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by James Love, The American Prospect

For several decades, the pharmaceutical industry has benefited from a combination of government intervention and laissez faire: the federal government provides stringent intellectual property right protections and generous public subsidies for research -- but does not regulate drug prices.

As a result, the United States has been a leader in the development of new drugs, but it also faces the highest drug prices in the world.

Until recently, there has been little public controversy over the pricing of drugs or the terms under which private firms obtain the rights to government-funded research. But as health care costs have soared and policy makers attempt to deal with AIDS and the general crisis of health coverage and cost, the drug companies are coming under increasing scrutiny.

No sooner had Bill Clinton taken office than he began criticizing drug prices. As part of national health care reform, the administration and Congress are considering various proposals to subsidize vaccines and broaden government and private insurance coverage of pharmaceutical products. Measures to expand health care coverage while containing costs would seem to require new attempts to control drug prices.

As part of national health care reform, the administration is rethinking how public interests intersect -- and collide. An important part of this question is how the government manages the transfer of publicly funded drug research and to what extent it regulates private companies that benefit from this transfer. The stakes are enormous.

If the drug companies are to be believed, government attempts to control drug prices would cripple the industry's research and development efforts, slow the pace of innovation, and damage one of the nation's leading high-technology export industries.

But if the government fails to act, the result will be continued inflation of drug prices, often at the expense of patients who can't afford to buy drugs they need, taxpayers who bear costs under Medicaid and Medicare, and consumers who generally face higher insurance premiums.

The federal government funds about 42 percent of all US health care research and development (R&D) expenditures, including a significant portion of R&D costs for new drugs. The government plays a particularly important role in the highest risk research projects, including basic research, where commercial payoffs are least certain. It also pays a significant share of the later stages of drug development.

For example, in the area of federal expenditures on human use clinical trials, a relatively advanced area for drug development, the National Institutes of Health (NIH) will spend an estimated $868.8 million in fiscal year 1993.

The Center for the Study of Responsive Law's Taxpayer Assets Project (TAP) recently studied the role of federal funding in the development of new drugs approved for marketing by the Food and Drug Administration between 1987 and 1991. The results illustrate the degree to which the drug industry relies on government money to develop privately owned products.

While the FDA approves hundreds of drugs every year, the number of new or important drugs is relatively small.

For example, in 1991 the FDA approved 327 new and generic drugs and biologic products. Only 30 approvals were for new molecular entities (NMEs) -- drugs distinctly different in structure from those already on the market.

Only ten of these drugs received a priority rating, which is reserved for drugs that afford a "significant therapeutic gain," treat "severely debilitating or life threatening illness," or treat AIDS. For the group, seven of the ten priority drugs were developed with significant federal funds.

The Taxpayer Assets Project also studied the funding of all cancer drugs that were discovered since the National Cancer Institute's (NCI) new drug program began in 1955 and approved for marketing by the FDA through 1992. Of the 37 cancer drugs, 92 percent, or 34 cancer drugs, were developed with federal funding.

A more surprising finding of the Taxpayer Assets study concerned the pricing of the NMEs that received FDA approval from 1987 to 1991. The median wholesale cost (a completed treatment or a year, whichever was less) was $1,485 for the drugs that were developed without federal funding, and $4,480 for the drugs that were developed with federal funding.

That is, the drugs that were developed with government funding were 3 times as expensive as the drugs developed without government funding. In 1991, the most recent year of the study, drugs developed with federal funding were over 11 times more expensive than drugs developed without federal funding.

Why are drugs developed with government funding so expensive? From the point of view of the drug companies, the answer is why not -- that is, why not charge whatever the market will bear?

The Cost Of Drug Development

Drug companies emphasize the high costs and risks associated with the development of new drugs and argue that these factors justify the policies concerning the transfer of government-funded technology to the private sector.

However, while there is broad recognition that drug development is a risky and costly enterprise, there is considerable controversy over the methods used to "transfer" ownership of government funded technology to the industry.

The most widely quoted estimate for the cost of developing a new drug was a Tufts University study sponsored by the pharmaceutical industry, which pegged the average cost of developing a new drug at $231 million, based on industry data on the costs of clinical trials for 99 new drugs.

The Tufts study's $231 million dollar figure has been widely misinterpreted. The Tufts researchers found that the average inflation-adjusted cost of clinical research was about $20.4 million.

But by including a number of adjustments, including the "dry hole" risks of failures and the opportunity costs of capital (foregone profits) the researchers came up with a figure of approximately $75 million. To get the $231 million figure, the Tufts researchers added $156 million, which they estimated to be the cost of pre-clinical research, adjusted for inflation, the cost of capital, and the risk of failure.

The $156 million for pre-clinical research, however, was not supported by project level data, but was calculated on the basis of very rough aggregated data, using heroic assumptions.

While the industry has used the Tufts study to emphasize the high costs of drug development, it can also be used to argue that the prices for drugs developed with federal funds should be priced much lower than drugs developed without federal funding.

If, for example, the government has funded the pre-clinical research, then two-thirds of the cost of developing a new drug has already been paid for. And if the drug company obtains the rights to the drug after the conclusion of Phase II trials, more than 84 percent of the development costs are already accounted for.

The Tufts study also dramatically illustrates the significance of the point at which a company acquires the technology. Government-funded medical R&D typically focuses on the early stages of a drug's development, when the risks are the highest.

For many drugs, the government has paid for most or all of the pre-clinical research, and it frequently funds the development of the drug all the way through FDA Phase II and Phase III trials. In these cases, which are many, the drug should not be priced as though the firm had borne all the risks and made all the investments.

After all, citizens should not have to pay twice for the development of the drug, first as taxpayers and then as health care consumers.

But current federal policies for managing what drug companies do with government research still reflect the priorities of the Reagan and Bush era agenda, where a commitment to corporate interests often came at the public's expense.

Throughout the 1980s, lawmakers enacted a series of "technology transfer" laws designed to provide incentives for commercial development and to prevent foreign interests from benefiting from US-funded research and development. These laws made it increasingly easy for drug companies to obtain exclusive rights to federal research without being subject to pricing controls. To appreciate how this combination of protection and laissez faire plays out, consider the case of the drug Taxol.

Taxol, an important new oncology drug, may be an effective treatment for breast, lung, and ovarian cancers. Taxol's only approved source is the bark of the Pacific Yew, a rare and slowly maturing tree that is found mostly on federal lands.

Taxol was discovered, manufactured, and tested in humans by NCI over a 30-year period. Early studies on cancer patients were carried out under government grants at a number of universities. By 1991 the federal government had completed Phase II clinical trials on six types of cancer, and had plans to test Taxol on 24 more.

According to Dr. Samuel Broder, Director of NCI, the federal agency was "totally responsible" for the development of Taxol, including the collection of the Yew bark; all biological screening in both cell cultures and animal tumor systems; chemical purification, isolation, and identification; and sponsorship of all clinical trials. Broder has estimated the taxpayers will spend about $35 million on past and future Taxol research.

Rather than allow many firms to develop Taxol competitively, NCI decided to award the rights to a single firm in the form of a CRADA (a Cooperative Research and Development Agreement, a contract between federal agencies and firms outlining the terms of joint research efforts). The notice for the CRADA was published in the Federal Register in August 1989, and firms were given just 45 days to respond, despite the complexity of the CRADA proposal. Four companies responded.

The winning "bidder," was Bristol-Myers, a firm that was particularly well prepared, due largely to the fact that it had hired an NCI official, Dr. Robert Wittes, who had knowledge of the NCI Taxol program. The Bristol-Myers Squibb "bid" was submitted jointly with Hauser Chemical company, the firm that was then under contract to NCI to manufacture Taxol for the government's clinical trials.

The Bristol-Myers/NCI CRADA gave the firm exclusive rights to NCI's government-funded research, including the records of research completed before Bristol-Myers entered the Taxol picture, as well as all "new studies and raw data" from future NCI-funded Taxol research, which NCI agreed to make "available exclusively to Bristol-Myers," so long as the company is "engaged in the commercial development and marketing of Taxol."

The company also received the exclusive rights to harvest the Pacific Yew trees found on federal lands.

In return, the government receives no money or royalties, but only Bristol-Myers Squibb's "best efforts" to commercialize Taxol, including a commitment to supply Taxol for government-run clinical trials, which were needed to obtain FDA marketing approval for the drug, and to an ambiguous "fair pricing" clause for Taxol.

The fair pricing clause is dubious. Prior to the CRADA, NCI had used Hauser Chemical, a private firm, to manufacture Taxol for research purposes. Bristol-Myers Squibb continued to contract with Hauser both to supply the government with approximately 17 kilos of Taxol and to provide Bristol-Myers Squibb Taxol for commercial sales, once the company received FDA marketing approval.

According to Securities and Exchange Commission filings, Hauser agreed to supply Bristol-Myers Squibb with more than 400 kilos of Taxol by August of 1994, subject to FDA marketing approval, for approximately $100 million, or about $.25 per milligram.

The FDA approved Taxol for sale in the United States in December of 1992, and Bristol-Myers Squibb announced a wholesale price of $4.87 per milligram, more than 19 times the cost of the drug from Hauser.

To appreciate the magnitude of the markup, consider that the 400 kilos of Taxol produced by Hauser for $100 million had a wholesale value of $1.94 billion. (The difference between the cost of the drug from Hauser and the wholesale value of the product was greater than the entire cost of all drug company investments in human use clinical trials in 1989, the latest year for which data are available.)

For a patient taking Taxol, who responds to the treatment, the cost of the drug may exceed $10,000 -- while Bristol-Myers Squibb's costs of manufacturing the drug are about $500. Based upon the available data, it is unlikely that BMS spent more than $5 million manufacturing Taxol for NCI sponsored clinical trials prior to receiving FDA approval.

The company has defended its pricing of Taxol by making sweeping assertions of the huge investments that it has made to secure "future supplies" of Taxol or Taxol analogues. But these "investments" appear to consist primarily of "commitments" for long-term contracts, such as the Hauser contract, which are related to obtaining supplies for its commercial sales of Taxol, or to secure alternative sources of Taxol.

Thus while the invention of Taxol was in the public domain, and an important source of the drug was found on public lands, NCI was able to create substantial barriers that would discourage other firms from entering the Taxol market.

The Taxol CRADA also illustrates the lengths to which the government will go to enhance monopoly power in the marketing of new drugs, even when technologies are not patent-able. Taxol sales are expected to exceed $800 million per year, which are large, even by industry standards.

The technology transfer acts of the 1980s have also made it easier for nonprofit institutions doing government-funded research to obtain property rights. Non-government organizations, however, have few incentives to manage R&D property rights in the public interest.

In 1990, 84 percent of the NIH's $7.14 billion R&D budget was used by nonprofit institutions, including $4.18 billion by universities and $1.8 billion by other nonprofit institutions. With billions of dollars at stake, universities and their faculties have pursued the licensing and marketing of new medical technologies, looking only at the potential marketing profits.

According to the National Science Board, academic patents on health and biomedical related inventions have increased particularly rapidly, constituting about 24 percent of all academic patents received in the late 1980s -- double their share a decade ago. There is also considerable speculation that many important federally funded health care inventions are patented privately, by firms with ties to faculty members who want to avoid sharing royalties and licensing fees with their university employers.

There are also substantial problems concerning conflicts of interest. For example, the Scripps Research Institution has had a first right of refusal contract with Johnson & Johnson to commercialize certain chemical and pharmaceutical research, while several members of the Scripps faculty, including the president, have independent consulting agreements with Johnson & Johnson.

The president of Scripps, who must negotiate the royalty and profit-sharing agreements between Johnson & Johnson and Scripps, is on the payroll at both institutions. Scripps has just signed a ten-year contract with Sandoz, the Swiss pharmaceutical firm, which gives this foreign-owned company the rights to commercialize an estimated billion dollars in federal health care research -- a kind of reverse industrial policy.

Pharmaceutical Orphanages

In those cases where academic researchers do publish findings in journals and enter the public domain, pharmaceutical firms are able to obtain seven years of exclusive marketing rights under the provisions of the federal Orphan Drug Act, regardless of whether or not the company contributed to the research that led to the drug's discovery or knowledge of its efficacy in treating particular diseases.

The law, originally enacted to encourage the development of drugs that would be unprofitable due to small markets, has been repeatedly modified to the advantage of pharmaceutical companies.

Today the only condition imposed on companies seeking orphan drug designation is that a drug must serve a client population of under 200,000. But this number is deceptive.

For example, an estimated 6.8 million Americans suffer from cancer, but, a firm can distinguish particular types of cancer for orphan designation. Thus, for example, ovarian cancer, the fifth-leading cause of death among women victims of cancer, has an estimated client population of 164,000, well under the 200,000 limit.

Under the Orphan Drug Act, the FDA has become an ad hoc rival to the Patent and Trademark Office. While that office allocates exclusivity marketing rights to inventors, the FDA awards exclusivity to the first firm that obtains FDA marketing approval. In some instances, one orphan blocks entrance by other drugs that have their own patents and arguably different medical characteristics.

For many drugs, the Orphan Drug Act actually adds a new element of risk to the development process, as it is possible to be barred from marketing a drug with a valid patent. Firms with patents have even been beaten to the punch by firms that don't hold patents, creating cases where the firm that holds the FDA orphan drug exclusivity must license the patent from the firm barred from the market.

The Orphan Drug Act has vastly increased the monopoly pricing power for many drugs, and it has created special challenges for drugs developed with public funds. The first firm to obtain FDA approval to market a drug that can qualify as an orphan is automatically granted marketing exclusivity, regardless of the company's role in the drug's development.

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