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7th Cir. Orders Disgorgement When Class Objectors’ Private Settlements Were Exposed

class action dietary supplementsThe U.S. Court of Appeals for the Seventh Circuit recently held that settling an objection to a class action settlement in return for a private payment to the objector can be inequitable, and if so that disgorgement is the appropriate remedy.

A copy of the opinion in Frank v. Target Corporation is available at:  Link to Opinion.

In November 2011, plaintiff Pearson filed a putative class action in federal court in Illinois alleging that defendants had made false claims about certain dietary supplements they manufactured and distributed.

In March 2013, two months before the settlement was submitted for approval to the trial court in Illinois, Randy Nunez filed his own putative class action against the same defendants in federal court in California. Nunez was stayed pending the Illinois federal court settlement negotiations (“Pearson I”).

The parties in the Illinois suit negotiated a settlement and the trial court approved it over the objection of class member Theodore Frank in January 2014. Frank appealed and the Seventh Circuit reversed, noting the settlement was plagued by “fatal weaknesses” and amounted to a “selfish deal” between class counsel and defendants that “disserve[d] the class.”

After the Seventh Circuit vacated the Pearson I settlement, Nunez asked the trial court in California to lift the stay and to name his lawyers interim counsel of the Pearson subclass Nunez hoped to represent. The California court granted both motions.

In April 2015, the parties in the Illinois litigation negotiated and submitted to the trial court for approval a new settlement known as “the Pearson II settlement.” Before the trial court, three class members objected to the Pearson II settlement: Nunez, Steven Buckley, and Patrick Sweeney, who are all appellees in the present matter.

Nunez’s objection was based on the parties’ refusal to include Nunez’s counsel in their negotiation of the Pearson II settlement. Nunez moved to intervene in Pearson, pointing to his counsel’s interim appointment order in Nunez. The Illinois federal trial court denied intervention but invited Nunez to object to the forthcoming Pearson II settlement when it was presented. Nunez objected in a four-page submission, he argued that his counsel was the only counsel “with authority” to settle his proposed class’s claims and that defendants should not be permitted to auction off the case to the cheapest class counsel (without giving any reason to believe that had actually happened with the Pearson II settlement).

In another four-page submission, Buckley argued that class counsel were entitled to no more than 20 percent of the settlement fund in fees, not the 33 percent the proposed settlement promised them.

Sweeney objected pro se. In his four-page submission, he suggested implementing several measures to improve oversight of the settlement distribution process. Sweeney acknowledged this was not “the ‘usual’ procedure” but urged its adoption nonetheless.

The Illinois federal trial court approved the Pearson II settlement. All three objectors appealed. All three dismissed their appeals before briefing began.

The dismissals struck Frank as suspicious and possibly in bad faith and he sought to reopen the case by filing a motion for disgorgement of any payments made to objectors in exchange for dismissing their appeals. The trial court denied the motion for lack of jurisdiction. Frank appealed again.

The Seventh Circuit reversed, concluding that the trial court had jurisdiction to entertain Frank’s motion and that Frank should have been allowed to pursue his theory. On remand, discovery showed that the three objectors had all received side payments in exchange for dismissing their appeals — $60,000 each to Nunez and Buckley and $10,000 to Sweeney, totaling $130,000 — while the class had received nothing. The Illinois trial court concluded that “the record failed to confirm suspicions of blackmail or other wrongdoing” and denied disgorgement.

Nunez, Buckley, and their counsel asserted that they had pursued their objections in good faith, not for the purposes of blackmail. The Illinois federal trial court could not say the same for Sweeney but found the question ultimately “irrelevant” because there was “no basis to conclude that the side settlements harmed the class” by taking money that had been earmarked for it. The trial court therefore denied Frank’s motion.

Frank appealed and Nunez and Buckley appeared to defend their payments.

The Seventh Circuit began its review by defining the long-established principles of equity present in the law. Notably, it has long been axiomatic “that no person shall profit by his own wrong.” Town of Concord v. Town of Goffstown, 2 N.H. 263, 265 (1820). A fiduciary’s self-dealing is treated as a “constructive” fraud.  See, e.g., Joseph Story, Commentaries on Equity Jurisprudence 304 (1836). As a general rule, “wherever confidence is reposed, and one party has it in his power, in a secret manner, for his own advantage, to sacrifice those interests, which he is bound to protect, he shall not be permitted to hold any such advantage.” Id. at 320; see also, e.g., Snepp v. United States, 444 U.S. 507, 515 (1980) (same).

For application of these principles, the Seventh Circuit looked to Young v. Higbee Co., 324 U.S. 204 (1945) where the Supreme Court applied the principles to class litigation. In Young, Potts and Boag, two preferred shareholders of the bankrupt Higbee Company, objected to confirmation of the company’s bankruptcy plan. The trial court confirmed the plan over their objection and while their appeal was pending, they sold their preferred shares along with the appeal to Bradley and Murphy for seven times the shares’ market value. Young, another preferred shareholder, moved in the district court for an accounting of profits from the settlement. The motion was denied and Young appealed. The Supreme Court reversed the denial, finding that Potts and Boag’s dismissal had been bought at the expense of the class of shareholders they purported to represent.

The critical step in the Court’s reasoning in Young was to recognize that the appellants had taken on a fiduciary duty to the other shareholders similarly situated: “This control of the common rights of all the preferred stockholders imposed on Potts and Boag a duty fairly to represent those common rights.”

The Seventh Circuit thus 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.”

The Seventh Circuit found that the present matter turns on a simple either/or proposition whose logic flows directly from Young.

The objectors in the present matter made general claims of general defects in the Pearson II settlement. “Either those objections had enough merit to stand a genuine chance of improving the entire class’s recovery, or they did not. If they did, the objectors sold off that genuine chance which was the property of the entire class, for their own, strictly private, advantage. If they did not, the objectors’ settlements of meritless claims traded only on the strength of the underlying litigation, also the property of the entire class, to leverage defendants’ and class counsel’s desire to bring it to a close. Either way, the money the objectors received in excess of their interests as class members “was not paid for anything they owned,” and thus belongs in equity to the class.”

The Seventh Circuit next examined the objections of Nunez and Buckley.

Nunez asserted that his counsel had “sole settlement authority” to settle the claims of the Pearson subclass he sought to represent in Nunez. That would have meant the Pearson II settlement was at best unenforceable as to that subclass and at worst void in its entirety. The Seventh Circuit noted, after the Pearson II settlement, the Nunez case was a dead letter, so “Nunez’s only settlement leverage, like Buckley and Sweeney’s, was the value of being a nuisance, getting in the way of defendants’ and other plaintiffs’ desires to put Pearson itself to rest.”

Buckley contended that class counsel were being overcompensated at the class’s expense to the tune of 13 percentage points of the common fund, or $975,000, in part as a result of billing for hours spent defending the same “selfish deal” the Court vacated in Pearson I.

In its assessment of the claims of Nunez and Buckley, the Seventh Circuit was quick to point out that what each did was “to advance these superficially plausible objections in the space of four pages each, light on citations to law and fact, and to sell them — before speaking a word in their defense — at discounts from face value ranging from 94 percent (Buckley) to 99.2 percent (Nunez).”

The Seventh Circuit believed this conduct “testifies that, whatever merit their objections might have had, the objectors themselves did not believe them or take them seriously, from the day they were filed to the day they were settled.”

Finally, the Seventh Circuit addressed the appropriate remedy noting “In theory, the best remedy for the objectors’ private appropriation of value that belonged to the class would be to pay those sums into the common fund for direct distribution to all class members.” However, here, the distribution of $130,000 would be self-defeating because the administration costs would swallow the benefits.

Thus, the Seventh Circuit held the appropriate remedial framework was a constructive trust, which has long been used as a remedy for unjust enrichment obtained from a fiduciary’s breach of duty, ordering payment to the Orthopedic Research and Education Foundation.

Accordingly, the judgment of the Illinois federal trial court was reversed, and the case remanded for further proceedings consistent with the opinion.

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Ryan Grotz practices in Maurice Wutscher's Commercial Litigation, Consumer Credit Litigation, and Appellate groups. He has substantial experience in all phases of commercial litigation, including motion practice, written discovery, depositions, mediations, and bench and jury trials. Ryan received his Juris Doctor from the Chicago-Kent College of Law, where he was an associate editor on the Access to Justice Student Editorial Board. He was awarded his Bachelor of Business Administration degree from the University of Iowa. Ryan is licensed to practice law in Illinois and the U.S. District Court for the Northern District of Illinois. For more information, see https://mauricewutscher.com/attorneys/ryan-grotz/

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