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1999 Term, Number 2 / September 28, 1999

The Supreme Court continued to accelerate its announcement of granted cases, issuing its second round of grants nearly a week before the new Term formally opens next Monday, October 4. The Court granted certiorari in ten cases (two of them consolidated), three of which are of potential interest to the business community. Under a special briefing schedule set by the Court, amicus briefs in support of the petitioners are due on Friday, November 12, 1999, and amicus briefs in support of the respondents are due on December 13. Any questions about this case should be directed to Donald Falk (202-263-3245) or Eileen Penner (202-263-3242) in our Washington office.

1. ERISA — Breach of Fiduciary Duty — Managed Care — Financial Incentives for Cost-Effective Care. Many health maintenance organizations (HMOs) and other managed care plans provide participating physicians with financial incentives to provide cost-effective care. The Supreme Court granted certiorari in Pegram v. Herdrich, No. 98-1949, to determine whether physician-administrators in HMOs with those incentives breach fiduciary duties under the Employee Retirement Income Security Act of 1974, 29 U.S.C. § 1001 et seq. ("ERISA").

ERISA imposes fiduciary duties on persons with discretionary authority over the management or administration of private employee benefit plans. See 29 U.S.C. § 1002(21)(A). A fiduciary under ERISA has duties of care and loyalty, and must act "solely in the interest of the [plan] participants and beneficiaries and * * * for the exclusive purpose of: (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan * * * ." Id. § 1104. ERISA gives plans and plan beneficiaries a federal cause of action for breach of these duties. See id. § 1109(a), 1132(a).

Cynthia Herdrich was an ERISA health plan beneficiary whose health plan contracted with a physician-owned HMO to provide medical care. Herdrich's appendix ruptured while she waited eight days for an ultrasound procedure — a delay she attributed to her HMO's requirement that she undergo the procedure in a facility staffed by the HMO. Herdrich brought (and eventually prevailed on) medical malpractice claims against the health care providers. She also brought additional state-law claims focused on the operation of the HMO; those claims were dismissed as preempted by ERISA, see 29 U.S.C. § 1144(a). Herdrich then amended her complaint to allege that her doctor and HMO had breached their fiduciary duties under ERISA by using cost-containment incentives that could financially reward the doctors who operated the HMO. The district court dismissed this cause of action for failure to state a claim.

A divided panel of the Seventh Circuit reversed. 154 F.3d 362 (1998). The court of appeals first determined that the doctor and HMO were fiduciaries within the meaning of ERISA because, in its view, they exercised discretionary authority in deciding disputed claims under the health plan. Id. at 370-371. The Seventh Circuit then held that Herdrich had stated a claim for a breach of the defendants' fiduciary duties under ERISA because she had alleged that they had delayed in providing her with necessary treatment for the sole purpose of receiving financial bonuses under the HMO's cost-cutting incentives. Id. at 373. Although the majority recognized that ERISA permits fiduciaries to maintain dual loyalties, ibid., it nevertheless emphasized that a fiduciary breaches the duty of care when the fiduciary acts to benefit its own interests, id. at 371. The majority also provided a long disquisition on what it viewed as "the deleterious affects [sic] of managed care on the health care industry." Id. at 375; see id. at 375-379.

Judge Flaum dissented, finding that the mere existence of structural incentives to limit costs could not "give[] rise to a cause of action for breach of fiduciary duty under ERISA." 154 F.3d at 381. In addition, Judge Easterbrook (joined by Chief Judge Posner and Judges Flaum and Diane Wood) sharply dissented from denial of rehearing en banc. 170 F.3d 683 (7th Cir. 1999). Judge Easterbrook did not believe that the doctor and the HMO were acting as fiduciaries of the ERISA plan when they chose a course of medical treatment. He warned that the panel decision threatened the continued operation of HMOs and other managed care plans. In particular, Judge Easterbrook noted, the majority opinion "implies that the principal organizational forms through which medical care is delivered today are unlawful," and that as a consequence "the cost-saving achieved by managed care must be abandoned." Id. at 686.

This case is of obvious interest to managed care plans and providers. The case is of broader interest to the business community in light of the prevalence of health and other benefits plans governed by ERISA, and the widespread adoption by employers of managed care plans as part of their health benefits packages. The Supreme Court's decision could alter the way in which benefit plans are designed and administered, effectively precluding cost-saving incentives and techniques.

2. State Taxation — Due Process — Commerce Clause — Deduction Offsets for Dividends of Non-Unitary Subsidiaries. The Commerce and Due Process Clauses of the Constitution limit the ability of States to tax the income of corporations that operate in many States. In a nutshell, a State may tax a proportionate share of an out-of-state corporation's income from its "unitary" business (i.e., business related to its in-state activities). A State may not tax income from out-of-state, non-unitary businesses owned by the corporation. The California franchise tax (i.e., corporate income tax) requires each nondomiciliary corporation to offset any deduction for business interest expense with dividend income from non-unitary out-of-state subsidiaries (see Cal. Rev. & Tax Code § 24344(b)) — income that California cannot constitutionally tax. California corporations are not subject to the offset, however, and dividend income from California subsidiaries also is exempt from the offset requirement. The Supreme Court granted certiorari in Hunt-Wesson, Inc. v. Franchise Tax Board, No. 98-2043, to decide whether that practice violates the Due Process and Commerce Clauses.

Hunt-Wesson, Inc. is the successor to Beatrice Companies, Inc., a Delaware corporation domiciled in Illinois. Beatrice received dividends from several foreign subsidiaries that were not part of Beatrice's unitary business. Beatrice also incurred interest expenses on business loans that were not related to the non-unitary foreign subsidiaries. Beatrice claimed these interest expenses as deductions on its California franchise tax returns.

The California Franchise Tax Board disallowed Beatrice's interest expense deduction by an amount equal to the dividend income received from Beatrice's non-unitary subsidiaries during that year, and assessed a tax deficiency against Beatrice. Beatrice paid the deficiency, and then unsuccessfully sought a refund from the Board.

Hunt-Wesson, as Beatrice's successor, filed suit in California state court seeking a refund. In an unpublished opinion, the trial court held that the interest offset provision violated both the Due Process and Commerce Clauses of the United States Constitution. The California court of appeal reversed, also in an unpublished opinion. The court of appeal relied on California Supreme Court precedent holding that the inclusion of nontaxable dividends in the statutory offset computation does not constitute taxation of the dividends themselves. See Pacific Telephone & Telegraph Co. v. Franchise Tax Board, 498 P.2d 1030 (1972). The California Supreme Court denied Hunt-Wesson's petition for review.

The decision of the California court of appeal appears to be in tension with several Supreme Court decisions. First, the Court has held that a State may not tax the dividends that a nondomiciliary corporation receives from its non-unitary subsidiaries, e.g., ASARCO, Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982) (due process); see also Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992) (clarifying that limitations on extraterritorial taxation rest on both the Due Process and the Commerce Clauses). Second, the Court has made clear that a State may not limit a tax benefit to its own domiciliaries or to those who invest in corporations conducting in-state activity, e.g., South Central Bell Telephone Co. v. Alabama, 119 S. Ct. 1180 (1999); Fulton v. Faulkner, 516 U.S. 325 (1996).

Although this case is of obvious importance to corporations that are taxed in California, the constitutional questions raised by this case have substantial implications for all multistate taxpayers. By offsetting or disallowing legitimate deductions where there is no relationship between the disallowed expense and exempt income, California in effect indirectly taxes income it cannot tax directly. If California prevails, other States may use similar devices to impose what amounts to multiple taxation on non-unitary out-of state income.

3. Appellate Procedure — Erroneously Admitted Evidence — Grant of Judgment to Defense. The Supreme Court granted certiorari in Weisgram v. Marley Co., 120 S. Ct. __ (2000) to determine whether a court of appeals may order entry of judgment as a matter of law after concluding that expert testimony was improperly admitted at trial and that the remaining evidence does not raise a triable issue of fact.

Bonnie Jo Weisgram died in a fire. Her son and her home insurer sued the manufacturer of one of her home's baseboard heaters, alleging that a defect in the heater caused the fire. In support of their theory of causation, the plaintiffs presented testimony from the fire captain who investigated the fire, an electrician who styled himself a "fire investigator," and a metallurgist. The district court rejected challenges to that testimony as unreliable and inadmissible under Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993), and a jury awarded approximately $600,000 to the plaintiffs.

A divided panel of the Eighth Circuit reversed. 169 F.3d 514 (1999). The majority found the testimony of the purported experts wholly unreliable and concluded that the district court had abused its discretion in admitting it. Without that testimony, the Eighth Circuit held, the evidence was insufficient to prove the plaintiffs' case. 169 F.3d at 517, 521-522. The court of appeals accordingly found that the defendant was entitled to judgment as a matter of law. In a footnote, the Eighth Circuit explained that it was not required to remand the case for a new trial to permit plaintiffs to present new evidence in lieu of their belatedly rejected expert testimony. Id. at 517 n.2. The court explained that the case was close and that plaintiffs had already had one "fair opportunity to prove their claim." Ibid. Judge Bright dissented on the admissibility issue and on the ground that the appropriate relief for any error was a new trial, not judgment as a matter of law. Id. at 525-526.

The Eighth Circuit's decision conflicts with the decisions of several other circuits holding that a motion for judgment as a matter of law must be determined on the record as it stood at the close of trial and may not be granted based on a belated ruling of inadmissibility. See, e.g., Sumitomo Bank v. Product Promotions, Inc., 717 F.2d 215, 218 (5th Cir. 1983); Schudel v. General Electric Co., 120 F.3d 991, 995 (9th Cir. 1997); Jackson v. Pleasant Grove Health Care Ctr., 980 F.2d 692, 695-96 (11th Cir. 1993).

This case is of substantial importance to the business community. Many product liability cases turn on expert testimony alone. Under the rule endorsed by the Weisgram majority, a defendant who challenges the erroneous admission of such testimony can obtain a total victory on appeal, terminating the litigation. The availability of that broad remedy would also increase the bargaining power of defendants seeking to settle expert-dependent product liability cases after a verdict and before a ruling on appeal.

This Mayer, Brown, Rowe & Maw Supreme Court Docket Report provides information and comments on legal issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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