In its 1999 proxy statement, UnitedHealth Group made sure investors knew of a few small relationships between its directors and the company. While reassuring shareholders that all the directors on its compensation committee were independent of management, it pointed out that the insurer paid immaterial amounts for insurance policies bought from the company headed by one director, while the law firm of Walter Mondale, another board member, was also the company's corporate counsel.
Following the New York Stock Exchange's 2004 imposition of stricter standards for director independence, UnitedHealth (UNH) had eliminated even those minor ties by the time the 2005 proxy was filed. This time, it told investors that all the members of its comp committee met the NYSE's independence test, and that no relationships or ties existed between directors and the company.
How nice of them to share. Of course, what the proxy neglected to mention were significant personal and financial ties between ousted CEO William McGuire, and William Spears, a New York investment adviser and long-time head of UnitedHealth's compensation committee.
Controversial Agreement Those ties were outlined in a report, released Monday, prepared for the UnitedHealth board by William McLucas, a former head of the SEC's enforcement division and now with the Washington, D.C., law firm of Wilmer Cutler Pickering Hale & Dorr. According to the report, Spears has served as a trustee since 1992 for two trusts set up for McGuire's children. And from 1994 to mid-2006, he also acted as an investment manager for McGuire, overseeing assets ranging from $15 million to $55 million in 2006.
In June, 1999, the CEO even invested $500,000 in Spears's money-management firm when he bought it back from the larger conglomerate that then owned it. Several months later, Spears was the company's point person in negotiating what proved to be a highly lucrative, highly controversial employment agreement for McGuire.
Nor is McGuire the only company executive with a financial relationship with Spears. Stephen Hemsley, who was named Oct. 16 to succeed McGuire as UnitedHealth's chief executive, also hired Spears to manage his money. Starting with a $12 million account in 2001, by 2006, Spears was managing $52 million of Hemsley's money as well. As a result of the probe, Spears has agreed to leave UnitedHealth's board (see BusinessWeek.com, 10/16/06, "Hard Times for UnitedHealth").
Declaration of Independence All of which has raised an obvious question: Just how could a director with those substantial—and presumably remunerative—ties to key officers be considered independent? And why weren't those ties made clear to shareholders? "It's a real stretch to say this guy is independent," says Jacob Frenkel, a securities lawyer and former SEC enforcement official. "The company and its principals will be hard pressed to justify a rationale for not disclosing that relationship."
The answer appears to lie in how independence is defined. Before 2004, when the disputed grants occurred, the standards in place were vague. Legal experts say it's unclear whether Spears would have met them. But in the wake of Enron, WorldCom, and other corporate scandals, both the NYSE and Nasdaq strengthened the rules concerning independent directors for the companies listed on their exchanges. The SEC vetted those rules but has no separate requirements for independence of its own.
At the NYSE, where UnitedHealth's stock is listed, all directors on a compensation committee must be independent, meaning they should have no material relationship with the company. A director or an immediate family member can't have been an employee of the company within the last three years, for example, or have been an executive officer of any other firm that has either made payments to, or received payments from, the company in excess of $1 million.
The Element of Surprise But while the rules are explicit in forbidding certain links between the directors and the company, they never specifically address relationships that might exist between directors themselves. Indeed, they're strangely silent on the potential problems that could arise from outside ties between directors. Instead, boards are asked generally to consider the other "persons or organizations with which the director has an affiliation" when assessing the materiality of a director's relationship with the company.
That lack of specificity may have led McGuire, Hemsley, and Spears to conclude that their financial relationships didn't have to be disclosed to investors. But experts say they may have strayed perilously close to the legal edge—and indeed may well have crossed over it. "The question is what was said [to shareholders] about the relationships they had, and whether that would be rendered false and misleading by the new facts," says Donald Langevoort, a professor of securities law at Georgetown University.
"Post-Sarbanes Oxley, there's so much emphasis on director independence that any fact that would come as a surprise to shareholders should be disclosed, so that they won't be surprised." Through a company spokesman, McGuire and Hemsley declined to comment on Oct. 17. Spears also declined to comment.
Close to the Edge If nothing else, those ties should have been reported to the rest of the board, which, under current NYSE rules, would then have been required to assess whether Spears truly qualified as independent. While the board would still have had the right to conclude that Spears' judgment wasn't influenced by those ties, it would have been required to let shareholders know how they reached that conclusion.
"The whole purpose of these regulations is to say that if something is close to the line, it should be disclosed, and a board waiver secured," says John Coffee, a professor at Columbia Law School.
But none of this appears to have happened at UnitedHealth. According to McLucas' report, McGuire and Spears said they believed that the board was aware of the money management relationship in 1999. In October of that year, UnitedHealth's general counsel, David Lubben, sent an e-mail to the company's outside counsel outlining McGuire's financial relationship with Spears, and indicated that some disclosure of a "conflict" had been made to the full board.
Claiming No Knowledge However, McLucas found no documentation or board minutes to back this up and says no other directors recalled being aware of the relationship when Spears was negotiating McGuire's 1999 employment contract. It's unclear when they later learned of those links—or that Hemsley, too, had hired Spears.
And all of the directors said they were unaware that McGuire's investment in Spears's firm, which ended in 2003, had taken place until the recent probes into options began. A source close to the probe says no evidence exists that the directors knew of Spears's role as a trustee for McGuire's children either.
Moreover, there's no evidence that the board reconsidered whether Spears still qualified as an independent director or discussed the need to disclose those financial ties to shareholders after the NYSE tightened up its disclosure rules.
No Job Too Small Governance experts say that the lack of public disclosure appears particularly egregious, in light of the potential sums involved. Directors now are routinely forced to disclose links that appear to offer far less potential for personal gain than may have occurred at United.
If a director works for another firm that does business with the company, or has a relative working for the firm, those links must be disclosed no matter how small the sum or how minor the job. "If the amounts involved are de minimus, that's not going to affect independence," says Robert McCormick, head of proxy research for financial advisers Glass Lewis. But given the amounts of money involved at UnitedHealth, "this deal raises lots of concerns."
While the exact terms of Spears's deal with McGuire and Hemsley aren't known, the relationship appears to have given him plenty of potential for gain. Money managers typically pocket fees starting at 0.5% of assets under management for accounts of around $50 million. For complex investment strategies, the fees could run higher.
How Widespread a Problem? But even at that rate, Spears could have made roughly $250,000 a year from both McGuire and Hemsley for overseeing their accounts. Moreover, in negotiating McGuire's 1999 contract, Spears potentially had a direct interest in increasing McGuire's pay: As a money manager, the more money your client makes and has available to invest, the more you typically earn.
For shareholders, the UnitedHealth disclosures raise a further question: Do directors at other boards have personal ties that have gone unreported as well? For now, there's no way of knowing, because of the lack of clarity in the rules governing such ties.
But that could change. Securities experts say the NYSE will be forced to look closely at the language in the current regulations to see if UnitedHealth or its executives have clearly breached them. Ultimately, the flagrancy of UnitedHealth's weak disclosures could lead the exchanges to beef up their regulations to more explicitly deal with relationships between directors.
Barred for Life The questionable disclosure also raises the legal stakes for all involved. Questions about Spears's independence could bolster attempts by shareholders suing over the alleged backdating of options and McGuire's compensation to win money back from McGuire and even the directors themselves. With the SEC and federal prosecutors still weighing whether to bring civil or criminal charges over the alleged backdating against UnitedHealth and its execs, further charges related to the poor disclosure could also be added.
Columbia professor Coffee also believes that the new revelations could put Spears more squarely in the SEC's sights. If they conclude he misrepresented his independence, they could seek to have him barred for life from serving as a director of a public company. Moreover, Coffee says that if McGuire, Hemsley, or Spears were found to have misled other directors about their relationships, that would increase the chances of criminal charges being filed.
All of that, as much as any change in the NYSE's rulebook, would make clear the fact that such relationships don't pass the smell test. "We would essentially see the regulations strengthened through enforcement," says Frenkel.