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Supreme Court to Review Decision on Right to Sue HMOs Under ERISA

March 2000
By Jeffrey D. Mamorsky, Greenberg Traurig, New York Office

On February 23, 2000, the U.S. Supreme Court heard arguments in a significant and controversial case of first impression by the Seventh Circuit Court of Appeals which held that a physician-owned HMO could be sued for breach of fiduciary duty under ERISA as a result of allegedly delaying needed medical treatment and passing on the cost savings to the owner/physicians in the form of annual bonuses. In so ruling, the Seventh Circuit concluded that the owner/physicians were ERISA fiduciaries since they had discretionary authority to decide all disputed and non-routine claims under the plan (Herdrich v. Pegram, et al,154 F. 3d 362 (7th Cir. 1998) reh. denied, 170 F. 3d 683 (7th Cir. 1999)). The decision of the Supreme Court is expected to be released in early summer.

The Seventh Circuit Court found that the defendants breached their fiduciary duty in two ways. First, the defendant owner/physicians hired themselves to provide medical services under the plan while cutting costs by minimizing the resources expended on each patient. By minimizing these expenditures, the defendants preserved funds to be distributed to themselves as year-end bonuses. Second, the same owner/physicians who were eligible to receive year-end bonuses as a result of cost savings had the sole authority to determine whether health care claims would be paid. Thus, the Court found a structural incentive to deny care both at the point of delivery (i.e., the treatment decisions affecting patient care) and at the point of entry (i.e., the coverage decisions). These structural incentives resulted in a breach of fiduciary duty under ERISA.

A strongly worded dissent to the denial of en banc review pointed out that the question of whether HMOs are gatekeepers of medical services, and therefore play a fiduciary role, or merely provide a benefit promised under an ERISA plan that they do not administer, is a "fundamental divide for fiduciary status under ERISA." Unless the HMO exercises discretion "in the administration of the plan" it is not a fiduciary under ERISA. According to the dissent, this ERISA "divide" is "not an all-or-none affair" and may, indeed, boil down o a matter of characterization. For example, if one conceives of particular medical services as the "benefit" under the plan, then the owner/physician serves as the gatekeeper to those benefits and handling claims for medical benefits defined by a plan is a fiduciary role under ERISA. But if instead one conceives of the HMO system as the benefit provided by the ERISA plan, then the owner/physicians are not fiduciaries but just the supplier of medical care.

A well-reasoned dissent to the Seventh Circuit opinion emphasized that although there was an incentive to deny claims and maintain large year-end bonuses, duel loyalties are not per se unlawful under ERISA. Unlike the common law of trusts, ERISA Section 408(c)(3) permits an employer or other plan sponsor to have its own "officer, employee, agent or other representative" serve as trustee or other fiduciary. According to the dissent, one justification for this departure from the common-law tradition is that allowing a plan sponsor to designate its own agent as a fiduciary reassures the sponsor that, in devoting its assets to the plan, it has not relinquished all ability to ensure that the plan's resources are used wisely.

Moreover, the dissent emphasized that market forces help reduce the risk that the fiduciary's conflict of interest in making coverage decisions will work to the detriment of the plan and the plan beneficiaries. For example, companies that sponsor ERISA plans want to see their employees' claims granted because they want their employees satisfied with their fringe benefits. These corporate employers have the sophistication and bargaining power necessary to take their business elsewhere if an insurer consistently denies valid claims. In the long run, said the dissent, this type of practice would harm an insurer by damaging its chances to acquiring new customers. Thus, no conflict of interest exists because paying meritorious claims is in the insurer's best interest. The dissent recognized that the "monitoring of plan administrators by sponsors and beneficiaries is sometimes imperfect, and there is no guarantee that a sponsor will be able to find satisfactory alternatives in the market-place." However, in the dissent's view, the mere existence of an incentive to deny coverage is not enough to support an inference that market forces have failed in this case to protect the interest of beneficiaries.

On the other hand, the dissent admitted that the defendants' incentives to limit care in the case at issue are so high that they may work to the detriment of the plan and plan beneficiaries. However, the dissent concluded that the task of identifying appropriate limits for incentives is and should be an important item on the legislative and regulatory agenda. If the complaint is indeed asserting that the incentives in this case are excessive, said the dissent, then the plaintiffs in effect are inviting the Court to make its own determination about appropriate incentive levels in managed care. In the dissent's view, judicial efforts to determine permissible levels of financial incentives through the vehicle of ERISA's fiduciary rules are unnecessary and ill-advised. "Such a move would preempt legislative and regulatory efforts in this area and could seriously disrupt the ability of plan sponsors and beneficiaries to manage plan assets by agreeing to incentives that encourage cost conscious medical decision making."

Finally, the dissent agreed that it did share the majority's concern about the possibility of incentives that may harm plan beneficiaries, and that courts have a role in ensuring that incentives are implemented in accordance with the fiduciary duties imposed by ERISA. In the dissent's view, "this role is triggered when the market fails to ensure that the interests of sponsors, administrators, and beneficiaries are in alignment." Plan sponsors are likely to take their business elsewhere if they perceive that incentives are working to the detriment of beneficiaries or the plan itself.

This view, if adopted by the Supreme Court, puts the onus on employer plan sponsors and trustees (in the case of multiemployer plans) to monitor the performance of administrators to ensure that "incentives do not rise to dangerous or undesirable levels." However, in order for the market to function in this context, the dissent emphasized the sponsors and beneficiaries need information about the financial incentives that are in place. Thus, the dissent agreed with the Seventh Circuit and other Courts of Appeals in holding that the failure to disclose financial incentives is a breach of fiduciary duty under ERISA..


Carle Clinic Association, P.C. ("Carle"), Health Alliance Medical Plans, Inc. ("HAMP"), and Carle Health Insurance Management Co., Inc., operated a pre-paid health insurance plan which provides medical and hospital services. Cynthia Herdrich ("Herdrich") was covered under a plan subscription through her husband's employer, State Farm Insurance Company. Dr. Lori Pegram ("Pegram"), a physician who practiced with Carle, a health care provider under the plan, discovered an inflamed mass in Herdrich's abdomen. Pegram told Herdrich to wait eight days to receive the necessary diagnostic procedure, ultra-sound, at a Carle-staffed facility fifty miles away, instead of allowing the procedure to be performed at Herdrich's local hospital. During the eight-day waiting period, Herdrich's appendix ruptured, resulting in peritonitis, a life-threatening condition.

Herdrich sued Pegram, Carle and HAMP in state court. She sued Pegram and Carle for medical malpractice, alleging that she contracted peritonitis due to Pegram's negligence in failing to provide her with timely and adequate medical care. Herdrich also sued Carle and HAMP for common law fraud based on their failure to disclose that Carle had an ownership interest in HAMP, and that the compensation of plan doctors, such as Pegram, was increased to the extent the doctor (1) minimized diagnostic tests, (2) used Carle and HAMP facilities, and (3) minimized emergency and consultation referrals.

The defendants removed the case to federal court. Herdrich's medical malpractice claim went to trial, and she was awarded $35,000 in compensatory damages. The district court also held that Herdrich's common law fraud claim was preempted by ERISA, so it granted Herdrich the opportunity to amend the claim to clearly state an ERISA cause of action. Herdrich's amended complaint said that the defendants breached their fiduciary duty to plan beneficiaries by depriving them of proper medical care, and retaining the resulting saving for themselves. The district court dismissed the ERISA claim on the ground that Herdrich failed to show how any of the defendants were plan fiduciaries. Herdrich then appealed the dismissal of her ERISA claim to the Seventh Circuit. The Seventh Circuit held that Carle and HAMP were fiduciaries under ERISA Section 3(21)(A) since they had the "discretionary authority" to decide all disputed and non-routine claims under the plan.


According to the Seventh Circuit, Herdrich's complaint properly stated a claim for breach of fiduciary duty under ERISA since she sufficiently alleged facts which set forth that:

  1. the defendants are plan fiduciaries;
  2. the defendants breached their fiduciary duties; and
  3. a cognizable loss resulted.

1. Fiduciary Status

ERISA Section 3(21)(A) defines the term "fiduciary" as a person who (i) exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority of control respecting management or disposition of its assets . . . or (ii) has any discretionary authority or discretionary responsibility in the administration of such plan.

According to the Seventh Circuit, Congress, when it enacted ERISA, intended that this statutory definition of "fiduciary" be broadly interpreted, and consistent with the expressed intent of Congress, the courts have routinely construed the ERISA term, "fiduciary," broadly. In so holding, the Seventh Circuit emphasized the importance of discretionary control and authority in determining who is a plan fiduciary. For example, in an earlier decision, the Seventh Circuit held that it was the employer's retention of control of the claims process that brought about the fiduciary status.

In the case at issue, the Seventh Circuit emphasized that the "defendants have the exclusive right to decide all disputed and non-routine claims under the plan." The defendant-physicians managed the Plan, including the doctor referral process, the nature and duration of patient treatment, and the extent to which participants were required to use Carle-owed facilities. In fact, said the Court, the board of directors consisted exclusively of the Plan physicians who were thus in control of each and every aspect of the HMO's governance, including their own year-end bonuses. In the Seventh Circuit's view, this level of control satisfied ERISA's requirement that a fiduciary maintain "discretionary control and authority." We can reasonably infer, said the Seventh Circuit, that Carle and HAMP were plan fiduciaries due to their discretionary authority in deciding disputed claims.

2. Breach of Fiduciary Duty

A plan fiduciary must perform his duties in accordance with the standards set forth in ERISA Section 404(a)(1) which provides that

"a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and

  1. for the exclusive purpose of:
    1. providing benefits to participants and their beneficiaries, and
    2. defraying reasonable expenses of administering the plan;
  2. with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims . . ."

A fiduciary breaches its duty of care under Section 404(a)(1)(A), said the Seventh Circuit, whenever it acts to benefit its own interests. For example, ERISA expressly prohibits fiduciaries from "deal[ing] with the assets of the plan in his own interest or for his own account," or receiv[ing] any consideration for his own personal account from any party dealing with such plan in connection with a transaction involving the assets of the plan. The requirement that an ERISA fiduciary act "with an eye single to the interests of the participants and beneficiaries" is the most fundamental of his or her duties, and "must be enforced with uncompromising rigidity." This duty, emphasized the Court, the violation of which subjects a fiduciary to liability under ERISA Section 409, is directed particularly at schemes "tainted by a conflict of interest and thus highly susceptible to self dealing," like the one at issue here.

Under Section 409, any person who is a fiduciary with respect to a plan who breaches any of the responsibilities, obligations, or duties imposed upon fiduciaries by ERISA is personally liable to make good to such plan any losses to the plan resulting from each such breach, and to restore to such plan any profits of such fiduciary which have been made through use of assets of the plan by the fiduciary, and shall be subject to such other equitable or remedial relief as the court may deem appropriate, including removal of such fiduciary (emphasis added).

The Seventh Circuit concluded that a number of authorities are "particularly instructive in assisting us to determine whether the allegations in Herdrich's complaint, and the logical inferences drawn therefrom, are sufficient to demonstrate that there was a breach of the defendants' fiduciary duty." For example, the Court pointed out that it had earlier held that a fiduciary breached its duty of loyalty and care under ERISA when it misled its pension plan participants by failing to give them complete material information concerning the terms of reimbursement under the person plan. Also, the Court noted that the Eighth Circuit had concluded that the defendants therein, much like Carle and HAMP, breached their fiduciary duty by failing to disclose to plan participants a secret incentive structure that provided financial rewards to primary care physicians who minimized their use of test and referrals.

Drawing parallels to the case under consideration, the Court concluded that Herdrich adequately set forth in her complaint the intricacies of the defendants' incentive structure leading to a breach of fiduciary duty. The Plan dictated that the very same HMO administrators vested with the authority to determine whether health care claims would be paid, and the type, nature, and duration of care to be given, were those physicians who became eligible to receive year-end bonuses as a result of cost-savings. Because the physician/administrators' year-end bonuses were based on the difference between total plan costs (i.e., payments by plan beneficiaries), an incentive existed for them to limit treatment and, in turn, HMO costs as so to ensure larger bonuses. "With a jaundiced eye focused firmly on year-end bonuses," said the Court, "it is not unrealistic to assume that the doctors rendering care under the Plan were swayed to be most frugal when exercising their discretionary authority to the detriment of their membership."

The Court emphasized that the mere existence of a conflict between the incentive scheme for Carle doctors to limit medical care and treatment, on the one hand, and the fiduciary duty of Carle to the beneficiaries, on the other, without more, does not automatically give rise to a cause of action for breach of fiduciary duty under ERISA. Rather, the Court held that incentives can rise to the level of a breach where, as here, the fiduciary trust between plan participants and plan fiduciaries no longer exists (i.e., where physicians delay providing necessary treatment to, or withhold administering proper care to, plan beneficiaries for the sole purpose of increasing their bonuses).

Carle's policy requires plan participants to receive medical care from Carle-staffed facilities in what they classify as "non-emergency" situations. Because Herdrich's treatment was considered to be "non-emergency" her appendix ruptured, resulting in the onset of peritonitis. In an effort to defray the increased costs associated with the surgery required to drain and cleanse Herdrich's ruptured appendix, Carle insisted that she have the procedure performed at its own Urbana facility, necessitating that Herdrich travel more than fifty miles from her neighborhood hospital in Bloomington, Illinois. After reviewing these facts, the Court concluded that Herdrich suffered a life-threatening illness (peritonitis), which necessitated a longer hospital stay and more serious surgery at a greater cost to her and the Plan.

The "market forces" the dissent refers to hardly seem to have produced a positive result in this case, said the Seventh Circuit. "We are far from alone in our belief that market forces are insufficient to cure the deleterious affects of managed care on the health care Industry." "Across the country, health care critics and consumers are complaining that the quality of medical treatment in this nation is rapidly declining, leaving a fear that the goal of managing care has been replaced by the goal of managing costs."

To regain trust, said the Court, HMOs need to be more sensitive to the doctor-patient relationship and remove the physician from direct financial interest in patient care. Instead, doctors should have a predetermined budget and be able to advocate for patients without direct personal gain or loss.

Another hot-button issue for HMO members, said the Court, is the fear that a life-saving experimental procedure will be denied because of its cost. As a result, the industry should follow the lead of the handful of HMOs that have established outside, independent panels to make final decisions. Also, said the Seventh Circuit, according to the Physician Payment Review Commission in Washington, D.C., sixty percent of all managed-care plans, including HMOs and preferred-provider organizations, now pay their primary-care doctors through some sort of "capitation" system. That is, rather than simply pay any bill presented by the doctor, most HMOs pay their physicians a set amount every month based on the number of patients. For example, at Chicago's GIA Primary Care Network, physicians get $8.43 each month for every male patient ... and $10.09 for every female patient .... Some HMOs, such as Oxford Health Plans, Cigna and Aetna, have "withhold" systems, in which a percentage of the doctors' monthly fees are withheld and then reimbursed if they keep their referral rates low enough. Others like U.S. Healthcare, pay bonuses for low referral rates.

There is ample evidence that a bottom-line mentality is taking over, said the Seventh Circuit. HMOs refer to the proportion of premiums they pay out for patient care as their "medical-loss ratio" – a chilling choice of words. The Association of American Medical Colleges reported last November that medical loss ratios of for-profit HMOs paying a flat fee to doctors for treatment averaged only 70% of their premium revenue. The remaining 30% went for administrative expenses and profit.

Doctors who are dissatisfied with the corporate, profit-driven nature of HMOs, as well as the loss of independence in the doctor-patient relationship, are also considering competing head-on and are forming their own HMOs, just as was done here. Many of these physicians and surgeons have joined their respective specialty practices and linked up with local hospitals to compete with regional HMOs for managed care contracts. But in these circumstances, as in our case, said the Court, doctors often assume the dual role of care-provider and HMO administrator, and are ultimately held accountable for breaches of fiduciary duty.

Here, the Court concluded that the Carle physicians were intimately involved with the financial well-being of the enterprise in that the yearly "kickback" was paid to Carle physicians only if the annual expenditure made by physicians on benefits was less than total plan receipts. According to the complaint, Carle doctors stood to gain financially when they were able to limit treatments and referrals. Due to the dual-loyalties at work, Carle doctors were faced with an incentive to limit costs so as to guarantee a greater kickback.

As a result, the Seventh Circuit held that the language of the plaintiff's complaint was sufficient in alleging that the defendant's incentive system depleted plan resources so as to benefit physicians who, coincidentally, administered the Plan, possibly to the detriment of their patients. On the surface, said the Court, it does not appear to us that it was in the interest of plan participant for the defendants to deplete the Plan's funds by way of year-end bonus pay-offs. Accordingly, the Court held that based on the record before it the plaintiff has alleged sufficiently a breach of the defendants' fiduciary duty.

3. Loss to Plan

Finally, the defendants argued that Herdrich's claim must be dismissed because she does not allege that she suffered any loss attributable to the defendants' disputed breach. Specifically, they contended that beneficiaries in an ERISA plan may not recover anything other than the benefits provided expressly in the Plan itself. "This is a mischaracterization of the law," said the Court.

Under ERISA Section 409, "Any person who is a fiduciary with respect to a plan who breaches any of the responsibilities, obligations, or duties imposed upon fiduciaries by [ERISA] shall be personally liable to make good to such plan any losses to the plan resulting from each such breach." ERISA's "draftsmen were primarily concerned with the possible misuse of plan assets, and with remedies that would protect the entire plan, rather than with the rights of an individual beneficiary." In such suits, said the Court, plan beneficiaries have standing to bring an action on behalf of the plan itself to recoup monies expended in violation of ERISA, as the plaintiff has done here. The fiduciary duties set forth in Section 404 run only to the plan, and not to individual beneficiaries. In her complaint, Herdrich alleged that as a result of the defendants' actions, the Plan was deprived of the supplemental medical expense payment amounts in controversy. Accordingly, the Seventh Circuit held that Herdrich alleged with sufficiently clarity that the Plan suffered a loss as a result of the defendants' actions.


© 2000 Greenberg Traurig

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