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Fraud in 280 Characters or Less: SEC Enforcement and the Privatization Process


Credit: EU News


Introduction

Tesla CEO once dubbed “Teflon” Elon, for his ability to escape unscathed from legal fights, wins again. On February 3, 2023 a federal jury returned a verdict clearing Elon Musk of defrauding investors in his 2018 tweet about potentially taking Tesla private. The infamous tweet stated "Am considering taking Tesla private at $420. Funding secured." Funding in fact was not secured, but it took the jury just two hours to clear Musk and Tesla of the claims, holding the “Teflon” Elon moniker true again. So why did Musk prevail? If Musk’s tweet didn’t amount to securities fraud, then what does? If he had funding secured, what does going private actually entail?

Securities Fraud

A security typically refers to an instrument, such as a note, stock, bond, or transferable share. Securities Fraud is typically defined as the “misrepresentation or omission of information to induce investors into trading securities.” The Securities and Exchange Commission (SEC) broadly references the federal anti-securities fraud liability encompassed in Rule 10b-5, the broadest federal anti-securities fraud measure, which is promulgated under Section 10(b) of the Exchange Act of 1934. 10b-5 outlines the elements of securities fraud that must be shown to find an individual liable for fraud. Rule 10b-5 allows the SEC to pursue criminal actions as well as creates a private right of action for private plaintiffs to bring forth civil actions for securities fraud, so long as they have standing. Private plaintiffs are found to have standing if they purchased or sold a security in relation to the alleged fraud. Claiming that the alleged fraudulent misrepresentation caused you to forego purchasing or selling a security does not constitute standing. In an action instituted by private plaintiffs, they must show (1) that the individual misrepresented or omitted a material fact; (2) that the individual did so knowingly or with scienter; (3) that the plaintiff reasonably relied on the individual’s material misrepresentation; and (4) that the plaintiff’s reasonable reliance on the material misrepresentation caused their loss.


Testifying as the star witness, Musk asserted that the tweet was “absolutely truthful” as he had ongoing plans to take Tesla private and would have either obtained funding from The Saudi Public Investment Fund or sold a stake in SpaceX to fund the plan. Musk was afraid his plans to take Tesla private had been leaked, due to a report by the Financial Times that “Saudi Arabia was building a sizable stake in Tesla”, and thus made the tweet to put Tesla investors on equal-footing. Alex Spiro, Musk’s lawyer, told jurors in his closing arguments that although the tweet was “technically inaccurate,” Musk did have ongoing plans to take Tesla private and the funding was secured.


The investors’ lawyer argued for the substantial harm caused by the tweet, calling an expert witness to testify that the tweet jolted the market, and an economist to testify that investors lost $12 billion in over 10 days following the tweet. The investors argued that every public company is required to communicate the market truthfully and accurately. He stated, “the market understood ‘funding secured’ to mean an actual commitment,” which in reality did not exist.


Privatization in Action


In deciding to own and operate a business, executives often arrive at a crossroads at some point in the life cycle of their company: should the business be a publicly traded company, or a private entity owned by a select few?


The investors’ lawyers attempted to leverage multiple facts to illustrate that Musk’s 2018 take-private tweet was untruthful. The jury was informed of Musk’s relationship with the governor of Saudi Arabia’s Public Investment Fund, the supposed source of funding which Musk had obtained for the take-private action. However, the investors’ lawyers argued that Musk had no intention of taking Tesla private, since he barely consulted with his own bankers and had no formal writing to outline the take-private plan. Moreover, according to the investment-banking witnesses called to testify, they were left in the dark on the specifics of the deal even a week after the tweet was posted, including who the funding would be supplied by and how it would be structured.


Due to the nature of public companies, there is often an associated level of prestige that implies a degree of “operational and financial size and success”. However, due to the deluge of regulatory, administrative, financial reporting, and corporate governance regulations that these companies must adhere to, they may be unable to place as much focus on their operation and growth. As a result, shareholders or executives may pounce on the opportunity to take the company private. There are a number of reasons why a company may decide to go private in addition to struggling to comply with regulations. A company may be taken private because the benefits of a public company have lessened, e.g. compliance efforts take time and focus away from corporate development or adherence to Wall Street’s Quarterly earnings reports leads to reduced prioritization of long-term goals of the company. Similarly, the executives may want to maintain more control over their business and not be bound to the demands of their investors.


Alternatively, the push to go private may arise because the shareholders are being approached with higher-than-market prices by investors. Often when evaluating whether to go private, businesses are referring to converting their publicly traded company into a private entity through a series of transactions. Private equity buyouts, management buyouts, and tender offers are a few of the mechanisms that are utilized to take a company private.


Many of these transactions to take a company private implicate significant amounts of debt. The acquiring company will turn to outside financing sources, such as investment banks or other lenders, to complete the deal. As a result, the newly acquired company’s cash flow may be utilized to pay off the debt that was incurred to finance the takeover and the assets of the company will be used as collateral. Following this privatization, the company’s shareholders are unable to trade their shares in the open market, however, most will have already sold their shares for more than the market price as compensation for foregoing ownership in the company.


SEC Enforcement and Guidance


While a jury ultimately cleared Musk of liability for his “funding secured” tweet, the tweet in question was not without consequences. In 2018, the SEC charged Musk with fraud, resulting in Musk and Tesla each paying a $20 million penalty, Musk's departure as Chairman of the Board, and tighter oversight over his Twitter activity. These controls require pre-approval of any written communication that could contain material information about Tesla or its shareholders. Musk has pushed back against these restrictions arguing that they infringe on his right to free speech. The court, however, ultimately rejected this argument, finding the restrictions were voluntarily agreed upon by Musk and thus did not violate his First Amendment rights.

The SEC's recent crackdown on social-media-related securities fraud is not limited to Musk's case. They have also brought charges against various individuals and groups, including eight influencers involved in a $100 million stock manipulation scheme, a trader responsible for a stock skyrocketing 4,000%, and a penny stock pump-and-dump scheme by a user with over 70,000 followers.


The growing use and misuse of Twitter - and social media in general - has been apparent. Since its launch, Twitter has become a key tool not only for corporate communications but for investors – many who are young and novice traders – to coordinate trading plans. With this growth in use, it’s no surprise that the market is vulnerable to sudden news and events. In 2013, a single fake tweet by the hacked AP account sent the markets temporarily careening, losing $200 billion before recovering shortly after. More recently, a November 2022 fake tweet stating “insulin is free now” by an Eli Lilly impersonator caused an over 4% drop in the stock price. Given Twitter’s influence as a platform for information, events such as these have led the SEC to release guidance on the need to exercise extreme caution when navigating social media.

As social media's influence in the investing community grows, regulators will need to continue to adapt and monitor these platforms for fraudulent activity. The scope of enforcement in gray areas like retweets, shares, and likes is still unclear.


*The views expressed in this article do not represent the views of Santa Clara University.

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