By Michael Schloss and Stephen Wilkes
On August 4, 2023, a Ninth Circuit panel reversed a District Court decision in favor of AT&T – holding that AT&T breached its fiduciary duties by, among other things, failing to consider whether Fidelity’s compensation pursuant to a service contract amendment rendered the contract a “prohibited transaction” under ERISA.[1] Shortly thereafter, on November 9, 2023, en banc hearing was denied. So now the questions addressed in the AT&T decision are final in the Ninth Circuit – unless, of course, the Supreme Court takes up the issue. Because the Ninth Circuit’s opinion creates a clear split among the circuit courts and because, as discussed below, clear rules regarding the issue are critically important to those trying to comply with the law, the Supreme Court should and, it is hoped, will take this up.
Background:
Without getting too technical, at its heart, the AT&T court viewed ERISA section 406(a)(1)(C) (which bars plan fiduciaries from causing a plan to obtain services from a party in interest unless it does so pursuant to an exemption under ERISA §408) as a “per se” rule. In doing so, it noted that § 408(b)(2) already “broadly exempts” services covered by §406(a)(1)(C)): “Specifically, § 408(b)(2) broadly exempts from § 406’s bar transactions for ‘services necessary for the establishment or operation of the plan.’ 29 U.S.C. § 1108(b)(2)(A).”[2] On this basis, the AT&T court concluded:
Section 406(a)(1)(C) is not a complete ban; instead, it requires fiduciaries, before entering into an agreement with a party in interest, to understand the compensation the party in interest will receive, evaluate whether the arrangement could give rise to any conflicts of interest, and determine whether the compensation is reasonable.[3]
In concluding that § 406(a)(1)(C) covered the transaction at issue – AT&T’s amended contract with Fidelity – the AT&T court disagreed with two other courts that had recently found that § 406(a)(1)(C) was not necessarily a “per se” rule that would cover such a routine transaction: Sweda v. University of Pennsylvania, 923 F.3d 320 (3d Cir. 2019); and Albert v. Oshkosh Corp., 47 F.4th 570 (7th Cir. 2022).
The Sweda court had concluded that § 406(a)(1)(C) should not be read broadly so as to categorically “prohibit ubiquitous service transactions and require a fiduciary to plead reasonableness as an affirmative defense.”[4] The AT&T court disagreed on the grounds that the Sweda approach does not follow the statutory text. Similarly, the Oshkosh court had concluded, “[i]t would be ‘nonsensical’ to read § 406(a)(1) to prohibit transactions for services that are essential for defined benefit plans, such as recordkeeping and administrative services.”[5] And, again, the AT&T court disagreed, concluding that a literal reading of § 406 is correct.[6]
Further widening the circuit split (and muddying the judicial waters), on November 14, 2023, the Second Circuit issued a decision in Cunningham v. Cornell Univ., 2023 U.S.App.LEXIS 30195 (2nd Cir. 11/14/2023), that not only disagreed with the AT&T decision, but also broke from the reasoning of the other circuits, thus trying to split the proverbial baby. In particular, the Cunningham court concluded that ERISA § 408’s exemptions are not simply affirmative defenses to conduct proscribed by § 406(a) but that they must be pled as having been violated as part of the plaintiff’s charging allegations:
[W]e hold that to plead a violation of 1106(a)(1)(C), a complaint must plausibly allege that a fiduciary has caused the plan to engage in a transaction that constitutes the “furnishing of . . . services . . . between the plan and a party in interest” where that transaction was unnecessary or involved unreasonable compensation. 29 U.S.C. §§ 1106(a)(1)(C), 1108(b)(2)(A).[7]
The 2nd Circuit focused on the language of § 406(a) itself, which starts, “Except as provided in section 408 of this title….” Thus, the 2nd Circuit held that, because § 406(a) incorporates by reference the exemptions contained in § 408, the burden is on the plaintiff complaining about a violation of § 406(a) to plead and prove that the behavior did not fall within the scope of an exemption. The 2nd Circuit noted that § 406(b) does not contain similar language citing ERISA section 408 and, thus, allegations of violations of § 406(b) do not have a similar additional pleading requirement. On this basis, the Cunningham court distinguished the case before it from those discussed in Lowen v. Tower Asset Mgmt., 829 F.2d 1209, 1213 (2d Cir. 1987) and Henry v. Champlain Enters., Inc., 445 F.3d 610, 618-19 (2d Cir. 2006).[8]
Why is This Important:
Today we have what appears to be a three-way split among the circuits in recent decisions on a fundamental pleading issue of importance to the regulated community. As noted by the ERISA Industry Committee (“ERIC”) in its amicus brief filed in AT&T on September 11th:
This case presents questions of enormous practical importance to Amici’s members, because it threatens to make one of the most ubiquitous pieces of retirement plan operation (arm’s-length negotiations with third parties for necessary plan services) presumptively unlawful… The panel’s decision undoes years of litigation establishing the pleading burden ERISA plaintiffs have in challenging retirement plan fees, and would add to the growing pressures plan sponsors and plan administrators face from serial filings and cookie-cutter complaints leading to protracted and expensive discovery.
Similarly, the Chamber of Commerce of the United States, in an amicus brief filed on September 8th noted:
This case presents questions of practical importance to amicus and its members because the panel decision invites protracted and expensive litigation against fiduciaries who procure services on market terms through arms’- length negotiations. . . . As a practical matter, therefore, the panel decision will increase the cost and complexity of providing retirement-plan benefits to employees— exactly what Congress was trying to avoid.
From a legal standpoint, the law is now clear as the proverbial mud. We don’t really know for sure whether the AT&T decision should be limited to its unique set of facts or if it stands for a broader interpretation. Today we have three different standards on what plaintiffs must plead in order to proceed to discovery, depending on which circuit they are in: (a) a per se standard adopted by the 9th Circuit in AT&T and the 8th Circuit in Braden v. Wal-Mart Stores, Inc., 588 F.3d 585, 601 (8th Cir. 2009) which simply requires pleading a violation of § 406(a)(1)(C); (b) the standard adopted by the 3rd Circuit in Sweda and the 7th Circuit in Oshkosh requiring plaintiffs to plead an additional element to their § 406(a)(1)(C) claims or (c) the standard adopted by the 2nd Circuit in Cunningham requiring plaintiffs to explain how the applicable § 408 exemption had not been met.
What Will Happen Next:
We presume in the coming months we will see filings with the Supreme Court[9] for certiorari consideration of one or more of the cases decided recently, with the potential for some level of participation from the Department of Justice, the Department of Labor or the Internal Revenue Service
What to Do Now?
- Clearly, plan fiduciaries must negotiate and execute service provider payments made under third-party arrangements with an eye focused on the reasonableness of those arrangements. And any renegotiation of a service provider agreement must pass muster under ERISA § 408(b)(2) and PTE 2020-02 to avoid treatment as a prohibited transaction.
- This process should include a review of any indirect compensation, and overall compensation as to reasonableness and whether the fees are prudent.
- Third party disclosures of revenue sharing or other indirect payments must be fulsome and adequate enough to enable the plan fiduciary to make informed and prudent decisions.
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[1] Bugielski v. AT&T Servs, 76 F.4th 894 (9th Cir. 2023).
[2] Id., at 901.
[3] Id., at 908-909.
[4] Sweda, at 336.
[5] Oshkosh, at 585.
[6] The AT&T court also distinguished the Supreme Court’s decision in Lockheed Corp. v. Spink, 517 U.S. 882 (1996), but for different reasons not relevant here.
[7] Id. at *20-21. Although the Second Circuit does not explicitly reject the Sweda and Oshkosh reasoning (stating “We agree – but only in part”), its decision to incorporate 408 exemptions into plaintiffs’ pleading requirements would be unnecessary if it concluded – like the Sweda and Oshkosh courts had concluded – that the provisions of 406(a)(1)(C) had not been breached by the behavior alleged in the first place.
[8] It is unclear why the Cunningham court did not distinguish its holding from the court’s prior holding in Marshall v Snyder, 572 F.2d 894, 900 (2nd Cir. 1978) that “the burden of proof is always on the party to the self-dealing transaction to justify its fairness” since, like the Cunningham case, the allegations in Marshall v. Snyder involved violations of ERISA § 406(a)(1)(C) and the issue was whether beneficiaries had to prove the unfairness of the transaction.
[9] If the Supreme Court does take up one or more of appellate cases for review, it will not be the first time some of the Justices will have reviewed the underlying nature of ERISA’s prohibited transactions. In Harris Trust v Salomon Smith Barney, 530 U.S. 238 (2000) Justice Thomas, joined by a unanimous court, concluded that § 406(a) embodied “per se prohibitions on transacting with a party in interest.” And prior to her appointment to the Supreme Court, in Henry v. Champlain Enters., 445 F.3d 610 (2nd Cir. 2006), Justice Sotomayor, citing Comm’r v. Keystone Consol. Indus., Inc., 508 U.S. 152, 160 (1993) noted that § 406(a) was enacted “to bar categorically a transaction that was likely to injure the pension plan”)and that, in order to prevail, the fiduciaries had the burden to demonstrate compliance with an exemption.