Ownership and Control Rights' Allocations and Incomplete Contracts: Empirical Analysis of Drug Development Partnerships
Hyttinen, Lilia, Academy of Accounting and Financial Studies Journal
As a rule, pharmaceutical firms commonly outsource new drug innovations to biotechnology firms. Yet, because biotechnology firms are often small to medium size, and do not have the resources to conduct larger scale clinical trials, promising drug targets are further developed in collaboration with larger pharmaceutical corporations. Strategic alliances have become an increasingly common vehicle for organizing corporate investment (Palia, Ravid and Reiser, 2008). The motivation for this analysis is the observation that while considering the partnering a development of a new drug, counterparts have to decide, either to buy a technology , or only to license commercialization rights; they must also decide how they go about contract design. A few new trends have emerged, yet many of these developments are currently only corroborated by anecdotal evidence; I have documented empirical evidence to support the industry observations. To my knowledge, there are no empirical papers yet, that have examined the transfer of control of the cash flow rather than transfer of pharmaceutical assets' ownership.
This paper investigates how and at what stage of a drug development process the ownership or control over an asset and a cash flow generated by that asset are allocated within a partnership, using the data from pharmaceutical and biotechnology industries. Furthermore, I take a closer look at the design of partnership contracts and the ways partners use contractual provisions, such as an option to license a new drug, or, an acquisition of minority stake in the partner's equity.
At the outset not all possible future contingencies can be included in the contract, since they are simply too difficult to describe in advance. If the initial contract does not outlay all the future contingencies, the key question becomes how future decisions are made? And, more importantly, how they are reflected in the choices of parties at ex-ante stage.
In contract theory research (Grossman and Hart, (1986) and Hart and Moore (1990)), the view taken to incompleteness: even if a contract does not specify all contingencies in the contract ex ante, it is possible to agree ex ante on the decision--making process. The question is who should have decision and control rights, since they are the keys to decisions and actions when unforeseen contingencies arrive. How should decision rights and cash flow rights be allocated in the initial contract between the parties? Contracts that employ real option features are becoming increasingly common in pharmaceuticals universe.
Additionally, because 62% of partnerships in the sample are cross-border, I have examined whether the international factor contributes to an ownership transfer or a contract design, possibly, because of the monitoring and costly state verification issues (Diamond, (1991); Winton, (1995)). In the area of financial contracting under moral hazard ("hidden action"), the critical issue is what are the variables that are observable and verifiable and thus, contractible. In most moral hazard problems in economics, the main trade-off is identified as between risk sharing and incentives (Jensen and Meckling, (1976); Leland and Pyle (1977); Myers and Majluf, (1984)).
At first, the prediction is examined that within a framework of drug development partnerships, it is not the ownership of the assets, but, rather, the revenues generated by the assets are important. Following works of Aghion and Bolton (1993), Kaplan and Stromberg (2003), Robinson and Stuart (2007), and Dessein (2005), I distinguish between the technology ownership determined by who holds a title on a drug's patent, and the control rights that establish who holds commercialization rights. For example, Amgen has developed a drug Apanesp and hold patent title (ownership) of the drug, while Johnson & Johnson has licensed the rights to manufacture and market the drug (controlling the drug). …