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SEC Sues Elon Musk: What That Means For Tesla

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Here’s the tweet from Aug 7 that got the charismatic and somewhat eccentric CEO of Tesla (TSLA - Free Report) in trouble with the SEC:  “Am considering taking Tesla private at $420. Funding secured.”

This sent shares up as people scrambled to get ahead of the deal that inevitably raises prices in such cases. Musk’s subsequent tweet about the change in plans sent shares down, hurting some investors. Short sellers were the worst impacted, because they borrow shares to sell them and only buy later to repay the lender when prices go down. So the rise in prices forced them to buy at higher prices.

"Unlike market participants reading his tweets, Musk knew that his ostensibly 'secured' funding was based on a 30 to 45 minute conversation regarding a potential investment of an unspecified amount in the context of an undefined transaction structure," the SEC complaint filed in the Southern New York District Court charging him of fraud reads. "As a result of Musk's false and misleading statements and material omissions, investors who purchased Tesla stock in the period after the false and misleading statements but before accurate information was made known to the market were harmed.”

The SEC seeks financial penalty and his bar from directorships in any public companies.

Tesla maintains that there was no wrong doing because Musk probably thought that the communication was enough, that it didn’t result in any financial gains to him and that he was likely later convinced by the fund to change his mind.

Implications for Musk

The SEC’s allegation is serious giving rise to civil proceedings against Musk. The DoJ has also asked Tesla for documents and the company said that it was cooperating with the department. The DoJ entering the picture would mean criminal proceedings. So let’s see what the government needs to prove in order to convict him of fraud-

Fraud in legal terms is understood to mean, “A false representation of a matter of fact—whether by words or by conduct, by false or misleading allegations, or by concealment of what should have been disclosed—that deceives and is intended to deceive another so that the individual will act upon it to her or his legal injury.”

So fraud must be proved by showing that the defendant's actions involved five separate elements: (1) a false statement of a material fact, (2) knowledge on the part of the defendant that the statement is untrue, (3) intent on the part of the defendant to deceive the alleged victim, (4) justifiable reliance by the alleged victim on the statement, and (5) injury to the alleged victim as a result.

In light of this definition, Musk’s statement that he was “considering taking Tesla private” seems significant because he never said that it was a done deal. So the following part saying “at $420. Funding secured.” would mean that if he did take the decision, it would be at $420 a share. It also seems to indicate that the funding part was more certain than his decision.

Moreover, his actions didn’t show that he was trying to make the most of the impact of false information on share prices, i.e., he didn’t use the subsequent price increase to sell any shares.

So it doesn’t look like he was deliberately making a false statement to deceive anybody.

As regards the question of justifiable reliance on his statement, there seems to be two ways to think about it. Coming from the CEO and the kind of CEO that is synonymous with the company itself, investors can assume the statement to be true. It isn’t as clear however whether they were justified in acting on the statement without checking with the company or getting him to confirm the statement (since the tweet looks ambiguous) as a part of due diligence.

The SEC guidelines from 2013 say that using social media like Twitter (TWTR - Free Report) and Facebook (FB - Free Report) to communicate with investors is valid as long as investors are informed that the company is using that method of disclosure. In Tesla’s case, management said in a press release also in 2013,“please follow Elon Musk’s and Tesla’s Twitter accounts” for additional information, indicating that the company was using that method to disclose information to investors.

Musk has however been routinely blocking people for their negative comments on him and/or Tesla, amounting to the flouting of Reg FD rules about broad, non-exclusionary distribution of the information to the public. So in effect, he has been treating his Twitter handle as a personal account instead of a corporate account, which explains his loose, informal statements. And this is the real problem since it boils down to a question of responsibility.

While he may not be guilty of fraud, Musk definitely looks irresponsible here, which may cost him his role at Tesla, and possibly bar him from future directorships.

Implications for Tesla

This is bad news.

To expand further, Tesla the stock is not worth a whole lot without Musk. It is the leader’s vision, ambition, work and drive that makes Tesla what it is. Even the PR machinery is all about Musk. So pushing Musk from the scene is bad for the company and its investors, and the biggest overhang on Tesla stock. See the action over the past week-

We have no idea about the leadership depth at the company, but judging from the way Musk functions, it isn’t much.

Tesla is in the middle of an important product ramp that would definitely be disrupted without the person heading the effort.

As regards fund raisings, Musk has been instrumental on this front but some investors have been wary of his eccentricities and without him, they may be persuaded to consider Tesla.

Recommendation

Tesla shares have a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

 

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