A drama is playing out in Boston federal court before a respected judge that could prove to be a legal “Watergate,” one that could reshape class action practice.[1] Combining elements that are both sordid and comic, this litigation has already shown that the leading experts on legal ethics disagree significantly over what must be disclosed to the court approving a class action settlement. More importantly, although this episode could prove to be an isolated aberration, the other possibility is that the behavior at issue in this case may occur regularly. As all New York City tenants know when they see a single cockroach crawl across their kitchen sink, that lone example may have many cohorts lurking just beneath the surface. There is never just one cockroach. Put differently, an active market may today exist in which politically connected attorneys charge extraordinary contingent fees, requiring payments in the millions of dollars, for introducing and connecting prominent plaintiffs’ law firms with public pension funds and other institutions capable of serving as lead plaintiffs in major class actions.[2] The attorney who plays this hidden brokerage role does no work on the case, makes no appearance in court, and may not be known to the client, most of the class counsel in the case, the class representatives, or the court!

Our story begins on a benign note. A group of plaintiffs’ law firms bring and ultimately settle three class actions against State Street Bank and Trust Company, alleging unfair and deceptive practices by the bank, which served as the custodial bank for public and private pension funds in conducting foreign exchange transactions. These consolidated class actions settled for $300 million, and Judge Mark Wolf approved the settlement on November 2, 2016, and awarded plaintiffs’ counsel an approximately 25 percent fee award–or, more specifically, $74,541,250 in attorneys’ fees and $1,257,699.94 for expenses.[3] This was not a securities class action, and thus the Private Securities Litigation Reform Act (“PSLRA”) did not apply.[4] Rather, this was a new style of consumer class action that grew out of an earlier California qui tam cause of action that first revealed that custodial banks were overreaching public pension funds. Counsel in both that successful qui tam action and the first subsequent class action raising similar claims (which was against the Bank of New York Mellon) were Lieff Cabraser Heimann & Bernstein, LLP (“Lieff Cabraser”) and the Thornton Law Firm (“Thornton”).[5] Their class action settled in the Southern District of New York in September 2015 for $355 million, plus other fines and penalties paid to public agencies.[6] In the State Street litigation, class counsel was Labaton Sucharow LLP, which had had a longstanding relationship with the lead plaintiff, the Arkansas Teacher Retirement System (“ATRS”).  Although the Labaton firm is a recognized and competent player in securities and other class litigation, it is seldom classified (in my judgment) with the preeminent firms of the plaintiffs’ bar, and it brought in Lieff Cabraser and Thornton for their expertise in forex trading litigation. This strategy worked, and a settlement was reached and approved in 2016. But neither Lieff Cabraser nor Thornton nor the other firms in the other consolidated actions seemed to have learned about a special agreement that Labaton had relating to ATRS as a lead plaintiff.

These facts began to emerge when the Boston Globe reported on December 7, 2016, that plaintiffs’ counsel had double counted the hours of some attorneys.[7] As a result, some 9,322.9 hours were overstated, resulting in an overcharge of a little over $4 million. Plaintiffs’ counsel reported this overcharge to the court and suggested that instead of reducing the fee award by the amount of the double counting, the court should just accept that the lodestar multiplier would rise to become 2.0 (instead of the prior figure of 1.60). The court (Senior District Court Judge Mark Wolf) decided instead, after a hearing, to appoint the Hon. Gerald E. Rosen, a retired federal judge from Michigan, as a special master, to conduct an investigation and make a report, compensating him out of the settlement fund.[8]

In the course of conducting this investigation, the special master more or less stumbled across a bombshell: As soon as the court authorized the fee award, Labaton had immediately paid $4.1 million (or 5.5 percent of the total fee award) to Damon Chargois of Chargois & Herron, LLP, an attorney who practiced in Houston, Texas and never appeared in (or worked on) the State Street litigation. This amount was more than double what several other plaintiffs’ firms had received that had worked diligently on the case for years.

Why? Chargois had introduced Labaton to the then executive director of the Arkansas Teacher Retirement System, arranging initial meetings in 2007. As consideration for these services, Labaton had agreed to pay Chargois & Herron “20% of any attorneys’ fees received by Labaton in any litigation involving an institutional investor for whom Chargois had facilitated the introduction, including ATRS…”[9] Chargois was not expected to act as “local counsel” or perform any other services.

In his report, the special master identified at least nine cases in which the Labaton firm paid Chargois a percentage of Labaton’s total fee award.[10] These cases began in 2009 and included both state and federal actions; most were securities class actions, but some were shareholder suits and one was an antitrust class action. In addition, the special master cited press reports to the effect that Labaton was representing ATRS in a pending case alleging that the major U.S. banks had rigged the auction of securities sold by the U.S. Department of the Treasury.[11]

Although the special master was very cautious and restrained in the language he used to describe Chargois’ services, Judge Wolf in his opinion quoted an email that Chargois sent the Labaton firm justifying his services. It stated:

“We got you ATRS as a client after considerable efforts, political activity, money spent and time dedicated in Arkansas, and Labaton would use ATRS to seek legal counsel appointments in institutional investor fraud and misrepresentation cases. Where Labaton is successful in getting appointed lead counsel and obtains a settlement or judgment award, we split Labaton’s attorney fee award 80/20 period.”[12]

These references to “favors” and “political activity” could have criminal law implications, as the Hobbs Act and bribery statutes could be violated if payments were made on a quid pro quo basis to public officials. Press reports have indicated that the Arkansas Legislature has begun an investigation.[13] One would like to know here to whom Chargois may have made payments in respect of ATRS.[14]

This column will not speculate about whom Chargois might have possibly paid off. But $4 million is a lot to pay (in just this case) simply for an introduction. But two conclusions do seem to follow from these facts: First, having an established relationship with a public pension fund is a very valuable asset, which may enable a firm to run the litigation, bringing in other plaintiffs’ firms to supply the intellectual talent. It has long been clear that some pension funds have been “serial plaintiffs,” suing in case after case over a long period.[15] Much has also been written about the “pay to play” system under which plaintiffs’ firms make regular and substantial political contributions to elected state officials who determine whether the pension fund will take part in a securities class action.[16] But even more shadowy practices may enable specialized intermediaries to play a brokers’ role that directs payments to fund officials.

Second, although plaintiffs’ attorneys in securities litigation do face real risk in some cases, there seem to be significant “rents” in the fee award system if they can willingly surrender 20 percent of their revenues (over a series of cases) simply for the introduction. Indeed, because the Labaton firm promised 20 percent of all its revenues in cases in which it represented ATRS, the $4.1 million paid in this case represents only the tip of the proverbial iceberg.

The most bizarre part of this story was yet to come. Once the special master prepared his very thorough 377 page report and the court had indicated its intent to release his findings over the Labaton firm’s objection, Labaton moved to recuse the court on grounds of bias. In a careful opinion at the end of June, Judge Wolf denied this motion, and the First Circuit quickly denied Labaton’s appeal.[17] Next, Labaton sought to disqualify the special master and to preclude him from reaching any additional findings. Here, they may have had some success, as in August, the special master indicated his willingness to reconsider some findings.[18]

This brings us to the critical policy issues. The special master found that Labaton in failing to disclose its relationship with Chargois had violated duties (i) to its client (ATRS), (ii) to the class, (iii) to co-counsel, and (iv) to the court. Specifically, it found:

“The evidence produced during the investigation clearly reveals that Labaton engaged in consistent, conscious, and calculated efforts to conceal Chargois from all the participants in the State Street litigation.”[19]

With respect to the duty to inform ATRS, the special master cited the Massachusetts Rules of Professional Conduct, which appear to require the lawyer to obtain the client’s consent before dividing fees with lawyers outside the law firm.[20] Here, the special master relied on a report prepared for him by NYU Ethics Professor Stephen Gillers, and the Labaton firm in turn retained several other law professors specializing in legal ethics, who predictably disagreed. In my view, Labaton’s experts make very strained arguments, while Professor Gillers was lucid and concise, but most readers will not care about Massachusetts law.

The Labaton firm also owed duties to the entire class, and the special master found that this required them to disclose “that an attorney who did no work on the case would receive $4.1 million from the Settlement fund and that this payment obligation arose from a pre-existing obligation of Labaton’s own.”[21] Here, the special master relied on Rule 23(e)(3) of the Federal Rules of Civil Procedure, which requires that the “parties seeking approval (of a class action settlement) must file a statement identifying any agreement made in connection with the proposal.” In rebuttal, Harvard Law Professor William Rubenstein, a class action expert retained by Lieff Cabraser, opined that fee allocation agreements do not need to be included in the notice to the court.[22] As he described the law, the language of Rule 23(h), which cross references Rule 54 (d)(2) of the Federal Rules of Civil Procedure, thus adopts the language in Rule 54(d)(2)(B)(iv) that a motion for fees must “disclose, if the court so orders, the terms of any agreement about fees for the services for which the claim is made.” Essentially, Professor Rubenstein argued that disclosure of fee allocation agreements need not be disclosed–absent a court order. He testified:

“I’m saying Rule 23 says that the burden’s on the Court.”[23]

Professor Rubenstein also took this position with respect to class counsel’s obligation to disclose the Chargois payments to the court. That is, counsel must disclose to the court such an agreement only if the court orders it. But, because this issue of referral fees has seldom, if ever, arisen before in class actions, most courts will not be aware of the possibility of such a payment out of the settlement fund. In fairness, Professor Rubenstein may be right about the ordinary fee allocation agreement among counsel appearing or working on the case, but this was an extraordinary agreement with a third party who did no work but claimed 20 percent.

Thus, a policy issue arises: If there is to be adequate transparency, courts may need to modify their behavior at class action settlement hearings. Specifically, they need to ask counsel whether payments have been, are being, or will be made (directly or indirectly) out of the settlement fund to lawyers (or other intermediaries) for past, present, or future services related to the litigation (including “introduction” or “referral” fees). To be sure, it might be preferable if a court distinguished Professor Rubenstein’s plausible reading of the  Federal Rules by noting that this is a very material deviation from normal practice that allocated a significant percentage of the fees to a third party and thus was especially material. Or, it might be desirable for the Federal Rules Committee to rephrase the rule. Still, it takes the Rules Committee a decade of debate to move a comma. Thus, it is today too easy for class counsel to hide behind the court’s failure to make a specific order requiring disclosure of fee allocation agreements. For the future, courts that do not ask this question are inviting deception.

Many questions remain unanswered about the Labaton affair. Although the special master worked diligently, we simply do not know if the Labaton firm used this same procedure with other intermediaries to obtain lead plaintiffs in other cases. Have other firms employed similar practices? Even apart from the settlement and fee award context, this same question should be asked at the time a lead plaintiff is selected. Have the lawyers proposing the lead plaintiff paid or incurred any expense or entered into any agreement to compensate others for introducing them to the client? As I suggested at the outset of this article, never assume that there is only one cockroach. More are likely lurking in the woodwork!

Finally, this is a classic case of a governance failure within a law firm. Just as most of the partners at the Dewey firm knew little about the guaranteed compensation payments that sunk that firm, only two or three partners at Labaton understood what they had promised to Chargois.

Many on both sides of the Bar may wish that this episode gets swept under the judicial rug, because it tends to embarrass the Bar. Some had the same attitude when the Milberg Weiss scandal first broke, but four partners were ultimately convicted of fraud offenses in that case. This story also needs a full investigation and a considered judicial evaluation, not a quiet settlement.

ENDNOTES

[1] This story begins with the decision of District Court Judge, Mark L. Wolf, to appoint a Special Master (retired District Court Judge Gerald Rosen of the Eastern District of Michigan) to investigate conceded irregularities in the fee petitions of plaintiffs’ counsel in a large class action. See Arkansas Teacher Retirement System v. State Street Bank and Trust Company, 232 F. Supp. 3d 189 (D. Mass. 2017). But the true explosion came later when the special master’s findings were released in 2018, and one plaintiffs’ firm sought (unsuccessfully) to recuse Judge Wolf after he refused to redact certain findings in that report. See Ark. Teacher Ret. Sys. v. State St. Bank & Trust Co., 2018 U.S. Dist. LEXIS 111320 (D. Mass. 2018). For the Special Master’s very thorough 377 page report, see Ark. Teacher Ret. Sys. v. State St. Bank & Trust Co., 2018 U.S. Dist. LEXIS 111409 (D. Mass. June 28, 2018).

[2] To this author’s mind, it is entirely logical that plaintiffs’ law firms located in New York (or Philadelphia or California for that matter) would use such an intermediary, because they do not interact — socially, culturally or geographically — with the politicians who tend to run state public pension funds (particularly in Arkansas). The issue is not the use of the intermediary, but the disclosures that must be made to the client, co-counsel, the class, and the courts.

[3] See sources cited supra at note 1.

[4] Although there were no formal sub classes, the court regularly refers to two different sets of plaintiffs’ counsel, the attorneys for the “Consumer Class” and the attorneys for the “ERISA Class.” The latter attorneys appear never to have known about the $4.1 million fee to Chargois and objected to it on its disclosure.

[5] The California qui tam litigation was unsealed on October 20, 2009, when the California Attorney General filed a Complaint-in-Intervention against State Street. This litigation had been begun by Lieff Cabraser and Thornton in 2008. For a discussion of the action’s origins, see Special Master’s report, supra note 1, at 10-12.

[6] See In re The Bank of N.Y. Mellon Corp. Forex Transactions Litig., SDNY No. 12-2335. This case settled in September 2015 (after intensive litigation) for $335 million and the chief class counsel was Lieff Cabraser. I should disclose that I served as an expert witness for Lieff Cabraser in this case. Although filed first, the State Street litigation followed in the wake of the BONY Mellon litigation, which served as the template for the State Street litigation.

[7] See Andrea Estes, “Critics Hit Law Firms’ Bills After Class Action Lawsuit,” BOSTON GLOBE, December 17, 2016.

[8] See 232 F. Supp. 3d 189. At this point, only double counting and the inflated rates of some contract attorneys were at issue.

[9] See Special Master’s Report, supra note 1, at 92.

[10] Id. at 124.

[11] Id. at 124-25, n. 10 (describing In re Treasury Securities Auction Antitrust Litig., as a “multi-trillion dollar action” in which Labaton is again representing ATRS). This raises the prospect (still very remote) of a multi-billion payment being owed to Chargois.

[12] See Ark. Teacher Ret. Sys. v. State St. Bank & Trust Co., 2018 U.S. Dist. LEXIS 111320 (D. Mass. June 28, 2018) at *10.

[13] See Scott Flaherty, “Labaton Fee Deal in State Street Case Prompts Arkansas Legislative Inquiry,” The American Lawyer, August 2, 2018.

[14] If Chargois made no payments to politicians, fund officials, or related parties in Arkansas, this deal may have been honest, but it represents one of the dumbest blunders (and largest overpayments) that a plaintiffs’ firm has ever made.

[15] The most notorious example may be the Louisiana Municipal Police Employees’ Retirement Fund (or “LMPERS”). See Erika Fry, “Louisiana Pension,” FORTUNE, September 18, 2014. The Chamber of Commerce has long demanded reforms. See U.S. Chamber Institute for Legal Reform, “Frequent Filers: The Problem of Shareholder Lawsuits and the Path to Reform”, February 2014. This column is not endorsing any legislative reforms.

[16] For example, see “Pay-to-Play Torts,” Wall Street Journal, October 31, 2009 (alleging that Labaton had given $58,000 to the Massachusetts State Treasurer and $47,000 to the New York State Comptroller who is the sole trustee for the New York State pension fund). The New York Daily News has reported that the New York State Comptroller “has raked in more than $200,000 in campaign cash from law firms looking to represent the state’s pension fund in big-money suits.” Id.

[17] For Judge Wolf’s decision, see supra note 1. In late July 2018, the First Circuit declined Labaton’s petition for a writ of mandamus. See Chris Villani, “1^st Circ. Denies Labaton Bid to DQ Judge in $75M Fee Fight,” LAW 360, July 25, 2018. This author finds it difficult to believe that Labaton sought a writ of mandamus on this issue, and it suggests more than a hint of desperation.

[18] See Jack Newsham, “Special Master to Reopen $4M State Street Fee Probe,” Law 360, August 2018.

[19] See Special Master Report, supra note 1, at 247.

[20] Rule 1.5(e) of the Massachusetts Rules of Professional Conduct (as in effect in 2011) stated that a division of fees between lawyers not in the same law firm, required disclosure to the client and client consent and that “the total fee is reasonable.” Id at 251 Experts retained by Labaton found ways to distinguish this rule, but they did not convince the special master, the court, or me. Another applicable Massachusetts Rule (Rule 7.2(b) was also debated, but is outside this column’s interests.

[21] See Special Master Report, supra note 1, at 274.

[22] Id. at 278.

[23] Id. at 279-280.

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.