Case study 3
Quandary at National Health Company
N. Ahadiat, & D. Rice
Abstract
National Health
Company (NHC) became one of the nation’s leading providers of healthcare during
the early 2000s, through aggressive mergers and acquisitions. The company provides both in and out patient
care such as convalescent care, rehabilitation, physical therapy, outpatient
surgical centers, ultrasounds, mammograms, MRI’s, CT scans, and other medical
services. The company’s rapid expansion
initially resulted in a substantial amount of profit and success in the
healthcare market. However, it became
increasingly difficult to maintain the growth and expansion in light of the
economic climate, continued pressure from Medicare, the insurance companies to
cut costs, competition from other health field carriers and the concern over
potential government funded health care programs. As the NHC’s management failed to sustain the
expected growth, its management resorted to other strategies that not only
maintained the expectation of its shareholders, but would also allow management
to keep their extravagant life style.
In this case, we will follow the struggles and anguish faced
by Karen Larson, NHC’s Chief Financial Officer, as she battles her way through
making the right financial and corporate governance decisions and not to allow
herself to be allured, by fancy titles, avarice and greed as well as upper
management pressure placed before her. We will present not only the decisions
she has to make but also the outcome of her decisions.
Background
National Health Company (NHC) is one of the nation’s largest
providers of healthcare. It is ranked in
the top ten nationally in terms of size and revenue. The company reached its ranking by expanding
rapidly through aggressive mergers and acquisitions throughout the late 1990’s
through the 2006. The company had 50 facilities across the nation in 1990. By 2006 the company had purchased another 28
hospitals and 45 outpatient rehabilitation facilities from National Health
Enterprise. In 2003, NHC purchased
ReLive, a major healthcare chain. In
2005, NHC acquired Medical Surgical Corporation, Novacare, Health Imaging,
Horizon and several other healthcare providers, with acquisition costs totaling
approximately $2.5 billion. The buying
binge positioned the company as one of the major players in the healthcare
industry.
As the expansions continued, the NHC’s stockholders became
accustomed to a period during which they enjoyed double digit growth rate in
their investments. Yet, once this growth
began to truly slow down, management and Karen Larson, NHC’s Chief Financial
Officer (“Karen”) did not pay any heed but instead took various steps to ensure
that the price of the stock would continue to soar.
In December 2008, Karen was celebrating a triumphant moment
in her career. She had been made the CFO
in a company she loved. For Karen, this
moment did not come soon enough. For 20
years, she had set her sight on this position.
She had toiled in the trenches, putting in long hours and sacrificing
even her vacation time in hopes of attaining her dream job. Achieving this position was a fitting
culmination of her years of dedication.
It was a richly deserved reward that she cherished and relished. Now Karen was too pre-occupied with her
thoughts. As she sat huddled in the
corner of her dark prison cell, surrounded by belligerent, mentally unstable
inmates, Karen Larson’s mind could not help but revisit the fateful day when
her plunge from the lofty perch in a major corporation to the bowels of prison
began. Painfully, it was time for her to
trace back her steps to what had brought her here.
The Plan
No sooner had Karen
settled on her new position, when her troubles started. Approximately nine months into her new job,
Karen Larson was lying awake, sleepless and listless on her bed. Her thoughts
wandering around the meeting she had earlier in the day with several other
members in upper-level management.
George Dawson (“George”), the CEO of the company had gathered all the
members of upper-level management with direct relations to the finance and
treasury departments. George had started
the meeting with a speech about how proud he was to be working with such
trustworthy and loyal associates, and how he was very fond of everyone and how
they were all like family to him. After
George’s welcoming introduction, the real topic of the meeting came into
play. George stated that, “I’m sure
you’re all aware of our current financial position as a company.” Karen and everyone there nodded with the
understanding of his statement. He
continued, “This recent quarter has been very bleak, the bleakest one this
company has ever seen in its history.”
Everyone continued to nod in agreement with his words. George went on, “However, I believe our
company can pull through this stumble.
All I ask is a small favor in order to bring the company to new
heights.” A deep silence swept across
the room in the anticipation of his next words.
“All I ask is that we hide the stumble we had this quarter from the
public. Not everyone in the public might
agree with our strengths and abilities.
And if word got out that we the giant in the healthcare industry was
faltering, it would hurt the company as a whole. And we wouldn’t want that now
would we?” Whispers started out among
everyone all at once, at the notion of what was being asked of them. George, the CEO of the company, the one that
she had looked up to, was asking her and everyone else in the room to commit
fraud and falsify the accounting books and records. George started to silence the whispers, as he
continued, “I will hold personal responsibility in this act and request. All I’m asking for is to make this one
quarter look positive to the eyes of the public. And next quarter, I’ll ensure the company
truly has a positive quarter. I’ll let
you all think it over for a few days, and we’ll continue this meeting then.”
Over the next several days Karen agonized over the decisions
that she was going to have to make, yet there were so many unanswered
questions. These questions continued to
spin in her mind. Was she really a part
of the play to deceive the public? And
if she wasn’t, should she tell someone about the company’s wrongdoings and the
CEO? She thought about the sincerity of
George Dawson when he stated that he would bring the company into positive cash
flow over the next quarter, in line with the financial markets
expectations. Then she thought about all
her fellow associates, all of her friends and all of the people who worked under
her. She had been working for NHC for
over 20 years, she had worked hard and diligently to gain her last position as
Chief Financial Officer. She had also
worked hard to gain the trust and loyalty of her fellow associates. However, what the members of top management
had asked her to do against the oath she had sworn when she became a CPA, and
her fiduciary duties as one of the officers in the company. It also went against the very morals and
fibers of her upbringings and had left her in utter turmoil. She continued to ponder. What would have been the outcomes if the
company had reported a loss? What would
have been the outcomes if she and those involved did not get caught in the
fraud they were about to commit? What
was she going to do?
The Afterthought
A debate raged in
Karen’s head. She thought if she agreed
to commit fraud then the company would have no reason to lay off any of their
workers. All of the jobs would be saved. But then what if the jobs were saved but the
investors lost their money? She shook
the thoughts out of her head. It was
only going to be this one quarter, as far as she could tell and dared to
believe and hope for. She convinced
herself then that agreeing to commit to the act would be the best course,
especially if everyone else in the meeting agreed to it. She didn’t want to be the outcast, nor did
she want to disappoint everyone. She
didn’t want to constantly have to look over her back with all the ridicules
about why she didn’t go along with the decision. And she definitely wasn’t going to tell anyone
for fear of losing her own position in the company; the position that she had
worked so hard to achieve. Karen had
finally decided that she was going to accept the CEO’s plea.
The next meeting took place around October of 2009. The meeting room was quiet. All her fellow upper management associates
looked tired, as if they too didn’t get very much sleep the last few days. But they also all had a stern look; she could
tell that everyone else probably went through a similar ordeal to her own. She could also see in their eyes, as they
waited for George, that they were all going to agree with what George had
proposed a few days earlier.
As George walked
through the doors of the meeting room, he was quick to notice the deadly
silence, and was quick to break it and get down to business. He asked, “So has everyone come to a
decision?” They all nodded their
heads. “What is it then?” George asked,
“Are you with or against me?” A short
silence fell over everyone, as no one seemed willing to be the first to admit
to conspiring to the devious plan. Then
Patricia Kim the corporation’s in-house counsel stood up and gave her answer,
“I agree to your idea George and stand behind you and your decision all the
way.” At that moment, everyone else was
quick to chime in with similar affirmations.
The rest of the meeting went into a discussion of how they
were going to hide this from the public and cover their tracks to make it
difficult for an auditor to find the deception, if one ever came to
investigate. The plan that they came up
with was to decrease a contra asset account as well as the expense accounts,
either of which would increase earnings and correspondingly the assets. In addition, they were going to create fictitious
journal entries to correspond with the generally accepted accounting
principles. Furthermore, they were going
to create false documents to support the bogus accounting entries.
After the meeting adjourned, George came into Karen’s office
and said “we are going to be reporting all of this additional income and with
the capital gain NHC had from the sale of an asset this year, I am concerned
about the inability from a cash flow standpoint for NHC to pay its corporate
income tax. We need to find a way to
offset the company’s potential tax liability, which in part was due to a large
capital gain from the sale of an asset and I would like you to consider some of
the tax shelters out there.” Karen
wanting to help out George came across a tax shelter, called “Son of Boss”,1
which was designed to reduce capital gains.
The transaction is a “listed transaction” with the IRS. However, George had made it clear that it was
necessary to defer any immediate issues with their taxes with the Securities
and Exchange Commission (SEC) or the Internal Revenue Service (IRS) and
requested that Karen not file the listed transactions form with the IRS. Karen complied with this request in order to
please her boss.
The Aftermath
The plan went off without a hitch. Everything had gone according to plan. However, the next quarter rolled by and
passed rather quickly and still George didn’t or couldn’t hold up his end of
the bargain. They all held another
similar meeting, and George asked to continue the plan for another
quarter. One quarter after another came
and passed with no end to the accounting and financial subterfuges
insight. Then one day, rather
unexpectedly and
without discussing it with anyone, George sold his stocks of
NHC.
Even though NHC’s
business was supposedly booming, the first of National Heath Company’s
accounting problems started to surface in late 2010 after George sold $85
million in stocks several days before the company posted a large loss, the
first in the company’s history. The SEC
started to investigate whether or not George’s decision to sell his stocks was
related to the posting of a large loss.
NHC hired an outside law firm to review George’s stock sale in order to
try to postpone the SEC’s investigation.
The outside law firm concluded that the sale and profit loss were not
related. This however did not ease the
SEC’s suspicions. The SEC not only
looked into the stock sale but began examining the books and records of the
company along with the FBI. As the
investigations progressed, various employees were interviewed, including
Karen. The FBI and the Department of
Justice met with Karen and offered her a reduced sentence if she would come
clean with what she knew. On the evening
of June 13, 2012, FBI agents executed search warrants at the company’s
headquarters after the company’s CFO Karen agreed to wear a wire, in which she
was able to get George to talk about the fraud.
A number of months thereafter, the Federal Grand Jury issued
indictments against all upper management, including Karen for committing fraud,
for falsifying NHC’s books and records, and for aiding and abetting to defraud
shareholders. Now, less than a year
later, Karen agreed to a plea deal in which she would be sentenced to 18 months
in prison and a fine of $500,000 in return for her cooperating with the
government. Had she not cooperated with
the government she could have received 10 years.
As Karen Larson sat outside the courtroom waiting to testify
for the government against George, the government’s first defendant, she began
to recollect her thoughts on her misguided actions and the ordeals she would
now have to go through. She no longer
was a CFO, she no longer had a job, she lost her CPA license, she lost her
right to practice before the IRS, she was facing 18 months in prison and when
she get out of prison, she could look forward to repaying $500,000 in
restitution.
What could she have
done to avoid these problems, especially of the devastating pitfall of
languishing in prison for 18 months? How
she could be so foolish, Karen muttered to herself in retrospection. What was she thinking? How could she possibly believe that the fraud
would only last a quarter? George was a
human, not a god. Karen sighed
deeply. She had allowed herself to be
deceived. She had been myopic to think
that she could save her own skin and her colleagues’ jobs through fraud. Perhaps now, Karen thought bitterly, she
would be able to clearly discern her misguided actions to ensure that she never
acts in that manner again. With at least
another year of her life devoted to testifying on behalf of the government
against other defendants with respect to the fraud committed by NHC and its
officers and directors and 18 months of prison time yet to serve, Karen will
certainly have sufficient time to dwell on all her missteps.
Questions for Discussion
1. What are the laws governing the proper practice of
accounting and finance?
2. What are the protections afforded to a
whistle blower that affect the finance and accounting community?
3. What are Karen Larson’s fiduciary duties
toward the company as vice president to the CFO?
4. What are the pros
and cons of each of her options?
5. May the IRS impose
a tax preparer penalty under IRC §6694? Has the Corporation violated any of the
tax laws where the IRS could impose a penalty? If so, under what sections of
the Internal Revenue Code?
6. What ethical
duties were violated by Karen under the AICPA Statements on Standards for Tax
Services as well as those set forth under Circular 230?
References
American Bar Association.
(n.d.). Fiduciary duties and
potential liabilities of directors and officers in financially distressed
corporations. Retrieved February 24,
2007 from www.abanet.org/buslaw/newsletter/000 3/materials/tip3.pdf
Burch, R. G. (2006).
Director oversight and monitoring: the standard of care and the standard
of liability post-Enron. Copyright (c)
University of Wyoming, Wyoming Law Review 2006 (6 Wyo. L. Rev. 481).
Healy Law Offices. (n.d.)
A day in the life of a corporate officer: A general discussion of how
officers and directors run corporations.
Retrieved February 25, 2007 from http://www.healylaw.com/corp.htm#Fi
duciary
Mercer, K. C., &Tomasco, P. B. (September 6, 2001). Fiduciary duties of officers and directors to
creditors. Retrieved February 24, 2007
from http://www.brownmccarroll.com/article s_detail.asp?ArticleID=37
Occupation Safety and Health Administration, U.S. Department
of Labor (2003). Whistleblower Protection – General. Retrieved February 20,
2007 from http://www.osha.gov/OshDoc/data_Wh
istleblowerFacts/whistleblower_protecti ons-general.pdf Sarbanes-Oxley.
(November 19, 2002).
Sarbanes-Oxley Act of 2002.
Retrieved February 20, 2007 from
http://www.sarbanesoxley.com/section.php?level=1&pub_id=S arbanes-Oxley
Securities and Exchange Commission.
(June 10, 2004).
Securities Act of 1933. Retrieved February 20, 2007 from
http://www.sec.gov/divisions/corpfin/3 3act/index1933.shtml Securities and
Exchange Commission. (June 10, 2004).
Securities Exchange
Act of 1934. Retrieved February 20, 2007
from
http://www.sec.gov/divisions/corpfin/3 4act/index1934.shtml
Footnote 1: “Son of
Boss” tax shelters were designed to reduce federal income tax obligations from
the sale of a business or other appreciated assets. Assume that the statute of limitations was
not an issue, as in the Supreme Court case of U.S. vs. Home Concete&
Supply, LLC, 566 U.S.___(2012). Assume
that our client’s executive offices are located in Texas in which is a 5th
Circuit case, Klamath Strategic Inv. V. U.S. 568 F.3d 537 (5th Cir. 2009), held that the transaction lacked any
economic substance and was nothing more than a sham.
Authors N. Ahadiat, Accounting Department, College of
Business Administration, California State Polytechnic University, Pomona, CA
91768, nahadiat@csupomona.edu D. Rice, Accounting Department, College of
Business Administration, California State Polytechnic University, Pomona, CA
91768
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