Option backdating cases which are tried to verdict are rare. The SEC and DOJ settle most of these cases long before trial. Previously, in some cases tried to verdict, they have had success. Recent high profile criminal prosecutions against the co-founder and senior executives of Broadcom, however, were dismissed for witness tampering by prosecutors, raising significant questions about the quality of the evidence and the decision to prosecute.

Last week, the SEC has had an option backdating case dismissed by the court at the conclusion of the evidence and before the jury could deliberate for a failure of proof. SEC v. Shanahan, Case No. 4:07-cv-1262 (E.D. Mo. Filed July 12, 2007). The case was brought against Michael F. Shanahan and his son, Michael F. Shanahan, Jr. The father is the former CEO of Engineered Support Systems, Inc. The son was a member of the board’s compensation committee. According to the SEC, both defendants participated in an option backdating scheme from which they, as well as others, profited.

Specifically, the SEC’s complaint alleged that from 1997 through 2002 father and son participated in a scheme to backdate about $20 million in options for senior executives and employees. Approximately $16 million of those grants were issued to senior executives. In at least two instances, the father approved the issuance of backdated grants which had been previously backdated to obtain a more favorable pricing. In other instances, the father approved additional grants for non-employees. Overall, the father obtained about $8.9 million from backdated grants while the son made approximately $379,000. Both defendants are alleged to have caused the annual reports as well as other filings of the company to be falsified as a result of the scheme.

Following eight days of trial, Michael F. Shanahan, Jr., in a separate trial, moved for dismissal of all claims prior to their submission to the jury. The SEC argued in large part that the son was responsible for a series of false statements and omissions in the filings. In a February 12, 2010 ruling, the court granted the defendant’s request. In each instance the court concluded that the SEC had failed to meet its burden of proof.

First, on the Securities Act Section 17(a) and Exchange Act Section 10(b) claims, the court concluded that the SEC failed to submit evidence regarding the applicable standards. To establish these claims, the SEC is required, the court held, to demonstrate recklessness. To prove this type of conduct, the Commission must demonstrate highly unreasonable omissions or misrepresentations which are characterized by an “extreme departure from the standards of ordinary care and which present a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it.”

Here, however, the SEC offered no evidence of what the appropriate standard might be. “In other words, the SEC did not present an expert or a lay witness to discuss the responsibilities and duties of a nonemployee Director . . .” such as the defendant. Under these circumstances, the jury would be left to speculate. While the SEC did offer testimony from an expert on the stock option plan involved here, that witness admitted that the key sentence in the plan regarding pricing was susceptible to conflicting interpretations.

Second, the SEC also failed to meet its burden of proof on its claims under Securities Act Sections 17(a)(2)& (3) and Exchange Act Section 14(a). Here, the standard is negligence. Citing the Commission’s proposed jury instructions, the court concluded that again the SEC failed to submit any evidence of the appropriate standards governing the conduct of a director such as the defendant.

Finally, the SEC failed to meet its burned on its Section 13(a) claims. In this case, the Commission’s theory is that the defendant aided and abetted violations by the company. To establish aiding and abetting the SEC must prove a primary violation and that the defendant substantially assisted in that violation. Stated differently, the defendant would have to be shown to have acted with a wrongful purpose the court held.

Here, again there is a failure of proof. Assuming there is a primary violation, the standard as to the defendant is flexible, as both parties agreed. A person who engages in atypical business behavior which lacks a business justification may be found liable as an aider and abettor with a minimal showing of knowledge. If, however, the actions of the party are routine business practices a higher degree of knowledge is required. Here, the SEC failed to demonstrate that defendant’s actions amounted to atypical business behavior or that the transactions lacked a business justification. This is particularly true in view of the SEC’s expert testimony regarding the vagueness of the plan. Accordingly, the court dismissed all of the Commission’s claims against the defendant and discharged the jury before deliberations.

Michael F. Shanahan, Sr. settled with the Commission before trial. Mr. Shanahan Sr. consented to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and proxy provisions. He also agreed to pay a civil penalty of $750,000 and to the entry of an officer and director bar. Previously in July 2008, Mr. Shanahan Sr. pleaded guilty to falsifying company records in violation of Exchange Act Sections 13(b)(2) & (5). He was sentenced to three years probation and ordered to pay restitution of about $7.8 million and a $40,000 criminal fine. See Litig. Rel. 21362 (Jan. 6, 2010).