The US Department of Justice (DoJ) has led the charge against the sector and they have become particularly emboldened post the 2008 global financial crisis to pursue ever larger settlements. Alongside the increased financial penalties, we have been concerned by the reputational damage and operational impact arising from stricter scrutiny of companies and enforcement of regulation in the US, UK and Europe. Key trends we see are “extraterritorial” legislation, meaning that companies may be prosecuted in countries other than their home jurisdiction, as well as strong enforcement actions on companies that fail to prevent corrupt practices through adequate measures1. Issues leading to regulatory action include:
Many of the leading global pharmaceutical companies have fallen foul of these violations. These include GlaxoSmithKline (GSK), Johnson & Johnson, Pfizer and Novartis amongst others. Neither have these breaches been confined to the major developed markets. We have seen a rapid shift in regulatory intolerance to corrupt practices in emerging markets where there had been a perception that rule of law was weak and paying bribes was a cost of doing business. This has been most notable in China, as President Xi Jinping has overseen a widescale crackdown on graft. GSK was fined $490 million after it was found guilty of bribery in 20142.
The focus on the financial impact has largely been on the immediate cost of dealing with the violations – namely the headline amount of the regulatory settlement. However, we consider this amount to be only a portion of the overall commercial harm that a company suffers when its employees are caught ‘breaking bad’. We have identified the following areas which on their own may not be significant but in total can be material to the company’s performance. Much of this is also relevant to the financial industry which has struggled with similar issues.
Sales practices in the pharmaceutical sector have been an area of long-term concern to us and we have been conducting engagement on this issue for more than a decade, both one-on-one and collaboratively in the US with investor groups led by the United Auto Workers. Our engagement intensified as the regulatory fines and settlements mounted and the poor business conduct within the industry became increasingly material to investors. A key turning point was GSK incurring in quick succession a US$3 billion settlement in the US in 2012 for bribing doctors, and the China incident in 2013/14.
Since the start of 2014, we have engaged more than 70 global healthcare companies on this issue including many of the world’s leading research and generic pharmaceutical companies. We have travelled to the US, Europe, Japan and China to meet companies and the key recommendations we have been making to businesses are:
Over the years, we have occasionally encountered somewhat cynical views that ethics issues are purely a cost of doing business. We do not subscribe to this view. Our analysis has been that there are some companies which have repeatedly attracted litigations, regulatory investigations and settlements, while there are others – with robust practices – which have not attracted any. For example, according to research in the 2016 Access to Medicine Index, only Gilead and Novo Nordisk (of 20 major global pharmaceutical companies in the rankings) avoided settlements for breaches of criminal or civil laws or regulations relating to corruption or unethical marketing between 2013-2016 (inclusive).
So, how can investors identify companies which are at higher or lower risk of potential violations? Our engagement has allowed us to narrow down to three risk factors.
Clawback is defined as the provision by which companies can recover bonuses (and other variable pay) after they have vested and have been paid out. These provisions have become increasingly commonplace in certain industries such as banks and pharmaceuticals, and in markets such the US, UK, Switzerland and France. They traditionally cover material financial restatements but there are now increasing moves for clawbacks to also cover instances where employees are held accountable for a broad range of misconduct. We consider clawbacks as an essential and effective way for employers to both incentivize certain behaviours and to hold employees accountable for their actions.
Given the severe financial penalties which can result from staff misconduct, there is growing recognition that effective compensation policies can deter unethical behaviour. In light of this, a working group comprised of Amgen, Bristol-Myers Squibb Company, Eli Lilly, Johnson & Johnson, Merck & Co., Pfizer, and thirteen institutional investors (including BMO Global Asset Management), endorsed a set of principles called the ‘Principal Elements of a Leading Recoupment Policy’ (April 2013) aimed at deterring ethical breaches3.
In 2016, we conducted an engagement project in which we urged 30 leading pharmaceutical companies to establish:
While many companies were willing to implement a Clawback policy covering misconduct, very few were willing to commit to ongoing annual disclosures of whether clawbacks were used in the reporting period. Shire was one of the few to do so. We also conducted engagement on the same issue with major financial companies. It is worth noting that JPMorganChase have now agreed to do so, and clawback reporting is available in its annual proxy statement.
Over the past five years, we have seen a widespread recognition from the pharmaceutical industry that conduct of employees poses a serious risk to commercial performance. We have seen efforts by the companies to improve senior executive and board-level oversight and accountability on this issue, and to; revise and strengthen management systems to assess, identify and monitor potential conduct-related regulatory breaches. Many of the companies are open and willing to discuss the issue and the challenge of reform in an honest fashion. We have had good access to senior executives and board members for in-depth discussions. This has provided signal of how seriously companies are taking reform.
What we are still not seeing sufficiently is companies clearly linking these issues to pay outcomes in a transparent fashion, nor are we seeing meaningful performance reporting in this area. On the latter point, US companies in particular have been reluctant to disclose how they are performing in this area.
Finally, despite the fact that companies are taking the issue seriously, we need to be realistic in recognising that genuine culture change takes time, particularly for the large multinational firms. Top-level messages being heard and followed by employees in distant markets is one of the key hurdles in implementing long-term change, with the loyalty of employees in many markets often likely to be with their line manager than a Chief Executive in another continent. The time in the industry is for companies not to just say that culture reform is taking place but to show investors the hard evidence that it really is happening.
1For example the US Foreign Corrupt Practices Act and the UK Bribery Act
2Full analysis of the GSK’s China incident is available in ESG Viewpoint “Bribery in China: Lessons from GSK” February 2014
4 For clients of the reo engagement overlay service this is provided as a confidential appendix to this ESG Viewpoint