Expanded Liability for Private Companies: Indirect Purchasers

Based on a recent decision of the federal district court in California in the case Colman et al v. Theranos, private companies may be sued by parties not directly involved in the purchase of their securities. This court case should caution companies on their public statements and the extent of their due diligence and restrictive provisions in agreements entered into during financing rounds.

Background

As most privately held corporations, Theranos is incorporated in Delaware with authority to do business in another state where it primarily operates, which in this case is California. Theranos develops proprietary blood-testing technology that took it through three successful rounds of private capital raises valuing the company in the billions. In this case, the plaintiff did not invest directly in Theranos securities, but in funds specifically formed to acquire Theranos’ stocks.

As the complaint sets forth, uncontested by the judge, Theranos engaged in an advertising campaign for the purposes of raising capital from 2013 through to 2015. This campaign became the basis for this litigation when newspaper publications and federal agencies investigated and in some instances charged Theranos with sanctions starting in 2015 due to major failures of its product and technology. After these developments came to light, plaintiffs sued Theranos and its executives, who had allegedly participated in the capital raising campaign, for securities fraud under California law, among other grounds.

The Court’s Ruling

The court found that “indirect purchasers” of pre-IPO shares, i.e. purchasers who bought security interests privately from intermediaries and not from the issuer, could pursue a claim against the company for manipulating of the market through fraud. The court reasoned that – because the statutes are designed to eliminate and take action against fraud affecting the market and the price of the issuer’s securities – there is no requirement or obligation for purchasers to have direct dealings with the issuer and that false advertising could form the basis of the false statement giving rise to securities fraud claims.

While the facts here may be an uncommon case of fraud, by its decision, the court has demonstrated a willingness to extend the availability of recourse to California investors under California law.

Practical Consideration

As a result, we recommend that companies should consider the following: