CASE STUDY:
Litigation against Service Provider under Gain-Sharing Contract    

West Virginia Public Employees Insurance Agency et al. v. Merck & Co., Inc. et al.: Alleged Manipulation of Pricing  (Circ. Ct. Kanawha County, W. Va.), complaint filed, Nov. 2002.    

        Complaint.  On November 13, 2002, West Virginia's Attorney General and the state's Public Employees Insurance Agency ("PEIA") announced a lawsuit against Merck & Co., Inc. and its pharmacy benefits manager ("PBM") affiliate Medco alleging breach of a two-year contract (2000-2002).   Merck-Medco is reportedly the second largest PBM services provider in the United States.   The plaintiffs allege misrepresentation in anticipated cost savings.   This complaint reportedly follows in the tracks of a similar complaint against the state's prior PBM services provider.

        The case sheds new light on the concept of "gain-sharing" between service providers and their clients.  It also highlights some of the emerging issues in outsourcing contracts generally, especially involving services to regulated  suppliers (pharmacies) and publicly-owned customers (governments and governmental pension funds).

        Caveats About One-Sided Analysis:  At the time of this writing (mid-November 2002), this www.outsourcing-law.com commentary is based solely on the plaintiffs' announcement, and none of the defendants had evidently seen the complaint.  For discussion, we assume that Merck and Medco have meritorious defenses and will assert them in court, and that the matter will be resolved in due course through litigation.   We express no opinion on the merits of the claims or the accuracy of the description of the claims as the plaintiffs have announced.   In particular, from an unrelated report, Merck Health (formerly Medco) takes the view that various operational considerations, such as its highly automated pharmacy facilities under one roof, for example, demonstrate an assured cost saving:

"The high volume of drug purchasing and dispensing at the Willingboro [NJ] pharmacy translates into lower costs to the patient and his/her health plan provider by leveraging greater discounts and effecting higher rates of generic substitution, as well as formulary compliance."   Also, "In an era where the dramatic rise in prescriptions written has spawned pharmacist shortages and medication errors, Medco Health Solution Inc.'s pharmacy here, and a sister operation in Nevada, are part of a "Pharmacy for the Future" network that is a keystone in lowering the cost and improving the quality of prescription healthcare services for millions of Americans."  Medco Health, quoted at:  http://www.quicken.com/investments/news/story/?story=NewsStory/BW/20021114/a2323_1037304482.var&p=MRK

        Contract Terms.   Announcing the lawsuit, West Virginia's Attorney General claimed that, in its contract with PEIA, Merck-Medco guaranteed that PEIA would save money on drug plan costs.  The PBM services provider was reportedly obligated to pay 95% of all savings to its client, keeping the remaining 5% as its fee.

        Causes of Action.    The plaintiffs say they made several allegations.  

        Fraudulent Inducement.   PEIA claims that it relied on Merck-Medco's "guaranteed savings" representations in its award of the contract.   The PEIA claimed that Merck-Medco did not meet the savings targets and instead may have cost the State of West Virginia millions.

        Consumer Fraud.   The state's attorney general also claimed that the price misrepresentations were fraud on the state's consumers.   "Merck-Medco’s conduct is unlawful and has caused harm to the citizens of West Virginia by increasing their prescription drug costs," said Attorney General McGraw.

       Conflict of Interest; Loss of Potential Gains that Would have Been Shared. The complaint filed in the Circuit Court of Kanawha County, West Virginia, also alleged that Merck-Medco steered PEIA members to purchase Merck & Co., Inc. manufactured drugs even though they were more expensive than therapeutically equivalent drugs.

        Fraudulent Retention of Group Purchasing Discounts and Rebates.  Additionally, the complaint alleged that Merck-Medco kept fraudulently rebates and discounts from drug manufacturers that should have been passed on to PEIA and its members.

    Lessons for Service Providers on Gain-Sharing Contracts.   PBM contracts are uniquely focused on gain-sharing.   In essence, the pharmacy benefits manager is entrusted with the task of aggregating the purchasing power of millions of individual patients and to deliver the benefit of volume purchase discounts and rebates from drug companies to the patients and the governments and health insurance companies that finance the drugs.

        Conflict of Interest and Self-Dealing.   If a PBM service provider is to maximize the gains available for sharing, it must not divert any gains to the profits of any affiliated company that manufactures prescription drugs.   In this particular situation, the service provider was affiliated with the manufacturer.   Any such affiliation could be a conflict of interest, eliciting disputes such as this case.  

Lesson #1: Transactions with Affiliates: If the service provider offers goods or services of an affiliated company, it will be in a conflict of interest.   Such relationships could scare away potential customers, serve as the basis for the termination of a contract for "breach" or fraudulent inducement and invite a claim for damages from lost savings. 

        Benchmarking.  In PBM contracts, the customer can easily compare the pricing of the goods and services that the PBM service provider offers to market prices.   In other contracts, price benchmarking may be more an art than a science. 

Lesson #2: Transparency of Pricing: The more transparent the pricing, the more accountable the service provider will be.   As of January 2002, a number of PBM customers were demanding greater price transparency for disclosure of the terms and conditions of deals that the PBM strikes with the drug manufacturers.  

        Guarantee of Cost Savings.   In this case, the complaint focused on the fact that the PBM service provider had allegedly "guaranteed" the cost savings.   In life, some "guarantees" are "too good to be true."  "Guarantees" of profits are the basis for securities law violations.  Guaranteed savings are warranties in which one party assumes the risk of failure and the other is entitled to the rewards whether or not the savings are realized.

Lesson #3: Definitions: Service providers who guarantee price savings should set parameters on expected levels or on the conditions under which such levels are to be achieved.

        Consumer Protection Laws.   Consumer protection laws may be applicable where medical reimbursements are made by government.   The fact that the government reimburses the pharmacy costs might not affect the fact that the ultimate "customers" are consumers.

Lesson #4: Consumer Protection Laws: Any contract that contains a guaranteed price saving to a large mass of beneficiaries, or is premised on one, is an invitation for a consumer protection claim.   Consumer fraud is not involved where there is only one customer, such as a business corporation.  Government contracting can likewise involve claims of consumer fraud in addition to breach or fraudulent inducement.

        Fiduciary Role of Agent vs. Independent Service Provider.  Classic "outsourcing" involves the transfer of an existing function from the customer to a service provider.  In a model where the service provider only serves as agent for the customer to negotiate, obtain and pass along volume purchasing discounts and rebates, the service provider may take on the role of an agent or even a fiduciary.   The terms of the contract need to be explicit, though, if this theory is to be valid.   Disputing this point, in January 2002, Merck-Medco's General Counsel, David Machlowitz, reportedly said "We are not a fiduciary under ERISA, and we don't claim to be.  We are not a public utility.  We do help people save money."

Lesson #5: Characterization of a Relationship Having an Uneven Allocation of Gains:  Where the contract provides for the customer to receive virtually all (95%) of the "gains," the service provider needs to work hard to deliver maximum gains.  An uneven allocation of gains makes the service provider an agent or potentially even a fiduciary, trading using the rights of its customer.   Whether this makes the PBM a statutory "fiduciary" under ERISA requiring the PBM to "act in the best interest" of its customer, as two reported prior lawsuits against PBM's have alleged, remains to be seen.   Also, the question of "agency" and the agent's duty of loyalty is one of fact, depending on the contract and the circumstances of the relationship.

        Low Hanging Fruit: Redefinition of the Scope of Services.  If a customer such as a state government is unhappy about the PBM service provider's performance, it can pluck the "low hanging fruit" by negotiating on its own and eliminating the PBM as a middleman.  There have been reports of formation of a consortium of state governments to negotiate directly with the pharmaceutical companies.   Such states have reportedly considered proposals to hire benefit managers that would be paid only for handling claims, not for making decisions on purchasing and authorizing (under agreed rules) reimbursement for a doctor's dispensing of different alternative drugs.

Lesson #6: A Buyer's Consortium Might Replace the External Service Provider.   Buyers relying on a third party to generate savings are awaking to the opportunities of consortium purchases.  The concept of a buyer's cooperative is permitted under the Robinson-Patman Act and is specifically contemplated under the Internal Revenue Act of 1986.  Some buyers' consortia exist already for purchases of medical supplies.  Disgruntled sophisticated buyers are considering in-sourcing, or redefining the scope, of the services that a "PBM" will provide.

        Focus on Delivery, Not Formulary.   The customer may be at fault for the alleged favoritism that PBM's show to high-priced "formulary" prescription drugs, rather than generic drugs.  Under the typical PBM contract, patients have a financial incentive to demand and get prescription drugs, since the patient's financial contribution ("co-pay") is lower than for generic drugs.

Lesson #7: Listen to the Customer and Make the Customer Responsible for Customer-Induced Outcomes.   Service providers should make clear that any consumer choices that are skewed toward high-priced goods or services reflect, indeed are due to, the customer's choice.  This issue applies in particular to cases where the service provider's "fees" are measured by the "cost savings" from volume purchases and rebates.    If the customer wants a different outcome, a service provider might argue, then the customer should change the financial incentives.  The customer would then be responsible for deciding whether the patient gets the generic or prescription (formulary) drug.  This would change the role of the PBM into one that merely handles claims, not deciding which drugs to offer to the patients.  

        Choose the Right Product for the Individual Consumer, and Overall Costs will Decline.  A system that rewards the service provider based solely on cost savings on purchasing goods or services rewards behaviors that relate solely to costs.   Customers that want the service provider to be measured by a different standard of care, such as selecting the right drug (or other product) for the consumer (patient), should define that preference in the contract.

Lesson #8: Promote the Right Results through the Reward System.   Payment systems that reward certain behaviors of a services provider will not promote "unrewarded" behaviors.   The tradeoff should be explicit to avoid disappointed expectations of a "free ride" or some ancillary benefits that will never be rewarded financially.  Customers believing that the services provider will perform both rewarded and unrewarded behaviors need to re-examine their own belief system and consider the rules of Truth in Outsourcing.

        Regulatory Considerations.   Payment-reimbursement services to a regulated industry such as doctors and pharmacists might arguably involve the exercise of judgment and discretion that requires the same regulation.   Pharmacists have been lobbying state governments to exercise more regulatory control over PBM's, arguing that PBM functions should be regulated by state pharmacy boards and state insurance commissioners.  Some insurance commissioners have expressed concerns about the solvency of PBM's or the commingling of PBM reimbursement monies with operating accounts, either of which could affect the solvency of the pharmacies and drug companies that the PBM's reimburse.

Lesson #9: Managing the Regulator's Expectations.  It is not enough to manage the customer's expectations of the outsourced services.   The successful service provider will also work within the regulatory framework to avoid, if possible, any suggestion that it is performing a task that requires the judgment of a licensed professional, such as a doctor, pharmacist, lawyer, architect, engineer or banker.  But certain regulators have different approaches to this, and the service provider should know and adapt to the limits of public policy.

    Conclusion.  This case strikes at the heart of the business model of PBM's: volume purchasing, aggregation of demand, contracting for rebates from drug manufacturers and pharmacies, with sharing of the "guaranteed" cost savings.   The case may portend additional lawsuits against PBM service providers, particularly where they are affiliates of drug companies. 

    For service providers in other industries, the lessons can be useful reminders about the basic issues in the management of customer expectations, building and maintaining the "base case" for the deal, and managing both the contract negotiation and the implementation over time.