On July 11, 2016, the Wall Street Journal reported that the Securities and tesla logoExchange Commission is investigating whether Tesla Motors Inc. violated the securities laws, apparently by not disclosing timely a fatal crash involving a Tesla Model S. Tesla’s handling of the incident from a disclosure standpoint raises interesting issues involving materiality and risk factors.

It seems the SEC is examining whether Tesla should have disclosed information regarding the fatal crash in offering documents relating to the sale of approximately $2.8 billion of Tesla common stock, nearly $600 million of which were sold by Tesla CEO, Elon Musk.

tesla crashHere are the facts. On May 7, 2016, a Model S Tesla featuring Tesla’s autonomous driving technology “Autopilot” collided with a tractor trailer that had turned in front of it, killing the driver of the Model S.  Ironically, the driver, Joshua Brown, regularly posted videos of his rides in the car, and he was clearly a big fan of Autopilot. On May 10, Tesla filed its first quarter 10-Q without any reference to the crash.  Eight days later, Tesla filed a preliminary prospectus with the SEC to sell up to 10,697,674 shares of common stock without mentioning the crash.  Two days after that, Tesla filed a prospectus supplement disclosing the pricing of the offering (up to $2 billion of stock, approximately $1.4 billion by Tesla and nearly $600 million by Musk), and again with no disclosure regarding the crash.  On June 29, Tesla learned the National Highway Traffic Safety Administration would conduct a preliminary evaluation of the crash, which Tesla addressed in a blog post after the markets closed the following day.

As to Tesla’s blog post, one thing that caught my attention was the part that states that Tesla informed the NHTSA about the accident “immediately after it occurred”. Yet the accident took place on May 7 and Tesla didn’t notify the NHTSA until May 16, a full nine days later.  In Tesla’s defense, it claimed that the extent of the wreckage made remote data analysis impossible, and it had to dispatch its internal investigators to the scene of the accident which slowed down the process.

As a general rule, SEC reporting companies must disclose categories of information specifically mandated by regulation as well as any information that’s material to investors. But there is no clearly defined standard for whether the May 7 accident was “material” enough to require disclosure. Instead, general standards regarding materiality have been established in SEC rules, judicial decisions and administrative guidance.  As a general proposition, information is deemed material if “there is a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision”.  For a fact to be material, there must be a substantial likelihood that the fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.

So is the crash material to Tesla investors? If so, the failure to disclose it would be deemed to be a material omission. One place to look for evidence of materiality is the stock market. In this case, the reaction of the stock market tesla stockseems to indicate that the crash is not material.  The day the news broke about the NHTSA investigation (June 29), the stock closed at $210.19, up from 201.79 the day before.  It rose to $212.29 on the first day after Tesla blogged about the crash (July 1), and it closed at $234.79 on July 29, the last trading day before this blog post.  In fact, the only noticeable drop in price after the crash date of May 7 occurred on June 22, when Tesla shares cratered (down $22.95 from the previous close of $219.61) in reaction to Tesla’s bid for Solar City.

The history of auto fatalities may be another reason the crash itself should not be deemed to be material. In 2015, there were an estimated 38,000 auto fatalities in the United States. Nearly 1.3 million people die in road crashes each year worldwide, an average of 3,287 deaths per day.  In its June 30 blog post, Tesla asserted that the May 7 crash was the first fatality in the 130 million miles driven with Autopilot.  By comparison, Tesla asserted that there is a fatality every 94 million miles for all American vehicles and one every 60 million miles worldwide, which Tesla asserts proves it has a “better-than-human” driving capability.  Companies do disclose safety recalls and product liability suits when they trigger significant financial charges, but not fatal crashes.  Perhaps the reason may be that fatal car crashes in and of themselves are not perceived to have a material adverse effect on a company.

But perhaps an argument in favor of materiality here is that Tesla had been aggressively promoting its Autopilot technology, which it bills as the most tesla autopilotadvanced self-driving system on the road. Investors have been drawn to Tesla shares in large part on the conviction that the company is on the cutting edge of technology, particularly with Autopilot, and may be poised to leap ahead of more traditional car manufacturers. A fatal crash, however, could lead to a change in perception of autonomous vehicles in general, and Autopilot in particular, on the part of both the public and the insurance industry. But even assuming as much, it appears that Tesla did not determine that the car was actually on Autopilot at the time of the crash until after it filed its 10-Q and offering prospectus.

One of the stranger aspects of this story is the email and tweet battle that broke fortuneout between Musk and Fortune Magazine. Fortune editor Alan Murray tweeted “[s]eems pretty material to me,” with a link to the magazine’s online article in which Musk is quoted saying in an email that the matter was “not material” to Tesla shareholders. Musk then retorted to Murray on Twitter: “Yes, it was material to you — BS article increased your advertising revenue. Just wasn’t material to [Tesla], as shown by market.”  Murray then predicted that the materiality issue would be resolved in a lawsuit, implicitly inviting shareholders to sue (sort of like Trump inviting the Russians to find Hillary Clinton’s deleted emails).

Another interesting aspect to all this is Tesla’s risk factor disclosure. Tesla’s 10-Q filed on May 10 for the quarter ended March 31 contained a risk factor entitled “We may become subject to product liability claims, which could harm our financial condition and liquidity if we are not able to successfully defend or insure against such claims”, in which it stated that a successful liability claim associated with its technology, including the Autopilot feature, could harm the company’s financial condition, “could generate substantial negative publicity about [its] products and business and would have material adverse effect on [its] brand, business, prospects and operating results” (emphasis added).  Seems like Tesla is careful to draw a distinction between an isolated crash and a products liability claim.  Also, in its June 30 blog post, Tesla referred to the foregoing risk factor as “boilerplate”, something Tesla may regret saying as the SEC has a long history of discouraging intensely boilerplate disclosures.  And finally, the part of that risk factor that really jumped off the page at me was that “We self-insure against the risk of product liability claims, meaning that any product liability claims will have to be paid from company funds, not by insurance.”  My hunch is that self-insurance is not very common in the industry, and it will be interesting to see whether Tesla revisits its insurance approach in the aftermath of all of the post-crash scrutiny.