The health care industry of the 1990s is moving rapidly toward "integration" of various functions to achieve greater efficiencies. Companies involved in the delivery of health care are trying different combinations and alliances in an effort to control health care costs while taking advantage of the synergies possible with new technologies.

The integration of pharmaceutical manufacturers and pharmacy benefit management firms (PBMs) has been the subject of criticism by some private groups, including pharmacy associations, and scrutiny by government agencies, notably the Federal Trade Commission (FTC).

Most concerns have focused on the potential of these mergers to be anti-competitive under the antitrust laws. However, there is evidence that what's behind the integration is an effort by pharmaceutical manufacturers to move away from products and become service-oriented companies to better position themselves in a managed care world.

Pharmacy benefit management companies try to control prescription drug costs by creating formularies of approved drugs for use by participating physicians and pharmacists. PBMs encourage physicians to prescribe more cost-effective drugs. They also monitor the effectiveness of particular drugs.

PBMs presently cover about 120 million lives, and are expected to include more than 200 million by the end of the decade. The recent rise of PBMs has coincided with a reduction in drug price increases, from 9.5% in 1989 to 3.1% in 1993. Much of the contribution of PBMs to lowered prescription drug prices has resulted from demanding discounts from pharmaceutical manufacturers in return for placing their products on the formularies.

In the past two years, three pharmaceutical manufacturers have acquired the three largest PBMs, which by some measures comprise 80% of the pharmacy benefit management market. In July 1993, Merck & Co, acquired Medco Containment Services for $6.6 billion. British pharmaceutical manufacturers SmithKline Beecham PLC agreed to buy Diversified Pharmaceutical Services last May for $2.3 billion. The most recent acquisition, of PCS Health Systems by Eli Lilly & Co., for $4 billion, was delayed by an FTC review of the deal, which resulted in a proposed consent decree.

The proposed consent decree requires that Lilly-PCS maintain an open formulary and restricts the exchange of competitive information between Lilly and PCS. Under the decree, the open formulary is to be composed of pharmaceuticals selected by an independent committee of health care professionals. The ranking of drugs on the formulary is to reflect discounts and other cost reductions which PCS is required to accept from Lilly's competitors.

The decree also mandates a "fire wall" separating the drug manufacturer and the PBM to prevent Lilly's access to non-public information. As a result of its examination of Lilly's acquisition of PCS, the FTC has taken the unusual step of reopening its investigations of the Merck-Medco and SmithKline Beecham-DPS deals, which it had previously approved, and has announced that it is investigating other alliances between PBMs and pharmaceutical companies.

The FTC's power to seek the restrictions contained in the Lilly proposed consent order arises from section 5 of the Federal Trade Commission Act and section 7 of the federal Clayton Act, which condemns mergers whose effect "may be substantially to lessen competition, or to tend to create a monopoly."

Mergers among competitors are called horizontal mergers, while mergers among firms serving different functions in a given market are called vertical mergers. The acquisitions of PBMs by pharmaceutical manufacturers fall into this second class of "vertical mergers" because the merging companies previously served different functions in the prescription drug market. Manufacturers produced and marketed the drugs, while the PBMs arranged large volume purchases of drugs and compiled patient information for managed care systems.

Horizontal mergers are much more likely to raise antitrust concerns than vertical mergers, since the former directly eliminate a competing firm. While relatively few vertical mergers have been condemned as anti-competitive, the magnitude of the recent pharmaceutical company-PBM combinations and the potential for structural marketplace changes have caused regulators to raise questions under several theories of competitive harm.

"Foreclosure" theories focus on the competitive harm which might result if pharmaceutical company-owned PBMs closed their formularies to competitors of the parent manufacturer. The "facilitation of collusion" theory concerns the relationship of vertical integration to competition among drug manufacturers. In an "open" formulary such as the one required by the proposed Lilly consent order, a group of therapeutically equivalent drugs are listed and ranked according to rebates or discounts promised by the drug manufacturer, with the PBM providing reimbursement for whichever medication is prescribed. In contrast, a "closed" formulary contains a limited list of preferred drugs from any therapeutically equivalent class, and the PBM will only reimburse for prescriptions which conform to the formulary.

By requiring that PCS maintain an open formulary, the FTC is responding to charges that pharmaceutical manufacturers might place their own drugs on closed formularies of their own PBMs. This would eliminate competition for formulary slots which might otherwise lead to lower drug prices. Enhancing these concerns are the actions and statements of the drug companies themselves. Already, the PMBs owned by Merck and SmithKline reportedly have closed their formularies to some extent. Eli Lilly Chairman Randall Tobias triggered similar concerns with his statement, reported in the August issue of "American Druggist", that the PCS merger "will help sell even more Prozac."

By automatically placing their own drugs on closed formularies of vertically integrated PBMs, the pharmaceutical manufacturers are said to "foreclose" these slots on the formulary from other pharmaceutical manufacturers. The weight given to "foreclosure" as a theory of competitive harm has fluctuated according to changes in political and economical thinking. Early Supreme Court vertical merger cases disallowed mergers which foreclosed more than a de minimis share of the supplier (here, the pharmaceutical manufacturer) or the distributor (PMB) market. Vertical integration was especially quick to be condemned where, as here, there was a pattern of integration in the industry.

The rise of the so-called "Chicago school" of antitrust analysis in the 1980s limited the application of the foreclosure theory. These scholars and judges emphasised the potential efficiencies of vertical mergers, limiting the foreclosure theory to those situations in which integration is so widespread in the industry that simultaneous entry into both markets is required to compete.

According to the Chicago school, any attempt by the vertically integrated firms to lower quality or increase prices will result in consumers' taking their business to the "independent" firms. If the consumers remain with the integrated entities, it is because the merger has produced efficiencies or other pro-competitive benefits, at least some of which are passed on to the consumer. In other words, as long as there are any unintegrated firms in the market, a vertical merger, at most, would cause a "realignment" of the lines of distribution.

In recent years, however, "post-Chicago" scholars have suggested that foreclosure need not rise to the level of requiring dual-market entry in order to be anti-competitive. As applied to pharmaceutical company-PBM mergers, the theory suggests that an integrated manufacturer might charge a rival PBM more for its unique products than it charges its own PBM, thereby placing rival PBMs at a competitive disadvantage.

A review of early market responses to the manufacturer-PBM mergers indicates the "realignment" theory, so far, best explains the effect of vertical integration. Caremark, an independent PBM which has supply arrangements with four major drug manufacturers, recently renewed a pharmacy contract covering 150,000 lives when the employer "ruled out two other competing vendors - DPS and Medco - because of their alliances with drug makers." Robert Pfotenhauer, former chief executive officer of Pharmacy Direct Network (the pharmacy-owned PBM), said PDN "has an opportunity to help level the playing field and ensure that there will be fair competition" and is predicted to be "a significant entity that [will have] some fairly immediate impact on the prescription benefit management world." Bill Jenison, President of Pharmacy Gold, said the pharmaceutical company-PBM mergers will allow his independent PBM to "leverage more enrolment because of our clinical objectivity and independence."

With existing PBMs prepared to handle increased market share, and new PBMs forming, the arguments that the manufacturer-PBM mergers increase the barriers to entry into the industry, or foreclose unique products or services, are weakened. Additionally, no pharmaceutical company makes every drug on a formulary list, so the possibility of strict foreclosure is diminished because the PMBs must maintain supplier relationships with other manufacturers. A different issue arises from these continued supplier relationships concerning more subtle ways in which vertical mergers can facilitate collusion among the drug manufacturers. By requiring that Lilly maintain a "fire wall" to prevent access to competitive pricing information, the FTC addresses the possibility that vertical mergers between pharmaceutical manufacturers and PBMs might lead to anti-competitive information exchanges.

Price-fixing, explicit or implicit, is one of the principal anti-competitive activities condemned by the antitrust laws. In fact, an agreement to fix prices is a per se violation of the antitrust laws. Consequently, government agencies such as the FTC may use their pre-merger review powers to ensure that a market does not become conducive to collusion as a result of the proposed acquisition. The risks of collusion are believed to be high in concentrated markets where a few competitors hold much of the business.

The degree of concentration in the pharmaceutical manufacturing market depends on whether the market is evaluated according to aggregate market share or market share within individual drug categories. In 1993, at least 18 companies had worldwide sales of over $3 billion. Until the Glaxo-Burroughs Wellcome merger, Merck was America's largest drug company, although it only had a 10% share of the "highly fragmented" U.S. pharmaceutical market.

On the other hand, competition in each of the major drug categories is limited typically to only a handful of manufacturers.

If the market is evaluated in terms of individual drug categories and thus considered highly concentrated, vertical mergers are thought to enhance the possibility of collusion by making it easier to monitor the prices of competitors. When a group of companies agree to form a cartel and fix prices, individual companies have an incentive to cheat on the cartel by offering a slightly lower price and capturing a larger market share. Thus, the cartel has an interest in monitoring the prices charged by each of its members to ensure that prices do not go below the agreed-upon level.

By controlling PMBs, drug manufacturers may learn the prices of pharmaceuticals being charged by their competitors. Requiring a pharmaceutical manufacturer-PBM to open formularies might actually encourage such information monitoring, since the PBM will gather price information on drugs directly competing with those manufactured by its parent. Even absent collusion, competitive pricing information could replace "blind" bidding with a bid which was only slightly below that offered by a competitor. It is thus no surprise that the FTC joined its requirement of formulary access with restrictions on information exchanges between the PBM and its parent manufacturer.

On the other hand, the exchange of pricing information can be pro-competitive. Information from customers about the pricing practices of competitors often leads a company to lower its price.

The major pro-competitive benefit claimed to result from manufacturer-PBM mergers is the assimilation of patient information from various sources. PBMs are developing large databases of patient information gathered from health care providers which can be used to monitor whether drug therapy has helped patients to avoid hospital or physical visits. The theory is that PBMs (and their manufacturer parents) will create a market for disease management systems, which will offer patient education, monitoring, and distribution, as well as pharmaceuticals.

By gaining access to patient data, pharmaceutical manufacturers hope to demonstrate that greater use of prescription drugs is a more efficient method of controlling diseases. If the mergers encourage the development and utilisation of patient information, the potential benefits of lowered overall health costs should be recognised. By stressing the greater cost-effectiveness of drug treatment as compared to other health care products, such as doctor visits, disease state management could be a form of enhanced interbrand competition among pharmaceutical companies, hospitals and other health care providers.

Nonetheless, many wonder whether access to PBM databases was worth the $1.3 billion paid. According to the Financial Times, "It is clear that there are less expensive ways of accessing such patient data. Indeed, health maintenance organisations hold far more complete treatment information than distributors and are quite willing to share it for relatively small consideration."

If patient information is an insufficient justification for PBM mergers, the acquired companies must have offered something more. By placing these mergers in the context of changes to the pharmaceutical industry generally, it becomes apparent that what the PBMs offered manufacturers was a better chance for success in the managed care world of the future. Consolidation is widespread throughout the pharmaceutical industry. In addition to the PBM mergers, during the last year Swiss drug manufacturer Roche Holding Ltd purchased U.S. pharmaceutical company Syntex Corp. for $5.3 billion in cash and French pharmaceutical company Elf Sanofi S.A. bought the prescription drug business of Sterling Winthrop Inc. Last August, American Home Products offered $8.5 billion to purchase American Cyanamid Co.

In January, Glaxo Plc. made a surprise bid for Wellcome Plc., its British rival. The $14.8 billion deal is expected to be finalised this month. Also, Hoechst AG, the German chemical and pharmaceutical giant, is in talks with Dow Chemical to buy Marion Merrell Dow for an estimated $7.1 billion. Many analysts consider this pattern of consolidation the beginning of a general contraction of the pharmaceutical industry from its present 40 or so companies to perhaps four or five.

In light of market flaws which have removed the ultimate consumer from appreciating the full costs of prescription drugs in the past, it is likely that the pharmaceutical industry simply contained more companies than a competitive market could support, and the pharmaceutical manufacturers acquired the PBMs in an attempt to diversify and enhance their chances of survival in the changing market.

In describing the benefits of acquiring DPS, J.P. Garnier, SmithKline's executive vice-president said, "SmithKline can move rapidly into the blossoming business of managed care. This is our future."

Comments by Eli Lilly executives concerning PCS indicate a similar goal of expanding the company's role in health care to "become a broader organisation, more capable of meeting our customers' expectations." Some industry analysts characterise the manufacturer acquisitions of PBMs as the first step in moving away from a product orientation to a service orientation.

The theory of survival through diversification is logical in light of the uncertainty about the role of the government in health care. Through the acquisition of PBMs pharmaceutical companies may simply be trying to assure themselves of a more secure place in the evolving health care system of the future.

Elinor Hoffmann is a partner, specialising in antitrust legislation and counseling, and C Allen Garrett is an associate of Coudert Brothers, a New York law firm. Coudert has represented pharmaceutical manufacturers in antitrust and other legal matters.

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