HealthSouth Massive Accounting Scandal. As it turns out, red flags flew all around HealthSouth but no one seemed to take notice till it was too late.
Yes, a few people on Wall Street took shots at the company well before it collapsed completely. But even the most tepid reports tended to sound more indifferent than alarmed until the rehabilitation hospital chain’s accounting gimmickry was exposed and the sell recommendations at last flooded in.
Still, at least one analyst hinted last year at earnings manipulation when the stock was still $14. And even after that, HealthSouth’s board went on to approve lavish perks and gloss over related-party deals that should have at least raised some eyebrows in the post-Enron era of “corporate governance.”
Certainly, these small clues alone couldn’t have revealed a massive accounting scandal that had apparently been kept secret for more than 15 years, but they at least provided hints that something was amiss.
Just over a year ago, Banc of America analyst Gary Taylor fretted over ‘HealthSouth’ in his first-ever “Show Me the Money” analysis of earnings quality in the health care sector. Taylor included HealthSouth in a small group of health care players whose earnings quality was low, due to a widening gap between reported earnings and actual cash flow. Moreover, he singled out HealthSouth as the only company in the sector with disturbing dips in reserves sometimes a sign of earnings inflation.
“Dramatic declines in [reserves] raise a flag warranting further investigation of earnings quality,” Taylor said. At ‘HealthSouth’, he said, “Reserves appear to have fallen dramatically over the last year.”
A quarter after Taylor raised his concerns, HealthSouth’s reserves suddenly stabilized. Taylor labeled HealthSouth the “most improved performer” in his follow-up analysis last May. But he never warmed up to the stock, maintaining his neutral rating before finally throwing in the towel a year after throwing up a flag and urging investors to sell both stocks and bonds in the company earlier this week.
By then, the Securities and Exchange Commission had accused ‘HealthSouth’ and former CEO Richard Scrushy of engaging in “massive” accounting fraud that boosted earnings by at least $1.4 billion in the past four years alone. A former company CFO had pleaded guilty to fraud, and his recent successor was about to do the same. HealthSouth’s stock, which closed at $3.91 a share ahead of last week’s scandal, was on its way to pocket-change trades on the lowly Pink Sheets. And the company was skating toward probable bankruptcy.
“Unfortunately, we cannot say that we are surprised,” Taylor said in his downgrade on Monday. “We characterized HealthSouth’s earnings quality as low and identified the year-to-year balance sheet reserve reductions that are indicative of earnings overstatement.”
Still, Taylor’s concerns found only brief mention in a broad 53-page report issued on the entire sector nearly a year ago. But of course, 20/20 hindsight makes that subtle warning and a few others blindingly obvious today.
In 1998 around the time HealthSouth’s alleged $1.4 billion earnings fraud started to ramp up Scrushy scored himself a sweetened employment contract from the company he’d founded and built into an outpatient empire.
Scrushy would receive a base salary of at least $1.2 million, regardless of the company’s performance. But he could triple his compensation if the company hit its monthly performance targets. Even if ‘HealthSouth’ fell short on certain months, Scrushy could still collect the entire $2.4 million extra if the company made up for the shortfall and met all performance goals by year’s end.
In the early years of that agreement, Scrushy actually offered to delay and/or reduce some of his compensation. But by 2001 he was pulling in far more than his contract had originally promised. The company’s latest proxy shows Scrushy collecting $3.96 million in salary, $6.5 million in bonuses and 1.2 million stock options the year before news of a deep cut by Medicare and big insider sales by Scrushy triggered an SEC investigation that uncovered what appears to be years of fabricated earnings.
Just months before its fortunes turned south, ‘HealthSouth’ eagerly justified Scrushy’s generous compensation in the proxy provided to shareholders.
“Mr. Scrushy’s leadership has been essential to HealthSouth’s success and growth,” the April 2002 proxy states. “The committee believes that it is important to ensure that, if Mr. Scrushy is successful in leading ‘HealthSouth’ to achieve the goals set forth by the board of directors, his compensation will be [competitive] .”
But Scrushy apparently needed even more. He also took out a $25 million company loan, which he repaid this year by selling half his ‘HealthSouth’ shares shortly before a questionable earnings warning sent the stock into a tailspin.
Oddly enough, the chairman of the compensation committee which approved both Scrushy’s salary and his loan also serves on the company’s audit committee. Financial experts now view this rare arrangement as problematic, since the two committees are supposed to have clearly separate goals.
Still, the audit committee comprising two longtime friends of Scrushy and the CEO of a glass company wasn’t alone in conducting potentially poor police work. HealthSouth’s independent auditor, Ernst & Young, apparently never detected any signs of the rampant fraud regulators now allege took place.
In a formal response last week, Ernst & Young threw up its hands in innocence, declaring: “When individuals are determined to commit a crime, a financial audit cannot by expected to detect that crime.”
But some experts aren’t buying that claim. They fully expect regulators to broaden their net to include HealthSouth’s outside auditors and perhaps even the company’s longtime banker.
For at least 15 years, investment bankers who now work for UBS Warburg provided expert advice and arranged crucial financing to help HealthSouth grow.
But UBS also helped out on at least one side deal that stood to enrich both the bank and individual HealthSouth executives personally.
In late 1999, HealthSouth spent $2.2 million on a large stake in a private health care-related venture called MedCenterDirect.com. ‘HealthSouth’ executives and directors also personally invested in the company. So did a limited liability company controlled by UBS.
By 2001, ‘HealthSouth’ was buying more than $100 million worth of products and services through the e-commerce site. It was also propping up the company with $15 million worth of loan guarantees. Then, less than a year ago, it again joined forces with UBS to pump another $5 million worth of capital into the Internet-based venture.
In the meantime, HealthSouth went on to form Source Medical Solutions, another company partially owned by HealthSouth executives. ‘HealthSouth’ paid Source Medical $2.5 million for software-related services in 2001 and has advanced the company $82 million for startup costs and guaranteed another $6 million in Source Medical loans.
Both companies rely heavily on HealthSouth for business. The majority of HealthSouth’s 2,000 facilities buy their products through MedCenterDirect.com. And roughly 1,000 of the 3,500 facilities served by Source Medical carry the ‘HealthSouth’ name.
“HealthSouth is certainly an important customer,” said Mike Ragsdale, vice president of marketing and communications at Source Medical. “It’s impossible to know what’s going to happen, of course. But we’re here to support their efforts in any way we can.”