Fourth Circuit Decision Casts Doubt on State Efforts to Regulate Drug Pricing

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By Andrew L. Bab, Maura K. Monaghan, Paul D. Rubin and Jacob W. Stahl

Drug pricing has become an increasingly contentious political issue in recent years, leading a number of states to enact laws intended to reduce drug prices and curtail alleged “price gouging.”

State efforts to regulate drug pricing potentially conflict with a number of federal regulatory regimes that implicate drug pricing, including patent law, Food and Drug Administration law, and regulations issued by the Centers for Medicare and Medicaid Services. State drug pricing regulations are subject to limits imposed by the U.S. Constitution, particularly “dormant commerce clause” jurisprudence, which in certain circumstances prohibits states from regulating commerce outside their borders.

In the first major appellate decision addressing state efforts to regulate drug pricing, the U.S. Court of Appeals for the Fourth Circuit held that a Maryland “price gouging” law is unconstitutional. The court invalidated the Maryland law because it attempted to regulate national drug pricing decisions. As addressed below, this decision highlights potential Constitutional defects associated with many state drug pricing laws and similar laws that are currently under consideration in state legislatures throughout the country. Moreover, it is far from clear that any of these state statutes—if permitted to stand—will have a meaningful impact on drug pricing. Arguably, they may even have a detrimental impact on consumers.

What Factors Influence Drug Prices?

State efforts to regulate drug pricing confront a number of fundamental challenges, two of which are often paramount.

First, there are many ways to describe a drug’s “price,” often leading to significant confusion when attempting to determine the appropriate “price” to regulate. Between the drug manufacturer and patient, there are a number of intermediaries, including wholesalers, pharmacy benefit managers (“PBMs”), payers (private insurers or the government), and pharmacies. The graphic below summarizes typical interactions among these parties:

Transactions involving these parties can have a significant impact on drug pricing. At least five different metrics have been designed to describe drug costs: Average Wholesale Price, Wholesale Acquisition Cost (“WAC”), National Average Drug Cost, Average Sales Price, and Average Manufacturer Price. Most of these metrics are defined in federal statutes or regulations.

The state statutes addressed below are generally triggered by changes in the WAC, a pricing measure defined by federal law. The WAC is generally defined as the “list” price at which the drug is offered to wholesalers. Wholesalers, however, typically do not pay the WAC price because manufacturers often offer discounts and rebates. Moreover, the manufacturer may provide rebates to “downsteam” participants in the supply chain, and other members of the chain may add their own fees. The WAC therefore does not reflect the amount that anyone (let alone the consumer) typically pays for a prescription drug.

Second, drug pricing reflects the costs and risks faced by both innovators and generic drug manufacturers. According to the Tufts Center for the Study of Drug Development, it typically costs innovators on the order of $2 billion or more to successfully pursue a New Drug Application (although development costs will vary depending on the circumstances), and drug development projects often result in costly failures. Moreover, drug development is now often focused on diseases that affect relatively small population subgroups. Patent and FDA law incentivize drug development notwithstanding these costs and risks by providing innovators with exclusivity periods during which there can be no generic competitors in the market. During this period, innovators can set prices at levels at which they can recover research and development costs and realize profits. State laws that attempt to regulate prices charged by innovators therefore are in significant tension with federal laws designed to incentivize drug development.

Generic manufacturers have different considerations. They typically do not invest in new drug development and do not benefit from any market exclusivity. Generic drug pricing is typically influenced by factors such as the cost of manufacturing the drug and the number of competitors selling the same drug.

The Fourth Circuit’s Decision

In 2017, Maryland enacted a statute which provides that “[a] manufacturer or wholesale distributor may not engage in price gouging in the sale of an essential off-patent or generic drug.” “Essential” drugs (i) appear on the World Health Organization’s model list of essential medicines or (ii) are designated by the state as “essential” due to their ability to treat either life-threatening or chronic conditions that substantially impair daily activity. “Price gouging” is defined as “an unconscionable increase in the price of a prescription drug.” An “unconscionable increase” means an increase that is “excessive;" is not justified by the cost to produce the drug; results in consumers having no choice but to purchase the drug because of its importance to their health; and is made in cases where there is insufficient competition in the market. The statute adds that a party accused of violating this statute “may not assert as a defense that the [entity] did not deal directly with a consumer residing” in Maryland. If there is a violation, the state attorney general may seek to enjoin violation of the statute or an order requiring the violator to restore to any consumer or payor any money resulting from a price increase that violates the statute. Maryland’s governor, Larry Hogan, declined to sign the bill because of constitutional and other concerns, but the statute went into effect because he did not veto it.

The Maryland statute was challenged by a trade group for the generic pharmaceutical industry as violating the dormant commerce clause and for being unconstitutionally vague. The U.S. District Court for the District of Maryland held that the statute was constitutional, but the Fourth Circuit reversed in AAM v. Frosh, No. 17-2166 (4th Cir. 2018), because the statute violated the dormant commerce clause.

The dormant commerce cause is a corollary to Congress’ power to regulate interstate commerce. It embodies a “principle against extraterritoriality,” under which states may not regulate conduct that occurs “wholly outside of [their] borders.” The Maryland statute violated this principle for three reasons:

First, the statute targets conduct that occurs outside of Maryland. The statute applies only to types of drugs that are “made available for sale” in Maryland, but its application is not limited to transactions that take place in Maryland. Indeed, Maryland acknowledged—and likely intended—that the statute governs “upstream” transactions between a manufacturer and wholesaler, both of which are out of state. The court did not consider the ultimate sale of drugs to Maryland consumers as constituting a sufficient nexus.

Second, even if the statute had a direct nexus to sales in Maryland, the statute would still be unconstitutional, because it controls the price of transactions outside of the state. The court explained:

  • The Act, by its own terms, is not fixated on the price the Maryland consumer ultimately pays for the drug. Instead, the lawfulness of a price increase is measured according to the price the manufacturer or wholesaler charges in the initial sale of the drug. . . . [T]he conduct the Act targets is the upstream pricing and sale of prescription drugs, and the parties agree that nearly all of these transactions occur outside Maryland. Therefore, the Act effectively seeks to compel manufacturers and wholesalers to act in accordance with Maryland law outside of Maryland. This it cannot do.

The court further elaborated that the statute operates as a price control. It bars manufacturers from charging an “unconscionable” price during the manufacturer’s initial sale of the drug to a wholesaler. Therefore, the statute has the practical effect of setting the price of goods that are sold outside of Maryland’s borders. State laws which attempt to control prices out of state violate the dormant commerce clause.

Third, the statute burdens interstate commerce because it targets wholesale rather than retail pricing. If other states also enacted legislation that regulated wholesale pricing, drug manufacturers could be subject to conflicting requirements. This problem could be exacerbated by the absence of clear guidance regarding what constitutes an “unconscionable” price increase. Therefore, situations could arise in which a wholesale transaction was permissible in the state in which it occurred but would be unlawful in another state such as Maryland.

The Fourth Circuit’s Decision May Imperil State Drug Pricing Laws

The Fourth Circuit’s decision has implications not only for other potential state-law “price gouging” statutes, but also at least some of the state-law drug “transparency” provisions that have been passed over the previous two years, including the following:

California (enacted 2017): This statute requires a drug company to give 60 days’ notice if it plans to increase the WAC of a prescription drug by more than 16 percent over the course of the prior two years. This notice must be provided to government and private payors in the state as well as PBMs. The disclosure must include, among other things, a description of the financial and non-financial factors that were used to make the decision to increase the WAC and an explanation for how each of these factors explain the increase in WAC cost. The manufacturer is permitted to limit its disclosure to information that is publicly available—although the statute does not state what happens if the public information is insufficient or incomplete. A government agency will publish the data on a website within 60 days of receiving it.

Nevada (enacted 2017): This statute requires a government agency to prepare a list of prescription drugs which are essential for treating diabetes. It also requires the creation of a second list comprising essential diabetes drugs that that have been subject to a WAC increase by a percentage equal to or greater than (i) the percentage increase in the Consumer Price Index (“CPI”) Medical Care Component over the past year; or (ii) twice the percentage increase in the CPI Medical Care Component over the previous two years. For drugs on the first list, the manufacturer must disclose information including the costs of producing the drug, the marketing and advertising costs for the drug, and the profit the manufacturer has earned from selling the drug. For drugs that are also on the second list, the manufacturer must also disclose a list of factors that contributed to the WAC increase and an explanation of each factor that is attributable to that increase. A government agency is required to compile an annual report containing this information and to post that information on its website.

Oregon (enacted 2018): This statute requires the manufacturer of a prescription drug to provide a disclosure to a government agency if there has been a net increase in the WAC of 10 percent or more over the previous year. The disclosure must include, among other things, the factors that contributed to the price increase, the research and development costs associated with the drug that were paid with public funds, and the manufacturer’s profit attributable to the prescription drug. This information will be posted to a government website and is exempt from publication only if two criteria are met: (i) the information is a trade secret and (ii) the public interest does not require disclosure of this information.

The above-listed “transparency” statutes share two common features. First, they all contain disclosure requirements that are triggered by WAC increases. Second, multiple states require companies to divulge highly sensitive pricing information not only privately to the government but also to the public (in the case of Nevada and potentially Oregon if the state believes disclosure is in the public interest) or other members of the supply chain (in the case of California). Companies wishing to challenge the laws may argue that these state statutes suffer from the same infirmities as the Maryland statute: (i) they regulate out-of-state conduct; (ii) they operate as extraterritorial price controls; and (iii) they impose significant burdens on interstate commerce.

Triggered by Out of State Conduct: All of the statutes that set disclosure requirements based on WAC increases are arguably triggered by out-of-state conduct. The WAC is a pricing measure specified by federal law and is a national list price. Just as Maryland’s “price gouging” statute is unconstitutional because it reaches upstream pricing decisions that frequently have no nexus to sales to consumers in Maryland, so too a state “transparency” statute would be unconstitutional if it reaches national WAC pricing decisions.

Price Controls: Restrictions on the timing of changes in price may be deemed price controls. The California statute arguably does just that by imposing limitations on a drug manufacturer’s ability to increase the WAC: if a drug manufacturer wants to raise the WAC above the 16 percent threshold, it cannot do so immediately but instead must wait 60 days.

The statutes of the states that require disclosure of proprietary information to the public (Nevada and potentially Oregon) or other players in the marketplace (California) may also operate as de facto price controls. Drug pricing strategy is often a core part of drug manufacturers’ business models. Most companies would shudder at the thought of being forced to divulge their business plans to competitors and payors and the complexities of their pricing decisions might well get lost in a subsequent public relations battle with legislators and the media. Therefore, for many companies, the consequences of being compelled to divulge their drug pricing strategies are so severe and punitive that they effectively preclude WAC increases above the disclosure threshold.

Potential for Inconsistent Regulation of Interstate Commerce: As the Fourth Circuit explained in AAM, because the Maryland law targets wholesale rather than retail pricing, analogous requirements from other states may subject drug manufacturers to conflicting requirements. It is noteworthy that the court reached this conclusion on the basis of a hypothetical conflict that has not actually materialized. The existence of multiple drug pricing statutes potentially creates an even greater risk of inconsistent regulation of interstate commerce. Any drug manufacturer that wanted to increase the WAC for a particular drug would have to answer the following questions:

  • Does the drug fall into a particular category that is regulated by state law (e.g., diabetes in Nevada) or has otherwise been selected for regulation?
  • Does the WAC increase trigger disclosure requirements under any state drug pricing statute? If disclosure is required, then: (i) is there a prohibition against raising the WAC until disclosure and passage of a specified amount of time; and (ii) will the disclosed information be made available to the public or other members of the industry?
  • Does the WAC increase potentially trigger any “price gouging” statutes?

Even a drug manufacturer located in a state with no drug pricing statute potentially would have to conduct a survey of every other state and comply with the most restrictive provisions of every state. Thus, any state could effectively impose restrictions on drug pricing nationwide. That is the opposite of what is contemplated by the Constitution, namely that the federal government is the principal regulator of commerce among states.

It should also be noted that not every state “transparency” statute contains the terms that trigger the types of potential constitutional problems described above. For example, Vermont’s statute requires a state regulator to identify up to 15 prescription drugs for which (i) Vermont spends significant resources and (ii) the WAC increased by 50 percent or more over five years or 15 percent or more over the past year. For all such drugs, the manufacturer must provide a justification for the price increase, including a list of factors that contributed to the price increase and the role played by each such factor. Unlike the statutes described above, Vermont’s law provides that any information disclosed by drug manufacturers cannot be released to legislators and the public. Thus, the Vermont statute does not threaten drug manufacturers with the punitive consequences of having sensitive data released if they raise the WAC above a specified threshold.

State Drug Pricing Laws Are Unlikely to Result in Significant Price Reductions and May Even Backfire

Even if the state drug pricing laws are upheld, they still are unlikely to have the desired effect of reducing drug prices for three reasons:

First, there is little relationship between WAC prices and what consumers actually pay. The WAC price reflects the starting point for drug pricing at the very top of the prescription drug supply chain. The amount that the consumer pays at the pharmacy, however, will be dependent on a host of other factors including:

  • Any rebates or discounts negotiated by wholesalers, distributors, or PBMs.
  • The portion of any rebate that may be kept by PBMs as payment for their services.
  • A markup to the drug’s price that is charged by the pharmacy.
  • The amount paid by the health insurer.

Therefore, even if the state statutes were to affect WAC pricing, any charges at that level might not get passed to the consumer level. A drug manufacturer might, for example, respond to state laws triggered by WAC increases by setting the WAC of a newly approved drug at a very high level initially and offset the WAC with large rebates. Over time, in lieu of raising the WAC, the manufacturer can simply cut back on rebates. The primary beneficiaries under that scenario may be PBMs who keep a portion of rebates for themselves as compensation. Indeed, this would exacerbate a concern raised by FDA Commissioner Scott Gottlieb and the White House Counsel of Economic Advisors that PBMs are contributing to higher drug costs by skewing incentives toward greater rebates rather than lower prices at the consumer level.

Second, the state statutes might cause drug prices to rise by decreasing competition. The Federal Trade Commission has previously cautioned that laws requiring the disclosure of sensitive pricing and cost information may facilitate coordination or even collusion among competitors. That concern is particularly acute when there are few competitors in the marketplace. Where there are a small number of drugs in a therapeutic class, drug manufacturers may have less incentive to offer steep discounts if they have information about their competitors’ pricing structure and can rapidly match discounts offered by their competitors.

Third, statutes like California’s, which require a waiting period before certain increases in the WAC may be implemented, could have a disruptive effect on the market. If payors and PBMs are notified that significant price increases will be forthcoming in 60 days, they may respond by attempting to stockpile as much of the drug as they can before the price increase goes into effect. That may result either in drug shortages or increases in drug prices. Indeed, Nevada’s governor vetoed an earlier drug pricing statute because, among other things, he was concerned that a requirement that the WAC could not be raised until 90 days after disclosure would prove disruptive because it would result in hoarding of the drug at issue.

Outlook

The Fourth Circuit’s decision is unlikely to be the last word on state drug pricing statutes as the constitutionality of the California and Nevada statutes are currently being challenged. Drug companies should carefully monitor drug pricing bills that are currently being considered in state legislatures. If new legislation is enacted, drug companies should consider whether such laws may be challenged on constitutional grounds as well.

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Andrew L. Bab, Maura K. Monaghan, and Paul D. Rubin are partners and Jacob W. Stahl is counsel with Debevoise & Plimpton LLP. The authors gratefully acknowledge the contributions of Harold W. Williford.

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