How China's Probe of GlaxoSmithKline Could Play Out

TAIPEI, Taiwan ( TheStreet) -- Chinese police are investigating GlaxoSmithKline ( GSK) and making arrests related to allegations that employees paid bribes to sell drugs.

The Chinese Ministry of Public Security's probe over the past month also involves possible tax-related violations and has widened to include common employees of the British pharmaceutical giant as well as in-country management, official media say.

Eighteen people were arrested last week, China's official media reported.

I won't offer an opinion on what the company did or didn't do.

But if the courts say laws were broken, what happens to GlaxoSmithKline will probably follow one of three formulas for foreign multinationals facing legal problems in China.

Scenario 1. GSK has enough experience in China to know it should cooperate with investigators and keep a low public profile. Violations of the sort suspected in the current probe are considered standard operating procedures for Chinese companies. But if a foreign firm gets charged, despite any history of living closer to the law than its local peers, the charges stick at least in the media because China's ubiquitous nationalism favors local firms over foreign rivals.

Consider Foxconn (2317.TW), a Taiwanese consumer electronics assembler. A rash of suicides in 2010 and a mass worker strike hurt its public image and raised questions about labor conditions. One answer seeker was Apple ( AAPL), which had hired Foxconn to make consumer electronics in China.

Analysts said at the time mainland Chinese firms were treating workers worse than Foxconn, but none faced the same scrutiny.

In November last year, labor rights activists accused Samsung Electronics of hiring girls as young as 16 at two China plants and requiring workers to sign blank contracts. The allegations grabbed attention because Samsung is a global brand. What about its local counterparts?

GSK, one of the world's biggest pharmaceutical makers, shows signs of working with Chinese authorities. If that cooperation goes well, the company might need to pay a fine and develop a well-publicized internal cure for whatever legal ailments that that the police find. Its executives have condemned whatever happened but not explained the acts in much detail.

"Certain senior executives of GSK China who know our systems well appear to have acted outside of our processes and controls which breaches Chinese law," Glaxo international executive Abbas Hussain, Glaxo's president, International -- Europe, Japan, Emerging Markets & Asia Pacific, said in a statement. "We have zero tolerance for any behavior of this nature."

The company is hinting at an in-house remedy rather than a harsher penalty.

"We will actively look at our business model to ensure we make a significant contribution to meeting the economic, healthcare and environmental needs of China and its citizens," Hussain says. "Savings made as a result of proposed changes to our operational model will be passed on in the form of price reductions, ensuring our medicines are more affordable to Chinese patients."

Share prices of GlaxoSmithKline, which makes everything from Sensodyne toothpaste to advanced cancer drugs, paled slightly last month but have held up on the whole.

I'd put my health in the hands of this scenario. But if the Chinese government aims to use GSK's case to prove some point to a bigger swathe of people about the country's legal or business climate, I expect something else to happen:

Scenario 2. GSK's stated commitment to work closely with the cops fizzles because the cops are under pressure to net as many employees for as many alleged crimes as possible. They might force confessions (still the local policing style) and give incentives for workers who tattle on one another. Then they would publicly compare the company's top China people to a major illness. Someone might get locked up for a while.

In addition to the arrests so far, authorities have barred a U.S. national believed linked to the case from leaving China. There's also a fair sum at stake: 3 billion yuan ($489 million) supposedly allocated to bribe money over the past six years, the official China Daily newspaper reports.

For a parallel case against a foreign firm in China, remember Australian miner Rio Tinto ( RIO). In 2010, four of its executives, including a foreign national, were sent to jail for taking bribes and stealing commercial secrets.

Bribes and stealing secrets? Those words might not quite appear in the official employee handbooks of Chinese companies, but those who ignore these informal guidelines for a modern cutthroat world may find themselves out of work.

Still, the central leadership isn't happy about that, especially as they try to make health care more affordable to common Chinese, and may try to sacrifice GSK as a chicken to scare monkeys in other drug companies. Central leaders may also want to show an international audience that its laws are serious, policing effective and China not a steal for multinationals.

Scenario 3. Powerful players in China's growing, ever changing and hypercompetitive medical industry sell drugs similar to GSK's but lack the name recognition to scale up.

According to this scenario, police may have been ordered from higher-ups with friends in the medical field to make as many busts as possible.

KPMG rated the British drug producer the eighth-largest medical multinational in China in the first quarter of 2011, with $378 million in sales.

This sort of theory, common as it is, seldom bears evidence. But if this is really the case, Chinese authorities will build up their case to stick people in jail and hurt GSK's future business in China.

At the time of publication the author had no position in any of the stocks mentioned.

Ralph Jennings is on LinkedIn.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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