For some top officials at HealthSouth even those with a tolerance for Alabama heat last August must have felt like one of the most sweltering months on record.
HealthSouth began the month by dazzling Wall Street with a final upside surprise. But company insiders had plenty of reason to sweat. By mid-August, HealthSouth’s top executives were risking actual jail time in promising that the company’s earnings were real. And nervous insiders were no longer willing to cross their fingers and simply hope for the best.
After 15 years of allegedly cooking the books, HealthSouth was scrambling for a new strategy.
The company chose a complicated one. HealthSouth would suddenly split itself in two and reshuffle management in such a way that would give founder Richard Scrushy trusted lieutenants people who have since confessed to fraud in key positions at both companies. Scrushy himself would step down as CEO of HealthSouth so he could serve as chairman of both entities. And the company would blame an imminent plunge in earnings entirely on Medicare.
HealthSouth unleashed the complex plan just as August drew to a close. Wall Street, stunned by the $175 million hit from Medicare, barely noticed anything else. Management’s own focus the planned spinoff of its surgery unit went largely ignored.
“Some of us saw this [the spinoff] as just a magician’s trick of distraction,” said Fulcrum analyst Sheryl Skolnick.
At the time, HealthSouth promoted the spinoff as a way to free its surgery unit the crown jewel of the company from the Medicare problems slowing its other business segments down. But federal investigators now say that HealthSouth fabricated much of the sudden Medicare hit to help cover up a multibillion-dollar accounting fraud. As a result, some people are starting to look back at that forgotten spinoff plan with fresh suspicion.
It was “a very ballsy coverup of a very naked fraud,” one former employee concluded. “Splitting the company up would make it more difficult to trace the earnings fraud.”
HealthSouth had embraced split-up plans during tough times before.
In 1992, Scrushy declared that HealthSouth had grown so much since going public that it was “absolutely necessary” to restructure. So he laid out a plan to divide HealthSouth into three pieces each with its own president and CFO through an informal division that left the parent company intact. From there, he went on to build HealthSouth into a far-flung health care giant boasting a presence in all 50 states.
Since then, some people have started to question the company’s early restructuring. After all, Scrushy was fretting over HealthSouth’s growth less than a month after failing to pull off a high-profile merger that would have made the company even larger than it already was. And neither HealthSouth nor its larger suitor the former Continental Medical ever gave the market a real reason for calling off the merger after performing months of due diligence.
Contacted last month by reporters, Continental’s co-founder said he was prohibited from discussing the matter by a confidentiality agreement he signed after the deal was tabled. But a federal investigation, accusing HealthSouth of accounting games that date back more than a decade, has certainly raised some suspicions.
In a formal complaint and accompanying statement released last month, the Securities and Exchange Commission stated: “Shortly after HealthSouth became publicly traded in 1986, and at Scrushy’s instruction, the company began to artificially inflate its earnings to match Wall Street analysts’ expectations and maintain the market price for HealthSouth’s stock. HealthSouth’s fraud represents an appalling betrayal of investors.”
While the SEC continues to broaden its probe, the agency’s original complaint focused on an alleged $1.4 billion profit-pumping scheme that began in 1999. That’s the same year HealthSouth rolled out a second restructuring plan, this one an official spinoff intended to split inpatient and outpatient services and reignite the old fire beneath HealthSouth’s stock.
By then, HealthSouth had already built itself into the nation’s first 50-state health care chain, taking extraordinary steps to refine itself into a strong brand name that would feel immediately familiar to patients everywhere. The company even hired its longtime auditor, Ernst & Young, to help out on the side. HealthSouth kept the auditors busy, sending them out for surprise inspections to check for everything from trash in the parking lot to rust on the medical equipment at dozens of the company’s nearly 2,000 facilities every day. But the massive fraud charges now pending indicate that E&Y fared worse in its primary job of keeping the company’s books clean.
“They can’t possibly defend their negligence here because it’s so blatant as to rise to recklessness,” said a former HealthSouth employee. “E&Y could lose it all over this one.”
For its part, E&Y has maintained that HealthSouth carried out an elaborate accounting scheme that no outside auditor could detect. The SEC has lent some credence to this argument, saying that HealthSouth deliberately fabricated documents to hide the company’s true financial condition from its auditors. The agency has filed no charges against E&Y.
In the end, HealthSouth called off the 1999 spinoff and kept its chain of well-scrubbed facilities intact. That decision, coupled with an earnings warning, left Wall Street grumbling. But HealthSouth quickly set out to win investors back. And the company was well-equipped with top-dog accountants hailing from E&Y to make things happen.
James Bennett, who was president and operating chief at the time, had spent eight years as a health care accountant at E&Y before joining HealthSouth. And William Owens, the company’s CFO, got his start at the Birmingham E&Y branch that counted HealthSouth as its largest client.
Though Bennett left the company in 2000, Owens allegedly went on to help Scrushy juice HealthSouth’s earnings by more than $1 billion before the company trotted out a final split-up plan last August.
In a conference call Aug. 27, which allotted no time for analyst questions, Scrushy initially glossed past the Medicare hit by saying it would have “somewhat of a negative impact” on the company. He then spent most of his time elaborating on the “exciting” plan to spin off HealthSouth’s most successful business to create a stand-alone surgery company. Scrushy tapped Owens, who’d already risen to become president of HealthSouth, to take over as CEO. And he put HealthSouth CFO Weston Smith in charge of finances at the new surgery company.
Recently, Owens and Smith became the first in a string of HealthSouth officials to plead guilty to accounting fraud. But at the time, Scrushy described both men as outstanding leaders who would be surrounded by capable experts.
“We are dividing the management teams today,” Scrushy announced last August. “We will be very effective in terms of separating these two companies out.”
On an ordinary day, one that didn’t also bring a $175 million earnings warning, analysts might have shared some of Scrushy’s enthusiasm for the plan. After all, HealthSouth’s surgery division was already pumping out more than $1 billion in annual sales. Freed from the HealthSouth umbrella, it could feasibly fetch the higher multiples then boasted by other stand-alone surgery centers.
“It seemed logical to want to extract the value of the surgery centers from the entanglement” of the Medicare problems, Skolnick said. “You could at least take the argument without fainting from disbelief.”
But in retrospect, HealthSouth’s reasons for the spinoff no longer add up. From the time he introduced the idea until the time he scrapped it soon thereafter, Scrushy pointed to the sudden Medicare problems which were apparently overblown as a primary trigger for the division.
Today, some HealthSouth critics see the planned spinoff as little more than an elaborate coverup scheme for an even more elaborate fraud. But whatever the motive, the plan was quickly derailed. Within weeks of the announcement, the SEC had launched an investigation into HealthSouth’s Medicare warning and insider trades by Scrushy. By September, HealthSouth was calling off the spinoff because of “less than ideal” market conditions. And by January, Scrushy was rushing back to lead a company that was about to crumble around him.
After federal investigators began issuing subpoenas in February, Scrushy had just enough time for one last note of optimism. In a conference call with analysts March 3, Scrushy predicted that top management would begin meeting with the SEC in two weeks and clear away the clouds for a turnaround year in 2003.
Nine days later, the first of two HealthSouth CFOs cracked. Smith, followed by Owens and a string of finance employees, began spilling details about an alleged accounting scam that had remained a HealthSouth “family” secret for more than a decade.
By the end of March, HealthSouth had officially fired both its founding CEO and its longtime auditing firm. But critics viewed the firings as token actions taken too late by a board whose audit committee was falsely portrayed as strong and independent by former management. And some have come to see the entire HealthSouth fiasco as the Enron of the deep South.
A few believe Enron has clearly been upstaged.
“Scrushy has the makings of the poster bad boy of the Sarbanes-Oxley Act,” said a former HealthSouth employee. “This will be the biggest high-profile corporate fraud in history.”