Read my Lipsky: reliance on consent orders in pleadings.

• Author: Levenberg, Kevin

INTRODUCTION I. RELIANCE ON CONSENT ORDERS UNDERLIPSKY AND RULE 12(f) A. The Lipsky Decision B. Lipsky in the Lower Courts C. Rejecting the Broad Application of Lipsky 1. A Close Reading of Lipsky 2. Rule 12(f) and Pleadings Law and Policy II. RELIANCE ON CONSENT ORDERS AND RULE n(b)(3) A. The Duty of Independent Investigation B. Policing Factors to Ensure Adequate Investigation Notice 1. Notice 2. Reliability 3. Good Faith Attempt at Independent Verification III. PUBLIC POLICY IMPLICATIONS CONCLUSION INTRODUCTION

On January 26, 2011, the U.S. Commodity Futures Trading Commission (CFTC) settled charges against respondents Daniels Trading Group LLC and two of its employees. (1) According to the CFTC, the respondents violated the Commodities Exchange Act (CEA) by exceeding speculative position limits in rough rice futures contracts traded on the Chicago Board of Exchange. (2) The CFTC described its case against the respondents in a publicly released Order Instituting Proceedings (CFTC Order). (3) In the Order, the CFTC explained that it had "reason to believe" that the respondents violated the CEA because they traded in excess of speculative position limits on at least thirty-eight trading days, among other violations. (4) Moreover, the CFTC stated that the respondents "were able to repeatedly violate speculative limits because [they] concealed the actual ownership and control of certain rough rice futures positions." (5) Although the respondents consented to the entry of the Order, they did so "[w]ithout admitting or denying any of the findings." (6)

The plaintiffs' bar reacted quickly. One day later, on January 27, 2011, a class action complaint was filed in the Northern District of Illinois against all of the respondents named in the CFTC Order. (7) Like the CFTC, the plaintiffs alleged that the defendants attempted to manipulate the rough rice futures market by trading in excess of speculative position limits. (8) In their complaint, the plaintiffs quoted extensively from the CFTC Order. (9) For example, the plaintiffs alleged that the defendants "were able to repeatedly violate speculative limits because [they] concealed the actual ownership and control of certain rice futures positions." (10)

The district court took a dim view of the allegations that were "derived wholesale" from the CFTC Order. (11) It dismissed the complaint because plaintiffs' recitation of the CFTC's findings did not state a claim under the CEA. (12) In reaching its decision, the court adopted the reasoning of the 1976 Second Circuit opinion Lipsky v. Commonwealth United Corp. (13) for the "well-established precedent" that plaintiffs may not cite unadjudicated findings from consent decrees in their pleadings. (14)

Contrary to the district court's pronouncement, Lipsky's meaning is not settled. Questions of whether and to what extent plaintiffs may properly rely on findings from consent orders have been litigated mostly at the district court level. Among the courts of appeals, only the Second Circuit in Lipsky has confronted the issue directly. (15) Furthermore, commentators have provided little clarification, mostly offering functional advice for practitioners. (16) Because the law on this question is unsettled, litigants have frequently disputed the matter, typically through motions to strike pursuant to Rule 12(f) or Rule 11(b)(3) of the Federal Rules of Civil Procedure.

On its face, Rule 12(f) does not require courts to strike references to consent orders. Rather, Rule 12(f) permits courts to strike any "redundant, immaterial, impertinent, or scandalous matter." (17) To prevail on a motion to strike, the moving party generally must show: (1) no admissible evidence in support of the allegations is available; (2) the allegations are irrelevant; and (3) the moving party would be prejudiced if the allegations were permitted to stand. (18)

Lower courts, however, are divided in their application of Rule 12(f) to allegations relying on consent orders. Citing Lipsky, some courts hold that these allegations must be struck as per se immaterial under Rule 12(f). Other courts limit Lipsky's reach and interpret Rule 12(f) to permit plaintiffs to derive allegations from consent orders. The latter group more persuasively argues that neither Lipsky nor Rule 12(f) requires courts to strike every allegation based on a consent order. Part I of this Comment describes the Lipsky decision and its application in lower courts. Properly construed, Lipsky has a narrow scope; it supports striking only those references to consent orders that ultimately would be inadmissible at trial. Otherwise, Lipsky and Rule 12(f) permit plaintiffs to rely on consent orders to allege facts establishing a claim of liability.

But that does not settle the matter. Plaintiffs must also satisfy the duty of independent investigation. Under Rule 11(b)(3), by submitting a signed pleading to the court, the attorney certifies that "to the best of the person's knowledge, information, and belief, formed after an inquiry reasonable under the circumstances[,] ... the factual contentions have evidentiary support or, if specifically so identified, will likely have evidentiary support after a reasonable opportunity for further investigation or discovery." (19) Judges may strike allegations that do not satisfy Rule 11(b)(3), though they need not engage in a separate Rule 12(f) inquiry to do so. (20)

Recently, lower courts have considered whether plaintiffs can satisfy their Rule 11(b)(3) obligations when relying on consent orders. Part II describes various applications of Rule 11(b)(3) to complaints relying on consent orders and argues that courts should adopt a flexible approach because the duty of independent investigation varies with the circumstances of each case. Although courts generally agree that plaintiffs may not copy and paste allegations from consent orders without any independent investigation, courts have applied divergent standards in more nuanced situations. In particular, courts have struggled to answer whether plaintiffs must independently verify each allegation derived from consent orders and whether consent orders are sufficiently reliable sources. To effectively police compliance with Rule n(b)(3) when plaintiffs derive allegations from consent orders, courts should require plaintiffs to provide notice of their reliance and to reasonably attempt to verify the information through other sources. Moreover, while courts should not treat all consent orders as inherently suspect, they should inquire into the reliability of a particular consent order.

Although this Comment separates discussions of Rule 12(f) and Rule n(b)(3) into different Parts, the Rules interact and, in some instances, overlap. (21) Notably, both rules limit the plaintiff's evidentiary burden at the pleadings stage. Under Rule 11(b)(3), a plaintiff is not required to plead admissible evidence. The plaintiff must only allege the existence of facts that will likely have evidentiary support after reasonable opportunity for further investigation or discovery. And under Rule 12(f), courts may strike allegations only after finding that there will be no available admissible evidence supporting the allegations. (22) Neither rule requires any allegation or source to be especially probative or reliable. (23)

Thus, Parts I and II share an argument: by aggressively striking references to consent orders, many courts have imposed evidentiary and investigative obligations on plaintiffs that are improper at the pleadings stage. When plaintiffs allege facts derived from consent orders, they will rarely violate Rule 11(b)(3), Rule 12(f), or even Lipsky if properly interpreted.

Notwithstanding this argument, Part III raises the concern that permitting plaintiffs to rely on consent orders in pleadings could hamper regulatory enforcement policy. Regulatory agencies have compelling reasons to settle enforcement actions through consent orders. Accordingly, agencies typically limit the collateral effects of consent orders to preserve defendants' incentives to settle. These incentives may shift if the law clearly permitted plaintiffs to rely on consent orders when bringing suits that "piggyback" off of regulatory actions. However, Part III surmises that any shifts in incentives would be minor. But even if regulatory enforcement policy favors prohibiting plaintiffs from relying on consent orders, Parts I and II show that courts should not stretch Rules 11(b)(3) and 12(f) to give effect to this policy.

1. RELIANCE ON CONSENT ORDERS UNDER LIPSKY AND RULE 12(f)

   Federal appellate courts rarely confront motions to strike under Rule 12(f) of the Federal Rules of Civil Procedure. (24) As a result, Lipsky has influenced dozens of district courts that are faced with motions to strike, including those where plaintiffs attempt to rely on consent orders. (25) However, lower courts have struggled to apply Lipsky consistently because of the conflicting policies and rules it articulates, as well as the confusing set of facts underlying the decision.

   Section I.A describes the Lipsky opinion and suggests that the opinion is inconclusive on the extent to which plaintiffs may rely on consent orders in their pleadings. On the one hand, the opinion potentially supports a broad rule requiring courts to strike almost any allegation derived from a consent order. On the other hand, the opinion could be read narrowly to permit plaintiffs to allege information derived from consent orders and to use them as a source of information to suggest that admissible evidence will likely be available at trial. Section I.B discusses the various justifications that lower courts have offered to support the broad and narrow applications of Lipsky. Finally, Section I.C argues that the narrow application should be adopted based on a close reading of Lipsky, generally accepted motion to strike law, and pleadings-stage policy.

   1. The Lipsky Decision

      The plaintiff in...