Lessons for Startups from the Liz Holmes Trial
Theranos founder Liz Holmes has been found guilty on four counts in her trial about Theranos’s blood tests and business prospects. Although fraud is a very factual inquiry, the case of Liz Holmes has some valuable lessons for Silicon Valley.
Holmes is alleged to have exaggerated claims as to the viability of Theranos’ technology. At trial, the government introduced evidence that Holmes misled investors by falsely claiming Theranos’ tests had been vetted by Pfizer and that their technology was being used by the US military in the field, among other things. The government also alleged that Holmes and Ramesh “Sunny” Balwani lied to investors about their tests and exaggerated the company’s performance. In fact, it was alleged that the company’s blood-testing devices did not work and most of the blood testing was being done on commercially available machines made by other manufacturers.
In some ways, Theranos is not much different from a lot of companies in Silicon Valley. Fake it ’til you make it is not just a mantra, it is a way of life for some entrepreneurs. Investors expect puffing and optimism from entrepreneurs. The court found that Holmes had crossed the line into criminal fraud. Many startup entreprenuers might be asking themselves what the difference is between what Holmes did and what they might have done.
Common law fraud generally consists of nine elements: (1) a representation of fact; (2) falsity; (3) materiality; (4) knowledge of its falsity or ignorance of its truth; (5) the intent that it be acted on; (6) an injured party’s ignorance of the falsity; (7) the injured party’s reliance on the representation; (8) the party’s right to rely on the representation; and (9) proximate injury.[i] It is a misrepresentation of a material fact used to induce someone to do something. That is much different than an opinion that no reasonable person would believe is an objective fact, often referred to as puffing. Misrepresentations, generally, whether they be fraudulent, negligent or innocent, only apply to statements of fact. Misrepresentation is actionable because it involves misrepresenting facts.
Securities fraud is different than common law fraud. Securities fraud describes several causes of action some of which are for other forms of misrepresentation.[ii] When lawyers talk about securities fraud, we usually mean Rule 10b-5, under the Securities Act of 1933 (the “33 Act”). The ’33 Act prohibits (1) schemes or artifices to defraud, (2) false statements of fact or omissions that make truthful affirmative statements misleading and (3) acts or practices that operate as frauds or deceits.[iii] These claims can be brought by private investors, the SEC, or both because the ’33 Act authorizes what we call a private right of action. In addition, as Liz and Sunny have learned, the Department of Justice can base a criminal complaint on securities fraud.[iv]
What are the lessons to be learned from the Holmes trial? First, an entrepreneur should never lie about a fact. This includes making up numbers or lying about having customers. Founders are often wildly optimistic and may count on revenues from sales calls that are not yet binding orders. Representing that a company has revenue when it does not can get a company and its founders into trouble. Exaggerating the capabilities of a technology can give rise to a fraud claim. Failing to disclose facts that that make truthful statements misleading can also result in a fraud claim.
The Liz Holmes trial should be a wakeup call to Silicon Valley. United States v. Holmes may not have created any new standards, but it serves as a reminder as to the fact that there are rules, and even startups are subject to those rules, and there is a limit to how much a company can exaggerate before it is guilty of fraud.
[i] See, e.g., Strategic Diversity, Inc. v. Alchemix Corp., 666 F.3d 1197 (9th Cir. 2012); Rice v. McAlister, 268 Ore. 125, 128, 519 P.2d 1263, 1265 (1975); Heitman v. Brown Grp., Inc., 638 S.W.2d 316, 319; Prince v. Bear River Mut. Ins. Co., 2002 UT 68 (Utah 2002).
[ii] Samuel W. Buell, What is Securities Fraud? 61 Duke L. J. 511, 541 (2011).
[iii] United States v. Naftalin, 441 U.S. 768, 774 (1979).
[iv] 18 U.S.C. § 1348 (2006) [covers any person who knowingly executes or attempts to execute, a scheme or artifice (1) to defraud any person in connection with … any security of an issuer (required to register or report under the ’34 Act); or (2) to obtain, by means of false or fraudulent pretenses, representations or promises, any money or property in connection with the purchase or sale of … any security of an issuer (required to register or report under the ’34 Act)].