Why the SEC Sued Elon Musk, and What It Means for Tesla

Securities fraud secured? A lawsuit filed by the Securities and Exchange Commission (SEC) on Thursday alleges that Tesla (NASDAQ: TSLA) CEO Elon Musk made "false and misleading statements" about the possibility of taking the company private -- and asks the court to bar him from serving as an officer or director of a public company.

Tesla's share price quickly fell over 10% in after-hours trading following the news, as investors scrambled to handicap the odds of a Musk departure.

The selling pressure could continue: In a note released early Friday, Citigroup analyst Itay Michaeli downgraded Tesla to "sell," saying that the SEC's action has increased the risk of a "downward confidence spiral."

There's still much we don't know about the government's case against Musk and (possibly) Tesla itself. But here's what we do know, and what might be coming next.

The SEC's allegations against Elon Musk

Simply put, the SEC is alleging that Musk did not, in fact, have "funding secured" when he tweeted these statements on Aug. 7, and that these statements disrupted the market for Tesla's stock.

From the SEC's complaint:

And the reason for the agency's action:

The SEC alleges that taken together, Musk's statements and related conduct add up to a series of violations of Rule 10b-5. Rule 10b-5 is a regulation that was created under the Securities Exchange Act of 1934. It prohibits the "employment of manipulative and deceptive devices" in connection with the purchase or sale of any security.

In short: The SEC is alleging that Musk's tweets and statements amounted to securities fraud.

Wait. Isn't "securities fraud" a crime?

Not necessarily. Rule 10b-5 is a regulation, not a law. That's why the SEC filed a lawsuit -- a civil claim for damages -- rather than asking the U.S. Department of Justice to seek a criminal indictment.

That doesn't mean the penalties won't be severe, though.

How the SEC wants to penalize Elon Musk

The SEC's suit asks the court to impose some serious consequences on Musk, including:

  • Banning him from serving as an officer or director of a public company, or of a private company that is required to register its securities because it has a large number of non-accredited shareholders (as a gone-private Tesla might have been).
  • "Disgorging" (handing over to the feds) any profit he might have made from trading Tesla's stock after his statements, plus interest. (It's not clear that Musk did this, but if he did, he'll have to give up the gains.)

The SEC is also asking the court to enjoin Musk from violating Rule 10b-5 again, to make him pay a fine, and for "such other and further relief as this Court may deem just, equitable, or necessary."

What does this SEC lawsuit mean for Tesla investors?

Tesla is what we call a "story stock": Its sky-high valuation is driven by the belief that the company has immense growth potential, not by the company's fundamentals (which are frankly rather dicey at the moment). That belief centers on Musk himself, whom fans and many investors see as a visionary genius leading humanity to a sustainable future. (I am not actually exaggerating here.)

Whether you think Musk is a genius or just an adept showman, it's clear that he is much of the company's story. What happens to that story -- to Tesla's valuation -- if Musk is forced to step down as CEO, or forced out of the company entirely?

Nothing good, certainly.

What is Tesla worth without Elon Musk?

The fact that the SEC is alleging a Rule 10b-5 violation isn't a surprise -- I predicted it way back on Aug. 12, and I wasn't the only one -- but the possibility that Musk could be removed from Tesla is something of a surprise, and one that has sent investors and traders scrambling to figure out what a Musk-less Tesla might be worth.

Tesla's market cap is around $52.5 billion as I write this, making it more valuable than either General Motors (NYSE: GM) ($47.5 billion) or Ford Motor Company (NYSE: F) ($36.8 billion), two established auto giants that together sold over 16 million more vehicles than Tesla did in 2017.

Much of that is a premium for the story -- for Musk -- despite Tesla's growth potential. Without him, we have to look at fundamentals, and fundamentally, Tesla is a mess right now. Factoring in both Tesla's growth potential and the significant risks involved, a valuation of $10 billion to $15 billion might be appropriate -- if Tesla gets competent leadership after Musk's departure, and some additional funding to get it past the current cash crunch.

That's a big haircut from current levels. Of course, it could be even worse: If criminal charges are brought, it's possible that Tesla could be pushed into a significant restructuring, or even bankruptcy.

What's next for Tesla, here?

The SEC said in its complaint that its investigation is continuing. It may be working with the Justice Department, which has requested documents from Tesla -- a sign that a criminal investigation is likely under way.

Several media outlets reported on Friday that the SEC's lawsuit was filed hours after Tesla made a last-minute decision to withdraw from a settlement agreement that included both Musk and Tesla itself.

It's possible that the SEC will add Tesla to its suit in the coming days. It's also possible that Tesla and Musk will try to negotiate a quick settlement. And of course it's possible that this suit is just the beginning, that more counts will be added and criminal indictments handed down.

We don't know which way this is going to go yet. But given what we do know, there are plenty of reasons for Tesla investors to be worried.

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John Rosevear owns shares of Ford and General Motors. The Motley Fool owns shares of and recommends Tesla. The Motley Fool recommends Ford. The Motley Fool has a disclosure policy.