SEC v. Shanahan: A Backdating Case Survives Summary Judgment

In Securities Exchange Commission v. Shanahan et al., 2010 WL 148440 (E.D.Mo. Jan. 12, 2010), the Commission brought charges against Michael F. Shanahan, Sr. for options backdating.  The United States District Court for the Eastern District of Missouri granted in part and denied in part defendant’s Motion for Summary Judgment.  Specifically, the court granted defendant’s motion because it found that the SEC failed to present any evidence that defendant provided substantial assistance to the corporation in its alleged failure to keep accurate records.  On five other counts, however, the court denied the motion for summary judgment because the SEC presented both evidence that option pricing and alleged option backdating were in fact material to investors and evidence to create an issue of fact regarding defendant’s involvement and knowledge of wrongfulness of the alleged conduct.

Engineered Support Systems, Inc. functioned as a holding company for a number of wholly-owned subsidiaries that design and manufacture military support equipment and electronics for the U.S. Department of Defense.  Defendant Michael F. Shanahan, Jr. served on the corporation’s Board of Directors between 1994 and 2006 and on the Board’s Compensation Committee between 1995 and 2002.  The Compensation Committee was charged with managing the company’s compensation plan, which it did in part by administering the company Stock Option Plan (“Plan”).  The Committee had exclusive power to grant options subject to the approval of the Chairman of the Board, Michael F. Shanahan, Sr.  The Plan was maintained for the company’s officers, key employees and consultants.  The company’s non-employee director compensation was handled under a different plan called the Non-Employee Director Plan.  Options under the Stock Option plan vested immediately and were granted with an exercise price equal to the closing market price of ESSI’s common stock on the date the options were granted. 

The SEC alleged that between 1997 and 2002 the company issued backdated stock options that contained a lower exercise price than the price of the common stock on the date the options were awarded.  The backdated options allowed the recipients to realize immediate profit that had not been authorized by the company’s shareholders.  The SEC alleged that, as a result of the backdated options, ESSI’s officers, employees, and directors realized an increase in compensation by approximately $20 million.  As a result, the SEC asserted violations against defendant.  Specifically, the SEC alleged violations of Section 17(a) of the Securities Act of 1933 (Count I); violations of Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5 (Count II); violations of Section 14(a) of the Exchange Act and Exchange Act Rule 14a-9 (Count III); Aiding and Abetting ESSI’s violations of Section 13(a) of the Exchange Act and Exchange Act Rules 12b-20 and 13a-1 (Count VI); and Aiding and Abetting ESSI’s violations of Section 13(b)(2)(A) of the Exchange Act (Count VII).

Defendant Shanahan filed a Motion for Summary Judgment asserting that there existed no issues of material fact.  With regard to Counts I, II, III, and VI, the SEC presented evidence that the Stock Option Plan was misleading to investors because it contained a sentence stating that options were granted with a price equal to the market value on the date the option is granted.  Defendant claimed that such a sentence was not material as a matter of law. 

Materiality requires a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information available.  The information also must be a part of the total mix of information available to investors. The SEC presented evidence that investors depended on stock option grants to evaluate whether ESSI was a profitable investment.  In addition, the court found that investors would also value information regarding management’s integrity. 

With regard to Count VI, the Eighth Circuit test for aiding and abetting contained three parts: 1) the existence of a securities law violation by the primary party (as opposed to the aiding and abetting party); 2) “knowledge” of the violation on the part of the aider and abettor; and, 3) “substantial assistance” by the aider and abettor in the achievement of the primary violation.  The court assumed a violation by ESSI, and thus turned to elements two and three. 

A determination of knowledge requires consideration of knowledge and substantial assistance together, where knowledge is lacking, one must have a greater showing of substantial assistance.  Shanahan, Jr., claimed that he was merely an outside director, he was not responsible for ensuring compliance with accounting rules, and that he did not set the strike price of options.  The SEC presented faxes, notes, and e-mails that corroborated Shanahan’s involvement.  The court found this evidence was sufficient.

Finally, the SEC alleged in Count VII that Shanahan, Jr. aided and abetted the company in its failure to keep accurate records of transactions and disposition of assets, specifically maintaining records reflecting the dates on which the committee authorized the Company’s option grants.  Defendant argued that it was not his responsibility to maintain such records, thus he could not have aided and abetted.  The court agreed with defendant, and granted his motion for Count VII. 

The primary materials for this case may be found on the DU Corporate Governance website.