Pharmaceutical Industry: Innovation and Developments: Innovation and Developments [1 ed.] 9781621004394, 9781612093949

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Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved. Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved. Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

BUSINESS ISSUES, COMPETITION AND ENTREPRENEURSHIP

PHARMACEUTICAL INDUSTRY: INNOVATION AND DEVELOPMENTS

Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved.

No part of this digital document may be reproduced, stored in a retrieval system or transmitted in any form or by any means. The publisher has taken reasonable care in the preparation of this digital document, but makes no expressed or implied warranty of any kind and assumes no responsibility for any errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of information contained herein. This digital document is sold with the clear understanding that the publisher is not engaged in rendering legal, medical or any other professional services.

Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

Copyright © 2011 by Nova Science Publishers, Inc. All rights reserved. No part of this book may be reproduced, stored in a retrieval system or transmitted in any form or by any means: electronic, electrostatic, magnetic, tape, mechanical photocopying, recording or otherwise without the written permission of the Publisher. For permission to use material from this book please contact us: Telephone 631-231-7269; Fax 631-231-8175 Web Site: http://www.novapublishers.com NOTICE TO THE READER The Publisher has taken reasonable care in the preparation of this book, but makes no expressed or implied warranty of any kind and assumes no responsibility for any errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of information contained in this book. The Publisher shall not be liable for any special, consequential, or exemplary damages resulting, in whole or in part, from the readers‘ use of, or reliance upon, this material. Any parts of this book based on government reports are so indicated and copyright is claimed for those parts to the extent applicable to compilations of such works.

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Independent verification should be sought for any data, advice or recommendations contained in this book. In addition, no responsibility is assumed by the publisher for any injury and/or damage to persons or property arising from any methods, products, instructions, ideas or otherwise contained in this publication. This publication is designed to provide accurate and authoritative information with regard to the subject matter covered herein. It is sold with the clear understanding that the Publisher is not engaged in rendering legal or any other professional services. If legal or any other expert assistance is required, the services of a competent person should be sought. FROM A DECLARATION OF PARTICIPANTS JOINTLY ADOPTED BY A COMMITTEE OF THE AMERICAN BAR ASSOCIATION AND A COMMITTEE OF PUBLISHERS. Additional color graphics may be available in the e-book version of this book.

LIBRARY OF CONGRESS CATALOGING-IN-PUBLICATION DATA Pharmaceutical industry : innovation and developments / editors, David A. Mancuso and Isobel M. Grenada. p. ; cm. Includes bibliographical references index. ISBN 978-1-62100-439-4 (eBook) 1. Drug development. 2. Pharmaceutical industry. 3. Drugs--Law and legislation. I. Mancuso, David A. II. Grenada, Isobel M. [DNLM: 1. Drug Industry--economics. 2. Drug Industry--legislation & jurisprudence. 3. Drug Discovery-economics. 4. Drugs, Generic--economics. QV 736] RM301.25P428 2011 615'.19--dc22 2011003550

Published by Nova Science Publishers, Inc. † New York

Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

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Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

BUSINESS ISSUES, COMPETITION AND ENTREPRENEURSHIP

PHARMACEUTICAL INDUSTRY: INNOVATION AND DEVELOPMENTS

DAVID A. MANCUSO Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved.

AND

ISOBEL M. GRENADA EDITORS

Nova Science Publishers, Inc. New York

Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

CONTENTS

Preface Chapter 1

Authorized Generic Pharmaceuticals: Effects on Innovation John R. Thomas

Chapter 2

Authorized Generics: An Interim Report Federal Trade Commission Report

Chapter 3

Remarks of J. Thomas Rosch, Commissioner, Federal Trade Commission, before the World Generic Medicine Congress, Hearing on ―Pay-for-Delay Settlements, Authorized Generics, and Follow-On Biologies: Thoughts on the How Competition Law Can Best Protect Consumer Welfare in the Pharmaceutical Context‖

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vii

Chapter 5

Chapter 6

Chapter 7

Chapter 8

1 15

49

Federal R&D, Drug Discovery, and Pricing: Insights from the NIH-University-Industry Relationship Wendy H. Schacht

61

Pharmaceutical R&D and the Evolving Market for Prescription Drugs Congressional Budget Office

91

Federal Taxation of the Drug Industry and Its Effects on New Drug Development Gary Guenther

101

Pharmaceutical Patent Litigation Settlements: Implications for Competition and Innovation John R. Thomas

127

FDA‘s Authority to Regulate Drug Compounding: A Legal Analysis Jennifer Staman

147

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vi Chapter 9

Contents Promotional Spending for Prescription Drugs Congressional Budget Office

159

171

Index

173

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Chapter Sources

Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

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PREFACE As the scope of available drug therapies expands, spending on prescription drugs has become the fastest-growing category of total spending on health care in the United States. Recently, that growth has slowed and that slowdown reflects changes in both the supply and demand for prescription drugs. This new book examines the innovation, development and complexity issues present in the pharmaceutical industry. Chapter 1- The practice of ―authorized generics‖ has recently been the subject of considerable attention by the pharmaceutical industry, regulators, and members of Congress alike. An ―authorized generic‖ (sometimes termed a ―branded,‖ ―flanking,‖ or ―pseudo‖ generic) is a pharmaceutical that is marketed by or on behalf of a brand-name drug company, but is sold under a generic name. Although the availability of an additional competitor in the generic drug market would appear to be favorable to consumers, authorized generics have nonetheless proven controversial. Some observers believe that authorized generics potentially discourage independent generic firms both from challenging drug patents and from selling their own products. Chapter 2- This Interim Report presents the first set of results from a study undertaken by the Federal Trade Commission of the effects of authorized generic drugs on competition in the prescription drug marketplace. Authorized generic drugs (referred to in this chapter as ―AGs‖) are drugs that are approved by the Food and Drug Administration (―FDA‖) as brandname drugs, but that the brand subsequently chooses to market (or have marketed) as generic, as well as brand-name, drugs. The trade dress typically is different for the brand-name drug and its AG equivalent, but the drug products are chemically identical. Chapter 3- This year marks the 25th Anniversary of the Drug Price Competition and Patent Restoration Act of 1984, known to all of us as the Hatch-Waxman Act. That Act, of course, is credited with creating the modern regulatory framework that allows generic, lowercost drugs to come to market. From an antitrust standpoint, however, the Hatch Waxman Act has also unleashed several challenging practical and theoretical questions at the intersection of competition law and patent policy. Should the law incentivize settlements of costly patent litigation that delay generic entry or, in certain cases, unilaterally ban those settlements? Can those settlements ever be held ―reasonable‖? To what extent does the entry of Authorized Generics during the Hatch Waxman 180-day exclusivity period into the marketplace ultimately help or harm consumers? What time frame of patent protection strikes the right balance between incentivizing innovation in the biologic context while ensuring the production of less-expensive biosimilars? Running through all of these issues is the debate

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David A. Mancuso and Isobel M. Grenada

about how and to what extent the law should strike a balance between creating the right incentives for brand firms to innovate and develop groundbreaking drugs while still ensuring that generic firms have the incentives to enter the market. Chapter 4- Public interest in approaches that might provide prescription drugs at lower cost, particularly for the elderly, has rekindled discussion over the role the federal government plays in facilitating the creation of new pharmaceuticals for the marketplace. In the current debate, some argue that the government‘s financial, scientific, and/or clinical support of health-related research and development (R&D) entitles the public to commensurate considerations in the prices charged for any resulting drugs. Others view government intervention in price decisions based upon initial federal funding as contrary to a long-term trend of government promotion of innovation, technological advancement, and the commercialization of technology by the business community leading to new products and processes for the marketplace. Chapter 5- Investment in research and development (R&D) over the past several decades has produced a wealth of valuable new drug therapies that have made it possible to treat major illnesses that were not treated previously or were not treated as effectively. As the scope of available drug therapies expanded, spending on prescription drugs became the fastest-growing category of total spending on health care in the United States. Between 1994 and 2004, real (inflation-adjusted) spending on prescription drugs rose at an average annual rate of 11.1 percent, compared with 3.5 percent for hospital care and 4.3 percent for physicians‘ services. More recently, however, that growth has slowed: From 2004 to 2007, drug expenditures grew by an average of just 3.2 percent per year, slightly less than the rate of growth in overall health care spending. As a fraction of total spending on health care, spending on prescription drugs rose from 6 percent in 1994 to around 11 percent in 2004, where it has remained (see Figure 1). Chapter 6- A key issue in congressional debates over expanding consumer access to prescription drugs is the impact of proposed initiatives on the development of new medicines. Some of the initiatives entail significant changes in one or more of the federal policies affecting new drug development. One such policy is federal taxation of firms that invest in this development. Chapter 7- Although brand-name pharmaceutical companies routinely procure patents on their innovative medications, such rights are not self-enforcing. Brand-name firms that wish to enforce their patents against generic competitors must commence litigation in the federal courts. Such litigation ordinarily terminates in either a judgment of infringement, which typically blocks generic competition until such time as the patent expires, or a judgment that the patent is invalid or not infringed, which typically opens the market to generic entry. Chapter 8- Compounding is a process of combining, mixing, or altering ingredients in order to create a medication for a particular patient. While drug compounding has historically been regulated primarily by states, recent questions have been raised about the extent to which the Federal Food Drug and Cosmetic Act (FFDCA) governs this practice, and what authority the U.S. Food and Drug Administration (FDA) has to regulate a compounded drug as a ―new drug,‖ subject to approval by the FDA, as well as other requirements. In general, the FDA maintains that drug compounding activities are subject to FDA oversight, but will exercise discretion in enforcing various provisions of the FFDCA. Chapter 9- Pharmaceutical companies‘ efforts to promote prescription drugs have attracted the attention of policymakers because such activities may affect the rate at which

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different drugs are prescribed and consumed, the total amount spent on health care, and, ultimately, health outcomes. Those promotional activities—usually undertaken on behalf of brand-name, rather than generic, drugs—may influence consumers and health care professionals through a variety of channels. For example, advertisements for prescription drugs that are aimed at consumers may prompt individuals to seek medical treatment they might otherwise have delayed. Such advertisements may also influence individuals to request a specific drug that is higher or lower in price or that is more or less effective than one they had previously used. Promotional efforts aimed at physicians may help them keep abreast of the latest drug therapies and improve their ability to treat patients. Those efforts may also lead doctors to prescribe brand-name medications that are more expensive than alternatives.

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In: Pharmaceutical Industry: Innovation and Developments ISBN: 978-1-61209-394-9 Editors: David A. Mancuso and Isobel M. Grenada © 2011 Nova Science Publishers, Inc.

Chapter 1

AUTHORIZED GENERIC PHARMACEUTICALS: EFFECTS ON INNOVATION John R. Thomas

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SUMMARY The practice of ―authorized generics‖ has recently been the subject of considerable attention by the pharmaceutical industry, regulators, and members of Congress alike. An ―authorized generic‖ (sometimes termed a ―branded,‖ ―flanking,‖ or ―pseudo‖ generic) is a pharmaceutical that is marketed by or on behalf of a brand-name drug company, but is sold under a generic name. Although the availability of an additional competitor in the generic drug market would appear to be favorable to consumers, authorized generics have nonetheless proven controversial. Some observers believe that authorized generics potentially discourage independent generic firms both from challenging drug patents and from selling their own products. These perceived disincentives result from the provisions of the Drug Price Competition and Patent Term Restoration Act of 1984. Better known as the Hatch-Waxman Act, this legislation provides independent generic firms with a reward for challenging patents held by brand-name firms. That ―bounty‖ consists of a 1 80-day generic drug exclusivity period awarded to the first patent challenger. During the 1 80-day period, the brand-name company and the first generic applicant are the only firms that receive authorization to sell that pharmaceutical. At the close of this period, other independent generic competitors may obtain marketing approval and enter the market, ordinarily resulting in lower prices for generic medicines. Some commentators view the 1 80-day exclusivity period as a crucial incentive for generic firms to challenge patents held by brand-name firms. Under this view, the launch of an authorized generic during the 180-day exclusivity period makes the recovery of litigation expenses more difficult. In turn, the possibility that a brand-name firm will sell an authorized generic during the 180-day exclusivity period may decrease the incentives of generic firms to challenge patents in the first instance.

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Other observers believe that authorized generics benefit consumers by increasing competition in the generic market. Because the authorized generic is manufactured by the brand-name firm and identical to its own product, consumers may be encouraged to switch to the lower-cost authorized generic alternative. Authorized generics may also facilitate the settlement of patent litigation between brand-name and independent generic firms. As an historical matter, certain of these settlement agreements have allowed authorized generics to enter the market, and therefore promoted competition, prior to the expiration of the relevant patent term. Recent judicial opinions have upheld FDA practices allowing authorized generics. If authorized generic practice is deemed appropriate, then no action need be taken. Legislation introduced in the 111th Congress, H.R. 573, presents another option. Under H.R. 573, authorized generics may not be sold during the term of the 180-day generic exclusivity. Rising health care costs have for many years focused congressional attention upon the development and availability of prescription drugs. Recently, the presence of ―authorized generic‖ pharmaceuticals in the drug marketplace has been the subject of congressional concern.1 An ―authorized generic‖ is a pharmaceutical that is marketed by or on behalf of a brand-named drug company, but is sold under a generic name. The brand-name firm may distribute the drug under its own auspices or via a license to a generic drug company. The price of this ―authorized copy‖ is ordinarily lower than that of the brand-name drug.2 Some sources refer to authorized generics as ―branded,‖ ―flanking,‖ or ―pseudo‖ generics.‖3 Authorized generics may be pro-consumer in that they potentially increase competition and lower prices, particularly in the short-term. They have nonetheless proven controversial. Authorized generics ordinarily enter the market at about the time the brand-name drug company‘s patents are set to expire.4 Some observers argue that such products may possibly discourage independent generic firms both from challenging drug patents and from selling their own generic products.5 The potential diminution in independent generic incentives may in turn lead to less desire on the part of brand-name firms to market authorized generics themselves. Legal challenges to authorized generics practice have thus far been unsuccessful in the courts. Legislation has been introduced regarding authorized generic practice, however. In the 111th Congress, H.R. 573 proposes to prevent pharmaceutical firms from selling authorized generics. This chapter presents an analysis of the innovation and public health issues relating to authorized generic drugs. The report begins with a review of the procedures through which independent generic drug companies receive government permission to market their products and resolve patent disputes with brand-name firms. It then provides detailed background information pertaining to the concept of authorized generics and assesses their potential impact upon patent challenges and consumer welfare. The report closes with a summary of congressional issues and possible alternatives.

MARKETING APPROVAL AND PATENT ISSUES FOR GENERIC DRUGS The practice of authorized generics has arisen within a complex statutory framework established by the Drug Price Competition and Patent Term Restoration Act of 1984,6

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legislation more commonly known as the Hatch-Waxman Act.7 Under parameters established by that statute, a manufacturer that wishes to sell a generic drug must both obtain marketing approval from the Food and Drug Administration (FDA) and account for any patent rights that pertain to that product. This chapter first addresses FDA marketing approval procedures for generic drugs, and then turns to possible patent implications.

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FDA Approval Procedures The FDA regulates the marketing of pharmaceuticals in the interest of public health.8 Under this regime, the developer of a new drug must demonstrate that the product is safe and effective before it can be distributed to the public. This showing typically requires the drug‘s sponsor to conduct both preclinical and clinical investigations.9 In deciding whether to issue marketing approval or not, the FDA evaluates the test data that the sponsor submits in a socalled New Drug Application (NDA). Prior to the enactment of the Hatch-Waxman Act, the federal food and drug law contained no separate provisions addressing marketing approval for independent generic versions of drugs that had previously been approved by the FDA.10 The result was that a would-be independent generic drug manufacturer had to file its own NDA in order to sell its product.11 Some independent generic manufacturers could rely on published scientific literature demonstrating the safety and efficacy of the drug by submitting a so-called paper NDA. Because these sorts of studies were not available for all drugs, however, not all independent generic firms could file a paper NDA.12 Further, at times the FDA requested additional studies to address safety and efficacy questions that arose from experience with the drug following its initial approval.13 The result was that some independent generic manufacturers were forced to prove once more that a particular drug was safe and effective, even though their products were chemically identical to those of previously approved pharmaceuticals. Some commentators believed that the approval of an independent generic drug was a needlessly costly, duplicative, and time-consuming process. 14 These observers noted that although patents on important drugs had expired, manufacturers were not moving to introduce independent generic equivalents for these products due to the level of resource expenditure required to obtain FDA marketing approval.15 In response to these concerns, Congress enacted the Hatch-Waxman Act, a statute that has been described as a ―complex and multifaceted compromise between innovative and generic pharmaceutical companies.‖16 Its provisions included the creation of two statutory pathways that expedited the marketing approval process for independent generic drugs. The first of these consist of Abbreviated New Drug Applications, or ANDAs. An ANDA allows an independent generic applicant to obtain marketing approval by demonstrating that the proposed product is bioequivalent to an approved pioneer drug, without providing evidence of safety and effectiveness from clinical data or from the scientific literature. The second are socalled § 505(b)(2) applications, which are sometimes still referred to as ―paper NDAs.‖ Like an NDA, a § 505(b)(2) application contains a full report of investigations of safety and effectiveness of the proposed product. In contrast to an NDA, however, a § 505(b)(2)

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application typically relies at least in part upon published literature providing pre-clinical or clinical data. The availability of ANDAs and § 505(b)(2) applications often allow an independent generic manufacturer to avoid the costs and delays associated with filing a full-fledged NDA. They may also allow an independent generic manufacturer, in many cases, to place its FDAapproved bioequivalent drug on the market as soon as any relevant patents expire.17 As part of the balance struck between brand-name and independent generic firms, Congress also provided patent proprietors with a means for restoring a portion of the patent term that had been lost while awaiting FDA approval. The maximum extension period is capped at a five-year extension period, or a total effective patent term after the extension of not more than 14 years.18 The scope of rights during the period of extension is generally limited to the use approved for the product that subjected it to regulatory delay. 19 This period of patent term extension is intended to compensate brand-name firms for the generic drug industry‘s reliance upon the proprietary pre- clinical and clinical data they have generated, most often at considerable expense to themselves.20

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Resolution of Patent Disputes In addition to being the holder of an FDA-approved NDA, the brand-name pharmaceutical firm may own one or more patents directed towards that drug product.21 The product described by an independent generic firm‘s ANDA or § 505(b)(2) application may possibly infringe those patents should that product be approved by the FDA and sold in the marketplace. The Hatch-Waxman Act therefore establishes special procedures for resolving patent disputes in connection with applications for marketing generic drugs. In particular, the Hatch-Waxman Act requires each holder of an approved NDA to identify patents it believes would be infringed if a generic drug were marketed before the expiration of these patents.22 The FDA then lists these patents in a publication titled Approved Drug Products with Therapeutic Equivalence Evaluations, which is more commonly known as the ―Orange Book.‖23 Would-be manufacturers of independent generic drugs must then engage in a specialized certification procedure with respect to Orange Book-listed patents. An ANDA or § 505(b)(2) applicant must state its views with respect to each Orange Book-listed patent associated with the drug it seeks to market. Four possibilities exist: (1) that the brand-name firm has not filed any patent information with respect to that drug; (2) that the patent has already expired; (3) that the generic company agrees not to market until the date on which the patent will expire; or (4) that the patent is invalid or will not be infringed by the manufacture, use or sale of the drug for which the ANDA is submitted.24 These certifications are respectively termed paragraph I, II, III, and IV certifications.25 An ANDA or § 505(b)(2) application certified under paragraphs I or II is approved immediately after meeting all applicable regulatory and scientific requirements.26 An

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independent generic firm that files an ANDA or § 505(b)(2) application including a paragraph III certification must, even after meeting pertinent regulatory and scientific requirements, wait for approval until the drug‘s listed patent expires.27 The filing of an ANDA or § 505(b)(2) application with a paragraph IV certification constitutes a ―somewhat artificial‖ act of patent infringement under the Hatch-Waxman Act.28 The act requires the independent generic applicant to notify the proprietor of the patents that are the subject of a paragraph IV certification.29 The patent owner may then commence patent infringement litigation against that applicant. If the NDA holder demonstrates that the independent generic firm‘s proposed product would violate its patents, then the court will ordinarily issue an injunction that prevents the generic drug company from marketing that product. That injunction will expire on the same date as the NDA holder‘s patents. Independent generic drug companies commonly amend their ANDAs or § 505(b)(2) applications in this event, replacing their paragraph IV certifications with paragraph III certifications.30 On the other hand, the courts may decide in favor of the independent generic firm. The court may conclude that the generic firm‘s proposed product does not infringe the asserted patents, or that the asserted patents are invalid or unenforceable.31 In this circumstance, the independent generic firm may launch its product once the FDA has approved its ANDA or § 505(b)(2) application. In addition, the independent generic firm may benefit from a 180-day period of marketing exclusivity, a concept this chapter describes next.

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Generic Marketing Exclusivity The Hatch-Waxman Act provides prospective manufacturers of independent generic pharmaceuticals with a reward for challenging the patent associated with an approved pharmaceutical. The reward consists of a 180-day generic drug exclusivity period awarded to the first ANDA applicant to file a paragraph IV certification. During this 180-day period, the FDA may not approve another ANDA containing a paragraph IV certification with respect to the same drug.32 Notably, the 180-day generic drug exclusivity applies only to ANDA applicants, and not to those filing § 505(b)(2) applications.33 Commentators have long referred to this provision as creating ―generic exclusivity‖ or ―180-day exclusivity.‖34 As originally enacted, the Hatch-Waxman Act allowed the brandname firm and the first independent generic applicant to share the market for the first 180 days of generic competition. At the close of this period, other independent generic competitors could receive FDA marketing approval. Because market prices often drop considerably following the entry of additional generic competition, the first independent generic applicant could potentially obtain more handsome profits than subsequent market entrants.35 Congressional enactment of the Medicare Modernization and Improvement Act of 200336 clarified that more than one patent challenger can enjoy ―generic exclusivity,‖ provided that certain conditions are met. Following the 2003 statute, all ―first applicants‖ are potentially entitled to the 1 80-day generic exclusivity.37 The statute defines the term ―first applicant‖ to mean all applicants who, on the first day on which a substantially complete generic application with paragraph IV certification is filed, did themselves file a substantially

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complete generic application with a paragraph IV certification.38 The statute therefore makes clear that multiple first applicants—that is to say, more than one generic that filed a paragraph IV generic application on the same day—may each enjoy ―shared exclusivity.‖ The 180-day generic exclusivity period is intended to ameliorate collective action problems that may arise with regard to pharmaceutical patent challenges.39 Stated less technically, an independent generic firm that challenges a patent must bear the expensive, upfront cost of litigation. If the independent generic firm is successful, however, the challenged patent is declared invalid with regard to the entire pharmaceutical industry. Any firm—not just the one who challenged the patent—could then introduce a competing product to the marketplace. Understandably, this forced sharing may undermine the incentives any one independent generic firm would possess to challenge a brand-name firm‘s patent. The award of 180 days of generic exclusivity is therefore intended to allow a successful patent challenger to capture an individual benefit for its effort, in turn encouraging such challenges in the first instance.40

THE CONCEPT OF AUTHORIZED GENERICS

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Authorized Generics Practice As noted previously, an ―authorized generic‖ is a pharmaceutical that is marketed by or on behalf of a brand-name drug company, but is sold under a generic name.41 Authorized generics are thus similar to ―private label‖ products, which are manufactured by one firm but sold under the brand of another. Although private label products are commonplace in food, cosmetic, and other markets, they have only recently attracted attention in the pharmaceutical industry.42 Current interest in authorized generics is largely due to a shift in corporate strategies that has been traced to the early 1990‘s. Until that time, many entrants in the pharmaceutical industry engaged exclusively either in selling brand-name, innovative drugs, or in selling generic drugs. Several other brand-name firms began to market authorized generics shortly before patents on their products were due to expire. Among such products were Nolvadex® (tamoxifen), authorized by the Stewart Pharmaceutical Division of ICI Americas (now AstraZeneca) and sold by Barr Laboratories; Dyazide® (triamterene/hydrochlorothiazide), marketed by SmithKline Beecham Pharmaceuticals (now GlaxoSmithKline); and Ventolin® (albuterol), authorized by GlaxoSmithKline and sold by Dey LP.43 Many brand-name firms did not continue to sell authorized generics at that time, however, reportedly due to a lack of profitability.44 One reason for the ―resurgence‖ of authorized generics in the early 2000‘s is that physicians, pharmacists and patients more rapidly switch to generic drugs upon their introduction to the marketplace than a decade ago.45 Because the rate of generic adoption is much greater now, brand-name firms reportedly are more willing to ―genericize‖ their own brands in order to capture a share of that market.46 The expanding generic adoption rate has also reportedly led to an industry trend where brandname houses acquire generic firms.47 This development too may encourage authorized generics practice in the future.

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In line with current trends, a number of successful paragraph IV ANDA applicants have faced competition from authorized generics during the 180-day generic exclusivity period. These independent generic firms include Barr, for the product Allegra® (fexofenadine);48 Eon, for the product Wellbutrin SR® (bupropion SR);49 and Teva, for the product Glucophage®.50 Some industry analysts believe that authorized generics will form an increasingly prominent feature of the U.S. pharmaceutical market in the future.51 Other commentators believe that this time has already arrived: According to one account, since 2004 ―authorized generic versions have appeared for nearly all drugs with expiring U.S. patents.‖52

Authorized Generics within the Hatch-Waxman Framework Authorized generics practice has proven controversial due to the Hatch-Waxman Act‘s architecture and incentive structures. Some commentators have voiced concerns that the introduction of authorized generics, particularly during the 180-day market exclusivity granted to the independent generic firm that brought a paragraph IV challenge, thwarts the policy goal of encouraging the introduction of generic pharmaceuticals.53 In particular, critics argue that the use of authorized generics may discourage firms from filing paragraph IV patent challenges if their litigation expenses cannot be recouped through the 1 80-day market exclusivity period.54 As antitrust attorney David A. Balto explains:

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The bounty from challenging a patent is very important. Pharmaceutical patent litigation is a multimillion-dollar proposition. But for the potential reward of six-month exclusivity that represents the vast majority of potential profits from generic entry, many firms might forgo challenging patents.55

For example, the FDA ruled that the generic manufacturer Apotex was entitled to 180day exclusivity for its version of the anti-depressant drug Paxil® in 2003. The brand-name drug company, GlaxoSmithKline, introduced an authorized generic version of Paxil®. Although Apotex anticipated sales of up to $575 million during the 180-day generic exclusivity period, its sales were reported to be between $150 million and $200 million.56 In a 2004 filing with the FDA, attorneys for Apotex asserted ―that the authorized generic crippled Apotex‘s 180-day exclusivity—it reduced Apotex‘s entitlement to about two-thirds—to the tune of approximately $400 million.‖57 In addition, brand-name firms commonly introduce authorized generics on the eve of generic competition. Without an independent generic patent challenger in the first instance, brand-name firms may themselves make diminished, or delayed, use of the authorized generic strategy. As a result, the pro-competitive benefits of authorized generics may be postponed, or not realized at all, should independent generic rivals become less willing to challenge patents held by brand- name firms.58 On the other hand, authorized generics potentially offer several benefits both to drug companies and to consumers. Authorized generics are commonly less expensive than the brand-name drug. The introduction of an authorized generic therefore allows a lower-cost product to be made available to the consumer.59 As the FDA opined in a statement issued in July 2004:

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Marketing of authorized generics increases competition, promoting lower prices for pharmaceuticals, particularly during the 180-day exclusivity period in which the prices for generic drugs are often substantially higher than after other generic products are able to enter the market.60

In addition, once a generic version of a drug becomes available following patent expiration, brand-name firms may lose considerable market share. Indeed, many health management organizations and insurance companies reportedly promote the use of generic substitutes for brand-name medications once they become available.61 Absent participation in the generic market, brand-name firms may not be able to take advantage of investments they previously made with respect to their manufacturing facilities. Authorized generics therefore allow brand-name firms to continue to employ their manufacturing facilities at or near peak capacity even following patent expiration.62 Authorized generics may also support the research and development efforts of brandname firms by providing them with additional revenue. Authorized generics may supply the brand-name firm with an additional income source, such as a royalty on sales made by its generic subsidiary or contracting partner.63 These funds, or some portion of them, can potentially be employed in support of pharmaceutical innovation. Authorized generics may also facilitate settlement of patent infringement suits between brand- name and independent generic firms. A judicial holding of patent invalidity may have a severe impact upon a brand-name firm in terms of its lost revenue. Many observers also believe that patent litigation is an uncertain venture.64 By settling patent litigation, and allowing an ANDA applicant to produce an authorized generic, brand-name firms may potentially better manage risk. Such a technique provides a more stable revenue stream, both in support of the brand-name firm‘s research and development activities and for its investors. The generic company making an authorized generic can also benefit by not having to expend funds on litigation with an uncertain outcome or pursue an ANDA at the FDA, while expanding its product line, acquiring manufacturing experience, and gaining the first-mover advantage in the generic market.65 The use of authorized generics as a litigation settlement mechanism also impacts consumers, but in a manner that is both less certain and likely varies on a case-by-case basis. On one hand, particular settlement agreements may provide for the sale of authorized generics years before the disputed patent is set to expire. As a result, consumers may gain early access to a lower-cost alternative to the brand-name drug. On the other hand, had the generic firm refused to settle and ultimately prevailed in the litigation, then the market would have been open to full competition even earlier. The impact upon competition of a litigation settlement likely depends upon a number of complex factors, including the strength of the patent, the number of potential generic competitors, and the precise terms of the litigation settlement agreement.

Legality of Authorized Generics The policy debate concerning authorized generics has been accompanied by legal challenges before the FDA and the courts concerning this practice. Opponents of authorized generics have contended that the Hatch-Waxman Act‘s generic exclusivity provisions should

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be understood as excluding authorized generics from the marketplace for the 180-day period.66 The FDA has taken the opposite view, however, reasoning that the Hatch-Waxman Act does not require a brand-name pharmaceutical company to file any sort of application in order to market the drug as an authorized generic.67 In turn, the 180-day period of generic exclusivity provided by the Hatch- Waxman Act only applies to ANDA or § 505(b)(2) applications with paragraph IV certifications. As a result, the 180-day generic exclusivity period does not bar authorized generics from entering the market. Two notable judicial opinions have recently upheld the FDA‘s position favoring authorized generics. In the first of these opinions, Teva Pharmaceutical Industries, Ltd. v. Crawford,68 the Court of Appeals for the D.C. Circuit found no reasonable reading of the Hatch-Waxman Act that would allow authorized generics to be barred by the 180-day generic exclusivity period. In that case, independent generic manufacturer Teva had previously entered into an arrangement with Purepac Pharmaceutical Co., the first paragraph IV ANDA applicant with respect to the drug gabapentin. Teva and Purepac had agreed to share the 180day generic exclusivity period. During that period, however, Pfizer sold its own authorized generic version of gabapentin, which was priced substantially below the price of its brandname drug.69 Teva responded by petitioning the FDA to prohibit the marketing of authorized generic versions of gabapentin during the 180-day generic exclusivity period. Alternatively, Teva asserted that Pfizer should be required to file a supplemental NDA before selling an authorized generic.70 According to Teva, the impact of the latter proposed ruling would lead to the same outcome as the first: Pfizer would be compelled to respect the 180-day generic exclusivity period established by the Hatch-Waxman Act. The FDA denied the petition, resulting in a Teva lawsuit against the FDA. The district court confirmed the FDA‘s views, concluding that ―[n]othing in the statute provides any support for the argument that the FDA can prohibit NDA holders from entering the market with [an authorized] generic drug during the exclusivity period.‖71 Teva then appealed to the Court of Appeals for the D.C. Circuit, which affirmed. Chief Judge Ginsburg began his opinion by observing that the Hatch-Waxman Act did not stipulate the manner in which the holder of an approved NDA must market its drug. Further, prior to the enactment of the Hatch-Waxman Act, nothing in the Food, Drug, and Cosmetic Act prevented the NDA holder from marketing an authorized generic. The D.C. Circuit thus saw the issue as whether it should ―declare that a previously lawful practice became unlawful when the Congress passed a statute that said nothing about that practice.‖72 The Court of Appeals further rejected Teva‘s ―functional‖ interpretation of the HatchWaxman Act. According to Teva, the practice of authorized generics had ―developed only recently as a routine brand-name business strategy‖ and therefore had not been anticipated by Congress. Further, authorized generics practice severely diminished generic incentives to challenge pharmaceutical patents. According to Teva, then, ―adhering to the ‗literal‘ terms of the statute would lead to an absurd result, namely, that [the Hatch-Waxman Act] grants only a ‗meaningless‘ exclusivity against subsequent ANDA filers rather than a ‗commercially effective‘ exclusivity that runs against the NDA holder as well.‖73 The D.C. Circuit responded by reasoning that the balance between innovation and competition struck by the Hatch-Waxman Act was ―quintessentially a matter for legislative judgment,‖ such that ―the court must attend closely to the terms in which the Congress expressed that judgment.‖74 Here, Chief Judge Ginsburg reasoned, the statute was

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unambiguous. Although the Hatch-Waxman Act barred the approval of subsequent ANDAs for 180 days, the statutory language simply did not speak to marketing arrangements made by the holder of the approved NDA. The court of appeals further observed that, even in the event that an NDA holder authorized a generic, the 180- day exclusivity period continued to bar other firms from marketing a generic version of the drug. As a result, authorized generic practice hardly rendered the Hatch-Waxman Act‘s generic exclusivity provisions ―meaningless.‖75 In conclusion, because the Hatch-Waxman Act ―clearly does not prohibit the holder of an approved NDA from marketing, during the 180-day exclusivity period, its own ‗brand-generic‘ version of its drug,‖ FDA practices concerning authorized generics were affirmed.76 A second judicial opinion, Mylan Pharmaceuticals, Inc. v. U.S. Food and Drug Administration,77 also concluded that the Hatch-Waxman Act ―does not grant the FDA the power to prohibit the marketing of authorized generics during the 180-day exclusivity period.... ‖78 That case involved the pharmaceutical nitrofurantoin, which is used to treat urinary tract infections. When the FDA approved a paragraph IV ANDA filed by Mylan Pharmaceuticals, Inc, to sell nitrofurantoin, NDA holder Proctor & Gamble Pharmaceuticals, Inc., licensed a third party generic firm to sell an authorized generic version of the drug. Mylan reportedly lost sales of ―tens of millions‖ of dollars due to this arrangement.79 Mylan challenged the FDA approval of authorized generics practice before the U.S. District Court for the Northern District of West Virginia. Mylan appealed the district court‘s dismissal of its case to the Court of Appeals for the Fourth Circuit, which affirmed. Citing the D.C. Circuit‘s decision in Teva v. Crawford with approval, the Fourth Circuit similarly concluded that the statute clearly defined the 180-day exclusivity period only with respect to other paragraph IV ANDAs, not to authorized generics.80 The Fourth Circuit therefore concluded that ―[a]lthough the introduction of an authorized generic may reduce the economic benefit of the 180 days of exclusivity awarded to the first paragraph IV ANDA applicant, § 355(j)(5)(B)(iv) gives no legal basis for the FDA to prohibit the encroachment of authorized generics on that exclusivity.‖81 As a result, the district court‘s judgment was affirmed. It is possible to criticize the statutory construction of both Teva v. Crawford and Mylan v. FDA. In particular, neither court of appeals stressed that the Hatch-Waxman Act describes the 180-day time frame as an ―exclusivity period.‖82 The term ―exclusivity‖ might be viewed as a curious drafting choice in view of the ruling that generic firms must potentially compete alongside authorized generics during the 180-day period. On the other hand, the notion of ―shared exclusivity‖ that arose following the Medicare Modernization Act amendments may be viewed as codifying congressional intent that multiple generic applicants may enter the market during the 180-day marketing exclusivity period.83 In addition, many prescription drugs are available in a number of different dosage forms and strengths. Under current Hatch-Waxman Act practice, each strength and dosage form is considered a separate drug product for which a distinct generic applicant can qualify for 180-day exclusivity. 84 As a result, the term ―exclusivity‖ may be considered to have a particular meaning in the Hatch-Waxman Act—one that does not necessarily mean that independent generic firms will not face competition during the 180-day period even in the absence of authorized generics. Of course, these provisions may also impact the incentives that independent generic firms possess to challenge pharmaceutical patents.

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In any event, Teva v. Crawford and Mylan v. FDA currently represent the law of the land. Absent further judicial developments or congressional activity, authorized generics will be judged as legitimate means for NDA holders to market their products under the HatchWaxman Act.85

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CONCLUDING OBSERVATIONS Although Congress made significant amendments to the Hatch-Waxman Act as recently as 2003,86 authorized generics were not subject to discussion at that time. The rise of this practice, as well as the vigor of the debate surrounding it, suggests both the pace of change within the industry and the prominence of the pharmaceutical industry within the national public health system. As discussion of authorized generics continues, Congress may wish to have a sense of its legislative options. Should Congress conclude that authorized generics are appropriate, then it may simply take no action. The opinions of the D.C. and Fourth Circuits suggest that, as currently drafted, the Hatch-Waxman Act does not allow the FDA to restrict the ability of brand-name firms to sell or approve of authorized generics.87 Absent legislative input, the FDA may be unlikely to alter its interpretation of the Hatch-Waxman Act in this respect in the future. Alternatively, Congress could simply disallow authorized generics practice. In the 111th Congress, H.R. 573 proposes to prohibit NDA holders from manufacturing, marketing, selling, or distributing an authorized generic drug. The term ―authorized generic drug‖ is defined as ―any version of a listed drug ... that the holder of new drug application ... seeks to commence marketing, selling, or distributing, directly or indirectly, after receipt of a notice‖ that an ANDA has been filed. 88 Drugs marketed by firms eligible for the 1 80-day generic exclusivity, or that are sold by anyone after that exclusivity has expired, are not considered to be authorized generic drugs. Another option is to require brand-name firms to file a supplemental NDA, or a similar application, with the FDA when they market authorized generics.89 This filing would then place the brand-name firm in the same category as generic applicants who did not qualify as the first to file. In turn, the 180-day generic exclusivity period would then apply against the authorized generic. Notably, whether the 180-day generic exclusivity period strikes an appropriate balance between encouraging patent challenges and ensuring prompt access to generic medications is itself a contested proposition within the pharmaceutical industry.90 Discussion of the authorized generics issue may also prompt further reflection on the basic structure of incentives within the Hatch- Waxman Act. Current interest in authorized generics reflects longstanding congressional concern for the appropriate balance between innovation and competition within the pharmaceutical industry. Although academic inquiry into authorized generics practice remains in its early phases, it is notable that knowledgeable commentators have reached disparate views of the benefits or detriments of this practice. Some observers stress that authorized generics benefit consumers by providing enhanced access to lower-cost alternatives to branded drugs, while others express concerns that authorized generics will defeat the incentives that independent generic

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firms possess to challenge pharmaceutical patents. Future studies may shed additional light on the impact of authorized generics upon consumer welfare.

End Notes

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1

See Thomas Chen, ―Authorized Generics: A Prescription for Hatch-Waxman Reform,‖ 93 Virginia Law Review (2007), 459; Saami Zain, ―Sword or Shield? An Overview and Competitive Analysis of the Marketing of ‗Authorized Generics‘,‖ 62 Food & Drug Law Journal (2007), 739. 2 See Leila Abboud, ―‗Authorized Generics‘ Duel Grows,‖ Wall Street Journal (March 25, 2004); Leila Abboud, ―Drug Makers Use New Tactic to Ding Generic-Drug Firms,‖ Wall Street Journal (January 27, 2004). 3 See ―Blockbuster Drugs with Expiring Patents Gain New Hope: Generic Drugs,‖ Drug Week 352 (April 15, 2005). 4 Stephen Barlas, ―‗Authorized‘ Generics May Pose Unauthorized Problems: Government Worries About Potential Brand-Name Blocking Technique,‖ 30 Pharmacy and Therapeutics no.8 (2005), 435. 5 See Michelle L. Kirsche, ―Despite Challenges, Generics Dispensing is on the Rise,‖ 27 Drug Store News no. 4 at 20 (March 21, 2005). 6 P.L. 84-417, 98 Stat. 1585 (1984). 7 See, e.g., Laura J. Robinson, ―Analysis of Recent Proposals to Reconfigure Hatch-Waxman,‖ 11 Journal of Intellectual Property Law (2003), 47. 8 CRS Report RS22946, Food and Drug Administration (FDA): Overview and Issues, by Erin D. Williams. 9 See G. Lee Skillington and Eric M. Solovy, ―The Protection of Test and Other Data Required by Article 39.3 of the TRIPS Agreement,‖ 24 Northwestern Journal of International Law and Business (2003), 1. 10 See Alfred B. Engelberg, ―Special Patent Provisions for Pharmaceuticals: Have They Outlived Their Usefulness?,‖ 39 IDEA: Journal of Law and Technology (1999), 389. 11 See James J. Wheaton, ―Generic Competition and Pharmaceutical Innovation: The Drug Price Competition and Patent Term Restoration Act of 1984,‖ 34 Catholic University Law Review (1986), 433. 12 See Kristin E. Behrendt, ―The Hatch-Waxman Act: Balancing Competing Interest or Survival of the Fittest?,‖ 57 Food and Drug Law Journal (2002), 247. 13 Id. 14 See, e.g., Justina A. Molzon, ―The Generic Drug Approval Process,‖ 5 Journal of Pharmacy and Law (1996), 275 (―The Act streamlined the approval process by eliminating the need for [generic drug] sponsors to repeat duplicative, unnecessary, expensive and ethically questionable clinical and animal research to demonstrate the safety and efficacy of the drug product.‖). 15 See Jonathan M. Lave, ―Responding to Patent Litigation Settlements: Does the FTC Have It Right Yet?,‖ 64 University of Pittsburgh Law Review (2002), 201 (―Hatch-Waxman has also increased the generic drug share of prescription drug volume by almost 130% since its enactment in 1984. Indeed, nearly 100% of the top selling drugs with expired patents have generic versions available today versus only 35% in 1983.‖). 16 Natalie M. Derzko, ―A Local and Comparative Analysis of the Experimental Use Exception—Is Harmonization Appropriate?,‖ 44 IDEA: Journal of Law and Technology (2003), 1. 17 See, e.g., Sarah E. Eurek, ―Hatch-Waxman Reform and Accelerated Entry of Generic Drugs: Is Faster Necessarily Better?,‖ 2003 Duke Law and Technology Review (August 13, 2003), 18. 18 35 U.S.C. § 156(b) (2004). 19 35 U.S.C. § 156(b)(1) (2004). 20 CRS Report RL32377, The Hatch-Waxman Act: Legislative Changes Affecting Pharmaceutical Patents, by Wendy H. Schacht and John R. Thomas. 21 Patents, which are administered by the United States Patent and Trademark Office (USPTO), provide their owner with the ability to exclude others from making, using, selling, offering to sell or importing into the United States the patented invention. 35 U.S.C. § 271(a) (2004). The term of the patent is ordinarily set at twenty years from the date the patent application was filed, 35 U.S.C. § 154 (2004), although pharmaceutical patents may be extended in order to compensate for a portion of the patent term that was lost during FDA marketing approval procedures. 35 U.S.C. § 156 (2004). Patent proprietors are permitted to file a civil suit in federal court in order to enjoin infringers and obtain monetary damages. 35 U.S.C. § 281 (2004). Although issued patents enjoy a presumption of validity, accused infringers may assert that the patent is invalid or unenforceable on a number of grounds. 35 U.S.C. § 282 (2004). 22 21 U.S.C. § 355(c)(2) (2004). 23 See, e.g., Jacob S. Wharton, ―‗Orange Book‘ Listing of Patents Under the Hatch-Waxman Act,‖ 47 St. Louis University Law Journal (2003), 1027. 24 21 U.S.C. § 355(j)(2)(A)(vii) (2004). 25 See Douglas A. Robinson, ―Recent Administrative Reforms of the Hatch-Waxman Act: Lower Prices Now In Exchange for Less Pharmaceutical Innovation Later?,‖ 81 Washington University Law Quarterly (2003), 829.

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21 U.S.C. § 355(j)(5)(B)(i) (2004). 21 U.S.C. § 355(j)(5)(B)(ii) (2004). 28 Eli Lilly and Co. v. Medtronic, Inc., 496 U.S. 1047, 15 USPQ2d 1121 (1990). 29 21 U.S.C. § 355(j)(2)(B)(i) (2004). 30 21 C.F.R. § 3 14.94(a)(12)(viii)(C)(1)(i) (2006). 31 Although patents enjoy a presumption of validity, 35 U.S.C. § 282 (2004), that presumption is not uncontestable. Accused infringers may demonstrate that the patent does not meet the standards established by the Patent Act, and as a result should not have been issued by the U.S. Patent and Trademark Office. Id. In addition, an accused infringer may demonstrate that the patent is unenforceable on a number of grounds, among that its owner has engaged in ―misuse‖ of the patent. Id. 32 21 U.S.C. §355(j)(5)(B)(iv) (2004). 33 U.S. Dept. of Health and Human Services., Food and Drug Admin., Center for Drug Evaluation and Research, Guidance of Industry, Listed Drugs, 30-Month Stays, and Approval of ANDAs and 505(b)(2) Applications Under Hatch-Waxman, As Modified by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, at 5 n. 14 (October 2004). 34 See, e.g., Valerie Junod, ―Drug Marketing Exclusivity Under United States and European Union Law,‖ 59 Food and Drug Law Journal (2004), 479; Gerry J. Elman, ―FDA Approval of Generic Drugs: Instituting a First Successful Defense Requirement for Generic Exclusivity,‖ 22 Biotechnology Law Reporter 97 (April 2003); Frederick Tong, ―Widening the Bottleneck of Pharmaceutical Patent Exclusivity,‖ 24 Whittier Law Review (2003), 775. 35 See Michael Bobelian, ―1984 Act Led to a Boom in Prescription Drug Litigation,‖ 231 New York Law Journal 1, col. 3 (May 24, 2004). 36 P.L. 108-173, 117 Stat. 2066 (2003). 37 21 U.S.C. §355(j)(5)(B)(iv)(I) (2004). 38 21 U.S.C. §355(j)(5)(B)(iv)(II)(bb) (2004). 39 Mova Pharm. Corp. v. Shalala, 140 F.3d 1060, 1064 (D.C. Cir. 1998). 40 See generally Joseph Scott Miller, ―Building a Better Bounty: Litigation-Stage Rewards for Defeating Patents,‖ 19 Berkeley Technology Law Journal (2004), 667. 41 See Leila Abboud, ―‗Authorized Generics‘ Duel Grows,‖ Wall Street Journal (March 25, 2004); Leila Abboud, ―Drug Makers Use New Tactic to Ding Generic-Drug Firms,‖ Wall Street Journal (January 27, 2004). 42 See John Schmeltzer, ―Upscale Generics Make Gains: ‗Private Label‘ Items Battling Brand Names,‖ Montgomery County Herald (May 19, 2006). 43 ―As brand-generic alliances grow, opponents cry foul,‖ Drug Store News (August 23, 2004). 44 Sanda Levy, ―Why authorized generics are making a comeback,‖ Drug Topics: The Online Newspaper for Pharmacists, available at http://www.drugtopics.com/drugtopics/article/articleDetail.jsp?id=111159. 45 Id. 46 Id. 47 See Andrew Humphries and Nick D‘Amore, ―Generic Deluge: As U.S. Regulators Receive a Record Number of Generic Drug Applications, Pharmaceutical Companies Continue to Align With or Combat Generic Competition,‖ 24 Med Ad News no. 11 (November 1, 2005), 1. 48 See Beth Understahl, ―Authorized Generics: Careful Balance Undone,‖ 16 Fordham Intellectual Property, Media, and Entertainment Law Journal (Autumn 2005), 355. 49 Id. 50 See Tara Croft, ―Building Teva,‖ Daily Deal (October 25, 2004). 51 See James Richie, ―Prasco‘s market share Rx: authorized generic drugs: Firm helps pharmaceutical companies retain profits,‖ Cincinnati Business Courier (February 6, 2006). 52 Tony Pugh, ―Drug companies battle generics with their own copies,‖ Duluth News-Tribune (April 30, 2006). 53 See Understahl, supra note 48. 54 Tony Pugh, ―Loophole may dampen generic-drug boom,‖ San Jose Mercury News (May 3, 2006), A1. 55 David A. Balto, ―We‘ll Sell Generics Too: Innovator drug makers are gaming the regulatory system and harming competition,‖ 39 Legal Times no. 12 (March 20, 2006). 56 See Jenna Greene, ―The Drug Industry Has Figured Out a Way to Best Generic Competition, and Pharmaceutical Patent Litigation Could Free-Fall,‖ 183 New Jersey Law Journal (January 23, 2006), 217. 57 See Pugh, supra note 54. 58 See Narinder Banait, ―Authorized Generics: Antitrust Issues and the Hatch-Waxman Act,‖ Mondaq (November 4, 2005). 59 Morton I. Kamien and Israel Zang, ―Virtual Patent Extension by Cannibalization,‖ Southern Economic Journal, July 1999. 60 U.S. Food and Drug Administration, FDA Supports Broader Access to Lower Priced Drugs, FDA Talk Paper, July 2, 2004. A study prepared by IMS Consulting for the Pharmaceutical Research and Manufacturers of America reached a similar conclusion, determining that the average price discount to brand-name drugs during the 180-day exclusivity period is greater when an authorized generic has been marketed than when one has 27

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not. IMS Consulting, Assessment of Authorized Generics in the U.S. (Spring 2006), available at http://www.phrma.org/files/ IMS%20Authorized%20Generics%20Report_6-22-06.pdf. 61 Kathleen Kerr, ―Prescription Hurdles: Need Brand-Name Drug? Generic May Come First,‖ Newsday (March 16, 2006), B13. 62 Jon Hess and Elio Evangelista, Authorized Generics: Lifecycle Management’s Compromise in the Patent Wars (Cutting Edge Information, August 23, 2005), 4. 63 Id. 64 See James Bessen and Michael J. Meurer, ―Lessons for Patent Policy from Empirical Research on Patent Litigation,‖ 9 Lewis and Clark Law Review 1 (2005). 65 Christopher Worrell, Authorized Generics, presentation given at The 5th Generic Drugs Summit, September 2729, 2004, and David Reiffen and Michael R. Ward, “Branded Generics” as a Strategy to Limit Cannibalization of Pharmaceutical Markets, May 2005, 2-4 available at http://www.ut a.edu/faculty/mikeward/brandedgenerics.pdf. 66 See Generic Pharmaceutical Association, Comment in Support of Citizen Petition Docket No. 2004P-0075/CP1 (May 21, 2004), available at http://www.fda.gov/ohrms/dockets/dailys/04/June04/060404/04p-0075-c00003vol1.pdf. 67 See M. Howard Morse and Richard E. Coe, ―Authorized Generics Are Good for You: Competition from drug pioneers shouldn‘t trouble the FTC,‖ 29 Legal Times no. 15 (April 10, 2006). 68 410 F.3d 51 (D.C. Cir. 2005). 69 Id. at 52. 70 Id. at 52-53. 71 Teva Pharm. Indus. v. FDA, 355 F.Supp.2d 111, 117 (D.D.C. 2004). 72 410 F.3d at 53. 73 Id. at 54. 74 Id. 75 Id. 76 Id. at 55. 77 454 F.3d 270 (4th Cir. 2006). 78 Id. at 271. 79 Id. at 273. 80 Id. at 275. 81 Id. at 276 82 21 U.S.C. § 355(j)(5)(B)(iv) (2004). 83 See supra notes 36-3 8 and accompanying text. 84 See Apotex, Inc. v. FDA, 414 F. Supp. 2d 61, 64 (D.D.C. 2006). 85 See generally Thomas P. Noud and Paul T. Meiklejohn, ―The Developing Law of Pharmaceutical Patent Enforcement,‖ 87 Journal of the Patent and Trademark Office Society (2005), 921. 86 Medicare Modernization and Improvement Act, P.L. 108-173, 117 Stat. 2066 (2003). 87 See supra notes 68-81 and accompanying text. 88 H.R. 573, § 1. 89 This option is essentially the same as the one that Teva unsuccessfully argued before the Court of Appeals for the District of Columbia Circuit in the Teva v. Crawford case. See supra note 70 and accompanying text. 90 Letter of Robert A. Armitage, Eli Lilly and Company, Re: Authorized Generic Study (June 5, 2006), available at http://www.ftc.gov/os/comments/genericdrugstudy3/060605lilly.pdf.

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Chapter 2

AUTHORIZED GENERICS: AN INTERIM REPORT Federal Trade Commission Report

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EXECUTIVE SUMMARY This Interim Report presents the first set of results from a study undertaken by the Federal Trade Commission of the effects of authorized generic drugs on competition in the prescription drug marketplace. Authorized generic drugs (referred to in this chapter as ―AGs‖) are drugs that are approved by the Food and Drug Administration (―FDA‖) as brandname drugs, but that the brand subsequently chooses to market (or have marketed) as generic, as well as brand-name, drugs. The trade dress typically is different for the brand-name drug and its AG equivalent, but the drug products are chemically identical. The study was commenced at the request of Senators Grassley, Leahy, and Rockefeller, who asked the Commission to examine ―the short term and long term effects on competition of the practice of ‗authorized‘ generics.‖1 Representative Waxman, one of the co-authors of the Hatch-Waxman Act, also requested the FTC to study ―the impact of so-called ‗authorized generics‘ on competition in the prescription drug marketplace.‖2 Aspects of these issues are relevant to current legislative debates, and this Interim Report seeks to provide pertinent information in a timely fashion. This Interim Report provides factual information and economic analysis to date of the short-term effects of AGs on competition during the 180 days of marketing exclusivity that a generic may be awarded in certain circumstances under the Hatch-Waxman Act. This Interim Report does not examine long-term and/or overall effects of AGs on such competition. This economic analysis is based on substantial data sets obtained from governmental and non-governmental sources and on documentary information provided by brand and generic companies in response to compulsory information requests. Specifically, our preliminary analysis addresses the following short-term effects:

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Federal Trade Commission Report 

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Effects on wholesale and retail generic prices from AG competition against one ANDA generic3 during the 180 days of marketing exclusivity that an ANDA generic may be awarded after seeking entry prior to expiration of the corresponding brandname drug‘s patents. Effects of AG competition on the revenues of, and quantities sold by, one ANDA generic during the 180 days of marketing exclusivity that an ANDA generic may be awarded after seeking entry prior to expiration of the corresponding brand-name drug‘s patents. Patent settlement agreements reviewed by FTC staff in which a brand has agreed not to compete against the generic with an AG for a certain amount of time and the ANDA generic has agreed to defer its entry for a certain period of time. Such agreements have recently become more common.

Our initial analysis suggests that consumers benefit and the healthcare system saves money during the 180-day exclusivity period when an AG enters the market, due to the greater discounting that accompanies the added competition provided by the AG. Consistent with competition to provide a relatively homogenous product, the data indicate that AG entry significantly decreases the revenues of a first-filer generic company during its 180-day exclusivity period. This revenue reduction is likely to change the calculus of business decision- making in some circumstances for both generic and branded firms, but at this stage we have not analyzed whether AG entry deters generic entry prior to patent expiration that otherwise would take place. Finally, between FY2004-FY2008, about one-quarter of final patent settlements with first-filer generics involved an explicit agreement by the brand not to launch an AG to compete against the first filer, combined with an agreement by the first-filer generic to defer its entry past the settlement date. This preliminary analysis, however, describes various brand-ANDA agreements involving AGs but does not address whether limitations on AG entry during the 180- day exclusivity period would have an effect on the incidence of reverse settlements that are harmful to consumers. Through enactment of the Hatch-Waxman Act,4 Congress established the regulatory framework under which a generic manufacturer may obtain approval of its drug by the Food and Drug Administration (―FDA‖) by filing an Abbreviated New Drug Application5 (―ANDA‖) in which it is allowed to rely on the clinical data first submitted by the brandname drug manufacturer to establish the safety and efficacy of the generic drug. To encourage generic entry as soon as warranted, that Act allows a generic drug manufacturer to file a socalled ―Paragraph IV‖ ANDA certifying (a) its generic drug will not infringe patents listed in the FDA‘s ―Orange Book‖ (―Orange Book patents‖) in regard to the relevant brand-name drug product, and/or (b) that the relevant Orange Book patents are invalid. Typically, patent litigation then ensues, and the FDA may not approve the generic drug until 30 months after the generic filed notice of the Paragraph IV ANDA to the brand (or after a favorable decision in the litigation, if earlier). At that point the FDA may authorize the marketing of the generic drug under the ANDA application, and the first-filed paragraph IV ANDA applicant becomes entitled to 180-days of marketing exclusivity. The 180 days of marketing exclusivity generally protect one first-filed ANDA applicant from competition with other ANDA applicants during the 180-day period. This 180 days of marketing exclusivity was intended to provide an incentive for ANDA-filers to challenge brand-name patents and seek generic entry prior to patent expiration.

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The 180-day marketing exclusivity does not, however, preclude competition from an AG. The courts have determined that AGs can be marketed during that period, because they are approved under a brand-name drug‘s NDA rather than an ANDA.6 As the practice has become increasingly common, it has generated increasing controversy, with generic companies contending that AGs undermine the goals of the Hatch-Waxman Act, and brand companies defending AGs as procompetitive and consistent with the Act. It is in this context that the FTC has undertaken this study. The FTC‘s preliminary data analysis shows the following: 





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

 



Retail prices are on average 4.2 percent lower, relative to the pre-generic brand price, when an AG competes with one ANDA generic during the 180-day exclusivity period than when an AG does not enter. Wholesale prices are on average 6.5 percent lower, relative to the pre-generic brand prices, when an AG competes with one ANDA generic during the exclusivity period than when an AG does not enter. Revenues of a sole ANDA generic company during the 180-day exclusivity period drop substantially with AG entry, with estimates of the average decline ranging from 47% to 51%. The revenue effect for generics is so much larger than the price effect for consumers primarily because the AG represents a very close substitute for the ANDA generic and therefore typically obtains significant market share at the expense of the ANDA generic. This is confirmed by an analysis of the quantities dispensed by retail pharmacies. To prevent this loss of revenue, a generic may be willing to delay its entry in return for a brand‘s agreement not to launch an authorized generic – that is, a brand‘s agreement not to compete with the generic through an AG – during the generic‘s 180 days of marketing exclusivity. Between FY2004-FY2008, about one-quarter (38 out of 152) of the final patent settlements reviewed by the FTC contained provisions relating to AGs. Between FY2004-FY2008, 76 final patent settlement agreements were with first-filer generics. About one-quarter (20 out of 76) of those patent settlements involved (1) an explicit agreement by the brand not to launch an AG to compete against the first filer, combined with (2) an agreement by the first-filer generic to defer its entry past the settlement date by, on average, 34.7 months. With regard to these twenty settlements, branded sales of the affected products ranged from $12.6 million to $5.3 billion, with an average market size of $917 million and a median market size of $514 million. Five of the settlements covered products with annual sales of $1 billion, $1.1 billion, $2.1 billion, $2.5 billion, and $5.3 billion. Such agreements can harm consumers in two ways:  First, generic entry, and the accompanying discounts, would not be available to consumers as soon as otherwise would be the case. Because generic drugs often are priced substantially below the price of branded drugs, 7 overall prescription drug costs could be significantly increased by even a few additional months of branded prices in a large market.  Second, consumers would lose the benefit of price discounts from AG competition during the 180-day marketing exclusivity. The consumer harm in

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Federal Trade Commission Report such instances arises because the brand has agreed not to compete against the independent generic during the exclusivity period. The consumer harm arises from the absence of AG competition against an ANDA generic, not from the presence of AG competition against an ANDA generic.8

1. PRELIMINARY FINDINGS ON THE SHORT-TERM IMPACTS OF AUTHORIZED GENERICS I. Introduction This chapter presents the FTC‘s preliminary data analysis of the impact of AGs during the 180-day exclusivity period that may be granted to the first challenger of a patent covering a brand-name drug. Given the limited scope of our preliminary analysis, this chapter makes no attempt to reach any conclusions about the net impact of AGs on consumers or the economy. The FTC‘s preliminary data analysis shows the following: 



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



Retail prices are on average 4.2 percent lower, relative to the pre-generic brand price, when an independent generic competes with an AG during the 180-day exclusivity period than when an AG does not enter. Wholesale prices are on average 6.5 percent lower, relative to the pre-generic brand prices, when an AG competes with one independent generic during the exclusivity period than when an AG does not enter. Revenues of a generic company during the 180-day exclusivity period drop substantially with AG entry, with estimates of the average decline ranging from 47 percent to 51 percent. The revenue effect for generics is so much larger than the price effect for consumers primarily because the AG represents a very close substitute for the independent generic and therefore typically obtains significant market share at the expense of the independent generic. This is confirmed with an analysis of the quantities dispensed by retail pharmacies.

This preliminary analysis uses the same basic methodology as two prior studies of the impact of AGs during the 180-day exclusivity period, but applies that methodology to new data that accounts for a longer period of time and more drug products than the data used in the prior studies. In 2006, IMS Consulting conducted a study commissioned by the Pharmaceutical Research and Manufacturers of America (PhRMA) to measure the impact of authorized generics upon costs to the health care system through their influence on generic pricing.9 The study compared two sets of drugs for which generic entry occurred via 180-day exclusivity. The first group included nine drugs where an authorized generic drug competed against a single generic firm during the 180-day exclusivity period. The second group included nine drugs for which a generic drug company with 1 80-day exclusivity did not face AG competition. The study concluded that, relative to the price of the brand drug, wholesale

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generic prices were about 16 percent lower when the first generic faced competition from an authorized generic. A second study by Hollis and Liang10 addressed similar questions using similar analysis on the same set of drugs, but with retail prices instead of wholesale prices. For reasons that will be discussed later in this chapter, they consider the price of generic drugs relative to the price of the corresponding brand drug prior to generic entry. Hollis and Liang conclude that the average retail generic discount off the pre-entry brand price was 15 percent without an AG and 20 percent with an AG, which nets out to a 5 percent impact caused by AG entry.11 The full description of the new analysis presented in this chapter spells out in more detail the similarities and differences between our analysis and the analysis in these two previous studies. Among other things, our study included at least twice the number of drugs or more, depending on how multiple strengths or dosage forms of the same drug are counted, than were included in the prior studies. Also, the statistical properties of the average discounts were not discussed in either prior study, while we present standard errors for all calculated averages and perform statistical tests when comparisons are being made between averages. In addition, we test our results through cross checking (e.g., comparing results for both retail and wholesale prices) and provide multiple estimates (e.g., unweighted and weighted averages). We also analyze the impact of AGs on expenditures and quantities.

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II. Preliminary Empirical Results The preliminary findings reported here will focus exclusively on the impact of AG competition within FDA- granted 180-day exclusivity periods. We do not directly address the impact of the presence of authorized generics on the decisions of generic companies to initiate paragraph IV challenges, or to seek approval of an ANDA from the FDA. However, some light will be shed on the facts relevant to such decision making through an analysis of the impact of AG entry on generic drug manufacturer revenues (as a proxy for generic manufacturer profits) during the exclusivity period. We start with a description of the data before turning to our preliminary results.

A. Description of the Data Our empirical analysis combines information from several different data sources. A license for both the retail12 and wholesale13 sales information was purchased from IMS Health Services (IMS). This is the same source of data used by virtually all of the prior research looking at the impact of AGs, including the study sponsored by branded manufacturers (IMS Consulting) and the study sponsored by the generic manufacturers (Hollis and Liang). Although these data may not account for all factors relevant to particular questions, we know of no data set that captures all of the information we would like to include in this analysis. Where possible, the final study will use additional econometric techniques to account for factors that could not be directly addressed with the available data. Whether a drug faced a paragraph IV challenge and the dates of any 180-day exclusivity period arising from the challenge was determined from information from the Food and Drug Administration (FDA). Authorized generic drug information was based on information from the FDA and from press statements and was verified using data subpoenaed from the

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pharmaceutical firms. This information includes whether the brand issued an authorized generic version of the drug and the identity of the AG distributor. A detailed description of the data and how it was processed is provided in the appendix to this chapter. To summarize, we used monthly wholesale and retail prices and quantities for all non-injectable drugs for 2003 through 2008 and limited our sample to drugs that first faced generic competition within that period. Throughout this text, the term ―drug product‖ or ―drug‖ refers to a full specification of active ingredient(s), dosage form, and strength. We included a monthly observation for a drug only if in that month, a generic manufacturer with 180-day exclusivity was either the only generic in the market, or was joined in the market only by an AG. When the independent generic manufacturer was the only generic on the market, we refer to that as an ANDA-Only drug. The 51 drugs that are classified as ANDAOnly drugs in our sample are listed in Table A5 in the appendix. When the independent generic was joined in the market by only an AG, the drug is referred to as an ANDA+AG drug. The 53 drugs that are classified as ANDA+AG in our sample are listed in Table A6 in the appendix.

B. Empirical Analysis of Market Outcomes During Exclusivity Periods The Commission‘s preliminary analysis provides new evidence on two fundamental questions pertaining to the short-term impact of authorized generics. These questions are: 

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

Given the presence of a lone ANDA generic, what impact does AG entry have on retail and wholesale prices during the 180-day exclusivity period? What effect does AG entry have on the revenues of the generic and brand companies during the exclusivity period?

Although the full study will address additional market circumstances, this chapter shares the focus of the IMS and Hollis and Liang studies by concentrating on drugs for which one independent generic firm was granted 180-day exclusivity, and either was the lone generic on the market or was joined only by an authorized generic.14 As in previous studies, this analysis will focus on comparisons across groups of drugs, distinguished by whether an AG was marketed, to estimate the effect of AG entry. Because the decision whether to market an AG is a choice made by a branded drug manufacturer with a good understanding of the market for that drug, it is not appropriate to assume that drugs are randomly assigned to the group with an authorized generic (ANDA+AG) or the group without (ANDAOnly). For instance, consider a drug for which consumers are thought to be very reluctant to switch to a generic. In this situation, the branded company may choose not to issue an AG because it expects the AG to have low sales. Furthermore, an independent generic company trying to market a generic version of this drug may find it necessary to offer deeper than average discounts on this drug in order to entice consumers to switch to the generic. It would be errant to conclude that the lack of an AG caused the deep discount. This is just one example of how market conditions that may determine whether an AG is issued may also influence market outcomes in the generic market.15 Our final study will include econometric analysis that attempts to account for this problem by controlling for factors that are strong predictors of the likelihood of AG entry. For instance, we have found that when generic entry occurs via 180-day exclusivity, AGs are

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much more likely to enter markets with relatively large pre-generic entry brand sales than they are to enter smaller markets. The final study will contain econometric analysis that controls for the size of the pre-generic entry branded market. However, the prior literature generally did not control for factors such as this, so the analysis presented below serves primarily as an update to the results of these prior studies.

1. Price Discounts

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The price of a drug is calculated as the total dollars spent on that drug divided by some measure of the quantity of the drug purchased. We obtained from IMS measures of the total dollars in both the retail and wholesale data. For this study, absolute quantities were measured in terms of extended units of the drugs. An example of an extended unit is a 200mg tablet. To the extent that we have data on different sized bottles of 200mg tablets of a drug, we aggregated over the bottle sizes to state everything in terms of the 200mg tablets. The standard measure of price used throughout this chapter is the calculated monthly price for an extended unit of the drug (defined by active ingredient(s), strength, and dosage form16) divided by the average price of an extended unit of the branded version of that drug in the three months preceding generic entry. This is referred to as a relative price.17 Normalization is necessary to allow comparisons and aggregation across drug products that may have very different nominal prices. Since differences in the competition among generics, such as may be caused by AG entry, may prompt different pricing responses from the brand, normalization by contemporaneous brand prices could confuse the brand response with differences in generic pricing. Furthermore, we follow the recent related literature and report these relative prices in terms of the percentage discount off of the pre-entry brand price, which we generally refer to as the ―generic discount‖. 18

a. Retail Generic Discounts The most straightforward impact on consumers from AG entry is the effect that the additional competition has on the prices they pay for their prescriptions. Reported in Table 1A are the mean retail generic discounts and their standard errors (abbreviated SE), throughout the six months of exclusivity for drugs of all market sizes. Note that the average discounts off of pre-entry brand prices are higher for ANDA+AG drugs than for ANDA-Only drugs in every month of exclusivity, and this difference is highly statistically significant in all but the first month.19 Averaged across all months of exclusivity, consumers receive a 13.1 percent discount on a generic drug with exclusivity facing no AG competition. With AG competition, discounts average 17.2 percent off the pre-entry brand price. Taken together, these two discounts imply that consumers receive a 4.2 percent greater discount off of the pre-entry brand price for drugs where a generic manufacturer with lone exclusivity faces competition from an AG than when no AG enters. This difference is close to the 5 percent Hollis and Liang found using a similar methodology on retail discounts for a different set of drugs over a different period of time. Also note that this difference stays relatively constant throughout the exclusivity period. The decision of a branded company to launch an AG depends on market characteristics, some of which may also have an impact on pricing in those markets. Of the 95 drugs in our

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sample—which is limited to certain drugs for which generic entry occurred by 180-day exclusivity after 2003—authorized generics entered into 53 of them. However, the decision to enter with an AG differs substantially based on the pre-generic entry sales of the branded drug. The results below suggest that consumers tend to receive deeper discounts with AG entry into higher sales drugs. We derived this conclusion by splitting the sample of drugs into ―high sales‖ drugs and ―low sales‖ drugs, with the dividing line determined by whether the brand sales for the three months preceding generic entry were above or below the median of all drugs that first faced generic competition in our time window and for which at least one generic firm was granted exclusivity by the FDA. The median drug in the retail data had pre-entry brand annual sales of $130 million. Authorized generics entered for only 16 of the 49 low sales drugs (or 33 percent). Naturally, this implies that AG entry was much more common for products with high sales, where AG entry occurred for 37 out of 46 drugs in our sample (80 percent).20 Considering only low sales drugs, the average generic discounts over all months of exclusivity were 14.1 percent (0.7 percent) and 17.6 percent (0.8 percent) in ANDA-Only and ANDA+AG markets respectively, with standard errors reported in parentheses as will be the convention henceforth. This difference is statistically significant at any standard level. On the other hand, for high sales drugs, the generic discounts are 9.4 percent (1.3 percent) and 17.1 percent (0.5 percent) in ANDA-Only and ANDA+AG markets respectively, so AGs appear to have a larger impact on discounts in high sales markets. This difference is also statistically significant at all reasonable levels. Table 1-A. Average Retail Generic Discount: Unweighted Means

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Drug Group ANDA-Only ANDA+AG

Mean SE Mean SE

Difference One sided difference in means test, p-value

1 12.1% 2.1% 15.8% 1.4% -3.7% 6.6%

2 13.1% 1.5% 17.1% 0.8% -4.0% 1.1%

Month of Exclusivity 3 4 5 13.2% 13.5% 14.2% 1.4% 1.3% 1.4% 17.6% 17.9% 17.6% 0.8% 0.8% 0.9% -4.4% -4.4% -3.4% 0.5% 0.3% 2.5%

6 12.4% 1.4% 17.4% 1.1% -5.0% 0.3%

All 13.1% 0.7% 17.2% 0.4% -4.2% 0.0%

Table 1-B. Average Retail Generic Discount: Dollar Weighted Means Drug Group ANDA-Only ANDA+AG

Mean SE Mean SE

Difference One sided difference in means test, p-value

1 17.3% 1.4% 14.7% 1.4% 2.6% No test

2 14.9% 0.8% 15.4% 0.8% -0.5% 36.0%

Month of Exclusivity 3 4 5 15.0% 14.9% 14.9% 0.8% 0.8% 0.9% 15.9% 16.1% 16.1% 0.8% 0.8% 0.9% -0.8% -1.2% -1.2% 3 .0% 23.0% 24.0%

6 15.4% 1.1% 15.9% 1.1% -0.5% 41.0%

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All 15.2% 0.4% 15.8% 0.4% -0.6% 14.0%

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Another way to investigate the connection between the relative size of the markets and the impact of AG entry is to calculate the average discounts with more weight being put on high sales drugs. In Table 1-A, the average discounts were calculated by putting equal weight on each drug. One way to think of what this average represents is that it is the expected discount a consumer would receive for the generic drug if one were to randomly select one of the drugs from the list of drugs in our sample. In Table 1-B, each drug/month observation is weighted by the total dollar sales of the generics for that drug/month. One interpretation of these averages is that it is the discount received for a randomly selected dollar spent on the generic drugs in our sample. The differences reported in Table 1-B are typically around 1% or less, and are not statistically significant. This is consistent with Hollis and Liang‘s analysis of similarly weighted average retail prices. One point worth mentioning is that when weighting observations in this way, one drug, clopidogrel 75mg tablets, becomes very important in the ANDA-Only calculation, accounting for over 40 percent of the weight. The weighted-average ANDA-Only discount for the six months of exclusivity falls to 11.3 percent if this drug is dropped from the weighted average, which would bring the difference between ANDA-Only and ANDA+AG drugs back to roughly the same level as was reported for the unweighted average s.21 Although retail prices may reflect the most obvious measure of impact of AG entry on consumers, they have several limitations. First, retail prices may not accurately reflect all of the payments made by consumers for prescription drugs. For instance, individuals who receive prescription drug benefits as part of a health insurance plan also pay premiums, some of which should appropriately considered to be an expenditure on drugs. To the extent that insurance plans can receive lower pricing for prescription drugs, some of those savings may be passed on through lower premiums. Also, the source of our retail data, IMS Health‘s National Prescription Audit, only tracks sales at retail pharmacies.

b. Wholesale Price Discounts The wholesale level transactions in our data represent purchases of drugs by pharmacies from manufacturers and wholesalers. To the extent that savings recognized by pharmacies filter through the health care system, this supplies an alternate measure of the impact of AGs on prices. As noted in the appendix, the data do not account for various types of discounts, and would also not reflect changes in the insurance premiums of consumers. To the extent that both the retail and the wholesale data do not include all relevant discounts, our analysis based on these data may overstate or understate the level of discounting. For that reason, it is particularly beneficial to have the wholesale data as a second source of information about pharmaceutical pricing with which the impact of AGs can be studied. One benefit of the wholesale data is that it contains information about purchases by more outlets, such as nonretail pharmacies, hospitals, and HMOs, for instance, than were covered by the retail data. Reported in Table 1-C are the unweighted average wholesale generic discounts off of the pre-entry brand prices throughout the six months of exclusivity for drugs of all market sizes. As with the retail discounts, the average wholesale discount is higher in markets that experienced AG entry in each of the months, and the difference is statistically significant at any standard level for all but the first month of exclusivity. Averaged over all months, wholesale prices in ANDA+AG markets reflect a 6.5 percent deeper discount than in ANDAOnly markets. This difference is considerably smaller than what IMS Consulting found in

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their analysis of wholesale prices for a different set of drugs, over a different time period, using slightly different methodology. The final study will explore potential reasons for this divergence. The retail data revealed differences for discounts between high sales drugs and low sales drugs. Those differences are present, but less pronounced in the wholesale data, though the pvalue for one-sided difference in means test is less than one percent for each of the comparisons. Averaged across all exclusivity months in low sales drugs, the average relative wholesale discount in ANDA-Only markets is 23.3 percent (0.6 percent), compared to 29.3 percent (2.1 percent) in ANDA+AG markets. For high sales markets, ANDA-Only discounts average 19.5 percent (0.6 percent) while average ANDA+AG discounts are 28.6 percent (1.1 percent). Another distinction between the wholesale discounts and the retail discounts is that weighting observations by the dollar sales of the drugs caused the differences to diminish in the retail data. In the wholesale data, the weighted averages, reported in Table 1 -D, reveal differences between ANDA-Only and ANDA+AG drugs that are somewhat higher than with the unweighted averages. Again, clopidogrel gets in excess of 40 percent of the weight for the ANDA-Only drugs, but dropping it from the wholesale weighted average discount calculation has little impact on the weighted average. Table 1-C. Average Wholesale Generic Discount: Unweighted Averages Drug Group ANDA-Only

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ANDA+AG

Mean SE Mean SE

Difference One sided difference in means test, p-value

1 21.3% 1.3% 22.8% 2.7% -1.6% 30%

2 21.8% 1.0% 26.3% 2.2% -4.5% 3.6%

Month of Exclusivity 3 4 4 22.4% 22.4% 22.9% 1.1% 1.1% 1.1% 28.9% 30.5% 32.4% 2.3% 2.1% 2.3% -6.5% -8.2% -9.5% 0.7% 0.1% 0.0%

6 23.1% 1.1% 33.1% 2.9% -10% 0.1%

All 22.3% 0.5% 28.8% 1.0% -6.5% 0.0%

Table 1-D. Average Wholesale Generic Discount: Dollar Weighted Means Drug Group ANDA-Only ANDA+AG

Mean SE Mean SE

Difference One sided difference in means test, p-value

1 15.1% 0.7% 18.7% 2.6% -3.6% 9.6%

2 18.0% 0.8% 24.3% 2.0% -6.3% 0.2%

Month of Exclusivity 3 4 5 18.8% 18.2% 20.2% 0.6% 0.7% 0.7% 26.7% 28.7% 29.8% 2.0% 2.0% 2.0% -7.9% -11% -9.6% 0.0% 0.0% 0.0%

6 20.2% 0.7% 29.6% 2.4% -9.4% 0.0%

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All 18.3% 0.3% 26.4% 0.9% -8.1% 0.0%

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2. Wholesale Expenditures We now turn to an analysis of total wholesale expenditures on this same set of drugs. The primary reason for considering these expenditures is to approximate how the revenues of a first-filer generic manufacturer are affected by competition from an AG. Of course, it would be preferable to have an estimate of the impact on profits instead of revenues, and the full study will address the impact on profits, not just revenues. However, some simple math tells us that the percentage decrease in revenues in this case understates the percentage decrease in profits. 22 Our measure of wholesale expenditures is the total dollars reported in the IMS National Sales Perspective database. The intent of this analysis is to use wholesale level expenditures by pharmacies as a proxy for the revenues of manufacturers. Because the data represent pharmacy purchases from manufacturers and wholesalers, our proxy is imperfect to the extent that it includes wholesaler margins on the drugs that pass through wholesalers. Our results could be biased if the proportions of drugs going through wholesalers are systematically different between ANDA-Only and ANDA+AG drugs, but we have no reason to believe that is the case. Just as with prices, expenditures have been normalized by corresponding data from the branded product prior to generic entry. Relative expenditures are expressed in terms of a fraction of the pre-entry brand sales, where monthly expenditures are divided by the average monthly expenditures on the brand for the three months prior to generic entry, and are referred to as relative expenditures. Again, this normalization is employed to allow aggregation across drugs. Table 1 -E presents the relative expenditures on the ANDA generic drug for both types of markets for drugs of all sales levels. Except in the initial month, the differences are both economically large and statistically significant. Averaged over all months, monthly expenditures on the ANDA generic in ANDA-Only markets are approximately 61.1 percent of the monthly expenditures on the brand drug in the months preceding generic entry. By contrast, ANDA generic expenditures in ANDA+AG markets are only 32.7 percent of the pre-entry brand expenditures. The expenditures on the ANDA generic in ANDA+AG markets are 47 percent 23 lower than in ANDA-Only markets. Since this data is based on calendar months, and expenditures accumulate over the month, the expenditure numbers for the first month could be misleading if, for example, the generic drug entered the market on the last day of the month. This was not a problem for prices because prices are reported per extended unit. On the other hand, generic sales may take some time to ramp up when first introduced, so there may be reason to expect first month sales to be lower than in later months, even when the generic enters on the first day of the first month. This problem cannot be resolved with the data we have, so we will estimate this important difference in expenditures a second way, by dropping the first month from the average. The average relative wholesale expenditures change to 65.6 percent and 32.1 percent for ANDA-Only and ANDA+AG markets, respectively, if the average is taken over months 2 through 6. That is, over the last five months of the exclusivity period, average relative wholesale expenditures on the ANDA generic drop by 51 percent when there is AG competition.

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Federal Trade Commission Report Table 1-E. Average Relative Wholesale Expenditures on the ANDA Generic Drug Group

ANDA-Only ANDA+AG

Mean SE Mean SE

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Difference One sided difference in means test, p-value

1 42.4% 4.9% 35.6% 3.5% 6.8% 24.0%

2 71.1% 10.7% 35.0% 3.0% 36.1% 0.0%

Month of Exclusivity 3 4 5 59.7% 62.8% 69.5% 6.6% 3.9% 6.0% 28.7% 32.3% 30.4% 1.7% 1.7% 2.1% 31.1% 30.6% 39.1% 0.0% 0.0% 0.0%

6 65.0% 4.8% 34.4% 2.6% 30.7% 0.0%

All 61.1% 2.7% 32.7% 1.0% 28.4% 0.0%

This difference may be easier to understand in the context of an example. The annualized pre-generic entry brand expenditures of the median drug in our wholesale sample were roughly $170 million, or $85 million for six months. The averages above imply that expenditures on an ANDA generic that obtains an exclusivity period for that drug would be 61.1 percent of that total over the exclusivity period if the independent manufacturer faced no AG competition; thus expenditures on the ANDA would be roughly $51.9 million. If an AG entered that market, the expenditures on the ANDA would fall to $27.8 million (32.7 percent of $85 million) assuming all else remains the same about the market for this drug. Therefore, expenditures on the ANDA generic entrant into the median sized market would be roughly $24.1 million dollars less in the ANDA+AG market.24 If the average expenditure estimates that excluded the first month are used, the difference in expenditures on this median drug becomes $28.5 million. The analysis of prices for high sales and low sales drugs indicated that AG entry tends to have more of an impact on generic prices of high sales drugs than low sales drugs. The same is not true of expenditures. For high sales drugs, relative expenditures on the ANDA fall from 49.7 percent (2.0 percent) in ANDA-Only markets to 31.4 percent (1.1 percent) in ANDA+AG markets, or a 32 percent decrease. In low sales markets, relative expenditures on the ANDA decrease more substantially, from 65.3 percent (3.6 percent) to 36.3 percent (2.5 percent) between ANDA-Only and ANDA+AG markets, for a 43 percent decrease. This relative wholesale expenditure data can also shed some light on how the brand manufacturer fares in ANDA+AG markets relative to ANDA-Only markets.25 Table 1-F reports relative expenditures on the brand drug during ANDA-Only exclusivity periods, and both brand and AG expenditures during ANDA+AG exclusivity periods. Notice that the brand expenditures drop more rapidly and to lower levels in the presence of an AG.26 It is difficult to determine whether this is caused by the AG or is due to other differences in these markets. We will revisit this question in the next section that looks at the impact of AG entry on quantities sold. In the ANDA+AG markets, the brand expenditures decrease so substantially that in months three through six, expenditures on the AG exceed brand expenditures. It is also worth noting that in each month of exclusivity, the brand plus the AG expenditures for the ANDA+AG drugs exceed the brand expenditures for the ANDA-Only drugs. If an AG is marketed by a subsidiary of the brand company, this evidence would suggest that the parent company makes higher revenues in the ANDA+AG markets than in the ANDA-Only markets during the exclusivity period.

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Authorized Generics: An Interim Report Table 1-F. Average Wholesale Relative Expenditures on Brand and AG Drug Group ANDA-Only ANDA+AG

Brand-Mean Brand-SE Brand-Mean Brand-SE AG-Mean AG-SE

1 87.5% 3.7% 79.7% 3.5% 17.7% 2.1%

2 50.3% 3.2% 34.4% 2.0% 24.9% 2.0%

Month of Exclusivity 3 4 5 39.8% 34.9% 30.4% 2.5% 2.7% 2.2% 23.8% 23.7% 18.3% 1.0% 1.4% 1.1% 23.9% 24.6% 24.6% 2.0% 1.8% 1.8%

6 30.0% 3.2% 16.7% 1.4% 25.9% 2.6%

All 47.1% 1.8% 33.0% 1.5% 23.6% 0.8%

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3. Retail Quantities Another way to see the impact of authorized generics is to consider the quantities sold by various types of manufacturers with and without AG entry. Because wholesale quantities following generic entry can reflect the filling of the supply chain with the generic, the focus here is on quantities dispensed by pharmacies using our retail data. In order to aggregate across a wide variety of drugs, quantities need to be normalized. The normalization used here is the same as was used for prices and expenditures, dividing current quantity of extended units dispensed by the pre-entry brand quantity. This normalization allows meaningful aggregation across drugs, reveals whether the drugs were dispensed more or less than they were prior to generic entry, and gives an accurate measure of the relative market presence of the various types of drugs. Table 1 -G reports the relative quantities for the brand and the ANDA generic for ANDA-Only drugs across the six months of exclusivity. The first thing to note is that the brand relative quantities fall very quickly, with the brand losing more than half its sales by the third month, and over 70 percent by the end of exclusivity. Also note that the sum of brand and ANDA relative quantities is slightly less than 100 percent in all but the sixth month, meaning that these drugs tended to be dispensed somewhat less frequently after generic entry, though typically only by a couple of percentage points. Table 1-G. Average Relative Retail Quantities Dispensed: ANDA-Only Manufacturer Type Brand ANDA

Mean SE Mean SE

1 82.1% 2.9% 13.9% 2.0%

2 50.6% 3.1% 45.5% 4.0%

Month of Exclusivity 3 4 5 38.7% 34.4% 29.8% 2.5% 2.1% 1.9% 57.3% 62.9% 67.7% 3.8% 3.7% 3.6%

6 28.8% 1.7% 75.9% 4.8%

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All 46.1% 1.6% 51.5% 2.0%

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Federal Trade Commission Report Table 1-H. Average Relative Retail Quantities Dispensed: ANDA+AG

Manufacturer Type Brand AG

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ANDA

Mean SE Mean SE Mean SE

1 80.6% 2.8% 7.2% 1.1% 12.8% 1.9%

2 32.8% 1.4% 26.7% 1.7% 43.2% 1.7%

Month of Exclusivity 3 4 5 23.8% 21.3% 17.7% 1.2% 1.2% 1.2% 30.1% 33.1% 36.1% 1.9% 2.3% 2.4% 47.4% 49.3% 50.4% 1.8% 2.1% 2.2%

6 16.3% 1.4% 37.5% 3.2% 55.7% 3.0%

All 32.4% 1.5% 28.1% 1.0% 42.8% 1.2%

Relative quantities for ANDA+AG drugs appear in Table 1-H. Just as with ANDA-Only drugs, the brand quantities drop off quickly. In fact, the decrease is quicker and more pronounced for ANDA+AG drugs. One possible explanation for this is that the added generic competition causes more severe erosion of brand sales. Another explanation is that branded companies recognize that the brand will lose relatively more sales for particular drugs, and they decide to try to regain some of those losses by issuing an AG. Nothing in these tables can distinguish between these two explanations. More sophisticated analysis in the final study will attempt to better control for the factors that make launching an AG attractive to shed more light on this question.27 Though this does not help distinguish between these explanations, it is interesting to note that the combined quantities of the Brand and the AG in Table 1-H exceed the Brand quantities in Table 1 -G in each corresponding month. Also note that the average AG relative quantity is greater than 25 percent in all but the first month, but is always substantially lower than the relative quantity of the ANDA generic. Finally note that the ANDA generic‘s share drops from 51.5 percent for ANDA-Only drugs to 42.8 percent for ANDA+AG drugs, which is a 17 percent reduction in quantity. This illustrates the point discussed earlier that an important reason the independent generic makes less revenue when facing AG competition is that it loses sales to the AG.

CONCLUSION The launch of an AG can have impacts that extend beyond the brand and generic companies to consumers and other firms. Consistent with the prior research, our initial analysis suggests that consumers benefit and that the healthcare system saves money during the 180-day exclusivity period when an AG enters the market, due to the greater discounting that accompanies the added competition provided by the AG. These results also indicate that AG entry significantly decreases the revenues of a first-filer generic company that obtains 180-day exclusivity. The impact of AG entry likely changes the calculus of business decisionmaking for both the generic and brand firms. These impacts will be explored further in the final report.

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2. THE USE OF AUTHORIZED GENERICS IN PATENT SETTLEMENT AGREEMENTS As reported in the prior section, AG competition typically reduces a first-filer generic‘s revenues during the 180 days of marketing exclusivity by approximately 50 percent. To prevent this loss of revenue, a generic may be willing to delay its entry in return for a brand‘s agreement not to launch an authorized generic – that is, a brand‘s agreement not to compete with the generic through an AG – during the generic‘s 180 days of marketing exclusivity. Such agreements can harm consumers in two ways: 





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

First, generic entry, and the accompanying discounts, would not be available to consumers as soon as otherwise would be the case. Because generic drugs often are priced substantially below the price of branded drugs, 28 overall prescription drug costs could be significantly increased by just a few additional months of branded prices in a large market. Second, consumers would lose the benefit of price discounts from AG competition during the 180-day marketing exclusivity. The consumer harm in such instances arises because the brand has agreed not to compete against the independent generic during the exclusivity period. The consumer harm arises from the absence of AG competition against an independent generic, not from the presence of AG competition against an independent generic.29 Between FY2004–FY2008, about one-quarter (38 out of 152) of the final patent settlements reviewed by the FTC under the MMA contained provisions relating to AGs. Between FY2004–FY2008, 76 final patent settlement agreements were with firstfiler generics. About one-quarter (20 out of 76) of those patent settlements involved (1) an explicit agreement by the brand not to launch an AG to compete against the first filer, combined with (2) an agreement by the first-filer generic to delay its entry past the settlement date by, on average, 34.7 months. Branded sales of the affected products ranged from $12.6 million to $5.3 billion, with an average market size of $917 million and a median market size of $514 million. Five of the settlements covered products with annual sales of $1 billion, $1.1 billion, $2.1 billion, $2.5 billion, and $5.3 billion.

I. The Problem of Anticompetitive Brand-Generic Patent Settlement Agreements Patent litigation between a brand and a generic typically occurs when a generic seeks entry prior to expiration of the patents on a corresponding branded drug by alleging that such patents are invalid or not infringed by the generic‘s drug product. That litigation often is settled rather than litigated to conclusion. Such settlements do not necessarily implicate antitrust law. For example, if the brand and generic settle the litigation simply by agreeing on a time for generic entry that is prior to patent expiration but later than immediate entry, such a settlement most likely reflects the parties‘ views on the likelihood of success of their

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respective patent challenges and patent defenses, as well as their respective tolerances for risk. These types of simple settlements, with no other provisions, do not generally raise competition concerns. Other settlements in this context can raise serious competition concerns, however, because they appear to involve compensation from the brand to the generic to delay generic entry beyond the time of a simple compromise date along the lines described above (hereinafter, the ―simple compromise date‖). The FTC has challenged a number of these settlements as anticompetitive. Such settlements, known as ―exclusion payment‖ or ―pay for delay‖ settlements30, thwart the goal of the Hatch-Waxman Act to encourage generic companies to challenge questionable patents and promptly ―make available more low cost generic drugs,‖ while protecting legitimate patent claims covering innovator drugs.31 Settlements potentially raising ―exclusion payment‖ issues are now common.32 Congress is now considering a variety of legislative proposals regarding ―pay for delay‖ settlements, and the Commission supports restricting such settlements. Most recently, some brand-generic patent settlement agreements filed under the MMA appear to use provisions relating to authorized generics – instead of monetary payments – as a means to compensate a generic in return for a generic‘s agreement to delay its entry beyond the simple compromise date. Moreover, material produced in connection with the FTC‘s Section 6(b) study of authorized generics confirms that a brand-name company may agree to refrain from offering a competing AG to maximize the net present value of both the brand and generic products. In one case, documents from the brand showed how an agreement not to compete with an AG increased both the brand-name and generic companies‘ revenues. This was true because of (1) the overall drop in brand revenues that would occur at generic entry, and (2) the generic‘s drop in revenues due to AG competition from the brand.33 Indeed, the branded firm projected that if it launched an AG to compete with the first-filer generic during its 180 days of marketing exclusivity, the net present value of the generic‘s product would decline by nearly a third. If, however, the brand agreed not to offer an authorized generic, and the generic agreed to further delay its entry in exchange for that agreement, the combined net present value of both companies‘ products would be maximized, according to the brand company‘s documents.34 The combination of documents such as this, along with increased numbers of MMA filings including provisions relating to AGs, prompted staff to examine the role of AGs in Hatch-Waxman settlements. 35

II. The Possible Use of AGs to Compensate Generics for Deferring Generic Entry To examine the role of AGs in Hatch-Waxman settlements, staff categorized the final patent settlement agreements that the FTC has received under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (―MMA‖) for fiscal years 2004 through 2008, along with one additional agreement received outside the MMA framework.36 During that period, there were 38 final patent settlement agreements with provisions involving AGs.37

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Figure 1. Overall Breakdown of Final Patent Settlement Agreements Involving Provisions on Authorized Generics: Fiscal Years 2004-2008.

A. Agreements Involving AGs Thirty-eight final patent settlement agreements from FY2004-FY2008 contained provisions that involved AGs. These agreements fall into four basic categories:

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Federal Trade Commission Report (1) As to the product whose patents are being litigated by the brand and the generic, the brand expressly agrees not to use an AG to compete against the first-filer generic for a period of time (20 agreements); (2) As to the litigated product, either (a) there is no explicit promise not to compete, but the agreement incentivizes the brand not to use an AG to compete against the firstfiler (6 agreements), or (b) the brand explicitly agrees not to engage in AG competition, but the generic is not eligible for the 180-day exclusivity period (4 agreements); (3) As to the litigated product, the brand appoints a subsequent-filer generic as the brand‘s AG to compete with the first filer (2 agreements); or (4) As to a different product that is not the subject of litigation between the brand and the generic, the brand appoints the generic as the brand‘s AG (6 agreements). Figure 1 breaks down these agreements by type of AG provision.

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A. Type (1) Agreements: Explicit Commitments Not to Compete with an AG. Twenty settlement agreements with a first-filer involved an explicit commitment by the brand not to use an AG to compete with the first-filer for all (or at least a portion) of the first filer‘s 180 days of marketing exclusivity.38 Brands explicitly agreed not to compete with an authorized generic only in patent settlements involving a first filer. A first filer is defined as a generic entitled to the 180 days of marketing exclusivity at the time of the settlement agreement.39 Agreements with first-filers are particularly attractive because the first-filer may control generic entry.40 As noted above, Type (1) agreements may be based on a promise by the generic to delay entry, which increases the period of time that consumers are deprived of the benefits of brand-generic competition. In addition, such agreements also deprive consumers of AG-ANDA competition whenever generic competition does begin for the litigated product. These twenty settlements involving explicit brand promises not to compete with an AG were not evenly distributed over the five-year period. The number increased from zero in FY 2004 to nine in FY 2007. In FY 2008 there were five such agreements. Figure 2 presents the data for each fiscal year. The detailed terms of settlements involving a restriction on the first-filer‘s ability to market its product and an explicit promise by the brand not to launch or sponsor an authorized generic varied. 

Slightly more than half – 11 out of 20 – allowed the generic to offer its own product without facing competition from the brand‘s AG for some period of time. In the other nine cases, either the brand agreed exclusively to supply the generic with the brand‘s AG, or the generic could choose whether to market its own product or the brand‘s AG. In either case, the result would be no competition between an AG and the firstfiler‘s generic product for a certain period of time.  The length of time during which the brand agreed not to launch or sponsor an AG ranged from 10 days to 45.5 months. The average length of the restriction on the brand‘s ability to offer a competing AG was 13.5 months, and the median was six months.

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

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

33

Branded sales of the affected products ranged from $12.6 million to $5.3 billion, with an average market size of $917 million and a median market size of $514 million.41 Settlements between FY 2004 and FY 2008 included settlements covering products with annual sales of $1 billion, $1.1 billion, $2.1 billion, $2.5 billion, and $5.3 billion. For these particular agreements, agreements not to offer a competing AG generally governed products with relatively low sales. In larger markets, the restriction on AG competition rarely lasted more than six months. Figure 3 plots the duration of agreements not to offer competing AGs against sales levels. The length of time between the settlement and the date when generic entry was allowed to commence ranged from 1.75 months to 101 months. For six products, the time from settlement to allowable entry was more than four years.42 Under the terms of eight agreements, generic entry was prohibited for at least three years. The average interval from settlement to allowable generic entry was 34.7 months, and the median was 30.1 months.

Four of the Type (1) agreements filed under the MMA provided for AG competition, and consumer discounts, on a different product, however. In these agreements, although the brand agreed not to compete with an AG against the first filer‘s generic product, the brand appointed that generic firm as the brand‘s AG to compete against a different generic product. Such agreements typically offer the generic a certain percentage of the revenues from sales of the brand‘s AG in the other product market, and they can provide consumer discounts through AG competition on the other product, assuming the royalties or supply price to the generic is not too high. At the same time, such an agreement also can provide additional value to persuade a generic to delay its entry on the litigated product. For example, in one situation, a brand allowed the generic to launch the brand‘s AG for the product strength for which the generic was not the first-filer, in addition to agreeing that the brand would not compete with an AG for the product strengths for which the generic was the first filer. This agreement ensured that the generic would have sole 180-day exclusivity on the strengths for which it was the firstfiler, and that it could compete with the company that was the first-filer on the third strength during that first filer‘s 180- day exclusivity. Thus, the settling generic would have a full line of strengths at generic entry, giving it an advantage over the first-filer on the third strength.

A. Type (2) Agreements: Other Promises by Brand Not to Compete with AG on Litigated Product Type (2) agreements are difficult to categorize. In six of these agreements, there was no explicit promise by the brand not to compete with an AG. Instead, each of the agreements included provisions under which either royalties due to the brand dropped significantly if the generic faced competition within a specified period of time or some other provision discouraged the brand from offering a competing AG. These agreements actually may operate as promises by the brand not to launch or sponsor an authorized generic for a period of time, but their effect is difficult to judge.

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Four of the Type (2) agreements involved an explicit promise from the brand not to compete with an AG, but the generic did not have the right to 180-day marketing exclusivity. In one of these cases, the first-filer waived its exclusivity rights to allow another generic, with which the first-filer had a contractual relationship, to market the product at issue in the litigation. The settlement agreement restricted the brand‘s ability to launch an AG for that product and indicated that the parties expected that the generic that was to market the product would be the only generic in the marketplace for at least the 180-day period. In a second case, the generic had been deemed by the FDA to have forfeited its exclusivity. Under the settlement, the brand granted the generic an exclusive license to market the generic‘s product as of a specified date. In a third case, the generic had entered ―at-risk,‖ thus triggering the exclusivity period. The settlement, which occurred after the triggering of the exclusivity period, involved the generic‘s promise to exit the market for a period of time. Upon re-entry by the generic, the brand agreed to exclusively supply the generic with product. The last agreement involved an explicit promise by the brand not to compete with an AG for the life of the patent, but the generic was not eligible for the 180-day exclusivity period.

C Type (3) Agreements: Brand Appoints Subsequent Filer as AG on Litigated Product Settlements with subsequent filers involving AG provisions raise complex issues. In one of the two Type (3) agreements filed under the MMA, the brand agreed to supply the subsequent filer with product to market as an AG and continued litigating with the first-filer. The other agreement would allow the subsequent filer to market the brand‘s AG for the litigated product during the first filer‘s exclusivity, but only if the first filer did not settle its litigation. Otherwise, the subsequent filer could market the brand‘s AG 181 days after the first filer‘s launch. Such agreements have the potential to reduce prices to consumers through AG competition during the 180-day exclusivity period. At the same time, they might affect

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generic entry by eliminating a patent challenge that could have precipitated generic competition. For example, a subsequent filer may obtain a court decision of patent invalidity that would allow the first filer to market its product,43 or a subsequent filer could obtain a court decision of invalidity or non- infringement that would trigger the first-filer‘s exclusivity period or its forfeiture.44 The Federal Circuit has recognized that brand name companies may seek to settle with subsequent filers, because branded firms ―have a strong incentive to avoid litigation that would trigger the first Paragraph IV ANDA filer‘s exclusivity period and allow the FDA to approve subsequent . . . ANDAs 181 days‖ thereafter.45

D Type (4): Brand Appoints Generic as AG on Another Product In six agreements, the brand appointed the generic as the brand‘s AG for another product. Type (4) agreements can provide AG competition, and consumer discounts, during an 180day marketing exclusivity period for a different drug – not the drug whose patents are being litigated by the brand and generic. Consumer discounts on the second drug may result from the first-filer generic‘s agreement to delay its entry on the litigated product.

III. More Complex Possible Strategies to Forestall Generic Entry through Agreements Involving Authorized Generics

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Some of the patent settlement agreements reviewed by staff, and discussed in Section II above, revealed more complex strategies used in agreements involving AGs; these strategies depend on the presence of certain factors. Two types of these more complex strategies are discussed below.

A. Multiple Dosage Forms/Products and Exclusive Agreements Relating to AGs Several recent settlement agreements reflect terms regarding two products (including, for these purposes, two dosage forms) involving an agreement not to compete with an AG for one product and an agreement exclusively to supply an AG for the other product. The essence of these arrangements is that the generic company is permitted to market an AG or ANDAgeneric for one product soon after settlement, but entry is deferred for the other product, which usually has much higher sales.46 Such a package of commitments could induce the generic to defer entry on the high-sales product by promptly providing it with revenues on the low-sales product, and shielding it from a competing AG with respect to one or both of the products. B. Strategic Information Disclosures Another category of settlements between brand-name companies and subsequent filers could operate to induce the first-filer to delay entry. In these agreements, the subsequent filer‘s ability to market an AG during the first-filer‘s 180-day exclusivity depends on whether the first filer does or does not take certain actions. By ensuring that those terms, normally kept confidential, become known by the first-filer, the branded firm may induce the first-filer to delay entry to avoid triggering the subsequent filer‘s right to enter as an AG during the first filer‘s 180 days of marketing exclusivity.

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For example, one agreement provided that if the first-filer launched its ANDA-generic product without entering a settlement with the brand, the subsequent filer would be allowed to market the AG during the first-filer‘s 180-day exclusivity.47 However, if the first-filer settled with the brand and launched its ANDA-generic pursuant to a license under the brand‘s patents, the subsequent filer could not market the AG until 181 days after the first-filer‘s launch. The brand and the first-filer subsequently entered a settlement that deferred ANDAgeneric entry for about three years and confirmed that the first-filer would not face a competing AG during its 180-day exclusivity.48 Another agreement allowed a subsequent filer to market the AG during the first-filer‘s 180- day exclusivity if the first-filer launched its ANDA-generic product ―at risk,‖ after a district court determination that the challenged patents were invalid, unenforceable, or not infringed. However, if the first-filer deferred entry until after a decision by a court of appeals, the agreement provided for launch of the AG six months after the first-filer‘s launch, i.e., after its 180-day exclusivity.49 Making the relevant terms of this agreement known to the first-filer could deter it from launching ―at risk‖ after a district court win. Firms can make the terms of agreements with subsequent filers known to the first filer through a variety of means – by publicly announcing the relevant terms of the agreement; by using the agreement as a tool in settlement negotiations with the first-filer; or even by making the agreement available in a public forum. Indeed, one of the described agreements was made publicly available in the branded firm‘s 8-K filing with the Securities and Exchange Commission.50 If interpreted as an offer not to compete, an inappropriate disclosure could raise competition concerns.51

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CONCLUSION Review of recent brand-generic settlements reveals that agreements not to compete with authorized generics have a significant potential for use as exclusion payments in patent settlement agreements. Any restrictions on pay-for-delay agreements should account for all viable forms of brand-generic payments to delay entry, including an agreement not to compete with an AG. http://www.ftc.gov/os/caselist/0510008/060314ana0510008.pdf.

APPENDIX : DESCRIPTION OF DATA Our data was acquired from several sources. The retail and wholesale price, expenditure, and quantity data were licensed from IMS Health, Inc. Authorized generic drugs and their distributors were identified based on information produced by pharmaceutical companies pursuant to the Commission‘s information requests (―Special Orders‖), press releases, and information provided by the FDA.52

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1. IMS Health Inc The Federal Trade Commission (FTC) purchased a license for information representing nationally aggregated, monthly sales information for each non-injectable prescription medication distributed in the United States over the period 1/2003-12/2008 from IMS Health. This information included: (1) the National Sales Perspective (NSP) Survey which represents wholesale level quantity and dollar sales53 information for drugs purchased by retail and nonretail pharmacies; and (2) the National Prescription Audit (NPA) Survey which represents retail quantity and dollar sales54 information for prescriptions dispensed primarily at retail pharmacies. All sales information in both sets of data is reported in aggregate form within channels, and for the analysis presented here, the data have been aggregated across channels. In addition to monthly sales information, both surveys provided detailed information about each drug. This information included the National Drug Code (NDC), strength, dosage form, manufacturer and name of the active ingredient(s) in a single dose. Taken together, this information gave us data on each drug at the 11-digit NDC level of specificity, broken down by channel. We used this information to define a single observation in the analysis as an active ingredient(s)-dosage form-strength-manufacturer combination.55 IMS also provided the date the drug was first recorded as having sales (dates as early as 1950 are reported), the therapeutic class of the drug, whether the medication was sold over-the-counter or as a prescription, and whether the manufacturer of the drug is a generic or a brand manufacturer.56 Our sample is limited to tablet and capsule dosage forms of prescription drugs. It excludes all products that are not oral solids, including syrups, ointments, liquids of any kind, over-the counter medications, vitamins and decongestants. We exclude anything that is not an oral solid because extended quantity units are difficult to compare across medications of different forms. We also excluded over-the-counter medications and vitamins because they were often sold in different venues than is collected by IMS. We excluded decongestants because the set of active ingredients included in decongestant combinations was very large, and often changes over time.57 Finally, we excluded all drugs that did not first face generic competition during the period 4/2003 - 11/2008.58 Drugs were defined as facing generic competition during the period if the earliest producer of the drug was a brand manufacturer as identified by IMS, and the drug was observed with positive sales of a second manufacturer who IMS indicated did not have positive sales prior to 4/2003. We used the manufacturer and brand status information provided by IMS to classify each drug into one of two types: brand and generic. Company and FDA information was used to further classify the generic drugs as either independent generics or authorized generics. The date of generic entry was defined as the first date in which a manufacturer other than the brand was first observed with positive sales.59 The number of generic manufacturers producing each drug was also constructed from the IMS data using information about the manufacturer identified therein. The number of manufacturers producing a product was defined as the count of manufacturers observed with positive sales during the month and includes the authorized generic marketer. Our IMS data does not differentiate between true pharmaceutical manufacturers and repackagers. Repackagers purchase supply from true manufacturers, and typically sell them in some alternate form of packaging, such as blister packs.60 Our manufacturer count excluded firms that we determined were highly likely to be repackagers.61 The indicator of whether the

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molecule faces an authorized generic competitor was defined by whether the authorized generic manufacturer has positive sales during the month. The sample was then further refined to include monthly observations for a drug only if a generic manufacturer with FDA-granted exclusivity was either (i) the sole generic marketed that month or (ii) faced generic competition only from an AG. When the independent generic manufacturer was the only generic on the market, we refer to that as an ANDA-Only drug. The 51 drugs that are classified as ANDA-Only drugs in our sample are listed in Table A5. When the independent generic was joined in the market by an AG, the drug will be referred to as an ANDA+AG drug. The 53 drugs that are classified as ANDA+AG in our sample are listed in Table A6. Nine drugs62 show up in both lists, so there are a total of 95 unique drugs in our sample.63 A drug can show up in both lists when, for instance, the authorized generic enters several months after the independent generic. In that situation, the drug would be ANDA-Only for the first several months, then switch to ANDA+AG when the authorized generic enters.

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2. FDA and Company Data Sales information from IMS was supplemented with data collected from the FDA and the drug manufacturers. These sources were used to identify whether a firm issued an authorized generic and the name of the authorized generic marketer when applicable. Details about relevant Hatch-Waxman related legal actions associated with each drug, including whether the drug faced a paragraph IV challenge and the end date of exclusivity periods associated with paragraph IV challenges, were collected from the FDA. We identified AGs from information produced by pharmaceutical companies pursuant to the Special Orders and from information provided by the FDA. The Special Orders requested the proprietary/trade name of the AG, the proprietary name of the brand-name drug for which the NDA authorizes the marketing of the AG, the active ingredient, the dosage form, the NDA number of the brand-name drug that authorizes the marketing of the AG, and the strength of the authorized generic. This information was collected from both the generic and brand manufacturers. In addition, we requested that the brand manufacturers provide the name of the entity associated with each NDC labeler code so that we could identify the distributor of the authorized generic. The most relevant Hatch-Waxman related information was whether the drug faced a paragraph IV patent challenge, and whether a generic manufacturer was granted exclusivity related to a paragraph IV challenge. The FDA provides a list of drugs facing paragraph IV challenges on its website.64 For all drugs associated with a 180-day exclusivity period, we identified the date that generic exclusivity ended for the drug. These dates were determined from information provided by the FDA. We defined a month to be a part of the exclusivity period if the 28th of the month occurred prior to the exclusivity end date. 65

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Table A1. Dosage-Form Mapping Three-Lettered Code (as provided by IMS) ABA Tablets Uncoat Regular Ordinary ACA Tablets Coated Regular Ordinary AAA Capsules Regular Ordinary AAE Capsules Regular Soluble AAF Capsules Regular Sprinkle ABC Tablets Uncoat Regular Chewable ACC Tablets Coat Regular Chewable ABD Tablets Uncoat Reg Buccal/Sub-Lingual BBD Tab Uncoat Long Acting Buccal/Sub-Lingual AGD Lozenge Reg Buccal/Sub-Lingual ABE Tablets Uncoat Regular Sol ABZ Tablets Uncoat Regular Oth ACZ Tab Coated Regular Othr BAA Capsules Long Acting Ordinary BAZ Capsules Long Acting Other AAZ Capsules Regular Other BBA Tablets Uncoat Long Acting Ordinary BBE Tablets Uncoat Long Acting Sol BBZ Tablets Uncoat Long Acting Other BCA Tablets Coated Long Acting Ordinary BCZ Tablets Coated Long Acting Other AGA Lozenge Regular Ordinary RB Mouth Throat Lozenges BGA Lozenge Long Acting Ordinary BDA Granulate Long Acting Ordinary Doseform=Tablet/Capsule

Analysis Dosage Form Tablet Tablet Capsule Capsule Capsule Chewable Chewable Buccal/Sublingual Buccal/Sublingual Buccal/Sublingual Orally Disintegrating/Ecteric Coated Orally Disintegrating/Ecteric Coated Orally Disintegrating/Ecteric Coated Extended-Release Capsule Extended-Release Capsule Extended-Release Capsule Extended-Release Tablet Extended-Release Tablet Extended-Release Tablet Extended-Release Tablet Extended-Release Tablet Lozenge Lozenge Extended-Release Lozenge Extended-Release Granule Other

Table A2. USC5 Therapeutic Categories Eliminated as Decongestants. 14310 Anti-histamine/Decongestant 14330 Anti-histamine/Decongestant/Analgesic 14390 Comb W/O Expectorant,Other 14510 Expectorant/Decongestant 14560 Expectorant/Decongestant/Analgesic 34380 Narcotic Cough/Expectorant 34510 Non-Narcotic Cough/Decongestant 34520 Non-Narcotic Cough/Anti-histamine 34540 Non-Narcotic Cough/Decongestant/Anti-histamine 34560 Non-Narcotic Cough/Anti-histamine/Analgesic 34570 Non-Narcotic Cough/Decongestant/Anti-histamine/Anal 34590 Non-Narcotic Cough Comb W/O Expectorant,Other 34610 Non-Narcotic Cough/Decongestant/Expectorant 34650 Non-Narcotic Cough/Decongestant/Analgesic/Expectorant 34680 Non-Narcotic Cough/Expectorant

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Table A3. USC5 Therapeutic Categories Eliminated as Vitamins 11420 Vitamin K & Related,Oral 32200 Lipotropics 37340 Emollients & Protectives 43100 Enzymes,Local/Topical 48111 Ferrous,Iron Alone 48112 Ferrous,Iron Combination 48120 Liver 48130 Vitamin B12 48190 Hematinics,Other 60500 Calcium Supplements 60600 Complete Food Supplement 60700 Nutrients & Supplements 73000 Tonics 76110 Multivitamin Prenatal 76121 Multivitamin-Pediatric Chewable W/Fluoride 76122 Multivitamin-Pediatric Drops W/Fluoride 76123 Multivitamin-Pediatric Liquid W/Fluoride 76131 Multivitamin-Pediatric Chew without Fluoride 76132 Multivitamin-Pediatric Drops without Fluoride 76133 Multivitamin-Pediatric Liq without Fluoride 76140 Multivitamin General 76212 B-Complex,Plain,Oral 76222 B-Complex,W/C,Oral 76230 B-Complex,Other Combination 76310 Ascorbic Acid 76320 Vitamin A 76330 Vitamin A & D 76340 Vitamin D 76350 Niacin 76380 Vitamin E 76390 Vitamins,Other 84210 Natural Medicine Other,Herbals 84220 Natural Medicine Other,Nutritn 84230 Natural Medicine Other,Topical

Table A4. Firms Counted as Repackagers Allscripts Pharm American Hlth Pkg DHS Incorporated Dispensexpress Drx Innoviant Pharmacy

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Authorized Generics: An Interim Report Table A4. (Continued) Keltman Pharmaceutical Major Pharm Nucare Pharmaceutical PD-RX Pharmaceutical Pharma Pac Pharmpak Phys Total Care Physician Partner Physician Therapeutics Quality Care Pharmaceutical Repackager Southwood Pharm Unit Dose Labs (UDL)

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Table A5. ANDA-Only Drugs Alendronate 5mg, 10mg, and 40mg Tablets Amlodipine/Benazepril 2.5-10mg, 5-10mg, 5-20mg, and 10-20mg Capsules Ciprofloxacin 100mg Tablets Clopidogrel 75mg Tablets Colestipol 1000mg Tablets Desmopressin 0.1mg, 0.2mg Tablets Dexmethylphenidate 2.5mg, 5mg, and 10mg Tablets Didanosine 200mg, 250mg, and 400mg Extended-Release Capsules Eplerenone 25mg and 50mg Tablets Famciclovir 125mg, 250mg, and 500mg Tablets Fenofibrate 54mg and 160mg Tablets Fosinopril/Hydrochlorothiazide 10-12.5mg Tablets Ganciclovir 250mg and 500mg Capsules Hydrochlorothiazide/Quinapril 10-12.5mg, 20-12.5mg, and 20-25mg Tablets Lamotrigine 25mg, 100mg, 150mg, and 200mg Tablets Metformin 750mg Extended/Sustained-Release Tablets Mirtazapine 15mg and 30mg Orally Disintegrating Tablets Moexipril 7.5mg and 15mg Tablets Paroxetine 12.5mg and 25mg Extended/Sustained-Release Tablets Ramipril 1.25mg, 2.5mg, 5mg, and 10mg Tablets Venlafaxine 25mg, 37.5mg, 50mg, 75mg, and 100mg Tablets

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Federal Trade Commission Report Table A6. ANDA+AG Drugs

Acetaminophen/Tramadol 37.5-325mg Tablets Alendronate 35mg Tablets Amlodipine/Benazepril 2.5-10mg, 5-10mg, 5-20mg, and 10-20mg Capsules Eplerenone 25mg and 50mg Tablets Fexofenadine 3 0mg, 60mg, and 180mg Tablets Finasteride 5mg Tablets Fosinopril 10mg, 20mg, and 40mg Tablets Glyburide/Metformin 1.25-250mg, 2.5-500mg, and 5-500mg Tablets Metformin 500mg Extended/Sustained-Release Tablets Metoprolol 100mg and 200mg Extended/Sustained-Release Tablets Moexipril 7.5mg and 15mg Tablets Omeprazole 40mg Extended-Release Capsules Ondansetron 4mg and 8mg Tablets; 4mg and 8mg Orally Disintegrating Tablets Oxybutynin 15mg Extended/Sustained-Release Tablets Oxycodone 10mg, 20mg, and 40mg Extended/Sustained-Release Tablets Paroxetine 10mg, 20mg, 30mg, and 40mg Tablets Pravastatin 10mg, 20mg, 40mg, and 80mg Tablets Risperidone 0.25mg, 1mg, 2mg, 3mg, and 4mg Tablets Sertraline 25mg, 50mg, and 100mg Tablets Simvastatin 5mg, 10mg, 20mg, 40mg, and 80mg Tablets

End Notes

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1

See Letter from Senators Charles Grassley, Patrick J. Leahy, and John D. Rockefeller, IV to Deborah Platt Majoras, Chairman, Fed. Trade Comm‘n (May 9, 2005). 2 See Letter from Hon. Henry A. Waxman, U.S. House of Representatives, to Deborah Platt Majoras, Chairman, Fed. Trade Comm‘n (Sept. 13, 2005). 3 Generic drugs approved by the FDA through the filing of an Abbreviated New Drug Application (―ANDA‖) will be referred to as ―ANDA generic‖ drugs when necessary to distinguish them from AGs. 4 Drug Price Competition and Patent Restoration (Hatch-Waxman) Act of 1984, Pub. L. No. 98-417, 98 Stat. 1585 (1984), codified as amended at 21 U.S.C. § 355. 5 See 21 U.S.C. § 355(j) (2008). 6 See Teva Pharm. Indus. v. Crawford, 410 F.3d 51, 54 (D.C. Cir. 2005). 7 See, e.g., Congressional Budget Office, How Increased Competition from Generic Drugs Has Affected Prices and Returns in the Pharmaceutical Industry (July 1998) at 31 (―Because generic drugs are priced much lower than their brand-name counterparts, they are a source of substantial savings.‖), available at http://www.cbo.gov/showdoc.cfin?index=655&seguence=0. 8 In some cases, the brand appoints the generic to distribute the brand‘s AG during the 180-day period of marketing exclusivity. In such circumstances, there is still no competition between an ANDA-generic‘s product and a brand‘s AG. 9 IMS CONSULTING, IMS HEALTH, ASSESSMENT OF AUTHORIZED GENERICS IN THE U.S. (2006), http:// www.phrma.org/files/IMS%20Authorized%20Generics%20Report_6-22-06.pdf (prepared for PhRMA), referred to throughout this text as ―the IMS Study‖. 10 AIDAN HOLLIS AND BRYAN A. LIANG, AN ASSESSMENT OF THE EFFECT OF AUTHORIZED GENERICS ON CONSUMER PRICES (2006), http://www.gphaonline.org/sites/default/files/GPhA_AG_Study.pdf, GPhA Study, referred to throughout this text as ―Hollis and Liang‖. 11 Id. at 14. Hollis and Liang go further however, and argue that even the 5% difference overstates the immediate benefits from authorized generics. In particular, the authors argue that each of 18 drugs in their analysis should be weighted by sales. When this is done, Hollis and Liang conclude that the average generic discount off of the pre-entry brand price is virtually identical with and without AGs. Id. at 15. 12 The full reference for data that will be referred to as retail or NPA data is: IMS Health, IMS National Prescription Audit Plus 7TM, Years 2003 to 2008, Data Extracted January 2009. The channels included in our IMS

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National Prescription Audit data are Chain Stores, Food Stores, Independents, Long-Term Care, and Mail Service. 13 The full reference for data that will henceforth be referred to as wholesale or NSP data is: IMS Health, IMS National Sales PerspectivesTM, January 2003 to December 2008, Retail and Non-Retail Channels, Data Extracted February 2009. The channels included in our NSP sample are: Chain Stores, Clinics, Federal Facilities, Food Stores, HMOs, Home Health Care, Independents, Long-Term Care, Mail Service, Misc-Other, Misc-Prisons, Misc-Universities, and Non-Federal Hospitals. The analysis presented here aggregates over these channels. 14 Our analysis of the prior research on AGs suggests that gaining an accurate understanding of the effect during the 180-day exclusivity period is of primary importance, yet obviously AG entry can have impacts that extend beyond the 180-day exclusivity period. For instance, the IMS Study estimated the effect of AG entry on prices after the exclusivity period, as did a second study, Ernst R. Berndt et al., Authorized Generic Drugs, Price Competition and Consumers’ Welfare, 26 HEALTH AFFAIRS 790 (2007). Both studies found that the additional competition caused meaningfully greater discounts only when the number of independent generics who eventually enter is small, generally five or fewer. Another strand of research addresses the effect of AG entry on the decision to pursue paragraph IV challenges. The general take-away from these studies is that AG entry is most likely to have a consequential impact on challenges for drugs with relatively low sales volume. See MARC GOODMAN ET AL., MORGAN STANLEY, QUANTIFYING THE IMPACT FROM AUTHORIZED GENERICS (2004), and David Reiffen & Michael R. Ward, Branded Generics as a Strategy to Limit Cannibalization of Pharmaceutical Markets, 28 MANAGERIAL AND DECISION ECONOMICS 251 (2007). Not only do these studies point out areas for further analysis that will appear in our final report, they put into context some of the results reported in this preliminary study, particularly the comparisons made between outcomes for drugs with high and low sales volumes. 15 The problem of inference in this case is that the owner of the brand has a choice to market an authorized generic; that is, the choice to market an AG is endogenous. For this reason it is difficult to determine the market impact of an AG because the firm does not randomly choose when to offer an AG. The following analogy demonstrates the difficulty in determining the causal effect. Suppose we observe that when pedestrians use umbrellas, drivers turn on their windshield wipers. It would be incorrect to conclude that the pedestrians‘ decisions determine the drivers‘ behavior because both behaviors are typically caused by rain falling from the sky. The econometric problem in estimating the effect of an AG on prices, revenues, or output is that the analogue to "rain" in the drug example cited here is the anticipated profitability of selling the authorized generic, which is not observable. 16 Note that defining the unit of observation in this way treats blockbuster drugs and niche products equally. Also note that drugs that tend to be offered in multiple dosage forms or strengths will be more heavily represented in the data than drugs that are offered in a single strength and dosage form. Statistically, it may not be appropriate to treat the prices for a 100mg tablet of a drug and a 200mg tablet of the same drug from the same manufacturer as being independent observations. This statistical issue is not of a kind that is normally expected to bias the estimates, but it does require qualification of the calculated standard errors and statistical significance levels. The econometric analysis in the final study will account for these concerns. 17 For both the retail and wholesale analysis, the monthly generic price for an ANDAOnly drug is calculated as the total sales dollars of the generic drug divided by the extended units sold. The monthly generic price of an ANDA+AG drug is the sum of the total sales dollars from the ANDA and the AG divided by the total extended units sold of the ANDA and the AG. That is to say, in ANDA+AG markets, the generic price is a weighted average of the ANDA and the AG prices. To get relative prices, each of these are normalized by the pre-entry price per extended unit of the corresponding brand product. 18 To be precise about how these are being calculated, let G be the average price of a generic drug in the current month, and B be the average price of the brand drug in the three months prior to generic entry. The relative price would be calculated as G/B. The discount off of the pre-entry brand price is 1-G/B. 19 The statistical significance of these differences is reported as the p-value of a one- sided difference in means Student t-test without an assumption of equal variances. For instance, the 6.6% p-value reported for month 1 in Table 1-A means that the probability of observing the ANDA-Only sample mean discount being 3.7% lower than the ANDA+AG sample mean discount, based on the sample size and variance observed in the data, is no more than 6.6% if the null hypothesis that the ANDA-Only discount is at least equal to the ANDA+AG price is true. (In these tests, the null hypothesis is specified as the opposite of what we expect. The 1.1% p- value reported for month 2 means that it is considerably less likely that the month 2 data would be observed if the true ANDA-Only discount is higher than the true ANDA+AG discount. Put simply, the lower the p-value, the more statistically significant is the result. 20 Since the median market size being used to distinguish high sales from low sales drugs is the median of all drugs that entered with exclusivity in our time frame, the number of high and low sales drugs in our restricted sample need not equal one another. 21 The circumstances surrounding the launch of generic clopidogrel are atypical. Apotex launched the generic ―at risk,‖ meaning the patent litigation was still unresolved. Subsequently, the courts upheld the patent and

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prevented Apotex from continuing to sell the generic. However, Apotex had managed to sell several months‘ supply while on the market, and these sales show up in our data. For the details of this situation, see Stephanie Saul, Court Upholds Plavix Patent Of Bristol And Sanofi, N.Y. TIMES, June 20, 2007, at C3. 22 Revenues equal price times quantity, and in this instance, the decline in revenue is caused by a decline in both the price and the quantity of the independent generic with AG entry. To see how profits change when price and quantity drop, consider first just a price decrease. A 1% price decline, holding quantities fixed, will cause revenues to fall by 1%, and will decrease the gross margin, (price minus variable cost), and thus the incremental profits (revenues minus variable costs) by more than 1%. The nominal decline in total profit is the same as the nominal decline in incremental profit, but with positive fixed costs, this would represent an even larger percentage change in total profits (incremental profits minus fixed costs). A 1% decrease in quantity, holding price fixed, will decrease revenues by 1% and will decrease incremental profits also by 1%, assuming constant average variable costs, which will again cause a greater than 1% decline in total profits. Therefore, reporting the decline in ANDA revenues caused by AG entry understates the impact on profits. 23 This 47% difference is calculated as the difference between the independent generic‘s relative expenditures for ANDA-Only versus ANDA+AG drugs, 61. 1%-32.7%, divided by ANDA-Only relative expenditures, 61.1%. 24 To the extent that wholesaler margins are included in these expenditure figures, this estimate may overstate the impact on the first filer. 25 Because these wholesale expenditures do not account for payments from brand manufacturers to third-party payers, such as pharmacy benefit managers, brand wholesale expenditures are best thought of as a proxy for brand gross revenues. See Chapter III of the FTC 26 It may seem odd that the total relative expenditures for a group of drugs typically exceed one hundred percent. For instance, in month one for the ANDA-Only drugs, the independent generic‘s average relative expenditure is 84.9%, from Table 1-D, and the brand‘s average relative expenditure is 42.4%, from Table 1-F; these sum to 127.3%. We suspect that some of this increase in total expenditures at the wholesale level may be due to the filling of the supply channel with the generic. This does not indicate a problem with using this expenditure data as a proxy for revenues; sales for the purpose of filling up the supply channel still represent revenues for the manufacturer. Data presented in the next chapter show that the quantities actually dispensed by pharmacies (retail quantities) during the exclusivity period by the brand and generics are roughly equal to brand quantities prior to generic entry. Combined with the evidence above about wholesale generic discounts, an implication of the retail quantity data is that the total wholesale value of the drugs dispensed falls upon generic entry. 27 One such factor discussed above was the size of the market for the branded drug, prior to generic entry. However, relative retail quantities do not differ systematically between high sales and low sales drugs. 28 See, e.g., CONG. BUDGET OFFICE, HOW INCREASED COMPETITION FROM GENERIC DRUGS HAS AFFECTED PRICES AND RETURNS IN THE PHARMACEUTICAL INDUSTRY (1998) at 31, http://www.cbo.gov/ftpdocs/6 xx/doc655/pharm.pdf. 29 In some cases, the brand appoints the generic to distribute the brand‘s AG during the 180-day period of marketing exclusivity. In such circumstances, there is still no competition between an independent generic‘s product and a brand‘s AG. 30 Pursuant to settlement, a generic company may pay a royalty to the brand to gain an earlier entry date than it would get by compromising on the date alone, while an exclusion payment – a payment from the brand to the generic – buys a later entry date. See Alden F. Abbott & Suzanne T. Michel, The Right Balance of Competition Policy and Intellectual Property Law: A Perspective on Settlements of Pharmaceutical Patent Litigation, 46 IDEA 1, 14 (2005). 31 H.R. Rep. No. 98-857(I), at 14, 28 (1984), reprinted in 1984 U.S.C.C.A.N. 2647, 2647, 2661. Although initial judicial reactions reflected concern with such arrangements, see In re Cardizem CD Antitrust Litig., 332 F.3d 896, 908 (6th Cir. 2003), subsequent appellate rulings adopted a far more permissive position. See In re Ciprofloxacin Hydrochloride Antitrust Litig., 544 F.3d 1323, 1336 (Fed. Cir. 2008); In re Tamoxifen Citrate Antitrust Litig., 429 F.3d 370 (2d Cir. 2005), amended by, 466 F.3d 187 (2d Cir. 2006); Schering Plough Corp. v. FTC, 402 F.3d 1056 (11th Cir. 2005). Other cases remain in litigation. See FTC v. Cephalon, Inc., No. 08cv2141 (E.D. Pa. complaint filed Feb. 13, 2008), available at http://www2.ftc.gov/os/c aselist/0610182/080213complaint.pdf; FTC v. Watson Pharmaceuticals, Inc., No. 09-00598 (C.D. Cal. first amended complaint filed Feb. 12, 2009), available at http://www2.ftc.gov/os/ca elist/0710060/090212amendedcmpt.pdf. 32 In the two most recent years for which data has been compiled, nearly half of all of the final settlements filed under the MMA involved compensation to the generic patent challenger and an agreement by the generic firm to refrain from launching its product for some period of time. BUREAU OF COMPETITION, FED. TRADE COMM‘N, AGREEMENTS FILED WITH THE FEDERAL TRADE COMMISSION UNDER THE MEDICARE PRESCRIPTION DRUG, IMPROVEMENT, AND MODERNIZATION ACT OF 2003: SUMMARY OF AGREEMENTS FILED IN FY 2006 (2007), http://www.ftc.gov/reports/mmact/MMAreport2006.pdf (14 of 28 final settlements involved compensation to the generic patent challenger and a restriction on entry); BUREAU OF COMPETITION, FED. TRADE COMM‘N, AGREEMENTS FILED WITH THE FEDERAL TRADE COMMISSION UNDER THE MEDICARE PRESCRIPTION DRUG, IMPROVEMENT, AND MODERNIZATION ACT OF 2003: SUMMARY OF AGREEMENTS FILED

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FY 2007 (2008), http://www.ftc.gov/os/2008/05/mmaact.pdf (14 of 33 final settlements involved compensation to the generic patent challenger and a restriction on generic entry). 33 This reflects the fact that competition typically dissipates total profits accruing to suppliers so that the sum of duopoly profits is less than monopoly profits. See, e.g., Mark A. Lemley & Carl Shapiro, Probabilistic Patents, 19 J. ECON. PERSPECTIVES 75, 91 n.15 (2005). 34 See Confidential Company Document (comparing forecasted net present values for early and late launches, with and without an AG). 35 This chapter cites all agreements arising from settlements or patent litigation, including settlements, licenses and supply and distribution agreements as ―Settlement Agreements‖ (SA). 36 The numbers set forth in this Section and in the accompanying charts reflect preliminary analysis and may be subject to minor changes. 37 Agreements were counted based on the number of New Drug Applications involved in the litigation. For instance, if a spray formulation and a tablet formulation of a pharmaceutical involved two NDAs and both were subject to the litigation, the settlement arrangements were considered two agreements. 38 A brand can compete with an AG either through launching it on its own or by authorizing another firm to market the brand‘s AG. In these settlements, the brand agreed not to launch or sponsor its AG in competition with the first filer‘s generic product for some period of time. 39 Under some circumstances, there can be competition from other first-filers during the 180-day exclusivity period. See 21 U.S.C. § 355(j)(5)(B)(iv)(II)(bb) (2008) (providing that exclusivity may be shared by applicants filing on the same day). 40 Hatch-Waxman rewards the first filer to challenge a branded drug patent with 180 days of market exclusivity, and bars the FDA from approving any later applicants until the period has expired or been forfeited. Thus, an agreement with a first-filer that defers entry may create a ―bottleneck,‖ blocking the approval of subsequently filed ANDAs. See FED. TRADE COMM‘N, GENERIC DRUG ENTRY PRIOR TO PATENT EXPIRATION ch. 5 (2002). Although Hatch-Waxman has been amended to address this problem, by providing that first-filers forfeit their exclusivity under certain circumstances, settlement agreements still have the potential to create bottlenecks that block subsequent applicants. See Protecting Consumer Access to Generic Drugs Act of 2009: Hearing on H.R. 1706 Before the Subcomm. on Commerce, Trade, and Consumer Protection of the H. Comm. on Energy and Commerce, 111th Cong. (2009) (prepared statement of the Fed. Trade Comm‘n) (forfeiture provisions of the MMA do not relieve bottleneck when a first generic applicant enters a settlement agreement with the brand-name company and there is no court decision of invalidity or non-infringement), available at http://www.ftc.gov/os/2009/03/P859910payfordelay.pdf; see also Letter from Gary J. Buehler, Dir., Office of Generic Drugs, U.S. Food and Drug Admin., to Marc A. Goshko, Executive Dir., Teva Parenteral Medicines, regarding Docket No. 2007N-0389, at 5 n.6 (Jan. 17, 2008) (noting that when a first-filer enters a settlement agreement without a final judgment of invalidity or non- infringement, the ―inability to force a forfeiture of 180-day exclusivity could result in delays in the approval of otherwise approvable ANDAs‖) http://www.fda.gov/ohrms/dockets/DOCKETS/07n0389/07n-0389-let0003.pdf. 41 The annual sales data are from IMS Health, IMS National Prescription Audit Plus 7 TM, Years 2003 to 2008, Data Extracted January 2009. In one instance, when IMS data for the product at issue was unavailable, information was drawn from Top 200 Drugs for 2005 by Sales, http://www.drugs (last visited June 19, 2009). All sales figures are for the full calendar year prior to the settlement agreement or for the last full year prior to generic entry. 42 One of these settlements barred entry until 6–8 months before expiration of late-issued patents confined to a single form of the drug‘s active ingredient. See [Redacted] SA (permitting entry six months before patent expiration). Under another settlement, the agreed-upon entry date gave the brand the full length of the primary composition-of-matter patent on the drug. 43 Under the original provisions of the Hatch-Waxman Act, a victory by a subsequent filer triggered the first-filer‘s exclusivity, allowing the FDA to approve the subsequent filer‘s ANDA 180 days later. 21 U.S.C. § 355(j)(5)(B)(iv)(II) (2000). Although this court-judgment trigger has been eliminated and does not apply to ANDAs filed after December 2003, a judgment of invalidity won by the subsequent filer would typically speed resolution of the first-filer‘s case. 44 Pursuant to amendments contained in the MMA, a court decision now triggers a forfeiture provision: if the firstfiler does not launch its product within 75 days of a court decision, it forfeits its exclusivity, and the FDA is permitted to approve subsequent filers. See 21 U.S.C. § 355(j)(5)(D); Caraco Pharm. Labs. v. Forest Labs., 527 F.3d 1278, 1284–88 (Fed. Cir. 2008). 45 Caraco, 527 F.3d at 1284. 46 See [Redacted] SA (entry on low-sales product, about 2 months after settlement; on blockbuster product, more than 3 years ); [Redacted] SA (entry on low-sales product, about 7 months after agreement; on blockbuster product, nearly 5 years); [Redacted] SA (products with similar sales, one with entry about one week after execution of the agreement, the other about 3 years). For these agreements, both products contain the same active ingredient, i.e., one is a line extension of the other, and the generic was the first-filer for both products. (In one case, the paragraph IV certification was made after the agreement.) A fourth agreement, involving IN

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high- and low-sales drugs that are unrelated, raises similar issues. See [Redacted] SA (prohibition on competing AG with respect to only the low-sales product, with ANDA entry for that product permitted upon execution of the agreement; entry of the high-sales product about 17 months from execution). There was no paragraph IV certification with regard to the high-sales product in this agreement because it is an old antibiotic. 47 Absent a settlement between the first-filer and the brand, the agreement allows the subsequent filer to launch the AG on the day the first-filer launches its ANDA-generic product following a final court decision of patent invalidity, unenforceability, or non-infringement. [Redacted] SA. If the first-filer launches its ANDA-generic product at risk, the agreement provides that the brand and the subsequent filer will mutually decide whether to launch the AG during the first-filer‘s 180-day exclusivity. Id. 48 See [Redacted] SA (appointing the first-filer the exclusive AG distributor but requiring the brand to supply the AG only if the first-filer was unable to obtain final FDA approval of its ANDA). 49 [Redacted] SA (definition of Authorized Generic Launch Date). 50 See [Redacted] SA. Most AG supply agreements are not publicly available. 51 Invitations to collude have been judged unlawful under Section 2 of the Sherman Act, United States v. Amer. Airlines, 743 F.2d 1114 (5th Cir. 1984), and the Commission has issued consent orders in several cases involving allegations that an invitation, even when unaccepted by the competitor, violated Section 5 of the FTC Act. See, e.g., In re Valassis Commc‘ns, No. C4160 (F.T.C. Apr. 28, 2006) (consent order resolving allegations of an invitation to collude in dividing the market made by one company during a public conference call with securities analysts); see also Analysis of Agreement Containing Consent Order to Aid Public Comment, In the Matter of Valassis Communications, Inc., available at http://www.ftc.gov/os/case list/0510008/060314ana0510008.pdf. 52 The Federal Trade Commission received prescription sales information from over 100 drug firms representing drug-level sales information over the period 1/1/2000–3/31/2007. Unfortunately, much of the firm data proved intractable due in part to inconsistencies across firms, and sometimes across drugs within a firm. For example, the firms often applied discounts, charge-backs, returns, drug expirations and other product flow information as periodic accounting adjustments. These adjustments were made on irregular bases over time and could differ in timing across dollar and quantity sales of the same drug. As a consequence, the sales adjustments frequently led to negative sales dollars and quantities, which made calculation of meaningful prices problematic. These issues led us to purchase sales information from a data vendor. Some analysis of the sales information obtained from the manufacturers will likely appear in the final study, but the sales information reported here comes entirely from the data purchased from IMS Health. 53 It should be noted that certain discounts may not be accounted for in this data. According to the IMS Study, ―Assessment of Authorized Generics in the U.S.‖ at 19, prepared by IMS Consulting, IMS Health in 2006 for PhARMA, and available at http://www.phrma.org/files/IMS%20Authorized%20Generics%20Report_6-2206.pdf, ―However, prompt payment cash discounts and bottom-line invoice discounts are not reflected in the dollar purchase amounts. Also, it should be noted that volume purchase estimates may not always reflect drop shipment activity.‖ As long as these omitted discounts do not vary systematically between authorized generics and independent generics, not having information on these discounts should not bias our findings. 54 IMS refers to these dollar amounts as the ―cost to consumers.‖ 55 Dosage forms are defined using the ―three-lettered‖ code defined by IMS. The mapping of this variable into dosage forms used in the analysis is provided in Table A1. This mapping was necessary in order to match the IMS and FDA data. 56 One relevant molecule, Bupropion, is associated with multiple therapeutic classes for each strength and dosage form. We exclude it from the analysis. In addition, Nitrofurantoin had several molecular names listed in the FDA data, and was therefore excluded from the analysis. 57 The lists of USC codes used to define whether a medication is a decongestant or a vitamin are provided in Tables A2 and A3. 58 We normalized several market outcomes, such as prices, based on the market conditions that existed prior to generic entry. Consequently, even though we have data for the first three months of 2003, it was used only to calculate pre-generic entry market characteristics for drugs that experienced generic entry early in 2003. 59 On occasion, positive but small sales figures were observed for a generic firm earlier than our information suggests they could be on the market. Therefore, we excluded generic sales that occurred prior to the FDAdefined exclusivity period and represented less than 0.5% of pre- entry brand sales. 60 See FED.TRADE COMM‘N, PHARMACY BENEFIT MANAGERS: OWNERSHIP OF MAIL- ORDER PHARMACIES (2005) at ch. VI (for more information on repackagers), http://www.ftc.gov/reports/pharmb enefit05/ 050906 pharmbenefitrpt.pdf. 61 Although repackagers were not included in the count of manufacturers, the sales associated with them were used to construct price and sales figures. A list of companies we judged to be repackagers is provided in Table A4. One potential source of error in our data is incorrectly identifying the repackagers, which could cause us to overstate or understate the number of active generic manufacturers of a drug.

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These nine drugs are comprised of the four strengths of Amlodipine/Benazepril, two strengths each of Eplerenone and Moexipril, and one strength of Omeprazole. 63 These 95 drugs include multiple strengths and dosage forms of some drugs. These 95 drugs represent 35 unique molecule combinations. 64 See U.S. Food and Drug Admin., Paragraph IV Patent Certifications (June 15, 2009) http://www.fda. gov/downloads/Drugs/DevelopmentApprovalProcess/HowDrugsareDevelopedan dApproved/ApprovalApplications/AbbreviatedNewDrugApplicationANDAGenerics/UCM 1543 50.pdf (list is updated twice a month). 65 For example, if the exclusivity period as identified by the FDA ended on June 15, 2005 then the exclusivity would include the months December 2004–May 2005 but would exclude June from the exclusivity. However, if the end date of the exclusivity was identified as June 30 th then the month of June would also be included in the exclusivity period.

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In: Pharmaceutical Industry: Innovation and Developments ISBN: 978-1-61209-394-9 Editors: David A. Mancuso and Isobel M. Grenada © 2011 Nova Science Publishers, Inc.

Chapter 3

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REMARKS OF J. THOMAS ROSCH, COMMISSIONER, FEDERAL TRADE COMMISSION, BEFORE THE WORLD GENERIC MEDICINE CONGRESS, HEARING ON “PAY-FOR-DELAY SETTLEMENTS, AUTHORIZED GENERICS, AND FOLLOW-ON BIOLOGIES: THOUGHTS ON THE HOW COMPETITION LAW CAN BEST PROTECT CONSUMER WELFARE IN THE PHARMACEUTICAL CONTEXT” This year marks the 25th Anniversary of the Drug Price Competition and Patent Restoration Act of 1984, known to all of us as the Hatch-Waxman Act. That Act, of course, is credited with creating the modern regulatory framework that allows generic, lower-cost drugs to come to market. From an antitrust standpoint, however, the Hatch Waxman Act has also unleashed several challenging practical and theoretical questions at the intersection of competition law and patent policy. Should the law incentivize settlements of costly patent litigation that delay generic entry or, in certain cases, unilaterally ban those settlements? Can those settlements ever be held ―reasonable‖? To what extent does the entry of Authorized Generics during the Hatch Waxman 180-day exclusivity period into the marketplace ultimately help or harm consumers? What time frame of patent protection strikes the right balance between incentivizing innovation in the biologic context while ensuring the production of less-expensive biosimilars? Running through all of these issues is the debate about how and to what extent the law should strike a balance between creating the right incentives for brand firms to innovate and develop groundbreaking drugs while still ensuring that generic firms have the incentives to enter the market. All of these overlapping issues have been the subject of much discussion at the Commission over the last year and today I would like to discuss their application in three different contexts. First, I will discuss the various legal standards that the Commission, the courts, and now Congress have offered for determining when pay-for-delay settlements are anticompetitive. Second, I will offer some thoughts on the debate over whether the entry of

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Authorized Generics during the 180-day exclusivity period is harmful to competition. Third and finally, I will discuss the ongoing debate over the proper pathway for follow-on biologics.

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I. I would like to begin by discussing ―pay-for-delay‖ settlements. As you know, these are settlement agreements where a patent holder makes a payment (or provides something else of value) to the generic company to settle the generic company‘s claim that the brand‘s patent is invalid. As part of the agreement, the generic company typically agrees to stay off the market for a period of time that may or may not cover the life of the patent. Ironically, these agreements are a negative by-product of the Hatch Waxman Act which was intended to bring generics to market faster and creates an industry-specific scheme that regulates competition in the pharmaceutical markets. Under Hatch Waxman, the first generic firm (or firms) to file an Abbreviated New Drug Application (―ANDA‖) with the FDA asserting that the brand‘s patents are invalid or not infringed by the generic drug may enter the market without going through FDA approval and obtains an exclusive right to market a generic version of the drug for 180 days which creates a duopoly during that 180-day period.1 In response to the ANDA, the brand firm may file a patent infringement suit to establish validity and infringement. It is the settlement that arguably creates the antitrust problem because, once the generic firm that has obtained the rights to that 180-day exclusivity period under Hatch Waxman agrees in exchange for payment from the brand firm to stay off the market, there is no competition. For nearly the last decade, the FTC has challenged these agreements on the grounds that, by keeping generics out of the market, they eliminate competition with the brand firm and therefore deprive customers of competitive prices. At the courts, we have generally not had much success. Initially, courts divided over whether pay-for-delay settlement agreements were per se illegal. In 2003 in the Cardizem litigation (a private lawsuit), the Sixth Circuit rejected the brand patentee‘s argument that the pay-for-delay agreements were presumptively procompetitive and good for innovation and held that the payments there were per se illegal because the agreement between the brand and the generic ―was, at its core, a horizontal agreement to eliminate competition in the market for Cardizem CD throughout the entire United States, a classic example of a per se illegal restraint of trade.‖2 A few months later, however, Judge Posner, sitting as a district court judge, rejected this view in dicta in his Asahi Glass decision.3 There he reasoned that ―a ban on reverse payment settlements would reduce the incentive to challenge patents by reducing the challenger‘s settlement options should he be sued for infringement, and so might well be thought as anticompetitive.‖4 In the next wave of cases, federal appellate courts addressing pay-for-delay settlement agreements held that the agreements under review did not violate the antitrust laws because the agreements were within the scope of the brand firm‘s patent and therefore did not have anticompetitive effects beyond the monopoly power conferred by that patent. The Eleventh Circuit was the first appellate court to so hold in ScheringPlough.5 There, the court rejected the FTC‘s claim that the settlement agreement failed under the rule of reason because the brand firm‘s payment to the generic constituted a quid pro quo for the generic‘s agreement to defer entry into the market and therefore had anticompetitive effects because it eliminated

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competition.6 The Eleventh Circuit reasoned that the traditional rule of reason analysis – under which courts analyze whether the defendant‘s conduct had anticompetitive effects – was not ―appropriate in this context‖ because ―[b]y their nature, patents create an environment of exclusion, and, consequently, cripple competition.‖7 As a result, the Eleventh Circuit reasoned, the proper analysis was to examine ―the extent to which antitrust liability might undermine the encouragement of innovation and disclosure.‖8 The court held that the settlement agreement‘s legality rested on (1) the patent‘s potential exclusionary scope; (2) the extent to which the settlement agreement created exclusions beyond that scope; and (3) the resulting anticompetitive effects.9 Because it held that the settlement in Schering did not have anticompetitive effects that were beyond the scope of the patent‘s potential exclusionary effect, the Eleventh Circuit refused to find liability under the antitrust laws. However, in my view, the court did not answer definitively the critical question of whether the merits of the patent could be litigated in order to determine whether the settlement was within the scope of the patent. The next year in In re Tamoxifen Citrate Antitrust Litigation,10 the Second Circuit applied Schering and held that a plaintiff must show that the agreement‘s exclusionary effects exceed the patent‘s scope. However, in my view, the Court did not go so far – as some have suggested – as to require that a plaintiff show that the litigation initiated and settled by the brand was a sham under the Supreme Court‘s decision in Professional Real Estate Investors v. Columbia Pictures Industry (which I will refer to as ―PRE‖).11 Nor, in my judgment, did the Tamoxifen court require a showing that the litigation settled a claim involving a patent that the brand obtained through fraud on the PTO. To the contrary, it observed, [W]e do not . . . think there is a ―requirement‖ that ―antitrust plaintiffs must show that the settled litigation was a sham, i.e. objectively baseless, before the settlement can be considered an antitrust violation....‖ There is no such requirement. . . . A plaintiff need not allege or prove sham litigation in order to succeed in establishing that a settlement has provided defendants ―with benefits exceeding the scope of the tamoxifen patent.‖ Whether there is fraud or baseless litigation may be relevant to the inquiry, but it is hardly, we think, ―the... standard,‖ as the dissent posits in order to take issue with it.‖

Two years later, however, in In re Ciprofloxacin Hydrochloride Antitrust Litigation,12 the Federal Circuit went further and, rejecting the distinction that the Second Circuit crafted in Tamoxifen, held that pay-for-delay settlement agreements were essentially per se legal. The court held that those agreements were legal unless the plaintiffs could prove (1) that the brand‘s patent infringement lawsuit fell within the ―sham‖ exception to the Noerr-Pennington doctrine set out in the Supreme Court‘s decision in PRE, or (2) that the settlement terms were outside the scope of the brand‘s patent. In June, the Supreme Court refused to consider the Federal Circuit‘s decision when it denied the Cipro plaintiffs‘ petition for certiorari.13 More recently, however, two developments suggest that there is reason to believe that the tide may be turning again – this time in the Commission‘s favor. First, in a companion case to the Federal Circuit‘s Cipro case,14 the Second Circuit appears to be revisiting whether it applied the correct standard in Tamoxifen. Over the summer, the Second Circuit requested the Justice Department‘s views on the correct standard for analyzing the validity of reverse payments. Judge Pooler, who dissented from the Second Circuit‘s Tamoxifen decision,15 is on the Cipro panel – a fact that provides further fodder to suggest that the Second Circuit is,

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indeed, revisiting its test. In response to the Second Circuit‘s request for the views of the United States, the Department of Justice filed a brief this summer and took the position that the court should essentially apply a truncated rule of reason.16 Under that analysis, if a plaintiff makes a prima facie showing that a reverse payment took place, it has proved an agreement that is ―presumptively unlawful.‖17 The DOJ argued that the defendants can then rebut that showing through a rule of reason analysis showing that the settlement agreement did not unreasonably restrain competition, such as by showing that the consideration paid was equivalent to the patent holder‘s expected litigation costs.18 Under the DOJ‘s analysis, if the settlement bans generic competition for the life of the patent, ―defendants will be unable to carry their burden.‖19 The DOJ‘s position brought it largely into line with the FTC‘s position in Schering. A decision from the Second Circuit could come any day. The second development has been on the Hill, where the FTC has been urging Congress – with recent success – to adopt legislation that would address pay-for-delay settlements. In the House, a provision barring agreements that include both the generic filer‘s receiving anything of value and agreeing to limit or forego production or marketing its generic drug, was incorporated into the health care reform bill, H.R. 3962, that passed the chamber on November 8th. Section 2573 of that bill amends the Federal Food, Drug, and Cosmetic Act to prohibit pay-for-delay agreements, with certain exceptions, but also to allow the FTC to promulgate rules exempting certain agreements if the Commission finds such agreements to be for the benefit of consumers. That bill passed the House as part of the health care reform legislation. In the Senate, the Judiciary Committee last month passed S. 369 with an amendment that would create a presumption that pay-for-delay agreements are illegal, but allow parties to overcome that presumption by establishing by clear and convincing evidence that the agreement‘s procompetitive benefits outweigh its anticompetitive effects. Unlike the House provision, which amends the Food, Drug, and Cosmetic Act, the Senate proposal amends the FTC Act and contains a provision allowing for the assessment of civil penalties. Like the House version, the Senate proposal would permit the FTC, by rule, to except additional payfor-delay agreements from the bill's coverage. We‘ll have to wait and see what happens to these proposals in the upcoming months. In light of all these legal standards, where do I come out? In my current view, the optimum standard is not that such agreements should be per se illegal. Instead, paralleling the DOJ‘s brief in the Second Circuit, I believe that the Commission and courts should evaluate antitrust liability in reverse payments cases under the ―truncated rule of reason‖ standard embraced by the Supreme Court in NCAA v. Board of Regents20 and FTC v. Indiana Federation of Dentists.21 My thinking is as follows. Under the Supreme Court‘s decision in Palmer v. BRG,22 I believe a pay-for-delay settlement agreement is ―inherently suspect‖ because it is a putative market division agreement between a competitor (the branded pharmaceutical company holding the patent) and a potential competitor (the generic pharmaceutical company challenging the validity of infringement of the patent) when the parties also agree on when the generic company can enter the market without infringement. Since the agreement is ―inherently suspect,‖ under the truncated rule of reason analysis adopted by the D.C. Circuit in Polygram Holding23 and the Fifth Circuit in North Texas Specialty Physicians,24 the burden shifts to the defendant to justify the payment. At that point in my view – and I depart from the DOJ‘s brief in Cipro at this juncture – I believe that the defendants should be able to defend the settlement by introducing evidence of

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the strength of the patent. Indeed, although the DOJ has since backpedaled from such a position, the Solicitor General advocated such a view before the Supreme Court when it urged the Court to take the Tamoxifen appeal.25 A rule that purports to give defendants get an opportunity to defend their settlement, but then prohibits them from introducing evidence that could go to the core of why they settled the case (i.e., the merits of the original patent challenge) is not, in my view, fair because it unduly stacks the deck in the plaintiff‘s favor. But whether or not my views ultimately prevail is a debate for a different day. Looking ahead, history tells us that the Commission can only safely assume that the law will remain the status quo – the Supreme Court has repeatedly passed on opportunities to evaluate the correct legal standard26 and I am not experienced enough in the ways of the Hill to make any guarantees about how things will end up in Congress. Assuming that to be so, there are several open questions on the horizon. I will opine on answers to just a few. First, in the face of the existing federal appellate decisions, under what circumstances could the Government or a private plaintiff nevertheless prevail in an antitrust challenge to a pay-for-delay settlement agreement under current U.S. law? As I read the cases, there are at least two such circumstances. Under one scenario, a party contesting a pay-for-delay settlement agreement can prevail if it can show that the brand firm‘s infringement lawsuit qualifies as a sham under PRE or rests on a patent that was obtained through fraud on the PTO. Under a second scenario, I also continue to believe that based on the Eleventh Circuit‘s decision in Schering and Judge Posner‘s decision in Asahi Glass that, at least outside of the Federal Circuit, a party contesting a reverse payment agreement can prevail if it can show that it is highly unlikely that the patent is valid or that it is likely that the generic firm did not infringe the patent.27 Put another way, the validity or scope of the brand‘s patent does not need to be taken at face value – Schering does not create an irrebuttable presumption that the brand firm‘s patent is valid and/or that it will be infringed by the generic. A second and tougher open question – and the one that courts have yet to really grapple with – is what must the party challenging the reverse payment prove in order to show that validity and/or infringement are sufficiently unlikely. One option would be for the parties to engage in the battle of experts that often occurs in patent litigation and essentially resolve the validity or infringement claim on the merits. That would of course be expensive and would require either in-house or outside expertise. A second option would be for the party challenging the reverse payment agreement to prove that validity is highly unlikely or infringement is unlikely through direct evidence such as internal statements or evaluations by the brand and generic firms. The problem with direct evidence, however, is that it rarely actually exists. A third and more viable option would be for the party challenging the reverse payment agreement to prove that validity is highly unlikely or that infringement is unlikely by relying on circumstantial evidence, including the parties‘ positions at the time of the settlement, projections from the firms about the patent‘s validity or the likelihood of infringement, or the existence of a demonstrably excessive ―reverse payment.‖28 Thus, for example, evidence that the masks—for fixing prices, in violation of antitrust law.‖ Asahi Glass, 289 F. Supp. 2d at 991. But see Cipro, 544 F.3d at 1337 (―We disagree that analysis of patent validity is appropriate in the absence of fraud or sham litigation.‖). reverse payment equals or exceeds the generic firm‘s potential profits if it wins (taking into account the remaining life of the patent and the lower profit margins if there is competition), buttressed by other evidence (for example, that the payment was made despite the presumption of validity

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or evidence from an ex-employee or because the parties‘ documents show the payment was made because it was believed the brands‘ patent was invalid) might be sufficient to create an inference that the patent is in fact invalid.29 A third question that remains to be answered is whether the courts are simply wrong in looking at pay-for-delay settlement agreements in the vacuum of the antitrust laws. As I discussed at the outset, U.S. firms and courts operate against the backdrop of not only federal antitrust and intellectual property laws, but also the Hatch-Waxman Act, which regulates the introduction of generic drugs into the market place. Professor Scott Hemphill has argued that courts should give the Hatch-Waxman Act independent relevance in considering the legality of reverse payment settlements.30 His argument is that, because the Hatch-Waxman Act reflects a congressional judgment, it deliberately favors litigated challenges to brand patents rather than settlement. That judgment, of course, is the polar opposite from the view expressed in Schering, Tamoxifen, and Cipro that courts should favor patent settlements over litigation. Put another way, it may be correct that, in a world without the Hatch-Waxman Act, a policy that defaults in favor of settlement is arguably appropriate. But that is not the policy that we arguably have in the U.S. in the context of generic drugs where Congress has made a policy judgment in favor of litigated challenges. A fourth question that the Commission may have to face is how, in the absence of a legislative fix, we should proceed to challenge these settlements going forward. Under one view, the FTC should use our administrative trial process (which we term ―Part 3‖). If the FTC proceeded down that path and filed an administrative complaint against parties to a reverse payment agreement, a decision by the ALJ (regardless of the outcome) would almost invariably be appealed to the entire Commission. At that point, the FTC itself could weigh in through a written opinion. Although the FTC‘s decision would be subject to appeal to a federal appellate court, this process would nevertheless allow the FTC to clearly articulate its views of what the legal standard should be. A second strategy is to pursue cases where we include specific allegations that the reverse payment reflects a quid pro quo for an agreement to divide the market coupled with specific allegations that the brand firm‘s infringement claim is weak. The FTC has recently done just that twice in cases filed in the federal district court in Pennsylvania and the federal district court in California. The FTC‘s specific allegations of market division and weak infringement claims distinguish these cases from Schering, Tamoxifen, and Cipro and my hope is that they will yield a different result. As a third and final strategy, to avoid the unfavorable law that has developed in the last few years, the FTC could altogether side-step claims that these agreements are collusive horizontal agreements in violation of Section 1 of the Sherman Act and challenge these practices under Section 5 of the Federal Trade Commission Act which gives us broad (and largely undefined) authority to challenge ―unfair methods of competition‖ but which does not provide an escape from the Noerr-Pennington doctrine. As I discussed in a speech last month,31 one proper use of Section 5 might be in those contexts where proceeding under Section 5 will have fewer collateral consequences than a challenge under Section 1 or Section 2.32 This is an especially important consideration when federal court private treble damage litigation involving the same conduct is pending or threatened. A plaintiff cannot rely on favorable Section 5 case law in a federal treble damage action. Neither can a federal district court rely on such a decision because the FTC alone can avail itself of Section 5 at the federal level. Thus, a fair argument can be made that, to the extent the FTC really wants to take full

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control over regulating pay-fordelay settlement agreements (as some in Congress have suggested would be advisable), suing under Section 5 – as opposed to Section 1 – would be a better course. At the end of the day, there is of course the question of whether any one of these strategies is the best approach. Perhaps we should simultaneously pursue all of these strategies in an effort to foster more critical thinking on this topic and increase our likelihood of success.

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II. A second issue that the Commission has tackled this year concerns whether Authorized Generics – and more specifically, the entry of Authorized Generics during the 180-day exclusivity period created by Hatch Waxman – are anti- or pro-competitive. As you know, Authorized Generics are prescription drugs that are produced by brand pharmaceutical companies, but are marketed under a private (generic) label at generic prices. Over the past few years, generic manufacturers have argued to the FDA and the courts that the Hatch-Waxman Act bars Authorized Generics from entering the market during the 180day exclusivity period that starts running when a generic makes a Paragraph IV ANDA filing. The FDA has taken the position that it lacks authority to delay entry of Authorized Generics during the 180-day period and has noted that, even if it did have authority, the marketing of Authorized Generics ―appears to promote competition in the pharmaceutical marketplace, in furtherance of a fundamental objective of the Hatch Waxman amendments.‖33 In 2005, the United States Court of Appeals for the D.C. Circuit agreed with the FDA that nothing in the Hatch-Waxman Act prohibits brands from marketing Authorized Generics during the 180-day exclusivity period.34 In March 2006, in response to a request from Senators Grassley, Leahy, and Rockefeller,35 the Commission announced that it would study what effects, if any, Authorized Generics have on pharmaceutical competition.36 The Commission issued an Interim Report over the summer summarizing its findings to date.37 As the Commission‘s Interim Report and the statements that Chairman Leibowitz and I separately issued38 suggest, where one comes out on the debate over the competitive benefit or harm caused by Authorized Generics has boiled down to two issues. First, how and to what extent should the Commission consider whether the entry of Authorized Generics during the 180-day exclusivity period decreases the incentives for generics to bring paragraph IV challenges under Hatch Waxman? The generic pharmaceutical lobby of course claims that the entry of Authorized Generics during this period decreases the incentives for generics to bring Paragraph IV challenges, while advocates of Authorized Generics claim that an Authorized Generic‘s entry lowers prices and is therefore good for consumers.39 Second, to what extent should the fact that Authorized Generics are sometimes used as a pawn in pay-for-delay settlements cause the Commission to limit (or support legislative limitations on) their availability? As I made clear in my concurring statement,40 I believe the answers to these questions from a competition standpoint are straightforward. First, as to whether Authorized Generics should be allowed to enter during the 180-day period, I believe that the Commission‘s main focus – as an antitrust agency – should be on

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whether Authorized Generics are good or bad for consumer welfare. Consumer welfare, in tern, is judged in this context by whether the introduction of Authorized Generics causes prices to increase or overall output to decrease. Thus far, I have seen no evidence of either effect. To the contrary, every bit of data that I have seen so far shows that when AGs enter the market during the 180-day exclusivity period, prices for generic drugs go down. That, of course, is not surprising: when one generic enters the market during the 180-day exclusivity period, it may bring the brand‘s price down slightly, but it still has a ―monopoly‖ so-to-speak over those purchasers interested in buying a generic product. The introduction of an Authorized Generic, of course, upsets that monopoly by creating competition for purchasers of generic drugs and, in turn, further depresses prices for generic drugs. Likewise, from a consumer welfare standpoint, I have not seen evidence suggesting that the entry of Authorized Generics during the 180-day exclusivity period somehow decreases the total output of the particular generic drug at issue (i.e., the total quantity of that generic drug – authorized or not – that comes to market). Indeed, the Interim Report made no attempt to analyze that issue. As to the second issue, from an antitrust perspective, I believe that evaluating whether Authorized Generics are, in some absolute sense, ―good‖ or ―bad‖ based on whether they create additional incentives for parties to enter into pay-for-delay settlements, asks the wrong question. Any analysis that simply assumes (as the Interim Report did) that, because pay-fordelay settlements are bad for consumers, all of the subjects employed in those settlements – including promises to launch or not launch Authorized Generics – are bad, puts the cart before the horse. As I said in my concurring statement, if pay-for-delay settlements that implicate Authorized Generics are a problem, the way to remedy that problem is not to ban Authorized Generics from marketing their products during the 180-day exclusivity period.41 Instead, it is (at most) to analyze the legality of those agreements under the truncated rule of reason and provide that a brand‘s promises not to manufacture AGs will be presumptively illegal, absent proof adduced by the parties to the agreement to justify their agreement.42

III. The final issue that I would like to discuss is the ongoing debate over the pathway to market for follow-on biologics. As most of you no doubt know, biologics are drugs manufactured using living tissues and microorganisms and are classified as ―large molecule‖ drugs in comparison to their ―small molecule,‖ chemically-synthesized equivalents. Biologics are increasingly used to treat arthritis, cancer, diabetes, and other diseases. In theory, followon biologics are like generic drugs in that they provide a lower cost replica of the original large molecule biologic drug. However, because follow-on biologics are not ―identical‖ (in the same way a small molecule generic drug is to its brand counterpart), follow-on biologics pose significant challenges from a regulatory standpoint. Currently, no regulatory pathway exists in the United States for such follow-on biologics to enter the market and compete with their pioneer counterparts.43 One year ago, the Commission held a roundtable to consider issues associated with creating a pathway for follow-on biologics, including the competitive effects of creating such a pathway. Following that roundtable, in June, the FTC released a report that concluded that

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providing the FDA with the authority to approve such FOBs would be an efficient way to bring these lower-priced drugs to market.44 The Report concluded that a 12- to 14-year regulatory exclusivity period was too long to promote innovation by these firms, particularly since they likely will retain substantial market share after FOB entry. The Report also concluded that special procedures to resolve patent issues between pioneer and FOB manufacturers before FDA approval, which are not needed, could undermine patent incentives and harm consumers. Finally, the Report concluded that FOB manufacturers are unlikely to need additional incentives – such as a 180-day marketing exclusivity period – to develop interchangeable FOB products. As a threshold matter, I believe that we need to make sure that we are providing sufficient incentives for pioneer firms to spend the time and money to develop pioneer drugs. My understanding is that the process to develop such drugs takes approximately 8 years. In developing those incentives, there are two issues in my view. First, are the incentives that the Hill is currently debating the right ones? Under the current proposed legislation, a firm developing a pioneer drug will receive patent protection plus an addition period of exclusivity for 12 years. That legislation is contrary to the recommendation that the FTC made in June in its follow-on biologics report, where the FTC concluded that innovative products should not receive additional market exclusivity beyond the term of their patents. It is not clear to me why pioneer firms need more exclusivity than what is already conferred by the patent laws. Moreover, it is inexplicable to me why any statutory exclusivity period should be conferred on drugs whose patentability is suspect (either because there is no prospect of infringement or because the patent is invalid). Second, will the fixes that the Hill is debating create disincentives for generics to enter the market at all? Under the current bill, the generic firm would be required to share with the pioneer all of its information regarding its own developments ostensibly to ensure that they do not infringe on the pioneer‘s patent. That seems like an empty premise if the bill also provides statutory exclusivity on top of the patent. Moreover, that disclosure requirement will chill generic firm development in the first place because all of the trade secretes flowing from development will have to be disclosed. In conclusion, although the answers are not always immediately crystal clear, the Commission has sought to determine what conduct will best facilitate competition (and therefore protect consumer welfare) in each of these three contexts. To be sure, however, the answer that leads to the best competitive framework will not always make the brand lobby happy or the generic lobby happy. Thankfully, however, as an independent Commissioner, I am not beholden to either party of any lobby. That may not always make the Hill or various interest groups happy, but it does mean that I will always listen to both sides carefully and that when I provide you with an opinion about what practices will best facilitate competition, you can be sure that I am bringing my antitrust experience to bear in the interests of consumers.

End Notes 1

In some cases, multiple generic firms file ANDAs on the same day and therefore share the right to 180-days of exclusivity. 21 U.S.C. § 355(j)(5)(B)(iv). 2 In re Cardizem CD Antitrust Litig., 332 F.3d 896, 908 (6th Cir. 2003). Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

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Asahi Glass Co., Ltd. v. Pentech Pharms., Inc., 289 F. Supp. 2d 986, 994 (N.D. Ill. 2003). Id. at 994. 5 Schering-Plough Corp. v. FTC, 402 F.3d 1056 (11th Cir. 2005). 6 Id. at 1065. 7 Id. at 1065-66. 8 Id. at 1066. 9 Id. 10 466 F.3d 187 (2d Cir. 2006). 11 Prof’l Real Estate Investors v. Columbia Pictures Indus., 508 U.S. 49, 60-61 (1993). 12 In re Ciprofloxacin Hydrochloride Antitrust Litig., 544 F.3d 1323 (Fed Cir. 2008). 13 Id., cert. denied, 129 S. Ct. 2828 (June 22, 2009) (No. 08-1194). 14 In re Ciprofloxacin Hydrochloride Antitrust Litig., (2d Cir.) (No. 05-2851). 15 In re Tamoxifen Citrate Antirust Litig., 446 F.3d at 221 (Pooler, J., dissenting). 16 Brief for the United States, In re Ciprofloxacin Antitrust Litig., 21-23 (2d Cir.) (No. 05-2851), available at http://www.justice.gov/atr/cases/f247700/247708.htm. 17 Id. 18 Id. at 27-32. 19 Id. at 29. 20 468 U.S. 95, 109 (1984). 21 476 U.S. 447 (1986). 22 Palmer v. BRG of Georgia, Inc., 498 U.S. 46 (1990) (per curiam). 23 Polygram Holding v. FTC, 416 F.3d 29 (D.C. Cir. 2005). 24 North Texas Specialty Physicians v. FTC, 528 F.3d 346 (5th Cir. 2008). 25 See, e.g., Brief of United States at 13, Joblove v. Barr Labs., Inc. (―In re Tamoxifen Antitrust Litig.‖), No. 06-380 (U.S. May 23, 2007). See also Brief for the United States, In re Ciprofloxacin, supra n. 16 at 26, n.9 (―We have suggested elsewhere that a court could conduct a limited evaluation of the claims in the settled patent litigation rather than conduct a full trial of those claims, U.S. Joblove Br. at 13, but as part of a rule of reason analysis, not as a single decisive determination, id. at 12-13. We acknowledge some tension between statements in our Joblove brief and our current views.‖). 26 See, e.g., In re Cardizem, 332 F.3d 896 (6th Cir. 2003), cert. denied, 543 U.S. 939 (2004); Schering-Plough Corp., 402 F.3d 1056 (11th Cir. 2005), cert. denied, 548 U.S. 919 (2006); In re Tamoxifen, 429 F.3d 370 (2d Cir. 2005), amended, 466 F.3d 187 (2d Cir. 2006), cert. denied, 127 S. Ct. 3001 (2007); In re Ciprofloxacin, 544 F.3d 1323 (Fed Cir. 2008), cert. denied, 129 S. Ct. 2828 (June 22, 2009). 27 In Schering, for example, the court noted that ―there has been no allegation that the‘743 patent itself is invalid‖ and that ―in the absence of any evidence to the contrary, there is a presumption that the ‗743 patent is a valid one, which gives Schering the ability to exclude those who infringe on the patent.‖ Schering, 402 F.3d at 1068 (emphasis added). Similarly, in Asahi Glass, Judge Posner noted that if ―a seller obtain[ed] a patent that it knows is almost certainly invalid‖ and then settled infringement litigation by requiring that the generic competitor not sell the patented products for less than the price specified in the license, ―the patent, the suit, and the settlement would be devices— masks—for fixing prices, in violation of antitrust law.‖ Asahi Glass, 289 F. Supp. 2d at 991. But see Cipro, 544 F.3d at 1337 (―We disagree that analysis of patent validity is appropriate in the absence of fraud or sham litigation.‖). 28 Schering does not reject the use of circumstantial evidence to resolve the issues of validity and/or infringement. To be sure, Schering rejects as a sufficient basis for finding invalidity or non-infringement the existence of a reverse payment, standing alone. Schering, 402 F.3d at 1075 (―Simply because a brand-name pharmaceutical company holding a patent paid its generic competitor money cannot be the sole basis for a violation of the antitrust law. . . ‖). Moreover, in Schering the court said that ―the size of the payment should not dictate the availability of the settlement remedy.‖ Id. Thus, under Schering, the circumstantial evidence of invalidity or non-infringement cannot consist solely of the existence of a reverse payment; nor can the size of the payment, standing alone, dictate findings of invalidity or non-infringement. 29 This circumstantial evidence of course is not dispositive. The brand (and the generic) can introduce evidence to rebut the inference of invalidity and/or noninfringement created by the circumstantial evidence. For example, they may present expert testimony on these issues (which of course can be tested on cross-examination). However, circumstantial evidence of the sort described should be sufficient to create an inference of invalidity and/or non-infringement and hence make out a prima facie case. If not dispelled by contrary testimony (weighed in the light of cross-examination), the circumstantial evidence should also be sufficient to support conclusions of invalidity and/or non-infringement. 30 See C. Scott Hemphill, Paying For Delay: Pharmaceutical Patent Settlement As A Regulatory Design Problem, 81 N.Y.U.L. Rev. 1553 (Nov. 2006). 31 See J. Thomas Rosch, ―Wading Into Pandora‘s Box: Thoughts On Unanswered Questions Concerning the Scope and Application of Section 2 & Some Further Observations on Section 5,‖ Remarks before the LECG Summit

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on Antitrust Law & Economics, Newport, RI (Oct. 3, 2009), available at http://www.ftc.gov/speeches /rosch/091003roschlecgspeech.pdf. 32 Id. at 25. 33 Letter from William K. Hubbard, Associate Commissioner for Policy and Planning, Department of Health & Human Services, to Stuart A. Williams, Chief Legal Officer, Mylan Pharmaceuticals Inc., and James N. Czaban, Heller Ehrman White & McAuliffe LLP (July 2, 2004) at 2, available at http://www.fda.gov/ohrms/dockets/dailys/04/july04/070704/04 p-0261 -pdn000 1 .pdf. 34 Teva Pharm. Indus., Ltd. v. Crawford, 410 F.3d 51 (D.C. Cir. 2005); see also Mylan Pharmaceuticals, Inc. v. FDA, 454 F.3d 270, 271 (4th Cir. 2006) (concluding that the Hatch-Waxman Act ―does not grant the FDA the power to prohibit the marketing of authorized generics during the 180-day exclusivity period‖). 35 See Press Release, Grassley, Leahy, Rockefeller Request Study on Impact of ―Authorized‖ Generics (May 12, 2005), available at http://leahy.senate.gov/press/200505/051205b.html (reprinting Letter to Chairman Deborah Platt Majoras, May 9, 2005). 36 Press Release, FTC Proposes Study of Competitive Impacts of Authorized Generic Drugs (Mar. 29, 2006), available at http://www.ftc.gov/opa/2006/03/authgenerics.shtm; Comment Request, 71 Fed. Reg. 16779, 16780 (Apr. 4, 2006). 37 Federal Trade Commission, Authorized Generics: An Interim Report (June 2009), available at http://www.ftc.gov/os/2009/06/P062105authorizedgenericsreport.pdf. 38 See Statement of Chairman Jon Leibowitz on the Release of the Commission‘s Interim Report on Authorized Generics (June 2009), available at http://www.ftc.gov/os/2009/06/P062105authgenstatementLeibowitz.pdf; Concurring Statement of Commissioner J. Thomas Rosch on the Release of the Commission‘s Interim Report on Authorized Generics (June 2009), available at http://www.ftc.gov/os/2009/06/P062105 authgen concurringrosch.pdf. 39 Compare Letter from Kathleen Jaeger, President & CEO, Generic Pharmaceutical Association, to Office of the Secretary, Federal Trade Commission 3 (June 27, 2006), available at http://www.ftc.gov/os/comments/ genericdrugstudy3/062806gpha.pdf (arguing that the sale of authorized generics during the exclusivity period ―reduces the value of the 180-day exclusivity‖ and diminishes the incentives for generic entry), with Richard E. Coe and M. Howard Morse, Authorized Generics are Good for You: Competition from drug pioneers shouldn‘t trouble the FTC, Legal Times (Apr. 10, 2006), at 37 (―There is little doubt that authorized generics benefit consumers by driving down prices for generic drugs. They are legal under the current regulatory scheme, and the suggestion that their introduction somehow violates antitrust law is baseless.‖). 40 Concurring Statement of Commissioner J. Thomas Rosch on the Release of the Commission‘s Interim Report on Authorized Generics (June 2009), available at http://www.ftc.gov/os/2009/06/P062105 auth genconcurringrosch.pdf. 41 Id. at 3. 42 Id. 43 In 2004, the European Union enacted the world‘s first regulatory system for follow-on biologics. See European Commission Directive 2003/63/EC, Art. 10 (2004). More recently, Canada has also established a pathway for follow-on biologics. See Minister of Health: Health Products, Food and Drug Branch, Draft Guidance for Sponsors: Information and Submission Requirements for Subsequent Entry Biologics (2008), available at: http://www.hc-sc.gc.ca/dhp-mps/brgtherap/activit/consultation/sebpbu/2008- 1 -eng.php. 44 See FTC, Press Release, ―FTC Releases Report on Follow-on Biologic Drug Competition‖ (June 10, 2009), available at http://www.ftc.gov/opa/2009/06/biologics.shtm; Emerging Health Care Issues: Follow-on Biologic Drug Competition: A Federal Trade Commission Report (June 2009), available at http://www.ftc.gov/os/2009/06/P083901biologicsreport.pdf.

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Chapter 4

FEDERAL R&D, DRUG DISCOVERY, AND PRICING: INSIGHTS FROM THE NIHUNIVERSITY-INDUSTRY RELATIONSHIP Wendy H. Schacht

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SUMMARY Public interest in approaches that might provide prescription drugs at lower cost, particularly for the elderly, has rekindled discussion over the role the federal government plays in facilitating the creation of new pharmaceuticals for the marketplace. In the current debate, some argue that the government‘s financial, scientific, and/or clinical support of health-related research and development (R&D) entitles the public to commensurate considerations in the prices charged for any resulting drugs. Others view government intervention in price decisions based upon initial federal funding as contrary to a long-term trend of government promotion of innovation, technological advancement, and the commercialization of technology by the business community leading to new products and processes for the marketplace. The government traditionally funds R&D to meet the mission requirements of the federal departments and agencies. It also supports work in areas where there is an identified need for research, primarily basic research, not being performed in the private sector. Over the past 25 or more years, congressional initiatives have expanded the government‘s role to include the promotion of technological innovation to meet other national needs, particularly the economic growth that flows from the use of new and improved goods and services. Various laws facilitate commercialization of federally-funded R&D through technology transfer, cooperative R&D, and intellectual property rights. The legislated incentives are intended to encourage additional private sector investments often necessary to further develop marketable products. The current approach to technology development attempts to balance the public sector‘s interest in new and improved technologies with concerns over providing companies valuable benefits without adequate accountability or compensation.

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Some question whether or not the current balance is appropriate, particularly with respect to drug discovery. The particular nature and expense of health-related R&D have focused attention on the manner in which the National Institutes of Health (NIH) undertakes research activities. Critics maintain that any need for technology development incentives in the pharmaceutical and/or biotechnology sectors is mitigated by industry access to governmentsupported work at no cost, monopoly power through patent protection, and additional regulatory and tax advantages such as those conveyed through the Hatch-Waxman Act and the Orphan Drug Act. Supporters of the existing approach argue that these incentives are precisely what are required and have given rise to robust pharmaceutical and biotechnology industries. It remains to be seen whether or not decisions related to federal involvement in issues related to pharmaceutical R&D will change the nature of the current approach to government-industry-university cooperation.

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OVERVIEW Public interest in approaches that might provide prescription drugs at lower cost, particularly for the elderly, has rekindled discussion over the role the federal government plays in facilitating the development and marketing of new pharmaceuticals. In the current debate, some argue that the government‘s financial, research, and/or clinical support of health-related R&D entitles the public to commensurate considerations in the prices charged for any resulting drugs. Others view government intervention in price decisions based upon initial federal funding of basic research as contrary to a long-term trend of government promotion of innovation, technological advancement, and the commercialization of technology by the business community leading to new products and processes for the marketplace. The federal involvement in R&D stems, in part, from the understanding that technological advancement is a key element in economic growth. Many of the innovations that stimulate technological progress are rooted in basic research. However, because the returns to basic research accrue to society as a whole and often can not be captured by the firm performing the work, there tends to be underinvestment in these activities. Thus, the government typically funds fundamental research as a ―public good.‖ Concurrently, the government has an interest in ensuring that the results of this enterprise are applied to generate new goods and services to meet the demands of citizens. The benefits of research emerge when innovations are available in the marketplace. In recognition of this, the Congress has passed legislation to facilitate the commercialization of new technology. Government policies implemented over the past 25 or more years include incentives to increase private sector investment in technology development through technology transfer, cooperative R&D, and intellectual property rights. The intent is to encourage academia and industry to commit the necessary, and often substantial, resources required to take the results of federally- supported R&D and generate products or processes to meet market demand. Utilizing patent ownership and facilitating collaborative government-university-industry efforts, the current legislative approach attempts to balance the public‘s need for new technologies and techniques with concerns over providing companies valuable benefits without adequate accountability or compensation. The reservation of certain rights for the

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government that permit federal intervention in specific circumstances associated with health and safety concerns are intended to act as safeguards for the public. Some Members of Congress have questioned the adequacy of the current balance between public and private needs. The particular nature of health-related research and development, and the substantial federal investment in this area (over $30 billion was appropriated to NIH for medical research in FY2009),1 has led critics of the current system to argue that the necessity of incentives is mitigated by such factors as free access to the results of federally funded work, by the monopoly power permitted by patent protection, and by other regulatory and tax advantages such as those conveyed by the Hatch-Waxman Act or the Orphan Drug Act. Therefore, some maintain, a more direct payback should be required including recoupment of public sector financial support or government involvement in price decisions. Others counter that these inducements have played an important role in making the U.S. pharmaceutical and biotechnology industries innovative, productive, and competitive. They point out that while the government contributed to development of the Internet, as well as to the telecommunications, semiconductor, and aviation industries, no one is advocating federal involvement in cost considerations in these areas as they are in the health field. This paper explores the reasons behind government funding of research and development and subsequent efforts to facilitate private sector commercialization of the results of such work. It does not address issues associated with drug costs or pricing. Instead, the report looks at the manner in which the National Institutes of Health (NIH) supports research to encourage the development of new pharmaceuticals and therapeutics, particularly through cooperative activities among academia, industry, and government. The goal is to offer insights concerning the discussion on whether or not use of the results of the federal R&D enterprise warrants government input into price decisions made by the private sector. Concerns surrounding innovation in health-related areas will be explored within the broader context of the government‘s role in facilitating technological progress.

GOVERNMENT SUPPORT FOR R&D The U.S. government is estimated to have spent $147.0 billion for research and development in FY2009 (excluding American Recovery and Reinvestment Act funding).2 Traditionally, the government funds R&D to meet the mission requirements of the federal departments and agencies (e.g., defense, public health, environmental quality). It also supports work in areas where there is an identified need for research, primarily basic research, not being performed in the private sector. Federal funding reflects a consensus that while basic research is the foundation for many innovations, the rate of return to society as a whole generated by investments in this activity is significantly larger than the benefits that can be captured by any one firm performing it.3 ―Government support of basic scientific research represents an example of the government furnishing a good, scientific knowledge, that improves social well-being ... a good that cannot be sold because those who do not pay receive the benefits anyway.‖4 Estimates of a social rate of return on R&D spending over twice that of the rate of return to the inventor of the product often leads to underinvestment by the business community.5 In addition, incentives for private sector financial commitments are

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dampened by the fact that spending for R&D runs a high risk of failure. The rewards of basic research tend to be long-term, sometimes are not marketable, and are not always evident. Congressional initiatives have expanded the government‘s role in R&D to include the promotion of technological innovation to meet other national needs, particularly the economic growth that flows from the commercialization and use of new products and production processes by the private sector.6 Technological advancement is an important factor in the Nation‘s economic growth. Experts widely accept that technical progress is responsible for up to one-half the growth of the U.S. economy and is one principal driving force for increases in our standard of living.7 Historically, industrial expansion was based on the use of technology to exploit natural resources. Today, such growth tends to be founded on scientific discoveries and engineering knowledge (e.g., biomedical applications, electronics) and is even more dependent than before on the development and use of technology. Technology can help drive the economy because it contributes to the creation of new goods and services, new industries, new jobs, and new capital. It can expand the range of services offered and extend the geographic distribution of those services. The application of technologies also can contribute to the resolution of those national problems that are amenable to technological solutions. Technological progress is achieved through innovation, a process by which industry provides new and improved products, manufacturing processes, and services. Research and development are important to this technological advancement in many ways. R&D contributes to economic growth by its impact on productivity. For more than two decades various experts studying the effects of research and development have found that productivity growth in an industry or a firm is generally directly and significantly related to the amount spent previously on R&D in that industry or company. 8 Analysts estimate that one-half of productivity increases (output per person) are the result of investments in research and development.9 Others argue that innovations arising from R&D are the most important ones.10 Profound changes in our society have been brought about by advances in research, resulting in new products and processes in the areas of medicine, semiconductors, computers, and materials, to name just a few. To leverage the substantial federal investment in R&D, government policies and practices provide incentives for private sector utilization of the results of this endeavor to make products and processes for the marketplace. Legislative initiatives (discussed below) facilitate the commercialization of government-funded research and development through mechanisms that encourage government-industry-university collaboration. Joint federal efforts with the private sector offer a means to get government-generated research and technical know-how to the business community where it can be developed, commercialized and made available for use to meet the needs of government agencies or to stimulate economic growth vital to the nation‘s welfare and security. In addition, cooperative ventures among government institutions, companies, and academia allow for R&D to cross traditional boundaries of knowledge and experience. Ideas, expertise, and know-how are combined, facilitating a mix that may lead to more creativity and invention.

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INDUSTRIAL R&D Industry also has an interest in cooperative efforts with government and/or academia. As new technologies are generated and their impact more widespread, industry has had to commit an increasing amount of resources to the performance of R&D. Concurrently, shortened product cycles have led to expanded demands for new technology and higher costs for technology development as reflected in the 54.9% increase in company support for such work between 1997 and 2007 (using constant 2000 dollars).11 The rising expense of research and development has been juxtaposed with increasing international competition and shareholder demands for short- term returns. Thus, partnerships are a result of ―today‘s complex technologies, intense competition, and information overload [that] have required new approaches‖ beyond the funding of scientists to pursue their own interests.12 Cooperative R&D permits work to be done which is too expensive for one company to fund or of marginal value for any given firm. Companies have developed alternative means of acquiring new technologies while controlling the requisite costs. External alliances allow access to innovations without the expense and risks of generating them independently. Thus, collaboration permits firms to acquire the basic research they need from outside organizations. Experts argue that, for certain industries, the more extensive a firm‘s emphasis on external sources of technical knowledge, the greater its total factor productivity growth.13 A survey undertaken by PriceWaterhouseCoopers found ―businesses that outsource [their R&D] are growing faster, larger, and more profitable than those that do not.‖14 The perceived benefits to this approach are reflected in increasing company support for external R&D. In 2005, companies funded $11.7 billion in outside research and development, 5.7% of the total firm financed R&D, up from 3.7% in 1993.15 In the early 1980s, just after the passage of the Bayh-Dole Act, less than 2% of industry funding was directed at extramural research. 16 It should be noted that joint ventures are not always successful due, in part, to failed concepts, cultural differences between companies or organizations, managerial and financial issues, or conflicting goals and objectives. However, studies by PriceWaterhouseCoopers identify numerous benefits that have resulted from partnering including increased sales of existing products; improved competitive position; increased productivity; development of more new products or business lines; and better operations or technology. Of the fastest growing U.S. firms, 56% have partnered in the past three years ―resulting in more innovative products, more profit opportunities—and significantly higher growth rates.‖17 An earlier survey undertaken by the company concluded that ―collaborative growth firms are spending more on new product development while focusing more on bigger winners and on innovation ... [and] ... are not reluctant to go outside their organization to work with others in the development of their innovative new products.‖18 This trend is reflected in the pharmaceutical industry. There are an increasing number of alliances, particularly between large businesses and small biotech companies.19 According to Ernst & Young, the number of strategic alliances in this sector more than doubled from 2005 to 200620 while data from the National Science Foundation indicated a 726% increase in R&D expenditures contracted out in the United States by the pharmaceutical and medicine industries between 2000 and 2005.21 One study found that ―nearly a third of new pharmaceutical products are now developed through alliances.‖22 Other research shows that

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―drugs developed in alliances are more likely to succeed in clinical trials.‖23 It appears that ―merging technological knowledge and skills from different companies improves the innovation process.‖24 In addition to joint projects among companies, industry-university cooperation in R&D provides another important means to facilitate technological innovation. Traditionally, much of the basic research integral to certain technological advancement is funded by the government but performed in academia. Companies are increasingly looking toward this community to provide the underlying knowledge necessary for the development of commercial products without financing the large overhead costs associated with in-house research. A study by the late Professor Edwin Mansfield demonstrated that ―over 10% of the new products and processes introduced in [the 8 industries explored] could not have been developed (without substantial delay) in the absence of recent academic research.‖25 According to David Blumenthal at the Harvard School of Medicine, by the mid to late 1 990s, over 90% of life science companies in the United States had a cooperative relationship with universities.26

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PATENTS Much of this cooperative work, whether government-industry, government-university, industry- university, or industry-industry, is facilitated by the patent system. Patents protect the inventor‘s investments in generating the knowledge that is the basis for innovation. The U.S. Constitution states that patents are intended to promote ―the progress of science and the useful arts.‖ As research and development become more expensive, ownership of title to inventions has been used by the federal government as a means to foster increased private sector activities to generate new and improved products and processes for the marketplace. In an academic setting, the possession of title is expected to provide motivation for the university to license the technology to industry for further refinement and application in expectation of royalty payments. The patent system is grounded in Article I, Section 8, Clause 8 of the Constitution and is intended to stimulate new discoveries and their reduction to practice, commonly known as innovation. The grant of a patent provides the inventor with a means to capture returns to his invention through exclusive rights on its practice for 20 years from date of filing. This is designed to encourage those investments necessary to further develop an idea and generate a marketable technology. At the same time, the process of obtaining a patent places the concept on which it is based in the public domain. In return for a time limited monopoly right to specific applications of the knowledge generated, the inventor must publish the ideas covered in the patent. Proponents argue that, as a disclosure system, the patent can, and often does, stimulate other firms or individuals to invent ―around‖ existing patents to provide for parallel technical developments or meet similar and expanded demands in the marketplace.27 Innovation produces new knowledge. One characteristic of this knowledge is that it is a ―public good,‖ a good that is not consumed when it is used. This ―public good‖ concept underlies the U.S. patent system. As Professor John Shoven points out, ―The use of an idea or discovery by one person does not, in most cases, reduce the availability of that information to others.‖28 Therefore the marginal social cost of the widespread application of that information

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is near zero because the stock of knowledge is not depleted. This is why the federal government funds basic research. ―Ordinarily, society maximizes its welfare through not charging for the use of a free good.‖29 However, innovation typically is costly and resource intensive. Patents permit novel concepts or discoveries to become ―property‖ when reduced to practice and therefore allow for control over their use. They ―create incentives that maximize the difference between the value of the intellectual property that is created and used and the social cost of its creation.‖30 The patent process is designed to resolve the problem of appropriability. If discoveries were universally available without a means for the inventor to realize a return on investments, most commentators are convinced that there would result a ―much lower and indeed suboptimal level of innovation.‖31 Although research is often important to innovation, it appears that, on average, it constitutes approximately 25% of the cost of commercializing a new technology or technique, thus requiring the expenditure of a substantial amount of additional resources to bring most products or processes to the marketplace. The grant of a patent provides the inventor with a mechanism to capture the returns to his invention through exclusive rights on its practice for 20 years from date of filing. That is intended to encourage those investments necessary to further develop an idea and generate a marketable technology. The utility of patents to companies varies among industrial sectors. Patents are perceived as critical in the drug and chemical industries. That may reflect the nature of R&D performed in these sectors, where the results often are relatively easy to reproduce.32 Others have pointed out that drug patents are more detailed in their claims and therefore easier to defend.33 In contrast, studies have found that in many other industries the protection offered by patents is diminished by the ability to invent around the patent and limited by the disclosure of vital information in the patent itself.34 In the aircraft and semiconductor industries patents have not been the most successful mechanism for capturing the benefits of investments. Instead, lead time and the strength of the learning curve were determined to be more important.35 According to one study, in the semiconductor and related equipment industry, secrecy and lead time were deemed significantly more important than patents. Similar findings characterize the aerospace and machine tool industries, among others.36 The degree to which industry perceives patents as effective has been characterized as ―positively correlated with the increase in duplication costs and time associated with patents.‖37 The patent system has dual policy goals—providing incentives for inventors to invent and encouraging inventors to disclose technical information.38 Disclosure requirements are factors in achieving a balance between current and future innovation through the patent process, as are limitations on scope, novelty mandates, and nonobviousness considerations.39 Patents can give rise to an environment of competitiveness with multiple sources of innovation, which is viewed by some experts as the basis for technological progress. This is important because, as Professors Robert Merges and Richard Nelson found in their studies, in a situation where only ―a few organizations controlled the development of a technology, technical advance appeared sluggish.‖40 The patent system has long been subject to criticism, however. Some observers have asserted that the patent system is unnecessary due to market forces that already suffice to create an optimal level of innovation. The desire to obtain a lead time advantage over competitors, as well as the recognition that technologically backward firms lose out to their rivals, may well provide sufficient inducement to invent without the need for further incentives.41 Other commentators believe that the patent system encourages industry

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concentration and presents a barrier to entry in some markets.42 Still other observers believe that the patent system too frequently attracts speculators who prefer to acquire and enforce patents rather than engage in socially productive activity.43 When analyzing the validity of these competing views, it is important to note the lack of rigorous analytical methods available for studying the effect of the patent law upon the U.S. economy as a whole. The relationship between innovation and patent rights remains poorly understood. As a result, current economic and policy tools do not allow us to calibrate the patent system precisely in order to produce an optimal level of investment in innovation. Thus, each of the arguments for and against the patent system remains open to challenge by those who are unpersuaded by their internal logic.

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LEGISLATIVE INITIATIVES Reflecting the importance of cooperative R&D to the government, a series of legislative provisions use intellectual property rights to foster collaboration between all the parties in the research and development enterprise leading to the generation of new and improved products and processes for the marketplace. Both P.L. 9 6-480, the Stevenson-Wydler Technology Innovation Act (known as the ―Stevenson-Wydler Act‖),44 as amended, and P.L. 96-517, Amendments to the Patent and Trademark Act (commonly referred to as the ―Bayh-Dole Act‖ after its two main sponsors, former Senators Birch Bayh and Robert Dole),45 are the basis for efforts at using patents and licensing to facilitate cooperative R&D, technology transfer, and the commercialization of technology supported by the federal government. These laws affect the way the National Institutes of Health, and other government agencies, interact with the academic community and industry in the R&D arena. It is in this area where the sometimes competing goals of prescription drug cost containment and encouragement of technologybased innovations may conflict. While the result of different legislative histories and concerns, the Stevenson-Wydler Act and the Bayh-Dole Act were passed to encourage the use of technologies funded by and/or developed by the federal government in pursuit of the departments‘ and agencies‘ mission requirements. However, they address intellectual property issues that arise from different R&D relationships. The Stevenson-Wydler Act contains provisions concerning assignment of title to inventions arising from collaborative work between federal laboratories and outside cooperating parties where no direct federal funding is involved. The Bayh-Dole Act primarily addresses the distribution of patents resulting from federally-funded research and development performed by outside organizations and prescribes the licensing of governmentowned inventions.46

The Stevenson-Wydler Technology Innovation Act P.L. 96-480, the Stevenson-Wydler Act, as amended, was enacted to encourage use of technologies developed in the federal laboratory system. This is to be accomplished by technology transfer, the process by which technology generated in one organization, in one

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area, or for one purpose is applied in another organization, in another area, or for another purpose. In the defense and space arenas it is often called ―spin-off.‖ The original Act, provided federal departments and agencies with a mandate to transfer technology as well as established mechanisms by which to accomplish this goal. P.L. 99-502, the Federal Technology Transfer Act of 1986 and P.L. 101-189, the FY1 990 Department of Defense Authorizations, amended the law and created cooperative research and development agreements (CRADAs) as a means to undertake the transfer activity. A CRADA is a specific legal document (not a procurement contract) that defines the collaborative venture. It is intended to be developed at the laboratory level, with limited agency review. The work performed must be consistent with the laboratory‘s mission. In pursuing these joint efforts, the laboratory may accept funds, personnel, services, and property from the collaborating party and may provide personnel, services, and property to the participating organization. The government can cover overhead costs incurred in support of the CRADA, but is expressly prohibited from providing direct funding to the industrial partner. The act does not specify the dispensation of patents derived from the collaborative work, allowing agencies to develop their own policies. At the least, the law permits the non-federal collaborating party the ―option to choose an exclusive license for a pre-negotiated field of use for any such invention under the agreement.‖ The laboratory director also may negotiate licensing agreements for related government-owned inventions previously made at that laboratory to facilitate cooperative ventures. In all cases, the government retains certain rights, including a ―nonexclusive, nontransferable, irrevocable, paid-up license to practice the invention or have the invention practiced throughout the world by or on behalf of the Government for research or other Government purposes.‖ Under ―exceptional circumstances,‖ the government may exercise its right to require a party, to which it assigned title or granted exclusive license to an invention, to license the technology to another organization if it is necessary to address health and safety needs not being addressed; to meet requirements for public use specified by federal regulation not being met; or if the cooperating party has not performed its obligations as specified in the agreement. Preference in determining CRADAs is given to small businesses, companies that will manufacture in the United States, or foreign firms from countries that permit American companies to enter into similar arrangements. According to Senate report 99-283 that accompanied the legislation, ―the authorities conveyed by [the section dealing with CRADAs] are permissive‖ to promote the widest use of this arrangement.47 It should be noted that CRADAs are only one form of cooperative activity, but because they can be easily identified and quantified they tend to be the most visible. Other mechanisms include personnel exchanges and visits; licensing of patents; work for others; educational initiatives; information dissemination; the use of special laboratory facilities and centers set up in particular technological areas; cooperative assistance to state and local programs; and the spinoff of new firms. Currently, federal laboratories legislatively are prohibited from competing with the private sector and can only offer the use of expertise and equipment which is not readily available elsewhere. Technology transfer and cooperative efforts are expressly forbidden to interfere with the laboratories‘ R&D mission-related activities.

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The Bayh-Dole Act P.L. 96-517, the Bayh-Dole Act, evolved out of congressional interest in developing a uniform federal patent policy to promote the utilization of inventions made with the support of the federal research establishment.48 Such action was deemed necessary because, at the time the legislation was under consideration, only 5% of federally-owned patents were being used. While there were several possible reasons for such a low level of utilization (including no market applications), this was thought by many to be one consequence of the practice by most agencies of taking title to all inventions made with government funding while only permitting the nonexclusive licensing of contractor inventions.49 Without title to inventions, or at least exclusive licenses, companies may be less likely to engage in and fund the additional R&D necessary to bring an idea to the marketplace. The Bayh-Dole Act, by providing universities, nonprofit institutions, and small businesses with ownership of patents arising from federally-funded R&D, offers an incentive for cooperative work and commercial application. Royalties derived from intellectual property rights provides the academic community an alternative way to support further research and the business sector a means to obtain a return on their financial contribution to the endeavor. Each nonprofit organization (including universities) or small business is permitted to elect (within a reasonable time frame) to retain title to any ―subject invention‖ made as a result of R&D funded by the federal government; except under ―exceptional circumstances when it is determined by the agency that restriction or elimination of the right to retain title to any subject invention will better promote the policy and objectives of this chapter.‖50 The owner of the intellectual property must commit to commercialization of the patent within a predetermined time frame agreed to by the supporting agency and the performing organization. As stated in the House report to accompany the bill, ―the legislation establishes a presumption [emphasis added] that ownership of all patent rights in government funded research will vest in any contractor who is a nonprofit research institution or a small business.‖51 Certain rights are reserved for the government to protect the public interest. The government retains ―a nonexclusive, nontransferable, irrevocable, paid-up license to practice or have practiced for or on behalf of the United States any subject invention throughout the world ... .‖ The government also retains ―march-in rights‖ that enable the federal agency to require the contractor (whether he owns title or has an exclusive license) to ―grant a nonexclusive, partially exclusive, or exclusive license in any field of use to a responsible applicant or applicants ... ‖ with due compensation, or to grant a license itself under certain circumstances. The special situation necessary to trigger march-in rights involves a determination that the contractor has not made efforts to commercialize within an agreed upon time frame or that the ―action is necessary to alleviate health or safety needs ... ‖ that are not being met by the contractor (15 U.S.C. sec. 203). The Bayh-Dole Act also addresses the licensing of inventions to which the government retained title typically because of past agency practices or because of a public interest. Title 35 U.S.C. §209 proscribes the licensing of this type of invention. The law permits federal departments to offer nonexclusive, exclusive, or partially exclusive licenses under certain conditions and with specific rights retained by the government. These include the right to terminate the license if commercialization is not pursued as provided in the business plan or if the government needs the license for public use. The agencies are required to inform the

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public about the availability of a patent for licensing. Notices are to be published in the Federal Register for a period of three months and if a company displays intent to license, the laboratory must place an additional notice and offer 60 days for objections. In providing licenses, small businesses are given preferences and licensees must agree that ―any products embodying the invention or produced through the use of the invention will be manufactured substantially in the United States.‖

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NIH-UNIVERSITY-INDUSTRY COLLABORATION: THE RESULTS The primary mission of the National Institutes of Health ―is science in pursuit of fundamental knowledge about the nature and behavior of living systems and the application of that knowledge to extend healthy life and reduce the burdens of illness and disability.‖52 To achieve this, NIH funds over $29 billion of both in-house and extramural R&D; 10% of this total is for work within NIH laboratories and 80% goes to contractors, primarily universities and non-profit research institutions.53 Simultaneously, the Stevenson-Wydler Technology Innovation Act and the BayhDole Act provide the agency with the ―statutory mandate to ensure that new technologies developed in those laboratories are transferred to the private sector and commercialized in an expeditious and efficient manner.‖54 Thus, NIH is faced with two interrelated goals: ―promoting the health of the American people and all mankind through research in the biosciences, and fostering a vigorous domestic biotechnology industry.‖55 While the legislation discussed in this paper provides a general framework within which to achieve some of these objectives, there are specific issues associated with health research that have generated concerns not raised in other industrial sectors. Given the particular interest in health-related R&D, the increased commercial potential, and cost considerations, questions are being raised within Congress as to the adequacy of current arrangements. Most experts agree that closer cooperation can augment funding sources (both in the public and private sectors), increase technology transfer, stimulate additional innovation, lead to new products and processes, and expand markets. Yet, others point out that collaboration may provide an increased opportunity for unfair advantages, excessive private sector profits at the expense of the public, conflicts of interest, redirection of research, and less openness in sharing of scientific discovery.

Intramural Research Intramural research performed at the National Institutes of Health accounts for approximately 10% of the NIH budget. Typically, NIH keeps title to inventions made in its laboratories. In FY2009, NIH (and FDA) scientists filed 353 invention disclosures and 156 new U.S. patent applications, while 110 patents were issued. During the fiscal year, 215 licenses were executed and $91.2 million in royalties collected on existing licenses. This is in contrast to 10 years earlier in FY1 999 when 294 inventions were disclosed, 169 patent applications filed, and 163 patents issued. At that time, 204 licenses were executed and royalty payments totaled $44.6 billion. Over the FY1999-FY2009 time period, $760.7 million in royalties were generated from licenses on NIH-owned patents.56

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To date, NIH has identified 26 FDA approved products that have been developed with technology from the NIH intramural research program.57 It should be noted that NIH did not develop the final product; technologies derived from NIH supported research are involved in producing or administering the product.58 According to the General Accounting Office (now the Government Accountability Office), NIH was responsible for 95% of the royalties collected by six agencies (Department of the Army, Department of the Navy, Department of the Air Force, Department of Energy, and the National Aeronautics and Space Administration) studied between 1996 and 1998. In addition, NIH had the largest number of licensing agreements during this time.59 A 2009 report by the Department of Commerce, National Institute of Standards and Technology, found that income from technologies licensed by the Department of Health and Human Services (HHS) accounted for 5 9.2% of the total amount of license fees collected by all federal laboratories during FY2007.60

Policies The articulated policy of the Public Health Service (PHS), the parent agency of NIH, as well as the Food and Drug Administration, and the Centers for Disease Control, is to ―ensure that new technologies developed in those laboratories are transferred to the private sector and commercialized in an expeditious and efficient manner‖ while protecting the public interest.61 The policies associated with the patenting and licensing of inventions made within NIH are designed to ―balance new product development with appropriate market competition.‖62 Cooperative Research and Development Agreements (CRADAs) must reflect the mission requirements of NIH and not divert resources from the agency‘s mandate.63 It also is expected that scientific input from the collaborating party will advance the capabilities of government scientists in their work. In this environment, ideas and results are to be discussed openly. Publication of the knowledge generated by NIH-supported research is required, after providing time to apply for patent protection. To support the transfer of technology and the widespread use of the intellectual property, as well as to further a longstanding tradition of scientific freedom, PHS research results are published freely. Publication of research is not to be significantly delayed for the purpose of either filing patent applications on patentable subject matter, or conducting further research to develop patentable subject matter.64

NIH practice is to patent inventions arising from intramural R&D within the provisions of the law and to transfer the technology through the use of licensing whenever possible instead of assignment of patent title to the outside entity. The organization ―will seek patent protection on biomedical technologies only when a patent facilitates availability of the technology to the public for preventive, diagnostic, therapeutic, or research use, or other commercial use.‖65 Under a CRADA, the producing Party will retain ownership of and title to all CRADA Subject Inventions, all copies of CRADA Data, and all CRADA Materials produced solely by its employee(s). The Parties will own jointly all CRADA Subject Inventions invented jointly and all copies of CRADA Data and all CRADA Materials developed jointly. 66

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Typically, the collaborating party has the option to elect an exclusive (or nonexclusive) license to any subject invention not made solely by an employee of this collaborating entity. Accordingly, the terms of the license will fairly reflect the nature of the CRADA Subject Invention, the relative contributions of the Parties to the CRADA Subject Invention and the CRADA, a plan for the development and marketing of the CRADA Subject Invention, the risks incurred by the Collaborator and the costs of subsequent research and development needed to bring the invention to the marketplace.67

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Decisions on licensing are to be made to ―ensure development of each technology for the broadest possible applications, optimizing the number of products developed from PHS technology.‖ Thus, non-exclusive or co-exclusive licenses are used if possible; exclusive licenses are to be for specific indications or fields of use. When a mandatory exclusive license is used as under a CRADA, NIH requires that the licensee grant sublicenses to ―broaden the development possibilities when necessary for the public health.‖ The resulting technology is to be made available for research purposes. Technologies licensed to industry are required to be expeditiously commercialized, ―offered and maintained for sale, and made reasonably accessible to the public.‖ The public interest is maintained through efforts to encourage development of competing products and through royalty-bearing licenses that reflect ―a fair financial return on the public‘s research investment.‖68

Fair Pricing Clause Prior to 1995, NIH had included what was known as a ―fair pricing clause‖ in its cooperative research and development agreements and many licensing arrangements. In 1989, the Public Health Service (PHS) instituted a policy addressing the pricing of products resulting from a government-owned patent licensed by NIH on an exclusive basis to industry or an invention jointly developed with industry under a CRADA and then licensed exclusively to the collaborator. The language used in the contract stated: Because of [NIH‘ s] responsibilities and the public investment in research that contributes to a product licensed under a CRADA, DHHS [Department of Health and Human Services] has a concern that there be a reasonable relationship between the pricing of a licensed product, the public investment in that product, and the health and safety needs of the public. Accordingly, exclusive commercialization licenses granted for the NIH intellectual property rights may require that this relationship be supported by reasonable evidence.69

While there was no statutory requirement mandating this type of clause, it was instituted in response to public and political pressures resulting from concern over the cost of AZT, a drug used in the treatment of HIV infection. However, according to the NIH, ―AZT was not developed under a CRADA or exclusive license nor, to date, has it been determined that the government has a patentable interest in this medication.‖70 No other federal department or agency, with the exception of the Bureau of Mines, had established such a requirement. The clause was removed in 1995 at the request of Dr. Harold Varmus, then Director of NIH, after a review of the situation and several public hearings. He concluded that the evidence indicated ―the pricing clause has driven industry away from potentially beneficial

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scientific collaborations with PHS scientists without providing an offsetting benefit to the public.‖71 While sharing concerns over the ―potential inaccessibility‖ of drugs due to costs, ―NIH [agreed] with the consensus of the advisory panels that enforcement of a pricing clause would divert NIH from its primary research mission and conflict with its statutory mission to transfer promising technologies to the private sector for commercialization.‖72 A study by the Department of Health and Human Services Inspector General found that companies viewed the clause as a major problem in the NIH CRADA approach.73 Opponents of the clause argued that the uncertainty of the pricing clause exacerbated a process already fraught with risk. According to industry sources, not knowing what the determination of ―fair‖ pricing would be at the end of a long and expensive research, development, and commercialization process was a strong deterrent to entering into cooperative arrangements. Many of the pharmaceutical and biotechnology companies declined to undertake CRADAs. Some firms even declined opportunities for joint clinical trials with NIH in anticipation of future price control demands. At the public hearings most of the patient advocacy groups called for repeal of the fair pricing clause. NIH reportedly was reluctant to make definitive decisions on pricing. At that time, reasonable pricing was defined as a price within the range of existing therapies.74 However, a differentiation was made between the reasonable pricing clause and ―price setting:‖ the latter was seen as regulation and had been considered inappropriate for NIH. According to 1991 testimony of Dr. Bernadine Healy, then Director of NIH, the laboratory was ―probably ... unqualified‖ to undertake drug pricing because it has not been involved in such activities. Instead, NIH ―should approach fair pricing as a co-inventor of a fundamental discovery and use ... leverage as an agency that knows what we brought to the table.‖ Dr. Healy maintained that the laboratory should not be ―too intrusive‖ or get ―too involved in the financial and proprietary activities of companies.‖75

Source: National Institutes of Health, Office of Technology Transfer http://www.ott..nih.gov/about_nih/ statistics.html. Figure 1. NIH CRADAs

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The effect of abandoning the clause was immediate. Subsequent to rescission of the clause in April 1995, the number of CRADAs executed by NIH increased substantially (see Figure 1).

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Extramural Research Extramural research, primarily at universities or medical centers, comprises the major portion of NIH research funding (approximately 84% of the total). Under law mandated by the Bayh-Dole Act, federal departments and agencies do not retain title to inventions made with government funding when the research is performed by an outside contractor. Since the federal organization does own the patent, it does not receive royalty payments for any licensing agreements. Nor does the agency have direct say, other than as provided in the Bayh-Dole Act, in the way these technologies are commercialized. 76 Across all technology areas, the Bayh-Dole Act appears to be successful in facilitating the commercialization of technology.77 The latest published licensing survey by the Association of University Technology Managers (AUTM) found that in FY2007, 686 new commercial products were brought to market, 555 new companies were created, and 5,109 new licenses/options were granted as a result of technology transfer from the academic community.78 In 1980, 390 patents were awarded to universities;79 by 2005, this number increased to 2,725.80 While these figures include all types of R&D, funding for university research in the life sciences comprises by far the largest portion of academic research support. In 2007, 54.3% of total R&D expenditures at academic institutions went to finance the medical, biological, and life sciences. The federal government remains the primary source of this funding.81 The use of this academic research, funded in large part by the federal government, appears to be particularly important to the business community. Studies have found that ―growth companies with university ties have productivity rates almost two-thirds higher than peers.... ‖82 In the pharmaceutical industry, research indicated that over one-quarter of new drugs depended on academic research for timely commercialization.83 ―NIH funded basic research makes a positive and significant contribution to pharmaceutical product innovation.‖84 Further, there is evidence demonstrating that public science, ―research performed in and supported by governmental, academic and charitable research institutions,‖ plays a crucial role in private sector technology development.85 Work prepared for the National Science Foundation indicated that ―public science plays an essential role in supporting U.S. industry, across all the science-linked areas of industry, amongst companies large and small, and is a fundamental pillar of the advance of U.S. technology.‖86 This study demonstrated that of the papers cited in patents granted to U.S. companies during the years 1987-1988 and 1993-1994, 73% were authored at academic, governmental, and other public facilities (domestic or foreign) as compared with 27% from industrial sources. Similarly, research by Professors Cohen, Nelson, and Walsh found ― ... that public research importantly affects industrial R&D in a broad range of industries ... ‖ and ― ... the share of R&D projects affected by public research is likely even greater than that which makes use of either the research findings or the techniques and instruments generated by public research.‖87 The

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biomedical community relies on this basic work more heavily than other industries with 79% of drug and medicine patents citing the results of public science.88 A May 2000 internal study on NIH Contributions to Pharmaceutical Development and a U.S. Congress, Joint Economic Committee report on The Benefits of Medical Research and the Role of the NIH issued the same time, document the part government funded research plays in drug development.89 Scientists supported by the government ―contributed by discovering basic phenomena and concepts, developing new techniques and assays, and participated in clinical applications of the drugs.‖90 While it is often many years before the research is utilized to generate marketable results, top selling pharmaceuticals ―are the result of a great deal of basic research on the disease mechanism which allowed more specific targeting of the underlying problem.‖91 Federal funding is also important in the search for new and additional uses for existing drugs since private sector firms will not use a technology covered by a patent because of infringement issues.92 Results of a study by Professor Andrew Toole demonstrated that ―federally funded basic research is a positive and significant contributing factor in pharmaceutical product innovation.‖93 However, it is often particularly difficult to exactly identify the government‘s contribution to a new drug, particularly since a product typically embodies more than one patent. Generally, there are multiple sources of input from multiple parties in drug development. This is demonstrated by NIH‘s detailed analysis of the top 5 drugs with sales of over $1 billion in 1994 and 1995 cited in the paragraph above. In its 2000 case study, NIH found that [r]esearch may be targeted to the cure of a particular disease, or aimed at understanding basic mechanisms and gaining knowledge for which no immediate application is apparent. Disease-targeted research can be effective in fueling progress in a given area. However, just as often results from other fields of research led to breakthroughs in disease concepts or in drug discovery. These five drugs all arose from both disease-specific and unrelated fields of research.94

In response to congressional direction, the National Institutes of Health looked at 47 FDA- approved drugs that had sales of $500 million or more a year to determine the role of NIHsponsored technologies in their development. As described in the resulting July 2001 report, A Plan to Ensure Taxpayers’ Interests are Protected, ―NIH sought to determine whether the agency, directly, or through a grantee or contractor, held any patent rights to the drugs.‖95 NIH funded technologies were found to have been used in the development of four of these pharmaceuticals: Epogen® and Procrit® are based on different uses of a patented process technology developed at Columbia University with support from NIH grants. Columbia licensed their technology to Amgen for Epogen® and to Johnson & Johnson for Procrit®. Neupogen® is manufactured by Amgen using patented technologies for a process and a composition licensed from Memorial Sloan-Kettering Cancer Center (MSKCC). These technologies were developed with NIH grant support. Taxol® is manufactured by Bristol Myers Squibb (BMS) using a patented process technology developed by Florida State University (FSU) with NIH grant funds. In addition, the NIH has rights to an underlying technology arising from a NIH CRADA collaboration

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with BMS. The NIH has received from BMS tens of millions of dollars in royalties from FY1997 to FY2000 under the license to the NIH technology. 96

A 2003 study by GAO found that government financial support of extramural research and development had resulted in inventions that ―were used to make only 6 brand name drugs associated with the top 100 pharmaceuticals that VA [the Veteran‘s Administration] procured for use by veterans and 4 brand name drugs associated with the top 100 pharmaceuticals that DOD dispensed in 2001.‖97 What these, and other reports document is that ―while NIH‘s federally funded research has contributed in a substantial, dramatic, yet general, way to advances in medicine and biology, the direct contributions to a final therapeutic product as a consequence of the Bayh-Dole process is limited and difficult to determine.‖98 In addition to multiple sources of innovation, tracking the federal contribution is made more difficult by the fact that the government does not retain ownership of inventions made by contractors.

ISSUES AND OPTIONS

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The actual and expected benefits flowing from the biomedical community go beyond economic consideration of the importance of technological progress to the Nation. The potential life saving quality of many of the products associated with this type of R&D provides an additional dimension. In addition to the opportunities to generate profits on sales of products, provide jobs, and stimulate investments, advances in biotechnology and pharmaceuticals also can facilitate economic growth through improvements in productivity resulting from a healthier population. Professor Frank Lichtenberg suggests that the benefits of new drugs include ―longer life, better quality of life, and reductions in total medical expenditure.‖99

Pricing Decisions and Recoupment Federal support for health-related R&D amounts to approximately 22% of the total federal R&D budget, second only to the R&D funding spent for defense. 100 The sizable public sector investment has raised the issue of a more direct return to the federal government and taxpayers for their support of R&D. The significant portion of public resources spent by the government in this arena, and provided to the private sector at no cost, has prompted some observers to call for government involvement in the establishment of some pharmaceutical prices. Others argue that the government should ―recoup‖ its investment from firms using federally supported R&D after profits are generated. Such suggestions are based on several factors. In addition to funding research performed by individual companies, under certain circumstances, the government furnishes the private sector ownership of the intellectual property resulting from this public investment. Patent protection gives firms monopoly rights on these innovations for a specified amount of time. Concurrently, the government has conveyed added and substantial financial, regulatory, and tax advantages through legislation such as the Hatch-Waxman Act and the Orphan Drug Act. According to one commentator, ―the drug industry was able to grow rapidly not only because

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its structure evolved in an atmosphere relatively free from close examination, but also because it developed in a fairly unrestrictive regulatory setting.‖101 Another critic of existing policy, Daniel Zingale, formerly the executive director of AIDS Action, offered the following analogy: ―imagine if General Motors could get the American taxpayer to heavily subsidize its research and development, fund government programs that purchase half of its cars and then get many of those same taxpayers to buy a new car each and every year.‖102 In the late 1990s, an investigation of health-related R&D by the Boston Globe‘s Spotlight Team led them to conclude that pharmaceutical companies are ―piggybacking on government research‖ and then charging ―onerous prices.‖103 In the article it was argued that ―by funding the early stages of research and testing, NIH assumes great risk while reaping few financial rewards.‖ The Globe‘s research indicated that 45 of 50 top-selling drugs resulted from government funding of approximately $175 million. ―The average net profit margin of the companies making those drugs was 14 percent in 1997, more than double the 6 percent average for industrial companies in the Standard & Poor‘s 500.‖ The government typically funds basic research because the resulting knowledge is considered a public good. It is often assumed that incentives, including patent protection, encourage firms to take steps to bring the results of this fundamental research to market. However, it also has been argued that health care has both public and private benefits and is therefore not a classical public good.104 By providing patent protection to the results of federally-funded research, a company receives an individual benefit based upon public investments. According to one observer, the suggestion that incentives for drug development, particularly patent protection, are necessary for innovation in this field may be ―exaggerated, given governmental subsidization of research and development costs.‖105 The public investment in R&D ―replaces some portion of the patent- conferred incentives that are necessary to encourage companies to undertake privately financed research.‖106 For example, it has been argued that the high prices associated with AIDS-related drugs can not be attributed to the high cost of R&D and a lengthy regulatory process because of the substantial federal investment in such research and fast track approval of these drugs.107 Proponents of recoupment and/or federal cost controls assert that the monopoly power of patents should be modified by ―public subsidization‖108 They contend that the public has a right to a return on its investment. However, certain observers claim that ―this right is not preserved under the patent system, which ascribes solely to the patent holder all proprietary rights and interests in the patented product or process.‖ The ―extraordinary gains‖ generated by prices on the resulting drugs ―cannot be explained by the usual ‗incentives‘ rationale for conferring patent monopolies.‖ Instead, those who favor government input into price decisions maintain that the prices of the resulting pharmaceuticals and therapeutics should reflect the public contribution to these products and processes. ―In other words, public support of quasi-public goods must be balanced by some degree of public sharing in the fruits of the investment, as well as input into the nature of that sharing.‖ Critics of policies to recoup federal research support or government involvement in pricing decisions argue that advocates of such actions misunderstand the actual nature of the NIH role in research and pharmaceutical development. They maintain that federal support for basic research reflects a consensus that such work is critical because it is the foundation for many new innovations and that any returns created by this activity are generally long term, sometimes not marketable, and not always evident. Yet the rate of return to society as a whole generated by investments in research is significantly larger than the benefits that can be

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captured by the firm performing the work. According to a study by Professors Iain Cockburn and Rebecca Henderson, the rate of return to government funded biomedical research may be 30% a year, a figure that may actually be higher because calculations do not account for the broader effects of pharmaceutical innovation on health and well-being.109 The National Institutes of Health funds ―basic research aimed at understanding biological mechanisms and gaining knowledge for which no immediate application is apparent has been a vital supply of new ideas, and can only be sustained through public support.‖110 This fundamental knowledge contributes to the general pool of knowledge which industry may use to generate specific products. In the health-related arena, NIH supports research, primarily at universities, directed at the underlying mechanisms of disease; research and knowledge that are applied by the private sector to develop specific treatments for disease.111 Studies demonstrate the ―important role that the public sector plays in providing fundamental insights in basic knowledge as a basis for drug discovery.112 The basic research ―feeds an independent step in the discovery process called the ‗drug concept‘ or ‗rock turning‘ period ... [which] is the very first point in the pharmaceutical innovative process and necessarily precedes chemical synthesis.‖113 This research generally is composed of work supported by the government and publicly available as well as knowledge resulting from internal firm R&D.114 The information and concepts generated by this research have a ―substantial impact‖ on pharmaceutical R&D.115 According to NIH:

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The research supported and conducted by the NIH is sometimes mischaracterized as necessarily resulting in the commercialization of drug products. In truth, much of NIH funding supports the exploration of fundamental biological mechanisms that would otherwise not be pursued due to the lack of market incentives. Such research can lead to early-stage findings and provide clues that may eventually lead to medical advancements for diseases for which existing methods of therapy are nonexistent, inefficient, or suitable only for a select population.116

This is not to imply that the private sector does little in relation to the government in the pharmaceutical arena. Pharmaceutical companies spend more than NIH on R&D; primarily for applied research and development directed at generating new drugs for the marketplace. Some analysts argue that the federal role is overstated because existing studies use citations as a measure of each sector‘s contribution to drug development. This, critics maintain, skews the results because the government encourages, and even requires, publication of research results while industry often discourages such practices.117 What appears to be the case is that benefits move in both directions between the government and the private sector.118 A comprehensive study by NIH of 5 top selling drugs demonstrated ―that public and private sector biomedical research are interwoven, complementary parts of the highly successful U.S. biomedical science endeavor.‖119 Taking the results of this study further, Janice Reichert and Christopher-Paul Milne of the Tufts Center for the Study of Drug Development at Tufts University noted that for the set of drugs looked at by NIH, the government‘s involvement was greatest in the preclinical and clinical development of drugs that were treatments for serious or life-threatening diseases ... [where] there was clearly a public health benefit derived from facilitating the development of these drugs. The NIH was also involved in the discovery

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and/or development of compounds that were in the ―public domain‖ (i.e., knowledge of the existence and method of preparation of the compounds was publicly available before therapeutic potential was identified) ... These types of compounds initially might not have been of interest to the pharmaceutical industry, because possible patent claims were limited.120

Those who oppose changes in the current approach to intellectual property ownership of the results of federally funded R&D argue that the promise of a large return on investment ―is precisely the tool sanctioned by the Constitution to promote the progress of science.‖121 It is because pharmaceuticals and biotechnology are so research intensive that they rely heavily on patents. Intellectual property is important because the ―costs of drug innovation are very high while the costs of imitation are relatively low.‖122 The domestic pharmaceutical industry typically reinvests 8 to 20% of its revenues in R&D, and oftentimes substantially more, in contrast to other industries where the rates are about 3 to 4%, according to testimony presented by Dr. Arthur Levinson, CEO of Genentech.123 Ownership of intellectual property is particularly important to biotechnology companies that typically are small and do not have profits to finance additional R&D. According to the Biotechnology Industry Organization, most of these firms finance research and development from equity capital not profits. Only 5% of biotech companies have sales and therefore depend on venture capital and IPOs.124 Industry advocates maintain the patents are a necessity for raising this equity capital and that price controls would deter investors.125 Thus, some experts maintain that ―the ability of companies to control their discoveries through the establishment of intellectual property rights is fundamental to the competitiveness of [such] industry.‖126 Elimination of the incentives associated with technology transfer and increased R&D through patent ownership and control over intellectual property would reduce innovation according to many experts. Columbia University‘s Frank Lichtenberg states that ―weakening patent protection (e.g. by government violation of patents) may have a chilling effect on private R&D investment, and therefore reduce the health and wealth of future generations.‖127 A similar opinion was expressed by John E. Calfee of the American Enterprise Institute. Noting that, ―one of the least- appreciated effects of faster research and development is to quicken the competitive process itself,‖ Calfee argues that ―although the scientific effort required for new drugs costs a great deal of money, the drugs are worth far more than they cost. Eliminate the financial reward, however, and you cut off the supply.‖128 Dr. M. Kathy Behrens, a director of the National Venture Capital Association, testified at hearings before the Joint Economic Committee on September 29, 1999 that ―health care proposals which impose drug price controls, or Medicare drug benefits which provide marginal reimbursement, can create a perception or reality that the industry‘s potential return is limited or at greater risk.‖129 Other experts concur with this assessment. Research undertaken by Professor John Vernon found ―that pharmaceutical price regulation has a negative effect on firm R&D investment ... [and] could impose a very high cost in terms of foregone medical innovation.‖130 One study has suggested that the threat of price controls during the first Clinton Administration had a detrimental effect on private sector support of pharmaceutical research and development.131 Actual experience and cited studies suggest that companies which do not control the results of their investments—either through ownership of patent title, exclusive license, or pricing decisions—tend to be less likely to engage in related R&D. This likelihood is reflected in the provisions of the Bayh-Dole Act (as well as other laws). Providing

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universities, nonprofit institutions, and small businesses with title to patents arising from federally funded R&D offers an incentive for cooperative work and commercial application. Royalties derived from intellectual property rights provide the academic community an alternative way to support further research and the business sector a means to obtain a return on its financial contribution to the endeavor. While the idea of recoupment was considered by the Congress in hearings on the legislation prior to the act‘s passage in 1980, it was rejected as an unnecessary obstacle, one which would be perceived as an additional burden to working with the government. Policy makers thought such a program to be particularly difficult to administer.132 Instead, Congress accepted as satisfactory the anticipated payback to the country through increased revenues from taxes on profits, new jobs created, improved productivity, and economic growth. For example, according to the MIT Technology Licensing Office, in 1998, 15% of the sales of licensed products derived from federally funded university research was returned to the government in the form of income taxes, payroll taxes, capital gains taxes, and corporate income taxes. This was estimated to be 6 times the royalties paid by companies to the universities.133 The emergence of the biotechnology industry and the development of new therapeutics to improve health care are often cited indications of such benefits.

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Research Tools The focus on intellectual property ownership of the results of federally funded R&D has led some critics to charge that the patenting of fundamental research prevents further biomedical innovation. Law professors Rebecca Eisenberg and Arti Rai argue that due to implementation of the Bayh-Dole Act ―[p]roprietary claims have increasingly moved upstream from the end products themselves to the ground-breaking discoveries that made them possible in the first place.‖134 While patents are designed to spur innovation, Rai and Eisenberg maintain that certain patents hinder the process. From their perspective, permitting universities to patent discoveries made under federal funding, the Bayh-Dole Act ―draws no distinction between inventions that lead directly to commercial products and fundamental advances that enable further scientific studies.‖135 These basic innovations are generally known as ―research tools.‖ Eisenberg and Professor Richard Nelson argue that ownership of research tools may ―impose significant transaction costs‖ that result in delayed innovation and possible future litigation.136 It also can stand in the way of research by others: Broad claims on early discoveries that are fundamental to emerging fields of knowledge are particularly worrisome in light of the great value, demonstrated time and again in history of science and technology, of having many independent minds at work trying to advance a field. Public science has flourished by permitting scientists to challenge and build upon the work of rivals.137

Similar concerns were expressed by Harold Varmus, President of Memorial SloanKettering and former Director of the National Institutes of Health. In July 2000 prepared testimony, he spoke to being ―troubled by widespread tendencies to seek protection of intellectual property increasingly early in the process that ultimately leads to products of

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obvious commercial value, because such practices can have detrimental effects on science and its delivery of health benefits.‖138 While the Bayh-Dole Act and scientific advances have helped generate a dynamic biotechnology industry, there have been changes that ―are not always consistent with the best interests of science.‖139 However, as Varmus and others acknowledge, the remedies to this situation are not necessarily associated with the Bayh-Dole Act or its implementation by NIH. Yale President Richard Levin notes that while some research should be kept in the public domain, including research tools, the fact that it is privatized is not the result of the Bayh-Dole Act, but rather the result of patent law made by the courts and the Congress. Therefore, he believes that changes to the act are not the appropriate means to address the issues.140 Current law, as reaffirmed by court decisions, permits the patenting of research tools. However, there have been efforts to encourage the widespread availability of these tools. Marie Freire, formerly Director of the Office of Technology Transfer at NIH, testified that the value to society is greatest if the research tools are easily available for use in research. She asserted that there is a need to balance commercial interests with public interests.141 To achieve this balance, the National Institutes of Health has developed guidelines for universities and companies receiving federal funding that make clear research tools are to be made available to other scientists under reasonable terms.142 In 1999, NIH issued a policy paper, Sharing of Biomedical Research Resources, Principles and Guidelines for Recipients of NIH Research Grants and Contracts, which ―calls for the sharing of [research] tools among non-profit organizations with minimal terms and impediments.‖143 This approach, now included as a requirement in NIH grants, is reflective of subsequent changes to the BayhDole Act that stated the results of the federal R&D enterprise should be achieved ―without unduly encumbering future research and discovery.... ‖144 In addition, the U.S. Patent and Trademark Office made changes in the guidelines used to determine the patentability of biotechnology discoveries. A study by Professors John Walsh, Ashish Arora, and Wesley Cohen found that although there are now more patents associated with biomedical research, and on more fundamental work, there is little evidence that work has been curtailed due to intellectual property issues associated with research tools. 145 According to this view, scientists are able to continue their research by ―licensing, inventing around patents, going offshore, the development and use of public databases and research tools, court challenges, and simply using the technology without a license (i.e., infringement).‖ According to the authors of the report, private sector owners of patents permitted such infringement in academia (with the exception of those associated with diagnostic tests in clinical trials) ―partly because it can increase the value of the patented technology.‖

Government Rights: Royalty Free Licenses and Reporting Requirements The government retains certain rights under the Bayh-Dole Act to protect the public interest. The act states that the government is provided a ―nonexclusive, nontransferable, irrevocable, paid-up license to practice or have practiced for or on behalf of the United States any subject invention throughout the world.... ‖ This license, commonly known as a ―royalty free license,‖ has been the subject of some discussion including whether or not this permits

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government purchasers to obtain discounts on products developed from federally funded R&D, particularly pharmaceuticals. A July 2003 GAO report addressed this issue and concluded that the license entitles the government to practice or have practiced the invention on the government‘s behalf, but ―does not give the federal government the far broader right to purchase, ‗off the shelf‘ and royalty free (i.e. at a discounted price), products that happen to incorporate a federally funded invention when they are not produced under the government‘s license.‖146 The study states that rights in one patent do not ―automatically‖ permit rights in subsequent, related patents.147 Because the government apparently holds few licenses on the biomedical products it purchases (generally through the Veteran‘s Administration and the Department of Defense),148 federal officials indicated that procurement costs were best reduced by use of the Federal Supply Schedule and national contracts.149 Government licenses are used primarily in the performance of research in the biomedical area.150 A related issue is that of tracking the government‘s interest in patents resulting from federally funded research and development. Under the Bayh-Dole Act, grantees are required to report annually on the utilization of any invention arising from federally funded R&D. The Code of Federal Regulations (37 CFR 404.14(h)) states that these ―reports shall include information regarding the status of development, date of first commercial sale or use, gross royalties received by the contractor, and such other data and information the agency may reasonably specify.‖ [emphasis added] In an August 1999 study, GAO noted that federal contractors and grantees were not meeting the reporting requirements associated with the Bayh-Dole Act, making it difficult to identify and assess what licenses the government retained, among other things.151 Three years later, in a follow-up report, GAO stated that four of the five agencies had taken steps to insure improved compliance with the law including several new monitoring systems, although more needed to be done. 152 To keep track of inventions subject to the Bayh-Dole Act, in 1995 NIH created Interagency Edison (iEdison), an Internet-based reporting system (that is also used by other federal agencies). In response to the findings of GAO, suggestions by the NIH Interagency Edison Working Group, and recommendations contained in the report A Plan to Ensure Taxpayers’ Interests are Protected, new reporting requirements were implemented effective January 1, 2002 that include ―the commercial name of any FDA-approved products, utilizing any subject invention, which have reached the market during the annual reporting period.‖153

CONCLUDING OBSERVATIONS To date, the U.S. system of research, development, and commercialization has had a clear impact on the pharmaceutical and biotechnology industries. Policies concerning funding for research, intellectual property protection, and cooperative R&D have played an important part in the economic success of these sectors.154 American pharmaceutical firms have ―consistently maintained a competitive edge in international markets‖ and lead in new drug discoveries.155 According to industry sources, U.S. investment in health-related R&D exceeds all other countries156 and has demonstrated a pattern of R&D investment that has increased at approximately twice the rate of R&D growth in Europe.‖157 Incentives for innovation in the industrial community clearly have contributed to substantial research and development by the pharmaceutical and biotechnology sectors. In

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2008, total pharmaceutical industry spending on R&D was estimated to be $65.2 billion.158 Domestic R&D spending for members of the Pharmaceutical Researchers and Manufacturers Association (PhRMA) in 2008 was $38.4 billion with 20.3% of domestic sales reinvested in research and development.159 The industry employs approximately 291,000 individuals in highly skilled jobs.160 American biotechnology companies spent $30.4 billion on R&D, generated $57.0 billion in product sales, and produced $70.1 billion in revenue during 2008.161 An industry that did not exist 25 years ago, U.S. biotechnology has provided new products and processes for the international marketplace, including more than 200 biotech drugs and vaccines, with potential for many more advances. Some observers question whether or not there are unintended consequences to current policies and programs related to innovation that may need to be addressed. As discussed in this paper, the current legislative approach promotes the private sector use of the results of federally funded research and development, particularly through incentives to cooperative activities among government, industry, and academia. This approach attempts to balance the public‘s interest in new or improved products and processes for the marketplace with concerns over providing companies valuable benefits without adequate accountability or compensation. In general, incentives for the commercialization of government-supported R&D have been created in response to the argument that the economic benefits to the Nation‘s research investment occur when new goods and services are available to meet public demand, create new jobs, improve productivity, and increase our standard of living. To date, these potential benefits have been considered more important than the initial cost to the government. However, the particular nature of health-related R&D and the substantial federal investment in this area have caused uncertainty over whether or not the present balance is appropriate. Critics of the current approach argue that the need for technology development incentives in the pharmaceutical and/or biotechnology sectors is mitigated by industry access to government- supported R&D at no cost, monopoly power through patent protection, and other regulatory and tax advantages. They maintain that the benefits to industry are such that the public has the right to expect a more direct financial return for the federal investment and, therefore, the government should be permitted to provide input into certain drug pricing decisions. Those who disagree point out that the collaborative public-private environment created by federal policies and practices has generated extraordinary innovation in the pharmaceutical and biotechnology industries. These sectors have provided significant benefits to the health and well-being of the Nation. It remains to be seen if changes will be made and if the nature of government-industryuniversity cooperation will be altered.

End Notes 1

See http://officeofbudget.od.nih.gov/pdfs/FY09?Final%20Conferrence.pdf. CRS Report R40710, Federal Research and Development Funding: FY2010, coordinated by John F. Sargent Jr., 5. 3 Edwin Mansfield, ―Social Returns From R&D: Findings, Methods, and Limitations,‖ Research/Technology Management, November-December 1991, 24. See also: Charles I. Jones and John C. Williams, ―Measuring the Social Return to R&D,‖ Quarterly Journal of Economics, November 1998, 1119 and Richard R. Nelson and Paul M. Romer, ―Science, Economic Growth, and Public Policy,‖ in Bruce R. Smith and Claude E. Barfield, eds. Technology, R&D, and the Economy, (Washington, The Brookings Institution and the American Enterprise Institute, Washington, 1996), 57. 4 Baruch Brody, ―Public Goods and Fair Prices,‖ Hastings Center Report, March-April 1996, 8. 2

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For a list of relevant research in this area see Council of Economic Advisors. Supporting Research and Development to Promote Economic Growth: The Federal Government’s Role, (October 1995), 6-7. 6 For information on relevant legislation see CRS Report RL33528, Industrial Competitiveness and Technological Advancement: Debate Over Government Policy, by Wendy H. Schacht. 7 Gregory Tassey, The Economics of R&D Policy (Connecticut: Quorum Books, 1997), 54. See also Edwin Mansfield, ―Intellectual Property Rights, Technological Change, and Economic Growth,‖ in: Intellectual Property Rights and Capital Formation in the Next Decade, eds. Charls E. Walker and Mark A. Bloomfield (New York: University Press of America, 1988), 5. 8 Alden S. Bean, ―Why Some R&D Organizations Are More Productive Than Others,‖ Research/Technology Management, January-February 1995, 26. See also: Edwin Mansfield, ―How Economists See R&D,‖ Harvard Business Review, November-December 1981, 98. 9 Zvi Griliches, ―The Search for R&D Spillovers,‖ Scandinavian Journal of Economics, 1992, 29-47. Cited in: Council of Economic Advisors, Supporting Research and Development to Promote Economic Growth: The Federal Government’s Role, October, 1995, 1. 10 Ralph Landau, ―Technology, Economics, and Public Policy,‖ in: Technology and Economic Policy, eds. Ralph Landau and Dale W. Jorgenson (Cambridge: Ballinger Publishing Co. 1986), 5. 11 National Science Foundation, National Patterns of R&D Resources: 2007 Data Update, Table 8, available at http://www.nsf.gov/statistics 12 John Carey, ―What Price Science?‖ Business Week, 26 May, 1997, 168. 13 Alden S. Bean, ―Why Some R&D Organizations Are More Productive Than Others,‖ Research/Technology Management, January-February 1995, 26. 14 PriceWaterhouseCoopers, Trendsetter Newsletter, March 13, 2000, available at http://ww w.barometersurveys.com. 15 Science and Engineering Indicators, 2008, Appendix table 4-50, available at http://www.nsf.gov/statistics append/c4/at04-50.pdf. 16 John E. Jankowski, ―R&D: Foundation for Innovation,‖ Research/Technology Management, March-April 1998, 17. 17 PriceWaterhouseCoopers, ―Partnerships Have Big Payoffs for Fast-Growth Companies,‖ Trendsetter Barometer, August 26, 2002, available at http://www.barometersurveys.com. 18 Coopers and Lybrand, L.L.P., ―Partnerships Pay off for Growth Companies,‖ Trend Setter Barometer, 6 January, 1997, available at http://www/barometersurveys.com. 19 Patricia M. Danzon, Sean Nicholson, Nuno Sousa Pereira, Productivity in Pharmaceutical-Biotechnology R&D: The Role of Experience and Alliances, National Bureau of Economic Research, Working Paper 9615, April 2003, 5 available at http://www.nber.org/papers. See also, Nadine Roijakkers and John Hagedoorn, Inter-firm R&D Partnering in Pharmaceutical Biotechnology since 1975: Trends, Patterns, and Networks, Research Policy, April 2006, 444. 20 Ernst & Young, Beyond Borders, Global Biotechnology Report 2007, 29, available at http://www.ey.com/ beyondborders. 21 Science and Engineering Indicators, 2008, Appendix table 4-51, A4-82 22 Jon Hess and Elio Evangelista, ―Pharma-Biotech Alliances,‖ Contract Pharma, September 2003, available at http://www.contractpharma.com/articles/2003/09/pharmabiotech-alliances 23 Patricia M. Danzon, Sean Nicholson, Nuno Sousa Pereira, Productivity in Pharmaceutical-Biotechnology R&D: The Role of Experience and Alliances, Journal of Health Economics 24, 2005, 319. 24 Francis Bidault and Thomas Cummings, ―Innovating Through Alliances: Expectations and Limitations,‖ R&D Management, January 1994, 33. 25 Edwin Mansfield, ―Academic Research and Industrial Innovation: An Update of Empirical Findings,‖ Research Policy 26, 1998, 775. 26 David Blumenthal, ―Academic-Industrial Relationships in the Life Sciences,‖ The New England Journal of Medicine, December 18, 2003, 2453. 27 For more information see CRS Report 97-599, Patents and Innovation: Issues in Patent Reform, and CRS Report 98- 862, R&D Partnerships and Intellectual Property: Implications for U.S. Policy, both by Wendy Schacht. 28 John B. Shoven, ―Intellectual Property Rights and Economic Growth,‖ in eds. Charls Walker and Mark A. Bloomfield, Intellectual Property Rights and Capital Formation in the Next Decade (New York, University Press of America, 1988), 46. 29 Robert P. Benko, ―Intellectual Property Rights and New Technologies,‖ in Intellectual Property Rights and Capital Formation in the Next Decade, 27. 30 Stanley M. Besen and Leo J. Raskind, ―An Introduction to the Law and Economics of Intellectual Property,‖ Journal of Economic Perspectives, Winter 1991, 5. 31 Kenneth W. Dam, ―The Economic Underpinnings of Patent Law,‖ Journal of Legal Studies, January 1994, 247. 32 Henry Grabowski, ―Patents, Innovation and Access to New Pharmaceuticals,‖ Journal of International Economic Law, December 2002, 849.

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33

Levin, Richard C. and Alvin K Klevorick, Richard R. Nelson, and Sidney G. Winter. Appropriating the Returns for Industrial Research and Development, Brookings Papers on Economic Activity, 1987, printed in The Economics of Technical Change, ed. Edwin Mansfield and Elizabeth Mansfield. (Vermont, Edward Elgar Publishing Co., 1993), 255 and 257. 34 Wesley M. Cohen, Richard R. Nelson, and John P. Walsh, Protecting Their Intellectual Assets: Appropriability Conditions and Why U.S. Manufacturing Firms Patent (or Not), NBER, February 2000, available at http://www.nber.org/papers/w7552. 35 Appropriating the Returns for Industrial Research and Development, 253. 36 Protecting Their Intellectual Assets: Appropriability Conditions and Why U.S. Manufacturing Firms Patent (or Not), Table 1. 37 Appropriating the Returns for Industrial Research and Development, 269. 38 Robert P. Merges, ―Commercial Success and Patent Standards: Economic Perspectives on Innovation,‖ California Law Review, July 1988, 876. 39 The Economic Underpinnings of Patent Law, 266-267. Scope is determined by the number of claims made in a patent. Claims are the technical descriptions associated with the invention. In order for an idea to receive a patent, the law requires that it be ― ... new, useful [novel], and nonobvious to a person of ordinary skill in the art to which the invention pertains.‖ 40 Robert P. Merges and Richard R. Nelson, ―On the Complex Economics of Patent Scope,‖ Columbia Law Review, May 1990, 908. 41 See Frederic M. Sherer, Industrial Market Structure and Economic Performance (1970), 384-387. 42 See John R. Thomas, ―Collusion and Collective Action in the Patent System: A Proposal for Patent Bounties,‖ University of Illinois Law Review (2001), 305. 43 Ibid. 44 15 U.S.C. sec. 3701 and following. 45 35 U.S.C. sec. 200 and following. 46 For a detailed discussion of the legislative provisions of the Stevenson-Wydler Act and the Bayh-Dole Act see CRS Report RL33527, Technology Transfer: Use of Federally Funded Research and Development; CRS Report RL32076, The Bayh-Dole Act: Selected Issues in Patent Policy and the Commercialization of Technology; and CRS Report RL30320, Patent Ownership and Federal Research and Development (R&D): A Discussion on the Bayh-Dole Act and the Stevenson-Wydler Act, all by Wendy H. Schacht. 47 Senate Committee on Commerce, Science, and Transportation, Federal Technology Transfer Act of 1986, Report to Accompany H.R. 3773, 99th Cong. 2nd sess., 1986, S.Rept. 99-283, 10. 48 House Committee on Science and Technology, Government Patent Policy, 95th Cong., 2nd sess., May 1978, H.Rept. Prt. 4. 49 Government Patent Policy, 5. 50 Ibid. 51 Federal Technology Transfer Act, Report to Accompany H.R. 6933, 3. 52 National Institutes of Health, About NIH, available at http://www.nih.gov/about/. 53 See http://www.officeofbudget.od.nih.gov/UI/2008/Congressional%20Approps.pdf and http://www.nih.gov/about/ budget.htm. 54 Office of Technology Transfer, National Institutes of Health, Public Health Service (PHS) Patent Policy, available at http://ott.nih.gov/policy 55 President‘s Council of Advisors on Science and Technology. Achieving the Promise of the Bioscience Revolution: The Role of the Federal Government. Washington, December 1992. Introductory letter, no page number. 56 Information on NIH patent and licensing procedures in this section, unless otherwise noted, is available at http://ott.nih.gov/about_nih/statistics 57 National Institutes of Health, FDA Approved Therapeutic Drugs and Vaccines Developed with Technologies From the Intramural Research Program at the National Institutes of Health, available at http://ott.nih.gov/about_nih/ fda_approved_products.aspx. 58 Mark L. Rohrbaugh, NIH: Moving Research from the Bench to the Bedside, Testimony before the House Committee on Energy and Commerce, Subcommittee on Health, July 10, 2003 available at http://ott.nih.gov. 59 General Accounting Office, Technology Transfer: Number and Characteristics of Inventions Licensed by Six Federal Agencies, GAO/RCED-99-173, June 1999, 6, 7. 60 National Institute of Standards and Technology, U.S. Department of Commerce, Summary Report on Federal Laboratory Technology Transfer, Fiscal Year 2007, January 2009, 14 and 15, available at http://patapsco.nist.gov/ts/ 220/external/Federal _Lab _Tech _Transfer _Report _Congress _2007.pdf. 61 Public Health Service (PHS) Patent Policy. 62 National Institutes of Health, A Plan to Ensure Taxpayers’ Interests are Protected, ―Technology Transfer Mission Statement,‖ Appendix A-3.3, July 2001, available at http://ott.nih.gov/policy 63 Office of Technology Transfer, National Institutes of Health, Cooperative Research and Development Agreements (CRADAs) and Material Transfer Agreements (MTAs), available at http://ott.od. nih.gov/cradas/model_agree.html.

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Public Health Service (PHS) Patent Policy. Ibid. 66 Office of Technology Transfer, National Institutes of Health, PHS Model CRADA, 2005, available at http://ott.nih.gov/doc/CRADAModel2005.doc. 67 Ibid. 68 Office of Technology Transfer, National Institutes of Health, Public Health Service (PHS) Licensing Policy, available at http://ott.nih.gov/policy 69 National Institutes of Health, ―Press Release and Backgrounder,‖ NIH News, April 11, 1995, 7. 70 Ibid., 4. 71 Ibid., 1. 72 Ibid., 3. 73 Reginald Rhein, ―Will NIH‘s Fair Price Clause Make CRADAs Crumble?,‖ The Journal of NIH Research, March 1994, 41. 74 NCI Seeking Prices for CRADA Products in Line with Existing Therapies; Indigent Care Important, The Blue Sheet, January 27, 1993, 10. 75 House Committee on Small Business, The National Institutes of Health and Its Role in Creating U.S. HighTechnology Industry Growth and Jobs, Hearing, 100th Cong., 1st sess., December 9, 1991, 22-23. 76 A Plan to Ensure Taxpayers’ Interests are Protected. 77 For a detailed discussion of the impact of this legislation across the federal government see The Bayh-Dole Act: Selected Issues in Patent Policy and the Commercialization of Technology. 78 Association of University Technology Managers, U.S. AUTM Licensing Survey: FY2007, available at http://www.autm.net/AM/Template.cfm?Section=Licensing_Surveys_AUTM&TEMPLATE=/CM/ ContentDisplay.cfm&CONTENTID=3958. 79 National Science Board, Science and Engineering Indicators—1993, National Science Foundation, Washington, 430. 80 U.S. Patent and Trademark Office, Utility Patents Assigned to U.S. Colleges and Universities, available at http://www.uspto.gov/web 81 National Science Foundation, Division of Science Resources Statistics, Survey of Research and Development Expenditures at Universities and Colleges, FY2007, available http://www.nsf.gov/statistics 82 Coopers and Lybrand L.L.P., ―Growth Companies with University Ties Have Productivity Rates Almost TwoThirds Higher Than Peers,‖ Trend Setter Barometer, January 26, 1995, 1. 83 Nathan Rosenberg and Richard R. Nelson, ―American Universities and Technical Advance in Industry,‖ Research Policy, May 1994, 344. 84 Andrew Toole, The Impact of Public Basic Research on Industrial Innovation: Evidence from the Pharmaceutical Industry, May 9, 2008, 4, available at https://editorialexpress.com/cgi-bin/conference IIOC2008&paper_id=1 15. 85 G. Steven McMillian, Francis Narin, and David L. Deeds, ―An Analysis of the Critical Role of Public Science in Innovation: The Case of Biotechnology,‖ Research Policy, 2000, 1. 86 Francis Narin, Kimberly S. Hamilton, and Dominic Olivastro, The Increasing Linkage Between U.S. Technology and Public Science, paper presented to the House Committee on Science, March 17, 1997, 15. 87 Wesley M. Cohen, Richard R. Nelson, and John P. Walsh, ―Links and Impacts: The Influence of Public Research in Industrial R&D,‖ Management Science, January 2002, 21. 88 Francis Narin, Kimberly S. Hamilton, and Dominic Olivastro, ―The Increasing Linkage Between U.S. Technology and Public Science,‖ Research Policy, 1997, 328. See also: G. Steven McMillan, Francis Narin, and David Deeds, ―An Analysis of the Critical Role of Public Science in Innovation: The Case of Biotechnology,‖ Research Policy, 2000, 1. 89 National Institutes of Health, NIH Contributions to Pharmaceutical Development, Case Study Analysis of the Top- Selling Drugs, May 2000, administrative document and U.S. Congress, Joint Economic Committee, The Benefits of Medical Research and the Role of the NIH, May 2000, available at http://jec.senate.gov. 90 NIH Contributions to Pharmaceutical Development, Case Study Analysis of the Top-Selling Drugs. 91 Ibid. 92 The Benefits of Medical Research and the Role of the NIH. 93 Andrew A. Toole, The Impact of Public Basic Research on Industrial Innovation: Evidence From the Pharmaceutical Industry, Discussion Paper, Stanford Institute for Economic Policy Research, November 2000, available at http://siepr.stanford.edu/home.html. 94 NIH Contributions to Pharmaceutical Development. 95 A Plan to Ensure that Taxpayers’ Interests are Protected. 96 Ibid. 97 General Accounting Office, Technology Transfer, Agencies’ Rights to Federally Sponsored Biomedical Inventions, July 2003, GAO-03-536, 2. 98 A Plan to Ensure that Taxpayers’ Interests are Protected. 65

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Frank Lichtenberg, ―Cipro and the Risks of Violating Pharmaceutical Patents,‖ National Center for Policy Analysis, Brief Analysis No. 380, November 15, 2001 available at http://www.ncpa.org/pub/ba/ba38.PDF. 100 National Science Foundation, Federal R&D Funding by Budget Function Fiscal Years 2006-2008, Table 2, available at http://www.nsf.gov/statistics 101 Mary T. Griffin, ―AIDs Drugs and the Pharmaceutical Industry: A Need for Reform,‖ American Journal of Law and Medicine, 1991, 6. 102 Adriel Bettelheim, ―Drugmakers Under Siege,‖ CQ Outlook, September 25, 1999, 10. 103 Alice Dembner and the Globe Spotlight Team, ―Public Handouts Enrich Drug Makers, Scientists,‖ The Boston Globe, April 5, 1998. 104 Steven R. Salbu, ―Aids and Drug Pricing: In Search of a Policy,‖ Washington University Law Quarterly, Fall 1993, 13-14. 105 Ibid., 6. 106 Ibid., 7. 107 AIDS Drugs and the Pharmaceutical Industry: A Need for Reform, 11. 108 Information and quotes in this paragraph from: Aids and Drug Pricing: In Search of a Policy, 5-20. 109 Ian M. Cockburn and Rebecca M. Henderson, Publicly Funded Science and the Productivity of the Pharmaceutical Industry, NBER Conference on Science and Public Policy, April 2000, available at http://www.nber.org. 110 National Institutes of Health, NIH Contributions to Pharmaceutical Development, Case Study Analysis of the Top- Selling Drugs, Administrative document, May 2000. 111 Ibid. 112 Publicly Funded Science and the Productivity of the Pharmaceutical Industry. 113 The Impact of Public Basic Research on Industrial Innovation: Evidence From the Pharmaceutical Industry. 114 Ibid. 115 Wesley M. Cohen, Richard R. Nelson, and John P. Walsh, ―Links and Impacts: The influence of Public Research on Industrial R&D,‖ Management Science, January 2002. 116 National Institutes of Health, Report to Congress on the Affordability of Inventions and Products, July 2004, 3, available at http://ott.od.nih.gov/policy 117 J anice M. Reichert and Christopher-Paul Milne, ―Public and Private Sector Contributions to the Discovery and Development of ‗Impact‘ Drugs,‖ American Journal of Therapeutics, 2002, 543-555. See also: Charles G. Smith and John R. Vane, ―The Discovery of Captopril,‖ The FASEB Journal, 2003, 788-789. 118 Publicly Funded Science and the Productivity of the Pharmaceutical Industry. 119 NIH Contributions to Pharmaceutical Development, Case Study Analysis of the Top-Selling Drugs. 120 Public and Private Sector Contributions to the Discovery and Development of “Impact” Drugs. 121 Evan Ackiron, ―Patents for Critical Pharmaceuticals: The AZT Case,‖ American Journal of Law and Medicine, 1991, 18. 122 Patents, Innovation and Access to New Pharmaceuticals. 123 U.S. Congress, Joint Economic Committee, Putting a Human Face on Biotechnology: A Report on the Joint Economic Committee’s Biotechnology Summit, February 23, 2000, 5 available at http://www.senate.gov/~jec/ bio_report.htm. 124 Information derived from: Richard Pops, BIO 2004 CEO and Investors Conference Keynote Speech, February 25, 2004 and Biotechnology Industry Organization, Biotechnology Industry Statistics, both available at http://www.bio.org. 125 Drugmakers Under Siege. 126 U.S. Department of Commerce, Office of Technology Policy, Meeting the Challenge: U.S. Industry Faces the 21st Century, The U.S. Biotechnology Industry (Washington, July 1997), 16. 127 Cipro and the Risks of Violating Pharmaceutical Patents. 128 John E. Calfee, ―Why Pharmaceutical Price Controls are Bad for Patients,‖ AEI On the Issues, March 1999 available at http://www.aei.org/oti. 129 Putting a Human Face on Biotechnology: A Report on the Joint Economic Committee’s Biotechnology Summit, 8. 130 John A. Vernon, ―Drug Research and Price Controls,‖ Regulation, Winter 2002-2003, 25. 131 Cipro and the Risks of Violating Pharmaceutical Patents. 132 For example see U.S. House of Representatives, Committee on Science and Technology, Government Patent Policy, Hearings, September 23, 27, 28, 29, and October 1, 1976, 94 th Cong. 2nd sess., 1976; United States Senate, Select Committee on Small Business, Government Patent Policies, Hearings, December 19, 20, and 21, 1977, 95th Cong. 1st sess., 1978; and U.S. Senate, Committee on Commerce, Science, and Transportation, Patent Policy, Hearings, July 23 and 27, and October 25, 1979, 96 th Cong. 1st sess., 1979. 133 Kenneth D. Campbell, ―TLO Says Government Research Pays Off Through $3 billion in Taxes, MIT Tech Talk, April 15, 1998, available at http://web. 134 Arti K. Rai and Rebecca S. Eisenberg, ―Bayh-Dole Reform and the Progress of Biomedicine,‖ American Scientist, January-February 2003, 52.

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Ibid. Rebecca S. Eisenberg and Richard R. Nelson, ―Public vs. Proprietary Science: A Fruitful Tension?,‖ Daedalus, Spring 2002. 137 Ibid. 138 U. S. Congress, House Committee on the Judiciary, Subcommittee on Courts and Intellectual Property, Hearings on Gene Patents and Other Genomic Inventions, July 13, 2000, available at http://www.house.gov/judiciary seve0713.htm. 139 Ibid. 140 National Academy of Sciences, Board on Science, Technology, and Economic Policy, Workshop on Academic IP: Effects of University Patenting and Licensing on Commercialization and Research, April 17, 2001 [transcript], 262 available at http://www.nas.edu. 141 U.S. Congress, Senate Committee on Appropriations, Subcommittee on Labor, Health and Human Services, Education and Related Agencies, Hearings, August 1, 2001. 142 Available on the NIH website at http://www.nih.gov. 143 NIH: Moving Research From the Bench to the Bedside. 144 Ibid., see also P.L. 106-404, Section 6. 145 John P. Walsh, Ashish Arora, Wesley M. Cohen, ―Working Through the Patent Problem,‖ Science, February 14, 2003, 1021, see also John P. Walsh, Charlene Cho, Wesley M. Cohen, ―View for the Bench: Patents and Material Transfers,‖ Science, September 23, 2005, 2002-2003. 146 Technology Transfer: Agencies’ Rights to Federally Sponsored Biomedical Inventions, 7. 147 Ibid., 8. 148 Ibid. 149 Ibid., 12. 150 Ibid., 10. 151 General Accounting Office, Technology Transfer: Reporting Requirements for Federally Sponsored Inventions Need Revision, August 1999, GAO/RCED-99-242, 2. 152 General Accounting Office, Intellectual Property: Federal Agency Efforts in Transferring and Reporting New Technology, October 2002, GAO-03-47, 29. 153 National Institutes of Health, Changes in Grantee/Contractor Reporting of Intellectual Property Utilization, Notice NOT-OD-02-019, December 13, 2001. 154 Iain Cockburn, Rebecca Henderson, Luigi Orsenigo, and Gary P. Pisano, ―Pharmaceuticals and Biotechnology,‖ U.S. Industry in 2000 (National Academy Press, Washington, 1999), 365. 155 Department of Commerce, International Trade Administration, U.S. Industry &Trade Outlook 2000 (McGrawHill, 2000), 11-16. 156 PhRMA, Pharmaceutical Industry Profile 2006, 48, available at http://www.phrma.org. 157 PhRMA, Pharmaceutical Industry Profile 2003, 16, available at http://www.phrma.org. 158 PhRMA, Pharmaceutical Industry Profile 2009, inside front cover, available at http://www.phrma.org. 159 Ibid., inside front cover and 50. 160 Bureau of Labor Statistics, U.S. Department of Labor, Career Guide to Industries, 2006-07 Edition, Pharmaceutical and Medicine Manufacturing, available at http://www.bls.gov/oco/cg/cgs009.htm. 161 Ernst & Young, Beyond Borders, Global Biotechnology Report 2009, 34 available at http://www.ey.com/Global/ assets.nsf/International/Industry_Biotechnology_Beyond_Borders_2008/$file/ Biotechnology_Beyond_Borders_2008.pdf. 136

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In: Pharmaceutical Industry: Innovation and Developments ISBN: 978-1-61209-394-9 Editors: David A. Mancuso and Isobel M. Grenada © 2011 Nova Science Publishers, Inc.

Chapter 5

PHARMACEUTICAL R&D AND THE EVOLVING MARKET FOR PRESCRIPTION DRUGS

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Congressional Budget Office Investment in research and development (R&D) over the past several decades has produced a wealth of valuable new drug therapies that have made it possible to treat major illnesses that were not treated previously or were not treated as effectively. As the scope of available drug therapies expanded, spending on prescription drugs became the fastestgrowing category of total spending on health care in the United States. Between 1994 and 2004, real (inflation-adjusted) spending on prescription drugs rose at an average annual rate of 11.1 percent, compared with 3.5 percent for hospital care and 4.3 percent for physicians‘ services. More recently, however, that growth has slowed: From 2004 to 2007, drug expenditures grew by an average of just 3.2 percent per year, slightly less than the rate of growth in overall health care spending. As a fraction of total spending on health care, spending on prescription drugs rose from 6 percent in 1994 to around 11 percent in 2004, where it has remained (see Figure 1). That slowdown in the rate of growth in spending reflects changes in both the supply of and the demand for prescription drugs. On the supply side, the patents for many top-selling drugs have expired, subjecting them to competition from cheaper generic compounds. The resulting decline in spending on those drugs has not been fully offset by added spending on new brand-name drugs because, at the same time, the rate at which new drugs are being introduced has slowed substantially. On the demand side, many health plans have sought to control the growth in their expenditures by creating stronger incentives for their enrollees to choose generic drugs or cheaper brand-name drugs. Decisions regarding pharmaceutical R&D depend largely on drug manufacturers‘ expectations about future revenues. Expectations about revenues are shaped by the conditions affecting the potential demand for each drug, such as the size of its market, its price, and the amount of competition expected from other drugs. The greater the expected revenue from a prospective new drug, the more willing a drugmaker will be to invest to develop it. Those decisions will help determine which drug therapies become available in the future and thus will affect future growth in health care costs. This brief describes the current state of

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investment in drug R&D and the factors that influence it. It also examines how various policy options to control the growth in health care costs or to expand insurance coverage could affect R&D spending.

Source: Congressional Budget Office based on data on spending for health services and supplies, as defined in the national health expenditure accounts, maintained by the Centers for Medicare and Medicaid Services.

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Figure 1. Spending on Prescription Drugs as a Percentage of Total Spending on Health Services and Supplies, 1980 to 2007

Source: Congressional Budget Office based on data from the Food and Drug Administration. Notes: The data, which are for new molecular entities (NMEs) only, exclude extensions and new approved uses of existing drugs. New molecular entities are drugs based on a molecule not used before in any pharmaceutical product. Priority drugs are those that, according to the Food and Drug Administration, provide a ―significant therapeutic or public health advance.‖ Beginning in 2004, approvals include those for biologics (large-molecule drugs such as monoclonal antibodies, growth factors, and recombinant proteins). The Food and Drug Administration approved five such drugs in 2004 (four given priority status); two in 2005 (both priority drugs); four in 2006 (all priority drugs); two in 2007 (one priority drug); and three in 2008 (two priority drugs). See www.fda.gov/cder/rdmt/default.htm. Figure 2. Average Annual Approvals of New Drugs by the Food and Drug Administration, 1970 to 2008

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Table 1. Changes in Components of Demand for Prescription Drugs, Selected Years, 2000 to 2008 Market Real Expendituresb Prescriptions Share of Average per Total Average Annual Year Filleda Generic c Prescription (Billions of Increase in Total (Billions) Drugs (Dollars) dollars) (Percent) (Percent) 2000 2.9 42 56 178 n.a. 2002 3.1 42 65 215 10.4 2004 3.3 48 70 246 7.2 2006 3.4 53 70 263 3.5 2008 3.5 58d 72 265d 0.8 Source: Congressional Budget Office based on data from U.S. Census Bureau, www.census.gov/prod/2008pubs/09statab/health and National Association of Chain Drug Stores (2008 data are from www.nacds.org/pdfs/Pharmacy/2008CommunityPharmacyResults. pdf). a Includes chain drug stores, independents, mass merchants, supermarkets, and mail-order pharmacies; excludes in-patient prescriptions. b Adjusted for inflation using the gross domestic product implicit price deflator. c Excludes mail order. d Value for 2007.

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The Rate of New-Drug Development The rising-then-slowing pattern of growth in prescription drug spending (shown in Figure 1) is related to the evolving pace of new-drug introductions and patent expirations over the past two decades. Many of the new drugs introduced in the 1 990s enabled physicians to treat previously untreated or undertreated conditions, and growth in spending on prescription drugs naturally accelerated. Drug introductions spiked in the mid- to late 1990s but have declined since 2000—in most years, back to levels not seen since the 1 980s. The introduction of priority drugs—drugs that, according to the Food and Drug Administration (FDA), provide a ―significant therapeutic or public health advance‖—has also slowed, from an average of more than 13 a year in the 1990s to about 10 a year in the 2000s (see Figure 2). With the decline in priority-drug approvals, a key source of rising drug expenditures—a rise in the number of top- selling drugs—has subsided. Between 1996 and 2006, the number of drugs with annual sales of $1 billion or more (in 2000 dollars) increased from 6 to more than 50, and the share of industry revenues produced by those ―blockbuster‖ drugs rose from around 12 percent to nearly 50 percent. Since then, patent expirations and the arrival of competition from generic drugs have apparently reduced the revenue from brand-name drugs more quickly than it is being replaced by revenue from the introduction of new drugs. The number of drugs reaching $1 billion in annual sales, for example, has started to decline.1 For the pharmaceutical industry as a whole, slower revenue growth could continue until sales of new drugs once again outpace revenue losses from expiring patents. Slower revenue growth for drugmakers does not mean that consumers are using fewer prescription drugs. In fact, the number of prescriptions continues to increase, albeit more slowly since 2004 (see Table 1). But generic drugs, which cost less than their brand-name

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counterparts, now comprise a greater share of prescriptions, having increased from 42 percent in 2000 to 58 percent in 2007.

Investment in R&D

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According to Pharmaceutical Research and Manufacturers of America (PhRMA), the industry‘s trade association, member firms spent $50 billion on pharmaceutical R&D in 2008, a 2.6 percent real increase over the amount the previous year (see Figure 3). 2 That increase is unusually small; over the past 30 years, PhRMA has seldom reported less than a 5 percent real annual increase in R&D spending, and the average has been almost 9 percent. Because global drug R&D spending is not estimated consistently over time, it is difficult to know exactly how it has changed. However, PhRMA‘s estimates account for a majority of that spending.

Source: Congressional Budget Office based on data from Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 2009 (Washington, D.C.: PhRMA, April 2009); and National Science Foundation, Federal Funds for Research and Development (various years), www.nsf.gov/statistics. Data from PhRMA members are self-reported. Notes: Spending amounts are adjusted for inflation using the gross domestic product implicit price deflator. PhRMA = Pharmaceutical Research and Manufacturers of America; NIH = National Institutes of Health. a About three-quarters of total spending on research and development (R&D) consists of spending by U.S.-owned companies and U.S. spending by foreign-owned companies; the remaining one-fourth reflects overseas spending on R&D by U.S. subsidiaries of foreign-owned firms. The total excludes non-U.S. R&D spending by non-U.S. companies. Figure 3. Annual Spending on R&D by Drug Companies and on Research by the National Institutes of Health, 1980 to 2008

Pharmaceutical R&D in the private sector is complemented by health-related research funded by the public sector—most of it through the National Institutes of Health (NIH). Much Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

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of that funding is for basic research on the mechanisms of disease, which ultimately supports the discovery of new drug therapies. Public funding has tended to grow more slowly than private drug R&D except from 1998 to 2004, when NIH‘s research funding doubled in real terms (see Figure 3). It subsequently declined by 6 percent over the next four years. However, including the one-time increase of $10.4 billion in stimulus funding provided by the American Recovery and Reinvestment Act of 2009 (ARRA, Public Law 111-5), which remains available through September 2010, real growth in NIH‘s research funding will nearly equal that in private R&D over the 1998–2010 period. Analysts have found that increased public spending on basic (health-related) research stimulates additional private drug R&D.3 Conversely, slower growth in public R&D spending could mean fewer new opportunities for drug development. Basic research can also help reduce the costs of R&D. For example, advances in biomedical science could provide ways to identify potential failure earlier in the development process, reducing the amount spent on failed drugs. In pharmaceutical research, the time and resources spent on drugs that ultimately fail in clinical trials account for a substantial fraction of total R&D spending. Companies‘ R&D expenditures depend on the number of projects, their duration, the probability of failure, and financing costs. Scientific advances can reduce R&D costs for particular kinds of drugs but can also open up new areas of drug development that may be costly to pursue. R&D financing costs can be affected by revenue growth. Established drug companies—those with a variety of drug products on the market—can finance R&D using revenues from sales of existing drugs. If faced with slower revenue growth, however, some firms might turn to outside investors, who—because they know less about the firm‘s research progress and odds of success—would generally demand a higher return to compensate for that uncertainty, slightly raising R&D costs. Real R&D spending per successful new drug has been rising for many years, largely because of growth in the size and length of clinical trials and an increased rate of failure. Those changes generally reflect drug companies‘ strategic choices about which kinds of drugs to pursue— choices that depend on anticipated demand and scientific opportunities. In particular, drug companies are devoting more resources to developing drugs for chronic illnesses.4 In many cases, those drugs require prolonged use, so longer clinical trials are necessary. Development times vary by type of drug but have been averaging about 12 years from discovery through clinical trials to approval by the FDA. Although private drug companies have been pursuing increasingly costly R&D projects, they would not do so if they did not expect to recoup their investment through sales of the resulting drug products.

THE ROLE OF HEALTH INSURANCE IN THE DEMAND FOR PRESCRIPTION DRUGS AND DRUG R&D The scope of health insurance coverage of prescription drugs has been expanding for many years. From 1997 to 2007, the share of consumers‘ total drug expenses paid for by third parties (private health insurance plans and public programs) rose from 67 percent to 79 percent.5 At least partly as a consequence, the number of prescriptions filled has risen substantially, increasing by 72 percent over the same period.6

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Insurance plays a significant role in determining the demand for prescription drugs and, ultimately, drug R&D. By shielding individuals from the full costs of the drugs they use, insurance encourages higher spending on drugs. For example, spending can increase when insured individuals fill prescriptions that they would have forgone if they lacked insurance or when those individuals choose a more expensive drug than they would have if they faced the full cost. Insurance plans have sought to control the growth in their drug expenditures by adjusting the cost-sharing provisions in their policies to encourage beneficiaries to make cost-effective choices. A typical policy now provides generic drugs to beneficiaries in exchange for a relatively small copayment but requires somewhat higher copayments for ―preferred‖ brandname drugs and still higher copayments for ―nonpreferred‖ brand-name drugs. Some brandname drugs may be placed in the preferred tier because of their unique therapeutic benefits; others are put in that tier because the manufacturer has offered the insurance plan a price concession. Copayments for brand-name drugs in the preferred and nonpreferred tiers have been rising more quickly than have those for generic drugs (see Figure 4), strengthening incentives to choose generics. The creation of the Medicare Part D drug benefit in 2006 is a prominent example of how an expansion in coverage affects the demand for prescription drugs and alters incentives to undertake drug R&D. With Part D in place, the fraction of U.S. seniors who have drug coverage increased from about three-quarters before the program began to around 90 percent in early 2009, a gain of around 8 million covered individuals.7 That coverage expansion almost certainly contributed to the growth in the number of prescriptions in recent years, although health plans participating in Part D often give their enrollees incentives to make cost-effective drug choices. Some tentative evidence suggests that, as a result of demographic shifts and increased demand from Medicare beneficiaries, drugmakers are devoting more R&D resources to developing drugs for conditions related to aging.8 That finding is consistent with the more general results from a number of studies showing that spending on drug R&D is responsive to changes in demand: On average, R&D spending has been found to go up by an average of about 1 percent for every increase of 1 percent in potential sales.9 The fraction of the population that is older than 65 is projected to rise from about 13 percent to about 20 percent during the next 20 years.10 That demographic change, combined with the greater demand for drugs resulting from Part D, will continue to influence private R&D investment for some time.

POLICY OPTIONS AND THEIR IMPLICATIONS FOR R&D The federal government finances a large and growing share of prescription drug sales— roughly 29 percent in 2007 compared with less than 15 percent five years earlier—and it faces severe long-term budgetary pressures, with rising health care costs playing a key role. A number of policy options for reducing those costs or for expanding insurance coverage would affect the market for prescription drugs. This section presents a sampling of such options— some of them detailed in the Congressional Budget Office‘s December 2008 report Budget Options, Volume 1: Health Care. All of them have potential implications for the revenues that

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drug companies would expect to earn from new products and, therefore, for the incentives to invest in drug R&D. In general, policies that would lower expectations about revenues would discourage R&D investment, and those that would raise expectations would stimulate R&D. For some policies, the effects on expected revenues would vary by product or therapeutic area; total R&D investment might not be affected, but patterns of R&D resource allocations could be.

Expand Prescription Drug Coverage The Congress is considering proposals that would increase the fraction of the population covered by health insurance. Depending on the breadth of the expansion and the provisions for drug coverage, such proposals would probably increase the quantity of prescription drugs purchased in the United States. A simple expansion in health insurance coverage—for example, broader eligibility criteria for Medicaid—would increase drugmakers‘ current and expected future revenues, making investing in R&D more attractive for drug companies. However, the impact of a major health care reform proposal on incentives to undertake R&D would depend not just on the number of newly covered individuals but also on other factors such as changes in payment policy.

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Expand the Medicaid Rebate Paid by Manufacturers of Brand-Name Drugs In the fee-for-service part of Medicaid, drugmakers pay a rebate to Medicaid for each drug that the program purchases on behalf of its beneficiaries. For brand-name drugs, that rebate has two components. The first part, known as the basic rebate, equals 15.1 percent of a drug‘s average manufacturer price (AMP—the price that the drugmaker receives from sales to retail and mail-order pharmacies) or, if it is greater, the difference between the AMP and the lowest transaction price (the ―best price‖ that the drugmaker receives from sales to certain private buyers). The second part, the additional rebate, equals the difference between a drug‘s current AMP and the AMP at the time it was originally marketed, adjusted for inflation using the consumer price index for urban consumers (CPI-U). (Drugmakers owe no additional rebate if growth in a drug‘s AMP does not exceed growth in the CPI-U.) The President‘s 2010 budget proposes changes to both components of the rebate for brand-name drugs. For the basic rebate, the President‘s budget would raise the flat rebate percentage from 15.1 percent to 22.1 percent, yielding savings for the federal government and state governments.11 A potential drawback is that drugmakers, faced with reduced revenues from Medicaid, might invest somewhat less to develop drugs whose sales would be concentrated in the Medicaid program. The President‘s 2010 budget also includes a proposal to alter the additional rebate by treating many future modifications of existing drugs more like the original product in calculating rebate obligations. Under current law, a drugmaker can avoid the additional rebate by slightly modifying an existing product; doing so establishes a new AMP that can exceed the inflation-adjusted AMP of the old product without triggering an additional rebate. The proposed change would lead to savings for the federal and state governments because rebates

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would increase. That policy would make it somewhat less attractive for drug- makers to improve existing drugs, although if the clinical benefits of those improvements were sufficiently great, manufacturers would still find it worthwhile to develop them because of the higher prices they could command outside the Medicaid market.

Require Drugmakers to Pay a Minimum Rebate on Drugs Covered by Medicare Part D Some proposals would require manufacturers of brand-name drugs to pay the federal government a rebate equal to 15 percent of the price they receive from sales of drugs for Part D beneficiaries to retail and mail-order pharmacies, plus an additional rebate if a drug‘s price grows faster than inflation. Such a policy would reduce, by the amount of those rebates, the manufacturers‘ expected revenues from sales for Medicare beneficiaries. That, in turn, would reduce manufacturers‘ incentives to invest in R&D on products that would be expected to have significant Medicare sales.

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Increase the Availability and Use of Follow-On Biologic Drug Products Biologics—drug products derived from living organisms—constitute a small but growing share of health care spending. Some biologics face competition from other brand-name drugs that have similar therapeutic effects. For example, several competing brand-name biologics are used to treat rheumatoid arthritis. To date, however, brand-name biologics face no competition from follow- on imitators in the way that conventional brand-name drugs do (from generic compounds) when their patents expire. The absence of such competition makes it more difficult for private health plans to negotiate discounts for biologics. The Congress is considering proposals that would establish an abbreviated regulatory pathway for approving follow-on biologics under the Public Health Service Act. (Such proposals aim to create a streamlined process analogous to the one for generic drugs under the Federal Food, Drug, and Cosmetic Act.) Also, the Medicare Payment Advisory Commission (MedPAC) has recommended changes to Medicare‘s payment incentives that would encourage the use of follow-on biologics as they become available. The overall impact of such policy changes on R&D is difficult to predict. An abbreviated regulatory pathway and stronger incentives for doctors or patients to choose follow-on biologics would encourage investment in the development of those imitative products and reduce the expected returns to R&D from original, pioneering biologics. However, there would probably be fewer manufacturers of imitative biologics than there are of conventional generics because biologics are far more complex and more costly to develop than are conventional drugs. So the reduction in the returns to R&D from pioneering biologics—and therefore in the incentives to undertake that R&D—might not be great.

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Pharmaceutical R&D and the Evolving Market for Prescription Drugs

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Source: Congressional Budget Office based on data from Kaiser Family Foundation and Health Research and Educational Trust, Employer Health Benefits: 2009 Annual Survey (Washington, D.C.: Kaiser/HRET, 2009), Exhibit 9.4. Note: Tier 1 (generic) drugs are copies of brand-name drugs whose patents have expired and that therefore may be produced and distributed by multiple drug companies. Tier 2 (preferred) drugs are brand-name drugs that typically are still protected by patents and therefore have no generic substitute. Tier 3 (nonpreferred) drugs are brand-name drugs that typically have a generic substitute. Figure 4. Average Copayment for a Prescription Drug, by Tier, Selected Years, 2000 to 2008

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Incorporate Findings on Comparative Effectiveness into Decisions about Insurance Coverage The Congress recently expanded government support for research on the comparative effectiveness of various medical treatments for patients with particular conditions.12 Many medical experts suggest that creating more data on comparative effectiveness and providing appropriate financial incentives to encourage the use of those data could allow payers to slow the growth in health care costs and also improve the quality of care. If payers could do that, drug companies might invest less in the development of so-called me-too drugs—new products with effects similar to those of an existing class of drug— because they would anticipate earning less revenue from such products if a comparative effectiveness (CE) study showed that they were no better than existing drugs. Drug manufacturers‘ incentives to develop highly innovative, breakthrough products would not necessarily decline, however. The effects of CE data on pharmaceutical revenues are difficult to predict because it is not possible to know beforehand what a CE study would find. (Nor is it possible to know exactly which therapies would be studied.) So it is not clear what effects increased support for CE studies would have on pharmaceutical R&D. Some CE studies might find that a newer, costlier brand-name drug confers few or no added benefits compared with those from cheaper compounds. If payers responded by discouraging the use of that drug, or if they limited its use to a restricted set of patients for whom substantial clinical benefits could be demonstrated, the revenues from that drug would be lower. Other CE studies might find that a particular drug confers benefits comparable with or superior to those from a costly medical procedure. Such a finding would lead to more widespread use of that drug and to higher revenues for its manufacturer.

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Health plans could use findings from CE studies to negotiate more effectively with drug manufacturers over a drug‘s price and its placement within the plans‘ drug formularies. However, such studies can be costly: Because differences between drugs are likely to be narrower than those between a drug and a placebo, CE studies can—for statistical reasons— require larger, more costly clinical trials. Establishing criteria for deciding which treatments to compare could help ensure that resources are expended cost-effectively on CE studies, and public-sector sponsorship of those studies could contribute to greater objectivity in their findings.

End Notes 1

Data on the number and revenue share of drugs with billion- dollar sales are from Murray Aitken, Ernst R. Berndt, and David M. Cutler, ―Prescription Drug Spending Trends in the United States: Looking Beyond the Turning Point,‖ Health Affairs, Web Exclusive (December 16, 2008), pp. W151–W160. 2 See Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 2009 (Washington, D.C.: PhRMA, April 2009), Table 1, p. 50; Table 2, p. 51; Figure 9, p. 32. About three-quarters of total R&D spending consists of all spending by U.S.-owned companies and U.S. spending by foreign-owned companies; the remaining one-fourth reflects overseas R&D spending by U.S. subsidiaries of foreign-owned firms. The total excludes non-U.S. R&D spending by non-U.S. companies. (In addition, other pharmaceutical firms based in the United States but not belonging to PhRMA spent $15 billion.) 3

Michael R. Ward and David Dranove, ―The Vertical Chain of Research and Development in the Pharmaceutical Industry,‖ Economic Inquiry, vol. 33, no. 1 (January 1995), pp. 70–87.

4

Joseph A. DiMasi, Ronald W. Hansen, and Henry G. Grabowski, ―The Price of Innovation: New Estimates of Drug Development Costs,‖ Journal of Health Economics, vol. 22, no. 2 (March 2003), p. 181.

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5

Congressional Budget Office calculation based on data on spending on prescription drugs, as defined in the national health expenditure accounts, maintained by the Centers for Medicare and Medicaid Services. 6 Kaiser Family Foundation, Prescription Drug Trends (September 2008), 7 For pre-Part D coverage, see Congressional Budget Office, Issues in Designing a Prescription Drug Benefit for Medicare (October 2002), and Dana Gelb Safran and others, ―Prescription Drug Coverage and Seniors: Findings from a 2003 National Survey,‖ Health Affairs, Web Exclusive (April 19, 2005), pp. W5–W160. For coverage under Part D, see Kaiser Family Foundation, The Medicare Prescription Drug Benefit (March 2009). 8 See Margaret E. Blume-Kohout and Neerag Sood, The Impact of Medicare Part D on Pharmaceutical Research and Development, Working Paper 13857 (Cambridge, Mass.: National Bureau of Economic Research, 2009). 9 See, for example, F.M. Scherer, ―Price Controls and Global Pharmaceutical Progress,‖ Health Affairs, vol. 28, no. 1 (2009), pp. W161–W164. 10 Wan He and others, 65+ in the United States: 2005, Current Population Reports, Series P23-209 (U.S. Census Bureau, December 2005), Figure 2-6, p. 12, www.census.gov/prod/ 2006pubs/p23-209.pdf. 11

12

CBO previously analyzed a similar policy option, specifically, raising the basic rebate percentage from 15.1 percent to 23.1 percent while maintaining the best-price provision. That option would reduce the federal deficit by $7.2 billion over the 2010–2019 period. See Option 74 in Congressional Budget Office, Budget Options, Volume 1: Health Care (December 2008). For background on rebates, see Congressional Budget Office, ―The Rebate Medicaid Receives on Brand-Name Prescription Drugs,‖ letter to the Honorable Charles E. Grassley (June 21, 2005). For a discussion of research on comparative effectiveness and its possible effects on future health care spending, see Congressional Budget Office, Research on the Comparative Effectiveness of Medical Treatments: Issues and Options for an Expanded Federal Role (December 2007).

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In: Pharmaceutical Industry: Innovation and Developments ISBN: 978-1-61209-394-9 Editors: David A. Mancuso and Isobel M. Grenada © 2011 Nova Science Publishers, Inc. .

Chapter 6

FEDERAL TAXATION OF THE DRUG INDUSTRY AND ITS EFFECTS ON NEW DRUG DEVELOPMENT Gary Guenther

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SUMMARY A key issue in congressional debates over expanding consumer access to prescription drugs is the impact of proposed initiatives on the development of new medicines. Some of the initiatives entail significant changes in one or more of the federal policies affecting new drug development. One such policy is federal taxation of firms that invest in this development. This chapter examines the impact of federal taxation on the incentive to invest in new drug development. More specifically, it looks at the provisions in current tax law that affect the performance of the drug industry, compares the industry‘s federal tax burden with that of other major industries, and assesses the effect of federal taxation on the incentive to invest in new drug development. This information may be useful to the 111th Congress as it considers the pros and cons of proposed changes in the U.S. health care system. An industry‘s federal tax burden refers to the effects of federal taxation on its return on investment through statutory provisions that define taxable income, make adjustments to this income, and establish tax rates and credits against tax liability. Economists generally measure an industry‘s federal tax burden as its average effective tax rate, which is the ratio of its federal tax liability after all credits (except the foreign tax credit) to its taxable income, expressed as a percentage. This measure has some limitations, such as the inability of average effective rates to capture the effects of tax provisions that accelerate the timing of deductions or delay the recognition of income. A comparison of average effective federal tax rates for the drug industry and major U.S. industries indicates that the share of the drug industry‘s worldwide net income paid as federal taxes was similar to the average share for all industries from 2000 through 2006. This has not always been the case. For much of the 1990s, the drug industry‘s tax burden was significantly lower than the average tax burden for all industries. But starting in the late 1990s, the drug industry‘s federal tax burden began to rise as the U.S. possessions tax credit was phased out.

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Drug firms were major beneficiaries of this credit. They also appear to benefit substantially, if not disproportionately, from three tax preferences whose combined effect is not fully reflected in average tax rates: (1) the deferral of federal income tax on the retained earnings of foreign subsidiaries of U.S.-based corporations, (2) the expensing of research outlays, and (3) the expensing of advertising outlays. Available evidence suggests that current federal tax law bolsters the incentive to invest in new drug development for some firms but not for others. The most powerful drivers of this investment seem to be the quest by certain drug firms for sustained competitive advantage and profit growth and the available technological opportunities for developing new, safe, and effective medicines. Still, all other things being equal, a substantial increase in the industry‘s tax burden might slow growth in this investment by raising the industry‘s cost of capital and reducing its cash flow. At times, it appears that a major segment of the drug industry cannot avoid being the center of controversy. Firms that develop, produce, and sell brand-name or patented drugs have been praised for their successes in developing safer or more effective versions of existing medicines and new medicines that advance the treatment of a variety of diseases.1 Yet these same firms have been rebuked for selling the same drugs at higher prices in the United States than in many other developed countries; their attempts to minimize competition from cheaper generic drugs; their relatively high profitability; and spending as much or more on advertising and product promotion than research and development (R&D).2 Framing these contrasting sentiments is a continuing debate among lawmakers over the best way to improve access to medicines for Americans of all ages and income levels, without establishing costly new federal entitlement programs or undermining key incentives for new drug development. An important issue in this debate is the likely impact of initiatives of this sort on the commercial development of new medicines. Some initiatives would entail significant changes in one or more of the federal policies affecting new drug development. The federal government plays a varied and far-reaching role in that process. This role encompasses a variety of laws and programs, including direct federal funding of drug-related research and development (R&D), federal regulation of the safety and efficacy of new medicines and the use and promotion of approved medicines, federal patent protection for prescription drugs, federal support of biomedical research and education in universities, federal financing of drug purchases through Medicaid and Medicare, and federal tax subsidies for research and the purchase of health insurance and medicines. This chapter examines one of the federal policies influencing the domestic climate for new drug development: federal taxation of firms that develop, produce, and sell drugs as a main line of business. As will be seen, the federal tax code affects the incentive to invest in new drug development in several ways. The net result of these interactions forms the core of the report. More specifically, the report analyses the drug industry‘s federal tax burden from 1995 to 2006, the most recent year for which federal corporate tax return data are available. This burden refers to the federal income taxes paid by drugmakers as a percentage of their taxable income; tax returns with and without net income are used to compute the industry‘s federal tax burden. Depending on its size, this burden has the potential to constrain the incentives for business investment in new drug development. The report begins with an examination of the distinguishing traits of the drug industry, then identifies the tax provisions that have the

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 103

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biggest impact on the industry‘s return on investment, and concludes with an assessment of the effects of federal taxation of the industry on the incentives to invest in new drug development. As discussed in this chapter, the drug industry encompasses a varied collection of corporations, all of whom derive the largest share of their income from one or more of the following commercial activities: (1) manufacturing biological and medicinal products; (2) processing botanical drugs and herbs; (3) isolating active medicinal ingredients from botanical drugs and herbs; and (4) producing pharmaceutical products intended for internal and external use in such forms as tablets, capsules, powders, ointments, and solutions.3 This group of firms includes both large, traditional pharmaceutical firms that tend to concentrate on developing small-molecule drugs from chemicals, makers of generic versions of such drugs, and small, fledgling biotechnology firms that focus on developing biologics, which are large-molecule drugs derived from living cells. In the period examined here, the vast majority of drug firms had no net income, and thus no tax liability. But drug firms with net income accounted for most of the industry‘s assets and gross income.4 It is unclear from available business tax data if the drug firms with losses were primarily producers of pharmaceuticals or biologics. Excluded from the group of drug firms discussed here are firms organized as noncorporate entities, such as partnerships and limited liability companies. It is not known how much these firms contribute to total income, assets, employment, or tax liability for the drug industry. But their shares are unlikely to be substantial, since the drug firms (e.g., GlaxoSmithKline, Merck, Pfizer, Lilly, Amgen) that account for most industry profits and taxes are all organized as corporations. The information presented here may be of use to the 111th Congress as it weighs the advantages and disadvantages of proposals to modify how health care is financed and delivered in the United States.

DISTINGUISHING CHARACTERISTICS OF THE DRUG INDUSTRY RELEVANT TO ITS FEDERAL TAX BURDEN Many industries have distinctive traits, which can be thought of as defining features tied to the goods and services they sell, the technologies used to produce them, and the main forces driving competitive success and long-term growth in employment and output. The drug industry is one of these industries. What arguably distinguishes firms that develop, produce, promote, and sell patented or branded drugs is their propensity to invest heavily in R&D and advertising, a focus on certain therapeutic categories to the exclusion of others, a strong reliance on patents to generate profits and bolster competitiveness, and an extensive network of foreign subsidiaries. As this chapter shows, several of these traits have important implications for the industry‘s federal tax burden.

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Heavy Spending on R&D Relative to Sales The drug industry is one of the most research-intensive of all U.S. industries. This means that it spends a large amount on R&D relative to its receipts. At the same time, drug firms receive little direct R&D funding from federal government agencies. According to estimates by the National Science Foundation, U.S. producers of drugs and medicines spent the equivalent of 12.7% of domestic net sales on domestic R&D in 2005; by contrast, the same ratio that year was 3.3% for all industries and 3.6% for manufacturing.5 U.S. producers of drugs and medicines spent $34.8 billion of their own and other non-federal funds on domestic R&D in 2005, while federal spending on domestic drug R&D totaled only $41 million. Many drug firms invest heavily in R&D simply because it has long served as the industry‘s primary engine for growth in sales and profits. Those that become industry leaders achieve and sustain their stature by developing a steady stream of products that gain wide acceptance among doctors and their patients. Though discovering and developing new drugs often is a time- consuming, risky, and costly process,6 firms that succeed can earn sizable profits, at least until generic versions of the drugs or so-called me-too patented drugs enter the market.7 Because drug patents have a finite life, leading drug firms face continuing pressure to develop new and innovative drugs to lay a solid foundation for future growth. Those firms whose development efforts falter often end up struggling to survive in the face of stiff generic competition for their key drugs whose patent protection has expired. In recent years, some firms in this position have merged with larger, more successful firms in order to remain in business, while those that develop so-called blockbuster drugs prosper.8 Advances in the technology for finding promising new drug candidates over the past quarter century have greatly increased the number of drug compounds with significant therapeutic potential being discovered. Yet the entry of new breakthrough drugs into the market appears to have slowed considerably in the past 10 to 20 years. A 2002 study by the National Institute for Health Care Management Foundation found that 35% of the 1,035 new drug applications approved by the FDA from 1989 to 2000 were new molecular entities (NMEs), which the FDA defines as drugs containing novel active ingredients, and that about one-third of those NMEs (or 15% of new drug approvals) were deemed to offer significant therapeutic advantages over existing drugs.9 In addition, the number of NMEs approved by the FDA has decreased steadily since reaching a peak of 56 in 1996: a total of 17 NMEs were approved in 2007.

Substantial Investment in Advertising and Product Promotion Most major drug firms also spend large sums on promoting the use of their branded products directly to physicians and consumers. Firms that develop new innovative medicines seem especially inclined to invest heavily in advertising. Early in a new drug‘s commercial life cycle, advertising and promotion typically are aimed at capturing a major share of the market as quickly as possible. But later in the cycle, the main thrust of these efforts often shifts to fending off or thwarting competition from generic drugs or me-too drugs. According to one source, promotional spending by drug firms totaled $10.4 billion in 2007, down from $12.0 billion in 2006, but up from $4.3 billion in 1996. Of the amount spent

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 105 in 2007, $3.7 billion went into direct advertising to consumers, and $6.7 billion was directed at physicians and other health care providers.10 The high priority given to informing doctors and encouraging what seems to be a form of brand loyalty among them reflects a fundamental feature of the market for prescription drugs that is absent from the markets for many other consumer goods and services. In deciding which drugs to use in treating an illness, consumers defer to the judgment and consent of third parties—namely, doctors and insurance companies.

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Fragmented Competitive Structure Another distinguishing trait of the drug industry is its fragmented competitive structure. This fragmentation has two critical aspects. One concerns the markets for brand-name drugs themselves; the other is related to what might be described as the technological focus or orientation of drug firms. No single firm or small cluster of firms dominates the domestic market for branded drugs. According to U.S. Census Bureau, in 2002, the most recent year for which figures are available, the four largest producers contributed 34% of the value of domestic shipments of medicines; the eight largest, 49%; and the 20 largest, 70%.11 The absence of a dominant seller is partly due to the multitude of therapeutic categories and the high cost of carving out a position of dominance in any particular category. Some drug formularies, which are lists of approved drugs that are covered under specific insurance plans, encompass as many as 16 therapeutic categories and over 100 sub-categories. Drugs classified in one sub-category generally cannot be substituted for drugs in another sub-category. For this reason, the economist F. M. Scherer once described the drug industry as a ―collection of differentiated oligopolies.‖12 Nonetheless, some firms are able to establish at least a temporary supremacy in certain segments of the market for prescription drugs. Such dominance is most likely to arise when a firm brings a new innovative drug to the market. For example, Wyeth has dominated the market for female hormone replacement therapy, while Pfizer has captured a substantial lead in the market for cholesterol-reducing medications. Some firms create what amount to new markets with their drug innovations, as Pfizer did with its launch of Viagra for the treatment of erectile dysfunction, and Merck did with its development of Proscar for the treatment of enlarged prostrate glands.13 The drug industry can also be divided into three subgroups that differ primarily in their approach to new drug development. Those subgroups are pharmaceutical firms, biotechnology firms, and generic drug firms. Though mergers and strategic alliances involving firms from all subgroups have blurred the boundaries among the three subgroups in recent years, it still remains the case that pharmaceutical firms tend to focus on developing small-molecule drugs from chemicals; biotechnology firms tend to focus on developing biologics, which are large-molecule drugs derived from living cells; and generic drug firms tend to focus on making low-cost copies of branded drugs that have lost their patent protection. While comprehensive data on profits for firms in each subgroup are hard to find, there is little doubt that the average pharmaceutical firm is larger in assets, sales, and employment, and more profitable than the average biotech or generic drug firm.

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Pharmaceutical firms compete against biotech and generic drug firms in many therapeutic categories. But the scope of competition between the pharmaceutical and biotech subgroups has narrowed in recent years, as pharmaceutical firms have invested tens of billions of dollars in acquiring biotech firms.14

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Strong Reliance on Patent Protection under Regulatory Oversight by the Food and Drug Administration The central role played by technological innovation in the growth and transformation of the drug industry over time points to another key distinguishing trait of the industry: a heavy reliance by leading firms on patents for drugs that have gained regulatory approval to generate relatively high rates of return on investment and bolster or sustain their dominance in segments of the market where they compete. Patents grant to their owners a temporary legal monopoly over the commercial uses of an invention. In the United States and most other advanced industrialized nations, the life of a patent has been 20 years from the date of application since June 8, 1995. A patent holder may license other firms to exploit the invention in exchange for royalties, which can be thought of as compensation for relinquishing exclusive control over the commercial applications of a new technology. Drug firms claim patents for the design of drug compounds, their formulation as drug therapies, their uses in treating diseases, and their methods of manufacture.15 Under the Drug Price Competition and Patent Term Restoration Act of 1984, drug companies may obtain an extension of the life of their patents of as much as five years to compensate for time lost during clinical testing. 16 Patents serve as an important competitive weapon for leading drug firms. Their usefulness in the quest for profits and growth is inextricably bound up with the lengthy, costly, and stringent approval process that all promising new drug candidates must undergo before they can be sold in the United States. The Food and Drug Administration (FDA) regulates the introduction of new drugs. It requires that new drugs pass through three phases of clinical testing on humans. Phase I is intended to test the safety of a new drug. Phase II begins to test the efficacy of the drug, as it continues to examine its safety at higher doses. In the third and final phase, the drug is subjected to more complex and rigorous tests for the purpose of ascertaining its safety, efficacy, and optimal dosages using relatively large groups of ill patients. Once the FDA confers its stamp of approval, everyone in the industry knows what the innovating drug company knows: that the drug provides the desired therapy. In the absence of patent protection, imitators could easily develop identical substitutes at a fraction of the cost incurred by the innovator. But by obtaining a patent for the molecular design of the drug, the innovator can effectively block entry by substitutes for a number of years, as slight variations in the design must undergo the full testing and approval process. For this reason, it is not surprising that drug industry executives tend to view patents as a highly effective mechanism for appropriating the returns to investment in R&D. According to the results of a survey of 650 R&D managers from 130 industries conducted by Richard Levin in the mid- 1970s, R&D managers in the pharmaceutical industry gave product patents a higher rating as a means of protecting the competitive advantages from technological

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 107 innovation than did the R&D managers in any other industry.17 More recently, in an analysis of the results of a 1994 survey of R&D managers at U.S. manufacturing firms with a minimum of $5 million in sales or with business units with at least 20 employees, Wesley Cohen, Richard Nelson, and John Walsh found that the drug industry had the highest mean percentage (50.2%) of product innovations for which patents were deemed an effective mechanism for capturing the returns to those innovations; the average mean percentage for patents for all manufacturing industries was 34.8%.18 The industry‘s aggressive use of patents for products that have gained regulatory approval may explain why drug firms have long been among the most profitable of all firms. From 1960 to 1991, the reported rate of return on stockholders‘ equity for the pharmaceutical firms included in the annual ranking of the top 500 industrial corporations by Fortune magazine averaged 18.4%, compared to 11.9% for all firms;19 as recently as 2001, pharmaceuticals ranked first in return on shareholders‘ equity (33.2%) among the 48 industries represented in the Fortune 500; in 2007, the industry ranked 12th (20.3%) out of 51 industries.20 One indication that patents are critical to the profitability of drug firms lies in the difference in selling prices between branded drugs and their generic counterparts. Patented medicines often command much higher prices than their generic counterparts, which enter the market only after the patents expire.21

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Extensive Foreign Operations No account of the distinctive traits of the U.S. drug industry with a bearing on its federal tax treatment would be complete if it failed to mention the industry‘s extensive operations in U.S. possessions and foreign countries. For many U.S.-based drug firms, these operations have had a significant impact upon their revenue streams, competitive postures, and federal tax burdens. Most major U.S. drug firms own foreign subsidiaries that manufacture and sell drugs and conduct R&D; many of these subsidiaries are located in Europe and Japan, the two largest regional markets (measured in U.S. dollars) for patented medicines after the United States.22 Like U.S. automobile producers, major pharmaceutical firms recognized in the 1960s that if they were to have success in foreign markets, they needed to establish a manufacturing and research presence in those markets.23 There are several ways to illuminate the large foreign presence of the drug industry. Perhaps the most comprehensive source of data on foreign direct investment abroad by U.S. firms is the U.S. Department of Commerce. According to Commerce data, in 2005, a total of 46 U.S.-based drug firms with domestic assets valued at $447 billion had established a total of 421 majority-owned foreign affiliates with assets valued at $181 billion.24 Most of these firms should be regarded as pharmaceutical firms. Sales by the foreign affiliates that year totaled $126 billion, and they employed 207,900 workers. A second but more limited source of information on the foreign operations of U.S. drug firms is the Pharmaceutical Research and Manufacturers of America (PhRMA), the primary trade association for the domestic drug industry. Most member companies should be regarded as pharmaceutical firms. In 2007, domestic sales by PhRMA member companies amounted to an estimated $190 billion, while foreign sales by U.S.-based PhRMA member companies and the U.S. affiliates of foreign-based PhRMA member companies totaled an estimated $82

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billion, or 43% of domestic sales.25 In the same year, PhRMA member companies spent an estimated $35 billion on domestic R&D, while foreign R&D spending by U.S.-based PhRMA member companies and the U.S. affiliates of foreign-based PhRMA member companies totaled an estimated $9 billion, or 26% of domestic R&D spending.26 Although the importance of foreign markets varies from company to company, it appears that the U.S. drug industry may derive as much as 40% of its revenue from foreign sales.27 The industry‘s foreign operations may account for an even higher portion of its overall profits. In 2003, six of the largest U.S.-based pharmaceutical firms received over 65% of their combined profits from foreign operations, up from about 38% in 1994.28

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FEDERAL INCOME TAXES PAID BY THE DRUG INDUSTRY BETWEEN 1990 AND 2006 Federal income taxes paid from 1990 to 2006 by corporations that derive the largest share of their income from the manufacture and sale of drugs are shown in Table 1. The figures in the table are taken from tax returns filed by corporations with and without net income and include any corporate alternative minimum taxes owed by drug firms. In collecting and publishing corporate tax data by industry, the IRS defines the drug industry in the same manner as the North American Industry Classification System. According to that definition, the industry consists of firms that derive the largest share of their revenue from one or more of the following sources: manufacturing biological and medicinal products; processing botanical drugs and herbs; isolating active medicinal ingredients from botanical drugs and herbs; and manufacturing pharmaceutical products for internal and external use in forms such as tablets, capsules, vials, powders, and solutions. The industry‘s taxable income shown in Table 1 combines domestic income earned by U.S.-based corporations and U.S. affiliates of foreign-based firms and a portion of the income earned by foreign branches and subsidiaries of U.S.-based corporations. Such a mix is appropriate because the United States, unlike many other developed countries, taxes business income on the basis of residence, not according to territorial source. Consequently, corporations chartered in the United States owe taxes to the federal government on their worldwide income. U.S.-based firms also pay income taxes to foreign governments on much of the income earned by their foreign affiliates. To avoid double taxation of this income, U.S. tax law permits U.S.-based firms to claim a credit for foreign income tax payments that cannot exceed their U.S. tax liability on the foreign-source income. In addition, U.S. affiliates of corporations chartered in other countries are required to pay federal income taxes on any income they earn in the United States. Federal tax law permits U.S.-based firms to defer the payment of federal income taxes on profits earned by their foreign subsidiaries until those profits have been repatriated to the U.S. parent.

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 109

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Table 1. Federal Income Tax Liability for the Drug Industry, 1990 to 2006 (millions of dollars) Federal Tax Credits Average Income Claimed Income Tax After Taxable Effective Year Tax (Except the Credits (Except the Income Tax Before Foreign Foreign Tax Credit) Rate (%)a Credits Tax Credit) 1990 15,934 5,482 1,825 3,657 22.9 1991 17,452 6,026 2,070 3,956 22.7 1992 19,920 6,920 2,238 4,682 23.5 1993 19,997 7,092 2,441 4,651 23.2 1994 24,837 8,752 2,479 6,273 25.2 1995 23,963 8,502 1,880 6,622 27.6 1996 24,810 8,816 1,948 6,868 27.7 1997 27,627 9,729 1,983 7,746 28.0 1998 29,218 10,240 2,204 8,216 28.1 1999 30,912 10,851 1,138 9,713 31.4 2000 31,102 10,918 1,027 9,890 31.8 2001 32,958 11,435 1,060 10,375 31.5 2002 31,185 10,975 1,193 9,783 31.4 2003 40,186 14,112 2,010 12,102 30.1 2004 38,078 13,354 1,414 11,940 31.3 2005 60,117 21,080 1,563 19,517 32.5 2006 53,852 18,852 1,339 17,513 32.5 Source: U.S. Internal Revenue Service, Statistics of Income Division (SOI), Corporation Source Book, 1990 to 2006; covers corporate tax returns only, with and without net income; available at http://www.irs.ustreas.gov/ taxstats. a. Income tax after credits (except the foreign tax credit) divided by taxable income and multiplied by 100.

It is clear from the figures in the table that the industry benefitted from existing business tax credits (excluding the foreign tax credit): from 1990 to 2006, its average tax liability after credits was 86% of its average tax liability before credits. (The reason for excluding the foreign tax credit from these calculations is explained below.) At the same time, it is clear that the combined value of these credits trended downward from 1990 to 2000 and then reversed course. The primary force behind this decline was a phase-out of the possessions tax credit that commenced in late 1997 and stretched through the end of 2005. In addition, the relatively high levels of taxable income in 2005 and 2006 were due to the billions of dollars in foreign earnings drug firms repatriated from overseas subsidiaries under the temporary repatriation tax holiday established by the American Jobs Creation Act of 2004 (see pp. 19-20). The main tax credits claimed by the drug industry are shown in Table 2. Their impact on the industry‘s federal tax burden is discussed below.

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Foreign Tax Credit Unlike the other tax credits shown in the table, the foreign tax credit confers no benefit on a firm that claims it. Section 901 of the Internal Revenue Code (IRC) permits a corporation chartered in the United States and paying income and related taxes to a foreign government through a foreign subsidiary to claim a limited credit for those taxes in the tax year when the foreign earnings are repatriated as dividends. This statutory provision is intended to avoid the double taxation of income earned by foreign branches or subsidiaries of U.S.-based corporations and repatriated to the U.S. parents. As a result, the foreign tax credit should be added to a firm‘s tax liability in measuring its federal tax burden. The credit may not exceed the federal income tax owed on repatriated foreign-source income and may not offset any federal tax owed on domestic-source income. In addition, the U.S. Treasury does not refund foreign income taxes paid in excess of the federal tax liability for repatriated foreign-source income. For foreign tax credits earned after October 22, 2004, any such excess may be carried back one year and then carried forward up to 10 years, subject to the same limitations.

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Possessions and Puerto Rican Economic Activity Tax Credit The drug industry was a major beneficiary of what was known until 1996 as the possessions tax credit under IRC Section 936. Under the Small Business Job Creation Act of 1996, the credit was revised and reborn as the Puerto Rican Economic Activity Credit (PREAC) under IRC Section 30A; it expired on December 31, 2005. In 2005, the industry was able to reduce its federal income tax liability by more than 2% by using the credit; drug firms accounted for 53% of the total amount of the credit claimed by all industries. When the PREAC was available from 1997 to 2005, corporations chartered in the United States could exclude from federal taxation as much as 40% of their income from business operations in Puerto Rico, the U.S. Virgin Islands, and other U.S. territorial possessions. To take advantage of the exclusion, a firm had to derive 80% of its overall gross income from business operations in one or more of these possessions, and 75% from the active conduct of a business there. The PREAC itself was equal to a firm‘s tax liability on possession-source income, subject to one of two alternative caps enacted in 1993. Under one cap—known as the ―economicactivity limitation‖—the credit was restricted to certain wage and depreciation costs; under the second cap—known as the ―percentage limitation‖—the credit was limited to 40% of the credit a firm could have claimed under rules that applied before 1993. Under a provision of the Small Business Job Protection Act of 1996, the credit was modified to phase out by the end of 2005 for firms claiming it in 1996 and was repealed immediately for all other firms.29 The act also set forth separate phase-out rules for firms subject to the percentage limitation and those subject to the economic-activity limitation.

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 111 Table 2. Main Federal Tax Credits Claimed by the Drug Industry from 1990 to 2006 (millions of dollars, unless otherwise noted)

Year

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1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Foreign Tax Credit

Possessions Tax Credit

Prior-Year Alternative Minimum Tax Credit

1,205 1,367 1,613 1,886 1,960 2,633 2,628 2,204 2,677 2,938 2,414 2,280 3,234 4,842 3,455 6,655 2,327

1,666 1,883 2,033 2,150 2,116 1,611 1,651 1,591 1,459 866 689 621 611 594 585 466 432

2 20 7 63 73 55 78 63 50 50 26 23 5 5 72 129 8

General Business Tax Credita Orphan Research Drug Tax Total Tax Creditb Credit 15 NA 142 18 235 150 17 264 180 19 306 208 19 307 271 0b 164 214 24 252 219 52 552 329 50 630 514 66 714 222 79 802 312 70 806 416 47 778 576 89 736 1,411 109 758 757 142 915 968 159 902 885

Source: U.S. Internal Revenue Service, SOI, Corporation Source Book, 1990 to 2006; covers tax returns only, with and without net income; available at http://www.irs.ustreas.gov/taxstats, and unpublished data obtained from SOI. a. Under IRC Section 38, the general business credit is a limited, non-refundable credit against income tax that is claimed after all other non-refundable credits, except for the credit for the alternative minimum tax. The general business credit is the sum of the rehabilitation credit, the energy credit, the reforestation credit, the work opportunity credit, the welfare-to-work credit, the alcohol fuels credit, the research credit, the low- income housing credit, the enhanced oil recovery credit, the disabled access credit, the renewable resources electricity production credit, the empowerment zone employment credit, the Indian employment credit, the employer Social Security tip credit, the orphan drug credit, the new markets credit, small employer pension plan start-up costs credit, and the employer-provided child care credit. There is a limit on the general business credit that a corporate taxpayer may claim in a given tax year: it may not exceed its tax liability less the greater of (a) the tentative alternative minimum tax or (b) 25% of regular tax liability above $25,000. If the general business credit claimed in the current year exceeds this limitation, the excess or unused credit may be carried back one year or forward 20 years. With the exception of 1995, the combined value of the orphan drug tax credit and research tax credit claimed by the pharmaceutical industry exceeded the total general business credit it was permitted to claim by substantial margins. The reason lies in this limitation. b. The orphan drug tax credit was suspended from January 1, 1995 to June 30, 1996. Under the Small Business Job Protection Act of 1996 (P.L. 104-188), the credit was reinstated from July 1, 1996 to May 31, 1997 and made part of the general business credit. The credit has never been reinstated for the period from January 1, 1995 to June 30, 1996.

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There is some evidence the drug industry responded to the possessions tax credit by establishing a substantial manufacturing presence in Puerto Rico. According to a 1992 report by the then General Accounting Office, a total of 26 drug firms owned manufacturing operations there in 1990. The firms realized an estimated tax savings of $10.1 billion that year from those operations, which produced 17 of the 21 most commonly prescribed drugs in the United States in the early 1990s.30

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Prior-Year Minimum Tax Credit Corporations over a certain size, like individuals, are subject to two parallel income tax systems: the regular income tax and the alternative minimum tax (AMT).31 Each tax year, a corporation is required to compute its tax liability under both systems and pay whichever is greater. Each tax system has its own rules for the measurement of income and use of deductions, and the tax rates for each differ. In general, the corporate AMT is erected upon a broader definition of income and a less generous set of deductions. Furthermore, most business tax credits, such as the research tax credit, cannot be used to reduce AMT liability. In computing its AMT, a corporation begins with its regular taxable income and modifies it through a series of additional computations known as adjustments and preferences. Adjustments may or may not raise taxable income for the AMT, while preferences are determined on a property-by-property basis and affect taxable income only to the extent that they increase it.32 Because the corporate AMT is based on a broader measure of taxable income than the regular corporate income tax, nearly every corporation would pay the AMT every year if it were not the case that the AMT rate is much lower than the maximum rate under the regular tax system. The tax rate under the corporate AMT is 20%, whereas the top corporate tax rate is 35%. This means that a corporation‘s taxable income must be at least 75% greater under the AMT than the regular tax before the corporation must pay the AMT. A firm ends up paying the AMT mostly because of differences in the timing of certain deductions, especially the deduction for depreciation. Many corporations can and do switch between paying the AMT and paying the regular tax. As a result, a credit for taxes paid under the AMT is allowed to keep the AMT from leading to the collection of taxes in excess of the value of timing differences for certain deductions. The tax credit for AMT payments can be used only to offset future regular income tax liability; any unused credits may be carried forward indefinitely. But the AMT credit cannot be used to lower a business taxpayer‘s regular tax liability below its tentative minimum tax. This means that if a corporation pays the AMT in two consecutive years and then uses its AMT credits over the following two years, its total tax liability in that period would be equal to what it would have been if it had paid the regular tax only. In effect, the AMT accelerates payment of the regular tax. There is an opportunity cost to this acceleration in the form of forgone earnings from using the AMT payments for some other purpose. 33 The longer the gap between paying the AMT and using all AMT credits, the greater this cost. As shown in Table 2, the AMT credits claimed by drug firms varied widely from year to year. Nevertheless, on the whole, they accounted for a small share of the credits used in any

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 113 given year. In 2005, for example, the AMT credits used by pharmaceutical firms came to 2% of the AMT credits claimed by all industries. Such an outcome is not surprising. The corporations that are most likely to pay the AMT are those that invest heavily in assets subject to accelerated depreciation under the regular tax system, relative to their earnings. Differences in the treatment of depreciation of these assets between the corporate AMT and the regular tax system account for most of the adjustments and preferences that enter into the computation of the AMT. On the whole, drug firms invest less in such assets as a share of earnings than the manufacturing sector as a whole, which typically accounts for half of total corporate AMT liability in a tax year. In 2002, for instance, pharmaceutical firms spent the equivalent of 5.0% of their value added on plant and equipment; by contrast, manufacturing firms spent 6.6% of their combined value added for the same purpose.34

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General Business Credit The general business credit (GBC) under IRC Section 38 consists of 31 separate and distinct tax credits.35 Each credit is computed separately on the appropriate tax form. In general, the GBC may not exceed a business taxpayer‘s net regular income tax, less the greater of its tentative minimum tax liability, or 25% of the net regular tax liability above $25,000. In this case, a taxpayer‘s net regular income tax liability is defined as the sum of its regular tax liability and alternative minimum tax liability, less all non-refundable credits. If the GBC is greater than this limitation in a tax year, the excess may be carried back one year or forward up to 20 years (with some exceptions). Thus, the GBC a firm may claim in a tax year is the sum of GBCs carried forward to that year, the GBC for that year, and GBCs carried back to that year. As Table 2 shows, most of the drug industry‘s allowable claims for the GBC since 1990 apparently have been derived from a single credit: the credit for increasing research expenditures under IRC Section 41. From 1991 to 2006, the research credit claimed by the industry exceeded its allowable GBC in every year except 1995, 2003, and 2005. In the same period, the cumulative value of the research credit claimed by the industry exceeded the cumulative value of its allowable GBC by $1.1 billion. These differences indicate that at least some pharmaceutical firms have had sizable reserves of unused research tax credits to draw upon to reduce their regular tax liabilities in future years.

Research Tax Credit Under IRC Section 41, business taxpayers may claim a tax credit for their spending on qualified research above a base amount.36 The incremental design is intended to give firms an incentive to spend more on research than they otherwise would. The credit lowers the aftertax cost of undertaking qualified research above the base amount: one dollar of the credit reduces that cost by the same amount. The research credit is composed of five separate and distinct non-refundable credits: a regular research credit, an alternative incremental research credit (or AIRC), an alternative simplified incremental credit (or ASIC), a credit for contract basic research, and a credit for contract energy research. All five are due to expire at the end of 2009, and the AIRC is

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unavailable in 2009. A business taxpayer may claim no more than the basic and energy research credits and one of the remaining three in a single tax year. To prevent a taxpayer from reaping a double tax benefit from the same expenditure, any research tax credit claimed must be subtracted from the amount of qualified research expenses deducted under IRC Section 174. Most claims for the credit involve the regular credit. It has been extended 13 times and significantly modified six times. The credit is equal to 20% of a firm‘s qualified spending on eligible research conducted in the United States and its territorial possessions above a base amount. Several rules governing the use of the credit tend to push its marginal effective rate below its statutory rate for many of the firms that use it. Of particular importance are the definition of qualified research and the requirements that the deduction for qualified research expenses under IRC Section 174 be reduced by the amount of the research tax credit, and that the base amount equal 50% or more of current-year research expenses. The regular, alternative, and basic research credits apply to the following expenses only: wages and salaries of researchers, supplies and materials used in qualified research, leased computer time for qualified research, and 65% to 100% of payments for contract research (depending on the nature of the research and the type of entity conducting it). Among all industries, the drug industry is a leading beneficiary of the research credit: in 2006, it claimed $902 million in research tax credits, or 12% of the total amount of such claims by all industries. Yet there is reason to suspect that the credit has not had a major impact on investment in new drug development in recent years. From 2000 to 2006, the drug industry‘s total claims for the credit represented 3% of total domestic R&D spending by PhRMA member companies. In addition, even drug firms that spend hundreds of millions of dollars or more on R&D cannot expect to take advantage of the regular credit in a given tax year. A 2001 CRS report estimated that Merck was unable to claim a regular research tax credit in 1998, despite spending $1.8 billion on R&D that year.37 The explanation for this result lay in the rules governing the regular credit‘s use, especially the requirement that the base amount be equal to 50% or more of current-year expenditures on qualified research. These rules may also explain why relatively few drug firms claim the research credit from year to year: in 2005, for instance, no more than one in five of pharmaceutical firms that filed a corporate income tax return claimed the research tax credit.

Orphan Drug Credit Only one of the credits shown in Table 2 seems targeted at the drug industry: the orphan drug tax credit. In 2006, firms classified in the industry by the IRS contributed 52% of the total value of claims for the credit by all industries. Under IRC Section 45C, a firm may claim a tax credit equal to half the cost of human clinical trials for drugs intended to treat rare diseases; such drugs are also known as orphan drugs. The credit indirectly subsidizes the cost of capital for investment in the development of such drugs, as human clinical trials, which are conducted in three phases, constitute the most time-consuming and costliest step in the new drug development process.38 The statutory provision defines a rare disease or condition as one likely to afflict fewer than 200,000 individuals residing in the United States, or one likely to afflict more than 200,000 such individuals but for which there is no realistic prospect of recovering R&D costs from U.S. sales alone. The credit applies to expenditures for the supplies and the wages and salaries of

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 115 researchers used in clinical trials for orphan drugs, but not for the structures and equipment used in the trials. It is a permanent provision of the tax code and a component of the general business credit, and thus subject to its limitations. Since the orphan drug credit was enacted in 1983 as one of a series of measures aimed at stimulating increased investment in the development of new drugs to treat rare diseases and conditions, at least 325 such drugs have gained regulatory approval in the United States.39 But contrary to the credit‘s intended purpose, some of them went on to become major sources of revenue for their producers, including Glaxo Wellcome‘s anti-AIDS drug Retrovir AZT, Amgen‘s anti-anemia drug Epogen, and Genentech‘s human growth hormone Protropin.40

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FEDERAL TAX BURDEN ON THE DRUG INDUSTRY AND MAJOR U.S. INDUSTRIES FROM 2000 TO 2006 Generally, the federal tax burden on an industry refers to how the tax code affects its return on past investment. This effect emerges through the definition of taxable income, adjustments to taxable income (e.g., deductions and exemptions), tax rates, and adjustments to tax liability (e.g., tax credits and minimum tax payments). For the most part, these provisions serve the dual purpose of raising the revenue needed to fund government operations and programs and offering firms meaningful incentives to engage in or eschew certain activities. The tax credit for increasing research expenditures obviously exemplifies the second purpose. Expressed in its simplest terms, an industry‘s federal tax burden indicates how much of its profits it must surrender to comply with current tax law. As this burden expands and all other things being equal, firms have fewer funds than they otherwise would to use as they wish. Economists define a firm‘s tax burden as its share of real pre-tax economic income paid in taxes. But it is difficult to determine a firm‘s economic income from business tax return data, as certain provisions in the tax code drive a wedge between a business taxpayer‘s economic income and its taxable income. So another approach must be taken to measure business tax burdens. One option is to substitute taxable income as determined under current federal tax law for pre-tax economic income. This approach is used here. A widely used measure of an industry‘s federal tax burden is its average effective tax rate, which is the ratio of its federal income tax liability after credits to its taxable income, expressed as a percentage. As such, the ratio reveals the net effect of the federal tax code on the industry‘s pretax returns on previous investments. Some economists construe this effect as the extent to which the tax code penalizes or rewards the economic activities of the firms making up the industry. There are some limitations to the usefulness of the average effective tax rate as a measure of an industry‘s federal tax burden. One limitation is that the rate reflects the impact of the tax code on the returns to an industry‘s previous investments; thus it may be an unreliable indicator of the federal tax burden on current or future investments. In addition, average effective tax rates do not provide a comprehensive measure of the federal tax burden for an industry because they cannot capture the influence of provisions in the tax code that accelerate the timing of tax deductions or delay the recognition of income for tax purposes. A better measure would be the marginal effective tax rate for an industry, which would capture

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the effect of all relevant tax provisions on its pre-tax returns on new investment.41 But it is difficult to compute such a rate for most industries because the value of some widely used tax benefits (e.g., expensing of R&D costs) cannot be estimated using available financial or tax return data, and not all firms in an industry invest the same amount in the same mix of assets in a given tax year. Nonetheless, if average effective tax rates are applied consistently across industries and over time, they can shed light whether their federal tax burdens differ, and if so, to what extent. Table 3 shows the average effective federal tax rates for the drug industry and all major U.S. industries from 2001 to 2006. As noted above, the rates compare the industries‘ federal income tax liability after all credits except the foreign tax credit with their worldwide taxable income (as reported on their federal income tax returns). As such, they address neither the domestic tax burden on domestic income nor the worldwide tax burden on worldwide income for the industries. Instead, the rates represent something of a hybrid of the two measures: the federal tax burden on domestic income plus foreign income that has been recognized for federal tax purposes. As noted earlier, the foreign tax credit should be excluded from an industry‘s net tax liability because the credit is intended to prevent the double taxation of foreign-source income. Including it would understate the federal tax burden on the industries, in some cases by a significant margin. Table 3. Average Effective Tax Rates for the Drug Industry and Major U.S. Industries from 2001 to 2006 (%)

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Industry

2001

2002

2003

2004

2005

2006

Average Rates for 2001 to2006 33.0 29.0

All Industries 33.0 33.0 32.5 33.0 33.0 33.0 Agriculture, Forestry, 28.0 27.0 29.0 30.0 30.0 29.0 Fishing, and Hunting Mining 33.0 34.0 33.0 35.0 35.0 33.0 34.0 Construction 31.0 32.0 32.0 32.0 33.0 32.0 32.0 Manufacturing 32.0 33.0 32.0 33.0 33.0 33.0 33.0 Drugs 32.0 31.0 30.0 31.0 32.5 32.5 31.5 Transportation, Warehousing 32.0 31.0 29.0 32.0 31.0 31.5 31.0 & Utilities Wholesale & Retail Trade 33.0 33.0 33.0 33.0 33.0 33.5 33.0 Finance, Insurance & Real 34.0 33.0 33.5 33.0 33.0 34.0 33.5 Estate Information 31.5 30.0 32.0 33.0 34.0 35.0 32.0 Services 32.0 33.0 32.0 33.0 33.0 32.0 32.5 Source: Calculations done by CRS using data from U.S. Internal Revenue Service, Statistics of Income Division, Corporation Source Book, 2001 to 2006; covers tax returns only, with and without net income; available at http://www.irs.ustreas.gov/tatstats. Note: As calculated here, the average effective tax rate for an industry is the ratio of its federal income tax liability after all credits, except the foreign tax credit, to its worldwide taxable income, expressed as a percentage.

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 117 The data in the table indicate that the drug industry‘s federal tax burden in 2001 to 2006 was similar to the average tax burden for all industries. Such a finding may come as a surprise to those who have the impression that the industry long has benefitted unfairly or disproportionately from certain business tax preferences. Though the table does not show this, the industry‘s tax burden did rise in the late 1 990s, driven by a phase-out of the possessions tax credit that began in 1997 and lasted through 2005. If marginal effective federal tax rates could be computed for typical investments made by the industries shown in Table 3, it is likely that the rate for the drug industry would be among the lower ones. This is because the effects of some tax preferences that tend to benefit drug firms more than other firms are not fully reflected in average effective tax rates. These preferences involve both the deferral of federal income taxes and accelerated depreciation. Three tax preferences in particular are likely to yield significant tax savings for U.S.-based drug firms and thus warrant further examination: (1) the deferral of federal income taxes on net income retained by foreign subsidiaries of U.S.-based corporations; (2) the expensing (or deduction as a current cost) of qualified research spending; and (3) the expensing of advertising and promotional costs.

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Deferral of Federal Income Taxes on Foreign-Source Income As noted above, the federal government taxes corporations based or chartered in the United States on their worldwide income and grants them tax credits for foreign income tax payments they make on foreign-source profits up to their federal tax liability on those profits. But federal tax law does not treat all foreign-source income equally. Profits earned by foreign branches of a U.S.- based corporation are subject to federal taxation in the year when they are earned, regardless of whether the profits are repatriated to the U.S. corporate parent. In contrast, profits earned by foreign corporate subsidiaries of the same corporation are subject to U.S. taxation only when they are repatriated to the parent firm in the form of dividends, royalty payments, or other income. The subsidiaries‘ profits may be taxed by the host countries, but any profits they retain are exempt from federal taxation until the profits are repatriated. Such an exemption represents a deferral of U.S. income tax liability. Deferral of this variety can generate a substantial tax benefit, particularly in cases where U.S. firms locate subsidiaries in countries with lower tax rates than the United States. The reason lies in the time value of money. In essence, a dollar received today is worth more than the same dollar received in some future year. So the longer a taxpayer can defer a tax payment, the less it is worth in current dollars.42 As a result, U.S.-based firms with subsidiaries in countries with lower tax rates than the United States can reduce the present value of their federal tax burden by having the subsidiaries retain their earnings for one or more years. Although these subsidiaries may pay income taxes on their annual earnings to host-country governments, those taxes would be lower than the U.S. income taxes that would be due on the same profits in the year when they were earned. Thus, the opportunity to defer federal taxes on foreign-source income gives U.S.-based firms a significant incentive to invest in countries with lower income tax rates than the United States.43 There is some evidence that U.S.-based drug firms have taken advantage of this opportunity. According to a 2004 article in Tax Notes, the effective foreign income tax rate on

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the foreign profits of six major U.S. pharmaceutical firms was 17.6% in 2003, while the maximum U.S. corporate tax rate was 35%.44 Unrepatriated foreign earnings reported by the same six companies rose from $10.1 billion at the end of 1993 to $101.0 billion at the end of 2004, a tenfold increase.45 And another report in Tax Notes pointed out that six pharmaceutical firms were among the top 20 of 67 U.S.-based multinational firms ranked according to accumulated undistributed or unrepatriated foreign earnings reported in the 10-K reports they filed for 2003 with the Securities and Exchange Commission.46

Temporary Dividends Received Deduction under IRC Section 965 Further evidence that the drug industry is a major beneficiary of the opportunity to defer federal taxes on profits earned by the foreign corporate subsidiaries of U.S.-based corporations comes from the industry‘s response to a provision in the American Jobs Creation Act of 2004 (AJCA, P.L. 108-357) that granted U.S.-based firms a temporary tax reduction for the repatriation of some of those profits. Under IRC Section 965, which was added by AJCA, U.S. corporations could claim a deduction equal to 85% of the cash dividends above a base-period-amount they received from their controlled foreign corporations (CFCs) and then invested in the United States according to an eligible plan approved by a top corporate officer and the board of directors.47 For corporations paying a marginal tax rate of 35%, the deduction lowered the tax rate on any dividends received to 5.25%: 0.35 x 0.15. Corporations were allowed to claim the dividends received deduction (DRD) once: either in their last tax year before October 22, 2004 (the date when AJCA was signed into law) or their first tax year during the 12 months starting on October 22, 2004. The base-period amount for a corporation was defined as the average amount of cash dividends it received from CFCs in three of the five most recent tax years ending on or before June 30, 2003, disregarding the years with the lowest and highest repatriation amounts. In addition, the DRD was limited to the greater of $500 million, or the amount of earnings permanently reinvested outside the United States (as shown on a firm‘s most recent balance sheet after June 30, 2003), or 35% of the tax liability attributed to earnings permanently reinvested outside the United States. A recent study by the Internal Revenue Service (IRS) found that 843 U.S.-based corporations claimed the one-time DRD by repatriating $362 billion in cash dividends from 2004 through 2006.48 Drug firms accounted for 3% of all the firms claiming the deduction but contributed 32% of the entire amount of repatriated cash dividends. The average drug firm repatriated $3.6 billion in qualifying dividends, compared to $370 million for the average firm. In addition, drug firms claiming the deduction reported permanently reinvested foreign earnings equal to 13% of their assets; for all firms claiming the deduction, the same ratio was under 2% of their assets. Transfer of Intangible Assets Like Drug Patents to Low-Tax Countries The opportunity to defer U.S. taxes on the profits of foreign corporate subsidiaries is linked to a practice used by major U.S.-based pharmaceutical firms to reduce their worldwide tax burdens. It entails the transfer of drug manufacturing and intangible assets like drug patents to offshore subsidiaries in countries whose corporate tax rates are lower than those of the United States.

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 119 While the extent of this practice and its impact on the federal tax burdens of drug firms are not well-documented, its basic elements are well-established.49 In what could be regarded as the standard or classic case, seeking to lower the effective worldwide tax rate it reports to shareholders, a U.S.-based drug company transfers a patent for a drug it has developed to a subsidiary located in a country with lower corporate tax rates than the United States. The subsidiary then helps fund further research in the United States on the drug, allowing it to claim ownership of the patent without having to buy it from its American parent.50 Once the drug is approved for sale in the United States, the subsidiary produces it at a cost of a few cents a pill. The pills are then shipped to the American parent, which sells them to pharmacies or wholesalers for several dollars a pill. But in accounting for the profit from U.S. sales of the drug on its federal income tax return, the American parent company attributes almost the entire amount to the foreign subsidiary, not itself, because the subsidiary holds the patent for the drug. The final result is that most of the profit is transferred to the host country for the subsidiary and taxed there, while the remainder is taxed at a higher rate in the United States. No federal income tax can be levied on the subsidiary‘s share of the profit until it is repatriated. This practice is not necessarily illegal under U.S. tax law. But it does make it possible to use loopholes or gaps in the law to shelter profits in so-called foreign tax havens. Since drug prices are higher in the United States than in most other developed countries, the legality of this practice has been questioned. Some argue such a price difference is proof that the vast share of industry profits should be attributed to U.S. operations, not to any foreign operations. Yet that apparently is not the case. According to a 2006 analysis by Martin Sullivan of Tax Analysts, nine of the largest U.S. pharmaceutical firms reported to shareholders that foreign earnings accounted for 69.9% of their combined worldwide profits in 2005, up from 39.2% in 1999.51 Proceeding on the assumption that an industry‘s profits should be assigned to the location of ―value-creating economic activity‖ for tax purposes, Sullivan estimated that reported foreign profits should have accounted for 43% of the combined worldwide profits for these firms in 2005. This meant that an additional 27% of the firms‘ worldwide profits that year should have been subject to U.S. taxation.52

Expensing of Qualified Research Spending Drug firms also derive substantial benefit from the tax treatment of research expenditures under IRC Section 174. Under that provision, a business taxpayer may deduct as a current expense (or expense) its research expenditures in the tax year when they are made.53 To qualify for this treatment, those expenditures must meet the following criteria: (1) they must relate to a firm‘s trade or business, (2) they cannot be considered capital costs, and (3) they must be directed at ―activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.‖54 In practice, only the wages and salaries of research personnel, the cost of supplies and materials used in qualified research, and related overhead costs may be deducted under IRC Section 174. By contrast, the cost of structures and equipment used in this research must be recovered over 15 years and three years, respectively, using allowable depreciation methods.

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Business spending on R&D typically creates intangible assets (such as patents) that generate a stream of revenue over a number of years. Such an outcome indicates that the economic life of these assets is longer than one year, a view that has been backed by several studies.55 So it seems reasonable and fair that a firm, in computing its taxable income, should treat its spending on R&D as a capital expense that is recovered over the useful life of the assets it generates, using an appropriate depreciation method. Yet the tax code allows firms to treat R&D expenditures as a current expense rather than a capital expense. This option gives rise to a significant subsidy for business R&D investment in the form of a reduced marginal effective tax rate on the returns to this investment. In theory, expensing (or the deduction of the entire amount of a capital expenditure in the year when it is made) lowers the marginal effective tax rate on the returns to investment in affected assets to zero.56 The addition of the research tax credit under IRC Section 41 makes the rate negative for eligible investments. Consequently, the user cost of capital for R&D investment is significantly lower than for many other investments a firm might make, including the acquisition of new plant and equipment.57 Supporters of the expensing of R&D expenditures say that such a subsidy is justified on the grounds that it addresses a market failure associated with investment in research: namely, that firms tend to invest less than optimal amounts in research because they cannot appropriate all the returns to innovation. Drug firms are likely to benefit from this tax subsidy more than many other firms because of the drug industry‘s strong propensity to invest in R&D. In 2006, according to estimates by the National Science Foundation (NSF), drug firms spent an estimated 13.5% of their domestic net sales on R&D performed in the United States. By contrast, the same ratio for all industries was 3.4%; for manufacturing firms, 3.6%; and for non-manufacturing firms, 2.9%.58 Drug firms spent $38.8 billion on R&D in 2006, according to the NSF. Assuming that its average effective federal tax rate that year was the same as its average effective federal tax rate for 2000 to 2005 (31%), and that the entire amount could be deducted as a current expense under IRC Section 174, the industry was able to lower its tax liability in 2006 by $12 billion by deducting the full amount of its R&D expenditures.59

Expensing of Advertising Spending Drug firms also appear to benefit disproportionately from the tax treatment of outlays for business advertising. Under current federal tax law, advertising expenses are deductible in the tax year when they are incurred, provided they pass two tests: (1) they are reasonable in amount; and (2) they are related to a firm‘s lines of business. These expenses must serve the purpose of developing goodwill among customers or soliciting immediate sales. There is a clear similarity in the tax treatment of outlays for advertising and outlays for R&D: both are deductible as a current expense. Expensing constitutes a significant tax subsidy in that it theoretically leads to a marginal effective tax rate of zero on any profits generated by an asset. In the case of advertising, this tax treatment would be justified on economic grounds if advertising yielded no benefits for a firm beyond the year when the cost of the advertising is

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 121 incurred. But this might not be the case. There is some evidence that spending on advertising can create intangible assets with economic lives extending beyond a single year. In certain markets (including prescription drugs), advertising fosters the growth of what might be called brand recognition and consumer loyalty. These effects can operate like an intangible asset in that they can boost a firm‘s profits and keep them at levels they might not attain otherwise. For instance, Ernst R. Berndt and three colleagues found in a study of the U.S. market for anti-ulcer drugs that efforts by leading manufacturers to promote H2antagonist prescription drugs to physicians through detailing and medical journal advertising had ―substantial effects‖ on the growth of domestic demand for the drugs and the sellers‘ market shares from 1977 to 1993.60 In doing the study, they divided these marketing efforts into those aimed at expanding overall demand for H2-antagonist drugs, and those aimed solely at expanding the market shares of the leading sellers. Berndt and his colleagues then estimated that the cumulative value of the marketing intended to expand overall demand depreciated at a rate of zero, but that the cumulative value of the marketing intended to expand market shares depreciated at an annual rate of close to 40%.61 Others have estimated that the depreciation rate for the intangible assets created by commercial advertising falls in the range of 20% to 30%.62 To the extent that advertising creates intangible assets with economic lives of longer than one year, the expensing permitted under current tax law has the effect of lowering the cost of capital for investment in advertising, relative to the cost of capital for investment in assets with longer tax lives, all other things being equal. Still, there is lingering uncertainty about the actual rate at which advertising loses its economic value. Available evidence points to differing conclusions about the economic life of advertising; it also indicates that the true depreciation rate may differ considerably by mode of advertising (e.g., television advertising, magazine advertising, radio advertising).63 As a result, it is difficult to assess to what extent the tax code subsidies investment in advertising. Whatever the actual degree of subsidy, there is little question that drug firms benefit more from the expensing of advertising expenditures than many other firms because of their relatively strong propensity to invest in advertising. In 2005, the most recent year for which U.S. corporate tax data are available, the drug industry claimed a total deduction for advertising equal to 4.6% of business receipts; for all industries, the share was 1.2%.64 Drug firms deducted $13.1 billion for advertising that year, yielding a tax savings of $4.3 billion at the industry‘s average effective federal tax rate of 3 2.5% that year.

FEDERAL TAX POLICY AND INVESTMENT IN NEW DRUG DEVELOPMENT Tax policy is one of many channels through which the federal government influences the domestic climate for new drug development. Business taxation helps shape this climate through its impact on a firm‘s user cost of capital for R&D investment and its supply of internal funds (or retained earnings). The user cost of capital is the cost a firm incurs as a result of owning a tangible or intangible asset. It embraces both the opportunity cost of forgoing other investments and the direct costs of ownership, such as depreciation, the acquisition cost of the asset, and taxes. In

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general, the user cost of capital indicates the rate of return an investment project must earn in order to break even. As a firm‘s user cost of capital declines, the number of investment projects it can profitably undertake increases, all other things being equal. There is considerable evidence that business investment responds to changes in the user cost of capital, although the magnitude and duration of the response over the business cycle are matters of ongoing debate and research among economists.65 One factor affecting the user cost of capital is the tax burden on the returns to an investment. Generally, as this burden decreases, so does the cost of capital.66 A widely used measure of this burden is the marginal effective tax rate. This rate, which is calculated by subtracting the after-tax rate of return on a new investment from the pre-tax rate of return and dividing by the pretax rate of return, reflects the statutory income tax rate faced by a firm, as modified by any tax provisions that subsidize or penalize the investment. Under current law, the federal tax burden on the returns to R&D investment is relatively low because of two research tax subsidies discussed earlier: (1) the tax credit for increases in research spending above a base amount under IRC Section 41, and (2) the option to deduct qualified research expenditures as a current expense under IRC Section 174. In combination, they have the potential to push the cost of capital for R&D investments below that of most other investments a firm might make, such as purchases of plant or equipment or instituting a new training program for employees. According to an analysis by economist Bill Cox, the credit and expensing allowance have the combined effect of taxing the returns to R&D investment at a negative rate, which is to say that after-tax rates of return exceed pre-tax rates of return.67 The same two tax subsidies can also boost R&D investment by increasing a firm‘s cash flow or supply of internal funds. Some firms base their annual R&D budgets on the amount of money they expect to have on hand after paying all expenses in a given year. For them, the cost of internal funds may be significantly lower than the cost of external funds, such as capital raised through borrowing or issuing new shares of stock. Small start-up biotechnology firms are especially likely to find themselves in this position, as potential investors or lenders may lack the needed information to evaluate their long-term prospects for commercial success. A firm‘s supply of internal funds depends in part on how much it earns in profits and how much of those profits it must set aside to cover its anticipated income tax liability. In the short run, firms that rely heavily on retained earnings to finance new R&D investments can invest more as their tax liabilities fall, all other things being equal. Of course, a firm could use any increase in cash flow for other purposes, including hiring new employees, training current employees, or paying higher dividends to shareholders or owners. In addition, the opportunity under federal tax law to move profits to subsidiaries located in low- tax countries through the transfer of drug patents to those subsidiaries and the deft use of transfer pricing can make it possible for major U.S.-based pharmaceutical firms to reduce their worldwide tax burden. An indicator of the effect of tax policy on new drug development is the drug industry‘s federal tax burden, as measured by average effective tax rates. From 2000 to 2006, the industry‘s rate was nearly the same as the average rate for all industries. Yet in the same period, the average drug firm devoted a much higher percentage of its revenue to R&D than the average firm. So while the average drug firm pays about the same amount of federal income tax per dollar of taxable income as the average firm, the former spends a larger share of each dollar of gross income on the development of new technology. This difference

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Federal Taxation of the Drug Industry and Its Effects on New Drug Development 123 suggests that new drug development is driven by forces other than federal tax subsidies. Among the key ones are the opportunities for novel drug compounds opened up through advances in basic research, the regulatory requirements for the drug approval process, the competitive strategies of drug firms, and the potential earnings from investing in the development of new drugs.68 It is also worth noting that not all drug firms are affected equally by federal taxation. The typical pharmaceutical firm has profits and thus can take advantage of the research and orphan drug tax credits, the expensing of advertising and research expenditures, and the deferral of profits earned by foreign subsidiaries to lower its tax burden and boost its after-tax rate of return on equity. By contrast, the typical biotech firm has a net operating loss and thus can take advantage of none of those tax incentives in the short run. The typical generic drug firm has a tax profile that more closely resembles that of the pharmaceutical firm, with the exception that the former spends a fraction of what the latter spends on drug discovery, drug testing and clinical trials, and advertising and promotion.

End Notes

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1

In 2007, companies that were members of the Pharmaceutical Research and Manufacturers of America, the principal U.S. trade association for the pharmaceutical industry, spent an estimated $35.4 billion on domestic pharmaceutical research and development (R&D), up from $21.4 billion in 2000. (See Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 2008 (Washington: 2008), p. 52, available at http://www.phrma.org.) The number of new molecular entities and new biologics approved by the U.S. Food and Drug Administration dropped from 36 in 2004 to 18 in 2007. 2 According to the most recent data for the Fortune 500 companies, the ratio of after-tax income to revenues for the pharmaceutical industry in 2007 was 15.8%, compared to a median ratio for all Fortune 500 companies of 6.5%. Total promotional spending by the pharmaceutical industry totaled an estimated $10.4 billion in 2007, down from $11.9 billion in 2004. (See the Henry J. Kaiser Family Foundation, Prescription Drug Trends (Washington: Sept. 2008), p. 2, available at http://www.kff.org.) 3 This definition matches the definition of the pharmaceutical and medicine manufacturing industry (sector 32451) used in the North American Industry Classification System (NAICS). The Internal Revenue Service (IRS) uses this system to classify corporate tax returns by industry. 4 In 2006, for example, only 510 out of the 1,678 tax returns filed by corporations classified by the IRS in the drug industry reported net income or income subject to taxation. But the 510 firms with net income accounted for 86% of industry assets and 91% of industry receipts. 5 National Science Foundation, Division of Science Resources Statistics, InfoBrief: Expenditures for U.S. Industrial R&D Continue to Increase in 2005; R&D Performance Geographically Concentrated, NSF 07-335 (Arlington, VA: Sept. 2007) tables 2 and 3, pp. 3-4. 6 According to research findings summarized by PhRMA, the period from the synthesis of a new compound to its approval by the U.S. Food and Drug Administration (FDA) can last 10 to 15 years; only one out of every 5,000 compounds synthesized in a laboratory ends up gaining FDA approval; the cost of developing a new drug (including the cost of failures) rose from $175 million in 1975 to $1.3 billion in 2006 for large pharmaceutical firms; and only two out of 10 newly approved drugs earn enough revenues to cover their R&D cost. See Pharmaceutical Research and Manufacturers of America, Profile 2008: Pharmaceutical Industry (Washington: 2008), p. 6. 7 When a drug loses its patent protection, several generic drug makers typically enter the market at once, charging prices that are as much as 80% below the price for the original patented drug. This price competition usually causes the market share of the seller of that drug to drop sharply in a relatively short time. 8 A blockbuster drug is commonly thought of as a drug whose annual worldwide sales equal or exceed $1 billion. See Herman Saftlas, Industry Surveys, Healthcare: Pharmaceuticals (Standard & Poor‘s, Nov. 27, 2008), p. 22. 9 National Institute for Health Care Management Foundation, Changing Patterns of Pharmaceutical Innovation (Washington: May 2002), p. 3, available at http://www.nihcm.or/research. 10 Kaiser Family Foundation, Prescription Drug Trends (Washington: Sept. 2008), pp. 2-3, available at http://www.kff.org.

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U.S. Census Bureau, 2002 Economic Census: Concentration Ratios in Manufacturing (Washington: May 2006), Table 2, p. 27. 12 F. M. Scherer, Industry Structure, Strategy, and Public Policy (New York: HarperCollins, 1996), p. 337. 13 Standard & Poor‘s Industry Surveys, Healthcare: Pharmaceuticals, p. 33. 14 Ibid., p. 13. 15 U.S. Congress, Office of Technology Assessment, Pharmaceutical R&D: Costs, Risks, and Rewards (Washington: GPO, Feb. 1993), pp. 290-293. 16 For more details on the provision in the act allowing for patent-term extensions, see CRS Report RL3 0756, Patent Law and Its Application to the Pharmaceutical Industry: An Examination of the Drug Price Competition and Patent Term Restoration Act of 1984 (“The Hatch-Waxman Act ”), by Wendy H. Schacht and John R. Thomas. 17 F. M. Scherer, Industry Structure, Strategy, and Public Policy (New York: Harper-Collins, 1996), p. 361. 18 Wesley M. Cohen, Richard R. Nelson, and John P. Walsh, Protecting Their Intellectual Assets: Appropriability Conditions and Why U.S. Manufacturing Firms Patent (or not), working paper 7552 (Cambridge, MA: National Bureau of Economic Research, Feb. 2000), table 1, p. 32. 19 Ibid., p. 342. 20 Available at http://money.cnn.com/magazines 21 Once a prescription drug‘s patent expires, one or more generic versions, which are chemical copies of the patented drug, usually become immediately available at lower prices. The price of a new generic drug is typically 25% to 50% lower than that of its branded counterpart. 22 According to IMS Health Inc., drug sales in the United States totaled $207.4 billion in the 12 months ending in July 2008, while Japan recorded drug sales of $64.4 billion and combined sales in Germany, France, Italy, Spain, and the United Kingdom came to $32.3 billion. See Standard & Poor‘s Healthcare: Pharmaceuticals (New York: Nov. 27, 2008), p. 10. 23 Scherer, Industry Structure, Strategy, and Public Policy, p. 342. 24 The data can be accessed at http://www.bea.gov/bea/di/home/directinv. 25 Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 2008 (Washington: PhRMA, 2008), p. 58, available at http://www.phrma.org. 26 Ibid., p. 52. 27 Standard & Poor‘s, Healthcare: Pharmaceuticals, p. 31. 28 The firms were Pfizer, Johnson & Johnson, Merck, Bristol-Myers Squibb, Abbott Laboratories, and Schering Plough. See John A. Almond and Martin A. Sullivan, ―Drug Firms Park Increasing Share of Profits in LowTax Countries,‖ Tax Notes, Sept. 20, 2004, p. 1,336. 29 For further details on the design of the credit and congressional proposals to extend it, see CRS Report RS20695, The Puerto Rican Economic Activity Tax Credit: Current Proposals and Scheduled Phaseout, by David L. Brumbaugh. 30 U.S. General Accounting Office, Pharmaceutical Industry: Tax Benefits of Operating in Puerto Rico, GAO report GGD-92-72BR (Washington: May 1992), pp. 4-7. 31 Since 1998, so-called small corporations have been exempt from the AMT. To qualify for the exemption, a corporation‘s average gross receipts cannot exceed $7.5 million in the three previous tax years. 32 Andrew Lyon, ―Alternative Minimum Tax, Corporate,‖ in The Encyclopedia of Taxation & Tax Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds. (Washington: Urban Institute Press, 2005), p. 9. 33 Ibid., p. 10. 34 The source for the data is the 2002 economic census conducted by the U.S. Bureau of the Census. The census is conducted every five years; data from the 2007 census are still being collected. See http://www.ce nsus.gov/econ/ census02. 35 The GBC in any tax year is the sum of the investment credit, the work opportunity credit, the alcohol fuels credit, the research credit, the low-income housing credit, the enhanced oil recovery credit, the disabled access credit, the renewable electricity production credit, the empowerment zone employment credit, the Indian employment credit, the employer social security tip credit, the orphan drug credit, the new markets credit, the small employer credit for pension plan startup costs, the credit for employer-provided child care facilities and services, the qualified railroad track maintenance credit, the biodiesel and renewable diesel fuels credit, the low-sulfur diesel fuel production credit, the marginal oil and gas well production credit, the distilled spirits credit, the advanced nuclear power facility production credit, the non-conventional fuels credit, the energyefficient home credit, the energy-efficient appliance credit, the alternative motor vehicle credit, the alternative fuel vehicle refueling property credit, the Hurricane Katrina housing credit, the Hurricane Katrina, Rita, and Wilma employee retention credit, the mine rescue team training credit, the credit for contributions to selected community development corporations, and general credits for an electing large partnership. 36 For more details on the design of the credit and initiatives in the 1 10 th Congress to modify it, see CRS Report RL3 1181, Research and Experimentation Tax Credit: Current Status and Selected Issues for Congress, by Gary Guenther.

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CRS Report RL3 0479, The Research and Experimentation Tax Credit: Current Law and Selected Policy Issues for the 106th Congress, by Gary Guenther. 38 Pharmaceutical Research and Manufacturers of America, 2002 Industry Profile, pp. 19-22. 39 As of May 16, 2008. 40 Standard & Poor‘s, Healthcare: Pharmaceuticals, p. 21. 41 The marginal effective tax rate on business income is the expected pre-tax rate of return minus the expected aftertax rate of return on a new investment, divided by the pre-tax rate of return. It typically accounts for the statutory tax rate, accelerated depreciation allowances, and economic rates of depreciation adjusted for inflation. Nonetheless, the rate can be adjusted to reflect the influence of other detailed provisions of the tax code. In essence, the rate summarizes the tax incentives to invest in a particular asset or set of assets. As such, it may bear little relation to an industry‘s average effective tax rate, which measures the actual tax paid in a given year as a share of actual capital income in that year earned from all past investment. For more information on the computation and uses of the marginal effective tax rate, see Don Fullerton, ―Marginal Effective Tax Rate,‖ in The Encyclopedia of Taxation and Tax Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds. (Washington: Urban Institute Press, 1999), pp. 231-233. 42 To some analysts, the deferral of tax payments is analogous to receiving an interest-free loan from the federal government. For more details on the benefits of tax deferral, see Emil M. Sunley, ―Deferral of Tax,‖ in The Encyclopedia of Taxation and Tax Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds. (Washington: Urban Institute Press, 2005), pp. 75-77. 43 U.S. Congress, Senate Committee on the Budget, Tax Expenditures: A Compendium of Background Material on Individual Provisions, committee print, 106th Cong., 2d sess. (Washington: GPO, Dec. 2000), p. 32. 44 The six firms are Pfizer, Johnson & Johnson, Merck, Bristol-Myers Squibb, Abbott Laboratories, and Schering Plough. See John A. Almond and Martin A. Sullivan, ―Drug Firms Park Increasing Share of Profits in LowTax Countries,‖ Tax Notes, Sept. 20, 2004, p. 1,337. 45 Martin A. Sullivan, ―U.S. Drug Firms Bring Home $98 Billion,‖ Tax Notes, Apr. 17, 2006, p. 285. 46 The analysis focused on the top 100 of the Fortune 500 in 2003. Of these companies, 67 reported unrepatriated foreign profits of $352.5 billion in 2003. Six of the top 20 companies were pharmaceutical firms: Pfizer, Merck, Bristol-Myers Squibb, Schering-Plough, Eli Lilly, and Wyeth. They reported a total of $95.6 billion in accumulated unrepatriated foreign profits in 2003, or 27% of the total for the entire sample of 67 companies. See John A. Almond and Martin A. Sullivan, ―While Congress Dawdles, Trapped Foreign Profits Surge,‖ Tax Notes, June 28, 2004, pp. 1587-1592. 47 A controlled foreign corporation is a corporation located in a country outside the United States in which U.S. shareholders own directly or indirectly more than 50% of either the foreign corporation‘s total combined voting power or the total value of all stock on any day of a tax year. 48 Melissa Redmiles, ―The One-Time Received Dividend Deduction,‖ Statistics of Income Bulletin, Spring 2008 (Washington: Internal Revenue Service, 2008), p. 104. 49 See Alex Berenson, ―Drug Makers Reap Benefits of Tax Break,‖ New York Times, May 8, 2005, p. 20. 50 Alex Berenson, ―Tax Break Used by Drug Makers Failed to Add Jobs,‖ New York Times, July 24, 2007, p. C1. 51 Martin A. Sullivan, ―Drug Firms Move Profits to Save Billions,‖ Tax Notes, Aug. 7, 2006, p. 472. 52 Ibid., p. 472. 53 Under IRC Section 174(b), business taxpayers have the option of treating R&D expenditures as a deferred expense and amortize them over a period of not less than 60 months, beginning with the month a taxpayer first realizes benefits from the expenditures. 54 See Internal Revenue Service Final Regulation § 1. 174-2(a)(1). 55 Estimates of the rate of depreciation for R&D capital range from 15% to 30% per year. See James R. Hines, Jr., ―No Place Like Home: Tax Incentives and the Location of R&D by American Multinationals,‖ NBER Working Paper 4574 (Cambridge, MA: National Bureau of Economic Research, Dec. 1993), p. 7; and Bronwyn H. Hall and John van Reenen, ―How Effective Are Fiscal Incentives for R&D? A Review of the Evidence,‖ NBER Working Paper 7098 (Cambridge, MA: National Bureau of Economic Research, April 1999), p. 6. 56 Because of the availability of a research tax credit, the marginal effective rate on a portion of business R&D investment is actually negative. 57 This assumes that a firm is unable to benefit from the small business expensing allowance under IRC Section 179. In 2008, a business taxpayer may write off or expense up to $250,000 of the qualified assets it places in service that year. This allowance is subject to two limitations: a dollar limitation and an income limitation. Under the former, the allowance is reduced by the amount by which total spending on qualified assets in a tax year exceeds a phaseout threshold; in 2008, that threshold is $800,000. Under the latter, the allowance a taxpayer claims cannot exceed the taxable income it earns through the active conduct of the trade or business in which the qualified assets are used. For more information on the small business expensing allowance, see CRS Report RL3 1852, Small Business Expensing Allowance: Current Status, Legislative Proposals, and Economic Effects, by Gary Guenther.

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58

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National Science Foundation, Division of Science Resources Statistics, U.S. Business R&D Expenditures Increase in 2006; Companies’ Own and Federal Contributions Rise, InfoBrief, NSF 08-313 (Arlington, VA: Aug. 2008), tables 2 and 3. NSF restricts its measure of R&D expenditures to compensation for researchers and the cost of materials, supplies, and overhead used in R&D. 59 It should be noted that the nominal value of this tax savings might be the same even if pharmaceutical firms were required to recover the R&D expenses according to a depreciation schedule based on the economic lives of the intangible assets (mainly patents) they create. But the savings would be spread out over a number of years, reducing its present value in 2006 dollars. 60 Ernst R. Berndt, Linda Bui, David Reiley, and Glen Urban, ―The Roles of Marketing, Product Quality and Price Competition in the Growth and Composition of the U.S. Anti-Ulcer Drug Industry,‖ Working Paper 4904 (Cambridge, MA: National Bureau of Economic Research, Oct. 1994), pp. 35. Detailing is the widespread industry practice of promoting drugs directly to physicians by sending marketing representatives to doctor offices and hospitals. 61 Ibid., p. 36. 62 See Mark Hirschey, ―Intangible Capital Aspects of Advertising and R&D Expenditures,‖ Journal of Industrial Economics, vol. 30, no. 4, June 1982, pp. 375-3 89. 63 U.S. Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options (Washington: GPO, 1997), p. 377. 64 Internal Revenue Service, Statistics of Income Division, 2005 Corporation Source Book, Publication 1053 (Washington). 65 Harvey S. Rosen, Public Finance, 6th edition (New York: McGraw-Hill/Irwin, 2002), p. 409. 66 For a discussion of the impact of taxes on the user cost of capital, see Jane G. Gravelle, ―Cost of Capital,‖ in The Encyclopedia of Taxation and Tax Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds. (Washington: Urban Institute Press, 1999), pp. 68-70. 67 See CRS Report 98-871, Science, Engineering, and Mathematics Education: Status and Issues, by Christine M. Matthews, pp. 14-18. 68 U.S. Government Accountability Office, New Drug Development: Science, Business, Regulatory, and Intellectual Property Issues Cited as Hampering Drug Development Efforts, GAO-07-49 (Washington: Nov. 2006), pp. 25-36.

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In: Pharmaceutical Industry: Innovation and Developments ISBN: 978-1-61209-394-9 Editors: David A. Mancuso and Isobel M. Grenada © 2011 Nova Science Publishers, Inc.

Chapter 7

PHARMACEUTICAL PATENT LITIGATION SETTLEMENTS: IMPLICATIONS FOR COMPETITION AND INNOVATION John R. Thomas

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SUMMARY Although brand-name pharmaceutical companies routinely procure patents on their innovative medications, such rights are not self-enforcing. Brand-name firms that wish to enforce their patents against generic competitors must commence litigation in the federal courts. Such litigation ordinarily terminates in either a judgment of infringement, which typically blocks generic competition until such time as the patent expires, or a judgment that the patent is invalid or not infringed, which typically opens the market to generic entry. As with other sorts of commercial litigation, however, the parties to pharmaceutical patent litigation may choose to settle their case. Certain of these settlements have called for the generic firm to neither challenge the brand-name company‘s patents nor sell a generic version of the patented drug for a period of time. In exchange, the brand-name drug company agrees to compensate the generic firm, often with substantial monetary payments over a number of years. Because the payment flows counterintuitively, from the patent proprietor to the accused infringer, this compensation has been termed a ―reverse‖ payment. Commentators have differed markedly in their views of reverse payment settlements. Some observers believe that they are a consequence of the specialized patent litigation procedures established by the Hatch-Waxman Act. Others have concluded that when one competitor pays another not to market its product, such a settlement is anti-competitive and a violation of the antitrust laws. Since 2003, Congress has required that litigants notify federal antitrust authorities of their pharmaceutical patent settlements. That legislation did not dictate substantive standards for assessing the validity of these agreements under the antitrust law, however. That determination was left to judicial application of general antitrust principles. Facing different

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factual patterns, some courts have concluded that a particular reverse payment settlement constituted an antitrust violation, while others have upheld the agreement. Congress possesses a number of alternatives for addressing reverse payment settlements. One possibility is to await further judicial developments. Another option is to regulate the settlement of pharmaceutical patent litigation in some manner. In the 111th Congress, S. 369, the Preserve Access to Affordable Generics Act, would establish a presumption that certain reverse payment settlements are unlawful. S. 369 then establishes relevant factors to be weighed in deciding whether that presumption has been overcome through a showing that the procompetitive benefits of the settlement outweigh its anticompetitive effects. The increasing costs of health care have focused congressional attention upon both the development and public availability of prescription drugs. Congress has long recognized that the patent system has an important role to play in the pharmaceutical industry in each respect. The Drug Price Competition and Patent Term Restoration Act of 1984,1 commonly known as the Hatch-Waxman Act,2 in part reformed the patent laws to balance incentives for innovation and competition within the pharmaceutical industry. Congress subsequently amended this legislation on several occasions, most recently via the Medicare Prescription Drug, Improvement, and Modernization Act of 2003.3 Recently, congressional attention has been directed towards one aspect of the patent system, the settlement of pharmaceutical patent litigation. Although brand-name pharmaceutical companies commonly procure patents on their innovative products and processes, such rights are not self- enforcing. If a brand-name drug company wishes to enforce its patents against generic competitors, it must pursue litigation in the federal courts.4 Such litigation ordinarily terminates in either a judgment of infringement, which typically blocks generic competition until such time as the patent expires, or a judgment that the patent is invalid or not infringed, which typically opens the market to generic entry. As with other sorts of commercial litigation, however, the parties to pharmaceutical patent litigation may choose to settle their case.5 Certain of these settlements call for the generic firm to neither challenge the brand-name company‘s patents nor sell a generic version of the patented drug. In exchange, the brand-name drug company agrees to make cash payments to the generic firm. This compensation has been termed an ―exclusion‖6 or ―exit‖7 payment or, because the payment flows counterintuitively, from the patent proprietor to the accused infringer, a ―reverse‖ payment.‖8 Commentators differ markedly in their views of reverse payment settlements. Some observers believe that they result from the specialized patent litigation procedures established by the Hatch- Waxman Act.9 Others conclude that when one competitor pays another not to market its product, such a settlement is anti-competitive and a violation of the antitrust laws.10 Since 2003, Congress has required that litigants notify federal antitrust authorities of their pharmaceutical patent settlements.11 To date, Congress has not stipulated substantive standards for assessing the validity of these agreements under the antitrust law, however. That determination was left to judicial application of general antitrust principles. Uniformity of results has not been a hallmark of this line of cases. 12 Facing different factual patterns, some courts have concluded that a particular reverse payment settlement constituted an antitrust violation,13 while others have upheld the agreement.14 The judicial tendency is towards a more favorable view of reverse payment settlements, however.15 In the 111th Congress, one legislative proposal would take a different approach. The Preserve Access to Affordable Generics Act (S. 369) would establish a presumption that certain reverse payment settlements

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are unlawful. S. 369 then establishes relevant factors to be weighed in deciding whether that presumption has been overcome through a showing that the procompetitive benefits of the settlement outweigh its anticompetitive effects. This chapter introduces and analyzes innovation policy issues concerning pharmaceutical patent litigation settlements. It begins with a review of pharmaceutical patent litigation procedures under the Hatch-Waxman Act. The report then introduces the concept of reverse payment settlements. Next, the report analyzes the status of reverse payment settlements under the antitrust laws. The report closes with a summary of congressional issues and alternatives.

PATENT DISPUTES UNDER THE HATCH-WAXMAN ACT

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Patent Fundamentals In order to obtain patent protection, individuals and firms must prepare and submit applications to the U.S. Patent and Trademark Office (USPTO) if they wish to obtain patent protection. 16 USPTO officials, known as examiners, then assess whether the application merits the award of a patent.17 Under the Patent Act of 1952,18 a patent application must include a specification that so completely describes the invention that skilled artisans are able to practice it without undue experimentation. The Patent Act also requires that applicants draft at least one claim that particularly points out and distinctly claims the subject matter that they regard as their invention. 19 While reviewing a submitted application, the examiner will determine whether the claimed invention fulfills certain substantive standards set by the patent statute. Two of the most important patentability criteria are novelty and nonobviousness. To be judged novel, the claimed invention must not be fully anticipated by a prior patent, publication or other knowledge within the public domain.20 The sum of these earlier materials, which document state-of-the-art knowledge that is accessible to the public, is termed the ―prior art.‖ To meet the standard of nonobviousness, an invention must not have been readily within the ordinary skills of a competent artisan based upon the teachings of the prior art.21 If the USPTO allows the application to issue as a granted patent, the owner or owners of the patent obtain the right to exclude others from making, using, selling, offering to sell or importing into the United States the claimed invention.22 The term of the patent is ordinarily set at twenty years from the date the patent application was filed.23 Patent title therefore provides inventors with limited periods of exclusivity in which they may practice their inventions, or license others to do so. The grant of a patent permits inventors to receive a return on the expenditure of resources leading to the discovery, often by charging a higher price than would prevail in a competitive market. In the pharmaceutical industry, for example, the introduction of generic competition often results in the availability of lower-cost substitutes for the innovative product. 24 A patent proprietor bears responsibility for monitoring its competitors to determine whether they are using the patented invention. Patent owners who wish to compel others to observe their intellectual property rights must usually commence litigation in the federal district courts.

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FDA Approval Procedures Although the award of a patent claiming a pharmaceutical provides its owner with a proprietary interest in that product, it does not actually allow the owner to distribute that product to the public. Permission from the FDA must first be obtained.25 In order to obtain FDA marketing approval, the developer of a new drug must demonstrate that the product is safe and effective. This showing typically requires the drug‘s sponsor to conduct both preclinical and clinical investigations.26 In deciding whether to issue marketing approval or not, the FDA evaluates the test data that the sponsor submits in a so-called New Drug Application (NDA). Prior to the enactment of the Hatch-Waxman Act, the federal food and drug law contained no separate provisions addressing marketing approval for independent generic versions of drugs that had previously been approved by the FDA.27 The result was that a would-be generic drug manufacturer had to file its own NDA in order to sell its product.28 Some generic manufacturers could rely on published scientific literature demonstrating the safety and efficacy of the drug by submitting a so-called paper NDA. Because these sorts of studies were not available for all drugs, however, not all generic firms could file a paper NDA.29 Further, at times the FDA requested additional studies to address safety and efficacy questions that arose from experience with the drug following its initial approval.30 The result was that some generic manufacturers were forced to prove once more that a particular drug was safe and effective, even though their products were chemically identical to those of previously approved pharmaceuticals. Some commentators believed that the approval of a generic drug was a needlessly costly, duplicative, and time-consuming process.31 These observers noted that although patents on important drugs had expired, manufacturers were not moving to introduce generic equivalents for these products due to the level of resource expenditure required to obtain FDA marketing approval. 32 In response to these concerns, Congress enacted the Hatch-Waxman Act, a statute that has been described as a ―complex and multifaceted compromise between innovative and generic pharmaceutical companies.‖33 Its provisions included the creation of two statutory pathways that expedited the marketing approval process for generic drugs. The first of these consist of Abbreviated New Drug Applications, or ANDAs. An ANDA allows an independent generic applicant to obtain marketing approval by demonstrating that the proposed product is bioequivalent to an approved pioneer drug, without providing evidence of safety and effectiveness from clinical data or from the scientific literature. The second are socalled § 505(b)(2) applications, which are sometimes still referred to as ―paper NDAs.‖ Like an NDA, a § 505(b)(2) application contains a full report of investigations of safety and effectiveness of the proposed product. In contrast to an NDA, however, a § 505(b)(2) application typically relies, at least in part, upon published literature providing pre-clinical or clinical data. The availability of ANDAs and § 505(b)(2) applications often allow a generic manufacturer to avoid the costs and delays associated with filing a full-fledged NDA. They may also allow an independent generic manufacturer, in many cases, to place its FDAapproved bioequivalent drug on the market as soon as any relevant patents expire.34 As part of the balance struck between brand-name and generic firms, Congress also provided patent proprietors with a means for restoring a portion of the patent term that had

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been lost while awaiting FDA approval. The maximum extension period is capped at a fiveyear extension period, or a total effective patent term after the extension of not more than 14 years.35 The scope of rights during the period of extension is generally limited to the use approved for the product that subjected it to regulatory delay.36 This period of patent term extension is intended to compensate brand-name firms for the generic drug industry‘s reliance upon the proprietary pre- clinical and clinical data they have generated, most often at considerable expense to themselves.37

Resolution of Patent Disputes

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During its development of accelerated marketing approval procedures for generic drugs, Congress recognized that the brand-name pharmaceutical firm may be the proprietor of one or more patents directed towards that drug product. These patents might be infringed by a product described by a generic firm‘s ANDA or § 505(b)(2) application in the event that product is approved by the FDA and sold in the marketplace. The Hatch-Waxman Act therefore established special procedures for resolving patent disputes in connection with applications for marketing generic drugs. In particular, the Hatch-Waxman Act states that each NDA applicant ―shall file‖ a list of patents that the applicant believes would be infringed if a generic drug were marketed prior to the expiration of these patents.38 The FDA then lists these patents in a publication titled Approved Drug Products with Therapeutic Equivalence Evaluations, which is more comm.only known as the ―Orange Book.‖39 Would-be manufacturers of generic drugs must then engage in a specialized certification procedure with respect to Orange Book-listed patents. An ANDA or § 505(b)(2) applicant must state its views with respect to each Orange Book-listed patent associated with the drug it seeks to market. Four possibilities exist: (1) that the brand-name firm has not filed any patent information with respect to that drug; (2) that the patent has already expired; (3) that the generic company agrees not to market until the date on which the patent will expire; or (4) that the patent is invalid or will not be infringed by the manufacture, use or sale of the drug for which the ANDA is submitted.40 These certifications are respectively termed paragraph I, II, III, and IV certifications.41 An ANDA or § 505(b)(2) application certified under paragraphs I or II is approved immediately after meeting all applicable regulatory and scientific requirements.42 An independent generic firm that files an ANDA or § 505(b)(2) application including a paragraph III certification must, even after meeting pertinent regulatory and scientific requirements, wait for approval until the drug‘s listed patent expires.43 The filing of an ANDA or § 505(b)(2) application with a paragraph IV certification constitutes a ―somewhat artificial‖ act of patent infringement under the Hatch-Waxman Act.44 The act requires the independent generic applicant to notify the proprietor of the patents that

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are the subject of a paragraph IV certification.45 The patent owner may then commence patent infringement litigation against that applicant.

Generic Exclusivity

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In order to encourage challenges of pharmaceutical patents, the Hatch-Waxman Act provides prospective manufacturers of generic pharmaceuticals with a potential reward. That reward consists of a 1 80-day exclusivity period awarded to the first ANDA applicant to file a paragraph IV certification.46 Once a first ANDA with a paragraph IV certification has been filed, the FDA cannot issue marketing approval to a subsequent ANDA with a paragraph IV certification on the same drug product for 180 days. Because market prices could drop considerably following the entry of additional generic competition, the first paragraph IV ANDA applicant could potentially obtain more handsome profits than subsequent market entrants—thereby stimulating patent challenges in the first instance.47 As originally enacted, the Hatch-Waxman Act stipulated that the first paragraph IV certification triggered entitlement to the 180-day generic exclusivity period. The ANDA applicant need take no further steps whatsoever. In particular, the statute did not require the generic applicant to pursue a favorable judgment with respect to the challenged patent, seek FDA approval of the ANDA, or market its generic product once the FDA granted marketing approval.48 Some commentators believed that the legislation led to abuses by certain first paragraph IV ANDA applicants, who ―parked‖ their period of exclusivity in order to bar generic competition, rather than actively pursue the marketing of their own generic products. As pharmaceutical patent expert Alfred Engelberg has asserted: Experience has shown that the first ANDA applicant to file a patent challenge may never trigger the start of the 1 80-day period, thereby blocking the FDA from granting approval to any generic product. More often than not, the first generic challenger will enter into a lucrative cash settlement with the patent owner that results in a judgment in favor of the patent and prohibits the challenger from marketing a product under its ANDA until the patent expires. Therefore, the 1 80-day exclusivity period never starts. And no subsequently filed ANDA can be approved unless a final judgment adverse to the patent is obtained by one of the subsequent applicants. But even in that circumstance, the winning party would be compelled to wait 180 days before enjoying the fruits of its victory and would not receive any exclusivity of its own. This result is dictated by the fact that, under the language of the statute, the 180 days of exclusivity belong solely to the first challenger and not to the first winner.49

When Congress amended the Hatch-Waxman Act in 2003, it responded to this concern over ―bottlenecking‖ by generic firms. The Medicare Prescription Drug, Improvement, and Modernization Act (MMA) established a number of ―forfeiture events‖ that, if triggered, cause a first paragraph IV ANDA applicant to lose its entitlement to the 1 80-day generic exclusivity.50 Among the forfeiture events are: (1) failure to market its product promptly; (2) failure to obtain FDA approval to market the generic drug in a reasonably timely manner; and (3) all of the certified patents that entitled the applicant to the 1 80-day generic exclusivity period have expired.51 If the first paragraph IV ANDA applicant forfeits its exclusivity, then this period does not ―roll over‖ to the second such applicant. In that event, no generic firm

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enjoys exclusivity at all.52 The possibility of forfeiture was intended ―to prevent the practice of ‗parking‘ the exclusivity period and to force generic manufacturers to market promptly.‖53

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FUNDAMENTALS OF REVERSE PAYMENT SETTLEMENTS As discussed previously, a generic firm‘s filing of a paragraph IV ANDA may result in a patent infringement suit brought by a brand-name drug company. In such a litigation, if the NDA holder demonstrates that the independent generic firm‘s proposed product would violate its patents, then the court will ordinarily issue an injunction that prevents the generic drug company from marketing that product. That injunction will expire on the same date as the NDA holder‘s patents. Independent generic drug companies commonly amend their ANDAs or § 505(b)(2) applications in this event, replacing their paragraph IV certifications with paragraph III certifications.54 On the other hand, the courts may decide in favor of the independent generic firm. The court may conclude that the generic firm‘s proposed product does not infringe the asserted patents, or that the asserted patents are invalid or unenforceable.55 In this circumstance, the independent generic firm may launch its product once the FDA has finally approved its ANDA or § 505(b)(2) application. In addition to the issuance of final judgment in favor of either the brand-name drug company or generic firm, another resolution of pharmaceutical patent litigation is possible. This legal situation led to a number of cases with varying details, but a common core fact pattern. Upon filing a paragraph IV ANDA, a generic firm would be sued for patent infringement as provided by the Hatch-Waxman Act. The NDA holder and generic applicant would then settle their dispute. The settlement would call for the generic firm to neither challenge the patent nor produce a generic version of the patented drug, for a period of time up to the remaining term of the patent. In exchange, the NDA holder would agree to compensate the ANDA applicant, often with substantial monetary payments over a number of years. Opinions about the effects of reverse payment settlements upon social welfare have varied. Some commentators believe that such settlements are anticompetitive. They believe that many of these agreements may amount to no more than two firms colluding in order to restrict output and share patent-based profits.56 Such settlements are also said to eliminate the possibility of a judicial holding of patent invalidity, which may open the market to generic competition and benefit consumers.57 On the other hand, some commentators have found nothing inherently troublesome about reverse payment settlements. Among their observations is that there is a general judicial policy in favor of promoting settlement. Settlements can allow the parties to avoid the expenses of litigation, achieve a resolution to the dispute in a timely manner, and avoid the risk of an uncertain result in the courtroom.58 The settlement of litigation further serves the goal of resolving disputes in a peaceful manner, and also preserves scarce judicial resources.59 Second, any settlement of litigation between rational actors necessarily involves an exchange of benefits and obligations. As Judge Richard Posner has explained:

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Third, certain reverse payment settlements have allowed for the introduction of generic competition prior to the date the relevant patent expires. It is possible, for example, for the brand- name and generic firms to ―split‖ the remaining patent term, with the generic firm being allowed to market a competing product prior to the running of the full patent term. Such agreements may potentially benefit consumers, certainly in comparison to a judgment that the patent is not invalid and infringed.61 Finally, the dispute settlement procedures established by the Hatch-Waxman Act may themselves promote the use of reverse payment settlements in pharmaceutical patent litigation. In patent litigation outside the Hatch-Waxman Act context, the accused infringer is ordinarily using or marketing the patented technology. A judicial finding of infringement would expose the accused infringer to an injunction, along with damages awarded for past uses and sales. As a result, the accused infringer may well be willing to compensate the patent proprietor in order to avoid the risk of such a holding.62 Some observers believe that the structure of the Hatch-Waxman Act alters the traditional balance of risks between the plaintiff-patentee and accused infringer. As explained by one federal district court: [I]n creating an artificial act of infringement (the ANDA IV filing), the Hatch-Waxman Amendments grant generic manufacturers standing to mount a validity challenge without incurring the cost of entry or risking enormous damages flowing from infringing commercial sales.... Because of the Hatch-Waxman scheme, [the generic firm‘s] exposure in the patent litigation was limited to litigation costs, but its upside—exclusive generic sales—was immense. The patent holder, however, has no corresponding upside, as there are no infringement damages to collect, but has an enormous downside—losing the patent.63

As a result, some commentators believe that it is entirely predictable that the unique procedures of the Hatch-Waxman Act have resulted in the new phenomenon of reverse payment settlements.64 At the present time, the congressional response to pharmaceutical patent litigation settlements has been limited. In the 2003 Medicare Prescription Drug, Improvement, and Modernization Act (MMA),65 Congress mandated that the Department of Justice (DOJ) and the Federal Trade Commission (FTC) receive copies of certain patent settlements agreements in the pharmaceutical field. The filing requirement applies to agreements executed on or after January 7, 2004, between an ANDA applicant, on one hand, and either the NDA holder or an owner of an Orange Book- listed patent, on the other.66 Such agreements trigger the statutory notification requirement if they relate to one of three topics: (1) The manufacture, marketing, or sale of the brand-name drug that is the listed in the ANDA; (2) The manufacture, marketing, or sale of the generic drug for which the ANDA was submitted; or

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(3) The 1 80-day generic exclusivity period as it applies to that ANDA, or to another ANDA filed with respect to the same brand-name drug.67 The MMA stipulates that certain agreements are not subject to this filing requirement. In particular, agreements that solely consist of purchase orders for raw materials, equipment and facility contracts, employment or consulting contracts, or packaging and labeling contracts do not need to be submitted to the DOJ or FTC.68 Further, the filing obligation applies only to ANDAs that include a paragraph IV certification. In particular, agreements with respect to § 505(b) (2) applications need not be filed. Although the MMA imposed a filing obligation upon certain patent settlements between pharmaceutical firms, that legislation did not set substantive standards as to the validity of these agreements.69 Both prior and subsequent to congressional enactment of the MMA, however, various government and private actors asserted that certain reverse payment settlements violated the antitrust laws. In order to resolve these claims, different courts applied general principles of antitrust law. Facing different factual patterns, the courts ultimately reached varying results.70 After introducing the basic concepts of antitrust law, this chapter next reviews several of the more notable judicial opinions analyzing reverse payment settlements.

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ANTITRUST IMPLICATIONS OF REVERSE PAYMENT SETTLEMENTS The primary legal mechanism for addressing conduct alleged to be anti-competitive— including reverse payment settlements—consists of the antitrust laws. The antitrust laws are comprised of the Sherman Act, the Clayton Act, the Federal Trade Commission Act, and other federal and state statutes that prohibit certain kinds of anticompetitive economic conduct. Although a complete review of the antitrust laws exceeds the scope of this chapter, other sources provide more information for the interested reader.71 Section 1 of the Sherman Act declares ―[e]very contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade ... to be illegal.‖ The courts have long interpreted this language as applying only to unreasonable restraints of trade. The determination of whether particular conduct amounts to an unreasonable restraint of trade is commonly conducted under the ―rule of reason.‖ Under this approach, ―the finder of fact must decide whether the questioned practice imposes an unreasonable restraint on competition, taking into account a variety of factors, including specific information about the relevant business, its condition before and after the restraint was imposed, and the restraint‘s history, nature, and effect.‖72 The rule of reason essentially calls upon courts to reach a judgment of reasonableness by balancing the anticompetitive consequences of a challenged practice against its business justifications and potentially procompetitive impact. Other sorts of restraints are deemed unlawful per se. Per se illegality is appropriate ―[o]nce experience with a particular kind of restraint enables the Court to predict with confidence that the rule of reason will condemn it.‖73 The Supreme Court has explained that ―there are certain agreements or practices which because of their pernicious effect on competition and lack of any redeeming virtue are conclusively presumed to be unreasonable and therefore illegal without elaborate inquiry as to the precise harm they have caused or the

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business excuse for their use.‖74 Among the practices that have been judged per se violations include price fixing, group boycotts, and market division.75 As this chapter will review, the courts have differed in their approaches to reverse payment settlements in pharmaceutical patent litigation. The Court of Appeals for the Sixth Circuit has held that one reverse payment settlement constituted a per se violation of the antitrust laws. The Courts of Appeals for the Second, Eleventh, and Federal Circuits have declined per se treatment to reverse payment settlements, employing a more permissive mode of analysis based upon the traditional rule of reason approach.76 This chapter next reviews the facts and holdings of significant judgments addressing the antitrust implications of reverse payment settlements.

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Sixth Circuit In In re Cardizem CD Antitrust Litigation,77 the Court of Appeals for the Sixth Circuit held that a reverse payment settlement agreement between Hoescht Marion Roussel Inc. (HMR) and Andrx Pharmaceuticals was per se invalid under the antitrust laws. HMR marketed the prescription drug CARDIZEM CD® and owned several patents pertaining to that product. Andrx was the first generic firm to file a paragraph IV ANDA pertaining to CARDIZEM CD®. HMR subsequently sued Andrx for patent infringement as provided by the Hatch-Waxman Act. Shortly after the FDA tentatively approved Andrx‘s ANDA, HMR and Andrx agreed to an interim settlement. Under the terms of that deal, Andrx agreed to refrain from marketing a generic version of CARDIZEM CD® until one of three events occurred: namely, that Andrx obtained a final, unappealable judgment in its favor with respect to its patent claims; that HMR licensed Andrx to market a generic version of CARDIZEM CD®; or that HMR licensed a third party to do so. Andrx further agreed to continue pursuing its ANDA at the FDA and not to relinquish or transfer its 1 80-day period of generic marketing exclusivity. In exchange, HMR paid Andrx $10 million per quarter.78 Various purchasers of CARDIZEM CD® subsequently brought suit against HMR and Andrx, alleging several violations of state and federal antitrust laws. The District Court for the Eastern District of Michigan subsequently concluded that the HMR-Andrx agreement constituted a horizontal market allocation agreement that was per se illegal under the antitrust laws.79 Following an appeal, the Court of Appeals for the Sixth Circuit affirmed. The court of appeals characterized the deal as one in which HMR and Andrx agreed to eliminate competition in the CARDIZEM CD® market. Because Andrx was entitled to the 180-day generic exclusivity, and because its agreement occurred prior to the 2003 amendments to the Hatch- Waxman Act,80 Andrx was able to ―park‖ its generic exclusivity and prevent all other generic firms from marketing. The Sixth Circuit reasoned that the HMRAndrx agreement was appropriately classified as a so-called horizontal agreement; that is to say, a restraint of trade involving businesses at the same level of competition. Such agreements had long been classified as antitrust violation per se, the court explained.81 In reaching this conclusion, the Sixth Circuit explicitly rejected several arguments offered by HMR and Andrx. The defendants asserted that because the courts did not have extensive experience with reverse payment settlements, they lacked a sufficient basis for declaring them

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per se illegal. The Sixth Circuit instead noted that ―[w]hatever may be its peculiar problems and characteristics, the Sherman Act, so far as price-fixing agreements are concerned, establishes one uniform rule applicable to all industries alike.‖82 Judge Oberdorfer further stated that ―it is one thing to take advantage of a monopoly that naturally arises from a patent, but another thing altogether to bolster the patent‘s effectiveness in inhibiting competitors by paying the only potential competitor $40 million per year to stay out of the market.‖83 The first court of appeals to address reverse payment settlements, the Sixth Circuit is thus far the only appellate court to apply a rule of illegality per se to reverse payment settlements. Subsequent courts, facing somewhat different factual circumstances, gave these settlements less strict antitrust oversight by applying an analysis that more closely resembled the traditional rule of reason approach. This chapter next reviews these developments, which arose from judicial opinions issued by the Eleventh and Second Circuits.

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Eleventh Circuit In Valley Drug Co. v. Geneva Pharmaceuticals, Inc.,84 the U.S. Court of Appeals for the Eleventh Circuit declined to employ the per se rule employed by the Sixth Circuit. Instead, the Eleventh Circuit adopted a more permissive method of analysis that resembles the traditional rule of reason. The Valley Drug case involved an arrangement Abbott Laboratories had reached with two different generic firms, Zenith Goldline Pharmaceuticals and Geneva Pharmaceuticals. Abbott was the NDA holder of the drug HYTRIN®, prescribed for treatment of hypertension and enlarged prostate. Abbott also owned several patents pertaining to HYTRIN®, including U.S. Patent No. 5,504,207 (the ‗207 patent). Zenith and Geneva each filed paragraph IV ANDAs with respect to HYTRIN®, resulting in patent infringement litigation.85 Abbott subsequently negotiated separate settlement agreements with Zenith and Geneva. In both agreements, the generic firm promised not to sell any pharmaceutical product containing terazosin hydrochloride, the active ingredient in HYTRIN®, until a relevant Abbott patent expired or was held invalid, or someone else introduced a generic version of this drug. Each generic firm also promised not to transfer or sell its rights to a 180-day exclusivity under the Hatch-Waxman Act. In return, Abbott promised to pay each generic firm a significant sum of money each month, subject to a number of termination events, including introduction of a generic version of HYTRIN® by a third party.86 At trial, the district court held that the two settlement agreements constituted a horizontal market allocation that was per se illegal under the Sherman Act. According to the district court, the generic houses were poised to market a generic version of HYTRIN®, but simply agreed not to enter the market due to their deal with Abbott.87 Following an appeal, the Eleventh Circuit reversed the district court‘s opinion and remanded for further proceedings. In reaching this result, the court of appeals held that the standard of per se illegality was ―premature‖ and inappropriate. 88 According to Judge Anderson, the district court had not appropriately factored the existence of the ‗207 patent into the analysis. The court of appeals explained that: [A] patentee‘s allocation of territories is not always the kind of territorial market allocation that triggers antitrust liability, and that is so because the patent gives its owner a Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

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John R. Thomas lawful exclusionary right. In characterizing the Agreements as territorial market allocations agreements, the district court did not consider that the ‗207 patent gave Abbott the right to exclude others from making, using, or selling anhydrous terazosin hydrochloride until October of 2014, when it is due to expire. To the extent that Zenith and Geneva agreed to market admittedly infringing products before the ‗207 patent expired or was held invalid, the market allocation characterization is inappropriate.89

Rather, the court of appeals identified several factors that should be considered by the district court on remand, including:

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(1) the scope of the exclusionary potential of the patent; (2) the extent to which the agreements exceed that scope; and (3) the resulting anticompetitive effects.90 In its subsequent decision in Schering-Plough Corp. v. FTC,91 the Eleventh Circuit confirmed the approach taken in Valley Drug. This case concerned the Schering-Plough Corp. (Schering) drug K-DUR 20®, which is used to treat or prevent low potassium levels in the blood. Although the drug‘s active ingredient, potassium chloride, lies in the public domain, Schering‘s U.S. Patent 4,863,743 claims an extended-release coating used in K-DUR 20®. The ‗743 patent expired on September 5, 2006.92 When two generic firms, Upsher-Smith Laboratories (Upsher) and ESI Lederle Inc. (ESI), filed paragraph IV ANDAs, Schering promptly brought suit for patent infringement. Schering subsequently resolved its differences with Upsher and ESI via two separate agreements. During its negotiations with Upsher, Schering refused to pay Upsher merely to ―stay off the market.‖93 Schering did agree to license five of Upsher ‘s products, however. In addition, Upsher promised not to market a generic version of K-DUR 20® prior to September 1, 2001.94 In exchange, Schering promised to pay Upsher a $60 million up-front royalty, along with $10 million in milestone royalty payments and royalties of 10% or 15% on sales.95 Under the ESI settlement, Schering agreed to allow ESI to market a generic version of KDUR 20® on January 1, 2004. Schering also agreed to pay $5 million to cover ESI‘s legal fees, as well as $10 million if ESI received FDA approval to market its generic product by a certain date. Finally, Schering obtained the right to license two generic products from ESI for $15 million.96 Following a complaint by FTC counsel, the FTC Commission held that these arrangements were anticompetitive under the rule of reason.97 Schering and Usher appealed the Commission‘s decision to the Eleventh Circuit, which reversed. Confirming its analysis under the contours laid out in Valley Drug, the Eleventh Circuit first observed that the ‗743 patent enjoyed a statutory presumption of validity.98 Further, under the terms of their agreements with Schering, Upsher was able to market a generic product a full five years before the ‗743 patent‘s expiration, while ESI could market two years in advance. 99 The Eleventh Circuit next concluded that the licenses granted to Schering constituted adequate consideration for the payments made by Schering, rather than amounting to thinly disguised payoffs to delay the introduction of generic competition. According to Judge Fay, Schering had long been interested in licensing those products. As a result, the ScheringUpsher and ScheringESI agreements were legitimate settlements within the scope of the ‗743 patent‘s exclusionary power. 100

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Finally, the court of appeals compared the scope of the ‗743 patent with that of the ScheringUpsher and Schering-ESI agreements. Judge Fay concluded that they were commensurate, with each specifically addressing controlled release microencapsulated potassium chloride tablets. As a result the agreements could not be said to be overly broad, nor did they delay the entry of other generic products.101 As a result, the decision of the FTC was reversed.102

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Second Circuit The issue of reverse payment settlements came before the Second Circuit in In re Tamoxifen Citrate Antitrust Litigation.103 This judicial opinion resulted from extremely complex factual and legal circumstances. Zeneca was the owner of patent covering tamoxifen, the most widely prescribed drug for the treatment of breast cancer. A generic firm, Barr Laboratories, filed an ANDA that it subsequently amended to include a paragraph IV certification. Zeneca responded by filing a charge of patent infringement in keeping with the procedures of the Hatch-Waxman Act. In an opinion issued in 1992, the district court held that the tamoxifen patent was invalid and unenforceable104 Zeneca appealed the district court‘s judgment. While the appeal was pending, Zeneca and Barr entered into a confidential settlement agreement. As part of that deal, Barr agreed to amend its ANDA to include a paragraph III certification and further agreed not to sell its own generic version of tamoxifen until the patent‘s expiration in 2002. In exchange, Zeneca agreed to pay Barr $21 million and to provide Barr with a non-exclusive license to sell an ―authorized generic‖ version of tamoxifen—that is to say, an Zeneca-manufactured tamoxifen under Barr‘s label. 105 The parties further agreed that if the tamoxifen patent were declared invalid or unenforceable, then Barr could revert to its paragraph IV certification.106 Pursuant to the settlement, and consistent with governing law at that time, the court of appeal remanded the case to the district court, which then vacated its judgment of invalidity and unenforceability.107 Following the settlement between Zeneca and Barr, three other generic firms—Novopharm Ltd., Mylan Pharmaceutical, Inc., and Pharmachemie B.V.—filed tamoxifen ANDAs with paragraph IV certifications.108 Zeneca once more filed charges of patent infringement against each of these firms as allowed by the Hatch-Waxman Act. In each of these three cases, the court refused to rely upon the vacated 1992 judgment to hold that Zeneca‘s tamoxifen patent was invalid. Further, the courts hearing the Noveopharm and Pharmachemie cases upheld the validity of Zeneca‘s tamoxifen patent.109 The Mylan case ended with a consent order that FDA approval of the generic application would not become effective prior to the expiration of the tamoxifen patent.110 While those three cases were pending, the FDA granted tentative approval for Pharmachemie to market a generic version of tamoxifen. However, Barr petitioned the FDA to recognize that Barr was entitled to 180 days of generic marketing exclusivity111 as the first paragraph IV ANDA applicant. The effective result was that the FDA prevented the marketing of other generic versions of tamoxifen until either the Zeneca patent expired, or 180 days elapsed from the date that Barr sold its own generic version of tamoxifen. Of course, because Barr was already distributing Zeneca‘s ―authorized generic,‖ Barr apparently had little incentive to launch its own generic product.112

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Consumers and consumer groups subsequently filed numerous lawsuits challenging the settlement between Zeneca and Barr on antitrust grounds. The trial court rejected these claims, however, and on appeal the Second Circuit affirmed.113 The Second Circuit began by observing that although a tension existed between antitrust law and patent law, the courts have long favored settlements of litigation. The court of appeals saw the law as well-settled that ―‗where there are legitimately conflicting [patent] claims ... , a settlement by agreement, rather than litigation, is not precluded by the [Sherman] Act,‘ although such a settlement may ultimately have an adverse effect on competition.‖114 In view of longstanding policies favoring the settlement of litigation, the court of appeals concluded that ―without alleging something more than the fact that Zeneca settled after it lost to Barr in the district court that would tend to establish that the Settlement Agreement was unlawful, the assertion that there was a bar—antitrust or otherwise—to the defendants‘ settling the litigation at the time that they did is unpersuasive.‖115 The Second Circuit largely based its conclusion upon the fact that the outcome of patent litigation was unpredictable. That the 1992 judgment had found the tamoxifen patent invalid was, by itself, not of great moment: ―That Zeneca had sufficient confidence in its patent to proceed to trial rather than find some means to settle the case first should hardly weigh against it.‖116 While holding that the reasonableness of the settlement must be judged at the time the agreement was concluded,117 the court of appeals further observed that federal district courts in the later lawsuits disagreed with the 1992 judgment and upheld the tamoxifen patent.118 The Second Circuit next declined to condemn the existence of reverse payments in a pharmaceutical patent settlement as an antitrust violation per se. Agreeing with the analysis of the Eleventh Circuit in the Schering-Plough case that the Hatch-Waxman changed the relative risk profiles of the patent holder and accused infringer, the court of appeals found ―no sound basis for categorically condemning reverse payments employed to lift the uncertainty surrounding the validity and scope of the holder‘s patent.‖119 The court of appeals further disagreed with the plaintiffs‘ contention that the Zeneca-Barr settlement was unlawful because ―[t]he value of the consideration provided to keep Barr‘s product off the market ... greatly exceeded the value Barr could have realized by successfully defending its trial victory on appeal and entering the market with its own competitive generic product.‖120 To the contrary, the Second Circuit reasoned, it may well make economic sense for the patent proprietor to pay its generic rival more than its expected earnings. The reason, of course, is that the total profits of the patent holder and generic firm in a competitive market would be less than the supracompetitive profits earned by the patentee alone, and that the patent proprietor might find it sensible to pay a portion of that difference to the generic firm. The Second Circuit further held that ―so long as the patent litigation is neither a sham nor otherwise baseless, the patent holder is seeking to arrive at a settlement in order to protect that to which it is presumptively entitled: a lawful monopoly over the manufacture and distribution of the patented product.‖121 The Second Circuit‘s analysis continued with a review of the terms of the Zeneca-Barr settlement agreement. Citing Schering-Plough, the court of appeals framed the question as ―whether the ‗exclusionary effects of the agreement‘ exceed the ‗scope of the patent‘s protection.‘‖122 The court of appeals characterized the tamoxifen patent as a compound patent, rather than one directed towards a more limited formulation. As a result, although the settlement precluded Barr from manufacturing any generic form of tamoxifen, so too did

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Zeneca‘s compound patent. The settlement agreement therefore did not restrain the marketing of non-infringing products, the court reasoned. 123 The Second Circuit further explained that the Zeneca-Barr settlement also allowed Barr to introduce a authorized generic market into the tamoxifen market. Although the price difference between the Zeneca and Barr products was modest, this consumer benefit nonetheless occurred almost nine years before Zeneca‘s patent was due to expire. As a result, the settlement agreement produced more competition than would have occurred had the parties not settled and Zeneca had prevailed on appeal. 124 As a result, the Second Circuit affirmed the trial court‘s conclusion that the Zeneca-Barr settlement did not violate the antitrust laws.

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Federal Circuit In In re Ciprofloxacin Hydrochloride Antitrust Litigation,125 the Federal Circuit agreed with the Second and Eleventh Circuits that reverse payment settlements should be analyzed under the rule of reason to determine whether they impose an unreasonable restraint on competition or not. That litigation involved a patent claiming ciprofloxacin hydrochloride, the active ingredient in the antibiotic CIPRO®. That patent is owned by Bayer AG and Bayer Corp. (collectively ―Bayer‖). When a generic firm, Barr Labs., Inc. (―Barr‖), filed a paragraph IV ANDA, Bayer responded by bringing suit for patent infringement under the provisions of the Hatch-Waxman Act on January 16, 1992. That litigation resulted in an agreement where Bayer would sell CIPRO® to Barr for resale or make quarterly payments to Barr of $49.1 million.126 Bayer paid Barr a total of $398 million under this agreement. 127 In 2000 and 2001, purchasers of Cipro and several advocacy groups brought antitrust action claiming that the agreements violated the antitrust law. The district court rejected these arguments,128 and on appeal the Federal Circuit affirmed. The Federal Circuit initially concluded that a rule of per se illegality was inappropriate because the courts could not confidently predict that reverse payment settlements had an anticompetitive effect with limited potential for procompetitive benefit. As a result, the court of appeals concluded that rule of reason was the appropriate mode of analysis.129 Applying the rule of reason, the Federal Circuit confirmed that the plaintiffs had failed to demonstrate that the settlements agreements violated the antitrust laws. The court of appeals reasoned that the scope of the Bayer-Barr agreement did not exceed that of Bayer‘s patent. As a result, Bayer‘s rights as a patentee allowed it to exclude generic firms from profiting from its invention. 130 The court of appeals further concluded that, in the absence of evidence of fraud before the USPTO or sham litigation, the court need not consider the validity of the patent in its antitrust analysis. Judge Prost observed that a patent is presumed valid, and held that a ―settlement is not unlawful if it serves to protect that to which the patent holder is legally entitled—a monopoly over the manufacture and distribution of the patented invention.‖131 In upholding the settlement, the Federal Circuit cited with favor the district court‘s observation that no evidence demonstrated that it blocked other generic firms from challenging Bayer‘s patent. Indeed, Judge Prost observed, the patent survived subsequent

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challenges by four other generic manufactures.132 Finally, the court of appeals also cited ―a long-standing policy in the law in favor of settlements‖ in support of its conclusion.133

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ISSUES AND OBSERVATIONS In the absence of explicit congressional guidance, the federal courts have applied general principles of antitrust law to reach varying results with respect to pharmaceutical patent litigation settlements. It is significant that the different cases considered by these courts have each involved their own, distinct set of facts. Nonetheless, the difference between the per se rule on one hand, and alternative approaches similar to the rule of reason on the other, have arguably contributed to different judicial outcomes. Several options are available for Congress. One possibility is to await further judicial developments. While the United States Supreme Court has not yet addressed pharmaceutical litigation patent settlements, it is possible that the highest Court may do so in the future. Supreme Court review would resolve the arguable split among the courts of appeal with respect to this issue. Continuing case law developments in the lower courts could also lead to an informed consensus on the antitrust consequences of reverse payment settlements. Another option is to regulate the settlement of pharmaceutical patent litigation in some manner. In the 111th Congress, S. 369, titled the Preserve Access to Affordable Generics Act, would so address reverse payment settlements. That legislation was introduced on February 3, 2009, by Senator Kohl. The Committee on the Judiciary reported the legislation with an amendment in the nature of a substitute on October 15, 2009. S. 369 would amend the Federal Trade Commission (FTC) Act to allow the FTC to initiate a proceeding against the parties to any agreement resolving or settling a patent infringement claim in connection with a drug product. The legislation would create a presumption that such an agreement has anticompetitive effects and be unlawful if the ANDA filer receives anything of value and the ANDA filer agrees not to research, develop, manufacture, market, or sell the ANDA product for any period of time. This presumption of unlawfulness shall not apply if the parties to the agreement demonstrate by clear and convincing evidence that the precompetitive benefits of the agreement outweigh the anticompetitive effects of the agreement. In considering whether the settling parties have met that burden, the legislation requires consideration of (1) the remaining term of the relevant patent, compared with the agreed upon entry date of the ANDA product; (2) the value to consumers of the competition from the ANDA product; (3) the form and amount of consideration provided to the ANDA filer; (4) the revenue the ANDA filer would have received by winning the patent litigation; (5) the reduction in the NDA holder‘s revenues if it had lost the patent litigation; (6) the time period between the date of the agreement conveying value to the ANDA filer and date of the settlement of the patent case; and (7) any other relevant factor.134 Under S. 369, in determining whether the settling parties have met their burden of overcoming the presumption of unlawfulness, it shall not be presumed that entry of the ANDA product would not have occurred until the expiration of the relevant patent or statutory exclusivity. Nor shall it be presumed that the agreement‘s provision for entry of the ANDA product prior to the expiration of the relevant patent or statutory exclusivity means

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that the agreement is pro-competitive, although such evidence may be relevant to the determination. Further, S. 369 expressly does not prohibit a resolution or settlement of a patent litigation claim in which the consideration granted by the NDA holder to the ANDA applicant includes only one or more of the following: (1) the right to market the ANDA product prior to the expiration of any relevant proprietary rights; (2) a payment for reasonable litigation expenses not to exceed $7.5 million; and (3) a covenant not to sue the ANDA product for patent infringement. The penalty for violating this provision consists of an injunction and other equitable relief, as well as a civil fine not to exceed three times the value received by a party that is attributable to the violation. 135 Other alternatives are also possible. For example, in the 110th Congress, S. 316, also titled the Preserve Access to Affordable Generics Act, proposed to outlaw such agreements. In particular, that bill would amend the Clayton Act to provide in part:

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It shall be unlawful under this Act for a person, in connection with the sale of a drug product, to directly or indirectly be a party to any agreement resolving or settling a patent infringement claim [in] which—(A) an ANDA filer receives anything of value; and (B) the ANDA filer agrees not to research, develop, manufacture, market, or sell the ANDA product for any period of time.136

This proposed legislation would have effectively made reverse payment settlements a per se antitrust violation, as the Sixth Circuit concluded in the Cardizem CD case. That legislation was not enacted. The settlement of pharmaceutical patent litigation forms an important issue because such litigation is itself important to our public health system. Our patient population relies upon brand- name drug companies to develop new medicines, but it also relies upon generic firms to increase access to such medications once they have been developed. The Hatch-Waxman Act provides for patent litigation between these two traditional rivals as a primary vehicle through which these competing demands are mediated. When concluded in a manner that comports with antitrust principles, such settlements may further the public policy goals of encouraging the labors that lead to medical innovation, but also distributing the fruits of those labors to consumers.

End Notes 1

P.L. 84-417, 98 Stat. 1585 (1984). See, e.g., Laura J. Robinson, ―Analysis of Recent Proposals to Reconfigure Hatch-Waxman,‖ 11 Journal of Intellectual Property Law (2003), 47. 3 P.L. 108-173, 117 Stat. 2066. 4 35 U.S.C. § 281 (2006). 5 See John Fazzio, ―Pharmaceutical Patent Settlements: Fault Lines at the Intersection of Intellectual Property and Antitrust Law Require a Return to the Rule of Reason,‖ 11 Journal of Technology Law and Policy (2006), 1. 6 See Herbert Hovenkamp et al., ―Balancing Ease and Accuracy in Assessing Pharmaceutical Exclusion Payments,‖ 88 Minnesota Law Review (2004), 712. 7 Valley Drug Co. v. Geneva Pharms., Inc., 344 F.3d 1294, 1309 (11 th Cir. 2003). 8 See Thomas F. Cotter, ―Refining the ‗Presumptive Illegality‘ Approach to Settlements of Patent Disputes Involving Reverse Payments: A Commentary on Hovenkamp, Janis & Lemley,‖ 87 Minnesota Law Review (2003), 1789. 9 See Kent S. Bernard & Willard K. Tom, ―Antitrust Treatment of Pharmaceutical Patent Settlements: The Need for Context and Fidelity to First Principles,‖ 15 Federal Circuit Bar Journal (2006), 617. 2

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10

See Thomas F. Cotter, ―Antitrust Implications of Patent Settlements Involving Reverse Payments: Defining a Rebuttable Presumption of Illegality in Light of Some Recent Scholarship,‖ 71 Antitrust Law Journal (2004), 1069. 11 Medicare Prescription Drug, Improvement, and Modernization Act of 2003, P.L. 173 ,1 17 Stat. 2066, § 1112(a). 12 See John R. Thomas, Pharmaceutical Patent Law (2005), 572-73. 13 In re Cardizem CD Antitrust Litigation, 332 F.3d 896 (6th Cir. 2003). 14 Schering-Plough Corp. v. FTC, 402 F.3d 1056 (1 1th Cir. 2005). 15 See James C. Burling, ―Hatch-Waxman Patent Settlements: The Battle for a Benchmark,‖ 20-SPG Antitrust (2006), 41. 16 35 U.S.C. § 111 (2006). 17 35 U.S.C. § 131 (2006). 18 P.L. 593, 66 Stat. 792 (1952). 19 35 U.S.C. § 112 ¶ 2 (2006). 20 35 U.S.C. § 102 (2006). 21 35 U.S.C. § 103 (2006). 22 35 U.S.C. § 271(a) (2006). 23 35 U.S.C. § 154(a)(2) (2006). 24 See Jayanta Bhattacharya & William B. Vogt, ―A Simple Model of Pharmaceutical Price Dynamics,‖ 4 Journal of Law & Economics (2003), 599. 25 CRS Report RL3 0989, The U.S. Drug Approval Process: A Primer, by Blanchard Randall IV. 26 See G. Lee Skillington & Eric M. Solovy, ―The Protection of Test and Other Data Required by Article 39.3 of the TRIPS Agreement,‖ 24 Northwestern Journal of International Law and Business (2003), 1. 27 See Alfred B. Engelberg, ―Special Patent Provisions for Pharmaceuticals: Have They Outlived Their Usefulness?,‖ 39 IDEA: Journal of Law and Technology (1999), 389. 28 See James J. Wheaton, ―Generic Competition and Pharmaceutical Innovation: The Drug Price Competition and Patent Term Restoration Act of 1984,‖ 34 Catholic University Law Review (1986), 433. 29 See Kristin E. Behrendt, ―The Hatch-Waxman Act: Balancing Competing Interest or Survival of the Fittest?,‖ 57 Food & Drug Law Journal (2002), 247. 30 Id. 31 See, e.g., Justina A. Molzon, ―The Generic Drug Approval Process,‖ 5 Journal of Pharmacy & Law (1996), 275 (―The Act streamlined the approval process by eliminating the need for [generic drug] sponsors to repeat duplicative, unnecessary, expensive and ethically questionable clinical and animal research to demonstrate the safety and efficacy of the drug product.‖). 32 See Jonathan M. Lave, ―Responding to Patent Litigation Settlements: Does the FTC Have It Right Yet?,‖ 64 University of Pittsburgh Law Review (2002), 201 (―Hatch-Waxman has also increased the generic drug share of prescription drug volume by almost 130% since its enactment in 1984. Indeed, nearly 100% of the top selling drugs with expired patents have generic versions available today versus only 35% in 1983.‖). 33 Natalie M. Derzko, ―A Local and Comparative Analysis of the Experimental Use Exception—Is Harmonization Appropriate?,‖ 44 IDEA: Journal of Law and Technology (2003), 1. 34 See, e.g., Sarah E. Eurek, ―Hatch-Waxman Reform and Accelerated Entry of Generic Drugs: Is Faster Necessarily Better?,‖ 2003 Duke Law & Technology Review (Aug. 13, 2003), 18. 35 35 U.S.C. § 156(b) (2006). 36 35 U.S.C. § 156(b)(1) (2006). 37 See CRS Report RL30756, Patent Law and Its Application to the Pharmaceutical Industry: An Examination of the Drug Price Competition and Patent Term Restoration Act of 1984 (“The Hatch-Waxman Act”), and CRS Report RL32377, The Hatch-Waxman Act: Legislative Changes Affecting Pharmaceutical Patents, both by Wendy H. Schacht and John R. Thomas. 38 21 U.S.C. § 355(b)(1) (2006). 39 See, e.g., Jacob S. Wharton, ―‗Orange Book‘ Listing of Patents Under the Hatch-Waxman Act,‖ 47 St. Louis University Law Journal (2003), 1027. 40 21 U.S.C. § 355(j)(2)(A)(vii) (2006). 41 See Douglas A. Robinson, ―Recent Administrative Reforms of the Hatch-Waxman Act: Lower Prices Now In Exchange for Less Pharmaceutical Innovation Later?,‖ 81 Washington University Law Quarterly (2003), 829. 42 21 U.S.C. § 355(j)(5)(B)(i) (2006). 43 21 U.S.C. § 355(j)(5)(B)(ii) (2006). 44 Eli Lilly & Co. v. Medtronic, Inc., 496 U.S. 1047 (1990). 45 21 U.S.C. § 355(j)(2)(B)(i) (2006). 46 21 U.S.C. § 355(j)(5)(B)(iv) (2006). Section 505(b)(2) applications do not qualify for the 180-day generic exclusivity period. U.S. Department of Health & Human Services, FDA, Center for Drug Evaluation & Research, ―Guidance for Industry, Listed Drugs, 30-Month Stays, and Approval of ANDAs and 505(b)(2) Applications Under Hatch-Waxman, As Amended by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003,‖ at 5 n.14 (Oct. 2004).

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See generally Mova Pharm. Corp. v. Shalala, 140 F.3d 1060, 1064 (D.C. Cir. 1998). Thomas, supra note 12, at 356. 49 Alfred B. Engelberg, ―Special Patent Provisions for Pharmaceuticals: Have They Outlived Their Usefulness?,‖ 39 IDEA: The Journal of Law and Technology (1999), 389. 50 P.L. 108-173, 117 Stat. 2066. 51 21 U.S.C. § 355(j)(5)(D)(i) (2006). 52 Thomas, supra note 12, at 366. 53 Brian Porter, ―Stopping the Practice of Authorized Generics: Mylan‘s Effort to Close the Gaping Black Hole in the Hatch-Waxman Act,‖ 22 Journal of Contemporary Health Law and Policy (2005), 177 (citation omitted). 54 21 C.F.R. § 3 14.94(a)(12)(viii)(C)(1)(i) (2006). 55 Although patents enjoy a presumption of validity, 35 U.S.C. § 282 (2006), that presumption is not uncontestable. Accused infringers may demonstrate that the patent does not meet the standards established by the Patent Act, and as a result should not have been issued by the U.S. Patent and Trademark Office. Id. In addition, an accused infringer may demonstrate that the patent is unenforceable on a number of grounds, among that its owner has engaged in ―misuse‖ of the patent. Id. 56 See John E. Lopatka, ―A Comment on the Antitrust Analysis of Reverse Payment Patent Settlements: Through the Lens of the Hand Formula,‖ 79 Tulane Law Review (2004), 235. 57 See Jonathan M. Lave, ―Responding to Patent Litigation Settlements: Does the FTC Have It Right Yet?,‖ 64 University of Pittsburgh Law Review (2002), 201. 58 See generally Chris Guthrie, ―Better Settle Than Sorry: The Regret Aversion Theory of Litigation Behavior,‖ University of Illinois Law Review (1999), 43. 59 See Stephen McG. Bundy, ―The Policy in Favor of Settlement in an Adversary System,‖ 44 Hastings Law Journal (1992), 1. 60 Asahi Glass Co. v. Pentech Pharmaceuticals, Inc., 289 F. Supp. 2d 986 (N.D. Ill. 2003) (emphasis in original). 61 See Marc G. Schildkraut, ―Patent-Splitting Settlements and the Reverse Payment Fallacy,‖ 71 Antitrust Law Journal (2004), 1033. 62 See Kristopher L. Reed, ―A Return to Reason: Antitrust Treatment of Pharmaceutical Settlements Under the Hatch- Waxman Act,‖ 40 Gonzaga Law Review (2004), 457. 63 In re Ciprofloxacin Antitrust Litigation, 261 F. Supp. 2d 188, 251 (E.D.N.Y. 2003). 64 Cotter, supra note 10. 65 P.L. 108-173, 117 Stat. 2066. 66 MMA, §1112(a)(1). 67 MMA, §1112(a)(1). 68 Id. at §1112(c)(1). 69 See Thomas, supra note 12, at 571. 70 See M. Elaine Johnston, et al., ―Antitrust Aspects of Settling Intellectual Property Litigation,‖ 867 Practising Law Institute/Patent (June 2006), 159. 71 See CRS Report RL3 1026, General Overview of United States Antitrust Law, by Janice E. Rubin. 72 Id. at 906 (quoting Arizona v. Maricopa City Medical Soc., 457 U.S. 332, 343 n. 13 (1982)). 73 Id. 74 Northern Pacific Railroad Co. v. United States, 356 U.S. 1, 5 (1957). 75 Rubin, supra note 71. 76 See generally Larissa Burford, ―In re Cardizem & Valley Drug Co.: The Hatch-Waxman Act, Anticompetitive Actions, and Regulatory Reform,‖ 19 Berkeley Technology Law Journal (2004), 365; Richard D. Chaves Mosier & Steven W. Ritcheson, ―In re Cardizem and Valley Drug: A View from the Faultline Between Patent and Antitrust in Pharmaceutical Settlements,‖ 20 Santa Clara Computer & High Technology Law Journal (2004), 497. 77 332 F.3d 896 (6th Cir. 2003). 78 Id. at 901-03. 79 105 F. Supp. 2d 682, 699 (E.D. Mich. 2000). 80 See supra notes 48-49 and accompanying text. 81 105 F. Supp. 2d at 907. 82 Id. at 908 (quoting United States v. Socony-Vacuum Oil Co., 310 U.S. 150, 222 (1940)). 83 Id. 84 344 F.3d 1294 (11th Cir. 2003). 85 Id. at 1298-99. 86 Id. at 1300-01. 87 Id. at 1301-03. 88 Id. at 1304. 89 Id. at 1305. 90 Id. at 1312. 91 402 F.3d 1056 (11th Cir. 2005). 48

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Id. at 1057. Id. at 1059. 94 Id. 95 Id. at 1060. 96 Id. at 1060-61. 97 In re Schering-Plough Corp., Docket No. 9297 (Dec. 8, 2003) (available at 2003 WL 22989651). 98 402 F.3d at 1068. 99 402 F.3d at 1067-68. 100 Id. at 1068-72. 101 Id. at 1073. 102 Id. 103 429 F.3d 370 (2d Cir. 2005). 104 See Imperial Chem. Indus., PLC v. Barr Labs., Inc., 795 F. Supp. 619 (S.D.N.Y. 1992). 105 429 F.3d at 377. For further discussion of authorized generics, see CRS Report RL33605, Authorized Generic Pharmaceuticals: Effects on Innovation, by John R. Thomas. 106 429 F.3d at 378. 107 Subsequent to that decision, the Supreme Court held in U.S. Bancorp Mortgage Co. v. Bonner Mall Partnership, 513 U.S. 18 (1994), that mootness by reason of settlement does not justify vacatur of a federal civil judgment. See U.S. Philips Corp. v. Sears Roebuck & Co., 55 F.3d 592, 598 (Fed. Cir. 1995). The Supreme Court‘s ruling did not have retroactive effect, however, and as a result the tamoxifen patent remained extant. 108 429 F.3d at 378-79. 109 See Zeneca Ltd. v. Novopharm Ltd., 111 F.3d 144 (Fed. Cir. 1997); Zeneca Ltd. v. Pharmachemie B.V., 2000 WL 34335805 (D. Mass. Sept. 11, 2000). 110 Zeneca UK Ltd. v. Mylan Pharms., Inc., No. 00-2239 (W.D. Pa. 2000). 111 See supra notes 46-47 and accompanying text. 112 429 F.3d at 379-80. 113 In re Tamoxifen Citrate Antitrust Litigation, 277 F.Supp.2d 121(E.D.N.Y. 2003). 114 Id. at 386 (quoting Standard Oil Co. v. United States, 283 U.S. 163, 171 (1931)). 115 Id. at 389. 116 Id. at 389. 117 Id. at 388. 118 Id. 119 Id. at 391. 120 Id. at 39 1-92. 121 Id. at 392. 122 Id. at 397 (quoting Schering-Plough, 402 F.3d at 1076). 123 Id. at 398. 124 Id. at 399-400. 125 544 F.3d 1323 (Fed. Cir. 2008). 126 Id. at 1327-29. Other generic drug companies associated with Barr also concluded agreements with Bayer. Id. 127 Id. at 1329 n.5. 128 Id. at 1329-30. 129 Id. at 1331-32. 130 Id. at 1333. 131 Id. at 1337. 132 Id. at 1340. 133 Id. at 1333. 134 S. 369, § 3. 135 Id. 136 S. 316, § 3 (110th Congress).

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In: Pharmaceutical Industry: Innovation and Developments ISBN: 978-1-61209-394-9 Editors: David A. Mancuso and Isobel M. Grenada © 2011 Nova Science Publishers, Inc.

Chapter 8

FDA’S AUTHORITY TO REGULATE DRUG COMPOUNDING: A LEGAL ANALYSIS Jennifer Staman

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SUMMARY Compounding is a process of combining, mixing, or altering ingredients in order to create a medication for a particular patient. While drug compounding has historically been regulated primarily by states, recent questions have been raised about the extent to which the Federal Food Drug and Cosmetic Act (FFDCA) governs this practice, and what authority the U.S. Food and Drug Administration (FDA) has to regulate a compounded drug as a ―new drug,‖ subject to approval by the FDA, as well as other requirements. In general, the FDA maintains that drug compounding activities are subject to FDA oversight, but will exercise discretion in enforcing various provisions of the FFDCA. In 1997, Congress enacted the FDA Modernization Act of 1997 (FDAMA), which was a comprehensive revision of the FFDCA. Section 127 of FDAMA added Section 503A to the FFDCA, which excepted compounded drugs from various ―new drug‖ requirements, conditioned upon the compounded drugs meeting a variety of restrictions. One of the restrictions in Section 503A of the FFDCA was that drug providers were prohibited from soliciting or advertising particular compounded drugs. These speech restrictions were challenged on First Amendment grounds and were struck down by the Supreme Court in Thompson v. Western States Medical Center. Following this decision, there has been controversy over the current status of compounded drugs under the FFDCA and whether the remaining provisions of Section 503A remain good law, an issue that the Supreme Court did not address in Western States. The two circuits that addressed this issue took different positions. While the Ninth Circuit in Western States determined that Section 503A was struck down in its entirety, the Fifth Circuit in Medical Center Pharmacy v. Mukasey found that the lawful provisions of Section 503A are still in effect. Accordingly, these cases have created an interesting scenario of non-uniform enforcement throughout the U.S. In the Fifth Circuit, compounded drugs are specifically exempted from new- drug, adulteration, and misbranding

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requirements of the FFDCA if certain criteria are met; while in the Ninth Circuit (and, according to the FDA, the rest of the United States), compounded drugs are subject to these requirements, but the FDA may exercise discretion in taking action against an entity that violates these provisions. This chapter provides a brief historical overview of the FDA‘s regulation of drug compounding and addresses these conflicting decisions. The report will also address the FDA‘s current authority to regulate compounded drugs under the FFDCA in light of these decisions, and discuss possible future developments, including the recent controversy over compounding bioidentical hormone replacement therapy (BHRT) drugs.

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BACKGROUND Drug compounding is a process in which a pharmacist combines, mixes, or alters various drug ingredients to create a medication for an individual patient in response to a practitioner‘s prescription.1 It is generally used to prepare medications that are not typically commercially available, such as a drug in a lower dosage for a child, or a drug without a dye or a preservative in response to a patient allergy.2 Compounding is considered a traditional component of the practice of pharmacy and has historically been regulated at the state level.3 The Federal Food Drug and Cosmetic Act (FFDCA), as amended, establishes certain minimum standards for the manufacturing, marketing, and distribution of drugs, and authorizes the FDA to ensure that drugs and other products marketed in the United States are safe and effective for their intended uses.4 The act prohibits any person from introducing a ―new drug‖ into interstate commerce unless it is approved by the FDA. A ―new drug‖ is defined by the act as ―[a]ny drug (except a new animal drug or an animal feed bearing or containing a new animal drug) the composition of which is such that such drug is not generally recognized ... as safe and effective for use under the condition prescribed, recommended, or suggested in the labeling thereof.‖5 In order to be determined to be safe and effective, new drugs are subject to a lengthy approval process, which is supervised by the FDA. The FFDCA also contains requirements preventing drugs from being adulterated6 or misbranded.7 Until 1997 with the enactment of the FDA Modernization Act of 1997 (FDAMA, discussed below),8 Congress had not explicitly addressed whether compounded drugs had to meet these requirements of the FFDCA.9 For approximately the first 50 years of the FFDCA, pharmacists compounded drugs without getting FDA approval for these drugs, and regulation of drug compounding was left to the states.10 The reason for this, in large part, is because it is widely recognized that compounded drugs could not meet the FFDCA‘s drug approval requirements because compounded drugs are traditionally made in small amounts for an individual patient (e.g., safety and efficacy trials are impracticable, and compounding pharmacies cannot afford testing for the new drug approval process to meet the needs of individual patients).11 Thus, the question of whether the FDA could regulate compounded drugs was generally not disputed until around the early 1990s when the FDA became concerned that some pharmacists were engaged in large-scale bulk compounding that was, in the FDA‘s view, more akin to drug manufacturing and an attempt to avoid the FFDCA‘s new drug requirements.12 In response to these perceived abuses, the FDA issued a Compliance Policy Guide in 1992 addressing its position regarding its authority to regulate compounding.13 The

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FDA declared ―that while retail pharmacies ... are exempted from certain requirements of the [FFDCA], they are not the subject of any general exemption from the new drug, adulteration, or misbranding provisions‖ of the FFDCA.14 While the FDA also indicated that its guidance was not intended to affect a pharmacist‘s traditional role of compounding drugs extemporaneously in reasonable quantities and pursuant to a valid prescription, the FDA warned that it ―may, in the exercise of its enforcement discretion, initiate federal enforcement actions ... when the scope and nature of a pharmacy‘s activity raises the kind of concerns normally associated with a manufacturer.‖ The 1992 Compliance Policy Guide set forth certain factors the FDA would consider in determining whether to exercise enforcement discretion against a compounding pharmacy whose activities raise concerns similar to those of drug manufacturers, including soliciting business to compound specific drug products, using commercial scale manufacturing or testing equipment to compound drug products, and compounding (on a regular basis or in excessive amounts) drug products that are commercially available in the market place and that are essentially generic copies of commercially available, FDA-approved drug products.15 In order to ―clarify the status of pharmacy compounding under Federal law,‖16 (or perhaps in reaction to the FDA‘s 1992 Compliance Policy Guide),17 Congress added Section 503A (21 U.S.C. § 353a) to the FFDCA as part of the FDA Modernization Act of 1997 (FDAMA), which specifically addressed the FDA‘s role in the regulation of drug compounding. Section 503A of the FFDCA, as added by FDAMA, exempts compounded drugs from FFDCA requirements regarding drug adulteration, misbranding, and new drug approval, provided that certain conditions are satisfied.18 Among these requirements, a drug product must be compounded by a licensed pharmacist or physician for an indentified individual patient based on a valid prescription.19 The compounded drug must comply with standards of an applicable U.S. Pharmacopoeia, or made from FDA-approved drug ingredients, meet certain manufacturing criteria, and the drug compounded must not be one that appears on a list of drugs (published by the Secretary) of drug products that have been withdrawn or removed from the market because the product, or components of the product have been found to be unsafe or not effective.20 Further, the drug provider compounding the drug may not ―compound regularly or in inordinate amounts ... any drug products that are essentially copies of a commercially available drug product.‖21 Section 503A of the FFDCA also provided that the exemptions from the FFDCA‘s new drug and other requirements only applied to drug products compounded based on a valid prescription that was not solicited.22 Further, the section states that a drug may be compounded and subject to the exemptions only if the pharmacy, licensed pharmacist, or licensed physician does not advertise or promote the compounding of any particular drug.23 In November of 1998, just days after the provision became effective, several compounding pharmacies challenged the restrictions on solicitation and advertising as being an impermissible regulation of speech under the First Amendment.

THOMPSON V. WESTERN STATES MEDICAL CENTER24 In Western States, a group of licensed pharmacies brought an action against the Secretary of Health and Human Services (HHS) and the Commissioner of the FDA, claiming that

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FDAMA‘s restrictions on solicitation and advertising violated the pharmacies‘ rights to free speech under the First Amendment.25 The district court evaluated whether the provisions were an impermissible government regulation of commercial speech26 under the factors articulated in Central Hudson Gas and & Electric v. Pub. Service Comm ’n of New York,27 and granted the pharmacies summary judgment on the basis that the provision was indeed a violation of the First Amendment. In evaluating whether the other provisions of Section 503A remained intact, the district court found that there is ―no question‖ that the other sections could be severed28 from the remaining sections.29 The court explained that the modification of the statute did not prevent it from operating as law, based on the numerous other requirements that must be met in the production and distribution of compounded drugs. The Ninth Circuit Court of Appeals affirmed the district court‘s holding that the speech provisions of section 503A were unconstitutional, but also reversed in part, holding that the compounding provisions were not severable from the rest of the section.30 In discussing the severability issue, the court explained that the solicitation and advertising provisions were an essential component in balancing the preservation of compounded drugs alongside the desire to prevent pharmacists and others from engaging in drug manufacturing. The court pointed to legislative history that, in its opinion, demonstrated an intent to strike this balance.31 The court further indicated that the legislative record demonstrated that Congress meant to exempt compounding pharmacists from FFDCA requirements only in return for a prohibition on the promotion of specific compounded drugs. The court also dismissed the applicability of the existing severability clause in the FFDCA32 as not indicative of a presumption that Congress intended for unoffending provisions of FDAMA to remain valid. The court explained that because Congress approved the severability clause before FDAMA‘s passage, there was no indication of whether the clause was to only apply to the original FFDCA, or to the FFDCA as amended by FDAMA. In its brief requesting Supreme Court review on the First Amendment issue, the government indicated its acquiescence with the court of appeals‘ conclusion that, if the solicitation and advertising provisions in Sections 503A(a) and (c) are unconstitutional, they are not severable from the other provisions of Section 503A. Accordingly, the government did not seek review of that holding. 33 The Supreme Court later affirmed the lower court rulings that the speech restrictions were unconstitutional, but because neither party petitioned for certiorari on the severability issue, the Court articulated that it ―had no occasion‖ to review that portion of the court of appeals‘ decision.34

2002 FDA COMPLIANCE POLICY GUIDE Western States did not address the FDA‘s authority to regulate drug compounding in the absence of the FDAMA provision. Because (at least in part) of the confusion about the extent of the FDA‘s authority to regulate compounding remaining after this decision, the FDA issued a Compliance Policy Guide in 2002, largely similar to the compliance guide issued in 1992.35 The FDA stated that because the Supreme Court did not rule on the severability issue, the Court ―therefore left in place‖ the Ninth Circuit holding that the other provisions of Section 503A were not severable, and the section was therefore invalid. Accordingly, the

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FDA determined that it needed to issue guidance to the compounding industry regarding the factors the agency would consider in exercising enforcement discretion with regard to pharmacy compounding. The FDA indicated that it did not intend the Compliance Policy Guide to regulate traditional compounding practices (i.e., pharmacists who extemporaneously compound reasonable quantities of drugs upon receipt of a valid prescription for an identified patient). In addition, the FDA noted that it would continue to defer to the state authorities regarding ―less significant violations‖ of the FFDCA. However, the FDA explained its concern with pharmacies that were not compounding in the regular course of business, but were manufacturing large quantities of drug products without a prescription for them. The FDA explained that when the scope and nature of a pharmacy‘s activities raise the kinds of concerns normally associated with a drug manufacturer and result in significant violations of the new drug, adulteration, or misbranding provisions of the act, it determined that it should seriously consider enforcement action. The FDA set out nine acts it would consider in pursuing an enforcement action: 1. Compounding of drugs in anticipation of receiving prescriptions, except in very limited quantities in relation to the amounts of drugs compounded after receiving valid prescriptions 2 Compounding drugs that were withdrawn or removed from the market for safety reasons 3 Compounding finished drugs from bulk active ingredients that are not components of FDA-approved drugs, without an FDA sanctioned investigational new drug application 4. Receiving, storing, or using drug substances without first obtaining written assurance from the supplier that each lot has been made in an FDA-registered facility 5. Receiving, storing, or using drug components not guaranteed to meet official compendia requirements 6. Using commercial scale manufacturing or testing equipment for compounding drug products 7. Compounding drugs for third parties who resell to individual patients or offering compounded drug products at wholesale to other state licensed persons or other commercial entities for resale 8. Compounding drug products that are commercially available in the marketplace or that are essentially copies of commercially available FDA-approved drug products 9. Failing to operate in conformance with applicable state law regulating the practice of pharmacy. The FDA indicated that the list of acts was not exhaustive, and that other factors may be appropriate to consider in enforcement actions.

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MEDICAL CENTER PHARMACY V. MUKASEY In September 2004, 10 licensed pharmacies specializing in drug compounding brought suit challenging FDA‘s authority to regulate compounded drugs.36 In Medical Center Pharmacy v. Ashcroft (later changed to Medical Center Pharmacy v. Gonzalez and then Medical Center Pharmacy v. Mukasey), plaintiffs sought, among other things, a declaration that drugs compounded by licensed pharmacists were not ―new drugs‖ per se under the FFDCA. The district court granted summary judgment on the pharmacies‘ claim, finding that compounded drugs were ―implicitly exempt‖ from the new-drug requirements.37 The court, relying on language of the Supreme Court from Western States, reasoned that if compounded drugs were not exempt from the new-drug requirements, the drugs would have to undergo the new-drug approval process, which would be impracticable. The court indicated that the FDA‘s 2002 Compliance Policy Guide, which exempts traditional compounding from the scope of the guidance, and instead focuses on the regulation of pharmacies that manufacture drugs ―under the guise of compounding,‖ provided additional support for the position that traditional compounding was not subject to the new-drug approval requirements. The court also opined that the remainder of Section 503A was severable following Western States. The court explained that it was not bound by the Ninth Circuit, and that the severability statute in the FFDCA is ―clear and unambiguous.‖38 On appeal, the Fifth Circuit disagreed with the district court, finding that compounded drugs are ―new drugs‖ and are subject to the drug approval, adulteration, and misbranding requirements.39 However, in light of the fact that the provisions of 503A were severable, the court found that compounded drugs are subject to a ―limited exemption‖ from the those requirements if the drugs are compounded in accordance with the non-speech provisions of that section. The court based its holding in part on the definition of ―new drug,‖ under the FFDCA. Given that a compounded drug is created by mixing or combining an approved drug with something else to create a ―concoction‖ that has not been previously approved for use, a compounded drug was, based on the plain language of the statute, a new drug.40 Further, given that the FFDCA contains certain exceptions to the new drug definition (e.g., for ―grandfathered‖ drugs), the court found meaning in the lack of an exemption to the new-drug definition for drugs created by compounding. The pharmacies in Medical Center Pharmacy had argued that including compounded drugs under the new drug definition would, in effect, extinguish the practice of traditional compounding. The court also acknowledged the idea that interpreting the new-drug definition so as to include compounding did appear inconsistent with the idea that compounding should be able to persist and not be subject to the rigorous requirements of new drug approval. However, the court pointed out that these issues can be reconciled. Under the court‘s reasoning, even if compounded drugs are effectively made unlawful by the new drug definition and approval requirements, pharmacists could still continue compounding because the FDA has the ability exercise enforcement discretion and can decline enforcement of ―minor violations.‖41 In other words, the FDA would be in a position, as it did historically, to use this discretion and not enforce new drug requirements on compounded drugs. While the court expressed some reluctance to rely on the FDA‘s discretion in its enforcement of drug compounding, the court still found that because the FDA has demonstrated willingness to

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accommodate traditional compounding, pharmacies would still be able to compound drugs even if they were deemed new drugs. The Fifth Circuit also pointed to the enactment of FDAMA as evidence that Congress intended that the new-drug provision apply to drugs created by pharmacy compounding.42 However, in order to rely on FDAMA as justification for why compounded drugs could be considered new drugs under the FFDCA, the court evaluated whether the statute was still valid in light of the Western States decision. The court examined the severability clause in the FFDCA and found, contrary to the Ninth Circuit, that the severability clause applied to Section 503A. The court explained that if Congress did not want the FFDCA‘s severability clause to apply to Section 503A, it would have specifically said so. Further, the court did not see the free speech provisions as so central to the purpose of FDAMA that Congress would not have passed the statute without them. The Fifth Circuit also stated that the remaining requirements were sufficient to accomplish the goal of protecting access to compounded drugs while preventing pharmacies from engaging in large-scale drug manufacturing.43 The court also disagreed with the Ninth Circuit in finding that the legislative history to FDAMA was ―inconclusive‖ as to whether Congress would not have enacted FDAMA without the speech provisions of Section 503A. 44

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ISSUES WITH CURRENT FDA AUTHORITY TO REGULATE DRUG COMPOUNDING AND POSSIBLE FUTURE DEVELOPMENTS As discussed above, the Western States and Medical Center Pharmacy cases directly conflict on the question of whether the non-speech provisions of Section 503A are severable and thus, whether the remaining sections of the statute are still in effect. Based on these two decisions, the FDA has determined that it will apply the non-advertising provisions of Section 503A of the FFDCA to entities that are located within the jurisdiction of the Fifth Circuit (Texas, Louisiana, and Mississippi) as well as to the plaintiffs that brought the Medical Center case.45 In all other locations, the FDA will continue to apply the enforcement policy articulated in the 2002 Compliance Policy Guide. In other words, the current situation presents an interesting scenario of non-uniform enforcement throughout the United States. In the Fifth Circuit, compounded drugs are specifically exempted from adulteration, misbranding, and new drug provisions of the FFDCA, subject to meeting certain criteria; while in the Ninth Circuit (and, according to the FDA, the rest of the United States), compounded drugs are subject to these provisions, but the FDA may exercise discretion in taking action against a pharmacy that violates them. The parties in Medical Center Pharmacy did not petition the Supreme Court for review, and thus, uncertainty remains about the FDA‘s authority to regulate compounded drugs as new drugs. Courts may still evaluate the FDA‘s position that compounded drugs are new drugs, or, relatedly, whether the non-speech provisions of Section 503A of the FFDCA that include an exemption for these drugs remain intact. If these types of challenges were to occur outside of the Fifth or Ninth Circuits, a court could rely upon, but would be under no obligation to follow, the Western States/Medical Center Pharmacy precedent. Unless a future case on these issues reaches the Supreme Court, the question of the extent to which the FDA may regulate compounded drugs may not be settled unless Congress takes legislative action.

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Under the current drug compounding regime outside of the Fifth Circuit, some have expressed concern that the FDA‘s 2002 Compliance Policy Guide creates confusion regarding when FDA enforcement authority will be used.46 It has been argued that the FDA Compliance Policy Guide lacks a clear description of the circumstances under which the agency will take action against pharmacies.47 The FDA has countered that the guidance ―gives them flexibility to respond to a wide variety of situations where the public health and safety are issues.‖48 The FDA‘s authority to regulate compounded drugs is set forth in a guidance document. In contrast to agency rules, which have the force and effect of law, guidance documents are merely considered to be a general statement of policy.49 These statements of policy are agency statements that ―advise the public prospectively of the manner in which the agency proposes to exercise a discretionary power.‖50 Congress has passed requirements specific to FDA guidance documents, which state that such documents ―shall not create or confer any rights for or on any person, although they present the views of the Secretary on matters under the jurisdiction of the Food and Drug Administration.‖51 Under regulations prescribing FDA good guidance practices, it is stated that guidance documents do not establish legally enforceable rights or responsibilities and do not legally bind the public or the FDA.‖52 Accordingly, if a court were to evaluate the position the FDA takes in its 2002 Compliance Policy Guide, a court may choose not to defer to the FDA‘s position on when it may exercise enforcement discretion, or whether compounded drugs are ―new drugs.‖ However, in Medical Center Pharmacy, the Fifth Circuit evaluated the FDA‘s statutory interpretation that compounded drugs were new drugs under a standard that is more deferential to agency action, a standard that is typically reserved for products of formal agency process (e.g., notice and comment rulemaking). 53 It should be noted that the few courts that have evaluated the Compliance Policy Guide have found the guidance to be appropriate or reasonable.54 If a future court were to take up the issue of whether the non-speech provisions in Section 503A are severable, it is difficult to predict how a court would rule. Under Supreme Court severability precedent, ―[u]nless it is evident that the Legislature would not have enacted those provisions which are within its power, independently of that which is not, the invalid part may be dropped if what is left is fully operative as a law.‖55 Further, a key inquiry evaluating severability is whether without the unconstitutional provision, ―the statute will function in a manner consistent with the intent of Congress.‖56 The Court has also indicated ―when Congress has explicitly provided for severance by including a severability clause in the statute ... the inclusion of such a clause creates a presumption that Congress did not intend the validity of the statute in question to depend on the validity of the constitutionally offensive provision.‖57 The courts in both Western States and Medical Center Pharmacy relied on various statements in the legislative history of FDAMA as evidence of whether the solicitation and advertising provisions of FDAMA were integral to the rest of the statute. However, neither court was able to point to a statement that explicitly referenced the unconstitutional provisions of Section 503A and the intent behind them. In addition, as in these two cases, if courts in another jurisdiction were to review whether Section 503A is severable, a court would likely evaluate the severability clause of the FFDCA. A court could agree with the Ninth Circuit, finding that because the severability clause was enacted prior to FDAMA, it is not clear whether it was to apply to the amended portions of the FFDCA.58 Alternatively, a court could just as easily side with the Fifth Circuit and hold that the severability clause kept Section 503A of the FFDCA intact, assuming that if Congress had not wanted the clause to apply, it would have said so.59

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The issue of the FDA‘s authority to regulate compounded drugs may be revisited by a court in the case of pharmacies engaged in the business of compounding ―bioidentical hormone replacement therapy‖ (BHRT) drugs, which some claim are identical to certain hormones produced in the body. In particular, BHRT drugs may use the substance estriol, which the FDA has indicated is not an active ingredient contained in any FDA approved drug and has not been demonstrated under FDA standards to be safe and effective for any use.60 While FDA regulation of compounded BHRT drugs has been controversial for the past few years,61 in 2008, the FDA issued a number of warning letters to pharmacies, indicating that the pharmacies were making false and misleading claims about their ―BHRT‖ drugs, including claims that compounded ―BHRT‖ drugs are safer or more effective than FDAapproved hormone therapy drugs and claims that compounded ―BHRT‖ drugs can prevent or treat serious illnesses such as Alzheimer‘s disease and certain forms of cancer.62 In addition, the FDA warned the pharmacies that they may not compound drugs containing the estrogen substance estriol without a valid investigational new-drug application. The FDA explained that firms that do not properly address violations identified in warning letters may be subject to further enforcement, including injunctions that prevent additional violations and seizure of these drugs. It appears that there has not yet been a legal challenge to FDA‘s enforcement actions with regard to BHRT compounding activity.

End Notes 1

See Western States Medical Center v. Shalala, 238 F.3d 1090, 1092 (9th Cir. 2001). Western States Medical Center et. al., v. Shalala, 69 F. Supp. 2d 1288, 1292 (D. Nev. 1999). See also Statement of Steven K. Galson, Acting Director, Center for Drug Evaluation and Research, U.S. Food and Drug Administration, before the Senate Committee on Health, Education, Labor and Pensions, Hearing on ―Federal and State Role in Pharmacy Compounding and Reconstitution: Exploring the Right Mix to Protect Patients,‖ (Oct. 23, 2003). 3 It should be noted that drugs may be compounded for animal use. See, e.g., Medical Center Pharmacy v. Mukasey, 536 F.3d 383, 406-409 (5th Cir. 2008); United States v. Algon Chemical, Inc., 879 F.2d 1154 (3rd Cir. 1989). The statutes, regulations, and FDA policies governing compounding for animals differ from those governing drug compounding for humans. This chapter will only address federal law as it relates to drug compounding for human use. 4 21 U.S.C. § 301 et seq. The FFDCA regulates several other products besides drugs, including certain foods, cosmetics, and dietary supplements. 5 21 U.S.C. § 321(p). Exceptions are made for certain ―grandfathered‖ drugs used prior to the FFDCA, as well as drugs intended only for investigational use. 6 Under the FFDCA, a drug may be deemed adulterated if ―the methods used in, or the facilities or controls used for, its manufacture, processing, packing, or holding do not conform to or are not operated or administered in conformity with current good manufacturing practice to assure that such drug meets the requirements of this Act ... as to safety and has the identity and strength, and meets the quality and purity characteristics, which it purports or is represented to possess.‖ See 21 U.S.C. § 351 for a complete definition. FDA regulations set forth various standards for good manufacturing practices, including standards relating to personnel, facilities, and drug product containers. 21 C.F.R. § 211.1 et seq. 7 The FDA approves drugs for specific uses that are reflected in their labeling. A drug may be deemed to be misbranded if, among other possibilities, the labeling is false or misleading or if its labeling does not bear ―adequate directions for use.‖ 21 U.S.C. § 352. 8 Food and Drug Administration Modernization Act, P.L. 105-115, 111 Stat. 2296 (Nov. 21, 1997). 9 It should be noted that the FFDCA does address compounded drugs in two areas. First, under Section 5 10(g) of the FFDCA, pharmacies are exempt from registering as drug manufacturers under the act if the pharmacies maintain establishments ―in conformance with any applicable local laws regulating the practice of pharmacy and medicine and which are regularly engaged in dispensing prescription drugs or devices, upon prescriptions of practitioners licensed to administer such drugs or devices to patients under the care of such practitioners in the course of their professional practice, and which do not manufacture, prepare, propagate, compound, or

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process drugs or devices for sale other than in the regular course of their business of dispensing or selling drugs or devices at retail.‖ 21 U.S.C. § 360(g)(1). In other words, this provision appears to recognize that traditional compounding by pharmacists is not manufacturing. Richard R. Abood, PHARMACY PRACTICE AND THE LAW, Fifth Ed. (2008). Second, similar language limits the types of pharmacy records that the FDA may review during an inspection. See 21 U.S.C. § 374. 10 See Western States, 535 U.S. at 362. 11 Statement of Steven K. Galson, Acting Director, Center for Drug Evaluation and Research, U.S. Food and Drug Administration, before the Senate Committee on Health, Education, Labor and Pensions, Hearing on ―Federal and State Role in Pharmacy Compounding and Reconstitution: Exploring the Right Mix to Protect Patients,‖ (Oct. 23, 2003). See also Thompson v. Western States, 535 U.S. 357, 369 (2002) (―...it would not make sense to require compounded drugs created to meet the unique needs of patients to undergo the testing required for the new drug approval process. Pharmacists do not make enough money from small-scale compounding to make safety and efficacy testing of their compounded drugs economically feasible, so requiring such testing would force pharmacists to stop providing compounded drugs.‖) 12 Medical Center Pharmacy, 536 F.3d at 389. The FDA‘s concern over the practice of compounding has also been, in large part, due to certain patient injuries caused by compounded drugs. The Agency has asserted that it knows of more than 200 adverse events involving 71 compounded products since 1990, including certain instances with ―devastating repercussions.‖ See, U.S. Food and Drug Administration, The Special Risks of Pharmacy Compounding, available at http://www.fda.gov/consumer/updates/compounding053107.html. 13 Compliance Policy Guide No. 7132.16 (Mar. 1992). 14 Id., as cited in Western States, 535 U.S. at 362. It should also be noted that prior to the enactment of FDAMA, courts found that compounded drugs were new drugs. See, e.g., Prof‘ls & Patients for Customized Care v. Shalala, 56 F.3d 592, 593 n.3 (5th Cir. 1995). 15 Compliance Guide 7132.16, as cited in Medical Center Pharmacy, 536 F.3d at 391. 16 Compliance Policy Guide 460.200 (May 2002); see also Medical Center Pharmacy, 536 F.3d at 390. 17 Id. at 391. 18 See Section 127 of P.L. 105-115. 19 21 U.S.C. § 353(a) 20 21 U.S.C. § 353a(b)(1). 21 21 U.S.C. § 353a(b)(1)(D). 22 21 U.S.C. § 353a(a). 23 21 U.S.C. § 353a(c). 24 Thompson v. Western States Medical Center, 535 U.S. 357 (2002). 25 Western States Medical Center, et al., v. Shalala, 69 F. Supp. 2d 1288 (D. Nev. 1999). 26 The First Amendment to the United States Constitution provides that ―Congress shall make no law ... abridging the freedom of speech, or of the press.... ‖ Despite its absolute language, it provides no protection to some types of speech and only limited protection to others. One type of speech to which it applies only limited protection is commercial speech, which is ―speech that proposes a commercial transaction.‖ Board of Trustees of the State University of New York v. Fox, 492 U.S. 469, 482 (1989). Commercial speech may be banned if it advertises an illegal product or service, and, unlike fully protected speech, may be banned if it is unfair or deceptive. For a more general discussion of First Amendment jurisprudence regarding freedom of speech, see CRS Report 95-8 15, Freedom of Speech and Press: Exceptions to the First Amendment, by Henry Cohen. 27 447 U.S. 557 (1980). For commercial speech, the Supreme Court has prescribed the four-prong Central Hudson test to determine its constitutionality. This test asks initially (1) whether the commercial speech at issue is protected by the First Amendment (that is, whether it concerns a lawful activity and is not misleading) and (2) whether the asserted governmental interest in restricting it is substantial. ―If both inquiries yield positive answers,‖ then to be constitutional the restriction must (3) ―directly advance[ ] the governmental interest asserted,‖ and (4) be ―not more extensive than is necessary to serve that interest.‖ Id. at 566 (1980). 28 When one section of a law is held unconstitutional, courts are faced with determining whether the remainder of the statute is ―severable,‖ i.e., it remains valid, or whether the whole statute is nullified. In general, courts examine whether the statute can fully operate without the unconstitutional provision in the manner that Congress intended. See infra notes 55-59 and accompanying text. 29 Western States, 69 F. Supp. 2d at 1309-10. 30 Western States Medical Center v. Shalala, 238 F.3d 1090 (9th Cir. 2001). 31 For example, the Ninth Circuit cited a House report explaining that FDAMA was designed to ―ensure continued availability of compounded drug products as a component of individualized drug therapy, while limiting the scope of compounding so as to prevent manufacturing under the guise of compounding.‖ H.Rept. 105-399, as cited in Western States, 238 F.3d at 1097. 32 Section 901 of the FFDCA provides, ―If any provision of this Act [21 U.S.C. §§ 301 et. seq.] is declared unconstitutional, or the applicability thereof to any person or circumstances is held invalid, the constitutionality of the remainder of the Act ... and the applicability thereof to other persons and circumstances shall not be affected thereby.‖ 21 U.S.C. § 391.

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FDA‘s Authority to Regulate Drug Compounding: A Legal Analysis 33

Thompson v. Western States Med. Ctr., 2001 U.S. Briefs 344, 11 (Aug. 24, 2001) Western States, 535 U.S. at 365. 35 Food and Drug Administration, Compliance Policy Guides Manual § 460.200, Pharmacy Compounding (May 2002), available at http://www.fda.gov/ora/compliance 36 Medical Center Pharmacy, et al., v. Gonzales, et al., 451 F. Supp. 2d 854 (W.D. Tex.)(2006). 37 Id. at 858. 38 Id. at 864. 39 Medical Center Pharmacy v. Mukasey, 536 F.3d 383 (5 th Cir. 2008). 40 Id. at 394-95. 41 Id. at 398-99. 42 Id. at 400. 43 The Fifth Circuit also pointed to the Supreme Court‘s evaluation of the advertising provision in Western States: Several non-speech-related means of drawing a line between compounding and large-scale manufacturing might be possible here.... It might even be sufficient to rely solely on the nonspeech-related provisions of FDAMA, such as the requirement that compounding only be conducted in response to a prescription or a history of receiving a prescription, 21 U.S.C. § 353a(a), and the limitation on the percentage of a pharmacy‘s total sales that out-of-state sales of compounded drugs may represent, § 353 a(b)(3)(B).... Nowhere in the legislative history of FDAMA or petitioners’ briefs is there any explanation of why the Government believed forbidding advertising was a necessary as opposed to merely convenient means of achieving its interests. Medical Ctr. Pharm. v. Mukasey, 536 F.3d at 404 n.43 (citing Western States, 535 U.S. at 372-73.) (emphasis added). 44 See also United States v. Bader, 2009 U.S. Dist. LEXIS 63490 (D. Colo. 2009), where a Tenth Circuit district court evaluated a motion for reconsideration over whether human growth hormone imported by a pharmacist was a ―finished, consumer-usable‖ drug that was improperly smuggled and distributed under various federal criminal provisions, and the FFCDA, or whether it was used as an ingredient in a compounded drug under which the pharmacist may be able to escape liability. In discussing whether the pharmacist had engaged in drug compounding, because Bader was a party in the Medical Center Pharmacy case, the court found that the provisions of FDAMA were considered severable. The court, in granting the motion, found that the trial court would need to determine, among other things, whether the pharmacist‘s conduct violated the terms of FDAMA. 45 See, e.g., Letter from Alonza E. Cruse, Director, Los Angeles District, U.S. Food and Drug Administration, to Ari S. Schafer, Civic Center Pharmacy (Dec. 16, 2008), available at http://www.fda.gov/f oi/warning_letters/s7071c.pdf. 46 U.S. Government Accountability Office, GAO-04-195T Prescription Drugs, State and Federal Oversight of Drug Compounding by Pharmacies, Testimony Before the Committee on Health, Education, Labor, and Pensions, U.S. Senate (Oct. 2003). 47 Id. According to GAO testimony, pharmacy associations pointed to terms in the guidance, such as ―very limited quantities‖ and ―commercial scale manufacturing or testing equipment‖ that are not defined, and observed that FDA also has the right to consider other factors in addition to those in the guidance without giving further clarification. Id. at 12. 48 General Accountability Office, note 46 supra. 49 Jeffrey S. Lubbers, A GUIDE TO FEDERAL AGENCY RULEMAKING 94 (4th ed. 2006). Executive Order 13422 sets forth a definition of a guidance document. Executive Order 13422, Further Amendment to Executive Order 12866 on Regulatory Planning and Review, Jan. 18, 2007, http://www.whitehouse.gov/news /releases/2007/01/20070118.html. 50 Tom C. Clark, Attorney General, Attorney General‘s Manual on the Administrative Procedure Act, at 30 n.3 (1947), http://www.law.fsu.edu/library/admin/1947iii.html; see, e.g., Chamber of Commerce v. United States Department of Labor, 174 F.3d 206, 212 (D.C. Cir. 1999). 51 21 U.S.C. § 371(h). The provisions on guidance documents were added in 1997 by FDAMA § 405. 52 21 C.F.R. § 10.115(d)(1). 53 Under Supreme Court precedent, certain agency actions should be afforded deference by the courts. In Chevron U.S.A. Inc. v. Natural Resources Defense Council, 467 U.S. 837 (1984), the Supreme Court established a twopart test for judicial review of agency statutory interpretations. First, a reviewing court must determine ―whether Congress has directly spoken to the precise question at issue.‖ If it has, the agency must of course comply with clear congressional intent, and regulations to the contrary will be invalidated. Second, in instances where congressional intent is not clear and the statutory language is ambiguous, the courts will likely defer to any reasonable agency interpretation, even if another interpretation is more plausible. However, the Supreme Court in Christensen v. Harris County, 529 U.S. 576 (2000) and United States v. Mead Corp., 533 U.S. 218 (2001) analyzed Chevron’s application, ruling that Chevron deference applies only if an agency‘s interpretation is the product of a formal agency process, such as adjudication or notice-and-comment rulemaking, through which Congress has authorized the agency ―to speak with the force of law.‖ Mead Corp., 533 U.S. at 229. Although a notice about the Compliance Policy Guide was published in the Federal Register 34

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and public comments were requested (in accordance with the FDA‘s good guidance practices), it would seem more likely that a court would not employ Chevron deference in evaluating the agency‘s interpretation as provided in the guidance document. But, as discussed above, courts still employ this deferential standard outside of this formal agency action. See also In re the Matter of Establishment Inspection of Wedgewood Pharmacy Inc., 270 F. Supp. 2d 525 (D.N.J. 2003) (court applies Chevron deference to 2002 Compliance Policy Guide). 54 See, e.g., In the Matter of Establishment Inspection of Wedgewood Pharmacy, 421 F.3d 263 (3 rd Cir. 2004)(court of appeals finds the guide ―a reasonable basis under which to initiate an inspection under the FFDCA‖). See also Schaerrer v. Stewart‘s Plaza Pharm., Inc., 79 P.3d 922, (Utah 2003)(In examining whether compounding pharmacy‘s conduct fell into category of ―pharmacist‖ or ―drug manufacturer,‖ court states that ―[w]hile the policy statements of the FDA are by no means binding on this court, they do provide meaningful guidance on a question that few, if any, courts in this country have yet considered.‖). It should also be noted that FDA regulations define a guidance document to include ―documents that relate to: ... inspection and enforcement policies.‖ 21 C.F.R. § 10.1 15(b)(2). Thus, while not addressed in the Wedgewood case, given that the Compliance Policy Guide addressed when the FDA will exercise enforcement discretion on drug compounding, one could argue that the guide is an appropriate exercise of FDA authority. 55 Alaska Airlines, Inc. v. Brock, 480 U.S. 678, 684 (1987)(quoting Buckley v. Valeo, 424 U.S. 1, 108 (1976) (per curiam), Champlin Refining Co. v. Corporation Comm'n of Oklahoma, 286 U.S. 210, 234 (1932). 56 Alaska Airlines, 480 U.S. at 685. 57 Id. at 686 (citing INS v. Chadha, 462 U.S. 919, 932 (1983); Champlin Refining Co. v. Corporation Comm'n of Oklahoma, 286 U.S. 210, 235 (1932). 58 Western States, 238 F.3d at 1098-99. 59 Medical Center Pharmacy, 536 F.3d at 401-402. 60 Letter from Alonza Cruse, footnote 45 supra. 61 For a discussion of this controversy, see Bruce Patsner, Pharmacy Compounding of Bioidentical Hormone Replacement Therapy (BHRT): A Proposed New Approach to Justify FDA Regulation of These Prescription Drugs, 63 Food Drug L.J. 459 (2008). 62 Warning letters are available at http://www.fda.gov/cder/pharmcomp/default.htm.

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Chapter 9

PROMOTIONAL SPENDING FOR PRESCRIPTION DRUGS

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Congressional Budget Office Pharmaceutical companies‘ efforts to promote prescription drugs have attracted the attention of policymakers because such activities may affect the rate at which different drugs are prescribed and consumed, the total amount spent on health care, and, ultimately, health outcomes. Those promotional activities—usually undertaken on behalf of brand-name, rather than generic, drugs—may influence consumers and health care professionals through a variety of channels. For example, advertisements for prescription drugs that are aimed at consumers may prompt individuals to seek medical treatment they might otherwise have delayed. Such advertisements may also influence individuals to request a specific drug that is higher or lower in price or that is more or less effective than one they had previously used. Promotional efforts aimed at physicians may help them keep abreast of the latest drug therapies and improve their ability to treat patients. Those efforts may also lead doctors to prescribe brand-name medications that are more expensive than alternatives. The way that pharmaceutical manufacturers promote prescription drugs has changed significantly in the past decade. Until the late 1 990s, pharmaceutical manufacturers confined their marketing efforts largely to physicians and other health care providers. In the late 1990s, however, drugmakers began marketing directly to consumers—a practice known as direct-toconsumer (DTC) advertising. The Food and Drug Administration (FDA) issued draft regulatory guidance in 1997 (which was finalized two years later) that clarified the agency‘s expectations about the way information in DTC advertisements should be presented in the broadcast media. Since then, the manufacturers of many prescription drugs have increased their purchases of air time on television and of advertising space in newspapers and magazines in an effort to make consumers aware of their products and to encourage them to visit their doctors to request a prescription. In 2008, spending on DTC advertising totaled $4.7 billion, nearly one-fourth of pharmaceutical manufacturers‘ expenditures for all promotional activities. Those developments may be having an impact on the functioning, cost, and effectiveness of the nation‘s health care system.

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Marketing to Physicians and Consumers Drug companies use advertising and promotions in much the same way that producers of other goods do: to inform consumers about an advertised product‘s existence and uses and, if alternatives are available, to persuade consumers that the advertised product is better than competing products. If successful, advertising can spur demand for the good and therefore boost its producer‘s sales and profits. Pharmaceutical manufacturers incur most of the costs of producing a drug during the research and development phases and during the process of gaining the FDA‘s approval to put the drug on the market. Any additional sales that advertising generates can be highly profitable because the prices that manufacturers receive for their products generally exceed the cost to manufacture and distribute those additional units. Drug companies face a different task in making sales than do the producers of most consumer goods, however, because several separate actors must be persuaded that a prescription drug merits purchasing. First, a consumer must perceive that visiting a doctor to seek diagnosis and treatment offers a benefit. Then, following an examination to diagnose the patient‘s condition, the doctor must determine an appropriate treatment and, when warranted, write a prescription. Finally, the consumer must fill that prescription for the manufacturer to make a sale. (In many cases, the individual‘s insurer can also influence prescription drug purchases by determining whether or not to include a drug on the formulary of drugs it covers and by deciding how large a copayment to assign to it.1) Recognizing that both consumers and physicians take part in the decision to purchase a drug, pharmaceutical manufacturers adopt different marketing strategies for reaching each group. Direct-to-consumer advertising appears in magazines and newspapers, on television and radio, on outdoor billboards, and increasingly online. Drug companies also promote their products to physicians in a variety of ways. They send sales representatives to meet with physicians, nurse practitioners, and physicians‘ assistants in a practice called detailing. During those sales calls, the representatives discuss drugs manufactured by their company that are relevant to the physician‘s specialties, and they may provide product samples and reprints of academic literature that discuss their company‘s products. In addition to detailing, pharmaceutical manufacturers purchase advertisements for their drugs in medical journals. They also sponsor professional meetings and events, both in person and online, including some that offer physicians credit for continuing medical education.2

Overall Marketing Trends Pharmaceutical manufacturers spent at least $20.5 billion on promotional activities in 2008.3 Detailing to physicians, nurse practitioners, and physicians‘ assistants cost $12 billion, accounting for more than half of that promotional spending (see Figure 1). Drug companies spent another $3.4 billion sponsoring professional meetings and events and about $0.4 billion placing advertisements in professional journals. Pharmaceutical manufacturers spent the rest of their promotional budgets, $4.7 billion in 2008, on direct-to-consumer advertising. To place those figures in context, the Pharmaceutical Research and Manufacturers of America (PhRMA) estimated that, among its members, domestic sales of pharmaceuticals and medi-

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cines totaled $189 billion in 2008 and domestic spending on research and development totaled $38 billion.4 In 2008, promotional expenditures equaled 10.8 percent of the U.S. sales reported by PhRMA, in line with most years since the early 1 990s, during which time that share has remained between 10 percent and 12 percent. The growth of pharmaceutical manufacturers‘ overall promotional spending has slowed from a double-digit annual pace in 2003 and 2004 to a rate that is close to zero. That slowdown is probably related, at least in part, to the decline in the number of new drugs that have received FDA approval since 2000. In the second half of the 1990s, the FDA approved an unusually large number of drugs, some of which were the first on the market to treat certain conditions and a number of which treat widespread conditions. Not only are fewer new drugs being approved of late, but more drugs also face competition from generic versions. Those factors may be particularly important in explaining declining spending on DTC advertising, which peaked at $5.2 billion in 2006, because pharmaceutical manufacturers tend to use more DTC advertising for drugs that have especially broad potential markets, drugs with few or no substitutes, or drugs with some combination of those characteristics.

Source: Congressional Budget Office based on data from SDI Promotional Audits. Notes: The starting date for each type of marketing reflects the date at which SDI began including the series in its collection of data. Detailing refers to the practice in which pharmaceutical representatives make sales calls to physicians and other health care professionals to discuss the uses of a particular prescription drug and its benefits for patients. DTC = direct to consumer. Figure 1. Promotional Spending by Type of Marketing Activity, 1989 to 2008

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To study the potential effects of promotional spending for prescription drugs, the Congressional Budget Office (CBO) analyzed data from SDI, a company that collects and sells information about the pharmaceutical industry. CBO examined data on promotional activities from 1989 to 2008 for drugs in the classes of medications that include most outpatient drugs that were produced in tablets or capsules and were among the top-selling drugs in 2003.5

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Direct-to-Consumer Marketing Until the late 1990s, the use of DTC advertising was limited, consisting mainly of print advertisements that presented the required disclosure of the risks associated with the advertised product in a manner similar to the summaries offered in advertisements directed to physicians. Television advertising was less popular, however, because presenting the labeling information required by the FDA in a 30- or 60-second commercial proved impractical.6 A guidance document issued by the FDA in draft form in August 1997 and finalized two years later laid out an approach for pharmaceutical manufacturers to use in radio and television commercials that would comply with the risk-disclosure requirement. Instead of presenting all of the potential adverse effects as they appear in the package labeling, drugmakers could provide a brief summary and refer viewers to a toll-free number, Web site, physician, or print advertisement that would provide more-detailed information about potential risks and sideeffects.7 Subsequent guidance documents from the FDA focused on similar issues in print advertisements. Since the FDA published its draft guidance document on DTC advertising in the broadcast media, drug companies have spent most of their DTC budgets on television commercials. However, some observers have questioned how carefully DTC advertising— especially television commercials—balances the presentation of a drug‘s potential benefits and risks, as well as whether such advertising plays a useful role in the nation‘s health care system.8 In 2008, pharmaceutical manufacturers spent $2.6 billion on DTC advertising for the drugs in CBO‘s data set, equal to about 55 percent of the industry total for that year. Television commercials, including those broadcast on cable stations, accounted for $1.6 billion of those outlays, while expenditures for print advertising totaled about $900 million. The newest outlet for direct-to-consumer advertising—the Internet—still represents a small share of such advertising. Drug companies spent $93 million in 2008 on online banner and display ads and for ad time in streaming video presentations for the drugs in CBO‘s data set. In addition to that amount, drug companies also purchased sponsored links on search engines and hosted their own product- or disease-specific Web sites. Regulators have begun issuing warnings to manufacturers to ensure that the presentation of risks and benefits in Internet advertisements complies with the law.9

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Different Marketing Strategies for Different Drugs

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Pharmaceutical manufacturers use different marketing strategies for the drugs they produce. Many drugs are promoted solely to physicians, with no attempt to reach consumers. Others are heavily promoted to consumers and, in varying degrees, to physicians as well. That different marketing strategies are used for different drugs is not surprising because there is no consensus among experts about the effects of such strategies on the sales or prices of prescription drugs. For DTC advertising, studies that have analyzed the effects for a few specific drugs or classes of drugs have shown mixed results; the writing and filling of prescriptions increased for some advertised drugs but not for others.10 For detailing, some analyses have found positive effects on the number of prescriptions written for the targeted drug, but others suggest that detailing‘s effects are unclear.11 Of the more than 2,000 drugs included in CBO‘s data set, 700 to 800 have some promotional spending reported in any given year. For nearly all of those drugs, some spending on detailing was recorded. However, manufacturers purchased DTC advertisements for fewer than 100 of those drugs in each of the years since 1995, the year the data set begins to encompass DTC advertising, making DTC advertising the least frequently used form of drug promotion (see Figure 2). Journal ads and professional meetings are used to promote fewer drugs than detailing but more drugs than DTC advertising.

Source: Congressional Budget Office based on data from SDI Promotional Audits. Notes: The starting date for each type of marketing reflects the date at which SDI began including the series in its collection of data. Detailing refers to the practice in which pharmaceutical representatives make sales calls to physicians and other health care professionals to discuss the uses of a particular prescription drug and its benefits for patients. DTC = direct to consumer. Figure 2. Promotional Activity for Prescription Drugs in CBO‘s Data Set, 1989 to 2008

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Though pharmaceutical manufacturers use DTC advertising for only a small set of drugs, they spend heavily on DTC advertising for those drugs. For those drugs in the data set that were promoted using DTC advertising, average expenditures for such advertising peaked at $41.8 million in 2006. The average detailing expenditure for drugs promoted through detailing that year was $10.4 million. Drug companies spend far less per drug to promote drugs through advertisements in medical journals or by sponsoring professional meetings and events. In 2008, for the drugs in CBO‘s data set with such expenditures, they spent about $1 million per drug on journal advertisements and $3.6 million per drug on meetings and events. Drugs promoted using DTC advertising are, on average, newer to the market than drugs promoted through detailing, but the difference in the average expenditures for DTC advertising and detailing seems largely a result of the distribution of the two types of spending. Drug companies spend similarly large annual amounts on detailing and DTC advertising for a few drugs (in some cases, more than $200 million a year on each); but they spend small amounts on detailing for many more drugs. Among the June 2003). drugs in CBO‘s data set, the 10 with the highest DTC expenditures in 2008 accounted for 30 percent of expenditures for DTC advertising industrywide. That concentration is nearly twice what was observed for detailing, where the 10 drugs with the highest expenditures totaled 16 percent of the industry‘s detailing expenditures. That difference may be explained, in part, by the fact that detailing visits can include discussions of more than one product while each DTC advertisement typically focuses on only one drug. According to CBO‘s analysis, when pharmaceutical manufacturers promoted drugs to consumers, they also spent more, on average, promoting those drugs to physicians. For those drugs in CBO‘s data set with reported spending on DTC advertising, their manufacturers spent an average of $40.5 million per drug in 2008 on promotional activities directed to physicians—14 times the average amount they spent when promoting drugs exclusively to physicians. That difference may indicate that manufacturers use promotional activities directed to physicians and DTC advertising to reinforce each other. Although DTC advertising might spur a consumer to visit his or her doctor, the physician must prescribe the drug; therefore, manufacturers would seek to ensure that physicians were also informed about the drugs they advertised to consumers. Alternatively, pharmaceutical manufacturers could have spent extensively to promote to physicians those drugs marketed with DTC advertising even if advertising to consumers was not permitted, perhaps because of the size of the potential market for those drugs. DTC advertising is almost never used in isolation. Detailing is far more likely to be the exclusive promotional outlet for a drug. Even if manufacturers find that it is not useful to promote certain drugs directly to consumers—for example, because the condition they treat is relatively rare—drug companies would still want to ensure that doctors know about their product and any advantages it has over its competitors.

MARKET CHARACTERISTICS THAT INFLUENCE PROMOTIONAL STRATEGIES A pharmaceutical manufacturer‘s decision to use DTC advertising or other types of marketing tools depends on the potential size of the market for a given prescription drug, the

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current competition in that market, and the amount of time that has elapsed since the drug received FDA approval. Manufacturers may also choose to alter their marketing mix over time, especially as new competitors enter the market, the manufacturer faces the end of a drug‘s patent protection and the entry of generic versions on the market, or the manufacturer introduces new dosage forms, extended-release versions of a drug, or new combination drugs. The balance of this brief focuses on those issues for the two largest components of pharmaceutical manufacturers‘ promotional expenditures—detailing and DTC advertising.

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Market Size Treatments for common conditions that affect a large portion of the population—such as high cholesterol, insomnia, or reduced bone density—are a primary focus of direct-toconsumer advertising. Many top-selling drugs have some of the highest DTC advertising expenditures. Drugs that have large potential markets are likely candidates for direct-toconsumer advertising because a substantial share of the intended audience may benefit from the treatment and may seek out and receive a prescription for the advertised drug. That effect may be even more important if that large potential market includes many individuals whose condition is undiagnosed or untreated. Drugs that treat rare illnesses are less likely to be the subject of DTC advertising because manufacturers would have to spend considerable amounts to reach the few individuals suffering from such illnesses.12 If a drug has both a large potential market and is approved to treat chronic or long-term conditions, its manufacturer may be even more likely to embrace DTC advertising.13 For those drugs, individuals who receive a prescription may continue with the advertised drug for a long time, producing a steady stream of sales for the pharmaceutical company if it succeeds in building brand loyalty. For patients already taking an advertised drug, DTC advertisements may serve as a reminder to refill the prescription. DTC advertising is less common for drugs (such as antibiotics) that address acute conditions (such as an infection)—perhaps because individuals are more likely to seek care for an acute condition without being prompted by an advertisement or because such drugs are typically prescribed only for a short time.14 Detailing expenditures are reported for nearly all the drugs in CBO‘s data set, regardless of market size. The more extensive use of detailing and other promotions to physicians is not surprising because physicians must be prepared to treat patients with both long- and shortterm illnesses and both rare and common complaints. Nonetheless, there is substantial overlap among the types of drugs that have sizable expenditures for both direct-toconsumer advertising and detailing (see Figure 3). Among the 10 drug classes in CBO‘s data set with the highest spending for DTC advertising in 2008, 5 classes are also among the 10 classes with the highest detailing expenditures.

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Source: Congressional Budget Office based on data from SDI Promotional Audits. Notes: Detailing refers to the practice in which pharmaceutical representatives make sales calls to physicians and other health care professionals to discuss the uses of a particular prescription drug and its benefits for patients. DTC = direct to consumer; SNRI = serotonin-norepinephrine reuptake inhibitors. Figure 3. Spending for DTC Advertising and Detailing to Health Care Professionals Among the 10 Drug Classes in CBO‘s Data Set with the Highest DTC Spending, 2008

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Competing Drugs Direct-to-consumer advertising and detailing differ in the depth of the information they provide. DTC advertisements are more limited, generally informing patients only that a drug exists and naming or describing the conditions it is approved to treat. Detailing, like other promotions to physicians, may go beyond that to help doctors differentiate one drug from another. That difference helps explain the distinct patterns in DTC and detailing expenditures for drugs facing a different number of competitors within the same class of drugs. Pharmaceutical manufacturers tend to spend more, on average, on DTC advertising for drugs that have few or no direct competitors (meaning there are few other drugs that treat the same condition using the same mechanism) than on products with numerous alternatives. Excluding some classes of drugs with the highest-selling and most- advertised drugs—where a drug‘s potential market size might overwhelm other factors in setting a marketing plan—the data analyzed by CBO show that average spending per drug on DTC advertising generally declines as the number of competitors in the same class increases (see Figure 4). When a class includes more drugs, pharmaceutical manufacturers tend to spend less, on average, on DTC advertising because the benefits of that advertising (higher sales) may be diffused among the other drugs in the class. Several factors may contribute to that outcome. Like any monopolist, a drug manufacturer whose product has no competition can turn a profit on an advertising-induced increase in demand because a monopolist can set the drug‘s price above what it costs to satisfy that increased demand. In addition, companies that produce drugs with few or no competitors run little risk that advertising for those drugs will spur demand for competing

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products. That circumstance is particularly important for DTC advertising because, at most, an advertisement might motivate an individual to contact his or her doctor and ask to be prescribed the advertised drug. The physician would have to assess the patient‘s condition and then judge the advertised and requested drug to be the most effective course of treatment. The greater the number of other medications available, the greater the possibility that the prescriber will choose a treatment other than the drug the patient saw advertised. Some research suggests that DTC advertising encourages individuals to visit their doctors and increases sales for the advertised drug‘s class—but not necessarily for the advertised drug itself.15 Detailing expenditures do not exhibit the same relationship between average spending and the number of competitors in a drug class. Even when there are several alternative treatments available, drug manufacturers have an incentive to spend on detailing to help doctors differentiate their drugs from those of their competitors. In a visit to a physician, a drug company‘s sales representative can remind the doctor of the company‘s products, provide samples that the physician can distribute to patients, and compare the benefits and risks of the company‘s drugs with those of competing treatments. Because the physician decides which drug best meets a patient‘s needs, any increase in sales that results from detailing expenditures is likely to accrue directly to the drug that is the focus of the detailing rather than to any potential substitutes.

Source: Congressional Budget Office based on data from SDI Promotional Audits. Notes: Drug classes are specified at the 5-digit level of the IMS Uniform System of Classification. To account for cases in which a drug‘s potential market size might overwhelm other factors, four classes in CBO‘s data set were excluded from this figure: nonbarbiturate sleep aids, statins, erectile dysfunction drugs, and proton-pump inhibitors. Drugs in those classes account for 35 percent of the expenditures for DTC advertising reported in CBO‘s data set. DTC = direct to consumer. Figure 4. Average Spending per Drug on DTC Advertising, by the Number of Competitors in a Given Class of Drugs, 1995 to 2008

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Source: Congressional Budget Office based on data from SDI Promotional Audits and Food and Drug Administration, Electronic Orange Book (accessed June 2009), available at www.accessdata .fda.gov/scripts Note: DTC = direct to consumer; FDA =Food and Drug Administration. Figure 5. Time Path of DTC Spending for Prescription Drugs

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Years since FDA Approval Although there are substantial differences among drugs in the amount spent in a given year on advertising and promotions to physicians, there are fewer differences in those patterns over a drug‘s life cycle. Pharmaceutical manufacturers promote more of their products to both physicians and consumers in the first few years after a drug has received approval from the FDA.16 Manufacturers tend to reduce spending for both DTC advertising and detailing the longer the product is on the market (see Figure 5). The longer a product remains on the market, the more likely it is to face competition both from other brand-name drugs and from generic versions. 17 For advertised drugs, the average spending on DTC advertising per drug stays fairly constant for several years, while average spending for detailing falls off more quickly, dropping 18 percent from year 1 to year 2.18 Drug companies typically persist for several years in their advertising campaigns for drugs with large DTC advertising expenditures. In many cases, that occurs because pharmaceutical manufacturers use DTC advertising to introduce drugs with large potential markets, and it may take time to penetrate those markets. Drug companies may also continue high DTC spending to attract customers before a competitor enters the market. Pharmaceutical manufacturers keep a detailing presence for many drugs for a number of years, but average spending declines more quickly. That observation suggests that drug companies may spend substantially to introduce physicians to a new drug and then reduce the intensity of their physician-directed efforts thereafter.

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End Notes

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1

Pharmaceutical manufacturers promote their products to health insurers and pharmacy benefit managers (PBMs) to encourage them to include their products on plans‘ formularies and to assign those products a low copayment. See, for example, SDI, ―SDI Reports: Takeda Touts New Drugs to Managed Care‖ (press release, Plymouth Meeting, Pa., August 31, 2009). 2 In several recent cases, the appropriateness of certain promotional activities undertaken by pharmaceutical companies has been called into question and some companies have come under scrutiny for promoting products for uses not approved by the FDA. See, for example, Department of Justice, ―Justice Department Announces Largest Health Care Fraud Settlement in Its History‖ (press release, Washington, D.C., September 2, 2009). 3 That amount (obtained from SDI Promotional Audits) does not include the expense of the free samples that pharmaceutical manufacturers distribute to physicians, which one study estimated to have a retail value of $ 18.4 billion in 2005. See Julie M.Donohue, Marisa Cevasco, and Meredith B. Rosenthal, ―A Decade of Directto-Consumer Advertising of Prescription Drugs,‖ New England Journal of Medicine, vol. 357, no. 7 (August 16, 2007), pp. 673–681. It also excludes other activities that may have promotional value, such as efforts targeting PBMs and research grants that encourage studies and publications about products. 4 Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 2009 (Washington, D.C.: PhRMA, April 2009). 5 CBO‘s data set was constructed using information from SDI‘s Promotional Audit Suite. The data set includes 111 drug classes as defined by the IMS Uniform System of Classification and covers a majority of the top 200 (in dollar sales) outpatient brand-name drugs sold in solid form (for oral administration) in 2003 and their closely related therapeutic substitutes. Other dosage forms are not included in the data set. The starting date for each type of promotional spending varies, as SDI has expanded its data collection to include other types of promotional spending. 6 See statement of Janet Woodcock, M.D., Director, Center for Drug Evaluation and Research, Food and Drug Administration, before the Senate Special Committee on Aging, Regulating Prescription Drug Promotion (July 22, 2003). 7 For the final version of the draft guidance document, see Department of Health and Human Services, Food and Drug Administration, Guidance for Industry: Consumer-Directed Broadcast Advertisements (August 1999). 8 See, for example, Direct-to-Consumer Advertising: Marketing, Education, or Deception?, hearing before the Subcommittee on Oversight and Investigations of the House Committee on Energy and Commerce (May 8, 2008); and The Impact of Direct-toConsumer Advertising on Seniors’ Health and Health Care Costs, hearing before the Senate Special Committee on Aging, Serial No. 109-14 (September 29, 2005). 9 See, for example, Department of Health and Human Services, Food and Drug Administration, Warning Letter to Johnson & Johnson regarding a Webcast video promoting Ultram ER, May 12, 2009; and Warning Letter to Bayer Healthcare Pharmaceuticals, Inc., regarding sponsored links on Internet search engines for Levitra, Yaz, and Mirena, March 26, 2009. 10 See W. David Bradford and others, ―How Direct-to-Consumer Television Advertising for Osteoarthritis Drugs Affects Physicians‘ Prescribing Behavior,‖ Health Affairs, vol. 25, no. 5 (September/ October 2006); and Michael R. Law, Sumit R. Majumdar, and Stephen B. Soumerai, ―Effect of Illicit Direct to Consumer Advertising on Use of Etanercept, Mometasone, and Tegaserod in Canada: Controlled Longitudinal Study,‖ BMJ, vol. 337 (September 6, 2008). 11 Some studies suggest that detailing may have positive effects on the number of prescriptions written for a given drug. See Natalie Mizik and Robert Jacobson, ―Are Physicians ‗Easy Marks‘? Quantifying the Effects of Detailing and Sampling on New Prescriptions,‖ Management Science, vol. 50, no. 12 (December 2004), pp. 1704–1715; Puneet Manchanda and Pradeep K. Chintagunta, ―Responsiveness of Physician Prescription Behavior to Salesforce Effort: An Individual Level Analysis,‖ Marketing Letters, vol. 15, no. 2-3 (2004), pp. 129–145; and Michael A. Steinman and others, ―Characteristics and Impact of Drug Detailing for Gabapentin,‖ PLoS Medicine, vol. 4, no. 4 (April 2007). Other studies find no clear effects from detailing. See Meredith B. Rosenthal and others, Demand Effects of Recent Changes in Prescription Drug Promotion (Menlo Park, Calif.: Kaiser Family Foundation, June 2003). 12 Internet advertising may offer a more targeted approach for manufacturers whose products treat rare conditions. To date, however, there are no apparent differences between drugs advertised online and those advertised in more traditional media. 13 See General Accounting Office, Prescription Drugs: FDA Oversight of Direct-to-Consumer Advertising Has Limitations, GAO-03-177 (October 2002), p. 13. 14 Of the 260 antibiotics included in CBO‘s data set, DTC advertis-ing is reported for only 13. Average annual DTC advertising expenditures for those antibiotics were smaller than for other drugs in the data set—$2.9 million compared with $32 million.

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Congressional Budget Office

15

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See Toshiaki Iizuka and Ginger Zhe Jin, ―The Effect of Prescription Drug Advertising on Doctor Visits,‖ Journal of Economics and Management Strategy, vol. 14, no. 3 (2005); and Rosenthal and others, Demand Effects of Recent Changes in Prescription Drug Promotion. 16 Drugs approved before the FDA issued its 1997 draft guidance document on advertising may not have any reported spending for DTC advertising for several years into their life cycle. 17 With brand-name competitors, drug manufacturers may still have strong incentives to promote their drugs to differentiate them from rivals. A generic version does not offer the same incentive because, in order to win FDA approval, a generic drug must have demonstrated bioequivalence to its brand-name counterpart. In addition, most states permit or mandate that pharmacists substitute generics when they are available and when the physician has not specified that the brand-name drug is necessary. 18 The jump in participation and average expenditures from year 0 (the year in which FDA approval was received) to year 1 (the following year) is probably due to the fact that, for many drugs, year 0 does not constitute a complete calendar year.

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CHAPTER SOURCES

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The following chapters have been previously published: Chapter 1 – This is an edited, excerpted and augmented edition of a United States Congressional Research Service publication, Report Order Code RL33605, dated January 29. 2010. Chapter 2 – This is an edited, excerpted and augmented edition of a United States Federal Trade Commission publication, dated June 2009. Chapter 3 – These remarks were delivered as Statement of J. Thomas Rosch, given at the World Generic Medicine Congress, dated November 19, 2009. Chapter 4 – This is an edited, excerpted and augmented edition of a United States Congressional Research Service publication, Report Order Code RL32324, dated January 6, 2010. Chapter 5 – This is an edited, excerpted and augmented edition of a United States Congressional Budget Office publication, dated October 26, 2009. Chapter 6 – This is an edited, excerpted and augmented edition of a United States Congressional Research Service publication, Report Order Code RL31511, dated March 18, 2009. Chapter 7 – This is an edited, excerpted and augmented edition of a United States Congressional Research Service publication, Report Order Code RL33717, dated January 6, 2010. Chapter 8 – This is an edited, excerpted and augmented edition of a United States Congressional Research Service publication, Report Order Code R40503, dated January 29, 2010. Chapter 9 – This is an edited, excerpted and augmented edition of a United States Congressional Budget Office publication, dated December 2, 2009.

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INDEX

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A Abbreviated New Drug Applications, 3, 130 access, viii, 8, 11, 62, 63, 65, 84, 101, 102, 111, 124, 143, 153 accountability, 61, 62, 84 accounting, 23, 46, 119, 160 Administrative Procedure Act, 157 advancement, viii, 61, 62, 64, 66 advantages, 62, 63, 71, 77, 84, 103, 104, 164 adverse effects, 162 adverse event, 156 advertisements, ix, 159, 160, 162, 163, 164, 165, 166 Advertisements, 169 advertising space, 159 advocacy, 74, 141 aerospace, 67 agencies, 61, 63, 64, 68, 69, 70, 72, 75, 83, 104 agency actions, 157 aggregation, 21, 25, 27 AIDS, 78, 88, 115 Air Force, 72 alliances, 13, 65, 85, 105 alternative treatments, 167 alters, 96, 134, 148 American Recovery and Reinvestment Act, 63, 95 American Recovery and Reinvestment Act of 2009, 95 anemia, 115 annual rate, viii, 91, 121 antibiotic, 46, 141 antitrust, vii, 7, 29, 49, 50, 51, 52, 53, 54, 55, 56, 57, 58, 59, 127, 128, 129, 135, 136, 137, 140, 141, 142, 143 architecture, 7 arthritis, 56, 98 assessment, 52, 80, 103 assets, 89, 103, 105, 107, 113, 116, 118, 120, 121, 123, 125, 126 atmosphere, 78 authorities, 69, 127, 128, 151

authority, viii, 54, 55, 57, 147, 148, 150, 152, 153, 154, 155, 158 Authorized generic drugs, vii, 15, 36 authorized generics, vii, 1, 2, 6, 7, 8, 9, 10, 11, 13, 15, 18, 19, 20, 21, 27, 30, 36, 37, 42, 46, 59, 146 average variable cost, 44

B background information, 2 balance sheet, 118 ban, vii, 49, 50, 56 base, 83, 113, 114, 118, 122 basic research, 61, 62, 63, 65, 66, 67, 75, 76, 78, 79, 95, 113, 114, 123 Bayer-Barr agreement, 141 Bayh-Dole Act, 65, 68, 70, 75, 80, 81, 82, 83, 86, 87 behaviors, 43 beneficiaries, 96, 97, 98, 102 benefits, 7, 11, 23, 32, 42, 51, 52, 61, 62, 63, 65, 67, 77, 78, 79, 80, 81, 82, 84, 96, 98, 99, 116, 120, 125, 128, 129, 133, 142, 161, 162, 163, 166, 167 bias, 43, 46 biodiesel, 124 biomedical applications, 64 biosciences, 71 biotechnology, 62, 63, 71, 74, 77, 80, 81, 82, 83, 84, 103, 105, 122 brand-name drug company, vii, 1, 2, 6, 7, 127, 128, 133 breast cancer, 139 broadcast media, 159 Bureau of Labor Statistics, 89 business community, viii, 61, 62, 63, 64, 75 business cycle, 122 business strategy, 9 businesses, 65, 69, 70, 71, 81, 136 buyers, 97

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Index

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C calculus, 16, 28 campaigns, 168 cancer, 56, 139, 155 candidates, 104, 106, 165 capital expenditure, 120 capital gains, 81 capsule, 37 case law, 54, 142 case study, 76 cash, 46, 102, 118, 122, 128, 132 cash flow, 102, 122 category a, 11 Census, 93, 100, 105, 124 certification, 4, 5, 45, 131, 132, 135, 139 challenges, 2, 6, 7, 8, 11, 19, 30, 38, 43, 54, 55, 56, 82, 132, 142, 153 Chamber of Commerce, 157 chemical, 67, 79, 124 chemicals, 103, 105 Chevron deference, 157 cholesterol, 105, 165 chronic illness, 95 Cipro, 51, 52, 53, 54, 58, 88, 141 City, 145 class, 37, 99, 166, 167 classes, 46, 162, 163, 165, 166, 167, 169 Clayton Act, 135, 143 climate, 102, 121 clinical application, 76 clinical trials, 66, 74, 82, 95, 100, 114, 123 Clinton Administration, 80 clopidogrel, 23, 24, 43 collaboration, 64, 65, 68, 71, 76 combined effect, 102, 122 commerce, 148 commercial, 66, 70, 71, 72, 75, 81, 82, 83, 102, 103, 104, 106, 121, 122, 127, 128, 134, 149, 150, 151, 156, 157, 162 commercialization of technology, viii, 61, 62, 68, 75 commercials, 162 community, viii, 61, 62, 63, 64, 66, 68, 70, 75, 77, 81, 83, 124 compensation, 30, 44, 61, 62, 70, 84, 106, 126, 127, 128, 134 competition, vii, viii, 2, 5, 7, 8, 9, 10, 11, 13, 15, 16, 17, 18, 19, 20, 21, 22, 25, 26, 28, 29, 30, 32, 33, 34, 35, 36, 37, 38, 42, 43, 44, 45, 49, 50, 51, 52, 53, 54, 55, 56, 57, 65, 72, 91, 93, 98, 102, 104, 106, 123, 127, 128, 129, 132, 133, 134, 135, 136, 138,뫰140, 141, 142, 161, 165, 166, 168 competitive advantage, 102, 106

competitive process, 80 competitiveness, 67, 80, 103 competitors, viii, 1, 5, 8, 67, 127, 128, 129, 137, 164, 165, 166, 167, 170 complaints, 165 complexity, vii compliance, 83, 150, 157 composition, 45, 76, 148 Compounding, v, viii, 147, 148, 151, 153, 155, 156, 157, 158 compounds, 80, 91, 98, 99, 104, 106, 123 computation, 113, 125 computing, 112, 120 conference, 46, 87 conflict, 68, 74, 153 conformity, 155 Congress, iv, v, vii, 1, 2, 3, 4, 9, 11, 16, 30, 49, 52, 53, 54, 55, 62, 63, 71, 76, 81, 82, 86, 87, 88, 89, 97, 98, 99, 101, 103, 124, 125, 127, 128, 130, 131, 132, 134, 142, 143, 146, 147, 148, 149, 150, 153, 154, 156, 157, 171 Congressional Budget Office, v, vi, 42, 91, 92, 93, 94, 97, 99, 100, 126, 159, 161, 162, 163, 166, 167, 168, 171 congressional debates, viii, 101 consensus, 63, 74, 78, 142, 163 consent, 46, 105, 139 conspiracy, 135 Constitution, 66, 80, 156 constitutionality, 156 consumer goods, 105, 160 consumer loyalty, 121 consumer price index, 97 consumers, vii, ix, 1, 2, 7, 8, 11, 16, 17, 18, 20, 21, 22, 23, 28, 29, 32, 34, 46, 49, 52, 55, 56, 57, 59, 93, 95, 97, 104, 105, 133, 134, 142, 143, 159, 160, 163, 164, 168 containers, 155 controversial, vii, 1, 2, 7, 155 convention, 22 cooperation, 62, 66, 71, 84 cosmetics, 155 cost, vii, viii, 2, 6, 7, 8, 11, 30, 44, 46, 49, 56, 61, 62, 63, 67, 68, 71, 73, 77, 78, 80, 84, 94, 96, 100, 102, 105, 106, 112, 113, 114, 117, 119, 120, 121, 122, 123, 126, 129, 134, 159, 160 cost controls, 78 counsel, 138 Court of Appeals, 9, 10, 14, 55, 136, 137, 150 covering, 18, 30, 33, 139 CPI, 97 creation of new pharmaceuticals, viii, 61 creativity, 64

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Index critical thinking, 55 criticism, 67 critics, 7, 63, 79, 81 CRS report, 114 cultural differences, 65 current balance, 62, 63 customers, 50, 120, 168

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D damages, iv, 12, 134 data analysis, 17, 18 data collection, 169 data set, 15, 19, 162, 163, 164, 165, 167, 169 database, 25 decongestant, 37, 46 deduction, 112, 114, 117, 118, 120, 121 defendants, 51, 52, 136, 140 deficit, 100 deflator, 93, 94 demographic change, 96 Department of Commerce, 72, 86, 88, 89, 107 Department of Defense, 69, 83 Department of Energy, 72 Department of Health and Human Services, 72, 73, 74, 169 Department of Justice, 52, 134, 169 Department of Labor, 157 depreciation, 110, 112, 113, 117, 119, 120, 121, 125, 126 depth, 166 developed countries, 102, 108, 119 development of new medicines, viii, 101, 102 DHS, 40 diabetes, 56 diagnosis, 160 diesel fuel, 124 direct cost, 121 direct costs, 121 direct investment, 107 directors, 118 disability, 71 disadvantages, 103 disclosure, 36, 51, 57, 66, 67, 162 diseases, 56, 79, 102, 106, 114, 115 distribution, 45, 64, 68, 140, 141, 148, 150, 164 district courts, 129, 140 District of Columbia, 14 divergence, 24 doctors, ix, 98, 104, 105, 159, 164, 166, 167 DOJ, 52, 134, 135 domestic demand, 121 dominance, 105, 106

dosage, 10, 19, 20, 21, 35, 37, 38, 43, 46, 47, 148, 165, 169 draft, 129, 159, 162, 169, 170 drawing, 157 drug discovery, 62, 76, 79, 123 drug expenditures, viii, 91, 93, 96 drug patents, vii, 1, 2, 67, 104, 118, 122 Drug Price Competition and Patent Restoration Act of 1984, vii, 49 drug testing, 123 drug therapies, vii, viii, ix, 91, 95, 106, 159 drug therapy, 156 duopoly, 45, 50

E earnings, 102, 109, 110, 112, 113, 117, 118, 119, 121, 122, 123, 140 economic activity, 119 economic growth, 61, 62, 64, 77, 81 economics, 43 economy, 18, 64 education, 102, 160 elderly, viii, 61, 62 electricity, 111, 124 eligibility criteria, 97 employees, 107, 122 employment, 103, 105, 111, 124, 135 empowerment, 111, 124 encouragement, 51, 68 energy, 111, 113, 124 enforcement, 74, 147, 149, 151, 152, 153, 154, 155, 158 engineering, 64 England, 85, 169 environment, 51, 67, 72, 84 environmental quality, 63 equipment, 67, 69, 113, 115, 119, 120, 122, 135, 149, 151, 157 equity, 80, 107, 123 erosion, 28 ESI, 138, 139 estriol, 155 estrogen, 155 Europe, 83, 107 European Commission, 59 European Union, 13, 59 evidence, 3, 20, 26, 44, 52, 53, 56, 58, 73, 75, 82, 96, 102, 112, 117, 118, 121, 122, 130, 141, 142, 143, 153, 154 exclusion, 30, 36, 44, 51, 103, 110, 128 execution, 45 Executive Order, 157

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Index

exercise, viii, 69, 147, 148, 149, 152, 153, 154, 158 expanding consumer access to prescription drugs, viii, 101 expenditures, viii, 19, 25, 26, 27, 44, 65, 75, 91, 93, 95, 96, 113, 114, 115, 119, 120, 121, 122, 123, 125, 126, 159, 161, 162, 164, 165, 166, 167, 168, 169, 170 expertise, 53, 64, 69 exploration, 79 exposure, 134

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F FDA, v, vii, viii, 2, 3, 4, 5, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 19, 22, 34, 35, 36, 37, 38, 42, 45, 46, 47, 50, 55, 57, 59, 71, 72, 76, 83, 86, 93, 95, 104, 106, 123, 130, 131, 132, 133, 136, 138, 139, 144, 147, 148, 149, 150, 151, 152, 153, 154, 155, 156, 157, 158, 159, 160, 161, 162, 165, 168, 169, 170 FDA approval, 4, 10, 46, 50, 57, 123, 131, 132, 138, 139, 148, 161, 165, 170 federal agency, 70 federal courts, viii, 127, 128, 142 Federal Food Drug and Cosmetic Act (FFDCA), viii, 147, 148 federal funds, 104 federal government, viii, 61, 62, 66, 67, 68, 70, 75, 77, 83, 87, 96, 97, 98, 102, 104, 108, 117, 121, 125 Federal Government, 85, 86 federal income tax, 102, 110, 115, 116, 119, 122 federal law, 155 Federal Register, 71, 157 Federal Trade Commission, v, vii, 15, 37, 44, 46, 49, 54, 59, 134, 135, 142, 171 Federal Trade Commission Act, 54, 135 financial, viii, 61, 62, 63, 65, 70, 73, 74, 77, 78, 80, 81, 84, 99, 116 financial incentives, 99 financial support, 63, 77 First Amendment, 147, 149, 150, 156 fixed costs, 44 flexibility, 154 food, 3, 6, 130 Food and Drug Administration (FDA), viii, 3, 12, 19, 93, 106, 123, 147, 159 force, 45, 64, 109, 133, 154, 156, 157 foreign direct investment, 107 fraud, 51, 53, 58, 141 freedom, 72, 156 fruits, 78, 132, 143 funding, viii, 61, 62, 63, 65, 68, 69, 70, 71, 75, 76, 77, 78, 79, 81, 82, 83, 95, 102, 104

funds, 8, 61, 62, 63, 67, 69, 71, 76, 78, 79, 104, 115, 121, 122

G GAO, 77, 83, 86, 88, 89, 124, 126, 157, 169 General Accounting Office, 72, 86, 88, 89, 112, 124, 169 General Motors, 78 generic drugs, vii, 2, 3, 4, 6, 8, 11, 13, 15, 17, 19, 23, 29, 30, 36, 37, 42, 54, 56, 59, 91, 93, 94, 96, 98, 102, 104, 130, 131 generic name, vii, 1, 2, 6 Georgia, 58 Germany, 124 goods and services, 61, 62, 64, 84, 103, 105 government funds, 63, 67 government intervention, viii, 61, 62 governments, 97, 98, 108, 117 grants, 9, 76, 82, 117, 169 Grenada, iii gross domestic product, 93, 94 growth, vii, viii, 61, 62, 64, 65, 75, 77, 81, 83, 91, 92, 93, 95, 96, 97, 99, 102, 103, 104, 106, 115, 121, 157, 161 growth factor, 92 growth hormone, 115, 157 growth rate, 65 guidance, 142, 149, 151, 152, 154, 157, 158, 159, 162, 169, 170 guidelines, 82, 88

H Harvard School of Medicine, 66 Hatch-Waxman Act, vii, 1, 3, 4, 5, 7, 8, 9, 10, 11, 12, 13, 15, 16, 17, 30, 45, 49, 54, 55, 59, 62, 63, 77, 124, 127, 128, 129, 130, 131, 132, 133, 134, 136, 137, 139, 141, 143, 144, 145 health, vii, viii, ix, 2, 3, 8, 11, 18, 23, 52, 61, 62, 63, 69, 70, 71, 73, 77, 78, 79, 80, 81, 82, 83, 84, 91, 92, 93, 95, 96, 97, 98, 99, 100, 101, 102, 103, 105, 128, 143, 154, 159, 161, 162, 163, 166, 169 Health and Human Services, 13, 72, 73, 74, 89, 149, 169 health care, vii, viii, ix, 2, 18, 23, 52, 78, 80, 81, 91, 96, 97, 98, 99, 100, 101, 103, 105, 128, 159, 161, 162, 163, 166 health care costs, 2, 91, 96, 99 health care professionals, ix, 159, 161, 163, 166 health care reform, 52, 97 health care system, 18, 23, 101, 159, 162

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Index health expenditure, 92, 100 health insurance, 23, 95, 97, 102 health services, 92 health-related research, viii, 61, 63, 95 HHS, 72, 149 hiring, 122 histamine, 39 historical overview, 148 history, 53, 81, 135, 150, 153, 154, 157 HIV, 73 hormone, 105, 115, 148, 155, 157 hormones, 155 House, 42, 52, 70, 86, 87, 88, 89, 156, 169 House of Representatives, 42, 88 housing, 111, 124 human, 114, 115, 155, 157 Hurricane Katrina, 124 hybrid, 116 hypertension, 137 hypothesis, 43

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I identity, 19, 155 imitation, 80 impacts, 8, 28, 43 improvements, 77, 98 incidence, 16 income, 8, 72, 81, 101, 102, 103, 108, 109, 110, 111, 112, 113, 114, 115, 116, 117, 119, 120, 122, 123, 124, 125 income tax, 81, 102, 108, 110, 111, 112, 113, 114, 115, 116, 117, 119, 122 individuals, ix, 23, 66, 84, 96, 97, 112, 114, 129, 159, 165, 167 industrial sectors, 67, 71 industries, 62, 63, 64, 65, 66, 67, 75, 80, 83, 84, 101, 103, 104, 106, 107, 110, 113, 114, 116, 117, 120, 121, 122, 137 industry, vii, 1, 4, 6, 7, 11, 50, 62, 63, 64, 65, 66, 67, 68, 71, 73, 75, 77, 79, 80, 81, 82, 83, 84, 93, 94, 101, 102, 103, 104, 105, 106, 107, 108, 109, 110, 111, 112, 113, 114, 115, 116, 117, 118, 119, 120, 121, 122, 123, 125, 126, 128, 129, 131, 151, 162, 164 infection, 73, 165 inflation, viii, 91, 93, 94, 97, 98, 125 ingredients, viii, 37, 103, 104, 108, 147, 148, 149, 151 injuries, 156 injury, iv INS, 158 insomnia, 165

institutions, 64, 70, 75, 81 intellectual property, 54, 61, 62, 67, 68, 70, 72, 73, 77, 80, 81, 82, 83, 129 intellectual property rights, 61, 62, 68, 70, 73, 80, 81, 129 interest groups, 57 Internal Revenue Code (IRC), 110 Internal Revenue Service, 109, 111, 116, 118, 123, 125, 126 Internet, 63, 83, 162, 169 intervention, viii, 61, 62, 63 inventions, 66, 68, 69, 70, 71, 72, 75, 77, 81, 83, 129 inventors, 67, 129 investment, 62, 63, 64, 68, 73, 77, 78, 80, 83, 84, 92, 95, 96, 97, 98, 101, 102, 106, 114, 115, 116, 120, 121, 122, 124, 125 investments, 8, 61, 63, 64, 66, 67, 77, 78, 80, 115, 117, 120, 121, 122 investors, 8, 80, 95, 122 IRC, 110, 111, 113, 114, 118, 119, 120, 122, 125 IRS, 108, 114, 118, 123 isolation, 164 Israel, 13 issues, vii, 2, 15, 30, 34, 46, 49, 55, 56, 57, 58, 62, 63, 65, 68, 71, 76, 82, 129, 152, 153, 154, 162, 165 Italy, 124

J Japan, 107, 124 Joint Economic Committee, 76, 80, 87, 88 joint ventures, 65 judicial review, 157 judiciary, 89 Judiciary Committee, 52 jurisdiction, 153, 154 justification, 153

L labeling, 135, 148, 155, 162 laws, 50, 54, 57, 61, 68, 80, 102, 127, 128, 129, 135, 136, 141, 155 lead, ix, 2, 9, 64, 67, 71, 79, 81, 83, 98, 99, 105, 142, 143, 159 Leahy, 15, 42, 55, 59 learning, 67 legality, 51, 54, 56, 119 legislation, 1, 3, 52, 57, 62, 69, 70, 71, 77, 81, 85, 87, 127, 128, 132, 135, 142, 143 legislative proposals, 30

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Index

license fee, 72 life cycle, 104, 168, 170 life sciences, 75 light, 12, 19, 26, 28, 52, 58, 81, 116, 148, 152, 153 Limitations, 84, 85, 169 limited liability, 103 liquids, 37 litigation, vii, viii, 1, 2, 5, 6, 7, 8, 16, 29, 32, 34, 35, 43, 44, 45, 49, 50, 51, 52, 53, 54, 58, 81, 127, 128, 129, 132, 133, 134, 136, 137, 140, 141, 142, 143 Louisiana, 153 lower prices, 1, 2, 8, 124 loyalty, 105, 121, 165

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M magazines, 124, 159, 160 magnitude, 122 major illnesses, viii, 91 majority, 7, 94, 103, 107, 169 management, 8 manufacture, 4, 56, 69, 106, 107, 108, 131, 134, 140, 141, 142, 143, 152, 155, 160 manufacturing, 8, 11, 64, 103, 104, 107, 108, 112, 113, 118, 120, 123, 140, 148, 149, 150, 151, 153, 155, 156, 157 mapping, 46 marginal social cost, 66 market failure, 120 market incentives, 79 market share, 8, 13, 17, 18, 57, 121, 123 marketing, 1, 3, 4, 5, 9, 10, 11, 12, 15, 16, 17, 29, 30, 32, 34, 35, 38, 42, 44, 52, 55, 56, 57, 59, 62, 73, 121, 126, 130, 131, 132, 133, 134, 136, 139, 141, 148, 159, 160, 161, 163, 164, 166 marketing mix, 165 marketplace, vii, viii, 2, 4, 6, 9, 15, 34, 49, 55, 61, 62, 64, 66, 67, 68, 70, 73, 79, 84, 131, 151 mass, 93 materials, 64, 114, 119, 126, 129, 135 matter, iv, 2, 9, 57, 72, 129 measurement, 112 media, 159, 162, 169 median, 17, 22, 26, 29, 32, 33, 43, 123 Medicaid, 92, 97, 98, 100, 102 medical, ix, 63, 75, 77, 79, 80, 99, 121, 143, 159, 160, 164 Medicare, 5, 10, 13, 14, 30, 44, 80, 92, 96, 98, 100, 102, 128, 132, 134, 144 Medicare Modernization Act, 10 medication, viii, 37, 46, 73, 147, 148 medicine, 64, 65, 76, 77, 123, 155

medicines, viii, 1, 101, 102, 104, 105, 107, 143, 161 methodology, 18, 21, 24 microorganisms, 56 mission, 61, 63, 68, 69, 71, 72, 74 misuse, 13, 145 mixing, viii, 147, 152 MMA, 29, 30, 33, 34, 44, 45, 132, 134, 135, 145 modification, 150 modifications, 97 monitoring, 83, 129 monopoly, 45, 50, 56, 62, 63, 66, 77, 78, 84, 106, 137, 140, 141 monopoly power, 50, 62, 63, 78, 84 motivation, 66 multinational firms, 118

N naming, 166 National Aeronautics and Space Administration, 72 National Institutes of Health, 62, 63, 68, 71, 74, 76, 79, 81, 82, 86, 87, 88, 89, 94, 95 National Science Foundation, 65, 75, 85, 87, 88, 94, 104, 120, 123, 126 National Survey, 100 natural resources, 64 net present values, 45 net profit margin, 78 New England, 85, 169 new molecular entities (NMEs), 92, 104 norepinephrine, 166 North America, 108, 123 nuclear power, 124 null, 43 null hypothesis, 43

O objectivity, 100 officials, 83, 129 oil, 111, 124 Oklahoma, 158 oligopolies, 105 openness, 71 operations, 65, 107, 108, 110, 112, 115, 119 opportunities, 53, 65, 74, 77, 95, 102, 123 overhead costs, 66, 69, 119 overlap, 165 oversight, viii, 137, 147 ownership, 62, 66, 70, 72, 77, 80, 81, 119, 121

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Index

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P Pacific, 145 packaging, 37, 135 parallel, 66, 112 patent policy, vii, 49, 70 patents, vii, viii, 1, 2, 3, 4, 5, 6, 7, 9, 10, 12, 13, 16, 29, 30, 32, 35, 36, 45, 50, 51, 54, 57, 66, 67, 68, 69, 70, 71, 75, 78, 80, 81, 82, 83, 91, 93, 98, 99, 103, 104, 106, 107, 118, 120, 122, 126, 127, 128, 130, 131, 132, 133, 136, 137, 144, 145 pathways, 3, 130 Paxil, 7 pay-for-delay, 36, 49, 50, 51, 52, 53, 54, 55, 56 payroll, 81 penalties, 52 performance, 65, 83, 101 permit, 52, 63, 67, 69, 83, 170 pharmaceutical industry, vii, 1, 6, 11, 65, 75, 80, 84, 93, 106, 111, 123, 128, 129, 162 Pharmaceutical manufacturers, 160, 163, 166, 168, 169 Pharmaceutical R&D, v, 91, 95, 124 pharmaceuticals, viii, 2, 3, 5, 7, 8, 61, 62, 63, 76, 77, 78, 80, 83, 103, 107, 130, 132, 160 physicians, viii, ix, 6, 91, 93, 104, 105, 121, 126, 159, 160, 161, 162, 163, 164, 165, 166, 168, 169 placebo, 100 playing, 96 polar, 54 policy, vii, viii, 7, 8, 49, 54, 67, 68, 70, 72, 73, 78, 82, 86, 87, 88, 92, 96, 97, 98, 100, 101, 121, 122, 129, 133, 142, 143, 153, 154, 158 policy issues, 129 policy options, 92, 96 policymakers, viii, 159 population, 77, 79, 96, 97, 143, 165 potassium, 138, 139 potential benefits, 84, 162 precedent, 153, 154, 157 preparation, iv, 80 prescription drug marketplace, vii, 15 prescription drugs, vii, viii, 2, 10, 23, 37, 55, 61, 62, 91, 93, 95, 96, 97, 102, 105, 121, 128, 155, 159, 162, 163 present value, 30, 45, 117, 126 preservation, 150 preservative, 148 President, 59, 81, 82, 86, 97 price competition, 123 price deflator, 93, 94 price effect, 17, 18 price index, 97

PriceWaterhouseCoopers, 65, 85 prima facie, 52, 58 principles, 127, 128, 135, 142, 143 private benefits, 78 private sector, 61, 62, 63, 64, 66, 69, 71, 72, 74, 75, 76, 77, 79, 80, 82, 84, 95 private sector investment, 61, 62 probability, 43, 95 procurement, 69, 83 producers, 103, 104, 105, 107, 115, 160 product market, 33 productivity, 64, 65, 75, 77, 81, 84 productivity growth, 64, 65 productivity rates, 75 professionals, ix, 159, 161, 163, 166 profit, 44, 53, 65, 71, 78, 82, 102, 119, 166 profit margin, 53, 78 profitability, 6, 43, 102, 107 project, 122 promote innovation, 57 promotional activities, ix, 159, 160, 162, 164, 169 property rights, 61, 62, 68, 70, 73, 80, 81, 129 proposition, 7, 11 protection, vii, 49, 57, 62, 63, 67, 72, 77, 78, 80, 81, 83, 84, 102, 104, 105, 106, 123, 129, 140, 156, 165 proteins, 92 public domain, 66, 80, 82, 129, 138 public goods, 78 public health, 2, 3, 11, 63, 73, 79, 92, 93, 143, 154 Public Health Service Act, 98 public interest, 70, 72, 73, 82 Public interest, viii, 61, 62 public investment, 73, 77, 78 public policy, 143 public resources, 77 public sector, 61, 63, 77, 79, 95 public support, 78, 79 publishing, 108 Puerto Rico, 110, 112, 124 purity, 155

Q quality of life, 77

R R&D investments, 122 radio, 121, 160, 162 ramp, 25 rate of return, 63, 78, 107, 122, 123, 125

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Index

raw materials, 135 reactions, 44 reasoning, 9, 152 recognition, 62, 67, 101, 115, 121 recommendations, iv, 83 recovery, 1, 111, 124 reform, 52, 97 Reform, 12, 85, 88, 89, 144, 145 regulations, 154, 155, 157, 158 regulators, vii, 1 regulatory framework, vii, 16, 49 regulatory requirements, 123 rehabilitation, 111 relative prices, 21, 43 relative size, 23 relevance, 54 relief, 143 replacement, 105, 148, 155 requirements, viii, 4, 61, 63, 67, 68, 69, 72, 83, 114, 123, 131, 147, 148, 149, 150, 151, 152, 153, 154, 155 resale, 141, 151 research and development, viii, 8, 61, 63, 64, 65, 66, 68, 69, 73, 77, 78, 79, 80, 83, 84, 91, 94, 102, 123, 160, 161 research funding, 75, 95 research institutions, 71, 75 researchers, 114, 115, 126 reserves, 113 resolution, 45, 64, 133, 143 resource allocation, 97 resources, 62, 64, 65, 67, 72, 77, 95, 96, 100, 111, 129, 133 response, 3, 15, 21, 50, 52, 55, 73, 76, 83, 84, 118, 122, 130, 134, 148, 157 restrictions, 36, 147, 149, 150 retail, 15, 17, 18, 19, 20, 21, 22, 23, 24, 27, 36, 37, 42, 43, 44, 97, 98, 149, 156, 169 Retail prices, 17, 18 retained earnings, 102, 121, 122 revenue, 8, 16, 17, 18, 28, 29, 44, 84, 91, 93, 95, 99, 100, 107, 108, 115, 120, 122, 142 Revenues, 17, 18, 44 rewards, 45, 64, 78, 115 rheumatoid arthritis, 98 rights, iv, viii, 3, 4, 34, 50, 61, 62, 66, 67, 68, 69, 70, 73, 76, 77, 78, 81, 82, 127, 128, 129, 131, 137, 141, 143, 150, 154 risk, 8, 30, 34, 36, 43, 46, 64, 74, 78, 80, 133, 134, 140, 162, 166 risk profile, 140 risks, 65, 73, 134, 162, 167 royalty, 8, 44, 66, 71, 73, 75, 82, 117, 138

rules, 52, 110, 112, 114, 154

S safety, 3, 12, 16, 63, 69, 70, 73, 102, 106, 130, 144, 148, 151, 154, 155, 156 sample mean, 43 savings, 23, 42, 97, 98, 112, 117, 121, 126 science, 66, 71, 75, 79, 80, 81, 82, 95 scientific knowledge, 63 scope, vii, viii, 4, 18, 50, 51, 53, 67, 91, 95, 106, 131, 135, 138, 139, 140, 141, 149, 151, 152, 156 scripts, 168 Secretary of Health and Human Services (HHS), 149 securities, 46 security, 64, 124 seizure, 155 seller, 58, 105, 123 sellers, 121 semiconductor, 63, 67 semiconductors, 64 Senate, 52, 69, 86, 88, 89, 125, 155, 156, 157, 169 serotonin, 166 services, iv, viii, 61, 62, 64, 69, 84, 91, 92, 103, 105, 124 settlements, vii, 16, 17, 29, 30, 32, 33, 35, 36, 44, 45, 49, 50, 52, 54, 55, 56, 127, 128, 129, 133, 134, 135, 136, 137, 138, 139, 140, 141, 142, 143 shape, 121 shareholders, 107, 119, 122, 125 shelter, 119 Sherman Act, 46, 54, 135, 137 showing, 3, 51, 52, 96, 128, 129, 130 significance level, 43 small businesses, 69, 70, 71, 81 social security, 124 Social Security, 111 social welfare, 133 society, 62, 63, 64, 67, 78, 82 SOI, 109, 111 Solicitor General, 53 Spain, 124 speech, 54, 147, 149, 150, 152, 153, 154, 156, 157 spending, vii, viii, 63, 65, 84, 91, 92, 93, 94, 95, 96, 98, 100, 102, 104, 108, 113, 114, 117, 120, 121, 122, 123, 125, 159, 160, 161, 162, 163, 164, 165, 166, 167, 168, 169, 170 spending on prescription drugs, vii, viii, 91, 93, 100 spin, 69 sponsored links, 162, 169 Spring, 14, 89, 125 standard error, 19, 21, 22, 43 standard of living, 64, 84

Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

181

Index state, 4, 21, 69, 91, 97, 98, 129, 131, 135, 136, 148, 151, 154, 157 state authorities, 151 states, viii, 66, 80, 82, 83, 131, 147, 148, 149, 158, 170 statistics, 74, 85, 86, 87, 88, 94 statutes, 135, 155 statutory provisions, 101 stimulus, 95 stockholders, 107 structure, 11, 78, 105, 134 subgroups, 105 subsidy, 120, 121 substitutes, 8, 106, 129, 161, 167, 169 sulfur, 124 supermarkets, 93 supplier, 151 suppliers, 45 supply chain, 27 Supreme Court, 51, 52, 53, 135, 142, 146, 147, 150, 152, 153, 154, 156, 157 survey, 65, 75, 106 synthesis, 79, 123

testing, 78, 106, 123, 148, 149, 151, 156, 157 therapeutic benefits, 96 therapeutic effects, 98 therapeutics, 63, 78, 81 therapy, 79, 105, 106, 148, 155, 156 thoughts, 49 time frame, vii, 10, 43, 49, 70 total factor productivity, 65 tracks, 23 trade, vii, 15, 38, 50, 57, 94, 107, 119, 123, 125, 135, 136 training, 122, 124 traits, 102, 103, 107 transaction costs, 81 transactions, 23 transfer pricing, 122 transformation, 106 Treasury, 110 treatment, ix, 73, 102, 105, 107, 113, 119, 120, 136, 137, 139, 159, 160, 165, 167 trial, 54, 58, 137, 140, 141, 157 triggers, 45, 137

U

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T tamoxifen, 6, 51, 139, 140, 141, 146 tax data, 103, 108, 121 tax deduction, 115 tax incentive, 123, 125 tax policy, 122 tax rates, 101, 112, 115, 116, 117, 118, 119, 122 tax return data, 102, 115, 116 tax system, 112, 113 tax treatment, 107, 119, 120 taxation, viii, 101, 102, 103, 108, 110, 116, 117, 119, 121, 123 taxes, 81, 101, 102, 103, 108, 110, 112, 115, 117, 118, 121, 126 taxpayers, 77, 78, 113, 125 techniques, 19, 62, 75, 76 technological advancement, viii, 61, 62, 64, 66 technological progress, 62, 63, 67, 77 technologies, 61, 62, 64, 65, 68, 71, 72, 74, 75, 76, 103 technology, viii, 61, 62, 64, 65, 66, 67, 68, 69, 71, 72, 73, 75, 76, 80, 81, 82, 84, 104, 106, 122, 134 technology transfer, 61, 62, 68, 71, 75, 80 telecommunications, 63 television commercial, 162 tension, 58, 140 territorial, 108, 110, 114, 137 test data, 3, 130

U.S. Department of Commerce, 86, 88, 107 U.S. Department of Labor, 89 U.S. economy, 64, 68 U.S. Treasury, 110 UK, 146 ulcer, 121 underlying mechanisms, 79 uniform, 70, 137, 147, 153 United, vii, viii, 12, 13, 37, 46, 50, 52, 55, 56, 58, 65, 66, 69, 70, 71, 82, 88, 91, 97, 100, 102, 103, 106, 107, 108, 110, 112, 114, 115, 117, 118, 119, 120, 124, 125, 129, 142, 145, 146, 148, 153, 155, 156, 157, 171 United Kingdom, 124 United States, vii, viii, 12, 13, 37, 46, 50, 52, 55, 56, 58, 65, 66, 69, 70, 71, 82, 88, 91, 97, 100, 102, 103, 106, 107, 108, 110, 112, 114, 115, 117, 118, 119, 120, 124, 125, 129, 142, 145, 146, 148, 153, 155, 156, 157, 171 universities, 66, 70, 71, 75, 79, 81, 82, 102 urban, 97 urinary tract, 10 urinary tract infection, 10

V vacuum, 54

Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova

182

Index

variable costs, 44 variations, 106 venture capital, 80 Viagra, 105 video, 162, 169

W

Y yield, 54, 117, 156

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wages, 114, 119 Washington, 12, 84, 86, 87, 88, 89, 94, 99, 100, 123, 124, 125, 126, 144, 169 wealth, viii, 80, 91 web, 87, 89

welfare, 2, 12, 56, 57, 64, 67, 111, 133 well-being, 63, 79, 84 West Virginia, 10 wholesale, 15, 18, 19, 20, 21, 23, 24, 25, 26, 27, 36, 37, 43, 44, 151 Wholesale prices, 17, 18 workers, 107 worldwide, 101, 108, 116, 117, 118, 119, 122, 123

Pharmaceutical Industry: Innovation and Developments : Innovation and Developments, edited by David A. Mancuso, and Isobel M. Grenada, Nova