INTRODUCTION AND HISTORY HealthSouth Corporation is the nation’s largest provider of inpatient rehabilitative healthcare services1; it was founded in 1984 by Richard M Scrushy along with four other people as Amcare, Inc., it opened its first facility in Little Rock Arkansas and another one a year later in Birmingham Alabama. In 1986 the company went public and was listed on the NASDAQ Stock Exchange under ticker symbol HSRC. Throughout the 1980’s and 1990’s the company expanded rapidly through mergers and acquisitions. By 1992 the company had $400 Million in annual revenues and by the end of 1999 the company’s annual revenues exceed $1 Billion and it had expanded to 118 inpatient rehabilitation hospitals, 5 medical centers, 1,379 outpatient rehabilitation centers, 230 surgery centers, 129 diagnostic centers and 124 occupational medicine centers.2 HealthSouth has always participated actively in the Medicare program and they’ve received Medicare reimbursements since the eighties and nineties, to extent that over 40% of their revenues came from the Medicare program and beneficiaries in that time period, and in their more recent filings this percentage has increased to a whopping 70% in 2010.3-4 HealthSouth’s stock trades on the New York Stock Exchange (NYSE) under the ticker symbol HLS, with a December 9, 2011 closing price of $16.94, a market capitalization of roughly $1.61 Billion. In 2010 their revenues were $1.99 Billion and their Net Income $899 Million.5 From 1996 to 2002 CEO Richard M. Scrushy received approximately $267 million in compensation from HealthSouth, including more than $7.5 million in base salary, more than $53 million in bonuses, and stock options valued at more than $206 million when exercised. He also received valuable benefits including company loans, and the use of automobiles, aircraft, and other HealthSouth assets.6
THE SALE The first sign of trouble surfaced in 2002, when Scrushy sold HealthSouth shares worth $75 Million on May 14 and $25 Million on July 31, prior to releasing a market warning on August 27 indicating that quarterly earnings would not be in line with expectations because a change in Medicare legislation that could “significantly lower reimbursements”.7 The disclosure caused the stock to fall more than 50% while the sale triggered the FBI to open a criminal investigation against Scrushy for “possible securities violations”,8 while at the same time a number of HealthSouth shareholders filed civil lawsuits against the CEO for insider trading. 9 An independent law firm concluded the sale was not directly related to the loss, but investors should have taken the warning.
THE ALLEGATIONS AND THE CHARGES On March 18, 2003 the FBI served search warrants and raided HealthSouth’s headquarters in Birmingham, Alabama and left with an unspecified amount of financial documents.10 A day later the Securities and Exchange Commission (SEC) charged HealthSouth and Scrushy with accounting fraud by inflating earnings by at least $1.4 Billion since 1999,11 later the Justice Department identified another $1.1 Billion in overstated earnings, and finally in November of the same year a federal Grand Jury indicted Scrushy on 85 counts including conspiracy, securities fraud, money laundering and charges related to overstating HealthSouth’s earnings to meet analyst’s earnings estimates. According to federal investigators, the company overstated earnings to meet analysts’ earnings estimates, while hiding the accounting fraud from the auditors.12 The investigation centered on Scrushy and the role he played in “cooking the books”, however the role of Board of Directors in corporate governance, the role of the auditors, the effect of conflict of interest between the accounting firm and its consulting arm on auditing, whether the relationship between an investment bank and a company affects the quality of the bank’s research reports on the company; whether the executive compensation that overly relies on company’s earnings provides an incentive for committing such fraud; whether a strong leader can silence all voices of reason in an organization were highlighted.13 The SEC explained the scheme involved meetings (quarterly) among some senior company officials, prior to earnings releases, to create “dirt” to fill the earnings hole to meet Wall Street analysts’ earnings expectations and hide firm’s true financial condition, thus fixing the “problem”. HealthSouth’s senior accounting personnel convened meetings of so called “family members” to “fix” the earnings. These entries primarily consisted of reducing a contra revenue account, called "contractual adjustment", and/or decreasing expenses, (either of which increased earnings), and correspondingly increasing assets or decreasing liabilities. Essentially, to balance the company’s books, false increases in earnings were matched by false increases in company’s assets. Since, the contractual adjustment accounts are based upon an estimate of the difference between what the company billed a patient and the amount of money insurance companies reimbursed HealthSouth, there was a limited paper trail and it was very difficult for the auditors to verify individual entries.14

HOW THE ETHICAL DILEMAS STARTED It is my argument that the accounting fraud didn’t happen overnight. In order to understand how it snowballed to $2.7 Billion, I ask that we back almost 25 years to 1986, a couple of months before HealthSouth would go public. At that time, CEO Richard Scrushy and CFO Aaron Beam met with their investment banker so he could review the company’s financials prior to underwriting the public offering, the banker asked Beam how he was treating the start-up costs, to which he answered he was “expensing” them, the banker suggested a more aggressive approach, that he should “capitalize” which would make HealthSouth’s financials profitable from day one, the accounting adjustment was made and the HealthSouth went public. I consider this to be one of the crucial turning points in the accounting scandal although no fraud was even perpetrated15; Scrushy learned accounting could be “flexible” and “changed to your benefit”. This small concession would lead to a greater compromise and eventually fraud. In the late 80’s and early 90’s HealthSouth was growing at a pace of 20%-30% per year, but as the company matured it was getting harder to meet the analysts’ earnings estimates, the company was growing but at a more modest rate than the one estimated by analysts, this was primarily due to changes in Medicare that modified the way they reimbursed costs and also competition were getting more aggressive, the company then moved to a more aggressive style of accounting by lowering their reserves for bad debts which would increase income, and continuing to meet analysts’ estimates16-17. During the 2nd Quarter of 1996 the company was falling well short of analysts’ estimates. CFO Aaron Beam and Controller Bill Owens met with CEO Richard Scrushy to inform him that quarterly earnings would not meet analysts’ estimates, to which Scrushy adamantly answered that was not going to happen and they were not going to report “bad numbers”, he argued in an intimidating fashion that the numbers could be “fixed” because it had been done before and, he also argued that if earnings were not met their own stock options would be worthless, their names would be tainted and investors would be disappointed. This was the point of no return, as the three men conspired to report false earnings, with the help from Owens, who was a former CPA for HealthSouth’s auditing firm, he knew auditors would not scrutinize any accounting entry under $5000; finally Owens created hundreds of false entries totaling $4 Million to meet analysts’ estimates18. This was the time to notify the regulators to avoid prosecution, but the prospect of enriching and benefiting themselves proved to be enough motivation to forgo their ethical values to fraudulently inflate their operation and the financial condition of HealthSouth. In 1997 after four quarters of fraudulently inflating the numbers CFO Beam quit, albeit he didn’t report the wrongdoings immediately, and over the next couple of years the company went through several CFO’s, Michael Martin (97-00), William Owens (00-01), Weston Smith (01-02) and Malcolm McVay (02-03)19. HealthSouth’s fraud is distinguished by its size, complexity, length and the number of overpaid CFO’s who participated and contributed to the fraud20. On July 30, 2002 US Congress passed the Sarbanes-Oxley Act in large part as response to the Enron-Arthur Anderson fraud; one of the most important provisions included was Section 302 which created new responsibilities for company executives. Both CEO and CFO had to sign and attest under oath that all the information contained in the filing was true21. By the time SOX was passed Weston Smith had taken over as CFO, he and William Owens went to Scrushy in an effort come clean and finally release the correct information about earnings, to which the CEO argued the same guilt and sob story he had previously told former CFO Beam to get him to inflate the earnings, but this time Smith found out that Scrushy was in the midst of selling some of his stock options and he could not afford to have any bad news about the company because he would lose a significant portion of this profits. A couple of weeks later, Smith decided he was not going to sign the new SOX attestation, he was threatened by Scrushy and ultimately signed based on the fear that something bad could happen to him and his family.22 In August 2002 Smith finally gave in and signed the attestation, which is a direct violation of Sarbanes-Oxley, a couple of days later HealthSouth announces the drop in profits for quarter. HealthSouth shares dropped two thirds; this prompted an SEC investigation into the timing of the announcement and large sales of stock by CEO Richard Scrushy in May and July, as possible insider trading. 23 In March 2003 CFO Weston Smith decides to contact federal investigators and come clean, however they had already been contacted by Controller William Owens months before and on March 18, 2003 the FBI raided the headquarters of HealthSouth. CEO Scrushy is indicted on November 4, 2003 on 85 counts from securities fraud to conspiracy. As a result of Securities and Exchange Commission charges, the Justice Department charged HealthSouth for overstating its earnings but additionally for submitting fraudulent Medicare cost reports and fined the firm in excess of $450 Millions in 2003.24
CONCLUSION
HealthSouth’s case should teach us a powerful lesson on corporate governance, business ethics, corporate fraud and corporate social responsibility. It highlights the pitfalls in corporate management when the various actors - directors, auditors, investment bankers, company executives – work solely in the interest of a few and ignore the interests of other shareholders. Too many corporate managers, auditors, and analysts let the desire to meet earnings expectations override good business practices. There were several warning signs that investors should have detected, but the most distinct one was that HealthSouth matched analysts’ earnings expectations for 48 consecutive quarters from 1998 to 2002, which simply doesn’t happen. Ethical issues occur in all professions but the accounting profession has experienced arguably the deepest crisis in its history with the discovery of fraudulent financial reporting scandals at companies such as Enron, WorldCom, Tyco and HealthSouth to name a few.25 The passing of Sarbanes and Oxley, after decades of self-regulation for accounting professionals is the step in the right direction; however it is also pertinent to mention the importance of auditing, morality, ethics (both personal and corporate). HealthSouth was able to keep their scheme going for 7 years because there was collusion at the highest levels of management which made the crime very difficult to catch.