William H. Rehnquist: We'll hear argument now in Number 98-1949, Lori Pegram v. Cynthia Herdrich. Mr. Phillips.
Carter G. Phillips: Thank you, Mr. Chief Justice, and may it please the Court: I think it is no exaggeration to suggest that the future of medical care, both in its delivery and in its regulation, are in some way implicated by the Court's decision today. The health care plan involved here is a standard health care plan within the employee benefits plan under ERISA. Carle offers vanilla, plain vanilla managed care operations. As Judge Easterbrook said in his denial of rehearing, that if Carle's set-up violates ERISA, then all managed care does so as well. Accordingly, the question is whether or not the court needs to have that kind of a dramatic effect on the managed care industry in this particular context, and I suggest to you that the answer to that is no, because there is a perfectly available and valid remedy for the people in Ms. Herdrich's position, and that is medical malpractice law. She had--
Sandra Day O'Connor: Well now, I gather that the Ms. Herdrich did recover in a malpractice action in this very case.
Carter G. Phillips: --In this very case, Justice O'Connor, she... the defendants were found liable, and she received 35,000 as full compensation for her... for the injuries that she suffered. There's no question, based on that determination, that there's been an error in judgment and that it fell below the standards of care for medical malpractice purposes, and that there are available perfectly valid remedies under State law to her. The question then is, is there some reason to add over those perfectly complete remedies under State law an ERISA remedy as well, and while I think that question can be posed out of narrowly--
Antonin Scalia: The question isn't whether there's some reason. The question is whether it's been added, right?
Carter G. Phillips: --That's absolutely true, Justice Scalia. The question... does Congress intend for--
Antonin Scalia: I mean, it's really not a policy question that's up to us. It's either there or it's not there.
Carter G. Phillips: --That's right. The question is whether Congress intended to add ERISA over and above the malpractice law, and I think it's important in making that determination to realize that this is essentially a zero-sum situation. That is, to the extent you expand Federal law under ERISA, the more you have to narrow State law because of the ERISA preemption provision under section 514(a). That says that every matter that is within plan administration, everything that relates to an ERISA plan, right, and therefore is protected under Federal law, preempts all State law that's related to it, and it seems to me quite clear under those circumstances that the court should be quite loath to expansively interpret ERISA, and certainly there's very little evidence that Congress meant to do so.
Ruth Bader Ginsburg: Mr. Phillips, would you clarify one thing? You said all HMO's would fall because this is a plain vanilla scheme, and yet your opponents say that it's only a particular kind of HMO, one where the physicians have this incentive because of their bonuses, and that not all HMO's work that way.
Carter G. Phillips: I think actually Judge Easterbrook, in his dissenting opinion below, had the better of that argument, and he argued, and I think quite rightly, that the allegations in the respondent's complaint basically lay out the kinds of incentives that are inherent in any managed care operation in terms of questions of medical necessity, experimental treatment... all of the elements that go into trying to control what was in the 1980's an extraordinarily expensive health care system are embodied in the Carle Clinic's managed care plan, so in that sense I don't think it is significantly different from any other managed care operation, Justice Ginsburg.
John Paul Stevens: Mr. Phillips, could you just clarify one simple point for me? Perhaps I should ask your opponent, but given the fact that she's already recovered for the malpractice, what do you understand the nature of her recovery would be? Assume she's right and you're wrong.
Carter G. Phillips: I think it's very difficult to know. Maybe you should ask him that question. My understanding is, first she's made no claim for damages under ERISA, and for good reason. There are none available. There are no benefits that she has not been provided under any plan, however you want to define it, and so there's no basis for recovery there. She seeks no injunctive relief, so I don't know that, and indeed the amended Count III focuses on some kind of a treatment with respect to a pot of money when... and with respect to a plan that simply doesn't exist, so I have no idea what it is that respondent thinks that she will gain from this, except perhaps attorney's fees. Obviously there is a provision for attorney's fees under ERISA, but in terms of her own stake in this, it seems to me it is quite ephemeral, and... I'm sorry, go ahead.
John Paul Stevens: You don't contend there isn't really a live case here, though?
Carter G. Phillips: Oh, no. I don't contend there isn't a live case. What I do contend is that it's... you know, if you go down this path, at the end of the process you're going to be hard-pressed to come up with much of a remedy that's going to make any difference to her at this stage in the process.
Antonin Scalia: Mr.-- --Well, you agree there's not a live case if she's not seeking any remedy?
Carter G. Phillips: Well, she is... I mean, what she is seeking--
Antonin Scalia: Is a judgment, but not a remedy.
Carter G. Phillips: --Is a judgment with--
Antonin Scalia: A judgment is not a remedy.
Carter G. Phillips: --No, no, I understand that, Justice Scalia, but what she is seeking is... I mean, her claim is that there is a pot of money and that that pot of money can be moved around. I don't think there's any basis for that logically in terms of how this scheme works out, but that's not a basis to claim there's no jurisdiction. That's simply a basis to answer Justice Stevens' question which is, at the end of the day, when it's all said and done, if she got everything she wanted out of this, what's likely to come out of it? My sense is there isn't much but, again, respondent may be in a better position to analyze that.
Sandra Day O'Connor: Mr. Phillips, are there any circumstances under which an HMO can be found to be a fiduciary, for instance, in administering claims or benefits to which a covered employee is entitled?
Carter G. Phillips: I think there are some circumstances in which that would be certainly the case under the narrower of... narrowest of the theories that we put forward in opposition to the judgment below. We do have one theory in this case regarding the scope of the definition of the term, plan. Under that, I'm not sure there would be any circumstances where the HMO would be... have fiduciary responsibilities, but under our narrower interpretation we don't really disagree with the United States that if, in fact, you're talking about an HMO that's making coverage or claim determinations wholly apart from medical treatment decisions, and I want to get to that in a second, it could potentially be a situation where there would be some potential fiduciary responsibility, but then that raises a whole slew of questions with respect to what kinds of incentive plans, or incentive arrangements might breach that fiduciary duty and the issues that stem from that inquiry, none of which, I submit to you, is posed in this particular case.
Antonin Scalia: Why is that? Do we know that there are no such coverage determinations being made by this HMO?
Carter G. Phillips: There is no allegation in the complaint as it's defended before this Court with respect to coverage allegations. If you look at the respondent's brief at page 9, she could not be clearer in arguing that the exclusive focus of the case is... let me see if I can find the language here. The sole focus of attention of amended Count III, which is--
William H. Rehnquist: Where are you reading from, Mr.--
Carter G. Phillips: --I'm sorry. It's on page 9 of the blue brief. I mean, of the red brief. I apologize.
William H. Rehnquist: --Whereabouts on page 9?
Carter G. Phillips: It's sort of in the middle, as I recall. I'm sorry, the last sentence of the second full paragraph--
William H. Rehnquist: Thank you.
Carter G. Phillips: --and I'll just quote it. The sole focus of attention of amended Count III is the design and administration of an undisclosed physician incentive to withhold treatment. I think the only fair way to interpret that language is to say that what we're talking about here is basically the provision of care, the provision of medical care and the methods of compensation.
Antonin Scalia: To people who are covered?
Carter G. Phillips: Yes.
Antonin Scalia: To people who are covered, not excluding people from coverage?
Carter G. Phillips: Right, exactly.
Ruth Bader Ginsburg: Suppose you-- --But Mr. Phillips, maybe... maybe your opponent thought it unnecessary to say anything to that effect because in your very own memorandum in opposition to the plaintiff's motion to remand to the State court you allege that... and this is on page 24a of the brief in opposition... you allege that Health Alliance was the administrator and fiduciary of the plan within the meaning of ERISA, so if you yourself alleged that Health Alliance was the administrator, then certainly you lull the other side into security on that point. You had conceded it.
Carter G. Phillips: Well, I think you have to read that in context, Justice Ginsburg. I mean, we certainly conceded it for purposes of the disclosure issues and the bad faith claims that were the basis for the remand order, or the remand issue in that context. We have never conceded that we were a fiduciary for purposes of the amended Count III complaint. We have consistently argued that we have no fiduciary responsibilities with respect to claims in Count III, and in any event, even if the respondent's memory lasted long enough to sort of have that uppermost in her mind at the time she filed her brief in this Court, we had clearly laid out our theory of this case, which is that we are not a fiduciary for these purposes. Her defense of the judgment below is very focused, and I think it spares the Court a significant amount of time and energy having to sort out a variety of the issues that have frankly divided the Solicitor General and the petitioners in this case, questions of what goes into plan design as opposed to fiduciary responsibilities, questions of how broadly do you define the plan and its benefits. None of those issues are any longer on the table. What is on the table is whether the provision of medical care and the methods of compensation for medical care, right, are part of, quote, plan administration within the meaning of section 1002(21)(A), which is the definition provision in ERISA for a fiduciary, and it is completely counterintuitive to suggest that plan administration extends to the provision of medical care, just as a matter of simple language of the statute. And then second, and what I think is really the most driving force in all of this, is the relationship between Federal and State law, because it seems to me absolutely inconceivable that if the Court were to decide that these kinds of medical treatment judgments and the compensation schemes that go into them are, in fact, administration of an ERISA plan, that that then doesn't preempt all State law that relates to those issues, which means--
Anthony M. Kennedy: Suppose that you go to your doctor and you give him or his staff your health care policy, your HMO policy and you say, I can't understand this stuff. Is my operation covered or not? And the doctor says, no it isn't, because he doesn't want to do it, it's too expensive, et cetera. Then you elect not to have it and something happens. Is there some gray areas where the doctor may be wearing two hats and really be determining eligibility for you, because you do... I'm sure patients do rely on doctors to tell them this type of thing.
Carter G. Phillips: --I think there is a possibility of a situation like that arising. That's certainly not the allegation in the complaint here. I think in that situation, though, you still have to take a very careful look at, you know, if we're just talking about a physician making a statement and making a mistake, I don't think that's part of the exercise of discretion in plan administration. That's simply potentially a breach of contract that somebody could deal with differently. You know, the key here is, to what extent do you want to drive in the elaborate mechanisms of ERISA as part of an effort to interfere with the relationship between the physicians and the patients in the HMO context, and my own judgment is the Court would be quite better served by trying to move ERISA back further in the scheme of things, but at a minimum it certainly shouldn't be intruded into the physician-patient relationship to the extent of deciding what kinds of medical treatment judgments are valid, and what kinds of compensation schemes are permissible.
Anthony M. Kennedy: Do we talk about the employee or the patient's legitimate expectation as to what that employee is receiving from the doctors? They go to the doctor either for medical care or for advice about what the plan means. Is that the beginning point, the legitimate expectations of the covered employee?
Carter G. Phillips: I think it would be a mistake to hinge ERISA scope on the subjective intent of the patient under these circumstances.
Anthony M. Kennedy: Reasonable legitimate expectations.
Carter G. Phillips: Well, even that I think is probably a mistake, because the question... the question is, you know, you're in a fiduciary world when you're administering a plan, and the question is... and then you have... because then you have a whole series of questions, is there a breach of fiduciary duty, and what the remedy for it is, and what I'm suggesting is, I don't think the Court wants to get into the business of saying that this is, in fact, a fiduciary relationship based on ERISA. It's certainly a physician-patient fiduciary responsibility.
Stephen G. Breyer: But how do we get out of... I mean, the statute says that a fiduciary is a person under ERISA. An ERISA fiduciary is a person who exercises discretionary authority or control respecting management of a plan who has any discretionary authority or responsibility in the plan's administration. That's what the statute says.
Carter G. Phillips: Right.
Stephen G. Breyer: Then what they've alleged... whether it's true or not, they've alleged it. They say that these people here, the HMO, have been given by contract the authority to administer disputed claims. I take it that they've been given by contract the authority to decide, am I covered by the policy that my employer bought, or am I not, and in particular they say that's true of emergency treatment, that's true as to whether something is... is it routine, is it experimental, which plans are covered, which claims are covered, which are not. Now, that's their allegation, so how in your view is that not administering the discretionary administration of the employer purchase plan itself?
Carter G. Phillips: Well, there are two answers to that, Justice Breyer. Under our broader theory none of this is within the... an employer welfare benefit plan, in which case none of this is subject to any kinds of ERISA requirements, but the second, and I think the more pointed answer to that really comes to the question of what has she in fact alleged, and can you read the complaint potentially to embrace what you've described--
Stephen G. Breyer: Oh, I just read, was reading from the--
Carter G. Phillips: --Justice Breyer, but the question is, what does she mean by those particular words, because all she's really doing there is alleging how the plan operates and then using the statutory language. But go back to page 9 of her brief, Justice Breyer, and analyze exactly what it is that she says. The sole focus of that complaint, that entire count of that complaint, is limited to the question of financial incentives to deprive someone of particular medical treatment. That's what she's defended the judgment of the Seventh Circuit reinstating her claim on, that's what's before the Court, and I don't see why the Court should go beyond that analysis in trying to resolve what otherwise seems to me a very significant thicket that it would other... that it would have to address.
Stephen G. Breyer: --So you say forget Roman numeral ii, small ii, just focus on i.
Carter G. Phillips: Just read it in the way the respondent has asked you to read it. I'm not asking you to do any more than the respondent has pitched this argument to you herself. There's no reason to start over. Let's start where the respondent starts and analyze the case.
Ruth Bader Ginsburg: But then you're making of this a pleading case. You're saying she didn't allege it, not that she couldn't allege it.
Carter G. Phillips: Right.
Ruth Bader Ginsburg: So if we accept your position it goes back, and they amend the complaint to say no, we're talking about the role of this HMO in making eligibility and coverage determinations.
Carter G. Phillips: You assume, Justice Ginsburg, that she simply somehow made a mistake here rather than a conscious judgment to attack what it is that is the gravamen of her complaint. Her complaint is not a coverage issue. Her complaint is the quality of care that she received. It is bound up in the malpractice claim that she brought, so that's--
William H. Rehnquist: In a sense this has to be a pleading case, because the district court granted a motion to dismiss.
Carter G. Phillips: --Oh, absolutely, Mr. Chief Justice. On the other hand, it is also a case that comes to the Court as presented by the parties, and the respondent has told you how she defends the judgment below, and I think the Court ought to accept that.
Antonin Scalia: Mr. Phillips, is it clear that making a determination as to coverage is the exercise of discretion in the administration of a plan?
Carter G. Phillips: No, it's not clear. I mean, there are a whole slew of questions.
Antonin Scalia: I hate to depart from that as a premise, because I'm not sure that premise is correct.
Carter G. Phillips: I don't accept that premise either, but what I'm asking the Court to do is to avoid having to address that issue by reaching what I think is a narrower and much simpler ground for reversal in this particular case.
David H. Souter: Let me ask you a... it may be a too-simple question, but I understand your answer to Justice Breyer, but I think, like him and maybe some others here, I can't help but think of what the next case is going to be, depending on how narrowly or broadly we might decide this, if we decide it in your favor. Is there a kind of a simple-minded administrative answer to some of our problems, and what I'm thinking of is this. Let's assume that there can be some decisions about coverage which, if made in bad faith, would, in fact, be decisions about the management of the plan and that would, in fact, if made in bad faith, involve a breach of fiduciary duty. The assumption that I have made is that characteristically those decisions are not made by physicians, that someone walks into a clinic or an office and gets some treatment. In an HMO, when they go in the person at the front desk says, the plan doesn't cover appendixes. Doctors don't make decisions like that, by and large. When there's a true reimbursement scheme the procedure is done, the claim is submitted to the insurance company, and somebody in an office somewhere says, oh, this plan doesn't cover appendixes, so most of the decisions which might be called management decisions, which, if made in bad faith could arguably be breaches of fiduciary responsibility, are probably not going to be physician decisions. Am I being too simple-minded in looking at it--
Carter G. Phillips: No, Justice Souter, and I don't have--
David H. Souter: --If I am, you're going to be in trouble later. [Laughter]
Carter G. Phillips: --I might be in trouble already, but... no, I don't have any problem with that. All I'm saying is that in this context what she's complaining about is the physician decision to withhold treatment.
David H. Souter: Right.
Carter G. Phillips: The Court ought to just focus on what it is she has alleged and leave for another day the situation you pose. I don't concede it, but I don't think the Court needs to address it at this time.
Antonin Scalia: In his hypothetical the person at the front desk may be an employee of the physician's. I mean, that's... that's the gravamen of this complaint.
Carter G. Phillips: I assume that was--
Antonin Scalia: The whole HMO is owned by physicians, so you know, if some secretary at the front desk... it's the physician's, because they own the HMO and employ the secretary.
Carter G. Phillips: --That's true. I mean, I understand that, but again, I don't know why we would go beyond the specific allegations in the complaint, as defended by the respondent here. I'd reserve the--
Ruth Bader Ginsburg: Mr. Phillips, wasn't it emphasized by the other side that if only there were somebody else making the coverage and eligibility decisions, if only that, they would have no complaint? I thought that that was very clear from the respondent's presentation, that they weren't complaining about treatment, that the only thing they were complaining about was having the coverage eligibility determination made by the physician.
Carter G. Phillips: --Well, I would read page 9 of their complaint once again and tell you what the sole focus of their claim is, which is that the physician-incentive system causes the physician to withhold... I mean, the compensation system causes the physician to withhold treatment. That's the allegation that she's put before the Court.
William H. Rehnquist: Thank you, Mr. Phillips. Mr. Feldman, we'll hear from you.
James A. Feldman: Mr. Chief Justice, and may it please the Court: It's our position that the treatment allegations of the complaint, which regard the incentive to the physicians, to the treating physicians concerning their treatment of their patients, are governed... essentially State claims that are governed by State law but are not governed by ERISA because they don't have to do with fiduciary duty under ERISA. On the other hand, the administration allegations of the complaint, if there are any there, and it's unclear to me whether there are or not, but insofar as the complaint is alleging that there was deficiencies that have to do with the claims processing function of the HMO, that is an activity that is governed by ERISA and not State law. However, it's our position that they did not... that the complaint does not allege a violation of ERISA's fiduciary duties with respect to those issues.
David H. Souter: It's also your position, I take it, that not every claim of an error in the claim processing function without more would state a breach of... a claim for breach of fiduciary duty?
James A. Feldman: That's true.
David H. Souter: In other words, if they just get it wrong, if a fiduciary just gets it wrong, that's not a breach of fiduciary duty without something more.
James A. Feldman: That's true, but insofar as the fiduciary is someone... it's an error that had to do with the exercise of discretion under the plan in deciding what... whether a certain kind of procedure is covered, then it would be a breach of fiduciary duty. I'm not sure it makes that much difference, because if it's just an error in construing the plan, the claimant would have a claim under 502(a) for the benefit that was due in any event.
Antonin Scalia: How do you... you see, I never thought that a judge has discretion in deciding whether the law means this or that. There's a right answer and a wrong answer. The judge tries to find the right answer, and isn't it the same thing when somebody determines plan coverage? It seems to me strange to talk about discretion in determining plan coverage. Why is that a discretionary administration of the plan?
James A. Feldman: I think discretion in this sense is used in the terms of applying the plan terms to a wide variety, sometimes fairly vague plan terms to a wide variety of different cases, and that does have something in common with what judges do, and judges do exercise discretion sometimes, but in the Varity Corporation v. Howe, the Court said... I'm reading from page 511, 516 U.S. on 511... a plan administrator engages in a fiduciary act when making discretionary determination about whether a claimant is entitled to benefits under the terms of the plan documents. So at some point there is a fiduciary, and... who... where that person has some discretion, is making a judgment about applying some broad terms to maybe a particular set of facts, or construing what the terms mean, that person does become a fiduciary under ERISA. Now, it's our position that a doctor doesn't merely by accepting a patient and forming a doctor-patient relationship. Within a doctor-patient relationship, as it has long been understood, the doctor's duties are governed by principles of medical ethics and by State law, and ERISA basically has nothing to do with that, whether it's provided by an HMO or not. But where... and if... and in this case that's all that apparently happened, in fact, to the plaintiff, but where there is a claim made, not... which is generally not... may or may not be made to a doctor, it may be some other functionary, but somebody who's not... doesn't have a doctor-patient relationship with the plaintiff, if a claim is made that somebody wants something covered, that triggers the claims processing function of the plan and can trigger ERISA's fiduciary duties.
John Paul Stevens: May I ask you a question? The definition of what fiduciary duty is, that they must always discharge the duties solely in the interests of the participants and the beneficiaries, so that if you take this literally, and if you say that's a fiduciary responsibility, every debatable case would have to be ruled in favor of the beneficiaries.
James A. Feldman: Right. I don't think that's right. They have to faithfully apply the terms of the plan. That's their primary duty, and I will say that... well, the primary duty is to--
John Paul Stevens: It doesn't mean you always have to rule in favor of the--
James A. Feldman: --That's right. In fact, the fiduciary 1104... it's capital (D) there, I think... specifically says that the fiduciary has to comply with the plan documents and with the plan--
John Paul Stevens: --If you have an ambiguous plan document, if its duty is to act solely in the interests of the participant or the beneficiaries, it's a pretty tough standard.
James A. Feldman: --Well, I... I don't think it's, though... I think the sense of, in the interests of the participant or the beneficiary, what that means there is to make determinations under... as to what's covered and what's not covered in accordance... strictly in accordance with the terms of the plan, not in accordance with other considerations either for or against the particular individual, because that beneficiary doesn't have the right to anything, other than what the plan document's entitles him or her to.
David H. Souter: But Mr. Feld... that makes perfect sense except when you bear in mind what you said a moment ago to Justice Scalia. We have language in these plans in which there's a range in which reasonable judgments can be made and still be faithful to the language, and in that situation I think Justice Stevens, the answer to Justice Stevens' question has got to be, it's always got to be made in the patient's favor.
James A. Feldman: No, I don't think that that's--
David H. Souter: You've always got to choose the point in the reasonable spectrum that gives the plaintiff what the... the patient what the patient wants. Either that or it's not a discretionary judgment. Yeah. I don't see... I don't see any--
James A. Feldman: --In fact, the Court--
David H. Souter: --Or it's not a fiduciary--
James A. Feldman: --In fact, the Court has held, I think, quite to the contrary, that where a fiduciary under ERISA is given discretion by the plan to make those kinds of determinations, courts will accord deference to the discretion given to the fiduciary--
Ruth Bader Ginsburg: --Mr. Feldman, I had thought--
James A. Feldman: --within some range where the fiduciary doesn't have... isn't... the plan documents don't give the fiduciary any discretion and the courts don't accord it and will decide any legal suits that arise from it based just on the terms of the plan.
Ruth Bader Ginsburg: --You seem not to be taking the position that I thought would be the one that you would take, which is that the word beneficiaries is plural, and sometimes what may be in the best interests of a particular plaintiff could be against the interests of the class of beneficiaries. That came up in the former pay-for-services--
James A. Feldman: The... it's... there are certainly many circumstances under which ERISA fiduciaries do have a duty to the plan as a whole, where, for example, they are sitting on a trust, on some assets. How they spend that... which does not... was not true here. How they spend that money, they have a duty to the plan and to all of the beneficiaries there, but I think when you're talking about a claims administrator at an insurance company or an HMO, their duty is to apply the plan documents to this individual and however it comes out, it comes out. They shouldn't be saying, well, I don't want to give this individual benefits because it might somehow save money for the employer and the employer might therefore--
William H. Rehnquist: --Mr. Feldman, couldn't the administrator say, if I resolve every single debatable point in favor of each beneficiary, other beneficiaries are going to suffer?
James A. Feldman: --Well, you know, I just don't think that that's quite right, because this person, fiduciary, this kind of limited purpose fiduciary... it's not a general fiduciary who's a trustee of the plan, but it's someone who's just a fiduciary insofar as this person is making... is ruling on a claim for benefits. This person... all this person should be keeping in mind is, what are the terms of the plan, and how does that apply to this particular claim.
William H. Rehnquist: Yes, that's--
James A. Feldman: And because there's a contract here the fiduciary is supposed to be applying that contract to the terms of this claim, and whatever it permits--
William H. Rehnquist: --You yourself had said the terms can be very vague.
James A. Feldman: --Right, and they should be construing them in a reasonable, consistent way, and so on, not always... certainly not always in favor of the beneficiary, not against the beneficiary.
Stephen G. Breyer: Well, what we're talking about here is not a particular decision in relation to a particular beneficiary, I thought. I thought we were talking... what they allege is that a plan that sets up a certain structure with economic incentives is wrong, and when you decide what kind of a plan, can't you take the interests of all the beneficiaries into account?
James A. Feldman: That's... yes.
Stephen G. Breyer: And that, isn't that the issue before us?
James A. Feldman: That's correct, except--
Stephen G. Breyer: All right. Except--
James A. Feldman: --Except--
Stephen G. Breyer: --When you apply it you have to look at this beneficiary, but when you're deciding specifically whether to have a rule that gives an incentive to doctors to do X, Y, or Z, that's a matter for all the beneficiaries, isn't it?
James A. Feldman: --Except that if the HMO... as far as the treatment, what we call the treatment allocations--
Stephen G. Breyer: Well, you... yes.
James A. Feldman: --the HMO is deciding that as a matter of how to pay its employees, and it really has nothing to do with ERISA at that point.
Stephen G. Breyer: Well, but that's on your question as to assume--
James A. Feldman: As far as the other side--
Stephen G. Breyer: --Assume they are a fiduciary for the sake of argument.
James A. Feldman: --We're... and they are a fiduciary insofar as people go and make claims, not in the doctor-patient relationship, but to the--
Stephen G. Breyer: All right, so your argument is that what gets them out of this is, they're not fiduciaries in respect to making up the incentive rules under the plan.
James A. Feldman: --But as far as the doctors are not. Now, as far as how they are paying the people who are making the claims, when the claims are being processed it's both the HMO and the individual who's doing it who become fiduciaries... who become fiduciaries for that purpose, and insofar as they're doing that, there may be some fiduciary limits that ERISA places on the kinds of incentive structures. We gave an example in our brief. If the HMO said to its claims people something which... you know, I'm not suggesting anybody has done this, but we're going to give you a bounty of 100 for every claim you've denied--
Stephen G. Breyer: Okay. That's my question.
James A. Feldman: --I think that would raise a serious problem.
Stephen G. Breyer: All right, fine. If in some circumstances it can, a particular incentive structure, created by some administrators who maybe are a part of the organization they're suing, could, in fact, violate ERISA, and in other times it wouldn't violate ERISA, what's the principle as to when it does and when it doesn't?
James A. Feldman: And I would... our position is that the... you start off from the point that ERISA specifically recognizes that benefits can be provided through insurance or otherwise. Now, an insurer is always in a position, whenever a claim is made against an insurance policy, just like an HMO--
William H. Rehnquist: Thank you, Mr. Feldman. Mr. Ginzkey, we'll hear from you.
James P. Ginzkey: Thank you, Mr. Chief Justice, may it please the Court: Mr. Phillips indicated that it's no exaggeration to indicate that this particular lawsuit is an attack on managed care as a whole, that what we have is a standard plain vanilla HMO. I beg to differ with that. We don't have, in this case, a standard, plain vanilla HMO, and maybe drawing a comparison to another type of HMO is the best example of what I'm trying to describe here. Take an HMO like Humana. Humana is a publicly traded corporation. There are over 167 million outstanding shares of Humana stock. The owners of the Humana stock, as owners, are a group of people that are separate and distinct from Humana, the company that employs the claims reviewers and the medical directors. Separate and apart from that group is then the contracted physicians that provide the services, so in many, if not most HMO's, you've got three distinct groups. You've got the owners, separate and apart from the employees of the company making the claims decisions, separate and apart from the doctors who are providing the primary care. Here, all three groups are one. They're all one entity.
Stephen G. Breyer: But what has that to do with it, because if they had it separate, then your clients or some future clients would simply sue the right group. I mean, I take it the underlying substantive question is, whoever is making this decision, you're saying it's a breach of a fiduciary relationship to have a set of economic incentives that makes them look at costs as well as health. Now, the separation issue is one, that even assuming you're right on that, it's very hard for me to believe in respect to cost incentives that the same Congress that in 1973 wrote an HMO act, and the same Congress that has provided for incentives that encourage HMO's throughout, in ERISA, without saying anything, wanted to gut its own HMO legislation. Now, that's where I start on this, and I put that up front, because I want to know how your theory doesn't achieve a result that I just find it very hard to believe Congress wanted.
James P. Ginzkey: The Health Maintenance Organization Act was passed in 1973. ERISA was passed in 1974. In 1974, we did not have the forms of managed care that we now have. With respect to the HMO act of 1973, that is enabling legislation. It does not specify anywhere in that act what cost containment mechanism should or should not be used. That is not specified, and it to my knowledge is not specified by any... in any regulation by the Department of Labor or any other bureaucracy of the Federal Government. The phenomenon that we have with respect to these physician bonuses, the physician incentives, is a relatively recent phenomenon. It first came to the Government's attention in the 1986 report by the GAO, where they concluded that incentives seem to have a deleterious effect on the health of the patients being treated by the doctors who are incentivized.
Stephen G. Breyer: What they're saying is that we think, for example, if you have a group of people who look after a child from the time it's born to the time it dies, they'll get interested, through our incentives, in what's called preventive care, and will end up with a lot less disease. Now, to do that, you have to have doctors who pay attention to patients all across the board, and you also have to tell those doctors, don't use the most expensive treatment before you look at what will actually benefit the patient throughout the cost of his life.
James P. Ginzkey: And we're not suggest--
Stephen G. Breyer: The whole course of his life. Now, that, I take it, is the theory that underlies these kinds of cost incentives that are built into the plan. Now, if Congress... doesn't Congress make that judgment with HMO's, or similar kinds of judgments?
James P. Ginzkey: --No, I don't believe that Congress does make--
Stephen G. Breyer: What is your... but I'm asking not my theory, I'm asking your theory on this.
James P. Ginzkey: --Well, and I want to come back to the question that you posed immediately before that, and that question was, why does it make a difference that in this particular structure, this corporate structure of this HMO, you've got the employees who are making a claims decision, the medical directors, all four of them, being the same doctors who profit from that bonus at the end of the year. You don't have an independent third party administrator making those claims decisions. That's one of the major distinctions in this case. It also explains some of the Solicitor General's, I think misconceptions with respect to various relationships of the parties, because the doctors that are the owners, the sole owners of the HMO, and employ themselves as the primary care physicians, aren't dealing at arm's length. One of the positions of the Solicitor General is that you can't have any limitations, as we suggest in this particular case, upon an HMO's right to contract with doctors. That assumes that the contracting that's going on is at arm's length. It's not here. They're one and the same entity.
Ruth Bader Ginsburg: How many HMO's fall in this pattern of physician-owned... you said that you thought most were not that way. Do you have any idea how many are?
James P. Ginzkey: I don't have percentages, Justice Ginsburg. I can tell you that there are a substantial number of doctor-owned HMO's, but I'm not aware of one that is structured like this, where the doctors not only are the owners, and employing themselves on the opposite end, they're also the decisionmakers in the middle.
William H. Rehnquist: But if you don't have many doctors, they presumably can't afford to hire an independent administrator. I mean, if you're going to have a small organization.
James P. Ginzkey: I don't know what the cost of a third-party administrator would be, but I can tell you that the cost in-house is getting paid for by the premiums being charged in any event.
Antonin Scalia: Mr. Ginzkey, I didn't get your response to Justice Breyer's question about what difference does it make whether there's separation or not. Let's assume that doctors don't make the decisions, so you have some other organization that makes the decisions. So long as that organization has the same incentive of keeping costs down, wouldn't that organization fall prey to the same complaint that you make here?
James P. Ginzkey: No.
Antonin Scalia: It isn't... nothing distinct about doctors making it. Your complaint is that whoever is making the decision about what treatment ought to be given has a financial incentive that is not necessarily coincident with the best interests of the patient. That's going to be the case whether it's the doctor doing it or somebody further up the line, so long as you have this kind of an HMO.
James P. Ginzkey: The difference is, Your Honor, that the claims administrators with a third party administration firm aren't getting paid to deny the claims, and that's what's happening here, because the claims administrators of this HMO are the very owners of the HMO that share in the year-end distribution. The year-end distribution is not something that isn't controlled by the physicians to a certain extent, because these are actuarially underwritten plans, and by that I mean this. When the HMO makes a bid to State Farm Insurance that we're going to cover this particular individual at 100 per month, that's what it's going to cost us to provide that health care for that much for that individual, that's not the premium that is charged. There's a premium loading factor that is added in here, and what--
Antonin Scalia: You say that they have to bring in not only somebody other than the doctors, but somebody other than the doctors who has no financial interest in the whole enterprise.
James P. Ginzkey: --No, not--
Antonin Scalia: Hire some firm to make medical decisions of whether you get this operation or not--
James P. Ginzkey: --Not some--
Antonin Scalia: --some firm that is not the owning doctors of the HMO and that also has no financial interest in the whole enterprise.
James P. Ginzkey: --No, Your Honor, that's not what I'm saying.
Antonin Scalia: Well then, I don't know--
James P. Ginzkey: I'm saying that you've got to have somebody that is making those claims decisions that doesn't have a basis, isn't receiving money to deny the claims, because that's what's going on here.
William H. Rehnquist: --But that's-- --Well, supposing you hire-- --That's what I said. Supposing a small group of doctors hires an administrator and the administrator administers claims, and then the doctors tell him, you know, you're just allowing a lot of stuff we don't think you should allow, and as a result our income is going down. What's the result there?
James P. Ginzkey: Here, if I can draw on the analogy, or the explanation I was trying to give earlier, here what you have is the, let's say 100 per member per month cost of providing the medical care. That's increased. There's premium loading factors, generally about 20 percent, that's added on right on top. That 120 then is paid on a monthly basis to the HMO. The 20 profit is taken off the top. That constitutes profit, administration costs and costs of advertizing, but--
William H. Rehnquist: Well, but you're giving your own hypothesis, but I put a hypothesis to you that I wish you would respond to.
James P. Ginzkey: --And I'm trying to respond to that.
William H. Rehnquist: Would you respond a little more directly?
James P. Ginzkey: I think that there is a difference between the scenario that you have suggested and a scenario where the claims determiners are the ones who are doing the determination of the actuarial underwriting so that they know what's going to be in that risk pool at the end of the year and, to the extent that they can deny claims, there's more money in the risk pool for distribution at year-end to them.
David H. Souter: Well, there's a difference perhaps in degree. There is a difference in the degree of finesse, but isn't... at the end of the day, isn't the operative fact that in any HMO the interest of the HMO and the interest of every employee, whether... of the HMO, whether it be a doctor or a nondoctor administrator, is to hold down health cost, because unless they do so the HMO is going to go out of business? And it seems to me that that interest is there, whether it is in the stark shape that it takes here, or whether it's in a more subtle shape which it takes on your hypothesis of what is right, but the same interest is there, and it seems to me that it is equally... if the interest in this case is at odds with fiduciary duty, I don't see why the interest in the more subtle case isn't equally at odds with fiduciary duty.
James P. Ginzkey: It's the mechanism that we're focusing on here, Your Honor.
David H. Souter: But why... I know it is, but why does the mechanism make a difference, because what you say is wrong with the mechanism is that it induces these so-called fiduciaries to say, no care for you, but that same mechanism operating at a perhaps less obvious level is inherent in any HMO, so I don't see why the mechanism makes the difference.
James P. Ginzkey: The mechanism makes the difference here because these physicians in their capacity as owners of this HMO are getting paid bonuses to deny care, and let me explain that a little bit further. Counsel indicates that on page 9 of our red brief we took the position that the sole focus of attention of amended Count III is the design and administration of an undisclosed physician incentive to withhold treatment. That's taken out of context. That entire paragraph on page 9 deals with cost containments, and what we're saying is, we're only focusing on one cost containment mechanism. We're not arguing about, for instance, pre-certification. Pre-certification is a cost containment element that can be used, employed by managed care, that is going to lower health care costs, but it's not going to be a situation where the doctor is getting paid a bonus to look the other way when somebody is sick so--
David H. Souter: In effect, the... the rule of decision that you want us to come down with I think is, we've just got to draw lines here and say, the breach of fiduciary duty is clear when the doctors get a year-end payment and make the decision. There is, however, no breach of fiduciary duty, or at least not a cognizable one, when the interest between denying coverage and ultimate compensation is more subtle than that. That's the rule of decision that you want?
James P. Ginzkey: --I am not asking this Court to outlaw physician incentives, to declare them illegal.
David H. Souter: Right, and in order not to do so, aren't you asking us for a rule of decision something like what I just put to you?
James P. Ginzkey: There is going to have to be a line drawn, and I think that the line is drawn with reference to incentives reaching the level of undue influence so that it affects patient care.
Stephen G. Breyer: Now, suppose... you may have a very good answer to this, and I'm on exactly the same track, but take as separate a person as you want, you know, somebody who has nothing to do with doctors, that works for the ERISA trust plan of a company, and that person says, here's what our plan's going to do. We're going to take a bunch of doctors, and we're going to pay them 3,300 per patient per year, and we say, doctors, you take on some patients. Now, we'll tell you about this money. What you don't spend, you keep. All right? That's our rule. And now what's sort of... what's bothering me is that the rule that you want would outlaw the rule that I just said, and why isn't that so?
James P. Ginzkey: Because the rule that we're suggesting here is not that broad, Your Honor.
Stephen G. Breyer: I know, but what I... see, my rule draws its strength from the fact that we know there are a group of ethical rules governing medicine, and doctors, we believe, governed by this when they take the 3,300, will try to look for the best way of saving the patient anyway, and if they can do so with a little saving extra money, that's to their benefit. So that's why my rule sounded okay. Maybe it's true, maybe it's not, but your role sounds as if it abolishes my rule, so now, how... why not?
James P. Ginzkey: Because that type of incentive doesn't rise to the level of undue influence that is going to have a deleterious effect, necessarily, on patient health care, and let me point the Court to the study that was performed in 1998 out in California. Excuse me. It was published in 1998, in the New England Journal of Medicine. It was 766 primary care physicians in the State of California. A questionnaire went out. I believe it was anonymous. A questionnaire goes out, do you have any incentives in your managed care or HMO plan? Yes. 40 percent of them have incentives. Do they influence you, at least to some degree? Over 50 percent say, yes, they influence us to some degree. Third question, are they unduly influencing you, and that's not the word that's used in the report. What they say is, or what the doctors say, 17 percent of them in that study, and I think that that study is probably representative of health care in the United States, what 17 percent of those doctors in California say is that those incentives are high enough, large enough that they feel it does compromise quality of care. That's what the physicians say. That's what they're telling us. We don't have to hypothecate.
William H. Rehnquist: Well, do you think they all attributed the same meaning to the word unduly, which is extremely vague?
James P. Ginzkey: That was my term, Your Honor, and that was a bad term. The--
William H. Rehnquist: What did the questionnaire say?
James P. Ginzkey: --Are the incentives high enough that it is having a significant, deleterious effect on health care that you're providing, and 17 percent of them said yes, so--
William H. Rehnquist: Well then, I take your answer to be that you're saying that I thought what was a good legal rule isn't, and you don't mind that if I decide for you we also make unlawful under ERISA the rule that I talked about, the 3,300 per patient, or are you going to distinguish it?
James P. Ginzkey: --I think you have to distinguish it.
William H. Rehnquist: All right. Now, can you tell me... maybe you've said this already, and I'm sorry if I'm asking you to repeat it, but the distinction precisely between the one I had and the one you want is?
James P. Ginzkey: Depending on what the rate of capitation is in your hypothetical, it might be a violation of the rule that I'm suggesting, but what I'm suggesting is that the courts should make that determination on a case-by-case basis and just not exempt entire groups--
Sandra Day O'Connor: Well, Mr. Ginzkey--
James P. Ginzkey: --from ERISA.
Sandra Day O'Connor: --why should the courts get into this slippery slope problem that you're posing for us when Congress has designed a scheme that's built on private furnishing of health care through health maintenance organizations that are privately owned, and where there are inherently incentives to keep costs down at the HMO in order to provide the care and make it pay for itself? And that's the scheme Congress has authorized, and they are served by doctors that have ethical obligations in the treatment of patients, and I suppose Congress relied on the ability of the enforcement of those ethical obligations to curb what otherwise might appear to be an unfortunate financial incentive to cut costs, and I... why should the courts get involved in this messy business of deciding what scheme is an undue infringement and what isn't?
James P. Ginzkey: Let me respond firstly by saying I'm only aware of one case where a Federal court specifically addressed the issue of whether or not the ethical opinions promulgated by the American Medical Association are enough to counterbalance an incentive that a doctor might have to cut care, and that decision I cited in my... I believe it was the reply at the writ stage, and that court decided that the ethical opinions aren't enough to counterbalance strong financial incentives, and therefore we can't rely on the physicians' ethics in situations like this. But let me get also to the question that you posed concerning why should you get involved. This Court in Varity v. Howe said that Congress, when it passed ERISA, adopted the common law principles of trusts. Congress didn't specify what the courts were supposed to do in each and every case. Congress said that the courts across this land should look at pension benefit funds, or pension benefit programs, or welfare, health care programs, applying the law of trusts, and try to determine, using the principles of equity under the law, common laws of trust, what is acceptable and what's not acceptable.
John Paul Stevens: Can I ask you the question I asked your opponent at the beginning of the case? What's really at stake for your client in this case, at this stage?
James P. Ginzkey: My client does not stand to profit individually or personally from this case. What we are seeking is to recoup the bonuses that we believe are paid in violation of fiduciary duties under ERISA.
William H. Rehnquist: Recoup it for the plan?
James P. Ginzkey: For the plan, and hopefully a couple of different things happen. Premiums come down for a period of time, or coverage is broadened for a period of time, or a combination of the two for a period of time, but with reference to a broad attack on managed care, that can't happen under ERISA, because under ERISA the plaintiff can sue only on behalf of the plan, unless it's a denial of benefits, and then you get the cost of the benefits back, but under no circumstances do plaintiffs get compensation for pain and suffering, mental anguish, and there's no compensation or payment for--
John Paul Stevens: And who would the... if there's this money that should... that's been accumulated, who would get the fund? Would it go back into the HMO, or would it go to the--
James P. Ginzkey: --To the risk pools. To the risk pools.
Antonin Scalia: --Is that-- --I thought she was suing on her own behalf.
James P. Ginzkey: No, on behalf of the plan.
Antonin Scalia: On behalf of the plan? Well, let me... I'm a little confused by some of your presentation, because you talked about coverage determinations, and as I understand what occurred here, there was no denial of coverage to your--
James P. Ginzkey: That's correct.
Antonin Scalia: --To your client.
James P. Ginzkey: That's correct.
Antonin Scalia: It was acknowledged that what she was suffering from was covered by the plan, and what her complaint was is that she got procedure A whereas she should have had procedure B, which was more expensive, and they didn't give her B because of the cost. Isn't that right? So how do we get into the coverage determination question at all? Why is that even involved in the case?
James P. Ginzkey: This is not a denial of benefits case. What--
Antonin Scalia: So we don't have to consider that, then, right?
James P. Ginzkey: --It's not a denial of coverage case. That's not what we're alleging.
Antonin Scalia: Okay.
James P. Ginzkey: The benefits, or excuse me, the expenses that were incurred for her hospitalization and emergency surgery were paid in full. We're not seeking to recover those.
Antonin Scalia: You say she should have had some other kind of treatment, which would have been more expensive, right?
James P. Ginzkey: No.
Antonin Scalia: No?
James P. Ginzkey: No.
Antonin Scalia: I thought it was.
James P. Ginzkey: This is not a medical malpractice case. There is no individually named physician that's a defendant in amended Count III. This is not about quality of care. This is exclusively--
John Paul Stevens: But explain something else to me, if you would. The HMO here contracted with State Farm Mutual, is it, and who would get the money if there is... the doctors had to pay some money? The HMO wouldn't get it, because they are the doctors.
James P. Ginzkey: --It would go back into the risk pools.
John Paul Stevens: To the risk pool?
James P. Ginzkey: If I can go back to the analogies example that I was trying to draw previously, say you have somebody in relatively good health, and the per member per month charge for the cost of--
John Paul Stevens: I have a... forgive my stupidity, but what is the risk pool? Who... what fund of money... who owns that? Is that the insurance company's property?
James P. Ginzkey: --That's plan assets.
John Paul Stevens: It's a plan asset.
James P. Ginzkey: That's a plan asset.
William H. Rehnquist: Well, who would physically... supposing you get this money, who actually gets title to it?
James P. Ginzkey: It's managed by the HMO.
William H. Rehnquist: So it goes back to the HMO.
James P. Ginzkey: Well, it goes back into the risk pool--
William H. Rehnquist: Well, but--
James P. Ginzkey: --but it's for the benefit, for the health benefit of the participants, as opposed to being available for bonuses for physicians.
Ruth Bader Ginsburg: --And what qualifies you as a representative of the people in the risk pool?
James P. Ginzkey: ERISA specifically states that any plan participant can bring a suit on behalf of the plan.
David H. Souter: Mr. Ginzkey, may I go back to your answer to Justice Scalia? You were telling him what this case was not. You said, it's not a malpractice case.
James P. Ginzkey: It's not.
David H. Souter: It's not a coverage case. It's not a denial of benefits case. What is it?
James P. Ginzkey: It's a breach of fiduciary duty case.
David H. Souter: Resulting in what kind of harm? I mean, in a malpractice case we know what the harm is. In a coverage case, we... and so on. What exactly is the harm? The harm is simply that the risk pool is smaller than it otherwise would be?
James P. Ginzkey: The harm is that the money that is paid into the risk pool by State Farm and the employee... because this is a contributory plan. 50 percent of the premium is paid by the employee. The harm here is that that money, which is supposed to be used exclusively for health care, is not being used exclusively for health care.
David H. Souter: So you're basically making a financial management claim. You're saying, they're misapplying funds?
James P. Ginzkey: Yes, absolutely. They are breaching their fiduciary duties with respect to the management of the risk pools. The risk pools have exclusively in them money to be used for the funding of medical expenses. And you asked what the harm is. What strikes me about this case, unusual about this case is that the courts zealously protect money for money's sake with respect to pension plans, and let me explain that. If you look at the John Hancock v. Harris Trust case that this Court decided in 1993, or some other cases that are dealing with pension benefits, any fiduciary under one of those plans has never been able to deal with the funds in that plan in profit, self-profit from the dealing of... with those funds.
David H. Souter: Well, I will... you know, I will assume that, but may I just come back to a follow-up question. Assuming, and you know your case, this is a mismanagement of funds case--
James P. Ginzkey: Yes.
David H. Souter: --am I right that in order for you, which I think we've all been assuming, am I right that in order for you to make out your case that there has been mismanagement of funds, it's necessary for us to accept the proposition that whenever a physician in an HMO has a strong financial incentive to make a medical decision, that that medical decision is therefore a fiduciary decision, and is therefore... and therefore a claim against him is preempted from State malpractice law in favor of ERISA fiduciary law?
James P. Ginzkey: No, you do not make that assumption.
David H. Souter: Then it's not the median term. Why isn't it the median term in order to get your result?
James P. Ginzkey: We're confusing a couple of two different issues, because there's more than one level involved in this case. One of the lower levels that is involved, if I can use that terminology, is the determination by the primary care physicians as to what is and what is not medically necessary. That not only is a treatment decision, but based upon the wording of this plan, it's also a coverage decision, so--
David H. Souter: And that kind of decision was involved in this case?
James P. Ginzkey: --But we're not--
David H. Souter: Isn't it? I mean, isn't that your understanding of what you're claiming, that that kind of decision was crucial to your claim in this case?
James P. Ginzkey: --No, because there was nothing that the physician felt that was medically necessary that was denied.
David H. Souter: Are you saying that it just happens to be a coincidence that you are bringing this financial mismanagement claim under the same... with the... joined with the same pleadings that happen to make malpractice claims? Are you saying that out of the blue, even if your client had lived a totally healthy life and never been denied an immediate appendectomy, that you could bring this claim, and it's a mere coincidence that you happen to be here in the context of this case?
James P. Ginzkey: Essentially that's correct, Judge.
David H. Souter: Okay.
James P. Ginzkey: That's correct, because--
Antonin Scalia: I didn't realize--
James P. Ginzkey: --Because--
Antonin Scalia: --I didn't realize you were making any ERISA claim. I thought you were making State claims, and the reason all of this comes up is that the objection to your Count III and Count IV State claims was that they were preempted by ERISA.
James P. Ginzkey: --No. We're making an ERISA claim.
Antonin Scalia: Where does that appear in your--
James P. Ginzkey: It's amended Count III. That's in the joint appendix.
Stephen G. Breyer: --Amended Count III. So we've actually... now, your client's appendectomy is irrelevant, the malpractice is irrelevant, has nothing to do with it, it's entirely... which is... I mean, and then it's going to come down to either the fiduciary issue, or if you are fiduciaries, we have to figure out what the standard is on what incentives could be so extreme that they violate the obligation to everybody. Is that basically where we are?
James P. Ginzkey: That's exactly right, Judge.
Stephen G. Breyer: And what in your view is the standard for determining whether... because you concede that some incentive plans could be okay, so what's the standard for determining... and I think the Government concedes that there could be some that weren't okay.
James P. Ginzkey: And I agree.
Stephen G. Breyer: All right. I know.
James P. Ginzkey: I agree.
Stephen G. Breyer: So now we've got a lot of agreement here, and what we've got to-- [Laughter] What, in your view, is the difference in the standard, then, as to when they're okay when they're not okay?
James P. Ginzkey: That's going to be a difficult line to draw. It's kind of like the line that the Court's going to have to draw with respect to the Webster Hubbell case that was argued yesterday. It's going to be a difficult line to draw, but the fact that it's difficult to draw doesn't mean we don't draw it.
Stephen G. Breyer: All right. How would you draw it?
James P. Ginzkey: The phrase that I have used is undue influence, because again, drawing on the study from California, the median incentive was 10,400, but some of those incentives got up to 40 to 50,000. If I'm a physician, and I have a 100,000 annual salary by contract, and I've got two kids in college, and I can make another 50,000, that's a lot of incentive. That's an improper... that's an undue influence. That's an improper incentive.
William H. Rehnquist: Thank you. Thank you, Mr. Ginzkey. The case is submitted.


Earl Warren: Number 486, W. Palmer Dixon et al., Petitioners, versus United States. Mr. Brandes.
Bernard E. Brandes: May it please the Court. This case is before the Court on certiorari to the Second Circuit. There are two issues involved and the first of the two issues, the same issue is involved in the companion case of the Midland-Ross Corporation in which the government is the petitioner. That case follows immediately after this case. So far as the first issue was concerned, the facts are relatively simple. The year involved is the year 1952 and accordingly the provisions of the 1939 Internal Revenue Code apply. In that year, the petitioner's here were members of the partnership engaged in the business of dealing in securities. In addition, the partnership from time to time purchase securities for its own account as principal. In early nine -- commencing in early 1952, the partnership purchased certain securities consisting of promissory notes that had been issued at a discount and did not bear interest. It is conceded that these securities were properly identified and marked for investment as is required of a deal of in securities so that they constituted in the hands of the partnership, capital assets. These securities were sold after -- certain of these notes were sold in 1952 after they have been held for more than six months. And the gain on the sale was reported by the partnership and therefore by the petitioners as a long-term capital gain. On audit, the Internal Revenue Service held that the gain which had been reported on sale as long-term capital gain was in reality interest income and so far as the notes which as of the end of the year had not yet been sold, as to those notes even though they had not yet been sold, there was a requirement for a picking up on a pro rata basis of the discount at which those notes had been issued. The first issue is therefore a very narrow confined issue with statuary construction under the 1939 Code. It is an issue that does not exist in the context of this case under the 1954 Code because as we propose to develop the law that has been changed.” Properly stated was, the issue is very simple, what under the 1939 Code was the status of issue discount and to what is the answer to that question is to be determined only in the light of the words of the statute as written, in the light of a demonstrated intent of Congress and in the light of such precedent as we have on the issue and so far as precedent is concerned, the only precedent close to this issue consists of decisions of this Court. Now, in the court below and continued here, the respondent has offered a very simple, disarming approach to the issue. The respondent's approach basically is, discount is like compensation for the use of money. Interest is also compensation for the use of money. Accordingly, discount and interest must be related and the measure involved of compensation for the use of money must be the measure of ordinary taxable income in the nature of interest that must exist. Now, this approach which I have taken the liberty of terming it a simple and disarmingly simple approach was fully accepted by the court below and so far as we can ascertain from the opinion, the Court did not proceed to examine what it is that we there offered and there offered again by way of material that shows that Congress was aware, that obligations were issued at a discount and was aware that the tax treatment which attached to obligations that were issued at a discount were different. Further --
Potter Stewart: These were the notes, promissory notes?
Bernard E. Brandes: Yes sir.
Potter Stewart: Purchased from the obligor, from the maker?
Bernard E. Brandes: In some instances from the maker and in other instances from other dealers.
Potter Stewart: On the date of issue or --
Bernard E. Brandes: In all as I remember about one instance on the date of issue.
Potter Stewart: And in 1952 and then these sales were also within the calendar year 1953?
Bernard E. Brandes: These sales were within the calendar year 1952 as to certain of the notes which were thus purchased.
Potter Stewart: Well, and the only -- that's the only income in question in this case, is it, 1952?
Bernard E. Brandes: Well, in 1952 is the only year before the Court. However, on audit of 1952, the Internal Revenue Service reclassified the gain on the sale of the notes which were sold. And in addition, with regard to the unsold notes on the ground that the discount which had been accumulating on those unsold notes, was ordinary income in the nature of interest they forced in accrual.
Potter Stewart: These are accruals experience appropriate (Voice Overlap)
Bernard E. Brandes: These are accruals -- the partnership is an accrual basis taxpayer.
Potter Stewart: And it's not – I probably should know this, but I don't know if the partnership of course is not itself a tax payer.--
Bernard E. Brandes: Right sir.
Potter Stewart: -- but a reporter of a return --
Bernard E. Brandes: The partnership files an --
Potter Stewart: And if -- if the partnership is on the accrual basis, does this automatically put all the partners on the accrual basis?
Bernard E. Brandes: No sir. We thought --
Potter Stewart: Not such as the business -- as to that part of the income account, a very income account in the partnership or not?
Bernard E. Brandes: The individuals are not on the accrual basis, but they must pick up in their individual returns, what it is that the partnership return shows as their share of income (Voice Overlap).
Potter Stewart: Even though they'd be on a cash basis?
Bernard E. Brandes: Even though they'd be on the cash basis.
Potter Stewart: That's -- what about your --
Bernard E. Brandes: The partnership return is just an information --
Potter Stewart: I understand -- I know that.
Bernard E. Brandes: -- that discloses what it is that each of the partners must report. Returning to this approach based on compensation for the use of money, although it involves the anticipating part of our argument here, because it is so fundamental to our position to point out and to have the Court realize that the measure of compensation for the use of money is not the measure of interest. I should like at this point to refer the Court to its decisions in the Bond Premium cases. Just as that obligation is issued at a discount, it is issued at a premium. This Court has upheld the treasury in holding that the amount of premium paid does not reduce the amount of interest yield on the obligation, unless there is special legislation. In other words, if an investor holds an obligation which he acquired at a premium, he is required to pick up and report the full amount of the interest yield without reduction for the premium, unless there is special legislation which authorizes the amortization of the premium, which special legislation came into being in 1942 --
Byron R. White: And then yield within the technical sense?
Bernard E. Brandes: Pardon me sir.
Byron R. White: Are you using a yield in any technical sense or are you just using it to --
Bernard E. Brandes: Yield in the --
Byron R. White: -- in the returns that he had --
Bernard E. Brandes: -- in the economic --
Byron R. White: He must --
Bernard E. Brandes: -- or the investments.
Byron R. White: He must return all the interest that you'd paid to him?
Bernard E. Brandes: Right sir, without any reduction.
Byron R. White: It maybe different than yield.
Bernard E. Brandes: Well, or -- if you use the terminology of yield, then all the interest that is paid to him is not the yield.
Byron R. White: That's right. That's alright, and then that isn't what you mean. Do you mean that he has to return all the interest you'd paid to him?
Bernard E. Brandes: Right. Turning to what we believe that we are in a position to prove with regard to the intent of Congress in connection with the 1939 Code as in support of our position that under the 1939 Code, unlike under the 1954 Code, issue discount is a capital item. We should like to refer to the structure of the statue to the fact that there were specific provisions of the statue which should have been superfluous. If the rule is as respondent contends namely, if the rule is that issue discount is always an income item. We also -- to demonstrate the state of the lower pride to the 1954 Code will show that the administrative practice existing at least prior to 1953 was to regard issue discount as a capital item. The capital gains and losses provisions of the 1939 Code are very clear. They define capital assets and they further define that any gain realized on the sale of a capital asset is a capital gain and that it is true, is as far as they go and there's -- in that connection. Within that framework if we went no further, it would be very difficult to find why. This discount when realized on sale should not be a capital gain. There was a sale and there was a profit and it was realized after six months. If we are to believe that there are some hidden, ipso limitations on the definition of what constitutes a capital gain, it is most material to observe that within the framework of Section 117, which is the pertinent Section, the Congress has inserted a very explicit exception. Securities that have been -- short-term securities that have been issued at a discount and without interest, the statue goes on to say. By any government, do not constitute capital assets by excluding them from the definition. Congress saw to it that any gain on those securities was ordinary income. Now, it is true that the respondent has come forward with some explanation of the background of that section of the statue. But the fact remains that the existence of this section of the statue shows that the Congress was in a position and knew how to deal with issue discount under the 1939 Code, when it was faced with the need so to deal with issue discount under the 1939 Code. There were other examples as specific enactments dealing with issue discount that should have been superfluous, if the rule under the 1939 Code was as is contended. There are special provisions in Section 207(d) and 207(e) dealing with certain insurance companies and specifically requiring those certain insurance companies to accrue and report is ordinary income discount and on the counter balance to accrue and report by way of reduction of ordinary income on premium. Going back into the legislative history, we find specific statements in the Congress wherein they displayed their understanding and awareness of the fact that debt obligations were issued at a premium under the discount and that different -- were being issued with expressed interest under the discount and that different tax consequences attached to the different types of obligations. We have at some length delved upon the Senate debate in 1929. This debate was occasioned by a proposal which authorized the issue of treasury bills at a discount. At that time, interest on U.S. obligations was exempt from the tax. It was recognized that to make the treasury bills competitively saleable, there had to be some exemption factor attached to them. The proposal of the treasury and accepted by the senate finance committee was to attach the exemption factor by providing in the statue that all gain on the sale or rather disposition of these bills should be exempt from tax. The debate in the Senate shows that there was considerable opposition to such a proposal, because it was felt that there should not be any weakening of the structure which required all capital gains to be subject to tax. The debate in the senate further shows that the senate was fully aware of the fact that the discount at which these bills were being issued represented to use the words of Senator Reid “Hire for the use of money” and further demonstrates that the Senate believes because it had been so advised by the treasury that under then existing regulations of the treasury, discount, issue discount when realized would be taxed as capital gain. And accordingly, the exemption for interest which then existed pertaining to obligations of the United States could not apply to a treasury bill. The Congress again displayed the great awareness of the situation by carving out the discount, by specifically legislating that the discount shall be labeled and classified as interest. And in that way, the Congress permitted to be attached to the discount at which these bills were issued, the exemption then applying for interest. In 1938, there was a subcommittee appointed as a part of the study leading to 1939 Code. This subcommittee considered whether or not to eliminate the capital gains tax. Because time is running out, I cannot now read to you the excerpt from this committee's report, but I should like to refer You Honors to it. It is on, page 15 of my brief, and clearly again shows that the Congress was aware of the practice and was aware of the different tax results that existed. I have no place in the respondent's paper been able to find any statement by respondent, that his practice was other than during this period prior to 1953, 1952 and prior, other than to treat issue discount as capital gain. We have in our papers, references to the acquiescence which stood through five major legislative overhauls in a case which held that issue discount when realized was capital gain. At the very beginnings of 1952, there was a special ruling issued in publishing the tax services, which again repeated respondent's position that issue discount when realized was taxable as a capital gain. Now, it's true that the statue was changed in 1954. However, I invite the Court's attention to the structure of the statue. It is as clearly as prospective an application as any statue could be. It applies only to obligations issued after December 31, 1954, and that although the statue itself was passed in August of 1954. Furthermore, in one specific instance, in Section 1232, where they wanted to change the existing rules, they have yet another effective date of March 1954. In connection with the enactment of the 1954 Code, the House Ways and Means Committee clearly stated that this is a change in the law that under the prior law issue discount was taxed when realized as a capital item. With regard -- I have mentioned the situation with regard to bond premium and there legislative history was the same. The situation is to bond premium to bring up more in line with concepts of finance and economics was corrected in 1942. The respondent's answer here apart from the argument to which I have referred is primarily that discount is deductible to the issuer. Now, I can't find that that is an answer to the problem because as regards premium, premium has always been an item of increase to the issuers income even at the time when it was not an item of decrease to the holder's income with regard to the obligation. In summary so far as this first point --
Potter Stewart: Discount is deductible to the issuer?
Bernard E. Brandes: Yes sir.
Potter Stewart: From his ordinary income whether or not his on the accrual basis?
Bernard E. Brandes: Under the regulations of the treasury, it must be amortized over the life of the security.
Potter Stewart: What ever his basis is?
Bernard E. Brandes: Right.
Potter Stewart: I mean whether it'd be cash or accrual?
Bernard E. Brandes: Right. That is correct sir. Now, I have -- there are several -- there are two things about this first point that I'd like to repeat and reiterate. One is, I think the government should come forward and clearly state what it is, what its position with regard to issue discount prior to 1953 since we are here dealing with the year 1952. And further to explain why, the government did not approach Congress prior to 1954 to amend the statue. Is the government not now in the position where it is coming to this Court and presenting to the Court arguments and reasons that should have been more properly presented to the Congress and which were not presented to the Congress until 1954. The second point that's involved in this case is a matter of fundamental importance and the administration of the tax laws. It involves the question of the extent to which taxpayers are privileged to rely on public pronouncements of the Internal Revenue Service and are privileged to believe that if those pronouncements are changed or if the position set forth therein is changed, they will be changed on the basis that does not discriminate as between taxpayers or as among the taxpayers. The partnership here purchased the securities at a time when it fully believed, because of the preexisting government practice that had been announced in more than one place and particularly announced in the acquiescence in the Fulton's case, that issue of discount when realized would bring about capital gain. The government withdrew the Caulkins acquiescence in 1955. At the time when the Caulkins acquiescence was withdrawn, the government stated that it could not and there was no basis to distinguish the discount element present in any security from the discount element present in any other security. In addition, although the Caulkins acquiescence which was a -- well, let me say this about acquiescence, that all of the things that the treasury may say “the most significant on this side of the table is the acquiescence.” This is what the practitioner and the businessman go high. When the Caulkins acquiescence was withdrawn, the government withdrew it not only retroactively without warning, but withdrew it on a basis that discriminated.
Justice Bernnan: You distinguish that – you don't ask us to overrule Automobile Michigan [Inaudible]
Bernard E. Brandes: No sir. I ask you to follow Automobile Club of Michigan. In that case if you will remember sir, the Automobile Clubs' exempt status was revoked in 1945 and carried back to 1943. The Automobile Club said that the Commissioner should not be permitted retroactively to change his position. This Court held that the Commissioner is privileged to change his position to correct the mistake of law, but whether he has acted properly always depends on the circumstances of the case. And in the discussion of the circumstances of the case, if my memory serves me correctly, there are two aspects that are emphasized. One is that the carry back to 1943 gave the Automobile Club no cause for complaint, because in 1943 it had already been placed on notice by a publicly issued general counsel's memorandum that clubs such as it would no longer be exempt from tax. And most importantly, when the Internal Revenue Service changed its position, it was uniformly applied clear across the boards to every taxpayer similarly situated. In this case, we have a retroactive application without warning and we have a discriminatory application, because the withdrawal of the Caulkins acquiescence is not applied as against particular taxpayers who purchased a particular kind of security. Even though at the same time, the Internal Revenue Service admitted that there was no basis on which to distinguish one discount security from any other discount security. If I may sir, I should like to save the remaining time.
Earl Warren: You may -- you may Mr. Brandes. Mr. Goodman.
Frank I. Goodman: Mr. Chief Justice, may it please the Court. Despite the shortage of time available today, I'd like to begin by restating very briefly the facts of this case. The partnership of which the petitioners were members, in 1952 purchased $43 million worth of short-term promissory notes, either directly from the obligor corporations or through brokers -- through dealers and agents. These notes bore no stated rate of interest, but in each case, they were issued at discounts ranging from two and three-eights to three and three-quarters percent. By the end of the tax year, the partnership had sold 20 of these 33 notes for an aggregate gain of $500,000, virtually all of it should be result of discounts at which the notes were originally issued. The other 13 notes remained on hand unmatured. The Commissioner determined that the excess of the face amount of the notes over the amount money for which they were purchased represented interest, accruing over the life of each note, both those that were sold and those that were not sold. And since the partnership was on the accrual basis, the interest accruing on each of the notes was required to be included within the partnership's taxable income for the year and therefore, in the taxpayers distributed shares. The taxpayers concede that this treatment would have been entirely appropriate if the notes that had provided for interest in so many words. But they say, that because the interest element -- because the compensation they received for the use of their money was not specifically labeled as such, but was simply added to the amount which the borrower agreed to pay on the maturity of the notes, that they are not required to accrue it and that they are entitled to treat it as capital gain upon the sale of the notes.
Byron R. White: Everybody agreed that if -- that the state [Inaudible] or that it would be --
Frank I. Goodman: That's right sir. And that is true despite the --
Byron R. White: Of all [Inaudible]
Frank I. Goodman: Well, the cases holding it to be true dates from about 1954.
Byron R. White: Yes.
Frank I. Goodman: Before that time, I think that there was a considerable degree of confusion on this subject. There is no case one way or the other specifically indicating the view prior to 1954. We think this --
Byron R. White: This is the acquiescence that you talked about here cover those very interests?
Frank I. Goodman: Well, of course we don't know what the Commissioner's acquiescence covered except a particular case that was before the Court. That was a non-interest bearing security which was issued at a discount for all practical purposes. Our contention on that subject is that the case in which the Commissioner acquiesced doesn't even apply to this case for a somewhat different reason that Mr. Justice White, you talked -- you get into those --
Potter Stewart: That was the retirement not a sale.
Frank I. Goodman: Essentially that's right. Yes Mr. Justice Stewart.
Potter Stewart: And under that 178 –
Frank I. Goodman: That's right. That's our position on the Caulkins case. We think the petitioners that --
Hugo L. Black: That's at the Caulkin?
Frank I. Goodman: Caulkins, that's the name of it. We think that the petitioner's contention is wholly formalistic and that it becomes all the more extraordinary when one further fact is noted which was not adverted to by Mr. Brandes. The record shows that as each of these notes was purchased, it was immediately pledged as security for a bank loan in an amount exactly equal to the face amount of the note. Now, that indicates I think fairly clearly that the partnership obtained the $43 million with which to purchase these notes by borrowing it from a bank specifically for the purpose. In 1952, it paid interest on the money which it borrowed in the amount of $625,000 and claimed that amount as an ordinary deduction on its income tax return. At the same time, the profit which it realized on the notes which it sold amounted to only $495,000. So the tax consequences aside the net effect of the borrowing and lending transactions was an economic loss of $130,000. Now, the explanation for this seeming folly lies of course in the tax consequences. Assuming that the partners were in the 60% bracket which seems a reasonable assumption, the net effect of their obtaining ordinary interest -- ordinary deduction on the interest which they pay while obtaining capital gain on the interest which they received is to reduce their overall tax bill by $250,000, thus not only completely wiping out the economic loss which they incurred before taxes, but giving them a fairly handsome after-tax profit to boot. And indeed so long as the taxpayers are in the 40% bracket or higher, they stand to gain on this arrangement. To us, this is merely another illustration of the fact that unless the tax law conforms to the economic realities of a transaction, gimmicks and devices will readily be found to exploit the artificiality and to obtain advantages which the Congress never dreamed of giving. Our position could be illustrated by a simple analogy, a disarming analogy as Mr. Brandes has referred to it without saying in anyway why it isn't completely applicable to this case. If A gives B -- A lends B a $100 in return for B's promise to repay the $100 a year later, plus $6 extra, this obligation can be worded in a number of different ways. The note could say a $100 plus 6% interest. It could say a $100 plus 6%, a $100 plus $6 interest, or $100 plus $6 or as in the present case, the note could simply say a $106. Now, every one of these forms of expression obviously means exactly the same thing and our basic position in this case is that the tax consequences of each of these transactions should be exactly the same whether the interest is specifically labeled as such and whether or not it is stated as a percentage of the amount borrowed or as an amount added to what the borrower agrees to repay on maturity. In each case, the $6 increment represents exactly the same thing economically and that is compensation paid by the borrower to the lender in exchange for the use of the lender's money. In short, interest as this Court has defined it in Deputy versus du Pont. Now, in the case of the note with the stated interest of 6%, everyone agrees that an accrual basis taxpayer has to accrue the $6 increment ratably over the term of the note. We say that precisely the same should be true in the case of the non-interest bearing note promising a $106 at maturity.