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Monday, January 7, 2013

UPDATE. From the producer to the customer - is the shortest way the best way ? Considerations about the advertising and pharma industries.

In February 2014 the Romanian Government issued an Emergency Government Ordinance (EGO), no 2/2014, which extends the public service obligations to ensure the uninterrupted provision of drugs also to the manufacturers and their authorized importers.  In addition, EGO 2/2014 provides that for the drugs included in the national health programs (financed through the National Health Fund), there must be at least 3 authorized wholesale distributors.   It is interesting to note that the obligation to have at least 3 distributors is imposed in respect of all the medicaments included in such programs, notwhitstanding they are in a dominant/monopoly position or not. Although the concern on which such a provision is based is to ensure competition, there is  problem with the wording of the law: it does not specify, as it should have beeen, that the 3 distributors should be independent from the producer and also not part of the same group of companies.  Otherwise, there will be no competition. 
In order to respond to the concerns of the producers, EGO 2/2014 also includes provisions which create more controls over the parallel trade with their products.
The President of Romania refused to enact and decided today, 16 July 2013, to send the bill aproving EGO 25/2013 back to the Parliament for further reconsideration. The main arguments invoked by the President refers to the same infringement of the economic freedom of the TV stations and of their clients and the breach of the principle of the free competition.
Both the story of the "direct distribution" of the pharmaceutical products and the story of prohibiting use of intermediaries and wholesalers for advertising space  go ahead and the concerns expressed by me seem to become reality.
First, I heard (from two reliable sources, as rules for good journalism require) that the producers of pharmaceutical products which introduced a "direct distribution" system started, recently, to "discriminate" between their own products in a funny if not abnormal way - they pretend that payment for the products for which distribution is made directly is made in advance (!), due to the fact that the buyers (the pharmacies) would not offer sufficient guarantees regarding payment of the price (?).  On the other hand, the same pharmacies seem to be financially "healthy" when payment for any other products supplied by the same producers is at stake, so that no advance payment or guarantee is required.  It is interesting to note that in the current system, pharmacies sell less not more of the products for which payment is now asked upfront and also that there is no visible sign that pharmacies are doing worse than last year, for instance. Then, "qui podest"? Are the producers involved in the "direct distribution" determined to test to the end the determination of the Romanian competition authority?
In the second situation, the televisions, which were considered as the true beneficiaries of the Emergency Government Ordinance 25/2013 (at least the large ones), where forced to face the realities of the market when they wanted to receive payment for adds and campaigns already aired but they were postponed politely because 1) proper contracts, in line with the new legislation, should be signed between the advertisers and the respective television and 2) the usual payment terms by the advertisers are much longer than those used by the media agencies.  As a direct result of the market realities the televisions might face payment problems and they will need to re-consider how their cash-flow is organized. Life is tougher than the movies, isn't it ? In the same time, the advertisers are getting nervous as they come to realise that they have to deal - and to balance - such a large number of televisions.  The televisions should bear in mind that the advertising is the promise and the hope of potential additional incomes made by the undertakings which buy advertising time and that the beneficiaries would prefer that payment for such a service is made after they get the additional income, not earlier.  It is an issue of cash flow for them, too, and the problem is of particular importance in industries which operate based on more reduced profit margins.  So, how long until all the market players will realize that the EGO 25/2013 does not offer any solutions but add to the problems already affecting them and that other solutions should be put in place ?


The Romanian Competition Council decided yesterday, 12 March 2013, to open an industry investigation into the potential effects of the direct distribution of the pharmaceutical products on the Romanian and EU internal market and on the consumers. 
The aim of the investigation is to asses with maximum of accuracy the likely effects of such a change in the distribution model, in order to allow market players - producers and distributors alike - to asses correctly their behaviour and its impact on the market.  The Romanian Competition Council will rely on the input received from the manufacturers, the distributors and other stakeholders in order to reach its conclusions as soon as possible and prevent market players into crossing the red line with regard to the compliance with the competition rules. 

The economy is about goods being produced by manufacturers and services being provided by service providers and then these goods and services being used by the consumers.  In order for the goods to change hands and for the consumers to get what they need, an equally operation of sale would suffice. The economy would be a pretty simple equation. 
The economy might look simple and straightforward but reality shows that it is far from being so simple.  The road between producers and their consumers should be the shortest and sometimes it is.  But in most cases, the goods change hands not just one time but several times.  Wholesalers, retailers and other kinds of intermediaries interfere in the trade between the producers and the consumers. As things get more complicated, somewhere in the business relations other benefits should emerge in order to justify the increased complexity. As long as the economic process was always concerned with efficiency and businesspeople constantly looked for cutting costs and increasing their margins, using intermediaries in their trade must make sense or, otherwise, do not exist at all.

These considerations came into my mind as I was analyzing two recent developments in the legislative and business environment of Romania.

The first event was related to a Government Emergency Ordinance, issued in November 2012, which aim was, among other things, to impose a different business model in the relations between TV stations, advertising and media buying agencies and their clients - beneficiaries of adverstising on television.  According to the draft Government Ordinance (at the time of writing of this post, the legislative act was not yet published), TV stations are, virtually, forbidden to pay intermediaries for the sale of their advertising time to their clients  (!). Moreover, from the wording in the draft GO, it  results that media buying agencies cannot act as wholesalers either, purchasing volumes of advertising minutes from the TV stations and, then, reselling them to final clients.  It is easy to imagine that the draft law was received with consternation and even fury, mainly from the publicity industry.  An obvious result of the GO, if applied, would have been the closing of large segments of this industry, to the detriment of both sizes of the market - TV stations and purchasers of TV advertising. In the context of the harsh economical conditions, the entire publicity industry might have been in danger.  The new norms were received with almost equal dissatisfaction by the corporations who were buying advertising time on TV. They are supposed, from now on, to handle their TV campaigns on their own, by entering in direct commercial relations with each TV station and negotiating with every station which was worth putting in a campaign (!).  The Romanian broadcasting market is quite fragmented, although dominated by a few large broadcasters, so that organising a well focused campaign will prove to be a difficult – and more costly - endevour.
Athough there was no public outcry from them, even the TV stations might be seriously affected by the proposed legislation.  The TV stations are in direct competition and they all have the same advertising time available for sale, as this time is capped through regulations issued by the audio-visual regulator ("CNA").  If an intermediary could no longer be used for promoting the sale of the advertising time (the GO is not formally forbidding making use of distributors but the interdiction to provide any payment for their work will have a similar effect), the TV stations would suffer. They will have to handle directy a few hundred significant corporate advertisers. This would mean that they will have to hire specialied staff and create special departments and, besides, the TV stations would incur the risk of  not selling their advertising space timely and at the best prices.  Their cash-flow would suffer, too, as long as, prior to the draft GO, media buying agencies used to acquire and pay up-front for the advertising time.  The smaller TV stations would be the worst hit by the interdiction to hire intemediaries.
If everybody would have sufered from such a governmental measure, which could be reasons or the forces behind it ? Inspite of the rumours assigning the "paternity" of the GO to a certain broadcaster (certain commentators even named the draft GO after the name of press magnate), its roots lie rather in a poor understanding of the role of the distribution in the economic mechanism.  As advertising budgets were shrinking, some might have thought that they should get a larger slice of the pie.  Such a goal is legitimate but it might bring side effects offsetting the increase in the slice.  The slice itself may not get any bigger as long as new efforts must be put in place in order to achieve this result - the disapearence of the intermediaries will not, by itself, add more revenues for the broadcasters.  The transaction costs on both sides of the market will increase and this will result in lower revenues for the TV stations and higher advertising costs for the beneficiaries of the advertising.
The lesson is that intermediation in the distribution of any goods or services should not be made impossible (of course, nor it should be imposed) through legislative norms.  If using intermediaries will result in the best desirable outcome, this is for the market to decide.  Intermediaries will be there if they are capable of bringing substantial benefits to both sides of the market. If not, they will disappear.  The State cannot and should not arbitrate, ever, on such issues, as this means to touch at the very heart of the market economy. This is both an issue of defending a basic legal principle and an issue of efficiency in the economy.

A second situation which justify a discussion on the benefits and the evils of the intermediaries in distribution is the announced introduction, on the Romanian market, of a so-called "direct distribution" by a major international producer of medicaments (its features were not, however, of a direct distribution system). The mentioned producer sought the opinion of the Romanian Competition Council on the distribution system envisaged by it (?!).  The producer intended to start distributing some of its products directly to the pharmacies after distributing them for 20 years through large distribution companies.  There were no complaints made against these distributors, neither other disputes between them and the drugs producer.  The later simply wanted to change the way it distributes some of its products, without invoking any market problems or constraints.  The request made to the Competition Council raised a few question marks: what triggered the change, why the producer wanted to have some kind of clearence from the antitrust agency and why it insisted in getting some formal reply, although the Romanian antitrust agency does not issue non-intervention decisions or any other documents with a similar effect ?
But the most peculiar aspect of the new distribution system was that the products distributed directly to the pharmacies were exactly those which provided the producer a dominant position on the respective relevant markets, perhaps even monopoly rights, based on valid patents or patents which expired relatively recent !  Thus, the main or the only form of competition possible for these products was the inter-brand competition of the distributors.  The change was set to occur in a very difficult financial context, where payments from the public health fund have huge delays, of at least 1 year ! In this context, the distributors serve, unwillingly, as "buffers" between the weak payment capability of the health fund and the producers.  Distributors are the direct clients of the producers and not the health fund, so that the later can always ask payment from the former.
The Romanian Competition Council eventually sent a letter to the producer, making it aware of the fact that the elimination of the distributors in respect of the products in dominant or monopoly position virtually means that competition itself will be eliminated with regard to these products.  By contrast, such a system of distribution raises, in principle, no concerns, if the distributed drugs have much lower market shares (in Romanian law, a company is presumed to be in a dominant position if it has a market share of at least 40%).  The Romanian Competition Council also decided to publish, in January 2013, guidelines to all the companies active on the pharmaceutical markets, incorporating the opinions sent to the applicant and other clarifications resulting from the recent jurisprudence of the Council.

In this case, like in the case mentioned above, I consider that companies should be free to choose their distribution system, taking into account their interests but without neglecting or acting against the interests of the consumers.  A rational producer would design its distribution system in such a way as to minimize its costs and increase its margin of profit.  The problem with the system  designed by the drugs producer who asked the opinion of the antitrust agency, is that it apparently fails to meet the rationality criteria that I just mentioned.  The specialized distributors enjoy benefit of scales economies which allows them to operate at lower costs and these economies are very difficult (if not impossible) to be matched by any drugs producer, distributing only its products. In addition, the market for distribution of medicaments is quite fragmented (there are at least 10 significant players) and the competition among the distributors is fierce, which, in its turn, forces the distributors to transfer their efficiencies to their clients and, eventually, to the final consumers.  Accordingly, the new system is likely to result in higher prices and, hence, not to be to the benefit of the consumers. At first sight, it is not even beneficial for the producer, unless this follows a different purpose - there were concerns raised regarding a more strict control over the supply of the products included in the new system and the limitation of the parallel exports from Romania into the EU Internal Market.  The concerns are based on the fact that the products in discussion seem to be favoured for export in other EU countries (Romania has one of the lowest prices in EU for most medicaments subsidizied from the health fund) and on the fact that the Romanian Competition Council sanctioned, in 2011, two other international drugs producers for limiting the parallel trade by their distributors in other countries of the European Union.
Although such a purpose would be against the competition rules from the Treaty on the Functionning of the European Union and from the Romanian Competition Law, it would be, at least, rationale ! With respect to the drugs producer, the increases in costs and the possible reductions of its profit margin would be compensated by benefits obtained in other EU member countries.
To conclude, the elimination of the distributors by companies in dominant and monopolist position is highly suspicious and likley to go counter the interest of the consumers, even if it brings positive effects to the dominant itself.  
Going back to the benefits – and evils  - of the distributions, a few aspects must be borne in mind
Regarding the customers, they might need or they might not need a middleman  but then they, or the producer, will have to take over the distribution task itself, including storage, transportation and the attached risk of loss of the products or of the failure to realize the envisaged profits. 

Distributors are, generally, more flexible than manufacturers and the success story of large companies worldwide, from Wall Mart or Carrefour, to Dell and EADS, shows that these are stories of the success of supply chains in which distributors moved swiftly and were able to solve the problems arising from interruption of raw materials supply, poor quality, bad weather conditions or human errors. 

The distributors are also, often, more flexible, in terms of their financial conditions, mainly their payment terms. Distributors may easily bundle products from different producers, thus responding to specific requests from the market – for example, the needs of a hospital or of a purchaser of advertising space. 

In short, in the modern business background, intermediaries and distributors are one of the "necessary evils".  

Whoever finds a suitable replacement should raise his hand and speak out !