Chapter 12 Special Considerations in Settlements
§ 12.01 Attorney fee award disposition in settlement
Most cases are settled; not tried. If a statute or case law regarding
your lawsuit provides for an award of attorney fees to the prevailing
party, take special notice of that attorney's fees law during your negotiations for
settlement. If you are not explicit during settlement, questions arise
whether the settlement was intended to include attorney’s fees, and
whether attorney fees were waived.
In the settlement agreement make it clear whether:
there is a waiver of attorney fees as a part of the
settlement, or
the amount of attorney fees has been agreed upon, or
the issue of attorney fees is outstanding — and the court
retains jurisdiction of the case to decide that issue.
Most commonly, when cases are resolved by a settlement agreement, the
parties end the case by a stipulation of dismissal. In Kokkonen v.
Guardian Life Insurance Co.,1 the dismissal order entered
by the parties’ agreement neither incorporated the terms of the
settlement in the body of the order nor reserved enforcement power in
the court. The Kokkonen case held that enforcement of the
settlement agreement was not a matter of a renewal or continuation of
the original case but rather an entirely new contract beach cause of
action. As such, the alleged breach of the settlement agreement had to
be brought as a new action, one that the federal Kokkonen court
observed would have to be brought in state court, because no federal
cause of action was involved in a simple breach of contract case. So
unless jurisdiction of the case is reserved to the trial court to
enforce the settlement agreement, there will be problems of enforcement.
There is a further problem for the party that believes they prevailed
in obtaining the settlement, perhaps even a settlement providing 100% of
everything sought in the pleading filed in the case. If you are not a
"prevailing party," then you are not entitled to an amount for attorney
fees. You do not qualify as a "prevailing party" because of a settlement
agreement — unless the settlement agreement is incorporated into an
order of a court. In the federal courts, Buckhannon v. West Virginia
Department of Health and Human Resources,2 mandated that
unless a court has issued an order which creates a "material alteration
of the legal relationship between the parties" or "a judicially
sanctioned change in the legal relationship of the parties," then there
is no "prevailing party" for an award of attorney fees. State decision
law is tending to follow this pattern for the future. In short, if you
represent the plaintiff, do not settle and dismiss the case, expecting
an attorney fee to be awarded by the court because your settlement
agreement paid the plaintiff money and everything else the plaintiff
wanted.
On the other hand, if the settlement agreement is incorporated into
the dismissal order, and the court retains jurisdiction to
enforce the terms of the agreement in the order of dismissal, then the
court’s order of dismissal based on the settlement agreement becomes the
legal equivalent of a consent decree on the merits. Note the two
separate requirements: incorporation into the decree, and the court’s
retention of enforcement powers.
In a consent decree on the merits, a winning party can be a
"prevailing party."3 A consent decree, in an appropriate
case, may serve as the basis for an award of attorney's fees. If the
consent decree does not include an admission of liability by the
defendant, there needs to be some court-ordered change in the legal
relationship between the parties.4 To define a plaintiff as a
"prevailing party," defendants could agree to a declaration ordered by
the court’s consent decree that plaintiffs have certain rights or that
defendant’s procedures will be improved, or both. If there is neither a
declaration of rights, nor an ordered change in what defendant will do
in the future, nor an admission of liability, a court in an enforcement
proceeding may decline to find the plaintiff was a "prevailing party" or
award attorney fees.
U WARNING. If the defendants insist
on a nonadmission-of-liability clause in a settlement agreement,
plaintiffs' counsel should insist three items: (1) additional or more
specific language defining and implementing relief, (2) a specific
agreement that plaintiffs are the prevailing party, and (3) a specific
agreement that plaintiffs are entitled to attorney fees. Each of these
three items must be included; otherwise a nonadmission-of-liability
clause can be interpreted to mean that as a matter of law the plaintiff
was not a prevailing party. The court (prodded by counsel) can declare
that the parties joint agreement that plaintiff is a "prevailing party"
does not legally make it true, and the court’s decision on the law is
otherwise.
§ 12.02 Settlement tactic for defendants; trap for plaintiff’s
counsel
Some attorneys have gotten caught up in disputes with their clients
and grievance committees because of the lawyer’s faulty understanding of
"who owns the attorney fee award."
Do attorney fees awarded to a prevailing party belong to the
attorneys who labored to earn them or to their clients? The answer to
that question is important in settlements. For example, if the attorney
fee award is likely to be more than the attorney’s fee contract with the
client provides, if the client "owns" the fee award, the client may
benefit by waiving the attorney fee award as a condition of a
comfortable settlement, or may want to keep the awarded attorney fee for
herself. As another example of why that question is important, consider
that the answer to that question of "ownership" of the fee award
determines who must sign the settlement agreement as a party to the
settlement contract.
In some few states, and in some few instances, — if the fee contract
between attorney and client specifies that the attorney fee award will
be the attorney’s fee due from the client, then it is held that the
attorney fees awarded to a prevailing party belong to the attorneys, not
to their clients, absent an agreement to the contrary.5 The
theory of such fee ownership is that to increase public vindication of
fundamental public policies attorneys need assurance that, if they
obtain a favorable result for their client, they will actually receive
reasonable attorney fees, instead of the sum a middle class or poor
client is willing to pay to prosecute the matter.
However, in most states and under most federal statutes, and almost
always in federal court, the reasoning is that where fees can be awarded
to the "prevailing party," the right to receive the attorney fee award
belongs exclusively to that party and not to the party's lawyer, thus
allowing clients – not the lawyer – to bargain with the adversary about
the attorney fees, including waiving statutory attorney fee awards.
6
Generally, the legal theory is that the right to seek and to receive
an attorney fee is a cause of action (or part of it) that the client
owns. Attorneys are ethically forbidden from taking an assignment of the
cause of action they are prosecuting for the client. That means, among
other things, just as the client cannot assign his/her entire liability
cause of action to the attorney, so too the attorney ethically cannot
request the client to assign the right to recover the attorney fee to
the attorney.
This fact of non-assignabilty of causes of action to the attorney for
the client forms the base for a settlement tactic for defendants in
cases involving fee-shifting states authorizing an attorney fee award to
the prevailing party. Here’s why. The norm in most civil rights,
employment, and like cases is for the attorney to undertake the case on
the basis of a contingent fee. Defendants in such cases can use the
tactic of offering a lump-sum settlement that could benefit a plaintiff
but not provide enough for their lawyer’s time investment in the case.
It’s a tactic that works in small damages cases.
For example, suppose a case of racial discrimination in employment,
that the claimant’s attorney has the case on a 33% contingency fee
contract, and has put in $50,000 of time bringing the case up to the
courthouse door. Suppose further that the main economic damage of the
plaintiff is the payment of $20,000 in lost wages until she found
alternative better-paying employment. The defendant offers a total of
$60,000 for a total settlement "including any claim for attorney fees."
To the plaintiff such a settlement sounds good: she gets $60,000,
deducts and pays her attorney $20,000 in accord with the fee contract,
and she winds up with $40,000 for her $20,000 in economic loss. But to
the attorney, he winds up with $20,000 in fees to pay for $50,000 of
time invested.
Alert defense counsel will always issue a demand for production of
the plaintiff attorney’s fee contract. If the fee award is a part of the
issues, then the attorney-fee contract is a legitimate target of
discovery. Once a contingent fee contract is found, the defense always
should think in terms of a lump sum settlement "including any claim for
attorney fees."
There are many civil rights and other cases that present legitimate
claims by an individual where the plaintiff secures an attorney even
though the case is a low-value case with little damages to be recovered
for the injury. Attorneys seek various ways of protecting themselves,
often by fee contract clauses that are not ethically proper or are
otherwise unenforceable. For example, the lawyer in Pony v. County of
Los Angeles7 was working on such a case, and reasonably
expected that the defendant would offer to settle for a small amount
including the attorney fee award. To protect himself he devised a
retainer agreement that transferred a plaintiff's right to seek fees to
the attorney himself -- letting him sue for his fees even after his
client settled. As happens in these cases with regularity, the U.S.
Circuit Court of Appeals held the fee contract clause invalid.
The Supreme Court has held that Section 1988 vests the right to
seek attorney's fees in the prevailing party, not her attorney, and
that attorneys therefore lack standing to pursue them. [citing
numerous cases] . . . Once the prevailing party exercises her
right to receive fees, [assuming the fee contract gives the attorney
the fee award] the attorney's right to collect the vests, and he may
then pursue them on his own. Virani, 89 F.3d at 578. Unless and
until the party exercises this power, however, the attorney has no
right to collect fees from the non-prevailing party, and the
non-prevailing party has no duty to pay them. Id. A prevailing party
may waive her statutory eligibility for attorney's fees as a
condition of settlement. Evans, 475 U.S. at 737-38 (concluding that
42 U.S.C. § 1988 does not create a general rule prohibiting
settlements conditioned on the waiver of fees).
In this case, Pony, the prevailing party, did not exercise her
rights to pursue attorney's fees. To the contrary, she waived them
as a condition of settlement with the County. Accordingly, under the
Court's ruling in Evans and our ruling in Virani, Mitchell has no
standing to pursue attorney's fees merely as a result of his
position as Pony's former attorney.
Mitchell argues that he need not rely on his status as Pony's former
attorney. He contends that he has standing under his retainer
agreement with Pony, whereby she assigned her rights to apply for
attorney's fees to him. If the assignment is valid, Mitchell argues,
he stands in her shoes and may assert her rights to statutory
attorney's fees as if she had asserted them herself. However, Pony's
putative assignment to Mitchell is invalid because the right to seek
attorney's fees under 42 U.S.C. § 1988 is a substantive cause of
action which cannot be transferred contractually.
Pony v. County of Los Angeles, 433 F.3d 1138 (9th Cir.
2006).
§ 12.03 Tax problem in settlements
It is common for parties to settle a case after a verdict. Clients of
the prevailing party normally will assume the award of attorney’s fees
goes to the attorney and hence the attorney fee is not income to be
reported to, or taxed by, the IRS. Clients may make the same assumption
if the settlement agreement provides for payment of an attorney fee
directly to the attorneys. The clients’ assumption is wrong. To prevent
later claims of legal malpractice in the attorney’s advice regarding
settlement, the attorneys for the prevailing party should keep in mind
that the client’s normal expectation may be wrong.
The Internal Revenue Department takes the position that the award of
the attorney fee is owned by the party, not her attorney, and taxes the
full award received by the party, including the attorney fee, even if
the fee is paid directly to the attorney. In cases where attorney fees
exceed the damage awards -- such as in public interest litigation where
relief is injunctive or awards are minimal -- a client could be forced
to pay more in taxes than he or she won in the award.
In the case of a litigation recovery the income-generating asset
is the cause of action derived from the plaintiff's legal injury.
The plaintiff retains dominion over this asset throughout the
litigation. . . . When a litigant's recovery constitutes income, the
litigant's income includes the portion of the recovery paid to the
attorney as a contingent fee.
Commissioner of Internal Revenue v. Banks, 125 S.Ct. 826,
543 U.S. 426, 160 L.Ed.2d 859 (U.S. 01/24/2005). 8
(After the client has paid the IRS, then the IRS gets a second bite
of the apple by taxing the income received by the attorney!)
Plaintiffs in lawsuits alleging employment discrimination and other
civil rights claims fare better on their taxes—if they recovered their
awards after the American Jobs Creation Act became law in October 2004.
A provision in the Jobs Creation Act9 relieves plaintiffs who
settle or win court awards under a broad array of federal and state
civil rights statutes from having to pay taxes on the attorney fee
portions of their awards. Before the American Jobs Creation Act, a
prevailing plaintiff would have had to pay taxes on the entire award
amount. For some taxpayers a deduction is available for the expense of
recovering the income. For others the operation of the Alternative
Minimum Tax10 comes into play and does not allow any
miscellaneous itemized deductions.
Notice the Jobs Creation Act relief statute applies only to
prevailing plaintiffs, not to prevailing defendants. Furthermore, it
does not address awards of attorney fees outside the specified federal
and state civil right statutes.
What all this boils down to is that trial counsel should probably
disclaim professional ability to advise the client on tax consequences,
tell the client the attorney fee may be taxable to the client, and tell
the client to see tax counsel for advice before a settlement, if taxes
are a concern to the client.
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