In the recently published decision Dennis v. Kellogg Company, No. 11-55674, 2012 WL 2870128 (9th Cir. July 13, 2012), the Ninth Circuit reversed the district court’s approval of a purported $10.64 million settlement between defendant Kellogg and a class of consumers alleging false advertising. The Ninth Circuit rejected the settlement for three reasons: (1) the District Court did not apply the correct legal standard in evaluating the proposed cy pres charities that were to be the recipients of the settlement funds, and thereby abused its discretion; (2) the settlement failed to name the charities that would receive cy pres donations; and (3) the District Court’s award of $2 million in attorneys’ fees, the maximum amount Kellogg had agreed not to oppose, was excessive.

In 2009, a consumer filed a complaint claiming that Kellogg falsely marketed Frosted MiniWheats cereal as scientifically proven to increase children’s cognitive functions. In 2010, after little litigation, plaintiff’s counsel, counsel for a prospective plaintiff, and Kellogg’s attorneys reached a settlement. Among the terms of the eventual settlement, Kellogg agreed to establish a $2.75 million fund for distribution to class members on a claims-made basis. Class members submitting claims would receive $5 per box of cereal purchased, up to a maximum of $15. Any remaining funds would be donated to charitable organizations whose goal was to “feed the indigent.” These charities would be selected by the parties and approved by the court in accordance with the cy pres doctrine, which allows unclaimed portions of class action settlements to be donated to a charity that serves class members’ interests. In addition, Kellogg agreed to distribute another $5.5 million “worth” in Kellogg foods to charities that feed the poor. Lastly, Kellogg also agreed to pay class attorneys’ fees and costs of an amount not to exceed $2 million.

Two class members objected to the settlement, contending that the settlement did not comply with the cy pres doctrine and that the proposed attorneys’ fee award was excessive. The District Court for the Southern District of California approved the settlement over the two class members’ objections, including the full amount of attorneys’ fees sought by plaintiff counsel. Class objectors appealed, contending that the District Court abused its discretion in approving the settlement.

On appeal, the Ninth Circuit reversed the District Court, holding that the settlement failed to meet the “fair, reasonable, and adequate” threshold for approval under Rule 23(e)(2), for three reasons – the settlement (1) incorrectly applied the cy pres doctrine, (2) failed to identify with particularity the charities that would receive donations as a result of the settlement, and (3) awarded excessive attorneys’ fees to plaintiff counsel. In reviewing the District Court’s approval of the settlement, the Ninth Circuit applied a “higher standard of fairness” and engaged in “a more probing inquiry,” because class counsel had negotiated a settlement agreement before the class had been certified.

First, the Ninth Circuit concluded that the District Court had not applied the correct legal standard governing cy pres charitable donations. Under the cy pres doctrine, donations may be awarded in lieu of distribution of monetary relief to class members, but the award must be guided by the interests of such class members and the underlying claims in the case. The settlement was deficient, the Court held, because the subject of the lawsuit was false advertising, not feeding the indigent. To fulfill the goals of the cy pres doctrine, the settlement should have been made “not to charities that feed the needy, but organizations dedicated to protecting consumers from, or redressing injuries caused by, false advertising.”

A second ground for rejecting the settlement, the Court concluded, was the parties’ failure either to name the recipient charities or to specify how the value of the $5.5 million in donated food would be measured.

Finally, the settlement was deficient because it would result in excessive attorneys’ fees. The Court evaluated the $2 million in attorneys’ fees using two common methods: a “percentage of the fund” analysis and the lodestar method. Under the percentage method, the Court calculated the fees as a percentage of the common fund and arrived at 19 percent when the $5.5 million cy pres distribution was included. The Ninth Circuit has established 25 percent as a benchmark for reasonable attorneys’ fees. However, the Court questioned the 19 percent figure in this case, noting that counsel for the parties had not adequately explained how they had measured the value of the cy pres distribution portion of the common fund. When the cy pres portion was excluded, the fees amounted to 38.9% of the monetary relief available to the settlement class, a number the Court considered “extremely generous.”

As a cross-check, the Court used the lodestar method, which involves multiplying the number of hours reasonably expended by a reasonable hourly rate, sometimes employing a multiplier. The Court determined that the $2 million in attorneys’ fees divided by the 944.5 hours counsel worked on the case resulted in a $2,100 hourly rate. Such fees were “impermissibly high considering what the defective settlement provides the class.”

In the wake of Dennis v. Kellogg, counsel drafting settlements including cy pres provisions would be well-advised to assess whether the charities chosen have a sufficient nexus to the facts alleged in the complaint. Dennis v. Kellogg also signals that courts in the Ninth Circuit are likely to carefully assess proposed attorneys’ fee awards, especially with settlements reached before significant litigation has taken place. Finally, as to any in-kind benefits provided in connection with the settlement, counsel should be prepared to support with evidence how the valuation of such benefits was derived.