Lessons From Theranos

On January 3, 2022, Elizabeth Holmes, founder of Theranos and darling of Silicon Valley, was found guilty by the District Court for the Northern District of California of defrauding investors, wire fraud and conspiracy to commit wire fraud. She faces 20 years in prison. Throughout the trial, Ms Holmes, the managing director and CEO of the company, maintained that her staff misled her about the efficacy of its technology.

While this is a case concerning a CEO on the other side of the world, directors in Australia should reflect carefully. The trial serves as a pertinent reminder to Australian directors of the significant risks involved in directorship and raises difficult questions about the extent to which directors can rely upon the information provided to them under Australian law.

The facts

The year was 2003. A 19 year old Elizabeth Holmes was on the fast track to fortune. Her company, Theranos, had been touted by media and moguls alike as a revolution in global healthcare. The product: small automated devices that could deliver rapid blood testing with a sample the size of a pinhead. By 2013, Theranos was valued at $10 billion USD.

But in 2015, the rug was pulled from under Elizabeth Holmes, and the façade she had used to fool the likes of Rupert Murdoch and Larry Ellison came crumbling down. Medical research professors John Ioannidis (Stanford University) and Eleftherios Diamandis (University of Toronto) independently published articles in reputable journals questioning the validity of Theranos’s technology. Investigative journalist John Carreyrou then brought Theranos’ unproven claims to the public’s attention in his article for The Wall Street Journal. The effect of the article was devastating.

Soon after its publication, Theranos was hit with legal actions and investigations from medical authorities, investors, the U.S. Securities and Exchange Commission, Centers for Medicare and Medicaid Services (CMS), the Attorney General of the State of Arizona, former business partners and patients.

News poured out about the company’s deceitful and fraudulent practices:

1. Theranos was using traditional blood testing machines instead of the company’s Edison devices to run its tests.
2. In order to conceal the lab’s true operating conditions, Holmes had created a fake lab for the then Vice President Joe Biden’s tour.
3. Theranos had lied about the FDA classifications of its technology.
4. Its laboratories did not meet state regulations and, in some cases, were even classified as an “immediate jeopardy to patient health and safety”.^[1]

The scandal was enormous.

On August 31, 2021, the criminal trial of Ms Holmes commenced in the United States District Court for the Northern District of California. On January 3, 2022, Holmes was found guilty on four counts of defrauding investors – three counts of wire fraud and one of conspiracy to commit wire fraud. She faces a maximum sentence of twenty years in prison and a fine of $250,000, plus restitution, for each count of wire fraud and for each count of conspiracy.

Evidently, Ms Holmes could not establish that her actions resulted from her reliance upon incorrect information provided by her employees. But what if she could establish that reliance? Would that be enough in an Australian Court?

It might be.

Director’s duties in Australia

Picture a director of an Australian company listening at a board meeting to the Chief Technology Officer (CTO) as they explain the virtue and infinite potential of a new medical device the company had created. The CTO is passionate; she is compelling, and she asks the board for a large allocation of the company’s budget for further research and development. She insists that the payoff will be enormous.

What is the onus on a director in this situation?

The starting point is to consider the Directors’ Duties contained within sections 180 – 183 of the Corporations Act 2001 (Cth) (CA). In summary, the Directors’ Duties impose obligations on Australian company directors and officers to:

1. exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise in their position (Duty of Care and Diligence);^[2]
2. exercise their powers and discharge their duties in good faith in the best interests of the corporation and for a proper purpose;^[3]
3. not improperly use their position to:^[4]
   1. gain an advantage for themselves or someone else; or
   2. cause detriment to the corporation; and
4. not improperly use the information obtained by virtue of their position to:^[5]
   1. gain an advantage for themselves or someone else; or
   2. cause detriment to the corporation.

Importantly, a director or officeholder will not be found to have breached their Duty of Care and Diligence (or its equivalent at common law or in equity) in respect of a decision concerning the business operations of the company, if they:^[6]

1. make the decision in good faith for a proper purpose;
2. do not have a material personal interest in the subject matter of the decision;
3. inform themselves about the subject matter of the decision to the extent they reasonably believe to be appropriate; and
4. rationally believe that the decision is in the best interests of the corporation.^[7]

This protection for directors is known as the ‘business judgment rule’, and it acts as a safety net for directors acting in the company’s best interests while also providing clear steps that a director can follow to minimise their risk of liability.

However, the business judgment rule is drafted broadly to encompass the myriad of situations in which a director will be required to make a decision concerning a company’s business operations. Because of this broad wording, it can be difficult for directors to ascertain what they must do in each situation to ensure that they have met the protective ambit of the business judgment rule. Relevantly - in the scenario posed above - what is required of the directors to be satisfied that they have adequately informed themselves about the CTO’s proposal and its effect on the company? What is ‘reasonably appropriate’ in this situation?

Thankfully, section 189 of the CA clarifies the business judgment rule requirements by providing a presumption in favour of a director where they have reasonably relied on information or advice provided by: employees with specialist knowledge, professional advisers, and experts in certain circumstances. Without setting out the entirety of s 189 of the CA, its effect was neatly summarised by Beach J in ASIC v Mitchell,^[8] where His Honour stated:^[9]

“…s 189 requires that where the director relies on information, professional or expert advice, he must do so in good faith and only after having made an independent assessment of the information or advice. In this context, independent assessment requires no more than that the director, having listened to and assessed what his colleagues have said, must bring his own mind to bear on the issue using such skill and judgment as he may possess. Further, there must be evidence that he in fact relied on the information provided.”

Section 189 is most often considered in connection with a complaint that there has been a failure to exercise reasonable care and diligence under s 180(1). However, it can also be utilised in relation to an alleged breach of one of the directors’ duties contained in sections 181 – 183 of the CA.

In ASIC v Mariner Corporation Ltd (2015) 241 FCR 502, Beach J explained that in determining whether a director has complied with their Duty of Care and Diligence:^[10]

“It is not in doubt that the circumstances of the particular company concerned inform the content of the duty. These include the size and type of the company, the size and nature of the business it carries on, the terms of its Constitution, and the composition of the board of directors.

It is also not in doubt that in considering the acts or omissions of a particular director, one looks at factors including the director’s position and responsibilities, the director’s experience and skills, the terms and conditions on which he has undertaken to act as a director, how the responsibility for the company’s business has been distributed between the directors and the company’s employees, the informational flows and systems in place and the reporting systems and requirements within the company.”

The takeaway here is that there is significant nuance to be observed in considering whether a director has breached their duties by relying upon the information of another. In most circumstances, where a director:

1. has been genuinely diligent;
2. has satisfied themselves of the expertise and competence of the person providing the information; and
3. has formed an independent assessment of that information using the knowledge available from their own experience,

a director will not be found to have breached their duties.

In addition to the obligations imposed by the directors’ duties, there are specific minimum standards that a director must meet in fulfilling their objective duty of competence.^[11] For example, a director must:

1. acquire at least a rudimentary understanding of the business of the corporation and become familiar with the fundamentals of the business in which the corporation is engaged;^[12]
2. keep informed about the activities of the corporation;^[13]
3. monitor the corporate affairs and policies;^[14]
4. have the ability to read and understand financial statements;^[15] and
5. maintain familiarity with the financial status of the corporation by a regular review and understanding of financial statements.^[16]

If Ms Holmes’ case: (1) was held in Australia with Australian law, and (2) solely focused on her reliance on technical information provided to her by Theranos employees,^[17] then Ms Holmes may have had a defence to any claim that she had breached her directors’ duties if she could show that she made proper enquiries as to the validity of that information.

However, as in Ms Holmes’ case, a director will often be put in a position where they have cause to doubt the accuracy of the information being provided to them. In that circumstance, Australian law provides that a director must take all steps that a reasonable director acting in their position would take to ascertain the veracity of that information before satisfying themselves that they are justified in relying upon it.

If you have any questions about your duties as a director, contact one of our commercial lawyers for expert advice.