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Apr 20, 2016

What the Theranos calamity can teach start-ups about governance

From directors exercising sufficient due diligence to crisis communications strategy, there is much newer firms can learn from Theranos' missteps

It’s unusual to see a start-up get mired in a mess as high profile as Theranos has, but other fledgling firms may well appreciate the abundance of corporate governance lessons the case is providing.

With news earlier this week that the SEC and Department of Justice are investigating the blood-testing company for possible fraud, the stakes are extremely high. Even though shares of the privately held start-up aren’t yet available to the public, the company is still covered by the anti-fraud provisions of federal securities laws, and ‘a misstatement or omission of material fact in connection with the sale of its securities to venture capital firms could constitute a violation,’ as reported yesterday by the New York Times.

The alleged misstatements under investigation by the US government are significant, including claims to have partnerships with GlaxoSmithKline and Pfizer, which both companies have denied, and that the Food and Drug Administration (FDA) had tested for accuracy and approved Theranos’ blood tester, Nanotainer – which the FDA has denied. There is also the inevitability of future lawsuits related to deficiencies in the firm’s laboratory processes discovered last fall by the Centers for Medicare & Medicaid Services, which said in January the lab errors were severe enough to have ‘jeopardized patients’ health,’ as reported by Bloomberg News.

These findings, which were publicly documented for the first time in a redacted report released in March, suggest some major oversight failings by Theranos’ board, which includes luminaries such as former secretary of state George Shultz and retired US Marine Corps general and former commander of the US Central Command James Mattis.

But even if Theranos is found guilty of fraud, that doesn’t necessarily mean members of its board will be held personally liable, says Richard Morris, a corporate partner at law firm Herrick, Feinstein. The due diligence defense for directors established under Section 11 of the Securities Act of 1933 in the context of a securities offering, and Delaware fiduciary standards enable board members to rely, to a reasonable extent, on auditors, lawyers, investment bankers and other experts to have conducted appropriate due diligence over various matters under investigation, Morris explains. ‘If they exercised their fiduciary duty of good faith and loyalty, performed their due diligence and were reasonably prudent, even if there was fraud or a complete meltdown, they would not likely be liable.'

When it comes to Theranos’ lab conditions and procedures, it’s very likely the directors would be relying on reports by the company’s officers, attesting to their being best in class. ‘If you have officers state they have lab conditions and this is what that class is, and presumably you have a third party that comes in and does an assessment as part of the due diligence, that would have worked,’ Morris says.

Theranos’ board members may just as easily have relied on due diligence by investment bankers, venture capitalists or private equity fund managers who, in the course of private placements and other funding activities would likely have had to look at lab conditions and hired someone to do an analysis of lab conditions and procedures, Morris continues. And when it comes to a company’s internal procedures, the board’s audit committee would likely have looked at statements about lab conditions provided for fund-raising and someone on the board would have had to ask, ‘How has this been proven?’, he adds.

At the time that doubts about the accuracy of Theranos' devices began to go viral, just two of the board's 12 members had any scientific or medical background, which would appear to have been key to directors putting stronger questions to senior management about various claims the company was making. While a 12-person board is quite large for a startup, 'having two people with a scientific background would, on the face of it, be sufficient,' says Morris. But companies need to examine the core competencies of such directors and confirm they are people known in their industry, he adds.

CEO and founder Elizabeth Holmes’ heated public attacks in response to the Wall Street Journal’s reporting of faults in Theranos’ technology, followed months later by backtracking and public apologies, have been described as a prime example of disastrous crisis communications strategy. When such accusations emerge, it’s critical the company takes each one seriously, says Morris.

‘Board members have to be apprised of what’s being said in the blog about them,’ he explains. ‘[Given] the fact that there’s investigation, there needed to be a way [for this to be] communicated to the board and a standard response mechanism. You need people who are going to take it seriously and provide resources to answer it quickly. This example contained an issue where there were concerns about transparency at the beginning, and it is typically a mistake for people not to be transparent and not to address concerns in the open.’

David Bogoslaw

Associate Editor and Online features producer for Corporate Secretary