º¬Ðß²ÝÉçÇø

This article seeks to clarify the connection between income indicators highlighted by recent IPO obstacles faced by pharmaceutical companies, the relevant IPO regulations and the basic logic linking these issues to anti-corruption efforts in the sector. The author does not offer solutions but rather raises questions for further consideration and collective problem solving.

Applicable IPO rules

Pharmaceutical companies seeking to list on domestic exchanges must meet financial criteria under various listing standards, all of which underscore the necessity of achieving scale in operating revenue. For those aiming to list on the Sci-Tech Innovation Board, for example, compliance with the four indicators set out in the Guidelines for Assessing Sci-Tech Innovation Attributes (Trial) is also required, further highlighting the importance of revenue.

Given the substantial costs associated with drug development and production, net profit is an inadequate measure of a pharmaceutical company¡¯s investment value or suitability for listing. Instead, revenue and market share are regarded as key indicators of a company¡¯s maturity. For pharmaceutical companies, revenue is considered far more significant than cost, and a more aggressive approach to expenditure may be justified.

Sales expense indicators

Given that revenue is far more critical than costs for pharmaceutical companies, increasing expenditure to drive higher income is a logical strategy. As a result, these companies typically incur substantial sales expenses including promotional costs, sales staff salaries, travel and office expenses related to sales, business entertainment, training and conference fees. The following examples illustrate sales expense indicators for listed and prospective listed pharmaceutical companies.

1. 1. LJX is an innovative pharmaceutical manufacturer specialising in the research, development, production and sale of chemical drug formulations and patented traditional Chinese medicines. From 2019 to 2022, the company¡¯s sales expenses accounted for 61.29%, 47.60%, 46.11% and 45.09% of operating income, respectively, with promotional service fees comprising 95.55%, 93.27%, 91.22% and 91.44% of total sales expenses, respectively, over the same period.
   2. JTR is primarily engaged in the research, development, production and sale of patented traditional Chinese medicines. Between 2020 and 2022, the company¡¯s sales expenses represented 49.03%, 50.86% and 51.95% of operating income, with promotional fees accounting for 90.77%, 94.23% and 95.29% of total sales expenses, respectively.

Listing inquiry and responses

During the listing review, regulators may raise questions regarding elevated sales expenses. Below is an example.

1. 1. Listing review inquiry. The issuer is requested to explain the reasons and justifications for the high number of promotional service meetings held between 2019 and 2022 (6,013, 8,611, 8,471 and 4,024 meetings, respectively), as well as the rationale for the high proportion of promotional service fees. The issuer should also clarify whether there is any occasion of commercial bribery, false invoicing or improper benefit transfers.
   2. Issuer¡¯s general response. The company¡¯s relatively high promotional expenses are primarily due to industrywide adoption of the ¡°two-invoice system¡±, which has prompted prescription drug companies to shift from the traditional distributor model to a delivery-agent framework. Under this arrangement, delivery agents are solely responsible for transporting medicines to end-user medical institutions, while drug promotion falls to manufacturers.

Many pharmaceutical manufacturers have limited in-house marketing capabilities and therefore outsource promotional activities to third-party service providers. Due to its relatively small scale and insufficient sales staff, the company is unable to manage nationwide promotion internally and must rely on external providers. As the company remains in a growth phase, it engages multiple third-party promotion agencies to expand market reach, resulting in elevated sales expense ratios and promotional service fee ratios.

1. 3. Issuer¡¯s partial response regarding conference fees. The relatively high proportion of departmental meetings within promotional expenditure is primarily due to the highly specialised nature of the products, which necessitates direct engagement with medical professionals to discuss efficacy.

The company employs a targeted promotion strategy, favouring smaller-scale departmental meetings as they can be conducted directly within hospital departments, ensuring greater convenience and efficiency. Additionally, as part of its focus on market penetration into secondary and county-level hospitals ¨C where large-scale academic promotions are logistically challenging ¨C departmental meetings prove more practical to organise.

1. 4. Issuer¡¯s partial response regarding channel maintenance fees. Channel maintenance primarily involves promotion service providers managing relationships with healthcare providers, including real-time monitoring of product distribution, end-of-period inventory levels and the collection of actionable market feedback from partner hospitals.

These responses highlight the overall situation in the pharmaceutical industry, where marketing is prioritised over research and development, resulting in a significant imbalance in expenditure.

Criminal risks

To absorb or conceal substantial sales and promotional expenses, certain pharmaceutical companies may expose themselves and their accomplices to significant legal risks. Examples include:

1. 1. Paying for fictitious or inflated promotional fees, enabling promotional service providers to accumulate off-the-books funds for commercial bribery. Accomplices may include the promotional service providers, their employees and outsourced labour providers.
   2. Inflating materials procurement costs or fabricating purchases to generate slush funds with suppliers for illicit payments. Accomplices may include materials suppliers and those facilitating fund flows.
   3. Deploying covertly affiliated promotion agencies¡¯ own capital for bribery. Enablers may include nominee shareholders and operators of linked agencies.

In summary, the key to pharmaceutical companies achieving positive outcomes in the capital market lies in their ability to shift from a marketing-led to a research-driven model, and to lawfully increase the income of downstream clients, such as doctors.

Zhang Nan is a senior partner and director of investment and fund business division at W&H Law Firm. He can be contacted by phone at +86 138 1778 2085 and by email at nan.zhang@weihenglaw.com