We last left Bally Total Fitness (NYSE:BFT) at the close of fiscal 2000, when the company had reached its peak and was ready to seek a buyer. Who was the lucky buyout candidate? A company that would get itself into one of the biggest financial scandals of the early 21st century -- HealthSouth.

Naturally, this would prove to be a disaster. While the merger attempt was never made public, there were still signs that something was amiss. Therein lie the next three big lessons for investors:

  1. Beware the abrupt board bember departure.
  2. Personally vet his replacement.
  3. Beware the board that gives itself unwarranted raises.

Bally starts to sweat
During the trial of former HealthSouth CEO Richard Scrushy, who was eventually acquitted of all charges, former HealthSouth CFO Weston Smith testified that the deal with Bally fell through because of "problems we found during due diligence."

But neither the failed merger, nor these problems were made public. Had they been, it might have been a good thing for Bally to get out the bad news immediately, address it, and get past it. The company might have had a chance to overcome its problems and rebuild under new management instead of letting those problems fester. This is not without precedent: Tyco (NYSE:TYC) and Cendant (NYSE:CD) have survived scandals, only to flourish afterward.

Instead, Bally forged ahead silently. Revenue growth slowed. Share dilution continued. The company sold off receivables to boost cash flow. Then, in late 2002, Lee Hillman resigned as CEO.

Now, investors should always ask questions when a company changes management -- especially at the very top. If you cannot satisfy yourself with the reasons given for the change, then you should consider selling the stock. You might want to re-evaluate a stock when someone says he wants "to pursue new challenges and interests and spend more time with family," as Hillman did. At the very least, any astute investor could have looked at the loss Bally reported in 2002, seen its continued shareholder dilution, and figure out why Hillman "resigned." And, in fact, enough investors did just that, and the stock sold off 20% upon the announcement.

In retrospect, however, we have the Scrushy trial information about the failed merger to demonstrate our lesson. Since HealthSouth had found problems during due diligence, it's reasonable to assume that somebody at Bally either knew about the accounting problems all along or was informed of them. Given the potential executive wealth that was erased by the merger's failure, could it be that Hillman had come under considerable pressure prior to his departure?

Could an investor still have foreseen the impending disaster at Bally? Possibly, if he or she continued to ask questions. Hillman was replaced by Chief Operating Officer Paul A. Toback in December of 2002. The first question an investor might have asked is why an external search was not conducted to find a replacement for Hillman, although it's often easier to promote the COO -- the natural guy to assume the position.

The Emperor has no experience
But wise investors would ask additional questions about their new CEO. They would personally vet their new boss. After all, who was Paul Toback? According to the company's 2003 10-K, Toback was the director of administration for Chicago Mayor Richard Daley until 1993. He then became the executive assistant to the chief of staff for then-President Bill Clinton for two years. From 1995 to mid-1997, he was the COO for a private company called Globetrotter Engineering in Chicago. He then joined Bally in 1997.

Most investors might look at Toback's resumé and see six years of experience at Bally and feel comfortable with his selection as CEO. A conservative investor might wonder how Toback went directly from politics to the COO position at Globetrotter Engineering -- without any (announced) experience running a business.

A conservative investor should have asked himself the following questions at this point: Was it connections, merit, or both, that got Toback the Globetrotter job? How much did Toback learn at Globetrotter to prepare him for Bally? How much did he learn about running Bally before becoming CEO?

All we know is that Toback ended up as COO and then CEO of Bally and began earning $300,000 a year in salary and the same amount in bonuses. The company's problems mounted in 2003, after he took charge. Membership revenue was stagnant. It wasn't too surprising, since member retention had been a long-standing problem at Bally. During fiscal 2001, 2002, and 2003, Bally added almost 900,000 members each year, yet the total number of members barely changed. People were leaving in droves almost as fast as new ones signed up. Product services and sales dropped for the first time. Costs were soaring. Servicing its massive debt, to the tune of $60 million a year, cut into its free cash flow.

Despite the company's poor performance in 2003, the entire board granted itself raises (Toback's salary and bonus totaled $775,000) and more than 700,000 stock options, redeemable at $6 and $7 per share. Call me old-fashioned, but I feel that management should grant itself raises only when the company is doing well.

Read more of Larry's series and other Takes on Bally's:

Fool contributor Lawrence Meyers does not own, nor is short, shares of Bally nor any other company mentioned in this article.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.