When Merck & Co. separates pharmacy-benefits manager Medco into a public company this summer -- ending a nine-year marriage -- investors who buy Medco shares also will pick up some heavy baggage.

According to Medco's recently filed preliminary prospectus, the soon-to-be independent pharmacy-benefits manager will continue to be beholden to its former parent, Merck, even if that becomes detrimental to Medco.

Of course, prospectuses typically warn about a multitude of negative possibilities that may never happen. But in Medco's case, the prospectus lays out the terms of a relationship that appears to hand Medco the short end of the financial stick.

As a pharmacy-benefits manager, or PBM, Medco contracts with large employers and health insurers to administer their prescription-drug plans. Then, combining the buying power of those clients, Medco can extract discounts and rebates from large drug makers, passing on some of those savings to its clients. Among Medco's biggest clients are General Motors, Delta Air Lines and several major Blue Cross and Blue Shield health plans.

During the past several years, every major drug maker who owned a PBM except for Merck, based in Whitehouse Station, N.J., sold it off amid complaints about conflicts of interest voiced by customers as well as federal and other government regulators. The concern: If a PBM is owned by a drug manufacturer, it may be more likely to push its parent company's medications than worry about getting the best prices for its clients. Such conflicts ultimately could cost the PBM customers and drag down its results. So in January, when Merck announced it would spin off its PBM into an independent company, it seemed Medco finally would be able to lose the cloud of suspicion that it had a hidden agenda to push Merck medicines.

But this latest Securities and Exchange Commission filing suggests the cloud isn't going away anytime soon. In fact, according to the prospectus, Medco plans to enter into a five-year contract with Merck that forces Medco to push a certain amount of Merck drugs. "What that tells me is that Merck is still keeping some of its claws in Medco," says Daren Marhula, who covers pharmacy-benefit stocks for U.S. Bancorp Piper Jaffray.

A spokesman for Merck said the company couldn't comment because of its quiet period triggered by the filing.

Merck intends to first offer about 20% of Medco to the public this summer. Within the subsequent 12 months, Merck likely will spin off the rest of the shares to its own shareholders. Analysts are guessing Medco would be valued about $10 billion, thus the initial public offering would raise about $2 billion. A substantial portion of the proceeds from the sale would be used to pay down Merck debt.

It's really no wonder that Merck would try to keep some hold on the PBM. Medco, which managed $30 billion of drug spending for more than 65 million Americans in 2001, is influential when it comes to which medications consumers use. In the filing, Medco finally admits something competitors have suspected for years: "The market share of Merck products under plans we manage or administer has in the aggregate exceeded the market share of Merck products from sales by Merck to other customers."

That could be music to the ears of Medco's competitors, who could end up being the real winners after the spinoff. AdvancePCS, Express Scripts and Caremark Rx, which in aggregate provide pharmacy-benefit services to more than 100 million Americans, have long suggested to potential customers that Medco can't be objective in choosing the best and lowest-priced drugs because of Merck's ownership. So the disclosures in the prospectus are "better than any of those CEOs could have imagined," says Kevin Berg, analyst at First Albany. He says Medco's rivals are likely using the prospectus as part of their marketing materials.

Indeed, certain language in the prospectus plays directly into the fear that Medco has placed Merck's interests in front of those of all others. The agreement with Merck "requires us to use our best efforts to avoid any practices that restrict or discourage use of Merck products and not take any action to prefer other products," the filing says. Of course, the accord makes an exemption "for clear and objective safety reasons or where such actions would have a clear and objective material adverse economic impact on a plan sponsor." But clearly, Merck medicines will be favored.

The penalty for not maintaining a certain level of market share for Merck medications is steep. Not only will Medco not receive discounts and rebates, but it will be required to pay Merck "liquidated damages," which will amount to a "substantial majority of Merck's lost revenues."

Such obligations to one pharmaceutical firm for a PBM -- which has to negotiate expertly with a wide variety of drug makers to get the lowest prices for its clients -- poses problems for other relationships. Medco acknowledges that, under this pact, it "may have to take steps to comply with the agreement that create uncertainties and risks for our business relationships with other pharmaceutical manufacturers and with our clients." In addition, this Merck contract "may reduce our flexibility in negotiating agreements with other pharmaceutical manufacturers or our ability to earn rebates under agreements with them."

More importantly, Medco's deal with Merck appears to be unique, even though the company has said for some time that it negotiates with Merck just as it does with any other drug maker. Instead, the filing discloses that the accord with Merck "contains a number of terms that are not contained in, or are substantially different from comparable provisions of, our agreements with other pharmaceutical manufacturers."

Meanwhile, Medco's spinoff could have other adverse effects, according to the filing. UnitedHealth Group, Medco's largest client, can terminate its contract following the spinoff. Some analysts speculate UnitedHealth, the country's largest health insurer based in Minneapolis, will likely terminate, and run a PBM business in-house, or at the very least negotiate for a better contract, rather than wait until the contract expires in 2005. Medco's revenue from UnitedHealth in 2001 was $4.6 billion, about 16% of Medco's total revenue. A UnitedHealth spokesman says, "We expect our relationship to continue. We have a very good relationship and believe they are doing an excellent job working with us to meet the needs of our clients."

UnitedHealth isn't the only one who could back out this summer. Medco's filing says "a few clients" can terminate their contracts following the spinoff.

Meanwhile, the prospectus doesn't paint a rosy picture of the PBM industry's prospects, even as it opens a window into the sector's secretive rebates and discounts. "Consolidation among drug companies has enabled drug makers to decrease the amount of rebates they offer" to PBMs for peddling their products, it says. "Competitive pressures also have caused Medco and others to share with clients "a larger portion of the rebates received from pharmaceutical manufacturers, increase the discounts offered to clients and reduce the prices charged to clients for services." As a result, the company's gross margins fell to 4.4% in 2001 from 5.5% in 1999.