Courts are questioning whether the trust doctrine of cy pres may be used in class action litigation to permit the distribution of unclaimed settlement funds to charities.1 While proponents argue that cy pres distributions punish corporate wrongdoing, deter future misconduct and deny “windfalls” to settling defendants, there is mounting concern that the process can erode public confidence in the bar and the judiciary. Of equal concern, leading scholars — and courts — believe that the process is simply unconstitutional.

A recent decision from the U.S. District Court in New Mexico is a case in point. In In re Thornburg Mortgage, Inc. Securities Litigation, 2012 U.S. Dist. LEXIS 107934 (July 24, 2012), the court struck a cy pres provision in an agreed class action settlement that would have made a local charity the primary beneficiary of a class settlement, while excluding some class members from participating in the settlement at all. Here’s what happened.

The Public Offering

Before the Great Recession, Thornburg Mortgage, Inc., (Thornburg) a publicy traded real estate investment trust, specialized in the issuance of “jumbo” and “super jumbo” residential mortgages. Id. at *3. The company acquired its capital through public offerings of its securities and short-term borrowings, including reverse repurchase agreements, issuance of asset-backed commercial paper, and the issuance of collateralized debt obligations. Id. at *6.

In May and June of 2007, Thornburg held a series of public offerings raising more than $190 million. Id. at **10-11. However, as the economy soured and the company was forced to liquidate its most valuable securities at steep discounts to satisfy margin calls from prior investments, the value of the company — and its shares — plummeted. Id. at *11. Eventually, the stocks it sold in May and June of 2007 for $25.00 per share were worth just $0.69 per share. Id. at **11-15.

In August 2007, four lawsuits were filed, each alleging violations of federal securities law and each seeking to certify a class of plaintiffs. Id. at **17-18. The cases were consolidated and, in April 2012, the parties presented a proposed joint settlement, requested class certification and sought court approval. Id. at **18-19.

The Class Action Settlement

The terms of the settlement were startling. The stipulation provided for:

  • $2,000,000 cash settlement fund;
  • $500,000 in attorneys’ fees (“up to” 25% of the total settlement fund);
  • $260,000 in litigation “costs”; and
  • $1,240,000 net fund for distribution.

Id. at **19-20.

The total recovery for each plaintiff was just a penny per share, and only claims of $10.00 or more would be paid from the fund. Id. at *21. Thus, only shareholders with at least 1,000 shares could participate in the settlement — the rest were excluded.

In addition, funds that were unclaimed after one year would be subject to “cy pres” distribution to the Center for Civic Values in Albuquerque, New Mexico. Id. at **20, 41. The Center for Civic Values "'envisions a society in which all people understand, value and participate in the process of self-government,' and furthers 'its vision by providing education and resources to encourage public participation in the law.'" Id. at *41. It also administers the New Mexico Interest on Lawyers Trust Fund Accounts program. Id.

The court struck the cy pres provision of the proposed settlement and expressed two fundamental concerns supporting its decision.

The First Problem: Strangers to the Case

First, the court said that “class actions are disputes between parties and the money damages should remain among the parties, rather than be distributed to some third party.” Id. at *25. The court reasoned that the parties did not initiate the suit “so that class action damages can be distributed to third parties not involved in the litigation and without standing to sue for the damages they receive through the mechanics of court intervention.” Id. at * 27.

At the core of the court’s concern is this: strangers to a lawsuit — who have not been harmed by any wrongdoing alleged in the case — have no right receive any payment from funds intended to compensate those who were injured as a result of the alleged wrongdoing. Indeed, the Rules Enabling Act (28 U.S.C. § 2072(b)) says that procedural rules — including Rule 23 — may not “abridge, enlarge, or modify any substantive right” of any party. The court noted that “the class action should [not] be a free-standing device to do justice.” Id. at *21. It is simply a rule of procedure that is meant to facilitate joinder of similar claims of multiple parties that would be too expensive or inefficient to try separately.

Using Rule 23 as a vehicle to distribute unclaimed funds to unrelated third parties who lack standing serves no compensatory purpose. It both enlarges the rights of non-parties by giving them a right to receive distributions of money paid to compensate someone else’s injury, and abridges a defendant’s right to limit its payment to parties who actually suffered an injury. See Klier v. Elf Atochem N. Am., Inc., 658 F.3d 468, 480 (5th Cir. 2011) (Jones, J., concurring) (“It is inherently dubious to apply a doctrine associated with the voluntary distribution of a gift to the entirely unrelated context of a class action settlement. . . .”).

The Second Problem: The Reputation of the Court

Second, the court said that it is “unseemly for judges to engage in the selection of third-party beneficiaries and to distribute class action damages to third parties.” Id. at *25. There “is no principled rationale” for choosing among different charities, id. at *30, and “allowing judges to choose how to spend other people’s money ‘is not a true judicial function.’” Id. at **30-31 (quoting A. Liptak, "Doling out Other People’s Money", New York Times, Nov. 26, 2007, at A14). The court was especially troubled by the possibility that judicial discretion as to which charity should receive a distribution — which is rarely subject to appellate review — could be used to direct gifts to organizations that could indirectly benefit the court. Id. at **33-35.

The deeper problem is that unfettered discretion to make charitable gifts “tarnishes the judiciary’s image and creates the appearance of impropriety.” Id. at *32. The public might think that the court is more “interested in being a big shot . . . than really making certain that class members get every penny to which they are entitled.” Id. at * 32.

Indeed, the stakes are even higher for state court judges who must stand for reelection. The risk that the public may believe that they are motivated by self-promotion is inescapable. To make matters worse, many plaintiffs’ lawyers actively promote their practices — and their standing in the local community — by advertising the “charitable” contributions “they” have “given” through cy pres distributions.

Is it too much to think that public confidence in the judiciary and the bar can be eroded by the perception that lawyers are using class actions for self-promotion rather than to benefit their clients? This perception is justified where, as here, class members are actually excluded from participating in the class settlement fund simply because their claims were too small to matter.

Article III Standing

Finally, the decision is notable for what it does not say. The court noted that its "rejection of the validity of cy pres awards does not rest on any constitutional holding." Id. at 39. Acknowledging that constitutional concerns "may be another problem casting doubt on the validity of cy pres awards," the court evidently felt constrained by its "obligation to avoid deciding constitutional issues not necessary to the disposition of a case." Id. at 37-38.

Instead, the decision rests on the court's conviction that cy pres awards are a "bad idea" that "do not adequately reflect the best interests of absent class members, create an appearance of impropriety, and are not the best use of the Court's time and resources." Id. at 39.

As good as these reasons are, the constitutional issues are the most important to consider. As the court noted, cy pres distributions raise serious standing issues under Article III because they “transform 'the judicial process from a bilateral private rights adjudicatory model into a trilateral process.’” Id. at *39 (quoting M. Redish, P. Julian, & S. Zontz, Cy Pres Relief and the pathologies of the Modern Class Action: A Normative Paradigm, 62 Fla. L. Rev. 617, 641 (2010)).

Indeed, transferring money to someone who has suffered no injury and who was never part of the underlying dispute is simply beyond the scope of a court's constitutionally-defined role: redress of injuries suffered by parties to the lawsuit. In one stroke, cy pres "violates both the constitutional separation of powers and the case-or-controversy requirement of Article III." M. Redish, P. Julian, & S. Zontz, >supra at 642.

Though the court got it right when it described cy pres as a "bad idea," enforcing Article III standing requirements is the better basis for rejection of such awards.

The Elephant in the Room

And one more thing.

A striking feature of the proposed award was the relationship between the size of the individual awards and the amount of fees and costs recovered by the plaintiffs' counsel. Of the $2 million awarded to the plaintiff class members, $560,000 (or 38 percent of the total award) went to their counsel.

But the settlement value to each plaintiff was just one penny per share, and only those with minimum claims of $10.00 were permitted to apply for payment. Although the court struck the latter provision, it noted that as originally proposed, "the Center for Civic values might be the single largest recipient of the class action award." Id. at *43.

Here's the elephant in the room: the fee calculation was based on the total $2 million award, most of which would have gone to the cy pres recipient and not to the class members. The cy pres award thus increased the size of the attorneys’ fee award without conferring any corresponding value to the class members. In fact, the class award literally could not have been smaller. The plaintiffs used Rule 23 to achieve a result so trivial that only the lawyers and strangers to the suit stood to gain anything of value.

Worse, this cy pres award — like most — creates the false impression that the class action vehicle has vindicated important rights, when in fact, is has been used to advance a right so trivial that most class members will not even bother to make a claim. While this enriches class counsel and punishes class defendants, neither of these results is authorized by the Rules Enabling Act or Rule 23. See M. Redish, P. Julian, & S. Zontz, supra at 660-61 (“Not only does the availability of cy pres awards have the potential to increase the total available fund only as a punishment to the defendant legitimize cases where the class might not otherwise be certified, but it can also increase the likelihood and absolute amount of attorneys’ fees awarded.”).

In re Thornburg Mortgage, Inc. Securities Litigation is the latest in a series of thoughtful cases addressing the flaws with cy pres awards, and striking them on its own motion. Settling defendants should not hesitate to challenge cy pres distributions and insist that residual settlement funds be returned at the close of the claims period.