Tuesday, June 17, 2014

Valeant Pharmaceuticals Part V: Share pledges

Today is the day of Valeant's "fact based" presentation. As I demonstrated in Part IV you need to verify "facts" presented by Valeant. Mr Pearson (the CEO) stated categorically that Valeant bought their debt down quite quickly after the Biovail merger. They did not.

So here is a "fact" that I would like clarified.

One of the great bull stories of Valeant is how the CEO, Mr J Michael Pearson, is a "hidden billionaire" who can't sell any of his stock until 2017.

Bill Ackman of Pershing Square, Valeant's partner in its campaign to buy Allergan, says:
“Now how is management compensated? This is one of the more unusual and leveraged shareholder aligned compensation packages we've ever seen. So the way it works for Mike and Howard, the CEO and the CFO of the company, if over the period of their long-term incentive compensation grant, which are typically long-term periods, the company's share price, the total return does not equal or exceed 15%, they get no long-term incentive compensation. If it's above 15%, they get 100% of their PSUs vest. If it's above 30% compounded, they get 200%. If it's 45% compounded, they get 300%. At 60%, they get 400% of their PSU grant. So that, again, focused on IRR on a long-term basis. And then it's not just that they get compensated, but they receive stock in the company that they can't sell. Mike owns 10.6 million shares. He's sort of a hidden billionaire. He can't sell this stock until 2017. So we like that long-term alignment and that leveraged compensation for performance.” [Source: Transcript of Investor Meeting dated April 22nd, 2014, Page 16 - however you can find an edited version in this SEC file.]
There are dozens of such statements and restrictions on selling shares apply to many senior managers. This is a key part of the bull case.

Mr Ackman's statement was made in a presentation filed the day after the proxy was filed. Just the day before Valeant disclosed that the CEO had pledged a quarter of a billion dollars worth of stock. See this quote:
Because of the expansive share ownership requirements applicable to Mr. Pearson, the Board has permitted Mr. Pearson to pledge certain of his shares. As of March 31, 2014, Mr. Pearson had pledged 2,028,516 shares, representing approximately 19% of his shares beneficially owned (including purchased shares, shares received in settlement of equity compensation awards, and shares underlying vested but undelivered awards and vested but unexercised options). In addition, the Valeant shares held by Mr. Pearson that are not subject to pledging arrangements far exceed the Company’s general share ownership guidelines (requiring executives to hold shares with a value equal to or greater than two times the combined amount of their base salary and target annual cash bonus). Notwithstanding the large number of un-pledged shares that Mr. Pearson continues to own, the Board, together with the Talent and Compensation Committee and the Nominating and Governance Committee, has committed to reducing the level of pledging generally at the Company in the future. Valeant has adopted a policy disallowing future pledges unless an exception is approved by the Board and will consider permitting Mr. Pearson to sell shares to reduce the level of pledging.

There are three key details: (a). Mr Pearson has been permitted to pledge over two million shares (more than a quarter of a billion dollars), (b) there is pledging throughout the company that the compensation committee is committed to reducing and (c) to that end Mr Pearson may be permitted to his shares.

Pledging has been used by several CEOs to effectively sell shares without fully disclosing the sales and sometimes in contravention of employment rules. ISS, a leading shareholder advisory service, has been targeting pledging and hedging of corporate stock as a governance issue for some time. Dodd Frank also made recommendations on the issue.

The proxy discloses that the pledge was made "in connection with loans used to fund tax and other obligations associated with vesting and delivery of equity incentive awards and purchases of Company shares". This seems unrealistic as most tax bills come only on the selling of those shares and a quarter of a billion dollars is a rather large pledge.

I have some questions:

Question 1: What sort of transaction has Mr Pearson pledged the shares for? An equity swap (which is a de-facto share sale)? Maybe a loan? The shares then will be sold if the stock goes down - and Mr Pearson gets to keep the cash. Or is it for something else?

Question 2: And under what circumstances will Mr Pearson be allowed to sell shares contrary to the employment contract detailed by Mr Ackman?

You can't tell from the disclosure but it is possible that Mr Pearson has - contrary to the myths around Valeant - taken a couple of hundred million dollars off the table. I have learned that statements by Mr Pearson (such as the statement about bringing debt down quite quickly) need to be verified. Mr Ackman almost certainly wrote his long presentation several days before the proxy was filed and probably did not learn about the pledge until after he wrote his presentation.

Question 3: The compensation committee is "committed to reducing the level of pledging generally at the Company". Which other executives have pledged shares, in what quantity, and are those pledges properly disclosed in public filings (especially in filings regarding executive compensation)?

The proxy also discloses that the company only adopted an "anti-pledging policy" in 2014. Moreover that "anti-pledging policy exempts existing margin and accounts and pledging accounts, which are permitted to continue until they expire, and allows the Board to make further exceptions to the policy when determined by the Board to be in the best interests of the Company".

Some will argue that I am being pedantic. A quarter of a billion dollars (the value of Mr Pearsons pledge) is small compared to the value that Mr Pearson has has created at Valeant - a company worth over 40 billion.

After all, what is a quarter of a billion dollars between friends?



Anonymous said...

It's time for some self-reflection John... unless you're doing this on purpose.

The quote you've included is egregiously out of the context, and you're not stupid, so my guess is you know it. In the preceding sentences, it clearly answers your questions as they pertain to Mr Pearson. He's pledged the shares to settle tax obligations from the vesting of stock that he's not allowed to sell until 2017, but is still subject to taxation. It's a hefty tax bill, and I doubt any normal human being has that kind of cash on hand, so it's really only reasonable to pledge the shares... or sell them under the pretense of paying taxes, but Mike doesn't want to sell his stock.

How can you ignore that? It's right there! And by the way, this isn't the first filing that it's been mentioned in, so Ackman not having known about the pledging when he put his presentation out is a non-issue. Your lack of research on the topic though, that is an issue.

John Hempton said...

Really? I mentioned the tax issue - and I do not think that tax bill is plausible.

Oh, and yes, on this one, I believe the GAAP numbers.


Anonymous said...

John -

You should familiarize yourself with basic tax accounting for restricted stock. Here is a link to help toward that: http://www.grantthornton.com/staticfiles/GTCom/Tax/CBC%20files/Restricted_stock_tax_impact.pdf

Restricted stock becomes taxable as ordinary income upon vesting. Given Pearson's awards were linked to stock price performance and VRX has creates tremendous shareholder value, he has considerable stock grants. As they vest there are also considerable tax implications.

Why would you not go back through the proxies and figure out all the tax grants and vesting schedules before you write this post? That may have led you to actually google "restricted stock taxation" and be better informed.

It you held yourself to the same standard that you hold Pearson...

John Hempton said...

The restricted stock becomes taxable on - according to that document - the earlier of...

• Date on which the property is no longer subject to a substantial risk of forfeiture, or
• Date on which the property becomes transferable.

The employment contract as stated SPECIFICALLY allows for forfeiture and does not allow transfer.

Unless they wrote that employment contract exceptionally badly there is no tax event-

I figure a company with this much tax planning did not write the contract that badly... unless they wanted to.


Anonymous said...

Eh, as a prior recipient of RSU's, I can assure you that the definition of "transferable" does not necessarily correspond to being able to sell it. Depending on how those agreements were written up the IRS may not care one whit about the 2017 lockup.

Anonymous said...

I will review contract in detail again in morning, but I believe that the restricted stock is subject to forfeiture if the performance and time requirements are not met. If these conditions are met, the stock vests (and in case of RSUs is considered "granted"). At this point the restricted stock is taxable. He also likely has elected 83(b) on those dates to lock in value at the Fair Market Value of the stock as of the vesting date (if he believes the stock will go up as he certainly does, this shifts more of the tax burden to a capital gain rather than ordinary income).

Are you implying that his contract suggests that his Restricted Stock is never taxable? That is just simply incorrect and does not

Separately, you keep drilling down on the debt comment in the interview snipped you had in prior post - it is very clear at that time he was taking about delevering Net Debt / adj EBITDA - not an absolute decline in net debt (as he did a number of M&A deals between Biovail close and Cephalon hostile). Most people that had or were doing work on VRX at the time understood that clearly.

Anonymous said...

Yes agree. Again the lock-up pertains to his ability to sell the stock. Ordinary income is recognized when the units vest (and upon eligible election of 83b it is recognized at grant) - not when units are sold. When sold, capital gains are assessed.

John Hempton said...

If a company with this many tax lawyers (and it is a tax-lawyer driven entity) drew the CEOs employment contract that badly they would have almost certainly drawn every other staff members that badly.

The pledging would be massive, widespread and dealing with tax - as the senior executives have been exceptionally well remunerated in deferred shares.

I have read a few contracts and I see nothing of the sort. Basicallly I think of the tax thing that they are making it up.

Unless they deliberately allowed the shares to be alienated.

Incidentally, my understanding is allowing them to be pledged is themselves the taxable event.


John Hempton said...

What my anonymous commentator here seems to think is that the most tax driven company in North America can't get its tax structuring right in any sensible way.

If you can't structure this properly (and you can) then executives all the way over America would be pledging shares for deferred compensation.

Its not happening. The commentator is delusional. Which is I think a character of many $VRX longs.


Brian Chan said...

John, let's not attack the character of anyone here, be it delusional or not. I am sure there are delusional individuals on both sides of the camps.

The crux is what are the bulls missing or perhaps what you could be missing that the bulls see that you don't?

Certainly, there are very smart bulls (to name Sequoia, Lou Simpson, ValueAct and many others). They have a long proven record who are not duds who just get into the long game just because of a "promotional" CEO, unless they lost their minds as well. Their record and behavior have been that they are independent thinkers, not one who just trust the CEO at his words? Is it likely that all of them all all delusional and misled? Perhaps but unlikely.

Who are they all missing out? I am sure they read the 10Ks, proxies and things like you do.

And their position makes up from high single digit to over 20% of their stock portfolio. I am quite sure these investors are not ones who studied their investment and not follow up since their investment. I am sure they studied before they put money into it and then also follow up with some maintenance work thereafter.

Thomas said...

http://www.cityam.com/article/1402967265/morgan-stanley-emails-exposed-bid-battle they have VRX on a buy

Anonymous said...

The terms of the PSUs are independent of the terms in Pearson's employment contract. The PSUs vest in 3 years if and only if the stock compounds at >10%. Separately, Pearson, as part of his employment agreement, has agreed not to sell a share until 2017. I can assure you the IRS isn't going to wait until 2017 (and probably further out than that if Pearson signs a new contract) for the tax bill to be paid for PSUs that vested 3 or 4 years ago.

gv said...

There is another possibility.
Participants may elect to be taxed at the time of the grant (Section 83b of the IRC). But if later the restricted share award is canceled, you will not get a refund or deduction.
Maybe Pearson chose to shift a possible income from ordinary income to capital gain. He surely is a self-confident man, I guess.
Of course taxes are due before the shares are even vested.
I neither see why pledging would pose a problem. He bears the risk because he remains the owner. So what is the problem?

Anonymous said...

I don’t feel qualified to add much to this line of inquiry. I’m a bull but I find the 2M share pledge to be odd. The proxy states that Pearson’s pledge was “in connection with loans used to fund tax and other obligations associated with vesting and delivery of equity incentive awards and purchases of company shares.”

Pearson’s employment agreement prevents him from selling any shares until 2017, EXCEPT for tax purposes. So if the pledge is to pay taxes and acquire shares as the proxy states, then he had the option to simply sell some shares to cover the cost, but he decided not to. This prompts a couple questions, how large was the tax bill and cost to acquire shares? And how much cash would he have received for pledging 2M shares with a value of about $115 per share? If these figures line up, then I don’t see any problems. Perhaps he’s drinking his own kool-aid and simply wanted to maintain beneficial ownership over the shares because he expects the stock to go much higher. If the pledge allowed him to effectively cash out a good chunk of money, then I think shareholders deserve an explanation as to why the Board approved this.

I don’t see this as a smoking gun, but it does deserve an explanation.

Anonymous said...

Not sure if serious. If your first comment is true, how can this NOT be a taxable event? Given that risk of forfeiture is increasingly unlikely due to share price appreciation, wouldn't that trigger a taxable event?

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