Caremark's ( CMX) customers could be opening some unwelcome mail.

Texas prosecutors have started requesting information from Caremark clients as they seek to determine whether the pharmacy benefit manager, or PBM, has engaged in Medicaid fraud. They have already issued a civil investigative demand to at least one major Caremark client -- the city of Austin -- and hope to send out similar letters, without the company's review, going forward.

Caremark has launched a courtroom battle in an effort to keep that from happening. The company submitted the letter that was sent to Austin as an exhibit to support a protective order that would block other letters from going out. The judge has yet to publish a ruling.

In the meantime, however, Caremark did say that the court has asked the government to supply the company with copies of any demand letters sent out to its customers and that it is "satisfied" with that action.

For Caremark, the courtroom saga is the latest part of a sweeping Medicaid fraud investigation that has been building against the company for years. Federal and state prosecutors have accused the PBM of failing to properly reimburse Medicaid -- the so-called "payer of last resort" -- for drugs that should have been covered by the company's clients. The government has estimated damages in the case at $500 million.

Caremark has denied any wrongdoing and insists that it owes the government nothing. Ultimately -- even though Caremark itself rejected the Medicaid claims -- the company's unsuspecting customers could wind up on the hook.

For now, at least, the government seems to have one particular target in mind.

"The city of Austin is not a party to this action," the Texas attorney general stresses in a recent courtroom filing that defends the office's use of civil investigative demands. "The state's action in this case is only against Caremark."

In the meantime, the company's stock continues to perform quite well. Shares of Caremark, while down 19 cents to $49.76 on Friday, have nearly doubled over the past two years.

Special Delivery

By now, Caremark's customers have already started learning about the government's suspicions and have found themselves swept up in the questioning as well.

Austin, for example, fielded a letter explaining that the Texas attorney general has begun "investigating the possibility of unlawful acts" carried out by PBMs that may be failing to properly reimburse the state's Medicaid program. The letter goes on to mention the possibility of "false and inaccurate reporting" about customers who qualify for Medicaid and Caremark benefits alike.

"Such activities may violate the Texas Medicaid Fraud Prevention Act," the civil investigative demand states. "The Office of the Attorney General of Texas has reason to believe you may have information relevant to its investigation and, therefore ... asks that you answer each of the submitted interrogatories and produce all of the requested documents and other information by the deadline set out below."

The Texas prosecutor then asks the city to supply a slew of data about its relationship with Caremark -- including specific details about its contract -- within about one month. PBMs have fiercely protected such information, inviting attacks about transparency, in the past.

Robert Garis, a pharmacy professor at Creighton University who has studied PBMs extensively, welcomes the latest development.

"I am encouraged every time I see either private litigation or government mandates for transparency," Garis says. "Employers have been, unfortunately, somewhat naive. They have tended to trust the PBM industry a little bit too much and have assumed that the PBMs would look out for their best interests."

Garis says that many PBM clients still have no idea that the industry has attracted so much government scrutiny. Thus, he says, he is "quite sure" that the demand letters from Texas -- revealing the Medicaid fraud probe of Caremark -- will come as a surprise to some.

Legal Strategy

Caremark is doing its best to derail the government's case altogether.

Originally, Caremark sought a declaratory judgment in Tennessee upholding the company's ability to reject Medicaid claims due to contract restrictions. That effort failed, but Caremark has since tried to use a single remark in the court's unfavorable decision to its advantage.

After ruling against Caremark and in favor of the government, the judge concluded that "the dispute between the parties is based on a good faith disagreement about a complex area of the law."

Caremark says that it previously believed that Medicaid had to abide by the same contract restrictions as other clients and even cited legal precedents supporting that stand. In turn, prosecutors have argued that Medicaid is entitled -- and even obligated under law -- to recover payments for drugs that should have been covered by third parties such as Caremark.

Caremark claims that it finally went to court in an effort to settle the issue once and for all. In a recent motion to dismiss the government's complaint, Caremark now suggests that it should not be punished under the False Claims Act -- which has resulted in massive penalties for others -- because of confusion about complicated legal matters.

"The government insists that Caremark's failure to accede to its legal position, even at a time when no court had ever supported the government's position, is somehow actionable under the False Claims Act," Caremark's motion states. "There is nothing remotely illegal or fraudulent about Caremark's adherence to the terms of its customers' plans and its reliance on established case law. The government's attempt to characterize Caremark's lawful conduct as a violation of the False Claims Act is entirely spurious and should be rejected by this court."

However, government prosecutors insist that Caremark knew exactly what it was doing when it allegedly set out to defraud Medicaid. Indeed, they allege that the company even designed special "dummy" computer codes that would reject Medicaid claims automatically.

Thus, those involved in the case scoff at the notion that Caremark had no idea it was doing anything wrong. Lawyers representing the Caremark "relator" who first blew the whistle on the company feel that they can prove otherwise.

"We believe the relator's evidence (which was not presented to the Tennessee court) demonstrates that her concerns about Caremark's conduct were voiced early and often and that such concerns were flagrantly disregarded by Caremark during her tenure with the company," says Marlene Martin, a San Antonio attorney helping the government with its case. "The relator looks forward to showing the Texas judge and jury her evidence that Caremark knowingly made false statements to the Medicaid programs and thereby avoided its obligation to pay the government."

In the meantime, Caremark brass continues to sell a load of company stock. This month alone, 10 Caremark insiders -- including senior finance and legal executives -- have carried out big sales. CEO Edwin "Mac" Crawford raked in the most of all through an options transaction, executed just last week, that netted him more than $16.5 million.