A couple of weeks ago, the SEC unveiled a civil lawsuit against Elon Musk, alleging that the three tweets he made on August 7 constituted “false and misleading statements”. These are violations of Section 10(b) of the 1934 Exchange Act and Rule 10b-5 thereunder.
Musk quickly agreed to settle the charges, which includes paying a $40 million fine to be distributed to “harmed investors”, and to step down as Chairman – but not CEO.
The SEC lawsuit is a possible precursor to even bigger problems for Musk – an alleged criminal investigation by the Department of Justice.
The SEC lawsuit’s most serious prayer for relief was barring Musk from running Tesla. So far, Tesla shareholders have dodged a bullet, for the company to lose its Emperor -- the Rent-Seeker of the Century, The Greatest Showman, The Great Snake Oil Salesman – would be devastating. Musk’s ability to scare up capital and grab government handouts has no equal.
Despite the SEC settlement, the government has a possible and more serious second bite at the apple with the alleged criminal inquiry.
For Tesla shareholders, then, this rumored probe creates uncertainty – even more uncertainty than Tesla’s business alone has.
To analyze the extent of risk, we first must ask “what exactly is the difference between a civil and criminal case in this situation?”
Civil vs. Criminal
In securities cases, the DOJ only tends to prosecute individuals who not only demonstrated clear intent to defraud investors, but demonstrably damaged them by taking money away from them. That’s a general statement, but the idea behind it is that the DOJ has limited resources and it must go after clear-cut cases as opposed to ones that are highly nuanced.
The Securities Act of 1933 and Exchange Act of 1934 actually only require demonstration of intent, but prosecutors may struggle getting a jury to convict if they cannot show there were damages directly associated with the fraud.
Both civil and criminal fraud generally have five components that constitute the burden of proof: There must be 1) Misrepresentation of a material fact 2) made with knowledge of its falsity 3) that was made with intent to induce the victim to rely on the misrepresentation, 4) in which the victim relies upon the misrepresentation, and 5) suffers damages as a result of that reliance.
1) Misrepresentation of a material fact
This could cut either way in any alleged criminal complaint. The SEC, in its complaint, admits that Musk did meet with viable investors. Musk himself, according to the Wall Street Journal, believed the Saudis offered him a verbal okay on a deal. In reading the complaint, Musk may thus have a viable “good faith” defense.
What exactly is a “material fact”? It seems like a slam-dunk that announcing a possible private buyout at $420 would be considered a material fact, but the definition is not so cut and dry.
In Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011), a unanimous SCOTUS decision said that the materiality element of fraud is not a bright-line determination, but that it is only satisfied if there is “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.”
Musk’s statement very likely fits this definition of “material fact”. Since there appears to be no discussion of $420 per share in any communications that the SEC has mentioned, not only was there a misrepresentation, but the idea that he specifically referenced a buyout price would place Musk in a very bad position.
A clever attorney might argue that there so much information about both Musk and Tesla hits the market at any given moment, that Musk’s tweets did not significantly alter the total mix of information viewed by a reasonable investor.
A criminal case will rest more on the idea that there was clear intent to misrepresent.
2) Made with Knowledge of its Falsity
This clause is a corollary to the previous one. If Musk is determined to have had a good faith belief in a going-private transaction, then this portion of the burden will not stand up, either.
If it is determined that Musk did not have a good faith belief in such a transaction, then it follows that he knew what he tweeted was false.
3) Made with intent to induce the victim to rely on the misrepresentation
Here is where there is significant departure between a civil and criminal proceeding.
Did Musk want investors to rely on the alleged misrepresentation? Did he want to drive up the stock to harm short-sellers? Was he trying to enrich himself in the process?
From a civil standpoint, the matter is somewhat difficult to pin down. In most SEC civil enforcement proceedings, there is a pattern of clear behavior to get people to buy a stock – i.e. a pump-and-dump. Musk himself was concerned, according to the SEC, that an increase in the stock price (before he made the tweets) would cost a potential buyer more to execute a buyout. That seems to run counter to the idea of inducing victims to rely on his tweets.
In a criminal case, the DOJ likes cases in which – to be somewhat hyperbolic – there is a Snidley Whiplash rubbing his hands together with an evil plan to dupe investors into buying worthless stock while he sells and gets rich.
That does not seem to be the case here.
4) The victim relies on the misrepresentation
Per the SEC complaint: “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.”
There is little question that this exists in either a civil or criminal case.
5) The victim suffers damages as a result
There’s nuance here that is not easily parsed.
If Musk did not act in good faith, and knew the tweets were false, then the stock fell after he abandoned the going-private narrative. While that is generally enough to be identified as “damages”, a prosecutor cannot rely on a jury to go along with that argument. The stock didn’t go to zero. It still hovered in the low 300’s. Only investors who sold were actually damaged. The stock could still go higher.
The DOJ likes to prosecute cases in which the companies involved are outright frauds, with no products or revenue. That’s not the case here. There’s risk in getting regular jury laymen to feel badly for investors who can afford a $300 stock in the first place.
But whom does the DOJ put on the stand in a court of law who cries their eyes out at losing all their savings? This isn’t Enron. It isn’t a penny stock fraud. The DOJ prosecutors could even think they have a great case, but unless there’s an obvious and relatable victim, there may not be enough to prosecute.
Does it Matter?
The facts, however, may not matter to Tesla shareholders or bondholders. The fact that an SEC lawsuit has now been settled but that a possible criminal probes still exists creates significant additional risk for Tesla investors of all stripes.
Uncertainty. That’s the keystone.
Uncertainty is amplified every time there is another rumor or another leak, or another turn in the case at the preliminary hearing or during discovery or at any other time.
Investors are not only held hostage by uncertainty, but there is very limited and short-term upside available during this period.
Tesla’s underlying business is struggling. The only upside catalysts are some kind of surprises in deliveries or orders, raising additional capital, or a turn in the case. These will be short-term upside spikes.
Bad news is more likely to cause a longer-term selloff, because little pieces of bad news are more likely to continue. Meanwhile, what if the DOJ indicts Musk? Even if he is acquitted down the road or makes a plea, the mere announcement of an indictment and arrest will destroy the stock.
Musk’s Other Businesses
It isn’t just the SEC and alleged DOJ probe that’s problematic. Musk is behaving erratically. Smoking a doobie on The Joe Rogan Podcast was stupid.
Not only that, Air Force regulations may prohibit it. The Air Force has acknowledged the incident but, following a tweet by Fox Business’ Charles Gasparino and a report in TheVerge.com, an Air Force spokeman stated, “It’s inaccurate that there is an investigation. We’ll need time to determine the facts and the appropriate process to handle the situation.” The issue is whether Musk’s behavior violated whatever security clearance he may have.
There’s also the matter of The Federal Acquisition Regulation, Subpart 23.5, “Drug-Free Workplace”, which has requirements as far as any contractor’s behavior is concerned – contractors such as SpaceX.
Section 23.504(b): “No individual shall be awarded a contract of any dollar value unless that individual agrees not to engage in the unlawful manufacture, distribution, dispensing, possession, or use of a controlled substance while performing the contract.”
Cannabis is a Schedule 1 controlled substance according to the DEA. SpaceX can kiss its government contracts goodbye.
Bottom Line: why own any security related to Elon Musk?