Entry limiting agreements: First‐mover advantage, authorized generics, and pay‐for‐delay deals

• Author: Franco Mariuzzo,Arnold Polanski,Farasat A. S. Bokhari
• Date: 01 July 2020
• Published date: 01 July 2020
• DOI: http://doi.org/10.1111/jems.12351

J Econ Manage Strat. 2020;29:516–542.516

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wileyonlinelibrary.com/journal/jems

Received: 9 May 2019

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Revised: 6 February 2020

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Accepted: 19 April 2020

DOI: 10.1111/jems.12351

ORIGINAL ARTICLE

Entry limiting agreements: First‐mover advantage,

authorized generics, and pay‐for‐delay deals

Farasat A. S. Bokhari

1,2

|Franco Mariuzzo

1,2

|Arnold Polanski

1

1

School of Economics, University of East

Anglia, Norwich, UK

2

Centre for Competition Policy, University

of East Anglia, Norwich, UK

Correspondence

Farasat A. S. Bokhari, School of

Economics, University of East Anglia,

Norwich NR4 7TJ, UK.

Email: f.bokhari@uea.ac.uk

Abstract

During patent litigation, pay‐for‐delay (P4D) deals involve a payment from a

patent holder of a branded drug to a generic drug manufacturer to delay entry

and withdraw the patent challenge. In return for staying out of the market, the

generic firm receives a payment, and/or an authorized licensed entry at a later

date, but before the patent expiration. We examine why such deals are stable

when there are multiple potential entrants. We combine the first‐mover ad-

vantage for the first generic with the ability of the branded manufacturer to

launch an authorized generic (AG) to show when P4D deals are an equilibrium

outcome. We further show that limiting a branded firm's ability to launch an

AG before entry by a successful challenger will deter such deals. However,

removing exclusivity period for the first generic challenger will not.

1|INTRODUCTION

A pay‐for‐delay (P4D) deal is a ‘reverse payment’from a patent holder to another drug manufacturer seeking entry for

its generic equivalent drug. They arise in out of court settlements because the patent holder has sued the potential

entrant for infringement of its intellectual property. The deals are referred to as ‘reverse payments,’because the

payment is from the infringed to the infringer, rather than the other way around. In return for the payment, the generic

firm abandons its challenge and agrees to stay out of the market. Moreover, it often also acquires a right from the patent

holder to enter at a later date, but before the patent expiration itself as an authorized licensed generic with an exclusive

license. The branded firm may additionally agree not to launch an in‐house generic during the exclusive license period.

The eventual entry by a generic firm takes place at a later date, potentially well after a court may have declared the

patent invalid, but also typically before the expiration of patent itself.

Prior literature has relied on institutional details of the American legal system vis‐à‐vis the market authorization

rules and provisions of the Hatch–Waxman Act of 1984, particularly section IV of the Act (called a ‘para IV challenge’)

to provide an explanation of how P4D deals come about (Bulow, 2004; Frank, 2007; Hemphill, 2009; Mulcahy, 2011;

Regibeau, 2013; Scott Morton, 2013; Scott Morton & Kyle, 2011). As has been noted in this literature, these deals are

typically initiated after the patent protecting the molecule expires, but while other patents associated with the drug, as

registered by the US Food and Drug Administration (FDA), remain in force. The first generic company to successfully

file for market authorization under section IV of the Act is explicitly rewarded a 6‐month exclusivity period, during

which time no other generic firm can market its drug. Such a reward is not available to later challengers even if the first

one settles with the patent holder.

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction in any medium, provided

the original work is properly cited.

© 2020 The Authors. Journal of Economics & Management Strategy published by Wiley Periodicals LLC

There are clear trade‐offs in arriving at such a deal. The generic firm can reject the deal and face litigation cost and

take its chances in the court. If it wins, it can earn duopoly profits for 180days, followed by an N‐opoly period in which it

shares the generic segment of the market with other generic producers. Alternatively, it can avoid the uncertainty and

litigation costsand accept a suitable payment. The challenger gains from settling as long as the paymentto stay out at least

equals the expected future profit net of litigation costs. However, if the patent is strong, the monopolist may not offer a

deal as long as the litigation costs are less than its expected monopoly profits. Conversely, a reverse payment settlement

that keeps the challenger out of the market is also profitable for the branded firmas it can maintain its monopoly position

(Drake, Starr, & McGuire, 2015; McGuire, Drake, Elhauge, Hartman, & Starr, 2016) and the paymentdoes not exceed the

expected difference between monopoly and duopoly profits minus litigation costs. But the settlement can also expose the

monopolist to future challenges by other generic producers as it can signal a weak patent.

We focus on the incentives involved in reaching P4D deals before filing for generic entry, that is, ex ante P4D deals

when no generic can use its first‐filer (FF) status with the FDA to block entries by other generic challengers.

1

The main

goal of this paper is to answer the following key question: If the originator can pay off the generic producer to refrain

from challenging its patent, and to stay out of the market for some time, how much do they have to pay, and why do

other generic challengers not grab the same opportunity to also get paid off? And if indeed this is possible, then how is

the initial deal profitable for the originator if there are many potential challengers?

In the FTC v. Actavis Inc. case argued before the US Supreme Court, the 5–3 majority opinion pointed out that the

180‐day exclusivity of the Hatch–Waxman Act is precisely why P4D deals are stable.

2

The majority opinion goes on to

state that because the 180‐day exclusivity is not available to later challengers (even if the first challenger settles in a P4D

case), the low potential reward prevents others from seeking entry. Note however that the first to file for a generic entry

enjoys no statutory exclusivity period in the European Union, and yet entry limiting reverse payments take place on

both sides of the Atlantic.

In this paper we investigate how P4D deals would arise if the 180‐day exclusivity were available to the late filers, as

in the ex ante settlements, or for instance, if exclusivity was awarded to first successful challenger (hereinafter FSC

system) rather than to the FF system as suggested in Hemphill and Lemley (2011). We use two key features of the

pharmaceutical industry to provide an explanation for the stability of P4D deals. The first is a first‐mover advantage for

a generic firm that is distinct from any exclusivity period or even an incumbency period, and arises due to higher

willingness‐to‐pay (WTP) for the first generic relative to other generics. The second is the ability of a branded man-

ufacturer to launch a generic, known as an authorized generic (AG), either itself or via a third party under a licensing

agreement that can undercut incentives for independent generic entry.

We propose a simple model with one branded firm with a patent and many potential challengers. The branded firm

can threaten the first challenger to launch its own generic (an in‐house AG, some times known as a ‘pseudo‐generic’)

and deprive the challenger of any first‐mover advantage in the generic segment. However, in this case it would incur a

cost associated with acquiring a speciality to successfully market a generic. Alternatively, if this cost is too high, it can

offer to pay off the first challenger to stay out of the market. If the deal is accepted, the branded firm can use the first

challenger to ward off entry by any subsequent challengers. It can do so by threatening to launch a generic via the first

paid‐off challenger prior to the second challenger's entry in case a patent litigation outcome is in favor of the latter. If at

any stage the branded firm chooses to execute the threat (launch an AG), it takes away the challenger's first‐mover

advantage thereby reducing the latter's incentive to contest entry. However, launching a generic either in‐house or via

the first challenger, also forces the branded firm to enter into a triopoly rather than engage in a competitive duopoly

against the winning challenger, and hence the threat may not always be credible.

We provide conditions under which the threat becomes credible. We show that if the first‐mover advantage exists

and is larger than a threshold, then under an endogenously determined licensing fee for the AG (determined via take‐it‐

or‐leave‐it offer), the branded firm is better off in a triopoly with the AG than in a competitive duopoly. This is because

if the first generic entrant can capture a significantly large share of the generic market, then both the branded firm and

the challenger can agree on a licensing fee that allows the launch. Similar reasoning applies to the case when the

branded firm can launch its own in‐house generic at zero (or low) cost and cannibalize its branded product, the only

difference being that it fully captures any profits associated with the sales of the AG rather than a negotiated licensing

fee. In the ensuing triopoly, the branded firm gets to recoup some of the losses relative to its favored monopoly position

due to the sales of the AG via the licensing fee (or all of generic's profit if it was self‐launched) and hence it is better off

than being in a duopoly. Thus for a large enough first‐mover advantage, the threat to launch an AG either itself or via

the first challenger is credible, and working backward, second and subsequent potential challengers may optimally

choose to stay out of the market if their expected profit is lower than the cost of litigation.

BOKHARI ET AL.

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