China: Brief Analysis Under Anti-Monopoly Law ("AML") Of The Management Model To Ensure Distributors A Minimum Resale Profit Margin In The Healthcare Industry

Last Updated: 16 January 2017
Article by David Qi and Rundong Liu

In early 2016, the Price Supervision and Anti-monopoly Bureau of China's National Development and Reform Commission ("NDRC") issued the article "Key Issues on Price Supervision and Anti-monopoly in 2016"1 which specified the target industries for antitrust enforcement in 2016, covering industries such as vehicles and parts, telecom, finance, and pharmaceuticals and medical devices. On June 29, 2016, Mr. LU Yanchun, Deputy Head of the NDRC Price Supervision and Anti-monopoly Bureau, indicated during his speech in Shanghai that China will specifically strengthen its anti-monopoly enforcement in the pharmaceutical industry against illegal conduct under the PRC Anti-Monopoly Law (hereinafter, the "AML"), including conduct such as "negotiated price lifting" and "willful price lifting", etc.2 This is not the first time that NDRC has clearly demonstrated its commitment to monitoring the health care industry. As early as May 4, 2015, NDRC specifically promulgated the "Notice on Strengthening Price Supervision in the Pharmaceutical Market"3, which strictly prohibits collusion among operators as well as operator involvement in manipulating market prices.

Given the current situation, we note that some manufacturers in the healthcare industry have adopted a management model for their sales channels which offers a promise of minimum resale profit margins for distributors for the purpose of ensuring the stability and efficiency of the reseller channel.

I. Methods to ensure distributors a minimum resale profit margin

Article 14 of AML regulates vertical monopoly agreements, which mainly targets resale price maintenance or minimum resale price agreements entered into between operators and their trading counterparts.4 In the healthcare industry, the model for realizing the minimum resale profit margin, which is usually promised by manufacturer to distributors, is as follows: if a distributor, in carrying out the policy, suffers loss or fails to reach the minimum resale profit margin as promised by the manufacturer, the manufacturer will make up the insufficient portion by giving subsidies. For example, in order to ensure that the minimum profit rate be gained by a secondary distributor, a first level distributor may have to sell products to the secondary distributor at a price at less profit than the promised minimum profit margin, in which case the manufacturer will make up the missing portion by giving subsidies at an equal amount (see Figure 1).

Figure 1

Therefore, from the methods to ensure distributors a minimum resale profit margin (see Figure 1), we can see that since the manufacturer makes the profit promise for all levels of distributors by means of rebate or reward based on the terminal price and the minimum profit margin is guaranteed, it may appear that this kind of management model suggests a restriction on the highest resale price by a certain level distributor to its next level distributor (in practice, the resale price may be below the price for minimum profit margin because of the policy). However, despite operators' conduct in restricting the maximum resale price for trading counterparts can also affect market competition, it is not a typical violation under the current AML.

II. Discussion on the nature of the promising distributors a minimum resale profit margin

However, there might be an indirect price restraint in essence for this kind of management model in ensuring distributors the lowest resale price, and this kind of management model also has problems in internal logistics.

The core of the problem is that, in normal business activities, the ex-factory price of products is generally the first to be determined, and then the market determines the terminal price step by step from one level of distributors to next level of distributors. In terms of putting aside the appearance of pricing order, the conduct to ensure distributors' minimum resale profit margin actually requires the next level distributor to resell the products no less than a certain percentage of the selling price of its up-level distributor (the resale price of distributors might be fixed or restrained within a certain range of price, because of the minimum profit margin guarantee), which theoretically may constitute price fixing or restraint of minimum resale price.

As shown in Figure 1, superficially, the manufacturer is encouraging the first-level distributors to resell products to the second-level distributors at a price no more than a certain percentage of the terminal price. However, if we ignore the normal order of commodity pricing and judge from the results instead, we can see that, in the implementation of this management model, the final transaction price of distributors at all levels may be gradually fixed within a range of calculable price under the incentives of rebate and subsidies.

III. Analysis on Competitive Effects

Due to the difference between the form and substance of this management model, whether there are sufficient concerns to cause AML enforcement would need our further analysis regarding the effects it may bring upon market competition.

Under the management model of ensuring distributors a minimum resale profit margin, due to the pressure or incentives given by a one party of agreement (e.g., manufacturers may monitor distributors' resale prices and take action against those distributors who fail to adhere to the policy. Such actions include cancellation of rebates, refusal to supply products or early termination of a cooperation agreement, etc.) and together with the instinct of merchant premiums, the terminal price produced therefrom is likely to be widely implemented.

Although superficially this pattern only encourages restraints of the maximum resale price, due to operators' instincts for profit-seeking in the course of implementation of this management model, it is very likely to cause the negative effects of price fixing or resale price maintenance. In addition, the competition between distributors is to be substantially reduced by this pattern (assuming it is in a market with free and complete competition, it is possible that the normal profit margin of such products may not reach 10%, and thus the resale price under normal circumstances may be lower). Furthermore, if this model is to be adopted widely in the industry, it is possible that the terminal prices of products will be increased in light of reduced competition as a whole, which is obviously in contrary to the goal of AML enforcement agencies to increase the welfare of consumers and promote market competition, etc.

IV. Our View

With the overall growth and development of China's economy, and after several years of development since the promulgation of the AML, the relevant supporting legal system has continued to be perfected and refined, and the enforcement of AML has become normalized. The anti-monopoly legal system is considered the "Economic Magna Carta"5 of the legal framework of modern society, and the healthcare industry is one that closely relates to the interests of innumerous consumers. Now that China is steadily advancing its reform of the healthcare industry, the total market and scale involved in this industry is significant, it is inevitable that the AML enforcement agencies will strengthen and focus their monitoring of this industry. NDRC has specifically indicated that, even though some pharmaceutical companies don't directly control the retail price of drugs, they may still be subject to investigation by AML enforcement agencies if they attempt to affect the retail prices of drugs by controlling supply and rebate levels.6 In such a climate, from the perspective of potential AML enforcement it is imperative to reconsider the models for management of the distribution channels which have generally been adopted in the healthcare industry, and the potential risks for the relevant enterprises shall not be ignored.

Footnotes

1 "Key Issues on Price Supervision and Anti-monopoly in 2016", Price Supervision and Anti-Monopoly in China, 02, 4 March 2016

2 Xinhua Net reports: http://news.xinhuanet.com/2016-06/29/c_1119136394.htm, on June 29, 2016

3 "NDRC Notice on Strengthening Price Supervision in Medicine Market", FaGaiJiaJian [2015] No. 930, on May 4, 20

4 Article 14 of the AML, operators are prohibited from reaching any of the following monopoly agreements with their trading counterparts:

(1) on fixing the prices of commodities resold to a third party;

(2) on restricting the lowest prices for commodities resold to a third party; and

(3) other monopoly agreements as determined by the Anti-monopoly Law enforcement agencies under the State Council.

5 United States v. Topco Assocs., 405 U.S. 596, 610 (1972), a typical case by US Supreme Court in 1970s, in which SPC expressed the significant public properties and meanings of anti-trust laws, and regarded Anti-trust law as the "Economic Magna Carta", "They [anti-trust laws] are as important to the preservation of economic freedom and our free-enterprise system as the Bill of Rights is to the protection of our fundamental personal freedoms."

6 See Xinhuanet news report, available at http://news.xinhuanet.com/2016-06/29/c_1119136394.htm, June 29, 2016.

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