Jeffrey Sonnenfeld is Senior Associate Dean for Leadership Studies at the Yale School of Management and Lester Crown Professor of Management Practice and co-author of FIRING BACK (Harvard Business School Press).
Distracted by the biotech sector’s promise of improving society’s health, some investors are ignoring unhealthy governance practices. Iconic financial institutions and revered investors are infected with biotech fever, and many have suspended their normal good judgment and have blessed unsavory practices at firms such as Mylan (MYL), Theranos, Valeant (VRX), and Turing Pharmaceuticals.
It is no accident that we are seeing a sudden rash of drugmaker duplicity. Profiteers eagerly exploit opportunities when markets are fueled by emotion, hope, and hype.
In the intoxicating days running up to the dot-com crash, many innovative firms soared as they disrupted the defensive old order. Those who challenged the hype were disparaged as neo-Luddites defending the past. Leading governance consultants wrote of “e- board governance,” a term used to differentiate this kind of structure from the traditional governance-oriented boards of established companies. Such new age board oversight tolerated venture capitalists serving on well more than a dozen boards; specious pro forma financial reporting; backdating stock options; booked barter deals; and other reckless practices.
Once again, a set of “new age” entrepreneurs is playing by their own questionable rules. As investors say “what the heck, biotech?” and grow discouraged by the sector, it is time for the market to cleanse itself.
Here is a rundown of the governance nightmares that are surfacing at these former stock market darlings.
Mylan’s Managers are Muzzling Shareholders
On Friday, Mylan lost a proxy fight with rival generic drug maker Perrigo to pursue a $26 billion takeover of the company. Despite its strong balance sheet, Perrigo was unable to counter Mylan’s hostile bid with a classic “PacMan” reverse offer. And Mylan’s chairman Robert Coury, who doesn’t even have a scant 1% stock ownership at his company, has made the firm his own barony through a maneuver that the SEC has since blocked from recurring.
The regulator said in late October that it would no longer allow a clever maneuver that transfers shareholders’ control of a company to entrenched management through the use of an arcane Dutch governance device called “stichting.” Mylan used the tactic this spring when they ratified the firm’s merger with Abbott Labs’ Netherlands-based generics operation, shifting the Pittsburgh company’s incorporation from the U.S. to the Netherlands. With this move, Mylan created a foundation called a “stichting” that basically allows the company’s chairman to control board compensation and decline any takeover offers. Thus Perrigo could not attempt a “PacMan” defense by purchasing its unwanted suitor.
In fact, Mylan shareholders now have no takeover premium if the company were to be acquired because of its legally protected, entrenched management. Fortune reported earlier that of the more than a dozen analysts, investors, and governance experts they polled, only one remembered ever reading about “stichting.” Using defensive governance tactics, Mylan resisted overtures from rival Teva, which had made a 48% premium bid this spring.
In late October, the SEC ruled that companies involved with acquisitions must put each change to its governance to a separate vote, rather than approve a merger and governance change in one fell swoop. “I have no doubt that, if given a second chance, shareholders would not approve Mylan’s governance changes,” Berkeley legal expert, Steven Davidoff Solomon wrote in last week’s New York Times. Mylan’s management now indicates they may allow such a vote at some future time.
Coury, who is a former benefits consultant, has helped transform Mylan from a regional drugmaker into a global generics force, and he has encountered little resistance from the board during his empire building. He even named Mylan’s massive 280,000-square-foot headquarters after himself. And the contracts of Coury and CEO Heather Bresch permit the two executives to use the company’s two jets for personal travel. Over barely three years, according to The Wall Street Journal, Coury charged up to $2 million in aviation expenses to the company, which included flights to support the electro-pop music career of his son, Tino.
Making governance matters more complicated, Mylan revealed on October 30 that it was the subject of an ongoing SEC investigation of improper reporting of possible conflicts of interest involving company real estate deals and their lead director.
Theranos Opts For Celebrity Over Substance
Theranos may very well be a maverick business that’s disrupting the established players in the world of blood testing, but there is a nagging fear it may turn out to be just another chapter in American healthcare’s long history of hucksterism.
The 19th century medicine shows featured charismatic pitchmen who made grandiose claims about magical elixirs that could cure all manner of ailments. Many wonder if Theranos founder Elizabeth Holmes was following in that tradition. Channeling the image of Apple’s Steve Jobs, sporting his trademark black turtleneck, Holmes electrified trade shows with exciting claims regarding a mysterious diagnostic technology for which supporting research was guarded due to intellectual property concerns.
Holmes, who dropped out of a Stanford engineering program to launch her business in 2003, invented a blood-testing process that requires only a few drops of blood from someone’s finger rather than the standard vein puncture that called for vials of blood. With $400 million in investment, the company valued itself as a $9 billion enterprise, making Holmes worth half that amount.
Theranos’ underlying technology was never subject to scientific scrutiny through the publication of its processes and results in peer-reviewed journals. Recently, Theranos promised to be more transparent about its technology. Last month, The Wall Street Journal revealed complaints from Theranos employees that most of the 235 tests the company offers are not performed using its revolutionary technology but rely instead on the standard equipment of competitors like Siemens.
Ian Gibbons, a British biochemist hired by Holmes to research systems that could process tiny quantities of fluids, was named on 23 of the firm’s patents over eight years of work. He committed suicide in 2013, reportedly telling his wife that the technology he helped develop didn’t work. Wired concluded Theranos had succumbed to Silicon Valley PR pressure and made promises beyond its capabilities.
Theranos strenuously denied these critiques and disparaged the motives of debunkers following an FDA inspection last in October. At the same time, it suspended the use of its heavily touted micro volume blood testing technique for all but one diagnostic test. A key driver of Theranos’ valuation was weakened through by these events. Walgreens halted the expansion of its partnership with Theranos last month, and reports this week indicated that a partnership between the company and Safeway was about to dissolve as well. Many fear that Theranos’ real business model is not based on a revolutionary blood testing technique, but simply somewhat cheaper blood collection through retail partnerships.
So, where has the board been during this mess? Several years ago, a handful of renowned chemical engineering and biotech experts suddenly left Theranos’ board, leaving a collection of retired diplomats, politicians, and soldiers to provide cover. There is much to admire about former Secretaries of State Henry Kissinger and George Shultz; former Secretary of Defense William Perry; former Senators Sam Nunn and Bill Frist; General James Mattis; and Admiral Gary Roughead, but you can’t rely on such public officials to weigh in knowledgeably about the development of new blood diagnostic methods.
As we have seen in previous governance failures, from Bernie Madoff to Enron, excessive use of marquee names is often a management tactic to take attention away from the problems in the core business model. In one of the most cynical frauds relying on marquee names, John Bennett founded the Foundation for New Era Philanthropy, a Ponzi scheme of pyramid donors who believed that a mysterious donor was doubling gifts given from 1980 through 1995. Hiding under the glistening endorsements of renowned financiers John Templeton and John Whitehead, 1,100 donors, scores of religious institutions, and venerated non-profits including The Boy Scouts of America, the Environmental Defense Fund, Haverford College, The University of Pennsylvania, Harvard University, Princeton University, Stanford University, Planned Parenthood, The Philadelphia Orchestra, the United Way, and The Nature Conservancy were defrauded of hundreds of millions of dollars. The scam was exposed when a determined accounting professor refused to be bullied by the endorsements and took his concerns to the Wall Street Journal.
Where the Value Went for Valeant
The halo effect of marquee name endorsements may have clouded investors’ judgment of Valeant Pharmaceuticals. The firm received high profile endorsements from “smart money” hedge fund investors like Pershing Square’s Bill Ackman for a biotech business model not built upon scientific research and discovery, nor upon less expensive drug distribution, but instead upon the acquisition of research-based pharma labs, the subsequent dismantling of those labs’ R&D operations, and massive price hikes of the valuable drugs previously developed by those acquired companies.
This controversial business model was pioneered by former McKinsey star CEO Michael Pearson. Was this destruction of research value really the best way to reward shareholders and society? Sure, Valeant cut research to less than 3% of revenues over the past five years for a total shareholder return of 354%. But over the same period, Gilead invested 10% in R&D and achieved a more impressive 450% return over the same period while Allergan invested 7.6% of revenues and reaped 471% return over five years. Even legacy pharmaceutical firm Eli Lilly has invested 24% of revenues in R&D and achieved an impressive 173% five-year return. Pfizer invested 14% of revenues and earned a 133% five-year return.
Nonetheless, Valeant became a Wall Street darling as its stock soared to $260 through a pile-up of 30 acquisitions of enterprises ranging from Salix for $12.5 billion to Bausch & Lomb for $8.7 billion. And it became a Canadian company along the way. Valeant’s growth was defined almost entirely by acquisitions, totaling $26.4 billion in purchases since 2010. Indeed, it bought 23 companies in just the last two years. These acquisitions were fueled by cheap debt and hyped stock prices. Only 19% of the capital comes from internal resources.
This juggernaut will not last. As Fortune’s Stephen Gandel summarized last week, “in the past month, allegations have surfaced that Valeant’s true success may have been built on something else: price gouging; a secret network of specialty pharmacies; and fraud.” Valeant CEO Michael Pearson has said that an internal investigation has yet to discover any instances of fraud or wrongdoing. Meanwhile, the company’s stock has fallen by 70%, from a high of $263.80 earlier this year to $73.32.
Years ago, investor Jim Chanos of Kynikos smelled a problem at Valeant, as did Andrew Left of Citron Research. The air really came rushing out of the balloon as The Wall Street Journal investigated Valeant’s covert controlling ties to a network of exclusive specialty pharmacies, replete with unrevealed business obligations, secret employee identities, disguised names, and misleading purposes.
Many knowledgeable pharma CEOs I spoke with over the past month have told me they long held suspicions about Valeant’s business model, beyond the Wall Street myth-making. But they expressed reluctance to raise issues, given the major financial titans who lined up behind the company. This is identical to what I heard from the CEOs of the nation’s leading telecoms 15 years ago, who were unable to figure out how WorldCom’s business model actually worked.
Turing’s Price Gouging
Valeant and Mylan have come under fire for allegedly exploiting opportunities for drug profits. Valeant, for example, this year pumped up its prices on old heart drugs Isuprel and Nitropress by 525% and 212%, respectively. Meanwhile, Mylan has seized opportunities to increases prices of old generic drugs like its workhorse antibiotic doxycycline, whose price rose to $1,849 a bottle in April 2014, up from just $20 in October 2013.
These moves, however, pale in comparison to what has happened to Daraprim, a 62-year-old drug used to treat malaria and toxoplamsmosis, which was jacked up by 5455% this fall, just one month after Turing Pharmaceuticals CEO Martin Shkreli acquired the remedy from Impax Laboratories for $55 million. The price of the drug, which is frequently used by HIV patients, jumped from $14.50 to $750 a pill. Shkreili is under investigation by the U.S. Justice Department related to his conduct while leading a different drug maker.
The biotech world has found its voice in this fiasco. In a recent survey of biotech leaders conducted by BioSpace, 92% said that Turing’s price increases were not justified. The Biotechnology Industry Organization recently voted to remove Turing Pharmaceuticals as a member, and the trade group PhRMA has similarly condemned the firm. The market may have corrected this problem already: San Diego-based Imprimis Pharmaceuticals reported this October that it could offer a similar version of the drug for $1 a pill.
There are plenty of lessons from biotech’s fall. Most importantly, business leaders and boards need to have the courage to ask hard questions. Sometimes emperors truly are naked—regardless of the momentum of their stock, the prominent names behind them, and the mysterious power of their business models.
The biotech industry is founded on trust. In 1986, I spoke with Jim Burke of Johnson & Johnson about his company’s recovery from the Tylenol poisonings: “We were cashing in on 100 years of trust that had been built up. All of the previous managements who built this corporation handed us on a silver platter the most powerful tool you could possibly have. The thing that worries me most is that people don’t understand that institutional trust, which is real, palpable, and bankable. So that every act that builds that trust enhances the long-term value of that business, and every time you put a product that is inferior or an improper payment, you destroy that trust.”
Mylan’s governance shenanigans, Theranos’ technology troubles, Valeant’s mystery partnerships, and Turing’s price gouging do not encourage such trust.