Critics Oppose Health Net’s For-Profit Plan

If there are people surprised by the controversy and bidding war surrounding health-care provider Health Net, they shouldn’t be.

The management of the state’s second-largest health maintenance organization, with 840,000 members, is under fire for its plan to convert from nonprofit to for-profit status by paying $127 million to charity over 15 years--supposedly its “fair market value,” as state law requires.

Consumer advocates and health firms that want to take over Health Net say that sum far understates the Woodland Hills-based company’s value and sets up management to reap huge gains if it later takes the company public or resells it.

The company says it is just following the law, which allows it to reject higher bids from outside suitors. But if the recent history of California HMOs is an indication, the critics have a point.

Since the mid-1980s, at least three other nonprofit HMOs have made the conversion. And in each case, management harvested huge profits by reselling the health plans or going public after making the switch to for-profit status.

To critics, the wide spreads raise questions about the state law that permits such conversions--and about the state Department of Corporations, which enforces the law.

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. But a year later, a joint venture led by Aetna Life & Casualty Co. bought the HMO for $37.5 million.

FHP International Corp., an HMO operator based in Fountain Valley, and HEALS, an HMO in Northern California, also boomed in value soon after converting to for-profit operations.

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

Consumers Union, the nonprofit publisher of Consumer Reports, says the $127 million that Health Net is offering to donate to charity vastly understates the firm’s actual value. The firm’s management, in the second step of its conversion plan, has proposed purchasing the company for $1.5 million--a deal that could earn executives millions of dollars in any subsequent sale.

Some of the outside bidders for Health Net, including Blue Cross of California, also complain that Health Net’s management--which dominates the HMO’s board--has a conflict of interest in making a takeover bid while it’s evaluating outside offers. Those offers range up to $300 million.

And on Monday, Insurance Commissioner John Garamendi jumped into the fray. In a letter to Thomas Sayles, newly appointed commissioner of the Department of Corporations, Garamendi noted 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.”

Warren Barnes, supervising counsel for the agency, declined comment on specific cases. But he 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 of its own in valuing HMOs, instead using “standard business evaluation techniques.” Even with those standards, he said, “valuing companies is infinitely more complex than anybody’s gut reaction.”

But Snyder chastised the Department of Corporations for taking a “mild-mannered approach” in reviewing HMO conversions.

“We’re going to call upon Gov. (Pete) 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.”

Health Net spokesman Jim Lucas, one of the 32 members of the management buyout group, said the HMO is not shortchanging the public if it rejects the higher takeover bids. The higher offers would burden Health Net with excessive debt, thereby reducing the HMO’s level of service, its payment to doctors and “the long-term financial stability of the company,” he argued.

Health Net last year earned $42.6 million on revenue of $886 million. The buyout group doesn’t “discount the possibility” of going public, but it has promised the Department of Corporations that management won’t sell any of its stock for at least two years after the conversion.

Nonprofit HMOs began converting to for-profit status in the mid-1980s as more health plans--hurt by cutbacks in federal reimbursements for medical care--looked to the financial markets for capital.

HEALS, for instance, converted to for-profit status in 1987 with a $2.1-million donation to charity. Last 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 also is one of the suitors bidding for Health Net.)

In the Inland Health Plan conversion in 1985, the HMO sought to convert after stating its value as $165,000, based on a valuation by Ernst & Young (then known as Ernst & Whinney), the same accounting firm employed by Health Net.

At the time, Inland’s annual revenue was $18 million and its net worth was $2.6 million, according to a lawsuit filed in federal court in Los Angeles by several doctors who challenged the conversion.

The Department of Corporations approved the deal after ordering Inland to raise its charitable donation to $562,000. According to the lawsuit, Inland’s management and some other investors then bought the HMO’s stock for $15,000. The following year, the management group sold Inland to Aetna and its partners for $37.5 million.

The lawsuit was settled two months ago on undisclosed terms.

Ernst & Young, in response to questions from The Times, 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.

The state attorney general’s office joined Consumers Union in objecting to FHP’s conversion in 1985. But the 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, with a market value of $150 million. FHP’s executives held 76% of the stock, worth $114 million.

Then-Atty Gen. John K. Van De Kamp backed a lawsuit, filed to block the conversion, that alleged the conversion price 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 involved in the FHP case, said Atty. Gen. Daniel E. Lungren won’t get involved in the Health Net case. “The court ruled we don’t have jurisdiction,” he said. “And that’s that.”

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.