When attorneys general from two dozen states filed suit in 2010 to block healthcare reform on the grounds that forcing individuals to carry insurance is unconstitutional and that it violates state sovereignty, various legal experts cast doubt on such arguments, and Lord Abbett remained bullish on managed care, generic drugs, and pharmaceutical distributors.

Two years later, the probability that the Court will overturn part or all of the 2,500-page legislative package (alternately called "Obamacare") has increased. Or so the consensus would appear, given the tough questions some of the justices asked during three days of oral arguments last April. From the tenor of those sessions, a number of investors have inferred that the Supreme Court will rule that Congress overstepped its authority to repair a system that consumed nearly 18% of the nation’s gross domestic product (GDP) in 2010. (See Chart 1.)

What happens, though, if the Supreme Court torpedoes one of the biggest pieces of social legislation in American history? Among the most likely consequences: Congress will probably be sent back to the drawing board. Thirty-four million uninsured Americans would be left in the lurch, many of them continuing to rely on exorbitantly priced care from emergency rooms of hospitals that they may never pay for. Billions of dollars that the pharmaceutical and hospital industries have already paid toward the cost of healthcare reform might go down the drain or, at best, be factored into future attempts to reform the system. Already overextended states might have to foot an even higher bill for low-income patients. But the strongest and best-managed providers might still benefit as the federal government, their biggest customer, continues to pay for healthcare via Medicare, Medicaid, and veterans' and children's programs.

In weighing the constitutionality of the ACA, the Supreme Court is expected to zero in on the constitutionality of the so-called individual mandate, which requires most Americans to purchase health insurance by 2014 or face a financial penalty.

One of the additional questions the panel is expected to address is whether the federal Anti-Injunction Act prohibits states and other parties from challenging the individual mandate. If the individual mandate is ruled unconstitutional, the Court would also have to decide whether it can be severed from the Affordable Care Act. The Court will also decide whether Congress overstepped its authority by imposing heavy regulations on states that receive Medicaid funding.¹

Of course, no one can predict for certain how the "court of last resort" will adjudicate a controversial law that has divided the country for more than two years. But in the following discussion, Deepak Khanna, Lord Abbett Partner and Portfolio Manager for Large Cap Value and Multi Cap Value, and Lavina Talukdar and Devesh Karandikar, Lord Abbett Research Analysts for the Domestic Equity Research Team, probe several scenarios.

All or Nothing?
"In my view, either the whole law will be thrown out or the whole law will stay intact," said Khanna. "If the Court throws out the entire system, then the managed care industry would no longer have to pay excise taxes to the government to defray the cost of healthcare reform. Minimum medical loss ratios [which require managed care companies to pay at least 80–85% of their revenues on medical claims or quality improvements] would go away. And companies would start to bring in more money," said Khanna. Should the Court reject only the individual mandate, the economic consequences, political backlash, and risk of chaos would be huge, he added.

"If the Court invalidates the individual mandate and keeps the rest of the law," Khanna continued, "you're going to have uninsured folks who can get insurance if they fall sick [the so-called 'optionality' provision] and the managed care companies cannot deny them." If that happens, managed care premiums [which have already risen under Massachusetts's healthcare reform plan²] will go through the roof because the companies have to compensate for that loss on that individual by raising premiums for others to offset the costs of more sick customers."

While Khanna expects the Court will uphold expansion of Medicaid with more than 46 million Americans living below the poverty line, including a growing number of retirees, he believes the demise of the individual mandate would weaken Obamacare so much that the Court would have to throw out the optionality provision. He also believes the Court would also have to throw out the provision that extends insurance coverage to children up to age 26 if they're still living in their parents' house.

In that scenario, Congress would be faced with reshaping a massive piece of legislation—clearly a daunting task during a presidential election year. After all, it took 18 months to pass the original bill, and that was with a Democrat-majority government. If Republicans win the White House in November and gain seats in the Senate and House of Representatives, the chances of coming up with an alternate healthcare reform package seem remote, especially in light of last year's budget paralysis and impending budget cuts and tax increases (the so-called looming ""). In any event, the risk is that ongoing political rancor will eclipse the original mission of containing healthcare costs. "That was the whole point of this legislative exercise, but nobody is talking about that any more," said Khanna.

Considering the unfathomable repercussions of such a scenario, Khanna believes the probability of the Supreme Court upholding Obamacare in its entirety is greater than either parts of the law surviving or all of the law being thrown out.

Bolstering his view is a recent Wall Street Journal article that described how one pillar of Obamacare—the creation of online state exchanges where individuals and small business can shop for coverage—has put the nation's 29 Republican governors in an awkward position. "A lot of Republican governors like the concept," wrote economics editor David Wessel. "It has been championed as a market-friendly alternative to government-run health insurance, one that would harness market forces to address one of the U.S.'s biggest economic challenges: rising healthcare costs."³

What complicates matters, though, is the fact that those exchanges would also be where individuals sign up for Medicaid or federal subsidies to buy insurance. One expert quoted by the Journal suggested that there would be considerably more exchanges operating today if the exchanges weren't the chosen vehicle to distribute healthcare subsidies. As of late May 2012, 33 states (12 of them with Republican governors) accepted federal grants to build exchanges, but only 13 states and the District of Columbia have exchanges in place. (See Map 1.) If President Obama wins a second term and the ACA is upheld, the federal government will impose its own specifications on states that haven’t set up their own exchanges before January 1, 2014.⁴ "Exchanges are a very practical solution to a problem that needs to be solved," former Utah Republican governor Mike Leavitt told a governors' conference last year.⁵

Given that ringing endorsement and the fact that other Republican governors would like to see competitive pricing on insurance exchanges, Khanna is assuming that the Supreme Court will reject arguments that the ACA has infringed on state sovereignty and ultimately decide to leave the healthcare system the way it is. "That would be in the best interests of everybody, including the states," he said.

Biotechs, Drugs, and Rock 'n' Roll
Since ACA was passed in March 2010, the biotech and pharmaceutical industries have rebated billions of dollars in excise taxes back to Uncle Sam to defray the cost of healthcare reform, anticipating that they would be amply rewarded when 34 million newly insured citizens enter the system.

What happens to all that revenue if the Supreme Court overturns Obamacare in its entirety? Talukdar believes the money would be lost. But with the elimination of such taxes, she estimates earnings per share for pharmaceutical and biotech companies, on average, would likely rise 3–5% going forward.

Some might ask whether those companies could sue to recover funds for a system that barely got off the ground. Don’t count on it. “Taking legal action to claw back those taxes paid would be very difficult,” said Talukdar. “While giving up that much money might seem like a raw deal, taking the federal government to court could backfire politically because health care is going to be an issue for every single [iteration of] Congress. Those industries may just want to use that money as bargaining chips in the next round of negotiations.”

In any event, overturning ACA would reintroduce a cloud of uncertainty that could depress the multiples of biotech and pharma stocks for some time. “You might have a little bit of a relief rally, as if to say, 'Whoopee—free markets!' but that sentiment would likely not last long because policymakers and healthcare providers alike would still have to wrestle with ways to solve the systemic problem we're in. Spending is still growing too fast. People are living far longer than the life expectancy when Medicare was created in 1965. We cannot afford healthcare anymore. So ultimately that question has to be answered.”

In response to the conventional wisdom that the Supreme Court justices would vote along party lines, Talukdar suggested that the panel might put some weight on the enormous economic impact on patients who cannot pay for catastrophic events, such as a car accident, heart attack, or stroke, when they're admitted to the hospital.

"In the United States, we don't turn anyone away, so in essence those folks are free riders, and the more hospitals incur the costs of treating patients who can't pay, the more premiums for people with health insurance go up," said Talukdar. "So I find that a very compelling reason to try and keep this law. I don’t know if it speaks to the constitutionality [of the act], but it could sway any justices who are on the fence to uphold the law given the consequences that out-of-control costs have on the healthcare system as a whole."

Bracing for Volatility
Like a long, complex surgery, the Supreme Court will have to weigh how the removal of one element of ACA will affect other vital elements of healthcare reform.

Suppose the Court overturned just the individual mandate and allowed provisions for community rating (requirements that insurers charge similar rates evenly across the community whereby everyone pays the same rate regardless of age, health status, or claims history) and guaranteed issue (accepting anyone who applies for insurance coverage) to remain. "That would be a negative for health insurers," said Karandikar, who covers managed care companies, "because they would have to take all comers no matter how sick they are, and there would be no offsetting risk pool adjustment. What I mean by that is, when you have the individual mandate, you have the young and healthy that would be subsidizing the older and sicker. And if everyone isn’t required to carry coverage, then you won’t have that offset. That would be the worst-case scenario for managed care and could actually send stocks down."

Of course, whatever the Court decides is likely to roil the markets, but in the longer term, Karandikar believes managed care companies will become integral to saving the system money. "That's because they’ll become what they were intended to be: the gatekeepers—managers of the payment of care—and since they touch all aspects of care, they have a unique view of not just inpatient hospital payments or utilization but also pharmaceutical data, outpatient data, and physician office visits. So I think they'll be very integral to the system in managing costs, and the government will rely on them in the future to save the system money."

While an even stronger managed care industry might trigger fears about the quality of care and patient safety, the emergence of retail health clinics offering a range of services may attract a greater number of poor patients who tend to overcrowd emergency rooms because they're not aware of other primary care options. Wal-Mart, for instance, last year announced it was seeking partners to help it "dramatically lower the cost of health care by becoming the largest provider of primary health care services in the nation."⁶ Meanwhile, more and more hospital procedures are moving to lower-cost, less capital-intensive outpatient facilities.

"Something's got to give," said Talukdar. "Looking ahead, you've got to worry about large cuts to reimbursement of healthcare expenditures, particularly at hospitals, which account for the biggest portion of Medicare expenditures and are already undergoing significant consolidation. As budgetary pressures increase, you also have to worry about hospitals taking more substantial cuts as the years progress."

As the presidential campaign heats up, Massachusetts's experience with comprehensive healthcare reform since 2006 will no doubt figure prominently in debates. Massachusetts now has the lowest rate of uninsured residents in the nation, while the rate of uninsured has continued to rise nationally. (See Chart 2.) But according to the Kaiser Family Foundation, affordability and cost containment remain thorny issues, and while there is pending legislation on provider payment reform, the state will have to make additional changes to comply with the ACA, if it survives.⁷

—Reported by Steve Govoni