Many readers undoubtedly saw the news last week of the enforcement action the SEC filed against Theranos, Inc., its founder, Chairman, and CEO Elizabeth Holmes, and its President and COO Ramesh “Sunny” Balwani. Theranos and Holmes have settled with the agency, although the complaint against Balwani apparently will be going forward. The SEC’s action is interesting at many levels, and it has several important implications that should not be overlooked. The SEC’s March 14, 2018 press release about the charges can be found here. The SEC’s complaint against Thernos and Holmes can be found here. The SEC’s separately complaint against Balwani can be found here.
As I discussed in an earlier post (here), Theranos is, or rather, was, one of the Silicon Valley firms known as a “unicorn,” based on company valuations exceeding $1 billion. Indeed, Theranos itself achieved valuations as high as $9 billion based on its supposedly revolutionary proprietary technology that the company claimed would enable to the company to provide a full range of laboratory tests from a few drops of blood. The company ultimately raised $700 million dollars from investors in a series of private offerings.
The indispensable person at the center of the company’s story is Holmes, , whose photogenic and fresh-faced earnestness clearly was a key part of 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 succeeded in portraying herself as articulate visionary — and who, like Jobs, favors black turtlenecks. Indeed, media reports about Thernaos often contained extensive comparisons between Holmes and Jobs.
While press reports were, at least for a time, generally flattering about Holmes, some journalists began to ask probing questions about the company and its technology. A December 2014 profile of Holmes in The New Yorker raised alarm bells; among other things, the company was secretive to the point of paranoia about exactly how its process worked. This might have been concern if the process had been rigorously tested; however, several medical and health care professionals quoted in the New Yorker article noted their concerns that the company’s process had not been peer-reviewed. More significantly, an October 2015 Wall Street Journal article (here) revealed 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. Questions and regulatory issues followed.
The SEC’s Enforcement Action
In its enforcement actions filed against Thernos and its executives alleges that the defendants had in fact been engaged in “an elaborate, years-long fraud in which they exaggerated or made false statements about the company’s technology, business, and financial performance.” Among other things, the complaint alleges that the defendants deceived investors by telling them the company’s technology “could conduct comprehensive blood tests from finger drops of blood, revolutionizing the blood testing industry” when in fact “proprietary analyzer could complete only a small number of tests, and the company conducted the vast majority of patient tests on modified and industry-standard commercial analyzers manufactured by others.” The complaint also alleges that the defendants deceived investors about the extent and value of its business relationship with the U.S. Department of Defense.
Holmes and the company reached a settlement with the SEC in which, among other things, Holmes agreed to pay a $500,000 fine and to relinquish her voting control of the company. The settlement is subject to court approval. Importantly, neither Holmes nor the company admitted or denied the SEC’s allegations. As noted above, Balwani was not a party to the settlement and the proceedings against him apparently will continue.
There are many interesting aspects of these events, but perhaps the most noteworthy, and the one I wanted to be sure to emphasize here, is that Theranos is a private company. Indeed, the SEC’s press release contains an express statement from Steven Peikin, the co-director of the SEC’s enforcement division, that “there is no exemption from the anti-fraud provisions of the federal securities laws simply because a company is non-public, development-stage, or the subject of exuberant media attention.”
The simple but important point that should not be lost amidst the more attention-grabbing aspects of this situation is that a private company and its executives can be held liable for violations of the federal securities laws. While there is nothing revolutionary or even new about this point, it is one that is often overlooked when distinctions are being drawn between private and publicly traded companies. There may be a common misconception that private company officials are not subject to possible liability under the federal securities laws. However, as the SEC official’s statement underscores, there is no exemption in the federal securities laws for companies whose shares are not publicly traded.
The SEC official’s statement about development stage companies and about companies that are the subject of exuberant media attention may be equally important. The SEC clearly meant this enforcement action to send a message to Silicon Valley and to the many start-up companies that have managed to secure lofty valuations based on disruptive business models and fueled by media attention. Indeed, the press release quotes Jina Choi, Director of the SEC’s San Francisco Regional Office, as saying “The Theranos story is an important lesson for Silicon Valley,” adding that “Innovators who seek to revolutionize and disrupt an industry must tell investors the truth about what their technology can do today, not just what they hope it might do someday.”
Although in the end things turned out rather badly for Holmes and for Theranos, there may be those who think that she got off rather easily. A $500,000 penalty for a $700 million fraud may seem disproportionately low to some – to investors in particular. A Vanity Fair article about the SEC’s enforcement action quotes a venture capital investor as saying ““If what she’s been charged with is true, she’s a criminal who should be in prison.” (Earlier on in the sequence of events, there were reports that the U.S. Department of Justice was investigating Theranos; it is not clear from the SEC’s actions and disclosures and accompanying press coverage where the DOJ’s investigation stands.)
While investors may have been damaged by the company’s allegedly misleading statements, there is a more tragic side to this story as well. As Matt Levine noted in his March 14, 2018 Bloomberg article about the SEC’s enforcement action (here), “The problem with launching a blood-test machine that doesn’t work isn’t just that you swindle the investors who funded the machine’s development. You are also out there performing a lot of fake blood tests.” The Wall Street Journal, as Levine further notes, reported on the “trail of agonized patients” who got blood-test results from Theranos that turned out to be wrong; Theranos ultimately “voided” two years of results from its machines because they were not sufficiently accurate. The moral load from this kind of deception far outweighs the blameworthiness from the securities fraud.
Some readers may recall that around the same time as the news that the SEC was investigating Theranos, several investors filed securities lawsuit against Thernos and Holmes. (One of these cases is discussed in an earlier post, here.) As Alison Frankel discusses in her interesting March 15, 2018 post on her On the Case blog (here), the challenge that many of the claimants in these actions face is that they did not themselves invest directly in Theranos; rather, they invested in funds that in turn invested in Theranos. As Frankel’s post details, the question is whether or not these “indirect” investors have the right to proceed against Thernos. The related question is whether or not a class of these indirect investors can be certified, particularly given that in the absence of publicly traded shares the claimants cannot rely on the fraud on the market theory. Frankel also raises the question of the extent to which the SEC’s enforcement action could affect the dynamic of the pending class certification motion.
But as I said above, while there are many interesting angles on the Theranos story, perhaps the most important point, and the one that should not be lost sight of, is that private company officials are not exempt from potential liabilities under the federal securities laws. Among the many important implications of this fact is that the potential securities law liabilities need to be taken into account when structuring D&O liability insurance for private companies and their executives.
Private company D&O insurance policies typically include a Securities Liability exclusion; the wordings of these exclusions vary and in some instances might preclude coverage for claims against the company and its executives alleging violations of the securities laws.
The SEC’s enforcement action against Theranos, as well as the continuing investor damages lawsuits, underscore the importance for private company policyholders of reviewing the Securities exclusions in their D&O insurance policies in order to understand how the policy would respond in the event of the kinds of problems that Theranos and its executives have faced.