By approving misdated stock option grants, the ex-CEO of Engineered Support Systems profited by $8.9 million with the full support of a compensation-committee member — who also happened to be his son — according to the Securities and Exchange Commission.
On Thursday, the SEC charged ESSI founder and former chief executive Michael Shanahan Sr., and Michael Shanahan Jr., a former compensation committee member, with taking part in a backdating scheme over six years that gave undisclosed, in-the-money stock options to themselves and other officers, employees, and directors. One of officers was the CFO, who is facing criminal charges.
The SEC also accused Shanahan’s son of personally profiting from the scheme by $379,738. Now the CEO of brokerage firm Huntleigh McGehee, Shanahan Jr. was a director and member of ESSI’s compensation committee from 1994 to January 2006, when DRS Technologies bought ESSI.
On at least 10 occasions from 1997 to 2002, the measurement dates of stock option grants were backdated under the Shanahans’ watch. In some cases they were “double-backdated” — meaning they were initially misdated, later canceled, and reissued when the stock price reached a new low — the SEC alleges.
As the CEO of ESSI, Shanahan Sr. was ultimately responsible for authorizing all of the stock option awards until he retired in May 2005, the SEC notes in its complaint. Further, he personally signed about 300 falsely dated option award letters. His son also allegedly considered himself similarly responsible for the company’s stock option granting process. The SEC claims Shanahan Jr. said “you’re looking at it” when asked whether ESSI had a compensation committee.
Arthur Margulis, Shanahan Sr.’s attorney, told CFO.com he has not yet had a chance to read through the SEC’s 24-page submission with the U.S. District Court for the Eastern District of Missouri. However, “my preliminary review makes it apparent that there are flaws and misstatements in the complaint,” he said.
The attorney for Shanahan Jr., James Martin, was similarly critical of the SEC’s charges. “I have not seen evidence that there was any intent to defraud. In fact we have documentation that shows the opposite,” he told CFO.com.
The commission alleges that ESSI issued stock options with a lower exercise price than the worth of the company’s common stock on the dates the options were awarded. While that action itself isn’t considered illegal, it went against the company’s policy and was not disclosed to shareholders, according to the SEC.
In total, ESSI employees and directors received about $20 million in unauthorized and undisclosed compensation, the SEC says. The Shanahans “knew, or were reckless in not knowing, that these representations were false and misleading,” the SEC wrote in its complaint.
In effect, by not taking a compensation expense of $9.8 million in its 2002 financials, ESSI overstated its pretax operating income by 25 percent.
Besides the alleged backdated profits pocketed by the Shanahans, Gary Gerhardt, the company’s former CFO, gained $1.9 million, the SEC says. Gerhardt, who was recently indicted on 10 counts of backdating and claims what he did was not illegal because ESSI’s audit firm, PricewaterhouseCoopers, knew about the incorrect dates. Therefore, Gerhardt contends, the backdating was disclosed.
Federal prosecutors have accused Gerhardt of telling his controller, Steven Landmann, to backdate stock options on eight occasions between December 1996 and August 2002. Landmann has pleaded guilty to one charge of making false statements in an annual report and settled SEC charges. He is expected to testify against Gerhardt, who also faces SEC charges.
In the case against the Shanahans, the SEC alleges that Shanahan Jr. instructed Gerhardt on which measurement dates to use for some of ESSI’s stock option awards. For example, on July 16, 2002, Shanahan Jr. sent an E-mail to Gerhardt to mark four executives’ stock options at the lowest point of ESSI’s stock price that quarter, which had been July 14. When the stock price fell again less than 10 days later, Shanahan Jr. allegedly asked Gerhardt to revise the stock option dates to July 24. The option certificates were ultimately issued on August 9.
ESSI also participated in so-called double-backdating, which sometimes resulted in little profit to company officials, according to the SEC’s version of events. In 1999, ESSI canceled stock options granted on April 21 that had fallen out of the money by 6 cents on July 15. In mid-July the company reissued the options with the new grant date of July 1, when the common stock had been at the lowest point that year. Because of the re-repricing, the options were then worth $169,500 more than the stock’s market price.