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UnitedHealth's Options Scandal Shows Familiar Symptoms

By Steven Pearlstein
Wednesday, October 18, 2006

Anyone with health insurance from UnitedHealth Group knows what happens if you fail to fill in every box on the form, or attach the requisite back-up material, to get reimbursed for a $40 prescription. You're not going to see a dime until you've been put on hold for 30 minutes, faxed the paperwork twice to somebody in Minnetonka, Minn., and demanded to talk to a supervisor.

So imagine my surprise when I read this week about the loosey-goosey process UnitedHealth used to issue billions of dollars' worth of stock options to top executives over the past few years. According to a report prepared by lawyers at WilmerHale, the board of directors and its compensation committee didn't bother keeping good notes about their decisions regarding pay negotiations and stock options. And the documents authorizing those options conveniently left the date blank, so that someone -- even today, it's not exactly clear who -- could later pick the date that just happened to make the options as valuable as possible.

Isn't it odd that a company could be so persnickety when it comes to pinching pennies from doctors and patients, and so cavalier when it comes to lavishing executives with hundreds of millions of dollars of shareholders' money?

Or maybe it's not. Maybe what we have here is the most outrageous corporate scandal since Enron and WorldCom.

The crux of the UnitedHealth story concerns employee stock options. Just to review, an option lets the employee buy a share of the company stock at a predetermined "strike" price -- usually the market price at the time of issue -- and then sell it in the future, when and if the stock is worth more. The benefit to the employee is the difference between the strike price and the subsequent sales price. The cost to shareholders is that all their stock is now worth a bit less because the newly issued shares dilute their stake.

Thanks to clever reporting by the Wall Street Journal earlier this year, we now know that corporate executives have been routinely setting strike prices on dates when the shares hit temporary lows -- rather than the dates on which the options were issued, which is what most people assumed. It's yet another game played by corporate executives at dozens of companies to pick the shareholders' pockets. And it's the latest evidence of how executive compensation has become a cancer, eating away at the souls of even the most successful American corporations.

Consider the case of William McGuire, who over the past 15 years has transformed UnitedHealth from a struggling regional insurer in Minnesota into the second-largest health insurer in the country, largely through acquisitions of companies like Mid Atlantic Medical Services of Rockville. One in six Americans is a UnitedHealth customer. Under McGuire's leadership, the company's market value has risen to $60 billion. During that same period, he amassed stock options more valuable than those of any chief executive in history: $1.5 billion.

Even by today's standards, McGuire's compensation has been obscene. The big change came in 1999, when, in negotiations over a new contract, he demanded a pay package that would give him 2 percent of UnitedHealth shares. Significantly, McGuire insisted that he alone get to decide the timing of those options. And he wrote in a provision that he could be fired only upon a felony conviction, or failure to rectify a serious problem after repeated notices from the board.

The board of directors that agreed to such a lavish, one-sided contract included several luminaries: Tom Kean, the former governor of New Jersey and later chairman of the 9/11 commission; James Johnson, the former chief executive of Fannie Mae who created the culture that led to that company's costly accounting scandal; Gail Wilensky, a respected health-policy expert who once ran the Medicare and Medicaid programs; and former vice president Walter Mondale.

What were these directors possibly thinking? We have some insight on that from William G. Spears, a Wall Street money-manager who was a member of the compensation committee in 1999. He explained to the Journal that if the board had refused to go along with McGuire's piggy requests, "Bill would take it as a signal that directors weren't enthusiastic about his leadership. That would be a distraction, at the very least. Bill takes these things as a benchmark of how directors feel about him."

Well, we wouldn't want Bill to feel unappreciated, would we? Particularly if you're Spears, and you're also managing millions of dollars in McGuire's personal assets, and serving as trustee for two trusts set up for the benefit of McGuire's children, and you just accepted an investment of $500,000 from McGuire to help finance the repurchase of your firm from a financial conglomerate. Such potential conflicts of interest are supposed to be reported to other directors, of course, as well as the shareholders in the company's annual proxy report. But that was just another tiny detail that somehow slipped through the cracks.

McGuire was not the only one to benefit from the directors' ineptitude. There was also his trusty chief operating officer, Stephen Hemsley, who upon being hired in June 1997 was presented with 400,000 stock options with an issue date of five months earlier. Hemsley told the WilmerHale lawyers that he "didn't recall focusing at the time" on the $2.9 million gimme he'd just been handed as a result of the backdating.

You might say that Hemsley comes honestly to his lack of focus and ethical sensitivity. Before coming to UnitedHealth -- I'm not making this up -- he'd spent the previous 23 years at Arthur Andersen, rising to chief financial officer. That's the same accounting firm that helped bring you Enron, WorldCom and Freddie Mac. And, you'll be shocked to learn, it's the same Arthur Andersen that served as a consultant to Spears and other members of UnitedHealth's compensation committee.

Around the same time that UnitedHealth directors were rubber-stamping McGuire's employment contract, they also approved another of McGuire's stock option initiatives. The company stock was in a slump, making worthless many of the options held by company executives, including 750,000 by McGuire. As McGuire explained it, morale was suffering and it was getting harder to retain key employees. Some companies had addressed this problem by "repricing" options -- lowering the strike price so the options were magically valuable again. But, as the WilmerHale lawyers put it so delicately, there were "disadvantageous accounting and disclosure ramifications" to repricing. Translation: bad publicity and a hit to earnings. So McGuire came up with the cute idea of having the board simply "suspend" the old options and issue new ones with a lower strike price.

The directors agreed. But the following August, after the stock price had risen substantially, the board also agreed to McGuire's request to "reactivate" the suspended options, essentially doubling the number of stock options issued. The motivation was unclear, but according to WilmerHale, these actions were never properly accounted for or reported to shareholders. Translation: accounting and securities fraud. And this little bit of double dipping added another $250 million to McGuire's net worth, the Journal reported.

One of the more interesting revelations from the WilmerHale report is that these and other outrages at UnitedHealth pretty much stopped following the 2002 passage of the Sarbanes-Oxley law, requiring directors and outside auditors to ensure that companies had adequate internal controls. The U.S. Chamber of Commerce and other business groups have been running around the country, complaining the law has overreached, stifling American risk-taking and innovation. I wonder if backdating stock options is the sort of risk-taking and innovation the chamber has in mind.

In response to these revelations, you'd think UnitedHealth directors would at least have had the manners to apologize to shareholders, if not to resign. Instead, they've followed the well-worn path of insisting they did nothing wrong while taking steps to ensure it won't happen again.

After praising him for his "leadership, energy and vision," the board allowed McGuire to retire with his full pension and all his options. The good doctor graciously agreed to reprice his options from the most favorable to least favorable dates -- a concession that could cost him $200 million.

Hemsley was rewarded for his lack of focus by being named to succeed McGuire as chief executive. He was also directed to root out the senior executives in the legal, accounting and personnel departments who provided the bad advice on which the board and chief executive now say they have relied. Hemsley, too, has volunteered to reprice his options.

Spears announced his resignation from the board, which expressed "gratitude for his many contributions during his 15 years of service."

And, in a stunning example of the barn door and the departed horse, UnitedHealth's directors declared they would no longer award stock or stock options to top executives.

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