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The Antitrust Section of the American Bar Association
Chicago, Illinois
Robert Pitofsky, Former Chairman

The views expressed are those of the Chairman and do not necessarily reflect the views of the Federal Trade Commission or any other Commissioner or staff.

One of the perplexing problems that antitrust enforcers encounter involves the need to make a call on a transaction - whether to challenge or not - at a time when the alleged anticompetitive effects and the alleged redeeming virtues are highly uncertain. The question I would like to raise with you today is whether there is a modification to the traditional approach to remedy that might be introduced to minimize the errors that may occur as a result of deciding such issues at a time when so much is unknown.

The classic example of the kind of problem I have in mind involves mergers. Enforcement officials are presented with the following quandry. Sponsors of the proposed merger claim efficiencies, but there is also some reason to fear substantial anticompetitive effects. Often the case for efficiencies is plausible, while the anticompetitive effects fall somewhere between reasonably likely and highly speculative. To complicate the situation, assume that the industry itself is in the process of dynamic change and even the types of businesses in the market are in flux. Assume further that an innovative remedy can be devised that might reduce the risk of anticompetitive effects to an acceptable level.

The issues I describe will often be central to enforcement decisions in the information technology sector - where pro and anticompetitive effects are uncertain because they occur against a background of dynamic changes in market structure and market participants.

Despite theoretical and empirical uncertainties, enforcers might well be justified in initiating an action in the situation I describe. After all, Congress was emphatic in directing the enforcement agencies to challenge transactions where the affect "may be to substantially lessen competition" (emphasis supplied) and indicated that its concern was with probabilities and not certainties. Brown Shoe Co. v. United States, 370 U.S. 294, 323 (1962). At the same time, the Supreme Court emphasized that its concern was not with "ephemeral possibilities" but with threats somewhat more substantial.

The set of problems I describe emerged in connection with the Federal Trade Commission's recent review of Eli Lilly's acquisition of a PCS Health Systems, professionally managed prescription drug benefit program ("PBM").** In November, 1994, the Commission decided not to block the transaction but rather issued a proposed consent order that permitted the acquisition to go forward with certain behavioral restrictions. Last week, the Commission finalized that order with minor modifications, but included an unusual provision. In something of a break with past procedure, the Commission notified the parties that it would continue to monitor competitive effects of the transaction in the rapidly changing pharmaceutical industry, and would revisit questions about the effectiveness of the order, the effect of the transaction on other drug companies and on prices to consumers, and ultimately the legality of the underlying vertical merger, several years down the road. It is this approach that I want to discuss today.

To set the stage let me explain more fully the transaction the Commission was called upon to review. In a sense, the case involved the "information technology" sector - though in an unusual context.

PBMs are new factors in the prescription drug field. They are organizations that operate as brokers between drug companies on the one hand and various payment groups on the other - for example managed care providers, corporations, labor unions, retirement systems, and federal and state employee plans. By aggregating buying power, they can obtain discounts from drug manufacturers. The PBMs select participating pharmacists and administer point of sale claims processing systems when insured consumers purchase prescription drugs. They also provide record keeping services and ensure quality control. Also, they select and describe drugs available to consumers through pharmacies, and negotiate quantity discounts - often very substantial - with pharmaceutical manufacturers.

One important device that facilitates the negotiation of discounts from drug companies is the formulary - that is a PBM produced compendium of information about drug products listed by therapeutic category, along with cost information. Formularies are made available to physicians, pharmacies and third party payers and they help to guide the various parties in prescribing and selling drug products. PBMs often influence drug pricing by encouraging in various ways the most effective drug treatment - including substitution of generic or lower cost drugs to customers. Most doctors prescribe and most customers buy through "open" formularies which allow for reimbursement by the payment group of virtually any drug approved by FDA. A closed formulary limits reimbursement to specific drugs listed. Between open and closed formularies, there is a variety of hybrids that restrict the number of drugs listed.

The key to the ability of PBMs to drive prices down in the drug market is the fact that drug companies will give larger discounts if they can be the provider of the sole drug or one of only a few drugs in a particular therapeutic category in the formulary. In effect, the drug companies pay for exclusive or near exclusive dealing. Services provided by PBMs have proved very popular so that over 125 million Americans currently purchase some or all of their drugs through a PBM and that number is expected to increase to 200 million by the year 2000. Some people believe that the rate of increase in drug prices has declined in recent years, and that is a result of the leverage exerted by these PBMs.

While there are many PBMs, three of the largest were purchased by three large drug companies in the past few years. Most recently Eli Lilly acquired PCS, the largest PBM in the country. The FTC challenged the merger, alleging among other theories that PCS would be eliminated as an independent negotiator of prices and that other drug companies, particularly those supplying drugs that compete with Lilly, might be foreclosed from future PCS formularies.

The case was settled by a consent order. Lilly was allowed to complete the transaction, but the crucial term of the settlement was that it would agree to maintain an open formulary which would not inappropriately exclude products of other drug companies. Discounts offered to the open formulary must be accepted and accurately recorded in ranking drugs. Lilly may still offer payment groups a closed formulary where presumably more substantial discounts would lead to a lower total price package. A committee independent of Lilly and PCS - a so-called pharmacy and therapeutics committee - would decide which drugs to include in the open formulary on the basis of objective scientific criteria. There are antidiscrimination and fencing in provisions in the order, but the ones I have described were critical to the Commission's decision to authorize the transaction.

Although the Lilly/PCS transaction presents an unusually complicated competitive story, the outlines of an enforcer's dilemma should be apparent. On the one hand, the parties to the transaction can advance plausible efficiency claims turning on the integration of complementary products and services. Some would argue that a vertical merger is not essential or even the best way to achieve those complementary efficiencies but that is difficult to determine.

On the other hand, there are possible anticompetitive effects. Drug companies could prefer their own products in closed or hybrid formularies, thereby excluding independent drug company products from a substantial share of the market. The fact that the Lilly/PCS transaction was the third in a series adds weight to the argument. If it is true that independent drug companies are impeded in efforts to get to the market through these vertical mergers, drug prices could increase. Also, foreclosure could have an effect on incentives to devote R & D resources to developing drugs that compete with those controlled by rival drug companies that control formularies. Another possibility is that these mergers will trigger a trend toward closed formularies which may offer some short term efficiencies to consumers but long term will raise the specter of higher drug prices. Finally, critics of the transaction pointed out the possibility that the three drug companies owning formularies (and perhaps other drug companies who acquire or initiate new formularies down the road), will tend to prefer each other in the listing of drug information. This kind of reciprocal trading of preferences arguably will undermine the ability of non-vertically integrated drug companies to compete effectively.

While these possible anticompetitive effects are significant - and led the Commission to challenge the transaction in the first place - it is not clear now that any will actually occur, or that any will occur once the Commission's "open formulary" remedy is in place. Closed formularies are the exception rather than the rule. Physicians and insurers tend to resist formularies that impair their ability to select the drug they regard as most appropriate for particular patients. If a drug company attempts to use a closed formulary to prefer its own products, the payment group might be sufficiently alert to switch to the open formulary, maintained as a result of the Commission order, and thereby defeat any anticompetitive strategy. Finally, reciprocal preferences among vertically integrated drug companies would not be an easy arrangement to introduce or monitor and in any event would be fairly obvious to physicians and payment groups - and of course to the government.

In response to this array of considerations, the Commission approved a negotiated consent order with Lilly, along the lines I have described, but then added the following statement. The Commission believes that, based on the evidence currently before it, this Order provides the most appropriate relief available. Nevertheless, in light of the rapidly evolving nature of the markets for pharmaceutical products and Pharmacy Benefits Management ("PBM"), the Commission remains concerned that this acquisition, together with other vertical integration in these markets, could lead to anti- competitive consequences that require additional relief. Thus, the Commission will continue to monitor this industry carefully, both through ongoing investi- gations and Lilly's compliance obligations under the order.

The statement went on to say that it would look at the extent and effects of foreclosure, possible anticompetitive reciprocal dealing, and the effect of vertical integration on prices and availability of pharmaceuticals. If subsequent developments indicate anticompetitive effects, despite the presence of the negotiated order, the Commission commits itself to seek other relief including, if necessary, post-acquisition divestiture.

The advantages of this approach are obvious. The parties are allowed to complete the transaction, and achieve claimed efficiencies, and the Commission has an opportunity to observe whether anticompetitive effects actually emerge. There are some other indirect and more subtle possible advantages. First, parties claiming efficiencies or brushing off the possibility of anticompetitive practices may be induced in the years following the merger to pursue more aggressively the efficiencies or avoid more carefully anticompetitive effects. Second, lawyers, economists and others defending transactions may be a little more cautious in submitting extravagant claims if they know they will be called to account at a later date. Enforcement officials in Canada, where subsequent review has occurred for many years, report their sense that both indirect effects in fact have occurred.

There are of course some formidable arguments against initiating this new approach. Among those that have occurred to me are the following:

  1. Some will say that the continuing supervision entailed in this kind of review will dissipate Commission resources and may suggest that the Commission is acting more as a regulator than a law enforcer. The image might be of an administrative Big Brother looking over the shoulder of business people, constantly checking on their behavior. I believe that mischaracterizes the approach. The Commission will not continuously supervise anything. It simply puts the parties on notice that at some future time - two, three or four years down the road - it intends to revisit the market segment and the transaction to see if the transaction and others like it led to anticompetitive effects. In the meantime, as always, Commission staff would investigate any complaints that anticompetitive effects had emerged.
  2. It may be difficult several years later to identify cause and effect. For example, drug prices may go up or market share of the companies owning PBMs may increase, and yet it will be difficult to know whether those effects can be attributed to the merger or to one of a hundred other causes. But economic cause and effect is a constant problem in enforcing competition laws. That retrospective determination is no more difficult than a prediction that efficiencies will occur, entry barriers will be surmounted if prices go up, or a company will fail.
  3. It could be claimed that effective subsequent review, as a practical matter, can only occur if there are provisions that the parties to the transaction will not dissipate or scramble the asset. For example, the parties may conclude six months before subsequent review that anticompetitive effects have occurred and therefore sell off key assets, move important staff to the parent company, or otherwise anticipate a negative government reaction. On the other hand, a provision preventing the parties from dissipating or integrating the assets may hamstring business people and prevent them from doing what they think is right for their acquired company. For the time being, there is no thought of doing any more than reviewing the transaction at a later date. 
  4. Finally, some may anticipate that this is only step one in the direction of a more intrusive approach. In Lilly/PCS, all the Commission did was put the parties on notice that it would take another look, something the agency had the power to do anyway. Examining the anticompetitive effects of a merger in light of post acquisition evidence and at the time of suit rather than at the time of the transaction is standard American antitrust law. Some may anticipate that the next step might be to clear the deal on condition that the Commission concludes several years later that it is satisfied that efficiencies were achieved or anticompetitive effects did not occur. I should add that any such approach would have to permit judicial review of the Commission's decision, or, in my view, it would be unacceptable. I am not sure at this point whether that sort of "conditional clearance" approach is justified. That is a subject that will be addressed by witnesses during the hearings the Commission has scheduled for this fall - including testimony by Canadian enforcement officials who have in fact pursued that sort of policy.

Let me offer a few final thoughts. Circumstances that justify "subsequent review" or "conditional clearance" are rare. Most times, the enforcement agencies are in a position to make the difficult prediction that anticompetitive effects will or will not occur. On the other hand, some of the most important transactions in some of our most dynamic and fast changing industries, including specifically industries in the high tech sector of the economy, could be better treated in the way I have described. Second, in those situations in which the realistic choice is between challenging a transaction in court or clearing it subject to later review, the parties should regard subsequent review as the preferred outcome. Finally, the approach offers some hope, never air tight, that enforcement officials perplexed by the uncertainties of a situation, will not make the mistake of allowing deals to proceed that have major anticompetitive and anticonsumer effects. If the significant anticompetitive effects begin to occur after the transaction is complete, all concerned parties know the enforcement agency may review the deal again and take actions necessary to preserve or restore a competitive market.