Ethical Dilemma

Oct 2, 2018 |

“Theranos is Shutting Down”

According to the article, Theranos is going out with barely a whisper. Once heralded as a revolutionary new way to conduct a blood test to detect myriad diseases, all with a single finger prick, the company is making preparations to close its operations, according to a letter sent to shareholders.

“We are now out of time,” David Taylor, the company’s chief executive and general counsel, informed investors recently. Theranos’s efforts are now focused on avoiding bankruptcy.

It’s in default under a credit agreement reached last year with Fortress Investment Group, Mr. Taylor told shareholders. The company is negotiating a settlement with Fortress, which would then own the company’s intellectual property and allow Theranos to distribute its remaining cash — some $5 million — to unsecured creditors.

“Because the company’s cash is not nearly sufficient to pay all of the creditors in full, there will be no distribution to shareholders” under the plan, Mr. Taylor said in the letter.

The process of dissolving the company is expected to take six to 12 months.

Founded in 2003 by Elizabeth Holmes, a 19-year-old Stanford University dropout, Theranos promised to shake up the entire lab industry, making blood tests much easier and less expensive than traditional methods.

A charismatic executive who wore black turtlenecks and spoke passionately about giving people control over their health information, Ms. Holmes attracted high-profile investors and assembled a Who’s Who of directors, including two former secretaries of state and two former United States senators. General Jim Mattis, the current secretary of defense, also served on the board.

At its peak, the privately held company was valued at a lofty $9 billion, and Ms. Holmes was promoted as one of the nation’s most successful female entrepreneurs. But questions emerged about the accuracy of the company’s testing, and federal regulators barred Ms. Holmes from owning and operating a laboratory for two years in 2016.

In March, the Securities and Exchange Commission charged Ms. Holmes with widespread fraud, accusing her of exaggerating — even lying — about her technology. In announcing the charges, the S.E.C. said that Theranos and Ms. Holmes agreed to a settlement.

Then in June, Ms. Holmes was indicted on criminal charges, and she has pleaded not guilty.
The company’s travails are the subject of a book by The Wall Street Journal reporter, John Carreyrou, called “Bad Blood: Secrets and Lies in a Silicon Valley Startup,” and a forthcoming movie.

Lawyers for the company and Ms. Holmes did not respond to requests for comment.
Ramesh Balwani, the company’s former president who continues to fight the civil and criminal charges against him, issued a statement through a representative: “As an investor who put millions of dollars of his own money and nearly seven years of his life into Theranos, Mr. Balwani was saddened to see the letter from Theranos to investors yesterday.”

Discussion Questions

1. Define fraud. Referencing the supplemental article included in Teaching Tip 2 of this newsletter, explain the particular type of fraud Elizabeth Holmes is alleged to have committed.

Fraud as defined as wrongful or criminal deception intended to result in financial or personal gain. In order to prove fraud (which can result in both civil and criminal liability), the plaintiff/prosecutor must prove the following elements:

a) The defendant made a false statement of fact;
b) The defendant made the false statement of fact with knowledge of its falsity or reckless indifference as to its truth;
c) The defendant made the false statement with intent that the listener rely on it;
d) The listener relied on the false statement; and
e) The listener was harmed (economically, physically, or both) as a result.

As indicated in the supplemental article included in Teaching Tip 2 of this newsletter, Ms. Holmes is alleged to have committed both fraud and securities fraud, misleading the public (including doctors and patients) and Theranos investors by promoting medical devices and tests that not only did not work, but also endangered lives.

2. In your reasoned opinion, is securities fraud a particularly egregious type of fraud? Explain your response.

This is an opinion question, so student responses may vary. In your author’s opinion, securities fraud is a particularly egregious type of fraud. Not only does it affect one or more actual victims, but in a high-profile case, it can undermine confidence in the securities market. Confidence in the securities market depends on investor access to accurate information regarding the nature of a particular company and its product(s).

3. As indicated in the article, Theranos will cease to exist. It will distribute its remaining cash (approximately $5 million) to unsecured creditors, and there will be no distribution to shareholders. In terms of the company’s remaining $5 million, why will creditors be preferred over shareholders? Should creditors be preferred over shareholders? Explain your response.

In crafting bankruptcy law, the United States Congress has made a policy statement by preferring creditors over shareholders in the distribution of bankruptcy assets. This underscores the risk that shareholders take when they invest in a company, even if they mistakenly believe that their investment decision was a wise one and are victims of fraud themselves.