On September 2, 2009, the U.S. Justice Department announced that pharmaceutical giant Pfizer Inc. and its subsidiary Pharmacia & Upjohn Co. Inc. agreed to pay a record $2.3 billion to resolve criminal and civil liability arising from the illegal promotion of four drugs.

The trusted companies were accused of engaging in fraudulent and misleading marketing programs for Bextra, an anti-inflammatory drug that Pfizer pulled from the market in 2005; Geodon, an anti-psychotic drug; the antibiotic Zyvox; and Lyrica, an anti-epileptic drug. The marketing also caused false claims to be submitted to government healthcare programs for uses of the drugs that were not medically accepted and therefore not covered by those programs.

In the wake of the sanctions, Knowledge@Emory spoke with Sundar Bharadwaj, a professor of marketing at Emory University’s Goizueta Business School, about how negative publicity can affect the stock value of pharmaceutical companies, and why some companies engage in this kind of behavior knowing they face stiff penalties if caught. Bharadwaj is a co-author of a recently released research paper titled “Regulatory Exposure of Deceptive Marketing and Its Impact on Firm Value,” which will be published in the November issue of the Journal of Marketing.

Knowledge@Emory: We understand that the paper you co-authored with Goizueta doctoral graduate and current Singapore Management University assistant professor Martha Myslinski Tipton, and Wharton professor of legal studies and business ethics Diana C. Robertson, focused on the aftershocks that strike a pharmaceutical company after it’s been proven to have engaged in deceptive marketing. So beyond the direct costs incurred, like fines and product recalls, what sort of financial collateral damage does a firm generally sustain?

Bharadwaj: Our analysis shows that incidents of exposed deceptive marketing are associated with significant negative abnormal returns amounting to a drop of one percent, which translates into an $86 million wealth loss for the median-sized firm in our sample. Bigger firms pay a bigger price. For example, a firm as large as Pfizer (with a market cap of $110.69B on October 5, 2009) would have faced a wealth loss of nearly over $1B.

Knowledge@Emory: What prompted you and your co-authors to conduct this study?

Bharadwaj: Researchers have found that negative events like product recalls and drug withdrawals can influence stock market value. However, there was not much research about the indirect costs associated with these negative events.

Although some studies have indicated that the indirect impact of negative events can be far greater than the direct costs, such as fines and restocking fees, associated with the event, deceptive marketing has received surprisingly little consideration from academic researchers. This is so despite the frequency of its use and the intensity of attention that deceptive marketing receives from regulatory agencies and the popular press.

Knowledge@Emory: Why did you focus on the pharmaceutical industry?

Bharadwaj: For several reasons.An absence of blockbuster drugs has shifted the focus of the industry from research to marketing, and some researchers estimate pharmaceutical firms spend significantly more on marketing promotions than research and development. Even the conservative, self-reported measures show pharmaceutical promotion totaling $29.9 billion in 2005 and growing at an average annual rate of 10.6% since 1996.

Also, since the U.S. Food and Drug Administration loosened regulations governing direct-to-consumer marketing in 1997, pharmaceuticals have increased direct-to-consumer (DTC) expenditures at an average rate of 14.3%. Merck’s DTC promotional spending on Vioxx in 2000, for example, exceeded the amount spent by Budweiser and Pepsi.

Knowledge@Emory: But don’t drug companies have some of the strongest marketing guidelines, especially when compared to other categories of businesses?

Bharadwaj: That’s true, but instances of deceptive marketing continue to occur among drug companies. This is so despite the fact that pharmaceutical marketing is regulated by the FDA’s Division of Drug Marketing and Communications. It also occurs even though behavioral studies have found that deception engenders distrust and leads to avoidance of the perpetrator.

Furthermore, many negative marketing-related events, such as the exposure of a firm that uses deceptive marketing, may not have an immediate impact on cash flows. Instead it tends to drive a rapid response from investors who adjust their valuation of a stock based on the firm’s expected cash flows. However, the effect on firm valuation has not previously been measured. Our work is important because maximizing shareholder value is a principal concern of public firms, and understating the value impact of such actions may inform managers of the potential downsides of such actions.

Knowledge@Emory: Who else should be concerned about the fallout?

Bharadwaj: The study has implications for Wall Street investors, Main Street managers, academic researchers, and public policy. As a result of our study, Main Street managers and Wall Street investors can arrive at better-informed decisions about the financial risk of potentially destructive marketing strategies. Our findings indicate that Main Street managers need to consider both the target audience and the potential harm when communicating with outside stakeholders. Managers also will want to consider how these factors will interact with brand market share and advertising spending.

Our study also offers important insights for policymakers who have to consider ways to dissuade firms from utilizing misleading claims, since we are able to quantify the average financial penalty of different types of misleading claims following an FDA citation. Although under certain conditions, we found that regulatory exposure of some acts of deception had no impact on firm value and a few even boosted share prices, we did conclude that cited firms do incur a significant financial penalty. For the most part, FDA cites are associated with significant and negative impacts on market value. We believe this analysis provides a set of factors that regulators should consider when evaluating the violations that may require additional fines to offset gains in sales.

Knowledge@Emory: Let’s say the FDA proves that a company has engaged in deceptive marketing. In such a case, is there much of a relationship between the kind of ad campaign the company abused, and the degree of market losses suffered by the company as a result of being sanctioned by the FDA?

 

Bharadwaj: It appears so. High-cost promotions directed at consumers, and highly egregious, unsubstantiated effectiveness claims are associated with significantly greater negative market value changes, while deceptive activities with lower total costs, such as unsubstantiated superiority claims and direct-to-consumer print advertising, are not associated with those negative abnormal returns.

Knowledge@Emory: Earlier, you mentioned that when a deceptive marketing incident is exposed, investors are quick to factor that into their calculations of future cash flow. What other parties are affected by deceptive marketing, and does their behavior impact the expected change in a company’s market valuation?

Bharadwaj: Highly egregious acts impact several groups of stakeholders, and we considered the aggregate impact of changes in behavior by these groups when we calculated the financial impact of the event. Physicians, for example, suffer if risk information is omitted in a promotion. They are typically concerned about suboptimal patient treatment, and as a result are also worried about protecting themselves against malpractice suits.

Knowledge@Emory: Even though the pharmaceutical company distributed false information?

Bharadwaj: Our understanding is that,according to the Learned Intermediary Rule, physicians are responsible for warning consumers of the dangers associated with a drug regardless of the information conveyed in direct-to-consumer advertising.

So if the deception involves highly egregious omissions of risk information, the potential for patient harm is higher and more physicians will seek alternative treatments to minimize their own liability.

Fewer prescriptions will decrease the firm’s expected revenue from sales of the drug. Not only does this impair future revenues, but exposure of deceptive marketing that involves severe risk consequences is likely to reduce the response or returns to the marketing actions of the firms, and cited pharmaceuticals will subsequently have lower returns on their marketing efforts.

Physicians may also be more wary of information originating from the firm and will tend to distrust the clinical trials conducted by the offending firm. As a result, firms will have to spend more on marketing activities to achieve the same returns as before the event, and the offending firm is likely to find its revenue is decreasing even as it has to spend more on marketing and sales efforts.

Knowledge@Emory: Besides physicians, what other parties are likely to be affected by, and in turn affect the revenue stream of deceptive pharmaceutical companies?

Bharadwaj: Consumers who were previously misled by the cited pharmaceutical firm may take legal action against it if the omitted risk information led to severe harm. On the one hand, if consumers who used the firm’s product suffer minimal consequences as a result of the deception, they are not likely to be able to make a strong legal case. But if the total physical or financial harm caused by the deception is high, the potential litigation from misleading consumers could result in enormous financial burdens for the firm.

Misleading marketing practices have previously resulted in multi-million dollar fines and class action lawsuit settlements, such as in the Vioxx case. In fact in 2008, Merck was ordered to pay claimants $4.85 billion, the largest settlement in pharmaceutical history, as a result of concealing information about fatal side effects associated with its arthritis drug Vioxx.

Prospective customers constitute another class that may turn against a pharmaceutical company that’s engaged in deceptive marketing practices. Consumers can reduce firm revenues by changing their physicians’ prescribing behavior as well as their own purchasing patterns. For example, prospective customers may seek alternative treatments out of fear for their health. Although the benefit-to-risk ratio may still be objectively favorable, research indicates that consumers have a tendency to overweigh negative information, especially if they mistrust the firm.

Additionally, consumers, like physicians, are likely to be less receptive to future attempts at persuasion following a case of deceptive marketing. Studies support this, including one that considered salmonella poisoning of peanut butter. The study found that the incident led to quadruple jeopardy: a loss of baseline sales, reduced price, increased cross-price elasticities [the change in quantity demanded of one good when there is a price change in an equivalent or substitute good], and reduced marketing instrument effectiveness. Thus, a cited firm will have to spend more on its marketing activities to achieve the same returns that it did before the violation.

 

Knowledge@Emory: What other kinds of effects will the exposure of deceptive marketing have on the offending company’s finances?

Bharadwaj: Any statement that makes a drug appear to be better than it is or better than its substitutes may draw sales away from its direct competitors, and under the Lanham Act, firms can sue competitors for deceptive advertising. Normally this may be difficult to prove, but an outright omission of risk information with clear and egregious consequences is easier to prove and more likely to be taken to court.

The Lanham Act allows for monetary damages to be recovered from the misleading firm, thus negatively affecting its future cash flows.

State and federal agencies also heavily penalize firms found to have engaged in deceptive advertising. Any award is frequently used to fund consumer protection education programs and to cover the increasing costs of treating harmed consumers.

Unsubstantiated claims for effectiveness may leave firms vulnerable to legal action by government agencies seeking reimbursement for unnecessary or ineffective medications paid for by programs like Medicaid.

So in the wake of an FDA citation, highly egregious omissions of risk information are likely to result in reduced estimates of cash flows due to decreasing future sales and increasing marketing costs and legal liability. In accordance with the efficient market hypothesis, a decrease in estimates of future cash flows will be reflected in negative abnormal stock returns.

Knowledge@Emory: Given the multiple sources of online information available today, is it more likely that negative information about a company will spread faster than, say, in the pre-Internet era?

Bharadwaj: Yes. The potential negative word-of-mouth from disappointed patients in the current environment of blogs and online forums is likely to be significant.

For example, research indicates that the airline industry suffered a negative stock market reaction after negative consumer comments spread online. Patients are likely to be more involved with pharmaceutical products than airlines, so negative news about an issue like unsubstantiated efficacy claims should lead to a significant reduction in future cash streams for the cited firms.

Knowledge@Emory: With all the scrutiny the industry faces and the significant negative effectsassociated with making false claims, why do you think some pharmaceutical companies continue to engage in this practice?

Bharadwaj: It’s a cost-benefit decision. First, they may believe there’s a small chance of actually getting caught by the FDA or another agency. Also, the decision makers may believe their company can realize a good profit between the time they launch a scheme and the time they actually get cited by the FDA.

Knowledge@Emory: Canconsumers do anything to protect themselves from unethical pharmaceutical advertising?

Bharadwaj: They can try to be more wary of the efficacy and other claims that are made, but the fact is they rely on their doctors to be their proxy. So physicians need to function as gatekeepers. I believe that the FDA is trying to take a harder line against unsubstantiated claims and other violations, but our study indicates that the rate of medical advertising is rising significantly faster than the increase in the FDA’s budget. So even though the number of violations appears to be dropping, it may simply be that the FDA is not citing as many as it used to. An alternative and more benign explanation may be that pharmaceutical firms are getting better at understanding and following FDA guidelines on fair balance in DTC advertising.