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Thursday, March 10, 2005
Law on CEO Awareness on Trial With HealthSouth's Scrushy
Fear began to overwhelm Weston L. Smith soon after Congress passed a law requiring top executives to vouch for the accuracy of their books.
Within days of the 2002 law, Smith refused to certify documents that he feared could expose him to prison time for inflating profit. Then, under pressure from co-workers, he wavered and agreed to sign them. Months later, the HealthSouth Corp. finance chief wavered again -- turning in the company he worked for and touching off the nation's first major prosecution of a chief executive under the new law.
Since opening statements six weeks ago, the criminal trial of Smith's former boss, Richard M. Scrushy, has underscored how high the stakes have become for top corporate executives. Under the law, key executives at more than 12,000 companies are required personally to vouch for the numbers they provide regulators and investors in securities filings. If those numbers are phony, they face a maximum of 20 years in prison.
But that law is only now beginning to be tested in court.
Lawyers and governance experts across the nation are closely watching the trial in Birmingham as a bellwether for the strength of the new law. Members of Congress designed the measure as a way to hold executives accountable, after former chief executives at Enron Corp. and WorldCom Inc. claimed ignorance of huge frauds that helped force their companies into bankruptcy protection and cost investors billions of dollars.
For his part, Scrushy contends that he was duped by subordinates. While prosecutors have not produced documents tying Scrushy to the fraud, they have amassed more than a dozen guilty pleas from HealthSouth officials, including all five of the company's former finance chiefs, who agreed to testify against Scrushy in exchange for leniency in sentencing.
"An acquittal in this case would severely undermine the utility of the criminal certification statute in future prosecutions," said Michael L. Zuppone, a former Securities and Exchange Commission lawyer who now represents business clients.
The threat of prison time may be the biggest force driving business leaders to promote good corporate practices in the past few years, experts said. Losing a case such as the Scrushy prosecution, in which the government has audiotapes of the defendant and so many corporate insiders lining up to testify, could help contribute to a growing backlash against government regulation of business interests.
"The certification symbolically brought home to CEOs and CFOs that it's not just a general idea of responsibility but that it's very specific," said Peter C. Clapman, senior vice president and chief counsel for corporate governance at TIAA-CREF, a New York investment firm.
So far, regulators have used the new requirement that top officials certify their companies' numbers to pursue a smattering of other cases. SEC regulators have filed at least six other civil enforcement cases against corporate officials using the measure, which is part of a broader package of corporate reforms known as the Sarbanes-Oxley law. Criminal authorities proceeded in at least two of those cases, now pending in federal courts in Oregon and New York.
"The certification requirements make it much harder for top management to pass the buck by blaming lower-level employees or a rogue subsidiary for improper accounting that leads to inaccurate financial statements," said Washington corporate defense lawyer W. Neil Eggleston.
To prevail in a criminal case, however, government lawyers must prove that the executives intended to break the law -- typically a tough case to make since corporate officials rarely leave a paper trail if they are engaging in fraud, said former SEC lawyer Jacob S. Frenkel.
That burden may be even more insurmountable at large companies, where top executives have tried to build structures to protect themselves by forming multiple layers of checks and balances since the law took effect in the summer of 2002.
Many chief executives and finance chiefs require employees further down the chain of command to prepare their own written certifications, modeled on documents the top officials must sign. The process helps top executives establish a record that they took reasonable steps to ensure accurate numbers.
Colleen S. Cunningham, chief executive of Financial Executives International, a trade group for finance officials, said about 90 percent of public companies require the heads of individual business units to sign their own internal certification letters.
"It just adds an extra degree of comfort," Cunningham said. "If someone doesn't sign it, you're scratching your head and saying, 'Maybe I should spend more time at that unit.' "
Legal experts say the principle of chief executive awareness lies at the heart of the ongoing Scrushy trial, where three former HealthSouth finance executives already have testified that Scrushy ordered them to "fix" or "help" the numbers to meet ambitious earnings targets dating to the mid-1990s. In all, prosecutors say, a long-running fraud at the rehabilitation hospital chain amounted to $2.7 billion.
Smith, who has yet to be sentenced on related criminal fraud charges to which he pleaded guilty in 2003, is expected to take the witness stand later this month in the government's case.
William T. Owens, Smith's friend and former colleague, testified last month that Smith agitatedly told him in August 2002, less than a week after the Sarbanes-Oxley law passed, that he "just couldn't sign the certifications and was quitting."
U.S. Attorney Alice H. Martin, who is leading the Scrushy prosecution, successfully batted back an attempt last year by defense lawyers to have the law declared invalid because it was allegedly too vague for the average corporate official to understand.
In her opening statement to jurors in January, Martin highlighted wildly inaccurate securities filings signed by Scrushy -- who she said spent more than $200 million on fancy cars, diamond jewelry and waterfront property, mostly in profit from sales of HealthSouth stock, between 1996 and 2002.
"Richard Scrushy gave phony numbers to the public," she said. "The purpose was to make HealthSouth look like it was making more money than it was."
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