Question

1) Biovail Scandal in 2009

a) Give a brief overview of the company?

b) What were the sources, schemes, and motivation of the financial statement fraud?

c) What were the factors that contributed to the fraud?

d) What was the form of Financial Statement Fraud?

e) How was the fraud detected and were there Red Flags?

f) What was the outcome of the fraud and what investigative methods were used and how were the findings communicated?

g) How could the financial statement fraud have been prevented?

Answer 1

1a)

A deal that sees Canadian drug maker Biovail Corp. merge with California-based Valeant Pharmaceuticals International is "doomed to fail" under a huge debt load, Biovail founder Eugene Melnyk says.

Shareholders of the two companies approved the merger in separate votes earlier Monday. Biovail's shares which rose in the months ahead of the vote, were down 1.9 per cent at $27.32 on the Toronto Stock Exchange.

Biovail, Canada's largest publicly traded drug maker, said 99.9 percent of votes cast at the special meeting of shareholders in Toronto were in favour of the deal.

"At the end of the day, this is a tragedy and a travesty …," Melnyk told CBC.

Melnyk, who founded the company more than 20 years ago and saw it grow to a market capitalization of $7.5 billion US before jettisoning most of his shares earlier this year, is concerned about the huge amount of debt that was required to complete the deal.

Bloomberg News reported last week that the terms include a loan of between $950 million US and $1 billion due in 2015 and another loan totalling between $625 million and $675 million. Valeant is also seeking a $175 million revolving line of credit.

The total value of the merger is about $3.2 billion US.

"It is doomed to fail in two or three years," he said. "They won't be able to pay back the debt."

Melnyk warned Sunday in a letter to both companies that the deal was bad for taxpayers and shareholders and would also result in job losses.

The new company said it planned to slash 1,100 jobs, or 25 per cent of the combined workforce in a bid to cut costs.

"The job losses that will occur are just unconscionable and all are centered around trying to avoid tax and making a financially engineered deal that has nothing to do with running a pharmaceutical company," he said.

Two California lawmakers also expressed concern about the deal last week and asked the U.S. Securities and Exchange Commission and the Department of Justice to investigate.

Melnyk warned Sunday in a letter to both companies that the deal was bad for taxpayers and shareholders and would also result in job losses.

The new company said it planned to slash 1,100 jobs, or 25 per cent of the combined workforce in a bid to cut costs.

"The job losses that will occur are just unconscionable and all are centered around trying to avoid tax and making a financially engineered deal that has nothing to do with running a pharmaceutical company," he said.

Two California lawmakers also expressed concern about the deal last week and asked the U.S. Securities and Exchange Commission and the Department of Justice to investigate.

The California Assembly members raised concerns about the company's attempt to avoid paying taxes as well as the impending job losses in their state.

Melnyk, the millionaire owner of the Ottawa Senators National Hockey League team and a stable of expensive racehorses, stepped down as executive chairman of Biovail in 2007.

Since then he has been at odds with the company after it unveiled its new strategic direction into treatments for diseases of the central nervous system.

He said the merger with Valeant was a poor attempt by Biovail to mask that the change in strategy was not working.

"The only way to bail and save face is to do a very complex financial transaction," he said. "This deal may get through and it may close, but I would hate to be holding that paper (the debt) four years from now."

This wasn't the first time Melnyk has butted heads with the company.

In 2008, he called for a special shareholders meeting to vote on two board nominees backed by him, and on changes to the company's governance, before reaching an agreement.

Although he stepped away from Biovail, Melnyk has not completely left the pharmaceutical industry.

He now focuses his attention on his privately held drug delivery company, Trimel BioPharma, and on Fusion Brands, a dermatology, cosmetics and biological sciences firm.

Trimel, which he formed in 2008, has a number of products under development, with two products expected to be in late-stage trials by the spring of 2011. At least one regulatory filing is expected by the end of the same year.

Melnyk still faces regulatory issues in Canada surrounding his involvement in Biovail's accounting and disclosure practices, dating back to 2001.

2a)

Biovail Corporation was a Canadian pharmaceutical company, operating internationally in all aspects of pharmaceutical products. Its major production facility was located in Steinbach, Manitoba. It merged with Valeant Pharmaceuticals International in 2010.

In March 2006, CBS program 60 Minutes featured Biovail in a story about its lawsuit against hedge fund SAC Capital Partners and Camelback (now known as Gradient Analytics), among others. According to Eugene Melnyk, "there's a group of people that got together and essentially attacked the company by putting out false reports, and we're just fighting back for our shareholders." ^[1]

The alleged conspiracy began with Camelback, an Arizona stock-analysis firm that advertises that it publishes impartial financial reports on companies to help investors evaluate stocks. In the spring of 2003, the hedge fund SAC asked them for a report on Biovail. Darryl Smith, Mark Rosenblum, Demetrios Anifantis, and Robert Ballash, former Camelback employees, alleged that Camelback had allowed their client SAC to determine the content and timing of their reports on Biovail.^[1]

Camelback said those former employees were lying and disgruntled, that Anifantis and Ballash were fired because of unethical conduct; Smith for poor performance; Rosenblum was laid off. These four say they were let go after they complained to their superiors about Camelback's practices. SAC denied all the charges in Biovail's lawsuit and said that the decline in the Biovail's stock was due to earnings shortfalls and regulatory investigations.^[1]

In March, 2008, the United States Securities and Exchange Commission (SEC) sued Biovail and some of its former officers, alleging that "present and former senior Biovail executives, obsessed with meeting quarterly and annual earnings guidance, repeatedly overstated earnings and hid losses in order to deceive investors and create the appearance of achieving earnings goals. When it ultimately became impossible to continue concealing the company's inability to meet its own earnings guidance, Biovail actively misled investors and analysts about the reasons for the company's poor performance." Biovail settled for $10 million US.^[2] Gradient Analytics, successor to Camelback, issued a press release stating that the SEC's suit "confirms the validity of Gradient's critical analysis of Biovail but raises serious questions about how companies retaliate against analysts with threats, intimidation, and lawsuits."^[3][4]

60 Minutes has been accused of botching the Biovail story by the Columbia Journalism Review's Audit columnist and The New York Times' Joe Nocera, who felt Lesley Stahl accepted Biovail's conspiracy theories about short sellers without proper consideration.^[5][6][7]

SAC and Gradient filed a suit against Biovail for malicious prosecution in February 2010.

3a)

Biovail Corp.'s merger with Valeant Pharmaceuticals caps the company's recovery from falling sales and financial scandals. A timeline of the Canadian drug developer's internal struggles and legal battles:

May 2007: Biovail is notified that the Securities and Exchange Commission is looking into bringing civil action against the company for alleged accounting fraud. Four executives also are investigated, including founder, Chairman and CEO Eugene Melnyk.

June 2007: A generic version of the company's Wellbutrin XL smoking-cessation drug wins FDA approval, cutting annual sales of the brand-name antidepressant by more than half to $212 million from $450 million. Melnyk, also owner of the Ottawa Senators hockey team, retires as CEO.

March 2008: Biovail agrees to pay the SEC $10 million to resolve civil allegations of accounting fraud and deceiving investors. The company does not acknowledge or deny wrongdoing. It later settles two class action lawsuits.

April 2008: Bill Wells is named permanent CEO of Biovail.

May 2008: Biovail says it plans to focus on drugs that treat central nervous system disorders. Ex-CEO Melnyk, still a major shareholder, disagrees, believing the company should maintain its focus on hard-to-copy generic drugs. Melnyk tries to regain control of the company by nominating a slate of directors to replace Biovail's board.

Separately, a Biovail unit pays $25 million to settle federal criminal charges it paid doctors to prescribe its blood pressure drug Cardizem LA when the drug was being launched in 2003.

May 2009: The company also resolves its proxy dispute with Melnyk by placing Frank Potter, one of his nominees, on the board. Melnyk agrees not to participate in any proxy fights or shareholder proposals until after the company's 2010 annual meeting.

December 2009: Ex-CFO Kenneth Howling settles fraud charges with the SEC.

June 2010: Biovail agrees to combine with Valeant Pharmaceuticals International. The combined company will keep Valeant's name and Biovail's corporate structure, including its Canadian headquarters. Leadership will be divided between the companies, with J. Michael Pearson of Valeant serving as CEO and Bill Wells of Biovail acting as non-executive chairman. The SEC's litigation against Melnyk, ex-CFO Brian Crombie and ex-controller John Miszuk appears headed to trial in New York district court.

4a)

Contributing factors to fraud include: Poor internal controls, Management override of internal controls, Collusion between employees, and Collusion between employees and third parties.

Red flags are warnings that something could be or is wrong.

Auditors, employees, and management need to be aware of red flags in order to monitor the situation and then take corrective action as needed.

Employees who notice that red flags are ignored believe that they won’t get caught.

A little fraud soon becomes a large one if left to grow.

5a)

When the managers of a company provide false financial information, it's called financial statement fraud. Financial statement fraud is usually committed with the intention of making financial gains, such as by using the false information to increase the value of the company's stock.

Misappropriations-: One of the most serious forms of financial statement fraud is when statements are altered to mask theft or embezzlement. This can be done in a number of ways, such as through double-entry bookkeeping or the inclusion of fictitious expenses. In this case, the fraud is committed for purely personal gain, and not through an interest in altering public perception of the company.

False Asset Evaluations-:Another means of financial statement fraud is to make assets appear more valuable than they actually are. Although the entries in the financial statements may be true, the appraisals that led to these statements being written are incorrect. For example, if an oil company deliberately appraises a non-producing well as worth the same as one that produces oil, and include this valuation on its financial statement, this is a form of fraud.

Overstatement of Revenue-: One of the most basic forms of financial statement fraud is the overstatement of revenue. In this form of fraud, a company states that it took in more money in a certain period of time than was the case. This may be done for several reasons, all related to creating the perception that the company is worth more than it is..

Recording Uncertain Sales-:Another form of financial statement fraud is to record sales that have not yet gone through as sales that have already been transacted. This can take several forms, including sales that are currently being negotiated or sales that are expected for the next quarter. This form of fraud is closely related to the recording of false revenues. Like false revenues, this form of fraud is designed to make the company appear more profitable than is the case.

Concealment-:Concealment is a form of fraud in which certain liabilities or other harmful disclosures that make hurt the company are kept off a financial statement. For example, if the company took on a number of liabilities, such as by taking out a loan or issuing debt, this will generally need to be recorded. By keeping such disclosures off the statement, the company looks in better financial shape than is the case.

6a) Red flags are mechanisms that can be used by internal auditors for early detection of possible fraud. In this context, the aim of this study was to identify the relevance credit unions’ internal auditors attribute to red flags in assessing fraud risk.in other words Red flags are mechanisms that can be used by internal auditors for early detection of possible fraud. In this context, the aim of this study was to identify the relevance credit unions’ internal auditors attribute to red flags in assessing fraud risk. Design/methodology/approach – This article is characterized as descriptive concerning its goals, as a survey as to is procedures, and as quantitative in reference to its approach to the problem. The sample onsists of 51 internal auditors working in Credit Union Centers in southern Brazil. Findings – Results indicate that, in the assessment of fraud risk, internal auditors attribute greater importance to red flags referring to operational activities and internal control procedures. In addition, it is suggested that internal auditors are not impartial concerning their perception of relevance of most of the warning signs of the possibility of fraud. Originality/value – The findings contribute by demonstrating to internal auditors the need for greater attention to the use of red flags as auditing tools.

7a)

Organisations investigate business upsets because they are required to by law or their own company standards, or the public or shareholders expect it. But, whatever the motivation, the goal is to identify why the incident happened and to take action to reduce the risk of future incidents.

Investigations often find that similar scenarios have occurred previously but, for a variety of reasons, did not result in serious consequences. This is increasingly recognised in high-risk industries where “near misses” are also investigated as well as incidents which actually resulted in loss.

A six-step, structured approach to incident investigation (Fig 1) helps to ensure that all the causes are uncovered and addressed by appropriate actions.

Step 1 – Immediate action

In the event of an incident, immediate action to be taken may include making the area safe, preserving the scene and notifying relevant parties. The investigation begins even at this early stage, by collecting perishable evidence, e.g. CCTV tapes, samples.

Step 2 – Plan the investigation

Planning ensures that the investigation is systematic and complete. What resources will be required? Who will be involved? How long will the investigation take? For severe or complex incidents, an investigation team will be more effective than a single investigator.

Step 3 – Data collection

Information about the incident is available from numerous sources, not only people involved or witnesses to the event, but also from equipment,

Step 4 – Data analysis

Typically, an incident is not just a single event, but a chain of events. The sequence of events needs to be understood before identifying why the incident happened.

When asking why, we need to identify the root and underlying causes, as well as the direct causes. Failures and mistakes don’t just happen by themselves; organisations allow error-enforcing environments that encourage direct causes to develop and persist. Such environments, and the basic management failings behind them, are the root causes – the ultimate source of the incident.

While human error plays a part in the majority of incidents, people are not generally stupid, lazy, forgetful or wilfully negligent. Human errors occur because of influencing factors associated with the work, the environment, an individual’s mental or physical abilities, the organisation and its management systems. Any investigation which sets out to find someone to blame is misguided.

Step 5 – Corrective actions

Many investigations make the mistake of raising actions which deal only with the direct causes – a quick fix, putting last-lines-of- defence back in place. By ignoring the root and underlying causes, not only do they miss an opportunity to reduce the risk of recurrence of the incident, but they also leave open the possibility that other, dissimilar incidents may also occur, arising from the same, common root cause.

Step 6 – Reporting

The investigation is concluded when all outstanding issues have been closed out and the findings have been communicated so that lessons can be shared. Communication mechanisms include formal incident investigation reports, alerts, presentations and meeting topics.

8a)The first step in financial statement fraud prevention is strong internal accounting controls. Internal controls begin at the transaction level of accounting and dictate which employees can complete processes and tasks within the company. Internal controls may also be instituted outside the accounting office to strengthen company operations. An example of an operational internal control is allowing certain employees the authorization of purchase orders. An employee who authorizes the purchase of an asset should not be allowed to choose where to purchase the asset. Setting dollar limits for authorized purchases or using approved vendors can help to enforce this control. An important internal control for accounting is the segregation of duties. This ensures that more than one person handles certain financial information. A common segregation is in the cash accounts. The same employee is not allowed to sign checks, post them in the accounting system and reconcile the bank statement. This control prevents embezzlement. This type of segregation can be spread throughout the accounting department.

Audits-: Companies should test their financial information for accuracy by having an audit of their financial statements. This helps management understand where weaknesses are in their accounting department and allows them to take corrective measures quickly. Audits should test the controls objectiveness. Are the transactions complete and valid regarding the information? Do the transactions appear reasonable? Is any information not being reported because of internal control limitations? Audits should also test activities. Who is completing the task? Is a high level of security applied to financial information? Can the activity be easily reviewed in a timely manner? Audits should also review the internal control process. Many publicly held companies are required by the Securities and Exchange Commission (SEC) to have their outside auditors attest to the effectiveness of internal controls.

A business owner's worst nightmare has come true. A longtime trusted employee has confessed to misappropriating company funds. Unfortunately, business owners are often consumed with managing employees, customer service and putting out daily fires that a majority of the financial responsibilities are entrusted to someone else. However, once an entrepreneur has become the victim of fraud he searches for answers to prevent the situation in the future. A strong system of internal controls helps companies deter employees from committing fraud.

Educate management on the three indicators of fraud. According to the Association of Certified Fraud Examiners, financial statement fraud involves the intentional publishing of false information in any portion of a financial statement. To help prevent fraudulent activities, management must implement internal controls, or structure, and know what situations to look for. Individuals commit fraud when under situational or financial pressure, when the opportunity to commit fraud is present and when the perpetrator easily rationalizes the fraudulent activity.

Segregate accounting functions. One of the main factors of an effective internal control system is segregation of duties. Management helps to prevent fraud by reducing the incentives of fraud. One incentive, the opportunity to commit fraud, is reduced when accounting functions are separated. The act of segregating duties separates the recordkeeping, authorization and review functions in the accounting process. To segregate duties, involve more than one person in the financial statement preparation process. Therefore, or fraud to occur two employees must collude to perpetrate the crime.

Establish a strong control environment. A strong control environment, otherwise known as a strong tone at the top, involves enlisting management to demonstrate ethical behavior. The ACFE notes that whatever tone management sets will have a trickle-down effect on employees of the company. A strong tone is developed by establishing and complying with a written set of policies. The policies must be concise and include consequences when procedures are disobeyed. In addition, according to the ACFE’s Fraud Examiners Manual, one of the easiest ways to establish a strong moral tone for an organization is to hire morally sound employees.

Initiate annual examinations of financial statements by an outside party. In many cases, management is the party committing fraud. Management may feel pressure to meet financial goals for the company or may receive incentives if certain goals are met. To help prevent management from engaging in overly aggressive adjustments to the financial statements, have an independent party examine financial statements on an annual basis. Engaging an auditor to perform a financial statement review or audit deters employees from knowingly presenting incorrect financial statements.

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