THE BLOG
06/25/2013 10:36 am ET Updated Aug 25, 2013

The 'Reverse Payment' Drugs Case: The Most Important Economic Issue You Never Heard of -- And Why There Might Still Be Some Hope for Antitrust

It's good to be a seller of drugs, legal or otherwise. Your clients often literally can't live without them, and so the pay tends to be good. It's probably better to sell legal drugs, at least in the United States, where a complex of federal laws affords branded drugs elaborate protection from competition. Top pharmaceutical firms typically enjoy some of the highest profit margins of any companies in the world.

But in a story that's all too familiar, it turns out they haven't earned those profits just through ordinary patent protection. For the past few decades they've also gotten away with some major nonsense, which likely kept prices of branded drugs much higher than they otherwise would have been, and which most everyone except the lower federal courts believed should violate the antitrust laws.

To make a misleadingly long story short, branded drug companies appear to have squeezed quite a bit more money out of their products by paying off generic drug companies to stay out of their markets. Now, you might be thinking, that sounds like a violation of antitrust law. But drug companies managed to convince most courts that these agreements, which have come to be known as "reverse payment settlements," were really just honest settlements of litigation, meant to resolve good faith disputes over the validity of their patents. In part the courts seemed a bit mystified by the statutory complexity surrounding these deals, especially under the so-called "Hatch-Waxman Act," an innovation of the mid-90s meant (ironically) to bring more competition to drug markets. But in part I think it's also just because the courts have become so skeptical of antitrust law that, to our collective detriment, many of them seem to doubt that a defendant could ever violate it.

Well, at least in the case of reverse payment drug deals, that's all probably come to something of an end. Last week the Supreme Court decided Federal Trade Commission v. Actavis, Inc., holding that pay-off agreements like this are not only subject to the antitrust laws, but likely violate them wherever the payment is "large." Likewise, another group of companies was just hit with a big fine in Europe for the same conduct. (In the EU case, investigators dug up internal documents referring to a "club" being formed and "a pile of $$$" to be shared among the participants.)

Actavis and the EU action will likely have impacts on drug markets, but I think it's quite important to try to see them in their broader context. The Supreme Court has sent an important message about competition as a public value, and has reminded us that the death of antitrust has been over-reported.

The Simple Truth Beneath the Seemingly Complex "Reverse Payment" Story

Imagine you carelessly drive your car and injure a pedestrian, who then sues you. But after filing the suit, and before trial, the pedestrian offers to pay you a large sum of money in order to settle the case, and in fact it's substantially more than any reasonable estimate of the costs of litigating the suit. That wouldn't make any sense at all.

But that is essentially what happens in "reverse payment" settlements. The branded drug maker sues the generic firm that is seeking to enter its market, alleging that the generic has infringed its patent. But the branded firm -- the plaintiff -- then offers the generic firm -- the defendant -- what is typically a very large sum of money to settle the case. Why would it do such a thing?

Well, consider another simple example that will make the parties' motives more clear. Imagine that instead of an auto accident, a case involves two companies who sell the same product. Imagine that one of them, Company A, has established a presence in the state of Georgia, and has enjoyed freedom from competitors there. But the other, Company B, is eager to enter Georgia and compete. Company A believes it may have some legally enforceable rights that would be infringed if Company B enters. But instead of suing, Company A offers Company B a "settlement" of its disputed claims, under which only one of them will sell the product in Georgia, and will do so as the "licensee" or "agent" of the other. Accordingly, the two will split the profits of those sales. Under those circumstances, a "settlement" under which the apparent victim pays off the infringer at least makes more sense. While Company A might characterize it as nothing more than a good faith resolution of a legal dispute, the real motivations are pretty clear. Both companies can make more money if they don't compete, and rather share the spoils. But it is also antisocial. An incumbent seller is obviously just bribing a challenger not to compete, and everyone except their shareholders is worse off.

Sure enough, those were roughly the facts in a famous case decided by the Supreme Court in 1990, Palmer v. BRG of Georgia, in which the Court found the agreement so anticompetitive as to be automatically illegal under the antitrust laws. Last week's Actavis decision, breaking with almost all the lower courts that had reached the question, finally held that the drug company deals are more or less the same thing, and the opinion prominently cites Palmer to make the point clear.

The Actavis Court acknowledged that the legal context of reverse payment drug deals, at least superficially, is more complex than a scenario like Palmer. To simplify, Hatch-Waxman's drafters tried to do what they could to enhance drug market competition, and they took as a major goal to encourage legal challenge to potentially invalid drug patents. They believed the Patent and Trademark Office too easily granted patents to drug firms, and hoped that healthy legal challenge would invalidate weak ones. But here was the problem: when a generic firm took steps to introduce a drug in competition with a branded drug, its very preparation was sufficient basis for the branded firm to sue it for patent infringement. That created a context in which the branded firm could reach a deal with a would-be competitor. You, as the branded, allegedly patent-protected incumbent, sue, alleging that the generic would-be entrant's mere preparation to enter is patent infringement. But then you say, "hey, we can work this out. I'll just give you a large amount of money, and I will agree to drop my suit against you, so long as you agree not to enter the market until the term of my disputed patent expires."

To most observers, these deals seemed terrible as soon as they first appeared, and contrary to the very purpose of the Hatch-Waxman law. (Orrin Hatch -- a named sponsor of the law, and hardly some left-wing, pro-plaintiff firebrand -- took to the Senate floor to call them "appalling.") Critics -- which includes most people who looked at these deals -- saw them as the incumbent, who typically had weak claims to patent protection, simply splitting the spoils of its monopoly position with a competitor. If that characterization of the deals is correct, as most people have thought and as the Supreme Court has now affirmed, the deals are very likely illegal. For that reason, critics commonly referred to reverse payment settlements by a more pejorative term: pay-for-delay.

To make matters worse, the drugs at issue in the vast bulk of these deals appear to have had weak claims to patent protection. A brief filed in Actavis by the American Antitrust Institute and cited in the Court's opinion so explains at length, citing extensive empirical support. Quite a lot of these drugs have patents that are "evergreen." That is, the companies that make them simple make small changes to the formulation or delivery system for the drugs every time the patent is about to run out, and then get a new patent to cover the "innovation," thereby giving the "innovator" another several years of exclusivity.

Actavis involved just one such drug: "Androgel," which permits the application of synthetic testosterone through a gel that is rubbed on the skin. As the AAI brief explained, synthetic testosterone turns out to have existed since 1935 and it could not in itself be patented now, and the application of medicines through gels has existed for decades. So Androgel is hard to describe as any sort of meaningful innovation.

As a matter of fact, generic firms have quite rarely challenged strong, legitimate patents under the Hatch-Waxman process, which might protect genuinely innovative contributions. This fact in itself is quite telling: Who better than an industry insider to know when a branded firm's claims to innovativeness are baloney? (This doesn't make the generic firms heroes, by the way. The reason generics would target the weakest patent claims is that they could predict that incumbent firms with weak but valuable patents would be most willing to pay them large bribes to settle, rather than to litigated the patent infringement suits to conclusion and likely invalidity.)

The finally vindicated hero of this story is the Federal Trade Commission, one of the two federal agencies that enforce our antitrust laws. (See the agency's rather crowing press release.) The Commission was among the first to challenge reverse payment deals, and under the leadership of its recently departed Chair Jon Leibowitz, it doggedly brought case after case in the face of many courtroom losses. The Actavis decision hands the Commission not only a win in one case, but a tough new legal standard that likely will make reverse payment drug deals much less common.

The Broader Significance and the Hope for Antitrust Law

Actavis is probably important for pharmaceutical competition, and I wouldn't be surprised if reverse payment drug deals more or less become a thing of the past. But in itself that may be a narrow victory. For one thing, it would affect only one industry -- reverse payments have almost never been observed outside the drug sector, apparently because they are really only effective within the idiosyncratic framework of the Hatch-Waxman Act. Moreover, the likelihood is that drug companies will simply seek relief from Congress, where they have huge leverage, and will acquire a Hatch-Waxman amendment or some other legislation that allows them to get around Actavis, and keep generics out of their markets.

But the case has a broader significance, in that a (bare) majority of the Supreme Court has again sent a message about its views of substantive antitrust and its continuing importance. (The case also says something about the Court's minority, unquestionably the most conservative bloc of Justices since before the famous "court-packing" controversy of the 1930s. That they could look at this deal and join in the defensive, exceptionally pro-business, anti-consumer dissent written by Justice Roberts shows just how true that characterization is.) In some sense, I think the deepest message and the most lasting significance of Actavis is this: The deepest theme in antitrust is the struggle between the general and the specific. Or, put in slightly different terms, the theme is the struggle between the simple and the complex. Simple antitrust rules -- like the one announced in Actavis, under which most reverse payments will be simply illegal, without much room for equivocation -- imply an important generalization about the world. The generalization is that markets and industries are mostly the same, as far as competition goes; competition, without cooperation among competitors, is the strongly preferred presumption for all markets, even though defendants there might say that their circumstances are so very special and complicated. I take that message from Actavis because the Court effectively said that, though the Hatch-Waxman Act and the other circumstances of drug competition are very complex, the scenario before the Court was simple. And it was a simple, anti-social, anti-competitive scheme, which will henceforth be illegal.

That's good for us all, and let's hope the lower courts are listening.