This article discusses the potential liability resulting from the underpayment of Mylan NV (NASDAQ: MYL) EpiPen Medicare and Medicaid Rebates.
Mylan is a generic drug manufacturer that sells roughly 600 drugs in the US market and just over 1,400 drugs around the world. Total revenues expected for 2016 is roughly $11 billion and the average expected earnings per share is $4.74 per share. $5.34 is next year's average expected earnings per share.
However, these earnings estimates do not include the likely penalties from the antitrust lawsuits, the impact from penalties resulting from underpayment of Medicare / Medicaid EpiPen rebates, or the 20 class action lawsuits filed for various reasons.
I bought Mylan early in February of 2014 after reading some quite informative articles on Seeking Alpha followed by my own research and due diligence. Back then, Mylan had nice earnings growth, good value, and most analysts were recommending the stock as a buy. My outlook for the stock has dramatically changed.
I sold my shares shortly after the antitrust lawsuit was announced in December of 2016 for a small loss, not counting the tax consequences from the tax inversion.
The tax inversion, which is a small story in itself, resulted in moving Mylan's tax headquarters to the Netherlands in order to reduce US tax liability. Mylan's working headquarters has not actually moved and is still located in a suburb of Pittsburgh, PA. While shareholders will be paying capital gains taxes on their shares, management was granted an extra $32.5 million to help ease their tax burden.
The reason for my change in outlook is because of:
- Allegations of underpaying EpiPen rebates due to EpiPen misclassification as a generic drug.
- The antitrust lawsuits.
- The school contract agreement that prevents a school from buying an auto-injector from a competitor, which triggered an antitrust investigation.
- The changing political outlook regarding drug price regulation. Some legislation has already passed to regulate price increases for generic drugs.
On Oct. 7, 2016, many news outlets ran a story that Mylan had settled EpiPen underpayments of Medicare and Medicaid rebates for $465 million, including a story in the NY Times. However, there did not seem to be any confirmation from the Department of Justice (DOJ) or the CMS. On Nov 15, 2016, Business Insider ran a story that said:
"In a letter sent to Senator Chuck Grassley of Iowa, the assistant attorney general said the DOJ would not be able to testify at an upcoming hearing because 'it hasn't agreed to any settlement with any potential party.' "
Reuters also published a story that said that the CMS has not agreed to any settlement either.
So, this appears to be a denial of any settlement agreement and it looks like both the DOJ and the CMS are not interested in settling for the discussed amount at this time. One reason for this appears to be because of concerns from individuals like Elizabeth Warren, West Virginia Attorney General Patrick Morrisey, and Senator Richard Blumenthal.
Both Warren and Morrisey claim that the settlement figure is too low and Warren said that if it is accepted, it would "make crime pay." In a Bloomberg article:
"Mylan NV's $465 million settlement with the U.S. Department of Justice over Medicaid rebates for its EpiPen allergy shot is a'sweetheart deal,' and the company should face a criminal investigation, Senator Richard Blumenthal said Wednesday...
Blumenthal, a Democrat from Connecticut, said on Bloomberg TV that the settlement was 'inadequate' given the financial shortfall may be more than $700 million, and there may also be state money that should be recovered. A former federal prosecutor and Connecticut attorney general, he said Mylan may have deliberately misclassified the EpiPen...
Blumenthal previously wrote a letter that described the settlement as 'a shadow of what it should be' and criticized it for not requiring Mylan to admit to any wrongdoing."
Is EpiPen a brand name drug or a generic? Wayne Shreffler, chief of pediatric allergy and immunology at Massachusetts General Hospital, said in a Washington Post article:
"It's like Kleenex - it's even more dominant. I think academics like me are very careful when speaking to say 'epinephrine auto injector,' but for most of the community, they just say 'EpiPen.' "
Further down in the article:
"Mylan lobbied lawmakers - both directly and indirectly - to increase the availability of epinephrine auto injectors in U.S. schools. Although these legislative efforts were not supposed to benefit a particular company, the brand has such a lock on the market that when President Obama signed the School Access to Emergency Epinephrine Act in 2013, a news announcement simply called it the 'EpiPen Law.' "
EpiPen Settlement Accounting
Mylan took a charge of $465 million for the 3rd quarter of 2016 for the proposed settlement. This seems to be at least a bit odd since both the DOJ and the CMS denied any agreement.
How could there be a payment if there is no agreement? If there was no payment, then is the $465 million charge in the 3rd quarter correct under generally accepted accounting principles? I asked that very question of Mylan's auditor, Deloitte and pointed out that settlements like this usually take years to work out.
I wanted to know if Mylan should restate 3rd quarter earnings minus the $465 million charge. But, they did not respond. If you are a professional accountant and have some experience in this area, then I would love to hear your opinion as to whether Mylan should restate earnings minus the $465 million charge and whether or not the auditor should insist they do so.
The intent of the classification regulation is to require companies to classify single source drugs under patent protection and a New Drug Application (NDA) differently than generic drugs that typically have many producers, no patents, costs less, and costs much less to develop.
In exchange for a 20-year exclusive period of time to market a drug, brand name producers pay a higher rebate rate of 23.1% compared with a 10% rebate rate for generic producers. Furthermore, an inflation rebate also applies to brand name drugs.
According to an article on CNBC, if EpiPen was not correctly classified, then the inflation rebate penalty should provide rebates of up to "100 percent of the average manufacturer's price." In effect, Mylan would see little to no net revenue from sales of EpiPen to Medicare and Medicaid since starting to sell the drug in 2007. From another article on CNBC:
"The Grassley analysis finds that the share of Mylan's revenue for EpiPens from the taxpayers went up each year from 2011 to 2015, from 23.3 percent in 2011 to 53.4 percent in 2015," the senator's office said...
Grassley's comments came a day after the acting administrator of the CMS, Andrew M. Slavitt, said in a letter that Medicaid and Medicare Part D had paid nearly $1.3 billion in EpiPen purchases from 2011 through 2015, before factoring any rebates from Mylan."
The Slavitt letter also said that the drug does not meet the definition of a multiple source drug and should be classified instead as a single source drug or brand drug. Mylan was expressly told multiple times that EpiPen was not correctly classified. According to the letter:
"It is the manufacturer's responsibility to report accurate product and pricing data to the Medicaid Drug Rebate Program and pay proper rebate amounts. Manufacturers that fail to accurately report product and pricing data to the rebate program and pay insufficient rebates may be subject to liability under the False Claims Act, a penalty of up to $100,000 per item of false information under the Rebate Agreement, or other government actions or claims."
So, even if the CMS lost the documents proving that Mylan was notified of the misclassification, the fact is that according to the regulation - the company is responsible for correctly classifying the drug. Whether or not the CMS notified Mylan is irrelevant. This means that a jury could find Mylan liable for significant penalties on top of the rebates they owe.
Get Out Of Jail Free Letter?
The question of liability in this case is a little unclear. The problem for the DOJ is a letter dated Oct. 23, 1997 from the Medicaid Drug Rebate Program that said:
"Regarding your newly purchased products, EPIPEN and EPIPEN-EZ, product numbers 0301-01, 0302-01, 0303-01 and 0304-01 under labeler number 00268, I have been in contact with Mr. Herb Gerstenzang, FDA in order to determine the Drug Category for you to use when reporting them to us. Because these products are included in a package with a new delivery system, they are listed by the FDA under an NDA (New Drug Application). The products themselves, however, are listed under an ANDA (Abbreviated New Drug Application) because they are very old products and made by many generic drug companies.
After having a discussion with Herb, we determined that, even though the current NDCs of these products (00268-0301 through 0304) are listed under an NDA, it is entirely fitting and proper for you to report them to the Drug Rebate Program with a Drug Category of "N" (Non-innovator, Multiple Source) and be subject to the lowest rebate amount of 11% of quarterly AMP."
Based on this letter, I initially thought that the company was off the hook. Even if the government brought a suit against them, and the jury found that they owed the additional rebates because the classification information given was wrong - there is no way that penalties could apply since the letter is quite explicit and all that Mylan is guilty of is classifying the product as instructed. In an article published by Stat News:
"For its part, Mylan continues to maintain that EpiPen was classified and reported to Medicaid correctly.
A Mylan spokeswoman wrote us that the company has previously stated that EpiPen meets the definition of a non-innovator drug in the Medicaid rebate law. EpiPen has been classified as a non-innovator since long before Mylan acquired the product. Mylan's classification of EpiPen as a non-innovator drug is consistent with longstanding written guidance from the federal government."
But, if Mylan really believes this, then why on earth would they even consider offering anything at all, let alone $465 million if the classification was correct? Think about that for a minute. The only reasonable conclusion is that either Mylan must believe the drug was not properly classified or perhaps legal counsel advised to settle because they believed the drug was not properly classified. I see no other reasonable explanation for the $465 million settlement offer. Do you?
So, this suggests that the letter from the Medicaid Drug Rebate Program somehow no longer applies. Why would that be? It turns out that in 2005, a couple of years before Mylan bought the division of Merck that markets EpiPen, the company that actually manufactures the EpiPen came up with a new device. They received approval for a new patent in December of 2005.
So, a new EpiPen product with a patent expiring in 2025 replaced the 1997 product. The 2005 patent came in quite handy when Mylan used it in court to help prevent Teva from marketing a generic alternative to EpiPen.
4 patents currently protect the current edition of EpiPen. 3 of these patents were approved in 2010, 2011, and 2014. It is quite clear that Mylan was and still is trying its best to protect and extend the EpiPen brand life with multiple patents.
In 2009, EpiPen was once again redesigned. If there is any doubt about just how different the latest version of the EpiPen is from the one that Mylan acquired in 2007, then perhaps a statement from a Mylan spokeswoman, given in an article by NBC News may be of interest:
"As anyone who has used the product knows, the epinephrine auto-injector we have in the market today is substantially different than the one we acquired," said Mylan spokeswoman Lauren Kashtan in statements emailed to NBC News."
In the Washington Post article:
"The pattern of large, biannual price increases for EpiPen began in 2009. In an earnings call that year, Bresch, Mylan's chief executive, told investors that the company would be introducing a new version of EpiPen's auto injector device, one with patent protection that would make it more difficult for a generic competitor to enter...
The month that the company launched the improved product, Mylan boosted the list price of the drug by 20 percent.
'Having a new version of the drug ... you're essentially wiping the slate clean - if any generic company wants to create a generic version, they're going to have to start a lawsuit,' said Jacob Sherkow, an associate professor at New York Law School. 'You get to start the pricing strategy process all over again.' "
The letter also says that the products covered are EpiPen product numbers 0301-01, 0302-01, 0303-01 and 0304-01 under labeler number 00268. According to this FDA document dated May, 2016, on page 9 the product number for the latest version of EpiPen is 49502-500-02. The number 49502 represents the labeler code for Mylan Specialty L.P according to this FDA document.
The letter is quite clear in that the ruling only covers product numbers 0301 - 0304 and does not mention anything about other product numbers that begin with 5. Therefore, technically the letter does not cover the newer EpiPen products since they have different product numbers.
So, if this goes to court, the DOJ can now argue that the Medicaid Drug Rebate Program letter no longer applies since even Mylan has said that the product is significantly different than the one they acquired in 1997 and that they took steps to ensure it would remain that way by preventing other generics from entering the marketplace via significant patented improvements.
The DOJ can also argue that the letter only applies to EpiPen products with the specified product number starting with 03 and does not cover any products with a product number starting with a 5. With this analysis in mind, it is quite understandable why Mylan's legal counsel might suggest settling. For those still in doubt, key questions for the jury are:
- Is it reasonable for a drug company to constantly make changes to a product to extend the exclusive brand life and not be required to reclassify that drug as a brand drug - especially if they use those patents in court to prevent other drug companies from marketing a less costly generic?
- Was it ever the law's intention to give some drug makers a perpetual free pass to pay the generic drug rebate for a brand name drug while the company constantly applies for new patents?
- Doesn't a company have an obligation to at least check with the CMS after obtaining a new patent that extends the drug's exclusive life to determine if the generic classification is correct?
If Merck had checked with the CMS back in 2005 as well as Mylan back in 2009 and followed the government's suggested classification instructions, there would not be a problem today.
If the DOJ presents the jury with these questions and calls the right witnesses to testify, then they should be able to convince the jury that Mylan followed neither the spirit nor the letter of the classification law.
If the DOJ can also show evidence that Mylan was notified multiple times that EpiPen was not properly classified, then that would help cement penalties because now evidence of arrogance and clear disregard for the law can be shown.
But, in this layman's opinion, it is not required. A jury should be able to find Mylan negligent of failing to classify EpiPen as a brand name drug and that penalties are definitely appropriate.
Rebate Amount Owed
If Mylan is required to reclassify EpiPen as a brand name drug from prior years, then the total amount of rebates Mylan owes can be calculated at 23.1 percent of net sales, plus the inflation rebate since they started selling the drug in 2007, minus the amount they have already paid.
So, from 2011 - 2015 the company had net sales of $1,294,716,260 according to Slavitt's letter, which includes both Medicaid and Medicare Part D.
To calculate the rebates, the amount of all combined revenue from EpiPen sales to the government needs to be estimated. From 2011 through 2015, that is provided by Slavitt's letter. For 2016, an estimate of $450 million can be used.
From 2008 - 2010, a reasonable estimate can be made from an article published by the Kaiser Family Foundation (KFF). From 2008 - 2010, the annual amount of spending on Medicare Part D was $8.7 million, $10.8 million, and $13.7 million respectively.
According to Slavitt's letter, the total amount spent from 2011 through 2015 for Medicare Part D was $334,639,684. For Medicaid it was $960,076,576. The ratio of Medicaid to Medicare spending during this time is thus 2.87 to 1.
For 2007, the amount of Medicare spending was $7 million. This is the year that Mylan bought the drug and this was in early October. So, a reasonable estimate of 1/4 of $7 million can be used for that year - which is $1.75 million. Adding up all the amounts spent for Medicare the years 2007 - 2010 yields $34.95 million.
Multiplying this value by 2.87 produces a rough estimate for Medicaid EpiPen spending of $100.31 million. Adding in the figure for Medicare gives $135.26 million. So, the estimate for total government spending for EpiPen Medicare Part D and Medicaid is thus $135.26 million for years 2007 - 2010.
So, the total estimated amount of spending for both Medicare Part D and Medicaid for years 2007 through 2016 is thus:
|For years 2007 - 2010||$135,260,000|
|For years 2011 - 2015||$1,294,716,260|
|For year 2016||$450,000,000|
Thus, if we assume that the 1997 letter did not apply for any years after 2005, then according to Raffat of Evercore and mentioned earlier, the inflation rebate under the program can make the rebates equivalent of up to 100 percent of the average manufacturer's price for drugs that have aggressive price increases.
According to the KFF article, Medicare and Medicaid spending on each EpiPen increased from $71 in 2007 to $466 in 2015 (from Slavitt's letter), or 656%. This is clearly much higher than the inflation rate of roughly 20% over the last 10 years (i.e. prices are now 20% higher than they were 10 years ago). This means that the government is entitled to the vast majority of the $1,879,976,260 that is owed minus the rebates already paid.
The rebates Mylan paid can be inferred from Slavitt's letter:
"From 2011 through 2015, total Medicaid spending on EpiPen was $960 million, increasing from $66 million in 2011 to $365 million in 2015. After rebates, net Medicaid spending over this five-year period was approximately $797 million."
So, it looks like Mylan has already paid $960 million - $797 million = $163 million in rebates. Subtracting this amount from $1,879,976,260 yields $1,716,976,260.
For 2016, Mylan also probably paid a rebate of 13%. So, assuming that was paid on $450 million, that amount would come to $58.5 million. Subtracting this amount from $1,716,976,260 gives $1,658,476,260. So, it looks like Mylan owes just under $1.66 billion for the EpiPen rebates on top of what they have already paid and this amount is before any penalties are applied.
If this goes to trial, one thing a jury will look at is if Mylan has ever incorrectly classified other drugs and failed to pay the proper amount in rebates. According to a DOJ press release in October, 2009, Mylan and UDL, which Mylan acquired in 1996, paid $118 million to resolve underpayment of rebate obligations for more than 15 drugs.
Since Mylan has underpaid Medicare rebates in the past, it will most likely face more severe penalties this time around. At a minimum, treble (triple) damages will most likely apply. That would mean that Mylan would have to pay $4,975,428,780 to settle the allegations. There are also much heavier and more brutal penalties that may apply.
In the underpayments article published by CNBC:
"Mylan's exposure could grow higher if it is found to have violated the False Claims Act, Evercore noted. In addition to the maximum fine of triple damages, or more than $2.1 billion, Mylan could be assessed a fine of $100,000 per instance, or every time it sold an EpiPen through Medicaid.
'If you do $100,000 times the numbers of prescriptions written, then the number goes stupid,' said Umer Raffat, senior analyst at Evercore, who conducted a webinar presentation on Mylan's EpiPen situation Friday morning. 'You're talking about hundreds of billions of dollars.' "
Some articles on the settlement suggest that the false claim act penalty is $5,550 - $11,000 per claim. This is wrong on two accounts. First, the false claim act penalties were almost doubled on August 1, 2016 to a range of $10,781.40 - $21,562.80 per claim.
Second, this section of law does not apply here because there is another agreement that drug companies sign with the social security administration that explicitly covers penalties. This agreement says that the manufacturer can be held liable for $100,000 for each item of false information. Also, there appears to be an additional $50,000 penalty that may be applied for each act.
This means that the total potential amount of liability per prescription sold would be between $100,000 and $150,000. If at least 2 million prescriptions for EpiPen were sold to the government starting in late 2007, then the total amount of potential liability would be between $200 billion - $300 billion under the false claims act.
If a jury came back with a judgment of even $50 billion, then Mylan would be insolvent and forced to file for bankruptcy. Not only would shareholders be left with nothing, so would unsecured bondholders.
The DOJ has never tried to put a company out of business with penalties like this in the past - at least not recently as far as I know. Even if the DOJ and the new administration had the political will to do so, they would have to convince a jury as well as the judge that the penalties were reasonable. They would also have to convince various appellate court judges to uphold that judgment since Mylan would most likely appeal all the way up to the supreme court.
The problem with these gigantic penalties is that the question of reasonableness or letting the punishment fit the crime might not be easy to defend. Just because the law or agreement says massive penalties should apply does not necessarily suggest that they are fair or reasonable and thus constitutional.
For example, it is entirely possible for a city or town to enact legislation to require jaywalkers pay a $50,000 fine, but it is quite doubtful the fine would hold up in court since it is excessive, unfair, and unreasonable. However, if the DOJ does pursue these penalties and they hold up on appeal, then filing for bankruptcy would not let Mylan off the hook since the government is first in line to be paid.
So, it seems at least somewhat unlikely that doomsday penalties will apply in this case. However, if the DOJ believes that additional penalties should be paid, then they are probably resourceful enough to come up with other penalties that are fair and reasonable.
If I were Mylan's legal counsel, I would really hate for a pool of 12 angry jurors to decide this case because of the huge price increases in not only this case, but many other generic drugs as well. Sometimes a jury's decision on liability can be quite unpredictable and rather brutal.
Summary & Conclusion
- CMS claims Mylan underpaid rebates due to misclassifying the EpiPen.
- Mylan claims that EpiPen is properly classified and shows a "Get Out Of Jail Free" letter to prove it.
- Mylan announces an agreement with the DOJ, but the DOJ and the CMS do not confirm and later disavow any agreement.
- Congratulations to those behind Mylan's brilliant offer to settle for less than a tenth of the estimated total potential liability, including likely penalties. This was most likely due to the brilliant insight from Mylan's legal counsel and they probably had a very difficult sell job.
- The "Get Out Of Jail Free Letter" is analyzed and is found to not apply to the newer versions of EpiPen.
- Total potential liability, including quite reasonable treble damages is estimated at close to $5 billion. The penalties could escalate depending on the DOJ's mood, outlook, and political will.
If the payout is in the neighborhood of $5 billion, then it will destroy two years of earnings. This is just the beginning of Mylan's legal woes. There are now at least 20 different class action lawsuits filed against the company.
More importantly, On December 15, the NY Times ran a story with the headline "20 States Accuse Generic Drug Companies of Price Fixing". If Mylan investors are a little nervous about a "paltry" $5 billion payout in this case, then they will be downright terrified of the potential antitrust liability that could involve up to 30 of Mylan's drugs. But, these are topics for a future article.
Strong Sell - based on likely settlements and judgments for multiple sins that will probably result in zero to negative earnings over the next several years.
Other Analysts recommending sell:
- Jefferson Research - I have found their research reports to be quite helpful in the past.
Both research reports are available for free to Fidelity customers from the Research / Stocks menu.
Stock Price Prediction:
Less than $10 per share within 2 years. This could happen much faster depending on how quickly the DOJ and other agencies move.
Disclosure: I am/we are short MYL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This is my first article ever written to recommend selling a stock. I have no business relationship with any other short sellers. I am not a professional short seller and this is the first time in over 10 years I have shorted a stock.