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Conseco's plan to align the interests of managers and shareholders has an alarming downside.
Andrew Osterland, CFO Magazine
April 1, 2000
By all rights, Rollin Dick should be contemplating a comfortable retirement about now. During much of his 14-year career at Conseco Inc., the 68-year-old CFO helped the fast-growing insurer achieve celebrity status on Wall Street. Together with CEO Stephen Hilbert, Dick steered the Carmel, Indiana-based company through a blitz of acquisitions that fashioned $8.3 billion Conseco from a host of smaller, independent insurance companies. For his efforts, he collected the usual rewards: a fat salary, multi-million-dollar bonuses, and generous stock option grants. To these, add one more thing that Dick had not counted on: crushing personal debt stemming from a management incentive program gone badly awry.
Dick's rueful experience supplies a cautionary tale for executives who dream about lavish equity stakes in their high-flying companies. Along with fellow Conseco executives who became millionaires in headier days, Dick leaped at an opportunity that seemed too good to refuse. Already a large holder of Conseco stock, he embraced the company's offer to guarantee bank loans used to purchase still more stock.
With Conseco stock trading far below the purchase price, it is fair to say that managers have never had a steeper stake in boosting the price of Conseco shares. Without a dramatic price increase, these executives have no hope of realizing any gains. At this point, in fact, a modest loss may be too much to wish for. All told, Conseco executives and directors have borrowed approximately $600 million to purchase shares of Conseco stock now worth only $295 million. Dick alone, based on his 1998 proxy filings, owes about $30 million more than the current value of his shares.
In 1996, when Conseco adopted the scheme, borrowing to buy stock seemed like a great idea. Bank of America provided the funds to senior managers and directors; Conseco guaranteed repayment and covered the interest payments with personal loans to executives. The climate was inviting. After battling skeptics and short-sellers, who saw no future for a collection of no-name life and health insurance firms, Hilbert stood on the verge of vindication. Far from stumbling, Conseco's cash flow and stock price surged.
Flush with success in 1994, Hilbert took aim at venerable Kemper Financial Services, with its attractive portfolio of insurance products and mutual funds. Investors nervous about the lofty price tag punished Conseco's stock price, and Kemper ended up in the hands of Zurich Group. Afterwards, Conseco stock resumed its upward momentum.
Green Tree Snag In the first two years of the loan program, insiders bought 8.5 million of Conseco's shares, which tripled in price during that period. A snag developed, however, on April 6, 1998, when Hilbert announced his intentions to purchase St. Paul, Minnesota-based Green Tree Financial Corp., a consumer finance company specializing in lending to owners of manufactured houses. One day after they nudged Conseco's stock to a record $58, investors gave the transaction a thumbs down. Conseco's stock price immediately slipped by 15 percent. Doubts centered on the difference between Green Tree and previous acquisitions, which relied largely on cutting costs and streamlining operations. Green Tree offered no such consolidation gains. For its investment in Green Tree to pay off, Conseco would have to become adept at cross-selling financial products to its combined customer base, a tricky strategy in the fiercely competitive financial services industry. Moreover, the quality of Green Tree's earnings was in question because of the company's aggressive accounting practices.
Investors who bailed out early look like the lucky ones. Green Tree's accounting tactics soon came back to haunt its new owner. In 1998, Conseco took a $550 million hit against earnings because of higher than expected refinancings by Green Tree customers. And instead of expanding its business, Conseco had to cut it back to satisfy credit-rating agencies, which continued to rate Conseco below investment grade. Meanwhile, cross-selling strategies have yet to show results. "They bit off more than they could chew," says securities analyst Colin Devine of Salomon Smith Barney, a unit of Citigroup, in New York.
The skidding stock price hit $15 a share in early March, leaving leveraged executives with no choice but to soldier on in hopes that Conseco could recover its luster. Much as some might like to depart, they would have to reckon first with their debts. "The company could cut their salaries by 80 percent and they are not going anywhere," says author Graef Crystal, who keeps tabs on executive compensation.
For its part, the company's official line puts a brave face on a bleak situation. "We're as closely aligned with our shareholders' interests as any company in America," says Conseco spokesman John Dolphin. Ordinarily, investors might take some small comfort in knowing that managers are suffering along with them. In Conseco's current predicament, however, alignment may not be so appealing. When managers take such large risks with their personal assets, what does it reveal about their judgment as stewards of other shareholders' assets?
Compensation consultant Alan Johnson, of Johnson Associates, says insider buying is often simply bravado. "It's kind of a macho thing to do," Johnson says. "You put your money on the line." Worse, judgment seemed to deteriorate along with managers' net worth. Insiders actually stepped up their buying as the stock price declined. They bought another 7.1 million shares in 1999 with borrowed money, before the program was discontinued this year.
Paying The Piper
So what does a company do about a $300 million shortfall? A resurgent stock price or a fat buyout premium could cause the whole problem to vanish. But with the bloom off Conseco's rose, earning investors' confidence will require exceptional results. So far, that is not happening. Operating earnings per share in the fourth quarter of 1999 slumped 29 percent from a year earlier, and 1 percent for the whole year. Wall Street's earnings consensus for calendar 2000 is now $2.83, 12 percent less than last year's results. What's more, the entire life insurance sector is out of favor with investors addicted to soaring technology stocks. And financiers looking for a bargain buyout won't bid up the price just to bail out managers.
If the price continues to languish, alternatives are not very appealing. "The company can't get out of this," says Crystal. "Stock options can be repriced, but if you [own the stock], you're talking about a genuine loss." Conseco's board members, several of whom are carrying underwater loans, have three options. They can forgive all or part of the loans; they can collect them, possibly at a cost of pushing some executives into personal bankruptcy; or they can wait. With every payment of interest, however, the problem only gets worse.
Each alternative has its drawbacks. Many companies have forgiven loans to executives. But generally, these loan agreements stipulate forgiveness as performance measures are met, and they are negotiated at the outset. Kodak, for instance, lent CEO George Fisher $8.2 million in 1993 to buy company stock, and forgave the loan over a five-year period. Such loans are treated as a form of compensation, and provided they are spelled out in advance, they seldom cause any upheaval, says Ken Bertsch, corporate governance director for TIAA-CREF, the country's largest private pension fund.
Wiping the slate clean after the fact is another matter, however. Besides the fact that it sticks outside shareholders with the tab for mistakes insiders make with personal investments, it triggers additional tax bills. With Conseco executives likely to be in the highest tax brackets, that could pile another $130 million onto the bill already due. This appears to rule out forgiveness. "They would have a shareholder revolt on their hands," one institutional investor declares.
As to shoving executives into bankruptcy, that would only spell more recriminations and legal nightmares. Instead, observers predict that Conseco will take the path of least resistance. They expect the board to refinance the bank loans next year.
While Rollin Dick puts his retirement plans on hold, Crystal suggests at least one useful application of Conseco's outsized incentive program. "You can use it as a selection device," Crystal declares. "If any executive accepts it, fire him immediately."
Andrew Osterland is a senior editor at CFO.
Ten companies that are bankrolling executive share purchases.
1. HealthSouth: $50.0 million*
2. Integrated Health Svcs.: $13.4 million
3. Tupperware: $7.7 million
4. Hilton Hotels: $5.0 million
5. Compaq Computer: $5.0 million
6. Mattel: $4.2 million
7. W.R Berkley: $3.5 million
8. Bindley Western Industries: $3.2 million
9. Safeguard Scientifics: $2.0 million
10. Borg Warner Automotive: $2.0 million
*Authorized Source: Executive Compensation Advisory Services