The U.S. Supreme Court has issued its highly anticipated decision in Cunningham v. Cornell University, resolving an ongoing split among the federal circuit courts regarding whether or not a plaintiff alleging a prohibited transaction in violation of section 406(a) of the Employee Retirement Income Security Act of 1974 (ERISA) must also allege that none of the exemptions to the prohibited transaction rule in ERISA section 408 apply. In its decision, the Supreme Court unanimously determined that a plaintiff faces no such requirement, because the statutory structure and text of ERISA present the section 408 exemptions as affirmative defenses that must be pled and proven by the defendant (i.e., the plan sponsor).

Under this ruling, in order to allege a prohibited transaction and survive a motion to dismiss at the pleading stage, a plaintiff now needs to prove only the existence of three elements: (1) a transaction; (2) for direct or indirect furnishing of goods, services or facilities; and (3) with a party in interest. Essentially, a plaintiff must simply allege that a prohibited transaction occurred. The Supreme Court’s decision significantly lowers the bar for a plaintiff alleging a prohibited transaction in violation of ERISA section 406(a) to survive a motion to dismiss.

Implications

Exempted prohibited transactions have become an essential part of plan administration; contracts with service providers for recordkeeping and other administrative services are prohibited under section 406(a), and yet these crucial relationships are utilized by a vast majority of plan sponsors. Most plans rely on the exemption in ERISA section 408(b)(2)(A), which permits “contracting 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.” Under the Cornell University decision, a plan sponsor merely hiring a recordkeeper would be sufficient grounds for a lawsuit—regardless of whether the fees are reasonable.

Therefore, the three-element pleading standard laid out in the Cornell University decision is an exceptionally low threshold, describing essentially every transaction between a plan sponsor and a service provider, even those that are firmly and clearly permitted by section 408. The Supreme Court recognizes that its own decision could therefore result in permissible service provider transactions being challenged in court, and such challenges surviving the dismissal stage based on this new, lower pleading threshold.

While some commentary appears to anticipate a veritable tidal wave of litigation in the aftermath of the Supreme Court’s ruling, there may be no reason to panic. It seems unlikely that plan participants and plaintiffs’ attorneys will bring a vast number of new, otherwise meritless claims based solely on the Cornell University threshold. Instead, it seems more likely that most fiduciary lawsuits will now include a prohibited transaction claim alongside other allegations, including allegations of unreasonable fees or other fiduciary breaches. Additionally, this lower threshold could allow those prohibited transaction claims to survive the pleading stage, prolonging additional litigation into discovery and beyond.

Regardless of the ultimate impact of Cornell University on rates of litigation and the number of new prohibited transaction claims against plan fiduciaries, plans and plan sponsors can minimize litigation risk and the costs of any litigation that does occur through consistent adherence to certain procedural steps.

Demonstrating Procedural Prudence

To protect against claims of fiduciary breach and therefore reduce the likelihood of litigation in the aftermath of Cornell University, plan sponsors must rely on procedural safeguards to ensure all service provider transactions firmly and unequivocally comply with the reasonable compensation for necessary services exemption of ERISA section 408. Accordingly, plan sponsors should engage in ongoing, comprehensive contract review and benchmarking of fees, focusing on the following key considerations.

  • Contract Review. Ongoing contract review, both formal and informal, encourages plan sponsors to reflect on a plan’s ongoing service provider needs and existing provider relationships to determine whether the selection and retention of a service provider is a reasonable and prudent choice, including whether:
    • A service is still necessary for the operation of the plan;
    • The level of services provided is proportionate to the fees charged;
    • The quality of services provided to both the plan sponsor and any affected participant is satisfactory; and
    • The terms of the contractual agreement are favorable to the plan, including the termination provisions, such that the plan sponsor will be able to exit the contractual relationship immediately if the service and fees are no longer reasonable according to the needs of the plan.
  • Utilizing Requests for Proposals (RFPs). Before selecting a service provider, plan sponsors should engage in a formal RFP process surveying any potential providers. This process facilitates meaningful comparison between providers and enables fiduciaries to document their prudent process in selecting the best possible providers for the plan. After initial selection, plan sponsors should also regularly engage in the RFP process, particularly for higher-risk providers such as recordkeepers and investment managers and consultants.
  • Regular Benchmarking of Fees. Recognizing that the RFP process can be costly and time intensive, plan sponsors should consider regularly benchmarking plan fees and expenses against industry averages and comparable plans. This process should be completed at least every three years, but ideally more regularly, and offers a detailed analysis and lasting record of whether such fees and expenses are reasonable. This helps ensure that the plan sponsor and the plan are not overpaying for services, which could expose plan sponsors to additional fiduciary liability.

As with all fiduciary decisions, any action taken to review a current service provider or solicit proposals from potential new service providers should be well documented.

Strategies to Reduce Litigation Costs

If a participant were to initiate a lawsuit alleging that a plan sponsor has engaged in a prohibited transaction, either as an independent claim or alongside other claims (for example, alongside a claim alleging unreasonable fees), plan sponsors can utilize a variety of litigation strategies to minimize the resultant costs.

  • Request a Detailed Reply From the Plaintiff. A defendant plan sponsor can include thorough support for the applicability of an ERISA section 408 exemption in its answer to the plaintiff’s complaint and request that the court direct the plaintiff to file a reply. The plaintiffs would then need to put forward specific allegations that the exemption does not apply. If the plaintiffs’ reply fails to include the requested allegations, a defendant plan sponsor could move to dismiss at that stage.
  • Request a Showing of Injury. Plaintiff participants still need to demonstrate an injury in any claim of fiduciary breach, alleging a prohibited transaction or otherwise. If a plaintiff fails to show such an injury, a defendant plan sponsor can move to dismiss on that ground.
  • Request to Limit Discovery. A defendant plan sponsor can request that a court limit discovery to only the narrow issue of the applicability of the exemption.
  • Request Sanctions and Fees. If a plaintiff brings a meritless claim alleging the existence of a prohibited transaction—for example, where a plaintiff or plaintiff’s counsel ignores the clear applicability of a section 408 exemption—a defendant plan sponsor can request that a court assess sanctions or award attorneys’ fees and other costs incurred related to the action.

Conclusion

It is ultimately uncertain how high the predicted wave of prohibited transaction litigation will rise in the aftermath of Cornell University, but existing procedural safeguards and litigation strategies remain available to shield plan sponsors from exposure and reduce the likelihood of legal action. As this is an evolving issue, we recommend that plan sponsors watch for future developments and discuss any ongoing concerns with counsel.