In a case with important implications for late-stage private companies, a federal magistrate judge ruled last week that investors in funds holding private company securities can bring fraud claims against the issuer of the securities and its officers, even though the plaintiffs had no dealings with the issuer or its officers and hold no actual shares.
The dispute involves the securities of Theranos, a private life sciences company headquartered in Silicon Valley. In Colman v. Theranos, a case of first impression, U.S. Magistrate Judge Nathanael Cousins of the Northern District of California held that California Corporations Code sections 25400(d) and 25500 permit suits by “indirect purchasers” of pre-IPO shares, i.e. purchasers who bought securities interests from intermediaries and not from the issuer. The court reasoned that because the statutes are designed to combat fraud affecting the market and price for the issuer’s securities, there is no requirement that a purchaser have direct dealings with the issuer, or even that the purchaser have relied specifically on any alleged false statement made by the issuer. Instead, the court held, false public statements which are alleged to have affected the market for the issuer’s securities, and which the issuer made to induce purchase of the company’s shares generally, can form the basis for a claim under California law. The court further held that plaintiffs may sue corporate officers responsible for the allegedly false statements.
Not only is the dramatic expansion of liability to indirect purchasers noteworthy, but also striking is the court’s finding that Theranos’ consumer-facing advertising and publicity about its products and company prospects can form the basis for a securities fraud claim. The court accepted without challenge the plaintiffs’ assertion that Theranos’ “advertising campaign [about the company’s product] was for the purpose of raising capital.” In essence, at least at this stage of the proceedings, the court accepted the plaintiffs’ argument that the defendants pushed a false public “story” about Theranos to increase the valuation of the company’s securities, which would benefit Theranos.
Lawsuit Comes Amid Increased Attention to Sales of Pre-IPO Shares
Theranos has raised over $700 million selling shares to venture and other private funds, as well as individual accredited investors, and was until recently considered a highly valued “unicorn,” or private company valued at $1 billion or more. Theranos is known for its highly-publicized efforts to create technology to test for a number of diseases using only a few drops of blood from the patient.
The plaintiffs in the case did not invest directly in Theranos securities. Instead, they invested through funds created by intermediaries for the sole purpose of purchasing Theranos securities. One plaintiff purchased “member interests” in a fund set up to purchase Theranos shares. The other plaintiff purchased “Series B units” issued by a fund allegedly set up to acquire and hold Theranos securities obtained from current and former Theranos investors and personnel. Neither fund was affiliated with Theranos.
Beginning in 2015, Theranos increasingly came under fire after a series of media articles challenged the efficacy of the company’s technology. In 2016, two plaintiffs filed a putative class action on behalf of anyone who directly or indirectly purchased or committed to purchase “an interest in Theranos securities.” The plaintiffs claim that the value of their securities interests are now nearly worthless as a result of the defendants’ alleged fraud. The suit alleges fraud, unfair competition and violations of California’s securities laws and names as defendants Theranos, its founder/CEO Elizabeth Holmes, and its former chief operating officer Ramesh Balwani.
The lawsuit follows in the wake of increased attention to platforms that offer to broker sales of pre-IPO shares, or offer interests in funds that hold such pre-IPO shares.
Court Allows Majority of Claims Under Common Law and California’s Unfair Competition Law
The court held that the plaintiffs could pursue claims against Theranos and its officers under California Corporations Code sections 25400(d) and 25500.  The court’s holding emphasized the statute’s broad purpose in preventing sellers of securities from manipulating the market through fraud. The court noted that the statute does not require any relationship between the seller and the buyer, or require that a plaintiff demonstrate reliance on the alleged misrepresentations. It also noted the absence of any persuasive authority limiting liability to the corporate issuer. Thus, the court found that the plaintiffs could pursue claims against Theranos and its officers even though there was admittedly no privity, or other direct relationship, between plaintiffs and defendants.
The court further held that the complaint’s listing of allegedly false public statements about the company’s products, including consumer-facing advertising, could form the basis of the false statements giving rise to securities fraud claims. The complaint cited specific newspaper articles, interviews and other statements that were part of Theranos’ advertising campaign touting its technology, and alleged that the plaintiffs relied upon the statements before purchasing interests in Theranos securities through the relevant third-party funds. The court held that the allegations were reasonably specific, demonstrated justifiable reliance, and stated a plausible claim for fraud.
The court further held that the plaintiffs could pursue common law claims against Theranos and its officers. However, the court did grant the defendants’ motion to dismiss claims brought under California Corporations Code sections 25401 and 25501.  The court held that those statutes expressly require privity between plaintiffs and defendants, which the plaintiffs failed to allege.
Finally, the court found that the intermediaries who sold the fund interests to the plaintiffs, including on-line private securities broker SharesPost Financial Corporation, may be required to be joined as defendants because they may be essential parties. Because joining the additional parties could affect the plaintiffs’ chosen venue, the court ordered further briefing on this point.
Practical Considerations for Private Companies
To reduce potential exposure to similar indirect purchaser claims, private companies should consider doing the following:
- When making public statements about the company and its products, private companies should be careful to not overly hype future prospects, and should use cautionary language where appropriate. Companies should be particularly cautious when discussing the valuation of its securities.
- Companies should ensure that its securities expressly reflect any restrictions on transfer. They should further notify intermediaries brokering or selling interests in the company’s securities of any transfer restrictions and consider publicizing the restrictions on the company’s website or through other means.
- To the extent a private company seeks to prevent or limit public secondary market sales of its securities, it should put intermediaries and potential securities purchasers on notice that the company does not sanction such sales, and that transfer restrictions may make any sales null and void. Further, companies should direct intermediaries to make potential purchasers aware of the transfer restrictions and that the company disclaims all liability to purchasers, including indirect purchasers of fund interests.
- Companies should consider making periodic disclosures on their website or through other public means noting that the company’s securities are not registered, and that any advertisement campaign by the company is not intended to be used in connection with the offer, sale or purchase of the company’s securities.
Conclusion: Decision May Be the First of Many in this Emerging Area
The recent emergence of public trading in the securities of private, unlisted companies is creating new questions about the reach of liability when aggrieved security holders and aggressive plaintiffs’ law firms seek redress for losses. Private companies that have chosen to not publicly list their securities or to facilitate secondary market trading in their stock no doubt will find last week’s decision both puzzling and distressing. But while Magistrate Judge Cousins’ decision last week certainly is an important first decision in the emerging legal landscape in this area, it is just that—a first decision, and one made on a motion to dismiss without a fully developed record. Other courts may well reject the expansive view of the California securities laws offered by the court. In the meantime, private issuers can and should take steps to mitigate potential future exposure to similar suits from indirect purchasers.