Last week, when the Treasury effectively scuttled the Pfizer-Allergan merger, there was much rejoicing: politicians and pundits alike were thrilled that tax inversion greed had been stopped, and that companies like Pfizer would have to “pay their fair share.” Investors seemed to rejoice as well: the biotech and pharma stock market indices shot up nearly 6% and 2.5%, respectively, one of their best single day moves in years. No one much liked the merger, except for Pfizer and Allergan.
In fairness, I’m one of them. I generally hate mega-mergers because they are so disruptive, in particular to the R&D groups that are already under attack across the industry. Organizational paralysis surrounds these mergers, and R&D productivity, challenging in the best of moments, is woefully setback even further during these mergers. I also dislike the idea that companies are rewarded for financial engineering and tax optimization; I generally subscribe to the old-fashioned notion that Pharma companies should compete via their product innovation.
But despite the celebration, the events of last week leave me disappointed and concerned. The termination of the Pfizer-Allergan merger for “adverse changes in tax law” sets a very bad precedent that the stable rule of law doesn’t matter.
I know I’m a week late to react to the news, but couldn’t help myself with a post on the topic. I won’t go into the details of the Treasury’s regulations, but Cooley put out a piece yesterday that goes into the specifics (here).
Fundamentally, my biggest concern with the new rules regards the importance of predictability in business. Strategic planning, essential to running sustainable enterprises, requires the predictability of transparent and forward-looking laws, along with proper due process and accountability. This stable rule of law creates a business environment that encourages investment in R&D pipelines, job growth, capital spending, and infrastructure.
These Treasury rule changes are a dramatic example of ex post facto law-making: changing the rules that companies and their business planning functions have operated on for years in a retrospective manner. Specifically, the determinations made by the Treasury and IRS will effectively “disregard” and reclassify the past three years of equity stock in order to disqualify the inversion. Given Allergan’s merger-driven growth, this effects how a number of their large transactions are classified for the IRS (like Forest, Watson, Warner-Chilcott, etc) and effectively prevents Pfizer from inverting its corporate structure as part of the deal. It would be one thing if the Treasury put in place new rules that would prevent future inversions, but a three year “look back” that changes the rules of corporate engagement is, I think, a very troubling precedent.
Imagine if the rules of a football game changed at the start of the fourth quarter; forget what your team learned in practice or game planning, the players would have to adjust real time to the new rules in the middle of a game. But worse than that, the new rules would be applied retroactively to the prior three quarters – changing the score, invalidating touchdowns, altering referee calls that were made under the prior rule regime. This isn’t viable, fair, or predictable.
Further, it appears the rule changes were geared to blow up this specific tax inversion deal before it closed. Ryan Ellis in Forbes framed it up with emphasis: “the Treasury Department has acted like a banana republic bureaucracy and changed the rules late in the game just to make a political point.” In an election year with both sides spouting protectionist themes, everyone is bound to like the idea of forcing Pfizer to stay all-American.
The predictable rule of law is critical for all businesses types and their investors, but especially for those of us in the long cycle time world of pharmaceuticals and R&D. We invest over 7-10 year timeframes. Business strategy is fundamentally about forward-looking planning over those time intervals, taking into account strategic resource allocation and risk management. Pharma companies face a myriad of risks in R&D around technical, clinical, financial, regulatory, and reimbursement – and put in place risk mitigation plans to try to manage them. But risks involving retroactive rule-changes aren’t typically ones most businesses can manage around, nor should they.
Our sector has some good examples of major law or regulatory initiatives that are worth reflecting on, especially relative to what retroactive rule-changes would have been.
- Patents. When the USPTO changed the rules from “first to invent” to “first to file” it took 18 months to transition – the law was signed in September 2011, and the new system went into effect in March 2013. Patent applications submitted before that effect date were treated via the old system. Imagine for a moment if the rule change was retroactive and “looked back” a few years while asserting the “first to file” rules – or that the rules were specifically changed to invalidate one particular application – this would have been absurd, and created lots of uncertainty in the business community.
- Regulatory. The FDA has been increasingly transparent with industry over the past two decades, providing Special Protocol Assessments, Orphan and Breakthrough Designations, and PDUFA review clocks, among many other initiatives for improving the regulation of product development and approval in the US. This openness and engagement around predictable timelines, costs, requirements make the FDA a reasonably functional regulatory body, even if there are disagreements at times. But imagine if the FDA just announced that all PDUFA dates agreed to in past were no longer valid, or that drugs that launched under the protection of Orphan Designations over the past few years were no longer protected. These would be disaster scenarios from an investment perspective, and the unpredictability would drive capital out of our sector.
- Payors. CMS pays for a significant percentage of drugs in the US; they are the 800-lbs gorilla of the payor landscape. There are aspects of the current payment system, like the Medicare Part B Drug Payment Model of “ASP plus six percent”, that need serious improvement and alternative models. But instead of retroactively changing the rules, CMS recently put forward a set of broad pilots to test new payment models, including value-based pricing and indications-based pricing; while the proposals are far from perfect and perhaps even heavy-handed in their “pilot” application, they are least testing them on a forward-looking basis and have engaged industry in working through the concepts. It’s not perfect but it’s still opens the door to a predictable set of future scenarios from a planning perspective – giving businesses time to think, prepare, and engage on these new concepts.
In each of the above examples, our sector has benefited from predictable business framework upon which to operate. Fortunately, we’ve not faced unpredictable behavior of the Pfizergan magnitude at other institutional stakeholders in our sector – but a precedent-setting rule-change regulation like what just happened does give me pause that it could extend elsewhere.
Beyond business planning, the unexpected termination has also wreaked havoc inside of two large Pharma companies. As John LaMattina, former head of R&D at Pfizer, highlighted in a recent Forbes post, the social costs of scuttling the merger are very large: revisiting the February re-organization, a ton of senior leadership time wasted, and countless hours of professional anxiety (and resume-prep) inside of these companies.
Lastly, the termination of the Pfizer-Allergan deal also emphasizes the importance of corporate tax policy. Instead of trying to retroactively change the rules to ban a specific and large tax inversion deal, politicians and bureaucrats should focus on addressing the underlying driver of the practice: fixing the uncompetitive US corporate tax system.
Two issues need to be addressed with corporate taxes: first, the US corporate tax rate is one of the highest in the world; second, the US is one of the only countries that taxes revenues generated outside the US. The latter non-territorial issue creates huge piles of offshore cash that can’t be brought back and reinvested in the US in a tax efficient manner. So through tax deferral mechanisms (and “earnings stripping” arrangements), companies accumulate ex-US profits offshore where they can be used for ex-US transactions and reinvestments – rather than being brought back to the US for investment here. This could all be addressed with a more competitive US corporate tax policy more similar to the rest of the world, and we could get back to competing less on financial structure and more on innovation. There’s broad bipartisan support to fixing corporate tax policy but it’s not happening anytime soon.
Why do we accept that a US-domiciled pharma company should be less competitive on a tax basis than foreign firms? Novartis, Roche, GSK, Sanofi, and AZ all benefit from being headquartered in Europe, where they have lower taxes on their ex-US income, and they can bring that post-tax capital into the US to invest. Yet US-domiciled companies like Pfizer, Merck, Biogen and others have to keep their offshore cash outside the US, unable to use it in a competitive manner – putting them at a financial disadvantage on a relative basis.
This is a watershed moment for the global business community domiciled in America. We need to insist our elected officials in Washington prioritize fixing our uncompetitive corporate tax system – and we need to reinforce the importance of a predictable rule of law so that business and investors can plan for the future.
Sadly, it’s an election year – so nothing will get done, and politicians on both sides are likely to celebrate the breakup of Pfizer and Allergan with large amounts of bread and circuses.