HealthSouth Corporation: Fraud, Greed and Corporate Governance

Manmohan D. Chaubey, Ph.D.

The Pennsylvania State University
One College Place
Du Bois, PA 15801 (USA)
Tel: 814-375-4846
Fax: 814-375-4784
Email: mdc13@psu.edu

Case for ICMC2006

International Conference on Management Cases
4-5 December 2006
IMT Ghaziabad, India
 HealthSouth Corporation: Fraud, Greed and Corporate Governance

During the 1990s, Richard M. Scrushy, the former CEO of HealthSouth Corporation,

engineered many acquisitions of rehabilitation clinics, outpatient surgical care operators,

nursing homes and other health care companies. In 2003, the Securities and Exchange

Commission (SEC) accused the company and Scrushy of inflating earnings to the tune of

$1.4 billion since 1999. In November 2003, a federal grand jury indicted Scrushy on 85

counts including conspiracy, securities fraud, money laundering and charges related to

overstating HealthSouth’s earnings by nearly $3.0 billion. According to federal investigators,

the company overstated earnings to meet analysts’ earning estimates, while hiding the

accounting fraud from the auditors. However, questions were raised whether the auditors

failed to find or simply overlooked the fraud at HealthSouth.

Central to the investigation was the issue of what role Scrushy played in “cooking the

books.” However, as the case unfolded, it highlighted many other issues such as: The role of

Board of Directors in corporate governance; the role of the auditors; the effect of conflict of

interest between an 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.

Background

Scrushy, once a high school dropout, worked as a gas station attendant and a

bricklayer before retuning to school and earning his diploma. He studied at University of

Alabama, Birmingham and graduated with a degree in respiration therapy in 1974. After

graduation he became an instructor at UAB. In 1979, Scrushy left the academia and took up

a position at a Texas health care management firm. The firm was sold in 1983 and Scrushy
decided to go on his own with a new business idea. In 1984, with help from some friends and

an initial investment of $50,000, he founded HealthSouth in Little Rock, Arkansas. In 1985

he moved the company to Birmingham, Alabama (Heylar, 7/7/03). HealthSouth went public

in 1986.

Richard Scrushy spotted certain trends that he incorporated in his very successful

business model for HealthSouth. These trends were: Lower reimbursement for medical care,

new emphasis on rehabilitation as opposed to surgery, the need to get employees back to

work faster, and the absence of brand names in health care. He also wanted his rehabilitation

centers to look more like upscale clubs than a hospital. He used his super sales skills,

boundless energy and entrepreneurial skills in setting up clinics, making acquisitions and

expanding the company. He concentrated on acquiring contracts with managed care

operations and self-insured companies for workers’ compensation rehabilitation. He focused

individual facilities on specific ailments. To keep costs down, he standardized the physical

layouts of his facilities and used same floor plan and furnishing for all locations (Hoover’s,

2006).

By 1988, HealthSouth had expanded to nearly 40 facilities in 15 states. Scrushy

expanded HealthSouth through acquisitions. The company acquired most of the

rehabilitation services business of National Medical Enterprise and became the largest

provider of rehabilitation services in 1993. By 1992, HealthSouth was generating revenues to

the tune of $400 million and operated 145 clinics. Scrushy formed MedPartners and entered

physician practice management (PPM) field. Scrushy engineered many acquisitions and

MedPartners became the largest PPM in the country. HealthSouth further expanded into

inpatient rehabilitation hospitals and outpatient surgery centers (Hoover’s, 2006).

HealthSouth also entered the traditional hospital field in 2000 through acquisition of a

hospital in Birmingham, Alabama and announced plans for a $300 million “digital hospital”
near its corporate center. By 2000, the company was dominated the rehabilitation services

market and was very profitable. Eventually, HealthSouth became the largest provider of

outpatient surgery, diagnostic and imaging services as well as rehabilitation services in the

United States with 1,700 facilities and 51,000 employees. A summary of the company’s

finances and number of employees is given in Appendix I.

As head of third largest publicly held company in Alabama and one of the fastest

growing health care companies in the country, Richard Scrushy became a celebrity in

Birmingham (Alabama). As a philanthropist, he made sizable donations to charities,

churches and universities. However, Scrushy was also known as an ambitious man who

wanted to be the highest paid CEO in the United States. He was a strong leader, surrounded

by friends and colleagues who learned to do things his way, or get out of the way. He was

even called a “supercilious bully” by some ex-colleagues. Scrushy was terminated from the

company after the SEC sued HealthSouth for “cooking the books” in March 2003 (Heylar,

2003).

The SEC Investigation & Indictments

In 2003, the Securities and Exchange Commission accused in a civil law suit the

HealthSouth Corporation and Richard M. Scrushy of inflating the company’s earnings by

$1.9billion since 1999 (Securities and Exchange Commission, 2003). In separate criminal

charges, 15 former executives pleaded guilty of participating in a scheme to fake corporate

profits to meet Wall Street Expectations. The former executives pleading guilty included five

former chief financial officers, a senior vice president in the tax department, a financial vice

president, and a vice president of investment. The scheme involved regular meetings among

certain senior company officials to find the “dirt” to fill the earnings hole to meet Wall

Street’s earnings expectations and hide firm’s true financial condition (Wilke and Terhune

(2003). Some of these executives claimed that Scrushy directed the fraud. These former
executives agreed to cooperate with the Government in exchange for leniency and for

avoiding possible jail term.

The SEC alleged that when HealthSouth’s earnings fell short of Wall Street analysts’

expectations, Scrushy directed company’s personnel to “fix it” by inflating the company’s

earnings. HealthSouth’s senior accounting personnel convened meetings of so called “family

members” to fix earnings. These meetings agreed upon accounting entrees to reduce a contra

revenue account and/or decreasing expenses, 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

(Frieswick, 2003).

HealthSouth scandal is distinguished by the length of the fraud and the number (five) of

CFOs who participated. Apparently, Scrushy’s powerful personality and greed that stretched

from Scrushy to his five CFOs, who were overpaid in their positions, helped contribute to the

fraud. Another structural contributor to the fraud was the fact that most decisions were made

at the executive level, which limited checks and balances along the way.

Mr. Scrushy was finally indicted by a federal grand jury in November of 2003 on 85 Deleted: The SEC is expected to indict

counts including conspiracy, securities fraud, money laundering and other charges related to a

scheme to overstate HealthSouth’s profits by nearly $3 billion. He was also accused of using Deleted: i

corporate funds (money laundering) to buy personal items such as luxurious cars, boats, Deleted:

famous paintings, expensive jewelry, antique rugs, etc. The IRS and other authorities traced Deleted: during late 2003
Deleted: ;
assets that could be tied to alleged fraudulent acts. If Scrushy were found guilty of criminal

charges, the government could seize and sell the assets.

 In September of 2004, the U.S. attorney in Birmingham announced that Richard

Scrushy faced new federal charges of perjury and obstruction of justice in a revised

indictment by a grand jury. The new 58-count indictment consolidated the 85-count

indictment that had been previously announced. Scrushy pleaded not guilty to all counts.

Scrushy could face what would amount to a lifetime sentence in prison and a fine of more

than $30 million if convicted of all charges. Prosecutors are also seeking $278 million in

assets. Scrushy has denied any wrongdoing and pleaded not guilty to all charges. He was Deleted: is

free on $10 million bail bond, while awaiting trial.

The Scrushy Trial

The Scrushy trial began in January 2005. Following jury selection, the chief federal

prosecutor, Alice M. Martin, alleged that Scrushy was the mastermind behind the financial

fraud at HealthSouth and that he knew about, participated in, and profited from the

conspiracy. The defense contended that Scrushy was a victim of the fraud; that the fraud was

conceived and perpetrated by senior accounting personnel who misled Scrushy and the

outside auditors. The defense attacked the credibility of HealthSouth’s CFOs, claiming that

they agreed to the plea bargain and to testify against Scrushy to gain reduced sentences.

Former CFO William T. Owens in cooperation with the Federal Bureau of

Investigation wore a recorder in a meeting with Scrushy. The tape indicated that Scrushy was

a hands-on CEO who exhorted his senior executives to take measures to keep profits high and

prevent losses on their stock investments. On the tape, Scrushy had warned of dire financial

consequences both to Owens and to the company. However, Scrushy never used the words

fraud, illegal or scheme in nearly three hours of the tape (Johnson, 2005). Owen could not

point to any memo or document that would indicate Scrushy’s involvement in the fraud.

Owens was later sentenced to five years in prison along with two years of probation.
 Owens testified that Ms. Diana Henze, a former assistant vice president of finance at

the company had figured out the fraud and she took her suspicions to HealthSouth’s

compliance department. She was transferred to another division and was subsequently

passed over for promotion (Reeves, 2005). Ms. Henze’s testimony did not directly implicate

Scrushy but it did corroborate that the financials submit by the company to government did

not reflect reality.

Kenneth Livesay, a former assistant controller at HealthSouth also testified that

Scrushy was aware of the fraudulent scheme. His testimony also did not implicate Scrushy

directly since the CEO was not present at any of the “family” meeting that he had attended.

Livesay also listed all nine of the executives who were members of the family; Scrushy’s

name was not on that list. When asked why he did not confront Scrushy on the issue, he

replied that it was not a common practice to discuss the fraud openly and that Scrushy was an

intimidating leader whom you did not cross (Shmukler, 2005). The defense contended that

Livesay and others lied to hide the fraud from Scrushy and to keep their own overpaid

position in the company. Livesay was later sentenced to six months of home confinement,

five years of probation, a fine of $10,000, and a forfeiture of $750,000 in capital gains.

Former chief financial officer Michael Martin pleaded guilty to fraud charges. Martin

testified that he oversaw the accounting fraud from 1997 to his leaving in 2000 at the behest

of Scrushy. He asserted that Scrushy asked him to rework the accounts to help meet Wall

Street analysts’ expectations. He gave pep talks at the “family” meetings assuring the

members that they will not have to do this forever and they will figure out a way to end the

fraud. The defense portrayed Martin as a hothead who made idle threats to employees. In

response to a defense question on why he did not leave the company, Martin replied that he

did not see a way out (Morse and Shmukler, 2005). Martin was later sentenced to six month

of home detention, forfeiture of $3,375,000 in capital gains, and a fine of $50,000.

 Tadd McVay, Aaron Beam and Weston Smith were the other former CFOs who

testified against Scrushy. They all testified that they had discussed the fraud scheme with

Scrushy. Smith was sentenced to 27 months in prison, one year probation after his release

from the prison and forfeiture of $1,500,000 in assets. Beam received a reduced sentence of

three months in prison, $10,000 in fine, one year probation and a forfeiture of $275,000 in

capital gains.

The Role of Auditors at HealthSouth

HealthSouth’s auditors, Ernst and Young (E&Y) failed to uncover the $2.5 billion

systematic overstatement of earnings. The auditors allowed the company to keep on its

books $500 million of overvalued accounts receivables owed to it by financially distressed

health care technology firms. The auditors did not insist on establishing adequate reserves

for these receivables (Glater, 2003).

E&Y also had other non-audit business dealings with HealthSouth. In 2000-01 the

accounting firm conducted a janitorial, cleanliness and physical appearance inspection of

HealthSouth facilities. E&Y used a 50-point checklist designed by Scrushy. The pristine

audit scores were used by HealthSouth in its marketing campaign. The accounting firm

received the $2.6 million fee for the inspection as “audit related fee.” The work was clearly

not audit related. This raises suspicion about the impartiality and independence of the

auditors (Weil, 2003, 2003a).

The HealthSouth Board

During the second half of 2002, HealthSouth announced the creation of a special litigation

committee, composed of independent directors, to deal with shareholder lawsuits following a

company warning that earnings would fall well below expectations. However, Larry D.

Striplin, Jr., an old friend of Scrushy and a co-director of a local bank, co-contributor to a

local college with a baseball field called Scrushy-Striplin Field, and a national football
foundation, was a HealthSouth independent director appointed to the litigation committee.

Striplin’s company had obtained a $5.6 million contract to install glass at a HealthSouth

hospital during 2002. In that year Striplin’s glass firm had total sales of $9 million. Striplin

claimed his glass-contracting firm submitted the lowest bid through a competitive bidding

process overseen by the general contractor. On the other hand, Scrushy (in a January 2003

interview) felt surprised and upset when Striplin disclosed his company’s winning bid in the

CEO’s office. Scrushy said, “If I had known about (the bidding) I would have stopped

him…I don’t like the way it looks.” Striplin’s fellow litigation committee members heard

about the contract on their first meeting and were concerned about a possible public outcry

over his supposed lack of independence. Within two months, Striplin resigned from the

litigation panel, relinquished the chairmanship of the board of director’s compensation

committee and left the audit committee. Striplin, however, remained on the board of

directors and a member of the compensation committee (Lublin, 2003). During 2001, the

year in which Striplin had led the compensation committee Scrushy received exceptional Deleted: ,
Deleted: ,
compensation, collecting $3.96 million in salary, $6.5 million in bonuses and 1.2 million in Deleted: ,

stock options. His salary in 2001 was more than double his 1999 salary. According to

Striplin, Scrushy earned all that he received. During the litigation committee meeting,

Striplin indicated that he didn’t feel that his company’s glass contract might affect his

independence or ability to challenge Scrushy. Having shown a lack of independence and a

definite conflict of interest, we must really ask how the board of directors could nominate

Striplin once again for a seat on the board. Did Scrushy or HealthSouth treat all board

members the same way Striplin was treated?

The compensation received by Mr. Scrushy was based upon the company meeting its

budgetary targets. The accounting fraud at the company helped to meet earning targets. Mr.

Scrushy received a bonus of $6.5 million in 2001. A large part of this bonus was due to the
alleged inflation in earning. The SCE has estimated that during the period of 1999-2001,

Scrushy’s salary totaled $9.2 million, of which $5.3 million depended upon budgetary targets

which were attained through “cooking the books.”

Scrushy Shifts Place of Worship

Prior to his indictment, Mr. Scrushy and his wife began attending weekly services at a

primarily African-American congregation in Birmingham. He preached regularly at black

churches in Birmingham area. He also hosted a Christmas themed TV program on which he

invited prominent African-American ministers as guests. He also made large cash donations

to these churches. Scrushy made an effort to build sympathy among religious conservatives

and African-Americans (Romero and Wilson, 2005). Some have questioned if Scrushy’s

motivation in all of this was to influence the predominantly black jury members.

The Verdict

After 21 days of deliberation, the jury cleared Scrushy of all 36 criminal charges. The

jurors, in post-trial interview, suggested that the CFOs who testified against Scrushy lacked

credibility (Johnson, 2005a). According to the jurors, the prosecutors did not present enough

evidence to show that Scrushy was guilty beyond a reasonable doubt.

 Appendix I

Historical Financials & Employees

Year Revenue Net Income Net Profit Employees

($ mil.) ($ mil.) Margin
Dec 2005 3,207.7 (445.9) -- 24,000
Dec 2004 3,753.8 (174.5) -- 40,000
Dec 2003 3,957.6 (434.6) -- 40,000
Dec 2002 3,960.1 (466.8) -- 51,000
Dec 2001 4,380.5 202.4 4.6% 51,537
Dec 2000 4,195.1 278.5 6.6% 53,216
Dec 1999 4,072.1 76.5 1.9% 51,260
Dec 1998 4,006.1 46.5 1.2% 51,901
Dec 1997 3,017.3 330.6 11.0% 56,281
Dec 1996 2,436.5 220.8 9.1% 36,410
Dec 1995 1,556.7 78.9 5.1% 26,427

Source: Hoover’s Inc. http://premium.hoovers.com. HeathSouth Corporation-Historical

Financials and Employees.
 Appendix II

Extent of Overstated Earnings as Determined by the SEC

Income (Loss before 1999 2000 2001 For six

Income Taxes and Form 10-K Form 10-K Form 10-K months ended
Minority Interests (in June 30, 2002
$millions)

Actual $(191) $194 $9 $157

Budgeted 230 559 434 340

Misstated Amount 421 365 425 183

Misstated Percentage 220% 188% 4,722% 119

 References

Frieswick, Kris (2003). “How Audits Must Change”. CFO. Boston: Jul 1, 2003.

Glater, Jonathan D. (2003) “HealthSouth Looks Deeper Into Its Books.” New York
Times. (Late Edition, East Coast). New York, N.Y.: Jul 12, 2003. p. C.1

Helyar, John (2003). “The Insatiable King Richard He Started As A Nobody. He Became A
Hotshot CEO. He Tried To Be A Country Star. Then It All Came Crashing Down. The
Bizarre Rise and Fall of Healthsouth's Richard Scrushy.” Fortune Magazine, July 7, 2003.

Hoover’s Inc. (2006). http://premium.hoovers.com. HealthSouth Corporation-Profile,

Accessed on (August 10, 2006)

Johnson, Carrie (2005). “Credibility Of Ex-CFO Questioned; Owens Opportunistic, Scrushy

Lawyers Say”, The Washington Post. (Final Edition). Washington, D.C.: Feb 12, 2005.
pg. E.01

Johnson, Carrie (2005a). “Jury Acquits HealthSouth Founder of All Charges”. The
Washington Post. (Final edition), Washington, D.C.: Jun 29, 2005. p. A.01

Lublin, Joann S. (2003). “Boardrooms Under Renovation; Independence Of Directors Is

Elusive Goal”. Wall Street Journal, (Eastern edition). New York, N.Y.: Jul 22, 2003. p. B1

Morse, Dan & Evelina Shmukler (2005). “Executives on Trial: HealthSouth CFO's
Testimony May Bolster Case for Defense; Prosecution Witness Says He Punched a Co-
Worker, Wanted to Kill Some Others”. Wall Street Journal. (Eastern edition). New York,
N.Y.: Mar 9, 2005. pg. C.4

Romero, Simon & Glynn Wilson (2005). “Race, Religion and the HealthSouth Founder's
Trial”. New York Times. (Late Edition, East Coast). New York, N.Y.: Feb 17, 2005. pg. C.1

Securities and Exchange Commission (2003). “Complaint: HealthSouth Corporation and

Richard M. Scrushy”. http://www.sec.gov/litigation/complaints/comphealths.htm. Accessed
on August 10, 2006.

Shmukler, Evelina (2005). “Executives on Trial: Witness Says Scrushy Skipped HealthSouth
'Family' Meetings”. Wall Street Journal. (Eastern edition). New York, N.Y.: Feb 28,
2005. pg. C.4

Weil, Jonathan (2003). “HealthSouth - Proxy Document Says Company Performed Janitorial
Inspections Misclassified as Audit-Related.”. Wall Street Journal. (Eastern edition). New
York, N.Y.: Jun 11, 2003. pg. C.1

Weil, Jonathan (2003a). “HealthSouth and Ernst Renew Flap Over Fee Disclosures.” Wall
Street Journal. (Eastern edition). New York, N.Y.: Jul 1, 2003. pg. C1

Wilke, John R., Chad Terhune & Carrick Mollenkamp (2003). “HealthSouth Ex-Chairman
Faces Charges He Took Part In Big Accounting Fraud”. Wall Street Journal. (Eastern
edition). New York, N.Y.: Nov 4, 2003. p. A.3.
 Teaching Notes

HealthSouth Corporation: Fraud, Greed and Corporate Governance

Case Summary

During the 1990s, Richard M. Scrushy, the former CEO of HealthSouth Corporation,

engineered many acquisitions of rehabilitation clinics, outpatient surgical care operators,

nursing homes and other health care companies. Mr. Scrushy had been a respiratory therapist

who spotted a niche in the health care market and utilized his entrepreneurial talents,

marketing skills, and super salesmanship to set up and run what became the third largest

publicly held company in Alabama. Eventually, HealthSouth became the largest provider of

ambulatory surgery and rehabilitative health care services in the United States with 1,700

facilities and 51,000 employees.

In 2003, the Securities and Exchange Commission (SEC) accused the company and

Mr. Scrushy of inflating earnings to the tune of $1.4 billion since 1999. In November 2003, a

federal grand jury indicted Mr. Scrushy on 85 counts including conspiracy, securities fraud,

money laundering and charges related to overstating HealthSouth’s earnings by nearly $3.0

billion. According to federal investigators, the company overstated earnings to meet

analysts’ earning estimates, while hiding the accounting fraud from the auditors. However,

questions were raised whether the auditors failed to find or simply overlooked the fraud at

HealthSouth.

Central to the investigation was the issue of what role Mr. Scrushy played in “cooking

the books.” However, as the case unfolded, it highlighted many other issues such as: The

role of Board of Directors in corporate governance; the role of the auditors; the effect of

conflict of interest between an 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.

This case can be used for teaching corporate governance, business ethics, corporate

fraud, and corporate social responsibilities. 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 stakeholders.

1. What is the role of the company’s Board of Directors in:

Providing oversight of company’s CEO’s performance?

Protecting the long-term interest of the shareholders?
Providing oversight of company’s financial performance through its audit
committee?

2. A portion of executive compensation is based upon company’s performance? How

can we ensure that the Executives do not use the company to their own benefit?

3. What is the role of company auditors? How do we ensure auditor’s impartiality and

independence?

4. Why is the role of ethics in management? What are the consequences of unethical

behavior?

5. What is corporate social responsibility? Is committing fraud not only illegal, but also

unethical and socially irresponsible?

6. Are there limits to the powers of a chief executive? How can this power be

controlled?

7. What is the role of other senior executives? Can you visualize senior level executives

conspiring to cook the book without the knowledge of the CEO? Under what

conditions that could happen? What can prevent such a situation?