The U.S. Supreme Court’s decision last week in Cunningham v. Cornell University lowered the bar for pleading prohibited transaction claims, allowing claims to proceed based solely on allegations that an ERISA-governed plan engaged in a transaction with a third party — regardless of how benign or even beneficial the transaction may be. But while the Court in some ways opened the door to more prohibited transaction claims, it also encouraged district courts to use novel approaches to usher meritless claims out the door.
ERISA provides that a fiduciary shall not cause a plan to engage in certain “prohibited transactions” with a party in interest, unless a statutory or administrative prohibited transaction exemption applies. The statutory exemptions from the prohibited transactions include one for “reasonable arrangements with a party in interest” for services “if no more than reasonable compensation is paid” and certain disclosure requirements are satisfied.
Participants in Cornell University’s retirement plans sued Cornell and other plan fiduciaries alleging, among other claims, violations of 29 U.S.C. § 1106 (the prohibited transactions statute) by compensating service providers with fees from plan assets. These service providers offered investment options to plan participants and served as the plan’s recordkeepers. By reason of providing recordkeeping services, they were “parties in interest” for purposes of the prohibited transactions provision.
The district court granted Cornell’s motion to dismiss the prohibited transaction claim, holding that plaintiffs failed to plead facts suggesting self-dealing or other disloyal conduct. The Second Circuit affirmed, using different reasoning: It held that plaintiffs must plead that the conditions of the exemption in Section 1108 of ERISA (the statutory exemption referenced above that exempts reasonable arrangements with service providers) were not satisfied. Otherwise, in the Second Circuit’s view, ERISA would produce absurd outcomes by allowing plaintiffs to pursue claims merely by alleging that a plan compensated another entity that provides it with necessary services.
The Supreme Court reversed. It explained that the exemptions in Section 1108 are affirmative defenses — not elements of a prohibited transactions claim — and rejected each of Cornell’s arguments to the contrary.
Although the Court rejected Cornell’s argument that this reading would result in “an avalanche of meritless litigation” against ERISA plans, it acknowledged the oddity of allowing a viable claim to be pled merely because plan fiduciaries engaged in a transaction that, from all that appears in the complaint, actually benefitted the plan. The Court articulated five “tools” that district courts may use to screen out these meritless claims. First, district courts may dismiss claims where a defendant files an answer raising an exemption, the district court orders the plaintiff to file a reply under Federal Rule of Civil Procedure 7, and the reply fails to plausibly rebut the assertions that support the exemption. Second, district courts may dismiss suits for failure to identify a cognizable injury under Article III. Third, district courts may mitigate litigation expenses by ordering expedited or limited discovery in cases that proceed past the motion-to-dismiss stage. Fourth, a district court may impose Rule 11 sanctions against a plaintiff and counsel who lack a good-faith basis to believe that a Section 1108 exemption does not apply. And fifth, ERISA’s fee-shifting statute allows district courts to order losing plaintiffs to pay the opposing party’s attorneys’ fees and costs.
Of the five tools the Court identified, only one — the use of Rule 7 to weed out meritless claims — is truly novel. Justice Alito’s concurrence observed that “[i]t does not appear that this is a commonly used procedure,” and that may be an understatement. Now that it has the Supreme Court’s imprimatur, however, the Rule 7 approach is likely to be deployed in any case where defendants believe they can assert a viable exemption. While that tool may be more cumbersome than a motion to dismiss, it has the potential to result in the dismissal of claims far sooner, and with far less expense, than a motion for summary judgment.
