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How five CFOs cooked the books at HealthSouth.
Alix Stuart, CFO Magazine
June 1, 2005
It could be an episode of "The Sopranos." As revenues at $2.4 billion HealthSouth Corp. begin to falter, CEO Richard Scrushy in the role of Tony Soprano, browbeats "the family", a group of top lieutenants including five CFOs, into falsifying a wide range of financial reports. Despite the family's misgivings, their own greed and Scrushy's threats keep the scam in operation for at least six years, until the "holes" become too big to fill with "dirt" alone. Only when a last-ditch effort conceal the fraud by taking the company private fails does the last CFO left standing finally crack under the pressure, and agree to wear a wire for the FBI.
That, at least, is the scenario described by the 15 executives who testified again Scrushy. (As of press time, no verdict in the trial had been reached.) Scrushy and his "family" are charged with recording as much as $2.7 billion of fake revenues on the company's books over six years, and correspondingly adjusting the balance sheets and paper trails. Methods included overestimating insurance reimbursements, fiddling with fixed-asset accounts, improperly booking capital expenses, and overbooking reserve accounts.
According to the testimony of CFOs Aaron Beam Jr., Michael D. Martin, William T. Owens, Weston Smith, and Malcolm "Tadd" McVay, each one realized the error of his ways, but most felt helpless to blow the whistle or even leave the company. Scrushy "managed greatly by fear and intimidation," according to Owens, who served as HealthSouth's third CFO from 2000 to 2001 (and again for part of 2003). Second CFO Martin testified that he tried to quit at least three times during his 1997 to 2000 tenure. "[Scrushy] said, 'Martin, you can't quit. You'll be the fall guy.'" The remark "petrified" him.
Now, facing federal criminal charges and possible jail time, all five CFOs have pleaded guilty and turned state's evidence, hoping to put Scrushy in jail for the rest of his life — and reduce their own sentences.
A Sunny Surface
From the outside, HealthSouth looked like a normal company. The revenues and cash-flow figures the company disclosed seemed reasonable, according to Gimme Credit analyst Carol Levenson and others. A constant stream of acquisitions, along with HealthSouth's unique mix of inpatient and outpatient facilities, made it hard to compare the company with others or even itself. And even after analysts like Levenson, Merrill Lynch's A. J. Rice (a witness for the prosecution), and Jefferies & Co.'s Frank Morgan (a witness for the defense) began to question the quality of the numbers in late 2002, they overwhelmingly said they never suspected the massive fraud.
HealthSouth also maintained impeccable corporate policies — on paper. A confidential whistle-blowers' hotline had been set up in 1997. The company's nonretaliation policy gave the compliance director direct access to the board of directors. Its centralized finance function seemed like an advantage at the time, since other health-care companies were falling apart because of problems in field offices.
Many employees of HealthSouth, particularly those who worked at medical centers in other parts of the country, thought they worked for an ethical company. A former regional manager who oversaw finances for facilities in several states says that the message from headquarters never conflicted with her personal values. "They were always stressing honesty in what we did, and that was how we ran it in the field," she says. "We had no reason to think they did any different."
The Big Five
At first glance, the CFOs who worked for HealthSouth seem more down-home than dastardly, although a closer look reveals an intricate network of personal and business relations dating back decades.
HealthSouth's first CFO was Aaron Beam, now 61, a CPA who cofounded the company in 1984. In a memoir on his college Website, he recounts that, having grown up in a small town in northern Louisiana, "I almost thought I had enrolled in college in a foreign country" upon arriving at Louisiana State University's Ourso College of Business Administration in 1963.
"My personal experience is that he was a very nice guy, a give-you-the-shirt-off-his-back sort of guy," says Freddie Luft, who has worked with Beam on LSU alumni events. For one, he says, Beam offered his residence for events such as the Annual Crawfish Boil.
When Beam retired in 1997, HealthSouth treasurer Michael Martin took his place. Martin, now 44, had joined the company in 1989 after a stint at AmSouth Bank, where he had worked with Scrushy in his role as senior health-care lending officer.
"If you were imagining someone this might happen to, it wouldn't be Mike," says W. Jack Duncan, a business professor at the University of Alabama Birmingham who has known Martin for about 20 years. Martin came from a working-class family in Birmingham, says Duncan, and paid his way through school by working at AmSouth Bank while attending classes part-time. Both sat on company boards, and the two had many conversations about fiduciary responsibility. "Mike really seemed to have a good handle on it," says Duncan.
According to Martin's testimony, his 11-year tenure at HealthSouth was punctuated by threats to leave, which several times convinced Scrushy to lower earnings estimates. But after Martin finally did leave in 2000 (after three years as CFO), HealthSouth lent about $45 million to a company he subsequently formed, which he then used to buy four properties from his former employer. The loans weren't put up for board approval, and neither the loans nor Martin's involvement was disclosed when the company reported the sales in Securities and Exchange Commission filings.
Upon Martin's departure, controller Bill Owens stepped in as HealthSouth's third CFO. Like his predecessors, Owens was a local boy. (When asked to surrender his passport in order to be released on bail, he said he'd never left the country, except to go to Mexico, and so didn't have one.) He had attended Troy University in southern Alabama, become a CPA, and worked for Ernst & Young (then Ernst & Whinney) in Birmingham for five years before joining HealthSouth as controller in 1986. E&Y audited HealthSouth until 2003.
After just one year as CFO, Owens moved up to COO in August 2001 and, for about six months, CEO. That paved the way for CFO number four, Wes Smith, who had joined the company as director of reimbursements in 1987 and became controller and senior vice president, finance, in March 2000.
Smith, a CPA, graduated from the University of North Alabama in 1982 with a BS in accounting and, like Owens, worked for E&Y's Birmingham office before Owens recruited him to HealthSouth. He and Owens were close friends; in fact, Owens is godfather to one of Smith's children.
Like Owens, Smith lasted just a year in the CFO slot. He left in 2002 after marrying another HealthSouth senior vice president of finance, Susan Jones, and realizing, some speculate, that the passage of Sarbanes-Oxley could implicate his wife as well as himself. To keep Smith on board, Scrushy apparently placated him with roles that removed him from the fraud, including a spot as vice president of inpatient services, where he remained until the indictment.
Enter CFO number five, Tadd McVay. McVay, who became CFO in late August 2002, had joined HealthSouth in 1999 after a stint as CFO of Capstone Capital Corp., a Scrushy-controlled firm. An undergraduate English major with an MBA from the University of North Carolina at Chapel Hill, McVay helped HealthSouth refinance its long-term debt in 2002. His attorney, J. Don Foster of Jackson, Foster & Graham, describes him as a "devoted father" and a "very bright guy."
McVay has testified that he didn't know how pervasive the fraud was until his promotion to CFO. In that role, he says, he became the sounding board for analysts and investors who were "ranting and raving" about Scrushy as earnings shortfalls emerged, he says, and begging McVay to get rid of him.
In response, McVay convened a meeting at his home in November 2002 with Owens and corporate counsel William Horton to discuss Scrushy's ouster, only to have Owens turn around and inform Scrushy. Afraid of losing his job, McVay backed off. According to McVay's testimony, "Mr. Scrushy assured me that he and Mr. Owens were committed to correcting the inflation of the cash and [said] that all companies fudge their numbers." Owens, too, said he had been comforted by Scrushy's promise that he would take care of Owens's family if anything were to happen to him.
By January 2003, however, Scrushy had demoted McVay to treasurer and pulled Owens back into the CFO spot. Owens remained CFO through March 2003, when he turned informant for the FBI.
The Question of Motive
The HealthSouth scandal is distinguished by the duration of the fraud, and the number of CFOs who participated in it. Why did so many conspire for so long? "If you were rational and just balanced risk versus reward, you would never do something like this," says Robert Prentice, professor of business law at the McCombs School of Business at the University of Texas at Austin.
Scrushy clearly fits the profile of the overbearing CEO who, like Bernard Ebbers, Jeffrey Skilling, and Dennis Kozlowski, sets the wrong tone at the top. Certainly, Scrushy's powerful personality was a major factor in keeping the scheme a secret for so long. (Having installed security cameras throughout headquarters to keep watch on his employees, he generally allowed the rank-and-file into his executive suite only to berate them.)
But many other factors also made HealthSouth susceptible to fraud. "I wish I could say it was all about Scrushy, but I can't," says Edwin Hartman, director of the Prudential Business Ethics Center at Rutgers University. "There's a lot of research that suggests a HealthSouth could happen anywhere."
Greed, of course, played a role. Large stock sales by Scrushy and Martin provided a motive to prop up the stock. "Even though we knew we were committing fraud, we felt it was important to keep the stock price up for at least a year," Martin testified regarding a 1997 period in which he sold $3 million worth of shares and Scrushy sold $100 million.
In general, the executives caught in corporate scandals so far "have been underqualified and overpaid for the positions they held," says Jonathan Schiff, founder of the Finance Development & Training Institute. Certainly the CFOs of HealthSouth, like their peers at Enron, WorldCom, and Tyco International, reached the top at an early age.
Like their counterparts at Clinton, Mississippi-based WorldCom, the hometown boys of HealthSouth faced a paucity of other job opportunities. And HealthSouth paid them well. By way of comparison, Sloan D. Gibson IV, the CFO of AmSouth Bancorp (one of the few other public companies in Birmingham), received salary and bonus totaling about one-quarter of the $2.4 million Martin received in his first year on the job.
The absence of other options and the close personal and business ties among members of the group (all had worked for HealthSouth's bank or auditor or with Scrushy before joining the company) no doubt reinforced group loyalty at the expense of a broader public. It's easier to hurt a nameless, faceless mass of investors, says Prentice, than to endanger yourself and the people you know — a point Scrushy was quick to exploit. "If you want to go public with all this, get ready to get fired, and everyone goes down with you," Scrushy told Owens, according to the transcript of the recording Owens made of Scrushy.
Apart from the organizational culture, what made the fraud possible on a structural level was Scrushy's elevation of so many decisions to the executive level, which limited checks and balances along the way. The accounting systems in the field did not interface with the corporate enterprise-resource-planning software, making it necessary for results to be consolidated by hand at the corporate level (again, in an echo of WorldCom). That made it easy to fudge numbers, since the internal-audit staff was directed to review only the field numbers, not the consolidated numbers. In fact, E&Y auditors noted in 2001 that "management is dominated by one or a few individuals without effective oversight by the board of directors or audit committee." E&Y also observed that the internal-audit function was understaffed, undertrained, and lacking in independence.
Employees who tried to voice concerns were stymied. Diana Henze, vice president of finance in 1998, told a congressional panel in 2003 that as early as 1998 she noticed that earnings would jump with each iteration of quarter-end consolidations. At first, she accepted the explanation that some reserves had been reversed, but her doubts increased as the unexplained earnings "bumps" continued throughout 1999. She confronted then-controller Owens, accused him of fraud, and later told her boss, Kenneth Livesay, that she intended to report the fraud.
When Henze went to corporate compliance director Kelly Cullison in November 1999, however, she found that Cullison lacked the authority to investigate her allegations. Cullison, who became compliance director in 1997 at the tender age of 26, corroborated the story, also before Congress. "I did not have access to the supporting documents to determine whether or not the journal entries were legitimate," she said. She stated that she brought the case to her supervisor, co-founder Tony Tanner, who told her the complaint had been resolved and that the case was closed. "Because of the way HealthSouth was structured, a complaint like Diana's had to go up the chain of command to be properly investigated," adds Cullison, who left the company in 2001 to start her own business.
Soon after making her complaints, Henze missed a promotion she felt she had earned. She testified to Congress that Owens told her she had been held back for refusing to comply with the fraud. Soon after, she requested and received a transfer out of accounting and into the IT group. She is currently vice president of accounting systems and controls.
At long last, Owens blew the whistle himself. He testified that his wife's threat to file for divorce convinced him to go to the FBI. But by that time, the jig was up: major investors were calling for Scrushy to quit; new Sarbanes-Oxley directives were making the cover-up harder to maintain; and a plan to take the company private through a leveraged buyout failed because the company lacked the cash to cover its portion of the deal.
Since Scrushy's ouster, HealthSouth has begun to regroup. Guy Sansone, of Alvarez & Marsal, came in as interim CFO in March 2003 to help stave off bankruptcy and begin the refinancing process as well as regulatory settlements. Last fall, Sansone was able to turn over the reins to John Workman, former CEO and CFO of U.S. Can Corp. "We're looking forward to not having to deal with the sins of the past," says the new CFO, who has helped oversee a reconstruction of the 2000-2003 10-Ks that will take about a million hours of work by approximately 300 consultants.
New policies, such as hiring an outside firm to handle whistle-blower calls and scheduling the board to meet independently with auditors, have been instituted. The new CEO, Jay Grinney, is deliberately relaxing the culture in hopes of assuaging employees' learned fears about speaking the truth. The once-forbidden executive suite is now open to all, and lower-level managers are being given more authority over areas like purchasing.
Personal turnarounds for the former CFOs remain uncertain. So far, they have received relatively light sentences, and no jail time. But federal prosecutors are already appealing these decisions to a higher court. And Scrushy's defense team has pilloried the "family," exposing some unseemly details of their private lives. For instance, defense attorneys prodded Beam to admit that he had engaged in adulterous relationships and had even helped one of his girlfriends get a job at HealthSouth before retiring in 1997. And Martin admitted to punching former treasurer Leif Murphy at his going-away party because he felt "betrayed." (Murphy was apparently the only person who quit immediately upon learning of the fraud.)
Owens has perhaps come under the most fire. Scrushy's defense has tried to portray him as the true "godfather" of the operation. Under cross-examination, Owens admitted to being delinquent in filing his tax returns between 1995 and 2003, and spending more than $3 million in cash to buy real estate.
Today, according to his attorney, Martin is employed by CannonGate Partners, the private-equity and consulting firm he helped start after leaving HealthSouth. According to their attorneys, Owens and McVay are job-hunting, and Smith is a self-employed accountant.
Many believe that no matter what really happened at HealthSouth, the CFOs will remain the bad guys in Birmingham. A lavish donor to local colleges, libraries, and medical centers as well as a regular preacher at area churches, Scrushy is a local hero, with supporters in all corners. He had even aired his own TV talk show each day before court.
As his lawyers subject the CFOs to ridicule, Scrushy is shown cooking grits for his children. That's the sort of spin on family values that perhaps only the Soprano family could really appreciate.
Alix Nyberg Stuart is a contributing editor of CFO.
Six years of fundamental reporting were engineered by five CFOs...
Aaron Beam Jr., age 61
Tenure: Co-founder and CFO from 1984097, director from 1993-97.
Notable facts: Has a regulation-size football field on his property. Admitted to adultery during cross-examination.
Michael D. Martin, age 44
Tenure: Joined as treasurer in October 1989, named SVP finance and treasurer in February 1994, EVP finance and treasurer in May 1996. CFO from October 1997-February 2000, then EVP investments. Director from 1998-2000.
Notable facts: Won outstanding alumni award in 2002 from UAB business school. Likened HealthSouth to the firm in John Grisham's novel of the same name.
William T. Owens, age 46
Tenure: Joined as controller in March 1986, promoted to group SVP and controller in March 1998. CFO from February 2000-August 2001, also January-March 2003; president and COO August 2001-2002; CEO August 2002January 2003: director from March 2001-2003.
Notable facts: Never had a passport. Godfather to one of Weston Smith's children.
Weston Smith, age 44
Tenure: Joined in February 1987 as director of reimbursement, promoted to SVP of finance and controller in March 2000. CFO from August 20012002, EVP of inpatient operations until 2003.
Notable fact: Speculation that he is trying to protect his wife, Susan Jones-Smith, who was also a finance executive at the company and appeared before Congress, but has not been criminally charged.
Malcolm "Tadd" McVay, age 43
Tenure: Joined in September 1999 as VP of finance, named SVP of finance and treasurer in February 2000. CFO from August 2002-January 2003, treasurer from January-March 2003.
Notable fact: On the witness stand, accused prosecution of making him look like "the scum of the earth."
...and Their Staff
Richard Botts, SVP for taxes, May 1998-July 2003
"Members of HealthSouth's accounting staff provided Botts with false depreciation schedules, which were tied to and included fictitious assets on the company's general ledger," which Botts then filed with tax officials.
Jason Brown, VP of finance, May 2000-July 2003
Created documents to show HealthSouth selling $27 million worth of stock in another company in 2002 rather than in 2001. Also altered same-facility volume numbers (for Q3 '02) to understate decline in volume.
Catherine Fowler, treasury, VP, and cash manager, May 1994-March 2003
Charged with creating paper trail to falsify date of stock sale.
Emery Harris, various positions including assistant controller, 1992-2003
Charged with making and causing others to make false entries "for the purpose of artificially inflating HealthSouth's earnings, and designed the fictitious accounting entries to avoid detection.... through methods such as manipulation of the 'contractual adjustment' or other expense accounts to inflate revenue on the income statement and false... entries on the balance sheet concerning PP&E."
Will Hicks, VP of investments, March 1999-July 2003
"Hicks caused investment-portfolio summaries of assets to be provided to the auditors that contained false information and omitted material facts concerning HealthSouth's investment in a company that owned assisted-living facilities."
Kenneth Livesay, assistant controller, 1989-1999, CIO, 1999-2003
Directed staff members to commit fraud. "Methods included overbooking reserve accounts...which could later be bled out into revenue, creating fictitious entries in the fixed-asset system...and overstating intangible-assets accounts."
Angela C. Ayers, VP and various accounting positions, 1994-2003
Cathy Edwards, VP and various accounting positions, 1993-2003
Rebecca Kay Morgan, group VP and various accounting positions, 1987-2003
Virginia B. Valentine, assistant VP and various accounting positions, 1995-2003.
These four pleaded guilty to making false entries into the PP&E, cash, inventory, and goodwill accounts at various times from 1999 to 2002, and creating false documents to support the entries.
A History of Deceit
1984: Richard Scrushy, Aaron Beam, Tony Tanner, Eugene Smith, and John Midkiff establish HealthSouth Corp.
1994: Scrushy becomes CEO.
1996: Fraud begins. (May have started earlier, but government so far can't prove it.)
1997: Merger with Horizon CMS allows HS to shift $300 million of expenses to Horizon's books and wrongly record $400 million in goodwill assets.
1998: Scrushy claims earnings per share will hit $1 despite internal projections of only 78 cents.
Q1 1998: HealthSouth reports $587 million in expenses, versus $700 million actual. (Company devises plan to blame managed care and federal balanced-budget bill.)
Q2 1998: HealthSouth estimates $932 million in revenues versus $888 million actual. Announces $593 million expenses versus $688 million actual. Actual net income: $36 million versus $117 million expected.
Q3 1998: Actual expenses are $743 million versus expected $669 million
1999: Diana Henze voices concern about fraud; HealthSouth lowers earnings estimates at Martin's prompting; 10-K misstates pretax income by $421 million (220 percent).
2000: 10-K misstates pretax income by $365 million (188 percent).
2001: 10-K misstates pretax income by $425 millopm (4,722 percent).
August 2002: HealthSouth announces that new Medicare billing guidance will reduce annual earnings by $175 million (versus $20 million-30 million actual impact).
Fall 2002: SEC begins civil investigation, sparked by a newspaper article about the August announcement.
Q3 2002: HealthSouth overstates assets (PP&E) by at least $800 million (10 percent).
March 2003: Owens agrees to wear a wire; FBI agents storm Birmingham headquarters.
Sources: SEC complaint; testimony from Martin, Owens, and Neal Seiden; Martin Cohen's testimony before Congress