Quandary at National Health Company

N. Ahadiat, & D. Rice

Abstract

National Health Company (NHC) became one of the natio

ns leading providers of

healthcare during the early 2000s, through aggressive m

ergers and acquisitions. The

company provides both in and out patient care such a

s convalescent care, rehabilitation,

physical therapy, outpatient surgical centers, ultras

ounds, mammograms, MRIs, CT

scans, and other medical services. The companys rap

id expansion initially resulted in a

substantial amount of profit and success in the heal

thcare market. However it became

increasingly difficult to maintain the growth and e

xpansion in light of the economic

climate, continued pressure from Medicare, the insu

rance companies to cut costs, com-

petition from other health field carriers and the c

oncern over potential government

funded health care programs. As the NHCs managemen

t failed to sustain the expected

growth, its management resorted to other strategies

that not only maintained the expec-

tation of its shareholders, but would also allow man

agement to keep their extravagant

life style.

In this case, we will follow the struggles and angu

ish faced by Karen Larson, NHCs

Chief Financial Officer, as she battles her way throug

h making the right financial and

corporate governance decisions and not to allow hers

elf to be allured, by fancy titles,

avarice and greed as well as upper management pressur

e placed before her. We will

present not only the decisions she has to make but

also the outcome of her decisions.

Background

National Health Company (NHC) is one of

the nations largest providers of

healthcare. It is ranked in the top ten na-

tionally in terms of size and revenue. The

company reached its ranking by expand-

ing rapidly through aggressive mergers

and acquisitions throughout the late 1990s

through the 2006. The company had 50 fa-

cilities across the nation in 1990. By 2006

the company had purchased another 28

hospitals and 45 outpatient rehabilitation

facilities from National Health Enterprise.

In 2003, NHC purchased ReLive, a major

healthcare chain. In 2005, NHC acquired

Medical Surgical Corporation, Novacare,

Health Imaging, Horizon and several oth-

er healthcare providers, with acquisition

costs totaling approximately $2.5 billion.

The buying binge positioned the company

as one of the major players in the

healthcare industry.

As the expansions continued, the NHCs

stockholders became accustomed to a pe-

riod during which they enjoyed double

digit growth rate in their investments.

Yet, once this growth began to truly slow

down, management and Karen Larson,

NHCs Chief Financial Officer (Karen)

did not pay any heed but instead took var-

ious steps to ensure that the price of the

stock would continue to soar.

102

In December 2008, Karen was celebrating a

triumphant moment in her career. She

had been made the CFO in a company she

loved. For Karen, this moment did not

come soon enough. For 20 years, she had

set her sight on this position. She had

toiled in the trenches, putting in long

hours and sacrificing even her vacation

time in hopes of attaining her dream job.

Achieving this position was a fitting cul-

mination of her years of dedication. It was

a richly deserved reward that she cher-

ished and relished. Now Karen was too

pre-occupied with her thoughts. As she

sat huddled in the corner of her dark pris-

on cell, surrounded by belligerent, mental-

ly unstable inmates, Karen Larsons mind

could not help but revisit the fateful day

when her plunge from the lofty perch in a

major corporation to the bowels of prison

began. Painfully, it was time for her to

trace back her steps to what had brought

her here.

The Plan

No sooner had Karen settled on her new

position, when her troubles started. Ap-

proximately nine months into her new job,

Karen Larson was lying awake, sleepless

and listless on her bed. Her thoughts

wandering around the meeting she had

earlier in the day with several other mem-

bers in upper-level management. George

Dawson (George), the CEO of the com-

pany had gathered all the members of up-

per-level management with direct rela-

tions to the finance and treasury

departments. George had started the

meeting with a speech about how proud

he was to be working with such trustwor-

thy and loyal associates, and how he was

very fond of everyone and how they were

all like family to him. After Georges wel-

coming introduction, the real topic of the

meeting came into play. George stated

that, Im sure youre all aware of our cur-

rent financial position as a company. Ka-

ren and everyone there nodded with the

understanding of his statement. He con-

tinued, This recent quarter has been very

bleak, the bleakest one this company has

ever seen in its history. Everyone contin-

ued to nod in agreement with his words.

George went on, However, I believe our

company can pull through this stumble.

All I ask is a small favor in order to bring

the company to new heights. A deep si-

lence swept across the room in the antici-

pation of his next words. All I ask is that

we hide the stumble we had this quarter

from the public. Not everyone in the pub-

lic might agree with our strengths and

abilities. And if word got out that we the

giant in the healthcare industry was falter-

ing, it would hurt the company as a whole.

And we wouldnt want that now would

we? Whispers started out among every-

one all at once, at the notion of what was

being asked of them. George, the CEO of

the company, the one that she had looked

up to, was asking her and everyone else in

the room to commit fraud and falsify the

accounting books and records. George

started to silence the whispers, as he con-

tinued, I will hold personal responsibility

in this act and request. All Im asking for

is to make this one quarter look positive to

the eyes of the public. And next quarter,

Ill ensure the company truly has a posi-

tive quarter. Ill let you all think it over for

103

a few days, and well continue this meet-

ing then.

Over the next several days Karen agonized

over the decisions that she was going to

have to make, yet there were so many un-

answered questions. These questions con-

tinued to spin in her mind. Was she really

a part of the play to deceive the public?

And if she wasnt, should she tell someone

about the companys wrongdoings and the

CEO? She thought about the sincerity of

George Dawson when he stated that he

would bring the company into positive

cash flow over the next quarter, in line

with the financial markets expectations.

Then she thought about all her fellow as-

sociates, all of her friends and all of the

people who worked under her. She had

been working for NHC for over 20 years,

she had worked hard and diligently to

gain her last position as Chief Financial

Officer. She had also worked hard to gain

the trust and loyalty of her fellow associ-

ates. However, what the members of top

management had asked her to do against

the oath she had sworn when she became

a CPA, and her fiduciary duties as one of

the officers in the company. It also went

against the very morals and fibers of her

upbringings and had left her in utter tur-

moil. She continued to ponder. What

would have been the outcomes if the com-

pany had reported a loss? What would

have been the outcomes if she and those

involved did not get caught in the fraud

they were about to commit? What was

she going to do?

The Afterthought

A debate raged in Karens head. She

thought if she agreed to commit fraud

then the company would have no reason

to lay off any of their workers. All of the

jobs would be saved. But then what if the

jobs were saved but the investors lost their

money? She shook the thoughts out of her

head. It was only going to be this one

quarter, as far as she could tell and dared

to believe and hope for. She convinced

herself then that agreeing to commit to the

act would be the best course, especially if

everyone else in the meeting agreed to it.

She didnt want to be the outcast, nor did

she want to disappoint everyone. She

didnt want to constantly have to look

over her back with all the ridicules about

why she didnt go along with the decision.

And she definitely wasnt going to tell an-

yone for fear of losing her own position in

the company; the position that she had

worked so hard to achieve. Karen had fi-

nally decided that she was going to accept

the CEOs plea.

The next meeting took place around Octo-

ber of 2009. The meeting room was quiet.

All her fellow upper management associ-

ates looked tired, as if they too didnt get

very much sleep the last few days. But

they also all had a stern look; she could tell

that everyone else probably went through

a similar ordeal to her own. She could al-

so see in their eyes, as they waited for

George, that they were all going to agree

with what George had proposed a few

days earlier.

As George walked through the doors of

the meeting room, he was quick to notice

104

the deadly silence, and was quick to break

it and get down to business. He asked,

So has everyone come to a decision?

They all nodded their heads. What is it

then? George asked, Are you with or

against me? A short silence fell over eve-

ryone, as no one seemed willing to be the

first to admit to conspiring to the devious

plan. Then Patricia Kim the corporations

in-house counsel stood up and gave her

answer, I agree to your idea George and

stand behind you and your decision all the

way. At that moment, everyone else was

quick to chime in with similar affirma-

tions.

The rest of the meeting went into a discus-

sion of how they were going to hide this

from the public and cover their tracks to

make it difficult for an auditor to find the

deception, if one ever came to investigate.

The plan that they came up with was to

decrease a contra asset account as well as

the expense accounts, either of which

would increase earnings and correspond-

ingly the assets. In addition, they were go-

ing to create fictitious journal entries to

correspond with the generally accepted

accounting principles. Furthermore they

were going to create false documents to

support the bogus accounting entries.

After the meeting adjourned, George came

into Karens office and said we are going

to be reporting all of this additional in-

come and with the capital gain NHC had

from the sale of an asset this year, I am

concerned about the inability from a cash

flow standpoint for NHC to pay its corpo-

rate income tax. We need to find a way to

offset the companys potential tax liability,

which in part was due to a large capital

gain from the sale of an asset and I would

like you to consider some of the tax shel-

ters out there. Karen wanting to help out

George came across a tax shelter, called

Son of Boss,

11

which was designed to re-

duce capital gains. The transaction is a

listed transaction with the IRS. Howev-

er, George had made it clear that it was

necessary to defer any immediate issues

with their taxes with the Securities and

Exchange Commission (SEC) or the Inter-

nal Revenue Service (IRS) and requested

that Karen not file the listed transactions

form with the IRS. Karen complied with

this request in order to please her boss.

The Aftermath

The plan went off without a hitch. Every-

thing had gone according to plan. How-

ever, the next quarter rolled by and passed

rather quickly and still George didnt or

couldnt hold up his end of the bargain.

They all held another similar meeting, and

George asked to continue the plan for an-

other quarter. One quarter after another

came and passed with no end to the ac-

counting and financial subterfuges insight.

Then one day, rather unexpectedly and

11

Son of Boss tax shelters were designed to re-

duce federal income tax obligations from the sale of

a business or other appreciated assets. Assume

that the statute of limitations was not an issue, as in

the Supreme Court case of

U.S. vs. Home Concete &

Supply, LLC, 566 U.S.___(2012)

. Assume that our

clients executive offices are located in Texas in

which is a 5

th

Circuit case,

Klamath Strategic Inv. V.

U.S.

568 F.3d 537 (5

th

Cir. 2009), held that the

transaction lacked any economic substance and

was nothing more than a sham.

105

without discussing it with anyone, George

sold his stocks of NHC.

Even though NHCs business was suppos-

edly booming, the first of National Heath

Company's accounting problems started to

surface in late 2010 after George sold $85

million in stocks several days before the

company posted a large loss, the first in

the companys history. The SEC started to

investigate whether or not Georges deci-

sion to sell his stocks was related to the

posting of a large loss. NHC hired an out-

side law firm to review Georges stock sale

in order to try to postpone the SECs in-

vestigation. The outside law firm con-

cluded that the sale and profit loss were

not related. This however did not ease the

SEC's suspicions. The SEC not only

looked into the stock sale but began exam-

ining the books and records of the compa-

ny along with the FBI. As the investiga-

tions progressed, various employees were

interviewed, including Karen. The FBI

and the Department of Justice met with

Karen and offered her a reduced sentence

if she would come clean with what she

knew. On the evening of June 13, 2012,

FBI agents executed search warrants at the

company's headquarters after the compa-

ny's CFO Karen agreed to wear a wire, in

which she was able to get George to talk

about the fraud.

A number of months thereafter, the Feder-

al Grand Jury issued indictments against

all upper management, including Karen

for committing fraud, for falsifying NHCs

books and records, and for aiding and

abetting to defraud shareholders. Now,

less than a year later, Karen agreed to a

plea deal in which she would be sentenced

to 18 months in prison and a fine of

$500,000 in return for her cooperating with

the government. Had she not cooperated

with the government she could have re-

ceived 10 years.

As Karen Larson sat outside the court-

room waiting to testify for the government

against George, the governments first de-

fendant, she began to recollect her

thoughts on her misguided actions and the

ordeals she would now have to go

through. She no longer was a CFO, she no

longer had a job, she lost her CPA license,

she lost her right to practice before the IRS,

she was facing 18 months in prison and

when she get out of prison, she could look

forward to repaying $500,000 in restitu-

tion.

What could she have done to avoid these

problems, especially of the devastating pit-

fall of languishing in prison for 18

months? How she could be so foolish, Ka-

ren muttered to herself in retrospection.

What was she thinking? How could she

possibly believe that the fraud would only

last a quarter? George was a human, not a

god. Karen sighed deeply. She had al-

lowed herself to be deceived. She had

been myopic to think that she could save

her own skin and her colleagues jobs

through fraud. Perhaps now, Karen

thought bitterly, she would be able to

clearly discern her misguided actions to

ensure that she never acts in that manner

again. With at least another year of her

life devoted to testifying on behalf of the

government against other defendants with

respect to the fraud committed by NHC

106

and its officers and directors and 18

months of prison time yet to serve, Karen

will certainly have sufficient time to dwell

on all her missteps.

Questions for Discussion

1. What are the laws governing the proper

practice of accounting and finance?

2. What are the protections afforded to a

whistle blower?

3. What are Karen Larsons fiduciary du-

ties toward the company as vice presi-

dent to the CFO?

4. Aside from participating in the scheme,

what are Karen Larsons other options

in face of the dilemma?

5. What are the pros and cons of each of

her options?

6. May the IRS impose a tax preparer pen-

alty under IRC 6694?

7. Has the Corporation violated any of the

tax laws where the IRS could impose a

penalty? If so, under what sections of

the Internal Revenue Code?

8. What ethical duties were violated by

Karen under the AICPA Statements on

Standards for Tax Services as well as

those set forth under Circular 230?