Grant of summary judgment to Cornell University affirmed in excessive fee case
A recent Second Circuit decision involving Cornell University could make it easier for fiduciaries to succeed in dismissing prohibited transaction claims and could even point the way to more successful outcomes in excessive fee litigation generally. This decision seems to be the continuation of a generally favorable (with some exceptions) litigation trend for fiduciary liability insureds.
On November 14, 2023, the Second Circuit affirmed the grant of summary judgment to Cornell University in its excessive fee case. Although Cornell had been forced to go through expensive (though favorable) discovery in relation to other counts of the complaint, the prohibited transaction claim was dismissed on the initial motion without discovery. In confirming judgment in its entirety for Cornell University, the Second Circuit affirmed the district court’s dismissal of the prohibited transaction claim on the basis that the plaintiffs were required in the first instance to plead the lack of a relevant exemption. This decision was in contradiction to decisions from some other circuits which treat prohibited transaction exemptions as an affirmative fact-intensive defenses whose applicability can’t be determined at the motion to dismiss stage. (including last year’s Ninth Circuit’s decision in the AT&T excessive fee class action).
The AT&T decision was particularly controversial, since it found that renegotiating an existing recordkeeping contract was a presumptive prohibited transaction, and then it held that the defendants had the burden of proving a relevant exemption. Despite the filing of several amici briefs, the 9th Circuit declined to have an en banc rehearing of the AT&T decision.
This article will discuss the holding in the Cornell University case in contrast to the AT&T case, since the two decisions sit at opposite ends of the spectrum which constitutes the current state of ERISA prohibited transaction case law.
Section 406 of ERISA (29 U.S.C. section 1106) addresses two main types of “prohibited transactions”: section (a) relates to “transactions between plan and party in interest” and section (b) relates to “transactions between plan and fiduciary”.
Section 408 of ERISA (29 U.S.C. section 1108) deals with “exemptions from prohibited transactions”, with section (b) containing an “enumeration of transactions exempted from Section 1106 prohibitions”. Consequently, if an exemption applies, then a transaction is not, in fact, prohibited (and, as a corollary to that principle, if an exemption does not apply then any transaction within the ambit of Section 406 is prohibited). The exemption most commonly cited by defendants in countering allegations of prohibited transactions is the one contained in section 408(b)2 of ERISA: “b. The prohibitions provided in section 1106 of this title shall not apply to any of the following transactions: …2(A) 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.”
Most excessive fee lawsuits include allegations of prohibited transactions, which are considered to be breaches of the duty of loyalty, although the primary allegations are generally for breaches of the duty of prudence. It is not surprising that plaintiffs would include such allegations where a plan engages in transactions with the fiduciary as a service provider, such as when a plan sponsor’s proprietary funds are offered as pension plan investments (situations which trigger the application of ERISA section 406(b)). It is less intuitive, however, when plaintiffs are questioning fees in relation to transactions with third parties such as recordkeepers who are not affiliated with the plan sponsor but are alleged to be “parties in interest” (situations which can trigger the application of ERISA section 406(a)).
The Cornell and AT&T cases both had allegations arising under section 406(a) of ERISA (29 U.S.C. section 1106), which relates to alleged prohibited transactions involving alleged parties in interest. Consequently, the threshold issue before both courts was “what constitutes a party in interest?” Then the next question was “what’s the pleading standard for stating a claim for a prohibited transaction involving a party in interest; namely which party has the initial burden relating to whether or not an exemption applies?”
In remanding the AT&T case back to the district court which had previously granted summary judgment, the Ninth Circuit issued pro-plaintiff holdings on both of the above-stated questions. First, it interpreted the term “party in interest” broadly, taking the definition at face value despite its inherent circularity. The Ninth Circuit avoided the question of whether absolutely every vendor transaction is a prohibited transaction by pointing to the specific fact that AT&T had a pre-existing long-term relationship with Fidelity which warranted the application of prohibited transaction rules to the recent negotiations between the parties.
On the second question, the Ninth Circuit agreed with the Eighth Circuit in holding that the existence of section 408 exemptions must be established by defendants as an affirmative defense which can’t be resolved without factual development.
The Second Circuit didn’t disagree with the Ninth Circuit on the scope of the “party in interest” definition, despite pointing out that several courts have strained to prevent the circularity inherent in interpreting the definition of party in interest as broadly as its plain language suggests: “[Courts] have adopted different means of narrowing the statute. The Third Circuit, in Sweda v. University of Pennsylvania, read the provision to require allegation of "an element of intent to benefit a party in interest." 923 F.3d at 338. The Tenth Circuit, in Ramos v. Banner Health, limited the statute's apparent scope by holding that "some prior relationship must exist between the fiduciary and the service provider to make the provider a party in interest under § 1106." 1 F.4th 769, 787 (10th Cir. 2021). And the Seventh Circuit, in Albert, held that, to state a claim, the alleged transaction must "look[] like self-dealing," as opposed to "routine payments for plan services." 47 F.4th at 585.”
The Second Circuit found that those courts were adding requirements not present in the statute, and so didn’t wind up taking issue with the theoretically broad scope of section 406(a)’s potential sweep. Instead, the Second Circuit sought to address the potentially impractical results of such a wide net by following the Third, Seventh and Tenth Circuits in holding that plaintiffs have the initial burden of pleading that an exemption doesn’t apply to an alleged prohibited transaction involving parties in interest. In doing so, the Second Circuit gave effect to a subtle but arguably important distinction between the structure of sections 406(a) and 406(b).
The Cornell decision pointed out and gave meaning to the significant difference in the structure of the two main parts of section 406; subsection (a) relating to parties in interest starts with a reference to 408 (“subject to the exemptions contained in section 408”) so section 408 is incorporated and analysis of it is a prerequisite to application of 406(a). By contrast, section 406(b) doesn’t have that lead-in and so should appropriately be treated differently. This distinction is particularly important if a court is going to read the definition of “party in interest” expansively as was the case in AT&T.
After this statutory analysis, the Second Circuit stated that “it is not enough [for plaintiffs] to allege that the fees were higher than some theoretical alternative service. Whether fees are excessive or not is relative "to the services rendered," Jones [v. Harris Assocs.], 559 U.S. at 346, and it is not unreasonable to pay more for superior services. Yet, here, Plaintiffs have failed to allege any facts going to the relative quality of the recordkeeping services provided, let alone facts that would suggest the fees were "so disproportionately large" that they "could not have been the product of arm's-length bargaining."” (see Cunningham v. Cornell University)
Unfortunately, on initial motion the district court didn’t apply the same high pleading standards to the alleged prudence claims, allowing them to survive until they were dismissed on a motion for summary judgment (which was then affirmed by the Second Circuit).
The Second Circuit (which includes New York state) is an important circuit, housing many large entities with large defined contribution plans. District courts in the Second Circuit will follow the Cornell decision, and courts in other circuits will hopefully be influenced by the decision’s careful analysis and attention to specific language in section 406(a) of ERISA. As a result, it can be anticipated that prohibited transaction claims involving alleged parties in interest will be dismissed with greater frequency in the future.
Meanwhile, plaintiffs will continue to also allege imprudence claims such as the ones which the district court in the Cornell case chose not to dismiss on initial motion. However there are arguments that it does not make sense that the pleading standards for prohibited transactions should be higher than for prudence claims which don’t involve any alleged conflicts of interest (see, for example, Lessons from the Cornell Excess Fee Dismissal). Defendants in some cases have argued that unconflicted fiduciary decisions should be analyzed according to a “business judgment rule” standard, commonly applied in litigation involving corporate officers and directors, which provides deference to the decisions of unconflicted fiduciaries. The Second Circuit here may be considered to have implicitly endorsed such arguments through its citation to the decision in the 2006 Walt Disney corporate derivative suit. This line of argumentation may have achieved some traction with the Third Circuit, which recently issued the following order in the Westco Distribution case:
“At oral argument, the parties should be prepared to address whether, in light of the Supreme Court’s requirement that we give “due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise” and the fact that ERISA’s duty of prudence is derived from the common law of trusts, this Court may properly substitute its business judgment for that of an ERISA fiduciary acting in good faith. Hughes v. Nw. Univ. 142 S. Ct. 737, 741–42 (2022); see, e.g., Wilmington Tr. Co. v. Coulter, 200 A.2d 441, 449 (Del. 1964); In re Bank of N.Y., 323 N.E. 2d 700, 704 (N.Y. 1974); Charitable Corp. v. Sutton, 26 Eng. Rep. 642, 9 Mod. 350, 355–56 (Ch. 1742). (AR) [Entered: 04/11/2023 10:08 AM]”(information available on Pacer).”
It can also be argued that recent affirmations of dismissals by the Sixth, Seventh, Eighth and Tenth Circuits (CommonSpirit, Oshkosh, MidAmerican Energy and Barrick Gold respectively), in which the courts held that plaintiffs didn’t provide convincingly appropriate benchmarks and comparisons, reflect a trend of raising the pleading bar towards a similar default of “business judgment rule”-type deference to unconflicted fiduciary decisions. Perhaps the reasoning in these appellate decisions will impose on plaintiffs a pleading burden similar to the standard which the Second Circuit applied to the prohibited transaction claim in the Cornell case: plaintiffs must plead “facts that would suggest the fees were "so disproportionately large" that they "could not have been the product of arm's-length bargaining."”
It appears that the decision in the Cornell University case is overall a positive step for excessive fee defendants, although the district court in that case stopped short of applying consistent pleading standards for prudence claims as well as prohibited transaction claims. The increased clarity could be a boon to both sides of the litigation if courts were to clearly articulate the appropriate pleading standard for duty of prudence claims as being the same as that applicable to prohibited transaction claims, and ideally that both standards should be considered akin to that required to overcome the business judgment rule protections afforded to unconflicted officers and directors in the world of corporate duty litigation, since there is a legacy of decades of case law which has fleshed out the contours of that pleading standard.
Fortunately, although the coverage provided by fiduciary insurance policies can vary substantially, virtually all fiduciary policies cover excessive fee class actions (including prohibited transaction claims) for both defense and indemnity, subject to any specific exclusions. This is because of certain common features which are designed to provide such coverage: generally broad coverage for plan sponsors and alleged fiduciaries, carve-outs from the benefits exclusion for claims involving investment losses, plus final adjudication standards and non-imputation as to Insured Persons in relation to the conduct exclusions. Furthermore, there are good arguments that the conduct exclusions don’t even apply to excessive fee claims, since they typically focus on imprudence as opposed to allegations of dishonesty or wrongful financial profit. Even alleged breaches of the duty of loyalty involving prohibited transactions shouldn’t trigger the conduct exclusions in cases like the one involving Cornell University, since the theoretically wrongful financial profit was allegedly gained by the purported “party in interest” and not the plan sponsor or a plan fiduciary. It would only be in cases involving transactions which allegedly implicate section 406(b) of ERISA (transactions between the plan and a fiduciary as opposed to a party in interest vendor) that an insurer might raise a question as to whether the exclusion relating to wrongful financial profit to an Insured could be potentially implicated if there was a final non-appealable adjudication to that effect (in relation to a particular Insured).
Willis Towers Watson hopes you found the general information provided in this publication informative and helpful. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal advisors. In the event you would like more information regarding your insurance coverage, please do not hesitate to reach out to us. In North America, Willis Towers Watson offers insurance products through licensed entities, including Willis Towers Watson Northeast, Inc. (in the United States) and Willis Canada Inc. (in Canada).
