Tai Jan Bao v. SolarCity Corporation: Accounting Practices Lead to Securities Fraud Claim
In Tai Jan Bao v. SolarCity Corporation, No. 14-cv-01435-BLF, 2016 BL 2378 (N.D. Cal. Jan. 05, 2016), the United States District Court for the Northern District of California granted SolarCity, Chief Executive Officer Rive, Chief Financial Officer Robert Kelly, and Chairman of the Board of Directors Elon Musk’s (collectively, “Defendants”) motion to dismiss a complaint filed on behalf of purchasers of SolarCity common stock (“Plaintiffs”).
According to the allegations, SolarCity Corporation derived revenue in two ways: renewable twenty-year leases of solar energy products, and sales of solar energy systems. Between December 2012 and March 2014 (“Class Period”), SolarCity’s accounting formulas shifted overhead costs from sales to leases. This enabled SolarCity to amortize costs over a twenty-year period, allowing the corporation to post consistent sales profit during the Class Period. SolarCity filed restated financials in March 2014, showing SolarCity had a negative gross margin for six affected quarters.
The Plaintiffs claimed Defendants committed securities fraud in violation of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 (“Act”) by shifting overhead costs from sales to leases. Specifically, Plaintiffs alleged the Defendants deliberately manipulated accounting formulas to portray profitability and secure financing. The Plaintiffs also sought to hold Chairman Musk jointly and severally liable under Section 20(a) of the Exchange Act.
A successful securities claim under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 requires the plaintiff show: (1) a material misrepresentation or omission by defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation. To successfully plead scienter, the plaintiff must show a defendant made false or misleading statements either intentionally or with deliberate recklessness.
In seeking to show a “strong inference” of scienter, Plaintiffs relied on statements by eight confidential witnesses (“CWs”). To satisfy pleading requirements, confidential witnesses must describe events with sufficient particularity to establish reliability and personal knowledge, and indicate scienter. While Plaintiffs provided confidential witnesses in an effort to show Defendants knew or deliberately ignored the accounting error, the court found the CW’s statements were too “conclusory, speculative, and/or vague to hold weight.” Specifically, the court noted “most glaringly, not a single “most glaringly, not a single confidential witness alleges that Defendants knew of accounting error central to this case.” Nor did the evidence give rise to “core-operations inferences.”
The court then held Musk was not jointly and severally liable. To hold the individuals joint and severally liable, a plaintiff must prove a primary violation of federal securities laws where the “defendant exercised actual power or control over the primary violator” by providing specific facts showing specific control over a company’s “preparation and release of allegedly false and misleading statements.”
Plaintiffs claimed Chairman Musk should be held jointly and severally liable because he maintained the power to direct or cause the direction of management or policies of SolarCity. Plaintiffs argued Musk exercised actual authority, where he signed financial documents, was related to SolarCity’s officers, owned outstanding shares, and because, as CEO Rive explained, Musk “instruct[ed] [Rive] to swerve into a pothole” to avoid invisible walls. Musk may have been a “visionary” but such status did not “suffice to show Musk’s control over SolarCity.”
Accordingly, the court dismissed all claims under Section 10(b) and Rule 10b-5 with leave to amend, and dismissed the Section 20(a) claim against Musk without leave.
The primary materials for this case may be found on the DU Corporate Governance website.