Suit Says Ernst and UBS Knew of HealthSouth Fraud

By Gretchen Morgenson and Reed Abelson, 01/09/04

HealthSouth's outside auditors and investment bankers knew of fraudulent accounting at the company long before financial problems came to light last year, according to a lawsuit filed yesterday on behalf of stock and bond investors.

The suit, filed in United States District Court in the Northern District of Alabama, contends that Ernst & Young, HealthSouth's former accounting firm, and UBS Warburg, its former investment banker, were aware of fraud at the company even as they signed its financial statements and sold HealthSouth securities to the public.

The investors filing the suit bought HealthSouth stock and bonds from 1998 to 2002.

Richard M. Scrushy, the founder and former chief executive of HealthSouth, was indicted last fall on 85 criminal counts that accuse him of inflating profits by $2.74 billion from 1996 to 2002. He has denied any role in the misconduct. In the nine months since the financial problems came to light, 15 former HealthSouth executives have pleaded guilty to manipulating the company's financial results.

The Alabama Retirement Systems, the lead plaintiff in the HealthSouth bondholder litigation, invested $35 million in the company's bonds and lost half that investment when the HealthSouth fraud was disclosed, said John P. Coffey, a lawyer at Bernstein Litowitz Berger & Grossmann in New York who represents the Alabama pension fund.

"It is especially appalling that at the same time UBS bankers were urging investors to buy HealthSouth bonds, their own internal documents show that UBS considered HealthSouth to be a 'borderline' credit risk with a declining business model,'' Mr. Coffey said. "And the bank even conditioned loaning money to HealthSouth on an internal decision to reduce the bank's credit exposure in months, if not weeks, after setting up the credit facility."

The lawsuit's accusations that HealthSouth's investment bankers and auditors knew about the fraudulent accounting is attributed to an unidentified former senior HealthSouth executive who was involved in the fraud.

As early as 1994, according to the lawsuit, Ernst & Young knew HealthSouth was overstating earnings. As the accounting firm concluded its audit of the company's 1993 financial statements, the lawsuit said, a partner overseeing the account told a senior executive of HealthSouth to agree to a particular accounting treatment because Ernst & Young had looked the other way on $27 million in overstated earnings.

"The allegation is based on an unattributed quote, which we have no reason to believe is accurate,'' a spokesman for Ernst & Young, Charles Perkins, said. "The problems at HealthSouth were the direct result of former management at the company, and Ernst & Young should not be included in the lawsuit."

Ernst & Young auditors who signed off on the company's financial reports year after year have previously said that they believed the results, though five chief financial officers at HealthSouth have since said they were lies.

The lawsuit also contends that from 1999 through the fall of 2002, a UBS investment banker had regular conversations about the fraud at HealthSouth with a former company executive who had taken part.

The discussions involved the likelihood of criminal prosecution and the penalties that could result against both of them, the suit contends.

Benjamin D. Lorello, a managing director of UBS Securities and head of its health care banking group, was also aware of the fraud at HealthSouth, the complaint contends. Nevertheless, UBS helped the company arrange a string of acquisitions, sold billions of dollars of HealthSouth securities to investors and issued glowing research reports on the company, it added.

Indeed, the lawsuit contends, UBS documents show that in 2000, as the bank was negotiating to provide HealthSouth with a $687 million credit line, the bank considered the company to be "borderline." And in 2002, UBS documents indicate that while the firm was willing to approve a $120 million loan to HealthSouth, the bank's credit risk committee recommended reducing its exposure to $50 million of the loan after six months.

"Whilst we have not reviewed the claim in detail, as we have said previously, we have no reason to believe that anyone at UBS had any knowledge of the fraud at HealthSouth," Mark Arena, a UBS spokesman, said. "We believe any claim that UBS had knowledge of the fraud is without merit and UBS will defend itself vigorously against any such claim."

Howard Capek, who followed HealthSouth as a research analyst at UBS, is also named in the suit. It contends that in 2001, as Mr. Capek recommended HealthSouth shares to the firm's clients, he acknowledged to a business acquaintance that the company had accounted improperly for its expenses.

Thomas Fitzpatrick, Mr. Capek's lawyer, described the accusations against Mr. Capek as "totally baseless, as far as I know, and indeed libelous."

Mr. Lorello's lawyer, Robert J. Anello, said, "Mr. Lorello did not have any knowledge of the fraud at HealthSouth."

Mr. Lorello testified last year at a Congressional hearing on HealthSouth that he "was not aware of and did not suspect that anyone at HealthSouth was engaged in improprieties.''