This article is about a legal dispute between PharmAthene (NYSEMKT:PIP) and SIGA Technologies (NASDAQ:SIGA) and relate to a 2011 ruling by Vice Chancellor Parsons, and the Delaware Supreme Court's May 24, 2013 response, which remanded damages-related issues to the Vice Chancellor. In the light of the Supreme Court's opinion, the Vice Chancellor now must impose another remedy, and is likely to do so before the end of May. Before he does, he must answer two key questions: "What kinds of damages may he impose?" and "What forms of remedy are permissible?"
After briefly reviewing background information familiar to most followers of these two companies, I provide answers to each question. Then I use the answers to describe three possible remedy options, and assess (1) how well each meets four key evaluation criteria, and (2) their relative favorability to PharmAthene and consequent effect on PharmAthene's valuation. Finally, I briefly comment on the "de-scoping of PharmAthene's SparVax contract with BARDA." However, I intend to write more extensively about PharmAthene's pipeline after its next earnings conference.
In 2006, SIGA found itself financially strapped while trying to conduct R&D on Arestvyr (formerly known as ST-246, its antiviral drug for treating smallpox). It signed a bridge loan and a merger agreement with PharmAthene that called for PharmAthene to provide financial and technical assistance. Both agreements said that if a merger was not completed, the parties would negotiate in good faith to execute a definitive license agreement in accordance with the terms of a License Agreement Terms Sheet (LATS) that was attached as an exhibit to both documents. After receiving an NIH grant, SIGA torpedoed the negotiations by proposing economic terms that were so different from those contained in the LATS that PharmAthene sued, claiming that SIGA had breached its contractual obligation to negotiate in good faith.
The Vice Chancellor found in favor of PharmAthene and imposed expectation damages on SIGA. Although the Supreme Court upheld the Vice Chancellor's finding that SIGA had breached its contractual obligation to negotiate in good faith, as mentioned above, it also remanded the remedy to the Vice Chancellor because he had combined two justifications. After explaining why one of them couldn't be used, it instructed him to submit a remedy supported by a defensible rationale, unencumbered by an alternative that doesn't apply.
Question 1: What Kinds of Damages May be Imposed?
There are four kinds of damages that could conceivably be imposed in this case: reliance, expectations, punitive, and equitable. I shall discuss each.
Reliance damages would compensate or reimburse PharmAthene for expenses it incurred to support SIGA prior to the breach. Everyone agrees that the dollar amount would be minimal. SIGA argues that a reliance damages remedy is the only one available. Because the Vice Chancellor has made clear that he does not accept SIGA's position on this matter, I will not say any more here.
Expectation damages attempt to restore injured parties to their position prior to the injury, in this case prior to SIGA's breach. Prior to this case, it was not clear whether it was permissible in Delaware to impose an expectation damages remedy in a case involving the breaching of a contractual obligation to negotiate in good faith, but the Supreme Court affirmed that it was possible (The Vice Chancellor hedged his bet precisely because, prior to this case, it was not clear that expectation damages could be imposed).
Although expectation damages may be imposed in such cases, "a plaintiff can only recover those damages which can be proven with reasonable certainty. Moreover, no recovery can be had for loss of profits which are determined to be uncertain, contingent, conjectural or speculative." This restriction will be discussed under Question 2 (relating to the form of the remedy), but that there is no doubt in my mind that the Vice Chancellor intends to impose expectation damages. The remaining questions in this section are whether there will also be either of two other kinds of damages imposed.
Punitive damages can add a surcharge if there is a finding of additional malevolence. PharmAthene has asserted that SIGA has engaged in two kinds of accounting maneuvers that amount to additional acts of bad faith. Collectively, according to PharmAthene, they are designed to diminish income due PharmAthene, or delay or indefinitely postpone any payments to PharmAthene. One alleged maneuver is to delay revenue recognition, and the other is to inflate the expenses attributable to manufacturing and delivering Arestvyr, thereby reducing the amount of profit that SIGA would need to share with PharmAthene.
I will not describe SIGA's rebuttal because in the January status conference, the Vice Chancellor indicated that he did not intend to impose punitive damages for these alleged bad faith actions. However, that does not mean that he might be even more careful in crafting both his revised remedy and the subsequent order implementing it. I describe some specific ways that he might do this under Question 2.
Equitable remedies are designed by Courts to do justice in specific situations where money does not provide complete relief to parties who have been injured. They may only be granted when both of the following conditions have been met.
1. The Court must take into account the breaching party's knowledge, state of mind, and motives. In deciding whether this condition has been met, the Vice Chancellor can take solace in the following passage from the Supreme Court's opinion: "Under Delaware law, 'bad faith' is not simply bad judgment or negligence, but rather it implies the conscious doing of a wrong because of dishonest purpose or moral obliquity; it is different from the negative idea of negligence in that it contemplates a state of mind affirmatively operating with furtive design or ill will. Not only did SIGA's negotiating position differ substantially from the LATS's terms, but also the Vice Chancellor . . . correctly concluded that SIGA took that position in bad faith" (p. 28). The justices at both levels have already made up their mind that SIGA's knowledge, state of mind, and motives justify an equitable remedy.
2. The Court must conclude that it cannot find a form of expectation damages that will grant "such relief as justice and good conscience may require." If the Court concludes that "legal" forms of expectation damage are inadequate or impracticable (see Chavin v. Rosen, Del. 1968), then it "has broad discretion to form an appropriate remedy for [the] particular wrong" (Both passages are from p. 86 of the Vice Chancellor's 2011 opinion). I shall discuss how this criterion applies to this case under Question 2.
2. What Forms of Remedy are Permissible?
There are three basic options (or a combination thereof) that could apply here: a single lump sum payment, an income stream, or granting "specific performance."
A single lump sum payment. In his 2011 opinion, the Vice Chancellor ruled out this possibility on the grounds that it would be to speculative. PharmAthene has tried to convince him that there are several reasons for accepting an estimate of what PharmAthene would have eventually earned had the negotiations been carried out in good faith, but their legal team has not provided the kind of information that will cause him to change his mind. I do not expect that there will be a single lump sum payment, but there might indeed be a substantial initial payment to be combined with another remedy component to take into account money that SIGA has already received for delivering courses of treatment to BARDA.
An income stream. The Vice Chancellor's 2011 remedy consisted of PharmAthene receiving a portion of SIGA's future Arestvyr-related net profits. This form of income stream only comes into play when there is revenue upon which calculations can be based. The Vice Chancellor believes that this feature allows this form of remedy to escape the earlier-quoted limitation on expectation damages: "A plaintiff can only recover those damages which can be proven with reasonable certainty. Moreover, no recovery can be had for loss of profits which are determined to be uncertain, contingent, conjectural or speculative." SIGA has disputed whether in fact an income stream can escape that limitation, but I have written about this argument here (both in the article and in the comments), and see no need to repeat the opposing arguments.
Specific performance. The concept of ordering specific performance involves requiring breaching parties to perform specific acts, usually what they have agreed to perform under the terms of the contract. In this case, there are two variations.
1. Negotiating in good faith. This is the specific act that SIGA was contractually obligated to carry out. It is also what the Vice Chancellor, in his 2011 opinion, viewed as the correct application of the doctrine of specific performance to this case. He rejected ordering that the two parties resume negotiations because of the practical difficulties (especially because of the onerous burden that the Court would assume) of attempting to force SIGA to negotiate in good faith when it would not do so earlier. I know of no reason why he would now conclude that it would be productive to order SIGA to negotiate in good faith.
2. Ordering SIGA to transmit the license for Avestyr to PharmAthene. PharmAthene argues that the Court may grant PharmAthene the license for Arestvyr. Not only does SIGA vigorously rebut this contention, but the Vice Chancellor explicitly ruled against PharmAthene's request in 2011. Therefore, if he were to consider doing so now, he would have to reverse himself.
Why, in 2011, did the Vice Chancellor deny PharmAthene's request to grant it a license?
1. He was convinced that specific performance must be interpreted narrowly. As mentioned above, the Vice Chancellor asserted that "PharmAthene's request for specific performance must be construed as a request for an order compelling SIGA to negotiate in good faith a license agreement for ST-246 and not for an order specifically enforcing the LATS" (p. 76). In other words, he concluded that there is no contractual obligation for SIGA to transfer the license.
2. He was convinced that the LATS was missing some essential provisions. Despite Reason #1, the Vice Chancellor devoted considerable space to providing a substantive reason for denying PharmAthene's request. Were he to consider granting a license, he was persuaded by SIGA's argument that although he found that the two companies had agreed upon all essential economic terms required for a license, they had not yet agreed upon other provisions SIGA asserted were essential.
What might prompt him to change his position?
1. If he is convinced that specific performance may be interpreted more broadly. A Chancery Court "has broad discretion to form an appropriate remedy for a particular wrong" (2011 opinion, p. 78). Specifically, although it is customary for a specific performance order to require that the breaching party perform the act required under the contract (in this case, that SIGA negotiate in good faith), the Court may designate another action.
2. If he is convinced that the alleged essential provisions are no longer material. In its 1/8/14 post-hearing response brief, PharmAthene argued the "LATS contains all the essential terms for a binding license agreement, and thus no further negotiations are necessary. The other terms SIGA has claimed previously it would have expected in a license agreement are not material and/or cured by the passage of time, e.g., choice of law (not material), joint research and development committee (the product is in the final stage of development-there is nothing left for SIGA to do), and patent prosecution ( . . . patents covering ST-246 have already issued). To the extent any terms remain open and relevant, they are not material and can be supplied by the Court as part of the exercise of its equitable authority" (pp. 48-49).
3. If he is convinced that the conditions for imposing a specific performance remedy have been met. Quoting Corkscrew Mining Ventures v. Preferred Real Estate Investors (Del. 2011), the Vice Chancellor said that the "party seeking specific performance must show by clear and convincing evidence that: (1) a valid contract exists; (2) the party is ready, willing, and able to perform; and (3) the balance of the equities tips in favor of the party seeking performance" (2011 opinion, p. 78). Of course the rub here is that although a valid contract exists, it does not explicitly require that SIGA transfer the license, but only engage in good faith negotiations to consummate a definitive license agreement consistent with the terms of the LATS. However, as indicated in Point #1, the Court is permitted to require that SIGA go beyond the contractual obligation.
Furthermore, PharmAthene has made a compelling case that it is fully prepared to use the license competently and wisely. It has also asserted that there is little need for SIGA to be involved. Specifically, in its post-hearing response brief, PharmAthene said "Any claimed need for SIGA to be involved in any further product development and manufacture is belied by its own public statements" (p. 25). PharmAthene then quotes SIGA as follows:
"We do not have the ability independently to conduct the clinical trials, and certain animal trials, required to obtain regulatory approval for our products. We depend upon independent investigators, contract research organizations, and other third-party service providers to conduct trials of our drug candidates and expect to continue to do so. We rely heavily on these third parties for successful execution of our trials, but do not exercise day-to-day control over their activities."
Given the earlier statement from the Supreme Court (pertaining to SIGA's acting in bad faith), I shall not say more about the third condition (that is, there is little doubt that the Courts at both levels have concluded that "the balance of the equities" does in deed tip in favor of PharmAthene).
4. If he is convinced that the money is inadequate given that PharmAthene has lost the opportunity to control a unique asset. SIGA's breach deprived PharmAthene of the unique opportunity to continue the development and commercialization of the first drug of its kind, and the subject of numerous issued patents that address a new biodefense market. PharmAthene has the relationships with the FDA and the experience that SIGA lacks, which is why SIGA entered into contracts with others as described above. PharmAthene has made a case that had they had control, Arestvyr would be closer to receiving FDA approval, and to entering into additional contracts within and beyond the United States, which would benefit not only PharmAthene, but also SIGA. This is why sharing profits does not adequately compensate PharmAthene for its lost expectations.
5. If he is convinced that granting the license is the best way to meet key evaluation criteria. Here are the criteria that I believe matter to the Vice Chancellor:
- the extent to which both companies are restored to their pre-breach positions,
- the extent to which the Vice Chancellor's finding about how terms might be adjusted is reflected,
- the extent to which SIGA is discouraged from engaging in accounting maneuvers,
- the extent of the Court's ongoing supervisory burden, and
- the chances of being upheld by the Supreme Court.
The criterion that requires elaboration is the second one. The Vice Chancellor based his 2011 ruling on his discovery that right before the breach, both companies expressed a willingness to accept an adjustment in the LATS's economic terms that was very close to what he had proposed.
Some observers claim that the Supreme Court was criticizing the substance of his remedy when it said, "A Vice Chancellor must look to the contract as a source for a remedy on the breach of an obligation to negotiate in good faith" (p. 31). These observers were inferring that the Supreme Court was instructing him to abandon his speculation about what terms might have been agreed upon and rely solely on what the LATS actually said. To bolster their contention, they point to the following statement: "The Vice Chancellor's factual conclusions support a finding that . . . neither party could in good faith propose terms inconsistent with that agreement" (p. 37).
However, another statement and a footnote on the same page taken together leave little doubt that the Supreme Court considers the Vice Chancellor's analysis to be wholly within bounds. Here is the statement in the text: "[T]he Vice Chancellor made two key factual findings, supported by the record: (1) 'the parties memorialized the basic terms of a transaction in . . . the LATS, and expressly agreed in the Bridge Loan and Merger Agreements that they would negotiate in good faith a final transaction in accordance with those terms." This portion of the text ends with a footnote number, and here is what the footnote says: "He also found 'that the parties also recognized that the negotiations probably would introduce new terms and lead to some adjustment of terms expressly embodied in the LATS, while other terms in the LATS were almost certain to remain'" (Footnote 100, p. 37).
Implications: Three Remedy Options
I believe that the Vice Chancellor will choose among the three remedy options that are displayed in Table 1. Below, I refrain from restating what is in the table, but instead focus on the nature of the modifications mentioned.
A slightly modified 2011 remedy. The 2011 remedy modified the LATS provisions in a number of ways. It increased the amount that PharmAthene would owe SIGA before profit participation from $16 million to $40 million, it dropped the royalty that SIGA would receive off the top, it abandoned the provision that stated that whether or not SIGA would receive a share of profits depended upon whether they were derived from contracts with the U.S. Federal government, and it replaced the arrangement whereby SIGA would only split profits that exceeded 20% with a 50/50 split of all profits. These features are all maintained in this slightly modified version.
The important modification in the Vice Chancellor's 2011 remedy has to do with how net sales were defined in his 2012 implementing order: "Net sales in any Accounting Period, means all revenue recognized in such Accounting Period consistent with the recognition of such revenue during the preparation of SIGA's GAAP-based financial statements (provided that SIGA employs accrual method accounting under GAAP in good faith and does not structure the terms of Commercial Sales for the purpose of delaying recognition of revenue under GAAP or otherwise avoiding the spirit of its obligations under the 'equitable payment stream' ordered in this Final Order and Judgment)" (Emphasis added, p. 11).
Clearly, the Vice Chancellor was trying to prevent SIGA from inappropriately delaying the recognition of revenue, but it appears as if SIGA has tried to do so anyhow. Under the accrual method, revenue is recognized when sellers have done what they were obligated to do. Because Arestvyr has not been approved by the FDA, it may need to be reformulated. If it does need to be reformulated, the contract gives BARDA the right to require SIGA to replace without charge the already received courses of treatment with the reformulated version. Because of this contract feature, SIGA has asserted that under GAAP, SIGA may not recognize the revenue until FDA approval has been received.
Meanwhile, SIGA acknowledges that it may use the money that it receives from BARDA for any purpose, and will not need to pay it back. BARDA withheld $102 million to be paid when FDA approves Arestvyr, which, according to PharmAthene, will more than cover the cost of manufacturing any reformulated replacements.
PharmAthene had argued that SIGA has misinterpreted GAAP. Instead of trying to figure out what GAAP actually requires, the Vice Chancellor may try to invoke the italicized portion of the above quoted passage. However, SIGA can claim that it did not structure the terms of sale to delay revenue recognition or avoid the spirit of its obligations, but rather BARDA insisted on doing so to ensure that it has an FDA-approved product. In other words, the Vice Chancellor left a serious loophole, which he should now recognize. He can fix the loophole by modifying the definition of net sales so that it also includes any payments received in a quarter that are subject to profit sharing.
To respond to its concern that SIGA was inflating its costs, PharmAthene proposed fixing costs as either a set percentage of sales or a fixed dollar amount. While this makes sense to me, I suspect that the Vice Chancellor will decline to do so because of the difficulty of coming up with an arrangement that would fit all future contracts under changing circumstances. This is a serious issue given that SIGA claims that Arestvyr has not been especially profitable (so that PharmAthene should expect little), yet (1) if the FDA approves Arestvyr without requiring any modification, SIGA will receive approximately $240 per course of treatment, and (2) its witness (Professor Dietrich) acknowledged that SIGA has represented to BARDA that the cost of manufacturing a course of treatment ranged between $20 and $30. The purpose of the modified 2011 remedy involving an independent accountant is to provide a mechanism for resolving the controversy regarding whether costs are inflated.
A modified 2011 remedy involving an independent accountant. One of the features of the LATS was that when PharmAthene held the license SIGA would receive 8% of the gross (see the footnote in Table 1 for a more accurate statement), and would also, only on contracts with the U.S. Federal Government, receive half of any profits that exceeded 20 percent. The Vice Chancellor decided to abandon the distinction between contracts with the U.S. Federal Government and with any other entity, and all three of the remedies discussed here do so as well. Accordingly, in this second remedy, SIGA would share profits that exceeded 20 percent for all contracts.
However, reverting to the LATS arrangement in this second remedy changes the incentive for SIGA when trying to calculate its costs. Under the slightly modified 2011 remedy, SIGA receives a greater percentage of the gross when its costs are high. Under the (more substantially) modified 2011 remedy involving the independent accountant, SIGA receives a greater percentage of the gross when its costs are low.
Of course, the other feature of this second remedy is that it involves an independent accountant appointed by PharmAthene. The Vice Chancellor introduced the role of such an accountant in his 2012 implementing order, but the accountant's role was solely to review and verify SIGA's books. In this second remedy, the accountant's role is expanded beyond reviewing the books to include receiving the payments from Arestvyr customers (or other who are paying Arestvyr-related fees, etc.), and disbursing the money after it has verified that the records are accurate. This arrangement provides another incentive to SIGA: to deliver its records as soon as possible.
A license based on the LATS, but modified per later developments. The third remedy accepts all of the Vice Chancellor's economic terms, since it is no longer necessary to try to influence SIGA one way or another with respect to calculating its costs-that is with one exception: The Vice Chancellor will need to make special provisions to deal with expenses that SIGA has already incurred up until the time that the license is transferred.
Note that none of the three options contain a provision for a lump sum payment to deal with payments that SIGA has already received from BARDA. Clearly, there would be such a payment in all three cases, but it would be based upon examining the books and figuring out what is due. In other words, it need not complicate the process of evaluating and deciding among the options.
Evaluating the Remedy Options
Table 2 applies the five evaluation criteria listed earlier to the three remedy options. Because the reasoning underlying all but one of the cells is either self-evident or can be inferred after a little reflection, I focus on the one cell most likely to surprise most observers: the assertion that the chances that the Supreme Court will uphold granting a license are moderate to high.
Here is my reasoning. Recall the quote from the Supreme Court that began "[T]he Vice Chancellor made two key factual findings, supported by the record." I quoted the first factual finding, supported by the record, but not the second. The second is rather amazing: "but for SIGA's bad faith negotiations, the parties would have consummated a license agreement." Note that the Supreme Court didn't say that they probably would or almost certainly would. They simply said that they would have consummated a license agreement. To me, this is a very clear signal to the Vice Chancellor: If you think that you can justify using your broad discretion to fashion a remedy to include specific performance, and if in this case it would not be practicable to order the particular action that SIGA was contractually obligated to perform, then reconsider whether it is appropriate to grant a license.
Evaluating the Favorability of the Remedy Options to PharmAthene
Table 3 gives my take on how each remedy option works out for PharmAthene. Clearly, all three remedies are highly favorable for PharmAthene. That is what the justices at both levels have determined is justified in this case, and Delaware law and case law collectively provide the means.
Table 3 also provides a qualitative assessment of the impact on PharmAthene's valuation. Here are some numbers to add color. The total income to SIGA for selling the 1.7 million courses of treatment is $409,811,755, assuming that the FDA approves Arestvyr. According to SIGA's CEO, there will be an additional bonus if SIGA proves that Arestvyr has a seven-year shelf-life (11/5/12 earnings call), but I have no way of estimating the size of that bonus.
As mentioned earlier, Dietrich affirmed that SIGA had represented to BARDA that the cost to manufacture a course of treatment did not exceed $30. To underestimate PharmAthene's share of the profit, I shall use the maximum figure. Accordingly, the cost of goods = 1.7 million doses X $30 = $5.1 million.
Table 4 shows SIGA's total 2011-2013 R&D and SG&A expenses, which I found here. I will use the three-year total ($104.1 million) even though much of the R&D was either subsidized by the U.S. Federal Government or allocable to SIGA's other pipeline (which it had currently suspended). When the cost of goods, R&D, and SG&A are subtracted from the $409.8 million, the net profit is $300.6 million.
Using the slightly modified 2011 remedy, $40 million would go to SIGA off the top, and the remainder would be split evenly between the two companies. Since I have overestimated each category of expenses and not included the 7-year shelf-life bonus, I conclude that PharmAthene's share is at least $130 million.
In previous articles, I have given a quantitative analysis of PharmAthene's likely share price, using estimates based on P/E ratios under various scenarios. However, I now believe such an approach focuses attention on the wrong issue. The key issue is how the money will be spent. That is the subject of the brief last section.
Coping with the De-Scoping
BARDA has pulled back from funding the Phase 2 trials of SparVax (PharmAthene's anthrax product) and DOD is not funding future R&D for its product to protect soldiers and civilians from chemical agents. I will write more about his in a subsequent article, but I have reached two conclusions.
1. The government is scaling back support not because it is getting cold feet about the effectiveness of either product or R&D program, but rather because severe budget reductions have affected virtually all military programs.
2. PharmAthene will be able to invest the litigation proceeds in many productive ways that harness their staff's infrastructure, competencies, experience, and existing relationships. These can include using some of the money to fund the trials that have already been designed, using it to make acquisitions, or to form partnerships with others. They can also seek additional funds from other governments, and apply for other U.S. Federal Government programs that will become available. As they already signaled when they announced the (now terminated) plan to merge with Theraclone Sciences, they are interested in expanding their portfolio to include infectious diseases so that they are not focused solely upon military contracts.
The Vice Chancellor will impose his remedy within the next couple of weeks. It will be at least as favorable to PharmAthene as the previous one, and will contain some additional protections against accounting manipulations. SIGA will appeal but PharmAthene will prevail, perhaps by the end of 2014. It will receive more than $130 million, and perhaps half a billion or more from additional contracts, both domestic and foreign. Remember that BARDA has its eyes on purchasing 12 million additional courses of treatment. PharmAthene has both the infrastructure and direction to harness its litigation proceeds to move its product line forward and expand its business. In 12 months, the stock price, which closed on May 13 at $1.46, will at least double, and could well triple. I invite you to enjoy the ride.
Disclosure: I am long PIP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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