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The HealthSouth Scandal

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Abbie Bergtholdt

on 24 September 2014

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Transcript of The HealthSouth Scandal

The HealthSouth Scandal
Corporate Accounting Fraud
"Activities undertaken by an individual or company that are done in a dishonest or illegal manner, and are designed to give an advantage to the perpetrating individual or company."
Many companies seek to falsify financial statements to make the company appear more successful than it actually is
Corporate fraud in the US has affected market values, destroyed private 401(k) plans, and devalued public pension funds. Tyco, Dynegy, WorldCom, and others joined Enron’s fraudulent accounting ranks in 2002. HealthSouth became a member of that disreputable group a year later
Aaron Beam "The CFO Unwilling to Speak Out"
HealthSouth Corporation
Based in Birmingham, Alabama, HealthSouth is the United States's largest owner and operator of inpatient rehabilitative hospitals
The company was incorporated on February 22, 1984 by its founder Richard M. Scrushy
Throughout the mid-1990s, HealthSouth expanded rapidly through mergers and acquisitions. In 1995 the company changed its name to HealthSouth Corporation to better reflect its diversified interests in healthcare
The Damage
On March 19, 2003, the SEC charged HealthSouth and its CEO, Richard Scrushy, with accounting fraud

Fifteen HealthSouth accounting and finance executives pled guilty by the end of 2003, and Scrushy remained under indictment in mid-2004 on 85 criminal charges

HealthSouth was the first company to violate Sarbanes-Oxley

Where are they now?
Scrushy has been out of prison for 2 years and still forcefully denies having done anything wrong at HealthSouth, and blames subordinates for its troubles
He has talked to potential investors about starting up a company to take advantage of opportunities opened up by Obamacare
Works as a motivational speaker
Beam & Smith now lecture business students on corporate ethics
Beam has recently self-published a book about his experience, titled HealthSouth: The Wagon to Disaster
Detection of the Fraud
In late 2002, Richard Scrushy sold $100 million in stock right before he announced that profits were expected to fall. He claimed deceptively that this was due to a change in Medicare funding

Scrushy was attacked, class actions by shareholders followed and the SEC started investigating insider trading

Following the Enron scandal criminal investigators started looking at accounting practices in other companies. HealthSouth became a target towards the end of 2002
How did they do it?
Instead of expensing start-up costs, they would capitalize them

They would manipulate ledgers to scheme auditors and keep sold assets on the balance sheets

They made multiple entries to inflate its perceived earnings and push its shares to ridiculous heights.

They methodically added the extra non-existent money in multiple small amounts.

These inflated figures were used to secure bank loans and raise money from the market.

The inflated script was used to buy all its competitors which further boosted its stock.

They also boosted its income stream by defrauding Medicare and cheating on patient care.

Richard Scrushy "Ringleader"
Weston Smith
"The CFO turned Whistleblower"
At the company's height in 2003, it recorded nearly $4.5 billion in revenue, dominated the rehabilitation, surgery and diagnostic services market and employed more than 60,000 people at 2,000 facilities in every state of the U.S. along with its facilities in the United Kingdom, Canada, Australia, Puerto Rico and Saudi Arabia
The company was the largest publicly listed healthcare company in the US based on the number of locations and the third based on revenue
So where did it all go wrong?.......
Who was involved?
Accounting Personnel
CEO and Founder of HealthSouth
He was the son of a middle class family and worked to support his family
He earned his GED, and began studying respiratory therapy at Wallace State Community College. He later entered the respiratory therapy program at the University of Alabama at Birmingham (UAB)
Scrushy was offered a position teaching at UAB, where he was promoted to director during his two and a half years there
In the late 1970s, he was offered a position with Lifemark Corporation, a Houston, Texas based health care company, and within years became CEO
Scrushy left Lifemark in 1983 and founded Amcare, Inc. The new company had initial capital between $50,000-$70,000. With the assistance of 4 partners from Amcare Inc. and a $1 million dollar investment by Citicorp Venture Capital, Scrushy took the quickly growing company and founded HealthSouth in 1984
What Happened to HealthSouth?
Founder, Chairman, and CEO, Richard M. Scrushy, was accused of directing company employees to falsely report grossly exaggerated company earnings in order to meet stockholder expectations
The story of how the books were “cooked” involves several people and simple methodology
Top company officials reviewed quarterly unpublished financial results and compared the results to market expectations. If they were short, managers were ordered to “fix it.”
Accounting staff members then held “family meetings” to manipulate the results which they called “filling the gap”
4th CFO
Worked for E&Y before Owens recruited him to HealthSouth
Credited with being the first-ever whistleblower to warn federal investigators
He came forward after the U.S. Congress passed the Sarbanes-Oxley Act of July 2002
1st CFO
A CPA who cofounded the company in 1984
"Very nice guy, a give-you-the-shirt-off-his-back sort of guy,"
Micheal Martin "The Director of the Fraud"
Bill Owens "The Architect of the Fraud"
2nd CFO
HealthSouth treasurer
Succeeded Beam after he retired in 1997
CFO for 3 years
3rd CFO
A CPA, and worked for Ernst & Young for five years before joining HealthSouth as controller in 1986
Coined as the leader of a group of executives who committed the fraud
Tadd McVay "The Refinancer"
5th CFO
Joined HealthSouth in 1999 after a stint as CFO of Capstone Capital Corp., a Scrushy-controlled firm
Helped HealthSouth refinance its long-term debt in 2002
By January 2003, however, Scrushy had demoted McVay to treasurer and pulled Owens back into the CFO spot
The HealthSouth auditors were Ernst and Young
E&Y failed to uncover the $2.5 billion systematic overstatement of earnings
They allowed the company to keep on its books $500 million of overvalued accounts receivables to it by financially distressed health technology firms
The auditors did not insist on establishing adequate reserves for these receivables
Management knew that the auditors automatically looked at any transaction over $5,000.

Therefore, employees would only move small amounts of money at a time - between $500 and $4,999.

Income was overstated by almost $5 Billion. If the average journal entry was $2,500, it would have required around two million journal entries and all the documentation to support the fabricated entries.
How was the fraud concealed?
There were no direct entries to revenue
The paper trail was limited
There were several intermediate journal entries, making it more difficult to trace
Entries spread over various facilities
Avoided exceeding a certain dollar amount threshold for additions to fixed assets at any particular facility
Created false documents to support fictitious accounting entries

Employees knew not to question Scrushy's requests, for they feared for their jobs if they did. The intimidating environment is what kept employees from coming forward for so long.
Detection of the Fraud continued...
In February 2003 the SEC ordered documents which HealthSouth was forced to give them

The recent SOX corporate reform law had increased penalties. Senior accountants confessed to their involvement in the fraud. (Smith & Owens)

In the middle of March 2003 the FBI and the SEC raided HealthSouth's headquarters. The next day civil actions were commenced against Scrushy and HealthSouth. The company was delisted from the stock exchange

General Information
"We can't dissappoint Wall Street"
Pressure to meet Wall Street's revenue expectations
Wanted to keep their spot on Fortune's 500 list
The focus during that time on sales volume and good economic news created a compelling incentive for companies to adopt aggressive accounting policies
"This is just temporary"
"Everyone does it"
Started to believe it was just business
If accounting policies and procedures didn't violate GAAP, then it was viewed as compliant with GAAP. If it was GAAP, it must be legal – and if legal it must be morally and ethically acceptable
The Fraud Triangle
Scrushy provided an "What I say goes" environment, where he knew his employees were too fearful to not follow his fraudulent ways and ideas
Technical Skills
Employees at HealthSouth saw that you could slightly change the numbers and get away with it
They knew accounting practices well, and how to take advantage of them
In the 1990s, there was a convergence in the US of several forces creating economic growth/wealth at a pace never seen before
The Extent of the Fraud
& Role of Accounting Personnel

A forensic audit conducted by Pricewater-houseCoopers concluded that HealthSouth earnings were overstated by anywhere from $3.8 billion to $4.6 billion dollars

The scandal’s postmortem report found additional fraud of $500 million, and identified at least $800 million of improper accounting for reserves, executive bonuses, and related-party transactions
Ken Livesay "The Assistant Controller"
Assistant Controller and Chief Information Officer
He would download the company’s true earnings
into his computer, figure out how much adjustment
(fraud) was needed to meet analyst’s earnings expectations, and pass along the figures to two superiors in the Finance department
He went from a disapproving participant to a willing and committed participant
Hannibal "Sonny" Crumpler "The Controller"
VP & Division Controller
A willing participant from the beginning
He attended meetings where the “gap” would be identified and found where to put the fraudulent postings
He would give the staff accountant’s fake journal entries to put on the company’s books.
How the Fraud Could Have Been Prevented

Diana Henze "The Voice that went Unheard"
VP of finance in 1998
She confronted then-controller Owens, accused him of fraud, and later told her boss, Ken Livesay, that she intended to report the fraud
Because of the way HealthSouth was structured, a complaint like Diana's had to go up the chain of command to be properly investigated
Requested and received a transfer out of accounting and into the IT group.
The Punishments
Richard Scrushy
Denied any knowledge of the fraud
He and his defense team went to great lengths to put together an extremly manipulative strategy to portray him as an innocent bystander
In June 2005, Scrushy was acquitted on all 36 of the accounting fraud counts against him, most notably one count in violation of the Sarbanes-Oxley Act
In 2006 he got a bribery conviction for paying $500,000 to former Alabama Governor Don Siegelman's campaign for a state lottery in exchange for a seat on a state hospital regulatory board. He spent about five years in federal custody.
In June, 2009, he was sued for fraud by HealthSouth investors and ordered to repay his company $2.8 billion.
Permanent "officer and director ban"
Aaron Beam
Received three months in prison, $285,000 in criminal fines and forfeitures, and legal fees in excess of $750,000
There was a degree of leniency in exchange for his testimony against Scrushy
Ken Livesay
Avoided jail time
Received 5 years probation
Had a $10,000 fine, had to forfeit $750,000 for his part in overstating HealthSouth's earnings and assets, and spend six months under electronic monitoring
Ernst & Young
E&Y was fined, sued, and required to pay $109 million by the stock holders
The suit contends that they were aware of fraud at the company even as they signed its financial statements
Agreed to the settlement without admitting to or denying the allegations
Aaron Beam on the Scandal
Michael Martin
Received a three year prison sentence and $2,450,000 in fines and penalties
Bill Owens
Sentenced to 5 years in prison
The judge did not impose a fine, citing Mr. Owens's inability to pay
Weston Smith
Received 27 months in federal prison with 2 years of probation
Ordered to forfeit $1.5 million in ill-gotten gains
Tadd McVay
Received 5 years probation
Fined $10,000 and ordered to forfeit $50,000
Hannibal "Sonny" Crumpler
The only executive, other than Scrushy, who pleaded not guilty to involvement and who went to trial by jury to be convicted
Sentenced to 8 years in prison and a fine of $1.4 Million
The longest term imposed in the huge accounting scam
Diana Henze
Was not implicated in the wrongdoing
Government Regulations Enacted as Result of HealthSouth Scandal

Public Company Accounting Reform and Investor Protection Act
Corporate and Auditing Accountability and Responsibility Act
Pay close attention to dramatic increases and decreases in stock prices
Perform Trend Analysis, which measures changes over time in a company’s financial statements
Perform Ratio Analysis, which can compare different items in a single company’s current financials or contrast them with similar items in the financials of competitors or other companies operating in similar industries
Ethical Organizational Culture starting at the top
Strict internal controls
Strained relationship between management and the auditors
Red Flags
Unusual increase in journal entries made
Receivables that are not correlated with revenues
Reserves that are not correlated with balance sheet items
Earnings that consistently and precisely meet analysts’ expectations
What I learned...
What Happened to HealthSouth?
Robert P. May was elected as interim CEO and Joel C. Gordon as Chairman
Guy Sansone, of Alvarez & Marsal, came in as interim CFO in March 2003 to help stave off bankruptcy and begin the refinancing process as well as regulatory settlements
HealthSouth never had to file for Chapter 11 Bankruptcy Protection
New policies, such as hiring an outside firm to handle whistle-blower calls and scheduling the board to meet independently with auditors, have been instituted
CEO is deliberately relaxing the culture in hopes of easing employees' learned fears about speaking the truth
Lower-level managers are being given more authority over areas like purchasing
The company completed its recovery and relisted its stock on the New York Stock Exchange under the symbol HLS
It currently operates one division: inpatient rehabilitation
The audit function is important
Collusion among several members of management makes the commission of crimes almost impossible to stop and difficult to catch
Small concessions lead to greater compromises and, unchecked, will lead to serious ethical lapses and even crime
The culture of the company is simply the sum total of its leadership and employees

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