Securities & Exchange Commission v. Shanahan

United States Court of Appeals
FOR THE EIGHTH CIRCUIT
___________

No. 10-1820
___________

Securities and Exchange Commission, *
*
Plaintiff - Appellant, *
* Appeal from the United States
v. * District Court for the
* Eastern District of Missouri.
Michael F. Shanahan Jr., *
*
Defendant - Appellee. *
___________

Submitted: January 11, 2011
Filed: July 19, 2011
___________

Before WOLLMAN, LOKEN, and SMITH, Circuit Judges.
___________

LOKEN, Circuit Judge.

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 court1 granted Shanahan Jr.’s
Rule 50(a)(1) motion for judgment as a matter of law, concluding that the SEC had

1
The Honorable Jean C. Hamilton, United States District Judge for the Eastern
District of Missouri.
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

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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.”

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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-1.2

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

2
The SEC does not appeal the district court’s grant of summary judgment
dismissing an additional claim that Shanahan Jr. aided and abetted ESSI’s violation
of § 13(b)(2)(A) of the Exchange Act, 15 U.S.C. § 78m(b)(2)(A). See SEC v.
Shanahan, No. 4:07-cv-270, 2010 WL 148440, at *5-6 (E.D. Mo. Jan. 12, 2010).

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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 filed with the SEC and available to purchasers and sellers
of ESSI stock included the OPS in a “Shareholders’ Equity” footnote:

. . . [O]ptions may be granted to employees and directors of the
Company to purchase shares of the Company’s common stock. Options
granted are at an option price equal to the market value on the date the
option is granted. . . . The Company applies Accounting Principles Board
Opinion No. 25 . . . and related interpretations in accounting for all stock
option plans. Accordingly, no compensation expense has been
recognized for stock option awards.

The SEC’s expert statistician, Professor of Finance Randall Heron, testified that
between 1995 and 2002, ESSI granted options having an exercise price equal to the
stock’s lowest price during that month eleven times, nine of which also coincided with
the stock’s lowest price of the quarter, a pattern that disappeared after passage of the
Sarbanes-Oxley Act in July 2002.3 According to Heron, the probability of the pre-

3
The Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 403(a), 116 Stat. 745,
788 (July 30, 2002), codified at 15 U.S.C. § 78p(a)(2)(C), requires firms to disclose
stock-option transactions to certain officers and directors within two business days

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Sarbanes-Oxley grants occurring as they did without backdating was less than one in
a billion. Thus, the SEC presented ample evidence to submit to the jury the issue
whether ESSI granted “backdated” options.

The SEC also presented ample evidence that Shanahan Jr. was a knowing
participant in this process. The Stock Option Plan provided that it was administered
by the ESSI Compensation Committee, which was given authority to “determine
optionees and the number of shares subject to each option granted,” subject to
approval by CEO Shanahan Sr. During the entire period in question, the
Compensation Committee consisted of Shanahan Jr. and two or three other
nonmanagement directors. The Compensation Committee met once or twice per year
to discuss issues including the grant of stock options. ESSI Vice-President/Controller
Steve Landmann, a certified public accountant and witness for the SEC, testified that
he initially drafted ESSI’s stock-option plans, proxy statements, and Forms 10-K and
then circulated his drafts to all Board members, including Shanahan Jr.4 Landmann
also prepared for Shanahan Sr.’s signature option certificates and grant letters
notifying employee-recipients of their awards. Rather than dating the options on the
date the certificates were prepared and pricing them “at the money” on those dates,
Landmann used earlier dates provided by Chief Financial Officer (CFO) Gary
Gerhardt. Gerhardt, also a witness for the SEC, testified that “the price would have
been established by some combination of everybody involved” and admitted that “the
dates that we ended up picking were low dates.”

and, according to expert-witness Heron, thereby “reduce[d] the ability to look back
through time and potentially backdate an option.”
4
Landmann testified that he received proposed changes to the draft proxy
statements from Shanahan Jr. “more than once.” In support, the SEC introduced a
copy of a 1999 statement in which Shanahan Jr. made handwritten changes to the
“Employment Agreements” section of the Compensation Committee Report.

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 Shanahan Jr., called by the SEC during its case in chief, testified that he and the
Compensation Committee focused primarily on the complex task of allocating
available options among the executives in this rapidly expanding enterprise, leaving
option pricing to the finance and accounting departments. But the SEC introduced
numerous documents approved by the Committee and by Shanahan Jr. reflecting the
grant of options bearing dates prior to the apparent decision dates that resulted in
lower exercise prices. For example, on July 25, 2002, Shanahan Jr. sent an email to
Gerhardt asking, “If the options have not been issued to date, I think yesterday[’]s
close was a new low for the quarter. Can we go with the lower number? Do we need
to have a comp. meeting to do it?” Subsequent emails reflected that the final
allocation of these options was not approved before August 8, 2002, yet the grant
certificates bore a July 24, 2002 date and price.

The SEC’s evidence was far weaker on the question whether ESSI’s backdating
practice together with the OPS constituted false statements or omissions made in
connection with the offer, sale, or purchase of securities. ESSI literally complied with
the OPS because the exercise price was always “the closing price of the Stock on the
date that the Stock Option is granted,” that is, the date that appeared on the option
certificate. The SEC argues on appeal that “the only reasonable reading” of the OPS
was that it misrepresented “that ESSI did not, and would not, issue backdated
options.” But the only evidence that this was the only reasonable reading of the plain
language of the OPS was the opinion of statistical expert Heron, who was not
qualified as an expert on this question and whose lay opinion was of little if any
probative value. Moreover, on cross-examination Heron admitted that a colleague had
published a prominent article on the subject noting:

the stock option plans that I have looked at do not explicitly prohibit
such activities. The plans generally state that the exercise price should
be the market price at the grant date, but do not state that the grant date
cannot precede the decision date.

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Erik Lie, On the Timing of CEO Stock Option Awards, Mgmt. Sci., Vol.51, No. 5,
802, 807 (May 2005).

The SEC’s evidence that ESSI’s backdating practice and its OPS disclosures
were materially fraudulent was even more deficient. Proof of materiality requires
proof of “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 made available.” Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988)
(quotation omitted). The SEC’s only witness on this issue whose testimony is in the
record on appeal was Selman Akyol, a research analyst for a brokerage firm who
analyzed ESSI’s stock during the period in question. Akyol testified:

Q. Mr. Akyol, were you ever aware before 2006 that ESSI was
pricing stock option grants in-the-money or -- or backdating those
grants?

A. No, I was not.

Q. Mr. Akyol, as an analyst, is that something you would have liked
to have known during the time -- period of time you covered the
company?

* * * * *

A. Yes.

Q. Why is that?

A. As an analyst, I would like to know everything.

We have reviewed how the SEC’s case was weak as to falsity and almost non-existent
as to materiality because these deficiencies were highly relevant to the two issues on
which the district court granted judgment as a matter of law, scienter and negligence.

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 A. Scienter. The element of scienter requires proof of “intent to deceive,
manipulate, or defraud.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976).
Although the Court has repeatedly declined to address the issue, most recently in
Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1323 (2011), we are among
the circuits holding that a finding of scienter may be based upon “severe
recklessness,” that is:

those highly unreasonable omissions or misrepresentations that involve
not merely simple or even inexcusable negligence, but an extreme
departure from the standards of ordinary care, and that 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.

Fla. State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 645, 654 (8th Cir. 2001)
(quotation omitted). This definition of recklessness is “the functional equivalent for
intent,” requiring proof of “something more egregious than even ‘white heart/empty
head’ good faith.” Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th
Cir.), cert. denied, 434 U.S. 875 (1977). It is insufficient to show that a defendant
should have known that a material statement or omission was false or misleading.
“That is a viable claim of negligence, but not of fraud.” In re Ceridian Corp. Secs.
Litig., 542 F.3d 240, 249 (8th Cir. 2008).

At the close of the SEC’s evidence, the district court found “no evidence that
Mr. Shanahan, Jr. knew the alleged omissions or misrepresentations at issue . . .
presented a danger of misleading buyers or sellers,” and insufficient evidence to
permit a finding that “the alleged misrepresentations or omissions . . . presented a
danger of misleading investors so . . . obvious that Mr. Shanahan, Jr. must have been
aware of it.” We agree.

Shanahan Jr. testified that he relied on the ESSI finance and accounting
departments, outside and general counsel, and the company’s independent auditors to

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ensure that the stock option Plans were properly administered and that ESSI proxy
statements made appropriate and accurate disclosures. It is undisputed that none of
these professionals ever raised to Shanahan Jr. any concern regarding option dating
and pricing and the OPS disclosures.5 He never questioned the accuracy of the OPS
and did not recall discussing the meaning or import of the OPS during Compensation
Committee meetings. Depending on others to ensure the accuracy of disclosures to
purchasers and sellers of securities -- even if inexcusably negligent -- is not severely
reckless conduct that is the functional equivalent of intentional securities fraud. See
SEC v. Pasternak, 561 F. Supp. 2d 459, 513-14 (D.N.J. 2008).

The SEC argues that “the danger of misleading investors must have been
obvious for Shanahan Jr.” because the plain language of the OPS disclosures “so
clearly state[s] that the company was issuing at-the-money options.” No doubt, “[a]n
egregious refusal to see the obvious, or to investigate the doubtful, may in some cases
give rise to an inference of recklessness.” Novak v. Kasaks, 216 F.3d 300, 308 (2d
Cir. 2000) (quotation and ellipses omitted). But to prove severe recklessness that is
the functional equivalent of intentional fraud, the SEC must prove that the danger of
misleading buyers or sellers of securities was so obvious that Shanahan Jr. must have
been aware of it. Here, the SEC’s evidence failed to meet this heavy burden in two
respects.

5
Controller Landmann testified that he often objected to CFO Gerhardt that
grant dates that corresponded to prior low points in the price of ESSI stock were
improper, but he admitted that “the specific [Plan] language does not tie grant date and
decision date.” Landmann never raise this concern with either Shanahan Sr. or
Shanahan Jr. Gerhardt denied that Landmann ever objected to grant dates or pricing,
denied that he ever told Landmann to pick a low date from a range, and testified that
he never perceived a problem with ESSI’s practice of dating and pricing Plan options.
Shanahan Sr. testified that no one, including ESSI’s outside auditors, ever told him
that the stock-option Plan was being administered improperly.

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 First, the evidence established that ESSI’s option dating practice was not clearly
contrary to the plain language of the OPS. As commentator Erik Lie put it, the OPS
“d[id] not state that the grant date cannot precede the decision date.” It seems likely
that the average investor would read the OPS as stating that ESSI does not issue “in-
the-money” stock options. But the OPS was ambiguous, and avoiding ambiguous
statements that may mislead investors was primarily the responsibility of ESSI’s
accounting and finance professionals, not an outside director such as Shanahan Jr.,
who had no training in this highly complex subject. The SEC’s proof permitted, at
most, the reasonable inference that Shanahan Jr. as outside director reviewed and
approved an objectively misleading statement with knowledge of facts that rendered
the statement misleading.

Second, even if Shanahan Jr. should have perceived an apparent contradiction
between ESSI’s option dating and pricing practice and its OPS disclosures, he is not
liable for securities fraud unless he recklessly failed to see an obvious danger that
investors would be materially misled. On this issue, the SEC’s weak proof of
materiality is fatal to its case. During the period 1996-2002, it is undisputed that no
one at ESSI, 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 in connection with purchases and sales of ESSI stock. After unrelated
corporate scandals and passage of Sarbanes-Oxley changed public perceptions and the
regulatory climate, “backdating” took on the universal look of inherent evil. But evil
must be proved based on contemporaneous standards; at least with respect to outside-
director Shanahan Jr., the SEC failed to prove it. For example, the SEC’s
documentary evidence showed Shanahan Jr. consistently initialed and
contemporaneously dated documents reflecting that Compensation Committee option-
granting decisions were finalized on a date later than the grant date reflected on the
option certificates. This transparency is not the behavior one would expect from an
intentional or severely reckless violator of the securities laws.

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 Based on the SEC’s case in chief, no reasonable juror could find that Shanahan
Jr.’s participation in the alleged backdating of ESSI stock options posed “a danger of
misleading buyers or sellers . . . so obvious that [he] must have been aware of it.”
Green Tree, 270 F.3d at 654. The SEC’s evidence of scienter fell far short of the
allegations of fraudulent backdating held to be insufficient in Edward J. Goodman
Life Income Trust, 594 F.3d at 790-93. Accordingly, the district court did not err in
granting Shanahan Jr. JAML on the SEC’s § 17(a)(1), § 10(b), and Rule 10b-5 claims.

B. Negligence. Sections 17(a)(2) and (3) of the 1933 Act provide that it is
unlawful in the offer or sale of securities “to obtain money or property” by means of
an untrue material statement of fact or omission, or to engage in any practice or course
of business “which operates or would operate as a fraud or deceit upon the purchaser.”
Like other circuits, we construe the Supreme Court’s decision in Aaron as requiring
proof that a defendant acted negligently to establish a violation of § 17(a)(2) or (a)(3).
See Pagel, Inc. v. SEC, 803 F.2d 942, 946 (8th Cir. 1986); SEC v. Hughes Capital
Corp., 124 F.3d 449, 453, 454 (3d Cir. 1997). In granting judgment as a matter of law
dismissing these claims, the district court explained:

Upon consideration of the standards set forth by the SEC itself
through its proposed instructions, I find these claims must also be
dismissed for a failure of proof. In other words, the SEC presented no
evidence, through expert or lay testimony, documentary evidence or
otherwise with respect to the degree of care that an ordinarily 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.

Finally, and perhaps most importantly, the SEC offered absolutely
no evidence regarding Mr. Shanahan, Jr.’s duties as a member of ESSI’s
Board of Directors and as a member of the Compensation Committee.
Absent this basic framework, once again, the Jury would be left to

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 speculate as to whether a duty existed on the part of Mr. Shanahan, Jr.,
and, if it did, whether he failed to perform that duty.

On appeal, the SEC argues that ESSI’s alleged backdating was “clearly”
contrary to the plain language of the OPS, and thus “a jury could determine in light
of their common experience in human affairs that Shanahan Jr. recklessly or
negligently departed from a reasonable course of action.”6 But, as we have explained,
the SEC failed to prove that the OPS was unambiguous. Therefore, determining
whether Shanahan Jr. negligently made untrue material statements of fact or
omissions, or engaged in a practice that operated as a fraud or deceit upon purchasers
of ESSI stock, involved complex issues of options accounting; Plan administration;
the intricacies of securities filings; and the proper allocation of responsibilities
between ESSI’s finance and accounting professionals, outside auditors, inside and
outside counsel, Board of Directors, and Compensation Committee. As it is
undisputed that Shanahan Jr. was an outside director who had no personal expertise
in these matters, that ESSI complied with the accounting principles known at that time
to apply, and that no one alerted Shanahan Jr. to any possible concern over ESSI’s
manner of dating and pricing options issued under the Plan, we agree with the district
court that the SEC’s failure to present any evidence that he nonetheless violated an
applicable standard of reasonable care was fatal to its case.

III. Issuing false or misleading proxy solicitations: § 14(a) & Rule 14a-9

Section 14(a) of the Securities Exchange Act provides that it is unlawful to
solicit a proxy respecting any registered security in contravention of SEC rules and
regulations. SEC Rule 14a-9(a) provides that no proxy statement may contain any

6
Shanahan Jr. admitted that his position as ESSI director entailed a fiduciary
duty to shareholders. A director’s duty of care “is that which ordinarily prudent and
diligent men would exercise under similar circumstances.” Boulicault v. Oriel Glass
Co., 223 S.W. 423, 426 (Mo. 1920) (quotation omitted).

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false or misleading statement or omission with respect to a material fact. Section
14(a) “was intended to promote the free exercise of the voting rights of stockholders
by ensuring that proxies would be solicited with explanation to the stockholder of the
real nature of the questions for which authority to cast his vote is sought.” TSC
Indus., Inc. v. Northway, Inc., 426 U.S. 438, 444 (1976) (quotations omitted).

Neither the Supreme Court nor this court has decided whether scienter is an
element of an action brought under § 14(a). See Va. Bankshares, Inc. v. Sandberg,
501 U.S. 1083, 1090 n.5 (1991); Shidler v. All Am. Life & Fin. Corp., 775 F.2d 917,
926 (8th Cir. 1985) (“strict liability is not the appropriate standard of liability”). We
agree with those courts that have concluded that scienter is an element, at least for
claims against outside directors and accountants. See Adams v. Standard Knitting
Mills, Inc., 623 F.2d 422, 428 (6th Cir.), cert. denied, 449 U.S. 1067 (1980); Salit v.
Stanley Works, 802 F. Supp. 728, 733 (D. Conn. 1992). As the SEC failed to prove
scienter, that is reason enough to affirm the district court’s dismissal of these claims.

Alternatively, we agree with the district court that the SEC failed to prove a
negligent violation of § 14(a) and Rule 14a-9 by Shanahan Jr. Whether Shanahan Jr.
as outside director exercised reasonable care in overseeing the solicitation of proxies
is not the same question as whether he exercised reasonable care in overseeing the
disclosure of ESSI’s stock-option granting practices to investors. Issues of materiality
may well be different, and it may be reasonable to expect an outside director to
recognize a misleading proxy solicitation, even if he has no experience with the
intricacies of administering stock-option plans. But the SEC’s proof made no attempt
to address these distinctions and did not counter Shanahan Jr.’s undisputed testimony
that he did not draft the proxy statements, believed the statements were truthful and
accurate, did not perceive that the OPS might be misleading in light of ESSI’s options
dating and pricing practice, and was never made aware of any reason to be concerned
that this practice was not fully disclosed.

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 On this record, we agree with the district court that, absent probative evidence
regarding Shanahan Jr.’s duties as outside director and member of the Compensation
Committee, the jury could only speculate as to whether he failed to exercise
reasonable care in overseeing ESSI’s proxy communications with shareholders. The
evidence at trial established, during the time in question, serious debate among
accounting professionals as to the appropriate manner in which to price employee
stock options, and academic debate surrounding the propriety of retrospectively priced
options. Compare Shidler, 775 F.2d at 927 & n.14 (upholding a finding that
defendants were not negligent in soliciting proxies for a merger using a voting
procedure later determined to violate an ambiguous Iowa statute).

IV. Aiding and Abetting: § 20(e)

To establish aiding and abetting liability under § 20(e) of the Securities
Exchange Act, the SEC must prove (1) a primary violation of the securities laws; (2)
“knowledge” of the primary violation on the part of the alleged aider and abettor; and
(3) “substantial assistance” by the alleged aider and abettor in achieving the primary
violation. K&S P’ship v. Cont’l Bank, N.A., 952 F.2d 971, 977 (8th Cir. 1991), cert.
denied, 505 U.S. 1205 (1992). “Negligence . . . is never sufficient,” and “a bare
inference that the defendant must have had knowledge” of the primary violator’s
transgressions is insufficient. Camp v. Dema, 948 F.2d 455, 459 (8th Cir. 1991)
(quotation & citation omitted).7 Here, even if we assume a primary violation of
§ 13(a) of the Securities Exchange Act and Rules 12b-20 and 13a-1 by ESSI based
upon the presence of the OPS in its shareholder-disclosure documents, the SEC’s

7
Section 20(e) of the Securities Exchange Act has recently been amended to
include liability for persons who “recklessly provide[] substantial assistance to another
person in violation of a provision of this chapter.” See Dodd-Frank Wall Street
Reform and Consumer Protection Act, Pub. L. No. 111-203, § 929O, 124 Stat. 1376,
1862 (July 21, 2010), codified at 15 U.S.C. § 78t(e). This amendment, however, is
not applicable to this appeal.

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failure to prove that Shanahan Jr. was severely recklessness or negligent regarding the
parallel violations alleged against him was also a failure to prove “knowledge” of
ESSI’s alleged primary violations. Therefore, the district court’s dismissal of the
§ 20(e) claim must be affirmed.

V. The District Court’s in Limine Ruling

Prior to trial, the district court granted Shanahan Jr.’s motion in limine to
exclude any reference to an Incentive Stock Option Agreement between Shanahan Sr.
and ESSI granting Shanahan Sr. 10,000 additional stock options per point each time
ESSI’s stock closed above its previous record high. When initially proposed by
Shanahan Jr. in June 1998, the Agreement was characterized by the chairman of the
Compensation Committee as “ridiculous” because it “would end up [granting options
for] more stock than we had outstanding.” Nevertheless, the SEC contended, the
Agreement was implemented in 2001, without appropriate proxy statement
disclosures, resulting in Shanahan Sr. receiving options to acquire 1.2 million shares
in 2001 and 2002, twenty times more than he received in 1997. The district court
granted the motion in limine under Rules 404(b) and 403 of the Federal Rules of
Evidence, explaining that any alleged impropriety was not “sufficiently similar to the
backdating issues that are at the center of this case,” that the issue risked confusing the
jury, and that it would waste time.

On appeal, the SEC argues that this evidence should have been admitted to
show “motive, intent, plan or scheme, absence of mistake, and to demonstrate
Shanahan Jr.’s active role and substantial influence on the Compensation Committee.”
At the least, the SEC argues, the court abused its discretion in not admitting as
evidence of Shanahan Jr.’s involvement in the backdating of stock options a January
10, 2001 email from Shanahan Jr. to Gerhardt on the subject of “MFS Stock Options
(incentive)” stating:

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 Your calculations seem in line to me as far as the number of shares is
concerned. The option price should be the same as the other options
issued to the group that year. If there was more than one option price
issued, then the average of those prices should be used. Your thoughts?

A district court has broad discretion whether to admit evidence, and we will not
reverse “absent a clear and prejudicial abuse of that discretion.” Hoselton v. Metz
Baking Co., 48 F.3d 1056, 1059 (8th Cir. 1995) (quotation omitted); accord Coast-to-
Coast Stores, Inc. v. Womack-Bowers, Inc., 818 F.2d 1398, 1403-04 (8th Cir. 1987).
Here, the Agreement touched on several complex, collateral matters, including
whether it ever became part of Shanahan Sr.’s employment contract. There was no
clear abuse of discretion in excluding it under Rule 403. Moreover, the Agreement
and the email in question would have been cumulative to other evidence showing
Shanahan Jr.’s involvement in administering the employee stock option Plan and
would not have cured the deficiencies in the SEC’s proof of recklessness and
negligence. Accordingly, any abuse of discretion was not prejudicial.

The judgment of the district court is affirmed.
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