Appeal from the United States District Court for the Eastern District of Missouri.
The opinion of the court was delivered by: Loken, Circuit Judge.
Submitted: January 11, 2011
Before WOLLMAN, LOKEN, and SMITH, Circuit Judges.
The Securities and Exchange Commission (SEC) brought this civil action
against Michael Shanahan Jr., alleging that, as an outside director of
Engineered Support Systems, Inc. ("ESSI"), he violated numerous
federal securities laws by participating in the grant of backdated,
"in-the-money" stock options to ESSI officials including his father,
CEO Michael Shanahan Sr. At the close of the SEC's case in chief after
eight-and-one-half days of trial, the district court*fn1
granted Shanahan Jr.'s Rule 50(a)(1) motion for judgment as a
matter of law, concluding that the SEC had
failed to prove the requisite elements of scienter and negligence.
Judgment as a matter of law is appropriate when "a party has been
fully heard on an issue during a jury trial and the court finds that a
reasonable jury would not have a legally sufficient evidentiary basis
to find for the party on that issue." Fed. R. Civ. P. 50(a)(1). We
review the district court's ruling de novo, applying the same Rule
50(a)(1) standard. Roberson v. AFC Enters., Inc., 602 F.3d 931, 933
(8th Cir. 2010). We agree that the SEC's evidence was insufficient in
these respects and therefore affirm.
I. The Practice and Claims at Issue
A company whose common stock is registered with the SEC and publicly traded, such as ESSI during the time in question (1996 to 2002), must disclose to shareholders and investors the compensation paid to its executives. One common form of compensation is the stock option, which grants a recipient the right to purchase a specified number of shares of the company's stock at a specified price, referred to as the "exercise" or "strike" price. When the market price of a publicly traded stock is equal to an option's exercise price, the option is said to be "at the money." When the market price exceeds the exercise price, the option is "in the money." If an option is "at the money" when granted, it will only enrich the recipient if the stock price rises in the future. But if the option is granted "in the money" and can be exercised immediately, it is to that extent equivalent to a cash bonus if the recipient is an employee. The grant of "in-the-money" options rewards favored employees without requiring cash outlays by the company. But it also affects investors because it dilutes the position of shareholders when the option is exercised.
The issue in this case is "backdating." Like the plans of most publicly held companies, ESSI's Stock Option Plan for employees and consultants provided, "The option price of shares subject to any Stock Option shall be the closing price of the Stock on the date that the Stock Option is granted." This appears to be a requirement that options be granted "at the money." But if those administering the plan select a grant date prior to the date when they make the final decision to grant an option, when the stock's price was lower, and set the exercise price as the closing price on that prior date, the option complies with the literal language of this provision but grants immediate "in-the-money" compensation to an employee recipient. Must this practice be disclosed as some form of executive compensation in the company's financial reports that are filed with the SEC and published to investors and shareholders? As one circuit recently summarized this complex question:
Backdating options is not itself illegal under the securities laws, nor is it improper under accounting principles. Under Generally Accepted Accounting Principles ("GAAP") Board Opinion No. 25 ("APB 25"), however, backdated options must be recorded as a compensation expense to the corporation because they effectively give recipients immediate compensation . . . . A corporation that fails to follow APB 25 and record backdated options as a compensation expense will necessarily misstate its expenses and income in its financial reports.
Edward J. Goodman Life Income Trust v. Jabil Circuit, Inc., 594 F.3d 783, 788 (11th Cir. 2010). ESSI at all times in question retained a major accounting firm to help ensure that its SEC filings and investor disclosures were proper.
In this case, the SEC alleged that ESSI engaged in unlawful undisclosed backdating of options granted to its executives during the time in question. But the SEC did not allege or attempt to prove that ESSI failed to follow APB 25 (or any other accepted accounting principle) in failing to disclose this practice in its filed proxy statements and Form 10-K annual financial statements. Rather, the SEC alleged ESSI's backdating was fraudulent because it violated ESSI's unambiguous representation in its proxy statements and financial-statement footnotes that all options had been and would continue to be granted at an exercise price equal to the fair-market price of ESSI's stock on the date of the grant. Like the parties and the district court, we will refer to these statements as the Option Pricing Sentence or "OPS."
Alleging that the OPS was "materially false," or at least omitted "material facts relating to the Company's stock option program," the SEC's complaint asserted that the practice resulting in the following violations:
(1) Securities fraud in violation of Section 17(a)(1), (2), and (3) of the Securities Act of 1933, 15 U.S.C. § 77q(a); Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b); and Exchange Act Rule 10b-5, 17 C.F.R. § 240.10b-5;
(2) Issuing false or misleading proxy solicitations in violation of Section 14(a) of the Exchange Act, 15 U.S.C. § 78n(a); and Exchange Act Rule 14a-9, 17 C.F.R. § 240.14a-9; and
(3) Aiding and abetting ESSI's filing of a false annual report in violation of Section 13(a) of the Exchange Act, 15 U.S.C. §§ 78t(e), 78m(a); and Exchange Act Rules 12b-20 and 13a-1, 17 C.F.R. § 240.12b-20, .13a-1.*fn2
The complaint sought a permanent injunction against future violations, disgorgement of ill-gotten gains, civil monetary penalties, and an order barring Shanahan Jr. from acting as an officer or director of any publicly traded company.
II. Securities Fraud: § 17(a), § 10(b), & Rule 10b-5
To establish a violation of these antifraud provisions of the federal securities laws, the SEC must prove that Shanahan Jr. made a material misstatement or omission in connection with the offer, sale, or purchase of a security by means of interstate commerce. See SEC v. Phan, 500 F.3d 895, 907-08 (9th Cir. 2007). Violation of § 17(a)(1), § 10(b), and Rule 10b-5 require proof that Shanahan Jr. made misrepresentations or misleading omissions with scienter; violation of § 17(a)(2) and (3) require proof that he acted negligently. See Aaron v. SEC, 446 U.S. 680, 695, 697, 700-01 (1980). The district court concluded that the SEC offered insufficient evidence to satisfy either standard. To frame these issues, we will begin by summarizing the SEC's proof of the other elements of securities fraud.
During the period in question, because shareholders were being asked to approve an additional allocation of ESSI shares to the Plan, every proxy statement included a "Report of the Compensation Committee." The full text of the Plan also appeared in ESSI proxy statements whenever the Board of Directors sought shareholder approval of a revised Plan. Both the proxy statements and each version of the Plan included the OPS (with minor textual variations). In addition, each ESSI Form 10-K annual report ...