UNITED STATES DISTRICT COURT

EASTERN DISTRICT OF MISSOURI

EASTERN DIVISION

SECURITIES AND EXCHANGE COMMISSION, )

)
Plaintiff, )
)
vs. ) No. 4:07-CV-270(JCH)
)
MICHAEL F. SHANAHAN, JR., )
)
Defendant. )

TRIAL PROCEEDINGS -- VOLUME 10

BEFORE THE HONORABLE JEAN C. HAMILTON

UNITED STATES DISTRICT JUDGE

FEBRUARY 12, 2010

APPEARANCES:

FOR PLAINTIFF: ROBERT M. MOYE

JONATHAN S. POLISH
JEFFREY A. SHANK
SECURITIES AND EXCHANCE COMMISSION
175 W. Jackson, Suite 900
Chicago, IL 60604
(312) 353-7390

FOR DEFENDANT: STUART L. GASNER

JENNIFER A. HUBER
KEKER & VAN NEST, LLP
710 Sansome Street
San Francisco, CA 94111
(415) 391-5400

JAMES G. MARTIN
ARMSTRONG TEASDALE, LLP
One Metropolitan Square, Suite 2600
St. Louis, MO 63102-2740
(314) 621-5070

COURTROOM CLERK: CARRIE LIPPOLD

REPORTED BY: DEBORAH A. KRIEGSHAUSER, FAPR, RMR, CRR

Official Court Reporter
United States District Court
111 South Tenth Street, Third Floor
St. Louis, MO 63102
(314) 244-7449
 VOLUME 10 3

1 (Proceedings began at 9:06 AM.)

2 (The following proceedings were held outside the

3 hearing and presence of the Jury:)

4 THE COURT: Please be seated. Good morning.

5 MR. GASNER: Good morning, Your Honor.

6 MR. MOYE: Good morning.

7 MR. MARTIN: Good morning, Your Honor.

8 THE COURT: Let the record reflect the Jury is not in

9 the courtroom.

10 This morning I want to read to you my ruling on the

11 Defendant's motion.

12 This matter is before me on Defendant Michael F.

13 Shanahan, Jr.'s Motion for Judgment as a Matter of Law. In

14 his motion, Mr. Shanahan asserts that after eight days of

15 trial testimony, the SEC has failed to completely show that he

16 acted intentionally with severe recklessness or even

17 negligently in his alleged backdating of options or other

18 wrongdoing. Mr. Shanahan, therefore, asks that I end this

19 case now and avoid the necessity of submitting this complex

20 matter to the Jury.

21 In its trial brief, the SEC summarized the factual

22 predicate for its case as follows:

23 Quote, "Shanahan, Jr., helped lead a scheme involving

24 other individuals at ESSI to provide unauthorized compensation

25 to Shanahan, Sr., and other ESSI employees and Directors,

 VOLUME 10 4

1 including himself, by falsifying the purported dates on which

2 stock options were granted, and this practice contradicted

3 affirmative statements regarding stock option pricing and

4 executive compensation made in ESSI's proxy statements, Form

5 10-K annual reports, and Form S-8 registration statements,"

6 end quote.

7 The alleged misrepresentations consist of virtually

8 identical language which I will refer to as the "Option

9 Pricing Sentence." Specifically, in Paragraphs 38 and 40 of

10 its Complaint, the SEC alleges the proxy statements and

11 attached stock option plans, quote, "stated that all options

12 had been granted at an exercise price equal to the fair market

13 value of the stock on the date of the award," end quote, and

14 that, quote, "options granted under the plan would be granted

15 at fair market value on the date of the award," end quote.

16 In Paragraph 43, with respect to Forms 10-K, the SEC

17 alleges that ESSI, quote, "falsely represented that the

18 Company's stock options are granted at an option price equal

19 to the market value on the date the option is granted," end

20 quote. And with respect to the Form -- Forms S-8, the SEC

21 alleges in Paragraph 45 that the description of stock option

22 plans and the plans themselves, quote, "expressly stated that

23 options under each plan were to be granted at the fair market

24 value of the Company's stock on the date of the award," end

25 quote.
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1 In the remaining Counts of its Complaint, the SEC

2 asserts the following claims for relief against Mr. Shanahan,

3 Jr.: Violations of Section 17(a) of the Securities Act;

4 Violations of Section 10(b) of the Exchange Act and Exchange

5 Act Rule 10(b)(5); Violations of Section 14(a) of the Exchange

6 Act and Exchange Act Rule 14(a)(9); and Aiding and Abetting

7 ESSI's violations of Section 13(a) of the Exchange Act and

8 Exchange Act Rules 12(b)(20) and 13(a)(1).

9 The SEC has now concluded its evidence, and

10 Mr. Shanahan, Jr., asserts that he is entitled to judgment as

11 matter of law because a reasonable jury would not have a

12 legally sufficient evidentiary basis to find for the SEC on

13 any of its claims. For ease of discussion, I will group

14 together the claims with related standards.

15 First, Section 17(a)(1), Section 10(b) and Rule

16 10(b)(5).

17 As acknowledged by the parties, the SEC's claims

18 under Section 17(a)(1), Section 10(b) and Rule 10(b)(5)

19 requires scienter as an element. To show that Mr. Shanahan,

20 Jr., acted with scienter, the SEC must prove that he possessed

21 a mental state embracing an intent to deceive, manipulate or

22 defraud or acted with severe recklessness. At oral argument

23 on the motion, the parties focused on recklessness.

24 Recklessness is limited to those highly unreasonable

25 omissions or misrepresentations that involve not merely simple

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1 or even inexcusable negligence but an extreme departure from

2 the standards of ordinary care and that present a danger of

3 misleading buyers or sellers which is either known to the

4 Defendant or is so obvious that the Defendant must have been

5 aware of it.

6 On this, I rely on SEC v. Thielbar and Florida State

7 Board of Education v. Green Tree Financial Corporation.

8 The SEC quotes this standard in its proposed jury

9 instruction.

10 Having considered all the evidence presented in this

11 matter, I find the SEC has not submitted sufficient evidence

12 to submit on these claims. While acknowledging that

13 Mr. Shanahan, Jr.'s alleged actions must have represented an

14 extreme departure from the standards of ordinary care, the SEC

15 offers absolutely no evidence with respect to the standards of

16 care that would apply in this situation. In other words, the

17 SEC did not present an expert or a lay witness to discuss the

18 responsibilities and duties of a Nonemployee Director, such as

19 Mr. Shanahan, or any applicable industry practice or custom

20 during the relevant time period, nor did it point to

21 provisions in the stock option plans or other documentary

22 evidence tending to establish such things. Without knowing

23 what the standards of ordinary care were in this situation,

24 the Jury would be left to speculate with respect to whether

25 Mr. Shanahan, Jr.'s alleged behavior constituted a departure

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1 from those standards, much less an extreme departure.

2 Furthermore, the SEC presented no evidence that

3 Mr. Shanahan, Jr., knew the alleged omissions or

4 misrepresentations at issue here presented a danger of

5 misleading buyers or sellers. Instead, Steven Landmann, a

6 Certified Public Accountant and former ESSI Controller, was

7 the only witness to testify that he was concerned the grant

8 dates were not in accordance with what he perceived the

9 options plan to require, but he also said that he never

10 informed Mr. Shanahan, Jr., of this discrepancy.

11 Finally, with respect to whether the danger of

12 misleading investors was so obvious that Mr. Shanahan, Jr.,

13 must have been aware of it, the SEC's own expert, Professor

14 Randall Heron, testified that he understood the Option Pricing

15 Sentence to require that the exercise price be equal to the

16 market price on the date of the Compensation Committee meeting

17 approving the award of options, but then acknowledged that his

18 colleague and close collaborator, Dr. Erik Lie, found that

19 virtually identical language in other stock option plans did

20 not specifically prohibit the grant date from preceding the

21 decision date. When pressed on why Dr. Lie might disagree

22 with him, Professor Heron suggested it was because Dr. Lie did

23 not have sufficient knowledge of applicable accounting

24 principles, something Mr. Shanahan, Jr., admittedly also

25 lacked.
 VOLUME 10 8

1 Finally, adding to the confusion, Steven Landmann,

2 the only other SEC witness with knowledge of accounting

3 principles, did not agree with either interpretation of the

4 Option Pricing Sentence but, instead, interpreted it to mean

5 the grant date did not have to be the same as the decision

6 date but could be a date subsequent to the date on which the

7 Compensation Committee met.

8 In light of these circumstances, I cannot say the

9 alleged misrepresentations or omissions here presented a

10 danger of misleading investors so obviously -- obvious that

11 Mr. Shanahan, Jr., must have been aware of it.

12 The SEC has failed to carry its burden of

13 demonstrating recklessness, and so I will grant his motion

14 with respect to the SEC's claimed violations of Section

15 17(a)(1), Section 10(b) and Rule 10(b)(5).

16 Turning now to Section 17(a)(2), 17(a)(3) and 14(a)

17 and Rule 14(a)(9).

18 For purposes of the instant motion, I will assume the

19 remainder of the SEC's claims in Count I of its Complaint and

20 its claim in Count III of its Complaint are all predicated on

21 the theories of negligence. The SEC defined "negligence" in

22 its proposed jury instructions as follows: Quote, "Third,

23 that the Defendant acted negligently, by which I mean he

24 failed to exercise ordinary care. The phrase 'ordinary care'

25 means that degree of care that an ordinarily careful person

 VOLUME 10 9

1 would use under the same or similar circumstances. The degree

2 of care used by an ordinarily careful person depends upon the

3 circumstances which are known or should be known and varies in

4 proportion to the harm that person reasonably should foresee.

5 In deciding whether a person was negligent or failed to use

6 ordinary care, you must consider what that person knew or

7 should have known and the harm that should reasonably have

8 been foreseen. In determining whether the Defendant was

9 negligent, it is proper for you to consider whether he

10 exercised reasonable care in obtaining and communicating

11 information and whether he undertook an appropriate

12 investigation before making statements to investors or

13 prospective investors. Further, you should consider the

14 Defendant's duties as a member of ESSI's Board of Directors

15 and as a member of the Compensation Committee and whether he

16 acted with due care in carrying out those duties."

17 Upon consideration of the standards set forth by the

18 SEC itself through its proposed instructions, I find these

19 claims must also be dismissed for a failure of proof. In

20 other words, the SEC presented no evidence, through expert or

21 lay testimony, documentary evidence or otherwise with respect

22 to the degree of care that an ordinarily careful person would

23 use under the same or similar circumstances, whether

24 Mr. Shanahan, Jr., exercised reasonable care in obtaining and

25 communicating information, or whether he undertook an

 VOLUME 10 10

1 appropriate investigation before allegedly making statements

2 to investors or prospective investors.

3 Finally, and perhaps more importantly, the SEC

4 offered absolutely no evidence regarding Mr. Shanahan, Jr.'s

5 duties as a member of ESSI's Board of Directors and as a

6 member of the Compensation Committee. Absent this basic

7 framework, once again, the Jury would be left to speculate as

8 to whether a duty existed on the part of Mr. Shanahan, Jr.,

9 and, if it did, whether he failed to perform that duty.

10 And I rely on Lafarge North America, Incorporated v.

11 Discovery Group, 574 F.3d 973.

12 I will, therefore, dismiss Counts 1, II and III of

13 the SEC's Complaint in their entirety.

14 Turning now to Section 13(a), Rules 12(b)(2) and

15 13(a)(1).

16 To establish its Count VI claim for aiding and

17 abetting, the SEC had to show that the primary party, ESSI,

18 committed a securities law violation and that Mr. Shanahan,

19 Jr., knowingly and substantially assisted ESSI in committing

20 that violation. Again, I will assume for purposes of the

21 instant motion that the SEC established a violation of the

22 securities laws by the primary party, ESSI.

23 The SEC, thus, was required to show that

24 Mr. Shanahan, Jr., acted knowingly; in other words, with

25 knowledge of a wrongful purpose.

 VOLUME 10 11

1 And I rely on that -- rely on SEC v. Cohen.

2 The parties agree that the extent of knowledge that

3 must be shown is flexible. Under Eighth Circuit law in Camp

4 v. Dema, quote, "A party who engages in atypical business

5 transactions or actions which lack business justification may

6 be found liable as an aider and abettor with a minimal showing

7 of knowledge. Conversely, a party whose actions are routine

8 and part of normal everyday business practices would need a

9 higher degree of knowledge for liability as an aider and

10 abettor to attach," end quote.

11 Upon consideration of the evidence presented at

12 trial, I find that the SEC has failed to establish that

13 Mr. Shanahan, Jr.'s actions amounted to atypical business

14 transactions or actions lacking business justification. The

15 SEC is held to a higher standard, therefore, in proving

16 Mr. Shanahan, Jr., had the requisite degree of knowledge to be

17 held as an aider and abettor.

18 Once again, however, I find the SEC has failed to

19 meet its burden. As I've stated, of the SEC's witnesses, only

20 Steven Landmann testified that even he knew the options were

21 retrospectively priced, let alone that such pricing was

22 wrongful, and he specifically testified he never disclosed his

23 concerns to Mr. Shanahan, Jr. Mr. Shanahan, Jr., himself

24 certainly never testified he knew about the alleged options

25 backdating. Furthermore, in light of the SEC's own witnesses'

 VOLUME 10 12

1 testimony highlighting the confusion surrounding the Options

2 Pricing Sentence, together with Mr. Shanahan, Jr.'s admitted

3 lack of knowledge of accounting principles, I find no evidence

4 that he would have appreciated the wrongfulness of the

5 activities even if he had known of them.

6 For these reasons, I will grant Defendant Michael F.

7 Shanahan, Jr.'s Motion for Judgment as a Matter of Law and

8 dismiss the SEC's Complaint in its entirety.

9 At this time we will -- I'll bring in the Jury and

10 dismiss the Jury.

11 (Jury seated by the Clerk.)

12 (The following proceedings were held within the

13 hearing and presence of the Jury:)

14 THE COURT: Please be seated. Ladies and Gentlemen,

15 good morning.

16 THE JURY: Good morning.

17 THE COURT: I apologize for the delay. As I

18 mentioned yesterday when I -- when we recessed, I mentioned to

19 you that I had a number of issues, some legal matters to take

20 up with the attorneys, and we did work on that all afternoon.

21 And as a result of some rulings that I made and have

22 communicated to the attorneys, the case will not need to be

23 presented to a jury, and so we will no longer need your

24 services on this case.

25 I want to express my deep appreciation to all of you.

 VOLUME 10 13

1 This was a very complex case, a very difficult case, and you

2 all have been extraordinarily attentive, and I appreciate that

3 very much. So we do appreciate the assistance that you have

4 given us. And at this time you are free to go on home, back

5 to work.

6 Again, thank you very much for your service as

7 jurors.

8 THE CLERK: All rise.

9 THE COURT: This Court is in recess.

10 (Court adjourned at 9:23 AM.)

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CERTIFICATE

I, Deborah A. Kriegshauser, Registered Merit Reporter

and Certified Realtime Reporter, hereby certify that I am a

duly appointed Official Court Reporter of the United States

District Court for the Eastern District of Missouri.

I further certify that the foregoing is a true and

accurate transcript of the proceedings held in the

above-entitled case and that said transcript is a true and

correct transcription of my stenographic notes.

I further certify that this transcript contains pages

1 through 13 inclusive and that this reporter takes no

responsibility for missing or damaged pages of this transcript

when same transcript is copied by any party other than this

reporter.

Dated at St. Louis, Missouri, this 12th day of

February, 2010.

_________________________________

/s/ Deborah A. Kriegshauser

DEBORAH A. KRIEGSHAUSER, FAPR, RMR, CRR

Official Court Reporter