Avoiding Subprime Contractors and Contracts

Could sloppy due diligence practices hurt CMOs and their clients?
Oct 02, 2007
Volume 31, Issue 10

This summer's crisis in the financial markets is a timely reminder of the costs and disruptive consequences of sloppy due diligence. Biopharmaceutical and pharmaceutical companies as well as contract manufacturing organizations (CMOs) would do well to heed the lessons of the mortgage meltdown.

Jim Miller
The root cause of the debacle in the financial markets was the poor due diligence practices of mortgage lenders and of the institutions that invested in mortgage-backed securities. Mortgage brokers and packagers were most concerned with maintaining the high volume of originations, which generated a lot of fees for them. Knowing that the mortgages would be packaged and sold to investors, they had little concern for the ability of borrowers to sustain payments on their loans, and made little effort to check the veracity of income and other credit information that borrowers provided.

Although the subprime mortgage sector itself is a small part of the overall financial market, its problems had implications across all financial sectors. It made investors appreciate that they had undervalued risk in their rush to chase high returns, and caused them to make terms on higher-risk assets more onerous. It also made them look more closely at the creditworthiness of those assets.

Effect on companies

What can pharmaceutical companies and CMOs learn from this? Our experience has been that both parties to contract manufacturing transactions have been remarkably lax about their due diligence practices. While pharmaceutical companies will send armies of quality assurance staff to audit a CMO's operations, they seldom put much effort into reviewing its financial status. In the 2005 edition of the PharmSource–Pharmaceutical Technology Outsourcing Survey, only 17% of pharmaceutical company respondents said they reviewed their contractor's financial statements at least annually.

Companies need to remember that adverse business developments at their CMO are likely to be more catastrophic than compliance or technical problems. Even when a CMO receives a warning letter from the US Food and Drug Administration, it is usually able to continue shipping product while correcting deficiencies. However, a client may be forced to take drastic measures if its CMO is facing financial distress.

A clear case in point occurred this summer. In July, Inyx (New York, NY), a contract dose manufacturer, had its United Kingdom operations placed in receivership, and its US subsidiary filed for Chapter 11 bankruptcy protection. The actions came after Inyx's principal lender, Westernbank Puerto Rico, declared the three UK subsidiaries in default of their loan covenants and demanded repayment of the $120 million loan outstanding to the company. Inyx had nearly $80 million in revenues, and clients have included Merck Generics (Darmstadt, Germany), NovaDel Pharma (Flemington, NJ), Kos Pharmaceuticals (now owned by Illinois' Abbott Laboratories), Genpharm (Quebec), and UCB (Brussels).

Inyx has been supplying product to UCB, from which it acquired operations in 2005, and Aventis, whose Puerto Rico facility was also acquired by Inyx in 2005.

Proper due diligence could have alerted these companies to Inyx's highly leveraged financial situation, and to its management's association with a previous CMO's business failure. As a public company, its precarious balance sheet was readily available to potential clients. Now, these companies are dealing with a potential interruption of product supply and having to consider a takeover of facilities they had previously sold.

Impact on clients

A CMO faces a different and more complex due diligence problem. It must deal with at least three dimensions:

1. Does the client have the financial means to pay for our services?

2. Will the client's product achieve the projected manufacturing volumes if the product is approved?

3. Does the client have the management and technical expertise and experience to get the product to regulatory approval?

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