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IN RE WELLCARE MGMT. GROUP

April 29, 1997

In re THE WELLCARE MANAGEMENT GROUP, INC. SECURITIES LITIGATION


The opinion of the court was delivered by: MC AVOY

 I. BACKGROUND

 Before the Court are two motions to dismiss the plaintiffs' *fn1" Amended Complaint pursuant to Fed. R. Civ. P. 9(b), Fed. R. Civ. P. 12(b)(6), and 15 U.S.C. § 78u-4, *fn2" brought separately by (1) the defendants WELLCARE MANAGEMENT GROUP, EDWARD A. ULLMAN, and MARYSTEPHANIE CORSONES, the respective former president and present chief financial officer of Wellcare (the "Wellcare defendants"), and (2) the defendant DELOITTE & TOUCHE, Wellcare's auditors for the 1993 and 1994 fiscal years.

 It is the Wellcare defendants' position that the plaintiffs' Amended Complaint fails to plead scienter as required under § 10(b) of the Securities and Exchange Act of 1934. In addition, and assuming that the Court agrees with the Wellcare defendants' first position, the Wellcare defendants contends that the plaintiffs' § 20(e) claim, alleging controlling person liability, should be dismissed.

 It is the defendant Deloitte & Touche's position that the plaintiffs have failed to allege a viable § 10(b) claim.

 The Court now turns to the factual allegations made by the plaintiffs against each category of defendant.

 A. Wellcare Defendants

 The class period is March 28, 1994 through May 14, 1996.

 The defendant Wellcare is a managed health care holding company. Wellcare's revenue consisted largely of premiums earned by WCNY, a wholly owned subsidiary health maintenance organization. One of Wellcare's largest expenses was the medical expenses incurred by WCNY. These "medical expenses" include hospital charges, physician fees, and related health care costs, and estimates of benefit claims incurred but not yet reported. This case relates to alleged improper accounting and reporting activities by the defendants aimed at deceiving investors by artificially inflating reported revenues and deflating expenses.

 The defendant Edward Ullman is Wellcare's founder, and served as Wellcare's Chairman, President, and Chief Executive Officer from its inception in 1983 until April 30, 1996. Ullman remained as a director and President of Wellcare until September 10, 1996, when he was replaced as President. Ullman signed each of the company's Form 10-K annual reports and Form 10-Q reports filed with the SEC during the class period.

 Ullman was employed under a four-year agreement which provided for an annual bonus of 2% of Wellcare's uncapped pretax profits for 1994, and 2% of Wellcare's net profits up to a maximum of $ 200,000 per year thereafter. Ullman was also entitled to receive an additional bonus if so determined by the Board of Directors. Under Ullman's employment contract, he was entitled to receive options to purchase shares of Wellcare common stock on January 1 of each year during the term of his employment and stock appreciation rights that vested 25% each calendar year.

 The defendant Marystephanie Corsones joined Wellcare, from Coopers & Lybrand, as Finance Director in July 1993, and since May 1994 has served as Wellcare's Chief Financial Officer and Vice President of Finance. Corsones has been a member of Wellcare's Board of Directors and Audit committee since November 1994. Corsones signed each of Wellcare's 10-K and 10-Q forms beginning in the second quarter of 1994.

 The Amended Complaint alleges that the price of Wellcare stock was artificially inflated as a result of the Wellcare defendants' knowing or reckless conduct which caused Wellcare to report inflated revenues, lower medical expenses, and lower medical loss ratios for the years ended 1993-1995, all in violation of §§ 10(b) and 20(a) of the Securities Exchange Act of 1934.

 To sustain the price of its stock, Wellcare had to demonstrate that it was a growing company. This allegedly led to a series of actions by the Wellcare defendants designed to show higher earnings and reduced expenses.

 The following transactions are alleged by the plaintiffs as the basis for their claims:

 Purchase of Mid-Hudson

 Mid-Hudson Health Plan, Inc. ("Mid-Hudson") was a not-for-profit HMO that had been managed by Wellcare since it was established in 1984. The plaintiffs allege that Mid-Hudson was no more than a shell corporation, dependent on Wellcare for its existence. The alleged wrongdoing by the Wellcare defendants occurred in connection with the acquisition of Mid-Hudson.

 When Wellcare acquired Mid-Hudson, it accounted for the acquisition as a purchase in Wellcare's year-end 1993 financial statements. The plaintiffs contend that Mid-Hudson was always a "special purpose entity," and as such, the acquisition should have been treated as a consolidation, thereby merging the financial statements for each entity. The ultimate result of treating the acquisition as a purchase rather than a consolidation was to inflate the net income of Wellcare from $ 2.830 million to $ 4.648 million, and earnings per share from $ 0.56 to $ 0.93. In addition, Wellcare recognized $ 6.549 million of "Goodwill," i.e., the difference between the purchase price of $ 2.44 million and Mid-Hudson's negative net worth of $ 4 million. Thus, Wellcare's assets and retained earnings were overstated by $ 4.109 million. The plaintiffs further allege that such accounting procedures do not comply with GAAP.

 1994 Transactions

 Again with the aim of showing increased net income and reduced expenses, the plaintiffs allege that Wellcare engaged in a series of improper transactions in 1994. In brief, on April 5, 1994, Ullman directed the payment by Catskill Medical of over $ 100,000 to doctors to whom Wellcare owed money, despite the fact that some of the debts predated the incorporation of Catskill Medical. On May 13, 1994, Wellcare received a $ 250,000 payment from Catskill Medical which was accounted for as a deficit payment, thereby reducing the amount of medical expenses incurred by Wellcare, despite the fact that there is no record of Catskill owing Wellcare such an amount. In late June 1994, 40 checks totaling $ 1,500,000 were received by Wellcare. However, the true source of these funds was two bank loans personally guaranteed by Ullman. In 1994, a total of $ 2.7 million was transmitted by companies such as Catskill Medical to Wellcare. Such funds were accounted for as deficits, but actually came from bank loans guaranteed by Ullman. The plaintiffs allege that medical expenses were understated by Wellcare in 1994 by $ 4.7 million, despite the fact that such expenses were actually rising.

 Sale of Wellcare Medical Management to PrimErgy, Inc.

 The plaintiffs also allege that in 1995, in an effort to create the illusion of profitability, Wellcare sold Wellcare Medical Management, a wholly owned medical management subsidiary, to PrimErgy, Inc., for $ 570,000 cash and a note for $ 5.13 million. However, PrimErgy, Inc. allegedly was formed for the sole purpose of acquiring Wellcare Medical Management. In addition, just prior to the sale, Wellcare allegedly transferred $ 5.1 million to Wellcare Medical Management. The significance of this sale was to show the note as an asset on Wellcare's books, despite the dubious value of the note. Apparently, Wellcare Medical Management was virtually worthless absent the cash transfer from Wellcare. Wellcare even retained an option to repurchase Wellcare Medical Management in five years. Finally, it seems that Ullman personally guaranteed a $ 3 million line of credit to sustain the thinly capitalized PrimErgy shortly after the sale.

 Sale of Bienestar Trademark

 A March 16, 1996 Barron's article first publicized these transactions. The price of Wellcare stock immediately fell 12%. Within two weeks, despite an initial rebuttal to the article, Wellcare announced that it believed "a restatement will be required."

 Wellcare then submitted a Form 12b-25 Notification of Late Filing with the SEC seeking two weeks additional time for the completion of an audit to permit further review and investigation as a result of the Barron's article. The two weeks became two months.

 Ullman was removed as Chairman and Chief Executive Officer, NASDAQ notified Wellcare that it was delisting the company's common stock, effective May 13, 1996, and the ...


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