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.
- Countries of operation: does the company operate in markets which are likely to result in high penalties for regulatory breaches (the US) or in markets where the regulatory quality and rule of law are weak?
- How staff are paid: does the company rely on revenue growth from aggressively growing sales and/or are sales teams incentivised with big bonuses for hitting ambitious (but unrealistic) sales targets? Is the key performance measure for sales teams solely revenue based or does it include other factors such as quality of sales, customer satisfaction and regulatory knowledge?
- Drugs portfolio strength: does this company have a drugs portfolio in a strong competitive position? Would sales staff possibly need to induce doctors in other ways than just the efficacy of the drugs themselves?
Accountability in pay
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:
- A compensation clawback policy ¬which would allow for recovery of bonus and other incentive compensation paid to executives and any employee who is involved in misconduct causing financial or reputational harm to the company. We provided a suggested model clawback policy4.
- Clear disclosures and regular reporting of clawback policy implementation which would allow investors and other interested stakeholders to assess whether the clawback policy has been put to use. This should include details of whether the clawback was used in the reporting period, the nature of the incident which prompted it andhat monetary value was clawed back.
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.