HealthSouth: A Spitting Image of Enron


Based out of Birmingham, Alabama, HealthSouth flourished from a $50,000 investment to a Fortune 500 company. Richard Scrushy, CEO and founder of HealthSouth, led the company from a single office to thousands of rehabilitation, diagnostic, and outpatient centers across the nation. With a domineering attitude and an authoritative presence in the company, Scrushy was accused of falsifying financial statements during the years leading up to the establishment of the Sarbanes-Oxley Act in 2002; Scrushy was the first executive tried under this act. According to Scrushy, all of his employees and management staff had turned against him, and had simply falsified financial statements for their own personal gain. After all, who would ever suspect Birmingham’s biggest benefactor (Scrushy) to commit such devious, fraudulent actions? After a thorough investigation, Richard Scrushy was charged on 36 counts of accounting fraud for inflating HealthSouth’s earnings by billions of dollars. The Scrushy case is particularly notable, and disappointing, given his strong presence in both the healthcare industry and society more generally: an admirable and well-respected CEO deliberately manipulated internal control procedures to provide a higher financial standing to all investors. The following pages will detail the history of HealthSouth, the incentives and rationalizations behind falsifying HealthSouth’s financial statements, and the ethical dilemmas faced throughout the entire period of HealthSouth’s most impactful company-wide scandal.

Founded in 1984, HealthSouth has rapidly grown into a leader in health medicine, especially in sports therapy. Handling upwards of over 100,000 patients a day, the company has become a well-known and highly regarded rehabilitation and outpatient care center. However, HealthSouth did not primarily begin as a rehabilitation center, but rather as a clinic that assisted patients by lowering the steep out-of-pocket costs they would otherwise face at hospitals due to less overhead. Scrushy saw a niche in this market when he began as a respiratory therapist who assisted patients at home. Scrushy saw that patients began using rehabilitation centers as a means of cutting costs and reducing medical expenses (International Directory). Spurred by this realization, Scrushy designed and structured treatment plans to meet the specific needs of his patients while providing the highest standard of care. With personal testimonies from Dan Marino, Michael Jordan, and other professional athletes, HealthSouth tapped into a larger sports market; Scrushy saw sports therapy as a promising and profitable business venture, so he utilized his biology background to propel him into sports science (Anderson). Scrushy considered HealthSouth’s initial business operations to be short-term and limiting in the early nineties since insurance providers and employers were eager to remove chronically ill patients from the health care system. With Scrushy’s new plan to target younger athletes and other injured individuals, HealthSouth shifted its focus from chronically ill patients to those with the potential to recover (Anderson). HealthSouth pursued its shift in focus by absorbing new companies, acquiring more rehabilitation facilities, outpatient centers, and even imaging centers, allowing for its specialized care to be offered across the nation. HealthSouth’s dynamic atmospheres allowed for a large customer base ranging in all ages. With such specialized care, HealthSouth seemed positioned to succeed, and customers could have never predicted the closure of hundreds of centers following the company’s accounting fraud scandal.

In addition to surprising and inconveniencing customers, HealthSouth’s falsified financial statements impacted shareholders and several other stakeholder groups. On March 19, 2003, the SEC filed accounting fraud charges against HealthSouth (“Securities and Exchange Commission”). Investigations showed that, since the late nineties, HealthSouth had overstated earnings by billions of dollars to meet and even exceed Wall Street expectations, giving shareholders a false impression of HealthSouth’s standing in the marketplace (See Figure 1). It was even said that if actual earnings were presented in a way that contrasted Wall Street predictions or expectations, Scrushy forced employees to “fix it,” or adjust the numbers to match what financial moguls expected of HealthSouth (Anderson). Investors, in turn, bought HealthSouth stock based on the financial position the company had in the market. This investor activity drove up the price of HealthSouth’s stock, an outcome that seems to be a potential motive behind Scrushy’s incentive to falsify financial statements. Given the fact that CEOs have stock options tied into the company, they have the option to buy the stock and immediately sell for more money. Thus, Scrushy personally benefitted from having a higher stock price, since the outcome of selling his stocks yielded more personal profit; Scrushy sold $99 million (stock priced at $10-$14/share) in HealthSouth stock only days before a huge loss was recorded (See Figure 2 for Scrushy’s annual pay). Scrushy claimed that he was “entitled to gaining millions of dollars” because he grew the business from the ground up (Anderson); when the stockholders lost billions, Scrushy made millions. When questioned about his personal gain and the rationalizations during this fraudulent period, Scrushy immediately shifted all of the blame towards his CFOs, both past and present, claiming that the fraudulent financial image was a way for them to attain power, status, and even promotions; everyone, including the SEC, was “against him” (Anderson). Despite the testimonies of past and present employees and CFOs, Scrushy was acquitted on 36 counts of accounting fraud in 2005; the trial went entirely in his favor. Scrushy’s defense asserted that his CFO was on “mood-altering drugs” during the time he acted as CFO, and that the former CFO was “obsessed with the company’s stock movements.” In the years following, HealthSouth had to restate earnings to account for the million-dollar discrepancies between their actual losses versus their recorded revenues (HealthSouth Founder).

HealthSouth is not the first, and is certainly not the last, company to face accounting fraud scandals. In 2001, Enron, a Houston-based energy trading company, was able to inflate revenue by keeping hundreds of millions worth of debt off its books (“The Biggest Stock Scams”). Enron tricked investors and analysts into thinking the company was fundamentally stable, when in fact it was not. Earnings figures were inflated; the motivation behind such devious upper-management behavior, which was facilitated by the external auditors of Arthur Andersen, was again personal gain. Rather than relaying accurate information to investors, both Enron and HealthSouth cost their shareholders billions of dollars, and both fraud scandals stand as two of the most notorious accounting fraud scandals in history. Looking at both companies through a fraud triangle, a commonly used accounting metric, one is able to dissect the fraudulent acts based on opportunities, incentives, and rationalizations (See Figure 3). Beginning with opportunities, both companies obtained weak internal controls that allowed for such fraudulent activities to occur; internal controls include adequate separation of duties, proper authorization of transactions and activities, adequate documents and record, physical control over assets and records, and independent checks on performance. In both cases, the individual–Richard Scrushy or Jeffrey Skilling–who either told employees to fix figures to reflect a better financial position or created an atmosphere where cutthroat competition prevailed, also signed off on the financial statements or had the authority to affirm the financial statements. Scrushy and Skilling, thus, were free to act without significant checks and balances and could fabricate their companies’ ideal financial images. Also, simple transactions were made complex to hide the real nature of the fraud, such as special purpose entities (SPEs) and decreasing values in contra revenue accounts to allow for higher recorded revenue. Both examples demonstrate opportunities for accounting fraud to occur in businesses given the absence of adequate internal controls. Secondly, incentives are presented for upper-level management or other executives involved in financial reporting. Pressures for compensation packages, increased personal wealth, and greed all stood at the forefront of Enron and HealthSouth’s accounting scandals. HealthSouth incentives revolved around personal wealth and greed: Scrushy sold stocks at a higher price and earned $99 million and his CFO allegedly misstated earnings for the effect of a higher stock price, then the likely promotion, and ultimately, power (Anderson). For Enron, incentives for accounting fraud were linked to compensation packages and greed. Work performance evaluations and compensation packages or bonuses were based on performance (stock execution) rather than viability. In this case, greed and compensation packages work simultaneously since compensation packages were based on the individual, so people determined their actions based on increased earning potential. Though several other incentives could be attributed to both scandals, greed, compensation schemes, and personal wealth were emphasized throughout each case. Lastly, individuals rationalized their actions related to falsifying financial statements for either Enron or HealthSouth. Both companies rationalized their actions from a “we have to do this or else…” perspective: where personal assets are at risk, shareholders might not invest in the stock, and the company runs serious financial risk. Employees could have feared for the company’s financial future, and thereby their own financial futures, and may also have feared confronting Skilling and Scrushy. Individuals who contributed to fraudulent activities in both Enron and HealthSouth took years before they reported such falsifications. What might have begun as a “one-time action” turned into expensive and highly publicized accounting fraud scandals. Both companies suffered consequences from their fraudulent actions, which demonstrate the inescapable fraud triangle of opportunities, incentives, and rationalizations.

As described in the previous paragraphs, HealthSouth did not abide by ethical practices when reporting its earnings to the public. Considering the company through a deontological lens, one can establish the company’s ethical position by judging the morality of an action based on the action’s adherence to a rule or rules. Morality, in this context, is a matter of duty. When engaging in business practices, executives and all employees of a company are expected to perform and decide ethically and morally. However, companies like HealthSouth demonstrate just how far certain executives and upper-level management will extend themselves beyond moral thresholds to prove a better financial position in the market and thus increase stock price. As an executive, Scrushy had the moral obligation to provide an atmosphere that performed ethically and morally. However, rather than thinking of the effects accounting fraud has on a company’s stakeholders, shareholders, and the company itself, Scrushy was more interested in the short-term benefits from an increased stock price. Similarly, he was so consumed by his desire to match or exceed the expectations of Wall Street, that he went to great lengths to cover up the reality of HealthSouth’s business operations. Though Scrushy may not have individually contributed to the financials, he was the most responsible for any accounting errors or fraudulent practices at HealthSouth. In 2002, Congress passed the Sarbanes-Oxley Act, which required CEOs and CFOs to sign off on the accuracy and soundness of their companies’ financial statements. From a deontological perspective, the executives and management of HealthSouth did not adhere to the legal regulations set in place by Congress. Similarly, the HealthSouth Business Code of Conduct states that employees or those involved in reporting financials will “record [the] financial results with integrity” (“HealthSouth Corporation” 17). Therefore, HealthSouth and those most involved with falsifying financial statements and overstating earnings did not practice ethically or morally since no one followed the rules set in place by either Congress or HealthSouth itself.

Kant, through deontological ethics, believed that human beings follow laws of their choosing by acting rationally, and the notion of being a “free creature” enables humans to be rational and moral; the categorical imperative is a requirement of reason (Bowie 4). Consider what would happen if accounting fraud was a universal law, a maxim where an action is universalized. Is it morally permissible to allow any executive, no matter how greedy or dishonest, to falsify financial statements and record misstated revenue to demonstrate a better position in the market? The answer is no. It is simply not possible for the principle of falsifying financial statements to be universally accepted. From an accounting standpoint, if investors can no longer trust the market, they will no longer invest, and companies decrease their equity and, in turn, decrease their assets to offset the change in equity (all else equal). As a result, companies run the possibility of being forced into bankruptcy due to the fluctuating asset, liability, and equity accounts. Kant’s second formulation of the categorical imperative states that one should “treat the humanity in a person as an end and never as a means merely” (Bowie 7). From this, a distinction between positive and negative freedom in humans is drawn. With regards to HealthSouth, Scrushy, as CEO, had the freedom to deceive the public and coerce his employees into stating earnings in a way that exceeded Wall Street expectations. Thus, Scrushy utilized his power to negatively impose his will. Similarly, Scrushy interacted with his employees in a way that inhibited human rationality and employees’ moral capacities, so there was no period of time where Scrushy positively exercised his personal freedom as a CEO. It is important to note, however, that employees are expected to behave responsibly without supervision. Kant’s third and final formulation of the categorical imperative asserts that a business firm should act as a moral community, and that the interests of stakeholders must be considered before any decision is made (Bowie 10). Although there are seven organizational principles to this formulation, HealthSouth did not specifically consider the interests of all affected stakeholders during its frequent decisions to falsify financial statements and relay inaccurate information to the public. The potential short-term gains of the fraud outweighed the potential long-term ramifications; the HealthSouth executives, managers, and those involved in creating financial statements never considered the consequences of their actions, which cost shareholders billions of dollars and affected various stakeholder groups. Kant goes beyond the categorical imperative by stating that one’s action is moral if it is morally motivated. Ultimately, truly moral actions cannot be spurred by motives of self-interest (Bowie 12). In the case of HealthSouth, Scrushy was completely motivated by his own self-interest, aiming to raise stock prices to match expectations Wall Street predicted for HealthSouth to augment company and personal profit. Since HealthSouth’s actions were neither ethically nor morally motivated, the actions are not justified, nor are they moral.

To conclude, the actions of HealthSouth were a result of the choices that were made with a purpose in mind: to meet and/or exceed the expectations predicted by Wall Street in order to maximize profit. HealthSouth vastly overstated its earnings and violated shareholder trust by costing them billions of dollars. Once highly regarded in the community and well-respected in the healthcare industry, Scrushy is now despised for his fraudulent actions. At one point, Scrushy had his name on several buildings around Birmingham, but his unethical and immoral business practices led to his downfall. HealthSouth has taken years to restructure internal controls, hire new executives and management, and re-establish the trust of investors, but the company continues to thrive today. With the several accounting fraud cases presented to the public, individuals want to know why executives or employees contribute to such vicious, fraudulent cycles. When opportunities, incentives, and rationalizations present themselves, the severity of the potential consequences might not be closely examined or analyzed. When considering the personal incentives behind fraudulent actions, one must not forget to consider the sets of rules established by the company or by Congress, especially in the accounting industry. Scrushy did not foster an environment that engaged in ethical or moral practices, although he was acquitted of all charges brought against him. Scrushy ultimately believed that since he lived out the “American Dream” by growing a business from a small company to a prominent leader in the healthcare industry, he was entitled to compensation and deserved liquidity. Scrushy’s rationale presents a deeper consideration: does an executive’s investment and success in a company permit behavior that violates ethical and moral codes? Does corporate power and financial success somehow create legal, ethical and moral immunity?

Figures:

hs-numbers

Figure 1

scrushypay

Figure 2

Fraud-Triangle

Figure 3

Works Cited:

Anderson, Robert, Josh Fine, and Mike Wallace. 60 Minutes. New York, NY: Columbia Broadcasting System, 2003.

Bowie, Norman E. “A Kantian approach to business ethics.” A Companion to Business Ethics (ed Robert E. Frederick), Blackwell Publishers Inc., 1999.

“HealthSouth Corporation Standards of Business Conduct.” HealthSouth Corporation Standards of Business Conduct. SEC. 14 Apr. 2016.

“HealthSouth Founder Acquitted.” LexisNexis® Academic. Facts on File, 30 June 2005. 14 Apr. 2016.

International Directory of Company Histories, Vol. 33. St. James Press, 2000.

“Securities and Exchange Commission.” HealthSouth Corporation and Richard M. Scrushy: Lit. Rel. No. 18044 / March 20, 2003. SEC, 20 Mar. 2003. 14 Apr. 2016.

“The Biggest Stock Scams Of All Time | Investopedia.” Investopedia. N.p., 29 Dec. 2003. 14 Apr. 2016.

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