The SEC does not disclose its ongoing investigations, but from news reports I believe the Commission has issued a formal order of investigation related to Tesla's non-disclosure of the Florida autopilot fatality in May. I believe it is highly probable there are other issues the SEC is looking at besides the lack of timely disclosure of the Florida autopilot crash, including the Company's ongoing use of non-GAAP revenue. There is also a high likelihood that senior personnel at the Commission have Tesla on their radar. This is evidenced by the way in which the existence of the fatal autopilot crash non-disclosure investigation was leaked to the Wall Street Journal. If this is the case, the SEC staff will have broad latitude to explore whatever potential enforcement theories it cares to pursue, at such time as it deems appropriate. Tesla could expend significant resources responding to and defending against these investigations, creating a drag on the Company, consuming cash and management attention at a critical time.
Leak of the Fatal Autopilot Crash Disclosure Investigation
On Monday, July 11, the Wall Street Journal reported that Tesla was under investigation by the Securities and Exchange Commission for failure to disclose the fatal accident involving the Company's autopilot self-driving system prior to its public offering of shares in May. Tesla responded that it was unaware that the SEC was investigating non-disclosure of the fatal autopilot crash. Did the Wall Street Journal get it wrong? Was this article planted by Tesla short sellers?
Not likely. I have little doubt that the SEC is investigating Tesla. This is not because I have access to any confidential information relating to ongoing SEC investigations - I don't. It's based solely on my experiences working both for and around the SEC for the last 20 years.
What the press and public refer to as "the SEC" is both a rule-making, quasi-judicial group of five commissioners that collectively form "the Commission," and the thousands of staffers that make up "the staff." The staff has very limited power to investigate without Commission authorization. In order for the staff to subpoena records and testimony, it must first obtain from the Commission a formal order of investigation. The way this typically works is the staff goes to the Commission with a draft order, and the Commission considers the order and then either approves or disapproves it. This can be done in a regular quorum session of the Commission or seriatim. Once the formal order is approved by the Commission, the staff is free to subpoena documents and testimony from the registrant.
SEC investigations are confidential. When the SEC was created in the wake of the Great Crash of 1929, Congress and the Roosevelt administration were concerned that the SEC's powers could be abused, so they purposely designed the agency with built-in safeties. One of these is that investigations are private until either 1) the SEC sues the respondent in a Federal court, or 2) the SEC takes administrative action or settles with the respondent and issues a press release.
Nevertheless, there are occasionally leaks from inside the Commission to the press. In my experience, these leaks often seem to come from a high level. That makes sense - members of the staff could lose their job and career if they were discovered to have leaked. Commissioners and their senior staff, on the other hand, are political appointees, not lifers. They know the Washington landscape much better, and they only stay with the agency for a few years. Also, having generally come from Congressional staff or senior positions in cabinet-level government organizations such as the Department of Justice, the Commissioners and their individual staffs are intimate with the media.
Leaks of this nature can indicate a high degree of concern or agitation with a registrant at the Commission level. They are perhaps frustrated with a company's recalcitrance and want to show the market they are responding. In the case of Tesla, the Commission has likely been watching for some time. Indeed, the existence of a Tesla "task force" inside the SEC would not surprise me at all, given the Company's continuing issues and the CEO's affinity for making public statements via Twitter.
The Tesla leak felt like a high-level leak. Why? Because it was picked up by one top-level media outlet - the Wall Street Journal - and the Company didn't appear to be aware of it yet. This was likely a case in which the Commission approved the formal order, and it was leaked before the staff had time to drop subpoenas on the Company. If Tesla is indeed being investigated by the SEC, and the Commission has issued a formal order of investigation into the fatal autopilot crash, the staff will not be limited by the four corners of the formal order - once its nose is in the tent, it can follow the scent of evidence wherever it leads.
Not that there isn't plenty to focus on with the fatal autopilot crash. Recall that the crash, which occurred in Florida on May 7, preceded the Company's shelf registration on May 18 by eleven days. In Tesla's Form 10-Q for the quarter ended March 31, 2016, the Company disclosed the following risk factor, which specifically mentions the possibility of liability claims arising from driver injury or death related to the autopilot feature:
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.
Product liability claims could harm our business, prospects, operating results and financial condition. The automobile industry experiences significant product liability claims and we face inherent risk of exposure to claims in the event our vehicles do not perform as expected resulting in personal injury or death. We also may face similar claims related to any misuse or failures of new technologies that we are pioneering, including autopilot in our vehicles and our Tesla Energy products. A successful product liability claim against us with respect to any aspect of our products could require us to pay a substantial monetary award. Our risks in this area are particularly pronounced given the limited number of vehicles and energy storage products delivered to date and limited field experience of our products. Moreover, a product liability claim could generate substantial negative publicity about our products and business and would have material adverse effect on our brand, business, prospects and operating results. 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.
The Company obviously knew about the fatal autopilot crash on May 18th, when it filed its registration statement, yet did not make any disclosure. This despite its own acknowledgement of the materiality of such a disclosure for investors. This is always a tempting fact pattern for an SEC investigator; the Company admitted publicly in the above risk factor that a product liability claim would be material to investors - otherwise why write the risk factor - but then failed to disclose information about an event that could give rise to such a claim in a registration statement eleven days later. Bear in mind that registration statements are governed by the Securities Act of 1933; as opposed to periodic filings such as Forms 10-K and 10-Q, which fall under the Securities Exchange Act of 1934. The burden of proof under the '33 Act is significantly lower, and this legislation contains the doctrine of constructive fraud, under which negligence can be construed as fraud without the government having to prove intent. This is what's known in the business as "low-hanging fruit."
Tesla's carefully worded "we have not received any communication from the SEC on this issue" response to the WSJ story about the SEC's investigation of non-disclosure of the fatal autopilot crash led some to believe that there may have been a pre-existing investigation or investigations of Tesla by the SEC. Pre-existing or not, a logical area of additional inquiry would be the Company's consistent and continuing reporting of non-GAAP amounts in contradiction of SEC rules.
On May 17, 2016, the SEC released updated Compliance and Disclosure Interpretations ("May 17 Interpretation") on non-GAAP reporting. SEC guidance on non-GAAP financial measures was first codified in Regulation G in 2003.
Key items prohibited by the May 17 Interpretation include:
- Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;
- A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);
- Describing a non-GAAP measure as, for example, "record performance" or "exceptional" without at least an equally prominent descriptive characterization of the comparable GAAP measure;
- Presenting a non-GAAP performance measure with certain adjustments, including one that excludes normal, recurring cash operating expenses that are necessary to operate a registrant's business;
- Presenting a non-GAAP measure inconsistently between periods, such as adjusting for a particular charge or gain in the current period and not adjusting for similar charges or gains in prior periods, unless the change between periods is disclosed and the reasons for it explained;
- Presenting a non-GAAP measure that substitutes individually tailored revenue recognition and measurement methods for those of GAAP, such as adjustments to accelerate revenue recognized ratably over time in accordance with GAAP as though such revenue was earned when customers are billed.
This last item is the one I would like to focus on. In order to get a sense of how large-cap public companies are responding to the May 17 Interpretation, I reviewed Forms 8-K including Exhibit 99.1, and press releases. Between July 1 and August 8, 2016, a total of 1,653 large accelerated fliers filed a Form 8-K including Exhibit 99.1. Of these, 1,413 included non-GAAP disclosures.
Now, one of the most interesting things about the May 17 Interpretation is what appears to be a broad prohibition on the use of non-GAAP revenue measures by public companies. Let's look closely at what the May 17 Interpretation says regarding non-GAAP revenue:
Question: A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognition ratably over time in accordance with GAAP as though it earned the revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?
Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G.
The question and answer above makes it clear that non-GAAP revenue measures, particularly those that accelerate revenue for which GAAP requires ratable recognition over time, are not to be included in documents filed with or furnished to the SEC. The SEC goes even further in banning these measures from being provided anywhere else, such as on company websites. This Q&A is explicit in its prohibition of non-GAAP revenue measures that accelerate unearned deferrals.
So, what is the state of play with non-GAAP revenue in the wake of the May 17 Interpretation? Utilizing the MyLogIQ comprehensive database, I identified Forms 8-K filed with the SEC between July 1 and August 8, 2016. This date range was chosen as it provides for companies reporting with quarters ended June 30, 2016.
The table shows the number of large accelerated filers disclosing non-GAAP measures and Non-GAAP revenue in press releases between July 1 and August 8, 2016.
Large Accelerated Filers July 1 through August 8, 2016
As seen in the table above, while 1,397, or 83%, of the 1,681 large accelerated filers identified referred to "non-GAAP" in a press release during the July 1 through August 8 period, only 53, or 3%, of those large accelerated filers referred to or disclosed "non-GAAP revenue."
Upon review of the 53 large accelerated filers that referred to non-GAAP revenue in a press release, most of these filers make adjustments falling into two categories: unrealized foreign currency gains and losses, and fair value purchase price adjustments. But Tesla continues to present a non-GAAP revenue number that appears to be in contravention of the SEC's May 17 Interpretation:
From Tesla's Q2 press release:
Total Q2 GAAP revenue was $1.3 billion, while non-GAAP revenue was $1.6 billion for the quarter, up 31% from a year ago. Total Q2 gross margin was 21.6% on a GAAP basis and 20.8% on a non-GAAP basis.
Automotive revenue was $1.2 billion on a GAAP basis and $1.5 billion on a non-GAAP basis, which includes a $293 million net increase in deferred revenue and other long term liabilities resulting from lease accounting used for indirect leases issued through our bank partners and cars sold with an RVG.
This is really quite staggering - Tesla appears to have gone rogue. It looks as if the Company has read the May 17 Interpretation; it has changed the order and is now presenting GAAP results first. But there's that non-GAAP revenue, which accelerates revenue required to be recognized ratably under GAAP as though it were earned when the customers were billed. This is precisely what the SEC prohibited in the May 17 Interpretation.
Tesla an SEC Target?
Will the SEC sue Tesla over this alone? Doubtful. Would a federal court rule in favor of the SEC? Who knows. The point is the SEC is likely now viewing Tesla as a company that flouts its rules with impunity. The SEC can investigate Tesla for a long time. They're government lawyers, and this is what they do. That's one reason why companies don't typically flout their rules.
I indicated above that the SEC was carefully designed with safeties so that it would create a healthy environment for the capital markets, but wouldn't interfere or become activist by butting into registrants' businesses. I see many commenters on SA and elsewhere asking "Where is the SEC?" when a company does something the commenters don't approve of. The SEC does not tell companies how to run their businesses, or not to engage in transactions. And that's a good thing. They wouldn't be working at the SEC if they were brilliant strategists and managers. They are securities lawyers and accountants, and the regulatory model is one of disclosure. If you don't follow the rules, they can come back and whack you with comment letters and civil enforcement actions later on. They move slowly and cautiously by design, but getting on their radar the way Tesla appears to have done can create a lot of problems down the road.
And the Commission itself becomes especially concerned - and is likely to be intimately involved - in those rare situations in which registrants knowingly ignore explicit guidance. These actions may be seen as challenges to the authority of the agency. If the Commission becomes highly agitated with a registrant, it can use its considerable powers and resources to bring such registrants to heel, eventually. History is littered with high-flying companies that attracted the SEC's attention through their combativeness, effectively inviting the agency inside to witness the fall; Gulf + Western come to mind, as do Enron and Peregrine Systems.
Tesla appears to be under SEC investigation for its non-disclosure of the fatal autopilot crash in its subsequent share registration. The SEC will follow the evidence developed in this investigation wherever it leads, and Tesla's non-GAAP disclosures are certainly a strong contender to be an issue. Together with shrinking demand for existing models despite recent price cuts, refusal to provide an update on Model 3 reservations, growing inventory and inventory in transit, and the myriad issues surrounding the SolarCity (SCTY) merger, the existence of this investigation places additional risk on the Company's shares. Yet, despite the bad news, the stock continues to trade in a relatively narrow range. Tesla is beyond "defying gravity" in the traditional sense.
Disclosure: I am/we are short TSLA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.