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Secrets for Sale


Don't hate the player, hate the game.


In a copyrighted piece published August 7, 2005, Seattle Times reporters Luke Timmerman and David Heath report the results of a months-long investigation into insider trading in the biotechnology sector. Their investigation uncovered a distressingly common practice of doctors accepting payment in return for providing inside information on ongoing and unpublished clinical trials. This practice is so common, several multi-million dollar businesses exist solely to service hedge funds who wish to interview doctors for information.

Early indications are this story will cause quite a splash, so we wanted to take some time to provide you with our thoughts on the subject.

Loss of investor confidence

We have written at some length previously how the biotech sector is particularly reliant on investor confidence. Development-stage biotechnology stocks have no revenues and, therefore, very little in the way of financials investors can use to perform traditional valuations. Analysis of the science, diligent tracking of the company's progress, and an unusual amount of faith are necessary to be an investor in these companies.

And investing in these companies is important. Without the billions in equity provided by investors via the purchase of common stock and convertible debt, these companies would have no way to perform the ground-breaking medical research to create new treatments for cancer, macular degeneration, diabetes, pain relief, degenerative diseases, and more.

With only one of ten biotech companies actually succeeding, biotech investors already have a tough row to hoe. It is likely investors who have faced losses in the sector (as all have) will be discouraged by the Seattle Times investigative report. The article makes it clear the playing field is not level and that those with financial resources can purchase inside information easily.

We expect some investors - particularly individual investors - will lose confidence in the sector unless the SEC and other regulatory agencies make definitive claims the week of August 8 that they are launching investigations into this matter. Any loss of confidence will not just harm valuations in the sector, but any significant flight of capital will harm medical research in the long term.

Doctor consulting is not always bad

We need to draw a distinction here. We have no problem compensating doctors for time taken to discuss scientific principles, clinical trials, and other information provided the discussions are limited to reported data or the use of drugs already on the market. In fact, we believe doctors should be encouraged to speak about completed clinical trials whose data has already been made public. Their opinions serve as an excellent check and balance against management teams who can be too promotional for the good of their investors. And nobody wants to muzzle doctors who believe a marketed drug has safety problems.

We will go one step further and make the declaratory statement that any regulatory action or decision by internal ethics boards that prohibits doctors from talking about studies already made public would be dangerous, ill-advised, and completely missing the point of the Seattle Times article.

The disturbing finding of the Seattle Times investigation is how blithely doctors exchanged insider information for monetary compensation. In one case, a doctor had membership on a trial safety committee which provided him access to all unblinded information in the unreported trial. Not even the company sponsoring the clinical trial has access to that information. His conversations about that drug and those unreported data were wholly inappropriate. The fact that he got paid makes the situation all the more egregious.

How to solve the problem

The SEC needs to address the development-stage biotech sector's unique challenges quickly and with considered authority. In April of this year, we sent a letter to then-Chairman William Donaldson describing the selective disclosure that occurs because management teams are prohibited by scientific organizations from releasing material information to their own shareholders. This issue of selective disclosure is an easy one to address and we suggested four short amendments to Regulation Fair Disclosure that would solve the problem.

The issues raised by the Seattle Times piece are more difficult. There are, of course, already rules in place to prevent the sharing of inside information. The SEC should enforce those rules vigorously. They should also begin a dialogue - separate from the Regulation FD matters mentioned in our April letter - to develop guidance clarifying the difference between illegal communication of insider information and beneficial conversations about clinical data that has already been reported to shareholders.

The SEC should begin its investigation immediately to prevent the "loss" of important information linking the access of inside information with trading activities at hedge funds and NASD/NYSE registered firms. Particular attention needs to be paid to the timing of analyst research, changes in trading flow from major clients, options activity, options expiration dates, selective disclosure to preferred clients of this insider information, and the dates of conversations with doctors in possession of inside information.

Ethics Boards of academic institutions are certain to become involved in this discussion. We will make this open offer right now to doctors and researchers: If your institution is considering a blanket ban on conversations with investors, contact us. We will take the time needed to have as many conversations as necessary with members of your Ethics Board to help them understand the difference between insider trading and rigorous vetting of scientific data once it is reported. The medical profession and, frankly, our society are extremely capable of drawing fine distinctions between proper and improper behavior. There is no need to abandon that capability in this situation.

Investors have a more difficult decision. On one hand, the activities uncovered by Mr. Timmerman and Mr. Heath make it clear the field has been stacked against individual investors for at least the last 12-24 months. As an investor, you need to make the decision how to proceed. Should you leave the sector and look for opportunities elsewhere? A recent Business Week article noted one of the companies facilitating this scandal also hooks hedge funds up with insiders in other industries. This suggests perhaps you'd have to leave equities altogether to escape this behavior.

We won't speak to other sectors for now. Where biotech is concerned, the data are the data. We know from experience the information obtained from doctor interviews - interviews we do, but do not pay for - that doctors' predictions are not always correct. In many cases, they have seen only a small percentage of the patients on a trial and their experience may not be relevant to the entire trial's outcome. While there is no question this pattern of paying doctors for inside information has harmed companies and investors, in the end the data will arrive intact and additional judgments on the worth of the company can be made at that point.

The silver lining

The Seattle Times story presents an exceptional opportunity to drive important investment reforms. Accounting scandals drove important new legislation and this scandal is at least on par with those issues. Individual investors and principled professionals who know the current state of affairs is not sustainable should take a few minutes and express their thoughts on the Seattle Times article to their Congressional representatives and the SEC.

Good will come of this story for biotech investors. We cannot fathom a reaction to this story that will let the current state of affairs continue unchallenged. Choking off this type of inside information may reduce unexplained volatility in the sector and restore some badly-needed balance between both sides of the trade. Such a shift will not happen overnight and it will not limit the exceptional risk inherent in biotech investing. What it will hopefully do is make things more fair and there are tangible benefits to that.

The head of the Senate Finance Committee, Senator Charles Grassley (R-IA) has already called on the SEC to investigate the matters raised in the story. Perhaps by the week's end we'll know whether Congressional hearings will be scheduled.

Closing thoughts

We would like to applaud Luke Timmerman and David Heath for doing the considerable legwork necessary to bring this story to light. We would also like to commend the editors of the Seattle Times and the Knight-Ridder chain for their editorial integrity in publishing this story and their commitment to providing it wide exposure.

This is a bittersweet day for the sector our firm has chosen to study. The extent of the insider trading is discouraging, but the fact it has been brought to light so thoroughly holds significant promise.

We are uncertain of both the effect of this story on the sector and, frankly, on our own business. Where the latter is concerned, we would hope it underscores the necessity for independent research in a market overly burdened by conflicts of interest. Where the former is concerned, we hope for the sake of patients everywhere Wall Street has not burned the bridge between investor cash and the advances in medical science made by development-stage biotech companies. Good will come of this provided the SEC, Congress, and individuals stay focused on addressing the problem via smart rulemaking and legislation.

If you have thoughts on the matter, in addition to sharing them with your representatives in Congress, I'd like to hear them. Email me here.

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No positions in stocks mentioned.

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