Clawbacks, SEC comments, and the complexity of clinical trials

On October 26, 2022, the U.S. Securities and Exchange Commission (SEC) codified into law the final rule for clawbacks of previously awarded compensation. For small and scaling biotech organizations, private life science companies with aspirations to go public, or large/multinational pharmaceutical organizations, this new rule is material and consequential. The bar is raised under the new rule, whereby companies must clear a high hurdle of accuracy in financial statements and reporting. Otherwise, companies face the potential for personal accountability in the form of compensation clawbacks covering disclosures in the past three years and encompassing even smaller infractions. For this reason, biotech finance and accounting leaders should be sharpening their process around financial reporting, especially related to clinical trials.

Clinical Trials and Materiality

For many biopharma organizations, the costs associated with clinical trials are highly material to SEC disclosures, often representing a significant portion of a company’s expenditures, and they represent a significant challenge for reporting. Clinical trials are a unique type of organizational undertaking: very expensive, often outsourced, dispersed across vendors and geographies, incredibly complex and convoluted. While the clinical components of a trial are vast, so too are the financial implications: accounting for millions or billions of dollars spent across a vast network of sites, investigators, and vendors is an incredibly intensive endeavor coupled with the need to plan and manage runway for the next trial or program. As noted by Crunchbase, “while most tech companies enter the market armed with millions in revenue, a strategy toward profitability, a solid capital expense, and strong projections for the long haul, few of the record 143 biotech startups that made their public debut last year had a product to sell.” Biotechs run fundraising round to fundraising round as they seek successful endpoints or aim for a public offering to help weather the expense of getting a drug to market. Far too often, biotechs do not invest in financial operations until the last possible second, usually only spurred by compliance considerations or due diligence requirements for their IPO.  

Rapid growth creates a financial maturity gap as biotechs by necessity race to fill the positions and cover the competencies needed to cover regulatory compliance, auditor scrutiny, and investor expectations. As companies bring scrutiny to bear on their internal controls and processes, auditors, investors, and regulators pick through their books with a fine-toothed comb leading up to the initial public offering. Once public, Section 404(a) of the Sarbanes-Oxley Act requires company management to report on the effectiveness of internal controls over financial reporting (ICFR) while Section 404(b) requires an auditor attestation with respect to an issuer's ICFR. These regulations ensure audits happen on an annual basis and numbers are "reviewed" quarterly. If the auditors find these processes and controls lacking, they’ll let you know.  After internal review, audit, and public disclosure are complete, the SEC will review the filing document itself to validate that the filing is compliant with accounting standards and disclosure requirements. If not, they will direct the filing company towards compliance with accounting rules and suggest that non-accounting items are disclosed in a way that provides investors with the right information.

Which takes us back to the comments.  

According to the SEC, in issuing comments to a company, [SEC] staff may request that a company provide additional supplemental information so the staff can better understand the company’s disclosure, revise disclosure in a document on file with the SEC, provide additional disclosure in a document on file with the SEC, or provide additional or different disclosure in a future filing with the SEC. The SEC’s EDGAR search platform is littered with examples from the biotech space of the difficulties inherent in clinical trials. Below we’ve highlighted a few examples and share some feedback on how you might avoid a similar paper trail. 

For investors to know, you’ve gotta show 

Getting well ahead of investor expectations is key from S-1 to beyond the public offering.  

In one filing, a biotech respondent is asked “to better inform investors about the near-term clinical trials expected to be completed with the net proceeds from the offering, the uncertainty regarding predicting clinical trial costs, and the expectation that additional funding may be required to complete longer-term clinical trials.”

Long-term forecasting is a tough process even in comparatively simple businesses, and biotechs certainly are not simple. Predicting and managing clinical trial costs is a volatile endeavor and cost overruns are commonplace (94% of 100+ biotech finance and accounting leaders that Auxilius polled recently shared that they had experienced site budgets out of line with initial projections). Biotech leaders fill this void in one of several ways: increasing the staffing necessary to cover manual work, hiring consultants and auditors to build out processes and controls, or adopting technologies and solutions dedicated to the task. 

Without the right tools and tactics, granularity remains out of reach 

In another letter, the SEC inquires “If [the biotech does] not track your research and development costs by project, please disclose that fact and explain why you do not maintain and evaluate research and development costs by project. Provide other quantitative or qualitative disclosure that provides more transparency as to the type of research and development expenses incurred (i.e., by nature or type of expense) which should reconcile to total research and development expense…”

Once upon a time, clinical trials might have only retained one or two vendors at a time. But, thanks to greater levels of interconnectivity, changing regulations, increasing complexity, and other factors, it’s not uncommon for a clinical trial to involve 10–20 vendors simultaneously and sponsors have only increased their reliance on outsourced vendors in recent years. Between 2016–2017, 43–45% of clinical trial operations were handled by third parties. Since then, the percentage of third-party vendors in clinical trials has jumped as high as 65%. What this means for sponsors is that accurate data on work performed and cost can be hard to gather, lag significantly, and only be reconciled months (or even years) after the trial. In short, this means that expense-level data is hard to come by unless you have the resources or toolsets to aggregate and manage data from the CRO to the vendor. Biotechs are increasingly turning to technology to bridge this divide, though industry-agnostic solutions or spreadsheets are typically ill-suited to the task.

Accruals, accruals, accruals 

Accruals are often the financial Achilles heel of a clinical trial. Many sponsors – considering the complexity and resource drain of calculating clinical trial accruals – decide the time/effort trade-off to track monthly accruals isn’t worth it and manage accruals on a quarterly basis. In these cases, organizations risk taking a potentially significant accrual reversal in the month following the expense leading to inaccurate monthly accounting. One biotech reversed an accrual “due to a Related Party correcting an overstatement of total Research and Development Expenses recognized over the period” but other examples abound.

In many sponsor organizations, accrual calculations start with the clinical operations lead recounting the events of the period. The finance team uses the resulting accrual estimates to re-forecast the remaining study costs through the completion of the trials. Sponsors with healthy accrual practices operate the other way around. These organizations begin their clinical trial with a granular forecast that serves as the starting point for monthly accrual estimates. These sponsors calibrate their own expected view of the world with the granular data they are receiving from their vendor and incremental knowledge from their own ClinOps team to triangulate on the most accurate accrual estimate. Finance takes the accurate picture of what happened in the prior period to [recalibrate] the forecast.

In summary: let’s keep the comments (and clawbacks) to a minimum 

Where does that leave us? In short, biotech finance and accounting requirements are tough: scrutiny, complexity, and volatility conspire to create an environment unlike most other sectors, uniquely regulated and regimented. But there are lessons to be learned, especially by those who have taken the path before. 

Take a few minutes to do an EDGAR search or two: you’ll be interested in what you find. (Just make sure those comments aren’t about you!) 

Author’s note: Each example was pulled from the EDGAR search platform as part of the public record. Company names were excluded at Auxilius’ discretion.