How the Regulatory Landscape Is Affecting Med Tech Deals

Medical device companies continue to attract significant venture capital investments despite the economic downturn.

In the first half of 2010, medical device companies raised $1.272 billion in 156 deals, according to the MoneyTree Report by the National Venture Capital Association and PricewaterhouseCoopers, based on data from Thomson Reuters (publisher of VCJ).

So far, some notable venture deals in the medical tech sector in the second half of 2010 include the orthopedics startup DFine (which raised $36.2 million); sleep apnea device maker Ventus Medical ($40 million); oncology company Metamark Genetics ($22 million); spinal disc maker AxioMed ($14.5 million); back pain startup SI-BONE ($10.6 million); stomach surgical device maker EndoGastric Solutions ($30 million); and stent system provider Tryon Medical ($20 million), to name a few.

From a deal lawyer’s perspective, due diligence for prospective venture investments in medical device companies has focused historically on corporate “niceties” (such as charter/bylaws, stockholder agreements and material contracts) and intellectual property (patents and patent applications) for key technologies.

Given the changing regulatory landscape, however, a rigorous review of compliance with the growing number of regulatory schemes affecting the medical device industry is also essential to ensure that valuation assumptions are accurate. Recently, Food and Drug Administration regulations and the Foreign Corrupt Practices Act (FCPA) have been of particular concern to medical device companies and their investors.

FDA Diligence

FDA Commissioner Margaret Hamburg has made it clear in recent months that the FDA intends to strengthen its enforcement efforts, particularly through the warning letter (Form 483) process. Of course, even the most basic due diligence review includes an examination of any Forms 483 that may have been issued by the FDA to a medical device company.

Although it is a positive sign if the FDA has never issued a Form 483 to the company—or if the company demonstrates that all issues raised in a Form 483 have been satisfactorily resolved—a thorough due diligence review should not stop there. For one thing, FDA inspectors do not always uncover all problems that an inspection might find. Further, after the last inspection, product development efforts may have evolved, attention to design control procedures may have diminished, complaints may have arisen, and so on.

The following are some of the problem areas that deserve particular attention during the due diligence process:

Recently, Food and Drug Administration regulations and the Foreign Corrupt Practices Act have been of particular concern to medical device companies and their investors.”

• Complaint Files. The due diligence team should review a representative sample of complaint files, as well as the company’s medical device reporting systems to confirm that adequate procedures are in place and that those procedures are followed.

• Promotional Materials. The claims made in the company’s promotional materials should be reviewed by the due diligence team to ensure that they are consistent with the indications for use specified in the FDA 510(k) clearances and the FDA premarket approvals.

• Preclinical Testing. Depending on the type of medical device, preclinical testing for efficacy and safety (and biocompatibility for implantable devices) may be required. The due diligence team should confirm that the appropriate tests were conducted and that the design history file includes a rationale for conducting each particular test. Further, the team should confirm that the testing is conducted in appropriate facilities under controlled conditions and following relevant FDA guidelines.

• Product Development. The due diligence team should review the company’s design control processes to ensure that they are adequate for the products currently under development and that the processes are being followed and that all steps are properly documented.

• Foreign Markets. Most medical device companies depend on non-U.S. markets for a considerable amount of their sales. The due diligence team should review the status of the international marketing authorizations, such as the CE (Conformité Européenne) mark for products distributed in the European Union that have met consumer safety, health or environmental requirements.

FCPA Diligence

Another area of recent concern for medical device companies is the FCPA. The FCPA makes it a crime for any agent or employee of a U.S. company operating overseas to offer a bribe to any public official of a foreign country. This law is traditionally enforced by the U.S. Department of Justice (DOJ).

In addition, the U.S. Securities Exchange Commission has gone after public companies for keeping inaccurate books in cases where questionable payments might not have been recorded. Fines and penalties for violating the FCPA can be in the tens of millions of dollars and up to a year of imprisonment for individuals involved.

One might ask, “How does FCPA apply to XYZ Medical Device Company? It’s not involved with officials of foreign governments, and it’s certainly not involved with bribery.”

Given the current regulatory landscape, the resources spent on the due diligence process could mean the difference between a successful and failed investment.”

Nonetheless, medical device companies are particularly vulnerable to FCPA investigations because of the interaction of their sales forces with health care professionals. In most markets outside the United States, doctors are affiliated with government hospitals and are considered government officials under FCPA. Medical device companies are also vulnerable because of their use of third parties, such as distributors or contract sales forces, in foreign markets. Under the FCPA, companies may be liable for corrupt payments or other benefits that these third parties provide to these government officials.

In 2008, structural heart defect device company AGA Medical agreed to pay a $2 million fine under the FCPA and enter into a deferred prosecution agreement with the DOJ in connection with payments the company made to doctors in China.

Other medical device companies that have been targeted for potential FCPA violations in recent years include Biomet, Zimmer, Stryker, Smith & Nephew and Medtronic. In December 2009, Siemens AG reached the largest settlement ever in an FCPA case, agreeing to pay a $450 million criminal fine to the DOJ, $350 million in disgorgement of profits to the SEC and about $569 million to the Office of the Prosecutor General in Munich. The company was charged with making thousands of payments, totaling about $1.4 billion, to third parties to bribe government officials to give their business to Siemens, including bribes relating to their medical device sales in China, Russia and Vietnam.

Given this landscape, it is important that due diligence of a medical device company include a review of the company’s FCPA policies and procedures. At the very least, irrespective of size or capitalization, any U.S. medical device company that distributes its product in a foreign market should adopt a compliance and ethics program designed to prevent and address FCPA violations. This program should include clear guidelines, penalties for non-compliance, mandatory training and an anonymous reporting system. The DOJ may take the existence of such a program into account when considering whether to charge a company with FCPA violations.

In addition to reviewing the company’s FCPA program and confirming its implementation, the due diligence team should review all third-party representative agreements to ensure that they contain appropriate anti-corruption representations and undertakings, with audit and termination rights. The financial diligence team should also review the company’s accounting systems to verify the company’s ability to “follow the money” in all foreign transactions.

The lessons for the venture capital community are simple: Do your homework before investing in a medical device company, and find the right practitioners to assist you. A corporate generalist might be well qualified to draft the investment documents. But when it comes to the FDA or the FCPA or any of the other laws or regulations currently affecting the medical device industry, a venture capital firm should secure the services of industry-focused legal professionals with the right type of regulatory experience to conduct the due diligence review. Given the current regulatory landscape, the resources spent on the due diligence process could mean the difference between a successful and failed investment.

Jim McKnight is an attorney at the New York office of law firm Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, where he represents medical device companies and investors. He can be reached at JMMcKnight@mintz.com.