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Tuesday
Jan242017

Compliance Alert: China imposes ‘two invoice’ limit on pharma distribution

China announced a new policy this month that aims to reduce corruption and control the price of pharmaceuticals by effectively requiring there to be at most one distributor between the pharmaceutical manufacturer and the end hospital.

The National Health and Family Planning Commission, in coordination with seven other Chinese ministries, issued the Opinions on the Implementation of the Two-Invoice System in Drug Procurement by Public Medical Institutions (for Trial Implementation) (“Two-Invoice Opinions”) on January 9, 2017. Covington’s translation is available here.

The Two-Invoice Opinions, which are focused on reducing both prices and corruption, require that during the distribution process from a manufacturer to the hospital, a total of only two tax-valid invoices, or fapiao, may be issued. One invoice is issued by the manufacturer to its distributor, and another invoice is issued by the distributor to a hospital.

The Opinions contain limited exceptions for exclusive distributors and for intra-company transfers between a distributor and its controlled subsidiaries. In essence, the new Opinions do not contemplate the multi-level distributor/sub-distributor models that many global pharma companies have implemented in China.

(For more about tax invoices (fapiaos) in China, particularly how they can be misused for fraud and corruption, please see our earlier series.)

Under the new Opinions, hospitals must request and check both the invoice issued by the distributor and photocopies of the invoice from the manufacturer.  The practical effect of this requirement should be to both reduce overall prices to hospitals -- by reducing one or more layers of distributors -- and also to give hospitals and regulators visibility over the margins enjoyed by distributors.

The Two-Invoice Opinions, which have been under discussion for several years, are part of a broader package of healthcare reforms announced in late December 2016. The Two-Invoice Opinions are being implemented first in 11 provincial-level areas and 200 pilot cities. Although the Opinions apply only to pharmaceuticals, some provinces reportedly have been implementing similar policies for medical devices. Implementation is currently encouraged but not mandatory in other areas, but a nationwide mandatory rollout is expected in 2018.

The immediate effect of this regulation on pharmaceutical companies in China depends on the sales model. The sales model for some large multinational pharmaceutical companies and their joint ventures in China has been a de facto two-invoices system: from manufacturers to distributors (typically large logistic companies with extensive sales and logistic networks covering broad geographic areas in China), and from distributors to end hospitals.  

The sale price from manufacturers to logistic companies are typically around 95 percent of the final sales prices to hospitals, with the logistic companies earning around a 3-8% margin for the services they provide.  Some companies might also have market penetration in certain remote areas where second-tier (or even third-tier) distributors are necessary. In that case, the Two-Invoice Opinions might require those companies to transact directly with local distributors, which, in our experience, are usually smaller and less likely to be concerned with compliance.

The Two-Invoice Opinions will also impact the large majority of PRC domestic pharmaceutical companies, which have long utilized multiple layers of distribution. One purpose of these multiple layers of distribution is to outsource sales and marketing to local distributors because most domestic pharmaceutical companies do not have the financial resources to have internal sales teams similar to multinational pharmaceutical companies. Under this sales model, drugs go through one or multiple layers of distributors before they are delivered to hospitals, with the prices from manufacturers to the first-tier distributors typically being around 25% of the final sale price to hospitals.

Such multiple layers of distribution have created opacity for manufacturers and significant margins for different layers of distributors that could be used for improper payments to healthcare professionals.  The implementation of the Two-Invoice Opinions to some extent puts some limits on such practice.  

The net effect of this regulation on corruption in the broader pharmaceutical industry in China is not clear. Over the long term, the Two-Invoice Opinions will likely accelerate the trend of centralizing the fragmented distribution environment into a smaller number of large Chinese pharmaceutical distributors, many of which are state-owned or state-controlled, such as Sinopharm, Shanghai Pharmaceuticals, and China Resources. These larger distributors should have more internal resources to deploy, if they choose, to support compliance initiatives.

Over the short and medium term, however, some manufacturers may need to deal with a larger number of distributors to be able to have the same geographic coverage. For pharmaceutical manufacturers seeking to conduct due diligence on their distributors, this may increase (or at least not reduce) the burden on the compliance function over the short to medium term. Over the longer term, assuming consolidation, dealing with a smaller number of larger first-tier distributors is probably a net positive for pharmaceutical manufacturers.

It is not uncommon in China for hospital employees to suggest -- or even seek to designate -- a local distributor as the preferred distributor to that hospital for a given product (or all products), which could raise red flags about improper connections between the local distributor and hospital employees. While the Two-Invoice Opinions would not necessarily eliminate such practices -- the manufacturer could in theory sell directly to the local distributor -- the Opinions should give manufacturers stronger grounds to push back on selling to scores of local distributors that have connections to only one or a few local hospitals.

Finally, the Opinions encourage the use of electronic invoices, which can reduce the incidence of fake and inflated invoices* that can be used for fraud and corruption.

Covington’s longer analysis of the Two-Invoice Opinions is available upon request from the author.

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Eric Carlson, a contributing editor of the FCPA Blog, leads Covington & Burling LLP’s anti-corruption investigations and compliance practice in Asia, with a particular focus on China. He is based in Shanghai, speaks fluent Mandarin and Cantonese, and can be contacted here.