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Small Business Waivers is Not So
Simple: Practical Considerations for
Structuring Investments in Emerging
Pharmaceutical Companies in Light
of SBA’s Restrictive Policies
By John Manthei, Carolyne Hathaway
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Practical Considerations for
Structuring Investments in Emerging Pharmaceutical Companies
in Light of the Small Business
Administration’s Restrictive Policies
By John Manthei, Carolyne Hathaway and Rebecca Schaefer
M
uch of the innovation in the pharmaceutical
industry originates in small drug companies with
limited portfolios of novel, developmental-stage
products. These companies rarely have products that have
been approved for marketing by the U.S. Food and Drug
Mr. Manthei is a
partner and Global
Co-Chair of Health
Care and Life
Sciences Practice
at Latham &
Watkins LLP
FDLI
Administration (FDA) and are therefore often dependent on
venture capital investments to fund their activities.
Small businesses in the life sciences arena require far more
capital investment than in any other industry due to the costs
associated with researching, developing and obtaining FDA
Ms. Hathaway is a
partner at Latham
& Watkins LLP
Ms. Schafer is
Deputy General
Counsel, University
of North Carolina
September/October 2011
UPDATE
51
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approval for new therapies. It can take
over a decade and hundreds of millions
of dollars to develop a promising new
treatment from the time of creative
inception to introduction to market.
Sensitive to these realities, Congress
provided waivers and reductions of user
fees for irst-time, small businesses applicants in both the Prescription Drug
User Fee Act (PDUFA) and the Medical
Device User Fee and Modernization Act
(MDUFMA). he express purpose of
these exclusions is to ease the signiicant
inancial burden that would otherwise
be levied on irms that can least aford
it, thereby preserving their incentive
for innovation.1 Whether or not a small
business is eligible for waiver of user fees
can mean a diference of more than $1.5
million, the fee set for FDA review of a
new drug application (NDA) in 2011.2
For new medical devices, the user fee
for review of a pre-market approval application (PMA) in 2011 is set at nearly
$250,000, compared to a fee of only
$59,000 for small businesses.3
Despite the legislative intent and
policy rationales underlying the small
business waivers, and ignoring the
market reality that few small drug
development companies are able to
commercialize their technologies without signiicant venture capital backing,
the U.S. Small Business Administration
(SBA) is increasingly denying small
business status to irms by virtue of
their “ailiation” with larger institutional investors. As a result, start-up
innovators can be overwhelmed by
the sum of user fees for FDA review
paid by pharmaceutical giants, such
as Pizer. Accordingly, emerging irms
and the venture capital groups who
invest in them should be mindful, at
the outset, of SBA rules and how they
are currently applied, or risk losing
52
UPDATE
September/October 2011
eligibility for a small business waiver in
the future.
his article sets forth key information regarding the SBA’s approach to
small business determinations, along
with speciic steps parties can consider
in structuring investments to avoid
common pitfalls and to minimize the
risk of being denied waiver of PDUFA/
MDUFMA user fees.
Legal Landscape
PDUFA deines a small pharmaceutical company as “an entity that has
fewer than 500 employees, including
employees of ailiates,”4 and MDUFMA
deines a small medical device irm as
“an entity that reported $100,000,000 or
less of gross receipts or sales in its most
recent Federal income tax return for
a taxable year, including such returns
of all of its ailiates.”5 Regardless of
which threshold applies (employees or
revenues), both deinitions pivot on the
meaning of “ailiate,” which the statutes
deine as “a business entity that has a
relationship with a second business
entity if, directly or indirectly, one business entity controls, or has the power
to control, the other business entity; or
a third party controls, or has power to
control, both of the business entities.”6
hese principles of ailiation combine
to render many venture-backed companies “other than small” because once
the institutional investor is considered
to “control” a portfolio irm, all of that
investor’s portfolio companies are
likewise considered ailiated by virtue
of being under the common control of
their mutual investor.
Small business determinations are
oten quite complex and technical.
Accordingly, FDA generally refers applicants for small business waivers to
the SBA, which has an entire body of
regulations, administrative guidance
and case law delineating the speciic circumstances in which ailiation arises.
SBA proceeds under the broadly-construed general principle that “control,”
the operative factor in determining afiliation, may arise through ownership,
management or other relationships or
interactions between parties.7
he following outlines some of the less
than obvious circumstances in which
SBA perceives such control to exist:
Minority Stock Ownership. If two
or more entities each own, control or
have the power to control less than 50
percent of a irm’s voting stock, such
minority holdings are equal or approximately equal in size and the aggregate
of these minority holdings is large as
compared with any other stock holdings, SBA presumes that each entity
controls or has the power to control the
company.8 herefore, if Investor A and
Investor B each hold approximately ten
percent of a small drug development
irm and their aggregated 20 percent
exceeds the holdings of any other single
shareholder, then both Investor A and
Investor B may be considered to control, and thus be ailiates of, the irm.
By the same rationale, any portfolio
company of Investor A and Investor B
whose stock distributions are similarly
situated will likewise be considered afiliated. his presumption is rebuttable
by a showing that such control or power
to control does not in fact exist.9 However SBA case law does not deine the
relevant factors for rebuttal and recent
precedent suggests that SBA rigidly applies the regulatory presumption.10 he
portfolio company can attempt to aggregate the holdings of its own oicers
and directors by ailiation through an
“identity of interest” (described below),
such that these aggregate holdings are
large relative to those of the irm’s inwww.fdli.org
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vestors, but SBA has repeatedly resisted
such arguments.
Negative Control. Ater the minority shareholder rule, perhaps the most
common circumstance in which SBA
inds an investor to be an ailiate of
a small business is through ailiation
by negative control. his principle of
ailiation is potentially one of the most
nebulous, and one of the trickiest to
navigate, because “negative control” can
arise from many standard contractual
terms. SBA has explained that “negative
control includes, but is not limited to,
instances where a minority shareholder
has the ability, under the concern’s
charter, by-laws, or shareholder’s agreement, to prevent a quorum or otherwise
block action by the board of directors
or shareholders.”11 hus, SBA may ind
ailiation where a company’s governing
documents and/or operative agreements
(e.g. Investor’s Rights Agreements,
Voting Agreements, Series X Preferred
Stock Purchase Agreements, Certiicates of Incorporation, By-Laws, etc.)
endow investors with supermajority
approval rights or the de facto ability to
veto action by the management of the
small business in question.
In a rare ruling acknowledging that
investors reasonably require and should
be entitled to maintain the means to
protect their investments, SBA concluded that possessing supermajority
approval rights over certain “extraordinary” corporate decisions (e.g.
amending or repealing the certiicate of
incorporation, issuing additional stock
or entering into a substantially diferent
business) are merely intended to give
preferred stockholders a meaningful
opportunity to participate in decisions
that fundamentally afect their investment and do not constitute control over
day-to-day business decisions so as to
FDLI
give rise to ailiation.12 Although helpful, SBA has construed this limitation
narrowly and has subsequently distinguished most of the appeals that have
attempted to rely upon it.13 For example,
SBA has found negative control to exist
where shareholders have supermajority
approval rights over the creation of debt
and payment of dividends,14 hiring and
compensation of corporate oicers and
the ability to alienate or encumber assets, amend or terminate existing lease
agreements, purchase equipment or
increase employee compensation.16
Stock Options and Convertible Securities. SBA treats stock options and convertible securities as though those rights
have been granted and exercised. hus,
SBA considers such options to have a
present efect on the power to control a
company.17 An investor who holds only
unexercised options that, if exercised,
would result in a minority shareholding suicient to confer ailiation under
the minority shareholder rule, may be
considered to be an ailiate.
Common Management. Ailiation
may also arise where one or more oficers, directors, managing members or
partners who control the board of directors and/or management of the emerging
drug company also control the board of
directors/management of one or more
other concerns.18 hus, if a partner of
Investor A serves on the board of directors of a small pharmaceutical company
in which it has invested, Investor A may
be considered an ailiate of the portfolio company as a result of the partner’s
ability to “control” the operations of both
entities. Likewise, this principle may, in
turn, ailiate each portfolio company
in which a representative of Investor A
holds a position on the board.
Identity of Interest. he concept
of ailiation through “common
management” is conceptually similar
to the broader principle of ailiation
based on an identity of interest. SBA
regulations provide that ailiation may
arise among two or more individuals
or irms that have identical or substantially identical business or economic
interests, such as individuals or irms
with common investments or irms that
are economically dependent through
contractual or other relationships.19 SBA
has found ailiation based on an identity
of interest when an investor, who was
identiied as a key employee of the small
business, also played an important role
in the development of other portfolio
companies.20 SBA has found suicient
“identity of interest” even where the
individual had historically participated
in multiple business ventures but had
since resigned from management of the
company at issue.21
Refusal to Provide Information. he
refusal to provide information regarding a small business’s investors and their
respective portfolio companies can also
give rise to an adverse size determination.
If a irm whose size status is at issue fails
to submit requested information, SBA is
empowered to presume that disclosure of
the information would demonstrate that
the concern is other than small.22
Policy Implications &
SBA Trends
he numerous common circumstances under which the SBA inds ailiation,
even in the case of passive investors and
attenuated relationships, can virtually
preclude venture-backed small biotechnology irms from qualifying for FDA
waivers. To preserve their small business
status and eligibility for waiver or reduction of user fees, such entities are limited
in their ability to avail themselves of
the capital market. his result imperils
the research and development of novel
September/October 2011
UPDATE
53
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therapies by small companies who are
the lifeblood of pharmaceutical and
medical device innovation.23 he problem is particularly acute in the case of
orphan drug and humanitarian device
development, where small irms are responsible for developing the overwhelming majority of novel treatments.24 he
diiculties associated with collecting the
clinical information necessary to support an FDA application in an orphan
patient population, combined with the
fact that many larger companies do not
see a clear business case for developing
products to serve such small markets,
gives rise to a corresponding need
for these small companies to rely on
risk-taking venture investors.25 Absent
venture capital inancing, such innovation on the part of small business will be
greatly limited.
Despite the obvious chilling efect that
SBA’s interpretations have on investment, the associated negative impact on
small irms’ ability to bring promising
new therapies to market and Congress’s
clear intent to avoid precisely these results, SBA appears to be unsympathetic
to such policy arguments. he agency remains quite rigid in its application of its
regulations and in its adherence to unfavorable precedent. For these reasons, it
is important for venture capital investors
and small biotechnology irms alike to
consider the following steps to minimize
the risk of “ailiating” with each other
for purposes of size determinations.
Means to Avoid an Adverse
Size Determination
While adhering to each of these
recommendations may not be appropriate or feasible in all circumstances, the
following list is intended to provide approaches that can be taken to minimize
the risk of an adverse size determination:
• Ensure that investors’ holdings in
54
UPDATE
September/October 2011
determination (e.g. requesting
information about the number
of employees or gross receipts
of an investor’s other portfolio
companies), respond timely to
SBA correspondence and explain
the reasons why such information
is not relevant and why ailiation
does not exist.
voting stock are small relative to the
holdings of the founders, oicers
and directors of the small business
in question.
• Avoid organizing stock holdings such
that two or more minority shareholder
investors hold equal or approximately
equal numbers of shares.
• In arranging percentages of stock
holdings, note that SBA treats
convertible stock options as though the
rights have been granted and exercised.
• Avoid having representatives of any
single investor occupy a majority
of seats on the small irm’s board
of directors.
• If a representative from an investor
is planning to serve on the small
irm’s board of directors, select a
representative that does not also serve
as an oicer, director or principal
partner of the investor’s organization.
• Structure the small irm’s governing
documents (e.g. Certiicate of
Incorporation, By-Laws, etc.)
and operative agreements (e.g.
Investor’s Rights Agreements, Voting
Agreements, Series X Preferred
Stock Purchase Agreements, etc.)
to grant investors approval or de
facto veto rights only over decisions
that afect the fundamental nature
of the business. Avoid applying
supermajority approval rights or
other protective provisions to more
routine business operations such as
incurring debt, paying dividends,
hiring oicers, determining
compensation levels, entering or
terminating real property leases and
purchasing equipment.
• Respond in good faith to all
SBA information requests. If it
appears that the SBA reviewer is
trending towards an adverse size
Conclusion
In light of SBA’s broad construction
and application of the principles of
ailiation, small, venture-backed drug
and medical device innovators are at
risk of losing eligibility for reduced or
waived user fees when they submit their
premarket approval applications to
FDA. Avenues are available to appeal an
adverse size determination, irst to SBA’s
Oice of Hearings and Appeals and
from there to federal court.
However, given SBA’s adherence to
unfavorable precedent and the cost of
further litigation, it is obviously best
for small developmental stage companies and their investors to take steps to
minimize the likelihood of being considered to be ailiates in the irst place.
Venture capital irms and the small
pharmaceutical and device companies
in which they invest should consider the
risk of ailiation that arises from SBA’s
interpretation of applicable regulations
and, if possible, take proactive steps to
minimize the likelihood of an adverse
determination when structuring their
investments. FDLI
1.
138 Cong. Rec. 33,610-11 (1992) (statement of Sen.
Edward Kennedy) (“[W]e must ensure that user
fees are not a disincentive to the development of
new drugs by small businesses, especially innovative biotechnology irms. he legislation contains
reduced fees for small businesses, and allows a
complete waiver of fees in special circumstances.
We will continue to work to see that user fees
do not retard the development of promising
therapies. … [T]he Secretary will consider the
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2.
3.
4.
5.
6.
7.
8.
9.
10.
inancial burden imposed by fees on the ability
of companies, especially small companies, to
continue innovative research and development
programs.”).
75 Fed. Reg. 46,952, 46,953 (Aug. 4, 2010).
U.S. Food & Drug Admin., Guidance for Industry, FDA, and Foreign Governments: FY 2011
Medical Device User Fee Small Business Qualiication and Certiiation (Aug. 2, 2010).
21 U.S.C. § 379h(d)(4)(A).
21 U.S.C. § 379j(d)(2)(A).
21 U.S.C. § 379g(11).
U.S. Small Business Admin., Guidance: Ailiation, available at http://www.sba.gov/idc/groups/
public/documents/sba_homepage/ailiation_discussion.pdf (last accessed Dec. 17, 2010).
13 C.F.R. § 121.103(c)(2).
Id. In considering whether a concern has
adequately rebutted the presumption found in 13
C.F.R. § 121.103(c)(2), SBA applies the following
standard: “suicient evidence to create a genuine
issue of material fact as to whether the regulatory
presumption is correct.” Size Appeal of Tech. Support Servs., SBA No. SIZ-4794, at 14 (2006).
See, e.g., Size Appeal of Novalar Pharm., Inc.,
SBA No. SIZ-4977 (2008); Size Appeal of Eagle
Pharm., Inc., SBA No. SIZ-5023 (2009).
FDLI
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
13 C.F.R. § 121.103(a)(3).
Size Appeal of EA Eng’g, Sci., & Tech., Inc., SBA
No. SIZ-4973 (2008).
See, e.g., Novalar, supra note 10.
See, e.g., Eagle Pharmaceuticals, supra note 10.
See, e.g., Size Appeal of Firewatch Contracting of
Florida, LLC, SBA No. SIZ-4994 (2008).
See, e.g., Size Appeal of Dependable Courier
Services, Inc., SBA No. SIZ-2110 (1985).
13 C.F.R. § 121.103(d).
13 C.F.R. § 121.103(e).
13 C.F.R. § 121.103(f).
See Novalar, supra note 10, at 12.
See Size Appeal of DooleyMack Gov’t Contracting, LLC, SBA No. SIZ-5086 (2009).
13 C.F.R. § 121.1008(d).
H. Miller, User Fees Confuse and Abuse,
FORBES (Aug. 6, 2009) (“[S]mall companies
… are the source of most of the innovation in
pharmaceutical R&D.”), available at http://www.
forbes.com/2009/08/06/user-fees-taxes-opinionscontributors-henry-i-miller.html.
S. Villa et al., Orphan Drug Legislation: Lessons for Neglected Tropical Diseases, INT’L J.
HEALTH PLANNING & MGMT. (2008).
25.
See Testimony of Mary Dwight, Vice President of
Government Afairs, Cystic Fibrosis Foundation, before the U.S. House of Representatives
Small Business Committee (June 17, 2009) (“he
risks related to the research and development of
new therapeutic products are substantial and far
greater for development of an orphan drug than a
conventional drug. he rewards for development
of an orphan drug are also limited by the size of
the market. his combination of factors argues
against industry involvement in orphan drug
research.”); E. Seoane-Vasquez, Incentives for Orphan Drug Research & Development in the U.S.,
ORPHANET J. RARE DISEASE, 3(33): 1186-92
(Dec. 2008) (“Small businesses [ ] are more prone
to target orphan drugs… he relatively small
number of orphan drugs developed by large
companies may be explained by priorities that
emphasize research toward drugs with a larger
potential for proit.”).
September/October 2011
UPDATE
55