HHS learns from SEC: fraudster execs will be barred from drug industry

FORTUNE -- The federal government is fed up with the amount of fraud, especially recurring fraud from the same companies, happening in the pharmaceutical industry. So regulators have decided that when it comes to punishments, it's time to get personal.

From now on, individual executives risk being ejected from their jobs -- and perhaps even barred from the industry -- for fraud their companies commit, even if they did not participate or even know about the crimes.

All that's required for the government to flex this remarkably broad authority -- underpinned by the Responsible Corporate Officers Doctrine -- is that the executives were in a position to have stopped the fraud that resulted in a criminal conviction or plea.

The new approach, emerging from the unusually powerful Inspector General's office in the Department of Health and Human Services, reflects frustration with corporate recidivism even in the face of ramped-up fines, penalties and disgorgements.

"We are going to start to use that authority in the appropriate circumstances to get high level executives out of companies, so that the company has a better shot at changing its behavior, so that it does not become a recidivist," explains Lewis Morris, chief counsel to the Inspector General.

"It's our expectation that in the next several months you will begin to see the fruits of that new strategy," he adds. His targets include anyone going on corporate retreats, from VP of sales up to and including CEOs.

The initiative is part of the Obama Administration's effort to slash health care fraud, estimated to cost taxpayers 3% to 10% of total sector spending -- $27 to $80 billion this year. Pharmaceutical fraud cases are usually comprised of kickbacks to doctors, overpricing, or off-label marketing, or a mix of the three.

In the government's most recent major settlement -- in which AstraZeneca agreed to pay $520 million -- the fine represented 16.5% of the $8.6 billion income (between 2001-2006) from U.S. sales of Seroquel, a powerful anti-psychotic. AstraZeneca (AZN) turned this narrowly approved drug into a cash cow by marketing it for much wider use, including by the elderly and children, even though they are particularly vulnerable to "serious and debilitating side effects."

All the while, AstraZeneca was operating under a corporate integrity agreement (CIA) with the Inspector General, imposed after a 2003 off-label marketing case. Drug company Pfizer (PFE, Fortune 500), which was fined $2.3 billion just last September, is now on its third CIA. Steeper fines and harsh individual penalties should help put more teeth into these agreements and keep companies from flouting them.

Yet there's still wiggle room

"Usually by the time someone becomes a senior executive they are very aware of the pitfalls in the organization, and they have become masters at not doing something wrong or not getting caught doing something wrong," explains Peter Rost, a former senior Pfizer executive turned industry gadfly.

Incentive-based compensation systems -- typically 40% to 50% of salespeople's income comes from hitting their numbers -- are one weak point. "They are going to work real hard to increase those numbers and do whatever it takes, and if they think somebody gave them a wink about doing this or that, they are going to run with it." says Rost.

Booting senior executives out for any fraud under their watch might end the wink-and-nod system, giving hope to critics.

"I love this idea. It's a sign that there is a creative mind in government," says Patrick Burns of the Taxpayers Against Fraud Education Fund. "Bring the pain, you bring the change. The pain can't only be felt by a nameless, faceless corporation, it has to sit in the living room of somebody who is in charge of designing a fraud, green-lighting a fraud or ignoring a fraud; I don't think you need to hang too many people from the gibbet for that message to be transmitted."

The government's new approach essentially acknowledges that while some companies may be too big to exclude from its programs, particular executives are not. Another potential punitive action, says Morris, would be to strip companies of their patent protection, allowing generic firms to sell cheaper drugs. Both offer tremendous leverage because 30% to 40% of most drugs are purchased by the government, and that dependency is rising.

An early shot over the industry's bow came when HHS imposed a 12-year exclusion from all Federal health care programs against the CEO, chief scientific officer, and the general counsel of Purdue Frederick, who had each pled to misdemeanor misbranding of OxyContin in 2008. That case wrecked the lives of thousands who were inadvertently addicted to the drug.

Sliding to recidivism

For all these efforts, it's still not been easy to keep companies on the straight and narrow. One problem is enforcement: The Justice Department has a backlog of some 500 sealed cases against drug companies, of which more than 100 deal with off label marketing. Since only a handful are settled yearly, the backlog is growing. (A lengthy list of past offenders is available.)

The industry, says Morris, is trying to stay ahead of things by thinking of "ways to curtail the sort of wild, wild west of marketing," by, for example, basing sales compensations on group rather than individual performances. The industry seems ambivalent, downplaying the extent of the problem -- 'these are the exceptions, not the rule' -- while trumpeting its many new standards.

But he continues, "until the industry itself says: 'This compensation based system is problematic -- we keep getting in trouble, we have to come up with a better mousetrap, a better set of incentives,' I think we will see recidivism."

"I actually think that the companies have cultures of compliance where they are trying very hard to follow the law and do the right thing," says Diane Bieri, EVP and general counsel for PhRMA, the trade association. "The law is not always crystal clear and until the company is aware of a regulator's view on a particular practice. the company may hold a different view or may not think a practice is a problem."

Even so, senior executives will now have greater personal incentive to make sure their companies are staying on the safe side of the law.