China has launched the “two-invoice” system in drug distribution on a trial basis, aiming to improve transparency in drug prices and eliminate excessive profit margins associated with multi-tier distribution models. This is the first time Chinese regulators have officially launched the two-invoice system, which had been debated for over a decade. The system is expected to be fully implemented in public hospitals across the country by the end of 2018.
Major implications for the pharma industry
The two-invoice system – the issuing of the manufacturer’s invoice to the distributor followed by the distributor’s invoice to the end customer (the hospital) – has important implications for pharma companies doing business in China. Such companies may have to adjust their business model, for example:
- Engage more first-tier distributors to ensure geographic coverage by restructuring second- or third- tier distributors as first-tier distributors.
- Sell drug products directly to hospitals with the assistance of qualified logistic service providers.
- Review pricing strategy including strengthening internal marketing function or outsourcing the promotion and marketing function.
The two-invoice system will also impact large Chinese pharma distribution companies, which may acquire smaller operators to broaden their geographic coverage and improve their logistics service capabilities. Meanwhile, contract sales organizations (“CSO”) may find their services in demand for the provision of sales and promotion services to pharma companies.
From a compliance perspective, the new system has the potential to reduce corruption risk as it requires pharma companies to assess their distribution channels and network of third party intermediaries, and improve the transparency of their invoicing procedures.
What are the highlights?
On 12 December 2016, the State Council together with seven ministries (including the National Health and Family Planning Commission and the State Administration of Food and Drug) jointly issued the Opinions on Implementation of Two-Invoice System in Drug Procurement by Public Medical Institutions (for Trial Implementation) (“Ministerial Opinions”). The key features of the Ministerial Opinions include:
- Defining the “two-invoice” requirements. The two-invoice system generally requires a drug manufacturer to only issue one invoice to its distributor followed by the distributor issuing a second invoice to the end customer hospital. Only one distributor is permitted to distribute drug products between the manufacturer and the hospital. The system also encourages manufacturers to directly sell drug products to hospitals with assistance from logistic service providers. Exceptions are granted for (i) exclusive distributors of imported drugs, or intra-company transfers (such as between a distributor and its subsidiaries); (ii) emergency circumstances; (iii) distribution of specially administrated drugs (such as anesthetic); and (iv) hospitals located in remote and rural areas.
- Strengthening administration of invoices. Hospitals are required to obtain not only the invoice issued by the distributor to the hospital, but also the invoice issued by the drug manufacturer to the distributor affixed with the manufacturer’s company chop. This allows the ex-factory drug prices and profit margins of the distributors to be fully transparent to the hospitals.
- Penalties for non-compliance. Manufacturers or distributors that fail to comply may be disqualified from attending future bidding events or providing logistics support for hospitals and heath care institutions, and blacklisted for drug procurement practices.
On 24 January 2017, the State Council issued Several Opinions on Further Reform and Improvement of Drug Production, Circulation and Use Policies reiterating the goal to fully implement the two-invoice system across China by the end of 2018. They emphasize that distributors and hospitals should maintain detailed drug sales and purchase records to ensure consistency across invoices, books and records, drug products, and payments.
Local regulators (such as in Guangdong, Shaanxi, Anhui, Chongqing and Hainan) have issued implementing rules on the two-invoice system. While some rules slightly deviate from the Ministerial Opinions on how the concept of “two invoices” is defined, the common objective is to consolidate drug distribution and reduce prices.
Actions to consider: An opportunity to reassess risk
Depending on how existing business models are affected by the two-invoice requirement, pharma companies should remain alert to the following compliance issues:
- Restructuring distribution models requires a reassessment of third-party compliance due diligence. When onboarding former second- or third- tier distributors as first-tier distributors, pharma companies should consider enhanced compliance due diligence particularly in where the smaller distributors serviced remote markets or would have had little or no interaction with the typical standards and controls required amongst multinationals subject to stringent anti-bribery compliance. Current distributors acquiring smaller players will need to put in place pre- acquisition compliance due diligence and carefully consider post- acquisition integration measures.
- A potential restructuring presents an excellent opportunity for pharma companies to train and communicate on anti-bribery risk and expectations for CSOs and newly on-boarded distributors.
- Engagement of CSOs may trigger potential third-party intermediary compliance risks and should therefore be subject to comprehensive compliance due diligence, on-going monitoring and periodic audits.
- A direct sales model requires continuous oversight of the use of medical education funds, sponsorships, donations and incentive programs.
- Invoice administration requires robust record-keeping mechanisms and systems, sound internal control procedures and protocols as well as on- going monitoring and auditing.
The newly launched two-invoice requirement will likely have a fundamental impact on the Chinese pharma industry in the next few years. To stay ahead of the curve, we recommend that legal counsel and compliance officers of pharma companies work closely with business teams to review business strategies, identify compliance risks, and strengthen compliance controls.