[SOLVED] The story of Theranos, a company that

The story of Theranos, a company that sought to make blood tests cheaper, is a cautionary tale for Silicon Valley about what can happen when a company fails to develop internal control systems or overrides them, and when the CEO creates a psychological climate built on fear. The facts of this case were first discussed in Case 3-5 back in chapter 3. A review of those facts followed. We then turn to the accounting and fraud issues that led to the demise of the company and legal proceedings that continue to this day.
The leadership-style of Elizabeth Holmes, the CEO, created an environment of don’t go against the boss. She was backed up by Ramesh “Sunny” Balwani, the chief operating officer, who railed against anyone in the organization seeking to get the word out about the problems with the blood testing process and that it did not work as intended. Along the way, the company blocked would-be whistleblowers and one, Tyler Schultz, voiced his concerns about the product to the media.
The Theranos case shows what can happen when corporate governance barely exists and there are no independent directors or an audit committee to provide checks and balances on top management behavior. It also illustrates the lengths that a company can go to deceive business partners, patients, and doctors who rely on their blood-testing equipment to produce cheaper and quicker results. In the end, it is a story of a hard-charging CEO with ethical blind spots who was motivated by greed and hubris.
Case Overview
In 2003 Elizabeth Holmes dropped out of Stanford University to start Theranos, a privately-held company that would make blood tests cheaper, more convenient, and accessible to consumers. Simply by using a pin prick, she claimed blood could be analyzed quickly for diseases. Holmes believed the testing procedures were a revolution in the way diagnostics were done and would revolutionize preventative medicine. Using a machine called the Edison, pharmacies were able to use this portable blood test from a drop of blood. Unfortunately, the reports generated by the machine were not accurate. Most tests could not be accurately performed with a needle prick but required a venipuncture.
Physicians could not get information on how the tests were done. The whole process was sort of a black box, which had mysterious or unknown internal functions or mechanisms. Theranos was very secretive about the workings of the machinery and knew it did not work as intended.
Holmes duped just about everyone about the efficacy of Edison. She was able to raise hundreds of millions of dollars until an employee, Tyler Schultz, blew the whistle. For twelve years, Holmes essentially ran a Ponzi scheme by attracting investment funds from primarily venture capitalists that saw it as a unique opportunity to cash in on the boom in Silicon Valley.
Tyler Shultz, whose job involved checking the accuracy of the blood analysis results in the company's Edison machines, claimed he knew right away that the devices did not work as advertised. Shultz said: “Right off the bat, you could tell that this thing does not do hundreds of tests from a single drop of blood. This device can only run one test at a time. So, if you came in and ordered 300 tests, even if those tests could be run on the Theranos platform, you'd have to run them on 300 different devices.”
Schultz blew the whistle on the fraud at Theranos. In an interview with the Markkula Center for Applied Ethics, he commented on how corporate culture contributed to the Theranos failure. He described responses to concerns he expressed as retaliatory. He was seen as not being a team player and even a troublemaker.
As far as its corporate governance systems were concerned, Elizabeth Holmes, the chief executive officer, and Ramesh “Sunny” Balwani, the chief operating officer, served as chairperson of the board of directors and a member of the board, respectively. A group of mostly figure-heads also served on the board including George Shultz, a former U.S. secretary of state and the grandfather of whistleblower Tyler Schultz. A majority of board members lacked the experience necessary to ensure due diligence on the part of the company.
The majority of the board members were not qualified with respect to knowledge of how financial information should be disclosed and lacked experience in dealing with products and services like Theranos. Holmes controlled the board so she controlled the information flow.
Chronology of Events
Partnerships
Between 2012 and 2015, Theranos partnered with Safeway, Walgreens, and the prestigious Cleveland Clinic, to market its product to labs and the public. The following summarizes those deals.
In 2012, Safeway invested $350 million into retrofitting 800 locations with clinics that would offer in-store blood tests. Following missed deadlines and questionable results, the deal was called off in 2015.
In 2013, Theranos partnered with Walgreens to offer in-store blood tests at more than 40 locations. Following a story in the Wall Street Journal by John Carreyrou that was critical of the claims of the company, Walgreen’s suspended plans to expand blood-testing centers in their stores. In 2016, Walgreens’ filed a lawsuit against Theranos for breach of contract. In 2017, the original claim for damages of $140 million was settled for less than $30 million.
In March 2015, the Cleveland Clinic announced a partnership with Theranos in order to test its technology and decrease the cost of lab tests. Theranos became the lab-work provider for Pennsylvania insurers AmeriHealth Caritas and Capital BlueCross.
In July 2015, the Food and Drug Administration approved the use of the company’s fingerstick blood testing device (the Edison) for the herpes simplex virus outside a clinical laboratory setting. Theranos was awarded the 2015 Bioscience Company of the Year.
Exposure and Downfall
In his Wall Street Journal article, Carreyrou revealed that Theranos was using traditional blood testing machines instead of the company’s Edison devices to run its tests. Carreyrou, who had interviewed Tyler Shultz, the Theranos whistleblower, said he attempted to bring his concerns to the attention of management to no avail. He blew the whistle by reporting the company to the New York State Department of Health.
Theranos claimed the allegations were “factually and scientifically erroneous.” Walgreen’s suspended plans to expand blood-testing centers in their stores. The Cleveland Clinic announced it would work to verify Theranos technology.
In January 2016, the Centers for Medicare and Medicaid Services (CMS) sent a letter to Theranos after inspecting its Newark, California lab, reporting that the facility caused “immediate jeopardy to patient health and safety” based on a test to determine the correct dose of the blood-thinning drug warfarin.
In 2016, Walgreens and Capital BlueCross announced a suspension of Theranos blood tests from the Newark lab.
In March 2016, CMS regulators announced plans to enact sanctions that included suspending Elizabeth Holmes, the chief executive officer, and Ramesh “Sunny” Balwani, vice president and chief operating officer, from owning or operating a lab for two years and CMS would revoke the Newark labs license.
By April 2016, Theranos came under criminal investigation by federal prosecutors and the SEC for allegedly misleading investors and government officials about its technology. The U.S. House of Representatives Committee on Energy and Commerce requested information on what Theranos was doing to correct its testing inaccuracies and adherence to federal guidelines.
Company Response
In May 2016, Theranos announced that it had voided two years of results, representing one percent of its tests, from its Edison device.
In July 2016, Theranos announced that the CMS had revoked its license and issued sanctions including the suspension of approval to receive Medicare and Medicaid payments, and a civil monetary penalty. Theranos announced its intention to appeal the decision by regulators to revoke its license to operate the Newark lab and other sanctions.
October 2016, Theranos announced that it would close its laboratory operations and wellness centers and lay off about 40 percent of its work force to work on miniature medical testing machines.
On January 17, 2017 Theranos announced that it had laid off approximately 155 people and closed the last remaining blood-testing facility after the lab failed a second major U.S. regulatory inspection.
Legal Actions
Theranos defrauded investors, who lost nearly $1 billion. The company was accused of defrauding doctors and patients as well by providing inadequate test results that could have resulted in improper treatment and prescription decisions.
What happened at Theranos was more than corporate fraud. The actions of the company compromised public health and safety. Normally, we might look to the company’s code of ethics for guidance as to what went wrong. However, it did not appear that the company had a code of ethics. One thing is clear. There was a lack of ethics and integrity starting at the top of the company’s corporate governance system. The culture at the top was to ignore the warnings signs that the blood testing system did not work. The company pursued growth at all costs and made false and misleading statements to cover up the deficiencies in the product.
Legal Settlements
Continuing with the timeline, Theranos settled several legal actions as it wound down the business as follows.
In April 2017, a lawsuit by Partners Investments LP alleged that Theranos had misled company directors about the practices concerning laboratory testing and that it had secretly bought lab equipment to run fake demonstrations. The company reached an undisclosed settlement.
In April 2017, Theranos reached a settlement with CMS agreeing to stay out of the blood-testing business for at least two years in exchange for reduced penalties and signed a consent decree over violations of the Arizona Consumer Fraud Act. Alleged violations included false advertisement and inaccurate blood testing. Also, Walgreens and Capital BlueCross announced a suspension of Theranos blood tests from the Newark lab.
In August 2017, Theranos announced it had reached a settlement with Walgreens.
In March 2018, the SEC charged Theranos, Holmes and Balwani in an “elaborate years-long fraud” wherein they “deceived investors into believing that its key product – a portable blood analyzer – could conduct comprehensive blood tests from finger drops of blood.” Holmes reached a settlement with the SEC, which requires her to pay $500,000 forfeit 19 million shares of company stock and be barred from having a leadership role in any public company for ten years. Balwani did not settle with the SEC.
On June 15, 2018, Holmes and Balwani were indicted on multiple counts of wire fraud and conspiracy to commit wire fraud. According to the indictment, investors, doctors, and patients were defrauded. The indictment alleged that the defendants were aware of the unreliability and inaccuracy of their products but concealed that information. If convicted they each face a maximum fine of $250,000 and 20 years in prison. The case was expected to begin in March 2021.
In September 2018, it was announced that, with the approval of the company’s board of directors and shareholders, Theranos would begin the process of corporate dissolution. The company owed at least $60 million to unsecured creditors. The move to dissolve rather than file for bankruptcy left the company with $5 million to distribute to creditors.
Corporate Culture
Elizabeth Holmes told John Carreyrou in the interview that she did not start out to perpetrate a con, she just had a vision and lost sight of right and wrong as she pursued a goal to become a billionaire. In other words, she had ethical blind spots because she was immersed in pursuing her own self-interest to the detriment of doctors, business partners, and patients.
Holmes did not tell the board of directors about the problems with the testing equipment and the challenges faced by the company in financing its continued operations. Holmes never told the board of directors about what had transpired at the company and problems with the testing equipment. Holmes sought out board members that had accomplished resumes but that did not mean they were experts in matters faced by Theranos or that they would challenge Holmes’s decisions. They did not understand the intricacies of blood testing. They did not know enough to question her decisions. In that regard, they were not independent of Holmes and, in all likelihood, were reluctant to ask probing questions once it became known the company was in trouble.
The company also stifled dissent as when one of its employees, Erika Cheung, told Sunny Balwani about the flawed quality controls at the company that had ignored problems with the process of analyzing blood. As further described below, Balwani basically told Cheung to mind her own business.
Fraudulent Reporting of Operating Results
According to the federal indictment, Holmes and Balwani defrauded doctors and patients (1) by making false claims concerning Theranos’s ability to provide fast, reliable, and cheap blood tests and test results, and (2) by omitting information concerning the limits of and problems with Theranos’s technologies. Allegedly, the defendants knew Theranos was not capable of consistently producing accurate and reliable results for certain blood tests. Other allegations include:
• The defendants made numerous misrepresentations to potential investors about Theranos’s financial condition and its future prospects, including that its patients’ blood was being tested using Thermos-manufactured analyzers; when, in truth, they knew that the company had purchased and used third party, commercially available-analyzers.
• The defendants’ represented to investors that Theranos would generate over $100 million in revenues and break even in 2014 and that the company was expected to generate approximately $1 billion in revenues in 2015; when, in truth, Theranos would generate only negligible or modest revenues in 2014 and 2015.
• The defendants used a combination of direct communications, marketing materials, statements to the media, financial statements, models, and other information to defraud potential investors about the company’s revolutionary and proprietary analyzer, Edison. Supposedly, the machine could perform a full range of clinical tests using small blood samples drawn from a finger stick at a faster speed than previously possible and with more accurate and reliable results. Allegedly, the defendants knew that the claims about the analyzer were false. It was slower than competing devices and, in some respects, could not compete with existing, more conventional machines.
Whistleblowing
Tyler Schultz claimed to know something unethical was going on that could have major repercussions on the company. He complained to Holmes that the research results were tampered with and multiple quality control tests were failing. Shultz said the prototype of Edison only had an accuracy of 65 percent while the required accuracy results were 95 percent, adding that Theranos was knowingly misrepresenting information to its users. He told HBO in a documentary that if a hundred people who had syphilis came and got tested on the Theranos devices, the company would only tell 65 of them that they had syphilis and told the other 35 that they were healthy: no need for medical intervention.
Schultz’s whistleblowing came with costs. He had signed non-disclosure and confidentiality agreements. Theranos went after Shultz in court, claiming he was revealing trade secrets and forcing his parents to spend between $400,000-$500,000 on his defense.
In an interview with ABC News for its 20-20 television show in May 2019, Erika Cheung, pointed out the flawed quality controls at the company that had ignored problems with the process of analyzing blood. Cheung said she raised these issues directly with Balwani who reacted by saying, “What makes you think that we have problems? What was your training in statistics?...I’m tired of people coming in here and starting fires where there are no fires and sort of thinking that there are problems when there are no problems.” Cheung realized her concerns were falling on deaf ears. She told the reporter that “This was not an environment, that is not a culture, where they really care about what consequences this might have on patients.”
Financial Reporting and Audit Problems
An investigative journalist, Francine McKenna, wrote an article for MarketWatch that analyzed the operating and financial reporting environment at Theranos. The article outlines the financial reporting issues related to the Theranos fraud.
The operating deficiencies described above and false reporting to partners masked the fact that Theranos was bleeding cash. In December 2017, Holmes was forced to mortgage all of Theranos’s assets to Fortress Investment Group in return for a desperately needed $100 million loan. The terms of the loan agreement included the requirement to finally produce audited financial statements, something that had not been attempted since at least 2009, according to Phiilippe Poux, Theranos’s last chief financial officer.
Poux stepped up the process of preparing financial statements for the calendar year 2017 that could eventually be audited. The goal of the 2017 audit was to get a clean opinion on Theranos’s financials — that is, the auditors’ “reasonable assurance” that the numbers did not include a material misstatement due to error or fraud.
Theranos closed a deal in December 2017 to borrow $100 million from Fortress Investment Group and it became Theranos’s most important creditor. The deal gave Fortress a lien on all of Theranos’s assets, including its portfolio of patents.
One additional covenant was a requirement to get an independent auditor’s opinion on its 2017 financial statements by June 2018. Fortress released $65 million when the deal closed, with the rest contingent on achieving certain milestones, as well as the audit. In an interview with MarketWatch, Poux said that: “We would have been in default of the Fortress agreement if a clean opinion was not delivered by that date.”
As Poux and his staff finalized the financial statements, significant adjustments had to be made for additional expenses, in particular legal expenses, incurred after December 31, 2017. Poux told MarketWatch that it became painfully obvious the company’s cash-burn rate would outstrip the funds available.
The external auditors began work on the audit in April 2018. To avoid the auditor’s “going concern” warning, Theranos needed to prove it would have enough cash to support itself for 12 months from the date of the audit report, which was expected to be in June 2018. The problem was the auditors discovered that Theranos did not have sufficient cash to survive long enough to secure regulatory approval for its blood testing product.
Holmes unsuccessfully solicited additional financial support from investors in April 2018. Her effort to sell the company that spring also failed. Achieving the Fortress milestones — and securing more funds — before the cash was depleted was essential.
Fraud Charges
On March 14, 2018, the SEC filed charges against Theranos, Holmes and Balwani for fraud. The SEC’s suit alleged that the company had “never told” Walgreens it was having problems successfully developing a proprietary analyzer that was capable of conducting a comprehensive set of blood tests from drops of blood drawn from a finger. Instead, Theranos was actually testing some blood on modified third-party analyzers.
Theranos and Holmes settled the SEC’s fraud charges immediately. Holmes agreed to a settlement that stripped her of voting control of Theranos, banned her from being an officer or director of any public company for 10 years and required her to pay a $500,000 penalty. Balwani, who had become the company’s president in 2009 after guaranteeing a line of credit for Holmes, is still fighting the allegations.
On June 15, 2018, federal prosecutors filed criminal charges against Holmes and Balwani, alleging they had defrauded investors out of hundreds of millions of dollars and also defrauded doctors and patients.
To add to its fraud problems, Poux and David Taylor, who became Theranos’s CEO shortly after Holmes was indicted, had been signing what Poux called “certificates of compliance” on a monthly set of financial statements presented to the board.

In the end, the auditors knew that even if Theranos had received the remaining $35 million in funding from Fortress by the summer of 2018, the company would not have had enough cash to support itself for 12 months, according to the auditor’s opinion on the company’s 2017 financial statements. The auditors had no choice but to issue a going concern alert.
In the aftermath of legal proceedings against Holmes and Balwani, payments by the company of legal fees incurred by them and other former executives and directors had stopped.
The story of Theranos is a cautionary tale where one lie leads to another and before you know it the story snowballs out of control and coverups ensue. The culture of the company was such that it hid important information from the public, pharmacies, medical professionals, and the government. It is a classic case of the ethical slippery slope.
Questions.
1. Describe the corporate culture failures at Theranos that enabled the fraud to occur.
2. What were the consequences of the fraudulent accounting and financial reporting at Theranos?
3. What kind of leadership existed at Theranos? What was Holmes’ leadership style? How did this contribute to the problems at Theranos and, ultimately, its downfall?

Question: The story of Theranos, a company that