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Short selling and the role of in-house counsel

Laval, Quebec-based Valeant Pharmaceuticals lost almost more than half of its market value ($10 billion) since Oct. 21, 2015 when Citron Research, which shorted Valeant’s stock, first publicly alleged that Valeant fraudulently “stuffed the channels,” calling it the “Enron” of Big Pharma.  

Citron alleges that Valeant used a tiny mail-order pharmacy, Philidor RX Services LLC, which it controlled (it has since cut all ties with it), and a network of affiliated pharmacies across the United States, to store inventory and record those transactions as sales as well as ordering employees at Philidor to change codes on prescriptions so it would appear that physicians required, or patients preferred, Valeant’s brand-name drugs — not less expensive generic versions — be dispensed.  

In addition to the drastic drop in its market value, Valeant is being assailed on the regulatory front. The Securities and Exchange Commission, the U.S. Department of Justice, and a variety of other government agencies have launched investigations into the claims.  

Valeant’s response

Valeant for its part has asked prosecutors to investigate Citron’s “completely untrue” allegations alleging its claims are similar to “someone who runs into a crowded theater and falsely yells fire” with a view to opportunistically driving down the company’s shorted stock. Valeant’s board has said it properly accounts for sales through its pharmacy partners and only books revenue once its medicines reach the patient.

Valeant went on to defend itself, explaining that it never had an ownership interest or control over Philidor, although it purchased an option to acquire ownership in August 2013.

In answer to the allegations, Valeant appointed an ad hoc committee chaired by the company’s lead outside director to fully review and report on its relationship with Philidor and its business practices.

Citron’s allegations have caused Valeant to reflect back on whether it might have approached matters differently. In recent months, it had been in the crosshairs of the U.S. government as well as patient groups because it had dramatically raised the price of a number of its proprietary medicines.  In recent days, we have begun to hear from Valeant and its advisers that it regrets that some matters had not been handled differently. Its public admissions hold some important lessons for in-house counsel.

Improved public disclosure

Pharmaceutical companies are notorious for having complex interconnected relationships with entities within its supply chain that raise important questions concerning corporate governance and business ethics.  Valeant has not disclosed that, although Philidor operates independently and does not report to Valeant, Valeant does have the right to access Philidor’s books, records, and facilities, and that they do share some common facilities (e.g. sales and marketing, call centre, etc.). It was also revealed that Valeant was Philidor’s sole customer.

These facts had never previously been publicly disclosed. Valeant has attempted to explain that it was because its special relationship with Philidor and its affiliates was not considered material to Valeant’s business under Generally Accepted Accounting Principles.  

Although its lack of full disclosure may have been legal, the fact that the board and its legal counsel chose not to mention their special relationship left Valeant vulnerable to Citron’s alarming allegations and set it back on its heels in terms of trying to bring light to these matters.  

A lesson learned here is that, sometimes, mere compliance with legal disclosure requirements is not enough. Companies need in special circumstances to err on the side of caution and disclose matters that may give rise to injurious allegations and strive to avoid reputational risk.  

Ardour

One of Valeant’s top investors has offered that Valeant made a meaningful mistake of underinvesting in its public relations. When Citron first shocked the markets with its allegations, Valeant only offered a curt denial of Citron’s claims by way of a press release, an analysts’ call, and by way of a very short media interview. Over the ensuing days, it incrementally released additional information, which had a salutary effect, convincing many analysts to maintain their “stay” or “buy” ratings for Valeant’s stock.  

The slow start may have been an indication that Valeant did not have a robust and time-effective public relations program. The decline in a targeted company’s stock can be so quick that the firm has little opportunity to disprove rumours before its stock is trashed. In-house counsel can be instrumental in not only helping to design an appropriate PR strategy, particularly in regard to co-ordinating the firm’s regulatory and legal response, but also in ensuring that the program is rehearsed, well understood, and practical.   

Many of the programs I have seen are overly complicated, have too many actors involved, and, as a result, they are cumbersome. The importance of performing dry runs to tighten up and tweak plans cannot be overemphasized.

Objectivity

While we can lament the occasional opportunism of short-sellers and the power they have to crush a stock beyond what its fundamentals merit, short-sellers can also be useful in uncovering fraudulent accounting and other problems at companies and identifying companies that are overvalued. We should not forget that a short-seller laboured through Enron’s annual report, and was one of the first to predict that its then-high-flying stock would ultimately tumble.  

When first confronted by the allegations, Valeant issued a blanket denial stating that, in all respects, it acted within legal boundaries. Companies that are shorted often have a tendency to become defensive and entrenched.  

In-house counsel should remind management and the board that their actions may ultimately play out in front of the courts and the regulators.  They can help bring much needed objectivity to the table. It may be that the short-seller is entirely right. The CEO, the CFO, and the directors may have a hard time coming to grips with the allegations, so in-house counsel needs to take a step back and, with its knowledge of the law, as well as its sense of the optics, be able to provide a rational and objective assessment as to whether the criticism is warranted and help shape an appropriate response. Counsel’s opinion can be pivotal. It is rare in my experience for companies and their boards to fall on their swords without the concurrence of legal counsel, whether in-house or external.  

Careful boards will want the concurrence of both, but because time is of the essence, the likelihood is that the recommendation of in-house counsel, which has a better understanding of the firm’s practices, the industry, the individuals, and organizations involved, will be given great weight.


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