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A Diagnosis of Fraud At HealthSouth

Apr 14, 2003 | FT.COM

They are tearing down Richard Scrushy in Birmingham, Alabama. The former chief executive of scandal-hit HealthSouth is a ubiquitous presence: there is a Vestavia Hills Richard M. Scrushy public library; a Jefferson State Community College Richard M. Scrushy campus; a Scrushy-Striplin baseball field at Birmingham-Southern College; a Scrushy Parkway.

Now, at the corporate museum at HealthSouth's headquarters, all the personal memorabilia have been removed. At the American Sports Medicine Institute someone has sprayed "thief" on a statue of its benefactor.

The saga of US corporate scandals that began with Enron, Tyco and WorldCom is moving from the sublime (remember Dennis Kozlowski's $6,000 shower curtains?) to the ridiculous. The wrongdoing discovered at the US healthcare group may involve far smaller sums but the greed and deceit are arguably every bit as egregious. No fewer than three former chief financial officers have admitted taking part in accounting fraud. They are members of a larger group of insiders known as "the family" that, federal prosecutors say, massaged quarterly earnings to meet Wall Street's expectations over a period of 15 years or more.

In the past five years, the Department of Justice alleges, earnings and assets were overstated by $2.5bn. At its peak, in April 1998, HealthSouth's market capitalisation was only $12.2bn. The company, founded in 1984, runs nearly 1,700 facilities, including outpatient surgery, rehabilitation and diagnostic imaging centres, mostly in the US.

As it struggles to stave off bankruptcy, its fall will be remembered as the first fraud to be targeted under the Sarbanes-Oxley Act, the sweeping corporate governance legislation passed last year in response to scandals at Enron and elsewhere. But, just as tellingly, the discovery of wrongdoing also stems from a closer general scrutiny of boardroom behaviour.

Regulators allege that a large number of employees and billions of dollars of improper accounting were involved. They say staff at the head office inserted incorrect entries into many of the books sent to Birmingham from about 1,450 health centres.

To avoid arousing the suspicion of Ernst & Young, the independent auditors, which have now been fired, numbers were increased by small amounts in a variety of places. The most profitable trick, say prosecutors, was the manipulation of estimated health insurance payments to inflate revenue. The books of 255 health centres run as joint partnerships were avoided.

"While you had a number of people involved, the head perpetrators really kept a lot of the other conspirators in the dark," says Bryan Marsal, who was recently hired as a restructuring specialist by the company. "They basically knew what the guidelines were of Ernst & Young and the [adjusted numbers] fell below guidelines."

Court papers filed by the Securities and Exchange Commission, the US's chief financial regulator, broadly bear out that analysis. But E&Y is scarcely exonerated. It will have to explain not only why it signed off fraudulent books for so long but also its action on specific accounting issues. The amount of cash on HealthSouth's balance sheet, one of the easiest items to check, was overestimated by $300m at one point.

E&Y says it is outraged by the malfeasance at its former client. It emphasises that neither it nor any of its staff "are the subject or target of any investigation".

With the DoJ having secured nine admissions of guilt, attention is closing in on Mr Scrushy, a figure reviled by HealthSouth's new management as the "imperial leader". Mr Scrushy, who has been fired by HealthSouth and is accused of accounting fraud and insider trading in a civil case lodged by the SEC, maintains he is innocent of any wrongdoing. In court last week, in a separate hearing to regain control of some of his frozen assets, he took his Fifth Amendment right to silence in response to most questions.

But people close to the company insist the fraud was maintained for so long because of his influence. As chief executive, they say, he held sway over a circle of young, ambitious locals glad to accept an opportunity that was rare in Birmingham: a chance to be a leader in a Fortune 500 company and amass wealth. The parties and glamorous lifestyle were even more of a draw.

Emery Harris, one of the senior executives who admits helping inflate earnings, was only 33 and already a group vice-president. Other mid-level executives, including those who admitted their guilt last week to conspiring to commit securities fraud, were hired with little accounting experience but given senior finance positions relatively quickly.

According to plea agreements, Rebecca Kay Morgan, 35, rose to group vice-president of finance though she had taken only a few accounting courses when she was first hired in 1987. Cathy Edwards, 39, was also employed by the accounting department with no experience and later became vice-president. Both women helped falsify ledgers and account statements, practices they said they were assured were to be temporary.

Mr Scrushy, meanwhile, was making a name for himself around town. He attended one gala function after another, playing in country music bands, and donated millions of dollars to Birmingham charities. Even last month, as investigators closed in, he was still being lavish with company money: 10 days before he was put on leave Mr Scrushy was buying four-year deals on corporate boxes at some of the southern US's top leisure venues. "There were just wasteful, shameful things going on here at a corporate expense level right up until the eve of his departure," Mr Marsal says.

The "family" had been nervous about the extent of the accounting fraud since last year, prosecutors say. But their fears were heightened by the arrival of Sarbanes-Oxley, in particular its requirement that chief executives and chief financial officers swear to the accuracy of company accounts in SEC filings. Prosecutors' lawsuits say Mr Scrushy was persuaded to rein in the fraud. As a result, HealthSouth embarked on a second, smaller deception to mask the bigger problem.

In an attempt to whittle down Wall Street expectations, Mr Scrushy agreed to a scheme that would blame reduced earnings on a change in billing rates on Medicare, the federal healthcare funding system. In late August, HealthSouth announced that the Medicare change would reduce its annual earnings by about $175m - a false estimate, according to the SEC, which says the figure should have been $20m-$30m.

The shares fell nearly 44 per cent to $6.71 that day. With the revelation on September 19 that the SEC had started an insider trading investigation, shares fell another 27 per cent to $3.05.

Core staff, including Mr Scrushy, are accused of having improperly sold shares for years. The SEC says that since 1991 Mr Scrushy sold "at least 13.8m shares for proceeds in excess of $170m", based on knowledge of HealthSouth's "actual financial results and the impact that disclosure of those results would have".

Beyond Birmingham, the power of the Scrushy charm was also waning. Late last year Providence Capital, a New York investment group led by Herbert Denton, began to circle the company. It bought a stake in HealthSouth when the shares were about $4, then began to sound out other shareholders about making changes.

In the post-Enron atmosphere, Mr Denton quickly found support. Some 50 shareholder representatives turned up at Providence's offices in Manhattan's 5th Avenue. Another 100 or so fund managers and assorted shareholders thought the company needed to be remodelled and dialled into the conference call. Providence says about 40 per cent of the shares were represented.

Mr Scrushy was also on the telephone, listening to a brewing rebellion focused on the number of his long-time acquaintances on HealthSouth's board. He had to sit through a litany of allegations and repeated accounts of bad governance and ill-treatment of shareholders. Providence set out numerous transactions between HealthSouth and companies in which it held an interest; dealings between independent directors and the company; company loans to executives; repriced stock options; a prior Medicare probe settlement with the Department of Justice; profit warnings; executive share sales; and a host of one-off charges against earnings.

Mr Scrushy, people on the call say, handled the complaints with aplomb. "The company was working to improve matters," one person recalls. "No one suspected fraud at that stage." But another person says HealthSouth's credibility hardly shone through, adding: "I'm not surprised at what has happened since."

Mr Scrushy embarked on a governance charm offensive in New York. He saw a handful of respected experts and tried to hire them for a four-person advisory committee that would find outside directors and suggest reforms. Mr Denton agreed to take part and in January the company announced it was looking to recruit more outside directors. An eventual overhaul of the board beckoned; and perhaps that would in time have exposed wrongdoing.

Meanwhile, though, regulators were receiving help from Weston Smith, a former chief financial officer. According to prosecutors, people had started to come forward at the start of the year, complaining of pressure and of not wanting to commit perjury before a grand jury looking at alleged wrongdoing in the company. Sarbanes-Oxley had increased the penalties for white-collar crime from five years to, in some instances, 20 years. Alice Martin, the US attorney running the Justice Department's case in Birmingham, says: "We've had witnesses say that Sarbanes-Oxley was discussed among the accounting people."

The HealthSouth prosecution is now proceeding at speed, a prime example of the new "real-time" law enforcement against white-collar crime. Under this approach, charges are brought as soon as there is enough information to do so, rather than waiting until the investigation is complete.

The aim is to help rebuild the confidence of investors battered by boardroom trickery and poor disclosure. But making an example of HealthSouth may invite another conclusion: if the old regulatory regime failed to catch a fraud of such scale and duration, investors will wonder, how many more are out there?

Richard Shelby, head of the Senate banking committee, happens to come from Tuscaloosa, just a few miles from Birmingham. "Corporate fraud continues to erode investor confidence," he says. "We have not gotten to the bottom of these problems yet. There are more to come."

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