SECURITIES EXCHANGE ACT OF 1934
Release No. 42992 / June 30, 2000
ACCOUNTING AND AUDITING ENFORCEMENT
Release No. 1283 / June 30, 2000
File No. 3-10245
In the Matter of
Allegheny Health, Education
FINDINGS, AND IMPOSING
The Securities and Exchange Commission deems it appropriate that cease-and-desist proceedings be instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Allegheny Health, Education and Research Foundation ("AHERF").
In anticipation of the institution of these proceedings, AHERF has submitted an Offer of Settlement that the Commission has determined to accept. Solely for the purpose of these proceedings, and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, AHERF, without admitting or denying the findings contained herein, except that it admits to the jurisdiction of the Commission over it and over the subject matter of these proceedings, consents to the entry of the findings and the issuance of this Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing Cease-And-Desist Order.
Accordingly, IT IS ORDERED that proceedings against AHERF be, and hereby are, instituted.
On the basis of this Order and the Offer submitted by AHERF, the Commission finds that:1
AHERF. AHERF is a Pennsylvania nonprofit healthcare organization formed in 1983. AHERF was the parent holding company and sole member or owner of numerous subsidiaries.2 On July 21, 1998, AHERF instituted bankruptcy proceedings under Chapter 11 of the United States Bankruptcy Code on behalf of itself and four of these subsidiaries in the U.S. District Court for the Western District of Pennsylvania.
This matter involves actions by senior executives at AHERF, at its height the largest nonprofit health care organization in Pennsylvania, to grossly overstate the income of AHERF and some of its subsidiaries, thereby masking the enterprise's deteriorating financial condition. On July 21, 1998, AHERF and four of its subsidiaries filed for protection under Chapter 11 of the U.S. Bankruptcy Code. However, from at least December 1996 through February 1998, AHERF and some of its subsidiaries collectively known as the Delaware Valley Obligated Group ("Delaware Valley") issued annual financial statements and municipal securities disclosure reports that materially misrepresented, among other things, AHERF's and Delaware Valley's net income. AHERF, through certain members of its senior management and in violation of Generally Accepted Accounting Principles ("GAAP"): (i) overstated Delaware Valley's 1996 net income before extraordinary item and change in accounting principle by approximately $40 million by failing to adjust Delaware Valley's bad debt reserves to account for uncollectible accounts receivable; (ii) overstated Delaware Valley's and its own 1997 net income through the inappropriate transfers of approximately $99.6 million in reserves that were utilized to address the bad debt reserve shortfall not addressed in 1996, as well as an additional shortfall in 1997; and (iii) overstated its 1997 net income by misclassifying certain restricted trust funds. The misclassification of the restricted funds and the transfers resulted in the overstatement of AHERF's consolidated net income for the period ended June 30, 1997 by approximately $114.3 million. Significantly, both Delaware Valley and AHERF would have posted substantial net losses for fiscal year 1997 without the fraudulent activity.3 Among the victims were investors holding more than $550 million of publicly offered bonds issued by or on behalf of three of the bankrupt subsidiaries.
Before its bankruptcy in July 1998, AHERF was a Pittsburgh-based collection of non-profit acute-care hospitals, a medical university, physician practice groups, and numerous other affiliated entities. From 1987 to 1997, AHERF expanded rapidly, acquiring other non-profit healthcare organizations, including several in the Philadelphia metropolitan area: the Medical College of Pennsylvania, United Hospitals, Inc., Hahnemann University Hospital and the Graduate Health System ("Graduate"). Acquired entities became direct or indirect subsidiaries of AHERF. As an umbrella holding company, AHERF managed and provided centralized corporate support services for the acquired entities, but did not assume liability for their pre-existing debt. The obligation to repay debt within AHERF was placed on collections of one or more of its non-profit subsidiaries known as "obligated groups." Each subsidiary within an obligated group was jointly and severally liable for the debt of that obligated group. By 1997, AHERF had five obligated groups: Allegheny General Hospital ("Allegheny General"), Allegheny University Medical Centers, Delaware Valley, Allegheny Hospitals, Centennial ("Centennial"), and Allegheny Hospitals, New Jersey.
On July 21, 1998, AHERF filed for protection under Chapter 11 of the U.S. Bankruptcy Code in U.S. District Court for the Western District of Pennsylvania on behalf of itself, the Delaware Valley hospitals and university, the Centennial hospitals and the Allegheny University Medical Practices. According to the bankruptcy petition and supporting documents, AHERF and these subsidiaries accumulated $1.3 billion in outstanding debt. The outstanding debt included approximately $396 million of publicly offered bonds issued by or on behalf of Delaware Valley and $154.3 million of publicly offered bonds issued on behalf of Graduate and assumed by the Centennial Hospitals. On September 2, 1998, following substantial media coverage about the bankruptcy, AHERF issued a press release in which it acknowledged that its audited financial statements for 1997 were inaccurate. In the release, AHERF stated that "[n]o further reliance should be placed on the financial statements" or upon the accompanying report prepared by AHERF's independent auditor.
3. AHERF's Continuing Disclosure Obligations
By the time of the bankruptcy in July 1998, AHERF's obligated groups were responsible for at least thirteen bond issues, with outstanding debt of more than $900 million.4 The individual issues ranged from $12.7 million to $306 million, the latter incurred on behalf of Delaware Valley in a 1996 refinancing of its older bonds (the "Delaware Valley refinancing"). At least $400 million of AHERF bonds were not credit enhanced, meaning that they were not supported by a letter of credit or bond insurance. The obligated groups, through AHERF as their agent, provided to nationally recognized repositories annual Secondary Market Disclosure Reports ("Disclosure Reports") containing audited financial statements, debt coverage ratios and other information with respect to certain of its obligated groups.5 These Disclosure Reports were made available to the public through these repositories and were the most easily accessible source of information for investors and potential investors in AHERF bonds. The obligated groups also were required by contract to periodically disclose financial information to, among others, credit enhancers and bond trustees, and some of the agreements required certifications by company officers as to the accuracy of the submitted information.
4. Misrepresentations in Financial Statements and Disclosure Documents
AHERF's rapid growth and consequent debt left it with significant pressures to maintain stable financial results and positive net income. It was in this environment that AHERF, through certain of its senior officers and in violation of applicable accounting principles, misstated its financial statements and schedules to overstate the 1996 and 1997 net income of AHERF, including that of some of its subsidiaries, in materials disseminated to the public, including investors and potential investors in the various AHERF bonds.
a. AHERF's Financial Reporting Function
At all relevant times, AHERF's financial reporting function, including the initial preparation of financial statements, was primarily handled by AHERF's Corporate Support Services Department (the "Accounting Department"). This department was under the control of AHERF's Chief Financial Officer, who reported to AHERF's Chief Executive Officer. Significant aspects of the financial reporting function also were the responsibility of other departments or entities within AHERF. For example, separate AHERF entities each had their own Chief Executive Officers and Chief Financial Officers. These individuals also participated, to varying degrees, in AHERF's financial reporting.
b. The 1996 $40,000,000 Overstatement
In October 1996 AHERF decided to write off approximately $81 million in Delaware Valley uncollectible accounts receivable. This decision was made more than two months prior to AHERF's issuance of Delaware Valley's 1996 financial statements and was based on information that indicated that the accounts receivable were impaired as of Delaware Valley's June 30, 1996 balance sheet date. This write off would have necessitated an approximately $40 million increase to Delaware Valley's bad debt reserve and bad debt expense. Despite this, and in violation of GAAP, AHERF failed to adjust Delaware Valley's bad debt reserve as of June 30, 1996, resulting in a $40 million overstatement of Delaware Valley's net income before extraordinary item and change in accounting principle and corresponding misstatements in the 1996 Delaware Valley Disclosure Report.
During fiscal year 1996, AHERF senior management was aware of substantial increases in, and collection problems with, Delaware Valley's patient accounts receivable. They attempted to diagnose and address this issue through, among other things, changes in management and internal meetings. By early fall 1996 AHERF decided to write off approximately $81 million in Delaware Valley patient accounts receivable.6 It then implemented a plan by which to write those accounts off in quarterly installments, beginning in October 1996. Although Delaware Valley's reserve for bad debts was insufficient at June 30, 1996, AHERF made no effort to adjust the 1996 financial statements, which were being finalized contemporaneously with this decision to write off $81 million. Under GAAP, Delaware Valley should have increased its bad debt reserve.7 AHERF ultimately determined that the bad debt reserve shortfall as of June 30, 1996 was approximately $40 million. This shortfall calculation was based upon the $81 million write off and its effect on Delaware Valley's bad debt reserve, using Delaware Valley's methodology for computing its bad debt reserve.
Between December 12, 1996 and January 7, 1997, AHERF distributed Delaware Valley audited financial statements and 1996 Disclosure Report to the public. Appropriately adjusting Delaware Valley's bad debt reserve would have, among other things, reduced its reported net income of $27 million before extraordinary item and change in accounting principle by approximately $40 million and similarly reduced its reported net accounts receivable figure of $253 million by approximately $40 million. Moreover, the management discussion and analysis ("MD&A") portion of the Disclosure Report implied that the $72.2 million increase in Delaware Valley accounts receivable during fiscal year 1996 was a temporary phenomenon that would resolve itself upon completion of Patient Billing department consolidation and conversion. In addition, the referenced patient accounts receivable figure, taken from the Delaware Valley balance sheet, should have represented amounts that, in the judgment of AHERF, were still collectible. However, months before the date of the Disclosure Report, AHERF knew or was reckless in not knowing that accounts receivable were overstated by, at least, $40 million, and that the primary cause of the increase in net accounts receivable was, in fact, the failure of AHERF to adequately increase Delaware Valley's bad debt reserve. Increasing the bad debt reserve would have, in turn, decreased the Delaware Valley net accounts receivable figure on its balance sheet. Despite this knowledge, AHERF did not correct the misstatement and, by not doing so, hid the misstatements contained in the Delaware Valley fiscal 1996 audited financial statements and the financial information contained within the Disclosure Report.
c. The 1997 $114,300,000 Overstatement
The AHERF consolidated financial statements and consolidating schedules for fiscal year 1997 overstated both AHERF and Delaware Valley net income through AHERF's inappropriate transfer of $99.6 million from the Graduate Hospitals to the Delaware Valley and its misclassification of $54.7 million in trust funds. Correcting both misstatements, AHERF's reported consolidated net income was overstated by approximately $114.3 million. Moreover, AHERF's 1997 Disclosure Report included misstatements pertaining to the decrease in Delaware Valley accounts, as well as misleading narrative information about intercompany account balances and restructuring expenses.
i) The Transfer of $99.6 Million in Reserves
The failure to address the accounts receivable problems described above in fiscal year 1996 and the continued deterioration of accounts receivable in fiscal year 1997 resulted in approximately $111 million of write offs of uncollectible accounts receivable by June 30, 1997. However, Delaware Valley did not have sufficient bad debt reserves in fiscal year 1997 to absorb $111 million in write offs and still maintain an adequate bad debt reserve under GAAP for its remaining accounts receivable. Proper accounting treatment under GAAP required increasing these reserves through bad debt expense, thereby decreasing Delaware Valley's net income.8 In violation of GAAP, AHERF increased Delaware Valley's reserves without recognizing the corresponding charge to income. Specifically, during the third and fourth quarters of fiscal 1997, AHERF, through a series of intercompany transactions, transferred to Delaware Valley $99.6 million of reserves from various Graduate hospitals.9 Although AHERF did this to address Delaware Valley's bad debt reserve shortfall, $40 million of that shortfall properly was attributable to fiscal year 1996. During the time the transferred reserves were established, the Graduate hospitals were held in a separate company controlled by AHERF that was not included in the AHERF consolidated financial statements.10 As a result, AHERF and Delaware Valley avoided the negative earnings impact of establishing the reserves required under GAAP.
By virtue of the transfer of reserves from the Graduate hospitals to Delaware Valley to cover bad debt, the AHERF 1997 audited consolidated financial statements, distributed to the public on or about February 6, 1998, overstated reported net income of $21.9 million by, approximately, $59.6 million.11 Similarly, Delaware Valley 1997 reported net income of $23.7 million, reflected on the consolidating schedules, was overstated by, approximately, $59.6 million. Moreover, as part of the bond agreements, AHERF certified to bond trustees and others that, among other things, the 1997 financial statements were prepared in conformity with GAAP.
The 1997 Disclosure Report, also distributed to the public on or about February 6,1998, mirrored the numbers contained in the 1997 financial statements, thereby repeating the misstatements described above. Moreover, the MD&A discussion for Delaware Valley attributed a $50.7 million decrease in patient accounts receivable to enhanced patient accounts receivable collection and more cost effective billing and accounts receivable management. In fact, accounts receivable decreased in 1997 by virtue of the transfers from the Graduate reserves, not an improved collection process.
Moreover, Centennial was portrayed more negatively than its financial condition warranted.12 The MD&A discussion for the Centennial Hospitals attributed $46.1 million in restructuring costs to "the recognition of reserves for patient accounts receivable third-party reimbursement issues, inventory obsolescence, pension costs and self insurance reserves for malpractice and workers' compensation claims." In fact, at least $28.4 million of these reserves were considered excess at June 30, 1997 and were utilized for a different, undisclosed purpose - covering Delaware Valley's bad debt reserve shortfall.13 Moreover, the MD&A section attributes a change from a $48.8 million receivable to a $100.2 million payable position in Centennial intercompany account balances to the inclusion of the intercompany balances of two new entities in the obligated group, intercompany charges for corporate support services and borrowings for operating and cash flow requirements, and the transfer of pension and self insurance liabilities from Centennial's balance sheet to AHERF. Unmentioned are the reserve transfers to Delaware Valley, which for accounting purposes were treated from Centennial's perspective as an intercompany account payable.
ii) The Misclassification of Trust Funds
In fiscal year 1996, AHERF, through senior management, misclassified five irrevocable trusts held by an independent trustee known collectively as the "Lockhart Trusts," with a market value as of June 30, 1996 of $87.3 million.14 Applicable state law and the trust documents provided that the capital gains attributable to the Lockhart Trusts were part of the corpus of the trust and accordingly inaccessible to AHERF.
In adopting FAS 116,15 AHERF misclassified the Lockhart funds by treating permanently restricted funds in the Lockhart Trusts as available to AHERF. However, by early fiscal 1997 AHERF senior management had received notice that its classification of the Lockhart Trusts was incorrect. In November 1996, AHERF senior management received and reviewed written notice from the independent trustee to the effect that the Lockhart Trust documentation explicitly provided that only income (and not capital gains) was available to AHERF. In response, AHERF senior management discussed, but did not modify, the Lockhart Trust classification. In addition, for fiscal year 1997, AHERF improperly recognized $54.7 million from the Lockhart Trust assets as income.16 As a result, without considering the impact of the Delaware Valley fraud described above, AHERF overstated its reported net income in its consolidated audited financial statements for 1997 by $54.7 million.
C. Legal Discussion: AHERF Violated Section 10(b) of the Exchange Act and Rule 10b-5 Thereunder
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder make it unlawful to make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. Any issuer that releases information to the public that is reasonably expected to reach investors and trading markets will be subject to the antifraud provisions. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied sub nom, Coates v. SEC, 394 U.S. 976 (1969). The antifraud provisions are equally applicable to disclosures in the secondary market for municipal securities. See Statement of the Commission Regarding Disclosure Obligations of Municipal Securities Issuers and Others, Exchange Act Rel. No. 33-7049, 1994 SEC LEXIS 700 (March 9, 1994).
AHERF, through certain of its senior officers, violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. As described above, AHERF materially overstated Delaware Valley's net income before extraordinary item and change in accounting principle by, approximately, $40 million, in the 1996 Delaware Valley audited financial statements and Disclosure Report. It further overstated its consolidated net income by $114.3 million and Delaware Valley's net income by $59.6 million in the 1997 AHERF audited consolidated financial statements and consolidating schedules and the 1997 Disclosure Report. In both Disclosure Reports, AHERF hid its true financial condition from the public through its misleading disclosures and omissions as to Delaware Valley accounts receivable, the transactions related to its transfer of $99.6 million from Graduate and its misclassification of the Lockhart Trusts. Finally, its statements to trustees and others permitted AHERF to continue unchecked in its conduct.
In view of the foregoing, the Commission deems it appropriate to accept the Offer submitted by AHERF and accordingly:
IT IS ORDERED pursuant to Section 21C of the Exchange Act that AHERF cease and desist from committing or causing any violations and any future violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
By the Commission.
Jonathan G. Katz
1 The findings herein are made pursuant to AHERF's Offer and are not binding on any other person or entity in this or any other proceeding.
2 AHERF's underlying entities are referred to as "subsidiaries," although technically AHERF was their sole "member", not a shareholder.
3 A reference to fiscal year 19xx is from July 1 of the previous year through June 30, 19xx.
4 In order to take advantage of lower tax-exempt interest rates, the obligated groups generally borrowed money through various conduit public authorities. The public authorities issued publicly offered tax-exempt municipal bonds on behalf of the obligated group. The obligated group in turn assumed responsibility for repaying that debt. For convenience this order refers to the bonds as if the responsible obligated group, not the conduit public authority, issued them. Approximately 41% of this debt was issued by or on behalf of Delaware Valley, 28% by or on behalf of Allegheny General, and 22% by or on behalf of Centennial and Allegheny Hospitals, New Jersey. The remaining 9% was issued by or on behalf of Allegheny University Medical Centers and Canonsburg Hospital, the latter of which joined AHERF in fiscal year 1998.
5 See Exchange Act Rule 15c2-12, which generally prohibits broker-dealers from underwriting primary offerings of municipal securities after July 1995 unless the issuer and/or an entity obligated to repay the debt contractually agrees to submit to national repositories annual Disclosure Reports as well as timely information concerning events, if material, such as principal and interest payment delinquencies, non-payment related defaults and rating changes. AHERF provided annual Disclosure Reports for all of its obligated groups.
6 Although this decision was made in the fall of 1996, the factors leading to this decision existed as of June 30, 1996.
7 Pursuant to Statement of Financial Accounting Standards ("FAS") 5, an entity's bad debt reserve should reflect, at a given point in time, the estimated probable loss inherent in the entity's accounts receivable. On the balance sheet, the reserve is deducted from total accounts receivable (an asset of the entity) so that the resulting figure represents the net realizable value (i.e., the amount estimated to be collectible). On the income statement, periodic increases in the reserve are reflected as charges against earnings. FAS No. 5 further provides that events that occur subsequent to the balance sheet date (here, June 30, 1996) but prior to the issuance of the financial statements, provide additional evidence with respect to conditions that existed on the balance sheet date and affect the estimates inherent in the process of preparing financial statements.
8 See discussion of FAS 5 in note 6, above.
9 The Graduate hospitals in Pennsylvania joined AHERF as members of Centennial. The Graduate hospital in New Jersey became a separate subsidiary of AHERF known as Allegheny Hospitals, New Jersey. Of the $99.6 million transferred, $50 million was created as part of the purchase price computation and $29.9 million through charges and restructuring reserves. The precise source of the remainder is unclear from the available records but it derived from some combination of purchase price adjustments, restructuring reserves and pre-existing Graduate reserves.
10 AHERF used this separate entity to temporarily hold assets of acquired entities pending a determination whether to incorporate them into the AHERF system.
11 Because $40 million of the $99.6 million shortfall should have been offset against Delaware Valley 1996 net income before extraordinary item and change in accounting principle, AHERF consolidated and Delaware Valley 1997 net income are only overstated by $59.6 million.
12 In contrast to AHERF's 1997 consolidated audited financial statements, which included only two months of operations for Centennial, the 1997 Disclosure Report provided a full twelve months of financial results for Centennial, albeit on an unaudited basis.
13 As stated above, $29.9 million of the reserves derived from Graduate restructuring reserves- $28.4 million from the Philadelphia hospitals (Centennial) and $1.5 million from the New Jersey hospital (Allegheny Hospitals, New Jersey). Of course, any Graduate reserves deemed to be excess should have been eliminated by adjustments to Graduate's income statement or balance sheet, depending on whether those reserves were originally restructuring charges or part of the purchase price.
14 Notwithstanding the misclassification described below, the investments held by the independent trustee were never actually liquidated or transferred.
15 This standard required AHERF to reclassify all of its net assets as unrestricted, temporarily restricted, or permanently restricted. Under FAS 116, permanently restricted net assets result from donor contributions whose use by AHERF is limited by donor-imposed stipulations that neither expire by passage of time nor can be fulfilled or otherwise removed by actions of the organization. Temporarily restricted net assets result from donor contributions whose use by AHERF is limited by donor-imposed stipulations that either expire by passage of time or can be fulfilled and removed by actions of the organization pursuant to those stipulations. Unrestricted net assets are those assets without donor-imposed stipulations.
16 Under GAAP, the income statement for a non-profit entity includes as income funds released from restriction and used for operations. Net income or loss is then shown to increase or decrease unrestricted net assets, as appropriate.