Pharmaceutical and Life Science Industry: Risky Business
KMPG International recently released a report entitled, “An Overview of Risk and Disclosure in the Global Pharmaceutical and Life Sciences Industry.” The report highlights the significant business risk factors disclosed by leading pharmaceutical and other life sciences companies in their 2011 annual reports and financial statements. KPMG reviewed the most recent relevant filing of the 34 largest pharmaceutical and other life sciences companies and considered their quantitative and qualitative disclosures. Key findings include:
- US companies and foreign companies filing with the US Securities and Exchange Commission (SEC) disclose broadly twice as many risks as non-US filers.
- Overall, there was a 13 percent increase in the aggregate total number of risks disclosed by the sample of companies we reviewed.
- Pricing, patent-related risks and generic competition dominate disclosure tables.
- Political instability, natural disasters and the risk posed by use of information technology show the greatest increase in disclosure.
- US healthcare reform, European economic risk, and emerging market risk are new risks disclosed by more than 15 percent of filers for the first time.
- Six companies with more than 30 percent of sales from the European Union (EU) did not disclose specific EU risk.
- Emerging market risk was disclosed by less than a quarter of the companies.
- Disclosure of R&D pipelines remains relatively limited, influenced by the problems and lack of success of recent years, and competitive pressures. Only one company estimates its return on R&D spending.
- We observed no meaningful trend in disclosure related to M&A activity.
- Contingent legal liabilities are dominated by product liabilities ahead of sales and marketing and patent litigation liabilities.
KPMG identified rising legal, political, personnel and scientific risk, combined with a loss of trust as one of five key challenges for the industry. The survey saw companies taking steps to reduce legal risk. Although a decline in legal liabilities was too early to predict, “the absence of significant increase in contingent legal liabilities relating to sales and marketing practice is a positive sign.”
Political risk is understood and disclosed, at least partially, for US and EU markets. For emerging markets it is much less well-disclosed. Emerging markets also carry significant personnel risk driven by a shortage of staff qualified for employment in the life sciences industry.
“The pharmaceutical companies’ behaviors that have created the perception that they put their commercial goals above the interests of governments, payors, prescribers and patients are at the heart of the loss of trust of these stakeholders.” KPMG, however, sensed “the beginning of the cultural change that is essential to rebuilding trust is underway.”
KMPG noted that “industry is faced with some real opportunities to counterbalance these risks. The most important of these is innovation. True innovation is still valued highly, particularly in the US and in Japan. Delivery of innovative products is rewarded by commensurate returns even in the face of the multiple reforms in both these markets, although it is harder to say the same is true, in general, of Europe. Many of the opportunities for innovation are in more specialist markets.”
The report notes that, “In-house research and development may not be capable of delivering the requisite innovation that should result in more collaboration and also more mergers and acquisitions (M&A), especially involving small and medium-sized companies. More collaboration will mean more royalty payments and a potential long-term increase in the cost of sales. It is also possible that collaborating companies will focus more on selling, marketing and branding and other activities characteristic of consumer markets.”
KMPG stated that, “large-scale M&A is expected to be more challenging as most of the large companies are already the product of a significant acquisition and are working toward rationalizing excess capacity and resources.” Accordingly, they recommended that “M&A and alliances should involve careful examination of the risks of fully developing the compound and bringing it to market as part of effective due diligence on behalf of the acquirer.”
KPMG identified eight risks reported by more than 15 percent of companies for the first time:
- US healthcare reform legislation, i.e. the Patient Protection and Affordable Care Act of 2010
- European economic risk
- Emerging market risk
- Product safety
- International business risk
- Anti-bribery and corruption legislation
- Counterfeit products
- Competition from biosimilars
Social Media Risks
KMPG noted that there are “clear risks for companies” using social media, despite the great opportunities or potential they may hold. Risks from social media use include
- Threats to the control of confidential information or intellectual property,
- Increased levels of reputational risk (that develop at viral speed), and
- The potential for regulatory infractions.
“If a social media solution provider updates or changes its functionality policies, for instance, companies can be left with less control over community commentary, resulting in a reduced ability to maintain compliance in this rapidly expanding marketing area.” KPMG noted that in all uses of social media—whether Facebook, Twitter, etc.—the “sponsoring organization must remain vigilant about the content and tone of the messaging being generated by the audience in response to the organization’s intended message.”
“Consumers are more frequently turning to these channels to comment on the effectiveness of a product, and this could very likely develop into a mechanism for reporting adverse events. Therefore, the sponsoring organization must remain involved in the ongoing dialogue through carefully developed monitoring programs and moderation of comments being publicly captured in these social media applications.”
2011 marked the beginning of a four-year period during which patent protection for products with $120 billion in sales is being lost. Risks related to intellectual property protection and generic competition appear most frequently. Patent life also drives the need for R&D organizations to deliver sufficient products with potential to replace the revenue being lost to generic competition in the face of increasingly stringent regulatory requirements, which may result in failure. The worldwide pressure on pharmaceutical pricing in the face of tough economic conditions features frequently.
This is impacting individual company and market growth rates, exacerbated by economic crises, European austerity measures, pricing pressures and continuing healthcare reform in the US. Emerging markets that have been engines of both growth and shifts in global market dynamics have not been immune to some negative trends, particularly price reductions, although the extraordinary volume growth opportunity acts as a strong counterbalance. To a greater or lesser extent, these factors are disclosed as risks by the industry, together with many other well-known and some newly emerging factors.
US Patient Protection and Affordable Care Act of 2010
Eighty-seven percent of US filers and 83 percent of Foreign US Filers specifically identified the impact of the US Patient Protection and Affordable Care Act of 2010 as a risk to their businesses, although the language varied from the exact wording of the Act to “US healthcare reform in 2010”, “increased rebates,” “mandated contribution taxes,” and “other contributions to close the Medicare Part D coverage gap” were all cited.
Emerging market risk
Slightly less than a quarter of filing companies disclosed risks associated with strong growth from emerging markets. These risks included:
- The strong, often double-digit growth rates experienced in recent years may not continue.
- Some developing countries have reduced (or threatened to reduce) the duration of patent protection to facilitate early generic competition.
- Companies may not be able to realize the expected benefits of significant investments in emerging growth markets.
- There may be a relatively limited number of people with the skills and training suitable for employment in life science enterprises.
- Companies may be required to rely on third-party agents, which may put them at risk of liability.
- Many emerging countries have currencies that fluctuate substantially and should these currencies devalue without it being possible to offset the devaluations with price increases, products may become less profitable.
R&D pipeline disclosures
KMPG’s report noted that, “the approach to disclosure on R&D pipelines varied widely. Some companies have moved away from any discussion of early stage compounds, which makes sense given that early stage R&D has always had more failure than success, and that in the wake of a relatively disappointing decade for pharmaceutical R&D, the external world has become skeptical of early promise turning into actual revenue dollars. It seems that some of the industry is dealing with the rising risk in R&D by choosing to disclose less detail about their pipelines. For instance the mechanism of action of pipeline compounds is not readily revealed by a number of major companies, including some US companies.”
More than 80 percent of companies disclose the most recent pipeline information in a formal link on their website. Those that do not disclose pipeline information are some generic companies and foreign US filers. Disclosure of discontinued projects remains rare, with less than a quarter of companies making this explicit. Disclosure of the estimated return on R&D spending remains unique to GlaxoSmithKline.
There was a 30 percent increase in the disclosure of legal proceedings including adverse outcome of litigation and government investigations. In spite of extensive risk management input to board audit committees, there has been a rise in the number of settlements for violations of a variety of laws as exemplified by data from the US over the past 20 years with a very rapid rise since 2003. Since 2005, the annual value of the settlements has exceeded $1billion reaching $4.4 billion in 2009.
There were two noteworthy agreements reached with the US government over sales and marketing practices in late 2011. In November 2011 GlaxoSmithKline agreed in principle to a $3 billion settlement with the US government to conclude its most significant ongoing Federal investigations, two of which were related to sales and marketing practices: the investigation begun by the US Attorney’s office of Colorado in 2004 and the Department of Justice’s investigation of the development and marketing of Avandia. In December 2011 Merck agreed to pay US$950 million to settle criminal and civil charges with the US Department of Justice related to research, marketing and selling activities with respect to Vioxx.
Pharmaceutical companies are frequently involved in a number of legal proceedings and the disclosures regarding the resulting contingent liabilities vary from company to company. The majority of legal proceedings involve actions by US state or federal government, or US patent disputes. Disclosure by US filers and foreign filers is, therefore, typically substantially more lengthy than that of foreign filers. Legal risks include:
- 14% patents
- 42% product liability
- 26% sales and marketing
- 18% other
KPMG concluded that, “industry needs to reverse these trends to begin to win back confidence and trust from consumers and governments alike.”