grounds that even if the appellate court were to reduce the fee as excessive, any refunded money would simply revert to the defendants.  Since class members would get no proximate financial benefit from a reduced fee, they are not aggrieved by the Court’s ruling (under this view) and lack standing to appeal.  At least one appellate court, the Third Circuit in the General Motors Pickup case, refused to accept this rationale. However, there are many judges across America upon whom the class action bar is eager to test their theory.

Scientists long ago gave up on the idea of the perpetual motion machine, but lawyers have done handsomely by reviving the concept.  Their system hums along smoothly on an endless stream of fees, serving the interests of the attorneys, the defendants they sue, and the judges who hear the cases, with results that seem appealable to no one but the Lord Almighty. And we, the general public, are the losers.