71 The Alabama Lawyer 128 (2010). Corporate Governance and the Healthsouth Derivative Litigation.

• Author: By Ken Randall and Hunter Hill

Alabama Lawyer

2010.

71 The Alabama Lawyer 128 (2010).

Corporate Governance and the Healthsouth Derivative Litigation

Corporate Governance and the Healthsouth Derivative LitigationBy Ken Randall and Hunter HillOn June 18, 2009, Jefferson County Circuit Judge Allwin Horn entered a judgment of nearly $3 billion against former HealthSouth CEO Richard Scrushy in the derivative action filed on the corporation's behalf. Scrushy used the company he founded, the industry leader in rehabilitative health care, to perpetuate a colossal fraud on the market. Scrushy and his CFOs overstated HealthSouth's net income by $3.1 billion over seven years and traded HealthSouth's stock in order to take advantage of this fraud, harming not only HealthSouth and its shareholders but the market as a whole. Following extensive litigation, involving perhaps the most blatant breach of corporate governance by a homegrown Alabama company, Judge Horn conclusively gave Scrushy the title "CEO of the fraud." (Tucker v. Scrushy, No. CV-02-5212 at p. 25 (Jefferson County Cir. Ct., Ala. June 18, 2002) (memorandum opinion)).

The Structure of the Litigation

Three different trials compose the corpus of the HealthSouth fraud litigation. In 1998, a class of stockholders filed a direct securities fraud suit in federal court against HealthSouth and several insiders, including Scrushy, claiming that management materially misrepresented the effects of certain acquisitions and Medicare changes in 1997 on HealthSouth's financial position. In the wake of sharply declining earnings in the third quarter of 2002, several other securities fraud class actions were filed by various stockholder and bondholder groups. After the financial fraud at HealthSouth became public in March 2003, the old and new federal court securities fraud cases were consolidated into a class-action dubbed In re HealthSouth Corporation Securities Litigation. While Scrushy refused to settle, HealthSouth and the other directors and officers settled the case for $445,000,000, covered by stock issuance and insurance.

Secondly, the SEC brought criminal charges against Scrushy, filed in federal court, with claims providing the first real test for provisions in the Sarbanes-Oxley Act ("SOX"), which were intended to assist the prosecution of accounting fraud. The business and legal communities viewed this proceeding as a relative failure. HealthSouth settled for only $100,000,000 in civil damages and was enjoined from further breaches of securities laws, while not admitting to any wrongdoing. As is well known by now, though five former HealthSouth CFOs, who had plead guilty, testified against the former CEO, Scrushy was acquitted on these securities fraud criminal charges.

Our focus, Tucker v. Scrushy, was a derivative action filed by shareholders on behalf of HealthSouth. The action began in August 2002, before the HealthSouth accounting fraud was made public, when a shareholder, Wade Tucker, filed suit against Scrushy, then CEO, and various other officers and directors in the Circuit Court for Jefferson County, Alabama, for various breaches of fiduciary duty stemming primarily from self-dealing transactions.(fn1) After the accounting fraud was announced, Judge Horn found that demand would have been futile and appointed Wade Tucker as the derivative plaintiff, who had authority to assert the claims of HealthSouth resulting from the accounting fraud that was discovered in March 2003. Several other suits were consolidated under this name and were placed under the care of Judge Horn. After a bench trial in May 2009, the court found that the damages that should be awarded against Scrushy totaled $3,115,103,000. After certain judgment credits related to previous recoveries on behalf of HealthSouth in this same derivative litigation, Judge Horn entered a judgment against Scrushy and in favor of Wade Tucker, derivatively for HealthSouth Corporation, in the sum of $2,876,103,000 for fraud, insider trading, negligence and self-dealing.

As in the Bernie Madoff case, efforts are now underway to identify, find and liquidate Scrushy family assets, the fruits of corporate waste and unjust enrichment from massive breaches of fiduciary responsibilities. It is doubtful that full recovery ever will be made.

These three proceedings, combined, found HealthSouth, Scrushy, other officers and directors, auditors, and investment bankers liable for well over $3 billion in damages and disgorgements.

The Derivative Litigation: A Myriad of Fiduciary Violations

For publicly-traded corporations, the officers' and directors' ultimate responsibility is to the company's owners, the shareholders. In The Wealth of Nations, Adam Smith wrote that "being managers rather of other people's money than of their own, it cannot be well expected that they should watch over it with the same anxious vigilance with which . . . partners . . . frequently watch over their own." Functional capital markets require that investors turn over their capital to these managers, normally complete strangers. In fact, the U.S. Supreme Court held that the essence of a "security" is "whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others."(fn2) The security is the fundamental building block of our public markets, requiring investors to trust that other people will produce worthwhile financial returns. In other words, our very market economy is defined by trust.

Therefore, the law has imposed certain indispensable fiduciary duties on officers and directors to foster confidence that they will maximize the investors' returns.(fn3) Under standard corporate-governance nomenclature, fiduciary responsibility includes the "duty of care" and the "duty of loyalty." A case involving a breach of care "is essentially a negligence cause of action," according to Dr. Richard Thigpen's renowned treatise, while a breach of loyalty "relates more to the law of fraud."(fn4)

Scrushy's behavior was a tremendous breach of both the duty of care and the duty of loyalty. Courts have utilized a spectrum of standards in defining the duty of care, but Scrushy violated that duty from one end of the spectrum to the other. Delaware law governed the derivative litigation. Even if under Delaware's business judgment rule "director liability is predicated upon concepts of gross negligence,"(fn5) Scrushy clearly violated that standard of care. Similarly, the derivative action demonstrates Scrushy's complete disregard of his duty of loyalty to advance HealthSouth's best interests, through his multiple acts of self-dealing.

Forecast Failures

There were at least two motivations for the fabrication of HealthSouth's earnings. The first involved the company's failure to...