Appeal from the United States District Court for the Northern District of Illinois, Eastern Division, No. 85 C 1456 - Marvin E. Aspen, Judge.
Cudahy, Posner, and Kanne, Circuit Judges.
Class actions differ from ordinary lawsuits in that the lawyers for the class, rather than the clients, have all the initiative and are close to being the real parties in interest. This fundamental departure from the traditional pattern in Anglo-American litigation generates a host of problems well illustrated by this appeal, which challenges the settlement in a class action.
In 1983, the Chicago law firm of Joyce and Kubasiak filed Tunney v. Continental Illinois National Bank in an Illinois state court. This was a class action on behalf of persons who had borrowed money from Continental at interest rates pegged to Continental's prime rate. The complaint alleged that since 1973 Continental had defrauded (and broken its contracts with) these borrowers by failing to adhere to its agreement to charge an interest rate pegged to the "prime rate," which the loan agreements defined as the rate the bank charges "for 90-day unsecured commercial loans to large corporate customers of the highest credit standing." The complaint alleged that throughout this period Continental had made loans to large corporate customers at rates well below the prime rate quoted to members of the class. In 1984 the state court judge certified the suit as a nationwide class action, appointed Joyce and Kubasiak to represent the class, and certified his certification for an interlocutory appeal. Because of the settlement negotiations described later in this opinion, the appeal was never taken; neither was notice to the class ever issued. Joyce and Kubasiak conducted little discovery, and did little other investigating, concerning the merits of the "prime rate" claim.
In 1985, Mars Steel Corporation, represented by Jerome Torshen, sued Continental in federal court in Chicago on behalf of a class defined identically to that in the Tunney suit. The only violation alleged in Mars was a violation of the RICO statute (Racketeer Influenced and Corrupt Organizations, 18 U.S.C. §§ 1961 et seq.), for a period beginning in 1973; treble damages were sought. Although Mars was filed after Tunney, Torshen, unlike Joyce and Kubasiak, pursued discovery on the merits. To comply with his document demands Continental developed a computer program that enabled it to discover which 90-day unsecured loans made between January 1980 and September 1982 might have been made below its prime rate. The computer search turned up 140 questionable loans, but further investigation showed that none of these was below prime within the meaning of the loan agreements with the members of the class. Some of the loans were for fewer than 90 days, some for more than 90 days; some were at fixed interest rates rather than rates pegged to the prime rate; some had not been made to corporate customers; some imposed compensating-balance requirements that had the effect of jacking up the real interest rate; and in some the interest rate was misstated because of clerical error. There is no suggestion that in making loans to large corporate customers for periods different from 90 days or at fixed interest rates rather than rates pegged to a fluctuating prime rate Continental was attempting to circumvent the terms of the loan agreements with the members of the class.
Discovery set the stage for settlement negotiations, which Continental conducted separately with Joyce and Kubasiak and with Torshen. Early in 1986 Joyce and Kubasiak offered a settlement whereby Continental would agree not to oppose a request for an attorney's fee of $2 million (later reduced to $1.25 million) and the class members would be given an opportunity to take out new loans from Continental at below-market rates. Continental refused the offer, and shortly afterward settled with Torshen. Under the terms of the settlement Continental would not oppose Torshen's request for $305,000 in fees, while the members of the class, defined as all corporate borrowers from Continental since 1973 at rates tied to the prime rate, would be entitled to take out new loans from Continental of up to $100,000 for one year at an interest rate roughly one-half of one percent below the borrower's previous interest rate. If (a big if) interest rates had not changed, Continental would be giving a $500 interest credit to every member of the class who wanted to borrow and met the bank's standards of creditworthiness. If interest rates had risen, the class members would do better than this; if rates had fallen, they would dod worse. Since there are 23,000 class members, the maximum value of the settlement to them if interest rates have not changed is $11.5 million.
The proposal by Joyce and Kubasiak would have entitled most class members to borrow up to $200,000 for up to one year at an interest rate one percent below the average interest rate that Continental had charged the borrower during the complaint period (i.e., since 1973). Class members who had borrowed more than $200,000 from Continental during that period would be allowed to borrow up to an amount equal to one more than $2,000,000. How favorable this offer is to the class, compared to Torshen's, depends primarily on the relationship between current interest rates and those prevailing during the complaint period (not just, as with Torshen's offer, on the relationship between current interest rates and the interest rates paid by members of the class most recently). As the record does not contain the necessary data for estimating the actual value to the class of either settlement, there is no reason to suppose either that Joyce and Kubasiak's offer is "sweeter" than Torshen's or that the reverse is true.
Without holding an evidentiary hearing the district judge gave preliminary approval to the Mars settlement, at the same time certifying the suit as a class action for settlement purposes only. This mode of class certification, not expressly provided for in Rule 23, is perhaps best interpreted as tentative certification. See In re Beef Industry Antitrust Litigation, 607 F.2d 167, 177-78 (5th Cir. 1979). The judge also ordered that notice of the class action and of the settlement proposal be disseminated to the class by mail and publication. Only two members of the class objected to the settlement - one being Tunney, of course. Wiesbrook, another member of the class and a client of Joyce and Kubasiak's, opted out of the settlement in order to keep the state court suit alive.
The district court then held a "fairness" hearing and decided that the settlement was fair and approved it, thus extinguishing by operation of res judicata the claims of all class members who had not opted out. Only 1.5 percent of the class members had opted out, a surprisingly small fraction if the settlement is as bad as Joyce and Kubasiak argues. Cf. Wellman v. Dickinson, 497 F. Supp. 824, 833 (S.D.N.Y. 1980). Although not all members of the class are corporations, all (we surmise) are business borrowers rather than consumers and all must have known - the notice clearly told them - that, if the settlement went through, it would extinguish their legal rights against Continental.
Tunney appeals, charging that the class should have been certified long before the settlement was given even preliminary approval, that the settlement is unfair, that the class notice was inaccurate and misleading, and that he (realistically, Joyce and Kubasiak) was denied an opportunity to present evidence of the settlement's unfairness either before preliminary approval of the settlement or at the fairness hearing.
Rule 23(c)(1) of the Federal Rules of Civil Procedure provides that, "As soon as practicable after the commencement of an action brought as a class action, the court shall determine by order whether it is to be so maintained." Mars, filed in 1985, was not certified as a class action until 1986 (and then only for purposes of settlement), when the district judge, before notifying the members of the class but after considering objections to the proposed settlement, gave the settlement his preliminary approval. It is hard to see why the propriety of maintaining the suit as a class action could not "practicably" have been determined much earlier. And, common though the practice of deferring class certification while settlement negotiations are going on is, it not only jostles uneasily with the language of Rule 23(c)(1) but also creates practical problems. Settlement negotiations are made more complicated when the parties don't know whether they are trying to settle a class action or an action limited to the named plaintiffs, don't know whether the named plaintiffs would be deemed adequate representatives of the class if the case proceeded to trial, and don't know the composition and size of the class. The danger of a premature, even a collusive, settlement is increased when as in this case the status of the action as a class action is not determined until a settlement has been negotiated, with all the momentum that a settlement agreement generates -- if its class status is ever determined, for Judge Aspen never did make a formal determination that this class action could be maintained consistently with the criteria of Rule 23. And where notice of the class action is, again as in this case, sent simultaneously with the notice of the settlement itself, the class members are presented with what looks like a fiat accompli. Moreover, the delay may make opting out of the class action less feasible than if members of the class had received prompt notice, not because the statute of limitation will have run (the filing of the suit will have stopped it from running) but because evidence may be growing stale.
Mainly for these reasons the practice of deferring class certification until a settlement has been negotiated has been criticized, see, e.g., McDonald v. Chicago Milwaukee Corp., 565 F.2d 416, 420 (7th Cir. 1977); Manual of Complex Litigation 59-61 (5th ed. 1982); cf. Premier Electrical Construction Co. v. National Electrical Contractors Ass'n, Inc., 814 F.2d 358, 363 (7th Cir. 1987); Watkins v. Blinzinger, 789 F.2d 474, 475 n. 3 (7th Cir. 1986), yet every court that has addressed the question, including our own, has declined to hold that the procedure is a per se violation of Rule 23 and therefore requires that the settlement automatically be disapproved. See, e.g., Simer v. Rios, 661 F.2d 655, 664-66 (7th Cir. 1981); McDonald v. Chicago Milwaukee Corp., supra, 565 F.2d at 420; Glidden v. Chromalloy American Corp., 808 F.2d 621, 627 (7th Cir. 1986); Weinberger v. Kendrick, 698 F.2d 61, 72-73 (2d Cir. 1982) (Friendly, J.). In re Beef Industry Antitrust Litigation, supra, 607 F.2d at 173-78. Two considerations explain this result. The first, stressed in Simer, is that since a suit begun as a class action may often and quite properly be settled as an individual action, that is, without preclusive effect on other members of the class, it would be a waste of time and money if before such a settlement could be negotiated a class-certification proceeding, possibly entailing the issuance of notice to the members of the class, had to be conducted in every case. (Of course, notice was settled as a class action.) Against this it can be argued that plaintiffs will be tempted to add class claims in order to intimidate the defendant, then delete them by way of compromise. But second, the procedure creates only a possibility, not a certainty, of abuse, a possibility held in check by the requirement that the judge determine the fairness of the settlement before he can approve it.
Simer and Weinberger emphasize, consistently with the last point, that when class certification is deferred, a more careful scrutiny of the fairness of the settlement is required. We agree, and that brings us to the second issue presented by the appeal, the fairness of the settlement. The fairness of a settlement of a legal dispute is the adequacy of the consideration supporting a contractual promise: a matter best left to negotiation between the parties. A settlement is a contract, and normally the test for the fairness of a contract is strictly procedural: were the parties competent adults duly apprised of the basic facts relating to their transaction? The problem in the class-action setting, and the reason that judicial approval of the settlement of such an action is required, see Fed. R. Civ. P. 23(e), is that the negotiator on the plaintiffs' side, that is, the lawyer for the class, is potentially an unreliable agent of his principals. See, e.g., Dam, Class Actions: Efficiency, Compensation, Deterrence, and Conflict of Interest, 4 J. Legal Stud. 47 (1975); Rosenfield, An Empirical Test of Class-Action Settlement, 5 J. Legal Stud. 113 (1976). Ordinarily the named plaintiffs are nominees, indeed pawns, of the lawyer - and their only coordination is through him. One solution, illustrated by the events narrated above, is competition by other lawyers to represent the class. It is only a partial solution, because a lawyer may be able to obtain a large fee not just by outbidding another class lawyer but, alternatively, by "selling out" the class, a danger discussed in In re General Motors Corp. Engine Interchange Litigation, 594 F.2d 1106, 1125 (7th Cir. 1979). Joyce and Kubasiak hints that Torshen sold out the class to Continental (which was eager to buy) in exchange for a $305,000 mess of potage. The danger of collusive settlements - vividly described many years ago by Justice Jackson in Cohen v. Beneficial Industrial Loan Corp., 337 U.S. 541, 549-50, 93 L. Ed. 1528, 69 S. Ct. 1221 (1949), and rendered much greater than in the ordinary litigation by the tenuousness of the control exerted by the client (principal) over the lawyer (agent) - makes it imperative that the district judge conduct a careful inquiry into the fairness of the settlement to the class members before allowing it to go into effect and extinguish, by the operation of res judicata, the claims of the class members who do not opt out of ...