Fifteen Eighty Four

The federal convictions of two founders of technology companies over the last year has illustrated the fine line between the over-optimism of entrepreneurs who believe they can change the world and the criminal intent to defraud investors. As it has become routine for stock valuations to reflect the future profits that may be generated by a promising but speculative venture, there is a greater need to police lies about the innovation that supports such valuations.

In October 2022, a jury in Manhattan concluded that Trevor Milton, the founder of the emissions-free truck manufacturer Nikola, was guilty of criminal securities fraud. Milton on multiple occasions made public statements that misrepresented facts about the company’s products. Most notoriously, Milton’s company released a video of one of the company’s early prototypes that appeared to be driving under its own power when in fact the truck was filmed after being pushed down a large hill.

Just a few weeks after the Milton conviction, a federal judge in San Francisco denied the request of Elizabeth Holmes, the founder of Theranos, for a new trial in her criminal case. Holmes claimed that her company had developed a working prototype of a blood testing device, the Edison, that could run multiple tests using just a single drop of blood. The device did not work but this did not deter Holmes and the company from entering into contracts with pharmacy chains to conduct tests on real customers. In meetings with investors, Holmes presented projections of exponential revenue growth that had no basis to raise hundreds of millions of dollars.

Securities fraud claims involving failed technologies have a long history. During the 1980s, the computer company Apple, which at the time was newly public, attempted to build on the success of its iconic Apple II home computer by developing a computer called the Lisa that targeted the business market. A key feature of the Lisa was a high-performance disk drive called the Twiggy. In a number of public statements, the company implied that the disk had gone through rigorous testing and was ready to be launched. Internally, the company’s engineers acknowledged that the drive had numerous glitches and could not be finished in time. Apple’s misrepresentations were sufficient for a jury to award $100 million to plaintiffs who brought a securities fraud lawsuit after Apple’s stock price fell when the company announced that it would have to discontinue the Twiggy. The result was widely noted by technology companies, which successfully lobbied for greater restrictions on securities litigation.

The criminal conviction of Enron’s CEO was based in part on misstatements about the performance of the company’s efforts to create a video streaming service. The project was at best a speculative bet but investors were willing to pay more for Enron’s stock based on the possibility of its success. Enron violated accounting rules to hide multi-million losses associated with the service to keep its market value high.

In securities fraud cases directed at misstatements about failed technologies, defendants typically will argue that they sincerely believed that they would succeed in the end. There are hiccups and obstacles to the successful development of any world-changing product. Defendants will claim that they believed in good faith that they could overcome these challenges. Imposing criminal liability on entrepreneurs for trying to innovate would disincentivize the risktaking necessary to innovate.

Prosecutors will counter this argument by producing specific evidence that the defendants lied about the product to lure investors. Whether the motive is to raise additional funds from private investors or stir the enthusiasm of retail investors, securities fraud attempts to depict a failed product as one that is on the road to success.

It is notable that the Holmes and Milton cases involved high profile founders. At the height of their fame, each was more than a billionaire on paper. It is possible that their statements and conduct triggered heightened additional scrutiny of their companies after troubles were revealed. One might question whether prosecutors may have singled them out because of their spectacular falls from grace. If investors had not been so willing to value the possibility of success so highly, it is unlikely that the failures at Theranos and Nikola would have resulted in such scrutiny. Holmes and Milton might complain that their punishments were unfair because they should not be held responsible for the inflated values of entrepreneurial companies.

But both Holmes and Milton encouraged the inflation of their company stock prices in a deceptive manner. Given the evidence of their knowledge that their statements were false, their convictions are likely to be upheld on appeal.

The history of securities fraud regulation shows how lying about innovation can result in serious sanctions. Especially in this age of entrepreneurship, there is too much at stake for the deception of investors to go unscrutinized.