Responding to IPO scrutiny over medical device distribution

A recent Chinese TV drama, The Youth Memories, tells the inspiring story of a group of Beijing youngsters in the 1970s finding strength from each other to overcome a multitude of challenges while growing up through gaokao national exams, military service and ultimately going into business together. Their business ventures began with authorised sales of imported medical devices, and gradually evolved into developing domestic devices for export.

Interestingly, the drama reveals several issues that plagued China’s medical device industry during its growth: expensive devices, limited hospital budgets, and a staggering number of patients desperately in need of advanced treatment.

To resolve these issues, medical institutions and medical device manufacturers gradually came up with a co-operative mode for device distribution, accompanied by suspicion and doubt over commercial bribery and unfair competition.

Having combed through relevant Star Market IPO cases, this article summarises key concerns of securities regulators when reviewing compliance of medical device distributions, and what can be learned from them.

Direct distribution

When conducting compliance review on the distribution of medical devices, securities regulators tend to focus on whether the act constitutes commercial bribery or unfair competition that involves bundled sales of consumables and ancillary equipment under the guise of lease, donation or distribution.

Based on the responses of IPO applicants to review enquiries, companies needing to argue the legitimacy of their operations may consider the following lines of thought:

• While sales of reagents/consumables took place concurrently with the distribution of the medical device/equipment, the issuer and client executed separate agreements for both activities. The sales and distribution were independent from each other, with the former serving as neither a precondition nor postcondition for the latter.

Additionally, the transaction took place on the basis of arm’s length negotiation. There was no clause mandating the purchase of any reagents/consumables under the distribution agreement for the device/equipment, nor any that set out a minimum reagent or consumable purchase amount or volume to use the device/equipment.

• The issuer may have provided the device/equipment free of charge to the client to promote the sales of the reagents/consumables, but ownership of the device/equipment remained with the issuer, while the client obtained only the right to use said device/equipment within a specified period. Therefore, the act did not constitute sales via bribery in money or otherwise.
• Lease or gratuitous provision of device/equipment is both consistent with industry practice and sound in business logic. The issuer adopted this method to promote the sales of the reagents/consumables and maximise the profitability of its portfolio. By leasing or providing for free the device/equipment to the client, the overall business revenue and consolidated gross margin level may see favourable increase due to stimulated sales of reagents/consumables, which possess higher gross profit margins.

In addition, a unit of medical device/equipment can be quite pricey. Lease or gratuitous provision would benefit clients by relieving their financial pressure, thereby maintaining good co-operative relations.

Reliance on distributors

When reviewing the compliance of medical device distribution via intermediary distributors, securities regulators look at whether the distributor has been penalised for giving away or distributing the device/equipment, as well as if normal operations of the issuer would be materially and negatively impacted.

According to responses to review enquiries, issuers often need to illustrate that:

1. The distributor conducts its activities as an independent legal entity, and any resultant legal consequences shall be borne by itself;
2. Whether the distributor has been penalised by market regulatory authorities due to suspected offences such as commercial bribery or unfair competition in relation to the gifting or distribution of medical devices during the reporting period; and
3. The transaction amount between the issuer and distributor during the reporting period takes up a relatively small percentage of the issuer’s operating revenue, which means that even if the co-operation was discontinued, and the distributor were cut off from the medical device, the impact to the issuer’s operating results would be limited.

Therefore, the gifting or free distribution of medical devices would not materially or negatively affect the issuer’s normal business operations.

Key takeaway

Based on this research on Star Market IPOs and current understanding of the Anti-unfair Competition Law, if prospective issuers are questioned on whether their medical device distribution constitutes unfair competition, they should focus their argument on whether there was damage to the market order of fair competition.

For this focus, the specific demonstration direction includes but is not limited to: verifying if the act is consistent with the practice of the medical device segment; if there is any clause that affects the fair competition of other parties (e.g. minimum reagent/consumable purchases, purchase amounts, unreasonable liquidated damages, or exclusion clauses); and if commercial bribery or other dishonest means were involved in the obtaining of trade opportunities or competitive advantages.

If medical devices are distributed via intermediary distributors, prospective issuers should draw regulatory attention to not only if it involved unfair competition, but also the transaction amount with the distributor, its percentage of the operating revenue and, should the co-operation be terminated, if its normal operations would be materially and negatively affected.

Baker Chen is a partner at Llinks Law Offices. He can be contacted at +86 21 3135 8759 and by email at baker.chen@llinkslaw.com
Fiona Zhu is a contractual partner at Llinks Law Offices. She can be contacted at +86 21 3135 8790 and by email at fiona.zhu@llinkslaw.com