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New biotech clawback policies aren't very sharp

Monday, 28-April-2014

There must have been a corporate governance conference for biotech executives lately, or at least a white paper distributed throughout the industry, because I have noticed a handful of companies taking the same governance action over the last few weeks.  I was a little surprised the first time I saw it, but after four or five times, it all became too much of a coincidence.  There must be something going on.  What I am talking about is how the fashionable thing in biotech is to institute clawback policies all of a sudden.  Maybe you have noticed this happen at a company you invest in as well.


A clawback policy, if you have not heard the term, is a fancy way of saying to take money back from executives who have already been paid bonuses or large salaries when something goes wrong.  It was an especially common term on Wall Street after the banking crisis, because the government wanted to use clawbacks to recover some of the millions paid to executives who contributed to the downfall.  I am not sure how successful the government was in doing that (my guess is not very successful), but I also assumed it was something that would get straightened out and used more effectively over time.  Apparently, clawback euphoria has now hit biotech.


A good example of the industry’s foray into the concept is this 8-K filing Orexigen Therapeutics (Nasdaq: OREX) submitted to the SEC on Friday afternoon.  I am not intentionally picking on Orexigen, by the way.  They are a semi-large holding of mine, and I think the stock offers attractive risk/reward at current prices.  I also have nothing but good things to say about their management team.  I simply chose this filing because it is latest example I have seen.  So with that being said, the key sentence in Orexigen’s 8-K is the following:

“As set forth in the Policy, in the event that the Company is required to restate its financial statements as a result of fraud, intentional misconduct or gross negligence of any Officer, the Committee is authorized to recoup bonus and other incentive cash compensation awarded to or received by such Officer(s) during the 12-month period following the filing of the original financial statements.”

As you can see, a big problem with this particular clawback policy (all of the ones I have seen in biotech match it practically word-for-word) is that it only reaches as far as fraud and misconduct, which should be a given.  I certainly hope a company would automatically go after someone if the person cooked the books.  How is this not already a stated policy?  It is pretty sad, and very typical of biotech, when going after fraud is some huge step in the right direction. This reads more like a token gesture than the board actually looking out for shareholders.


With that in mind, I would like to point out what, in my experience as an investor, is by far the most common situation in biotech where a real clawback would be welcomed and warranted.  It has to do with failed drug launches.  I’ll bet I have seen a dozen times where a CEO gets a huge bonus and pay raise when a drug is approved, presides over the worst commercial launch possible, and then sells millions of dollars of stock while everything deteriorates in real time. Those cases are very frustrating because you sit there and watch a CEO actually get rewarded for destroying value. What almost always ends up happening in the end is that he or she leaves with riches in tow, and shareholders are left holding the bag.  The cherry on top is that your drug is usually way past the point of irreparable harm by then so good luck picking up the pieces.


In my opinion, a clawback would be highly appropriate in those types of cases because, while it is true that FDA approval is a big accomplishment, it is really only half the battle.  True value is not created in drug development by approval alone, but additionally by how much patients ultimately benefit from the product.  If you have the former down but underachieve at the latter, what have you really accomplished?  Unfortunately too many boards forget that it is commercial success and long-term value creation that matters.


Some boards will argue that this issue is already covered by compensation policies.  While "pay for performance" is a nice term, I haven’t seen many biotech companies ace the concept in practice.  The real measure of how effectively compensation was designed is not the good times, but these instances where launches have gone badly. It is funny how management almost always ends up okay either way.  That is why I think clawbacks are warranted in some cases. It is just common sense that someone shouldn’t walk away from a failed drug with tons of money.


The bottom line is that fraud and misconduct alone are not going to cut it if biotech companies want to convince shareholders that their clawback policy is for real.  While it is nice that the industry is starting to take a look at the issue, boards should go much further than they currently are doing.  Incorporate performance, watch out for failed drug launches, and align the clawback with shareholder interests just as you would with compensation.  Boards need to be more serious when setting these policies up if they want shareholders to think they are credible.

Who Am I?
Brad Loncar

I'm an individual investor from Kansas City.  My focus is on biotech stocks, but I enjoy investing in all industries. I'm an old-school, buy and hold investor who believes the best way to outperform and grow capital is to own innovative companies with good management teams over the long-term. more>>

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