With Tesla No Longer Going Private, Focus on SEC Enforcement Heightens
On August 24th, Elon Musk announced he would no longer be attempting to take the company private. With the announcement, this ends investor debate on whether they had the funding, and whether it was even possible to take the company private. Attention now shifts towards potential SEC enforcement actions that might be taken, as well as on the fundamentals of the business.
In this article, I'll focus on potential SEC enforcement, and specifically on enforcement associated with Musk's disclosures on Twitter. Note that there is another SEC investigation into the company's Model 3 targets, which is beyond the scope of this article.
The primary issue at hand is Musk's disclosure of a speculative tender offer without significant documentation supporting it. Recall that Musk tweeted that he was considering taking Tesla private, and that funding was secured. Additionally, he noted that investor support was confirmed, and that the only reason it wasn't confirmed was that it was contingent on a shareholder vote.
Given that the offer probably did not meet the documentation requirement that the SEC requires for a tender offer, it's difficult to see how Musk does not receive an enforcement action from the SEC.
There's a wide range of punishments that could occur as a result of the improper disclosures. The spectrum below illustrates a range of potential enforcement actions. Note that this is primarily for illustrative purposes and is perhaps not the full range of outcomes. On the left is a light punishment. At that extreme, it would be some sort of light fine. On the other extreme is a much harsher punishment - criminal charges for Musk, his removal from his position as Chairman and CEO, and a significant fine to Tesla that could be in the billions.
First, online discussion largely has been focused on the far right (the red circle). There is a loud and vocal short crowd online, and my own perception of the consensus here is that punishment will include the removal of Musk and billions of dollars in fines that will add to the company's cash woes. An important caveat is that this is highly dependent on where you are on the internet, as there are also very loud, vocal supporters of Musk as well.
Second, it appears that the stock currently is pricing in levels closer to the left. This is based on the fact that the stock today sits ~6% below the pre-announcement price (but I would note that this could potentially fall further on Monday after the announcement to not go private is incorporated into the stock price). If the street truly believed that Musk had a high chance of being removed, I'd argue that the stock would probably be trading lower given that Musk is a key part of the bull thesis. Add in a significant fine that could necessitate additional funding, and the stock would be even further below its current price.
My own opinion is that the odds of Musk being removed are also closer to the left as well, for several reasons which I'll outline next. In my opinion, the discussion online seems to largely be speculative, and is missing a more nuanced discussion about what it would take to actually remove a CEO from a company, and what the magnitude in fines could potentially be.
Reason 1: The Bar for Removal of a CEO Seems High
The bar for the removal of a CEO at a public company seems fairly high. According to former SEC officials, a key factor that will determine the severity of possible enforcement will come down to whether there was intent to mislead investors and manipulate the stock market.
Is there evidence of this? Some will argue yes, given Musk's propensity to talk about short-sellers and his desire to inflict pain on them. Musk has tweeted about short-sellers numerous times, and even mentioned them in his blog post announcing his intention to take the company private. Combine that with the fact that Musk did not seem to have enough documentation to support his language around the offer, and this seems to be enough to give online short-sellers a reason to confidently proclaim that Musk will be going to jail.
But does this pass the high bar that is required to show intent behind his tweets? Note that gross negligence and intent to mislead are very different claims. At a minimum, it appears likely that Musk was highly negligent. But to prove that he tweeted this out in order to hurt short-sellers and knew that the funding was not secured (in his mind) is a difficult notion to prove in a court of law. His tweets about the short-sellers seem only to prove that he dislikes short-sellers, which is not inconsistent with many other CEOs, and is not illegal.
Additionally, the idea that Musk was purposely lying just to hurt short-sellers for the next couple weeks would require an image of Musk as an extremely short-sighted CEO, and is one that is hard to reconcile. To be fair, Musk shoots from the hip and sets targets that he often does not achieve. But it's quite a stretch to think that Musk would purposely lie just to inflict pain on short-sellers for a couple weeks before the inevitable truth comes out that funding was not secured.
Admittedly, many people do see Musk as a short-sighted CEO, and therefore the latter point is not a persuasive one to that audience. So let's focus instead on the legal bar for fines and the removal of a CEO.
Reason 2: BP Oil Spill Informs Us of Potential Consequences for Lying to Investors
To further support the notion that it's difficult to prove that a CEO knowingly misled investors, and to gain insight into how the SEC could potentially act, we should look at prior incidents where the SEC took action against companies.
To be clear, precedent is not 100% translatable given that Tesla's situation is by definition, unprecedented. CEOs don't disclose private takeout offers over twitter in so few characters. And I'll touch on this later in the article as a key consideration for why one can't rule out a punishment further to the right of the spectrum. With that said, there is still some read-through that can be offered by looking at past actions.
A great prior example in which the SEC took action against executives that lied to investors was the BP oil spill. The BP incident began on April 20th, 2010. The Deepwater Horizon oil rig exploded, and sank two days later. Eleven employees died from the incident, and the oil rig ultimately leaked out an estimated 5 million oil barrels, causing extensive damage to the environment.
As outlined by the SEC in its press release, BP executives initially disclosed to investors that they believed the oil leak rate to be "up to 5,000 barrels a day" despite having up to 6 different internal metrics that suggested the leak was much higher, with one metric suggesting it was as high as 146,000 barrels per day.
Executives continued to defend this rate, even admonishing higher third party estimates as "scaremongering," despite having numerous internal metrics suggesting otherwise, and nothing to back a 5,000 upper limit rate. Investors were not formally alerted to the fact that the rate could be higher until August 2, when the government and academics studying the leak announced that the rate was closer to 52,700 to 62,200 barrels per day.
The SEC investigated the incident and came to an agreement with BP to have the company pay $525 million over three years, representing the third largest charge at the time in the institution's history. Note that the fine was agreed to in late 2012, more than two years after the revelation that BP had understated the leak rate. Additionally, the $525 million fine was used to pay off harmed investors from the misinformation.
Also note that there were many other fines and charges associated with the damage to the environment, negligence on safety inspections, lying to Congress, and obstructing justice by deleting evidence. However, I don't believe these are relevant to the Tesla situation, which is focused primarily on disclosures to investors (although, as I'll note later, represent a risk).
How comparable is this to the Tesla situation, and what are the takeaways? The two situations are admittedly not 100% comparable, and it's important to note the differences.
There are several factors that suggest BP's situation was worse than Tesla's, in my opinion. First, in the BP incident, the lying was more pervasive, as it lasted for multiple months, and was consistent across multiple executives. Even if we grant that Musk was lying, he clarified his position and corrected his original tweets within a week with a follow-up blog post. It was during that blog post that it became more apparent that Musk did not have anything more substantial to the funding claim than discussions with investors. From a disclosure perspective, this was much quicker than in the BP incident, which didn't even involve any correction at all from the company.
Second, in terms of shareholder harm, the BP situation was potentially more harmful as well. BP's market cap at the time was around $150 billion compared to Tesla's ~$50-60 billion. Additionally, BP stock was ultimately impacted even more due to the lack of accurate disclosures. Ten days after the incident, the stock declined just 10% as investors believed the leak to be somewhat contained (based on the company's inaccurate disclosures). However, as the idea that the initial disclosures may have been significantly understated became more widespread, the stock declined even more, reaching a 54% decline at one point. Ultimately, after disclosures of a more accurate leak estimate multiple months later (from the government and academics), the stock settled at a 30-40% decline.
This compares to Tesla, which did not see as dramatic of a swing, and over a much shorter period of time. Using end of day pricing, Tesla was up 11% at its peak the next day, and now sits 6% below its levels prior to the announcement.
Finally, in terms of public perception, a disastrous oil spill that involved multiple deaths and rich oil executives lying to investors in order to downplay the damage arguably looks worse than the Tesla situation. The SEC faced immense pressure to penalize BP significantly.
In the end, despite these factors making the situation arguably worse, the fine associated with the improper disclosures was $525 million that was spread out over three years, and no executives were forced out (and I would again reiterate that to my knowledge, the other fines and charges were related to other issues not associated with improper investor disclosures). Additionally, it should be noted that the fine was enforced two years after the incident, showing just how slow the SEC moves (and enforcing Jim Cramer's point), and potentially giving Tesla enough time to build a cash position and afford the fine.
Let's pull up that spectrum again and place the BP incident on it. In my opinion, BP's situation would fall to the left of center.
In my opinion, the BP incident demonstrates just how high the bar is for proving an intent to mislead. Even with empirical evidence that executives misled investors on the rate of the leak, causing even more significant losses to the stock, the executives still managed to stay at the company, and the fine (related to the misinformation) was below $1 billion and spread out over multiple years.
Not all of the differences between the two situations work in favor of Tesla, though. One key difference working against Tesla is the fact that CEOs have never disclosed private takeout offers in such a hasty and unplanned way. The SEC could choose to make Tesla an example for all future companies and penalize them in an even harsher way. As much was noted in this article, which stated that the SEC is facing immense pressure to punish Musk for his lackadaisical attitude towards disclosures.
That punishment could come in the form of a huge fine that could be higher than what BP faced. If the timeline is short enough and the fine significant enough, it could force Tesla to issue another equity raise in order to cover the obligation. And while I personally don't see it as being likely, we still can't fully rule out the possibility that the SEC would try to remove Elon Musk serving as an executive at a public company, either.
Additionally, while the SEC's other investigation of Musk and his targets on the Model 3 is beyond the scope of this article, it could become relevant if the SEC chooses to holistically consider the charges against the CEO.
Finally, as I mentioned earlier, BP did receive additional fines and criminal charges associated with lying to Congress and covering up evidence. If it is revealed that Tesla took similar actions, then the chances of enforcement falling further to the right increase significantly, and the possibility of other charges open up as well.
While the SEC is Limited by What Can Be Shown in Court, We Can't Rule Out The Tail Events
Considering everything here, I find it unlikely that the enforcement on Musk and Tesla would fall further to the right on the spectrum, and view it as more likely that the punishment is somewhere on the left. With a high bar for proving intent to mislead, and a precedent in which the SEC punished an arguably more egregious attempt to mislead investors with a $525 million fine over three years, it seems more likely that Tesla will be hit with a decent-sized fine, but not remove Musk from his role. However, given the unprecedented nature of the disclosures, we are still left with the possibility for tail events to occur.