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91–232PDF 2004

THE FINANCIAL COLLAPSE OF HEALTHSOUTH

Part 2

HEARING

BEFORE THE

SUBCOMMITTEE ON

OVERSIGHT AND INVESTIGATIONS

OF THE

COMMITTEE ON ENERGY AND

COMMERCE

HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

NOVEMBER 5, 2003

Serial No. 108–59

Printed for the use of the Committee on Energy and Commerce

(

Available via the World Wide Web: http://www.access.gpo.gov/congress/house

2

COMMITTEE ON ENERGY AND COMMERCE

W.J. ‘‘BILLY’’ TAUZIN, Louisiana, Chairman

MICHAEL BILIRAKIS, Florida

JOE BARTON, Texas

FRED UPTON, Michigan

CLIFF STEARNS, Florida

PAUL E. GILLMOR, Ohio

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

NATHAN DEAL, Georgia

RICHARD BURR, North Carolina

Vice Chairman

ED WHITFIELD, Kentucky

CHARLIE NORWOOD, Georgia

BARBARA CUBIN, Wyoming

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

CHARLES W. ‘‘CHIP’’ PICKERING,

Mississippi

VITO FOSSELLA, New York

ROY BLUNT, Missouri

STEVE BUYER, Indiana

GEORGE RADANOVICH, California

CHARLES F. BASS, New Hampshire

JOSEPH R. PITTS, Pennsylvania

MARY BONO, California

GREG WALDEN, Oregon

LEE TERRY, Nebraska

ERNIE FLETCHER, Kentucky

MIKE FERGUSON, New Jersey

MIKE ROGERS, Michigan

DARRELL E. ISSA, California

C.L. ‘‘BUTCH’’ OTTER, Idaho

JOHN D. DINGELL, Michigan

Ranking Member

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

RICK BOUCHER, Virginia

EDOLPHUS TOWNS, New York

FRANK PALLONE, Jr., New Jersey

SHERROD BROWN, Ohio

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

ALBERT R. WYNN, Maryland

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

LOIS CAPPS, California

MICHAEL F. DOYLE, Pennsylvania

CHRISTOPHER JOHN, Louisiana

TOM ALLEN, Maine

JIM DAVIS, Florida

JAN SCHAKOWSKY, Illinois

HILDA L. SOLIS, California

DAN R. BROUILLETTE, Staff Director

JAMES D. BARNETTE, General Counsel

REID P.F. STUNTZ, Minority Staff Director and Chief Counsel

SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATIONS

JAMES C. GREENWOOD, Pennsylvania, Chairman

MICHAEL BILIRAKIS, Florida

CLIFF STEARNS, Florida

RICHARD BURR, North Carolina

CHARLES F. BASS, New Hampshire

GREG WALDEN, Oregon

Vice Chairman

MIKE FERGUSON, New Jersey

MIKE ROGERS, Michigan

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

(Ex Officio)

PETER DEUTSCH, Florida

Ranking Member

DIANA DEGETTE, Colorado

JIM DAVIS, Florida

JAN SCHAKOWSKY, Illinois

HENRY A. WAXMAN, California

BOBBY L. RUSH, Illinois

JOHN D. DINGELL, Michigan,

(Ex Officio)

(II)

C O N T E N T S

Page

Testimony of:

Capek, Howard, former Managing Director, UBS Warburg Equity Research and Healthcare Group ...................................................................... 125

Davis, Lanny J., formerly of Patton Boggs, former Counsel to

HealthSouth and Richard Scrushy .............................................................. 128

Givens, Sage, Board of Directors and Audit Committee Member,

HealthSouth Corporation ............................................................................. 32

Gordon, Joel, Acting Chairman, Board of Directors, HealthSouth Corporation ................................................................................................................. 28

Hirsch, Hal, formerly of Fulbright & Jaworski, former Counsel to

HealthSouth .................................................................................................. 124

Lamphron, James P., former Engagement Partner on HealthSouth account at Ernst & Young; Richard Dandurand, Engagement Partner,

HealthSouth account at Ernst & Young; and Wayne Dunn, former

Senior Manager on HealthSouth account at Ernst & Young .................... 90

Lorello, Benjamin, Head of Global Healthcare Finance Group, UBS Warburg ................................................................................................................ 126

May, Robert, Acting Chief Executive Officer, HealthSouth Corporation ..... 40

McGahan, William, former Co-Head of Global Healthcare Finance Group,

UBS Warburg ................................................................................................ 127

Striplin, Larry D., Board of Directors and former Chairman of Compensation Committee, HealthSouth Corporation ................................................. 38

Wallance, Gregory J., Member, Ad Hoc Advisory Group, Organizational

Sentencing Guidelines, U.S. Sentencing Commission ............................... 9

Watkins, Phillip, former Member of the Board of Directors and Compensation Committee Member, HealthSouth Corporation ........................ 35

(III)

(1)

THE FINANCIAL COLLAPSE OF

HEALTHSOUTH

WEDNESDAY, NOVEMBER 5, 2003

HOUSE OF REPRESENTATIVES, COMMITTEE ON ENERGY AND COMMERCE, SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATIONS, Washington, DC.

The subcommittee met, pursuant to notice, at 10 a.m., in room

2123, Rayburn House Office Building, Hon. James C. Greenwood

(chairman) presiding.

Members present: Representatives Greenwood, Stearns, Burr,

Walden, Ferguson, Rogers, DeGette, and Davis.

Staff present: Kelli Andrews, majority counsel; Ann Washington,

majority counsel; Casey Hemard, majority counsel; Mark Paoletta,

majority counsel; Tom DiLenge, majority counsel; Yong Choe, legislative clerk; Jill Latham, legislative clerk; Auturo Silva, deputy

communications director; Edith Holleman, minority counsel; and

Voncille Hines, minority research assistant.

Mr. GREENWOOD. This hearing of the Oversight and Investigations Subcommittee of the House Committee on Energy and Commerce will come to order.

And the Chair recognizes himself for the purpose of making an

opening statement.

This morning we hold the second day of our hearing on the financial collapse of HealthSouth. Yesterday HealthSouth’s former CEO

and Chairman of the Board Richard Scrushy was indicted by a

Federal Grand Jury on 85 counts of criminal conduct, including allegations of money laundering, securities fraud and of being the

ringleader of a vast conspiracy to defraud HealthSouth’s investors.

Mr. Scrushy stands accused of masterminding a scheme to boost the company’s income over a period of 7 years by $2.7 billion. $2.7

billion; that is an incredible amount of money. How many retirees

invested their savings with HealthSouth relying on figures that

told them the Company was in sound financial health? How many

young families just starting out decided to invest their hard earned

dollars in HealthSouth relying on the public statements of CEO

Richard Scrushy?

In my view, the overarching themes of Mr. Scrushy indictment

are greed and more greed with a good dose of intimidation.

According to the indictment, over a period of 7 years Mr. Scrushy received about $267 million in compensation from HealthSouth, including $53 million in bonuses alone. These amounts are truly

staggering. Keep in mind, this does not include any proceeds that

Mr. Scrushy may have received from investments made from

2

HealthSouth related companies. It does not include other business

ventures that Mr. Scrushy participated in with various

HealthSouth Board members.

Mr. Scrushy’s $267 million, 7 year compensation package also

does not include HealthSouth’s financing of Mr. Scrushy’s entertainment vehicle that included the girl band Third Phase, nor the

13 private jets that HealthSouth purchased under his watch.

As we now know, Mr. Scrushy received with the blessings of the Board’s compensation committee a $10 million bonus in 2002. This

is the same year that HealthSouth’s stock lost half its value in a

couple of days following the company’s August 27 announcement.

So while Mr. Scrushy raked in tens of millions, HealthSouth’s

shareholders watched their investment disintegrate.

Today we will have the opportunity to question members of the

Board of Directors about Mr. Scrushy’s outrageous compensation.

The criminal indictment of Mr. Scrushy also validates many of

the concerns raised by various witnesses in our hearings a few

weeks ago, including the intimidating atmosphere fostered by Mr.

Scrushy that included hidden cameras and armed security guards.

This indictment alleges that in connection with the conspiracy to

inflate HealthSouth earnings, Mr. Scrushy controlled ‘‘his coconspirators, HealthSouth employees and the Board of Directors by

threats, intimidation, taking various steps to monitor the activities

of such persons, including obtaining and reading their emails, placing them under surveillance and installing equipment that permitted him to easedrop on electronic and telephonic communications, obtaining large compensation package for coconspirators and

recommending the forgiveness of HealthSouth loans to coconspirator’’ from the indictment.

Today we will have the opportunity to hear from various Board

members about their experiences with Mr. Scrushy and the ways

in which he exerted control over them collectively and individually.

Three weeks ago this subcommittee looked at internal safeguards

at the company failed allowing this fraud to take place. Today we

will look at the role other parties played in this debacle, including

the Board of Director, the external auditors, the investment bankers and other advisors.

In the course of examining how management of a Fortune 500

company could commit a $2.7 billion fraud, we have reviewed the

oversight exercised by the Board of Directors over the years. And

what we have learned raises serious concerns. Among the concerns

is a lack of formal procedures. This was best illustrated in our

hearing 3 weeks ago when former corporate counsel Bill Horton

confirmed that although there were multiple audit committee meetings in 2001, minutes were only maintained at one of those meetings.

Our examination has also revealed that Board members had

business relationships with HealthSouth and Mr. Scrushy raising

questions about how they dealt with conflict of interest. These are

just a few of the areas I look forward to discussing with Board

members this morning.

As we probe how the massive fraud could go undetected for so

long, we will hear from HealthSouth’s external auditor, Ernst &

Young. In addition to performing HealthSouth’s financial audits,

3

Ernst & Young also performed operational examinations known as

pristine audits, for which they were paid even greater fees than for

the financial audits.

I look forward to hearing from Ernst & Young about how it could

maintain its independence in performing financial audits when it

was also engaged in another higher revenue area of work with

HealthSouth.

During our last hearing we heard from former HealthSouth employee Michael Vines who contacted Ernst & Young with allegations of fraud. This morning the former engagement partner and

senior manager on the account can describe for us in detail how

they responded to the allegations.

We are also joined by HealthSouth’s lead investment bankers for

over 15 years. We are interested in learning from them whether

their do diligence process for large debt offerings they were leading

on behalf of HealthSouth they ever raised any questions about

HealthSouth’s financial condition. And if not, why not?

We are also interested in understanding how investment bankers

with expertise in healthcare companies and a longstanding relationship with HealthSouth did not question HealthSouth’s assertion that a Medicare billing directive would have an immediate impact of a significant portion of the company’s revenues.

Finally, we will explore the issues associated with a company

conducting its own internal investigation into matters relating to

conduct of its executive officers. For example, we will explore the

issue of independence surrounding these internal investigations

sanctioned by a corporation’s Board of Directors and whether

HealthSouth’s internal investigation was in any way compromised

at all.

We look forward to asking two of the attorneys that worked on

HealthSouth’s internal investigation questions on these matters.

I want to thank all of the witnesses for attending.

I now recognize the gentlelady from Colorado, Ms. DeGette, for

her opening statement.

Ms. DEGETTE. Thank you, Mr. Chairman, for holding this second

hearing on the multibillion dollar HealthSouth financial fraud. But

more importantly, thank you for this very illuminating series of

hearings we have had over the last few years on corporate responsibility issues.

Three weeks ago this very subcommittee watched as the smug

former CEO of HealthSouth, Richard Scrushy, proclaimed his innocence in an interview with ‘‘60 Minutes.’’ In that interview Mr.

Scrushy maintained that dispute the allegations of fraud and the

15 executives of HealthSouth that had already plead guilty to

fraud, he did not anticipate criminal charges. ‘‘I did not expect that

at all,’’ he said. ‘‘I think an objective review of the evidence will

show that Richard Scrushy was not involved in any of these alleged

crimes, and they will see that I was not part of the scheme.’’

Indeed, an objective review of the evidence is in, and as we just

heard yesterday Mr. Scrushy was indicted with 85 counts of fraud

ranging from conspiracy to mail, wire and securities fraud and

money laundering. A veritable smorgasbord of charges.

The basic allegation is that Mr. Scrushy directed a broad conspiracy of at least 15 other HealthSouth officers to inflate

4

HealthSouth’s revenues quarter after quarter, year after year. Allegedly, over a 7 year period Mr. Scrushy and his team inflated

revenues by $2.7 billion, cash by $370 million, goodwill by $740

million and put a billion dollars of fictitious assets on its balance

sheet.

While the degree of alleged fraud at HealthSouth is breathtaking, it is no means unique. We have seen this sort of trickery,

deceit and greed at Enron, Qwest, World Com and many others. In

each of these cases management’s self-interest has triumphed over

its obligations to shareholders. And, of course, the result is that investors have lost billions.

But as we take a step back and examine egregious instances of

fraud, another disturbing pattern emerges, a pattern in which the

Board of Directors, the very entity that has the fiduciary duty to

protect the shareholders of a company, merely pandered to the

whims of management in order to satisfy their own selfish interests. These Boards, awash in conflicts, functioned as a rubberstamp

approving highly risky transactions without question and never examining the dubious write-offs and one time charges that were routine in the financial statements. They consistently acted in their

self-interest, not asking the difficult questions nor conducting the

proper due diligence for fear that their takings may be in jeopardy.

However, these are not just instances of negligence and complacency. In the end these Boards functioned as the enablers of corporate fraud.

In the case of HealthSouth, several of the Board members who

are here today have served on HealthSouth’s Board for nearly 20

years, presiding over, knowingly or otherwise the fraudulent actions of Mr. Scrushy and yet not one of them raised a red flag.

There are some obvious reasons for this.

The HealthSouth Board was riddled with conflicts of interests.

The directors invested in Mr. Scrushy’s business ventures and he

invested in theirs. They allowed HealthSouth to sign contracts with

companies in which they had financial interested without even a

cursory review of the fairness of those contracts.

For example, they did not ask questions about why HealthSouth

was investing in and giving its business to Source Medical, in

which dozens of company officials had investments. The audit company rarely met and seemed unconcerned that the internal audit

function was weak, underfunded and had no access to the corporate

books. The compliance committee, apparently, never knew that

there were no procedures in place for independent investigation of

potential criminal activities at the highest levels of the company.

They never heard about employees’ allegations of significant

changes at the end of every quarter.

Directors raised questions about the restructuring and the one

time write-off charges that appeared every year, but then they

never went any further to discuss them with the auditors.

The Board acquiesced in September 2002 when Mr. Scrushy decided that the independent law firm hired by HealthSouth to investigate the allegations against Mr. Scrushy would also become the

company’s SEC defense attorney and, of course consequently under

Mr. Scrushy’s control. It acquiesced when Mr. Scrushy fired FTI

Consulting, the company that was supposed to be reviewing the imVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 91232.TXT HCOM1 PsN: HCOM1
5

pact of Transmittal 1753 before getting a final report. The result

was that they never heard that the author had serious questions

about the truth of the statements made by Mr. Scrushy in the 2002

third quarter investor call about the impact of Transmittal 1753.

But as in the case of Enron and others, such fraudulent activity

extends well beyond the management team and the Board of Directors. It reaches the auditors who were signing off on statements

quarter after quarter. It extends to the bankers who, suspicious of

the company’s finances, unconditionally provided capital as well as

a buy rating on the company’s stock. And Ernst & Young never noticed that $370 million in cash on the HealthSouth books didn’t

exist, nor $740 million in goodwill, or a billion dollars in fixed assets. They did not notice the dozens of nonstandard journal entries

made by the corporate accounting department to change the contractual adjustment entries submitted by the facilities. And I could

go on and on.

Yesterday’s indictment of Mr. Scrushy, the first indictment of a

CEO under Sarbanes-Oxley, is an example of the effectiveness of

the legislation crafted by this committee designed to curtail corporate malfeasance. However, Mr. Chairman, such legislation is

just a first step on the long road to adequate corporate reform. We

must ensure that there are appropriate policies in place so to guarantee that directors are truly independent and act in the interest

of the shareholders.

To date, Congress has addressed the responsibility of corporate

officers and auditors, and that is a good first step. But we have not

addressed the responsibility of the board to assure shareholders

that fraud is not being committed. It is time that we do so.

Thank you, Mr. Chairman.

Mr. GREENWOOD. The Chair thanks the gentlelady and recognizes for an opening statement the vice chairman of the subcommittee, the gentleman from Oregon, Mr. Walden.

Mr. WALDEN. Thank you very much, Mr. Chairman. And thank

you for convening this second hearing on the financial collapse of

HealthSouth.

The subcommittee’s previous hearing shed some light on the internal workings of this healthcare giant. After the first hearing I

was left with the feeling that many opportunities to report, address

and halt the coordinated fraud that was occurring at HealthSouth

were either missed or ignored. One lie led to another and each dishonest inflated profit statement stood on the shoulders of the previous one.

Much of the fraud that was committed by former HealthSouth

executives preceded the landmark Sarbanes-Oxley Corporate Accountability Act. Now, as a result of that act CEOs and CFOs are

now required to certify to the truthfulness of their company’s financial reports. External auditors must attest to a company’s internal

controls. Audit committee members are required to be independent

of corporate management. Whistleblower procedures must be established and complaints to be made to the independent audit committee, not management. And it’s now a Federal offense for corporate officers to mislead outside auditors.

The timing of this fraud relevant to the implementation of Sarbanes-Oxley does not make it more palatable nor less lawful. HowVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 91232.TXT HCOM1 PsN: HCOM1
6

ever, now that Congress has taken decisive steps to tighten internal controls, enhance corporate governance and encourage employees from executives to rank and file to report fraud, I am hopeful

the tide will turn and instances of unchecked corporate fraud will

become a thing of the past.

But at the end of the day Congress cannot legislate the morality

or integrity of CEOs and CFOs of our Nation’s publicly traded companies. However, we have an obligation to investors to make the

framework is in place to catch fraudulent and criminal acts, force

refunds of ill-gotten gains and exact appropriate punishment on

those who commit such acts.

We also have a responsibility to monitor current laws and regulations and to investigate where gaps may exist, and fill them.

With that said, I am eager to hear from our witnesses on the

usefulness of Sarbanes-Oxley in routing out fraud, on how we regain investor confidence and present subsequent devastating financial failures.

I am also interested in hearing from the Board of Directors who

are represented today on what they saw and what they did not see,

and how other boards of other major corporations might spot what

you missed.

Mr. Chairman, I look forward to the opportunity to hear from our

panel.

And I return the balance of my mine.

Mr. GREENWOOD. The Chair thanks the gentleman.

The gentleman from Michigan, Mr. Rogers, for an opening statement.

Mr. ROGERS. I will waive my statement this morning, Mr. Chairman.

Mr. GREENWOOD. Mr. Ferguson from New Jersey.

Mr. FERGUSON. Thank you, Mr. Chairman.

Thanks for holding this important hearing, this subcommittee’s

second, on the egregious fraud carried out by the management at

HealthSouth. I want to commend you, Mr. Chairman, and the committee staff for all the hard work that has gone into holding these

hearings and to investigate the fraud that took place at this huge

company.

Yesterday, as was noted, former HealthSouth CEO Richard

Scrushy received a special delivery from the United States Department of Justice. Unfortunately for Mr. Scrushy, this delivery was

not another Rolls Royce or another Renoir or Picasso to add to his

collection. Instead, he was delivered a 38 page indictment detailing

85 criminal counts for his suspected role as the ringleader in the

massive fraud propagated by the executive team at HealthSouth.

This fraud has led to no fewer than 15 former HealthSouth employees, including 6 former chief financial officers and other key executives to plead guilty to crimes related to this fraud. Each has implicated Mr. Scrushy as the fraud’s mastermind.

The number of HealthSouth employees who have pled guilty in

this scheme number more than those who have been indicted in the

Enron, Tyco, WorldCom and Global Crossing cases combined.

Mr. Scrushy represents the first indictment of a corporate executive under the newly enacted Sarbanes-Oxley Act. In fact, the strict

7

standards of accountability set up by Sarbanes-Oxley may have

been what led this massive collusive fraud to have been revealed.

In our last hearing we heard from a panel of people who noticed

bad things happening at HealthSouth. They said they wanted to do

the right thing, but in each case they failed to reveal the fraud to

any outside the company. They dealt with it internally and each

time their concerns were stifled by management complicit in the

fraud.

One component of Sarbanes-Oxley was that an independent

whistleblower channel to the audit committee was established for

all public companies. Perhaps this would have motivated whistleblowing employees to break away from internal management and

finally go to the audit committee, or even alert the outside auditors.

Most importantly, however, I am pleased to see that this law will

hold accountable a man who, according to the indictment, led a

large group of conspirators to cook the books for their own personal

gain. Tragically, their gain came at the expense of thousands of innocent shareholders and employees who invested their savings,

their careers, their whole livelihood in HealthSouth. Unfortunately,

the team of bad actors at HealthSouth was bent on conspiring to

defraud the investing public, their auditors and even the Federal

Government with no regard for their fiduciary responsibilities to

innocent stakeholders and the public.

The company has now purged many of the bad actors. There are

still well meaning Board members and others, people who care

about this company and their employees and their investors, and

we will hear today about they are doing to right the ship and to

reform the ills that have plagued the company prior to this year.

I look forward to hearing from the witnesses today and for learning more about how to prevent these types of tragedies in the future.

I thank you, Mr. Chairman.

I yield back.

Mr. GREENWOOD. The Chair thanks the gentleman.

The gentleman from Florida, Mr. Stearns, for an opening statement.

Mr. STEARNS. Good morning, and thank you, Mr. Chairman.

I also, like my colleagues, commend you for holding this second

hearing on the financial scandal at HealthSouth.

This is an important hearing. It comes at a time when many

things are converging on Wall Street and here in Washington.

We heard last month from employees inside. Today we broaden

our scope to hear from the accounting firm as well as the Board

of Directors.

I think the question most of us are asking with the indictment

of Mr. Scrushy, you have 15 other executives, senior executives, 5

CFOs that go back intermittently I think almost to 1986, and then

you have 10 other senior level people, treasurer, comptroller all cooperating, also admitting there was fraud. So in this sea of fraud

with 15 senior level executives admitting and cooperating, is it possible that the Board of Directors and the accounting firm knew

nothing about this? And I guess the question they would have to

ask themselves, since the Board of Director’s primary responsibility

8

is to the shareholders, did they exercise their fiduciary responsible

and duty for them.

I read this interview, a portion of the interview in the corporate

Board minutes. And I say this to my colleagues, we have this article ‘‘My Sixteen Days on the HealthSouth Board.’’ And this is by

Betsy Atkins.

She went on the Board on March 7, 2003. And, of course, by then

came March 19, 11 days later when everything fell apart when the

FBI agents started to break down the door.

One of the first things she noticed and she says in the article,

is the ‘‘dozen or so law firms that the company was paying.’’ ‘‘Nationally and locally, and some of them were billing like crazy.’’ And

so was this a telltale sign?

And I think, Mr. Chairman, it might be careful for our counsel,

our counsel to talk to her at some later time.

I think that, as someone else mentioned about the SarbanesOxley Act, I think it was in effect helping and working. So I think

that’s a good point. There is some good news out of this hearing.

As Chairman of the Commerce Consumer Protection Trade I

have jurisdiction over FASB, which the Financial Accounting

Standards Board. So I am interested to see if all of that has a role

here, the accounting standards and so forth. But it does not appear

to be as much as so as it was in Enron.

So, Mr. Chairman, I again commend you and this staff for doing

a good job in having this hearing. And I look forward to the testimony.

Mr. GREENWOOD. The Chair thanks the gentleman.

If there are no other members prepared to make opening statements, we’ll call forth our first panel, which consists of one individual, Mr. Gregory Wallance. Mr. Wallance, good morning, sir.

Mr. Wallance is a member of the Ad Hoc Advisory Group on the

Organizational Sentencing Guidelines of the U.S. Sentencing Commission.

Good morning, sir. Thank you for joining us.

Is your microphone turned on? Push the button there.

Before you begin, I need to advise you that this is an investigational hearing and we take our testimony under oath, and I need

to ask you if you have any objections to giving your testimony

under oath.

Mr. WALLANCE. I do not.

Mr. GREENWOOD. Okay. You have the right to be represented by

counsel before this subcommittee. Do you wish to be represented by

counsel?

Mr. WALLANCE. No, no. I waive that right. Thank you.

Mr. GREENWOOD. You are not on the hot seat, sir. But I do need

you to stand your right hand.

[Witness sworn.]

Mr. GREENWOOD. Okay. Thank you, sir. You are now under oath

and now we would be delighted to hear your opening statement,

sir.

9

TESTIMONY OF GREGORY J. WALLANCE, MEMBER, AD HOC ADVISORY GROUP, ORGANIZATIONAL SENTENCING GUIDELINES, U.S. SENTENCING COMMISSION

Mr. WALLANCE. Great. Well, thank you, Chairman Greenwood,

thank you members for the opportunity to be here this morning.

My name is Gregory J. Wallance. I am currently a partner at

Kaye Scholer, a law firm in New York City. I served for 5 years

as a Federal prosecutor. My current practices involves representation of both corporations and individuals in white collar cases, as

well as advising companies on corporate compliance and internal

investigations. And these are subjects on which I write and lecture.

Recently I had the privilege of serving as a member of the Ah

Hoc Advisory Group to the United States Sentencing Commission

on the Organizational Sentencing Guidelines. Our recent report,

issued on October 7, addressed among other issues the role and responsibility of the board of directors or highest governing authority

of an organization to assure that the organization’s business activities fully comply with the law. And I think it is worth noting that

the Sentencing Commission gets a great deal of credit for, in effect,

revolutionizing the field of corporate compliance.

In 1991 the Commission promulgated the Organizational Sentencing Guidelines to govern the sentencing of organizations for

most offense in Federal court. A critical feature of those guidelines

was an embedded carrot and stick. If a corporation implemented an

effective compliance program, then if it ended up facing a criminal

conviction, it would receive a significantly more lenient fine if it

had such a program. But, if it failed to implement such a program,

then it would receive a significantly higher fine, and in some cases

dramatically so.

And the Organizational Sentencing Guidelines describe seven

steps that a corporation could take to assure itself that it had such

an effective program, including certain auditing and monitoring

procedures, disciplinary measures and the like. However, the

guidelines were silent on the role of a board of directors in ensuring compliance with law on the part of the corporation.

On the tenth anniversary of those guidelines, the Sentencing

Commission announced the formation of our Advisory Group. We

were empaneled in February 2002. There were 15 of us, a variety

of experiences, academics, former prosecutors, former high level

Department of Justice official, and a sitting United States Attorney. We were tasked with reviewing the effectiveness of the Organizational Sentencing Guidelines with special emphasis on these

particular criteria for a compliance program.

Two factors were very influential in our report. First, was simply

the passage of time. In the 10 years since the enactment of these

guidelines, there had been a great deal of experience in the design

and implementation of compliance programs. But the second was

that the formation of our committee, our advisory group, coincided

with the corporate scandals involving Enron, WorldCom, Tyco and

Adelphia, which greatly contributed to the public’s lack of confidence in the capital markets and which also led to very significant legislative and regulatory changes effecting corporate governance.

10

What struck was that in all of these, or most of these scandals,

the alleged malfeasance occurred at the senior management level

and occasionally at the board level. Even when there was no actual

malfeasance by members of the board, there were often instances

of negligence. As a result, we concluded that the current absence

in the organizational guidelines criteria for an effect program of

any mention of the board of directors’ role needed to be addressed.

In effect, the obvious needed to be stated. Ultimately the board of

directors is responsible for all of the activities of the organization

including its compliance with law.

And while I’ll save for questions the details of some of our recommendations, I want to give you the essence of what we suggested needed to be incorporated in any amendments of these

guidelines, and it’s that as follows:

That the board can only perform this oversight function if it reasonably educated about the business of the organization and the illegal activities to which it might be exposed to the foolish and misguided deeds of its employees and, if the board is actively, indeed

proactively engaged in compliance oversight.

And, again, I am happy to give you more details in response to

questions.

In making these recommendations, though—and pardon me, I

am a little bit horse. We do not think that we were breaking new

ground.

Mr. GREENWOOD. You are welcome to help yourself to a glass of

water there.

Mr. WALLANCE. Thank you.

Over the years I think you could find that essentially the same

standards laid out in a variety of pronouncements by both courts,

commentators and professional organizations. But, unfortunately,

over the past 2 years we have learned the bitter lesson that lessons

can never ben learned enough. And we therefore hope that this report will be of assistance both to the Sentencing Commission as it

considers possible amendments to the guidelines, as well as to this

committee in the course of its investigation.

So thank you, and I’d be pleased to answer any questions.

[The prepared statement of Gregory J. Wallance follows:]

PREPARED STATEMENT OF GREGORY J. WALLANCE

Thank you Chairman Greenwood, Members.

My name is Gregory J. Wallance. I am currently a partner at Kaye Scholer LLP,

a New York based law firm. I served for five years as an Assistant United States

Attorney in the Eastern District of New York. My practice currently involves white

collar defense representation of both individuals and corporations, internal investigations and advising corporations on corporate compliance. I also lecture and write

on corporate governance and compliance. I am grateful for the opportunity to appear

before this Committee to address the issue of the role and responsibility of a board

of directors of a corporation in assuring that the corporation’s activities fully comply

with the law.

Recently, I had the privilege of serving as a member of the Ad Hoc Advisory

Group to the United States Sentencing Commission on the Organizational Sentencing Guidelines, whose recent report addresses this issue. As background, the

Sentencing Commission deserves a great deal of credit for, in effect, revolutionizing

the field of corporate compliance. In 1991, the Commission promulgated the organizational sentencing guidelines (‘‘OSG’’), also known as the Chapter 8 guidelines, to

govern the sentencing of organizations for most federal criminal violations. The OSG

became effective on November 1, 1991. They provide incentives for organizations to

report violations of law, cooperate in criminal investigations, discipline responsible

11

1Dan K. Webb & Steven F. Molo, Some Practical Considerations in Developing Effective Compliance Programs: A Framework for Meeting the Requirements of the Sentencing Guiudelines,

71 Was. U.K.Q. 375 (1993). 2 In re Caremark Int’l, 698 A.2d 959, 970 (Del. Ch. 1996).

employees and take the steps needed to prevent and detect criminal conduct by

their agents. A critical feature of the OSG was the creation of a sentencing credit

for organizations that put in place ‘‘effective programs to prevent and detect violations of law.’’ For organizations that have no such program, the OSG mandate high

fines, in some instances, dramatically so. The OSG described 7 steps that an organization could take to implement such a program, including the use of auditing and

monitoring systems, dissemination of compliance materials, and means for employees to report violations of law without fear of retaliation.

Although such a compliance program is not a legal obligation, corporations began

implementing them. One commentator noted that, ‘‘without question, the organizational sentencing guidelines ‘‘greatest practical effect thus far is to raise the business community’s awareness of the need for effective compliance programs.’’ 1 The

OSG even shaped corporate governance law. In 1995, the Delaware Chancery Court,

in In re Caremark Litigation, approved settlement of a shareholder derivative suit

alleging that the Caremark directors had breached their duty of care by failing to

supervise the conduct of Caremark’s employees. In doing so, the court emphasized

the importance of the role and responsibility of the board of directors to assure that

the corporation functions within the law to achieve its purpose. The Chancery Court

stated that the OSG ‘‘offer powerful incentives for corporations today to have in

place compliance programs to detect violations of law, promptly to report violations

to appropriate public officials when discovered and to take prompt, remedial efforts.’’

The Court distinguished a prior opinion that arguably could be read to state that

directors have no responsibility to assure that adequate reporting systems are in

place, by stating: ‘‘Any rational person attempting in good faith to meet an organizational governance responsibility would be bound to take into account this development and the enhanced penalties and the opportunities for reduced sanctions that

the federal sentencing guidelines offer.’’ 2

On the tenth anniversary of the OSG, the Sentencing Commission announced the

formation of the Advisory Group. We were empaneled in February 2002. The Group

consisted of 15 lawyers, former prosecutors and Department of Justice officials, academics, compliance professionals and a United States Attorney, all with wide experience in corporate governance and compliance programs. The Advisory Group was

tasked with reviewing the general effectiveness of the guidelines for sentencing corporations, with special emphasis on the application of the criteria for an effective

compliance program. We were asked to submit a final report to the Commission in

18 months. The Advisory Group sought and reviewed information from a variety of

sources, both in written statements and at a public hearing.

Two factors were especially influential in shaping our report. One was simply the

passage of time. In the 10 years since the OSG became effective, a great deal of

experience had been gained in designing and implementing compliance programs.

The other was that the formation of the Advisory Group coincided with the corporate scandals involving Enron, Worldcom and other companies, which greatly contributed to the public’s lack of confidence in the capital markets. The scandals also

led to significant legislative and regulatory changes affecting corporate governance

and compliance.

The Advisory Group delivered its report to the Sentencing Commission on October

7, 2003. The report, 138 pages in length with 444 footnotes, contains an appendix

setting forth the recommended OSG compliance criteria. The report is notable for

several important proposals.

First, the Advisory Group recommended that the Sentencing Commission promulgate a stand-alone guideline, § 8 B2.1, defining ‘‘an effective program to prevent and

detect violations of law.’’ Currently, the criteria for such a program is in the Chapter

8 guidelines’ commentary. The recommendation was intended to give the compliance

criteria for an effective program special emphasis and visibility.

Second, in the proposed new guideline, the Advisory Group proposed, inter alia,

the following changes to those criteria:

• emphasizing the importance of an organizational culture that encourages an organizational-wide commitment to compliance with the law. • provision of a definition of ‘‘compliance standards and procedures.’’ • specification of the responsibilities of an organization’s governing authority and

organizational leadership for compliance. • providing adequate resources and authority to individuals with responsibility for

the implementation of the program.

12

3See the role of the Board of Directors in Enron’s collapse, S. Rep. No. 107-70(2002).

4Most commentary received by the Advisory Group supported adding specific references to the

guidelines to amplify the role of the governing authority, providing direct access between the

governing authority (or one of its committees) and a company’s compliance officer, to ensure

prompt and unfiltered communications. 5 As defined in commentary to this proposed guideline and Application Note 1, the ‘‘governing

authority’’ of an organization is ‘‘(A) The Board of Directors or (B) if the organization does not

have a Board of Directors, the highest level governing body of the organization.’’

• revision of the current terminology ‘‘propensity to engage in violation of law,’’

which has been the source of considerable confusion in the past. • inclusion of training and dissemination of compliance training materials and information as a criteria for an ‘‘effective program.’’ • requiring as part of monitoring and auditing the ‘‘periodic evaluation’’ of the effectiveness of the compliance program. • a mechanism for anonymous reporting. • on-going risk assessments as part of the implementation of an effective program.

Third, the Ad Hoc Group recommended modifications to the OSG to clarify under

what circumstances a waiver of the attorney-client privilege and work product protections is required for an organization to receive credit for cooperation with law enforcement.

Of special interest to this committee are the Advisory Group’s recommendations

regarding the role of the ‘‘governing body’’—in most cases a board of directors—in

assuring that the corporation complies with the law. In virtually all of the recent

corporate scandals, the alleged malfeasance occurred at the senior management end/

or governing authority level. Even where there was no actual malfeasance by members of the governing authority, there were often instances of negligence.3

As a result of the foregoing, the Advisory Group concluded that the current absence in the OSG of any discussion of the role of the governing authority needed

to be addressed. In effect, the obvious needed to be stated: ultimately, the governing

authority is responsible for the activities of the organization.4 It can only perform

this function if its members are reasonably educated about the business of the organization and actively engaged in compliance oversight.

The Advisory Group therefore proposed a new guideline defining the compliance

roles of the organizational leadership at three levels: (1) members of an organization’s governing authority, which generally means the Board of Directors; 5 (2) executives comprising an organization’s managerial leadership; and (3) one or more individuals having primary, day to day responsibility for the organization’s program

to prevent and detect violations of law. To quote from the proposed guideline:

• ‘‘The organizational leadership shall be knowledgeable about the content and operation of the program to prevent and detect violations of law.’’

• ‘‘The organization’s governing authority shall be knowledgeable about the content

and operation of the program to prevent violations of law and shall exercise reasonable oversight with respect to the implementation and effectiveness of the

program to prevent and detect violations of law.’’

• ‘‘Specific individual(s) within high-level personnel of the organization shall be assigned direct, overall responsibility to ensure the implementation and effectiveness of the program to prevent and detect violations of law. Such individual(s)

shall be given adequate resources and authority to carry out such responsibility

and shall report on the implementation and effectiveness of the program to prevent and detect violations of law directly to the governing authority or an appropriate subgroup of the governing authority.’’

As to the top level body in charge of organizational affairs, i.e., the Board of Directors, the proposed guideline states that the Board should be knowledgeable about

the content and operation of the organization’s compliance program. The Board’s

knowledge about program features and operations should include, inter alia, practical management information about the major risks of unlawful conduct facing

their organization; the primary compliance program features aimed at counteracting

those risks; and the types of problems with compliance that the organization and

other parties with similar operations have encountered in recent activities.

Significantly, the proposed guidelines do not specify the fact finding procedures

or methods that members of a governing authority should use in acquiring this type

of information. The proposed guidelines leave to the particular organization the

choice of methods to gather and deliver information to governing authority in a

manner that best fits the organization’s overall operations.

Under our proposed guideline, the governing authority should exercise reasonable

oversight with respect to the implementation and effectiveness of the program. This

obligation recognizes that such oversight is a key part of the duties of top level orgaVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6621 91232.TXT HCOM1 PsN: HCOM1
13

6 As stated in the Report at p. 61, ‘‘Typically, however, members of a governing authority will

gain information on the features and operations of a program to prevent and detect violations

of law through reports from senior organization managers or other experts (in large organizations), or through information about program features and operations gained in the course of

day-to-day management and oversight of related organizational activities (in small organizations). The proposal anticipates that members of a governing body will update their information

about program features and operations periodically. This update would occur at least annually,

and more frequently when legal changes or shifts in organizational activities raise new compliance risks for the organization.’’ 7The Conference Board Commission on Public Trust and Private Enterprise, Findings and

Recommendations, Part 2: Corporate Governance (January 9, 2003) p.9.

nizational officials. Effective management requires that a Board of Directors, for example, be proactive. They must seek information about compliance programs, evaluate such information when received, and monitor the implementation and effectiveness of responses when compliance problems are detected.

For example, the governing authority of the organization or some appropriate subgroup (such as an audit committee) should receive periodic reports from the person

or persons in high level management with direct, overall responsibility for an organization’s compliance program. The Advisory Group’s report envisions that a board

of directors would hear from such persons periodically as to the nature, progress

and success of the compliance program without the potential filtering or censoring

influence of senior organization managers. In cases of actual or apparent involvement in, or support for, illegal conduct by top level organizational executives, our

report suggests that the head of the organization’s compliance program should take

steps to ensure that the course of this behavior are made directly known to the organization’s governing authority, or an appropriate subgroup of the governing authority, or the organization’s qualified legal compliance committee.

In addition, as described in the proposed new commentary at § 8B2.1 Application

Note 3 (B), the governing authority or an appropriate subgroup, periodically should

receive information on the implementation and effectiveness of the compliance program from the individual or individuals with day-to-day operational responsibility

for the program. Direct contact with those who have such day-to-day responsibility

will, for example, help the governing authority more effectively assess the adequacy

of resources being made available to the program.6

In making these recommendations, we do not think that we were breaking new

ground. More than 7 years ago, the In re Caremark decision had defined the role

of the board of directors in substantially the same terms.

More recently, the Conference Board’s Commission on Public Trust and Private

Enterprise stated in a similar manner:

In fulfilling its oversight function, boards must monitor management’s operating performance as well as ethical and legal compliance. In approving strategies, boards need to understand, among other things, the corporation’s capital

allocation, debt levels, risks and vulnerabilities, compensation strategy and

growth opportunities. Importantly, they must engage management on the central issues facing the company and have a firm grasp on the tradeoffs that lie

at the heart of a corporate enterprise. 7

Unfortunately, over the past two years we have learned the hard lesson that lessons can never be learned enough. We therefore hope that the Advisory Group’s report will be of assistance to the Commission as it considers amendments to the OSG

and to this Committee in the course of its investigations.

Thank you.

Mr. GREENWOOD. We thank you very much for your testimony

and for your willingness to help us in this endeavor.

The Chair recognizes himself for 10 minutes for our questioning.

Mr. Wallance, would it be fair to say that the Advisory Group’s

report was designed, at least in part, to help companies improve

their corporate governance by providing them with additional guidance regarding the factors that are likely to result in effective programs to prevent and detect violations of law?

Mr. WALLANCE. Yes. Yes. That is correct. And I do not mean to

suggest in my remarks that the only issue we were addressing was

the role of the board of directors. In fact, we provided, I think,

which are a number of recommendations in a variety of areas from

auditing and monitoring to disciplinary measures, to—and I think

14

this is one of our significant recommendations—that the objective

of the compliance program has to be to create a culture of compliance such that commitments to compliance with law is as important a value to the business as a profit margin or revenue growth,

or what have you.

Mr. GREENWOOD. Okay. At this point I would like you to turn

your attention to the report itself. One of the recommendations in

the report was to expand the definition of ‘‘effective program to

present and detect violations of the law to include two essential

components: (1) Exercise do diligence, and; (2) Otherwise promote

an organizational culture that encourages a commitment to compliance with law.’’ That’s on pages 52 to 54.

Mr. Wallance, how important is it for organizations to create a

culture in which compliance with the law is the expected behavior

rather than an unwelcome constraint?

Mr. WALLANCE. I think it is paramount. Ultimately to be effective, the commitment to compliance has to come from the very top

of the organization, otherwise employees are not going to respond.

And it is the notion of creating an embedded culture of compliance

that we were driving at.

Now, we are not suggesting that there is some elusive goal here

that is somewhat touchy-feely, if you will. What we were careful to

point out is that you achieve this culture of compliance, not simply

by saying it or mouthing the words. It is not enough to talk-thetalk, you have got to walk-the-walk. And if the company implements the specific criteria or recommendations that we sent out,

then we think it will achieve the corporate compliance culture

which is best designed to deter the kind of breakdowns in corporate

governance that we have witnessed over the last 2 years.

Mr. GREENWOOD. Okay. Can you detail some steps that companies should or could take to ensure such a culture of compliance?

Mr. WALLANCE. Well, I think it is a range, and let me identify

a couple of areas. I think companies need to do risk assessments.

What do our kinds of business, what kind of potential violations of

law do our business activities expose us to? What kinds of legal

problems have companies in similar business lines encountered in

the past? And then once it has made that assessment, direct the

resources of its compliance program to deterring and preventing

those kinds of violations of law.

We suggested that not only does there need to be effective auditing and monitoring, but in fact the compliance program itself

should be periodically audited and monitored for its own effectiveness, which is a standard accounting tool. But it is not enough to

set it up. You have got to make certain it is working.

We suggested that training should be a necessary part of any

compliance program. Training of all employees at virtually of all

levels, although of course training will vary depending on the level.

Whereas, the current guidelines do not make it an essential component, it is sort of left open as an option.

We also suggested there have to be three levels of oversight. The

board, as I described.

Senior management has to be given, somebody in senior management has to be given accountability and responsibility for the dayto-day operation of the compliance program.

15

And, and these were complaints I heard over the years as I tried

to revise companies, they be given both the resources and the authority to carry out that responsibility. We heard from many people, very very well intentioned people in responsible for compliance

that they were not getting enough resources to do their job.

And then, of course, at the lowest level we have to give employees an opportunity to report violations of law that they may have

witnessed both free from retaliation, which is in the current guidelines but we also recommend it. And this is consistent with Sarbanes-Oxley, that a company as part of an effective program set up

a means of anonymous reporting so that an employee can at least

convey information that needs to be acted on in the most comfortable manner for him so if he’s fearful he’ll be retaliated against,

at least he has this means.

Mr. GREENWOOD. It would seem to me that this almost has to be

initiated from the very top or, at least, initiated by the board.

Mr. WALLANCE. Right.

Mr. GREENWOOD. Because if a CEO has a character that isn’t the

kind that would want to see this kind of compliance, then it seems

to me it would a fairly bold thing for an underling to recommend

the initiation of this kind of culture, would it not?

Mr. WALLANCE. Yes, I think that is an important point and well

worth taking. I think if the company encourages openness and says

we have zero tolerance for violations of law and we want employees

to report them and you will not be retaliated against, it is likely

to elicit the kind of information that I think companies desperately

need in order to fulfill their obligations both to the shareholders as

well as their obligations imposed by law.

If on the other hand what is communicated, either directly or implicitly is we cut corners, we are more interested in profits, the bottom line counts, do not raise technical legal considerations, then it

is not going to get that information and it will end up being, as we

have seen in the last year, in the position of many hapless companies and with, unfortunately, consequences really for all of us.

Mr. GREENWOOD. And if it does not come from the management

side and if this culture of compliance is to be initiated by the board

of directors itself, I mean how would that come to be? I mean, does

a new director after being welcomed to the board raise his or her

hand and say I would like to initiate a culture of compliance here?

Mr. WALLANCE. Well, I think that ultimately the board has to

take upon itself, and that is what we are recommending it be

given, the responsibility not for day-to-day management. I want to

be careful to draw that distinction. The boards cannot do that. But

to make certain that the procedures and controls are in place to

give the company as much assurance as possible that it is doing

what it needs to do to prevent violations of law. And not only

should it do that in the sense of saying let me see your procedures,

let me see your personnel handbook, let me see your compliance infrastructure, show me the mechanism you have got for anonymous

reporting for hotlines, but it should be out there talking to people.

It should be, to some extent, kicking the tires. It should have a regular line of communication with the senior management person

who has that day-to-day responsibility and give him a direct reporting line to the board.

16

And second, and we recommended this, it needs to be out there

talking to the people in the field with operational day-to-day responsibility. This does not actually have to be done by the whole

board. It can be done by a subgroup such as the audit committee.

It does not require an enormous amount of time, but it will require

time. It may want to talk to the internal auditors to find out what

they are doing.

And just to give you an example of one I encountered, which is

a company, let us say, of 30,000 employees, a 100 factories or office

locations, has have five internal auditors who visit those locations

once every 10 years. That suggests that they may not be focusing

enough resources on the auditing function. And then the board can

say to the management why should we not have more, should we

not get more. And I think if management is responsible, they will

do something about it.

Mr. GREENWOOD. Have you looked at HealthSouth Corporation

enough to have an opinion as to whether the culture of compliance

that you have described existed there?

Mr. WALLANCE. I would say this: I am not familiar with the details of how HealthSouth and the governance of HealthSouth, but

I will say that it is not rocket science when 15 high level employees

including CFOs for the last years all plead guilty to felony conduct

in connection with the conduct of the affairs of the company to say

this company does not have a culture of compliance with law.

Mr. GREENWOOD. Okay. The report states in part ‘‘Ultimately the

governing authority is responsible for the activities of the organization. It can only perform this function of its members are actively

involved in compliance reviews and reasonably educated about the

business of the organization and the legal and fiduciary duties of

the governing authority members.’’

One of the Advisory Committee’s proposed changes states: ‘‘The

organization’s governing authority shall be knowledgeable about

the content and operation of the compliance program to prevent

and detect violations of the law and shall exercise reasonable oversight with respect to the implementation and effectiveness of the

programs to prevent and detect violations of the law.’’

As a preliminary matter does governing authority generally refer

to a company’s board of directors, is that what you’re referring to

there?

Mr. WALLANCE. Yes. We had a definition. It means the board or

if there is no board, perhaps in a private company solely owned,

the highest authority within the company to decide matters of substance for the company.

Mr. GREENWOOD. Okay.

The gentlelady from Colorado is recognized for 10 minutes.

Ms. DEGETTE. Thank you, Mr. Chairman.

Mr. Wallance, you have both served in the criminal arena and

now in the civil area. And as I was reviewing your testimony last

night it occurred to me these recommendations that the Advisory

Commission was preparing were for the Sentencing Guidelines in

the criminal arena, is that right?

Mr. WALLANCE. Well, yes.

Ms. DEGETTE. But the same principles I think would apply. I

mean, it is not just trying to set a criminal standard, but really it

17

is trying to say what should the highest and best practices be for

board conduct, correct?

Mr. WALLANCE. That is correct. And I would like to point out

that when we define a report an effective report to prevent and detect violations of law, we did not limit, and we were quite deliberate about this, the meaning of the term violations of law to criminal violations.

Ms. DEGETTE. Right. Because in fact when you are talking about

board conduct, it will be infrequent if ever that you could prove in

a criminal court the means required for felony conduct, right? I

mean, most of this is taking place not at that kind of level of specific intent, right?

Mr. WALLANCE. It tends to take place at the operational level.

Ms. DEGETTE. Right.

Mr. WALLANCE. But the point is that if a corporation—a corporation cannot deter and prevent violations of criminal law unless it

attempts to deter and prevent violations of all law.

Ms. DEGETTE. Exactly. And so what your recommendations are

really designed to do is to prevent the kinds of criminal activity

that we are seeing with HealthSouth and the indictments we have

seen out of that by a best practices kind of system, right?

Mr. WALLANCE. Yes. That is essential.

Ms. DEGETTE. Now, what just occurred to me, though, is having

practiced myself both in the criminal and civil realm some years

ago, especially with white collar crime, what is really effective in

deterring that crime is if the individual has personal exposure,

which is in some ways why Sarbanes-Oxley has been so effective

not because of all the things we did, but because they have to sign

that financial disclosure, the financials, right?

Mr. WALLANCE. Yes. I agree.

Ms. DEGETTE. Do you agree with that?

Mr. WALLANCE. Yes. I think that was one of the innovative futures of Sarbanes-Oxley is the notion of personal accountability for

the financial reports and disclosure.

Ms. DEGETTE. Right. Because all the CEOs I know are reviewing

these things like they never have before, which is good. Even in a

company where you do have a good culture, it is important, do you

not agree?

Mr. WALLANCE. I do agree with that.

Ms. DEGETTE. Okay. So here’s my question to you is what kind

of incentive can we give to corporate boards to have the same level

of care and concern for all these wonderful things that your Advisory Commission has put in place? What is the incentive for them

to actually do this?

Mr. WALLANCE. Well, one of the incentives, and to some extent

it exists already, is that if the board fails to adequately supervise

the company, and particularly when it comes to legal compliance,

it is potentially exposed to shareholder suits. And that was really

the teaching of the ‘‘Caremark’’ decision in the Delaware Chancery

Court in 1996 which suggested that in so many words that if a

company fails to follow the precepts of the organizational guidelines compliance criteria, then the board is not doing its oversight

job and could be exposed to shareholder suits. So that is one deterrent.

18

I also think that a deterrent has been set up in the past 2 years

just by the sheer immensity of the scandals, their devastating impact on individuals, the publicity and so on.

I do think that these kinds of hearings will also contribute to

that.

Ms. DEGETTE. I cannot help but think back to the boards I have

worked with in my life and, I am not sure before the last few years

and the congressional hearings and Sarbanes-Oxley and everything, really corporate board members really understood what their

role was. Would you agree with that?

Mr. WALLANCE. Well, not entirely. I do think that the vast majority of boards and companies in America are well intentioned to

take their responsibility seriously. I think that over the last 10

years because of the Organizational Sentencing Guidelines there

has been a growing awareness of the need for compliance. We have

witnessed it. It is laid out in our report, quotes from various people

about just how 10 years ago there was not a field of corporate compliance.

I think that we are always going to have people who do not take

the responsibility seriously or worse. All we can do is try to put in

place as many incentives as you’re suggesting as we can to defeat

it to deter them from doing that kind of either malfeasance or misfeasance.

Ms. DEGETTE. But I mean even though people have been aware

of these guidelines, I am not sure people have really necessarily

understood what their role is as a board member to implement

them, and especially in some of the high profile situations we have

had.

I have sat here and we have done Enron and Qwest and Tyco

and on and on and on. And the theme that runs through it besides

the evil doers at the top of the corporate management is boards,

many of the board members have been well meaning, but they just

did not understand. And they knew their role was to have oversight, but they did not understand how to accomplish that.

Mr. WALLANCE. Well, I agree that more needs to be done. And

we perceive of the absence in the guidelines of any recognition of

the role and responsibility of the board as something that needs to

be addressed.

Ms. DEGETTE. Have you had time, I know it is short notice, to

review the new SEC rules that were adopted by the New York

Stock Exchange and NASDAQ about the strengthening of corporate

governance standards? This just happened yesterday.

Mr. WALLANCE. I have not. But I was somewhat familiar with

the proposals before they were adopted.

Ms. DEGETTE. And do you think that is going to help this along?

Mr. WALLANCE. Yes, I think it will. I think the notion of compliance that address the high level officers, among other things, I

think all of them are very needed and necessary.

But let me explain, what we were trying to do in this report and

recommendations was pull all of this together. It was not so much

that we have invented something new under the sun. But I think

we have taken from Sarbanes-Oxley, from the experience of the

last 10 years, from the experience learned in these scandals, from

19

the regulatory changes and the SOR changes and put it all in one

place for the guidance of companies.

Ms. DEGETTE. And I think that is excellent guidance. But I also

think that if you have rules that are being required by the SEC

and other governing entities, that might put some legal teeth behind the recommendations you are making.

Mr. WALLANCE. On that I completely agree. Because ultimately

what these guidelines are voluntary.

Ms. DEGETTE. Right. That is what I am trying to say.

Mr. WALLANCE. A corporation is not legally obligated to adopt

them. So to the extent they are embedded in law and regulation,

then obviously they will have that much——

Ms. DEGETTE. They will be that much more effective because

companies will have not just a recommendation, they will have a

requirement they have to abide by.

Now your report recommends that a company should do

proactive monitoring and auditing of its own compliance and audit

programs to see if they actually work instead of just having a compliance officers and internal auditor make periodic reports. How

should that be carried out and who should do that?

Mr. WALLANCE. Well, we suggested that it could be done by a

subgroup, it could be the audit committee, particularly one that

may have independent directors on it. And we envision that they

would hear from persons involved in compliance periodically as to

the nature, the progress, the success of the compliance program

without the sort of the potential censoring or filtering that senior

managers might bring to that process.

Ms. DEGETTE. Right.

Mr. WALLANCE. So that is one way.

The other is to talk to people in the field. And I think they have

to become familiar with both the compliance program in some detail as well as the business activities that may expose the company

to risk, and what is being done to avoid that kind of risk.

Ms. DEGETTE. Now, in this case in 1999 there was a major allegation of fraud by the top officers of the company. And that turned

out to be accurate, by the way. But it was submitted to

HealthSouth compliance officer. There was no evidence that the

compliance officer ever investigated the allegation and the complainant was told that she needed to be placated.

What type of structure could you put into place in that type of

situation to give that compliance officer more authority and independence?

Mr. WALLANCE. I am not in a position to comment on that specific situation.

I would say as a general rule it has to be made clear, including

by the board in various written statements, that reports of wrongdoing need to be investigated. It doesn’t mean that people are presumed to be guilty before any investigation has taken place. But

when senior compliance officers receive reports of wrongdoing, they

need to be examined and investigated and appropriate response implemented.

Ms. DEGETTE. And I would think it would be helpful also if there

were some kind of outside person that the compliance, either indeVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00027 Fmt 6633 Sfmt 6602 91232.TXT HCOM1 PsN: HCOM1
20

pendent director or someone on the board, they could go to if they

were not getting that kind of response internally.

Mr. WALLANCE. Well, one thing many companies are doing is

providing separate outside counsel to the audit committee or to, in

effect, a litigation committee depending on the circumstances so

that that committee if it receives reports of potential wrongdoing

can have its own legal advice as to how to respond to it.

Ms. DEGETTE. And those would be outside counsel with no other

conflicts, no other engagements with the company, correct?

Mr. WALLANCE. Yes. I think in general what you’re now getting

into is how internal investigations need to be conducted.

Ms. DEGETTE. Right.

Mr. WALLANCE. And I can respond, perhaps, on that subject

briefly, which is I do think having done them, that it is important

to preserve the credibility of the investigation. That it be done in

a way that does not leave any question as to whether things were

not done because of potential——

Ms. DEGETTE. You know, my time has expired. And I appreciate

it. If we have some time for a second round, I will come back to

that.

Thank you.

Mr. GREENWOOD. The gentleman from Oregon, Mr. Walden, is

recognized for 10 minutes.

Mr. WALDEN. Thank you, Mr. Chairman.

I guess my first question is do you think that there is an adequate mechanism in place for people who decide to represent shareholders on a board to be trained in their responsibilities? How do

you ever as a board member know all these rules and regulations?

You are off running your company and somebody says to you

that would be a great addition to our board. Let us see if they run,

and they do and they show up. And you have got a domineering

CEO that is quite successful and does all these sort of strange

things to board members, including having his own security person

follow him around.

My question is as a perspective board members, how do you

know what you are supposed to look for and is there any need for

some sort of requirement of training?

Mr. WALLANCE. Well, we did recommend that there be training

at all levels of the company. We did not exclude the board. Now,

obviously the training for the board is going to be a little bit different than the training for the plant manager.

Mr. WALDEN. Yes.

Mr. WALLANCE. But there is no reason why a board cannot insist

on having the general counsel or the head of compliance walk it

through the compliance program in some detail just the way it has

presentations on the company’s financial statements. It does not

mean it has to read every law or regulation. There is a supervisory

component to this. But it can be proactive in getting information

that would allow it to judge whether processes and controls are

properly being implemented through a sure compliance with law.

Mr. WALDEN. But what if that board relies on an outside auditors to evaluate those controls and that outside auditors says the

controls in place are permitable?

21

Mr. WALLANCE. Well, there is no question that a board is ultimately going to have rely on the outside auditor. The outside auditor is not doing his job, all right, absent some red flags that the

board perceives, then the system may break down.

But I do think that the board has to be alert. I think this is the

teaching of these scandals is that the board has to be alert to potential red flags that would indicate there may be a conflict of interest. For example, transactions with no apparent economic substances.

Mr. WALDEN. Right.

Mr. WALLANCE. Asking questions, why are we doing this if there

is no economic substance. What is the business purpose behind

this. Asking those kinds of questions in the course of receiving information about the company’s business operations, I do think is a

responsibility of a board to act on, again, these kinds of red flags.

Mr. WALDEN. If an auditor’s report showed that year after year

there’s a red flag that came that said management is too strong

over the board, should that: (a) be reported to the board and if so,

what should be done about it?

Mr. WALLANCE. I honestly have not encountered that kind of a

management letter from an auditing company. Assuming it was

somewhat specific about why that created governance issues, then

yes. If that comes to the attention of the board, they need to look

into it and decide whether any particular remedial action is called

for.

Mr. WALDEN. How should an auditor handle a situation where

somebody sends them an email, their name, address on it says look

at these specific issues within this company. I think there is a

problem, and they are very specific in where to look?

Mr. WALLANCE. I think it needs to be acted on and investigated.

There are a number of instances where it was that kind of an

anonymous note that was received either within management or by

an accounting firm that ultimately led to the uncovery of serious

problems. And to the extent that there is enough detail to follow

up and it presents at least on its face an issue of concern, then it

needs to be investigated.

Mr. WALDEN. What would be the appropriate response? If you

were the outside auditor and you got an email like that on a company you were responsible for looking at, what would the steps be

you would take?

Mr. WALLANCE. Well, I am not an outside auditor. I am an attorney. I would just suggest that I think it would be the auditor’s responsibility to make certain it is brought to the attention of somebody within the company who has the discretion and the authority

to act on it, to then take it and deal with it in an appropriate way.

Mr. WALDEN. Would it also be a recommendation that the auditor would go back to the person making the claim?

Mr. WALLANCE. Well, again, you are now asking me for standards governing the conduct of auditors, which is somewhat outside

of my expertise.

I think just in general I would say the organization needs to follow up on that kind of information. And there is some very practical reasons why. Because if it does not, the next place that anonyVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6602 91232.TXT HCOM1 PsN: HCOM1
22

mous note or letter may go to is ‘‘The Wall Street Journal.’’ And,

if it does not go there, it may go to the U.S. Attorney’s Office.

So, hopefully, at the end it is not so much—and this is part of

it—that it is just that companies should want to be good corporate

citizens. That is certainly a part of it, they should be. But there is

a very practical self interest in getting on top of these kinds of

problems at the earliest possible time when the company will have

the most options available to it to deal with those problems.

Mr. WALDEN. It appears in the case that we are reviewing here,

HealthSouth, that the people who were aware of potential problems

or alleged frauds were reporting to their compliance officers who

were apparently also involved in the fraud. How do you get around

that on a governance issue and does Sarbanes-Oxley do that with

the outside whistleblower protections and things of that nature?

Mr. WALLANCE. It helps. Okay. All of these things help at the

end of the day. Will any of these programs prevent, and again I am

not referring to HealthSouth.

Mr. WALDEN. That is fine.

Mr. WALLANCE. But a determined effort, a conspiracy if you will,

by senior management including the people in charge of compliance

to avoid the law? No. At the end of the day it will not. Some of

these things are going to occur regardless of our best efforts. What

we can do is try to deter and prevent these sorts of things from

happening.

Mr. WALDEN. Do you see any remaining gaps out there after we

pass Sarbanes-Oxley? Is there something that has come forth since

then that causes you to say, gee, you ought to look here, change

this?

Mr. WALLANCE. Well, I think to the extent there are any gaps,

I would like to think that the Ad Hoc Advisory Group’s report fills

them. But I want to stress, we were guided in large part by Sarbanes-Oxley.

Mr. WALDEN. Right.

Mr. WALLANCE. And the other regulatory measures that have

been enacted in the last 2 years.

Mr. WALDEN. Right.

Thank you, Mr. Chairman. I yield back the balance of my time.

Mr. GREENWOOD. And the Chair thanks the gentleman.

The gentleman from Florida is recognized for 10 minutes.

Mr. STEARNS. Thank you, Mr. Chairman.

And, Mr. Wallance, as I understand your background you were

a prosecuting attorney on white collar crime?

Mr. WALLANCE. Yes, that is correct.

Mr. STEARNS. And then you were a litigator on the private side?

Mr. WALLANCE. Yes, that is what I currently do.

Mr. STEARNS. And have you ever been on a board of directors?

Mr. WALLANCE. No, I have not.

Mr. STEARNS. Okay. So this information is pretty much just from

your perspective as a litigator?

Mr. WALLANCE. Well, it is partly from my perspective as a litigator, partly from my experience in prosecuting corporations as a

prosecutor. And from participating in such activities as this Ad Hoc

Advisory Group.

23

Mr. STEARNS. Give me a definition of what a proactive board of

directors? I mean, just maybe one or two sentence what the definition is proactive?

Mr. WALLANCE. They do not wait to be told what is happening.

Mr. STEARNS. Okay.

Mr. WALLANCE. They ask, and go out and find out what is happening in their company.

Mr. STEARNS. Okay. At what point should a board of director ask

for forensic accounting audit? What flags do they have to see forensic, you know, find out something is not right, we are getting letters saying there is fraud? I mean, they had letters going back to—

I have one here from November 12, 1998 from a ‘‘fleeced shareholder.’’ It could be anybody.

But what is the thing that triggers in their mind that?

Mr. WALLANCE. Well, there is no hard and fast rule. I cannot

give you golden rule for triggering a forensic audit.

I think the company has to receive some kind of substantive information that would appear to either be credible or derived from

some reliable source that suggests that there is a potential for a

violation of law, and then act on that. Whether a forensic is required may not be apparent immediately. You may have to do some

initial investigation. And at a certain point if the concerns appear

serious enough, and again there is no——

Mr. STEARNS. Hard and fast is what you are saying?

Mr. WALLANCE. Just generalizations, then it may be appropriate

to have that kind of level of scrutiny.

Mr. STEARNS. If this board was proactive and they had some concern, I think you have indicated they should meet with members

of the company’s internal audit department?

Mr. WALLANCE. I want to be careful. We did not try to be prescriptive, that prescriptive in our——

Mr. STEARNS. Well, just let me ask you personally. If a company,

the board of directors had some indication that there was a problem, should they in your definition of being proactive meet with the

company’s internal audit department?

Mr. WALLANCE. If I were sitting on an audit committee of a

board of directors——

Mr. STEARNS. Right.

Mr. WALLANCE. [continuing] and an issue arose that required or

should have been looked at by the internal auditors or was, yes, I

would meet with them.

Mr. STEARNS. Okay.

Mr. WALLANCE. I would go talk to them.

Mr. STEARNS. Okay.

Mr. WALLANCE. And ask them what are you doing about this or

what are you doing about complying——

Mr. STEARNS. So we have a Board of Directors right behind you.

So they have to say in their mind there was enough for me to say

to the Chairman of the Board we should sit down and meet with

the internal audit department. And so in your own estimation that

is what the normal reaction if they have any apprehension?

Mr. WALLANCE. Again, I am not in the position to address

HealthSouth specifically.

24

Mr. STEARNS. Oh, no, I understand. But in a generic sense you

are saying yes?

Mr. WALLANCE. But, yes depending if there is a serious issue

that the internal auditors knew about or should have known about,

then there really is no reason why a proactive audit committee

would not hear from the internal auditors.

Mr. STEARNS. Okay.

Mr. WALLANCE. Again, it is very case-by-case specific.

Mr. STEARNS. If I went to the Fortune 500 companies, how many

of those board of directors are defined as proactive in your opinion?

I mean, just approximately? Most of them or none of them?

Mr. WALLANCE. I could not—I would not——

Mr. STEARNS. You would not venture a guess?

Mr. WALLANCE. I would not want to give you an opinion having

not done a survey.

I will point out that in the last week or 2 there was an article

in ‘‘The Wall Street Journal’’ about how much more time board

members are devoting to their duties. Again, I think the vast majority of board members in this country are responsible. I think

they will be more active than ever, as suggested by this ‘‘Wall

Street Journal’’ article as a result of these scandals.

Mr. STEARNS. Yes.

Mr. WALLANCE. But we have work to do.

Mr. STEARNS. Okay. So let us say we have this proactive board

of directors and under your guidelines there is some flags. So they

sit down and they say okay, we want to meet with the internal

audit department. Okay. So under your definitions that is what

they do.

They sit down with the internal audit department and they find

out that the internal audit department did not have access to the

company’s corporate books and records. What would that mean to

you?

Mr. WALLANCE. Well, it would suggest potentially there has been

a breakdown of governance in at least that respect. The way you

present it, yes, if the auditors need those books and records to do

their job and they’re not getting them, that is a problem that needs

to be addressed.

Mr. STEARNS. Let me ask you about the composition of a board

of directors. You know, generally what happens these board of directors are distinguished men and women in various fields and

they are friends of the CEO, and they are selected. In your opinion

is there an importance to the composition of the board? Is that significant?

Mr. WALLANCE. Yes, I think it is but we did not try to address

that in the report. What I will point out is that there has been legislation and regulation which addresses the need for independent

board of directors including independent members of that board, including on the audit committee.

There is also, you know, a very health debate about what size

the board to be; too small or too big is not desirable. There is, you

know, an argument that it should be a certain size. I do not really

have views on those. Those are the sorts of things that we have

left, again in our report, to the judgment of companies and boards

to make as to how, in effect, organize themselves.

25

Mr. STEARNS. You mentioned the three levels of authority earlier.

You talked about the board, senior management and then the employees to be able to whistleblow. I think those are the three you

mentioned. And you said in each case they must have the resources

and authority to act.

How do you provide a climate that people feel free to be ‘‘a whistleblower’’ or to go forward and say hey something is wrong here?

Because we have seen from the previous hearings we have had like

Ms. Watkins and others, that even when they lay it out, A to Z,

it is all covered up.

Mr. WALLANCE. Well, let us distinguish between the reporting

and then the acting on the reporting.

To encourage the reporting——

Mr. STEARNS. Right. That is good.

Mr. WALLANCE. [continuing] there are a variety of ways, and

companies have been incredibly creative in the last 10 years

through training programs, dissemination of written materials, personnel handbooks which employees are obligated to read and sign

that they have read, which all lay out the company’s commitment

to compliance with law and give them means to report with assurance of no retaliation which is now codified in Sarbanes-Oxley.

Mr. STEARNS. Right.

Mr. WALLANCE. And as we have suggested, anonymous reporting.

But I think that if that commitment is communicated in sincere

fashion from the highest levels of the company we want you to talk

to us, we want to know what is going on, I think it will get the

reporting in needs.

Mr. STEARNS. In Tab 72 of our reports there is this memo from

a ‘‘fleeced shareholder’’ to HealthSouth as well as Ernst & Young.

And, frankly, in his roughly 250 words he lays out the whole problem. And this was November 12, 1998. So 5 years ago. And he talks

about the clever tricks that are being used to pump up the numbers. He says something that a novice accountant could catch, but

is not being caught. He talks about the balanced budget amendment was passed and the impact it would have in Medicare, and

how is HealthSouth management being effected by the balance

budget amendments cutback. And they cannot possibly be doing as

well as they say. And does anyone believe their nonsense about

managed care pressure. And then he has even little things like how

can the company carry tens of millions of dollars in account receivable that are well over, I think it says 360 days or something.

But this kind of memo comes up.

Now, the Board of Directors would never know about this. This

could go to HealthSouth, or it could go to Ernst & Young. And how

do you protect this kind of information, say, this could be a shareholder but it probably is an employee of HealthSouth? Because to

have this kind of detail that they know, I do not think is a shareholder. I think this is somebody inside. So, I would think this

would be sort of a miniature whistleblower. And how you get this

information so it is promulgated to the Board of Directors, and how

do you get Ernst & Young to act on it?

Mr. WALLANCE. Well, we suggest that there needs to be three

levels of corporate compliance responsibility. And, hopefully, you

are right, you would not expect that to get to the board. You would

26

hope that it would be brought to the attention, if the procedures

are working correctly, to at least the first or second level. The dayto-day or they hope the person with overall responsibility. If you

have responsible people in those positions, they will act on it. It

does not mean they have to hire an outside law firm and start an

internal investigation or hire forensic accountants. But they will

want to follow up and find out if there is any substances to this.

And depending on what they find out, they can either bring it to

the attention of the board and recommend that various measures

be taken, or they are satisfied that it does represent, let us say, a

crank there is no substance. Then if they have satisfied themselves,

then maybe no further action is needed.

But the board cannot do it all. I do not want to suggest that.

Mr. STEARNS. No, I know. It has got to be a team effort.

Mr. WALLANCE. Yes. Exactly.

Mr. STEARNS. Thank you, Mr. Chairman.

Mr. GREENWOOD. The Chair thanks the gentleman.

Before we dismiss you, Mr. Wallance, one further question. Ms.

DeGette had a question on the table and we are both just interested in your response as to how you would set up an independent

examination of the kind that this company did, and what you

would do, what your recommendations would be to a company that

wanted to set up a truly independent outside review?

Mr. WALLANCE. Yes. I think we are now talking about internal

investigations, which we touched on earlier. I think a company

needs to—I think in general it would want to hire an outside law

firm. There is some debate, you know, in the literature about

whether it can do it itself or not. But I think it has to be guided

by this principle, which is if it undertakes an internal investigation, the investigation has to be done credibly. And the best way

to assure credibility, the appearance of credibility is to hire outside

disinterested law firms and accounting firms, again depending on

the circumstances, to conduct an independent investigation and

give the board or the appropriate subgroup or the next level of compliance responsibility the unvarnished results of its investigation so

that the company can act responsibly on those results.

Mr. GREENWOOD. And suppose that that outside law firm is retained to do the internal examination and then subsequent to that,

defend the company? Can there be anything approximating an

independent examination if they have the expectation that they

may or may not continue to be retained for purposes of defense

work?

Mr. WALLANCE. You know, that is a harder question to answer.

The one that typically comes up is not so much when the outside

law firm represents the company in the ensuing investigation, if

there is one. And it may make a lot of sense for it to do so, because

it is familiar with facts. If it was a credible law firm, then it may

be the best firm to deal with, for instance, investigators.

Typically where the issue comes up is when you hire a law firm

that has ongoing work, is doing ongoing work, especially if the

work that it is doing is the subject of the investigation. Then I

think the company has to ask itself, okay, are we going to assure,

you know, as great an opinion we have of these lawyers, as well

suited as they may to do this investigation, are we going to assure

27

the appearance of credibility or would it be better to hire a law

firm, or at least one that has not done work in that area that is

the subject of the investigation.

Mr. GREENWOOD. And are there circumstances under which you

would think that that credibility could be maintained if the subject

of the investigation, the CEO for instance, had access to that report

before it was published?

Mr. WALLANCE. Well, that’s another, that is a very tricky area.

And if I may, it is——

Mr. GREENWOOD. Before it was published or before it was even

presented to the board?

Mr. WALLANCE. And again, here is the thing and I have lectured

on this, I have set up hypotheticals based on it, there is no real

clear answer. You are sort of caught between two issues.

First of all, the people managing the company do need to know

something about what is going on and the fact of the internal investigation and what its findings are. On the other hand, if the

people managing the company’s conduct, if their conduct is the subject of the investigation, then you have the problem with the appearance of credibility.

There is no easy answer. It is one of the most difficult I know.

One solution that has been suggested is you do inform the person

whose conduct is at issue, but who is also a manager of what is

going on, but then suggest that he not be involved in the day-today running of the internal investigation. And that to the extent

he receives information, he receives information at the same time

independent directors receive it. That has been one suggestion.

Every case is different. It is an exquisitely difficult issue for an

outside lawyer advising a company under those circumstances. And

you have identified a very, very real issue for internal investigations.

Mr. GREENWOOD. Well, we thank you again. You have helped set

the standards that will guide us in the rink throughout the rest of

the hearing today, and we appreciate that.

Mr. WALLANCE. Well, thank you for the opportunity.

Mr. GREENWOOD. Okay. You are dismissed, sir.

And we now call forward our second panel, consisting of Mr. Joel

Gordon, Acting Chairman of the Board of Directors of HealthSouth

Corporation; Mr. Robert May, Acting Chief Executive Officer of

HealthSouth Corporation; Ms. Sage Givens, Board of Director and

Audit Committee Member of HealthSouth Corporation.; Mr. Larry

Striplin, Board of Director and former Chairman of Compensation

Committee for HealthSouth Corporation, and; Dr. Phillip Watkins,

the former member of the Board of Director and Compensation

Committee Member for HealthSouth Corporation.

You may be seated.

Welcome, and we thank you all for your attendance here this

morning.

It is my responsibility pursuant to the Rules of the Committee

to inform you that because this is an investigative hearing, we take

our testimony here under oath. And so I need to ask if any of you

object to giving your testimony under oath this morning. Seeing no

objection, I also would inform you that you are entitled to be repVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00035 Fmt 6633 Sfmt 6602 91232.TXT HCOM1 PsN: HCOM1
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resented by counsel. And would ask if any of the witnesses wish

to be represented by counsel.

Mr. Gordon, do you, sir?

Mr. GORDON. Yes, I do.

Mr. GREENWOOD. And would you identify by name and by pointing to your counsel, please?

Mr. GORDON. Yes. Pointing to No. 1, Mr. Bob Bennett, who is

counsel for the corporation and Mr. Mike Madigan, who is counsel

to the Board.

Mr. GREENWOOD. Thank you, sir.

Ms. Given, are you represented by counsel this morning?

Ms. GIVENS. Yes, I am. It is the same two gentlemen.

Mr. GREENWOOD. Same two gentlemen?

Dr. Watkins?

Dr. WATKINS. Same two gentlemen.

Mr. GREENWOOD. Mr. Striplin?

Mr. STRIPLIN. Same two gentlemen.

Mr. GREENWOOD. Mr. May?

Mr. MAY. Same two gentlemen.

Mr. GREENWOOD. How efficient. Very good.

I would ask now that if you would stand and raise your right

hands, please.

[Witnesses sworn.]

Mr. GREENWOOD. Okay. You each under oath. And are now welcome to give your opening statements.

Mr. Gordon, do you have an opening statement?

Mr. GORDON. Yes, I do.

Mr. GREENWOOD. Okay. You are recognized for 5 minutes to give

that opening statement. I suggest that you pull your microphone a

little bit directly to you, and make sure it is on. And we would look

forward to your statement, sir.

TESTIMONY OF JOEL GORDON, ACTING CHAIRMAN, BOARD OF

DIRECTORS, HEALTHSOUTH CORPORATION; SAGE GIVENS,

BOARD OF DIRECTORS AND AUDIT COMMITTEE MEMBER,

HEALTHSOUTH CORPORATION; PHILLIP WATKINS, FORMER

MEMBER OF THE BOARD OF DIRECTORS AND COMPENSATION COMMITTEE MEMBER, HEALTHSOUTH CORPORATION;

LARRY D. STRIPLIN, BOARD OF DIRECTORS AND FORMER

CHAIRMAN, COMPENSATION COMMITTEE, HEALTHSOUTH

CORPORATION; AND ROBERT MAY, ACTING CHIEF EXECUTIVE OFFICER, HEALTHSOUTH CORPORATION

Mr. GORDON. Mr. Chairman, ranking member, and members of

the subcommittee, good morning.

My name is Joel Gordon and I am Interim Chairman of the

HealthSouth Board of Directors, having been appointed Interim

Chairman on March 19, 2003. On behalf of the entire HealthSouth

team and our more than 48,000 employees throughout the country,

I appreciate the opportunity to appear before the subcommittee.

As yesterday’s indictment of Richard Scrushy, the former Chairman and CEO, indicates, Mr. Scrushy, along with former members

of management, directed a massive accounting fraud at

HealthSouth. The Department of Justice has charged that they not

only defrauded the company and its shareholders, but also the

29

Board of Directors. I look forward to answering your questions and

describing the progress that the Board and the company have made

over the past 7 months in stabilizing our business since the massive accounting fraud first came to light.

As you may know, HealthSouth is a leader in inpatient and outpatient rehabilitation, diagnostics and outpatient surgery. In its

short history, HealthSouth has grown to become the Nation’s largest provider of healthcare services, with nearly 1,700 locations

throughout the country and abroad, and more than 48,000 employees. With our broad network of outstanding facilities, highly skilled

physicians and therapists, and state-of-the-art technology and

equipment, we are able to provide all of our patients easy access

to high quality healthcare.

Since March 2003, when we were first made aware of the allegations of accounting fraud, the company and its new management

team have actively cooperated with, and assisted to the best of our

abilities, all government inquiries so that the people who committed this fraud can be brought to justice. We did this because it

is the right thing to do—and it is in that same spirit that I and

my fellow board members have come here today to answer your

questions.

HealthSouth’s public stockholders have clearly been harmed by

the fraud, and I can assure you that I understand very well the

frustration and outrage of shareholders who have lost value in the

company’s stock. My family and I have been, and continue to be,

the largest non-institutional stockholder in HealthSouth. I acquired

these shares when I sold my company, Surgical Care Affiliates, to

HealthSouth in 1996 in an all stock deal, and I have held on to virtually all these shares—over 99.9 percent.

My family currently owns 9.5 million shares and I have options

on an additional 500,000 shares that came from the acquisition of

Surgical Care, which is the result of a lifetime of work. The value

of my shares has shrunk from a high of approximately $290 million

to a very small fraction of that today, the largest loss of any individual shareholder. But, I am determined to build HealthSouth

back to a respected position in the healthcare community and to

help restore value for our stakeholders.

When the accounting fraud first was disclosed last March, the

HealthSouth Board took quick and decisive action. We put Mr.

Scrushy on an immediate leave of absence and installed a new

leadership team. Shortly thereafter, Mr. Scrushy’s employment

agreement was declared null and void.

We assembled a first-rate team of experienced outside advisors

to help the company through this crisis. We hired

PricewaterhouseCoopers to conduct a forensic review and terminated our relationship with Ernst & Young as our auditors. We

also retained Skadden Arps as our coordinating legal counsel to assist us. And we brought in the firm of Alvarez & Marsal for their

financial and operating restructuring expertise.

Immediately we began implementing measures to stabilize the

company’s operations, without disrupting the most critical part of

our business; patient care. We have been able to make steady

progress in each of our primary goals of protecting our core clinical

and patient needs, improving and strengthening our cash-flow, and

30

restoring the company’s financial credibility. While there is much

work to be done, we are seeing real and measurable success day

in and day out.

In addition to assisting with all government inquiries, we recognize that many of our stakeholders; stockholders, bondholders, suppliers, employees, and patients have been hurt by the actions of the

people who committed the fraud and we are doing everything possible to rectify that.

On a business level, we have been working diligently to meet our

financial obligations, and to restore the company’s credibility with

our stockholders and the investing public. In mid-August,

HealthSouth, a company that most people in the early weeks predicted would file for bankruptcy protection, made a payment of

$117 million representing all past due interest owed our creditors.

On October 1, the regular scheduled semi-annual interest payment

due our bondholders of approximately $40 million was made. We

intend to remain current on all upcoming interest payments, and

to repay all the principal amounts in full.

The progress we have been making over the past 7 months in our

business is due in large part to the hard work and dedication of

our thousands of employees throughout the country, and I would

like to take this opportunity to thank them. They have remained

focused on their work and have not let the wrongdoings of a small

group of individuals derail the future of our company. Without this

commitment to delivering outstanding care to our patients each

and every day, the recent success at HealthSouth would not have

been possible.

As the son of an immigrant who grew up in a coal mining community of 600, I understand hard work and the commitment it

takes to ensure success.

To underscore my commitment to these employees and stockholders, I have chosen to defer receipt of any salary as Interim

Chairman until the company’s recovery is stable and secure, and

the company is on a solid financial footing.

I have also voluntarily canceled the consulting agreement I had

as a result of selling Surgical Care Affiliates to HealthSouth in

1996.

Let me conclude by saying that throughout my 7 years of service

to the Board, I believe I have exercised independent judgment in

all matters. As a major shareholder, I am outraged by the conduct

of this company’s former management, who successfully concealed

thousands of fraudulent accounting entries from Ernst & Young

and the Board, to the detriment of all HealthSouth stakeholders.

The Board and management team remains committed to taking

the necessary action to ensure that we reach the goal of restoring

the long term health and vitality of HealthSouth.

Mr. Chairman, I will, to the best of my ability, be glad to answer

any questions you or other members of the subcommittee may

have.

[The prepared statement of Joel Gordon follows:]

PREPARED STATEMENT OF JOEL GORDON

Mr. Chairman, Ranking Member, and members of the Subcommittee, good morning.

31

My name is Joel Gordon and I am Interim Chairman of the HealthSouth Board

of Directors, having been appointed Interim Chairman on March 19, 2003. On behalf of the entire HealthSouth team and our more than 48,000 employees throughout the country, I appreciate the opportunity to appear before the Subcommittee.

As yesterday’s indictment of Richard Scrushy, the former Chairman and CEO, indicated, Mr. Scrushy, along with former members of management, directed a massive accounting fraud at HealthSouth. The Department of Justice has charged that

they not only defrauded the Company and its shareholders, but also the Board of

Directors. I look forward to answering your questions and describing the progress

that the Board and the Company have made over the past seven months in stabilizing our business since the massive accounting fraud first came to light.

As you may know, HealthSouth is a leader in inpatient and outpatient rehabilitation, diagnostics and outpatient surgery. In its short history, HealthSouth has

grown to become the nation’s largest provider of healthcare services, with nearly

1,700 locations throughout the country and abroad, and more than 48,000 employees. With our broad network of outstanding facilities, highly skilled physicians and

therapists, and state-of-the-art technology and equipment, we are able to provide all

of our patients easy access to high quality healthcare.

Since March 2003, when we were first made aware of the allegations of accounting fraud, the Company and its new management team have actively cooperated

with, and assisted to the best of our abilities, all government inquiries so that the

people who committed this fraud can be brought to justice. We did this because it

is the right thing to do—and it is in that same spirit that I and my fellow Board

members have come here today to answer your questions.

HealthSouth’s public stockholders have clearly been harmed by the fraud, and I

can assure you that I understand very well the frustration and outrage of shareholders who have lost value in the Company’s stock. My family and I have been,

and continue to be, the largest non-institutional stockholders in HealthSouth. I acquired these shares when I sold my company, Surgical Care Affiliates, to

HealthSouth in 1996 in an all stock deal, and I have held on to virtually all these

shares—over 99.9 percent. My family currently owns 9.5 million shares and I have

options on an additional 500,000 shares, which is the result of a lifetime of work.

The value of my shares has shrunk from a high of approximately $290 million to

a very small fraction of that today—the largest loss of any individual shareholder.

But, I am determined to build HealthSouth back to a respected position in the

healthcare community and to help restore value for our stakeholders.

When the accounting fraud first was disclosed last March, the HealthSouth Board

took quick and decisive action. We put Mr. Scrushy on an immediate leave of absence and installed a new leadership team. Shortly thereafter, Mr. Scrushy’s Employment Agreement was declared null and void. We assembled a first-rate team of

experienced outside advisors to help the Company through this crisis. We hired

PricewaterhouseCoopers to conduct a forensic review and terminated our relationship with Ernst & Young as our auditors. We also retained Skadden Arps as our

coordinating legal counsel to assist us. And we brought in the firm of Alvarez &

Marsal for their financial and operating restructuring expertise.

Immediately we began implementing measures to stabilize the Company’s operations, without disrupting the most critical part of our business—patient care. We

have been able to make steady progress in each of our primary goals of protecting

our core clinical and patient needs, improving and strengthening our cash flow, and

restoring the Company’s financial credibility. While there is much work to be done,

we are seeing real and measurable success day in and day out.

In addition to assisting with all government inquiries, we recognize that many of

our stakeholders—stockholders, bondholders, suppliers, employees, and patients—

have been hurt by the actions of the people who committed the fraud and we are

doing everything possible to rectify that.

On a business level, we have been working diligently to meet our financial obligations, and to restore the Company’s credibility with our stockholders and the investing public. In mid-August, HealthSouth—a company that most people in the early

weeks predicted would file for bankruptcy protection—made a payment of $117 million representing all past due interest owed our creditors. On October 1st we made

the regularly scheduled semi-annual interest payment due to our bondholders of approximately $40 million. We intend to remain current on all upcoming interest payments, and to repay all the principal amounts in full.

The progress we have been making over the past seven months in our business

is due in large part to the hard work and dedication of our thousands of employees

throughout the country, and I would like to take this opportunity to thank them.

They have remained focused on their work and have not let the wrongdoing of a

small group of individuals derail the future of our Company. Without this commitVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00039 Fmt 6633 Sfmt 6621 91232.TXT HCOM1 PsN: HCOM1
32

ment to delivering outstanding care to our patients each and every day, the recent

success at HealthSouth would not have been possible. As the son of an immigrant

who grew up in a coal mining community of 600, I understand hard work and the

commitment it takes to ensure success.

To underscore my commitment to these employees and stockholders, I have chosen to defer receipt of any salary as Interim Chairman until the Company’s recovery

is stable and secure, and the Company is on a solid financial footing. I have also

voluntarily cancelled the consulting agreement I had as a result of selling Surgical

Care Affiliates to HealthSouth in 1996.

Let me conclude by saying that throughout my seven years of service to the

Board, I believe I have exercised independent judgment in all matters. As a major

shareholder, I am outraged by the conduct of this Company’s former management,

who successfully concealed thousands of fraudulent accounting entries from Ernst

& Young and the Board, to the detriment of all HealthSouth stakeholders.

The Board and management team remain committed to taking the necessary actions to ensure that we reach the goal of restoring the long term health and vitality

of HealthSouth.

Mr. Chairman, I will, to the best of my ability, be glad to answer any questions

you or other members of the Subcommittee may have.

Mr. GREENWOOD. Thank you, Mr. Gordon. We appreciate that.

Ms. Givens.

TESTIMONY OF SAGE GIVENS

Ms. GIVENS. Good morning, Mr. Chairman.

Mr. GREENWOOD. Good morning.

Ms. GIVENS. Ms. DeGette, and members of the subcommittee.

My name is Sage Givens. I am a member of the Board of Directors of HealthSouth. I am the Founding Managing Partner of Acacia Venture Partners, which was the first venture capital firm to

specialize in healthcare services. Since 1983 I have helped many

leading healthcare services companies from the ground up by providing badly needed capital. Like HealthSouth these companies

have been successful because they provide millions of Americans

with high quality healthcare at affordable prices.

I joined HealthSouth’s Board of Directors in 1985, when my firm

First Century Partners invested in the company. After the company went public in 1987, I was annually re-elected to the

HealthSouth Board by shareholders. I have remained on the Board

because I believe so strongly in what HealthSouth stands for; high

quality, affordable healthcare.

The HealthSouth Board over the years has included many distinguished and accomplished individuals. This Board has also surrounded itself with experts in the fields of finance, compensation,

financial reporting, compliance and ethics. The Board was regularly briefed by nationally recognized firms such as Ernst & Young,

Mercer Human Resource Consulting, Strategic Management Systems, and many others.

Although we do not have the details of how this fraud occurred,

what we have learned so far is that it was a very carefully orchestrated, highly sophisticated accounting fraud, designed to evade detection. Indeed, at HealthSouth we had numerous controls and systems in place that should have helped to detect this fraud. Unfortunately, when high-level management conspires to commit a criminal act, I do not know of any corporate governance policy that

would prevent such criminal behavior. From the beginning, I have

been a vigilant, active and well prepared Board member. I have

asked the tough questions and have been unafraid to express my

33

thoughts forcefully. Any implication to the contrary is just plain

wrong and goes against my reputation for being a tough but fairminded director of numerous companies over the years, both public

and private.

It is difficult to convey how shocked and saddened I have been

since learning of the fraud committed against the company. After

all, it was touted by many one of the best rehabilitation companies

and the first healthcare company to establish itself in all 50 states.

It was associated with numerous world-class physicians and established a preeminent reputation in the treatment of sports injuries,

cardiac and stroke patients, and was endorsed by prominent figures in many walks of life.

Now I would like to take the opportunity to address the subject

of the audit committee which was discussed during the first day of

your hearings, Mr. Chairman. I have been a member of the audit

committee since 1989. Early on, the company selected Ernst &

Young, one of the most highly experienced and nationally recognized accounting firms in the country.

The audit committee met regularly and was often joined by representatives of Ernst & Young. Detailed questions were asked of

Ernst & Young at these meetings about the company’s finances and

we were regularly assured that the company’s accounting practices

and internal control systems were among the best in the country.

Audit committee members, as well as other Board members,

queried Ernst & Young about any and all accounting deficiencies

to be addressed and corrected. None, not one, was ever raised by

the auditors in the 13 plus years I served on the audit committee.

Indeed, in Ernst & Young’s Management reports for the last 3

years, the auditors declared that they found ‘‘no material errors,

fraud, or possible material illegal acts.’’

Finally, I would like to respond to questions about business relationships with HealthSouth that are described as ‘‘Related Party

Transactions.’’ As you know, Federal securities law contemplates

and permits such transactions.

I am a venture capitalist and I specialize in the healthcare industry. My job is to find new and innovative companies which can

deliver superior healthcare services at affordable prices to all

Americans. When I found examples of companies which provide

good medical care at affordable prices, I not only invested my company’s capital in those companies, but I thought it made good sense

to share those opportunities with HealthSouth. Sometimes

HealthSouth thought it was in the company’s and its shareholders’

best interests to invest and it did so. And more times than not,

HealthSouth declined to make an investment.

There is not one example of a time when I or my firm pressured

HealthSouth to make an investment. In virtually all of those transactions, HealthSouth and its shareholders have benefited.

HealthSouth, despite the enormity of the malfeasance committed

by a few individuals, has clearly contributed a great deal to the

healthcare industry. The fact that the company is still standing

strong and has staved off bankruptcy is a testament to its employees and the quality of medical care it has provided to millions of

patients. Indeed, I believe that with the dedication and leadership

of the Board and the new management team, HealthSouth will conVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00041 Fmt 6633 Sfmt 6602 91232.TXT HCOM1 PsN: HCOM1
34

tinue to make an enormous contribution to medical care in this

country. My focus as a Board member has always been, and continues to be, to ensure HealthSouth’s future as a viable, strong and

ethical business.

Thank you.

[The prepared statement of Sage Givens follows:]

PREPARED STATEMENT OF SAGE GIVENS

Mr. Chairman, Ranking Member, and members of the Subcommittee, good morning.

My name is Sage Givens. I am a member of the Board of Directors of

HealthSouth. I am the Founding Managing Partner of Acacia Venture Partners,

which was the first venture capital firm to specialize in healthcare services. Prior

to that, I was a principal at First Century Partners, where I managed the firm’s

healthcare practice. The venture funds with which I have been associated have

helped build many leading healthcare service companies from the ground up by providing badly needed capital to help them get started and to grow. Like HealthSouth,

these companies have been successful because they provide millions of Americans

with high quality healthcare at affordable prices.

I joined HealthSouth’s Board of Directors in 1985, when First Century Partners

invested in the Company. As a condition of its investment, First Century required

a seat on the Board, and my partners selected me to fill that seat. At that time,

HealthSouth was a private company with only 2 facilities and less than $2.0 million

in revenues. After the Company went public in 1987, I was annually re-elected to

the HealthSouth Board by shareholders. I have remained on the Board because I

believe so strongly in what HealthSouth stands for—high quality, affordable

healthcare.

The HealthSouth Board over the years has included many distinguished and accomplished individuals. This Board has also surrounded itself with experts in the

fields of finance, compensation, financial reporting, compliance and ethics. The

Board was regularly briefed by nationally recognized firms such as Ernst & Young,

Deloitte & Touche, Mercer Human Resource Consulting, Strategic Management Systems, and many others.

Although we do not have all of the details of how this fraud occurred, what we

have learned so far is that it was a very carefully orchestrated, highly sophisticated

accounting fraud, designed to evade detection. Indeed, at HealthSouth we had numerous controls and systems in place that should have helped to detect this fraud.

Unfortunately, when high-level management conspires to commit a criminal act, I

do not know of any corporate governance policy that would prevent such criminal

behavior. How to prevent this type of fraud in the future is certainly a challenge

for boards all across this country.

As long as I have served on this Board, I have strongly believed that this was

a company which simultaneously rewarded its shareholders while providing outstanding service to hundreds of thousands of patients per year. From the beginning,

I have been a vigilant, active and well-prepared Board member. I have asked the

tough questions and have been unafraid to express my thoughts forcefully. Any implication to the contrary is just plain wrong and goes against my reputation for

being a tough but fair-minded director of numerous companies, both public and private.

It is difficult to convey how shocked and saddened I have been since learning of

the fraud committed against the Company. After all, HealthSouth was touted by

many as being a premier healthcare company. It was the first and best national rehabilitation company and the first healthcare company to establish itself in all 50

states. It was associated with numerous world-class physicians and established a

preeminent reputation in the treatment of sports injuries, as well as of cardiac and

stroke patients, and was endorsed by prominent figures in many walks of life.

I would like to take the opportunity to address the subject of the Audit Committee

which was discussed during the first day of your Hearings, Mr. Chairman. I have

been a member of the Audit Committee since 1989. Early on, the Company selected

Ernst & Young, one of the most highly experienced and nationally recognized accounting firms in the United States. The Audit Committee met regularly and was

often accompanied by representatives of Ernst & Young. Detailed questions were

asked of Ernst & Young at these meetings about the Company’s finances and we

were regularly assured that the Company’s accounting practices and internal control

systems were among the best in the country.

35

Audit Committee members, as well as other Board members, queried Ernst

&Young about any and all accounting deficiencies to be addressed and corrected.

None, not one, was ever raised by the auditors in the 13+ years I served on the

Audit Committee. Indeed, in Ernst &Young’s Management Reports for the last 3

years, the Auditors declared that they found ‘‘no material errors, fraud, or possible

material illegal acts.’’

Finally, I would like to respond to questions about business relationships with

HealthSouth that are described as ‘‘Related Party Transactions.’’ As you know, federal securities law contemplates and permits such transactions. I am a venture capitalist and I specialize in the healthcare industry. My job is to find new and innovative companies which can deliver superior healthcare services at affordable prices

to all Americans. That is why my company invested in HealthSouth to begin with.

When I have found examples of companies which provide good medical care at affordable prices, I not only invested my company’s capital in those companies, but

I thought it made good sense to share those opportunities with HealthSouth. Sometimes HealthSouth thought it was in the Company’s and its shareholders’ best interests to invest and did so. And more times than not, HealthSouth declined to make

an investment. There is not one example of a time when I or my firm pressured

HealthSouth to make an investment. In virtually all of those transactions,

HealthSouth and its shareholders have benefited.

HealthSouth, despite the enormity of the malfeasance committed by a few individuals, has clearly contributed a great deal to the healthcare industry. The fact that

the Company is still standing strong and has staved off bankruptcy is a testament

to its employees and the quality of medical care it has provided to millions of patients. Indeed, I believe that with the dedication and leadership of the Board and

the new management team, HealthSouth will continue to make an enormous contribution to medical care in this country. My focus as a Board member has always

been, and continues to be, to ensure HealthSouth’s future as a viable, strong and

ethical business.

I support this Committee’s efforts to identify the facts and to seek ways of preventing this type of fraud in the future. Thank you.

Mr. GREENWOOD. Well, thank you, Ms. Givens.

Dr. Watkins, do you have an opening statement, sir?

TESTIMONY OF PHILLIP WATKINS

Mr. WATKINS. Good morning, Mr. Chairman, ranking member,

and members of the subcommittee.

My name is Dr. Phillip Watkins. I am a former member of the

HealthSouth Board of Directors. I resigned from the Board in February 2003 and am proud of my long service on behalf of

HealthSouth and its stockholders. And I welcome the opportunity

to share with the subcommittee my insight into the Board’s functions.

Let me describe my background. I am a cardiologist in private

practice in Birmingham where I grew up. Went to undergraduate

and medical school, trained at the Mayo Clinic in and specialized

in cardiovascular disease.

I first became involved with HealthSouth, which was a startup

brand new company then known as Amcare, in 1983, after I first

met Richard Scrushy. Mr. Scrushy proposed a merger of my practice’s cardiac rehabilitation facility with Amcare to form what is

known at that time as a ‘‘CORF’’ or a comprehensive outpatient rehabilitation facility.

In 1984, I was asked by Mr. Scrushy to join the company’s Board

of Directors, 2 years before HealthSouth became a publicly traded

company. As a physician and director, it was determined that I

could add valuable insight by talking to our physicians and helping

to meet their needs in working at and with our facilities. Our ability to provide high quality, efficient, low cost patient care was the

core of the company’s business.

36

Early on, I was appointed Chairman of the Board’s audit & compensation committee. At that time the company was a startup with

such a small Board that these two functions were combined to form

one committee. At that time, many companies followed that practice. Later, the committees were separated into two distinct committees.

As Chairman of the audit & compensation committee, I worked

with and relied upon the outside experts hired by our Board. For

example, we hired Mercer Human Resource Consulting to assist

our committee on compensation questions and act as our compensation consultants. Mercer retains a reputation as one of the largest

and most relied upon compensation consulting firms in the country.

Mercer analyzed the compensation trends of similar firms in the

healthcare industry and, along with other experts we employed, advised the compensation committee on our compensation plans. It

was based upon this information and advice that we determined

the compensation packages of HealthSouth’s management team.

By all accounts, HealthSouth was growing at an exciting pace,

and was singled out by publications such as ‘‘Forbes’’ and ‘‘Fortune,’’ as an up and coming star in the field of outpatient surgery

and rehabilitation. Since I joined the HealthSouth Board in 1984,

I have seen HealthSouth grow from a company with two rehabilitation facilities, one in Little Rock and one in Birmingham, to become

the largest outpatient surgery, rehabilitation and diagnostic services company in the world with over 48,000 employees.

The compensation for HealthSouth senior executives, including

Mr. Scrushy, was based upon this apparent outstanding performance, and the committee was always assured by the independent

analyses of experts such as Mercer that the Board’s compensation

philosophy was entirely in keeping with the best practices at the

time. Specifically, we implemented a performance based incentivecompensation program, which included annual bonuses, stock option grants under a stockholder approved option plan. We now

know the numbers we relied on and were certified by our outside

accountants to calculate these numbers were fraudulent. If the

compensation committee had known of the fraud, Mr. Scrushy and

others had done, we would have been terminated him immediately

and they would never have received any of their salaries, bonuses

or and stock options.

I was as shocked and angry as the rest of the public when I

learned that senior members of HealthSouth’s management team

had been perpetrating a fraud on HealthSouth’s stockholders. As

the indictment stated, the Board of Directors was similarly deceived by fraud. These criminal conspirators were able to fraudulently conceal or otherwise alter information and documents that

all of the experts including the accounting firm of Ernst & Young

could not detect the fraud. As a corporate director, I relied upon

the accuracy of information provided to me by both management

and by outside experts such as Ernst & Young. It is now evident

that because the truth had been so thoroughly concealed by certain

former members of management, the probing questions and activism of this Board could not have discovered the existence of this

accounting fraud.

37

Let me conclude by saying that I am proud of my service to the

HealthSouth Board. HealthSouth enabled me to combine my obligation as a medical doctor to patients along with that as a director

to the company to its stockholders. Had I known of the hidden

fraud being perpetrated on us all, I would have acted quickly and

decisively, just as the current Board has done in removing those responsible.

HealthSouth is one of the great healthcare companies in America

and I am confident that it will continue to go forward under the

guidance of the new management team.

I look forward to answering any questions.

[The prepared statement of Phillip Watkins follows:]

PREPARED STATEMENT OF PHILLIP WATKINS

Mr. Chairman, Ranking Member, and members of the Subcommittee, good morning.

My name is Dr. Phillip Watkins, and I am a former member of the HealthSouth

Board of Directors. I resigned from the Board in February 2003 and am proud of

my long service on behalf of HealthSouth and its stockholders. I welcome the opportunity to share with the Subcommittee my insight into the Board’s functions at

HealthSouth.

First, let me describe my background. I am a cardiologist in private practice in

Birmingham where I grew up. I attended the University of Alabama, the Medical

College of Alabama, trained at the Mayo Clinic in Internal Medicine and specialized

in Cardiovascular Disease. I am currently the Medical Director of The Autonomic

Disorders and Mitral Valve Prolapse Center located in Birmingham, Alabama.

I became involved with HealthSouth, a brand new company then known as

Amcare, in 1983, after I first met Mr. Scrushy. Mr. Scrushy proposed a merger of

my practice’s cardiac rehabilitation facility with Amcare to form what is known as

a ‘‘CORF’’—Comprehensive Outpatient Rehabilitation Facility. The unique concept

of a CORF was to combine outpatient surgery and rehabilitation facilities into one

stand-alone medical complex in order to ease patient burden and expense, and ultimately provide for more successful patient recoveries.

In 1984, I was asked by Mr. Scrushy to join the Company’s Board of Directors,

two years before HealthSouth became a publicly traded company in 1986. As a physician and director, it was determined that I could add valuable insight by talking

to physicians and helping to meet their needs in working with our facilities. Our

ability to provide high quality, efficient, low cost patient care was the core of the

Company’s business.

Early on, I was appointed Chairman of the Board’s Audit & Compensation Committee. At that time the Company was a startup with such a small board that these

two functions were combined to form one committee. At that time, many companies

followed this practice. Later, the committees were separated into two distinct committees.

As Chairman of the Audit & Compensation Committee, I worked with and relied

upon the outside experts hired by our Board. For example, we hired Mercer Human

Resource Consulting to assist the Committee as our compensation consultants. Mercer retains a reputation as one of the largest and most relied upon compensation

consulting firms in the country. Mercer analyzed the compensation trends of similar

firms in the healthcare industry and, along with other experts, advised the Compensation Committee. It was based upon this information and advice that we determined the compensation packages of HealthSouth’s management team.

By all accounts, HealthSouth was growing at an exciting pace, and was singled

out by numerous industry publications, including Forbes and Fortune, as an up and

coming star in the field of outpatient surgery and rehabilitation. Since I joined the

HealthSouth Board in 1984, I have seen HealthSouth grow from a company with

two rehabilitation facilities—one in Little Rock and one in Birmingham—to become

the largest outpatient surgery company, rehabilitation company and diagnostic services company in the world with over 48,000 employees throughout the country. The

compensation for HealthSouth senior executives, including Mr. Scrushy, was based

upon this apparent outstanding performance, and the Committee was always assured by the independent analyses of experts such as Mercer that the Board’s compensation philosophy was entirely in keeping with the best practices at the time.

Specifically, we implemented a performance based incentive-compensation program,

38

which included annual bonuses and stock option grants under a stockholder-approved option plan.

We now know the numbers we relied on and were certified by our outside accountants to calculate senior management compensation were fraudulent. If the Compensation Committee had known of the fraud, Mr. Scrushy and others would have

been terminated immediately and would never have received these salaries, bonuses, and stock options.

I was as shocked and angry as the rest of the public when I learned that senior

members of HealthSouth’s management team had been perpetrating a fraud on

HealthSouth’s stockholders. The Board of Directors was similarly deceived. These

criminal conspirators were able to fraudulently conceal or otherwise alter information and documents such that all of the experts including the accounting firm of

Ernst & Young did not detect the fraud. As a corporate director, I relied on the accuracy of information provided to me by management and by outside experts such

as Ernst & Young. It is now evident that because the truth had been so thoroughly

concealed by certain former members of management, the probing questions and activism of this Board could not have discovered the existence of this accounting

fraud.

In addition to questioning former management and outside experts, the Company

had in place internal control systems designed, in part, to catch fraud. But every

system of checks and balances is only as good as the people who are there and use

them. Ms. Henze testified that she did use the compliance system we had set up

to receive and act upon such information. That’s how the compliance system was

supposed to work. It is incomprehensible to me how designated compliance personnel could have received such apparently clear information and could not have

told Ernst & Young, the Audit Committee or the Board.

Just to be clear, the fraud occurred at a corporate level. Ernst & Young conducted

the corporate-wide audit. In contrast, internal audit conducted facility level audits.

The Subcommittee heard testimony two weeks ago from Ms. Teresa Sanders and

Mr. Greg Smith of HealthSouth’s internal audit department. The Audit Committee

did meet on a regular basis with Ms. Sanders and Mr. Smith and received their reports and questioned both of them. In fact, I had more internal auditors added to

the internal audit staff after talking to Ms. Sanders. They never told us they had

any suspicion of impropriety.

Let me conclude by saying that I am proud of my service to the HealthSouth

Board. HealthSouth enabled me to combine my obligation as a medical doctor to patients with that as a director of the Company to the stockholders. Had I known of

the hidden fraud being perpetrated on us all, I would have acted quickly and decisively, just as the current Board has in removing those responsible. HealthSouth is

one of the great healthcare companies in America and I am confident that it will

continue to be under the guidance of the new management team. I look forward to

answering any questions you or any other members of the Subcommittee may have.

Mr. GREENWOOD. Thank you, Dr. Watkins.

Mr. Striplin, do you have an opening statement, sir?

TESTIMONY OF LARRY D. STRIPLIN

Mr. STRIPLIN. Mr. Chairman, ranking member, and members of

the subcommittee, good morning.

Mr. GREENWOOD. You need to turn on your microphone and

maybe point it toward you a little bit. Turn it down a little bit so

it’s pointing toward you. There you go.

Mr. STRIPLIN. Mr. Chairman and ranking member, and members

of the subcommittee, good morning.

My name is Larry Striplin, and I am a member of the

HealthSouth Board of Directors. And I joined the Board in April

1999, and have been proud to serve with the talented and experienced directors seated next to me today.

As you know, HealthSouth grew from a company with two patient care facilities, one in Little Rock and one in Birmingham, to

a company with more than 1,700 facilities across the country.

HealthSouth has set the standard for providing state-of-the-art rehabilitation services to patients ranging from professional athletes

39

recovering from sports injuries to grandparents recovering from

strokes.

First, let me tell you a little of my background. I am a native of

Selma, Alabama. I graduated from Birmingham-Southern College

with a degree in education. I pursued my education at George Peabody College (now a part of Vanderbilt University) in Nashville,

Tennessee, where I obtained a master’s degree in Education.

I have owned and operated my own business, Nelson Brantley

Glass Company, since 1963 and am currently the Chairman and

CEO of this company. I also serve as CEO of Circle ‘‘S’’ Industries.

Also, in 1977, I established American Fine Wire, which was one of

Selma’s largest employers. I am a member of the Boards of directors of Kulicke & Suffa Industries, Inc., which purchased American

Fine Wire.

In addition to my work with my own companies, I have always

been actively involved in various civic activities. I was instrumental in establishing the Alabama Sports Hall of Fame and have

served on its Board of Directors for 23 years, 13 of those as Chairman.

I also founded and serve as Chairman of the Bryant Jordon Student Athletic Foundation, which provides scholarships to student

athletes.

And have served as Chairman of the Birmingham Park and

Recreation Board, a member of the Birmingham Business Leadership Council, and a board member of the Alabama Sports Foundation and the American Sports Medicine Institute.

I am currently a trustee of Birmingham-Southern College and its

executive committee. And I also serve on the board of the University of South Alabama.

In part, it was HealthSouth’s work in the field of sports rehabilitation that drew me to the company. I was proud to help direct a

company that had such a positive impact on the health and fitness

of people of all walks of life.

When the allegations of fraud came to light in March 2003, I was

as shocked and dismayed as my fellow directors. Nonetheless, the

Board quickly took steps to stem the crisis and stabilize the business. As you know, Mr. Scrushy was put on an immediate leave of

absence, and we appointed Joel Gordon as interim Chairman and

Bob May as interim chief executive. Additionally, we brought in a

first-rate experienced outside advisors headed by Bryan Marsal,

our chief restructuring officer, to assist us in getting control of the

situation. These three people, with the help of many others, have

done an outstanding job. And our first priority, of course, was to

ensure that HealthSouth was able to continue to provide the much

needed healthcare services to all of its patients.

I am pleased to report that HealthSouth has made tremendous

progress over the past 7 months under the leadership of these interim management team. Our employees have also played a very

large role in the company’s recovery, and I would like to take this

opportunity to thank them. They have remained focused on the

task at hand and they have continued to deliver high quality care

to thousands of patients every day.

40

Mr. Chairman I will, to the best of my ability, be glad to answer

any questions you or other members of the subcommittee may

have.

[The prepared statement of Larry D. Striplin follows:]

PREPARED STATEMENT OF LARRY D. STRIPLIN

Mr. Chairman, Ranking Member, and members of the Subcommittee, good morning.

My name is Larry Striplin, and I am a member of the HealthSouth Board of Directors. I joined the Board in April 1999, and have been proud to serve with the

talented and experienced directors seated next to me today. As you know,

HealthSouth grew from a company with two patient care facilities—one in Little

Rock, Arkansas, and one in Birmingham, Alabama—to a company with more than

1,700 facilities across the country. HealthSouth has set the standard for providing

state of the art rehabilitation services to patients ranging from professional athletes

recovering from sports injuries to grandparents recovering from strokes.

First, let me tell you about my background. I am a native of Selma, Alabama. I

graduated from Birmingham-Southern College with a degree in education. I pursued

my education at George Peabody College (now Vanderbilt University) in Nashville,

Tennessee, where I obtained a masters degree in Education.

I have owned and operated my own business, Nelson Brantley Glass Contractors,

since 1963 and am currently CEO of this company. I also serve as CEO of Circle

‘‘S’’ Industries. Also, in 1977, I established American Fine Wire, which was one of

Selma, Alabama’s largest employers. I am a member of the boards of directors of

Kulicke & Suffa Industries, Inc., which purchased American Fine Wire.

In addition to my work with my own companies, I have always been actively involved in various civic activities. I was instrumental in establishing the Alabama

Sports Hall of Fame and have served on its board of directors for twenty-three

years, thirteen of those as Chairman. I also founded and serve as Chairman of the

Bryant Jordon Student Athletic Foundation, which provides scholarships to student

athletes. I have served as Chairman of the Birmingham Park and Recreation Board,

a member of the Birmingham Business Leadership Council, and a board member

of the Alabama Sports Foundation and the American Sports Medicine Institute. I

am currently a Trustee of Birmingham-Southern College and its Executive Committee. I also serve on the board of the University of South Alabama.

In part, it was HealthSouth’s work in the field of sports rehabilitation that drew

me to the Company. I was proud to help direct a company that had such a positive

impact on the health and fitness of people from all walks of life.

When the allegations of fraud came to light in March 2003, I was as shocked and

dismayed as my fellow directors. Nonetheless, the Board quickly took steps to stem

the crisis and stabilize the business. As you know, Mr. Scrushy was put on an immediate leave of absence, and we appointed Joel Gordon as Interim Chairman and

Bob May as Interim Chief Executive Officer. Additionally, we brought in a first-rate

team of experienced outside advisors—including Bryan Marsal, our Chief Restructuring Officer—to assist us in getting control of the situation. These three people—

with the help of many others—have done an outstanding job. Our first priority, of

course, was to ensure that HealthSouth was able to continue to provide the much

needed healthcare services to all of its patients.

I am pleased to report that HealthSouth has made tremendous progress over the

past seven months under the leadership of the interim management team. Our employees have also played a very large role in the Company’s recovery, and I would

like to take this opportunity to thank them. They have remained focused on the task

at hand and have continued to deliver high quality care to thousands of patients

every day.

Mr. Chairman I will, to the best of my ability, be glad to answer any questions

you or other members of the Subcommittee may have.

Mr. GREENWOOD. Thank you, Mr. Striplin.

Mr. May?

TESTIMONY OF ROBERT MAY

Mr. MAY. Mr. Chairman, ranking member, and members of the

subcommittee, good morning.

My name is Robert May, and I am the interim chief executive officer of HealthSouth, and a member of the HealthSouth Board of

41

Directors. I appreciate the opportunity to appear before the subcommittee today and look forward to answering your questions. I

also look forward to describing for you the deliberate and purposeful steps taken by our Board of Directors, our management team,

and our employees since we, along with the rest of the public, first

became aware of the allegations of accounting fraud at the company.

I joined the company’s Board of Directors at the end of September 2002 along with my fellow Board member, Jon Hanson, as

independent directors. Among our other duties, we looked forward

to helping the company to conform its governance platform to the

requirements of the newly enacted Sarbanes-Oxley Act and the proposed listing standards of the New York Stock Exchange.

From 1973 to 1993, I held a variety of executive and operational

positions at Federal Express Corporation, most recently as President of Business Logistics.

Following my tenure with FED EX, I became chief operating officer and a director of Cablevision Systems Corp., where I was part

of the executive team that helped transition the company through

new operating strategies and the use of new technologies.

Since the allegations of accounting fraud were first disclosed last

March, the Board acted quickly and decisively to ensure that Mr.

Scrushy and those members of management alleged to have assisted him in perpetrating a fraud on HealthSouth stockholders

were immediately terminated.

For the past 7 months, I have been serving as the interim CEO,

helping to lead the company’s day-to-day operations. As a part of

the interim management team, I have worked to help stabilize the

company’s financial situation and refocus our core operations on

patient care.

As you have heard from previous testimony, some employees at

HealthSouth felt afraid and intimidated, feelings no employee

should have in the workplace. We have sought to transform the

culture of HealthSouth, especially at the corporate headquarters.

On a symbolic level, we have taken down Mr. Scrushy’s name from

our corporate conference center; opened up the formerly restricted

executive floors to all employees; and closed the executive dining

room so that our leadership team eats in our cafeteria with the

company’s employees.

I also hold regular, open, informal brown bag lunch meetings

with employees from all levels and departments of the Company;

encouraging them to ask questions or raise issues and sharing information about our plans and goals for the company. While this

is not an unusual practice in corporate America, it began at

HealthSouth only when the interim management team took charge.

The response has been encouraging at all levels of the company.

We also hold regular broadcasts to reach our 48,000 employees in

the field, and we have traveled extensively to many of our field locations throughout the country.

We have also looked closely at our governance policy and compliance programs. I chair the corporate governance committee. My fellow committee members and I have recently updated our governance and compliance systems, a process that began when I joined

the Board. Further changes are about to be incorporated as a result

42

of adopting recent changes suggested by the New York Stock Exchange.

Assisting in our effort is a team of outside expert advisors, including the noted Professor Charles M. Ellson, the Director of the

Center for Corporate Governance at the University of Delaware.

With the aid of this governance advisory panel, my fellow directors and I drafted corporate governance policies for our Board committees that meet or exceed the requirements of Sarbanes-Oxley

and the New York Stock Exchange with respect to important issues

such as director independence. These new guidelines take into account not only legal and regulatory requirements, but also current

corporate governance best practices.

HealthSouth’s governance committee, again with the input from

our governance advisory panel, began to search for additional corporate directors who could bring valuable new experience and abilities to the Board. We have retained two nationally recognized

search firms and have interviewed numerous candidates. Despite a

lapse in our directors and officers insurance, we have attracted a

talented, courageous new Board member, Lee Hillman, who now

serves as Chairman of the audit committee.

I know this Committee is interested in the internal investigation

conducted by the outside law firm of Fulbright & Jaworski into the

issue of insider trading and management’s knowledge, specifically

that of Richard Scrushy, of the impact on company earnings of a

new Medicare billing rule known as CMS Transmittal 1753.

The Board retained Fulbright & Jaworski on September 17,

2002, prior to my Board appointment, and granted Fulbright & Jaworski total access to all corporate records and mandated that all

management and employees cooperate fully in this internal investigation. The Board received regular updates, and ultimately, on

October 21, 2002, received a report which indicated that, based on

Fulbright’s review, they could find no evidence that Mr. Scrushy

had known of the impact of Transmittal 1753 at the time of certain

stock sales executed by him. The Board was never given a reason

to believe that the Fulbright & Jaworski investigation was anything other than a thorough and adequate investigation into insider trading allegations. I and other directors certainly understood

from the briefings conducted by Fulbright & Jaworski that they

had found no evidence of inappropriate or illegal conduct by Mr.

Scrushy connected with his sale of stock. We continue to cooperate

with all government authorities as they look into this and other

areas.

My focus now is on stabilizing the company’s financial position

in order to ensure a viable future. We have made progress, and I

am pleased to say that we are strengthening relationships with our

payors, vendors, doctors and other outside parties critical to the

continued success of HealthSouth.

We are also developing new sources of revenue in our core areas,

as demonstrated by new and expanded contracts with payors. As

interim CEO, I have promised our 48,000 employees that we are

committed to a future where the company’s goal of providing excellent patient care comes first.

We believe the fundamentals are in place at numerous levels of

HealthSouth for renewed success, but we will continue to improve

43

the corporate culture to ensure that appropriate principles are effectively put into practice. Continuing to examine and enhance policies to prevent corporate fraud is important. However, in my opinion, the most critical element in prevention is providing a culture

where employees are able to ask questions, challenge decisions and

communicate with management in an open and direct fashion. It

was a group of individuals who committed the fraud and engaged

and criminal activities at HealthSouth, and without an employee

stepping forward in this case, we still might not know the depths

of the fraud that was perpetrated against the company and its

stakeholders.

Let me end by saying that the Board and the management team

are committed to taking the necessary actions to ensure that we

reach the goal of restoring the long-term health and viability of

HealthSouth, and we are committed to assisting this subcommittee

in its work.

Mr. Chairman, I appreciate this opportunity and will, to the best

of my ability, be glad to answer questions you or any other members of the subcommittee may have.

[The prepared statement of Robert May follows:]

PREPARED STATEMENT OF ROBERT MAY

Mr. Chairman, Ranking Member, and members of the Subcommittee, good morning.

My name is Robert May, and I am the Interim Chief Executive Officer of

HealthSouth, and a member of the HealthSouth Board of Directors. I appreciate the

opportunity to appear before the Subcommittee today and look forward to answering

your questions. I also look forward to describing for you the deliberate and purposeful steps taken by our Board of Directors, our management team, and our employees

since we, along with the rest of the public, first became aware of the allegations

of accounting fraud at the Company.

I joined the Company’s Board of Directors at the end of September 2002 along

with my fellow Board member, Jon Hanson. Among our other duties, we looked forward to helping the Company to conform its governance platform to the requirements of the newly enacted Sarbanes-Oxley Act and the proposed listing standards

of the New York Stock Exchange.

From 1973 to 1993, I held a variety of executive and operational positions at Federal Express Corporation, most recently as President of Business Logistics. Following my tenure with FED EX, I became chief operating officer and a director of

Cablevision Systems Corp., where I was part of the executive team that helped transition the Company through new operating strategies and the use of new technologies.

Since the allegations of accounting fraud were first disclosed last March, the

Board acted quickly and decisively to ensure that Mr. Scrushy and those members

of management alleged to have assisted him in perpetrating a fraud on HealthSouth

stockholders were immediately terminated.

Since late March 2003, I have been serving as the Interim CEO, helping to lead

the Company’s day-to-day operations. As part of the interim management team, I

have worked to help stabilize the Company’s financial situation and refocus our core

operations on patient care.

As you have heard from previous testimony, some employees at HealthSouth felt

afraid and intimidated, which should have no place in any workplace. We have

sought to transform the culture of HealthSouth, especially at the corporate headquarters. On a symbolic level, we have taken down Mr. Scrushy’s name from our

corporate conference center; opened up the formerly restricted executive floors to all

employees; and closed the executive dining room so that our leadership team eats

in our cafeteria with the Company’s employees.

I also hold regular, open, informal brown bag lunch meetings with employees from

all levels and departments of the Company—encouraging them to ask questions or

raise issues—and sharing information about our plans and goals for the Company.

While this is not an unusual practice in corporate America, it began at HealthSouth

only when the interim management team took charge. The response has been enVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00051 Fmt 6633 Sfmt 6621 91232.TXT HCOM1 PsN: HCOM1
44

couraging at all levels of the Company. We also hold regular broadcasts to reach

our 48,000 employees in the field, and we have traveled to many of our field locations throughout the country.

We have also looked closely at our governance policies and compliance programs.

I chair the Corporate Governance Committee. My fellow committee members and I

have recently updated our governance and compliance systems, a process that began

when I joined the Board. Further changes are about to be incorporated as a result

of adopting recent changes suggested by the New York Stock Exchange. Assisting

in our effort is a team of outside expert advisors, including the noted Professor

Charles M. Ellson, the Director of the Center for Corporate Governance at the University of Delaware. With the aid of this governance advisory panel, my fellow directors and I drafted corporate governance policies for our Board committees that meet

or exceed the requirements of Sarbanes-Oxley and New York Stock Exchange with

respect to important issues such as director independence. These new guidelines

take into account not only legal and regulatory requirements, but also current corporate governance best practices.

HealthSouth’s Governance Committee, again with the input from our governance

advisory panel, began to search for additional corporate directors who could bring

valuable new experience and abilities to the Board. We have retained two nationally

recognized search firms and have interviewed numerous candidates. Despite a lapse

in our Directors and Officers insurance, we have attracted a talented, courageous

new Board member, Lee Hillman, who now serves as Chairman of our Audit Committee.

We have also drafted and approved charters for Board committees and reengineered our compliance programs. As part of those revised compliance procedures,

the Corporate Compliance Officer now reports independently to the Compliance

Committee. In that same vein, the internal auditor reports independently to the

Audit Committee.

I know this Committee is also interested in the internal investigation conducted

by the outside law firm of Fulbright & Jaworski into the issue of insider trading

and management’s knowledge, specifically that of Richard Scrushy, of the impact on

Company earnings of a new Medicare billing rule known as CMS Transmittal 1753.

The Board retained Fulbright & Jaworski on September 17, 2002, prior to my Board

appointment, and granted Fulbright & Jaworski total access to all corporate records

and mandated that all management and employees cooperate fully in this internal

investigation. The Board received regular updates, and ultimately, on October 21,

2002, received a report which indicated that, based on Fulbright’s review, they could

find no evidence that Mr. Scrushy had known of the impact of Transmittal 1753 at

the time of certain stock sales executed by him. The Board was never given a reason

to believe that the Fulbright & Jaworski investigation was anything other than a

thorough and adequate investigation into insider trading allegations. I and other directors certainly understood from the briefings conducted by Fulbright & Jaworski

that they had found no evidence of inappropriate or illegal conduct by Mr. Scrushy

connected with his sale of stock. We continue to cooperate with all government authorities as they look into this and other areas.

My focus now is on stabilizing the Company’s financial position in order to ensure

a viable future. We have made progress, and I am pleased to say that we are

strengthening relationships with our payors, vendors, doctors and other outside parties critical to the continued success of HealthSouth. We are also developing new

sources of revenue in our core areas, as demonstrated by new and expanded contracts with payors. As interim CEO, I have promised our 48,000 employees that we

are committed to a future where the Company’s goal of providing excellent patient

care continues to come first.

We believe the fundamentals are in place at numerous levels of HealthSouth for

renewed success, but we will continue to improve the corporate culture to ensure

that appropriate principles are effectively put into practice. Continuing to examine

and enhance policies to prevent corporate fraud is important. However, in my opinion, the most critical element in prevention is providing a culture where employees

are able to ask questions, challenge decisions and communicate with management

in an open and direct fashion. It was a group of individuals who committed the

fraud and engaged in criminal activities at HealthSouth—and without an employee

stepping forward in this case, we still might not know the depths of a fraud that

was perpetrated against the Company and its stakeholders.

Let me end by saying that the Board and management team are committed to

taking the necessary actions to ensure that we reach the goal of restoring the longterm health and viability of HealthSouth, and we are committed to assisting this

Subcommittee in its work.

45

Mr. Chairman, I appreciate this opportunity and will, to the best of my ability,

be glad to answer questions you or any other members of the Subcommittee may

have.

Mr. GREENWOOD. The Chair recognizes himself for 10 minutes.

And, Mr. Gordon, I would like to pose some questions to you, if

I might.

If you would turn to Tab 6 in your binder. Okay. See that document there? And there are handwritten notes. Those handwritten

notes, is that in your writing?

Mr. GORDON. Yes it is.

Mr. GREENWOOD. Okay. And identify what the document is,

please.

Mr. GORDON. It’s the Board minutes of August 7, 2002.

Mr. GREENWOOD. Okay. Turn to page 3 of that document. Is that

your handwriting there?

Mr. GORDON. Yes, it is.

Mr. GREENWOOD. Okay. Can you say what that says? Read what

that says, next to where ‘‘The Chairman’s review.’’

Mr. GORDON. Okay. What it says, we were discussing a presentation made by the bankers in regard to spinoff for other things.

And I commented that I thought the presentation was very poorly

devised and not achievable.

Mr. GREENWOOD. Now, did you comment that that reflects what

you said outside or does that reflect your thoughts at the time?

Mr. GORDON. No, that reflects my thoughts when the minutes

came in, and I put this on and sent it back to the secretary—for

his consideration to be included in the minutes.

Mr. GREENWOOD. Okay. And when did you get these minutes?

Mr. GORDON. I cannot give you the exact dates. Basically we

had—minutes came very slowly. I have in my records where I had

a waiver of notice of 13 minutes that came—that covered the period from February—probably from November 2002 through March

2003 that I received in probably February to sign a waiver of notice

of minutes, and I never signed that and returned it.

Mr. GREENWOOD. Okay. When you wrote ‘‘presentation was poorly designed and not achievable,’’ what were you referring to who

made this presentation to the Board?

Mr. GORDON. Well, this was a presentation made by Mr.

McGahan, and I guess the presentation was that the surgery center division was worth eleven times—and from my experience in

the industry, I just did not think that was an achievable number.

I thought something more like seven times would be something

would be a market that would be received.

Mr. GREENWOOD. All right. And did you say at that time, at the

time of the presentation?

Mr. GORDON. I said that at the time of the meeting. The time of

the Board meeting.

Mr. GREENWOOD. Was Mr. Scrushy there at that time?

Mr. GORDON. Yes.

Mr. GREENWOOD. And how did he react? Did he react to your

comment?

Mr. GORDON. He reacted that the bankers had thought they had

sources that would pay that much to buy the surgery center operation.

46

Mr. GREENWOOD. Is that the same meeting where Mr. Scrushy

told the Board that there was a Medicare transmittal regarding out

patient group therapy?

Mr. GORDON. Yes.

Mr. GREENWOOD. Okay. What did Mr. Scrushy say about the impact of the transmittal at the time?

Mr. GORDON. I think that presentation was made by Mr. Owens,

and he said that it would effect the company somewheres between

$15 and $20 million.

Mr. GREENWOOD. He thought that would be the impact of the

Medicare, the transmittal?

Mr. GORDON. Yes.

Mr. GREENWOOD. Okay. Did you have concerns about the fact

that a few days earlier Mr. Scrushy had announced excellent earnings for the company?

Mr. GORDON. Yes.

Mr. GREENWOOD. Okay. Can you explain those concerns?

Mr. GORDON. Well, I was concerned that we had reported on August 6 that our earnings were within line and we expected to

achieve the goal for 2002, and then we came out on August 8 and

said we had this problem and that we would not make those earnings. And I was concerned about dissemination of information. I did

not know if that was accurate.

Mr. GREENWOOD. Okay. And turn to Tab 7 on page 3, if you

would. Do you see that?

Mr. GORDON. See what?

Mr. GREENWOOD. These are Board minutes from the August 26,

2002 meeting.

Mr. GORDON. Yes.

Mr. GREENWOOD. Okay. Do you recall attending that meeting?

Mr. GORDON. Yes.

Mr. GREENWOOD. Okay. And during that meeting did Mr.

Scrushy ask the Board to ratify a spinoff of the surgery division?

Mr. GORDON. That was—yes.

Mr. GREENWOOD. And did you agree with——

Mr. GORDON. A spinoff or a sale. At that time, I guess it was a

spinoff.

Mr. GREENWOOD. I beg your pardon?

Mr. GORDON. I did agree at that time, yes, at the right price if

we could do it.

Mr. GREENWOOD. Okay. So you agreed with the proposal?

Mr. GORDON. Yes.

Mr. GREENWOOD. Okay. Did you vote for the spinoff?

Mr. GORDON. I believe I did not vote against it. I think I just

choose to abstain.

Mr. GREENWOOD. You abstained?

Mr. GORDON. Yes.

Mr. GREENWOOD. And why did you abstain?

Mr. GORDON. I was not exactly confident that this was the right

thing to do for the company or for the stakeholders.

Mr. GREENWOOD. Did you not just say you thought it was a good

idea at the time?

Mr. GORDON. Well, I think basically if we could accomplish it

eleven times, it was. I did not feel confident we could do that.

47

Mr. GREENWOOD. And did you say that?

Mr. GORDON. Yes.

Mr. GREENWOOD. So you said I do not think we are going to be

able to make the profit out of this that you have presented here.

Was there discussion about that?

Mr. GORDON. I do not think I did not say there would not be a

profit. I said we could not achieve——

Mr. GREENWOOD. The level?

Mr. GORDON. [continuing] the level of sale price that we expected.

Mr. GREENWOOD. Okay. All right.

And was there discussion? I mean, was this not the division that

you brought in, was this not——

Mr. GORDON. I think there was discussion, but it was very confidently expressed that this was achievable.

Mr. GREENWOOD. Okay. And so you abstained?

Mr. GORDON. Yes.

Mr. GREENWOOD. Now, is it accurately reflected in the minutes

that ‘‘no votes were cast against the motion?’’

Mr. GORDON. I do not recall that, and I do recall not being in

favor of it. But I do not know if it’s—you know, it is—if I recall

I abstained.

Mr. GREENWOOD. Okay.

Mr. GORDON. Now I did not vote against it.

Mr. GREENWOOD. Okay. So then the minutes would reflect that

there were no votes cast against it?

Mr. GORDON. That is right, I did not vote against it.

Mr. GREENWOOD. Just your abstention?

Is that the way you would have wanted the minutes to reflect

your opposition?

Mr. GORDON. When I—again, I would not have wanted them to

be that way, but that is the way they turned out. And I think later

I did suggest if that was accurate, and I was told they were accurate. And that was the way we reflected.

Mr. GREENWOOD. What was your reaction to Mr. Scrushy an- nouncement of the $175 million impact on the company?

Mr. GORDON. To me it was shock. I was just shocked to how it

could have been one number so—in early August and be such——

Mr. GREENWOOD. $15 or $20 million you were told initially?

Mr. GORDON. Yes.

Mr. GREENWOOD. Okay. And then Mr. Scrushy said actually it is

$175 million, not $15 or $20 million?

Mr. GORDON. I think Mr. Owens probably made that—made that

report.

Mr. GREENWOOD. Were you suspicious?

Mr. GORDON. I wondered why such a large change in such a

short amount of time, why it was.

Mr. GREENWOOD. Did you wonder that out loud?

Mr. GORDON. I do not recall saying that out loud at that time.

Mr. GREENWOOD. Why would you not? I mean, you are a member

of the Board of Directors, you are sitting there, you are shocked.

You said you are shocked, you are amazed that a number that was

originally presented at $15 to $20 million had——

Mr. GORDON. I requested——

48

Mr. GREENWOOD. [continuing] quickly grown to $175 million. You

are an important member of the Board of Directors you are

shocked, you yet kept silent?

Mr. GORDON. I requested further information where I could

search for myself what the consequence was. At the time I was not

totally familiar with 1753. I wanted to read that and see what the

consequences. I thought——

Mr. GREENWOOD. At that Board meeting at that moment you

said I would like some more information on this, or was that——

Mr. GORDON. I think privately I told some officers that I would

like to have a copy of it 1753 and see if could see——

Mr. GREENWOOD. Okay. Would you turn to Tab 8, please.

Mr. GORDON. Sir?

Mr. GREENWOOD. Tab 8 in your book. Do you see that document

there?

Mr. GORDON. Yes. Yes.

Mr. GREENWOOD. Would you identify that document?

Mr. GORDON. This is a letter on August 30 that I wrote to Richard Scrushy.

Mr. GREENWOOD. Okay. And why did you write this letter?

Mr. GORDON. Why? I was concerned that I did not have enough

information about what was taking place in regard to this spinoff

or sale of the facilities, what was taking place generally in regard

to the future of the company and I was writing for more information for my consideration.

Mr. GREENWOOD. You said in this letter, you said ‘‘Based on the

information provided by UBS Warburg, I remain unconvinced that

this is the best route to maximize shareholder value, as you no

doubt surmised from my comments during the Board meeting and

my abstention vote with regard to this matter on the August 26,

2002 Board of Directors meeting.

Mr. GORDON. Right.

Mr. GREENWOOD. So you were unconvinced on August 30.

Did Mr. Scrushy ever respond to this letter and, in fact, give you

the information that you wanted?

Mr. GORDON. No.

Mr. GREENWOOD. Did you continue to register opposition to the

spinoff?

Mr. GORDON. I continued to—yes. I continued to write him about

further information that I required, and I never received anything

I asked for.

Mr. GREENWOOD. Were any other Board members aware of your

concerns? Did you share your concerns with other Board members?

Mr. GORDON. I do not believe I did at this time. I did in a later

correspondence.

Mr. GREENWOOD. Okay. What did you make of the fact that you

wrote this? You had enough concern to write this letter and you

never got a response to it?

Mr. GORDON. Well, starting about this time, Mr. Scrushy and I

had many differences. We have had differences from day one that

I had been on the Board. Those differences got more and more evident as time went on.

Mr. GREENWOOD. In the indictment that was issued yesterday,

there was talk of intimidation used by Mr. Scrushy. As you and

49

Mr. Scrushy had this apparent falling out and you had lots of difference of opinions, can you characterize the way he treated you?

Was he abusive toward you?

Mr. GORDON. Well, he never intimidated me, because I am the

type of fellow that someone such as him would not intimidate.

And many times he dressed me down that I was not one to grow

the company, I did not hear what he had to say; when I asked

questions, I got that thing. But it never intimidated me.

Mr. GREENWOOD. Did he do that in front of others?

Mr. GORDON. Yes.

Mr. GREENWOOD. Okay. Did Mr. Scrushy ever say to you that he

wanted to remove certain members from the Board?

Mr. GORDON. Yes.

Mr. GREENWOOD. And who were those Board members and what

were the circumstances?

Mr. GORDON. Well, I had a private meeting with him in February

2003. And——

Mr. GREENWOOD. How did that come to be? Why was that? Was

that at your request or his?

Mr. GORDON. I had been corresponding him with on a regular

basis and he could tell that my correspondence was, I guess, getting more and more concerned. And he called and asked me would

I come down and visit him. At the time, I said I will wait until the

next Board meeting. And then he called back, his secretary called

and said he would sure like to visit with you. And I asked, I said

well I will try to work it into my schedule.

And so I went down and visited with him.

Mr. GREENWOOD. Where was this meeting?

Mr. GORDON. In Birmingham at the corporate office.

Mr. GREENWOOD. At the corporate office. Okay.

Mr. GORDON. And at the time he proposed to me that there may

be some people did not want me on the Board, but he would like

to have me on the Board under one condition, and if I would vote

against Bob May, he would support me. My response was ‘‘Richard,

I do not play games like that.’’

Mr. GREENWOOD. Okay.

Mr. GORDON. And I did not have any——

Mr. GREENWOOD. My time has expired.

A final question for me. As we now know from the criminal in- dictment, this $175 million impact was a sham designed by

Scrushy to hide the fraud. Did you have any suspicions about that?

During the fall of 2002 did you think it was more than just an

overly optimistic expectation, or rather, excuse me. Did you think

it was more than just bad corporate news, but in fact might have

been a scheme or a sham to hide other dealings?

Mr. GORDON. I did not have—at that time, I did not have any

idea that it was a sham. You know, as the things turned out, I see

that it probably was. But at that time I had no thought of that.

Mr. GREENWOOD. The gentlelady from Colorado is recognized for

10 minutes.

Ms. DEGETTE. Thank you, Mr. Chairman.

Mr. Gordon, did you ever see Mr. Scrushy attempt to intimidate

others the way you just described to the Chairman he was trying

to intimidate you?

50

Mr. GORDON. I do not think I did, no.

Ms. DEGETTE. Now, when the allegations of insider trading and

other allegations of misconduct came to your attention in the summer of 2002, you decided that an independent counsel should be

hired by the compliance committee, right?

Mr. GORDON. As Chairman of the compliance committee, I decided that was my responsibility.

Ms. DEGETTE. And you decided to hire them, right?

Mr. GORDON. Yes.

Ms. DEGETTE. And why did you do that?

Mr. GORDON. I read the charter of the compliance committee and

in that it said the responsibility of the Chairman of the compliance

committee and the compliance committee was to point out——

Ms. DEGETTE. And there were allegations made, and so you decided to hire an independent counsel?

Mr. GORDON. There were allegations made and it was our responsibility to hire an independent outside counsel to do that.

Ms. DEGETTE. I know.

Mr. GORDON. At the compliance committee’s direction and at corporate expense.

Ms. DEGETTE. Now you told our sommittee staff yesterday that

you had raised the concerns that you had about the large one-time

charges that HealthSouth seemed to take every year. And I think

as it was relayed to me, you said this did not seem to be a good

way to do business.

Did you bring those concerns to Mr. Scrushy?

Mr. GORDON. I brought to him that I was concerned that we took

large write-offs on a frequent basis, and that was recognized because I had never been a member of the audit committee. I was

invited in the audit committee in 2002 because he said you are always interested in write-offs. Why do you not come to the committee and see what is going on.

Ms. DEGETTE. So how long had you been bringing this issue of

the write-offs to Mr. Scrushy, how many years?

Mr. GORDON. I cannot tell you how many. I know on numerous

occasions I said why do we have to take write-offs.

Ms. DEGETTE. Well, was it like 2002?

Mr. GORDON. Probably 2001 and 2002.

Ms. DEGETTE. Thank you.

And what did Mr. Scrushy say when you brought these concerns

to him?

Mr. GORDON. That we had facilities that were closed, no locations

that were no longer productive. They had to write those off and

they had substantial goodwill that had to be written off.

Ms. DEGETTE. Did you go to the audit committee or to your external auditors and ask them to look further into these write-off?

Mr. GORDON. I did—on my own, I did not go.

Ms. DEGETTE. Why not?

Mr. GORDON. I was assured that this was in the normal course

of business of——

Ms. DEGETTE. Who assured you of that?

Mr. GORDON. Mr. Scrushy.

51

Ms. DEGETTE. Now, do you know from your experience whether

the audit committee had any better understanding than you do

about why these write-offs occurred?

Mr. GORDON. I do not.

Ms. DEGETTE. Now, Mr. Gordon, you were also the first Board

member to suggest that the Board get an inside counsel to investigate the various allegations against Mr. Scrushy. Fulbright & Jaworski was hired on September 17. And on September 18 there was

an unrecorded telephonic meeting in which the Board hired Fulbright as its SEC defense counsel instead of any independent counsel. Did you participate in that telephone call?

Mr. GORDON. I participated in that meeting. I do not believe it

was telephonic. The decision was made at an in-person meeting.

Ms. DEGETTE. There was an in-person meeting. When was that,

do you remember?

Mr. GORDON. I believe September 17.

Ms. DEGETTE. Okay. And why did you go along with this decision

about Fulbright if you were the one that suggested the

independent——

Mr. GORDON. Well, I had suggested Wilmer Cutler, and I had

talked to them about accepting the commission as independent

counsel. I reported——

Ms. DEGETTE. But Fulbright & Jaworski was hired?

Mr. GORDON. That is right.

Ms. DEGETTE. Not Wilmer Cutler, right?

Mr. GORDON. At that meeting the name Fulbright & Jaworski

came up.

Ms. DEGETTE. Yes.

Mr. GORDON. And I responded, I know the firm, they have done

work for me in the past and I have high regard for them. I have

no problem with them representing.

Ms. DEGETTE. So why did you then go along with them hiring

Fulbright as the SEC counsel, defense counsel instead of independent counsel?

Mr. GORDON. Why did I go along?

Ms. DEGETTE. Do you understand the difference? I assume you

do?

Mr. GORDON. Yes, I do.

Ms. DEGETTE. So why did you go along with that?

Mr. GORDON. Well, what I understood and I registered it in several later afterwards, I thought the compliance department had

been taken out of the decisionmaking process. And if you go to further letters, I expressed that very strongly in a number of letters

to Mr. Scrushy and others about my concern about how the counsel, independent counsel was selected.

Ms. DEGETTE. Okay. So now, but see, that is the problem exactly. They are no longer independent now, right?

Mr. GORDON. I had concerns about that.

Ms. DEGETTE. Well, so what happened with those concerns? Did

anybody get back to you about that?

Mr. GORDON. I wrote several letters.

Ms. DEGETTE. And did you hear back?

Mr. GORDON. I finally got a response from Lanny Davis, I believe.

52

Ms. DEGETTE. And what did Mr. Davis say?

Mr. GORDON. Well, I had written I wanted copies of the investigation, I wanted copies of the engagement letter and so forth. And

he suggested they would be forthcoming.

Ms. DEGETTE. And were they?

Mr. GORDON. No.

Ms. DEGETTE. You never heard a thing?

Mr. GORDON. No.

Ms. DEGETTE. Okay. Now, I want to ask Ms. Givens a couple of

questions. You were on the audit committee, I think from its inception right?

Ms. GIVENS. No, I was on the audit committee since 1989.

Ms. DEGETTE. I’m sorry. You have been on the audit almost 15

years then, right?

Ms. GIVENS. Since 1989 until the present.

Ms. DEGETTE. Okay. Now, we have received testimony of two internal auditors that the committee rarely met with them and it

was often in the presence of the full Board. We heard about this

at our last hearing where they would say now we are having an

audit committee meeting in the middle of the Board meeting.

The current internal auditor did not meet with your committee

for a stretch of 17 months. Do you think that is vigilance on the

part of the audit committee?

Ms. GIVENS. Well, I would not characterize the facts the way you

have. We as an audit committee met with the internal auditors on

regular basis. And, indeed, we thought that it was so important

that we included them in the full Board meeting——

Ms. DEGETTE. Did you meet with them separate from the Board

meetings?

Ms. GIVENS. Yes.

Ms. DEGETTE. And how often?

Ms. GIVENS. It depended on the year. But often——

Ms. DEGETTE. Okay. In 2000, how often did the audit committee

meet separately with the external auditors?

Ms. GIVENS. With the external auditors?

Ms. DEGETTE. I’m sorry, with the internal auditors.

Ms. GIVENS. Well, generally we met with the internal auditors on

about the same frequency as we met with the external auditors.

Ms. DEGETTE. Okay. So how many was that in 2000?

Ms. GIVENS. In 2000, it was—I do not know the exactly number,

but I would say 3 or 4 times.

Ms. DEGETTE. Separate from the Board meetings?

Ms. GIVENS. Sometimes—generally the way that we worked it

was that we had committee meetings prior to the Board meetings.

And then the audit committee along with the external auditors

would join the full Board.

Ms. DEGETTE. Would there be separate minutes then of the audit

committee meeting that was before the Board meeting if that had

in fact occurred?

Ms. GIVENS. There generally were.

Ms. DEGETTE. Okay. Yes, I mean we have had people come in

and say that most of the time the audit committee met during the

Board meeting. They would be lying if they said that? What your

testimony is——

53

Ms. GIVENS. Again, I cannot——

Ms. DEGETTE. By the way, you are under oath. Is that you generally had separate audit committee meetings either right before

the Board meeting or at different times, is that right?

Ms. GIVENS. If I can—if I can clarify for you.

Ms. DEGETTE. Sure.

Ms. GIVENS. I would appreciate it.

We regularly had audit committee meetings that were separate

from the Board. In addition to that, the auditors as well as the

audit committee would join the full Board to give a presentation.

So that we would preclude the full Board from having to listen to

all of the details that we needed to get into, but a general presentation would be made subsequently to the full Board.

Ms. DEGETTE. Okay. If you will take a look at Tab 31, the second

page of that. That is the proxy statement. And what it says as a

final second to last paragraph is ‘‘The audit committee met separately from the Board once in 2001.’’ Would that be your recollection?

It is the very bottom of the page. The third full paragraph on the

page.

Ms. GIVENS. Yes. I assumed that you are referring to I think

what I have tried to correct a couple of times before. The proxy reflected that the audit committee met only once during 2001. That

is not correct.

Ms. DEGETTE. So this is wrong?

Ms. GIVENS. This is incorrect, that is right.

Ms. DEGETTE. How often did the audit committee meet in 2001

separate from the Board?

Ms. GIVENS. In 2001 the audit committee met, to the best of our

ability in going—in going over calendars, etcetera, we met three

times in person and there was an additional three times that the

Chairman of the audit committee met with the auditors to go over

quarterlies.

Ms. DEGETTE. And were there minutes kept at these meetings?

Ms. GIVENS. Apparently there was minutes kept of only one

meeting, and that was why it was reflected that way.

Ms. DEGETTE. Whose job was it to keep the minutes of the audit

committee meetings?

Ms. GIVENS. Generally we had a secretary there to keep minutes.

Ms. DEGETTE. And at the three meetings that you had in-person

meetings and additional telephonic meetings, was there a secretary

there?

Ms. GIVENS. There should have been. Someone named Brad Hale

generally took the minutes.

Ms. DEGETTE. Do you recall Brad Hale being there?

Ms. GIVENS. I recall Brad Hale being in the vast majority of committee meetings I have been in. But I cannot tell you——

Ms. DEGETTE. Now, as a member of the audit committee, were

you circulated drafts of the minutes when you met?

Ms. GIVENS. If you could just me finish my——

Ms. DEGETTE. I’m sorry.

Ms. GIVENS. [continuing] answers, it would be very helpful. Because I—please——

Ms. DEGETTE. Go for it.

54

Ms. GIVENS. The full answer to the last question was that I could

not tell you exactly which meetings Mr. Hale was in. But he generally took notes and minutes at most of the Board meetings and

the committee meetings.

Ms. DEGETTE. So as a member of the audit committee were you

circulated minutes of the audit committee meetings which you had

attended either in person or telephonically to review?

Ms. GIVENS. Generally, that would have been the Chairman of

the audit committee would have reviewed them.

Ms. DEGETTE. You were not the Chairman of the audit committee?

Ms. GIVENS. That is correct.

Ms. DEGETTE. So your view is you never saw—you would not

have seen the audit committee——

Ms. GIVENS. I saw some of them, but it was the responsibility of

the audit committee Chairman.

Ms. DEGETTE. Okay. Mr. Chairman, my time has expired.

Mr. GREENWOOD. The gentleman from Florida, Mr. Stearns.

Mr. STEARNS. Thank you, Mr. Chairman. And I appreciate the

gentleman letting me go forward. I have to go to luncheon, so I will

just get my questions in.

I am not going to go into it, but I have a quick questions. This

Mike Vines memo, which is Tab 78, it was in the summer of 2002.

Let me ask staff, was this addressed to the Board of Directors or

was this addressed to the—okay. So this went to Ernst & Young.

But did you folks know about Mike Vines? He said I know that

HealthSouth based out of Birmingham, Alabama has severe problems in the accounting department. So this was sort of a whistleblower, a former employee and he sent this to Ernst & Young. Was

this ever brought to your attention.

Mr. May, I do not think you were on the Board. Were you on the

Board?

Mr. MAY. No, I was not.

Mr. STEARNS. Okay. Let me just go right on down, just yes or

know, did you know about Mike Vines’ memo talking about the severe problems in accounting at HealthSouth?

Mr. STRIPLIN. No, I did not.

Mr. STEARNS. Did not.

Mr. Watkins?

Mr. WATKINS. No, I did not.

Mr. STEARNS. Ms. Givens?

Ms. GIVENS. No, I did not.

Mr. STEARNS. Okay.

Mr. Gordon?

Mr. GORDON. No, I did not.

Mr. STEARNS. Okay.

Now, Ms. Givens, you are a audit committee member, Board of

Directors, so I guess you are in charge of the audit committee. Did

you ever hear anything about this ‘‘fleeced shareholder’’ letter that

was sent in November 12, 1998?

Ms. GIVENS. I was not made aware of it until recently.

Mr. STEARNS. Just recently? So recently being when?

Ms. GIVENS. The last 2 or 3 months.

55

Mr. STEARNS. Last 2 or 3 months? So that is 5 years ago the

memo was saying there is severe problems at HealthSouth, it was

addressed to the company as well as Ernst & Young and you were

never told of it.

Anyone else on the Board? Mr. Gordon, were you told about it?

Mr. GORDON. No.

Mr. STEARNS. Mr. Watkins?

Mr. STRIPLIN. What’s the date of the memo?

Mr. STEARNS. The memo is November 12, 1998.

Mr. STRIPLIN. Well, I was—I got on the——

Mr. STEARNS. Could you bring the mike just a little closer to you?

Mr. STRIPLIN. I got on the Board in April 1999, but——

Mr. STEARNS. So you would not know.

Mr. STRIPLIN. But I would not know.

Mr. STEARNS. But even so, there was no rumor, no one ever told

you about this memo——

Mr. STRIPLIN. No.

Mr. STEARNS. [continuing] describing all the problems at the corporation?

Mr. STRIPLIN. No.

Mr. STEARNS. Okay.

Let me ask you then about this pristine audits that Mr. Scrushy

did. He asked Ernst & Young to go in and to see if the magazine

racks were arranged and whether the toilets were clean and to do

a complete audit of the facilities in terms of cleanliness, which

seems a little bit unusual for an accounting firm, a large accounting firm like Ernst & Young to be doing that. Did all of you know

about the pristine audits?

I mean, Mr. Gordon, did you know about it?

Mr. GORDON. Yes.

Mr. STEARNS. Ms. Givens?

Ms. GIVENS. Yes, I did.

Mr. MAY. Yes.

Mr. STEARNS. And did you know that Mr. Ernst & Young was

charging more for the pristine audits, at least it looks like from the

audit piece proxy disclosure, they were charging more for those audits than they were for the actual audit of the books of the company?

Mr. GORDON. No.

Mr. STEARNS. Okay. We have here a 2000 a charge to audit fees

were about a million dollars and then 2001 it was a $1.1 million.

The pristine audit fees, this is to check the laboratories, the toilets,

the magazine racks, the bowls in the men’s room, that was

$1,250,000 in 2000. And in 2001 it was $1,332,000. So you can see

by hundreds of thousands of dollars Ernst & Young was charging

more to check the magazine racks and the toilets than they were

to do the audit.

Let me just go from left to right. Mr. Gordon, did you know about

this?

Mr. GORDON. I saw it. I did not know about the total charges

until I saw the annual report information. I knew that we were

doing a pristine audit——

Mr. STEARNS. But you did not know what the figures were?

Mr. GORDON. I did not know what the figures were.

56

Mr. STEARNS. Okay. And Ms. Givens, you were now the audit

committee Chairman, did you—you were a member, and I guess

your designation is audit committee member.

Ms. GIVENS. That is correct.

Mr. STEARNS. Did you know about these figures that they were

charging more for the pristine audits than actual audit of the

books?

Ms. GIVENS. I did not really compare the two, but I was ware

that we were paying a significant amount to oversee those facilities, yes.

Mr. STEARNS. I mean, we are going to ask Ernst & Young if they

have an overseas international division doing pristine audits, but

I do not think they do. This is probably one of the few they ever

did. Did you find that a little unusual to have an audit firm who

was doing your book to do the same thing to check all the facilities

like this?

Ms. GIVENS. Well, I think that it would make sense for me to explain to you why we thought that the pristine audit was so important. This is a national health service company——

Mr. STEARNS. No, I understand. I can understand why it is important. But for your audit of people who are auditing your books

to be doing it, it seems like it should be an outside maintenance

company or——

Ms. GIVENS. It is the same firm, but it is not the same people.

Mr. STEARNS. Okay.

Ms. GIVENS. And Ernst & Young——

Mr. STEARNS. But it all goes to the same company?

Ms. GIVENS. Yes.

Mr. STEARNS. Okay. But I mean, you are trying to justify—are

you saying today that it is acceptable for Ernst & Young to do the

pristine audits and to do the audit of the company? You see no

problem with that? Just yes or no.

Ms. GIVENS. Well, I would prefer not to answer just yes or no.

Mr. STEARNS. Well, it is pretty simple. The question is Ernst &

Young is doing pristine audits, which is basically hotel/motel inspection of facilities at the same time you are doing the books. Do

you think that is a conflict of interest? Just yes or no. You just say

no or yes.

Ms. GIVENS. I think that different people were performing a task

and in their respective areas——

Mr. STEARNS. Mr. Chairman, can I get a yes or no to this question?

I mean, it is just a reasonable yes or no. Was there a conflict of

interest in your mind for them to be doing it?

Ms. GIVENS. No, there was not.

Mr. STEARNS. Okay. That is fine. Listen, this is all hindsight. I

mean, I am asking you—I mean, I do not know anyone of us had

to do your job, I am not sure how we would do it. So we are very

empathetic here and we are just trying to understand it.

Let me ask Mr. Watkins, did you know about the pristine audits?

Mr. WATKINS. Yes, I was aware of it. I was not aware the actual

amount split out for that portion versus the total fees that we paid

Ernst & Young until——

57

Mr. STEARNS. And you had no idea that you folks were paying

them more to check the maintenance then you were to do the

books?

Mr. WATKINS. My recollection is that I did not.

Mr. STEARNS. Okay. And Mr. Striplin, did you?

Mr. STRIPLIN. Yes. I was aware of the pristine audits, but I did

not—I was not aware of the fact that it was that much. Had no

breakout.

Mr. STEARNS. And Mr. May, did you know?

Mr. MAY. These charges were before I came on board.

Mr. STEARNS. Okay. Now, Ms. Givens, the way they show it in

the books here, it says audit related fees. I mean, do you think it

is appropriate if you are doing maintenance checking of cleanliness

that they would throw this into audit related fees?

Ms. GIVENS. This is a question that the Chairman and I both had

and asked of E&Y, because we thought that it was a little bit odd

as well. But we were reassured by E&Y that it was an

appropriate——

Mr. STEARNS. Okay. In retrospect, in hindsight what do you say

today? Do you think they should have had that type of service

thrown into audit related fees? Because I do not find—I mean audit

implies the books and there are other terms they use in the military, in the hotel business, in various businesses when you actually

inspect a facility for cleanliness. But in retrospect do you think

they should have included it as audit expenses?

Ms. GIVENS. That is something you will have to ask E&Y. I was

relying on their expertise to categorize it properly.

Mr. STEARNS. Do you know if the company is still spending

money on pristine audits?

Ms. GIVENS. I believe that we have discontinued the pristine audits.

Mr. STEARNS. And why did you discontinue?

Ms. GIVENS. If you could address that to Bob May, I would appreciate it.

Mr. STEARNS. Okay. Mr. May? And when did you stop the pristine audits?

Mr. MAY. Well, the pristine audits essentially have not been conducted to any large degree during 1930. The checklist for the operational audit still is up on our website. Our local operations are

doing self audits at the time being.

Mr. STEARNS. Okay. Do you think that calling it audit related,

Mr. May, is false and misleading?

Mr. MAY. Actually, I do not. During my tenure at Federal Express we had similar audits that we would call operational audits.

And I think it is just a matter of semantics.

Mr. STEARNS. Was it done by your accounting firm?

Mr. MAY. Generally it was done by an internal audit group within the company.

Mr. STEARNS. That is right. But it was not done by the accounting firm who were auditing your books?

Mr. MAY. Not that I recall, no.

Mr. STEARNS. Yes. I just have about 30 seconds left. And I just

wanted to ask Mr. Striplin just a question about Scrushy’s salary.

I just got to get this in.

58

In 2001 and 2002 did the compensation committee approve the

bonuses for Mr. Scrushy of $16.5 million?

Mr. STRIPLIN. As I recall, we did.

Mr. STEARNS. Yes, you did. And do you recall how the compensation committee determined that?

Mr. STRIPLIN. Well, obviously, it would not have been what it

was if we had known that it had fraud in it. But——

Mr. STEARNS. Well, it turns out that in September 2, 2002,

HealthSouth shareholders lost over 50 percent of the value of their

stock in a matter of days. And the compensation committee approved continuing Mr. Scrushy’s salary at $1.2 million. And, you

know, I guess the question is as your role as the compensation

committee person on the Board, it seems like at some point when

shareholders are losing 50 percent of their value, you might start

looking at the salary of the CEO, just a——

Mr. MAY. Well, I do not recall the timing on that.

Mr. STEARNS. Yes.

Mr. MAY. But we always got mostly involved in the—in relationship to salaries and bonuses.

Mr. STEARNS. All right.

Thank you, Mr. Chairman.

Mr. GREENWOOD. The Chair thanks the gentleman.

And recognizes the gentleman from Oregon, Mr. Walden for 10

minutes.

Mr. WALDEN. Thank you, Mr. Chairman.

I was just reading through the HealthSouth operational division

1998/99 pristine audit checklist. It is sort of a sad irony. It is a

good thing to check, but number 34 was 3 people or less have a key

to the cashbox or the safe combination, list names and titles. And

I just find it ironic when the company’s being in effect raided by

allegedly the CEO and others that we got to check for a cashbox

key. It is important to do, I realize, but it is still interesting.

And I do not have an objection, certainly to doing pristine audit.

I mean, I was on a hospital board. We did quality control as well.

We did these sorts of surveys. But we did them internally, as Mr.

May, I think you have suggested is being done today. And I do

think they are important because image is important, cleanliness

is important; all of that. So I do not have a problem with that.

My question, though, Mr. May—well, you came on later so maybe

Mr. Gordon or Ms. Givens, is how this contract—the question that

gets raised is how did this contract get let? And was it sole sourced.

Did you put it out for bid? Is it something Mr. Scrushy sort of negotiated with Ernst & Young on the side? Do you recall why Ernst

& Young—I think the question we are all trying to get at is why

Ernst & Young, not why a pristine audit.

Ms. GIVENS. A good question, and I do not know the answer to

that.

Mr. WALDEN. A lot of money.

You do not know the answer to that?

Ms. GIVENS. I do not know the answer.

Mr. WALDEN. Does anybody know the answer to that? Yes, Mr.

Watkins—Dr. Watkins?

59

Mr. WATKINS. One thing I recall is this was presented to the

Board as a good thing to do for patient safety, cleanliness, etcetera,

was——

Mr. WALDEN. Sure.

Mr. WATKINS. [continuing] that the idea behind using Ernst &

Young was they had people in these areas, it would be less expensive we were told to have them because they would not have to

travel from an airplane from corporate headquarters to inspect

these in 50 States. So theoretically it would have been cheaper. As

it turns out, it was not cheaper.

Mr. WALDEN. It was not true, right? And was there not some—

do I not recall reading something that the internal auditor or someone said it could be done a lot cheaper internally? Teresa Sanders,

I believe said that. It is easier for us, obviously, looking back now

that all the documents are here. But——

Mr. WATKINS. I do not recall specifically, but our internal audit

people when they did their field audits did not inspect every facilities, whereas with the pristine audit, I think we tried to get a larger number of audits done and had a larger field force by using

Ernst & Young.

Mr. WALDEN. Are you aware of any other firms that do this kind

of work, pristine audit type work?

Mr. WATKINS. I am not personally aware.

Mr. WALDEN. Yes. Okay. When was the pristine audit program

started? Do you remember, Dr. Watkins?

Mr. WATKINS. I don’t recall.

Mr. WALDEN. Okay. All right. I want to get into some other expenditures as well just briefly.

In the ‘‘Fortune’’ magazine story about HealthSouth that ran, I

do not know, I do not know if I have a date on it. June 23, 2003.

It talks about HealthSouth spending $13 million on two seasons of

a TV show in 2001 and how Mr. Scrushy recruited Jason Hervey

to become a HealthSouth executive, much to the shock of many in

the firm. Are you familiar with that expenditure, anybody on the

Board? Because this seems like a lot of money to go off into TV.

Mr. Gordon, do you remember that instance?

Mr. GORDON. Is the microphone on?

Mr. WALDEN. Yes, it is, sir.

Mr. GORDON. The thing I remember about that, he was promoting, and it did have some merit, about branding our company

and HealthSouth would be branded throughout the United States

and we have a sponsorship of TV shows. And that these could be

sold to cable channels and so forth. And he presented it as being

something that could be very profitable for the company. And that

was the basis. That it would build a brand name, it would build

a loyalty among teenagers, and so forth. And it could be sold and

be profitable to the corporation.

Mr. WALDEN. All right.

Let me move on to another issue, and I think this one is probably

one that concerns me as much as anything I have seen so far. This

is the so-called ‘‘fleeced shareholder.’’ I guess it is a fax. And it was

sent, it says regarding HealthSouth/Ernst & Young to list is all it

says. But it made its way into the company, is my understanding.

60

Are any of you familiar with this now or were you when it came

in?

Mr. WATKINS. I am not, not at the time.

Mr. WALDEN. Ms. Givens?

Ms. GIVENS. Not at the time.

Mr. WALDEN. And you two were not on the Board. All right.

Well, it is on Tab 72 of the book there if you want to take a look.

Because I think that gets to sort of a fundamental issue here as

well of what do you think happened to this memo? My understanding is it went to Mr. Strong, who chairs the audit committee.

And while you are reading it, maybe I could share with others.

It says ‘‘You bring the smoke, I will bring the mirrors. At least

the market has shown the wisdom to devalue HS stock. Wish I got

out in time. I have a list of questions which I hope might be of interest to you. How can the HS outpatient clinics treat patients

without precertification, book the revenue, carry it after being denied payment? How can the company carry tens of millions of dollars in accounts receivable that are well over 360 days? How can

some hospitals have no bad debt reserves? How did the E&Y auditors in Alabama miss this stuff? Are these clever tricks to pump

up the numbers or something that a novice accountant could

catch?’’ It goes on and on.

‘‘You people and I have been hoodwinked. This note is all that

I can do about it. You all can do much more. If you do is’’ I am

just quoting. ‘‘If all you do is look into to it to see if what I say

is true.’’ And then lists distribution various places.

Do you know if this got to Mr. Strong, Ms. Givens, since you are

on the audit committee? Do you know now since you did not know

then? Do you know if it eventually——

Mr. GIVENS. I believe that it went to Mr. Strong, yes.

Mr. WALDEN. Okay. And do you know what happened from there

on?

Ms. GIVENS. My understanding, and it is only secondhand.

Mr. WALDEN. Yes.

Ms. GIVENS. Is that Mr. Strong gave it to the auditors and that

there was a full investigation with the auditors and they decided

that it did not have any merit, and therefore they dismissed it and

it was not brought to the full audit committee’s attention.

Mr. WALDEN. Okay. And I guess that would be the next question.

Do you think as a member of that audit committee it should have

been brought to your attention?

Ms. GIVENS. It is hard for me to say in hindsight. I think that

Mr. Strong did the right thing in taking it to the auditors.

Mr. WALDEN. Right.

Ms. GIVENS. And I think it was a judgment call on his part.

Mr. WALDEN. You are still on the audit committee today?

Ms. GIVENS. Yes, I am.

Mr. WALDEN. If a letter like this came in today, what should

happen?

Ms. GIVENS. I think under the circumstances, we would pay very

close attention to a letter like this. But I would use my judgment

and may, indeed, give it to E&Y immediately as well.

Mr. WALDEN. But not—you would share it with the other members of the audit committee, though, would you not?

61

Ms. GIVENS. I think today I would, yes.

Mr. WALDEN. I would hope. I think as I have mentioned, I served

on a small bank committee and on the audit committee, and I

would be furious as a member of that audit committee if something

like that came in, even if it’s anonymous and not shared.

Ms. GIVENS. Well, I am—can I just say something to correct myself?

Mr. WALDEN. Yes.

Ms. GIVENS. I had not seen the Vines’ email or the ‘‘fleeced

shareholder’’ until recently, so I have gotten them confused. And

apparently the Vines’ email went to Mr. Strong, but the ‘‘fleeced

shareholder’’ letter never went to anybody on the Board or the

audit committee.

Mr. WALDEN. Oh, it did not?

Ms. GIVENS. So I misspoke.

Mr. WALDEN. All right. Then I may have misspoke, too. I was

under the impression that this did get into HealthSouth because

there is a memo from Mr. William T. Owens to Mr. William W.

Horton——

Ms. GIVENS. That would be our legal counsel.

Mr. WALDEN. Yes.

Ms. GIVENS. And our CFO, and they may indeed have received

it. But no one on the Board of the audit committee received it.

Mr. WALDEN. Okay. Because it says it is directed in your memo

dated November 11, ‘‘I have completed a detailed review of the

matters raised in the anonymous correspondence sent to Ernst &

Young. My findings are as follows,’’ and he goes through and details bad debt, accounts receivable over 360 days, outpatient centers, precertification.

Was Bill Owens a member of the Board?

Ms. GIVENS. He has been a member of the Board and I do know

during that period if he was a member of the Board.

Mr. WALDEN. Okay. Do you think then that this should have

been referred to the audit committee?

Ms. GIVENS. I would have hoped it would have been.

Mr. WALDEN. Okay.

Ms. GIVENS. I think someone on the audit committee should have

seen it, yes.

Mr. WALDEN. Yes. Let me go onto something different.

Are you familiar with the FTI work, the work done by——

Ms. GIVENS. Are you speaking to me?

Mr. WALDEN. Yes, or anybody, but I assume the work done by

FTI?

Ms. GIVENS. Yes, I am.

Mr. WALDEN. We were told that the FTI—actually, I am going

to Mr. May, I guess. And the issue is FTI. And the work that was

done by FTI, was that ever presented to the Board?

Mr. MAY. No, it was not.

Mr. WALDEN. Was the Board told that it would cost a million dollars to finish that work?

Mr. MAY. Yes. The Board was told that the current charges to

FTI were approximately $1.4 million, and it would be approximately another million dollars to complete the study.

62

Mr. WALDEN. And do you know who told you that and when you

were told that?

Mr. MAY. Richard told the Board that in a Board meeting. I am

not sure if the entire Board was assembled. I was there.

Mr. WALDEN. Do you know about when approximately, which

Board meeting that was?

Mr. MAY. My recollection would be sometime in November.

Mr. WALDEN. Of 2002?

Mr. MAY. 2002, yes.

Mr. WALDEN. 2002. It is interesting, because on Tuesday, November 12, 2002 Mr.—well, L. Davis at pattonboggs.com got an email

from Deborah Smith of fticonsulting.com that showed that the expenses were about $116,756 to finish that audit. Does that sound

like something you now know?

Mr. MAY. That was never communicated to the Board.

Mr. WALDEN. Even recently?

Mr. MAY. Even recently.

Mr. WALDEN. Turn to Tab 23, if you would, in the book, sir. Both

of these were sent, right?

I will give you a chance to look at that.

Mr. MAY. Yes, I have looked at it.

Mr. WALDEN. Well, I am trying to figure out how to ask this.

Why would Mr. Scrushy tell you it would be a million to finish at

approximately the same time that this memo was being sent to L.

Davis from Deborah Smith, FTI Consulting saying that $116,000 to

finish the work? And have you had a chance to look at FTI’s first

report now?

Mr. MAY. I saw a draft of it this week and looked at it just very

quickly.

Mr. WALDEN. Just this week?

Mr. MAY. Yes.

Mr. WALDEN. Wow.

Have any of you seen the FTI draft? Have you asked for it?

Ms. GIVENS. No.

Mr. STRIPLIN. No.

Mr. WALDEN. Okay. Nobody’s ask for it.

Did any of you ask why it was not finished, other the million—

Ms. Givens?

Ms. GIVENS. I was under the impression that FTI was finished,

that they had completed their work.

Mr. WALDEN. Who gave you that impression?

Ms. GIVENS. As I recall, we were told that at the Board by Mr.

Scrushy.

Mr. WALDEN. By Mr. Scrushy? Was Mr. Davis present at that

Board meeting?

Ms. GIVENS. I cannot recall.

Mr. WALDEN. Mr. May?

Mr. MAY. I do not recall, either.

Mr. WALDEN. Anyone?

Mr. STRIPLIN. No.

Mr. WALDEN. Would your minutes reflect that, who is in attendance at a Board meeting?

Mr. MAY. Minutes would, yes.

Mr. WALDEN. All right. We will check that.

63

Mr. Chairman, my time has expired.

Mr. GREENWOOD. The Chair thanks the gentleman.

And recognizes himself for 10 minutes for inquiry. And Mr. May,

I would like to ask a few questions of you, if I could.

Did the Chairman of the Board Richard Scrushy ever make derogatory remarks about Board members to other Board members?

Mr. MAY. Yes, he did.

Mr. GREENWOOD. Okay. Was that typical of him?

Mr. MAY. I would say that it was—yes, it was typical.

Mr. GREENWOOD. Okay.

Mr. MAY. It became typical.

Mr. GREENWOOD. Okay. Did any Board member ever indicate to

you that Mr. Scrushy had said negative things about you to them?

Mr. MAY. Other Board members said that he made negative comments about myself and John Hanson, certainly.

Mr. GREENWOOD. What kind of comments?

Mr. MAY. That he was not certain that we should remain on the

Board, those sorts of comments.

Mr. GREENWOOD. Did Ms. Givens ever relay information to you

about what Mr. Scrushy had told her about you?

Mr. MAY. Ms. Givens related to me that Richard Scrushy had informed here that Richard had had a private investigator investigate me, yes.

Mr. GREENWOOD. Okay. Ms. Givens, can you corroborate that,

did you in fact tell Mr. May that Mr. Scrushy had a private investigator looking into him?

Ms. GIVENS. Yes, I told the full Board that.

Mr. GREENWOOD. Okay. And how did you come to know that?

Ms. GIVENS. Mr. Scrushy shared that with me.

Mr. GREENWOOD. What is your understanding as to why he

would have done that?

Ms. GIVENS. My understanding was that he came upon some information which made him doubt his selection of Mr. May, and so

he further investigated it.

Mr. GREENWOOD. And who did he hire to do that?

Ms. GIVENS. I have no idea.

Mr. GREENWOOD. Do you know, Mr. May?

Mr. MAY. I do not.

Mr. GREENWOOD. Okay. Mr. May, have you seen invoices for payments for a private investigator by HealthSouth?

Mr. MAY. Yes, I have.

Mr. GREENWOOD. How many invoices have you seen?

Mr. MAY. Approximately 20, and just to be accurate, I have seen

the summary of those invoices, not the invoices themselves.

Mr. GREENWOOD. Okay. Did you ever ask HealthSouth’s head of

corporate security Jim Goodreau about whether an investigation of

you had occurred?

Mr. MAY. Yes, I did.

Mr. GREENWOOD. And what did he say?

Mr. MAY. He said I did not—we did not conduct an investigation

and we did not hire a private investigator to have you investigated.

And if we did, I would know about it.

Mr. GREENWOOD. And who would have had the authority to hire

such an investigator?

64

Mr. MAY. I cannot answer that question. I do not know who

would have the authority.

Mr. GREENWOOD. Okay. Ms. Given, when Mr. Scrushy told you

that there were some things about Mr. May might make him an

inappropriate Board members did he share with you what those

things were?

Ms. GIVENS. Yes, he did.

Mr. GREENWOOD. And can you share that with us, please?

Ms. GIVENS. Yes. He mentioned that he thought Mr. May was

using two different names and Social Security numbers, for what

purpose I do not know. He also indicated that he was associated

with numerous bankruptcies and with litigation with companies

with which he had been associated.

Mr. GREENWOOD. Mr. May, is that the case? Were you using two

different names and two different Social Security numbers?

Mr. MAY. No, sir.

Mr. GREENWOOD. Just Mr. May?

Mr. MAY. Just Mr. May.

Mr. GREENWOOD. Okay. Ms. Givens, I am interested to know how

you dealt with all of this. I mean, did you find it, as you said in

your opening, you had been involved in a lot of corporate matters

of corporations. Did you find it unusual that a CEO would come to

a Board member and say I am having another Board member investigated because I think he is using two Social Security numbers

as two separate identities?

Ms. GIVENS. Well, I think that it is more customary today than

in the past to ensure that your Board members are good upstanding citizens. And so if there were something that came to his attention that made him wonder about that, I could understand why he

might pursue it. However, I did ask—I did not repeat any of that

information to anyone, and I asked for the report so I could see it

myself.

Mr. GREENWOOD. And did you receive that report?

Ms. GIVENS. I have not.

Mr. GREENWOOD. And when did that happen? When did you have

that discussion with Mr. Scrushy?

Ms. GIVENS. To the best of my recollection, it was probably the

first quarter of 2003.

Mr. GREENWOOD. Okay. So, here we are in the last quarter of

2003 and you still do not know whether it was ever determined

that Mr. May had a secret identity.

Ms. GIVENS. No. I asked for that report of the general counsel

as well since Mr. Scrushy was removed. And I have encouraged Mr.

May to find that report as well.

Mr. GREENWOOD. And it has never been found. You have never

found the results of such report?

Ms. GIVENS. No. And I do know who conducted it.

Mr. GREENWOOD. You said you shared with the Board as a whole

that Mr. Scrushy had told you that Mr. May was under investigation?

Ms. GIVENS. On the day that—it was on the day or a couple of

days after we removed Mr. Scrushy, right after the fraud was uncovered. We had, as you can imagine, numerous Board meetings to

decide how to manage the company. And during the Board meeting

65

where we selected Mr. Gordon to be the acting Chairman, we

also—someone nominated Mr. May to be the acting CEO. And I

thought it was my duty to at least let the rest of the Board know

with Mr. May on the call that there were certain allegation to ensure that we were not putting in place someone else whose background might not be appropriate to serving the company. But I

gave Mr. May the opportunity to respond, and he did.

Mr. GREENWOOD. Mr. May, would you turn to Tab 66? You will

find there a memo that is to you and Mr. John Hanson from Fulbright & Jaworski, dated October 31, 2002. And there are photocopies attach that show shreds of documents. Do you see that?

Mr. MAY. Yes.

Mr. GREENWOOD. Okay. These were found on the fifth floor of the

executive tower. The first question I have for you, whose offices

were situated on the fifth floor of the executive office tower?

Mr. MAY. At the time of this memo, my recollection would be

Tom Carmon, Brad Hale, Weston Smith, Bill Owens, Richard

Scrushy. And there may be one or two others.

Mr. GREENWOOD. The senior management?

Mr. MAY. Senior management, yes.

Mr. GREENWOOD. Okay. Was the fifth floor easily accessible by

others?

Mr. MAY. No, it was not.

Mr. GREENWOOD. Why not?

Mr. MAY. There was a fairly elaborate locking system with a card

key that you needed to access to get to the fifth floor.

Mr. GREENWOOD. By elevator?

Mr. MAY. By elevator, yes.

Mr. GREENWOOD. Okay. So it would be not likely that other employees could wonder in and have shredded these documents, necessarily?

Mr. MAY. I would—I would guess not.

Mr. GREENWOOD. Okay. Looking at these shreds, you can discern

what some of them say.

For example, on the last page there’s a quote ‘‘7150’’ which is the

billing code for group therapy. There is also a quote ‘‘175M based

on.’’

When was the Board made aware that Fulbright had discovered

shredded documents on the fifth floor?

Mr. MAY. I believe that Fulbright first made us aware of shredding of documents prior to me coming onto the Board, and then

again in their report on, I believe, October 21.

Mr. GREENWOOD. Mr. Gordon, were you aware of the fact that

these documents had been shredded and were you aware of that

before you received the report from Fulbright?

Mr. GORDON. Yes. I was aware that they had found at the time

they said a small amount of shredded documents on the fifth floor.

That they had been placed——

Mr. GREENWOOD. Who told you that?

Mr. GORDON. I do not recall exactly who did tell me that. I do—

I had heard it before the Fulbright, before it came out.

Mr. GREENWOOD. Did you not tell our committee staff just yesterday that the first time you were aware of the shredded documents

was when you read about them in the Fulbright report?

66

Mr. GORDON. Yes, I did. That’s right.

Mr. GREENWOOD. Right. So you said two different things on two

different days now; which would you like to stand by?

Mr. GORDON. The first time was—I did not hear about it before

the Fulbright report.

Mr. GREENWOOD. So you did or did not hear about it?

Mr. GORDON. I did not hear about it.

Mr. GREENWOOD. Your testimony today is that the first time you

heard about it was when you read it in the Fulbright report?

Mr. GORDON. Right.

Mr. GREENWOOD. So you misspoke a moment ago?

Mr. GORDON. That is correct.

Mr. GREENWOOD. All right.

Mr. May, was there a discussion of hiring a firm to reconstruct

the shredded documents?

Mr. MAY. Yes.

Mr. GREENWOOD. Did the special litigation committee ever issue

reports or opinions from its investigation of allegations in the derivatives lawsuit?

Mr. MAY. No. The special litigation committee never did issue a

report.

Mr. GREENWOOD. Okay. Okay. Mr. Gordon, would you go to Tab

15? Okay. What is that document?

Mr. GORDON. That is a letter that I wrote to Lanny Davis at Patton Boggs.

Mr. GREENWOOD. And when did you write that letter?

Mr. GORDON. On November 1, 2002.

Mr. GREENWOOD. And what does the letter mean to convey?

Mr. GORDON. It was in response to a letter that I had received

by him on October 15.

Mr. GREENWOOD. And did you tender your resignation from the

corporate compliance committee in that letter?

Mr. GORDON. Yes. At a previous Board meeting they had said I

had conflict and they had asked me to resign as Chairman of the

compliance committee. And I told them I would consider that and

would confirm it back later. And I waited a week, and thought

about, and confirmed that back in a letter with my thoughts on

that.

Mr. GREENWOOD. Look at Tab 14, if you would. Are those the

minutes from the October 29 meeting?

Mr. GORDON. Yes.

Mr. GREENWOOD. They state that you resigned from the committee at that meeting, is that correct?

Mr. GORDON. I did not resign the committee at that meeting. It

was suggested that I resign, but I told them that I would consider

it and get back. They asked me to resign. I did not resign.

Mr. GREENWOOD. Why did you resign?

Mr. GORDON. Why did I?

Mr. GREENWOOD. Yes.

Mr. GORDON. They quoted me, I guess, things that said I had a

conflict. I had been—I had sold a company to HealthSouth and as

part of the acquisition deal, I had a consulting contract. And they

said that consulting contract put me into conflict.

Mr. GREENWOOD. And were those facts true?

67

Mr. GORDON. I did have a consulting contract.

Mr. GREENWOOD. And for how long prior to when they asked you

to resign?

Mr. GORDON. That was part of the deal that was concluded in

1996. Since 1996.

Mr. GREENWOOD. Did you feel that having that consulting contract compromised your ability to act on behalf of the investors of

the company?

Mr. GORDON. Sir, most certainly not. I had, as I have indicated

early, $290 million of my family’s—well, my family had it at stake.

And $250,000 it was certainly not going to compromise my independence.

Mr. GREENWOOD. Okay. Back to your letter, I am going to direct

your attention to the last paragraph where you wrote ‘‘I have followed closely your statements to the press about the company, the

investigation and who is or is not responsible for the issues that

have faced the company recently. To the extent that you’’ Mr. Davis

you are addressing, ‘‘feel the need to address any issues regarding

my service as Chairman of the compliance committee, I would expect that the circumstance under which the compliance committee

was not permitted to act would be accurately and fairly disclosed

as well. If this issue is not handled properly, I will consider making

my own disclosure.’’

What did you mean by that?

Mr. GORDON. At the time I did not feel that Mr. Davis was properly respecting my position as Chairman of the compliance.

Mr. GREENWOOD. Can you elaborate on that? What made you feel

that way?

Mr. GORDON. Well, what made me feel that way originally, I had

proposed hiring Wilmer Cutler. That was not accepted. I thought

that was my responsibility. And from that, I had a $4,000 bill from

attorneys, which I did not think was significant. Mr. Davis had indicated to me that that was a—I guess, not a good way to spend

the corporate money. It was an inappropriate expenditure.

Mr. GREENWOOD. What was the $4,000 spent on?

Mr. GORDON. My counsel had been advising me as what my duties were with the compliance committee.

Mr. GREENWOOD. Okay. Your words in the letter said ‘‘I would

expect that the circumstances under which the compliance committee was not permitted to act.’’ So what did you think was not

being disclosed?

Mr. GORDON. What I thought——

Mr. GREENWOOD. And you had pretty much threatened to disclose it yourself if he didn’t.

Mr. GORDON. I was Chairman of the compliance committee.

Mr. GREENWOOD. Yes, sir.

Mr. GORDON. And by the charter of the compliance committee it

specifically spelled out that the compliance committee had the responsibility to select and hire an independent counsel. And I called

a meeting of the committee. The committee approved this.

When it came to the Board meeting, I reported when the time

come to report the compliance committee, I reported that I had

been in contact with Wilmer Cutler who has had experience the

68

New York Stock Exchange and others, was an outstanding firm.

And I would recommend they be hired.

And from somewhere in the Board a recommendation come why

do we not consider Fulbright & Jaworski.

Mr. GREENWOOD. Do you know who made that recommendation?

Mr. GORDON. I do not recall. I believe it was Mr. Newhall.

Mr. GREENWOOD. And was there discussion about that?

Mr. GORDON. Was a discussion. And I responded that I have no

objection to Fulbright, they had worked for me in the past in my

businesses, and I was perfectly comfortable if it was the will of the

Board, and I would support them.

Mr. GREENWOOD. So you have got one instance there. You are

the Chairman of the compliance committee. You and the compliance committee decide that Cutler is the firm to hire. And you go

to the Board and you present that. And somebody else makes another suggestion, and then you go along with it. But was that the

only—when you refer to your letter ‘‘the circumstances under which

the compliance committee was not permitted to act,’’ were there

other circumstances under which the compliance committee in your

opinion was not permitted to act other than this one issue of the

recommendation of a law firm?

Mr. GORDON. Well, later when I found that the meeting went forward and the suggestion was made we ought to get in touch with

Fulbright & Jaworski to discuss their selection, and the attorney

got on the phone he said ‘‘I am really excited about working for—

with HealthSouth. I have been getting myself up to speed for the

last 3 days, and I am ready to hit the ground running tomorrow.’’

Mr. GREENWOOD. And what did you take from that?

Mr. GORDON. I did not say anything at that time. Later in the

meeting after things quieted down, I just said I have a question.

And I do not understand how my duties as Chairman of the compliance committee got taken away and we did not have the final authority on this.

Mr. GREENWOOD. So it sounds to me that the choice was a fait

d’accompli by the time of the Board meeting if that firm had already spent 3 days gearing up to it?

Mr. GORDON. Well, the response, Mr. Chairman, is I didn’t know

what you were up to.

Mr. GREENWOOD. That is what you said?

Mr. GORDON. That’s what the Chairman, Mr. Scrushy said.

Mr. GREENWOOD. So the compliance committee ultimately had no

say whatsoever about which law firm would do the investigation,

is that correct?

Mr. GORDON. Yes, that is correct.

Mr. GREENWOOD. And the compliance committee itself did no review, correct?

Mr. GORDON. Repeat that, please.

Mr. GREENWOOD. The compliance committee itself did not do any

kind of a review itself?

Mr. GORDON. No. It was—and then right after that I was asked

to resign.

Mr. GREENWOOD. Right after that you were asked to resign?

Mr. GORDON. Yes.

Mr. GREENWOOD. My time has expired.

69

The gentlelady from Colorado is recognized for 10 minutes.

Ms. DEGETTE. Ms. Givens, I will admit to being surprised by

your previous answers, which is why I was trying to probe. And the

reason is because 3 weeks ago when we had our first hearing on

this HealthSouth issue, Greg Smith, who has been the internal

auditor of the company since December 1999 testified under oath

that he had not met privately with the audit committee during the

first 18 months he was there, except for once when he first started

in December 1999. So that was the period of the 2000, half of 2001,

the period where you said that the audit committee met separately

at least 3 times and had some telephone conversations. And Greg

Smith also told that he hasn’t met with the audit committee since

March 2003.

And the other reason I was surprised is because we have been

provided with minutes from only one audit committee meeting during that period of time, and that was the one that Greg Smith

talked about.

So I guess my question to you is, is do you think Greg Smith is

lying to the committee?

Ms. GIVENS. I do not know if he is or not. I can tell you what

my recollection is.

Ms. DEGETTE. But you stick by what you said earlier today?

Ms. GIVENS. Well, I think there may be some confusion about

what meeting alone means. We met regularly with internal audit,

very often the external auditors were there as well. And so he may

be referring to meeting specifically alone as an individual with the

audit committee.

Ms. DEGETTE. No, actually what he was saying is meeting with

the audit committee separate and apart from meetings that were

part of the regular Board meeting. That is what he was saying.

And also without the other auditors.

Ms. GIVENS. Okay. Well, very often we did combine the audit

function internal and external.

Ms. DEGETTE. But your testimony is you did that separate and

apart from the Board meetings.

Ms. GIVENS. Sometimes——

Ms. DEGETTE. Either before it or——

Ms. GIVENS. Generally that was the case, yes.

Ms. DEGETTE. Okay. Mr. Gordon, I just wanted to follow up on

one of the chairman’s questions, which was you had said that this

consulting contract would not—you would not feel that that gave

you any kind of conflict. But legally, and I think the reason you

had to step down from the Chairman of the compliance committee,

is legally because of that consulting contract you would not be considered an independent director, correct?

Mr. GORDON. Well, I think it is several interpretations of that.

And some things I have seen, I would be considered, others I would

not be.

Ms. DEGETTE. But in the interim you have discontinued that

consulting contract, correct?

Mr. GORDON. Yes.

Ms. DEGETTE. If you could, if you do not mind, take a look at

Tab 28 in the notebook. And this is an SEC proxy statement for

1998. Do you see that there?

70

Mr. GORDON. I see schedule 14A, is that what——

Ms. DEGETTE. Yes, 14A information.

Mr. FERGUSON. Okay.

Ms. DEGETTE. Now, on the third page of that it says about the

middle of the page, shareholder proposal. ‘‘The Board of Directors

adopt a policy that no Board member shall serve on the compensation committee if he or she is not an independent director.’’ And

then it goes down to a definition.

Then the next page it says ‘‘The purpose of this proposal is to incorporate within the audit and compensation committee a standard

of independence that will permit objective decisionmaking on compensation issues at HealthSouth.’’ Do you see that there?

Mr. GORDON. Right now I am looking for it.

Ms. DEGETTE. It’s the very top, it says page 15 of 91. It is the

very top of the page.

Mr. GORDON. Okay.

Ms. DEGETTE. Have you ever seen this document before, by the

way?

Mr. GORDON. I think I saw that in a proxy statement before the

annual meeting.

Ms. DEGETTE. Okay. Before the annual meeting then, that would

be in 1998?

Mr. GORDON. That year. Yes.

Ms. DEGETTE. Okay. And then it goes on to say on that same

page 15 that HealthSouth has arranged a credit agreement with

Nations Bank allowing the company to invest up to $5 million in

Acacia Venture Partners, a private venture capital fund. C. Sage

Givens is the founder and the managing general partner of Acacia

Venture Partners. And it goes on to say that Givens’ firm recently

invested $4 million in a Managed Care U.S.A. contract. And then

at the bottom of the page it says ‘‘The current members of the committee have all been directors since the initial public offering in

1996 and have served on the committee.’’ And the basic suggestion

here of the shareholders is that people who serve on the audit and

compensation committee should be independent directors and

should not have these conflicts.

Do you recall what the response of the Board to these proposals

was?

Oh, I am sorry. And also, Mr. Watkins apparently jointly owns

some property in Florida with Mr. Scrushy.

So my question is do you recall the Board talking about that proposal?

Mr. GORDON. I do, and I think the Board considered the request

and came up with the decision that the members were acting in a

very independent manner and they did not see the conflict.

Ms. DEGETTE. So it did not bother you that these conflict existed?

Mr. GORDON. Well, this was presented by Steel Workers or something, I think.

Ms. DEGETTE. Yes, I know.

Mr. GORDON. It was not——

Ms. DEGETTE. But still it was a proposal.

Mr. GORDON. Making changes, we were going to make some

changes, but at this point we did not see anything critical in it.

71

Ms. DEGETTE. Right. You did not see a problem?

Mr. GORDON. At that point.

Ms. DEGETTE. And then if you will take a look at Tab 2 of the

binder.

Mr. GORDON. Which one? Two?

Ms. DEGETTE. Tab 2. This is—yes, it is also 14A from April 1999.

Have you seen this before?

Mr. GORDON. Where are you at? I am not keeping up with you.

Ms. DEGETTE. Tab 2.

Mr. GORDON. Okay. I am under Tab 2.

Ms. DEGETTE. At the top it says ‘‘Begin privacy enhanced message,’’ see that there?

Mr. GORDON. Okay. Yes.

Ms. DEGETTE. Yes. Okay. That is page 1. Then if you flip over

to the second page, it says page 18 of 105 on the second page.

Mr. GORDON. Okay.

Ms. DEGETTE. And I will just tell you, this is a 14A information

from April 1999, a year later, okay? And here there is a shareholder resolution that is again requesting the Board of Directors to

amend the articles of incorporation and bylaws to the extent necessary to provide that at least three quarters of all Board members

are ‘‘independent.’’ And it goes on to say ‘‘The proposal seeks to establish a level of independence that they believe will permit clear

and objective decisionmaking in the best long term interests of all

shareholders by the HealthSouth’s 12 directors or company insiders, 6 is the CEO of Med Partners and Mr. Scrushy as the former

Chairman and current director.’’ And they go on to say they believe

that there would be a lack of independence and that is why they

are proposing that three-quarters of the Board members would be

independent.

Do you recall seeing that shareholder proposal at the annual

meeting in 1999?

Mr. GORDON. I do not.

Ms. DEGETTE. Okay. Do you remember any discussion about

that?

Mr. GORDON. I am sure it would have been discussed. I do not

recall.

Ms. DEGETTE. You do not recall a discussion?

Mr. GORDON. I do not recall.

Ms. DEGETTE. What do you think of that proposal?

Mr. GORDON. I think in retrospect looking now it has some merit.

But I——

Ms. DEGETTE. Why is your consulting agreement not in this

proxy, do you know?

Mr. GORDON. If it was—it was—my consulting agreement was a

part of the original transaction before I became a director.

Ms. DEGETTE. Right.

Mr. GORDON. It was done in 1995, in I believe September. And

part of the legal papers HealthSouth and the Chairman of the company insisted that I have a non compete for 10 years in North

America. That I could not be in any——

Ms. DEGETTE. No, I understand. I am sorry, I do not mean to interrupt. We have limited time.

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I understand that was your agreement, and I am not arguing

about that. I understand there was consideration and everything

else. But the question we are asking is about independent Board

members. And the question is why was that—do you know why

that was not discussed in 1999?

Mr. GORDON. As I recall, it was listed in the proxy statement in

1997, in 1998. And then after that, I think it just disappeared.

Ms. DEGETTE. Do you know why?

Mr. GORDON. I do not know why.

Ms. DEGETTE. Okay.

Mr. GORDON. I had nothing——

Ms. DEGETTE. But you still did have that agreement?

Mr. GORDON. I had a consulting contract for 10 years.

Ms. DEGETTE. Okay. And did it appear in 2000, 2001?

Mr. GORDON. I checked back, I do not believe I saw it in 2000.

Ms. DEGETTE. Who would have been in charge of listing that?

Mr. GORDON. Chief legal counsel, Mr. Horton.

Ms. DEGETTE. I just have a couple of last questions.

Yesterday we received, and I am sure all of you have seen,

maybe you have not read it in depth, this indictment of Mr.

Scrushy, 85 counts. And as someone who has been involved in all

these corporate responsibility hearings the last few years along

with the Chairman, what struck me when I read this and when we

had our hearings a few weeks ago, was this was not a complicated

financial unraveling like with Enron or it was not some edgy accounting like it was with Qwest or some of the other telecom companies. To me this is garden variety fraud. What you have is some

accounting practices which are just plain to see.

And you have your CEO being indicted with 85 counts. You have

15 senior employees of the company pleading guilty to criminal

fraud, which to me is extraordinary.

And so the question I want to ask all of you, particularly those

of you who have been on the Board for longer, excluding Mr. May

I would say, all of you have testified today that you have taken extraordinary steps as Board members to exercise due diligence. In

retrospect, do you think there is anything the Board could have

done to identify or to prevent this kind of fraud which had, as you

have all stated today, seriously threatened the financial health of

this company?

Mr. Gordon?

Mr. GORDON. I think when you look back on it, the Board did

what were reasonable measures to perform in the best interest of

the stockholders and make the management abide by the proper

accounting and—when someone is determined to commit fraud, it

is very difficult to find. I think that Sarbanes-Oxley will certainly

be a great benefit going forward to this, because it does——

Ms. DEGETTE. But there is nothing you think the Board could

have done?

Mr. GORDON. I think, you know, certainly there is something we

could have done. I would not say that at all. I think that it is something that in retrospect could have been done. But the company

performed very well. The earnings were——

Ms. DEGETTE. Yes, it sure did.

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Mr. GORDON. Now they certainly were manipulated. But in retrospect of seeing the growth of the company over the last 5 or 6, 7

years and the performance, the first indication was the company

was doing very well. Now no one had any suspicion of fraud.

Ms. DEGETTE. Okay. Ms. Givens, do you think there is anything

the company could have done differently to detect this? I’m sorry,

the Board.

Ms. GIVENS. I have certainly asked myself that daily since learning about the fraud last March. And I have looked at what we did

as a Board, what I did as an individual and I can sincerely say that

I always exercised the highest ethics, that I tried to be diligent in

my duty as a Board—member of the Board. And I went out and

I actually sought, I just did not fly in and fly out at Board meetings. I went out and I talked with employees. I visited facilities. We

talked with the financial community. And never once did anything

come to at least my attention that would lead me to conclude that

there was anything wrong.

So in hindsight, I cannot think of how I would have been aware

of it.

Ms. DEGETTE. Dr. Watkins?

Mr. WATKINS. I agree. We were repeatedly assured that we had

the proper measures in place for compliance, detection of fraud.

Our auditors in their letter to us repeatedly, as Ms. Givens has

quoted, found no material evidence of fraud or other practices.

So at this point, I still do not know how we would have detected

this.

Ms. DEGETTE. Well, do you think—and I know my time is close

to being up, if you had had independent counsel that were truly

independent, would that have helped?

Mr. WATKINS. Independent auditors or counsel?

Ms. DEGETTE. Counsel, the investigative counsel?

Mr. WATKINS. Again, I do not know. This was so widespread and

this actually occurred even before——

Ms. DEGETTE. Right. So if they had been independent, would

they not have found that?

Mr. WATKINS. Again, that would be pure speculation. I do not

know. I do not know.

Ms. DEGETTE. Mr. Striplin?

Mr. STRIPLIN. I am not sure.

Mr. GREENWOOD. You are going to need your microphone, Mr.

Striplin.

Mr. STRIPLIN. I am not sure looking forward, to answer your

question, that I would ever make another good Board members, because I would be looking under every rock. And I call myself being

due diligence in this situation——

Ms. DEGETTE. You do not think that that is the definition of a

good Board member?

Mr. STRIPLIN. Well, I thought I was doing what I was supposed

to be doing. I had no indication. If this man had been my only son,

I would not feel any different than I do now. We just, all of us in

shock. But the question answered—asked what would we do, I

think we would, obviously, on Monday morning after you have

played the game on Saturday night, you would—and you know

what your mistakes were, you certainly would not go back and not

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be better and be more concerned about the due diligence. You

would do everything, particularly in the areas of accounting and—

there has got to be consenting that we could do better.

And I think that I am so very proud of this Board of Directors

of what we are doing right now, and the results that we have had.

I think that Brian Marsal and Joel, and Bob have just done an excellent job. And I think that the future of this company is going to

be safe.

Ms. DEGETTE. Mr. May, let me ask you, you are the captain of

the ship going forward. Are there changes that can be made to the

Board procedures? You know, I am not questioning the commitment or dedication of the Board members. But are there changes

that the company can and will make to the Board procedures to ensure that this kind of level of widespread fraud can never happen

again?

Mr. MAY. The answer is yes.

Ms. DEGETTE. And what would those be?

Mr. MAY. And there have been significant changes to our governance guidelines. There have been significant changes to our compliance program. Essentially, we have taken a look at what, you

know, what are those things that we could reasonably do based on

what we know today and have set in motion to put corrective action in place as quickly as possible to make sure that something

like this never occurs again.

Ms. DEGETTE. Mr. Chairman, I know we are out of time. I would

just ask if Mr. May would mind supplementing his answers with

a brief summary of the changes that have been made toward Board

governance. That would be very helpful.

Mr. MAY. I will have those to you tomorrow.

Mr. GREENWOOD. Thank you, gentlelady.

Before I yield to Mr. Walden, a couple of quick questions for Ms.

Givens.

Ms. Givens, were you present at the Board meeting where Mr.

Scrushy asked Mr. Gordon to resign?

Ms. GIVENS. To resign?

Mr. GREENWOOD. From the compliance committee?

Ms. GIVENS. I do not recall that, no. I do not know if I was or

not. I do not recall.

Mr. GREENWOOD. Okay. Did you know whether you had an opinion as to whether he should resign?

Ms. GIVENS. No.

Mr. GREENWOOD. Okay. So you were not involved in that whatsoever? You did not have an opinion one way or the other?

Ms. GIVENS. I was not involved in that, no.

Mr. GREENWOOD. Okay.

Mr. Walden?

Mr. WALDEN. Thank you, Mr. Chairman.

This issue of hiring Fulbright & Jaworski is of interest. Because

if I understand it right, Mr. Gordon, your compliance committee

recommended a different firm. You took that to the Board of Directors and you presented that as your committee’s recommendation.

And then who is it, Mr. Newhall then recommend a different firm.

Well, no. You recommended Wilmer & Cutler?

Mr. GORDON. Right.

75

Mr. WALDEN. Wilmer Cutler and Pickering. And it was Mr.

Newhall then that recommended Fulbright & Jaworski. And then

there was some discussion. How would you characterize that discussion? Was it heated, was it friendly, was it—I mean, what took

place in that Board meeting, because it’s not reflected? The tone is

certainly not reflected here.

Mr. GORDON. That discussion was not heated, because at the

time I did not suspect anything was going on. And so when they

nominated Fulbright, I knew——

Mr. WALDEN. No, you nominated Wilmer, right?

Mr. GORDON. I nominated Wilmer Cutler.

Mr. WALDEN. Yes. Yes.

Mr. GORDON. And Fulbright was nominated. And I know the

firm. They are an excellent firm. And they have done work for me.

I have no problem with the company. If it is the will of the Board,

they are fine.

Now where I got disturbed was later when I found out they had

been talking to them before I gave my report.

Mr. WALDEN. And who is ‘‘they?’’

Mr. GORDON. The Chairman, I believe. And perhaps Mr. Davis

is what I surmised.

Mr. WALDEN. Perhaps Mr. Davis and certainly—well, the Chairman. Because when they came on the phone, was this still during

a Board meeting you had the phone conversation?

Mr. GORDON. Yes.

Mr. WALDEN. They are like on speaker phone in the Board room?

Mr. GORDON. Yes.

Mr. WALDEN. And they said great thanks, we have been gearing

up for 3 days?

Mr. GORDON. He said we are looking forward to going to work.

We have spent the last 3 days getting up to speed on HealthSouth

and we are ready to hit the ground running tomorrow.

Mr. WALDEN. So somebody had already cut this deal with them,

in effect?

Mr. GORDON. That is what I suspected. I had no definite knowledge, but I suspected that.

Mr. WALDEN. But had you not already agreed to retain Wilmer?

Mr. GORDON. Yes. I had worked with a gentleman named—well,

I had worked with a gentleman named Harry Wise at that firm,

and he had committed he could take the assignment. And I told

him I had to get Board approval.

Mr. WALDEN. Right.

Mr. GORDON. And I would get back to him just as quick as the

Board met to confirm his hiring.

Mr. WALDEN. All right. And did I hear you correctly as saying

Mr. Scrushy said he did not know what your committee was up to

with regard to this?

Mr. GORDON. No. He said he did not know what I was up to.

Mr. WALDEN. What you were up to?

Mr. GORDON. Yes. Right.

Mr. WALDEN. All right. And do you know how he meant that?

How did you interpret that? He did not know you were looking at

hiring outside firm, or you did not know you were talking to Wilmer & Cutler?

76

Mr. GORDON. I think he, in retrospect, was concerned that I was

trying to do a thorough and independent study and I do not know

if he wanted one done on it that way.

Mr. WALDEN. Do you know what prompted Mr. Newhall to make

this recommendation to the firm that, obviously, someone had been

talking to for 3 days?

Mr. GORDON. No, other than the fact that they are outstanding

firm and he was familiar with them.

Mr. WALDEN. Just sort of out of the blue he picks another name?

Mr. GORDON. I do not know if it was out of the blue, but that

is the first I heard.

Mr. WALDEN. All right. Mr. May—oh, Mr. Gordon, before I leave

you, on the Fulbright & Jaworski supplemental letter regarding

Mr. Scrushy, the minutes on the meeting on October 29, 2002 say

‘‘The Board reviewed Fulbright & Jaworski’s supplemental letter

clearing Mr. Scrushy of all allegations of insider knowledge concerning the impact of a Medicare reimbursement rule change prior

to his stock and loan repayment transactions in May and July

2002. The Board voted to release to the press the results of the

findings on October 30, 2002.’’

If you would turn to Tab 96 you will find a copy of these minutes,

and I do believe the handwriting on here is yours and reflects, perhaps, your comments at some point. Tab 96.

Mr. GORDON. Ninety-six.

Mr. WALDEN. At the bottom of the first page, handwritten there

it says ‘‘Did not clear RS of all knowledge.’’

Mr. GORDON. Yes.

Mr. WALDEN. Is that your handwriting?

Mr. GORDON. Yes, it is.

Mr. WALDEN. What did you mean by that?

Mr. GORDON. As far as I was concerned, I did not think the report cleared him of all knowledge of it.

Mr. WALDEN. Why? What did you know——

Mr. GORDON. I did not know anything. Excuse me, go ahead.

Mr. WALDEN. Yes. What did you know that led you to think that?

Mr. GORDON. I did not know anything. I just from the way my

handling of my chairmanship of the compliance committee, I had

some suspicion. And I just did not think the report was definitive

in clearing him of all knowledge.

Mr. WALDEN. On the next page, Mr. Gordon, on page 2 at the

top, it says ‘‘RS’’ underlined and then it says ‘‘challenges Fulbright

report.’’ I think it says ‘‘report on shredding and—’’

Mr. GORDON. Other items.

Mr. WALDEN. ‘‘other items. Lanny Davis to meet with’’—can you

read your handwriting for me there?

Mr. GORDON. Yes. To meet with Hal Hirsch to work out wording.

Mr. WALDEN. What did you mean by that?

Mr. GORDON. When the Fulbright—original preliminary report

from Fulbright came in, and it was a discussion that it had shredding in it. And he said shredding is not appropriate, it is not appropriate in that report. It should be removed.

Mr. WALDEN. Why did he say that? Did anybody question him on

that; Mr. Scrushy, on why he would say shredding is not appropriate?

77

Mr. GORDON. Well, it was just a general conversation. It was in

the document. He was instructing counsel, his counsel to discuss

this with Fulbright and see if there is some way to work out getting the reference to shredding out of the documents.

Mr. WALDEN. Before it was released, before it was finalized? So

Mr. Scrushy was trying to influence what was in the Fulbright report?

Mr. GORDON. Yes, I would say so.

Mr. WALDEN. And did I not read somewhere here that in part of

the shredded documents that have been recovered there are some

documents where they have recovered pieces that indicate transmittal or parts of the word Transmittal 1753?

Mr. GORDON. I think there was a suspicion of that, yes.

Mr. WALDEN. Then I want to go, Mr. May, to you if I could. I

have before me a copy of the news release. And I do not think it

is in the book, or at least in that book. It is actually in the one for

the next panel, but it is the news release that was on your

HealthSouth website. It is dated October 30. And it says, this is

quoting you now, ‘‘This thorough outside review conducted by Fulbright & Jaworski puts to rest any question whether Mr. Scrushy

had any inkling or knowledge of the Medicare reimbursement rule

change or its impact prior to his stock transactions in May and

July 2002.’’ It said ‘‘Independent director Robert P. May, Chairman

of the Board corporate governance committee and special litigation

committee.’’ Are those your words?

Mr. MAY. Yes, they are.

Mr. WALDEN. Did you write them?

Mr. MAY. No, I did not.

Mr. WALDEN. Who wrote them?

Mr. MAY. A collection of the lawyers who were working for the

company at that time.

Mr. WALDEN. Was one of those Mr. Davis?

Mr. MAY. Yes.

Mr. WALDEN. Was he the principal author of those words?

Mr. MAY. I am not sure if he was the principal author, he was

one of them.

Mr. WALDEN. Okay. Because I have also from the ‘‘Birmingham

Business Journal’’ October 27, 2003—well, no. Yes, October 27,

2003 there is a quote and it says ‘‘Davis had a hand in writing the

release and he now says’’ this is quoting Davis ‘‘I take full responsibility’’ for including May’s quote embellishing Fulbright &

Jaworski’s conclusion, a take that didn’t set well with the firm.

I want to read for you an email that we have from a Neil Gold

to Hal Hirsch with a cc to Felice Gallant. Privileged and confidential. This is with regard to the news release. ‘‘Hal, this is hilarious.

Is it a parity or is it for real? A few thoughts and questions. One,

I did not know we had the power to clear Richard.’’ And if you look

at—well, you do not have the news release. ‘‘The first paragraph

of the news release indicates that Mr. Scrushy was cleared by an

outside investigation. In fact, our letter says quite the contrary,’’

according to Mr. Gold.

‘‘Second, what is the legal definition of inkling? Is it more than

a scintilla.’’ And the word ‘‘inkling’’ is used in your quote written

apparently in part by Mr. Davis saying that Scrushy had—puts to

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rest any question whether Mr. Scrushy had any inkling or knowledge.

‘‘Three,’’ and I am quoting here, ‘‘do these idiots realize that 2

months after May 14 is July 14?

Four, our investigation began on September 24, not September

17.’’ The news release says September 18. ‘‘And was essentially

completed except for the supplemental reports by October 21, a period of 4 not 6 weeks.’’ And the 6 weeks is listed in your press release.

‘‘Five, we did not review 59,000 documents and 546,300 pages,

we merely applied our search parameters to those documents and

pages. Our report specifically states that we did not examine documents not responsive to the search terms.

Six, our conclusion is not stated accurately as it omits the ‘in the

view of’ clause the Fulbright & Jaworski has uncovered.

Seven, there is no way to confirm a person’s absence of knowledge.

These are just top-of-the-head thoughts about this. Have a good

flight,’’ it says.

Do you still stand by what is in this news release and your

quotes?

Mr. MAY. I am not familiar who—with the individual who wrote

that email. My principal contact with Fulbright & Jaworski was

Hal Hirsch.

Mr. WALDEN. Okay.

Mr. MAY. Hal Hirsch reviewed that quote. Hal Hirsch approved

that quote. And therefore, yes, I stand by that quote.

Mr. WALDEN. Let me quote an email from Hal Hirsch, dated October 29, 2002, 1:30 p.m. This followed the one I quoted from Neil

Gold which was at 11:52 the same day.

‘‘Carl and I told Horton much of what you stated, though we all

acknowledge a lack of control. Horton is working on improving the

statement be good. HMH.’’

My question is do you still stand by these statements today?

Mr. MAY. I said by the quote that was made at the time.

Mr. WALDEN. Mr. Gordon, do you think those statements are accurate in the news release?

Mr. GORDON. I would question them.

Mr. WALDEN. Could you speak just a little closer? I am sorry.

Mr. GORDON. I would question it.

Mr. WALDEN. You would question the statements in the news release?

Mr. GORDON. Yes.

Mr. WALDEN. Why?

Mr. GORDON. I guess as I have expressed earlier, I think that I

do have some questions about the independence of the investigation.

Mr. WALDEN. Did you raise any objections at the time to the

news release, or did you even get a chance to see it?

Mr. GORDON. I did not see it until after it was in the papers.

Mr. WALDEN. Did not see it?

One final question or set of questions. One of the things that

strikes me as I listen to your testimony and having talked with you

all, and with the testimony of others, was this a company that was

79

dominated by a CEO who engaged in intimidation and manipulation to the point that people feared for their own safety and jobs

if they questioned Mr. Scrushy?

Mr. Gordon?

Mr. GORDON. Repeat that again for me, if you would?

Mr. WALDEN. I will try. Was this a company where employed and

perhaps even Board members felt or today feel intimidation or that

Mr. Scrushy was manipulative based on his actions? When I hear

about the fact that he had his security guard, you know, follow you

out of a Board meeting. You know, you hear these other things

about the security arrangements at the company. And, sure, companies have those. But the taping in the back of his pickup. The

fact his security guard finds the CFO committed suicide. These

things sound unusual.

Mr. GORDON. Well, I think the company—or I may go back. The

company was enjoying unparalleled success and people were making really good money on salary and options. So there was a lot of

harmony. And I never saw a lot discord in—around the company.

Everybody seemed to be very happy and working on a progressive

basis. The company was growing and so forth.

Now, as things got tough over the last 6 or 8, 10 months——

Mr. WALDEN. Sure.

Mr. GORDON. [continuing] I saw some of that. I did see on occasionally when I disagreed with him, he would raise his voice and

express his dissatisfaction. There was not a discussion. It was him

demanding why you saying this, why you doing this, and so forth.

Mr. WALDEN. I mean, I do not know, maybe it is the way it

works. But when I think about manipulation, basically saying you

know, Mr. Gordon, they want you off the Board but I will keep you

on if you get Mr. May off the Board and——

Mr. GORDON. He had a history of working one Board member

against the other.

Mr. WALDEN. Is that not manipulation?

Mr. GORDON. I would think so.

Mr. WALDEN. Do any of you, given the indictments, given the

statements, do any of you fear for your individual safety throughout this process?

Mr. GORDON. Honestly, when I drive around Birmingham at

night in a Yukon that they provide me to go, I do have some concerns. I definitely do. There has been remarks that you got to be

watching yourself.

Mr. WALDEN. Anyone else?

Mr. MAY. I would have to say that my wife certainly has expressed her concern for my safety. I do not have any concern.

And I also, if you would not object, I would like to just clarify

my statement on my quote.

Mr. WALDEN. Sure.

Mr. MAY. What I want to be clear is that at the time I made that

quote, I believed that quote to be correct.

Mr. WALDEN. How about today?

Mr. MAY. Today, you know, we understand that things are very

much different and there is a different set of facts in place in terms

of the conspiracy, you know, committed against the company by a

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group of individuals and what information was known by those individuals during this same period of time.

Mr. WALDEN. So today you think maybe Mr. Scrushy had insider

knowledge?

Mr. MAY. I think based upon what was in the indictment and

what has been known, there has never been a transaction that Mr.

Scrushy took part of that did not have insider information.

Mr. WALDEN. All right. Anyone else want to comment on any of

this? If not, thank you, Mr. Chairman.

Mr. GREENWOOD. The Chair thanks the gentleman.

Before recognizing Mr. Stearns, there are just a couple of things

that are hanging out there that need to be clarified.

Ms. Givens, when I asked you earlier if you were present at the

Board meeting when Mr. Gordon was asked, it was recommended

that he be removed from the compliance committee, you either indicated that you were not there or that you do not recall being

there. If you want to, you can consult—I am not sure what tab this

is. I will get that for you in a moment. But I think it is 28. It is

the Board meeting for October 29 at Tab 14.

Tab 14 is the Board meeting and it is from October 29. It indicates that you were at that Board meeting, and it indicates that

the Board discussed Mr. Gordon’s ineligibility to serve on the compliance committee because of his status as an employed consultant

of the corporation.

So, now that you have looked at the Board minutes and see that

they indicate you were there, does that fresh your memory and do

you recall that, in fact, you were there?

Ms. GIVENS. I have not approved these minutes and one of the

reasons that I did not approve the minutes was that they had me

being there at some of the Board meetings where I was not. And

I actually, indeed, was present at some where they did not have me

recorded.

And it is also unclear as to whether or not we participated by

phone or in person.

And so the fact that—and it has only been in the recent minutes

where that has been a problem.

Mr. GREENWOOD. Okay. As you look at these minutes and the

discussion that they reflect, is your memory jogged to recall that

you in fact were there?

Ms. GIVENS. If you can give me a moment, I would be happy to

do that.

Mr. GREENWOOD. Certainly. It says ‘‘all directors and guests were

physically present with Mr. Scrushy in the Board room.’’ It does

not indicate that the Board members were telephonically linked.

Ms. GIVENS. This sounds familiar, yes.

Mr. GREENWOOD. Okay. So you were there when the Board discussed Mr. Gordon’s ineligibility to serve on the compliance committee because of his status as an employed consultant of the corporation.

Ms. GIVENS. Yes.

Mr. GREENWOOD. During that discussion did you agree that that

would be a good reason to remove Mr. Gordon from the compliance

committee because of that conflict of interest?

81

Ms. GIVENS. As I recall that issue, that was recommended to us

by our corporate counsel who let us know that he was now disqualified from being on the compliance committee.

Mr. GREENWOOD. Because of that consulting fee?

Ms. GIVENS. That is right.

Mr. GREENWOOD. Which had been around for how many years,

Mr. Gordon?

Mr. GORDON. Seven.

Mr. GREENWOOD. Okay. So Mr. Gordon’s got a consulting fee for $250,000 for 7 years. He has got a multi-hundred million dollar

stake in the company. And you sat there and thought that it made

sense to remove him because he would have a conflict of interest

because of the consulting fee, is that correct?

Ms. GIVENS. Well, that was under the recommendation by the

corporate counsel.

Mr. GREENWOOD. Okay.

Ms. GIVENS. And I would have to rely on their expertise.

Mr. GREENWOOD. Right. Now, has been mentioned, you yourself

had financial dealings of significantly greater magnitudes with the

company, millions of dollars. Did it occur to you to say well wait

a minute, if that applies to him, what about me? HealthSouth had

arranged a credit agreement with Nations Bank allowing the company to invest $5 million in a Acacia Venture Partners, a private

venture capital fund with Sage Givens as the founder and managing partner. Did you say, wait a minute, if that constitutes a conflict of interest for him, $250,000, what about me?

Ms. GIVENS. The potential conflicts of interest were always disclosed and reviewed by our internal counsel.

Mr. GREENWOOD. So were Mr. Gordon’s, correct?

Ms. GIVENS. Apparently the internal counsel thought that it was

inappropriate for Mr. Gordon to continue to serve. He did not mention my inability to——

Mr. GREENWOOD. I understand that. But, I mean, Mr. Gordon,

they had this arrangement for 6 or 7 years. You are sitting there

in the Board room. They say we have suddenly discovered—in the

interim Mr. Gordon writing some strong letter questioning what is

going on at HealthSouth. After Mr. Gordon starts writing these letters, the general counsel suddenly up and discovers the $250,000

is a conflict of interest for which he should be removed from the

compliance committee.

You are sitting there. Did it not go through your head that I

have got multi-million dollars of conflict of interest. And if he

should go, then I should go. And, in fact, according to the minutes

they asked you to take his seat on the compliance committee, is

that correct?

Ms. GIVENS. You have just asked me 2 or 3 questions.

Mr. GREENWOOD. Okay. You can answer them all.

Ms. GIVENS. The first one is when you talk about conflicts of interests, I would not characterize my relationship with the company

as having a conflict of interest.

Second——

Mr. GREENWOOD. What did you think conflicted the interests of

Mr. Gordon? What would constitute the conflict of interest? What

is the difference? In other words, the theory I would assume that,

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gee, Mr. Gordon would not dare question the way this company is

managed because after all, they are paying him $250,000. You

know, the implication is that he would not be a good steward of the

investor’s dollars because he is being influenced by $250,000 a year

gain. Is that not the theory of conflict of interest?

Ms. GIVENS. In this case I really relied on our internal

counsel——

Mr. GREENWOOD. Not your own judgment at all?

Ms. GIVENS. I am not a lawyer. And I relied on legal expertise.

Mr. GREENWOOD. Neither am I. I am not a lawyer. But I can

understand——

Ms. DEGETTE. Will the gentleman yield?

Mr. GREENWOOD. Just a second, I will.

I can understand what this is about. This is about making sure

that members of boards of directors execute their fiduciary responsibility to the investors and that their judgment in executing that

responsibility is unclouded by their own personal financial interests. That is a no-brainer. Everybody understands that concept.

Ms. GIVENS. I would agree with that.

Mr. GREENWOOD. And so Mr. Gordon gets bounced off the compliance committee, you take his seat and I cannot understand why

you would not say if they are bouncing him for that, what about

me.

Ms. GIVENS. At no time have I thought that I have not acted in

the best interest of the shareholders.

Mr. GREENWOOD. Did you think Mr. Gordon was not acting in

the best interests or that he had an apparent conflict of interest?

In other words, to remove your fellow Board member from the compliance committee is not about—nobody said he is not acting wisely. This $250,000 has clouded his judgment. They said well he is

getting the $250,000, so it might appear to our stockholders and to

others, our investors, that he is conflicted. So did you think he was

conflicted? Did you think he was acting and using poor judgment?

Ms. GIVENS. No, sir, I did not. But I relied on the internal counsel to make a judgment as to whether or not it was appropriate for

him to continue to serve. And I believe that the issue then was that

he was deemed an employee of the company because of that compensation. Not that it was a conflict of interest, but the rules and

regulations, I think, required that he get off.

Mr. GREENWOOD. And who was the counsel whose judgment you

relied upon?

Ms. GIVENS. Bill Horton.

Mr. GREENWOOD. Mr. Gordon, you are shaking your head no. It

was not Mr. Horton who made that recommendation?

Mr. GORDON. Lanny Davis.

Mr. GREENWOOD. It came from Lanny Davis.

Mr. GORDON. Yes.

Mr. GREENWOOD. You did not know that, Ms. Givens?

Ms. GIVENS. I did not.

Mr. GREENWOOD. Okay. Did you want to question——

Ms. DEGETTE. Yes. I just wanted to follow up and say if you were

relying on advice of counsel and counsel said Mr. Gordon had that

conflict of interest, did it not occur to you to ask counsel what

83

about my financial dealings with the company, or why is that different?

Ms. GIVENS. I have asked that on a regular basis, and I have always been given the response that I was not conflicted. And, indeed, most recently I had to have an independent evaluation of

whether or not I was independent to be able to serve on the audit

committee. And that evaluation was performed, and I have been

deemed independent.

Ms. DEGETTE. Who has told you at various times that advice?

What are the names?

Ms. GIVENS. Independent internal counsel Bill Horton.

Ms. DEGETTE. Okay.

Ms. GIVENS. And more recently Wilkie Farr of New York.

Ms. DEGETTE. A layer in New York?

Ms. GIVENS. A law firm in New York.

Ms. DEGETTE. Okay. Great. Thank you.

Mr. GREENWOOD. The gentleman from Florida is recognized for

10 minutes.

And I appreciate the indulgence of the panel.

Mr. STEARNS. Thank you, Mr. Chairman.

I would just say to this panel here, it is like the dentist chair.

We are almost over, so we appreciate your forbearance here. And

I just have the last set of questions here, right, Mr. Chairman? So

after me we are all done.

There is a couple of things we just want to get on the record, so

I will just take you through it.

And I will start with Mr. Striplin, if you would answer this, what

was the first that the company, that you learned that the company

was going to be financially impacted by the Medicare reimbursement policy about $175 million? Was it at a Board meeting?

Mr. STRIPLIN. Yes. Yes.

Mr. STEARNS. And we understand it was, I think, in prior testimony you have given August 26, 2002?

Mr. STRIPLIN. Yes. Yes.

Mr. STEARNS. So over a year ago you were told about the $175

million impact because of the Medicare reimbursement, right?

Mr. STRIPLIN. Right.

Mr. STEARNS. Did Mr. Scrushy tell the Board about the material

impact of this $175 million?

Mr. STRIPLIN. Yes, he did.

Mr. STEARNS. Did you have any suspicions about the announced

impact on the company?

Mr. STRIPLIN. Well, we had just been told that it was going to

be about $15 million—$15 to $20 million, as I recall within 30 days

of that. And it was sort of a shock to all of us.

Mr. STEARNS. To hear $175 million?

Mr. STRIPLIN. That is right.

Mr. STEARNS. Go up from $15 million to $175 million?

Mr. STRIPLIN. That is correct.

Mr. STEARNS. In a matter of how many days?

Mr. STRIPLIN. As I recall, it was in 30 days.

Mr. STEARNS. Yes.

Mr. STRIPLIN. The prior Board meeting.

84

Mr. STEARNS. Do you recall the committee staff telling us that

you were shocked by the amount and you felt snookered by Mr.

Scrushy? Do you remember those words? We are just trying to get

these on the record. I think you indicated that you were sort of

flabbergasted and I think the words you used, you were shocked

and snookered by Richard Scrushy. So we are just asking confirmation for the record on that.

Mr. STRIPLIN. I think I did make that statement.

Mr. STEARNS. Okay. And perhaps you would maybe just give us

why you felt that way. Was it just an emotional or did you have

an intellectual reason for it?

Mr. STRIPLIN. No. I just felt like that in a short period of time

that we didn’t know what we were talking about.

Mr. STEARNS. Yes, it was getting out of hand.

Mr. STRIPLIN. One of those kind of things.

Mr. STEARNS. Did you ever call Mr. Scrushy after the Board

meeting of that August 26, 2002 to discuss the $175 million impact?

Mr. STRIPLIN. I do not recall.

Mr. STEARNS. Yes.

Mr. STRIPLIN. I do not think I did.

Mr. STEARNS. Well, we have here you do recall it in a prior testimony, so we are just——

Mr. STRIPLIN. Well, remind me.

Mr. STEARNS. In fact, you said yes and then you went on to say

you asked Mr. Scrushy, you said ‘‘What the hell is going on here

with this number.’’ That is what, Mr. Striplin, you told us, the staff

here. So we are just trying to get it on the record.

Mr. STRIPLIN. Well, if I said that, I think that it was true.

Mr. STEARNS. Okay. I mean, it is a pretty quote, what in the hell

is going on.

Mr. STRIPLIN. Yes.

Mr. STEARNS. I think that was a good quote. Yes.

I guess the next question is after you said that, what did Mr.

Scrushy say to you?

Mr. STRIPLIN. I do not recall. I was known to confront a lot on

different things.

Mr. STEARNS. Oh, you were?

Mr. STRIPLIN. Yes.

Mr. STEARNS. Do you recall, this is what you told our staff, you

said that Mr. Scrushy responded ‘‘We have just got some things we

have got to charge off.’’ Do you remember him or recall him saying

that to you?

Mr. STRIPLIN. I do not really recall that. But if I said that at the

time, I did remember it.

Mr. STEARNS. Okay. All right.

Mr. STRIPLIN. Yes.

Mr. STEARNS. Did you ever tell any other Board members about

this conversation, your feelings and your conversation with Mr.

Scrushy? I mean, this is a pretty big impact. It goes from $15 million to $30 million to $175 million. At some point did you share

this with other Board members?

Mr. STRIPLIN. Not that I recall.

85

Mr. STEARNS. Let me ask the rest of the Board members if the

conversations that we have just had did Mr. Striplin, Mr. Gordon,

tell you anything about his conversation with Mr. Scrushy in which

he said what the hell is going on and Scrushy oh, we’re just charging off a couple of things? Do you remember that?

Mr. GORDON. No.

Mr. STEARNS. Ms. Givens?

Ms. GIVENS. No, I do not.

Mr. STEARNS. And Dr. Watkins?

Mr. WATKINS. No.

Mr. STEARNS. And Mr. May?

Mr. MAY. I was not aware of the conversation.

Mr. STEARNS. Okay. I guess, Mr. May, you were not there at the

time.

Let me go then, Mr. Gordon, if you would be so kind, we are

going to Tab 90. And I will take a moment here for you to get to

Tab 90. And specifically I am talking about page 2 at the bottom

of the page. This Tab 90 represents minutes of the February 7,

2003 Board meeting, and I draw your attention to the bottom that

states ‘‘Mr. Scrushy also advised the Board that he was seeking approval from the Board to leave Dr. Watkins’ stock options open

until their normal expiration date as part of his agreement to be

available to consult with the Board on an as-needed-basis. After

discussion upon mother duly made by Mr. Striplin and second by

Mr. Newhall, the following motion was approved with Mr. Gordon

abstaining.’’

So the question is in the whole matter of life do you remember

that, Mr. Gordon, abstaining?

Mr. GORDON. Yes, I do.

Mr. STEARNS. Okay. I guess the question we are all asking is

why did you abstain?

Mr. GORDON. I abstained because I had recognized Bill’s excellent service to the Board and I thought Dr. Watkins had been a

very capable Board member. But he had options that were remaining outstanding that expired over the next 6 or 8 years. And I did

not think it was appropriate that a Board member who resigned

should maintain his stock options. If he resigned, he could exercise

them at that point. But he was not entitled to maintain them over

the next 6 to 8 years. So I discussed the fact that I did not think

it was appropriate for him to have his options extended that long.

Mr. STEARNS. That sounds like a square shooter. I think you are

saying something that most of us would all agree with. But what

did Mr. Scrushy say about why Dr. Watkins’ stock options should

be extended? I mean, did he say something in a meeting that you

recollect?

Mr. GORDON. Yes. He says let us let him have them, we might

need him to testify sometime.

Mr. STEARNS. He said we might need him to testify. Now, testify,

what did you think he meant when Mr. Scrushy said let us give

him the stock option and by so doing would you not consider that

quid pro quo or some kind of salve here to get him in case he has

to testify, that he would be on the right side; is that not what you

are saying? That is the implication.

86

Mr. GORDON. In my mind, I thought that was the implication

and I thought it might be flip. I did not really know if he was making a flip or not.

Mr. STEARNS. So Mr. Scrushy said he might be called to testify.

Now ‘‘called’’ does not mean by the Board.

Mr. GORDON. I think he might be required to testify.

Mr. STEARNS. Must be required. So that would require the law

would ask him to testify. Would that be a safe understanding in

your estimation, somebody beyond the Board? Because the required

is not voluntary. So Mr. Scrushy at that point was saying maybe

in a indirect fashion that, hey, we had better be nice to this fellow

because he might be required to testify under oath.

So my question to you is did that send up any flags?

Mr. GORDON. At that time things were coming to a conclusion

that they would eventually receive, and I think at that time, you

know, the comment was suspect, to say the least.

Mr. STEARNS. Yes. Well, Mr. Watkins, I guess you are next here.

So the question is the obvious thing here is it looks like a quid pro

quo just from the outside. So did Mr. Scrushy give—did you have

any conversations now that this was sort of a quid pro quo; we will

give you a stock option, if you are required to testify you will work

with us?

Mr. WATKINS. Never. In fact, I have never thought that until this

very minute that he said to the Board.

As part of my agreement when I resigned from the Board, I simply requested that I be allowed to keep my stock options. They

were all under water. They were worthless, but my feeling was it

was a reward for 18 years of service. It was not unusual business

practice to let a Board member continue to have their options. And

I agreed to be a consultant and help in any way with the company.

But I never have heard that quote before. And Richard Scrushy did

not say that to me. He may have expected that, but I certainly

never would have done that.

Mr. STEARNS. Mr. Scrushy never talked to you about this idea

that if you will resign, you will get your stock options? He never

mentioned anything like that to you?

Mr. WATKINS. No. No. Actually, I brought it up. I asked if I do

go ahead and resign, is it okay if I go ahead and just keep my stock

options. I know they are under water, they are worthless, but I

would like to keep them because I have faith in this company. And

I will be glad to work for it.

Mr. STEARNS. Okay. Had you ever heard what Mr. Gordon said

before? You said this is the first time you have ever heard that Mr.

Scrushy said he may be required to testify?

Mr. WATKINS. Absolutely. I have never heard that before.

Mr. STEARNS. Okay. Anybody else know anything? Okay.

Let me move to my last, Mr. Chairman, series of questions here.

And this is to Mr. May.

If you would be so kind to turn to Tab 25, it is one page. It is

a memorandum to George Strong from yourself. You are acting

chief executive officer. This is dated June 11, 2003.

Mr. MAY. Actually the date that is on the memorandum is not—

that is the date this memorandum was printed. The timeframe in

87

which the memo was originally created and sent to George, was

back in March 2003.

Mr. STEARNS. The date on the memo from George Strong is

wrong?

Mr. MAY. Correct.

Mr. STEARNS. And the date should be March 2003?

Mr. MAY. Correct.

Mr. STEARNS. And is it just what? The computer puts it out,

when the set of computers some date, or tell me why the wrong

date here. I mean, how would you argue that it is the wrong date

when it says ‘‘6/11/2003?’’

Mr. MAY. I know when I created the document.

Mr. STEARNS. Okay.

Mr. MAY. And when it was printed for the committee.

Mr. STEARNS. Okay. Let me just review this. I will sort of paraphrase because you know the thing.

The main point of this memo, and I will not laboriously go down

and read it, but the question was are there any Enron type issues

or exposure here. Ernst & Young focused heavily on those type of

items when evaluating our books. And what Mr. Strong said ‘‘What

assurance can we have from Ernst & Young that next year we do

not have the same issues? Obviously, if we do the consequences

would be disastrous. I leave this question in your hands to handle

as you deem appropriate.’’

So, I guess what about Mr. Lamphron’s statements to the Board

prompted you to raise these issues with the Chairman of the audit

committee?

Mr. MAY. There were a couple of things. At that meeting we were

handed a set of minutes for approximately the last 12 months to

approve. I asked that they must be given to me to review before

given to a whole Board to be approved. I took those minutes with

me and at that Board meeting, E&Y, this is the year end, E&Y

gave their year end report about the work that they had done in

the previous year and how the Board could rely on E&Y’s assurances that the books accurately reflected the business, etcetera,

etcetera.

So on the way home I was reading these minutes to review them,

and came upon the minutes from the previous year’s meeting, same

time. And those minutes reflected in 1901 the extensive work that

E&Y did in taking a look at our books and records in light of the

fact that Enron and WorldCom and all of those companies had

made the news that year.

Mr. STEARNS. Yes.

Mr. MAY. So at the Board meeting in Orlando that happened in

2003 for a year end 2002, I heard similar assurances from E&Y

and at that same Board meeting there was—we had our fourth

quarter earnings report where we had significant write-offs.

Mr. STEARNS. $600 million charge was inconsistent with—was

there not a $600 million dollar write-off?

Mr. MAY. Correct. So my question was with such a careful exam- ination, why are we having a $600 million charge off.

Mr. STEARNS. Now, again, like we talked about these with this

Striplin, was this not presented at the eleventh hour? I mean, it

is sort of like just came out under the cracks, $600 million charge?

88

And was this not sort of inconsistent with the eleventh hour call,

as you understand it?

Mr. MAY. I believe that we were—the Board was notified of the

charge off the day prior to the earnings release, I believe. If that

is your question.

Mr. STEARNS. And what was your reaction to that? I mean, did

you have the same reaction as Mr. Striplin and say what the hell

is going on?

Mr. MAY. I certainly had a lot of questions as to why the Board

was not given more notice than the day prior to the earnings release.

Mr. STEARNS. When these things happen like this, do they—

when you go home at dinner at night, I mean do you say, hey we

got to do something here. Something is going on here. Tomorrow

morning I am getting up early and I am going in there and heads

are going to roll.

I mean, what did you do in terms of activity the next day with

this?

Mr. MAY. You certainly, you know, ask yourself those questions;

what is it that you can do to get at answers. And then I think——

Mr. STEARNS. But you just took the answer as credible and

moved on?

Mr. MAY. The answer to what, sir?

Mr. STEARNS. That the $600 million popped up?

Mr. MAY. No, I would not say we took the answer as it was laid

out. We wanted to have answers as to why the charge offs were,

you know, were to the size that they were.

Mr. STEARNS. Yes.

Mr. MAY. And then certainly simply a few weeks later is when

the revolution of the fraud occurred.

Mr. STEARNS. Did you ask him why it came up so soon and so

unexpectedly? And what was his reply?

Mr. MAY. The question was—I believe was answered or asked on

the call that we had prior—the evening prior to earnings release

as to why, you know, we were given such notice. And the answer

was that there was a lot of complicated things that needed to be

done at the year end.

Mr. STEARNS. Who gave you that answer, just for the record?

Who gave that answer that——

Mr. MAY. I cannot——

Mr. STEARNS. [continuing] certain things just came up?

Mr. MAY. I cannot be certain exactly who gave me that answer.

But I believe it was Bill Owens.

Mr. STEARNS. I assume it must have been the chief financial officer?

Mr. MAY. Again, I am not certain, but I believe it was Bill

Owens.

Mr. STEARNS. Okay. What was the response of Mr. Strong? Did

Mr. Strong respond to your suggestion, your memo?

Mr. MAY. Mr. Strong indicated verbally to me that, you know, it

was something that he would look into and make sure that we got

answers on.

Mr. STEARNS. Did he actually get answers on this?

89

Mr. MAY. I am not certain. You would have to ask George. But

as I said, a couple of weeks later or just a few weeks later, you

know, the world fell apart with the fraud disclosure.

Mr. STEARNS. Let us move until today. You are sitting in your

desk operating now as the acting chief executive officer. If this had

occurred to you today, what would be your response?

Mr. MAY. If this type of write-off occurred at your end?

Mr. STEARNS. If you were notified in such short notice like you

were, I mean if you had the same thing happen to you today, I assume your behavior might be a little different?

Mr. MAY. I would say I would look——

Mr. STEARNS. Would you accept the fact that somebody told you

these are just some write-offs, nothing to worry about?

Mr. MAY. No, I would throw them out the door.

Mr. STEARNS. I think that is what you would do, yes.

Thank you, Mr. Chairman.

Mr. GREENWOOD. The Chair thanks the gentleman.

The Chair thanks the panel.

Ms. Givens, just one final request. If you would, either you or

would you have your attorneys send us a copy of the report that

they determined your independence with regard to the audit committee, that would be helpful for our inquiry.

Ms. GIVENS. Be happy to.

Mr. GREENWOOD. We thank all of you for being here for these

many hours. We wish all of you and HealthSouth well as you try

to reconstruct this company into the future.

Thank you.

And we are going to recess now until 2:30. And we will take the

third panel at that time.

[Whereupon, at 1:58 p.m., the subcommittee recessed, to reconvene at 2:37 pm. the same day.]

Mr. GREENWOOD. The committee will come to order. We welcome

the third panel, who have already found themselves to the table.

Let me introduce you, Mr. Richard Dandurand. Am I pronouncing that right?

Mr. DANDURAND. Yes, Mr. Chairman.

Mr. GREENWOOD. All right. Is the former engagement partner on

HealthSouth account at Ernst & Young; Mr. Wayne Dunn is the

former senior manager on HealthSouth account at Ernst & Young,

and; Mr. James Lamphron is a former engagement partner on

HealthSouth account at Ernst & Young.

Gentlemen, as you may know, this committee takes its testimony

under oath, and so I need to ask if any of you object to giving your

testimony under oath this afternoon.

Mr. DANDURAND. No, I don’t.

Mr. GREENWOOD. Okay. I need to also advise you that pursuant

to the rules of the House and this committee, you are entitled to

be represented by counsel. Do you wish to be represented by counsel this morning? Okay. And are you all represented by the same

counsel?

Mr. DANDURAND. That’s correct.

Mr. GREENWOOD. Okay. Mr. Lamphron, would you identify your

counsel by name and point to them, so we know who they are?

90

Mr. LAMPHRON. Sitting directly behind me is Steve Farina and

Matt Harrington of Williams & Connelly.

Mr. GREENWOOD. Okay. Very well.

In that case, I am going to ask if you would stand and raise your

right hands.

[Witnesses sworn.]

Mr. GREENWOOD. Okay. You are under oath. And it is my understanding that Mr. Lamphron is going to give an opening statement

of approximately 7 minutes for all three of you.

Mr. LAMPHRON. That is correct.

Mr. GREENWOOD. That is fine. And the floor is yours, sir.

TESTIMONY OF JAMES P. LAMPHRON, FORMER ENGAGEMENT

PARTNER ON HEALTHSOUTH ACCOUNT AT ERNST & YOUNG;

RICHARD DANDURAND, ENGAGEMENT PARTNER,

HEALTHSOUTH ACCOUNT AT ERNST & YOUNG; AND WAYNE

DUNN, FORMER SENIOR MANAGER ON HEALTHSOUTH ACCOUNT AT ERNST & YOUNG

Mr. LAMPHRON. Thank you.

Good afternoon, Chairman and members of the subcommittee.

My name is Jim Lamphron and I am a partner in the firm of

Ernst & Young. Beginning with the audit for the year 2000 I

served as the engagement partner with responsibility for the financial statement audits that we performed for HealthSouth.

I am here this morning with my colleague Wayne Dunn, who for

the last several years has been the senior manager on the engagement, and my former partner who is now retired, Dick Dandurand.

Dick was the engagement partner on HealthSouth before I took

over.

I am 56 years old, married for 34 years, and have 3 adult children. After completing my undergraduate degree and serving as an

officer in the Marine Corps, I became an auditor in 1975. That was

with the firm of Arthur Young & Company that later merged in

1989 with Ernst & Whinney to form the firm of Ernst & Young.

Both firms were founded approximately 100 years ago, and today

Ernst & Young employs over 25,000 people in the United States.

First let me say that, to a person, we at Ernst & Young feel for

and share the outrage of the many upright and decent people at

HealthSouth, and in the investing community who have been

harmed by this fraud. Investors, retirees and employees have all

been harmed. As a resident of Birmingham, I can attest that the

entire city has suffered and will continue to suffer from the

aftereffects of the fraud perpetrated at HealthSouth.

I don’t know of another fraud that is quite like. According to the

Department of Justice and the SEC, a specific aim of the criminal

conspiracy was to undermine and sabotage Ernst & Young’s work

as auditors. The fraud is also unprecedented in terms of management involvement. Yesterday. the company’s founder and CEO,

Richard Scrushy was indicted on 85 counts of fraud and other

charges. And as you know, 14 other HealthSouth executives have

already pled guilty, including every former CFO. And the U.S. Attorney in Birmingham says that the indictments will continue, and

that her probe is extending further into non-financial areas of the

company. As you observed at the first of these hearings, Chairman

91

Greenwood, HealthSouth presents the unique and uniquely troubling story of a corrupt criminal enterprise.

At the outset, let me try and answer a few of the questions that

I think you may have.

People ask me how a fraud of this scale could go undetected by

the auditors. The U.S. Attorney has stated over and over again

that we were a target of the collusive fraud. We were given fake

documents, altered documents, and were lied to, over and over

again. Through the collusion among the senior management of

HealthSouth, our audit was impeded and undermined. As Teresa

Sanders, the former head of Internal Audit at HealthSouth, testified before this subcommittee, and I will say as Mr. Wallance testified before this subcommittee this morning, when you have a collusive fraud involving multiple members of management and where

documents are falsified, it is entirely possible to defeat a financial

statement audit.

People ask me if, in hindsight, there was one more thing that I

or my team would have done. I have asked myself that question

many times since March 19. I have looked back through our work

papers. I have tried to find that one string that, had we yanked it,

would have unraveled this fraud. I know we planned and conducted

solid audits. We asked the right questions. We sought out the right

documentation. Had we asked for additional documentation there

or asked another question there, I think that it would have generated another false document and another lie. With each guilty

plea that is announced, we see where the fraud was systematically

expanded to undermine our audit procedures.

Finally, people ask me what is the likelihood of this happening

again. The shorter answer is that there is no system, no audit and

no law that can be made invulnerable to a collusive band of criminals. Character and ethics cannot be legislated. That said, I believe

our system has been significantly strengthened of late, the requirements and procedures legislated by Congress in the SarbanesOxley Act will, in my estimation, make another fraud of this type

less likely. It fact, it may be that the requirements for officer certification and harsh criminal penalties is what brought down the

walls of silence around this fraud. The new rules being adopted by

the SEC and The New York Stock Exchange will also promote corporate accountability and improve corporate guidance.

I also believe the U.S. Attorney in Birmingham should be praised

for her vigorous prosecution of this case. And the hearings being

held by this subcommittee will undoubtedly be constructive in publicizing the aftereffects of the fraud further, so as to discourage others from following the same path.

Finally, let me say, I have spent almost 3 decades building my

professional reputation. The criminals that ran HealthSouth exploited many people, including me and my colleagues and throughout the firm. In a very personal way I share the anger and frustration of this subcommittee, the investing public and the Birmingham community.

Mr. Chairman, we have worked to assist you and your staff in

every respect during the course of the subcommittee’s investigation.

I am happy to answer the subcommittee’s questions, as are my colleagues.

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[The prepared statement of James P. Lamphron follows:]

PREPARED STATEMENT OF JAMES P. LAMPHRON

Good Morning Mr. Chairman and members of the Committee. My name is Jim

Lamphron and I am a partner in the firm of Ernst & Young. Beginning with the

audit for the year 2000 I served as the engagement partner with responsibility for

the financial statement audits Ernst & Young conducted for HealthSouth Corporation. I am here this morning with my colleague Wayne Dunn, who for the last several years has served as senior manager on the HealthSouth audit. My former partner Richard Dandurand, now retired, also joins me. Dick was the engagement partner on HealthSouth before I took over.

After completing my undergraduate degree and serving as an officer in the United

States Marine Corps, I became an auditor in 1975. That was with Arthur Young

& Co., which combined with Ernst & Whinney in 1989 to form Ernst & Young. Both

of the predecessor firms were founded approximately 100 years ago, and today Ernst

& Young employs more than 20,000 people in the United States.

First let me say that, to a person, we at Ernst & Young feel for the many outstanding and decent people at HealthSouth and in the investing community who

have been harmed by the HealthSouth fraud. Investors, retirees and employees

have all been harmed. Residing in Birmingham, as I do, I can attest that the entire

city has suffered and will continue to suffer from the aftereffects of the fraud perpetrated at HealthSouth.

I don’t know of another fraud that is quite like HealthSouth. According to the Department of Justice and the SEC, a specific aim of the criminal conspiracy at

HealthSouth was to undermine and sabotage Ernst & Young’s work as auditors. The

fraud is also unprecedented in terms of management involvement. So far, fifteen

HealthSouth executives have pled guilty to fraud, including every former Chief Financial Officer. And the US Attorney in Birmingham advises that the indictments

will continue, and that her probe is extending further into non-financial areas of the

company. As you observed at the first of these hearings, Chairman Greenwood,

HealthSouth presents the unique and uniquely troubling story of a corrupt criminal

enterprise.

At the outset, let me try and answer a few of the questions that I think you may

have.

People naturally ask me how a fraud of this scale could go undetected by the auditors. The US Attorney has stated over and over again that we were a target of the

collusive fraud. We, the auditors, were given fake documents, altered documents,

and were lied to, over and over again. Through the collusion among the senior management of HealthSouth, our audit was impeded and undermined. As Teresa Sanders, the former head of Internal Audit at HealthSouth, testified before this Subcommittee, when you have a collusive fraud involving multiple members of management and where documents are falsified, it is entirely possible to defeat a financial

statement audit.

People ask me if, in hindsight, there was one more thing that I or my team should

have done. I have asked myself that question many times since March 19th. I have

looked back through our workpapers. I have tried to find that one string which, had

we yanked it, would have unraveled the fraud. I know we planned and conducted

solid audits. We asked the right questions. We sought out the right documentation.

Had we asked an additional question here, or asked for an additional document

there, I am convinced that the fraud and deceit would have expanded to generate

another lie, another fake document. With each guilty plea that is announced, we see

where the fraud was systematically expanded to undermine our audit procedures.

People also ask me about internal controls and if HealthSouth had appropriate

controls in place. A simple example of an internal control that is probably familiar

to all of us is the requirement of two signatures on checks of a certain size. That

is a classic internal control, and is drawn from a basic insight about human nature:

a one-person crime is far more likely than a two-person crime. The internal controls

at a large corporation are an application of the same principle, albeit often more

complex. We look to see that multiple layers of people and departments are involved

in different transactions. We look for sign-offs. We look for documentation. What did

my team do at HealthSouth? We did all those things and more. HealthSouth had

in place a formidable system of internal controls. Could those controls be circumvented by a fraud that encompassed the entire senior management of the company? The unfortunate answer is yes.

Finally, people ask me what is the likelihood of this happening again. The short

answer is that there is no system, no audit, and no law that can be made completely

invulnerable to a collusive band of criminals. Character and ethics cannot be legisVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00100 Fmt 6633 Sfmt 6621 91232.TXT HCOM1 PsN: HCOM1
93

lated. That said, our capital market system has been significantly strengthened of

late. The requirements and procedures legislated by Congress in the Sarbanes-Oxley

Act will, in my estimation, make another fraud of this type less likely. It may be,

indeed, that it was the requirement of officer certifications and the threat of harsh

criminal punishment that finally brought down the walls of silence surrounding the

HealthSouth fraud. New rules being adopted by the SEC and the exchanges will

also promote corporate accountability and improve corporate governance. The US

Attorney in Birmingham should be praised for her vigorous prosecution of this case,

which sends the right message. And the hearings being held by this Subcommittee

will undoubtedly be constructive in publicizing the aftereffects of the fraud so as to

discourage others from following the same path.

Mr. Chairman, we have worked to assist you and your staff in every respect during the course of the Subcommittee’s investigation. I am happy to answer the Committee’s questions, as are my colleagues.

Mr. GREENWOOD. Thank you, Mr. Lamphron. I appreciate that.

And thank you for your cooperation thus far, thank you for your

corporation in the next hour or so.

Has Ernst & Young, as you have reviewed documents that describe how this fraud was perpetrated, and as you have even recently I am sure you have read the indictment where a lot of this

is set forth, has Ernst & Young changed any of its procedures?

Have you sat around the table and brainstormed how you might

change procedures so that this does not happen again?

Mr. LAMPHRON. Well first, Mr. Chairman, let me say that we

really have not been able to examine documents relating to the

fraud. We have, of course, gone back and reviewed our work papers, our procedures, our processes.

The firm has addressed this and other situations. For example,

we early adopted many of the provisions of the new auditing standard on fraud. We did that in 2002.

We have conducted extensive training of our people. As an example in the past year or so I have been to 40 hours of training dealing with Sarbanes-Oxley, SAS 99 fraud awareness.

Mr. GREENWOOD. But when you say have not been to see documents, what I want to know is have you had the opportunity, I

mean HealthSouth still exists, it is under new management, you

have some new people on the Board and so forth, have you been

able to go in and look at documents within the company at all?

Mr. LAMPHRON. We have not.

Mr. GREENWOOD. You have not? And why is that?

Mr. LAMPHRON. I am not sure. I—I——

Mr. GREENWOOD. Have you asked for the opportunity?

Mr. LAMPHRON. We have been—I have been led to believe that

we do not have access to the documents.

Mr. GREENWOOD. And who led you to believe that?

Mr. LAMPHRON. Well, in general conversations with my attorney.

Mr. GREENWOOD. That you do not have access to—that Ernst &

Young cannot go back and look? In other words, I understand you

reviewed your work papers. But, obviously, there are—and I do not

know whether it may be the case that the Justice Department has

ceased all these documents, you do not have access to them for that

reason. Is that your understanding?

Mr. LAMPHRON. Well, that could be part of it. Another reason

might be because Pricewaterhouse is in the process of conducting

a forensic audit. They are not through with that. My understanding

is it will be some time before they release their findings.

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Mr. GREENWOOD. Okay. So is it fair to say that this company

through fraud, there is no dispute about that, and you guys were

lied to——

Mr. LAMPHRON. Correct.

Mr. GREENWOOD. And you were lied to to the tune of $2.4 billion

dollars of the phony income that they got by you that you were not

able to know; you still do not know how they did that?

Mr. LAMPHRON. Our knowledge of that is limited to the things

we have read in the press. Probably, maybe even less than the extent that you know.

Mr. GREENWOOD. Yes. Okay. Have you had a chance to review

the indictment?

Mr. LAMPHRON. I have scanned the indictment and discussed it

with our attorneys.

Mr. GREENWOOD. Okay. Let me ask you to turn to Tab 78 in the

binder, please. And I am going to ask all of you to look at that.

Mr. Lamphron and Mr. Dunn, this is the email from former

HealthSouth employee Michael Vine to Ernst & Young in which he

asserted that there were ‘‘severe problems with the company’s accounting, particularly with respect to the capitalization of expenses

in certain accounts.’’

When and how were you first made aware of the allegations in

this complaint?

Mr. LAMPHRON. I was made of that when, as you may see there,

the email was sent to one of our national websites and on July 1

that email was routed to me.

Mr. GREENWOOD. Okay. And what did you do with that email?

Mr. LAMPHRON. Immediately I called our professional practice director, that is the person in our consulting chain. I informed him

of the contents of the email. And together we planned to discuss

what we should do, our communications and our investigation.

Mr. GREENWOOD. And did you inform HealthSouth about the allegations?

Mr. LAMPHRON. I did. I made a call the very next day. This was

July 2. Near the July 4 holiday. The only person I could reach at

that time was Weston Smith, who was controller at the time. I informed him of the allegations. I asked for a—to see if we could put

together a conference call with Richard Scrushy, Bill Owens and

himself.

Mr. GREENWOOD. Did you inform the audit committee at

HealthSouth about this?

Mr. LAMPHRON. Not right at that time, but later I did. I had——

Mr. GREENWOOD. When was that?

Mr. LAMPHRON. That was after we had—the company had conducted their investigation, after we had talked to them, after we

had conducted our independent investigation. And then I talked to

the Chairman of the audit committee and informed him of our findings. And at that point he indicated he was satisfied with what we

had done.

Mr. GREENWOOD. So how did you proceed to looking into this?

What did you do to satisfy yourself with regard to this memo internally as Ernst & Young?

Mr. LAMPHRON. Sure. The first thing we did was, of course, notify the company and give them an opportunity to—a brief period

95

of time to perform their own investigation to see if there were anything to these allegations.

We met with them a few days later. They discussed——

Mr. GREENWOOD. And let me stop you there. Is there such thing

as a standard operating procedure when an auditing firm receives

a tip from an outside party alleging misconduct on the part of a

client?

Mr. LAMPHRON. Absolutely.

Mr. GREENWOOD. At least in retrospect, my inclination would be

well, gee, if my client is cooking the books, I am not sure that the

first thing I want to do is to tip them off to the allegation. I might

want to look at it internally ourselves to see if we are missing

something. Because, as you said in your opening statement, if they

want to go back and give you another false statement, it would not

be hard to do.

Mr. LAMPHRON. Well, there is two pieces of auditing literature,

SAS 54, illegal acts, and SAS 99 on dealing with the detection of

fraud during an audit, both of which say if something like this occurs, we are to communicate to management at a level higher than

where the issue or the fraud was reported, which we did. And in

fact, went all the way to the audit committee level.

Mr. GREENWOOD. Did Mr. Owens ever suggest that Mr. Vines

might have had a motive behind his allegations?

Mr. LAMPHRON. He did. When we met with him after they had

conducted their investigation, they mentioned that Mr. Vines had

been fired during a few months previous to this.

Mr. GREENWOOD. Did they say why?

Mr. LAMPHRON. Yes. They said he had been—had several instances of I think it was fraternizing with women in the department or women he had been supervising. He had been warned

about it by human resources. Had been on several occasions. And

in a final case had been released.

Mr. GREENWOOD. Did you review Mr. Vines’ personnel record to

verify that?

Mr. LAMPHRON. I did not.

Mr. GREENWOOD. Okay. Did you try to contact Mr. Vines personally either by phone or email to gain fuller understanding of his allegations before commencing the investigation?

Mr. LAMPHRON. Well, I did but I would first say that his——

Mr. GREENWOOD. When did you do that?

Mr. LAMPHRON. I did that after discussing our findings with the

Chairman—I did try. Let me clarify that. No I did contact him.

Mr. GREENWOOD. But still after you went to the company? In

other words, when the email came in, you looked at the email, his

email address is not—is right on there. You did not attempt to engage him directly in a conversation?

Mr. LAMPHRON. I did not. If you—you know, reading the email

you can see that it was very, very specific and down to the point

of identifying the specific accounts that were affected. We thought

at that point we had enough knowledge to conduct our investigation.

Mr. GREENWOOD. Okay. But you did not think it would have

been prudent if you had contacted him first?

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Mr. LAMPHRON. No. Again, I felt like we had enough direction in

his email to begin the investigation.

Mr. GREENWOOD. Before commencing your review, did you make

any attempt to discover which division of HealthSouth Mr. Vines

worked in or which business units or regions of the company Mr.

Vines had responsibility for in order to better focus your inquiry?

Mr. LAMPHRON. Well, we knew that he worked in fixed assets,

in which division, I do not think we knew at the time. But we——

Mr. GREENWOOD. You knew that because the company told you

that?

Mr. LAMPHRON. But we expanded our investigation to include all

divisions.

Mr. GREENWOOD. Okay. Did you know at the time that he

worked in the in-patient division, and did you know that this business unit of nationwide responsibility was unit three?

Mr. LAMPHRON. Well, at the time I did not, but that is not entirely correct. He handled in-patient facilities and also handled 500

out-patient facilities. Between he and his two cohorts, they handled

all 1881 facilities.

Mr. GREENWOOD. But did you know that he had sole responsibility for unit three?

Mr. LAMPHRON. No, I knew there were three people who divided

the work up. And, again, we tested records from all three divisions.

Mr. GREENWOOD. Is it true that you only learned about Mr.

Vines’ position in the in-patient division after he testified in April

2003 at the Scrushy Asset Forfeiture hearing?

Mr. LAMPHRON. That is correct.

Mr. GREENWOOD. Okay. Is it not also true that you did not learn

which business units Mr. Vines had responsibility for until after

committee staff inquired about them to you doing a recent interview?

Mr. LAMPHRON. I do not know.

Mr. GREENWOOD. Okay. Let us turn to the actual review you did.

I understand that Ernst & Young requested that HealthSouth provide all reclassifications from the three accounts mentioned by Mr.

Vines in his email, is that right?

Mr. LAMPHRON. That is correct.

Mr. GREENWOOD. Okay. I also understand that in two of the

three schedules of reclassifications provided to you by HealthSouth,

there were no reclassifications from business unit No. 3, the business unit for which Mr. Vines had principal nationwide responsibility. Did you notice that at the time of your review?

Mr. LAMPHRON. No, because that is not correct.

Mr. GREENWOOD. Okay. Help me out.

Mr. LAMPHRON. There were reclassifications from business unit

three, which we examined and found them to be appropriate.

Mr. GREENWOOD. But in only in one of the three accounts, is that

correct?

Mr. LAMPHRON. I do not know.

Mr. GREENWOOD. Okay. Mr. Dunn, do you know?

Mr. DUNN. I do not know the answer to that, no sir. I believe a

couple of the accounts did not have 03, but I do not know if it was

only one.

97

Mr. GREENWOOD. Okay. I do not know if you are able to check

your records, but the staff is telling me that you went over with

them when they interviewed you.

Mr. DUNN. We did—we did discuss that. And what I am saying

is I recall that it was not on a couple of the schedules we had, but

I do not recall that we had all the schedules that I investigated at

the time. If we remember our interview, we talked about the fact

that I only kept certain of the documents. And so I did not know

if there were items from 03 for the other ones I did not retain.

Mr. GREENWOOD. And when did you first learn that the data

runs provided by HealthSouth did not include any unit three reclassifications in two of the three accounts? Is it not true that the

committee staff had to recently point this out to you in an interview?

Mr. DUNN. Say that again, please.

Mr. GREENWOOD. When did you first learn that the data runs

provides by HealthSouth did not include any unit three reclassifications in two of the three accounts?

Mr. DUNN. I do not know when I first learned that. I do not know

if I learned it at the time of the staff or if I had seen it previously.

But we did discuss that with the staff.

Mr. GREENWOOD. Okay. So given the fact I assume that you did

not audit any of the reclassifications from business unit three and

two of the three accounts noted by Mr. Vines in his email, is that

your understanding? You did not audit any reclassifications from

business unit three in two of the three accounts noted by Mr. Vines

in his email?

Mr. DUNN. In two of the three accounts related to the information we had——

Mr. GREENWOOD. There were 7072 and 7995——

Mr. DUNN. I do not know the specific accounts, but I know it was

two of the accounts, and I do not know which period it was. I do

not know if it was the December period or the May period.

Mr. GREENWOOD. Okay. So it is correct that you did not audit

two of these three accounts for business unit three?

Mr. DUNN. For two of the three accounts there were not reclassifications associated with business unit three on some of the periods. And so we would not have any samples from business unit

three.

Mr. GREENWOOD. And with respect to the third account for which

HealthSouth provided Ernst & Young reclassifications from business unit three, you did not sample or review any unit three reclassifications below $5,000, is that right?

Mr. DUNN. I do not know the answer to that. I am sure it is in

the information we provided, but I do not know the answer to that.

Mr. GREENWOOD. Okay. Staff says that is correct.

So given that Mr. Vines’ concerns dealt with unit three reclassifications below $5,000, I take it that your conclusion that his allegations were unfounded is it itself unfounded?

Mr. DUNN. Well, I would point out that the email he sent did not

alleged any specific amounts. It just said reclassifications in those

accounts. So, you know, based on that there was not a reason we

would specifically look for items under $5,000.

Mr. LAMPHRON. Mr. Chairman, if I may?

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Mr. GREENWOOD. Yes, please.

Mr. LAMPHRON. First, let me tell you we took this allegation very

seriously. Mr. Dunn and I decided on our audit approach. Between

the two of us we have got 40 plus years of experience. And to the

best of our ability, we designed an approach to determine if his allegations were correct.

Now, I know that under oath in Federal court Mr. Vines testified

that his two co-workers, who between the three of them, encompass

every facility the company has, they were all engaged in fraudulent

activities. Our review encompassed all the divisions for several

months. And so at the time we thought what we did was sufficient.

Mr. GREENWOOD. But when he sent the email, I mean the thing

that struck us and the staff, and it is puzzling, is this is such a

specific email. This says ‘‘If you look under three rocks, you will

find three smoking guns.’’

Mr. LAMPHRON. Yes.

Mr. GREENWOOD. And it tells you exactly what to find. And what

we are trying to understanding why it is that it seems like in fact

the thing to have done with someone who has got that specific information, would have been to get in contact with him immediately

and say tell us exactly where to look.

Mr. LAMPHRON. Yes. Well, again Mr. Chairman, because the

email was so specific, we did not feel like we needed to do that at

this point.

Now, even today——

Mr. GREENWOOD. But Mr. Dunn was just saying, we did not have

specific enough—I mean, on one hand we are hearing you say we

did not have specific enough information to know where to look. On

the other hand, you are saying the information was so specific we

did not have to ask where to look. Which is it?

Mr. LAMPHRON. Well, it is that we—our review encompassed

every division for several months. And if what Mr. Vines says is

true, that his two cohorts were involved in that, and again he said

that in Federal court under oath, then our review should have discovered it.

Now, I need to say that even at this date we do not know that

what Mr. Vines was talking—mentioned in his email has anything

to do with this fraud that we are here today to discuss. In fact,

through counsel, Mr. Owens, the——

Mr. GREENWOOD. You are not saying you know that it did not.

You are just saying that you do know that it did?

Mr. LAMPHRON. We do not know that it did. And we know that

Mr. Owens subsequent to pleading guilty to the fraud charges, indicated that this was not how they did the fraud. And, of course,

us not having access to the corporate records at this point, we have

had no opportunity to go back and see if it was part of this fraud

or if it was not.

Mr. GREENWOOD. Okay. My time has long since expired.

The gentlelady from Colorado is recognized.

Ms. DEGETTE. Thank you very much, Mr. Chairman.

Following up on the Chairman’s questions, now you were in the

independent—and by the way, I do not know which of you did

what, so rather than waste my time saying what do you know,

99

chime in—you know, speak up when I ask these questions if you

know the answers, okay?

Mr. LAMPHRON. Yes, ma’am.

Mr. DUNN. Yes, ma’am.

Ms. DEGETTE. Thank you.

Now, you all were engaged as the independent auditors for

HealthSouth, correct?

Mr. LAMPHRON. That is correct.

Ms. DEGETTE. Now you received this now infamous email from

Mr. Vines, June 2, 2002, the one you were just talking to the

Chairman about, correct.

Mr. LAMPHRON. Correct.

Ms. DEGETTE. Now in this email it said ‘‘In December 2001

HealthSouth moved expenses to capital accounts.’’ And then it lists

specifically three accounts as of December 31, 2001, correct?

Mr. LAMPHRON. Correct.

Ms. DEGETTE. Now, what you have testified to, Mr. Lamphron,

is then what you did when you found this out in late June, you contacted the Board, I believe. Or who did you contact?

Mr. LAMPHRON. I contacted——

Ms. DEGETTE. You contacted Mr. Owens?

Mr. LAMPHRON. Mr. Owens, Mr. Smith, Mr. Harris and George

Strong.

Ms. DEGETTE. And you gave them an opportunity to research

this internally, and that is standard operating procedures for you?

Mr. LAMPHRON. That is correct.

Ms. DEGETTE. Correct?

Mr. LAMPHRON. Yes.

Ms. DEGETTE. How long did you give them again?

Mr. LAMPHRON. I first made them aware of this either on July

2 or July 3 and we met with them on July 8. And they reported

their findings and we began our independent investigation then.

Ms. DEGETTE. Now, when you began your independent investigation since, as you have testified, you had three specific account

numbers that Mr. Vines gave you, what did you do? Did you ask

the company to provide you with information on those accounts?

Mr. LAMPHRON. That is the only way that we get access during

the audit process. We ask——

Ms. DEGETTE. Did you ask them to provide all the information

on those accounts as of December 31, 2001?

Mr. LAMPHRON. We asked them—we selected 2 months during

the 2001 year.

Ms. DEGETTE. And what months were those?

Mr. LAMPHRON. Those were May and December and asked for all

the reclassifications from those three accounts, and actually one

more during those 2 months.

Ms. DEGETTE. Okay. And take a look at Exhibit 79 in your notebook. These are listings of some of the 7200 accounts from December 31, 2001. Mr. Dunn or Mr. Lamphron, whoever, does that look

like the information they gave you, the company gave you?

Mr. LAMPHRON. It does not look like the information he gave me.

Ms. DEGETTE. Okay. Well, what I would like you to do, the both

or if you want to, all three of you, flip through this exhibit. And

I will tell you what it is. We got this exhibit from Mr. Vines. And

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what it shows is that for a number of 7200 accounts it shows capital internet costs, page after page after. Three pages of it. Attached to that are what look like some ledger pages showing a variety of expenses being reclassified as software capital internet costs.

Can you see that in flipping through Exhibit 79 there?

Mr. LAMPHRON. Yes.

Ms. DEGETTE. Now, what it looks like to me is there is these accounts, like on the first page it says Florence Carpet & Tile, Inc.,

$541.73. Further down the page DoobyDoo Grease Exhaust System.

On the next page Nasif’s Texaco. And it goes on and on like that.

Hobart. Moody’s Sprinkler Company. Ace Glass Service. It is pretty

clear in looking at these ledger sheets that these are all expenses

from all of the HealthSouth facilities. Would that be fair to say?

Mr. LAMPHRON. Yes.

Ms. DEGETTE. But then when you look at it, he is transferring

it to capital accounts. Do you see that there, Mr. Lamphron? If you

look at, it says software capital internet costs. On those pages

where it says Florence Carpet & Tile and all of those.

Mr. LAMPHRON. Yes.

Ms. DEGETTE. Okay. And then you will have to take my word for

this because we have gone back through and looked at it, and gone

through it with Mr. Vines. You can trace these numbers here back

to the numbers on the first page by looking at both the facility

number and the amount.

Now, I do not know about you, but you guys are trained professionals. If you had this information, I would think Mr. Dunn, Mr.

Lamphron, you would say something is not right here. Would that

be accurate?

Mr. LAMPHRON. Very accurate.

Ms. DEGETTE. But you did not have this information, did you?

Mr. LAMPHRON. We did not.

Ms. DEGETTE. What you had was simply maybe not this list, but

lists of information like this that the company gave you that just

showed capital internet costs, right?

Mr. LAMPHRON. Correct.

Ms. DEGETTE. So there is no way Ernst & Young would have

been able to figure out that this information had been transferred

to a capital—which is, by the way, pretty standard basic accounting

fraud, right?

Mr. LAMPHRON. Yes.

Ms. DEGETTE. Capitalizing expenses?

Mr. LAMPHRON. Yes.

Ms. DEGETTE. That is pretty basic.

Mr. LAMPHRON. Yes.

Ms. DEGETTE. I only had to take accounting 101 to know that.

So, I mean, but if you did not have this, you would not know that

this was fraudulent, right?

Mr. LAMPHRON. Right.

Ms. DEGETTE. And you would not have known that that was

fraudulent unless you talked to Mr. Vines, right? Just based on

what the company’s giving you, you’re never going to be able to

find out where this information came from, right?

Mr. LAMPHRON. That is as we have subsequently learned, that is

correct.

101

Ms. DEGETTE. Right. And see, the problem is when you have

widespread fraud going on, it is the fox guarding the hen house.

Because you are asking the company that you are supposed to be

independently auditing for the information that they are not doing

what Mr. Vines says they are doing specifically. He said they are

capitalizing expenses, right?

Mr. LAMPHRON. That is correct. But——

Ms. DEGETTE. Now, I think probably it would be fair to say that

if you had to redo this today, you would have called Mr. Vines,

right?

Mr. LAMPHRON. Do what?

Ms. DEGETTE. If you had to redo this independent investigation?

Mr. LAMPHRON. Well, I tried to call Mr. Vines.

Ms. DEGETTE. Oh, you did?

Mr. LAMPHRON. I did.

Ms. DEGETTE. And what happened?

Mr. LAMPHRON. I placed three phone calls, got no answer. On the

third call I left—I identified myself, indicated I was with Ernst &

Young and asked him to call me.

Ms. DEGETTE. Did you try to try to email him?

Mr. LAMPHRON. I did not.

Ms. DEGETTE. Did you know that it was his phone? Did he—was

his voice on there identifying himself?

Mr. LAMPHRON. I am not sure how the message was at the time.

But it is the number that is identified in his email.

Ms. DEGETTE. And when did you try to contact him?

Mr. LAMPHRON. After we had our discussion with the Chairman

of the audit committee. And we thought it would be appropriate to

follow up with Mr. Vines.

Ms. DEGETTE. When was that?

Mr. LAMPHRON. Sometime later in July. I am not sure of the

exact date.

Ms. DEGETTE. Yes. By then, later in July, if you felt you had

done enough, you had been all the way through the audit committee, why were you trying to call Mr. Vines then?

Mr. LAMPHRON. Mr. Strong, Chairman of the audit committee

felt it would be appropriate to sort of close the loop with Mr. Vines,

tell him our findings and to——

Ms. DEGETTE. Let me help you out. Because in your notes it

says: ‘‘also decided to communicate with employee and let him

know we had followed up on his concerns,’’ and found nothing of

any concern, right?

Mr. LAMPHRON. That is right.

Ms. DEGETTE. So that is why you were trying to call him? You

had done your investigational calling and said there is nothing

wrong, right?

Mr. LAMPHRON. To let him know the results.

Ms. DEGETTE. Yes.

Mr. LAMPHRON. That is right.

Ms. DEGETTE. Okay. Now, the indictment that came down

against Mr. Scrushy yesterday said that HealthSouth had manufactured $370 million in cash accounts on its balance sheet. My

question is does not Ernst & Young as an auditor send out conVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00109 Fmt 6633 Sfmt 6602 91232.TXT HCOM1 PsN: HCOM1
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firmation letters to a client’s bank to see if the cash claimed on the

balance sheets actually exist?

Mr. LAMPHRON. We do. We do not send them out to every account. In the case of HealthSouth——

Ms. DEGETTE. How much of a company’s cash accounts do you

attempt to verify?

Mr. LAMPHRON. Well, let me say that they had over 2600 cash

accounts.

Ms. DEGETTE. Right. So how many of those letters——

Mr. LAMPHRON. We selected a sample choosing the most—the

largest balances, the most active accounts and sent confirmations

to those.

Ms. DEGETTE. How many was that, do you know?

Mr. LAMPHRON. I think it was around 50.

Ms. DEGETTE. Fifty out of 2600?

Mr. LAMPHRON. That is right.

Ms. DEGETTE. Do you think that that’s within industry standards for an independent audit?

Mr. LAMPHRON. Absolutely.

Ms. DEGETTE. Did all those accounts have money in them or

were they zero balance accounts?

Mr. LAMPHRON. A number of them had money in them. Some

were zero balance.

Ms. DEGETTE. How many of the 50 had money in them?

Mr. LAMPHRON. The 50?

Ms. DEGETTE. Yes.

Mr. LAMPHRON. I do not know.

Ms. DEGETTE. Is it not true that most of your audit was on this

pristine audit? Most of your time was spent on this pristine audit?

Mr. LAMPHRON. Absolutely not.

Ms. DEGETTE. Okay. You spent all of your time on the books?

Mr. LAMPHRON. I spent virtually zero time on the pristine audits.

Ms. DEGETTE. Well, what about other members of Ernst &

Young?

Mr. LAMPHRON. No one has—who was part of the engagement

team except, as I understand, maybe in the very first year to get

the program off and going, was involved in the pristine audits.

We——

Ms. DEGETTE. But, in fact——

Mr. LAMPHRON. We had separate engagement teams.

Ms. DEGETTE. Okay. But overall, the money that Ernst & Young

was paid was paid more for doing pristine audits than for doing financial audits.

Mr. LAMPHRON. Well, that is not correct either.

Ms. DEGETTE. That is not correct?

Mr. LAMPHRON. Not in any year did the fee for the pristine audits exceed our fee for doing audit work for the company.

Ms. DEGETTE. Okay. Thank you for clearing that up. Because

that is not the information that we were given.

Mr. LAMPHRON. Okay.

Ms. DEGETTE. But we will follow up in a few minutes.

I yield back right now.

Mr. GREENWOOD. The gentleman from Oregon, Mr. Walden, 10

minutes.

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Mr. WALDEN. Thank you, Mr. Chairman.

I wonder if any of you at the panel is familiar with a firm known

as CFRA? Does that ring a bell?

Mr. LAMPHRON. I have—the first time I heard of them was a day

ago.

Mr. WALDEN. Okay.

Mr. DUNN. Same thing.

Mr. WALDEN. Okay.

Mr. DUNN. Earlier this week.

Mr. WALDEN. Because, our staff has found a memo, perhaps provided by you all. Well, it is from 1995 to Ernst & Young from

CFRA where they appear to have done a rather thorough look at

HealthSouth. And on the cover of this memo on Ernst & Young letterhead, dated April 3, 1995, it is to G. Marcus Neas.

Mr. LAMPHRON. Neas.

Mr. WALDEN. Neas from James P. Conley. It says HealthSouth

Corp. Have you seen this? It is under Tab 69 in the book.

Mr. LAMPHRON. I have seen it, again, yesterday.

Mr. WALDEN. And you have read it?

Mr. LAMPHRON. Yes, sir.

Mr. WALDEN. Okay. Do you have any idea what the purpose of

this memo was, why it was done, why it was requested?

Mr. LAMPHRON. I would assume James Conley, Jim Conley was

a senior partner in our professional practice director group. A consulting partner.

Mr. WALDEN. Why would he have this in his possession?

Mr. LAMPHRON. Well, I can only guess and assume that somehow

this report came to his attention. He read it, he voiced his concerns

through this memo to Mark Neas, the engagement partner at the

time. And I would suspect that Mr. Neas responded back by April

19 as he was asked to do.

Mr. WALDEN. Except nobody can find the copy of that response,

is my understanding.

Mr. LAMPHRON. Well, that is my understanding also. But I would

like to add that, again, Jim Conley was our senior consulting partner. Very experienced, very knowledgeable, very well respected in

the firm. And I have total confidence that he would not have let

this drop.

Mr. WALDEN. Okay.

Mr. LAMPHRON. Mark Neas got back to him, I am certain of.

Mr. WALDEN. Then why would he put on here please do not copy

or send the report to the client?

Mr. LAMPHRON. I do not know.

Mr. WALDEN. Would that be standard on these sorts of reports;

someone senior in your company would say don’t share this report

with a client?

Mr. LAMPHRON. Well, I do not know. I would not say that is

standard. I do not know how he came to have this report. It, you

know, this report could be confidential, it could be for subscribers

to a newsletter or something. We just do not know.

Mr. WALDEN. Okay. But he had it, so it is in your firm? And your

firm is on retainer at this point to do the audits for HealthSouth,

right?

Mr. LAMPHRON. Right.

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Mr. WALDEN. Okay. Because I would like to just—Mr. Chairman,

I am sure all this is in the record, but as I read it today for the

first time, it strikes me as really this company CFRA appears to

have detected the disease that was running throughout

HealthSouth back in 1995. And it says things like ‘‘We would question the motive of any company that takes a large write-off in the

immediate aftermath of an acquisition by writing off $49.7 million

on the date of the acquisition, however HealthSouth gives the appearance of ‘clearing the deck’ of expenses that would otherwise

have to be charged in future periods against operating income.’’

Now, we know from testimony from Mr. Gordon that he began to

have some concerns about rather large write-offs that took place

every year. And I have seen in other documents concerns like that

as well.

They go on to talk about accounting for startup and related costs

and how some of these startup—how HealthSouth capitalizes organization, partnership formations and startup costs and subsequently amortizes such costs over 3 years. Go on. And then they

say ‘‘We feel that such costs should be expense as incurred since

they appear to constitute ordinary recurring operating expenses.’’

And we know later on that while maybe not specifically here, certainly in their payments they tried to amortize or capitalize payment under 5,000 as a way to hide from you all the opportunity

to look at those accounts.

Mr. LAMPHRON. Yes, sir.

Mr. WALDEN. They go on to talk about a weak control environment. It says ‘‘In general, we feel the outside members of a public

company’s Board of Directors should lack any significant affiliation

with either the company, its executive officers or other Board members outside their services as directors and their ownership stake

in the company. We also advocate the Board should be comprised

of individuals with a diverse set of experiences and perspectives.

Furthermore, we feel a public company should avoid engaging in

any significant related parties transactions with either its directors

officers or any relatives of such directors or officers. As outlined

below, HealthSouth’s Board appears lacking with regard to such

criteria.’’

Then they go through the various relationships among Board

members citing specifically Strong, Givens and I think Chamberlain, it would indicate here, perhaps, and how they are interrelated

with Scrushy.

Then they go on talking about CEO compensation. ‘‘On a more

sober note, we would argue the willingness of a company to engage

in the wholesale repricing of options granted to its CEO and other

executive officers, in effect all such offers to ‘‘have their cake and

eat it, too.’’ We consider such an approach a clear transfer of

wealth to executive option holders from other company shareholders. If they do this, they ought to be explicitly reported in the

annual proxy statement.’’

And when apparently they tried to do a more generous stock option, it was voted down in 1994. And they say ‘‘We are nevertheless

troubled by HealthSouth’s attempt to implement a plan that institutional investors who reported led the charge against the stock option plan would consider out of bounds.’’ I raise this because these

105

all appear to be things that came up again and again, now as you

go back and look. And you all, somewhere the very upper echelons

of your company had this in your possession. And you say somebody, obviously, responded to it because you know these people.

Are these issues, as you audited the company, you discovered on

your own as well? Were they ever identified?

Mr. LAMPHRON. Well, these issues, as best I can tell, every one

of them that is mentioned was available in public filings. These are

things we were aware of.

For instance, the $49 million write-off.

Mr. WALDEN. Right.

Mr. LAMPHRON. We were aware of that. We audited it. It was totally proper. And, in fact, was required by accounting standards.

What he suggests that it be made a part of the purchase price allocation is not good accounting. It is not the rules.

Mr. WALDEN. All right. Did you or your auditors feel that management was dominated by one or a few individuals without effective oversight by the Board of Directors or the audit committee?

Mr. LAMPHRON. We were—I assume you are——

Mr. WALDEN. I am referring to Tab 78, I believe it is. ‘‘Wherein

your internal documents under management’s control consciousness and operating style.’’ Apparently year after year this box was

checked on your internal documents. That and management’s excessive interest in maintaining or increasing the client stock price

or trend earnings. Those were both checked yes?

Mr. LAMPHRON. Yes.

Mr. WALDEN. These were issues you were concerned about then

and how Mr. Scrushy ran the company?

Mr. LAMPHRON. Well, let me say the point of this document is to

help us assess internal controls at the entity level.

Mr. WALDEN. Okay.

Mr. LAMPHRON. Not over cash receipts, cash disbursements, but

over HealthSouth.

Mr. WALDEN. Okay.

Mr. LAMPHRON. We were aware that Mr. Scrushy had a strong

personality.

Mr. WALDEN. Understatement.

Mr. LAMPHRON. And that he was involved in the day-to-day operations of the company. And that is what that response means.

Mr. WALDEN. Okay.

Mr. LAMPHRON. Now, having a strong personality does not mean

you are engaged in fraud. There are a lot of very successful companies that have leaders like that.

Mr. WALDEN. Sure. In fact, most have that.

Mr. LAMPHRON. What it tells us is it is an element. It is a risk

element and we assess that in the context of the entire internal

control environment.

Mr. WALDEN. Mr. LAMPHRON. Let me give you an example.

Mr. WALDEN. Okay. Go ahead, give me an example.

Mr. LAMPHRON. Well, let me give you an example. On something

like that with a dominant personality as the CEO, we would look

to see for things like was he personally presenting accounting

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counting issues. Did we feel like he was pushing his CFO and controller. And that is not the thing we found. In fact——

Mr. WALDEN. Okay. Let me go to a point then. Because also in

your monitoring checklist it is checked yes that internal audit is

not adequately staffed or trained, does not have appropriate specialized skills given the environment. Internal audit is not independent, authority and reporting relationships and does not have

adequate access to the audit committee or equivalent. The scope of

internal audit’s activities is not appropriate. Balance between financial and operational audits, coverage and rotation, decentralized operations. And internal audit has limited authority to examine all aspects of the client’s operation or fails to exercise its authority.

All four of those are also checked.

Mr. LAMPHRON. Yes, sir. That was our acknowledgement that we

were not in our audit process going to place much reliance on the

work that internal audit did. I mean, let me say that prior to

today, and there was no requirement. Until yesterday, as a matter

of fact, that a company has to have an internal audit department.

Mr. WALDEN. Right.

Mr. LAMPHRON. Second, if they choose to have one, there is no

direction that says here is what they have got to do.

Mr. WALDEN. All right.

Mr. LAMPHRON. And companies can choose to employ them several ways. They can direct them toward operational auditing or exclusively in operational areas, which we knew that is what they

did. And what that meant to us is we are not going to place much

reliance on their work. In fact, we replaced the hours that another

internal audit department, let us say, that did financial auditing;

we essentially replaced all those hours. So we put in thousands of

hours doing the kind of work that internal audit might do.

Mr. WALDEN. Then why the next year in comments and additional information would you—whoever wrote this say ‘‘Overall, we

believe that management has designed an environment for success.

As a result of this environment, management has designed sufficient controls and oversight functions in order to prevent instance

of material misstatement of the financial statements. We believe

the management is ethical, competent and fully aware of all potential business developments.’’

If you had some of these other concerns over the years about the

internal audit committee not really being properly trained, having

appropriate access to books and things, was it your view then that

you all had all that access and so the internal audit was not

that——

Mr. LAMPHRON. Well, with respect to internal audit, it just

meant that we had to do the work, which we did. And those are

just several of the factors in many, many factors in assessing the

internal control environment.

Mr. WALDEN. Did you ever share those concerns that you say you

had about the internal control environment, concerns that led you

to replace the hours that otherwise would be done; did you ever

share any of that with the audit committee, the Board or management?

Mr. LAMPHRON. No.

107

Mr. WALDEN. Why?

Mr. LAMPHRON. Because they were well aware of it. We were at

meetings when internal audit—at Board meetings when internal

audit reported the scope of activities. We knew the Board and the

audit committee were well aware of the charge that internal audit

had. And that was operationally based. I mean, that is a management decision as to—and a Board decision and an audit committee

decision as to how you are going to employ those resources.

Mr. WALDEN. Did you ever recommend changes? Did you ever

see—I guess what I struggle with is, for example, there is a boxed

checked here. It says ‘‘Management’s excessive interest in maintaining or increasing the client’s stock price earnings trend’’ is

checked yes.

Mr. LAMPHRON. It is checked yes, but let me say I would be——

Mr. WALDEN. That would be a red flag, I would——

Mr. LAMPHRON. Well, we did not take it as red flag. It is just our

acknowledgement that this is a public company and their focus is

earnings, like probably most if not all public companies focus on

earnings. So it is—I would not at all call it a red flag. It was another factor for us to consider in designing our audit.

Mr. WALDEN. I am just trying to put myself in the place of one

of those Board members relying on you who have far more experience than they do at this sort of look. And I guess, and maybe I

am just misreading all this, I look at it and say there was something that caused whoever filled out this forms year after year to

say management is probably a little more aggressive than most,

and he would not have checked yes. I mean, is that not accurate?

There are internal auditing control issues that need to be watched.

And yet none of that gets conveyed to the Board. So they do not

think you are seeing anything wrong. In fact, you are telling them

they got controls, right?

Mr. LAMPHRON. Yes, sir. Let me say that how they employed internal audit, how management and the Board——

Mr. WALDEN. Right.

Mr. LAMPHRON. [continuing] decide to use them——

Mr. WALDEN. It is totally their decision?

Mr. LAMPHRON. It is their decision. So we do not mark it up as

hey, that is a weakness. That is how they choose to do it.

Mr. WALDEN. So that was not in your responsibility——

Mr. LAMPHRON. Right.

Mr. WALDEN. [continuing] when you analyzed the company for

outsiders to look at?

What if internal audit said you have access, the internal auditors

do the corporate books, too? I mean, they did not, but——

LAMPHRON. I am not sure what you are asking. I am sorry.

Mr. WALDEN. Well, my point is what if management had said,

okay, we are going to have our internal auditor to do 33 other

things, and you say, you know, looking at it from the inside I do

not think they are doing it right, but that is not my view. That is

not our responsibility. So to heck with that. We will go do our

thing, ignore that. We do not have a responsibility to tell the Board

anything about what we spot as concerns.

Mr. LAMPHRON. Sure

108

Mr. WALDEN. Concerns enough that we put them year after year

on our internal documents.

Mr. LAMPHRON. Yes.

Mr. WALDEN. Meanwhile we put that it is great controls, everything is in place.

Mr. LAMPHRON. Right.

Mr. WALDEN. There is no way you can have a misstatement of

financial.

Mr. LAMPHRON. Well, if their internal audit department was

charged with doing financial audits, and——

Mr. WALDEN. Which they did.

Mr. LAMPHRON. And in our assessment we found them to be incompetent or not well trained, or not well supervised, we would

bring—we would talk to the audit committee. Because by having

internal audit focus that way, they would be expecting that in the

design of our audit we would place reliance on the work internal

audit does. That was not an issue.

Again, they choose to use them over here. All it meant was we

had to use more of our people and take more time in doing the

audit.

With respect—you indicated that we viewed management as

being aggressive.

Mr. WALDEN. Yes.

Mr. LAMPHRON. I need to sort of clarify that. I think we viewed

the Chairman as being a dominant personality, aggressive person.

We did not view management way.

I can tell you that from 2000 forward when I was engagement

partner and had meetings with the CFO, with the controller to discuss accounting issues, every time that I can think of they said

what do you think, how should this be accounted for. We told them,

and they said okay, that is what we will do. We want to do the

right thing.

Now, certainly there is some irony there after all we have come

to learn.

Mr. WALDEN. Sure.

Mr. LAMPHRON. But that was their persona. That was the picture

they put up in front of us. They were not aggressive. They were

not—they were not pushing the accounting envelop.

Mr. WALDEN. They were not cavalier?

Mr. LAMPHRON. Again and again they said we want to do the

right thing. You tell us what that is and——

Mr. WALDEN. All right. But in your 1999, I guess, proceeding,

you are in charge of this, both yes and no are checked when it says

‘‘Management displays a cavalier attitude toward an inadequate

monitoring of significant business risks.’’ ‘‘Management’s excess interest to maintain or increasing client stock price earnings trend’’

is checked yes. ‘‘Management dominated by one or a few individuals without effective oversight by the Board of Directors or audit

committee.’’

Those are not flags that should—that you share with an audit

committee? None of those rise to the level? They rose to somebody’s

level to check them here.

Mr. LAMPHRON. Well, again, having a focus on earnings for a

public company is normal. We did not——

109

Mr. WALDEN. But that is not what you say. I mean, it is management’s excessive interest.

Mr. LAMPHRON. Well, that is the way the checklist is worded

and, you know, we do not have the ability to modify it. But I can

tell you the intent in the years I was responsible for it when we

checked that, it is a reminder. That is what this whole checklist

is, it is a reminder. And we say, sure, they are a public company.

These guys are focused on earnings. Let us keep that in mind as

we do our audit, as we plan our audit, as we conduct our procedures. And that is what we did.

Mr. WALDEN. Looking back, and I realize that it is a lot easier

to see looking back, when I read this checklist and see a pretty

clear picture that a company is driven by a very strong executive

who lacks oversight by the Board and audit committee who is consumed with earnings numbers in an area where there is cavalier

attitude toward business risks—I mean I look at what you all did

and say that it was like you were pointing but you did not know

when to pull the trigger. Because you were seeing all the indicators, but somehow it got passed you.

Mr. GREENWOOD. The time of the gentleman has expired.

Mr. LAMPHRON. Congressman Walden, I would concede that looking back you can certainly take a different view of these things.

But at the time onsite——

Mr. WALDEN. You did not see it?

Mr. LAMPHRON. [continuing] they were not red flags. They were

not red flags at us. Sorry.

Mr. WALDEN. Thank you, Mr. Chairman.

Mr. GREENWOOD. The gentleman from Florida, Mr. Stearns recognized for 10 minutes.

Mr. STEARNS. Thank you, Mr. Chairman.

We all up here have the benefit of hindsight, you know. So we

are able to ask these questions that, you know, in the overall operations day-to-day for us seem significant, but perhaps for you it

was not. And one I want to talk about is the Tab 72, which is the

letter from a ‘‘fleeced shareholders’’ to Ernst & Young and

HealthSouth. You probably heard us talk about this when we were

talking to the Board of Directors.

Mr. LAMPHRON. Yes, sir.

Mr. STEARNS. They could say that this letter, anonymous letter

that came from a ‘‘fleeced shareholder’’ in November 12, 1998, so

that was 5 years ago, talked all in detail about some of the problems with HealthSouth. So the letter, evidently, went to you folks

and I guess it is to Mr. Dandurand.

Mr. DANDURAND. Yes.

Mr. STEARNS. Were you involved with the account, the

HealthSouth account when the ‘‘fleeced shareholder’’ facts came in

to your company?

Mr. DANDURAND. Yes, Congressman.

Mr. STEARNS. Okay. Now, you saw a copy of the letter yourself?

Mr. DANDURAND. Oh, yes.

Mr. STEARNS. Okay. Okay. And would you not agree with me,

somebody who wrote this letter had to have a pretty good idea of

what was the problems? I mean, they talked about the impact of

Tefra reimbursements. They talked about the balanced budget

110

amendment, and the cutbacks and the Medicare. They talked about

how the Ernst & Young auditors in Alabama missed things. I

mean, it seemed if I got this memo, it would sort of put some antenna up.

Now, I know you folks are busy. So my question is did you folks

address the allegations that are in this letter from 5 years ago, and

what did you do?

Mr. DANDURAND. Yes, Congressman.

Mr. STEARNS. Sure.

Mr. DANDURAND. We took this very, very seriously. We do not get

these kinds of letters very often.

Mr. STEARNS. Especially with this kind of detail.

Mr. DANDURAND. And, unfortunately, it was anonymous. And it

is in detail.

We took two actions related to the receipt of this letter. And, as

you can see, this letter came to the Chairman of our firm. It went

to the SEC. It went to HCFA.

Mr. STEARNS. It went to the SEC?

Mr. DANDURAND. Yes. HCFA, the American Institute of Certified

Public Accountants.

Mr. STEARNS. Did the SEC respond to this?

Mr. DANDURAND. I am not aware they ever did.

Mr. STEARNS. They never called you and said, look what is the

story on this letter? You better get hopping on it or anything.

Mr. DANDURAND. I know they did not do that.

Mr. STEARNS. They did not? Okay.

Mr. DANDURAND. That is correct.

But what we did, we took two actions really as a result of this

letter.

Mr. STEARNS. Yes.

Mr. DANDURAND. We took a similar action that was described

earlier, in that we notified the company that we had received this

letter——

Mr. STEARNS. When you notified the company, was Mr. Scrushy

aware of these allegations? Did he get told?

Mr. DANDURAND. I believe he did. In fact, I have been told and

I am positive, I feel very comfortable that he was aware of these

allegations. Yes.

Mr. STEARNS. When I look at the memo it has, you know as you

mentioned, Morgan Stanley. It was cc’d to a lot of people. We do

not know, in fact, whether they got it at all. But at least the memo

said it was sent to them, so we just have to speculate. We assume

they got it, but we have never confirmed it. But you have never got

anything back from any of these people on the cc saying we got this

memo, what is the story?

Mr. DANDURAND. That is correct, Congressman.

Mr. STEARNS. Okay.

Mr. DANDURAND. We know we got ours.

Mr. STEARNS. All right. Yes. Okay. So you think you have a pretty sure, what? Ninety percent sure that Mr. Scrushy was aware of

the allegations?

Mr. DANDURAND. Yes, I am.

Mr. STEARNS. A 100 percent?

Mr. DANDURAND. It is 5 years ago.

111

Mr. STEARNS. Yes, you do not know. I know.

Mr. DANDURAND. And I am under oath. I just, you know——

Mr. STEARNS. Okay.

Mr. DANDURAND. [continuing] feel uncomfortable saying 100 percent.

Mr. STEARNS. All right. So the question is——

Mr. DANDURAND. I will say 95, 90, whatever.

Mr. STEARNS. Right. And so Mr. Scrushy knows about it. You

folks know about it. And do you think the Board of Directors knew

about it?

Mr. DANDURAND. No, I do not.

Mr. STEARNS. You do not think so? And did you ever tell the

Board of Directors?

Mr. DANDURAND. No, and I would like to explain that, if I could.

Mr. STEARNS. Yes. Yes.

Mr. DANDURAND. Because I think it is important to understand

the actions that we did take.

We took two actions, as I mentioned earlier. The first was to notify the company in accordance with our professional standards to

let them know that we had received this letter. And in that context, I called Michael Martin, who was the chief financial officer at

the time, and told him that I wanted to come share this letter with

him, which I did that same afternoon.

I met with——

Mr. STEARNS. I think that is very good.

Mr. DANDURAND. I met with Mr. Martin and Mr. Owens at the

time, who was the controller of the company. I shared the letter

with them. And then the discussion started as to how the letter

should be responded to.

My initial recommendation was the company ought to consider

hiring an independent counsel to investigate this and report back.

Mr. Martin and Mr. Owens felt that maybe at this time it was premature, which certainly was their prerogative, and in that context

I suggested then that it needs to be—should be audited or reviewed

by someone independent of the financial folks. And suggested Mr.

Horton, who is the general counsel, might be the appropriate person or certainly someone might consider that.

Mr. STEARNS. Do you know if Mr. Horton got the memo and did

anything?

Mr. DANDURAND. Oh, I he got the memo because——

Mr. STEARNS. So you are 100 percent sure he got the memo, but

you are not sure what he did?

Mr. DANDURAND. Well, I will try and explain——

Mr. STEARNS. Okay.

Mr. DANDURAND. [continuing] exactly what I remember of the

whole situation.

So at that point Mr. Horton was called and invited to Mr. Martin’s office.

Mr. STEARNS. Yes.

Mr. DANDURAND. And certainly the letter was shared with him.

There was some discussion about how the review ought to proceed.

My recommendation, again, was to again keep it independent. I

suggested that Teresa Sanders, who was the——

112

Mr. STEARNS. When you say ‘‘independent,’’ you mean outside the

company?

Mr. DANDURAND. Outside of the area where the allegations were

being directed.

Mr. STEARNS. Which should be the right way to do it, sure.

Mr. DANDURAND. I would think so.

Mr. STEARNS. Yes.

Mr. DANDURAND. At least thought so at the time.

Mr. STEARNS. Right.

Mr. DANDURAND. And that—and then I offered Ernst & Young’s

help in that capacity.

Mr. STEARNS. Was any report resulting from this independent—

was an independent counsel selected?

Mr. DANDURAND. No, it was not. General counsel——

Mr. STEARNS. Nothing was done then? General counsel did it?

Mr. DANDURAND. No, general counsel did.

Mr. STEARNS. Did you see the report from the general counsel?

Mr. DANDURAND. Well, I had several conversations with him and

followed up verbally.

But the point I would like to make in addition to that action, is

that Ernst & Young took our own independent action related to

those charges. The——

Mr. STEARNS. So you invested the ‘‘fleece’’ memo yourself?

Mr. DANDURAND. Well, not only did I do it, but the firm sent two

of our associates from the PPD office over to independently look at

our work.

Mr. STEARNS. You actually met with the audit committee at

HealthSouth and gave it to them, and told them about it?

Mr. DANDURAND. No, we did not.

Mr. STEARNS. No? Okay.

Mr. DANDURAND. We did an independent review. And if you read

the letter——

Mr. STEARNS. Because, Mr. Horton you gave it him, you suggested outside counsel?

Mr. DANDURAND. Yes.

Mr. STEARNS. He did not go ahead with it. So at this point you

left it in his responsibility and then you acted independently on

your own?

Mr. DANDURAND. That is correct. But I would like to go back to

that, because there is I think one more important element that you

reminded me of; is that I did suggest that the company inform Dr.

Watkins, who at that time was Chairman of the audit committee.

And they told me that they would about receiving the letter.

Mr. STEARNS. So under that scenario, the Board of Directors was

told about it?

Mr. DANDURAND. Well——

Mr. STEARNS. Hearsay? From your——

Mr. DANDURAND. I had a lot of confidence in Mr. Horton and assumed that that took place. I do not know what——

Mr. STEARNS. So your inner feelings was I have done the right

thing. I have given it to the counsel. I have made a recommendation. But Ernst & Young never went back and took each allegation

and investigated it down into detail?

113

Mr. DANDURAND. No, that is not correct. And I would like to

make myself clear on that.

Mr. STEARNS. I got another whole area I want to explore. So I

am sorry, I do not mean to do this.

Mr. DANDURAND. We certainly did. The firm sent 2 representatives over to look at our work papers, to talk to our engagement

team, to go down each and every charge in that letter. And to——

Mr. STEARNS. And were they all considered false or correct?

Mr. DANDURAND. Well, I——

Mr. STEARNS. I mean, for example, did the Ernst & Young auditors in Alabama miss things that the ‘‘fleece’’ letter says? Just yes

or no.

Mr. DANDURAND. I say no.

Mr. STEARNS. Okay. What about the idea that, this is an accounting question, how can the company carry tens of millions of dollars

in accounts receivable that are well over 360 days? Is that normal.

Mr. DANDURAND. Well, in a company of this size——

Mr. STEARNS. It is, yes.

Mr. DANDURAND. [continuing] and I remind you it is over a billion dollars a healthcare company, yes.

Mr. STEARNS. So when they say the accounting slick, the cost reports are not accurate, so your opinion is this memo is false and

this memo is incorrect and you corroborated through your investigation that this has no validity; that is your statement today?

Mr. DANDURAND. My statement is we concluded that——

Mr. STEARNS. Had no validity?

Mr. DANDURAND. [continuing] it had no impact on the financial

statements.

Mr. STEARNS. Okay. So I would say we can pretty much say from

Ernst & Young’s standpoint this memo had no validity?

Mr. DANDURAND. We did not believe the charges——

Mr. STEARNS. Did you go back to Mr. Horton and tell him look,

we have looked at this and this doesn’t mean anything?

Mr. DANDURAND. I do not remember having that conversation.

Mr. STEARNS. Okay.

Mr. DANDURAND. I also would like to point out that we did provide the staff with a detailed description of our procedures in case

I forgot something here.

Mr. STEARNS. Yes. Okay. Let me just turn quickly to the pristine

audits. And you probably heard my conversation with the Board of

Directors on this. You know ‘‘The Wall Street Journal’’ did an article on this, and if you like you can probably to Tab 89. It talked

about, you know, this pristine audits that you performed. You had

junior level executives go into HealthSouth and armed with a 50

point checklist to reevaluate things; whether toilets were free of

stains, trash receptacles had liners. And so did Ernst & Young in

fact advise HealthSouth to classify pristine audits as audit related

services? Because I have here this audit fees for proxy disclosure,

and you have the audit fees and then you have audit fees related.

And that, evidently, is what you put the pristine audits.

So the question I have you, did you classify these pristine audits

when you were actually looking at whether toilets were free of

stains and trash receptacles had liners, was that a separate audit

related fee on the accounting statement?

114

Mr. DANDURAND. Congressman, I believe those standards for the

description of audit related——

Mr. STEARNS. Are normal?

Mr. DANDURAND. Came into being after I retired. So I am not

comfortable knowing what those figures are.

Mr. STEARNS. But you folks did this?

Mr. LAMPHRON. That classification was done for the 2001/2000.

Mr. STEARNS. Yes. And I guess the question——

Mr. LAMPHRON. When I was the engagement partner.

Mr. STEARNS. Yes. I am sorry. Mr. Lamphron, you were the one

I probably should address this question. I am sorry.

Okay. This was done, and it was done this way. Now in a ‘‘Wall

Street’’ article it was brought out that this was done, and low and

beyond, I guess the SEC sent you folks a letter on July 8, 2003

about it. Do you remember this letter?

Mr. LAMPHRON. I think I have seen a copy of it.

Mr. STEARNS. It sort of said that what you did in classifying

these pristine audits of checking the toilets and things would not

be correct today. Let me just read from the letter, and if you do

not have it, I can give it to you.

‘‘The Commission current rule states that registrants are to disclose under the caption audit related fees, the aggregate fees billed

in each of the last 2 fiscal years for assurance and related service

by the principal accountant that are reasonably related to the performance of the audit review or the registrant’s financial statement.’’

So they are saying that you were wrong to put it into the audit

related fees and that classification is incorrect.

Mr. LAMPHRON. I do not think they were saying we were wrong

at the time. I think that the letter says that under the new rules

they would not be classified as audit related, and we agree completely.

Mr. STEARNS. The article quotes the SEC former chief accountant

Lynn Turner as saying ‘‘Ernst & Young arguing that checking the

cleanliness of a facility is audit related goes well beyond the pale

of sanity and common sense.’’

On a common sense level does it make sense for you to classify

this as audit related?

Mr. LAMPHRON. Under the——

Mr. STEARNS. I mean in retrospect. I am sorry.

Mr. LAMPHRON. Under the existing rules there wee three classifications. Audit, which deals with just the corporate audit and the

quarterly reviews; information technology work and other. We classified it in other.

We went further and put a subcategory that was not required or

defined at the time of audit related because they were operational

audits.

Mr. STEARNS. Today would you classify it the same way?

Mr. LAMPHRON. No. There is guidance that makes it very clear

we would not put it in that category.

Mr. STEARNS. I think you would not be off base to say you did

it wrong. I mean, you seem to be hedging a bit, but it seems to me

that you are saying you would not do it this way today.

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Mr. LAMPHRON. I am not hedging. I am saying that at the time

with no guidance on what would go in audit related, that we considered these operational audits and as such, we put them in audit

related.

Mr. STEARNS. Okay. But the SEC former chief account Lynn

Turner disagrees with you.

Mr. GREENWOOD. The time of the gentleman has expired.

Mr. STEARNS. Yes. Thanks.

Mr. GREENWOOD. The gentleman from New Jersey, Mr. Ferguson

is recognized for 10 minutes.

Mr. FERGUSON. Thank you, Mr. Chairman.

Mr. Lamphron, I am over here.

You have been going for a while. Do you want to take a sip of

water or something.

Mr. LAMPHRON. I am okay. Thank you.

Mr. FERGUSON. I do not know if you saw the last hearing, our

first hearing on this.

Mr. LAMPHRON. I did.

Mr. FERGUSON. The last hearing we heard a lot about internal

controls at HealthSouth. Can you tell some of the nonaccountants

here a little bit about internal controls. What do we mean when we

say internal control?

Mr. LAMPHRON. Let me give you an example. A very classic example would be where a business has a policy where checks above

a certain amount have to be signed by two people instead of just

one. That’s—the basis of that is just human nature, knowing that

it is easier for a crime to be committed by one person than it is

by two people who to do that have to engage in collusive activities.

Mr. FERGUSON. So having a check signed by two people or limiting people who can authorize certain transactions, those are examples of internal controls?

Mr. LAMPHRON. Sure.

Mr. FERGUSON. What are some examples of internal controls that

were in place at HealthSouth?

Mr. LAMPHRON. Well, one that comes to mind deals with their

cash They had a treasury group that monitored cash balances on

all 2600 accounts on a daily basis. Now, all the activity that affected the financial statements recording cash disbursements, cash

receipts was done in the general accounting department. So the

control was you had this group in treasury separate and distinct

that overlooked that and made comparisons and that sort of thing.

Mr. FERGUSON. Are publicly traded companies required by law to

have internal control?

Mr. LAMPHRON. Yes, absolutely. The Fair Practices Act requires

that.

Mr. FERGUSON. And who is responsible for maintaining this system of internal controls at a publicly traded company?

Mr. LAMPHRON. Well, I think it extends to senior management

all the way through the CEO, but from a practical standpoint it is

typically the CFO who has that—who deals with those sorts of

things.

Mr. FERGUSON. What about the auditors? Do the auditors have

a role in maintaining the internal controls at a company, the outside auditors?

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Mr. LAMPHRON. Well, we review internal controls as part of every

audit. If we saw weaknesses, we would communicate those to management, to the audit committee.

Mr. FERGUSON. How is Sarbanes-Oxley effecting that?

Mr. LAMPHRON. Well, significantly, I think. One provision I am

thinking of is 404 of Sarbanes-Oxley which requires management

to attest—to evaluate and to test to those internal controls. And

then for us to audit management’s attestation.

Mr. FERGUSON. If management is in intent on circumventing internal controls to commit fraud, is there something that the auditors can do about that?

Mr. LAMPHRON. No. I think we heard from numerous people, it

is very clear in our professional literature that collusive fraud may

be impossible to detect.

HealthSouth had a—on paper HealthSouth had a formidable system of internal controls. They were doing all the right things. We

heard from Mr. Wallance this morning about best practices and

corporate governance. And we were sitting in there thinking they

did all those things. They had policies, procedures in place.

Now, obviously, what we did not know was there was a large

group of criminals sort of behind the scene that were overriding

those controls. And there is no system that is going to prevent that.

Mr. FERGUSON. So is that your opinion of what happened here?

That they could have had the best system of internal controls in

the world, but if you had management intent on doing an end run

around those internal controls, it undermine the effectiveness of

those internal controls?

Mr. LAMPHRON. That is correct.

Mr. FERGUSON. Is that your opinion?

Mr. LAMPHRON. Yes, sir.

Mr. FERGUSON. Okay. Let me return to a line of questioning that

I had pursued in the first hearing. You said you had seen, you had

watched the first hearing.

Specifically in some questions I asked Ms. Henze because when

she was—and I asked her some questions about what she did when

she realized or found out that there was fraud being committed or

when she suspected there was fraud going on. And when she confronted Mr. Owens and he did not deny the fraud, do you recall

that from her testimony?

Mr. LAMPHRON. Yes, sir.

Mr. FERGUSON. Ms. Henze was known to your audit team?

Mr. LAMPHRON. She was known very well to us. In fact, for several years she was the primary audit coordinator.

Mr. FERGUSON. How often did Ernst & Young talk with her?

Mr. LAMPHRON. Daily, every other day.

Mr. FERGUSON. Regularly?

Mr. LAMPHRON. During the course of the audit, yes.

Mr. FERGUSON. Did she ever tell anybody on the audit team

about the fraud that she had uncovered or suspected?

Mr. LAMPHRON. Never once.

Mr. FERGUSON. Okay. That is what she said as well.

Did she report her concerns—she did report her concerns of fraud

internally, though. She talked with some folks at the compliance

department, Kelly Cullison in particular. Is that correct?

117

Mr. LAMPHRON. That is correct.

Mr. FERGUSON. And Ms. Cullison testified that she confirmed

that these fraudulent adjustments had been described to her by

Ms. Henze and that they in fact had been made. She then referred

the entire matter to her boss, Mr. Tanner. Correct?

Mr. LAMPHRON. That is correct.

Mr. FERGUSON. Who was one of the founders of the company. He

was serving as the head of compliance.

Mr. LAMPHRON. Right.

Mr. FERGUSON. That is right?

Mr. LAMPHRON. Yes.

Mr. FERGUSON. Was Ms. Cullison known to your audit team?

Mr. LAMPHRON. Yes. As a matter of fact, a routine part of each

audit we would ask her in her role as—in the compliance department about the nature of the complaints and issues. In fact, I got

to tell you, I listened to the testimony a couple of weeks ago and

I cannot tell you how frustrated I was. And let me tell you why.

Subsequent to Henze going to Cullison and Cullison going to

Tanner, we sat down and met with them face-to-face. There were

two Ernst & Young partners and another person there. We asked

them, tell us about activities in the compliance department. Tell us

about anything that has come to your attention, whether resolved

or whatever the status. Tell us anything that might have any effect

on the financial statements. And they looked us in the eye and lied

to us.

Mr. FERGUSON. You made an actual inquiry of Ms. Cullison?

Mr. LAMPHRON. That is correct.

Mr. FERGUSON. A direct inquiry?

Mr. LAMPHRON. That is correct.

Mr. FERGUSON. Okay.

Mr. DANDURAND. Can I respond, because I was the one that

made that inquiry?

Mr. FERGUSON. Sure.

Mr. DANDURAND. And it is very important to me that everyone

understand that 6 feet away from me was the answer to everything

that was going on. And we asked the right question, and we still

did not get the right answer.

Mr. FERGUSON. So Mr. Tanner, he was not able to recall much

about his final years at HealthSouth. But you are saying that your

audit team at Ernst & Young, you made an actual inquiry, affirmative inquiry of Ms. Cullison and Mr. Tanner?

Mr. LAMPHRON. Yes, and I would add Mr. Hale was at the meeting. But he was due to take over the department. So our questions

were to Tanner and Cullison.

Mr. FERGUSON. And you asked them if any allegations of fraud

had been made or brought up?

Mr. LAMPHRON. We asked them exactly that.

Mr. FERGUSON. And did you ask the compliance officials what

complaints they had perhaps received or substantiated?

Mr. LAMPHRON. We asked them to describe the nature of those.

And I believe as we have it documented, the description is that

fairly routine personnel type issues that they were able to push off

to people in human resources.

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Mr. FERGUSON. So Ms. Henze brought her concerns to Ms.

Cullison. Ms. Cullison brought her concerns to Mr. Tanner. You

and your team directly asked Mr. Tanner and Ms. Cullison about

any allegations or suspicion of fraud. And they told you there was

none?

Mr. LAMPHRON. Yes.

Mr. FERGUSON. And this is all in connection with the 1999 audit?

Mr. LAMPHRON. That is correct. In fact, the meeting was on December 3, 1999.

Mr. FERGUSON. Okay. And at that meeting did Ms. Cullison say

anything about what Ms. Henze had come to her about?

Mr. LAMPHRON. Absolutely not.

Mr. FERGUSON. Okay.

Mr. LAMPHRON. No hint, no wink, no reference, nothing.

Mr. FERGUSON. Okay. So, I just want to get this straight. You

asked them a straight question, they were mum with regard to the

1999 audit?

Is it your opinion that—I mean, it just seems to me a lot of this

could have been avoided if they had spoken up at that time.

Mr. LAMPHRON. Absolutely. And even outside of that meeting

with respect to Henze, I mean, we probably met with her 50 or 100

times during the audit process for several years. She just had multiple opportunities to just say one thing to us. She did not take that

opportunity.

Mr. FERGUSON. This meeting that you are talking about, is it

documented?

Mr. LAMPHRON. Yes, sir.

Mr. FERGUSON. Where?

Mr. LAMPHRON. In our work papers, and I think we have provided that to your staff. I am not certain, but we can certainly get

it for you.

Mr. FERGUSON. That is all I have, Mr. Chairman. Thank you. I

yield back.

Mr. GREENWOOD. The Chair thanks the gentleman.

The Chair recognizes himself for 5 minutes.

A cynic connecting the dots after the fact might think something

like this: According to the indictment the fraudulent activity began

around 1996. In 1995 there is a report from the Center For Financial Research and Analysis that says—there is a lot of red flag, or

at least pink flags or some things to worry about with this company.

In 1996 right after Mr. Scrushy allegedly started cooking the

books, he decides out of the clear blue sky to make—basically double the amount of money he is paying to his auditors. Makes up

kind of this cockamamie pristine audit business. You get the

‘‘fleeced stockholder’’ piece in 1998. You get the email in 2002. Connecting the dots from where we sit today, it makes us fairly suspicious.

Mr. Dandurand, you said that in response to the issue about the

‘‘fleeced shareholder’’ letter that you do not get letters like that

very often.

Is it common for an auditing firm to have a client with this sort

of number of things happening where you get these allegations

coming in, is that routine or is this extraordinary to have allegaVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00126 Fmt 6633 Sfmt 6602 91232.TXT HCOM1 PsN: HCOM1
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tions of this specificity and this seriousness come in with regard to

a client? Anyway?

Mr. DANDURAND. Go ahead.

Mr. LAMPHRON. Well, you know, first I would remind you that

with respect to the ‘‘fleeced shareholder’’ letter and the Vines’

email, that is 5 years between those. So it is not like we sat there

and these things were tumbling down on us. But we were aware

of those.

Mr. GREENWOOD. Yes.

Mr. LAMPHRON. But, you know, we took——

Mr. GREENWOOD. You have already very well explained.

Mr. LAMPHRON. [continuing] those and investigated them.

Mr. GREENWOOD. Yes. And you have already explained it. I am

not questioning.

Mr. LAMPHRON. Yes.

Mr. GREENWOOD. I am just trying to get to a specific point, which

is is this unusual? Do you have other clients where you have had

two, even 5 years apart, two hand grenades hurled over the transom like this?

Mr. LAMPHRON. Not that I can recall right now, Mr. Chairman.

Mr. GREENWOOD. Okay. Ms. Givens said in her 13 years on the

Board, Ernst & Young never brought a single problem to their attention. Is that true? The Board’s attention, never brought a single

concern?

Mr. LAMPHRON. I cannot speak to the entire 13 years, but I can

say that, you know, I know we talked to her about proposed audit

adjustments where we felt balances should be different than what

we recorded. You might call that an issue.

You know, beyond or before 2000, I just do not know.

Mr. GREENWOOD. Okay. What about this policy that, Mr.

Lamphron, you said that the standard operating procedures is if

something comes in, a compliant like this comes in from the outside, that you go over to a person in superior position to that person to bring it to their attention? It seems to me that it is not the

little guys that have a whole lot at stake in managing earnings and

falsifying books. It is the big dogs at the top that have the stock

options and a whole lot to gain in bonuses and all of the rest if

earnings are fraudulently managed. And I am not attributing that

to you. You are following the standard operating procedures. But

help us out here. Does that make sense?

It seems to me that in each of these cases that we have seen over

the last several years, it is the guys at the top that are gaming the

system. It is the guys at the bottom that frequently have the best

insight into what is going wrong with the company.

Mr. LAMPHRON. Well, again, I followed all of our internal——

Mr. GREENWOOD. No, I know you did. And I am not faulting you.

You think it is a good idea? Do you understand the concern that

I might have?

Mr. LAMPHRON. I do. And I would respond by saying we went to

the Chairman of the audit committee. Now, it does not go much

higher.

Mr. GREENWOOD. Okay. Mr. Dandurand, you had told us earlier

that you made an inquiry of Mr. Tanner and Cullison about whethVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00127 Fmt 6633 Sfmt 6602 91232.TXT HCOM1 PsN: HCOM1
120

er any allegation of fraud were made. Did you review the compliance, the log complaints for fraud?

Mr. DANDURAND. I did not, Mr. Chairman.

Mr. GREENWOOD. Okay. Was that ever part of your audit procedure to do that?

Mr. DANDURAND. We did not, to my knowledge.

Mr. GREENWOOD. You can do a sampling of the complaints that

came in on the log?

Mr. DANDURAND. No, we do not. I have a lot of confidence in both

Mr. Tanner and Ms. Cullison, and the entire corporate compliance

program that was put into place.

Mr. GREENWOOD. You took their word for it that——

Mr. DANDURAND. Unfortunately, I did.

Mr. GREENWOOD. Okay. You would not do that again if you had

it to do over again?

Mr. DANDURAND. Well, I do not know what I would do——

Mr. GREENWOOD. Final question. When was the pristine audit

program started?

Mr. DANDURAND. I believe in 1996.

Mr. GREENWOOD. Okay. And in retrospect, and I am not casting

the tiniest dispersion on Ernst & Young when I say this, in retrospect when you see an indictment that says that the fraud began

in 1996 do you wonder whether Mr. Scrushy said to himself I am

about to start cooking some serious books here and I have an auditing company that might find out about this, let me invent a lovely sweetener of the pot? Has that thought occurred to you?

Mr. DANDURAND. It never has. And, Mr. Chairman, HealthSouth

is not a significant client to Ernst & Young. Never has been.

Mr. GREENWOOD. Okay. Fair enough.

What percentage of your income was HealthSouth?

Mr. DANDURAND. Oh, that is difficult.

Mr. GREENWOOD. In the Birmingham office?

Mr. DANDURAND. I have been retired. Well, we do not measure

particularly Birmingham office, per se.

Mr. GREENWOOD. Anybody else know what percentage it is in

Birmingham?

Mr. DANDURAND. You may have the information related to that.

I have seen percentages calculated, and I do not agree with the

way they were calculated.

Mr. GREENWOOD. Anybody else?

Mr. LAMPHRON. We manage our practice on an area basis. And

it was no more than one to one and half percent in any year.

Mr. GREENWOOD. Okay. We seem to have some documents that

says it was 15 percent.

Mr. DANDURAND. I have seen those documents. And I disagree

with how that was calculated. That basically adds up the pristine

audit revenues and puts them in the Birmingham office, whereas

all that work was done throughout the entire firm and was not

done in the Birmingham office. So although——

Mr. GREENWOOD. Did Ernst & Young make more profit on the

financial audits or on the pristine audits?

Mr. DANDURAND. Oh, I do not remember.

Mr. LAMPHRON. I do not know. But this questioning raises the

issue of can we be—is were we influenced by that.

121

Mr. GREENWOOD. And I am not raising that question. I am trying

to find out whether Mr. Scrushy, that might have been his intention.

Mr. LAMPHRON. Well, just to put in perspective. Again, 1 to 1.5

percent on an area basis, firm wide less than I think .1 of 1 percent. But I would just repeat what we hear almost every week, and

certainly our new people that start, they hear it probably the first

day. There is no client too important to cause us to jeopardize their

professional reputation.

Mr. GREENWOOD. Glad to hear that.

Mr. LAMPHRON. It did not influence me, and it did not influence

this team.

Mr. GREENWOOD. I believe you.

The gentlelady from Colorado is recognized for 5 minutes.

Ms. DEGETTE. Thank you, Mr. Chairman.

I wanted to follow up on my question to you, Mr. Lamphron,

about whether you made more fees on the pristine audits or on the

audit fees. And you unequivocally said no.

Mr. LAMPHRON. Right.

Ms. DEGETTE. So I went back to where I was confused, because

I had been reading the proxy disclosure for 2000 year end, and if

you want to look at Tab 85, you know what I am talking about?

Mr. LAMPHRON. Yes.

Ms. DEGETTE. Because what it says in the proxy disclosure

which was filed with the SEC, it says audit fees, total audit fees

for 2000, $1,026,649. And for that same year then, at least on this

proxy disclosure, it says pristine audits $1,250,000 which is more,

correct?

Mr. LAMPHRON. Let me explain my statement. Is that what you

would like me to do?

Ms. DEGETTE. And then for 2001 same thing it is $1,165,750 for total audit fees and then $1,332,261 for pristine audits. You would

not disagree that is what this proxy disclosure says, correct?

Mr. LAMPHRON. That is what the proxy disclosure says.

Ms. DEGETTE. Okay. So why do you not tell me what you meant?

Mr. LAMPHRON. Well, at the time—the proxy rules have changed.

But at the time in 2000/2001 the definition of audit fees was very

narrow. It was the audit of the consolidated financial statements

and the quarterly reviews. In addition to that, each and every year

we did a number of other audits.

Ms. DEGETTE. Right. Which are in also in the proxy.

Mr. LAMPHRON. Thirteen, 14, sometimes 15 or more audits.

Ms. DEGETTE. Right.

Mr. LAMPHRON. The question was did our audit fees, were our

audit fees less. Our audit fees were not. You add all the audit fees

together and exceeded what we received on the pristine audit.

Ms. DEGETTE. Right. But my question to you was based on what

was filed at the SEC, which says the total audit fees were less than

the pristine audit. I just wanted to clear the record up. You know,

I think we are talking about apples and oranges.

One last question, which is the same question I asked to the last

panel. Like the Chairman, I would never impugn your integrity or

your motives. But I must say, I do have a concern when you have

a firm that has been engaged to perform an independent audit,

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when you have a CEO who was indicted yesterday on 85 counts of

fraud. And as we discussed earlier, a pretty basic textbook kind of

fraud, for the most part. Fifteen senior executives including 5

CFOs have plead guilty to criminal offenses. And you folks were

the external auditors.

I have heard today you had conversations with people, you talked

to folks, you asked the company for some records which they supplied you when allegations were made.

Hindsight is 20/20, but in conducting an independent audit

today, is there more you could do to stop this kind of widespread

fraud, which of course hurts all the employees of HealthSouth plus

the stockholders? Any of you.

Mr. LAMPHRON. Well, again, if there—regardless of how well the

system of internal controls is developed, if there is widespread collusive fraud, it may not be detected. But——

Ms. DEGETTE. So your answer is no? You do not think there is

anything else that could be done to avoid this?

Mr. LAMPHRON. Well, I was going to go on and say that there are

a number of things that have happened since then that have—we

have got a new auditing standard, for instance, which basically increases our attention we pay to the potential for fraud. We heightened the awareness on the engagement team. We spent 300,000

hours in Ernst & Young educating our people on fraud awareness.

I mean, there is a lot of things we have done. And we would hope

we would detect fraud, but again if we are examining a transaction

and we ask senior management, financial management and then

we go and ask the people in general accounting, and if we ask legal

counsel, and if we ask treasury, and we if we ask tax and they all

give us the same answer——

Ms. DEGETTE. Yes.

Mr. LAMPHRON. [continuing] and the same documents, you will

never uncover it.

Ms. DEGETTE. You know what it depends on, and you know this

and I know this, we all know this. It does not depend on what

those people say. It depends on what the records show, right? And

I think the thing to do is next time go in and get the supporting

documentation. If that had happened, for example, with the allegations that were made in this case, you would have caught it right

away. Do you not think so?

Mr. LAMPHRON. Possibly, but the implication that we do not

check documentation is, you know—we—to the extent there is documentation, we look for it. We do not audit by conversation.

Ms. DEGETTE. Thank you.

Mr. LAMPHRON. What we know at this point is that they falsified

documents.

Ms. DEGETTE. Well, okay. Thank you very much.

Mr. GREENWOOD. The gentleman from Florida for 5 minutes.

Mr. STEARNS. Mr. Chairman, thank you.

Just sort of a summary comment here. I have here the indictment of the United States of America versus Richard Scrushy, the

defendant. And I am reading on page 11 about the overall acts.

And it is staggering how much money that we are talking about.

It said from 1996 to the year 2003 Richard Scrushy and others reviewed internal financial statements setting forth the actual finanVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00130 Fmt 6633 Sfmt 6602 91232.TXT HCOM1 PsN: HCOM1
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cial condition. And from that same period of time, with coconspirators, senior officers they falsified record.

Then it says coconspirators including members of the corporate

accounting staff made and caused to be made entries in the books

and records of HealthSouth which causes the following approximate amount of fictitious income to be included in the annual report to stockholders and SEC filings for the year 1996 through

2001 and intended to be included in the annual report to stockholders and SEC filings for the year 2002.

Let me just read the amounts, and I know you know them. And

this is all alleged now. But, I mean, this is staggering. Amount of fictitious income in 1996 was $70 million. 1997 $700

million. 1998 550 million. 1999 $390 million. 2000 $350 million.

2001 $450 million. And 2002 $230 million. For a total, grand total

of $2.740 billion dollars, fictitious fraudulent income.

That does not include what the coconspirators of the corporate accounting staff added to that. And they have $370 million in cash.

Approximately $27 million in the stock of a publicly traded company.

And so, I mean, when you look at the amount of money that was

fictitious and fraudulently—it does not happen in 1 year. It happens in 1, 2, 3, 4, 5, 6, 7 years. And that must be, in all honestly

just between you and I, staggering to you as the accounting firm

of record for this kind of fictitious income under your watch. And

I have to point that out, that it is hard to believe that that all

amount could—I mean, this is not $10 or $100, this is billions of

dollars.

So, you know, I will certainly give you an opportunity to comment on that. That is just my closing comment. It is probably very

difficult for you to do, because this is alleged by the Department

of Justice.

Mr. LAMPHRON. There is no doubt it is staggering, shocking.

Again, we share your outrage with this whole thing. You know, we

had what we thought was a very prosperous, very fast growing organization, the pride of Birmingham. And if you look at those numbers, which last night was the first time I had a chance to look at

them, what you see is they were basically not making any money

and often had losses.

Mr. STEARNS. And, you know, sometimes of the tip of the iceberg

is nine-tenths below the water. So this is what the Justice Department finds, $2.74 billion. It could be much more. So, let us hope

not for the stockholders and shareholders. But that is my only comment.

Mr. Chairman, I return the balance of my time.

Mr. GREENWOOD. The Chair thanks the gentleman.

The Chair thanks the members of the panel, the witnesses.

Thank you for your testimony. We appreciate it. And you are now

excused.

Mr. LAMPHRON. Thank you.

Mr. GREENWOOD. And the Chair would call forward our fourth

and final panel consisting of: Mr. Howard Capek, former Managing

Director of UBS Warburg Equity Research and Healthcare Group;

Mr. Benjamin Lorello, head of Global Healthcare Finance Group at

UBS Warburg; Mr. William McGahan, former co-head of Global

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Healthcare Finance Group at UBS Warburg; Mr. Lanny Davis, formerly of Patton Boggs, former counsel to HealthSouth and Richard

Scrushy, and; Mr. Hal Hirsch, formerly of Fulbright & Jaworski,

former counsel to HealthSouth.

Gentlemen, we welcome you. We thank you for your patience.

As you may have heard me say to the other panels, the other

witnesses, that it is the practice of the Oversight and Investigation

subcommittee to take testimony under oath. And I need to ask if

any of you object to giving your testimony under oath. I see no such

objection.

I also, pursuant to the rules of the House and this committee,

need to advise you that you are entitled to be represented by counsel. And so, I would ask if any of you are, in fact, represented by

counsel today.

Mr. Hirsch? Make sure your microphone is turned on and pointed pretty much at your face. And identify your attorney for us,

please.

Mr. HIRSCH. Yes, sir. Edwin Chessler of Corvas Sven & Moore.

And Mr. Chessler is sitting behind me.

Mr. GREENWOOD. Very well.

Mr. Capek?

Mr. CAPEK. Yes, sir. Thomas Fitzpatrick and Patricia Braur sitting right behind me.

Mr. GREENWOOD. Very well.

Mr. Lorello?

Mr. LORELLO. Yes, sir. Robert Lorello.

Mr. GREENWOOD. Very well.

Mr. McGahan?

Mr. GREENWOOD. Very well.

And Mr. Davis?

Mr. DAVIS. Mr. Lustin.

Mr. GREENWOOD. Mr. Lustin, very well.

Welcome to all of the counsel.

At this point I would ask you as soon as you pour the water

there, to stand and raise your right hands, please.

[Witnesses sworn.]

Mr. GREENWOOD. Okay, in so saying you are under oath.

And I will begin with you, Mr. Hirsch, and ask if you have an

opening statement?

TESTIMONY OF HAL HIRSCH, FORMERLY OF FULBRIGHT & JAWORSKI, FORMER COUNSEL TO HEALTHSOUTH; HOWARD

CAPEK, FORMER MANAGING DIRECTOR, UBS WARBURG EQUITY RESEARCH AND HEALTHCARE GROUP; BENJAMIN

LORELLO, HEAD OF GLOBAL HEALTHCARE FINANCE

GROUP, UBS WARBURG; WILLIAM MCGAHAN, FORMER COHEAD OF GLOBAL HEALTHCARE FINANCE GROUP, UBS WARBURG; AND LANNY J. DAVIS, FORMERLY OF PATTON BOGGS,

FORMER COUNSEL TO HEALTHSOUTH AND RICHARD

SCRUSHY

Mr. HIRSCH. I do not, sir. I am solely here to answer the questions of the committee, to the best of my ability.

Mr. GREENWOOD. Very well. I appreciate your being here.

Mr. Capek, do you have an opening statement, sir.

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TESTIMONY OF HOWARD CAPEK

Mr. CAPEK. I have an opening written statement which I have

submitted, and I am prepared to answer all of your questions.

[The prepared statement of Howard Capek follows:]

PREPARED STATEMENT OF HOWARD CAPEK, FORMER MANAGING DIRECTOR, UBS AG

Mr. Chairman, members of the House Committee on Energy and Commerce, my

name is Howard Capek. Until July of this year, I served as a Managing Director

in UBS AG’s Equity Research department.

I began my equity research career after earning a master’s of business administration from the Johnson Graduate School of Management at Cornell University in

1993. Upon graduation, I joined Merrill Lynch as a healthcare research associate

and was soon promoted to assistant vice president, working under one of that firm’s

senior analysts. I later joined Credit Suisse First Boston as a senior associate, after

following the senior analyst with whom I had worked at Merrill Lynch. I was promoted to vice president in December of 1996, and in March of 1998, upon the departure of my superior, was named senior analyst following healthcare providers.

I joined UBS in May of 1999 as an executive director, providing research coverage

to institutional investors on long-term care and alternate site healthcare providers.

I was promoted to Managing Director in December of 2001. Over the past three

years, I’ve expanded my research coverage to 35 companies across five health care

sectors, including drug wholesalers and specialty distributors, prescription drug benefit managers, contract research organizations, alternate site providers and

healthcare real estate investment trusts. When UBS completed its acquisition of

Paine Webber in November 2001, I also began providing my research to retail shareholders.

During my time at UBS, I was consistently ranked in the top quartile among the

approximately 75 analysts in the research department by the UBS institutional

sales, trading and retail departments and research management. I was also ranked

top 10 in categories of stock-picking, responsiveness to clients, and sector knowledge. In addition, I was ranked top-5 in stock picking by The Wall Street Journal

2002 all-star survey, a poll compiled solely on objective criteria. Over the last two

and one-half year period, as well as the individual analyzed periods (calendar 2001,

2002, and the first six months of 2003), my buy-rated stocks have outperformed the

major market and healthcare indices.

Of course, none of this meant that my stock picking was right all the time. However, I do believe it meant that the quantitative approach I took to analyzing stocks

was beneficial to UBS clients. These clients felt comfortable using my research reports and earnings models to help them anticipate how a company might perform

in the future, thereby contributing to their investment decision making process.

As with all equity stock market investing, no return can be guaranteed. Any of

a thousand uncertainties can change anticipated return outcomes and the validity

or success of any business model or bundle of assets. One of the greatest uncertainties involves the human element, the management of a company. Senior managers

make decisions that can affect the value and profitability of a company and they

also control a great deal of what the outside world gets to see. As with any member

of the investing public, analysts must rely on the honesty, accuracy and completeness of audited and unaudited information that a firm’s senior management team

regularly makes available to the public.

My exposure to Healthsouth began while working at Merrill Lynch under Lucy

Olwell, a top ranked analyst in the healthcare sector. Lucy decided to pick up coverage of the company in the mid 1990’s, because it was a significant factor in several healthcare services sectors and because its large market capitalization made it

one of the biggest such firms. We continued coverage of Healthsouth when the two

of us moved to CSFB from Merrill, and I took over Ms. Olwell’s portfolio of coverage,

including Healthsouth, following her departure from CSFB in 1998.

Throughout much of the period I covered Healthsouth, I rated the stock a buy or

strong buy. Throughout my entire career my ratings on every stock that I had covered were based on potential appreciation to a price target that I would expect the

stock to eventually reach, typically one-year into the future. My price targets were

derived from my projections of a firm’s future cash flows and relative sector returns

and cost of capital. My projections and modeling were ultimately based on audited

financial information that was publicly available and whatever information

Healthsouth management and their investor relations department routinely conveyed to me and the investment community.

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One challenge that any analyst faces is supporting an investment thesis or recommendation over the long-term, despite short-term fluctuations in a stock, which

can make those recommendations seem counterintuitive, particularly in retrospect.

If an analyst were to change recommendations with trading momentum, he would

inevitably be perceived as reactive rather than proactive, and would quickly become

less valuable to his clients. Although there were times where the stock price performance of Healthsouth ran counter to my recommendations, I maintained that in

the long term, the company’s value would be better recognized. Indeed, from February 2000 through mid 2002, Healthsouth stock price performance supported this

view.

With the benefit of hindsight, we now know that a significant portion of

Healthsouth’s financial history was predicated on fraud. Had I known this at any

time, not only would I have never assigned it a positive rating, I would have

dropped coverage of the company. For the many analysts in the sector that had positive ratings on Healthsouth, including myself, I do not believe that any of the operating changes and volatility that occurred from time to time in any way foretold the

nature or magnitude of fraud that took place.

Another concern the Committee has raised in its investigation of the Healthsouth

matter is the potential for conflict between investment banks and their stock research departments. Prior to the recent Wall Street settlements, a research analyst

job description included, if not required, regular interaction and discussion with investment bankers. At times, such discussions gave bankers the opportunity to suggest coverage of certain stocks and required research analysts be available to lend

their opinions on potential corporate transactions that involved banking services.

That said, my record shows that the final word on coverage and ratings always fell

first and foremost to my analysis and sector coverage considerations, and that my

recommendations, based on quantifiable expected price targets, were always appropriate, unconflicted and fair.

At any point while a company I covered was on a ‘‘restricted list,’’ that is to say

where I was not permitted to publish research coverage due to investment banking,

my interaction with clients complied with what I understood to be Firm policies at

the time. The two widely publicized emails, which were taken grossly out of context

by the media, were consistent with my understanding of UBS policy at that time.

Members of the Committee, what I have tried to demonstrate in these remarks

is that, despite short term trends sometimes defying my recommendations; despite

the challenges in maintaining continuity in research when dealing with restrictions

imposed by investment banking; and despite the many uncertainties associated with

stock picking, my efforts as an analyst have led to what I believe was an unbiased,

modeled approach to research that benefited my clients in making their investment

decisions. Throughout my entire career as an analyst, my intentions have been honest, my opinions have been independent and my actions have been proper.

Mr. GREENWOOD. Very well.

Mr. Lorello?

Mr. LORELLO. Yes. I would like to give an opening statement.

Mr. GREENWOOD. In that case, you are recognized for 5 minutes.

Did you submit a copy of your statement to the committee?

Mr. LORELLO. I believe the statement has been or will be submitted.

Mr. GREENWOOD. Will be. We would have liked to have had it before now, but you are entitled to present it. And so you are recognized for 5 minutes.

TESTIMONY OF BENJAMIN LORELLO

Mr. LORELLO. Chairman Greenwood, and members of the subcommittee, my name is Ben Lorello. Currently I am Managing Director of UBS and head of the Global Healthcare Investment Banking Group.

I am here today at the subcommittee’s invitation to answer questions concerning the work UBS has done for HealthSouth. I will assist the committee in anyway I can, and would be glad to share

some thoughts on potential ways to lessen the opportunity for this

type of fraud that HealthSouth has brought to light.

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I have worked in the investment banking industry for 25 years

and have spent the last 20 or so managing healthcare groups. First

at Salomon Smith Barney, and then at UBS.

I am proud to be an employee of UBS and proud of what the

healthcare teams I have managed have accomplished during the

last 2 decades in helping clients achieve their strategic goals and

also in their capital formation.

HealthSouth was a client of UBS from 1999 until March 2003.

UBS views HealthSouth as an important healthcare company, providing valuable services to millions of patients in modern facilities

across the country. Indeed, due to the qualify of the company’s operations and many thousands of honest, dedicated employees, it appears that HealthSouth will be able to withstand the accounting

fraud perpetrated by its former executives.

Throughout its relationship with HealthSouth, experience UBS

deal teams conducted extensive due diligence on HealthSouth.

Under UBS’ systems of checks and balances, the firm’s commitment committees evaluated the deal teams’ due diligence and made

an independent assessment of whether to proceed with each transaction.

UBS’ due diligence started with and relied upon HealthSouth’s

audited financial statements. Until the announcements of criminal

prosecutions against the HealthSouth officers in the spring of this

year, I was not aware of or did not suspect that anyone at

HealthSouth was engaged in any improprieties.

Further, I want to emphasize a point made by members of this

subcommittee and underscored in the indictment filed yesterday,

which is that HealthSouth management engaged in an elaborate

conspiracy to cover up, conceal and keep secret the fraud from its

auditors, its underwriters and lenders such as UBS, and from numerous other outsiders. As a result, HealthSouth’s investors, dozens of underwriters and lenders and many companies who sold

themself to HealthSouth in return for stock, all of whom necessarily and appropriately relied on the integrity of the financial

statements were by design misled and defrauded.

I believe the work of the subcommittee and others in Congress

have done to expose to examine corporate fraud will limit these

types of abuses in the future. The reforms implemented under the

Sarbanes-Oxley Act will make corporate boards and audit committees for vigilant and corporate executives more accountable.

I can assure you that UBS for its part will continue its commitment to conducting its business with the highest ethical standards.

Thank you.

Mr. GREENWOOD. Thank you, Mr. Lorello.

Mr. McGahan, do you have an opening statement, sir?

You need to turn on your microphone, please.

TESTIMONY OF WILLIAM MCGAHAN

Mr. MCGAHAN. Mr. Chairman, my name is William McGahan,

and I am a former employee of UBS. I have no opening statement,

other than to say that I have tried as best as I can to assist the

committee staff with its inquiry, and I am here today to answer

any questions that you may have.

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Mr. GREENWOOD. Thank you. And we appreciate it both of those

things.

Mr. Davis, do you have an opening statement, sir?

TESTIMONY OF LANNY J. DAVIS

Mr. DAVIS. Yes, I do, Mr. Chairman.

Mr. Chairman, thank you for giving me this opportunity to respond to questions and to explain the role that I played in this

matter.

First, I had no role regarding the accounting fraud issues that

were the subject of the indictment. I was asked to provide legal

media and crises management advice about the singular question

about insider knowledge: What did Mr. Scrushy know and when

did he know it.

I set three conditions to my representation when Mr. Scrushy

and the Board asked me to undertake it.

First, full cooperation and transparency with the SEC.

Second, an honest and complete investigation of the insider information charges against Mr. Scrushy by a distinguished law firm.

And third, full waiver of attorney/client privilege so that the SEC

would have immediate and complete access to all of the fruits of

the investigation, not just the report itself, but all underlying materials so that they could continue the investigation wherever the evidence led.

In the absence of agreement on those three conditions, full transparency, an outside investigation and waiver of attorney/client

privilege, I would not have undertaken this representation.

On the issue of transparency, I sent to the Chairman, to the Director of the Enforcement Division of the Securities and Exchange

Commission on a Sunday evening after I received those commitments from Mr. Scrushy, the following email that you can find at

Tab A of my testimony.

‘‘I understand that it is also possible that that the Board of Directors will appoint another law firm to conduct its own review.

The management of HealthSouth has given me full authority to

communicate with your office and to commit to respond fully and

cooperatively with any questions or concerns your office might

have, to disclose the results of any inquires, to reveal promptly any

improper conduct that may be ascertained, and, if appropriate, to

assist the company in remedial efforts when and if it is determined

that such are necessary.

Before an investigation had begun, before Fulbright & Jaworski

had been retained, I had committed in writing to the Chairman of

the Director of the Enforcement Division to waive all privilege and

to send over the results of the investigation including underlying

documents. And I did so with the knowledge and permission of the

Board and Mr. Scrushy.

At one point Mr. Scrushy began to resist on my commitment of

transparency. And there is another email that I would appreciate

your looking at, which is at Tab B where I basically reminded Mr.

Scrushy that I was not going to renege on that commitment, and

I said in part in arguing against the full release of this report to

the SEC, which Mr. Scrushy was now raising some weeks later,

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‘‘Not releasing the full report will look like a pullback on our prior

commitment to transparency with little credible explanation.’’

Second, Mr. Chairman, I was committed to a complete and accurate Fulbright & Jaworski report with no attempt—no attempt to

influence the conclusions. I did ask Mr. Hirsch who headed up this

investigation for the opportunity to hear the report read to me

ahead of time. He objected, because he thought it would appear as

if I was attempting to compromise the independence of his work.

And, of course, I was not.

I had two reasons for asking him to do that, Mr. Chairman. The

first is that I needed to prepare our media team for a public release

of the conclusions of the report because I had committed to sending

this over to the SEC and to releasing it publicly.

I assured Mr. Hirsch that my intention was not to influence in

anyway the conclusions. In fact, my intention was to bolster the

credibility and independence of his work, precisely because credibility was the issue in the media as well as at the SEC.

So at Tab C in answer to Mr. Hirsch’s legitimate concerns about

reading me the conclusions ahead of time, I sent him an email. And

I said to him the report is in ‘‘final form, and that would be the

understanding BEFORE you read. Advance reading has no impact

on Fulbright’s credibility.’’

The second reason that I wanted it read ahead of time is that

I was concerned that there may be open issues that would create

uncertainties in which the media and the SEC would ask why did

you not address those open issues. And it turns out after he read

the report to the Board there were two open issues. One was the

shredding issue, which we heard about for the first time on October

22. The other was what happened at a staff meeting where Mr.

Scrushy might have been told about the possibility of the impact

of this rule change.

So we asked Mr. Hirsch and his team to go back and reinvestigate and elaborate on this shredding issue, which I saw as explosive, legally as well as after Arthur Anderson and Enron in the

media.

And second, I asked him to reinterview to the best he could everybody at this July meeting to close those two issues that were

left open in the first report.

On October 29 he delivered two reports. One was the reinterview

of the July meeting on the insider trading issue. The second was

a much more extensive report on the shredding issue which led to

the conclusion we cannot answer this definitively, let us turn both

over the SEC.

So on October 29 and several days thereafter, despite some resistance from Mr. Scrushy, we kept our word and we sent all the

reports, the preliminary report done in early February, the October

21 report with the two open issues and the October 29 report on

shredding and report on insider information to the SEC with all of

the underlying documents.

Now, there was one issue that arose between me and Mr. Horton.

I learned from somebody at HealthSouth that despite my commitment to the SEC, that Mr. Horton had attempted to convince a

Fulbright lawyer not to send over certain emails that showed some

awareness by Mr. Horton and Mr. Owens of the impact of the rule

130

change prior to Mr. Scrushy exercising his stock options. I felt that

by reneging on our commitment at that point, especially if Mr. Horton was the influence behind that reneging, that it would look like

a conflict of interest by Mr. Horton, since I was worried that he

was withholding the very same emails which evidenced that he had

some foreknowledge. So I sent an email to Mr. Scrushy. And that

email, unfortunately, has been put out in fragmentary fashion by

a member of your staff. I urge you to read the entire email. Because the opening of the email expresses my concern that the Fulbright attorney was being influenced by Mr. Horton to renege on

our commitment to send everything to the SEC. So I said we must

cutoff Fulbright this morning, not this afternoon, but immediately

before more harm is done. That is the only fragment released, or

at least printed, by some of the members of your staff 2 weeks ago.

But the rest of the email explains my concern about keeping the

commitment the company had made to the SEC.

And so I then went on to say we must supervise—before more

harm is done, other than the Fulbright attorney, and only if he is

willing to be supervised by me and my law partner and not by Horton, who is the focus of the Board’s investigation and Fulbright &

Jaworski’s, and likely the SEC’s. At the very least, Horton’s effort

to convince the Fulbright attorney to assert a privilege and withhold documents from the SEC without consultation with me, constitutes a potential conflict of interest of him and the company.

So in conclusion, I had the greatest of respect for the job that

Fulbright did and for the job that Mr. Hirsch did. It was never

even slightly my intention to influence the credibility or perceived

independence of that inquiry. And at the end of the day, after we

handled the inside information allegation and released everything

to the SEC, my job was over by approximately by December 2002

to early 2003.

Thank you.

[The prepared statement of Lanny J. Davis follows:]

PREPARED STATEMENT OF LANNY J. DAVIS

Good afternoon, Mr. Chairman.

Thank you for giving me this opportunity to report on my representation of

HealthSouth Corporation and its former Chairman, Richard Scrushy.

In September 2002 I was asked by Mr. Scrushy and the HealthSouth Board of

Directors to offer legal, media, and crisis management advice concerning published

reports in late August that Mr. Scrushy may have improperly used inside information prior to his sale of substantial amounts of HealthSouth stock in May and late

July 2002. The alleged inside information was that the federal Medicare agency, the

Center for Medicare and Medicaid Services (‘‘CMS’’), had changed its rules on physical rehabilitation reimbursements, changes that would allegedly have had a substantial negative impact on HealthSouth’s earnings.

The classic question raised in the media in late August 2002 when the story first

broke on these insider trading issues was: What did Mr. Scrushy know about this

Medicare rule change, and when did he know it?

I am proud of my work for HealthSouth in this matter, because, throughout my

representation, I was faithful to three commitments I made to the SEC on

HealthSouth’s behalf when I began the engagement:

—First, full cooperation and transparency with the SEC;

—Second, an honest and complete investigation of the insider information charges

against Mr. Scrushy by a distinguished outside law firm;

—And third, full waiver of attorney client and work product privileges so that the

SEC would have immediate and complete access to all of the fruits of that investigation—not just the report itself, but all underlying materials—and could

continue the investigation wherever the evidence led.

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1. Commitment to Transparency and Cooperation With SEC

From my very first conversations with Mr. Scrushy in early September 2002, I

conditioned my willingness to represent him personally and the HealthSouth on his

and the Board of Directors’ express acceptance of these three commitments. They

agreed.

I memorialized those commitments in an email I sent to Stephen M. Cutler, Director of the SEC’s Enforcement Division, on Sunday evening, September 15, 2002,

which you can find attached to my testimony as Tab A. This email was sent three

days before the SEC decided to initiate its own investigation of Mr. Scrushy and

HealthSouth. The key last two sentences of this email read:

‘‘I understand that it is also possible that the Board of Directors will appoint

another law firm to conduct its own review. The management of HealthSouth

has given me full responsibility to communicate with your office and to commit

to respond fully and cooperatively with any questions or concerns your office

might have, to disclose the results of any inquiries, to reveal promptly any improper conduct that may be ascertained, and, ifappropriate, to assist the company in remedial efforts when and if it is determined that such are necessary.’’

I always counseled HealthSouth and Mr. Scrushy to honor that commitment, even

though they received conflicting advice at times from others. For example on October 21, 2002, shortly before Fulbright and Jaworski delivered its first report, Mr.

Scrushy and others in senior management questioned whether the entire report

should be released. I direct your attention, at Tab B, to an email I transmitted to

the entire public relations and legal teams, dated October 21, 2002, at 12:00 AM

that morning. Despite concerns raised by Mr. Scrushy and other company officials

as to whether it was wise to transmit the entire Fulbright report to the SEC and

release it publicly, I argued in favor of the company maintaining its commitment

to give the SEC the full report. I stated, in relevant part:

‘‘Not releasing it [the full Report] will look like a pullback on our prior commitment to transparency—with little credible explanation.’’

I am pleased to report that HealthSouth honored its commitment and shared with

the SEC not only the report that Fulbright & Jaworski prepared, but all of the background materials that Fulbright relied upon, including documents, analyses, and reports of interviews. Many people and companies under investigation talk about full

cooperation; very few, if any, deliver. Mr. Scrushy and HealthSouth deserve credit,

not blame, for fulfilling the commitment I made to the SEC.

2. Commitment To Complete and Accurate Fulbright Report—With No Attempt to Influence Conclusions

HealthSouth’s hiring of Fulbright & Jaworski fulfilled its second commitment to

the SEC—the retention of a nationally renown law firm to complete an outside investigation into the insider trading issues. This Committee should understand that

I counseled Mr. Scrushy and the Company to maximize, not undermine, the integrity of Fulbright’s investigation. The Company’s goal of weathering this crisis could

only be achieved if the regulators, the media, and the market credited Fulbright’s

conclusions. I counseled—and HealthSouth and Mr. Scrushy understood and

agreed—that only an honest, independent, and aggressive investigation would suffice.

With this in mind, I counseled Mr. Scrushy and the Company that a committee

of independent Board members, and not the Company, should retain Fulbright so

that their investigation would be truly independent in fact and would be recognized

as independent by the courts, by the regulators, and by the public. The Company

decided otherwise and directly retained Fulbright to conduct the investigation and

to represent it before the SEC.

Our commitment to release the Fulbright report promptly inevitably complicated

my efforts to advise Mr. Scrushy and the Company on the most effective means to

communicate Fulbright’s findings. In the typical situation, where reports such as

these are closely guarded and selectively released, there is always plenty of time,

after the report is prepared, to review its findings and to consider how to communicate them. But in a setting where we had committed to prompt release of the report, we did not have the luxury of time. To help formulate this advice, I asked Fulbright to show, or at least read to me, portions of its October 21, 2002 report before

the date on which Fulbright delivered the report to the Board.

I had two reasons for asking Fulbright to show or read me the conclusions—neither of them had anything to do with attempting to influence the conclusions.

The first reason was to prepare the media team for public release of the conclusions of the report.

I assured Fulbright partner Hal Hirsch in an October 21 email, as I was trying

to persuade him to read the report to me ahead of time, that I had no interest in

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changing a single word of the Report, which I understood to be ready for transmittal

to HealthSouth’s Board of Directors. In asking Mr. Hirsch for the opportunity to review the Report shortly before its presentation to the Board, I emphasized: the Report ‘‘is in final form—and that would be the understanding BEFORE you read—

advance reading has no impact on Fulbright credibility to the S.E.[C] [sic] or anyone

else if factually neither he nor anyone else is ableto make any changes.’’ [Tab C].

The second reason I wanted to hear the final conclusions ahead of time was to

permit me to advise Mr. Hirsch whether there were open issues left unresolved in

the Report that might lead to additional questions in the media and, thus, continuing uncertainties in the public markets. I understood that for the Report to be

credible, it had to be not just independent, but complete, leaving literally no stone

unturned.

As things turned out, I was correct in this concern.

The October 21 Fulbright Report presented to the Board left open two important

questions that needed further investigation.: (1) the circumstances surrounding the

shredding of documents during the time of the Fulbright review; and (2) whether

Mr. Scrushy had heard about the Medicare rule change at a large staff meeting in

early July 2002, several weeksbefore he exercised stock options and repaid Company

loans.

At my and the Board’s request, the Fulbright team undertook a supplemental investigation of both of these matters. On October 29, Fulbright presented two final

Reports that more extensively addressed both those issues.

The October 29 Report concerning Mr. Scrushy’s alleged insider knowledge confirmed the conclusions in Fulbright’s October 21, 2002 Report: namely, there was

no evidence uncovered by Fulbright to date that showed that Mr. Scrushy had inside knowledge of a material adverse effect of the CMS rule change.

A separate Report, also dated October 29, addressed the circumstances of the

shredding more extensively. Fulbright could not reach any definitive conclusions

about the shredding issue and determined that the SEC was in a better position

to continue and complete that investigation.

But I want to emphasize two crucial and undisputed facts: First, I only asked to

review the October 21 and 29 reports ahead of time and not to change any of

Fulbright’s conclusions in these reports; and, second, the purpose and result of my

review of the first October 21 report was to urge Fulbright to conduct further investigation, not to soften any of its findings.

Both of these final October 29 reports, as well as the October 21 incomplete report

and a preliminary two-page report dated October 2, were transmitted to the SEC

as promised, and, as far as I knew at the time, the underlying emails and documents that were the basis of Fulbright’s conclusions on the insider knowledge issue.

3. Completion of Fulbright’s Services—SEC To Continue Investigation With Benefit

of All Fulbright Reports and Underlying Documents

After Fulbright completed its final reports and sent them to the SEC, I recommended (with Mr. Scrushy’s concurrence) that Fulbright no longer needed to continue billing time to HealthSouth. I did so for three reasons.

First, I believed it was more appropriate for the SEC, as the chief enforcement

agency, to continue the investigation on this and other matters—without

HealthSouth having to continue to be burdened by substantial additional legal expenses.

Thus, as you will note from the email to Mr. Hirsch dated November 6, and found

at Attachment D, I stated to Mr. Hirsch:

‘‘I have advised Richard [Scrushy] that with the investigation regarding himself

completed, we will continue to fully cooperate with the S.E.C. and therefore do

not need Fulbright’s services any more.’’ [Emphasis added].

Second, as I expressed in an email and in several telephone conversations in early

November 2002—after the final reports had been delivered to the SEC—I was told

that HealthSouth’s general counsel might be attempting to persuade Fulbright to

withhold certain documents from the SEC on grounds of attorney-client privilege,

which would have been a breach of HealthSouth’s commitment to the SEC, as I had

stated in my email of September 15 to the Director of the Enforcement Division of

the SEC.

The Company’s general counsel, Mr. William Horton, had told me directly on several occasions that as a general matter he did not favor turning over all documents

to the SEC and waiving attorney-client and work product privilege. I did not question his sincerity in taking this position. I did question his judgment, however, in

light of the position I had previously taken with the SEC.

Further, among the documents underlying the October 21 and 29 Fulbright Reports were certain emails authored by Mr. Horton that suggested that he had some

133

knowledge and concerns, before Mr. Scrushy’s stock transactions, that the CMS rule

change might have a significant negative impact on the Company’s earnings. I was

concerned that some of the documents Mr. Horton reportedly wanted to refrain from

delivering to the SEC might be these same emails creating at least the appearance

of a potential conflict of interest.

On or about November 3, I was told by a HealthSouth official that Mr. Horton

might be trying to convince an attorney from Fulbright not to send all the underlying documents and emails to the SEC. Therefore, on November 4, I sent Mr.

Scrushy an email (found at Attachment E) stating that Fulbright should be terminated immediately because ‘‘Horton’s effort to convince [the Fulbright attorney] to

assert a privilege and withhold documents from the SEC without consultation with

me constitutes a potential conflict of interest for him and the Company.’’

To this day I am not sure whether Mr. Horton, in fact, was taking this position

with respect to these specific documents. I certainly am not suggesting that he was

doing anything improper. But I was concerned enough to write this email at the

time.

The third reason I believed that Fulbright did not need to continue any investigation was that Special Litigation Committee of the Board had retained its own outside and independent counsel to investigate the same transactions at issue in the

Fulbright investigation. The Committee had done so to help it defend a civil stockholder derivative lawsuit. The Company did not believe that it should pay two separate law firms to continue investigating the same transactions, and I agreed.

To repeat: Clearly my overriding concern was maintaining the Company’s commitment to the SEC concerning transparency and waiver of privilege—and preventing

the harm that might be done to the Company and its shareholders if that commitment were reneged upon.

To this day I have nothing but the greatest respect for the integrity and professional skills exhibited by Mr. Hirsch and his colleagues at Fulbright & Jaworski for

the job they did in these very difficult circumstances. Nothing I have seen or heard

since then casts any doubt upon the integrity of their conclusions or the independence of their efforts.

Conclusion

I appreciate the chance to clear up any questions about my role in the

HealthSouth matter. We tried to learn and apply the lessons of Enron and the high

standards of Sarbanes-Oxley. My role in HealthSouth was to counsel for and to insist upon transparency and cooperation. That was sound legal advice, good corporate

governance, and the only truly effective way for HealthSouth and Mr. Scrushy to

address the questions that had been raised.

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Mr. GREENWOOD. Thank you, Mr. Davis.

And just for the record, our staff releases only entire emails, not

fragments thereof. And so what is printed is beyond our control as

well.

Mr. DAVIS. I understand.

Mr. GREENWOOD. Thank you.

The Chair recognizes himself for 10 minutes for questioning.

And I want to start with Mr. Capek.

The reason that this committee holds hearings, holding this

hearing on this matter and the reason that we have held other

hearings is ultimately to find out whether the laws and the processes that are in place to protect the investor are working. And in

the case of HealthSouth, we found out that barricade after barricade that was supposed to be erected to protect the investor were

breached. The employees who had the responsibility to give the investors honest information, failed to do that. The Board of Directors, for right or wrong as we learned this morning, were unable

to protect the investors from this fraud. The accountants were unable to protect the investors from this fraud. And that is not to say

we are guessing blame there, it is just the fact the matter is that

they testified that they could not do that.

One of the barricades that is erected in our economic system is

the stock analyst. And, of course, as you well know, Mr. Capek, you

have a very important responsibility in trying to make sure that

investors have good honest information with which they can base

their judgments and make a whole economic system work.

I am going to ask you, Mr. Capek, to turn to Tab 1 in the binder

there. This is a report you published on HealthSouth in May 1999,

and in big bold letters on the first page is the word or the words

‘‘strong buy.’’ Do you have that document, sir?

Mr. CAPEK. It starts on the first pages, a fax to L. Murphy from

myself?

Mr. GREENWOOD. Yes. The second page of that document.

Mr. CAPEK. The second page, the draft, dated June 4. Yes, sir.

Mr. GREENWOOD. Right. Okay. Would you identify the document,

please?

Mr. CAPEK. This is a research report, a draft, dated June 4, 1999

written by me with my current rating at the time on HealthSouth,

which was a strong buy.

Mr. GREENWOOD. Okay.

Mr. CAPEK. The title of the report is ‘‘Reiterating the Strong Buy,

Dispelling Some Near Term Market Concerns.’’

Mr. GREENWOOD. Very well.

What does ‘‘strong buy’’ mean to an investor. What are you trying to signal to the investment community when you say strong

buy?

Mr. CAPEK. That my price target, which according to the report

here, was $20 and the stock was trading at $14.44 at the time; is

greater than a 20 percent upside to my price target or what I

would theorize as my fair value of the company roughly 12 months

out from now.

Mr. GREENWOOD. So would a strong buy imply as well that you

do not see any immediate downside to the company, is that right?

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Mr. CAPEK. No. It is a rating that I have applied for the last year

and half. It is not even a category a strong buy rating that the

firm, UBS, has. But, no, there can be volatility with the stock up

or down.

Mr. GREENWOOD. Right. But it does mean that the stock is at a

price where it should be bought. You’re recommending people buy

it and continue to do well in the foreseeable future?

Mr. CAPEK. Yes, sir.

Mr. GREENWOOD. Okay. Would you please turn now to Tabs 3

and 4 in your binder? And identify the document in Tab 3. I will

identify it. There are two separate emails written to Susan Zeeb by

you in response to her questions about HRC, which refers to

HealthSouth. Is that correct?

Mr. CAPEK. Yes, sir.

Mr. GREENWOOD. Have I correctly identified the document.

Mr. CAPEK. Yes, sir.

Mr. GREENWOOD. Okay. Let us look at the first email on Tab 3.

This is written a few months after you have indicated that

HealthSouth was a strong buy, which is as we just discussed. And

you state ‘‘I would love to publish on this pig, then I would not be

spending so much time in Birmingham in July/August, at least

there is no humidity. Okay. On HRC, what is your fax number, I

will send you a few charts and graphs which should glaringly highlight the company’s inability to collect and convert sales into cash

and also their inability to reinvest cash at good rates of return.’’

Would you agree that this is not a positive statement about

HealthSouth’s stock?

Mr. CAPEK. It is a reactionary statement to Ms. Zeeb’s original

email, which I believe the reply separator is dated below, where

she seems to be responding to ‘‘it’s acting like such a pig again,’’

the stock price. So in hindsight being the perfect looking glass that

it is, I would have in my response put the word ‘‘pig’’ in quotes because responding to what she was saying or asking——

Mr. GREENWOOD. Was that the kind of language you would use

to recommend that she buy that stock?

Mr. CAPEK. No, sir.

Mr. GREENWOOD. Okay.

Mr. CAPEK. I was not—I did not have a strong buy recommendation on the stock at this point in time.

Mr. GREENWOOD. What recommendation did you have at this

point in time?

Mr. CAPEK. I did not have a rating. I was restricted on the stock.

Shortly after the last research report that you referenced in Tab 1,

sometime in mid-June I was restricted on HealthSouth stock.

Mr. GREENWOOD. Okay.

Mr. CAPEK. So I did not have a rating.

Mr. GREENWOOD. Yes. Were you aware when you wrote the

strong buy recommendation that—and did you have in your possession charts and graphs which would glaringly highlight the company’s inability to collect and convert sales into cash and their inability to reinvest cash at good rates of return?

Mr. CAPEK. Yes, sir. Actually, the draft report, dated June 4 that

you referenced in Tab 1, was a summation of high points from my

larger report dated May 18. And actually, as I was going to conVerDate 11-MAY-2000 08:30 Mar 04, 2004 Jkt 000000 PO 00000 Frm 00148 Fmt 6633 Sfmt 6602 91232.TXT HCOM1 PsN: HCOM1
141

tinue, the charts and graphs that I was sending Ms. Zeeb were my

analysis of historical return on invested capital, margin analysis,

spending trends, all based on historical data and all of it that was

published in the May 18 report on HealthSouth.

Mr. GREENWOOD. When you used the term ‘‘pig’’ what did you

mean?

Mr. CAPEK. I was——

Mr. GREENWOOD. I know you were echoing her, but you——

Mr. CAPEK. I was just taking the word that she said and putting

it into my response. She was referring the stock as acting like a

pig again, assuming she meant volatility on August 18/19 when

these were written. And I was just putting it back in there to her.

It didn’t mean anything beyond that.

As I said, if I had put it in quotes or if I had not put it in at

all——

Mr. GREENWOOD. Well, how can you explain what appears to us

to be two polar statements about this company? Strong buy, which

is your official statement that you send out to investors and in a

private email saying nothing but negative things about this company, particularly as I have said and read a couple of times here,

the company’s inability to collect and convert sales into cash and

their inability to reinvest cash at good rates of return? Those qualities do not seem like the qualities of a company that one would

normally expect to receive a strong buy recommendation, do they?

Mr. CAPEK. They can be. And in my May 18 report was the theory was the trend would reverse in the near term. There is a cycle

to cash collection. There is a cycle capital spending. And you want

to own the stock when the cycle is at the inflection point. And

when I wrote the report in May, my strong buy rating in June

when the follow reiteration, my thoughts were the next quarters

based on the managed care or commercial pricing cycle and how

they pay their bills, and how HealthSouth had been spending

money, that that cycle would turn. And you would be in what I

would call a cash hog mode or the company would be.

So my strong buy rating is on the stock and I regret using the

word ‘‘pig’’ in response to when my institutional client used it, it

was poor judgment. But beyond that, I was not changing my

investment——

Mr. GREENWOOD. Well, did you think that your email to her

would be the kind of email that would prompt her to invest in this

company?

Mr. CAPEK. I was not trying to elicit her to buy or sell the stock.

I was responding to her. I thought maybe she had not seen or did

not have a copy of my large report from May. Here are these historic charts and graphs, take a look. I was trying to help her explain the trading activity that she referred to that the stock was

acting like a pig.

Mr. GREENWOOD. You said that you were restricted. Why were

you restricted?

Mr. CAPEK. In mid-June I was asked to participate in a piece of

presentation to the Board at HealthSouth to discuss the split out

of the company into two pieces. The in-patient business and the

out-patient business. And at the time I was still involved in working on that.It was publicly disclosed by the company that they

142

hired UBS Warburg to advise them on that, and that is what I was

doing. So I was not publishing on HealthSouth.

Mr. GREENWOOD. So you were not allowed to publish reports and

you also were not allowed to discuss material issues about the company with outside investors, is that right?

Mr. CAPEK. Correct.

Mr. GREENWOOD. Okay. Let us look at the next email at Tab 4.

This is dated September 10, 1999, also to Ms. Zeeb. And in this

email, again, referencing HealthRC, HealthSouth, you state ‘‘I

would not own a share.’’ Is this statement consistent with your

strong buy rating of HealthSouth?

Mr. CAPEK. Again, I did not have a strong buy rating at the time.

I was still restricted. But to put this email in context, on Friday,

September 10, on Thursday September 9 HealthSouth announced

that they were not going to go forward with the split up of the company and that they were taking charges, they were reducing earnings guidance, changing some management spots and a whole

bunch of stuff along those lines.

So, again, I do not know why we do not have the rest of, but I

was responding again to Ms. Zeeb, and I was commenting kneejerk to that press release of less than a day before saying what a

mess. I just would not own a share right now.

Mr. GREENWOOD. And would you have owned a share when you

made your strong buy recommendation?

Mr. CAPEK. Yes, sir.

Mr. GREENWOOD. Okay. And the vents that you just listed occurred prior to your strong buy recommendation—after your strong

buy recommendation but prior to your declaration that you would

not own a share?

Mr. CAPEK. Yes, sir.

Mr. GREENWOOD. Okay. Were you aware at the time that you

wrote these emails that you were on a restricted list regarding

HealthSouth?

Mr. CAPEK. Yes, sir.

Mr. GREENWOOD. Okay. Had UBS informed you that you were no

longer on the restricted list during the time you wrote these

emails?

Mr. CAPEK. No, sir.

Mr. GREENWOOD. Okay. When you re-initiated coverage of

HealthSouth——

Mr. CAPEK. Yes, sir.

Mr. GREENWOOD. [continuing] how did you rate it then?

Mr. CAPEK. In February 2000, I re-initiated coverage on

HealthSouth with a strong buy.

Mr. GREENWOOD. Okay.

Mr. CAPEK. At the time I initiated coverage again, February

2000, keeping in mind again my rating is commiserate to the upside potential and what I think the stock is fairly valued at. The

stock was $5. My price target was $11, I believe. Contrast that to

my May rating where the stock was $14, my price target was $20.

So valuation parameter had changed based on while I was restricted the company reported two quarters of earnings, expectations had come down, the stock gone down to 5. And on a clean

143

slate, I thought the $5 stock was worth 11, based on the projections, forecasts I had then in February.

In fact, actually the stock went up over the next 18 months going

to high teens. But be that as it may, yes, I re-initiated coverage in

February 2000 with a strong buy.

Mr. GREENWOOD. So the only time that you would not buy a

share was the time during which you were restricted, is that right?

Mr. CAPEK. Coincidentally with timing of announcements and

what it says in the emails, yes.

Mr. GREENWOOD. Okay. So your testimony is that in June when

you wrote—when did you write your strong buy recommendation?

Was that in June?

Mr. CAPEK. My initiation of coverage was in the end of May

1999. Excuse me. The June 4 graph that you referred to was a reiteration of that report.

Mr. GREENWOOD. Okay. So between June 4 and February, which

were your two strong buy recommendations——

Mr. CAPEK. Yes, sir.

Mr. GREENWOOD. [continuing] you went from strong buy to pig

can’t earn money, I would not own a share of it back to strong buy?

Mr. CAPEK. I was restricted on the stock in mid-June, and when

I re-initiate coverage, that time line of events the way the company

disappointed two expectations reported results—yes, sir. Given the

way the stock price traded, yes.

Mr. GREENWOOD. My time has expired.

The gentlelady from Colorado is recognized for 10 minutes.

Ms. DEGETTE. Mr. Capek, there is another email that is not in

the book. If we can have staff give you a copy of it. This is an email

from Susan Lee to you, dated Tuesday, September 24, 2002. And

what Ms. Lee says in this email is that several of your institutional

clients were concerned about HealthSouth’s high capital expenditure figures quarter after quarter and were worried that

HealthSouth was capitalizing expenses. And she even says similar

to what WorldCom was doing. And in her email she says that when

talking to your client, she tried to ‘‘concentrate on strong cash, but

that it did not sound like he was buying it.’’ She continued by saying that she was aware that HealthSouth ‘‘is expanding their facilities and that there are some maintenance costs.’’ And then she

asks ‘‘Are we looking at anything else here?’’ Do you recall getting

that email from her?

Mr. CAPEK. I have seen it in the process of gathering and reviewing documents for the last—since March, but I do not recall it.

Ms. DEGETTE. You do not remember specifically?

Mr. CAPEK. No, ma’am.

Ms. DEGETTE. But do you remember some discussions during

that time period of September 2002 wondering about the capitalizing of expenses of HealthSouth?

Mr. CAPEK. In September 24—on September 24—well, Susan Lee

was my associate.

Ms. DEGETTE. Yes, I know.

Mr. CAPEK. Okay. Yes, and that——

Ms. DEGETTE. I mean, these are pretty serious allegations in

here, would you not say so?

144

Mr. CAPEK. I would not call them allegations. But, yes, they are

serious and they are points that I have scrutinized with the company over time, and investors had been aware of.

Ms. DEGETTE. You had scrutinized the issue of whether there

were high capital expenditure figures?

Mr. CAPEK. Yes.

Ms. DEGETTE. And what was your conclusion?

Mr. CAPEK. The company was investing, they were opening new

facilities or hospitals. And at some point it would slow. I mean, cap

X did fluctuate year to year. In 2002, we are to the point September 24 that the earnings——

Ms. DEGETTE. Let me ask you something, how long have you

been in the business?

Mr. CAPEK. Ten years, roughly.

Ms. DEGETTE. Ten years. And I think you said at least in your

written testimony you have kind of a complex method by which you

decide whether you recommend buy or not, right?

Mr. CAPEK. Yes.

Ms. DEGETTE. So do you concentrate on healthcare enterprises?

Mr. CAPEK. I cover only healthcare services.

Ms. DEGETTE. Now, during this period in 2002, or you know

1999 to 2003, were the capital expenditure figures for HealthSouth

different from other similar healthcare entities? Did you look at

that?

Mr. CAPEK. Yes, I did look at it on the per bid basis or as a percentage of total cash-flow. And it is not out of line.

Ms. DEGETTE. It did not seem that different to you?

Mr. CAPEK. No.

Ms. DEGETTE. Okay.

Mr. CAPEK. When you look at——

Ms. DEGETTE. Now——

Mr. CAPEK. If I can?

Ms. DEGETTE. I’m sorry.

Mr. CAPEK. At September 24, you are less than 1 month after the

August 27 announcement from the $175 million reduction, a number of things going on. The company points to slowdown in surgery

volume trends. So the stock had traded down. When you look at

complex valuation methodologies, one of the things at this point

and well before September 24 as one of the investment risks in my

research, I pointed out management’s credibility with hitting cap

X targets and other things. So I do not think there is anything new

being discussed here.

Ms. DEGETTE. I am having difficulty understanding you. I am

sorry, if you could just speak into the mike.

Mr. CAPEK. Okay.

Ms. DEGETTE. Thank you.

Mr. CAPEK. I said September 24, the date of this one email, it

is less than 1 month——

Ms. DEGETTE. No, I heard that part.

Mr. CAPEK. Okay.

Ms. DEGETTE. But my question is then if there was a lot going

on, do you recall calling this investor and talking to him about all

of these issues, management credibility and all these things?

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Mr. CAPEK. I do not recall, and I do not know these institutional

investors, for what firms they work at, who they are. If Susan

asked me to call them back, I am sure I did either from the road

or——

Ms. DEGETTE. But you do not recall that conversation?

Mr. CAPEK. No. And on average——

Ms. DEGETTE. Were you aware that after 2000 that HealthSouth

did not make any more facilities acquisitions. And, in fact, they

were closing facilities?

Mr. CAPEK. Yes, ma’am.

Ms. DEGETTE. So what were they spending their capital expenditure money on if they were actually closing facilities?

Mr. CAPEK. They were consolidating——

Ms. DEGETTE. Did you wonder about that?

Mr. CAPEK. They were consolidating out-patient facilities. So if

you were closing an MRI facility or a diagnostic center, the actual

magnet or whatnot was being moved to another location that was

already there. And, actually, at this point——

Ms. DEGETTE. So what you are saying they were not really closing facilities, they were just shifting them?

Mr. CAPEK. They were closing some of those out-patient and satellite facilities.

Ms. DEGETTE. Right.

Mr. CAPEK. They were also opening nine new hospitals. And

hospitals——

Ms. DEGETTE. So you thought that was where the capital expenditures had——

Mr. CAPEK. Roughly a $100 to $120 million a hospital, yes.

Ms. DEGETTE. Okay. Now, were you concerned about what Susan

Lee was saying in this email?

Mr. CAPEK. I was concerned, as I said, and I wrote about my concerns and risk factors in my written document—my written——

Ms. DEGETTE. Do we have those? Does the committee have

those?

Mr. CAPEK. In my interview, yes, we went through my packet of

research. But——

Ms. DEGETTE. No, wait. I am sorry. Is that answer yes we have

those documents?

Mr. CAPEK. Yes.

Ms. DEGETTE. Okay.

Mr. CAPEK. And if you do not, I will be happy to get them to you.

Ms. DEGETTE. Okay. Now, I have another question. I would like

to get them. I do not know. Do we have those? Staff does not know.

If you can provide us with another copy, that would be very helpful.

Now, as recently as March 2003 the company was, obviously, unraveling. There was a Department of Justice probe. There was

Transmittal 1753. There were all these news articles. Mr. Davis

can tell us all about what was going on in that period. Yet you

were still making a buy rating. Can you please tell me your rationale for that?

Mr. CAPEK. Yes. And, again, my methodology of rating stocks is

based on what I expect the stock to trade at in fair value. There

146

was still roughly $3 plus of tangible book value on the company

and the stock was trading between 5 and 6. When I looked at——

Ms. DEGETTE. Well, were you concerned about the effect that all

of these other issues like the Department of Justice probe and

Transmittal 1753, etcetera, would have on the business. I mean,

you had actually been expressing these concerns way back to 1999

in various ways, right?

Mr. CAPEK. Yes. And to answer your question, yes, I did have

those concerns. But I also felt or estimated that at $5 a share, the

way the stock was trading and based on what—based on audit financial for many years at tangible book value per share with $300

plus million in cash, the coverage ratios—I mean your concerns,

when you are asking my concerns about capital spending, you tie

those into my projections for cash-flow and coverage ratios. Can

this company service its debt. I cover the healthcare rates, which

many of my competitors do not. The real estate companies that

own the facilities. In the case of the rates that had business or had

rents outstanding to HealthSouth, HealthSouth was current within

1 month of all of their rents. And they remain that way through

today, by the way.

So, yes, I was concerned, cognizant——

Ms. DEGETTE. Even though their stock has plummeted? I mean,

if someone had actually bought the stock in March 2003, they

would have lost a lot of money, right?

Mr. CAPEK. I have not followed the stock since.

Ms. DEGETTE. Okay.

Mr. CAPEK. But probably. At some point the stock was .08 cents,

and I think today it is——

Ms. DEGETTE. Well, let me just ask you—I am sorry, they only

give us limited time.

Mr. CAPEK. It is okay.

Ms. DEGETTE. Yes. Wrap up.

Mr. CAPEK. Yes, I was concerned. But relative to where the stock

was trading, the tangible book value and what I expected based on

historic results what their true cash-flow was, the company was

okay.

Ms. DEGETTE. Now, before 2002 when Attorney General Spitzer

entered into the settlement with all the investment banking companies, a number of firms were both performing banking and research analyst functions. And I am wondering if your firm was

doing that with HealthSouth?

Mr. CAPEK. I was never called on to perform banking functions.

Ms. DEGETTE. No, no. I am talking about your firm. Were people

doing banking and research analyst functions at your firm?

Mr. CAPEK. No. Not—in healthcare and to what I was exposed

to, no. Healthcare research analyst reported to research and——

Ms. DEGETTE. Mr. Lorello, do you know the answer to that question? Was your firm performing banking functions and also research analysis functions?

Mr. LORELLO. On the same companies?

Ms. DEGETTE. On HealthSouth?

Mr. LORELLO. Yes.

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Ms. DEGETTE. Tell me, if you know, what percentage of the income your firm received from HealthSouth was received from banking and what was received from research analysis?

Mr. LORELLO. I cannot give you the statistic on the research, but

I can give it to you on the banking.

Ms. DEGETTE. How much was from banking?

Mr. LORELLO. Approximately 2 percent of our group’s revenues of

the healthcare group’s revenues came from HealthSouth.

Ms. DEGETTE. And what was the rough amount of that revenue?

I do not know what your group’s revenues were, so I do not know

what 2 percent is.

Mr. LORELLO. I think in any given year, about $5 to $6 million.

Ms. DEGETTE. Okay. And what about the research analysis. You

do not know how much of your firm’s income came from that?

Mr. LORELLO. Well, yes. That question would be the sales and

trading commissions that we generate from research and on the equity side, I just do not know the answer to that.

Ms. DEGETTE. Mr. Chairman, I would ask if either this witness

or someone else from the company can supplement in writing the

answers to give me that information.

Do you know, Mr. Lorello, is your firm now performing both of

these functions for HealthSouth? Both banking and the research?

Mr. LORELLO. Well, we no longer have a relationship with

HealthSouth.

Ms. DEGETTE. Okay. So the answer is no.

Mr. LORELLO. Yes.

Ms. DEGETTE. Are you doing it for anybody?

Mr. LORELLO. Well, with the Spitzer legislation that has resulted

in the settlement, is a complete and total separation now between

banking and research.

Ms. DEGETTE. There is a firewall, right?

Mr. LORELLO. It is even thicker than that.

Ms. DEGETTE. Okay. Thank you.

Thank you, Mr. Chairman.

Mr. GREENWOOD. The Chair thanks the gentlelady.

The gentleman from Florida is recognized for 10 minutes.

Mr. STEARNS. Mr. Chairman, thank you.

And, Mr. Hirsch, I would just like to chat with you briefly here.

You were hired at the request of Mr. Davis, is that——

Mr. HIRSCH. I was hired by Fulbright & Jaworski.

Mr. STEARNS. Yes.

Mr. HIRSCH. Who was hired by HealthSouth. I believe at the recommendation of——

Mr. STEARNS. Of Mr. Davis.

Mr. HIRSCH. Yes, sir.

Mr. STEARNS. Yes. Okay. And you came in and you did a report

on October 1, 2002. You did another report on October 21, 2002.

Then you had two more reports on October 29. Is that true?

Mr. HIRSCH. Yes, sir. And one on March 14, 2003.

Mr. STEARNS. Okay. Right.

As a result of these reports, did you think at that time that your

investigation cleared Mr. Scrushy of any culpability dealing with

the sale, inside trading?

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Mr. HIRSCH. I am not certain from your question as to what that

time was. But if I can——

Mr. STEARNS. I mean, as a result of these four reports and the

additional reports that came, did you in your own mind feel my reports pretty much show consistently that Mr. Scrushy did not

know, and when you—he did not know about the $175 million

shortfall. And then when he sold the stock, that it was not insider

trading. Do you feel comfortable at saying at that point your report

said that?

Mr. HIRSCH. No, sir. My report never said that.

Mr. STEARNS. Right.

Mr. HIRSCH. And in fact, prior to the issuance of any of the reports and at the time of the engagement, I advised Mr. Scrushy,

the Board and all other related counsel that we would never be

able to say that.

Mr. STEARNS. No.

Mr. HIRSCH. I advised that we would not be able to prove a negative. That we would most likely, at best if there was in fact a complete inability to establish that Mr. Scrushy had done it——

Mr. STEARNS. Okay.

Mr. HIRSCH. [continuing] the negative.

Mr. STEARNS. Okay. Then on October 30, 2000, there was a press

release issued by HealthSouth. Did you receive a copy of this press

release?

Mr. HIRSCH. I received a copy of that press release, sir.

Mr. STEARNS. And the press release said HealthSouth Chairman

Richard Scrushy cleared by outside investigation of advanced

knowledge of Medicare rule change prior to stock transaction. Did

you know about the press release?

Mr. HIRSCH. I saw the press release on the morning of the 29th,

I believe.

Mr. STEARNS. And I guess the basic question is what was your

reaction when you saw that press release?

Mr. HIRSCH. I was very dismayed by the contents of the press release, and immediately contacted general counsel who had sent it

to me, Mr. Horton. Advised him of all of my concerns. I was also

accompanied by——

Mr. STEARNS. And the reason you were concerned was because

it had the word ‘‘cleared’’ when your investigation did not say that?

Mr. HIRSCH. That was one of our concerns, sir.

Mr. STEARNS. Okay. And did you have conversation with Mr.

Scrushy, Mr. Horton or Mr. Davis later that afternoon about that

press release?

Mr. HIRSCH. No, sir.

Mr. STEARNS. You got no calls from any of them?

Mr. HIRSCH. Yes, sir. That afternoon on October 29, that is correct.

Mr. STEARNS. I think our staff said when they talked to you, you

said you got a call from three of them at 4 p.m. on October 29 asking if there is anything in the—from using that press release as it

was already written and passed out?

Mr. HIRSCH. Yes, sir. I was confused as to whether it was that

or the following.

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Mr. STEARNS. And did you communicate really clearly to them

your position that you were upset?

Mr. HIRSCH. Yes, sir.

Mr. STEARNS. Did they go back and change the press release?

Mr. HIRSCH. No. That was not exactly the connotation or the purpose of their call to me. But, in fact, no there were no changes to

the press release.

Mr. STEARNS. Okay. Was there reaction from the law firm of Fulbright & Jaworski to this press release?

Mr. HIRSCH. Is the question what was the reaction?

Mr. STEARNS. Yes. What was F&J’s reaction to the press release?

Mr. HIRSCH. We advised Mr. Horton, and I advised others, that

the press release was unacceptable. We had no control over the

issuance of the press release. When, in fact——

Mr. STEARNS. Did you——

Mr. HIRSCH. Excuse me, sir.

Mr. STEARNS. That is good.

Do you know a Mr. Felice Gallant?

Mr. HIRSCH. I do know a woman who is an attorney at Fulbright

& Jaworski named Felice Gallant, yes.

Mr. STEARNS. This is Tab 77 from Neil Gold to Hirsch with a cc

copy to Felice. This is what he said to you:

‘‘Hal, this is hilarious. Is it a’’—and he is talking about the press

release. ‘‘Is it a parity or is it for real? A few thoughts and questions. One, I did not know we had the power to clear Richard. In

fact, our letter says quite the contrary. What is the legal definition

of inkling? Is it more like scintilla? Do these idiots realize that 2

months after May 14 is July 14?’’ And it goes on.

Do you remember that memo?

Mr. HIRSCH. Very much so, yes.

Mr. STEARNS. Okay. Do you agree with that memo?

Mr. HIRSCH. I do not agree with the colorful connotation of that

memo.

Mr. STEARNS. No. But I mean content, in terms of the just saying

what are we clearing Richard for, because our evidence shows he

was not cleared.

Mr. HIRSCH. In fact, sir, we never cleared Mr. Scrushy. I am certain that the staff has seen, and I believe you have seen that our

report reflects totally different statements.

What in fact we did do is, I had spoken to Mr. Horton. We advised Mr. Horton of the errors. We had no control over the press.

We advised what was wrong with the press release. I believe it is

a subsequent email to either Mr.—I know to Mr. Horton, as well

possibly copying others and Mr. Gold evidencing in fact that I had

contemporaneous conversation with Mr. Horton evidencing or explaining all of those issues.

Mr. STEARNS. Did you threaten to say listen, if you do not change

that press, we are going to resign as counsel if a corrective press

release were not issued?

Mr. HIRSCH. Yes, sir, we did.

Mr. STEARNS. Okay. And what was Mr. Davis’ reaction to the decision concerning the press release?

Mr. HIRSCH. Subsequently after the press release was issued,

and it became public, we advised that the press release needed to

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be revised to reflect the actual state of what our report had said.

And that report, in fact, did not say what the first press release

was. The results was that there was a dialog and there was a

change by the company, a revised press release was negotiated on

the 1st of November and it was issued before the business—the

opening of business on November 4.

Mr. STEARNS. Did you ever communicate to Mr. Davis that you

felt that this whole press release was being finessed based upon

your conclusions and was really a PR?

Mr. HIRSCH. I do not think I ever connoted it in that way, sir.

I think what I had——

Mr. STEARNS. But you did tell him?

Mr. HIRSCH. I did tell him bluntly that it was wrong.

Mr. STEARNS. You said, listen, we are all in the same team here.

You are trying to finessed this. This is not right. I did not say this.

We are going to do a retraction or I am off?

Mr. HIRSCH. I do not think I said in that——

Mr. STEARNS. In those terms, but——

Mr. HIRSCH. But I do not think I said—I know I would have said

we are all on the same team. I know that the press release had

to be revised. The company was under a Securities Exchange review. We needed to be certain that the public information that was

being disseminated was consistent with what we believe was correct. And because that press release seemed to be somewhat inconsistent with our report at the minimum, that we required a revised

press release. And the company acceded.

Mr. STEARNS. Okay. Let me just move to document shredding.

Mr. HIRSCH. Yes, sir.

Mr. STEARNS. Did you discover during your investigations that

potentially relevant documents to the investigation were shredded

in a file room on the fifth floor of the executive office tower?

Mr. HIRSCH. We founded shredded documentation. My staff did.

The relevance of the documents were not determined until a time

thereafter. But, yes, sir.

Mr. STEARNS. And was the incident reported to the Board?

Mr. HIRSCH. The incident was reported to the Board, sir, yes.

Mr. STEARNS. Okay. And Mr. Scrushy?

Mr. HIRSCH. And to Mr. Scrushy.

Mr. STEARNS. Okay. And what about Mr. Horton, what was his

reaction when he was told about it?

Mr. HIRSCH. I had advised 2 days after the day after my—I believe it was 2 days after my engagement, of Fulbright’s engagement, I had spoken to Mr. Horton on the telephone and asked him

what the document retention policy was at HealthSouth. I was advised, in fact, that there was not one that was consistent with what

I needed. So I directed Mr. Horton, or instructed me, to issue a notification to the 50 some thousand employees that every single document needed to be retained in everything except the daily newspapers.

Mr. STEARNS. Well, that sounds like you acted very honorably. I

mean, you just sensed something was happened. You immediately

said, hey, listen we got to stop this. And so that was good.

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And you do not have to answer this, but did you know why this

shredding was not mentioned in the October 1, 2002 Board meeting

minutes?

Mr. HIRSCH. I have no understanding as to how the minutes

were kept, who kept them or anything.

Mr. STEARNS. Okay. Let us go to the shredded documents. Evidently, you were able to get a copy of these shredded documents?

Mr. HIRSCH. We found two bags, sir.

Mr. STEARNS. Yes. Two bags. So we have here in subtab 88 copies of these shredded documents.

Do the shredded documents, even though they are shredded,

there appears in looking at them myself that some of the shredded

documents contain notations dealing with 1753 and $175 million.

And, in fact, when I looked at this I have got from Richard Scrushy

on one of the shredded documents. And I have got $175 million. In

fact, I have got $175 million, 1, 2, 3, 4—3 times. You know about

these.

Mr. HIRSCH. Pretty much so, yes. We found them, sir.

Mr. STEARNS. So if we have shredded documents that indicate

that we are talking about 1753, we are talking $175 million and

they have the word Scrushy in it, from Scrushy, I do not know

what that means. I guess probably you do not either. And probably

it would be difficult to conjecture. But it appears that these shredded documents were about the $175 million and 1753, and somebody was trying to destroy documents dealing with relevant pertinent information that could apply to this whole investigation you

were doing. Could I say that?

Mr. HIRSCH. You can say that, sir. We were—my and our concerns were greatly heightened.

When we found the shredded materials, we told Mr. Horton he

had a problem, he needed to send out another memo. There was

another document retention memo sent out to the firm, to the employees, the 50 some odd thousand. We then subsequently advised

the company that every shredder needed to be sequestered or removed from the premises.

We ultimately, as you have seen I am sure in our report, made

tasking recommendations to the Board which specifically included

retaining an outfit who could seek to reconstruct these shreds for

the purpose of trying to ascertain what was going on.

What you see here, sir, this October 31 memo, was one to the

Board subsequent to the Board meeting that I believe was had on

the 29th where the Board members were being provided copies of

what we had found and asking them for their authority under the

tasking instructions or suggestions we had found as to whether

they were going to authorize us to retain an outfit to try and reconstruct.

Mr. STEARNS. I will just conclude, Mr. Chairman, and ask this

final question to Mr. Hirsch.

Did you feel at this point that the scope of your investigation was

being reduced significantly?

Mr. HIRSCH. On October 31, sir? There was certainly an attempt,

and the emails I think reflect that the staff has shown me and refreshed me, that there was an effort to indicate that our services

had been completed. That as a result of the first four reports that

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you have referenced, that our work had been finished. We had a

disagreement and believed there was more work to be done.

Mr. STEARNS. Did the Board ever instruct you or anybody to reconstruct these shredded documents? I mean, from what I see here,

I mean it does not seem like it is impossible to reconstruct these

shredded documents?

Mr. HIRSCH. I am sorry. That it is or is not impossible, sir.

Mr. STEARNS. I think it looks possible to reconstruct these shredded documents. Did the Board ever instruct you and say, look, we

see all these very pertinent terms there. Why do you not go ahead

and reconstruct the shredded documents?

Mr. HIRSCH. We were persistent and the Board was agreeable.

We did retain an outfit named Corefax. They made significant efforts and we have provided, I believe to staff, copies of what

Corefax was able to do. In fact, they had large room, little pieces

of data. We have photographs of what they were able to reconstruct.

Mr. STEARNS. So the Board never directed you to reconstruct the

shredded documents?

Mr. HIRSCH. They authorized us to do it, though, sir.

Mr. STEARNS. Do it.

Mr. HIRSCH. But in fact——

Mr. STEARNS. It was difficult to do?

Mr. HIRSCH. We were told by Corefax they could not do it. As I—

with my very limited understanding of shredding——

Mr. STEARNS. Mine, too.

Mr. HIRSCH. Well, I am grateful to know——

Mr. STEARNS. Because we shred documents, and I do not know

how you do it.

Mr. HIRSCH. We do not shred documents, sir.

Mr. STEARNS. Yes.

Mr. HIRSCH. But notwithstanding that, apparently if they are

shredded once——

Mr. STEARNS. Yes.

Mr. HIRSCH. Life is easier.

Mr. STEARNS. Yes.

Mr. HIRSCH. If they are shredded and crosshatched, it is near

impossible——

Mr. STEARNS. The permutations?

Mr. HIRSCH. Right. And apparently the very advanced shredding

machines which seem to be located with each photocopier machines, maybe 50 or 60 of them, in the facility that you are speaking of there, crosshatched each of them. And these were, in fact,

were a part of those.

Mr. STEARNS. Thank you, Mr. Hirsch.

And thank you, Mr. Chairman.

Mr. GREENWOOD. The Chair thanks the gentleman.

Recognizes himself for another 10 minutes.

Mr. DAVIS. Mr. Chairman.

Mr. GREENWOOD. Yes, Mr. Davis.

Mr. DAVIS. Excuse me for interrupting you. At some point either

in your questioning or somebody else’s I would like an opportunity

to respond to Congressman Stearns’ and his references to me, and

the exchange that just occurred with Mr. Hirsch.

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Mr. GREENWOOD. We will try to do that. We will try to do that.

And I suspect that after I ask Mr. Hirsch questions, we will have

some more things that you want to say.

Mr. DAVIS. Thank you. And I hope Congressman Stearns will be

here to hear me out, and we can set the record straight.

Mr. GREENWOOD. Mr. Hirsch?

Mr. HIRSCH. Sir?

Mr. GREENWOOD. When was the report reviewed with the Board?

Mr. HIRSCH. I beg your pardon, sir, which report? The shredding

report?

Mr. GREENWOOD. No, no. The October 21 report?

Mr. HIRSCH. I believe that was on October 22, sir. But I am not

certain. But I believe it was the following day.

Mr. GREENWOOD. Okay. Was anyone provided a copy of the report prior to the October 22, 2002 Board meeting?

Mr. HIRSCH. No, sir. I handed it out to the members myself.

Mr. GREENWOOD. Okay. And did Mr. Davis ever ask you to provide him a copy of the report in advance of that Board meeting?

Mr. HIRSCH. Yes, sir.

Mr. GREENWOOD. Okay. Would you look at Tab 57 and if you will

begin with Tab 57. And could you identify that?

Mr. HIRSCH. Well, the upper left hand corner of the email of the

document evidences that it’s an email that would have come from

my machine, as my name is on it. It appears to be an email from

Lanny Davis to me on October, 17, 2002.

Mr. GREENWOOD. Okay. And he asks you in that email ‘‘Can I

get a rough draft tomorrow, please?’’ This is on October 17, 5 days

before it was presented to the Board meeting. ‘‘You promised I

would not have to wait any longer than that. Need more than 1

day to register concerns. Let us talk early in A.M. Hope all is well,

etcetera.’’

How did you respond to that email?

Mr. HIRSCH. I do not recall exactly how I responded. I can tell

you the transposition of events if you like, sir.

Mr. GREENWOOD. Go ahead, please.

Mr. HIRSCH. All right. What had occurred is that there was a dialog had where Mr. Davis had requested a copy or the opportunity

to see the document in advance. I was very reticent to do so for

fear that the integrity of the report might be compromised. Mr.

Davis, as I best understood, was responsible for a number of things

with regard to the engagement, particularly and including the

media issues. I was very sensitized to the media issues and did not

want any of my reports, Fulbright’s reports, to be disseminated to

anybody prior to them going to my client through the Board of Directors.

The result is that I attempted to—advised Mr. Davis that I did

not want to give him a copy. Notwithstanding that, a dialog was

had by Mr. Davis with myself and myself with my colleagues at

Fulbright & Jaworski. And Mr. Davis advised of one thing, one

point he made, it reigned true; and that is that Mr. Davis was cocounsel and he may have facts, information or knowledge which

might impair or impact upon our report. Mr. Davis had people on

the ground doing investigation even before Fulbright began. And

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Mr. Davis wanted to be certain that there were not facts that

would be in error.

In discussing those issues with Fulbright and myself, I certainly

personally concluded that the very last thing I wanted to do is have

a report that would go in error.

Ultimately, I agreed to Mr. Davis’ request, such that I would

read the document to him, which I did. And your staff has refreshed me, as I did not recall, it seems that it was the morning

of the 20th, that Sunday. And I had read Mr. Davis and Mr. Goldberg, his associate, the entire report that morning.

I did not thereafter—and it was the final report. There were no

changes ever made to the report. The report was finished at that

point and in that condition was provided and read to the Board on

the 22nd.

Mr. GREENWOOD. Okay. Would you refer to Tab 63.

Mr. HIRSCH. Sixty-three, sir?

Mr. GREENWOOD. Yes, please.

Mr. HIRSCH. Yes, sir.

Mr. GREENWOOD. Okay. Did you get permission from Bill Horton

to read the report to Mr. Davis?

Mr. HIRSCH. Yes, sir. That was very important to me. I wanted

the company’s authority to be able to do what I was doing before

I had done it. And my contact with the company was general counsel, Bill Horton. And he gave me that authority.

Mr. GREENWOOD. Now, are these words yours? ‘‘We have just finished with an ultimate draft of the report due to the Board on

Tuesday. I expect a copy near midnight. Lanny Davis has requested to see and comment on the report in advance. Fulbright

will not allow me to transmit a draft, but with your authority as

general counsel, I can allow him to read it’’—it should say at, I assume, ‘‘or in our office tomorrow morning or read it to him. I therefore request your authority to do so.’’

Mr. HIRSCH. Yes, sir. Typos and all.

Mr. GREENWOOD. And did you in fact read him the report?

Mr. HIRSCH. I read it to him. He was—I do not recall if he was

unable or unwilling, or whatever it may have been. I think he was

unable to come to the Fulbright offices in DC, so it was agreed that

I would read it to him.

Mr. GREENWOOD. Okay. At the top of that email it says—there

is an email from you to Bill Horton, dated Sunday, October 20,

2002 at 10:53 a.m. It says ‘‘In the process right now and he is

happy so far.’’ To whom are you referring there?

Mr. HIRSCH. I am referring to Lanny Davis that Mr. Davis was

happy that I was reading it to him. He had wanted me to read it,

and he was happy that I was reading it to him.

Mr. GREENWOOD. And did you read the entire report to him?

Mr. HIRSCH. Yes, sir.

Mr. GREENWOOD. Word-for-word?

Mr. HIRSCH. Yes, sir.

Mr. GREENWOOD. Okay. Did he have any comments on the report? Did he identify any factual errors or did he express any concerns or want any corrections made?

Mr. HIRSCH. Your staff asked me that. And the best that I can,

you know, reach into the recesses of my mind from that time is

155

that I do not recall Mr. Davis referencing anything, having concerns other than indicating that he wanted to—I basically recall

him saying he wanted to think about it and he would get back to

me. But I do not think he had any substantive comments or nonsubstantive comments, for that matter.

Mr. GREENWOOD. When you read in the conclusion of the report

that Mr. Scrushy was present during a Monday morning meeting

on July 8, 2002, during which the existence of Transmittal 1753

was referenced, do you recall Mr. Davis registering any response to

that?

Mr. HIRSCH. I—as you say that now, I recall Mr. Davis having

a reaction, but I cannot replicate the reaction. It was something

along the lines of surprise, as best I can describe it.

Mr. GREENWOOD. Surprise? Okay.

And if you would look at 67?

Mr. HIRSCH. Yes, sir.

Mr. GREENWOOD. And at the page, the third page of that, the

bottom there is an email from you to Mr. Davis at Patton Boggs,

dated October 21, 2002 at 7:25 a.m. So this would be the next day

after you read Mr. Davis——

Mr. HIRSCH. I am sorry, sir.

Mr. GREENWOOD. Okay.

Mr. HIRSCH. You said page 3, do you mean page——

Mr. GREENWOOD. Tab 67. I am sorry. Page 2 on Tab 67.

Mr. HIRSCH. Thank you, sir.

Mr. GREENWOOD. Do you see the——

Mr. HIRSCH. I do, sir, yes.

Mr. GREENWOOD. Okay. So this was the morning after you had

read Mr. Davis the report. Would you characterize that email for

us?

Mr. HIRSCH. I think—I do not know what you mean by characterize. Do you want me to explain it?

Mr. GREENWOOD. Yes.

Mr. HIRSCH. There had been a request that I read the email

again or—beg your pardon, the report again or provide it again to

other people. And I thought that that was something that might

compromise both the integrity of what we had done at Fulbright

and possibly, more likely, get the document into the hands of the

media or other people than my client before I delivered it. Once I

delivered it, they could do as they like.

Mr. GREENWOOD. And did Mr. Davis want Mr. Scrushy to have

access to the report?

Mr. HIRSCH. In accordance with this email that appears, yes sir.

But I do not have a specific recollection other than what the email

says.

Mr. GREENWOOD. And did you know at the time that Mr. Davis

represented Mr. Scrushy and the Board?

Mr. HIRSCH. I have subsequently found that I did not know that.

When I met with staff, I did not recall when I was apprised of that.

As you might expect, I became quite curious because staff was curious. And I found that I was apprised of that on November 8, 2002.

Mr. GREENWOOD. Well, the email says ‘‘Despite the issues of propriety when the SEC demands advice as to who had preknowledge

of the report before its release, as it always does, do you really

156

think that it is wise to say that RMS’’ referring to Richard Scrushy,

‘‘was given the opportunity to influence the report. This would undermine all F&G has done.’’

What made you have concern about the fact that Mr. Scrushy

might have opportunity to influence the report?

Mr. HIRSCH. I do not recall why I used the word influence. But

my concern is always when anyone sees a report or any document

prior to when it is ready to be presented, that there will be a question as to whether or not that person did or had the opportunity

to influence the report. My concern is very heightened with regard

to integrity. I did not want anyone in hindsight to be able to say

that there was an opportunity for someone to influence whether

they did or they did not.

Mr. GREENWOOD. Now, did you know at the time that the arrangement that Mr. Davis had was that he would represent the

Board and the Mr. Scrushy, and if they became in conflict, that he

would then, his allegiance would go to Mr. Scrushy, not to the

Board.

Mr. HIRSCH. That is what I spoke to before. Let me be more

clear.

Apparently there was an email that went from Mr. Davis to Mr.

Scrushy. It was a 4 or 5 page email that was dated September 22,

2002. When we imagined Mr. Scrushy’s personal computer in his

office, apparently we came to a copy of that document. And that

document reflected what you are saying, sir.

I did not see, and I believe that my staff did not see that document until November 8. And on November 8 a copy of that email

was sent to me by one of the attorneys in the Fulbright office who

had been down in Birmingham and provided it to me. That was the

first time that I had seen it.

Mr. GREENWOOD. Okay. For the information of all, we have 7 or

8 votes coming. I did not want to keep this panel here for that

length of time. I want to be fair to the gentlelady from Colorado,

I want to be fair to Mr. Davis.

So I am going to ask that in the next 10 to 12 minutes, Ms.

DeGette, that you do your best to answer—ask questions and if you

can, give Mr. Davis an opportunity to say something.

Ms. DEGETTE. You know, it would be a first if I had to answer

questions. So I appreciate you letting me ask the questions, Mr.

Chairman.

Mr. Hirsch, your firm was originally hired to be independent

counsel for HealthSouth special litigation committee, correct?

Mr. HIRSCH. I was told when I entered the middle of a Board,

yes.

Ms. DEGETTE. And then when you got down to Birmingham, Mr.

Scrushy convened a telephonic Board meeting to hire Fulbright &

Jaworski as the defense counsel, right?

Mr. HIRSCH. When I arrived in Birmingham, litigation attorneys

for a company apprised me that there was an SEC investigation of

he company and they wanted us to handle that. I apprised them

that we could not do that if we were——

Ms. DEGETTE. Right.

Mr. HIRSCH. [continuing] in fact to do the SLC

Ms. DEGETTE. Because it would be conflict.

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Mr. HIRSCH. Then we could not.

Ms. DEGETTE. Right.

Mr. HIRSCH. In fact could not. And there was a dialog had between litigation counsel who arrived at the facility and Mr.

Scrushy that they wanted us to take on the other engagement,

which I said that we would do——

Ms. DEGETTE. But, so the answer is——

Mr. HIRSCH. Yes. But I said——

Ms. DEGETTE. Yes.

Mr. HIRSCH. [continuing] we would do that in the event that the

Board authorized it.

Ms. DEGETTE. Right. And that is what you did, right?

Mr. HIRSCH. That is correct.

Ms. DEGETTE. So do you know did the special litigation committee ever hire anybody to do the job you were originally contacted to do?

Mr. HIRSCH. I do know they did that.

Ms. DEGETTE. I am sorry?

Mr. HIRSCH. I do know that they did that.

Ms. DEGETTE. Did they?

Mr. HIRSCH. They did, yes.

Ms. DEGETTE. Who did they hire?

Mr. HIRSCH. I believe the name of the first, I do not know the

gentleman’s name, I do not recall, but it was Balch & Bingham.

They were retained. They were, I believe, an Alabama firm. And

they were retained to represent the committee. And they did do

that.

Ms. DEGETTE. Right. And did they do anything, do you know?

Mr. HIRSCH. I do not know what they did.

Ms. DEGETTE. Did they ever come up with a report?

Mr. HIRSCH. I met—I met telephonically with the gentleman

from Balch & Bingham on three occasions, I believe they told staff,

and I met with his special litigation committee in person with him

by telephone for an extended period at a particular time. I gave

him the information——

Ms. DEGETTE. But you do not know if they ever did anything?

Mr. HIRSCH. I do not.

Ms. DEGETTE. Thank you.

Mr. HIRSCH. I know that we provided——

Ms. DEGETTE. I am sorry.

Mr. HIRSCH. I am sorry.

Ms. DEGETTE. We have to go vote.

Mr. HIRSCH. Certainly.

Ms. DEGETTE. Hang on 1 second.

Mr. DAVIS. Just to be perfectly fair, if you are going to vote and

there is has been 10 or 12 minutes of conversations about me, I

should have an opportunity to respond.

Mr. GREENWOOD. We are in discussion about that.

Ms. DEGETTE. Mr. Davis, you are so right.

Mr. GREENWOOD. We are going to do that. And——

Mr. DAVIS. This is very unfair that I have no opportunity to respond to 10 or 15 minutes of references to me that are not entirely

accurate.

Mr. GREENWOOD. Actually, if I may, Mr. Davis?

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Mr. DAVIS. All right.

Mr. GREENWOOD. Okay. We are in discussion right now about

trying to be fair to you. And it is our conclusion that if you would

like additional opportunity, the only way to manage that will be to

come back in about an hour and you will have plenty of time to——

Mr. DAVIS. Well, how about giving me 5 minutes right now before you leave to vote? Because there are members of the media

here who have——

Ms. DEGETTE. Go ahead. Because I cannot come back. Just go

ahead. Go.

Mr. DAVIS. Well, Madam Congresswoman——

Ms. DEGETTE. Go.

Mr. DAVIS. It is only fair——

Ms. DEGETTE. Mr. Davis, 5 minutes. It is yours.

Mr. DAVIS. Mr. Chairman, may I?

Mr. GREENWOOD. Yes, sir.

Mr. DAVIS. I will try to be brief, and I apologize——

Ms. DEGETTE. Go.

Mr. DAVIS. My first comment is that I take responsibility for the

word ‘‘cleared,’’ because I believed that that was a reasonable inference in the Fulbright report. It is not correct that that word

‘‘cleared’’ was not circulated as a draft press release throughout the

day, including circulated to Fulbright & Jaworski.

Second, I included in that press release the entire last paragraph

that included all of the Fulbright’s caveats that you cannot prove

are negative.

Also, never having heard any objection to the word ‘‘cleared’’ in

exchanges of emails throughout the entire day, I would never have

sent a press release without the approval of all of the counsel involved, and that is the position that I am taking.

Second, regarding the reason that I asked for the report to be

read ahead of time, I simply ask you again to look at Tab C. I only

wanted ahead of time advance notice so that I could prepare for the

media and address whether there were any open issues.

And third, most importantly, the shredding issue and the July

issue was not addressed in the first draft and, in fact, I did not

hear the sentence about shredding read to me over the phone until

it was read to the full Board. Because it was read, we then asked

Fulbright go back ahead of time. There was absolutely no intention

to influence the results of that report.

Thank you, and I am sorry for interrupting, Madam Congresswoman.

Ms. DEGETTE. Mr. Chairman, I would also—what I had originally intended to do was ask unanimous consent that Mr. Davis

could supplement his answer in writing for the committee. Because

I also believe that it is very important that he be given an opportunity to respond to the allegations. And so I would ask that.

Mr. GREENWOOD. This is what I would propose——

Ms. DEGETTE. If that is all right with him.

Mr. DAVIS. Thank you.

Mr. GREENWOOD. I would propose we have 8 minutes and 42 seconds to the vote. We will need about 3 of those minutes to get to

the floor.

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Ms. DeGette, you have 5 minutes additional if you would like.

And then I am going to propose that we will reconvene in approximately 1 hour.

I would ask if there is anyone on the panel who cannot be back

here in an hour?

Ms. DEGETTE. I cannot be here. I will send someone back over.

Mr. GREENWOOD. Okay. In that case, Mr. DeGette, do you wish

to take time now?

Ms. DEGETTE. Mr. Chairman, I have no further questions.

We have been here. It has been a long day. I want to thank the

panel for coming. And once again, I would say, you know, there is

5 minutes. If Mr. Davis wants to talk now, if he wants to supplement his answer in writing, I really—I think we have got the gist

of it. And I am, frankly, done.

Mr. DAVIS. Well, if the Madam Congresswoman will allow me, in

a few more minutes I only have a couple of more points that I

would like to make, but I did not want to crowd her time.

Mr. GREENWOOD. Here is what we are going to do. We are going

to be fair to you, Mr. Davis. We are going to be fair to the process,

which means that we are not going to just give you the last word

and then walk away from that either.

So, regretfully, because everyone’s schedule is impacted by this,

we will recess and we will return in approximately 1 hour at the

conclusion of the next six votes.

The committee is in recess.

[Brief recess.]

Mr. GREENWOOD. The subcommittee will reconvene with apologies to all of you for the interruption.

The Chair will recognize himself for 10 minutes.

And, Mr. Davis, I am going to give you an opportunity to make

things as clear as you can, but I am going to do it by asking you

some questions rather than just the microphone over to you.

Mr. DAVIS. I thought you were talking to me.

Mr. GREENWOOD. Welcome, Mr. Davis.

Prior to the break, Mr. Hirsch testified that he read you the entire Fulbright report over the phone. And I am going to ask you

to turn to Tab 63. You will find there an email from Mr. Hirsch

to Bill Horton. And this email, October 20, Mr. Hirsch responds to

Mr. Horton’s statement to make arrangements to review the draft

with you. Mr. Hirsch replies: ‘‘In the process right now, and he is

happy so far.’’

Mr. Hirsch contends that this was written contemporaneous with

reading you the report. During our staff interview with you, staff

specifically asked you whether Mr. Hirsch had read the report to

you. You told staff that Mr. Hirsch had paraphrased the last two

sentences of the report for you. In your statements to the committee today you have suggested that you heard more than a paraphrased last two sentences.

So, will you please state for the record what Mr. Hirsch read to

you on the phone?

Mr. DAVIS. Yes, am I am happy to clarify that.

First of all, I appreciate the fact that Mr. Hirsch and I agree that

I did not attempt to alter any conclusions and he had too much integrity and independence to alter any conclusions, and that is the

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central issue for me that I never attempted to influence the truth

coming out here. I did everything I could to get the truth out.

On the issue of what happened on that Sunday morning, reasonable memories can differ. Adam Goldberg, my young colleague and

I, were trying to convince Mr. Hirsch to read us the entire report

so that we could prepare for a press plan, not to influence the outcome.

It is my best recollection that he read the last paragraph, not the

last two sentences, of the report and paraphrased was in fact a report that was about the process of the investigation; how many witnesses were interviewed, how many documents were reviewed. But

that only the last paragraph was what I remember him paraphrasing or reading which led to the last two sentences comment

that I made——

Mr. GREENWOOD. Let me interrupt you there.

Mr. DAVIS. Yes.

Mr. GREENWOOD. If you turn to Tab 63 and 64, you will see

memos from Mr. Hirsch. The first, on Sunday October 20 at 10:53

a.m. went to Bill Horton. ‘‘In the process right now, and he is

happy so far’’ that was in response to Mr. Horton’s email which

said ‘‘Please make arrangements with Lanny to review the draft.’’

On Tab 64 we have another email from Mr. Hirsch, this is to

Tom Dowdel on the same day at 12 p.m., and he says I am on with

Lanny, all is well. I need 15 minutes.

The separation there is an hour and 7 minutes and he still

seemed to need 15 minutes. If he was on the phone with you all

of that time, one would assume that he would be able to read more

than the last couple of sentences?

Mr. DAVIS. We were talking about a lot of things during that

telephone. It was a Sunday morning. We were talking about the

press implications, the Board meeting and he was trying to paraphrase the earlier sections of the report. So the entire conversation,

and Adam Goldberg and I tried to remember this before my staff

meeting, took about an hour. But that hour was not filled—that

hour was not filled——

Mr. GREENWOOD. You said in answer to my previous question

that your recollection is that Mr. Hirsch read you the last couple

of sentences?

Mr. DAVIS. He paraphrased almost verbatim by reading, but said

he was paraphrasing the entire last paragraph called on the conclusion. And then——

Mr. GREENWOOD. He paraphrased other sections of the——

Mr. DAVIS. Paraphrased the parts of the report before the conclusion that were essentially process about how many people were

interviewed and how many documents were reviewed.

Mr. GREENWOOD. Now let me return to you, Mr. Hirsch, because

I believe you responded earlier to a question that, I think it was

I who posed, which was I thought you response was that you read

the entire report to Mr. Davis, word-by-word. Is that correct?

Mr. HIRSCH. That is my recollection, sir, yes.

Mr. GREENWOOD. Okay. And it’s an extraordinary different set of

recollections. Because reading a report word-for-word is a time consuming and lengthy process. And is it your recollection, Mr. Hirsch,

that you began to read that report and were you interrupted by Mr.

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Davis during the reading of that report, or did he allow you to read

the entire report word-for-word and then discussion commenced

after that?

Mr. HIRSCH. My recollection is that I read the report from beginning to end, sir.

Mr. GREENWOOD. Mr. Davis, how do you reconcile that?

Mr. DAVIS. I had a different recollection. I do not reconcile it.

And I can only say that the sentence——

Mr. GREENWOOD. It strikes me as impossible for two people to

recollect that differently. In other words——

Mr. DAVIS. One of us is right.

Mr. GREENWOOD. In other words, one of you is right, and I dare

say, telling the truth. The fact of the matter is reading a report

word-for-word is a laborious thing to do and it hard for me to imagine someone doing that—not doing that, instead just paraphrasing

some sections and recollecting a word-by-word verbatim reading of

the document. And it is also very difficult for me to imagine having

someone having a report read to him word-for-word and not being

able to recollect that process.

Mr. DAVIS. Well, Mr. Chairman, you are addressing that comment to me.

Mr. GREENWOOD. Yes.

Mr. DAVIS. I would assume you would address the same comment to Mr. Hirsch. We have different recollections. It could be an

honest failure of memory, as much as anything else.

I have a clear recollection that Mr. Hirsch read me the conclusion, but said I am going to paraphrase it and then read me the

whole last paragraph and then summarized the earlier parts of the

report. That is my clear recollection.

Mr. GREENWOOD. Hal Hirsch, would you turn to item 61, please?

And this is a memo that apparently you sent to Hal Hirsch on the

Saturday night before, at 7:14 p.m. I am sorry. It was from Hal

Hirsch to you. And he says ‘‘Call in the morning when you wake

up and we can go over it line-by-line on the phone.’’ That is the

HealthSouth report. Do you remember receiving that?

Mr. DAVIS. Yes, I do.

Mr. GREENWOOD. Okay. And so we have got him saying to you

call me tomorrow morning, I will read the whole thing line-by-line.

We have got him sitting here saying and I did in fact read it to

him line-by-line, word-by-word. And you are saying that all you

recollect was a paraphrasing of a small portion of the report?

Mr. DAVIS. I actually said I have a clear recollection that he did

not read it line-by-line, but he did the last paragraph virtually as

I saw when I got to Alabama, and he actually read the entire report to the Board that the final paragraph was virtually the same.

But there was a sentence that I did not know about until he read

it to the Board on October 22. And that sentence was the sentence

pertaining to shredding. That is the first time that I knew that

there was a sentence about shredding in the report. I did not even

know that on Sunday when we discussed the contents of the report.

Mr. GREENWOOD. Mr. Hirsch, do you recall reading that statement, that sentence to Mr. Davis?

162

Mr. HIRSCH. That sentence, not specifically, sir. I recall reading

the report. That is all I recall, sir. I do not recall any other great

moment of reading the report, of that conversation.

Mr. GREENWOOD. Is it unusual that you would have read this report line-by-line to an attorney representing a client?

Mr. HIRSCH. I had read all of the prior read—I read the prior report to the Board line-by-line. When I met with the Board on October 22, I read this report line-by-line, even though I gave them a

copy. The same thing with the report on October 29.

So, it was not unusual or out of the ordinary in this circumstance. This is the best that I can recall, sir.

Mr. DAVIS. Mr. Chairman, it may help for me to add that I would

have liked to have the whole report read to me from beginning to

end that Sunday morning, because I wanted to prepare for a press

plan. And since both—since both Mr. Hirsch and I agree on the

most important point, which my email Tab C states, I had no intention of effecting Mr. Hirsch’s conclusion.

Mr. GREENWOOD. Then turn to Tab 57.

Mr. DAVIS. And I believe that he agrees with me on that.

Mr. GREENWOOD. Tab 57 is an email from you to Mr. Hirsch on

October 17. So this is 3 days prior. And in that email you say ‘‘Can

I get a rough draft tomorrow, please. You promised I would not

have to wait any longer than that. Need more than 1 day to register concerns. Let’s talk early on in A.M., etcetera.’’

So you just a moment ago said I had no intention of altering a

report.

Mr. DAVIS. To influence the conclusions of the report. And I said

in my opening statement, Mr. Chairman, what my concerns were,

which turned out to be correct.

My concerns were that there would be open issues unresolved,

that would raise more questions in the media and in the public

markets. And it turned out after Mr. Hirsch read the report to the

full Board, including the sentence that I had not heard before

about shredding, my reaction was before we release this report, we

need a further investigation of the shredding and a further investigation of the July meeting. That is what I mean by the word ‘‘concerns,’’ and only that, sir. Not substantive, and not about effecting

conclusion, which Mr. Hirsch and I both agree I did not do.

And I do hope that you will reread, Mr. Chairman, Tab C, which

is my email of October 21. Mr. Stearns suggested by pointing to the

word ‘‘influence’’ in the email that he read, that Mr. Hirsch used

the word I was possibly trying to influence. This email came 30

minutes after the email that Congressman Stearns read. And I was

responding to Mr. Hirsch’s legitimate concerns on the appearances.

And so I said this was me and Mr. Deaver and Mr. Powell wanting

to hear the report read ahead of time without influencing or altering the report.

And here is what I said at Tab C. ‘‘If it is in final form—and that

would be the understanding BEFORE you read—final form, advance reading has no impact on Fulbright credibility to the SEC or

anyone else.’’ That’s for me, the most important email to persuade

Mr. Hirsch it was okay to read me something ahead of time if I

did not try to influence the outcome, other than completing open

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issues that might be raised because they had not been finally resolved.

Mr. GREENWOOD. Mr. Hirsch, would you turn to Tab 93, please.

Mr. HIRSCH. Yes, sir.

Mr. GREENWOOD. Could you identify that document?

Mr. HIRSCH. No, sir. I mean, I can tell you that it appears to be

some Jason Hervey’s email system from Richard Scrushy, dated

Friday, November 8 at 9:15:02 to Jason Hervey, subject: Re thank

you. I have not seen it before, sir, so I cannot otherwise identify

it.

Mr. GREENWOOD. Well, the one below it.

Mr. HIRSCH. Oh, I see. The one below it. Yes. Thank you. Thank

you. Yes.

Okay. That is an email from me to Richard Scrushy, sir.

Mr. GREENWOOD. Okay. Now that says in your email, and that

was written on Friday, November 8, 2002, it says, I will read a section of it, it says ‘‘That is because Lanny Davis filters everything

that you hear. Ever wonder why he badmouths all your people, including officers, lawyers and new directors? The billing issues arose

because Davis advised that he would determine how much and if

we got paid. From the start, Davis has tried to use the reviews as

media props, not as you had described, to find out the truth. If they

were used as corporate America uses them and the SEC views

them, then your release and media statements would have said

something like Scrushy unaware of 1753 when he sold the stock.

That is what we said.’’

Now, can you explain what you meant when you wrote that?

Mr. HIRSCH. This email was sent to Richard Scrushy because I

was somewhat frustrated at the—from the events of the first press

release, the need for the second press release and at this same time

about the issues that related to the engagement, whether or not we

were finished, we were not finished. Our primary engagement was

the CMS work, the Transmittal 1753. These securities were secondary. Richard Scrushy’s stock transfers were tertiary.

It was important that we working for the company were allowed

to finish the CMS work. It was important that our work not be filtered by anybody, and I was very concerned with regard to the media’s potential influence in what we were doing and the word getting out differently than what we had undertaken. So I wrote this

email.

Mr. DAVIS. May I comment, Mr. Chairman?

Mr. GREENWOOD. Yes. Please do, Mr. Davis.

Mr. DAVIS. Thank you.

I think Hal Hirsch did an outstanding job for this company. And

I think he did it under very, very difficult circumstances.

Mr. GREENWOOD. Please bear with us.

I am sorry, go ahead.

Mr. DAVIS. I think Hal Hirsch did an outstanding job for

HealthSouth and wrote a report not under anybody’s influence with

a high amount of integrity.

We had a very difficult time with hurt feelings on both sides

about the press release that was issued, which led to a revised

press release. After that very difficult time, and I believe this email

164

was written during that time period, I felt that our assignment was

over and that it was up to the SEC to continue the investigation.

On November 6, 2 days before this email, at Tab D to my statement I wrote an email to Mr. Hirsch in which I said ‘‘Richard

Scrushy has instructed me to inform you that, other than Peter

Unger, who is the SEC attorney, that you will do no further work

for HealthSouth.’’ ‘‘I have advised Richard that with the investigation regarding himself completed,’’ remember we had sent everything over to the SEC and waived attorney/client privilege including all the documents, ‘‘that we will continue to fully cooperate

with the SEC, and therefore’’ it is the SEC that should continue,

‘‘we do not need Fulbright services any longer.’’ Now, some months

after this unfortunate hurt feelings period of time for both of us,

Mr. Hirsch and I broke bread, he invited me to his son’s bar mitzvah. I have the greatest respect for him. And these hurt feelings

and these harsh statements have to be viewed in the context of

both of us being under a lot of stress at the time.

Mr. GREENWOOD. Anything you have, Mr. Hirsch?

Mr. HIRSCH. I think the answer is that this was not the result

of hurt feelings, sir. This had nothing to do with hurt feelings. This

was a result of my frustration over the fact that I was trying to

represent a client. I was trying to get a report and all the fact,

maintain the integrity of what we were doing, get the information

out to the world and the world would be first to our client, the

Board and second to whomever the Board wanted to give it to.

I was trying to go, as the email said, to go directly to the company, to speak directly to Mr. Scrushy. We have a voluminous

number of emails which led up to this, as you have seen. And I was

seeking only to get the information done and the report completed.

Mr. GREENWOOD. All right. We are going to pursue one line of

inquiry with Mr. McGahan, so you do not feel that you have come

here for no good reason.

And I want you to turn to Tab 15, please, sir. Do you have that

document? Okay. This is an email from a Roderick O’Neill to you

from March 15, 2002. Could you tell us what the meaning of this

email is?

Mr. MCGAHAN. Yes, sir. He is indicating to me that certain officers of HealthSouth have intentions or desires to buy into a

healthcare we called First Cambridge.

Mr. GREENWOOD. Define the REIT. It’s Real Estate Investment

Trust?

Mr. MCGAHAN. Yes, sir.

Mr. GREENWOOD. Okay. All right. And what else is this telling

you about who would be the investors in this?

Mr. MCGAHAN. Richard Scrushy’s daughter, Bill Owens, Bill Horton, Tadd McVay, Weston Smith, Richard Davis and Jason Brown,

all of whom are officers of HealthSouth or their designees.

Mr. GREENWOOD. Okay. Would you turn to Tab 13 then? Okay.

And would you identify that document, please?

Mr. MCGAHAN. This is a document from Ray Garson, who is a

fixed income analyst to two people who work in the healthcare investment banking group, regarding this original loan.

Mr. GREENWOOD. Okay. And if you look at the third, I guess,

paragraph there it says ‘‘Need to add transaction rational. Why is

165

HRC selling assets below market or alternatively why is HCI setting rents so low.’’ Okay. And do you know what the answer to

those questions are?

Mr. MCGAHAN. No, I do not.

Mr. GREENWOOD. It says we need—further down, three more

paragraphs down it says ‘‘Does HRC management or related parties own part of Cambridge or HCI.’’ Do you see that?

Mr. MCGAHAN. I do see that.

Mr. GREENWOOD. Do you know why he would want to know that?

Mr. MCGAHAN. I think he would want to know that because that

would be a normal due diligence question when making a loan to

a company.

Mr. GREENWOOD. Why do you not explain to us what you know

about what was going on here in terms of the loan, what the purpose of the loan was and what this real estate investment trust

was all about.

Mr. MCGAHAN. Okay. My understanding of First Cambridge was

that it was a group of real estate executives that were forming a

company to form a healthcare REIT. And I——

Mr. GREENWOOD. Real estate executives, are you including

Scrushy’s daughter and so forth?

Mr. MCGAHAN. No, sir.

Mr. GREENWOOD. Okay. Go ahead.

Mr. MCGAHAN. These executives I met, I believe in the summer

or fall of 2001. And the next I heard of this transaction was in December when Mr. O’Neill informed me that they were interested in

buying some healthcare properties from HealthSouth to start this

healthcare REIT, to start this company.

I gave him the go ahead. I thought this was a group of experienced executives and that they were going to be successful, I

hoped. They had said that we would have future investment banking business.

Mr. GREENWOOD. And why would HealthSouth guarantee their

loan?

Mr. MCGAHAN. Well, this was—they would guarantee the loan

because—in order to the healthcare REIT started. Because we

would be extending credit to the healthcare REIT and they would

do a sale lease back——

Mr. GREENWOOD. Did HealthSouth have a financial interest in

the REIT?

Mr. MCGAHAN. Our understanding, and again this is what people

told me at the time, was that they did not. And we were told in

December 2001 when this transaction was funded, that they did

not have an interest.

Mr. GREENWOOD. Did it strike you as appropriate for a publicly

held company to guarantee a loan which would go on their books,

and yet have no potential to benefit from the profits of the REIT?

Mr. MCGAHAN. Well, I thought that they would have a benefit

of the REIT, not the profits of the REIT. Healthcare REIT business, there is about 10 or 11 companies out there who are

healthcare REITs, all of which were started originally—almost all

of which were started by healthcare providers.

So Universal Health has a healthcare REIT, which they do not

own the substantial portion of it. National Medical Enterprises

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started a REIT, and on and on. And the benefit to those provider

companies is that they have a financing company that knows them

and works closely with them, and knows their properties, etcetera.

So it is an established practice, essentially, that healthcare providers have started healthcare REITs. And those have been very

successful companies over the years.

Mr. GREENWOOD. Okay. On Tab 15, going back to this email, it

says ‘‘I want to make sure we are doing nothing wrong on the

HealthSouth REIT. This is the current owner of REIT. No one has

put any money in and they want to designate ownership to a significant other, i.e. a wife, daughter, etcetera. Do you think there

will be a problem with this when and if they go public?’’ And then

the designation of percentage of ownership would be Richard

Scrushy’s daughter 20 percent, Bill Owens 10 percent, Horton 5

percent, Tadd 5 percent, Weston 5 percent, Richard Davies 3 percent, Jason Brown 1 percent, etcetera.

Why would you think that Mr. O’Neill would have a concern

about the propriety of this?

Mr. MCGAHAN. Well, I thought it was also a very bad idea.

Mr. GREENWOOD. You thought it was a bad idea?

Mr. MCGAHAN. Yes.

Mr. GREENWOOD. And why was it a bad idea?

Mr. MCGAHAN. At this time in March 2002 there were two other

companies, MedCenterDirect and Source Medical, of which the senior management of HealthSouth had some equity ownership interest. They were under—shareholders had concerns about these sorts

of arrangements, and I thought that it would be a very bad idea

to startup or have these executives invest in this company, and I

expressed——

Mr. GREENWOOD. But why was it a bad idea?

Mr. MCGAHAN. Because the senior executives were under pressure from their shareholders due to the fact of the perception of

conflict of interest of owning shares in a company that was doing

business with HealthSouth. And so I thought that would—to add

to that would be not a very smart thing.

Mr. GREENWOOD. Yes. Now, they had done something similar to

this for the company called Capstone, had they not?

Mr. MCGAHAN. Back in the 1990’s.

Mr. GREENWOOD. And were you involved with that?

Mr. MCGAHAN. Not originally, no. But later on——

Mr. GREENWOOD. Eventually?

Mr. MCGAHAN. Yes.

Mr. GREENWOOD. And who profited from that enterprise?

Mr. MCGAHAN. Well, that company, from what I recollect, went

public and in the low teens, had dividends of around 10 percent per

year for 4 or 5 years and was sold in the high teens. There was

also executives from the HealthSouth, to your point, that had an

equity ownership in that company as well. So all the shareholders

profited.

Mr. GREENWOOD. And made millions of dollars, as a matter of

fact, is that not right?

Mr. MCGAHAN. I believe so, yes.

Mr. GREENWOOD. Mr. Scrushy made millions of dollars as well?

Mr. MCGAHAN. I believe so, yes.

167

Mr. GREENWOOD. Okay. And did you think that was a bad idea

as well?

Mr. MCGAHAN. I thought that times had changed.

Mr. GREENWOOD. Because of the different expectations that the

stockholders might have?

Mr. MCGAHAN. I think that the stockholders in the equity markets and what they expected out of HealthSouth in March 2002

was much different than it was in the——

Mr. GREENWOOD. Did you share your view with others that you

thought it was a bad idea?

Mr. MCGAHAN. I did.

Mr. GREENWOOD. To whom did you express that?

Mr. MCGAHAN. I expressed it to Mr. O’Neill and to Mr. Leder internally. And then I called HealthSouth and spoke with Mr.

McVay, and then Mr. Owens, and then Mr. Scrushy.

Mr. GREENWOOD. Was the REIT ultimately formed by those individuals on the memo, on the email?

Mr. MCGAHAN. I am not sure. I expressed my concerns to Mr.

McVay. And then I further expressed, because he was principally

working on this transaction, he said he had heard me. But then I

went over his head and talked to Mr. Owens and Mr. Scrushy. And

they ultimately told me that they agreed with me.

Mr. GREENWOOD. Did you think that using significant others was

a way to hide the ownership of the HealthSouth executives?

Mr. MCGAHAN. I did not think that they were trying to hide that.

I thought that the entire thing was a bad idea, that included.

Mr. GREENWOOD. Okay. So was the REIT ultimately established?

Mr. MCGAHAN. What ultimately happened with this company

was it was originally funded in December 2001. This memo or this

came to our attention in March 2002. We expressed that it was not

a very good idea. We do know also that in—the loan was ultimately

paid off and this transaction was unwounded, and the properties

went back to be owned by HealthSouth.

Mr. GREENWOOD. Were you aware of the fact that the company’s

auditors did not disclose the guarantee in the company’s audited financial statements?

Mr. MCGAHAN. I was not personally aware of that at all until

later.

Mr. GREENWOOD. When did you become aware of it?

Mr. MCGAHAN. In preparation for this. Since I left UBS.

Mr. GREENWOOD. Preparation for this hearing?

Mr. MCGAHAN. Yes.

Mr. GREENWOOD. Did you know that the loan guarantee was extended for 4 days by UBS with the condition that CRC agreed with

the 4 day extension and expressed concerns with the fact that the

loan guarantee had not been reported and the associated potential

reputational risk to UBSW?

Mr. MCGAHAN. I did know a part of that, the extension. The

other part of it I am not sure that I did.

Mr. GREENWOOD. Did you know that they required that it be disclosed in the 10k?

Mr. MCGAHAN. My understanding that there was—from what I

remember, was that there were conversations between people at

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UBS and the company about the disclosure and to make sure that

it was an appropriate disclosure that HealthSouth was making.

Mr. GREENWOOD. Why do you think UBS agreed to this being

done as a side deal and kept off the books?

Mr. MCGAHAN. I think that just in terms of the structure of the

transaction, the original intent of the transaction was to form a

healthcare real estate investment trust that would then go out and

get other properties. The idea was that they would get $150 or

$200 million of other properties in addition to these $80 million

from HealthSouth and would go on and become a successful real

estate investment trust, just like the others.

It became apparent—and the only way to construct a company

like that is to do it the way that it was done. It became apparent

some time in 2002 that they were not going to get these properties.

It was going to be very difficult for them to do so. That—and that

this company really was not getting off the ground.

Mr. GREENWOOD. Well, why would they want it off the books?

Mr. MCGAHAN. Why would they want—I am sorry, sir?

Mr. GREENWOOD. The loan guarantee off HealthSouth’s books?

Mr. MCGAHAN. My understanding was that this was a normal

healthcare sale lease back transaction. I was not aware at the time

of the loan what was going on. My understanding was that there

was discussion between people at UBS, not myself, and the company about accounting for the loan. And it was represented to the

UBS people that this was an immaterial amount, it was an $80

million loan in a context of a $3.4, $3.5 billion debt balance sheet.

And it was an immaterial amount.

Mr. GREENWOOD. So the justification for not putting it on the

books was that it was immaterial?

Mr. MCGAHAN. No, that this was a sale lease back transaction.

It was being guaranteed by HealthSouth. There was some discussion between the UBS professionals and the company about how it

was going to be accounted for. And it was represented, I am told,

to the UBS people that the HealthSouth folks had had discussions

with their auditors and that this was going—that they were comfortable in the way that this was going to be accounted for.

Mr. GREENWOOD. Well, and theoretically then if you had a company of $3 or $4 billion size, if you take money off the books in $80

million increments it is de minimis, and therefore you do not have

to report it. Would that be your reasoning?

Mr. MCGAHAN. Again, you know, I think that obviously I think

your point is that if you take $80 million that they add up. But this

was one transaction and that it was ultimately unwound and the

properties went back to HealthSouth and the loan was repaid.

Mr. GREENWOOD. Okay.

Mr. CAPEK. Sir? Sir? If I may?

Mr. GREENWOOD. Mr. Capek?

Mr. CAPEK. When you look at the sale lease back transaction,

you know for the $80 million to be going away or coming off of the

books, when analysts calculate covered ratios and whatnot, you do

look in the footnotes for the REIT. Remember they are still

REITing. So we do capitalize the REIT expense and consider that

debt and add it back.

169

So even though the $80 million was going away in this example,

there would be REIT that we are capitalizing and adding back to

the total debt——

Mr. GREENWOOD. But the shareholders would not have been

aware of that, would they?

Mr. CAPEK. Well, disclosed in the footnotes of the annual report,

you do have the future REIT obligations, so they would be aware

of that obligation. Not the loan—the loan going away, but the obligation of the REIT.

Mr. GREENWOOD. Okay. I think 9 hours should do it.

I want to thank all of our witnesses. I thank you for indulging

us with this extra time we need for the break.

Oh, Mr. Walden, I am sorry. Nine hours is not enough.

The Chair recognizes the gentleman from Oregon for—I apologize

for not noticing you were here.

The gentleman from Oregon is recognized for 10 minutes.

Mr. WALDEN. Thank you, Mr. Chairman.

Mr. McGahan, you were in charge of this account, is that correct?

Mr. MCGAHAN. I was the coverage officer.

Mr. WALDEN. You are a coverage officer? Mr. Lorello, what role

did you play in this account?

Mr. LORELLO. I run the healthcare group, and this was one of our

clients.

Mr. WALDEN. Okay. After Bill McGahan joined Salomon and

Smith Barney and became the HealthSouth coverage officer, to

what extent though were you involved with HealthSouth and its

transactions?

Mr. LORELLO. Starting in the mid-1990’s, I would be invited to

annual Board meetings. And what attend those meetings along

with Mr. McGahan. And perhaps once a year would attend a meeting down in Birmingham.

Mr. WALDEN. Mr. McGahan, how often did you report to Mr.

Lorello on HealthSouth issues?

Mr. MCGAHAN. Periodically when I would see him in the office

and when there was something to talk about.

Mr. WALDEN. When there was something to talk about, does that

mean like every time there was something to talk about you fed

back to Mr. Lorello?

Mr. MCGAHAN. Mr. Lorello would keep track of the pipeline of

transactions and I would keep him updated on things that were

being contemplated or other transactions that were coming down

the pike. If there was also any significant items that would come

up, I would keep him informed. But it was periodically. I covered

about a 100 healthcare companies and so I would keep him

informed——

Mr. WALDEN. I see.

Mr. MCGAHAN. [continuing] on those as things were going on.

Mr. WALDEN. Okay. Could you turn to Tab 34, please? This is an

email chain from March 6 and 7 regarding an email from Mr.

Scrushy having the subject line ‘‘To hell with you guys.’’ Do you

recognize this message?

Mr. MCGAHAN. Tab 34?

Mr. WALDEN. Thirty-four, sir, yes.

Mr. MCGAHAN. Yes, sir.

170

Mr. WALDEN. Can you please read for the record Mr. Scrushy’s

message and then explain to us what Mr. Scrushy is so angry

about?

Mr. MCGAHAN. The original message?

Mr. WALDEN. Yes, please.

Mr. MCGAHAN. This is from Mr. Scrushy to me. ‘‘I will put up

the money myself. Please call Ben and tell him that I will put up

the $24 million personally. Cannot believe you guys are doing this.

I guess you guys are breaking up the 20 year relationship, Ben will

understand us moving it all somewhere else. We will come back

strong and kick butt again. Thanks for the help over the years. We

had some good times. Richard.’’

Mr. WALDEN. Okay. And then what was your response to that?

Mr. MCGAHAN. To Richard, ‘‘I will get it done. I promise. Do not

wash us away yet. I have talked to Bill and Tadd and tried to call

you, and I am all over it. I will call you in the morning with it

being done.’’

Mr. WALDEN. Okay. And that was your response to Mr. Scrushy,

right?

Mr. MCGAHAN. Yes.

Mr. WALDEN. And then you forwarded that on to——

Mr. MCGAHAN. This was Mr. Ryan.

Mr. WALDEN. That is right. And then——

Mr. MCGAHAN. I think I also informed Mr. Lorello that through

an email forward.

Mr. WALDEN. And I was going to refer to that one, too, which is

Tab 31. Could you read your comment?

Mr. MCGAHAN. I think that is to Mr. Leder.

Mr. WALDEN. Yes. I am sorry. To Mr. Leder.

Mr. MCGAHAN. ‘‘Just to fill you in what I got. Please get this

done ASAP.’’

Mr. WALDEN. Okay. And Mr. Lorello is copied on that as well?

Mr. MCGAHAN. I believe, yes.

Mr. WALDEN. Yes. Along with Roderick O’Neill.

And that was at what time, again, you sent that?

Mr. MCGAHAN. Around 5:14 p.m.

Mr. WALDEN. 5:14. Four minutes later on under Tab 32 you sent

a direct email to Mr. Lorello.

Mr. MCGAHAN. I guess.

Mr. WALDEN. You want to read that one, sir?

Mr. MCGAHAN. Yes, sir. ‘‘I hate my job. I resign. Go jump off a

bridge.’’

Mr. WALDEN. We have all had those days.

The only question I have is was the reference to you jumping off

a bridge or suggesting someone else should go jump off a bridge?

Mr. MCGAHAN. I am not sure.

Mr. WALDEN. You are not?

Mr. MCGAHAN. I think it was Mr. Lorello.

Mr. WALDEN. Should go jump off a bridge?

Mr. MCGAHAN. Yes.

Mr. WALDEN. Why?

Mr. MCGAHAN. I was just—I just had a bad day. When we had

a client that was requesting a loan and I was struggling with it,

171

and it is a very pressure filled environment. So, I was expressing

my frustration with my work.

Mr. WALDEN. And I want to get to what the source of that frustration might have been. If you could turn to Tab 26, please. This

is a Commitment Committee meeting concerning the proposed loan

to Source Medical Solutions, Inc.

Mr. MCGAHAN. Yes.

Mr. WALDEN. Which on page 48 a Mr. Baudin says ‘‘Yes. I am

sure what I am looking here at is—I am concerned about dealing

with these entities. I do not think we have got a full transparency

on the—on Source Medical. I do not like the fact that we have got

management who have been owning shares in this and now donating them to charities and so forth. I would not trust Scrushy, Rod,

further than we can throw him. I do not think this company management has been that transparent with us in the past.’’

And then a Chris Ryan responds ‘‘But that is true with both entities.’’

And Baudin replies ‘‘Yes.’’

Chris Ryan replies ‘‘Right. So what I mean, I am just—why

would you rather in 2007 4 years than an 2003 1 year.’’

Something from Baudin, ‘‘I would rather something be in 2003.’’

Ryan says ‘‘2004 1 year I guess. For 1 year at HealthSouth. Then

2007.’’

They go on.

‘‘I do not want to be lending to Source Medical Solution.’’ And

then somebody says ‘‘So you know.’’ And then somebody says

‘‘Please, please explain. I am confused. I don’t understood. You

doubt the validity of the guarantee. Is there a problem with it?’’

And Baudin says ‘‘I am not doubting the validity of the guarantee. I’m—what I do not like is the reputation that issues that

(something inaudible) we are running with this entity. I do not like

the fact that we keep getting asked to deal with these partially

owned companies and a lot of it revolves around just the noise that

is going on with the company. I mean, you know, the fact is there

is an SEC investigation and the FBI is in there. It just smells bad’’

and then Chris Ryan says. ‘‘Okay. The—the—I think the firm—

well, we ought to check if the firm wants to have a relationship

with the company. But—and that’s that. Then I think that is a fundamental issue. But at the firm let us just say we got a matter of

resolving that which not—not me or this committee and I think it

can. I agree with you. We should vet this before we lend anywhere

money in, and that this transaction—make sure that this client

that we want to continue to—to promote within the firm. But the

firm decides to, whoever, I am not sure who that body is, but we

will collect it. You know it is probably—maybe it is management

committee, let us say at Warburg. Let us say they decided they

want to push on the HealthSouth and therefore they want to try

to accommodate the client where we can we like—do our other client.’’

And then Baudin says ‘‘Chris, we are being asking to accommodate of client in a fashion that we typically do not, have not. We

do not get asked to accommodate other clients.’’

Chris Ryan ‘‘I disagree with that, David.’’

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Baudin comes back ‘‘Asked to provide clients, we—we view as—

as key clients of the firm and I am’’ Baudin says something. ‘‘But

we should only be doing it for companies with decent reputations

and this company’s tarnished its reputation in just about every

which way over the last year.’’

Ryan says ‘‘That is a fair—well, I think that is a fair comment,

at least as near—as near as I can tell. And I do not think it is certainly—it is not my call to.’’

And Baudin says ‘‘That clearing the way.’’

Ryan says ‘‘Turn this on that basis? Yes. Shares are traded,’’

etcetera, etcetera.

Who is David Baudin?

Mr. MCGAHAN. I believe—I do not work at UBS anymore, but I

believe he is the head of the credit area.

Mr. WALDEN. Mr. Lorello, is he head of the credit area?

Mr. LORELLO. Yes. Yes. He runs the——

Mr. WALDEN. Pardon me?

Mr. LORELLO. He runs the credit risk department.

Mr. WALDEN. He runs the credit risk department?

Mr. LORELLO. For the U.S.

Mr. WALDEN. For the United States at UBS? Are you familiar

with him? Do you and he communicate?

Mr. LORELLO. No, we do not.

Mr. WALDEN. So you had no idea about the concern of the head

of the credit department within UBS Warburg?

Mr. LORELLO. I became aware of this transcript in connection

with recent preparation.

Mr. WALDEN. Okay. Then help me understand how this works in

your company. You have these kind of people looking at these sorts

of loans and all at the credit department. And what is your role?

Your role, Mr. Lorello?

Mr. LORELLO. I run the healthcare group, investment banking

group.

Mr. WALDEN. Okay. And so you have worked with Scrushy for a

number of years?

Mr. LORELLO. Yes. Well, I have known him since 1987.

Mr. WALDEN. 1987. Okay. But HealthSouth, according to Mr.

Scrushy’s emails has had a 20 years relationship with UBS?

Mr. LORELLO. It has actually been since 1999 at UBS when we

joined. But with myself, it has been since 1987.

Mr. WALDEN. Since 1987? What as your relationship back in

1987? What were you doing?

Mr. LORELLO. I was at Salomon Smith Barney.

Mr. WALDEN. Okay. But you have been working with Mr.

Scrushy and his company for some time helping them get financing, right?

Mr. LORELLO. That is correct.

Mr. WALDEN. So you would go out then and recommend to various individuals who might want to buy bonds, the credit worthiness of this company and that bond, or bonds, is that right? What

do you do?

Mr. LORELLO. Well, can I——

Mr. WALDEN. Yes.

Mr. LORELLO. Perhaps put some of the pieces together here.

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The interchange here is between the Chairman of the Commitment Committee, which is Chris Ryan, and one of the members of

the Commitment Committee, which is David Baudin. He also was

the chief credit person at UBS in the Americas.

The way the process works is that when a transaction mandate

occurs, for instance, a loan, the deal team that is responsible for

that client and responsible for that project puts a memorandum together, does the due diligence and then presents that to the Commitment Committee. The Commitment Committee is charged with

approving or disapproving the loan. In this case, they actually turn

the loan down. And they are an independent body within UBS that

has the final authority over any transaction that the bankers are

proposing. So that is the interplay here.

It is between two members of the Commitment Committee who

are reviewing a loan for Source Medical. And who are making an

assessment as to whether or not they want to proceed with that

loan.

Mr. WALDEN. And they decide not to?

Mr. LORELLO. And they decide not to.

Mr. WALDEN. They raise some very disturbing questions, say, in

back a year ago. I mean, there has been problems with transparency, there is problems with different board members on different committees and all.

Mr. McGahan, were you familiar with any of this information or

the concerns that were raised?

Mr. MCGAHAN. I was familiar at the time, yes. Mr. Leder and

Mr. O’Neill had informed me that the credit committee was struggling with getting this loan approved. And the specific issues that

they were struggling with was they wanted to get the audited financial information before they would approve the loan. And they

also were struggling with the information flow. They did not think

they were getting——

Mr. WALDEN. Well, they could not get a balance sheet, could

they?

Mr. MCGAHAN. Over the short of time, that happened in February. In March, they could not get a balance sheet. They were trying to get financial information from HealthSouth and they would

not approve the loan until they got that information.

I thought that this was an example of the process that was working. There was checks and balances in the system. The credit people were doing their jobs. And the bankers were proposing and advocating a loan for a client. And the process worked, which was

that they did not approve the loan until they got an audited financial statement.

Mr. WALDEN. And you did not share any of this information with

Mr. Lorello, was he aware of it at the time?

Mr. MCGAHAN. I was not aware of the specifics of Mr. Baudin’s

comments. I knew through Mr. O’Neill and Mr. Leder that the

credit committee was struggling. And—but I thought we were in

the middle of a credit process. I thought that what was happening

was the credit folks were struggling to get to the goal line. I certainly forwarded on Mr. Scrushy’s email to let Mr. Lorello know

with my tag line that there was an issue. But I thought we were

174

in a process. And once the audited financial information came in,

that perhaps we could get to the goal. But that never came in.

Mr. WALDEN. Okay. Mr. Lorello, did you follow up on that email

that he sent you?

Mr. LORELLO. I do not specifically recall following up.

Mr. WALDEN. Did you follow up with Mr. Scrushy at all since he

personally referenced you?

Mr. LORELLO. No. I did not speak to Mr. Scrushy or anyone else

at HealthSouth.

Mr. WALDEN. Okay. What was your reaction? What did you do

after you got—I mean, this is a pretty big client, is it not? Was this

one of your bigger clients?

Mr. LORELLO. HealthSouth was an important client of our group.

Earlier I think someone had asked, the accounts were about 2 percent of our revenues.

Mr. WALDEN. How about in your division, though?

Mr. LORELLO. In my group.

Mr. WALDEN. In your group, 2 percent of your revenues?

Mr. LORELLO. Yes. Yes.

Mr. WALDEN. Okay. All right.

Did you believe that HealthSouth’s reputation was tarnished?

Mr. LORELLO. At this moment in time, March 2003?

Mr. WALDEN. Yes.

Mr. LORELLO. I looked at it as a company that was having some

financial difficulties. And clearly a number of issues that were out

there in the public market that were being vetted by our Commitment Committee and by others.

Being in the healthcare industry, it is not uncommon to have

companies who are experiencing reimbursement issues. Many of

our clients go through Medicare cuts. It is not unusual in

healthcare generally because it is a volatile industry to see companies go into favor and out of favor.

So, these were clearly issues. But we were continuing to work

with the company to try to help them.

Mr. WALDEN. Mr. McGahan, could we go to Tab 29? This was

sent to Roderick O’Neill and Michael Leder.

Mr. MCGAHAN. Yes.

Mr. WALDEN. You can both read that and explain it to me?

Mr. MCGAHAN. Sure. Would you like me to read it out load?

Mr. WALDEN. I am afraid so.

Mr. MCGAHAN. ‘‘I just got my ass wiped by Scrushy and Owens.

The key is the amendment. So focus only on that for now. They

need it by Tuesday. We must get it done. It must not leak into the

market that we are struggling. If it does, we are all dead. Start

with a detailed time line of how information has slowed over the

past 2 weeks. We must all agree on specifics of this by tomorrow

morning. We need the information from the company. Get Tadd

and Richard Davis working on everything that you need. We must

get this done. Our relationship is over.’’

Mr. WALDEN. What was your concern about something leaking

into the market?

Mr. MCGAHAN. I am talking about the bank market. And first of

all, I am reminding Mr. O’Neill and Mr. Leder about dealing with

the confidential information of the client. And what we are working

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with here is trying to get, I believe, a bank amendment approved.

And our credit folks were struggling to get that done, as indicated

by the—what we were just talking about.

I wanted to reenforce to Rod O’Neill and Mike Leder that they

should tell the bank syndication folks to make sure that they treated the information confidentially until we either got the loan approved or we did not. And that is what I meant by that.

Mr. WALDEN. Okay. Back on the email from Christopher Ryan to

you on March 7.

Mr. MCGAHAN. Which time again?

Mr. WALDEN. Well, you know, this is the whole back of the

Scrushy email. Tab 34. And it really is the second page of Tab 34.

And it is—I think you have written to Mr. Ryan saying ‘‘Chris, see

the email string below from CEO. Obviously, he is pissed. I have

Leder putting the time line together and I will send you any other

information from the company. The CEO is solely focused on the

amendment, not the 22 loan. What else can I do internally not to

permanently blow up this relationship by not getting there as soon

as possible on the amendment? Bill.’’

Mr. MCGAHAN. Right.

Mr. WALDEN. And then his—could you read his response to you

then?

Mr. MCGAHAN. Yes. He said—yes. ‘‘Internally not much. Externally it depends. If the time line exonerates HealthSouth, you

know better than me. If the time line demonstrates duplicity, I

would counsel Scrushy as a friend and an advisor to change the

company’s attitude toward the debt markets. He will need them.’’

Mr. WALDEN. Okay. What does he mean by if the time line demonstrates duplicity?

Mr. MCGAHAN. At this time, the credit folks and the credit process was being frustrated by their ability or lack of ability to get financial information from the company. They believed that they did

not have a good understanding of what the year end earnings announcement was going to be. They thought it was going to be one

thing, and I think it turned out to be another.

They also, I think there was a downgrade of the company’s earnings by a major rating agency, and they felt they did not know

about that.

So there was not good information flow. They could not get at

least a draft to the audited financial information. And so they felt

that they were not being treated well.

And so what we are attempting to do here is get the information,

get specific on what information we had, what we needed. And get

specific on the time line of that information flow. And—but what

Chris is saying to me in terms but if it turns out that they have

not been treating the bank market, they have not been treating us

well in terms of not giving us the information on time, not telling

us about the rating agency downgrade, you should tell him he

needs to change his attitude toward the debt market. And I agree

with that.

Mr. WALDEN. Okay. So and the effect was UBS still pushing the

billion dollar bond deal and a $22 million loan at a time when this

company basically is——

176

Mr. MCGAHAN. Well, the bond deal happened in May 2002. So

that as done. So we are now in March 2003.

Mr. WALDEN. But was it not going to be registered in August?

Mr. MCGAHAN. It was in fact registered. Again, this is, unless I

might have my dates confused, but this is Friday, March 7, 2003.

Mr. WALDEN. Right.

Mr. MCGAHAN. That happened—the bond deal happened, I believe, in May 2002 and was registered in August 2002. So—and I

think I have that right.

Mr. WALDEN. Okay.

Mr. MCGAHAN. But what was happening here was this was 10

days before or so that the fraud was disclosed. We were not getting

good information from HealthSouth. We’re are struggling through

a credit process, which I believe was working because we were

waiting on audited financial information. So I think there was a

process which was working, which was that there was an advocate

for the corporate finance client, the credit folks which wanted the

audited financial information. And it turned out that we were not

going to do anything as an institution until we got that information.

Mr. GREENWOOD. The Chair thanks the gentleman.

One more quick series of questions for you, Mr. McGahan, and

then we will wrap this up.

It was a billion dollar bond deal, a bond offering in May 2002.

Are you familiar with that?

Mr. MCGAHAN. Yes, sir.

Mr. GREENWOOD. Okay. Now it is my understanding that

HealthSouth initially filed with the SEC to register the bonds on

June 28 and amended that filing on August 22. I have also been

informed that in order for a registration to become effective,

HealthSouth would have had to make some affirmative notification

either by phone or writing within 48 hours of the effective date.

The question is what if between the time the bond offering was

filed for registration and the time the SEC permits registration to

take effect, for its registration to take effect, if HealthSouth were

to learn about a material negative impact on its finances; what

should happen to the pending bond registration?

Mr. MCGAHAN. My understanding, although I am not an attorney, my understanding is that it should updated.

Mr. GREENWOOD. Updated or——

Mr. MCGAHAN. In terms of the disclosure. If they have learned

new information, my understanding is——

Mr. GREENWOOD. So then they need to go, give that information

to the—and put it into the SEC?

Mr. MCGAHAN. Into the SEC, that is my understanding. Although we were not advising HealthSouth on that. It is for their

counsel and internal counsel.

Mr. GREENWOOD. So that is not UBS’ responsibility?

Mr. MCGAHAN. Absolutely. We have nothing to do with that.

Mr. GREENWOOD. It is the company’s responsibility?

Mr. MCGAHAN. Yes, sir.

Mr. GREENWOOD. And would the SEC likely postpone the permit?

Mr. MCGAHAN. I do not know.

Mr. GREENWOOD. The registration, I should say.

177

Mr. MCGAHAN. It is just an area that we work with them.

Mr. GREENWOOD. Now are you aware that yesterday’s indictment

of Mr. Scrushy includes ‘‘false statements, accounts directed to,

among other things, the June and the August SEC registration filings for the bond issue?’’

Mr. MCGAHAN. I was not aware of that. But that——

Mr. GREENWOOD. Okay. If you look at Tabs 20 and 21 in your

book. They indicate that in August 2002 by looks at the Tab 20

email, at least as early as August 13, HealthSouth was preparing

to issue a press regarding the impact of Transmittal 1753. The Tab

21 email and its attachment indicate that on August 23 the UBS

team saw a copy of the press release that contained the disclosure

of the Transmittal 1753 and its $175 million impact on earnings.

Is that what they indicate?

Mr. MCGAHAN. Yes, sir.

Mr. GREENWOOD. Okay. HealthSouth disclosed its financial hit to

UBS on August 23 and issued the press release on August 27. And

in between those dates on August 26 the registration became effective.

So I see it, UBS and HealthSouth had the opportunity to notify

the SEC to postpone registration of the these bonds, is that not

right?

Mr. MCGAHAN. No, sir. I was—we were—I personally was completely unaware of the registration process going on. And that is

not anything that we have anything to do with at all. So—they

work with outside counsel and attorneys on their public filings, but

not with the investment bankers.

Mr. GREENWOOD. Did UBS inform their inside counsel that this

was going on?

Mr. MCGAHAN. UBS did inform the—the proper folks in—in

terms of inside counsel what we were working on, but we had no

knowledge of the SEC filings or we were not reviewing them.

Whatever HealthSouth was doing in terms of the bonding venture,

we just did not have anything to do with.

Mr. GREENWOOD. On August 23 UBS knew that there was going to be $175 million impact on the company, right?

Mr. MCGAHAN. Yes.

Mr. GREENWOOD. Both HealthSouth and UBS knew that?

Mr. MCGAHAN. I believe so, yes.

Mr. GREENWOOD. And you felt no obligation to disclose that information to the SEC?

Mr. MCGAHAN. Well, my understanding of this was that

HealthSouth was in a mode to publicly disclose this as soon as they

had their arms around it. They were telling all the people that they

working with, including their internal—all the lawyers they were

working with, exactly what they were going to do.

But in terms of the public disclosures, we are not advising the

company on what disclosures they make. But I was under the impression at the time that they were going down the road to a rapid

disclosure of this information.

Mr. GREENWOOD. Well, why would they have sent those emails

to you if you were not advising them on their disclosures?

Mr. MCGAHAN. What I was referring to was on their legal disclosures, their public filings with the SEC. This was a draft of a press

178

release that they sent around which they announced, I believe,

within one or two business days of this circulation.

Mr. GREENWOOD. And UBS has no role whatsoever in the registration process for these bonds?

Mr. MCGAHAN. We do not.

Mr. GREENWOOD. And as far as you know, HealthSouth never informed the SEC on August 23 of this impact?

Mr. MCGAHAN. I just do not know. I have no idea.

Mr. GREENWOOD. Okay. Thank you.

And this time I mean. Thank you to all of you.

The hearing—without objection, we need to have all of the documents and the binders be entered into the record.

Without objection they will be entered.

And the hearing is adjourned.

[Whereupon, at 7:45 p.m., the subcommittee was adjourned.]

[Additional material submitted for the record follows:]

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Æ