In practice, certain drug and device manufacturers and distributors have long been using multiple intermediaries (or small local distributors). One reason for this multilayer model is to leverage the local distributors' connections to reach certain hospitals. However, the long distribution chains can also serve as a screen for increased margins and multiple invoices—sometimes fraudulent or inflated—to make illegal payments to officials and physicians in order to boost sales.

How the system works

The Two-Invoice System means that during the distribution process from a drug manufacturer to the hospital there may be only two tax-valid invoices (or fapiao). One invoice is issued by a manufacturer to a distributor, and another by the distributor to a hospital.

The Circular articulates several exceptions to the Two-Invoice System. First, a wholly-owned or wholly-controlled commercial company established by a pharmaceutical group that only sells the drug of that group (limited to one commercial company in China) or the exclusive distributor of imported drug products in China (limited to one) may be deemed a “manufacturer.” Therefore, the Two-Invoice System would not apply to the sale of products from a manufacturer to a commercial company within the same group, or from an imported drug maker to its exclusive distributor in China, because that is not considered “distribution” but rather a transfer between manufacturers. The Two-Invoice System would apply to subsequent transactions. However, it is not clear how this exception would work with the marketing authorization holder (MAH) system established last year, for instance, whether it also applies to a MAH's engaging a manufacturer or distributor to sell its products.

Second, an internal “transfer” of drug products from a pharmaceutical distributor to its wholly-owned (controlled) subsidiary or between wholly-owned (controlled) subsidiaries of that distributor is not considered a separate invoice for the purposes of the Two-Invoice System. However, no more than one invoice may be issued for such internal transactions. It remains to be seen how this should be interpreted and carried out in practice. (It is also worth noting that it is unclear whether “transfer” means that the contemplated intra-company group transactions here are something different from the usual buy/sale transactions between group companies.)

The Circular seems to suggest that an additional invoice, in addition to the “Two-Invoices”, would be permissible if distribution is to a “remote” township or village. It is not clear how this would work or what constitutes a “remote” area.

The Circular also sets forth requirements for distribution companies and hospitals to review invoices. Distribution companies must carefully check invoices from manufacturers against details of the products, and hospitals must do the same for the invoice from the distributor and photocopies of the manufacturer's invoice. The hospital must compare the two sets of invoices. The practical effect of this requirement will be to give hospitals visibility over the margins enjoyed by distributors.

Policy implementation

The Two-Invoice System will first be implemented in the 11 provinces that are involved in pilot comprehensive medical reforms and 200 cities for pilot public hospital reform. The provinces are Anhui, Chongqing, Fujian, Hunan, Jiangsu, Ningxia, Qinghai, Shaanxi, Shanghai, Sichuan, and Zhejiang. All other regions are encouraged to implement the Two-Invoice System. The Circular indicates that the mechanism will be enforced nationwide by 2018.

In the identified areas, public hospitals are required to “gradually” implement the Two-Invoice System while all other types of hospitals are encouraged to. Compliance with the system will become a prerequisite for participation in procurement processes with public hospitals. For procurement through bidding, the manufacturers must participate in the bidding directly (rather than entrusting distributors to do so on their behalf), and must prove that they are compliant with the Two-Invoice System.

Drug makers and distributors that fail to implement the Two-Invoice System may lose their qualifications to participate in the bidding process, win a bid, or distribute pharmaceutical products. Non-compliant manufacturers may also be blacklisted from engaging in drug sales to public hospitals in a locality.

The Circular states that the government supports major pharmaceutical distributors with comprehensive networks and reputations for quality, as well as the establishment of national and regional drug logistics parks and distribution centers. However, it is not clear what benefits distributors would acquire if they meet this description and/or participate in these parks. The practical effect would be to continue the trend of centralizing distribution in a handful of distributors, many of which are owned or controlled by the state.

AML compliance

The National Development and Reform Commission (NDRC) has long focused on vertical anti-competitive conduct, such as retail price maintenance (RPM), in the pharmaceutical and medical device sectors. On December 7, 2016, it fined Medtronic (Shanghai) Management Co. Ltd. Rmb118 million ($17.3 million) for engaging in RPM and other vertical restraints. Medtronic, which used a multilayer distribution system in China, was found to have restricted resale prices of its distributors at all levels, despite the fact that these distributors are independent market players rather than Medtronic's affiliated entities.

With the implementation of the Two-Invoice System, resale prices will be more transparent because it requires end hospitals to compare the two sets of invoices when procuring drugs. This makes it even more important for drug makers to comply with the PRC Anti-Monopoly Law and not restrict the resale prices of their distributors.

Business model revamp

The Two-Invoice System may bring significant reform to existing distribution practices and business models that drug and device companies have been using in China.

Each manufacturer will need to assess their distribution models in China with this new policy in mind, and make necessary adjustments to minimize their compliance risk. Companies that have been using a “multilayer” distributor model would need to revamp their business model to comply with the Two-Invoice System.

While the Circular has established the nationwide framework for the Two-Invoice System and its general principles, there are still some gaps in the concepts, scope, timeline, and implementation, which need to be closed by local implementing rules. Companies should actively participate in comments on the draft implementing rules released by local governments, and raise their business concerns and recommendations for the governments' consideration.

The Two-Invoice System could trigger a new round of mergers and acquisitions among distribution companies, which may take this opportunity to expand into other areas by acquiring local distributors. Some manufacturers may also consider building up their distribution capacity through acquisitions.

From a healthcare policy standpoint, the System could reduce protectionist procurement practices in the provinces. This could facilitate the flow of drugs and devices to patients and ultimately make the bidding processes fairer.

Andrew (Shaoyu) Chen, Partner, and Richard Li, Associate
Covington & Burling
Beijing and Shanghai

The Chinese government has announced a new policy to fundamentally reduce marked-up prices and corruption in multi-tier distribution chains. The policy effectively requires, under most circumstances, at most only two invoices to be issued throughout the distribution chain, with one from the manufacturer to a distributor, and another from the distributor to the end hospital. Though this applies only to drugs, some provinces reportedly have been implementing similar policies for medical devices.

Eight central ministries, including the National Health and Family Planning Commission, China Food and Drug Administration, National Development and Reform Commission and the Medical Reform Office of the State Council, released the new policy, described in the Circular on Issuance of the Implementing Opinions on the Launch of the “Two-Invoice System” in Pharmaceutical Procurement by Public Medical Institutions (Trial Implementation) (Circular). The Circular takes effect from the issuance date of December 26, 2016.

Drug manufacturers using complex, multilayer distribution chains will likely be required to revamp their distribution models to comply with this change. Drug makers and distributors must prepare for the implementation of the Two-Invoice System in the drug procurement by public medical institutions.

The new system has been under discussion for several years and is part of a larger healthcare reform set forth in the 13th Five-Year Plan on Deepening Reform of the Medical and Healthcare System, released by the State Council on December 27, 2016. One of the key goals of the Five-Year Plan is to establish a more regularized and procedure-oriented supply chain for drugs, with process reforms for manufacturers, distributors and end users. The ultimate objective is to ensure a steady supply of safe and effective drugs at lower prices.

Targeting corruption and prices

The Two-Invoice System aims to reduce drug prices and corruption that can occur in lengthy distribution chains between the manufacturer and the end-user hospital. The Circular states that the policy will “regulate the order of drug distribution, reduce distribution links, and lower the unreasonably high drug prices” and act as “an effective measure to clean up the distribution environment, crack down on 'money-laundering by invoice fraud', and strengthen the regulation of the pharmaceutical market.”

In practice, certain drug and device manufacturers and distributors have long been using multiple intermediaries (or small local distributors). One reason for this multilayer model is to leverage the local distributors' connections to reach certain hospitals. However, the long distribution chains can also serve as a screen for increased margins and multiple invoices—sometimes fraudulent or inflated—to make illegal payments to officials and physicians in order to boost sales.

How the system works

The Two-Invoice System means that during the distribution process from a drug manufacturer to the hospital there may be only two tax-valid invoices (or fapiao). One invoice is issued by a manufacturer to a distributor, and another by the distributor to a hospital.

The Circular articulates several exceptions to the Two-Invoice System. First, a wholly-owned or wholly-controlled commercial company established by a pharmaceutical group that only sells the drug of that group (limited to one commercial company in China) or the exclusive distributor of imported drug products in China (limited to one) may be deemed a “manufacturer.” Therefore, the Two-Invoice System would not apply to the sale of products from a manufacturer to a commercial company within the same group, or from an imported drug maker to its exclusive distributor in China, because that is not considered “distribution” but rather a transfer between manufacturers. The Two-Invoice System would apply to subsequent transactions. However, it is not clear how this exception would work with the marketing authorization holder (MAH) system established last year, for instance, whether it also applies to a MAH's engaging a manufacturer or distributor to sell its products.

Second, an internal “transfer” of drug products from a pharmaceutical distributor to its wholly-owned (controlled) subsidiary or between wholly-owned (controlled) subsidiaries of that distributor is not considered a separate invoice for the purposes of the Two-Invoice System. However, no more than one invoice may be issued for such internal transactions. It remains to be seen how this should be interpreted and carried out in practice. (It is also worth noting that it is unclear whether “transfer” means that the contemplated intra-company group transactions here are something different from the usual buy/sale transactions between group companies.)

The Circular seems to suggest that an additional invoice, in addition to the “Two-Invoices”, would be permissible if distribution is to a “remote” township or village. It is not clear how this would work or what constitutes a “remote” area.

The Circular also sets forth requirements for distribution companies and hospitals to review invoices. Distribution companies must carefully check invoices from manufacturers against details of the products, and hospitals must do the same for the invoice from the distributor and photocopies of the manufacturer's invoice. The hospital must compare the two sets of invoices. The practical effect of this requirement will be to give hospitals visibility over the margins enjoyed by distributors.

Policy implementation

The Two-Invoice System will first be implemented in the 11 provinces that are involved in pilot comprehensive medical reforms and 200 cities for pilot public hospital reform. The provinces are Anhui, Chongqing, Fujian, Hunan, Jiangsu, Ningxia, Qinghai, Shaanxi, Shanghai, Sichuan, and Zhejiang. All other regions are encouraged to implement the Two-Invoice System. The Circular indicates that the mechanism will be enforced nationwide by 2018.

In the identified areas, public hospitals are required to “gradually” implement the Two-Invoice System while all other types of hospitals are encouraged to. Compliance with the system will become a prerequisite for participation in procurement processes with public hospitals. For procurement through bidding, the manufacturers must participate in the bidding directly (rather than entrusting distributors to do so on their behalf), and must prove that they are compliant with the Two-Invoice System.

Drug makers and distributors that fail to implement the Two-Invoice System may lose their qualifications to participate in the bidding process, win a bid, or distribute pharmaceutical products. Non-compliant manufacturers may also be blacklisted from engaging in drug sales to public hospitals in a locality.

The Circular states that the government supports major pharmaceutical distributors with comprehensive networks and reputations for quality, as well as the establishment of national and regional drug logistics parks and distribution centers. However, it is not clear what benefits distributors would acquire if they meet this description and/or participate in these parks. The practical effect would be to continue the trend of centralizing distribution in a handful of distributors, many of which are owned or controlled by the state.

AML compliance

The National Development and Reform Commission (NDRC) has long focused on vertical anti-competitive conduct, such as retail price maintenance (RPM), in the pharmaceutical and medical device sectors. On December 7, 2016, it fined Medtronic (Shanghai) Management Co. Ltd. Rmb118 million ($17.3 million) for engaging in RPM and other vertical restraints. Medtronic, which used a multilayer distribution system in China, was found to have restricted resale prices of its distributors at all levels, despite the fact that these distributors are independent market players rather than Medtronic's affiliated entities.

With the implementation of the Two-Invoice System, resale prices will be more transparent because it requires end hospitals to compare the two sets of invoices when procuring drugs. This makes it even more important for drug makers to comply with the PRC Anti-Monopoly Law and not restrict the resale prices of their distributors.

Business model revamp

The Two-Invoice System may bring significant reform to existing distribution practices and business models that drug and device companies have been using in China.

Each manufacturer will need to assess their distribution models in China with this new policy in mind, and make necessary adjustments to minimize their compliance risk. Companies that have been using a “multilayer” distributor model would need to revamp their business model to comply with the Two-Invoice System.

While the Circular has established the nationwide framework for the Two-Invoice System and its general principles, there are still some gaps in the concepts, scope, timeline, and implementation, which need to be closed by local implementing rules. Companies should actively participate in comments on the draft implementing rules released by local governments, and raise their business concerns and recommendations for the governments' consideration.

The Two-Invoice System could trigger a new round of mergers and acquisitions among distribution companies, which may take this opportunity to expand into other areas by acquiring local distributors. Some manufacturers may also consider building up their distribution capacity through acquisitions.

From a healthcare policy standpoint, the System could reduce protectionist procurement practices in the provinces. This could facilitate the flow of drugs and devices to patients and ultimately make the bidding processes fairer.

Andrew (Shaoyu) Chen, Partner, and Richard Li, Associate
Covington & Burling
Beijing and Shanghai