Valeant's "Sergeant Schultz Defense" Could Fail Against Securities Fraud Action

Sergeant Schultz of Hogan's Heroes was notorious for being clueless. Whenever Schultz exclaimed, "I know nothing ... I see nothing!", it was difficult to hold him accountable for the goings on at Stalag 13. In legal parlance, the Sergeant Schultz defense connotes the ability to deny knowledge of the actions of others due to lack of evidence.

A recent class action lawsuit against Valeant VRX claims that denials of certain facts or key information was still damaging to investors. Based on the fact pattern, the Sergeant Schultz defense may not work this time.

Below are key details of the suit brought by Laura Potter and Robbins Geller Rudmand & Dowd LLP, and my interpretation:

Robbins Geller On Valeant's Business Model

Valeant's strategy of acquiring other pharmaceutical companies and cutting R&D costs helped the company's stock skyrocket from $173 on February 20, 2015 to $263 on August 5, 2015 -- a gain of over 50%. However, the company's business practices came under fire in September.

On September 28, 2015:

• Valeant issued a press release stating that it had issued a letter to employees relating to changes in the company's share price to address [i] concern that Valeant's business model is dependent upon large price increases in the U.S. pharmaceutical business and [ii] concern over Valeant's exposure to U.S. drug price reimbursement.
• Bloomberg reported that Democratic members of the House Oversight and Goverment Reform Committee sent a letter to Chairman Jason Chaffetz urging him to subpoena Valeant documents related to "massive price increases" for two heart drugs.
• The September 28th letter also revealed that on July 31, 2015 members of the House Oversight Committee had a joint call with representatives from Valeant, and the Valeant representatives failed to adequately answer the members' questions over the company's skyrocketing prices.
• The letter also stated that on August 12, 2015, Ranking Member Cummings sent a document request to Valeant, and that on September 3, 2015 Valeant sent a dismissive letter to Cummings refusing to provide any requested documents.

After closing at $199.47 on September 25th, VRX dropped (16%) to close at $166.50.

Shock Exchange Interpretation:

A few things stand out about the above narrative. First of all, Valeant was aware as early as July 31st that the House Oversight Committee was seeking documents pursuant to price increases for certain drugs; however, it did not divulge this information to employees or shareholders. The timing of when management alerted employees -- September 28th -- seems rather suspicious. This is the same date that a Bloomberg report was released about the House Oversight Committee's inquiry over Valeant's price increases.

Lastly, the September 28th letter to employees apparently stated that price increases only accounted for a small and declining part of Valeant's business. According to the class action lawsuit, an October 5, 2015 New York Times article pointed out that the company's Q2 financial statements represented that Valeant's growth in the U.S. and other developed markets was "driven primarily by price." The letter to employees contradicts the public financial statements.

• On the face of it, it appears that Valeant knew the information was going to go public and in an attempt to preempt Bloomberg, alerted employees. Secondly, it appears that management found the information to be "material" enough to alert employees.
• If management deemed the information to be material in September, then I don't see how it would have been any "less material" in July when management first received the House Oversight Committee letter. It may be difficult to take the Sergeant Schultz defense about the potential impact the government inquiry could have on the share price.
• The market also found the news material; that's why the shares sold off 16% the day it was divulged.
• Given that drug price increases were a major part of Valeant's business model, the government's questions over those price increases could have potentially damaged the company's business model. Had management divulged the House Oversight Committee's letter in July, [i] the stock may have sold off in July [ii] investors could have potentially avoided losses between July and September.

Robbins Geller On Valeant's October 19th Q3 Earnings Call

• The company raised its Q4 earnings guidance. However, the stock fell 7.7% after management announced a shift in its business model and questions swirled around its previously unknown relationship with specialty pharma, Philidor.
• Management announced it would spin off certain drugs which had received price increases and drawn regulatory scrutiny. It also announced it would tamp down acquisitions and focus more on R&D.
• Management described how Philidor improved patients' access to medicines at an affordable price. It was also beginning to represent a higher percentage of Valeant's revenue. Management did not previously disclose its relationship with Philidor because it deemed Philidor as a competitive advantage and did not want to disclose it to competitors.
• Valeant disclosed it had a claim again R&O -- one of the pharmacies its in specialty pharma network -- for product R&O sold on Valeant's behalf. Total sales were $69 million and the net revenue to Valeant was $25 million.

Shock Exchange Interpretation:

The change in the company's business model was material; thus the stock sold off nearly 8%. One could have reasonably deemed that threats to the company's business model -- a curtailment in price increases, a lack of future acquisitions, etc. -- could have also been material. Again, threats to the company's business model were known to Valeant as early as July.

Oddly enough, Valeant mentioned the $69 million owed from R&O, but never divulged that R&O had [i] disputed the claim and [ii] represented that it had never done business with Valeant. R&O's claim was that a third party -- maybe even Valeant -- was using R&O's pharmacy ID number to fill prescriptions was not made public until October 21st by Citron Research. On October 21st Valeant's shares were halted, and eventually closed down about 19%.

Again, since the R&O fraud claim could have been deemed a threat to Philidor and ultimately, Valeant's business model, a reasonable person may have deemed it material enough to divulge prior to the Citron short article. R&O's fraud claim was made in early September.

Potential Impact On Valeant

The market has previously been fixated on Valeant's exposure to any potential fraudulent behavior at Philidor; I estimated that regulators could potentially seek about $545 million, while longs have called the exposure de minimis. However, this class action lawsuit appears to be less of a "who done it." It claims Valeant failed to disclose and misrepresented adverse facts; such actions deceived the market and artificially inflated the stock price to the detriment of buyers of the stock.

Valeant faces a potential pay out to shareholders, and could incur legal fees in defending itself. In addition, the lawsuit could distract management from its main task of preserving cash flow and paring its $31 billion debt load.

Conclusion

While management has claimed the Sergeant Schultz defence in explaining its relation to Philidor, I believe that angle could be less believable in addressing the class action lawsuit. Avoid VRX.