Friday, October 20, 2006

Enough of UnitedHealth Group

Enough is enough! We have been very patient with our holding of United Healthcare (UNH) since April, thinking that the unquestionable strength of their franchise would ultimately outweigh their options backdating scandal. Listening to the comments of CEO William McGuire in the early months of the inquiry, we were reasonably sure that what had happened, while inappropriate and possibly naive, would likely not involve blatant wrongdoing on the part of senior management and the board of directors.

We were too optimistic. The internal probe commissioned by the company’s board of directors and carried out by William McLucas, former director of the SEC’s enforcement division, and member of the law firm of Wilmer Cutler Pickering Hale & Dorr (WilmerHale), was released on Sunday. It concluded that 29 of the largest options grants at UnitedHealth over a 12-year period most likely were backdated to benefit insiders. Quoting the Wall Street Journal: “The WilmerHale report suggests that Dr. McGuire misled lawyers conducting the probe of the options grants at issue…. To the end, Dr. McGuire insisted that year after year he actually did call or otherwise contact a compensation-committee member to set an options grant in motion on what, in hindsight, turned out to be a wildly favorable day. ‘Certain facts run contrary to this assertion’, the WilmerHale report says, citing memoranda Dr. McGuire wrote on or after the purported grant dates referring to possible grants in the future tense. The report also takes a skeptical view of the circumstantial evidence presented by Dr. McGuire to document that the compensation-committee notifications did in fact take place.”

The report also points out that William Spears, a member of the UNH board of directors and chairman of the board’s compensation committee during most of the period under review, had a personal money-management relationship with Dr. McGuire and that Dr. McGuire was an investor in Mr. Spears’firm (according to “Business Week” Stephen Hemsley, then COO and now CEO, had, in 2006, a $56 million money management relationship with Mr. Spears). It also points out that Mr. Spears was chairman of an ad-hoc committee of the board formed to negotiate management agreements with Dr. McGuire and Mr. Hemsley. The implication for us is that the “fox was guarding the chicken coop” and no on else on the board of directors, either knew anything or moved to do anything about it. It is very hard to believe that the board’s compensation committee, the audit committee and the ad-hoc compensation subcommittee, were completely in the dark about options backdating and the financial entanglements of Spears, McGuire and Hemsley. A careful reading of the WilmerHale report reveals implications of hand-written notes, e-mails, discussions etc. that no one can specifically recall. This is very reminiscent of the short memories of certain politicians when facing imminent legal actions.

Dr. McGuire and the company’s general counsel, David Lubben have agreed to leave the company and Mr. Spears has resigned from the board. Mr. Hemsley, who also benefited greatly from the options backdating, will become CEO. However, the WilmerHale report finds that Hemsley did not participate in the actual backdating. Both his and McGuire’s options will be repriced to make them legal, but neither of them is giving up any options or their attendant wealth. In addition, an independent corporate governance watchdog firm estimates that Dr. McGuire will be given a $6.5 million separation payment and $5.1 million a year for the rest of his life under the terms of his management contract. Regardless of what his contract might say, this to us would be compensation for blatant wrong doing and would be an unconscionable act by this board of directors. Are there to be no consequences?

We are certain that this is only the beginning of what will happen to senior UNH executives, the board and the company in general. Hemsley’s involvement is sure to be challenged, leaving an open question of who is capable of running the company in the future. On today’s conference call, the Goldman Sachs analyst (who has maintained a sell rating on UNH for the past several months) asked what could well be the 64 dollar question: “What have you heard from AARP about this whole corporate governance matter?” Hemsley’s answer was very carefully worded (in the negative) because AARP is a huge client for Medicare drug plans and a long-time critic of both political and business practices. UNH can surely expect to hear more from AARP and other major customers.

The WilmerHale report, both in its frankness and between its lines, establishes a strong starting point for the SEC’s ongoing inquiry, as well as the adjudication of the several shareholder lawsuits already filed and those sure to follow. Our feeling is that we would prefer to watch this as disinterested parties, without client capital exposed. For our long-time clients, UNH has generated a handsome gain over the years. For several more recent clients, it represents a loss. In either case, we will redeploy this capital to companies where risk is something we can manage, instead of being exposed to the future actions of the SEC, the Justice Department and the courts on UNH. Enough is enough!

Note: At the time of publication, neither Jack nor Peter Falker, nor the clients of FalkerInvestments Inc. had any positions in UNH.