The Medco/STRS decision in more detail: Mixed Courtroom Decision at Medco

By Melissa Davis, Senior Writer

12/20/05

URL: http://www.thestreet.com/stocks/healthcare/10258388.html

Some people think a courtroom setback could end up dealing a serious blow to Medco (MHS:NYSE) and its pharmacy benefit management peers.

On Monday, an Ohio jury ordered Medco to pay $7.8 million for allegedly defrauding and violating its legal duties to the state's teacher retirement system. To be fair, the sum represents just a fraction of the huge damage award -- totaling more than $300 million -- that the state had been seeking from the company. The jury was unable to reach a verdict on punitive damages, so the state must now fight for the award in a future trial.

In the meantime, Medco general counsel David Machlowitz says that "the evidence supported complete vindication" of the company and that Medco will appeal the jury's decision. Still, Ohio Attorney General Jim Petro sees plenty of reason to celebrate right now.

"The verdict is the first time a U.S. jury has recognized that a company managing pharmacy benefits has a legal duty to act in the best interest of retirees and pensioners," states a press release issued Tuesday by Petro's office. "And it is likely to have repercussions for the entire ... PBM industry."

Notably, Petro says, the jury found that Medco owed a fiduciary duty to the teacher's retirement system. The jury determined that Medco had breached that duty, he says, and committed "constructive fraud" as well.

But Stephanie Kanwit, special counsel for the PBM trade group Pharmaceutical Care Management Association, claims that companies like Medco are not fiduciaries at all.

Petro's "use of the word 'fiduciary' is totally out of context and inappropriate," Kanwit insists. "This doesn't change a thing. It's just a contract dispute between Ohio and Medco about who owed money to whom."

By definition, fiduciaries hold the legal power to make financial decisions for others. Industry critics argue that PBMs -- which arrange drug rebates and formulary lists -- qualify as fiduciaries and should, therefore, be required to act in the best interests of their clients.

Maine has passed a law that designates PBMs as fiduciaries, and other states have considered following suit. In the meantime, former Maine Senator Sharon Treat -- who sponsored her state's law -- views this week's jury decision as an important next step in reforming the PBM industry.

"It's very encouraging that a jury has found that PBMs have a fiduciary duty" to their clients, says Treat, who now serves as executive director of the National Legislative Association on Prescription Drug Prices. "It is important that this be recognized and that PBMs start acting accordingly. ... I think that their basic business model -- which depends on a variety of side deals -- is going to have to change."

PBMs have been accused of looking out for themselves, rather than their clients, and saving their customers less money than they should. The three biggest players -- Medco, Caremark (CMX:NYSE) and Express Scripts (ESRX:Nasdaq) -- all face government investigations. They have denied any wrongdoing.

Meanwhile, all three stocks have hit new record highs over the past month. However, short-sellers have recently begun placing bigger and bigger bets that the stocks are set to fall.

Medco rose 1.4% to $57.77 on Tuesday's news of the small jury award.

Split Decision

To be sure, Medco won some legal victories during the recent trial.

In late November, the company notes, the judge threw out several charges due to lack of evidence. Since then, the company adds, the jury has gone on to clear the company of improperly collecting mail-order dispensing fees. The jury also found itself unable to decide whether the company had pocketed drug rebates that belonged to its client instead.

J.P. Morgan analyst Lisa Gill found herself looking on the bright side.

"While all PBM contracts are different, we believe rejection of the mail-order claim and the non-decision on the rebate-sharing claim bode well for other contractual disputes," wrote Gill, who has an overweight rating on Medco's stock. In the meantime, "the amount of the (Medco) award is negligible."

Still, Medco could find itself paying out multimillion-dollar penalties to other -- bigger -- clients as well.

"Medco's wrongdoing against the Ohio state teachers' health plan is applicable to all health plans that have had contracts with Medco," says Linda Cahn, an attorney who is battling Medco in a big class-action lawsuit. And "in the few hours that have passed since the jury's decision, I have already received several calls from large health plans that believe their damages may surpass $100 million, since a relatively small health plan won a $7.8 million damage award" against the company.

Patrick Burns, a spokesman for Taxpayers Against Fraud, foresees a much larger jury award if a federal case against Medco -- which has been building against the company for years -- ultimately winds up in court. For starters, Burns points out that the federal health plan is about 40 times larger than the Ohio plan for teachers. Moreover, he says that the federal complaint involves a lot more charges -- that look easier to prove -- than the Ohio case did.

Burns wonders if Wall Street is paying attention.

"It will be interesting to see if the Wall Street analysts can do simple math and understand relative scale and the differences between the Ohio and federal lawsuits -- which are very, very different," he says. "My bet is that if Medco goes to trial (in the federal case), they will see a verdict north of $1 billion."