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From Securities Regulation Daily, April 25, 2016

Pharmaceutical company with inventory ailments must face fraud claims

By Amanda Maine, J.D.

A class action lawsuit against a pharmaceutical company may proceed after a federal court found that shareholders sufficiently alleged a scheme to increase inventory levels, painting a rosier picture of the company’s financial condition than what actually existed. Allegedly misleading statements made by the defendants in conference calls and press releases were not protected by the PSRLA’s safe harbor, and the plaintiffs cited enough circumstantial evidence of scienter to state a claim under Section 10(b) (In re Salix Pharmaceuticals, Ltd., April 22, 2016, Wood, K.)

Salix. Salix is a pharmaceutical company specializing in products that treat gastrointestinal diseases. Salix employed a “wholesale model” for distributing its products, meaning that wholesaler inventory levels can be a critical metric for evaluating the financial health of the company and product demand.

Channel-stuffing. Several private funds and a pension system who were stockholders in Salix alleged that Salix and two executive officers engaged in a scheme to increase the levels of wholesaler inventory vastly beyond prescription demand in order to give a more favorable impression of Salix’s financial performance, known as “channel-stuffing.” This caused Salix’s wholesale customers to accumulate at least nine months of inventory, where Salix had previously reported an inventory level of 10 to 12 weeks.

When companies interested in acquiring Salix discovered the channel-stuffing during the course of due diligence, they withdrew or reduced their offers. The inventory issue was revealed to the market in November 2014, and Salix’s stock price dropped 34 percent. Salix eventually issued restatements. The plaintiffs filed their original securities fraud complaint shortly thereafter, alleging that the defendants made false and misleading statements that artificially increased the price of Salix’s stock.

Merger. In February 2015, Salix announced that it would be acquired by Valeant Pharmaceuticals. The individuals who held the positions of CEO and CFO during the alleged scheme (and who resigned shortly after its discovery) were eligible to receive “change-in-control” payments worth tens of millions of dollars upon Salix’s acquisition, but the board was allowed to “claw-back” these payments if they had intentionally engaged in wrongdoing resulting in material harm to Salix. Before the acquisition by Valeant was finalized, the Salix board exercised this power and cancelled the payments to the former CEO and former CFO.

Misstatements or omissions. The plaintiffs alleged several misstatements or omissions made by the defendants relating to Salix’s drug inventory levels during conference calls and in press conferences. The defendants argued that the statements were forward-looking statements under the PSLRA’s safe harbor, as well as under the “bespeaks caution” doctrine, and therefore not actionable.

The court disagreed, noting that several of the statements cited by the plaintiffs may have been forward-looking in that they predicted future inventory levels, but advised that they also encompassed representations of present fact, which are not covered by the safe harbor. The court also noted that analysts had understood the defendants’ statements as representations of Salix’s current levels of wholesaler inventory, and not just future projections of inventory.

In addition, the defendants’ cautionary language under both the PSLRA and the judicially-created bespeaks caution doctrine were inadequate to avail the defendants of the safe harbor. The language used by the defendants was not “prominent and specific,” the court said, describing it as “brief and generic.” The defendants also failed to update the cautionary language over time to reflect new risks, noting that their cautionary statements were word-for-word in several conference calls and SEC filings cited by the plaintiffs.

Scienter. The court also determined that the plaintiffs adequately alleged a strong inference of scienter based on circumstantial evidence of recklessness. According to the court, the defendants were reckless in failing to learn about Salix’s true inventory levels, noting that potential acquirers were able to discover the true inventory levels with ease, and that the plaintiff could point to specific statements showing that the defendants were aware of or could access information about the true inventory levels.

The resignations of the former CEO and CFO, and that Salix’s board of directors exercised the clawback provisions to recover millions of dollars from them, also weighs in favor of a strong inference of scienter, the court said. In addition, the magnitude of the defendants’ fraud and the fact that it involved “core operations” also support a strong inference of scienter, according to the court.

The case is No. 14-cv-8925.

Attorneys: Gerald H. Silk (Bernstein Litowitz Berger & Grossmann LLP) for Pentwater Funds. Christopher J. Keller (Labaton Sucharow LLP) for Woburn Retirement System. Adam Samuel Lurie (Cadwalader, Wickersham & Taft LLP) for Salix Pharmaceuticals, Ltd.

Companies: Pentwater Funds; Woburn Retirement System; Salix Pharmaceuticals, Ltd.

MainStory: TopStory FraudManipulation AccountingAuditing DirectorsOfficers FormsFilings MergersAcquisitions PublicCompanyReportingDisclosure NewYorkNews

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