The U.S. Supreme Court recently issued a significant ruling on the rights of health benefit plans to recoup payments out of personal-injury settlements.

U.S. Airways Inc. v. McCutchen, 2013 U.S.LEXIS 3156 (April 16, 2013) involved James McCutchen, an employee of US Airways and a participant in that organization’s health benefits plan, who was severely injured in a car accident.

McCutchen filed suit against the other driver, but due to insurance limitations, his net recovery was only approximately $66,000, which was slightly less than the payment made by US Airways’ health benefit plan, which had reimbursed McCutchen’s medical providers to treat his injuries.

Because the US Airways plan was entitled to recoup its payments out of the third-party recovery obtained by plan participants, the question before the Supreme Court was whether US Airways’ claim for reimbursement was subject to equitable defenses such as limiting the right of recovery only to sums McCutchen recouped as medical expense reimbursement.

Another question was the applicability of the “common-fund doctrine,” which requires the party seeking reimbursement to pay a share of the attorney fees incurred in generating the third-party recovery.

The court ruling overturned the 3rd U.S. Circuit Court of Appeals’ ruling that equitable defenses can be raised regardless of contrary plan terms, but held that if an employee benefit plan is silent as to allocating the costs of recovery, the common-fund doctrine may be invoked.

Because the plan gave US Airways first claim on the entire third-party recovery, the court rejected the argument that McCutchen’s recovery could be allocated between economic and non economic losses. The court deemed the plan provision permitting first-dollar recovery merely part of a bargained for exchange that precluded any claim that the plan would be unjustly enriched if it could recoup its payments even if the entire settlement was denominated as recovery for the injuries themselves and for pain and suffering.

The court also wrote it was unable to find any cases where a court applied either the “double recovery” or the “common fund” rules to override contract terms. Thus, the Supreme Court rejected the solicitor general’s argument that the common-fund rule has a “special capacity” to trump conflicting contract terms. Despite the court’s acknowledgement of the common-fund doctrine’s “deep roots in equity,” it could find no ruling where a court permitted that rule to override express contract terms.

Nevertheless, since the benefit plan at issue was silent as to the allocation of attorney fees, the court ruled the common-fund doctrine applied as a default rule in construing the plan. The court cited several cases, including Wal-Mart Stores Inc. Assoc. Health & Welfare Plan v. Wells, 213 F. 3d 398, 402 (7th Cir. 2000), which teaches, “[C]ontracts … are enacted against a background of common-sense understandings and legal principles that the parties may not have bothered to incorporate expressly but that operate as default rules to govern in the absence of a clear expression of the parties’ [contrary] intent.” While the court deemed the plan terms clear enough to preclude the application of the double-recovery rule, the Supreme Court disagreed with the district court’s finding that the plan terms also precluded application of the common-fund doctrine.

Despite the plan’s provision that it had first claim on the entire recovery, there was no express statement as to whether that right was applicable to the gross recovery or the net recovery after allocation of costs. Thus, the court found that the common-fund doctrine resolves the ambiguity. The rationale for such a rule was expressed as follows:

“Third-party recoveries do not often come free: To get one, an insured must incur lawyer fees and expenses. Without cost sharing, the insurer free rides on its beneficiary’s efforts – taking the fruits while contributing nothing to the labor.”

The court also recognized that without the common-fund rule, the tort victim could be “made worse off by pursuing a third party.” Indeed, McCutchen’s net recovery after he paid fees to his personal-injury attorney left him with approximately $1,000 less than what US Airways sought, thus making McCutchen “pay for the privilege of serving as US Airways’ collection agent.” Such circumstances would deter tort victims from pursuing recovery for their injuries and plans would not have any funds they could recoup.

The Supreme Court has offered differing views on the appropriate body of law informing the Employee Retirement Income Security Act (ERISA). In Firestone Tire & Rubber Co. v. Bruch, 489 U.S. 101 (1989), the court applied trust law as ERISA’s source, ruling that in the absence of contrary plan terms, the de novo standard of review applied. That decision drew harsh criticism from ERISA scholar John Langbein who authored an article entitled, “The Supreme Court Flunks Trusts,” 1990 Sup.Ct.Review 223.

Langbein’s critique focused on the court’s distorted application of trust law instead of contract law. He also warned that Bruch permitted plan drafters to evade the de novo standard by drafting a clause vesting discretionary authority in the plan administrator, which indeed is what happened. Langbein also cited the 7th Circuit’s ruling in Van Boxel v. Journal Co. Employees Pension Trust, 836 F.2d 1048 (7th Cir. 1987), which pointed out that ERISA was intended to impose restrictions on unfair benefit plan terms since employee benefit plans are usually not bargained for. Such warnings have gone unheeded, though.

Thus, like Bruch, the McCutchen ruling will undoubtedly trigger plan amendments to preclude the applicability of what the Supreme Court characterized as “double recovery” as well as the common-fund doctrine. However, the ruling’s contract law analysis is puzzling. Moreover, freedom of contract is not inviolate. The law of contracts permits courts to negate contract terms that are contrary to public policy (Restatement of Contracts (Second) Section 178) or unconscionable (Section 208).

Permitting a “free ride,” to use the Supreme Court’s terminology and rationale, is contrary to public policy. Hence, as the solicitor general argued, the plan language should have been found subservient to the principle at stake. Sadly, this ruling is likely to have dire consequences.

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