By Damion Rallis, Senior Research Associate
Problems for Vertex Pharmaceuticals Incorporated (NASD:VRTX) really hit the fan this past May when the company revealed that it had overstated the clinical data for an experimental cystic fibrosis treatment. Since the troubling news, the company’s share price has steadily dipped, legal action has arisen, and ongoing governance-related red flags all would suggest that Vertex’s overall “C” ESG Rating and “Average” AGR Rating are at serious risk to decline into high risk territory.
Fortunately, our Litigation Risk model has already been sounding alarms for some time now, having fallen into “High Risk” territory at the end of 2011. Currently, Vertex’s litigation risk continues to increase, having dropped to a 2 at the end of October, which places them in the 2nd percentile of all companies in North America, indicating higher shareholder class action litigation risk than 98% of all rated companies in this region.
On May 4, Vertex Pharmaceuticals’ share price closed at $37.41; the following Monday the company released interim analysis of data from a study of KALYDECO™, one of its two main products, and VX-809, a potential drug candidate, that showed significant improvements in lung function among adults with cystic fibrosis. The press release crowed that “46% of patients experienced at least 5% absolute improvement in lung function (FEV1) from baseline; 30% of patients experienced at least 10% absolute improvement.” Due to the impressive results, Vertex’s share price surged to a close of $58.14, an incredible increase of 55% in only one trading day. (By May 15, it had topped $66.) On that very same day, four Vertex executives—Chief Commercial Officer Nancy Wysenski, Chief Scientific Officer Peter Mueller, and Senior Vice Presidents Lisa Kelly-Croswell and Amit Sachdev—jumped on the “cash out” button and sold a total of 361,680 shares valued at about $20 million. The insider selling continued through the end of the month as nearly $38 million was made on the heels of the positive test results. The trading was led by Chief Commercial Officer Nancy Wysenski, who benefited from two sales totaling 365,704 shares valued at almost $22 million.
So what’s wrong with a little insider selling? Nothing, per se, unless the initial stock bounce that predicated the sell-off was based on bogus information, as was the case at Vertex. On May 29, Vertex changed its mind and amended its previous test results so that 35% of patients (down from 46%) experienced at least 5% absolute improvement in lung function and 19% of patients (down from 30%) experienced at least 10% absolute improvement. About a week later, Vertex announced the retirement of Chief Commercial Officer Nancy Wysenski saying only that “after more than 30 years in health care, she has chosen to move on to the next chapter of her life, and we wish her all the best in retirement.” While retirement at the age of 54 is not unheard of, at best, Ms. Wysenski’s retirement seems to be an unlikely coincidence. While mistakes do happen the amended testing results were released the same week that Vertex received a letter from the FDA citing the company for violations due to an advertisement that was deemed “misleading because it overstates the efficacy, omits material facts, and minimizes important risk information about the drug product.”
Then, US Senator Chuck Grassley asked the US Securities and Exchange Commission to probe the insider sales, stating that he was “disturbed by reports concerning the release of clinical trial data by Vertex Pharmaceuticals Inc. (Vertex) and stock sold by Vertex executives.” While Vertex insisted that the insider sales were a function of 10b5-1 plans, which allow stock to be sold at regular intervals or when pre-specified prices are reached. While this may be the case, this does not address the timing of the testing results in the first place, as they could have easily been coordinated to maximized gains from pending stock sales. In any case, since the end of May Vertex’s share price has been in a steady decline.
More recently, Vertex shares dove on mixed clinical trial results and then again on disappointing third quarter financial results that saw the company’s year-over-year revenues fall from $659 million in 2011 to $336 million in 2012 as the company lost $57.5 million in the third quarter. In addition, the problems have mounted as several law firms have begun class action lawsuits and/or investigations concerning the May testing results and insider sales: Scott+Scott LLP and Johnson & Weaver, LLP in September; Levi & Korsinsky, LLP in October; and Morgan & Morgan in November. At GMI Ratings, none of these missteps come as a great surprise as we have been flagging the company for years as its ESG Rating has been no higher than “C” since 2003.
As we turn to the company’s governance profile, we start to get a clearer picture of some of the challenges facing Vertex investors and potential investors as the company engage in practices that not only fail to benefit its shareholders but also serve to reflect our worsening view of the company’s long-term sustainability risk. For instance, the company’s board is highly insulated from its shareholders. As an example of our concern, the company’s board is classified, which means that each director is not subject to shareholder election on an annual basis. As a result, this structure makes it substantively difficult and lengthy to gain control of a board majority. In addition, the company has charter and bylaw provisions that would make it difficult or impossible for shareholders to achieve control by enlarging the board or removing directors and filling the resulting vacancies. The combined effect of these mechanisms is to effectively reduce shareholder oversight.
Board insulation by design may contribute to policies which can further damage shareholder interests. Vertex Pharmaceuticals’ executive compensation practices reflect this possibility. First and foremost, Vertex shareholders are clearly in agreement that compensation practices are not favorable to shareholder interests as only 51% voted “yes” on Say for Pay in 2012, down sharply from last year when over 96% voted to approve compensation policies. This is a considerable increase in negative shareholder sentiment. To put this vote into perspective, out of 2,283 recorded US Say on Pay votes for 2012, only 68 companies recorded lower vote totals. The reasons for shareholder discontent were numerous. First of all, we note that former CEO Matthew W. Emmens received fiscal 2011 total summary compensation ($13,358,534) worth well over three times the median total summary compensation ($3,645,190) for the other named executive officers (NEOs). This raises concerns about internal pay equity. The bulk of remuneration paid to the former CEO for fiscal 2011 consisted of compensation elements not tied to performance-based targets. Of his total summary compensation of $13,358,534, his salary was $1,163,068 (which is over the IRC tax deductibility limit) and his equity award consisted of $7.3 million worth of option grants that vest simply over time without performance-contingent criteria. Equity awards should have performance-vesting features in order to assure proper alignment with company performance. Additionally, market-priced stock options in many cases simply reward executives for market correlated stock appreciation, rather than any aspect of individual performance. The only other form of long-term equity was based on annual performance goals, which represents a period of time that is woefully short of long-term.
Additionally, NEOs are eligible for annual incentive awards that are loaded with discretionary components, including an Individual Performance Factor that can increase awards by as much as 50%. While certain objectives may be quantifiable in nature, discretionary elements can undermine the credibility and effectiveness of a well-structured incentive plan. Discretionary incentive bonuses of this nature undermine the integrity of a pay-for-performance compensation philosophy. Terms for new CEO Jeffrey Leiden are not much better. As part of his golden hello award, the new CEO received time-vesting grants of 458,108 options and 50,017 shares of restricted stock, along with 133,378 performance-based restricted shares to effectively replace equity compensation from his former employer. Also, there are no executive stock ownership guidelines. To best align the CEO’s interests with company shareholders, the minimum stockholding requirement should be at least 10X base salary. Lastly, given the news from this spring, it is a profound disservice to shareholders that the company has not yet implemented clawback provisions related to the recoupment of incentive compensation awards. An overview of Vertex’s board composition may give some insight to these CEO-friendly compensation policies.
While there are only three long-tenured directors at Vertex, they maintain complete authority over the company’s standing committee structure: the majority of the Audit Committee consists of long-tenured directors while the three remaining board committees are all chaired by long-tenured directors. While we see the value in experience, it is increasingly difficult to consider directors independent after so many years of service. Long-tenured board members can often form relationships that may compromise their independence from management and therefore hinder their ability to provide effective oversight. In addition, despite the fact that CEO Leiden is also the Chairman, the company has not appointed an independent lead director, calling into question the board’s ability to act as an effective counterbalance to management. We also note that the presence of former CEO Emmens on the board along with the current CEO may present a formidable block for some of the board’s newly independent directors. Further strengthening the bond of the current and former CEO is the fact that they serve together on the board of Shire plc.
Unless the company decides to reconfigure the board’s leadership positions, we are not confident it will be able to effectively change direction and avoid even more disappointing earnings announcements and further share price declines.