In litigation involving an employee stock ownership plan, the Seventh Circuit has addressed the standards for pleading prohibited transaction and fiduciary breach claims under ERISA (Lisa Allen & Misty Dalton v. Greatbanc Trust Co., No. 15-3569, (7th Cir. Aug. 25, 2016)).

The defendant in this case, a trust company, served as the fiduciary for an employee stock ownership plan for employees of a privately held home-health-care company (see Practice Note, Employee Stock Ownership Plans (ESOPs)). The fiduciary directed the plan to purchase stock from the company's shareholders, which was financed by a loan from the company to the plan bearing a 6.25% interest rate. Following this transaction, the company's stock "began to tank" and later declined in value by nearly 50%. The company's shareholders continued to receive principal and interest payments on the loan.

The plaintiffs, consisting of company employees who were responsible for the loan payments, sued the fiduciary under ERISA alleging that it:

(See also Practice Note, ERISA Litigation: Causes of Action Under ERISA Section 502 and ERISA Litigation Toolkit.)

The district court dismissed these claims, reasoning that the employees had not adequately pleaded their fiduciary breach claim under standards addressed by the Supreme Court in Fifth Third Bancorp v. Dudenhoeffer (see Article, Fifth Third v. Dudenhoeffer: Advisory Board Roundtable Discussion and Legal Update, Supreme Court Rejects Moench Presumption of Prudence).

The employees' complaint alleged that the plan's purchase of employer stock and the employer's loan to the plan were prohibited transactions under ERISA Section 406 (29 U.S.C. § 1106). Although ERISA's prohibited transaction exemptions include exceptions for these transactions (under ERISA Section 408), the Seventh Circuit observed that the defendant-fiduciary failed to raise these prohibited transaction exemptions as an affirmative defense (29 U.S.C. § 1108). Rather, the fiduciary argued that the plaintiff-employees had the burden of pleading facts to negate the exemption's applicability, and they failed to do so. Disagreeing, the Seventh Circuit held that:

The Seventh Circuit noted that several other circuit courts of appeals had previously agreed with its position on this question.

The employees also alleged that the fiduciary breached its duties under ERISA by failing to conduct an adequate inquiry into the value of the employer's stock. According to the Seventh Circuit, the employees were not required to describe in detail the process that the fiduciary used to assess this value; it was enough to allege facts from which it could be inferred that the process was inadequate. The court concluded that an ERISA plaintiff alleging a breach of fiduciary duty:

The employees met this standard by alleging that:

The Seventh Circuit also observed that the district court's reliance on the Supreme Court's Dudenhoeffer decision was unwarranted. In that decision, the Court held that ERISA fiduciaries carrying out ESOP transactions may (in general) prudently rely on the market value of publicly traded stock (absent special circumstances). This case, however, involved an exchange involving only private stock, which has no market price because it is not traded on a public market.

ERISA's substantive standards, which are often technical in their own right, can prove a trap for the unwary when applied in the litigation context (see ERISA Litigation Toolkit). It would seem possible that the less burdensome pleading standard for plaintiffs articulated by the Seventh Circuit (that is, simply alleging the occurrence of a Section 406 prohibited transaction) may result in increased prohibited transaction litigation. The defendant-fiduciary, however, was unsuccessful in making this argument to the Seventh Circuit. Addressing these concerns, the Seventh Circuit suggested that the threat of frivolous litigation involving clearly exempt prohibited transaction claims is counterbalanced by factors such as the availability of sanctions under Federal Rule of Civil Procedure 11 (see Practice Note, Sanctions in Civil Litigation (Federal)).

This case also illustrates that an ESOP defendant in the private market may not rely on the standard set out in Dudenhoeffer in the Seventh Circuit.