Discretionary clause bans & ERISA preemption.

• Author: Pathak, Radha A.

1. INTRODUCTION

   The Employee Retirement Income Security Act of 1974 (ERISA) is a comprehensive federal statute that governs employee benefits. As its name suggests, it was enacted primarily to stabilize employer-provided retirement income, specifically pensions. (1) But even at the time of its passage, ERISA explicitly regulated employer-provided health care and disability benefits. (2) Such benefits have only increased in importance because a significant number of Americans receive health care through their employers. (3) While federal health care reform has taken center stage recently, (4) states have historically played a central role in regulating the interrelated areas of health care and insurance. Since ERISA's passage in 1974, however, states have had to contend with its preemptive effect, and the Supreme Court has weighed in on the relationship between ERISA and these traditional areas of state regulation on a number of occasions. (5) States' ability to exercise their traditional regulatory power has been upheld in a number of instances, (6) but the Court has been resistant to state efforts to enforce historically available remedies for behavior that is now regulated by ERISA. (7)

   This article focuses on a particular preemption question that is beginning to make its way through the Circuit Courts of Appeal. This potential preemption battle concerns state efforts to regulate--usually by banning--clauses within insurance contracts that purport to confer discretion upon the insurer in determining the meaning of the terms within the insurance contract, most importantly for the purpose of determining the insured's eligibility for insurance benefits. (8) Such a clause may read as follows: Insurer has full discretion and authority to determine the benefits and amount payable as well as to construe and interpret all terms and provisions of the plan." (9)

   The proposition set forth in such clauses--that the insurer's position about the meaning and applicability of the insurance contract carries more weight than the insured's position about those same issues--is contrary to the law in most states. States' regulatory regimes of insurance generally include private judicial enforcement, and the doctrines at play in those lawsuits generally seek to protect consumers, rather than favor insurers. That is, a person denied an insurance benefit can sue the insurer for breach of contract, and states have developed robust doctrines to govern such suits. If an insured is successful in proving that the insurer breached the insurance contract, the insured will receive the contested benefit as well as consequential damages of the breach and possibly also punitive damages if the insurance contract was breached in bad faith. More importantly for the purposes of this article, in such breach of contract cases, any ambiguity in the contract is interpreted against the insurer (because the insurer is the drafter). Contractual clauses that purport to confer interpretive authority upon the insurer are legally irrelevant.

   As a result of ERISA, however, such contractual provisions--commonly referred to as discretionary clauses--can have legal effect. The presence of such discretionary clauses can alter the standard of review--to the detriment of the insured--that a court will use in deciding whether an insurance benefit has been wrongfully denied. This point will be discussed in more detail below, but it suffices for the moment to note that the presence of such discretionary clauses has a totally different effect under federal law than it does under state law. In a benefits dispute governed by ERISA, such discretionary clauses may be accurate; a federal court may defer to the insurer's decision about the meaning of the insurance contract. In a benefits dispute that is governed by state law, on the other hand, such discretionary clauses have no legal effect. Consequently, the practical effect of such clauses (before the dispute arises) may well be to mislead the consumer, because the consumer is likely to believe that his or her rights in the event of a dispute with the insurer are less robust than they actually are. This may lead the consumer to accept a decision that the consumer would challenge if appropriately informed of his or her rights. It is therefore unsurprising that states have moved to regulate--mainly by banning--such discretionary clauses within insurance contracts. It is also unsurprising that insurance companies have challenged those state laws as preempted by ERISA. This article will evaluate the question of whether state regulation of discretionary clauses is preempted by ERISA. Only three Circuit Courts of Appeal--the Sixth, (10) Ninth (11) and Tenth (12)--have weighed in on the issue of preemption, but it is likely to arise elsewhere. (13)

   In order to understand the preemption question, it is necessary to review some basic principles about the statute. ERISA regulates any "employee benefit plan," which is defined as "an employee welfare benefit plan or an employee pension benefit plan" or a plan that is both a welfare benefit plan and a pension benefit plan. (14) An "employee welfare benefit plan" (15) is a plan that provides any of a vast array of employee benefits, but it will suffice to invoke two of the most significant: health care benefits and benefits in the event of an employee's disability. (16) The employer may purchase insurance to provide these benefits to the employee, but it need not do so; it may fund the health care plan or disability plan on its own. Welfare plans--and in particular health care and disability plans--are the focus of this article, but it is helpful to mention that an "employee pension benefit plan" (17) is basically any employer-sponsored plan that provides retirement income to its employees. (18) It may be a traditional pension plan (19) or an individual retirement account plan like a 401 (k). (20)

   ERISA speaks in terms of plan participants and beneficiaries. These individuals roughly occupy the same status as an "insured" and this article will--with the exception of a few paragraphs, including this one--use that term. If an insured (the participant or beneficiary) is denied a pension or welfare benefit which she believes she is due, the insured (the participant or beneficiary) may not bring a breach of contract lawsuit under state law to collect either the benefit or consequential damages resulting from its denial. Instead, the insured (the participant or beneficiary) is limited to the causes of action described in section 502 of ERISA, codified in section 1132 of Title 29.

   For the purposes of this article, section 502(a)(1)(B) is the most important--it creates a cause of action for a participant or beneficiary "to recover benefits due ... under the terms of [a] plan." (21) It also creates similar causes of action to "enforce ... rights under the terms of the plan and to clarify ... rights to future benefits under the terms of the plan." (22) A participant who has been denied plan benefits will frequently proceed under section 502(a)(1)(B), contending that such benefits were "due ... under the terms of the plan" and should therefore be paid to the participant. (23) But such an action differs from an ordinary breach of contract action in several important respects. First, the remedy available to the participant is simply the benefit; the participant may not recover consequential damages associated with the denial of the benefit. (24) Second, a number of circuits have adopted an administrative exhaustion requirement. (25) Finally, the federal district court will not necessarily conduct a de novo review of the decision to deny benefits. Instead, if the terms of the plan confer upon the administrator or fiduciary "discretionary authority to determine eligibility for benefits," then the federal court may review the decision under a discretionary standard, (26) which differs markedly from the level of scrutiny an insurer would ordinarily receive from a state court--or a federal court applying state law--in a lawsuit challenging the denial of insurance benefits.

2. DISCRETIONARY CLAUSES AND STATE LAW

   A number of states have taken steps to regulate discretionary clauses within insurance contracts. (27) Fourteen states have prohibited insurance companies from including discretionary clauses within insurance contracts: Alaska, (28) California, (29) Colorado, (30) Hawaii, (31) Illinois, (32) Kentucky, (33) Maine, (34) Michigan, (35) Montana, (36) New Jersey, (37) New York, (38) Oregon, (39) Texas, (40) and South Dakota. (41) Three states have adopted more limited bans: Idaho, (42) New Hampshire (43) and Utah (44) prohibit discretionary clauses within insurance contracts, but they exempt any insurance policy within an ERISA-governed plan. (45) For those plans, New Hampshire and Utah provide that the discretionary clauses must be worded in a certain way. (46) Indiana similarly imposes requirements upon the wording of discretionary clauses, but it does not forbid their inclusion in any insurance contracts. (47) Finally, Connecticut has addressed discretionary clauses by warning insurers that such clauses "cannot be used to improperly deny claims or to restrict any rights an insured has under the policy," but it has not banned such clauses or otherwise regulated them. (48)

   It is worth noting that there is no current and comprehensive analysis of state efforts to regulate discretionary clauses. The National Association of Insurance Commissioners promulgated a Model Act prohibiting the use of discretionary clauses, (49) and the organization maintains a current list of states that have taken some action relating to their proposed ban, (50) but their chart does not describe the state efforts in any great detail. Advocates have described state efforts in briefs, (51) but those descriptions may be similarly lacking in detail or possibly even unreliable. For example, in a petition-stage...