A dose of reality

It’s a personal injury lawyer’s dream. A client has a heart attack after taking a new prescription medication and sues the manufacturer. Then the news reports start: allegations that the pharmaceutical company has been distancing itself from – and even suppressing – information linking the drug to heart problems.

Unfortunately for Merck shareholders, this scenario isn’t a dream but a nightmare come true. When Vioxx, the company’s COX-2 arthritis drug, hit the market in 1999, the lawsuits started almost immediately. By the fall of 2004, the company had voluntarily taken the product off the market. Then in January 2005, colleagues of a Merck researcher charged that the company forced the employee to remove her name from a study linking the medicine to an increased risk of heart attack. Late that year, The New England Journal of Medicine revealed it had evidence that the authors of a Merck-sponsored study on Vioxx intentionally suppressed important data. The impact on the company and its share price has been considerable – and could get worse.

Of course, brutal product lawsuits are nothing new – just ask Bridgestone/Firestone or the big tobacco companies. There’s no shortage of stories on allegations of managers failing to act on knowledge (or suspicion) of a problem. Apart from consumer lawsuits and regulatory fines, a new world of trouble may await companies that knowingly or negligently ignore problems with their products. Intentionally withheld issues can, under certain circumstances, become cases of misreporting actual financial conditions – and this can lead to shareholder lawsuits and a tussle with the SEC. There may even be personal consequences for management and directors.

Central to the problem is that any major fault with a product will seriously impact corporate performance. As a result, withholding knowledge can cross the fine line between keeping truly competitive information secret and misrepresenting financial results. That may require a restatement and could lead to an investigation by the SEC.

‘If you’re going out to the financial markets and proclaiming, We’ve got this new wonder drug and third-quarter earnings are going to be X, and the management team and the board know clinical studies have proven that [the drug] is a dog, then you’ve committed financial fraud. You can get in trouble for that, and you can get sued,’ explains Evan Stewart, a partner at Zuckerman Spaeder LLP.

The first questions for a company discovering that management has withheld information are exactly what employees and management represented to the public, when they did so and how. Prior statements of earnings are likely safe. ‘That’s not a misstatement or misrepresentation of a financial condition,’ says Stewart. ‘What you are saying is those are ill-gotten gains.’

However, there are representations that could be challenged. For example, a company with reason to anticipate losses should reserve for a contingent liability, explains Parveen Gupta, a professor of accounting at Lehigh University. ‘It was just a matter of time before you were getting caught, so you knew the liability would arrive,’ he says, ‘but you failed to provide for the risk; therefore, the financial statement was misleading.’

Sales projections and other forward-looking statements are more clearly vulnerable. ‘If [a drug company has] been making future projections based on a drug being revolutionary and they know they’re based on falsehoods, then it not only has an FDA problem but an SEC problem,’ Stewart says, and the implications go beyond the drug industry. Any projections that a company makes – whether directly to analysts or in the form of an MD&A statement – can cause trouble, even when accompanied by reams of disclaimers. ‘Those caveats are subject to good faith and a good factual basis, and companies get into trouble if those projections aren’t made on real things,’ Stewart adds.

An expanded regulatory impact in such cases isn’t just theory. Sergio Garcia, partner and co-chair of Fenwick & West LLP, points to a case in September 2005 when the SEC filed a civil suit against Biopure. ‘The SEC alleged that the company had not adequately disclosed communications with the FDA regarding [an announced product],’ he says. ‘When the company disclosed that the SEC had initiated an investigation, its share price dropped 14 percent.’

What started the action against Biopure was a notification from the FDA to the SEC, making it clear that it doesn’t necessarily take complaints from shareholders to launch SEC activity, and that the commission is interested in what a company says, and doesn’t say, beyond financial statements. (Note: biotechnology is to some degree a special case – the long approval time for drugs and the lack of intermediary findings mean that investors are left looking to the company for information on a new product’s prospects.)

When management does fail to act on information and even conceals it, there are obvious costs to the company. ‘It depends a lot on the corporation,’ says Pat Meyer, a San Diego-based litigator who often represents plaintiffs in shareholder suits. ‘In some situations – Enron, WorldCom, Peregrine Systems – the stock goes down the tubes; they end up in the pink sheets, instead of publicly traded, and they end up in receivership.’ Even in less extreme cases, the stock price (and shareholders) takes a beating.

When people, rightly or wrongly, think they’ve been led astray, things can get nasty. In early January, when twelve miners died in a tragic accident at the Sago Mine in West Virginia, news reports stated that International Coal Group, which had gone public with a share price of $13.10, knew about hundreds of safety-related concerns from the Mine Safety and Health Administration. The stock immediately hit $8.72. If the allegations are proven, shareholders may well have cause to launch a suit.

According to Chyhe Becke, a principal with Deloitte Financial Advisory Service, a study published in the Journal of Financial Economics shows that among securities underwriters, on average there is a 50 percent decline in the share of the IPO market within the first year of an announced SEC investigation. What’s more, underwriter clients involved in the investigation lose 15 percent of their equity value in the first three days.

Taking action

Last month, Nortel agreed in principle to pay $2.4 billion in stock and cash to settle class action lawsuits stemming from corporate officers manipulating results to get their bonuses. ‘The median damages in shareholder lawsuits that settle are in the range of $6 million,’ Becke says, and more than 90 percent of all shareholder lawsuits settle. But some suits are much higher. She points to the lawsuit that Eliot Spitzer brought against the mutual funds for market timing. ‘Those investigations generated approximately $3 billion in regulatory damages, before considering things like private lawsuits,’ she adds.

And the results of alleged fraud can hang around for an extended period. Meyer is representing one group of investors in Peregrine Systems, the high-tech company that allegedly recognized revenues from deals that never closed, among other accusations. Not only are there suits under way, ‘but you now have several guilty pleas and an indictment against eleven people,’ she says. ‘We still don’t know everything, and it’s been five years.’

If and when sentences do come down, expecting home detention or a vacation at Club Fed is naive. ‘Look at the sentencing guidelines,’ says Frank Burke, a Steptoe & Johnson partner, chair of the firm’s securities litigation group and former assistant US attorney. ‘A sophisticated fraud of any kind will lead to a minimum of a three- to five-year jail term. We’re now seeing a lot of ten-year sentences and a couple of 25-year sentences.’

Even for those not legally punished, the shadow of an investigation or suit claiming fraud can cause havoc far beyond disruption of business. ‘A recent study shows that when a company restates its financial results … senior executives suffer a 60 percent turnover within the first two years following the restatement, compared with 36 percent at comparable firms,’ Becke says. ‘And 92 percent of the displaced executives are unable to secure comparable employment within four years of that restatement.’

There are also consequences for the board. ‘When a company is accused of fraud, its directors tend to lose appointments at other boards,’ she says. ‘There is a 50 percent drop in net board positions for directors in the top quartile of director compensation.’ In other words, the taint of scandal follows many who were associated with the company in question.
 
When companies are caught knowingly misrepresenting or suppressing information that could have an impact on financials or even the MD&A, many try to cover up. That course is generally futile. ‘If they are knowingly misbehaving,’ says Burke, ‘sooner or later the concealed malfeasance is going to come out.’ He cites a PricewaterhouseCoopers study that found 34 percent of frauds are detected by informants or by chance.

Despite this, senior managers often choose to ignore what they are told, and this can be an enormous mistake, according to Paul Murphy, a partner at Murphy Rosen & Cohen who represented the original whistleblower at Global Crossings. ‘Roy Olafson, who was the senior vice president of finance, raised the issues in the summer of 2002, and ultimately he was shunned and then terminated,’ says Murphy, adding that Global Crossings ‘characterized [Olafson] as disgruntled and claimed he was on a list to be terminated and that he must have found this out and was doing this to save his job.’ There was even a severance agreement in place, but upper management changed its mind at the last minute, offering a figure a third of the original.

‘Once he sued, they put all kinds of stuff in the press that was patently false,’ Murphy recalls. ‘They said he was a career litigator, that he had no background in finance.’ The publicity scheme soon backfired, given that Olafson had a solid grounding in finance.

Indeed, a company that decides to go after whistleblowers can be making a huge mistake. ‘Particularly if the whistleblower is a member of upper management, a highly compensated individual, then you’re running a huge risk,’ says Murphy, who defends corporations and represents plaintiffs. Even more damning is when companies immediately suspend people before conducting thorough and impartial investigations of the charges. ‘As soon as you say it, particularly if it’s in writing anywhere, that’s going to be exhibit A for the following lawsuit, because they’re suggesting the conclusion before they have a reason to suggest anything,’ he says.

The most sensible thing a board can do, according to Garcia, is to have a properly constituted internal disclosures committee, with representatives from every part of the business. ‘No matter how small your company, a disclosure committee is essential to ensure the completeness, accuracy and consistency of your approach to disclosing information that may be material to your company,’ he says.

When someone does withhold crucial information, the board must make sure that the company is first to break any news, says Michael Robinson, a vice president with communications consultancy Levick Strategic Communications and a former staffer at both Nasdaq and the SEC.

‘Bad news inevitably will come out,’ he says. ‘You always want to be in control of your bad news – almost more so than your good news. From a practical perspective … the SEC has said it will cut you a break if you bring problems to them. From a reputation perspective, most audiences – media, employees, vendors, partners – will give you a break if they see you’re doing what you can to do the right thing. By the time you get to trial, by the time a judge or jury registers a decision, it’s too late.’

In light of these eye-opening cases, and the more aggressive attitude of the SEC, many corporations are taking a close look at the ways they calculate and report risks, even if they’ve never considered them before.