The Madness of Shareholder Lawsuits
At least one investor (and likely soon many more) in Theranos is suing the company:
When Theranos founder Elizabeth Holmes announced that the company was shifting its focus, she said her team is lucky to have investors who believe in its mission. But there's at least one major investor who doesn't, and it has already sued the controversial blood-testing provider. According to The Wall Street Journal, Partner Fund Management (PFM) LP is accusing the startup of convincing it to pour $100 million into the startup by feeding it a "series of lies." The San Francisco-based hedge fund firm filed the lawsuit in Delaware today and sent out a letter to its own investors.
In the letter, the firm said:
"Through a series of lies, material misstatements, and omissions, the defendants (Theranos), engaged in securities fraud and other violations by fraudulently inducing PFM to invest and maintain its investment in the company."
At some level, shareholder lawsuits are utter madness. Consider the case where all owners of a company are suing the company. If they win, the amount they win from the company is offset by a drop in value of their ownership in the company. At best this is a break-even proposition but when lawyers fees are included, this is a recipe for immense value destruction.
I am not really an insider on these things, but my guess is that the explanation for the madness comes by relaxing my assumption above that "all owners" are suing. If only one owner is suing, then this becomes a potential mechanism for transferring value from other owners or investors. There are of course real situations where a certain minority class of shareholders is screwed by the majority, but I don't think that is the case here. In the case of Theranos, I assume the whole company is headed into a messy bankruptcy, and PFM is racing to the courthouse to be first in what is sure to become a messy litigation-fest. They likely have one or both of these goals
- Since they likely cannot sell their equity and cash out normally, given the uncertainty about the company's future, they may be able to effectively cash out by getting other owners to pay them off in a settlement of this suit.
- Since their equity may be worth zero soon, if they can win a lawsuit the payout becomes a much more senior form of indebtedness and might move them up towards the front of the line for any value that still exists in the company
Update: From one of my readers at a CPA firm: A key reason for shareholder suits is to trigger insurance coverage payouts for management and/or Board errors and omissions. This in theory both increases the company’s assets and creates a senior claim by the plaintiffs to those particular assets.
