Theranos Didn’t Just Harm Investors
(Bloomberg Opinion) -- Oh, Theranos.
In March, the Securities and Exchange Commission charged Theranos Inc., its founder and Chief Executive Officer Elizabeth Holmes, and its former President Sunny Balwani with fraud. The allegations were that Theranos, Holmes and Balwani lied to the investors who gave Theranos hundreds of millions of dollars to build a blood-testing device that used only a finger-prick sample of blood; Theranos never really built a working device, but went around saying or implying that it had. Holmes and Theranos settled with the SEC, and I wrote at the time that Holmes seemed to have gotten off lightly, paying only a $500,000 fine (plus giving up millions of worthless Theranos shares) for her role in a $700 million fraud. I also wrote:
Theranos really did deceive its investors, and they really were victims of its fraud. But they weren't the only victims. The problem with launching a blood-test machine that doesn't work isn't just that you swindle the investors who funded the machine's development. You are also out there performing a lot of fake blood tests. The Wall Street Journal has reported on the "trail of agonized patients" who got blood-test results from Theranos that turned out to be wrong, and Theranos ultimately "voided" two years of results from its machines because they were not sufficiently accurate. Building a fake blood-testing company that raises hundreds of millions of dollars from investors is bad, certainly, but it's not really any worse than any of the other securities fraud that we so often delight in around here. Building a fake blood-testing company that performs fake blood tests on thousands of people is much worse, even if it doesn't count as securities fraud.
The other shoe dropped on Friday, when federal prosecutors in San Francisco brought criminal wire fraud charges against Holmes and Balwani. Everything, I often say, is securities fraud, but even the things that aren’t securities fraud are wire fraud. It’s hard to do fraud, in this internet age, without using phone calls or emails or websites or text messages or something else that goes over a wire. “It’s one of the easiest crimes to prove,” writes Felix Salmon: “You show the lie, you show the wire, and boom—that’s all the jury needs.” And so the securities fraud alleged in the SEC case—lying to investors about Theranos’s business in order to convince them to buy Theranos shares—is also alleged to be wire fraud in the Justice Department case, and six of the 11 counts in the indictment are about that. (The first two are conspiracy counts.)
But the next three are different. They are about defrauding patients: Holmes and Balwani are accused of transmitting “by means of wire communication in interstate commerce certain writings, signs, signals, and pictures, that is, laboratory and blood test results and payments for the purchase of advertisements soliciting patients and doctors for its laboratory business.” Apparently sending fake blood test results—or paying to advertise a fake blood-testing business—is wire fraud these days.
That is a little strange. If you get a fake blood test result, the harm to you isn’t exactly that you were defrauded out of the price of that blood test. (And the agency selling ads to Theranos wasn’t defrauded at all!) It’s an awkward use of the wire-fraud statute but, you know what, I’ll allow it. “This conspiracy misled doctors and patients about the reliability of medical tests that endangered health and lives,” said the FBI Special Agent in Charge. That does seem more important than misleading Theranos’s investors.
On the other hand here is Felix Salmon:
But while it’s good that Holmes and Balwani are being prosecuted, there’s another message being sent here by the U.S. Attorney’s Office in the northern district of California. Which is, implicitly: If you’re a startup and you’re not in the highly regulated health-care industry, then you probably can continue to embrace Silicon Valley’s fake-it-till-you-make-it ethos without fear of criminal prosecution.
Look, for instance, at the long list of startup scandals enumerated by Erin Griffith in her December 2016 Fortune article about “the ugly unethical underside of Silicon Valley.” Theranos was there, of course, but so were, among many others, Hampton Creek; Zenefits; Lending Club; Skully; ScoreBig; Rothenberg Ventures; Faraday Future; Hyperloop One; and, of course, Uber. Most of those companies ended up embroiled in nasty civil lawsuits, but none of them, except for Theranos, ended up with criminal charges.
Salmon apparently wants the Silicon Valley federal prosecutors to bring a lot more criminal cases against overhyped startups, even when they are just overhyping vegan mayonnaise sales figures rather than life-altering blood tests. He is not wrong that everything is wire fraud, which means that prosecutors could charge every sort of startup overhyping as wire fraud. And it is true that, given that everything is wire fraud but most things are not prosecuted, the actual instances of charging wire fraud seem sort of random and capricious and bolt-from-the-blue.
But it seems right to me that, of all the startups to charge with wire fraud, prosecutors went with the one whose allegedly fake blood tests allegedly endangered patient lives. You really can’t prosecute every little startup exaggeration as wire fraud. A lot of those exaggerations—quite possibly even a lot of Theranos’s—are motivated by CEO overconfidence and delusion, and it is hard to distinguish among the CEO who promises the impossible because she is committing fraud, the CEO who promises the impossible because she is deluded, and the CEO who promises the impossible and then goes and does it. All three types flourish in Silicon Valley.
And Silicon Valley is basically a good ecosystem. It produces a lot of good stuff and makes a lot of venture capitalists rich. And sometimes startups fail, and sometimes it turns out that they were lying to their investors, but the investors—in aggregate, in expectation—are okay with that. The investors want to be lied to! They want to look into the eyes of entrepreneurs, and see the abyss staring back at them, and say “well okay this is weird, let’s see where this goes.” Move fast and break etc. etc. etc., you know the drill; you put your money on weird rebels pursuing high-variance outcomes, and when the variance is high—in either direction—you congratulate yourself for your boldness. If everyone you invest in just does what they say they’ll do, then you are not taking sufficient risks. It is not surprising that venture capitalist Tim Draper still defends Holmes even though she allegedly stole his money. He kind of wanted her to steal his money!
You know who was harmed by Theranos’s (allegedly) fake blood tests? The people who got the fake blood tests. If you have to send someone to prison, that's arguably a good reason. Not because she made some reckless promises to venture capitalists. The venture capitalists are fine.
Berkshire without Buffett.
Barron’s had a cover story by Andrew Bary this weekend about “Preparing Berkshire for a Future Without Buffett,” with suggestions like holding an investor day so shareholders can hear from more heads of Berkshire Hathaway Inc. divisions; doing stock buybacks; initiating a dividend; disclosing more subsidiary financial information; and, if his handpicked investment managers “can’t beat the market as their portfolios grow, maybe Berkshire ought to consider indexing some of its portfolio.” Run Berkshire as an index fund! Imagine! And yet it is Buffett’s advice to most investors who are not Warren Buffett.
All of these suggestions share a theme of reducing managerial discretion and giving more power to shareholders. Buybacks and dividends are a way to discipline managers, to give them less control over investing decisions (because they have less money to invest) and return that control to shareholders (because they get the money). More disclosure—in financials or at investor days—gives shareholders more opportunities to supervise the company. Indexing, obviously, reduces managers’ investing discretion.
This is all very, very, very normal corporate finance; you could look at any big company with a lot of cash, a big investment portfolio, and limited substantive engagement with shareholders, and make the same suggestions. But no one usually makes these suggestions to Warren Buffett, because he is Warren Buffett. Why pay a dividend? “For decades, a dollar in your hands has been better than a dollar in shareholders’ hands,” Bary says (oh yeah it’s styled as an open letter to Buffett). The whole point of Berkshire Hathaway is that investors trust Buffett to make money for them, and don’t feel the need, at this late date, to ask too many questions about how he does it.
But the interesting governance question is whether Buffett has built an institution that is (or ought to be) insulated from those normal sorts of corporate-governance pressures, or whether he's just a guy who is. Has Buffett proven that Berkshire shareholders should trust him, or has he built Berkshire into a company that deserves shareholder trust no matter who runs it?
For myself, I don’t particularly believe that there's any such thing: Shareholders should trust good management teams and not bad ones, and there is probably no set of procedures and succession plans and websites listing corporate values that can guarantee that the managers will always be good. Or, if there is—if there are companies that have enduringly positive cultures no matter who runs them—it is probably depersonalized, centered around general corporate aims and values rather than the cult of personality that they’ve got going on at Berkshire. (Will the next CEO have to drink Coke and eat cheeseburgers?)
So sure, as Berkshire transitions away from its beloved successful leader to replace him with some guys the investors barely know, it should do all the normal things—trot those guys out in front of investors, put careful limits on what those guys can do without board approval, take some cash out of those guys’ hands and give it to shareholders—that other companies do to build trust in their leadership.
But I admit that there is something sad and defeatist about that approach. It acknowledges that Buffett is special, and that his successors won’t automatically be. It locates the magic of Berkshire in Buffett, not in the company that he’s built; it hints that, for all his successes, his legacy will be limited. It’s probably right. But you can see why Buffett and Berkshire would resist it.
Oil is a perfectly normal thing for an institutional investor to invest in. “I think oil prices will go up so I’m gonna buy some oil”: very common thought process. But if you are a hedge fund, or a pension fund, or an endowment, and you think oil prices will go up, and you want to buy oil, you have a bit of a problem, which is: Where will you put it? Oil is … slippery? “It is also highly toxic, very difficult to store, and it smells bad,” my Bloomberg colleague Tracy Alloway once wrote. “Don’t try to buy a barrel of oil,” a broker told her; “It’ll kill you.”
But people want to buy oil, and financial markets abhor a vacuum, so there are ways for them to buy oil. Chiefly institutional investors buy oil futures, which allow them to bet on the price of oil without actually having to put smelly barrels in their garage. Futures are non-toxic and odorless, and you can store them in a computer. But of course some institutions—mostly specialists in energy trading—go and trade actual physical oil, and have the … tankers or ventilated warehouses or whatever … necessary to store it. And their trading—buying futures and selling physical oil, or vice versa—is what keeps futures prices in line with the actual price of oil. They provide, if you will, synthetic oil storage: If I want exposure to the price of oil without storing it, I buy futures, and the person who sells me the futures might be an arbitrageur who is hedging by buying and storing the oil herself.
Bitcoin is also, as far as I can tell, slippery, toxic, very difficult to store, and it smells bad. In particular, the history of Bitcoin involves a lot of incidents of:
- People losing or forgetting their private keys and being unable to access the Bitcoins they store directly in a Bitcoin wallet; and
- Exchanges getting hacked and losing the Bitcoins that they were storing for their customers.
If you are a person who is enthusiastic about Bitcoin, that is I suppose all part of the fun of investing in a novel censorship-resistant decentralized form of currency. But if you are an institutional investor, losing your Bitcoins because you forgot your private key, or because the exchange where you stored them got hacked again, is a bad look. Your clients will be unimpressed. This reality limits the ability of institutions to buy a lot of Bitcoin.
And now it’s changing:
“There are a lot of investors where custodianship was the final barrier,” [Multicoin Capital partner Kyle] Samani said in a phone interview. “Over the next year, the market will come to recognize that custodianship is a solved problem. This will unlock a big wave of capital.”
Samani has been “testing Coinbase Inc.’s new crypto custody service, one of scores of such offerings in development.”
Such projects would pave the way for vast tracts of investors to expand into crypto, potentially reviving prices in markets that have tumbled in recent weeks. Regulated crypto custody would allow more institutional buyers -- such as hedge funds and pensions -- to invest in Bitcoin, Ether and a multitude of other coins. Retail brokerages would have a safer way to let clients add crypto to portfolios stuffed with stocks and bonds.
And the services would provide peace of mind to Samani and other fund managers who’ve already waded into the market. Most investment advisers are required by the SEC to keep client funds with a qualified custodian.
Of course if the fate of all Bitcoin exchanges is to be hacked, then I am not sure that certification by the Securities and Exchange Commission will change that, and I look forward to the first qualified institutional Bitcoin custodian being hacked.
Remember, like, six months ago, when Cboe Global Markets Inc. and CME Group Inc. introduced Bitcoin futures? Part of the appeal of Bitcoin futures was that they would provide a convenient way for institutional investors to get short Bitcoin. But another part of the appeal—I still think the dominant part—was that they would provide a convenient way for institutional investors to get long Bitcoin. Just as with oil, if you are an institution, you can buy Bitcoin synthetically in the form of futures, and be exposed to its price movements, and let someone else—the person on the other side of the futures trade—worry about how to store the Bitcoins. You avoid the problem of custody by owning your Bitcoins synthetically. The Bitcoin futures, it seemed to me and a lot of people, “would pave the way for vast tracts of investors to expand into crypto,” boosting prices as institutional investors could finally get safe clean regulated exposure to Bitcoins.
And then Bitcoin futures started trading, and they were pretty tiny in comparison to the volume of actual physical Bitcoin trading, and the price of Bitcoin promptly fell off a cliff.
So I don’t know! Institutional-grade custodianship for Bitcoin seems like a good idea. But I have been burned once before. Providing the legal and regulatory and compliance tools for institutional investors to buy Bitcoins is, you know, fine. But if that’s all it took for a vast wave of pent-up institutional demand to come rolling into Bitcoin, that would have happened by now.
Elsewhere, the Bank for International Settlements is crypto-skeptical:
Cryptocurrencies cannot scale with transaction demand, are prone to congestion and greatly fluctuate in value. Overall, the decentralised technology of cryptocurrencies, however sophisticated, is a poor substitute for the solid institutional backing of money.
That’s from a new BIS report titled “Cryptocurrencies: looking beyond the hype,” which is basically 24 pages of burns like that. “The BIS, an 88-year-old institution in Basel, Switzerland, that serves as a central bank for other central banks, said cryptocurrencies are too unstable, consume too much electricity, and are subject to too much manipulation and fraud to ever serve as bona fide mediums of exchange in the global economy,” says Bloomberg’s Edward Robinson. I am not sure that that “ever” is fully justified—the BIS aims a lot of its fire at the idea of currently-existing Bitcoin serving as a dominant means of retail payment, which is different from saying that no cryptocurrency could ever serve a useful exchange function—but if you want to read some central bankers making fun of Bitcoin, it not unsatisfying.
According to science, people who enter into a calm, serene, mindful state by meditating “didn’t feel as much like working on” assignments like “editing business memos, entering text into a computer and so on,” “nor did they want to spend as much time or effort to complete them.” Well … yes? That does sound like it would be the effect of mindfulness. Like you would not want to be deeply present and connected with yourself and the universe while you were editing a business memo. The less mindful the better, really, is the rule with business memos.
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