TheranosEarlier this year, the SEC announced a “Silicon Valley Initiative,” reflecting the agency’s concerns about private and pre-IPO companies that were scoring sky-high valuations in private offerings. The agency said that it is particularly focused on so-called “unicorns” – that is, private companies with valuations greater than $1 billion. Although the agency did not name any of the specific companies in which it was interested, it soon became clear that one of the companies the agency was investigating was Theranos, the start-up company whose blood-testing technology and practices have recently gained media and regulatory scrutiny. The SEC’s scrutiny of a private company’s fund-raising practices was itself noteworthy; now, in yet another notable development, the privately-held company has drawn an investor lawsuit alleging securities fraud.


According to a front-page October 11, 2016 Wall Street Journal article entitled “Major Investor Sues Theranos” (here), a hedge fund has filed a lawsuit under seal in the Delaware Chancery Court against Theranos, its founder, Elizabeth Holmes, and its former Chief Operating Officer Sunny Balwani. The lawsuit was filed by Partner Fund Management L.P., a San Francisco based hedge fund that invests in health-care and technology companies. Partner invested $96.1 million in Theranos in February 2014, following meetings between fund personnel, Holmes and Balwani beginning in December 2013. The hedge fund’s filing of the suit came to light in a letter the fund sent to its investors on Monday.


The lawsuit is merely the latest event in the dramatic fall from grace of this formerly high-flying firm and for Holmes, whose photogenic earnestness helped to draw so much attention to the company (as I discuss in greater detail here). Indeed, Holmes was something of a media star, and at one time, the company’s valuation was as high as $9 billion. However, it all began to unravel last Octoberafter 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.


In April, just before the SEC investigation of the company came to light, it emerged that in March federal regulators had threatened a two-year ban from the blood testing business for Holmes and Balwani, after concluding that the company failed to fix what regulators have called major problems at its laboratory in California.


In May, the company voided thousands of blood test results. In July, the Centers for Medicare and Medicaid Services revoked Theranos’s license to operate a lab in California because of unsafe practices and to ban Holmes from the blood-testing business for at least two years. The company is appealing the ban.


Just last week, in an October 5, 2016 letter from Holmes to the company’s “stakeholders,” Theranos announced that it was shutting down its remaining test lab in Arizona, and was going to shift away from blood-testing to making technology intended to made blood-testing easier and cheaper. In her letter, Holmes thanked the company’s investors for proving the company with “the runway to realize our vision.”


As troubles at the company mounted, its outside investors, who had poured more than $800 million into the company, were mostly quiet. Until now.


According to the letter it sent to its investors, Partner alleges in the lawsuit it filed on Monday that “through a series of lies, material misrepresentations, and omissions,” Theranos, Holmes and Balwani “engaged in securities fraud and other violations by fraudulently inducing [Partner] to invest and maintain its investment in the company.” The lawsuit reportedly alleges that the company, Holmes, and Balwani engaged in securities fraud, negligent misrepresentation, and violations of the Delaware deceptive trade practices act, among other things.


The Journal reports that Partner alleges that Theranos overstated the scope of its submissions for FDA approval and its ability to meet the obligations it had undertaken in its partnerships with various companies including its agreements with the drugstore company Walgreens Boots Alliance.


For now, at least, it appears that Partner is the sole plaintiff. Because the fund’s complaint was filed under seal, there is now way to know if Partner is relying in particular on specific representations Holmes, Balwani and other company representatives made in its meetings with the hedge fund.


There is of course nothing new about private company investors filing lawsuits alleging that they were misled or had been induced by misrepresentations into making their investment. So the fact that Theranos and its executives have been sued for securities fraud is not necessarily distinctive or noteworthy in and of itself. What is noteworthy is not that investors have filed a securities fraud lawsuit; what is noteworthy is the scale of the claim, as well as its high-profile nature, given that the defendant company is privately held. The lawsuit also speaks to the more general concern about the large unicorn companies and their lofty valuations.


As I noted at the time that the SEC’s investigation of Theranos came to light earlier this year, the D&O industry in the U.S. has tended to view the world as neatly divided between public companies and private companies, with distinct attributes distinguishing the two categories. The rise of start-up private companies with valuations over $1 billion blurs the distinctions between the categories. When a company is raising hundreds of millions of dollars of investments with valuations ranging into the billions of dollars, and attracting front page attention in the national business press at the same time, it is hard to say that a company – even if entirely privately-held – has only the characteristics traditionally associated with the private company category as it has been traditionally conceived.


Of most immediate practical significance is that the D&O insurance industry’s view that there are two distinct kinds of companies, public and private, is the fact that the industry offers two distinctive and separate kinds of insurance policy forms, one for public companies and another for private companies. The most important distinction between the two kinds of policies is that the public company form is built around the possibility that the defendant company might incur liabilities under the securities laws, and the private company policy generally assumes that the insured company does not have liabilities under the federal securities laws. Theranos’s SEC investigation highlighted the fact that private companies can in fact potentially incur liability under the securities laws. The recently filed Delaware state court securities lawsuit against the company underscores the point.


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 typically found 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 are many variations of this exclusion, but for a company like Theranos which is engaged in extensive and massive fund-raising, the preferred exclusion would be one that only goes into effect if the company’s public registration of shares in connection with an IPO becomes effective.


The sheer size of many of these early stage companies with lofty valuations has another implication, with respect to the amount of insurance that the company may want to put in place. The hedge fund’s lawsuit, where it is seeking to recover its losses on a nearly $100 million investment, highlights the point that even though still private a company with a significant valuation faces potential liability exposures far beyond and different from the scale and size of liability exposures more traditional private companies have faced. A company with these surging valuations will want to take these considerations into account when deciding how much insurance to buy.


There are clearly 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.


The events surrounding Theranos and other “unicorn” companies are only the latest in a series of developments contributing to the breakdown of the insurance industry’s traditional sharp distinction between public and private companies. It may well be that the division was never as sharp or distinct as was usually perceived, but still old habits die hard.