A Response and an observation to big pharma scandal

by Daniel R. Hoffman, Ph.D.

Published Sep. 19, 2013, 6:00 a.m. ET

An astute reader shared his view of last week's posting that discussed the scandal involving pharma companies allegedly bribing Chinese physicians and administrators. He made the point that in most industries, paying marketing-sales people on the basis of sales volume will make them eventually gravitate toward bribery and other malfeasance. That tendency, in his view, applies particularly in situations that are either under-regulated or poorly supervised. Given the reader's perspective that the very nature of marketing-sales impels them toward rigging the game to hype sales, he feels that criticizing marketers for such behavior makes as little sense as disparaging a dog for barking.

Although the reader's viewpoint is open to disagreement on ethical grounds, the institutional pressures he mentions certainly ring true. For that reason last week's posting didn't hold marketing-sales responsible for the China scandal. Although those two functions drove pharma during the '90s, that's no longer the case. Finance and its mini-me, accounting, are now pharma's ubiquitous, dysfunctional, driving force.

Many people inside the pharma companies fail to recognize the pernicious hands of finance-accounting. In large measure this is because intermediaries carry out the dirty work for the two functions. For example R&D project teams and line marketers on the business side both recognize the malevolent hands of purchasing and human resources, but few operations managers seem to understand that those two departments are merely the hit men carrying out the directives of finance-accounting.

The very nature of finance-accounting across most business sectors during the past 25 years has largely been counterproductive. They have departed from the historically important role of finance, which was to provide capital for enhancing the development and productivity of manufacturing and service businesses. In that role finance made its money by aggregating capital, then making loans and investing the float to generate revenues. But today finance is no longer a service for manufacturing and other concerns. Now finance sees itself as the economy's major wealth producer. In the case of pharma, for example, finance uses this perspective to disdain both R&D and marketing, the core functions that make the industry what it is. They prefer turning pharma into a financial services industry that would compete with venture capital firms by investing in biotechs and startups.

The same reader made the point that the ascendance of finance as pharma's controlling function coincided with an altered approach to pharmacy benefits that payers started in the mid-'90s. The approach that payers developed at that time had the effect of eroding the me-too or "marginal incremental benefits" pillar of pharma's business model. It had long been an industry axiom that "it takes the me-too's to pay for the breakthroughs." That took a hit under the new approach because payers grew increasingly unwilling to pay for new brands that offered only marginal, incremental improvements.

Gradually pharma began to recognize that a marketing approach which promoted their respective brands as best-in-class offerings would no longer work. As a result they decided to circumvent the very idea of classes by developing a more personalized therapeutic approach that would make more money from selling fewer pills.

That response to tougher reimbursement policies posed a couple of major problems. In the first place the science for creating major outcome improvements based on genotyping is still about 20 years away from generating a raft of highly effective products. Secondly, drug development under any circumstances is inherently a high-risk business. That reality is what led pharma several decades ago to settle on a medicinal chemistry approach for creating new compounds. Medicinal chemistry involves, for example, substituting one atom for a closely related one in a molecule that's already known to work. Abandoning the medicinal chemistry method of minor tinkering only lengthens the already long odds against developing a successful new drug product.

These two reasons prevented pharma from totally scrapping either its me-too approach to developing new compounds or its best-in-class marketing strategy.

All of this means pharma has found it increasingly difficult to differentiate its new brands in a manner that can secure reimbursement and gain share. The lull in breakthrough research, together with marketing's reduced ability to create reasons for buying new drug brands, put finance in control.

One of the many malevolent ways that finance exerted its newly won influence was by constricting R&D budgets. The purse keepers decided that if differentiating benefits couldn't be baked into a compound's profile at the start of clinical development, then the expensive clinical program shouldn't even get funding. This pushed clinical project teams to load up their study protocols in a desperate effort to generate potentially differentiating data. The process turned clinical teams into camel-building committees whose study designs grew more complicated and more difficult to field. The result was that the work of trial sites grew more arduous and required more time for completing studies. That meant pharmas had to pay more to clinical sites for running trials. This downhill slide of allowing finance to have its way in drug development made the process longer, less productive and more expensive.

At the same time, finance forced out experienced clinical operations people during the past four years of downsizing and outsourced their function to understaffed, overburdened CROs that suffer from a 20% annual personnel turnover.

Then on top of the imperatives from finance that diminish R&D, pharma's growing tendency to violate the law in a regulated industry created a raft of criminal and civil liabilities. That brought the legal counsel's office into a position of overseeing operations. They perform that function by adding their debilitating mass of red tape to even the simplest, most straightforward procedures.

Although the lawyers claim their principal purpose consists of keeping the company out of court and reducing its exposure to criminal and civil liabilities, that's not really their main objective. Instead legal counsel sees its most important job as keeping senior management in control of the company and preventing plaintiff lawyers from pulling down the pants of C-suite officers in open court. They really couldn't care less about $3 billion fines because the shareholders pay those anyway. The record shows that fiduciary officers even signed contracts for higher compensation after their companies paid billion dollar fines.

So the point of last week's posting still stands. As an industry's innovativeness and the value of its products go down, finance and legal counsel exercise more control over it. R&D takes a back seat in an industry whose supposed purpose consists of developing better medications. Objectives come largely from finance, while legal counsel runs the operations for pursuing them. Pharma's operating control by those two functions is a sure sign of a sunset industry.

Also last week Merck made its new head of R&D, Roger Perlmutter, available for questioning by equity analysts. From their writeups and from conversations with a couple of analysts who attended the meeting, the following noteworthy points emerged.

Perlmutter expressed his annoyance with the extent to which Merck is a process-oriented company. That's a diplomatic way of saying the place is a hidebound jungle of entanglements and time-wasting procedures that hamstring people who try to accomplish things. While Perlmutter at least deserves some points for acknowledging that fact, his admission strikes anyone familiar with the industry as similar to revealing that Liberace was gay. No one who's familiar with pharma doesn't already know that about Merck, so Perlmutter's disclosure implies a low regard for his audience of analysts. But the fact that Merck has always tried to cover its flaws with a thick layer of arrogance is also well known.

What needs to be pointed out is that equity analysts wouldn't hold Perlmutter's patronizing remark against him because they are seldom concerned about whether or not company operations are dysfunctional. The demands and incentives of their occupation lead analysts to dismiss most news about poor organizational process with a wave of the hand. According to their mantra, "there's a big difference between a bad company and a bad stock," and analysts are only interested in the latter. In their opinion savvy investors can often make good money from companies with serious fundamental flaws. On the other hand they typically disdain good companies that move deliberately and steadily in the right direction because such stocks are less susceptible to volatile swings. Low volatility doesn't stimulate trading or leave much opportunity for either major appreciation or short selling, so the brokerage commissions and churning by which analysts justify their existence don't stand to gain anything. If Merck's share price in the short range looks to be as idle as a painted ship upon a painted ocean, analysts couldn't care less about it.

That explains why most analysts received Perlmutter's remarks with a long yawn, despite the fact that they rightly characterize Merck's pipeline as, at best, unexciting. A few even observed that any internal fix Perlmutter hopes to make is going to take at least five years to show results. Even in Merck's areas of research focus, cancer and heart disease, the company doesn't appear to have anything that really stands out. If slow, steady growth doesn't hold much interest for Wall Street, neither does gradual decline in the case of Merck. But don't let this observation apply exclusively to Merck. For the most part it is equally appropriate for the entire sector of Big Cap pharma.