UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-Q/A

 

 

 

Commission file number: 1-11397

 

 

 

 

Valeant Pharmaceuticals International

(Exact name of registrant as specified in its charter)

 

 

(949) 461-6000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes o     No þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  þ     Accelerated filer  o     Non-accelerated filer  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The number of outstanding shares of the registrant’s Common Stock, $0.01 par value, as of January 16, 2007 was 94,414,465.

 

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

INDEX

 

 

We are amending our quarterly report on Form 10-Q for the quarter ended March 31, 2006 filed on May 9, 2006 (the “Original Filing”) to restate our condensed consolidated financial statements for the three-month periods ended March 31, 2006 and 2005 and the related disclosures. See Note 2, “Restatement of Consolidated Financial Statements” of the Notes to Consolidated Condensed Financial Statements for a detailed discussion of the effect of the restatement. On January 22, 2007 we filed an amended Annual Report on Form 10-K/A for the year ended December 31, 2005.

 

The restatement of the Original Filing reflected in this amended quarterly report on Form 10-Q/A includes adjustments arising from the determinations of a Special Committee, consisting of independent members of the Board of Directors, which was formed in September 2006 to conduct a comprehensive review into the Company’s past stock option practices, as well as our internal review relating to our historical financial statements.

 

In July 2006, we were contacted by the Securities and Exchange Commission, or SEC, with respect to an informal inquiry regarding events and circumstances surrounding trading in our common stock and the public release of data from our first pivotal Phase 3 trial for Viramidine^® (taribavirin). In addition, on August 22, 2006, the SEC requested data regarding our stock option grants and exercises since January 1, 2000. The SEC has also requested information about our pursuit in the Delaware Chancery Court of the return of certain bonuses paid to Milan Panic, the former chairman and chief executive officer, and others, in connection with the Ribapharm initial public offering. We commenced an internal review by our finance department of stock option grants from 1982 to July 2006. In September 2006, our board of directors appointed a special committee of the board composed solely of independent directors (the “Special Committee”) to conduct a review of our historic stock option practices and related accounting. The Special Committee, with the assistance of outside legal counsel, undertook a comprehensive review of the stock option grants to our officers, directors and employees from 1982 to July 2006 under our various stock option plans in effect during this period. The Special Committee has concluded its investigation and has reported its findings to our board of directors.

 

On October 20, 2006, our board of directors concluded that certain of our consolidated financial statements should be restated to record the additional non-cash stock-based compensation expense items that had been incorrectly accounted for under accounting principles generally accepted in the United States, or GAAP. In addition, we have restated our financial statements to correct certain accounting errors which were previously identified but not considered to be material. These corrections related to accounting for employee tax withholding on certain compensation transactions, elimination of an intercompany difference, accounting for product exchanges (resulting in a revenue adjustment), and certain income tax adjustments.

 

For more information on these matters, please refer to Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Restatement of Consolidated Financial Statements, Note 2 of the Notes to the Condensed Consolidated Financial Statements, and Item 4, “Controls and Procedures.”

 

As a result of the findings of the Special Committee as well as our internal review, we concluded that it was necessary to amend our annual report on Form 10-K for the year ended December 31, 2005, originally filed on March 16, 2006, to restate our consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 and the related disclosures as well as “Management’s Report on Internal Control Over Financial Reporting” as of December 31, 2005. The annual report on Form 10-K/A, filed on January 22, 2007, also includes the restatement of selected consolidated financial data as of and for the years ended December 31, 2005, 2004, 2003, 2002 and 2001, and the unaudited quarterly financial data for each of the quarters in the years ended December 31, 2005 and 2004. We also concluded that we needed to amend the quarterly reports on Form 10-Q for the quarters ended March 31, 2006 and June 30, 2006, originally filed on May 9, 2006 and August 8, 2006, respectively, to restate our condensed consolidated financial statements for those periods. We also restated the September 30, 2005 financial statements with the filing of our September 30, 2006 Form 10-Q on January 22, 2007. We have not amended and we do not intend to amend any of our other previously filed annual reports on Form 10-K or quarterly reports on Form 10-Q for the periods affected by the restatement or adjustments other than (i) this amended quarterly report on Form 10-Q/A for the quarter ended March 31, 2006, (ii) the amended quarterly report on Form 10-Q/A for the quarter ended June 30, 2006 being filed on the same date as this filing, and (iii) the amended annual report on Form 10-K/A for the year ended December 31, 2005, filed January 22, 2007.

 

All of the information in this amended quarterly report on Form 10-Q/A is as of March 31, 2006 and does not reflect events occurring after the date of the Original Filing, other than the restatement, or modify or update disclosures (including, the exhibits to the Original Filing, except for the updated Exhibits 31.1, 31.2, and 32.1 described below) affected by subsequent events. For the convenience of the reader, this amended quarterly report on Form 10-Q/A sets forth the Original Filing in its entirety, as amended by, and to reflect, the restatement. The following sections of this Form 10-Q/A were adjusted to reflect the findings of the Special Committee as well as our internal review:

 

Part I — Item 1 — Unaudited Financial Statements;

Part I — Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations;

Part I — Item 4 — Controls and Procedures;

Part II — Item 1A — Risk Factors; and

Part II — Item 6 — Exhibits

 

This amended quarterly report on Form 10-Q/A should be read in conjunction with our amended Annual Report on Form 10-K/A for the year ended December 31, 2005, our periodic filings made with the SEC subsequent to the date of the Original Filing and any Current Reports filed on Form 8-K subsequent to the date of the Original Filing. In addition, in accordance with applicable SEC rules, this amended quarterly report on Form 10-Q/A includes updated certifications from our Chief Executive Officer and Chief Financial Officer as Exhibits 31.1, 31.2, and 32.1.

 

 

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

VALEANT PHARMACEUTICALS INTERNATIONAL

 

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

 

 

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

VALEANT PHARMACEUTICALS INTERNATIONAL

 

CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME

 

 

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

VALEANT PHARMACEUTICALS INTERNATIONAL

 

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

 

 

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

March 31, 2006

(Unaudited)

 

In the consolidated condensed financial statements included herein, “we”, “us”, “our”, “Valeant” and “the Company” refer to Valeant Pharmaceuticals International and its subsidiaries. The condensed consolidated financial statements have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared on the basis of accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The results of operations presented herein are not necessarily indicative of the results to be expected for a full year. Although we believe that all adjustments (consisting only of normal, recurring adjustments) necessary for a fair presentation of the interim periods presented are included and that the disclosures are adequate to make the information presented not misleading, these consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our annual report on Form 10-K/A for the year ended December 31, 2005.

 

 

Organization:  We are a global, science-based, specialty pharmaceutical company that develops, manufactures and markets a broad range of pharmaceutical products. In addition, we generate royalty revenues from the sale of ribavirin by Schering-Plough Ltd. (“Schering-Plough”) and F. Hoffman-LaRoche (“Roche”).

 

Principles of Consolidation:  The accompanying consolidated condensed financial statements include the accounts of Valeant, its wholly owned subsidiaries and all of its majority-owned subsidiaries. Minority interest in results of operations of consolidated subsidiaries represents the minority stockholders’ share of the income or loss of these consolidated subsidiaries. All significant intercompany account balances and transactions have been eliminated.

 

Marketable Securities:  We invest in investment grade securities and classify these securities as available-for-sale as they typically have maturities of one year or less and are highly liquid. As of March 31, 2006 and December 31, 2005, the fair market value of these securities approximated cost.

 

Acquired In-Process Research and Development:  We incurred an expense of $126,399,000 associated with acquired in-process research and development (“IPR&D”) related to the acquisition of Xcel Pharmaceuticals, Inc. (“Xcel”) in the three months ended March 31, 2005. Amounts expensed as IPR&D represent an estimate of the fair value of purchased in-process technology for projects that, as of the acquisition date, had not yet reached technological feasibility and had no alternative future use. The data used to determine fair value requires significant judgment. Differences in those judgments would have the impact of changing the allocation of purchase price to goodwill, which is an intangible asset that is not amortized.

 

The estimated fair value of these projects was based on the use of a discounted cash flow model (based on an estimate of future sales and an average gross margin of 80%). For each project, the estimated after-tax cash flows (using a tax rate of 35%) were probability weighted to take account of the stage of completion and the risks surrounding the successful development and commercialization. The assumed tax rates are our estimate of the effective tax rate for acquisitions of similar type of assets. These cash flows were then discounted to a present value using a discount rate of 18% which is our estimated, after tax, adjusted weighted average cost of capital.

 

The major risks and uncertainties associated with the timely and successful completion of these projects consist of the ability to confirm the safety and efficacy of the technology based on the data from clinical trials and obtaining necessary regulatory approvals. In addition, no assurance can be given that the underlying assumptions used to forecast the cash flows or the timely and successful completion of such projects will materialize, as estimated. For these reasons, among others, actual results may vary significantly from the estimated results.

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

 

Derivative Financial Instruments:  Our accounting policies for derivative instruments are based on whether they meet our criteria for designation as hedging transactions, either as cash flow or fair value hedges. Our derivative instruments are recorded at fair value and are included in other current assets, other assets, accrued liabilities or debt. Depending on the nature of the hedge, changes in the fair value of the hedged item are either offset against the change in the fair value of the hedged item through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings.

 

Comprehensive Income:  We have adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 130, Reporting Comprehensive Income. Accumulated other comprehensive loss consists of accumulated foreign currency translation adjustments, unrealized losses on marketable equity securities, minimum pension liability and changes in the fair value of derivative financial instruments.

 

Per Share Information:  Basic earnings per share are computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding. In computing diluted earnings per share, the weighted-average number of common shares outstanding is adjusted to reflect the effect of potentially dilutive securities including options, warrants, and convertible debt; income available to common stockholders is adjusted to reflect any changes in income or loss that would result from the issuance of the dilutive common shares.

 

Stock-Based Compensation Expense:  On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases under our Employee Stock Purchase Plan based on estimated fair values. SFAS 123(R) supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). We have applied the provisions of SAB 107 in its adoption of SFAS 123(R).

 

We adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006. Our consolidated condensed financial statements as of and for the three months ended March 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).

 

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated condensed statement of operations. Prior to the adoption of SFAS 123(R), we accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the intrinsic value method, stock-based compensation expense is recognized in the financial statements for the amounts related to restricted stock unit grants and stock options granted to employees at exercise prices which are less than the market price of our stock on the dates that the stock option is awarded. (See Note 2 regarding restatement of our financial statements for stock-based compensation expense.)

 

We have determined the fair value of stock option grants using the Black-Scholes option-pricing model (“Black-Scholes model”). Our determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors (See Note 8). The value of stock options that are expected to vest is amortized to expense using the straight line, graded vesting method over the vesting period of each stock option granted. Previously, for purposes of the disclosure only calculations under SFAS 123, the aggregate value of stock option grants was amortized to expense on a straight line basis.

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

Stock-based compensation expense included in the accompanying financial statements for the three months was $5,618,000 and $862,000 in the three months ended March 31, 2006 and 2005, respectively.

 

The following table provides the pro forma results if we had recognized stock compensation expense under the provisions of SFAS 123(R) in 2005:

 

 

Prior to the restatement discussed in Note 2, we reported that the pro forma net loss and net loss per share resulting from the application of SFAS 123R would have been $144,309,000 and $1.62 per share, respectively, for the three month period ended March 31, 2005.

 

Income tax benefits in the United States that are associated with the our stock option programs and stock compensation expense have been recorded net of a completely offsetting valuation allowance because, at this time, there is insufficient objective evidence to assure that the Company will have sufficient US taxable income to realize such benefits.

 

Assets Held for Sale:  Valeant has entered into a preliminary agreement of sale for a manufacturing facility in Warsaw, Poland. At March 31, 2006 the net book value of this facility ($7,421,000) is classified as assets held for sale and included in prepaid expenses and other current assets in the accompanying consolidated condensed financial statements.

 

Use of Estimates:  The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ materially from those estimates.

 

Reclassifications:  Certain prior year items have been reclassified to conform to the current year presentation, with no effect on previously reported net income or stockholders’ equity.

 

 

We are amending our quarterly report on Form 10-Q for the quarter ended March 31, 2006 to restate our condensed consolidated financial statements for the three month periods ended March 31, 2006 and 2005 and the related disclosures. On January 22, 2007 we filed an amended Annual Report on Form 10-K for the year ended December 31, 2005.

 

In July 2006, we were contacted by the Securities and Exchange Commission, or SEC, with respect to an informal inquiry regarding events and circumstances surrounding trading in our common stock and the public

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

release of data from our first pivotal Phase 3 trial for Viramidine^® (taribavirin). In addition, on August 22, 2006, the SEC requested data regarding our stock option grants and exercises since January 1, 2000. The SEC has also requested information about our pursuit in the Delaware Chancery Court of the return of certain bonuses paid to Milan Panic, the former chairman and chief executive officer, and others, in connection with the Ribapharm initial public offering. We commenced an internal review by our finance department of stock option grants from 1982 to July 2006. In September 2006, our board of directors appointed a special committee of the board composed solely of independent directors (the “Special Committee”) to conduct a review of our historic stock option practices and related accounting. The Special Committee, with the assistance of outside legal counsel, undertook a comprehensive review of the stock option grants to our officers, directors and employees from 1982 to July 2006 under our various stock option plans in effect during this period. The Special Committee has concluded its investigation and has reported its findings to our board of directors.

 

On October 20, 2006, our board of directors concluded that certain of our consolidated financial statements should be restated to record the additional non-cash stock-based compensation expense items and certain other items that had been incorrectly accounted for under accounting principles generally accepted in the United States, or GAAP.

 

Continuing the work done in September, the Special Committee analyzed in detail stock option grants awarded between November 1994 and July 2006 and analyzed supporting documentation for awards granted between 1982 and 1994. For the period between November 1994 and July 2006, the Special Committee’s analysis included an extensive review of paper and electronic documents supporting or related to our stock option grants, the accounting for those grants, compensation-related financial and securities disclosures and e-mail communications as well as interviews with numerous current and former employees and current and former members of our board of directors. While the Special Committee concluded that there were some errors as late as January 2006, the majority of errors in accounting for options pertain to those options granted prior to the change in our board of directors and management in mid-2002 (the “Change in Control”). None of the errors occurring in periods after the Change in Control related to options granted to the chief executive officer, chief financial officer or members of our board of directors.

 

The Special Committee made a determination, based on the available evidence, of measurement dates for each affected grant. If the grants were approved at a meeting of the compensation committee of the board of directors and there was no actual evidence of a change in the approved list of individual awards, the measurement date selected was the date of the compensation committee meeting. If there was actual evidence of a change in the list of individual awards and evidence of when the list became final, the measurement date selected was the date when the list became final. If there was actual evidence of a change in the list but evidence of when the list became final was not definitive, the measurement date was reconstructed using the best available evidence to ensure that an adequate amount of compensation expense was recorded in the restatement.

 

In total we recorded $31,049,000 of additional pre-tax, non-cash, stock-based compensation expense in the restatement to correct errors for awards granted from 1982 to date. Of this, $28,651,000 related to awards granted prior to the Change in Control and $2,398,000 to awards granted after the Change in Control. None of these changes affected our previously reported revenues, cash, or cash equivalents. As explained below, however, we also reported corrections for certain other items which impact our reported revenues and cash flow presentations.

 

Options Granted Prior to the Change in Control

 

The Special Committee found that the recorded grant dates for the majority of stock options awarded prior to the Change in Control differed from the actual grant dates for those transactions. In connection with that finding, the Special Committee concluded that, with respect to many broad-based grants of stock options prior to the Change in Control, prior management used a methodology of selecting a recorded grant date based on the lowest closing price during some time period (e.g., quarter, ten trading days) preceding the actual grant date. While the Special Committee did not reach a conclusion as to how prior management selected other recorded grant dates for broad- based or individual grants that did not use the lowest closing price methodology, there is some evidence that dates were selected based on the occurrence of an event or when the former chief executive officer, Milan Panic, agreed in

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

principle to the grant. While these and similar practices resulted in the grant of “in-the-money” options, and the Special Committee identified evidence that two pre-Change in Control directors may have been aware of these backdating practices, it does not appear that prior management pre-Change in Control attempted to conceal that the stock option grants were discounted using the backdating methodology.

 

Between November 1994 and the June 2002 Change in Control, eight broad-based grants were made. All of the 908 individual awards of options to purchase 6.9 million shares comprising those grants had recorded grant dates that differed from the actual grant dates for those transactions and each resulted in additional compensation charges that are reflected in our restated financial statements. Of those eight broad-based grants, six appear to have been annual grants that used the lowest closing price methodology and two appear to have been event-related (in those instances, there are lower prices between the recorded grant date and actual grant date). These eight broad-based option grants accounted for $11,488,000 of the $31,049,000 in pre-tax compensation charges.

 

During this period, options to directors to purchase a total of 334,000 shares were also found to have recorded grant dates earlier than the dates when the board of directors acted to approve the grants. The grants were dated in accordance with the 1994 Stock Option Plan which provided expressly that the grants were to be dated as of November 11, 1994. The board of directors, however, did not approve that stock option plan until January 1995. Accordingly, we are taking additional non-cash compensation charges equal to the difference between the closing stock price on the date of approval and November 11, 1994. These option grants to directors accounted for $148,000 of the $31,049,000 in pre-tax compensation charges.

 

Also during this period, there were 114 other individual grants of options to purchase a total of 2.0 million shares with stipulated grant dates earlier than the dates the compensation committee acted to approve these awards. The Special Committee could not determine whether the date of those grants were based on an event or when the former chief executive officer, Milan Panic, agreed in principle to the award. These individual option grants accounted for $4,538,000 of the $31,049,000 in additional compensation charges.

 

The restatement also includes a pre-tax charge of $997,000 related to a stock option grant to a former chief financial officer, who left in 2002. This grant of options to purchase 100,000 shares was granted to him with a recorded grant date a few days before he joined the Company in May 1998. The Special Committee concluded that this award of options was effectively amended in December 1998 to lower its exercise price. There is evidence which suggests that certain members of former management knew or should have known that this transaction and one other transaction (resulting in a pre-tax charge of $450,000) had accounting, tax, and disclosure consequences and that they failed to take appropriate action. These options have been accounted for as variable awards in accordance with FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation (“FIN 44”) in the restated financial statements. Variable accounting ceased in 2002 when these options were surrendered.

 

We also recorded $1,375,000 of additional pre-tax, non-cash, stock-based compensation expense in the restatement for awards granted between 1982 and 1994.

 

In total 1,038 individual awards of options to purchase a total of 9.2 million shares granted before the Change in Control were found to have been granted “in-the-money,” representing 71% of total awards granted in the period November 1994 through June 11, 2002. This included 87 awards of options to purchase 4.5 million shares awarded to ten executive officers, including the former chief executive officer, Milan Panic. These “in-the-money” awards to executive officers accounted for $10,507,000, or 34% of the total pre-tax accounting charge of additional stock-based compensation expense in the restatement.

 

Cash Surrender of Options at Change in Control in 2002

 

The election of certain persons as directors at the annual meeting of our stockholders on May 29, 2002 caused a Change in Control under our stock option plans. Our 1998 Stock Option Plan (the “1998 Plan”) provided that all outstanding options vested immediately upon the Change in Control and that an option holder had 60 days following the Change in Control to surrender his or her non-incentive stock options for a cash payment equal to the excess of

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

the highest closing price of the stock during the 90 days preceding the Change in Control, which was $32.50 per share, or the closing price on the day preceding the date of surrender, whichever was higher, over the exercise price for the surrendered options.

 

During the year ended December 31, 2002, we recorded a pre-tax charge of $61,400,000 related to our cash payment obligation under the 1998 Plan. The findings of the Special Committee relating to “in-the-money” options that were affected by the Change in Control require that we recognize the remaining grant date intrinsic value resulting from the acceleration of vesting for a number of these options and the value that certain other options could have been surrendered for cash under APB 25 and FIN 44. As a result, an additional compensation charge of $10,105,000 has been recorded in fiscal year 2002.

 

Options Granted After the Change in Control

 

The Special Committee also found that, due to flaws in the processes relied on to make our annual broad-based grants after the Change in Control, we did not correctly apply the requirements of APB 25 through December 2005. These option accounting errors, however, differ significantly from those made prior to the Change in Control. Unlike the broad-based grants made prior to the Change in Control, for which the recorded grant dates were selected from a period prior to the approval dates, the broad-based grants after the Change in Control were approved at either regularly scheduled meetings of the compensation committee or at meetings of the board of directors, and the exercise price for each of these grants was the closing price on the date of such meetings.

 

The stock option accounting errors after the Change in Control resulted from allocation adjustments to the list of grants to individual non-executives after the compensation committee or the board of directors had approved the allocation of an aggregate number of shares to be available to non-executive employees. In no event did the adjustments result in shares being granted in excess of the aggregate number of shares approved by the compensation committee or the board of directors. Further, none of those adjustments related to the chief executive officer, chief financial officer, or any member of the board of directors. The Special Committee concluded that there was no evidence that management operating since the Change in Control were aware that the processes used to grant and account for broad-based grants were flawed or that the process employed was for the purpose of granting in-the-money stock options. In reaching this conclusion, the Special Committee took note that that process had been consistently employed even for the November 2005 grants in which the process resulted in stock option grants at higher exercise prices than the closing price of our common stock on the date of finalization of the allocation list for non-executives. The Special Committee also concluded that there was no evidence that current management was aware of any financial statement impact, tax consequences or disclosure implications of its flawed processes.

 

Between May 2003 and November 2005, we made four broad-based grants (May 2003, November 2003, November 2004 and November 2005). The May 2003 grants were made to non-executive employees. The November 2003, 2004 and 2005 grants were made to a broad base of employees, including senior executives (the “November Grants”). With respect to each of the November Grants, the granting authority (either the compensation committee or the board of directors) made specific grants to specific members of executive management, including, among others, the chief executive officer, the chief operating officer, and the chief financial officer. Additionally, the broad-based grants made after the Change in Control were approved either at regularly scheduled meetings of the compensation committee or at meetings of the board of directors. The stock option accounting errors that affected 164 individual grants of options to purchase 1.5 million shares resulted from slight adjustments to the non-executive grant lists after the relevant compensation committee or board meetings. In no event did the adjustments result in shares being granted in excess of the number of options approved by the compensation committee or the board of directors. As a result of its work, the Special Committee made a determination of new measurement dates for each affected grant. With respect to three of the four broad-based grants (May 2003, November 2003 and November 2005), the measurement date selected was the date on which the rank and file list became final. With respect to the remaining broad-based grant (November 2004), there was actual evidence of a change in the rank and file list but inconclusive evidence when the list became final. The measurement date for that grant was reconstructed using the best available evidence to ensure that an

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

adequate amount of compensation expense was recorded in the restatement. A total of 14 other individual awards (0.1 million shares) made to rank-and-file employees since the change of control were also found to contain administrative stock option accounting errors.

 

To correct these errors, we recorded $2,398,000 of additional pre-tax, non-cash, stock-based compensation expense in the restatement for the period July 1, 2002 through March 31, 2006. These non-cash charges have no impact on previously reported revenues, cash or cash equivalents. As explained below, however, we also reported corrections for certain other items which do have an impact on reported revenues and cash flow presentations.

 

New Hire Grant Practices

 

The Special Committee investigated our new hire stock option grant practices and concluded that the new hire grants were appropriately accounted for under the applicable accounting principles. Until January 2004, our practice was to set forth, in a prospective employee’s offer letter a specific number of options, specifying that the strike price would be equal to the closing price on the new employee’s first date of employment pending approval of the compensation committee. Beginning in January 2004, the offer letters set the strike price equal to the closing price of our stock on the later of compensation committee approval or the employee’s start date.

 

With respect to our new hire grant practices prior to January 2004, the Special Committee reviewed each offer letter and related grant during the period June 2002 to January 2004 and a sample of offer letters and related grants prior to June 2002. The Special Committee also questioned relevant individuals about the option-related new hire practices and procedures. This intensive review confirmed that in each instance reviewed, the number of options approved was equal to the number of options set forth in the applicable offer letter, and that no material terms of the options were changed by the compensation committee in its approval process. Accordingly, the Special Committee concluded that, with respect to new hire grants prior to January 2004, compensation committee approval was a mere formality and that there had been finality with respect to the new hire grants upon the first day of employment, which had been used as the measurement date. Based upon the investigation, the Special Committee concluded that new hire grants were accounted for appropriately.

 

Income Tax Effects

 

Incremental, stock-based, pre-tax compensation charges resulted in tax benefits of $7,920,000. These tax benefits through 2000 were $1,940,000, recorded as an increase in the deferred tax assets with a corresponding increase in retained earnings. For 2001 through 2003, deferred tax assets increased by $5,980,000 and income tax expense decreased by the same amount. In 2004, the deferred tax asset was fully reserved with a valuation allowance.

 

As a result of the review of our stock option granting practices, management determined that the limitation of tax benefits for executive compensation imposed by Section 162(m) of the Internal Revenue Code (the “IRC”) was not considered in the income tax returns or financial statements prior to the Change in Control. The amount of this limitation has been impacted by the determination that many of the stock options were granted at prices below fair market value on the date of grant. As a result of correctly applying the Section 162(m) limitations, retained earnings have been decreased by $1,896,000 as of December 31, 2000 and income tax expense has been increased by $702,000, $518,000 and $748,000 in 2001, 2002 and 2003, respectively. Adjustments of ($205,000) and $122,000 for 2004 and 2005 respectively, did not affect tax expense due to the valuation allowance. Also, the cumulative impact on income tax of $3,864,000 was reversed in 2004. This occurred because the valuation allowance for the deferred tax assets decreased with the Section 162(m) reductions to the net operating loss.

 

As a result of our determination that the exercise prices of certain option grants were below the closing price of our common stock on the actual grant date, we evaluated whether the affected employees would have any adverse tax consequences under Section 409A of the IRC. It was determined that certain of these options were unvested as of December 31, 2004, and may be subject to Section 409A unless further action is taken. None of these options belong to persons who, as of the date of grant, were subject to the disclosure requirements of Section 16(a) of the Securities

 

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Exchange Act of 1934. Therefore, transition relief is available with respect to these options through December 31, 2007. Additional guidance may be available before that time that will allow us to determine whether Section 409A will apply to the circumstances under which these options were granted. Depending upon the determination about the correct treatment of these options for Section 409A purposes, the recipients of these options may make an election to exercise the options in a way that excludes them from Section 409A treatment. This election is available through December 31, 2007.

 

Summary and Other Items

 

In addition, we have restated the aforementioned financial statements to correct certain accounting errors which were previously identified but not considered to be material through December 31, 2005. These corrections related to accounting for employee tax withholding on certain compensation transactions, elimination of an intercompany difference, accounting for product exchanges (resulting in a revenue adjustment), and certain income tax adjustments. The cumulative effect of these errors on retained earnings as of December 31, 2005 was $4,714,000. The restatement impact through March 31, 2006 of these other corrections and of the non-cash charges for stock-based compensation that have resulted from the review of the Special Committee are summarized in the table below (amounts in thousands):

 

 

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The cumulative effect of the errors in 2002 and prior years of $39,774,000 was recorded as a reduction of retained earnings at December 31, 2002.

 

The pre-tax effect of the correction for stock-based compensation was $157,000, $206,000, $792,000, $2,503,000, $2,690,000, $3,491,000, $4,492,000 and $12,945,000 for 1995, 1996, 1997, 1998, 1999, 2000, 2001 and 2002, respectively. The cumulative pre-tax effect of the correction for stock-based compensation between 1982 and 1994 was $1,375,000.

 

The following table summarizes the specific income statement accounts as reported and as affected by the restatement for the three month periods ended March 31, 2006 and 2005.

 

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The following table summarizes the specific balance sheet accounts as reported and as affected by the restatement as of March 31, 2006 and December 31, 2005.

 

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The following table sets forth the impact of the restatement on our consolidated statements of cash flows from operating activities three months ended March 31, 2006 and 2005 (in thousands).

 

 

 

On April 3, 2006 Valeant announced a restructuring program to reduce costs and accelerate earnings growth.

 

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The program is primarily focused on our research and development and manufacturing operations. The objective of the restructuring program as it relates to research and development activities is to focus our efforts and expenditures on three late stage projects (Viramidine and Infergen, both of which are potential treatments of patients with hepatitis C, and retigabine, a potential treatment for partial onset seizures of patients with epilepsy) currently in development. The restructuring program is designed to rationalize our investments in research and development efforts in line with our financial resources. We intend to sell rights to, out-license or secure partners to share the costs of other major clinical projects and discovery programs that the research and development division has underway. The objective of the restructuring program as it relates to manufacturing is to further rationalize our manufacturing operations to reflect the regional nature of our existing products and further reduce our excess capacity after considering the likely delay in the launch of Viramidine.

 

The restructuring program is also expected to reduce selling, general and administrative expenses primarily through consolidation of the management functions in fewer administrative groups to achieve greater economies of scale. Management and administrative responsibilities for our regional operations in Australia, Africa and Asia (AAA), which have been managed as a separate business unit, will be combined with those of other regions.

 

We anticipate that the total restructuring program will result in charges that will range between $90,000,000 and $115,000,000. Although no impairments currently exist for any of our long-lived asset groups under the assets held and used model of FAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” these anticipated charges include potential future losses that may occur upon the disposition of specific assets related to our manufacturing operations in Switzerland and Puerto Rico, as well as assets of other operations that may be sold or abandoned. The anticipated charges also include employee severance costs resulting from a reduction of approximately 750 employees, the majority of whom work in the manufacturing facilities anticipated to be disposed.

 

We recorded a provision of $26,466,000 in the three months ended March 31, 2006 in connection with our decision to implement the restructuring program. This charge, which was reported in the Corporate operating segment, consists of the write off of the costs of assets to be abandoned in the restructuring process of $19,822,000 and an accrual for a portion of the severance costs of employees who will be terminated in the program of $6,644,000. The severance charges recorded in the three months ended March 31, 2006 relate to 103 employees in administrative and research positions whose positions were eliminated in the restructuring. The amount of the accrual for severance in the three months ended March 31, 2006 was determined in accordance with Financial Accounting Standard No. 112 “Employers’ Accounting for Postemployment Benefits.”

 

In compliance with Financial Accounting Standard No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” certain costs relating to the termination of employees in the restructuring program were not recorded in the three months ended March 31, 2006 but will be recorded when communicated to the affected employees (in the second quarter of 2006). Other costs associated with the restructuring and the associated termination of employees in connection therewith will be expensed as incurred. Additionally, losses from assets expected to be sold will be recorded upon disposal, or earlier if an impairment of the carrying value of the assets is identified under FAS 144.

 

Restructuring charges in the three month period ended March 31, 2005 relate to the decision to dispose of the Company’s manufacturing facility in China offset in part by the gain on the sale of a manufacturing plant in Argentina.

 

 

Infergen:  On December 30, 2005, we acquired the United States and Canadian rights to the Infergen business of InterMune, Inc. Infergen is indicated for the treatment of hepatitis C in patients who have not responded to other treatments or have relapsed after such treatment. In connection with this transaction we acquired the rights to the Infergen product as currently approved by the FDA and rights to a clinical trial underway to expand the clinical

 

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

applications of Infergen. We also employed InterMune’s marketing and research staffs who were dedicated to the Infergen product and projects and acquired third party contracts for the manufacture of Infergen. We paid InterMune consideration of $120,000,000 in cash at the closing. Additionally, we have agreed to pay up to an additional $22,400,000 of which $20,000,000 is contingent on certain milestones being reached.

 

Xcel Pharmaceuticals, Inc.:  On March 1, 2005, we acquired Xcel Pharmaceuticals, Inc. (“Xcel”), a specialty pharmaceutical company focused on the treatment of disorders of the central nervous system for $280,000,000 in cash. Under the terms of the purchase agreement, we paid an additional $7,470,000 for a working capital adjustment. Xcel’s portfolio consisted of four products that are sold within the United States, and retigabine, a late-stage clinical product candidate that is an adjunctive treatment for partial-onset seizures in patients with epilepsy. Approximately $44,000,000 of the cash consideration was used to retire Xcel’s outstanding long-term debt.

 

In connection with the Xcel acquisition, we completed an offering of 8,280,000 shares of our common stock in February 2005. After underwriting discounts and commissions, we received net proceeds of $189,393,000, which was used to partially fund the Xcel acquisition. The remainder of the funds required for the Infergen and Xcel acquisitions was provided by available cash on hand.

 

A portion of the purchase price for the Xcel acquisition was placed in an escrow account to cover potential claims under the purchase agreement that would arise within one year of the acquisition date. Prior to such date, we filed a claim for indemnification from the former Xcel stockholders with respect to certain breaches of representation and warranties made by Xcel under the Xcel purchase agreement relating to Medicaid rebates on preacquisition sales and certain third-party claims. As of March 31, 2006, approximately $5 million of the Xcel purchase price was in an escrow fund to pay indemnification claims.

 

The following unaudited pro forma financial information presents the combined results of operations of Valeant, Infergen and Xcel for the three month period ended March, 31 2005 as if the acquisitions had occurred as of January 1, 2005. The unaudited pro forma financial information is not intended to represent or be indicative of the Company’s consolidated results of operations or financial condition that would have been reported had the acquisitions been completed as of the date presented, and should not be taken as representative of our future consolidated results of operations or financial condition.

 

 

The above pro forma financial information includes charges for acquired in-process research and development of $126,399,000 with respect to Xcel and $47,200,000 with respect to Infergen and adjustments for amortization of identifiable intangible assets acquired and interest expense as a result of the retirement of Xcel’s long-term debt. The effect of the IPR&D charges of Xcel and Infergen on the pro forma loss per share is $1.89.

 

 

In the second half of 2002, we made a strategic decision to divest our Russian Pharmaceuticals segment, biomedicals segment, Photonics business, raw materials businesses and manufacturing facilities in Central Europe and Circe unit. During 2003, we disposed of the Russian Pharmaceuticals segment, biomedicals segment, Photonics

 

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business and Circe unit. During 2004, we disposed of one of the raw materials businesses and manufacturing facilities in Central Europe. During 2005 we completed the sale of the remaining raw materials business and manufacturing facility in Central Europe. In 2006 losses from discontinued operations consist of disposal of remaining real estate facilities and the wind down of administrative activities associated with these operations.

 

Summarized selected financial information for discontinued operations for the three months ended March 31, 2006 and 2005 is as follows (in thousands):

 

 

The assets and liabilities of discontinued operations are stated separately as of March 31, 2006 and December 31, 2005 on the accompanying consolidated condensed balance sheets. The major assets and liabilities categories are as follows (in thousands):

 

 

Environmental contamination has been identified in the soil under a facility built by the Company which housed operations of the discontinued biomedicals segment and is currently vacant. Remediation of the site will involve excavation and disposal of the waste at appropriately licensed sites some distance from the facility. Environmental reserves have been provided for remediation and related costs that we can reasonably estimate. Remediation costs are applied against these environmental reserves as they are incurred. As assessments and remediation progress, these liabilities will be reviewed and adjusted to reflect additional information that becomes available. Total environmental reserves for this site were $18,923,000 and $19,023,000 as of March 31, 2006 and December 31, 2005, respectively, and are included in the liabilities of discontinued operations. Although we believe that the reserves are adequate, there can be no assurance that the amount of expenditures and other expenses, which will be required relating to remediation actions and compliance with applicable environmental laws will not exceed the amounts reflected in reserves or will not have a material adverse effect on our consolidated financial condition, results of operations or cash flows. Any possible loss that may be incurred in excess of amounts provided for as of March 31, 2006 cannot be reasonably estimated.

 

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The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data):

 

 

For the three months ended March 31, 2006 and 2005, options to purchase 1,746,000 and 2,868,000 weighted average shares of common stock, respectively, were not included in the computation of earnings per share because we incurred a loss and the effect would have been anti-dilutive.

 

For the three months ended March 31, 2006 and 2005, options to purchase 9,324,000 and 1,901,000 weighted average shares of common stock, respectively, were also not included in the computation of earnings per share because the option exercise prices were greater than the average market price of the Company’s common stock and, therefore, the effect would have been anti-dilutive.

 

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The following tables present the details of certain amounts included in the consolidated balance sheet at March 31, 2006 and December 31, 2005 (in thousands):

 

 

Intangible assets: As of March 31, 2006 and December 31, 2005, intangible assets were as follows (in thousands):

 

 

Amortization expense for the three months ended March 31, 2006 and 2005 was $17,523,000 and $13,968,000, respectively, of which $14,364,000 and $10,709,000, respectively, related to amortization of acquired product rights.

 

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We experience losses in the United States tax jurisdiction, where our research and development activities are conducted and our corporate offices are located. We anticipate that we will realize the tax benefits associated with these losses from reductions of future taxable income resulting from products in our development pipeline, further growth in US product sales and other measures. However, at this time, there is insufficient objective evidence of the timing and amounts of such future U.S. taxable income to assure realization of the tax benefits, and valuation allowances have been established to reserve those benefits. The valuation allowance for the three months ended March 31, 2006 was approximately $6,500,000 resulting in a provision for income taxes of $7,542,000 which primarily represents the taxes payable on earnings in tax jurisdictions outside the United States and for state and local taxes payable within the U.S.

 

Our effective tax rate for the three months ended March 31, 2005 was affected by pre-tax losses resulting from a restructuring charge of $1,695,000 and the write-off of acquired IPR&D expenses in connection with the Xcel acquisition of $126,399,000. These charges are not deductible for income tax purposes. The tax provision in the three months ended March 31, 2005 relates to the expected taxes on earnings in tax jurisdictions outside the United States.

 

 

Stock Incentive Plan:  In April 2003, we implemented the Company’s 2003 Equity Incentive Plan (the “Incentive Plan”), which is an amendment and restatement of our 1998 Option Plan. The Incentive Plan increased the number of shares of common stock available for issuance from 11,604,000 to 18,104,000 in the aggregate. The Incentive Plan provides for the grant of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock awards, phantom stock and stock bonuses (collectively, “awards”) to our key employees, officers, directors, consultants and advisors. Options granted under the Incentive Plan must have an exercise price that is not less than 85% of the fair market value of the common stock on the date of grant and a term not exceeding 10 years. Under the Incentive Plan, 500,000 shares may be issued as phantom stock awards or restricted stock awards for which a participant pays less than the fair market value of the common stock on the date of grant. Generally, options vest ratably over a four year period from the date of grant.

 

Stock Options Issued Under the Incentive Plan:  The following table sets forth information relating to stock options issued under the Incentive Plan (in thousands, except per share data):

 

 

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

The schedule below reflects the number of outstanding and exercisable options as of March 31, 2006 segregated by price range (in thousands, except per share data):