Lessons From Theranos and the Trade Secret Defense

January 31, 2022

IP Watchdog

“Secrecy is the badge of fraud.”

— Sir John Chadwick

What a strange and compelling story. Brilliant young inventor conceives revolutionary machine, raises staggering amounts from investors, is fawned over by the press for a decade, then crashes to earth on revelations of faked demonstrations and technology that doesn’t work. When I learned of the recent jury verdict, I naturally turned over in my mind how all this could have happened to such a well-meaning person as . . . . . . . . . . John Ernst Worrel Keely.

Okay, you were expecting someone else. But since you may not have heard of Mr. Keely, let me fill you in, and explain the role that secrecy played in one of the country’s most elaborate and long-running scams. I assure you that the Theranos investors wish they had boned up on Mr. Keely’s operation.

Keely came to prominence in the 1870s, a time of breathtaking technological advancement. This was the decade of the phonograph, the telephone and the electric light bulb. Opportunity was in the air, ready to be seized upon by anyone with the foresight to identify, and invest in, the next big thing. 

Some corners of theoretical science, however, had not caught up with this state of the practical art. Although we knew a lot about how electricity worked, physicists of the time still clung to the idea that all space was filled with an unidentified substance called the “ether” which was necessary for the transmission of light and electromagnetic waves. This stubborn mystery attracted Keely’s attention, and in his Philadelphia laboratory he conceived a machine that would be run by a previously unknown, but incredibly powerful, force derived from the ether and activated by the vibration of tuning forks operating on water. 

Notice we use the word “conceive” here, just as patent lawyers would, to distinguish between having the idea and “reducing to practice” the invention. The first part can arrive quickly, in a “flash of genius” while the second part, building a device that works, can take years, or never happen at all. But part of Keely’s genius – he didn’t have a formal education – was his ability to spin the vision and to capture the imagination of his investors. And of course, to capture their money.

Introducing the “Etheric Generator”

In 1872, he invited a group of scientists, along with the press, to witness a demonstration of a rudimentary “etheric generator” that used vibrations to separate atoms of water, releasing enormous power. This effort resulted in enough eager investors to allow the Keely Motor Company to build and show off a more powerful version two years later. While he spoke of “quadrupole negative harmonics” and “etheric disintegration,” Keely blew into a tube and then poured in some tap water. As the machine started to grind and wheeze, the pressure gauge registered over 10,000 p.s.i. The press reported the reaction of one witness that, “great ropes were torn apart, iron bars broken in two or twisted out of shape, by a force which could not be determined.”

But the “force which could not be determined” was just too attractive to ignore. Technology was changing the world overnight, and if what Keely had could be scaled up, then the possibilities – and the profits – were practically limitless. The company was capitalized with over $5 million (the equivalent of more than $100 million today), from prominent investors like John Jacob Astor IV. A leading Philadelphia socialite provided Keely with a monthly salary to maintain his laboratory and his focus on perfecting his invention. 

The stockholders showed extraordinary patience. Year after year, at their annual meeting, Keely would send a report about some new development or discovery that reinforced the fundamentals but required extensive refinement. As promised delivery dates passed, Keely would provide new demonstrations, with increasingly impressive outputs from the machine. He enthused that his “etheric generator” would make other sources of power obsolete, and that a train could travel to San Francisco and back using the power generated from the “disintegration” of a single quart of water.

Throughout the more than twenty years of the company’s existence, Keely resolutely refused to share any details of how his technology worked, claiming that to reveal the secret would destroy its advantage over the competition. Although some nervous shareholders asked for an independent inspection, most were content with Keely’s explanations and accepted waiting.

Keely died in 1898, apparently without having revealed his secret to anyone. However, an investigation by The Philadelphia Press concluded that Keely’s motor had been “a delusion and deception,” and that the “mysterious force” which Keely claimed to have discovered derived from a three-ton tank of compressed air buried in the basement of his laboratory, connected to the workshop with pipes and wires hidden in the walls and in false floors. 

Hindsight Skews the Analysis

With the benefit of hindsight, it’s easy to see Keely’s investors as credulous rubes who let greed and hubris overcome their better judgment. But that’s the power of hindsight, isn’t it? Let’s say you were hanging around Palo Alto in 1998 and a couple of Stanford students named Larry and Sergey came to you saying they wanted to build an algorithm that would search information for free but bring in $100 billion a year in advertising revenue, would you have given them money to start what would become Google? Sure, you say, but that’s another application of the power of hindsight. The fact is that in real transactions like this we are stuck with trying to calculate risk without knowing all the facts.

So, if you’re an inventor with no track record to establish your credibility, or if you’re an investor who wants to ensure that the technology is “real,” how do you protect yourself? It’s understandable that the investor wants to look under the hood and poke around; and it’s just as understandable that the inventor wants to keep the secret under wraps, because if it gets out the value is destroyed. Both of these people have a legitimate interest in protecting themselves.

But that doesn’t mean that the inventor can lie. In her trial, Theranos founder Elizabeth Holmes admitted that she hid the fact that the company was not using its highly touted “finger prick” device to test patients’ blood and instead was using traditional test equipment from established companies. She tried to defend her behavior as protecting the company’s trade secrets about how it had modified that equipment. But the existence of trade secrets doesn’t allow the inventor to defraud. And it doesn’t – or shouldn’t – mean that investors have no obligation to check out the veracity of the inventor’s claims.

The Dilemma of Asymmetric Knowledge

The answer to this dilemma of asymmetric knowledge lies in finding creative ways to build trust and confidence, so that the risk on each side becomes clearer and more easily managed. In a process that I refer to as “progressive incremental disclosure,” the participants begin with no confidentiality agreement, but are open to establishing one. The inventor determines a series of “reveals” that can be expected to increase confidence in the investor, without giving away enough information to constitute a real risk to the integrity of the secret. Along the way, the inventor may demonstrate the technology in a way that shows its potential but again does not reveal the mechanism. In another step, the inventor may call on a respected third party to perform tests that can shed light on the plausibility of the innovative machine or process, without requiring access to everything about its operation.

At some point in this negotiation, trust and a willingness to accept risk may merge, leading the investor to agree to sign a nondisclosure agreement. That act may be significant, as it could interfere with the investor’s ability to deal with a competitor. But it also may not be enough. There are some innovations that are so easy to replicate that even with a nondisclosure agreement in place, not all the details will be made available. If it comes to that, at least the investor can make a decision based on having secured a lot more information than was available at the outset. And the parties will have tested their ability to rely on the trust imposed in one another.

In the end, it comes down to risk analysis, and a process of reducing risk through diligent investigation. For example, the investors in Keely Motor Company, had they looked a bit harder into Keely’s background, would have discovered that, before he became an inventor, he worked as a carnival barker.

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