In fact, not being a member of Bay Street’s nomenklatura is why Khmelnitsky was able to spot, long before anyone else, the early signs of what has since exploded into Canada’s biggest corporate scandal – namely Valeant Pharmaceuticals International, Inc. “This is really my issue with Valeant,” Khmelnitsky explains. “[It's the] combination of deep regulatory risks they are running and… the way they run the business being somewhere in the dark, dark grey.”

The view from Dimitry Khmelnitsky’s spartan 31st floor office overlooks the brooding towers of Bay Street’s financial district — the very heart of corporate Canada. Despite his enviable perch, the energetic 38-year-old investment analyst is an outsider. Born in Moscow, Khmelnitsky came to Canada 16 years ago after living in Israel. For nearly a decade, he’s worked for Veritas Investment Research Corp., an independent Toronto-based equity research firm renowned for ignoring the herd when it comes to analyzing companies.

North of the border, the Canada Revenue Agency is scrutinizing the company’s books. Meanwhile, investors in Canada and the U.S. are suing Valeant for insider trading and misrepresentation. “On the moral scale, I think everybody would agree that it's an immoral company,” insists Andrew Left, a Beverly Hills, California-based short seller who helped expose Valeant’s problems, suggesting a few weeks ago it might be “the Pharmaceutical Enron.”

Now, Valeant is the target of as many as six U.S. government probes over price-gouging, unusual accounting, and alleged bilking of the U.S. Medicaid system. Agencies such as the Internal Revenue Service (IRS), Department of Justice, Securities and Exchange Commission (SEC) and Federal Trade Commission have targeted the company. It’s also being pursued by the U.S. Congress and by two state-level U.S. Attorney’s Office bureaus in New York and Massachusetts.

And then it all fell apart, as Khmelnitsky predicted it might. Today, Valeant’s stock is trading at $130 – a drop of over 60 per cent since the summer – wiping out billions of dollars of Canadian investors’ holdings.

While Khmelnitsky was trying to raise the alarm, Bay Street and Wall Street traders and analysts whipped themselves into a feeding frenzy over Valeant, encouraging investors to pour billions into the stock. By this summer, Valeant’s shares hit a staggering C$348 on the TSX, with its market value (the total value of all of its shares) making it the biggest company in all of Canada, worth C$111.6-billion at one point – larger than the Royal Bank of Canada. Canadian Business magazine even named Valeant’s boss, Michael Pearson, Canada’s CEO of the year.

With 19,500 employees worldwide, Valeant is Canada’s largest pharmaceutical company, known for selling neurological, gastro-intestinal and dermatological drugs. For years, Khmelnitsky raised one red flag after another about the company’s problems, although his warnings were ignored and even mocked. “We lost clients,” he recalls. “We were kicked out of a boardroom once because people strongly disagreed with our opinions.”

Valeant’s board liked Pearson’s plan so much they made him CEO. Pearson put his plan into action, selling off foreign subsidiaries, focusing on the U.S. market and slashing R&D, which now accounts for only 3 per cent of its expenses – the lowest among major drug companies.

But Valeant was a money-loser. In 2007, Valeant asked the consulting giant McKinsey & Co. for help and they dispatched one of their most experienced consultants, Mike Pearson, a native of London, Ontario. Pearson dreamt up a strategy to turn Valeant around: instead of developing new drugs, they should cut R&D and simply acquire companies with established products, which would then be milked for all they were worth. Pearson felt most R&D was too risky, producing few profitable results.

Valeant’s origins go back to a company called ICN founded in California. In the early 2000s, it changed its name to Valeant, selling generic and neurology drugs.

So just how did this American pharmaceutical giant posing as a Canadian company come to attract so much attention for all of the wrong reasons?

The only reason Valeant is headquartered in Canada, most tax experts agree, is to avoid paying U.S. corporate income taxes – the result of a trick called “inversion,” whereby American companies move their head offices to other countries to chop their tax bill. Last month, Pfizer announced it was merging with an Ireland-based drug company for the same reason. “They claim, obviously, they have board meetings in Canada — all that’s nonsense,” says Khmelnitsky. “I don't think anyone, even the most ardent bulls who loves the company, would conceive that this is a Canadian company."

Ironically, Valeant is not really a Canadian company at all. True, its head office is located in Laval, Québec. But in reality, it’s an American corporation run out of Bridgewater, New Jersey.

Others say much worse. “A nice way of putting it is that [Valeant’s] a house of cards,” says one Bay Street accountant, speaking on condition of anonymity. “A not nice way to put it is that it’s a Ponzi scheme.”

Yet the company also flourished because it cut its taxes so dramatically. Which is where Canada comes in.

Still, one impact of this growth was to drive up Valeant’s stock price, which attracted heavyweight Wall Street investors. And Pearson and his executives got rich, with he and his top four managers pocketing US$123-million in combined compensation last year alone.

Then Pearson went on a buying binge, snatching up 80 drug companies over the past seven years. Annual revenues shot from US$757-million in 2008 to US$8.3-billion last year. The acquisitions were accomplished by borrowing heavily: the company now sits on US$29.5-billion worth of debt.

Five years ago, Valeant merged with Biovail Corp., a Canadian drug company. Biovail had taken advantage of Canada’s tax treaty with the offshore haven of Barbados, and was paying only 7 per cent income tax as a result, instead of the 22 per cent it could have been paying.

By merging with Biovail, Valeant became a Canadian company, and therefore could no longer be taxed in the U.S., but could exploit the Barbadian offshore tax structure. The result was Valeant’s tax bill fell from 36 per cent down to as low as 3 per cent — and it admitted last year to having saved US$2.5-billion in taxes since 2010 as a result. "Most of these tax treaties should be torn up," says Dennis Howlett, executive director of the Ottawa-based NGO, Canadians for Tax Fairness. "They do far more damage, and their benefits are non-existent."

Meanwhile, the company’s executives stayed in New Jersey. In total, only 186 employees work at Valeant’s Laval offices as compared to more than 400 at its New Jersey complex, from where Mike Pearson runs the company. "You’re supposed to maintain substantial business activity in the other country. And it’s highly questionable whether the level of activity engaged in by Valeant after the acquisition would constitute substantial business activity,” says Stanley Abraham, the director of U.S. taxation for Toronto-based accounting firm Zeifmans LLP.

Valeant, meanwhile, claims the merger with Biovail was not done for solely tax reasons but so they could grow more successfully.

Flawed business model?

Khemlnitsky began following Valeant in 2011 and soon soured on Pearson’s acquisition-driven business model. “It's flawed in that long-term, it becomes harder and harder to acquire companies,” he explains. “As you keep buying, the price of assets keeps rising, and you start paying more and more. So there is inflation, because other players enter the field. They mimic the structure.”

Another problem, says Khmelnitsky, is the enormous debt that accumulates. The larger the debt, the harder it becomes to obtain future financing. “Then it becomes a problem to go on the market to borrow more. And that's another reason why this strategy is unsustainable.”

Yet Valeant is forced to buy other companies because Pearson does not believe in developing new drugs.

Moreover, when Valeant has launched new products, it hasn’t always worked out well. In 2011, in conjunction with GlaxoSmithKline, Valeant released an anti-seizure drug called Potiga. Pearson was soon claiming the drug would generate tremendous sales. But it didn’t, and then serious side effects with Potiga emerged, including patients’ skin turning blue and abnormal colouring of their retinas. Says Khemlnitsky: “Valeant was forced to write down $645-million from the balance sheet as a result.”

Photos of blue skin colour caused by Valeant's anti-seizure drug Potiga

Khmelnitsky also noticed the company had a habit of being inconsistent with their statements. “If you take some of their major assertions… and you try to verify those statements with the information in their audited financial statements and quarterly reports and other facts – they don't coincide,” he says. For example, in 2014, the company said its injectables business was growing by double digits. But when Khmelnitsky later checked company documents, sales for injectables had actually dropped by double digits.

Allegations of insider trading

Despite Khmelnitsky publicly raising these kinds of concerns, Valeant’s shortcomings were ignored by investors—largely because all of the major Bay Street analysts were encouraging them to buy the stock. Still, a darker picture of the company emerged last year when Pearson formed an alliance with Bill Ackman, the most controversial hedge manager on Wall Street.

Ackman runs Pershing Square Capital Management LP, a New York-based US$18.5-billion hedge fund notorious for its aggressive, strong-arming tactics. In early 2014, Pearson discussed with Ackman about taking a run at Allergan Inc., a large drug company famous for making Botox. Ackman began buying Allergan’s stock.

The deal they reached was that Valeant would bid for Allergan. If the takeover failed, Ackman would cash in his Allergan stock (he bought nearly 10 per cent of the company), which would have shot up due to the attempted buyout. Then, he would give 15 per cent of any profits he made to Valeant. Indeed, once Valeant’s initial bid of US$46-billion was made, Allergan’s stock jumped by 22 per cent.

Bill Ackman photo by Richard Dew/Associated Press

But that’s when Valeant’s veneer began to crack. Allergan made it clear they had no desire to marry Valeant, heaping scorn on the company's business model, including its cuts to R&D. Allergan representatives compared Valeant to Tyco, the scandal-plagued company which built itself up through acquisitions and then collapsed in the late ‘90s.

The war of words got nasty, with lawsuits launched by both sides. Valeant eventually increased its offers, all of which were rejected. Instead, earlier this year, Allergan accepted a buyout bid from a European drug company.

Yet Ackman and Valeant still profited, as they’d arranged. Ackman cashed in his Allergan shares and walked away with US$2.3-billion – of which US$346-million he shared with Valeant. “[This] sets a bad precedent for the financial market,” argues Khmelnitsky. “It completely destroys the level playing field. The reason it destroys the level playing field is someone has advanced knowledge from which they can profit from, at a cost to others.”

Indeed, a lawsuit was launched by two American retirement funds against Ackman and Valeant, accusing them of insider trading. When Valeant and Ackman asked that the suit be dismissed, a California judge refused last month.

Valeant’s woes began to mount. Last year, Canadian billionaire Eugene Melnyk, the founder of Biovail and current owner of the Ottawa Senators hockey team – who had left Biovail under a cloud in 2007 – went public with his disgust about Valeant, saying it was masquerading as a Canadian company to exploit Canada’s tax treaties. In 2012, Melnyk had presented his concerns to U.S. tax authorities, calling himself an “official whistleblower.” Both the CRA and IRS launched investigations into Valeant, which are on-going.

Eugene Melnyk photo by Canadian Press

Melnyk charged that Valeant’s merger with Biovail was a deceitful transaction, designed to use the company simply for its tax benefits. “It's a house of cards,” he told the Financial Post in August 2014. “It's going to come crashing down on them, I'm telling you. And when it comes crashing down, it's going to happen so fast and so hard that people are going to lose fortunes.”

Accusations of price-gouging and fake sales

The wheels began to fall off in other ways. Given that the company spends so little on R&D and has considerable debt, it needs to profit from its product line as much as possible.

On February 10 of this year, Valeant bought the drug company Marathon Pharmaceuticals LLC, based in Illinois. On the very same day, Valeant increased the prices of Marathon’s two life-saving heart drugs, Nitropress and Isuprel, by 212 per cent and 525 per cent respectively. One vial of Isuprel went from US$215 to $1,346, while a vial of Nitropress went from US$257 to $805.

Recently it was discovered that two of Valeant’s dermatology drugs that treat skin cancer increased in price by 1,700 per cent over the past six years. The cost of a tube of Targretin gel rose to about US$30,320 by this year - 18 times as much as the $1,687 it was in 2009. Most of that increase appears to have occurred after Valeant acquired the drug early in 2013.

In a chart produced by the California-based short-selling firm Citron Research, it shows that prices for more than 30 of Valeant’s drugs and creams have risen massively since 2013 – as much as 2,288 per cent in one case. These price increases were made even though Valeant made no improvements to the drugs. (Valeant claims the price increases are justified, because they did a study that concluded prices before were “substantially below their true value to hospitals and patients.”)

“You have to remember what the job of these companies is,” remarks Marcia Angell, a Harvard University medical school professor, former editor of the New England Journal of Medicine, and author of the 2004 book The Truth about the Drug Companies. “It isn't to discover and develop good drugs – it's to make money… Drug companies are really marketing companies.”

Valeant’s price increases caught the attention of American politicians. Senator Bernie Sanders and other Congressional leaders began condemning the company. They grew more incensed when they learned Valeant was blowing them off after they'd sent letters asking the company to justify its price increases. In total, a group of 18 Democrats in Congress demanded that Valeant be subpoenaed over the price hikes of Nitropress and Isuprel.

And last month, the U.S. Senate opened an investigation into Valeant.

Pearson has responded to these criticisms by saying that the price increases have not been as dramatic as critics claim, and they did communicate with the U.S. Congress in a more detailed fashion.

The price-gouging charges began to affect Valeant's stock price. But what brought it crashing to earth was the equivalent of a pebble thrown into a still pond. This October, Andrew Left, the short-seller and owner of Citron Research, began issuing reports on Valeant, initially over its high drug prices. But in late October, when Left wrote about Valeant’s ties to Philidor Rx Services LLC, a Pennsylvania-based specialty on-line pharmacy company, all hell broke loose.

Specialty pharmacies are designed to deliver medications to patients with unique requirements, such as those suffering with complex conditions like cancer or multiple sclerosis.

Left pointed out that Philidor’s ownership seemed to be tied to Valeant. In fact, Left claimed that Valeant owned a network of these so-called “phantom” captive pharmacies.

Graph from CNN Money

Why was that a problem? “Citron believes the whole thing is a fraud to create invoices to deceive the auditors and book revenue,” wrote Left in a report. “Citron believes it is merely for the purpose of phantom sales or stuff the channel.”

"Channel stuffing" refers to recording sales of goods that have been shipped but not actually sold to customers. In short, Left was suggesting that by using specialty pharmacies like Philidor, Valeant might be artificially (and even fraudulently) inflating or manufacturing sales.

Left’s reports – in particular one where he suggested Valeant might be a “Pharmaceutical Enron” – helped drive Valeant’s stock down by almost half its value. But more importantly, it triggered a series of embarrassing revelations about Valeant’s ties to Philidor. Media outlets such as the New York Times, Wall Street Journal and Bloomberg began investigating. (Joe Nocera, a columnist with the Times, called Valeant a “sleazy company”.)

They soon discovered that, in fact, Valeant did have close ties to Philidor and other specialty pharmacies. They learned that Philidor was denied a license to sell drugs in California in 2014. To get around the ban, Philidor is accused of using one of its sister companies as a backdoor way of selling in that state.

Moreover, Philidor was accused of improperly using this sister pharmacy chain’s ID numbers to fill prescriptions and get reimbursements from insurance companies where Philidor did not have a license to operate; that Philidor instructed employees to submit claims under multiple pharmacy ID numbers after claims were rejected by insurers; and that Philidor employees altered doctors’ prescriptions to maximize reimbursements from insurers.

Valeant, meanwhile, said in a recent presentation to analysts it has seen “no evidence of illegal activity at Philidor.” The company said while they sell product through Philidor, it's an independent company.

The revelations were so damaging Valeant was forced to cut ties to Philidor in October and set up an ad hoc committee to investigate their links to the pharmacy. By then, U.S. attorney offices in New York and Massachusetts had issued subpoenas to Valeant over a host of issues, including over-charging government health programs.

Confidence in Mike Pearson was also waning. Last month, Goldman Sachs recalled a US$100-million personal loan it had given him. Even Bill Ackman, who has lost an estimated US$1.4-billion since Valeant’s stock tanked, began publicly questioning Pearson’s judgment. Pearson declined an interview request from the Observer but Valeant's media staff did provide statements and information in response to our questions.

Meanwhile, Canadian investors have lost billions. “The real story with Valeant, and it's a shame, is that many Canadian pension funds had to own this stock because there was an index of Canadian stocks to own,” says Left. “But it’s not a Canadian stock. So here’s a company that's manipulating the system in the United States and as it's going down, you have these Canadian shareholders who don't own it because it's Valeant – they own it because they have to buy indexes.”

For Dimitry Khemlnitsky, the problems with Valeant are not easily repaired. “The business model is no longer sustainable,” he says. “[They] can no longer do significant acquisitions in the near term and their business model revolved around making acquisitions, firing people and cutting R&D… They don't have access to cheap capital because their cost of borrowing has increased dramatically. It's much harder for them to raise drug prices given the increased scrutiny… So that leaves them essentially going back to the model which they'd derided in the past, where they have to grow internally.”