Third Circuit Rejects Settlement Class Certification Because District Court Conducted an Unnecessary Merits Inquiry in Addressing the Adequacy of the Named Plaintiffs

December 16, 2010

The Third Circuit’s landmark decision in In re Hydrogen Peroxide Antitrust Litig., 552 F.3d 305 (3d Cir. 2008), put that court squarely in the forefront of the evolving class action jurisprudence on a trial court’s obligation to resolve any factual, expert and legal dispute that is necessary to determine whether Rule 23’s class certification requirements are satisfied-even if the dispute overlaps the merits of the claims or defenses in the case.  A recent decision from the same court confirms an essential corollary to that rule.  A trial court errs if it resolves a merits-related issue that is not necessary to the determination of whether the class certification requirements are met.

In In re: Community Bank of Northern Virginia, 622 F.3d 275 (3d Cir. 2010), the Third Circuit vacated the certification of a nationwide settlement class because the trial court applied the wrong legal standard in assessing whether the named plaintiffs’ and their counsel’s decision to assert claims under one federal statute but not another made them inadequate representatives of the putative class.  The appellate court concluded that the lower court conducted an unnecessary (and likely incorrect) inquiry into the merits of the statute of limitations defense and instead should have focused on (a) the existence of an intra-class conflict that might require the creation of subclasses and (b) the justifications class counsel gave for their decision not to plead the claims that the objectors asserted would increase the value of the case.

The litigation involved a proposed nationwide settlement class of some 44,000 homeowners with home equity loans from two banks in what the plaintiffs alleged was a predatory lending scheme designed to charge excessive loan origination and title service fees.  The named plaintiffs asserted claims under the federal Real Estate Settlement Procedures Act (“RESPA”), 12 U.S.C. § 2601 et seq., which permits persons charged settlement service fees that violate the statute to recover three times the amount of the fees involved in the violation.  But they did not assert any claims under the federal Truth-in-Lending Act (“TILA”), 15 U.S.C. § 1601 et seq., or the related Home Ownership and Equity Protection Act (“HOEPA”), id. § 1639, which permit recovery of actual and statutory damages when certain specified disclosures are omitted or misstated.

Claims under RESPA, TILA, and HOEPA are all governed by a one-year statute of limitations.  In the six consolidated cases before the Third Circuit, every one of the 19 named plaintiffs closed on their home equity loan more than a year before the first lawsuits were filed.  Their complaints alleged an entitlement to rely on equitable tolling of the statute of limitations.  By contrast, some 14,000 of the 44,000 putative class members did not need the equitable tolling doctrine because their loans closed less than a year before the first lawsuits were filed.

The district court determined that the named plaintiffs’ and their counsel’s failure to assert TILA/HOEPA claims did not make them inadequate representatives under Rules 23(a)(4) and 23(g) because (1) no new named plaintiff attempting to assert TILA/HOEPA claims could satisfy Rule 15(c)’s conditions for “relat[ing] back” to the original complaints and (2) no absent class member could rely on equitable tolling to save an otherwise untimely TILA/HOEPA claim.  The Third Circuit was skeptical of the district court’s Rule 15(c) analysis and expressed “doubts” regarding its determination on equitable tolling-but concluded that “the merits inquiries the District Court conducted here . . . were unnecessary to evaluate the adequacy requirement[.]”  622 F.3d at 295-301, 303.  While re-affirming the principle it established in its earlier decisions in Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 259 F.3d 154, 168 (3d Cir. 2001), and Hydrogen Peroxide, 552 F.3d at 317, that a preliminary inquiry into the merits may sometimes be necessary to determine whether class certification requirements are met, the court ruled that the trial court’s inquiry into the merits of the statute of limitations defense here was not necessary.

Instead, the district court should have focused on the intra-class conflict that existed between those members (including all 19 named plaintiffs) who needed to rely on equitable tolling to save otherwise untimely claims and those who did not need to rely on equitable tolling because their claims were timely.  Specifically, the lower court should have considered whether the creation of subclasses would remedy the problem.  622 F.3d at 303-4.

The Third Circuit also concluded that class counsel’s decision not to assert the TILA/HOEPA claims “deserves more scrutiny.”  Id. at 305.  The court noted that the settling parties appeared to be arguing simultaneously that the RESPA claims were timely because of equitable tolling but that the TILA/HOEPA claims need not have been asserted because of a statute of limitations problem.  Also, because the lower court focused solely on the statute of limitations issue, it had not addressed the other reasons class counsel gave for their decision not to assert TILA/HOEPA claims.  The Third Circuit remanded the case to permit the lower court to address those justifications under Rule 23(g).