When is a plan service agreement open to challenge? A debate before the U.S. Supreme Court in January involved a lawsuit against plan fiduciaries at Cornell University raising that very issue. The decision being reviewed is Cunningham v. Cornell University, 86 F.4th 961 (2d Cir. 2023), and it could have a big impact on ERISA litigation, which many think has gotten out of control.
How Do You Control Speculative Litigation? Basic concepts such as standing-the requirement that a plaintiff show actual harm from the action being challenged-are applied in litigation to keep lawsuits by people without a stake in the case from flooding the courts.
There should also be a plausible suspicion of possible wrongdoing on the part of defendants before they are subjected to discovery and maybe even a trial. Lawsuits shouldn’t be fishing expeditions. Courts maintain the integrity of the legal system when they refuse to allow meritless litigation to proceed.
We have seen examples of courts establishing appropriate guardrails in the dismissal of several, but not all, of the lawsuits seeking to challenge the long-standing IRS-sanctioned practice of using plan forfeitures to reduce employer contributions. A judge in one of those cases against Honeywell described plaintiff’s claims as “not plausible” when granting defendant’s motion to dismiss.
Where plaintiffs claim that a plan has paid excessive fees in relation to a selected benchmark, courts are also increasingly looking to whether the benchmark was appropriate when considering motions to dismiss.
A decision in favor of defendants in the Cornell case could also prevent plaintiffs from challenging customary plan service arrangements where there is no indication of wrongdoing.
How Do You Interpret ERISA’s Language? The Supreme Court will be deciding whether it agrees with the Second Circuit’s interpretation of ERISA’s prohibited transaction language, which is drafted in a rather quirky way. Section 406 of ERISA begins “Except as provided in Section 1108 of this title;” [a reference to Section 408 of ERISA, which contains specific exemptions], and goes on to prohibit fiduciaries from entering into transactions involving “furnishing of goods, services or facilities between a plan and a party in interest.” Parties in interest include typical plan recordkeepers such as Vanguard or Fidelity. Recognizing that such agreements are essential to plan operations, Section 408 of ERISA, which is specifically incorporated in the introductory text of the prohibited transactions list, explicitly permits hiring a party in interest for services “necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid.”
Where is the Violation? Depending on how the Supreme Court reads those provisions, just having a service agreement such as a plan recordkeeping agreement with a party in interest could involve plan fiduciaries who have done nothing wrong in a protracted lawsuit. However, Section 406 and Section 408 of ERISA, when read together, clearly permit service arrangements with parties in interest provided the fees are reasonable in relation to the services provided . Put differently, it is a violation of ERISA to engage in a nonexempt prohibited transaction, not simply to have a contract with a service provider.
You would think that placed the burden of plausibly alleging that there was something improper about the service agreement on the plaintiffs, and that is exactly what the Court of Appeals for the Second Circuit did when it found that in order to avoid dismissal, plaintiffs had to claim not just the existence of the service contract, but that the fees were unreasonable or the services were unnecessary. The Second Circuit cited case law that “[a] statute should be interpreted in a way that avoids absurd results..” Justice Kavanaugh seemed to agree during oral argument, when he described a rule that just having a service agreement could subject plan fiduciaries to lawsuits as “nuts”.
Remember, under our pleading rules, plaintiffs weren’t required to prove the allegations in their complaint at that stage of the litigation. They would have an opportunity to obtain documents and testimony during discovery. They just needed to plead a plausible basis for a court to infer wrongdoing in the service arrangements.
The Other Circuits. Three other federal circuits (the 3rd, 7th and 10th) have, for different reasons, reached the same result as the Second Circuit on the issue of what plaintiffs must plead, and two federal circuits have failed to dismiss prohibited transaction claims just because they didn’t allege wrongdoing. Their analysis requires that defendants plead that an exemption applies as an affirmative defense, which allows the lawsuit to proceed.
The Practical Implications. Virtually all plans have contracts with outside service providers due to the complexities of compliance and the need for outside custody and recordkeeping. We should be encouraging plan sponsors to get professional assistance to run their plans well. Plaintiff’s position could allow almost any plan to be sued without even a whiff of improper behavior. No wonder Justice Kavanaugh described that position as “nuts”. However, the Justices appeared to be struggling to find a common basis for a decision during the oral argument and they could decide to rule against Cornell.
Although the Court has an important role in protecting participant rights under ERISA, ruling for Cornell will not hinder participants with reasons to suspect that nonexempt prohibited transactions may have occurred from suing plan fiduciaries. In fact, it will help courts focus on real violations of ERISA. It is also important to understand that if there is a basis for suspecting wrongdoing, defendants can still be required to show that an exemption actually applied.
Those of us who regularly advise plan sponsors and plan fiduciaries on fulfilling their ERISA responsibilities know that most fiduciaries take their responsibilities very seriously. Even if these fiduciaries are covered by fiduciary liability insurance, defending litigation is very time consuming and may saddle them with deductibles or other uncovered expenses. Responsible plan fiduciaries should be able to spend more of their time running their plans well and less of it defending purely speculative legal claims. A decision in favor of Cornell could help them do that.