The Signaling Effects of the FDA Orphan Designation

Pharmaceuticals are used to diagnose, treat, and cure diseases ranging from bacterial infections and headaches to cancer and multiple sclerosis. However, there are still many medical conditions for which there are few or no treatments. Therefore, encouraging further pharmaceutical innovation is an important public health goal. Central to encouraging innovation is to ensure sufficient investment in pharmaceutical firms, which can be difficult given the innate information asymmetries present in the pharmaceutical industry. Given the great uncertainty of successful development, investors would prefer having as much information as possible regarding the drug’s development. However, pharmaceutical firms cannot share all of the development information due to the fear that other companies may utilize proprietary information for their own projects. In order to overcome this information asymmetry, firms may use US Food and Drug Administration (FDA) drug designations to signal drug quality to investors.

While the FDA confers multiple different designations on drugs in development, this study will examine the signaling effects of the Orphan drug designation. The Orphan designation is given to drugs which treat a rare disease (defined as affecting fewer than 200,000 people in the US). This designation was created in 1983 by the Orphan Drug Act as a result of lobbying by patient groups to create additional incentives for firms to conduct drug research for rare diseases. Firms can apply for this designation after the drug has been approved to begin clinical trials. It is typically applied for early on in the drug development process, as receiving the designation confers additional tangible benefits for the firm (such as allowing for tax deductible clinical trial expenses).

This study will examine two main research questions: (1) whether the Orphan designation provides a signal of drug quality; and, (2) whether the strength of this signal has changed over time. To answer these questions, an event study methodology with the market model will be used. Event studies are used to determine whether there are abnormal stock returns after an event which is hypothesized to influence investors occurs. For this analysis, the event will be a firm’s announcement that it has received an Orphan designation from the FDA. Defining the study period as 1983-2012, a manual search for these announcements was conducted, and 718 unique announcements were found. Once the majority of inclusion criteria were applied, 332 announcements remained in the sample.

To evaluate whether the Orphan designation provides a signal of drug quality, a nonparametric t-test will be used to determine whether there are statistically significant abnormal returns present after the announcement of the receipt of the designation. To evaluate whether, over time, the average abnormal returns after an Orphan designation have changed, the announcements will be split into two time periods: 1983-2002 and 2002-2012. The average abnormal returns will be calculated for each of these two time periods, and then a nonparametric (Wilcoxon) test will be used to determine whether there is a statistically significant difference in returns between the two time periods.