Blindsided
How did GlaxoSmithKline miss all the red flags in China?
Ben Hirschler of Reuters investigates
With more compliance officers in China than in any country bar the United States, British drug maker GlaxoSmithKline Plc seemed well positioned to do things right.
But despite conducting up to 20 internal audits in China a year, including an extensive four-month probe earlier in 2013, GSK bosses were blindsided by police allegations of massive corruption involving travel agencies used to funnel bribes to doctors and officials.
The scale of funds signed off by GSK to pay travel agencies for organising educational medical meetings has triggered heated debate, with some saying such spending would have looked legitimate and others arguing it should have raised alarms inside GSK and at its external auditor PricewaterhouseCoopers (PwC).
GSK, which has described the allegations as "shameful,” has declined to comment on specific shortcomings in internal procedures. PwC declined to comment on the case, citing client confidentiality.
Britain's biggest drug maker, which has some 7,000 staff in China, has now hired Ernst & Young to conduct an independent review of its systems in China, and has also sent top-level executives to see how an alleged web of bribery worth up to three billion yuan ($489 million) was missed.
One possible reason, according to consultants who have worked for GSK as well as current and former employees, likely lies in both the care with which payments were kept off GSK's books and the senior level of the Chinese managers involved.
As the alleged bribes went through the accounts of travel agencies rather than GSK, and many of the individual amounts may not have been material, the issue was unlikely to have been picked up by auditors or the head office, some accountancy experts maintain.
"You'd look at invoices and expenses, and it would all look legitimate," says a senior executive at a top accountancy firm. "The problem with fraud - if it is good fraud - is it is well hidden, and when there is collusion high up, then it is very difficult to detect."
The failure comes despite GSK carrying out as many as 20 internal audits annually within different areas of its Chinese business, each of which typically uncovers around five employees infringing processes in some way, one source familiar with the matter says.
Medical education or bribe?
Four senior Chinese executives from GSK have been detained by the police, including vice-president and operations manager Liang Hong, who told Chinese state television how he channeled money through travel agencies by arranging medical conferences, some of which were never held.
Continuing medical education (CME) has long been a major area of investment for drug companies as they seek to encourage doctors to use their products by taking them to meetings where the latest advances in medicine are discussed.
In the United States and western Europe, such CME funding for doctors is now tightly controlled. But there is little oversight in emerging markets.
Industry experts say the GSK case shows the hazards facing pharmaceutical companies in China, where a culture of giving gifts is deep-rooted and doctors rely on payments for prescribing drugs to supplement their meagre incomes.
That makes China a particularly tricky jurisdiction in which to impose head office ethics, according to Lincoln Tsang, a partner at the London offices of law firm Arnold & Porter.
China is also probing potential malpractice at other firms, with Belgium drug maker UCB being visited by Chinese authorities last month.
GSK says its global code of conduct applies just as much in China as anywhere else, and it has zero tolerance for bribery.
Getting the internal audit rights is not straightforward for multinational companies - especially if high-up individuals, who auditors expect to be onside, turn out to be involved in the conspiracy because that is the local culture.
"There is a disconnect between the global decision makers and the guys running things on the ground," says Jeremy Gordon, director of China Business Services, a risk management company focusing on China.
"It's about initially identifying red flags, and then searching for specifics."
Travel agencies ‘used like ATMs’
Still other auditing experts are asking why and whether GSK auditors failed to comb through the Chinese unit's marketing expenses. They say that one red flag was the number of checks being written to travel agencies for sending doctors to medical conferences, although this may have been blurred by the fact that CME accounts for a huge part of drug industry marketing.
Nonetheless, it was an obvious area for suspicion, according to Paul Gillis, author of the China Accounting Blog and also a former PwC partner.
"Travel agencies are used like ATMs in China to distribute out illegal payments. Any company that does not have their internal audit department all over travel agency spending is negligent," he says.
Last month, GSK said it had put an immediate stop on the use of travel agencies identified so far by Chinese investigators and was reviewing all historic transactions.
The official Xinhua news agency said last month that authorities in Shanghai had suspended the business of the Shanghai Linjiang International Travel Agency, one of the businesses linked to GSK.
These travel agencies may have been a blind spot for GSK, auditing experts say. Previous charges of corruption that were raised by a whistleblower, and which GSK said earlier this year were without foundation, did not involve agencies.
China currently accounts for just 3.5 percent of GSK drug sales but demand is growing fast - up 17 percent last year - and the company is investing heavily, with more than 7,000 staff in China, as well as five factories and a research centre.
In the wake of the scandal, analysts at Berenberg bank say GSK was likely to have to implement a disruptive overhaul of its Chinese commercial organisation.
Compliance the buzzword for foreign firms in China after Glaxo
By Michael Martina
A Chinese bribery investigation into British drug maker GlaxoSmithKline has sent tremors through multinational pharmaceutical firms in China, prompting at least one to review how it does business in the country.
Experts say foreign companies across the spectrum are watching closely to see what happened to GSK and its four detained Chinese executives, given bribery and business go hand-in-hand in the world's second-biggest economy.
Chinese police last month accused GlaxoSmithKline of bribing officials and doctors to boost sales and raise the prices of its medicines. They said GSK transferred up to three billion yuan ($489 million) to 700 travel agencies and consultancies over six years to facilitate the bribes.
Britain's biggest drug maker said it was deeply concerned by the developments, which it called "shameful.”
On the same day the police announced its revelations, senior managers from another multinational pharmaceutical firm in China were telling staff to make sure they complied with Chinese regulations governing the industry, one employee said.
"The message from the top is that if I have to choose between compliance and winning business, I would rather lose the business," the employee told Reuters, requesting anonymity because of the sensitivity of the matter.
Bribes to government officials, underfunded hospitals and poorly paid doctors have long facilitated the regulatory approval, distribution and the pricing of medicines in China.
Experts say it was too soon to tell if the GSK investigation would change such practices.
On top of the police probe, China's National Development and Reform Commission is examining prices charged by 60 local and international drug makers including units of GSK, Merck & Co Inc and Astellas Pharma Inc.
"All the other players in the industry will be taking a look at their procedures, whether they face any active investigations or not," says John McFarland, head of fraud prevention at Hill & Associates, based in Singapore.
Corporate bribery rife
The GSK investigation is the highest-profile corporate probe in China since four executives from mining giant Rio Tinto were jailed in March 2010 for taking bribes and stealing commercial secrets. Three of those executives were Chinese, while the fourth was a Chinese-born Australian.
Past improper payouts in China have also landed other Western drug makers in trouble - although with U.S. rather than Chinese authorities.
Pfizer Inc and Eli Lilly & Co have both settled with Washington in the past 11 months over alleged corrupt payments in foreign markets, including China, and more cases under the U.S. Foreign Corrupt Practices Act are pending.
China is increasingly important for big drug makers, which rely on growth in emerging markets to offset slower sales in Western markets. IMS Health, which tracks pharmaceutical industry trends, expects China to overtake Japan as the world's second-biggest drugs market behind the United States by 2016.
Some lawyers in China say corporate bribery was so widespread that a single action in one industry was unlikely to halt the practice without sustained enforcement from the authorities.
But Richard Cassin, an expert on the U.S. Foreign Corrupt Practices Act and author of a popular FCPA blog, says China had drawn a line in the sand for foreign companies.
"The China investigation and detentions of executives of a giant Western company will shake up anyone responsible for compliance," he says.
A legal and compliance executive at a major multinational conglomerate in China says all eyes were on GSK.
"Businesses outside of the sector are really watching this to see whether this is an isolated circumstance," the executive, who was not authorised to speak to the media, told Reuters.
When announcing the accusations against GSK, Chinese police said they had uncovered information that pointed to similar violations made by other multinational pharmaceutical firms, although they have not named any companies.
Big pharma an easy target
Pharmaceutical companies are at the mercy of Chinese regulators in getting products licensed for import or manufacture in China, or to get them listed on the national drug registry. They typically rely on hired distributors to get their drugs to the market and into hospitals.
State broadcaster CCTV last month aired an interview with one of the detained GSK executives, who said he funneled money through travel agencies by arranging conferences, some of which were never held.
That money was then used to bribe officials, doctors and medical associations to facilitate sales or drug registrations.
According to sources with knowledge of the industry, China's sophisticated and thriving market for fake documents also allows local employees to provide forged paperwork to more senior or global managers.
Efforts made by drug firms at compliance training can even backfire, as some employees learn how to avoid detection.
Politics could also be playing its part in the focus on foreign drug companies.
China's government is faced with a $1 trillion healthcare bill payable by 2020, according to a report by consultants McKinsey, and is keen to cut the prices of medicines while at the same time try to provide universal access to healthcare.
That has made pharmaceutical companies vulnerable, says James Zimmerman, managing partner of law firm Sheppard Mullin Richter & Hampton and a former chairman of the American Chamber of Commerce in China.
"My take is that the PRC government is targeting the industry given that cost-effective healthcare for the masses is a critical current policy objective for China's aging population, and the government's legitimacy is at risk if it fails to deliver on its promise of affordable and accessible health care," Zimmerman says.
Why China pays too much for medicines
By Ben Hirschler, Ransdell Pierson and Kazunori Takada
China has a drug problem. While most Western countries spend 10 to 12 percent of their healthcare budget on medicines, in China, it is well over 40 percent - a disparity that goes to the heart of Beijing's crackdown on the industry.
A promise last month by GlaxoSmithKline to make its drugs more affordable in China in the wake of a bribery scandal is an important lever Chinese authorities may now use to start redressing the balance.
Britain's biggest drug maker has given no details on the size of the price cuts it will consider, but an examination of its discounts in other emerging markets suggests there may be scope for reductions for some medicines by a third or more. Other pharmaceutical firms might have to follow suit.
"Four executives were arrested, the company itself will probably be fined top to bottom, and they are having to cut prices," says one veteran industry executive in China, who declined to be identified.
"That'll send a signal to other players in the industry, and prices should come down."
Chinese police have detained four Chinese GSK executives in connection with allegations the drug maker funneled up to three billion yuan ($489 million) to travel agencies to facilitate bribes to doctors and officials to boost sales and raise the prices of its drugs.
GSK has said some Chinese executives appeared to have broken the law, but Chief Executive Andrew Witty said last month that the head office had no knowledge of the alleged wrongdoing.
None of GSK's competitors in China has publicly said they would cut prices, and major pharmaceutical companies reached by Reuters have so far declined to comment.
But a precedent was set earlier this month when Nestlé led other foreign milk powder makers in cutting prices in China after Beijing launched an investigation into possible price-fixing and anti-competitive behaviour in that sector.
Around the same time, the powerful National Development and Reform Commission said it was examining pricing by 60 local and international pharmaceutical companies.
"The Chinese government never does anything without a reason. China could be using these investigations partly to clean house and to also drive prices down," says Philip Urofsky at law firm Shearman & Sterling, who previously worked at the U.S. Department of Justice on cases involving the Foreign Corrupt Practices Act.
Big premium for foreign medicine
Data from the World Health Organization (WHO) and other groups shows how China's drug market has been thrown out of kilter by a system that effectively encourages public hospitals to prescribe large amounts of expensive medicine to earn revenue, given the cuts in government subsidies over 30 years.
"In China, a very high proportion of health expenditure is spent on medicines, which reflects both over-consumption and high prices," says Hans Hogerzeil, a professor of global health at the University of Groningen and a former WHO director of medicines policy.
As in many emerging markets, there is strong demand in China for Western drugs whose brands offer quality assurance in an environment where patients often worry over sub-standard or counterfeit treatments. As such, they can command hefty price premiums, even though they are no longer protected by patents.
Just how big a premium is revealed in data collected by Dutch-based Health Action International (HAI), a non-profit group focused on access to medicines.
HAI found that in China's Shaanxi province last year, prices charged for drugs made by the original Western drug company in both the public and private sectors were about 11 times the international reference price as calculated by the U.S.-based independent group Management Sciences for Health.
Exact comparisons with other markets are difficult, but a separate survey of prices in New Delhi, India, found the prices patients paid in the private sector for originator brands were much less at under five times the reference level.
China's government has also faced criticism that some drug prices are higher than in South Korea and Taiwan, both developed economies.
"You have to question why the Chinese government is buying high-priced originator brands for off-patent medicines. It's clear they could treat many more patients, without any increase in expenditure, if they only procured lower-priced, quality-assured generics," says Margaret Ewen, coordinator for global pricing at HAI.
Chronicle of a scandal
Compiled by Toby Geoghegan
July 4: NDRC, China's top economic planning agency, announces that it has opened an investigation into GSK
July 8: The Wall Street Journal says GSK’s China-based staff allegedly handed doctors cash and other rewards for prescribing Botox
July 8: GSK announces that it was investigating allegations that its staff had used improper tactics in marketing
July 11: China says that GSK executives have confessed to bribery and tax crimes
July 14: Chinese police says GSK broke the law to boost sales prices
July 15: Chinese police accuse GSK of using travel agencies to funnel bribes; GSK announces that it has stopped using the travel agencies accused in the probe
July 17: China announces a nationwide crackdown on the sale of illegal medicine and says it would tighten industry regulation
July 17: Chinese authorities block GSK’s finance head from leaving country
July 18: Shanghai authorities halt a travel agency's business over connections with GSK probe
July 18: China widens its drug industry probe by visiting Belgium's UCB
July 19: GSK sends three senior executives to China to handle the crisis
July 20: A British contractor is arrested in China amid GSK bribery inquiry
July 22: A GSK executive tells the Chinese government that the company will reform its business in the country
July 22: GSK announces that its executives “appear to have broken Chinese law”
July 23: A U.S. citizen is detained in connection with the GSK price-fixing probe
July 24: GSK admits that the China corruption scandal will hit business
July 24: The company appoints law firm Ropes & Gray for a review of its practices in China
July 25: GSK replaces the head of its China operations
July 27: Chinese media announces that 18 more people have been detained in connection with the GSK price-fixing probe
July 29: GSK’s former China head announces that he will return to China to aid the probe
‘Get employees on board with the idea of compliance’
Q&A with Jerry Ling, partner, Jones Day, Shanghai
By Liu Zhen
Q: How hard is it for multinational pharma companies to meet compliance requirements in China?
A: One of the things that makes China very difficult is the very low pay of doctors, which means they rely on commissions and other benefits. Another thing is that locally, the PRC government, especially the criminal authorities, has done little in this area. This meant people weren’t that scared of being caught. So what you had is the temptation for corruption, and not a lot of enforcement around it.
In my practice, a lot of clients are subject to the FCPA. However, many local Chinese employees have a certain disdain for this U.S. law, as they think it makes it very difficult to do business in China. And in certain companies, you have employees including some local management who just didn’t care about the U.S. and FCPA and compliance policies. Others actively circumvent their own compliance codes for their own benefit.
Q: What advice do you give your clients to avoid such risks?
A: Get employees on board with the idea of compliance. Your own salespeople and distributors on the ground know what is really going on in the hospitals, and these people have to be serious about compliance. They have to be scared of potential consequences in order for it to really work. Otherwise, it’s too easy to circumvent even the best compliance policies.
In-house counsel then need to take a firm stand by saying no when they need to say no. They should find legitimate and transparent ways to operate while staying compliant with various laws like the FCPA, UKBA. I think a good compliance officer really has to have a good relationship with people on the ground, helping them do things right.
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