Research Papers Healthsouth Corporation Scandal
Securities and Exchange Commission
Litigation Release No. 18044 / March 20, 2003
Accounting and Auditing Enforcement
Release No. 1744 / March 20, 2003
SEC Charges HealthSouth Corp., CEO Richard Scrushy
With $1.4 Billion Accounting Fraud
Commission Action Seeks Injunction, Money Penalties, Officer and Director Bar
Commission Obtains Emergency Relief
Securities and Exchange Commission v. HealthSouth Corporation and Richard M. Scrushy, CV-03-J-0615-S (N.D. Ala.)
The Securities and Exchange Commission announced that on March 19, 2003, it filed accounting fraud charges in federal district court in the Northern District of Alabama against HealthSouth Corporation ("HRC"), the nation's largest provider of outpatient surgery, diagnostic and rehabilitative healthcare services, and its Chief Executive Officer and Chairman Richard M. Scrushy.
The Commission's complaint alleges that since 1999, at the insistence of Scrushy, HRC systematically overstated its earnings by at least $1.4 billion in order to meet or exceed Wall Street earnings expectations. The false increases in earnings were matched by false increases in HRC's assets. By the third quarter of 2002, HRC's assets were overstated by at least $800 million, or approximately 10 percent. The complaint further alleges that, following the Commission's order last year requiring executive officers of major public companies to certify the accuracy and completeness of their companies' financial statements, Scrushy certified HRC's financial statements when he knew or was reckless in not knowing they were materially false and misleading.
According to the complaint:
- Shortly after HRC became publicly traded in 1986, and at Scrushy's instruction, the company began to artificially inflate its earnings to match Wall Street analysts' expectations and maintain the market price for HRC's stock. Between 1999 and the second quarter of 2002, HRC intentionally overstated its earnings, identified as "Income Before Income Taxes And Minority Interests," by at least $1.4 billion in reports filed with the Commission. HRC also overstated earnings, identified as "Income Before Income Taxes And Minority Interests," in the quarterly reports on Form 10-Q filed with the Commission during these years.
- Pursuant to the scheme, on a quarterly basis, HRC's senior officers would present Scrushy with an analysis of HRC's actual, but as yet unreported, earnings for the quarter as compared to Wall Street's expected earnings for the company. If HRC's actual results fell short of expectations, Scrushy would tell HRC's management to "fix it" by recording false earnings on HRC's accounting records to make up the shortfall.
- HRC's senior accounting personnel then convened a meeting to "fix" the earnings shortfall. At these meetings, HRC's senior accounting personnel discussed what false accounting entries could be made and recorded to inflate reported earnings to match Wall Street analysts' expectations. These entries primarily consisted of reducing a contra revenue account, called "contractual adjustment," and/or decreasing expenses, (either of which increased earnings), and correspondingly increasing assets or decreasing liabilities.
- Scrushy has personally profited from the scheme to artificially inflate earnings. He has sold at least 7,782,130 shares of HRC stock since 1999, when HRC's share price was affected by HRC's artificially inflated earnings. Moreover, Scrushy received salary and bonus payments based on HRC's artificially inflated earnings.
- In mid-2002, certain HRC senior officers and Scrushy discussed the impact of the scheme to inflate earnings because they were concerned about the consequences of the August 14, 2002 financial statement certification required under Commission Order No. 4-460, Order Requiring the Filing of Sworn Statements Pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934 (June 27, 2002). ("Order 4-460").
- Scrushy knew or was reckless in not knowing that HRC's financial statements materially overstated its operating results. Nevertheless, on August 14, 2002, he and HRC's Chief Financial Officer certified under oath that HRC's 2001 Form 10-K contained no "untrue statement of material fact." In truth, the financial statements filed with this report overstated HRC's earnings, identified as "Income Before Income Taxes And Minority Interests" on HRC's income statement, by at least 4,700 %.
The Commission alleges that HRC's and Scrushy's actions violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. Specifically, the Commission has charged HRC with violating Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, and Exchange Act Rules 10b-5, 12b-20, 13a-1, and 13a-13. The Commission has charged Scrushy with violating Section 17(a) of the Securities Act and Sections 10(b) and 13(b)(5) of the Exchange Act, and Exchange Act Rules 10b-5 and 13b2-1. The Commission also has charged Scrushy with aiding and abetting HRC's violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Exchange Act Rules 12b-20, 13a-1, and 13a-13.
For these violations, the Commission is seeking a permanent injunction against HRC and Scrushy, civil money penalties from both defendants, disgorgement of all ill-gotten gains and losses avoided by both defendants as a result of the conduct alleged plus prejudgment interest thereon. The Commission also is seeking an order (i) prohibiting Scrushy from serving as an officer or director of a public company, (ii) freezing the assets of Scrushy, (iii) requiring HRC to escrow in an interest-bearing account, all extraordinary payments (including compensation) to any director, officer, partner, controlling person, agent, or employee, and (iv) preserving HRC's documents.
The Commission also obtained emergency relief on March 19, 2003 against HRC and Scrushy in the District Court. HealthSouth consented to the entry of an order by the Court (1) requiring that the company place in escrow, under the Court's supervision, all extraordinary payments (whether compensation or otherwise) to its directors, officers, partners, controlling persons, agents, or employees, pursuant to the provisions of the Sarbanes-Oxley Act of 2002, (2) prohibiting the company and its employees from destroying documents relating to the company's financial activities and/or the allegations in the Commission's case against HealthSouth in Scrushy, and (3) providing for expedited discovery in the Commission's case. The Court also entered a temporary order freezing substantially all of Scrushy's assets.
Pursuant to a separate Commission order issued on March 19, 2003, trading in the securities of HRC was suspended for two business days due to the materially misleading information in the marketplace.
The Commission wishes to thank the U.S. Attorney's Office for the Northern District of Alabama, the U.S. Department of Justice, and the Federal Bureau of Investigation for their cooperation in this matter.
The Commission's investigation is continuing.
SEC Complaint in this matter
3In the process of HealthSouth’s spectacular rise, Scrushy became one of thehighest-paid CEOs in the country.
From 1995-97, for example, he earned a total of $8.5million in salary, $23 million in incentive bonuses, $4.8 million in stock option awards,and $700,000 in other compensation.
By March of 2002, Scrushy ownedapproximately 20.9 million shares of HealthSouth common stock (representing 5.1% of the total shares outstanding) with a combined market value of more than $287 million.
Problems at HealthSouth started to become evident in mid-2002. In May,Scrushy sold more than $75 million worth of HealthSouth stock, and in June he soldanother $25 million back to the Company. HealthSouth then disclosed in August that achange in Medicare payment policy would “significantly lower reimbursement,” causingthe Company’s stock to lose more than half of its value and leading to shareholder lawsuits alleging that Scrushy had acted on insider information when selling his shares.Then, in February of 2003, the Federal Bureau of Investigation (FBI) announced theopening of a criminal investigation of HealthSouth for “possible securities lawviolations.”
3. ALLEGATIONS OF CORPORATE ACCOUNTING FRAUD
After the close of business on March 18, 2003, the FBI used a search warrant toraid HealthSouth’s headquarters and seize the Company’s financial records,
rehabilitation, surgery centers, and diagnostic centers. It has since sold off all but the inpatientrehabilitation division.
HealthSouth 1997 10-K, p. 64.http://investor.healthsouth.com/secfiling.cfm?filingID=1005150-98-290.
HealthSouth 2001 10-K, p. 79.http://investor.healthsouth.com/secfiling.cfm?filingID=1005150-02-448.Calculation based on March 22, 2002 share price of $13.74 per Yahoo! Finance, available athttp://finance.yahoo.com/q/hp?s=HLS&a=02&b=18&c=2002&d=02&e=18&f=2002&g=d.
HealthSouth press release, March 19, 2009.http://investor.healthsouth.com/secfiling.cfm?filingID=1005150-03-613.