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Class Action Defense Cases-Central States v. Merck-Medco: Second Circuit Reverses Approval Of Class Action Settlement Because Conflict Of Interests Exists Between Class Representatives And Certain Members Of Class

Class Action Certification should have Included Subclass to Protect the Interests of Class Members that Objected to Distribution of Settlement Proceeds under Terms of Class Action Settlement Second Circuit Holds

Plaintiffs, beneficiaries and trustees of employee welfare benefit plans, filed a class action lawsuit against a pharmaceutical benefits manager (PBM) and its former parent company under ERISA (Employee Retirement Income Security Act) for breach of fiduciary duty; the class action complaint alleged that the PBM “fail[ed] to act in their best interest in its capacity as a pharmaceutical benefits manager for the plans.” Central States S.E. & S.W. Areas Health & Welf. Fund v. Merck-Medco Managed Care, L.L.C., ___ F. 3d ___, 2007 WL 3033489, *1 (2d Cir. October 4, 2007). Plaintiff and defense attorneys negotiated a class action settlement that was approved by the district court, id. As part of that process, the district court denied a motion by CareFirst, a third-party administrator (TPA), to intervene in the class action lawsuit. Following approval of the settlement, CareFirst and other objectors appealed challenging the district court orders “(i) certifying the instant action as a class action pursuant to Fed.R.Civ.P. 23(a) and (b)(3); (ii) approving the amended Settlement Agreement as fair, reasonable, and adequate; (iii) awarding legal fees and disbursements; and (iv) severing cases in which the ERISA plans opted out of the settlement.” Id. The Second Circuit remanded the matter for a district court determination of whether the class representatives had standing to prosecute the ERISA claims in the class action and to enter into the class action settlement; the lower court found that standing did exist. Id. The Second Circuit then reassumed jurisdiction over the appeal and, inter alia, affirmed the district court finding that the TPA had standing but held the lower court erred in failing to certify a subclass or consider arguments directed at protecting the interests of that subclass. As the Circuit Court summarized, “we conclude that the court erred both in certifying the class without properly considering the conflicts of interest among members of the class and in approving the Settlement Agreement.” Id.

In broad terms, the class representatives are trustees and beneficiaries of employee welfare benefit plans contracted directly or indirectly with Medco, a PBM, for pharmacy benefit management services. Merck-Medco, at *2. The PBM had authority, in its discretion, to “manage certain aspects of the Plans for the primary purpose of containing pharmaceutical costs.” According to the class action complaint, the PBM breached fiduciary duties to the plans under ERISA by favoring products manufactured by its parent company, Merck, by “interchanging lower cost competing drugs with relatively higher cost Merck drugs,” and by entering into agreements with pharmaceutical manufacturers, including Merck, that were financially beneficial to Medco but more expensive for the Plans. Id. The Second Circuit described the differences in the relationship of various plans to the PBM at page *2 as follows:

By way of an indirect contract, insured Plans paid set premiums to their insurance companies in exchange for full payment of their beneficiaries’ prescription drugs, and the insurance companies in turn contracted with Medco for plan management services. By contrast, capitated Plans paid set premiums directly to Medco in exchange for full payment of their beneficiaries’ drugs. In the case of both the insured and capitated Plans, respectively, the insurer or Medco bore the risk of higher drug cost in paying each beneficiary’s claims for prescription medications. Plans that were self-funded, however, did not pay set premiums to either an insurer or to Medco and instead paid the entire cost of the prescription drugs directly to Medco as PBM or through a third-party administrator for a fee. Accordingly, self-funded Plans alone carried the direct risk of higher drug cost.

(Italics added.)

While the class action certification order included “all employee welfare benefit plans that contracted with Medco, whether they were self-funded, insured, or capitated,” the class representatives included only plans that were insured or capitated. Merck-Medco, at *2. The terms of the class action settlement attempted to address the differences among plans, id., at *3. In general, defendants agreed to pay $42.5 million into a settlement fund, from which attorney fees and costs, not to exceed 30%, would be paid, id. The remaining settlement proceeds would be distributed among class members “based primarily on the amount of each settling Plan’s proportionate share of the total drug spend of all settling Plans for the class period.” Id. The Circuit Court summarized the relevant details of the class distribution at page *3 as follows:

Accordingly, each Plan’s proportionate share of the total drug spend varies depending on the nature of the Plan’s relationship with Medco. Insured or capitated Plans, which paid set premiums to an insurance company or Medco in exchange for full payment of their members’ drug prescriptions, receive an allocation that is reduced by 55% to reflect the fact that they were more insulated from the conduct alleged in the Complaint. Said differently, if a Plan “pays for prescription drug benefits on an insured or capitated basis (e.g., a fixed premium or per-member, per-month sum) or if [the] Plan does not participate in any brand-to-brand therapeutic interchange program administered by Medco, [its] proportionate share of the total drug spend will be reduced by fifty-five percent (55%) to reflect the fact that [the] Plan could not have been damaged directly by certain of the conduct that Plaintiffs allege increase[d] costs to Plans.” By contrast, Plans that were self-funded and assumed the financial risk of paying for their members’ prescriptions in their entirety receive a proportionate share of the total drug spend without any reduction.

The main objection to the proposed class action settlement came from members of self-funded plans, several of which objected to class action certification and to the terms of the settlement, and sought leave to intervene. Merck-Medco, at *3. The self-funded plans argued that they should be certified as a subclass, and asserted that a conflict of interest exists between the self-funded plans and the class representatives “because the Plans that paid set premiums to Medco or insurers to avoid the risk of paying claims would share in the settlement fund notwithstanding the fact that they suffered no damages.” Id. The district court rejected this argument, finding no conflict of interest, id., at *4. The Second Circuit disagreed holding that the class representatives were not “adequate” within the meaning of Rule 23(a)(4) because their interests were adverse to those of other members of the class, id., at *12. “Self-funded Plans differ significantly from insured or capitated Plans because only self-funded Plans assumed the direct risk of absorbing any increases in prescription drug costs that were caused by Medco’s conduct.” Id. The self-funded plans believed that the insured or capitated plans had suffered no compensable damage – the Circuit Court was not required to determine whether this was true, holding that it was a sufficient basis for certification of a subclass consisting of self-funded plans so that the argument could be developed and the interests of the self-funded plans protected, id., at 13. The current class representatives “had no incentive to maximize the recovery” of other class members – i.e., the self-funded plans – because they were interested in obtaining a recovery for insured and capitated plans as well, id. (citation omitted).

The Second Circuit also agreed with the self-funded plans that the class representatives had failed to prove how they calculated the 55% reduction in recovery for self-insured plans and, therefore, how that distribution could be deemed fair, adequate and reasonable. Merck-Medco, at *4. The district court had simply relied on class counsel to support this aspect of the settlement: “there is no indication how the 55% allocation discount was calculated or why it properly reflects the relative losses suffered by the Plans.” Id., at *14. To the contrary, the Circuit Court quoted the lower court as recognizing that the record “is silent as to how the proponents of the settlement derived the insured [P]lans’ claim reduction of 55% relative to the claims of the self-funded [P]lans.” Id. (citation omitted). The district court’s approval of the settlement did not contain “specific factual findings” or otherwise explain how it determined that the 55% reduction was reasonable, id., at *15. Accordingly, the Second Circuit remanded the case to the district for “for necessary findings and an explanation in support of any reduction in the shares of the insured or capitated Plans.” Id.

Importantly, the Circuit Court held that the amount of the settlement fund need not be renegotiated, as only the percentage distribution among insured, caiptated and self-funded plans had been challenged on appeal: this creates the risk for class counsel that a binding settlement will be approved that distributes nothing to the insured or capitated plan class members. The Second Circuit remanded the action solely so the district court could (1) certify a subclass of self-funded plans, and (2) with the benefit of briefing and argument from counsel for that subclass, make a factual, or whether some different percentage should be approved. Merck-Medco, at *17.

NOTE: We do not here discuss the Second Circuit’s discussion holding that the district court did not err in determining that the class representatives had standing, see Merck-Medco, at *9-*10, and that it did not err in denying CareFirst’s motion for leave to intervene in the class action, see id., at *10-*11. Nor do we discuss that aspect of the decision addressing attorney fees, see id., at *15-*17.