　The recent GSK scandal has justifiably raised questions about how the investment community should assess opportunities in China’s fast-growing pharmaceutical sector. The spotlight now being focused on GSK and other foreign pharma companies active in China, but domestically it is commonly understood to be a warning for the whole Chinese healthcare sector—companies, regulators, and healthcare professionals.

　Investors have long faced a challenge in balancing the potentially attractive financial fundamentals of high growth pharma companies in markets like China against the presence of obvious ESG risks. Part of the solution is to focus on reliable standards and patterns of disclosure. GSK is not unique in having flawed staff practices and oversight, but does it make sense to focus on policies based on “zero tolerance” in complex and rapidly changing markets like China?

　The one thing that investors and companies should not do is be surprised. Disclosures by Hong Kong Stock Exchange listed companies in SynTao’s new IPO database make it clear that corruption risks are common. The database captures ESG disclosures by Chinese companies listed in Hong Kong where they are required to provide disclosure of material ESG risks makes for relevant and informative reading.

Sinopharm Group Ltd	2009	Risks Factors	Discloses that: "In the pharmaceutical industry, corrupt practices include, among others, acceptance of kickbacks, bribes or other illegal gains or benefits by pharmacies, hospitals and medical practitioners from pharmaceutical manufacturers and distributors in connection with the prescription of certain pharmaceutical products."
		Industry Overview	States that most hospitals are owned and operated by the PRC government and that although the latest healthcare reform plan aims to reduce hospitals’ reliance on sales from hospital pharmacies, outpatients still primarily fill their prescriptions at hospital pharmacies.
Lansen Pharma	2010	Risk Factors	Description of the risks of corruption practices in the pharmaceutical industry.
		Risk Factors	Describes the potential impact of corruption risks on business performance.
		Industry Overview	Describes the corruption issues associated with the distribution of certain drugs in the PRC.
		Business	Details the measures taken to minimize the risk of being involved in corrupt practice claims due to third parties’ conduct.
Nt Pharma	2011	Risk Factors	Explains that they derive a significant portion of their turnover from the provision of services to GSK (primarily vaccine-related). 63.4% of their turnover was products manufactured by GSK in 2008, 65.5% in 2009, and 60.7% in 2010. Their distribution and promotion agreements with GSK typically last for three years.
		Risk Factors	Explains that historically the majority of their sales have been to provincial and municipal level CDCs, which then supply vaccines to local CDCs, but that this distribution model may change due to relaxed restrictions on direct sales to local CDCs. In either case, they are unable to control products until they reach the end users.
		Risk Factors	Explains that they have experienced problems with their internal controls. Certain tax receipts were not officially recognized as tax receipts, but they have paid the outstanding amounts. They have hired external consultants and auditors to address their issues with internal controls.
		Risk Factors	Explains that their previous problems with internal controls mean that compliance with PRC laws related to corruption and fraud could be difficult for them.
Fosun Pharma	2012	Risk Factors	Describes the concern that employees, distributors or thirdparty sales representatives could engage in corrupt practices that are frequent throughout the PRC where Fosun characterizes the usage of kickbacks, bribes and other illegal methods as commonplace to gain customers in pharmacies, hospitals and other medical practitioners. If any employees or affiliates violate laws, the company is ultimately responsible and may be subject to fines or closures under PRC law.

　In light of these disclosures and the unsurprising nature of the problem, the real question for investors is what systems or business model adjustments can be made in China to make drug companies more reliably compliant or resistant to corruption? China’s pharma sector is in the midst of dramatic regulatory change and enforcement has been neither strong nor consistent enough to tame entrenched practices. As a result, responsible investors may need to consider either exclusion strategies, calls for enhanced disclosure by multi-national and domestic leaders, or undertake much deeper fundamental research to identify business strategies that can insulate companies from the risks common to drug marketing and distribution. Indeed, it is arguably the case that multi-nationals like GSK hoped to insulate themselves from some elements of the problem by relying on domestic companies like Nt Pharma to distribute vaccine products, thereby “outsourcing” the risk to local companies.

　Whether it is global pharma sector leaders or China’s emerging pharma champ*ions, investors will need to look carefully at new government enforcement initiatives, and emerging healthcare policy initiatives that will affect drug distribution and healthcare sector profitability. In addition, they will need to take a real interest in practical strategies available to companies to restructure their drug approval and distribution risks. In the meantime, investors should be asking sector leaders and IPO sponsors tougher questions, not just about “risk factors”, but also about improved disclosure on their experience with strategies to overcome these risks.

　Written by Melissa Brown, Partner at Daobridge Capital Limited.

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