Medco

(MHS)

has suffered a relapse.

Like other pharmacy benefit managers, Medco took a hit Tuesday over concerns that problems in the broader insurance sector -- which is targeted by New York Attorney General Eliot Spitzer for alleged bid-rigging -- could prove contagious. Most analysts downplayed the exposure for health benefit companies, especially PBMs. But Medco was quietly nursing a fresh wound of its own.

The company recently lost two court motions in a whistleblower lawsuit being carried out by a federal prosecutor known for his tough stand on health care fraud. Jim Sheehan, a high-profile associate U.S. attorney in the Eastern District of Pennsylvania, has accused the company of defrauding federal customers by only partially filling, switching and even destroying their prescriptions. His case last month survived a motion to dismiss by the company.

For its part, Medco focused on the charges that were denied.

"Under court rules, a motion to dismiss requires the court to assume the facts alleged in the complaint are true -- a high legal threshold, which makes even partially successful motions to dismiss rare," Medco spokeswoman Ann Smith says. "This motion is a starting point in what will continue to be a vigorous defense against these charges, and we are pleased with the outcome."

Continuing its fight, Medco recently sought -- but failed -- to obtain courtroom permission to depose federal prosecutors. Medco also found itself unable to block new testimony from a former employee who, prosecutors feel, may have been previously influenced by company attorneys.

Patrick Burns, director of communications for Taxpayers Against Fraud, portrays Medco's recent setbacks as significant. Most notably, he says the court's ruling means that Sheehan will continue to prosecute the case.

Medco had asked to question the U.S. attorney's office about, among other things, its interviews related to the lawsuit. The government argued that Sheehan could wind up disqualified if that happened. The court ultimately sided with the government, saying that Medco is not entitled to the government's "work product and trial strategy."

Burns senses desperation in Medco's approach.

"That ham-fisted maneuver did not work," he says. "Instead, it telegraphed the fear the company has of Associate U.S. Attorney Jim Sheehan. It is a well-placed fear."

Even so, Burns portrayed a second court order as more "fascinating." The federal government won the right to depose former Medco employee Susan Elliott after pointing out that she had changed her testimony after discussions with company lawyers. Smith explained Medco's position on Tuesday.

"A review of the law shows that a privilege absolutely exists between a former employee and counsel for the company regarding communications pertaining to the employee's prior employment," she said.

Looking ahead, however, Burns believes that Elliott's new deposition could prove "quite revealing" and poses real concerns for the company.

But analysts remain unshaken. They said nothing about Medco's legal setbacks as they rushed instead to calm the market about Spitzer-related concerns.

Indeed, at least two analysts pointed to the Sheehan probe as a source of reassurance on Tuesday. They noted that Sheehan has already investigated the company extensively without ever raising price-rigging concerns like those now being voiced by Spitzer. As a result, they felt comfortable downplaying any potential new threat to the sector overall.

"PBMs have been the source of significant scrutiny over the years by a variety of sources," wrote Merrill Lynch analyst Thomas Gallucci. And "while such scrutiny has created share-price volatility in the past, the industry's business practices have not been materially impacted as a result of these examinations so far."

J.P. Morgan analyst Lisa Gill offered a similar view. Both analysts also portrayed Spitzer's probe of

Express Scripts

(ESRX)

, the PBM for New York state employees, as company-specific and apparently unrelated to the bid-rigging investigation.

Gallucci even recommends buying Express Scripts despite that probe. Barclays Capital analyst Koren Volk likes Medco.

Early this month, Volk published a "litigation update" about Medco's exposure. The analyst noted that Medco has already settled a number of state-level probes and calculates any federal penalty at no more than $500 million.

Still, Volk does blame Sheehan's investigation for the loss of Medco's lucrative contract with the federal government. And Burns expects further defeats going forward.

"Jim Sheehan has a habit of winning, and Medco has been playing a series of losing hands in court," Burns says. "It's worth mentioning that the biggest losing hand was played by Medco right at the start -- failing to settle" the case.

The company's stock, which peaked near $38 in May, rose 40 cents at midday Wednesday to $31.20.