Recent cases decided under the Employee Retirement Income Security Act (ERISA), such as Fought v. UNUM Life Ins. Co., 2004 U.S. App. LEXIS 17009 (10th Cir. Aug. 13, 2004), create serious new risks for plan administrators that deny benefits under an ERISA plan.

Cases like Fought have opened a floodgate to potential litigation for unwary employers, insurers and plan administrators that fail to identify and eliminate fiduciary conflicts of interest when deciding final appeals of health and disability benefits claims. Conflicted fiduciaries can no longer safely hide behind ERISA’s “arbitrary and capricious” standard for reviewing benefits denials, which deters litigation by posing a nearly insurmountable barrier for plaintiffs to overcome.

Now, conflicted fiduciaries may have to bear the ultimate burden of proving the propriety of a final denial of benefits—in other words, guilty until proven innocent. Once plaintiffs’ lawyers smell the blood spilled in cases like Fought, they will be emboldened to sue decision-makers more readily and to employ highly invasive, disruptive and costly discovery tactics designed to reveal conflicts.

This report summarizes recent cases, explains the consequences for HR professionals and their employers, and provides a summary of practical steps HR should take promptly to minimize or eliminate the traps flowing from costly conflicts of interest. In addition, it highlights the important benefits of outsourcing health and disability plan appeals to an independent third-party professional for resolution.

From Firestone to Fought—Opening the Floodgate

In Firestone Tire and Rubber Co. v. Bruch, 489 U.S. 101 (1989), the U.S. Supreme Court established the bedrock principle that an arbitrary and capricious standard applies to review of benefits decisions when plans specifically give administrators discretionary authority to determine eligibility for benefits and to interpret plan terms.

Under the arbitrary and capricious standard, courts essentially defer to the experienced judgment of plan administrators—the experts in resolving benefits questions—and limit their review to determining whether the administrator’s interpretation is reasonable and appears to have been made in good faith. This gives administrators tremendous latitude to make decisions with little fear that they will be overruled and deters disappointed plan participants from filing lawsuits.

In reviewing a plan administrator’s decision under the deferential arbitrary and capricious standard, the courts were limited to evaluating the administrative record, that is, the materials the administrator compiled in the course of making a final decision. This important limitation tended to guard sponsors and others involved in the decision from getting caught up in and having to respond to a plaintiff’s costly, distracting and time-consuming discovery tactics.

Nevertheless, the Firestone court left open the possibility that a less deferential standard of review might apply—making it easier to challenge and reverse an administrator’s final decision—when an administrator or fiduciary is operating under a conflict of interest. When a conflict exists, courts must consider the conflict as a “factor” in determining whether the fiduciary’s decision should be overturned. Since Firestone, courts have struggled to define when a conflict of interest exists and how to judicially remedy a conflict.

The Fought decision attempts to clarify when a conflict of interest arises and the legal effect of varying degrees of conflicts. In doing so, however, Fought exposes ERISA fiduciaries to greater risk and increased litigation by interpreting Firestone and subsequent cases in a way that makes it easier for aggressive plaintiffs’ lawyers to find and exploit conflicts of interest.

Trap for the Unwary

The Fought case springs legal traps for the unwary, conflicted ERISA fiduciary who fails to identify and eliminate, or at least minimize, conflicts of interest that taint benefits decisions. At the same time, Fought also provides an opportunity for ERISA fiduciaries to assess and, if necessary, modify their current relationships and practices in a way that enhances the defensibility of their decisions and deters unnecessary litigation. HR professionals must alert their employers, company executives and plan administrators to the risks Fought creates and should help them avoid the potentially devastating consequences by responding proactively.

The facts of Fought

Following elective heart surgery, Shirley O. Fought suffered a severe staph infection that hospitalized and disabled her. She sought coverage under her company’s long-term disability plan. UNUM served as the plan administrator and insurer, an admitted conflict of interest, since UNUM had a financial stake in the outcome of its decision. UNUM denied Fought’s claim for coverage, concluding that she suffered from a pre-existing condition excluded by the plan.

Fought submitted a formal request to have her claim re-opened, as well as letters from three doctors certifying that the infection was neither a pre-existing condition nor related to her pre-existing coronary artery disease. UNUM reviewed the letters but declined to reverse its previous decision. Fought retained legal counsel, who notified UNUM that Fought was appealing. After a review, UNUM again denied coverage, simply echoing the plan’s pre-existing condition language. Finally, Fought contacted a state agency, which corresponded with UNUM about the matter. In response, UNUM reiterated that the infection was the result of surgery to treat a pre-existing condition.

Fought sued UNUM, alleging that UNUM violated ERISA in denying her claim. UNUM admitted that it made its decision subject to a conflict of interest. Because UNUM acted as both the claims decision-maker and the payor of those claims, UNUM had an obvious financial stake in the outcome. Fought asked the trial court to allow her to engage in discovery designed to uncover the extent of UNUM’s conflict of interest. The judge denied Fought’s request.

UNUM moved for summary judgment to win the case without having to go through a costly trial. Though the trial court acknowledged the conflict of interest, it still favored UNUM by reviewing the denial under the deferential arbitrary and capricious standard. On that basis, the trial court granted UNUM’s motion for summary judgment, concluding that UNUM’s decision to deny benefits was not arbitrary or capricious.

Fought appealed and the appellate court held that the trial court applied the wrong standard of review. According to the 10th Circuit, rather than applying the typical arbitrary and capricious standard, the trial court should have applied a “sliding scale” standard affording UNUM much less deference given its clear conflict of interest. Pursuant to the “sliding scale” approach, the court still applies the arbitrary and capricious standard, but with a decreasing degree of deference to the administrator’s decision in proportion to the seriousness of the conflict of interest. The greater the conflict, the less deference is afforded to the expert administrator.

The appellate court directed the trial court to re-evaluate the case under the sliding scale approach. Significantly, because of the seriousness of UNUM’s conflict, the appellate court also instructed the trial court to shift the burden to UNUM to prove the propriety of its decision by adducing “substantial evidence” from the record.

By elaborating on and clarifying the sliding scale approach, the 10th Circuit helps fiduciaries to determine whether they are operating under a conflict and to assess the legal effect of the conflict.

Conflicts and their consequences

The Fought court is not the first to address the effect of a conflict of interest on the degree of deference to be afforded an administrator when reviewing a denial of benefits. Other federal circuits across the country also require a more scrupulous review of conflicted decisions. For instance, in Pinto v. Reliance Standard Life Ins. Co., 214 F.3d 377 (3rd Cir. 2000), the 3rd Circuit held that the deference afforded a fiduciary will be lessened to the degree necessary to neutralize the influence of a conflict. The 5th, 7th and 8th circuits have reached similar conclusions.

However, because the appellate courts disagree on precisely how a conflict alters the standard of review, the Fought court went a step further by defining types of conflicts—“standard” and “inherent”—and their legal effect. The plaintiff bears the burden of proving that a conflict of interest exists.

“Standard” Conflict of Interest. A standard conflict exists when a fiduciary wears two hats or acts in dual roles, and the plaintiff proves that the dual role actually jeopardized the decision-maker’s impartiality. Section 1102(c)(1) of ERISA recognizes that “[a]ny person or group of persons may serve in more than one fiduciary capacity with respect to [a] plan.” For that reason, simply serving in dual roles, such as plan administrator and employee of the plan sponsor, is not enough to create a conflict.

Factors to be considered in determining whether the dual role actually adulterates the decision-maker’s objectivity include whether: (1) the plan is self-funded, (2) the company that funds the plan also appoints and compensates the plan administrator, (3) the administrator’s performance reviews or compensation are linked to benefit denials, and (4) the provision of benefits has a significant economic impact on the company.

“Inherent” Conflict of Interest. An inherent conflict exists in one or more of three circumstances: (1) when the administrator is both insurer and administrator, because there is an inherent conflict between the discretion to pay claims and the need to remain financially sound; (2) when there is a proven conflict of interest; and (3) when a serious procedural irregularity exists.

When a plaintiff proves an inherent conflict, the burden shifts to the plan administrator to prove that its interpretation of the plan is reasonable and that its application of the plan terms to the claimant is supported by “substantial evidence.”

In Fought, the appellate court held that an inherent conflict existed for two reasons. First, UNUM served as both decision-maker and claim payor. Second, UNUM’s decision suffered from a “serious procedural irregularity.” Despite its admitted conflict, UNUM failed to obtain an independent evaluation or investigation to neutralize its bias.

Though not required, independent medical examinations are helpful, particularly in the face of an inherent conflict. In this regard, the 7th Circuit declared: “When it is possible to question the fiduciaries’ loyalty, they are obliged at a minimum to engage in an intensive and scrupulous independent investigation of their options to insure that they act in the best interests of the plan beneficiaries.” Hightshue v. AIG Life Ins. Co., 135 F.3d 1144, 1148 (7th Cir. 1998). Following the lead of other appellate courts, the Fought court emphasized that a conflicted fiduciary can satisfactorily eliminate the effect of its own prejudice “by obtaining an independent evaluation” or by seeking “independent expert advice.” The Fought court chastised UNUM, because it “denied Fought’s claim, which involved a complicated set of circumstances without seeking any independent review.”

Consequences of Fought

Exposure to litigation

Fought invites litigation to determine both whether a decision-maker operated under a conflict of interest and what impact the conflict may have played in the decision to deny benefits. Future litigation will focus on both the weight a conflict may have played in the fiduciary’s decision and on reasonableness of the decision.

Exposure to broader, more invasive discovery

Fought also opens the door to litigation targeted at discovering the existence and extent of conflicts of interest. Any and all records and information that could lead to the discovery of admissible evidence bearing on the existence and extent of a potential conflict arguably are fair game. Consequently, the time and expense of litigating benefits cases will increase as plaintiffs attempt to pry deeply into the intimate details of corporate governance; inter- and intra-organizational relationships relating to plan administration and finance; issues of cost containment, plan design, and budgeting; incentives available to those involved in the investigation and decision-making process; and any other matters that could lead to the discovery of admissible evidence necessary to enable plaintiffs to prove the existence of a conflict of interest. The increased risk of burdensome discovery alone could enable plaintiffs to leverage larger and more costly settlements to avoid distracting and precedent-setting litigation.

Damage to employee relations

Acrimonious litigation over employee benefit denials—which almost always involve highly sympathetic and emotional circumstances—leads to negative industrial and employee relations. True or not, benefit denials may appear to be unfair and aimed at enhancing company profits at the expense of employees and their families. Accordingly, it is counter-intuitive for companies to spend large amounts on employee benefits, while damaging employee morale and relations by failing to eliminate obvious conflicts.

Exposure to other liabilities

Through discovery, plaintiffs will attempt to determine if the employer followed all Health Insurance Portability and Accountability Act (HIPAA) rules and procedures. This might lead to litigation regarding the misuse of protected health information. Broadened discovery also may reveal whether plan rules were followed consistently or if “exceptions” were made evincing a serious procedural irregularity or some form of unlawful discrimination or retaliation. Aggressive trial lawyers may pursue other potential violations of ERISA, HIPAA, claims regulations or plan rules.

Steps To Take in Light of Fought

HR professionals should encourage their employers, administrators and insurers to use the lessons from Fought to better assess their own circumstances and, with legal counsel, develop strategies for responding to standard or inherent conflicts of interest. Some practical proactive steps to consider include the following.

Conduct a self-audit for conflicts

Attorneys, HR managers and benefits professionals responsible for plan management should conduct a self-audit to determine the existence of standard or inherent conflicts of interest. Conduct the audit in collaboration with counsel to preserve attorney-client privilege to the extent possible. Review the role of each decision-maker within the company. Auditors should be comfortable that these individuals will pass the Fought impartiality challenge. Certain senior HR professionals and finance managers would be suspect in this role. Individuals with bottom-line profit and loss responsibility may also be subject to challenge as well as those responsible for budgeting and cost containment.

Carefully scrutinize any plan where fiduciary decision-making authority has been delegated to a third-party insurer. Plan sponsors must understand the process used by the third-party insurers to review claims and to administer appeals. The administrator should be able to establish by substantial evidence that the decision to deny benefits was reasonable and appropriate. When conflicts are identified, the professionals should measure the degree of the conflict in view of the Fought factors and assess their potential impact in litigation.

Prepare for discovery and potential litigation

Conduct a careful review of the entire process of administering claim appeals to assess compliance with all relevant plan rules and federal regulations. Files should be complete and prepared for thorough review, if necessary. In addition, conduct a HIPAA audit to ensure that protected health information about employees and their dependents provided in the appeal process is adequately safeguarded and handled in accordance with HIPAA regulations.

Prepare for prompt response to appeals

Evaluate the process for administering appeals in light of claim regulations. New Department of Labor claim regulations place stringent timing requirements on making benefits decisions. Normally, these decisions must be made within 60 days of the plan’s receipt. Failure to comply with the new deadlines could allow the claimant to proceed to federal court. This places additional strain on an already tightly stretched internal HR or benefits staff to quickly assimilate the data and render the final decision.

Promptly identify and eliminate conflicts

For maximum defensibility of an administrator’s decisions, identify and correct actual or potential conflicts in the area of claims appeals. Once litigation and discovery begin, it may be too late to remedy a conflict. Arguably, the best solution for remedying conflicts, whether standard or inherent, is to outsource the claims appeal process, or at least the final decision, to an independent, expert decision-maker.

Benefits of Outsourcing

The Fought court suggested the importance of outsourcing in the face of an existing conflict when it quoted the Firestone case as follows: “If a disinterested party exercising discretionary powers has looked at evidence and rendered a decision, it is not only reasonable but a wise conservation of judicial resources not to have judges replicate the administrator’s work.” Removing the final decision from a conflicted internal administrator or third-party insurer and placing the discretionary authority with a truly independent and “disinterested” third party would shield decisions with the arbitrary and capricious standard of review. Some of the significant benefits of outsourcing the final determination of benefit plan appeals include:

• Reducing exposure to litigation.

• Retaining the greatest protection and integrity for benefit plan decisions.

• Avoiding invasive, time consuming and costly discovery.

• Avoiding potential HIPAA violations by removing protected health information from the hands of internal employees.

• Reducing the likelihood of breaching claim regulations.

• Improving industrial and employee relations through a process that will be perceived as fair and impartial.

• Allowing HR and benefits professionals to concentrate on higher value work rather than the administratively burdensome tasks of processing benefit plan appeals.

• Providing greater consistency in application of plan rules, ERISA regulations and benefit plan case law.