Valeant’s torrid March entered a new chapter on Monday morning when the company announced the search for a successor to current CEO Michael Pearson and the appointment of activist investor Bill Ackman to the board of directors – but the company also touched off a new, more personal controversy.
In a statement on the reorganization of the board, the company revealed that former chief financial officer and director Howard Schiller had been asked to resign by the board but had not complied.
The dispute ties to the board’s ongoing internal investigation into Valeant’s accounting practices with the now-defunct specialty pharmacy Philidor, which led to misstated 2014 and 2015 financial results. Valeant attributes the misstated results to improper conduct by Schiller and the former corporate controller, according to an 8-K filing submitted to the Securities and Exchange Commission.
Schiller quickly fired back on Monday afternoon. “Contrary to the statement in the 8-K and press release, at no time did I engage in any improper conduct that relates to any restatement of revenue the Company is considering,” he said in a statement provided by the law firm Winston & Strawn LLP. Claiming innocence of impropriety, Schiller said he had refused to resign from the board.
The SEC filing helps fill in how Valeant’s accounting practices led to the misstated results and lays out some of the preliminary findings of the investigation by the board’s ad hoc committee. It also presents evidence which conflicts with previous statements by Pearson and Valeant testifying to the appropriateness of the company’s accounting practices.
In February, Valeant disclosed preliminary findings of the ad hoc committee’s investigation which showed approximately $58 million in revenue should not have recognized in its 2014 year-end earnings report. This had a ripple effect, leading to incorrect financial results for Q1 2015, Valeant said. These results were also included in the Q2 and Q3 reports. Due to the errors, on Monday Valeant relayed the board’s determination that all of those reports “should no longer be relied upon.”
The problems stem from how Valeant recognized revenue related to products delivered to Philidor. In December of 2014, a subsidiary of Valeant entered a “purchase option agreement,” giving it rights to acquire 100% of equity interest in Philidor. Philidor was subsequently consolidated with Valeant for accounting purposes
Before the consolidation, Valeant reported revenues when it delivered product to Philidor, rather than when Philidor dispensed the product to actual patients. After the consolidation, Valeant switched to counting revenue at the time drugs were dispensed. However, some of inventory sold to Philidor before the consolidation was still on the Philidor’s books when the pharmacy was subsumed into Valeant. Valeant then redundantly recognized revenue as this previously sold inventory was dispensed to patients.
This effectively inflated fiscal year 2014 revenue by $58 million and net income by $33 million (0.7% of total revenue and 3.6% of total net income for the year). Eliminating the improperly recognized revenue in 2014 does reverse some of the effect, but Q1 2015 revenue will not automatically increase by $58 million because Valeant had also recognized revenue from those sales in Q1, the company said in its filing.
Valeant management concluded that at the time of the reporting, “one or more material weaknesses exist[ed] in the Company’s internal control over financial reporting and that, as a result, internal control over financial reporting and disclosure controls and procedures were not effective.”
In his rebuttal to the charges of improper conduct, Schiller said the accounting used with Philidor sales resulted from a “careful and reasoned accounting decision made by the Company’s Corporate Controller.” Schiller is careful to say he did not initially make the accounting decision but indicated he did agree with it.
The “tone at the top”
These accounting details conflict with what Valeant and Pearson said in October of 2015 when the Philidor scandal first emerged.
In a report submitted with the SEC on October 21, 2015, Valeant said that its audit and risk committee had reviewed the Philidor accounting and confirmed the “appropriateness of the Company’s related revenue recognition and accounting treatment.”
On October 26, Pearson released a statement saying “We stand by our accounting treatment of Philidor completely.” Chairman of the Board Robert Ingram echoed Pearson’s comments.
But four days later, Valeant severed its ties with Philidor.
The newest SEC filing goes on to state that the improper financial reporting was a byproduct of the performance-driven environment at Valeant: “The company has determined that the tone at the top of the organization and the performance-based environment at the Company, where challenging targets were set and achieving those targets was a key performance expectation, may have been contributing factors resulting in the Company’s improper revenue recognition.”
As the well-known science blogger Derek Lowe notes, Pearson had been widely hailed for bringing a new focus to Valeant, aimed at cutting unnecessary spending and adding new drugs more through acquisitions rather than R&D.
The ad hoc committee is continuing its investigation and hopes to finish in time for Valeant to file its annual report with the SEC before April 29. If it fails to do so, the company could be in breach of contract and face a default with its lenders.
There may be still be to come: The company said there is still a possibility the investigation may find additional accounting adjustments are necessary.