Private Company Lies

Private Company Lies

ELIZABETH POLLMAN*

Rule 10b–5’s antifraud catchall has been called one of the most conse-

quential pieces of American administrative law and one of the most

highly developed areas of judicially created federal law. Although the

Rule broadly prohibits securities fraud in both public and private com-

pany stock, the vast majority of jurisprudence, and the voluminous aca-

demic literature that accompanies it, has developed through a public

company lens.

This Article illuminates how the explosive growth of private markets

has left huge portions of U.S. capital markets with relatively light secur-

ities fraud scrutiny and enforcement. Some of the largest private compa-

nies by valuation grow in an environment of extreme information

asymmetry and with the pressure, opportunity, and rationalizing culture

that can foster misconduct and deception. Many investors in the private

markets are sophisticated and can bear high levels of risk and significant

losses from securities fraud. It is increasingly evident, however, that pri-

vate company lies can harm a broader range of shareholders and stake-

holders as well as the efficiency of allocating billions of dollars for

innovation and new business. In response to this underappreciated prob-

lem, this Article explores a range of mechanisms to improve accountabil-

ity in the private markets and ultimately argues for greater public

oversight and enforcement.

TABLE OF CONTENTS

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354

I. THE DEVELOPMENT OF RULE 10B–5 IN A PUBLIC MARKET PARADIGM . . 360

A. ORIGINS................................................ 361

B. EVOLUTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363

* Professor of Law, University of Pennsylvania Law School. © 2020, Elizabeth Pollman. For helpful

conversations and comments, thanks to Yifat Aran, Miriam Baer, Carlos Berdejó, Ryan Bubb, Elisabeth

de Fontenay, Jill Fisch, Jeff Gordon, Joe Grundfest, Zack Gubler, Dave Hoffman, Andrew Jennings,

Renee Jones, Kate Judge, Ann Lipton, Don Langevoort, Dorothy Lund, Peter Molk, Frank Partnoy, Ed

Rock, Eric Talley, Urska Velikonja, Andrew Verstein, Yesha Yadav, and participants at the Arizona

State University Sandra Day O’Connor College of Law faculty workshop, BYU Winter Deals

Conference, Tulane Corporate and Securities Roundtable, National Business Law Scholars Conference,

Corporate and Securities Litigation Workshop, and the Law & Economics Workshop at Columbia Law

School and NYU School of Law.

353

II. THE GROWTH OF PRIVATE MARKETS AND THE POTENTIAL FOR PRIVATE

COMPANY LIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368

A. THE NEW PRIVATE LANDSCAPE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370

B. THE POTENTIAL FOR SECURITIES FRAUD IN PRIVATE COMPANIES . . . 377

1. Pressure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379

2. Opportunity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380

3. Rationalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383

C. OBSTACLES TO RULE 10B–5 CLASS ACTIONS IN PRIVATE MARKETS . . 386

III. THE FUTURE OF POLICING FRAUD IN PRIVATE MARKETS . . . . . . . . . . . . . . 390

A. MAINTAINING THE STATUS QUO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391

B. INCREASING PUBLIC ENFORCEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . 393

C. ADJUSTING THE PUBLIC–PRIVATE LINE . . . . . . . . . . . . . . . . . . . . . . . . 396

D. EXPLORING ALTERNATIVE MECHANISMS TO INCREASE

ACCOUNTABILITY IN PRIVATE COMPANIES . . . . . . . . . . . . . . . . . . . . . 398

CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402

INTRODUCTION

One of the world’s great inventors, Thomas Edison, bemoaned the propensity

of technologists to lie about an exciting new invention of the late-nineteenth

century, the storage battery. In Edison’s words: “The storage battery is, in my

opinion, a catch-penny, a sensation, a mechanism for swindling by stock[]

companies. . . . Just as soon as a man gets working on the secondary battery it

brings out his latent capacity for lying.”

1

More than a century later, CEO–founder Elizabeth Holmes of blood-testing

startup Theranos found inspiration in Edison—but rather than making the world a

better place, she created a company valued at over $9 billion that was nothing

more than a dangerous house of cards.

2

At age nineteen, Holmes dropped out of

Stanford University to develop groundbreaking blood-testing technology that

could use just a drop of blood.

3

Over the next dozen years, Holmes became a

1. Interview by the New York Sunday Herald with Thomas Edison, in 10 THE ELECTRICIAN: A

WEEKLY JOURNAL OF THEORETICAL AND APPLIED ELECTRICITY AND CHEMICAL PHYSICS., 329, 329–31

(1883).

2. See John Carreyrou, SEC Charges Theranos CEO Elizabeth Holmes with Fraud, WALL ST. J.

(Mar. 14, 2018, 10:21 PM), https://www.wsj.com/articles/sec-charges-theranos-and-fou nder-elizabeth-

holmes-with-fraud-1521045648.

3. Id.

354 THE GEORGETOWN LAW JOURNAL [Vol. 109:353

celebrity CEO–founder, raising over $700 million from investors, building a

board with high-profile directors, and claiming that she had developed a revolu-

tionary portable blood analyzer.

4

Reporting by the Wall Street Journal exposed a devastatingly different story told

by employees who suggested that Theranos had falsified lab records to make it look

like its blood-testing technology met the industry standard.

5

According to employ-

ees, the vast majority of tests that Theranos offered to consumers were actually

being run on commercial devices made by third-party manufacturers.

6

The small

number of blood tests being run on Theranos devices were unreliable and posed a

public health threat to consumers.

7

Under Holmes’s leadership, the company oper-

ated in a high-pressure and secretive environment,

8

with “information compartmen-

talized so that only she had the full picture of the system’s development.”

9

Many

venture capitalists declined the opportunity to invest in Theranos when Holmes

refused to provide specific information about the technology for due diligence—but

that did not stop her from raising millions of dollars from an assortment of wealthy

investors.

10

As a matter of corporate governance, Holmes allegedly misled the

board

11

and had supermajority voting stock that gave her the opportunity to override

any controls that might otherwise be put in place.

12

The Securities and Exchange Commission (SEC) launched an investiga-

tion, finding that in addition to misleading representations about the state of

Theranos technology, Elizabeth Holmes and another executive had told

investors that the company would generate more than $100 million of reve-

nue in 2014, when in fact, Theranos had barely $100,000 of revenue that

year.

13

These revelations spurred the spectacular fall of the company, going

from a $9 billion valuation to virtually zero.

14

Holmes settled fraud charges

with the SEC in 2018, still maintaining that she had done nothing wrong.

15

4. Id.

5. See id.

6. Id.

7. Id.

8. JOHN CARREYROU, BAD BLOOD: SECRETS AND LIES IN A SILICON VALLEY STARTUP 33 (2018).

9. Id. at 20.

10. See id. at 16.

11. Id. at 50.

12. Id. at 298.

13. Carreyrou, supra note 2. In addition, the SEC found that Holmes had falsely claimed that

Theranos’s products were deployed by the U.S. Department of Defense on the battlefield in Afghanistan.

Id.

14. See id.

15. Press Release, U.S. Sec. & Exch. Comm’n, Theranos, CEO Holmes, and Former President

Balwani Charged with Massive Fraud (Mar. 14, 2018), https://www.sec.gov/news/press-release/2018-

41 [https://perma.cc/Q7AF-LXRT]; see also Mary McNamara, Opinion, The Elizabeth Holmes Story Is

Not About the Black and the Blinks, L.A. TIMES (Mar. 25, 2019, 1:45 PM), https://www.latimes.com/

entertainment/la-et-elizabeth-holmes-con-artist-20190325-story.html (noting that several people who

knew Holmes reported that Holmes believed that she was on a “noble mission,” which justified “fudg[ing]

the truth” and that she would eventually succeed).

2020] PRIVATE COMPANY LIES 355