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The ERISA Edit: Another Circuit Weighs in on Prohibited Transaction Pleading Standard

Employee Benefits Alert

Pursuant to ERISA § 406(a)(1)(C), a plan fiduciary cannot cause the plan "to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect . . . furnishing of goods, services, or facilities between the plan and a party in interest" — "[e]xcept as provided" in ERISA § 408. One exemption expressly set forth in ERISA § 408 provides that § 406(a)(1)(C)'s prohibitions "shall not apply" to "[c]ontracting or making reasonable arrangements with a party in interest for . . . services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefor." ERISA § 408(b)(2)(A). A "party in interest" includes "a person providing services" to an employee benefit plan. ERISA § 3(14)(B).

For more than a decade, a battle has been brewing in the U.S. Courts of Appeals over the proper interpretation of these statutory provisions. On Tuesday, the Second Circuit joined the fray, holding in Cunningham v. Cornell University, Nos. 21-88, 21-96 & 21-114, --- F.4th ----, 2023 WL 7504142 (2d Cir. Nov. 14, 2023), that the claims of thousands of plan participants failed at the pleading stage because the class plaintiffs had not alleged that the services of their retirement plans' service providers were unnecessary or that the compensation paid to the service providers was unreasonable. 

In reaching its decision, the Second Circuit rejected the Eighth and Ninth Circuits' literal construction of § 406(a)(1)(C). Those courts had previously held that a plan fiduciary engages in a prohibited transaction if he compensates any outside entity providing any services to the plan. More specifically, the Eighth Circuit had held that a plaintiff stated a claim under § 406(a)(1)(C) by alleging that a party in interest received "undisclosed amounts of revenue sharing payments in exchange for services rendered to the [p]lan." Braden v. Wal-Mart Stores, Inc., 588 F.3d 585, 601 (8th Cir. 2009). The Eighth Circuit concluded that § 408(b)(2)(A)'s exemption for reasonable compensation for services to the plan was an affirmative defense and therefore had no bearing on whether the plaintiff's claim withstood the defendant's motion to dismiss. Id. The Ninth Circuit had similarly construed § 406(a)(1)(C) in Bugielski v. AT&T Servs., Inc., 76 F.4th 894 (9th Cir. 2023), which we recently discussed here. Because that appeal involved a grant of summary judgment, the panel reached its decision without addressing whether § 408(b)(2)(A) is an affirmative defense. Last week, the Ninth Circuit denied rehearing en banc

In Cunningham, the Second Circuit instead sided with the Third, Tenth, and Seventh Circuits, which had held that the other courts' reading of § 406(a)(1)(C) was absurd, in that it would prohibit fiduciaries from paying third parties to perform essential services in support of a plan, which could not have been what Congress intended. Instead, the three courts narrowed § 406(a)(1)(C) in other ways: 

  • In Sweda v. Univ. of Penn., 923 F.3d 320 (3d Cir. 2019), the Third Circuit required allegations reflecting an intent to benefit a party in interest
  • In Albert v. Oshkosh Corp., 47 F.4th 570 (7th Cir. 2022), the Seventh Circuit held that, to state a claim, the transaction must look like self-dealing
  • In Ramos v. Banner Health, 1 F.4th 769 (10th Cir. 2021), the Tenth Circuit concluded that "some prior relationship must exist between the fiduciary and the service provider to make the provider a party in interest"  

In Cunningham, the Second Circuit affirmed the district court's dismissal of the plaintiffs' § 406(a)(1)(C) claim, though it rejected the lower court's conclusion that, to state a prohibited-transaction claim, a complaint must allege that the challenged transaction involved "self-dealing or disloyal conduct." Instead, the Second Circuit, in strong disagreement with the Eighth Circuit, held that ERISA § 408(b)(2)(A)'s exemption for reasonable compensation in exchange for necessary services was not an affirmative defense. According to the Second Circuit:

to plead a violation of § [406](a)(1)(C), a complaint must plausibly allege that a fiduciary has caused the plan to engage in a transaction that constitutes the "furnishing of . . . services . . . between the plan and a party in interest" where that transaction was unnecessary or involved unreasonable compensation

2023 WL 7504142, at *7 (citing ERISA §§ 406(a)(1)(C), 408(b)(2)(A)) (emphasis in original).

The court figured that its reading "flowed directly from the text and structure of the statute," given that § 406(a) begins with "a carveout" — i.e., "Except as provided in § [408] . . . ." Id. Thus, the court believed that § 408's exemptions, including for "reasonable compensation" paid for "necessary services," were "incorporated directly into § [406]'s definition of prohibited transactions." Id. The court acknowledged that when a statute is drafted with exemptions laid out apart from the prohibition, it is presumed that the exemptions are affirmative defenses. Id. But, as in § 406(a), "that presumption does not apply when the exemptions are incorporated directly into the text of the relevant provision." Id. "Thus, the fact that Congress drafted § [406] . . . to reference the § [408] exemptions supports the view that the burden of raising those exemptions lies, at least in part, with the plaintiff." Id. 

The court further held that: 

"[t]he broad scope of § [406](a) . . . places greater weight on the § [408] exemptions, in particular § [408](b)(2)(A), to limit the scope of the statute's prohibitions to only those transactions that actually present a risk of harm to the plan and raise the sort of concerns implicated by the duty of loyalty — the duty § [406](a) has been held to "supplement[]."

Id. at *8. "Put simply, when read on its own, § [406](a) . . . is missing an "ingredient of the offense." Id. at *9 (cleaned up). "That ingredient is the exemption for 'reasonable compensation' paid for 'necessary' services, reflected in § [408](b)(2)(A)." Id. Only by incorporating § 408's exemption into § 406's prohibition, "and thus limiting its reach to unnecessary or unreasonable compensation," can "the offensive conduct the statute discourages . . . 'be accurately and clearly described.'" Id. (quoting United States v. Cook, 84 U.S. 168, 174 (1872)). 

Because the Cunningham plaintiffs had alleged that because the plans' service providers were parties in interest and "their 'furnishing of' recordkeeping and administrative services to the Plans [wa]s a prohibited transaction unless Cornell prove[d] an exemption," their complaint failed to state a claim under § 406(a)(1)(C). Id. It fell on the plaintiffs "to allege in the first instance that the transactions were unnecessary or that the compensation was unreasonable." Id. Because the plaintiffs had "done neither," the district court was right to dismiss their prohibited-transaction claim. Id.

With the Second, Third, Tenth, and Seventh Circuits agreeing that § 406(a) must be read in conjunction with § 408(b) on the one hand, and with the Eighth and Ninth Circuits hewing to a literal reading of § 406(a) without incorporating § 408(b)'s exemptions on the other, the issue appears to be primed for the Supreme Court's intervention. As a policy matter, the courts certainly do not wish to be flooded with prohibited-transaction cases that do not, at the outset, require the plaintiffs to plead anything more than a plan fiduciary engaged a recordkeeper or investment manager to furnish services to the plan. The question is whether the Supreme Court will agree that the Eighth and Ninth Circuits' reading of the statute is, in fact, absurd.

In addition to dismissing the plaintiffs' prohibited-transaction claims at the outset, the district court later granted summary judgment in favor of defendants on plaintiffs' fiduciary-breach claims tied to recordkeeping fees and the retention of underperforming investment options. The Second Circuit affirmed as to the recordkeeping-fee claim because the plaintiffs failed to establish that the plans had suffered any related loss. The court also affirmed as to the investment-option claim, concluding that "no reasonable trier of fact could determine that Cornell's process [for investigating the merits of a particular investment] was flawed such that Cornell violated its duty of prudence."  

Upcoming Speaking Engagements and Events

Joanne Roskey, Anthony Shelley, and Dawn Murphy-Johnson will present the ERISA Industry Committee (ERIC) webinar, "Legal Developments in Employee Benefits Law," on November 17.

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