Friday, April 21, 2017

Theranos shareholders’ blue sky claims partially pass the test

By John M. Jascob, J.D., LL.M.

Indirect purchasers of shares of troubled life sciences company Theranos, Inc. may proceed with certain of their fraud claims against the company and two executives under the California Corporations Code. Although the plaintiffs purchased their shares through intermediaries, the prohibitions against market manipulation in Section 25400(d) of the Corporations Code are not limited to just the corporate entity that sells the stock. The plaintiffs’ misrepresentation claims under Sections 25401 and 25501 were dismissed, however, because those provisions require privity between buyer and seller (Colman v. Theranos, Inc., April 18, 2017, Cousins, N.).

Theranos. Founded in 2003 by defendant Elizabeth Holmes, Theranos purported to have developed proprietary technology that would allow commercial pharmacies to run a multitude of highly accurate blood tests from a few drops of a patient’s blood. After an extensive advertising and public relations campaign, Theranos raised over $700 million from individuals and investment funds in private offerings of securities.

In October 2015, however, the Wall Street Journal published an exposĂ© questioning the viability of Theranos’ technology. Following investigations by regulators, the Center for Medicare and Medicaid Services imposed sanctions on Theranos in July 2016. In November 2016, Walgreens sued Theranos for breach of contract. The plaintiffs then filed a class action complaint against Theranos, Holmes, and former President Ramesh Balwani, alleging that their shares had become worthless due to securities fraud on the part of the defendants.

Market manipulation claims. Turning first to the plaintiffs’ market manipulation claims under Sections 25400(d) and 25500, the court rejected the defendants’ argument that the claims were barred as a matter of law because the plaintiffs did not purchase their securities directly from Theranos. Although the plaintiffs purchased their shares through third-party venture funds, the court reasoned that the purpose of these provisions is to prevent the manipulation of the market by fraud. The court observed that the language of Section 25400(d) focuses on the actions of the seller of the securities, not the relationship between seller and buyer. Moreover, neither statute requires plaintiffs to prove their reliance on the misrepresentations. Accordingly, the court denied the defendants’ motion to dismiss.

Misrepresentation claims. The court found the defendants’ arguments to be persuasive, however, with respect to the misrepresentation claims brought under Sections 25401 and 25501. Unlike the anti-market manipulation provisions, Sections 25401 and 25501 focus on the relationship between the parties. Moreover, authority from the California appellate courts holds that these statutes, by their terms, limit recovery to plaintiffs who purchased the security from the defendant. As the plaintiffs had not alleged privity, the court granted the motion to dismiss the misrepresentation claims.

Joinder of intermediaries. The court did, however, find validity in certain of the defendants’ concerns about the intermediary relationship between the plaintiffs and the investment funds, while also noting that the plaintiffs had suggested that the intermediary sellers existed as an agent of Theranos. Accordingly, the court ordered the plaintiffs to show cause why the three investment funds should not be joined as required parties under Federal Rule of Civil Procedure 19.

The case is No.16-cv-06822-NC.

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