On The Case

Will the Theranos ‘indirect’ investor lawsuit break new legal ground?

(Reuters) - When the Securities and Exchange Commission announced its securities fraud case against Theranos, its soon-to-be-former CEO Elizabeth Holmes and former president Ramesh Balwani on Wednesday, Enforcement Division co-director Steven Peikin emphasized that the commission is committed to policing private companies, not just those that raise money on public exchanges. “Investors are entitled to nothing less than complete truth and candor from companies and their executives,” Peikin said in the SEC’s press release. “The charges against Theranos, Holmes and Balwani make clear 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 SEC doesn’t often exercise its power to bust private companies for violating federal securities laws, but its officials said they wanted to send a message to Silicon Valley entrepreneurs, whose startups can be valued at more than a billion dollars before they ever go public. Theranos is an especially vivid example. Holmes raised $700 million from investors, according to the SEC, but at its peak, her company was valued at around $9 billion.

The SEC’s complaint against Theranos and Holmes focused on alleged lies to investors who put money directly into the company. Those insiders were only part of the market for Theranos, though. To the extent the company’s multibillion-dollar valuation reflected investor demand for a stake in Theranos’ purportedly revolutionary – and widely publicized – technology for blood testing, it rested on “indirect” investors who bought shares in funds that actually owned Theranos stock.

Unlike the SEC, indirect investors can’t sue under federal securities laws. (Direct investors in private companies, of course, can bring fraud claims if they can show they relied on corporate misrepresentations.) But as I’ve previously reported, in the age of unicorn Silicon Valley startups, shareholder lawyers have developed a theory on how indirect investors can band together in class actions based on California’s corporate code.

That theory is about to undergo a critical test in a class action by indirect investors in, you guessed it, Theranos. Last month, shareholder lawyers at Hagens Berman Sobol Shapiro and Robbins Geller Rudman & Dowd filed a motion to certify a class of more than 200 investors who plunked down money in funds that owned shares of Theranos. Theranos, which is represented by Wilmer Cutler Pickering Hale & Dorr, filed the company’s opposition last Friday, days before Theranos and Holmes agreed to settle the SEC’s charges. The judge overseeing the indirect investors’ case, U.S. Magistrate Judge Nathanael Cousins of San Jose, has already denied Theranos’ motion to dismiss the case outright. Defeating class certification is now the company’s best hope to evade liability to its indirect investors.

As you know, securities fraud class actions depend on the idea of an efficient securities market reacting to significant corporate lies. Indirect investors in a privately-held company like Theranos can’t argue market efficiency. But they contend that under California corporate law (and the common law of fraud), they can be certified as a class to litigate “a straightforward overarching inquiry for the court: Should the overwhelming evidence of defendants’ fraud be presented in a single action that adjudicates all common factual and legal issues, or should approximately two hundred defrauded ‘indirect shareholder’ investors in the putative class be forced to either forgo recovery or initiate individual actions to present the same evidence and litigate the same factual and legal issues against the same defendants?”

The investors claim that Theranos and Holmes knew and encouraged some of the company’s direct shareholders to market indirect investments in funds holding Theranos stock. Holmes even tracked these “indirect shareholders,” according to the class certification motion.

And because all of them, according to shareholder lawyers, bought an stake in Theranos’ future after Holmes and other insiders made false statements, “each class member suffered financial harm caused by defendants’ actions above, when the truth came out and the value of their securities collapsed.”

Theranos responded that it’s impossible to discern a common interest in indirect investors who had all sorts of different motivations. “Theranos has never been a public company. It has never published quarterly or annual reports or prospectuses, announced financial results, held public investor calls, or publicly disseminated information about its business plans or finances,” the company’s brief said. “Class members could have read any of thousands of public references to Theranos — or none — and could have received private information — or not — but the only way to know is individual fact-finding … In an inefficient market such as this one, the only way to know whether an alleged misrepresentation affected a purchaser’s price is to examine each transaction.”

It’s not clear how, if at all, the Theranos and Holmes settlements with the SEC will affect class certification. I emailed five plaintiffs’ lawyers from Hagens Berman and Robbins Geller and didn’t hear back from any of them. Theranos lawyer Timothy Perla of Wilmer also didn’t respond to my email. Holmes and the company did not admit liability in their SEC settlements so there’s no risk shareholders can claim they’ve conceded wrongdoing.

On the other hand, it’s not an everyday thing for the SEC to allege “massive fraud” at a private company. Theranos reminded Judge Cousins that no court has previously certified a class of indirect investors, arguing that the indirect shareholders had given the court “no reason to break new ground.”

Maybe Judge Cousins will see the SEC case as a reason.