A Case Study in Ousting A Favorite CEO

From today's WSJ:

How a Giant Insurer Decided To Oust Hugely Successful CEO
By JAMES BANDLER and CHARLES FORELLE
December 7, 2006; Page A1

Over the past 15 years, the board of UnitedHealth Group Inc. couldn't have been more supportive of its chairman and chief executive, William McGuire. Directors lavished close to $2 billion in compensation on him, counting stock options, as he built UnitedHealth into one of the country's largest health insurers.

Some directors moved with him in social and charity circles. "We're so lucky to have Bill," director Mary Mundinger said earlier this year. "He's brilliant."

Last week, Dr. McGuire left his job, following a vote by the same board to dump him. It acted unanimously in October after concluding that his explanations for a pattern of unusually well-timed stock-option grants didn't add up. Dr. McGuire thus became one of the biggest casualties in the options backdating scandal, which so far has swept away more than 60 corporate officials, including 16 CEOs. (See related article on page A3).

How did one of America's most pliant boards turn on its star chief executive? Dr. McGuire's support slowly leached away over the course of a six-month internal investigation.

Documentation that could support his defense was sparse. A board-ordered statistical analysis undercut his arguments. And his closest board ally was sidelined by a conflict of interest that unsettled other directors. In the end, directors felt pressure after their lawyer told them federal regulators appeared likely to charge the UnitedHealth chief.

Now, Dr. McGuire and the board are girding for tense negotiations over how much of his giant cache of stock options, many still unexercised, he'll be able to take with him. He has already agreed to surrender about $200 million of those options' value, and people close to the situation say the company hopes to get back at the very least $250 million more. He is still likely to end up with more than $1 billion, although last week a federal judge hearing a shareholder lawsuit temporarily barred him from exercising any options or receiving any retirement pay.

Dr. McGuire's lawyer, David Brodsky, said, "While neither a lawyer nor accountant, Dr. McGuire believed that the processes by which options were granted were transparent, appropriate and approved. Indeed, experts who reviewed these processes never raised concerns at the time about the stock options program." Dr. McGuire himself declined to be interviewed.

Dr. McGuire's troubles began in March, when The Wall Street Journal published an article raising questions about exceptional patterns of stock-option grants at a number of companies, including UnitedHealth. In three separate instances, the article found, Dr. McGuire had received options at UnitedHealth stock's lowest closing price of the year.

That made them especially valuable, since options typically convey a right to buy the employer's stock in the future at the price on the grant date. The formula means a recipient can profit only if the stock rises. But it turns out many companies cheated by granting options on one date and pretending they had been issued earlier, when the stock was cheaper. Besides Dr. McGuire's grants at yearly lows, a number of his other grants were dated just before price runups.
After the article, Dr. McGuire initiated an internal investigation. In early April, the board formed a special committee. It hired William McLucas, a former Securities and Exchange Commission enforcement director, now at the law firm of Wilmer Cutler Pickering Hale & Dorr.

At the outset, Dr. McGuire could draw on a big reservoir of goodwill from directors. A former pulmonologist, he helped coordinate care when the wife of one director, William Spears, fell ill. Dr. McGuire's family foundation and the company gave generously to charities some directors were involved with. And directors had made millions from their UnitedHealth options as the stock soared more than 50-fold during Dr. McGuire's tenure. That enormous rise accounted for most of the millions Dr. McGuire earned.

Of 10 outside directors, the CEO had strong support from at least four: Mr. Spears, a New York money manager and friend; Ms. Mundinger, dean of Columbia University's nursing school; Thomas H. Kean Sr., a former New Jersey governor and chairman of the 9/11 commission; and Gail Wilensky, a specialist in health-care policy. The first three had served on the compensation committee during much of the period under scrutiny, making their own conduct an issue in the internal probe.

But Dr. McGuire's core allies would have little role in shaping the investigation. That fell to the special committee, led by James Johnson, a former chief of mortgage giant Fannie Mae who recently served as an adviser to Sen. John Kerry's presidential run. Also on the panel was Douglas Leatherdale, a former chief of insurer St. Paul Cos., and Richard Burke, a founder and retired CEO of UnitedHealth, who was friendly with Dr. McGuire. The committee closely supervised the lawyers and accountants doing the actual digging. Other directors were filled in later and less frequently.

Key Question

Complicating matters was that the board had given Dr. McGuire broad latitude to issue options to subordinates as well as to a right to choose when he wanted option grants to himself made.

After picking a date, he had to get approval from the compensation committee. The key question the WilmerHale lawyers faced: Did the board committee really approve Dr. McGuire's grants on the dates reflected in company regulatory filings? Or might they have been backdated to low-price days that would make them more lucrative?

Directors asked for records to show the options were approved on recorded grant dates. Management came up largely empty-handed. Some minutes of compensation-committee meetings were missing. Others didn't mention approval of any grants near a period in question.

In interviews with the WilmerHale lawyers and in phone calls with directors, Dr. McGuire said he hadn't backdated anything but, rather, had chosen to receive grants when the stock was low after a decline, according to people briefed on the conversations. He expressed disappointment that there wasn't more corroboration and that underlings hadn't kept proper paperwork.

Dr. McGuire also stated that as a man of high ethical standards, he wouldn't have fabricated anything. He said that after picking a date for his grants, he would seek approval from Mr. Spears, head of the compensation committee, or occasionally another panel member.

The main person who could verify this account was Mr. Spears. He told the board's lawyers that while he recalled conversations with Dr. McGuire, he couldn't be sure when they actually took place. Phone records showed the two talked frequently, often around the times of some grants, but these records proved little because the two were close friends.

Mr. Spears's value as a witness soon suffered a blow. The money manager told the lawyers he had handled more than $55 million of the McGuire family's fortune and had accepted a $500,000 investment in his own business from Dr. McGuire.

Mr. Spears maintained he had disclosed this conflict of interest to the board before. Two 1999 documents supported that account: an email and an executive's handwritten meeting minutes. But among the directors, only Mr. Kean thought it was possible he could recall having been told of the relationship, say people familiar with the matter; the others said they had no idea.

Many directors were "incredulous" when they learned of the financial tie at a meeting in the spring, according to someone who was there when the board was briefed. While directors felt
Mr. Spears was honest, the entanglements tainted any defense he might have made of Dr. McGuire. Aware of fellow directors' feelings, Mr. Spears stayed on the debate's sidelines in later meetings, says someone familiar with the gatherings.

Dr. McGuire expressed frustration that his reputation was being hurt by a scandal he considered hyped. "He indicated that this was way blown out of proportion and unfair," says Irwin Redlener, a friend and co-founder of the Children's Health Fund, a not-for-profit group

UnitedHealth supported.

On June 25, Mr. McLucas brought some compelling data to the board's special committee. His presentation showed that grants were regularly dated at or near the stock's lowest prices for the quarter, a suspicious pattern. Later, directors learned that after the mid-2002 passage of new federal rules requiring almost immediate disclosure of option grants, there wasn't a single quarter in which the large grants customarily given to top executives were dated at a quarterly low.

The point: After rules had made backdating impossible, Dr. McGuire's purported ability to pick propitious grant dates vanished. That juxtaposition wounded a key line of defense and "made everyone in the room sit up and focus," says one person close to the situation.

Mr. Johnson was becoming convinced the CEO would have to depart. The former Fannie Mae chief was well aware of how negative perceptions can hurt a company. In a 2004 accounting scandal that brushed close to him, Fannie Mae suffered a stock-price decline, congressional grilling and the loss of its chief executive at the time. One person recalls Mr. Johnson saying in June or July that it was unlikely Dr. McGuire would be able to survive.

On July 11, directors convened for a regular meeting in Minneapolis. Dr. McGuire made a pre-emptive move. He sent directors a five-page memo suggesting a series of steps to deal with the options problem, say people familiar with its contents. He said the board could reprice any tainted options, name a chief administrative officer to remedy deficient record-keeping and make other changes to processes. Deep in the memo, Dr. McGuire said he would be ready to leave if the board thought that was in the company's best interest.

The board didn't want to act before the full scope of the problem was known. It took no action.

In late August the lawyers running the probe made another unsettling finding. In late 1999, the board had approved new options for Dr. McGuire and others to replace a batch that were temporarily worthless. That is, their exercise price was higher than the current stock price because of a stock decline after they were issued. In granting the replacements, the company had suspended, rather than canceled, the old ones, largely for accounting reasons.

Mr. McLucas learned that in August 2000, the suspended options had been reactivated, meaning that the recipients, including Dr. McGuire, effectively got a huge second helping. For Dr. McGuire, the profit embedded in the extra options -- the difference between their exercise price and UnitedHealth's market price -- is now around $250 million. The maneuver skirted disclosure requirements and potentially violated accounting rules, WilmerHale lawyers concluded.

Mr. McLucas brought the issue to the special committee and eventually to other directors. Lawyers later said two directors recalled some discussion in 2000 of reactivating suspended options for other employees, but no compensation committee member recalled intending such a lucrative award for Dr. McGuire himself. "Alarm bells were going," says a person close to the board.

Skirmish Over Math

Meanwhile, a side skirmish broke out over math. The Wall Street Journal's analysis had found that the odds of Dr. McGuire's highly favorable pattern of awards occurring by chance were one in 200 million or greater. Some directors, including Ms. Mundinger, who has a doctorate in public health, criticized the Journal's methodology. The result was a lengthy statistical discussion among directors that resolved little.

After word reached directors that Dr. McGuire had hired a statistics firm to help him rebut the Journal's findings, the WilmerHale lawyers decided to bring in their own numbers experts. In a board meeting on Oct. 2, the lawyers presented an analysis from a firm called Lexecon Inc. It said there were many ways to crunch the numbers, each yielding different probabilities. But all the odds were very long. In the end, Dr. McGuire never presented statistical data to directors.

By early October, the investigative work was all but finished. A squadron of lawyers and accountants had plumbed millions of pages of documents and conducted interviews with more than 80 witnesses. After discussing Mr. McLucas's findings, special-committee members agreed that the situation was serious and the CEO's departure was a likely outcome.

It fell to Mr. Burke, the former UnitedHealth CEO, to travel to Minnesota to tell his old comrade the bad news. But to the surprise of some committee members, Mr. Burke proposed a solution short of Dr. McGuire's departure. He suggested the CEO temporarily step aside until the options tempest calmed, according to people familiar with the matter. Dr. McGuire rejected the idea out of hand, two people close to the situation say. If the board wanted him to leave, he said, he'd leave.

Outside directors set Friday, Oct. 13, as the day for a critical meeting at WilmerHale's Washington offices. The agenda: a review of the investigative report and a discussion of Dr. McGuire's fate. At that point, some directors hadn't yet made up their minds.

The meeting began around 10 a.m. in a large room filled with directors and their lawyers. Directors not on the special committee received the 14-page report for the first time that morning, a person close to the board says. The strongly-worded report concluded it was likely that backdating had occurred and that Dr. McGuire played a central role. Citing the CEO's claim that he didn't backdate any stock options, the report dryly said, "Certain facts run contrary to this assertion."

The report didn't suggest any complicity by directors on the compensation committee. It said it "might have been better" if they had paid more attention to the granting process and asked more questions.

Seated around the conference-room table, the directors took about a half hour to read through the report. No one spoke.

Directors asked Mr. McLucas for his assessment. According to several people, he said that he thought it was likely the SEC would bring charges against Dr. McGuire, and that the agency could seek to bar him from serving as an officer or director of a public company.

Mr. McLucas told directors they should make their decisions based on Dr. McGuire's conduct. But he also said they would be in a difficult spot if they voted to keep him and the SEC sought a short time later to remove him. UnitedHealth has since given the results of its probe to federal prosecutors and the SEC, neither of which has taken action.

At about 4 p.m., a subdued Dr. McGuire addressed directors. He spoke somberly, without notes, for about 40 minutes, talking about how much the company meant to him and how proud he was of its success. He said he believed he had acted ethically and appropriately, say people familiar with the meeting. "I apologize to everyone for putting the company through this trauma," one person recalls him saying.

Some directors couldn't meet his gaze. "It was an anguishing event," said another person in the room who had been close to Dr. McGuire.

Dr. McGuire's lawyer, Mr. Brodsky, of Latham & Watkins, made a brief presentation, saying the WilmerHale report had given short shrift to evidence of his client's innocence. Mr. Brodsky, a former federal prosecutor, said the CEO's money-management relationship with Mr. Spears had been properly disclosed, citing a company lawyer's 1999 email saying "the full board" had been apprised of financial conflicts.

Mr. Brodsky also contested the report's treatment of a McGuire memo that counted against him. In it, the CEO wrote to the compensation committee on Oct. 22, 1999, about a grant that "should be awarded." Despite his use of the future tense, this stock-option grant ultimately bore an earlier date: Oct. 13, the day the stock closed at its lowest price that year. Mr. Brodsky called this meaningless. He said the memo was a rewrite of an earlier draft, and Dr. McGuire merely hadn't fixed the verb tenses.

Dr. McGuire and his lawyer left the room, and directors asked Mr. McLucas for his impression of the defense. "I don't think there's anything we've heard that would change our assessment," one person recalls the lawyer saying.

Directors took no action that Friday. On Sunday, the board had scheduled a meeting in Minnesota. Exhausted, they changed plans and convened instead in Washington. Dr. McGuire didn't attend.

Mr. Spears, the compensation-committee member who managed some of Dr. McGuire's money, arrived at the meeting. He then submitted his own resignation from the board and left.

At the meeting, directors took a vote on a 14-step plan to deal with the options issue. It included Dr. McGuire's immediate departure as chairman and his resignation as chief executive by Dec. 1. The vote was unanimous. Mr. Burke traveled to Minnesota to deliver the news.

Later, several directors called Dr. McGuire to express their gratitude for his service and their sadness over the way things had ended. Dr. McGuire was distressed, said a person familiar with one of these conversations. "He continues to believe he did nothing wrong, which makes it all the more painful."

Last Thursday was the last day Dr. McGuire reported to his 10th-floor office. A private man, he left that day without emotional goodbyes. Said one person close to the matter, "He slipped out without anyone noticing."

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

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