Apr 13, 2016 @ 08:30 AM

Valeant Pharmaceuticals' Prescription For Disaster

This story appears in the May 10, 2016 issue of Forbes.

By Nathan Vardi and Antoine Gara

When you are speeding toward billionaire status, nothing says “I’ve arrived” more loudly than a big donation to one’s alma mater. In June 2014 Duke University announced that J. Michael Pearson, the CEO of Valeant Pharmaceuticals, one of the fastest-growing companies in America, and his wife, Christine, would be making a $30 million gift to its engineering school, on top of $23 million in earlier gifts that had resulted in renaming Duke’s nursing school building after her.

“We’re grateful the Pearsons share our vision,” Laurie Patton, former dean of Duke’s Trinity College of Arts & Sciences, said in a release that recognized the husband and wife as some of the school’s most prominent alums, as well as the fourth-largest contributors to its capital campaign.

Less than two years later it’s hard to view this announcement as anything more than a mirage. The Pearsons, it turns out, weren’t actually a couple–New Jersey court records show that Christine had sued her husband for divorce in 2013. In fact, a Florida magazine had featured him and another woman several years before as “a couple” who were in the midst of decorating their three-bedroom apartment–which documents show they purchased together–in a luxury high-rise in Miami Beach.

They also didn’t actually have the cash available to make the donation.

On paper, Michael Pearson, now 56, was a billionaire, but his wealth was locked up in Valeant stock, earned by meeting seemingly impossible shareholder-return goals. He was barred from selling his shares for years and even prohibited from borrowing against them.

Valeant’s board waived its policy in order to allow Pearson to borrow $100 million from Goldman Sachs against his stock to fund the Duke contributions, build a community swimming pool and finance his own tax obligations. But even this well-intended gesture turned south–by this past November, the aggressive moves that Pearson had used to juice Valeant’s stock were backfiring, its price was tumbling and Goldman had issued a margin call, resulting in the liquidation of 1.3 million of the CEO’s shares, a forced sale which spooked the market and sent the stock plummeting even more.

All told, Valeant’s market cap has fallen 87% since August–some $80 billion in shareholder value has vanished. The company has come under intense congressional scrutiny for its drug-pricing policies, lumping it in with the firestorm surrounding the new poster boy for corporate greed, Martin Shkreli. Next were revelations about an undisclosed mail-order pharmacy called Philidor Rx that Valeant essentially controlled, which was accused of using controversial methods to get patients, doctors and insurers to use expensive Valeant drugs instead of cheaper alternatives.

In March Valeant slashed its earnings and revenue projections and said its continuing inability to file its annual financial report could lead it to default on its $30 billion of debt because of covenants it has with its lenders. The company also announced that Pearson would leave Valeant as soon as a replacement CEO is chosen. (Pearson did not respond to numerous interview requests from FORBES.)

It would be easy to blame Valeant’s Icarus-like plummet on a CEO whose life is seemingly falling apart. Or on an unsustainable business model that was destined to catch up with itself. Or on the kind of financial-statement gymnastics–and an accompanying announcement from the company that blamed these ills on the “tone at the top of the organization”–that bear too much resemblance to those of Enron, Tyco and WorldCom for comfort.

And there’s some truth to all of those things. But the ultimate culprit here is something for which until recently Valeant was lauded far and wide as a role model for other corporations: its executive compensation plan.

Valeant’s plan was praised for years by everyone from activist hedge fund billionaire Bill Ackman to top executive-pay experts at the University of Chicago and Harvard Law School for its unique incentive model. Pearson and other top executives would receive relatively little in the way of cash compensation but massive amounts of incentive stock and options. And that stock would be tied up for extremely long periods (an extended vesting period–then for Pearson another three years). In short, Pearson and his team would be paid handsomely if they could create long-term value, in lockstep with their shareholders. There would be no easy cash-out.

On paper it worked brilliantly, and Pearson went on a tear that created tens of billions in value and continued for several years. Ackman, who invested $4 billion in the company, compared him to Warren Buffett. But the plan also put an inordinate amount of pressure on Pearson to sustain the growth, and the stock price, by whatever means he could. Valeant was built to become a pressure cooker. And eventually the lid exploded, taking the chef out with it.

For most of his career Michael Pearson was a consultant, and a very successful one at that. During his 23 years at McKinsey & Co., he became one of the firm’s most talented and hardworking partners, running its pharma practice as consigliere to CEOs like Johnson & Johnson’s William Weldon and Schering-Plough’s Fred Hassan.

Then he began to advise a moneylosing California drug company that had been around since 1960 and focused on neurology drugs and generics. When Valeant sought a new CEO in 2008, San Francisco’s ValueAct Capital, a hedge fund run by Jeffrey Ubben and Mason Morfit, recruited Pearson and designed his compensation plan. Pearson simultaneously brought outsider and insider credibility.

“We think he is ideally suited to run a business that is at heart a value investor in pharmaceutical products,” wrote Robert Goldfarb and David Poppe early in Pearson’s tenure, explaining to investors why their Sequoia mutual fund was on its way to making Valeant its biggest position, replacing Berkshire Hathaway.

He brought a mission: to prove that the “buy and cut” growth strategy he had long been preaching from McKinsey’s ivory tower was more than expensive hot air. In the first year of Pearson’s watch, Valeant, which then had revenues of about $800 million, made three acquisitions, including buying acne remedy specialist Dow Pharmaceutical Sciences for $285 million. And then he increased the pace: By last year he had swallowed more than 50 companies.

This debt-fueled acquisition strategy created rich fees for investment banks and sold investors on a low-cost pharmaceutical company model that emphasized boosting drug prices, gutting research and development budgets, firing employees and lowering taxes through a merger that moved Valeant’s tax address to Canada.

Instead of creating new drugs, Pearson bought and squeezed profits out of old remedies like Wellbutrin XL, an antidepressant; Isuprel, an off-patent heart drug; and Provenge, a prostate medicine whose maker had filed for bankruptcy. Pearson’s drug-price increases became legendary, and there were no U.S. laws on the books to stop him.

For example, Valeant boosted the price of its diabetes drug Glumetza by about 800% in 2015, the year Valeant bought it. The company acquired Carac cream in 2011, and the price for the treatment of cancerous skin conditions rose by 1,700% in six years, mostly on Valeant’s watch. Pearson defended his prices, claiming that just about anyone who needed Valeant’s drugs would receive them because patients were protected by insurance and financial assistance programs.

Pearson acquired some of the drugs and products in big deals for companies like Medicis (antiwrinkle medicines), Bausch & Lomb (contact lenses) and Salix (gastrointestinal treatment). Along the way more than 4,000 pharma employees in the U.S. alone fell victim to Pearson’s axe–as much as half of the workforces of companies he acquired. The result was a company, Valeant, headquartered in Canada and employing 18,000 but with executives in New Jersey, that spent 3% of its revenues on drug research and development while selling products in areas ranging from dermatology and eye care to gastrointestinal neurology and over-the-counter remedies.

Wall Street analysts, whose investment banking colleagues thirsted for Valeant’s fees, issued bullish reports, and big hedge funds rushed into the stock. Valeant’s shares soared by 2,450% in seven years, affording it a market cap of nearly $90 billion by 2015. Investment banks like Goldman Sachs and Deutsche Bank made $750 million in fees. ValueAct realized $1.15 billion in gains–and still retained a 4.4% stake in the company. Everybody got rich–at least on paper–board members, executives and, most of all, Pearson.

Pearson’s original employment agreement with Valeant, struck in February 2008, put him on track to become one of the richest executives in the pharmaceutical industry within three years, based on large amounts of stock and option awards. But the lockups were long, and the awards came with both hurdles (he needed to deliver a minimum 15% return annually) and incentives (his allotment tripled if the company produced a 45% annual return). In 2011 he renewed his employment contract–extending both the lockup (2017) and the bonus potential (maximum-return hurdles at 60%). His most recent deal, struck when Valeant’s stock changed hands for $141, included up to 2.25 million in performance share grants if Valeant’s stock hit $1,068 by 2020.

Yes, Pearson was incentivized. Perhaps fatally so. “They would cloak it in shareholder equity, as if there’s a bunch of widows and orphans [invested]–but it was just all about money,” says a former Valeant executive. “That was all that mattered.”

An early warning sign for Valeant came late on Sept. 30, 2009, as Pearson returned from his Madison, N.J. office to his New Vernon estate. Without signaling, Pearson made a fast right in his gray BMW and was almost immediately apprehended by Madison police. When Pearson lowered his window, the patrolman noticed a waft of alcohol coming from the vehicle.

Police records show that Pearson slurred his speech and was unable to touch the tips of his fingers together or recite the alphabet from the letter “D” to the letter “W.” After the officer had Pearson spit out his chewing tobacco, his breath test indicated that the chief executive had a blood alcohol level of 0.13%. Pearson ultimately pleaded guilty to driving under the influence and lost his driver’s license for three months.

DUIs are commonplace, even in executive suites, but Pearson’s 2009 drunken driving arrest fed concerns about Pearson’s behavior that were spread by both short-sellers targeting Valeant’s once lofty stock and employees in the corridors of the company’s offices.

Like many top executives, Pearson was a workaholic. He overate, and he traveled all the time. Even though Valeant was decentralized, with operating units run by their business leaders, Pearson micromanaged things he deemed important. His dedication to drive Valeant and its stock forward was fierce.

Pearson led grueling weekly calls with dozens of Valeant’s top business managers and made it clear they had to deliver their numbers on a weekly basis–or else. Though Valeant was ostensibly a science company, scientists were seen as unnecessary costs to be cut, unless the product they were working on looked almost certain to succeed. And as Pearson made acquisitions, those cuts came quickly: The company once handed out envelopes to Valeant’s new employees–if you got a black envelope, it meant you were fired, the Wall Street Journal reported.

Management turnover was high–more than half of Valeant’s top 15 executives have left the company since 2011–and those who stayed took their lead from the CEO. The culture was hard-charging, everyone kept late hours, and the distinctions between work and play became blurred. One former executive says Pearson was a heavy drinker who favored double bourbons and that he sometimes saw Pearson gulp down six to eight drinks before business dinners. Another former executive saw Pearson get inebriated at an important function during the negotiation of a major business acquisition.

Others who worked with Pearson told FORBES that his alcohol consumption never impeded his working ability. But at least one sizeable investor in Valeant’s stock was worried enough to raise an alarm to a board member, who shared the information with another board member. (Valeant’s response: “The company is not going to discuss or comment on topics related to Mr. Pearson’s personal life or family. Valeant announced on March 21 that it has initiated a search for a new CEO and that Mike Pearson will be leaving the company upon the appointment of his successor.”)

Senior management, for its part, was filled with Pearson diehards. He liked to hire cronies like his former McKinsey partner Robert Rosiello, who is now Valeant’s chief financial officer. Pearson hired his brother-in-law, who was paid $299,000 a year as director of corporate procurement/real estate. Ryan Weldon, head of Valeant’s U.S. dermatology operation, had been a summer associate at McKinsey and was the son of former J&J CEO Bill Weldon.

“Mike wanted to win at all costs and surrounded himself with people who would basically do whatever he told them to do,” said a former Valeant executive, who says he left because he was uncomfortable with positions that Pearson asked him to take.

As for the board, which, like management, was paid generously in restricted shares, there was no incentive to question the Pearson money machine. Indeed, by the beginning of 2015, eight of Valeant’s independent directors held $108 million of equity between them. Their stock, like the CEO’s, was also extremely restricted, incentivizing them to keep Pearson’s streak going a bit longer.

Ultimately, that proved impossible. “Their business model was: Borrow money, buy companies and boost prices,” says Erik Gordon, who studies the pharmaceutical industry at the University of Michigan’s Ross School of Business. “That’s a lousy business model, and it’s a business model which you know obviously comes to an abrupt end.”

Valeant’s golden run began to unravel starting last September after it came under attack for its drug-pricing policies and the tactics of its captive pharmacy, Philidor Rx. Philidor denied the accusations, but that didn’t stop a congressional subpoena and increased scrutiny that placed into question Valeant’s accounting and business model.

Pearson wrote a letter to his employees, saying it was nonsense to suggest that Valeant’s business model was dependent on drug-price increases or that there should be concerns around Valeant’s exposure to U.S. government drug-price reimbursement. It assured investors that Valeant’s sales to Philidor were recorded only when the product was dispensed to patients and then terminated its relationship with the pharmacy, which had been linked to 7% of its sales. ValueAct’s Morfit rejoined the company’s board, which also hired a former U.S. deputy attorney general to help on issues related to Philidor. To help replace Philidor, Pearson struck a deal with Walgreens to distribute Valeant products.

Then in December, Valeant announced that Pearson had been hospitalized after contracting a severe case of pneumonia and would be going on medical leave. The news further rattled investors. Press reports at the time indicated Pearson had been working around the clock to get the Walgreens deal done.

After about two months of convalescing, Pearson finally returned to the helm of Valeant at the end of February. Pearson told employees he was learning to walk again and that he had lost 30 pounds, Bloomberg reported. Within a month, he was on his way out.

Valeant has been trying to make former chief financial officer Howard Schiller the fall guy for the company’s current accounting woes. In March, when Valeant admitted that $58 million in revenue should not have been recognized in 2014 when its drugs were delivered to Philidor’s mail-order pharmacy, its statement used the phrase “tone at the top,” implying that the “improper conduct” was driven by Schiller.

The former CFO is accused of providing false information to the company’s auditor, PwC, in an effort to get it to sign off on Valeant’s 2015 10-K, critical to avoiding debt covenant default. Schiller, who refuses to leave the board despite being asked to, denies any wrongdoing.

Not a single person FORBES spoke with who was familiar with Valeant believes that Schiller was the company mastermind. It was always the Michael Pearson show at the Madison executive offices, which was converted from a YMCA building and still has a basketball court, emblazoned with Duke’s Blue Devil insignia.

Class action lawsuits have been filed, the SEC is investigating and the Senate Special Committee on Aging threatened to begin contempt proceedings against Pearson. Bill Ackman, who infamously compared Pearson to Buffett, was forced to join Valeant’s board in an effort to shore up billions of dollars that his Pershing Square has so far lost on its investment. Valeant is under attack by politicians for its drug-price gouging, and it recently said that it would need to restate previous financial results.

Effectively fired from the company he built but still technically its chief executive, Pearson has yet to fulfill his most important obligation, signing Valeant’s long overdue 10-K annual report. Valeant has some valuable assets, like Bausch & Lomb, but it’s also saddled with some $30 billion in debt associated with Pearson’s acquisition strategy. Without new deals or the ability to raise prices, it’s unclear where Valeant’s growth will come from.

Additional reporting By Matthew Herper.