180 years ago, Scottish journalist Charles Mackay published a three-volume work entitled Extraordinary Popular Delusions and the Madness of Crowds. In it, he skewered various scams and manias, writing as follows:
“We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is captivated by some new folly more captivating than the first.”
Some things never change.
Recently, Elizabeth Holmes and her former boyfriend, Ramesh “Sunny” Balwani, were sentenced to lengthy prison terms for a massive fraud committed through their now-defunct Silicon Valley company, Theranos. For nearly a decade, Balwani and Holmes shamelessly sold investors on the idea that they had miraculously developed a device, the size of a desktop printer, that could run hundreds of tests to detect a panoply of diseases on as little as a drop or two of blood taken from a patient's finger.
The problem was that the product didn’t work, and Holmes and Balwani knew it. Theranos raised nearly $1 billion from investors before a 2015 Wall Street Journal report first indicated that the entire enterprise was a scam. When Theranos demonstrated its product (initially called the “Edison”), small blood draws would be taken from volunteers. The samples would then be spirited into a back room where they would be diluted and run through standard testing machines made by legitimate manufacturers.
The weirdness of the Theranos story cannot be overestimated. I can only scratch the surface in this short blog post. Holmes, for example, was enthralled by the late Steve Jobs, to the point that she constantly wore his trademark black turtleneck shirt. She also hired former Apple employees. She practiced and adopted a baritone voice because she thought it would give her more gravitas. She managed to attract a group of former government heavyweights to her Board, including former Secretaries of State George Schultz and Henry Kissinger, and former Secretary of Defense James Mattis. None of them, of course, had any experience in the medical device industry. She also managed to convince Walgreens to put her product in its stores and promote the faulty (unknown to Walgreens) tests to customers.
Meanwhile, in a similar story, Sam Bankman-Fried, the supposed Wunderkind of the now-defunct cryptocurrency exchange and hedge fund FTX, has been arrested in the Bahamas for allegedly diverting vast sums held in client accounts to use as his personal “piggy bank,” as well as to make risky trades. (His parents called the Bahamian jail to ask that Sam be served vegan meals while a guest there. I can’t make this stuff up.)
Our firm mostly handles insurance coverage work for policyholders, so we usually arrive on the scene after a disaster has already happened. But having seen our share of swindles, cheats, and flim-flam artists over the years, we’re in a good position to try to answer the following question:
How do fraudsters manage to fool so many apparently smart people for so long? Here are a few lessons:
First, Ronald Reagan’s saying, “trust but verify,” didn’t go far enough. When it comes to investing in a business deal, the better credo is “Don’t trust anyone unless and until you verify the information presented.” This can be difficult when you have FOMO (Fear Of Missing Out), but that’s when it’s most important to be skeptical.
When investors asked Holmes how the Edison machine worked, she would tell them that the technology was so sensitive and proprietary that she couldn’t reveal it. The next words out of the potential investor’s mouth should have been, “We’ll sign an ironclad nondisclosure agreement, but we’re not investing unless and until we fully understand the product.” Instead, they trusted her – for no verified reason. After all, Henry Kissinger was on her Board!
Notably, although experienced investors like Rupert Murdoch shoveled hundreds of millions of dollars at Holmes, Pfizer wasn’t one of them. Pfizer investigated Theranos’s technology in 2008, but ultimately concluded that the startup wasn’t worth investing in. “Theranos does not at this time have any diagnostic or clinical interest to Pfizer,” Shane Weber, former director of diagnostics at Pfizer, wrote in December 2008. He added that “no further financial investment or clinical sample resources [should] be extended to Theranos.” Weber was rightly suspicious of Theranos’s grandiose claims.
Force yourself to look away from the “shiny object” and do objective due diligence. If your proposed business partners say they can’t give you answers because their system or product is too proprietary, then run, don’t walk, away. At the very least, you should be asking pointed questions like those proposed by the United States Supreme Court for the admission of expert testimony at trial, set forth in Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993) as follows:
- Whether the theory can and has been tested;
- Whether it has been subject to peer review;
- The known or expected rate of error; and
- Whether the theory or methodology employed is generally accepted in the relevant scientific community.
Remember: If it sounds too good to be true, it almost certainly is.
Second, beware the cult of personality. If one person is running the show, and there are no real checks or balances, it’s a giant red flag. So don’t be afraid to ask hard questions about corporate governance. How are decisions made in this organization? How is dissent handled? Do the people making decisions have extensive, real experience in implementing the products or services they’re touting? To analogize to world politics, think about what we see in Russia right now. Putin created a cult of personality, eliminated all opposition, and surrounded himself with sycophants. The results have been tragic and disastrous. As General George Patton once famously said, “If everyone is thinking alike, then somebody isn’t thinking.”
Third, don’t invest money in a venture unless you can afford to lose it. Enough said.