HealthSouth Corporation: Fraud, Greed and Corporate Governance
Manmohan D. Chaubey, Ph.D. The Pennsylvania State University University One College Place Du Bois, PA 15801 (USA) Tel: 814-375-4846 Fax: 814-375-4784 Email:
[email protected]
Case for ICMC2006 International Conference on Management Cases 4-5 December 2006 IMT Ghaziabad, India
HealthSouth Corporation: Fraud, Greed and Corporate Governance During the 1990s, Richard M. Scrushy, Scrushy, the t he former CEO of HealthSouth Corporation, engineered many acquisitions of rehabilitation clinics, outpatient surgical care operators, nursing homes and other health care companies. In 2003, the Securities and Exchange Commission (SEC) accused the company and Scrushy of inflating inflating earnings to the tune of $1.4 billion since 1999. In November 2003, a federal grand jury indicted Scrushy on 85 counts including conspiracy, securities fraud, money laundering and charges related to overstating HealthSouth’s earnings by nearl y $3.0 billion. According According to federal investigators, investigators, the company overstated earnings to meet analysts’ earning estimates, while hiding the
accounting fraud fraud from the auditors. However, questions questions were raised whether whether the auditors failed to find or simply overlooked the fraud at HealthSouth. Central to the investigation was the issue of what role Scrushy played in “cooking the books.” However, as the case unfolded , it highlighted many other issues such as: The role o f Board of Directors in corporate governance; the role of the auditors; the effect of conflict of interest between an accounting firm and its consulting arm on auditing; whether t he relationship between an investment bank and a company affects the quality of the bank’s research reports on the company; company; whether the executive compensation compensation that overly relies on company’s earnings provide s an incentive for committing such fraud; whether a strong
leader can silence all voices of reason in an organization.
Background Scrushy, once a high school dropout, worked as a gas station attendant and a bricklayer before before retuning to school and earning his diploma. diploma. He studied studied at University of Alabama, Birmingham and graduated with a degree in respiration respirat ion therapy in in 1974. After graduation graduat ion he became an instructor at UAB. In 1979, Scrushy left the academia and took up a position at a Texas health care management firm. The firm was sold in in 1983 and Scrushy
decided to go on his own with a new business idea. In 1984, with help from some friends and an initial investment of $50,000, he founded HealthSouth HealthSo uth in Little Rock, Arkansas. In 1985 he moved moved the company to Birmingham, Alabama (Heylar, 7/7/03). HealthSouth HealthSout h went went public in 1986. Richard Scrushy spotted certain trends that he incorporated in his very successful business model for HealthSouth. These trends were: Lower reimbursement for medical care, new emphasis on rehabilitation as opposed to surgery, surgery, the need to get employees employees back to work faster, and the absence absence of brand names in health care. He also wanted his rehabilitat ion centers to look more like upscale upscale clubs than a hospital. hospital. He used his super sales skills, boundless energy and entrepreneurial skills in setting up clinics, making acquisitions and expanding the company. company. He concentrated on acquiring acquiring contracts with managed care operations and self- insured companies for workers’ compensation rehabilitation. He focused individual facilities facilities on specific ailments. To keep costs down, he standardized the physical layouts of his facilities and used same floor plan and furnishing for all locations (Hoover ’s, 2006). By 1988, HealthSouth had expanded to nearly nearly 40 facilities in 15 states. Scrushy expanded HealthSouth HealthSouth through acquisitions. acquisitions. The company acquired acquired most of the rehabilitation services business of National Medical Enterprise and became the largest provider of rehabilitation services services in 1993. By 1992, HealthSouth was generating generating revenues to the tune of $400 million million and operated 145 clinics. Scrushy formed MedPartners MedPartners and entered physician practice management (PPM) field. Scrushy engineered many acquisitions acquis itions and MedPartners MedPart ners became the largest PPM in the country. HealthSouth HealthSo uth further expanded in into to inpatient rehabilitation hospitals and outpatient surgery centers (Hoover’s, 2006). HealthSouth also entered the traditional hospital field in 2000 through acquisition of a hospital in Birmingham, Alabama and announced plans for a $300 million “digital hospital”
near its corporate corpor ate center. By 2000, the company was dominated the rehabilitation services market and was very profitable. Eventually Eventually,, HealthSouth became the largest provider of outpatient surgery, diagnostic and imaging services as well as rehabilitation services in the United States with 1,700 facilities and 51,000 empl employees. oyees. A summary of the company’s finances and number of employees is given in Appendix I. As head of third largest publicly held company in Alabama and one of the fastest growing health care companies in the country, country , Richard Scrushy became a celebrity in Birmingham (Alabama). (Alabama). As a philanthropist, philanthropist , he made sizable donations to charities charities,, churches and universities. universities. However, Scrushy was also known as an ambitious man who wanted to be the highest paid CEO in the United States. He was a strong leader, surrounded by friends and colleagues who learned to do things his way, or get out of the way. He was even called a “supercilious bully” by some ex-colleagues. ex-colleagues. Scrushy was terminated terminat ed from from the company after the SEC sued HealthSouth for “cooking the books” in March 2003 (Heylar,
2003).
The SEC Investigation & Indictments In 2003, the Securities and Exchange Commission accused in a civil law suit the HealthSouth Corporation and Richard M. Scrushy of inflating the company’s earnings by $1.9billion since 1999 (Securities and Exchange Exchange Commission, 2003). In separate criminal charges, 15 former executives pleaded guilty of pa rticipating rticipating in a scheme to fake corporate profits to meet Wall Street Expectations. The former executives pleading pleading guilty included five former chief financial officers, a senior vice president in the tax department, a financial vice president, and a vice president of investment. The scheme involved involved regular meetings among certain senior company officials to find the “dirt” to fill the earnings hole to meet Wall Street’s earnings expectations and hide firm’s true financial condition (Wilke and Terhune
(2003). Some of these these executives executives claimed that Scrushy directed the fraud. These former former
executives agreed to cooperate with the Government in exchange for leniency and for avoiding possible jail term. The SEC alleged that when HealthSouth’s HealthSouth’s earnings fell short of Wall Street analysts’
expectations, Scrushy directed company’s personnel to “fix it” by inflating the company’s earnings. HealthSouth’s HealthSouth’s senior accounting personnel convened convened meetings of so called “family members” to fix earnings. earnings. These meetings meetings agreed upon accounting accounting entrees to reduce a contra
revenue account and/or decreasing expenses, and correspondingly correspondingly increasing assets or decreasing liabilities. liabilities. Essentially, Essentially, to balance the company’s books, false increases in earnings were matched by false increases in company’s assets. Since, the contractual
adjustment accounts are based upon an estimate of the difference between what the company billed a patient and t he amount of money insurance companies reimbursed HealthSouth, there was a limited paper trail and it was very difficult for the auditors to verify individual entries (Frieswick, 2003). HealthSouth scandal is distinguished by the length of the fraud and the number (five) of CFOs who who participated. Apparen Apparently, tly, Scrushy’s powerful personality and greed that stretched from Scrushy to his five CFOs, who were o verpaid in their positions, helped contribute contribute to the t he fraud. Another structural contributor to the fraud was t he fact that most decisions were made at the executive level, which limited checks and balances along the way. Mr. Scrushy was finally indicted by a federal grand jury in November of 2003 on 85
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The SEC is expected to indict
scheme to overstate HealthSouth’s profits by nearly $3 billion . He wa wass also accused of using
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corporate funds (money laundering) to buy personal items such as luxurious cars, boats,
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famous paintings, expensive jewelry, antique rugs, etc. The IRS and other authorities traced
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during late 2003
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counts including conspiracy, conspiracy, securities fraud, money laundering and other charges related to a
assets that could be tied to alleged fraudulent acts. If Scrushy If Scrushy were found guilty of criminal charges, the government could seize and sell the assets.
In September of 2004, the U.S. attorney in Birmingham announced that Richard Scrushy faced new federal charges of perjury and obstruction of justice in a revised indictment by a grand grand jury. The new 58-count indictment indictment consolidated consolidate d the 85-count indictment that had been previously announced. Scrushy pleaded not guilty to all counts. Scrushy could face what would amount to a lifetime sentence in i n prison and a fine of more than $30 million if convicted of all charges. Prosecutors Prosecuto rs are also seeking $278 million in assets. Scrushy has denied any wrongdoing and pleaded not guilty to all charges. He was free on $10 million bail bond, while awaiting trial.
The Scrushy Trial The Scrushy trial began in January 2005. Following jury selection, select ion, the chief federal prosecutor, Alice M. Martin, alleged that Scrushy was the mastermind behind the financial fraud at HealthSouth and that he knew about, participated in, and profited from the conspiracy. conspirac y. The defense contended that Scrushy was a victim of the fraud; that the fraud was conceived and perpetrated by senior accounting personnel who misled Scrushy and the outside auditors. The defense attacked the credibility of HealthSouth’s CFOs, claiming that they agreed to t he plea bargain and to ttestify estify against Scrushy to gain reduced sentences. Former CFO William T. Owens in cooperation with the Federal Bureau of Investigation wore a recorder in a meeting with Scrushy. The tape indicated that Scrushy was a hands-on CEO who exhorted his senior executives to take measures to keep profits high and prevent losses on their stock investments. On the tape, Scrushy had warned of dire financial consequences consequence s both to Owens and to the company. However, Scrushy Scru shy never used the words fraud, illegal or scheme in nearly nearly three hours of the tape (Johnson, 2005). Owen could not point to any memo or document that would indicate Scrushy’s involvement in the fraud.
Owens was later sentenced to five years in prison along with two years of probation.
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Owens testified that Ms. Diana Henze, a former assistant vice president of finance at the company had figured out the fraud and she took her suspicions to HealthSouth’s
compliance department. department. She was transferred transferred to another division and was subsequently subsequently passed over for promotion (Reeves, 2005). Ms. Henze’s testimon y did not directly implicate Scrushy but it did corroborate that the financials submit by the company to government did not reflect reality. Kenneth Livesay, a former assistant controller at HealthSouth HealthSouth also testified that Scrushy was aware of the fraudulent scheme. His testimony also did not implicate Scrushy directly since the CEO was not present at any of the “family” meeting that he had attended. Livesay also listed all nine of the executives who were members of the family; Scrushy’s
name was not on that list. list. When asked why he did not confront Scrushy on the issue, he replied that it was not a common practice to discuss the fraud openly and that Scrushy was an intimidat ing leader whom you did not cross (Shmukler, 2005). The defense contended that Livesay and others lied to hide the fraud from Scrushy and to keep their own overpaid position in the company. Livesay was later sentenced to six months of home home confinement, five years of probation, a fine of $10,000, and a forfeiture of $750,000 in capital gains. Former chief financial officer Michael Martin pleaded guilty to fraud charges. Martin testified that he oversaw the accounting fraud from 1997 to his leaving in 2000 at the behest of Scrushy. He asserted that Scrushy asked him to rework the accounts to help meet Wall Wall Street analysts’ expectations. expectat ions. He gave pep talks at the “family” meetings assuring the
members that they will not have to do this forever and they will figure out a way to end the fraud. The defense portrayed portrayed Martin as a hothead who made idle idle threats to employees. employees. In response to a defense question on why he did not leave the company, Martin replied that he did not see a way out (Morse and Shmukler, 2005). 2005) . Martin was later sentenced to six month of home detention, forfeiture of $3,375,000 in capital gains, and a fine of $50,000.
Tadd McVay, Aaron Beam and Weston Smith were the other former CFOs who testified against Scru shy. They all testified that they had discussed the fraud scheme with Scrushy. Smith was sentenced to 27 months in prison, one year probation after his release from the prison and forfeiture forfeiture of $1,500,000 in assets. Beam received received a reduced sentence of three months in prison, $10,000 in fine, one year probation and a forfeiture of $275,000 in capital gains.
The Role of Auditors at HealthSouth HealthSouth’s auditors, auditors, Ernst and Young (E&Y) failed to uncover the $2.5 billion
systematic systemat ic overstatement overstat ement of earnings. The auditors allowed the company to keep on its books $500 million of overvalued accounts receivables owed to it by financially distressed health care technology firms. The auditors did not insist on establishing adequate adequat e reserves for these receivables (Glater, 2003). E&Y also had other non-audit non-audit business dealings with with HealthSouth. In 2000-01 the accounting firm conducted a janitorial, cleanliness and physical appearance inspection of HealthSouth HealthSou th facilit facilities. ies. E&Y used a 50-point checklist designed by Scrushy. The pristine audit scores were used by HealthSout h in its marketing campaign. The accounting firm for the inspection as “audit related relate d fee.” The work was clearly received the $2.6 million fee for
not audit related. This raises suspicion suspicion about the impartiality and independence of the auditors (Weil, 2003, 2003a).
The HealthSouth Board During the second half of 2002, HealthSouth announced the creation of a special litigation committee, composed of independent directors, to deal with shareholder lawsuits following a company warning that earnings would fall well below expectations. However, Larry D. Striplin, Jr., an old friend of Scrushy of Scrushy and a co-director of a local bank, co-contrib co-contributor utor to a local college with a baseball field called Scrushy-Striplin Scrushy-Striplin Field, and a national football
foundation, was a HealthSouth independent director appointed to the litigation committee. committee. Striplin’s company had obtained a $5.6 million contract to install glass at a HealthSouth hospital during 2002. In that year Striplin ’s glass firm had total sales of $9 million. Striplin claimed his glassglass-contracting firm submitted the lowest bid through a competitive bidding process overseen by the general contractor. On the other hand, Scrushy (in a January 2003 interview) felt surprised and upset when Striplin disclosed his company ’s winning bid in the CEO’s office. Scrushy said, “If I had known about (the bidding) I would have stopped
him…I don’t like the way it looks.” Striplin’s fellow litigation committee members heard about the contract on their first meeting and were concerned about a possible public outcry over his supposed lack of independence. independence. Within two months, months, Striplin resigned from the litigation panel, relinquished the chairmanship of the board of d irector ’s compensation committee and left the audit committee. Striplin Striplin,, however, remain remained ed on the board of directors and a member of the compensation committee (Lublin, 2003). During 2001, the year in which Striplin had led the compensation committee Scrushy received exceptional compensation, collecting $3.96 million in salary, $6.5 million in bonuses and 1.2 million in stock options. His salary in 2001 was more than double his 1999 salary. According to Striplin, Scrushy earned all that he he received. During the litigat litigat ion committee meeting, Striplin indicated that he didn ’t feel that his company’s glass contract might affect his independence or ability to challenge Scrushy. Scrushy. Having shown a lack lack of independence and a definite conflict of interest, we must really ask how the board of directors could nominate Striplin once again for a seat on the board. Did Scrushy or HealthSouth treat all board members the same way Striplin was treated? The compensation received by Mr. Scrushy was based upon the company meeting its budgetary budgetar y targets. target s. The accounting fraud fraud at the company helped to meet earning targets. target s. Mr. Scrushy received received a bonus of $6.5 million in 2001. A large part of this bonus was due to the
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alleged inflation in earning. earning. The SCE has estimated estimated that during the period of 1999-2001, Scrushy’s salary totaled $9.2 million, of which $5.3 million depended upon budgetary targets
which were attained through “cooking the books.”
Scrushy Shifts Place of Worship Prior to his indictment, Mr. Scrushy and his wife began attending weekly services at a primarily African-American African- American congregation in Birmingham. He preached regularly regularl y at black churches in Birmingham area. He also hosted a Christmas Christmas themed TV program on which he invited prominent African-American African- American ministers as guests. He also made large cash donations to these churches. Scrushy made an effort to build sympathy among among religious conservatives have questioned if Scrushy’s and African-Americans (Romero and Wilson, 2005) . Some have
motivation in all of this was to influence the predominantly black jury members.
The Verdict After 21 days of deliberation, deliberation, the jury cleared Scrushy of all 36 criminal charges. The jurors, in post-trial interview, suggested that the CFOs who testified against Scrushy lacked credibility (Johnson, (Johnson, 2005a). According According to the jurors, the prosecutors did not present present enough evidence to show that Scrushy was guilty beyond a reasonable doubt.
Appendix I
Historical Financials & Employees Year
Revenue ($ mil.)
Net Income ($ mil.)
Net Profit Margin
Employees
Dec 2005
3,207.7
(445.9)
--
24,000
Dec 2004
3,753.8
(174.5)
--
40,000
Dec 2003
3,957.6
(434.6)
--
40,000
Dec 2002
3,960.1
(466.8)
--
51,000
Dec 2001
4,380.5
202.4
4.6%
51,537
Dec 2000
4,195.1
278.5
6.6%
53,216
Dec 1999
4,072.1
76.5
1.9%
51,260
Dec 1998
4,006.1
46.5
1.2%
51,901
Dec 1997
3,017.3
330.6
11.0%
56,281
Dec 1996
2,436.5
220.8
9.1%
36,410
Dec 1995
1,556.7
78.9
5.1%
26,427
Source: Hoover’s Inc. http://premium.hoovers.com. http://premium.hoovers.com. HeathSouth Corporation-Historical Corporation-Historical Financials and E mployees.
Appendix II
Extent of Overstated Earnings as Determined by the SEC Income (Loss before Income Taxes and Minority Interests (in $millions) Actual
1999 Form 10-K
2000 Form 10-K
2001 Form 10-K
For six months ended June 30, 2002
$(191)
$194
$9
$157
Budgeted
230
559
434
340
Misstated Misstate d Amount
421
365
425
183
Misstated Percentage
220%
188%
4,722%
119
References Frieswick, Kris (2003). “How Audits Must Change”. CFO. Boston: Jul 1, 2003. Glater, Jonathan D. (2003) “HealthSouth Looks Deeper Into Its Books .” New York Times. (Late Edition, East Coast). New York, N.Y.: Jul 12, 2003. p. C.1 Helyar, John (2003). “The Insatiable King Richard He Started As A Nobody. He Became A Hotshot CEO. He Tried To Be A Country Star. Then It All Came Crashing Down. The Bizarre Rise and Fall o f Healthsouth's Richard Scrushy.” Fortune Magazine, July 7, 2003. Hoover’s Inc. (2006). http://premium.hoovers.com. http://premium.hoovers.com. HealthSouth HealthSouth Corporation-Profile, Corporation-Profile, Accessed on (August 10, 2006)
Johnson, Carrie (2005). “Credibility Credibility Of O f Ex-CFO Questioned; Owens Opportunistic, Scrushy Lawyers Say”, The Washington Post. (Final Edition). Washington, D.C.: Feb 12, 2005. pg. E.01 Johnson, Carrie (2005a ). “Jury Acquits HealthSouth Founder of All Charges”. The Washington Post. (Final edition), Washington, D.C.: Jun 29, 2005. p. A.01 Lublin, Joann S. (2003). “Boardrooms Under Renovation; Independence Of Directors Is Elusive Goal”. Wall Street Journal, (Eastern edition). New York, N.Y.: Jul 22, 2003. p. B1 Morse, Dan & Evelina Shmukler (2005). “Executives on Trial: HealthSouth CFO's Testimony May Bolster Case for Defense; Prosecution Witness Says He Punched a CoWorker, Wanted to Kill Some Others”. Wall Street Journal. (Eastern edition). New York, N.Y.: Mar 9, 2005. pg. C.4 Romero, Simon & Glynn Wilson (2005). “Race, Religion and t he HealthSouth Founder's Trial”. New York Times. (Late Edition, East Coast). New York, N.Y.: Feb 17, 2005. pg. C.1 Securities and Exchange Commission (2003). “Complaint: HealthSouth Corporation and Richard M. Scrushy”. http://www.sec.gov/litigation/ http://www.sec.gov/litigation/complaints/comph complaints/comphealths.htm. ealths.htm. Accessed on August 10, 2006.
Shmukler, Evelina (2005). “Executives on Trial: Witness Says Scrushy Skipped HealthSouth 'Family' Meetings”. Wall Street Journal. (Eastern edition). New York, N.Y.: Feb 28, 2005. pg. C.4 Weil, Jonathan (2003). “HealthSouth - Proxy Document Says Company Performed Janitorial Inspections Misclassified as Audit-Related.”. Wall Street Journal. (Eastern edition). New York, N.Y.: Jun 11, 2003. pg. C.1 Weil, Jonathan (2003a). “HealthSouth and Ernst Renew Flap Over Fee Disclosures .” Wall Street Journal. (Eastern edition). edition). New York, N.Y.: Jul 1, 2003. pg. C1 Wilke, John R., Chad Terhune & Carrick Mollenkamp (2003). “HealthSouth Ex-Chairman Faces Charges He Took Part In Big Accounting Fraud”. Wall Street Journal. (Eastern edition). New York, N.Y.: Nov 4, 2003. p. A.3.
Teaching Notes HealthSouth Corporation: Fraud, Greed and Corporate Governance Case Summary During the 1990s, Richard M. Scrushy, Scrushy, the t he former CEO of HealthSouth Corporation, engineered many acquisitions of rehabilitation clinics, outpatient surgical care operators, nursing homes and other health care companies. Mr. Scrushy had been a respiratory therapist who spotted a niche in the health care market and utilized his entrepreneurial talents, marketing skills, and super salesmanship to set up and run what became the third largest publicly held company in Alabama. Eventually, HealthSouth became the largest provider of ambulatory surgery and rehabilitative health health care services in the United States with 1,700 facilities and 51,000 employees. employees. In 2003, the Securities and Exchange Commission (SEC) accused the company and Mr. Scrushy of inflating inflating earnings to the tune of $1.4 billion since 1999. 1999. In November 2003, a federal grand jury indicted Mr. Scrushy on 85 counts including conspiracy, securities fraud, money laundering and charges related to overstating HealthSouth’s earnings by nearly $3.0 billion. According According to federal investigators, the company overstated earnings earnings to meet analysts’ earning estimates, while hiding the accounting fraud from the auditors. However,
questions were raised whether the auditors failed to find or simply overlooked the fraud at HealthSouth. Central to the investigation was the issue of what role Mr. Scrushy played in “cooking the books.” However, as the case unfolded , it highlighted many other issues such as: The role of Board of Directors in corporate governance; the role of the auditors; the effect of conflict of interest between an accounting firm and its consulting arm on auditing; whether the relationship between an investment bank and a company affects the qua lity of the bank’s
research reports on the company; company; whether the executive compensation compensation that overly relies on company’s earnings provide s an incentive for committing such fraud; fraud; whether a strong
leader can silence all voices of reason in an organization. This case can be used for teaching corporate governance, business ethics, corporate fraud, and corporate social responsibilities. responsibilities. It highlights the pitfalls in corporate management management when the various actors — directors, directors, auditors, investment bankers, company executives — work solely in the interest of a few and ignore the interests of other stakeholders. 1. What is the role of the company’s Board of Directors in: Providing oversight of company’s CEO’s performance? Protecting the long-term interest of the shareholders? Providing oversight of company’s financial performance through its audit committee?
2. A portion of executive compensation is based upon company’s performance? How can we ensure that the Executives do not use the company to their own benefit?
impartialit y and 3. What is the role of com pany auditors? How do we ensure auditor’s impartiality
independence? 4. Why is the role of ethics in management? What are the consequences of unethical behavior? 5. What is corporate corpor ate social responsibility? respons ibility? Is committing fraud not only illegal, but also unethical and socially irresponsible? 6. Are there limits to the powers of a chief executive? executive ? How can this power be controlled? 7. What is the role of other senior executives? Can you visualize senior level executives conspiring to cook the book without without the knowledge of the CEO? Under what conditions that could happen? What can prevent such a situation? situat ion?
