Health Systems, WellPoint Must Pick Up the Pieces and Move On

It was mid-November, and Malik M. Hasan and Leonard D. Schaeffer, flanked by their lawyers, were meeting at the Woodland Hills Marriott.

The meeting, which had been called to smooth out final details in a $1.6-billion merger of their two health-care companies, suddenly collapsed after Hasan accused Schaeffer of reneging on key terms of the deal. Hasan lashed out angrily at a lawyer for Schaeffer’s company: “You’re a liar and a cheat,” Hasan said, “and I’m outta here.”

It was at that fateful meeting that a deal nine months in the making all but died--and a seemingly friendly merger dissolved into acrimony. The two Woodland Hills-based companies Friday formally canceled the merger that would have created the nation’s second-largest publicly held health maintenance organization.

Now Hasan’s Health Systems International and Schaeffer’s WellPoint Health Networks--two of the nation’s most successful managed health-care firms--must pick up the pieces and move on. But they may have lost ground in the fast-moving and highly competitive health-care market.

Though analysts say both companies are in strong competitive positions, their management teams have been preoccupied with merger negotiations for nearly a year. Meanwhile, such California rivals as Kaiser Foundation Health Plan and FHP International pressed ahead with corporate reorganizations to boost their competitiveness.

The merger has also distracted WellPoint and Health Systems from their plans to diversify outside California to create broad-based national managed care companies. Both companies are expected to intensify their efforts to search out merger and acquisition partners in the rapidly consolidating industry, but that task may be harder because of the acrimonious nature of their failed merger.

And both companies lost an opportunity to slash expenses through what they had estimated to be $200 million in merger-related cost savings. They also had hoped to benefit from each other’s strengths.

Health Systems is regarded as having one of the nation’s best-run HMOs in Health Net, which is popular with large corporate customers and is the state’s second-largest HMO. WellPoint also operates an HMO, CaliforniaCare, but most of its members are in less-restrictive types of managed care programs known as preferred provider organizations. WellPoint’s strength is with small- and medium-sized businesses.

“This has been a very traumatic experience,” Hasan said in a recent interview. “We will spend the next few months recovering.”

Closer to home, the companies must cope with the fallout of their aborted merger effort.

In the agreement that terminated the merger, the firms agreed not to sue each other. However, both companies anticipate shareholder lawsuits over a deal that Wall Street analysts had widely praised.

At Health Systems, the merger led to a series of top-level management defections that have weakened its marketing efforts. Departing executives included Roger F. Greaves, co-chairman and co-chief executive, a nationally known marketing expert and the company’s best-known spokesman. Others to leave included Vice Chairman Stephen D. Vogt, Chief Financial Officer Gerald M. Cooper and senior marketing executive Rita Duarte. Some of the company’s key salespeople were snagged by rivals such as Kaiser, the state’s biggest HMO.

The merger effort also created problems for Health Systems with some of its biggest corporate customers, who were concerned that the WellPoint acquisition could disrupt services or affect the quality of medical care for their employees, Hasan said. The merger may have been a factor in the loss of a few corporate accounts.

The customer problems were exacerbated after WellPoint’s CaliforniaCare unit flunked a quality review by a prominent national health-care accrediting organization. Health Systems blasted WellPoint’s subsequent decision to sue the National Committee for Quality Assurance. It accused WellPoint of knowing about the NCQA problem before the merger was announced in March but failing to disclose it to Health Systems officials.

Some analysts also believe the merger may leave Health Systems vulnerable to a takeover attempt by another insurer.

For WellPoint and its majority shareholder, nonprofit Blue Cross of California, the merger’s demise raises other problems. The most immediate is how to meet a state requirement to create a new health-care charity. Under California law, a nonprofit health-care company that changes to for-profit status is required to compensate the state for its years of tax-exemption, usually by creating a charitable foundation equal to the value of the company.

But Blue Cross and WellPoint’s plan for accomplishing that was dependent on completing the Health Systems deal. The firms would have established health-care charitable foundations with a total value of about $3.3 billion.

With the deal’s collapse, some observers say Schaeffer may face another confrontation with Department of Corporations Commissioner Gary Mendoza, whose agency regulates HMOs and who oversaw Blue Cross’ proposal to create the foundations.

As the merger unraveled last month, Mendoza was quick to point out that Blue Cross’s obligation to create the foundation was not over. Blue Cross officials hastily pledged to fulfill that obligation. Even so, some observers predict a new battle over how the foundation will be funded and whether Blue Cross will be allowed to reduce the amount of money available.

“Leonard’s got himself a much angrier regulator now,” said Steve Thompson, vice president of the California Medical Assn.

One possible way to finance the charity would be through a financial restructuring, perhaps through a stock buyback. But that could drain WellPoint’s resources for pursuing mergers.

Schaeffer bristles at any suggestion that Blue Cross would now attempt to shirk its duty. “The decision to make the contribution was made in September 1994,” he says. “We have been ready to do it any day of the week since then.”

Schaeffer may also face some angry Blue Cross directors, a group of which has demanded a special board meeting this week, sources said. The directors have asked, among other things, to discuss possible legal action that they might face over the failed merger.

The directors’ concerns were prompted, in part, by recent statements by Assemblyman Phillip Isenberg (D-Sacramento) that Schaeffer and Blue Cross directors may be personally liable for any losses of public charity funds resulting from the deal’s collapse. Isenberg is chairman of the Assembly Judiciary Committee, which oversees nonprofit organizations.

Schaeffer, meanwhile, says he remains committed to a national expansion program aimed at making WellPoint a powerhouse in the managed care industry. A cornerstone of that strategy will be mergers or acquisitions of Blue Cross and Blue Shield plans in other states. These plans insure about 35 million Americans and enroll a significant portion of people not currently enrolled in HMOs.

However, WellPoint and Health Systems may face a new reluctance from would-be merger partners because of the nastiness of their battle.

“It’s almost like a divorce before marriage,” Hasan says. “Now both people may be suspect.”

Health Systems management will spend the next few months in a “top-to-bottom review” of the company’s operations in California and elsewhere, Hasan says.

“We’re looking at how to improve work processes, we’re looking at staffing levels and a possible reorganization,” he says.

Health Systems recently completed the purchase of a Philadelphia-area HMO and is “looking at two to three other situations,” especially in the Northeast, Hasan says.

But he concedes that the company’s appetite for expansion may have been lessened somewhat by the WellPoint experience.

“There are some very compelling reasons to merge and to look at synergies,” he says. “But the cultural issues, we are finding, are sometimes very hard to overcome.”