No Time to Be Valeant

Medicine concept. Spilled pills from prescription bottle. 3dValeant in trouble

Valeant Pharmaceuticals has been a bit of a nightmare for customers, shareholders, and debt holders lately. Its strategy of acquiring established drugs, paying with debt, and doubling prices to cover the costs has provoked a furious response from consumers and lawmakers. Its mis-reporting of a troubling relationship with a specialty pharmacy called Philidor, two SEC investigations, delays in issuing its 2015 annual report, problems with its banks and bondholders, and turmoil in senior management ranks and on the board, have led to massive drops in its share and bond prices, soaring price increases in its credit default swaps, and a brutal series of downgrades from the rating agencies.

The timeline of Valeant’s troubles goes like this:

10/21/15 Short-seller Andrew Left’s Citron Research suggests Valeant is using Philidor to artificially increase revenues

10/26/15 Valeant defends its revenue accounting but announces its board is investigating the Philidor relationship

10/30/15 Valeant terminates its relationship with Philidor, which shuts down

12/29/15 Valeant CEO Michael Pearson goes on leave with pneumonia

1/1/16 Former CFO Howard Schiller becomes interim CEO

2/22/16 Valeant admits to overstating about $58 million revenue in revenues to Philidor in 2014 but says the investigation is continuing

2/28/16 Michael Pearson returns as CEO, and the company withdraws its earnings guidance for the fourth quarter of 2015

2/29/16 Valeant announces that it will not be able to meet the March 15, 2016 filing deadline for its 2015 annual report; the SEC launches a formal investigation into Valeant’s financial reporting

3/15/16 Valeant misses the deadline for delivering its annual report to its banks and bondholders

3/21/16 Valeant admits to $21 million more of overstated revenue in 2015, announces plans to replace CEO Michael Pearson, and accuses former CFO Schiller of “improper conduct”

Intended acceleration

Valeant’s serious credit problem’s began when it missed the deadline for filing its 2015 annual report under its bank credit agreement, which was a default on the company’s bank debt. The default gave the banks the right to accelerate their loans. Accelerate means demand immediate repayment in full regardless of the original repayment schedule.

That was a big problem for Valeant. If the banks accelerated, it would almost certainly force the company into bankruptcy, turning what seems like a mere technicality – an arbitrary filing deadline – into a full-blown financial disaster. Why do banks care so much about when a company issues its annual report?

It has to do with the importance of financial data in credit decision making. Banks consider many factors when they decide to make a loan: economic conditions, competitive dynamics, and management abilities among them. But analyzing financial data plays the biggest role.

Banks look carefully at measures of revenue growth, profitability, cash generation, leverage, coverage, and liquidity derived from borrowers’ financial statements. They use data from company financial statements in the models that dominate their risk-rating process. The reliability of that data is paramount, and a delay in delivering financial reports is a strong sign a company is having  problems producing data the banks can trust.

Promises, promises

So banks commonly require borrowers to submit financial statements on time. They do this in the covenants in their credit agreements. Covenant is a legal term for promise, and covenants in a credit agreement are promises the borrower makes to do or not do certain things.

Valeant’s bank agreement has 34 covenants, and the first one is “Financial Statements and Other Reports.” It requires the company to give the banks within 75 days of each year’s end an annual report certified by independent public accountants to fairly present Valeant’s financial position, results of operations, and cash flows.

Valeant managed to avoid a financial reporting meltdown. On April 11, 2016 it got a waiver of its reporting default from its banks. In a waiver, banks agree not to enforce a covenant default for a set period of time. That gives defaulting companies a chance to fix the underlying problem, or “cure the default.”

The banks gave Valeant until May 31, 2016 to deliver the 2015 annual report, lowered the minimum interest coverage ratio for the next year, and permitted $750 million more of unsecured debt; but not out of kindness alone. They raised the interest rate, imposed restrictions on acquisitions, and required prepayment of their loans from the proceeds of any asset sales. Valeant met the waiver deadline with time to spare when it issued certified financial statements for fiscal 2015 on April 29, 2016.

Lessons learned

In credit it’s common to focus on payment defaults; that is, missed interest or principal payments. But covenant defaults are important too, because they are such important risk management tools. Timely and accurate financial reports are fundamental to keeping track of changes in a borrower’s business, financial, and management risks.

Missing a filing deadline by six weeks was not a minor problem for Valeant. Thanks to the default and acceleration features in it bank debt and the cross-default terms in its bonds, Valeant’s filing delay was an existential threat. We’ll discuss the company’s bondholders and the threat of cross default in an upcoming post.

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