Good News for the Medical Device Industry

Good News for the Medical Device Industry

By David DuWaldt

October 22, 2008

On February 20, 2008, the United States Supreme Court issued a momentous decision in Riegel v. Medtronic.  This decision represents a major victory for the medical device industry since it provided that medical devices, which are approved under the Food and Drug Administration’s pre-market approval (PMA) process, cannot be subject to a products liability or other personal injury claim under state law.

The Riegel case was decided based on certain language contained within the Medical Device Amendments of 1976 (MDA), which preempt state law claims for damages when a medical device has undergone the PMA process.  While this case does provide relief to manufacturers with respect to those medical devices that did receive pre-market approval from the Food and Drug Administration, it is important to note that medical devices which only meet the “section 510(k) process” (a section of the MDA describing the review process) do not get relief from state law injury claims.  This particular issue has already been decided by the U. S. Supreme Court in the 1996 case of Medtronic v. Lohr, and therefore, distinguishes Lohr from the Riegel case.

So what economic effect might the Riegel case have on medical device manufacturers?  Like so many other questions, this will depend on several factors, including the type of medical devices being manufactured and sold.

The Food and Drug Administration provides for three different classes of medical devices: Class I, Class II, and Class III.  The Riegel case involved a Class III device: a balloon catheter used in connection with a coronary angioplasty procedure.  Class I devices are subject to the lowest level of review by the Food and Drug Administration and include such items as examination gloves and elastic bandages.  Class II devices, such as powered wheelchairs and surgical drapes, rise to a higher level of review relative to Class I devices.  Class III devices are critical for supporting and sustaining human life and include such devices as pacemaker pulse generators and replacement heart valves.  Logically, Class III devices are generally subject to a more rigorous review by the Food and Drug Administration.  Unless an exception is met, a new Class III medical device will be subject to the PMA process.  Due to the Riegel case, manufacturers of medical devices that have been subject to the PMA process will generally have less product liability risk in manufacturing and selling those approved medical devices.

An immediate benefit to the manufacturer of approved devices might include lower premiums paid on products liability insurance coverage.  In addition, a lender might be willing to loan funds at a lower interest rate to a manufacturer of medical devices that have been subject to the PMA process.  And, very importantly, the reduced risk has an effect upon the value of the business model.

Business valuation professionals often refer to matters having to do with the discount rate when utilizing an income approach to value a business.  In a business valuation engagement, the “Ibbotson Build-Up Method” is often used in determining the discount rate.  Under this method, risk premiums are added to the safe rate of return (yield on long-term government bonds) and, ultimately, a discount rate is derived.  Bear in mind that the higher the discount rate, the lower the valuation of the business.  So a higher discount rate suggests a greater business risk to the buyer of the business, which intuitively makes sense.  After all, why buy a business that does not provide an adequate rate of return to compensate for the risk associated with owning such a business?

Under the Ibbotson Build-Up Method, one of the risk premium elements that are added is an amount for “specific company risk.” It stands to reason that, with all other things being equal, a manufacturer of medical devices which is immune to state law personal injury claims has less business risk than a manufacturer of medical devices that can be subject to state law personal injury claims.  Therefore, the manufacturer which is immune to state law personal injury claims would deserve a lower discount rate, and higher valuation result.

Since the Riegel decision by the U.S. Supreme Court was fairly recent, moving forward, it will be interesting to observe the effect of this case on future mergers and acquisitions in the medical device industry.