Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), discussed here, requiring that a securities law plaintiff plead and prove facts establishing loss causation continues to have a significant impact on securities litigation. The High Court’s recent constriction of the Rule 8 pleading standards, first discussed in Dura and later honed in Ashcroft v. Iqbal, 129 S.Ct. 1937 (2009), is beginning to have significant impact. These decisions were brought together by the Eight Circuit to affirm the dismissal of a securities fraud damage action in McAdams v. McCord, Case No. 09-1303 (Filed Oct. 20, 2009).

McAdams is a securities fraud suit brought by three investors and their related entities against UCAP, Inc., several of its executives and the outside auditors, Moore Stephens Frost, PLC. Plaintiffs invested $10 million in UCAP, a multi-state provider of mortgage lending and brokerage services. Subsequently, in April 2004 the company announced that it would need to restate its financial statements for the periods ended September 30, 2002, December 30, 2002, and March 31, 2003. Six months later UCAP’s principal operating subsidiary filed for Chapter 11. In 2005 its shares were delisted.

Plaintiffs filed suit claiming that they purchased their shares at artificially inflated prices. The complaint alleged a series of misstatements by the company and its executives. The auditors also made false statements, issuing reports on the financial statements of the company for 2001 and 2002. Those unqualified opinions were false, the complaint asserts, because the underlying financial statements were not prepared in accord with GAAP and the auditors, plaintiffs claimed, knew that the financial condition of the company was far weaker than reflected in the financial statements. The truth emerged, the complaint claims, on April 23, 2004 when UCAP announced the need for a restatement.

The district court dismissed the second amended complaint. That court concluded that plaintiffs failed to meet the heightened pleading requirements of Federal Civil Rule 9 and the Private Securities Litigation Reform Act or PSLRA.

The Eighth Circuit affirmed, but on different grounds. While the complaint alleges a series of misstatements, after the Supreme Court’s decision in Central Bank of Denver, discussed here, there is no liability for aiding and abetting. Accordingly, the auditors can only be held liable, if at all, for misstatements or omissions they made. Here, that is only the two audit opinions.

The court put aside the question of whether fraud as to those statements was pleaded with particularity, focusing instead on Dura. Under that decision, plaintiff is required to plead facts demonstrating “’that the loss was foreseeable and that the loss was caused by the materialization of the concealed risk,’” quoting Schaaf v. Residential Funding Corp., 517 F.3d 544, 549 (8th Cir. 2008). The claims that the shares were purchased at an inflated price are clearly insufficient under Dura, the court held. While the complaint does claim the truth emerged with the announcement of a restatement, it fails to state the value of UCAP’s stock when the investors made their investment or the value before or after the need for the restatement was announced. Without these facts, the complaint fails to demonstrate that the investor’s losses were caused by the auditor’s misstatements.

The omission of these key facts is revealing the court noted, because in November 2003, months before the need for a restatement was announced, the company disclosed in an 8-K filing that its principal operating subsidiary was in danger of losing its only line of credit. The filing also stated that UCAP sold a controlling interest in the subsidiary to avoid its bankruptcy. Bringing together the requirements of Dura and Iqual, the court went on to conclude that lack of specificity about the value of UCAP stock “defeats the plausibility of the investors’ claim that MSF’s audit opinions … caused their losses.”

The SEC filed two settled administrative proceedings based on selling short in advance of an offering. While the cases themselves are routine, read in conjunction with others, they may confirm that enforcement has adopted a different approach on this issue. In the Matter of First New York Securities LLC, Adm. Proc. File No. 3-13656 (Filed Oct. 20, 2009); In the Matter of Perceptive Advisors LLC, Adm. Proc. File No. 3-13657 (Filed Oct. 20, 2009).

Each case revolves around an alleged violation of Rule 105 of Regulation M, “Short Selling in Connection with a Public Offering.” That regulation provides, in part, that it is unlawful to cover a short sale with securities acquired from an offering for cash made pursuant to a Securities Act registration statement if the short sale occurs during the five business days before the pricing of the offering and ending with its pricing.

New York Securities is alleged to have violated the Regulation in two instances, once in September 2005 and a second time in January 2007. Overall, the firm made profits of just under $40,000. Perceptive Advisors is alleged to have violated the Regulation in five instances during 2005, yielding profits of about $245,000.

Both firms settled. Each consented to the entry of a cease and desist order from committing or causing any violations and future violations of Rule 105 of Regulation M. In addition, First New York agreed to pay disgorgement of just over $39,000, prejudgment interest of about $9,400 and a civil penalty of $20,000. Perceptive Advisors agreed to pay disgorgement of about $245,000, prejudgment interest of about $68,800 and a civil penalty of $125,000. In both instances, the Commission stated that it considered the remedial acts and cooperation of the Respondent.

These cases appear to represent the final evolution of the SEC’s position on selling short prior to an offering. Previously, the Commission brought a series of cases focused on PIPE offerings and hedge funds. In those cases, typically the fund which learned about the offering had some sort of agreement to keep the information confidential. Before the announcement of the offering, the Fund then sold short and later covered that position with the shares from the offering. Since the PIPE could be expected to dilute the value of the outstanding shares, the short could be closed at an advantageous price.

In the PIPE cases, the fund and its operators were typically charged with violations of Exchange Act Section 10(b) and Securities Act Section 5. Most settled. See, e.g., SEC v. Friedman, Billings, Ramsey & Co. Civil Action No. 06-cv-02160 (D.D.C. Jan 4, 2007), discussed here.

In those which were litigated however, the SEC lost the Section 5 claim. See, e.g. SEC v. Mangan, Civil Action No. 06-cv-531 (W.D.N.C. April 25, 2006), discussed here. In some cases, such as Mangan it also lost the fraud claim. In others, the fraud claim settled. See, e.g., SEC v. Lyon, Civil Action No. 06 CV 14338 (S.D.N.Y. Filed Dec. 12, 2006).

Following those losses, the Commission appeared to have dropped the Section 5 claim but persisted with the Section 10(b) insider trading allegation. See SEC v. Ladin, Civil Action No. 1:08-CV-01784 (D.D.C. Filed Oct. 20, 2008), discussed here.

The two administrative proceedings filed today, read against the backdrop of the PIPE cases, appear to represent the current evolution of this type of case. To be sure, these cases do not contain the confidentiality agreements alleged in Mangan and similar cases. Cuban, discussed here, had such an agreement. The Commission’s appeal of its loss there clearly demonstrates the agency will continue to pursue that type of claim. At the same time, the two administrative proceeding brought today may confirm what Ladin suggested. In the future, the Section 5 claim will be omitted in some cases while in others a Rule 105 charge will be used when appropriate.