and Submitted December 4, 2017 San Francisco, California
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
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.
panel affirmed the district court's dismissal of a
securities fraud action brought on behalf of a class of
plaintiffs who bought SolarCity shares.
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.
SMITH, CIRCUIT JUDGE:
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.
AND PROCEDURAL BACKGROUND
SolarCity's Business Model and Accounting
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
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.
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.
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.
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.
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
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
SolarCity's Accounting Error and its Aftermath
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."
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.
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.
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.
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.