By Professor John Coffee, the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance
Next only to Volkswagen’s test evasions, the corporate behaviour that has most shocked and mystified observers in 2015 has been the series of drug price spikes engineered by a small number of pharmaceutical companies.
Exhibit A shows the pattern: one drug company acquires another and increases the latter’s drug prices by as much as 90 times. For example, in Exhibit A, Doxycycline jumps from $20 per bottle to $1,849, which is a 90-fold increase.
But there was more here than just price-gouging. First, prices skyrocketed only after the original drug producer is acquired and the acquirer usually shuts down or sharply curtails the operations of the acquired firm, focussing only on milking the potential profit from its existing products. For Valeant Pharmaceuticals, this became its basic modus operandi. A research report issued by a security analyst at Needham & Co found that, between 2011 and 2014, Valeant raised its list price on a drug by at least 20 per cent some 122 times. But it was only getting started back then. In late 2014 and 2015, Valeant took this business model into hyperspace, buying companies and raising prices into the stratosphere, as Exhibit B shows.
For example, in early 2015, Valeant catapulted the list price of Isuprel, a heart drug that it had just acquired, from $4,489 to $36,811 for 25 ampules – more than an 800 per cent increase. The stock market loved Valeant’s aggressive pricing and its stock price more than doubled, rising to over $260 per share by the summer of 2015.
But how did Valeant do this? Generally, it is not that easy to raise prices so astronomically. If a drug has no real competitor or substitute, a producer can exploit its monopoly power and this may have sometimes occurred. Nonetheless, the more common means to this same end was to hide from consumers the fact that generic substitutes were available. Valeant exploited this technique by using a nominally independent but actually very captured, electronic pharmacy, Philidor RX Services, which seems to have been dedicated to servicing Valeant. Philidor did not alert consumers to the availability of generic substitutes, and it agreed to seek reimbursement, itself, from insurers for Valeant’s inflated prices (so that customers had little reason to seek the best price). Until recently, no one knew that Valeant held an option to buy Philidor’s stock or that Valeant already consolidated Philidor’s financial results with its own financial statements. Had the market known that Philidor was the captured agent of Valeant, everyone (and especially the insurers) would have protested Philidor’s persistent refusal to use generic substitutes.
The Philidor disclosure shocked the market and more bad news quickly followed on its heels. The US Department of Justice announced that grand juries in New York and Boston were investigating whether Valeant had engaged in illegal price discrimination by offering discounts off the list price to favoured customers. Short sellers also alleged that Valeant had manipulated its financial statements by engaging in ‘channel stuffing’ with its retailers and Congress scheduled hearings into the industry’s pricing practices. The impact on Valeant’s stock price was foreseeable and dramatic: it has recently tumbled more than two-thirds from its high in 2015.
Where were Valeant’s board and major shareholders during all this? Here, we come to the heart of the matter. Valeant has a unique ownership structure, with large blocks of its stock held by activist hedge funds. One of these, ValueAct Capital, has a seat on its board and William Ackman, the CEO of Pershing Square Capital, became Valeant’s chief defender and virtual spokesman during its recent crisis, calling Valeant’s CEO “the most shareholder-friendly” chief executive that he knew. The Sequoia Fund, a large open-end mutual fund and Valeant’s largest shareholder, held so large a block that two of its outside directors resigned in protest when they learned of the size of the block (and Sequoia has subsequently experienced a reported 30 per cent decline in its own value, based largely on its overweighted position in Valeant). “The Department of Justice announced grand juries were investigating whether Valeant had engaged in illegal price discrimination”
“The Department of Justice announced grand juries were investigating whether Valeant had engaged in illegal price discrimination”
All these activists loved Valeant and its slash-and-burn strategy of acquiring other firms to milk their existing products, while suspending most research and development and laying off many of the employees. That tactic, just like Valeant’s pricing policies, seemed to maximise shareholder value – at least in the short-run. This may seem to bring us back to the standard debate over ‘short-termism’– but there is a significant difference. It is one thing to seek to maximise profits in the short-run (at worst, this is imprudent, not criminal), but quite another to maximise short-term profits by accepting long-term liabilities that will eventually come home to roost.
In common, both Valeant and the packagers of the asset-backed securitisations that underlay the 2008-2009 financial crisis appear to have made this same pact with the devil: take the money and run, while ignoring the longer term liabilities. Eventually, the toxic securitisations of the bubble era of 2005-2007 did default but the short-run fees were immense (and the investment bankers largely escaped the consequences when the inevitable collapse came). In the case of the recent drug spikes, it should have been foreseeable that astronomic price increases would produce outrage, investigations and reputational damage. Once, this risk would have caused most boards to exercise restraint. Indeed, it probably would still deter most boards.
But there are companies – like Valeant – that see the world differently and have less interest in long-term risks. Academic research suggests that the investment horizon of the firm is a function of the composition of its shareholders. The more that the shareholders consist of actively trading investors, the shorter the firm’s investment horizon tends to be. These actively-trading shareholders also seem able to repress long-term risks (perhaps because they do not expect to be around then). Valeant appears to be the paradigm of such a firm, dominated as it was by hedge funds and active traders, who could repress the long-term risks. Its focus on the short-term has been its most distinctive characteristic. One symptomatic piece of evidence is its disregard for research and development. The Wall Street Journal recently reported that, research and development expenditures at the pharmaceutical giants – Bristol-Myers Squibb, Merck and Pfizer – came to 27.8 per cent, 15 per cent and 14.2 per cent of their sales, respectively but research and development spending at Valeant amounted to only 3.6 per cent of its sales. Seemingly, Valeant thinks the long-run is for wimps.
What we now have learned is that such an attitude co-exists very easily with disrespect for legal and reputational risks. We do not yet know if Valeant broke the law, but a jury can easily reach a verdict today on whether it lacked common sense.
Revealingly, the major mutual funds that focus on pharmaceutical and health care stocks avoided Valeant, refusing to hold it in their portfolios, while hedge funds loaded up on the stock. For a time, these mutual funds paid a price, but now their prudence has been rewarded.
Perhaps, it is socially desirable that hedge fund and the other short-term investors who piled into Valeant’s stock this year lost their shirts. It may deter them from investing in future Valeants. But that seems unduly optimistic. Pershing Square just announced that it has raised its stake in Valeant to 9.9 per cent. Many hedge funds are obsessed with the short-run, because they know that their own investors expect high returns and can exit the fund, withdrawing their capital if they do not receive them. Also, hedge fund managers are compensated on a basis that focusses them on the short-run. Given these incentives, they will persist in their current behaviour.
The problem is that these short-term investors can often muster a temporary majority of a company’s shareholders, even though they plan to exit the firm in the near future.
In the past, actively trading shareholders, who moved in and out of a stock, had little influence over corporate affairs; they were much like a new resident in a community who is not yet registered to vote and hence lacks political clout. Today, however, hedge fund activists are new residents who have great clout within the shareholder community from the day they appear on the scene.
Knitted together by proxy advisors and sharing information reciprocally, they can quickly assemble in a ‘wolfpack’ and announce a proxy contest to elect new directors – unless the board takes specified actions that they demand to maximise profits in the short-run. Although, in fairness, styles do differ among hedge funds (and some hold for the longer term), most typically exit the firm after an average holding period of around one year. The result is a temporary majority focussed on the short-run. All this implies that there may be more Valeants on the horizon that will both cut research and development to the bone and play fast and loose with their legal and moral responsibilities.
About the Author:
Professor John Coffee is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.