HealthSouth Corporation: Fraud, Greed and Corporate Governance Manmohan D. Chaubey, Ph.D. The Pennsylvania State 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, the 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 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 nearly $3.0 billion. According to federal investigators, the company overstated 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 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 quality of the bank’s research reports on the company; whether the executive compensation that overly relies on company’s earnings provides 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 retuning to school and earning his diploma. He studied at University of Alabama, Birmingham and graduated with a degree in respiration therapy in 1974. After graduation 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 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 in Little Rock, Arkansas. In 1985 he moved the company to Birmingham, Alabama (Heylar, 7/7/03). HealthSouth 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, the need to get employees back to work faster, and the absence of brand names in health care. He also wanted his rehabilitation centers to look more like upscale clubs than a hospital. He used his super sales skills, boundless energy and entrepreneurial skills in setting up clinics, making acquisitions and expanding the company. He concentrated on acquiring contracts with managed care operations and self-insured companies for workers’ compensation rehabilitation. He focused individual 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 40 facilities in 15 states. Scrushy expanded HealthSouth through acquisitions. The company acquired most of the rehabilitation services business of National Medical Enterprise and became the largest provider of rehabilitation services in 1993. By 1992, HealthSouth was generating revenues to the tune of $400 million and operated 145 clinics. Scrushy formed MedPartners and entered physician practice management (PPM) field. Scrushy engineered many acquisitions and MedPartners became the largest PPM in the country. HealthSouth further expanded into 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 center. By 2000, the company was dominated the rehabilitation services market and was very profitable. 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 employees. 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, Richard Scrushy became a celebrity in Birmingham (Alabama). As a philanthropist, he made sizable donations to charities, churches and 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. Scrushy was terminated 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 Commission, 2003). In separate criminal charges, 15 former executives pleaded guilty of participating in a scheme to fake corporate profits to meet Wall Street Expectations. The former executives 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 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 executives claimed that Scrushy directed the fraud. These 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 earnings fell short of Wall Street analysts’ expectations, Scrushy directed company’s personnel to “fix it” by inflating the company’s earnings. HealthSouth’s senior accounting personnel convened meetings of so called “family members” to fix earnings. These meetings agreed upon accounting entrees to reduce a contra revenue account and/or decreasing expenses, and correspondingly increasing assets or decreasing liabilities. 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 the 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 participated. Apparently, Scrushy’s powerful personality and greed that stretched from Scrushy to his five CFOs, who were overpaid in their positions, helped contribute to the fraud. Another structural contributor to the fraud was the 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 Deleted: The SEC is expected to indict counts including conspiracy, securities fraud, money laundering and other charges related to a scheme to overstate HealthSouth’s profits by nearly $3 billion. He was also accused of using Deleted: i corporate funds (money laundering) to buy personal items such as luxurious cars, boats, Deleted: famous paintings, expensive jewelry, antique rugs, etc. The IRS and other authorities traced Deleted: during late 2003 Deleted: ; assets that could be tied to alleged fraudulent acts. 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 jury. The new 58-count indictment consolidated 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 prison and a fine of more than $30 million if convicted of all charges. Prosecutors are also seeking $278 million in assets. Scrushy has denied any wrongdoing and pleaded not guilty to all charges. He was Deleted: is free on $10 million bail bond, while awaiting trial. The Scrushy Trial The Scrushy trial began in January 2005. Following jury selection, 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. 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 the plea bargain and to testify 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 both to Owens and to the company.