Bill Ackman Takes Over Valeant's Defense
One of the strangest of many strange aspects of Valeant's Philidor network of specialty pharmacies is that it kept it secret. "As Philidor was not considered to be material to Valeant for reporting purposes, it was not specifically mentioned prior to October 2015," said Valeant's corporate controller on its call on Monday. And:
On our third quarter earnings call last week, Valeant disclosed its relationship with Philidor in light of the R&O litigation and investor interest. There remained no obligation for a disclosure as the amounts are not material and materiality is evaluated quarterly as part of Valeant's internal disclosure checklist.
Roddy Boyd at the Southern Investigative Reporting Foundation wrote about strange doings at Philidor last Monday (October 19). Since then, the company has lost almost half its market value, about $29 billion. 1 If investors don't think that Valeant's relationship with Philidor is material, they sure have a funny way of showing it.
Valeant has underinvested in public relations, government relations, and investor relations. This has been a very costly mistake
On the face of it, this is a strange thing to say. Neither Valeant nor Ackman has come out and said that Philidor committed fraud, but they gave some hints. 2 Valeant announced that it had "lost confidence in Philidor's ability to continue to operate in a manner that is acceptable to Valeant" and would shut it down, just a few days after forming an ad hoc board committee to look into it. And Ackman "said he essentially expected Valeant to be investigated by regulators and prosecutors for years and probably pay a fine for its involvement with Philidor Rx Services," and spent much of his presentation today looking at past pharmaceutical frauds to reassure investors that they ultimately worked out okay. But committing fraud is not an investor relations problem! It's a fraud problem! The job is to avoid committing fraud, not to be good at messaging the fraud to shareholders. "If your business model is susceptible to underinvestment in public relations, your business model probably needs to change."
Still Ackman is not wrong. The market's reaction to potential problems at Philidor is clearly driven in part by uncertainty about the extent to which those problems are also Valeant's. Philidor, after all, is not Valeant. It is a nominally independent company. But because Philidor was a surprise to Valeant's investors, it is easy for investors to doubt whatever Valeant says now. "We know the allegations have also led them to question Valeant and our integrity, and for that I take complete responsibility," said Valeant's chief executive officer. Secrecy always looks shady, and encourages conspiracy theories to develop and investors to assume the worst. Ackman today was critical of short seller Andrew Left, whose report last week claiming that Valeant might be "the Pharmaceutical Enron" seems to have been mostly nonsense. But it's hard to blame him for that. He was just rushing to fill an information void that Valeant had created. He discovered an extremely convoluted network of pharmacies that Valeant seems to have kept secret. He jumped to the (surely wrong) conclusion that they existed "for the purpose of phantom sales or stuff the channel." Others jumped to other, equally or more nefarious conclusions. Nobody assumed that Valeant owned a previously undisclosed option to buy a pharmacy with an option to buy a pharmacy with an option to buy a pharmacy that was suing Valeant, for entirely innocent purposes. That is just not an innocent-looking org chart.
There is also a more direct and simple investor relations problem, which is that when plaintiffs' lawyers, inevitably, sue Valeant for this stuff, they won't be suing for insurance fraud. They'll be suing for failure to disclose whatever went on at Philidor (fraud or not), because that is where the money is. That $29 billion of lost market value is $29 billion of damages that a shareholder class action can claim, and the claim will be helped considerably by Valeant's ham-handedness in disclosing, or not disclosing, what it was up to with Philidor.
So Ackman himself has more or less stepped in to be Valeant's investor relations department. His call today didn't work any better than the company's call on Monday, but it was much more detailed and interesting, as Ackman himself sort of pointed out. ("Mr. Ackman says he doesn’t like scripted, heavily-lawyered calls and doesn’t find them all that useful," referring to Valeant's call. 3 ) And he did sometimes serve as a conduit for the company. 4 So on the rather important question of, what was Valeant thinking in entering into a fully prepaid option to buy Philidor, Ackman found out the answer and told everyone:
Mr. Ackman talked to Valeant’s former CFO and current board member Howard Schiller this week, he says, about Philidor.
One reason they didn’t purchase Philidor outright. Mr. Ackman says that Mr. Schiller said it was challenging to find a lawyer who knew the specialty-pharmacy industry and the laws about the industry in all 50 states.
This is rather clearer than Valeant's previous public explanation, which is that it "ultimately determined the structured option acquisition with the oversight rights we negotiated provided security and the flexibility in the future to acquire a new growth platform." Schiller seems to have at least hinted that Valeant didn't want to buy Philidor outright because it was worried about potential legal issues at Philidor. That's the sort of thing that investors might want to know, and now they know it, but they know it because one big shareholder relayed a private conversation he had with a Valeant board member. That just seems sort of ad hoc. 5
But there's one huge advantage to Ackman doing Valeant's investor relations for it. A key element of Ackman's defense is that, even if Philidor did engage in "unlawful promotion of drugs," and even if that conduct could get Valeant in legal trouble, that trouble probably won't be a disaster. Sure, there might be a big fine. But lots of big pharmaceutical companies pay lots of big fines, and they're none the worse for wear:
He then had a former prosecutor go into a long case study of a recent scandal in which Novartis allegedly "paid kickbacks to specialty pharmacies to induce them to recommend Novartis medications," and in which allegedly "one of the pharmacies gave biased advice to encourage the use of Novartis drugs, and simultaneously understated serious, potentially life-threatening, side effects, using taking points that were approved by Novartis." (Novartis just settled for $390 million.) Sounds bad! Sounds worse than the fake-name and prescription-altering allegations at Philidor, honestly.
But imagine if Valeant itself had used that table of precedent fines on its own call! You can't just get up in front of your investors and say, hey, look, we might have to pay a big fine for some fraud, but we're in pretty good company; look at all these other guys who paid big fines for fraud. That is a terrible message, and doesn't fit at all with the more standard investor relations platitudes like, "We operate our business based on the highest standard of ethics."
But it's true! 6 Companies are fallible, and even quite widespread -- even "potentially life-threatening" -- fraud is not necessarily a reason to shut a company down. Drug companies do lots of terrible stuff. That table gives you some idea of how much. But they also, you know, make drugs! That help people! Get rid of their toenail fungus! Also probably more important things. It is fun to rail against corporate malfeasance -- Jesse Eisinger says, "Pershing Sq's Valeant ($VRX) call is a clear explanation of how corporate white collar enforcement is toothless" -- but obviously most corporations survive most scandals because the benefits of their business outweigh the harm from the scandals. 7
And so you can think coldly and dispassionately about companies that look scandalous. You can say: This scandal looks bad, and may lead to fines, but even after the fines and the clean-up, there is a good business here. The net present value of the business, minus the net present value of the fines, is still greater than the market price. There is no such thing as a toxic asset; assets are toxic or attractive based on their price. If this is a scandal that will cost Valeant $8 billion -- more than the biggest fine on that list -- then Valeant's $29 billion loss of market capitalization is $21 billion too much. So you should buy it! 8
Cold rational calculation comes naturally to hedge funds; thinking of legal risk in expected-value terms is no different from thinking of any other risk in expected-value terms. But it is unseemly when it comes from the company itself. Whatever they do, companies are expected to say that their highest priority is to ethical behavior. They have to sound shocked and chastened by scandal; it doesn't look good -- to the public, to shareholders, to regulators who are investigating -- to just put a price on it and move on. If you need to make the case that some bad stuff probably happened, but that the cost of that bad stuff is, in the scheme of things, no big deal, it is helpful to have a hedge fund make that case for you.
That is, from the $177.56 per share close on Friday, October 16 through a $93.77 close today, a 47 percent drop.
I should emphasize that I have no idea if Philidor committed fraud, but there are other hints. This Bloomberg article about Philidor altering prescriptions, this Wall Street Journal article about Philidor's training manual, and this Wall Street Journal article about Valeant employees working at Philidor under fake names are all ... worrying. But the best thing to read for the case against Philidor is this John Hempton post, which sums up many possible ways Philidor could get in trouble, and looks at the evidence for all of them.
There is no transcript of the call, and I am quoting Wall Street Journal's blog of it.
For instance, one question Ackman got was: Why isn't Valeant CEO Mike Pearson buying stock? And Ackman answered that he had asked Pearson that question, and Pearson had said that he might be in possession of material nonpublic information and so would be legally prevented from trading. Good answer! Weirdly filtered through Ackman.
I always wonder about Regulation FD, which prohibits companies from sharing material nonpublic information with favored shareholders without disclosing it publicly. Obviously, the reason investors talk to companies is to find out useful information, and the line between "useful" and "material" seems very hazy to me. And, I guess, to Valeant.
In that vein, look at slide 25 of Pershing Square's presentation, about its own due diligence on Valeant's specialty pharmacies. If that diligence was of interest to Pershing, might it have been of interest to shareholders broadly? Should Valeant have taken the hint and beefed up its disclosure about those pharmacies?
I really don't know the answer. I think Regulation FD is on shaky conceptual ground. Obviously investors do due diligence in an effort to find value-added information about the companies they invest in. The line between "due diligence" and "Regulation FD violation" and "insider trading" is, to me, not as clear as many people want it to be. I am quite certain that Pershing Square did nothing wrong, and I am reasonably sure that Valeant did nothing wrong in its communications with Pershing Square, but it just feels weird that Valeant talked so much with Pershing Square at such a sensitive time and never said anything material.
Oh by the way this is just fun:
Bill Ackman went to Valeant’s headquarters last Friday to deliver what he called a bit of a pep talk to the company’s employees.
He says he spoke to about 500 of them last week to give them the perspective of what a major shareholder thinks about the company.
I mean, maybe. As Matt Goldstein points out:
Valeant lesson: outsized shareholders like Pershing Sq or Sequoia are forced into the "its bad, but not so bad" defense bcuz hard to sell
"Valeant is now roughly 19% to 20% of Pershing Square’s portfolio, Mr. Ackman says," billions of dollars worth. It would be tough to sell.
Of course, you can still argue over specific cases. Ackman, for instance, thinks that Herbalife will be wiped from the face of the earth.
I mean, good lord, that is not investing advice. One obvious point is that those fines don't represent all of the possible consequences of the scandal, and Ackman dealt with many questions today about how important the Philidor distribution channel was to Valeant's growth, etc. Also, of course I have no idea how much, if anything, this will cost Valeant, and that $8 billion number is totally made up.
To contact the author of this story:
Matt Levine at firstname.lastname@example.org
To contact the editor responsible for this story:
Zara Kessler at email@example.com