A Case Study Analysis of Health Management Inc. Accounting Fraud

Clifford Hone's Problem

Clifford Hone had a problem. His company had come up short of its earnings target. For the fiscal year ended April 30. 1995. financial analysts had projected that Health Management. Inc. (HMI). I). a New York-based pharmaceuticals distributor. would post earnings per share of $0.74. Following the close of fiscal 1995, Drew Bergman, HMI's chief financial officer (CFO) informed Hone, the company's founder and chief execu-tive officer (CEO), that the actual earnings figure for fiscal 1995 would be approxi-mately $0.54 per share. According to Bergman, Hotte refused to lake the hit: that is, the almost certain drop in HMI's stock price that would follow the announcement of the disappointing earnings.' Instead, Hotte wanted HMI to report 1995 earnings in line with analysts' predictions.2 Bergman altered HMI's accounting records to allow the company to reach its 1995 earnings target. To lower cost of sales and increase HMI's gross profit and net income, Bergman inflated the company's year-end inventory by approximately 51.8 million.

Bergman also posted a few other smaller 'adjustments- to HMI's accounting records. Both Bergman and Hotte realized that the company would have to take elaborate measures to conceal the accounting fraud from its audit firm. Bergman was very familiar with BDO Seidman and its audit procedures since he had been employed by that accounting firm several years earlier. In fact, Bergman had supervised BDO Seidman's 1989 and 1990 audits of HMI. HMI's inventory fraud was not particularly innovative. Corporate executives who want to embellish their company's operating results are aware that among the easiest methods of achieving that goal is overstating year-end inventory. What was unique about HMI's inventory hoax was that it triggered one of the first major tests of an important and controversial new federal law, the 1995 Private Securities Litigation Reform Act (PSLRA). The PSLRA was the only law passed by Congress dur-ing President Clinton's first administration that overcame a presidential veto. Among the parties most pleased by the passage of the PSLRA were the large, international accounting firms.

These firms mounting litigation losses in the latter decades of the twentieth century had prompted them to lobby Congress to reform the nation's civil litigation system. In particular. the firms argued that they were being unfairly victimized by the growing number of class-action lawsuits. The bulk of these lawsuits were being filed under the Securities Exchange Act of 1934, one of the fed-eral statutes that created the regulatory infrastructure for the nation's securities mar-kets in the early 1930s. Top officials of the major accounting firms believed that the PSLRA, which amended key provisions of the 1934 Act, would make it more difficult for plaintiff attorneys to extract large legal judgments or settlements from their firms. The jury's verdict in favor of BDO Seidman in the HMI lawsuit seemed to support that conclu-sion. HMI's stockholders filed suit against BDO Seidman for failing to detect the inventory fraud masterminded by Drew Bergman and Clifford Hotte. Michael Young. a prominent New York attorney who headed up BDO Seidman's legal defense team, predicted that the case would become a "watershed event' in the accounting profes-sion's struggle to curb its litigation losses.'

Accounting Fraud at HMI

The federal securities laws passed by Congress in the early 1930s not only estab-lished a formal regulatory structure for the securities markets, they also strengthened an informal control mechanism that had long served to promote and preserve the integrity of the capital markets. That control mechanism was private securities liti-gation. The federal securities laws make it unlawful for companies registered with the SEC to issue financial statements that misrepresent their financial condition and operating results. However, the courts have also permitted those statutes to be used as the basis for civil actions. Investors and creditors can file tort actions to recover damages they suffer at the hands of parties who prepare or are otherwise associated with misrepresented financial statements of SEC registrants.

Prior to the passage of the federal securities laws and for several decades there-after, major institutional investors and large creditors, such as metropolitan banks. filed most private securities lawsuits. Individual investors and creditors who suffered damages as a result of relying on misrepresented financial statements generally found that it was not economically feasible to use the courts to recover their losses. During the 1970s, resourceful attorneys cured this 'problem' by employing the con. ceps of a "class-action' lawsuit. In such lawsuits. the legal claims of a large number of individual plaintiffs are consolidated into one joint claim, In exchange for represent-ing these joint plaintiffs, attorneys receive a contingent fee equal to a percentage of any collective judgment or settlement awarded to the plaintiffs.

Thanks to their newfound ability to file class-action lawsuits, attorneys special. izing in private securities litigation began vigorously suing parties directly or indi-rectly linked to allegedly false or misleading financial statements filed with the SEC. Most of these lawsuits claimed one or more violations of Rule 1064 of the Securities Exchange Act of 1934. That section of the 1934 Act prohibits the 'employment of manipulative and deceptive devices' in connection with the preparation and distri-bution of the financial statements of SEC-registered companies.' By the late 1970s, class-action lawsuits predicated on Rule 10b-5 violations were commonplace. One legal scholar observed that the 'low transaction cost' of fil-ing a class-action lawsuit under the federal securities laws Invited abuse of that tactic by plaintiff attorneys.' Former SEC Chairman Richard Breeden frequently spoke out against the epidemic of class-action securities lawsuits plaguing corpo-rations, their executives, and related parties. Breeden characterized the securi-ties class-action system "as a legal regime disconnected from principles of right and wrong that is riddled with abuse and that Involves nothing less than thinly veiled extortion?' 

Class-action securities lawsuits proved to be particularly problematic for the large accounting firms that audit the financial statements of most major public compa-nies. An unavoidable facet of these firms primary line of business is being burdened occasionally with a client whose executives choose to use 'creative' or even bl• tangy fraudulent accounting methods. An accounting firm that issues an unquali-fied opinion on financial statements later proven to contain material errors may only be guilty of accepting a client whose management is inept and/or unethical. Nevertheless, the financial resources of the large accounting firms make them invit-ing targets for investors and creditors who have relied to their detriment on mislead-ing financial statements.

The executives of many large accounting firms decided that the most rational approach to dealing with class-action lawsuits filed against them was to settle those lawsuits out of court as quickly and quietly as possible. Michael Cook, former CEO of Debitte & Touche, testified before Congress that his firm often used that strategy because of the leverage plaintiff attorneys had on his firm. That leverage stemmed from the enormous judgments Deloitte & Touche potentially laced it it allowed class-action lawsuits in which it was named as a defendant to go to trial. Most frus-trating to Cook and his colleagues at other accounting firms was the need to pay large sums to settle cases in which they were convinced their firms were not at fault. According to Cook, "I am forced to settle cases in which I believe our firm did nothing wrong:7 Skeptics questioned the veracity of such statements by Cook and other top execu-tives of major accounting firms. However, empirical research by Professor Zoe-Vonna Palmrose, an authority on audit-related litigation, suggested that the large accounting firms were often named as defendants in class-action lawsuits because of their 'deep pockets rather than because they were at fault.

The ability of plaintiff attorneys to goad defendants into settling was borne out by a study of class-action securities law-suits filed prior to the mid-1990s. Only 2 percent of those lawsuits went to trial, while 20 percent were dismissed. In the remaining 78 percent of those cases, the plain-tiffs received out-of-court settlements, often multimillion-dollar settlements, from the defendants?