Canada witnessed a fast growth in pharmaceutical industry in the early 21st century. By 2005 the sector was already contributing about $6 billion in growth domestic product (GDP) that boosted its annual growth by 7.7% in this year.
The industry was based on research and development (R&D) and in 2007, about $1.96 billion was spent on R&D programs. Each new drug required a great deal of R&D before it could be approved. The approval process started with preclinical testing and followed with an Investigational New Drug (IND) request with that was submitted to the Food and Drug Administration (FDA) before it could begin to test the drug on humans. A company’s bottom line could suffer drastically if the FDA did not grant approval. Biovail also got to join this lucrative business period in its many ventures.
Introduction to Biovail Corporation
Eugene Melnyk started his first company in 1982 known as Trimel that focused on creating crib notes for physicians and by the 1990s he acquired a proprietary technology and bought half-stake in Biovail Corporation. By mid-1990, Biovail was a full-service international pharmaceutical company. The company engaged in development of drugs, clinical tests, registration, manufacture and sale of pharmaceutical products in Canada and the United States. In 2001 Melnyk took over as the CEO, and it was during his leadership that the company faced several criminal, civil suits, and regulatory investigations that increased the organization’s speeding in legal fees.
On October 1st 2003, a traffic accident occurred that involved a Biovail delivery truck and a week later its stock at the TXS by 33%. Later that year, Bank of America instituted an investigation into the Biovail stocks and by the year 2006 the CEO had found himself on the media as SEC and OSC had raised suspicion on Biovail trading activities. The United States Securities and Exchange Commission issued a Wells Notice to Melnyk, where he settled the matter by paying Cdn$1 million and stepped down from the position of the CEO.
Three expert accounts were used by Bank of America to delve into Biovail’s press release on the accident that involved their truck in which they claimed huge losses that affected their share prices. The evident got from the investigations around the accident it was noted that the company had inflated the loss as one-third to one-half of the truck was empty. It means, the Biovail claim that the truck accident made it to fail to reach its target in the third quarter of 2003 was unacceptable to be accepted. Another reference that led to Biovail’s sell ratings to go down is its product sales growth had become negative in the same year.
Other areas of criticism included Biovail’s declining R&D spending, its highly inflated balance sheet, and the company’s low tax rate. The report noted that in 2003, Biovail’s blue chip product was purchased rather than developed in-house. The company’s balance sheet contained an externally high level of debt relative to its peer companies. In addition, Biovail’s tax rate was 6.9% as compared to the next lowest tax rate in its peer group at 19.8% (Mastrandrea, 2009). Finally, the operating earnings reported by the company substantially different from its earning as measured by generally accepted accounting principles (GAAP). The gap between Biovail’s pro forma earnings and GAAP earnings portrayed the company was growing faster than its underlying organic growth.
The company had perfected that art of misrepresenting its reports. In 2001 and 2002, Biovail released an income statement that revealed increased sales in products and net income (Mastrandrea, 2009). In 2003, the company recorded poor performance that it blamed on the truck accident, where they had a press release that its revenue for the 3rd quarter will lower than as projected. However, this was later confirmed to have been a scheme to lie to the public and inflate their profits.
Later that year, SEC accused Biovail for fraudulent dealings that involved three secretarial projects, and they used this to project that they had made losses (U.S. Securities and Exchange Commission, 2008). Biovail made an individual purpose entity, medical technology Corp. (Pharmatech), a development-stage company, to undertake an estimated $125 million in R&D activities on behalf of Biovail. Pharmatech’s sole shareholder invested US$1 million, of which $350,000 was refunded as a fee.
Additionally, the company fraudulently engaged in an alternative contract whereby they contracted Pharmatech to permit Biovail to purchase all its shares at any time they wanted before the close of the year 2006. On December 27, 2002, Biovail exercised its purchase option as a result of Pharmatech’s banker’s refusal to extend financing directly to Pharmatech. The SEC concluded that Biovail’s economic reports were significantly false and deceptive, causing net income to be overstated (U.S. Securities and Exchange Commission, 2008). These are among the issues that made the legal case against Biovail to succeed.
In October 2001, the company entered into an agreement with a distributor whereby Biovail would produce WXL which had not yet received FDA approval and then sell it to the distributor. Biovail pushed distributors to place an order for trade WXL prior to June 30, 2003, or the company would not fully commit its manufacturing facilities to producing WXL tablet prior to the product launch. Then, the distributor sent Biovail a purchase order, and Biovail invoiced the distributor for approximately US$8 million, resulting in an increased second quarter operating income of US$ 4.4 million.
In December 2002, Biovail acquired the rights to certain drugs and assumed a liability denominated. Because Biovail accounted its outcome in U.S. dollar, basically, it was necessary to report for the liability in statements in dollars by converting the liability at the current rate. On March 31st, 2003 this Canadian dollar had been reinforced in opposition to the U.S. dollars compared to its December 31, 2002, rate. After that the company published a few correct accounting reports then later went back releasing inaccurate statements.
Declaring Financial Performance to Stakeholders
In order for organizations to meet the requirements for the use of financial statements, instruments such as communicating performance and financial position are necessary. A company’s communication with the stakeholders ensures that there is an increased awareness of the organization to the investors by consistently delivering information about the dealings of the company through mails, annual meetings, as well as through their quarterly or annual company publications (Brennan and Merkl-Davies, 2018). The goal of engaging with shareholders is to improve the company’s visibility within the financial community, ensuring that key communications are delivered effectively and, eventually promote the capital flow at a lower cost. Successful shareholder communication strategies allow businesses to exert greater leverage over the wealth creation phase.
For instance, in the case of Biovail, there was no communication amongst the stakeholders as the strategic decision is solely based on the CEO who was also the chairman of the board of director, Eugene Melnyk. Hence, the transparency of the company’s performance can be manipulated. Recent emphasis on corporate governance stems mainly from the failure of rules, practices, and mechanism to adequately monitor and control top level managers’ decision. This situation results in changes in governance mechanism in corporations throughout the world especially, with respect to efforts intended to improve the performance of board of directors.
Annual Reports and Press Release
Annual reports and press releases are intended to provide the public with a company’s disclosure of its operations, financial activities such as profits and loss that has taken place over the past year. The reports evaluate the year’s results and address the management’s vision of the coming year and the location and prospects of the company. This is an important aspect of transparency to the public by a company.
Biovail Pro Forma
Pro forma reporting gives companies an influential position in presenting information about the company in the best ways possible. It is used to reflect the true state of the business and avoid accounting standards limitation that often underestimate companies’ assets as a result of adherence to conservatism principles. It is not bound by any standard or guidelines governing what is appropriate reporting or not, nor audited by external auditing bodies.
This can mislead investors as companies usually do not report poor financial position in pro forma reporting, and portray the business as a profit making venture. It can be noted that investors are expected to exercise due diligence and carefully examine pro forma reporting for inconsistencies with audited statements even though it might be detailed. Pro forma sometimes includes projections and projection statements that are difficult to ascertain, which include parameters that a company maybe estimating based on hypothetical best-case scenarios therefore leading some investors to fall victims to fraud.
Bank of America report on Biovail shows in exhibit 5, that Biovail’s pro forma earnings exceeded GAAP earnings by about 112%, and a variance of 100% for the median of the same measure across 16 peer companies. Such extremely exaggerated figures are a cause for concern that the numbers may be overly inflated and is a perfect example to showcase how pro forma reporting can significantly lead to massive differences when compared to audited historical statements.
Nonetheless, proforma reporting is necessary evil as transactions such as Mergers and Acquisitions (M&A), and disposal of assets, usually have numerous effects on a company financial accounts and that cannot be captured by historical statements. Accounting standard such as FASB and regulators like SEC have pronounced specific requirements and rules when a company uses a pro forma. The organization is required along with these guidelines to provide a financial statement to users with a reasonable insight on how the company management thinks the transaction is going to affect the operations of the business. An Example of such regulation is the SEC Regulation S-X and Rule 3-05.
In the case where additional regulation needs to be institutionalized for other pro forma reporting, then, additional regulation increases costs on businesses to ensure compliance and avoid regulatory risks.
They key test is whether financial statement users have adequate assurance into the financial situation of a company, which they can attain through comparative audited historical statements that can be used to gauge the value of any pro forma reporting, and when no comparative statements are available, regulation is recommended to ensure such reasonable assurance test is met. It can be noted that SEC and major international accounting regulatory bodies, should regulate pro forma reporting for major transactions not covered by historical audited statements, and include rules on what must be included in pro forma. This is in addition to the basis of calculations, which in our view is adequate and no additional regulation is required.
OSC and SEC investigate Biovail
In March 2008, both the United States Securities and Exchange Commission and the Ontario Securities Commission released a statement targeting the company, four former and current executive officers. Regulators were suspicious of how Biovail’s grew after the infamous truck accident that Biovail blamed for missing Q3/2003 earnings forecast, raising concerns that the company is making up excuses to justify bad performance and mislead investors. It became clear after the supposed accident that the company is possibly committing fraud.
Even through the truck load was shipped on September 30 Destination FOB, and was in transit on October 1st before the accident, indicating it has not been delivered to the customer yet, the company stated that the truckload loss materially affected Q3 results even though since the customer had not taken delivery of the goods yet and the truckload should not be recorded as revenue (in accordance with revenue recognition rules). This incident confirmed that something is clearly afoul with Biovail’s accounting practices. The forensic accounting commissioned by Bank of America later confirmed that the accident had no material effect on Q3 results.
The OSC and SEC also acted on findings related to suspicious trading activity by Melnyk during his tenure as CEO and executive chairman of the board, in which he failed to properly report insider trading activities, selling 1.3B worth of Biovail’s shares, while not disclosing his holdings to the public, trading using offshore trust accounts. In addition, the SEC and OSC zoomed in on the following fraudulent accounting schemes that Biovail used to manage its earnings.
It was inflating revenue through offloading costs to a Special Purpose Entity (SPE). Biovail established an SPE that undertook R&D work on its behalf in exchange for royalties. This SPE was marred with suspicions since inception, given that a former executive was the single investor that had his investment refunded and the majority of the funds contributed by Biovail itself. Biovail used this SPE as a vehicle to offload R&D costs off its books and record them on the SPE books under the assumption that it’s a separate entity. This resulted in overstating revenue by about 50% in Q3/2001, 18% in Q2/2002, 16% in Q3/2002. The structuring of the SPE ownership and the share option agreement give the indication that the SPE was purposefully designed to offload costs and inflate top line margins.
In addition, it recognized revenue from a fictitious bill and hold transaction. Biovail asked a distributed to submit a Purchase Order (PO) for goods that are not meant for sales as related FDA approval was not officiated yet, and immediately invoiced the distributor and recognized the $8 million revenue in Q2/2003, resulting in overstating Q2 operating income by $4.4 million. This was clearly fraudulent activity that drew the SEC and OSC attention.
Finally, there was misstatement of financial results by manipulating foreign exchange rates. Biovail chose to continue to use favorable exchange rates from prior quarters to get around losses resulting from appreciating the Canadian dollar, instead of using the current FX rates at the time of preparing its statements. This resulted in understating Q3/2003 results by $3.9 million. The company used such dubious processes to gain some extra monies through wrongful reporting.
Class-Action Law Suit
A class action lawsuit is a claim organized by a group of people, in the case of Biovail it’s the stakeholders who have a common goal as they want to rectify an illegal action done at the company. For Biovail, duration of time was specified for the start and conclusion of the period of claims, and all qualifying shareholders were notified and encouraged to contribute to the class action litigation. Once class-action certification was issued, all qualifying shareholders were notified and encouraged to contribute input. Eligible stakeholders were then entitled to a prorated portion of any rewards earned, net of legal expenses.
This class action could be settled by having an agreement with the company, going for negotiation, or it could end up in a trial when a decision is given by the judge after listening to both parties. In order to achieve bargaining power, the plaintiff had to show that management knowingly deceived shareholders through their activities or through the information that they had circulated and that these actions that led to the loss of share value. The shareholders would be successful because the CEO, Melnyk took over the responsibility of running the company and put them on the dark and not disclosing vital information to them.
Biovail’s 10 Years financial stability
In order for Biovail to have sustained financial stability in the 10 years the company should adopt the following strategies;
Biovail needs to enhance the authority give to its board of directors. All organization can suffer from unethical conduct of one of the board members or directors of the company. However, when there is power vested in the board of directors it because a hard task for someone to pull-off a scam without being detected. The Biovail case shows that all corporate owners are vulnerable to unethical behavior and very poor judgments in making decisions.
It further needs to look at the existence of market for corporate control. Melnyk is assumed to be responsible to be formulating and implementing the strategy that led to poor performance. When there is proper control measure dubious mangers and leaders of the organization will not get a chance to become fraudulent. This will help the company in case there is another CEO who wants to act in selfish-interest and go against the basic principles of organization accounting.
Finally, they need to strengthen the assessment, transparency and disclosure methods. Biovail need to improve and to be transparent in financial disclosure. There are weaknesses, however, in disclosure relating to corporate governance. Many of these are voluntary disclosures about board practice that the company has historically chosen not to make public. This can be done by forming a new audit committee to address the outstanding issues that limited the effectiveness in the past.
In conclusion, Biovial’s statement either in the form of financial reports or official statements that can be access publicly has provided information that is irrelevant with the actual state of the company. Biovail’s share price decline that has been accused at truck accident did not prove to be the main reason of the condition. Wrongful financial reporting and decision making are apparently made to profit specific group or individual without regarding the interest of whole shareholders.
Brennan, N. M., & Merkl-Davies, D. M. (2018). Do firms effectively communicate with financial stakeholders? A conceptual model of corporate communication in a capital market context. Accounting and Business Research, 48(5), 553-577. Web.
Mastrandrea, M. (2009). Accounting at Biovail-revised. Richard Ivey School of Business.
U.S. Securities and Exchange Commission (2008). SEC charges Biovail Corporation and senior executives with accounting fraud. sec. Web.