Medco ( MHS) could be on the verge of chasing away a nagging legal headache.

The giant pharmacy benefit manager has signaled a new willingness to settle a six-year-old government probe of its business practices. A court order issued last week says the parties have temporarily abandoned their original schedules -- which had them headed for a 2006 trial -- "to permit settlement discussions" instead.

The federal government has accused Medco of defrauding customers by shorting, changing and canceling their prescriptions. The government has already forced Medco to adopt different business practices -- a move that has hurt the company's margins -- but continues to seek monetary damages that, some believe, could top $1 billion.

For its part, Medco always has denied any wrongdoing while leaving the door open for a fair settlement that would put the litigation behind the company. Medco told on Tuesday that it would not comment on "speculation or rumor" about a possible deal.

Still, at least one Medco critic believes that the company could finally make a move.

"Settlement is in Medco's best interest -- and always has been," says Patrick Burns, a spokesman for Taxpayers Against Fraud. "If the Department of Justice joins a False Claims Act case, the facts are generally very bad. ... All in all, there are over 20 frauds listed (against the company), and the laundry list itself is something Medco does not want a jury to see."

In the meantime, Medco already has lost its highly lucrative contract with the federal government. Medco has essentially portrayed the government's case as a fishing expedition carried out by an overzealous prosecutor. Associate U.S. Attorney James Sheehan, who is leading the government's probe, has developed a reputation for pursuing companies suspected of engaging in health care fraud. The case against Medco is among the biggest of his career.

At times, the legal fight has proven quite contentious. Back in February, for example, presiding Judge Clarence Newcomer threatened Medco with legal sanctions if the company didn't start complying with courtroom deadlines and stop obstructing the discovery process. Newcomer, a longtime federal judge appointed by President Richard M. Nixon in 1971, died this summer.

Little has surfaced about the case since that time. Meanwhile, the company's stock has managed to rise by 45% over the past year. The shares slipped 24 cents to $55.48 on Tuesday but continue to trade within a few dollars of their all-time high.

Changing Its Ways

These days, Medco bills itself as the most transparent of the major PBMs.

By now, all three giant PBMs -- Medco, Caremark ( CMX) and Express Scripts ( ESRX) -- have been accused of secretly pocketing drug rebates and saving their clients less money than they should. Recently, however, Medco has begun offering new contracts that allow clients to see all rebates from manufacturers and keep that money for themselves. It has won some new business, albeit carrying smaller margins than past deals, as a result.

Medco has begun sharing more data with the investment community as well. Importantly, the company now publishes its own "rebate retention rate" -- which keeps dropping -- in its regulatory filings.

Medco CFO JoAnn Reed "stated that this disclosure was initiated in an effort to make Medco's business model more transparent to the public, and that it would become a standard feature of all future quarterly statements," notes Lawrence Abrams, an economist who performs consulting work tied to the PBM industry. But "what she did not say was that the disclosure was part of a $29 million settlement of a suit brought by 20 states alleging improper prescription switching by Medco."

That deal still left the feds asking for some money, however. Medco can now ink a new monetary settlement -- which some believe is happening -- or risk paying triple damages if it loses in court.

Resisting the Trend

Meanwhile, competitor Caremark still faces a multistate probe of its own.

Moreover, the company has been losing some business as well. At least two state groups, including the giant California Public Employees' Retirement System, have recently abandoned Caremark in favor of seemingly more transparent PBMs.

Alan Kellogg, a consultant who helps big organizations negotiate with PBMs, says that Caremark actually walked away from an existing contract covering 300,000 people instead of answering a call for so-called pass-through pricing.

"Everybody is moving toward transparency," says Kellogg, a principal at the consulting firm HealthLinX. "So unless Caremark changes its strategy, I think it could have problems."

Still, PBMs seem to be relying less on manufacturer rebates -- and far more on specialty drug sales -- for their future growth. Following a recent flurry of deals, all three of the major PBMs now operate big specialty pharmacies that supply especially expensive drugs.

Kellogg has already caught one PBM playing games in this high-stakes arena.

The PBM was trying to dispense Imitrex Injectable, a migraine treatment, at specialty rates rather than via traditional mail service billing, he explains. "This increased their reimbursement by 7 points," Kellogg says. "That's quite an increase for no additional work."

The specialty pharmacy business brings in much higher margins than more traditional PBM work. However, Medco at least has portrayed that difference as justified.

"The two business models are very different, with specialty requiring more services and an infrastructure to support these services," Medco's Ann Smith says. "This high-touch, coordination-of-care business model requires higher margins to support the delivery of these additional services."

Smith points to the specialty pharmacy business as a "very important part" of Medco's growth strategy right now. And she believes that business, with its 20%-plus growth rate, will "absolutely" become even more important as time goes by.

Abrams, who has been studying PBM transparency for some time, fears that PBMs will now seek to fatten their profits -- at their customers' expense -- on the drugs that cost the most.

"We've just been catching up with the last conflict," he declares. "And now there's this new one."

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