Companies are Demanding Cost Certainty in Class Action Litigation
Companies spend billions of dollars defending class action lawsuits each year. Compared to other forms of litigation, defending a class case is exceptionally challenging because the percentage of these cases that is considered “bet the company” continues to rise, while the overwhelming majority still results in settlement. Compounding the complexity of these matters is the universal understanding that the company’s and class counsel’s perspectives on settlement are wholly divergent.
When considering settlement structure, the parties must fashion a compromise which provides a meaningful benefit to the class in exchange for a release of claims and the conclusion of the litigation. In most cases, a claims made settlement achieves that balance as this structure: 1) allows class members to identify themselves (if there is no class list); 2) obtains one or more critical pieces of information from class members to validate claims and calculate the specific benefit; 3) allows class members to elect different benefit choices; and 4) prevents a windfall by just distribution of funds pro rata regardless of injury, harm or damage and instead allows people who feel aggrieved to take advantage of the settlement. However, a claims made settlement presents one fundamental challenge for companies as it creates massive uncertainty as to the ultimate cost of resolution.
For the business, the biggest impediment to resolution is the uncertain cost of settlement. Since businesses operate in a world of budgets, expenditures, financial forecasts and constituent accountability, they tend to focus on much different issues when considering settlement, including:
- How will the settlement impact the company’s reputation, finances and operations?
- Can the company afford the cost of settlement?
- Can the company afford the cost of continued litigation?
- How will the company approve a settlement that satisfies all internal constituencies?
- Will the company receive final approval from the court?
- What tax implications will the settlement have on the business?
In addition to the uncertain costs, companies then have to wrestle with the negative financial impact of settlement on their P&L. Auditors and accountants require the entire amount of the settlement be taken as a charge immediately on the company’s books. According to Peter Robbins, CPA of Clifton, Larsen and Allen:
Since a class action settlement agreement creates a known and probable liability, GAAP requires that the Company book the entire settlement and assumes 100% “take rate” participation in order to provide legal and financial transparency to the public regarding the claim. Thus, when a Company settles a class action lawsuit and establishes a claims-made process, it has two choices: (1) take a charge on its financial statements for the entire amount of the settlement, thereby possibly devastating its financial position to shareholders and others, or (2) purchase insurance thereby capping its maximum net liability to the amount of the insurance premium. Class Action Settlements: Financial and Tax Reporting, Arizona Bar Journal (March 2013).
From the company’s perspective, taking a charge against its P&L for the full aggregate settlement exposure can create a variety of negative business implications. The severity of these implications will depend on the size of the business, its financial health at the time of settlement and its risk tolerance; however, they can and will include things such as:
- Weakened financial statements
- Missed or reduced earnings
- Adverse impacts to raising capital
- Negative impacts on cash flow
- Obstacles to M&A transactions
- Potential breach of loan covenants
- Possible bankruptcy
In addition to the negative balance sheet impact, settlement of statutory damage cases can have profound tax implications. Per CPA Robbins, “if the settlement and payment represent a fine or statutory penalty (like TCPA, FCRA), then the payments are likely not tax deductible.” Class Action Settlements: Financial and Tax Reporting, Arizona Bar Journal (March 2013). The balance sheet and tax implications should be carefully weighed in all settlement decisions.
Since continued litigation and settlement both present a host of detrimental financial, legal and business repercussions, companies tend to move closer to resolution when they have cost certainty and can mitigate the negative implications of resolution. One solution is to allow companies to obtain risk transfer of the settlement. Then, companies can evaluate the true cost of settlement and avoid some of the significant risks and negative financial consequences of settlement.