INSURANCE LITIGATION

INSURANCE BAD FAITH AND ERISA PREEMPTION: THE TIDE HAS TURNED

By Douglas K. deVries, Esq.
deVries Law Firm, Sacramento
and
Robert K. Scott, Esq.
Law Offices of Robert K. Scott, Newport Beach

INTRODUCTION:

In UNUM Life Insurance Company of America v. Ward (1999 WL 224560, April 20, 1999), the U. S. Supreme Court held that California's common law notice-prejudice rule applicable to insurance claims is not preempted by ERISA (Employee Retirement Income Security Act of 1974). Ward's ERISA preemption analysis may further the demise of Pilot Life Insurance Company v. Dedeaux, 481 U.S. 41, 107 S.Ct. 1549 (1987) in relation to preemption of California insurance bad faith claims.

The Pilot Life decision has been roundly criticized. One approach to undermining Pilot Life was to argue that much of the decision is dictum because Pilot Life dealt with only Mississippi's common law of bad faith which was not limited to insurance, and that there is no real conflict between insurance-related state law tort remedies and ERISA's remedies. This approach has previously been generally rejected in California and the Ninth Circuit in large part because Pilot Life was based expansively on the ERISA "relate to" language, which was seen as preempting anything relating to the administration of a plan in combination with a broad interpretation of the effect of ERISA's civil enforcement scheme. See e.g., Kanne v. Connecticut General Life Ins. Co. 867 F.2d 489 (9th Cir. 1988) cert. denied, 492 U.S. 906 (1989); Commercial Life Ins. Co. v. Superior Court (1988) 47 Cal.3d 473; and concise discussion and analysis in DiMugno and Glad, California Insurance Law Handbook, Chapter 29 (Bancroft Whitney 1998).

There seems little doubt that the Ninth Circuit's ERISA "relate to" and "relationship test" preemption analyses are now, after Ward, incorrect and should be abandoned in favor of traditional federal preemption field and conflict preemption analysis as laid out in Ward.

THE WARD DECISION:

In Ward, an employee's ERISA/ disability insurance claim was denied on the ground that proof of claim was not filed within the time limits required by the policy. The issue presented was whether the ERISA plan was nevertheless subject to California's common law notice-prejudice rule, which provides as follows:

(A) Defense based on an insured's failure to give timely notice (of a claim) requires the insurer to prove that it suffered actual prejudice. Prejudice is not presumed from delayed notice alone. The insurer must show actual prejudice, not the mere possibility of prejudice. UNUM v. Ward at 1999 WL 224560, *6, citing Shell Oil Co. v. Winterthur Swiss Ins. Co. 12 Cal.App.4th 715, 760-761, 15 Cal.Rptr.2d 815, 845 (1st Dist. 1993).1

Ward's first prong held that the notice-prejudice rule constituted a law which regulated insurance, and thus escaped preemption under ERISA's savings clause, §514(b)(2)(A), 29 U.S.C. §1144(b)(2)(A) ("Except as provided in subparagraph (B), nothing in this subchapter shall be construed to exempt or relieve any person from any law of any State which regulates insurance, banking or securities.")2

The ERISA savings clause determination involves a collateral determination of whether the law regulates the business of insurance as that phrase is used in the McCarran-Ferguson Act, 15 U.S.C. §1011 et seq. The court first considered whether insurance was regulated from a "common sense view of the matter". Second, the court considered the three factors used to determine whether the regulation relates to the "business of insurance" phrasing of the McCarran-Ferguson Act. The three factors are as follows: (1) Whether the practice has the effect of transferring or spreading a policyholder's risk, (2) Whether the practice is an integral part of the policy relationship between the insurer and the insured, and (3) Whether the practice is limited to entities within the insurance industry. 1999 WL 224560, *7.

The court, in applying the common sense test, observed that the notice-prejudice rule was directed specifically at the insurance industry and was applicable only to insurance contracts. In fact, a survey of California law revealed no cases where state courts apply the notice-prejudice rule, as such, outside the insurance area. Ibid. In so holding, the court rejected UNUM's argument that the notice-prejudice rule resembled the broad Mississippi bad faith law that was at issue in Pilot Life. The Supreme Court distinguished the two, observing that while the notice-prejudice rule was a manifestation of the broader legal maxim that the "law abhors a forfeiture," the notice-prejudice rule is an application of a special mandatory rule firmly applied to insurance contracts, not a broad principle applied by courts widely to other relationships as was the Mississippi bad faith law. 1999 WL 224560, *8. Citing it as a "grounding (that) is key to our decision," the court observed that "California's insistence that insurers show prejudice before they may deny coverage because of late notice is grounded in policy concerns specific to the insurance industry." 1999 WL 224560, *9.

In so holding, the Supreme Court also rejected UNUM's assertion that a state regulation must satisfy all three McCarran-Ferguson factors, applied as rigid criteria, in order to "regulate insurance" under ERISA's savings clause. The McCarran-Ferguson factors are merely considerations to be weighed, but none of the criteria is necessarily determinative in itself. 1999 WL 224560, *10. The court observed that the notice-prejudice rule was integral to the relationship between insurer and insured (the second factor) and that the rule is limited to the insurance industry, not merely having an impact upon it, but rather being aimed at it (the third factor). 1999 WL 224560, *11. Of further significance in this regard, the court held that state laws regulating claims practices do involve regulation of insurance, including administration of insurance policies, even if they do not by their substantive terms become an integral part of the policy relationship. 1999 WL 224560, *11, fn.5.

Ward's second prong held that even if the notice-prejudice rule was saved from preemption under the ERISA savings clause, it nevertheless was preempted because it conflicted with substantive provisions of ERISA in three ways (e.g., conflict preemption).3

First, UNUM argued that the effect of the notice-prejudice rule was to alter the provisions of the insurance contract which conflicted with ERISA's requirement that plan fiduciaries act "in accordance with the documents and instruments governing the plan," 29 U.S.C. §1104(a)(1)(D), which UNUM urged had independent preemptive force. The court held that, consistent with prior rulings, state laws that mandate insurance contract terms are saved from preemption under ERISA. 1999 WL 224560, *11, citing Metropolitan Life Insurance Company v. Massachusetts, 471 U.S. 724, 105 S.Ct. 2380 (1985). Further, if an ERISA plan is an insured plan, as opposed to a self-funded plan, a state may regulate it indirectly through regulation of the insurer and the insurer's insurance contracts. Ibid. The court acknowledged that this could result in the states' varying insurance laws creating disuniformity for national plans, but the court observed that "such disuniformities...are the inevitable result of the Congressional decision to 'save' local insurance regulation." 1999 WL 224560, *11, fn.6.

UNUM's second conflict argument, which relied on Pilot Life's second prong contended that ERISA's civil enforcement provision §502(a), 29 U.S.C. §1132(a), which provides that plan participants may sue for plan benefits, also had independent preemptive force under the exclusive remedy doctrine. Ward rejects this contention on the ground that the issue was not raised by the facts of the Ward case because Mr. Ward had sued under 29 U.S.C. §1132(a)(1)(B) to recover benefits under the plan, as opposed to asserting a cause of action not provided for in the ERISA statute. The significance of the court's handling of UNUM's contention in this regard is twofold.

First, in its briefing, and in oral argument, UNUM attempted to characterize the notice-prejudice rule as being a remedy that could not be sought because it was not provided for under ERISA, and the court implicitly rejected that conflict analysis. Second, the court expanded the point by observing that "the (Ward) case therefore does not raise the question whether §502(a) provides the sole launching ground for an ERISA enforcement action." 1999 WL 224560, *11. By this observation the court highlighted the fact that the Solicitor General and the Department of Labor questioned the correctness of the court's earlier ERISA preemption analysis in Pilot Life. This point, questioning the Pilot Life analysis of ERISA's civil enforcement provision and its preemptive force, was magnified in a remarkable footnote, as follows:

FN7. We discussed this issue in Pilot Life Ins. Co. v. Dedeaux, 481 U.S. 41, 107 S.Ct. 1549, 95 L.Ed.2d 39 (1987). That case concerned Mississippi common law creating a cause of action for bad faith breach of contract, law not specifically directed to the insurance industry and therefore not saved from ERISA preemption. In that context, the Solicitor General, for the United States as amicus curiae, urged the exclusivity of §502(a), ERISA's civil enforcement provision, and observed that §502(a) was modeled on the exclusive remedy provided by §301 of the Labor Management Relations Act, 1947 (LMRA), 29 U.S.C. §185. The Court agreed with the Solicitor General's submission, 481 U.S., at 52-56. In the instant case, the Solicitor General, for the United States as amicus curiae, has endeavored to qualify the argument advanced in Pilot Life.& See Brief 20-25. Noting that "LMRA Section 301 does not contain any statutory exception analogous to ERISA's insurance savings provision," the Solicitor General now maintains that the discussion of §502(a) in Pilot Life "does not in itself require that a state law that 'regulates insurance,' and so comes within the terms of the savings clause, is nevertheless preempted if it provides a state-law cause of action or remedy." Brief 25; see also id., at 23 ("[T]he insurance savings clause, on its face, saves state law conferring causes of action or affecting remedies that regulate insurance, just as it does state mandated-benefits laws."). We need not address the Solicitor General's current argument, for Ward has sued under §502(a)(1)(B) for benefits due, and seeks only the application of saved state insurance law as a relevant rule of decision in his §502(a) action. Ibid.

In other words, the Solicitor General, has questioned whether Pilot Life's exclusive remedy preemption analysis was erroroneous, both factually and legally. Further, this discussion in a unanimous Supreme Court opinion, including Justice O'Connor, who authored Pilot Life, seems to constitute an invitation to the bar to present cases that re-examine Pilot Life.

Finally, in relation to conflict preemption analysis, the court rejected UNUM's argument that the notice-prejudice rule conflicted with ERISA §503, 29 U.S.C. §1133, which requires ERISA plans to provide notice and review of denied claims. The court observed that by providing a longer period of time to file claims rather than the minimum filing terms mandated by federal law, California's notice-prejudice rule "compliments rather than contradicts ERISA and the regulations." 1999 WL 224560, *12. As discussed below, this conflict preemption analysis is analogous to the court's preclusion-based conflict analysis in Humana, Inc. v. Forsyth, 119 S.Ct. 710 (1999).

It is apparent that the United States Supreme Court has abandoned the preemption analysis that formed the foundation for Pilot Life. However, Pilot Life has not been overruled; at least not yet. The court has not directly confronted that question, especially involving California's insurance bad faith law. In the year following Pilot Life, the California Supreme Court decided Foley v. Interactive Data Corp. (1988) 47 Cal.3d 654, 254 Cal.Rptr. 211, which held that California's bad faith cause of action applied only to insurance and to no other contractual relationship. When Ward is read replacing "California common law notice-prejudice: with :California common law bad faith," as delineated by Foley, a compelling analysis emerges to support the conclusion that ERISA does not preempt California's bad faith cause of action.4

THE FOLEY DECISION:

Foley v. Interactive Data Corp. (1988) 47 Cal.3d 654, 254 Cal.Rptr. 211, concerned a terminated employee who sued his employer for "bad faith." The California Supreme Court characterized the case as an attempt to extend tort liability for bad faith to the employment context from the insurer-insured relationship to which it had traditionally applied in California. The key holdings from Foley are as follows: (1)The tort remedy for bad faith in California is an exception to a general rule developed specifically for insurance contracts; citing, Comunale v. Traders & General Ins. Co. (1958) 50 Cal.2d 654, 658; Egan v. Mutual of Omaha Ins. Co. (1979) 24 Cal.3d 809, 818, 169 Cal.Rptr. 691; Crisci v. Security Ins. Co. (1967) 66 Cal.2d 425, 58 Cal.Rptr. 13; Gruenberg v. Aetna Ins. Co. (1973) 9 Cal.3d 566, 108 Cal.Rptr. 480; (2) imposition of bad faith tort liability on employers was "unprecedented," and a major departure from traditional principles of contract law; at 686-690; (3) The insurance relationship is unique in that (a) the insurer's and insured's interests are financially at odds, (b) insureds are not seeking a commercial advantage, and (c) in the face of bad faith refusal by an insurer to perform contractual obligations in a good faith manner, the insured cannot turn to the marketplace to find another insurance company willing to pay for a loss already incurred. At 691-692, 694.

THE FORSYTH DECISION:

Forsyth v. Humana, Inc., 114 F.3d 1467 (9th Cir. 1997), cert. denied 118 S.Ct. 559 1997, cert. gtd. 118 S.Ct. 2339 (1998) involves the interplay between the McCarran-Ferguson mandate to the states to regulate the business of insurance and civil remedies against insurers under federal RICO (Racketeer Influenced Corruption Organizations Act). Forsyth held that federal RICO remedies, including treble damages, could be applied in harmony with Nevada's regulation of insurance, including Nevada's causes of action for punitive and exemplary damages against insurance companies. 119 S.Ct. at 714. While ERISA was not directly involved in the Forsyth disposition, it is significant that the case revolved around interpretation of the McCarran-Ferguson Act, which is also relevant to ERISA savings clause analysis, and that the case involved conflict analysis that is analogous to Ward's conflict analysis.

In Forsyth, the conflict analysis related specifically to the proscription in §2(b) of the McCarran-Ferguson Act that "no act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any state for the purpose of regulating the business of insurance...unless such Act specifically relates to the business of insurance." 15 U.S.C. §1012(b). In adopting a "direct conflict" test the court noted that there was no direct conflict because RICO did not authorize conduct which the state laws prohibited, and conversely RICO did not punish conduct that the state law authorized or permitted. Forsyth declared the federal and state laws to be compatible and harmonious. Forsyth's direct conflict analysis is, in a sense, the mirror image of the conflict analysis applied in Ward to find that California's common law notice-prejudice rule does not conflict with ERISA's civil enforcement provision.

In addition, Forsyth refers to Shaw v. Delta Airlines, Inc., 463 U.S. 85, 103 S.Ct. 2890 (1983), an ERISA preemption case as being "similar in tenor." Shaw acknowledged that states have a paramount interest in protecting insurance policyholders and that the state law was preempted on that cases' facts only to the extent it prohibited practices that were lawful under federal law.

PRE-WARD U.S. SUPREME COURT CASES:

Recent U. S. Supreme Court cases foreshadowed, and further support, Ward's preemption analysis, as follows:

Metropolitan Life Insurance Company v. Massachusetts 471 US 724, 105 S.Ct. 2380 (1985), (state law mandating insurance benefits was a law which regulated the business of insurance and was saved from preemption by ERISA's savings clause).

New York State Conference of Blue Cross and Blue Shield Plans v. Travelers Insurance Company 514 US 645, 115 S.Ct. 1671 (1995), (an indirect economic influence on and administrative cost to a plan does not justify preemption).

California Division of Labor Standards Enforcement v. Dillingham Construction, N.A., Inc. 519 US 316, 117 S.Ct. 832 (1997), ( state law neither made "reference to" nor did it have "connection with" ERISA plans and therefore did not "relate to" ERISA plans and was not preempted); the concurring opinion by Scalia and Ginsburg observed that the ERISA preemption criteria set forth in some of the court's earlier cases has "in effect been abandoned" as "a project doomed to failure...." 117 S.Ct. 832, 842-843.

De Buono v. NYSA-ILA Medical and Clinical Services Fund, 520 U.S. 806, 117 S.Ct. 1747 (1997), (state tax on health care facilities operated by ERISA plan not preempted; under traditional preemption analysis "the starting presumption that Congress does not intend to supplant state law" is "considerable."

FMC Corp. v. Holliday 498 US 52, 111 S.Ct. 403, 112 L.Ed.2d 356 (1990) has been interpreted to stand for the proposition that Congress, by treating insured plans different from uninsured plans, the latter not being deemed the business of insurance, intended that ERISA reserve to the state's the direct regulation of insurers as well as the substantive terms of insurance contracts. See International Resources, Inc. v. New York Life Ins. Co., 950 F.2d 294, 301, (6th Cir. 1992). In this regard, Ward also emphasized FMC Corp. v. Holliday noting that "if a plan is insured a State may regulate it indirectly through regulation of its insurer and its insurer's insurance contracts." 1999 WL 224560, *11; FMC Corp., 498 U.S. at 64.

Emard v. Hughes Aircraft Company 153 F.3d 949 (9th Cir.1998) (ERISA preemption does not bar the application of California's community property law to ERISA insurance benefits); Washington Physicians' Service Ass'n. v. Gregoire 147 F.3d 1039 (9th Cir. 1998) (Washington's statute requiring that HMO's cover alternative medical treatments saved from preemption).

CONCLUSION

Recent pronouncements of the U.S. Supreme Court concerning ERISA preemption, including Ward's abandonment of Pilot Life's savings clause analysis, coupled with its calling into question of Pilot Life's exclusive remedy analysis, suggest the ERISA preemption tide has turned. Further analysis, especially of the exclusive remedy issue in the context of traditional conflict preemption analysis, and the effect of Foley on that analysis, is the next logical step in challenging ERISA preemption of California's insurance bad faith remedy.