Backdating Backlash

We have a substantial position in United Health Care (UNH), which, even at current levels, has doubled in value over the last few years. When the Wall Street Journal revealed in April that a probe had been initiated into the company’s practices of issuing executive stock options at prices that were essentially “too good to be true”, we decided, as long-term investors, to wait and see what would happen. Subsequently, this practice has been identified as being more widespread, so UNH is not alone in the SEC probe. We believe that UNH is the best company in the HMO segment of the health care industry and, right or wrong, we have not been anxious to hit the sell button, as so many investors (including, we are told, Fidelity Investments) have already done. This scandal has significantly lowered the price the market assigns to the company; however, we do not believe that it has substantially changed the value of the company’s extraordinary healthcare franchise.

Here’s what we know at this point: Based on a chart we got from Bear Stearns, UNH has had 16 option grants since 1994, four of which were issued on the exact date of the low close in the quarter; three of which were also lows for the year. The dates were 4/20/94, 10/27/97, 10/13/99 and 3/8/00. Using Big Charts, we went back and created the charts for the several months surrounding each of those grants. Interestingly, the first two just look like good calls on the part of management. The stock had been tanking for several days so they picked a day they thought would be close to the low and authorized the options. It also appears they might have known that some good news was about to be announced, because in both cases the stock went up significantly in the next week. Unfortunately, that pattern does not follow through on the last two grants in 1999 and 2000. In both cases, the stock had been trending lower, they picked the exact date of the low, and the stock slowly began to improve from that point. It would have been virtually impossible to choose those exact dates, so backdating seems quite likely. In their 10-Q SEC report filed in May (which under the circumstances would have been blessed by their auditors), they say that “the Company has identified a significant deficiency in its controls relating to stock option plan administration and accounting.” The context that follows implies that the board had given some sort of blanket authority to management and that the authority had been misused by someone in “the Company’s human capital, finance and legal departments”, which, of course all report to Bill McGuire, the CEO and largest stock option beneficiary. The 10-Q goes on to say that the board has changed all of that and it won’t happen again, because future option grants “are to be made by the Compensation and Human Resources committee, and no authority to grant options is delegated to management.” In other words, the fox is no longer guarding the chicken coop.

As a former corporate treasurer, I’m in shock about what UNH apparently did, and why. My first reaction, when the probe was announced in late April, was that it would not be at all difficult for the management of UNH to grant options at or near the low trading points in their stock. Assuming that they did it the way we always did, options are very easy to grant with a telephonic meeting of the board compensation committee, to be ratified by mail etc. I saw it done frequently and it was entirely proper, albeit opportunistic. In UNH’s case, with board authority apparently already making it so easy to grant options, at or near a low point, why would someone in management engage in backdating to the exact date of a low? At the least, this is very greedy, and at the worst it’s outright fraudulent, not to mention stupid. In any event, if backdating is proven, Bill McGuire would likely have to take responsibility and he likely will not go unpunished. That could be messy, a la Ace Greenberg at AIG. Greedy CEOs have been kicked around a lot lately and it probably isn’t over yet.

Reading between the lines of UNH’s recent SEC filing, it seems that they have pretty much acknowledged irregularities, so it’s just a matter of time before the full story will be released in another SEC filing. The company’s board has hired the former enforcement chief of the SEC, who has a reputation as a very tough lawyer, to conduct an investigation into exactly what happened. This very constructive move was announced more than a month ago, so it’s likely that a report will be forthcoming shortly, and that’s when all the information should be available for decision making. If it’s not any worse than what the company has already reported to the SEC, we will keep the stock and consider adding to it at current levels, which represent a substantial discount from what our model tells us the ongoing franchise is worth in the longer term, with or without Bill McGuire. However, if the news is worse than what we currently know, we may have to quickly protect our capital.

Trading action in the stock during the last week or so seems to indicate that the street believes the worst news is already out. We will wait and see. Stay tuned.

Jack Falker

Note: At the time of publication, the clients of FalkerInvestments Inc. and Jack and Peter Falker were long UNH.