HealthSouth Corp. and its chief executive, Richard Scrushy, may have been dealt a knockout blow by federal authorities who last week charged the nation's biggest rehabilitation hospital company with "massive accounting fraud" and a systematic betrayal of tens of thousands of investors.
The U.S. healthcare industry, scarred by several high-profile fraud cases in recent years, also could feel the long-term reverberations of a sensational scandal involving one of its best-known executives and a nationally recognized company with sites in all 50 states. If nothing else, the case could dramatically alter the landscape of leadership, setting the stage for the end of Scrushy's decades-long reign as one of the industry's most flamboyant personalities.
While many hospitals and healthcare systems have taken steps to tighten accounting controls and improve governance, the allegations against HealthSouth are almost certain to focus renewed attention on continuing concerns and problems (See Special Report, p. 26).
Tom Scully, administrator of the federal Centers for Medicare and Medicaid Services, declined to comment specifically about the HealthSouth case but said it "represents a need to look at bad corporate governance in the healthcare industry."
The charges also could pose an image problem for the industry and hinder its lobbying efforts, already threatened by the possibility of an expensive war with Iraq.
HealthSouth, according to the Securities and Exchange Commission, overstated profits by at least $1.4 billion since 1999 to meet or exceed Wall Street estimates. The allegations came just seven months after an earnings restatement and insider-trading charges triggered the investigation, sending HealthSouth stock tumbling to record lows.
Scrushy, the 50-year-old country-music buff who founded HealthSouth in 1984 and served as its chairman and chief executive officer, was placed on administrative leave last week amid allegations that he conspired to commit one of the largest corporate accounting frauds in U.S. history--and the biggest such case ever to involve the healthcare industry.
If the allegations prove true, HealthSouth will join companies like Enron Corp., Global Crossing, WorldCom and Tyco International in a national rogue's gallery of corporate greed and duplicity.
Federal officials contend HealthSouth consistently overstated earnings over many years to prop up the stock of well-heeled executives such as Scrushy, who netted nearly $100 million from two big trades in the months before a controversial profit warning in the summer of 2002 sliced the value of HealthSouth stock nearly in half within 24 hours.
Whenever earnings fell short of Wall Street's expectations, according to federal authorities, Scrushy demanded that his accounting personnel "fix it" by cooking the books with artificial earnings. At one point in 1997, according to the complaint, Scrushy rejected advice that he abandon the alleged scheme, saying, "Not until I sell my stock.' "
Federal authorities have said Scrushy may face criminal charges. One day after Scrushy was stripped of his job, the SEC obtained a court order to temporarily freeze "substantially all" of his assets.
The SEC said it believes that earnings in the company's 2001 annual report were overstated by "at least" 4,700%, despite Scrushy's certification under oath, on Aug. 14, 2002, that it contained "no untrue statement of a material fact." To balance HealthSouth's books, federal officials said, the fraudulent increase in earnings was matched by false increases in assets, a process that led to an $800 million overstatement of assets by the third quarter of 2002.
"HealthSouth's fraud represents an appalling betrayal of investors," said the SEC's director of enforcement, Steven Cutler, who announced the allegations March 19, the morning after agents from the FBI raided HealthSouth's headquarters in Birmingham, Ala.
The allegations, contained in a 19-page civil complaint filed in U.S. District Court in Birmingham, represent another black eye to an industry still reeling from the outlier-payment scandal that has tarred Tenet Healthcare Corp., Santa Barbara, Calif. The day before the charges were announced against HealthSouth, Tenet--also in the midst of a federal investigation--revealed its plan to sell or consolidate 14 of its 114 hospitals (See story, p. 6).
Scrushy, a one-time physical therapist who built his rehabilitation behemoth through a series of acquisitions and mergers, was not available for comment. A spokesman for HealthSouth released a two-sentence statement that read, "The recent events at HealthSouth's corporate office do not affect our ability to provide quality patient care. Our operations across the country continue uninterrupted."
On the same day the SEC filed its complaint, the U.S. Justice Department announced that HealthSouth's former chief financial officer pleaded guilty to four criminal charges, including securities fraud and the false certification of financial records. Weston Smith, 42, a resident of Hoover, Ala., who served as CFO from about August 2001 to August 2002, also agreed to cooperate in the government's investigation of HealthSouth, authorities said.
Smith, expected to provide key information in the government's case against Scrushy, is the first corporate official charged in connection with the Sarbanes/Oxley Act, the securities legislation enacted last year to help quell investors' fears in the wake of Enron and other corporate debacles. The law requires the CEOs of about 1,000 of the largest publicly traded companies to certify their financial statements for accuracy.
"This is the first prosecution to come under Sarbanes/Oxley; unfortunately, it involves the healthcare industry," said Larry Sanders, the chairman of the Chicago-based American College of Healthcare Executives and a leading industry proponent of ethics and good governance.
Arthur Levin, director of the New York-based Center for Medical Consumers, a not-for-profit advocacy group, warned that the allegations illustrate the potential problems with a trend toward privatization in the healthcare industry.
"Look at this year alone--what's happened at Tenet and HealthSouth," Levin said. "Do we want to put our healthcare system in the hands of folks who are apt to do this? It does raise questions about the wisdom of believing that privatization is the right solution."
Board shakes up management
HealthSouth's board moved swiftly to stanch the bleeding, placing Scrushy and CFO William Owens on administrative leave the day after the SEC leveled the charges. The board also created its own committee to launch an internal investigation and named two of its own members to replace Scrushy: Joel Gordon as acting chairman of the board and Robert May as acting CEO.
Frank Morgan, an analyst with Jefferies & Co., Nashville, said the company's board must act quickly and decisively to install a new leader who can regain the confidence of banks, employees and referral sources. He noted that HealthSouth, which has about 51,000 employees and is the only healthcare company operating in all 50 states, boasts a wide range of hard assets--1,229 outpatient rehabilitation clinics, 203 outpatient surgery centers, 117 rehabilitation hospitals and 127 diagnostic imaging centers.
"I don't think there's an issue of whether this is going to be a going concern," he said. "It's what happens with management, how they deal with this debt, that will make a difference. They've got to get the banks on board."
Polishing healthcare's image
For the healthcare industry, the allegations against HealthSouth and the developments involving Tenet came at the same time about 4,000 top healthcare administrators were gathered in Chicago for the ACHE's annual Congress on Healthcare Management. The ACHE has focused on ethical questions and good governance in recent years, even though the healthcare industry has so far weathered the storms of several fraud scandals.
At the same time HealthSouth was making national headlines as the latest poster child for corporate shenanigans, the ACHE was promoting its new "Image Campaign," using its Web site to invite its members to "enhance the image" of healthcare executives with advertisements, press releases and editorials provided by the organization.
Sanders, the ACHE's chairman and CEO of Columbus (Ga.) Regional Healthcare System, said the allegations highlight the fact that every industry, healthcare included, must have a series of checks and balances to ensure proper accounting procedures. He said he feared the allegations would tar the entire industry.
"It's appalling, really, to see any company do what has been alleged here," he said during a break in the ACHE meeting last week. "There's got to be an impact. It's almost like what happened in corporate America. So there's bound to be some impact on the healthcare industry.
Sanders highlighted the need for high ethical standards in healthcare management in a commentary in Modern Healthcare (March 17, p. 46).
"Of course, this is not a healthcare issue," he said. "This is a financial issue, a corporate issue. I don't read this as anything negative about the provision of healthcare. The unfortunate thing for healthcare is that it happens to be a healthcare company. I'm just sorry that healthcare has to be tainted by the potential wrongdoing of a couple of people."
That negative perception also may have implications in the way the healthcare industry is viewed on Capitol Hill, where elected officials determine how much money hospitals receive in federal programs.
Richard Wade, spokesman for the Chicago-based American Hospital Association, acknowledged that the allegations against one of the industry's best-known companies will have an immediate impact on that perception, saying, "This is like a huge rock that lands in a mud puddle--if you're standing anywhere near it, the mud's going to get all over you."
Wade said HealthSouth has declined past invitations to join the AHA. HealthSouth is a member of the Federation of American Hospitals, the Washington-based trade group that represents many of the nation's investor-owned hospital chains and healthcare systems.
When it comes to important funding decisions for the nation's healthcare system, Wade said, federal lawmakers will be able to distinguish between an investor-owned giant such as HealthSouth and the not-for-profit community hospitals that make up the bulk of the AHA's membership. "This will cause the people on Capitol Hill to ask some tough questions. HealthSouth is a niche player. It's a discrete part of the healthcare industry. Those people (on the Hill) will differentiate HealthSouth from the rest (of the healthcare industry)."
The ACHE's Sanders said he hoped the federal government wouldn't see accounting fraud as a pervasive practice among healthcare companies. "This is one of thousands of healthcare providers," he said. "This should not be seen as signal of some problem with Medicare and Medicaid."
The SEC's complaint charges that HealthSouth's scheme to overstate earnings began almost from the time Scrushy took his company public in 1986. Scrushy and several lieutenants would name a "desired" earnings-per-share number each quarter and insist that the accounting staff find some way to meet those expectations. Evoking images of something out of the "Godfather" movies, the officials were known by code names as the "family." "By 1997," the SEC complaint said, "the attendees referred to these meetings as `family meetings' and referred to themselves as `family members.' "
HealthSouth reported income before taxes of about $1.6 billion from 1999 through June 30, 2002, when it actually earned $169 million, according to the SEC. To balance the ledger, officials created false documents, going so far as to alter an existing invoice, the SEC said.
In August 2002, according to federal authorities, senior officers at HealthSouth convinced Scrushy to discontinue the false statements by blaming sharply reduced earnings on the changes in Medicare billing for group therapy. While Scrushy said it would reduce annual earnings by about $175 million, his financial officers estimated that it would cost only $20 million to $30 million a year--a relative pittance for a company expected to generate about $4.3 billion in revenue this year.
The complaint said Scrushy, convinced by senior officials to lower earnings expectations, devised the "scheme to blame" it on the new Medicare rules, which required providers to bill at lower group therapy rates when treating multiple patients in a single time period. "Scrushy intended that, by lowering Wall Street expectations, this press release would reduce the need to artificially inflate earnings in the future," the complaint said.
Faced with civil fraud allegations and the prospect of potential criminal charges, Scrushy is now in a fight for both his personal and professional lives. The big question is whether he--and his company--can survive the pummeling. Federal authorities are seeking repayment of any "ill-gotten gains" as well as unspecified civil penalties. The government also is seeking to freeze the assets of Scrushy, who is one of Alabama's richest men, and bar him from being a director of any publicly held company. In 2001, Scrushy was paid a salary of $4 million and a bonus of $6.5 million that was based on the allegedly fraudulent earnings goals.
Investors lose confidence
Investor reaction was swift. Standard & Poor's and Moody's Investors Service both lowered HealthSouth's credit ratings, focusing concerns on $345 million in convertible notes that come due April 1. In one report, S&P noted that it is "unclear how responsive the company's bank group will be should it need their assistance" in the refinancing of those notes.
Morgan, the Jefferies analyst, raised concerns that HealthSouth might not have enough cash on hand to satisfy that debt. "We know, according to the pleadings, that (assets were) inflated by $800 million as of June," he said. "You don't know, with this debt coming due, if there's enough cash on the balance sheet to fund the obligation."
The ratings agency said HealthSouth had about $3.3 billion of debt outstanding as of Dec. 31, 2002. Trading in HealthSouth stock was suspended by the government, a step taken by the SEC only twice in the last quarter century. HealthSouth's stock was valued as high as $18.30 a share as recently as early September 2001. Its all-time high was $30.56 in 1988. Before trading was suspended last week, it closed at $3.91 a share.
Ernst & Young, HealthSouth's outside auditing firm, is cooperating with authorities, according to a statement from the firm. The SEC complaint indicates HealthSouth's financial team falsified records to escape detection by its auditors, a contention highlighted in the statement by the accounting firm.
Bad news has become almost the norm for HealthSouth. The company has suffered through a string of legal difficulties and public relations disasters since its earnings-restatement announcement last August.
Within two days of that revelation, shares in HealthSouth lost about 60% of their value, plummeting to $5.05 a share on Aug. 28.
Dozens of investor lawsuits followed, charging Scrushy and other top HealthSouth officials with misleading statements and insider trading. On May 14, Scrushy had sold about 5.2 million shares of HealthSouth stock at $14.05, taking advantage of one of the highest stock prices of the year to net more than $74 million. On July 31, just weeks before the restatement announcement, Scrushy sold 2.5 million shares of stock back to HealthSouth at $10.06 a share, earning $25 million.
After the SEC launched an investigation of HealthSouth, Scrushy, speaking in a conference call with investors in mid-September, said the company voluntarily contacted the SEC and offered to provide it with "any information" it requested. Scrushy also hired a Houston-based law firm, Fulbright & Jaworski, to investigate the stock sales. Though the lawyers' October report "uncovered no oral interview or written document" that would have indicated that Scrushy had privileged information prior to his May and July stock deals, angry investors continued their legal fight through dozens of lawsuits.
Early last month, the U.S. attorney's office in Birmingham issued subpoenas for documents related to the trading of HealthSouth stock. Meanwhile, the FBI confirmed it had opened a criminal investigation into possible securities law violations by the company.
In a written statement at the time, Scrushy said, "As we have said before, we do not believe that HealthSouth or anyone associated with HealthSouth has done anything wrong."
Oscar Aylor, director of professional development at the Department of Health Policy and Administration at the University of North Carolina at Chapel Hill, said the charges against HealthSouth should force the healthcare industry to look inward. "It's a sad indictment of our industry," he said. "There's got to be a renewed focus on ethics in our business. We can talk the talk. We've also got to walk the walk."
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