Profiting From SCOTUS and Big Pharma: Part 1

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Few things are more American than free enterprise and the ability of parties to create mutually beneficial contractual obligations. As the cost of health care and prescription drugs continues to grow in size and importance, however, the interaction between branded-drug makers and generic manufacturers has come under increasing scrutiny. To this end, the Supreme Court of the United States announced last Friday that it will consider several points of law affecting the legality of so-called "reverse-payment" arrangements. These agreements, also commonly referred to as "pay for delay," involve a branded-drug maker compensating a generic competitor for staying out of the market. The financial impact of the decision will be significant for the entire pharmaceutical industry, and investors are well advised to understand the issues involved.

Breaking it down
In order to give this topic the thorough coverage it needs, this discussion will be broken into three distinct parts. In Part 1 below, I will discuss the history of the case and how it got to the Supreme Court. Part 2 will focus on the critical questions of law that are at issue and what considerations are most critical. Finally, Part 3 will analyze the ramifications of various potential outcomes. In each part, I will include some investment analysis in an effort to make this more than an academic exercise, but ultimately the three parts combined will be of the greatest value to you as an investor.

The mechanics of the cases
Reverse payments exist in the vortex between patent law and antitrust law. The chronology that leads to a reverse payment is as follows:

  1. A brand-name pharmaceutical is brought to market with the protection of a patent.
  2. A generic-drug maker receives approval from the Food and Drug Administration to manufacture a generic version of the brand-name drug.
  3. The brand-name patent holder files a patent infringement suit that alleges that the production of the generic will violate its ongoing patent protection.
  4. Rather than risk having its patent deemed invalid or suffer the expense of protracted litigation, the brand-name patent holder reaches a settlement with the generic-drug maker.

When the settlement involves both a cash payment from the brand-name patent holder to the generic-drug maker and an agreement by the generic-drug maker to delay the release of its product, a pay-for-delay, or reverse-payment, agreement is created.

Under the precepts of patent law, the patent holder has the right to negotiate for the protection of its patent if it does so in good faith. The Federal Trade Commission argues that the antitrust angle emerges from the inherently anticompetitive nature of the agreement because market participants are delayed from entering the market. The counterargument is that generics actually enter the market earlier than they might otherwise if the patent is found valid and enforced. Central to the issue is the presumption of validity, or lack thereof, regarding the patent in question.

The Federal Trade Commission
Under FTC Chairman Jon Leibowitz, reverse-payment arrangements have been a hotly pursued issue for nearly a decade. According to the commission's statistics, pay-for-delay agreements cost drug buyers as much as $3.5 billion each year. As many as 31 states have joined the FTC in its stance of this practice, and the America Medical Association has spoken out as well; Dr. Patrice Harris, who holds a position on the board of the AMA, argued, "Pay for delay keeps quality, low-cost generic drugs out of the marketplace and unnecessarily drives up costs for patients."

In pursuit of these beliefs, the FTC has filed multiple suits on the issue, several of which rose to be decided by the federal appeals courts in various circuits. The case upon which SCOTUS granted the writ of certiorari that will bring the case to the high court is Federal Trade Commission v. Watson Pharmaceuticals. The case was decided in the 11th Circuit in favor of allowing reverse payment agreements, and joining the decisions of both the Second and Federal Circuits. The outlying decision came last July in the Third Circuit in a case that involved two private litigants; that court ruled that the arrangements were implicitly anticompetitive and impermissible.

The cases
The case in the Third Circuit involved a potassium deficiency treatment, K-Dur, developed by Merck (NYSE: MRK  ) . In this case, the court ruled that individuals who had purchased the drug could pursue claims against the company for improperly paying Upsher-Smith Labs $60 million to delay the release of a generic alternative. The case has already been cited in ongoing litigation, when, last Thursday, U.S. Senior District Judge William Walls interpreted the ruling as meaning that these agreements are presumptively illegal only when actual payments are made. He wrote:

K-Dur's pressing concern is about uneven bargaining power -- companies with money buy off too easily generic challengers with lump payments. In settlement situations where monetary payments are off the table, companies with abundant cash have less leverage to delay entry of generic drugs.

The 11th Circuit case that will be heard by the high court involved a testosterone replacement therapy, Androgel, made by an Abbott Labs (NYSE: ABT  ) subsidiary. In this case, Abbott paid Watson (NYSE: AGN  ) and two other generic-drug makers $42 million per year in order to protect the roughly $125 million per year that the drug brought in for the company. In exchange for the payments, Watson agreed not to market its generic drug until 2015; the patent on the drug was not set to expire until 2020.

The existence of several lower decisions, not all of which are in agreement, tends to be a hallmark of cases that are accepted by the Supreme Court. The case is set to be decided by June 2013 and has the potential to alter the way drug companies do business. Between now and June, you can expect a myriad of interested parties to weigh in on the case.

Investment perspective
While the bulk of the heavy investment lifting will be reserved for part 3 of this series, it is important to place each section into a proper framework. Clearly, the results of the case will impact both Abbott and Watson, each of which are parties to the case, but the entire industry will be affected. For example, both Bristol-Myers (NYSE: BMY  ) and Teva (NYSE: TEVA  ) have been involved in several such arrangements since 2005. If the case is settled in favor of the drug companies, the litigation risk from the Third Circuit decision to Merck will be mitigated and any pending litigation will be quashed; this has the potential to save the companies millions.

If the case is decided in favor of the FTC, the entire industry will have to rethink how companies do business. Patent litigation will add costs to already expensive drugs, but generics may be more able to reach the market when they become available. You may recall above when I said that the impact turns on the presumption of patents being held valid or not; that should be clearer at this point. It remains early in the process to trade on the news, but this will be explored in more depth as we go.

Abbott, which is a party to the current case, also deserves an in-depth look before investors jump in. With the impending spinoff of its branded-drug business, Abbott is losing a massive blockbuster drug in Humira. It's a confusing event to understand, with many investors left wondering what to do with these two stocks once they're separated. To help investors better understand the upcoming event, the Fool has created a brand new premium report outlining both Abbott Labs and its spinoff, AbbVie. Inside, we outline all of the must-know opportunities and risks facing both companies, so make sure to claim this 2-for-1 report by clicking here now

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