Illumina: Fraud by Omission
"It is almost always the cover-up rather than the event that causes trouble."
How could Illumina insiders generate a material financial windfall on Grail and not disclose it to shareholders?
I suspect part of the answer is fraud by omission.
By omitting material facts that would potentially demonstrate Illumina had significant influence on Grail, Illumina insiders took advantage of known accounting assumptions regarding intercorporate classifications that reclassify Grail to an unrelated party (i.e. equity method accounting to cost method accounting). In turn, this enabled undisclosed financial windfalls via fiduciary-duty-breaching insider-trading (to be expanded on at a later date).
This is why the stakes are so high in the upcoming contested election between Carl Icahn and Illumina. If Carl Icahn wins one Board seat, I suspect all the questions I’ve raised will be answered without the need for an SEC or FTC investigation. Just to be clear, the facts will eventually come out. It’s really just a question of how long it’ll take.
If I’m right, we’re potentially talking about a serious black mark on a lot of illustrious careers and institutions who were involved in the alleged scheme. What’s remarkable is none of what I’ve raised requires a sophisticated, multi-year investigation or forensic accountants. All that’s needed is a handful of documents and a log of Grail equity transactions that one could get via Section 220 request.
Disclaimer: This newsletter is not investment advice. Views or opinions represented in this newsletter are personal and belong solely to the owner and do not represent those of companies that the owner may or may not be associated with in a professional capacity, unless explicitly stated. As previously disclosed, I submitted an SEC whistleblower tip regarding the Illumina situation.
Welcome to the Endgame
With this post, we’re now entering the endgame. I recognize Illumina shareholders need to submit their votes soon, so I’d expect the next write-up to come out shortly.
This piece focuses on fraud by omission, and helps to lay the groundwork for discussing insider trading next.
I didn’t stutter. I’m going to discuss insider trading next.
A Simple (Alleged) Story
Let’s do a recap.
The (Alleged) Story: Illumina insiders got greedy and utilized Illumina’s market power and standing to negotiate a compelling financial arrangement for themselves when they split-off Grail in 2016, and would later reap a meaningful undisclosed financial windfall as result of this self-dealing.
In the process of “hiding” these financial windfalls, Illumina insiders committed “fraud by omission”. By omitting just a few material facts, insiders were able to obscure these transactions and arguably felt emboldened to further pursue this scheme without consequence.
As the saying goes, it is almost always the cover-up rather than the event that causes trouble.
How “Fraud” Helps Illumina, Inc: Disgorgement of Profits
I don’t usually talk about fraud, if ever. It’s usually not helpful for the average long-term investor.
However, if what I’m positing turns out true, there’s certainly going to be a messy interim period which will include a financial restatement or two. In that scenario, Illumina (and its shareholders) may have legitimate standing to pursue disgorgement of profits from those who benefitted from the scheme.
It might take years, but we’re not talking trivial amounts of money here.
Fraud by Omission
Note: Consider this section big picture/generalized commentary. The specific securities laws Illumina insiders violated via “Fraud by Omission” (or other violation) will need to be investigated and litigated (i.e. actions outside of my expertise).
So what exactly is “fraud by omission”?
Basically, companies can’t file materially false or misleading reports or omit information necessary to render the statements not misleading.
“Make no mistake: If a company or executive misstates or omits information material to securities investors, whether in an earnings call, on social media, or in a press release, we will pursue them for violating the securities laws.” - SEC Chair Gary Gensler (11/2/2022)
Full disclosure, “fraud by omission” is the framing I think best describes what happened here, but there are other concepts like “affirmative misrepresentation”, which involves a material misrepresentation made to the investing public for the purpose of inducing the sale or purchase of stock. That could also fit.
My main point is that I believe Illumina omitted material facts regarding Grail and Grail transactions. They had a duty to disclose these facts, and by not doing so, misled investors (and arguably their auditors), which allowed insiders to facilitate undisclosed financial windfalls in Grail.
I’ve already highlighted and discussed how the company’s response the questions and issues I raised regarding undisclosed financial windfalls was a form of “fraud by omission” that misleads voters and leaves out material facts. This write-up focuses on how this tactic was used to arguably implement cost method accounting instead of applying equity method accounting.
Omitting Material Facts: Grail Becomes a “Cost” Investment
In my opinion, a noteworthy example of “fraud by omission” was Illumina’s decision to treat Grail as a cost method investment in Q1 2017 following Grail’s Series B round:
On February 28, 2017, GRAIL completed the initial close of its Series B preferred stock financing, raising over $900 million, in which the Company did not participate. Concurrent with the financing, GRAIL repurchased 35 million shares of its Series A preferred stock and approximately 34 million shares of its Series A-1 preferred stock held by the Company for an aggregate purchase price of $278 million. At this time, the Company ceased to have a controlling financial interest in GRAIL and the Company’s equity ownership was reduced from 52% to 19%. Additionally, the Company’s voting interest was reduced to 13%, and the Company no longer has representation on GRAIL’s board of directors.
Source: Illumina Q1 2017 10-Q
The reasons Illumina gives to account Grail as a cost method investment following the startup’s Series B round include:
Equity ownership was reduced from 52% to 19%
Illumina’s voting interest was reduced to 13%
Illumina no longer has representation on Grail’s Board
Relying on these facts alone, using cost method accounting can be reasoned as being appropriate given these parameters presume Illumina does not have “significant influence” on Grail to warrant equity method accounting.
For background, a key criteria in determining whether or not equity method or cost method accounting should be applied is the concept of significant influence:
An investor should generally apply the equity method of accounting for investments in common stock or in-substance common stock of corporations when the investor does not control, but has the ability to exercise significant influence over the operating and financial policies of the investee.
Source: PwC
When a company goes under 20% ownership and has no Board representation, there’s a presumption they can’t exercise significant influence, and thus, cost method accounting would be considered appropriate.
Other indicators of significant influence include:
Representation on the board of directors
Participation in policy-making processes
Material intra-entity transactions
Interchange of managerial personnel
Technological dependency
Extent of ownership by an investor in relation to the concentration of other shareholdings (but substantial or majority ownership of the voting stock of an investee by another investor does not necessarily preclude the ability to exercise significant influence by the investor).
The issue is the SEC does not apply a “bright line test” on this topic and something like stock ownership should really be viewed a “starting point” for evaluating “significant influence”.
The SEC will also look at the voting rights, veto rights and other protective and participating rights held by the investor. The greater the ability of the investor to participate in the financial, operating or governance decisions made by the investee, via any form of governance rights, the greater the likelihood that significant influence exists.
If Illumina had these rights (as well as influence over other essential decisions), that would arguably demonstrate they retained significant influence on Grail and should continue to use equity method accounting. However, insiders would then need to disclose any-and-all related transactions and financial windfalls they may have reaped in Q1 2017 and onwards under equity method accounting. Recall that in my original write-up, Malignant Governance, I suggested that a significant portion of the $900 million Series B capital raised was used to repurchase shares from unknown parties.
Consequently, I believe the use of cost method accounting in Q1 2017 and onwards is a form of fraud by omission that was partly informed by a desire to avoid disclosing insider transactions. Just because Illumina suggests they’re not exerting significant influence doesn’t mean they’ve lost the capacity/ability to exert it, and it certainly seems they’re omitting this material fact when disclosing their 19% ownership and Illumina’s Jay Flately coming off the Board as justification for cost method accounting.
Mosaic of Disclosures Signaling “Significant Influence”
While Illumina does not provide explicit disclosures (from what I can find) regarding their governance and voting rights at Grail, I believe there are a number of disclosures and pieces of information - shared years later - that indicate the company and/or insiders maintained significant influence, including:
Former Illumina CEO and Executive Chair Jay Flatley served as an observer of the board of directors of Grail “in his personal capacity”. Setting aside whose observer rights Mr. Flatley was using, the “personal capacity” language could mean equity interests held by Illumina insiders (either personally or through other vehicles) are being treated as “personal” stakes and not being included in Illumina’s 20% equity method ownership threshold (2018 Proxy)
Former Illumina CTO Mostafa Ronaghi served as a member of the Grail Board in May 2020 where he could participate in policy-making processes. (Illumina 424B3)
There was an “interchange of managerial personnel” between Illumina and Grail which may also include undisclosed consulting relationships. This includes Alex Aravanis joining Illumina as CTO before the Grail acquisition was consummated and Illumina executive Gautam Kollu joining Grail in December 2019 as Chief Commercial Officer.
Illumina’s Grail-related D&O insurance indicates the company’s ability to appoint representatives to Grail’s Board, and seems to imply Mr. Ronaghi’s Director appointment at Grail was done at the company’s behest even though it’s not explicitly stated. (Grail-Related D&O Insurance)
“Indemnitee is or was serving at the request of the Company as a director, officer, employee, agent or fiduciary of another corporation, partnership, joint venture, trust or other enterprise”
Grail not providing the key terms and obligations of the Voting and Right of First Refusal and Co-Sale Agreements in their S-1 filing, which signals to me Illumina maintained “significant influence” at the Board level to not disclose “equity method” triggering facts in their prospective IPO filing.
The fact of the matter is outsiders can’t take the voting disclosures and governance documents provided by Grail at face value. Key terms and obligations are housed in the Voting and Right of First Refusal and Co-Sale Agreements that Grail has not shared and cements how certain governance matters (i.e. Director appointments) are actually voted on.
For instance, the Voting Agreement subjects 96% of the total voting power and 100% of preferred stock to drag-along obligations regarding the Grail acquisition:
As of January 31, 2021, the GRAIL stockholders party to the GRAIL Voting Agreement that are subject to the drag-along obligation therein, together with the Selling Investors, collectively held 96.0% of the total voting power of GRAIL Stock, voting together as a single class, and 100.0% of GRAIL Preferred Stock.
Source: 424B3 Filings (2/9/21)
These drag-along rights also means Illumina can secure an acquisition of Grail in ways that would not be possible had Grail gone public and all the agreements in question terminated.
For example, Mr. Ronaghi might have to recuse himself from M&A discussions regarding Illumina-Grail, but that wouldn’t prevent him from signing-off and/or encouraging aggressive equity grants to insiders during/following deal discussions to potentially sway the Board vote on a deal and trigger drag-along obligations.
MNPI: Grail’s Voting and RoFR and Co-Sale Agreements
When I said Baillie Gifford and Edgewood Management’s vote in Illumina’s upcoming contested election is a bit complicated, I wasn’t trying to be bombastic or provocative on purpose.
By participating in Grail’s Series B, both parties (frankly all participants in Grail’s various private investment rounds) are potentially privy to material non-public information regarding Illumina’s (or Illumina insider’s) ability to assert “significant influence” and fraud by omission (or some equivalent/comparable securities violation) was potentially committed:
Simply put, I think Baillie Gifford and Edgewood Management may be in possession of material non-public information that have (in my opinion) governance, disclosure, fiduciary duty, regulatory, and accounting ramifications for Illumina and potentially those institutions as well.
In a worst case scenario, these parties could be complicit. I don’t think that’s the case, but there are real conflicts to deal with here. Also, if it comes out that Arch Venture Partners—or other parties that may be exposed or involved in this scheme—is quietly/informally campaigning on behalf of Illumina in the upcoming contested election, regulators will likely take a closer look at Baillie Gifford and Edgewood Management’s votes. I doubt either wants to explain any conversations/emails/meetings that may be found during discovery.
End Note: Friendly Reminder of SOX Duty to Report
Since the odds Illumina’s outside legal counsel will be reading this is 100% (hello!), I highly recommend they think through their up-the-ladder reporting responsibilities under Sarbanes-Oxley, which appears to be an area of renewed focus for the SEC in recent years. They should also think through the futility of reporting the issues to the CEO and General Counsel, and consider the merits and necessity of going straight to the Audit Committee. I’ve already “caught” the company omitting material facts and misleading shareholders in their response to the questions and issues I raised, and there’s arguably a pattern of this across filings as demonstrated in the cost vs. equity accounting issue.
I suspect Illumina is going to set some new case precedents on various topics— including the aforementioned up-the-ladder reporting—and the Board’s misleading, “bad faith” response to my initial article is going to be examined for material violation of securities laws and a breach of fiduciary duty. After all, the response wasn’t just a press release:
Illumina’s response to the questions and issues I raised was signed-off by the Board and filed in a proxy of a contested election to sway voters. There’s no room to be misleading in such documents.
I’m not a lawyer and Illumina’s outside counsel doesn’t have to believe me, but I’d like to think they recognize I’m probably directionally correct with my assessment. Executives are quite good at making their problems roll downhill, and the first heads on the chopping block are usually the front-line advisors.