Learn the risks of concentrating too much control on a single person within a small company, and the consequences that follow charges of witness intimidation.
The CEO of a start-up medical device company found himself in dire straits financially. He syphoned off funds from the company, then continued to do so even after the company returned to a solid financial footing. The company lacked adequate internal controls and failed to discover the fraud for years until the filing of an indictment by the Department of Justice exposed the fraud.
Upon completion of this case study, readers will be able to:
- Understand how opportunity and desperation can alter the behavior of individual actions.
- Describe measures small companies might take in order to deter fraud.
- Explain how the government reacts harshly when faced with an accused person committing further egregious acts.
- Identify potential areas of concern for an organization with insufficient internal controls.
Fraud, Medical Devices, Indictment, Oversight
Industry Current State
Small companies typically operate with minimal staff and on a shoe-string budget in order to conserve funds. This particularly applies to start-up companies that may have many assets such as patents and unique devices but still lack sales and revenue. Problems can arise, however, when the conservation of cash deprives a company of sufficient internal controls to maintain compliance.
Sanovas, Inc., based out of San Rafael, California, develops life science technologies for the medical community, specializing in minimally invasive surgical tools. The Company offers products allowing surgeons to access, visualize, diagnose, measure and treat obstructed passageways in areas of the body that are inaccessible. The company employs dozens of employees and reports revenue in the millions of dollars; a relatively small player in the industry.
Since inception, the company recorded over 90 patent filings, prototyped over 80 products, invented next generation Tissue Regeneration technologies and next generation Surgical Robots, created and entirely new classes of Interventional Balloon Catheters, Surgical Cameras, Biofeedback Technologies, In Vivo Diagnostic Technologies, and In Vivo Drug Delivery Technologies. Most of these products, however, remain investigational medical devices that have not been approved or cleared for use in the United States. These assets, nonetheless, value the company at over $1.34 billion.
Sanovas’ CEO, Larry Gerrans, graduated from the University of Arizona and subsequently worked as a surgical implant consult for Depuy Orthopedics, a division of Johnson & Johnson. He then moved on to Stryker and Smith & Nephew, two large medical device companies. He founded Sanovas in 2011 based on a passion he had for years, with a partner named Erhan Gunday. During the first few years, the company operated out of their homes, raising money, attending surgeries and creating patents.
Despite Sanovas’ lofty prospects and eventual high valuation, the company struggled with liquidity issues for years, as did the Company’s CEO Larry Gerrans. In fact, Gerrans’ fortunes ran in tandem with the company because Sanovas lacked funds to pay Gerrans a personal salary during its early years.
Those fortunes changed as Sanovas raised money from private investors. Gerrans took that opportunity to repay himself but also took liberties with corporate funds. He created shell companies, purportedly independent, to do work for the company. In reality, it was just a process to funnel money to himself. No internal oversight over Gerrans existed other than the Board of Directors, which met infrequently. And, while the company filled its Board of Directors with esteemed doctors, those doctors lacked significant experience in corporate governance.
The US Attorney’s Office indicted Gerrans on three counts of wire fraud and money laundering in July of 2018, for syphoning money out of Sanovas in order to pay cash for a home and a myriad of personal expenses.
The first count involved withdrawing $500,000 from his personal Individual Retirement Account, then using the funds to pay for personal expenses including vacations, jewelry, and spa treatments. Then, in March of 2015 after a newly constituted board of directors was convened at Sanovas, Gerrans claimed he used the IRA funds for Sanovas’ business and requested reimbursement for the liquidated IRA. Gerrans argued to the new board of directors that he should be reimbursed for the funds as deferred compensation.
The indictment then accused Gerrans of orchestrating the payment of bogus consulting fees to Halo Management Group, LLC. Gerrans allegedly caused invoices to be submitted by Halo to Sanovas even though Halo was not a legitimate independent consulting firm and provided no independent services to Sanovas, serving as nothing more than a front to syphon off funds from the company to purchase a personal home.
The Board of Directors immediately fired Gerrans after the filing of the indictment and quickly replaced him in order to contain the damage. The company, however, still remains largely aspirational with minimal revenue and a tarnished reputation, having lost millions of dollars to Gerrans’ fraud due to lack of internal controls.
Gerrans, in the meanwhile, elected to fight the charges in court instead of accepting a plea agreement, leading to a two-week jury trial and resulting in a conviction on five counts of fraud in January of 2020. The jury additionally convicted Gerrans for contempt of court, witness tampering and obstruction of justice for engaging in prohibited communication with a witness after his indictment. Prior to sentencing, the government further alleged Gerrans subsequently threatened the lives of Assistant US Attorneys who prosecuted his case. All of these factors bode poorly for Gerrans who received a 11-year sentence in November of 2020.
Start-up companies starving for capital must often prioritize limited resources in order to survive. They don’t necessarily have the luxury of considering such expense-oriented items as compliance out of the gate. The problem is, they also often neglect to add this key component once they do have sufficient capital to pay for it. This can especially the case for companies primarily driven by a controlling CEO.
Boards of Directors, however, exist for a reason. Individuals who serve on them cannot merely act as rubber stamps for the actions of the CEO. They must jump in and question business activities and stay informed in order to perform their role. If their unable or unwilling to do their jobs, then they shouldn’t serve as directors to begin with.
Start-up companies, much like all companies, must emphasize compliance once the business is generating sufficient capital to ensure compliance. Failure to do so can be equally calamitous to senior management, the Board of Directors and the company as a whole. Few employees or CEOs begin at companies with the intent to commit fraud. The proper mix of opportunity and motivation, however, can lead otherwise reputable people to actions they would not ordinarily undertake.
Industry Future State
Many people consider white collar crime particularly distasteful since it’s often driven by greed instead of lack of opportunity, unlike other crimes. As a result, it serves as a dog-whistle for government prosecutors who salivate at the prospect of bringing such cases. Companies of all types must therefore be vigilant at every level of the organization to deter fraud and minimize a company’s risk profile. Acting penny-wise and pound-foolish in terms of compliance will only increase the likelihood of enabling errant behavior and making companies clear and obvious targets for prosecution.