Abstract
Fraud has become a common practice and continues to be a serious problem facing businesses. Fraud cost investors hundreds of billions of dollars annually. investors of publicly traded companies are protected by certain regulations governing internal controls and financial reporting. Unfortunately for privately held companies, there are limits regulatory oversight, making fraud thrive in the private sector. This paper reviews the history of one of the recent frauds of the infamous biotech startup known as the Theranos case . T he paper will describe the weakness of the intern controls and how this contributed to the fraud.
Theranos Incorporation
Introduction
Theranos incorporation was founded by Elizabeth Holmes in 2013 after she dropped out of Stanford University at 19 years. Elizabeth used her tuition money to start the company, and at 30 years the company had reached its peak, raising over $700m in investment (Summerville, 2019). Before the company could rise to fame, Holmes at one point could not manage the company and turn to Balwani by then her boyfriend. The company at one point was being run by Elizabeth Holmes as the chief executive officer and Ramesh Balwani as the president (Summerville, 2019). Even though the company was valued at $ 9 billion, Holmes owned half the shares thus, the company remained a private entity.
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The company gained its popularity when Holmes successfully marketed a medical laboratory using a chip, she promoted one of its products which she claimed could perform hundreds of rapid tests which was inexpensive using one drop of blood(Summerville, 2019). She also claimed that the test results could be delivered to patients via phone within a few hours. Holmes and the company executives believed that they had invented a revolutionary blood-testing device. Holmes had always dreamt of designing a device that could handle a hundred tests using a single drop of blood drawn using pinprick and placed on a mobile device. After that, the phone could send the results faster than the ordinary labs(Summerville, 2019). Holmes was motivated by her fear for needles, this made her interested in biotech to offer a better solution
Theranos was popular as it claimed to have the ability to perform hundreds of tests such as cholesterol levels to other complex genetic analysis from a single pinprick of blood (Rubenfeld, 2018). This was an automated process that was fast and inexpensive. Holmes together with Ramesh Balwani worked tirelessly to attract well-known investors and powerful board members. Some of the board members recruited were Henry Kissinger and George Schultz the US secretary of state. others were Oracle founder Larry Ellison and her former university professors at Stanford. Other he members include Fisher Jurvetson of venture capital and Rupert Murdoch (Rubenfeld, 2018). Theranos believed that this technology could revolutionalize medicine at the same time save many lives all over the world.
Apart from having prominent board members, the company managed to attract many dealings with major healthcare service providers like Walgreens. Theranos partnered with Walgreens to set up a minilab which they promised to offer a quicker solution. However, Theranos secretly modified their machines to use small blood samples (Carreyrou, 2018). Not only did Theranos had malfunctioning devices, they secretly performed blood tests using the old testing methods, but they also failed to deliver what they had promised. In 2015, one of the companies Theranos intended to partner with, published reports about the defective devices claiming that the devices were not working as said(Carreyrou, 2018). Holmes was charged with massive fraud after investigation. She is currently awaiting trial, she has been charged with several counts of fraud.
History Of The Fraud
The Theranos case is the most shocking case of fraud in biotech in US history, which started as a convincing revolutionary story that easily convinced investors. The fraud started with Holmes using false statements to convince investors. She convinced prominent people that her technology invention was being used in the military, but in reality, these agreements did not exist (Denman, 2019). Besides, she also falsified the company review and presented exaggerated financial forecasts to attract potential investors (Denman, 2019). Holmes used a false financial outlook to ensure that the company's financial position looked healthy. The media analysis found only one peer-review study highlighting the success of a minilab (Denman, 2019). Thus, the media started questioning how a company with no proper technical background could create a revolutionary medical device to be used by the military.
Theranos used technology from other companies to run some of their tests, furthermore, these tests were not accurate as the company had claimed. For years, the companies had been presenting false and misleading statements to investors convincing investors that the company was financially strong and stable (Denman, 2019). F or example, in 2014, the company had highlighted that it had generated $ 100million in revenue and over 1 billion in 2015 (Denman, 2019). Besides, investors were misled by technological demonstrations, and the company misrepresented its relationship with the US Department of defense and its relationship with big companies like Walgreens (Denman, 2019). These were some of the shocking revelations made by the whistleblower.
With time, the company culture of intimidation and secrecy revealed that the company had repeatedly failed quality assurance, and one of the critical issues was that the company sent incorrect results to patients whereby life-changing decisions were made out of these results (Rubenfeld, 2018). All these lies were exposed by a whistleblower who finally published a report in the Wall Street Journal revealed that the company had been built on audacious lies (Rubenfeld, 2018). In the end, the prosecutors alleged that the company had duped investors of hundreds of millions of dollars defrauding doctors and patients who had trusted them with their lives. Holmes and Balwani were eventually accused of frauding investors for the years which they claimed Theranos machines could perform the test with a single drop of the blood sample.
Internal control weakness
Research studies reveal several factors behind the fraud, according to a study by AFCE, half of the fraud cases are signs of control issues. In this case, Theranos was a private entity owned by Elizabeth Holmes, meaning that she had unchecked power (Denman, 2019). the board of directors was not actively involved in the day to day running of the company. additionally, many of these boards of directors had no medical or technological knowledge to understand the product the company was selling (Denman, 2019). lack of check on the executive power and lack of transparency are some of the huge red flags investors in Theranos case missed.
Internally, the company had created a culture whereby the employees worked in a hostile environment. They also enforce an unethical culture of secrecy and fear. for example, they staged a lab to demonstrate their technology to potential investors which were not the actual technology they used(Carreyrou, 2018). Most employees worked in fear and could not speak put about the practices due to the strict-disclosure agreements they had signed(Carreyrou, 2018). With more powers, Holmes and her partner Balwani manipulated information to create a false image of the company.
Other studies also highlight t that financial difficulties are an important red flag which can show investors that the company lacks proper cash flow and assets to pay off its current liabilities, this is a sign of financial distress or misappropriation fraud (Denman, 2019). most frauds are perpetrated by the executives of the company who hold powers to continue this pretense for several years. According to Denman (2019), a higher position means have more control over information and creates an environment to engage in fraud . on the other hand investors and employees trust the management and might not question their decisions until it is too late.
Even though it expected that all companies have internal controls, especially public trade companies. The Securities and Exchange Commission under the Sarbanes-Oxley act of 2002 requires public companies to have audited financial statements to safeguard assets and also protect investors (Denman, 2019). as a result, an external auditor has to review the company's' internal controls to ensure that they are working well. Auditors are expected t access the company's information technology security, access control and how sensitive information is safeguarded(Denman, 2019). it is expected that the top management of a company sets the tone by acting with integrity and also showing ethical values that employees are expected to follow.
Risk assessment is a major consideration to asses the weak control area, some of the activities like segregation of duties, authorization processes, record keeping, independent check, physical safeguard mechanism are some of the reasonable assurance of reducing fraud. However, the level of effectiveness in implementing these activities mainly depends on trust(Denman, 2019). That is why investors, are expected to conduct a background check of the company and the leadership including the CEO before taking any steps to invest in the company(Denman, 2019). in the case of Theranos, the two executives lacked adequate knowledge in medical and technology . for example Holmes did not have any medical background and was university dropout with no degree in technology. Similarly, Balwani had no experience in the medical field.
In most public companies, it is easy to access information about internal controls that investors can review. However, for private companies, they are not compelled to disclose any information about their internal control (Denman, 2019). Besides, private company's reporting system is not well structured as compared to public companies(Denman, 2019). Some of their agreements vary based on investors' interest, however, as required by law, any private company with more than one million dollars assets and with more than 500 common stocks holder should file their financial reports with the SEC(Denman, 2019). Private companies are expected to file quarterly returns and also submit annual financial reports which are similar to public companies requirements .however, large companies avoid this process by keeping their stockholder below 500 . with limited regulatory measure and financial information being secret, investors in private companies cannot easily check the accuracy of the information.
B efore investing it is prudent to be skeptical of all the information presented by the top management, investors are expected to ensure that they put their money in a legitimate company by visiting the company, researching and reviewing the credentials of the company's' CEO and their board of directors. Investors need to understand the company values, and culture and how they spent their investment(Denman, 2019). when researching, investors need to be familiar with the company's financial projection and financial ratios, any unusual ratios would mean the company is not stable. lack of control is some of the key elements that provoke the individual to commit fraud like in the case of Holmes. The fact that she had access to key information with more powers she owned half of the company's shares, she created a culture of secrecy .this weak designed internal control was the recipe for fraud at Theranos. Eventually, Holmes was forced to resign and she lost her powers in Theranos, she was barred from being an officer or director of any public company. She eventually settled the case out of court for the civil charges as she awaits a criminal trial in 2020.
Current Status
Currently, Holmes and Balwani have been charged by the SEC of tow accounts of conspiracy to fraud and face the other nine counts of wire fraud. Elizabeth Holmes will face a trial in the federal court and the penalties for her charges is 20 years in prison and could pay millions of dollars as fine(Carreyrou, 2018). Her trial will be in August 2020 in San Jose. With more than 2 million page evidence from her defense team, Holmes maintains her innocence since her indictment last year. After being charged with several offenses Holmes has stepped down as the company CEO and the company ceased to operate(Carreyrou, 2018). Holmes has agreed to a settlement with the federal regulator, however other independent companies and investors have filed lawsuits after losing over $700 million (Carreyrou, 2018). the criminal charges against Holmes are pending since her trial is set to commence in Augst 2020.
Conclusion
The Theranos case reveals some of the complexities faced by investors when dealing with private companies like in the Theranos case. As compared to public companies, private entities have several risks and fraud thrives because of limited regulatory oversight. Investors of publicly traded companies are protected by certain regulations governing internal controls and also involve financial reporting. however, investors dealing with private companies need to conduct proper due diligence since they have limited protection against company risks. It is a fact that most investors are attracted by companies with strong financial positions as seen in the case. However, those who invest without due diligence are likely to lose their investment. thus, investors need to be proactive foresee some of the red flags and conduct thorough research before investing.
Investors need to find ways of detecting risks in private companies to prevent loose of their investment. On the other hand, private companies need to protect their reputation to win public trust. After the Theranos case, investors have become cautious and avoid dealing with private entities. With companies like Theranos ceasing operations, many investors have drawn important lessons as they hope to recover billions of dollars lost in this investment. The Theranos case is a good example of how weak internal controls can contribute to fraud. the main question is how a startup company with limited technological experience could have convinced larger companies and prominent investors that is could perform hundreds of rapid tests which was inexpensive using one drop of blood. Besides, what was the role of board members in ensuring that the company followed all the ethical requirements this is a good reflection of analyzing investor negligence.
References
Denman, D. E. (2019). 2018 Report On Occupational Fraud: Results And How Companies Can Protect Their Assets. Journal of Accounting and Finance , 19 (4).
Rubenfeld, S. (15 Mar. 2018). The Morning Risk Report: SEC Sees $700 Million Fraud at Theranos. The Wall Street Journal. blogs.wsj.com/riskandcompliance/2018/03/15/the-
Morning-risk-report-sec-sees-700- million-fraud-at-theranos/ Carreyrou, J. (4 May, 2018). Theranos Cost Business and Government Leaders More Than $600
Million. The Wall Street Journal, Dow Jones & Company, Summerville, A. (28 June 2019). Theranos Founder Elizabeth Holmes to Face Trial Next Year
on Fraud Charges. The Wall Street Journal . www.wsj.com/articles/theranos-founder- elizabeth-holmes-to-face-trial-next-year-onfraud-charges-11561754180.
