On The Case

Elon Musk just made it easier for shareholders to sue Tesla for fraud

(Reuters) - On Monday morning, six days after Tesla CEO Elon Musk tweeted that he was thinking about taking the company private at $420 a share, with “funding secured” for the transaction, Tesla published a blog post in which Musk clarified his tweet.

When he said that funding for the buyout was secured, Musk said, he was referring to a promise he believed he had received from the managing director of Saudi Arabia’s sovereign wealth fund. The Saudi fund, he said, had been encouraging him for nearly two years to use its capital to take Tesla private. At a meeting on July 31, after the Saudis acquired a 5 percent stake in Tesla on the public markets, the fund official told Musk it was too bad the company hadn’t previously worked with the Saudis to take Tesla private, according to Musk. The fund official, Musk said, suggested it wasn’t too late to change that.

“He strongly expressed his support for funding a going private transaction for Tesla at this time,” Musk wrote in his blog post. “I understood from him that no other decision makers were needed and that they were eager to proceed. I left the July 31st meeting with no question that a deal with the Saudi sovereign fund could be closed, and that it was just a matter of getting the process moving. This is why I referred to ‘funding secured’ in the August 7th announcement.”

The market responded to Musk’s blog post by dumping Tesla shares. The share price fell from a high of nearly $363 just after Monday’s opening to a low of $349 at around noon Monday. (Shares bounced back to over $353 on Monday afternoon.)

Musk and Tesla may have been trying to stanch the stream of revelations that has followed Musk’s tweet: The Wall Street Journal’s Aug. 8 report that the Securities and Exchange Commission is investigating Musk’s statement; an August 10 Bloomberg story that Tesla was only in the early stages of devising a plan to fund a go-private deal; and Reuters scoops that the Tesla board hadn’t received a financing plan from Musk before his tweet and that Saudi sovereign wealth fund “has shown no interest” in bankrolling a buyout.

But two plaintiffs’ lawyers who filed shareholder class actions against Tesla on Friday told me Monday that Musk’s blog will make it easier for them to pursue investor fraud claims.

“The blog post is as close as you’re going to get to an admission that funding was not secured when Musk tweeted,” said Reed Kathrein of Hagens Berman Sobol Shapiro, which filed a securities class action against Musk and Tesla on Friday night in San Francisco federal court. “It confirms what we thought.”

Tesla declined to comment in response to an email asking whether Musk’s blog post on Monday will make it easier for investors to claim securities fraud.

The Hagens Berman suit, as well as a similar class action filed about an hour earlier by Keller Lenkner, alleges that Musk’s original “funding secured” tweet and several followup postings artificially inflated the price of Tesla shares. The Keller Lenkner suit claimed Musk was manipulating Tesla’s share price to punish Tesla short-sellers betting against the company’s prospects.

Some short-sellers were so spooked by the spike in Tesla’s share price after Musk’s go-private tweets that they rushed to buy shares to cover their positions. Both Kathrein of Hagens Berman and Travis Lenkner of Keller Lenkner told me many of the hedge funds that have taken short positions in Tesla stock avoided the buying frenzy that followed Musk’s Aug. 7 tweets. Investors who didn’t buy Tesla shares after the Musk tweets cannot be part of the securities fraud class actions because, under U.S. Supreme Court precedent, only investors who trade shares based on corporate misrepresentations – as opposed to investors who just hold their positions – are considered to have been affected by the fraud.

When plaintiffs’ lawyers filed their lawsuits late Friday, they could not cite evidence that Musk knew buyout financing wasn’t actually secure at the time he tweeted that it was. The class actions argued that Tesla’s subsequent statements and actions implied uncertainty about the funding of any go-private deal: Why, for example, would Musk and Tesla now be holding meetings with bankers and other funding sources if the buyout financing were as secure as Musk represented it to be?

Musk’s blog post, Lenkner said, removes any ambiguity. “The statement makes it clear – funding was not secure when Musk tweeted,” he said.

Kathrein said Musk may have posted his explanation about Saudi funding to show that he really believed the money was in place when he tweeted that his financing was secure. In securities class actions, shareholders have to prove defendants acted with the intention of defrauding shareholders. But Kathrein said the U.S. Supreme Court’s 2015 decision in Omnicare v. Laborers District Council Construction Industry Pension Fund holds that corporations can’t pretend statements of fact are unactionable opinions.

The quick drop in Tesla’s share price as the market absorbed Musk’s disclosure, Kathrein said, will also help investors prove that Musk’s original tweet artificially inflated Tesla’s value. The share price corrected itself, under this theory, when Musk’s blog post on Monday revealed the truth that Tesla’s buyout funding is not secured. Stock drops following this kind of “corrective disclosure,” as this is known, are usually at the heart of securities fraud class actions because they allow investors to show the impact of the misrepresentation.

Not just short-sellers are included in the Tesla fraud class actions. Even long-term Tesla investors who bought shares after Musk floated that $420 per share buyout prospect in his Aug. 7 tweet would be part of the investor classes posited in the Hagens Berman and Keller Lenkner suits.

So what was the impact of Musk’s tweet? Both Kathrein and Lenkner estimated that damages could run to $1 billion – though I should caution that it’s way too early to put a definitive number on Tesla’s exposure. Lenkner said his scratchpad estimate is based on the millions of Tesla shares – more than $11 billion worth – traded on Aug. 7 and 8. Even if the share price was inflated by only 10 percent, Lenkner said, the high volume of trading leads to big potential damages.

The first hint of investor losses will come in about two months, when shareholders file briefs vying to lead the fraud litigation against Tesla. Typically, under the 1995 law governing private securities class actions, federal judges appoint the shareholder or group of shareholders with the biggest losses to head up the case. Plaintiffs’ lawyers use a variety of methodologies to calculate damages so it will be interesting to see their assessment of how Musk’s tweet affected share price.

It will also be interesting to see which Tesla investors end up bidding to lead the litigation. The two who have so far filed suits are relatively small investors. One spent about $1 million in Tesla share purchases after Musk’s tweets, the other, about $500,000. But shareholders now have two months to decide whether to compete to be in charge of the case. Lenkner said his firm is in discussions with hedge funds that had larger short positions in Tesla and bought shares to cover a portion of their shorts in the initial run-up following Musk’s tweet.

“Hedge funds that might normally be hesitant to sign up as a lead plaintiff might look at this and see there’s something there,” Lenkner said.

(Editor’s note: story has been updated to include Tesla declining comment)