Ernst & Young, HealthSouth’s auditors for more than a dozen years, trusted those now guilty of accounting fraud at the company and did not check some accounts investigators said were doctored, according to court testimony Wednesday.
William Miller, a principal with Ernst & Young, said the firm did not specifically audit accounts that federal investigators claim were the centerpieces of a scheme to overstate earnings by $2.5 billion.
Miller said the firm did look at HealthSouth’s accounting records and the general ledger, and found no deficiencies or inaccuracies.
HealthSouth paid Ernst & Young $3 million a year for its auditing services, James Lamphron, a partner in the auditing firm, testified.
The company had determined that HealthSouth had adequate internal controls in place, so the firm issued a “clean opinion” on all of HealthSouth’s quarterly and annual earnings reports filed with the Securities and Exchange Commission, according to Miller.
Miller said the company only issued those opinions because each time it got written assurances from HealthSouth founder and ex-CEO Richard Scrushy and HealthSouth’s chief financial officers that their books were clean. He said it was HealthSouth’s responsibility to prepare its earnings reports and verify their accuracy.
Miller testified during the ninth day of a hearing in which Scrushy is fighting to have at least $40 million of his frozen assets released.
When Scrushy lawyer Tom Sjoblom asked Miller how the fraud escaped the detection of Ernst & Young, Miller said, “We don’t know the answer to that. We don’t know the details of the fraud.”
Miller said fictitious invoices would have made it difficult for Ernst & Young to detect the manipulations.
“Pretty ingenious method, huh?” Sjoblom asked.
“Yes,” Miller said.
Miller testified that he received financial documents from Kay Morgan and Emery Harris, two accounting executives who already have pleaded guilty in the fraud.
Lamphron said the only clue to possible fraud was when a former HealthSouth employee named “Vines” sent an e-mail to the auditing company’s national Web site in late June or July 2002, requesting the firm look at suspected phony additions to the company’s fixed assets.
Bill Owens, then president and chief operating officer, and George Strong, chairman of the Board of Directors’ audit committee, discussed the e-mail with Lamphron, he testified.
Lamphron said that auditors did a two-week review, checking vouchers and the account, and concluded there was not a problem. He said he wanted Scrushy to be aware of the allegations and subsequent investigation. He said Owens told him he was.
Michael Vines, a former asset manager at HealthSouth, was one of the first witnesses called by the SEC to outline specific fraud he observed. Vines has also been identified as a frequent poster on a Yahoo! Finance message board for investors in HealthSouth’s stock. He pointed out aspects of the alleged fraud on the message board before the SEC filed its lawsuit.
Throughout the hearing, Scrushy’s lawyers have depicted him as a figurehead who was unaware of fraud carried out by executives who have pleaded guilty so far.
Sjoblom said that if Ernst & Young auditors were not able to discover the fraud, there is no way Scrushy knew about it.
“This fraud was clever, put together by a few people, a close knit group that somehow figured out to fly under the radar screen,” Sjoblom said.
Sjoblom suggests Owens, a former CFO and controller, masterminded the fraud with subordinates who came to work for HealthSouth after leaving Ernst & Young. The defense also claims Owens was attempting to overthrow Scrushy as chairman.
Ten former HealthSouth executives, including Owens, have entered into plea agreements with federal prosecutors.
One former CFO, Tadd McVay, took the witness stand Wednesday and invoked his Fifth Amendment right against self-incrimination about 70 times. McVay, also a former treasurer, agreed to plead guilty Monday, but has not entered a formal plea.
While taking the Fifth, McVay avoided a flurry of questions from attorneys for Scrushy and the SEC.
Sjoblom asked if Owens put him up to the fraud and promised him $500,000 to sign the phony third quarter earnings report in 2002. SEC attorney Bill Hicks countered with the same questions, but put Scrushy as the ringleader with the offer of half a million dollars as an incentive.
McVay invoked the Fifth each time.
Sjoblom asked if McVay hosted a meeting with Owens and others at his house last fall to discuss the coup of Scrushy from the chairman’s seat.
“You wanted more power, you wanted to be elevated,” Sjoblom insisted.
McVay took the Fifth.
Sjoblom tried to get him to admit Scrushy found out about the attempted coup and approached McVay, who then begged to keep his job.
McVay invoked the Fifth.
Sjoblom also went after McVay for a missing $300 million in cash from an alleged secret HealthSouth bank account. Sjoblom said Scrushy confronted McVay about the missing millions a week before the FBI raided the headquarters.
“Where is the $300 million, Mr. McVay?” Sjoblom demanded.
“I invoke the Fifth,” was McVay’s only reply.
Hicks said after the hearing the millions were make-believe, a fictional figure used in cooking HealthSouth’s books.
“My understanding is there is no phantom bank account or $300 million because there never was a $300 million to begin with,” he said.
The $300 million cash was made up in the second quarter 2002 earnings report HealthSouth filed with the SEC, Weston Smith, a former CFO, said in his guilty plea last month.
Sjoblom also tried to suggest McVay struck a quick deal with the U.S. attorney’s office Monday only after Scrushy’s defense subpoenaed him to appear at the hearing last Thursday. McVay was allowed to put off the subpoena for medical reasons.
Though he did sign his agreement to plead guilty on Monday, McVay has been negotiating his plea for several weeks, according to Richard Smith, deputy chief of the criminal division’s fraud section for the U.S. Department of Justice.
J. Don Foster, McVay’s lawyer, called the timing a “false issue” and said McVay planned to take the Fifth regardless of a plea agreement.
“He had a more compelling reason to take the Fifth since obviously he was a target of the investigation,” Foster said. “There is no connection between his plea Monday and his eye surgery.”
Scrushy has been fighting a freeze on his assets imposed by U.S. District Judge Inge Johnson after the SEC filed suit. The SEC accused Scrushy and HealthSouth of inflating profits by $1.4 billion. The agency also accuses Scrushy of insider trading.
A former HealthSouth executive who has pleaded guilty told investigators of another $1.1 billion in false profit. The SEC contends the fraud was orchestrated by Scrushy, who is not charged criminally but is the subject of a grand jury investigation.