Valeant’s financial restatement begs compliance questions

Valeant Pharmaceuticals’ announced financial restatement, which is projected to shift roughly $58 million in revenue from the second half of 2014 to the first half of 2015, has raised larger questions about the drug company’s compliance program and its business model. It could also serve as an early warning to all publicly listed U.S. companies about the increased room for misjudging the booking of sales once the Financial Accounting Standards Board rolls out its new revenue recognition standards in 2019.

The Canadian company said on February 22 that it would delay filing its 2015 Form 10-K until an ad hoc committee of its board has completed a review of accounting matters related to sales through a specialty distributor, Philidor Rx Services. Plans to proceed with a February 29 earnings call to discuss unaudited fourth-quarter results were revised when Valeant released a management and business update on February 28, announcing the immediate return of CEO Michael Pearson from a two-month medical leave for severe pneumonia, which would postpone reporting of preliminary fourth-quarter results. That, and the announcement of a previously undisclosed SEC probe prompted a selloff in shares, with the price ending 18 percent lower by the close of trading on February 29.

The financial restatement raises numerous compliance issues. Seth Taube, partner at Baker Botts who chairs its securities and shareholder litigation group, sees two sets of issues that Valeant’s internal investigation must clarify. First, are all sales being properly booked? And second, are the internal controls adequate to monitor whether or not sales are being booked properly?

“Ever since Sarbanes-Oxley, companies have to account for the controls they have in place,” Taube says. “Sometimes employees looking for a bonus will circumvent adequate controls and sometimes the controls are truly inadequate. If insufficient controls are dealt with internally, material weakness must be disclosed. [Valeant] needs to fix both, because only with both can the market rely on their information.”

“If insufficient controls are dealt with internally, material weakness must be disclosed. [Valeant] needs to fix both, because only with both can the market rely on their information.”

Seth Taube, Partner, Baker Botts

Taube believes the company is taking appropriate steps to regain investors’ trust, starting with an internal investigation by a special committee. That investigation, he emphasizes, must cover all sales, not just the narrow issue of it restatement. Taube adds that the investigation must also cover tone from the top—whether management is sending the right message of compliance—and it must measure internal controls, [including] accounting controls, internal audit, [and] whether monitoring roles are filled by the right people.

Valeant’s financial restatement is associated with sales the company booked prematurely, upon delivery to Philidor instead of when the drugs were bought by patients. While some sell-side analysts have shrugged off the restatement as a timing issue, others see signs of more serious concerns for the drug company, such as whether it will be able to maintain high profit margins while reducing prices on many of its products.  

Although the amount of revenue being shifted is relatively small, a BMO Nesbitt Burns analyst noted an outsized impact on earnings per share of nearly 3.7 percent, suggesting a net margin of nearly 60 percent on revenue booked on Philidor sales, as reported by the Wall Street Journal in February. That means Valeant is likely to be hard-pressed to achieve comparable levels of profitability generated through Philidor when relying on larger sales volumes through new distribution channels, BMO Nesbitt Burns said. 

Questions about the sustainability of Valeant’s business model have not been limited to concerns about profit margins. Investors began to pay closer attention to the firm’s business strategy in 2014 during a messy¾and ultimately unsuccessful¾hostile takeover bid for Botox manufacturer Allergan, and they concluded that Valeant’s preference for acquisitions over organic growth couldn’t be sustained.

REASON FOR DELAY

Below is an excerpt from Valeant Pharmaceutical’s notification that Form 10-K will be submitted late.
As previously disclosed, an Ad Hoc Committee of the Board of Directors of Valeant Pharmaceuticals International, Inc. was appointed to review the company’s relationship with Philidor RX Services and related matters. On February 22, 2016, Valeant announced that, based on the work of the Ad Hoc Committee, as well as additional work and analysis by the company, the company had preliminarily identified approximately $58 million of net revenues previously recognized in the second half of 2014 that should not have been recognized upon delivery of product to Philidor. Correcting the misstatement is expected to reduce reported 2014 GAAP EPS by approximately $0.10 and increase 2015 GAAP EPS by approximately $0.09.
The preliminary unaudited financial information provided above with respect to currently anticipated adjustments to 2014 and 2015 should not be viewed as final and remains subject to change based on the company’s ongoing procedures and review with respect to such periods. In addition, the Ad Hoc Committee is continuing its review of the circumstances and appropriate actions to be taken.
The filing of Valeant’s Annual Report on Form 10-K for the year ended December 31, 2015, will be delayed pending completion of the review of related accounting matters by the Ad Hoc Committee, with the assistance of its independent advisors, and the company’s ongoing assessment of the impact on financial reporting and internal controls. To date, the company has not determined whether any restatements will be required or whether any control deficiencies constitute material weaknesses. As a result, Valeant does not expect that it will be in a position to file its Annual Report on Form 10-K within the 15-day extension period provided in Rule 12b-25(b). The company is working diligently and intends to file its Annual Report on Form 10-K as promptly as reasonably practicable after the conclusion of these matters.
Source: Valeant Pharmaceuticals

“The real question is, are their margins going to take hits that won’t recover?” says Taube. “A company in its MD&A in its [proxy statement] is required to indicate how pressure on pharmaceutical companies to reduce margins will affect their business, particularly in light of this more narrow revenue recognition issue.”

But other governance experts warn the restatement may lead to deeper problems if a wholesale fraud investigation by the SEC materializes. Under that scenario, says Michael Volkov, a former federal prosecutor and a white-collar defense attorney with the Volkov Law Group, likely questions would focus on potential insufficiencies in Valeant’s controls and oversight. “How high up [in management] does the problem go?” Volkov asks. “What did the board know and when did it know it?”

Richard Morris, a corporate partner at Herrick, Feinstein LLP, says, “the board audit committee is the fulcrum of good corporate governance. They need to take their role seriously. Under Sarbanes-Oxley, the audit committee is able to have separate counsel from corporate counsel, [as well as] separate other professional services.” The aim should be that at the end of the process investors can have faith in the audit committee and be satisfied that what went wrong won’t go recur in the future, he adds.

Valeant could consider having its investor communications group weigh the transparency of its audit committee processes, Morris says. Just as companies now post their director biographies in their proxies, “you might talk about the counsel who’s retained [in an investigation].”

And even though the effective date for FASB’s new revenue recognition standards has been pushed back to regulatory periods starting after Dec. 15, 2018, “the data points that are required for proper revenue recognition have expanded considerably and will be further clarified,” Morris adds. “People need to start to identify [their] performance objectives in their contracts.”