Kentucky Civil Rule 23, which governs class actions procedures in Kentucky state court actions, contains an important provision that will change the way defendants approach class action settlements. The provision, CR 23.05(6), became effective in 2014. It provides that when the parties create a class action settlement fund, at least 25% of any remaining funds that are not distributed or used to cover fees and costs must go to a Kentucky legal aid IOLTA account. The rule, a potential boon to public legal aid and plaintiffs lawyers, forces defendants to structure class action settlement more carefully or else they risk paying a sizeable settlement tax.

CR 23.05(6) is a type of cy pres distributions statute, a concept that originated in the trusts context. While 23.05(6) is new and its effect is relatively uncommon, it is not unique among state class action rules. Recently, several states have enacted provisions either requiring or allowing for cy pres distributions from residual funds from class action settlements. At least seven other states have some kind of cy pres rule for class actions. In some of these states (Tennessee and Massachusetts, for example), unlike in Kentucky, the rule is simply permissive, granting a court the discretion to distribute some portion of residual class action funds if it so chooses. And in other states, such as North Carolina and California, the cy pres distributions apply to both class action settlements and judgments. There is no federal cy pres provision for class actions, although some federal courts will approve settlements when the parties themselves expressly allow for cy pres distributions of residual funds. See, e.g.In re Lupon Marketing and Sales Practices Litig., 677 F.3d 21 (1st Cir. 2012).

CR 23.05(6) provides that “where the claims process has been exhausted and residual funds remain, not less than twenty-five percent (25%) of the residual funds shall be disbursed to the Civil Rule 23 Account maintained by the Kentucky IOLTA Fund Board of Trustees . . . . and allocated to the Kentucky Civil Legal Aid Organizations . . . .” (emphases added). Thus, Kentucky courts must distribute residual funds to the IOLTA account; their only discretion is whether to distribute more than 25% of the remaining funds. The rule defines “residual funds” as “funds that remain after the payment of all approved class member claims, expenses, litigation costs, attorneys’ fees, and other court-approved disbursements to implement the relief granted.”

Class action settlements are often structured in such a way that the defendant contributes money to a settlement fund, from which class members obtain payments, the administrative costs of locating class members and handling claims are paid, and plaintiffs’ counsel receives its attorneys’ fees. Creating a settlement fund can be useful for defendants because it can cap exposure. For example, a defendant could ignore a settlement fund and simply agree to pay each claimant $10. The defendant estimates that there will be 100,000 claimants, so it expects to pay $1 million to class members plus plaintiffs attorneys’ fees and costs, for a total estimated settlement payment of $1.5 million. But if more class members make valid claims than expected, the cost of the settlement will increase. If there are instead 200,000 valid claims, the defendant will pay $2 million to class members, while administrative costs and plaintiffs attorneys’ fees will similarly increase, for a total settlement payment in this hypothetical example of $3 million. The defendant could insulate itself from this risk by instead agreeing to create a settlement fund of $2 million, from which all claims, administrative costs, and attorneys’ fees would be paid. If only 100,000 claimants came forward, $500,000 would remain in the settlement fund, which in many cases would revert to the defendant. If instead 200,000 claimants came forward, their claims would be proportionately reduced, and the defendant would not have to pay any more than the $2 million it already contributed to the settlement fund.

CR 23.05(6) comes into play when not enough claimants come forward to completely extinguish a settlement fund. In the example above where only 100,000 people make valid claims, instead of the $500,000 in residual funds reverting to the defendant, at least $125,000 would be diverted to the Kentucky legal aid account.

The lesson for defendants crafting a settlement of a class action in Kentucky state court is to avoid subjecting substantial amounts of money to CR 23.05(6). One surefire way to avoid its reaches is to remove a class action lawsuit to federal court. For those class action lawsuits that remain in Kentucky state court, defendants should, where possible, avoid creating a settlement fund. Where a settlement fund is unavoidable, defendants must keep the fund as small as possible, as no more than 75% of unclaimed funds will be returned.