At the end of September, the SEC announced that it had filed a complaint in federal court charging pharma Mylan N.V. with failing to timely disclose in its financial statements the “reasonably possible” material losses arising out of a DOJ civil investigation. The DOJ had investigated whether, by misclassifying its biggest product, the EpiPen, as a “generic,” Mylan had overcharged Medicaid by hundreds of millions of dollars. According to the complaint, although the investigation continued for two years, Mylan also failed to accrue for the “probable and reasonably estimable” material losses, as required under GAAP, until the announcement of a $465 million settlement with DOJ. In addition, some of Mylan’s other misleading disclosure flowed from its omission to discuss the claims. The SEC alleged that Mylan’s risk factor was misleading because it framed the government’s misclassification claim as a hypothetical possibility, when, in fact, the claim had already been made. As a consequence of these failures, the SEC alleged, Mylan’s SEC filings were false and misleading in violation of the Securities Act and Exchange Act. Mylan agreed to pay $30 million to settle the SEC’s charges. While the SEC complaint makes the matter sound straightforward, in practice, deciding whether, when and what to disclose or accrue for a loss contingency can often be a challenging exercise.
From 2014 to 2016, approximately 20% of Mylan’s annual sales of EpiPens were to Medicaid patients. As part of the legal framework for Medicaid sales, pharmas are required to classify their products as either “generic” or single-source “branded” drugs. Pharmas pay quarterly rebates to the government for drugs sold through Medicaid, and, notably, rebates paid for generic drugs are much lower than rebate rates for branded drugs. Not only did Mylan pay a 10% lower baseline rebate, it also did not pay any additional rebate when it dramatically increased the price of an EpiPen two-pack in 2016 from approximately $100 to over $600. Although the EpiPen had many of the characteristics of a branded product, the company had classified it as a generic on the basis of a 1997 letter expressing the view of a then-employee of the Centers for Medicare and Medicaid Services (CMS) that classification as a “generic” was appropriate. However, internally at Mylan, questions began to be raised regarding the classification when a Mylan executive learned that the 1997 generic classification “‘was basically just done as a result of a conversation two guys who were there at the time had.’”
CMS began to question the classification of the EpiPen in 2013 and, in late 2014, advised Mylan that it viewed EpiPen to be misclassified and that the 1997 letter should not be relied on as guidance. Mylan conducted an analysis of the potential financial impact of a change in classification, but did not change its classification. Shortly thereafter, Mylan learned of the DOJ investigation into Mylan for potential violations of the False Claims Act (which provides for treble damages) for overcharging the government for EpiPen sales to Medicaid patients. Mylan argued that the 1997 letter was controlling and asked the DOJ to close the investigation, but to no avail. Subpoenas and investigative demands flew and arguments continued back and forth over an approximate two-year period.
In an October 2015 analysis, Mylan showed the DOJ that, for just one quarter in 2015, potential damages ranged from approximately $12 million to $42 million. Taking into account the possibility of treble damages and multiple quarters, the SEC contends that “Mylan knew or should have known that the total possible loss arising from DOJ’s claims was exponentially higher than these amounts.” In June 2016, Mylan estimated that, for 2015 only, non-trebled damages would range from about $114 million to $260 million.
In July 2016, when the DOJ provided its own damages estimates and advised Mylan that it was prepared to sue, settlement talks began. In October 2016, a settlement in principle was reached for $465 million, leading Mylan to disclose the investigation and its resulting liability for the first time. The complaint alleges that “Mylan executives, including executives involved in the preparation and review of Mylan’s financial statements, were aware of the progress of DOJ’s investigation and settlement negotiations.”
Companies are required to disclose material loss contingencies under GAAP “if a loss is at least reasonably possible. A loss is considered ‘reasonably possible’ when the chance of the future event or events occurring is more than remote but less than likely.” In addition, a company is required to “record an accrual for a material loss contingency, as a charge against income in its financial statements, if a loss is probable and reasonably estimable.” Reg S-X provides that “financial statements filed with the SEC that are not prepared in accordance with GAAP are presumed to be misleading.”
In the complaint, the SEC charged that Mylan “knew or should have known” that the likelihood of a material loss resulting from the DOJ investigation was reasonably possible by at least the time of the filing of its Form 10-Q for the third quarter of 2015, but failed to disclose the contingency or its best estimate of the range of loss. As a result, the SEC charged, “Mylan’s quarterly reports on Form 10-Q and annual report on Form 10-K from at least the third quarter of 2015 through the second quarter of 2016 were materially false and misleading.” In addition, the disclosure omission was inconsistent with Mylan’s past practice with regard to similar DOJ investigations.
Moreover, the SEC alleged, by at least the Form 10-Q for the second quarter of 2016, Mylan “knew, or should have known,” that a material loss resulting from the DOJ investigation was probable and that a loss was reasonably estimable. But Mylan did not accrue “its best estimate of the loss (or, if it did not have a best estimate, the minimum amount of the loss within the estimated range of losses)” and, as a result, Mylan’s reported earnings were alleged to be “materially overstated” in the second quarter 2016 Form 10-Q and in an August 2016 Form 8-K.
Mylan’s books and records were also charged to be inaccurate and its internal controls ineffective. For example, “although Mylan’s controls required quarterly discussions of significant contingencies by its financial and legal teams, the controls failed to require material information be provided to the teams,” and certain team members did not have knowledge of material developments.
The complaint also charged that Mylan’s annual report risk factors in its 2014 and 2015 annual reports were materially misleading. Mylan had not disclosed the claim or the investigation in its risk factors, instead stating only that CMS “may take a position contrary to a position we have taken,” and that CMS may find its submissions to be incorrect. However, CMS had already taken a contrary position and asserted that the submissions were wrong. Framed as hypotheticals, the SEC charged, these risk factors were misleading.
Mylan was alleged to have violated Section 17 of the Securities Act in connection with sales of securities and Section 13 of the Exchange Act (and related rules) in connection with its periodic reports. It was also charged with failing to maintain internal controls sufficient to provide reasonable assurances that transactions were recorded as necessary to permit preparation of financial statements in conformity with GAAP. There were also claims for books-and-records violations. Without admitting or denying the SEC’s allegations, Mylan agreed to a final judgment ordering a $30 million penalty and permanently enjoining it from violating those provisions.