Acquisitions of U.S. Pharmaceutical/Health Care Companies: A Health Regulatory Focus

May 21, 2009

Panelists:
Scott Minars, Partner, Merger & Acquisition Services, Deloitte & Touche LLP
Lynn Shapiro Snyder, Member of the Firm; Co-Chair, Health Care Fraud Practice Group; Chair, Third Party Payment Practice Group, Epstein Becker & Green P.C.

Moderator:
Michael Levine, Member of the Firm; Head of CSR/Sustainability Practice, Epstein Becker & Green P.C.

A distinguished panel of business and legal specialists met to discuss regulatory trends in health care and life sciences and their impact on Japanese acquisitions of U.S. health care companies.

In the M&A landscape overall, the number of deals declined in 2008 as the financial crisis cut back on funding available to private-equity investors, said panelist Scott Minars of Deloitte. Nevertheless, Japanese in-out transactions--deals between a Japanese buyer and a non-Japanese seller--remained significant. Indeed, the value of all such transactions last year was greater than the total value of domestic transactions within Japan.

These statistics reflect several major pharmaceutical and health care transactions, including Takeda's acquisition of Millennium and Daiichi Sankyo's purchase of Ranbaxy. Just this week, Takeda announced its deal for biotech firm IDM Pharma, and Shionogi announced that its Sciele Pharma unit, acquired last year, would buy Victory Pharma, a private firm that specializes in medications for pain.

Not every Japanese health care acquirer ended up with a happy story, Mr. Minars noted. Daiichi Sankyo's Ranbaxy deal represents the lure of emerging markets, but the deal did not go well post-closing, as the Indian generic-drugs company faced FDA concerns about its manufacturing process. Ultimately a number of Ranbaxy products were barred from sale in the U.S., forcing writedowns. In another disappointment, Astellas withdrew its unsolicited tender offer for CV Therapeutics, which makes cardiovascular and related drugs, after CV found a white-knight buyer in Gilead Sciences.

The major issue driving a lot of the activity in pharmaceutical M&A is the impending expiration of patent protections on many big-name drugs; simply put, "they need to fill the pipeline," he said. Generics are gaining ground, and there's pressure on the health care industry as a whole to make products and services more affordable. Big companies hope that acquisitions will allow them to identify Phase I and Phase II candidates in a more cost-effective way than the in-house R&D process, which can take 10 or 15 years and cost hundreds of millions of dollars for a single drug. The small biotech firms, meanwhile, are starved for cash, with funding in the sector at a 10-year low. They're "not quite throwing themselves into the arms of a pharmaceutical company, but certainly willing to look at being acquired" to keep their programs going.

A decade ago, harmonization of technical standards allowed more foreign competition into Japan's pharmaceutical market, Mr. Minars concluded. Today, it's the Japanese industry that's expanding beyond domestic horizons and becoming competitive on a global basis.

Doing due diligence in pharmaceutical M&A involves a host of regulatory issues, from FDA rules to HIPAA privacy regulations and anti-kickback statutes, said Lynn Shapiro Snyder of Epstein Becker & Green. The health care team reviews FDA filings and reports on products, some currently marketed, some in clinical trials, and others under development. If research protocols for a clinical trial being conducted at a hospital have changed since the original application to the hospital's institutional review board, the team checks to see if the company has gone back and amended the original IRB submission. "We've had situations where during the due diligence we find out that they kind of took a left turn and forget to tell the IRB, and we have to clean it up. It doesn't mean it's fatal to the deal. It's just the matter of making sure that the day after your client owns the company, what we find gets fixed," she said.

In manufacturing and distribution, compliance issues can arise in a range of contexts, from the FDA's Good Manufacturing Practices (GMP) to Drug Enforcement Administration rules mandating change of ownership filings for makers of narcotics and other controlled substances. Contracts with third parties in the distribution chain, including pharmacy-benefit managers such as Medco and CVS Caremark, may provide for termination upon a change of control, which could complicate negotiations for companies planning an acquisition.

Marketing practices are another important arena for due-diligence review, Ms. Snyder noted. Although doctors are free to prescribe a drug for an off-label use, for example, pharmaceutical companies can't lawfully promote drugs for uses not covered in the approved FDA labeling unless they do new studies and go back to the FDA for approval so the labeling can be changed. This became a big issue for Pfizer in the course of its acquisition of Warner-Lambert, when the FDA charged that Warner-Lambert was promoting its epilepsy drug Neurontin for migraines and other illnesses not within the labeling approved FDA prescribing information.

Under the Medicaid program, which subsidizes health care for people too poor to afford to pay on their own, pharmaceutical firms owe rebates to the government based on the difference between their "best price," in the case of brand-name products, or the statutory price, in the case of generics, and the price at which they actually sold their products, she continued. This system requires participating companies to file quarterly reports on product prices. Historically, problems arise when companies make kickback payments to their customers. The filing itself may be accurate as far as it goes, "but the enforcers are going to say that the kickback that you gave was really an undisclosed discount, and it would have broken best price, and therefore for every transaction in America you owe me this much more per pill."

Activities that may give rise to violations of the Federal Anti-Kickback Statute and related state laws include financial relationships with customers, formularies, physicians and sales agents, she said. Kickback issues come up not only in the way discounts are priced, but also in the structure of product support services, educational grants and research funding. They may take the form of consulting payments to physicians and other referral sources, payments for meals and other business courtesies, and honoraria for speakers.

The Federal False Claims Act, applicable to Medicare and other government-paid health care programs as well as to Medicaid, provides that those who submit false bills to the government can be held liable for triple damages plus fines and penalties. And it's not just the regulators who can pursue violations, Ms. Snyder cautioned. Qui tam suits, which derive their name from a Latin phrase that dates back to medieval English law, allow private persons to bring fraud actions on behalf of the government and to share in any recovery. "There is a private bar and there are some whistleblowers that are professional whistleblowers" who "bring repetitive cases across multiple manufacturers on the same allegations," she said. "Very often the companies settle not because they couldn't win in court," but because a loss can mean "exclusion and debarment--if you lose in court, your products no longer enjoy coverage under Medicaid and Medicare, and the drug companies can't afford to not have their products covered."

Generally speaking, companies that do business with the federal government are encouraged to have a corporate compliance program that includes a written code of conduct, training programs, a hotline for staffers to report complaints anonymously, and a monitoring and auditing function overseen by the company's board of directors and corporate compliance officer, Ms. Snyder said. The monitoring process may even involve having the company's compliance officers accompany sales reps on the job to see if they are promoting the products appropriately.

"The government wants to know that when you find non-compliant behavior you don't have what I call decision paralysis," she added; firms must show that they "have the courage and the discipline to terminate or sanction" employees who break the rules, even if they're the company's top-selling salespeople.

Even tougher than federal law in some respects is the voluntary code of conduct drawn up by PhRMA, the Pharmaceutical Research and Manufacturers of America, a trade organization that represents brand-name pharmaceutical firms, she said. The organization's Code on Interactions with Healthcare Professionals, which has been adopted by most manufacturers in the sector, bans entertainment and recreation and limits support for continuing medical education and third-party educational and professional meetings.

PhRMA principles allow companies to provide medical professionals with modest meals at in-office and in-hospital meetings, but not restaurant meals. State laws may be more stringent still. Disclosure laws adopted in the state of Vermont provide that "you have to disclose everything that a physician even eats that comes from a pharmaceutical manufacturer's promotional activities, because historically the sales reps have been providing food at lunchtime in order to promote the product during the lunch hour," Ms. Snyder observed. "The time and effort to disclose it may mean that a company may just throw up its hands and say we're just not going to do it."

Health care and life sciences companies, like companies in other industries, are learning that in the realm of corporate social responsibility and sustainability, action speaks louder than words, suggested Michael Levine, a partner of Ms. Snyder at Epstein Becker & Green. Signing onto a CSR program such as the Private Equity Council's Guidelines for Responsible Investment, is a worthy first step, but failing to deliver on those promises may get you into deeper trouble. Public pension funds like CalPERS and NYCERS, the New York City Employee Retirement System, "are now actively policing" whether the funds in which they invest are complying with the standards they've signed onto. "Private equity is on the hot seat a little bit with this administration, you might say, and stakeholders will be looking for any sort of means to direct further attention onto them as a means of leverage against them."

Thus medical device companies are auditing suppliers to assess not only the quality of the work product, but also the quality of the production process and the quality of supervision. "You want to know that the suppliers have tools and knowledge to achieve higher levels of compliance so you're not forced to go to them constantly to look at them and to see what they're doing." And when problems are found, the matter can't end there: "you have to take action to remediate non-compliance."

There are a number of sources for standards in CSR and sustainability, Mr. Levine noted. Some, like the United Nations Global Compact, apply broadly across industries; others are narrower in scope, including the Private Equity Council's guidelines as well as the Equator Principles, a set of environmental and social benchmarks developed by the financial services industry for the project finance sector.

Socially responsible funds have served a niche market among mutual fund investors for many years, "but now we've seen recently that even the huge mutual funds like Vanguard and Fidelity" are screening portfolio companies based on social criteria, "in large part because of pressure that they received related to Darfur," he said.

"The business case here is you want to protect your investment. You’re spending a lot of money, and you have a brand that is important to protect" against activist shareholder pressures as against increased regulation, litigation, investigation and prosecution. The Second Circuit Court of Appeals recently allowed a group of plaintiffs to proceed in a case against Pfizer alleging that the company had acted in concert with the Nigerian government to conduct tests on an experimental drug without informed consent. "Nothing happened here in the United States," yet the case was sent back to district court for trial. "An important issue in this case is probably not ultimately the liability that you face"--Pfizer has denied the allegations, and there are procedural issues--but "the reputational injury that your company may suffer. And these cases are very vigorously followed by stakeholders with a big interest in this area."

Putting standards in place and being vigilant about enforcing them "will really matter on judgment day, because when the federal government, the Department of Justice, investigates you, or if you're before a judge on sentencing, they're going to look under the organizational sentencing guidelines to see whether you have an effective compliance program, whether your company has an ethical corporate culture and a respect for the rule of law," Mr. Levine concluded. "It will be great if you signed up for these programs," but "the government has said expressly that it will disfavor a paper program" that pays lip service to compliance but is not backed up by documented action.

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Q&A from the audience followed.

My understanding is that Ranbaxy's plant had received several Form 483 violations from the FDA before Daiichi Sankyo bought the company. When the situation escalated after the acquisition was completed, was that just bad luck, or could Daiichi Sankyo have protected itself better in this case?

Without commenting on that particular situation, Ms. Snyder said, it's not rare for pharmaceutical firms that are entering into a deal to have 483s, which are forms filed after an FDA plant inspection listing deficiencies and potential violations of the FDA's GMPs, or good manufacturing practices. "What we try and do is to take a look at how many there are, how serious they are, how many are repetitive, and this is just a piece of a bigger puzzle"; "then it's up to the business people to decide what to do next."

What are some of the major challenges for Japanese health care companies after the deal closes?

"The major challenge, not only in the pharmaceutical and health care sector but for any business, is culture," Mr. Minars said. "A Japanese company may have a much different perspective in terms of the management structure and the decision-making process, which can be quite frustrating" to management of the acquired company as companies try to integrate in an optimal fashion following an acquisition. Acquirers struggle with how best to measure synergies and how much autonomy to give the new subsidiary.

There's lots of competition for U.S. companies from generic drugs, and this will only grow as patents expire on big-name drugs in the next two or three years. Why are Japanese companies continuing to do acquisitions in this challenging environment?

It's based on individual company strategies, Mr. Minars said. Shionogi is doing the deal with Victory Pharma to acquire Victory's U.S. sales force. Other companies are looking to expand in a particular sector, for example oncology. "Each company has its own unique story, and it's important to evaluate the target company and see what the commitments" and restrictions are as well as the potential upside. The target may have already sold the rights to market a drug in a particular region, whether Europe or Asia or South America; there may be restrictions in co-development agreements for R&D with a third party.

The U.S. is a big market with an aging population, and "we still have a large number of people who do not have drug coverage who pay out of pocket," Ms. Snyder commented.

Will the efforts in Washington to reform the health care system have a chilling effect on deals?

"To some extent yes, because there is always a certain uncertainty," Mr. Minars replied. Yet the central goal of the reforms is to reduce costs, and so it's given impetus to some of these consolidations because of their potential for huge economies of scale.

"The more you can have a sales force that has 10 products in their bag visiting a doctor as opposed to five, the more you can survive and have more profitability," agreed Ms. Snyder. In her view, there will be some legislation by the end of the year, and "a greater flurry" in deals during the first quarter of 2010.

One area that will surely see an increase in transactions is health care information technology, which both saves costs and improves compliance, Mr. Minars added.

--Katherine Hyde