What the Avandia ruling means for Big Pharma

FORTUNE -- In a widely-anticipated ruling, a panel of experts will decide Wednesday whether or not to recommend that the FDA pull GlaxoSmithKline's blockbuster diabetes drug Avandia off the market in the United States.

But the final decision will have less of an impact on GlaxoSmithKline than it will on certain parts of the drug industry. This decision is a checkpoint for the FDA, and drug manufacturers are looking for clues about how it's going to regulate in the future. This is also the first major drug safety ruling by the agency under the Obama administration.

The panel is a group of 33 external experts who've met for two days, starting Tuesday, to discuss Avandia's safety. If the FDA decides to leave the drug on the market, it could still require GlaxoSmithKline to add more labeling to the drug's bottles or create programs to monitor patients already taking Avandia.

(Update: The majority of the FDA advisory panel voted to keep Avandia on the market in some form. Twelve members voted to pull the drug, ten voted to keep it on the market with revised labels and possible sales restrictions, and seven voted to add warnings and three people voted to leave the drug on the market as is. The FDA will issue it's decision in the coming months. The regulator doesn't have to follow the advice of an advisory panel, but historically, it has.)

Whatever happens, it will be the FDA's decision. And it matters, either way, to people making or investing in diabetes drugs, as more and more people need treatment. Diabetes global health-care costs for 2010 are $376 billion, according to the International Diabetes Federation. That number is predicted to grow to $490 billion by 2030.

Why it matters

If the drug gets pulled, investors will have to rethink the risks that come along with this kind of pharmaceutical. Avandia has been a blockbuster drug since it came to market in 1999, and it earned GlaxoSmithKline (GSK) $1.1 billion in revenue last year. But that's only about a third of what the drug was earning before the first FDA panel met to review Avandia in 2007.

"From an investing point of view, you're thinking 'Hey my drug's approved, in eight years is it going to be pulled off the market?'" says Les Funtleyder, a health-care analyst at industrial trading firm Miller Tabak + Co. Other pharma companies that make blockbuster diabetes drugs include Takeda (TKPHF), Novo Nordisk (NVO), and Eli Lilly (LLY, Fortune 500).

If Avandia stays on the market, the FDA will have to outline the protocol for keeping a controversial diabetes drug on the shelves. No one is questioning whether Avandia increases a patient's risk of heart disease -- it does. The question is whether it increases that risk more than Actos, another drug in the same class. If not, the FDA will have to decide if it's worth it to leave Avandia on the market if there's even a question of safety.

"At a certain point, the FDA just has to say, 'We just have to cut our losses and move on, it's taking too many resources'," says Seamus Fernandez, the managing director of pharmaceuticals at the investment bank Leerink Swann.

It's more difficult now to yank an approved drug than to reject a drug for approval. The FDA needs to improve its system for monitoring drugs that have already hit the market, says Funtleyder. If that happens, drug companies and investors will need to prepare for more post-market scrutiny.

The FDA is becoming more conservative about drug approval because it's being held more accountable, says Fernandez. "It's going to be difficult for the agency to get more conservative than it is today."

Avandia's sketchy past

Avandia has been controversial from the start. It was approved in 1999, the same year that the FDA approved a similar drug called Actos, made by Takeda Pharmaceuticals. The FDA flagged both drugs to be monitored for causing heart problems in patients.

In 2006, GlaxoSmithKline reported to the FDA on the safety of Avandia. A well-known cardiologist named Steven Nissen looked over the data and found it faulty. He and his colleague Kathy Wolinsky published a paper in the New England Journal of Medicine, saying that patients taking Avandia were at a significantly greater risk of heart failure than patients using Actos.

In 2007 the FDA called the first Avandia advisory panel. It stayed on the market, but the FDA required drug bottle labels explaining the greater risk of heart failure and guidelines for patients.

In 2009 the FDA received further reports questioning the panel's 2007 conclusion. Evidence also came out during the first day of the panel on Tuesday suggesting that GlaxoSmithKline knew Avandia was more dangerous than Actos, and withheld the data.

"One thing is abundantly clear," says Fernandez, "this is not the definitive study that GSK claimed that it might be."

But it's unclear if this will affect the FDA's ruling. In a pre-briefing call, FDA principal deputy commissioner Joshua Sharfstein said, "this is a meeting about the safety of the medication. It's not a meeting about whether the company acted appropriately." In other words, hiding data is bad, but it could still be difficult to prove that Avandia directly causes more health risks for high-risk patients.

The worst-case scenario for GlaxoSmithKline is that Avandia will be pulled because of safety issues. This could open the company up for more litigation down the road, according to Damien Conover, an analyst at Morningstar. It's already paid $460 million to handle most of the roughly 13,000 suits filed against the company. It had budgeted to pay more.

But overall, the company will probably be fine. Avandia contributes just over 2% of its revenue, and the drug loses its patent in about a year. "The real damage to that drug has been done in 2007," says Conover. Investors have had plenty of time to prepare.

But the case, at this point, is much bigger than the drug.