A Requiem for Independent Audits: The Last Days of Theranos

Back on April 20, 2016, almost three years ago, I wrote that former SEC Chair Mary Jo White warned an audience of Silicon Valley investors, private company officials, and advisers such as attorneys, accountants and bankers in a keynote address at Stanford University that “all private and public securities transactions, no matter the sophistication of the parties, must be free from fraud.”
April 20, 2016 | By Francine McKenna at MarketWatch
The SEC has jurisdiction over private company “unicorns” under the antifraud provisions of the Securities Exchange Act of 1934, Section 10(b) and Rule 10b-5, which apply to all companies, public or private.
Theranos, a blood-testing firm that was valued at $9 billion at its peak based on what early-stage investors paid for stakes, had confirmed on that same day it was under investigation by the SEC and by the Justice Department. The investigations focused on the quality and timeliness of disclosures to investors and business partners like Walgreens Boots Alliance Inc.
By March of 2018 the SEC had charged Theranos, Elizabeth Holmes, the founder of Theranos, and her former President and COO with fraud.
March 14, 2018 | By Francine McKenna at MarketWatch
On March 14, Holmes and Theranos settled what the SEC characterized as “massive” fraud charges. Balwani was charged by the SEC in the scheme but is fighting the allegations.
March 16, 2018 | By Francine McKenna at MarketWatch
Theranos and founder Elizabeth Holmes raised more than $700 million from mostly wealthy investors without ever having to provide anyone financial statements audited by an independent public accounting firm.
March 20, 2018 | By Francine McKenna at MarketWatch

The SEC’s complaint against Balwani describes the binder provided to potential investors. The package included a cover letter drafted and signed by Holmes, a company overview slide-deck presentation, reports of clinical trials Theranos performed with pharmaceutical companies, and financial projections on spreadsheets created from scratch by Balwani.

There were also lots of copies of articles and profiles about Theranos, including glowing profiles of Holmes from 2013 and 2014 by the Wall Street Journal, Wired and Fortune.

Materials within the binders stated that Theranos would generate over $100 million in revenues in 2014 and break even, according to the SEC complaint against Balwani. The unaudited financial statements that the SEC said Balwani created also projected Theranos would reach approximately $1 billion in revenue in 2015.

Conspicuously absent from the package that went to investors are income statements, balance sheets and cash-flow statements audited and signed by a qualified public accounting firm.

In June Holmes and Balwani were indicted on several counts of criminal conspiracy and wire fraud. She stepped down from the CEO role and Theranos general counsel David Taylor took over day-to-day operations.

I started calling David Taylor back in March at the time of the SEC charges, first to verify my suspicions based on the complaint that there had bene no outside audit firm in place at Theranos and no audited financial statements.  More importantly, via discussions with John Carryerou at WSJ, the attorney for the Partners Fund who invested in Theranos and also sued for fraud, and other sources I confirmed that none of the investors or business partners like Walgreen’s had ever insisted on or asked for outside audits of the company’s financial statements.

In early September the WSJ reported that Theranos would shut down.  I obtained exclusive details about the actual shutdown when it happened.

Sept. 17, 2018 | By Francine McKenna at MarketWatch

There was no likely path to achieving the Fortress milestones — and getting more funds — before the company ran out of cash, according to several people close to the company’s finances. Even if Theranos had received the remaining $35 million by this summer, the company would not have had enough cash to support itself for the next 12 months, according to an audit opinion on the company’s 2017 financial statements delivered to management and the board at the end of June by OUM & Co. LLP, a California-based firm that serves several publicly-traded pharmaceutical and medical device firms.The original Fortress loan agreement required Theranos to produce audited financial statements for 2017 with a clean opinion — reasonable assurance that the company’s accounts were free of material misstatement or fraud — by June 30, sources close to the transaction told MarketWatch. This was the first time the company had completed preparation of financial statements according to Generally Accepted Accounting Principles, the standard for public and larger private companies that solicit outside investments. It had also never received an auditor’s opinion on its financial information, according to people close to the company’s finances.

However, OUM’s audit opinion included an “emphasis of matter” paragraph that highlighted the existence of a material uncertainty regarding Theranos’ ability to continue as a going concern, according to people knowledgeable about the contents of that report, confirming executives’ fears that there would not be enough funding to commercialize the company’s products fast enough, and therefore secure additional funding from Fortress.

Fortress sees value in the company’s intellectual property and will likely seek a return on its investment by pursuing companies that have already commercialized earlier patents and request royalties, according to several people who are familiar with Fortress’ thinking.

When David Taylor took over as CEO, after the DOJ filed criminal charges against Elizabeth Holmes and Sunny Balwani, he agreed to be interviewed, along with his outside counsel, and all of the remaining executives and board members of Theranos who were there during the last 18 months.
The story is an exclusive that tells what happened in the last days and why the remaining executives had no choice but to finally shut the company down.
Oct. 16, 2018 | By Francine McKenna at MarketWatch
Ultimately, it was the accountants, not the scientists, who were left with no choice but to deliver the bitter pill to the Theranos board: The company had even less money than time.

Getting a handle on the numbers was less important than publicity to founder and CEO Elizabeth Holmes, until she was forced to mortgage all of Theranos’s assets to Fortress Investment Group in return for a desperately needed $100 million loan in December 2017. The terms of the loan agreement included the requirement to finally produce audited financial statements, something that had not been attempted since at least 2009, according to Theranos’s last chief financial officer.

There was an attempt by KPMG to audit and provide an opinion about a decade ago, but the process was not completed, and there was no final report, said Philippe Poux, who served as Theranos’s final CFO. A spokeswoman for KPMG declined to comment, citing client confidentiality.

 “Audits almost never find fraud,” the author of a recent article in CFO.com writes. The data shows that “external audits find it 4% of the time, and internal 15%.” Tiffany Couch, CEO of Acuity Forensics, writes that the idea of a “clean audit” is widely misunderstood:

“It is not uncommon to hear from non-accountants who incorrectly assume that a clean audit means there is no fraud on the books. This misunderstanding of the purpose of an audit is one of the main reasons why companies rely on them to detect fraud, when that is, in fact, not their true intent. An audit is a very specific type of financial engagement that is executed to determine whether a company’s financial statements are ‘reasonably stated.’ And while assessing fraud risk is part of those engagements, the procedures associated with most audits are not sufficient to actually root out and prove fraud.”

 The auditors says that audits are not designed to detect frauds, a mantra that is seared into every auditor’s brain the minute they step into a firm beginning with internships.
 But a federal judge used the profession’s own standards and its own words to say that’s not true and to prove it and render a record penalty against PwC.

In her decision, Judge Rothstein wrote that PwC admitted that it had failed to design its audits to detect fraud, violating auditing standards, but had agreed during the Colonial trial that it was required to do so.

Less than two years ago, Gary Westbrook, one of the PwC audit partners, testified in the TBW case that “audits are not designed to detect fraud.” However, he changed his tune at the Colonial trial, testifying that the firm did have a duty to design audit procedures to detect fraud. He also testified that if PwC failed to design its audit procedures to detect fraud, it would be a violation of auditing standards.

Source: Court records


Many of the same PwC engagement partners, audit managers and audit staff who were involved in the Colonial case gave deposition testimony under oath in the TBW trustee’s case. During the TBW case they had all repeatedly admitted that PwC did not design its audits to detect fraud.

Source: Court records


Rothstein concluded that PwC “did not design its audits to detect fraud and PwC’s failure to do so constitutes a violation of the auditing standards.”

The problem is if the Big 4 global audit firms say that audits aren’t designed to detect fraud and won’t look for it, what’s the point?
Well, a very long list of sophisticated investors in Theranos made the decision to invest hundreds of millions of dollars based on cash-basis unaudited financial information. They do not value the Big 4 audit enough to insist on it.
Such boldface-name investors as Mexican billionaire Carlos Slim; Betsy DeVos, now secretary of education; Oracle founder Larry Ellison; the Walton family of Walmart fame, who invested $150 million in Theranos; Greek shipping heir Andreas Dracopoulos; and members of South Africa’s Oppenheimer family, which controlled the diamond company De Beers Group, lost their entire investments.
Eliminating the audit mandate altogether is an idea that has been floated as the ultimate solution to the problems that plague the profession.
Turner argues that, for the system to work and investors to get the information they’ve paid for, major changes must be made. His first suggestion: provisions of the Securities Act of 1933 and the Securities Act of 1934 should be amended to remove the requirement that companies be audited. The audit firms are a “subsidized industry, like the credit rating agencies,” Turner told me, and companies are required to pay for “audits no matter the quality.” Instead, he recommends that every three to five years, investors vote on whether they want an audit. Turner says that would require auditors to “justify their existence to investors,” and this could “alter the behavior of auditors, as they would now be beholden to investors.”
Looks like the Theranos investors decided that audits are worthless, even if the cost is some “immaterial to them” fraud losses.