Here's a strange little SEC securities fraud case. Imaging3 is a small, now-bankrupt medical imaging device company that was developing a 3D scanner (pictured right, with CEO Dean Janes) that certain members of the medical establishment did not like, quite possibly because it didn't work, hard to tell. Imaging3 sought FDA approval for its scanner and, in October 2010, the FDA rejected its application. On November 1 after the close, the company announced that it had received this rejection and held a conference call with investors. Janes, the CEO, was mad:
Janes informed shareholders and others on the call that the FDA's rejection of the submission was not based on concerns regarding the device's technology or image quality or the safety of the device. Instead, at numerous points during the call, he described the FDA's denial as "ridiculous," "administrative," "not substantive," and"nonsensical."
During the November 1 call, Janes omitted any mention of the FDA's specific and substantive concerns. For example, he never explained in any way that the FDA had determined that the use of certain sample images was "scientifically invalid and useless," or that the FDA had expressed concerns about vibration hazards or overheating of the device.
So a difference of opinion then? The SEC is pretty sure Janes lied through his teeth about the FDA letter, though I feel like you could parse his words in a not-exactly-lying sort of way.1 Though: they do say Janes "subsequently admitted that his statements on the November 1 call were not '100% accurate' and that he did not publish the letter at the time because he did not 'think [it was] always good to put out negative information, though it would have been more accurate.'" So there's that.
Anyway Imaging3 hired a law firm and promised to keep trying to get the scanner approved.2 It didn't publish the rejection letter, but someone else did:
More than two months after the November 1, 2010 conference call, an Imaging3 investor posted a copy of the FDA's October 22, 2010 denial letter on an
online message board. The investor had obtained a copy of the letter pursuant to a FOIA request.
In response, Janes used his personal Facebook account to provide a link to the posting later that day.
Following the investor's disclosure of the FDA's denial letter and Janes's link to the post, on the next trading day, January 11, 2011, Imaging3's stock traded on heavy volume of 3.5 million shares, up more than 450% from the prior trading day's volume.
Imaging3 did not itself release a copy of the FDA denial letter until it posted a copy of the letter on its website on February 28, 2013.
Notice anything suspicious?3 "Following the disclosure, Imaging3's stock plummeted on heavy volume," is what the SEC does not say. It "traded on heavy volume" but up or down?
Umm neither? Here is as far as I can tell the actual path:
- November 1, 2010, just before Imaging3 discloses the existence of the FDA denial letter: stock closes at $0.25, after spending the previous week in a $0.25-$0.29 range.4
- November 2, 2010, after the call in which Janes describes the letter and rants against the FDA: stock opens at $0.09, closes at $0.13.
- The stock slowly recovers a bit.
- January 10, 2011, just before the actual letter is disclosed, the stock closes at $0.17.
- January 11, 2011, after the actual letter is disclosed, the stock opens at $0.16, and closes ... unch'd at $0.16.5 On heavy volume though.
- It stays in the mid-teens (cents) until April, then slowly fritters down to its September 2012 bankruptcy and current $0.0021 stock price. I don't think the scanner thingy was ever approved.
Got it? Janes's fraudulent efforts to prop up the stock price caused it to drop by 64%. When the fraud was revealed, the stock dropped by 6% (but on heavy volume), to close 23% above where it closed when he started the fraud. One conclusion: Janes was not very good at fraud. Another: you can see why this is an SEC case, rather than a private class action; investors don't seem to have actually lost any money from the fraud. (From the crappy scanner, sure.)
But also. CEOs of wee scrappy medical device companies are supposed to believe in their devices, possibly beyond what is justified by, y'know, properly conducted scientific tests. Optimism in the product, and pugnaciousness with the pencil-pushers in Washington who want to stand in its way, are part of the job description. The market has some ability to adjust for that: you can't take crazy small-cap CEO's literally. That's why the November 1 call featured multiple questions to the effect of "umm are you sure the FDA isn't worried about safety or image quality?" And it's why, despite Janes's assurances that it was all just a bureaucratic misunderstanding, the stock fell 64% after his reassurances - to below the level where it settled after the actual letter was revealed. Janes said that the FDA decision was better than it actually was, but the market heard him saying that the decision was worse than it actually was. The market overcompensated for his bullshit.
There's normally a certain amount of breathing room between this sort of gung-ho puffery and securities fraud, though sometimes there isn't, and it's not always clear how the choices are made. Saying Enron is doing great when it is in fact about to blow up everyone's retirement savings doesn't get you much sympathy, though saying Lehman is doing great when it is in fact about to blow up seems to be okay. Here, Janes's securities fraud doesn't seem to have defrauded anyone, so he's got that going for him. On the other hand, he publicly (and perhaps inaccurately) called a government regulatory agency's actions against him "just ridiculous." You could imagine why the SEC might want to give that a closer look?
1.Like, from the FDA:
The October 22 letter to Janes, for example, strongly criticized Imaging3's comparison of images obtained from the Dominion Scanner to sample images of"anatomical phantoms" obtained from the websites of the manufacturers of the predicate devices identified in the 510(k) submission. The letter stated that these comparisons were "scientifically invalid and useless." ... The FDA's October 22 letter also stated that the images submitted by Imaging3 of the Dominion Scanner were provided in a format with "no diagnostically useful information." ... The October 22 letter from the FDA also informed Imaging3 and Janes that the software documentation provided in Imaging3's submission "[was] not sufficient to determine the safety and effectiveness of the device." ... The FDA also stated in its October 22 letter that it had concerns about overheating in the Dominion Scanner since Imaging3 had not "demonstrated through real-world tests that this device maintain[ed] a safe temperature even when draped and used as it would be in a clinical environment."
So are those substantive safety and imaging quality concerns, or are they about the format and technicalities of the submission? They don't seem to say things like "these images are bad" or "your machine exploded"; they're more like "the format of your submission makes us worry that your machine might explode." Seems debatable to me. Here, meanwhile, is Janes:
Caller: Am I correct in assuming, or understanding that the reasons for the rejection were basically administrative in nature and not substantive with regards to the technology?
[Janes]: You're right on the money. Majority if not all questions were mostly about the package and how it was put together. Parts that they didn't agree with, you know, again asking for financial information. Where that came from I have no idea, I have to read the relevant code they specified but really and honestly, not really one question about the technology or its consistency.
But the FDA's questions that the SEC cites really are about the submission, not the technology. (Except maybe the last one?) They're all like "your submission doesn't tell us enough about the technology," so you can see why the SEC is mad, but I'm not sure that what Janes is doing here is exactly lying. Though, on the other hand: if you're on an investor call and you find yourself prefacing a statement with "really and honestly," you are in bad trouble.
2.From a January 8-K:
Upon receipt of the deficiency letter from the FDA denying its application to market its Dominion DViS product in the United States, the Company hired the law firm McDermott Will & Emery, a Washington D.C. law firm with expertise in FDA filings and their resolution. Since the process has taken longer than management anticipated, management felt it prudent to engage outside consultants with sufficient experience to assist the Company in the process. Upon review and discussion of its FDA application and response letters with the consultants, the Company's management feels confident in their ability to assist the Company with the preparation and follow-up of the re-filing of its 510(k) application. The consultants expressed the view that each deficiency cited by the FDA in its letter could be resolved and that FDA approval was achievable, although not guaranteed.
3.Ooh here's one thing: what are the ethics of disclosing material information on the CEO's personal Facebook page weeks before the company officially 8-K's it? Problematic, at least, particularly in 2011. The SEC will let this one go, though, and focus on the fraud.
4.Incidentally the SEC refers to that letter as being dated October 22. Imaging3 says they received it on October 25, or maybe October 28, whatever. (Does the FDA not use email?) Either way they waited at least a couple of business days before disclosing it, which is a little weird?
5.If relevant, there were about 375mm shares outstanding at the time, for a $60mm-ish market cap.