Thinking ESOPs: Supreme Court to Take Up ‘Prohibited Transactions’ and Burden of Proof Questions . . .

At a Glance

• In Cunningham v. Cornell University, the plaintiffs accused Cornell University and related fiduciaries of mismanaging the university’s retirement plans by allowing excessive fees and selecting poor-performing investment options. On October 4, 2024, the Supreme Court granted certiorari in this case.
• There is a broader contextual issue at play when discussing what is required to state a claim under ERISA: a prohibited transaction is not a “claim” under ERISA.

On October 4, 2024, the Supreme Court granted certiorari in Cunningham v. Cornell University. The case involves the standard for a plaintiff to plead a “prohibited transaction” claim under ERISA and the burden of proving causation of loss. In this edition of Thinking ESOPs, we discuss this important issue — which courts and parties seem to have overlooked — and its impact on ESOPs.

The Cunningham Case

Cunningham concerns a 403(b) retirement plan and claims that plan fiduciaries violated ERISA’s fiduciary standards and prohibited-transactions provisions. The allegations are fairly typical in the 401(k)/403(b) space: the plaintiffs allege that the plan paid excessive administrative fees and offered underperforming investment options.

The first issue relates to a motion to dismiss the defendants filed and the district court granted. ERISA § 406(a) contains a list of transactions that ERISA prohibits between a plan and a party in interest. Read in isolation, the list is so broad that it would prohibit nearly all (if not all) ERISA plans from existing. These prohibitions are tempered by exemptions in ERISA § 408, including exemptions for the most common arrangements between plans and parties in interest. Because prohibited-transactions provisions are found in one section and exemptions in another, it is not entirely clear whether a plaintiff can state a plausible claim merely by alleging a prohibited transaction or whether the plaintiff also must plead facts to indicate that the transaction was not exempt.

With respect to claims for excessive recordkeeping fees, the Third, Seventh and Tenth Circuits have held that a plaintiff cannot state a claim merely by alleging a transaction between a plan and a party-in-interest service provider. Relying on the tenet that a statute should not be read in a manner that leads to absurd results, these courts have held that a plaintiff must allege something more than just a plan’s payment to third parties for essential services. The Eighth and Ninth Circuits, however, have held that a plaintiff can state a claim merely by alleging the occurrence of a transaction that is prohibited under ERISA § 406(a); a plaintiff does not have the burden of pleading around exemptions.

The Second Circuit sided with the Third, Seventh and Tenth Circuits, but for different reasons. The court relied on lead-in language to ERISA § 406(a), which states “Except as provided in section 1108 . . .” This indicated that the exemptions in ERISA § 408 “are incorporated into 1106(a)’s prohibitions,” such that a plaintiff must allege not only a prohibited transaction, but also that the transaction was unnecessary or involved unreasonable compensation. In addition, the court relied on the principle that a broad exception to a prohibition often can be presumed in most cases. When an exception becomes integral to the offense itself, it becomes part of the claim, and the plaintiff bears the burden of proving a prima facie case that the exemption was not met before the burden will shift to the defendant. To state a claim for a prohibited transaction involving recordkeeping fees, it is not enough to allege that a fiduciary caused the plan to engage in the transaction. The complaint “must plausibly allege that the services were unnecessary or involved unreasonable compensation” to support “an inference of disloyalty.”

The Issue Courts Have Not Addressed

There is a broader contextual issue that courts and parties have seemingly just ignored, particularly when discussing what is required to state a “claim” under ERISA. A prohibited transaction is not a “claim” under ERISA. This point always gets lost on lawyers and courts alike. ERISA’s prohibited transactions provisions are found in “Part 4” of Subtitle B of ERISA — the shorthand citation to ERISA 406 comes from the fact that ERISA 1106 is found in Part 4. Part 4 is entitled “Fiduciary duties,” and the prohibited-transactions provisions are fiduciary obligations.

ERISA claims, by contrast, are found in Part 5, entitled “administration and enforcement.” ERISA § 502(a)(2) is a claim for loss to a plan caused by a fiduciary breach. ERISA § 502(a)(3) is a claim for appropriate equitable relief to remedy a breach of ERISA or a plan. Both claims have elements that a plaintiff must plead and ultimately prove. An ERISA § 502(a)(2) claim requires a plaintiff to plead and prove that (a) the defendant was a fiduciary; (b) the defendant breached a fiduciary duty; and (c) that the breach caused loss to a plan. An ERISA § 502(a)(3) claim varies in terms of elements depending on the underlying alleged breach and remedy being sought.

A prohibited transaction is, at best, an allegation of the type of fiduciary breach being alleged. It satisfies only one of the elements of an ERISA § 502(a)(2) claim. To plausibly plead a claim, a plaintiff must allege facts to show that the breach caused loss to the plan. If the plaintiff’s theory is that a plan paid too much to a service provider for recordkeeping fees, then the plaintiff must plead facts to plausibly indicate as much. The pleading burden and burden of proof always must fall on a plaintiff because a claim is not the same thing as a prohibited transaction.

Relevance to ESOPs

In the ESOP space, lawsuits will commonly challenge a transaction where an ESOP buys or sells stock. Such a transaction is prohibited under ERISA § 406, but it is subject to an exemption in ERISA § 408(e) for “adequate consideration.” Some courts, including (and most notably) the Seventh Circuit, have held that a plaintiff merely has to allege that an ESOP bought stock from a party in interest in order to state a claim. The Seventh Circuit gave no consideration to ERISA § 502(a) or the notion that a prohibited transaction is not a claim.

The Supreme Court’s decision in Cunningham might be broad enough to apply to any claim based on an underlying prohibited transaction. If so, the pleading standards for plaintiffs in ESOP cases, particularly in those courts that have absolved plaintiffs of the burden of pleading anything more than a prohibited transaction, might change.