China: Several Issues In Foreign Investor’s Acquisition Of Pharmaceutical Enterprises

Last Updated: 3 November 2014
Article by Jiang Hao

With the growing health issues, people are getting increasingly conscientious about their health. As a result, the pharmaceutical industry has become an important part of the national economy. In the meantime, the national pharmaceutical industry reform has also largely facilitated merger and acquisition within the pharmaceutical industry.

This absolutely presents a great opportunity for foreign investors to acquire domestic pharmaceutical enterprises. However, on the other hand, due to the particularity of pharmaceutical industry, foreign investors still face a series of issues during their acquisition of domestic pharmaceutical enterprises (pharmaceutical enterprises mentioned herein only refer to pharmaceutical-producing enterprises and pharmaceutical-trading enterprises).

I. Current Situation and Future Trend of Merger and Acquisition within the Pharmaceutical Industry

There has been an increasing popularity of acquisition and restructuring within the PRC pharmaceutical industry in the recent years. Each year, there are almost a hundred cases concerning pharmaceutical enterprise acquisition. According to statistics, in 2013 there were a total of 103 acquisition cases within the biotechnology and health insurance industry, involving a total amount of USD2.164 billion, showing a 53.7% and 27.6% year-on-year increase respectively, among which there are 48 VC/PE related acquisition cases in the biotechnology/healthcare field, accounting for 10.8% of all deals and ranking No. 1 among all fields. Up until August this year, there have been nearly 200 cases of acquisition and restructuring within the pharmaceutical industry, involving a total amount of nearly RMB50 billion. Such increase will continue to expand in the future.

The author believes that the popularity of acquisition within the pharmaceutical industry is caused by at least the following reasons:

1. China has an enormous pharmaceutical market. On the one hand, China has a huge population base, and problems of population aging, bad living habits, environment and food safety are getting increasingly severe. On the other hand, people are becoming more and more aware of health protection, and are getting increasingly affordable to make health-related payments. This indicates a huge demand and capacity of Chinese pharmaceutical market in the future.

2. The industrial policies stimulate the development of pharmaceutical industry. As an important livelihood issue, the PRC government lays much emphasis on pharmaceutical industry related policies. Since the launching of the healthcare reform in 2009, China has made huge investment in the pharmaceutical industry, and the healthcare insurance is gradually getting sound. In recent years, China has promulgated a series of regulations and policies, such as Guidance on Speeding up Merger and Reorganization of Key Industries and Enterprises, Opinions on Promoting the Development of Health Services, the 12th Five-Year Plan for Pharmaceutical Distribution Enterprises, and the 12th Five-Year Plan for the Development of Pharmaceutical Science and Technology, which expressly specify the importance of developing a number of key industries, such as healthcare, medicine, medical equipment, traditional Chinese medicine, and etc, and encourage enterprises producing similar products to realize large-scale and intensive business operation through merger and acquisition so as to increase industry concentration. According to these policies, acquisition among the pharmaceutical industry is generally supported by the state, as long as they are in line with the state industry guide.

3. The state's strengthening of regulation against pharmaceutical industry has also facilitated merger and acquisition. Due to the increasing emergence of safety accidents within the pharmaceutical industry, such as "poisonous drug capsules" and etc., while encouraging pharmaceutical industry development, the state has also strengthened regulation regarding requirements for pharmaceutical enterprises' production and operation. For example, the amendment of the Standards for Quality Control of Pharmaceutical Production (GMP) and the Standards for Quality Control of Pharmaceutical Trading (GSP) has reinforced the requirements for pharmaceutical-producing enterprises and pharmaceutical-trading enterprises respectively, which leads to the elimination of a number of small and medium-sized pharmaceutical enterprises due to their difficulty to meet such requirements. In the meantime, this provides an opportunity for some large-scale pharmaceutical enterprises, which are able to meet such requirements, to acquire those small and medium-sized pharmaceutical enterprises, and thus largely facilitated merger and acquisition.

II. Restrictions and Procedures for Acquisition of Domestic Pharmaceutical Enterprises by Foreign Investors

Distinguished from some special industries such as ICP and education industry, as well as healthcare institutions, the PRC regulation does not impose much restriction on the foreign investors' entry into the pharmaceutical industry in terms of capital contribution ratio. Also, no special approval is required during the establishment or acquisition procedures. This article will briefly introduce the restrictions and procedures for foreign investors' acquisition of domestic pharmaceutical enterprises as follows:

1. According to the Catalogue of Industries for Guiding Foreign Investment, fields of acquisition within the pharmaceutical industry can be generally classified as follows:

(1) Most of the pharmaceutical-producing industries are classified as the encouraged or permitted category, and there are no restrictions on foreign investor's capital contribution ratio. For example, the producing of new anti-carcinogen drugs, new cardio-vascular and cerebro-vascular drugs, new type of dugs produced by bioengineering technology, and vaccines.

(2) Certain drugs, such as penicillin and certain vitamin products, are classified as restricted category. However, there are no restrictions on foreign investor's capital contribution ratio, except for pharmaceutical enterprises producing active pharmaceutical ingredients (APIs) for anesthetics and Category I psychotropic drugs, which requires the Chinese party to take controlling shares.

(3) Only the processing of traditional Chinese medicine materials listed in the Regulation on the Protection of Wild Medicinal Resources and the Catalogue of China's Protected Rare, Precious and Endangered Plants, and the application of processing techniques for making small pieces of ready-for-use traditional Chinese medicines, and the production of traditional Chinese medicine under confidential prescriptions are classified as the prohibited category.

(4) Foreign investment in pharmaceutical trading business is under the permitted category and there are no restrictions on the foreign capital contribution ratio.

2. With respect to procedures, the procedures for foreign investors' acquisition of domestic pharmaceutical enterprises are the same as those in other industries, i.e. application for approval at Ministry of Commerce and registration at Administration of Industry and Commerce. Enterprises reaching declaration threshold under Provisions of State Council on Declaration Threshold for Concentration of Business Operator are required to submit declaration to Ministry of Commerce before applying for approval. Except for the above-mentioned normal procedure, this article makes following introduction regarding whether State Food and Drug Administration's special approval is required for foreign investors' acquisition of pharmaceutical enterprises.

As is known to all, foreign investors usually enter into certain industry by means of establishing new enterprises or acquisition, and the same applies to the entry of pharmaceutical industry. However, in recent years, there is an increasing popularity of acquisition over the establishment of new enterprises within the pharmaceutical industry. Such situation is closely related to the following factors: (1) acquisition and restructuring within the pharmaceutical industry are encouraged by state policies, which makes it difficult to establish new enterprises in practice; (2) acquisition of existing enterprises which have already obtained relevant mandatory licenses and certificates will save the trouble of going through complex procedure of applying for such certificates.

With respect to the second reason mentioned above, due to the change of enterprise type arising from the acquisition by foreign investors, certain type of certificates (e.g. ICP and etc.) must be re-applied. Therefore, under such circumstances, foreign investor may not achieve its goal by means of acquiring domestic enterprises.

Crucial certificate for pharmaceutical enterprise's production and operation in the pharmaceutical industry include Pharmaceutical Production Certificate, Pharmaceutical GMP Certificate, Pharmaceutical-trading Certificate, and Pharmaceutical GSP Certificate (the first two certificates are applicable to pharmaceutical-producing enterprises, and the latter two certificates are applicable to pharmaceutical-trading enterprises). Nevertheless, according to relevant laws and regulations concerning establishment of pharmaceutical enterprises and certificates mentioned above (including the Law on the Administration of Pharmaceuticals, Administrative Measures on Supervision of Pharmaceutical Production, Regulations on Pharmaceutical GMP Certificate, Regulations on Pharmaceutical-trading Certificate, Regulations on Pharmaceutical GSP Certificate), no mandatory pre-approval from the State Drug Administration is required for foreign investors' acquisition of pharmaceutical enterprises, neither are there any regulations requiring re-application of Pharmaceutical Production Certificate or other relevant certificates due to change of company shareholders (except for those mandatory change registrations regarding change of company name and etc.). In practice, foreign investors can directly apply with Ministry of Commerce for approval of its acquisition of domestic pharmaceutical enterprises. Therefore, the author holds a view that no mandatory pre-approval is required for foreign investors' acquisition of pharmaceutical enterprises. And by means of such acquisition, foreign investors can acquire those certificates and other resources owned by the target company. Of course, it is possible that the Ministry of Commerce may seek opinions from the State Drug Administration during its verification process, but this is not a formal pre-approval procedure.

III. Special Issues to Note during Due Diligence for Foreign Investors' Acquisition of Pharmaceutical Enterprises

When acquiring a domestic enterprise, the foreign investor will usually conduct detailed due diligence on the target company in order to determine whether such target company is worth acquiring and the purchase price. The key aspects of due diligence may vary based on the different industry of the target company. For due diligence conducted for acquiring a pharmaceutical enterprise, the author believes emphasis shall be given to the following aspects:

Certificates of Pharmaceutical Enterprises

Due to the particularity of pharmaceutical enterprises, it is a highly regulated area. Therefore, when acquiring pharmaceutical enterprises, the acquirer must confirm whether the target company has obtained all necessary certificates required for its production and operation. These certificates include:

(1) Pharmaceutical Production Certificate and Pharmaceutical GMP Certificate, which are prerequisites for pharmaceutical enterprises' production of drugs. According to the Law on the Administration of Pharmaceuticals and the Administrative Measures on Supervision of Pharmaceutical Production, the establishment of a pharmaceutical-producing enterprise is subject to prior approval from State Drug Administration and its issuance of a Pharmaceutical Production Certificate. Moreover, it is also subject to the application for Pharmaceutical GMP Certification with competent drug regulatory department in accordance with relevant rules implemented by the Sate Food and Drug Administration. Only upon the satisfaction of the above prerequisites can a pharmaceutical-producing enterprise start producing relevant drugs.

(2) Pharmaceutical-distribution Certificate and Pharmaceutical GSP Certificate, which are prerequisites for the sale (wholesale and retail) of pharmaceuticals by pharmaceutical-trading enterprises. According to the Law on the Administration of Pharmaceuticals and the Regulations on Pharmaceutical-trading Certificate, the establishment of a pharmaceutical-trading enterprise is subject to the issuance of a Pharmaceutical-trading Certificate as well as the application for Pharmaceutical GMP Certification with competent drug regulatory department in accordance with relevant rules implemented by the Sate Food and Drug Administration. Only upon the satisfaction of the above prerequisites can a pharmaceutical-trading enterprise start distributing relevant drugs.

(3) Pharmaceutical Products Registration Certificate and Imported Drug Registration Certificate. Trial experiment and production of new drugs, and repacking, sale of imported drugs are subject to drug registration as well as the issuance of Pharmaceutical Products Registration Certificate or Imported Drug Registration Certificate. The applicant of drug registration might not be such pharmaceutical-producing or pharmaceutical-trading enterprises themselves (i.e., the target company). However the above-mentioned registration certificates are required for the production and distribution of relevant drugs. When examining the target company, the acquirer shall also confirm whether the produced and distributed drugs have been duly registered.

It is worth noting that, apart from due diligence regarding the existence of such certificates, specific attention shall be paid to the validity period thereof, especially item (1) and (2) mentioned above. This is due to the state's strengthening of supervision over pharmaceutical-producing and pharmaceutical-trading enterprises. For example, the Standard for the Quality Control of Pharmaceutical-trading, implemented in June 2013 has greatly increased the entry level for pharmaceutical-producing enterprises. It further specifies that upon expiration of the pharmaceutical-trading Certificate or Pharmaceutical-GSP Certificate, the company must re-apply for such certificate in accordance with the latest standard. Such regulation indicates that the shorter the remaining valid period of relevant certificates, the shorter time will be left for the company to rectify so as to meet the latest standard. Under such circumstance, the acquirer must determine whether the company is able to timely rectify and meet the latest standard based on the current situation of that company. The acquirer shall reconsider whether to acquire such company if it finds it difficult for that company to meet the standard.

2. Commercial Bribery in Pharmaceutical Industry

For both systematic and practical reasons, commercial bribery has always been a serious issue within the pharmaceutical industry. In recent years, there have been some major commercial bribery cases, such as the GSK case. With the state's increasing regulation on anti-commercial bribery, foreign investors, when acquiring domestic pharmaceutical enterprises, must investigate and confirm whether the target company is involved in any commercial bribery activities.

Commercial bribery activities within the pharmaceutical industry usually occur during the promotion of pharmaceutical products and may take various forms, among which major commercial bribery activities include the following:

(1) Rebates. There are two types of rebates in commercial bribery within the pharmaceutical industry: (1) when selling pharmaceuticals, the pharmaceutical-producing and trading enterprises offer the hospital and drug store certain amount of rebates based on certain ratio of the sales amount; and (2) the pharmaceutical-producing and trading enterprises offer the doctor certain ratio of benefits based on such doctor's prescription amount of the concerned pharmaceuticals. Rebates are the most common form of commercial bribery within the pharmaceutical industry.

(2) Fees and Expenses under False Pretenses. In order to promote their products, the pharmaceutical-producing and trading enterprises often offer commercial bribery to medical institutions and relevant personnel therefrom by various means of research fee, conference fee, lecture fee, as well as offering domestic or international travels and tours. Such form of commercial bribery is well disguised and therefore difficult to discover. It is getting popularity among pharmaceutical enterprises in recent years.

When conducting due diligence on the target company, the acquirer must fully understand the target company's sales and operation model. Based on such information, the acquirer shall (1) verify whether there are any off-the-book rebates by conducting financial examination on the company; and (2) verify the truthfulness of those special contracts. For example, to verify whether actual research and development activities have been conducted under those research and development contracts signed with medical institutions, so as to verify whether there is any commercial bribery offered under false pretenses.

In addition, it is worth noting that in order to prevent and crack down on commercial bribery within the pharmaceutical industry, the state has promulgated a series of policies (e.g., Provisions on the Establishment of Commercial Bribery Records for the Purchase and Sale of Medicines, Notice on Implementation of the Commercial Bribery Records for the Purchase and Sale of Medicines, and etc.), which stipulate the requirements to record commercial bribery or other misconduct of pharmaceutical enterprises and to set business operational restrictions on those pharmaceutical enterprises and agents thereof with adverse records, such as disallowing medical institutions to purchase their products for certain time period. This has also provided a new method for due diligence on pharmaceutical enterprises. The acquirer can determine whether the target company has any adverse records relating to commercial bribery by checking the public record published by relevant public health departments, so as to decide whether to acquire the target company.

3. Intellectual Property Rights Relating to Pharmaceutical Production and Trading

Along the developmental history of Chinese pharmaceutical enterprises, there has been a long time that Chinese pharmaceutical enterprises did not emphasis on medical research and development, whether in the area of bio-medical or chemistry medical. Therefore, in most cases, domestic pharmaceutical enterprises do not hold relevant technology patents or pharmaceutical patents. Pharmaceutical production in China usually focuses on generic production and toll manufacturing, with less emphasis on independent research and development of new drugs. Of course, now there are a number of companies combine generic production with innovation and even manage to achieve continuous innovation. This leads to a relatively complicated regime of pharmaceutical enterprises' (especially pharmaceutical-producing enterprises') intellectual property rights. Therefore, when acquiring domestic pharmaceutical enterprises, foreign investors must investigate in this regard, which shall include at least the following: (1) Determine the ownership of the rights to use technologies required for pharmaceutical production. There are mainly three aspects: (1) use of invalid patents beyond protection period, which is commonly seen in generic productions. The due diligence must confirm whether the used technology is still under a valid patent; (2) use of licensed technology, which often happens under the toll manufacturing method, where the entrusted pharmaceutical-producing enterprise engages in pharmaceutical production subjected to a licensed technology granted by a foreign company. Under such circumstances, the due diligence shall focus on the truthfulness and content of such licensed technology; and (3) use of self-owned technology. Nowadays domestic pharmaceutical enterprises are paying more and more attention to the development of self-owned technology. In this regard, the acquirer shall confirm whether there has been a valid patent application for such technology and shall get to know the existing agreements with the inventor. (2) With regard to licensed technology, the acquirer shall confirm at least the following during the due diligence: (1) the basic content of the license, including term, licensed territory, whether the license fee has contributed an unreasonable proportion to the sales revenue, and etc.; and (2) whether the license will affect the acquisition. For example, whether the license agreement contains any restrictive clauses such as "in case of any change in the licensee's shareholder, the licensor may terminate the license at will."

The use of intellectual property rights is crucial for pharmaceutical-producing enterprises. Any slight carelessness may cause material adverse effect to the company's manufacturing. Therefore, when conducing due diligence for foreign investors' acquisition of pharmaceutical enterprises, the acquirer must strictly follow the above-mentioned rules.

IV. Post-acquisition Management of Pharmaceutical Enterprises

Lastly, this article intends to raise some simple suggestions with regard to foreign investors' post-acquisition management and operation of pharmaceutical enterprises.

1. With regard to team building, the acquirer shall pay attention to the coordination and integration among staffs from the foreign investor and staffs from the Chinese party. The joint venture established upon the acquisition, especially pharmaceutical-trading enterprises usually face serious problems in operation, i.e., disagreement among staffs from the foreign investor and staffs from the Chinese party. Conflicts between the Chinese party's team and the foreign investor's team in terms of operation concept, promotion scheme and etc., may even halt the development of the company. A lot of Sino-foreign pharmaceutical enterprises suffer from such problems. To establish an integrated business operation regime and to strengthen communication between the Chinese team and foreign team may effectively avoid such losses caused by internal conflicts.

2. Strengthening technical cooperation between the Chinese and foreign parties so as to enhance the joint venture's technical capability. One of the incentives for foreign investors' acquisition of domestic pharmaceutical enterprises and establishment of a joint venture is to integrate the foreign party's fund, technology advantage with the Chinese party's staff and market advantage. In terms of technology, the foreign investor shall strengthen cooperation with the joint venture and emphasize on conducting technical training to the joint venture's staffs. In addition, it is also important to enhance the joint venture's capability of self-research and development and to establish R&D centers by cooperation with R&D institutions both at home and abroad. Since the PRC pharmaceutical industry stimulus policies encourage pharmaceutical-producing enterprises to develop their own research and development capability, a pharmaceutical enterprise may only benefit from such policy support and thus achieve further development by means of strengthening its own research and development capability.

3. Focusing on operational compliance and preventing medical corruption. Operational compliance mentioned herein refers to the following: (1) there shall be no illegal activities during the production and operation of the pharmaceutical enterprise. For example, production and distribution of counterfeit drugs shall be strictly prohibited. It will be fatal to a company if such illegal activities happen; and (2) commercial bribery as mentioned above. With the state's increasing strike against commercial bribery, an enterprise must establish a complete set of internal anti-bribery rules, strengthen training on sales personnel, and conduct regular anti-bribery compliance check so as to ensure the company does not fall into the abyss of corruption.

4. Preventing monopoly activities in the pharmaceutical industry. Despite of PRC government continuous efforts in health care reform, the problems of difficulty in receiving medical treatment and high price of drugs have not been solved. Currently, the PRC government is seriously cracking down on activities of reaching pricing monopoly agreements, abuse of market ascendency, and etc. Such anti-monopoly measures may be extended to the pharmaceutical industry in the near future. After the foreign investor's acquisition of a pharmaceutical enterprise, it shall strengthen management in this regard by formulating anti-monopoly compliance manual so as to ensure lawful operation. In the meantime, it is also important to enhance staff training in order to deal with spot check by the relevant authorities. Above all, acquisition of a pharmaceutical enterprise is only a method and start point. Sound management and operation of the post-acquisition company shall be the ultimate target of the investors.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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