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Disgorgement is proper remedy for proceeds from ‘objector blackmail’ in class settlements

By Brandi O. Brown, J.D.

Three objectors who received side payments totaling $130K in exchange for dismissing appeals related to their class settlement objections must cough up those funds to be placed in a constructive trust.

In a decision with clear implications for employment-related class action settlements, the Seventh Circuit has ordered three objecting class members who received payouts in order to drop their objections to the settlement of a false claims suit to return the funds for placement in a constructive trust. The appeals court held that the district court had the equitable power to remedy the problem of “selfish” objector settlements, also referred to as “objector blackmail,” by ordering those settling objectors to disgorge for the benefit of the class the proceeds of those settlements. The district court’s decision was reversed (Pearson v. Target Corp., August 6, 2020, Hamilton, D.).

Objection leads to new settlement. In 2011, the named plaintiffs filed a putative class action in federal district court alleging that the defendants had made false claims regarding dietary supplements. Two years later, the parties negotiated a settlement, which was approved over a class member’s objection. That class member, Theodore Frank, appealed and the Seventh Circuit reversed, finding that the settlement was “plagued by ‘fatal weaknesses’ and amounted to a ‘selfish deal’ between class counsel and defendants that ‘disserve[d] the class.’” Two years later, the parties had negotiated a new settlement, which they submitted to the district court for approval. That agreement provided for a common fund of $7.5 million, as well as permanent injunctive relief.

Three new objectors receive $$. Three class members objected to the second settlement agreement, each filing four-page objections and providing different reasons for their objections. The settlement was approved, over those objections, and the three objectors appealed. However, they dismissed their appeals before briefing began. Those dismissals struck the previous objector, Frank, as questionable and he sought to reopen the case with the district court by moving for disgorgement of any payments that had been made to the objectors in exchange for their dismissal. The motion was denied and he appealed. In the second appeal, the Seventh Circuit reversed, concluding that the district court had jurisdiction to consider Frank’s motion.

District court denied disgorgement. On remand, discovery showed that Frank was correct—the three objectors had received side payments in exchange for dismissing their appeals. Two of them received payments of $60,000 each and the third, who was not represented by counsel on his objection, received $10,000. Meanwhile, the class received nothing. The district court denied disgorgement, finding that there was no basis to conclude the payments had harmed the class. Frank appealed. Only two of the objectors participated in the appeal and none of the original parties did.

Objectors have fiduciary duty. On its third look at this case, the Seventh Circuit again reversed the district court’s decision, concluding that it abused its equitable discretion by failing to address a critical piece of the evidence. Under “long-established principles of equity” the court explained, self-dealing by a fiduciary is constructively fraudulent. The court explained that it had “little difficulty” applying those equitable principles “to a private payment made to an objector in exchange for withdrawing the appeal of an objection asserting the interests of the class.” The court considered a 75-year-old decision of the U.S. Supreme Court, Young v. Higbee Co., which ordered disgorgement of private settlements obtained by objectors to confirmation of a bankruptcy plan.

The court read Young “to impose a limited representative or fiduciary duty on the class-based objector who, by appealing the denial of his objection on behalf of the class, temporarily takes ‘control of the common rights of all’ the class members and thereby assumes ‘a duty fairly to represent those common rights.’” It found its reasoning to be “squarely on point here.”

Belonged to the class. In this case, the objectors made sweeping claims of defects in the settlement, the court explained. Whether or not those objections had sufficient merit to “stand a genuine chance of improving the entire class’s recovery,” the objectors received money in excess of their interests as class members. If the objections had enough merit to stand a genuine chance of improving the class’s recovery, the objectors sold off that chance, which was property of the class, for their own private benefit. If the objections did not have a genuine chance of improving recovery, then they were leveraging the strength of the underlying litigation, which was also belonged to the class. Thus, the equity belonged to the class. Merit was not important to these objectors, the court concluded. What they did was put forward “superficially plausible objections” in short submissions that were “light on citations to law and fact” and then sell them.

Disgorgement proper. The objectors’ arguments against disgorgement were unpersuasive. Notably, the court rejected the argument, made by the objector who had objected that the percentage of fees to be paid to class counsel was too high, that his objection would not have increased defendants’ liability in any event. His “responsibility to the class depended not on whether defendants would have been required to pay more but on whether the class would have been entitled to receive more.” In the second settlement agreement, class counsel’s fees came out of the common fund and, thus, sustaining the objector’s objection would have directly benefited the class. He also argued, and the district court relied heavily on the contention that the defendants had paid independently from their own pockets without dipping into the common fund. “It would not alter our analysis if it were true,” the court explained. In fact, it wasn’t.

Noting that the question of remedy “poses a practical challenge” in this case, the court concluded that disgorgement was proper. It rejected the “poison-pill argument” for rescission of the entire settlement. In theory, the court explained, the best remedy would be to have those sums paid into the common fund for direct distribution. However, the parties appeared to agree that distribution of the $130,000 is no longer possible or would be self-defeating because the cost of doing so would “swallow the benefits.” The court concluded that the appropriate remedial framework was the constructive trust which, under the second settlement, would mean ordering payment to the Orthopedic Research and Education Foundation.