Red Flags in a Pharmaceutical Audit

Globally, regulatory authorities have developed a keen interest in the pharmaceutical industry. Recent enforcement actions, including the cases of GlaxoSmithKline, Johnson & Johnson, Valeant Pharmaceuticals, Abbott Laboratories etc., have paved the way for regulatory agencies to dig deeper into the malpractices prevalent in the pharmaceutical industry.

Back in 2014, the total pharmaceutical revenues worldwide had exceeded one trillion U.S. dollars for the first time. Increased competition owing to the growing size of the industry has noticeably increased the complexities of operations, sales and marketing, which in turn have led to an alarming spike in malpractices by stakeholders involved at various levels in the industry.

With the growth of the pharmaceutical industry and the unavoidable by-products that result from it, the industry is currently faced with a number of schemes that have been tailored to manipulate and defraud enforcement agencies and the public at large. The present article aims to identify the most common ‘red flags’ and fraudulent schemes that plague the pharmaceutical industry in India. Sufficient awareness about these fraudulent schemes is essential to equip auditors with a more focused and effective audit plan.

Red Flags and Fraudulent Schemes

The Indian pharmaceutical industry is faced with a number of challenges from a compliance point of view. The most prevalent fraudulent schemes in the industry relate to year-end targets, sales returns, etc., which are used as a veil to effectuate concerns around channel stuffing, free of cost products, free samples, fraud.

These schemes are deeply entrenched into the system and are mingled into the day-to-day operations and accounting practices employed in the industry. Owing to the complex manner in which these schemes operate, they remain concealed unless the substance of the activity is specifically analysed. As an auditor and as an industry expert, one should be adequately aware of these red flags and should develop a focused audit plan and procedures to detect any misconduct.

Channel Stuffing

Most of the companies engage in channel stuffing to inflate sales and earnings figures by deliberately sending distributors along its distribution channel more medications than they are able to sell to the public. The companies pay extra incentives to the distributors to hold up the inventory and not return it for a refund. Subsequently, the companies purchase back the inventory through shell companies created for this purpose at substantially lesser prices. This is generally done at the end of the financial year to inflate the revenue figures in the financial statements for investors.

Expired Inventory

Although expired drugs have no utility for end customers, pharmaceutical companies have devised ways to derive profit from them as well. The expired inventory of daily-use drugs of low value lying with distributors is recorded as sales in the companies’ accounts without them being actually sold. The inventory is essentially not taken back from the distributors citing the higher administration costs involved in retrieving these medicines.

Institutional Dealings

Companies that supply medication and drugs to government hospitals and institutions also indulge in bribery of government officials to obtain or retain contracts associated with government hospitals. Commercial bribery in the form of giving kickbacks to vendors or offering unethical incentives to doctors or hospitals to promote specific pharmaceutical products is very common across the pharmaceutical industry.

Many companies make use of illegal sales and marketing practices such as providing significant quantities of free samples to doctors, paying excessive fees or sponsorships including consulting fees and expenses for speaking engagements or participation in conference and meetings, etc. Companies offer discounts to different categories of institutional buyers such as hospitals, corporates, research agencies and others. The discounts are mostly passed on in the form of credit notes, which are subsequently misappropriated in collusion with the buyers.

Under the present Indian legal framework, the Uniform Code of Pharmaceutical Marketing Practices (UCPMP or Code) regulates various marketing practices prevalent in the pharmaceutical industry. There are talks of making the said Code mandatory for all pharmaceutical companies, but at the moment, the said Code is voluntarily implemented.

The Code stipulates that free samples must be provided on an exceptional basis only and an adequate system of controls and accountability must be maintained in respect of the supply of such samples. Further, the Code mandates that no gifts, pecuniary advantages, travel facilities, etc., should be offered or provided to healthcare professionals by pharmaceutical companies or their agents.

Furthermore, the Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 (Regulations) lays down the Code of Conduct for medical practitioners in their relationship with the pharmaceutical and allied health-sector industry. The Regulations specifically prohibit medical practitioners from receiving any gift, hospitality, travel facilities, cash or other monetary gains from any pharmaceutical company, its agents or sales representatives.

In view of the above legal framework, providing unethical incentives to medical practitioners seems to be fraught with problems. Such practices become particularly disconcerting when such incentives are offered to Central or State Government hospitals or medical practitioners associated with them. Such practices may in fact amount to bribery and pharmaceutical companies are liable to be prosecuted under the Prevention of Corruption Act, 1988.

Free Samples

The distribution channels in the pharmaceutical industry are equally plagued with compliance related issues. The distributors make use of the gaping loopholes in the industry to pocket weighty monetary benefits. Many a time, samples are provided free of cost to the distributors for distribution to end customers. However, these samples, if not specifically marked as “Free sample” are sold to the end customers at regular prices. Thus, the distributor records a profit of complete sale value violating the agency conditions with the company. Another pervasive malpractice involving free samples includes the situation where distributors return the free samples to the company portraying them to be the ones paid for, thereby pocketing the refund.

Grey Market

A huge racket perpetrated by distributors in the pharmaceutical industry involves selling of grey market or generic drugs after illegally labelling and branding them. This issue recently caused much hue and cry in the US with consequences not only limited to civil liabilities but also criminal proceedings against the accused.

Fictitious Sales

Distributors also engage in showing false sales through a set-up of shell companies to claim more incentives from the companies. Alterations of invoice numbers or other particulars of the invoices may also enable a distributor to claim incentives from the companies by reporting fictitious sales.

Developing an Approach

The common fraudulent schemes discussed above are certainly not exhaustive. However, as an industry practitioner and auditor, one can have a nuanced approach to specifically look out for potential schemes that companies might be employing to further unethical and illegal motives.

A well-designed agreement between a company and its distributor may enable a company to have the right to audit its books and records, thus keeping effective control over the distributor’s dealings and transactions. Also, a review of the companies’ books of accounts, discount schemes and customer database are essential for a successful and efficacious audit.

It is essential for every auditor to keep in mind the unique and rather ingenious antics that are likely to be encountered in the pharmaceutical industry so as to devise equally potent strategies to unearth and counter them.