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From the Team

So How Does Fraud Start?

I was lucky to be able to attend a breakfast session hosted by the National Association of Corporate Directors in Raleigh, NC last week.

It was good for me- a seasoned CFO- to get reminders of the dangers of fraud.

Red Hat’s General Counsel Michael Cunningham who interviewed Weston Smith, former CFO of HealthSouth, moderated it. Weston Smith is known as the whistleblower on former CEO Richard Scrushy’s billion-dollar fraud.

HealthSouth is the largest owner and operator of inpatient rehabilitative hospitals in the US with a $3B market cap. HealthSouth was once a Wall Street star with a market cap of over $13B in 1998.

As a CFO I was keenly interested in understanding how a Fortune 500 company with a 1800 hotline, highly reputable auditors, well known board members, internal audit teams and all the controls big companies had was able to continue for so long with rampant fraud. The external auditor even received a letter outlining the fraud from a former finance employee but they went directly to the people who created the fraud- allowing them ample opportunity to concoct a credible explanation!

Weston Smith served 14 months in federal prison, followed by a four-month stay in a halfway house in Alabama. He’s a very credible individual who having lost his CPA license now earns the salary of a new college grad.

Richard Scrushy was the CEO who created an environment of fear, lies and win at all costs. Scrushy had armed plainclothes security everywhere he went and made sure all the executive team knew this. When one “independent” board member threatened to dig deeper Scrushy said he would expose the director’s improper relationship to his wife.

The fraud ramped up on the first quarter after HealthSouth’s IPO and got increasingly worse. This fraud was no small cover up- the executives met each quarter in front of a whiteboard to figure out a credible way to message the story.

HealthSouth was in the bizarre position where it frequently paid more corporate taxes than actual profits.

Smith said, “You will all encounter that first time when you have an ethical decision to make. Make the wrong decision and you may spend the rest of your life compounding it and trying to cover it up. What is the foundation in your life that will keep you from slipping and making the mistakes I did?”

 Recommendations/Check-list

  • Allow Board Directors unfettered access to lower level management

  • Examine how accounting estimates are calculated – such as bad debt reserves, commissions and acquisition accounting.

  • Ask more questions of your audit team, dig deep and do not let up

  • Is there top talent on your Internal Audit team? Make a rotation in IA a part of your finance leadership development program.

  • How does bad news gets received? Many CEOs do not want to hear bad news. Red Hat’s policy is one of encouraging employees to voice their concerns until they are satisfied.

  • Examine your Target setting process, what are the break points for Exec bonus payouts? Is it all or nothing encouraging aggressive accounting?

  • Have Independent board directors and examine related transactions.

  • Have head of Internal Audit reporting to a board director.

  • Set the right ethical tone: Red Hat had Weston talk to the sales teams three times and the GC writes an email to all employees on ethics frequently.

  • Remember that rapid growth always brings challenges- especially in foreign locations. Internal Audit usually goes to these places only when there are material revenue contributions to big companies- and maybe way too late to remedy fraud.

  • Do you have too many internal promotions and a dearth of external hires especially in your finance function?

  • Are there excessive one-time charges making it hard to understand earnings?

  • Are there constant acquisitions allowing cover for creating reserves to boost profits when needed?

  • Is there a constantly changing business plan and performance that greatly exceeds that of competing companies?

 So how does a fraud start? With thoughts like: “This is only temporary….We can’t disappoint Wall Street….Everybody does it.”

 Interestingly, Scrushy was acquitted of fraud in a 2005 criminal trial but served a six-year sentence in federal prison in Texas for bribery.