Facebook is negotiating a settlement to a class-action lawsuit filed by members who objected to the social network using their likenesses to pitch products in ads called sponsored stories. Given the importance of these ads to Facebook’s business, what impact will the case have on the company?

Most marketers know that you are more likely to respond to a recommendation from a friend than a pitch from an advertiser. Facebook sponsored stories are fertile ground to exploit this tendency.

Sponsored stories are product ads that show pictures of your friends who have "liked" the product. Far and away, they have been the most effective form of advertising on Facebook. In the second quarter, Facebook users were more than twice as likely to click on sponsored stories compared to traditional display ads.

But a suit filed in federal court in California last year argues that state law requires compensation for people whose likenesses are used in ads. Friday, a judge rejected a settlement agreement that would have split $20 million among charities that protect consumer rights. (Facebook had argued that paying the plaintiffs directly would not be worthwhile, as the amount of damages that would go to each of the 70 million individuals affected would be miniscule.) In rejecting the settlement, the judge raised concerns about the percentage of the settlement and legal fees going to the law firms that brought the case.

The two sides are continuing to work toward an acceptable settlement, according to published reports.

It’s unclear what impact such a settlement would have on Facebook’s bottom line. Last week we reported on a test program in which people were shown ads regardless of whether or not their friends had liked the brand behind the ad. We’ve asked Facebook for comment and will update when we get a response, but in the past the company has declined to comment on pending litigation.

Small Speed Bump For Facebook

Sponsored stories have been the most effective of all the campaigns run by social media advertising firm Compass Labs, said the company's CEO, Dilip Venkatachari. He expects that any settlement would include provisions to make it easier for Facebook users to opt out of having their image included in sponsored stories. However, he does not expect such a settlement to have a big impact on Facebook’s revenue or its advertising programs.

“This could have a revenue impact,” Venkatachari said. “However, given how much data users publicly share on Facebook, we don't foresee many users opting out of sponsored stories, so we don't think the impact will be too severe.”

Facebook members "want friends and family to know what articles they are reading, what music they are listening to," Venkatachari said. "For example, I now know how often friends of mine go running and the distance. All this information is extremely valuable to advertisers, and . . . this opens up an extremely compelling revenue stream for the social network that could alleviate any potential negative impact from sponsored story opt-outs.”