8Ed.sol1.04 - CASE 1.4 HEALTH MANAGEMENT INC Synopsis This...

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CASE 1.4 HEALTH MANAGEMENT, INC. Synopsis This case profiles an imaginative accounting fraud orchestrated by two top executives of Health Management, Inc. (HMI), a New York-based pharmaceuticals distributor. The HMI fraud is noteworthy because it led to the first major test of an important federal statute, the Private Securities Litigation Reform Act of 1995 (PSLRA), that was intended to alleviate the growing burden of class-action lawsuits filed against accounting firms and other third parties under the Securities Exchange Act of 1934. (The PSLRA amended key provisions of the 1934 Act.) The PSLRA makes it more difficult for plaintiffs to successfully “plead” a case under the 1934 Act, that is, to have such a lawsuit proceed to trial. Among other provisions in the PSLRA is a proportionate liability rule. Under this liability standard, a defendant that is guilty of no more than “recklessness” is generally responsible for only a percentage of a plaintiff’s losses, the percentage of those losses produced by the defendant’s reckless behavior. HMI’s former stockholders filed a class-action lawsuit against BDO Seidman, HMI’s former audit firm. The plaintiff attorneys attempted to prove that the BDO Seidman auditors had been reckless during the 1995 HMI audit, which prevented them from discovering the large inventory fraud carried out by Clifford Hotte, HMI’s CEO, and Drew Bergman, the company’s CFO. The plaintiff attorneys repeatedly pointed to a series of red flags that the BDO Seidman auditors had allegedly overlooked or discounted during the 1995 audit. Additionally, the plaintiff attorneys charged that a close relationship between Bergman and Mei-ya Tsai, the audit manager assigned to the 1995 HMI audit engagement team, had impaired BDO Seidman’s independence during the 1995 audit. Bergman had previously been employed by BDO Seidman and had served as the audit manager on prior HMI audits. Following a jury trial in federal court, BDO Seidman was absolved of any responsibility for the large losses that HMI’s stockholders had suffered as a result of the 1995 inventory fraud. BDO Seidman’s lead attorney attributed that outcome of the case to the PSLRA. Absent the proportionate liability rule incorporated in the PSLRA, the attorney suggested that BDO Seidman would likely have chosen to pay a sizable settlement to resolve the lawsuit rather than contest it in the federal courts.
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24 Case 1.4 Health Management, Inc. Health Management, Inc.—Key Facts 1. Clifford Hotte and Drew Bergman engineered an accounting fraud to allow HMI to reach its 1995 earnings target. 2. The key element of the HMI fraud was an elaborate in-transit inventory sham that resulted in a material overstatement of HMI’s year-end inventory. 3. The HMI fraud triggered the first major test of an important federal statute, the Private Securities Litigation Reform Act (PSLRA) of 1995, which amended the Securities Exchange Act of 1934.
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