When auditors don’t look out for the public, everyone gets hurt. The injuries can be more than financial.

The SEC’s chief enforcer Gurbir Grewal has been asking auditors to step up in almost every speech he’s made since joining the SEC six months ago. In early December Grewal asked an audience of audit professionals, CFOs, and other regulators, “Where are the people who are supposed to be counseling folks to play within the guardrails not at the edges of the rules or outside the lines?”

The SEC’s Grewal can now ask, “Why didn’t any of the global accounting firms who worked for Theranos do their public duty?”

During Elizabeth Holmes’ four-month trial we learned that at least three Big 4 public accounting firms had provided services to Theranos, including audits, during its 15-year life as a company.

On Monday a jury in California found Theranos founder and former CEO Elizabeth Holmes guilty of four charges she cheated her investors. She was either acquitted or the jury could not decide on seven other charges, including that she had misled patients about the readiness and accuracy of her faulty device to test blood with just a drop.

In 2018 I wrote that the ultra-wealthy Theranos investors had abandoned basic due diligence and never requested audited financial statements before handing over hundreds of millions. Those investors would have been disappointed if they had asked because, reportedly, there were none to be had.

Philippe Poux took over as Chief Financial Officer of Theranos in mid-2017 as the company was deluged with investigations and lawsuits. His goal was to get a better picture of the company’s cash position and funding needs. With the exception of the first few years after Holmes founded the company in 2003 at age 19, Theranos hadn’t had a CFO or an auditor.

Elizabeth Holmes was forced out of her own company after settling securities fraud charges with the SEC in March of 2018. But it was an audit that finally forced Theranos to shut down.

Fortress Investment Group LLC, a division of SoftBank demanded an independent auditor’s opinion on Theranos’ 2017 financial statements as a condition of loaning the company $100 million in December 2017, $65 million immediately and the rest if it got a clean audit and met other conditions.

Theranos brought in a boutique audit firm that specialized in biotech. OUM & Co. LLP did its public duty by quickly concluding that Theranos would not have enough cash to commercialize its blood testing device with all regulatory approvals, even if it received the remaining $35 million in funding from Fortress by the summer of 2018.

Theranos’ last CEO David Taylor told me in 2018, “We were late with the product, and we ran out of time.”

On September 8, the first day of Holmes’ trial, former Theranos Corporate Controller Danise Yam, a former Deloitte San Jose and Hong Kong audit professional, testified that there were two Big 4 firms in an auditor role that had the chance early on to rein in Holmes’ “fake it until you make it” approach.

Holmes testified that Lucas Venture Group founder Don Lucas, one of her earliest investors, was the one who insisted she get an outside audit. Lucas also hired a law firm to review the company’s patents and asked for copies of the company’s contracts.

Yam testified that Ernst & Young was the company’s auditor in 2006 when she was hired. EY gave an opinion on Theranos’ financial statements for 2006, 2007 and 2008, according to Yam. Yam reported directly to Elizabeth Holmes between 2006 and 2017. She left Theranos in March 2017, when the company turned over accounting and finance to turnaround firm Alvarez & Marsal and hired Poux as CFO.

Ernst & Young did not reply to a request for comment to confirm its services to Theranos.

Poux had told me in 2018 that KPMG came in to do an audit in 2009, but the process was never completed, and there was no report. Yam confirmed in her testimony that Theranos hired KPMG as its auditor in 2009, replacing EY, but that it never issued any audit opinions.

Now we know why.

According to Yam’s testimony, KPMG had decided to audit the financial information for 2009 and 2010 at the same time and produce a report covering the two years together. However, KPMG disagreed with the company about the valuation of stock options granted to Holmes and several other employees in May 2010. KPMG, Yam testified, believed the valuation of the option grant should reflect the higher value that new financing had created for the company. The issue was never resolved and KPMG never issued an opinion on either the 2009 or 2010 financial statements.

However, KPMG hung around at Theranos, Yam testified. She said she continued to work with KPMG until 2015. Was that unusual, the prosecutor asked Yam. Yes, Yam testified, because a private company usually has a financial statement audit annually to lend “credibility” to financial information it gives existing and potential investors.

What was KPMG doing? Yam, testified that her responsibilities included everything a day-to-day Controller does. From Yam’s testimony:

Prosecutor: Did your duties include preparing financial statements?
Yam: Yes.
Prosecutor: Did your duties include ensuring that transactions were appropriately entered into the financial system?
Yam: Yes.
Prosecutor: What financial system did Theranos use during your tenure as Corporate Controller?
Yam: QAD [fm note: QAD is a full-featured manufacturing ERP software and supply chain solution that someone helped implement and set up.]
Prosecutor: Did you regularly provide Ms. Holmes with documents?
Yam: Yes.
Prosecutor: Did you regularly provide Ms. Holmes with documents summarizing the company’s financial condition?
Yam: Yes.
Prosecutor: Did you regularly provide Ms. Holmes with documents summarizing the company’s cash position?
Yam: Yes.
Prosecutor: Was it part of your job to make sure that Ms. Holmes was aware of the financial state of the company?
Yam: Yes.

Yam also testified she:

…did work around the equity. If the company grants options to employees, consulting directors, I would keep track of the number of options that we granted and the value we granted it at and the date… I also keep track of the capitalization summary of the company. When shareholders invest [I kept track of] which series of the preferred stock.

KPMG came in to replace EY as the company’s auditor in 2009 and decided sometime in late 2010 or early 2011, to step down as auditor but to instead stick around and provide consulting to the company. Things got a bit dicey, Yam testified, when cash became tight in early 2009 while KPMG was still the auditor of record.

From Yam’s testimony:

Prosecutor: As the Corporate Controller were you familiar with the company’s cash position in early 2009?
Yam: Yes.
Prosecutor: How would you describe the company's cash position in early 2009?
Yam: The company had problems, or issues, with paying vendor at that time.
Prosecutor: When you say "the company had problems or issues paying vendors at that point in time," what do you mean?
Yam: So during that, during that period, so we would -- during our normal course of business we buy, we buy supplies, we buy equipment, we buy, you know -- or we have to pay rent and something like that, and we usually have credit terms like the vendor would give us 30 days or 60 days to pay the bill.
But when that bill comes due sometimes during this first half of 2009, and sometimes I -- we just do not have the cash to pay all of them on time, so I would have to pick and choose which one we want to pay first.
Prosecutor: So you were picking and choosing which vendors Theranos would pay in this early 2009 time period?
Yam: Correct.
Prosecutor: Did you have discussions with Ms. Holmes about the company's cash position in early 2009?
Yam: Yes.
Prosecutor: At a high level, what was the substance of those discussions?
Yam: I let her know that we would not be able to pay all of the vendors and in one instance that I also told her that we wouldn't, you know -- I also suggest to her that we may have to withhold her payroll so that we could pay a few more vendor with the money. There's also a situation that we have to contact the banker to clear a check so that we can make the next payroll.
Prosecutor: When you say "we had to contact a banker to make sure that we would make the next payroll," what do you mean? Tell us what happened.
Yam: So, for that time, I already submitted the payroll record, and so the next day we need to have money in the bank account for that -- for the payroll company to draw the fund to pay our employees. And then we find out that the bank did not clear the check because they have to hold the check for a certain period of time when we don't have our money in the bank account to support that.
And so I brought that up to Elizabeth Holmes, and we were in a conference room together, and we called the banker and tried to convince him to let that go one time without a waiting period, and he refused to do that. So I have to contact the -- our customer who cut the check to us, and I have to contact the customer and have her contact the banker to prove that they -- the actual -- the check will be cleared as a legitimate check.
Prosecutor: Was Ms. Holmes aware that you were doing that?
Yam: Yes, we were in the conference room together.
Prosecutor: Okay. and was all of this as part of an effort to make sure that Theranos could pay its employees and meet its payroll?
Yam: Yes.

Yam testified the cash crunch was resolved, for the time being, when Theranos got a loan from Fidelity, the investment bank. The loan was guaranteed by COO Sunny Balwani, who was at that time in a relationship with Holmes.

In 2010, Theranos raised more money from investors, $45 million, Yam testified. Yam testifies that in 2012 she gave KPMG some 2010 and 2011 financial information.

Prosecutor: Up in the left-hand corner it says Theranos Inc. YE 12/31/2011 trial balance.
Yam: Yes.
Prosecutor: And what does YE stand for?
Yam: Year end.
Prosecutor: And trial balance, what is that?
Yam: It's the company financial balance of each account that is including all of the financial accounts including the assets and liability and income and expenses and equity.
Prosecutor: And was the trial balance something that you maintained in the ordinary course of your business?
Yam: Yes.
Prosecutor: Were you intending by this excel spreadsheet to provide accurate information to KPMG about Theranos' income statement for 2009, 2010, and 2011?
Yam: Yes.
Prosecutor: What was Theranos' revenue for 2009?
Yam: It was $2,793,846.
Prosecutor: And was Theranos' revenue for 2010 $1,401,305?
Yam: Yes.
Prosecutor: And was Theranos' revenue for 2011 $518,248?
Yam: Yes.
Prosecutor: And if we scroll down in the column b for the income statement there's a line for net loss.
Yam: Yes.
Prosecutor: And what is the net loss?
Yam: That's the revenue after subtracting for all of the expenses, and that's what the company basically was losing for that year.

Those revenue numbers seem to be going in the wrong direction. Which contracts were providing revenue to the company way back in 2009-2011?

Based on Yam’s testimony, it appears that KPMG would know the answer because the firm was working with Yam — who reported directly to Holmes during the majority of this time — doing the work of accounting and finance rather than auditing it. Yam, with KPMG’s help, was preparing financial statements, paying employees and vendors, and keeping track of option grants and investors’ stakes in Theranos.

Was KPMG also helping Holmes and Balwani create the presentations and other information sent to investors? Did that revenue and contract information, as well as cash position and net loss information, match what KPMG saw coming out of the company’s general ledger software while working with Yam? We don’t know because KPMG has never said.

KPMG did not reply to repeated requests for comment on the services it was providing to Theranos between 2009 and 2015 instead of an audit.

Global audit firm PwC had no interest in providing audit services either, but stayed busy with lucrative advisory work when things were already going badly for Holmes and Theranos, from September 2016 to the spring of 2019. PwC’s Justin Offen testified he worked for the company’s law firm, Wilmer Cutler Pickering Hale and Dorr LLP, to help Theranos respond to SEC and U.S. Justice Department investigations, all the while Theranos had no permanent CFO or an external auditor.

PwC spent more than 10,000 hours collecting text and email messages Holmes exchanged with Ramesh "Sunny" Balwani, the Theranos COO and Holmes's former boyfriend. Sometimes as many as 40 PwC employees were on site. PwC also helped wind down the company’s operations beginning in late 2018.

A PwC spokeswoman declined comment on its Theranos activities.

A spokesman from Deloitte did not respond to a request to comment on whether that firm ever provided services to Theranos, its executives or board, its investors, or related third-parties.

Many Theranos investments came from family offices and via referrals from early investors. Early investor Don Lucas became Theranos Chairman of the Board and introduced Holmes to Oracle founder Larry Ellison, who invested through his family office. Chris Lucas, Don Lucas’ nephew, also invested millions. He was called as a witness by the prosecution and admitted he piggybacked on his uncle’s due diligence efforts and didn’t do much of his own.

Henry Kissinger’s lawyer Daniel Mosley of Cravath Swain & Moore LLP, invested $6 million on behalf of Mosely Family Holdings. He introduced Holmes to several other clients who became investors including the Walton family, the DeVos family, and the Cox family. In total they kicked in $384 million, over half of a $730 million funding round.

Elizabeth Holmes is going to prison because of crimes against investors not against the patients of her faulty device. She was found guilty on four charges related to wire fraud against investors — PFM Healthcare Master Fund, Lakeshore Capital Management LP and Mosley Family Holdings LLC.

Brian Grossman oversaw PFM’s investment. The Financial Times wrote yesterday that he “testified that his firm had performed extensive due diligence on Theranos and come away impressed by the company’s purported work with the military and ability to run a full range of blood tests.”

I wrote about PFM’s lawsuit against Theranos in 2018:

The Partner Fund sued Theranos, Holmes and Balwani in 2016 after investing more than $96 million in 2014. The hedge fund accused Theranos of securities fraud, alleging that Holmes and Balwani had raised the funds “[t]hrough a series of lies, material misstatements and omissions.” These investors settled their lawsuit in 2017 for an undisclosed amount that was reportedly approximately half of their investment.

When I reported on Theranos in 2018 and talked to Grossman’s lawyer about the lawsuit, I specifically asked if PFM had asked for audited financial statements before investing. Since there were none when PFM invested, the firm obviously invested without seeing any audited financials. The attorney gave me this bland quote in 2018:

The SEC’s allegations are serious and are thankfully bringing more attention to what can fairly be described as atrocious misconduct.

It’s highly unusual to see a criminal case against a private company, but if it sells securities, or in this case raises money from accredited investors, the law does have remedies.

So why didn’t the jury hold Holmes accountable for the harm done to patients?

Marc Fagel, the former director of the SEC's San Francisco office, told me that the harm to patients likely drove the criminal prosecution of Holmes, even if the jury did not ultimately assign guilt for misleading the patients.

The defense was able to cast doubt on whether Holmes had scienter, or intent, to mislead patients.

Some question why anyone should worry about ultra-wealthy, so-called “accredited” investors, who didn’t insist on audited financial statements or do more due diligence. Prosecutor John Bostic told the jury in his rebuttal to the defense’s closing argument:

The level of due diligence doesn’t matter. A scheme to defraud is still a scheme to defraud even if it would only ensnare someone who is less careful than they should be.

It’s not the investors’ faults no one was there to protect them from themselves. Two audit firms, EY and KPMG, were there to do audits and didn’t raise their hands to signal to the public or the regulators that something might be amiss. One more, PwC, preferred to collect millions to help the company and its executives stay out of trouble while Theranos continued to use faulty medical devices with real patients.

SEC Director of Enforcement Gurbir Grewal told that Washington D.C. audience in December:

Independent auditors are supposed to be the first lines of defense against corporate misconduct. Investors and market integrity suffer and the trust gap widens when they fail to live up to their public duty.

Theranos investors lost money when gatekeepers failed to do their duty but its patients experienced the ultimate harm.

Postscript: Section 10A of the 1934 Act requires auditors to report to the SEC when, during the course of an audit, they detect likely illegal acts that have a material impact on the financial statements and appropriate remedial action is not being taken. See from 2012: “Are Auditors Reporting Fraud And Illegal Acts? The SEC Knows But Isn’t Telling”.

© Francine McKenna, The Digging Company LLC, 2022

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Elizabeth Holmes and her Big 4 audit firm…