Wharton's Wayne Guay and Georgetown's James Angel discuss the SEC's fraud case against Theranos CEO Elizabeth Holmes.

Once a darling of the start-up world, Elizabeth Holmes has now become a cautionary tale.

The founder of Palo Alto, Calif.-based Theranos has been charged with fraud by the U.S. Securities and Exchange Commission for misrepresenting the facts about its so-called revolutionary technology to carry out multiple blood tests using small blood samples and defrauding investors of $700 million. The case brings up a number of questions about how much leeway to give start-up founders and when controls need to be put in place, and also about how and when regulators should be involved.

Holmes, who graced the covers of numerous magazines and was once called “the next Steve Jobs,” must pay a $500,000 penalty and will be banned for serving on the board of publicly traded companies for the next decade. She will serve no jail time. The SEC has filed a separate case against Ramesh Balwani, who served as president and COO of Theranos between 2009 and 2016.

“I look at this largely as a corporate governance failure or a breakdown, where you had a founder that had complete effective control,” said Wharton accounting professor Wayne Guay, who is also editor of The Journal of Accounting and Economics. Theranos had a dual-class shareholding structure where Holmes had 100 votes for every one vote of other shareholders, and she retained total control of the composition of the company’s board.

“The board of directors was not filled with the types of professionals that we would expect — medical professionals and financial professionals and others,” said Guay. “It was filled with politicians and military advisers and others, and the oversight wasn’t there.” Among the board members of Theranos were former U.S. Secretaries of State Henry Kissinger and George Schultz, and former Secretary of Defense William Perry.

“The SEC is sending a very strong signal: Don’t lie to investors,” said James Angel, professor of business at Georgetown University’s McDonough School of Business and an expert in the structure and regulation of financial markets worldwide.

Guay and Angel discussed the takeaways from the Theranos case on the Knowledge at Wharton show on SiriusXM channel 111. (Listen to the full podcast using the player at the top of this page.)

Back in 2003, when Holmes was barely 20, she dropped out of Stanford University to launch Theranos based on proprietary technology for an analyzer that promised to conduct multiple blood tests with a single drop. Investors shelled out $700 million, lapped up visions of the Theranos technology serving a simple and affordable solution for billions of patients that need multiple blood tests and would welcome a product that called for only one pin prick.

“I look at this largely as a corporate governance failure or a breakdown.”–Wayne Guay

The SEC found that Theranos did not have the technology to deliver all that it promised, and that it was actually earning only a fraction of the projected revenues and making false statements to investors. Specifically, the SEC found that the company’s proprietary analyzer conducted only a dozen of the 200-odd tests it promised, and that it conducted the remaining tests on third-party, modified devices, and on commercially available analyzers. Holmes had also assured investors in 2014 that privately-held Theranos would earn $100 million in revenues, but it managed just a little more than $100,000 that year, the SEC said. Theranos had also falsely claimed that the U.S. Department of Defense had deployed its technology, the regulator added.

Robert Hughes, Wharton professor of legal studies and business ethics, highlighted the broader ethical issues raised by the Theranos case. “It is not a scandal when a startup’s new technology doesn’t work out as executives and investors hoped,” he said. “It is a scandal for a startup’s executives to lie about their technology’s current state of development, about where that technology has been used or about the company’s revenues.”

Hughes said startups should take to heart advice that Jina Choi, director of the SEC’s San Francisco regional office, dispensed in the Theranos case: “Innovators who seek to revolutionize and disrupt an industry must tell investors the truth about what their technology can do today, not just what they hope it might do someday.”

Dual-class Shares: Pros and Cons

Highlighting his argument that the central problem with Theranos was a travesty of good corporate governance controls, Guay said the culprit was the dual-class shareholding structure. Holmes did not have the requisite track record to be vested with the “trust and complete control of the company,” which she had because of the disproportionate voting control she possessed under the company’s dual-class shareholding structure, he added. Drawing from the Theranos case, he said the question facing other companies with dual-class shares is: “At what point might [companies] put some effective controls in place to give that control and the voting rights back to shareholders?”

Guay recalled that the SEC had disallowed dual-class shares some three decades ago before it permitted them to be used. Such shares are not uncommon, and are in place at Google, where founders Sergey Brin and Larry Page have effective voting control, and also at Facebook and Snap, the parent of the messaging app Snapchat, he said. “It’s been a big issue over the last couple of years, and it is something that should be debated,” he added, noting that it had been hotly debated during Snap’s initial public offering last year.

Guay noted that some advocates argue in favor of founders retaining control with dual-class shares during the formative years of a startup. But once the enterprise grows and reaches critical mass, it would make sense to have “sunset provisions [where they would] release that voting control to another group of investors,” he added.

“Some would argue that having a big block holder is actually a good thing,” said Angel. He recalled that Ford Motors, where the Ford family has long held dual-class shares, survived the Great Recession of 2008, whereas General Motors went through a bankruptcy. He explained why having a large, single block of voting shares helps.

“The reality comes down to problems of corporate governance in that the shareholder base is so widely dispersed that most shareholders don’t have any real power or influence or even the incentive to exercise power or influence — when you have an atomistic shareholder base,” Angel said. Yet, it remains a controversial subject, he added: “I don’t pretend that one type is always the best or always the worst.”

“In many fraud circumstances, they sometimes start with small lies, and then those small lies have to be backed up with bigger and bigger lies.”–Wayne Guay

Guay pointed to the risks with such excessive voting power. He noted that “plenty of empirical evidence” exists to show that the holder of a large block of shares can help with governance and monitor what the company is doing. “[But] in many cases, untested individuals who may be great developers of products, such as scientists and programmers, may not be the best persons to actually run the day-to-day operations of the company, or at least not once the company gets to be a certain size,” Guay said. “[Theranos] is a good case study in some of the dangers or the problems that crop up when you have a founder that [makes] some missteps and you don’t have that oversight or the ability to look over the founders’ shoulder and say, ‘I don’t think you should do that because you don’t have the voting rights.’”

“Does it really matter?” asked Angel. “One could also argue that the vast majority of shareholders don’t have any effective power, because management is entrenched and your shares are such a tiny fraction of total shares outstanding,” he said. He noted that the share price differentials between companies that have voting and non-voting stock “is not zero, but it’s not large, either.”

Crime and Sufficient Punishment

The SEC penalty for Holmes — a fine, debarment from being a public company director and no jail term — has also been controversial. “I can feel my blood pressure going up at the fact that so many people in the Great Recession got away with fraudulent behavior and did not go to jail,” Angel said. He noted that in the Theranos case, the SEC doesn’t have direct criminal enforcement ability, but passes on that role to the Department of Justice.

“Lawbreaking in business can result in both regulatory and criminal prosecution,” said Hughes. “The SEC settlement does not preclude criminal prosecution.” He noted that a criminal investigation is underway in the Theranos case, though no charges have been filed.

All the same, “the SEC has done what it can,” said Angel. “They’ve extracted a huge settlement. They’ve basically banished [Holmes] from the industry for a decade. It remains to be seen what the Department of Justice will now do.” Guay said the justice department would also want to send out a broader warning in any action it may take in the Theranos case. “In any [such] situation, there’s always a desire to punish people, but at the same time the role of punishment is often to serve as a deterrent,” he added.

Guay said what the justice department will do depends on “what they think they can prove.” He noted that “the burden of proof” is higher in a criminal case than it is in a civil case. “Typically, the SEC and the DoJ want to get to some settlement that looks like justice.” According to Guay, putting a CEO behind bars is “a very hard thing to do,” and the company and the CEO will “fight tooth and nail” against such a move. Angel noted that the justice department also “has other fish to fry” and would make choices in sharing its limited resources between chasing drug dealers, terrorists and errant CEOs.

“The SEC is sending a very strong signal: Don’t lie to investors.”–James Angel

“No matter what the Department of Justice does to her, she’s already tarnished; she’s already punished big time,” said Angel. Guay noted that Holmes, who owns 50% of the stock in Theranos, has also lost some $4.5 billion in personal wealth in the Theranos scandal, based on an estimate by Forbes magazine in June 2016. A year earlier, she had topped the Forbes list of America’s Richest Self-Made Women.

The Future

Angel expected Theranos to now become “a good candidate for an acquisition from someone else who wanted to get their hands on the technology without dealing with the scandal-ridden reputation.”

“Being acquired is certainly a possibility,” said Guay. “It would take them out of the public limelight and put them under the umbrella of another company. To the extent the technology they have is in fact very valuable, that would be certainly one way to go.” The company could also demonstrate to investors and regulators that it is “cleaning house” by replacing unsuitable board members and executives and putting in place the requisite oversight structures to prevent future frauds, he added.

Meanwhile, Theranos would not be completely out of the woods. Angel predicted that after the SEC verdict, it would see lawsuits alleging fraud, breach of contract, lack of performance, and so forth. In that setting, he said he would not be surprised if Theranos files for Chapter 11 bankruptcy protection. “Then someone else will probably pick up whatever technology assets are there out of the wreckage.”

“It is a scandal for a startup’s executives to lie about their technology’s current state of development, about where that technology has been used, or about the company’s revenues.”–Robert Hughes

Those court cases could make it difficult for Theranos to be acquired any time soon. “Anybody who is going to buy that company is going to want to get a handle on what the litigation risk is,” said Guay. “If all these lawsuits get filed, the acquirer is going to have to be really leery about what they’re taking on if they buy this company.” Added Angel: “That is another reason why the cleansing of Chapter 11 might actually be the best step forward, because that way you isolate all the claims from the old company and then the buyer could buy the assets and move on with it.”

As for Holmes’s future, Angel said, “she is very tainted, so no public company would really want to have her on board.” At the same time, he described her as “very intelligent, very talented and a great salesperson, [who] will land on her feet eventually.” Guay agreed. “Any kind of public role where a company would put her forward as a spokesperson or as a person of importance — that’s going to be a non-starter, at least for a while.”

Guay wondered how things may have come to such a pass at Theranos. “In many fraud circumstances, they sometimes start with small lies, and then those small lies have to be backed up with bigger and bigger lies,” he said. “[It is about] understanding how that all evolved here — whether this was something that [Holmes] felt she had to do or wanted early on, and then she dug herself a hole that she couldn’t get out of. It’s hard to know exactly how that evolved.”

Photo of Elizabeth Holmes by Max Morse for TechCrunch  – TechCrunch Disrupt San Francisco 2014, CC BY 2.0, https://commons.wikimedia.org/w/index.php?curid=45609023