On March 25, 2012, the Supreme Court heard oral argument on the legality of “reverse payment” or “pay for delay” agreements between brand-name and generic drug manufacturers.

Reverse payment agreements settle patent infringement actions brought by a brand-name drug manufacturer against a potential generic competitor under the Hatch-Waxman Act. In contrast to typical settlements of patent infringement actions, it is the patent holder (the brand-name drug manufacturer) that agrees to pay a large sum of money to the accused infringer (the generic) in exchange for an agreement that the generic will not challenge the patent or enter the market for a period of time.

There is a circuit split on the test that courts apply in scrutinizing whether such agreements are anticompetitive. The Second, Eleventh and Federal Circuits have applied a “scope-of-the-patent” test. Under the “scope-of-the-patent” test, a reverse payment agreement is permitted so long as the terms of the agreement do not expand the exclusionary scope of the patent. For example, an agreement that would prohibit a generic from entering the market until after the patent’s expiration would be prohibited under the “scope-of-the-patent” test. The Third Circuit, however, has applied a “quick look” test under which reverse payment agreements arepresumed anticompetitive unless proven otherwise. The Supreme Court granted certiorari in Federal Trade Commission v. Actavis to resolve this circuit split over the issue. Drug innovators generally advocate the “scope-of-the-patent” test, while the Federal Trade Commission (“FTC”) has argued for the more rigorous per se approach in which the burden is shifted onto the drug innovator to rebut the presumption that the settlement is anticompetitive.

Prior to the Supreme Court granting certiorari in Actavis, the 11th Circuit followed its own precedent and applied the “scope-of-the-patent” test. The 11th Circuit affirmed the dismissal of the FTC’s complaint, finding that the agreement in Actavis did not expand the scope of the patent at issue. Among other things, the agreement permitted the generic to enter the marketplace five years before the patent’s expiration, and the parties further agreed in a separate agreement that the generic would promote and share profits from the sales of the brand-name drug.

In the oral argument, the FTC opened by arguing that “a payment from one business to another in exchange for the recipient’s agreement not to compete is a paradigmatic antitrust violation,” and that “[r]everse payments to settle Hatch-Waxman suits are objectionable for the same reasons…[t]hey subvert the competitive process by giving generic manufacturers an incentive to accept a share of their rival’s monopoly profits as a substitute for actual competition…”

The justices did not appear to favor the FTC’s “quick look” test. Justice Breyer, along with Justice Sotomayor, suggested that district courts could resolve the question of whether a particular reverse payment settlement is anticompetitive by resort to the traditional antitrust “rule of reason” and that a shifting of the burden onto drug innovators to prove the agreement is not anticompetitive is unnecessary. Indeed, Justice Breyer expressed concerns that such a test would create an “administrative monster” in requiring the courts to decide whether or not the payments are for delay or something else. Justice Scalia took issue with the Hatch-Waxman Act itself, expressing concerns that understood antitrust principles should not be overturned “to patch up a mistake that Hatch-Waxman made.”

The justices also expressed concerns about adopting the opposing “scope-of-the-patent” test, which would, in essence, create a presumption of infringement by the generic product. Justice Sotomayor noted that settling an infringement action would create such a presumption – “I don’t know why we would be required to accept that there has or would be infringement by the product that has voluntarily decided not to pursue its rights.” The justices also expressed concerns that the financial incentives in adopting such a test would weigh in favor of settling cases, thereby reduce competition by generics, as the “scope-of-the-patent” test would in essence, incentivize brand name and generic manufacturers “in every single case . . . to split monopoly profits in this way to the detriment of all consumers.” Justice Kagan observed that “[i]t’s clear what’s going on here is that [the brand and generic firms are] splitting monopoly profits and the person who’s going to be injured are all the consumers out there.”

Stay tuned, as the Supreme Court is expected to issue its ruling before the end of its term in June 2013. This issue will have a significant impact on both brand-name and generic drug manufacturers as they consider their strategies on the transition from patent protection to generic competition. The decision will also likely have an impact for investors seeking to value pharmaceutical intellectual property.