Perdix Capital Management
April 10, 2015
Investing in special situations related to patent infringement litigation

Bass IPRs Unlikely to Target Short Term Price Manipulation

On April 7, Kyle Bass and Hayman Capital filed a petition for Inter-Partes Review (IPR) that challenged the validity of a patent owned by a third biotech company, Jazz Pharmaceuticals. The IPR system is a way to review the validity of U.S. patents without going through the district courts. The venue is considered to be favorable for companies challenging patents, and the success rate of invalidation in the process is higher than in district court.
The drug being targeted this time by Bass is Xyrem, a drug used to treat narcolepsy. The drug accounts for 67% of Jazz Pharmaceutical (JAZZ) product sales, and has accounted for the majority in the company’s revenue growth over the last two years.

This follows to Bass’s earlier attacks against Shire (SHPG) drugs Lialda and Gattex on April 1st, and Accorda Therapeutics’ (ACOR) drug Ampyra in February.
Bass’s first attack against Acorda’s Ampyra received significant attention, in part because the value of Acorda’s stock dropped significantly after each of the IPRs that Bass filed. However, we do not believe that the short term price fluctuations related to IPR filings are the primary objective of Bass’s strategy. A review of the four different products that Bass has challenged demonstrate that it is more likely his goal is to earn returns through a portfolio of short positions in companies that are overvalued based on the recent change in patent valuations, and proving that this is the case through the Inter-Partes Review process.

A profile of each target product is provided at the end of this article.

Short-term fluctuations seem minor

The two most recent targets of Bass’s IPRs demonstrate that the initial stock price drop is not likely the purpose of the strategy. Jazz’s stock price, after an initial weak opening, eventually finished the day with a slight gain. Shire’s stock also barely reacted to Bass’ two IPRs, with the price of Shire’s American depository receipts dropping by 1.4% the day after Bass’s after hours filing of two IPRs against Shire’s drugs Gattex and Lialda. These types of movements hardly seem worth the price of filing an IPR, which cost $500,000 or more to fight through completion.
In addition, these minor initial reactions could have been anticipated. Jazz’s patents are already under significant challenge from generic companies, and the market does not appear to view the Bass IPR as a significant new risk. Indeed, some generics have already challenged other patents protecting Xyrem with IPRs. The patent portfolio covering Xyrem includes 19 issued U.S. patents, and the patent that was the subject of Bass’s IPR had an outstanding IPR filed against it in January by Par Pharmaceuticals. Jazz is currently arguing the validity of their patent portfolio in litigation against five different pharmaceutical companies that wish to make a generic version of Xyrem.

Shire is also already facing challenges to its patents covering the drugs targeted by Bass. Those two drugs make up 14% of Shire’s total revenue. The largest of these, Lialda, is facing patent challenges by generic pharmaceutical companies in district court litigation. In Shire’s litigation against Mylan Pharmaceuticals, the court provided a claim construction ruling on the key patent on March 23rd, just a week before Bass filed the IPR petition.

Why third party IPR challenges are so valuable

The value behind Bass’ IPR strategy lies in the fact that a third-party investor can use an IPR to take an activist approach that uses available regulatory mechanisms to demonstrate a company is over-valued. How? Within 12- to 18-months of initiating an IPR, the patents covering the branded pharmaceuticals can be invalidated, significantly impacting years of projected revenue based on exclusivity in the market. This process was not previously available to third-parties. Previously, a brand’s patent was primarily only challenged by the generic drug manufacturers who filed applications for competing generic drugs with the FDA. Those challenges only took place in district court, and they may take years to reach a decision. By contrast, an IPR provides unique facets previously unavailable to third-party investors: (1) shorter time to invalidity than district court (12 - 18 months through IPR process versus approximately 3 years for district court litigation); (2) lower standards of proof for proving invalidity (preponderance-of-the-evidence versus clear-and-convincing evidence), which basically means that proving invalidity in an IPR is easier than district court; and (3) availability to third-parties, not just pharmaceutical companies that have filed applications for generic drugs.

Being a third party also enables Bass to take advantage of opportunities that generic companies fighting a patent litigation may not be in position to take. Under the doctrine of estopple, if a generic drug manufacturer files an IPR against a patent and loses, it loses the ability to bring up these challenges, and any challenge to validity that the drug manufacturer could have brought at the time, in any future litigation. This risk may influence generic manufacturers to pass on certain opportunities to challenge a patent in the IPR process, and instead wait to bring all challenges of the patents at one time in litigation after additional discovery has taken place. However, a third party is not burdened by these risks. Bass can present the most important challenges to any patent in the IPR process; if he loses, he can move on to the next target, minimizing his out-of-pocket risks. By being an independent third party, Bass can make the best arguments in the more favorable IPR venue and also minimize his risk on any one target.

That being said, we do not believe that the generics have colluded with Bass to have him file these IPRs on their behalf. Indeed, the petitions plainly state that the “real-party-in-interest” behind Bass’ IPRs (i.e., those parties who decided to actually file the IPRs, and who controlled and financed their filing) does not include any generics who may otherwise benefit from their filing. If those statements are false, or proved to be false, that could justify dismissal of the IPRs. We have to assume that Bass understands this, and would not take such a risk.

The long game

We believe that it is much more likely that Bass will be active in this space for a significant length of time (barring any legislative changes that prevent this type of activity). If Acorda, Shire and Jazz eventually lose their patent protection on the challenged products, the net impact to these companies’ market capitalizations will be very significant. While Bass may lose some portion of these challenges, and other macro-economic factors may drown out the loss of specific drugs to larger companies like Shire, these risks can be mitigated by Bass by taking a portfolio approach. We anticipate the number of companies targeted by Bass to increase, and the number of challenges per company issued by Bass to increase as well.

We will start to see the potential success for Bass’s strategy within the next four to six months, as the United States Patent and Trademark office decides on institution of this first round of IPRs. The institution decisions determine whether or not Bass’s IPR challenges have enough merit to warrant a proceeding. Success at achieving institution of these initial IPR proceedings will be an important early indicator of the ultimate success of his strategy.

We will be closely following each of these IPR challenges, and considering the merits of each of them within the context of any ongoing patent litigation concerning the target products. Understanding the likely outcome of these proceedings, and the risk that these proceedings have on the market exclusivity of the products the underlying patents cover, are the key to understanding the value of the companies that are the target of these challenges.

Addendum, Targeted Drugs:

Acorda
Market Cap: $1.4 billion
Target Drug: Ampyra
Daily price movement after IPR filing: -9.6%; -4.8%
Target drug revenue: $366 million
Target drug revenue contribution: 91%
U.S. Patents on target drug: 5
Other exclusivity: Orphan Drug, 2017

Shire
Market Cap: $47 billion
Target Drugs: Gattex / Lialda
Daily price movement after IPR filing: -1.4%
Target drug revenue: ~$100 million / $633 million
Target drug revenue contribution: 14%
U.S. Patents on target: 3 / 1
Other exclusivity: Orphan Drug 2019 / None

Jazz
Market Cap: $10 billion
Target Drug: Xyrem
Daily price movement: +0.5%
Target drug revenue: $780 million
Target drug revenue contribution: 67%
U.S. Patents on target: 19
Other exclusivity: None

Disclosure: we are long puts on Acordia Therapeutics. 
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