California Supreme Court Details Antitrust Analysis of “Reverse Payment” Patent Settlements

Last week, in In re Cipro Cases I & II, Case No. S198616, the Supreme Court of California adopted the United States Supreme Court’s application of the Rule of Reason to the antitrust analysis of so-called “reverse payment” patent settlements (and rejected plaintiffs’ arguments that settlement payments exceeding the costs of litigation or other services are per se unlawful), but also set forth a specific “structured” Rule of Reason analysis to be applied in analyzing such settlements.  A copy of the decision can be found here.

Reverse payment patent settlements

Under the Drug Price Competition & Patent Term Restoration Act of 1984 (also known as the Hatch-Waxman Act), codified as amended at 21 U.S.C. § 355, a prospective drug manufacturer may file a streamlined application with the Food and Drug Administration (“FDA”) asserting a generic drug’s bioequivalence with an existing pioneer drug.  The prospective generic manufacturer must file a certification regarding any patent bearing on the pioneer drug.  Under a so-called “paragraph IV” certification, the generic manufacturer can assert that the patent is invalid or will not be infringed by the proposed manufacture and sale of the generic drug.  21 § U.S.C. 355(j)(2)(A)(vii)(IV).

Submission of an application to manufacture a generic version of a pioneer drug covered by a patent is a technical act of infringement, and enables the pioneer manufacturer to file an infringement lawsuit.  The Hatch-Waxman Act provides somewhat unusual incentives (in the form of exclusive marketing and delayed follow-on generic application periods) to pioneer and first-to-file generic manufacturers.  “This legal regime means that, regardless of the degree of likely validity of a patent, the brand and first-filing generic have an incentive to effectively establish a cartel through a reverse payment settlement.”  In re Cipro Cases I & II, Slip Op. at 9.  In a reverse payment patent settlement, the parties agree that (i) the generic will stay off the market until the expiration of the patent term and (ii) the pioneer will pay the generic some compensation.

History of the Cipro Cases

Bayer markets Cipro, a well-known antibiotic.  In 1987, Bayer was issued a U.S. patent on the active ingredient in Cipro.  In 1991, 12 years before the scheduled expiration of the patent, Barr Laboratories filed an application to market a generic version of Cipro, and included a paragraph IV certification that Bayer’s patent was invalid and unenforceable.  Bayer sued Barr for patent infringement.  In 1997, the parties settled, agreeing that Barr would not market a generic version of Cipro prior to patent expiration.  In return, Bayer agreed to make payments to Barr and to supply it with Cipro for licensed resale beginning six months before patent expiration.  Pursuant to the settlement, between 1997 and 2003, Bayer paid Barr $398.1 million.

The settlement prompted numerous state and federal antitrust lawsuits.  The cases before the California Supreme Court arose from nine coordinated class action lawsuits in which indirect purchasers of Cipro alleged that the settlement violated the Cartwright Act (Cal. Bus. and Prof. Code §§ 16700, et seq.) as well as California’s Unfair Competition Law (id., §§ 17200, et seq.) and common law prohibitions against monopolies.  The trial court and the California Court of Appeal held that because the settlement did not restrain competition longer than the exclusionary scope of the patent, it did not violate the Cartwright Act.  The California Supreme Court, in the first state supreme court decision concerning reverse payment patent settlements following the U.S. Supreme Court’s decision in FTC v. Actavis, Inc., 133 S.Ct. 2223 (2013), reversed.

The California Supreme Court’s application of FTC v. Actavis, Inc.

In Actavis, the U.S. Supreme Court reversed a federal decision applying the “scope of the patent test” and holding that Hatch-Waxman reverse payment settlement agreements are “immune from antitrust attack so long as [their] anticompetitive effects fall within the scope of the exclusionary potential of the patent.”  Id. at 2227 (cit. omit.).  Instead, the Supreme Court held that such agreements should be evaluated under the Rule of Reason.  The California Supreme Court held that while Actavis “is not dispositive on matters of state law,” In re Cipro Cases I & II, Slip Op. at 19, “[w]hat does affect the weight to be accorded Actavis is the extent to which its analysis establishes the metes and bounds of patent law and policy,” because “[p]atent law is federal law.”  Id.

In the California Supreme Court’s view, “a critical insight undergirding Actavis is that patents are in a sense probabilistic, rather than ironclad: they grant their holders a potential but not certain right to exclude.”  Id. at 20.  While patents are presumptively valid, they are issued in the first instance by the Patent Office in often short, ex parte proceedings.  Moreover, under principles of collateral estoppel, even a court determination of validity operates only on the parties and does not extend from one infringement case to the next.  Id. at 21.  While a court injunction excluding a competitor from the marketplace does not create an antitrust problem, “[w]ith a settlement, any restraint arises directly from the private agreement and only indirectly from the patent, which remains in the background, motivating the parties’ actions according to their assessments of its strength.”  Id. at 22.  “The scope of the patent test is flawed precisely because it assumes away whatever level of uncertainty a given patent . . . may be subject to.”  Id.

Instead of applying the scope of the patent test, the proper question to ask is: “What would the state of competition have been without the agreement?  In the case of a reverse payment settlement, the relevant comparison is with the average level of competition that would have obtained absent settlement, i.e., if the parties had litigated validity/invalidity and infringement/noninfringement to a judicial determination.”  Id. at 29.  “[T]he period of exclusion attributable to a patent is not its full life, but its expected life had enforcement been sought.  This expected life represents the baseline against which the competitive effects of any agreement must be measured.”  Id. at 30.

The Court’s analysis of reverse payment patent settlements – a “structured” Rule of Reason analysis

The California Supreme Court then determined that reverse payment patent settlements are to be evaluated under the Rule of Reason, and, unlike the U.S. Supreme Court in Actavis, set forth a particular “structured” version of Rule of Reason analysis to be applied to such settlements – which looks to four objective factors as possible surrogates for a direct investigation of the patent’s strength.

To make out a prima facie case, a plaintiff must show (1) the settlement includes a limit on the settling generic challenger’s entry into the market, (2) the settlement includes cash or equivalent financial consideration flowing from the brand to the generic challenger, and the consideration exceeds (3) the value of goods and services (other than any delay in market entry provided by the generic challenger to the brand) as well as (4) the brand’s expected remaining litigation costs absent settlement.  Id. at 32.

The first two elements are self-explanatory.  The third element requires the plaintiff to establish that the consideration to the generic challenger exceeds the value of any other collateral products or services provided by the generic to the brand.  “Considerable caution is in order in evaluating settlements that include side agreements for generic products or services.  Historically, it appears brands and generics have engaged in business dealings outside the settlement context far less often than in it . . . . A side agreement involving difficult-to-value assets might conceivably be added to a patent settlement to provide cover for the purchase of additional freedom from competition.”  Id. at 34.  Nevertheless, the Court may have left open a defense where, e.g., a brand manufacturer can choose any one of five companies to be a contract manufacturer, and chooses the patent suit defendant as part of a settlement.

The fourth element requires the plaintiff to establish that the amount of the payment, over and above the value of collateral products or services from the generic, also exceeds the brand’s anticipated future litigation costs.  Id. at 35.  If the payment reflects traditional settlement considerations, such as avoided litigation costs or fair value for services, there is not the same concern that a patentee is using its monopoly profits to avoid the risk of patent invalidation or a finding of noninfringement.  Id., citing Actavis at 2236.

Although the plaintiff has the burden of proof on these four elements, because of defendants’ superior knowledge, once the plaintiff has shown an agreement involving a reverse payment and a delay, the defendants have the burden of production to come forward with evidence of litigation costs and the value of collateral products and services that might explain the compensation.  (If the defendants fail to do so, the plaintiff has satisfied its burden on these points.  If the defendants do so, the plaintiff has the ultimate burden of persuasion that any reverse payment exceeds litigation costs and the value of collateral products or services.  In re Cipro Cases I & II, Slip Op. at 36.)

Once a plaintiff has made out a prima facie case that a reverse payment patent settlement has anticompetitive effects, the burden shifts to the defendants to offer legitimate justifications and come forward with evidence that the challenged settlement is in fact procompetitive.  Id. at 42.  The Court rejected plaintiffs’ argument that every reverse payment in excess of litigation costs and collateral products and services is a per se violation of the Cartwright Act.  Id. at 43.  Although the Court did not specify what justifications may suffice, it did note that not “any justification will do.  An antitrust defendant cannot argue a settlement is procompetitive simply because it allows competition earlier than would have occurred if the brand had won the patent action . . . the relevant baseline is the average period of competition that would have obtained in the absence of settlement.”  Id. at 43.

Finally, the plaintiff retains the ultimate burden to show that a challenged settlement is anticompetitive.  Id. at 45.  If a plaintiff makes out its prima facie case and can dispel each additional justification the defendants put forward to explain the consideration, “the conclusion follows that the settlement payment must include, in part, consideration for additional delay in entering the market.  That payment for delay is condemned by the Cartwright Act . . . .”  Id. at 45-46.  The Court applied the same reasoning to the plaintiffs’ Unfair Competition Law and common law monopoly claims.  Id. at 51.

Conclusion

The California Supreme Court’s decision in In re Cipro Cases I & II tracks the approach of the U.S. Supreme Court in Actavis, but somewhat uniquely sets forth a “structured” Rule of Reason analysis to reverse payment patent settlements that specifies the precise prima facie elements of a plaintiff’s case, the defendants’ possible defenses, and the relative burdens of persuasion and production.  The decision may increase the number of state court challenges to such settlements, while at the same time provide guidance to defendants about how to structure any defense.

Howard M. Ullman is Of Counsel in Orrick’s San Francisco office.

Robert P. Reznick is a Partner in Orrick’s Washington, D.C. office.