The Madness of Shareholder Lawsuits

At least one investor (and likely soon many more) in Theranos is suing the company:

When Theranos founder Elizabeth Holmes announced that the company was shifting its focus, she said her team is lucky to have investors who believe in its mission. But there's at least one major investor who doesn't, and it has already sued the controversial blood-testing provider. According to The Wall Street Journal, Partner Fund Management (PFM) LP is accusing the startup of convincing it to pour $100 million into the startup by feeding it a "series of lies." The San Francisco-based hedge fund firm filed the lawsuit in Delaware today and sent out a letter to its own investors.

In the letter, the firm said:

"Through a series of lies, material misstatements, and omissions, the defendants (Theranos), engaged in securities fraud and other violations by fraudulently inducing PFM to invest and maintain its investment in the company."

At some level, shareholder lawsuits are utter madness.  Consider the case where all owners of a company are suing the company.  If they win, the amount they win from the company is offset by a drop in value of their ownership in the company.  At best this is a break-even proposition but when lawyers fees are included, this is a recipe for immense value destruction.

I am not really an insider on these things, but my guess is that the explanation for the madness comes by relaxing my assumption above that "all owners" are suing.   If only one owner is suing, then this becomes a potential mechanism for transferring value from other owners or investors.  There are of course real situations where a certain minority class of shareholders is screwed by the majority, but I don't think that is the case here.  In the case of Theranos, I assume the whole company is headed into a messy bankruptcy, and PFM is racing to the courthouse to be first in what is sure to become a messy litigation-fest.  They likely have one or both of these goals

  • Since they likely cannot sell their equity and cash out normally, given the uncertainty about the company's future,  they may be able to effectively cash out by getting other owners to pay them off in a settlement of this suit.
  • Since their equity may be worth zero soon, if they can win a lawsuit the payout becomes a much more senior form of indebtedness and might move them up towards the front of the line for any value that still exists in the company

Update:  From one of my readers at a CPA firm:  A key reason for shareholder suits is to trigger insurance coverage payouts for management and/or Board errors and omissions.  This in theory both increases the company’s assets and creates a senior claim by the plaintiffs to those particular assets.

  • Sam P

    As far as I can tell, Theranos has not had an IPO yet, so all current shareholders received their shares either by investing (venture capital) or as compensation (employees, founders).

    So likely they can't sell their shares because they'd likely need approval of the board to do so, rather than due to market conditions.

    I'm not a lawyer, but given how often startups fail, if this kind of lawsuit worked, I'd think we'd have heard more about them. It sounds to me that investors with Partner Fund Management would have at least a good case that PFM failed in its due diligence--given what I've read about Theranos, pretty much all the investors failed in their due diligence.

  • harries

    Sounds about right. I'll sue myself in order to prevent someone else from suing me for not being sufficiently litigious.

  • Maximum Liberty

    Warren:

    Assume first that the claim is made against the company AND the directors or officers.

    In that case:
    1. Theranos may have had directors & officers' insurance that might cover the claim, subject to a deductible and a limit.
    2. The eventual settlement of the claim with the directors and officers might require them to relinquish their shares. If one of the targets is a founder, that might be significant.

    Max

  • Trimegistus

    I think the underlying reason for this suit is that the investors were persuaded to invest money in the company by statements which were outright lies. That's called fraud.

  • BigHeadDennis

    Another consideration: one presumes that Theranos still has a few hundred millions of dollars in cash on hand, from rounds raised prior to the implosion. Current shareholders may be filing a lawsuit or lawsuits to force management to return the cash on hand and effectively shut the company down -- rather than spend the cash to launch their new product. The shareholder's calculation is that they would rather receive, say, $0.25 on the dollar, instead of nothing at all.

    Also, while I'm not at all familiar with exactly the position of the investor that filed the suit, it could well be a situation of LIFO -- the way private rounds are structured, the last money in often has a "preference" in getting money out. So the remaining cash may not be split evenly among ALL shareholders.

    Hope this helps!

  • Tanuki Man

    Anything that brings light to the media's SJW fetishistic lionization of the fabulist founder of Theranos is OK with me.

  • jim jones

    I knew it was a scam because Theranos is a woman and women never innovate

  • Eau de Javelina

    Another possible reason in this case is to emphasize to the limited partners in PFM that, "hey, we weren't negligent stewards of your capital, we were a victim of fraud so don't sue us".