Maintaining enforcement risk vigilance while pursuing pharma opportunities in China

While many of us remain indoors and practice social distancing, business opportunities, especially in the global pharmaceutical market, continue to grow at a rapid pace. Yet, as the world shrinks it is important to remain ever vigilant as the ability to access promising markets, such as China, is not without risks. Companies need to remain attentive to these risks. Certain industries, such as pharma, with its enhanced regulations and frequent interconnections with state-owned entities, are especially susceptible to corruption. It also remains no secret that the United States has recently expressed a strong interest in combating corruption in the Chinese market. This is unlikely to change in the post-pandemic world. Accordingly, it is critical to keep in mind the lessons learned from a recent settlement of a US-based pharmaceutical company (the Company) with the Securities and Exchange Commission (SEC) for violations of the Foreign Corrupt Practices Act (FCPA) involving its failure to implement appropriate controls over its Chinese distributor for a UK-based pharmaceutical manufacturer.

On November 1, 2018, well-before the publication of the settlement, then-Attorney General Jeff Sessions announced a new US Department of Justice (DOJ) policy, called the China Initiative, designed to protect US national security and economic interests in relation to unfair practices in China. One of the components of that initiative as defined in the DOJ Fact Sheet is to “Identify [FCPA] cases involving Chinese companies that compete with American businesses.” As part of the initiative, the DOJ proposed, among other things, to increase FCPA enforcement against Chinese companies that unfairly compete with US businesses. Since then, of the approximately 25 FCPA cases known to have been investigated and prosecuted by US regulators, 11 involved improper activity in China. While these investigations involve multinational companies rather than Chinese companies, it is clear that China is on US regulators’ radar and is likely to stay there.

While not falling squarely within the mandate of the China Initiative, this most recent settlement joins a group of companies investigated for improper acts in China. On February 28, 2020, the Company entered into an administrative settlement with the SEC (jointly tasked along with the DOJ with enforcing separate requirements of the FCPA) for violations of the internal accounting controls and recordkeeping provisions of that law. The investigation was related to the Company’s entry into the Chinese market in 2010 through its acquisition of Chinese subsidiaries of an established pharmaceutical distribution company, which maintained distribution agreements with manufacturers of medical prescriptions, devices, and consumer health products. The Chinese entity, in addition to its role as distributor of the products, maintained and operated accounts to facilitate payments for its distributors’ marketing efforts through local employees in China. When the parent company acquired the Chinese entity, it conducted a review of these accounts and terminated several accounts over FCPA-related compliance concerns associated with channeling the marketing expenses of third parties through its own books and records.

After determining that the marketing account for a European dermocosmetic company posed a minimal risk, the Chinese subsidiary maintained that account until 2016. During that time, the subsidiary regularly authorized and made payments from this account at the direction of the European company. The funds in this account were allocated for marketing, but were also used to pay sales and marketing employees who reported to and were supervised by the European distributor. Given the Company’s assessed level of risk for this arrangement, it did not implement sufficient internal controls with regards to these employees, including anti-corruption and bribery training or oversight of their interaction with third parties in China. This was particularly troubling because the employees conducted business over emails and a computer system controlled by the European company that were inaccessible to the Company. In 2016, the Company learned that several purported marketing payments were redirected to private healthcare professionals and employees of Chinese state-owned retail entities with influence over purchasing decisions. Given the insufficient internal controls, the marketing employees were able to easily conceal improper payments, which included cash, luxury goods, gift cards, and travel, as payments for “production fees” to complicit third party printing company vendors.

The SEC found that the Company employed insufficient internal controls of the marketing employees and the marketing account. According to the SEC, between March 1, 2013, and December 31, 2016, the Chinese subsidiary authorized more than US$250 million in payments from the marketing account and earned about US$5.4 million as the European company’s exclusive distributor in China. The Company agreed to a settlement of US$8.8 million for these violations.

This settlement serves as a fresh reminder of US regulators' interest in the enforcement against companies operating in China, especially when acquiring Chinese operations, even when it appears that there is no apparent US nexus. The Company was ultimately held to answer for a violation of the FCPA for its failure to implement appropriate controls over its Chinese distributor for a UK-based pharmaceutical manufacturer. This is a clear example of the willingness of US regulators to impose their jurisdictional reach into China. In these times of increasing opportunities in global markets, companies must continue to be diligent in overseeing their business relationships and payments. This is especially true when companies are operating in high-risk regions where the DOJ is vigilantly watchful according to its openly stated policy.