Supreme Court to Reevaluate Pleading Requirements for ERISA-Prohibited Transaction Claims

The U.S. Supreme Court recently granted a petition for a writ of certiorari to review the U.S. Court of Appeals for the Second Circuit's decision in Cunningham v. Cornell University, 86 F.4th 961 (2d Cir. 2023). In doing so, the nation's highest court is now positioned to provide greater clarity regarding the pleading standards for prohibited transaction claims under the Employee Retirement Income Security Act (ERISA). The decision to grant the petition will provide much-needed clarification on the pleading requirements associated with prohibited transaction claims involving a plan sponsor's contracts with plan service providers as there is currently a three-way split among the circuit courts on this issue. The forthcoming decision may also provide guidance for other types of prohibited transaction claims. Oral argument is scheduled for January. 

Background

ERISA Section 406(a), 29 U.S.C. § 1106, enumerates a list of "prohibited transactions" between a plan and a "party in interest." In particular, ERISA Section 406(a)(1) provides that, "Except as provided in section 1108" [ERISA § 408], "(1) A fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect—A) sale or exchange, or leasing, of any property between the plan and a party in interest; B) lending of money or other extension of credit between the plan and a party in interest; C) furnishing of goods, services, or facilities between the plan and a party in interest; D) transfer to, or use by or for the benefit of a party in interest, of any assets of the plan or E) acquisition, on behalf of the plan, of any employer security or employer real property … ." ERISA Section 408(b), 29 U.S.C. § 1108, provides a series of exemptions to Section 1106(a)'s list of prohibited transactions.

The key issue dividing the courts is the interplay between ERISA Sections 406 and 408 and the impact of the language, "[e]xcept as provided in section 1108 of this title," on the definition of prohibited transactions. In particular, the issue is whether the exemptions set out in Section 1108 are incorporated directly into ERISA Section 406's definition of a prohibited transaction, such that a plaintiff must plead facts that show that an exemption does not apply to the prohibited transaction claim .

The specific transaction at issue in Cornell University involves the "furnishing of goods, services or facilities between the plan and a party in interest." Under ERISA Section 408(b)(2), a transaction with a plan's service provider is not considered an unlawful prohibited transaction as long as "no more than reasonable compensation is paid." 29 U.S.C. § 1108(b)(2) ("The prohibitions provided in section 1106 of this title shall not apply to any of the following transactions….[c]ontracting or making reasonable arrangements with a party in interest for office space, or legal, accounting, or other services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefor.").

Currently, there is a three-way split among the courts whether plaintiffs are required to plead the mere existence of a contract involving the "furnishing of goods, services or facilities between the plan and a party in interest" to survive a motion to dismiss or if something more is required (such as an allegation of some type of misconduct associated with the service provider agreement or harm caused to the plan as a result of the service provider agreement).

The Per Se Violation Approach

The U.S. Courts of Appeals for the Eighth and Ninth Circuits have taken a per se violation approach, which is the most lenient pleading standard approach. Essentially, the plaintiff need only to allege that there was a service provider agreement between a plan and a party in interest. As explained in the recent Ninth Circuit decision in Bugielski v. AT&T Servs, 76 F.4th 894 (9th Cir. 2023), ERISA Section 406(a)(1)(C) represents a "per se" rule and that a plaintiff need only allege that a plan fiduciary engaged in a transaction with a service provider. The court further held that an exemption for reasonable compensation for services to the plan under Section 1108 is an affirmative defense that does not affect a plaintiff's ability to withstand a motion to dismiss. The Ninth Circuit's decision currently represents the most lenient standard for a plaintiff to plead a prohibited transaction by a fiduciary engaged in a transaction with a service provider, finding that even routine transactions with service providers implicate ERISA Section 1106. The Ninth Circuit's decision is currently pending with the Supreme Court on fully briefed petition for writ of certiorari.

The Violation-Plus Approach

The U.S. Courts of Appeals for the Third, Seventh and Tenth Circuits have taken a different approach. The Third Circuit held that similar allegations regarding service providers earning fees through revenue sharing were insufficient to state a claim, even though the plaintiffs alleged that the university and its fiduciaries had overpaid certain fees, reasoning that "absent factual allegations that support an element of intent to benefit a party in interest … at the expense of [plan] participants," the plaintiffs failed to plausibly allege a prohibited transaction under ERISA Section 406(a)(1)(C). The Seventh Circuit also rejected a "literal reading" of ERISA Section 406(a)(1)(C), ruling that to survive dismissal, plaintiffs must not only allege that a transaction falls within the text of ERISA Section 406(a)(1)(C), but also that the transaction "looks like self-dealing." The Tenth Circuit held that "some prior relationship must exist between the fiduciary and the service provider" to make that provider a party in interest.

The Second Circuit's Approach

In the Cornell decision, the Second Circuit charted its own path, taking somewhat a middle ground between the approaches outlined by the other circuits. The Second Circuit ruled that the language of ERISA Section 406(a)(1) could not be read to "demand explicit allegations of 'self-dealing or disloyal conduct.'" However, the court disagreed with the Eighth Circuit's finding that the ERISA Section 408 exemptions should be understood as affirmative defenses, concluding instead that certain exemptions were incorporated into ERISA Section 406(a)'s prohibitions. Thus, the Second Circuit held that in order to plead a violation of ERISA Section 406(a)(1)(C), a complaint must allege more than just the "furnishing of services between the plan and a party in interest" – it must also plausibly allege that the "transaction was unnecessary or involved unreasonable compensation" in order to survive dismissal.

Legal and Practical Implications of Supreme Court Review

The Supreme Court's review of the Second Circuit's decision in Cornell (and of the AT&T case if the petition for certiorari is granted) is expected to provide much-needed clarification on the interpretation of ERISA's prohibited transaction provisions, particularly regarding the interplay between ERISA Sections 406 and 408. The high court's guidance in this area could have significant legal and practical implications for defendants of prohibited transaction claims, potentially reshaping compliance practices, contractual arrangements, litigation strategies and risk management, which may help guide not only the parties involved, but also other entities subject to ERISA.

For example, depending on the scope of the opinion, plan fiduciaries may receive guidance regarding the burden of proof associated with other types of prohibited transaction claims, including those involving the sale of stock to or from an employee stock ownership plan (ESOP). Currently, courts place the burden of proof of establishing the ERISA Section 408(e) adequate consideration exemption to transactions involving the acquisition or sale by a plan of company stock on the defendants. However, if the Supreme Court finds that the exemptions to the prohibited transaction rules are embedded within the definition of a prohibited transaction itself, it is likely that plaintiffs will have to plead and establish that an ESOP transaction involving the acquisition of employer stock was not for adequate consideration. Such a shift in the burden of proof would be welcomed by plan sponsors and plan fiduciaries, increasing the likelihood of a favorable defense ruling on an early dispositive motion.

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