The Case of Elon Musk and the SEC: Re-examining Corporate Fraud

Posted: October 10, 2018

Elon Musk and Due Diligence

A Recent tweet by the Tesla Chief Executive Officer Elon Musk caused havoc when he publicly considered privatizing the company. After sending a tweet claiming he secured the necessary funding for privatization, shares skyrocketed by 6.4% — only to plummet 16% after Musk publicly stepped away from the plan in a blog post. In response, the Securities Exchange Commission filed a lawsuit against Musk, claiming he caused harm to investors and neglected to follow due diligence procedures.

The SEC sought civil penalties, asking the court to ban Musk from holding executive positions at any public company. They claimed Musk didn’t have the right to tweet so freely about such an important topic without informing key company members and investors. Specifically, the SEC found fault with Musk’s announcement to go private without consulting with Tesla’s independent directors.

Other SEC members believe the lawsuit went too far, especially when considering Musk only claimed to have the necessary funding in hand. Instead, some argue, the SEC should have issued investigated the issue, informing Musk and the company on proper ways to announce secured funding.

While not explicitly a case of corporate fraud, Musk’s actions remind company heads, and those enforcing rules outlined by the SEC, of the importance of abiding by due diligence rules when announcing privatization and material corporate information.

A Refresher on Due Diligence Rules

Many transactions result from the privatization of public companies, and the SEC enforces important rules for company heads and their affiliates to follow when going private.

Rule 13e-3 of the Securities Exchange Act of 1934 and Schedule 13-E may apply when going private and require that companies provide specific financial information to shareholders.

When going private, several key points are to be discussed. Schedule 13-E requires:

  • A discussion of the purpose of the transaction
  • Alternatives the company may have not considered
  • Whether the transaction is fair to unaffiliated shareholders
  • Whether any of the directors disagreed with the transaction or abstained from voting
  • Whether the majority of directors approved transactions

Many discussions and potentially difficult decisions take place and are made during privatization but are necessary for protecting shareholders during times of change. Mr. Musk, instead of abiding by the rules outlined by the SEC, chose to forgo the preliminary necessary steps before announcing his plans to go public via Twitter.

Section 404 of the Sarbanes-Oxley Act also outlines rules for announcing financial statements. If the SEC finds executives do not certify accurate financial statements, CEOs may face up to 20 years in jail.

By failing to provide due diligence when considering the privatization of his company, Mr. Musk placed himself in a dangerous situation resulting in a lawsuit. While the basis for corporate fraud seems far-fetched, Musk’s social media scandal resulted in one of the most high-profile lawsuits against a CEO in years.

The case beckons lawyers to consider how they may respond if general counsel were at Tesla’s disposal – which bring us to our next point.

Lawyers May Withdraw from Representation

Model Rules 3.3(a) and 1.16(b) outline procedures for dealing with clients who may have committed fraudulent crimes. Rule 3.3(a) requires a lawyer to take “reasonable corrective action” when dealing with a client who has offered false evidence, and a lawyer can do so by:

  • Remonstrating with the client
  • Advising the court (even if information needs be disclosed)lawyers meeting with a client to discuss fraudulent activity

Comment 10 to Rule 3.3 encourages courts to terminate representation once fraudulent activity on behalf of the client has been detected.

Similarly, Model Rule 1.6(b) encourages a lawyer’s right to optionally withdraw from representation if the client used the lawyer’s services to perpetrate a crime or fraud.

The Model Rules have been adjusted to protect lawyers and encourage communication with courts when representing clients who’ve knowingly committed fraud. Lawyers who don’t take action when representing clients who’ve committed fraud may be held liable.

Therefore, it’s important to understand the appropriate model rules and due diligence procedures when representing clients who may have committed a fraudulent crime. While Musk didn’t commit fraud, his casual use of social media crossed a line the SEC could not ignore – and reminded lawyers why abiding by rules outlined by the SEC is necessary.