DISMISSAL OF OPTION BACKDATING CLAIMS AFFIRMED
The SEC failed to overturn a directed verdict entered in favor of Engineered Support Systems, Inc. outside director Michael F. Shanahan Jr. in an options backdating case. SEC v. Shanahan Jr., No. 10-1820 (8th Cir. Filed July 19, 2011). The Circuit Court agreed with the district court’s conclusions that the Commission failed to establish a violation of the company’s plan or that Mr. Shanahan Jr. engaged in securities fraud.
The SEC’s complaint alleged that from 1997 through 2002 Michael F. Shanahan, the former CEO of the company, and his son, Michael Shanahan Jr., a member of the board and its compensation committee, 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. Mr. Shanahan Jr., as a member of ESSI’s compensation committee, was also involved in the approval process. Overall, the father obtained about $8.9 million from backdated grants while the son made approximately $379,000. Both defendants were alleged to have caused the annual reports as well as other filings of the company to be falsified as a result of the scheme. SEC v. Shanahan, Case No. 4:07-cv-1262 (E.D. Mo. Filed July 12, 2007).
Following eight days of trial on the SEC’s claims Michael F. Shanahan, Jr. 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.
The Circuit Court affirmed the dismissal of the SEC’s claims. Those centered on claims that the company engaged in the unlawful and undisclosed backdating of its options in violation of its disclosed plan which provided in part: “Options granted are at an option price equal to the market value of the date the option is granted . . . The Company applies Accounting principles Board opinion No. 25 . . . Accordingly, no compensation expense has been recognized for stock option awards.” The Commission did not claim that ESSI failed to follow APB 25 which governs the accounting for options.
Here the SEC clearly established that ESSI backdated its options the Court concluded. The Commission failed however to establish its claim that backdating the options clearly violated the disclosed ESSI plan. The evidence demonstrated that the price at which the options were issued corresponded to the stock price on the certificate date. That is all the plan actually requires if literally read. There is nothing in the plan which specifically prohibited backdating the options.
Furthermore, even if Mr. Shanahan Jr. perceived an apparent contradiction between the option dating and pricing practices of the company and its disclosed plan from his work on the compensation committee, the SEC did not establish that he recklessly failed to see an obvious danger that investors would be misled. It is undisputed that no one at the company, including its outside auditors who monitored compliance with APB No. 25 “perceived that the undisclosed grant of ‘in-the money’ stock options – which had no impact on ESSI’s financial performance – would be a material misstatement or omission . . .” Indeed, the Commission presented virtually no evidence on the question of materiality.
Likewise, the Commission failed to present any evidence to support its negligence based claims under Securities Act Sections 17(a)(2) & (2). In this regard the district court concluded that the SEC failed to present any evidence “with respect to the degree of care than an ordinary careful person would use under the same or similar circumstances, whether Mr. Shanahan, Jr. exercised reasonable care in obtaining and communicating information, or whether he undertook an appropriate investigation before allegedly making statements to investors or prospective investors.” The SEC’s contention on appeal that its claim was “clearly” supported by the plain language of the plan is simply incorrect.
Finally, the SEC’s claimed violations of Section 14(a) for proxy fraud and Section 20(e) for aiding and abetting must also fail. Under the facts here the SEC has simply failed to establish the intent required to establish a violation of either Section the Court concluded.
Michael F. Shanahan, Sr. settled with the Commission before trial, consenting 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).
Webcast: Securities Cases in the Supreme Court: A Review of the 2010-2011 Term and a Look at the Next, by Thomas Gorman, presented by Celesq-West Legal Education, available at http://bit.ly/jpoijv