Tesla Shareholders Ask Ninth Circuit for Reinstatement of Lawsuit Against Elon Musk for Short-Swing Trading
Elon Musk, the eccentric billionaire and aspirant Tony Stark, could find himself back in court after Tesla shareholders have asked the Ninth Circuit Court of Appeals to reinstate their claims against him. (Peter Hayes, Bloomberg Law). The shareholders allege that Mr. Musk personally profited off of a short-swing trade involving Tesla’s acquisition of SolarCity. Id. In July, a federal trial court had dismissed the shareholder’s lawsuit on the grounds that Musk could not be sued under federal securities laws for his actions. Id. The shareholders subsequently filed an appeal the following month. Id. This post will examine Tesla’s acquisition of SolarCity, the role that Elon Musk holds in each company and what the shareholder lawsuit is challenging.
Tesla is an automotive and electric company that was founded in 2003 with the hope of manufacturing a new generation of electric cars. (Tesla). Elon Musk is the founder and CEO of the company. Id. Since its inception, Tesla has evolved from producing strictly high-end sports cars to more economical car models to other forms of solar power generation and storage. The company went public in 2010 and has since seen its stock price grow over 1,000% in the past nine years. (SEC S-1 Filings). SolarCity was founded in 2006 by Peter and Lyndon Rive, and by 2013 was America’s largest residential solar installer. (Jacob Marsh, EnergySage). The Rive brothers, cousins of Elon Musk, credit their idea for SolarCity to a suggestion made by Musk. (Daniel Gross, Slate).
On November 21, 2016, Tesla finalized a $2.6 billion acquisition of SolarCity following approval by the boards of both companies. (Andrew Hawkins, The Verge). Musk believed the merger would allow both companies to better scale their battery and solar energy operations. Id. The deal was surrounded by skepticism from shareholders, as Tesla was already cash-strapped and the acquisition of a company that suffered from the same problem of high capital burn and low profitability posed a significant risk. A lawsuit over the acquisition alleged that Musk had overstepped his bounds by acquiring SolarCity and had not acted in the best interests of Tesla shareholders. (Jackie Wattles, CNN Money). The lawsuit is currently ongoing, and last year the Supreme Court of Delaware denied an interlocutory appeal for Musk’s motion to dismiss. (Musk v. Arkansas Teacher Retirement System, No. 221, 2018 WL 2072822 (A.3d May 3, 2018)).
Additionally, there were serious conflicts of interest issues surrounding the acquisition of the solar company. At the time of the merger, Musk was the largest shareholder of SolarCity, owning a 20% stake in the company and occupying a seat on the board of directors. (Bethany McLean, Vanity Fair). Musk’s brother, Kimbal, along with several investors, sat on the boards of both Tesla and SolarCity. Id. One judge in the matter found that it was “reasonably conceivable” that Musk effectively had control over the Tesla board and pushed for the acquisition. (Bethany McLean, Vanity Fair).
The current lawsuit, brought by shareholders John Olagues and Ray Wollney, alleges that Musk violated Section 16(b) of the Securities and Exchange Act of 1934, by realizing profits from an alleged “short-swing trade.” (Peter Hayes, Bloomberg Law). Articulated in Section 78p of the United States Code, the prohibition on short-swing trade profit is a strict-liability rule that requires the “trader to disgorge all profits realized on all purchases and sales within the specified time period [6-months], without proof of actual abuse of insider information, and without proof of intent to profit on the basis of such information." (15 U.S.C.A. § 78p (West 2011); Roth v. Reyes, 576 F.3d 1077, 1079 (9th Cir. 2009)). Simply put, corporate directors like Musk, are usually prohibited from acquiring their companies’ stock and then selling it within a 6-month period. Congress recognized that corporate insiders have greater access to material information that might not be available to the general public, and thus have an advantage to capitalize on short-term profits. (See Foremost-McKesson, Inc v. Provident Sec. Co., 423 U.S. 232, 243 (1976)). There are some exceptions to Section 16(b) that are provided in the Code of Federal Regulations under Section 16b-3. (17 C.F.R. § 240.16b-3).
Musk received 2.4 million shares of Tesla for his 22 million shares of SolarCity in the stock-for-stock acquisition. (Mary Anne Pazanowski, Bloomberg Law). After the acquisition was completed, Musk’s decision to subsequently sell shares of Tesla for a profit is what Mr. Olagues and Mr. Wollney believe violated the securities prohibition on short-swing trades. If found guilty under the statute, Must would be required to surrender any profit realized from the short-swing trade back to Tesla. (15 U.S.C.A. § 78p (West 2011)).
Musk responded, successfully in District Court, that any profits he had realized in the sale of Tesla shares after the merger were exempt from the short-swing trade law under Section 16b-3(d)(1) of the U.S. Code of Federal Regulations. (17 C.F.R. § 240.16b-3; Mary Anne Pazanowski, Bloomberg Law). The exception states that if the transaction is approved by the board of directors for the issuing company, it is then exempt from legal scrutiny under Section 16(b). Id. The District Court accepted this argument because the SolarCity-Tesla merger, the transaction that lead to Musk’s acquisition of Tesla shares, was approved by the board of directors. Id. The court decided to dismiss the plaintiff’s complaint on those grounds. Id. This current case is the appeal to that District Court dismissal. (Peter Hayes, Bloomberg Law).
This case is significant because it further highlights a constant stream of negative press surrounding Musk, who is viewed as an unconventional CEO. In the last year, the SEC filed a motion to hold Musk in contempt of court after he violated an agreement requiring him to submit any tweets to in-house counsel for review. (Lora Kolodny, CNBC) The National Labor Relations Board filed a complaint in August of last year accusing Musk of violating labor laws with a tweet about his employees’ decision to unionize. Id. Musk is also being sued for slander after referring to a rescuer of the Thai boys’ soccer team as a pedophile. Id. Since 2010, these actions are just a small sample of those filed against Musk, along with another 38 securities actions pending against Tesla and Musk.”. Id.
Moving forward, the implications of this short-swing trading lawsuit are serious for any shareholder of Tesla. The stock has already taken a serious beating because of Musk’s tussle with the SEC over his tweets. Shareholders, having witnessed the removal of Uber founder and ex-CEO Travis Kalanick, could be motivated to pursue the removal of Musk from his management position. With an already short lease, it is hard to think that any more securities law convictions would be acceptable to the board of directors at Tesla or the company’s shareholders.