Key takeaway: The Supreme Court held that to state an ERISA prohibited-transaction claim under 29 U.S.C. § 1106(a), a plaintiff needs only to plausibly allege the elements contained in § 1106(a) itself and does not need to address potential § 1108 exemptions, which are affirmative defenses rather than elements of an ERISA prohibited-transaction claim. The Court acknowledged the “serious” practical implications of its holding but suggested that a variety of procedural mechanisms may be available to discourage meritless lawsuits from being filed, including limited discovery, fee shifting, Rule 11 sanctions, and Federal Rule of Civil Procedure 7(a)(7).
On April 17, in Cunningham v. Cornell University, the Supreme Court resolved a split among the courts of appeals regarding the appropriate pleading standard to apply to prohibited-transaction claims under the Employee Retirement Income Security Act of 1974 (ERISA). In a unanimous decision, the Court held that a plaintiff need only allege the elements of a prohibited transaction listed in 29 U.S.C. § 1106(a) itself and does not need to plead that potential exemptions to those prohibitions, found in § 1108, are inapplicable. Section 1106(a) contains just three elements: (1) a listed transaction, typically between the plan and a “party in interest” (e.g., a service provider, participant, or fiduciary); (2) that a plan fiduciary causes the plan to engage in; and (3) is one that the fiduciary knows or should know constitutes a direct or indirect listed transaction. The prohibited transactions listed in § 1106(a) include, among other things, the sale of property between a plan and a party in interest, the lending of money between the plan and a party in interest, and the furnishing of goods, services, or facilities between the plan and a party in interest.
This provision commonly arises in retirement-plan or health-plan litigation. The retention of third parties to provide services necessary to the proper functioning of a plan is ubiquitous—plans regularly retain recordkeepers, auditors, accountants, lawyers, and others to provide services, and that retention constitutes a “prohibited transaction” under § 1106(a)(1)(C). That does not mean that plan fiduciaries that cause plans to engage service providers violate ERISA—to the contrary, ERISA expressly permits plan fiduciaries to do precisely that through a variety of exemptions found in § 1108, including § 1108(b)(2), which permits plans to make reasonable arrangements with a party in interest for services necessary for plans to operate “if no more than reasonable compensation is paid therefor.” Under the Court’s holding, however, those exemptions are affirmative defenses and, unless and until pleaded in an answer, not relevant to whether a plaintiff has plausibly alleged a prohibited transaction at the motion-to-dismiss stage, and the failure to plead the payment of unreasonable compensation is no basis for a district court to grant a motion to dismiss a prohibited-transaction claim. The Court noted, however, several other bases for dismissing prohibited-transaction claims before discovery and summary judgment, including a lack of Article III standing. As Justice Samuel A. Alito Jr. recognized in concurrence, this decision is a win for plaintiffs’ lawyers and greatly expands the potential for unmeritorious claims to survive motions to dismiss and result in expensive discovery for plan fiduciaries and sponsors.
The case arose when plaintiffs representing a class of current and former employees who participated in either of Cornell University’s two retirement plans (the Plans) sued in the Southern District of New York, alleging, among other things, that Cornell and its appointed fiduciaries had engaged in transactions prohibited under 29 U.S.C. § 1106(a). Cornell contracted with two companies that not only provided investment options for plan participants (in exchange for investment-management fees) but also provided recordkeeping services for the investment options on their respective platforms (in exchange for recordkeeping fees). According to the plaintiffs, these arrangements resulted in the payment of excessive fees by the Plans in violation of ERISA’s prohibited-transaction provisions and ERISA’s fiduciary duty of prudence.
The District Court had dismissed the prohibited-transaction claim at the pleading stage and the Second Circuit affirmed. The Second Circuit reasoned that § 1106(a), read in isolation, would “prohibit fiduciaries from paying third parties to perform essential services in support of a plan.” In the court’s view, that would lead to absurd results because any plan sponsor could be sued simply for the ubiquitous act of transacting with a service provider. And the court considered that § 1106(a) “begins with the carveout: ‘Except as provided in section 1108 of this title ….’” In the Second Circuit’s view, that text signaled that the exemptions set out in § 1108 are, therefore, “incorporated directly into § 1106(a)’s definition of prohibited transactions.” Accordingly, to avoid dismissal, the Second Circuit required the plaintiffs in this case to also allege “that [the] transaction was unnecessary or involved unreasonable compensation.”
The Supreme Court reversed. In an opinion written by Justice Sonia Sotomayor, the Court held that a plaintiff can state a claim for relief “by simply alleging that a plan fiduciary engaged in a transaction proscribed” by § 1106(a) and does not need to “plead allegations that disprove the applicability of” the exemptions in § 1108.
In reaching its decision, the Court reasoned that “when a statute has ‘exemptions laid out apart from … prohibitions’ and the exemptions ‘expressly refe[r] to the prohibited conduct as such,’ the exemptions ordinarily constitute ‘affirmative defense[s]’ that are ‘entirely the responsibility of the party raising’ them.” According to the Court, the § 1108 exemptions were written in the “orthodox format of an affirmative defense.”
None of Cornell’s arguments persuaded the Court that features of the prohibited-transaction statute nevertheless required plaintiffs to plead that at least some of the § 1108 exemptions do not apply. For example, Cornell stressed that, like the Second Circuit had noted, § 1106(a) begins by stating that its prohibitions apply “[e]xcept as provided in section 1108,” demonstrating that § 1106 and § 1108 together define a prohibited transaction, such that plaintiffs bear the burden of pleading the elements in both provisions.
The Court rejected that argument, emphasizing that Congress chose to label § 1108 as “exemptions,” meaning that even if § 1108 were best understood as elements, those elements should still be understood as placing the burden on defendants to prove their applicability. The Court also found “structural issues” in the respondents’ position, noting that because § 1108 has 21 enumerated exemptions in subsection (b) and incorporates hundreds of separate regulatory exemptions promulgated by the secretary of labor under subsection (a), it would raise “fairness” concerns to put the burden on plaintiffs to plead and disprove them. The Court stated that putting the burden on plaintiffs “would be especially illogical here, where several of the § 1108 exemptions turn on facts one would expect to be in the fiduciary’s possession.”
Finally, the Court addressed Cornell’s contention that the decision would result in an avalanche of meritless litigation. The Court recognized this was a “serious concern” but found it could not “overcome the statutory text and structure.” The Court also reasoned that district courts could use “existing tools” to screen out meritless claims before discovery, including dismissal of suits based on a lack of Article III standing for failure to allege an injury, expedited or limited discovery, and an award of attorneys’ fees under ERISA’s fee-shifting provision or Rule 11 sanctions in cases in which an exemption obviously applies. The Court also noted the use of Federal Rule of Civil Procedure 7(a)(7) as a possible solution. Federal Rule of Civil Procedure 7(a) empowers district courts to insist, following the filing of a defendant’s answer, that a plaintiff file a reply putting forward specific, nonconclusory factual allegations showing an exemption does not apply. And if a plaintiff fails to do so, the claims can be dismissed, presumably through a motion for judgment on the pleadings. And separate from the mechanisms identified by the Court in its Cunningham opinion, courts have frequently applied other tools to weed out meritless claims at the pleading stage, including the well-established rule that affirmative defenses can be grounds for dismissal when the face of the complaint or incorporated documents makes it apparent that those defenses apply, which is a general rule that we don’t read Cunningham to have disturbed. See, e.g., Jones v. Bock, 549 U.S. 199, 215 (2007).
Justice Alito joined the majority opinion but also wrote a concurring opinion joined by Justice Clarence Thomas and Justice Brett Kavanaugh. The concurrence recognized that the Court’s “straightforward application of established rules has the potential to cause . . . untoward practical results” because “[t]he administrator of an ERISA plan like the one at issue will almost always find it necessary to employ outside firms to provide services that the plan needs” and such outside firms will then be considered “parties in interest” under ERISA. “The upshot is that all that a plaintiff must do in order to file a complaint that will get by a motion to dismiss . . . is to allege that the administrator did something that, as a practical matter, it is bound to do.” The concurrence recognized the harms caused by that dynamic: “[I]n modern civil litigation, getting by a motion to dismiss is often the whole ball game because of the cost of discovery,” resulting in settlements that give a “windfall” to named plaintiffs and plaintiffs’ lawyers—costs that may be passed on to other plan participants. With respect to the “safeguards” highlighted by the majority, the concurrence encouraged district courts to “strongly consider utilizing” Rule 7(a)(7), as well as other tools, to dispose of insubstantial claims. But the concurrence concluded on a somewhat foreboding note: “Whether these measures will be used in a way that adequately addresses the problem that results from our current pleading rules remains to be seen.”
In addition to the safeguards mentioned by the opinion of the Court and Justice Alito’s concurrence, Congress could also amend ERISA to clarify the proper interplay between ERISA’s prohibitions and exemptions, thereby ensuring that plan sponsors and fiduciaries do not become the targets of strike suits simply for engaging in arm’s length transactions that are necessary for the proper functioning of plans and beneficial for plan participants.
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