U.S. stocks are roughly unchanged early on Friday afternoon, with the Dow Jones Industrial Average (DJINDICES:^DJI) and the S&P 500 (SNPINDEX:^GSPC) up 0.20% and 0.15%, respectively, at 1 p.m. EDT. Shares of embattled pharma Valeant Pharmaceuticals International Inc, on the other hand, are down 10.29% as the company tries to contain the fallout from the "Philidor affair."

Image source: Peter Roberts. Republished under CC BY 2.0.

Valeant Pharmaceuticals CEO J. Michael Pearson has finally recognized that Valeant's relationship with specialty pharmacy Philidor RX Services is untenable after Express Scripts Holding Company and CVS Caremark stopped doing business with Philidor. On Friday, Valeant announced it would sever all ties with Philidor.

The allegations that have surfaced over the past fortnight regarding Philidor's conduct and the relationship between the two companies are shocking. This week alone:

  • Bloomberg published a report according to which Philidor employees were instructed to change doctors' prescriptions in order to fill them with Valeant's branded drugs instead of cheaper generics.
  • The Wall Street Journal reported that several Valeant employees had been using aliases to send emails from Philidor email addresses.

There are plenty of other disturbing allegations (see here, here, and here, for examples).

Given that Valeant and Philidor were effectively operating as one (more on this later), why did Valeant balk at acquiring Philidor? The question is all the more relevant for two reasons:

  1. Valeant was highly acquisitive; indeed, acquisitions were the central plank of its strategy.
  2. Valeant had the option to buy Philidor for zero dollars, an option that expires in Dec. 2024, for which it had paid $100 million upfront.

The answer lies in the 90-page presentation Valeant put together to explain and defend its relationship with Philidor.

The presentation takes enormous pains to emphasize that Valeant believes it is not liable for any of Philidor's actions if they are found to be illegal and even delves into its indemnification rights vis-a-vis Philidor.

Amid this complexity, what is blindingly obvious is that Valeant went to extraordinary lengths to structure what was a de facto parent-subsidiary relationship with Philidor in such a manner that it could continue to claim that the two companies were de jure separate entities. Or, as the Financial Times' John Gapper put it: "As far as I can tell, Mr Pearson and his lawyers appear to have invented a way to lease Philidor."

As such, Valeant would be prepared with a simple defense under the very circumstances that have now arisen, in which Philidor is alleged to have engaged in gross misconduct: Philidor is a separate company for which we bear no liability.

However, although Valeant claims it "does not own or control Valeant," the facts on the ground are these:

  • The two companies have a joint steering committee.
  • Valeant has a right of approval over key appointments at Philidor.
  • Valeant included Philidor in its internal control testing and internal audit program for compliance with the Sarbanes-Oxley Act.
  • Valeant consolidates its financials with Philidor.

It it quacks like a subsdiary...

Valeant may have got the opportunity to put the "separate entities" defense to work this week, but it didn't impress investors. In fact, it has been all but useless in the court of market opinion.

In today's press release, Valeant said, "Philidor has informed Valeant that it will shut down operations as soon as possible, consistent with applicable laws." That's not the way it happened.

In reality, Valeant informed Philidor it would be shutting the company down. As Valeant pointed out in its presentation, "the bulk of Philidor's volume is related to Valeant product."

Re-building investors' trust will take a lot more than simply shutting down Philidor. Not to mention that Valeant's business model is under assault on multiple fronts (drug pricing, debt load, etc.). The visibility regarding Valeant's future operating model is very poor; individual investors ought to give this situation a wide berth.