On Nov 17 the Valeant (NYSE:VRX) saga took yet another dramatic and unexpected turn when former Valeant executive Garry Tanner and Philidor's founder and CEO Andrew Davenport were arrested and charged with perpetrating a multimillion dollar kickback scheme, with Valeant in the unfamiliar role as victim.
Preet Bharara, U.S. Attorney for the Southern District of New York, announcing the charges against Tanner and Davenport. Source: NYT/CNBC.
In this article I look into the details of this case, point out and try to make sense of its mysterious aspects, and discuss the implications for VRX shareholders.
The charges against Tanner and Davenport
The complaint alleges that Tanner denied Valeant his "honest services" by advancing the position of Philidor as Valeant's "alternative fulfilment" (NYSE:AF) provider against Valeant's best interests, and that he was induced to do so by Davenport through the promise of kickbacks from the money Davenport made from this as a major equity holder in Philidor.
The main way in which Tanner is alleged to have acted against Valeant's interests is by exposing it to "payor risk". He allegedly engineered by duplicitous means a situation where Philidor became Valeant's sole AF provider, thus exposing Valeant to the risk of losing all its AF business if for some reason the payors/PBMs decided to cut off Philidor from their networks. (PBMs = Pharmacy Benefit Managers.)
Why this is not a typical kickback case
In a typical kickback case it is clear that the victim company has been harmed by the kickback receiver's actions. For example, if an executive arranges an inferior contract for his/her company in return for a kickback from the contractor, then it is clear the company is worse off as a result of the executive's actions.
In the present case, however, it is not clear at all that Valeant was worse off as a result of Tanner's actions described in the complaint. In fact Valeant's business through Philidor grew to become very profitable and important for the company, bringing in 6.8% of Valeant's Q3 2015 revenue before Valeant broke off the relationship in late 2015. Its contribution to Valeant's revenue growth was even more significant. It would be practically impossible to prove in court that there were alternative approaches to developing the AF business that would have been more profitable for Valeant than the Philidor path that Tanner took.
Readers familiar with the Valeant saga may object at this point and say that even if Philidor was profitable for Valeant, it was the exposure of Philidor's shady business practices that led the PBMs to cut it off in late 2015. Valeant definitely suffered from this; indeed, it was a major contributor to Valeant's subsequent crash. Tanner, together with Davenport, undoubtedly share significant responsibility for Philidor's shady business practices since they were the ones who set up and ran Philidor in practice. Thus Tanner did indeed create serious payor risk for Valeant as claimed in the complaint, right?
Wrong. Tanner is indeed responsible to a significant extent for the payor risk that Philidor's shady practices created. However, and this is the most remarkable and mysterious aspect of this whole case, Tanner's responsibility for Philidor's business practices is not mentioned at all in the complaint. It is simply not part of the State's argument for how Tanner created payor risk for Valeant.
As I will demonstrate below, the State's actual arguments in the complaint for why Tanner is responsible for payor risk for Valeant's AF program are weak and should be easy to rebut in court. This justifies what I said above about this case not being a typical kickback case in that it is not at all clear that Valeant was worse off as a result of Tanners actions described in the complaint. But before proceeding, I want to emphasize the implication of the preceding remarks:
In bringing this case, the State has, for some mysterious reason, chosen not to use the one argument that would turn its case from a weak one into a very strong one. Namely, it has chosen not to use Tanner's responsibility for Philidor's shady business practices in its argument for why Tanner is responsible for creating payor risk for Valeant.
I am not the only one to notice the strange absence of Philidor's shady business practices in the complaint. It was the topic of a Business Insider article, and also touched on in a Bloomberg View article. The fact that the State's case is far from a slam dunk, and the challenges it will face in proving its case in court, were discussed in this NYT article.
Why the payor risk arguments against Tanner in the complaint are weak and easy to rebut
Tanner can argue that his relationships with his superiors at Valeant were of the usual subordinate-boss type where he gave his opinions and recommendations, and made requests, but the actual decisions were made by his bosses. In particular, the decision to go with Philidor as the sole AF provider, rather than diversify, was not Tanner's to make; it was made by his bosses who therefore bear the responsibility for it.
The only way the State can counter this is by arguing that Tanner gave wrong or misleading information, and biased opinions, which led his bosses to make decisions they would not otherwise have made. In fact there are specific allegations of this in the complaint. However, they are all straightforward to rebut.
For example, in response to allegations that he was unwilling to establish business relationships with other AF providers, he can say that he did investigate this but the deals others offered were inferior to the one he was able to get from Philidor. He can say that he used his close relationship with Davenport to get Philidor to beat the deals other AF providers offered and that this was to Valeant's financial advantage. (This would also justify why he told Davenport about the deals others offered as mentioned in the complaint.) Moreover, he can claim that the decision to stick with Philidor as the sole AF provider, rather than enter inferior relationships with other AF providers, was made by his bosses (which it probably was) after Tanner pointed out to them the inferiority of the deals offered by the other AF providers.
A prominent allegation is that Tanner pushed Valeant towards buying Philidor (which ended up as a deal to buy the option to acquire Philidor for $0) by falsely claiming that Philidor was planning to start doing business with other pharma companies. The complaint claims there is no evidence that Philidor was planning to do this. However, it is quite plausible that Davenport did contact other companies to hear if they would be interested in using Philidor as an AF provider, since the exclusive relationship with Valeant was a non-diversification risk to Philidor just as it was to Valeant. There may have been telephone conversations about this of which there is no record and which the other parties involved no longer remember. Davenport can say he exaggerated to Tanner the level of interest other companies expressed in doing business with Philidor, and that Tanner was therefore acting in good faith when he passed this on to the Valeant management.
The complaint relies heavily on what executives in the former Valeant management told the FBI during its investigation. To the extent that they contradict Tanner's story, he can claim that they are lying out of self-interest. Those executives certainly have an interest in putting as much of the blame as possible on Tanner for Valeant's payor risk, so that it doesn't fall on them.
The rebuttals above are in keeping with a statement issued by Tanner's lawyer (reported here) claiming that Tanner was just doing his job, and that he did it "exceptionally well, greatly benefiting Valeant's shareholders, and regularly communicated to his superiors what he was doing."
The point here is not that the allegations against Tanner are necessarily false but that it will be hard for the State to prove them in court.
Finally, it is worth noting that the non-diversification risk that Tanner is accused of being responsible for is only one part of the payor risk that Philidor represented for Valeant. Another major contributor to it was the secrecy around Valeant's relationship with Philidor. No one outside the company knew that Valeant had its own "captive" specialty pharmacy network until it was exposed in Oct 2015.
While it is neither illegal nor unique for a pharma company to own or have an exclusive relationship with a pharmacy network like this, the PBMs don't like such arrangements and seek to sabotage them by cooking up grounds to exclude the pharmacy from their reimbursement networks. In fact this happened to the Linden Care pharmacy network which had a semi-exclusive relationship with Horizon Pharma.
Thus, by having Philidor as a secret "captive" pharmacy network, Valeant's management (and board too, since it knew about this) created payor risk from the possibility that the relationship would be exposed (which it eventually was in Oct 2015).
So even if Tanner is responsible for the non-diversification payor risk (a charge that is easily rebutted as discussed above), Valeant's former management and board - the alleged victim in this case - are responsible for a significant and arguably more important part of the payor risk too. I expect this point will be emphasized by Tanner's defense team if/when the case goes to court.
Are the alleged kickback payments proof of guilt in this case?
Judging from the complaint there is irrefutable evidence that Davenport did transfer millions of dollars to Tanner after Philidor received payments from Valeant. However, as discussed in this NYT article, it will be challenging to prove in court that these were kickbacks. Tanner may have had an undisclosed equity stake in Philidor, in which case he is entitled to receive his share of the Philidor payments. Tanner would have breached his fiduciary duty to Valeant by not disclosing such an equity stake, but this is normally something that would result in a civil case brought by the employer, not a criminal case brought by the State. For more on this aspect of the case I refer readers to the thorough discussion in the NYT article.
Implications for VRX shareholders
Many VRX bulls rejoiced on SA after this case was announced, thinking that it meant Valeant would not be held responsible for Philidor's shady business practices, since Valeant was portrayed as the victim and the complaint alleges that Tanner and Davenport hid what they were up to with Philidor from Valeant's management.
The situation is less straightforward though. The complaint studiously avoids tying Tanner to Philidor's shady business practices, despite the fact that it would have greatly strengthened the State's rather weak case to do so. This is surely not an accident. It leaves open the possibility of Valeant's former management being held partially responsible for that, either through active involvement in it or through knowledge of it, and arguably indicates an intention by the State to at least keep open the possibility of prosecuting Valeant's former senior management for that. Since Valeant as a company benefited financially from Philidor's shady practices, the company itself would also be charged in this case.
Regarding Valeant's former managements involvement in Philidor, it appears that Tanner and Davenport's independent control of it decreased, and the Valeant managements involvement increased, during 2015 as the Philidor business became increasingly important to Valeant's earnings and growth. In fact there is evidence of this in the complaint itself: it quotes an email from Davenport to Tanner in July 2015 saying (on page 26 of the complaint; emphasis added)
They are too deep in our s--t. Can picture our butch and sundance ride into the sunset (or off the cliff as in the flick) as our wiggle room/ability to operate independently gets whittled down to nothing.
This indicates that Valeant's management was becoming more closely involved in Philidor's operations ("too deep in our shit"), thereby restricting Tanner's and Davenport's previous ability to "operate independently".
Further evidence of Valeant management's focus on and involvement in Philidor during 2015 is given in a Business Insider article, reporting on a leaked Valeant document showing management's attempts to find ways to further increase the profitability of its business through Philidor.
So it is quite plausible that Valeant's management became familiar with Philidor's operations during 2015, and therefore may have known and endorsed (some aspects of) its shady business practices.
On the other hand, after portraying Valeant as the victim of Tanner and Davenport in this case, it will now be awkward for the State to allege in a separate case that Valeant's former management was actually a partner in crime with them regarding Philidor's shady business practices. It will be awkward to allege that Valeant's management knew about Phildors shady practices after claiming in this case that Tanner and Davenport hid what they were up to with Philidor.
Therefore, if the State does bring such a case, I expect it will be very keen to reach an out of court settlement to avoid the embarrassment and credibility questions that will arise if it has to argue its case in court.
Valeant would probably also want very much to reach a settlement so as to put this matter behind it sooner, and would likely accept paying a relatively small fine, with no admission of guilt, to do so. This would be in the shareholders' interest too. Considering the State's awkward situation mentioned above, Valeant can now expect better settlement terms than it otherwise would have received if the present case hadn't been brought.
Thus, after this development, it appears that the worst case scenario for Valeant regarding Philidor's shady business practices is better than it was before. This should be a positive for the stock, although the market may take some time to recognize it.
On the other hand, this development is also a negative for the stock in the short term since it keeps the market's focus on Valeant's legal issues rather than the stabilization and improvements in its core businesses. It also shows that the Valeant saga is still able to throw unexpected curve balls - a negative since the market hates uncertainty.
I expect these negatives will dominate in the short term, but that the positive mentioned above will gradually assert itself in the market's consciousness and eventually dominate over the negatives. Of course there are many other factors currently affecting the VRX share price, and I expect factors such as asset sales and performance of Valeant's core business units to be more important than the ones discussed above going forward.
A final tidbit
As described in the complaint, Davenport set up an entity End Game LP to receive his share of the Philidor payments from Valeant, while Tanner set up another entity called Befrielse Consolidation to receive his "kickback" payments from Davenport. "End Game" is an obvious chess reference, just like the names of the other Philidor-related entities that Davenport set up in the past. The odd-sounding name of Tanner's entity, "Befrielse", also has a meaning, but one that has not been revealed previously. I will now reveal it exclusively here on SA:
I never thought my knowledge of Danish would come in handy like this, but guess what -- 'befrielse' is a Danish word. It is also a Swedish and Norwegian word, and has the same meaning in all three languages: 'liberation'. Apparently Tanner intended this money to liberate him from the burden of having to work for a living. And perhaps also indicates a plan to settle in Scandinavia? How ironic if it ends up putting him behind bars instead.
Business Insider also noted that this is a Swedish word but inaccurately translated it as 'exemption'. That is what comes out if one plugs it into Google Translate, which is probably what the BI writer did. While that is an occasional meaning of the word in some contexts, I can assure readers that the direct translation and usual meaning is 'liberation'.
Disclosure: I am/we are long VRX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.