Odd Lots - Episode 4: Can a Hedge Funder Cut Prescription Drug Costs?

Episode Date: November 30, 2015

(Bloomberg) -- Hedge-fund manager Kyle Bass has a plan that could cut the high cost of prescription drugs in the U.S. -- and make himself a lot of money. The strategy: Take short positions in a number of pharmaceutical companies while also trying to overturn their drug patents in court. Joining hosts Tracy Alloway and Joe Weisenthal to discuss Bass's unusual tactic is Guan Yang, an occasional Bloomberg View contributor who has researched the odd intersection of Wall Street and patent law.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. The Odd Lots podcast is brought to you by ExxonMobil. Energy lives here. Hello and welcome to the newest edition of Odd Lots. I'm Joe Wisenthal, managing editor of Bloomberg Markets and the co-host of What You Miss. And I'm Tracy Allaway, executive editor of Bloomberg Markets. So Tracy, there's been a lot in the news lately about controversies in the pharmaceuticals. industry. It seems like there's another story basically every day. There were politicians blasting the proposed merger of Pfizer and Allergan, basically accusing it of just being a way for Pfizer to pay less in U.S. taxes. And then, of course, there's a lot surrounding specifically pharmaceutical

pricing. Right. We've seen a lot of controversies in pharma stocks recently, especially in companies like touring and Valiant. In Valiant's case, we've actually seen the stock collapse recently on fears that the company is using this sort of shadowy network of pharmacies to get its brand name drugs prescribed more than cheaper generics. Right. And then, of course, there was touring, which got a ton of attention because it has this young CEO, Martin Schrelli, who came off very brash. And also, he acquired a drug and then said he was going to immediately increase the price 50-fold. So obviously, that outraged a ton of people. Indeed. So given all these controversies, there have obviously been a lot of calls for investigations and changes to the laws in order to go after pharmaceutical prices.

But what if the solution isn't with politicians but with hedge funds? Go on. Today we'll be talking about a hedge fund with a very interesting strategy, short pharma companies and then challenge their patents in the courts, in the hope that if their patents get overturned, the stocks eventually collapse. So the basic idea is someone shorts a stock, pharmaceutical stock, shorting. means you bet against the stock, you profit if it goes down. And then the way you make money on that, in this case is you go to court and say, hey, this company, their drug is based on this patent, but we think the patent is invalid. And if the court rules that it is invalid, then presumably

that company's business takes a huge hit and shorting the company works out really well. That's right. Sort of like a reverse patent troll. Yeah, exactly. So that sounds like a really weird strategy, but it also seems incredibly clever. So on that note, we want to bring in our guest, Guan Yang. Guan recently completed his PhD in finance and his research, both finance and intellectual property. He has his doctorate from NYU. So he's perfect to discuss this fascinating trade where we have a marriage of finance and intellectual property. Guan is also a Bloomberg view contributor. So, Guan, did we describe the strategy correct? Is that basically what the idea is? Yeah, that is basically what it is. It used to be that when you wanted to challenge

a patent, you could only do it, you could really only do it in court, and you can only do it if someone had actually sued you for infringing that patent. There wasn't really an effective way for a third party, like a hedge fund manager, to come in and say, I think this patent is invalid, even though we're all in some way affected by drug, high drug prices due to patents. So up until recently, let's say out there I saw that some company had a patent, and I thought it wasn't a valid patent. And we'll get to that in a second, what they it means a valid patent. But up until recently, I couldn't have just gone in suit. I would have needed to be more directly tied to it. Yeah, there was, there were a couple of administrative

procedures you could have done at the patent office, but they weren't very effective. They were expensive and slow, and that wasn't a great way to challenge patents. And so what changed? What was the law that enabled anyone to theoretically challenge a patent? So there was something called the America Invents Act of 2012. It's also called the Leahy Smith Act. And it was a patent reform package that introduced something called Interpartist Review. And it's basically a way to challenge a patent, even if you're not directly involved in infringing it or have been sued by the patent owner. Was the idea behind it to go after patent trolls, which people have been complaining about for a long time? That was definitely part of the idea. But I don't think the, I don't think the

Congress necessarily imagine that you would have hedge fund managers using this process. All right. So talk about specifically, there's this new law. It enables outsiders to challenge a patent. Talk about what does that mean challenge a patent? Why are some patents weak? Why are some patents challengeable? Usually a patent can be challenged because it's obvious. Basically, a patent has to be new. You have to have some new innovation over the existing technology or the state of the art out there. And it also has to be non-obvious. It can't be something that any pharmacist would be able to come up with if you present him with a particular problem. So usually people who are sort of critical of the patent system, nerds like me talk a lot about software patents

and business methods. These are often patents on ways of doing business, but on the internet. And even critics of the patent system often defend at least pharmaceutical patents because it's so obvious that it costs hundreds of millions or billions of dollars to develop these drugs, and you need some kind of incentive to make that investment. So it can be surprising to some people that a lot of drug patents can actually be weak, that there is prior art or some other way that the patent is flawed. How big of a deal is this? I mean, we hear a lot about, you know, we talked about the controversies already in terms of surging prescription drug prices. But if you think about the role that intellectual property and patents play in the

enormous cost that society pays for health care. Is this a significant issue that's worth going after? Drug spending in the U.S. last year was about 10% of total health care spending. So that doesn't sound like that much, except health care spending is pretty high in the United States compared to other countries. And it's also one of the fastest growing parts of... It's about $4 trillion per year? Yes. And prescription drug spending in the U.S. is a bit less than $400 billion, so about 10%. So one person who has decided to go after this particular sector is the manager of the hedge fund we've been alluding to, and that is Kyle Bass. Some people listening to this might already know who he is, but for others, maybe Joe, you could describe exactly who he is?

Yeah, basically, Kyle Bass has been in the news as a hedge fund manager for a long time for various reasons. During the housing crisis, he made a lot of money. He was one of the people that spotted the crash early and bet successfully that there would be a collapse there. He was also very well known for betting unsuccessfully for the most part against Japanese government bonds. He warned that because of high Japanese government debt that Japan could go bankrupt theoretically or of hyperinflation, that didn't work out. But this new strategy he has is what we've been talking about, where he's shorting pharmaceutical. pharmaceutical companies and then challenging their patents. So, Gwan, how did he embark on this path? And what specifically is he doing? He hooked up with a guy named Eric Spanenberg, who has sort of

been on the other side of the patent litigation game. He used to buy up a lot of patents and litigate them. And Spandenberg had identified a number of these pharmaceutical patents that he thought were weak and could be attacked in this way and basically enlisted Kyle Bass's help in taking that strategy to the next level. So Bass shorted or his fun, Hamon, capital shorted, a bunch of these pharma companies, and then petitioned to start interpartist review proceedings. One of the first patents that he went after was for a drug called Ampura, which is a multiple sclerosis drug made by a company called Accorda Therapeutics. It costs about $13,000 per patient per year. And he didn't succeed in that particular challenge,

although he's refiled it with new evidence. But he has succeeded in convincing the patent trademark appeals board to start proceedings against Lealda, which is an inflammatory bowel disease drug, and a couple of drugs that cure multiple or that treat multiple myeloma owned by cell gene. I've given up trying to keep track of every single proceeding, but it's probably about a dozen proceedings that he has out there where he's either trying to get the patent office to start a trial to test this patent, or they've already accepted it and there's going to be a trial at some point. So they are actually embarking on proceedings for some of these drugs. They are listening to Mr. Bass. Yes, definitely. They now, after they decide to institute interpartis

review proceedings, they have a deadline of one year, by which time they have to be done with the trial, basically. There's a few ways to get extensions, but this is much faster, a much faster process than if you had to go into district court and challenge patents. All right, let's take a real quick break for a word from our sponsor. You're listening to the Odd Thoughts podcast. brought to you by ExxonMobil. Energy lives here. We're back here with our guest, Guan Yang, talking about the strategy of shorting drug companies and trying to challenge their patents in court. So you mentioned that Kyle Bass, the hedge funder who's doing this, he hasn't had any outright successful victories yet. But it sounds like

his strategy is to some extent working. Is he making money on his bet so far? Just merely by the fact that he's making these challenges and some of these challenges have been greenlit? It doesn't look like, I don't know when he entered these shorts, but it doesn't look like he's made any huge profits yet. It's still pretty uncertain whether he's going to succeed in these challenges. And it's also uncertain whether even if he manages and validate a couple of patents or a couple of claims of those patents, for some of these drugs at least, they're covered by a whole bunch of patents. So there are a few more steps to actually turn these drugs into generic. that anyone would be able to produce, and that would really affect these drug companies' earnings.

So I'm curious, how has the pharma industry reacted to this? And also, how have patent lawyers and intellectual property rights people reacted as well? My sense is that the patent law profession is kind of split on whether this is a good idea. There are people who are saying that these patents are weak. They should be challenged, and the short-selling profit motive is a good way to do it. some of the, so Seljean, which owns a couple of the patents that he's challenged, has basically made a direct criticism, a direct attack on his strategy before the appeals board. They've said that the Congress, when they created this new interpartist review process, never intended for hedge fund managers, for short sellers to be able to use it, that these are people who don't have a

direct economic interest in the validity of these patents. And so far, at least in a couple of decisions, the appeals board has gone against Seljean and basically validated his overall approach. Are there any other industries that this could be applied to, this idea of challenging companies' patents and then shorting them, or is there something unique about the drug industry that makes this work? There's something unique about the drug industry, and there's also something unique about the particular targets that he's just gone after, because if you think about it, you need a drug with some patents that are actually weak.

If the patents turn out to be valid, he'll just have wasted a bunch of money. And in order to profit from this, you also, So Calabaz is not a generic drug manufacturer, so he can only make money in the financial markets. And he can only profit from the strategy if this particular drug is actually a big part of that pharma company's business. If it's a big sort of diversified pharmaceutical company,

their stock might not go down that much just by losing one drug. So like if he found some weak patent at Pfizer, for example, he could get it overturned, but it probably theoretically. But it wouldn't make a dent in the company. these stock price most likely. Maybe not that big a dent. And Pfizer might also fight back a lot harder than some of these companies. And so this wouldn't necessarily work at, say, software companies where the patent, overturning a patent wouldn't necessarily change the business that much.

I think the big problem with software patents is in large part that there are so many of them that, you know, it's sort of whack-a-mole. You can get one, but then you still have thousands or tens of thousands of other patents owned by people who could sue you. What do we think about the prospect of this strategy actually starting to reduce expensive pharma prices? I think it's hard to imagine that he's going to be able to make a huge dent in pharmaceutical costs, but these costs go up a lot. The statistic I saw was that U.S. pharmaceutical spending went up 13% in last year compared to the year before. And a lot of that growth in spending is due to just a few blockbuster drugs that are really expensive. And if he can take off a few percent

point of that growth, that would make a meaningful difference in the growth of health care spending in the country. Have any other investors done this, or any trying to glom onto his strategy or say, hey, this is smart? Or is it just him as far as you know? As far as I know, it's just him. I think it's in large part because it is kind of a risky strategy. It's hard to know.

He'll probably get a few of these patents invalidated as far as I can tell from people who've written about this, but it's hard to know whether it's actually going to be a profitable strategy. The strategy also seems like it would be kind of easy to free ride. Like once you, you don't, it's like I could short those same companies that he has and let him bear all the research costs and legal costs and all that stuff. Yeah, I think that's the case for a lot of these hedge fund choice strategies. I'm not really sure what the explanation is for why they still exists. So it's so rare that we actually mention these four words in the same sentence together, which would be hedge funds and societal good. But do you think that this is a hedge fund who,

might actually be able to affect some good for society? That's what Kyle Bass claims, at least, the entity that he's put together to challenge these patents is called the Coalition for Affordable Drugs. Oh, who could be against that? All right, so I'm in. And I don't know if he really believes that, you know, obviously he's in it to make money. But I think it's definitely possible that, even if he is sort of cynical about it, that the rest of us could benefit if he's ultimately successful. What about like the bigger picture? I mean, I mean, even outside of this specific strategy, do you think there's a lot of scope for just reducing the cost of the health care industry purely by, I'm trying to think of exactly the word, but just reducing the financialization of health care, just wringing a lot of costs out that people see as ridiculous that aren't really necessary for business models? So I'm not an expert in healthcare economics, but I definitely think there are things that could more that could be done with,

for example, negotiating drug prices centrally, especially in the U.S. And there are other things that could be looked at, not just in terms of patent protection. There's also the FDA gives a certain period of exclusivity between six months and seven years for certain new drugs and for certain generic drugs. And a lot of people who've researched drug prices think that some of those periods could be tweaked, either shortened or lengthen to provide better incentives for drug research. Going back to Kyle Bass for a second, do you think people would feel more comfortable with his strategy if he was sort of doing this out of the goodness of his heart and not necessarily to profit from shorting? You know, he's clearly a rich man. Had he set up this group to go after weak patents out of the goodness of his heart, what do you think the reaction would be then?

I think the reaction would be a lot more positive. I also think that if you had theoretically a nonprofit who had the strategy, that that nonprofit might approach things differently. They wouldn't necessarily just go after targets that both have weak patents and are an obvious short. They might go after Pfizer, for example. Right. Instead of going just after companies that were highly exposed to a small amount of intellectual property, they could actually just go after any weak patents that they saw even if there weren't a direct opportunity to profit in financial markets. The big guys. Yeah.

Let's just say, you know, you've been a long-time critic of a lot of intellectual property. And some people are really radical. They say there really just shouldn't be any patents at all. And all patents are sort of an intervention in the free market that are unnatural. And while I kind of get this argument for some technology, like software, for example, it seems harder to, defend for pharmaceuticals. Could you envision us having a pharmaceutical industry without patents, without intellectual property protection? I think I could. So I'm not as radical as a lot of these critics, of course. But I think the pharmaceutical patents are an area where if you did

abolish patents, you'd have to replace it with something. There would have to be some sort of incentive to spend all these billions of dollars on pharma research. And part of that could be a lot of the funding for health care in general, especially globally, comes from governments anyway. So you could take a lot of that money. And by that you mean just basically in terms of Medicare, Medicaid, all these big government programs that ultimately end up buying the drugs. In addition to basic research in drugs. And you could take a lot of that money and you could spend more money on public financing of drug research. And you could also have more prizes. So if you had a $10 billion prize for the cure to cancer or something, a drug company that meets the

criteria would get that prize, but then the drug would have no patent. It would just be a generic. Well, thank you very much, Guan Yang. That was fascinating. I learned a lot about pharmaceuticals, and thank you for joining us. Thank you. So Tracy, I'm really, I don't know about you, but I'm really fascinated now to see how this trade works out for Kyle Bass. It seems like it could be a fairly revolutionary tactic if he makes a lot of money on this. Yeah, same here. It's definitely one to watch. We'll keep watching Valiant and Turing as well. I'm intrigued by the idea of a world without patents. I'm also intrigued by kind of the entrepreneurship of a trade like this.

I mean, normally when you think of a hedge fund trade, you think of someone looking over financial market data and concluding that something is overvalued or undervalued. But this takes a lot of effort, going to court, and obviously there's science involved in identifying what a weak patent actually looks like. So I kind of admire the moxie that a trade like this requires to execute. Yep. I guess we'll have to wait to find out whether that moxie, pays off. All right, and that's it for today's edition of Oddlots. I'm Joe Wisenthaw. You can follow

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