The New Drug War - Pharmaceutical companies need profits to develop new drugs. Patients need pills that they can afford. Their interests are colliding at the Canadian border.

FORTUNE, February 23, 2004
By Roger Parloff

Four years ago, on the frozen prairies of Manitoba, two young pharmacists, working independently, founded a billion-dollar industry. In the process they created a quandary for global health-care policy, a hot-button issue for this year's U.S. presidential race, and a potential diplomatic crisis for Canada and the U.S.

It all started in Minnedosa (pop. 2,426), about two hours west of Winnipeg and three hours north of the North Dakota line—when the roads are passable. Freshly graduated pharmacist Andrew Strempler, then 25, noticed that prices of Nicorette gum were much lower in Canada than in the U.S. So he began selling it to Americans over eBay. (Nicorette does not require a prescription.) Soon he set up a website. Within three months, Strempler recalls, his sales had gone from about one box a week to 150 per day. His distributor informed him that he was selling more Nicorette than any drugstore in Canada.

Bordering On Lunacy

Canada regulates drug prices, keeping brand-name medications 30% to 80% cheaper than they are in the U.S. Americans are buying prescription drugs over the Internet from pharmacies in Canada, effectively importing price controls. U.S. pharmaceutical companies are crying foul, but some politicians want to legalize the practice. Below, five of the cross-border bestsellers. (Prices are for a three-month supply of each drug.)

At just about the same time, Winnipeg pharmacist Daren Jorgenson began selling glucose-monitoring equipment over the Internet. Jorgenson had first checked with U.S. officials to make sure that the sales were legal, which they were. But while making his inquiries, Jorgenson says, he came across a U.S. Food and Drug Administration official, whom he identifies only as "Tom." Tom told Jorgenson that what he really ought to be selling over the Internet was prescription drugs, because that's where the price disparity was greatest—about 30% to 80% on brand-name drugs—and where the demand was most urgent.

"I didn't think I could," says Jorgenson in an interview, alluding to U.S. laws generally forbidding the importation of pharmaceuticals except by manufacturers. But then Tom told him about the FDA's "personal use" policy. Jorgenson understood him to say that Americans were allowed to bring in a small supply of drugs (no more than three months' worth) for their own use.

Unquestionably, for many years busloads of American seniors lucky enough to live near the border have been crossing into Canada to buy cheap drugs with the tacit indulgence of U.S. Customs and the FDA. Nevertheless, the FDA says today that its "personal importation" policy has never actually authorized those bus trips, let alone what Jorgenson was contemplating. (The written policy countenances only noncommercial importation under defined circumstances, such as when drugs are prescribed in another country and equivalent drugs are unavailable in the U.S.)

By March 2000, after consulting with lawyers who could find no Canadian laws against selling prescription drugs to American customers, Jorgenson launched Strempler followed suit with

The business idea worked. Over the next three years, RxNorth's sales multiplied 20-fold, from $3.2 million (all figures are in U.S. dollars) in 2001 to about $70 million in 2003. Stempler's Minnedosa facility now employs about 200 people. "We employ 10% of the population," he says. "The other 90% are unemployable, because they're retired." Though Strempler has a matter-of-fact, understated manner, he wears a gem-studded ring the size of a PDA.

Meanwhile, Jorgenson's CanadaMeds and a second Internet pharmacy he subsequently set up each sold about $70 million last year. Revenue for the whole industry—there are now 64 Internet pharmacies in Manitoba and maybe 75 more scattered across the rest of Canada—was about $800 million in 2003.

Strempler and Jorgenson are two brass knuckles on Adam Smith's invisible hand, which is now battering away at the fragile lattice of geographic price disparities that overlays the global pharmaceutical market. Though that structure evolved for complex reasons, the fundamentals are simple. Most Western nations other than the U.S. regulate the price of prescription drugs, either through direct price controls or through other government-driven cost-containment schemes. In Canada, for instance, a federal board effectively sets ceilings on the prices of patented drugs, while each province exerts further downward pressure by creating formularies and capping reimbursements under its social insurance plan. (It is only brand-name drugs that are cheaper in Canada; generics actually cost less in the U.S. because of greater competition.) Though Canada's regulated prices exceed the manufacturers' rather trivial costs of making the pills, the companies claim that they do not begin to pay for the enormous R&D expenditures necessary to develop an innovative drug in the lab and see it through the years of animal testing and clinical trials needed to gain FDA approval. That process can often take as long as 12 years and cost as much as $802 million per drug that makes it to market, one academic study estimates. The manufacturers maintain that they must recover high returns where they can—i.e., the U.S.—to encourage the R&D that sustains the industry and benefits mankind. Greed might be a factor too.

The pressure is growing daily on U.S. politicians to alter that odd global price structure—in which the rest of the world seems to catch a free ride on the backs of American seniors. Expenditures on retail prescription drugs in America—$162 billion in 2002—now account for 10.5% of the nation's total health-care costs, which, in turn, consume 14.9% of the GDP. Prescription-drug expenditures are the fastest-growing piece of the health-care pie, having risen at a 15.6% annual rate from 2000 to 2002. As Americans live longer, as miracle drugs become an ever more crucial component of health care, as Medicare expands to encompass prescription-drug coverage, and as the baby-boom generation marches toward retirement, prognosticators can agree on only one proposition: Something's got to give.

You'll be hearing more about those issues in the coming weeks too, because Democrats believe President Bush is vulnerable on his pro-industry health-care stances. In the Democratic reply to the State of the Union address, Senator Tom Daschle urged legalization of Canadian drugs—as have all the Democratic presidential candidates.

But it's not just Democrats who are clamoring for legalization. For many of the 43 million Americans—including 40% of all seniors—who have no prescription-drug insurance, Canadian prices are a godsend. These Americans can't afford to heed safety warnings from FDA officials or lectures from economists about R&D incentivization. For them the new, gap-ridden Medicare prescription-drug benefit is unlikely to diminish the allure of Canadian drugs, even once it kicks in, in 2006. (No one knows yet if the government's discount drug card program, which launches in April, will afford greater benefits than existing discount cards, which have failed to deter seniors from exploring the Canadian option.)

More important, seniors aren't the only Americans who have come to see Canadian drugs as a quick fix. Elected state officials of both parties are looking north for relief from their own groaning budget crises. While Canadian Internet pharmacies currently account for a tiny percentage of the U.S. pharmaceutical market, that situation will change quickly if the officials have anything to say about it.

"We pay about $600 million just through Medicaid for pharmaceutical products," says Minnesota attorney general Mike Hatch. "We can save $300 million by using a Canadian-style system. Then add in the state employees—which is huge. We're talking real dollars here." (The Pharmaceutical Research and Manufacturers Association—known as PhRMA—claims that Hatch's savings calculations are outlandishly inflated.) In late January, Minnesota's Republican governor, Tim Pawlenty, added a page to his official website telling Minnesotans how to order drugs from Canada and also recommending specific Canadian Internet pharmacies. Asked in the past about the FDA's safety concerns, Pawlenty has famously responded, "Show me the dead Canadians."

Notwithstanding PhRMA's notorious clout in Washington—the association and its members reportedly spent $139.1 million on lobbying during the first six months of 2003—national policymakers are also sharply split on the legalization issue. To be sure, most pro-corporate conservatives oppose importation, which they see as a way of importing foreign price controls into this country, undermining R&D. That is the view held by, for instance, the Wall Street Journal editorial board, certain American Enterprise Institute commentators, free-market icon Milton Friedman, and Republican Senators Bill Frist and Orrin Hatch.

But many libertarian conservatives come down in favor of legalization, which they see as a way of destroying foreign price controls and finally forcing other nations to shoulder their fair share of R&D costs. How would that happen? They theorize that once the manufacturers realize that they can no longer rely on American consumers to pay for R&D, they'll force Canada and Europe to relax the limits on prices—on pain of cutting off those nations' drug supplies. Partisans of that theory include Cato Institute economists Roger Pilon and Edward Crane, and Republican Congressmen Dan Burton of Indiana, Jeff Flake of Arizona, and Gil Gutknecht of Minnesota. In fact, because Canada is so small a market, Cato types favor importation from other countries as well, including all the European Union countries. As sometimes happens, the libertarians are aligned with liberal Democrats on this issue. The day after President Bush signed the new Medicare law, Senators Daschle and Ted Kennedy each introduced bills that would, among other things, legalize importation from Canada.

What's most troubling about the drug-importation conundrum is that when you survey the chessboard and try to anticipate each player's future moves, most paths seem to lead to cataclysm. As ever more Americans turn to Canada for brand-name drugs, the manufacturers will limit Canada's supply—as at least six have already started doing. If the constriction in Canadian supply cuts off American seniors' lifeline to affordable drugs, state attorneys general may sue manufacturers alleging a collusive boycott—as Minnesota's Hatch is already threatening to do.

Meanwhile, manufacturers will start raising their Canadian prices—as at least four have done. Canadian price regulators will try to block those hikes—as Quebec is now trying to do. If manufacturers can't raise Canadian prices, they'll clamp down further on Canadian supply, creating shortages. If drug shortages threaten Canadians' health, Canada may cease honoring manufacturers' patents. And if Canada stops honoring U.S. patents, the U.S. might bring a complaint against Canada before the World Trade Organization. Or invade.

But we're getting ahead of ourselves.

When he launched CanadaMeds, Jorgenson placed a small ad in the Grand Forks (North Dakota) Herald. "I got a lot of reaction from regulatory bodies," he recalls. "Yours called ours." The Manitoba Pharmaceutical Association was very dubious about what Jorgenson was doing. "Whereas historically the pharmaceutical association inspected once or twice a year, we were getting inspected on a daily basis, seven days a week," he says. "We had search warrants issued against our premises. They took up vanloads of stuff and scoured through it for months and months."

Internet pharmacies raise two obvious regulatory issues, one small and one big. The small one concerns the mechanics of prescription-filling. Jorgenson, Strempler, and all genuine, licensed Canadian pharmacies require U.S. customers to provide short medical histories and to mail or fax a U.S. prescription for each drug sought. But Canadian law bars Canadian pharmacists from filling U.S. prescriptions. So the Internet pharmacies typically fax the U.S. patient's medical history and prescription to a Canadian doctor. The Canadian doctor reviews them, writes a Canadian prescription, and faxes that back to the pharmacy to fill. The problem is that the provincial regulatory bodies for doctors all take the position that it is a substandard practice for doctors to write prescriptions for patients they've never examined. Pharmaceutical regulators, in turn, are reluctant to let pharmacists run businesses predicated on substandard medical practices.

Then there is the bigger issue. Because pharmaceuticals are easy to counterfeit or dilute or sell past their expiration dates or damage through improper storage, Canada and the U.S. each use very similar "closed" systems of regulation. Deploying both federal and local authorities, each country oversees every step in the supply chain as a drug makes its way from manufacturer to wholesaler to retailer to patient. Though the manufacturing plants are often outside either the U.S. or Canada, each country's federal regulators—the FDA and Health Canada's equivalent agency—inspect those facilities and set up paper trails to ensure that the drugs pass through a seamless pipeline from that point forward. Regulators in each country get nervous when the pipeline is breached by an international transaction, since neither country has authority to inspect facilities or subpoena information across the border. Accordingly, the FDA and nearly every U.S. state board of pharmacy has denounced Canadian Internet pharmacies as unsafe; Health Canada has also acknowledged that it cannot guarantee the safety of drugs sent to America.

On the other hand, Health Canada has not tried to shut down the traffic, which it regards as fundamentally a U.S. issue. Moreover, its officials have taken offense at the FDA's sometimes broad-brush denigrations of Canadian pharmacies as a buyer-beware market. "We have no evidence at this time, in the context of Internet pharmacies, that there are unsafe products going to the United States," said assistant deputy health minister Diane Gorman last November, after a tense meeting with FDA commissioner Mark McClellan in Toronto. "It's very clear that Canada's safety record is second to none internationally," she pointedly added.

In fact, the FDA has hyped aspects of the safety threat. The agency periodically performs "blitz" inspections of drug packages entering the U.S. through the mail, for instance, and then reports that alarmingly high percentages of the packages seized—about 87% last November, for instance—contained drugs "unapproved" by the FDA. Photos are displayed of pills wrapped in baggies and bottles labeled in Chinese.

The phrase "unapproved drug" may be a bit misleading. In FDA parlance, a drug is unapproved if it is improperly labeled, and Canadian drugs are, by definition, improperly labeled. A Canadian box of Lipitor may be "unapproved" for no other reason than that it bears a Health Canada identification number instead of an FDA identification number. Canadian drugs also seldom carry precisely the same litany of small-print warnings that the FDA requires. In its public pronouncements the FDA doesn't distinguish between packages sent by licensed Canadian pharmacies—Manitoba's regulators require that return addresses be clearly displayed—and those sent, say, anonymously. The latter could come from any of the many illegitimate operators that advertise by spam, require no prescriptions, and claim to be Canadian but often aren't. Obviously, when people order V1AGR@ or VAL[I]UM from anonymous spammers, Lord knows what they receive in return. Licensed Canadian mail-order pharmacies cannot sell controlled substances like Valium at all. They primarily deal in long-term "maintenance" drugs—Plavix, Lipitor, and the like—rather than drugs that treat acute conditions. They typically send drugs to U.S. customers in the same sealed containers in which the manufacturers originally sent the drugs to Canadian wholesalers. In this respect, containers from licensed Canadian Internet pharmacies are arguably less likely to have counterfeit pills in them than ones from the U.S., where pills are often repackaged multiple times in their trek from the factory.

Notwithstanding serious misgivings, the Manitoba regulators have so far permitted the industry to survive—and, indeed, thrive. But as with many gray-market activities, thriving presents its own perils. If Canadian pharmacies were to begin selling too much of their supply to Americans, they could create shortages for Canadians. At that point Health Canada might abandon its neutrality toward the industry and shut it down—possibly overnight. Consequently, the industry is now divided against itself.

"We need to be prudent and responsible so that we don't jeopardize the drug supply," says Dave MacKay, who represents one side of the schism. He heads the Canadian International Pharmacy Association, or CIPA, a group of about 35 of the largest Internet pharmacies. MacKay supports the creation of websites, like Governor Pawlenty's, that assuage Americans' safety concerns by effectively accrediting legitimate Canadian pharmacies. But MacKay believes that his industry should not start entering into contracts with American municipalities or states. "We just cannot sustain that kind of volume," he says. "It's not a problem for one state. But as soon as one state sets the precedent, it's going to be 20 or 30 states. And if it's California or New York, we're gonna be dead in the water, because there's more Californians than there are Canadians."

But not everyone shares MacKay's commitment to prudence.

When Tony Howard, who runs, picks me up in a slush-encrusted Chevy van at the Detroit Metro airport in mid-January, I am surprised. I had assumed he'd send a chauffeur to take me to his office across the river in Windsor, Ontario. That's because I'd been told that Howard can't enter the U.S. any more for fear of being sued by the FDA—or maybe even arrested.

Howard received two warning letters from the FDA last fall advising him that CanaRx's operations violated the Federal Food, Drug, and Cosmetic Act and "present a significant risk to public health." Nevertheless, it is definitely Howard himself—cheerful, jokey, disheveled, logorrheic, intense—at the wheel. He immediately launches into a monologue without the formality of any questions having been posed. Just before entering the tunnel to Windsor, he stops at the Detroit post office and picks up a handful of prescription orders from a P.O. box he keeps there. He stopped listing this U.S. address on his website after the FDA sent its first warning letter last September, but some of Howard's longtime customers still don't know about the change.

Though he presents like Buddy Hackett, Howard, 54, is a bit of a crusader. He grew up in Windsor but has had homes on both sides of the border and thinks of himself as a North American, he says. About ten years ago, after an early heart attack, he sold his Windsor insurance consulting firm and retired. He and his wife spent much of their time in Florida and Phoenix, and many of the people they befriended were much older. After one asked him to buy drugs for her in Canada, he found out about the enormous price disparities. Outraged by those inequities, he and what are now his partners—his wife, two doctors, and a pharmacist—decided to take action.

They're not in it for the money, Howard claims: "We're all well-off individuals. We want to change the laws, not build an empire." Their goal is to shame the U.S. government into forcing drug companies to lower their American prices. If he succeeds, of course, he'll put the whole Canadian Internet pharmacy industry out of business—including himself. He says he doesn't care. "I've put in all this time without any pay"—he claims to have recovered no profits for himself so far—"to be that one person who can say, 'I was there, and I helped.' It will affect so many Americans."

Accordingly, Howard, who is not a pharmacist, declines to play by MacKay's rules. Howard tries to sign up American towns, cities, states, unions, seniors' groups, and corporations, offering to supply Canadian drugs to their employees, retirees, prisoners—whomever! He has set up a network of Canadian pharmacies—mainly conventional brick-and-mortar types—that have agreed to sell through him at a single low price, which is often even lower than those of the Internet pharmacies. In 2002, Howard sold his house in Florida—"My lawyers told me to divest of all U.S. property," he explains—and in July 2003 he went operational with his first client: Springfield, Mass.

Springfield's then mayor, Michael Albano, had seen the town's prescription-drug bills double since he took office in 1996. When he heard about Howard's operation, he traveled to Windsor and visited several pharmacies in the CanaRx network. In March he tried out the service on his own family and, happy with the results, chose to offer it to all Springfield's municipal employees and retirees. (The program is voluntary, in that nobody has to get his drugs through CanaRx; if an enrollee chooses to, however, the city agrees to cover his or her whole co-pay.) Albano says that about 3,300 Springfielders had used the program by the time his term as mayor expired in December, saving the city about $1 million. (Albano's successor has continued the program.)

Just as MacKay feared, once the Springfield precedent was set, Albano, Howard, and MacKay himself were deluged with inquiries. City officials from Miami, Seattle, Burlington, Vt., Boston, and Brockton, Mass., contacted them, as did state officials from Illinois, Minnesota, Iowa, Wisconsin, Michigan, North Dakota, Utah, West Virginia, New Hampshire, Rhode Island, and, yes, California. Illinois governor Rod Blagojevich's staff published an 85-page study last October setting forth a proposal that it claimed could safely provide Canadian drugs to state employees and retirees while saving the state as much as $56 million a year. He and Minnesota governor Pawlenty are hosting a national governors' summit on the topic in Washington, D.C., on Feb. 24.

So far, most officials have proved more cautious than Albano. Only Montgomery, Ala., and Westchester County, N.Y., are known to have actually followed Springfield's example, though Boston mayor Thomas Menino has vowed to launch a program by July. (Howard claims that he is already doing business with two other U.S. municipalities—as well as with two American unions and five corporations—but declines to name them, saying that they prefer to remain "under the radar.")

Since the arrival of Springfield-style operations, the FDA's rhetoric has grown more bellicose, and the agency has begun suing American intermediaries that try to profit from the trade. Last November the agency shut down Rx Depot—an Oklahoma chain of 85 storefronts that were connecting American seniors to Canadian pharmacies—and in January it sent a warning letter to Expedite-Rx, a Texas intermediary that helps the city of Montgomery get its supply.

Notwithstanding the earlier warnings to CanaRx, Howard's ensconcement across the border appears to be sheltering him. To this point, the FDA has also shied away from the ugly spectacle of suits against American mayors, municipal employees, or retirees—guaranteed PR fiascoes.

With neither Health Canada nor the FDA shutting down the cross-border traffic, pharmaceutical companies have taken matters into their own hands. In January 2003, GlaxoSmithKline's Canadian unit advised distributors that they were contractually barred from selling to pharmacies that resell to U.S. customers, demanded to see their sales records, and warned that violators would be cut off from all future GSK products. Subsequently AstraZeneca, Wyeth, Eli Lilly, Pfizer, and Novartis have taken steps to clamp down on supply. GSK, Lilly, Pfizer, and Bayer have also begun raising their Canadian prices.

In press releases each company has usually stressed the FDA's safety concerns as the driving motivation for making certain that their drugs are not resold to Americans. But professor Richard Epstein, a law and economics professor at the University of Chicago Law School, speculates that the companies are also delivering a different message. The message is addressed to Canada, he says, and goes like this: "Look, this is your population. This is your utilization. We'll sell you enough to satisfy that population. You want to resell to the United States? Kill your own people."

Shortly after GSK began its crackdown, Minnesota attorney general Hatch issued civil subpoenas to the company, stating that he was launching an investigation into a possible collusive boycott by pharmaceutical manufacturers against Canadian pharmacies that sell to U.S. seniors. Hatch says he infers collusion from the close proximity in timing among the six companies' actions, and he claims that such a boycott would violate state antitrust laws.

If the reader is puzzled, so was GSK. Its lawyers protested to a Minnesota judge in October that Hatch's subpoenas were "predicated on the remarkable proposition that actions by GSK ... to prevent the illegal importation of drugs from Canada into the United States can somehow give rise to liability under Minnesota's state antitrust laws." Hatch replies in an interview: "There are court cases that say you can't even boycott an illegal activity." In any event, he maintains, personal-use importation is legal, given the FDA's "long track record of permitting it."

Though Hatch's theories may sound aggressive, he's evidently not the only official propounding them. He's leading a multistate working group of 24 attorneys general focused on the issues, he says. In December the group submitted a letter to the Minnesota court urging enforcement of Hatch's subpoenas to GSK.

Will Hatch go after other drug companies too? "First, we want to get an order in this case," he says. "Probably nanoseconds after that order is issued, there will be [subpoenas] served on the others as well."

Though Strempler of RxNorth says he's been able to fill all his orders despite the supply crackdown, he's feeling the pinch financially. Suppliers that used to send him shipments on credit now require payment up-front, he says, and he has had to beef up inventory to ensure the continuity of his deliveries. MacKay admits that some Canadian pharmacists are even considering connecting their customers to pharmacies in other countries, like New Zealand, should the Canadian supply dry up. He hopes, he says, that CIPA members will be "transparent" with customers if they resort to such measures.

At one level the notion of legalizing the importation of prescription drugs is absurd on its face. If Canada's or any other nation's price regulations are a good idea, we should adopt such regulations here—not go through the Rube Goldberg mechanism of funneling all our drugs through a price-regulated foreign country.

But while importation may be an ideological dodge for some politicians—a way of getting the short-term benefits of price controls without admitting that's what they're doing—it's more than that. For other, more principled and more nervy people, importation is a high-stakes poker game. They hope it will force foreign countries to lift their price controls on pain of losing their drug supplies.

For most people, though, that's not what importation is about either. "It's a manifestation of an anger within the U.S.—almost like a temper tantrum," says Uwe Reinhardt, a health-care economist at Princeton University. "To my mind, the proper solution would be for Congress to make sure that every American has financial access to the drugs that are beneficial to them, through either their own insurance or subsidized insurance. And once that has been achieved, you can then talk about what prices for drugs should be paid."

But the second step turns out to be exceedingly difficult, he acknowledges, especially for those patented drugs that have unique and indispensable therapeutic benefits. For such drugs, he observes, "the drug manufacturers can in theory charge whatever the hell they like."

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