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Webb v. SolarCity Corp.

United States Court of Appeals, Ninth Circuit

March 8, 2018

James Webb, Lead Plaintiff, Plaintiff-Appellant,
SolarCity Corporation; Lyndon R. Rive; Robert D. Kelly, Defendants-Appellees.

          Argued and Submitted December 4, 2017 San Francisco, California

         Appeal from the United States District Court for the Northern District of California Beth Labson Freeman, District Judge, Presiding D.C. No. 5:14-cv-01435-BLF

          Jeremy A. Lieberman (argued), Emma Gilmore, and Jennifer B. Sobers, Pomerantz LLP, New York, New York, Plaintiff-Appellant.

          Ignacio E. Salceda (argued), Benjamin M. Crosson, and Cheryl W. Foung, Wilson Sonsini Goodrich & Rosati, Palo Alto, California, for Defendants-Appellees.

          Before: MILAN D. SMITH, JR. and SANDRA S. IKUTA, Circuit Judges, and JOHN D. BATES, [*] District Judge.

         SUMMARY [**]

         Securities Fraud

         The panel affirmed the district court's dismissal of a securities fraud action brought on behalf of a class of plaintiffs who bought SolarCity shares.

         The complaint alleged that the defendants violated §§ 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 when they changed the company's accounting formula prior to the initial public offering in order to misrepresent SolarCity's profitability. The panel held that plaintiff's third amended complaint failed to adequately plead facts giving rise to a strong inference of scienter, as required by the Private Securities Litigation Reform Act. Rather, based on the facts alleged, an inference of scienter was not at least as compelling as the inference of an honest mistake made by a mismanaged organization.



         Plaintiff-Appellant James Webb brought this class action lawsuit against Defendants-Appellees SolarCity Corporation (SolarCity or the company), Lyndon R. Rive, and Robert D. Kelly on behalf of the class of plaintiffs who bought SolarCity shares between December 12, 2012-the date of the company's initial public offering (IPO)-and March 18, 2014 (the Class Period). Webb claims that Defendants-Appellees violated § 10(b) of the Securities Exchange Act of 1934 (the Act), 15 U.S.C. § 78j(b), and 17 C.F.R. § 240.10b-5 (Rule 10b-5), and that Rive and Kelly also violated § 20(a) of the Act, 15 U.S.C. § 78t(a), when Defendants-Appellees changed the company's accounting formula prior to the IPO in order to misrepresent SolarCity's profitability. After allowing Webb to amend his complaint three times, the district court held that Webb's Third Amended Complaint (TAC) failed to adequately plead scienter, and dismissed it with prejudice. We have jurisdiction pursuant to 28 U.S.C. § 1291, and we affirm.


         I. SolarCity's Business Model and Accounting Protocols

         During the relevant time period, SolarCity was a Delaware corporation that sells renewable energy through the leasing and sale of solar energy systems. Defendant-Appellee Rive, who cofounded SolarCity in 2006 with his brother, Peter Rive, and cousin, Elon Musk, was the company's Chief Executive Officer. Defendant-Appellee Kelly was the company's Chief Financial Officer.

         Since 2006, SolarCity has grown significantly. The company went public in 2012, raising over $92 million, of which the company received $85, 305, 010 after expenses. SolarCity now operates in fourteen states and serves a mix of commercial entities, government entities, and residential users. The company claims to have "provided or contracted to provide solar systems or services to more than 50, 000 customers" since its founding.

         SolarCity generates its revenues by both selling and leasing its solar energy systems to these customers. SolarCity "offers its customers the option to either purchase and own solar energy systems, or to purchase the energy that its solar energy systems produce through various financed arrangements, i.e. long-term contracts structured as leases and power purchase agreements." If a customer chooses the second route, and executes a lease or power purchase agreement (PPA), SolarCity then "installs its solar energy system at the customer's premises and charges the customer a monthly fee for the power produced." With a lease, "the monthly payment is predetermined and includes a production guarantee." With a PPA, SolarCity charges the customer "a fee per kilowatt hour (kWh), based on the amount of electricity actually produced by the solar energy system." Thus, "[t]he amount of operating lease revenues depends partly on the amount of energy generated by solar energy systems under power purchase agreements, which in turn depends in part on the amount of sunlight." The standard lease or PPA agreement term is 20 years.

         The revenues generated by SolarCity's sales and leases are accounted for differently in SolarCity's financial records. Under generally accepted accounting principles (GAAP), "[r]evenue is comprised of the gross income generated by selling goods (sales) or by performing services (professional fees, commission income)." Accounting for sales revenues is simple: They "are generally recognized when the Company installs the solar energy system and it passes inspection by the utility or applicable authority." All costs associated with a sale are realized at the time of the sale, and subtracted from sales revenue to calculate gross profit. These costs include both the direct costs of each individual sale or lease, such as the cost of the solar system and its installation, and the indirect overhead costs that apply to the whole company, such as factory or facilities costs.

         Accounting for lease and PPA revenues-which are treated as operating leases for GAAP purposes-is more complex. Under GAAP, SolarCity must account for these revenues ratably, on a straight-line basis, over the term of each lease. This means that notwithstanding the "typically significant" total revenues collected over a lease's 20-year term, "SolarCity can only recognize a fraction of those revenues per year." Installation and overhead costs are amortized over the lease term, while costs from the underlying solar system itself are depreciated over its longer, thirty-year life.

         SolarCity uses a specific "burden ratio" (BR) to allocate its indirect overhead costs between its sales and lease divisions. The formula for its calculation is:

Allocable Indirect Overhead Costs BR = Prior Period Direct Costs Current Period Direct Costs

         SolarCity applies this ratio to its total direct expenses to determine how much overhead to allocate to each division. The burden ratio percentage is first allocated to the Leasing Division's total direct expenses, and then the remainder is allocated to the sales division. For example, if prior period allocable overhead costs were $10 million, and direct costs were $20 million, the correct burden ratio pursuant to the formula would be 50%. The Leasing Division would be allocated this percentage of the $20 million in total direct costs, resulting in an allocation of $10 million of overhead costs to leases. The $10 million remainder would be allocated to sales.

         II. SolarCity's Accounting Error and its Aftermath

         Beginning in the first quarter of 2012 and continuing for seven consecutive quarters, SolarCity failed to adhere to its GAAP-compliant protocols. During this period, the company retained prior period overhead costs in the numerator of its burden ratio formula, but omitted prior period direct costs from the denominator. As a result of that error, if $5 million of the $20 million direct costs in our example above were related to the prior period, the company would have calculated its burden ratio as 66.6% ($10 million / $15 million). Applying this ratio to the total direct costs of $20 million would result in an allocation of $13.3 million of overhead costs to leases, with only $6.7 million of overhead costs allocated to sales. Thus, SolarCity was able to push the costs associated with its sales from the sales' revenue onto leases, "where they would be amortized over the 20-year lease term."

         This error inflated the gross margins of the company's sales, which led the company to report profits inaccurately for both sales and leases. For example, while SolarCity reported gross sales margins of -19% in 2010 and -14% in 2011, beginning in Q1 2012, the company's sales margin jumped, and it reported a gross sales margin of % in 2012. SolarCity's accounting error also affected the company's reported net income and earnings per share, which led the company to materially understate net loss and report higher earnings per share.

         SolarCity's improved financial situation allowed the company to expand in 2013. After its December 2012 IPO, SolarCity made two secondary offerings on October 15, 2013, which generated net proceeds of $174.2 million from the issuance of 3, 910, 000 shares of stock and $222.4 million from the issuance of convertible senior notes. The company also made two major acquisitions. First, on September 6, 2013, SolarCity purchased assets from Paramount Energy Solutions, LLC, a direct-to-consumer marketer and one of SolarCity's channel partners. This purchase enabled SolarCity to develop and offer solar energy systems directly to a broader customer base, to compete better with other energy producers, and to lower its customer acquisition costs. SolarCity paid $3.7 million in cash and 3, 674, 565 shares-worth $108.8 million, or 95% of the total sale price-for Paramount's assets. Second, on December 11, 2013, SolarCity acquired Zep Solar, Inc., a manufacturer and licenser of solar system mounting apparatuses, and one of SolarCity's key suppliers. This acquisition enabled SolarCity to control the design and manufacture of the Zep Solar products, which are critical components in the installation of SolarCity's solar energy systems. SolarCity paid $157.823 million for Zep Solar with $2.4 million in cash and roughly three million shares of stock-equal to 98% of the total sale price.

         It was not until 2014 that SolarCity realized that it had made a serious accounting error. On March 3, 2014, the company "announced that it [had] discovered tens of millions in overhead expenses that it had incorrectly classified." The company explained that the misclassification resulted from "an error in the formula for allocating overhead expenses between operating lease assets and the cost of solar energy systems sales originating in Q1 2012." Specifically, the company had omitted prior period direct costs from the denominator of the burden ratio. This error was identified by "senior management, " who noticed that gross sales margins appeared inconsistent during the course of their review of preliminary year-end financial statements and internal controls. SolarCity announced that it would "reallocate overhead expenses from leased systems to systems sales, " which it expected would increase "the cost of solar energy systems sales [by] approximately $16-$20 million on the statement of operations for the nine month period [ending on] September 30, 2013" and by "approximately $20-$23 million" for the full year of 2012. In response, SolarCity's securities declined by $1.70 per share-just over 2%-to close on the day of the announcement at $83.26 per share.

         A second announcement was made on March 18, 2014. The company issued its restated financials for the year of 2012 and for each quarter of that year and 2013. "These disclosures revealed for the first time that the Company's solar energy systems sales unit had operated at a loss for six quarters (each quarter of 2013 as well as Q2 and Q4 2012) and barely broke even in two quarters (Q1 2012 and Q3 2012)." SolarCity securities declined again, dropping $4.40 per share-nearly 6%-to close at $72.70 per share on March 19, 2014, on unusually high trading volume. Overall, SolarCity's share price fell by $23.58, or 27.8%, between Friday, February 28 (the final close before the announcement) and Friday, March 28.

         III. ...

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