Editor’s note: This is the second of two parts. The first part ran on Monday.

It is fascinating how far Judge Richard A. Posner has come. Posner wrote the opinion in Rud v. Liberty Life Assur.Co.,438 F.3d 772 (7th Cir. 2006).

However, in Van Boxel v. The Journal Co. Employees’ Pension Trust, 836 F.2d 1048, 1052 (7th Cir. 1987), he wrote:

”[Employee benefit] rights are too important these days for most employees to want to place them at the mercy of a biased tribunal subject only to a narrow form of ‘arbitrary and capricious’ review, relying on the company’s interest in its reputation to prevent it from acting on its bias. Nor is it clear that the contractual perspective is the correct one in which to view claims under ERISA. A Congress committed to the principles of freedom of contract would not have enacted a statute that interferes with pension arrangements voluntarily agreed on by employers and employees. ERISA is paternalistic; and it seems incongruous therefore to deny disappointed pension claimants a meaningful degree of judicial review on the theory that they might be said to have implicitly waived it.”

Here, however, the court assumes that discretionary authority resulted from a contract negotiated between Rud’s employer and its insurer. That is a questionable proposition, though, since there is no evidence the employer (or the employees) understood the legal significance of the discretionary clause in the insurance policy, and that it would trigger a situation where the insurer’s claim decision would be largely insulated from judicial review. As the court well knows, insurers have been arguing with great creativity for more than fifteen years since the issuance of Firestone Tire & Rubber Co. v. Bruch, 489 U.S. 101 (1989) that obscure or arcane policy language triggers a deferential standard of review, and the 7th Circuit responded in Herzberger v. Standard Insur.Co., 205 F.3d 327, 332-33 (7th Cir. 2000), by stating, ”An employer should not be allowed to get credit with its employees for having an ERISA plan that confers solid rights on them and later, when an employee seeks to enforce the right, pull a discretionary judicial review rabbit out of his hat.” Even where the language may be clear, without an annotation explaining the significance of the provision, it is the rare employer or even broker, in this author’s experience, who understands the legal effect of discretionary clauses.

The court’s analysis of whether an insurer of group disability benefits is operating under a conflict of interest is even more provocative. As Wright v. R.R. Donnelley & Sons Co. Group Benefits Plan, 402 F.3d 67, 75 n.5 (1st Cir. 2005) points out, in contrast to the 7th Circuit’s analysis:

”We are nevertheless mindful that other circuits have rejected the market forces rationale and specifically recognized a conflict of interest when the insurer of an ERISA plan also serves as plan administrator, although there is no consistent approach in accordingly adjusting the standard of review. See, e.g., Fought v. UNUM Life Ins. Co. of Am., 379 F.3d 997 (10th Cir. 2004) (holding that plan administrators acting under an inherent conflict of interest have the burden of showing that their decision to deny disability benefits is supported by substantial evidence); Davolt v. Executive Comm. of O’Reilly Auto., 206 F.3d 806, 809 (8th Cir. 2000) (noting that de novo review may apply where ‘relationship places the ERISA benefits plan administrator in a perpetual conflict of interest’); Atwood v. Newmont Gold Co., 45 F.3d 1317, 1323 (9th Cir. 1995) (presuming conflict and shifting burden of proof to insurer); Brown v. Blue Cross & Blue Shield of Ala., Inc., 898 F.2d 1556, 1566-67 (11th Cir. 1990) (same);Pinto v. Reliance Standard Life Ins. Co, 214 F.3d 377, 393 (3d Cir. 2000) (adopting sliding scale approach); Doe v. Group Hospitalization & Medical Servs., 3 F.3d 80, 87 (4th Cir. 1993) (same); Wildbur v. ARCO Chem. Co., 974 F.2d 631, 638-42 (5th Cir. 1992) (same); Van Boxel v. Journal Co. Employees’ Pension Trust, 836 F.2d 1048, 1052-53 (7th Cir. 1987) (same).”

The 7th Circuit’s reliance on freedom of contract also departs from the Supreme Court’s adoption of trust law to govern ERISA law, rather than a contract law approach. Had the Supreme Court selected to apply contract law, there would have been no need for the Supreme Court to have admonished in Firestone:

”Of course, if a benefit plan gives discretion to an administrator or fiduciary who is operating under a conflict of interest, that conflict must be weighed as a ”facto[r] in determining whether there is an abuse of discretion.” Restatement (Second) of Trusts § 187, Comment d (1959). 489 U.S. at 115.”

Proving that it was no fluke that the Supreme Court meant to include trust law principles relating to conflicts into the ERISA law, the Court reiterated in Rush Prudential HMO, Inc. v. Moran, 536 U.S. 355, 384 n.15 (2002): ”In Firestone Tire itself we stated that the inquiry would home in on any conflict if a conflict was plausibly raised…. It is a fair question just how deferential the review can be when the judicial eye is peeled for conflict of interest. Thus, it is not simply a matter of ‘freedom of contract’ and a bargained for exchange that courts will honor a grant of discretion without peeling the judicial eye.”

In addition, while the 7th Circuit is indeed correct that insurance arrangements may be ubiquitous in the ERISA benefit world, that merely heightens the threat of such conflicts, particularly since insurers’ fiduciary obligation to their shareholders is in considerable tension with the exclusive benefit rule contained in 29 U.S.C. § 1104(a)(1), which was derived from the Restatement (Second) of Trusts ‘§ 170, mandating that plan fiduciaries act exclusively in the interest of plan participants and their beneficiaries for the purpose of paying benefits. In his landmark essay, ”The Supreme Court Flunks Trusts,” (1990 Supreme Court Review 207), Professor John Langbein discusses the origins of the Firestone case and the recognition by Judge Edward Becker, the author of the 3d Circuit opinion in that case and who also authored the Pinto case, that ERISA plans differ from private trusts. In Bruch v. Firestone Tire & Rubber Co., 828 F.2d 124, 143-44 (3d Cir. 1987), which involved a dispute over severance benefits, the 3d Circuit traced the development of the arbitrary and capricious standard of review from the Labor Management Relations Act and wrote:

”In their oversight of a trust where the impartiality of the trustee had been carefully assured, the LMRA courts could easily adopt the principle of trust law applicable with respect to judicial review of an impartial trustee’s execution of his duties. At least one court has done so in explicit reliance on § 187 of the Restatement of Trusts. See Brune v. Morse, 475 F.2d 858, 860 n. 2 (8th Cir. 1973). Because the LMRA’s precautions assure that the plan administrator will be neutral, it is easy to understand why the courts adopted this rule for judicial review of decisions made in the administration of an LMRA plan.

”In the unfunded pension plan at issue in Count I of the complaint in this case, however, there is no assurance of the trustee’s impartiality. The plan is controlled entirely by the employer, not by a group evenly divided between employer and employees. Because the plan is unfunded, every dollar provided in benefits is a dollar spent by defendant Firestone, the employer; and every dollar saved by the administrator on behalf of his employer is a dollar in Firestone’s pocket. As we have already seen, the principle articulated in § 187 does not govern judicial review of such a trustee’s decisions.

”Two rationales are most frequently advanced to justify deference even in this context to fiduciaries’ decisions. The first is that they have more expertise than judges in the management of pension plans; the implication is that the fiduciary whose decision is deferred to is more likely than the judge to have answered correctly the question about the meaning of the plan’s term. See Berry v. Ciba-Geigy Corp., 761 F.2d 1003, 1006 (4th Cir. 1985) (preferring the decision of plan administrators, ‘whose experience is daily and continual, [over that of] judges whose exposure is episodic and occasional;’ see also Ponce v. Construction Laborers Pension Trust, 628 F.2d 537, 542 (9th Cir. 1980) (‘trustees are knowledgeable of the details of a trust fund (both its purpose and its operation), and thus they are in a position to make prudent judgments concerning participant eligibility.)’

”We reject this rationale for two reasons. First, in the context of claims for benefits, the questions which courts must address do not usually turn on information or experience which expertise as a claims administrator is likely to produce. As in this case, the validity of the claim is likely to turn on a question of law or of contract interpretation. Courts have no reason to defer to private parties to obtain answers to these kinds of questions. Secondly, as we have explained, there is a significant danger that the plan administrator will not be impartial. The lack of impartiality offsets any remaining benefit which the administrators’ expertise might be thought to produce.

”It has also been argued that deferring to the administrator’s decision will make proceedings faster. We acknowledge that. But because the speed is attained by sacrificing the impartiality of the decision maker, we think that it comes at too great a cost.”

The Supreme Court mostly affirmed the 3d Circuit and its reliance on trust law principles although the Court allowed the parties to privately contract to grant discretion to the plan administrator subject to conflict of interest being weighed as a factor. Langbein was critical of the court’s allowance of discretionary authority because it departs from traditional trust law. He points out that de novo review applies in contract disputes because of the self-interest of the parties to a contract. Langbein adds that contracts rarely provide for an external decision maker such as a trustee, thus providing even further authority as to the need for a de novo standard of review. Thus, the fact that insurers do, indeed, profit from claim denials should be enough to establish a conflict of interest sufficient to trigger a de novo contract interpretation rather than for a court to defer to the insurer’s findings.”

An additional problem with the 7th Circuit’s insistence on evidence of an actual conflict, rather than presuming a conflict from the presence of a conflict, is that the court has taken away the tools needed to establish a conflict. In both Perlman v. Swiss Bank Corp. Comprehensive Disability Protection Plan, 195 F.3d 975 (7th Cir. 1999) and more recently, in Semien v. Life Insurance Co. of North America, 2006 U.S.App.LEXIS 2823 (7th Cir. 2/6/2006), the court ruled that no discovery may be undertaken, even on the issue of conflict of interest, unless the plaintiff has credible evidence of a conflict that can be presented to a court. That reasoning is circular since such evidence is almost always lacking in the absence of discovery.

Yet another factor to consider is that protections against misbehavior by ERISA plan fiduciaries are non-existent in ERISA, which may create an additional incentive to deny valid claims when an insurer faces no consequences for its actions. Dishman v. Unum, 1997 WL 906146 (C.D.Cal.) was the first case to recognize this paradox; more recently, in Radford Trust v. Unum Life Insur.Co. of America, 321 F.Supp.2d 226, 240 (D.Mass. 2004), the court observed, ”There are also obvious drawbacks to relying on private insurers, however. Although the profit motive drives companies toward efficiency, it creates a substantial risk that they will cut costs by denying valid claims. The market is somewhat inapt to punish insurers for engaging in such practices, particularly if the denials are not too flagrant, because the complexity of the insurance market and the imperfect information available to consumers make it difficult to determine whether an insurer is keeping its costs down through legitimate or illegitimate means. An individual claimant who encounters an insurance company that is disposed to deny valid claims must struggle to vindicate his rights at a time when he is at his most vulnerable. Often a newly disabled person will simultaneously confront increased medical bills and either termination of employment or diminished pay.”

Consequently, contrary to both the paternalistic language of the ERISA statute and Congressional intent that the law was intended for the protection of plan participants and to secure claimants’ rights and remedies (29 U.S.C. § 1001(b)), the courts have created a situation aptly characterized by University of Chicago economist Steven D. Levitt as ”freakonomics.” Levitt and his co-author Stephen J. Dubner, in their book Freakonomics, focus on how economic incentives often lead to perverse unintended results, some beneficial, but many of which are harmful. Clearly, when insurers are motivated by profits and have no worry about paying damages or even having the reasons given for their determinations given close judicial scrutiny, there is an opportunity for mischief.

Short of the Supreme Court overturning Firestone, there are at least three ways in which an outcome differing from the court’s decision in Rud may be accomplished. The first solution would be to find a more satisfactory means of dealing with the Supreme Court’s admonition in Firestone that the conflict must be addressed. The approach taken by the 11th Circuit in Brown v. Blue Cross & Blue Shield of Ala. Inc., 898 F.2d 1556 (11th Cir. 1990) is the one most faithful to a trust law analysis. Brown was the first ruling to recognize that when ”an insurance company pays out to beneficiaries from its own assets rather than the assets of a trust, its fiduciary role lies in perpetual conflict with its profit-making role as a business.” 898 F.2d at 1566-68. Brown also departs from the 7th Circuit in its finding that the court would have the power to overcome the parties’ freedom to contract for a deferential standard of review by finding it inconsistent with the ERISA statute, as Professor Langbein suggests. Ultimately, the court concluded that a deferential standard of review could be preserved because an ”abuse of discretion [will be found] more readily when conflicting interests are apparent.” 898 F.2d at 1563 n.6. Hence, Brown held the inherent conflict renders the benefit determination presumptively void, thus triggering a de novo review. Only if a de novo review supports the reasonableness of the benefit determination will the plan retain discretionary authority; and the plan bears the burden of showing that its determination was not influenced by the conflict but was made to benefit all plan participants.

Second, Illinois has already adopted a model law proposed by the National Association of Insurance Commissioners prohibiting discretionary clauses in health and disability insurance policies – 29 Ill.Reg. 10172 (July 15, 2005). It remains within the authority of the states to regulate insurance despite the broad sweep of ERISA preemption – 29 U.S.C. § 1144(b)(2)(A). The Supreme Court has already headed off the possibility that insurers could evade state regulation by incorporating discretion in other plan documents. In Unum Life Insur.Co. v. Ward, 526 U.S. 358, 376 (1999), the Court rejected that possibility by ruling it would improperly ”read the saving clause [§ 1144(b)(2)(A)] out of ERISA.”

Third, the 7th Circuit may have too quickly found the absence of a ”plan” document immaterial; the court also rejected the notion that ”Liberty Life [was] merely a contractor with an ERISA administrator or fiduciary.” *16. The fact is that Liberty probably was exactly that. In Johnson v. Watts Regulator Co., 63 F.3d 1129 (1st Cir. 1995) the court noted that when an employer separates itself from the plan, making it reasonably clear that the plan is a third-party offering, rather than hawking the plan to its employees as ”our plan,” no welfare plan governed by ERISA is stated. In many, if not most cases, an employer merely facilitates the availability of disability insurance coverage to employees who pay the premiums themselves with after tax dollars. It is unclear whether such an arrangement was employed in Rud; however, it is a subject worth investigating.

The bottom line question remains as to whether there is any policy justification for giving discretionary authority to insurers whose profit motive is in conflict with its contractual obligation to pay claims. One suggestion is that the current regime enables employers to purchase less expensive benefits because insurers will not have to face jury trials and costly litigation proceedings. However, the Supreme Court explicitly rejected that argument in Firestone with its observation that ”the threat of increased litigation is not sufficient to outweigh the reasons for a de novo standard… ” 489 U.S. at 115. Further, to offer an analogy, it is doubtful as a matter of common sense that any air traveler would be willing to buy a much less expensive ticket on an airline that arrives safely only 95 percent of the time when they can travel, albeit more expensively, on an airline that has a virtually 100 percent safety record. Employee benefits are too important, since they often have life and death consequences, to entrust payment decisions to insurers that can decide in their discretion when payments are due. Our court system would not trust insurers in any other context to make decisions reviewable only for arbitrariness; likewise, no policy reason supports giving such authority to insurers in the ERISA context.

This article was initially published in the Chicago Daily Law Bulletin. 

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