California’s New Scrutiny of Patent Litigation Settlements Will Not Stand Under Federal Law

cali sealThe California Supreme Court earlier this month issued an opinion that subjects litigants who settle their patent disputes to scrutiny under state antitrust law. The court reasoned that such settlements may create unreasonable restraints on trade. While the decision in In re Cipro Cases I & II to reinstate antitrust claims was not overly surprising—after all, the U.S. Supreme Court had previously held in FTC v. Actavis, Inc. that some patent litigation settlements might violate federal antitrust law—the breadth of the California Supreme Court’s decision could have a particularly negative impact on the free-enterprise system. Indeed, the decision suggests that parties to a patent litigation settlement will have great difficulty ever avoiding California antitrust liability if the settlement entails transferring anything of value from the patent holder to the alleged infringer. Because Cipro’s new state-law antitrust standard is so much more exacting than the standard announced by the U.S. Supreme Court in Actavis, federal antitrust law may well trump California’s standard. Indeed, were Cipro to reach the U.S. Supreme Court, the Court likely would reverse on federal preemption grounds.

“Reverse-Payment” Patent Settlements

When parties to litigation enter into a settlement, one would normally expect that any cash payments would flow from the defendant to the plaintiff. The normal expectations have been reversed in the context of litigation involving prescription-drug patents, however, as a result of financial incentives created by the Hatch-Waxman Act, a federal statute designed to ensure that generic versions of prescription drugs enter the market more quickly. The Act includes a provision that permits generic companies, by declaring to the Food and Drug Administration a belief that the patent held by a brand-name drug company is invalid, to essentially force the patentee to immediately file a patent infringement suit. It also grants huge financial awards to generic companies that successfully challenge drug patents.

The Act thereby allows a generic company to test patent validity in a manner that creates no risk for itself—e.g., it need not begin selling an infringing product (the normal prerequisite for a challenge to a patent’s validity) and thereby risk incurring a ruinous damages award—and at the same time threatens to destroy one of the brand-name company’s most valuable assets. Given the parties’ lopsided comparative risks, brand-name companies have much greater incentives to settle patent litigation than do generic companies, incentives that induce them to provide compensation to generic companies in order to encourage/advance/promote settlements.

Antitrust Challenges to Reverse-Payment Settlements

The Federal Trade Commission (FTC) has long complained about the allegedly anti-competitive effects of “reverse-payment” patent litigation settlements—i.e., settlements whose terms include a cash payment from the drug patent holder to the alleged infringer. The FTC contends that by making such payments, patent holders are in effect paying potential competitors not to compete, thereby restricting supply and driving up prices. For many years, federal appeals courts universally rejected the FTC’s contention; they concluded that such settlements cannot have an anti-competitive effect so long as the settlement does not prohibit any competition that was not already barred under the terms of the patent. They also concluded that because litigation is always a drain on productivity, settlements of patent disputes ought to be encouraged for their pro-competitive effects, and that existing patents ought to be presumed valid.

A 2012 Third Circuit decision created a circuit split by holding that a reverse-payment settlement is prima facie evidence of an unreasonable restraint of trade. Later that year, the U.S. Supreme Court granted certiorari in FTC v. Actavis, an Eleventh Circuit case where FTC unsuccessfully challenged the settlement of infringement litigation involving the drug AndroGel®, to resolve the circuit split. The Court adopted a compromise position, rejecting both the FTC’s prima facie evidence standard (which would impose on settling parties the burden of establishing that the settlement actually had pro-competitive effects) and the “scope of the patent” test adopted by most appeals courts (under which a settlement is unassailable so long as it does not bar competition outside the scope the patent had already barred).

Actavis declined to adopt any “bright line” test under federal antitrust law and instead directed lower courts to analyze the potential anti-competitive effects of reverse-payment settlements under a traditional rule-of-reason analysis. The Court repeatedly emphasized that courts must “balance” the competing interests of federal antitrust and patent law, explaining that patent and antitrust policies are both relevant in determining the extent of the “antitrust law immunity that is conferred by a patent.” In rejecting the FTC’s argument that reverse-payment settlements should be deemed “presumptively unlawful,” the Court explained that such presumptive rules are appropriate only when the anti-competitive effects of a challenged practice are readily apparent—and that reverse-payment patent litigation settlements do not meet that criterion. In remanding the case to the appeals court, the Court said that it would leave it to the lower courts to determine precisely how a rule-of-reason analysis should proceed.

In re Cipro: A Challenge Under California Antitrust Law

Plaintiffs’ attorneys have also challenged reverse-payment settlements under state antitrust law. In re Cipro is a challenge to a 1997 reverse-payment settlement of litigation over the patent to ciprofloxcin hydrochloride (“Cipro”), a commonly prescribed antibiotic. Attorneys filed suit under California antitrust law after a 2010 Second Circuit decision applied the scope-of-the-patent test to reject a challenge to the 1997 settlement under federal antitrust law. The California Court of Appeal dismissed the California antitrust law challenge in 2011, agreeing with the Second Circuit that the settlement was unobjectionable under the scope-of-the-patent test. The California Supreme Court granted the plaintiffs’ petition for review, and its decision earlier this month reversed the Court of Appeal.

The California Supreme Court’s decision claims to merely track Actavis, but that account overlooks significant differences between the two decisions. In particular, In re Cipro adopts the FTC’s (and Third Circuit’s) prima facie test, a standard explicitly rejected in Actavis. Plaintiffs should have little difficulty establishing a prima facie case in most reverse-payment cases; virtually all they need show is that settlement compensation paid by the patentee exceeded the litigation costs it would have incurred in the absence of a settlement. According to the California Supreme Court, once that standard is met, the burden of proof shifts to the defendants to demonstrate that the settlement promotes competition.

Moreover, unlike Actavis, In re Cipro held the settling parties’ demonstration that the patent is valid provides no defense. The court reasoned that for purposes of antitrust law, the validity of the patent should be determined as of the date of settlement, not when the antitrust challenge to the settlement later comes to trial. It further reasoned that a reverse payment in excess of the patentee’s expected future litigation costs indicates that, at the time of settlement, the patentee had some doubts that the patent would be upheld at trial and was willing to pay off the generic company rather than face the degree of likely competition represented by its reverse payment (i.e., losses likely incurred if the patent is declared invalid multiplied by the percentage likelihood of such a ruling). It ruled that California antitrust law condemns such excess payments because “what matters is whether a settlement postpones market entry beyond the average point that would have been expected at the time [of settlement] in the absence of agreement.” It light of that ruling, one is left to wonder whether the California Supreme Court believes that there are any plausible defenses to a prima facie case.

Another major distinction between Actavis and In re Cipro: the U.S. Supreme Court applied its federal antitrust law analysis only to cash payments and did not address whether its analysis might also apply to non-monetary benefits flowing to the generic company in connection with a settlement. In contrast, In re Cipro held that its analysis applies not only to cash payments but also to any “equivalent financial consideration flowing from the brand to the generic challenger.” But as I explained in a recent law review article, any settlement agreement can be characterized as involving a form of “consideration” to the defendant, who would not settle unless he had something to show for settlement. Thus, for example, if a patent is set to expire in eight years and the settlement provides that the generic company is granted exclusive rights to compete after six years, that grant can be characterized as “consideration” to the generic company in return for its agreement not to compete for the first six years. Yet, Actavis explicitly held that such early-entry agreements—which arguably are actionable under In re Cipro—are not subject to scrutiny under federal antitrust law.

Federal Preemption of California Antitrust Law

Because In re Cipro interprets California antitrust law with respect to reverse-payment patent litigation settlements so much more broadly than federal antitrust law, there is a strong argument that federal antitrust law preempts California’s new standard. As Washington Legal Foundation explained in two briefs (here and here) it filed with the California Supreme Court in In re Cipro, state antitrust laws—like all state laws—are subject to the restrictions imposed by the Supremacy Clause of the U.S. Constitution and are impliedly preempted to the extent that they conflict with federal law.

The U.S. Supreme Court has held that federal antitrust law is intended to serve as a floor, not a ceiling, on antitrust enforcement, and thus in most instances does not preempt state efforts to impose a stricter level of antitrust enforcement. But it has also held in Teamsters v. Oliver that state antitrust law must give way to the extent that it conflicts with a federal statute other than federal antitrust law.

In this case, the relevant federal law is federal patent law. Federal courts have not hesitated to find that state regulation is preempted to the extent that it conflicts with federal patent law. Actavis imposed limits on federal antitrust law in recognition of the exclusionary rights granted by Congress to patent owners and of the need to maintain a proper “balance” between those rights and the restrictions imposed by federal antitrust law on restraints of trade. Because Congress has established the requisite “balance,” States are prohibited from applying their antitrust laws in a stricter manner to patent-related agreements.

Despite the California Supreme Court’s insistence that it merely followed Actavis, there can be little doubt that the strict antitrust standards it imposed in In re Cipro were explicitly rejected by Actavis as undercutting federal patent law. In particular and as noted above, FTC had proposed the burden-shifting rule adopted in In re Cipro (under which defendants are required to prove that their settlement agreements are pro-competitive) to the U.S. Supreme Court in Actavis, but the Court rejected it as inconsistent with patent law. In addition, while In re Cipro rebuffed any effort by defendants to defend their settlement by demonstrating the validity of the underlying patent, Actavis left open such a defense as a means of proving that the settlement did not restrain any competition.

Moreover, unlike Actavis (which addressed only those settlements in which the patentee pays cash to the generic drug company), In re Cipro indicates that California antitrust restraints apply to settlement agreements in which the generic drug company receives any cash-equivalent financial consideration. As Judge Richard Posner of the Seventh Circuit has correctly pointed out, if all settlements in which the generic drug company receives something of value are to be classified as reverse-payment settlements, then “we shall have no more patent settlements.” Yet, there is nothing in the Hatch-Waxman litigation procedure to suggest that Congress meant for all of the (substantial) patent infringement litigation it incentivized to go to verdict without the possibility of mutually beneficial settlements.

Given the clear conflicts between In re Cipro and Actavis, it is difficult to envision the former withstanding a federal preemption challenge. For that reason, the In re Cipro defendants should seriously consider seeking U.S. Supreme Court review of the California Supreme Court’s decision.

Also published by Forbes.com at WLF’s contributor site

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s