In a speech last month, SEC Chair Mary Jo White signaled that the agency was going to be paying closer attention to private companies, particularly so-called “unicorns” – that is, the private venture-backed start-ups with valuations over $1 billion (as I discussed in a recent post). In her speech, White highlighted the concerns that can surround companies with these kinds of lofty valuations, noting that “the concern is whether the prestige associated with reaching a sky-high valuation fast drives companies to appear more valuable than they actually are.” It wasn’t clear at the time exactly what the agency’s scrutiny of these private companies might mean, but recent news involving the high-flying start-up company Theranos shows what White had in mind. The developments involving Theranos, in turn, raise the question of whether other high-flying privately held companies might also face scrutiny, as well.
Theranos is a venture funding-backed Palo Alto, California company that promised to revolutionize the blood testing business. The company’s website proclaims that the company‘s “breakthrough advancements have made it possible to quickly process the full range of laboratory tests from a few drops of blood.” Recent financing rounds valued the company at as much as $9 billion.
According to news reports, the company recently released an internal memo advising that the company has learned that it is under investigation by the U.S. Department of Justice and the Securities and the Securities Exchange Commission are investigating the company. According to the Wall Street Journal (here), the SEC is investigating whether Theranos “made deceptive statements to investors when it solicited funding.”
The advent of these investigations is just the latest bit of bad news to surface about the company. Last October, there were news reports that the company was using its proprietary blood-testing device in only a very small fraction of blood tests, and that there were internal questions about the device’s accuracy. Last week, it emerged that in March federal regulators had threatened a two-year ban from the blood testing business for the company’s founder, Chairman and CEO, Elizabeth Holmes, and the company’s President, Sunny Balwani, after concluding that the company failed to fix what regulators have called major problems at its laboratory in California.
I have particular interest in these developments; I became fascinated by the company after reading the December 15, 2014 New Yorker profile of Holmes, the company’s now 32 year-old founder. The article, like most stories about Theranos, was accompanied by a picture of the photogenic Holmes, whose youthful fresh-faced earnestness clearly has been indispensable to the company’s ability to attract hundreds of millions of dollars of venture funding. Holmes checks all of the key boxes in the Silicon Valley start-up checklist; like Mark Zuckerberg, she dropped out of college (Stanford, in her case) to start up her company, and like Steve Jobs, she is an articulate visionary — who, like Jobs, favors black turtlenecks. Indeed, the New Yorker piece includes numerous comparisons between Holmes and Jobs.
The one thing that is absolutely clear about Holmes is that she excels at attracting powerful supporters. The composition of the company’s board is astonishing; among its members are such heavyweights as former Secretaries of State Henry Kissinger and George Schulz; former U.S. Senators Sam Nunn and William Frist; William Foege, the former director of the Centers for Disease Control and Prevention; and David Boies, the prominent attorney and litigator. Holmes’s ability to win the support of investors and of these kinds of powerful friends, has not only been good for the company, it has worked out well for Holmes, too. She owns over 50 percent of the company, so when it was valued at $9 billion, she was a billionaire several times over.
Though the New Yorker article is generally favorable, some notes in the article sounded alarm bells. Among other things, the company is secretive to the point of paranoia about exactly how its process works. This might not be such a concern if the process had been rigorously tested; however, several medical and health care professionals quoted in the article noted their concerns that the company’s process have not been peer-reviewed.
These kinds of concerns and the recent problems that have emerged about its labs and testing processes raise questions about the company’s claims concerning its “breakthrough” processes. The fact that the company is under investigation does not, of course, mean that it has done anything wrong. It may be that the company will be entirely cleared. And it may turn out that the company’s processes are every bit as extraordinary and disruptive as the company claims.
What is most interesting about the news of the SEC’s investigation of Theranos is that the company’s shares are not publicly traded. As a columnist for Wired Magazine noted in an online post (here), the agency is investigating Theranos for fraud, which is “weird for a private company.” But as Wayne State Law Professor Peter Henning and Berkeley Law Professor Steven Davidoff Solomon noted in an April 20, 2016 post on the New York Times Dealbook blog (here), merely because the company’s shares are not publicly traded “does not exempt the company from the anti-fraud provisions of the federal securities laws.” A misstatement or omission of material fact in connection with the sale of its securities to venture capital firms “constitute a violation.” (SEC Chair White made essentially the same point in her speech last month.)
The idea that the SEC might investigate a privately held company is something to which will have to adjust, but it turns out that we may need to get used to the idea, because Theranos may not be the only one. According to an April 19, 2016 Law 360 article entitled “SEC’s Theranos Probe Shows Unicorn Hunt Not a Myth” (here, subscription required), the SEC has been investigating private companies in Silicon Valley for over a year, and at least one other unicorn company besides Theranos “has been under the agency’s microscope.” (The article does not name the other company that supposedly is also under investigation.)
These developments – and in particular the possibility of other investigations — obviously represent a significant concern for the Silicon Valley start up companies that so far seem to have drawn the agency’s attention, particularly the so-called unicorns on which the agency’s attention has been focused. There is nothing that says that the agency will stop there or limit its scrutiny just to the unicorn companies, although the larger companies do seem likeliest to attract attention.
As I noted previously when I commented on White’s speech, there has long been a belief that there is a sharp distinction between privately held and publicly traded companies. Under this view the liability exposures between the two kinds of companies were perceived to be distinct, with the risk of federal securities law liability exposures limited to publicly traded companies. The D&O insurance marketplace is built around a basic premise that private and public companies are fundamentally different. The D&O insurance for these two categories of companies are written in entirely different forms, in part based on the assumption that public companies have potential liability exposures under the securities laws, while private companies generally do not. SEC Chair White’s recent speech and the onset of the investigation involving Theranos make it clear that private companies have potential liability exposures under the federal securities laws.
There are a number of policy term and condition implications from all of this. Given the potential liability exposures that private companies may face, the Securities Exclusion in private company policies may need to be reviewed in order to ensure that the exclusion would not preclude coverage for securities law claims that might arise even while the company is still private. These concerns are most apparent for the larger private companies and for pre-IPO companies, but the concerns are not restricted to these kinds of companies alone.
There may be D&O underwriting implications from all of this as well, particularly with respect to the highly valued venture funding-backed firms in Silicon Valley and elsewhere. The size of these companies alone already would have put them in a different risk assessment category, but the possibility of securities law liability exposures dials up the risk assessment even further.
It may take some time for the D&O industry to sort through all of the implications, but the accepted view that there is a sharp, categorical distinction between privately held and publicly traded companies clearly must be reexamined. As I have noted before, there are a number of other recent developments that highlight the breakdown of this distinction. Thus, for example, the JOBS Act provisions that allow small private companies to raise financing through crowdfunding include provisions subjecting these companies to potential liability under the federal securities laws. There are similar kinds of concerns in connection with the SEC’s recent Regulation A+ financing regulations (about which refer here).
Perhaps the distinction between the two types of companies was never as sharp as might have been assumed in the past. But because old assumptions die hard, some adjustment will be required.