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Memorandum from Consumer Groups to State Regulators — Preliminary Issues Raised by the Regence/HCSC Affiliation

April 23, 2001

1. Introduction
On March 12, 2001, The Regence Group (“TRG”),(1) an Oregon public benefit corporation, and Healthcare Service Corporation (“HCSC”),(2) an Illinois mutual legal reserve company, filed a Form A with the insurance commissioners in Idaho, Illinois, Oregon, Texas, Utah, and Washington. In their Form A, HCSC and TRG expressed their intention to establish an “affiliation” of Blue Cross and Blue Shield (“BCBS”) plans in all six states.
Through their affiliation, the companies state that they are attempting to achieve economies of scale by consolidating a number of “background” services in an operating company (called “Opco,” for now) to be incorporated as an Oregon nonprofit mutual benefit corporation, while local health plans in each of the six states will continue to perform services that “touch the customer.” TRG and HCSC will be Opco’s only members and will capitalize Opco with $10 million.(3) A group of “interlocking” boards of directors will govern TRG, HCSC, and Opco. Overall, HCSC will possess the greatest number of seats on each board. Some individuals will apparently be members of all three boards. Form A, Section IV.
We, a coalition of consumer advocates, are concerned that this proposal may constitute a change of control by TRG in favor of Illinois-based HCSC, and that it may pose risks to nonprofit assets belonging to the people of Idaho, Oregon, Utah, and Washington. We are also concerned that the boards overlap so greatly that their members may not be able to avoid conflicts of interest. Because this deal is complex, we have developed a list of preliminary questions that we believe should be answered as the companies move forward with their proposal. As we learn more about this proposal, we may add new questions to this list.
2. Does this “affiliation” effectively transfer control of TRG to HCSC?
HCSC will acquire majority control of TRG following the affiliation. Buried in the complexities of this proposal are troubling provisions that appear to transfer control to HCSC of the plans in Idaho, Oregon, Utah, and Washington. HCSC will assume majority control of the boards of directors of TRG and the new Opco.(4) (See discussion about incorporation of Opco below.) Not only will HCSC have majority control of all three boards, the boards will also overlap so greatly that the same 17 individuals from HCSC and TRG will apparently control all three boards. It appears that the HCSC board has 10 directors who will also be on the TRG and Opco boards. It also appears that the TRG board has 7 directors who will also serve on the HCSC and Opco boards. The Opco board has 10 HCSC directors and 7 TRG directors, presumably the same people who will also control the TRG and HCSC boards. If the same 17 individuals are serving on all three boards, how can TRG and HCSC remain “separate and distinct corporations”? Form A, Section IV(c). If the companies are effectively merging, doesn’t this affiliation constitute a change of control of TRG, especially since HCSC will have a majority on its board as well as the joint Opco board?
Nonprofit assets may be transferred out of state, and HCSC rather than TRG will control the corporations empowered with making these decisions. Given the nonprofit character of the assets of TRG and the BCBS plans in Idaho, Oregon, Utah, and Washington, we are concerned that the Restated Articles and Bylaws vest far too much power in HCSC. As mentioned above, for transfers of assets from TRG, the Oversight Council has the authority to approve board votes on “material” transfers to HCSC. Yet, nowhere in the documents is “material” defined, and HCSC maintains control over enough seats on the TRG board to approve any non-“material” transfers. Will regulators require TRG and HCSC to define this term with specificity so that it is clear whether there is a potential risk of losing nonprofit assets in non-“material” amounts? If the companies are unwilling to balance the corporate boards with more TRG members, doesn’t this demonstrate that HCSC is gaining control?
TRG is also losing control over the transfer of assets from TRG to Opco. TRG’s Restated Articles and Bylaws set forth a newly constituted board and an “Oversight Council”(5) with certain prescribed powers. The Oversight Council has the important powers to vote on conversions of corporate form and “material” transfers of assets from TRG to HCSC. But the TRG board, controlled by HCSC directors, will maintain ultimate control on most issues. Compare Restated Bylaws of TRG Article II with Article V.(6) For example, the TRG board would be authorized to make transfers of assets, “material” or otherwise, to Opco. This, we believe, poses a significant risk to nonprofit assets belonging to the people of Idaho, Oregon, Utah, and Washington.
As a condition of approval, will regulators require TRG and HCSC to articulate a clear mission statement and a plan reflecting Opco’s nonprofit asset obligations to the people of Idaho, Oregon, Utah, and Washington? Will regulators impose upon the parties caps on the amounts of assets that can be transferred to Opco? The premise of the Oversight Council is to review certain decisions of the board, yet the Council is itself made up of the same Regence States Directors already on the board. As a result, the oversight council protects against HCSC-led decisions, but there may be other decisions relating to conversions and other specific transactions that should be reviewed independently. TRG’s nonprofit assets would be better protected by a truly independent oversight mechanism.
3. Does this “affiliation” effectively transfer control of TRG to HCSC because the Opco board of directors is controlled by HCSC members?
The formation of Opco. Fundamental to this affiliation is a proposal by HCSC and TRG to incorporate in Oregon a nonprofit mutual benefit corporation, referred to as “Opco” in the Form A. TRG and HCSC will be Opco’s only corporate members and will initially capitalize Opco with $10 million. Opco will enter into separate Administrative Service Agreements with TRG, HCSC and each of the existing Regence plans to perform certain services.(7) HCSC and TRG hope to generate economies of scale “in the background” with consolidation of these services while leaving other services that “touch the customer” with each of the local plans.
HCSC will have a controlling interest in Opco. HCSC has majority control of the Opco board. HCSC directors control 10 of 17 seats on the Opco Board. A super-majority is required for the sale, lease, transfer, or pledge of all or substantially all of the assets. Opco Bylaws, Article III, §11(c)(ii). Yet, it would appear that a simple majority of the directors present at a meeting can dispose of any other amount of assets–an amount less than “substantially all.” Bylaws, Art. III, §11(a) & (b). Following the language of the Bylaws, it is possible that a group of HCSC directors could dispose of Opco, and thus TRG, assets. Will regulators require TRG and HCSC to define “substantially all assets” and will regulators impose caps on what assets may be disposed of? Does the agreement to form Opco, on its face, impede the ability of TRG officers and directors to protect the assets of TRG and thus represent a breach of their fiduciary duty to TRG?
HCSC maintains firm control of its own board. Although HCSC obtains considerable control of the boards of Opco and TRG, it gives up little power in return. While HCSC’s Board will include TRG directors, the HCSC directors on the board alone constitute a quorum because HCSC possesses more than a majority (12 of 19, or 63%) of the seats on the board. HCSC Bylaws, Article V, §5. HCSC also has a majority of the seats on the TRG board. It also appears that HCSC will nominate the TRG and HCSC Board of Directors who will sit on HCSC’s Nominating and Governance Committee. HCSC will also vote all proxies for those nominees. Bylaws Article V, §1. Regulators should consider how this structure can be termed an “affiliation” when most of the power appears to be held by HCSC.
Given the volume of services that will be provided to the plans by Opco, will the “tail wag the dog”? Read in its entirety, the Administrative Services Agreement suggests that Opco will have significant control over all of the plans’ management and administrative functions and allows those plans to transfer funds to Opco. Is the creation of Opco a mechanism for HCSC to control the plans and their assets? Does this mean that the plans will have little say in strategic and operational planning, corporate development services and financial support of their own organizations?
Why was it necessary for the plans to create Opco? The filing indicates that Opco will have no employees and simply exists to subcontract with the member plans for services. Why is Opco necessary? Given that the work will be done by the member plans, can they not contract with one another to have that work done? This way, the nonprofit assets of the Idaho, Oregon, Utah, and Washington plans would not be put at risk. Instead, the creation of Opco leaves us wondering if it is simply a complex tool to mask a real takeover.
4. How will directors who serve on more than one board avoid conflicts of interest?
Board composition should be changed to eliminate the overlapping board members and thereby avoid recusal/quorum problems. Given the “interlocking boards” of directors, how will the 17 directors who apparently serve on all three boards avoid the inevitable conflicts of interests that will arise from time to time? Given the usual rule that a conflicted board member should recuse him/herself on any vote that presents a conflict, how can the companies obtain a quorum on any issue where TRG and HCSC have divergent interests? Article XI of TRG’s proposed Bylaws appears to turn a “blind eye” to the potential for conflicts when it summarily declares: “Any director whose interest in any transaction arises solely by reason of the fact that he or she is an officer or director of an Affiliate Company or Subsidiary that is entering into such a contract or transaction with the Corporation may be counted when present at meetings of the Board of Directors for the purpose of determining the existence of a quorum and may participate in any discussion or vote with respect to such contract or transaction.” This blanket waiver of conflicts of interest is very troubling.
More fundamentally, we question the need for overlapping board members, and we wonder what the purpose is, if not to effectuate what is essentially a merger. We are concerned that this is a way to achieve a merger without going through the formalities of actually merging the companies, and we wonder what regulatory and statutory requirements the parties are avoiding by not formally merging.
The potential for conflict is further demonstrated by the provisions outlining the manner in which third party solicitations must be handled. Section 6.06 of the Definitive Transaction Agreement requires that a party notify the other if it receives any solicitation regarding an Extraordinary Business Combination, defined in the Appendix as any sale, transfer, etc of 10% or more of the assets. This section says that the parties shall consult with one another, but the board of directors of each company “shall be entitled to exercise and fulfill their respective fiduciary duties with respect to their response [to the proposal].” Given that the boards are overlapping, the directors’ fiduciary duties to their different boards will likely conflict. If TRG is offered a great deal, the HCSC-affiliated directors (who control a majority of the TRG board) can prevent TRG from exercising this option if HCSC views the deal as contrary to its best interests.
1 The Regence Group is currently affiliated with Regence BlueShield of Idaho, a nonprofit mutual insurance company, and Regence BlueCross BlueShield of Oregon, Regence BlueCross BlueShield of Utah, and Regence BlueShield (Washington), nonprofit corporations incorporated in their respective states.
2 The Blue Cross and Blue Shield plans in Illinois and Texas are divisions of Healthcare Service Corporation.
3 See chart, “HCSC-Regence Proposed Corporate Structure,” and “Key to Chart,” attached.
4 HCSC States Directors control 12 of 19 seats on the HCSC Board; HCSC States Directors control 10 of 19 seats on the TRG Board; and HCSC States Directors control 10 of 17 seats on the Opco Board.
5 The proposed “Oversight Council” is in some ways a misnomer. While the Council provides a second review on any proposed conversion, it is composed entirely of Regence Directors, providing little or no true public accountability for what happens to Regence’s nonprofit assets. Instead, the Council provides for a second “rubber stamp” of a proposed conversion, rather than true oversight. A more appropriate oversight council would include representatives of consumer organizations, Regence enrollees, and staff from the Insurance Commissioner’s office and the Attorney General’s office in each state.
6 We are struck by the Regence and HCSC claims that the transaction is an “affiliation” which will allow each party to retain its own management and individual identity. Such claims have been made in other corporate takeovers only to be later abandoned. For example, when German car manufacturer Daimler merged with Chrysler, the two companies claimed it was a “merger of equals.” Later, the head of Daimler said “that he’d never thought of Chrysler as a partner at all, and that the ‘merger of equals’ talk was just puffery to make it easier for Chrysler to sign the deal.” Surowiecki, James, Chrysler’s New Best Friend, The New Yorker, December 25, 2000 at 64.
7 Among the services to be provided by Opco are financial support, information system, legal, human resource, procurement, corporate development, legislative/regulatory policy, claims, and HIPAA compliance. (Form A, Section IV(a).)