For plaintiffs’ counsel, one of the most important questions in a class-action settlement is how they will get paid. In McDaniel v. County of Schenectady, the Second Circuit explicitly compared the various methods of determining attorneys’ fees in class actions. McDaniel was a civil-rights case challenging strip-search policies for pretrial detainees. Approves settlement of the class action. The lower court approved the settlement, but awarded less in fees than the plaintiffs would have wanted. The analysis provides a good discussion of the advantages and disadvantages of both lodestar and percentage fees.

The case took three years of "vigorous" litigation, and approximately 1000 hours of plaintiff time. (Does this seem like a lot? It’s six months of billing for a single defense associate, but for many smaller-firm practitioners, it may be close to an uninterrupted year of work.) At that point, the parties were ready to settle. The district court approved the settlement, but used a lodestar method to calculate attorneys’ fees instead of a percentage of the common fund. The plaintiffs appealed.

The Second Circuit began by noting that

Although we have acknowledged that "the trend in this Circuit is toward the percentage method," it remains the law in this Circuit that courts "may award attorneys’ fees in common fund cases under either the ‘lodestar’ method or the ‘percentage of the fund’ method."

So it looked at the differences between lodestar and percentage of fund.

The lodestar method is not perfect. It creates an incentive for attorneys to bill as many hours as possible, to do unnecessary work, and for these reasons also can create a disincentive to early settlement. Under certain conditions, moreover, lodestar awards can create the near opposite incentive, encouraging attorneys to settle before trial even when it is not in their clients’ best interest. While under the lodestar method lawyers share the "downside" risk of trial (i.e., the possibility of an adverse judgment, and hence no fee), they do not share in the potential economic "upside" (i.e., fees as a percentage of a large common fund), especially since trial requires comparatively fewer hours than the process of trial preparation.

(Emphasis added, internal citations omitted.) That said, the court also found problems with awarding a percentage fund:

As we indicated in Goldberger, this Circuit’s adoption of the lodestar method was precipitated by the perception that percentage fees "tended to yield too little for the client-class, and an unjustified ‘golden harvest of fees’ for the lawyer." Particularly in cases that result in a very large monetary award, the percentage method holds the potential to result in attorneys’ fees many times greater than those that would have been earned under the lodestar of hourly rate multiplied by hours worked. The principal analytical flaw in Appellants’ argument for a presumptive percentage award as a "benchmark" in common fund cases lies in the assumption that there is substantial contingency risk in every common fund case that would justify such a multiplier.

Moreover, although the percentage method has the advantage of aligning the interests of plaintiffs and their attorneys more fully by allowing the latter to share in both the upside and downside risk of litigation, it can create perverse incentives of its own, potentially encouraging counsel to settle a case prematurely once their opportunity costs begin to rise.

(Emphasis added, internal citations and quotations omitted.) It’s interesting that neither fee award seems to align the interests of the class with the interests of the lawyers. While some might argue that aligning those interests shouldn’t matter, others view this inability to align incentives as one of the central struggles in class-action practice

Ultimately, the Second Circuit affirmed the district court’s use of the lodestar method. So how is this case useful for defense counsel? Aside from providing a balanced critique of percentage-of-fund fees (which can be more expensive for defendants), it lays out very clearly the advantages and disadvantages of the different methods of calculating attorneys’ fees in class-action settlements.