Anat Alon-Beck, law professor at Case Western Reserve University School of Law, and John Livingstone, research fellow at Case Western Reserve University School of Law and visiting lecturer at University of California, Berkeley, Haas School of Business, discuss trends in recent tech founder fraud scandals...
Are the recent tech founder scandals going to change Silicon Valley or future appetite for investments in tech firms? It seems that investors are unphased by losing millions through the failures of Elizabeth Holmes or the sudden collapse of crypto exchange FTX. Investors seem to love tech visionaries whose brash rhetoric fueled the recent tech boom and collapse. The following stories can serve as case studies on bad corporate governance, poor leadership, and a complete lack of oversight, for generations to come. Have we learned anything from them?
The press once celebrated Elizabeth Holmes as the youngest female entrepreneur and billionaire. Holmes dropped out of Stanford University to start Theranos, a blood-testing startup. Holmes quickly raised billions of dollars from non-traditional investors, and Theranos joined the prestigious “unicorn” club. Holmes appeared on the covers of magazines while Theranos enjoyed the benefits of an “all-star” board of directors, including a medical advisory board.
Theranos’s funding bubble burst when the Securities and Exchange Commission (“SEC”) charged Holmes with massive fraud. Now, three years later, Holmes has been convicted and sentenced to over 11 years in federal prison. Holmes was found to have defrauded investors but not patients. Many observed that this example illustrates perhaps that women may be sanctioned more harshly when their behavior violates sex-role stereotypes, like managing a startup. It is yet to be determined how harsh the verdict of Ramesh “Sunny” Balwani, the former president and chief operating officer of Theranos, is going to be.
Holmes, unfortunately, is not the only unicorn founder to get a lot of press coverage recently for breaking the law. The chief executive officers (“CEOs”) of WeWork, WrkRiot, Uber, and Zenefits have all resigned within the last three years due to various allegations of mismanagement and fraud. The founder of Nikola was convicted of similar fraud charges just last month. The ongoing collapse of FTX will undoubtedly see Sam Bankman-Fried charged by federal or state prosecutors.
These stories on mismanagement and fraud are drawing public attention to the operations, management, corporate governance structures and financings of unicorn firms. Despite these reports and the risks associated with investing in private firms, there is an argument that we should democratize access to private markets because retail investors are missing out on lucrative investment opportunities. This is driven by the fact that there are fewer listed firms and initial public offerings, the greater role of the private market in raising money, and the rise in the number of unicorn firms.
There are powerful industry groups, such as the Institute for Portfolio Alternatives, which successfully lobbied lawmakers to enable more Americans to access investments in private markets. But as more money flows into these riskier markets, two questions are coming to the forefront of the increasing number of scandals coming out of them. First, are the efforts to prosecute these cases coming down even handedly across demographic lines? No one disputes the fact that individuals like Elizabeth Holmes and Sam Bankman-Fried should answer for their misdeeds. Their actions remain reprehensible. But is there is a distinction between how certain individuals are convicted of similar crimes? Only time will tell on how similar fraud convictions are handled.
Secondly, who really should be considered the victim in these situations? Holmes was convicted of defrauding investors but not for defrauding patients. This naturally brings forward the debate on the merits of doctrines like caveat emptor. What if the parties are sophisticated and entered into “big boy letters”? A big boy letter is a type of agreement in connection with a private sale of securities, where the buyer agrees not to sue the seller over non-disclosure of material information that would generally not be disclosed to the public.
The investors in Theranos can’t be considered anything other than sophisticated. They were well represented by legal counsel and nearly all were considered to be “accredited investors,” the accepted measure of sophistication under US securities laws. While they were clearly defrauded, there are two natural questions from this debacle: were they monitoring, and if they were, were they competent to do so?
With big boy letters, the parties are essentially attempting to contract out of US securities laws. But this ignores Section 29(a) of the Securities Act of 1934, which provides that waivers of liability for securities fraud are void. Different courts have ruled differently on this issue, so it can also open conflict of laws issues. Several SEC Commissioners have spoken against these waivers and stated that they are not a defense in an SEC enforcement action. Moreover, what about doing “due diligence”? Due diligence is a rigorous process involving business and legal investigations by investors that determines whether or not the venture capital fund or other investor will decide to invest in the startup. It seems that there is an erosion of the due diligence standards, where sophisticated investors, i.e., VCs, are not conducting proper due diligence anymore, but rather continue to throw large amounts of capital around.
We saw this sort of behavior not too long ago, when the last tech bubble collapsed, so what has changed since? In our minds, the largest change has been the shift in where the capital itself is coming from. Traditional VC has long been well respected for its ability to invest in, govern, and monitor startups before helping them go public competently. But these investors admitted to doing little to no diligence, for fear of being cut out. Whereas “alternative venture capitalists” (“AVCs”), who depend on VCs to do the monitoring for them, are swimming in water where they have little to no experience and are paying for it harshly.
The real danger that comes from this flood of capital, however, is the ability for founders to pick their source of capital, rather than investors picking their investment. Traditional VCs don’t want to be boxed out of the next great success story, and AVCs have the capital to not care. That works when things are good, but as one investor in Theranos put it: “If something happens to the economy, then everyone is going to be toast.”
Anat Alon-Beck is a law professor at Case Western Reserve University School of Law. John Livingstone is a research fellow at Case Western Reserve University School of Law and visiting lecturer at University of California, Berkeley, Haas School of Business.
Suggested citation:Anat Alon-Beck and John Livingstone, The Elizabeth Holmes Sentencing: A Message on Investor Protection or a Lesson in Hubris?, JURIST – Academic Commentary, December 6, 2022, https://www.jurist.org/commentary/2022/12/alon-beck-livingstone-elizabeth-holmes-sentencing/.
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