Webb v. SolarCity Corporation: Founders' Conduct Regarding Accounting Error Before IPO Not Sufficient to Prove Scienter

In Webb v. SolarCity Corp., No. 5:14–CV–01435–BLF, 2018 BL 79348 (9th Cir. Mar. 08, 2018), the Ninth Circuit Court of Appeals affirmed the district court’s dismissal of a securities fraud action brought in a third amended complaint (“TAC”) by James Webb (“Plaintiff”), a member of a class of plaintiffs who purchased shares in SolarCity, against SolarCity Corporation and two of its cofounders, Lyndon Rive and Robert Kelly (collectively “Defendants”). The court held Plaintiff failed to adequately plead the scienter element necessary to state a claim under § 10(b) of the Securities Exchange Act of 1943 (“Act”).

According to the court’s factual background, SolarCity is an energy company that sells and leases solar energy systems. The costs associated with leases and sales are accounted for differently in SolarCity’s financials. While installation and overhead costs in each lease are amortized across the entire duration of the lease’s standard twenty-year term, the same costs in each direct sale are realized at the time of sale. SolarCity uses a formula, which divides the indirect overhead costs by the prior and current period direct costs to allocate the appropriate amount of overhead costs between the lease and direct sales systems. 

Plaintiffs alleged between 2012 and 2014 (the “Class Period”), SolarCity erroneously omitted the prior period’s direct costs from the denominator, causing its direct sale costs to be amortized with the costs associated with leases. The error created an artificial increase in SolarCity’s sales margins, though the company still reported net losses. Plaintiff claimed the error intentionally misrepresented SolarCity’s profitability just before its IPO in 2012, violating both § 10(b) of the Act and Rule 10b-5 of the Code of Federal Regulations.

To adequately state a claim under § 10(b) and Rule 10b-5, plaintiffs must prove six elements: (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. Here, the court only addressed the second element. Under 15 U.S.C. § 78u-4(b)(2)(A), scienter can be established when a complaint states facts “giving rise to a strong inference that the defendant acted with the required state of mind.”

The court held the alleged facts did not establish scienter. Plaintiff alleged there was a motive for fraud because SolarCity needed its sales division to appear profitable in order for its IPO to be successful. As additional evidence, Plaintiff proposed the leadership reorganization that occurred at SolarCity shortly before the announcement of the accounting error implied the existence of the scienter element. Plaintiff then noted Defendants’ Sarbanes-Oxley certifications indicated they were knowledgeable about the gross margins of the sales and lease systems. Lastly, Plaintiff contended the record revealed the core operations doctrine allowed an inference that “facts critical to a business’s ‘core operations’ . . . are known to a company’s key officers.”

The court noted that despite Plaintiff’s evidence, the actual conduct of Defendants was inconsistent with scienter. The facts suggested that Defendants took a hands-on approach to managing SolarCity’s sales division, and as a result they became aware of the company’s general unprofitability. Nevertheless, they did not sell any of their stock in SolarCity during the Class Period. Further, Defendants proactively disclosed the error to the public when it was discovered. The court also found Defendants’ actions allegedly indicating motive spoke only about routine corporate objectives rather than a particular fraudulent action. Finally, the court found the incorrect statements only misstated the degree of the company’s unprofitability instead of creating a “facade of profitability.” Resultantly, it was fair to note that the error was not immediately obvious to the Defendants.

For the above reasons, the court concluded that Plaintiff’s narrative of fraud was not more plausible than a non-fraudulent alternative and therefore affirmed the dismissal of Plaintiff’s TAC. 

The primary materials for this may be found on the DU Corporate Governance Website.