Imagine that you came up with a great idea for a new product. The idea was so good that you invested a lot of your money into developing the product and securing a patent. Then, a newcomer comes along, piggybacking on your efforts, and creates a duplicate version. What do you do?

Of course, the natural response is to take the newcomer to court. However, when you factor in the cost, along with the risk that your patent might not be upheld, you decide to settle. You're out some money, but you keep the protection for your product. Your potential rival makes some money, but has to wait to compete against you. Both sides can claim some measure of victory.

Pay for delay
This scenario gets played out fairly regularly in the pharmaceutical world. Two paths are typically followed in these so-called "pay-for-delay" situations. The first involves monetary payment. In one of the earliest examples, Abbott Labs (NYSE:ABT) allegedly paid Geneva Pharmaceuticals $4.5 million per month to delay production of Abbott's drug Hytrin.

In the second path, the branded drug-maker compensates the generic manufacturer by offering to not market its own authorized generic version when the drug goes off-patent. One example: GlaxoSmithKline (NYSE:GSK) allegedly agreed not to market its own authorized generic version of Lamictal in return for Teva Pharmaceuticals (NYSE:TEVA) delaying entering the market with its own generic drug. 

Sometimes, the details of the arrangements remain confidential. Pfizer (NYSE:PFE) reportedly reached an agreement recently with Impax Labs (NASDAQ:IPXL) about a generic version of Detrol.  However, whether the deal involved monetary compensation or other arrangements was not disclosed.

The American Medical Association wants to stop pay-for-delay altogether. AMA board member Dr. Patrice Harris stated, "Pay for delay keeps quality, low-cost generic drugs out of the marketplace and unnecessarily drives up costs for patients." 

The Federal Trade Commission concurs with the AMA. Until recently, the courts have not -- ruling consistently in favor of pharmaceutical companies engaging in pay-for-delay agreements. However, the Third Circuit Court of Appeals in July found the practice was anti-competitive. Merck (NYSE:MRK), which inherited the case with its acquisition of Schering-Plough, has escalated the question to the U.S. Supreme Court. 

The case for capitalism
Pharmaceutical companies can make the argument that they're simply trying to do what is in the best interests of their shareholders. The companies spend hundreds of millions, and sometimes billions, of dollars in developing drugs that help people suffering from diseases. 

Typically, the pharmaceutical companies file for and receive patents well before the Food and Drug Administration approves the drugs. This means that the time for which the drugs can be marketed with patent protection is shortened.

Many drugs never make it to market at all. Pharmaceutical companies must recover research and development costs of these drugs by generating sales from the drugs that do reach the market.

The pharmaceutical companies maintain that the Hatch-Waxman Act passed by Congress in 1984 creates an environment where pay-for-delay arrangements make the most sense financially for the brand-name drug companies and the generic manufacturers. They also assert that the arrangements don't keep other companies from marketing generic alternatives after the patent for the brand drug expires and sometimes even enable generics to reach the market sooner than they otherwise would.

At its core, a key goal of capitalism is to reward those who take risks. Brand-drug makers' perspective is that limiting the ability to settle legal cases also limits the ability for companies to reap the rewards for the considerable risks taken in developing drugs.
Some opponents argue that pay-for-delay deals are anti-competitive. However, that argument rests largely on an assumption that the original drug patent is invalid. If flaws in the patent approval process exist, defenders of the pharma companies could argue that those issues need to be addressed in the U.S. Patent & Trademark Office rather than take away a company's ability to settle lawsuits.  
The bottom line premise for pharma companies is that they are operating within the boundaries of a capitalist system where risk-taking has the opportunity to be rewarded. If the ability to engage in pay-for-delay deals is restricted, the likelihood is that brand drug-makers will simply increase prices to ensure sufficient returns on investment.
Foolish take
Defenders of pay-for-delay make some solid points. However, there is another side of the argument. These deals result in higher overall costs to the tune of $3.5 billion per year, according to research by the Federal Trade Commission. 
My view is that the right answer lies somewhere in the middle. Hatch-Waxman needs an overhaul. A better process for challenging patent validity should be enacted. If these measures are taken, pay-for-delay could and should go away.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.