Written by Wendy Li and Christopher Sindik
The Chinese government has changed the way medical devices and drugs are sold to hospitals, clinics and state-sponsored medical offices. These changes are already in effect in many parts of the country and by 2018 the rules, entitled “Trial Opinion on the Implementation of two-invoice system in Public Medical Institutions’ Drug Procurement” or the “two-invoice system” will be enacted across the entire country.
On 9 January 2017, a notice was issued by the National Health and Family Planning Commission and seven other Chinese ministries establishing the new two-invoice system. This system initial starts with a trial phase in 11 provinces starting in early 2017 with a coverage of more than 200 cities. The provinces participating in the trial are:
This fundamentally changes the way that health care and pharmaceutical companies sell in China
The new law aims to remove layers and therefore cuts distribution costs that are passed on to hospitals and buying entities which are mainly government supported. The process without the two-invoice system to get medicine and medical devices into China and into the hands of doctors and patients is somewhat complex with many layers of distributors and middlemen. The chain can often involve a half a dozen or more transactions between the initial import of the supplies to the final end-users. As the medical supplies pass through each link in the distribution chain, there is a slight profit made by that intermediary. The thinking is that the more transactions in the process, the higher the price; reduce the number of links and reduce the cost. The public and government are aware that these extra transactions in the distribution process were leading to higher medical prices. The government heavily supports the health care system in China and the impact of the high costs were felt by those that introduced the new two-invoice system.
The public has been critical of health care costs, conditions of hospitals and the speed and availability of medical supplies and services. Costs and demands for health care are increasing dramatically as China is struggling to handle a growing elderly population and an uptick in the birth rate with the repeal of the one-child policy.
Under the new system, the model is to have the manufacturer send their products to a distributor and then it goes directly to the hospital or health clinic. A simple process on its face but one that substantially changes the day-to-day activities of getting products into the marketplace. This simplification of the process, ironically, is going to make activities very complex for companies in the short-term as they change their distribution models.
One of the hopes of regulators is to reduce the possibility of bribery and corruption by reducing the amount of times money changes hands and the individuals involved. The goal of the system is to clean up the complex, multi-tiered distribution chain that is ripe for fraud, money laundering and corruption.
Those who want to stay viable in China are likely to increase their direct interactions with government officials meaning they will face additional compliance risks. The risks of dealing with the state-owned entities, interacting with government officials and health care professionals (HCPs) is certainly already on the radar of those in the health care industry. However, this new law shortens the distribution chain dramatically which brings manufacturers much closer to the government.
Some of the responsibilities of the distribution chain that are eliminated will either be repositioned to the companies themselves or placed with the remaining distributors. The existing employees that work with the government directly will be given more responsibility and other employees will be tasked with an increase workload if more of the process is brought in-house. This means more training and oversight, not only of employees, but of the third parties as their responsibilities are increased.
A clear understanding of this two-invoice system and its impact on the industry will provide you some ideas on how to best respond to this reform, stay compliant and manage new or heightened risks with your existing or future partners.
Two-invoice system and special provisions
Literally, “two-invoice system” refers to two-layer distributions, meaning that only two invoices can be issued throughout the entire transaction from manufacturer to end user. However, there are some exceptions to the laws that may allow for additional invoices and steps in the process. Some special provisions are important to note including:
- General distributors of foreign pharmaceutical manufacturers in China are treated as manufacturers, but the limitation is that one drug should only have one general distributor
- Drug allocation is allowed within groups and will not be considered as one of the two invoices
- An additional layer of distribution is afforded to transactions involving remote township-level and village-level medical institutions
- Exemptions can be made for emergency situations, such as outbreak of natural disaster, epidemic situations, etc.
- Distribution of narcotic drugs and psychotropic drugs of category I will follow existing regulations
These exceptions are should be considered as impacted companies examine the changes that they will make to their distribution networks. As the two-invoice system is in its pilot phase, companies have a grace period to adjust their distribution models and partnerships. No doubt some of those in the distribution chain now will not be there after changes are made. This is not going to be an easy change for many international distributors, cutting out the middleman can lead to increased pressure and competition amongst these companies and the possibility of misconduct to meet business objectives.
As new third parties enter and leave the distribution chain, it is important to look at the vetting process and identify what the high-risk targets are and how to remediate the risks presented. There have been several high-profile cases of companies paying fines for bribery and corruption, especially in the healthcare and pharmaceutical sector. While the two-invoice system aims to provide many benefits to end-users, it introduces another element of uncertainty for companies.
The consequences for non-compliance with the new system can be severe as companies that disobey the guidelines can be barred from working with the government in the future by being excluded from the tender processes. As the vast majority of medical products and drugs flow through government-owned clinics, exclusion would be devastating for companies.
What healthcare and medical device companies need to do:
- Know your distribution chain – Are the companies state-owned entities? What percent of that company is owned by the government? How do the vetting and ongoing monitoring processes change when dealing with these third parties?
- Understand the Acts Special Provisions – Do you qualify for an exemption? Are you servicing remote township-level and village-level medical institutions where an extra invoice in allowed? Are you distributing your products currently with the assumption that you are owed and excempt?
- Educate employees – Those employed in the pilot regions need to understand the new law, its intricacies, and how it may change their day to day interactions. For unaffected regions, the time to ramp up education is now so that your company can hit the ground running when the two-invoice system goes live there.
- Introduce controls and monitoring – Make sure that your company can ensure, beyond a doubt, that there are no more than two invoices in the process. This can mean close communications across groups and visibility into the movement of products across China.
Business impact from two-invoice system
From the perspective of the pharmaceutical industry in China, large-sized distribution companies or groups could be the initial beneficiary of two-invoice system.
In 2015, the Ministry of Commerce indicated that there were 13,508 medicine wholesale companies in China, 4,981 retail chains with 204,895 drugstores, and 243,162 retail pharmacies.
Of the medicine wholesale companies, the top 10 took 46.9% market share and the top 50 shared 63.1%. In 2015, the top three distribution companies have their respective sales revenue exceeded one hundred billion yuan (US$14.5 billion). Large-sized distribution companies are adjusting their business strategies and accelerating steps to extend distribution coverage and logistics capacities across the nation.
What will happen to companies that are cut out of the distribution process? Is there another way of existence for them rather than closing down shop? Apart from distribution, they also play a role in product marketing, promotions and sales support. When these functions are cut off, some of them will choose to transform themselves into contract sales organisations (CSO), who will receive separate marketing tasks, such as market surveying, arranging academic events, providing promotions or consulting services to earn fees from pharmaceutical companies. With the growing demands in professional sales and marketing in the pharmaceutical industry, more CSOs will emerge in China, which are expected to understand regulatory changes and be rich in resources.
Business impact on foreign pharmaceutical manufacturers
The simplified distribution chain could, to some extent, reduce corruption and increase drug price transparency, however, the reality is that most large pharmaceutical distributors in China are state-owned entities.
Considering the history of misconduct of some distributors, along with their growing influence in the centralization of fragmented distribution networks, there is little doubt that conflict of interest, channel stuffing, and corruption risks will continue. In addition, more CSOs may emerge and be employed so companies are encouraged to have increased oversight for those companies that aren’t directly involved in either of the two invoices produced in distribution but are supporting those efforts in the form of marketing, sponsorships, interactions with HCPs or other promotional activities. The risks that are reduced from distributions might not be necessarily eliminated entirely but, instead, transferred to other companies that try to influence the procurement process with marketing and sales-support activities.
Due diligence is an effective way to review a potential distributor or CSO compliance programme. Furthermore, an on-going monitoring and periodical compliance audit will be helpful to provide assurance that the business partners are adhering to your compliance standards.
Selling drugs and medical devices in China is no longer ‘business as usual’ and companies need to adjust their compliance programmes, distributions models, and relationships with third parties to comply and stay competitive.
What should companies do from a compliance perspective?
The answer is different depending on the existing processes, controls and policies that are in place at the company now. For companies that already have an effective and robust compliance programme, they need to mainly focus on proactive measures to vet their business partners as well as training for employees and third parties on the new processes to ensure compliance.
However, if a company has little in place now to ensure compliance in the distribution chain, there are several activities that need to be undertaken:
- In-depth due diligence: The combination of risk factors (government interactions, high risk industry, new laws, third parties, history of compliance failures) means that companies need a robust picture of their distributors and their relationship to government officials. Don’t skimp on this aspect of your compliance programme. Pick a due diligence provider that has extensive experience in China, local capabilities and knowledge of the laws and regulations.
- On-site compliance audits: Make sure that your third parties are abiding by your policies are doing work in a legal way. This is not only an opportunity to ensure that your partner is compliant with the two-invoice system but also a chance to create a deeper relationship.
- Live or online training: Some people doing work in China for your company might not know the details of the two-invoice system or even its existence. Be proactive about education so that issues can be prevented. This training can be for company employees as well as third parties.
- Technology to manage your third parties and the information about them: If misconduct does occur, an audit trail is key to proving that your company did the right thing. Companies should be able to quickly tell when a supplier came on board, how they were vetted, issues that were remediated and any documents or responses provided by the third party. For companies using thousands of third parties, this solution becomes even more critical.
Depending on the maturity and established system at the company, one or all of these possible tactics should be utilised.
Many of the changes need to be from individuals outside of the compliance department that directly work on the distribution of goods. However, compliance needs a seat at the table to look at changing risk profiles and controls to ensure that company policies and laws are being followed.
Changing the way that products are distributed and the third parties involved will have a major impact on the direct and indirect risks faced by companies. Historically, some of the factors that cause a relationship to be high risk can include:
- Involvement of third parties in a transaction
- Interactions with the government
- Changes to the distribution model
- High risk industry that is highly regulated
- History of significant enforcement actions in an industry
The introduction of the two-invoice system involves all of these areas. Companies need to educate their employees, conduct due diligence on third parties and increase compliance oversight to avoid fines, penalties and ensure future success in China.