Shareholders of

HealthSouth

, a company left for dead more than a year ago, are taking aim at the vultures circling above.

Last week, more than 100 HealthSouth shareholders -- many of them retail investors united through an Internet stock board -- officially urged the company to investigate a major fund manager who has made a name for himself by profiting from distressed companies. The shareholders, led by an accountant who runs a small investment fund in Atlanta, have raised questions about what they say are possible insider trading violations by Franklin Mutual Advisors Senior Vice President Michael Embler.

Embler is known as an aggressive scavenger who favors the debt of struggling companies like

Qwest

(Q)

and

WorldCom

. His fund scooped up HealthSouth bonds early last year, when the healthcare chain revealed a multibillion-dollar accounting fraud, and has since assumed a prominent role in a bondholder fight against the company. His group is seeking a big wad of cash to keep them from accelerating debt payments -- and triggering a possible bankruptcy -- under a technical default caused by the company's lack of audited financial statements. The group, known as the Unofficial Committee of Bondholders, has so far refused HealthSouth's cash offers as "clearly insufficient" and has accused the company of employing "strong-arm tactics" instead of negotiating in good faith with its creditors.

But HealthSouth shareholders -- on a roll before the bondholder fight heated up early this year -- are questioning Embler's own negotiating strategy. They claim that Embler's fund bought 25% of one class of bonds, "the minimum amount required to accelerate payment," so that it could single-handedly threaten HealthSouth about a technical default that has existed since the company disavowed its financial statements 14 months ago. HealthSouth has warned investors that it cannot file audited financial statements until next year.

"It appears that Embler and Franklin undertook

their actions pursuant to a carefully crafted plan to extort money from the company," wrote Bryan Prewitt of Zimmer Park Advisors. "It is our view that the demands being made by the UCB, which acts on behalf of a small number of bondholders, would greatly enrich this group at the expense of stockholders, the employees and the patients of the company."

Neither Embler nor the attorney representing his group returned phone calls from

TheStreet.com

on Wednesday.

Question of Timing

Prewitt says the bondholders are seeking roughly $300 million -- almost half of HealthSouth's cash -- to compensate them for a default that was already in place when they invested in the company. He also suspects that Embler, who personally sold HealthSouth stock just before seeking a lead role in the bondholder fight, may have unfairly traded on insider information.

Franklin Resources

(BEN) - Get Report

, the parent of Embler's fund, is itself engulfed in a huge stock-trading scandal. The giant mutual fund is one of dozens currently under investigation for allegedly generating profits through questionable "market-timing" practices.

Now HealthSouth shareholders are spotlighting Embler's personal transactions -- specifically the sale of 20,000 shares of HealthSouth stock in late January -- as well.

"This stock sale occurred suspiciously close to the time Embler was carrying out the plan to threaten the company with acceleration," Prewitt wrote in the shareholder letter to acting HealthSouth Chairman Joel Gordon. "Does this sale constitute insider trading, front running or any other violation of

Securities and Exchange Commission rules?"

The petitioning shareholders -- who collectively own 2.5% of HealthSouth's stock -- blame Embler's actions for a recent decline in their investment. The stock, which bottomed out last year below a dime a share, approached $6 in January before Embler plunged heavily into the bondholder fight. It later fell below $4 and, after a penny gain on Wednesday, is now trading at $4.70 a share.

Fair Game?

When contacted by

TheStreet.com

on Wednesday, HealthSouth had little to say about the shareholder letter except that it was "interesting."

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But Prewitt says he has fielded reassurance from HealthSouth that shareholder interests are "certainly aligned" with the company's own. In the meantime, HealthSouth has itself already grilled the noted vulture investor.

In a lengthy deposition taken two months ago, HealthSouth attorneys questioned Embler about everything from his role in the current bondholder fight to his reputation as a scavenger in general. HealthSouth, which questioned the fund manager as it sought an injunction against the possible acceleration, established that Embler was aware of the company's lack of audited financials -- a trigger for default -- when he bought the bonds. It also noted that details about accelerated payments and "make-whole" provisions were highlighted or underlined in the financial statements that Embler reviewed when making his investment. Moreover, the lawyers got Embler to admit that he "probably" examined specific language that allows big bondholders -- owning at least 25% of a certain class of notes -- to accelerate payment during a time of default.

Prewitt, citing SEC filings, says that Embler's fund actually sold three types of HealthSouth bonds and reinvested the money in a single class so that it could achieve a powerful 25% stake early this year. He also says that Embler pursued a leadership role in the bondholder fight during this same time frame.

Embler's own testimony validates this claim.

In a February email to consultants for the bondholders, HealthSouth attorneys said to Embler, "You said, 'Pick me. Pick me.' What were you asking to be picked for?"

"Participating in this small negotiating group," Embler responded. "I was a significant holder of the securities ... and felt that I would like to participate in that negotiation in hopes of ultimately resolving the continuing defaults of the company."

If anything, however, the dispute has only escalated since then. Bondholders last week overwhelmingly rejected HealthSouth's overtures and called for more cash as they head toward a June 30 hearing that, while unlikely, could decide the matter in the end.

"By withholding consents," the bondholders committee stated, "bondholders have sent a strong message to HealthSouth that significantly more compensation must be offered to waive the serious existing defaults and to make the significant amendments to the indentures being sought by HealthSouth."

Prewitt calls the situation a very unusual one. In general, he says, companies tend to make big payments to bondholders only when they trigger "real" defaults and find themselves hemorrhaging cash in the process. In contrast, he says, HealthSouth has remained current on all of its principal and interest payments.

Nevertheless, bondholders are asking for an 11% make-whole premium totaling $253 million -- compared to 1.4% offered by the company -- to resolve the current dispute.

"We have the right to demand anything we want to cure the default," Embler told HealthSouth attorneys bluntly. "The company is already in trouble with us. What we came in to do is try to work with the company to complete their journey out of trouble with us."

One attorney immediately shot back by asking, "Is this not a form of extortion?"

The attorneys then went on to explore Embler's reputation as a scavenger. Embler said he is not offended by the label. Indeed, he pointed out that he had landed on

Fortune's

list of the 40 richest people under 40 as a result of his success.

In the past, Embler's fund has invested heavily in other troubled healthcare companies as well. For example, it wound up with nearly one-quarter of the stock in

Kindred Healthcare

(KIND)

-- where Embler now serves as a director -- after the company went bankrupt in 1999.

Embler's boss, David Winters, last year told

SmartMoney

that the fund is always looking for bargains in the "treacherous" and "complicated" world of distressed securities. The fund often finds opportunity where common investors see only ruin.

"We're hopeful that there will be a lot more bankruptcies in the future," Winters told

SmartMoney

.

Prewitt, for one, is sickened. He says Embler's group has already "made out like bandits" by doubling their money on HealthSouth bonds but, nevertheless, keep asking for more under a technical default they are trying to exploit.

"Once you know the whole story, it will turn your stomach," Prewitt said. "It's a nasty scenario."