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How Did UnitedHealth's McGuire Get Same Options Twice?
By Charles Forelle and James Bandler
The Wall Street Journal
Friday, October 20, 2006


Investors and the public heaped scorn on William McGuire this week for his role in apparent stock-options backdating at UnitedHealth Group Inc.  But his thorniest legal problems could stem from a 1999 transaction in which backdating played only a minor role.

In the transaction, according to a report prepared by outside lawyers commissioned by UnitedHealth directors, Dr. McGuire and other employees were able to effectively get the same options twice, at favorable prices, while skirting disclosure requirements and potentially violating accounting rules.  For Dr. McGuire alone, the extra options are now valued at $250 million.  Just as troublesome for Dr. McGuire, the report concluded that it's unclear whether directors ever intended to give Dr. McGuire such a generous deal.

Dr. McGuire's role in implementing the transaction is amply documented.  The lawyers probing UnitedHealth found a 1999 memo from Dr. McGuire to directors in which he initiated the arrangement.  He also told the investigators that it was structured as it was in part to avoid having to reprice the options, which would have unpleasant accounting consequences, according to a person familiar with the matter.  That would cause a drag on earnings.

But UnitedHealth's outside lawyers believe that the accounting treatment was nonetheless improper.  That will likely require UnitedHealth to take substantial charges, and it may expose Dr. McGuire or others to allegations of accounting misdeeds.

Dr. McGuire, the longtime chief executive of UnitedHealth, stepped down as chairman of the giant Minnetonka, Minn.-based insurer Sunday, and he will leave his post as chief executive by Dec. 1.  The moves follow an internal investigation by the law firm of Wilmer Cutler Pickering Hale & Dorr, released in a report on Sunday, that found rampant backdating of stock options at the company, and attributed a substantial portion of the blame to Dr. McGuire.

"If I were at the SEC, I think I would have plenty from the WilmerHale report that would motivate me to look very hard at Dr. McGuire's conduct," said Donald C. Langevoort, a law professor at the Georgetown University Law Center.  The 1999 options-swap transaction, he added, "is a perfect example of a major compensation decision not being presented clearly and plainly to the investing public until well after the fact."

Dr. McGuire's lawyer, David M. Brodsky, said, "Dr. McGuire is an expert in health care but not the legal and accounting issues concerning options.  For that, he sought advice from others and relied on their advice."  He said he doesn't know who gave Dr. McGuire the guidance.

In late 1999, according to the WilmerHale report, Dr. McGuire was concerned that some stock options issued in the prior five years were "underwater" -- that is, carrying exercise prices above the stock's current market value.  Because options give recipients the ability to buy stock at a fixed exercise price, that meant the options couldn't immediately be cashed in for a profit.

On Oct. 22, 1999, Dr. McGuire wrote a memo to the board's compensation committee proposing an unusual maneuver.  He suggested that more than two million options held by him and others be "suspended," and that new ones be issued in their place with a lower exercise price.

The motivation for such a swap appears to be avoiding the deleterious accounting consequences of a straight "repricing" -- whereby options are simply given a new exercise price.

Accounting rules adopted in 1998 required repriced options to be recorded on a company's books under so-called variable accounting, a punishing method that requires assessing an option every quarter between vesting and expiration to determine if it gained in value, and recording any gain as an expense.  By contrast, the usual method of accounting for options that were issued at market value at the time of grant involved no expense whatsoever.

In any event, directors approved the swap, giving Dr. McGuire and others roughly the same number of new options at substantially lower exercise prices.  As it happens, the WilmerHale report concluded the new options likely were backdated to Oct. 13, 1999, the low point that year for UnitedHealth's stock, giving the recipients a running start to make a profit on their replacement options.

Dr. McGuire's actions were likely in vain, though.  The WilmerHale report said the 1999 replacement grant "was effectively a repricing for accounting purposes."  Though UnitedHealth itself hasn't come to a conclusion about how to account for the grant, it is likely the company will conclude that its past financial statements didn't record adequate compensation expenses -- meaning the company's earnings looked better to investors than they should have.

Charles Mulford, an accounting professor at Georgia Institute of Technology, said, "I would argue, in substance, this was a repricing and should have been accounted for as such."

In August 2000, the suspended options were reactivated.   That meant that Dr. McGuire and other employees got the best of both worlds -- owning both the original options, which were now "in the money" because the stock price had surpassed the exercise price, and the purported replacements.

The WilmerHale report said Dr. McGuire's 750,000 options were reactivated with an average strike price of $47.21, at a time when shares were changing hands at $81.81 -- an instant gain of $26 million for Dr. McGuire alone.

Though the reactivation was apparently approved by directors, the WilmerHale report suggested they may not have fully understood what they were doing.  The report cited missing or nonexistent documents, and said that minutes from the August 2000 board meeting don't even mention the reactivation.

Two directors "recalled that there was a discussion of the reactivation at [the August 2000] meeting," the report said.  But "no member of the Compensation Committee in 2000 specifically recalled that Dr. McGuire was the intended recipient of such a large grant of options."

Legal experts said the Securities and Exchange Commission will want to determine whether directors were, in effect, bamboozled.  "To the extent that the commission decides that Dr. McGuire or anyone else in senior management was not candid with the board and let them operate in the dark, I think the commission could turn that into the basis for an enforcement action," Prof. Langevoort said.

A person close to Dr. McGuire said the August 2000 reactivation was not a surreptitious pay grab.  Indeed, this person said, it was decided at a compensation-committee meeting and at a full board meeting.  This person added that employees with suspended options were sent a memo shortly after the meeting noting that the suspension had been lifted, and that such lifting didn't affect the 1999 supplemental grant.

In any case, the WilmerHale lawyers determined, the August 2000 reactivation should have been treated as a new grant altogether, requiring UnitedHealth to take a substantial charge against its earnings.

Dr. McGuire and UnitedHealth are negotiating the financial terms of his departure.  The question of whether he should be allowed to keep the now-disputed reactivated grant is likely to be a key element in those discussions.

--Mark Maremont contributed to this article

Write to Charles Forelle at charles.forelle@wsj.com and James Bandler at james.bandler@wsj.com


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