It’s looking like Enron all over again. Only this time, executives at HealthSouth, the beleaguered provider of outpatient surgery and diagnostic health-care services, appear more than willing to cop a plea.

Yesterday Reuters reported that the company’s former CFO, Michael Martin, is expected to plead guilty to charges of conspiracy to commit wire and securities fraud, as well as filing false numbers. Martin, the third ex—chief financial officer and ninth former HealthSouth executive to face criminal charges in the mushrooming accounting scandal, served as HealthSouth CFO from late 1997 until February 2000, when he left the company.

The charges reportedly accuse Martin of following orders from CEO Richard Scrushy to do everything possible to meet Wall Street’s earnings expectations. Scrushy was fired last week and is currently under criminal investigation. He has denied wrongdoing.

Eight former HealthSouth executives, including former CFOs Weston Smith and William Owens, previously pleaded guilty. The two are reportedly cooperating with investigators, who say company management has overstated earnings by $2.5 billion since 1997.

As if that wasn’t bad enough news for the Birmingham, Alabama-based company, on Monday a group of HealthSouth employees filed a lawsuit against the company’s stock-option plan (ESOP) and its trustees. The charges? Insider trading and breaching fiduciary duties.

Employees claim that while Scrushy was withholding information about the company financials, he sold or disposed of more than 7.7 million shares of HealthSouth common stock for more than $99 million.

In August 2002, HealthSouth management issued a press release disclosing that annual earnings would fall short by approximately $175 million. Following the announcement, the price of HealthSouth shares plunged nearly 60 percent, leaving investors dumbfounded.

“We intend to prove that HealthSouth’s ESOP trustees, led by Scrushy, had an affirmative obligation to protect the interests of the ESOP participants,” said Steve Berman, the attorney bringing the suit on behalf of company employees. He added: “We allege that when Scrushy and his cohorts misstated earnings, they had a duty to disclose to participants the risky nature of the ESOP and to begin diversifying the ESOP’s assets.”

Other defendants in the lawsuit include HealthSouth chief operating officer William Owens and senior vice president Brandon Hale. The suit was filed on behalf of employees who participated in the ESOP from January 1, 1999, to the present.

Performance Anxiety at GE?

Do big pension funds have enough clout to become catalysts for change in Corporate America?

Managers at the California Public Employees’ Retirement System (Calpers), the nation’s largest public pension fund, seem to believe so.

On Tuesday Calpers asked General Electric shareholders to vote for a resolution that would require the conglomerate to use performance-based stock options as opposed to the plain vanilla ones used most frequently among U.S. corporations, Reuters reported.

The object: to align management and shareholder interests more closely. Calpers officers argue that options are valuable to executives only if the share price rises. When option holders win, so do shareholders.

However, Calpers management argues that traditional options can be a one-way street, with upside potential but no downside risk. Such a setup can lead executives to manage companies more aggressively, increase corporate leverage, undertake risky ventures—or embrace overly aggressive accounting practices.

The short-term returns of such activities can be attractive, but they may not be in the long-term interests of shareholders, says Calpers management. Recent corporate collapses have led critics to argue that locking in gains from options motivated executives to deceive and work against the interests of shareholders.

In contrast to regular stock options, performance-based options are either linked to an industry index or tied to specific performance targets. In a letter, Calpers managers asked GE’s top 500 shareholders to vote for performance-based options to “ensure that executives get payouts for true outperformance and not simply by keeping a seat warm during a rising market.”

“Standard stock options give windfalls to executives who are lucky enough to hold them during a bull market and penalize executives during a bear market,” said Sean Harrigan, president of Calpers’s board of administration. He added that performance-based options “provide greater incentive for long-term superior performance and better alignment of interests for shareowners.”

Phantom Menace: Real Taxes on Fake Earnings

Just how far are executives willing to go to keep up appearances?

Pretty far, apparently. According to a recent joint study conducted by researchers at the University of Michigan Business School, the University of Chicago, and the University of North Carolina, companies that commit accounting fraud are willing to pay millions of dollars in additional income taxes on their bogus earnings.

On average, companies sacrifice 11 cents in additional income taxes per dollar of inflated pretax earnings, the study found.

It’s not all that surprising that managers who stretch company numbers might also be inclined to pay taxes on phony earnings. But the university researchers found it interesting that executives would be willing to pay real dollars to cover real taxes on imaginary earnings. “If firms expend cash to pay taxes on overstated earnings, that suggests that managers believe that inflated accounting earnings are more valuable than the cash transferred to the government,” said Michelle Hanlon, assistant professor of accounting at the University of Michigan Business School.

The study—which analyzed 27 companies that restated their financial statements in conjunction with Securities and Exchange Commission allegations of accounting fraud between 1996 and 2002—found that on average, managers at those companies overstated earnings by $124 million and paid $11.8 million in additional taxes.

Even with phony earnings, clever executives found tax loopholes. Half of the companies in the survey reported at least a portion of their inflated earnings as book income, not current taxable income. Hence they were able to defer paying taxes on some of their nonexistent earnings, the study found.

Among the 12 companies in the study that paid no current tax on their overstatement, 6 deferred some taxes on fraudulent earnings. The remaining 6 neither paid current taxes nor showed a restated deferred tax amount, but rather incurred tax losses and recorded no net tax provision in any of the years examined.

According to Hanlon, the results illustrate the stark trade-off managers face when contemplating earnings manipulation: the choice between noncash accounting earnings or cash (taxes).

It also underscores a long-held managerial precept: paying phony taxes is generally preferable to splitting rocks in an orange jump suit.

Short Takes

  • Lee Bird, the CFO at Gap Inc.’s Old Navy division, was promoted to chief operating officer of the company’s domestic Gap division. Patti Johnson, the former CFO at Kohl’s Corp., a specialty department store, will succeed Bird.

Bird joined Gap in April 2001 as head of finance for Old Navy. Before joining the San Francisco—based clothing retailer, he held senior finance positions at Gateway Inc., Allied Signal, and Ford Motor Co. Prior to joining Kohl’s, Johnson held senior finance positions at The Disney Store and at Family Restaurants. Johnson will report to Old Navy president Jenny Ming and Gap Inc. CFO Byron Pollitt.

Bird succeeds Ron Beegle, who is leaving the company. Since joining Gap Inc. in 1996, Beegle held senior management positions in the company’s Banana Republic and Gap divisions. He had been COO of Gap since June 2001.

  • Steven Allan, the former chief financial officer of failed high-tech company Media Vision Technology, was sentenced to three and a half years in a federal prison, according to Allan was convicted for his role in an early 1990s financial fraud at the Fremont, California-based company. Contracts at Media Vision were allegedly backdated and unsold merchandise was concealed on offshore barges in an effort to drive up the company’s stock price. After the scheme was revealed in 1994, the company fell into bankruptcy.

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