SEC Disrupts the Disrupters – Theranos and Its Executives

Silicon Valley is reputed to be the home of the disrupter – the firm with the revolutionary new business that moves past all the existing models. To be a disrupter there has to be something new, innovative and beyond what exists in the business space. Exaggeration, hype and groundless statements are not the stuff of a new, inventive disrupter but of an age old strategy – fraud. Unfortunately it is that age old strategy that was at the core of the Commission’s most recent case against a would-be Silicon Valley disrupter. SEC v. Holmes, Civil Action No. 5:18-cv-01602 (N.D. Calif. Filed March 14, 2018); SEC v. Balwani, Civil Action No. 5:18-cv-01603 (N.D. Calif. Filed March 14, 2018).

The cases center on one-time high flying Theranos, Inc., a California company that sought to disrupt – revolutionize – the diagnostic industry. The company is a named Defendant in Holmes, along with Elizabeth Holmes, the firm’s founder, CEO and controlling shareholder. Ramesh Balwani, the President and COO of the firm is the sole Defendant in the second case.

Theranos was created in 2003 by Ms. Holmes based on a vision of developing new diagnostic technologies. The idea was to use small sample testing and ease of access for prevention and early diagnosis. The company focused on developing a proprietary analyzer which would take blood from a fingerstick and conduct an array of tests. The device was called the Theranos Sample Processing Unit – TSPU. The early generation was capable of doing only a few tests.

After six years Theranos was running out of cash. Mr. Balwani joined the company as President and COO. Together with Ms. Holmes, the two executives sought to develop what they called the miniLab – a version of the TSPU that could perform a broader range of laboratory testing. By 2010 the machine was still not ready. Nevertheless, CEO Holemes and COO Balwani shifted focus to the retail clinical laboratory market, pursuing contacts with a large national pharmacy chain – Pharmacy A – and a large national grocery chain – Grocery A. The idea was to place miniLabs at designated Patient Service Centers in retail stores. Patients could then get their diagnostic tests performed while shopping.

The two Theranos executives created an approach for Grocery A and Pharmacy A to market their dream – and avoid running out of operating cash. The two firms were told that the Theranos device could conduct a broad array of tests through fingerstick or the puncture of a finger. The tests could be conducted within less than an hour and at a reasonable price, according to the marketing pitch.

Over a three year period, beginning in 2010, the company continued to work on developing its miniLab. Grocery A and Pharmacy A were the targets for launching the analyzer. In 2011, however, Pharmacy A told Theranos that FDA approval would be needed. This resulted in a modification of the approach. In phase one, before approval, Theranos would transport the blood samples from the pharmacy to a central lab where they would be run on a miniLab. Phase two would take place following FDA approval. At that point the miniLabs would be put in the stores.

Theranos continued to work on its analyzer and pitch Pharmacy A. By 2013 the Theranos executives convinced Pharmacy A to accelerate a portion of a $100 million “innovation fee” to aid the firm with broadening its roll out of services to the pharmacy. This was based on representations by Ms. Holmes and Mr. Balwani about their analyzer bolstered by what appeared to be a demonstration suggested that the miniLabs were being used to conduct tests, not modified third party devices or machines which was actually the case. Indeed, from 2013 when the retail strategy was rolled out until 2016 Theranos never used its miniLab for patient testing in its clinical laboratory. Rather, the company could do at most 12 tests on its TSPU and processed groups of 50 to 60 on modified third-party analyzers. Other tests done for Pharmacy A were on industry standard technology or other traditional equipment.

Ms. Holmes and Mr. Balwani touted their proprietary analyzers despite the lack of actual results in interviews with the Wall Street Journal and other media. A series of favorable articles created a wave of favorable publicity for the company. Yet the cash was running out. Before launching efforts to raise additional funds Ms. Holmes convinced the board of directors to split the firm’s stock in a 1 to 5 ration allowing for future fundraising and to create Class B shares with a super-voting 100x power that would go only to her. This gave Ms. Holmes over half of the firm’s outstanding shares but 99% of the voting power.

Starting later in 2013, and continuing into 2015, Ms. Holmes, Mr. Balwani and Theranos raised over $700 million from investors in two rounds of financing. Those investors believed that the company had successfully developed a proprietary analyzer that could run a full range of laboratory tests from a small sample of blood. The belief of those investors came from: 1) face to face meetings with Theranos executives; 2) demonstrations which made it appear that the promised results were being obtained when they were not; 3) reports furnished by Defendants that related clinical trial work Theranos performed, along with those of pharmaceutical companies, which made it appear those firms endorsed Theranos and its analyzer; 4) representations by Ms. Holmes and the company that the proprietary analyzer was capable of conducting a full range of testing despite the fact it had never been capable of such results; 5) assertions that the company manufactured its own analyzers when in fact it was modifying those of other firms; 6) false claims that the analyzer had been used by the Department of Defense and foreign government health and military organizations; 7) claims that the firm was moving forward with its arrangements with Pharmacy A and Grocery A when in fact those relationships stalled; and 8) false representations that the company either had or would generate $100 million in revenue in 2014 and was on track to make $1 billion in revenue in 2015.

By 2016 the company exited the commercial laboratory business. Grocery A and Pharmacy A terminated their relationships with the company. In 2017 the firm was on the brink of bankruptcy.

The complaints allege violations of Securities Act section 17(a) and Exchange Act section 10(b). The company and Ms. Holmes settled. Ms. Holmes agreed to pay a penalty of $500,000, to be barred from serving as an officer or director for 10 years, to return the remaining 18.9 million shares she obtained during the fraud and to relinquish voting control of the company. Mr. Balwani is litigating the action against him.

Program: Insights Into SEC Enforcement, is roundtable discussion of the Former Directors of the SEC’s Division of Enforcement that will be held on April 3, 2018 beginning a 4:30 p.m. at Georgetown University Law School. The program will be followed by a reception. Registration is available here without charge. The program is sponsored by the SEC Historical Society, the Federal Bar Association, and the Association of SEC Alumni.

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