A large class action lawsuit is most corporations’ worst nightmare. Even in a case where the damages sought by each member of the class are miniscule and the merits are questionable, the stakes are high. The cost to defend a class action suit can be astronomical, and many statutes allow the lawyers for prevailing class plaintiffs to recover their attorneys’ fees from the defendant.

However, the landscape for class action litigation is rapidly evolving in some surprising ways. Many of the recent changes are favorable to defendants, simultaneously limiting the size of potential classes and allowing companies to contractually reduce their exposure to class litigation. Several forces are driving this evolution, but the most powerful one by far is the Supreme Court, which has been steering a steady course towards limiting the rights of class action litigants. Savvy companies can take advantage of the recent changes to greatly reduce their risk for potential class actions.

Arbitration Nation

Corporate defendants have long perceived arbitration as a superior method for resolving their disputes with employees and customers. Compared to litigation in court, arbitration is seen as more efficient, less costly and more likely to yield a predictable and fair result.

With a series of decisions throughout the past several years, the Supreme Court has announced a strong policy in favor of permitting companies to enter into arbitration agreements that limit plaintiffs’ ability to file class proceedings.

The trend began with the 2010 decision in Stolt-Nielsen S.A. v. AnimalFeeds International Corp. In that case, the court found that an arbitration panel could not force the parties to arbitrate as a class where their arbitration clause was silent on the issue of whether class arbitration was permitted. The 2011 decision in AT&T Mobility v. Concepcion took this concept a step further. There, the Supreme Court struck down a California law that guaranteed plaintiffs the right to litigate claims on a class action basis and barred companies from forcing their customers to submit their claims to arbitration. The court ruled that the Federal Arbitration Act preempted the California law.

The Supreme Court’s June decision in American Express Co. v. Italian Colors Restaurant is perhaps the court’s strongest statement yet in favor of agreements that bar class arbitration. The court ruled that small businesses challenging part of the American Express merchant contract under antitrust law did not have the right to arbitrate their claims on a classwide basis despite the fact that the cost of arbitrating an individual claim would likely exceed the individual plaintiff’s potential recovery if they won their claims.

The upshot of these decisions is that companies can feel very confident that arbitration agreements that bar plaintiffs from arbitrating as a class will be enforceable.

“The lower courts are going to have a harder time invalidating arbitration agreements,” says Tony Lathrop, a member of Moore & Van Allen. “The theme throughout these cases is the Supreme Court’s desire to emphasize the Federal Arbitration Act. Arbitration agreements, where clearly spelled out, should be upheld.”

Clearly spelling out the terms of the agreement may prove to be the key to effectively managing liability through arbitration. The June Supreme Court decision in Oxford Health Plans v. Sutter demonstrates the perils of an imprecise agreement. There, a doctor brought a proposed class action against Oxford. The agreement stated all disputes would be arbitrated, but was silent on the issue of whether class arbitration was permitted. The arbitrator determined that it should be read to allow class arbitration. On appeal, the Supreme Court upheld that interpretation, finding that the arbitrator’s interpretation of the contract was entitled to deference as long as the arbitrator was arguably construing the language of contract—even if the reviewing judge thinks the arbitrator’s interpretation is clearly wrong.

That leaves Oxford in a difficult position—class arbitration often does not provide sufficient procedural safeguards that the result will be immune from a later court challenge by members of the class, but an unhappy defendant has little opportunity to appeal the arbitrator’s decision.

“Class arbitration is a scary proposition because it’s a one-way street,” says Mike Pennington, a partner at Bradley Arant Boult Cummings. “If the class wins, the defendant is stuck. If the defendant wins, it has no binding effect on the class.”

Moreover, despite the Supreme Court’s policy in favor of arbitration, lower courts are still wary of enforcing arbitration agreements that go too far in limiting plaintiffs’ rights. The key is not being too aggressive. There are several mistakes that companies make that result in an arbitration agreement being rejected.

“Arbitration clauses could still be found unenforceable where they would restrict a plaintiff’s statutory rights,” says Jennifer Patterson, a partner at Kaye Scholer. “For instance, a clause that says each party to an antitrust dispute bears its own costs of arbitration and prevents an award of attorneys’ fees could be contrary to the Sherman Act and could be invalidated.”

Likewise, even in light of the decision in Italian Colors Restaurant, arbitration agreements that set too high a cost threshold for getting to the arbitration forum may be found unenforceable.

“While cost alone isn’t a valid ground to overcome a class arbitration waiver, many corporations that want to avoid class actions are adopting the cost-sharing model from Concepcion,” Lathrop says. “There the defendant made it less difficult for plaintiffs to bring individual claims by providing some cost assistance. If a plaintiff won his case and obtained more than AT&T had offered in settlement, the company agreed to pay $7,500 and double attorneys’ fees. The court cited that in upholding the agreement.”

Duke-ing It Out

In Wal-Mart v. Dukes, lawyers representing female employees of Wal-Mart famously sought to certify the largest-ever class action—a proposed class of approximately 1.5 million people who claimed that systemic discrimination against women limited their pay and promotion opportunities at the discount retailer. After more than a decade of litigation, the Supreme Court determined in 2011 that the Dukes class could not be certified because there would be no way to establish on a classwide basis whether each member of the class was a victim of discrimination or whether there were legitimate reasons for her particular employment situation.

The Supreme Court raised the bar for class certification, mandating that in considering certification petitions, courts must look beyond whether plaintiffs are able to pose questions of fact and law common to the class members. Rather, the court held, courts must examine whether there is evidence applicable to all members of the class that could be presented at a single trial to prove liability on a classwide basis.

The impact of that decision was amplified by the March decision in Comcast v. Behrend, in which the Supreme Court held that the mandates of Dukes also apply to damages. Therefore, plaintiffs seeking class certification need to show that damages can be proved by a formula applicable to all members of the class without individualized inquiries into the class members’ particular losses.

“The court explained that the key to the analysis of whether certification is appropriate is not just whether there are common questions relevant to the whole class, but whether there are common answers to those questions,” Pennington says. “Plaintiffs have to show that each element of the claim, including damages, can be established on a classwide basis.”

Already Dukes and Comcast are transforming the process of certifying class actions. For example, in the 7th Circuit case Espenscheid v. DirectSat USA, Judge Richard Posner applied the reasoning of Dukes to a Fair Labor Standards Act collective action and determined that a class of 2,300 workers who claimed that they were not paid appropriately for overtime hours could not be certified because determining each class member’s damages would require a separate evidentiary hearing regarding the hours each person had worked.

“Class actions are no longer the favored method of resolving disputes,” says Weil, Gotshal & Manges Partner Jeffrey Klein. “With Dukes, the presumption is now against certification and courts are applying greater rigor to these petitions.”

Although plaintiffs now face an uphill battle to get large classes certified, there has not been a corresponding decline in putative class action suits. Rather, plaintiffs are trying out new strategies. One is filing multiple smaller and more focused class actions. Another is seeking certification under Federal Rule of Civil Procedure 23(c)(4), which allows courts to certify cases as class actions with respect to particular issues, rather than making the entire case a class action.

Finally, in the wake of Dukes and Comcast, both plaintiffs and defendants are seeing benefits in resolving their disputes in state court, where the rules are less restrictive. For plaintiffs, the advantage is a greater likelihood of certification; for defendants the advantage is a greater ability to purchase a broader peace. While the Class Action Fairness Act might limit the parties’ ability to agree to a no-opt-out settlement of class claims, the same rules don’t always apply in state court.

“One byproduct of all of these decisions is that there are additional incentives and pressures to stay in state court,” Pennington says. “At the settlement stage, you see a fair number of defendants agreeing that state court is a superior place to settle a class action.”

Settlement Strategy

Both plaintiffs and defendants have an interest in being able to reach binding settlements of class action suits. For defendants, settlement can ensure broad protection from future suits by members of the class on whose behalf the case is being settled. For plaintiffs, settlement ensures compensation to the class members without the uncertainty of litigating their claims before a jury.

But unlike in typical lawsuits, class actions cannot be settled without the approval of the presiding judge, who is charged with determining whether the proposed settlement is “fair, adequate and reasonable.” And that judicial evaluation is nowhere near a rubber stamp. Along with mounting negative press for class actions that yield enormous fees for counsel and little relief for class members, courts are becoming increasingly critical of petitions for approval of class action settlements.

“Class action settlements are a unique animal,” says retired Los Angeles County Superior Court Judge Peter Lichtman. “Both sides are advocating for approval, so the judge has to spot the weaknesses in the agreement himself. The judge almost becomes a fiduciary to the class.” Lichtman now serves as a mediator with JAMS.

Several issues are sure to set off alarm bells for judges, and unless handled wisely can sink a settlement agreement. In particular, courts are becoming increasingly critical of settlement funds that revert to the defendant if unclaimed. For instance, a company may agree to put $1 million dollars into a settlement fund to satisfy class members’ claims, but if plaintiffs only submit $50,000 worth of claims, the rest of the money returns to the company. Courts are more likely to approve settlements where the unclaimed funds go to a pre-determined charity that will promote the interests of class members (known as cy-près agreements).

Another hot issue is settlements where the fees being awarded to class counsel are disproportionate to the recovery for the class members. If class counsel is being awarded a million dollars in fees while members of the class are getting coupons worth a few dollars, courts are asking whether the settlement is fair.

“Many courts are saying, ‘we don’t like soft recoveries, we don’t like the fees, and we don’t like the publicity,’” Lichtman says. “The scrutiny isn’t necessarily justified if the suit is yielding a real change in the defendant’s behavior, but the judge needs to be informed about the actual value of the settlement to the class members.”

This is why class action settlements require defense counsel to be intimately involved in drafting highly detailed settlement agreements that clearly outline why the settlement is fair.

“The settlement agreement needs to include the information the judge will want to know, including an explanation of the underlying facts, the fees being sought by class counsel and the value the settlement provides to the class,” says Jennifer Romano, a partner at Crowell & Moring. “It’s unlikely a court will approve an agreement without scrutinizing the underlying facts and the fees.”