Academic journal article Journal of Private Enterprise

Insider Trading around New Drug Approvals

Academic journal article Journal of Private Enterprise

Insider Trading around New Drug Approvals

Article excerpt

This study examines the market reaction to new drug approval announcements by the Food and Drug Administration (FDA). According to the Tufts Center for the Study of Drug Development (2001a), the average cost to develop a new drug is $802 million and the typical time frame before it reaches the market is 10-15 years. A new drug that obtains FDA approval to be marketed to the public can contribute billions of dollars to the manufacturing pharmaceutical. For example, in 1998, the anti-ulcer drug Prilosec generated over $4.0 billion in sales for Astra Pharmaceutical. Zocor, a cholesterol reducer, contributed over $2.8 billion to Merck, and Claritin, an anti-allergy drug manufactured by Warner-Lambert, produced sales of more than $1.3 billion. Sales for the entire industry exceeded $102 billion, and profits grew by almost 18%-four times that of the average Fortune 500 firm (Tanouye, 1998).

New Drug Approval Process

Prior to marketing, these drugs, which emanate from the pharmaceutical and biotechnology industries, must go through a rigorous approval process with the FDA that includes pre-clinical testing and several stages of clinical trials. In order to assess safety, new drugs must undergo preclinical testing in animals. The findings of these data are used to open an Investigational New Drug application (IND). The IND is eventually submitted to the FDA to start human clinical studies. Human clinical tests proceed in three phases. In Phase I, the drug may be tested in patients, but is typically tested in a small number of healthy human volunteers, mostly to measure its safety, pharmacological effects, and how it is metabolized. Phase II's purpose is to determine the scientific validity (e.g., efficacy and side effects) of the drug using a larger group of patients actually suffering from the targeted disease. Phase III studies are expanded controlled and uncontrolled trials. They are done to gain additional data about effectiveness and safety needed to evaluate the benefits and risks of the drug. This phase typically tests hundreds to several thousands of people (Tufts Center for the Study of Drug Development, 2001b).

After the trials, if the drug performs as expected, the sponsor files a New Drug Application (NDA) with the FDA's Center for Drug Evaluation and Research (CDER). These applications include all the data developed during the clinical trials. FDA approval of an NDA gives the sponsor clearance to sell the drug for the indications approved (Glass, 1991). The Tufts Center for the Study of Drug Development (2001b) reports that a new product can take up to 15 years of testing before it reaches the marketplace.

Insider Trading

Since FDA decisions concerning new drugs can materially affect profitability and the corresponding value of the applying pharmaceutical, imminent approval (denial) would be good (bad) news to shareholders. Investors that anticipate the direction of the FDA decision could, therefore, profit (or avoid losses). It is well known that anticipating certain announcements can provide significant returns. For example, it is widely published that the purchase of shares in a merger target prior to the initial announcement produces a premium. For example, in 1999 Sprint jumped almost 19% around the announcement of a bid from MCIWorldCom (Lipin, Harris and Blumenstein, 1999).

In an environment where great rewards can be obtained by anticipating favorable announcements, the threat of insider trading flourishes. Substantive information about a firm that is unavailable to the general public is considered inside information. Since the information is not reflected in the current market price, the true value of the firm may be different. Asymmetric information is, thus, present whereby insiders know more than others and may be trading on the basis of this information. Trading on such information is, of course, illegal and the Securities and Exchange Commission (SEC) aggressively prosecutes violators. …

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