Friday, August 26, 2022
I’ll admit it – I frequently choose blog post topics based on what I can write quickly, and since obviously I’ve been following the Twitter case closely, that’s the topic for today.
This post is really meant as an explainer of the legal state of play; lawyers who have been following closely probably already know most of this, but for anyone else, this is for you.
It’ll be really, really long, so I cut
As we all know, Musk signed a merger agreement with Twitter in April (without first conducting due diligence), in July he purported to terminate the agreement, Twitter sued him to force him to close a few days later.
In his court filings, Musk has advanced three basic arguments for why he should be permitted to walk away from the deal, phrased in terms of defenses and in terms of his own counterclaims against Twitter.
The first set of arguments are contractual: given Twitter’s conduct and the facts on the ground, under the terms of the contract itself, Musk is not obligated to close.
The second argument accuses Twitter of committing fraud; Musk claims he was duped into making the purchase.
The third argument is about violations of the Texas Securities Act (TSA).
If Musk prevails on any one of his arguments, he gets to walk away. Contract, or fraud, or (forgive me while I control my laughter) violations of the TSA. Any one of those gets him out.
TSA. I’ll start with the TSA first, because it’s simple: I have not seen any reason to think Texas law applies to this transaction. The fact of Musk’s residence alone is not sufficient, and nothing else in Musk’s papers articulates a Texas connection. So, for now, I’m putting that one aside.
Fraud. The common law rule is, if Musk can show that Twitter made a false statement, on which he relied, and that Twitter intended to defraud him, Musk can rescind the contract.
To the extent Musk has to show materiality, it’s the same standard as it would be under federal law, namely, a fact where there is a substantial likelihood that a reasonable investor would have considered it significant. Note, this is not the same as a material adverse effect – that’s something else, we’ll get to it later. Materiality for fraud purposes is just ordinary, Basic v. Levinson materiality. We can stipulate for these purposes that any fraud Musk identifies would meet that standard.
What is the false statement?
The merger agreement explicitly states that Musk is only relying on the representations set forth in the merger agreement itself, and not on any outside materials:
Each of Parent and Acquisition Sub has conducted, to its satisfaction, its own independent investigation, review and analysis of the business, results of operations, prospects, condition (financial or otherwise) or assets of the Company and its Subsidiaries. In making its determination to proceed with the transactions contemplated by this Agreement, including the Merger, each of Parent and Acquisition Sub has relied solely on the results of its own independent review and analysis and the covenants, representations and warranties of the Company contained in this Agreement. Parent and Acquisition Sub hereby acknowledge that, notwithstanding anything contained in this Agreement to the contrary, (i) neither the Company nor any of its Subsidiaries, nor any other Person, makes or has made or is making any express or implied representation or warranty with respect to the Company or any of its Subsidiaries or their respective business or operations, in each case, other than those expressly given solely by the Company in Article IV; and (ii) neither Parent nor Acquisition Sub is relying on any express or implied representation or warranty, or the accuracy or the completeness of the representations and warranties set forth in Article IV, with respect to the Company or any of its Subsidiaries or their respective business or operations, in each case, other than those expressly given solely by the Company in Article IV.
That’s enforceable in Delaware – Musk is contractually barred from claiming fraud due to statements outside the merger agreement. He can’t claim fraud based on blog posts, Twitter executives’ tweets, statements to market analysts, or any materials of that nature. He can, however, claim fraud due to statements in the merger agreement itself.
And the statement he’s seizing on is:
Since January 1, 2022, the Company has filed or furnished with the SEC all material forms, documents and reports required to be filed or furnished prior to the date of this Agreement by it with the SEC (such forms, documents and reports filed with the SEC, including any amendments or supplements thereto and any exhibits or other documents attached to or incorporated by reference therein, the “Company SEC Documents”). As of their respective dates, or, if amended or supplemented, as of the date of the last such amendment or supplement, the Company SEC Documents complied in all material respects with the requirements of the Securities Act and the Exchange Act, as the case may be, and the applicable rules and regulations promulgated thereunder, and none of the Company SEC Documents at the time it was filed (or, if amended or supplemented, as of the date of the last amendment or supplement) contained any untrue statement of a material fact or omitted to state any material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, or are to be made, not misleading.
Notice that January 2022 was just a few months ago, so it’s only a small number of SEC filings that are at issue here, the main one being the 2021 10-K, filed in February 2022. In that document, Musk has seized on Twitter’s “monetizable daily active user” figure, or mdau. Twitter claims that of all the accounts on its platform, the mdau figure represents, in a general sense, the accounts that are held by real live humans who could – at least theoretically – be the subject of targeted advertising. Here’s how mdau is defined:
people, organizations, or other accounts who logged in or were otherwise authenticated and accessed Twitter on any given day through twitter.com, Twitter applications that are able to show ads, or paid Twitter products, including subscriptions.
Twitter estimates this number to be around 217 million for the fourth quarter of 2021. It also recognizes, however, that it may have improperly included some spam/’bots in that figure, and estimates the amount of spam in that figure to be around 5%. But that comes with a lot of caveats:
There are a number of false or spam accounts in existence on our platform. We have performed an internal review of a sample of accounts and estimate that the average of false or spam accounts during the fourth quarter of 2021 represented fewer than 5% of our mDAU [monetizable daily active users] during the quarter. The false or spam accounts for a period represents the average of false or spam accounts in the samples during each monthly analysis period during the quarter. In making this determination, we applied significant judgment, so our estimation of false or spam accounts may not accurately represent the actual number of such accounts, and the actual number of false or spam accounts could be higher than we have estimated. We are continually seeking to improve our ability to estimate the total number of spam accounts and eliminate them from the calculation of our mDAU, and have made improvements in our spam detection capabilities that have resulted in the suspension of a large number of spam, malicious automation, and fake accounts. We intend to continue to make such improvements. After we determine an account is spam, malicious automation, or fake, we stop counting it in our mDAU, or other related metrics. We also treat multiple accounts held by a single person or organization as multiple mDAU because we permit people and organizations to have more than one account. Additionally, some accounts used by organizations are used by many people within the organization. As such, the calculations of our mDAU may not accurately reflect the actual number of people or organizations using our platform.
Musk claims this statement is false because the mdau includes more than 5% spam, along with some assorted claims of double counting certain accounts and so forth. He also claims that the mdau representations are misleading because while Twitter touts mdau as a “key metric” by which to gauge its results, in fact, mdau is a made up metric, concocted by Twitter’s executives because it was easy to control, relatively undefined, and could be used as the basis for executive bonuses. Musk claims that in fact other metrics would be a far more important barometer of Twitter’s results. Finally, he claims the mdau figure is misleading because only a small portion of those people actually see advertisements – some, for example, may only log on briefly and never see an ad – and thus generate revenues.
Now, if you’re at all familiar with securities litigation, you can see why these are facially weak claims. Twitter’s 5% figure is heavily caveated; to falsify it, you’d have to show that Twitter does not, in fact, have a reasonable, good faith process for assessing spam amounts in the mdau. And, it may be a made up metric that was invented to goose executive compensation, but Twitter could pay its executives based on astrological signs if it wanted to, as long as that information was disclosed – which this was. Finally, Twitter never said the number consisted of “monetized” users; they are only “monetizable.”
But remember, Musk also has to show that he relied on this figure, and that Twitter intended to defraud him.
Reliance is the big weakness here, for a bunch of reasons: (1) Musk publicly claimed he was buying Twitter because he believed it was overrun with spam; (2) even as the disputes have been ongoing, Musk has taken to Twitter to announce that it is facially obvious that the 5% figure is too low, and any casual user of the platform would perceive as much; (3) he chose not to do due diligence, which suggests he did not, in fact, consider this figure – or any of Twitter’s representations – to be particularly important; and (4) his own claim is that this is a meaningless, concocted figure that Twitter can manipulate because it’s relatively undefined even in Twitter’s SEC filings – if that’s true, why did he purportedly pay $44 billion in reliance on it?
I assume this is why Twitter is sending so many subpoenas to anyone who has ever had a conversation with Elon Musk: It wants to show that Musk openly proclaimed he was buying Twitter because he did not believe the mdau figures and he wanted to do a better job at identifying and eliminating spam. Or at the very least, that these figures had nothing to do with his decision to purchase.
And then there’s intent to defraud. I’ll just leave it as, it’s probably not enough to show Twitter somehow intended to defraud public investors; it would have had to have intended to defraud Musk in this transaction, and what evidence is there that Twitter even knew Musk considered this significant?
Nonetheless, that’s the fraud claim, and if Musk prevails, he can walk away.
Contract. Musk has a collection of arguments that under the terms of the contract itself, he can walk away, largely because Twitter has failed to meet its own obligations, and the contract therefore gives him a right of termination.
One argument is that Twitter failed to conduct its business in the ordinary course after signing. If he’s right, that alone is a reason to walk away – but, for the reasons I stated here, that’s going to be tough for him given the contractual language.
Another argument is that Twitter failed to provide him with the information he was entitled to receive as part of the process having Twitter transition to a new owner; I talked about that here, and what it comes down to is, he has an uphill battle showing that he sought information for the purpose of closing the deal, rather than for the purpose of getting out of it. And Twitter has various subsidiary arguments, like, the information he requested was unreasonable, Twitter was entitled to withhold it due to competitive concerns, and whatnot.
That leaves the headline allegation, which, again, concerns the truthfulness of the mdau figure. Twitter represented that its SEC filings from January 2022 onward were truthful and complete; under the contract, Musk gets to walk away if that’s not true (i.e., if the filings were not truthful and complete), and if the falsity was so significant as to cause a material adverse effect. In other words, in fraud, Musk only has to show the misstatement was intended to defraud, and he relied on it; in contract, Musk has to show the misstatement caused a material adverse effect, because that is literally what the contract says (Steve Bainbridge breaks down the relevant contractual provisions here.)
We’ve talked about the weaknesses in his falsity argument; now we can talk about a material adverse effect. Many remorseful buyers have tried to meet that standard, and only one in Delaware’s history has succeeded. In sum, it requires Musk to show facts that will have a significant, long-term impact on Twitter’s finances, or facts that “would reasonably be expected to result in” such an effect. Musk has not put forth any facts that would suggest Twitter’s mdau numbers are not only false, but so very false, that an MAE would likely result.
But I want to point out two things about the contract claim.
First, it does not depend on any fault by Twitter. If Twitter’s mdau was negligently misstated – or even if it wasn’t negligent at all, they took all due care and still got it wrong – that is meaningless here. Falsity + MAE is all that’s required for Musk to prevail.
Second, notice that Musk’s diligence, or lack thereof, has very little role to play. At best, Twitter can use it with respect to the information rights claim – the argument goes something like, “Musk tried to use his contractual information rights to backdoor the diligence he waived earlier, and that’s beyond the scope of his contractual entitlement.”
Beyond that, though, it doesn’t matter whether Musk waived due diligence or not. Twitter represented its SEC filings were truthful; it agreed that if they were untruthful enough to qualify as an MAE, Musk could walk away; it’s stuck with that no matter what Musk did or didn’t do.
To put it another way, suppose Musk had done due diligence, and had discovered that Twitter’s mdau was egregiously false – so false that it qualified as an MAE. Suppose he signed the deal anyway. Suppose later he decided, you know what, never mind, I want out.
He would be prohibited from alleging fraud – no reliance – but he could still say that Twitter’s SEC filings were false enough to qualify as an MAE, and therefore he was relieved from contractual closing obligations.
This is a concept known as “sandbagging.” Party A makes a representation in an agreement, and agrees that if the representation is false, Party B can rescind the contract; Party B knows it’s false and signs the agreement anyway. Later, Party B uses the false representation as an excuse to rescind. Some states won’t allow it; Delaware, apparently, does. If Party A makes a false representation on which the contract turns, that’s on Party A (even if, say, the representation was negligent rather than intentional). Party A just handed Party B a free option.
Okay. That’s the substance of what’s in dispute. If Musk proceeds on a fraud theory, he has to show a false statement in the merger agreement/SEC filings, reliance, and Twitter’s intent. If Musk proceeds on a contract theory, he has to show a false statement in the SEC filings, significant enough to cause an MAE. A win on either theory is a win overall.
And now you perhaps have an idea of why I mentioned earlier that discovery disputes would be an early indicator. Because Twitter’s representations are so guarded, and Musk needs to do so much more than show they are false, it’s not obvious how a detailed analysis of millions of Twitter accounts would even be relevant here. But if Twitter has to produce that information, there’s always a risk the court would get dragged into a complex question about what counts as spam, without focusing on the fundamental question of what counts as false and whether the other elements of a claim are met.
But we also had a monkey in the wrench this week, and that’s a whistleblower, Peiter “Mudge” Zatko, who came forward with a complaint alleging multiple internal problems at Twitter. How does this affect the case?
Mudge alleges a lot of different things and it’s worth taking them point by point.
He begins by criticizing Twitter’s handling of spam on the platform, and even accuses Twitter of lying to Musk about spam. Sounds great for Musk, right? Wrong! Because even though he framed his complaint this way, that’s not in fact what he alleges. Here’s what he says about mdau:
Executives are incentivized to avoid counting spam bots as mDAU, because mDAU is reported to advertisers, and advertisers use it to calculate the effectiveness of ads. If mDAU includes spam bots that do not click through ads to buy products, then advertisers conclude the ads are less effective, and might shift their ad spending away from Twitter to other platforms with higher perceived effectiveness.
However there are many millions of active accounts that are not considered “mDAU,” either because they are spam bots, or because Twitter does not believe it can monetize them. These millions of non-mDAU accounts are part of the median user's experience on the platform. And for this vast set of non-mDAU active accounts, Musk is correct: Twitter executives have little or no personal incentive to accurately “detect” or measure the prevalence of spam bots.
In other words, he thinks the mdau figure is basically correct; he just thinks that Twitter can and should do a better job of cleaning up spam on the platform.
Mike Masnick has a detailed explanation here but I’ll sum: mdau is meant to represent the number of humans on the platform. Mudge’s complaint is that there’s too much spam on the platform. These are completely different things. If I say there are 10 humans on the platform, that remains true if there are also 10 spam accounts, or 100 spam accounts, or 500 spam accounts – there are still 10 humans, and that’s all that Twitter purported to represent, on the theory that advertisers care about the number of humans. The 5% figure is Twitter saying, “We think we have about 10 humans on the platform, but given the difficulty of calculating, it’s possible we’re off by 5%.” But that still has nothing to do with whether there is also spam on the platform, in addition to the accounts that (Twitter thinks) are human.
Why does Mudge say Twitter committed fraud, if he agrees the mdau figure is accurate? I assume he wants Dodd Frank whistleblower protection and maybe a piece of any SEC fines, and he doesn’t get either unless he can allege securities fraud.
But that’s not all that Mudge says. Mudge also alleges a cornucopia of other problems, everything from lax data security to weak IP protections to lying to regulators on multiple continents. The problem is, none of that is in Musk’s pleadings. As of this posting, Musk had not added anything to his pleadings concerning these new allegations (though Mudge’s complaint was submitted to Chancellor McCormick – twice! – as part of a spam discovery dispute).
That is awkward for Musk. He could ask permission from the court to amend his pleadings – which the court should grant “when justice so requires” – but does it here? We are on a tight timeline and substantial discovery has already been conducted. These new allegations open up whole new worlds of discovery while the clock is ticking. And though ordinarily Musk could argue that this is new information that was not available to him when he filed his papers, that’s only true because he waived due diligence. Mudge’s report to the board would likely have been the very first thing Musk got hold of if he had done due diligence before signing the deal.
But let’s say Musk does manage to amend his pleadings to include these new allegations. What does it get him?
Contract. It’s possible that, singly or in combination, taking into account potential regulatory penalties, all of Mudge’s allegations (if proven true) add up to an MAE. Twitter represented in the merger agreement (Section 4.9) that it was not currently experiencing an MAE; if it was, Musk is relieved of his closing obligations (Section 7.2(b-c)). Notably, even if no regulatory agency acts in time for the trial, remember, an MAE also includes matters that “would reasonably be expected to result in” an MAE, so future regulatory penalties may be taken into account.
Fraud. This one’s a little more complicated. Fraud requires a false statement, and of course, there’s nothing in the merger agreement about these matters (unless they would cause an MAE), and while Mudge tries mightily to find false representations about these matters in the SEC filings, they simply are not there.
But there is one possibility. Item 303 of Regulation S-K requires that the 10-K include disclosure of:
material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be necessarily indicative of future operating results or of future financial condition. This includes descriptions and amounts of matters that have had a material impact on reported operations, as well as matters that are reasonably likely based on management's assessment to have a material impact on future operations.
It’s possible Mudge has identified matters that would qualify. (It’s not a determinate standard, but for reference, the Second Circuit found Item 303 violated when a company knew, but did not disclose, of a trend of problems with respect to computer chips, even though it did not know the exact error rate, Panther Partners v. Ikanos Communications, Inc., 681 F.3d 114 (2012)). Which basically means that if these problems are serious enough to have an impact on Twitter’s finances going forward – even if not serious enough to qualify as an MAE – Twitter’s 2021 10-K may not have been complete, as it represented in the merger agreement.
And that’s your false statement.
What about intent? Mudge has a lot of claims about Twitter intentionally covering this stuff up; again, even taking his allegations at face value, I think the relevant question is whether Twitter intentionally defrauded Musk personally.
But the reliance element here is really the interesting one. Because this would be, functionally, an omission. And under federal fraud standards, reliance is presumed for “pure” omissions, namely, a simple failure to disclose required information. See Affiliated Ute Citizens v. U.S., 406 U.S. 128 (1972).
Does that standard apply under Delaware law? I don’t think it’s clear; I found very limited authority suggesting not, but those cases are sparse and did not seem to fully understand the federal regime (they conflated fraud-on-the-market with Affiliated Ute). So let’s just say, if Musk gets as far as showing both intent, and omissions of required disclosures, he certainly can press for a presumption of reliance – or maybe just a reduced burden of proving reliance.
But let’s switch gears now from issue spotter to practical reality.
Let’s say Musk does amend his pleadings, and does get Mudge’s allegations in as part of a play for fraud-by-omission.
Delaware has a highly developed set of standards for how to interpret merger agreements, and in particular, when to allow parties to walk away from them. If Delaware allows Musk to walk away based on omissions from SEC filings, omissions that do not add up to an MAE (which is not necessary for fraud), and allows it without a showing of reliance, that would be open season for every reluctant merger partner going forward, creating exactly the kind of deal uncertainty that Delaware strives mightily to avoid. And that means I can’t really see this claim succeeding.
So what this all adds up to is –
I’ll say it: Musk’s arguments do not appear to be very strong, though there is the wild card of whether Mudge has identified enough problems to qualify as an MAE.
That doesn’t tell us what will happen, though, because even if Musk is in the wrong here, there’s still the question of remedy – what’s Delaware gonna do about it? The contract itself seems to give the court only two choices: a billion dollars in damages, or specific performance (require Musk to go through with the deal). This post is already very, very long, so I’ll just leave with questions: Is there an adequate remedy at law? Does that matter? How much does the parties’ stipulation regarding the propriety of specific performance matter (Section 9.9)? Does the effect on third parties matter? Should the damages cap be taken into account when the court selects a remedy? Can the court award a higher damages figure than $1 billion? I can tell you that among academics, there’s a far greater dispersion of opinion on this question than on about the merits of who’s right and who’s wrong.
And that is where we are as of this posting, though I am sure matters will change immediately thereafter.