Health Net Takeover Bid Is Latest to Raise Outcry : Health care: Critics say the proposal undervalues the organization and shortchanges charity. It's an argument that's been heard in previous HMO conversions.

By JAMES F. PELTZ

July 23, 1991 12 AM PT

TIMES STAFF WRITER

If anyone is surprised by the controversy and bidding war surrounding the big health-care provider Health Net, they shouldn’t be.

Health Net, the state’s second-largest health maintenance organization with 840,000 members, wants to convert from nonprofit to for-profit status, a move that requires an HMO to donate a sum equal to its “fair market value” to a public charity or foundation.

Health Net officials say the Woodland Hills-based HMO is prepared to pay $127 million to charity over 15 years, although at least four outside bidders have offered up to $300 million for the HMO. Then, in the second step of its plan, Health Net’s management would technically purchase the newly converted HMO for another $1.5 million--a deal that could earn them millions of dollars in personal profits if Health Net was sold or went public down the road.

The whole proposal is under fire by Consumers Union, the nonprofit publisher of Consumer Reports, which claims that the $127-million figure vastly understates Health Net’s actual value and shortchanges the amount that would go to charity.

“The law has to be changed,” said Harry Snyder, West Coast director of Consumers Union. “This is stealing the public’s money.”

Some of the outside bidders for Health Net, such as Blue Cross of California, say Health Net’s management--which dominates the HMO’s board of directors--has a conflict of interest in making a takeover bid while evaluating the outside offers.

On Monday, state Insurance Commissioner John Garamendi jumped into the fray. In a letter to Thomas Sayles, commissioner of the California Department of Corporations--which must approve all HMO conversions--Garamendi cited the higher outside bids and urged Sayles “to ensure that the company’s customers and all California taxpayers receive maximum benefits and protection from this proposed transaction.”

But the controversy isn’t surprising given the recent history of California HMOs. Since the mid-1980s, at least three others have made the conversion and were acquired by their managements, who took advantage of the state law allowing such conversions, then reaped huge profits by reselling the HMOs or taking them public.

Inland Health Plan (now called Partners Health Plan of Southern California) in San Bernardino was converted in 1985. Its “fair market value” at the time was $562,000. A year later, it was sold to a joint venture led by Aetna Life & Casualty Co. for $37.5 million.

FHP International Corp., an HMO operator based in Fountain Valley, and HEALS, an HMO in Northern California, were also converted to for-profit status and were soon sold or publicly offered for prices that were exponentially higher than their stated fair market values at conversion.

For critics, the wide spreads raise questions about the law that permits the conversions as well as about the Department of Corporations itself.

Consumers Union’s Snyder chastised the Department of Corporations’ “mild-mannered approach” to reviewing HMO conversions, “which is looting the public trust.” The agency recently got a new commissioner, Sayles, who was appointed by Gov. Pete Wilson.

“We’re going to call upon Gov. Wilson personally to intervene with his Department of Corporations to stop this,” Snyder said. “Gov. Wilson does not want to be accountable for giving away public assets.”

Warren Barnes, supervising counsel for the agency, declined comment on specific cases, but said generally that “when the department approves any kind of transaction, we think the legal requirements are all met.”

He also said the agency does not have any guidelines in valuing HMOs, but rather uses “standard business evaluation techniques.” Even with those, “valuing companies is infinitely more complex than anybody’s gut reaction,” he said.

Health Net spokesman Jim Lucas, a member of the management buyout group, said the HMO is not shortchanging the public if it rejects the higher takeover bids. The extra sums being offered would be in the form of extra debt added to Health Net’s operations, which would reduce the HMO’s service, its payment to doctors and “the long-term financial stability of the company,” he said.

Conversions of nonprofit HMOs took hold in the mid-1980s as more health plans, hurt by cutbacks in federal reimbursement for medical care, looked to the financial markets for capital. But to tap those markets, they needed to be for-profit enterprises. Health Net cites the need for outside cash as the basis for its conversion plans.

The accounting firm Ernst & Young initially put Health Net’s fair market value at $108 million, but July 9 it revised the figure to $127 million to reflect the HMO’s more recent performance. That’s the amount Health Net proposes to donate to a newly formed public-health foundation.

Health Net’s plan also proposes that when the HMO converts, 32 members of its management--led by chief executive Roger F. Greaves--would technically buy the new, for-profit Health Net for $1.5 million. That investment would buy an HMO that last year earned $42.6 million on revenues of $886 million.

Of course, if Health Net was later sold or went public, Greaves and his investment group would almost assuredly pocket a handsome profit.

“We don’t discount the possibility” of going public, Health Net’s Lucas said. However, the HMO has promised the Department of Corporations that management won’t sell any of its stock for at least two years after the conversion.

In the case of HEALS, the HMO converted to for-profit status in 1987 with a $2.1-million donation to charity. In December, it was bought for $7.5 million by Qual-Med Inc., an HMO operator based in Colorado, which also assumed about $17 million of HEALS’ debt. (Qual-Med is one of the suitors bidding for Health Net.)

In the Inland Health Plan conversion in 1985, the HMO asked to convert after stating its value at $165,000, based on a valuation also provided by Ernst & Young (then known as Ernst & Whinney). This came at a time when Inland’s annual revenue was $18 million and its net worth $2.6 million, according to a lawsuit filed in federal court in Los Angeles by doctors who challenged the conversion.

But the Department of Corporations approved the deal after it decided that Inland’s charitable donation should be $562,000. In a second step, Inland’s management and other investors technically bought the HMO’s stock for $15,000, the lawsuit stated.

The following year, the management group sold the HMO to the Aetna group for $37.5 million. The whole transaction was perfectly legal, as Inland’s lawyers noted in disputing the doctors’ claims. (The case was settled two months ago for undisclosed terms.)

Ernst & Young, in response to questions for this article, issued a statement saying its valuations follow “methodologies recognized in the business community and deemed appropriate by the Department of Corporations.” It declined to elaborate.

Whether Consumers Union or any other critic will have any impact on the Health Net situation is debatable. Consumers Union and the state attorney general’s office also complained about the FHP conversion in 1985, but that deal went through as planned.

In that case, the Department of Corporations approved FHP’s plan to convert to for-profit status in exchange for making a $38.6-million donation to charity. Less than a year later, FHP went public, and its stock had a market value of $150 million. FHP’s executives still held 76% of the stock after the public offering, valued at $114 million.

A suit was filed to block the conversion and was supported by the attorney general’s office, which argued that the conversion value understated FHP’s actual value. But a Superior Court ruled that the Department of Corporations had the final say in HMO conversions and that FHP was not obligated to sell to the highest bidder.

James Schwartz, a deputy attorney general who was involved in the FHP case, said the attorney general’s office won’t get involved in the Health Net case because “the court ruled we don’t have jurisdiction. And that’s that.”

The Bidding War for Health Net

Here is a chronology of the acquisition bids for Health Net, the second-largest health maintenance organization in California. Under state law, Health Net’s board is not obliged to accept the highest price. * May 22: Health Net, based in Woodland Hills, confirms that in March, its management filed a proposal with the state Department of Corporations to acquire the HMO for $1.5 million at the same time Health Net converts from nonprofit to for-profit status. The conversion would cost $108 million, to be paid by Health Net over 15 years to a newly formed charitable foundation. * June 3: Shamrock Investments, a Los Angeles investor group, offers $200 million to acquire Health Net, including $40 million in cash and $160 million in a 14-year note. Also, Pacific Mutual Life Insurance Co., a large insurer based in Newport Beach, confirms it has offered at least $135 million and is negotiating to purchase Health Net. * June 10: Humana Inc., a major hospital operator based in Louisville, Ky., proposes to buy Health Net for $225 million. Health Net’s board, meanwhile, rejects the Shamrock and Pacific Mutual bids. * June 11: Blue Cross of California, also based in Woodland Hills and the state’s largest health insurer, proposes a straight merger with its CaliforniaCare HMO unit and Health Net. No cash would be exchanged, leaving the combined entity a nonprofit concern. * July 9: Health Net boosts its conversion value to $127 million, and awaits a ruling from the Department of Corporations. * July 12: Qual-Med Inc., an HMO operator based in Colorado, offers $300 million to buy Health Net even though its annual revenues are one-sixth those of Health Net’s.

Health Plan Conversions

Some California health maintenance organizations have taken advantage of state law to convert their firms from nonprofit to for-profit status by paying “fair market value” to a public charity. The HMOs were then either sold or went public for far more money.

Year Sum paid to HMO was charity at time Subsequent HMO converted of conversion selling price FHP 1985 $38.6 million $150 million* Inland Health 1985 $562,000 $37.5 million** HEALS 1987 $2.1 million $7.5 million*** Health Net Pending $127 million*+* --

* Market value after firm’s initial public stock offering July 2, 1986.

** Price paid by a joint venture that bought Inland Health in December, 1986.

*** Price paid by Qual-Med Inc. when it bought HEALS in December, 1990. Qual-Med also assumed $17 million of debt.

*+* Health Net management’s current estimate of HMO’s market value

Source: California Department of Corporations, lawsuits, the companies.