Valeant Pharmaceuticals International (NYSE: VRX) (Valeant) was recently the subject of a research report by Citron that alleged the company was the pharmaceutical Enron. The best summary is here by Bronte Capital. The stock price has collapsed and allegations continue to fly. Interestingly, the allegations swirling around Valeant relate to the accounting rule that was created to stop the abuses exploited by Enron – the variable interest entity (VIE).
Citron alleged that Valeant had a network of phantom pharmacies operated by Philidor. Valeant had an undisclosed option to purchase Philidor and consolidated the financial statements of Philidor on the basis that it was a VIE but did not disclose this accounting because the operations were deemed immaterial at 7% of sales. Citron alleged channel stuffing at the phantom pharmacies. Valeant stated that consolidation meant that sales to the VIEs could not be recognized until there was a sale to an outside customer. Valeant’s explanation of the accounting seems plausible, although I question whether the argument that VIE disclosures can be omitted at that level of materiality is correct.
VIE accounting rules were established to fix perceived abuses by Enron. Enron had used special purpose entities owned by its treasurer, Andy Fastow, to keep debt off its balance sheet. Accounting rules at the time required consolidation only when more than 50% of the shares were held by a corporation, so by having Fastow hold the shares the special purpose entities were not consolidated. That, of course, was highly misleading to investors who were surprised when Enron imploded. Detailed accounting rules established the concept of a variable interest entity, which required consolidation when a corporation had effective control and the right to the upside or responsibility for the downside of the performance of the VIE.
The new VIE rules put a stop to a popular technique for off-balance sheet financing, but had an unanticipated consequence. Chinese companies seeking foreign capital often operated in industries that prohibited foreign investment. Clever accountants figured out that they could circumvent those rules by using the VIE rules. Have Chinese operations owned by a Chinese individual, but use contracts to have those operations treated as a VIE for accounting purposes. Hundreds of Chinese companies listed in the US using this accounting trick, and many investors have been burned when the structures failed to work as promised.
Valeant has no Chinese operations that I am aware of, yet it appears to have used the VIE structure for similar reasons as Chinese companies. The wonder of the VIE structure for Chinese companies is it allowed management to tell different stories. To Chinese regulators they would claim the company was Chinese owned yet foreign investors would be told that they owned it. Valeant has been alleged to keep its relationship with Philidor confidential to the point that Valeant employees seconded into Philidor used fake names. There are also allegations that regulators were misled about the relationship. So the VIE structure may have enabled Valeant to tell two inconsistent stories – it treated Philidor as owned for financial accounting purposes while telling everyone else it was unrelated.
I do not believe the VIE accounting rules are operating as the Financial Accounting Standards Board (FASB) intended. While they effectively stopped Enron type abuses, they have enabled a whole new series of abuses. While this was formerly a problem that seemed mostly limited to US listed Chinese companies, Valeant indicates that creative accountants may have found ways to use the accounting for other nefarious purposes. It is high time for the FASB to take another look at this standard.