Merck's

(MRK) - Get Report

withdrawn painkiller, Vioxx, could soon leave pharmacy benefit manager (PBM)

Medco

(MHS)

with its own headaches.

Government officials have already accused Medco -- a former Merck subsidiary that was spun off to shareholders in August of 2003 -- of improperly favoring Merck brands like Vioxx and Zocor, a cholesterol treatment. They claim that Medco often switched patients from cheaper and potentially more appropriate drugs to Merck brands that generated lucrative rebates for the PBM. And they clearly suggest that Medco may have placed customers at risk in the process.

"The primary reason Medco Health switches drugs is to enhance its revenue regardless of health plan costs -- or of any potential adverse or life-threatening clinical outcomes to patients associated with the switch," states a pending federal lawsuit against the company.

Medco has denied the government's allegations. Moreover, prosecutors have never singled out Vioxx as a potentially unsafe drug. They filed their whistleblower complaint well before Merck decided this fall to pull Vioxx, following a study showing that the drug increased the risk of heart attacks and strokes in some patients.

Still, concerns about Vioxx have been floating around for years. And Medco was still part of Merck for much of that time.

"Did Medco know what Merck knew?" asks Mark Kleiman, a California lawyer who is monitoring the federal case against Medco. "I don't know. ...

But there is a lot of evidence that Merck and Medco worked hand in glove."

For its part, Merck claims that it withdrew Vioxx as soon as it realized its dangers. Meanwhile, Medco notes that it was hardly alone in distributing the popular painkiller.

"Vioxx was a medicine that was on the preferred formularies of literally scores of PBMs and health care companies," says Medco spokeswoman Ann Smith. "Medco dispenses

Food and Drug Administration-approved medications prescribed by physicians -- and we are very accurate and efficient at what we do."

Smith's comments came on the same day that the FDA fielded harsh criticism from one of its own. David Graham, a veteran executive at the agency, warned Thursday about the agency's lax handling of the pharmaceutical industry -- and of Vioxx risks in particular -- during a special Senate hearing.

"I would argue the FDA, as currently configured, is incapable of protecting America against another Vioxx," he stated. "We are virtually defenseless."

Merck's stock slid 19 cents to $28.88 on Thursday, while Medco fell 49 cents to $38.47.

Daring Duo

Critics have raised concerns about both companies since they originally joined forces more than a decade ago. In a groundbreaking deal for the industry, Merck agreed in 1993 to pay $6 billion for Medco so that Merck could distribute -- as well as manufacture -- prescription medications. Drug analysts applauded the deal. But some PBM insiders immediately warned of conflicts.

"You could have a situation where Medco becomes a warehouse full of Merck products," Henry Blissenbach, president of competing Diversified Pharmaceutical Services, told the

Wall Street Journal

upon news of the deal.

Blissenbach went on to question whether Medco would evolve into "just a distribution arm" of Merck. Whistleblower lawsuits, focused in part on Medco's relationship with Merck, eventually followed. Under fire, the two companies finally parted ways last year.

But their separation agreement came with strings attached.

"Under the terms of the IPO,"

Business Week

reported in mid-2002, "if Medco doesn't sell enough Merck products through the benefits plans it manages, it will have to pay the drug maker damages."

By then, it seems, Medco was more accustomed to collecting money from Merck and other drug manufactures instead. During the late 1990s, the PBM scored more than $3 billion in manufacturer rebates for promoting certain drugs, according to court documents cited by

The New York Times

before last year's spinoff.

The company "promoted Merck's own drugs especially vigorously," the

Times

documents stated. It favored, among others, "the Vioxx analgesic of Merck ahead of Celebrex from Pharmacia," the documents added.

Celebrex, a

Pfizer

(PFE) - Get Report

drug that chemically resembles Vioxx, hasn't been linked to serious cardiac risks.

Scary Tune

In June 2003, two months before the Medco IPO, federal prosecutors officially stepped in and joined the whistleblower lawsuits against the company. They accused Medco of improperly switching patients to Merck drugs in one of their original nine charges against the company. They have since specifically mentioned Vioxx as a favored Merck drug in a fuller amended complaint.

They also described how Medco allegedly carried out its strategy.

"To increase drug-switching success rates, Medco Health pressures employees and pharmacists working in the managed care department to obtain switches of drugs, and requires employees and pharmacists to meet a quota of calls to physicians and others each hour," the complaint states. "If employees fail to meet the quota, they are subject to disciplinary action and employment review."

In addition, the lawsuit says, Medco routinely ignores complaints from patients and their physicians, "including the health risks associated with inappropriate drug switches." It also claims that Medco pocketed $440 million -- in 2001 alone -- for favoring Merck drugs.

By then, some believe, Merck could -- or at least should -- have known about Vioxx's dangers.

"The unacceptable cardiovascular risks of Vioxx were evident as early as 2000," Richard Horton, editor of the British journal

The Lancet

, wrote on Thursday. Merck defended itself, saying it had acted responsibly.

Meanwhile, Medco has portrayed itself as essentially immune to its former parent's headaches. The company promptly issued a press release predicting "no financial impact due to Vioxx" on the very day that Merck yanked the drug. The company said it would simply use therapeutic alternatives to replace lost Vioxx sales.

But some still worry about Medco's legal exposure. Granted, most agree that Merck will bear most -- if not all -- of any lawsuit damages. But Kleiman, for one, suggests that Medco may not get off scot-free.

"This would matter from the federal prosecutors' perspective," he said. "Secretly switching people to drugs that may poison them ... is not the kind of behavior they really want to tolerate."

Fresh Peace

To be fair, however, Medco has already put some of its regulatory problems behind it. Earlier this year, Medco paid $29 million to settle allegations lodged against the company by 20 states. As part of that deal, the company also agreed to disclose "material differences in side effects between prescribed drugs and proposed drugs."

State prosecutors were quick to applaud the new arrangement.

"This settlement is important," Massachusetts Attorney General Tom Reilly said, "because it establishes standards that will protect patient safety and also ensures that health plans and patients really save money from PBM-managed switches."

Earlier this week, Medco won praise from another attorney general after following through with the monetary portion of its settlement in that state. Florida Attorney General Charlie Crist described Medco as a "good corporate citizen" for arranging to provide $2.3 million worth of drugs to the state's needy, the

Miami Herald

reported.

The same attorney general tried, but failed, to intervene in a separate whistleblower complaint against competing PBM

Caremark

(CMX)

. He left some critics convinced that he was less interested in protecting Florida citizens than in protecting Caremark itself.

Michael Leonard, the Chicago attorney who continues to control the Caremark case, criticized Crist for praising Medco when the company remains accused by federal prosecutors of "fraud on a massive basis."

"That's not just a mixed message," he said. "That's a horrible message."