Fiduciary Fundamentals: Lower Pleading Standard for 401(k) Plan Prohibited Transaction Suits

In its April 17 decision in Cunningham v. Cornell University, the U.S. Supreme Court established a plaintiff-friendly standard for ERISA prohibited transaction claims, resolving a circuit court split. As a result, plan sponsors may face increased litigation risks and costs. This article provides background on ERISA’s prohibited transaction rules, summarizes the Cunningham decision, and discusses potential implications of the decision and strategies for mitigating risks.

Background

Plan sponsors and other plan fiduciaries owe a duty of loyalty to 401(k) plan participants and beneficiaries and are required to act solely in participants’ and beneficiaries’ best interests. ERISA Section 406(a) sets forth certain “prohibited transactions” that must be avoided because they are likely to violate the duty of loyalty. Under Section 406(a), transactions for goods, services or facilities between the plan and a “party in interest” are prohibited, unless an exemption applies under ERISA Section 408(b). Parties in interest include plan fiduciaries, sponsors and service providers, such as third-party administrators, recordkeepers and investment advisers.

Section 408 provides for various exemptions. The broadest, and most frequently relied upon by plan sponsors, permits contracts for services that are necessary for the establishment or operation of the plan and for which reasonable compensation is paid. As many standard plan operations involve parties in interest, these exemptions are critical.

Pleading Standard and Cunningham v. Cornell University

Prior to the Cunningham decision, circuit courts were split over the pleading standard applicable to an ERISA prohibited transaction claim. The 8th and 9th Circuits had found that plaintiffs putting forth a prohibited transaction claim need only plead the elements of Section 406 — that a fiduciary caused the plan to engage in a transaction for goods, services or facilities with a party in interest. The 3rd, 7th and 10th Circuits had found that plaintiffs must also plead, in some respect, that an exemption did not apply — for example, that the transaction was unnecessary or that the amount paid was unreasonable.

In Cunningham, participants of Cornell University’s 403(b) plans — retirement plans similar to 401(k) plans but for employees of certain public institutions and nonprofit organizations — sued plan fiduciaries. Participants alleged that plan fiduciaries engaged in prohibited transactions with plan recordkeepers when the fiduciaries used plan assets to pay recordkeeper fees, which were allegedly unreasonable. The district court dismissed the claim. On appeal, the 2nd Circuit affirmed the dismissal, asserting that to state a prohibited transaction claim, in addition to pleading the elements under Section 406, plaintiffs must also plausibly allege that no exemption applied. 

In its decision, the Supreme Court unanimously reversed the 2nd Circuit, finding that plaintiffs alleging a prohibited transaction only have to plead that a plan fiduciary caused the plan to engage in a transaction for goods, services or facilities with a party in interest. Under the ruling, plaintiffs are not required to plead that an exemption does not apply. Rather, the Supreme Court held that the Section 408 exemptions are affirmative defenses, which must be asserted by the defendant.

Acknowledging the potential of the holding to result in frivolous or prolonged litigation, the Supreme Court suggested that lower courts employ tools to mitigate these risks. For example, lower courts might require plaintiffs to file a reply under Federal Rule of Civil Procedure 7 showing that the exemptions are inapplicable, place limits on discovery to keep costs in check, or impose Rule 11 sanctions against plaintiffs and attorneys when claims clearly falling within an exemption are brought.

Implications of the Decision

It is important to note that, in contrast to excessive fee claims (which allege breaches of duties based on unreasonable plan administrative fees borne by participants), prohibited transaction claims can arise even where participants are not paying for the applicable fees if the plan sponsor pays the fees out of plan assets (not from the plan sponsor’s general assets).

The Cunningham decision has significant implications for plan sponsors:

• Increased litigation risk. Now that plaintiffs may bring a prohibited transaction claim without alleging that the transaction was unnecessary or involved unreasonable compensation, the bar is low for challenging transactions with service providers. This may encourage plaintiffs to bring prohibited transaction claims and therefore force defendants to engage and defend such claims, resulting in an overall increase in prohibited transaction suits.
• Higher litigation costs. The lowered pleading standard makes it easier for claims to survive a motion to dismiss and for lawsuits to move into the discovery phase, making it more costly for plan sponsors to defeat claims with little merit.
• Pressure for early settlements. With a higher likelihood that claims will survive the pleading phase and that plan sponsors will face costly discovery, plan sponsors may choose to settle claims, even those that they could win, to avoid litigation expenses.

Strategies for Mitigating Risks

To mitigate risks associated with the Cunningham pleading standard, plan sponsors should adopt measures to strengthen compliance and preparedness:

• Review service provider agreements. Given the new pleading standard, plan sponsors need to be ready to defend against a prohibited transaction claim. Analyze agreements with service providers where the plan sponsor pays fees with plan assets to ensure that the applicable services are necessary and the compensation for such services is reasonable.
• Maintain fiduciary best practices and document decision-making. Plan sponsors should review their service provider contracts as a regular part of their fiduciary processes and document their reasons for concluding that the services provided under such contracts are necessary and the fees paid are reasonable.
• Consider paying fees directly. Plan sponsors looking for more certainty could consider paying fees to service providers directly from its general assets and not from the plan. 

In conclusion, while the Supreme Court’s decision in Cunningham settles the uncertainty over the pleading standard for prohibited transaction claims, it may usher in a period of increased prohibited transaction suits. Plan sponsors should be aware of this change and take steps to ensure compliance and reduce litigation risks where possible. For more information on prohibited transaction claims and how plan fiduciaries can best protect against the risk of litigation, please contact a member of our Employee Benefits team.