The infamous $2.8 billion accounting scandal at HealthSouth, which was perpetrated from 1996 through 2002, left a trail of misery in its wake. Included in the carnage was the imprisonment of CEO Richard Scrushy and several HealthSouth CFOs, among a number of other company officials.
Two of the finance chiefs — Aaron Beam, a HealthSouth co-founder and its CFO from January 1984 through September 1997, and Weston Smith, who blew the whistle on the fraud — recently offered a presentation to the New York City chapter of Financial Executives International.
In telling how they came to be swept up in the scandal, they didn’t try to mitigate their culpability, but they presented their story to the attendees in a cautionary light.
Beam said he was watching the NBC Nightly News on March 19, 2003, when the network led with news of the alleged scandal. “At that moment I knew I’d probably be in prison in the not-too-distant future,” he said.
HealthSouth started out offering outpatient medical-care facilities but quickly segued to owning and operating rehabilitation hospitals, which is still the company’s main business today. Success came fast, and in 1986, just two years after its launch, HealthSouth went public.
Beam said Scrushy, for whom he had worked previously, had convinced him to take the HealthSouth job in part by granting him 100,000 shares for a price of $5,000. When company stock soared from its IPO price of $6.50 to well more than $20 in a few months, Beam was suddenly worth millions.
“When we started the company my net worth wasn’t even $100,000,” he said. As soon as he could, he sold some stock and paid cash for a Mercedes. As the years went buy he built a large home in Birmingham, Ala., HealthSouth’s headquarters city, and bought a condo in New Orleans’ French Quarter. Every year he bought a new BMW, Porsche, Lexus, “or whatever kind of car I wanted that year.”
On trips to New York City, Beam noticed that most investment bankers wore expensive Hermes ties. “I bought $30,000 worth of them,” he said.
Meanwhile, as the company’s phenomenal growth continued over the next several years, it bought 12 jet airplanes.
Beam added, “You might say wow, what a success story. Two guys start a company with no real money and it becomes a Fortune 500 company in less than 10 years. What could go wrong?”
What went wrong, he said, was that he and Scrushy were greedy. “It was so much fun being rich, buying those ties and flying all over the world in our private jets.” Even at home in Birmingham, Beam found himself a “rock star.” He got free meals and drinks wherever he went.
Scrushy, Beam said, was especially greedy, going about saying he wanted to be a billionaire and the richest man in Alabama.
All of this, of course, was a recipe for fraudulent behavior.
“Richard would meet with analysts every year and ask them what we needed to do to keep our strong ‘buy’ rating for the stock,” Beam said. “And they would tell him, and he’d say ‘we can do that, no problem.’ It didn’t matter what our projections showed.”
That worked for several years, Beam recalled, as HealthSouth made a lot of money. Eventually, though, Scrushy promised more than the company could deliver, according to Beam.
“I started doing things like changing any accounting estimate I could, involving bad debts or whatever,” he said. “But over time Wall Street noticed that our earnings didn’t match our cash flow.”
In the summer of 1996, HealthSouth badly missed its earnings target. Beam and Bill Owens, the company’s chief accountant at the time and later its CFO, steeled themselves to tell Scrushy there was no choice but to report the shortfall.
Scrushy, said Beam, turned red and began to tremble. He screamed at the two finance executives that they’d lost their minds, that the company would absolutely not report bad numbers because the stock would crash and there would be lawsuits.
“You guys won’t be rock stars anymore,” Beam quoted Scrushy as saying. “You know how to fix these numbers. Now go back to your offices and do it!”
At that point, Beam told the FEI audience, he “should have stood up to Richard and said no. But I stand here before you today telling you that I was a coward. I was intimidated by Richard. I didn’t want to be the one to cause his net worth to go down by several hundred million dollars. I knew he had a gun in his briefcase. And of course, a part of me did not want the party to end. So that night, Bill Owens and I cooked the books.”
For the rest of the year and into 1997, HealthSouth’s auditors did not detect the fraud. “We begged Richard to tell Wall Street we were going to have a down year, but he wouldn’t do it,” Beam said.
At a meeting at the end of the first quarter of 1997, Scrushy “made eye contact with every one of us,” Beam said, “and he said he didn’t know what our game plan was, but that if we were ever caught he was going to deny everything.”
Beam now hated going to work. “I didn’t want to be the whistleblower,” he said, “but I knew what Richard was saying: you guys cross me, and I’ll bring more lawyers and money to the party than you will.”
And so, Beam retired. At one point Scrushy tried to convince him to come back, claiming the fraud had stopped. Beam didn’t bite, and the illegal conduct went undetected for years more.
The morning after hearing the news report on HealthSouth’s fraud, Beam and his wife met with a criminal attorney. The lawyer told Beam, “Do not lie to me. Do not lie to the federal government. Your former employees have told them you were involved. If you try to lie your way out of this, you’re going to prison for a lot of years.”
In a meeting with the FBI three days later, Beam was informed that 17 people had admitted their involvement in the fraud. The only key employee who denied knowing anything about it was Scrushy.
Scrushy, surprisingly, was acquitted, but a few months later he was tried again on different charges involving bribery payments to Alabama’s former governor. He was convicted at that trial, following which he served six years in prison.
Beam wound up spending only three months in jail. That was more than surprising, especially considering the harsh sentences handed down to some other HealthSouth officials, such as Owens, who got five years and served 43 months. “I don’t know why I got such a light sentence,” Beam said. “I’m human and didn’t volunteer to go to prison for any longer than I had to. But I’m a felon today, and will be a felon for the rest of my life.”
He concluded his presentation by telling the audience that the cases of HealthSouth and other big corporate accounting scandals, such as those at Enron and WorldCom, shared a common theme in that the companies were led by CEOs who were charismatic, good salesmen, and good at influencing people’s behavior.
“Those guys aren’t the ones who actually cook the books,” he said. “Lots of people are involved in these big frauds. The enablers. CFOs. There are CFOs in this room today. Why would a CFO do that?
“It might almost go to the nature of someone in accounting,” Beam mused. “An accountant doesn’t want to be in sales. He doesn’t want to be out front. He’s content being in the back room. But he learns over time that if he can make the numbers sing, he can advance.”
How They Did It
After Beam finished speaking, it was Smith’s turn. Despite being the one to finally blow the whistle on the scam, he didn’t fare as well in the aftermath as Beam did. Tried before a different judge, he got a 27-month sentence and served all of it.
At the FEI meeting, Smith, taking a more technical tack than Beam had, started by explaining that in the health-care field, accounts receivable reserves are “a big area of judgment.”
When you get a bill or statement for a doctor visit, he noted, you see right away what was billed and what the insurance company is paying. “You know there’s a massive contractual adjustment there, and that’s a big judgment number in health care,” Smith said. “And every industry represented in this room has its own areas of judgment…. You all know what your valuation areas are…. They can be subject to play if somebody really sets their mind to it.”
What HealthSouth did was understate its accounts receivable reserves and overstate its revenues. Pointing to a footnote on a chart on a screen that displayed HealthSouth financials, Smith said, “How do I know that footnote is absolute BS? Because I wrote it.”
In addition to the revenue recognition irregularities, misclassification of expenses was a common practice at HealthSouth.
“From an analyst’s perspective, or say you’re doing due diligence on the company or auditing the company, you might think that [dumping expenses into capitalizations, for example] is pretty easy to figure out,” Smith said. “All you really need to do is look at capitalized cost numbers. What does it look like on the balance sheet? As auditors like to say, if you audit the balance sheet to death, the income statement is going to fall out.”
But, Smith continued, HealthSouth put some of the costs removed from the income statement into areas like capital costs and cash. “Now there’s a nice smooth line on the balance sheet going forward,” he said. “The poor auditors do their analytical reviews and say, OK, everything looks smooth.”
During the height of the fraud, HealthSouth had $275 million of cash recorded on its balance sheet. How much did it actually have in the bank? Closer to $25 million. “Basically, it was a shell game,” Smith said.
Another big area of fraud was around mergers and acquisitions. “Let’s say we acquired net assets of $600,000 and intangibles of $400,000 fell out,” Smith said. “Basic boring accounting, right? What did we do, though? In our acquisition account we created every liability we could dream of and put them into the open entry under assumed debt. Then the net assets were understated, primarily through the accounts receivable reserves and things like that.”
Then, as an earnings shortfall inevitably occurred in the following year, HealthSouth had reserves to bleed off the balance sheet to make up for it.
In 1998, the company spent $766 million to acquire $15 million of net assets. That would probably be a perfectly legitimate percentage if an acquisition target were a social media company, say, with a lot of highly valued intellectual property, Smith noted. “But we were buying actual stuff,” he said. “There was no explanation for why we were such horrendous businessmen, [but] that was a massive vehicle for fraud for a number of years.”
By 2002 the gap between what HealthSouth was reporting and its actual numbers was hundreds of millions of dollars every year. There were as many as 126,000 fraudulent journal entries in a single quarter. The enormous risk Smith and his team were taking could no longer be ignored.
“I was losing my hair,” Smith said. “Then [Sarbanes-Oxley] came out and I read this new news about 20 years in prison.”
He decided to quit, but Scrushy played to his sympathies, asking what would become of all the family members of company executives if the fraud were dicovered. And there was little doubt that his departure would tip off the authorities that something was amiss. “The first year of Sarbanes-Oxley, a CFO quits before the attestation is signed? The party is over,” Smith said.
Finally, according to Smith, Scrushy looked at him and said, “Leading a Fortune 500 company is kind of like leading the Mafia. You don’t just walk away.”
So Smith caved. He signed the attestation letter. But later that year, he met with U.S. attorneys and the FBI and laid out the fraud for them to see. “I knew I was going to prison,” he told those gathered at the FEI meeting. “I was scared. But I did have one emotion that was stronger: thank God the lying is over.”
Smith lost everything. But more than that, “People who didn’t even work for HealthSouth lost career opportunities because of connections with HealthSouth. People’s husbands, wives, and kids were negatively affected by this all across the country.”
He concluded by telling those gathered, “That’s why I believe every one of you should live your life with a commitment to ethical conduct in everything that you do, and expect the very same from everyone who works for you.”