Merck develops and globally sells biopharmaceuticals manufactured in high production volumes at numerous facilities in the United States, Puerto Rico, Japan, Singapore, South Africa, Western Europe, Central and South America, and Asia overseen from its manufacturing headquarters in New Jersey. Therefore, the company is exposed to many product safety and quality related risks, including operating, regulatory adherence, financial, reputational, and litigation.

MSCI’s ESG Manager concludes that Merck has a high risk exposure on product safety and quality, but lacks the strong product safety and quality management policies and practices necessary for its level of risk – making it a laggard compared to peers.

The United States Food and Drug Administration (FDA) and increasingly its international counterparts are prioritizing that biopharma manufacturers produce more consistent and higher quality outcomes in their manufacturing production lots. To provide better regulatory oversight in this area, the FDA formed an Office of Pharmaceutical Quality (OPQ) in 2014 and developed a Pharma Quality System (PQS) with detailed guidelines in the areas of Quality, Production, Laboratory, Facilities Management, Materials, and Packaging/Labeling. Furthermore, the FDA’s PQS notes that biopharma company management is responsible for a company’s 1) leadership and commitment to quality, 2) quality planning, including addressing complaints, 3) resource management, 4) internal communication, 5) management review of manufacturing and quality, and 6) oversight of outsourced activities.²  Regulators also consider biopharma companies manufacturing site inspections with new drug approvals, which are key to helping the company achieve sustainable revenue and cash flow growth. As a result, it is important for biopharma companies’ Boards to include 1) specific committee oversight for manufacturing product quality and safety and 2) multiple members with biopharma manufacturing skills and experience to ensure the company is a leader in this key operating area and minimize the risks noted earlier.

Merck received a warning letter in 2016, a Form 483 in 2015, and six Form 483s in 2014, indicating potential manufacturing site and emerging quality issues in the company’s operations.

An October 2016 PWC survey reported that 85% of board members in the pharma/life sciences industry feel that regulatory compliance risks pose the greatest oversight challenges to their boards.³

As Merck’s reputation with institutional investors and sell side Pharma Industry Research Analysts improves, particularly with the future commercial potential of Keytruda, pressure may build over time for Merck’s management to meet operating margin, cash flow, and earnings metrics that support short-term shareholder return generation. We fear this pressure may potentially incentivize Merck’s management to misspend on necessary operating expenses and capital expenditures to support leading manufacturing product quality assurance and controls. Moreover, we know that the company’s CEO and Named Executive Officers total compensation is significantly tied to cumulative, three-year Operating Cash Flow and relative total shareholder return performance vs. its peer group, as well as revenues and EPS.