In February of this year, we posted an article on Value Investors Club detailing the aggressive accounting used by Linn Energy (LINE). Subsequently, on July 1, LINE announced that the SEC launched an investigation into LINE's usage of problematic accounting practices that artificially inflate their reported distributable cash flow (DCF). The result was an immediate 32% stock price decline and the real possibility that LINE's $4 billion acquisition of Berry Petroleum (BRY) will be scuttled. Questcor (QCOR) is another company with some questionable dealings and it is already being investigated by the U.S. Attorney General's Office in Pennsylvania. In particular, we question the manner in which Questcor conducts its free drug program in conjunction with the Chronic Disease Fund. Given the issues we raise with Questcor detailed below, we wonder what may come next.
Despite the fact that Questcor appears optically cheap, trading at just 13x 2013E EPS, we believe the company's increasing reliance on its co-pay and free drug programs operated in conjunction with the CDF can potentially put earnings at great risk as these programs are scrutinized.
Say Hello to the Chronic Disease Fund
The Chronic Disease Fund (CDF) is the 45th largest charity in the United States. It is bigger than Teach for America, the March of Dimes, Big Brothers Big Sisters of America and Doctors Without Borders USA. Six years ago it raised a tenth of the $200m in contributions it received in 2012. Its mission is to "support patients with chronic disease, cancer, or other life-altering conditions and provides financial assistance for FDA-approved specialty therapeutics used to treat those diseases." It performs this mission by providing co-pay assistance to impoverished patients who could not afford the drugs otherwise. Co-pay assistance donation dollars are largely solicited from pharmaceutical and biotech companies whose expensive drugs are then purchased with those same donations.
In other words, without these programs in existence, pharmaceutical and biotech companies could not sell their drugs because no one can afford them. The most surprising part of CDF's business is that it is not widely supported by the pharmaceutical community. Rather, 80% of its donations come from just two drug companies. But the CDF does not want you to know this fact and it has gone to great lengths to keep this truth and many others hidden from the public.
The CDF Is Hiding Something
The Chronic Disease Fund is a 501(c)(3) charity, which means that it is a tax-exempt charitable organization that receives a substantial part of its income from the general public. To prove that the CDF is a bona fide charity and not a private foundation it must meet either of two tests: the 33 1/3% test which requires it to receive one third or more of its funding from the general public or the 10% facts and circumstances test which requires it to receive 10% or more of its funding from the general public and meet several requirements. The CDF misses the 33 1/3% test by a mile and claims it meets the 10% facts and circumstances test. We question whether the CDF meets two requirements necessary to meet this second test: 1) Does the organization receive support from a representative number of persons? and 2) Does the organization have a governing body representative of the broad interest of the public? We first note that the CDF is doing its best to make sure the public does not know the identities of its major donors.
Charities must file a tax return with the IRS annually via a Form 990 and are required to file Schedule B, Schedule of Contributors with their Form 990s every year. Schedule B details the name, address and total contributions from every donor who has given more than $5,000 in a given year. Form 990s are public information but the identity of large donors can be redacted. Before 2009, the CDF complied with IRS regulations and included its Schedule B in all of its Form 990 filings. In its 2008 990 filing, for example, it noted in its filed Schedule B that it had seven large donors who collectively accounted for 97.8% of all donations ($90,138,000 out of $92,156,509). It clearly did not meet either the 33 1/3% test or the 10% facts and circumstances test and yet was deemed a bona fide public charity by the IRS. Why? Because brand new charities have five years from inception to meet either of these tests in order to be deemed a bona fide public charity by the IRS.
So what happened in year six (2009)? The CDF stopped filing Schedule Bs with the IRS despite noting on page 3 that "yes," the organization is required to complete Schedule B, Schedule of Contributors. Even the State of California noticed the missing Schedule B and requested that it be filed. In 2010, the CDF changed its mind and decided that "no," it did not have to file a Schedule B (see page 3 on 2010 Form 990). This is seemingly a violation of IRS rules regarding Form 990, which state that a charity must answer "yes" on Line 2 in Section IV of Form 990 if the charity "received during the year contributions of $5,000 or more from any one contributor" (see page 12). 2011 was the same for the CDF; they said "no."
In 2012, the CDF changed its mind once again and said that "yes," it did have to file a Schedule B with the IRS. It simply chose not to file it. In fact, in 2012 the CDF decided that it only had to make public half of its Form 990, just the Schedule A. The 2012 Form 990 filed on the company's website as well as the same form listed with several states' charity registries including North Carolina do not include more than half of the 2012 Form 990. Where is the rest? Lucky for us, the Freedom of Information Act (FOIA) enabled us to obtain the full 50 page document. The Schedule B is still missing! It would seem that the CDF does not want anyone, including the IRS, to know who its major donors are.
We also note that the 2012 Audited Financial statements presented on the North Carolina charity registry are incomplete; they are only eight pages long and are cut off right where the Concentration footnote indicating the percentage of donations made by large pharmaceutical companies normally resides. We spoke with the audit partner who completed the audit for the CDF and he confirmed that the 2012 financial statements are, in fact, 14 pages long -- and include a statement of cash flows. This is not a one-time mistake because the same shortened filings are available on several other states' charity registries. Misfiling financial statements and tax returns are not actions the IRS takes lightly.
So what exactly is the CDF trying to hide? It might be the fact that the 2011 Audited Financials highlight that 81% of its donations come from just two pharmaceutical companies. We have spoken with attorneys who specialize in setting up charities and they all said no pharmaceutical company's board of directors would ever be comfortable being the source of more than 20% of total donations made to a single charity. Or maybe it's the fact that the CDF is de facto controlled by its Founder and Chairman Michael Banigan who has full control of the board per the charity's bylaws: "(A) General Appointment and Removal Provisions: MICHAEL H. BANIGAN (i) shall appoint all Directors of the Corporation, (ii) may remove any then serving Director of the Corporation, and (iii) may designate and, once designated, remove successor Directors of the Corporation pursuant to a written notification to the Board of the Corporation." This second fact about the CDF is really the most interesting, and we explore it in detail below.
Due to the many reasons spelled out in this report, we believe that the CDF does not meet the conditions of a bona fide charity pursuant to the IRS 10% facts and circumstances rule.
It's All About Banigan
Michael Banigan is a serial entrepreneur and the founder and chairman of the CDF. As shown above, he controls the board of the CDF. He also owns numerous businesses that conduct millions of dollars of business annually with the CDF. We highlight page 2 of Schedule L of the Complete CDF 2012 Form 990, which notes that CDF spent $7.8m on services from three entities "controlled by an officer," CDF Services LP, Fourth Floor Realty and CDF Rx, Inc. All three of these businesses as well as one other, DiseaseTrak, are owned by Michael Banigan. All four of these businesses share an address with the CDF itself, 6900 Dallas Parkway Suite 200 Plano, TX 75024. In total, these four for-profit companies that Banigan owns have collected $41 million from the non-profit CDF the past five years.
According to the CDF 2008 Form 990, "Chronic Disease Fund uses DiseaseTrak, a software program supplied by the company, DiseaseTrak, a Delaware Corporation owned by Chronic Disease Fund, Inc.'s President, Michael Banigan (formerly DBA Chronic Disease Management Group). This agreement with DiseaseTrak was approved by the Chronic Disease Fund board of directors after a competitive bid process." How competitive could the process have been with Banigan as the owner of DiseaseTrak and one other CDF Trustee, Travis DeWayne Manning, as president of DiseaseTrak, which paid him $270,000 in salary in 2008? What's amazing is the fact that the CDF 2012 Form 990 on page 35 states,
"All transactions are approved by the company's Board of Directors with any organization associated with board member prior to the transactions."
Banigan controls the Board! He can elect and dismiss any of them at will. The CDF Board's independence needs to be called into question.
"After listening intently to the needs of specialty pharmaceutical manufacturers, Sonexus Health responded -- by developing integrated pharmaceutical commercialization solutions that now enable manufacturers to own their relationship with physicians and patients and control their product through the supply chain."
Unsurprisingly, Sonexus Health's corporate office shares the exact same address with the CDF. Michael Banigan's brother Jim is also an employee, working as president of Financial Solutions. Jon Kwiatkowski, division president of Pharmacy Services at Sonexus Health and former senior director of CDF Rx, is also employed by the CDF as a senior director; he was paid $147,992 for his work at the CDF in 2012, working 40 hours a week. He must be a workaholic, working 40 hours per week for the CDF while also working for the pharmacy division at Sonexus Health. We discuss the interrelationship between Sonexus Health, the CDF and Questcor in more detail below.
The Complete CDF 2012 Form 990 highlights one other way that Banigan has been able to enrich himself as a result of his control of the CDF. He had the CDF purchase DiseaseTrak for $36.5 million in 2012 (check page 29 -- Schedule D Part X). Again, we note that this transaction was left out of the 2012 Form 990 filed on CDF's own website. What's not clear is why a charity needs to own a business like this, or a specialty pharmacy like CDF Rx.
These facts call into question whether the CDF meets one very important piece of the 10% facts and circumstances test, "Does the organization have a governing body representative of the broad interest of the public?" It would seem, rather, that the CDF exists to enrich both pharmaceutical companies like Questcor as well as its chairman Michael Banigan.
Questcor's Free Drug Program Isn't Free
Defenders of Questcor will argue, "Questcor discloses how much money they give to co-pay assistance programs in their SEC filings." This is true: In the last four quarters, Questcor has reported that it has donated $11.3m (up 200% Y/Y) to co-pay assistance programs to help patients obtain Acthar. Assuming patients averaged a 10% co-pay means that this program generated $113m in sales for Questcor, 19% of QCOR's total net sales during that time. The fact that these co-pay assistance payments are growing at such a rapid rate, up 200% Y/Y ($11.3m the past four quarters) and up 65% Y/Y in the most recent quarter ($3.2m), indicates that Questcor is increasingly relying on these sorts of programs to boost sales.
What Questcor does not say is that they are also increasingly relying on their free drug program to direct patients to the CDF and its affiliates. In the past year Questcor has donated $177m (29% of net sales during that period -- up 90% Y/Y) of free drug to patients in the U.S. This program to-date has donated $360m worth of free Acthar to patients according to the company's most recently filed 10-Q. Questcor notes in its SEC filings that it does "not recognize any revenue from the Acthar free drug program." Again, this is technically true. However, we believe these free vials are vital to Questcor's misleading business plan.
The CDF is the only charity in the country that owns its own specialty pharmacy, CDF Rx. While CDF Rx's mere existence is key to understanding CDF's relationship with Questcor, we note that it does not appear to do much except distribute free vials of drug from Questcor. We visited CDF Rx's offices in Plano, TX and saw no one working when we looked through the heavily tinted windows of the office, one floor below that of the CDF itself. The 2009 CDF Annual Report highlights the fact that the organization planned to open its own pharmacy designed exclusively for free drug programs called CDF Rx the following year. The original goal was for CDF Rx to be a separate charity, but it never was able to file a Form 990 with the IRS. This timing is noteworthy because the very first time Questcor mentions in its SEC filings that it works with the CDF was in its Q2 2010 10-Q.
It is clear that 2010 was the first year that Questcor sought CDF's aid; the 2009 CDF Annual Report reported that it did not cover any diseases treated by Acthar. The 2010 CDF Annual Report, however, notes that the organization started covering acute exacerbations of multiple sclerosis and nephrotic syndrome, two diseases treated by Questcor's Acthar. The 2011 CDF Annual Report added exacerbations of lupus to its list of Funded Diseases. This is the same year that Questcor started marketing this usage of Acthar to physicians. Questcor sought the CDF's aid because high priced drugs like Acthar run into problems with reimbursement because insurers demand prior authorization.
In the same 10-Q that Questcor first mentions working with the CDF it also mentions another charitable organization, the National Organization for Rare Disorders (NYSE:NORD), that it works with to provide assistance to patients. One quick fact we wish to highlight: NORD no longer has an active program funding Acthar prescriptions according to NORD employees we spoke with. This means that the all of Questcor's co-pay assistance dollars and free drug vials are going to the CDF and no other charitable organization.
Questcor has had problems with insurance companies reimbursing patients for administration of Acthar. Aetna, for instance, "considers repository corticotropin [Acthar] not medically necessary for corticosteroid-responsive conditions [like multiple sclerosis] because it has not been proven to be more effective than corticosteroids for these indications. Aetna considers repository corticotropin experimental and investigational for all other indications because its effectiveness for these indications has not been established." Other insurance companies require a large amount of data from a potential patient's doctor indicating that alternative treatments, like much cheaper corticosteroids, have not been effective in treating the patient's disease. This process is known as prior authorization. This is a big barrier to adoption of Acthar because it is so expensive and because the medical literature surrounding its efficacy is limited. Questcor, however, has remained undeterred.
Questcor has a real problem with patients who have insurance with companies like Aetna or are uninsured. The free drug program with the CDF enables Questcor to fix these problems. When a patient contacts the CDF looking for assistance they are often given free drug, administered by their referring physician, to start treatment immediately. This free drug, distributed by the non-profit CDF Rx, comes with a catch: the patient must file for insurance via CDF-affiliated Sonexus Health, a for-profit marketing company. Sonexus Health offers "Prior Authorization" solutions on its website. What these solutions really entail is that Sonexus handles all of the referring physician's paperwork. This is an extremely important step in the process as most doctors are skeptical about the benefits of a decades-old drug that has not been in a successful NDA-approved clinical trial.
However, when the doctor is relieved of having to fill out numerous forms as well as argue for hours with insurance companies about why the drug is necessary he might be willing to give the drug a chance. We do not know whether there are any stronger inducements offered to referring physicians but we would not be surprised given the Attorney General investigation mentioned in the opening of this report. Ultimately, Sonexus Health and the CDF may be successful in finding the patient an insurance company willing to take them on; they often apply to three or more simultaneously. We believe that the CDF is in a great position to know which insurance companies are covering Acthar because they can share data with Sonexus Health and thus may have the ability to direct patients to those carriers. The patient is fine with the arrangement because the CDF pays for their co-pays AND their insurance premiums, if necessary.
The deal is great for the doctors because Sonexus Health takes care of all of the heavy lifting and can intimate that someone, often the CDF, will handle the co-pay. The simultaneous distribution of free drug, marketing to doctors and co-pay assistance is what makes this arrangement so outrageous. Sonexus, as a for-profit company, should never be allowed to handle the co-pay but with a non-profit like the CDF along for the ride this arrangement can be accomplished. As more and more insurance companies balk at paying millions of dollars for a drug with limited demonstrated efficacy the problem for Questcor will compound: the number of insurance companies who pay for Acthar will continue to shrink.
Finally, we think it is instructive to point out one very important conclusion we reached. While we have named several different entities, the CDF, CDF Rx, CDF Services LP, DiseaseTrak, Sonexus Health, we believe the truth is that they are simply one large commingled entity sharing an office suite and controlled by just one man.
The OIG Opinion Loophole
Pharmaceutical companies cannot donate money to charities explicitly to purchase drugs made by those same companies as such an arrangement would violate the anti-kickback statute of the Social Security Act. Violation of the statute is a felony. The CDF, however, found a clever away around this rule; drug companies that donate money to the CDF for co-pay assistance programs cannot earmark their donations for specific drugs but can earmark them for certain disease states (a "Funded Disease"). The CDF got the Office of Inspector General (OIG) of the Department of Health and Human Services (HHS) to approve this type of arrangement in an Advisory Opinion dated Sept. 14, 2006.
We note that the OIG issued its opinion relying "solely on the facts and information presented to us. We have not undertaken an independent investigation of such information. This opinion is limited to the facts presented. If material facts have not been disclosed or have been misrepresented, this opinion is without force and effect." The OIG relies so much on just the data presented to it that it turned a blind eye to the fact that the CDF's chairman, Michael Banigan, owns DiseaseTrak noting in Footnote 4,
"We have not been asked about, and express no opinion regarding, any arrangement between [Requestor] and the entity [DiseaseTrak] providing therapy management services."
The CDF currently maintains 37 separate 'Disease Trusts' with separate funds for each disease state. The CDF helps patients obtain funding for 78 distinct drugs, including Questcor's Acthar, to treat these diseases. We highlight three curious items: 1) every single indication for Acthar that currently generates revenue for Questcor is on the CDF's covered disease list (acute exacerbations of multiple sclerosis, lupus, infantile spasms, nephrotic syndrome, polymyositis, psoriatic arthritis, rheumatoid arthritis and Ankylosing spondylitis -- the last four all added in the last year when Questcor started marketing these usages of Acthar to physicians); 2) among the 78 drugs approved for reimbursement by the CDF only Questcor's Acthar is approved for treatment of nephrotic syndrome, infantile spasms and acute exacerbations of multiple sclerosis; and 3) while most of the drugs listed are trademarked only H.P. Acthar Gel is shown as such. It would seem that Questcor's lawyers (who else would think of adding a trademark?) have a direct line into the CDF. We note that the three indications listed above for which only Acthar can be prescribed combine to account for approximately 80% of Questcor's sales. In other words, if anyone, including Questcor, donates money to the CDF and earmarks its use for one of these three Disease States only Questcor's Acthar can be prescribed and purchased.
The OIG also notes that pharmaceutical company donors are not allowed to receive specific patient or drug data from the CDF. The OIG states,
"Upon request, Requestor informs donors of the aggregate number of all applicants for assistance for particular Funded Diseases and the aggregate number of patients qualifying for assistance for particular Funded Diseases. Requestor does not provide donors with any individual patient information. Requestor's reports to donors do not contain any information that would enable a donor to correlate the amount or frequency of its donations with the number or medical condition of patients that use its product or services."
The sanctity of this relationship is paramount; pharmaceutical companies are not allowed to know how exactly their donations are used or else the arrangement may be viewed as a kickback. The law forbids them from knowing exactly how many patients are treated or if they were even treated with their drug.
Take a look at the 2012 CDF Patient Application. In order to be considered as a patient, a person is required to authorize the CDF to share their demographic and contact information as well as physician name, disease and drug treatment information. Patients appear to then be required to agree to let the CDF share the information with the for-profit Sonexus Health which does not have to play by the same rules as the non-profit CDF. An authorized recipient like Sonexus Health may then "re-disclose" the information, seemingly without limitation. Who else but Sonexus Health's clients, pharmaceutical companies like Questcor, would want such information? It's a catch-22: patients cannot obtain assistance unless they disclose certain information and authorize the CDF to share it with companies like Sonexus Health.
Ultimately, we believe that the closeness with which the CDF, CDF Rx, Sonexus Health and Questcor conduct their operations makes the separation required to make these dealings kosher is a near impossibility. We have heard from experts in the field that several large pharmaceutical companies have declined to donate to patient assistance charities like NORD (National Organization for Rare Disorders) because NORD could not give the pharmaceutical companies the patient count or specific drug usage data. They felt that donating money to an organization like NORD, without any resultant data, would just go to help pay for a competitor's drug. This does not seem to be a problem for Questcor and its involvement with the CDF.
In its conclusion, the OIG ruled that the CDF can operate a co-pay assistance program as long as it remains, "an independent, nonprofit, tax-exempt organization that operates with absolute, independent, and autonomous discretion as to the use of donor contributions." For all of the reasons detailed above, we believe Banigan's control of the CDF and its numerous affiliates violates this first and most important requirement.
There is one other line in the OIG's opinion that caught our attention as it relates to a revelation highlighted in the beginning of a recent Barron's article (subscription required) questioning Questcor's relationship with the CDF. The OIG notes,
"No donor or affiliate of any donor… exerts any direct or indirect influence or control over Requestor or Requestor's program."
This statement is curious to us as we wish to know how Questcor knew the identities of certain registrants of the CDF's yearly conference. Later in the OIG's opinion it notes,
"Donors do not receive any information regarding other donors, except that Requestor's annual report and list of donations may be public available, as required by the IRS."
Even the Department of Health and Human Services knows the CDF should file a Schedule B! But we digress: If Questcor and the CDF are truly independent and Questcor does not exert any 'indirect influence or control' over the CDF then how would Questcor obtain this information and why would they send threatening letters from their lawyers to the canceled registrants?
We are confident that a supposed charity working hand in hand with a for-profit company marketing high priced drugs is not what the OIG had in mind when it approved the CDF's program. We also believe the OIG has been made aware of the arrangement between the CDF and Questcor. Finally, the OIG concludes its opinion on the CDF by stating,
"The OIG reserves the right to reconsider the questions and issues raised in this advisory opinion and, where the public interest requires, to rescind, modify, or terminate this opinion."
There Is Precedent Here
Barron's just questioned the coziness with which Questcor and the CDF conduct their operations. The outcome of this outing in the press is yet to be determined. We can, however, point to a similar situation involving the Wall Street Journal and a program similar to the CDF called Patient Services, Inc. (PSI). In a December 2005 article called "Through Charities, Drug Makers Help People - and Themselves" (subscription required), the WSJ wrote a few choice lines:
"Under this support system, drug-company money keeps patients insured -- and keeps insurers paying for the high-priced medicine. 'It's a win-win situation,' says Dana Kuhn, co-founder and president of Patient Services, a Midlothian, Va., charity, which solicits money from drug companies. 'Patients are helped and companies are helped. They make a small contribution to help the patient and get much more money back when the insurer pays for the drug.' … When he makes his pitch to companies, Mr. Kuhn says he emphasizes that they can make money by donating. … After the favorable [OIG] opinion, Mr. Kuhn says he found drug-company executives eager to donate. 'You could see the dollar signs shining in their eyes and they would jump over the table and say, 'When can I start?'"
The immediate result of the press generated from this article was a 40% reduction in donations made to PSI the following year. It would seem that the WSJ's reporting had a material impact on the usage of these co-pay programs by pharmaceutical companies. Perhaps they feared an investigation by any number of government entities including the IRS, HHS, OIG or DOJ. PSI is still in operation today but has largely cleaned up its act according to informed persons we spoke with. We also think it is important to highlight some differences between PSI to the CDF. First, the CDF is massive: it is more than 3x PSI's size. Further, according to PSI's 2012 Form 990 (filed in totality on their website) it met the 33 1/3% test handily: 49% of total support was from the public. Compare that to CDF's lowly 16%. Finally, we note that none of PSI's Trustees own any affiliates with which PSI conducts its business.
Very little in life is free and while patients who work with the CDF may not pay anything for their Acthar prescriptions, those same prescriptions are certainly not free for insurers or Medicare. Programs like these can artificially boost drug prices which insurers as well as the federal government ultimately pay for. The future of such programs we believe is uncertain.
We do not mean to suggest that all patient assistance programs are illegal, as we are aware that there are several legitimate ones in existence. The CDF, however, by virtue of its reliance on two huge donors, it's seemingly special relationship with Questcor, its wholly owned specialty pharmacy, a long history of inaccurately filing financial statements and tax returns, enormous riches generated for insiders and close association with several for-profit companies that share the same office space is not your run-of-the-mill patient assistance program. If there really were armed guards at CDF's yearly conference, according to Barron's, this would seem to demonstrate that they were very nervous about these facts being exposed. Questcor's actions would also seem to indicate that they are equally determined to see that its relationship with the CDF does not see the light of day. There is a long history of the Department of Justice and HHS Office of Inspector General investigating these organizations and we believe that when they look at the CDF and Questcor neither will stand up well to the scrutiny.
We estimate that nearly 50% of Questcor's revenues are generated as a direct result of its relationship with the CDF, and if this arrangement is ever modified or canceled a huge portion of earnings could be negatively impacted. Given the company's high incremental margins, we estimate that EPS could get cut by 60% if Questcor were no longer working with the CDF. If this were to happen then run-rate earnings would be approximately $2.30, and we think an appropriate multiple would be 10x. Our target price is thus $23.00 (-63%).
Disclosure: I am short QCOR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: This is not a recommendation to buy or sell any investment. Additionally, this document should not be relied upon to make an investment decision as the numbers and figures presented are solely the author's estimates. Investors should contact the company directly and read QCOR public filings to form their own opinions and make their own investment decisions. The author may transact in the securities of QCOR without notice.