HealthSouth Scam: Reasons, Investigation, Inquire, Judgment and Aftermath

HealthSouth, one of the largest healthcare services of the USA, was accused of a huge corporate accounting scandal, the infamous $2.8 billion accounting scandal which went for years, 1996 to 2002, to be precise. The founder and CEO of the company directed its employees to report highly exaggerated profits for the company to woo more investors. However, Scrushy, the CEO was acquitted of the charges of fraud, conspiracy, money laundering and violations of Sarbanes-Oxley law for corporate reporting. E&Y, the auditor for the company was also acquitted of the charges of fraud.
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Introduction

HealthSouth, one of the largest healthcare services of the USA, came into notice when the company was accused of a huge corporate accounting scandal, the infamous $2.8 billion accounting scandal which went for years, 1996 to 2002, to be precise. The founder and CEO of the company directed its employees to report highly exaggerated profits for the company to woo more investors. The company was earning record profits by the year 2003 when its annual revenue was approximately $4.5 billion. It dominated the rehabilitation, diagnostic and surgery industry. The first problem crippled in 2002 when the company reportedly sold shares worth $75 million. Right after this, the company released a loss statement for the company. By 2003, the U.S. Securities and Exchange Commission (hereinafter referred to as “SEC”) unfolded that the company has been exaggerating its revenues to the limit of $1.4 billion. As a repercussion, the shares of HealthSouth fell overnight. The CEO was charged for fraud but acquitted of all the charges. He was only charged for bribery in the end. He, along with the CFO and various other officers of the company was imprisoned for a term of five years. The details of this shocking scandal are provided hereunder.

Healthsouth

HealthSouth, now renamed as Encompass Health Corporation, is a leading healthcare and rehabilitation company which provides outpatient services in more than 1900 locations in United States, United Kingdom, Australia etc. It was incorporated in Birmingham, Alabama as a Delaware company in 1984 as Amcare, Inc. by Mr. Richard M. Scrushy. He was the founder and the CEO of the company. In the year 1985, the company changed its name to Healthsouth Rehabilitation Corporation. An year later, the company became public by listing of its shares on the NASDAQ Stock Exchange for the first time. The company started expanding at a rapid rate. By the year 1993, it was the largest company in its field with more than 50 centres throughout the USA. In that time, the annual revenue of Healthsouth touched the mark of $1 billion for the first time. Throughout 1990s, the company kept expanding through mergers and acquisitions. In the year 1995, the company changed its name again to ‘Healthsouth Corporation’ to reflect its wholesome services related to healthcare and not only rehabilitation. Healthsouth managed to make agreements with all major insurance companies, major corporations for managed care plans. Big companies which had memorandum of understanding signed with Healthsouth includes Walmart and Goodyear.The company constructed various rehabilitation centres throughout 1990s, and the cost efficient and effective services became the reason of its success. It also made alliances with professional sports clubs and schools for supply of rehabilitation and medicinal services. The company kept on flourishing as it acquired various small and big corporations in their field. Healthsouth made major acquisitions in the 1990s by purchasing National Surgery Centres. With its dominant position in rehabilitative health care, outpatient surgery and diagnostic imaging market, Healthsouth adopted the slogan “The Healthcare Company of the 21st Century” in order to maintain its standing as the leader in their field.

The Scandal

The first ever violation by HealthSouth came into notice in the year 1998 when it was accused under the Securities Exchange Act for misrepresentation of the financial position of the company and the failure to disclose the negative trends. This was handled by the company until it became major, by the year 2002. Larger problems started accumulating after the company sold $75 million worth shares right before the company posted a huge loss in its financial statements. The SEC accused the company of an accounting fraud by inflating the income/profits of company as high as $1.4 billion, which is more than 10% of the assets of the company. It was found out that the CEO of the company, Richard M Scrushy instructed the senior officials of the company to falsify the earnings of the company in the account books so as to be able to control the control the stocks of the company, to woo new investors and meet the expectations of the current shareholders. Allegedly, it began in the year 1996, which means that this continued for seven years. In some fiscal years, the company even overstated its profits at the rate of 4700% of its real annual profit. Interestingly, based on the inflated income, the company had to pay more amount as corporate taxes than its actual income.

The Investigation

By 2003, the CEO was charged on various accounts of Fraud. The SEC investigated whether the sale of stocks right before posting the losses are anywhere related to each other. An independent law firm was hired by Healthsource to review the matter, which concluded that the two events were unrelated. This report could not satisfy the SEC. The FBI agents searched the company’s headquarters but could not collect any major evidence. After a trial which ran for 2 years, Scrushy was acquitted of the 36 charges of accounting Fraud which couldn’t be proved against him, one being the violation of Sarbanes-Oxley Act.

Business Model of HealthSouth

The growth strategy of HealthSouth was based on the presumption that medicare is a no-loss business as the government as well as the individual people will always invest in here. The government provided subsidies and large reimbursements to medicare facilitators. The main scheme of HealthSouth was to aggressively acquire all the competing companies, which will cut the competition as well as pave path for receiving more of the government’s money. The strategy worked impeccably in the initial years so much so that the core business of rehabilitation was expanded and the company ventured into outpatient surgery, medicine and hospital services. However, in 1997, the government largely minimised the reimbursement that was going to hospitals, precisely to the point that the downfall of Medicare started. Approximately 40% of the revenue of Healthsouth was dependent on the same, the revenue hit real hard. The company could not cope with sudden losses. The flaws in its operations began to show. There was a huge loss in the number of patients visiting, yet the sales never declined. The company explained this magical growth occurred due to raising revenues through increased efficiency and cost cutting, but the reason was apparent. The numbers never went low because they didn’t exist, it was all fictitious.

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Process

HealthSouth got away with such a huge fraud for a long time. Their executives followed the following three basic steps-

  • Company officials compared their financial statements with that of the expectations of the analysts and investors.
  • The employees were instructed to manipulate the account books to bring the desired results.
  • The company even created false documents to conceal the financial statements.

The company which audited the accounts of HealthSouth was in a position to find out about the scandal. The executive of HealthSouth comprised of many former employees of Ernst & Young (hereinafter referred as “E&Y”), the auditor of the public accounts of HealthSouth. The fact that it could not show their connivance with HealthSouth, rather than their incompetence. The role of the auditor was also suspected in deceiving the public to keep up the fraud. It was found out that the employees deceived E&Y as well. One of the many ways to do so was by keeping the threshold of fixed asset addition at $5,000 as E&Y’s materiality threshold was above $5,000 only. As long as the company moved amounts of money less than $5,000 at a time, the error could not be noticed by E&Y. However, facilitating this needed enormous work. It would take approximately a million fake entries to provide the required documentation. The volume of work that was required to pull this fraud just shows how the cognizance of this fraud was widespread among all the employees and officers of the company.

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The Enquiry

The fraud has occurred in a very strategic time when there was a rapid economic growth but the laws were lackadaisical, which made it easier to commit frauds. The companies were allowed to make their own accounting methods under the guidelines provided in ‘Generally Accepted Accounting Principles’ (GAAP). Therefore, any method which would follow the general guidelines of GAAP, it was generally considered legally, morally and ethically adequate. It allowed HealthSouth to use creative accounting methods, which amounted to fraudulent behaviour on its part, to meet the expectations of the investors by showing profits. The fraud mainly included improperly capitalising expenses, overestimation of insurance reimbursements, showing overvalued rates of fixed assets, and use of faulty reserve accountings. The fraud included $2.5 billion in fraudulent entries, $500 million in incorrect accounting for goodwill and other items involved and $800 million on the count of aggressive accounting. All of this went undetected until 2003, when the scam came into notice. The full extent of the scam was exposed when the CFO Weston Smith realised that the fraud was about to be detected and the penalties were heinous as per the newly enacted Sarbanes-Oxley Act. He, along with his various other colleagues went to the authorities voluntarily and pleaded guilty. They also accepted that the CEO Scrushy was the one who was leading this entire scam. Scrushy, who obviously was the mastermind behind the entire fraud, still denied his involvement in any manner. He was acquitted of most charges levied against him, but for the accounting fraud which happened in his connivance, he was convicted a jail sentence of five years. What is mind boggling in this entire scenario is that justice has failed. If Scrushy is the mastermind, he has been let off with minimal punishment which is a failure of the justice system, or even the other employees who were the real culprits who not only did the fraud but also duped him, they have escaped with lenient sentences. In both ways, the real criminal has escaped the penalty for this massive crime. Even the judiciary was divided while hearing the matter, some judges concurred with the story of Scrushy whereas the rest with that of the other employees.

Timeline of HealthSouth Scam

The various events related to this massive corporate fraud unfolded in the following manner:

  • 1984- Scrushy, along with a small group of investors forms a company named HealthSouth
  • 1986- It became a Public company.
  • 1996- With a humungous growth over the decade, the company was the largest healthcare provider. It was also the time when this fraud began.
  • 2002- The first trouble cripples as the company had an all-time low earning due to the change in the Medicare reimbursement by the government.
  • 2003- The SEC filed a civil suit against the company and its officials accusing them of a huge accounting fraud. 15 executives of the company plead guilty whereas the CEO Scrushy pleads innocence.
  • 2004- New charges were added against them on the count of perjury and obstruction of justice.
  • June 2005- Scrushy acquitted of the charges of fraud, conspiracy, money laundering and violations of Sarbanes-Oxley law for corporate reporting.

Recovery

As soon as the fraud was discovered, the board of directors of the company held an emergency meeting to discuss the immediate actions that they can take to save the company. The first action was to remove Scrushy from the position of the Chairman and CEO of the company. It was decided that the company shall make all the payments and avoid bankruptcy. The company’s financial problems were too large to be handled internally; therefore, the company hired a reconstructing firm to help its reconstruction. The company prioritised payments, relieved all possible liabilities and reorganised the finances of the company. By the end of 2003, the company was able to avoid bankruptcy proceedings that were to be initiated against it.

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To overcome the losses, the company had to close various museums and stores. The company sold most of its corporate jets and helicopters. It had to halt the construction of a digital hospital which left the company in losses worth $400 million. The company made all efforts to disassociate itself with Scrushy. The Board removed his name from the records of the company. The company sold all its underperforming facilities, in order to minimise the losses. In the year 2004, the company restated its earnings and filed returns again for the year 2000 to 2003, in order to again become a current filer with the SEC. It could achieve its goal of becoming a current filer only in the year 2006 when it filed the financial report of the first quarter of 2006.

HealthSouth introduced a revamping plan to sell, spin-off and dispose its various departments with a 1 for 5 reverse stock splits. The final step in the recovery of the company from the scandal was in October 2006 when the company relisted its stocks in the New York Stock Exchange once again. In the year 2007, the company sold almost 600 of its outpatient centres for $245 million. The company further sold and reconstructed its various divisions in the coming years. Eventually, the huge HealthSouth Corporation branched into various offspring companies like MedPartners Inc., Capstone Capital Corporation and Source Medical Solutions, etc. 

An Ethical Detriment

For the handful of people who lost their hard earned money in this fraud, the implications were serious and heinous, so to say. What is noteworthy is that this institutional failure has more far reaching ethical implications than we understand. In a set up like a company, it is not very difficult to defraud innocent investors who don’t have much knowledge of the conniving means that the experts may use to manipulate the situation. Had the employees of HealthSouth working under any sort of ethical framework, based on what is right, valuing the principles of honesty, fairness, justice and respect, this would not happen. Every corporate fraud is a disregard of moral values against wealth and greed for earning it. Not that it is the right thing to do, but, had this been a one-time event, the actions of the executives of the company would probably have been justified, but knowing and continuing to participate in this clearly shows the lack of ethics in one and all.

Utilitarianism

What happened in the case of HealthSouth was exactly the opposite of utilitarianism.Utilitarianism means and states that a decision should be taken on such considerations as it does maximum benefits and minimum harms to the society. The executives of HealthSouth put their own interests on such a prioritised position that the rights of and the harm being caused to the shareholders did not bother them.

Faliure of E&Y

The ethical error lies on the part of E&Y as well. Even though it was found out that it had not been involved in the scam and that HealthSouth was exceptionally conniving in planning the fraud, yet it needs to be categorically stated that there was a failure on the part of the auditing company to do its job efficiently. The implication of their negligence had to be faced by the public with no fault of theirs.

Conclusion

There have been times more than once when the economy of the US was put under a shock and a massive blow by huge corporate scams coming into notice. The company had various chances to get back at place. The internal executives of HealthSouth were also loyal to each other in execution of the corrupt practices. It shows a lack of ethics when it was convenient for the executives to fool the innocent bunch of people who had invested in the company rather than mending their own ways. Another factor which surely played a role in allowing the fraud to take place was that the management of the company was dominated by a few people without effective checks by the board of directors, the audit committees and the agencies designated to curb such practices. This scam is a classic case of institutional failure, where the law is never enough when the greed of humans takes precedence over their ethics. The failure of an organisation can also be seen by the fact that this scheme continued till it was discovered. The executives manipulated the accounts for close to 40 quarters. While the fraud was occurring, there were multiple warnings to auditors from various whistle blowers, all of which went unnoticed. Various ex-employees of the company tried giving tip-off but it could not rescue the investors and the economy from this horrific torture. There needs to be a mechanism for that as well. 

Every time a fraud of this level is discovered, not only the investors, but the entire economy suffers. It, therefore, becomes imperative for the government to take such precautionary steps as are necessary to avoid such situation in future. There is a need of bringing up new laws and proper application of the existing ones.

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