For nearly three decades, ERISA plans have routinely included a provision that grants plan fiduciaries unfettered discretion to interpret and rule on issues concerning plan interpretation. These so-called “discretionary clauses” have been subjected to a firestorm of criticism by many states, which argue that the discretionary clauses lead to inequitable results for the plan participants. As a result, many states have enacted laws banning discretionary clauses in insurance policies. For insured plans, these laws have generally withstood ERISA preemption attacks. Two federal district courts in California have gone a step further and concluded that the California Insurance Code provision that bars discretionary clauses also applies to self-funded ERISA short-term disability plans.
The U.S. Supreme Court long ago held that reviewing courts should apply a de novo standard of review to plan fiduciaries’ decisions unless the benefit plan provides the fiduciary with discretionary authority to determine eligibility for benefits or construe the terms of the plan – a “discretionary clause” – in which case the decision should be reviewed for an abuse of discretion, i.e., under an arbitrary and capricious standard of review. Firestone Tire & Rubber Co. v. Bruch, 489 U.S. 101 (1989). Since Firestone, states and plan sponsors and fiduciaries have offered competing views of the benefits associated with plan provisions that allow for an abuse of discretion review. Supporters of the use of discretionary clauses contend that such clauses keep costs manageable, and the failure to control litigation costs will discourage employers from offering employee benefit programs in the first place. Supporters of bans on discretionary clauses argue that such bans help to eliminate unfairness and misleading policy language, and also minimize the conflicts of interest that exist when the claims adjudicator also pays the benefit.
State Bars to Discretionary Clauses
Many states ban or restrict discretionary clauses in ERISA insured plans and insurance policies. Plan sponsors and fiduciaries have challenged the enforceability of these state laws on the ground that they were preempted pursuant to ERISA § 514, which expressly preempts all state laws “insofar as they may now or hereafter relate to any employee benefit plan.” 29 U.S.C. § 1144(a). The states have argued that the clauses were insulated from preemption pursuant to ERISA’s “savings clause,” which provides that ERISA “shall [not] be construed to exempt or relieve any person from any law of any State which regulates insurance, banking or securities.” 29 U.S.C. § 1144(b)(2)(A). A state law regulates insurance within the meaning of section 514(b)(2)(A) of ERISA if it: (i) is “specifically directed toward entities engaged in insurance,” and (ii) “substantially affect[s] the risk pooling arrangement between the insurer and the insured.” Kentucky Ass’n of Health Plans v. Miller, 538 U.S. 329, 342 (2003).
The circuit courts have generally concluded that state bans on discretionary clauses regulate insurance and thus are saved from ERISA preemption. American Council of Life Insurers v. Ross, 558 F.3d 600 (6th Cir. 2009); Standard Ins. Co. v. Morrison, 584 F.3d 837 (9th Cir. 2009). The Tenth Circuit concluded that Utah’s limited state ban on discretionary clauses did not regulate insurance, and thus was preempted. The Court determined that the rule related to the form, and not the substance, of ERISA plans. Hancock v. Metro. Life Ins. Co., 590 F.3d 1141, 1149 (10th Cir. 2009). On that basis, the Tenth Circuit distinguished Utah’s rule from the state bans on discretionary clauses in Ross and Standard Insurance and suggested that a blanket prohibition on the use of discretion-granting clauses would have altered the court’s analysis.
As noted, these lawsuits involved fully insured ERISA plans, not self-funded plans. The distinction is important, since, under ERISA’s “deemer clause,” self-funded plans are deemed to not be “engaged in the business of insurance or banking for purposes of any law of any State purporting to regulate insurance companies, insurance contracts, banks, trust companies or investment companies.” 29 U.S.C. § 1144(b)(2)(B). Some courts have thus concluded that these plans are immune from state law bans on discretionary clauses. Guest-Marcotte v. Life Ins. Co. of N. Am., 2016 U.S. Dist. LEXIS 33815, at *21-23 (E.D. Mich. Feb. 17, 2016), adopted by, Guest-Marcotte v. Life Ins. Co. of N. Am., No. 15-CV-10738, ECF No. 42 (E.D. Mich. Mar. 15, 2016).
Application of Discretionary Bans to Self-Funded Plans
In what appear to be cases of first impression, two federal district courts in California have held that California’s ban on discretionary clauses applied to ERISA self-funded plans. Williby v. Aetna Life Ins. Co., 2015 U.S. Dist. LEXIS 116442 (C.D. Cal. Aug. 31, 2015); Thomas v. Aetna Life Ins. Co., 2016 U.S. Dist. LEXIS 107815 (E.D. Cal. Aug. 15, 2016).
In Williby, the court concluded that a plain reading of the state ban – which applies to any insurance policy, certificate or agreement – indicated that the law applied to self-insured plans because “an ERISA plan is a contract.” The court stated that its reading of the ban was supported by the legislative history of the state ban, wherein the California Insurance Commissioner’s counsel noted that ERISA “employer-sponsored disability contracts” with discretionary clauses deprive insureds of the benefits for which they bargained. The Williby court did not conduct any preemption analysis in reaching its conclusion. Because the court found the discretionary clause void and unenforceable, it reviewed Aetna’s denial of benefits de novo.
More recently, in Thomas, the court followed Williby and explained that the California Insurance Code’s prohibition against discretionary clauses applies, not only to insurance policies, but also to contracts in general, including self-funded ERISA plans. The court never reached the question of whether the state law was saved from preemption because it concluded that the state law did not relate to an ERISA plan, i.e., it did not have an “impermissible connection” with an ERISA plan. In so ruling, the court rejected Aetna’s reliance on Gobeille v. Liberty Mut. Ins. Co., 136 S. Ct. 936 (2016) in arguing that the ban was preempted because it impermissibly interfered with a key facet of ERISA plan administration by voiding discretionary clauses that allow for the uniform administration of plans and save administrators from having to master the laws of all 50 states. In Gobeille, the Supreme Court determined that a Vermont law, that required self-funded plans to report data related to payments for healthcare claims or pay a fine, was expressly preempted by ERISA. The Thomas court distinguished the California state law ban from the Vermont law Gobeille found to be preempted because the Vermont law added new requirements, including additional reporting for administrators of ERISA benefits plans, and thus created a new cause of action. The court further explained that since the California ban only enforced the default standard of review under ERISA, i.e., the de novo standard of review, it did not provide an alternative enforcement mechanism outside of ERISA’s civil enforcement provisions. The court acknowledged Aetna’s arguments that Williby was incorrectly decided but stated that absent further direction from the Ninth Circuit it was “reluctant to forge a new path” when all previous cases addressing the California ban – all of which involved fully insured plans, except for Williby – have concluded that it is not preempted by ERISA.
The rulings in California appear to be clearly at odds with precedent deeming self-funded plans to be outside the purview of ERISA’s “savings clause,” and thus insulated from state law regulation. They are an indication that, in some jurisdictions, the desire to regulate plan provisions that are deemed to be unfair may cause courts to circumvent these legal constraints. Although these decisions are not binding precedent, plan sponsors and fiduciaries should be mindful of them and watch for further developments, particularly those who may find themselves subject to the California ban on discretionary clauses.