Locke Lord QuickStudy: Filling in Some Actavis Gaps - California Supreme Court Adopts Structured Rule of Reason Test for Antitrust Scrutiny of Pay-for-Delay Settlements

Locke Lord LLP
May 27, 2015
A sweeping new opinion from the California Supreme Court revives California Cartwright Act challenges to pay-for-delay pharmaceutical patent settlements.  In re Cipro Cases I & II, (Case No. S198616, Slip Op. May 7, 2015).  A California court of appeal had applied the “scope of the patent” test to affirm dismissal of an antitrust challenge to a patent settlement concerning the popular drug Cipro.  The California Supreme Court reversed, reaching same fundamental conclusion as the United States Supreme Court did in last year’s Actavis opinion: reverse payment (or pay-for-delay) patent settlements may face scrutiny under antitrust law “even if they limit competition no more than a valid patent would have.”  The California Supreme Court also fleshed out a new structure for the applying the rule of reason test to patent settlements under the Cartwright Act, something that the United States Supreme Court had left open for lower courts to develop under the Sherman Act. 

The California Supreme Court Joins The U.S. Supreme Court In Rejecting The “Scope Of The Patent” Test
The California Supreme Court conducted an extensive and independent review of reverse payment settlements under California law, which can be substantively different than federal antitrust law.  The Court observed that the Hatch-Waxman Act “illustrates the law of unintended consequences” because, while it encourages and facilitates earlier generic alternatives to brand name drugs, it also creates “a series of new problems.”  These antitrust problems arise from incentives to “effectively establish a cartel” through a reverse payment settlement between the brand name provider and the first generic company that challenges a patent.  The reverse payment can be a way to split monopoly profits with the first-filing generic in exchange for lengthening the time that potential competition is excluded.  With more than a bit of understatement, the Court noted that “[t]his is probably not what Congress intended.”

The California Supreme Court discussed how to determine whether a reverse payment patent settlement imposes unreasonable – and therefore unlawful – restrictions on competition that are not justifiable under a patent’s limited and conditional grant of monopoly.  The Court held that it is not sufficient to simply ask whether a reverse payment settlement’s restrictions on competition are within the “scope of the patent.”  The Court found that standard gave too much weight to the presumption of patent validity and too little consideration to the potential for anticompetitive effects from limiting generic entry (i.e., “paying for freedom from competition”).  Like the United States Supreme Court in Actavis, the California Supreme Court directed that lower courts should make a deeper and more nuanced analysis of reverse payment settlements under the “rule of reason.”

California Establishes A New “Structured” Rule Of Reason Test For Reverse Payment Settlements
Having rejected the “scope of the patent” test, the California Supreme Court explained how to conduct a “rule of reason” inquiry for reverse payment settlements, accepting the invitation to “develop a gap in the law explicitly left by the Supreme Court.”  The California Supreme Court embraced the Actavis articulation of the relevant benchmark inquiry: “What would the state of competition have been without the agreement?”  The inquiry focuses on the anticompetitive effect attributable to the settlement agreement, as opposed to the anticompetitive effect attributable to the strength of the patent.

The Court noted that patent validity need not be actually litigated to isolate these effects.  The Court established a structured test to determine whether there is “cause to believe some portion of the [payment from the brand company to the generic company] is payment for exclusion beyond the point that would have resulted, on average, from simply litigating the case to its conclusion.”  Under this test, a plaintiff challenging a reverse payment patent settlement must show: 

  • A settlement that limits the generic company’s entry into the market;
  • Cash or equivalent financial consideration is paid from the brand name patent holder to the generic patent challenger.  Side deals to the settlement must be evaluated so they do not serve as cover or “fig leaves” for anticompetitive agreements.  Likewise, non-cash settlements or “other creative variations” in consideration should be evaluated;
  • The payment is greater than the brand name patent holder’s expected remaining patent litigation costs; and 
  • The payment is greater than the value of any goods or services (such as distribution or marketing services) the generic company will provide under the settlement. 


The California Supreme Court’s test aims to eliminate the possibility that litigation costs or other collateral benefits “explain” the reverse payment.  As the disparity in amount between the settlement payment and the litigation costs or collateral benefits increases, the inference of anticompetitive effect strengthens.  
If a plaintiff attacking a reverse payment settlement establishes the predicates above, the burden then shifts to the defense to offer legitimate procompetitive justifications for the reverse payment.  The ultimate burden of persuasion remains on the challenger, which must undermine the proffered settlement justifications and demonstrate that the settlement payment is excessive, and thereby anticompetitive and illegal.

Application Of The New Standard Is Heavily Dependent On The Facts And Therefore Uncertain In The Tough Cases
While the California Supreme Court broke new ground in establishing a structured test for evaluating reverse payment settlements, the new standard is heavily fact and context dependent, and applying it requires difficult judgments from trial courts.  One of the most significant questions is whether and in what circumstances a large reverse payment settlement – i.e., one that exceeds expected litigation costs and the value of collateral benefits – can be justified as procompetitive?  The California Supreme Court rejected the plaintiffs’ call for a blanket rule that all reverse payment settlements that exceed the value of litigation costs and collateral benefits are illegal.  However, the Court noted that proffered justifications will be scrutinized rigorously, saying “[t]his does not mean any justification will do.”  The Court expressly warned that the usual justifications offered by parties to a reverse payment settlement – that there will be earlier generic entry than if the brand name company had won the patent case or that the patent ultimately would have been found valid – do not satisfy the new test.  Beyond that, the Court did not provide guidance on potentially acceptable justifications, leaving it up to trial courts to evaluate them in light of the facts of each case. 

Another related practical problem with the new test is that litigation adversaries very often view the strengths of their patent cases very differently from each other.  The California Supreme Court opined that parties “can still use financial considerations to bridge small gaps arising from subjective perceptions of their probabilities of success in litigation; what they cannot do is use money to bridge their differences over the point when competitive entry is economically desirable.”  Trial courts will have to make reasoned and objective assessment of litigation probabilities, often after rancorous proceedings in which the parties each claimed the other had no legitimate chance of success.

The California Supreme Court noted the trend towards non-cash settlement terms in Hatch-Waxman litigation, warning against the use of “creative variations” in consideration to mask anticompetitive agreements.  Although this point is not developed fully in this opinion, the take-away is that trial courts will carefully scrutinize non-cash terms.  Parties should resist the temptation of assigning unrealistic values to these terms, either on the high or the low side.

Both the Actavis Court and the California Supreme Court have written that it should not be necessary to litigate and decide patent validity in order to determine whether a reverse payment settlement is anticompetitive.  But neither court suggests how a trial court can otherwise sensibly evaluate the average expected life of a patent or judge other essential elements of the new test.

Will Other Courts Follow California’s Structured Rule Of Reason Test?
The California Supreme Court perceived high potential for reverse payment settlements to have anticompetitive effects.  It accordingly rejected concerns that the new test for evaluating these settlements would hamper innovation, chill patent challenges, and prevent settlements that might actually raise consumer welfare.  A very interesting question for the future will be whether and to what degree federal courts adopt California’s rule of reason framework for analysis of reverse payment settlements.  If the two systems take materially different approaches, we anticipate forum shopping by settlement opponents.  It will also be more difficult for brand and generic rivals to predict accurately the enforceability of these settlements in advance.  

For more information on the matters discussed in this Locke Lord Quick Study, please contact the authors.