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 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: REPORTED BY: CARRIE LIPPOLD DEBORAH A. KRIEGSHAUSER, FAPR, RMR, CRR Official Court Reporter

FOR DEFENDANT:

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

VOLUME 10 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 (Proceedings began at 9:06 AM.) (The following proceedings were held outside the hearing and presence of the Jury:) THE COURT: MR. GASNER: MR. MOYE: Please be seated. Good morning.

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Good morning, Your Honor.

Good morning. Good morning, Your Honor. Let the record reflect the Jury is not in

MR. MARTIN: THE COURT: the courtroom.

This morning I want to read to you my ruling on the Defendant's motion. This matter is before me on Defendant Michael F. Shanahan, Jr.'s Motion for Judgment as a Matter of Law. In

his motion, Mr. Shanahan asserts that after eight days of trial testimony, the SEC has failed to completely show that he acted intentionally with severe recklessness or even negligently in his alleged backdating of options or other wrongdoing. Mr. Shanahan, therefore, asks that I end this

case now and avoid the necessity of submitting this complex matter to the Jury. In its trial brief, the SEC summarized the factual predicate for its case as follows: Quote, "Shanahan, Jr., helped lead a scheme involving other individuals at ESSI to provide unauthorized compensation to Shanahan, Sr., and other ESSI employees and Directors,

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including himself, by falsifying the purported dates on which stock options were granted, and this practice contradicted affirmative statements regarding stock option pricing and executive compensation made in ESSI's proxy statements, Form 10-K annual reports, and Form S-8 registration statements," end quote. The alleged misrepresentations consist of virtually identical language which I will refer to as the "Option Pricing Sentence." Specifically, in Paragraphs 38 and 40 of

its Complaint, the SEC alleges the proxy statements and attached stock option plans, quote, "stated that all options had been granted at an exercise price equal to the fair market value of the stock on the date of the award," end quote, and that, quote, "options granted under the plan would be granted at fair market value on the date of the award," end quote. In Paragraph 43, with respect to Forms 10-K, the SEC alleges that ESSI, quote, "falsely represented that the Company's stock options are granted at an option price equal to the market value on the date the option is granted," end quote. And with respect to the Form -- Forms S-8, the SEC

alleges in Paragraph 45 that the description of stock option plans and the plans themselves, quote, "expressly stated that options under each plan were to be granted at the fair market value of the Company's stock on the date of the award," end quote.

VOLUME 10 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 In the remaining Counts of its Complaint, the SEC

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asserts the following claims for relief against Mr. Shanahan, Jr.: Violations of Section 17(a) of the Securities Act;

Violations of Section 10(b) of the Exchange Act and Exchange Act Rule 10(b)(5); Violations of Section 14(a) of the Exchange Act and Exchange Act Rule 14(a)(9); and Aiding and Abetting ESSI's violations of Section 13(a) of the Exchange Act and Exchange Act Rules 12(b)(20) and 13(a)(1). The SEC has now concluded its evidence, and Mr. Shanahan, Jr., asserts that he is entitled to judgment as matter of law because a reasonable jury would not have a legally sufficient evidentiary basis to find for the SEC on any of its claims. For ease of discussion, I will group

together the claims with related standards. First, Section 17(a)(1), Section 10(b) and Rule 10(b)(5). As acknowledged by the parties, the SEC's claims under Section 17(a)(1), Section 10(b) and Rule 10(b)(5) requires scienter as an element. To show that Mr. Shanahan,

Jr., acted with scienter, the SEC must prove that he possessed a mental state embracing an intent to deceive, manipulate or defraud or acted with severe recklessness. At oral argument

on the motion, the parties focused on recklessness. Recklessness is limited to those highly unreasonable omissions or misrepresentations that involve not merely simple

VOLUME 10 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 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.

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On this, I rely on SEC v. Thielbar and Florida State Board of Education v. Green Tree Financial Corporation. The SEC quotes this standard in its proposed jury instruction. Having considered all the evidence presented in this matter, I find the SEC has not submitted sufficient evidence to submit on these claims. While acknowledging that

Mr. Shanahan, Jr.'s alleged actions must have represented an extreme departure from the standards of ordinary care, the SEC offers absolutely no evidence with respect to the standards of care that would apply in this situation. In other words, the

SEC did not present an expert or a lay witness to discuss the responsibilities and duties of a Nonemployee Director, such as Mr. Shanahan, or any applicable industry practice or custom during the relevant time period, nor did it point to provisions in the stock option plans or other documentary evidence tending to establish such things. Without knowing

what the standards of ordinary care were in this situation, the Jury would be left to speculate with respect to whether Mr. Shanahan, Jr.'s alleged behavior constituted a departure

VOLUME 10 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 from those standards, much less an extreme departure. Furthermore, the SEC presented no evidence that Mr. Shanahan, Jr., knew the alleged omissions or misrepresentations at issue here presented a danger of misleading buyers or sellers. Instead, Steven Landmann, a

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Certified Public Accountant and former ESSI Controller, was the only witness to testify that he was concerned the grant dates were not in accordance with what he perceived the options plan to require, but he also said that he never informed Mr. Shanahan, Jr., of this discrepancy. Finally, with respect to whether the danger of misleading investors was so obvious that Mr. Shanahan, Jr., must have been aware of it, the SEC's own expert, Professor Randall Heron, testified that he understood the Option Pricing Sentence to require that the exercise price be equal to the market price on the date of the Compensation Committee meeting approving the award of options, but then acknowledged that his colleague and close collaborator, Dr. Erik Lie, found that virtually identical language in other stock option plans did not specifically prohibit the grant date from preceding the decision date. When pressed on why Dr. Lie might disagree

with him, Professor Heron suggested it was because Dr. Lie did not have sufficient knowledge of applicable accounting principles, something Mr. Shanahan, Jr., admittedly also lacked.

VOLUME 10 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Finally, adding to the confusion, Steven Landmann, the only other SEC witness with knowledge of accounting principles, did not agree with either interpretation of the Option Pricing Sentence but, instead, interpreted it to mean the grant date did not have to be the same as the decision date but could be a date subsequent to the date on which the Compensation Committee met. In light of these circumstances, I cannot say the alleged misrepresentations or omissions here presented a danger of misleading investors so obviously -- obvious that Mr. Shanahan, Jr., must have been aware of it. The SEC has failed to carry its burden of demonstrating recklessness, and so I will grant his motion with respect to the SEC's claimed violations of Section 17(a)(1), Section 10(b) and Rule 10(b)(5). Turning now to Section 17(a)(2), 17(a)(3) and 14(a) and Rule 14(a)(9).

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For purposes of the instant motion, I will assume the remainder of the SEC's claims in Count I of its Complaint and its claim in Count III of its Complaint are all predicated on the theories of negligence. The SEC defined "negligence" in Quote, "Third,

its proposed jury instructions as follows:

that the Defendant acted negligently, by which I mean he failed to exercise ordinary care. The phrase 'ordinary care'

means that degree of care that an ordinarily careful person

VOLUME 10 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 would use under the same or similar circumstances.

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The degree

of care used by an ordinarily careful person depends upon the circumstances which are known or should be known and varies in proportion to the harm that person reasonably should foresee. In deciding whether a person was negligent or failed to use ordinary care, you must consider what that person knew or should have known and the harm that should reasonably have been foreseen. In determining whether the Defendant was

negligent, it is proper for you to consider whether he exercised reasonable care in obtaining and communicating information and whether he undertook an appropriate investigation before making statements to investors or prospective investors. Further, you should consider the

Defendant's duties as a member of ESSI's Board of Directors and as a member of the Compensation Committee and whether he acted with due care in carrying out those duties." 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

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appropriate investigation before allegedly making statements to investors or prospective investors. Finally, and perhaps more 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 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. And I rely on Lafarge North America, Incorporated v. Discovery Group, 574 F.3d 973. I will, therefore, dismiss Counts 1, II and III of the SEC's Complaint in their entirety. Turning now to Section 13(a), Rules 12(b)(2) and 13(a)(1). To establish its Count VI claim for aiding and abetting, the SEC had to show that the primary party, ESSI, committed a securities law violation and that Mr. Shanahan, Jr., knowingly and substantially assisted ESSI in committing that violation. Again, I will assume for purposes of the

instant motion that the SEC established a violation of the securities laws by the primary party, ESSI. The SEC, thus, was required to show that Mr. Shanahan, Jr., acted knowingly; in other words, with knowledge of a wrongful purpose.

VOLUME 10 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 And I rely on that -- rely on SEC v. Cohen.

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The parties agree that the extent of knowledge that must be shown is flexible. Under Eighth Circuit law in Camp

v. Dema, quote, "A party who engages in atypical business transactions or actions which lack business justification may be found liable as an aider and abettor with a minimal showing of knowledge. Conversely, a party whose actions are routine

and part of normal everyday business practices would need a higher degree of knowledge for liability as an aider and abettor to attach," end quote. Upon consideration of the evidence presented at trial, I find that the SEC has failed to establish that Mr. Shanahan, Jr.'s actions amounted to atypical business transactions or actions lacking business justification. SEC is held to a higher standard, therefore, in proving Mr. Shanahan, Jr., had the requisite degree of knowledge to be held as an aider and abettor. Once again, however, I find the SEC has failed to meet its burden. As I've stated, of the SEC's witnesses, only The

Steven Landmann testified that even he knew the options were retrospectively priced, let alone that such pricing was wrongful, and he specifically testified he never disclosed his concerns to Mr. Shanahan, Jr. Mr. Shanahan, Jr., himself

certainly never testified he knew about the alleged options backdating. Furthermore, in light of the SEC's own witnesses'

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testimony highlighting the confusion surrounding the Options Pricing Sentence, together with Mr. Shanahan, Jr.'s admitted lack of knowledge of accounting principles, I find no evidence that he would have appreciated the wrongfulness of the activities even if he had known of them. For these reasons, I will grant Defendant Michael F. Shanahan, Jr.'s Motion for Judgment as a Matter of Law and dismiss the SEC's Complaint in its entirety. At this time we will -- I'll bring in the Jury and dismiss the Jury. (Jury seated by the Clerk.) (The following proceedings were held within the hearing and presence of the Jury:) THE COURT: good morning. THE JURY: THE COURT: Good morning. I apologize for the delay. As I Please be seated. Ladies and Gentlemen,

mentioned yesterday when I -- when we recessed, I mentioned to you that I had a number of issues, some legal matters to take up with the attorneys, and we did work on that all afternoon. And as a result of some rulings that I made and have communicated to the attorneys, the case will not need to be presented to a jury, and so we will no longer need your services on this case. I want to express my deep appreciation to all of you.

VOLUME 10 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 jurors. THE CLERK: THE COURT: All rise. This Court is in recess.

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This was a very complex case, a very difficult case, and you all have been extraordinarily attentive, and I appreciate that very much. given us. to work. Again, thank you very much for your service as So we do appreciate the assistance that you have And at this time you are free to go on home, back

(Court adjourned at 9:23 AM.)

VOLUME 10 CERTIFICATE

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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

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