As was discussed in Part 1, the Supreme Court of the United States announced last Friday that it will consider the legality of so-called "reverse-payment" arrangements, or "pay-for-delay" agreements. These types of transactions involve a brand-name drug maker, like Merck (MRK -0.05%) or Abbott (ABT 0.49%), making cash payments to a generic-drug manufacturer, like Watson (AGN) or Teva (TEVA 1.01%), in exchange for keeping a generic drug off the market for a set period. The case has far-reaching implications that could change the pharmaceutical sector forever.

Breaking it down
In order to give this topic the thorough coverage it needs, this discussion has been broken into three distinct parts. In Part 1, I discussed the history of the case and how it got to the Supreme Court. In Part 2 below, I 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 an effort to make this more than an academic exercise, in each part, I will include some investment analysis; ultimately the three parts combined will be of the greatest value to you as an investor.

The heart of the case
To best understand the questions of law that will be considered in Federal Trade Commission v. Watson Pharmaceuticals, it is best start with the Petition for a Writ of Certiorari (link opens PDF); this filing determines which cases SCOTUS will hear. The petition states:

This case presents a recurring question of great economic importance that has divided the courts of appeals: how to judge the legality under the federal competition laws of a "reverse payment" agreement between a brand-name drug manufacturer and a potential generic competitor. In such an agreement, a patent holder (the brand-name manufacturer) agrees to pay a large sum of money to an accused infringer (its would-be competitor), and the competitor agrees that it will no longer challenge the patent and will not enter the market for a specified period of time.

The FTC's complaints arising from the reverse-payments arrangements between Abbott and Watson, which related to the sale of Abbott's testosterone replacement therapy, Androgel, were dismissed by the 11th Circuit Court of Appeals. The case goes to the Supreme Court on the appeal of the FTC. A resolution is expected by June.

Returning the Writ, the court is being asked to specifically answer certain questions (link opens PDF): "Whether reverse-payment agreements are per se lawful unless the underlying patent litigation was a sham or the patent was obtained by fraud (as the court below held), or instead are presumptively anticompetitive and unlawful (as the Third Circuit has held)." Embedded in the question itself are the various deeper questions of law that SCOTUS must decide. The split nature of the lower courts is one of the reasons the case is being heard.

The factual context
In the Androgel case, the FTC alleges that the price of the drug would have fallen by at least 75% when the generic version was released in 2007. This would have benefited consumers, but potentially would have cost the company as much as $125 million in annual revenue. Abbott filed suit alleging that the generic infringed upon its patents. Faced with this prospect of lost revenue, however, the company negotiated terms with the generic-drug makers. Watson and the other generic-drug makers chose to accept delaying the release of the cheaper options until 2015 in exchange for combined payments that amounted to roughly $42 million annually.

Hatch-Waxman
The other key statutory provision that must be considered in this case is the Drug Price Competition and Patent Term Restoration Act, commonly referred to as the Hatch-Waxman Amendments. The purpose of this legislation is to help bring viable generic drugs to the market on a truncated time table. The law provides  that "after a brand-name drug's NDA has been approved, and subject to certain periods of NDA exclusivity (see 21 U.S.C. 355(j)(5)(F)), any manufacturer may seek approval to market a generic version by filing an abbreviated new drug application (ANDA) with FDA." The approval process is much faster, and the level of detail that must be provided in the application is significantly reduced.

The critical parts of the amendments  that give rise to this case are: "the generic manufacturer may file a 'so-called paragraph IV certification,' which states that a given patent asserted by the brand-name manufacturer to cover its brand-name drug "is invalid or will not be infringed by the manufacture, use, or sale of the [generic] drug."" and, "The patent statute treats such a filing as itself an act of infringement, which gives the brand an immediate right to sue."

What these two elements create are a procedure by which the generic manufacturer may address the patent protection of the brand-name patent holder, while simultaneously creating a de facto right to sue for the brand-name patent holder. In far simpler terms, every time the generic's ANDA is filed, that company gets sued; it is the settlements to these suits that are at issue.

The antitrust angle
In response the agreement, the "FTC filed suit  under Section 5 of the Federal Trade Commission Act, 15 U.S.C. 45, to challenge respondents' agreements." This suit, in the 11th Circuit, held many structural similarities to those cases filed in other venues. The Writ lays out the FTC's argument as follows:

The FTC asserted that the generic competitors' agreements not to compete with Solvay, in exchange for payments from Solvay, were unfair methods of competition. Complaint 106, 108. The FTC further alleged that Solvay had unlawfully extended its monopoly on AndroGel(R), not on the basis of its patent, but by compensating its potential competitors. Id. 110-111. The FTC sought declarations that the agreements and Solvay's course of conduct were unlawful, and a permanent injunction against the parties' conduct pursuant to 15 U.S.C. 53(b).

Essentially, the FTC is alleging that the agreement is a violation of antitrust law because it compensates a market participant for not competing. The Commission argues that such an arrangement is facially anticompetitive and therefore unlawful.

The countervailing argument is that the agreement is only anticompetitive if one presumes that the patent is invalid and will not be infringed. If the patent is both valid and the generic drug does infringe the rights of the brand-name patent holder, then the agreement allows the competition between the companies to begin five years earlier than would be the case under an in-force patent. It is this reading that led the lower courts to find in favor of the drug companies in all but the Third Circuit. Additionally, the Second, 11th and Federal Circuits determined that because the settlement was reached under a legitimate patent law framework, the operation of antitrust law never came into play.

Presumption abounds
As I mentioned in Part 1, the presumptions made about the underlying patent are really at the center of this case. If you presume that the patent will not be upheld, the agreements quash competition. If the patent would be upheld, the agreement is a legitimate exercise of the patent holder's right to license under its patent and protect its intellectual property. If the patent case were required to be decided prior to a pay-for-delay agreement, the most basic rights of a party to settle a dispute would be challenged.

While ultimately SCOTUS will decide, I believe the rights of parties to contract among themselves, to settle, and to protect their intellectual property are sacrosanct and should be protected. There is no doubt that these agreements cost consumers tremendously, but the rights that would need to be cleared away in order to invalidate them are too important as they represent, in my opinion, the very fabric of American law.

The investment consequences
While the more thorough investment consequences will be left for Part 3, it is valuable to consider how this case will impact each of the companies in the industry. Bristol-Myers (BMY -0.30%), for example, has entered into such agreements over the past several years. Should SCOTUS determine that these agreements are permissible, those agreements will remain in place. Under this scenario, the Third Circuit's decision would be struck down and the liability that it created would be cleared away for Merck. If, on the other hand, SCOTUS finds these agreements unacceptable, the entire structure that exists between brand-name drug companies and generics will change. Stay tuned for Part 3 for more details on how.