The criminal indictments of two former HBO & Co. executives may scare healthcare software vendors into toeing the line on how they report financial performance to shareholders.
But the indictments by themselves won't ease high-stakes pressure in the industry for vendors to land big fish and for buyers to be able to wiggle off the hook.
The pressure arises from a sales practice in which providers must commit millions of dollars upfront for sophisticated software long before it's installed and performing as advertised, which leads customers to delay decisions and try to hedge their bets. But in doing so, they may play a role in inflating vendor revenue through illegal accounting practices.
Those are views of industry observers in the wake of federal securities fraud charges leveled late last month against Albert Bergonzi and Jay Gilbertson, co-presidents and co-chief operating officers of the Atlanta-based healthcare information systems and services company before it was acquired by San Francisco-based McKesson Corp. in 1999.
Bergonzi, 50, and Gilbertson, 40, will appear before U.S. District Judge Phyllis Hamilton this week in San Francisco. Attorneys said both will plead not guilty.
Federal prosecutors in a 17-count indictment allege that the two "systematically defrauded HBOC shareholders and the investing public" by inflating revenue and earnings through improper contracting practices and underreporting of expenses (Oct. 2, p. 2). The Securities and Exchange Commission filed a civil complaint alleging similar wrongdoing by the two executives.
The criminal indictment also identified 15 HBOC customers that agreed to various contingencies in purchasing software, which allowed prospects to sign a sales contract but gave them a way out if their remaining concerns were not resolved.
Such addendums have been common in the industry, said attorney Ed Getz, a partner in the Chicago office of Gardner, Carton & Douglas and vice chairman of its technology ventures group. "The vendor wants the deal. Providers won't do it unless the remedy is provided," Getz said.
But when contingencies are handled as separate agreements, called "side letters," they can be concealed by a vendor's officers and thus enable contracts to be counted as unencumbered revenue, which violates generally accepted accounting principles. Prosecutors allege that's just what happened in the HBOC fraud scheme.
"A side letter gives rise to questionable revenue practices on the part of a vendor, but it's not an issue of contractual concern for a customer," Getz said. "The provider's purpose is simply to get the remedy."
Prospective purchasers will have to think through such arrangements more completely, industry observers warned. "To have it as a totally side agreement begs the question of why," said Mitch Work, senior vice president of WorkingNets, an Altadena, Calif.-based company offering online resources to managers with purchasing responsibilities.
"Nobody wants to be tainted by somebody else's questionable acts," said Getz, referring to the 16 incidents in the indictment outlining illegal revenue accounting stemming from provider contractual agreements.
But sellers also are being given notice about side letters, he said. "Clearly from the lesson demonstrated in the HBOC experience, that's an unwise practice from the standpoint of the vendor."
"I think the industry has been scared straight," said Simmi Singh, chairman of the Center for Healthcare Information Management, an Ann Arbor, Mich.-based trade group for software vendors and consultants. "The books in healthcare are going to be clean for a long time to come."
That still leaves the problem of making sales and bringing in revenue. Selling to provider organizations is "a very complex, long-term endeavor" that can pit several vendors against each other in a costly campaign to win a multimillion-dollar contract, said Work, who spent a dozen years as a healthcare information technology consultant before joining WorkingNets last year.
"You're playing for high stakes," Work said of the healthcare software business. When only a few concerns such as financing or board approval stand in the way of a sale, a written contingency can pave the way for a contract signing and take competitors out of the chase, he said. "Contingencies by themselves are totally appropriate."
But in this case, the use of side letters was the "wrong way to go after a reasonably sound objective," said Singh, who is vice president of global insurance and health industry services at SeraNova, an information management company.
The contingency option has been complicated by the SEC and accounting standards authorities, which have cracked down on revenue recognition practices that record sales prematurely.
Though contingencies can seal a sale, they now prevent publicly traded companies from recording the sale as booked revenue until all the conditions are waived by the provider customer, he said. For that reason, "most vendors are loath to grant a refund remedy because it affects their revenue recognition potential," Getz said.
That could lead to situations in which a vendor will grant the contingency, but only if it's not reported as such, he said.
As long as companies are under investor pressure to meet quarterly earnings targets, the temptation to stretch the truth in disclosures to shareholders is there, Singh said.