On 3 January 2022, Elizabeth Holmes, the founder and CEO of the now defunct Silicon Valley blood testing company Theranos, was found guilty of conspiracy to commit fraud against investors and three charges of wire fraud. The verdict came after a months long, high profile case which has generated attention far beyond the confines of Silicon Valley and the healthcare sector. 

Much has been written about Theranos and Holmes in the years since the company ceased operating in 2018. From a legal perspective, one of the most fascinating aspects of the case has been the flaws in (and sometimes lack of) due diligence carried out by investors. It is interesting to see that traditional biotech investors largely stayed clear of Theranos but the case is nevertheless a clear reminder to anyone investing in the life sciences sector of the importance of due diligence. 

Due diligence has a number of purposes. It allows an investor in, or acquirer of a business to:

  • gather information about a target company;
  • test assumptions about a company and its business and technology;
  • check whether the proposed valuation is accurate;
  • identify risks which may need to be covered off in legal documentation (though warranties, indemnities and post-closing obligations); and
  • identify any potential deal breakers.   

Due diligence has a number of components including legal, financial, commercial and technical due diligence. 

The scope of legal due diligence undertaken will vary from deal to deal and will be determined in part by the risk appetite of the relevant investor or acquirer. It can range from an in depth review of the entire contents of a data room, extensive information requests and searches of public registers, to a focussed review of a limited number of specific areas and a review of key contracts only. Similarly, due diligence reports take many forms, some include a comprehensive summary of all findings while others will highlight only those "red flags" discovered in diligence. 

Most legal due diligence exercises follow a familiar format and include reviews of corporate information, material contracts and any litigation and pending disputes. In the life sciences sector investors or acquirers may also carry out specialist IP due diligence (for example, to review the company's patent portfolio and ascertain whether there are any material freedom to operate (FTO) issues). This aspect of the diligence will usually be carried out by a patent attorney. 

Given the fraud committed by Holmes it's difficult to know whether a more thorough due diligence process would have alerted investors to problems at Theranos before they invested. Certainly from a technical perspective in practice it would likely have been difficult to expose the flaws in Theranos' technology. The company relied heavily on its need to protect trade secrets as justification for withholding information and was notoriously secretive about the inner workings of its blood testing machines (offering investors little chance to see for themselves how the machine worked and using smoke and mirror tactics in demonstrations). However, some commentators have highlighted that the lack of peer reviewed research should itself have been a red flag. 

From a legal perspective it seems that investors took at face value claims by the company that it had partnerships in place with large pharmaceutical companies for use of Theranos devices in clinical trials, and with the US Department of Defence for deployment of the devices in the battlefield. In reality these partnerships did not exist. Perhaps a review of the company's material contracts as a part of legal due diligence would have exposed this. 

Thankfully the Theranos case is unusual as most companies seeking investment are not engaged in fraud. However, it stands as an important reminder to potential investors of the importance of conducting a well scoped and thorough due diligence exercise before committing funding.