A proposed $118.9 million revenue bond deal that many hoped would resuscitate Harvard Pilgrim Health Care Inc. (HPHC) was taken off the table late last Tuesday night when Massachusetts officials agreed to take the company into state receivership.

The move comes less than one week before the already-priced transaction was set to close and has left many market analysts scratching their heads.

At the epicenter of this debacle is a internal "accounting" discovery that HPHC's 1999 losses could be as much as $43 million more than the $134 million figure presented to investors in the initial bond offering prospectus. According to a source familiar with the situation, the egregious error was uncovered only after investment bank Salomon Smith Barney had pressured the state's largest HMO to finalize its disclosure documents in order that the final papers could be printed.

Alan Raymond, spokesman for Harvard Pilgrim, said that the discrepancy was primarily caused by the company's reliance on dual financial accounting systems rather than on a consolidated strategy. He explained, "We were running one system for general ledger and one for general finance and it caused the underestimations."

Harvard Pilgrim apprised state regulators of its situation last Monday morning and Massachusetts Supreme Court Justice Margaret Marshall subsequently put the HMO under the direction of Insurance Commissioner Linda Ruthardt. Salomon Smith Barney was not informed of the decision until just hours before Boston's daily newspapers went to press on Tuesday night. By that point, however, it was already a foregone conclusion that the bond offering would necessarily be scrapped due to erroneous financial statements.

This is not the first time that HPHC had trouble with its financial shortfalls. Following a reported $54 million loss in 1998, the company stunned Standard & Poor's analysts last October when it revealed a projected $100 million loss for 1999. That action helped spur a credit rating downgrade to single-B and gained HPHC a spot on the agency's negative credit watch list. Next, Harvard Pilgrim came out with the $134 million figure familiar to investors who had analyzed the bond offering.

According to S&P analyst Jack Reichman, all of this confusion would probably earn the company a triple-C-minus rating if HPHC hadn't been placed into receivership and been automatically accorded an R rating. Said Reichman, "This whole thing reflects the problems the company has had all along with poor information systems... and this despite the fact that they said they had it under control."

While Reichman stopped far short of implying any sort of management impropriety, there have been some market watchers who believe that Harvard Pilgrim may have at least suspected its error prior to last week. According to such speculation, the company hoped to complete the lease-backed deal before being forced into receivership. By this strategy, HPCH would have already gotten its financing from the sale of its properties and bondholders would have difficulty suing the company for securities fraud due to its newfound receivership statutes.

However, a lawyer unaffiliated with the transaction cautioned that such logic ignores the likely possibility of derivative action, or investors directly suing the company's officers. Moreover, Janice Hayes-Cha, deputy director of the independent state agency that planned to act as conduit issuer for the bonds, said, "We have absolutely no reason to doubt that Harvard Pilgrim has been completely forthright in terms of immediately revealing their information."

What might be even more remarkable than the assorted conspiracy theories surrounding Harvard Pilgrim is the fact that its bonds even got priced in the first place. Said one investor at the time of the deal's launch, "People have been burned pretty badly by the health care sector... they may have to wait until next year in order to get it done if they can get it done at all."

That being said, Salomon Smith Barney still had between 6-12 investors ready to finalize their commitment when the rug got pulled from under it last week.

The offering was officially issued by the Massachusetts Health and Educational Facilities Authority (HEFA), a public authority that provides access to the capital markets at low costs to health, educational and cultural institutions. It was also predicated on the proposed sale of five buildings to Civic Investments Inc., a single purpose holding entity set up by HEFA. Harvard Pilgrim was then to lease back the facilities from Civic with the lease payments, building mortgages and actual real estate assets subsequently being securitized by HEFA.

Harvard Pilgrim had originally intended to sell an additional three buildings to Civic, thus bringing the total bond issue to $147.6 million, but scaled back due to a combined lack of buy-side interest and a failure to complete an environmental review of one of the facilities. The subsequent $118.9 million was to be sold in three primary tranches, each with bullet maturities.

A market source said that Salomon had $3.6 million of commitments on its three-year notes carrying a 7.95% coupon, $66.2 million of commitments on its 17-year notes carrying an 8.65% coupon, and $45.5 million of commitments on its 30-year bonds carrying a 9% coupon. There were also buyers for $3.6 million of zero-coupon convertible equity certificates. All of the notes were tax exempt.

Massachusetts did not guarantee the bonds nor were any credit wraps included on the deal. However, a source who wishes to remain anonymous revealed that the insurance commissioner's office had agreed to pay out the coupons if the company eventually went into receivership.

Had the deal been completed, such a promise would have proved politically explosive in Massachusetts given the extensive public debate over whether or not the Harvard Pilgrim offering via HEFA was equivalent to a public bailout. The insurance commissioner's office did not return calls requesting comment on this issue.

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