One of the bigger securities stories these days is the “taking Tesla private at 420” trial going on right now, simply because it’s so rare to have a securities fraud class action trial at all.  And this one is even more bizarre because the judge has already granted summary judgment to plaintiffs on two key elements: falsity and scienter.

As readers of this blog are no doubt aware, in August 2018, Musk tweeted “Am considering taking Tesla private at $420. Funding secured.”  A couple of hours later he tweeted “Investor support is confirmed. Only reason why this is not certain is that it’s contingent on a shareholder vote,” linking to this blog post.  The blog post elaborated that Musk “would like to structure this so that all shareholders have a choice. Either they can stay investors in a private Tesla or they can be bought out at $420 per share” – a merger structure that never made sense legally.   Eventually Tesla backtracked with a blog post announcing that the company would remain public.

The plaintiffs now allege – and the jury is being asked to decide whether – those two tweets were fraudulent.

According to the jury instructions on file with the court, the jury will be told that in order to find Musk liable, they must find:

1) Elon Musk and/or Tesla made untrue statements of a material fact in connection with the purchase or sale of securities;

2) Elon Musk and/or Tesla acted with the necessary state of mind (i.e., knowingly or with reckless disregard for the truth or falsity of the statements);

3) Elon Musk and/or Tesla used an instrument of interstate commerce in connection with the sale and/or purchase of Tesla securities;

4) Plaintiff justifiably relied on Elon Musk and/or Tesla’s untrue statements of material fact in buying or selling Tesla securities during the Class Period; and

5) Elon Musk and/or Tesla’s misrepresentations caused Plaintiff to suffer damages.

And finally, the jury will be told to assume that both tweets were false, and that Musk acted with reckless disregard as to whether they were true.

That means one of the critical unresolved issues – and one that is central to Musk’s defense – is the element of materiality.

Now, that may seem odd, since the tweets were obviously material.  The market reacted wildly to them, so much so that Tesla trading was briefly halted on the NASDAQ.  (Although see my earlier post on that).

But that’s not the kind of materiality Musk means.

In fact, materiality as an element of a 10(b) claim has two different dimensions.  First, was the false statement material?  And second, were the undisclosed facts material – that is, was the difference between the true state of affairs, and the one portrayed by the defendant, material to investors?

To put it another way, these days, doctrines like puffery play an awfully big role in securities class actions, as many cases are brought based on undisclosed misconduct.  A scandal emerges; there is no doubt that the facts of the scandal – previously hidden from the market – are material to investors.  But silence about scandalous facts is not itself fraudulent; the plaintiffs need to show how the market was misled about these facts.  So, plaintiffs argue that certain high-level statements about ethics and legal compliance were false; courts are then asked to evaluate whether those statements were likely to influence investors.  These are disputes about whether the allegedly false statements themselves were material, in a situation where the undisclosed facts undoubtedly were.

But suppose a company overstates its quarterly earnings by $100.  This is a situation where the statement – an earnings report – was undoubtedly material (and false); what is in question is whether the undisclosed fact – that the earnings were false by a mere $100 – was material.  Investors likely would not see any material difference between the reported figure and the true figure. 

That’s the essence of Musk’s argument in the Tesla trial.  The judge has already ruled that funding was not secured, and investor support was not confirmed, so Musk claims that a handshake arrangement with the Saudi Public Investment Fund, and perhaps the availability of funding from other sources, ensured that funding was sufficiently far along that investors would not have drawn a distinction between “funding secured” and disclosure of the full truth.

That concept of “materiality” is, in fact, the heart of what was at issue in Basic v. Levison, 485 U.S. 224 (1988), the Supreme Court case that defined what materiality means for the purposes of Section 10(b).  There, Basic had engaged in discussions regarding a possible merger with Combustion Engineering, but when asked about it, Basic’s President told investors that no negotiations were underway, and that he was unaware of any reason for the “abnormally heavy trading activity” in Basic stock. This was all, of course, false, and the question was whether the undisclosed facts – the true state of merger negotiations – were material to investors.  Defendants argued for a bright-line rule, that until an agreement in principle is reached, any merger negotiations should be deemed automatically immaterial.  The Supreme Court rejected that argument, holding instead that materiality exists where there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”

In the case of merger negotiations, this would require courts to evaluate how probable the transaction appeared to be at the time.  Nascent discussions might be immaterial, but board level indicia of interest, such as active negotiations or instructions to investment bankers, might be very material to investors, even if there was no certainty that a deal would ultimately be reached. 

What’s ironic, then, is that the Tesla trial is the literal mirror image of Basic.  In Basic, a CEO denied merger negotiations, and the relevant question was whether those negotiations were far enough along to create a material distance between his denials and the true state of affairs.  In In re Tesla, Inc. Securities Litigation, the CEO declared an imminent merger, and the question is whether the underlying negotiations were sufficiently embryonic to create a material distance between his tweets and the true state of affairs.

A couple of months ago, I blogged about Menora Mivtachem Insurance v. Frutarom, 54 F.4th 82 (2d Cir. 2022).  There, a public company issued new stock in connection with a merger, and the S-4 contained false information about the target, supplied by the target.  The truth came out, the stock price fell, and shareholders sued the target and some of its officers under 10(b).  In that context, the Second Circuit held that the plaintiffs, who had purchased shares in the publicly-traded acquirer and not the target itself, did not have “standing” to pursue claims against the target defendants.

The original decision issued on September 30; on November 30, the Second Circuit issued some minor revisions to its ruling (deleting, as far as I can tell, language that suggested that the defendants in a 10(b) action must be agents of the subject company, i.e., that plaintiffs couldn’t sue if a stranger to a company made false statements about it and caused plaintiffs to make a purchase of that company’s stock).

The plaintiffs sought rehearing, and one of the arguments they made was that the Menora reasoning was so broad that purchasers of shares in a SPAC would be unable to sue managers of a target company for false statements made in connection with the de-SPAC transaction.  The Second Circuit denied the petition, and so, right on cue, defendants in the Lucid SPAC case pending in the Northern District of California cited Menora to argue that the plaintiffs had no standing to pursue their claims. The court rejected Menora – and even its predecessor, Nortel – in an extensive analysis of Blue Chip and standing requirements for 10(b) actions:

Blue Chip focused on the unique problem that arises when a plaintiff’s claim is based on inaction and when it is likely that oral testimony will be the primary, or only, evidence. That problem does not exist here or in Nortel. The transactions of plaintiffs in both cases are anchored by the time of the transactions and the amount and value of securities bought or sold….

Based on this Court’s survey, Nortel’s holding regarding standing has been considered in seven decisions outside of the Second Circuit. All but one of these decisions apply Nortel with little or no commentary on the Second Circuit’s reasoning.  The one case to address Nortel’s standing analysis (notably, the one court in the Ninth Circuit that has considered Nortel) concludes that the “Second Circuit’s rationale in that decision is problematic” and not supported by extensive reasoning.” Zelman, 376 F. Supp. 2d at 962.

Further, at least two of these decisions are no longer in line with the Second Circuit’s approach after Menora. Nortel had suggested in dicta that if two companies had a “direct relationship” such as that created during a merger, that plaintiffs who purchased one company may have standing to sue based on misrepresentations of the other party to the merger.  Menora held that there is no such exception. Two cases outside of the Second Circuit had found plaintiffs had standing under the “direct relationship” exception. It is unclear if, faced with the issue again, these courts would follow the Second Circuit’s current approach….

The Court also sees no benefit from limiting standing as defendants suggest. The goal of such a limitation appears to be to ensure Section 10(b) actions are only brought where a defendant’s conduct is meaningfully related to the plaintiff’s harm. This is already accomplished by the elements of Section 10(b) claims, which include that a misrepresentation must be material and made “in connection with” the purchase or sale of a security. Not only would defendants’ standing rule be redundant, it would conflict with Section 10(b) materiality analysis, under which a misrepresentation is material and actionable where “a reasonable investor’s decision would conceivably have been affected” by it.

In re CCIV/Lucid Motors Securities Litigation, 4:21-cv-09323 (N.D. Cal. Jan. 11, 2023).  The court did, however, grant the motion to dismiss on materiality grounds, because when the plaintiff purchased shares in the SPAC, neither the SPAC nor Lucid had acknowledged that a merger was likely.  I can’t find the decision on Westlaw or Lexis, but here’s a Law360 article about it.

Anyhoo, as I’ve said before, I’m not sure how much longer SPACs will be a thing, but it seems we have a bit of a disagreement among courts that’s likely to recur in different contexts.