The New Frontier of Investor Lawsuits and Private Company D&O Insurance Coverage: Theranos and Other “Unicorn” Lawsuits
On October 10, 2016, Partner Investments, L.P. and two related entities filed a lawsuit under seal in the Delaware Chancery Court against Theranos, Inc., Elizabeth Holmes, its founder; and Ramesh Balwini, the former Chief Operating Officer. Partner Investments is a San Francisco-based hedge fund that invests in health care and technology companies, and the lawsuit alleges that it invested $96.1 million in Theranos in February 2014 after a series of meetings between fund personnel and the individual defendants that started in December 2013. On November 8, 2016, Walgreen Company, a Walgreen Boots Alliance Inc. unit, filed a similar, $140 million, lawsuit against Theranos alleging that it also was induced to invest funds through misrepresentations about the state of Theranos’ technology and operations, even when the two entities were working together. The lawsuit was also filed under seal in a Delaware federal court. See Walgreens Co. v. Theranos Inc., No. 16-cv-1040 (D. Del. filed Nov. 8, 2016).
The 66-page Partner Investments lawsuit contains eleven causes of action, including: fraudulent misrepresentation and inducement; securities fraud under miscellaneous California statutes; negligent misrepresentation; violations of Delaware’s Deceptive Trade Practices Act and California’s Unfair Competition Law; and breach of the implied covenant of good faith and fair dealing, alleged against the company and its founder, Ms. Holmes. The Delaware Deceptive Trade Practices Act allows recovery of three times the amount of actual damages proved. In a letter sent to its investors about the lawsuit, Partner Investments explained that it was based on allegations that “through a series of lies, material misrepresentations, and omissions,” the defendants “engaged in securities fraud and other violations by fraudulently inducing [Partner Investments] to invest and maintain its investment in the company.”
What is unusual about this particular investor lawsuit against a private company is the scope and scale of the claim, and its high profile nature, considering that Theranos publicly had predicted in 2014 that it anticipated revenues in excess of $2 billion by 2016. Also, the lawsuit may be a precursor of what can be expected when large “unicorn” companies – private companies with valuations in excess of $1 billion – begin to fail and private investors see their investments become worthless.
Private companies, like publicly-held companies, typically carry Directors’ and Officers’ insurance coverage. But private companies, because they are not subject to the same regulatory oversight applied to public companies, often buy far lower insurance policy limits, and for much lower premiums. The implications for the future underwriting of private company D&O coverage in light of the Theranos lawsuit could be far-reaching. First, exposures arising from a private company securities fraud lawsuit that could result in damages approaching $300 million (which could result in the Theranos case if a Deceptive Trade Practices claim is established) cause significant concern for underwriters who previously viewed private companies as relatively immune from liabilities arising under the federal securities laws. Underwriters already have a somewhat difficult time assessing the exposures of large, and complex, high-tech companies such as Theranos, but the increased threat of securities law liability raises additional underwriting concerns. Second, a threat such as that facing Theranos puts other large private companies on notice as to what constitutes an adequate amount of private company D&O insurance in an environment where exceedingly high company valuations can come crashing down as the result of SEC investigations or other regulatory activity. As mentioned above, because private companies view themselves as generally off-limits to liabilities arising from federal securities laws, they often purchase D&O coverage at much lower limits than a publicly-held company with a similar valuation. Third, the so-called “Securities Exclusion” in many private company D&O policies can take different forms and must now be reviewed much more closely in light of the potential for more securities fraud lawsuits against other unicorn companies like that filed against Theranos.
Private companies engaged in massive fund-raising, like Theranos, will want to work with their trusted insurance advisors to review their private company policy forms very carefully, and the Securities Exclusion in particular, to make sure that any potentially applicable coverage limitations are written as narrowly as possible so as not to reduce the coverage otherwise available to respond to private investor securities fraud actions.