Theranos, Inc. was a high-flying former biotech company headquartered in Silicon Valley that claimed to have developed a point-of-care blood test that would allow health care professionals to assess the risks many diseases posed to a patient based on a few drops of that patient’s blood. The company’s valuation, before delivering a single product to market, soared into the several billions of dollars, and its founders graced the covers of numerous business publications lauding their genius. Until it all came crashing down for the fraud that it was from the outset.
The collapse of Theranos presents a unique case study for boards of directors of corporations in the medical technology industry, and really in any American industry that relies on its intellectual property to create value for its customers and shareholders.
What Happened at Theranos
According to allegations filed by the Securities and Exchange Commission (“SEC”) and the Department of Justice (“DOJ”) Theranos’ founder and CEO, Elizabeth Holmes, and one of its senior executives, Ramesh “Sunny” Balwani, defrauded investors and patients by leading them to believe that Theranos’ key product could conduct comprehensive blood tests from small drops of blood, and made false statements about Theranos’ business and financial performance to investors and customers.
What was Theranos’ board of directors doing while the company’s senior executives were perpetrating a massive fraud on the public for a period of several years?
Did those directors adequately fulfill their fiduciary duties to the company and its shareholders?
Did the company’s attorneys ever raise any red flags for the directors to consider during the entirety of the company’s existence?
The risks confronted by directors of companies in the medical technology industry, and frankly in all high technology industries, are particularly high. This is true for a variety of reasons, including:
- the importance of preserving the secrecy of the intellectual property underlying a company’s goods and services
- the complex scientific and clinical expertise required to understand and assess medical technologies and the intellectual property on which they’re based
- and the potential for harm to patients as a result of false or misleading statements disseminated to the public.
While state laws vary, generally, members of a corporation’s board of directors owe two core fiduciary duties to the corporation and its shareholders: The duty of care, and the duty of loyalty.
Board Fiduciary Duties – Duty of Care
The duty of care generally requires that directors use the care that an ordinarily careful and prudent person would use in similar circumstances when making decisions on the corporation’s behalf. This could include, for example, taking reasonable efforts to review all relevant information available and understand the related material facts.
In most jurisdictions, the duty of care will only be breached if the directors or officers are found to have acted in a grossly negligent way when discharging their management responsibilities to the company. In California, however, there is case law that strongly suggests that such liability will be imposed for mere negligence. Think of this duty as the obligation to manage the company’s business affairs competently.
Board Fiduciary Duties – Duty of Loyalty
The duty of loyalty, on the other hand, generally requires that directors act in good faith for the benefit of the corporation and its shareholders. For example, directors and officers must refrain from self-dealing and usurping corporate business opportunities. Think of this duty as the obligation to refrain from enriching yourself at the expense of the company and its shareholders.
Directors who breach their fiduciary duties can potentially face personal liability in many jurisdictions around the United States, and certainly in California and Delaware.
Lessons for Directors
So what lessons can directors in the medical and high technology industries take away from the Theranos’ debacle.
First, it’s imperative to put in place and maintain governance structures and internal controls to facilitate accuracy in financial statements and marketing claims. According to several publications, Theranos’ board of directors – which included former Secretaries of State, Defense Secretaries, senators and other high level military officers – did not have the proper regulatory and financial expertise to appropriately make decisions on behalf of Theranos’ shareholders. They also lacked the relevant expertise in the particular industry to bring different viewpoints to bear to identify and resolve critical issues confronting the company.
Second, having a scientific advisory board – or otherwise engaging independent people that possess that expertise – with knowledge in the relevant industry should be a priority for the board. Companies in the medical and high technology industries are encouraged to form scientific advisory boards or engage independent parties so that directors may consult with these experts when appropriate. It is important, and frequently useful, to have members of the advisory board available to inspect relevant business records and contracts.
Per the award winning investigative journalism undertaken by reporters at the Wall Street Journal, Theranos’ board of directors rarely questioned Holmes’ or Balwani’s management. Even worse, any member of the board that expressed a dissenting viewpoint or asked challenging questions was reportedly asked to resign. That should have been a huge red flag that fraud was afoot.
In the course of investing in corporations in the medical and high technology industries, entrepreneurs, venture capitalists, private equity investors, and their respective advisers, should take action to ensure the corporation is being run and governed for the benefit of all its investors.
Creating a system of transparency that promotes dissenting viewpoints and encourages challenging questions by board members to officers – who incidentally report to the board – allows the directors to thoroughly and properly oversee the people charged with managing the corporation. If you fail to do so, you run the risk of overseeing another Theranos and suffering the consequences of that failure, which could include personal liability for your ignorance or neglect.