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NEW YORK, Oct 26 (Reuters) - The pharmacy at the center of suspicions over Valeant Pharmaceuticals International Inc's business practices began as a small pilot project two years ago and quickly grew to account for 7 percent of the drugmaker's revenue.
Valeant disclosed on Monday details of its relationship with Pennsylvania-based Philidor Rx Services, defending the pharmacy against allegations of illegal activity while pledging to review the business carefully.
Few Valeant investors had heard of Philidor until last week, when influential short-seller Citron Research said it was being used to create "phantom accounts" and inflate the drugmaker's revenue. Valeant immediately denied the allegations, but shares in the company tumbled as investors questioned its pharmacy ties.
"When you ... construct an unusually complex and not transparent way of doing things, the first question is: 'Why didn't you do it the standard easy way?'," said Erik Gordon, a professor at the University of Michigan's law and business schools.
Valeant explained on Monday that the pharmacy began as a pilot under Medicis Pharmaceutical Corp, a maker of anti-wrinkle medicines and facial fillers that Valeant acquired in 2012. By January 2013, Valeant began studying how to build up the program, known at the time as the Medicis Alternate Fulfillment Program.
The pharmacy passed on discounts paid for by Valeant to patients with commercial insurance, often reducing their out-of-pocket costs to zero and helping them to pay for medicines that they could not otherwise afford. When the patient was covered, Valeant would bill insurance companies for reimbursement.
This process effectively denied patients access to cheaper or alternative drugs and circumvented the way health insurers typically pay pharmacies for drugs.
The program grew from distributing two drugs to at least 10 Valeant medications, including steroid cream Locoid and acne treatment Solodyn, Valeant said on Monday. Its biggest success may be distribution of the toenail fungus treatment Jublia, as Philidor now handles 44 percent of the drug's sales.
Philidor now is licensed in 46 states and the District of Columbia, and also distributes drugs through affiliates in California, Florida, New Jersey, South Carolina and Texas.
The company said it was ready to cooperate with Valeant's committee reviewing its business.
"Philidor's relationship with Valeant has benefited countless patients by ensuring they receive their medication quickly and efficiently," Philidor said in a statement.
Philidor's rapid rise led Valeant to spend $100 million in late 2014 on a 10-year option to buy the company for $0. The deal terms include other target-based payments of up to $133 million, $33 million of which have already been paid, it said.
Valeant said that Philidor was considering looking to other drugmakers to expand its business model, and the purchase option was meant to stabilize its ties to the distributor.
As part of their agreement, Valeant members sit on a joint steering committee with Philidor management, and the drugmaker has the right to influence hiring of key personnel, though it cannot replace the chief executive or management.
"We do not own or control Philidor," Valeant board member and former Chief Financial Officer Howard Schiller said during the conference call.
The size of the purchase option was below the company's standard for disclosure, Valeant said. Together with the fact that Valeant accounted for Philidor revenue as intercompany sales, the pharmacy dealings were undetectable in its quarterly financial reports.
In order to comply with accounting standards, Valeant said that it consolidates Philidor revenue as its own, and also that of other specialty pharmacies in the network. That includes R&O Pharmacy, a California specialty pharmacy that is part of Philidor's network. In recent months, Valeant sent a collection letter to R&O for not paying it for medicines distributed through its network. R&O has since filed suit against Valeant.
Philidor also has an option to acquire Isolani, another specialty pharmacy. That pharmacy in turn owns a 10 percent stake in and the option to acquire the rest of R&O. Isolani provides management and administrative services to R&O while Philidor provides back end services, Valeant said.
The intertwined companies had employees who worked for both Valeant and Philidor, the Wall Street Journal reported on Monday. Valeant did not address that point, but said that the board committee would look into that issue.
Charles Elson, a corporate governance expert at the University of Delaware, said that the committee will likely take weeks or months to report on its findings.
"They believe there's a problem. That's really all we can say for sure," Elson said. (Reporting by Caroline Humer; Editing by Michele Gershberg and Bill Rigby)