Accounting for “Bad Blood”
I have previously blogged about Theranos, explaining the course of events that led to its demise. Last week, founder and former CEO Elizabeth Holmes, was found guilty on one count of conspiracy to defraud investors as well as three wire fraud counts tied to specific investors. The jury found her not guilty on three charges and could not reach agreement on an additional three charges. Holmes faces up to 20 years in prison as well as a fine of $250,000 plus restitution for each count.
In case you’ve forgotten the story, here is a brief review.
Theranos was a privately held health corporation that was touted as a breakthrough technology company. It claimed to have devised blood tests that required only exceedingly small amounts of blood and could be performed very rapidly using small, automated devices the company had developed. However, the claims later proved to be false.
Theranos sought to make blood tests cheaper, more convenient, and accessible to consumers. Simply by using a pin prick, blood could be analyzed quickly for diseases. Holmes believed the testing procedures were a revolution in the way diagnostics were done and preventative medicine. Using a machine called the Edison, pharmacies were able to use this portable blood test from a drop of blood. However, most tests were not a needle prick but actually a venipuncture.
Physicians, patients, Medicare services, and others all relied on Holmes’s assurances. She duped just about everyone about the efficacy of Edison. For twelve years, Holmes essentially ran a Ponzi scheme by attracting investment funds from primarily venture capitalists that saw it as a unique opportunity to cash in on the boom in Silicon Valley. She was able to raise hundreds of millions of dollars until an employee, Tyler Schultz, blew the whistle.
According to a federal indictment, Holmes and Sunny Balwani, former President and Chief Operating Officer, defrauded doctors and patients (1) by making false claims concerning Theranos’ s ability to provide fast, reliable, and cheap blood tests and test results, and (2) by omitting information concerning the limits of and problems with Theranos’ s technologies. Allegedly, the defendants knew Theranos was not capable of consistently producing accurate and reliable results for certain blood tests.
Charges by the SEC
The SEC has jurisdiction over private company “unicorns” under the antifraud provisions of the Securities Exchange Act of 1934, Section 10(b) and Rule 10b-5, which apply to all companies, public or private.
The SEC had begun its investigation in 2017 and by March of 2018 the SEC had charged Theranos, Elizabeth Holmes, and Balwani with the massive fraud.
An investigative reporter, Francine McKenna, points out that the SEC’s complaint against Balwani describes the binder provided to potential investors. The package included a cover letter drafted and signed by Holmes, a company overview slide-deck presentation, reports of clinical trials Theranos performed with pharmaceutical companies, and financial projections on spreadsheets created from scratch by Balwani.
There were also lots of copies of articles and profiles about Theranos, including glowing profiles of Holmes from 2013 and 2014 by the Wall Street Journal, Wired and Fortune.
Materials within the binders stated that Theranos would generate over $100 million in revenues in 2014 and break even, according to the SEC complaint against Balwani. The unaudited financial statements that the SEC said Balwani created also projected Theranos would reach approximately $1 billion in revenue in 2015.
Conspicuously absent from the package that went to investors were income statements, balance sheets and cash-flow statements audited and signed by a qualified public accounting firm.
Following its investigation, on March 14, 2018, Holmes and Theranos settled with the SEC, while Balwani is fighting the allegations.
The Role of Audit Firms
The role of audit firms in the fraud has not been addressed in detail, except for a discussion by McKenna, on her online blog, The Dig.
Theranos and Holmes raised more than $700 million from mostly wealthy investors without ever having to provide anyone financial statements audited by an independent public accounting firm.
KPMG audited the firm in 2009, replacing Ernst & Young but never issuing any audit opinions. Smaller firms followed, also not issuing audit opinions with one exception explained below.
The public doesn’t always understand that the role of an audit is not to discover fraud but to assess the likelihood that fraud exists in the financial statements. It’s questionable whether the firms involved met their professional and ethical obligations in this regard, although the SEC has not charged any of the firms.
Looking for Loans to Keep Afloat
McKenna points out that in 2017, Theranos sought out a loan from the Fortress group because it had been bleeding cash. There were doubts about its ability to secure the loans considering its poor cash position. Even if the loan was granted, the company would not have had enough cash to support itself for the next 12 months, according to an audit opinion on the company’s 2017 financial statements delivered to management and the board at the end of June by OUM & Co. LLP, a California-based firm that serves several publicly traded pharmaceutical and medical device firms.
The original Fortress loan agreement required Theranos to produce audited financial statements for 2017 with a clean opinion (i.e., unmodified opinion) that would provide reasonable assurance that the company’s accounts were free of material misstatement or fraud — by June 30,2018. Reasonable assurance is not the same as a guarantee, contributing to the public’s misunderstanding of the role of auditors as discussed above. This was the first time the company had completed preparation of financial statements according to Generally Accepted Accounting Principles, the standard for public and larger private companies that solicit outside investments.
However, OUM’s audit opinion included an “emphasis of matter” paragraph that highlighted the existence of a material uncertainty regarding Theranos’ ability to continue as a going concern, according to people knowledgeable about the contents of that report, confirming executives’ fears that there would not be enough funding to commercialize the company’s products fast enough, and therefore secure additional funding from Fortress.
Summing it Up
There is a lot more to say about the fraud at Theranos. If you would like to read more about how and why the fraud occurred, I suggest picking up a copy of Bad Blood by John Carreyrou. I will track the legal issues related to the fraud and settlements as the Balwani trial begins, which has been delayed because of Covid. It’s also likely that Holmes will appeal the four-count finding of guilt.
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Blog posted by Dr. Steven Mintz, The Ethics Sage, on January 12, 2022. You can sign up for his newsletter and learn more about his activities at: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.