Confidentiality in Settlement Agreements Is Bad for Clients, Bad for Lawyers, Bad for Justice

You worked for months getting your case ready for trial, and at the final pretrial conference a settlement was finally struck, the trial was cancelled, everyone was happy, and you went back to the office. Weeks later you get the settlement agreement and see it contains something not discussed: a confidentiality clause. Maybe it’s a problem. Maybe not. Either way though, it’s heartburn and more time in a case you thought was over with.

A confidentiality clause seeks to prohibit the parties to a settlement from disclosing the settlement terms and sometimes more. Confidentiality raises numerous problems. This article will discuss perceived and real problems with the use of confidentiality clauses in settlement agreements and tips on dealing with and avoiding them.

What’s Wrong with Confidentiality?

There are valid reasons to oppose confidentiality. It can be bad for clients, bad for lawyers, and bad for the legal system.

Clients often object to confidentiality because they are frustrated and angry about what has happened to them and what the defendant did. Defendants want confidentiality often because of the feared perception of guilt that accompanies a settlement. The secrecy itself, on the other hand, may be adverse to public policy and protection of the public—in short, it can allow wrongful conduct to continue.

Confidentiality prevents the public from knowing about systemic wrongful conduct. It can also prevent regulators and government agencies from performing their duty to enforce the law and protect the public. The purpose of the court is to evenly administer justice to all so that all are protected by the law. When violations are hidden by confidentiality, the legal system itself is thwarted from fulfilling one of its fundamental purposes: to protect the citizenry from wrongful conduct.

Just as important, the legal system is funded by the citizenry. The use of government employees, monies, and buildings entitles the public to openness in all aspects of the legal process, including settlements that are achieved through use of the court system.

Society itself might be better off if all settlements were public knowledge. Wrongful conduct would be exposed not just for the economic justice of the victim, but for the broader societal purpose of curbing such wrongful conduct. Lawmakers and the public can see where problems exist, both in products and service suppliers, and act appropriately.

A good example is the Eleventh Circuit’s long-standing approach that settlements in Fair Labor Standards Act (FLSA) litigation should not involve confidentiality because it contravenes congressional intent behind the law and undermines regulatory efforts (Lynn’s Food Stores, Inc. v. United States, 679 F.2d 1350 (11th Cir. 1982)) and that FLSA settlement agreements must be filed in the court’s public docket (Hanson v. Wells Fargo Bank, No. 08-80182-CIV, 2009 WL 1490582 (S.D.Fla. May 26, 2009)).

Unlike most states, Florida has a statute that prohibits concealment of public hazards, which effectively prohibits confidentiality (Fla. Stat. Ann. 69.081). California has a similar statute that forbids nonfinancial confidentiality of motor vehicle problems in its Lemon Law settlements (Cal. Civil Code 1793.26).

Secrecy in settlements also hurts lawyers. A lawyer cannot place a fair and reasonable value on a case when the lawyer cannot compare it to other known cases. It is particularly harmful to inexperienced lawyers who may be most prone to undervaluing a case. The secrecy allows the perpetrator to assess a fair value while preventing the innocent victim from doing likewise.

Confidentiality does not actually promote settlement. The vast majority of cases already are settled without trial. Fundamentally, a settlement of a court case should be a public proceeding, just as a trial is a public proceeding of a court case.

Moreover, the legal system does not belong to any industry. It belongs to the public. Courts function best in the daylight of an open, transparent administration of justice. Otherwise, people cannot observe and understand what is going on and how the courts protect everyone by their fair administration of justice. Secrecy protects repeat offenders and harms everyone else. Openness is consistent with basic Constitutional principles of our government.

The law is clear that lawyers and litigants do not surrender their First Amendment free speech rights at the courthouse door (National Polymer Products, Inc. v. Borg-Warner Corp., 641 F.2d 418 (6th Cir. 1981); In re Halkin et al., 598 F.2d 176, 186–87 (D.C. Cir. 1979); Koster v. Chase Manhattan Bank, 93 F.R.D. 471, 475–76 (S.D.N.Y. 1982)). And those rights protect observers, too.

There is a well-established common law right of general access to all the records of court proceedings. Under the right to access doctrine, the public’s right of access to judicial proceedings and records is indisputable (Pichler v. UNITE, 585 F.3d 741, 746 n. 5 (3d Cir. 2009)), although not absolute (Nixon v. Warner Communications, Inc., 435 U.S. 589, 598 (1978)).

The right antedates the Constitution (United States v. Criden, 648 F.2d 814, 819 (3d Cir. 1981)), and there is a strong presumption in favor of access (Bank of America v. Hotel Rittenhouse Assocs., 800 F.2d 339, 343 (3d Cir. 1986)) that must be balanced against the factors militating against access (Littlejohn v. BIC Corp., 851 F.2d 673, at 678 (3d Cir. 1988)). It includes the right to inspect and copy judicial records, including transcripts of civil proceedings (Littlejohn, 851 F.2d at 678–680).

As a result, a private settlement that is put on the record may become a public record in spite of a confidentiality term in the agreement itself (see Peregrine Sys. Inc., 311 B.R. 679, 688 (D. Del. 2004)). Still, every court does have supervisory power over its own records and files, and ultimate discretion of sealed filings rests with the court itself.

Even so, whether or not to give confidentiality in a settlement is not the lawyer’s decision. It is the client’s case, and it is their decision to make, with the advice of counsel.

When the subject of confidentiality comes up, timing is everything. Once the terms of settlement have been agreed upon, they cannot be altered except by mutual agreement to the new term. Commonly, the terms are agreed upon and one party later prepares a written settlement agreement. It is at that point that difficulties can arise. If confidentiality was not mentioned prior to coming to terms, it cannot be forced upon an objecting party by later planting it in the settlement agreement (see Dyer v. Bilaal, 983 A.2d 349 (D.C. 2009)).

Confidentiality Breadth

Where confidentiality is requested, Defendants routinely ask that the settlement amount or terms be kept confidential. Some defendants, however, require confidentiality to include the nature and details of the dispute as well. Because court pleadings are rarely confidential, such broad language is likely unenforceable. Generally, the terms of confidentiality should be drawn as narrowly as possible.

Defendants may also want counsel for the plaintiff to sign the confidentiality agreement and be bound by it. Counsel should remember that the parties sign the settlement agreement and are bound by its terms—the case belongs to the client and not the attorney.

It is unethical for opposing counsel to ask for a prior restraint on counsel’s right to free speech as a term of the client’s settlement because this would interfere with the attorney’s advice to current and/or future clients (see ABA Model Rules of Professional Conduct, Rule 5.6(b); District of Columbia Bar, Ethics Op. 335; South Carolina Bar, Ethics Advisory Op. 10-04). The better general rule would be for plaintiff’s counsel never to sign any settlement agreement at all. After all, it is not the attorney’s settlement agreement because it is not the attorney’s claim that is involved in the case.

Confidentiality Carve-Outs

It is routine for the confidentiality clause to permit the settlement amount to be disclosed to tax preparers, accountants, and legal or financial advisors. Not so routine, although perhaps it should be, is a carve-out that allows a party to reveal facts from the underlying claim to industry regulators as permitted or required by law.

The conduct of many licensed and regulated industries are bound by laws and regulations, and it would be against public policy to require confidentiality of facts that evidence the violation of laws and regulations governing the settling defendant’s conduct and right to engage in a licensed occupation or regulated industry. Indeed, such a clause is likely unenforceable.

For instance, 18 U.S.C. 1512, the federal witness tampering statute, prohibits the “corrupt persuasion” of another with intent to influence or delay or prevent a person from giving testimony in any “official proceeding,” even if the proceeding does not yet exist. Most states also prohibit witness tampering. Confidentiality clauses that interfere with a victim’s ability to give testimony to any government agency or in court would seem to violate these laws. In a pattern and practice case, such clauses may actually be evidence of the perpetrator’s desire to spoliate subsequent claims by concealing evidence of the pattern conduct itself (Wright and Graham, Federal Practice and Procedure, vol. 23 on the Federal Rules of Evidence, § 5314 in the final paragraphs and at footnote 67).

Tax Consequences

A confidentiality clause may create a taxable event if not carefully drafted. The U.S. Tax Court has made it clear that a confidentiality clause must be supported by sufficient and clearly stated consideration or the Internal Revenue Service (IRS) can assign any “just or fair amount” as the amount of the consideration involved, and that, in any event, all consideration for confidentiality is taxable income to the recipient. See, for example, Amos v. Commissioner, T.C. Memo. Docket No. 13391-01, 2003-329, December 1, 2003. In this case, the Tax Court issued a Memorandum decision that probably made Dennis Rodman smile. At a 1997 National Basketball Association game, Rodman fell over a TV cameraman, Eugene Amos, while chasing a loose ball at the edge of the court. In the rage that followed, Rodman kicked Amos. Amos sued, and the case settled for $200,000. The settlement agreement recited the settlement amount and added a confidentiality and non-disparagement clause without stating how much of the payment was consideration for the clause. The agreement also included a liquidated damages clause of $200,000 if Amos violated confidentiality. Because that was the entire amount being paid, it was obvious that confidentiality was critically important to Rodman. Although payment to settle a personal injury claim is not taxable under the Internal Revenue Code, money paid to settle most claims is taxable. The IRS sought to make the entire payment taxable, and ultimately the Tax Court held that $80,000 was attributable to the confidentiality clause. Because the nature of the confidentiality clause itself was compensation for non-personal injuries, then some amount would be taxable. The settlement agreement was silent on how much, so the analysis fell to the intent of the party making the payment. Lacking any “sufficient and clearly stated consideration” in the agreement, the Tax Court was free to assign any “just or fair amount.”

Of course, the best way to avoid tax issues is to avoid the confidentiality clause. If that is not possible, then the clause should specifically state the amount of consideration for it or that there explicitly is no consideration being paid for it.

A provision should be made separately for any necessary confidentiality terms. Although it could be merely a clause in a settlement agreement, it may be wise to set it apart as an addendum to further evidence its independent consideration.

Most often the amount of the consideration is of little importance to a defendant—it is the clause itself that is desired. Because of the taxable income it creates, however, it is best to use a reasonable but nominal amount, such as $100, for example.

Breach and Enforceability

It is not uncommon to see defense efforts to insert a liquidated damages clause in the agreement, often for the entire amount being paid to settle the case. Plaintiff should never agree to such a term. It is very likely that the IRS will deem the liquidated damage amount as clear evidence of the value of confidentiality and ultimate proof of the amount of taxable income in the settlement. Just as ominous is the future danger the plaintiff is exposed to in the event of an unintended disclosure of the settlement terms. That threat may actually continue the adversarial relationship between the settling parties.

Although exceptional circumstances may sometimes exist, secrecy generally serves no good purpose in the civil justice system or in a democracy.