What Litigation Risk Means for Big Pharma and Biotech Valuations
As we incorporate ESG factors into our analysis, we see a manageable headwind.
When Morningstar incorporated environmental, social, and governance factors into our valuation analysis of Big Pharma and Big Biotech, we focused on material ESG issues in the social realm, where we think these companies are exposed to the most ESG risk. Sustainalytics offers a comprehensive, industry-based approach to ESG risk, the starting point of our analysis. Morningstar has concluded that valuation-affecting ESG risk for branded drug companies centers on pricing risk (largely in the United States) and litigation risk (largely product safety-related). This article takes a closer look at litigation risk.
We combine our analysis of potential future legal charges related to product governance and business ethics into a single measure of litigation risk. Within product governance, the pharma and biotech subindustries hold Sustainalytics’ highest exposure scores due to their highly regulated nature and record of costly events related to unintended side effects, manufacturing issues, and false and deceptive marketing. Here we focus on company exposure to litigation risk from unintended consequences of drug use. Drugs can create side effects leading to increased warnings on labels, product recalls, and major litigation, especially in the U.S.
While media headlines tend to raise the visibility of drug recalls and safety issues, and legal teams are aggressively pursuing drug companies related to drug side effects, overall legal costs for drug companies tend to be fairly manageable relative to total profits. Litigation costs for the large drug companies over the past five years in aggregate have averaged approximately 3% of normalized income. This looks manageable, particularly given average net margins in the 20s to 30s for the large-cap drug and biotechnology companies.
In aggregate, the 18 large-cap drug and biotech companies under Morningstar coverage have paid nearly $4 billion a year on average in litigation fees from 2016 to 2020. However, company disclosures of legal fees are very ambiguous. We believe this is partially because drug companies don’t want to tip off other legal teams regarding likely payment amounts. While the legal fees also include patent infringement, off-label marketing, fraudulent activities, and several other nondisclosed items, we estimate close to half of the legal costs stem from settlements related to plaintiffs claiming side effects from drug use. We make this assumption based on cross-referencing nonliability legal charges from Good Jobs First data with the estimated total legal costs reported by companies. In years with high product liability costs, nonliability costs represented a small fraction of total litigation costs. However, obtaining specific estimates of product liability costs versus nonliability legal costs is difficult due to the lack of transparency.
While historical payments by drug companies are helpful to put product governance costs in perspective, future potential costs are the most important when thinking about ESG costs for drug companies. We believe drugs that are used chronically for less severe diseases have the biggest potential for side effects and increase product governance and litigation risks for drug companies. Over the past couple of decades, several very prominent drug recalls have resulted in major litigation costs and lost sales. The majority of drugs that have faced litigation fit with our analysis, representing chronic, less severe diseases.
Beyond the highest-profile cases of product litigation, many drug companies face legal costs related to side effects for lesser-known issues. While drug companies put drugs through extensive clinical studies, some drugs reach the market with a side effect profile that is not fully known or documented in the prescribing label. As patients take newly launched drugs, unknown safety issues can arise. Even though safety issues might be related to other factors such as the underlying disease, in some cases the drug is causing side effects that were not fully communicated to the healthcare community, which opens up the drug company to litigation.
Besides the litigation around manageable side effects, in extreme cases, product withdrawals occur due to major unacceptable side effects. These withdrawals can not only lead to likely heavy settlement costs, but also cause a company to lose future potential sales from the withdrawn drug and create brand damage on other products while hurting the focus of the parent company. The withdrawn product also reduces the return on the large amount invested in research and development.
The legal system (especially in the U.S.) has a structure that offers strong financial incentives to legal teams to support patients hurt by unexpected side effects. These financial incentives run as high as allocating the plaintiff legal team a third or more of the settlement amounts. As a result, in the U.S., legal groups actively recruit plaintiffs, as shown by the $400 million-plus spent by trial lawyers in the first half of 2019 on advertising potential side effects of products, hoping to entice patients into class-action lawsuits. Beyond the active marketing by lawyers looking for plaintiffs, media headlines tend to draw significant attention to drug side effects, and this heightened attention can affect jury decisions. For example, in one of the larger drug cases involving potential side effects of pain drug Vioxx, one of the initial awards ruled Merck (MRK) liable for $253 million due to a potential Vioxx-related death. With 27,000 cases ultimately outstanding against Merck, extrapolating these damages to the entire plaintiff set would have bankrupted the company. However, the case was overturned on appeal, which also happened with several other Vioxx cases. Nevertheless, media headlines often prioritize calling out the major litigation costs facing drug companies when initial outsize awards are declared by the court.
We believe drugs used chronically open up more side effect litigation challenges than drugs used acutely. While some clinical studies evaluate drug safety for many years, some drugs are taken for decades in practice, opening up side effects that couldn’t be fully elucidated in clinical studies. Historically, the chronic therapeutic areas of cardiometabolic and neurological disease have led to large settlement payments.
However, outcome-based studies are mitigating concerns about chronic drug treatment. Following questionable surrogate endpoints in several cardiometabolic studies in the early 2000s, regulators and payers began pushing drug companies to run studies with hard endpoints such as overall survival. These studies tend to be longer and help neutralize the potential side effect litigation by showing the strong efficacy and surfacing more potential side effects.
In severe diseases, drug treatment typically is shorter, reducing the potential for off-target effects compounded over time. Also, the severity of the disease itself can lead to debilitating side effects or death, making other side effects less concerning. Drugs treating cancer and severe immunology diseases tend to have significant side effects. However, relative to the disease burden, the side effects are less significant.
Legal requirements limit drug companies to marketing drugs according to labels approved by regulatory agencies. However, doctors are free to prescribe drugs for a range of indications not approved in a drug’s label, and insurance companies can reimburse drug costs regardless of how the drug is used. This dynamic has created conflicts for drug companies, which historically wanted to maximize drug sales and were tempted to push drug sales in areas not approved. However, following a massive amount of fees paid by the industry during 2009-12, we believe drug companies now provide much stricter messaging, promoting drugs only to their approved labels. While this will probably continue to be a product governance concern, we believe the heavy historical fees associated with breaking this rule will limit the amount of fees in the future.
Business ethics encompasses a wide range of anticompetitive activities. Sustainalytics’ approach to exposure starts at the subindustry level, and while this can be adjusted for individual companies (with beta indicators), biotech and pharma companies generally see medium exposure on business ethics. Medium risk exposure derives from the fact that pharmaceuticals is a heavily regulated industry; as such, companies are subject to scrutiny on tax and anticompetitive practices, intellectual property rights, and ethical conduct related to product development, animal testing, and clinical trials.
Morningstar’s approach is centered on the company level, and we see exposure to business ethics risk as varying from company to company. Legal charges are the central way that business ethics issues affect our valuation, and while we’ve estimated that roughly half of legal charges are tied to business ethics (as opposed to product governance), company disclosures often make it difficult to tease the two apart.
When a branded drug begins to see patents expire, its company can establish a settlement with a generic company, allowing the latter to launch a generic with the promise that the launch will be delayed for a specified period. Historically, these settlements could include payments to the generic company and became known as pay-for-delay agreements. The Federal Trade Commission has argued that pay-for-delay was costing patients $3.5 billion annually. However, the number of settlements involving potential pay-for-delay has dropped since a 2013 Supreme Court ruling in favor of the FTC over Actavis, which concluded that these reverse settlements can violate antitrust law and be challenged in court. This culminated in a high-profile victory for the FTC against parent Teva (TEVA), which paid $1.2 billion to settle pay-for-delay charges for sleeping pill Provigil in 2015.
An FTC report noted that of the 232 patent settlements between branded and generic companies in 2016, 30 included explicit payment in the form of payment for the generic company’s legal fees (up to $7 million). Only one of these 30 included compensation beyond reimbursement of the generic company’s legal fees, and this was in the form of a promise not to launch an authorized generic for a certain period. However, 14 of the settlements in 2016 were deemed to include “possible compensation” to the generic company, so drug companies could be getting better at compensating generic entrants indirectly.
Several companies have been party to high-profile battles over intellectual property for key portfolio drugs. Outcomes can include up-front payments and annual royalty payments; in a massive settlement on PD-1 antibody patents, for example, Merck agreed to pay Bristol (BMY) and partner Ono (OPHLY) $625 million up front and single-digit royalties on Keytruda, which competes with Bristol/Ono’s Opdivo. A jury awarded Merck $2.54 billion as part of a hepatitis C drug patent fight with Gilead (GILD), but this ruling has since been overturned. One older notable settlement occurred in 2005 between GlaxoSmithKline (GSK) and Merck regarding HPV vaccine patent rights; Merck paid Glaxo an up-front payment and royalties as part of the deal. Glaxo’s Cervarix was never quite as strong a competitor as Merck’s Gardasil, and it was pulled from the U.S. market in 2016, giving Gardasil a monopoly. Because of the difficulty of parsing historical patents and determining which company was the innovator and if infringement occurred, we don’t model a valuation impact from future potential patent infringement settlements, and we don’t see any company that has established a record of historical infringement that affects our view of its prospects.
In addition to colluding with generic companies to keep branded drug prices high, drug companies can collude with their branded peers, particularly in markets with only two or three key competitors. Insulin players Sanofi (SNY), Eli Lilly (LLY), and Novo Nordisk (NVO) are being investigated for possible collusion on insulin price increases in the U.S. At a congressional hearing on the topic in April 2019, Sanofi blamed the U.S. drug rebate system for high insulin prices, saying that net prices for its long-acting insulin Lantus had fallen more than 30% since 2012, but out-of-pocket costs for patients increased 60% over this period due to list price increases. While recent net prices for insulin have fallen, this was largely due to biosimilar competition from Lilly’s Basaglar and doesn’t erase Novo’s and Sanofi’s shared history of double-digit annual price increases for long-acting insulins Lantus and Levemir ahead of Basaglar’s launch in late 2016. We think other markets with histories of large price increases, including multiple sclerosis and rheumatoid arthritis, could be at risk for future investigation, hitting companies like Biogen (BIIB), Amgen (AMGN), and AbbVie (ABBV) on business ethics, although there could be enough differentiation among these therapies to argue that the price increases are more independent than in the case of insulin. Price increases also affect our assessment of ESG pricing risk, as significant annual net price increases are a red flag for abuse of pricing power.
In 2018, the Food and Drug Administration released a list of drugs for which it had received inquiries from generic companies, which were struggling to gain access to branded drugs for the required bioequivalence testing. This list includes several drugs from some of the Big Pharma and Big Biotech names we cover. While these companies probably effectively delayed generics by denying access for required tests, we don’t expect changes here to have a significant impact on our valuations, as these drugs are generally older therapies where we include generic competition following patent expiration. Many of these drugs are protected under a risk evaluation and mitigation strategy, which has made it more difficult to gain access to a drug due to safety reasons.
With the passage of the CREATES Act in December 2019, we expect access to improve and REMS-associated protection from generic competition to decline. However, the Congressional Budget Office has estimated this will save only $3.7 billion over a decade, resulting in a relatively minimal impact on the industry and no changes to our valuations.
Donations to nonprofit foundations or patient advocacy groups can help patients afford expensive drugs. This indirect form of patient assistance can be used to help Medicare patients, as companies are not allowed to offer direct copay assistance to those with government-sponsored insurance. However, if the nonprofit is directing patients to the company’s drugs over those from competitors, this can trigger kickback-related legal fees and settlements. We base our assessments of the ethics surrounding nonprofit donations on past settlements and current investigations, as our visibility on the legality of recent donations is quite low. For example, Bloomberg Government reported that six major drug companies donated $680 million to nonprofits in 2018, more than double the $321 million in 2015, but a significant amount of this increase was due to a $350 million program at AbbVie that directed some of the company's tailwind from tax reform to charities that are unlikely to be tied to patient assistance programs, like Habitat for Humanity and Ronald McDonald House.
Investigations into drug company relationships with charities largely began in late 2015. Over the next couple of years, Johnson & Johnson (JNJ), Pfizer (PFE), Biogen, Celgene, and Gilead all received subpoenas from the Department of Justice relating to their donations to patient assistance groups. We saw a large settlement in late 2018 with the Justice Department regarding pulmonary arterial hypertension products, which J&J had recently acquired with Actelion. J&J paid $360 million for payments that ended up supporting Medicare patients taking these therapies. Smaller settlements, such as Pfizer’s $24 million payment related to cancer drugs Sutent and Inlyta and cardiovascular drug Tikosyn, as well as Amgen’s $25 million payment for Medicare support for Sensipar and Kyprolis payments, were insignificant to the companies’ cash flows.
Beyond settlements, the charity arrangements can create pressure on drug sales; government scrutiny of prostate drug charities led to sales declines for prostate drugs Xtandi (Pfizer) and Zytiga (J&J) in 2017. Given the large number of ongoing investigations, we think there could be future settlements and pressure on sales, but we expect that all drug companies are probably reducing these contributions to avoid further scrutiny. In addition, settlements with charitable organizations are likely to encourage improved independence from drug companies. For example, The Assistance Fund recently paid $4 million to settle Justice Department allegations that it allowed Teva, Novartis, and Biogen to essentially direct copay funding to Medicare patients for their multiple sclerosis drugs, and the Chronic Disease Fund and Patient Access Network Foundation also settled kickback allegations.
Beyond donations to nonprofits, drug companies also pay significant sums for lobbying in Washington, D.C. The pharma and health products industry spends the most on lobbying of any industry, according to OpenSecrets, with nearly $284 million in spending in 2018 (8.2% of all lobbying costs). This is up significantly over the past several years, as drug pricing reform has become more likely, but is similar to 2009 spending levels ahead of the Affordable Care Act. According to OpenSecrets, pharma and biotech trade groups PhRMA and BIO typically spend the most, but large-cap drug companies including Pfizer, Amgen, Roche (RHHBY), and J&J are typically among the biggest lobbying spenders for individual companies, at several million dollars a year each. We think it’s helpful to be aware of this spending but do not assign any penalties on valuation due to lobbying.
Several Big Pharma and Big Biotech companies either current rely or are likely to rely on the China market for sales growth. As sales expand in this market, companies could see increased exposure to the risk of bribery or corruption charges. Glaxo is the highest-profile example of this risk, as China fined Glaxo $489 million in 2014 for bribing health officials over 2010-13. Companies are also seeing exposure due to violations of a U.S. federal law, the Foreign Corrupt Practices Act, but these payments have so far been much smaller in scale. For example, Securities and Exchange Commission investigations of bribery in China resulted in a payment from Bristol ($14 million) in 2015, and from Glaxo ($20 million), Novartis ($25 million), and Astra ($6 million) in 2016. Sanofi paid $25 million in 2018 tied to bribery charges in the Middle East. Overall, we think the wave of payments on FCPA violations has probably passed, but a history of corruption charges weighs on our outlook for these companies.
Damien Conover does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.