August 7, 2018: “Am considering taking Tesla private at $420. Funding secured.”
October 4, 2018: “Just want to [word missing in original] that the Shortseller Enrichment Commission is doing incredible work. And the name change is so on point!”
In between these two tweets, Tesla saw its stock price soar to nearly $380 per share and then give back roughly $125 of that amount. Both Musk and Tesla agreed to settle SEC charges based on fraud (Musk) and for failure to implement disclosure controls or procedures concerning information tweeted by Musk (Tesla). The settlement calls for Musk to step down as Tesla’s board chairman and for Musk and Tesla to each pay a separate $20 million penalty. The agreement also calls for Tesla to appoint two new independent directors to its board and to establish a new committee of independent directors to establish controls and procedures to oversee Musk’s communications. U.S. District Judge Alison J. Nathan must approve the settlement for it to become effective.
The SEC’s civil action against Musk came as no surprise. The tweets generated immediate and significant activity in Tesla stock, which quickly drew the Enforcement Division’s attention. The Justice Department has also shown interest in the matter, and more than a dozen shareholders have already initiated class action fraud claims.
What was surprising in the SEC action was the request that the court bar Musk from serving as an officer or director of a public company. Under Section 21(d)(2) of the Exchange Act, in order to prevail, the SEC would have had to show by a preponderance of the evidence that Musk’s “conduct demonstrates unfitness to serve as an officer or director of any such issuer.” The officer-director bar claim dramatically raised the stakes for Musk beyond monetary penalties and likely played a role in his decision to settle the matter.
Judge Nathan must find that the settlement is “fair and reasonable,” and that it “furthers the objectives of the law upon which the complaint was based.” In an order dated October 4, 2018, she cited cases holding that a reviewing court must make a “minimal determination of whether the agreement is appropriate” before entering a consent order. The order also required the SEC and Musk to submit a joint letter to the court explaining why the judge should approve the settlement. She described this procedure as part of “this Court’s regular practice.”
There are limits to the scope of a district court’s review of a consent decree in the Second Circuit. That court found that U.S. District Judge Jed Rakoff abused his discretion when he refused to approve a settlement between the SEC and Citigroup because Citigroup did not admit wrongdoing. According to Judge Rakoff, the SEC policy “of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations deprives the Court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.”
The Second Circuit rejected Judge Rakoff’s inquiry into the adequacy of the Citigroup settlement. According to the appellate panel, the proper standard for district court review of an agency settlement is whether the agreement is fair and reasonable, and whether the public interest would be disserved. “Scrutinizing a proposed consent decree for ‘adequacy’ appears borrowed from the review applied to class action settlements, and strikes us as particularly inapt in the context of a proposed S.E.C. consent decree,” stated the court.
Under the Second Circuit standard, district courts should consider:
—the basic legality of the decree;
—whether the terms of the decree, including its enforcement mechanism, are clear;
—whether the consent decree reflects a resolution of the actual claims in the complaint; and
—whether the consent decree is tainted by improper collusion or corruption of some kind.
The Second Circuit concluded that district judges should make ensuring the consent decree is procedurally proper the “primary focus” of their inquiry. “The job of determining whether the proposed S.E.C. consent decree best serves the public interest, however, rests squarely with the S.E.C.,” concluded the panel.
One interesting aspect of the settlement agreement to note while judicial approval is pending is a specific reference to SEC Rule 202.5. Under this rule, a defendant who consents to a judgment or order that imposes a sanction may not deny the allegations in the complaint. According to the rule, “the Commission believes that a refusal to admit the allegations is equivalent to a denial, unless the defendant or respondent states that he neither admits nor denies the allegations.” The “Shortseller Enrichment Commission” tweet would probably not run afoul of this provision, but Mr. Musk should carefully consider this rule before sending further tweets that might be critical of the Commission or the settlement.
The Bullet Dodged—The Officer-Director Bar
In its civil complaint, the SEC sought to bar Musk from serving as an officer or director of a public company. As noted above, this remedy requires a showing of unfitness to serve based on the charged violations.
Congress codified the officer-director bar in Section 21(d)(2) in 1990 in the Securities Enforcement Remedies and Penny Stock Reform Act. Prior to the statute’s enactment, federal courts had barred individuals from serving as officers and directors under their general equitable powers.
The provision as enacted in 1990 required a showing of “substantial unfitness” to serve. In 2002, in the Sarbanes-Oxley Act, Congress eliminated the “substantial” qualifier. The exact purpose and legislative history of the change is a bit murky, but one Senate report states that:
The Commission has argued that the ‘‘substantial unfitness’’ standard for imposing bars is inordinately high, causing courts to refrain from imposing bars even in cases of egregious misconduct. The proposed bill rectifies this deficiency by modifying the standard governing imposition of officer and director bars from ‘‘substantial unfitness’’ to ‘‘unfitness.’’
The authorizing language for officer-director bars is not an “all or nothing” provision. District judges (and administrative law judges under a Sarbanes-Oxley Act addition) may tailor the remedy to bar an individual for a specified period of time if the judge decides that a permanent ban would be excessive.
The statute provides no guidance as to what conduct renders an individual unfit to serve, and the SEC has offered little in the way of advice or insight. The courts have looked to the work of one legal scholar, Professor Jayne W. Barnard of the College of William and Mary, and her multi-factor test set forth in a 1992 law review article (prior to the amendment of the statute). She called for courts to consider factors including:
—the magnitude, or “egregiousness,” of the underlying violation;
—the defendant’s previous violations of the securities laws, if any, and any other breaches of fiduciary duty as a corporate officer or director;
—the role of the defendant in the underlying securities-law violation;
—the degree of the defendant’s scienter in connection with the violation;
—the defendant’s personal gain, if any, from the underlying violation; and
—the likelihood of renewed misconduct.
Following the change in the statutory language, Prof. Barnard set forth another list of factors in a 2005 law review article for courts to review when determining if an individual meets the unfitness standard. These factors included:
—the nature and complexity of the scheme;
—the defendant’s role in the scheme;
—the use of corporate resources in executing the scheme;
—the defendant’s financial gain (or loss avoidance) from the scheme;
—the loss to investors and others as a result of the scheme;
—whether the scheme represents an isolated occurrence or a pattern of misconduct;
—the defendant’s use of stealth and concealment;
—the defendant’s history of business and related misconduct; and
—the defendant’s acknowledgement of wrongdoing and the credibility of any contrition.
The courts, beginning with the Second Circuit in SEC v. Patel in 1995, assessed a lack of fitness by looking to Professor Barnard’s factors. In SEC v. Bankosky, a 2013 decision, the Second Circuit observed that unfitness is “clearly a lower hurdle” than substantial unfitness,” and concluded that a trial court did not err in relying on the pre-amendment Patel factors to determine fitness to serve under the amended statutory language.
The Bankosky court suggested that the various iterations of the determinative factors may not be so determinative after all. According to the court, these factors “are neither mandatory nor exclusive; a district court may determine that some of those factors are inapplicable in a particular case and it may take other relevant factors into account as it exercises its “substantial discretion” in deciding whether to impose the bar.” The court must only provide “some indication of the factual support for each factor that is relied upon.”
A review of the district court cases in which the SEC has sought an officer-director bar suggests that the courts may have been looking to an older source than Professor Barnard’s law review articles for guidance, a source that states that “ask and you shall receive”—a review of more than 20 cases decided by district judges in the last five years showed that in every instance when the SEC requested a bar order, the court granted the request. In some cases, the judge granted a bar limited to a term of years rather than a permanent bar, but in none of the cases did an accused individual walk away from the bar with his position intact.
Judge Alison J. Nathan will likely approve the settlement after she reviews the submissions from the SEC and Elon Musk, given the restrictions placed on district court review of agency settlements in the Second Circuit. As a result, Elon Musk will lose not only a substantial amount of money and his chairmanship of Tesla, but will also face the challenge of an SEC rule that effectively prohibits him from denying any wrongdoing.
Would the court have imposed an officer-director bar on Musk if he had not settled? The SEC alleged a high degree of scienter in their initial complaint. According to the SEC, “Musk knew that he had never discussed a going-private transaction at $420 per share with any potential funding source, had done nothing to investigate whether it would be possible for all current investors to remain with Tesla as a private company via a ‘special purpose fund,’ and had not confirmed support of Tesla’s investors for a potential going-private transaction.” The Commission also cited his ongoing feud with short sellers of Tesla stock as evidence of his state of mind, citing his tweets that “Oh and uh short burn of the century comin soon, flamethrowers should arrive just in time” and that short sellers “have about three weeks before their short position explodes.” The complaint further noted that in the days before his tweets, Musk had done nothing that could be considered due diligence for a going private transaction. The tweets were, as alleged, “premised on a long series of baseless assumptions and were contrary to facts that Musk knew.”
In light of the degree of scienter alleged, and the willingness of district judges to impose these bars, Musk was at serious risk of a forced separation from his company, a separation that may have been permanent. In light of these circumstances, it may well have been a wise decision for Musk to part ways with $20 million, or, to put it in perspective from August 7, roughly $328,000 per character.