Many judges, mediators and litigators don’t yet have a working familiarity with Internal Revenue Code § 468B settlement funds (“468B Funds,” “Section 468B Funds,” or just “Funds”). These Funds are a settlement tool that is widely underused due to lack of familiarity with what they are and when and how to use them. The aim of this article is to help attorneys, ADR professionals and judges recognize when and how Section 468B Funds may be used to benefit all settling parties while promoting efficient use of attorney time and court time.
What Are Section 468B Funds?
Section 468B Funds exist as a temporary vehicle, or way station, in the handling of settlement proceeds: defendants obtain a binding release from liability by making a tax-deductible payment into a court or government-approved Fund; and claimants,1 who have no tax consequence as a result of this payment into a Fund, can then take as much time as they need to sort out important issues of their own such as allocating settlement shares, resolving liens (which sometimes involve complex pay-back and set-aside issues as to Medicaid and Medicare), and deciding on a form of distribution that will best serve each claimant’s unique needs (whether cash or structured settlements or special needs trusts to preserve eligibility for certain government benefits).
The procedure for creating and using a 468B Fund is as follows:
- Either litigating party petitions the court to order that a 468B Fund be established;
- The Fund is established, and the court appoints an administrator to oversee it;
- Each settling defendant pays an agreed amount into the Fund and is then released from liability pursuant to a settlement agreement which includes the Fund as a party and which must be approved by the court;
- With claimants’ consent, the Fund assumes the liability of all settled claims, and its administrator then proceeds to settle in an individualized way with each claimant; and
- Subject to court approval, the Fund’s proceeds are distributed pursuant to these individualized settlements, and the Fund is then dissolved.
In some respects, Section 468B operates like interpleader. That is, the interpleader “plaintiff” turns a disputed asset over to the court and lets everyone else fight over it, provided he or she is let off the hook. Similarly, the 468B defendant turns an agreed settlement amount over to a court-approved Fund and gets a binding release that is expressly approved by the Fund’s establishing authority. Section 468B also operates as a novation in that settling plaintiffs expressly agree: (i) to accept a sum certain in exchange for global release of all settling defendants; and (ii) to look solely to the 468B Fund (rather than to defendants) to satisfy all liability for their asserted claims.
Statutory and Regulatory Background.
In 1986, Congress added section 468B to the Internal Revenue Code (“I.R.C.”).2 At that time, I.R.C. § 468B conferred two advantages on defendants and liability insurers when settling tort cases. First, the statute gave these taxpayers the certainty of being allowed a current tax deduction in the amount of their payment into a 468B Fund. Before enactment of I.R.C. § 468B, defendants and their liability insurers could not deduct the amount of a settlement payment until economic performance was deemed to have occurred.3 Second, the statute enabled these taxpayers to settle class actions and other large tort claims before class members’ (or individual claimants’) shares of an overall damage award had been determined. This allowed defendants to disengage from litigation and to exit from the scene with a binding release in hand at an earlier juncture than would otherwise have been possible.
A 1988 amendment allowed the Treasury to develop regulations concerning the taxation of such funds,4 and in 1993 they defined a new type of 468B Fund called a “Qualified Settlement Fund” (“QSF”).”5 While Designated Settlement Funds (“DSFs”) are used only for tort settlements, QSFs may be used to resolve any claim “[a]rising out of a tort, breach of contract, or violation of law” (emphasis added).6 Also, a DSF requires a court order, whereas a QSF qualifies for I.R.C. § 468B tax treatment if established or approved by and under the continuing jurisdiction of any federal or state agency.7 Fund administrators must ensure that documentation in each transaction complies with applicable tax rules.
When and Why Are 468B Funds Used?
The original impetus for Section 468B Funds was to help defendants and their liability insurers solve tax and related financial problems in settling large class-action tort cases. In recent years, the use of 468B Funds has frequently been initiated by plaintiffs’ counsel who recognize their value as a settlement planning tool. Good settlements require careful planning, and 468B Funds provide breathing room for claimant-specific settlement issues to be addressed as needed.
Often, adequate time for good settlement planning simply isn’t available because settlements occur very quickly in the pressure cooker of litigation. When an acceptable settlement is within grasp, the defense typically wants to terminate litigation and extinguish liability as quickly and efficiently as possible. Plaintiff’s counsel wants to get paid and needs to recoup costs. This introduces a tension, particularly in larger cases and those with multiple claimants, because these cases have a myriad of issues to be addressed before all claimant-specific terms of a settlement can be resolved and settlement funds disbursed. Section 468B Funds help all these stakeholders meet their respective needs.
There is an important, and still unresolved, tax issue whether 468B Funds may be used at all in cases involving a single claimant as opposed to multiple claimants or multiple occurrences. The underlying tax problem is that, with a single-claimant 468B Fund, that taxpayer may be deemed to have the economic benefit of proceeds as soon as they are transferred into the Fund. Until Congress or Treasury issues clear determinations or guidance, courts and counsel should be very cautious about approving or using 468B Funds in single-claimant cases. Some of the advocates for using single-claimant 468B Funds propose that lienholders (like Medicare or Medicaid) have their own separate and additional claims against the Fund, but there is no tax authority for this position, and it should be viewed cautiously by counsel and skeptically by courts when petitioned to approve a Fund involving a single plaintiff or claimant who sustained the legal harm giving rise to the claim or controversy.8
Section 468B Funds are useful because they provide a neutral space that simultaneously serves the needs of plaintiffs and defendants:
- Efficient dispute resolution for a settling defendant, who pays an agreed amount into the Fund in exchange for a clear and binding release with court approval;9 and
- A safe harbor for claimants who need breathing room to resolve their own important issues before any particular form of distribution is decided upon and before tax and other financial results are locked in place upon “receipt” of settlement proceeds.
Meanwhile, the establishing court (or governmental authority) retains supervisory control over the 468B Fund, but does not need to become involved in actual Fund administration.
What Are the Mechanics of Setting Up and Operating a 468B Fund?
The procedure for setting up and operating a Section 468B Fund is fairly straightforward. These Funds are established via motion practice which varies somewhat from jurisdiction to jurisdiction. Here is a typical example showing how counsel and/or the Fund administrator interact with a court and with settling parties in setting up, running and terminating (winding up) a 468B Fund. Procedurally, the following steps need to occur in some way, which may be separately or concurrently as appropriate.
Creating the 468B Fund.
- Plaintiffs, settling defendants, or some combination of these parties move the court for a discretionary order to approve establishing a 468B Fund, and to provide for a complete release of liability for each settling defendant (and its liability insurer) upon payment of an agreed amount into the Fund’s account.10
- Simultaneously, any litigating party moves the court to enter an order appointing an administrator for the 468B Fund and to establish terms of the Fund’s administration.11
- The Fund administrator files a notice of acceptance of this appointment, submitting the Fund’s administration to the jurisdiction of the establishing authority.
- Administering the 468B Fund. Pursuant to the terms of the Fund’s administration, the Fund’s administrator does its business as follows:
- The administrator moves the court (or governmental authority) to enter its order approving settlement by and among plaintiffs, the Fund and any settling defendants, dismissing them with prejudice.
- Pursuant to court authorization, the administrator makes an initial distribution of attorney fees and costs to plaintiffs’ counsel,12 and of negotiated lien amounts to lienholders.
- The administrator files a declaration of supporting materials, which typically includes the following:
- The Settlement Agreement, Assignment and Release of Claims by and among plaintiffs, the Fund and settling defendants;
- Confirmation that all liens identified by claimants and their counsel have been addressed; and
- The Settlement Agreements and Releases between the Fund and each claimant.
- With court approval, the administrator then signs Settlement Agreements and Releases with all claimants.
- The administrator moves for an order approving the distributions to all claimants and to any remaining lienholders, certifying the individualized Settlement Agreements and Releases, and authorizing disbursement of remaining settlement proceeds pursuant to those agreements.
- Terminating the 468B Fund. When the Fund’s business is over and all of its liabilities have been met, the Fund is wound up, remaining assets are distributed, and the Fund terminates.13
How Are 468B Funds “Supervised” by a Court?
There is no federal statutory or regulatory guidance on how to supervise a Section 468B Fund. Some United States district courts have local rules of civil procedure (typically under Rule 67) that refer incidentally to DSFs, QSFs or Section 468B Funds.14 Local rules under Rule 67 of the Federal Rules of Civil Procedure merely govern the deposit, receipt, and treatment of court registry funds, and do not provide actual guidance for supervising Section 468B Funds as they are used in regular practice (except to the very limited extent a court registry happens to be used for this purpose, and in a jurisdiction having a rule of this type).
Over time, however, courts have gained practical experience in working with 468B Funds, and a growing body of case law shows judicial flexibility and practicality in doing so. Some of this case law is discussed below in the context of “practice pointers” for courts and for litigating attorneys.
Petitions to establish a 468B Fund.
Some plaintiffs have petitioned unilaterally to establish a Fund–over a defendant’s objection–and have argued that they “have a right” to force the defendant to put settlement monies into a 468B Fund (reasoning that the defendant gets a complete release and so should not care whether its check is written to the 468B Fund or to the claimants directly). This idea was soundly rejected in a 2006 case, where the U.S. government agreed with plaintiffs on a cash amount to settle all claims, but the parties did not reach agreement as to terms for structuring the settlement.15 Courts cannot create settlement agreements in the absence of party agreement.
Treasury regulations do not require that a 468B Fund be created in the same proceeding, by the same court, or even in the same state as the underlying claim or action.16 Regardless of whether a Fund’s establishing and supervising authority is the same or a different authority than the one that presided over the underlying claim, the judicial considerations that should apply when ruling on a petition to establish a 468B Fund remain the same. That is, where there is an objection to establishing a 468B Fund, the court should consider those objections and require the petitioning parties to show (i) that the benefits of establishing the Fund outweigh burdens imposed on the court in supervising it, and (ii) that defendants will not be prejudiced by using a 468B Fund to settle claims against them. Where there is no objection to establishing a 468B Fund, the court still has discretion to approve or deny doing so and should evaluate whether the benefits of establishing the Fund will outweigh burdens imposed on the court in supervising it.
Selection of a Fund administrator.
A Fund administrator is in many respects like a Special Master. If the Fund administrator performs his or her duties competently and responsibly, the court’s role in “supervising” a Fund is much easier. Here are some points to consider when petitioning a court to appoint a Fund administrator.
- Who chooses the Fund administrator? Responsibility for choosing a Fund administrator usually falls to the plaintiffs’ attorneys. Nothing in the federal statute or regulations specifies who may be a Fund administrator. Before counsel select or the court approves a Fund administrator, consider the range of duties this person will be charged with handling, and appoint someone who is qualified to perform these tasks. Selection and approval of a qualified person should not be taken lightly. Fund administrators have a number of duties that are inherently fiduciary in nature.
- Fiduciary duties. Duties that are fiduciary in nature include complying in all respects with the order establishing the Fund and the terms of its administration. Upon receiving settlement funds (typically, but not necessarily, cash), the Fund administrator holds and invests the settlement assets; represents and protects the interests of all claimants against the Fund; and files and pays the Fund’s liabilities including any tax liabilities.17 The parties may wish to choose and the court may prefer to appoint a fund administrator who is already held to fiduciary standards under applicable state law, for example, a corporate trustee. Where the parties choose and the court appoints a fund administrator who is not independently held to fiduciary standards under applicable law, it may be in claimants’ and their counsels’ interest to assure that a performance bond be posted.
- Investment and accounting duties. Although not required, Fund administrators are well advised to use (and supervising courts to require) an independent corporate or banking entity to hold and invest all settlement proceeds. This is a simple way to provide regular (monthly) accounting statements that can be furnished as needed to the supervising court, and to all interested parties.
- Negotiating duties in allocating settlement shares. The Fund administrator works directly with counsel for claimants (and with the claimants themselves, as needed) to allocate settlement shares. If there is a deadlock in allocating settlement shares, the administrator may use Fund proceeds to hire an independent mediator or even an arbitrator, if the terms of Fund administration so provide.
- Advising as to forms of distribution. If a particular Fund administrator is competent to advise claimants (and their counsel) as to available forms of distribution that may be appropriate for them, he or she may certainly do so. If the Fund administrator lacks this skill set (or if claimants and their counsel prefer), claimants and their counsel may retain their own advisors for this purpose.18
Terms of Fund administration.
One of the court’s key roles in supervising a 468B Fund is to review, before approving, the proposed terms of Fund administration. Here are a few practice points for courts and counsel to consider.
- Restrictions on handling Fund proceeds. As mentioned above, the order establishing the Fund should require that an independent corporate entity hold and invest all settlement proceeds. Also, the terms of Fund administration should define permissible investments.19
- Compensation of the Fund administrator The method of compensating a Fund administrator can give rise to conflicts of interest. For example, if, in addition to the administrator’s other duties, he or she will serve as the broker for any structured settlement annuities purchased to fund periodic payments to claimants, this gives rise to a conflict of interest when advising claimants as to the form of their distribution (i.e., structured settlement or no structured settlement). Likewise, this may also influence that administrator’s judgment when negotiating with claimants and their counsel as to allocation of settlement shares (i.e., seeking to allocate more settlement proceeds to claimants who use a structured settlement rather than some other form of distribution). The potential for conflict is lessened (but not eliminated) if the administrator is compensated strictly on an hourly basis or some other basis not linked to commissions earned on sale of financial products.20
- Subrogation and reimbursement claims The relationship between the 468B Fund and any liens and subrogation rights should be considered before a defendant transfers assets into the Fund. In effect, a 468B Fund shifts the issue of lien resolution away from the contributing defendant who settles, and into control of the court. An instructive example of how lien rights intersect with 468B Funds is provided by the settlement of a complicated drug product liability class action.21
- Disagreement as to allocation of the settlement shares The terms of Fund administration should always provide how to resolve disputes among any claimants who cannot (voluntarily) reach agreement as to allocation of settlement shares. Some provision for mandatory arbitration is usually advisable.
- Petition for distribution of Fund proceeds.
Before approving distribution of proceeds from the Fund, the court needs to be assured by the Fund administrator that all liabilities of the Fund have been addressed. This should always be documented in the case file so that the Fund’s business may then be wound up.
While their respective roles differ, judges, ADR professionals and litigators each have professional responsibilities that relate to achieving successful settlements. Armed with a better understanding of Section 468B Funds, courts will respond more knowledgeably and effectively when petitioned to approve them. Hopefully, mediators and arbitrators will be sufficiently informed about this settlement tool so they can identify appropriate cases and, with those parties’ consent, integrate 468B planning as part of their mediation or arbitration process. And, most importantly, litigating attorneys are the ones who need to identify cases where their respective clients will be better served by using a Section 468B Fund, plan for that possibility as early as possible in those cases, and be aware of available resources to assist as needed.22