Scrushy's Prognosis Looking Worse Than HealthSouth's

For once, an accused executive could make out worse than the company he allegedly poisoned.
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For once in the recent annals of corporate corruption, fate has lately been far kinder to

HealthSouth

(HLSH)

than to the corporate executive accused of laying it low.

The market barely skipped a beat last week when HealthSouth -- a company already on life support -- announced that its senior bondholders ruled the company in technical default. The stock, which eight months ago landed on the pink sheets at just 9 cents a share, momentarily slipped on the news but soon returned to its more recent perch around $3.

HealthSouth had, after all, defaulted on its bond terms -- by filing no financial statements -- months before the note holders actually complained. Thus, even the company was quick to downplay last week's warning.

"While there are natural tensions that arise in any negotiation process, today's action we believe is a very public tactic by the holders of these notes to try to extract greater value at the expense of other stakeholders," Joel Gordon, HealthSouth's interim chairman, stated. "We will continue to do what is right for the benefit of all HealthSouth stakeholders."

With common shareholders spared the worst, last week's real drama instead came at the expense of HealthSouth's wealthy founder. Richard Scrushy managed to rack up 85 criminal charges -- carrying hefty penalties and serious jail time -- as investors clung to their giant penny-stock gains.

For once, it seemed, top brass might actually pay more than the ordinary shareholders who are often left holding the bag.

"The penalties

Scrushy faces are very, very steep," said Alan Lieberman, who served as a federal prosecutor in the white-collar crime division of the U.S. Attorney's office in Philadelphia before joining the New York law firm of Blank Rome. "The stakes are so high that my expectation is that Mr. Scrushy will take this all the way for a jury to decide."

New Rules

Accused of orchestrating an elaborate scheme that spanned seven years and generated $2.7 billion in imaginary profits, Scrushy now faces charges ranging from conspiracy to securities fraud to false certification. But it is crimes like the latter, covered under the new Sarbanes-Oxley Act, that could cost him the most.

For every count covered by the new corporate governance law, Scrushy could pay a seven-figure fine and spend up to 20 years in prison. Lieberman, for one, has a hard time seeing the executive go scot-free.

"If you take a complicated case to trial, many, many things can happen," he admitted. "But I must tell you, I don't think I've ever seen a white-collar case with five CPA/CFOs testifying

against the defendant. It's going to be very difficult to make all of them out to be liars."

All told, 15 former finance executives have pleaded guilty to various charges of their own and are now cooperating in the government's case against Scrushy. The one-time respiratory therapist -- who cashed in on the empire he built less than a year before it collapsed -- is now headed for trial in early January. In the meantime, his 38-page indictment offers a detailed glimpse of the government's mounting case against him.

Game Plan

Although the government originally hinted at signs of fraud dating back to 1984 -- the very year HealthSouth went public -- it has narrowed its focus down to a recent seven-year window in its complaint against the company's founder.

Beginning in at least 1996, the feds allege, Scrushy supervised a scheme that inflated the company's profits and assets by $2.7 billion each in an effort to please Wall Street and push the stock price higher. Over the next seven years, the government states, Scrushy would go on to collect $267 million in pay -- $206 million of it from stock options -- based on the overstated strength of his company.

For his part, Scrushy has accused his subordinates of carrying out the scheme without his knowledge and hurting him, along with other shareholders, in the process. But the government portrays Scrushy as the captain of a long-running game that, if anything, some of his colleagues never wanted to play.

To control his "co-conspirators," the government claims, Scrushy used threats and intimidation, monitored company emails, installed eavesdropping equipment and provided big financial packages to those who were loyal to his cause. Moreover, the government says, Scrushy convinced his senior officers to certify false financial statements -- relied on by those who bought the company's securities -- by, among other things, "reminding them that they had already committed illegal acts," "suggesting that there was a 'plan' to take care of the fraud" and "suggesting that continuing with the scheme was the 'right' thing to do."

In an unintended way, the new Sarbanes-Oxley Act fulfilled its purpose by putting an end to the apparent, long-running scheme. Nervous about certifying false reports -- and facing the threat of prison -- HealthSouth executives allegedly devised a plan that would finally lower Wall Street expectations down to the company's real potential.

U.S. Rep. James Greenwood marveled at the elaborate plan during opening remarks last month at a congressional hearing on HealthSouth's collapse.

"What is unique in this case is how the company's senior officers crafted an elaborate ruse to 'come clean' with Wall Street about true projected earnings -- once it became obvious they would need to do so -- by blaming a Medicare billing policy for an immediate and ongoing $175 million annual hit to its books," Greenwood stated. "The reality, as we will hear today, is that this policy clarification would have little immediate impact and questionable long-term impact on HealthSouth."

Trick Strategy

As

TheStreet.com

reminded in early April, the Medicare "hit" wasn't the only bombshell HealthSouth was dropping in those days.

It also announced plans to split into two separate companies so that its lucrative surgery centers could be freed from the outpatient treatment clinics that Medicare was supposedly hurting. At the time, investors were so stunned by the Medicare news that they paid the spinoff plans very little mind. But

TheStreet.com

took a fresh look back at that planned breakup -- quickly scrapped after HealthSouth came under scrutiny -- and

concluded that the logic behind it never added up.

TheStreet.com

further speculated that HealthSouth may have planned the spinoff to make detection of the company's alleged accounting fraud more difficult to trace.

Since then, the government has also tied the breakup plan to the alleged accounting scheme. But it has indicated that HealthSouth was, at that point, less concerned about covering its tracks than in convincing executives to sign off on fraudulent financial statements one last time.

Scrushy "agreed to and helped devise a plan to offer

a senior officer who had balked at signing the Form 10-Q the position of CFO of the company that was to be spun off from HealthSouth and which was believed 'clean' -- that is, which was largely unaffected by fraudulent entries -- and promise the senior officer that they would 'not play games anymore' to induce the senior officer to sign the form," last week's affidavit states.

That senior officer, who appears to be former CFO Weston Smith, would soon become the first HealthSouth insider to plead guilty to fraud charges and turn against the company's founder.

Overtime Session

Meanwhile, HealthSouth has continued to operate under the threat of looming bankruptcy.

But the company, manned by an industry veteran and a turnaround artist, is still afloat. By July, in fact, it was promising to deliver $4.13 billion in revenue and $650 million in earnings before interest, taxes depreciation and amortization over the next 12 months. Merrill Lynch analyst A.J. Rice applauded the update -- the first for information-starved investors in months -- but nevertheless maintained his sell recommendation on HealthSouth shares.

"We believe the incremental information provided yesterday buys the company another 90 to 120 days from its creditors by painting the picture that a near-term bankruptcy filing would significantly impair the value of the company," he wrote. "Longer term, however, we are still concerned that the risk of a Chapter 11 filing will rise significantly when negotiations begin in earnest."

Rice's final report, issued less than two months later when he essentially dropped coverage of the stock, is among the last available on the company. Since then, HealthSouth has managed to stay current on all interest payments to its creditors. But even bond analysts, like SG Cowan's Kemp Dolliver, are still leery about forecasting the company's future.

Lieberman, at least, predicts the company will be spared a crippling indictment. Indeed, federal prosecutors have already praised HealthSouth for throwing open its books and fully cooperating with their probe.

"I don't think the

government is interested in piling on because that's seen as harming the shareholders," Lieberman explained. "If anything, the company was -- in a very real sense -- also a victim of what happened here."

Lieberman says the government will be far more interested in helping shareholders out. Already, the feds are eyeballing an eye-popping list of assets -- including multimillion-dollar beachfront property, armored SUVs, a Cessna aircraft and even a racing boat with the now-haunting name of "Monopoly" -- that they want Scrushy to forfeit as part of his alleged ill-gotten gains.

If the government succeeds, Lieberman said, shareholders stand to win.

"The whole point of

SEC

enforcement is to prevent the victimization of shareholders," Lieberman said. "Whatever monies can be recovered will, to the extent possible, go back to the company and its shareholders."