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Anatomy of a Bankruptcy

Part 5: Burning down the house

Friday, January 22, 1999
By Steve Massey, Post-Gazette Staff Writer

  day5.jpg (15509 bytes)

As the new dean at the Allegheny health system’s School of Nursing in Philadelphia, Gloria Donnelly wanted to do something special.

Lured from LaSalle University in 1996 by more money and the challenge of working for a large, seemingly solid institution, she embraced an idea to celebrate the 150th anniversary of Allegheny’s Hahnemann medical school not with a big bash, but by raising money for a local program that helps care for inner-city youth.

What better way to send a message about what Hahnemann and Allegheny were all about, Donnelly thought. The top Allegheny brass were enthusiastic about it, too.

So Donnelly and her staff pledged money to the program — Donnelly alone gave $4,000 through a payroll deduction plan.

There was only one problem. When Donnelly checked a year later, she found the money was never spent on the inner-city project.

To this day, Donnelly’s not sure where it went.

She’s not alone.

From comparatively small sums like Donnelly’s to ones in the tens of millions at the Allegheny Health, Education and Research Foundation’s own hospitals, money seems to be missing. Substantial amounts of money.

While federal and state investigators are still probing its financial affairs, the parent organization has admitted to withdrawing at least $50 million from endowments and other donor-restricted accounts at its scattered affiliates during the last year before entering bankruptcy.

The actual sums are likely to be far higher, if Forbes Health System and Allegheny Valley Hospital are any indication. The pair say the parent foundation raided $65.2 million from funds they had set aside to finance building acquisitions and renovations before joining the Allegheny system in 1997.

And, they maintain, the raid was orchestrated by AHERF Chief Executive Officer Sherif Abdelhak and his finance lieutenant, David McConnell, at a time the parent company was desperately looking for cash. Abdelhak and McConnell, who were ousted last spring, have repeatedly declined all requests for interviews.

Forbes and Allegheny Valley had joined the Allegheny system largely because they already had a working relationship with Allegheny General. The three were part of a network of community hospitals that the parent company formed to contract with managed-care insurers for business.

By merging, the two hoped the Allegheny network could consolidate accounting and other administrative functions, thus reducing costs and boosting profit margins to better compete with the fast-growing UPMC Health System.

Unfortunately, the combination also allowed the parent foundation to get its hands into the pockets of Forbes and Allegheny Valley. Both had taken steps to protect themselves. Before agreeing to the merger, they insisted on a pledge that their restricted funds would be left alone. And it is just these funds, Forbes and Allegheny Valley say, that the parent foundation raided.

Similarly, but on a smaller scale, the heads of several foundations and hospital research projects in Philadelphia have complained that millions of dollars appear to be missing from their endowments. And the Allegheny General Nursing Alumni Association says its bank accounts have been depleted of almost $500,000.

It’s clear that Allegheny needed the money — years of operating in the fast lane while the caution flag was out, had finally caught up with it — and it didn’t really view its actions as all that different from what it had done in the past.

Over the years, Abdelhak would familiarize himself with the fine print governing endowments and other donated funds to determine how the money was to be used and whether there was a way to use it for other purposes if necessary. The foundation also took money out of idle or little-used accounts, with the view that the borrowings represented loans that would be paid back.

A centralized cash-management system made it all the easier to shift the money around. Indeed, Allegheny was notorious for transferring funds among scattered affiliates, making it almost impossible for even veteran accountants, much less board members who’d meet just a few times a year, to keep track of it all.

"Stuff was moved back and forth so fast that we never saw the dollars missing," says a longtime director who sat on both Allegheny General’s and its parent foundation’s boards. "We had a cash problem for three or four years and didn’t really know it."

It’s not hard to understand why it was so hard to track the money.

There were dozens of Allegheny hospitals and affiliates and scores of accounts. Many subsidiaries and even the parent habitually filed tax and financial reports late. AHERF didn’t file its 1997 taxes until mid-May of 1998, 11 months after the end of the fiscal year. A report to bondholders, disclosing loan violations at its Philadelphia affiliates, wasn’t ready for 210 days, 120 days after it was due. And only in the past year did the Allegheny system compile a consolidated financial report for all its subsidiaries. Before, only reports on each individual subsidiary were available.

Even then, understanding the financial reports was a task. Allegheny administrators were masters at masking troubles, relying on creative bookkeeping, relaxed disclosure rules for nonprofit hospitals and misleading public statements to keep inquiries in check.

Allegheny General is a good example.

In fiscal 1996, it quit breaking out operating results in its annual financial statement, which was allowed by accounting laws. But the switch from what it had previously done hid operating losses — what it lost on day-to-day operations before factoring in interest and other investment income.

In 1996, operating losses totaled more than $20 million, and actually were closer to $40 million if one-time gains are excluded. The year before, operating losses topped $13 million, but Allegheny General

didn’t disclose that fact until 1997 — in a footnote in an obscure report to bondholders disclosing that 1995’s results had been restated. And the footnote didn’t even say the restatement resulted in an operating loss. Readers were left to do the math themselves.

Analysts at Moody’s Investors Service, the bond-rating agency, have expressed exasperation at Allegheny’s financial statements, saying the reports were among the most confusing and complicated they had ever seen. And they were stunned to uncover $117 million in loans to the Philadelphia operations classified as investments in 1997’s financial statements. The quality of the 1997 statements is so poor that even the parent foundation has since renounced them, saying they overstated assets by $123 million.

The accounting gimmickry didn’t catch everyone by surprise.

Since 1991, when Joseph Donnelly, a former corporate controller at Allegheny General’s parent company, resigned, Allegheny General and its related affiliates have experienced a handful of finance-department defections by high-level individuals concerned that caution was being thrown to the wind.

In many ways, the organization was simply reflecting the personality of its top financial officer, David McConnell. A race-car driver and owner of a kit-car company, McConnell took pride in pushing the envelope. He’d find out what was legally allowable and stay within those parameters. But he didn’t have any problem bumping up against the limits and would order subordinates to do whatever it took to make the numbers work.

A former Mellon Bank loan officer, who wouldn’t sign off on a loan McConnell and Abdelhak wanted for a new garage at Philadephia’s St. Christopher’s Hospital for Children, recalls a nasty meeting with the pair in 1992. McConnell was almost belligerent, the loan officer says, and Abdelhak was just as bad. At the end of the meeting, Abdelhak threatened to pull Allegheny’s business from Mellon if it didn’t get the loan. The loan officer didn’t back down, and the threat proved idle. Allegheny continued to do business with Mellon, which handled much of the health system’s investments and had representatives on Allegheny’s board.

 
   

Snapshot of AHERF
Spring 1998

Employees: 29,500
Revenue: $2.05 billion
Assets: $2.6 billion
Debt: $1.18 billion
Inpatient admissions: 128,388

* Based on Allegheny Health Education and Research Foundation and tax documents

 
 

The gung-ho, cutthroat accounting approach was a sharp departure from the 1980s, when Allegheny General was conservative, almost stingy, with its books. Then, for example, it would low-ball estimates of accounts receivable — primarily money owed it from insurers — arguing that it was prudent to be cautious because insurers were cracking down on reimbursements. The reality was the estimates were still low, but it allowed AGH to build reserves as more money came in than estimated.

Allegheny General used to be careful in other ways, too. It would designate funds for future construction and building improvements that weren’t likely or even scheduled to occur. And it took pride in providing lenders with accurate and reliable information about its financial position and projections.

But that began to change after the move into Philadelphia in 1988. The pressure to portray the company in the best possible light increased as the need to issue bonds and obtain bank loans increased.

One-time cash infusions and income boosts, which make the future look brighter at a costs of adding to future obligations, became a way of life.

Separate sale-leaseback transactions for Allegheny General’s North Side office buildings and parking lots in 1996 — in which the hospital agreed to sell the facilities to investors and then lease them back under long-term agreements — grossed $61 million and generated gains in excess of $23 million, but also obligated AGH to more than $100 million in future lease payments.

In September 1997, just before it lopped 1,200 workers off its Philadelphia payroll, the parent foundation entered into a financing agreement with GE Capital Public Finance, a lightly regulated lender of last resort, for up to $30 million for the lease and purchase of equipment. Leasing required less up-front outlays.

And in the merger with Forbes Health System and Allegheny Valley Hospital, the Allegheny health system took advantage of Medicare accounting law provision that lets hospitals recover a portion of merger-related costs from the government. The move, which required it to write down the value of Forbes and Allegheny Valley’s real estate holdings, resulted in a one-time addition to income of $7 million.

But all the one-time maneuvering to raise more cash and boost income was not enough. By late 1997, the combination of declining government reimbursements, increasing managed-care pressures, a bungled Philadelphia expansion and poorly managed ventures into insurance and doctors’ practices had resulted in losses of nearly $1 million a day.

Going to the bond markets, where Allegheny and its acquired affiliates had raised more than $1 billion over the previous decade, was no longer an option. Credit ratings on its Philadelphia operations were at junk-bond levels, and the North Side flagship was headed that way, too. Banks also were balking. The more they poked and probed, the more they uncovered a disaster waiting to happen.

Frank Cahouet, the retiring Mellon Bank chairman who would become chairman of Allegheny General in January 1998, was concerned enough about the health of the hometown institution and its Philadelphia operations that he began seeking ways to preserve the North Side flagship if the rest of the empire crumbled.

There was one possible option.

Vanguard Health Systems, a new Nashville-based hospital operations company founded by a former top executive at for-profit giant Tenet Healthcare and backed with Morgan Stanley & Co. money, was sniffing around. It approached Allegheny in late 1997 about buying a large chunk of its Philadelphia holdings, a move that would free Allegheny of struggling institutions and help it out of the hole it had dug for itself.

It wasn’t going be easy to let go. While there was speculation Abdelhak had pursued Graduate with a goal of turning around and selling the Philadelphia holdings to for-profit giant Columbia-HCA, that was never the case, insiders say.

Columbia was shopping around, but Abdelhak still believed in his vision of an empire. And Columbia would soon fall off anyway, caught up in a federal fraud investigation.

But now was different. Nothing Allegheny did seemed to stem the flow of red ink, and everything seemed to be hitting at once.

Doctors and nurses were complaining about short supplies. Vendors were complaining about not getting paid. Lenders were complaining that Allegheny’s Philadelphia operations had fallen out of compliance with loan covenants. And unions were balking at suggestions of pay cuts.

There was no more margin for error, no place to turn — except Vanguard. Negotiations intensified, and by March, the pair had cut a deal. Vanguard would buy six of Allegheny’s nine Philadelphia hospitals for at least $300 million. The two still had some issues to hammer out, namely a price, but they had some time — directors were told the deal would need to close within 120 days to be viable.

Abdelhak seemed to think it could work. At least that’s what he was saying publicly. In March, he maintained that the cuts made the previous fall had brought the Philadelphia hospitals to break-even, and that the Pittsburgh flagship had not been harmed by Philadelphia’s troubles.

The public statements, of course, contrasted sharply with the reality of the situation. Behind the scenes, the board could see the deterioration and would act to protect its interests, doubling officers’ and directors’ liability insurance from $50 million to $100 million in March, and doubling it again in June, to $200 million. Meetings of its executive committee increased to every two weeks, from four a year. In April, the possibility of bankruptcy was even discussed.

Yet in other ways, it was business at usual at Allegheny.

Pay cuts that Abdelhak had vowed management would take often turned out to be nothing more than the elimination of bonuses. Base pay remained the same and in a few cases even increased.

Quarterly meetings of the insurance subsidiary to review malpractice cases continued to be held in pleasing foreign locales. And in March, the board’s compensation committee approved a new benefit that effectively let Allegheny’s six top executives cash in $8 million in deferred benefits not due them until they resigned or retired — with some of the withdrawals occurring just a day before the bankruptcy filing.

It was a revelation that later outraged hundreds of lower-level Allegheny managers stuck trying to get their benefits from bankruptcy court, as well as nurses and other staffers who’d been forced to work longer hours with little or no pay increase the past few years. It came to symbolize the sense of entitlement that had gripped senior management.

It also tainted Anthony Sanzo, the former Allegheny General CEO who succeeded Abdelhak and who now is trying to hang on to control of the surviving Western Pennsylvania hospitals with the aid of Cahouet. Sanzo was among the top six officers to benefit from the deferred benefits deal.

Two members of the compensation committee, former Dollar Bank Chairman Francis Nimick and former Mellon Chairman J. David Barnes, say they don’t recall approving the payout.

Even though the issue had been before the committee for months, William P. Snyder III, who stepped down as Allegheny chairman last fall and who served on the compensation committee, apparently didn’t remember either. When the benefit was revealed after bankruptcy, he expressed shock in a statement issued by the parent foundation.

Other members of the compensation committee were former Westinghouse Chairman Douglas Danforth, who adopted new pay policies at Westinghouse that substantially raised compensation for top officers including himself, and Graemer Hilton, former president of Allegheny International, which went bankrupt, renamed itself Sunbeam and moved out of town.

All members of the compensation committee had a long affiliation with the Allegheny system, and insiders say the committee increasingly acted on its own the past few years, without the knowledge of other board members.

None of it would have mattered much if the Vanguard deal had closed. But by mid-March, a consortium of lenders led by Mellon, was becoming antsy. The Allegheny system wasn’t generating enough cash to remain in compliance with the terms of its $100 million line of credit, and at least two of the banks, Toronto Dominion and the Akron, Ohio, affiliate of Columbus-based Bank One, wanted their money back. Each was committed for $24 million, while Mellon’s exposure was $28 million.

Weeks of negotiations followed, but when First Chicago, which also had pledged $24 million, decided it wanted out, Mellon was on the hook and demanded repayment. Instead of seeking full restitution by the end of June or preferably September, as Allegheny had wanted, Mellon wanted it now, on April 22. Abdelhak didn’t even have time to get board approval. He just let the $89 million owed to the banks go — in violation of board policy requiring him to run all substantial transfers by it first.

Where he came up with all the the money is unclear. But $65.2 million came out of the Forbes-Allegheny Valley accounts that were supposed to be off-limits.

It was Abdelhak’s last significant act, one that outraged several directors when they found out.

Cahouet insists he had no knowledge of his bank’s action, even though it ate up cash at a time Allegheny could least afford it. Not that it necessarily would have prevented the bankruptcy. Vanguard was growing more circumspect, as its team of inspectors kept finding surprises, and not the good kind.

By late June, Vanguard had nixed the original deal. The pair kept talking, but its decision sealed Allegheny’s fate. With money running low and its one potential savior getting cold feet, Allegheny had run out of options.

On July 21, it filed for Chapter 11 bankruptcy, becoming the largest nonprofit health care system failure in history.

Allegheny had achieved national recognition, but hardly the kind that Abdelhak — and Snyder — had envisioned.

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