Impact and Lessons from a Latest FCPA Enforcement Case

Tag：dispute resolution and litigation-anti bribery and compliance，healthcare and pharmaceuticals-pharmaceuticals and medical devices

Summary of the Case

On May 11, 2023, the U.S. Securities and Exchange Commission ("SEC") issued a Cease and Desist Order, agreeing to the proposal of the involved company (hereinafter referred to as "Company P") to pay over 62 million USD and agree to report its compliance rectification to the SEC for a period of two years in exchange for terminating the investigation into Company P for its violation of the U.S. Foreign Corrupt Practices Act ("FCPA"). As a usual practice in case settlements, Company P neither admitted nor denied relevant facts.

Findings by the SEC

In its Cease and Desist Order, the SEC accused that employees, distributors, or sub-distributors of the Chinese subsidiary of Company P ("Company P's Chinese Subsidiary") improperly influenced public hospital staff to gain an advantage in certain public tenders held by the relevant public hospitals. Specifically, the illegal acts in the relevant public tenders conducted by Company P's Chinese Subsidiary mainly involved the following elements:

• Hospital staff responsible for drafting tender technical specifications decided the hospital's tender technical preferences and drafted technical specifications favorable to Company P's Chinese Subsidiary after consulting with employees, distributors, or sub-distributors of Company P's Chinese Subsidiary before the opening of the bidding period;
• The aforementioned hospital staff drafted relevant technical specifications to increase the possibility of Company P's Chinese Subsidiary winning the bid;
• The aforementioned hospital staff instructed Company P's Chinese Subsidiary or its distributors or sub-distributors to prepare three bids including Company P's Chinese Subsidiary and two other equipment manufacturers to meet the requirements of the public tender and to give the bidding process a legitimate appearance.

In the two examples of illegal conducts by Company P's Chinese Subsidiary mentioned in the Cease and Desist Order:

• A regional sales manager of Company P's Chinese Subsidiary gave the head of the Radiology Department of a public hospital an equivalent of about 14,500 USD in exchange for his assistance in a 4.6 million USD equipment purchase by the public hospital. Specifically, a sales team of Company P's Chinese Subsidiary discussed the specifications in the tender with the department head, and the distributor of Company P's Chinese Subsidiary prepared the accompanying bids with another manufacturer’s products;
• Employees of Company P's Chinese Subsidiary had discussed with the head of a relevant department at a public hospital about customizing technical specifications in a public tender worth 475,000 USD, so that only Company P's Chinese Subsidiary and two other manufacturers would be eligible to bid. In the end, one of the distributors of Company P's Chinese Subsidiary won the bid. The SEC determined that the winning bid was due to improper influence on the tender specifications.

In addition, the SEC also accused that the special price discounts given to distributors by Company P's Chinese Subsidiary gave space to the potential use of excessive profits to fund improper payments to employees of government-owned hospitals, thereby creating compliance risks. Specifically, the aforementioned special price discounts given to distributors did not retain sufficient written records to ensure their commercial legitimacy and management approval. The SEC believed that the combination of the lack of accounting internal controls and the pressure to achieve additional sales revenues created a risky environment where excessive distributor profits could be used to fund improper payments to employees of government-owned hospitals.

Furthermore, the SEC believed that Company P's Chinese Subsidiary did not execute relevant due diligence and training procedures in its interactions with distributors, nor did it sufficiently test high-risk sales activities to identify internal control deficiencies.

Jurisdiction and Main Content of the FCPA Accounting Provisions

This case was the first FCPA enforcement action against the healthcare industry in China since the Novartis case[1] in June 2020. What was unique about this case was that only the SEC dealt with the involved party in question under the FCPA's accounting provisions, while the U.S. Department of Justice ("DOJ") terminated its parallel investigation under the FCPA's anti-bribery provisions.

Compared to the FCPA's anti-bribery provisions, the FCPA's accounting provisions have a narrower jurisdiction, applying only to issuers whose securities are listed on a national securities exchange in the United States, including foreign issuers of American depositary receipts. During the relevant period of the case, Company P registered with the SEC as a Foreign Private Issuer and traded publicly on the New York Stock Exchange via secondary listing. Therefore, Company P fell under the jurisdiction of the FCPA's accounting provisions as an "issuer".

The FCPA's accounting provisions include the Books and Records Provision and the Internal Accounting Controls Provision. The Books and Records Provision requires issuers to establish and maintain reasonably detailed books, records, and accounts that accurately and appropriately reflect the issuers' transactions and asset dispositions. The Internal Accounting Controls Provision requires issuers to establish and maintain a sufficient system of internal accounting controls to reasonably ensure that: (i) transactions are executed in accordance with the management's general or specific authorization; (ii) transactions are recorded as necessary: (a) to ensure that financial statements are prepared in accordance with generally accepted accounting principles or any other conditions applicable to such statements, and (b) to maintain accountability for the company’s assets; (iii) access to assets is permitted only in accordance with management's general or specific authorization; and (iv) the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.

Resolution of the Case

Company P is not a first-time violator of the FCPA. As early as 2013, Company P had reached a settlement with the SEC for its similar conduct in Poland, which was allegedly violating the FCPA's accounting provisions. In that case, the SEC accused employees of Company P's Polish subsidiary of improperly paying public officials of local medical institutions in at least 30 transactions between 1999 and 2007, in order to increase the likelihood of Company P's success in medical equipment public tenders. The improper payments were erroneously recorded in Company P's financial books and records under various legitimate expense categories. Ultimately, the SEC reached a settlement with Company P, ending its enforcement action against Company P by disgorging the illegal gains (including prejudgment interest) totaling approximately 4.5 million USD. The SEC did not impose additional fines on Company P beyond the disgorgement of illegal gains, nor did it impose any mandatory compliance rectification or reporting requirements on Company P.

In this case, Company P once again violated the FCPA by improper behavior and improper accounting practices in public tenders. Compared to the resolution of its "first violation" a decade ago, the SEC not only disgorged Company P's illegal gains of approximately $47 million USD (including prejudgment interest) but also imposed an additional fine of $15 million USD and a two-year compliance rectification reporting obligation. In comparison, the SEC's penalties against Company P in this case were significantly more serious than those in the 2013 case.

Although Company P may have been at a disadvantage in terms of penalty discretion due to recidivism in this case, Company P's cooperation and compliance remedial measures after the case may have earned it some leniency to a certain extent. The SEC explicitly acknowledged Company P's cooperation and remedial measures in its Cease and Desist Order, including:

• Company P conducted an internal investigation into the relevant illegal activities and regularly reported the facts discovered in the investigation to the SEC, while also identifying key non-privileged documents and voluntarily providing translations thereof;
• Company P continued to implement remedial measures, including improving the compliance tone at the top and the middle (especially focusing on Company P's Chinese subsidiary), strengthening the accountabilities of business leaders for implementing compliance policies, emphasizing compliance as an important part of ethical business practices, terminating or disciplining involved employees of Company P's Chinese subsidiary, severing business relationships with involved distributors, improving its internal accounting controls related to distributor management, bidding practices, and the use of discounts and special pricing, and improving its compliance training.

Impact and Compliance Lessons from this Case:

1. Pay Attention to Key Risks in Public Tenders

In order to secure a winning bid, it is normal business practice for companies to lobby purchasing parties by demonstrating the advantages of their products. However, this kind of "business lobbying" should not be used as a shield for corrupt practices. Specifically, there are several takeaways regarding the interactions with purchasing parties and their personnel during the bidding process:

• All interactions should take place in a professional setting;
• Costs incurred from interactions with relevant parties or personnel thereof should be reasonable and lawful, without any corrupt intent, i.e., they should not be for the purpose of improperly influencing the exercise of official powers in order to obtain business opportunities for the company;
• Such costs (if any) should be accurately recorded in the company's accounting books and records.

2. The SEC's Latest Stance on the Offering Special price discounts to Third Parties Brings Challenges to the Existing Distribution Model in China

In this case, the SEC believed that the special price discounts given by Company P's Chinese Subsidiary to distributors may generate excessive profits which may subsequently create the risk of bribery. Although the SEC did not detail the special price discounts given by Company P's Chinese Subsidiary to distributors in its Cease and Desist Order, we can at least confirm the following points from its text:

• The special price discounts were not uniform discounts applicable to all distributors;
• The special price discounts were not approved by the company's senior management (it might have been approved only by middle management, such as regional managers);
• The special price discounts were not accurately recorded in the accounting books and records of Company P's Chinese subsidiary.

In China, pharmaceutical or medical device manufacturers generally adopt a distributor-based sales model. After the implementation of the “two-invoice” system for drug sales, the original multi-link distribution model was restricted, leading to the emergence of promotion service providers who replaced the prior distributors. However, manufacturers offered substantial discounts or rebates to not only distributors but also to promotion service providers. In many cases, manufacturers would also offer additional special price discounts to distributors or promotion service providers based on their requests or applications from sales representatives.

Existing commercial bribery cases have shown that most bribery funds were from distributors or promotion service providers. During investigations of commercial bribery cases, distributors or promotion service providers often argue that the funds come from pharmaceutical or medical device manufacturers in an attempt to evade responsibility or mitigate punishment. To directly prove that a pharmaceutical or medical device manufacturer was responsible for such commercial bribery, such as providing excessive discounts or special price discounts for bribery purposes, or that the decision to bribe came directly from the manufacturer, posed high demands on evidence collection for administrative or even criminal law enforcement authorities. Therefore, there have been many cases where only distributors were punished for commercial bribery.

In this case of Company P, although the SEC did not directly find that excessive profits generated from the given special price discounts to distributors had actually been used to fund bribery to public hospital staff, it nevertheless pointed out the existence of such risk and considered it as part of the factual basis for punishment. This posed a direct challenge to the practice of giving third-party partners high or even excessive discounts in the existing pharmaceutical and medical device distribution model in China and revealed the underlying risks. Whether this will become new angle for administrative law enforcement in the long run is worth observing.

Therefore, the use of distributors in various ways to circulate improper funds to cover up certain improper business behaviors is no longer "safe" in the current law enforcement environment as this “veil”, at least from the perspective of the SEC's enforcement of the FCPA's accounting provisions, has been pierced to a certain extent. In the future, transferring funds to distributors through abnormal concessions to fund improper payments will become a high-risk practice and is very likely to attract law enforcement actions.

3. Strengthen the Implementation of Corporate Compliance Systems

This case has once again demonstrate the importance of maintaining the dynamic effectiveness of a company's compliance system. The DOJ and the SEC have always emphasized that companies should pay attention to lessons learned from previous misconducts while the tones from the top and the middle level is assured. In this case, Company P was investigated by the SEC as early as in 2013 due to the improper behaviors of its Polish subsidiary during government public tenders. Ten years later, Company P once again allegedly violated the FCPA due to similar behaviors of its Chinese subsidiary. In the end, not only were unlawful gains disgorged and a fine imposed, but the company was also subject to a 2-year compliance rectification reporting obligation. Therefore, summary, analysis of past violations, and the integration of compliance lessons into the subsequent update of the compliance program, can effectively improve a company's corporate compliance program. This will also ensure that a company's compliance program improves dynamically, and operates effectively on an ongoing basis.

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