It's another week, another scandal for Valeant (VRX). On Wednesday U.S. District Judge David Carter in Santa Ana, California, said Valeant and Pershing Square's (PSHZF) Bill Ackman must face a lawsuit accusing them of insider trading in botox maker Allergan (AGN) prior to Valeant's unsuccessful takeover bid:

The lawsuit was filed on behalf of investors who sold Allergan shares in the two months before the defendants on April 22, 2014 announced an unsolicited $51 billion bid for Allergan.

Pershing had by then quietly amassed a 9.7 percent stake in Allergan, which soared in value after the bid was announced. Investors said Pershing bought those shares knowing that Valeant was preparing a bid that could, and later did, become hostile ... the judge, without ruling on the merits, found "serious questions" as to whether "substantial steps" had been taken toward a possible hostile bid, which would have required Valeant to disclose more or Ackman to stop his buying.

Valeant and Ackman have claimed no breach of duties by sharing information before the takeover bid became public knowledge. Now it seems Judge Carter will have the final say.

The Situation

Ackman's Pershing Square acquired a 10% stake ($5.3 billion) in Allergan in 2014. In October 2014 Judge Jackson had to decide whether Ackman could vote his 10% stake to seal a hostile bid by Valeant. Allergan countered that Ackman began acquiring his stake as early as February 2014 when he knew a takeover bid was imminent, and would create a windfall for his shares; in effect Ackman relied on inside information in acquiring Allergan shares. It also sought a court order blocking Ackman from voting his shares pursuant to a decision that could have removed six Allergan directors who opposed Valeant's takeover bid.

Judge Carter later agreed to allow Ackman to vote his shares; however, on November 17th Allergan agreed to a $219 per share bid from Actavis which trumped Valeant's $180 per share bid. Nonetheless, Ackman's Pershing Square stake stood to net $6 billion, of which Ackman said he would share 15% with Valeant.

Potential Impact On Valeant, Ackman

A potential ruling against Valeant and Ackman could hinge on whether they can prove Valeant's tender offer for Allergan had not been planned out before Ackman bought up Allergan's shares. A negative ruling could force Ackman to disgorge his profits made on the Allergan trade; this could also result in Ackman selling certain of his current Pershing Square holdings to come up with the cash. To the extent Valeant also shared in the booty, it would potentially have to disgorge its earnings and take a one-time charge on it profit and loss statement.

Valeant is currently the subject of an investigation on price gouging by the Senate Special Committee on Aging. The insider trading lawsuit and the murky details behind it could give the Special Committee the impression that Valeant is an entity designed for financial engineering, and not a traditional pharmaceutical company. If so, it may hinder Valeant's cause in protecting price increases pursuant to heart drugs Nitropress and Isuprel.

Secondly, Valeant recently decided to tamp down its acquisitions in order to pare its $30 billion debt load which is currently at junk levels. Valeant's management team has been great at growing revenue through via deals. However, in my opinion, the Philidor fiasco was evidence that the company has not exhibited best-in-class internal controls. If the company is to cut costs, pare debt and maintain excellent working relationships with doctors and pharmacy benefit managers, management will need all hands on deck. It will need to strengthen internal controls and have the full commitment and focus of management.

If a protracted insider trading case ties up management resources, Valeant could drop the ball on its debt repayment plan. Another misstep by Valeant could send VRX plummeting further. At least that's what I'm betting on. I'm short VRX.