Lessons from Theranos and the defense of trade secrecy

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“The existence of trade secrets does not allow the inventor to defraud. And that doesn’t – or shouldn’t – mean that investors have no obligation to verify the veracity of the inventor’s claims.

“Secrecy is the badge of fraud.”

—Sir John Chadwick

Elizabeth Holmes, Theranos

What a strange and captivating story. A brilliant young inventor designs a revolutionary machine, raises huge sums from investors, is adored by the press for a decade, then collapses on revelations of fake demonstrations and technologies that don’t work. When I learned of the recent jury verdict, I naturally thought about how 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 Keely, let me explain the role that secrecy played in one of the most elaborate and long-running scams in the country. I assure you that Theranos investors would have liked to have looked into the Keely operation.

Keely rose to prominence in the 1870s, a time of breathtaking technological advancement. It was the decade of the phonograph, the telephone and the light bulb. Opportunity was in the air, ready for 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 practical state of the art. Although we know a lot about how electricity works, physicists of the day still clung to the idea that all of space was filled with an unidentified substance called “ether” which was necessary for the transmission of light and electromagnetic waves. This nagging mystery caught Keely’s attention, and in his Philadelphia lab he devised a machine that would be driven by a previously unknown, but incredibly powerful, force derived from the ether and activated by the vibration of tuning forks. running on water.

Notice that we use the word “design” here, just as patent attorneys would, to distinguish between having the idea and “practicing” the invention. The first part can happen quickly, in a “flash of genius” while the second part, building a working device, can take years or never happen at all. But part of Keely’s genius – he had no formal education – was his ability to spin the vision and 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, as well as the press, to see a demonstration of a rudimentary “etheric generator” which used vibrations to separate water atoms, releasing enormous power. This effort resulted in enough enthusiastic investors to allow the Keely Motor Company to build and present a more powerful version two years later. While talking about “negative quadrupole harmonics” and “etheric disintegration,” Keely blew into a tube and then poured tap water into it. As the machine began to grind and hiss, the pressure gauge registered over 10,000 psi The press reported the reaction of a witness that “great ropes were torn, iron bars broken in half or bent, by a force that could not be determined.”

JOHN WORRELL KEELY, c1895.
John Worrell Keely and the Keely Engine. The most famous perpetual motion machine cheat of the 19th century. Source: Wikipedia

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

Shareholders have shown extraordinary patience. Year after year, at their annual meeting, Keely would send in a report of a new development or discovery that reinforced the fundamentals but needed extensive refinement. As the promised delivery dates passed, Keely would provide further demonstrations, with increasingly impressive outputs of the machine. He enthused that his “etheric generator” would render other energy sources obsolete and that a train could travel to San Francisco and back using the energy generated by the “disintegration” of a single liter of water. .

Throughout the company’s more than 20 years of existence, Keely has adamantly refused to share the details of how its technology works, saying revealing the secret would destroy its edge over the competition. Although some nervous shareholders demanded an independent inspection, most settled for Keely’s explanations and agreed to wait.

Keely died in 1898, apparently without revealing his secret to anyone. However, a survey conducted by The Philadelphia Press concluded that Keely’s engine had been “an illusion and a deception” and that the “mysterious force” Keely claimed to have discovered came from a three-ton compressed air tank buried in the basement of his laboratory, connected to the workshop with pipes and wires hidden in the walls and in the raised floors.

Hindsight skews the analysis

Looking back, it’s easy to see Keely’s investors as gullible rubies who let greed and hubris trump their better judgment. But that’s the power of hindsight, isn’t it? Let’s say you were hanging out in Palo Alto in 1998 and two Stanford students named Larry and Sergey came to you and said they wanted to create an algorithm that would look up information for free but bring in $100 billion a year in ad revenue – would you did he give them money to launch 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 forced to try to calculate the risk without knowing all the facts.

So if you’re an inventor with no track record to establish your credibility, or you’re an investor who wants to make sure the technology is “real,” how do you protect yourself? It’s understandable that the investor would want to look under the hood and dig; and it’s just as understandable that the inventor wants to keep the secret secret, because if he comes out, the value is destroyed. These two people have a legitimate interest in protecting themselves.

But that doesn’t mean the inventor can lie. In her lawsuit, Theranos founder Elizabeth Holmes admitted she was hiding the fact that the company did not use its much-vaunted ‘finger prick’ device to test patients’ blood and instead used equipment traditional test cases from established companies. She tried to defend her behavior by protecting the company’s trade secrets about how she had modified this equipment. But the existence of trade secrets does not allow the inventor to defraud. And that doesn’t – or shouldn’t – mean that investors have no obligation to verify the veracity of the inventor’s claims.

The dilemma of asymmetric knowledge

The answer to this asymmetric knowledge dilemma lies in finding creative ways to build trust, so that the risk on either side becomes clearer and more easily managed. In a process I call “incremental progressive disclosure,” participants start without a confidentiality agreement, but are open to establishing one. The inventor determines a series of “revelations” that can be expected to increase investor confidence, without disclosing enough information to pose a real risk to the integrity of the secret. Along the way, the inventor can demonstrate the technology in a way that shows its potential but again doesn’t reveal the mechanism. In another step, the inventor can hire a respected third party to perform tests that can shed light on the plausibility of the innovative machine or process, without needing to have access to everything related to its operation.

At some point in this negotiation, trust and the willingness to accept risk may merge, leading the investor to agree to sign a nondisclosure agreement. This act may be important because it could interfere with the investor’s ability to deal with a competitor. But that may also not be enough. Some innovations are so easy to replicate that even with a non-disclosure agreement in place, not all details will be available. If it comes down to it, at least the investor can make a decision based on having obtained much more information than was initially available. And the parties will have tested their ability to rely on the trust imposed on each other.

Ultimately, it comes down to risk analysis and a process of risk reduction through diligent investigation. For example, Keely Motor Company investors, had they looked a little deeper into Keely’s background, would have discovered that before he became an inventor, he worked as a carnival huckster.

Photo by James Pooley

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