July 23, 2018

Maryland’s Generic Drug Pricing Law Is Constitutional: A Recent Decision Misunderstands The Structure Of The Industry

By Darien Shanske and Jane Horvath

[Cross-posted from Health Affairs]

Maryland’s price gouging law, a first-in-the-nation state law, would protect consumers from egregious price hikes of certain generic and off-patent brand drugs made by three or fewer manufacturers. Bills based on the Maryland template are moving through a number of other state legislatures. On April 13, 2018, a split three-judge panel of the US Court of Appeals for the Fourth Circuit ruled that the Maryland law, HB 631, enacted in 2017, is unconstitutional based on the court’s interpretation of case law concerning the Dormant Commerce Clause (DCC).

However, the decision is wrong for numerous reasons, many of which were very cogently explained in a lengthy dissent. The Maryland attorney general has requested an en banc review, which is when all judges in the circuit review a decision made by a single three-judge panel. With luck, the entire circuit will get it right.

We will focus here on how this decision is based on a misunderstanding of how the US drug market and supply chain operate.

The Constitutional Doctrine At Issue: Dormant Commerce Clause

The Commerce Clause of the Constitution gives the US Congress the power to regulate commerce between the states. The DCC places limits on a state’s ability to disrupt interstate commerce. The primary focus of DCC doctrine is preventing state discrimination against out-of-state businesses. A secondary concern is preventing state laws that unduly burden interstate commerce. A tertiary concern is preventing states from regulating activity occurring out-of-state—extraterritorially. (For more information about these, the DCC, and state drug cost policy, please see this white paper.)

The Maryland price gouging law (HB 631) addresses generic and off-patent brands that are on the World Health Organization list of essential medicines and manufactured by three or fewer companies. When a drug is produced by only a few manufacturers, the producers can easily launch drugs at high prices, maintain high prices, and increase prices dramatically. High prices of important essential medicines that become unaffordable leave consumers with few, if any, treatment alternatives. This deeply problematic scenario is not just imagined, as both the Government Accounting Office and the US Senate Special Committee on Aging wrote reports detailing the problem. This is the problem the Maryland law addresses.

The generic drug industry sued based on two DCC issues. The first is that the HB 631 law violates the DCC by regulating industry financial transactions outside of Maryland—that is, the charge is that Maryland is regulating extraterritorially. Second, the industry claims that the Maryland law places an “undue burden” on interstate commerce.

Note that there was no argument that the Maryland law would somehow protect the Maryland drug industry, preventing such protectionism is the core concern of the DCC. Nevertheless, the majority of the Fourth Circuit panel found that the Maryland law failed on the secondary and tertiary aspects of the DCC—undue burden and extraterritoriality, respectively. As we will now explain, the court decision seems to have not considered how the pharmaceutical market works.

The Maryland Law Does Not Impose An Undue Burden On Interstate Commerce

The majority opinion found that the Maryland law placed an undue burden on interstate commerce. In the classic cases of undue burden, a state places a heavy burden on interstate commerce of a company or industry for a trivial reason. For instance, in one case, a state required trucks to use an unusual type of mud flap when driving in the state. The Maryland law is nothing like this. First, most obviously, the law is regulating something extremely important—namely generic drug prices—when no one else is doing so, and there is clearly a consumer health and safety issue.

Second, what Maryland is asking the generic drug industry to do is nothing as burdensome as stopping their trucks at the border and making them change their mud flaps. Rather, drug prices are already a product of an enormously complicated set of financial transactions that cross geographies. These financial transactions already vary based on where the product is made and the geography into which it will be sold.

For example, drug manufacturers will negotiate discounts with specific hospitals, health systems, or health plans. Who negotiates with whom depends on the importance of the payer/purchaser in the national or regional market, the product market competition, the importance of the product to company revenue, and other factors. If the negotiation with a hospital results in an on-invoice discount, the manufacturer has to have a financial process to ensure that the wholesaler does not lose money since the wholesaler buys the product from the manufacturer and distributes it nationally or regionally to different buyers (including more local distributors that would get the product to the hospital).

So manufacturer discount negotiations at a very local level—the hospital for instance—drive multiple financial transactions in distant geographies. Manufacturer discount rebate agreements (as distinct from on-invoice discounts) with a health plan also result in financial transactions in a state other than the corporate office of the health plan. This is all part of the business model, and these are only some of the interstate financial transactions required for individual companies to compete in the market. The necessity of working directly in many markets would be particularly important for products with three or fewer competing manufacturers—these are the products subject to the Maryland law—because this is a scenario in which price competition can move market share and profits.

Thus, given the structure of the pharmaceuticals market, and particularly the market for the regulated products, the Maryland law would hardly impose a burden, much less an undue one.

The Maryland Law Does Not Regulate Extraterritorially

The Fourth Circuit also found that the Maryland law violated the extraterritoriality doctrine. This doctrine is a bit variable, but the core rule is simple: A state cannot regulate conduct in another state. Clearly, Maryland was not trying to do this but trying to secure essential drugs at a reasonable price for its citizens. It is true that in so attempting to protect its citizens, there would possibly be a small impact on current transactions wholly out of state, but if this is the test for whether a state can regulate in our interconnected economy, then states cannot regulate much of anything. And, indeed, the decision was wrong on the law of extraterritoriality for just this reason, namely that it would undermine virtually all state regulations. For more on the doctrine, see here.

But perhaps one could defend the Fourth Circuit decision by noting that an effect on interstate pricing was especially likely because of the structure of the drug industry. This analysis, though superficially appealing, has to be rejected because, once again, Maryland is not creating a new or unique effect on interstate pricing. Even in the absence of the HB 631 law, the industry responds to the various limits that different payers put on reimbursement to generic drug dispensers. For example, each and every health plan and all Medicaid programs set their own maximum allowable costs (MACs) for generics and off-patent brands. MAC is just a term for setting dispenser reimbursement limits; it is the average of the prices among the competitors. Maryland health plans and Maryland Medicaid each set their own MACs for their own set of generic products. Furthermore, these various payment limits in Maryland are different from what each health plan in Virginia and Delaware set, all of which can require manufacturers to adjust prices for any one geography through financial transactions that likely occur out of state. This is day-to-day activity in the industry, indeed, it could be very difficult to sort out any small impact of the Maryland law because it would be completely in the mix of the current interstate pricing activity in response to payer limits on pharmacy and provider drug reimbursements—limits that can change weekly or monthly at a payer’s discretion.

So, if the Fourth Circuit’s analysis were correct, then any industry with a complicated business model that crosses state lines could not be regulated by the states. Even more peculiar, if an industry were not so organized, all an industry would need to do is tie itself in knots to escape regulation by the states. It can’t be that the constitutional power of states to protect the health of its citizens diminishes because a firm’s business model produces interstate ripples whenever a state tries to regulate its actions.

In the analogous area of state taxation, it is well-established that a state cannot subject an interstate business to double taxation (relative to an instate business) on account of how the state organizes its own tax system. However, if an interstate firm suffers from double taxation because of permissible decisions made by two states individually, then that is just a necessary byproduct of living in a federation where subnational units have substantial taxing and regulatory power.

But perhaps it makes a difference that part of the complexity here is a result of federal law? If the argument is that a federal law relating to generic drug prices preempts state regulation of prices charged to its citizens, then that is indeed a serious argument. The generic drug industry did not raise this issue precisely because there is no such federal law. Therefore, the court’s finding must rest on the argument that when a federal regulatory regime that does not regulate the prices of drugs that are available in Maryland and other states (because there is no federal law regulating generic drug prices) but does indirectly create possible interstate price linkages (because of federal programs such as Medicaid), then the states are not allowed to regulate those drug prices as if the federal government had preempted state regulation directly. Stating the argument clearly is to reveal how little sense it makes and also, not coincidentally, why it is not the law. There is an entire body of law—preemption—that considers when a federal law preempts a state law, and there is a presumption against preemption. Federal courts are not supposed to be in the business of finding creative ways to prevent states from protecting their citizens.

The structure of the pharmaceuticals market is opaque, as is US Supreme Court case law about the Dormant Commerce Clause. However, knowledge of the market is absolutely key to assessing state laws relative to the DCC. We do not think their decision will stand the test of time once it is understood how this complex market actually functions.