Most small and medium cap Biomedical companies today rely upon the enthusiasm of investors toward their ongoing research and development progress for corporate funding. For public companies in this space, the bulk of expenditures typically is devoted to phase II (exploratory) or phase III (pivotal) clinical trials. Such trials may take a few years to plan and execute. During that time, management generally expresses its confident belief that the research results will justify investor confidence in the company’s activities.
Such activities are properly called “research” because the eventual results are unknown at the outset of the project. And sometimes the results will be negative - yhat is the trials will fail to meet their desired endpoint. Such an outcome is not only deeply disappointing to investors, but there may be those who feel that the bad outcome was due to some failure of management oversight rather than to the complexities of emerging scientific understanding That disappointment may be expressed as a shareholder lawsuit nominally intended to return to investors some of their lost investment. Indeed, in 2000, 2.8% of the 4734 listed NASDAQ firms were the targets of securities class action suits. According to PricewaterhouseCoopers' Securities Litigation Study of 2003, biotech companies were served with 17 percent of all U.S. shareholder suits.
Many of the suits stem from the wide latitude companies have to disclose the substance of their communications with the FDA. Such correspondence with regard to open matters must be kept confidential by the FDA, and some companies have been accused of confusing optimism in their public characterization of such communications with fraudulent misrepresentation. In the past, Directors have had little personal liability for such matters; but recent court decisions reasserting States interest in the responsibilities of directors in managing corporate risk have changed that assumption.
Shareholder suits are typically defended by asserting protections provided by the “business judgement rule.” Courts have traditionally deferred to the business judgement of directors, if directors act in good faith, with loyalty and on an informed basis. In the post-Enron rush of public concern for proper corporate governance, much attention has been focused on the legislative confessional erected under the Sarbanes-Oxley rules. Not wanting to feel left out, the courts have waded into shareholder-corporation disputes as well, with the result that their traditional deference to the judgment of elected directors has now been given sharply defined limits.
In the well publicized Disney case in which a shareholder took exception to what was perceived as an overly generous severance package of $140MM to Disney ex-President and Eisner ex-friend Michael Ovitz. The court decided that “directors decisions will be respected by the courts unless the directors…reach their decision by a grossly negligent process that includes the failure to consider all material facts reasonably available.” While the Delaware court noted that liability is rarely imposed on directors for a breach of the duty of care, the facts alleged in this case did not include negligent or even grossly negligent decision-making, but rather the Chancellor hearing the case noted that the directors had not “exercised any business judgement or made any good faith attempt to fulfill the fiduciary duties they owed to Disney and its shareholders.” In other words, the courts would not look kindly upon directors who knew that “they were making material decisions without adequate information and without adequate deliberation.” What does this decision giving new life to the notion of a Director’s duty of good faith have to do with biomedical companies?
By creating new ground for a definition of the duty of good faith—thought by many in the past to be a subset of the duty of care—a new ground for shareholder action has been created. That is, if a major set of risk factors for a company is identified as FDA regulatory requirements, than it is necessary for biomedical Boards to better inform themselves about FDA related matters to avoid the charge that they have not “exercised any business judgement or made any good faith attempt to fulfill the fiduciary duties owed” their shareholders. Arguably, since many of the major risk factors self-identified by biomedical companies in offering memoranda relate to FDA regulatory issues and since major value drivers of most biotechnology companies and the major budgetary decisions made by the Boards of such companies involve decisions about FDA-regulated pivotal clinical trials undertaken by management, Boards should make informed decisions about such matters. Failure to review plans for such studies or failure to obtain expert opinion about such FDA-regulated program plans may be considered grounds courts to decline to defer to the business judgement of the Directors.
The Seventh Circuit recently weighed in on similar issues with regard to a pharmaceutical company’s failure to follow FDA mandated regulations essential to its business. Shareholders filing “In re: Abbott Laboratories Derivative Shareholders Litigation” wanted to hold the directors personally liable for losses suffered by Abbott over several years as a consequence of sanctions imposed by the FDA for failing to correct manufacturing and quality control deficiencies. That FDA regulations were a major factor in Abbott’s business success and a major risk factor to the corporation was not in doubt. For example, the Abbott 1996 10-K declared that: "[Abbott's products] are subject to comprehensive government regulation [which] substantially increases the time, difficulty, and costs incurred in obtaining and maintaining the approval to market newly developed and existing products…"
The plaintiffs’ allegations in that case continued: “Form 483s were ‘clearly information that was required to be brought to the attention of the Board members by the Chairman . . . who had a duty to [do so].’ Plaintiffs also note that the Audit Committee, which included several members of the board, "is charged with communicating regularly with Abbott management" concerning management's assessment of business risks.
The board as a whole has the responsibility to monitor risks that the firm faces. These risks include business risks, financial risks and legal risks. In association with public offerings of securities, the Securities and Exchange Commission (SEC) requires the listing of material risk factors associated with the offering preceded by the following legend:
"This offering involves a high degree of risk. You should consider carefully the risks and uncertainties described below and the other information in this prospectus, including the consolidated financial statements and the related notes appearing at the end of this prospectus, before deciding to invest in shares of our common stock. If any of the following risks or uncertainties actually occurs, our business, prospects, financial condition and operating results would likely suffer, possibly materially. In that event, the market price of our common stock could decline and you could lose all or part of your investment.”
Often, these Memoranda are never seen after the offering. However, they provide clear evidence that one of the greatest areas of risks for biomedical companies involves development of successful FDA regulatory strategies that allow timely completion of manufacturing requirements and clinical studies needed for market approval.
Clearly many of the risk factors overseen by Boards of biomedical companies involve FDA regulatory matters and similar regulations of foreign authorities. The clear identification of so many and so varied risks associated with FDA regulatory issues suggests that Boards are well advised to carefully review matters of FDA regulatory importance. Such matters may include 483 reports identifying deficiencies after an FDA inspection, unexpected communications from the FDA, and pivotal clinical study protocols. Directors need to be given time to study such critical documents and to discuss them in Board meetings and in executive session. Boards are increasingly expected to have the expertise to make independent judgment rather than to simply “rubber-stamp” management recommendations. Boards may include FDA experts in their number, may engage appropriate FDA legal counsel or hire FDA experts as appropriate to advise them on matters of particular importance to their company.
Many observers believe that the audit committee is one logical place to locate FDA regulatory oversight responsibility, since most regulatory risks have financial statement implications, and most of them have disclosure implications. The audit committee should receive regular reports from the company’s general counsel as to all legal risks, including FDA regulatory risks, facing the company. The committee should be confident that the company is adequately managing these risks and is receiving competent legal counsel. If necessary, the Board or the committee should engage its own outside counsel to assist it in evaluating FDA risks facing the company and management’s response. Counsel with specific FDA regulatory expertise should always be available to the Board and to relevant subcommittees.
Clearly the board as a whole has a duty to monitor the sources and degrees of business risk faced by the firm. As the risk disclosure sections of Offering Memoranda attest, many of the central risks of biomedical businesses involve understanding of and compliance with FDA regulatory requirements.
Be informed. Oversight is not adequately exercised by confirming that company management is aware of and asserts that it is responding to key issues--the board must fulfill its duty to supervise management on such issues related to major business risk. Directors should inquire about important matters such as FDA-regulated activities, even if the matters are not on the Board agenda.
Obtain and review material information, even if, as is often true of legal documents which Boards typically are given, the source material may be complicated. Directors are always expected to act on an informed basis. Directors should attempt to obtain all material information reasonably available to them. Arguably, FDA enforcement letters and unexpected FDA correspondence referencing key clinical studies, as well as pivotal clinical protocols, may fall into the category of documents which should be made available to Directors.
Whenever possible, Directors should receive and review relevant materials prior to meetings. Regulatory documents are often lengthy, and directors must have the opportunity to understand them.
To the extent possible, directors should receive final or substantially final versions of any proposed pivotal trial protocols. If the version approved by the FDA or counterparts in other jurisdictions is not in substantially the same form as that seen by the Board, the Directors should receive written responses from regulators and summaries of changes which have been requested in the protocol. Such documents often suggest hurdles that the Company will face in its quest for market approval and may be material to subsequent disclosures.
Consult with experienced FDA legal counsel or other experienced FDA experts. The board needs to understand in advance the legal implications of decisions affecting their activities which are regulated by the FDA, including a summary of available strategic alternatives and the differing consequences of alternative courses of action.
Seek the advice of experts. Directors should consult with experts where appropriate. The board may engage their own FDA expertise or counsel with FDA experience, rather than use an internal FDA regulatory management in order to obtain an independent assessment of the Company’s regulatory strategic plan and status.
Consider regulatory alternatives. Directors should consider alternatives to proposed courses of action. The record should show that the directors considered strategic alternatives and understood the consequences of the failure to act to change an existing plan which has come into question.
Take sufficient time for discussion and deliberation of FDA regulatory matters at board meetings. For most biomedical companies, FDA the development and execution of sound FDA regulatory strategy is key to understanding corporate capital needs and time to market issues. Directors must act deliberately.
For all members of the board it is important that efforts be made to remain informed about current developments in accounting and law, including FDA regulatory law, that may affect the corporation, its control and its disclosures, materiality of corporate disclosure being a major source of shareholder litigation among biomedical companies.