Health Net’s Plan to Shed Nonprofit Status Under Fire

State regulators are taking a second look at a controversial plan by Health Net’s management to acquire the big, nonprofit health maintenance organization and convert it to for-profit status.

A key issue is whether Health Net’s value has been fairly assessed. In order to convert to for-profit status, state law requires the company to make a financial contribution to a public charity in the amount of the company’s current value.

But critics, including Consumers Union, claim that the $108-million value put on the Woodland Hills-based HMO vastly understates its true worth and would in effect shortchange the public. The conversion law is designed to compensate the public for the company’s tax-exempt status while it grew as a nonprofit entity.

Health Net’s management is also under fire for not more openly disclosing their plans, which might result in company Chairman Roger F. Greaves and other members of the management team earning millions of dollars. Health Net, with 840,000 members, is the state’s second-largest HMO, after Oakland-based Kaiser Permanente.

Health Net’s management submitted the conversion plan in March to the Department of Corporations, where it has been available for public review. But company officials said they had been quietly negotiating with the state agency on plans to convert the HMO to for-profit status before the filing. Health Net did not announce the filing or make any other public statements about the proposal. Nevertheless, in the past two weeks details about the plan have been surfacing to a chorus of criticism.

The Department of Corporations, which was originally expected to rule on the conversion by Saturday, now says it doesn’t know when a decision will be reached. Greaves said last week that the agency told his company the ruling was delayed because “there’s been considerable political pressure” stemming from the complaints.

Wayne Simon, chief deputy commissioner of the Department of Corporations, disagreed, saying: “I don’t know as I would describe anything as political pressure.” But, he added, “I have questions of my own” about the proposed transaction.

Health Net says it needs to be for-profit to raise funds in the capital markets and attract talented executives, among other things. Although Health Net earned $42.6 million on revenue of $886 million last year, it lost a total of $60 million in 1987 and 1988, and the loss ate up two-thirds of the HMO’s cash reserves at the time, Greaves said. Because it was nonprofit, Health Net could not tap the capital markets to replenish its reserves, he said.

“I don’t want to go through that again without the opportunity to turn to another quarter for help,” he said.

According to Health Net’s proposal, if the HMO becomes a for-profit entity, 32 managers--led by Greaves--would acquire control of the HMO. In exchange, Health Net would make a contribution toward creating a new public charity--called the California Wellness Foundation--which would use the money to promote public health. In Health Net’s case, the contribution would be $108 million.

Harry Snyder, director of the West Coast office of Consumers Union, the nonprofit publisher of Consumer Reports magazine, asserted that $108 million is “tens of millions, if not hundreds of millions, short of the actual value” of Health Net. A $108-million contribution would not be fair to the charity, he said. Snyder, however, declined to put a specific value on the HMO.

Greaves said the $108-million value was independently derived by the accounting firm Ernst & Young under general guidelines set by the Department of Corporations. Health Net would first make a make a $15-million cash payment to the foundation, and the rest of the $108 million would be paid off over 15 years from cash generated by the HMO’s business.

Simon said he is re-evaluating the $108-million valuation for Health Net “to be sure we’re going to stand by that number or suggest something else.”

Health Net’s conversion also might give Greaves and the rest of his management team an opportunity to earn millions of dollars.

Greaves declined to say how much of the executives’ personal cash is being contributed to the initial equity of the new company that would own Health Net, although he conceded that “it pales in the face of $108 million.” Greaves also said he would own 15% of the new company, twice as much as the highest stake to be held by any other member of the management team.

If management’s combined cash investment is worth only a fraction of the company’s stated value, the executives stand to earn a considerable amount on that investment. That’s provided Health Net successfully manages the debt owed to the charitable foundation, and later is sold to another company, or sells stock to the public. Of course, if Health Net defaults on the debt, their equity could be wiped out.

As such, the proposed Health Net conversion is similar to a corporate leveraged buyout, in which a company is bought by new owners using mostly borrowed money.

Maryann O’Sullivan, executive director of Health Access, a consumer group that lobbies for affordable health care, complained that Health Net was not more forthcoming about its proposed conversion. She said the HMO “might have followed the letter of the law, but certainly not the spirit of the law, in letting the public know about these proposed changes.”

Greaves said he now regrets not formally announcing the conversion plan.

“In retrospect I wish we had out a general announcement, because I think I wouldn’t be getting the criticism now and I could have spread the inquiries . . . over time rather than having them concentrated in one week.”

Health Net was formed in 1977 by Blue Cross of Southern California, which merged four years later with Blue Cross of Northern California to create what is today simply Blue Cross of California. Health Net became an independent HMO in 1986. (HMOs provide health coverage through certain doctors and hospitals in exchange for a flat fee from members, as opposed to traditional medical insurers who reimburse clients for the cost of medical care.)

Several other HMOs nationwide have converted to for-profit status over the past decade, and Health Net is not the first to come under fire.

In 1985, a move by FHP International, a Fountain Valley-based HMO, to switch to for-profit status and be acquired by its management was also criticized by Consumers Union and challenged in court by the state attorney general. They claimed that the stated value of FHP--$38.6 million at the time--was much too low.

Nonetheless, the conversion went through.