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What We Can Learn From the SEC's Lawsuit Against Elon Musk


By Steve Jurvetson from Menlo Park, USA - Elon Musk Closing the 2016 Tesla Annual Shareholders' Meeting, CC BY 2.0, https://commons.wikimedia.org/w/index.php?curid=50670252

UPDATE: Charges against Elon Musk have been settled. Highlights of the settlement include:

  • "Musk will step down as Tesla’s Chairman and be replaced by an independent Chairman. Musk will be ineligible to be re-elected Chairman for three years;

  • Tesla will appoint a total of two new independent directors to its board;

  • Tesla will establish a new committee of independent directors and put in place additional controls and procedures to oversee Musk’s communications;

  • Musk and Tesla will each pay a separate $20 million penalty. The $40 million in penalties will be distributed to harmed investors under a court-approved process."

The Tweets that Lead to the SEC’s Complaints

A few days ago, September 27, 2018, the SEC filed a lawsuit against Elon Musk for committing securities fraud because of some tweets he published on August 7, 2018. He tweeted the following: “Am considering taking Tesla private at $420. Funding secured.”As a follow-up to his initial tweet, Musk also tweeted:

  • “Shareholders could [sic] either to sell at 420 or hold shares & go private.”

  • “My hope is *all* current investors remain with Tesla even if we’re private. Would create special purpose fund enabling anyone to stay with Tesla. Already do this with Fidelity’s SpaceX investment.”

  • “Investor support is confirmed. Only reason why this is not certain is that it’s contingent on a shareholder vote.”

Following the tweets, Tesla stock jumped 7%. The SEC alleged that the tweets caused market chaos and harmed investors.

The SEC also alleged that “Musk knew or was reckless in not knowing that each of these statements was false and/or misleading because he did not have an adequate basis in fact for his assertions," and that he “directly or indirectly made untrue statements of material fact and omitted to state material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”

The SEC's Evidence Against Musk

As support for the SEC’s case, it alleged the following:

  • Musk never discussed a going-private transaction with any potential funding source for $420/share

  • He had not investigated whether it was possible for all current investors to remain with Tesla as a private company via a “special purpose fund,” and had not confirmed support of Tesla’s investors for a potential going- private transaction.

  • He also knew that he had not satisfied numerous additional contingencies, the resolution of which was highly uncertain, when he unequivocally declared, “Only reason why this is not certain is that it’s contingent on a shareholder vote.”

  • Musk’s public statements and omissions created the misleading impression that taking Tesla private was subject only to Musk choosing to do so and a shareholder vote.

The Timeline of Events that Lead Up to Elon Musk’s August 7 Tweets

On the days leading up to Musk’s tweets, he had in fact talked to potential investors about going private.

On July 31, 2018, he spoke to a lead representative of a fund (the “Fund”) that recently acquired five percent of Tesla’s common stock. The representative was an authorized decision-maker for the Fund and represented that the Fund was interested in taking Tesla private.

On August 2, 2018, he wrote to his board, CFO and general counsel, “Offer to go private at $420.” The $420 price was based on a 20% premium over the price which Tesla was trading on August 1. On July 31, the stock had closed at $298, but spiked 17% following Tesla’s August 1 earnings report.

According to the SEC, “Musk realized that a spike in Tesla’s share price might make a going-private transaction not feasible because it would require an investor in the transaction to pay a “premium on a spike.””

On August 3, 2018, as a follow-up to Musk’s email, he and Tesla’s board had a conference call. Musk informed the board that the Fund was interested in taking Tesla private and that he wished for Tesla’s current shareholders to remain investors.

At least one board member informed him that it would be very difficult for small shareholders to remain invested if Tesla goes private.

Musk told the board that he wanted to contact shareholders about their interest in Tesla going private. The board approved and asked Musk to report back his findings.

On August 6, 2018, Musk talked to a private equity fund partner about going private. He was informed that to go private, Tesla could have no more than 300 shareholders. Currently, Tesla has over 800 institutional shareholders and many more individual shareholders. Given this, the fund partner informed Musk that his proposed transaction was “unprecedented.”

The August 7, 2018 Tweets and the Aftermath

Despite the uncertainty about whether going private was a possibility, he tweeted to his followers that Tesla was going private at $420 per share and it was only contingent on a shareholder vote.

In addition, public companies are required to notify NASDAQ at least 10 minutes before announcing certain corporate events, such as going private, but Musk made no announcement before tweeting to his followers.

On August 13, 2018, possibly after realizing the egregious mistake he made, Musk posted a blog explaining why he published the offending tweets.

The SEC Seeks the Ultimate Punishment for Musk

As punishment, the SEC seeks orders to disgorge of profits plus interest, penalties, and to bar Musk from ever serving as an officer or director of any public company again.

For some corporate executives, monetary penalties may be par for the course of doing business, but a bar from serving as an officer or director of a public company is devastating to blow to any corporate executive’s career.

As such, it is important to learn from the SEC’s lawsuit against Elon Musk to ensure that you do not upend your startup career before you get started.

Key Takeaways in the SEC Lawsuit Against Elon Musk

For some corporate executives, monetary penalties may be par for the course of doing business, but a bar from serving as an officer or director of a public company is devastating to blow to any corporate executive’s career.

The SEC’s complaint against Elon Musk is a good case study in how easy it is to violate securities laws and how severe the consequences can be.

As such, it is important to learn from the SEC’s lawsuit against Elon Musk to ensure that you do not upend your startup career before you get started.

1. Anti-Fraud Provisions Are Easy to Trigger

The SEC charged Elon Musk under Section 10(b) of the Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 thereunder.

What the Anti-Fraud Rules Say

These rules prohibit any direct or indirect “use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,”

  • To employ any device, scheme, or artifice to defraud,

  • To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

  • To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

What the Anti-Fraud Rules Mean

You Can Violate the Anti-Fraud Rules with Indirect Statements of Fact and Omissions of Fact

Under Section 10(b) and Rule 10b-5 of the Exchange Act, you can violate the anti-fraud rules even if you make indirect statements of material facts that are untrue or omit material facts that would make a statement not misleading.

For example, if Elon Musk linked to someone else’s twitter post about Tesla going private at $420 per share, that would be an indirect statement of fact.”

If he did not correct this statement with clarifying information such as the share price hasn’t been discussed and whether going private is even a possibility, it would be an omission of material facts, and thus, a violation of the anti-fraud rules.

You Don’t Have to Know That You Are Making a False or Misleading Statement

You don’t even have to know that you are making a false or misleading statement as long as you are reckless in not knowing.

Musk was in fact contemplating going private at $420/share and had been discussing this with potential investors and even his board.

However, he didn’t do any additional investigation to determine whether this was in fact possible, which suggests that at best, he was reckless in not knowing, which violates the anti-fraud rules.

2. Consequences for Securities Violations Are Severe

Possible Consequences for Securities Law Violations

The SEC can seek various penalties against those who violate the federal securities laws, such as disgorgement, civil penalties, and jail.

The SEC Seeks the Ultimate Civil Sanction Against Musk

In the case against Elon Musk, the SEC sought the ultimate sanction: an order ousting him from his current company and from ever serving in another on the board or as an executive of any public company.

If the SEC wins its lawsuit against Musk, it doesn’t merely affect his role at Tesla, it can prevent him from taking an executive or board position in any company and even owning over a certain percentage of voting stock in any company, public or private.

Under the Bad Actor Disqualification Rules, Companies That Are “Bad Actors” or Have Certain Affiliations with “Bad Actors” Will Face Bleak Obstacles Raising Money

The federal securities laws have “bad actor rules” that prevent companies that are lead by bad actors or where bad actors own 20% or more of a company’s voting shares from relying on certain securities exemptions from raising money, including Rule 506 of Regulation D, one of the most relied-upon exemptions for private companies to raise substantial—and unlimited—amounts of capital.

The bad actor disqualification provisions also apply to Regulation A and Regulation Crowdfunding, which takes another two exemptions off the table for raising money, forcing an issuer that is a bad actor or has certain affiliations with one to rely on a different exemption for raising money.

In Musk’s case, if the SEC prevails in its lawsuit against him, it could jeopardize his career at Space X. If Space X ever wants to raise funding, given Musk’s role as CEO, it would prevent Space X from raising funding under many exemptions absent a waiver. Similarly, if Musk owns more than 20% of SpaceX’s voting shares, SpaceX will face similar obstacles raising money. In addition, if it wants to go public, Musk would have to resign as CEO.

Perhaps given Musk’s clout, Space X can raise capital using Regulation S, which doesn’t have bad actor disqualification provisions. However, most emerging startups do not have Elon Musk’s celebrity status or connection to possible sources of capital.

A startup affiliated with a bad actor may have to forego all investment funding in the United States, leaving the startup to obtain investments from foreign investors or through other means of funding, such as bank loans. However, this assumes that those funding sources do not have similar restrictions against bad actors, which it may.

3. You Must Be Careful About How You Communicate With the Public, Especially if the Subject of Your Communication Involves Securities

Finally, the SEC’s lawsuit against Elon Musk reminds us that it is important to be careful about how you communicate with the public, especially if you are raising money or or discussing your securities in any way.

Before making such communications, especially in a public forum, you should run your communications by a qualified securities lawyer to ensure that the communications are permissible.

For blockchain startups, this includes selling tokens that, based on its features alone would not qualify as securities. One miscommunication with a potential buyer may cause him or her to think that you are selling a security, making you subject to securities laws.

In the SEC’s complaint against Musk, it alleged that he did not run his tweets by Tesla’s GC before tweeting them. If he did, the GC certainly would have advised Musk against tweeting.

The time to review a communication is before it is made, not after. Once a communication is made, it is too late. When Musk attempted to take back his August 7 tweets in a blog post on August 13, it was already too late.

We have reviewed communications on behalf of our clients to advise them whether they are compliant with securities laws and have helped our clients craft compliant communications and we’d love to help you to!

To schedule a free strategy session, click here.

This article is provided for informational purposes only and should not be construed as legal advice. Read our disclaimer here.

#securities #SEC