Insider Analysis: Pharmaceutical Outsourcing To China – Some Legal Issues

By: Susan Finder, Heller Ehrman, Hong Kong

Companies contemplating outsourcing arrangements with Chinese companies to handle clinical trials, contract research or manufacturing should be aware of some of the major regulatory issues in China’s pharmaceutical industry – as identified by the People’s Republic of China (PRC) government – which may have an impact on outsourcing. Several of the issues frequently encountered by companies outsourcing to China are listed below; practical solutions for  dealing with those issues also are discussed.

In the wake of the corruption scandals involving the top leadership of China’s State Food and Drug Administration (SFDA), as well as the deaths caused within China and in Central America by fraudulently produced drugs or bulk pharmaceuticals, the State Council has identified a litany of problems in the regulation of medical products:

• fraudulent approval of registration of drugs;

• fraud in implementing good manufacturing practices (GMPs) (i.e., Chinese GMPs), particularly in the manufacturing of injectable drugs;

• local government interference in the monitoring of drug safety;

• fraud in research submissions;

• fraud in clinical trials;

• fraudulently approved medical devices;

• fraudulently approved drug distribution companies; and

• inadequacies in informing the public about drug safety emergencies and adverse reactions.

State Council Proposes Solutions

To help resolve these problems, the Chinese government prescribed a series of solutions, which include:

• conducting spot checks of materials submitted in support of clinical trials;

• imposing the primary responsibility for drug safety monitoring on local government departments;

• requiring local governments to develop a system for informing the public about drug safety, including a national drug safety information system;

• increasing funding for local-level drug safety institutions;

• improving legislation;

• reforming the approval system (e.g., splitting the initial acceptance, evaluation, and approval of drugs); and

• improving the drug monitoring program for 30 percent to 80 percent of all drugs and medical devices.

However, given the pressure on local government to increase economic growth, the extensive corruption within the health care industry in China, and the pervasive lack of business ethics among certain entities, we are less than optimistic that the solutions proposed by the State Council will solve the underlying problems.

Accordingly, it is critical to act carefully when outsourcing to China; pharmaceutical companies should use caution at all stages of an outsourcing transaction. Some specific suggestions are provided below.

Due Diligence Is Key

When considering outsourcing to China, at the initial stages companies should do their own due diligence on the company (the “Vendor”) to which they plan to outsource or they should have an agent engage in due diligence on their behalf. In China, companies are required to have various types of licenses to engage in business; the type of license or certificate required depends on the business in which companies are engaging. All Chinese companies must have a business license and all non-profit organizations, such as research institutes and hospitals, must have an “institutional legal person certificate.” As such, due diligence should include verification of proper documentation in accordance with vendor type.

In our experience, it is not unusual for Chinese companies to overstate their competence. One Chinese company of which we are aware describes itself as a contract research organization (CRO) specializing in pharmaceutical research and development and offering a broad range of services, including all phases of clinical studies. In reality, this firm is approved as a consulting company and is not permitted, under Chinese law, to engage in pharmaceutical research and development or clinical studies. This firm may be subcontracting out those services, but it is unclear whether its foreign clients are aware that such subcontracting is occurring or whether the contractual arrangements between the parties cover such subcontracting.

Drug manufacturers in China are required to have a special license, in addition to its business license: a “Drug Manufacturing Certificate” issued by SFDA or its local counterpart. Any drug to be manufactured by the Chinese manufacturer must be within the scope of its manufacturing certificate and the license must be current. A local lawyer working for the U.S.-based pharma company also may be able to determine whether the manufacturer has been subject to any recent penalties.

Importance Of Contract Structuring

An additional outsourcing issue that we have encountered in China relates to contract structuring. In particular, problems may arise when a foreign manufacturer contracts with a U.S. company, but the outsourcing actually is being done by the PRC subsidiary of the U.S. company. In at least once instance of which we are aware, the confidentiality, non-disclosure, non-compete and assignment of inventions clauses in the outsourcing agreement did not reach the PRC subsidiary, leaving the intellectual property of the foreign manufacturer highly vulnerable. Pharmaceutical companies also should ensure that their intellectual property has been properly registered in China, because in many cases, the Chinese government will not protect unregistered intellectual property rights.

If an outsourcing contract is with a U.S. company rather than with the actual PRC entity providing the outsourcing services, your company must be sure that its contract protects your arrangements and details the subcontracting to the PRC entity. The subcontracting clauses are worth some thought, because of the frequent practice of subcontracting in China, as exposed by the recent spate of recalls of toys made in China.

It is important to consider whether you are comfortable with your intellectual property being in the hands of an entity several levels removed, and whether there is any confidentiality or non-compete obligation on the chain of subcontractors. We have found this to be problematic in outsourcing arrangements where the non-compete clause in the employment contracts of the PRC employees were invalid. This is a major issue, given the job hopping that occurs in China. It is critical for confidentiality to be included in your contractual arrangements, because China’s data protection and data privacy legislation is inadequate.

An additional issue in contract structuring is whether the entity with which you are in a contract with has assets, in the event that the transaction goes wrong and dispute resolution is required. If you are contracting with the U.S. parent company or a subsidiary, you should determine whether the company has assets to offset any future judgments. Because credit information is not widely available in China, due diligence regarding financial standing is more difficult.

Pay Attention To Dispute Resolution Clauses

If you contract with the PRC entity, the dispute resolution clause can be an issue. We do not recommend agreeing to litigation, both because a U.S. court judgment cannot be enforced in China and because there are extensive problems with corruption in the Chinese courts. For example, the former chief judge of China's Hunan Higher People's Court was sentenced to death at a trial in Beijing recently for taking bribes worth over $759,500, and such cases have occurred in many parts of China.

The preferred method of dispute resolution is arbitration, preferably outside of China, where the foreign party will have a greater choice of arbitrators, and the environment will be neutral. It is not unusual for Chinese parties in pharma outsourcing contracts to agree to arbitration in Hong Kong, at the Hong Kong International Arbitration Centre, or in Singapore, at the Singapore International Arbitration Centre.

A foreign arbitral award can be enforced in China under the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (the New York Convention) and Hong Kong awards under the Arrangement Concerning Mutual Enforcement of Arbitral Awards Between the Mainland and the Hong Kong Special Administrative Region (the Arrangement). Because Hong Kong is part of China, the Arrangement was entered into to provide for the mutual enforcement of arbitral awards on the mainland and China, to take the place of the New York Convention, which had governed the subject prior to the 1997 handover.

Vigilant Monitoring Can Help

After the outsourcing arrangements are in place, it is important to not become complacent about monitoring the situation. At the contract negotiation stage, you should insist on clauses: (1) permitting you or your agent to check ongoing production; and (2) requiring quality control inspections by your own or independent technical personnel. The recent toy recalls are evidence that the toy companies were not sufficiently vigilant about monitoring production and engaging in quality control.

Many foreign pharmaceutical companies are pleased with their outsourcing arrangements with Chinese companies. However, caution is advised to make sure that you are properly protected.

Susan Finder, special counsel, is a member of Heller Ehrman’s Asia Business Practice in Hong Kong. She has many years of experience advising foreign investors in China.

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