State Takes Another Look at HMO’s Conversion Plan : Management: Regulators don’t know when they will make a decision on Health Net’s controversial bid to switch to for-profit status.

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

Health Net, based in Woodland Hills, submitted the plan in March to the Department of Corporations, where it has been available for public review. But the HMO never made any other announcement about the proposal.

So it’s only been within the past two weeks that details have been surfacing publicly, and they’ve been greeted with criticism by consumer groups such as Consumers Union.

The Department of Corporations, which was initially expected to rule on the conversion by Saturday, now says it doesn’t know when a decision will be reached.

Health Net Chairman Roger F. 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 Corporations Department, disagreed, saying, “I don’t know as I would describe anything as political pressure,” but he added that “I have questions of my own” about the proposed transaction.

Health Net, with 840,000 members, is the state’s second-largest HMO, after Kaiser Permanente, and is a nonprofit organization, meaning it pays no taxes. But even before it filed its formal proposal in March, Health Net had been quietly negotiating with the Department of Corporations on its plan to change to for-profit status.

Health Net says it now needs to be for-profit to raise money 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 earlier 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.

Health Net’s proposal says that when the HMO becomes a for-profit entity, 32 members of its management--led by Greaves--would acquire control of Health Net.

In exchange, Health Net would follow state rules and 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.

That money is supposed to represent the fair market value of Health Net, and its contribution to the trust is a sort of repayment to the public for allowing Health Net to grow without the burden of paying income taxes.

But the $108-million valuation has come under fire. Harry Snyder, director of the West Coast office of Consumers Union, the nonprofit publisher of Consumer Reports magazine, asserted that $108 million vastly understates the value of Health Net, and therefore would shortchange the public charity.

Snyder declined to put a specific value on the HMO, but said $108 million is “tens of millions, if not hundreds of millions, short of the actual value” of Health Net.

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 plans to first 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.

Several other HMOs nationwide have converted to for-profit status over the past decade, and Health Net is not the first to have its proposal questioned. (HMOs provide health coverage through certain doctors and hospitals in exchange for a flat fee from members, as opposed to traditional medical insurance that charges according to specific services.)

In 1985, a move by FHP International, a Fountain Valley-based HMO, to switch to for-profit status and be acquired by its management also was 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.

Just a year later, FHP had a public stock offering that gave FHP a total stock-market value of $150 million. Immediately after the offering, management still had a 76% stake that was then worth $114 million. (FHP’s market value today is roughly $640 million.)

In Health Net’s case, the Corporation Department’s Simon said he’s 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 the executives’ personal cash is being contributed to the initial equity of the new company that would own Health Net, although he conceded “it pales in the face of $108 million.” Greaves also said he would own 15% of the new company, twice as much as the second-largest executive stockholder.

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 goes public--just as FHP did.

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 put 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 Blue Cross of California. Health Net became an independent HMO in 1986.