-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Nh3OMHay5L+39cK0j6psf8vwG+hjD2VCGWkAiEMPTttlQdYd3h/cH17G2LHNBMC+ UzCPBUZVF9h6S5kkiYgbYg== 0001047469-98-045210.txt : 19981230 0001047469-98-045210.hdr.sgml : 19981230 ACCESSION NUMBER: 0001047469-98-045210 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19980930 FILED AS OF DATE: 19981229 FILER: COMPANY DATA: COMPANY CONFORMED NAME: MAGELLAN HEALTH SERVICES INC CENTRAL INDEX KEY: 0000019411 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-HOSPITALS [8060] IRS NUMBER: 581076937 STATE OF INCORPORATION: DE FISCAL YEAR END: 0930 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-06639 FILM NUMBER: 98776588 BUSINESS ADDRESS: STREET 1: 3414 PEACHTREE RD N E STREET 2: STE 1400 CITY: ATLANTA STATE: GA ZIP: 30326 BUSINESS PHONE: 9127421161 FORMER COMPANY: FORMER CONFORMED NAME: CHARTER MEDICAL CORP DATE OF NAME CHANGE: 19920703 10-K405 1 FORM 10-K405 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998 / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ________________ TO ________________ COMMISSION FILE NO. 1-6639 MAGELLAN HEALTH SERVICES, INC. (Exact name of Registrant as specified in its charter) DELAWARE 58-1076937 - ------------------------------- ------------------ (State or other jurisdiction of (I.R.S. Employer Identification incorporation or organization) No.) 3414 PEACHTREE ROAD, N.E. SUITE 1400 ATLANTA, GEORGIA 30326 - ------------------------------- ------------------ (Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (404) 841-9200 -------------------------- Securities registered pursuant to Section 12(b) of the Act:
NAME OF EACH EXCHANGE ON WHICH TITLE OF EACH CLASS REGISTERED - -------------------------------------------------------------- ------------------------------ Common Stock ($0.25 par value) New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. /X/ The aggregate market value of the voting stock held by non-affiliates of the Registrant at November 30, 1998 was approximately $264 million. Indicate by check mark whether the Registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes / / No / / The number of shares of the Registrant's Common Stock outstanding as of November 30, 1998 was 31,612,554. DOCUMENTS INCORPORATED BY REFERENCE: The Registrant's Definitive Proxy Materials on Schedule 14A relating to its Annual Meeting of Stockholders on February 11, 1999 are incorporated by reference into Part III as set forth herein. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MAGELLAN HEALTH SERVICES, INC. ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998 TABLE OF CONTENTS
PART I PAGE ----- ITEM 1. Business................................................................... 2 ITEM 2. Properties................................................................. 37 ITEM 3. Legal Proceedings.......................................................... 38 ITEM 4. Submission of Matters to a Vote of Security Holders........................ 40 PART II ITEM 5. Market Price for Registrant's Common Equity and Related Stockholder Matters.................................................................... 41 ITEM 6. Selected Financial Data.................................................... 41 ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................................. 43 ITEM 8. Financial Statements and Supplementary Data................................ 57 ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure................................................................. 57 PART III ITEM 10. Directors and Executive Officers of the Registrant......................... 58 ITEM 11. Executive Compensation..................................................... 58 ITEM 12. Security Ownership of Certain Beneficial Owners and Management............. 58 ITEM 13. Certain Relationships and Related Transactions............................. 58 PART IV ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K............ 58
PART I ITEM 1. BUSINESS Magellan Health Services, Inc. (the "Company"), which was incorporated in 1969 under the laws of the State of Delaware, is an international healthcare company. The Company operates through five principal segments engaging in (i) the behavioral managed healthcare business, (ii) the human services business, (iii) the specialty managed healthcare business, (iv) the healthcare franchising business and (v) the healthcare provider business. The Company's executive offices are located at Suite 1400, 3414 Peachtree Road, N.E., Atlanta, Georgia 30326, and its telephone number at that location is (404) 841-9200. RECENT DEVELOPMENTS THE MERIT ACQUISITION. On February 12, 1998, the Company consummated the acquisition of Merit Behavioral Care Corporation ("Merit") for cash consideration of approximately $448.9 million plus the repayment of Merit's debt. Merit manages behavioral healthcare programs across all segments of the healthcare industry, including health maintenance organizations ("HMO's"), Blue Cross/Blue Shield organizations and other insurance companies, corporations and labor unions, federal, state and local governmental agencies and various state Medicaid programs. On September 12, 1997, Merit completed the acquisition of CMG Health, Inc. ("CMG"). CMG is a national managed behavioral healthcare company. Merit paid approximately $48.7 million in cash and issued approximately 739,000 shares of Merit common stock as consideration for CMG. The former owners of CMG may be entitled to additional consideration, depending on CMG's future performance. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Outlook--Liquidity and Capital Resources." HUMAN AFFAIRS INTERNATIONAL, INCORPORATED ACQUISITION. On December 4, 1997, the Company consummated the purchase of Human Affairs International, Incorporated ("HAI"), formerly a unit of Aetna/ U.S. Healthcare ("Aetna"), for approximately $122.1 million, which the Company funded from cash on hand. HAI manages behavioral healthcare programs primarily through employee assistance programs ("EAPs") and other behavioral managed healthcare plans. The Company may be required to make additional contingent payments of up to $60.0 million annually to Aetna over the five year period subsequent to closing. The amount and timing of the payments will be contingent upon net increases in the number of HAI's covered lives in specified products. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Outlook--Liquidity and Capital Resources." ALLIED HEALTH GROUP, INC. ACQUISITION. On December 5, 1997, the Company purchased the assets of Allied Health Group, Inc. and certain of its affiliates ("Allied"). Allied provides specialty managed care products, including risk-based products and administrative services to a variety of insurance companies and other customers, including Prudential, CIGNA and NYLCare. Allied has over 80 physician networks across the eastern United States. Allied's networks include physicians specializing in cardiology, oncology and diabetes. The Company paid approximately $70.0 million for Allied, of which $50.0 million was paid to the seller at closing with the remaining $20.0 million placed in escrow. The Company may be required to make additional contingent payments to the former owners of Allied depending on Allied's future performance. On November 25, 1998, the Company and the former owners of Allied amended the Allied purchase agreement, which resulted in the repayment of a portion of the initial escrowed amount to the Company and the reduction of potential future contingent payments to the former owners of Allied. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-- Outlook--Liquidity and Capital Resources." GREEN SPRING MINORITY STOCK CONVERSION. The minority stockholders of Green Spring Health Services, Inc. ("Green Spring") converted their interests in Green Spring into an aggregate of 2,831,516 shares of Company Common Stock during January 1998. Such conversion is referred to as the "Green 2 Spring Minority Stockholder Conversion." As a result of the Green Spring Minority Stockholder Conversion, the Company owns 100% of Green Spring. HUMAN SERVICES ACQUISITIONS. During fiscal 1998, the Company acquired seven businesses in its human services segment for an aggregate purchase price of approximately $57.0 million (collectively, the "Human Services Acquisitions"). The Human Services Acquisitions provide various residential and day services for individuals with acquired brain injuries and for individuals with mental retardation and developmental disabilities. CBHS TRANSACTIONS. On March 3, 1998, the Company and certain of its wholly owned subsidiaries entered into definitive agreements with Crescent Operating, Inc. ("COI") and Charter Behavioral Health Systems, LLC ("CBHS") pursuant to which the Company would have, among other things, sold the Company's franchise operations, certain domestic provider operations and certain other assets and operations. On August 19, 1998, the Company announced that it had terminated discussions with COI for the sale of its interest in CBHS. Furthermore, the Company exercised certain of its limited management rights pursuant to the Master Franchise Agreement (as defined) and, with CBHS's board support, made operational and management changes at CBHS. The Company has since restored all management rights to the CBHS board. See "Cautionary Statements--Subordination of Franchise Fees." The Company will continue to seek opportunities to divest its ownership interest in CBHS at a later date. THE TRANSACTIONS. On February 12, 1998, in connection with the consummation of the Merit acquisition, the Company consummated certain related transactions (together with the Merit acquisition, collectively, the "Transactions"), as follows: (i) the Company terminated its existing credit agreement (the "Magellan Existing Credit Agreement"); (ii) the Company repaid all loans outstanding pursuant to and terminated Merit's existing credit agreement (the "Merit Existing Credit Agreement") (the Magellan Existing Credit Agreement and the Merit Existing Credit Agreement are hereinafter referred to as the "Existing Credit Agreements"); (iii) the Company consummated a tender offer for its 11 1/4% Series A Senior Subordinated Notes due 2004 (the "Magellan Outstanding Notes"); (iv) Merit consummated a tender offer for its 11 1/2% Senior Subordinated Notes due 2005 (the "Merit Outstanding Notes") (the Magellan Outstanding Notes and the Merit Outstanding Notes are hereinafter referred to collectively as the "Outstanding Notes" and such tender offers are hereinafter referred to collectively as the "Debt Tender Offers"); (v) the Company entered into a new senior secured bank credit agreement (the "New Credit Agreement"), providing for a revolving credit facility (the "Revolving Facility") and a term loan facility (the "Term Loan Facility") which provides for borrowings of up to $700 million; and (vi) the Company issued the 9% Series A Senior Subordinated Notes due 2008 (the "Notes") pursuant to an indenture which governs the Notes ("Indenture"). The following table sets forth the sources and uses of funds for the Transactions (in millions): SOURCES: Cash and cash equivalents......................................... $ 59.3 New Credit Agreement: Revolving Facility(1)........................................... 20.0 Term Loan Facility.............................................. 550.0 The Notes......................................................... 625.0 -------- Total sources................................................. $ 1,254.3 -------- -------- USES: Direct Cash Merger Consideration.................................. $ 448.9 Repayment of Merit Existing Credit Agreement(2)................... 196.4 Purchase of Magellan Outstanding Notes(3)......................... 432.1 Purchase of Merit Outstanding Notes(4)............................ 121.6 Transaction costs(5).............................................. 55.3 -------- Total uses.................................................... $ 1,254.3 -------- --------
3 ------------------------------- (1) The Revolving Facility provides for borrowings of up to $150.0 million. As of September 30, 1998, the Company had approximately $92.5 million available for borrowing pursuant to the Revolving Facility, excluding approximately $17.5 million of availability reserved for certain letters of credit. (2) Includes principal amount of $193.6 million and accrued interest of $2.7 million. (3) Includes principal amount of $375.0 million, tender premium of $43.4 million and accrued interest of $13.7 million. (4) Includes principal amount of $100.0 million, tender premium of $18.9 million and accrued interest of $2.8 million. (5) Transaction costs include, among other things, costs paid at closing associated with the Debt Tender Offers, the Notes offering, the Merit acquisition and the New Credit Agreement. HISTORY During the late 1980's and the early to mid 1990's, the healthcare provider business began a rapid consolidation. The consolidation of the healthcare provider business was necessitated by the need of hospitals to reduce costs through economies of scale as a result of pressure on reimbursement rates and average length of hospital stay by third-party payors. At the time, the Company had a presence in both the psychiatric hospital industry and the general hospital industry. In fiscal 1993, the Company decided to focus solely on the psychiatric hospital industry and to attempt to acquire additional behavioral healthcare businesses. Accordingly, the Company sold its general hospitals and related assets in fiscal 1993 for $338 million with the net proceeds used to reduce long-term debt. In 1994, the Company acquired 40 psychiatric hospitals ("Acquired Hospitals") for approximately $171 million. The purchase of the Acquired Hospitals included the refinancing of most of the Company's then outstanding long-term debt, including the issuance of the Magellan Outstanding Notes. The Company has historically derived the majority of its revenue and earnings from providing healthcare services in an inpatient setting. Payments from third-party payors are the principal source of revenue for most healthcare providers. In the early 1990's, many third-party payors sought to control the cost of providing care to their patients by instituting managed care programs or seeking the assistance of managed care companies. Providers participating in managed care programs agree to provide services to patients for a discount from established rates, which generally results in pricing concessions by the providers and lower margins. Additionally, managed care programs generally encourage alternatives to inpatient treatment settings and reduce utilization of inpatient services. Third-party payors established managed care programs or engaged managed care companies in many areas of healthcare, including behavioral healthcare. The Company, which, until June 1997, was the largest operator of psychiatric hospitals in the United States, was adversely affected by the adoption of managed care programs as the principal cost control measure of the third party payors. Prior to the first quarter of fiscal 1996, the Company was not a provider of behavioral managed care services. During the first quarter of fiscal 1996, the Company acquired a 61% ownership interest in Green Spring, a managed care company specializing in mental health and substance abuse/dependence services. At that time, the Company intended to become a fully integrated behavioral healthcare provider by combining the behavioral managed healthcare products offered by Green Spring with the direct treatment services offered by the Company's psychiatric hospitals. The Company believed that an entity that participated in both the managed care and provider segments of the behavioral healthcare industry could more efficiently provide and manage behavioral healthcare for insured populations than an entity that was solely a managed care company. The Company also believed that earnings from its behavorial managed care business would offset, in part, the negative impact on the financial performance of its psychiatric hospitals caused by managed care. Green Spring was the Company's first significant involvement in behavioral managed healthcare. 4 Subsequent to the Company's acquisition of Green Spring, the growth of the behavioral managed healthcare industry accelerated. Under the Company's majority ownership, Green Spring increased its base of covered lives from 12.0 million as of the end of calendar year 1995 to 21.1 million as of the end of calendar 1997, a compound annual growth rate of over 32%. While growth in the industry was accelerating, the behavioral managed healthcare industry also began to consolidate. The Company concluded that this consolidation presented an opportunity for the Company to increase its participation in the behavioral managed healthcare industry, which the Company believed offered growth and earnings prospects superior to those of the psychiatric hospital industry. Therefore, the Company decided to sell its domestic psychiatric facilities to obtain capital for expansion in the behavioral managed healthcare business. The Company took a significant step toward implementing this strategy during the third quarter of fiscal 1997, when it sold substantially all of its domestic acute-care psychiatric hospitals and residential treatment facilities (collectively, the "Psychiatric Hospital Facilities") to Crescent Real Estate Equities Limited Partnership ("Crescent") for $417.2 million in cash (before costs of approximately $16.0 million) and certain other consideration. Simultaneously with the sale of the Psychiatric Hospital Facilities, the Company and COI, an affiliate of Cresent, formed CBHS to conduct the operations of the Psychiatric Hospital Facilities and certain other facilities transfered to CBHS by the Company. The Company retained a 50% ownership of CBHS; the other 50% of the equity of CBHS is owned by COI. In related transactions, (i) Crescent leased the Psychiatric Hospital Facilities to CBHS and (ii) the Company entered into a master franchise agreement (the "Master Franchise Agreement") with CBHS and a franchise agreement with each of the Psychiatric Hospital Facilities and other facilities operated by CBHS (collectively, the "Franchise Agreements"). The Company's sale of the Psychiatric Hospital Facilities and the related transactions described above are referred to as the "Crescent Transactions." Pursuant to the Franchise Agreements, the Company franchises the "CHARTER" System of behavioral healthcare to each of the Psychiatric Hospital Facilities and the other facilities operated by CBHS. In exchange, CBHS agreed to pay the Company, pursuant to the Master Franchise Agreement, annual franchise fees (the "Franchise Fees") of approximately $78.3 million. However, CBHS's obligation to pay the Franchise Fees is subordinate to its obligation to pay rent for the Psychiatric Hospital Facilities to Crescent. The sale of the Psychiatric Hospital Facilities provided the Company with approximately $200 million of net cash proceeds, after debt repayment, for use in implementing its business strategy of expanding its managed care operations. The Company used the proceeds to finance the acquisitions of HAI and Allied in December 1997. The Company further implemented its business strategy through the Merit acquisition. The Company undertook this transformation because it believed that the behavioral managed healthcare industry offers growth and earnings prospects superior to those available to the psychiatric hospital industry because, among other things, third party payors for healthcare services are continuing to seek to control the cost of providing care to their patients by instituting managed care programs or seeking the assistance of managed care companies. Furthermore, government payors are continuing to reduce reimbursement rates or coverage in an effort to control costs. INDUSTRY OVERVIEW Behavioral healthcare costs have increased significantly in the United States in recent years. According to industry sources, direct medical costs of behavioral health problems, combined with the indirect costs, such as lost productivity due to mental illness and alcohol and drug abuse, were estimated at more than $300.0 billion in 1990, the latest year for which statistics are available. In addition, according to industry sources, in 1994 (the most recent year for which such information was available), direct behavioral healthcare services treatment costs amounted to approximately $81.0 billion, or approximately 8% of total healthcare industry spending. These direct costs have grown, in part, as society has begun to recognize and address behavioral health concerns and employers have realized that rehabilitation of employees suffering from substance abuse and relatively mild mental health problems can reduce losses due to absenteeism and decreased productivity. In response to these escalating costs, behavioral managed healthcare companies such as Green Spring, HAI and Merit have been formed. These companies focus on care management techniques with 5 the goal of arranging for the provision of an appropriate level of care in a cost-efficient and effective manner by improving early access to care and assuring an effective match between the patient and the behavioral healthcare provider's specialty. As the growth of behavioral managed healthcare has increased, there has been a significant decrease in occupancy rates and average lengths of stay for inpatient psychiatric facilities and an increase in outpatient treatment and alternative care services. According to an industry trade publication entitled "Managed Behavioral Health Market Share in the United States 1997-1998" published by Open Minds, Gettysburg, Pennsylvania (hereinafter referred to as "OPEN MINDS"), as of January 1997, approximately 149.0 million beneficiaries were covered by some form of behavioral managed healthcare plan and an additional 19.5 million beneficiaries were enrolled in internally-managed behavioral healthcare programs within HMOs. The number of covered beneficiaries has grown from approximately 86.0 million beneficiaries in 1993 to approximately 149.0 million in 1997, representing an approximate 15% compound annual growth rate since 1993. In addition, according to OPEN MINDS, beneficiaries covered under risk-based programs are growing even more rapidly, from approximately 13.6 million as of January 1993 to approximately 38.9 million as of January 1997, representing a compound annual growth rate of over 30%. OPEN MINDS estimates that the revenues of behavioral managed healthcare companies totaled approximately $3.5 billion in 1996. OPEN MINDS divides the managed behavioral healthcare industry as of January 1997 into the following categories of care, based on services provided, extent of care management and level of risk assumption:
BENEFICIARIES PERCENT CATEGORY OF CARE (IN MILLIONS) OF TOTAL - ----------------------------------------------------------------------------------------- --------------- ----------- Utilization Review/Care Management Programs.............................................. 39.2 26.3% Risk-Based Network Products.............................................................. 38.9 26.1 Non-Risk-Based Network Products.......................................................... 31.9 21.4 EAPs..................................................................................... 28.3 19.0 Integrated Programs...................................................................... 10.7 7.2 ----- ----- Total............................................................................ 149.0 100.0% ----- ----- ----- -----
Management believes the current trends in the behavioral healthcare industry include increased utilization of risk-based network managed care products and the integration of EAPs with such managed care products. Management believes that these trends have developed in response to the attempt by payors to reduce rapidly escalating behavioral healthcare costs and to limit their risk associated with such costs while continuing to provide access to high quality care. According to OPEN MINDS, risk-based network products, integrated programs and EAPs are the most rapidly growing segments of the behavioral managed healthcare industry. UTILIZATION REVIEW/CARE MANAGEMENT PRODUCTS. Under utilization review/care management products, a managed behavioral healthcare company manages and often arranges for treatment, but does not maintain a network of providers or assume any of the responsibility for the cost of providing treatment services. The Company categorizes its products within this segment of the managed behavioral healthcare industry (as it is defined by OPEN MINDS) as administrative services only ("ASO") products. The Company does not expect this segment of the industry to experience significant growth, given the growth of risk-based products. NON-RISK-BASED NETWORK PRODUCTS. Under non-risk-based network products, the behavioral managed healthcare company provides a full array of managed care services, including selecting, credentialing and managing a network of providers (such as psychiatrists, psychologists, social workers and hospitals), and performs utilization review, claims administration and care management functions. The third-party payor remains responsible for the cost of providing the treatment services rendered. The Company categorizes its products within this segment of the behavioral managed healthcare industry (as it is defined by OPEN MINDS) as ASO products. RISK-BASED NETWORK PRODUCTS. Under risk-based network products, the behavioral managed healthcare company assumes all or a portion of the responsibility for the cost of providing a full or specified range of behavioral healthcare treatment services. Most of these programs have payment 6 arrangements in which the managed care company agrees to provide services in exchange for a fixed fee per member per month that varies depending on the profile of the beneficiary population or otherwise shares the responsibility for providing all or some portion of the treatment services at a specific cost per person. Under these products, the behavioral managed healthcare company not only approves and monitors a course of treatment, but also arranges and pays for the provision of patient care (either through its third-party network providers or staff providers or some combination of network and staff providers). Therefore, the behavioral managed healthcare company must be proficient in contracting with, credentialing and managing a network of specialized providers and facilities that covers the complete continuum of care. The behavioral managed healthcare company must also ensure that the appropriate level of care is delivered in the appropriate setting. Given the ability of payors of behavioral healthcare benefits to reduce their risk with respect to the cost of treatment services through risk-based network products while continuing to provide access to high quality care, this market segment has grown rapidly in recent years. In addition to the expected growth in total beneficiaries covered under behavioral managed healthcare products, this shift of beneficiaries into risk-based network products should further contribute to revenue growth for the behavioral managed healthcare industry because such contracts generate significantly higher revenue than ASO contracts. The higher revenue is intended to compensate the behavioral managed healthcare company for bearing the financial responsibility for the cost of delivering care. The Company's risk-based products are risk-based network products as defined by OPEN MINDS. EMPLOYEE ASSISTANCE PROGRAMS. An EAP is a worksite-based program designed to assist in the early identification and resolution of productivity problems associated with behavioral conditions or other personal concerns of employees and their dependants. Under an EAP, staff or network providers or other affiliated clinicians provide assessment and referral services to employee beneficiaries and their dependants. These services consist of evaluating a patient's needs and, if indicated, providing limited counseling and/or identifying an appropriate provider, treatment facility or other resource for more intensive treatment services. The EAP industry developed largely out of employers' efforts to combat alcoholism and substance abuse problems afflicting workers. A 1990 industry survey estimated the total costs of this dependency at approximately $98.6 billion per year. Many businesses have implemented alcoholism and drug abuse treatment programs in the workplace, and in some cases have expanded those services to cover a wider spectrum of personal problems experienced by workers and their families. As a result, EAP products now typically include consultation services, evaluation and referral services, employee education and outreach services. The Company believes that federal and state "drug-free workplace" measures and Federal Occupational Health and Safety Act requirements, taken together with the growing public perception of increased violence in the workplace, have prompted many companies to implement EAPs. Although EAPs originated as a support tool to assist managers in dealing with troubled employees, payors increasingly regard EAPs as an important component in the continuum of behavioral healthcare services. INTEGRATED EAP/MANAGED BEHAVIORAL HEALTHCARE PRODUCTS. EAPs are utilized in a preventive role and in facilitating early intervention and brief treatment of behavioral healthcare problems before more extensive treatment is required. Consequently, EAPs often are marketed and sold in tandem with managed behavioral healthcare programs through "integrated" product offerings. Integrated products offer employers comprehensive management and treatment of all aspects of behavioral healthcare. In an effort to both reduce costs and increase accessibility and ease of treatment, employers are increasingly attempting to consolidate EAP and behavioral managed healthcare services into a single product. Although integrated EAP/managed behavioral healthcare products are currently only a small component of the overall industry, the Company expects this market segment to grow. AREAS OF GROWTH Management believes that the growth of the behavioral managed healthcare industry will continue, as payors of behavioral healthcare benefits attempt to reduce the costs of behavioral healthcare while maintaining high quality care. Management also believes that a number of opportunities exist in the behavioral managed healthcare industry for continued growth, primarily for risk-based products. The following paragraphs discuss factors contributing to the growth of risk-based products and the increase in the number of covered lives in certain markets. 7 RISK-BASED PRODUCTS. According to OPEN MINDS, industry enrollment in risk-based products has grown from approximately 13.6 million covered lives in 1993 to approximately 38.9 million covered lives in 1997, a compound annual growth rate of over 30%. Despite this growth, only approximately 26% of total managed behavioral healthcare covered lives were enrolled in risk-based products in 1997. The Company believes that the market for risk-based products has grown and will continue to grow as payors attempt to reduce their responsibility for the cost of providing behavioral healthcare while ensuring an appropriate level of access to care. Risk-based products can generate significantly greater revenue per covered life than other non-risk product types. According to the OPEN MINDS survey, risk-based products account for approximately two-thirds of total managed behavioral healthcare industry revenue, but, as stated above, accounted for only approximately 26% of total covered lives in 1997. During fiscal 1998, risk-based products accounted for approximately 76% of the Company's behavorial managed healthcare revenue and represented approximately 30% of covered lives as of September 30, 1998. See "Cautionary Statements--Risk-Based Products." MEDICAID. Medicaid is a joint state and federal program to provide healthcare benefits to approximately 33.0 million low income individuals, including welfare recipients. According to the Health Care Financing Administration of the United States Department of Health and Human Services ("HCFA"), federal and state Medicaid spending increased from $69.0 billion in 1990 to an estimated $160.0 billion in 1996, at an average annual rate almost twice as fast as the annual increase in overall healthcare spending. Furthermore, according to HCFA, from 1991 to 1996 the number of Medicaid beneficiaries covered under full managed contracts grew at a compound annual rate of approximately 40% per year. The Company expects that the Balanced Budget Act of 1997 (the "Budget Act") will slow the growth of Medicaid spending by accelerating the trend of state Medicaid programs toward shifting beneficiaries into managed care programs in order to control rising costs. Despite the recent increase in managed care enrollment of Medicaid beneficiaries, Medicaid managed care enrollment as a percentage of all Medicaid beneficiaries remains small. As of June 1996, according to the National Institute for Health Care Management, only approximately 35% of all Medicaid beneficiaries were enrolled in some form of managed care program, and less than 7% were enrolled in risk-based programs. The Company expects the number of Medicaid recipients enrolled in managed behavioral healthcare programs to increase through two avenues: (i) subcontracts with HMOs and (ii) direct contracts with state agencies. As HMOs increase their penetration of the Medicaid market, the Company expects that many HMOs will continue to (or begin to) subcontract with behavioral managed healthcare companies to provide services for Medicaid beneficiaries. State agencies have also begun to contract directly with behavioral managed healthcare companies to provide behavioral healthcare services to their Medicaid beneficiaries. Iowa, Massachusetts, Nebraska, Maryland, Pennsylvania, Tennessee and Montana have decided to "carve out" behavioral healthcare from their overall Medicaid managed care programs and have contracted or are expected to contract directly with behavioral managed healthcare companies to provide such services. The Company expects that the Budget Act will accelerate the trend of states contracting directly with behavioral managed healthcare companies. During fiscal 1998, Medicaid programs accounted for approximately 23% of the Company's behavorial managed healthcare revenue and represented approximately 6% of covered lives as of September 30, 1998. Substantially all of the Company's Medicaid Contracts are risk-based. See "Cautionary Statements--Dependence on Government Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and "--Risk-Based Products" and "Business--Regulation--Budget Act." 8 COMPANY OVERVIEW GENERAL According to enrollment data reported in OPEN MINDS, the Company is the nation's largest provider of behavioral managed healthcare services. As of September 30, 1998, the Company had approximately 61.6 million covered lives under behavioral managed healthcare contracts and manages behavioral healthcare programs for over 3,000 customers. Through its current network of over 35,000 providers and nearly 5,000 treatment facilities, the Company manages behavioral healthcare programs for HMOs, Blue Cross/Blue Shield organizations and other insurance companies, corporations, federal, state and local governmental agencies, labor unions and various state Medicaid programs. The Company believes it has the largest and most comprehensive behavioral healthcare provider network in the United States. In addition to the Company's behavioral managed healthcare segment, the Company offers specialty managed care products related to the management of certain chronic medical conditions. The Company also offers a broad continuum of human services to approximately 3,350 individuals who receive healthcare benefits funded by state and local governmental agencies through National Mentor, Inc., its wholly-owned human services provider. Furthermore, the Company franchises the "CHARTER" System of behavioral healthcare to the Psychiatric Hospital Facilities and other facilities operated by CBHS, an entity in which the Company owns a 50% equity interest. The Company's professional care managers coordinate and manage the delivery of behavioral healthcare treatment services through the Company's network of providers, which includes psychiatrists, psychologists, licensed clinical social workers, marriage and family therapists and licensed clinical professional counselors. The treatment services provided by the Company's behavioral provider network include outpatient programs (such as counseling and therapy), intermediate care programs (such as sub-acute emergency care, intensive outpatient programs and partial hospitalization services), inpatient treatment services and alternative care services (such as residential treatment, home and community-based programs and rehabilitative and support services). The Company provides these services through: (i) risk-based products, (ii) EAPs, (iii) ASO products and (iv) products that combine features of some or all of these products. Under risk-based products, the Company arranges for the provision of a full range of behavioral healthcare services for beneficiaries of its customers' healthcare benefit plans through fee arrangements under which the Company assumes all or a portion of the responsibility for the cost of providing such services in exchange for a fixed per member per month fee. Under EAPs, the Company provides assessment services to employees and dependents of its customers, and if required, referral services to the appropriate behavioral healthcare service provider. Under ASO products, the Company provides services such as utilization review, claims administration and provider network management. The Company does not assume the responsibility for the cost of providing healthcare services pursuant to its ASO products. The Company conducts operations in five business segments: (i) behavioral managed healthcare, (ii) human services, (iii) specialty managed healthcare, (iv) healthcare franchising and (v) healthcare provider. The following describes the Company's five business segments: BEHAVIORAL MANAGED CARE. The behavioral managed healthcare segment is the Company's primary operating segment. The Company's behavioral managed care subsidiaries include Green Spring, HAI, and Merit. The following is a description of each of these subsidiaries prior to the Company's integration of its behavioral managed care businesses: Green Spring was one of the largest companies in the behavioral managed healthcare industry and was the largest behavioral managed healthcare provider to the Blue Cross/Blue Shield networks. Green Spring's client base included Blue Cross/Blue Shield plans, major HMOs and preferred provider organizations ("PPOs"), state employee programs, Fortune 1000 corporations, labor unions and a growing number of state Medicaid programs. 9 Merit was one of the leading behavioral managed healthcare providers in the nation. Merit managed behavioral healthcare programs for clients across all segments of the healthcare industry, particularly in the corporate and HMO segment. Merit was also a leading provider to Blue Cross/Blue Shield organizations and other insurance companies, corporations and labor unions, federal, state and local governmental agencies and various state Medicaid programs. HAI was one of the first and was one of the largest providers of EAP products. HAI had providers in all 50 states and serves many of the nation's largest companies, including Aetna, Exxon, JP Morgan, MCI, Northwest Airlines and Sears. The behavioral managed healthcare operations are now organized around three customer segments, as follows: (i) the Health Plan Division, focusing on the needs of health insurance plans and HMO's and their members; (ii) the Workplace Division, focusing on self-insured employers and labor unions and their employees and dependants; and (iii) the Public Sector Division, focusing on the needs of public purchasers of behavioral healthcare services and their constituents. HUMAN SERVICES. The Company's human services business provided specialty home-based behavioral healthcare services through Mentor to approximately 3,350 individuals in 105 programs in 20 states as of September 30, 1998. Mentor was founded in 1983 and was acquired by the Company in January 1995. Mentor's services include specialty home-based behavioral healthcare services, which feature individualized home and community-based health and human services delivered in highly structured and professionally monitored family environments or "mentor" homes. The mentor homes serve clients with chronic behavioral disorders and disabilities requiring long-term care, including children and adolescents with behavioral problems, individuals with mental retardation or developmental disabilities, and individuals with neurological impairment or other medical and behavioral frailties. As a result of the Human Services Acquisitions, Mentor also provides various residential and day services for individuals with acquired brain injuries and for individuals with mental retardation and developmental disabilities. SPECIALTY MANAGED HEALTHCARE. The Company's specialty managed healthcare business provides specialty risk-based products and administrative services to a variety of insurance companies and other customers, including Prudential, CIGNA and NYLCare. Allied has over 80 physician networks across the eastern United States. Allied's networks include physicians specializing in cardiology, oncology and diabetes. The specialty managed healthcare operations focus on the needs of health plans to manage their specialty care networks and disease management programs in areas such as diabetes, asthma, oncology and cardiology. HEALTHCARE FRANCHISING. The Company's wholly-owned subsidiary Charter Advantage, LLC ("Charter Advantage") franchises the "CHARTER" System of behavioral healthcare to the Psychiatric Hospital Facilities and other facilities operated by CBHS. See "Business--Charter Advantage." HEALTHCARE PROVIDER. The Company's provider operations include the ownership and operation of two psychiatric hospitals in London, England (a 45-bed hospital and a 78-bed hospital) and a 69-bed psychiatric hospital in Nyon, Switzerland (collectively, the "European Facilities"). The Company's provider operations also include its interest in six hospital-based joint ventures ("Joint Ventures"). The Company's joint venture partner in four of the Joint Ventures is Columbia/HCA Healthcare Corporation. Although the Company is the managing member of each Joint Venture, it has delegated its management responsibilities to CBHS. The Company pays CBHS a fee for managing the Joint Ventures equal to the Company's share of the earnings of the Joint Ventures. The Company's provider operations also include a Puerto Rican provider management business. 10 BUSINESS STRATEGY INCREASE ENROLLMENT IN BEHAVIORAL MANAGED HEALTHCARE PRODUCTS. The Company believes it has an opportunity to increase covered lives in all its behavioral managed healthcare products. The Company believes its market presence will further enhance its ability to increase ASO and EAP covered lives with large corporate, HMO and insurance customers. The Company further believes that it has an opportunity to increase revenues, earnings and cash flows from operations by increasing lives covered by its risk-based products. The Company is the industry's leading provider of risk-based products, according to data reported by OPEN MINDS, and believes that it may benefit from the continuing shift to risk-based products. According to OPEN MINDS, industry enrollment in risk-based products has grown from approximately 13.6 million in 1993 to approximately 38.9 million in 1997, representing a compound annual growth rate of over 30%. Despite this growth, only approximately 26% of total behavioral managed healthcare enrollees were in risk-based products in 1997. The Company believes that the market for risk-based products has grown and will continue to grow as payors attempt to reduce their cost of providing behavioral healthcare while ensuring a high quality of care and an appropriate level of access to care. The Company believes enrollment in its risk-based products will increase through growth in new covered lives and through the transition of covered lives in ASO and EAP products to higher revenue risk-based products. There are certain risks associated with increased enrollment in risk-based products. See "Cautionary Statements--Risk-Based Products." ACHIEVE SIGNIFICANT INTEGRATION EFFICIENCIES. The Company believes that the HAI and Merit acquisitions have created opportunities for the Company to achieve significant cost savings. Management believes that cost saving opportunities will result from leveraging fixed overhead over a larger revenue base and an increased number of covered lives and from reducing duplicative corporate and regional selling, general and administrative expenses. As a result, the Company expects to achieve approximately $60.0 million of costs savings on an annual basis by September 30, 1999. Such cost savings are measured relative to the combined operating expenses of Green Spring, HAI and Merit prior to the Merit acquisition. There can be no assurance that the Company will be able to integrate its operations according to its plan. See "Cautionary Statements--Integration of Operations." PURSUE ADDITIONAL SPECIALTY MANAGED HEALTHCARE OPPORTUNITIES. The Company believes that significant demand exists for specialty managed healthcare products related to the management of certain chronic conditions. The Company believes its large number of covered lives, information systems infrastructure and experience in managing behavioral healthcare programs position the Company to provide customers with specialty managed healthcare products. As a first major step in implementing this strategy, the Company acquired Allied, a provider of specialty managed care products for cardiology, oncology and diabetes patients, on December 5, 1997. See "Recent Developments--Allied Acquisition." The Company's highly leveraged financial position may prevent it from acquiring additional specialty managed healthcare providers. See "Cautionary Statements--Substantial Leverage and Debt Service Obligations." EXPANSION OF HUMAN SERVICES GEOGRAPHIC COVERAGE AND PRODUCT MIX. The human services industry is a very fragmented, $100 billion industry that continues to be consolidated by a few competitors. The Company believes it has an opportunity to increase its geographic coverage and leverage its human services product offerings on a nationwide basis. The Human Services Acquisitions diversified the product mix and increased the geographic market penetration of the human services segment. Mentor plans to launch national brain injury rehabilitation product lines and expand its product offerings in California as a result of the Human Services Acquisitions. EXIT FROM THE HEALTHCARE FRANCHISING AND HEALTHCARE PROVIDER OPERATIONS. The Company will continue its efforts to sell its three European hospitals, its 50% interest in CBHS, Charter Advantage and other provider operations in an effort to reduce the Company's long-term debt and improve liquidity. The 11 Company is currently involved in negotiations to sell some or all of the previously mentioned businesses. There can be no assurance that the Company will be able to sell any of these businesses. BEHAVIORAL MANAGED HEALTHCARE PRODUCTS AND SERVICES GENERAL. The following table sets forth the approximate number of covered lives as of September 30, 1998 and revenue for fiscal 1998 for the types of behavioral managed healthcare programs offered by the Company:
PROGRAMS COVERED LIVES PERCENT REVENUE PERCENT - ----------------------------------------------------------------- ----------------- ----------- ---------- ----------- (IN MILLIONS, EXCEPT PERCENTAGES) Risk-Based Products.............................................. 18.6 30.2% $ 786.1 75.7% EAP, ASO and other products...................................... 43.0 69.8 252.9 24.3 --- ----- ---------- ----- Total........................................................ 61.6 100.0% $ 1,039.0 100.0% --- ----- ---------- ----- --- ----- ---------- -----
The number of the Company's covered lives fluctuates based on the number of the Company's customer contracts and as employee, HMO and insurance company subscriber and government program enrollee populations change from time to time. On a pro forma basis including HAI and Merit, the number of lives covered by the Company's managed healthcare products at September 30, 1996 and 1997 would have been 45.7 million and 51.7 million, respectively. RISK-BASED PRODUCTS. Under the Company's risk-based products, the Company typically arranges for the provision of a full range of outpatient, intermediate and inpatient treatment services to beneficiaries of its customers' healthcare benefit plans, primarily through arrangements in which the Company assumes all or a portion of the responsibility for the cost of providing such services in exchange for a per member per month fee. The Company's experience with risk-based contracts (including the experience of Green Spring, HAI and Merit) covering a large number of lives has given it a broad base of data from which to analyze utilization rates. The Company believes that this broad database permits it to estimate utilization trends and costs more accurately than many of its competitors, which allows it to bid effectively. The Company believes that its experience has also allowed it to develop effective measures for controlling the cost of providing a unit of care to its covered lives. Among other cost control measures, the Company has developed or acquired clinical protocols, which permit the Company to assist its network providers to administer effective treatment in a cost efficient manner, and claims management technology, which permits the Company to reduce the cost of processing claims. The Company's care managers are an essential element in its provision of cost-effective care. Except in emergencies, treatment is required to be authorized by a Company care manager. Care managers, in consultation with treating professionals, and using the Company's clinical protocols, authorize an appropriate level and intensity of services that can be delivered in a cost-efficient manner. EMPLOYEE ASSISTANCE PROGRAMS. The Company's EAP products typically provide assessment and referral services to employees and dependents of the Company's customers in an effort to assist in the early identification and resolution of productivity problems associated with the employees who are impaired by behavioral conditions or other personal concerns. For many EAP customers, the Company also provides limited outpatient therapy (typically limited to eight or fewer sessions) to patients requiring such services. For these services, the Company typically is paid a fixed fee per member per month; however, the Company is usually not responsible for the cost of providing care beyond these services. If further services are necessary beyond limited outpatient therapy, the Company will refer the beneficiary to an appropriate provider or treatment facility. INTEGRATED PRODUCTS. Under its integrated products, the Company typically establishes an EAP to function as the "front end" of a managed care program that provides a full range of services, including more intensive treatment services not covered by the EAP. The Company typically manages the EAP and accepts all or some of the responsibility for the cost of any additional treatment required upon referral out 12 of the EAP, thus integrating the two products and using both the Company's care management and clinical care techniques to manage the provision of care. ASO PRODUCTS. Under its ASO products, the Company provides services ranging from utilization review and claims administration to the arrangement for and management of a full range of patient treatment services, but does not assume any of the responsibility for the cost of providing treatment services. Services include member assistance, management reporting and claims processing in addition to utilization review and care management. BEHAVIORAL MANAGED HEALTHCARE CUSTOMERS GENERAL. The following table sets forth the approximate number of covered lives as of September 30, 1998 and revenue for fiscal 1998 in each of the Company's market segments described below:
MARKET COVERED LIVES PERCENT REVENUE PERCENT - ----------------------------------------------------------------- ----------------- ----------- ---------- ----------- (IN MILLIONS, EXCEPT PERCENTAGES) Workplace (Corporations and Labor Unions)........................ 19.7 32.0% $ 141.6 13.6% Health Plans..................................................... 31.0 50.3 633.4 61.0 Public Sector.................................................... 7.8 12.7 240.3 23.1 Other............................................................ 3.1 5.0 23.7 2.3 --- ----- ---------- ----- Total........................................................ 61.6 100.0% $ 1,039.0 100.0% --- ----- ---------- ----- --- ----- ---------- -----
CORPORATIONS AND LABOR UNIONS. Corporations and, to a lesser extent, labor unions, account for a large number of the Company's contracts to provide behavioral managed healthcare services and, in particular, EAP and integrated EAP/managed care services. The Company has structured a variety of fee arrangements with corporate customers to cover all or a portion of the responsibility of the cost of providing treatment services. In addition, the Company operates a number of programs for corporate customers on an ASO basis. Management believes the corporate market is an area of potential growth for the Company, as corporations are anticipated to increase their utilization of behavioral managed healthcare services. In an effort to increase penetration of the corporate market, the Company intends to build upon Merit's experience in managing programs for large corporate customers (such as IBM, Federal Express and AT&T) and to market integrated programs to Merit's existing EAP customers and other prospective corporate clients. HEALTH PLANS. The Company is a leader in the HMO market, providing behavioral managed healthcare services to HMO beneficiaries. HMO contracts are full, limited or shared risk contracts in which the Company generally accepts a fixed fee per member per month from the HMO in exchange for providing a full or specified range of behavioral healthcare services for a specific portion of the HMO's beneficiaries. Although certain large HMOs provide their own behavioral managed healthcare services, many HMOs "carve out" behavioral healthcare from their general healthcare services and subcontract such services to behavioral managed healthcare companies such as the Company. The Company anticipates that its business with HMOs will continue to grow. The Company is also the nation's leading provider of behavioral managed healthcare services to Blue Cross/Blue Shield organizations, serving 28 Blue Cross/Blue Shield organizations as of September 30, 1998. HAI has contracts with its former owner, Aetna, pursuant to which HAI provides behavioral managed healthcare products to Aetna, including focused psychiatric review (a type of utilization review product), risk-based HMO products, administrative services for Aetna's "Managed Choice" product and provider network management services. PUBLIC SECTOR. The Company provides behavioral managed healthcare services to Medicaid recipients through both direct contracts with state and local governmental agencies and through subcontracts with HMOs focused on Medicaid beneficiary populations. In addition to the Medicaid population, 13 other public entitlement programs, such as Medicare and state insurance programs for the uninsured, offer the Company areas of potential future growth. The Company expects that governmental agencies will continue to implement a significant number of managed care Medicaid programs through contracts with HMOs and that many HMOs will subcontract with behavioral managed healthcare organizations, such as the Company, for behavioral healthcare services. The Company also expects that other states will continue the trend of "carving-out" behavioral healthcare services from their general healthcare benefit plans and contracting directly with behavioral managed healthcare companies such as the Company. See "Industry--Areas of Growth," "Cautionary Statements--Dependence on Government Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and "--Regulation--Other Proposed Legislation." The Company also provides EAPs and other managed care products for employees and their dependents who are beneficiaries of federal, state and local governmental agencies' healthcare benefit plans. Governmental agencies' healthcare benefit plans have historically contracted for managed behavioral healthcare services as part of their general healthcare contracts with HMOs or indemnity insurers. In turn, HMOs or indemnity insurers have either provided managed behavioral healthcare services directly or subcontracted such services to managed behavioral healthcare companies such as the Company. The Company currently provides services to a number of government employees either directly pursuant to a contract with the government agency or as a subcontractor to HMOs. More recently, governmental agencies have begun to contract directly with managed behavioral healthcare companies to provide these services. In addition, the Company currently manages contracts for CHAMPUS beneficiaries and is actively pursuing new contracts and subcontracts under the CHAMPUS program. In this market, the Company often bids for such contracts together with HMOs to provide the behavioral healthcare services portion of the overall CHAMPUS healthcare contract. BEHAVIORAL MANAGED HEALTHCARE CONTRACTS The Company's contracts with customers typically have terms of one to three years, and in certain cases contain renewal provisions (at the customer's option) for successive terms of between one and two years (unless terminated earlier). Substantially all of these contracts are immediately terminable with cause and many are terminable without cause by the customer or the Company either upon the giving of requisite notice and the passage of a specified period of time (typically between 60 and 180 days) or upon the occurrence of other specified events. In addition, the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements with HMOs, generally are conditioned on legislative appropriations. These contracts, notwithstanding terms to the contrary, generally can be terminated or modified by the customer if such appropriations are not made. See "Cautionary Statements--Risk Based Programs" and "--Reliance on Customer Contracts." The specific terms of the Company's contracts are determined by whether the contracts are for risk-based, EAP, integrated or ASO products. Risk-based and EAP contracts provide for payment of a fixed per member per month fee to the Company. The customer remits this fee to the Company monthly. With respect to ASO products, the Company is generally paid on a per member per month basis. The Company bills its customer for such services on a monthly basis. The Company's billing arrangements for integrated products vary on a case by case basis. BEHAVIORAL MANAGED HEALTHCARE NETWORK The Company's behavioral managed healthcare and EAP treatment services are provided by a network of third-party providers. The number and type of providers in a particular area depend upon customer preference, site, geographic concentration and demographic make-up of the beneficiary population in that area. Network providers include a variety of specialized behavioral healthcare personnel, such as psychiatrists, psychologists, licensed clinical social workers, substance abuse counselors and other professionals. 14 As of September 30, 1998, the Company had contractual arrangements covering over 35,000 individual third-party network providers. The Company's network providers are independent contractors located throughout the local areas in which the Company's customer's beneficiary population resides. Network providers work out of their own offices, although the Company's personnel are available to assist them with consultation and other needs. Network providers include both individual practitioners, as well as individuals who are members of group practices or other licensed centers or programs. Network providers typically execute standard contracts with the Company for which they are typically paid by the Company on a fee-for-service basis. In some cases, network providers are paid on a "case rate" basis, whereby the provider is paid a set rate for an entire course of treatment, or through other risk sharing arrangements. A network provider's contract with the Company typically has a one-year term, with automatic renewal at the Company's option for successive one-year terms, and generally may be terminated without cause by the Company or the provider upon 30 to 90 days notice. As of September 30, 1998, the Company's behavorial managed healthcare network included contractual arrangements with approximately 5,000 third-party treatment facilities, including inpatient psychiatric and substance abuse hospitals, intensive outpatient facilities, partial hospitalization facilities, community health centers and other community-based facilities, rehabilitative and support facilities, and other intermediate care and alternative care facilities or programs. This variety of facilities enables the Company to offer patients a full continuum of care and to refer patients to the most appropriate facility or program within that continuum. Typically, the Company contracts with facilities on a per diem or fee-for-service basis and, in some cases, on a "case rate" or capitated basis. The contracts between the Company and inpatient and other facilities typically are for one year terms and, in some cases, are automatically renewable at the Company's option. Facility contracts are usually terminable by the Company or the facility owner upon 30 to 120 days notice. The Psychiatric Hospital Facilities and other facilities operated by CBHS are members of the Company's hospital provider network on the same terms as are generally applicable to unaffiliated third-party treatment facilities. 15 COMPETITION Each segment of the Company's business is highly competitive. With respect to its managed care businesses, the Company competes with large insurance companies, HMOs, PPOs, third-party administrators ("TPAs"), independent practitioner associations ("IPAs"), multi-disciplinary medical groups and other managed care companies. Many of the Company's competitors are significantly larger and have greater financial, marketing and other resources than the Company, and some of the Company's competitors provide a broader range of services. The Company may also encounter substantial competition in the future from new market entrants. Many of the Company's customers that are managed care companies may, in the future, seek to provide behavioral managed healthcare and EAP services to their employees or subscribers directly, rather than by contracting with the Company for such services. Because of competition, the Company does not expect to be able to rely on price increases to achieve revenue growth and expects to continue experiencing pressure on direct operating margins. See "Cautionary Statements--Highly Competitive Industry." The Company's human services operations compete with various for profit and not-for-profit entities, including, but not limited to: (i) behavioral managed healthcare companies that have started managing human services for governmental agencies; (ii) home health care organizations; (iii) proprietary nursing home companies; and (iv) proprietary human services companies. The Company believes that the most significant factors in a customer's selection of services include price, quality of services and outcomes. The pricing aspect of such services is especially important to attract public sector agencies looking to outsource public services to the private sector as demand for quality services escalates while budgeted dollars for healthcare services are reduced. The Company's management believes that it competes effectively with respect to these factors. The Company believes it benefits from the competitive strengths described below: INDUSTRY LEADERSHIP. The Company is the largest provider of behavioral managed healthcare services in the United States, according to enrollment data reported in OPEN MINDS. The Company believes, based on data reported in OPEN MINDS, that it also now has the number one market position in each of the major product markets in which it competes. The Company believes its position will enhance its ability to: (i) provide a consistent level of high quality service on a nationwide basis; (ii) enter into agreements with behavioral healthcare providers that allow it to control healthcare costs for its customers; and (iii) market its behavioral managed care products to large corporate, HMO and insurance customers, which, the Company believes, increasingly prefer to be serviced by a single-source provider on a national basis. See "Cautionary Statements--Highly Competitive Industry" and "--Reliance on Customer Contracts" for a discussion of the risks associated with the highly competitive nature of the behavioral managed healthcare industry and the Company's reliance on contracts with payors of behavioral healthcare benefits, respectively. BROAD PRODUCT OFFERING AND NATIONWIDE PROVIDER NETWORK. The Company offers behavioral managed care products that can be designed to meet specific customer needs, including risk-based and partial risk-based products, integrated EAPs, stand-alone EAPs and ASO products. The Company's provider network encompasses over 35,000 providers and nearly 5,000 treatment facilities in all 50 states. The Company believes that the combination of its product offerings and its provider network allows the Company to meet its customers needs for behavioral managed healthcare on a nationwide basis, and positions the Company to capture incremental revenue opportunities resulting from the continued growth of the behavioral managed healthcare industry and the continued migration of its customers from ASO and EAP products to higher revenue risk-based products. See "Cautionary Statements--Risk-Based Products" for a discussion of the risks associated with risk-based products, which are the Company's primary source of revenue. 16 BROAD BASE OF CUSTOMER RELATIONSHIPS. The Company believes that the breadth of its customer relationships are attributable to the Company's broad product offerings, nationwide provider network, commitment to quality care and ability to manage behavioral healthcare costs effectively. The Company's customers include: (i) Blue Cross/Blue Shield organizations; (ii) national HMOs and other large insurers, such as Aetna/US Healthcare, Humana and Prudential; (iii) large corporations, such as IBM, Federal Express and AT&T; (iv) state and local governmental agencies through commercial, Medicaid and other programs; and (v) the federal government through contracts pursuant to the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS") and with the U.S. Postal Service. This broad base of customer relationships provides the Company with stable and diverse sources of revenue, earnings and cash flows and an established base from which to continue to increase covered lives and revenue. See "Cautionary Statements--Reliance on Customer Contracts" for a discussion of the risks associated with the Company's reliance on certain contracts with payors of behavioral healthcare benefits. PROVEN RISK MANAGEMENT EXPERIENCE. The Company had approximately 18.6 million covered lives under risk-based contracts at September 30, 1998, making it the nation's industry leader in at-risk behavioral managed healthcare products, based on data reported in OPEN MINDS. The Company's experience with risk-based products covering a large number of lives has given it a broad base of data from which to analyze utilization rates. The Company believes that this broad database permits it to estimate utilization trends and costs more accurately than many of its competitors, which allows it to bid effectively. The Company believes that its experience has also allowed it to develop effective measures for controlling the cost of providing a unit of care to its covered lives. Among other cost control measures, the Company has developed or acquired clinical protocols, which permit the Company to assist its network providers to administer effective treatment in a cost efficient manner, and claims management technology, which permits the Company to reduce the cost of processing claims. As the Company continues to integrate HAI and Merit into its behavioral managed healthcare operations, it will be able to select from the best practices of its subsidiaries to further enhance its utilization and cost control methodologies. See "Cautionary Statements--Integration of Operations" for a discussion of the risks associated with integrating the Company's recently acquired businesses, including the managed care operations it acquired in fiscal 1998, with its existing operations. The competitive environment affecting the Company's healthcare franchising and healthcare provider operations are discussed elsewhere. See "Charter Advantage--Competition." INSURANCE The Company maintains a general and professional liability insurance policy with an unaffiliated insurer. The policy is written on an "occurrence" basis, subject to a $250,000 deductible per occurrence and an aggregate deductible of $1.0 million for a three-year policy period ending June 2001. REGULATION GENERAL. The behavioral managed healthcare industry and the provision of behavioral healthcare services are subject to extensive and evolving state and federal regulation. The Company is subject to certain state laws and regulations, including those governing: (i) the licensing of insurance companies, HMOs, PPOs, TPAs and companies engaged in utilization review and (ii) the licensing of healthcare professionals, including restrictions on business corporations from practicing, controlling or exercising excessive influence over behavioral healthcare services through the direct employment of psychiatrists or, in a few states, psychologists and other behavioral healthcare professionals. These laws and regulations vary considerably among states and the Company may be subject to different types of laws and regulations depending on the specific regulatory approach adopted by each state to regulate the managed care business and the provision of behavioral healthcare treatment services. In addition, the Company is subject to certain federal laws as a result of the role the Company assumes in connection 17 with managing its customers' employee benefit plans. The regulatory scheme generally applicable to the Company's managed care operations is described in this section. The Company's managed care operations are also indirectly affected by regulations applicable to the operations of behavioral healthcare clinics and facilities. See "Charter Advantage--Regulation." The Company believes its operations are structured to comply with applicable laws and regulations in all material respects and that it has received, or is in the process of applying for, all licenses and approvals that are material to the operation of its business. However, regulation of the managed healthcare industry is evolving, with new legislative enactments and regulatory initiatives at the state and federal levels being implemented on a regular basis. Consequently, it is possible that a court or regulatory agency may take a position under existing or future laws or regulations, or as a result of a change in the interpretation thereof, that such laws or regulations apply to the Company in a different manner than the Company believes such laws or regulations apply. Moreover, any such position may require significant alterations to the Company's business operations in order to comply with such laws or regulations, or interpretations thereof. Expansion of the Company's business to cover additional geographic areas, to serve different types of customers, to provide new services or to commence new operations could also subject the Company to additional licensure requirements and/or regulation. LICENSURE. Certain regulatory agencies having jurisdiction over the Company possess discretionary powers when issuing or renewing licenses or granting approval of proposed actions such as mergers, a change in ownership, transfer or assignment of licenses and certain intracorporate transactions. One or multiple agencies may require as a condition of such licensure or approval that the Company cease or modify certain of its operations in order to comply with applicable regulatory requirements or policies. In addition, the time necessary to obtain licensure or approval varies from state to state, and difficulties in obtaining a necessary license or approval may result in delays in the Company's plans to expand operations in a particular state and, in some cases, lost business opportunities. Compliance activities, mandated changes in the Company's operations, delays in the expansion of the Company's business or lost business opportunities as a result of regulatory requirements or policies could have a material adverse effect on the Company. INSURANCE, HMO AND PPO ACTIVITIES. To the extent that the Company operates or is deemed to operate in one or more states as an insurance company, HMO, PPO or similar entity, it may be required to comply with certain laws and regulations that, among other things, may require the Company to maintain certain types of assets and minimum levels of deposits, capital, surplus, reserves or net worth. In many states, entities that assume risk under contracts with licensed insurance companies or HMOs have not been considered by state regulators to be conducting an insurance or HMO business. As a result, the Company has not sought licensure as either an insurer or HMO in certain states. The National Association of Insurance Commissioners (the "NAIC") has undertaken a comprehensive review of the regulatory status of entities arranging for the provision of healthcare services through a network of providers that, like the Company, may assume risk for the cost and quality of healthcare services, but that are not currently licensed as an HMO or similar entity. As a result of this review, the NAIC developed a "health organizations risk-based capital" formula, designed specifically for managed care organizations, that establishes a minimum amount of capital necessary for a managed care organization to support its overall operations, allowing consideration for the organization's size and risk profile. The NAIC initiative also may result in the adoption of a model NAIC regulation in the area of health plan standards, which could be adopted by individual states in whole or in part, and could result in the Company being required to meet additional or new standards in connection with its existing operations. Individual states have also recently adopted their own regulatory initiatives that subject entities such as the Company to regulation under state insurance laws. This includes, but is not limited to, requiring licensure as an insurance company or HMO and requiring adherence to specific financial solvency standards. State insurance laws and regulations may limit the ability of the Company to pay dividends, make certain investments and repay certain indebtedness. Licensure as an insurance company, HMO or 18 similar entity could also subject the Company to regulations governing reporting and disclosure, mandated benefits, and other traditional insurance regulatory requirements. PPO regulations to which the Company may be subject may require the Company to register with a state authority and provide information concerning its operations, particularly relating to provider and payor contracting. Based on the information presently available to it, the Company does not believe that the imposition of requirements related to maintaining certain types of assets, prescribed levels of deposits, capital, surplus, reserves or net worth, or complying with other regulatory requirements applicable to its insurance company, HMO, PPO or similar operations, would have a material adverse effect on the Company. Notwithstanding the foregoing, the imposition of such requirements could increase the Company's cost of doing business and could delay the Company's conduct or expansion of its business in some areas. The licensure process under state insurance laws can be lengthy and, unless the applicable state regulatory agency allows the Company to continue to operate while the licensure process is ongoing, the Company could experience a material adverse effect on its operating results and financial condition while its licensure application is pending. In addition, failure by the Company to obtain and maintain required licenses typically also constitutes an event of default under the Company's contracts with its customers. The loss of business from one or more of the Company's major customers as a result of such an event of default or otherwise could have a material adverse effect on the Company. UTILIZATION REVIEW AND THIRD-PARTY ADMINISTRATOR ACTIVITIES. Numerous states in which the Company does business have adopted, or are expected to adopt, regulations governing entities engaging in utilization review and TPA activities. Utilization review regulations typically impose requirements with respect to the qualifications of personnel reviewing proposed treatment, timeliness and notice of the review of proposed treatment, and other matters. TPA regulations typically impose requirements regarding claims processing and payments and the handling of customer funds. Utilization review and TPA regulations may increase the Company's cost of doing business in the event that compliance requires the Company to retain additional personnel to meet the regulatory requirements and to take other required actions and make necessary filings. Although compliance with utilization review regulations has not had a material adverse effect on the Company, there can be no assurance that specific regulations adopted in the future would not have such a result, particularly since the nature, scope and specific requirements of such provisions vary considerably among states that have adopted regulations of this type. There is a trend among states to require licensure or certification of entities performing utilization review or TPA activities; however, certain federal courts have held that such licensure requirements are preempted by ERISA. ERISA preempts state laws that mandate employee benefit structures or their administration, as well as those that provide alternative enforcement mechanisms. The Company believes that its TPA activities performed for its self-insured employee benefit plan customers are exempt from otherwise applicable state licensing or registration requirements based upon federal preemption under ERISA and has relied on this general principle in determining not to seek licensure for certain of its activities in many states. Existing case law is not uniform on the applicability of ERISA preemption with respect to state regulation of utilization review or TPA activities. There can be no assurance that additional licensure will not be required with respect to utilization review or TPA activities in certain states. "ANY WILLING PROVIDER" LAWS. Several states in which the Company does business have adopted, or are expected to adopt, "any willing provider" laws. Such laws typically impose upon insurance companies, PPOs, HMOs or other types of third-party payors an obligation to contract with, or pay for the services of, any healthcare provider willing to meet the terms of the payor's contracts with similar providers. Compliance with any willing provider laws could increase the Company's costs of assembling and administering provider networks and could, therefore, have a material adverse effect on its operations. 19 LICENSING OF HEALTHCARE PROFESSIONALS. The provision of behavioral healthcare treatment services by psychiatrists, psychologists and other providers is subject to state regulation with respect to the licensing of healthcare professionals. The Company believes that the healthcare professionals who provide behavioral healthcare treatment on behalf of or under contracts with the Company are in compliance with the applicable state licensing requirements and current interpretations thereof; however, there can be no assurance that changes in such state licensing requirements or interpretations thereof will not adversely affect the Company's existing operations or limit expansion. With respect to the Company's crisis intervention program, additional licensure of clinicians who provide telephonic assessment or stabilization services to individuals who are calling from out-of-state may be required if such assessment or stabilization services are deemed by regulatory agencies to be treatment provided in the state of such individual's residence. The Company believes that any such additional licensure could be obtained; however, there can be no assurance that such licensing requirements will not adversely affect the Company's existing operations or limit expansion. PROHIBITION ON FEE SPLITTING AND CORPORATE PRACTICE OF PROFESSIONS. The laws of some states limit the ability of a business corporation to directly provide, control or exercise excessive influence over behavioral healthcare services through the direct employment of psychiatrists, psychologists, or other behavioral healthcare professionals. In addition, the laws of some states prohibit psychiatrists, psychologists, or other healthcare professionals from splitting fees with other persons or entities. These laws and their interpretations vary from state to state and enforcement by the courts and regulatory authorities may vary from state to state and may change over time. The Company believes that its operations as currently conducted are in material compliance with the applicable laws, however, there can be no assurance that the Company's existing operations and its contractual arrangements with psychiatrists, psychologists and other healthcare professionals will not be successfully challenged under state laws prohibiting fee splitting or the practice of a profession by an unlicensed entity, or that the enforceability of such contractual arrangements will not be limited. The Company believes that it could, if necessary, restructure its operations to comply with changes in the interpretation or enforcement of such laws and regulations, and that such restructuring would not have a material adverse effect on its operations. DIRECT CONTRACTING WITH LICENSED INSURERS. Regulators in several states in which the Company does business have adopted policies that require HMOs or, in some instances, insurance companies, to contract directly with licensed healthcare providers, entities or provider groups, such as IPAs, for the provision of treatment services, rather than with unlicensed intermediary companies. In such states, the Company's customary model of contracting directly with its customers may need to be modified so that, for example, the IPAs (rather than the Company) contract directly with the HMO or insurance company, as appropriate, for the provision of treatment services. The Company intends to work with a number of these HMO customers to restructure existing contractual arrangements, upon contract renewal or in renegotiations, so that the entity which contracts with the HMO directly is an IPA. The Company does not expect this method of contracting to have a material adverse effect on its operations. OTHER REGULATION OF HEALTHCARE PROVIDERS. The Company's business is affected indirectly by regulations imposed upon healthcare providers. Regulations imposed upon healthcare providers include provisions relating to the conduct of, and ethical considerations involved in, the practice of psychiatry, psychology, social work and related behavioral healthcare professions and, in certain cases, the common law duty to warn others of danger or to prevent patient self-injury. Confidentiality and patient privacy requirements are particularly strict in the field of behavioral healthcare services, and additional legislative initiatives relating to confidentiality are expected. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") included a provision that prohibits the wrongful disclosure of certain "individually identifiable health information." HIPAA requires the Secretary of the Department to adopt standards relating to the transmission of such health information by healthcare providers and healthcare plans. Although the Company believes that such regulations do not at present materially impair the Company's 20 operations, there can be no assurance that such indirect regulation will not have a material adverse effect on the Company in the future. REGULATION OF CUSTOMERS. Regulations imposed upon the Company's customers include, among other things, benefits mandated by statute, exclusions from coverages prohibited by statute, procedures governing the payment and processing of claims, record keeping and reporting requirements, requirements for and payment rates applicable to coverage of Medicaid and Medicare beneficiaries, provider contracting and enrollee rights, and confidentiality requirements. Although the Company believes that such regulations do not at present materially impair the Company's operations, there can be no assurance that such indirect regulation will not have a material adverse effect on the Company in the future. ERISA. Certain of the Company's services are subject to the provisions of ERISA. ERISA governs certain aspects of the relationship between employer-sponsored healthcare benefit plans and certain providers of services to such plans through a series of complex laws and regulations that are subject to periodic interpretation by the Internal Revenue Service and the Department of Labor. In some circumstances, and under certain customer contracts, the Company may be expressly named as a "fiduciary" under ERISA, or be deemed to have assumed duties that make it an ERISA fiduciary, and thus be required to carry out its operations in a manner that complies with ERISA requirements in all material respects. Although the Company believes that it is in material compliance with the applicable ERISA requirements and that such compliance does not currently have a material adverse effect on the Company's operations, there can be no assurance that continuing ERISA compliance efforts or any future changes to the applicable ERISA requirements will not have a material adverse effect on the Company. OTHER PROPOSED LEGISLATION. In the last five years, legislation has periodically been introduced at the state and federal level providing for new regulatory programs and materially revising existing regulatory programs. Any such legislation, if enacted, could materially adversely affect the Company's business, financial condition or results of operations. Such legislation could include both federal and state bills affecting the Medicaid programs which may be pending in or recently passed by state legislatures and which are not yet available for review and analysis. Such legislation could also include proposals for national health insurance and other forms of federal regulation of health insurance and healthcare delivery. It is not possible at this time to predict whether any such legislation will be adopted at the federal or state level, or the nature, scope or applicability to the Company's business of any such legislation, or when any particular legislation might be implemented. No assurance can be given that any such federal or state legislation will not have a material adverse effect on the Company. 21 CAUTIONARY STATEMENTS--THE COMPANY. This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Important factors that could cause actual results to differ materially from the Company's forward-looking statements are set forth below and elsewhere in this Form 10-K. All forward-looking statements attributable to the Company or persons acting on behalf of the Company are expressly qualified in their entirety by the cautionary statements set forth below. Additional cautionary statements regarding the Company's healthcare franchising operations business are set forth below elsewhere herein. See "--Charter Advantage-- Cautionary Statements--CBHS." SUBSTANTIAL LEVERAGE AND DEBT SERVICE OBLIGATIONS The Company is currently highly leveraged, with indebtedness that is substantial in relation to its stockholders' equity. As of September 30, 1998, the Company's aggregate outstanding indebtedness was approximately $1.2 billion and the Company's stockholders' equity was approximately $187.6 million as of the same date. The New Credit Agreement and the Indenture permit the Company to incur or guarantee certain additional indebtedness, subject to certain limitations. The Company's high degree of leverage could have important consequences to the Company, including, but not limited to, the following: (i) the Company's ability to obtain additional financing for working capital, capital expenditures, acquisitions, general corporate purposes or other purposes may be impaired in the future; (ii) a substantial portion of the Company's cash flows from operations must be dedicated to the payment of principal and interest on its indebtedness; (iii) the Company is substantially more leveraged than certain of its competitors, which might place the Company at a competitive disadvantage; (iv) the Company may be hindered in its ability to adjust rapidly to changing market conditions; and (v) the Company's high degree of leverage could make it more vulnerable in the event of a downturn in general economic conditions or its business or in the event of adverse changes in the regulatory environment applicable to the Company. The Company's ability to repay or to refinance its indebtedness and to pay interest on its indebtedness will depend on its financial and operating performance, which, in turn, is subject to prevailing economic and competitive conditions and to certain financial, business and other factors, many of which are beyond the Company's control. These factors could include operating difficulties, increased operating costs, the actions of competitors, regulatory developments and delays in implementing strategic projects. The Company's ability to meet its debt service and other obligations may depend in significant part on the extent to which the Company can successfully implement its business strategy. There can be no assurance that the Company will be able to implement its strategy fully or that the anticipated results of its strategy will be realized. See "Business--Business Strategy." If the Company's cash flows and capital resources are insufficient to fund its debt service obligations, the Company may be forced to reduce or delay capital expenditures, sell assets or seek to obtain additional equity capital or to restructure its debt. There can be no assurance that the Company's cash flows and capital resources will be sufficient for payment of principal of and interest on its indebtedness in the future, or that any such alternative measures would be successful or would permit the Company to meet its scheduled debt service obligations. In addition, because the Company's obligations under the New Credit Agreement bear interest at floating rates, an increase in interest rates could adversely affect, among other things, the Company's ability to meet its debt service obligations. RESTRICTIVE FINANCING COVENANTS The New Credit Agreement and the Indenture contain a number of covenants that restrict the operations of the Company and its subsidiaries. In addition, the New Credit 22 Agreement requires the Company to comply with specified financial ratios and tests, including a minimum interest coverage ratio, a maximum leverage ratio, a minimum net worth test, a maximum senior debt ratio and a minimum "EBITDA" (as defined in the New Credit Agreement). There can be no assurance that the Company will be able to comply with such covenants, ratios and tests in the future. The Company's ability to comply with such covenants, ratios and tests may be affected by events beyond its control, including prevailing economic, financial and industry conditions. The breach of any such covenants, ratios or tests could result in a default under the New Credit Agreement that would permit the lenders thereunder to declare all amounts outstanding thereunder to be immediately due and payable, together with accrued and unpaid interest, and to prevent the Company from paying principal, premium, interest or other amounts due on any or all of the Notes until the default is cured or all Senior Indebtedness is paid or satisfied in full. Furthermore, the commitments of the lenders under the New Credit Agreement to make further extensions of credit thereunder could be terminated. If the Company were unable to repay all amounts accelerated, the lenders could proceed against the Subsidiary Guarantors and the collateral securing the Company's and the Subsidiary Guarantors' obligations pursuant to the New Credit Agreement. If the indebtedness outstanding pursuant to the New Credit Agreement were to be accelerated, there can be no assurance that the assets of the Company would be sufficient to repay such indebtedness and the other indebtedness of the Company. The value of the Common Stock would be adversely affected if the Company were unable to repay such indebtedness. RISK-BASED PRODUCTS Revenues under risk-based contracts are the primary source of the Company's revenue from its behavioral managed healthcare business. Such revenues accounted for approximately 52% of the Company's total revenue and approximately 76% of its behavioral managed healthcare revenue in fiscal 1998. Under a risk-based contract, the Company assumes all or a portion of the responsibility for the cost of providing a full or specified range of behavioral healthcare treatment services to a specified beneficiary population in exchange, generally, for a fixed fee per member per month. In order for such contracts to be profitable, the Company must accurately estimate the rate of service utilization by beneficiaries enrolled in programs managed by the Company and control the unit cost of such services. If the aggregate cost of behavioral healthcare treatment services provided to a given beneficiary population in a given period exceeds the aggregate of the per member per month fees received by the Company with respect to the beneficiary population in such period, the Company will incur a loss with respect to such beneficiary population during such period. Furthermore, the Company may be required to pay during any period amounts with respect to behavioral healthcare treatment services provided to a given beneficiary population that exceed per member per month fees received with respect to such beneficiary population during the same period. There can be no assurance that the Company's assumptions as to service utilization rates and costs will accurately and adequately reflect actual utilization rates and costs, nor can there be any assurance that increases in behavioral healthcare costs or higher-than-anticipated utilization rates, significant aspects of which are outside the Company's control, will not cause expenses associated with such contracts to exceed the Company's revenue for such contracts. In addition, there can be no assurance that adjustments will not be required to the estimates, particularly those regarding cost of care, made in reporting historical financial results. See Note 1 to the audited historical consolidated financial statements of the Company included herein. The Company will attempt to increase membership in its risk-based products. If the Company is successful in this regard, the Company's exposure to potential losses from its risk-based products will also be increased. Furthermore, certain of such contracts and certain state regulations limit the profits that may be earned by the Company on risk-based business and may require refunds if the loss experience is more favorable than that originally anticipated. Such contracts and regulations may also require the Company or certain of its subsidiaries to reserve a specified amount of cash as financial assurance that it can meet its obligations under such contracts. As of September 30, 1998, the Company had restricted cash reserves of $89.2 million pursuant to such contracts and regulations. Such amounts will not be available to the Company for general corporate purposes. Furthermore, certain state regulations restrict the ability of subsidiaries that offer risk-based products to pay dividends to the Company. Certain state 23 regulations relating to the licensing of insurance companies may also adversely affect the Company's risk-based business. See "--Regulation." Although experience varies on a contract-by-contract basis, historically, the Company's risk-based contracts have been profitable. However, the degree of profitability varies significantly from contract to contract. For example, the Company's Medicaid contracts with governmental entities tend to have direct profit margins that are lower than the Company's other contracts. The most significant factor affecting the profitability of risk-based contracts is the ability to control direct service costs. The Company believes that it will be in a better position to control direct service costs as a result of the HAI, and Merit acquisitions. RELIANCE ON CUSTOMER CONTRACTS Approximately 69% of the Company's revenue in fiscal 1998 was derived from contracts with payors of behavioral healthcare benefits. The Company's behavioral managed healthcare contracts typically have terms of one to three years, and in certain cases contain renewal provisions providing for successive terms of between one and two years (unless terminated earlier). Substantially all of these contracts are immediately terminable with cause and many, including some of the Company's most significant contracts, are terminable without cause by the customer upon the provision of requisite notice and the passage of a specified period of time (typically between 60 and 180 days), or upon the occurrence of certain other specified events. The Company's ten largest behavioral managed healthcare customers accounted for approximately 55% of the Company's behavioral managed healthcare revenue for fiscal 1998. The Company's contract with the State of Tennessee to manage the behavioral healthcare benefits for the State's TennCare program represented approximately 15% of the Company's behavioral managed care revenue and approximately 10% of the Company's consolidated revenue in fiscal 1998. There can be no assurance that such contracts will be extended or successfully renegotiated or that the terms of any new contracts will be comparable to those of existing contracts. Loss of all of these contracts or customers would, and loss of any one of these customers could, have a material adverse effect on the Company. In addition, price competition in bidding for contracts can significantly affect the financial terms of any new or renegotiated contract. The Company's customers may reevaluate their contractual arrangements with the Company as a result of the consummation of the Transactions. DEPENDENCE ON GOVERNMENT SPENDING FOR MANAGED HEALTHCARE; POSSIBLE IMPACT OF HEALTHCARE REFORM A significant portion of the Company's managed care revenue is derived, directly or indirectly, from federal, state and local governmental agencies, including state Medicaid programs. Reimbursement rates vary from state to state, are subject to periodic negotiation and may limit the Company's ability to maintain or increase rates. The Company is unable to predict the impact on the Company's operations of future regulations or legislation affecting Medicaid or Medicare programs, or the healthcare industry in general, and there can be no assurance that future regulations or legislation will not have a material adverse effect on the Company. Moreover, any reduction in government spending for such programs could also have a material adverse effect on the Company. In addition, the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements, generally are conditioned upon financial appropriations by one or more governmental agencies, especially with respect to state Medicaid programs. These contracts generally can be terminated or modified by the customer if such appropriations are not made. Finally, some of the Company's contracts with federal, state and local governmental agencies, under both direct contract and subcontract arrangements, require the Company to perform additional services if federal, state or local laws or regulations imposed after the contract is signed so require, in exchange for additional compensation to be negotiated by the parties in good faith. Government and other third-party payors are generally seeking to impose lower reimbursement rates and to renegotiate reduced contract rates with service providers in a trend toward cost control. See "Industry--Areas of Growth" and "Business-- Business Strategy." In August 1997, Congress enacted the Budget Act. The Medicare-related provisions of the Budget Act are designed to reduce Medicare expenditures over the next five years by $115 billion, compared to 24 projected Medicare expenditures before adoption of the Budget Act. The Congressional Budget Office projected in July 1997 that $43.8 billion of the reductions would come from reduced payments to hospitals, $21.8 billion from increased enrollment in managed care plans and $11.7 billion from reduced payments to physicians and ambulatory care providers. The five-year savings in projected Medicare payments to physicians and hospitals would be achieved under the Budget Act by reduced fee-for-service reimbursement and by changes in managed care programs designed to increase enrollment of Medicare beneficiaries in managed care plans. The increase in Medicare enrollment in managed care plans would be achieved in part by allowing provider-sponsored organizations and preferred provider organizations to compete with Medicare HMOs for Medicare enrollees. The Medicaid-related provisions of the Budget Act are designed to achieve net federal Medicaid savings of $14.6 billion over the next five years and $56.4 billion over the next ten years. The Budget Act achieves federal Medicaid savings in three areas. First, two-thirds of the savings over the next ten years are attributable to limitations on federal matching payments to states for reimbursements to "disproportionate share" hospitals. The next largest source of federal savings is a provision allowing states to shift the cost of Medicaid deductibles and coinsurance requirements for low-income Medicaid beneficiaries from their Medicaid programs to physicians and other providers. Most of the remaining savings derive from the repeal of the "Boren Amendment" and other minimum payment guarantees for hospitals, nursing homes and community health centers that serve Medicaid patients. These changes may have an adverse effect on the Company if they result in reduced payment levels for providers of managed behavioral healthcare services. Prior to adoption of the Budget Act, the states were prohibited from requiring Medicaid recipients to enroll in managed care products that covered only Medicaid recipients. The Medicaid laws required that the states enroll Medicaid recipients in products that also covered a specific number of commercial enrollees. This requirement of the Medicaid laws was intended to limit the ability of the states to reduce coverage levels for Medicaid recipients below those offered to commercial enrollees. Under prior law, the Secretary of the United States Department of Health and Human Services (the "Department") could waive the prohibition. The Medicaid-related provisions of the Budget Act give states broad flexibility to require most Medicaid recipients to enroll in managed care products that only cover Medicaid recipients, without obtaining a waiver from the Secretary of the Department that was required under prior law. The Budget Act also allows states to limit the number of managed care organizations with which the state will contract to deliver care to Medicaid beneficiaries. These changes could have a positive impact on the Company's business, if they result in increased enrollment of Medicaid beneficiaries in managed care organizations and increased Medicaid spending on managed care. However, these changes also may have an adverse effect on the Company if a number of states decide to limit the number of managed care organizations with which they will contract and to select the organization solely on the basis of the cost of care, which could result in increased cost competition for state contracts. The Company cannot predict the effect of the Budget Act, or other healthcare reform measures that may be adopted by Congress or state legislatures, on its managed care operations and no assurance can be given that either the Budget Act or other healthcare reform measures will not have an adverse effect on the Company. REGULATION The managed healthcare industry and the provision of behavioral healthcare services are subject to extensive and evolving state and federal regulation. The Company is subject to certain state laws and regulations, including those governing: (i) the licensing of insurance companies, HMOs, PPOs, TPAs and companies engaged in utilization review and (ii) the licensing of healthcare professionals, including restrictions on business corporations from practicing, controlling or exercising excessive influence over behavioral healthcare services through the direct employment of psychiatrists or, in a few states, psychologists and other behavioral healthcare professionals. In addition, the Company is subject to certain federal laws as a result of the role the Company assumes in connection with managing its customers' employee benefit plans. The Company's managed care operations are also indirectly 25 affected by regulations applicable to the establishment and operation of behavioral healthcare clinics and facilities. In many states, entities that assume risk under contracts with licensed insurance companies or HMOs have not been considered by state regulators to be conducting an insurance or HMO business. As a result, the Company has not sought licensure as either an insurer or HMO in certain states. Regulators in some states, however, have determined that risk assuming activity by entities that are not themselves providers of care is an activity that requires some form of licensure. There can be no assurance that other states in which the Company operates will not adopt a similar view, thus requiring the Company to obtain additional licenses. Such additional licensure might require the Company to maintain minimum levels of deposits, net worth, capital, surplus or reserves, or limit the Company's ability to pay dividends, make investments or repay indebtedness. The imposition of these additional licensure requirements could increase the Company's cost of doing business or delay the Company's conduct or expansion of its business. Regulators may impose operational restrictions on entities granted licenses to operate as insurance companies or HMOs. For example, the California Department of Corporations ("DOC") imposed certain restrictions on the Company in connection with its issuance of an approval of the Company's acquisition of HAI, including restrictions on the ability of the California subsidiaries of HAI to fund the Company's operations in other states and on the ability of the Company to make certain operational changes with respect to HAI's California subsidiaries. The DOC imposed substantially identical restrictions on the Company in connection with the Company's acquisition of Merit. The Company does not believe such restrictions will materially impact its integration plan. In addition, utilization review and TPA activities conducted by the Company are regulated by many states, which states impose requirements upon the Company that increase its business costs. The Company believes that its TPA activities performed for its self-insured employee benefit plan customers are exempt from otherwise applicable state licensing or registration requirements based upon federal preemption under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), and has relied on this general principle in determining not to seek licensure for certain of its activities in many states. Existing case law is not uniform on the applicability of ERISA preemption with respect to state regulation of utilization review or TPA activities. There can be no assurance that additional licensure will not be required with respect to utilization review or TPA activities in certain states. See "Business-- Regulation--Insurance, HMO, and PPO Activities" and "--Utilization Review and Third-Party Administrator Activities." State regulatory agencies responsible for the administration and enforcement of the laws and regulations to which the Company's operations are subject have broad discretionary powers. A regulatory agency or a court in a state in which the Company operates could take a position under existing or future laws or regulations, or change its interpretation or enforcement practices with respect thereto, that such laws or regulations apply to the Company differently than the Company believes such laws and regulations apply or should be enforced. The resultant compliance with, or revocation of, or failure to obtain, required licenses and governmental approvals could result in significant alteration to the Company's business operations, delays in the expansion of the Company's business and lost business opportunities, any of which, under certain circumstances, could have a material adverse effect on the Company. See "Business--Regulation--General," "--Licensure," "--Insurance, HMO and PPO Activities" and "--Utilization Review and Third-Party Administrator Activities." The laws of some states limit the ability of a business corporation to directly provide, control or exercise excessive influence over behavioral healthcare services through the direct employment of psychiatrists, psychologists, or other behavioral healthcare professionals. In addition, the laws of some states prohibit psychiatrists, psychologists, or other healthcare professionals from splitting fees with other persons or entities. These laws and their interpretations vary from state to state and enforcement 26 by the courts and regulatory authorities may vary from state to state and may change over time. The Company believes that its operations as currently conducted are in material compliance with the applicable laws, however there can be no assurance that the Company's existing operations and its contractual arrangements with psychiatrists, psychologists and other healthcare professionals will not be successfully challenged under state laws prohibiting fee splitting or the practice of a profession by an unlicensed entity, or that the enforceability of such contractual arrangements will not be limited. The Company believes that it could, if necessary, restructure its operations to comply with changes in the interpretation or enforcement of such laws and regulations, and that such restructuring would not have a material adverse effect on its operations. Several states in which the Company does business have adopted, or are expected to adopt, "any willing provider" laws. Such laws typically impose upon insurance companies, PPOs, HMOs or other types of third-party payors an obligation to contract with, or pay for the services of, any healthcare provider willing to meet the terms of the payor's contracts with similar providers. Compliance with any willing provider laws could increase the Company's costs of assembling and administering provider networks and could, therefore, have a material adverse effect on its operations. The Company's managed care operations are also generally affected by regulations applicable to the operations of healthcare clinics and facilities. See "Charter Advantage--Regulation." INTEGRATION OF OPERATIONS As a result of the Company's acquisition of Merit and HAI, the Company is the largest provider of managed behavioral healthcare services in the United States, according to the enrollment data reported in OPEN MINDS. The Company's ability to operate its acquired behavioral managed healthcare businesses successfully depends on how well and how quickly it integrates the acquired businesses with its existing operations. The Company expects to achieve approximately $60.0 million of cost savings on an annual basis by September 30, 1999. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." However, as the Company implements the integration process, it may need to implement enhanced operational, financial and information systems and may require additional employees and management, operational and financial resources. There can be no assurance that the Company will be able to implement and maintain such operational, financial and information systems successfully or successfully obtain, integrate and utilize the required employees and management, operational and financial resources to achieve the successful integration of the acquired businesses with its existing operations. Failure to implement such systems successfully and to use such resources effectively could have a material adverse effect on the Company. Furthermore, implementing such operational, financial and information systems or obtaining such employees and management could reduce the cost savings the Company expects to achieve. See "Business-- Business Strategy." HIGHLY COMPETITIVE INDUSTRY The industry in which the Company conducts its managed care businesses is highly competitive. The Company competes with large insurance companies, HMOs, PPOs, TPAs, provider groups and other managed care companies. Many of the Company's competitors are significantly larger and have greater financial, marketing and other resources than the Company, and some of the Company's competitors provide a broader range of services. The Company may also encounter substantial competition in the future from new market entrants. Many of the Company's customers that are managed care companies may, in the future, seek to provide behavioral managed healthcare services to their employees or subscribers directly, rather than contracting with the Company for such services. See "Business--Competition." RISKS RELATED TO AMORTIZATION OF INTANGIBLE ASSETS The Company's total assets at September 30, 1998 reflect intangible assets of approximately $1.16 billion. At September 30, 1998, net intangible assets were 60.4% of total assets and 616.9% of total stockholders' equity. Intangible assets include goodwill of approximately $992.4 million, which is amortized over 25 to 40 years, and other identifiable intangible assets (primarily customer lists, provider networks and treatment protocols) of approximately 27 $165.2 million that are amortized over 4 to 30 years. The amortization periods used by the Company may differ from those used by other registrants. In addition, the Company may be required to shorten the amortization period for intangible assets in future periods based on the prospects of acquired companies. There can be no assurance that the value of such assets will ever be realized by the Company. The Company evaluates, on a regular basis, whether events and circumstances have occurred that indicate that all or a portion of the carrying value of intangible assets may no longer be recoverable, in which case a charge to earnings for impairment losses could become necessary. Any determination requiring the write-off of a significant portion of unamortized intangible assets would adversely affect the Company's results of operations. A write-off of intangible assets could become necessary if the anticipated undiscounted cash flows of an acquired company do not support the carrying value of long-lived assets, including intangible assets. At present, no evidence exists that would indicate impairment losses may be necessary in future periods. SUBORDINATION OF FRANCHISE FEES The Company owns a 50% equity interest in CBHS, from which it receives the Franchise Fees. The Franchise Fees have in the past represented a significant portion of the Company's earnings and cash flows. The Franchise Fees payable to the Company by CBHS are subordinated in right of payment to the $41.7 million initial annual base rent and 5% minimum escalator rent due to Crescent. The Company is required to provide certain services to CBHS under the Master Franchise Agreement whether or not CBHS pays the Franchise Fees. However, the Company has no obligation to contribute additional capital or make advances to CBHS. See "Charter Advantage -- Franchise Operations." If CBHS encounters a decline in earnings or financial difficulties, such amounts due from CBHS to Crescent will be paid before any Franchise Fees are paid. The remainder of CBHS's available cash will then be applied in such order of priority as CBHS may determine, to all other operating expenses of CBHS, including the current and accumulated Franchise Fees. The Company will be entitled to pursue all available remedies for breach of the Master Franchise Agreement, except that the Company does not have the right to take any action that could reasonably be expected to force CBHS into bankruptcy or receivership. As a result of the Crescent Transactions, the Company no longer controls the operations of the Psychiatric Hospital Facilities and other facilities operated by CBHS. Accordingly, factors that the Company does not control will likely influence the amount of Franchise Fees that the Company will realize in the future. Based on operational projections prepared by CBHS management for the fiscal year ended September 30, 1999, and on CBHS' results of operations through September 30, 1998, the Company believes that CBHS will be unable to pay the full amount of the Franchise Fees it is contractually obligated to pay the Company during fiscal 1999. CBHS paid $40.6 million of Franchise Fees to the Company during fiscal 1998. The Company estimates that CBHS will be able to pay $0 to $15.0 million of Franchise Fees in fiscal 1999. Based on the amount of unpaid Franchise Fees ($38 million as of September 30, 1998), the Company exercised its limited management rights available to it under the Master Franchise Agreement and, with CBHS's Board Support, made operational and management changes aimed at improving profitability and cash flows at CBHS. The Company has since restored all management rights to the CBHS Board. See "Charter Advantage--Franchise Operations." The Company's relationship with CBHS and the business of CBHS are described elsewhere herein. Such information is relevant to an understanding of the factors having a bearing on the Company's receipt of Franchise Fees from CBHS. PROFESSIONAL LIABILITY; INSURANCE The management and administration of the delivery of behavioral managed healthcare services, like other healthcare services, entail significant risks of liability. The Company is regularly subject to lawsuits alleging malpractice and related legal theories, some of which involve situations in which participants in the Company's programs have committed suicide. The Company is also subject to claims of professional liability for alleged negligence in performing utilization 28 review activities, as well as for acts and omissions of independent contractors participating in the Company's third-party provider networks. The Company is subject to claims for the costs of services denied. There can be no assurance that the Company's procedures for limiting liability have been or will be effective, or that one or more lawsuits will not have a material adverse effect on the Company in the future. The Company carries professional liability insurance, subject to certain deductibles. There can be no assurance that such insurance will be sufficient to cover any judgments, settlements or costs relating to present or future claims, suits or complaints or that, upon expiration thereof, sufficient insurance will be available on favorable terms, if at all. If the Company is unable to secure adequate insurance in the future, or if the insurance carried by the Company is not sufficient to cover any judgments, settlements or costs relating to any present or future actions or claims, there can be no assurance that the Company will not be subject to a liability that could have a material adverse effect on the Company. See "Business-Insurance." The Company has certain liabilities relating to the self-insurance program it maintained with respect to its provider business prior to the Crescent Transactions. See Note 13 to the Company's audited historical consolidated financial statements included elsewhere herein. 29 CHARTER ADVANTAGE OVERVIEW On June 17, 1997, the Company consummated the Crescent Transactions, pursuant to which, among other things, it sold the Psychiatric Hospital Facilities to Crescent. In addition, the Company and COI, an affiliate of Crescent, formed a joint venture known as CBHS to operate the Psychiatric Hospital Facilities and certain other facilities transferred by the Company to CBHS. The Company and COI each own 50% of the equity interest of CBHS. The Company obtained its equity interest by contributing approximately $5 million of net assets, including five leased psychiatric hospitals, to CBHS. In fiscal 1997, subsequent to the initial capitalization of CBHS, the Company and COI each contributed an additional $17.5 million to the capital of CBHS. The Company has no obligation to make additional contributions to the capital of CBHS. The Company accounts for its 50% investment in CBHS under the equity method of accounting. In connection with the Crescent Transactions, the Company received approximately $417.2 million in cash (before costs of approximately $16.0 million) and warrants for the purchase of 2.5% of COI's common stock, exercisable over 12 years. The Company also issued 1,283,311 warrants to purchase shares of the Company's Common Stock to each of Crescent and COI at an exercise price of $30 per share. In related agreements, Crescent and CBHS entered into the facilities lease described below and the Company, CBHS and the Psychiatric Hospital Facilities and other facilities transferred by the Company to CBHS entered into the franchise agreements described below. Following the consummation of the Crescent Transactions, the Company formed a new business unit, "Charter Advantage," to franchise the "CHARTER" system of behavioral healthcare to operators of behavioral healthcare facilities. Currently, its primary customer is CBHS. The following discussion of Charter Advantage's operations, CBHS and the psychiatric hospital industry in general is relevant to an assessment of the factors having a bearing on CBHS's ability to pay Franchise Fees to the Company, the value of the Company's interest in the equity of CBHS and the future business prospects of CBHS. FRANCHISE OPERATIONS FRANCHISE AGREEMENTS. Charter Advantage franchises the "CHARTER" System of behavioral healthcare to the Psychiatric Hospital Facilities and other facilities operated by CBHS. Each facility has entered into a separate Franchise Agreement with Charter Advantage. Each franchisee is granted the right to engage in the business of providing behavioral healthcare utilizing the "CHARTER" System in a defined territory. Each franchisee is authorized to conduct a "Hospital/RTC Based Behavioral Healthcare Business," which is defined as the business of the operation of an acute care psychiatric hospital, part of an acute care general hospital operating an acute care psychiatric unit, a behavioral healthcare residential treatment center, a part of a facility operating a behavioral healthcare residential treatment center, or other similar facility providing 24-hour behavioral healthcare and the delivery of behavioral healthcare from such facility or other affiliated facilities; such behavioral healthcare to include inpatient hospitalization, partial hospitalization programs, outpatient therapy, intensive outpatient therapy, residential treatment, ambulatory detoxification, behavioral modification programs and related services. The "CHARTER" System is a system for the operation of Hospital/RTC Based Behavioral Healthcare Businesses under the "CHARTER" names and marks, and includes the right to use computer software, treatment programs and procedures, quality standards, quality assessment methods, performance improvement and monitoring programs, as well as advertising and marketing assistance, promotional materials, consultation and other matters relating to the operation of Hospital/RTC Based Behavioral Healthcare Businesses. The rights granted under each franchise agreement relate solely to a defined territory. The rights are non-exclusive except that Charter Advantage may not grant a franchise for, or itself operate, a facility located within a franchisee's territory using the "CHARTER" System. Charter Advantage, however, may 30 grant franchises or licenses to individual physicians, psychologists or other mental healthcare professionals, to operate businesses for the delivery of behavioral healthcare utilizing the "CHARTER" System at facilities in the franchisee's territory other than at an in-patient facility. Charter Advantage also reserves the right to grant franchises to others to operate behavioral healthcare businesses utilizing the "CHARTER" System other than in the franchisee's territory and to otherwise use and grant to others the right to use the "CHARTER" name or any other name for other businesses. In addition, Charter Advantage reserves the right to: (i) provide behavioral healthcare services incidental to the managed behavioral healthcare businesses or any other business the principal purpose of which is not the operation of a Hospital/RTC Based Behavioral Healthcare Business and (ii) pursuant to contracts with federal, state and local governmental agencies, provide health and human services, including behavioral healthcare services, to the mentally retarded, the developmental disabled, the elderly, persons under the control or supervision of criminal/juvenile systems and other designated populations. During the term of each franchise agreement, Charter Advantage provides franchisees with: (i) advertising and marketing assistance, including consultation, access to media buying programs and access to broadcast and other advertising materials produced by Charter Advantage; (ii) risk management services, including risk financial planning, loss control and claims management; (iii) outcomes monitoring; (iv) national and regional contracting services; and (v) consultation by telephone or at Charter Advantage's offices with respect to matters relating to the franchisee's business in which Charter Advantage has expertise, including reimbursement, government relations, clinical strategies, regulatory matters, strategic planning and business development. FRANCHISE FEES; SUBORDINATION. The Company and CBHS are parties to a Master Franchise Agreement pursuant to which CBHS pays the Company annual Franchise Fees for granting the right to utilize the "CHARTER" System to the facilities operated by CBHS. CBHS is obligated under the Master Franchise Agreement for annual Franchise Fees equal to the greater of (i) $78.3 million, subject to increases for inflation, and (ii) $78.3 million, plus 3% of CBHS's gross revenues over $1 billion and not in excess of $1.2 billion and 5% of CBHS' gross revenues over $1.2 billion. The Company, CBHS and Crescent have entered into a Subordination Agreement pursuant to which the Franchise Fees are subordinated to base rent and minimum escalator rent under the Facilities Lease between Crescent and CBHS with respect to the facilities operated by CBHS. Based on operational projections prepared by CBHS management for the fiscal year ended September 30, 1999, and on CBHS' results of operations through September 30, 1998, the Company believes that CBHS will be unable to pay the full amount of the Franchise Fees it is contractually obligated to pay the Company during fiscal 1999. CBHS paid $40.6 million of Franchise Fees to the Company during fiscal 1998. The Company estimates that CBHS will be able to pay $0 to $15.0 million of Franchise Fees in fiscal 1999. If the aggregate amount of Franchise Fees not paid exceeds $6.0 million, but is less than $18.0 million, the Company has the right to prohibit CBHS from paying any incentive compensation to CBHS's management and may prohibit the vesting of any equity in CBHS to which management of CBHS may be entitled during the period when Franchise Fees remain unpaid. If the aggregate amount of Franchise Fees not paid exceeds $18.0 million, but is less than $24.0 million, the Company has the right to prohibit any salary increases for key personnel of CBHS, to prohibit any additional hiring by CBHS and to prohibit CBHS from making any hospital acquisitions or entering into any hospital joint ventures directly or indirectly during such period. If the aggregate amount of Franchise Fees not paid exceeds $24.0 million, the Company may require CBHS to reduce by 5% the expenses approved in its current budget, to seek approval of expenditures, including capital and operating expenditures, on a monthly basis, and to transfer control and management of CBHS and the Psychiatric Hospital Facilities to the Company. Notwithstanding the foregoing, the Company does not have the right to take any action, in connection with the exercise of remedies against CBHS, that could reasonably be expected to force CBHS into bankruptcy or receivership, or similar proceedings, with respect to any dispute that may arise among the parties with respect to payment or nonpayment of the Franchise Fees. 31 Based on the amount of unpaid Franchise Fees ($38 million as of September 30, 1998), the Company exercised certain of the limited management rights available to it under the Master Franchise Agreement and, with CBHS' Board support, made operational and management changes aimed at improving profitability and cash flows at CBHS. The Company has since restored all management rights to the CBHS Board. The initial term of the Facilities Lease is twelve years. CBHS has the right to renew the lease for four additional terms of five years each. The base rent for the first year of the initial term was $41.7 million, which increases each year during the initial term by five percent compounded annually. Notwithstanding the foregoing, when accrued and unpaid Franchise Fees, including interest thereon, if any, equal or exceed $15.0 million, then CBHS's available cash is thereafter first applied to base rent and minimum escalator rent, under the Facilities Lease. The remainder of CBHS's available cash may then be applied in such order of priority as CBHS may determine, in the reasonable discretion of its Board of Directors (half the members of which are appointed by the Company), to all other operating expenses of CBHS, including, without limitation, the current and accumulated Franchise Fees, and any other operating expenses. CBHS OVERVIEW. CBHS is the nation's largest operator of acute-care psychiatric hospitals and other behavioral care treatment facilities. CBHS's psychiatric hospitals are located in well-populated urban and suburban locations in 32 states. Most of CBHS's hospitals offer a full continuum of behavioral care in their service area. The continuum includes inpatient hospitalization, partial hospitalization, intensive outpatient services and, in some markets, residential treatment services. CBHS's hospitals provide structured and intensive treatment programs for mental health and alcohol and drug dependency disorders in children, adolescents and adults. The specialization of programs enables the clinical staff to provide care that is specific to the patient's needs and facilitates monitoring of the patient's progress. A typical treatment program at a CBHS facility integrates physicians and other patient-care professionals with structured activities, providing patients with testing, adjunctive therapies (occupational, recreational and other), group therapy, individual therapy and educational programs. A treatment program includes one or more of the types of treatment settings provided by CBHS's continuum of care. For those patients who do not have a personal psychiatrist or other specialist, the hospital refers the patient to a member of its medical staff. A significant portion of hospital admissions are provided by referrals from former patients, local marketplace advertising, managed care organizations and physicians. Professional relationships are an important aspect of the ongoing business of a behavioral care facility. Management believes the quality of CBHS's treatment programs, staff employees and physical facilities are important factors in maintaining good professional relationships. CBHS's hospitals work closely with mental health professionals, non-psychiatric physicians, emergency rooms and community agencies that come in contact with individuals who may need treatment for mental illness or substance abuse. A portion of the Company's marketing efforts is directed at increasing general awareness of mental health and addictive disease and the services offered by the Company's franchisees. 32 INDUSTRY TRENDS. CBHS's hospitals have been adversely affected by factors influencing the entire psychiatric hospital industry. Such factors include: (i) the imposition of more stringent length of stay and admission criteria and other cost containment measures by payors; (ii) the failure of reimbursement rate increases from certain payors that reimburse on a per diem or other discounted basis to offset increases in the cost of providing services; (iii) an increase in the percentage of business that CBHS derives from payors that reimburse on per diem or other discounted basis; (iv) a trend toward higher deductibles and co-insurance for individual patients; (v) a trend toward limited employee behavioral health benefits, such as reductions in annual and lifetime limits on behavioral health coverage; and (vi) pricing pressure related to an increasing rate of claims denials by third party payors. In response to these conditions, the Company believes that CBHS will (i) strengthen controls to minimize costs and capital expenditures; (ii) review its portfolio of hospitals and sell, close or lease hospitals or consolidate operations in certain locations; (iii) develop strategies to increase outpatient services and partial hospitalization programs to meet the demands of the marketplace; (iv) implement programs to contest third party denials relating to valid pre-certified treatment and admissions; and (v) renegotiate contracts with managed care organizations at increased rates. SOURCES OF REVENUE. Payments are made to CBHS by patients, by insurance companies and self-insured employers, by the federal and state governments under Medicare, Medicaid, CHAMPUS and other programs and by HMOs, PPOs and other managed care programs. Amounts received from most payors are less than the hospital's established charges. COMPETITION. Each of CBHS's hospitals competes with other hospitals, some of which are larger and have greater financial resources. Some competing hospitals are owned and operated by governmental agencies, others by nonprofit organizations supported by endowments and charitable contributions and others by proprietary hospital corporations. The hospitals frequently draw patients from areas outside their immediate locale and, therefore, CBHS's hospitals may, in certain markets, compete with both local and distant hospitals. In addition, CBHS's hospitals compete not only with other psychiatric hospitals, but also with psychiatric units in general hospitals, and outpatient services provided by CBHS compete with private practicing mental health professionals, publicly funded mental health centers and partial hospitalization and other intensive outpatient services programs and facilities. The competitive position of a hospital is, to a significant degree, dependent upon the number and quality of physicians who practice at the hospital and who are members of its medical staff. The Company believes that CBHS competes effectively with respect to the aforementioned factors. However, there can be no assurance that CBHS will be able to compete successfully in the provider business in the future. Competition among hospitals and other healthcare providers for patients has intensified in recent years. During this period, hospital occupancy rates for inpatient behavioral care patients in the United States have declined as a result of cost containment pressures, changing technology, changes in reimbursement, changes in practice patterns from inpatient to outpatient treatment and other factors. In recent years, the competitive position of hospitals has been affected by the ability of such hospitals to obtain contracts with PPO's, HMO's and other managed care programs to provide inpatient and other services. Such contracts normally involve a discount from the hospital's established charges, but provide a base of patient referrals. These contracts also frequently provide for pre-admission certification and for concurrent length of stay reviews. The importance of obtaining contracts with HMO's, PPO's and other managed care companies varies from market to market, depending on the individual market strength of the managed care companies. In certain states, certificate of need laws place limitations on CBHS's and its competitors' ability to build new hospitals and to expand existing hospitals and services. CAUTIONARY STATEMENTS--CBHS The following factors are relevant to an understanding of the risks associated with CBHS's business and the ability of CBHS to pay Franchise Fees to the Company. 33 POTENTIAL REDUCTIONS IN REIMBURSEMENT BY THIRD-PARTY PAYORS AND CHANGES IN HOSPITAL PAYOR MIX. CBHS's hospitals have been adversely affected by certain factors influencing the entire psychiatric hospital industry. See"--Industry Trends" Any of these factors may result in reductions in the amounts that CBHS's hospitals can expect to collect per patient day for services provided or the number of equivalent patient days. Changes in the mix of CBHS's patients among the private-pay, Medicare and Medicaid categories, and among different types of private-pay sources, could significantly affect the profitability of CBHS's hospital operations. Moreover, there can be no assurance that payments under governmental and private third-party payor programs will remain at levels comparable to present levels or will, in the future, be sufficient to cover the costs of providing care to patients covered by such programs. GOVERNMENTAL BUDGETARY CONSTRAINTS AND HEALTHCARE REFORM. In the 1995 and 1996 sessions of the United States Congress, the focus of healthcare legislation was on budgetary and related funding mechanism issues. Both the Congress and the Clinton Administration have made proposals to reduce the rate of increase in projected Medicare and Medicaid expenditures and to change funding mechanisms and other aspects of both programs. The Budget Act, which was signed into law by President Clinton in August 1997, reduces federal spending by an estimated $140 billion. The majority of the spending reduction will come from Medicare cuts of $115.0 billion. The Congressional Budget Office projected in July 1997 that $43.8 billion of the reductions would come from reduced payments to hospitals, $21.8 billion from increased enrollment in managed care plans and $11.7 billion from reduced payments to physicians and ambulatory care providers. The five-year savings in projected Medicare payments to physicians and hospitals would be achieved under the Budget Act by reduced fee-for-service reimbursement and by changes in managed care programs designed to increase enrollment of Medicare beneficiaries in managed care plans. The increase in Medicare enrollment in managed care plans would be achieved in part by allowing provider-sponsored organizations and preferred provider organizations to compete with Medicare HMOs for Medicare enrollees. The Medicaid-related provisions of the Budget Act are designed to achieve net federal Medicaid savings of $14.6 billion over the next five years and $56.4 billion over the next ten years. The Budget Act achieves Federal Medicaid savings in three areas. First, two-thirds of the savings over the next ten years are attributable to limitations on federal matching payments to states for reimbursements to "disproportionate share" hospitals. The next largest source of federal savings is a provision allowing states to shift the cost of Medicaid deductibles and coinsurance requirements for low-income Medicaid beneficiaries from their Medicaid programs to physicians and other providers. Most of the remaining savings derive from the repeal of the "Boren Amendment" and other minimum payment guarantees for hospitals, nursing homes and community health centers that service Medicaid patients. CBHS management estimates that the Budget Act will reduce the amount of revenue and earnings that CBHS will receive for the treatment of Medicare and Medicaid patients. CBHS management estimates that such reductions approximated $10.0 million in fiscal 1998, and due to the phase in effects of the bill, will approximate $15.0 million in subsequent fiscal years. A number of states in which CBHS has operations have either adopted or are considering the adoption of healthcare reform proposals of general applicability or Medicaid reform proposals. Where adopted, these state reform laws have often not yet been fully implemented. The Company cannot predict the effect of these state healthcare reform proposals on CBHS's operations. The Company cannot predict the effect of other healthcare reform measures that may be adopted by Congress on the operations of CBHS and no assurance can be given that other federal healthcare reform measures will not have an adverse effect on CBHS. DEPENDENCE ON HEALTHCARE PROFESSIONALS. Physicians traditionally have been the source of a significant portion of the patients treated at CBHS's hospitals. Therefore, the success of CBHS's hospitals is dependent in part on the number and quality of the physicians on the medical staffs of the 34 hospitals and their admission practices. A small number of physicians account for a significant portion of patient admissions at some of CBHS's hospitals. There can be no assurance that CBHS can retain its current physicians on staff or that additional physician relationships will be developed in the future. Furthermore, hospital physicians generally are not employees of CBHS and, in general, CBHS does not have contractual arrangements with hospital physicians restricting the ability of such physicians to practice elsewhere. POTENTIAL GENERAL AND PROFESSIONAL LIABILITY. In recent years, physicians, hospitals, and other healthcare professionals and providers have become subject to an increasing number of lawsuits alleging medical malpractice and related legal theories. Many of these lawsuits involve large claims and substantial defense costs. CBHS maintains a general and hospital professional liability insurance policy with an unaffiliated insurer. In addition, CBHS' hospitals require all physicians on each hospital's medical staff to maintain professional liability coverage. Management believes that its coverage limits are adequate, however, there can be no assurance that a future claim or claims will not exceed the limits of these existing insurance policies or that a loss or losses for which insurance is unavailable will not have a material adverse effect on CBHS. GOVERNMENT REGULATION. The operation of psychiatric hospitals and other behavioral healthcare facilities and the provision of behavioral healthcare services are subject to extensive federal, state and local laws and regulations. These laws and regulations provide for periodic inspections or other reviews by state agencies, the Department and CHAMPUS to determine compliance with their respective standards of medical care, staffing, equipment and cleanliness necessary for continued licensing or participation in the Medicare, Medicaid or CHAMPUS programs. The admission and treatment of patients at psychiatric hospitals is also subject to substantial state regulation relating to involuntary admissions, confidentiality of patient medical information, patients' rights and federal regulation relating to confidentiality of medical records of substance abuse patients. CBHS is also subject to state certificate of need laws that regulate the construction of new hospitals and the expansion of existing hospital facilities and services. CBHS also is subject to federal and state laws that govern financial and other arrangements between healthcare providers. Such laws include the illegal remuneration provisions of the Social Security Act (the "Anti-Kickback Statute") and the physician self-referral provisions of the Omnibus Budget Reconciliation Act of 1993 ("Stark II") and state illegal remuneration and self-referral statutes and regulations that prohibit payments in exchange for referrals and referrals by physicians or other healthcare providers to persons or entities with which the physician or other healthcare provider has a financial relationship. The Medicare and Medicaid Patient and Program Protection Act of 1987 expanded the authority of the Department to exclude from participation in the Medicare and Medicaid programs those individuals and entities that engage in defined prohibited activities. The Department's exclusion authority was recently expanded under HIPAA and the Budget Act, which added additional grounds for exclusion, established minimum exclusion periods for certain offenses and expanded the scope of the exclusion to include all federal health care programs. The Department also has the authority to impose civil monetary penalties for certain prohibited activities. HIPAA increased the amount of authorized penalties from $2,000 per item or service claimed to $10,000 per item or service claimed, and increased the assessment to which a person may be subject in lieu of damages from two times the amount claimed for each item or service to three times the amount claimed. Both HIPAA and the Budget Act expanded the Department's authority to impose civil monetary penalties by adding additional activities for which civil monetary penalties may be imposed. 35 Provisions contained in HIPAA and the Budget Act also created new criminal healthcare fraud offenses that are applicable to both government programs and private health insurance plans and added new programs and increased funding for fraud and abuse detection and prevention. CHAMPUS regulations also authorize the exclusion of providers from the CHAMPUS program, if the provider has committed fraud or engaged in certain "abusive practices," which are defined broadly to include, among other things, the provision of medically unnecessary services, the provision of care of inferior quality and the failure to maintain adequate medical or financial records. State regulatory agencies responsible for the administration and enforcement of the laws and regulations to which CBHS' operations are subject have broad discretionary powers. A regulatory agency or a court in a state in which CBHS operates could take a position under existing or future laws or regulations, or change its interpretation or enforcement practices with respect thereto, that such laws or regulations apply to CBHS differently than CBHS believes such laws and regulations apply or should be enforced. The resultant compliance with, or revocation of, or failure to obtain, required licences and governmental approvals could result in significant alteration to CBHS' business operations, delays in the expansion of CBHS' business and lost business opportunities, any of which, under certain circumstances, could have a material adverse effect on CBHS. INTELLECTUAL PROPERTY The Company owns certain intellectual property which is important to its franchise operation. The Company has registered as trademarks both the "CHARTER" name and "800-CHARTER." The Company also owns the "Charter System," which is a system for the operation of businesses specializing in the delivery of behavioral healthcare under the "CHARTER" names and marks. The Charter System includes treatment programs and procedures, quality standards, quality assessment methods, performance improvement and monitoring programs, advertising and marketing assistance, promotional materials, consultation and other matters related to the operation of businesses specializing in the delivery of behavioral healthcare. EXECUTIVE OFFICERS OF THE REGISTRANT
NAME AGE POSITION - --------------------------------------- --- ------------------------------------------------------------------ Henry T. Harbin M.D.................... 51 President, Chief Executive Officer and Director Craig L. McKnight...................... 47 Executive Vice President and Chief Financial Officer John J. Wider, Jr...................... 51 President and Chief Operating Officer of Magellan Behavorial Health Clarissa C. Marques, Ph.D.............. 46 Executive Vice President of Clinical and Quality Management Gregory T. Torres...................... 48 President and Chief Executive Officer of Mentor
HENRY T. HARBIN, M.D. became President, Chief Executive Officer and a Director of the Company on March 18, 1998. Dr. Harbin served as President and Chief Executive Officer of Green Spring from 1994 to 1998. Dr. Harbin served as Executive Vice President of the Company from 1995 until becoming President and Chief Executive Officer of the Company. Dr. Harbin served as Executive Vice President and Chief Clinical Officer of Green Spring during 1993 and 1994. CRAIG L. MCKNIGHT became Executive Vice President and Chief Financial Officer of the Company in October 1995. From March 1995 through September 1995, he served as Executive Vice President-- Office of the President and Chairman. Mr. McKnight practiced public accounting with Coopers & Lybrand L.L.P. from 1985 through 1995. Coopers & Lybrand L.L.P. is an international accounting firm that provides accounting and auditing services, tax services and consulting services. As an audit partner at Coopers & Lybrand L.L.P., from 1985 to 1995, Mr. McKnight had responsibility for a wide range of hospital and managed care engagements, as well as assisting clients with formulating financing options, 36 financial restructurings and the purchase and sale of health plans and facilities. Mr. McKnight is also a director of OrthAlliance, Inc. JOHN J. WIDER, JR. has served as President and Chief Operating Officer of Magellan Behavorial Health ("MBH") since March 1998. Mr. Wider served as Executive Vice President and Chief Operating Officer of Green Spring from 1997 to 1998. Mr. Wider was President and General Manager for Cigna Healthcare Corporation's ("Cigna") Mid-Atlantic region from 1996 to 1997. Mr. Wider served as Area Operations Officer for Cigna during 1995 and 1996 and as Vice President of Sales of Cigna's Midwest region from 1993 to 1995. CLARISSA C. MARQUES, PH.D. has served as Executive Vice President of Clinical and Quality Management since March 1998. Dr. Marques served as Executive Vice President and Chief Clinical Officer of Green Spring during 1997 and 1998. Dr. Marques served as Senior Vice President of Green Spring from 1992 to 1997. GREGORY T. TORRES is President and Chief Executive Officer of Mentor, positions he has held since 1996. Mr. Torres served as Senior Vice President for Public Affairs of Mentor from 1992 until 1996. EMPLOYEES OF THE REGISTRANT At September 30, 1998, the Company had approximately 11,600 full-time and part-time employees, which excludes CBHS. The Company believes it has satisfactory relations with its employees. INTERNATIONAL OPERATIONS The Company owns and operates two psychiatric hospitals in London, England (a 45-bed hospital and a 78-bed hospital) and a 69-bed psychiatric hospital in Nyon, Switzerland. The Company's international hospital operations are not material to the Company's overall operations. ITEM 2. PROPERTIES GENERAL. The Company's principal executive offices are located in Atlanta, Georgia; the lease for the Company's headquarters expires in 1999. BEHAVORIAL MANAGED CARE BUSINESS. MBH leases its 190 offices with terms expiring between 1998 and 2008. MBH's headquarters are leased and are located in Columbia, Maryland. The lease for MBH Headquarters expires in 2004. HUMAN SERVICES BUSINESS. Mentor leases its 174 offices with terms expiring between 1998 and 2005. Mentor's headquarters are leased and are located in Boston, Massachusetts with the lease expiring in 2002. SPECIALITY MANAGED CARE BUSINESS. Allied and CMR lease their 11 offices with terms expiring between 1999 and 2004. HEALTHCARE FRANCHISING AND HEALTHCARE PROVIDER BUSINESS. The Company has an ownership interest in six hospital-based Joint Ventures that operate or manage 10 behavioral healthcare facilities ("JV Hospitals"). The Joint Ventures own six of the JV Hospitals and lease two of the JV Hospitals from the respective Joint Venture owners. The remaining two JV Hospitals are owned by the respective Joint Venture owners. The Company owns two behavioral healthcare facilities in the United Kingdom and one in Switzerland. One of the United Kingdom facilities is subject to a land-lease that expires in 2069. 37 ITEM 3. LEGAL PROCEEDINGS The management and administration of the delivery of behavioral managed healthcare services, and the direct provision of behavioral health treatment services, entail significant risks of liability. In recent years, the Company and its respective network providers have been subject to a number of actions and claims alleging malpractice, professional negligence and other related legal theories. Many of these actions and claims seek substantial damages and therefore require the defendant to incur significant fees and costs related to their defense. From time to time, the Company is subject to various actions and claims arising from the acts or omissions of its employees, network providers or other parties. In the normal course of business, the Company receives reports relating to suicides and other serious incidents involving patients enrolled in its programs. Such incidents may give rise to malpractice, professional negligence and other related actions and claims against the Company or its employees and network providers. As the number of lives covered by the Company and such other entities grows, the number of providers under contract increases and the nature and scope of services provided by them in their respective managed care and EAP businesses expands, actions and claims against such entities (and, in turn, possible legal liability) predicated on malpractice, professional negligence or other related legal theories can be expected to increase. See "Cautionary Statements--Professional Liability; Insurance." To the extent customers of the Company are entitled to indemnification under their contracts with the relevant entity relating to liabilities they incur arising from the operation of the relevant entity's programs, such indemnification may not be covered under the relevant entity's insurance policies. In addition, to the extent that certain actions and claims seek punitive and compensatory damages arising from alleged intentional misconduct by the Company, such damages, if awarded, may not be covered, in whole or in part, by the relevant entity's insurance policies. In the ordinary course of business, such entities are also subject to actions and claims with respect to their respective employees, network providers and suppliers of services. The Company does not believe that any pending action against it will have a material adverse effect on the Company. To date, claims and actions against the Company alleging professional negligence have not resulted in material liabilities; however, there can be no assurance that pending or future actions or claims for professional liability (including any judgments, settlements or costs associated therewith) will not have a material adverse effect on the Company. See "--Insurance" and "Risk Factors--Professional Liability; Insurance." From time to time, the Company receives notifications from and engages in discussions with various governmental agencies concerning its respective businesses and operations. As a result of these contacts with regulators, the Company in many instances implements changes to its operations, revises its filings with such agencies and/or seeks additional licenses to conduct its business. In recent years, in response to governmental agency inquiries or discussions with regulators, the Company has determined to seek licensure as a single service HMO, TPA or utilization review agent in one or more jurisdictions. In October 1996, a group of eight plaintiffs purporting to represent an uncertified class of psychiatrists, psychologists and clinical social workers brought an action under the federal antitrust laws in the United States District Court for the Southern District of New York against nine behavioral health managed care organizations, including Merit, CMG, Green Spring and HAI (collectively, the "Defendants"), entitled Edward M. Stephens, Jose A. Yaryura-Tobias, Judith Green, Ph.D., Fugen Neziroglu Ph.D., Ona Robinson, Ph.D., Laurie A. Baum, C.S.W., Agnes Wohl, C.S.W., and The On-Step Institute For Mental Health Research Inc., individually and on behalf of all others similarly situated v. CMG Health, FHC Options, Inc., Foundation Health PsychCare Services, Inc., Green Spring Health Services, Inc., Human Affairs International, Inc., Merit Behavioral Care Corp., MCC Behavioral Care Inc., United Behavioral Systems, Inc., and Value Behavioral Health, Inc., 96 Civ. 7798 (KMW) (the "Stephens Case"). The 38 complaint alleges that the Defendants violated Section 1 of the Sherman Act by engaging in a conspiracy to fix the prices at which the Defendants purchase services from mental healthcare providers such as the plaintiffs. The complaint further alleges that the Defendants engaged in a group boycott to exclude mental healthcare providers from the Defendants' networks in order to further the goals of the alleged conspiracy. The complaint also challenges the propriety of the Defendants' capitation arrangements with their respective customers, although it is unclear from the complaint whether the plaintiffs allege that the Defendants unlawfully conspired to enter into capitation arrangements with their respective customers. The complaint seeks treble damages against the Defendants in an unspecified amount and a permanent injunction prohibiting the Defendants from engaging in the alleged conduct which forms the basis of the complaint, plus costs and attorneys' fees. On May 12, 1998, the District Court granted the Defendants' motion to dismiss the complaint with prejudice. On May 27, 1998, the plaintiffs filed a notice of appeal of the District Court's dismissal of their complaint with the United States Second Circuit Court of Appeals. On November 16, 1998, the Second Circuit court issued a Summary Order affirming the District Court's decision. The plaintiffs have not filed a petition for rehearing, and the time allotted for doing so has expired. The plaintiffs have 90 days from the date of judgment to file a petition for certiorari with the United States Supreme Court. The plaintiffs have not indicated whether they will file such a petition. If no petition is filed, or if a filed petition is denied, this matter will have been concluded. The Company does not believe this matter will have a material adverse affect on its financial position or results of operations. On May 26, 1998, the counsel representing the plaintiffs in the Stephens Case filed an action in the United States District Court for the District of New Jersey on behalf of a group of thirteen plaintiffs who also purport to represent an uncertified class of psychiatrists, psychologists and clinical social workers. This complaint alleges substantially the same violations of federal antitrust laws by the same nine managed behavioral healthcare organizations that are the defendants in the Stephens Case. This claim is entitled Russell M. Holstein, Ph.D., Barbara I. Holstein, Ed.D., Tijen B. Eron, Ph.D., Roger Swift, C.S.W., Chuck Stannard, C.S.W., R. Anthony Moore, M.D., Maria T. Lymberis, M.D., the American Association of Private Practice Psychiatrists, Inc., the Black Psychiatrists of America, Inc. and the New Jersey Society for Clinical Social Work, Inc., individually and on behalf of their members and all others similarly situated, v. Green Spring Health Services, Inc., Human Affairs International, Inc., Merit Behavioral Care Corp., CMG Health, Inc., Options Healthcare, Inc., Value Behavioral Health, Inc., United Behavioral Health, Inc., Foundation Health Systems, Inc., and MCC Behavioral Care, Inc. The Defendants believe the factual and legal issues involved in this case are substantially similar to those involved in the Stephens Case. The Defendants intend to vigorously defend themselves in this matter. On August 28, 1998, the Defendants filed a joint motion requesting that the case be: (1) transferred to the Southern District of New York; (2) alternatively, that all proceedings be stayed pending the Second Circuit's determination of the Stephens appeal, given the res judicata effect of the Stephens dismissal; and (3) if the Court proceeds with the case, that the complaint be dismissed for failure to state a claim for substantially the same reasons as in Stephens. The plaintiffs have opposed this motion, which was argued on November 23, 1998. At the conclusion of the November 23 hearing, the court ruled that the case should be transferred to the Southern District of New York. The Defendants' motion to dismiss was deemed withdrawn without prejudice to its resubmission in the Southern District. The plaintiffs have stated that they intend to appeal the courts transfer order to the United States District Court for the District of New Jersey. The Company does not believe this matter will have a material adverse affect on its financial position or results of operations. The healthcare industry is subject to numerous laws and regulations. The subjects of such laws and regulations include, but are not limited to, matters such as licensure, accreditation, government healthcare program participation requirements, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Recently, government activity has increased with respect to investigations and/or allegations concerning possible violations of fraud and abuse and false claims statutes and/or regulations by healthcare providers. Entities that are found to have violated these laws and regulations may be 39 excluded from participating in government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed patient services. The Office of the Inspector General of the Department of Health and Human Services and the United States Department of Justice and certain other governmental agencies are currently conducting inquiries and/ or investigations regarding the compliance by the Company and certain of its subsidiaries and the compliance by CBHS and certain of its subsidiaries with such laws and regulations. Certain of the inquiries relate to the operations and business practices of the Psychiatric Hospital Facilities prior to the consummation of the Crescent Transactions. In addition, the Company is also subject to or party to litigation, claims and civil suits relating to its operations and business practices. In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company arising out of such litigation, civil suits and governmental inquiries. Furthermore, management believes that the resolution of such litigation, civil suits and governmental inquiries will not have a material adverse effect on the Company's financial position or results of operations; however, there can be no assurance in this regard. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 40 PART II ITEM 5. MARKET PRICE FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company has one class of Common Stock, $0.25 par value per share, which was listed for trading on the American Stock Exchange through December 30, 1996 (ticker symbol "MGL"), and on the New York Stock Exchange, effective December 31, 1996. As of November 30, 1998, there were 9,428 holders of record of the Company's Common Stock. The following table sets forth the high and low sales prices of the Company's Common Stock from October 1, 1996 through the fiscal year ended September 30, 1998 as reported by the American Stock Exchange (through December 30, 1996) and the New York Stock Exchange (since December 31, 1996):
COMMON STOCK SALES PRICES -------------------- CALENDAR YEAR HIGH LOW --------------------------- --------- --------- 1996 Fourth Quarter......................................................... 22 5/8 17 1/2 1997 First Quarter.......................................................... 26 20 5/8 Second Quarter......................................................... 29 1/2 24 1/2 Third Quarter.......................................................... 33 3/4 29 9/16 Fourth Quarter......................................................... 31 3/4 20 9/16 1998 First Quarter.......................................................... 26 18 5/8 Second Quarter......................................................... 28 7/16 24 Third Quarter.......................................................... 26 9 5/8
The Company did not declare any cash dividends during fiscal 1997 or 1998. As of November 30, 1998, the Company was prohibited from paying dividends on its Common Stock under the terms of the New Credit Agreement. Pursuant to the Green Spring Minority Stockholder Conversion, the Company issued the following number of shares of Common Stock to the following minority stockholders of Green Spring in exchange for their interests in Green Spring:
Blue Cross/Blue Shield of New Jersey 889,456 Health Services Corporation 163,148 Independence Blue Cross 889,456 Regence Blue Shield 889,456
The sale of such Common Stock to the minority stockholders of Green Spring was made pursuant to the exemption from registration under the Securities Act of 1933, as amended (the "Securities Act"), contained in Section 3(a)(10) of the Securities Act. As a result of the Green Spring Minority Stockholder Conversion, the Company owns 100% of Green Spring. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected historical consolidated financial information of the Company for each of the five years in the period ended September 30, 1998. The summary of operations and balance sheet data for the five years ended and as of September 30, 1998, presented below, have been derived from, and should be read in conjunction with, the Company's audited consolidated financial 41 statements and the notes thereto. The selected financial data set forth below should be read in conjunction with the Company's consolidated financial statements and the notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere herein.
YEAR ENDED SEPTEMBER 30, --------------------------------------------------------- 1994 1995 1996 1997 1998 --------- ---------- ---------- ---------- ---------- (DOLLARS IN THOUSANDS) STATEMENT OF OPERATIONS DATA: Net revenue............................................. $ 904,646 $1,151,736 $1,345,279 $1,210,696 $1,512,454 Salaries, cost of care and other operating expenses..... 661,436 863,598 1,064,445 978,513 1,294,481 Bad debt expense........................................ 70,623 92,022 81,470 46,211 4,977 Equity in loss of CBHS.................................. -- -- -- 8,122 31,878 Depreciation and amortization........................... 28,354 38,087 48,924 44,861 54,885 Amortization of reorganization value in excess of amounts allocable to identifiable assets.............. 31,200 26,000 -- -- -- Interest, net........................................... 39,394 55,237 48,017 45,377 75,375 ESOP expense............................................ 49,197 73,527 -- -- -- Stock option expense (credit)........................... 10,614 (467) 914 4,292 (5,623) Managed Care integration costs.......................... -- -- -- -- 16,962 Loss on Crescent Transactions........................... -- -- -- 59,868 -- Unusual items, net...................................... 71,287 57,437 37,271 357 458 Income (loss) before income taxes, minority interest and extraordinary items................................... (57,459) (53,705) 64,238 23,095 39,061 Provision for (benefit from) income taxes............... (10,504) (11,082) 25,695 9,238 20,033 Income (loss) before minority interest and extraordinary items................................................. (46,955) (42,623) 38,543 13,857 19,028 Minority interest....................................... 48 340 6,160 9,102 5,296 Income (loss) before extraordinary items................ (47,003) (42,963) 32,383 4,755 13,732 Extraordinary items-losses on early extinguishments or discharge of debt..................................... (12,616) -- -- (5,253) (33,015) Net income (loss)....................................... $ (59,619) $ (42,963) $ 32,383 $ (498) $ (19,283) INCOME (LOSS) PER COMMON SHARE--BASIC: Income (loss) before extraordinary items................ $ (1.78) $ (1.54) $ 1.04 $ 0.17 $ 0.45 Loss from extraordinary items........................... (0.48) -- -- (0.18) (1.07) Net Income (loss)....................................... $ (2.26) $ (1.54) $ 1.04 $ (0.02) $ (0.63) INCOME (LOSS) PER COMMON SHARE--DILUTED: Income (loss) before extraordinary items................ $ (1.78) $ (1.54) $ 1.02 $ 0.16 $ 0.44 Loss from extraordinary items........................... (0.48) -- -- (0.18) (1.06) Net income (loss)....................................... $ (2.26) $ (1.54) $ 1.02 $ (0.02) $ (0.62) BALANCE SHEET DATA (END OF PERIOD): Current assets.......................................... $ 324,627 $ 305,575 $ 338,150 $ 507,038 $ 399,724 Current liabilities..................................... 215,048 214,162 274,316 219,376 454,766 Property and equipment, net............................. 494,345 488,767 495,390 109,214 177,169 Total assets............................................ 961,480 983,558 1,140,137 895,620 1,916,290 Total debt and capital lease obligations................ 536,129 541,569 572,058 395,294 1,225,646 Stockholders' equity.................................... 56,221 88,560 121,817 158,250 187,635
42 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES SEPTEMBER 30, 1998 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company historically derived the majority of its revenue from providing behavioral healthcare services in an inpatient setting prior to the consummation of the Crescent Transactions on June 17, 1997. Payments from third-party payors are the principal source of revenue for most behavioral healthcare providers. In the early 1990's, many third party payors sought to control the cost of providing care to their patients by instituting managed care programs or seeking the assistance of managed care companies. Providers participating in managed care programs agree to provide services to patients for a discount from established rates, which generally results in pricing concessions by the providers and lower margins. Additionally, managed care programs generally encourage alternatives to inpatient treatment settings and reduce utilization of inpatient services. As a result, third-party payors established managed care programs or engaged managed care companies in many areas of healthcare, including behavioral healthcare. The Company, which until the consummation of the Crescent Transactions on June 17, 1997, was the largest operator of psychiatric hospitals in the United States, was adversely affected by the adoption of managed care programs by the third-party payors. Prior to the first quarter of fiscal 1996, the Company was not a provider of behavioral managed healthcare services. During the first quarter of fiscal 1996, the Company acquired a 61% ownership interest in Green Spring. At that time, the Company intended to become a fully integrated behavioral healthcare provider by combining the behavorial manged healthcare products offered by Green Spring with the direct treatment services offered by the Company's psychiatric hospitals. The Company believed that an entity that participated in both the managed care and the provider segments of the behavioral healthcare industry could more efficiently provide and manage behavioral healthcare for insured populations than an entity that was solely a managed care company. The Company also believed that earnings from its behavioral managed care business would offset, in part, the negative impact on the financial performance of its psychiatric hospitals caused by managed care. Green Spring was the Company's first significant involvement in behavioral managed healthcare. During the first quarter of fiscal 1998, pursuant to the Green Spring Minority Stockholder Conversion, the minority stockholders of Green Spring converted their interests in Green Spring into an aggregate of 2,831,516 shares of Magellan Common Stock. Subsequent to the Company's acquisition of Green Spring, the growth of the behavioral managed healthcare industry accelerated. Under the Company's majority ownership, Green Spring increased its base of covered lives from 12.0 million as of the end of calendar year 1995 to 21.1 million as of the end of calendar year 1997, a compound annual growth rate of over 32%. While growth in the industry was accelerating, the behavioral managed healthcare industry also began to consolidate. The Company concluded that this consolidation presented an opportunity for the Company to increase its participation in the behavioral managed healthcare industry, which the Company believed offered growth and earnings prospects superior to those of the psychiatric hospital industry. Therefore, the Company decided to sell its domestic psychiatric facilities to obtain capital for expansion in the behavioral managed healthcare business. On June 17, 1997, the Company sold the Psychiatric Hospital Facilities, which comprised substantially all of its domestic acute care psychiatric hospitals and residential treatment facilities, to Crescent for $417.2 million in cash (before costs of approximately $16.0 million) and certain other consideration. The sale of the Psychiatric Hospital Facilities provided the Company with approximately $200 million of net cash proceeds, after debt repayment, for use in implementing its business strategy to increase its participation in the managed healthcare industry. The Company used the net cash proceeds of approximately $200 million to finance the acquisitions of HAI and Allied in December 1997. 43 The Company further implemented its business strategy through the Merit acquisition. See "Business--Recent Developments--The Merit Acquisition". RESULTS OF OPERATIONS The following tables summarize, for the periods indicated, operating results by business segment (in thousands).
BEHAVIORAL HUMAN SPECIALTY HEALTHCARE HEALTHCARE CORPORATE 1996 MANAGED CARE SERVICES MANAGED CARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED - ---------------------------- -------------- --------- --------------- ------------ ----------- ----------- ------------- Net revenue................. $ 230,755 $ 69,813 $ -- $ -- $1,044,711 $ -- $ 1,345,279 -------------- --------- ------- ------------ ----------- ----------- ------------- Salaries, cost of care and other operating expenses.. 203,860 59,670 -- -- 766,129 34,786 1,064,445 Bad debt expense............ 1,306 233 -- -- 79,931 -- 81,470 Equity in loss of CBHS...... -- -- -- -- -- -- -- -------------- --------- ------- ------------ ----------- ----------- ------------- 205,166 59,903 -- -- 846,060 34,786 1,415,915 -------------- --------- ------- ------------ ----------- ----------- ------------- Segment profit (loss)(1)................. $ 25,589 $ 9,910 $ -- $ -- $ 198,651 $ (34,786) $ 199,364 -------------- --------- ------- ------------ ----------- ----------- ------------- -------------- --------- ------- ------------ ----------- ----------- -------------
BEHAVIORAL HUMAN SPECIALTY HEALTHCARE HEALTHCARE CORPORATE 1997 MANAGED CARE SERVICES MANAGED CARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED - ------------------------ -------------- ----------- --------------- ------------- ----------- ----------- ------------- Net revenue............. $ 369,974 $ 88,331 $ -- $ 22,739 $ 729,652 $ -- $ 1,210,696 -------------- ----------- ------- ------------- ----------- ----------- ------------- Salaries, cost of care and other operating expenses.............. 332,877 77,648 2,303 3,653 536,454 25,578 978,513 Bad debt expense........ 78 (12) -- -- 46,145 -- 46,211 Equity in loss of CBHS.................. -- -- -- 8,122 -- -- 8,122 -------------- ----------- ------- ------------- ----------- ----------- ------------- 332,955 77,636 2,303 11,775 582,599 25,578 1,032,846 -------------- ----------- ------- ------------- ----------- ----------- ------------- Segment profit (loss)(1)............. $ 37,019 $ 10,695 $ (2,303) $ 10,964 $ 147,053 $ (25,578) $ 177,850 -------------- ----------- ------- ------------- ----------- ----------- ------------- -------------- ----------- ------- ------------- ----------- ----------- -------------
BEHAVIORAL HUMAN SPECIALTY HEALTHCARE HEALTHCARE CORPORATE 1998 MANAGED CARE SERVICES MANAGED CARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED - ------------------------ -------------- --------- -------------- ------------- ----------- ----------- ------------- Net revenue............. $1,039,038 $ 141,032 $ 143,503 $ 55,625 $ 133,256 $ -- $ 1,512,454 -------------- --------- -------------- ------------- ----------- ----------- ------------- Salaries, cost of care and other operating expenses.............. 900,478 124,752 140,375 9,071 104,055 15,750 1,294,481 Bad debt expense........ 1,368 787 -- -- 2,822 -- 4,977 Equity in loss of CBHS.................. -- -- -- 31,878 -- -- 31,878 -------------- --------- -------------- ------------- ----------- ----------- ------------- 901,846 125,539 140,375 40,949 106,877 15,750 1,331,336 -------------- --------- -------------- ------------- ----------- ----------- ------------- Segment profit (loss)(1)............. $ 137,192 $ 15,493 $ 3,128 $ 14,676 $ 26,379 $ (15,750) $ 181,118 -------------- --------- -------------- ------------- ----------- ----------- ------------- -------------- --------- -------------- ------------- ----------- ----------- -------------
(1) Segment profit is the measure of profitability used by management to assess the operating performance of each business segment. See Note 15, "Business Segment Information", to the Company's audited consolidated financial statements appearing elsewhere herein. FISCAL 1997 COMPARED TO FISCAL 1998 BEHAVIORAL MANAGED CARE. Revenue increased 180.8% or $669.0 million, to $1,039.0 million for fiscal 1998 from $370.0 million in fiscal 1997. Salaries, cost of care and other operating expenses increased 170.5%, or $567.6 million, to $900.5 million for fiscal 1998 from $332.9 million in fiscal 1997. The increases resulted primarily from the acquisitions of HAI and Merit in fiscal 1998 and internal growth at Green Spring. The revenues and salaries, cost of care and other operating expenses of HAI and Merit, in the aggregate, were $559.8 million and $480.6 million, respectively, for fiscal 1998. Behavioral managed care revenues and segment profit increased as a result of the award of several new contracts in fiscal 1997 and 1998 and significant improvements in negotiated rates and terms of the TennCare contract in fiscal 1998. Bad debt expense was not significant in fiscal 1997 or 1998. 44 HUMAN SERVICES. Revenue increased 59.7%, or $52.7 million, to $141.0 million for fiscal 1998 from $88.3 million in fiscal 1997. Salaries, cost of care and other operating expenses increased 60.7%, or $47.2 million, to $124.8 million in fiscal 1998 from $77.6 million in fiscal 1997. The increases were attributable to the seven Human Services' Acquisitions consummated in fiscal 1998 and internal growth. Placements in Mentor homes increased 19.6% in fiscal 1998 to 3,350 by September 30, 1998. Bad debt expense was not significant in fiscal 1997 or 1998. SPECIALTY MANAGED CARE. Revenue was $143.5 million in fiscal 1998 compared to $0 in fiscal 1997. Salaries, cost of care and other operating expenses were $140.4 million in fiscal 1998 compared to $2.3 million in fiscal 1997. The increase in revenues and salaries, cost of care and other operating expenses were primarily related to the Allied acquisition. Allied's revenues and salaries, cost of care and other operating expenses were $142.3 million and $135.4 million, respectively, for fiscal 1998. Fiscal 1997 salaries, cost of care and other operating expenses represent start-up costs for CMR, the Company's initial involvement in the specialty managed care business. HEALTHCARE FRANCHISING. Revenue increased 144.6%, or $32.9 million, to $55.6 million in fiscal 1998 from $22.7 million in fiscal 1997. Salaries and other operating expenses increased 148.3%, or $5.4 million, to $9.1 million in fiscal 1998 from $3.7 million in fiscal 1997. Equity in loss of CBHS increased $23.8 million to $31.9 million in fiscal 1998. The increases resulted primarily from the effect of the consummation of the Crescent Transactions on June 17, 1997, resulting in only 106 days of franchise operations and CBHS operations in fiscal 1997, offset by declining operating performance at CBHS during the comparable period in fiscal 1998. See "--Impact of Crescent Transactions on Results of Operations." Also, see Note 4, "Investment in CBHS," to the Company's audited consolidated financial statements set forth elsewhere herein. HEALTHCARE PROVIDER. Revenue decreased 81.7%, or $596.4 million, to $133.3 million in fiscal 1998 from $729.7 million in fiscal 1997. Salaries, cost of care and other operating expenses decreased 80.6%, or $432.4 million, to $104.1 million in fiscal 1998 from $536.5 million in fiscal 1997. Bad debt expense decreased $43.3 million to $2.8 million in fiscal 1998 from $46.1 million in fiscal 1997. The decreases resulted primarily from the effect of the consummation of the Crescent Transactions on June 17, 1997, following which revenue, salaries and other operating expenses and bad debt expense from the Psychiatric Hospital Facilities and other facilities transferred to CBHS were no longer reflected in the Company's financial statements. During fiscal 1997 and 1998, the Company recorded revenue of $27.4 million and $7.0 million, respectively, for settlements and adjustments related to reimbursement issues ("Cost Report Settlements") with respect to psychiatric hospitals owned or formerly owned by the Company. During fiscal 1997 and 1998, the Company recorded reductions of expenses of $7.5 million and $4.1 million, respectively, as a result of updated actuarial estimates related to malpractice claim reserves. These reductions resulted primarily from updates to actuarial assumptions regarding the Company's expected losses for more recent policy years. These revisions are based on changes in expected values of ultimate losses resulting from the Company's claim experience, and increased reliance on such claim experience. While management and its actuaries believe that the present reserve is reasonable, ultimate settlement of losses may vary from the amount recorded and result in additional fluctuations in income in future periods. The fourth quarter of fiscal 1997 included increases to income before income taxes and minority interest of approximately $6.4 million for revenue and bad debt adjustments related to accounts receivable retained by the Company that were generated by the hospitals operated by CBHS. Such adjustments reflected a change in estimates of contractual allowances and allowance for doubtful accounts of such receivables based on the collection activity subsequent to the completion of the Crescent Transactions. CORPORATE OVERHEAD. Salaries and other operating expenses attributable to the Company's corporate headquarters' decreased 38.4%, or $9.8 million, due primarily to the transfer of personnel and overhead to CBHS and the healthcare franchising segment as a result of the Crescent Transactions. 45 DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased 22.3%, or $10.0 million, to $54.9 million in fiscal 1998 from $44.9 million fiscal 1997. The increase was primarily attributable to increases in depreciation and amortization resulting from the HAI, Allied and Merit acquisitions of $26.8 million, in the aggregate, during 1998, offset by the effect of the consummation of the Crescent Transactions, whereby the Psychiatric Hospital Facilities were sold to Crescent. INTEREST, NET. Interest expense, net, increased 66.1% or $30.0 million to $75.4 million in fiscal 1998 from $45.4 million in fiscal 1997. The increase was primarily the result of interest expense incurred on borrowings used to fund the Merit acquisition and related transactions offset by lower interest expense due to lower average borrowings and higher interest income due to temporary investments of the cash received in the Crescent Transactions through December 5, 1997. OTHER ITEMS. Stock option expense for fiscal 1998 decreased $9.9 million compared to fiscal 1997 primarily due to fluctuations in the market price of the Company's common stock. The Company recorded Managed Care integration costs of $17.0 million for fiscal 1998. See Note 11, "Managed Care Integration Plan and Costs," to the Company's audited consolidated financial statements set forth elsewhere herein. The Company recorded unusual items, net, of $0.4 million, during fiscal 1997, which consisted of a $5.4 million pre-tax gain on the sale of previously closed psychiatric hospitals offset by a $4.2 million charge for the closure of three psychiatric hospitals and one general hospital and a $1.6 million charge related to the termination of an agreement to sell the Company's European Hospitals. The Company recorded unusual items, net, of $0.5 million, during fiscal 1998, for a $3.5 million charge related to the termination of an agreement to sell CBHS offset by the net gain on the sale of hospitals of $3.0 million that were previously closed. The Company's effective income tax rate increased to 51.3% for fiscal 1998 compared to 40% in fiscal 1997. The increase was primarily attributable to non-deductible goodwill amortization of approximately $11.0 million resulting from the Merit acquisition in fiscal 1998. Minority interest decreased $3.8 million during fiscal 1998, compared to fiscal 1997. The decrease was primarily attributable to the Green Spring Minority Stockholder Conversion in January 1998 offset by Green Spring's net income growth in fiscal 1998 through January 1998. The Company recorded extraordinary losses on early extinguishment of debt, net of tax, of $5.3 million and $33.0 million during fiscal 1997 and 1998, respectively, related primarily to the termination of its then existing credit agreements in fiscal 1997 and 1998 and the extinguishment of the Magellan Outstanding Notes in fiscal 1998. See Note 7, "Long-Term Debt, Capital Lease Obligations and Operating Leases," to the Company's audited consolidated financial statements set forth elsewhere herein. FISCAL 1996 COMPARED TO FISCAL 1997. BEHAVIORAL MANAGED CARE. Revenue increased 60.3%, or $139.2 million, to $370.0 million in fiscal 1997 from $230.8 million in fiscal 1996. Salaries, cost of care and other operating expenses increased 63.3%, or $129.0 million, to $332.9 million in fiscal 1997 from $203.9 million in fiscal 1996. The increases resulted primarily from the inclusion of a full year of Green Spring operations in fiscal 1997 results and internal growth. Revenue and segment profit increased as a result of the award of several new contracts in the fourth quarter of fiscal 1996 and fiscal 1997, resulting in a 22% increase in covered lives to 16.6 million by September 30, 1997. Bad debt expense was not significant in fiscal 1996 or 1997. HUMAN SERVICES. Revenue increased 26.5%, or $18.5 million, to $88.3 million in fiscal 1997 from $69.8 million in fiscal 1996. Salaries, cost of care and other operating expenses increased 30.1%, or $17.9 million, to $77.6 million in fiscal 1997 from $59.7 million in fiscal 1996. The increases were primarily attributable to internal growth. Placements in Mentor homes increased 23% to 2,800 by September 30, 1997, while operating costs reflected program start-up costs and overhead investments necessary to maintain internal growth. Bad debt expense was not significant in fiscal 1996 or 1997. 46 SPECIALTY MANAGED CARE. Fiscal 1997 salaries, cost of care and other operating expenses represent start-up costs for CMR, the Company's initial involvement in the specialty managed care business. HEALTHCARE FRANCHISING. Revenue was $22.7 million for fiscal 1997. Salaries and other operating expenses were $3.7 million in fiscal 1997. Equity in loss of CBHS was $8.1 million in fiscal 1997. Operations for fiscal 1997 began with the consummation of the Crescent Transactions. HEALTHCARE PROVIDER. Revenue decreased 30.2%, or $315.1 million, to $729.7 million in fiscal 1997 from $1,044.7 million in fiscal 1996. Salaries, and other operating expenses decreased 30.0%, or $229.7 million, to $536.5 million in fiscal 1997 from $766.1 million in fiscal 1996. Bad debt expense decreased 42.3%, or $33.9 million, to $46.1 million in fiscal 1997 from $80.0 million in fiscal 1996. The decrease resulted primarily from: (i) the effect of the consummation of the Crescent Transactions on June 17, 1997, following which revenue, salaries and other operating expenses and bad debt expense from the Psychiatric Hospital Facilities and other facilities transferred to CBHS was no longer recorded as part of the Company's revenue; (ii) the closure of hospitals in fiscal 1996 and 1997; and (iii) reduced equivalent patient days at the Company's operating hospitals as a result of reduced average length of stay. During fiscal 1996 and 1997, the Company recorded revenue of $28.3 million and $27.4 million, respectively, for Cost Report Settlements with respect to Psychiatric Hospital Facilities owned or formerly owned by the Company. The Cost Report Settlements related primarily to certain reimbursement issues associated with the Company's financial reorganization in fiscal 1992 and the early extinguishment of long-term debt in fiscal 1994. During fiscal 1996 and 1997, the Company recorded reductions of expenses of approximately $15.3 million and $7.5 million, respectively, as a result of updated actuarial estimates related to malpractice claim reserves. These reductions resulted primarily from updates to actuarial assumptions regarding the Company's expected losses for more recent policy years. These revisions are based on changes in expected values of ultimate losses resulting from the Company's claim experience, and increased reliance on such claim experience. CORPORATE OVERHEAD. Salaries and other operating expenses attributable to the Company's headquarters decreased 26.5%, or $9.2 million, due primarily to the transfer of personnel and overhead to CBHS and the healthcare franchising business as a result of the Crescent Transactions. DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased 8.3%, or $4.1 million to $44.9 million in fiscal 1997 from $48.9 million in fiscal 1996. The decrease was primarily attributable to the effect of the consummation of the Crescent Transactions, whereby the Psychiatric Hospital Facilities were sold to Crescent, offset by increases in depreciation and amortization resulting from the Green Spring acquisition. INTEREST, NET. Interest, net, decreased 5.5%, or $2.6 million to $45.4 million in fiscal 1997 from $48.0 million in fiscal 1996. The decrease was primarily the result of lower interest expense due to lower average borrowings and higher interest income due to temporary investments of the cash received in the Crescent Transactions. Fiscal 1996 included approximately $5.0 million of interest income related to income tax refunds from the State of California for the Company's income tax returns for fiscal 1982 through 1989. OTHER ITEMS. Stock option expense for fiscal 1997 increased $3.4 million from fiscal 1996 primarily due to fluctuations in the market price of the Company's Common Stock. The Company recorded a loss on the Crescent Transactions of approximately $59.9 million during fiscal 1997. See Note 3, "Crescent Transactions," to the Company's audited consolidated financial statements set forth herein. During fiscal 1996, the Company recorded unusual items of $37.3 million. Included in the unusual charges was the resolution of a billing dispute in August 1996 between the Company and a group of insurance carriers that arose in fiscal 1996 related to matters originating in the 1980's. As part of the settlement of these claims, certain related payor matters and associated legal fees, the Company 47 recorded a charge of approximately $30.0 million. The Company is paying the insurance settlement in twelve installments over a three-year period. The Company's remaining obligation to make the settlement payments in fiscal 1999 is supported by a cash collateralized letter of credit. Other unusual items included: (i) charges of approximately $4.1 million during fiscal 1996 related to the closure of psychiatric hospitals; (ii) a charge of approximately $1.2 million related to impairment losses; and (iii) charges of approximately $2.0 million related to severance costs for personnel reductions. Minority interest increased $2.9 million during fiscal 1997 compared to fiscal 1996. The increase was primarily due to: (i) the Company acquiring a controlling interest in Green Spring in December 1995; (ii) Green Spring's internal growth subsequent to the acquisition date; and (iii) increased net income from hospital-based joint ventures. IMPACT OF CRESCENT TRANSACTIONS ON RESULTS OF OPERATIONS. The Company owns a 50% equity interest in CBHS, from which it receives the Franchise Fees. The Franchise Fees potentially represent a significant portion of the Company's earnings and cash flows. Based on operational projections prepared by CBHS management for the fiscal year ended September 30,1999, and based on CBHS's results of operations through September 30,1998, the Company believes that CBHS will be unable to pay the full amount of the Franchise Fees it is contractually obligated to pay the Company during fiscal 1999. CBHS paid $40.6 million of Franchise Fees to the Company during fiscal 1998. The Company estimates that CBHS will be able to pay $0 to $15.0 million of Franchise Fees in fiscal 1999. The Company expects to reflect Franchise Fee revenue in its statements of operations for future periods which is lower in amount than that specified in the Master Franchise Agreement if CBHS does not generate sufficient cash flows to allow for payment of future Franchise Fees. Based on the amount of unpaid Franchise Fees ($38 million as of September 30, 1998) the Company exercised the limited management rights available to it under the Master Franchise Agreement and, with CBHS's board support, assisted in making operational and management changes at CBHS aimed at improving profitability and cash flows. The Company has since restored all management rights to the CBHS board. See "Business--Charter Advantage" IMPACT OF THE MERIT ACQUISITION ON RESULTS OF OPERATIONS. As of September 30, 1998, the Company had approximately 61.6 million covered lives under behavioral managed healthcare contracts. The Company believes it has the number one market position in each of the major product markets in which it competes, according to enrollment data reported in OPEN MINDS. The Company believes that the Merit acquisition creates opportunities for the Company to achieve significant cost savings in its behavioral managed healthcare business. Management believes that cost saving opportunities will result from leveraging fixed overhead over a larger revenue base and an increased number of covered lives and from reducing duplicative corporate and regional selling, general and administrative expenses. As a result, the Company expects to achieve approximately $60.0 million of cost savings in its behavioral managed healthcare business on an annual basis by September 30, 1999. Such cost savings are measured relative to the combined operating expenses of Green Spring, HAI and Merit prior to the Merit acquisition. The Company spent approximately $13.0 million during fiscal 1998 and expects to spend $10.0 million to $15.0 million during fiscal 1999 in connection with achieving such cost savings. The Company expects to record additional managed care integration costs during future periods to the extent the integration of Green Spring, HAI and Merit results in additional facility closures at HAI and Green Spring and for integration costs incurred that benefit future periods. The full implementation of the integration plan is expected to be completed by fiscal 2000. 48 BEHAVIORAL MANAGED HEALTHCARE RESULTS OF OPERATIONS. The Company's behavioral managed healthcare segment results of operations are subject to significant fluctuations on a quarterly basis. These potential earnings fluctuations may result from: (i) changes in utilization levels by enrolled members of the Company's risk-based contracts; (ii) performance-based contractual adjustments to revenue, reflecting utilization results or other performance measures; (iii) retroactive contractual adjustments under commercial contracts and CHAMPUS contracts ("CHAMPUS Adjustments"); (iv) retrospective membership adjustments and (v) timing of implementation of new contracts and enrollment changes. HISTORICAL LIQUIDITY AND CAPITAL RESOURCES OPERATING ACTIVITIES. The Company's net cash provided by (used in) operating activities was $101.9 million, $73.6 million and $(4.2) million for fiscal 1996, 1997 and 1998 respectively. The decrease in cash provided by operating activities in fiscal 1998 compared to fiscal 1997 was primarily the result of: (i) higher interest payments ($54.4 million and $95.2 million in fiscal 1997 and 1998, respectively,) as a result of the Merit acquisition; (ii) reduced cash flows from the provider business, net of Franchise Fees received and (iii) the funding of liabilities related to the Merit acquisition. The decrease in net cash provided by operating activities in fiscal 1997 compared to fiscal 1996 was primarily the result of: (i) higher income tax payments ($9.3 million and $18.4 million in fiscal 1996 and fiscal 1997, respectively; (ii) $5.0 million of interest income related to income tax refunds from the State of California in fiscal 1996; (iii) higher insurance settlement payments ($24.6 million in fiscal 1996 and $28.5 million in fiscal 1997); and (iv) reduced cash flows from the provider business, net of franchise fees received. INVESTING ACTIVITIES. The Company acquired a 61% ownership interest in Green Spring during the first quarter of fiscal 1996. The consideration paid for Green Spring and related acquisition costs resulted in the use of cash of approximately $87.2 million compared to approximately $50.9 million for acquisitions and investments in businesses, including CBHS, during fiscal 1997. The Crescent Transactions resulted in net proceeds of $374.2 million, during fiscal 1997 and 1998, consisting of $393.7 million related to the sale of property and equipment to Crescent and CBHS less $19.5 million in costs and construction obligations. The Company made $20.0 million of cash capital contributions to CBHS during fiscal 1997. The Company is not obligated to make any additional capital contributions or advances to CBHS. The Company utilized $1.0 billion in funds, net of cash acquired, for acquisitions and investments in businesses, including the Allied, HAI, Merit and Human Services Acquisitions during fiscal 1998. FINANCING ACTIVITIES. The Company borrowed approximately $104.8 million, $203.6 million and $1.2 billion during fiscal 1996, 1997 and 1998, respectively. The fiscal 1996 borrowings primarily funded the Green Spring acquisition and $35.0 million of treasury stock purchases. The fiscal 1997 borrowings primarily funded the repayment of variable rate secured notes and other long-term debt (including the refinancing of a previous revolving credit agreement), acquisitions and working capital needs. The fiscal 1998 borrowings primarily funded the Merit acquisition and related long-term debt refinancing. The Company repaid approximately $85.8 million, $390.3 million and $438.6 million of debt and capital lease obligations during fiscal 1996, 1997 and 1998, respectively. The fiscal 1997 repayments related primarily to a previous revolving credit agreement and repaying other indebtedness as a result of the Crescent Transactions. The fiscal 1998 repayments related primarily to the extinguishment of the Magellan Outstanding Notes as part of the Merit acquisition. On January 25, 1996, the Company sold 4.0 million shares of Common Stock along with the Rainwater-Magellan Warrant pursuant to a private placement. The Rainwater-Magellan Warrant, which expires in January, 2000, entitles the holders to purchase 2.0 million shares of Common Stock at a per share price of $26.15, subject to adjustment for certain dilutive events, and provides registration rights 49 for the shares of Common Stock underlying the warrant. The warrant became exercisable on January 25, 1997. The Company received proceeds of approximately $68.6 million, net of issuance costs, from the Private Placement. Approximately $68.0 million of the proceeds were used to repay outstanding borrowings related to the Green Spring acquisition. The Company issued approximately 2.6 million warrants to Crescent and COI for $25.0 million in cash as part of the Crescent Transactions during fiscal 1997. On September 27, 1996, the Company repurchased approximately 4.0 million shares of Common Stock for approximately $73.5 million, including transaction costs, pursuant to a "Dutch Auction" self-tender offer to its stockholders. On November 1, 1996, the Company announced that its board of directors had approved the repurchase of an additional 3.0 million shares of Common Stock from time to time subject to the terms of the Company's then current credit agreements. During fiscal 1998, the Company repurchased approximately 0.7 million shares of its Common Stock for approximately $14.4 million. As of September 30, 1998, the Company had approximately $92.5 million of availability under the Revolving Facility of the New Credit Agreement, excluding approximately $17.5 million of availability reserved for certain letters of credit. The Company was in compliance with all debt covenants as of September 30, 1998. OUTLOOK-LIQUIDITY AND CAPITAL RESOURCES The interest payments on the Notes and interest and principal payments on indebtedness outstanding pursuant to the New Credit Agreement represent significant liquidity requirements for the Company. Borrowings under the New Credit Agreement will bear interest at floating rates and will require interest payments on varying dates depending on the interest rate option selected by the Company. Borrowings pursuant to the New Credit Agreement include $550 million under the Term Loan Facility and up to $150 million under the Revolving Facility. Commencing in the second quarter of fiscal 1999, the Company will be required to make principal payments with respect to the Term Loan Facility. The Company will be required to repay the principal amount of borrowings outstanding under the Term Loan Facility provided for in the New Credit Agreement and the principal amount of the Notes in the years and amounts set forth in the following table:
FISCAL YEAR PRINCIPAL AMOUNT - ------------- ----------------- 1999 $ 19.8 2000 32.4 2001 38.9 2002 49.4 2003 92.0 2004 156.5 2005 131.8 2006 29.2 2007 -- 2008 625.0
50 In addition, any amounts outstanding under the Revolving Credit Facility of the New Credit Agreement mature in February 2004. The Company has finalized its plans for the integration of the businesses of Green Spring, HAI and Merit. The Company expects to achieve approximately $60.0 million of cost savings on an annual basis by September 30, 1999. Such cost savings are measured relative to the combined operating expenses of Green Spring, HAI and Merit prior to the Merit acquisition. The Company spent approximately $13.0 million during fiscal 1998 in connection with achieving such cost savings, including expenses related to reducing duplicative personnel in its managed care organizations, contractual terminations for eliminating excess real estate (primarily locations under operating leases) and other related costs. The Company expects to spend another $10.0 million to $15.0 million in fiscal 1999 related to achieving such cost savings. POTENTIAL PURCHASE PRICE ADJUSTMENTS. During December 1997, the Company purchased HAI and Allied for approximately $122.1 million and $70.0 million, respectively, excluding transaction costs. In addition, the Company incurred the obligation to make contingent payments to the former owners of HAI and Allied. With respect to HAI, the Company may be required to make additional contingent payments of up to $60.0 million annually to Aetna over the five-year period subsequent to closing. The Company is obligated to make contingent payments under two separate calculations as follows: In respect of each Contract Year (as defined), the Company may be required to pay to Aetna the "Tranche 1 Payments" (as defined) and the "Tranche 2 Payments" (as defined). "Contract Year" means each of the twelve-month periods ending on the last day of December in 1998, 1999, 2000, 2001, and 2002. Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest with respect to such Contract Year in an amount equal to the product of (i) the Tranche 1 Cumulative Incremental Members (as defined) for such Contract Year and (ii) the Tranche 1 Multiplier (as defined) for such Contract Year. The vested amount of Tranche 1 Payment shall be zero with respect to any Contract Year in which the Tranche 1 Cumulative Incremental Members is a negative number. Furthermore, in the event that the number of Tranche 1 Cumulative Incremental Members with respect to any Contract Year is a negative number due to a decrease in the number of Trance 1 Cumulative Incremental Members for such Contract Year (as compared to the immediately preceding Contract Year), Aetna will forfeit the right to receive a certain portion (which may be none or all) of the vested and unpaid amounts of the Tranche 1 Payment relating to preceding Contract Years. "Tranche 1 Cumulative Incremental Members" means, with respect to any Contract Year, (i) the number of Equivalent Members (as defined) serviced by the Company during such Contract Year for Tranche 1 Members, minus (ii) (A) for each Contract Year other than the initial Contract Year, the number of Equivalent Members serviced by the Company for Tranche 1 Members during the immediately preceding Contract Year or (B) for the initial Contract Year, the number of Tranche 1 Members as of September 30, 1997, subject to certain upward adjustments. There were 3,761,253 Tranche 1 Members for the initial Contract Year, prior to such upward adjustments. "Tranche 1 Members" are members of managed behavioral healthcare plans for whom the Company provides services in any of specified categories of products or services. "Equivalent Members" for any Contract Year equals the aggregate Member Months for which the Company provides services to a designated category or categories of members during the applicable Contract Year divided by 12. "Member Months" means, for each member, the number of months for which the Company provides services and is compensated. The "Tranche 1 Multiplier" is $80, $50, $40, $25, and $20 for the Contract Years 1998,1999, 2000, 2001, and 2002, respectively. For each Contract Year, the Company is obligated to pay to Aetna the lesser of (i) the vested portion of the Tranche 1 Payment for such Contract Year and the vested and unpaid amount relating to prior Contract Years as of the end of the immediately preceding Contract Year and (ii) $25.0 million. To the extent that the vested and unpaid portion of the Tranche 1 Payment exceeds $25.0 million, the Tranche 1 51 Payment remitted to Aetna shall be deemed to have been paid first from any vested but unpaid amounts from previous Contract Years in order from the earliest Contract Year for which vested amounts remain unpaid to the most recent Contract Year at the time of such calculation. Except with respect to the Contract Year ending in 2002, any vested but unpaid portion of the Tranche 1 Payment shall be available for payment to Aetna in future Contract Years, subject to certain exceptions. All vested but unpaid amounts of Tranche 1 Payments shall expire following the payment of the Tranche 1 Payment in respect to the Contract Year ending in 2002, subject to certain exceptions. In no event shall the aggregate Tranche 1 Payments to Aetna exceed $125.0 million. Upon the expiration of each Contract Year, the Tranche 2 payment shall be an amount equal to the lesser of: (a) (i) the product of (A) the Tranche 2 Cumulative Members (as defined) for such Contract Year and (B) the Tranche 2 Multiplier (as defined) applicable to such number of Tranche 2 Cumulative Members, minus (ii) the aggregate of the Tranche 2 Payments paid to Aetna for all previous Contract Years and (b) $35.0 million. The amount shall be zero with respect to any Contract Year in which the Tranche 2 Cumulative Members is a negative number. "Tranche 2 Cumulative Members" means, with respect to any Contract Year, (i) the Equivalent Members serviced by the Company during such Contract Year for Tranche 2 Members, minus (ii) the Tranche 2 Members as of September 30, 1997, subject to certain upward adjustments. There were 936,391 Tranche 2 Members prior to such upward adjustments. "Tranche 2 Members" means Members for whom the Company provides products or services in the HMO category. The "Tranche 2 Multiplier" with respect to each Contract Year is $65 in the event that the Tranche 2 Cumulative Members are less than 2,100,000 and $70 if more than or equal to 2,100,000. For each Contract Year, the Company shall pay to Aetna the amount of Tranche 2 Payment payable for such Contract Year. All rights to receive Tranche 2 Payment shall expire following the payment of the Tranche 2 Payment in respect to the Contract Year ending in 2002, subject to certain exceptions. Notwithstanding anything herein to the contrary, in no event shall the aggregate Tranche 2 Payment to Aetna exceed $175.0 million, subject to certain exceptions. The purchase price the Company originally paid for Allied was subject to increase or decrease based on the operating performance of Allied during the three years following the closing. The Company was required to pay up to $40.0 million during the three years following the closing of the Allied acquisition based on Allied's performance relative to certain earnings targets. On November 25, 1998, the Company and the former owners of Allied amended the Allied purchase Agreement (the "Allied Amendment"). The Allied Amendment resulted in the following changes to the original terms of the Allied purchase agreement: - Approximately $18.9 million of the original $20.0 million placed in escrow by the Company at the consummation of the Allied acquisition, plus accrued interest, was repaid to the Company. - The Company paid certain of the former owners of Allied approximately $4.0 million in settlement of a portion of their potential future contingent consideration. - The Company's maximum remaining contingent consideration payable to the former owners of Allied is approximately $6.1 million, less the approximate $1.1 million that remains in escrow. The future contingent payments, if any, will be based upon the operating performance of Allied for fiscal 1999 through fiscal 2001. In connection with Merit's acquisition of CMG, the Company, by acquiring Merit, may be required to make certain future contingent payments in fiscal 1999 to the former shareholders of CMG based upon the performance of three CMG customer contracts. No contingent consideration will be payable to the former shareholders of CMG based on the performance of two of the three CMG customer contracts at September 30, 1998. The Company may still be required to pay contingent consideration to the former 52 shareholders of CMG depending on the financial performance of Choice Behavioral Health Partnership ("CHOICE"). CHOICE is a joint venture with Value Options, Inc. that services a contract with CHAMPUS. The Company and Value Options, Inc. each own 50% of CHOICE. The payment of contingent consideration to the former shareholders of CMG depends on the financial performance of CHOICE from October 1, 1996 to June 30, 1997, which is subject to a CHAMPUS Adjustment the Company expects to receive in fiscal 1999. Such contingent payments are subject to an aggregate maximum of $23.5 million. The Revolving Facility will provide the Company with revolving loans and letters of credit in an aggregate principal amount at any time not to exceed $150.0 million. At September 30, 1998, the Company had approximately $92.5 million of availability under the Revolving Facility. The Company estimates that it will spend approximately $50.0 million for capital expenditures in fiscal 1999. The majority of the Company's anticipated capital expenditures relate to management information systems and related equipment. The Company believes that the cash flows generated from its operations, together with amounts available for borrowing under the New Credit Agreement, should be sufficient to fund its debt service requirements, anticipated capital expenditures, contingent payments, with respect to HAI, Allied and CMG and other investing and financing activities. The Company's future operating performance and ability to service or refinance the Notes or to extend or refinance the indebtedness outstanding pursuant to the New Credit Agreement will be subject to future economic conditions and to financial, business and other factors, many of which are beyond the Company's control. The New Credit Agreement imposes restrictions on the Company's ability to make capital expenditures and both the New Credit Agreement and the Indenture governing the Notes limit the Company's ability to incur additional indebtedness. Such restrictions, together with the highly leveraged financial condition of the Company, may limit the Company's ability to respond to market opportunities. The covenants contained in the New Credit Agreement also, among other things, restrict the ability of the Company to dispose of assets, repay other indebtedness, amend other debt instruments (including the Indenture), pay dividends, create liens on assets, enter into sale and leaseback transactions, make investments, loans or advances, redeem or repurchase common stock and make acquisitions. See "Business-Cautionary Statements-Substantial Leverage and Debt Service Obligations." RECENT ACCOUNTING PRONOUNCEMENTS In March 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 establishes accounting guidance for internal-use software. SOP 98-1 requires the following: - Computer software costs that are incurred in the preliminary project stage (as described in SOP 98-1) should be expensed as incurred. Once the capitalization criteria of SOP 98-1 have been met, external direct costs of materials and services consumed in developing or obtaining internal-use computer software; payroll and payroll-related costs for employees who are directly associated with and who devote time to the internal-use computer software project (to the extent of the time spent directly on the project); and interest costs incurred when developing computer software for internal use should be capitalized. Training costs and data conversion costs should generally be expensed as incurred. - Internal costs incurred for upgrades and enhancements should be expensed or capitalized in accordance with SOP 98-1. Internal costs incurred for maintenance should be expensed as incurred. Entities that cannot separate internal costs on a reasonably cost-effective basis between maintenance and relatively minor upgrades and enhancements should expense such costs as incurred. - External costs incurred under agreements related to specified upgrades and enhancements should be expensed or capitalized in accordance with SOP 98-1. However, external costs related 53 to maintenance, unspecified upgrades and enhancements, and costs under agreements that combine the costs of maintenance and unspecified upgrades and enhancements should be recognized in expense over the contract period on a straight-line basis unless another systematic and rational basis is more representative of the services received. - Impairment should be recognized and measured in accordance with the provisions of FASB Statement No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF. - The capitalized costs of computer software developed or obtained for internal use should be amortized on a straight-line basis unless another systematic and rational basis is more representative of the software's use. SOP 98-1 becomes effective for financial statements for fiscal years beginning after December 15, 1998. The provisions of SOP 98-1 should be applied to internal-use software costs incurred in those fiscal years for all projects, including those projects in progress upon initial application of SOP 98-1. Costs incurred prior to the initial application of SOP 98-1, whether capitalized or not, should not be adjusted to the amounts that would have been capitalized had SOP 98-1 been in effect when those costs were incurred. The Company must adopt SOP 98-1 no later than October 1, 1999. Each of the Company's operating units maintains its own information systems, which include internal-use software as defined by SOP 98-1. The care management and claims processing systems used in the Company's managed care segments are the Company's most significant internal-use software applications. The Company adopted SOP 98-1, effective October 1, 1997. The Company's adoption of SOP 98-1 had no impact on its financial position or results of operations. In April 1998, the AICPA issued Statement of Position 98-5, "Reporting on the Costs of Start-up Activities" ("SOP 98-5"). SOP 98-5 requires all nongovernmental entities to expense costs of start-up activities as those costs are incurred. Start-up costs, as defined by SOP 98-5, include pre-operating costs, pre-opening costs and organization costs. SOP 98-5 becomes effective for financial statements for fiscal years beginning after December 15, 1998. At adoption, a company must record a cumulative effect of a change in accounting principle to write off any unamortized start-up costs remaining on the balance sheet when SOP 98-5 is adopted. Prior year financial statements cannot be restated. The Company will adopt SOP 98-5 effective October 1, 1998. The Company's adoption of SOP 98-5 will have no impact on its financial position or results of operations. Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but a Minority Shareholder or Shareholders Have Certain Approval or Veto Rights" ("EITF 96-16") supplements the guidance contained in AICPA Accounting Research Bulletin 51, "Consolidated Financial Statements", and in Statement of Financial Accounting Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries" ("ARB 51/FAS 94"), about the conditions under which the Company's consolidated financial statements should include the financial position, results of operations and cash flows of subsidiaries which are less than wholly-owned along with those of the Company and its subsidiaries. In general, ARB 51/FAS 94 requires consolidation of all majority-owned subsidiaries except those for which control is temporary or does not rest with the majority owner. Under the ARB 51/FAS 94 approach, instances of control not resting with the majority owner were generally regarded to arise from such events as the legal reorganization or bankruptcy of the majority-owned subsidiary. EITF 96-16 expands the definition of instances in which control does not rest with the majority owner to include those where significant approval or veto rights, other than those which are merely protective of the minority shareholder's interest, are held by the minority shareholder or shareholders ("Substantive 54 Participating Rights"). Substantive Participating Rights include, but are not limited to: i) selecting, terminating and setting the compensation of management responsible for implementing the majority-owned subsidiary's policies and procedures and ii) establishing operating and capital decisions of the majority-owned subsidiary, including budgets, in the ordinary course of business. The provisions of EITF 96-16 apply to new investment agreements made after July 24, 1997, and to existing agreements which are modified after such date. The Company has made no new investments, and has modified no existing investments, to which the provisions of EITF 96-16 would have applied. In addition, the transition provisions of EITF 96-16 must be applied to majority-owned subsidiaries previously consolidated under ARB 51/FAS 94 for which the underlying agreements have not been modified in financial statements issued for years ending after December 15, 1998 (fiscal 1999 for the Company). The adoption of the transition provisions of EITF 96-16 on October 1, 1998 will have the following effect on the Company's consolidated financial position:
OCTOBER 1, 1998 ----------- Increase (decrease) in: Cash and cash equivalents................................................................ $ (21,092) Other current assets..................................................................... (9,538) Long-term assets......................................................................... (30,049) Investment in unconsolidated subsidiaries................................................ 26,498 ----------- Total Assets........................................................................... $ (34,181) ----------- ----------- Current liabilities...................................................................... $ (10,381) Minority interest........................................................................ (23,800) ----------- Total Liablities....................................................................... $ (34,181) ----------- -----------
POTENTIAL IMPACT OF YEAR 2000 COMPUTER ISSUES The year 2000 computer problem is the inability of computer systems, which store dates by using the last two digits of the year (i.e. "98" for "'1998"), to reliably recognize that dates after December 31, 1999 are later than, and not before, 1999. For instance, the date January 1, 2000, may be mistakenly interpreted as January 1, 1900, in calculations involving dates on systems which are non-year 2000 compliant. The Company relies on information technology ("IT") systems and other systems and facilities such as telephones, building access control systems and heating and ventilation equipment ("Embedded Systems") to conduct its business. These systems are potentially vulnerable to year 2000 problems due to their use of date information. The Company also has business relationships with customers and health care providers and other critical vendors who are themselves reliant on IT and Embedded Systems to conduct their businesses. STATE OF READINESS The Company's IT systems are largely decentralized, with each major operating unit having its own standards for systems which include both purchased and internally-developed software. The Company's IT hardware infrastructure is built mainly around mid-range computers and IBM PC-compatible servers and desktop systems. The Company's principal means of ensuring year 2000 compliance for purchased software has been the replacement of non-compliant systems. This replacement process would have been undertaken for business reasons irrespective of the year 2000 problem; however, it would, more than likely, have been implemented over a longer period of time. The Company's internally-developed software was 55 either designed to be year 2000 compliant from inception or is in the process of being modified to be compliant. Approximately 70% of the Company's mid-range IT hardware has been certified as year 2000 compliant, with the remainder scheduled to be certified by the end of the second quarter of fiscal 1999. Most of the Company's non-compliant IBM PC-compatible servers and desktops have been replaced, with the remainder expected to be replaced by the end of fiscal 1999. Additionally, the Company is in the process of integrating recently acquired businesses and their associated IT systems. A primary focus of the integration is on standardization of systems where possible, including ensuring the year 2000 compliance of the surviving systems. Each of the Company's major operating units has a Chief Information Officer who is responsible for ensuring that all year 2000 issues are addressed and mitigated before any computational problems related to dates after December 31, 1999, occur. The Company's plan for IT systems consists of several phases, primarily: (i) Inventory--identifying all IT systems and the magnitude of year 2000 compliance risk of each according to its potential business impact; (ii) Date assessment--identifying IT systems that use date functions and assessing them for year 2000 functionality; (iii) Remediation--reprogramming, or replacing where necessary, inventoried items to ensure they are year 2000 ready; and (iv) Testing and certification--testing the code modifications and new inventory with other associated systems, including extensive date testing and performing quality assurance testing to ensure successful operation in the post-1999 environment. The Company has substantially completed the inventory and assessment phases for substantially all of its IT systems. The Company's IT systems are currently in the remediation and testing and certification phases. The Company plans to complete the remediation of substantially all of its critical IT systems by the end of the second quarter of fiscal 1999, the remediation of its other IT systems by the end of the third quarter of fiscal 1999 and the testing and certification of all of its IT systems by the end of fiscal 1999. The Company leases most of the office space in which its reliance on Embedded Systems presents a potential problem and is currently working with the respective lessors to identify and correct any potential year 2000 problems related to these Embedded Systems. The Company believes that its year 2000 projects generally are on schedule. EXTERNAL RELATIONSHIPS The Company also faces the risk that one or more of its critical suppliers or customers ("External Relationships") will not be able to interact with the Company due to the third party's inability to resolve its own year 2000 issues, including those associated with its own External Relationships. The Company has completed its inventory of External Relationships and risk rated each External Relationship based upon the potential business impact, available alternatives and cost of substitution. The Company is attempting to determine the overall year 2000 readiness of its External Relationships. In the case of significant customers and mission critical suppliers such as banks, telecommunications providers and other utilities and IT vendors, the Company is engaged in discussions with the third parties and is attempting to obtain detailed information as to those parties' year 2000 plans and state of readiness. The Company, however, does not have sufficient information at the current time to predict whether its External Relationships will be year 2000 ready. 56 YEAR 2000 COSTS Total costs incurred solely for remediation of potential year 2000 problems are currently estimated to be approximately $1.0 million in fiscal 1999. A large majority of these costs are expected to be incremental expenses that will not recur in the year 2000 or thereafter. Year 2000 costs incurred were $1.0 million in fiscal 1998 and were not material in fiscal 1997. The Company expenses these costs as incurred and funds these costs through operating cash flows. In addition, the Company estimates that it will accelerate approximately $5.0 million of capital expenditures that would have been budgeted for future periods into fiscal 1999 to ensure year 2000 compliance for outdated systems. Year 2000 compliance is critical to the Company. The Company has redeployed some resources from non-critical system enhancements to address year 2000 issues. Due to the importance of IT systems to the Company's business, management has deferred non-critical systems enhancements to become year 2000 ready. The Company does not expect these redeployments and deferrals to have a material impact on the Company's financial condition or results of operations. RISKS AND CONTINGENCY/RECOVERY PLANNING If the Company's year 2000 issues were unresolved, the most reasonably likely worst case scenario would include, among other possibilities, the inability to accurately and timely authorize and process benefits and claims, accurately bill customers, assess claims exposure, determine liquidity requirements, report accurate data to management, stockholders, customers, regulators and others, business interruptions or shutdowns, financial losses, reputational harm, loss of significant customers, increased scrutiny by regulators and litigation related to year 2000 issues. The Company is attempting to limit the potential impact of the year 2000 by monitoring the progress of its own year 2000 project and those of its critical external relationships and by developing contingency/recovery plans. The Company cannot guarantee that it will be able to resolve all of its year 2000 issues. Any critical unresolved year 2000 issues at the Company or its external relationships, however, could have a material adverse effect on the Company's results of operations, liquidity or financial condition. The Company has developed contingency/recovery plans aimed at ensuring the continuity of critical business functions before and after December 31, 1999. As part of that process, the Company has substantially completed the development of manual work alternatives to automated processes which will both ensure business continuity and provide a ready source of input to affected systems when they are returned to an operational status. These manual alternatives presume, however, that basic infrastructure such as electrical power and telephone service, as well as purchased systems which are advertised to be year 2000 compliant by their manufacturers (primarily personal computers and productivity software) will remain unaffected by the year 2000 problem. See "Business-Cautionary Statements--The Company". ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Information with respect to this item is contained in the Company's Consolidated Financial Statements and financial statement schedule indicated in the Index on Page F-1 of this Annual Report on Form 10-K and is incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 57 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to the Company's executive officers is contained under "Item 1. Business--Executive Officers of the Registrant." Pursuant to General Instruction G(3) to Form 10-K, the information required by this item with respect to directors and compliance with Section 16(a) of the Securities Exchange Act of 1934 has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION Pursuant to General Instruction G(3) to Form 10-K, the information required with respect to this item has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction G(3) to Form 10-K, the information required with respect to this item has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction G(3) to Form 10-K, the information required with respect to this item has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) DOCUMENTS FILED AS PART OF THE REPORT: 1. FINANCIAL STATEMENTS Information with respect to this item is contained on Pages F-1 to F-66 of this Annual Report on Form 10-K. 2. FINANCIAL STATEMENT SCHEDULES Information with respect to this item is contained on page S-1 to S-2 of this Annual Report on Form 10-K. 58 3. EXHIBITS
EXHIBIT NO. DESCRIPTION OF EXHIBIT - ------------ -------------------------------------------------------------------------------------------------------- 2(a) Stock Purchase Agreement, dated November 14, 1995, among Blue Cross and Blue Shield of New Jersey, Inc. Health Care Service Corporation, Independence Blue Cross, Medical Service Association of Pennsylvania, Pierce County Medical Bureau, Inc., Veritus, Inc., Green Spring Health Services, Inc. and the Company, which was filed as Exhibit 10(e) to the Company's Quarterly Report on Form 10-Q for the Quarterly period ended December 31, 1995, and is incorporated herein by reference. 2(b) GPA Stock Exchange Agreement, dated November 14, 1995, between Green Spring Health Services, Inc. and the Company, which was filed as Exhibit 10(f) to the Company's Quarterly Report on Form 10-Q for the Quarterly period ended December 31, 1995, and is incorporated herein by reference. 2(c) Real Estate Purchase and Sale Agreement, dated January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 2(a) to the Company's current report on Form 8-K filed on April 23, 1997, and is incorporated herein by reference. 2(d) Amendment No. 1, dated February 28, 1997, to the Real Estate Purchase and Sale Agreement, dated January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 2(b) to the Company's current report on Form 8-K filed on April 23, 1997, and is incorporated herein by reference. 2(e) Amendment No. 2, dated May 29, 1997, to the Real Estate Purchase and Sale Agreement, dated January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 2(c) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 2(f) Contribution Agreement, dated June 16, 1997, between the Company and Crescent Operating, Inc., which was filed as Exhibit 2(d) to the Company's current report on Form 8-K which was filed on June 30, 1997, and is incorporated herein by reference. 2(g) Stock Purchase Agreement, dated August 5, 1997, between the Company and Aetna Insurance Company of Connecticut, which was filed as Exhibit 2(a) to the Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference. 2(h) Master Service Agreement, dated August 5, 1997, between the Company, Aetna U.S. Healthcare, Inc. and Human Affairs International, Incorporated, which was filed as Exhibit 2(b) to the Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference. 2(i) Amendment to Stock Purchase Agreement, dated December 4, 1997, between the Company and Aetna Insurance Company of Connecticut, which was filed as Exhibit 2(c) to the Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference. 2(j) First Amendment to Master Services Agreement, dated December 4, 1997, between the Company, Aetna U.S. Healthcare, Inc. and Human Affairs International, Incorporated, which was filed as Exhibit 2(d) to the Company's current report on Form 8-K, which was filed on December 17, 1997, and is incorporated herein by reference. 2(k) Asset Purchase Agreement, dated October 16, 1997, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co,; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin, M.D. and Lawrence Schimmel, M.D., which was filed as Exhibit 2(e) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1997, and is incorporated herein by reference.
59
EXHIBIT NO. DESCRIPTION OF EXHIBIT - ------------ -------------------------------------------------------------------------------------------------------- 2(l) First Amendment to Asset Purchase Agreement, dated December 5, 1997, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and Lawrence Schimmel, M.D., which was filed as Exhibit 2(f) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1997, and is incorporated herein by reference. 2(m) Second Amendment to Asset Purchase Agreement, dated November 18, 1998, among the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida Specialty Network, LTD; Surgical Associates of South Florida, Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and Lawrence Schimmel, M.D. 2(n) Agreement and Plan of Merger, dated October 24, 1997, among the Company, Merit Behavioral Care Corporation and MBC Merger Corporation which was filed as Exhibit 2(g) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1997, and is incorporated herein by reference. 3(a) Restated Certificate of Incorporation of the Company, as filed in Delaware on October 16, 1992, which was filed as Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended September 30, 1992, and is incorporated herein by reference. 3(b) Bylaws of the Company. 3(c) Certificate of Ownership and Merger merging Magellan Health Services, Inc. (a Delaware corporation) into Charter Medical Corporation (a Delaware corporation), as filed in Delaware on December 21, 1995, which was filed as Exhibit 3(c) to the Company's Annual Report on Form 10-K for the year ended September 30, 1995, and is incorporated herein by reference. 4(a) Stockholders' Agreement, dated December 13, 1995, among Green Spring Health Services, Inc., Blue Cross and Blue Shield of New Jersey, Inc., Health Care Service Corporation, Independence Blue Cross, Pierce County Medical Bureau, Inc. and the Company, which was filed as Exhibit 4(d) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995, and is incorporated herein by reference. 4(b) First Amendment to Stockholders' Agreement, dated February 28, 1997, among Green Spring Health Services, Inc, Blue Cross and Blue Shield of New Jersey, Inc., Health Care Service Corporation, Independence Blue Cross, Pierce County Medical Bureau, Inc. and the Company, which was filed as Exhibit 4(af) to the Company's Annual Report on Form 10-K for the year ended September 30, 1997, and is incorporated herein by reference. 4(c) Exchange Agreement, dated December 13, 1995, among Blue Cross and Blue Shield of New Jersey, Inc., Health Care Service Corporation, Independence Blue Cross, Pierce County Medical Bureau, Inc. and the Company, which was filed as Exhibit 4(e) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995, and is incorporated herein by reference. 4(d) Stock and Warrant Purchase Agreement, dated December 22, 1995, between the Company and Richard E. Rainwater, which was filed as Exhibit 4(f) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995, and is incorporated herein by reference. 4(e) Amendment No. 1 to Stock and Warrant Purchase Agreement, dated January 25, 1996, between the Company and Rainwater-Magellan Holdings, L.P., which was filed as Exhibit 4.7 to the Company's Registration Statement on Form S-3 dated February 26, 1996, and is incorporated herein by reference.
60
EXHIBIT NO. DESCRIPTION OF EXHIBIT - ------------ -------------------------------------------------------------------------------------------------------- 4(f) Warrant Purchase Agreement, dated January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership which was filed as Exhibit 4(a) to the Company's current report on Form 8-K, which was filed on April 23, 1997, and is incorporated herein by reference. 4(g) Amendment No. 1, dated June 17, 1997, to the Warrant Purchase Agreement, dated January 29, 1997, between the Company and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 4(b) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 4(h) Indenture, dated as of February 12, 1998, between the Company and Marine Midland Bank, as trustee, relating to the 9% Senior Subordinated Notes due February 15, 2008 of the Company, which was filed as Exhibit 4(a) to the Company's Current Report on Form 8-K, which was filed April 3, 1998, and is incorporated herein by reference. 4(i) Purchase Agreement, dated February 5, 1998, between the Company and Chase Securities Inc., which was filed as Exhibit 4(b) to the Company's Current Report on Form 8-K, which was filed April 3, 1998, and is incorporated herein by reference. 4(j) Exchange and Registration Rights Agreement, dated February 12, 1998, between the Company and Chase Securities Inc., which was filed as Exhibit 4(c) to the Company's Current Report on Form 8-K, which was filed on April 3, 1998, and is incorporated herein by reference. 4(k) Credit Agreement, dated February 12, 1998, among the Company, certain of the Company's subsidiaries listed therein and The Chase Manhattan Bank, as administrative agent, which was filed as Exhibit 4(d) to the Company's Current Report on Form 8-K, which was filed April 3, 1998, and is incorporated herein by reference. 4(l) Amendment No. 1, dated as of September 30, 1998, to the Credit Agreement, dated as of February 12, 1998, among the Company, certain of the Company's subsidiaries listed therein and The Chase Manhattan Bank, as administrative agent, which was filed as Exhibit 4(e) to the Company's Registration Statement Form S-4 (no. 333-49335), which was filed on October 5, 1998, and is incorporated herein by reference. The Company agrees, pursuant in (b)(4)(iii) of Item 601 of Regulation S-K, to furnish to the Commission, upon request, a copy of each agreement relating to long-term debt where the total amount of debt under each such agreement does not exceed 10% of the Company's respective total on a consolidated basis. *10(a) 1992 Stock Option Plan of the Company, as amended, which was filed as Exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended September 30, 1994, and is incorporated herein by reference. *10(b) Directors' Stock Option Plan of the Company, as amended, which was filed as Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended September 30, 1994, and is incorporated herein by reference. *10(c) 1994 Stock Option Plan of the Company, as amended, which was filed as Exhibit 10(e) to the Company's Annual Report on Form 10-K for the year ended September 30, 1994, and is incorporated herein by reference. *10(d) Directors' Unit Award Plan of the Company, which was filed as Exhibit 10(i) to the Company's Registration Statement on Form S-4 (No. 33-53701) filed May 18, 1994, and is incorporated herein by reference. *10(e) 1996 Stock Option Plan of the Company, which was filed as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1996 and is incorporated herein by reference.
61
EXHIBIT NO. DESCRIPTION OF EXHIBIT - ------------ -------------------------------------------------------------------------------------------------------- *10(f) 1996 Directors' Stock Option Plan of the Company, which was filed as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1996 and is incorporated herein by reference. *10(g) 1997 Stock Option Plan of the Company, which was filed as Exhibit 10(i) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997, and is incorporated herein by reference. *10(h) Employment Agreement, dated February 28, 1995, between the Company and John Cook Barlett, Executive Vice President--Quality Improvement, which was filed as Exhibit 10(k) to the Company's Annual Report on Form 10-K for the year ended September 30, 1995, and is incorporated herein by reference. *10(i) Employment Agreement, dated March 31, 1995, between the Company and Craig L. McKnight, Executive Vice President and Chief Financial Officer, which was filed as Exhibit 10(l) to the Company's Annual Report on Form 10-K for the year ended September 30, 1995, and is incorporated herein by reference. *10(j) Employment Agreement, dated October 1, 1995, between the Company and E. Mac Crawford, Chairman of the Board of Directors, President and Chief Executive Officer, which was filed as Exhibit 10(m) to the Company's Annual Report on Form 10-K for the year ended September 30, 1995, and is incorporated herein by reference. *10(k) Employment Agreement, dated March 1, 1997, between the Company and E. Mac Crawford, which was filed as Exhibit 10(g) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1997, and is incorporated herein by reference. *10(l) Letter Agreement, dated November 9, 1993, between Green Spring Health Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995 and is incorporated herein by reference. *10(m) Letter Agreement, dated September 19, 1994 between Green Spring Health Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 1995 and is incorporated herein by reference. *10(n) Employment Agreement dated May 1, 1996, between the Company and Dr. Danna Mauch, President and Chief Operating Officer of Magellan Public Solutions, Inc. and Executive Vice President of the Company, which was filed as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1996 and is incorporated herein by reference. *10(o) Employment Agreement dated April 15, 1996, between the Company and John M. DeStefanis, President and Chief Operating Officer of Charter Behavioral Health Systems, Inc. and Executive Vice President of the Company, which was filed as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1996 and is incorporated herein by reference. *10(p) Employment Agreement dated May 7, 1996, between the Company and Steve J. Davis, Executive Vice President, Administrative Services and General Counsel, which was filed as Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1996 and is incorporated herein by reference.
62
EXHIBIT NO. DESCRIPTION OF EXHIBIT - ------------ -------------------------------------------------------------------------------------------------------- *10(q) Employment Agreement dated February 28, 1996, between Green Spring Health Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10(t) to the Company's annual report on Form 10-K for the year ended September 30, 1996, and is incorporated herein by reference. *10(r) Compensation Agreement dated September 30, 1996, between Magellan Health Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the Company and President and Chief Executive Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10(u) to the Company's annual report on Form 10-K for the year ended September 30, 1996, and is incorporated herein by reference. *10(s) Written description of the Green Spring Health Services, Inc. Annual Incentive Plan for the period ended September 30, 1998. *10(t) Written description of the Green Spring Health Services, Inc. Annual Incentive Plan for the year ended September 30, 1997, which was filed as Exhibit 10(w) to the Company's Annual Report on Form 10-K for the year ended September 30, 1997, and is incorporated by reference. 10(u) Master Lease Agreement, dated June 16, 1997, between Crescent Real Estate Funding VII, L.P., as Landlord, and Charter Behavioral Health Systems, LLC, as Tenant, which was filed as Exhibit 99(b) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 10(v) Master Franchise Agreement, dated June 17, 1997, between the Company and Charter Behavioral Health Systems, LLC, which was filed as Exhibit 99(c) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 10(w) Form of Franchise Agreement, dated June 17, 1997, between the Company, as Franchisor, and Franchise Owners, which was filed as Exhibit 99(d) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 10(x) Subordination Agreement, dated June 16, 1997, between the Company, Charter Behavioral Health Systems, LLC and Crescent Real Estate Equities Limited Partnership, which was filed as Exhibit 99(e) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 10(y) Operating Agreement of Charter Behavioral Health Systems, LLC, dated June 16, 1997, between the Company and Crescent Operating, Inc., which was filed as Exhibit 99(f) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. 10(z) Warrant Purchase Agreement, dated June 16, 1997, between the Company and Crescent Operating, Inc., which was filed as Exhibit 99(g) to the Company's current report on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by reference. *10(aa) 1998 Stock Option Plan of the Company which was filed as Exhibit (ay) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference. *10(ab) Letter Agreement, dated May 7, 1997, between Green Spring Health Services, Inc. and John J. Wider, Jr., Executive Vice President and Chief Operating Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10 (az) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference.
63
EXHIBIT NO. DESCRIPTION OF EXHIBIT - ------------ -------------------------------------------------------------------------------------------------------- *10(ac) Employment Agreement, dated March 12, 1997, between Green Spring Health Services, Inc. and Clarissa C. Marques, Chief Clinical Officer of Green Spring Health Services, Inc., which was filed as Exhibit 10 (ba) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference. *10(ad) Letter Agreement, dated February 2, 1995, between Green Spring Health Services, Inc. and Clarissa C. Marques, Senior Vice President of Green Spring Health Services, Inc., which was filed as Exhibit 10 (bb) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference. *10(ae) Employment Agreement, dated June 25, 1998, between the Company and Henry T. Harbin, M.D., President, Chief Executive Officer of the Company, which was filed as exhibit 10(a) to the Company's quarterly report on Form 10-Q for the quarterly period ended June 30, 1998 and is incorporated herein by reference. 10(af) Offer to Purchase and Consent Solicitation Statement, dated January 12, 1998, by the Company for all of its 11 1/4% Series A Senior Subordinated Notes due 2008, which was filed as Exhibit 10(ad) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference. 10(ag) Offer to Purchase and Consent Solicitation Statement, dated January 12, 1998, by Merit Behavioral Care Corporation for all of its 11 1/2% Senior Subordinated Notes due 2005, which was filed as Exhibit 10(ad) to the Company's Registration Statement on Form S-4, which was filed on April 3, 1998, and is incorporated herein by reference. 10(ah) Agreement and Plan of Merger by and among Merit Behavioral Care Corporation, Merit Merger Corp., and CMG Health, Inc. dated as of July 14, 1997. 21 List of subsidiaries of the Company. 23 Consent of independent public accountants. 27 Financial Data Schedule
- ------------------------ * Constitutes a management contract or compensatory plan arrangement. (B) REPORTS ON FORM 8-K: There were no current reports on Form 8-K filed by the Registrant with the Securities and Exchange Commission during the quarter ended September 30, 1998. (C) EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K: Exhibits required to be filed by the Company pursuant to Item 601 of Regulation S-K are contained in a separate volume. (D) FINANCIAL STATEMENT SCHEDULES REQUIRED BY REGULATION S-X: Information with respect to this item is contained on pages S-1 to S-2 of this Annual Report on Form 10-K. 64 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized. MAGELLAN HEALTH SERVICES, INC. (Registrant) Date: December 28, 1998 /S/ CRAIG L. MCKNIGHT ------------------------------------------ Craig L. McKnight Executive Vice President and Chief Financial Officer Date: December 28, 1998 /S/ JEFFREY T. HUDKINS ------------------------------------------ Jeffrey T. Hudkins Vice President and Controller (Chief Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE - ------------------------------ --------------------------- ------------------- /s/ HENRY T. HARBIN President, Chief Executive - ------------------------------ Officer and Director December 28, 1998 Henry T. Harbin /s/ EDWIN M. BANKS Director - ------------------------------ December 28, 1998 Edwin M. Banks /s/ G. FRED DIBONA, JR. Director - ------------------------------ December 28, 1998 G. Fred DiBona, Jr. /s/ ANDRE C. DIMITRIADIS Director - ------------------------------ December 28, 1998 Andre C. Dimitriadis /s/ A.D. FRAZIER, JR. Director - ------------------------------ December 28, 1998 A.D. Frazier, Jr. /s/ RAYMOND H. KIEFER Director - ------------------------------ December 28, 1998 Raymond H. Kiefer 65
SIGNATURE TITLE DATE - ------------------------------ --------------------------- ------------------- /s/ GERALD L. MCMANIS Director - ------------------------------ December 28, 1998 Gerald L. McManis /s/ DANIEL S. MESSINA Director - ------------------------------ December 28, 1998 Daniel S. Messina /s/ ROBERT W. MILLER Chairman of the Board of - ------------------------------ Directors December 28, 1998 Robert W. Miller /s/ DARLA D. MOORE Director - ------------------------------ December 28, 1998 Darla D. Moore /s/ JEFFREY A. SONNENFELD Director - ------------------------------ December 28, 1998 Jeffrey A. Sonnenfeld
66 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS The following Consolidated Financial Statements of the Registrant and its subsidiaries are submitted herewith in response to Item 8 and Item14(a)1:
PAGE --------- MAGELLAN HEALTH SERVICES, INC. Audited Consolidated Financial Statements Report of independent public accountants............................................................... F-2 Consolidated balance sheets as of September 30, 1997 and 1998.......................................... F-3 Consolidated statements of operations for the years ended September 30, 1996, 1997 and 1998............ F-4 Consolidated statements of changes in stockholders' equity for the years ended September 30, 1996, 1997 and 1998.............................................................................................. F-5 Consolidated statements of cash flows for the years ended September 30, 1996, 1997 and 1998............ F-6 Notes to consolidated financial statements............................................................. F-7
The following financial statement schedule of the Registrant and its subsidiaries is submitted herewith in response to Item 14(a)2:
PAGE --------- Schedule II--Valuation and qualifying accounts......................................................... S-1 Financial Statements in response to Rule 3-09 of Regulation S-X: CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC Audited Consolidated Financial Statements Report of independent public accountants............................................................... F-49 Consolidated balance sheet as of September 30, 1997 and 1998........................................... F-50 Consolidated statement of operations for the 106 days ended September 30, 1997 and the year ended September 30, 1998.................................................................................... F-52 Consolidated statement of changes in members' capital for the 106 days ended September 30, 1997 and the year ended September 30, 1998......................................................................... F-53 Consolidated statement of cash flows for the 106 days ended September 30, 1997 and the year ended September 30, 1998.................................................................................... F-54 Notes to consolidated financial statements............................................................. F-55
The following financial statement schedule for Charter Behavioral Health Systems, LLC and its subsidiaries is submitted herewith in response to Item 14(a)2:
PAGE --------- Schedule II--Valuation and qualifying accounts............................................................. S-2
CHOICE BEHAVIORAL HEALTH PARTNERSHIP The Audited Consolidated Financial Statements of CHOICE Behavioral Health Partnership ("Choice") will be filed in an amendment to this Form 10-K no later than March 31, 1999. Choice's fiscal year end is December 31, 1998. F-1 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Magellan Health Services, Inc: We have audited the accompanying consolidated balance sheets of Magellan Health Services, Inc. (a Delaware corporation) and subsidiaries as of September 30, 1997 and 1998, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the three years in the period ended September 30, 1998. These consolidated financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Magellan Health Services, Inc. and subsidiaries as of September 30, 1997 and 1998 and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1998 in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index to financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states, in all material respects, the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Atlanta, Georgia December 3, 1998 F-2 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
SEPTEMBER 30, --------------------- 1997 1998 --------- ---------- ASSETS Current Assets: Cash, including cash equivalents of $319,823 at September 30, 1997 and $14,185 at September 30, 1998 at cost, which approximates market value.......................... $ 372,878 $ 92,050 Accounts Receivable, less allowance for doubtful accounts of $40,311 at September 30, 1997 and $34,867 at September 30, 1998............................................... 107,998 174,846 Restricted cash and investments....................................................... -- 89,212 Refundable income taxes............................................................... 2,466 4,939 Other current assets.................................................................. 23,696 38,677 --------- ---------- Total Current Assets................................................................ 507,038 399,724 Assets restricted for settlement of unpaid claims and other long-term liabilities......... 87,532 37,910 Property and equipment, net............................................................... 109,214 177,169 Deferred income taxes..................................................................... 1,158 97,386 Investment in CBHS........................................................................ 16,878 -- Other long-term assets.................................................................... 20,893 46,481 Goodwill, net of accumulated amortization of $14,006 at September 30, 1997 and $32,785 at September 30, 1998...................................................................... 114,234 992,431 Other intangible assets, net of accumulated amortization of $5,855 at September 30, 1997 and $12,343 at September 30, 1998....................................................... 38,673 165,189 --------- ---------- $ 895,620 $1,916,290 --------- ---------- --------- ---------- LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable........................................................................ $ 45,346 $ 42,873 Accrued liabilities..................................................................... 133,921 193,530 Medical claims payable.................................................................. 36,508 195,330 Current maturities of long-term debt and capital lease obligations...................... 3,601 23,033 --------- ---------- Total Current Liabilities......................................................... 219,376 454,766 Long-term debt and capital lease obligations.............................................. 391,693 1,202,613 Reserve for unpaid claims................................................................. 49,113 30,280 Deferred credits and other long-term liabilities.......................................... 16,110 14,011 Minority interest......................................................................... 61,078 26,985 Commitments and Contingencies Stockholders' Equity: Preferred Stock, without par value Authorized--10,000 shares Issued and outstanding--none.......................................................... -- -- Common Stock, par value $.25 per share Authorized--80,000 shares Issued and outstanding--33,439 shares at September 30, 1997 and 33,898 shares at September 30, 1998.................................................................... 8,361 8,476 Other Stockholders' Equity: Additional paid-in capital............................................................ 340,645 349,651 Accumulated deficit................................................................... (129,955) (149,238) Warrants outstanding.................................................................. 25,050 25,050 Common stock in treasury, 4,424 shares at September 30, 1997 and 2,289 shares at September 30, 1998................................................................... (82,731) (44,309) Cumulative foreign currency adjustments............................................... (3,120) (1,995) --------- ---------- Total Stockholders' Equity........................................................ 158,250 187,635 --------- ---------- $ 895,620 $1,916,290 --------- ---------- --------- ----------
The accompanying Notes to Consolidated Financial Statements are an integral part of these balance sheets. F-3 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEAR ENDED SEPTEMBER 30, ------------------------------ 1996 1997 1998 -------- -------- ---------- Net revenue..................................................................................... $1,345,279 $1,210,696 $1,512,454 -------- -------- ---------- Costs and expenses: Salaries, cost of care and other operating expenses........................................... 1,064,445 978,513 1,294,481 Bad debt expense.............................................................................. 81,470 46,211 4,977 Equity in loss of CBHS........................................................................ -- 8,122 31,878 Depreciation and amortization................................................................. 48,924 44,861 54,885 Interest, net................................................................................. 48,017 45,377 75,375 Stock option expense (credit)................................................................. 914 4,292 (5,623) Managed Care integration costs................................................................ -- -- 16,962 Loss on Crescent Transactions................................................................. -- 59,868 -- Unusual items, net............................................................................ 37,271 357 458 -------- -------- ---------- 1,281,041 1,187,601 1,473,393 -------- -------- ---------- Income before income taxes, minority interest and extraordinary items....................................................................... 64,238 23,095 39,061 Provision for income taxes...................................................................... 25,695 9,238 20,033 -------- -------- ---------- Income before minority interest and extraordinary items......................................... 38,543 13,857 19,028 Minority interest............................................................................... 6,160 9,102 5,296 -------- -------- ---------- Income before extraordinary items............................................................... 32,383 4,755 13,732 Extraordinary items--net losses on early extinguishments of debt (net of income tax benefit of $3,503 in 1997 and $22,010 in 1998)........................ -- (5,253) (33,015) -------- -------- ---------- Net income (loss)............................................................................... $ 32,383 $ (498) $ (19,283) -------- -------- ---------- -------- -------- ---------- Average number of common shares outstanding--basic.............................................. 31,014 28,781 30,784 -------- -------- ---------- -------- -------- ---------- Average number of common shares outstanding--diluted............................................ 31,596 29,474 31,198 -------- -------- ---------- -------- -------- ---------- Income (loss) per common share--basic: Income before extraordinary items............................................................. $ 1.04 $ 0.17 $ 0.45 -------- -------- ---------- -------- -------- ---------- Extraordinary losses on early extinguishments of debt......................................... $ -- $ (0.18) $ (1.07) -------- -------- ---------- -------- -------- ---------- Net income (loss)............................................................................... $ 1.04 $ (0.02) $ (0.63) -------- -------- ---------- -------- -------- ---------- Income (loss) per common share--diluted: Income before extraordinary items............................................................. $ 1.02 $ 0.16 $ 0.44 -------- -------- ---------- -------- -------- ---------- Extraordinary losses on early extinguishments of debt......................................... $ -- $ (0.18) $ (1.06) -------- -------- ---------- -------- -------- ---------- Net income (loss)............................................................................... $ 1.02 $ (0.02) $ (0.62) -------- -------- ---------- -------- -------- ----------
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. F-4 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
YEAR ENDED SEPTEMBER 30, ------------------------------- 1996 1997 1998 --------- --------- --------- (IN THOUSANDS) Common Stock: Balance, beginning of period................................................. $ 7,101 $ 8,252 $ 8,361 Exercise of options and warrants............................................. 97 109 115 Green Spring Health Services, Inc. acquisition............................... 54 -- -- Issuance of Common Stock, net of issuance costs.............................. 1,000 -- -- --------- --------- --------- Balance, end of period....................................................... 8,252 8,361 8,476 --------- --------- --------- Additional paid-in capital: Balance, beginning of period................................................. 253,295 327,681 340,645 Stock option expense (credit)................................................ 914 4,292 (5,623) Green Spring Health Services, Inc. acquisition............................... 4,263 -- -- Exercise of options and warrants............................................. 1,636 8,156 3,867 Issuance of Common Stock, net of issuance costs.............................. 67,573 -- -- Green Spring Minority Stockholder Conversion................................. -- -- 10,722 Other........................................................................ -- 516 40 --------- --------- --------- Balance, end of period....................................................... 327,681 340,645 349,651 --------- --------- --------- Accumulated deficit: Balance, beginning of period................................................. (161,840) (129,457) (129,955) Net income (loss)............................................................ 32,383 (498) (19,283) --------- --------- --------- Balance, end of period....................................................... (129,457) (129,955) (149,238) --------- --------- --------- Warrants outstanding: Balance, beginning of period................................................. 64 54 25,050 Exercise of warrants......................................................... (10) (4) -- Issuance of warrants to Crescent and COI..................................... -- 25,000 -- --------- --------- --------- Balance, end of period....................................................... 54 25,050 25,050 --------- --------- --------- Common stock in treasury: Balance, beginning of period................................................. (9,238) (82,731) (82,731) Purchases of treasury stock.................................................. (73,493) -- (14,352) Green Spring Minority Stockholder Conversion................................. -- -- 52,774 --------- --------- --------- Balance, end of period....................................................... (82,731) (82,731) (44,309) --------- --------- --------- Cumulative foreign currency adjustments: Balance, beginning of period................................................. (822) (1,982) (3,120) Foreign currency translation gain (loss)..................................... (1,160) (1,138) 1,125 --------- --------- --------- Balance, end of period....................................................... (1,982) (3,120) (1,995) --------- --------- --------- Total Stockholders' Equity..................................................... $ 121,817 $ 158,250 $ 187,635 --------- --------- --------- --------- --------- ---------
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. F-5 MAGELLAN HEALTH SERVICES, INC. SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED SEPTEMBER 30, -------------------------------- 1996 1997 1998 --------- --------- ---------- (IN THOUSANDS) Cash Flows From Operating Activities Net income (loss)............................................................ $ 32,383 $ (498) $ (19,283) --------- --------- ---------- Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Gain on sale of assets................................................. (2,062) (5,747) (3,001) Depreciation and amortization.......................................... 48,924 44,861 54,885 Impairment of long-lived assets........................................ -- -- 2,507 Non-cash portion of unusual items...................................... 31,206 -- -- Equity in loss of CBHS................................................. -- 8,122 31,878 Loss on Crescent Transactions.......................................... -- 59,868 -- Stock option expense (credit).......................................... 914 4,292 (5,623) Non-cash interest expense.............................................. 2,424 1,710 2,935 Extraordinary losses on early extinguishments of debt.................. -- 8,756 55,025 Cash flows from changes in assets and liabilities, net of effects from sales and acquisitions of businesses: Accounts receivable, net................................................. 15,495 60,675 (1,585) Restricted cash and investments.......................................... -- -- (21,782) Other current assets..................................................... 129 4,708 (3,010) Other long-term assets................................................... 6,569 3,156 (7,840) Accounts payable and accrued liabilities................................. (7,516) (60,659) (43,724) Income taxes payable and deferred income taxes........................... 14,925 (14,669) (14,489) Reserve for unpaid claims................................................ (29,985) (26,553) (19,177) Other liabilities........................................................ (18,968) (23,038) (9,290) Minority interest, net of dividends paid................................. 6,406 9,633 (929) Other.................................................................... 1,022 (1,018) (1,701) --------- --------- ---------- Total adjustments........................................................ 69,483 74,097 15,079 --------- --------- ---------- Net cash provided by (used in) operating activities.................... 101,866 73,599 (4,204) --------- --------- ---------- Cash Flows From Investing Activities: Capital expenditures......................................................... (38,801) (33,348) (44,213) Acquisitions and investments in businesses, net of cash acquired............. (50,918) (50,876) (1,046,436) Distributions received from unconsolidated subsidiaries...................... -- -- 11,441 Decrease (increase) in assets restricted for settlement of unpaid claims and other long-term liabilities................................................ (17,732) 17,209 51,006 Proceeds from sale of assets................................................. 5,248 18,270 18,088 Proceeds from sale of property and equipment to Crescent and CBHS, net of transaction costs................................................... -- 380,425 (6,213) --------- --------- ---------- Net cash provided by (used in) investing activities.................... (102,203) 331,680 (1,016,327) --------- --------- ---------- Cash Flows From Financing Activities: Payments on debt and capital lease obligations............................... (85,835) (390,254) (438,633) Proceeds from issuance of debt, net of issuance costs........................ 104,800 203,643 1,188,706 Proceeds from issuance of common stock....................................... 68,573 -- -- Proceeds from exercise of stock options and warrants......................... 3,401 8,265 5,739 Proceeds from issuance of warrants........................................... -- 25,000 -- Purchases of treasury stock.................................................. (73,493) -- (14,352) Income tax payments made on behalf of stock optionee......................... (1,678) -- (1,757) --------- --------- ---------- Net cash provided by (used in) financing activities.................... 15,768 (153,346) 739,703 --------- --------- ---------- Net increase (decrease) in cash and cash equivalents........................... 15,431 251,933 (280,828) Cash and cash equivalents at beginning of period............................... 105,514 120,945 372,878 --------- --------- ---------- Cash and cash equivalents at end of period..................................... $ 120,945 $ 372,878 $ 92,050 --------- --------- ---------- --------- --------- ----------
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements F-6 MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements of Magellan Health Services, Inc., a Delaware corporation, ("Magellan" or the "Company") include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company's primary business segment, as of September 30, 1998, was its behavioral managed healthcare operations. The Company operates in four other business segments, which are described in further detail in Note 15, "Business Segment Information." The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. MANAGED CARE REVENUE Managed care revenue is recognized over the applicable coverage period on a per member basis for covered members and as earned and estimable for performance-based revenues. Deferred revenue is recorded when premium payments are received in advance of the applicable coverage period. FRANCHISE REVENUE Continuing annual franchise fees are recognized as the fees are earned and become receivable from franchisees, subject to an allowance for estimated uncollectible amounts. Costs relating to continuing franchise fees are expensed as incurred. Individual franchise sales are recognized when all material services or conditions relating to the sale have been substantially performed or satisfied by the Company. Direct costs relating to franchise sales are deferred until the related revenue is recognized up to the amount of anticipated revenue less estimated additional related costs. PROVIDER NET REVENUE Provider net revenue is based on established billing rates, less estimated allowances for patients covered by Medicare and other contractual reimbursement programs, and discounts from established billing rates. Amounts received by the Company for treatment of patients covered by Medicare and other contractual reimbursement programs, which may be based on cost of services provided or predetermined rates, are generally less than the established billing rates of the Company's hospitals. Final determination of amounts earned under contractual reimbursement programs is subject to review and audit by the applicable agencies. The Company recorded net revenue in fiscal 1996, 1997 and 1998 of $28.3 million, $27.4 million and $7.0 million, respectively, for the settlement and adjustment of reimbursement issues related to earlier fiscal periods. Management believes that adequate provision has been made for any adjustments that may result from such reviews in future periods. F-7 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) ADVERTISING COSTS The production costs of advertising are expensed as incurred. The Company does not consider any of its advertising costs to be direct-response and, accordingly, does not capitalize such costs. Advertising costs consist primarily of radio and television air time, which is amortized as utilized, and printed media services. Advertising expense was approximately $30.5 million, $19.2 million and $4.7 million for the years ended September 30, 1996, 1997 and 1998, respectively. CHARITY CARE The Company provides healthcare services without charge or at amounts less than its established rates to patients who meet certain criteria under its charity care policies. Because the Company does not pursue collection of amounts determined to be charity care, they are not reported as revenue. For the years ended September 30, 1996, 1997 and 1998, the Company provided, at its established billing rates, approximately $37.9 million, $19.5 million and $3.7 million, respectively, of such care. INTEREST, NET The Company records interest expense net of interest income. Interest income for the years ended September 30, 1996, 1997, and 1998 was approximately $10.5 million, $10.1 million and $11.9 million, respectively. CASH AND CASH EQUIVALENTS Cash equivalents are short-term, highly liquid interest-bearing investments with a maturity of three months or less when purchased, consisting primarily of money market instruments. RESTRICTED CASH AND INVESTMENTS Restricted cash and investments at September 30, 1998 include approximately $89.2 million that is held for the payment of claims under the terms of certain behavioral managed care contracts and for regulatory purposes related to the payment of claims in certain jurisdictions. CONCENTRATION OF CREDIT RISK Accounts receivable from human services revenue and healthcare provider revenue subject the Company to a concentration of credit risk with third party payors that include insurance companies, managed healthcare organizations and governmental entities. The Company establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific payors, historical trends and other information. Management believes the allowance for doubtful accounts is adequate to provide for normal credit losses. ASSETS RESTRICTED FOR THE SETTLEMENT OF UNPAID CLAIMS AND OTHER LONG-TERM LIABILITIES Assets restricted for the settlement of unpaid claims and other long-term liabilities include investments which are carried at fair market value. Transfer of such investments from the Company's insurance subsidiaries to Magellan or any of its other subsidiaries is subject to approval by certain regulatory authorities. The investments can be classified into three categories: (i) held to maturity; (ii) available for sale; and (iii) trading. Unrealized holding gains or losses are recorded for trading and available for sale F-8 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) securities. The Company's investments are classified as available for sale. The unrealized gain or loss on investments available for sale was not material at September 30, 1997 and 1998. PROPERTY AND EQUIPMENT Property and equipment are stated at cost, except for assets that have been impaired, for which the carrying amount is reduced to estimated fair value. Expenditures for renewals and improvements are charged to the property accounts. Replacements and maintenance and repairs that do not improve or extend the life of the respective assets are expensed as incurred. Internal-use software is capitalized in accordance with SOP 98-1 (as defined). See "--Recent Accounting Pronouncements" Amortization of capital lease assets is included in depreciation expense. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets, which is generally ten to forty years for buildings and improvements, three to ten years for equipment and three to five years for capitalized internal-use software. Depreciation expense was $40.0 million, $34.1 million and $24.0 million for the fiscal years ended September 30, 1996, 1997 and 1998, respectively. Property and equipment, net, consisted of the following at September 30, 1997 and 1998 (in thousands):
SEPTEMBER 30, ------------------------ 1997 1998 ----------- ----------- Land.......................................................................... $ 11,667 $ 11,607 Buildings and improvements.................................................... 70,174 78,886 Equipment..................................................................... 61,671 112,422 Capitalized internal-use software............................................. 2,048 33,923 ----------- ----------- 145,560 236,838 Accumulated depreciation...................................................... (37,038) (60,100) ----------- ----------- 108,522 176,738 Construction in progress...................................................... 692 431 ----------- ----------- Property and equipment, net................................................. $ 109,214 $ 177,169 ----------- ----------- ----------- -----------
INTANGIBLE ASSETS Intangible assets are composed principally of (i) goodwill, (ii) customer lists, and (iii) deferred financing costs. Goodwill represents the excess of the cost of businesses acquired over the fair value of the net identifiable assets at the date of acquisition and is amortized using the straight-line method over 25 to 40 years. Customer lists and other intangible assets are amortized using the straight-line method over their estimated useful lives of 4 to 30 years. Deferred financing costs are amortized over the terms of the underlying agreements. The Company continually monitors events and changes in circumstances which could indicate that carrying amounts of intangible assets may not be recoverable. When events or changes in circumstances are present that indicate the carrying amount of intangible assets may not be recoverable, the Company assesses the recoverability of intangible assets by determining whether the carrying value of such intangible assets will be recovered through the future cash flows expected from the use of the asset and its eventual disposition. No impairment losses on intangible assets were recorded by the Company in 1996. Impairment losses of approximately $14.4 million and $1.9 million were recorded in fiscal 1997 and fiscal 1998, respectively. (See Notes 3 and 11) F-9 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) MEDICAL CLAIMS PAYABLE Medical claims payable represent the liability for healthcare services authorized or incurred and not yet paid by the Company's managed care businesses. Medical claims payable are estimated based upon authorized healthcare services, past claim payment experience for member groups, adjudication decisions, patient census data and other factors. While Management believes the liability for medical claims payable is adequate, actual results could differ from such estimates. FOREIGN CURRENCY Changes in the cumulative translation of foreign currency assets and liabilities are presented as a separate component of stockholders' equity. Gains and losses resulting from foreign currency transactions, which were not material, are included in operations as incurred. NET INCOME (LOSS) PER COMMON SHARE Net income (loss) per common share is computed based on the weighted average number of shares of common stock and common stock equivalents outstanding during the period. The Exchange Option, as hereinafter defined (see Note 2), was classified as a potentially dilutive security for fiscal 1996, 1997 and 1998 for the purpose of computing diluted income per common share. The Exchange Option was anti-dilutive for fiscal 1996, 1997 and 1998 and, therefore, was excluded from the diluted income per common share calculations. The Exchange Option was exercised in January 1998. STOCK-BASED COMPENSATION In October 1995, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," ("FAS 123") which became effective for fiscal years beginning after December 15, 1995 (fiscal 1997 for the Company). FAS 123 established new financial accounting and reporting standards for stock-based compensation plans. Entities are allowed to measure compensation cost for stock-based compensation under FAS 123 or APB Opinion No. 25, "Accounting for Stock Issued to Employees." Entities electing to remain with the accounting in APB Opinion No. 25 are required to make pro forma disclosures of net income and income per common share as if the provisions of FAS 123 had been applied. The Company has adopted FAS 123 on a pro forma disclosure basis (see Note 8). RECENT ACCOUNTING PRONOUNCEMENTS In February 1997, the FASB issued FAS 128, which applies to entities with publicly held common stock or potential common stock. FAS 128 replaces APB Opinion 15, "Earnings per Share" and related interpretations. APB Opinion 15 required that entities with simple capital structures present a single "earnings per common share" ("EPS") on the face of the income statement, whereas those with complex capital structures present both "primary" and "fully diluted" EPS. Primary EPS shows the amount of income attributed to each share of common stock if every common stock equivalent were converted into common stock. Fully diluted EPS considers common stock equivalents and all other securities that could be converted into common stock. FAS 128 simplifies the computation of EPS by replacing the presentation of primary EPS with a presentation of basic EPS. The Statement requires dual presentation of basic and diluted EPS by entities with complex capital structures. Basic EPS includes no dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for F-10 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) the period. Diluted EPS reflects the potential dilution of securities that could share in the earnings of an entity, similar to fully diluted EPS under APB Opinion 15. The Company adopted FAS 128 during the fiscal year ended September 30, 1998. See Note 8, "Stockholder's Equity". In March 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 establishes accounting guidance for internal use software and requires the following: - Computer software costs that are incurred in the preliminary project stage (as described in SOP 98-1) should be expensed as incurred. Once the capitalization criteria of SOP 98-1 have been met, external direct costs of materials and services consumed in developing or obtaining internal-use computer software; payroll and payroll-related costs for employees who are directly associated with and who devote time to the internal-use computer software project (to the extent of the time spent directly on the project) and interest costs incurred when developing computer software for internal use should be capitalized. Training costs and data conversion costs should generally be expensed as incurred. - Internal costs incurred for upgrades and enhancements should be expensed or capitalized in accordance with SOP 98-1. Internal costs incurred for maintenance should be expensed as incurred. Entities that cannot separate internal costs on a reasonably cost-effective basis between maintenance and relatively minor upgrades and enhancements should expense such costs as incurred. - External costs incurred under agreements related to specified upgrades and enhancements should be expensed or capitalized in accordance with SOP 98-1. However, external costs related to maintenance, unspecified upgrades and enhancements and costs under agreements that combine the costs of maintenance and unspecified upgrades and enhancements should be recognized in expense over the contract period on a straight-line basis unless another systematic and rational basis is more representative of the services received. - Impairment should be recognized and measured in accordance with the provisions of FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." - The capitalized costs of computer software developed or obtained for internal use should be amortized on a straight-line basis unless another systematic and rational basis is more representative of the software's use. SOP 98-1 becomes effective for financial statements for fiscal years beginning after December 15, 1998. The provisions of SOP 98-1 should be applied to internal-use software costs incurred in those fiscal years for all projects, including those projects in progress upon initial application of SOP 98-1. Costs incurred prior to the initial application of SOP 98-1, whether capitalized or not, should not be adjusted to the amounts that would have been capitalized had SOP 98-1 been in effect when those costs were incurred. The Company adopted SOP 98-1 effective October 1, 1997. Each of the Company's operating units maintains its own information systems, which include internal-use software as defined by SOP 98-1. The care management and claims processing systems used in the Company's managed care businesses are the Company's most significant internal-use software applications. The adoption of SOP 98-1 had no impact on the Company's financial position or results of operations. F-11 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) In April 1998, the AICPA issued Statement of Position 98-5, "Reporting on the Costs of Start-up Activities" ("SOP 98-5"). SOP 98-5 requires all nongovernmental entities to expense costs of start-up activities as those costs are incurred. Start-up costs, as defined by SOP 98-5, include pre-operating costs, pre-opening cost and organizational costs. SOP 98-5 becomes effective for financial statements for fiscal years beginning after December 15, 1998. At adoption, a company must record a cumulative effect of a change in accounting principle to write off any unamortized start-up costs remaining on the balance sheet when SOP 98-5 is adopted. Prior year financial statements cannot be restated. The Company will adopt SOP 98-5 on October 1, 1998. The adoption of SOP 98-5 will have no impact on the Company's financial position or results of operations. Emerging Issues Task Force Issue 96-16, "Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights" ("EITF 96-16") supplements the guidance contained in AICPA Accounting Research Bulletin 51, "Consolidated Financial Statements", and in Statement of Financial Accounting Standards No. 94, "Consolidation of All Majority-Owned Subsidiaries" ("ARB 51/FAS 94"), about the conditions under which the Company's consolidated financial statements should include the financial position, results of operations and cash flows of subsidiaries which are less than wholly-owned along with those of the Company's wholly-owned subsidiaries. In general, ARB 51/FAS 94 requires consolidation of all majority-owned subsidiaries except those for which control is temporary or does not rest with the majority owner. Under the ARB 51/FAS 94 approach, instances of control not resting with the majority owner were generally regarded to arise from such events as the legal reorganization or bankruptcy of the majority-owned subsidiary. EITF 96-16 expands the definition of instances in which control does not rest with the majority owner to include those where significant approval or veto rights, other than those which are merely protective of the minority shareholder's interest, are held by the minority shareholder or shareholders ("Substantive Participating Rights"). Substantive Participating Rights include, but are not limited to: i) selecting, terminating and setting the compensation of management responsible for implementing the majority-owned subsidiary's policies and procedures, and ii) establishing operating and capital decisions of the majority-owned subsidiary, including budgets, in the ordinary course of business. The provisions of EITF 96-16 apply to new investment agreements made after July 24, 1997, and to existing investment agreements which are modified after this date. The Company has made no new investments, and has modified no existing investments, to which the provisions of EITF 96-16 would have applied. In addition, the provisions of EITF 96-16 must be applied to majority-owned subsidiaries previously consolidated under ARB 51/FAS 94 for which the underlying agreements have not been modified in financial statements issued for years ending after December 15, 1998 (fiscal 1999 for the Company). The F-12 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) adoption of the provisions of EITF 96-16 on October 1, 1998, will have the following effects on the Company's consolidated financial position:
OCTOBER 1, 1998 ----------- INCREASE (DECREASE) IN: Cash and cash equivalents....................................................... $ (21,092) Other current assets........................................................... (9,538) Long-term assets............................................................... (30,049) Investment in unconsolidated subsidiaries...................................... 26,498 ----------- Total Assets................................................................. $ (34,181) ----------- ----------- Current liabilities............................................................ $ (10,381) Minority interest.............................................................. (23,800) ----------- Total Liabilities............................................................ $ (34,181) ----------- -----------
In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("FAS 131"). FAS 131 redefines how operating segments are determined and requires disclosure of certain financial and descriptive information about a company's operating segments. The Company has adopted FAS 131 in fiscal 1998. Accordingly, segment disclosure for fiscal 1996 and 1997 has been restated to conform to the fiscal 1998 presentation. See Note 15, "Business Segment Information." RECLASSIFICATIONS Certain reclassifications have been made to fiscal 1996 and 1997 amounts to conform to fiscal 1998 presentation. 2. ACQUISITIONS AND JOINT VENTURES ACQUISITIONS MERIT ACQUISITION. On February 12, 1998, the Company consummated the acquisition of Merit Behavioral Care Corporation ("Merit") for cash consideration of approximately $448.9 million plus the repayment of Merit's debt. Merit manages behavioral healthcare programs across all segments of the healthcare industry, including HMOs, Blue Cross/Blue Shield organizations and other insurance companies, corporations and labor unions, federal, state and local governmental agencies and various state Medicaid programs. The Company accounted for the Merit acquisition using the purchase method of accounting. On September 12, 1997, Merit completed the acquisition of CMG Health, Inc. ("CMG"). CMG is also a national behavioral managed healthcare. Merit paid approximately $48.7 million in cash and issued approximately 739,000 shares of Merit common stock as consideration for CMG. The former owners of CMG may be entitled to additional consideration, depending on the performance of three CMG customer contracts. Such contingent payments are subject to an aggregate maximum of $23.5 million. No contingent consideration will be payable to the former shareholders of CMG based on the performance of two of the three CMG customer contracts at September 30, 1998. The Company may still be required to pay contingent consideration to the former shareholders of CMG depending on the financial performance of CHOICE Behavioral Health Partnership ("Choice"). Choice is a joint venture with Value Options, Inc. that services a contract with CHAMPUS (as defined). The Company and Value Options, Inc. each own 50% of Choice. The payment of contingent consideration, if any, to the former shareholders of CMG, depends on the financial performance of Choice from October 1, 1996 to June 30, F-13 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) 1997, which is subject to a CHAMPUS Adjustment (as defined) the Company expects to receive in fiscal 1999. In connection with the acquisition of Merit, the Company (i) terminated its existing credit agreement; (ii) repaid all loans outstanding pursuant to Merit's existing credit agreement; (iii) completed a tender offer for its 11.25% Series A Senior Subordinated Notes due 2004 (the "Old Notes"); (iv) completed a tender offer for Merit's 11.50% Senior Subordinated notes due 2005 (the "Merit Outstanding Notes"); (v) entered into a new senior secured bank credit agreement (the "New Credit Agreement") providing for a revolving credit facility (the "Revolving Facility") and a term loan facility (the "Term Loan Facility") of up to $700 million; and (vi) issued $625 million in 9.0% Senior Subordinated Notes due 2008 (the "Notes"). The following table sets forth the sources and uses of funds for the Merit acquisition and related transactions (the "Transactions") at closing (in thousands): SOURCES: Cash and cash equivalents.............................................. $ 59,290 New Credit Agreement: Revolving Facility (1)............................................... 20,000 Term Loan Facility................................................... 550,000 The Notes.............................................................. 625,000 ---------- Total sources...................................................... $1,254,290 ---------- ---------- USES: Cash paid to Merit Shareholders........................................ $ 448,867 Repayment of Merit existing credit agreement (2)....................... 196,357 Purchase of the Old Notes (3).......................................... 432,102 Purchase of Merit Outstanding Notes (4)................................ 121,651 Transaction costs (5).................................................. 55,313 ---------- Total uses......................................................... $1,254,290 ---------- ----------
- ------------------------ (1) The Revolving Facility provides for borrowings of up to $150.0 million. The Company had $112.5 million available for borrowing pursuant to the Revolving Facility after consummating the Transactions, excluding approximately $17.5 million of availability reserved for certain letters of credit. (2) Includes principal amount of $193.6 million and accrued interest of $2.7 million. (3) Includes principal amount of $375.0 million, tender premium of $43.4 million and accrued interest of $13.7 million. (4) Includes principal amount of $100.0 million, tender premium of $18.9 million and accrued interest of $2.8 million. (5) Transaction costs include, among other things, expenses associated with the debt tender offers, the Notes offering, the Merit acquisition and the New Credit Agreement. The purchase price allocation for the Merit acquisition is tentative and subject to adjustment pending determination of final valuation allowances on deferred tax assets, integration plan matters (see Note 11), CHAMPUS Adjustments (as defined) and certain other matters. The Company expects the Merit purchase price allocation to be finalized by February 12, 1999. HAI ACQUISITION. On December 4, 1997, the Company consummated the purchase of Human Affairs International, Incorporated ("HAI"), formerly a unit of Aetna/U.S. Healthcare ("Aetna"), for approximately F-14 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) $122.1 million, which the Company funded from cash on hand. The Company accounted for the HAI acquisition using the purchase method of accounting. HAI manages behavioral healthcare, primarily through EAPs and other behavioral managed healthcare plans. The Company may be required to make additional contingent payments of up to $60.0 million annually to Aetna over the five year period subsequent to closing. The amount and timing of the payments will be contingent upon net increases in the number of HAI's covered lives in specified products. The Company may be required to make additional contingent payments of up to $300 million to Aetna (the "Contingent Payments") over the five-year period (each year a "Contract Year") subsequent to closing. The amount and timing of the Contingent Payments will depend upon HAI's receipt of additional covered lives as computed, under two separate calculations. Under the first calculation, the Company may be required to pay up to $25 million per year for each of five years following the acquisition based on the net annual growth in the number of lives covered in specified HAI products. Under the second calculation, the Company may be required to pay up to $35 million per Contract Year, based on the net cumulative increase in lives covered by certain other HAI products. The Company is obligated to make contingent payments under two separate calculations (as previously described) as follows: In respect of each Contract Year, the Company may be required to pay to Aetna the "Tranche 1 Payments" (as defined) and the "Tranche 2 Payments" (as defined). Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest with respect to such Contract Year in an amount equal to the product of (i) the Tranche 1 Cumulative Incremental Members (as defined) for such Contract Year and (ii) the Tranche 1 Multiplier (as defined) for such Contract Year. The vested amount of Tranche 1 Payment shall be zero with respect to any Contract Year in which the Tranche 1 Cumulative Incremental Members is a negative number. Furthermore, in the event that the number of Tranche 1 Cumulative Incremental Members with respect to any Contract Year is a negative number due to a decrease in the number of Tranche 1 Cumulative Incremental Members for such Contract Year (as compared to the immediately preceding Contract Year), Aetna will forfeit the right to receive a certain portion (which may be none or all) of the vested and unpaid amounts of the Tranche 1 Payment relating to preceding Contract Years. "Tranche 1 Cumulative Incremental Members" means, with respect to any Contract Year, (i) the number of Equivalent Members (as defined) serviced by the Company during such Contract Year for Tranche 1 Members, minus (ii)(A) for each Contract Year other than the Initial Contract Year, the number of Equivalent Members serviced by the Company for Tranche 1 Members during the immediately preceding Contract Year or (B) for the Initial Contract Year, the number of Tranche 1 Members as of September 30, 1997, subject to certain upward adjustments. There were 3,761,253 Tranche 1 Members for the initial Contract Year, prior to such upward adjustments. "Tranche 1 Members" are members of managed behavioral healthcare plans for whom the Company provides services in any of specified categories of products or services. "Equivalent Members" for any Contract Year equals the aggregate Member Months for which the Company provides services to a designated category or categories of members during the applicable Contract Year divided by 12. "Member Months" means, for each member, the number of months for which the Company provides services and is compensated. The "Tranche 1 Multiplier" is $80, $50, $40, $25, and $20 for the Contract Years 1998, 1999, 2000, 2001, and 2002, respectively. For each Contract Year, the Company is obligated to pay to Aetna the lesser of (i) the vested portion of the Tranche 1 Payment for such Contract Year and the vested and unpaid amount relating to prior Contract Years as of the end of the immediately preceding Contract Year and (ii) $25.0 million. To the extent that the vested and unpaid portion of the Tranche 1 Payment exceeds $25.0 million, the Tranche 1 Payment remitted to Aetna shall be deemed to have been paid first from any vested but unpaid amounts F-15 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) from previous Contract Years in order from the earliest Contract Year for which vested amounts remain unpaid to the most recent Contract Year at the time of such calculation. Except with respect to the Contract Year ending in 2002, any vested but unpaid portion of the Tranche 1 Payment shall be available for payment to Aetna in future Contract Years, subject to certain exceptions. All vested but unpaid amounts of Tranche 1 Payments shall expire following the payment of the Tranche 1 Payment in respect to the Contract Year ending in 2002, subject to certain exceptions. In no event shall the aggregate Tranche 1 Payments to Aetna exceed $125.0 million. Upon the expiration of each Contract Year, the Tranche 2 Payment shall be an amount equal to the lesser of: (a)(i) the product of (A) the Tranche 2 Cumulative Members (as defined) for such Contract Year and (B) the Tranche 2 Multiplier (as defined) applicable to such number of Tranche 2 Cumulative Members, minus (ii) the aggregate of the Tranche 2 Payments paid to Aetna for all previous Contract Years and (b) $35.0 million. The amount shall be zero with respect to any Contract Year in which the Tranche 2 Cumulative Members is a negative number. "Tranche 2 Cumulative Members" means, with respect to any Contract Year; (i) the Equivalent Members serviced by the Company during such Contract Year for Tranche 2 Members, minus (ii) the Tranche 2 Members as of September 30, 1997, subject to certain upward adjustments. There were 936,391 Tranche 2 Members prior to such upward adjustments. "Tranche 2 Members" means Members for whom the Company provides products or services in the HMO category. The "Tranche 2 Multiplier" with respect to each Contract Year is $85 in the event that the Tranche 2 Cumulative Members are less than 2,100,000, and $70 if more than or equal to 2,100,000. For each Contract Year, the Company shall pay to Aetna the amount of Tranche 2 Payment payable for such Contract Year. All rights to receive Tranche 2 Payment shall expire following the payment of the Tranche 2 Payment in respect to the Contract Year ending in 2002, subject to certain exceptions. Notwithstanding anything herein to the contrary, in no event shall the aggregate Tranche 2 payment to Aetna exceed $175.0 million, subject to certain exceptions. The Company would record contingent consideration payable, if any, as goodwill and identifiable intangible assets. ALLIED ACQUISITION. On December 5, 1997, the Company purchased the assets of Allied Health Group, Inc. and certain affiliates ("Allied"). Allied provides specialty managed care services, including risk-based products and administrative services to a variety of insurance companies and other customers. Allied has over 80 physician networks across the eastern United States. Allied's networks include physicians specializing in cardiology, oncology and diabetes. The Company paid approximately $70.0 million for Allied, with cash on hand, of which $50.0 million was paid to the seller at closing with the remaining $20.0 million placed in escrow. The Company accounted for the Allied acquisition using the purchase method of accounting. The escrowed amount was payable in one-third increments if Allied achieved specified earnings targets during each of the three years following the closing. Additionally, the purchase price could have been increased during the three year period by up to $40.0 million if Allied's performance exceeded specified earnings targets. On November 25, 1998, the Company and the former owners of Allied amended the Allied purchase agreement (the "Allied Amendment"). The Allied Amendment resulted in the following changes to the original terms of the Allied purchase agreement: - Approximately $18.9 million of the original $20.0 million placed in escrow by the Company at the consummation of the Allied acquisition, plus accrued interest, was repaid to the Company. F-16 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) - The Company paid certain of the former owners of Allied approximately $4.0 million in settlement of a portion of their potential future contingent consideration. - The Company's maximum remaining contingent consideration payable to the former owners of Allied is approximately $6.1 million less approximately $1.1 million that remains in escrow. The future contingent payments, if any, will be based upon the operating performance of Allied for fiscal 1999 through fiscal 2001. The Company would record contingent consideration payable, if any, as additional goodwill. The preliminary allocation of the Allied purchase price to goodwill and identifiable intangible assets was based on the Company's preliminary valuations, which are subject to change upon receiving independent appraisals of identifiable assets. The Company expects the Allied purchase price allocation to be finalized by December 5, 1998. The following unaudited pro forma information for the years ended September 30, 1997 and 1998 has been prepared assuming the Crescent Transactions (as defined), Allied acquisition, HAI acquisition, Merit acquisition, the Transactions and the Green Spring Minority Shareholder Conversion (as defined) were consummated on October 1, 1996. The unaudited pro forma information does not purport to be indicative of the results that would have actually been obtained had such transactions been consummated on October 1, 1996 or which may be attained in future periods (in thousands, except per share data):
PRO FORMA FOR THE YEAR ENDED ------------------------------ SEPTEMBER 30, SEPTEMBER 30, 1997 1998 -------------- -------------- Net revenue...................................................................... $ 1,589,776 $ 1,813,768 Income before extraordinary item(1).............................................. 18,910 14,941 Net income(1)(2)................................................................. 13,657 14,941 Income per common share--basic: Income before extraordinary item............................................... 0.60 0.47 Net income..................................................................... 0.43 0.47 Income per common share--diluted: Income before extraordinary item............................................... 0.59 0.47 Net income..................................................................... 0.42 0.47
- ------------------------ (1) Excludes expected unrealized cost savings related to the Integration Plan (as defined), Managed Care integration costs (See Note 11) and Loss on Crescent Transactions. (2) Excludes the extraordinary losses on early extinguishment of debt for the year ended September 30, 1998, that were directly attributable to the consummation of the Transactions. HUMAN SERVICES ACQUISITIONS During fiscal 1998, the Company acquired seven businesses in its human services segment for an aggregate purchase price of approximately $57.0 million (collectively, the "Human Services Acquisitions"). The Human Services Acquisitions have been accounted for using the purchase method of accounting. The Human Services Acquisitions provide various residential and day services for individuals with acquired brain injuries and for individuals with mental retardation and developmental disabilities. GREEN SPRING ACQUISITION. On December 13, 1995, the Company acquired a 51% ownership interest in Green Spring Health Services, Inc. ("Green Spring") for approximately $68.9 million in cash, the issuance of 215,458 shares of Magellan Common Stock valued at approximately $4.3 million and the F-17 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) contribution of Group Practice Affiliates, Inc. ("GPA"), a wholly-owned subsidiary of the Company, which became a wholly-owned subsidiary of Green Spring. In addition, the minority stockholders of Green Spring were issued an option agreement whereby they could exchange their interests in Green Spring for an equivalent of the Company's Common Stock or subordinated notes (the "Exchange Option"). On December 20, 1995, the Company acquired an additional 10% ownership interest in Green Spring for approximately $16.7 million in cash as a result of an exercise by a minority stockholder of its Exchange Option. In January, 1998, the minority stockholders of Green Spring converted their collective 39% interest in Green Spring into an aggregate of 2,831,516 shares of the Company's common stock through exercise of the Exchange Option (the "Green Spring Minority Stockholder Conversion"). As a result of the Green Spring Minority Stockholder Conversion, the Company owns 100% of Green Spring. The Company issued shares from treasury to effect the Green Spring Minority Stockholder Conversion and accounted for it as a purchase of minority interest at a fair value of consideration paid of approximately $63.5 million. The Company recorded the investments in Green Spring using the purchase method of accounting. Green Spring's results of operations have been included in the consolidated financial statements since the acquisition date, less minority interest through January, 1998, at which time the Company became the sole owner of Green Spring. At each reporting date through January 1998, the Company assessed the fair value of the Exchange Option in relation to the redemption price available to the minority stockholders. In any period that the fair value of the Exchange Option was determined to be less than the redemption price, the difference would have been recognized as an adjustment to minority interest. No losses were recorded in fiscal 1996, 1997 and 1998 as a result of changes in the fair value of the Exchange Option. JOINT VENTURES Through its acquisition of Merit, the Company became a 50% partner with Value Options, Inc. in Choice, a managed behavioral healthcare company. Choice derives all of its revenues from a contract with the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS"), and with TriCare, the successor to CHAMPUS. The Company accounts for its investment in Choice using the equity method. F-18 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) A summary of financial information for the Company's investment in Choice is as follows (in thousands):
SEPTEMBER 30, 1998 -------------------- Current assets.......................................................... $ 22,974 Property and equipment, net............................................. 345 -------- Total assets.......................................................... $ 23,319 -------- -------- Current liabilities..................................................... $ 16,829 Partners' capital....................................................... 6,490 -------- $ 23,319 -------- -------- Magellan Investment in Choice........................................... $ 3,245 -------- -------- FOR THE 231 DAYS ENDED SEPTEMBER 30, 1998 Net revenue............................................................. $ 38,676 Operating expenses...................................................... 22,914 -------- Net income............................................................ $ 15,762 -------- -------- Magellan equity income.................................................. $ 7,881 -------- --------
In June 1996, Green Spring became a 33 1/3% member in Premier Behavioral Systems of Tennessee, LLC ("Premier") with Managed Health Network, Inc. and Columbia Behavioral Health of Tennessee, LLC equally owning the remaining membership interests. In July 1996, Green Spring's membership interest increased to 50% by virtue of Managed Health Network, Inc.'s withdrawal from Premier. Premier was formed to manage behavioral healthcare benefits for the State of Tennessee's TennCare program. The Company accounts for its investment in Premier using the equity method. The Company's investment in Premier at September 30, 1997 and 1998 was $(0.7) million and $5.8 million, respectively. The Company's equity in income (loss) of Premier for fiscal 1996, 1997 and 1998 was $(2.0) million, $(5.6) million and $4.7 million, respectively. Equity in income (loss) of CHOICE and Premier is included in net revenue. The Company is an owner in six hospital-based joint ventures ("Provider JV's") at September 30, 1998. Generally, each member of the joint venture leased and/or contributed certain assets in each respective market to the joint venture with the Company becoming the managing member. The Provider JV's results of operations have been included in the consolidated financial statements since inception, less minority interest. A summary of the Provider JV's is as follows:
OWNERSHIP MARKET DATE PERCENTAGE MINORITY OWNER/S - ----------------------------------- ----------------- ----------------- -------------------------------------------- Chicago, IL........................ June 1994 75% Naperville Health Ventures Boston, MA......................... February 1995 95% Westwood/Pembroke Corp., Psychiatric Associates of Norfolk County, Inc. Albuquerque, NM.................... May 1995 67% Columbia/HCA Healthcare Corporation Raleigh, NC........................ June 1995 50% Columbia/HCA Healthcare Corporation Lafayette, LA...................... October 1995 50% Columbia/HCA Healthcare Corporation Anchorage, AK...................... August 1996 57% Columbia/HCA Healthcare Corporation
F-19 2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) The Company's ownership interests in the Provider JV's have been managed by CBHS (as defined) for a fee equivalent to Magellan's portion of the joint ventures earnings since June 17, 1997. On October 1, 1998, the Provider JV's, excluding Westwood/Pembroke, were converted from consolidation to the equity method of accounting due to the Company's implementation of the transition guidance set forth in EITF 96-16. See Note 1, "Recent Accounting Pronouncements". 3. CRESCENT TRANSACTIONS On June 17, 1997, the Company consummated a series of transactions including the sale of substantially all of its domestic hospital real estate and related personal property (the "Assets") to Crescent Real Estate Equities Limited Partnership ("Crescent") and Charter Behavioral Hospital System, LLC ("CBHS"). In addition, CBHS was formed as a joint venture to operate the domestic portion of the Company's provider business segment. CBHS is owned equally by Magellan and Crescent Operating, Inc., ("COI") an affiliate of Crescent. The Company accounts for its 50% investment in CBHS under the equity method of accounting (See Note 4). The Company received approximately $417.2 million in cash (before costs estimated to be $16.0 million) and warrants in COI for the purchase of 2.5% of COI's common stock at $18.32, which are exercisable over 12 years. The Company also issued 1,283,311 warrants each to Crescent and COI (the "Crescent Warrants") for the purchase of Magellan common stock at an exercise price of $30 per share. (See Note 8.) In related agreements, (i) Crescent leased the hospital real estate and related assets to CBHS for initial annual rent beginning at approximately $41.7 million with a 5% annual escalation clause compounded annually (the "Facilities Lease") and (ii) CBHS will pay Magellan approximately $78.3 million in annual franchise fees, subject to increase, for the use of assets retained by Magellan and for support in certain areas. The franchise fees to be paid by CBHS to the Company are subordinated to the lease obligations in favor of Crescent. The assets retained by Magellan include, but are not limited to, the "CHARTER" name, intellectual property, protocols and procedures, clinical quality management, operating processes and the "1-800-CHARTER" telephone call center. Magellan provides CBHS ongoing support in areas including advertising and marketing assistance, risk management services, outcomes monitoring, and consultation on matters relating to reimbursement, government relations, clinical strategies, regulatory matters, strategic planning and business development. The Company initially used approximately $200 million of the proceeds from the sale of the Assets to reduce its long-term debt, including borrowings under its then existing credit agreement. In December 1997, the Company used the remaining proceeds from the sale of the Assets to acquire additional managed care businesses. See Note 2, "Acquisitions and Joint Ventures." The Company recorded a loss before income taxes of approximately $59.9 million as a result of the Crescent Transactions, which consisted of the following (in thousands): Accounts receivable collection fees............................... $ 21,400 Impairment losses on intangible assets............................ 14,408 Exit costs and construction obligation............................ 12,549 Loss on the sale of property and equipment........................ 11,511 --------- $ 59,868 --------- ---------
Accounts receivable collection fees represent the reduction in the net realizable value of accounts receivable for estimated collection fees on retained hospital-based receivables for CBHS pursuant to a contractual obligation with CBHS, whereby CBHS receives a fee equal to 5% of collections for the first F-20 3. CRESCENT TRANSACTIONS (CONTINUED) 120 days after consummation of the Crescent Transaction and estimated bad debt agency fees of 40% for receivables collected subsequent to 120 days after the consummation of the Crescent Transactions. The Company disposed of a significant portion of its provider business segment as part of the Crescent Transactions. The impairment loss on intangible assets resulted from reducing the book value of the Company's investment in CBHS to its approximate fair value at the consummation date. The fair value of CBHS was determined by the Company's financial advisors using a discounted cash flows analysis. The impairment losses represent the carrying amount of goodwill and other intangible assets related to the divested or contributed CBHS operations. The $5.0 million of exit costs accrued as a result of the Crescent transactions include incremental staffing, consulting and related costs to prepare and coordinate audits of terminating Medicare cost reports, prepare and file income tax, property tax, sales and use tax and other tax returns and perform accounting functions related to the divested businesses (CBHS). The Company incurred approximately $0.6 million and $1.8 million of such costs during the years ended September 30, 1997 and 1998, respectively. The Company constructed a hospital in Philadelphia as required by the Crescent Real Estate Purchase Agreement to replace the existing Philadelphia hospital operated by CBHS. The Company incurred approximately $5.5 million in construction costs through September 30, 1998. 4. INVESTMENT IN CBHS The Company owned a 50% interest in CBHS as of September 30, 1997 and 1998. The Company became a 50% owner of CBHS upon consummation of the Crescent Transactions. The Company accounts for its investment in CBHS using the equity method. A summary of financial information for CBHS is as follows (in thousands):
SEPTEMBER 30, 1997 SEPTEMBER 30, 1998 -------------------- -------------------- Current assets.................................... $ 148,537 $ 147,119 Property and equipment, net....................... 18,424 21,148 Other noncurrent assets........................... 8,633 8,871 ---------- ---------- Total Assets.................................... $ 175,594 $ 177,138 ---------- ---------- ---------- ---------- Current liabilities............................... $ 68,497 $ 141,379 Long-term debt.................................... 65,860 67,200 Other noncurrent liabilities...................... 7,481 35,437 Members' capital (deficit)........................ 33,756 (66,878) ---------- ---------- Total Liabilities and Members' Capital (Deficit)..................................... $ 175,594 $ 177,138 ---------- ---------- ---------- ----------
F-21 4. INVESTMENT IN CBHS (CONTINUED)
FOR THE 106 DAYS ENDED FISCAL YEAR ENDED SEPTEMBER 30, 1997 SEPTEMBER 30, 1998 -------------------- -------------------- Net revenue....................................... $ 213,730 $ 730,447 ---------- ---------- Operating expenses................................ 228,382 822,099 Interest, net..................................... 1,592 5,263 ---------- ---------- Net loss........................................ $ (16,244) $ (96,915) ---------- ---------- ---------- ---------- Cash used in operating activities................. $ (67,831) $ (788) ---------- ---------- ---------- ---------- Magellan equity loss(1),(3)....................... $ (8,122) $ (31,878) ---------- ---------- ---------- ----------
The Company's transactions with CBHS and related balances are as follows (in thousands):
106 DAYS ENDED FISCAL YEAR ENDED SEPTEMBER 30, 1997 SEPTEMBER 30, 1998 -------------------- -------------------- Franchise Fee revenue(1).......................... $ 22,739 $ 55,600 -------- -------- Costs: Accounts receivable collection fees............. $ 4,993 $ 1,980 Provider JV management fees..................... 2,111 5,329
SEPTEMBER 30, 1997 SEPTEMBER 30, 1998 -------------------- -------------------- Due to CBHS, net(2)............................... $ 5,090 $ 1,127 -------- -------- -------- -------- Prepaid Charter call center management fees....... $ -- $ 2,953 -------- -------- -------- -------- Investment in CBHS(1),(3)......................... $ 16,878 $ -- -------- -------- -------- --------
- ------------------------ (1) The Company's Franchise Fee revenue for the year ended September 30, 1998, was approximately $55.6 million while CBHS recorded Franchise Fee expense of approximately $78.6 million for the year ended September 30, 1998. Accordingly, the Company has eliminated the intercompany loss for the proportionate share of the difference between Franchise Fee revenue and expense reflected in the Company's financial statements and CBHS' financial statements of approximately $11.5 million. (2) The nature of hospital accounts receivable billing and collection processes have resulted in the Company and CBHS receiving remittances from payors which belong to the other party. Additionally, the Company and CBHS have established a settlement and allocation process for the accounts receivable related to those patients who were not yet discharged from their treatment on June 16, 1997. In an effort to settle these amounts on a timely basis, and in light of CBHS start up operations and cash flow requirements, the Company made advances to CBHS periodically during fiscal 1998, which have been repaid by CBHS. Such advances, net of all settlement activity and certain other amounts due to CBHS for certain shared services and related matters, resulted in the amount presented as due to CBHS. (3) Franchise Fees due from CBHS were approximately $38.0 million as of September 30, 1998. CBHS's independent public accountants' report on CBHS's financial statements for the year ended September 30, 1998 makes reference to uncertainty regarding CBHS's ability to continue as a going concern. The Company recorded equity in loss in excess of its investment in CBHS until all Franchise Fees due from CBHS were reduced to $0 at September 30, 1998. Equity in losses of F-22 4. INVESTMENT IN CBHS (CONTINUED) CBHS in excess of the Company's investment in CBHS of $5.1 million, excluding the $11.5 million in (1) above, have not been reflected in the Company's financial statements since the Company has no remaining obligation or commitment to fund CBHS and has no guarantees outstanding for any CBHS obligations. 5. UNUSUAL ITEMS GENERAL The following table summarizes unusual items recorded during the three years in the period ended September 30, 1998 (in thousands):
1996 1997 1998 --------- --------- --------- Insurance settlements....................................... $ 30,000 $ -- $ -- Facility closures........................................... 4,116 4,201 -- Asset impairments........................................... 1,207 -- -- Gains on the sale of psychiatric hospitals, net............. -- (5,388) (3,000) Termination of CBHS sale transaction........................ -- -- 3,458 Other....................................................... 1,948 1,544 -- --------- --------- --------- $ 37,271 $ 357 $ 458 --------- --------- --------- --------- --------- ---------
INSURANCE SETTLEMENTS In August 1996, the Company and a group of insurance carriers resolved a billing dispute which arose in fiscal 1996 related to matters originating in the 1980's. As part of the settlement of these claims, certain related payer matters and associated legal fees, the Company recorded a charge of approximately $30.0 million during fiscal 1996. The Company will pay the insurance settlement amount in twelve installments over a three year period, beginning August 1996. As part of the settlement, the Company and the insurance carriers agreed that the dispute and settlement would not negatively impact any present or pending business relationships nor would it prevent the parties from negotiating in good faith concerning additional business opportunities available to, and future relationships between, the parties. The Company will make final payments totaling $6.0 million in fiscal 1999 for insurance settlements. FACILITY CLOSURES During fiscal 1996 and 1997, the Company consolidated, closed or sold nine and three psychiatric facilities and its one general hospital (the "Closed Facilities"), respectively, exclusive of the Crescent Transactions. The three psychiatric facilities closed in 1997 were sold as part of the Crescent Transactions. The Closed Facilities that are still owned by the Company will be sold, leased or used for alternative purposes depending on the market conditions in each geographic area and are reflected as other long-term assets in the accompanying balance sheets. The Company recorded charges of approximately $4.1 million and $4.2 million related to facility closures in fiscal 1996 and 1997, respectively, as follows (in thousands):
1996 1997 --------- --------- Severance and related benefits........................................... $ 2,334 $ 2,976 Contract terminations and other.......................................... 1,782 1,225 --------- --------- $ 4,116 $ 4,201 --------- --------- --------- ---------
F-23 5. UNUSUAL ITEMS (CONTINUED) Approximately 620 and 700 employees were terminated at the facilities closed in fiscal 1996 and 1997, respectively. The recorded amounts have been paid as of September 30, 1998. The following table presents net revenue, salaries, cost of care and other operating expenses and bad debt expenses and depreciation and amortization of the Closed Facilities (in thousands):
YEAR ENDED SEPTEMBER 30, -------------------- 1996 1997 --------- --------- Net revenue............................................................ $ 82,568 $ 19,582 Salaries, cost of care and other operating expense and bad debt expenses............................................................. 86,426 23,263 Depreciation and amortization.......................................... 2,015 349
The Company also recorded a charge of approximately $2.0 million in fiscal 1996 related to severance and related benefits for approximately 275 employees who were terminated pursuant to planned overhead reductions. ASSET IMPAIRMENTS During fiscal 1996, the Company recorded impairment losses on property and equipment of approximately $1.2 million. Such losses resulted from changes in the manner that certain of the Company's assets were to be used in future periods and current period operating losses at certain of the Company's operating facilities combined with projected future operating losses. Fair values of the long-lived assets that have been written down were determined using the best available information in each individual circumstance, which included quoted market price, comparable sales prices for similar assets or valuation techniques utilizing present value of estimated expected cash flows. GAINS ON SALE OF PSYCHIATRIC FACILITIES, NET AND OTHER During fiscal 1997 and 1998, the Company recorded gains of approximately $5.4 million and $3.0 million, respectively, related to the sales of psychiatric hospitals and other real estate. The Company also recorded a charge of approximately $1.6 million during fiscal 1997 for costs incurred related primarily to the expiration of its agreement to sell its three European Hospitals. TERMINATION OF CBHS SALE TRANSACTION On March 3, 1998, the Company and certain of its wholly owned subsidiaries entered into definitive agreements with COI and CBHS pursuant to which the Company would have, among other things, sold the Company's franchise operations, certain domestic provider operations and certain other assets and operations. On August 19, 1998, the Company announced that it had terminated discussions with COI for the sale of its interest in CBHS. Furthermore, the Company exercised, in the fourth quarter of fiscal 1998, certain limited management rights available to it under the Master Franchise Agreement and, with CBHS's Board's support, made operational and management changes at CBHS aimed at improving profitability and cash flows. The Company has since restored all management rights to the CBHS Board. F-24 5. UNUSUAL ITEMS (CONTINUED) In connection with the termination of the CBHS sale transaction, the Company recorded a charge of approximately $3.5 million as follows (in thousands): Severance(1)....................................................... $ 488 Lease termination(1)............................................... 1,067 Impairment of long-lived assets.................................... 153 Transaction costs and other........................................ 1,750 --------- $ 3,458 --------- ---------
- ------------------------ (1) Relates to staffing reductions and lease terminations incurred in the Company's franchising and outcomes monitoring subsidiaries. 6. BENEFIT PLANS During fiscal 1992, the Company reinstated a defined contribution plan (the "Magellan 401-K Plan"). Effective January 1, 1997, the plan was amended to allow participants to contribute up to 15% of their compensation to the Magellan 401-K Plan. The Company makes a discretionary contribution of 2% of each employee's compensation and matches 50% of each employee's contribution up to 3% of their compensation. During the years ended September 30, 1996, 1997 and 1998, the Company made contributions of approximately $5.3 million, $5.7 million and $3.2 million respectively, to the Magellan 401-K Plan. Green Spring maintains a defined contribution plan (the "Green Spring 401-K Plan"). Employee participants can elect to voluntarily contribute up to 6% or 12% of their compensation, depending upon each employee's compensation level, to the Green Spring 401-K Plan. Green Spring matches up to 3% of each employee's compensation. Employees vest in employer contributions over five years. During the years ended September 30, 1996, 1997 and 1998 Green Spring contributed approximately $0.8 million, $1.3 million and $1.2 million, respectively, to the Green Spring 401-K Plan. Merit maintains a 401(k) savings plan covering substantially all employees who have completed one year of active employment during which 1,000 hours of service has been credited. Under the plan, an employee may elect to contribute on a pre-tax basis to a retirement account up to 15% of the employee's compensation up to the maximum annual contributions permitted by the Internal Revenue Code. Merit matches employee contributions at the rate of 50% of the employee's contributions to the 401(k) savings plan, up to a maximum of 6% of an employee's annual compensation. Merit's 401(k) savings plan contribution recognized as expense for the year ended September 30, 1998 was $1.1 million. F-25 7. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES Information with regard to the Company's long-term debt and capital lease obligations at September 30, 1997 and 1998 is as follows (in thousands):
SEPTEMBER 30, SEPTEMBER 30, 1997 1998 -------------- -------------- Credit Agreement: Revolving Facility (7.84% to 7.88% at September 30, 1998) due through 2004......................................... $ -- $ 40,000 Term Loan Facility (7.84% to 8.34% at September 30, 1998) due through 2006......................................... -- 550,000 11.25% Series A Senior Subordinated Notes.................... 375,000 -- 9.0% Senior Subordinated Notes due 2008...................... -- 625,000 6.31% to 11.50% Mortgage and other notes payable through 2005....................................................... 7,721 4,198 7.5% Swiss Bonds............................................. 6,443 -- 3.8% Capital lease obligations due through 2014.............. 6,438 6,448 -------------- -------------- 395,602 1,225,646 Less amounts due within one year........................... 3,601 23,033 Less debt service funds.................................... 308 -- -------------- -------------- $ 391,693 $ 1,202,613 -------------- -------------- -------------- --------------
The aggregate scheduled maturities of long-term debt and capital lease obligations during the five years subsequent to September 30, 1998 are as follows (in thousands): 1999--$23,033; 2000-- $32,429; 2001--$38,929; 2002--$49,429 and 2003--$92,030. The Notes which are carried at cost, had a fair value of approximately $534 million at September 30, 1998, based on market quotes. The Company's remaining debt is also carried at cost, which approximates fair market value. In connection with the acquisition of Merit, the Company (i) terminated its Credit Agreement; (ii) repaid all loans outstanding pursuant to Merit's existing credit agreement; (iii) completed a tender offer for the Old Notes; (iv) completed a tender offer for the Merit Outstanding Notes; (v) entered into the New Credit Agreement providing for Credit Facilities of up to $700 million; and (vi) issued the Notes. See Note 2--"Acquisitions and Joint Ventures--Merit Acquisition." The Company recognized a net extraordinary loss from the early extinguishment of debt of approximately $33.0 million, net of income tax benefit, during fiscal 1998, to write off unamortized deferred financing costs related to terminating the previous credit agreement and extinguishing the Old Notes, to record the tender premium and related costs of extinguishing the Old Notes and to record the gain on extinguishment of the 7.5% Swiss Bonds. The New Credit Agreement provides for a Term Loan Facility in an aggregate principal amount of $550 million, consisting of an approximately $183.3 million Tranche A Term Loan (the "Tranche A Term Loan"), an approximately $183.3 million Tranche B Term Loan (the "Tranche B Term Loan") and an approximately $183.3 million Tranche C Term Loan (the "Tranche C Term Loan"), and a Revolving Facility providing for revolving loans to the Company and the "Subsidiary Borrowers" (as defined therein) and the issuance of letters of credit for the account of the Company and the Subsidiary Borrowers in an aggregate principal amount (including the aggregate stated amount of letters of credit) of $150 million. F-26 7. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES (CONTINUED) The Tranche A Term Loan and the Revolving Facility mature on February 12, 2004. The Tranche B Term Loan matures on February 12, 2005 and the Tranche C Term Loan matures on February 12, 2006. The Tranche A Term Loan amortizes in installments in each fiscal year in amounts equal to $16.5 million in 1999, $28.0 million in 2000, $34.5 million in 2001, $45.0 million in 2002, $48.0 million in 2003 and $11.3 million in 2004. The Tranche B Term Loan amortizes in installments in amounts equal to $1.7 million in 1999, $2.2 million in each of 2000 through 2002, $41.8 million in 2003, $103.4 million in 2004 and $29.8 million in 2005. The Tranche C Term Loan amortizes in installments in each fiscal year in amounts equal to $1.7 million in 1999, $2.2 million in each of 2000 through 2003, $41.8 million in 2004, $101.9 million in 2005 and $29.1 million in 2006. In addition, the Credit Facilities are subject to mandatory prepayment and reductions (to be applied first to the Term Loan Facility) in an amount equal to (a) 100% of the net proceeds of certain offerings of equity securities by the Company or any of its subsidiaries, (b) 100% of the net proceeds of certain debt issues of the Company or any of its subsidiaries, (c) 75% of the Company's excess cash flow, as defined, and (d) 100% of the net proceeds of certain asset sales or other dispositions of property of the Company and its subsidiaries, in each case subject to certain limited exceptions. The New Credit Agreement contains a number of covenants that, among other things restrict the ability of the Company and its subsidiaries to dispose of assets, incur additional indebtedness, incur or guarantee obligations, prepay other indebtedness or amend other debt instruments (including the Indenture for the New Notes), pay dividends, create liens on assets, make investments, make loans or advances, redeem or repurchase common stock, make acquisitions, engage in mergers or consolidations, change the business conducted by the Company and its subsidiaries and make capital expenditures. In addition, the New Credit Agreement requires the Company to comply with specified financial ratios and tests, including minimum coverage ratios, maximum leverage ratios, maximum senior debt ratios, minimum "EBITDA" (as defined in the New Credit Agreement) and minimum net worth tests. At the Company's election, the interest rates per annum applicable to the loans under the New Credit Agreement are a fluctuating rate of interest measured by reference to either (a) an adjusted London inter-bank offered rate ("LIBOR") plus a borrowing margin or (b) an alternate base rate ("ABR") (equal to the higher of the Chase Manhattan Bank's published prime rate or the Federal Funds effective rate plus 1/2 of 1%) plus a borrowing margin. The borrowing margins applicable to the Tranche A Term Loan and loans under the Revolving Facility are currently 1.25% for ABR loans and 2.25% for LIBOR loans, and are subject to reduction if the Company's financial results satisfy certain leverage tests. The borrowing margins applicable to the Tranche B Term Loan and the Tranche C Term Loan are 1.50% and 1.75%, respectively, for ABR loans and 2.50% and 2.75%, respectively, for LIBOR loans, and are not subject to reduction. Amounts outstanding under the credit facilities not paid when due bear interest at a default rate equal to 2.00% above the rates otherwise applicable to each of the loans under the Term Loan Facility and the Revolving Facility. The obligations of the Company and the Subsidiary Borrowers under the New Credit Agreement are unconditionally and irrevocably guaranteed by, subject to certain exceptions, each wholly owned domestic subsidiary and, subject to certain exceptions, each foreign subsidiary of the Company. In addition, the Credit Facilities and the guarantees are secured by security interests in and pledges of or liens on substantially all the material tangible and intangible assets of the guarantors, subject to certain exceptions. The Notes are general unsecured senior subordinated obligations of the Company. The Notes are limited in aggregate principal amount to $625 million and will mature on February 15, 2008. Interest on the Notes accrues at the rate of 9.0% per annum and is payable semi-annually on each February 15 and F-27 7. LONG-TERM DEBT, CAPITAL LEASE OBLIGATIONS AND OPERATING LEASES (CONTINUED) August 15, commencing on August 15, 1998. The Notes were originally issued as unregistered securities and later exchanged for securities which were registered with the Securities and Exchange Commission. Due to a delay in the registration of the Notes to be exchanged, the Company was required to increase the interest rate on the Notes by 100 basis points per annum for the period from July 13, 1998 through November 9, 1998, the date of issuance of the Notes to be exchanged. The Notes are redeemable at the option of the Company. The Notes may be redeemed at the option of the Company, in whole or in part, at the redemption prices (expressed as a percentage of the principal amount) set forth below, plus accrued and unpaid interest, during the twelve-month period beginning on February 15 of the years indicated below:
REDEMPTION YEAR PRICES - ------------------------------------------------------------ ------------- 2003........................................................ 104.5% 2004........................................................ 103.0% 2005........................................................ 101.5% 2006 and thereafter......................................... 100.0%
In addition, at any time and from time to time prior to February 15, 2001, the Company may, at its option, redeem up to 35% of the original aggregate principal amount of the Notes at a redemption price (expressed as a percentage of the principal amount) of 109%, plus accrued and unpaid interest with the net cash proceeds of one or more equity offerings; provided that at least 65% of the original aggregate principal amount of Notes remains outstanding immediately after the occurrence of such redemption and that such redemption occurs within 60 days of the date of the closing of any such equity offering. The Indenture for the Notes limits, among other things: (i) the incurrence of additional indebtedness by the Company and its restricted subsidiaries; (ii) the payment of dividends on, and redemption or repurchase of, capital stock of the Company and its restricted subsidiaries and the redemption of certain subordinated obligations of the Company; (iii) certain other restricted payments, including investments; (iv) sales of assets; (v) certain transactions with affiliates; (vi) the creation of liens; and (vii) consolidations, mergers and transfers of all or substantially all the Company's assets. The Indenture for the Notes also prohibits certain restrictions on distributions from restricted subsidiaries. However, all such limitations and prohibitions are subject to certain qualifications and exceptions. The Company recorded extraordinary losses of approximately $5.3 million, net of tax, during fiscal 1997 to write off unamortized deferred financing costs related to its previous credit agreement and for costs related to paying off the variable rate secured notes. The Company leases certain of its operating facilities, some of which may be purchased during the lease term or at expiration of the leases. The book value of the capital leased assets was approximately $3.3 million at September 30, 1998. The leases, which expire at various dates through 2069, generally require the Company to pay all maintenance, property and tax insurance costs. At September 30, 1998, aggregate amounts of future minimum payments under operating leases were as follows: 1999--$31.1 million; 2000--$27.2 million; 2001--$23.2 million; 2002--$19.0 million; 2003--$14.5 million; subsequent to 2003--$65.5 million. Rent expense for the years ended September 30, 1996, 1997 and 1998 was $18.7 million, $19.2 million and $30.6 million, respectively. F-28 8. STOCKHOLDERS' EQUITY Pursuant to the Company's Restated Certificate of Incorporation, the Company is authorized to issue 80 million shares of common stock, $.25 par value per share, and 10 million shares of preferred stock, without par value. No shares of preferred stock have been issued as of September 30, 1998. COMMON STOCK The Company is prohibited from paying dividends on its Common Stock under the terms of the Indenture and New Credit Agreement except under certain limited circumstances. 1992 STOCK OPTION PLAN The 1992 Stock Option Plan provided for the issuance of approximately 3.4 million options to purchase shares of Common Stock. A summary of changes in options outstanding and other related information is as follows:
YEAR ENDED SEPTEMBER 30, ---------------------------------------------- 1996 1997 1998 ---------------- --------------- ----------- Balance, beginning of period................. 715,516 368,990 368,990 Canceled................................... -- -- -- Exercised.................................. (346,526) -- (362,990) ---------------- --------------- ----------- Balance, end of period....................... 368,990 368,990 6,000 ---------------- --------------- ----------- ---------------- --------------- ----------- Option prices, end of period................. $ 4.36-$22.75 $ 4.36-$22.75 $ 22.75 Price range of exercised options............. $ 4.36-$16.875 -- $ 4.36 Average exercise price....................... $ 4.59 -- $ 4.36
The exercise price of certain options would have been reduced upon termination of employment of a certain optionee without cause. The Company records compensation expense for the difference between the exercise price of these options and the fair value of the Company's common stock until the measurement date is known. Such compensation expense was included in stock option expense (credit) in the Company's statements of operations until such options were exercised in August 1998. Options issued pursuant to the 1992 Stock Option Plan are exercisable upon vesting and expire through October 2000. As of September 30, 1998, 100% of the options outstanding were vested. F-29 1994 STOCK OPTION PLAN The 1994 Stock Option Plan provided for the issuance of approximately 1.3 million options to purchase shares of Common Stock. Officers and key employees of the Company are eligible to participate. The options have an exercise price which approximates fair market value of the Common Stock at the date of grant. A summary of changes in options outstanding and other related information is as follows:
YEAR ENDED SEPTEMBER 30, ------------------------------------------------------------- 1996 1997 1998 ------------------- ------------------- ------------------- Balance, beginning of period...... 1,162,331 948,669 1,028,494 Granted......................... 161,000 341,166 -- Canceled........................ (330,162) (87,498) (298,276) Exercised....................... (44,500) (173,843) (49,001) ------------------- ------------------- ------------------- Balance, end of period............ 948,669 1,028,494 681,217 ------------------- ------------------- ------------------- ------------------- ------------------- ------------------- Option prices, end of period...... $ 15.687-$27.875 $ 15.687-$27.718 $ 15.687-$27.718 Price range of exercised options....................... $ 15.687-$27.875 $ 15.687-$27.875 $ 16.125-$22.875 Average exercise price.......... $ 20.70 $ 22.20 $ 19.903
Options granted under the 1994 Stock Option Plan are exercisable to the extent vested. An option vests at the rate of 33 1/3% of the shares covered by the option on each of the first three anniversary dates of the grant of the option if the optionee is an employee of the Company on such dates. Options must be exercised no later than ten years after the date of grant. As of September 30, 1998, 88.5% of the options outstanding were vested. 1996 STOCK OPTION PLAN The 1996 Stock Option Plan (the "1996 Plan") provides for the issuance of 1.75 million options to purchase shares of the Company's Common Stock. Options must be granted on or before December 31, 1999. Officers and key employees of the Company are eligible to participate. The options have an exercise price which approximates fair market value of the Common Stock at the date of grant. A summary of changes in options outstanding and other related information is as follows:
YEAR ENDED SEPTEMBER 30 ---------------------------------------------------------- 1996 1997 1998 ---------------- ------------------- ------------------- Balance, beginning of period.... -- 1,298,500 1,411,292 Granted....................... 1,413,000 310,667 50,000 Canceled...................... (114,500) (96,125) (42,000) Exercised..................... -- (101,750) (178,375) ---------------- ------------------- ------------------- Balance, end of period.......... 1,298,500 1,411,292 1,240,917 ---------------- ------------------- ------------------- ---------------- ------------------- ------------------- Option prices, end of period.... $ 15.75-$24.00 $ 15.75-$30.875 $ 15.75-$30.875 Price range of exercised options....................... -- $ 18.125-$18.875 $ 15.75-$25.156 Average exercise price.......... -- $ 18.348 $ 18.568
Options granted under the 1996 Plan are exercisable to the extent vested. An option vests at the rate of 25% of the shares covered by the option on each of the four anniversary dates of the grant of the F-30 option if the optionee is an employee of the Company on such dates. Options must be exercised no later than November 30, 2005. The 1996 Plan provides that the options granted thereunder, upon the occurrence of certain events, vest and become fully exercisable upon the "sale, lease, transfer of other disposition... of all or substantially all" of the Company's assets. Based upon a review of relevant Delaware case law, the Company believes that substantial uncertainty existed regarding whether the Crescent Transactions, which are described in Note 3, constituted a "sale ... of all or substantially all" of the Company's assets. Accordingly, the Company's Board of Directors determined it should treat the Crescent Transactions as such an event in order to eliminate the risk of a dispute. Options outstanding under the 1996 Plan immediately vested upon closing the Crescent Transactions. As of September 30, 1998, 94.5% of the options outstanding under the 1996 Plan were vested. 1997 STOCK OPTION PLAN The 1997 Stock Option Plan (the "1997 Plan") provides for the issuance of 1.5 million options to purchase shares of the Company's Common Stock. Options must be granted on or before December 31, 2000. Officers and key employees of the Company are eligible to participate. The options have an exercise price which approximates fair market value of the Common Stock at the date of grant. A summary of changes in options outstanding and other related information is as follows:
YEAR ENDED SEPTEMBER 30, --------------------------------------- 1997 1998 ------------------ ------------------- Balance, beginning of period......................... -- 988,333 Granted.............................................. 988,333 396,000 Canceled............................................. -- (652,055) ------------------ ------------------- Balance, end of period............................... 988,333 732,278 ------------------ ------------------- ------------------ ------------------- Option prices, end of period......................... $ 24.375-$31.00 $ 22.328-$31.063
Options granted under the 1997 Plan are exercisable to the extent vested. An option vests at the rate of 33 1/3% of the shares covered by the option on each of the three anniversary dates of the grant of the option if the optionee is an employee of the Company on such dates. Options must be exercised no later than February 28, 2007. As of September 30, 1998, 42.9% of the options outstanding under the 1997 Plan were vested. Certain of the options granted under the 1997 stock option plan were granted prior to the stockholder approval date. The measurement date for purposes of measuring compensation expense for such grants under the 1997 Stock Option Plan was the date of stockholder approval, which resulted in compensation expense of approximately $0.5 million and $0.2 million in fiscal 1997 and 1998, respectively. 1998 STOCK OPTION PLAN The 1998 Stock Option Plan (the "1998 Plan") provides for the issuance of 1.0 million options to purchase shares of the Company's Common Stock. Options must be granted on or before December 31, 2001. Officers and key employees of the Company are eligible to participate. The options have F-31 an exercise price which approximates fair market value of the Common Stock at the date of grant. A summary of changes in options outstanding and other related information is as follows:
YEAR ENDED SEPTEMBER 30, 1998 ------------------ Balance, beginning of period.............................................. -- Granted................................................................... 890,500 Canceled.................................................................. (90,000) ------------------ Balance, end of period.................................................... 800,500 ------------------ ------------------ Option prices, end of period.............................................. $ 14.56-$22.875
Options granted under the 1998 Plan are exercisable to the extent vested. An option vests over the period specified in each stock option grant. Options must be exercised no later than December 31, 2008. As of September 30, 1998, 8.3% of the options outstanding under the 1998 Plan were vested. 1994 EMPLOYEE STOCK PURCHASE PLAN The 1994 Employee Stock Purchase Plan (the "1994 ESPP") covered 600,000 shares of Common Stock that could be purchased by eligible employees of the Company. The initial offering period began on April 1, 1994 and expired on March 31, 1995. The second offering period began on April 1, 1995 and ended March 31, 1996. On the first date of these offering periods, each participant was granted an option to purchase shares of Common Stock at a purchase price equal to 85% of the fair value of a share of Common Stock on such date. Total options granted on April 1, 1994 and April 1, 1995 were 85,115 and 41,565, respectively, with option prices of $21.144 and $15.831, respectively. A total of 4,872 and 22,065 options were exercised at the end of the first and second offering periods, respectively. Effective August 1, 1995, the Company amended the 1994 ESPP to change the option price in subsequent offering periods to the lesser of (i) 85% of the fair value of a share of Common Stock on the first day of the offering period or (ii) 85% of the fair value of a share of Common Stock on the last day of the offering period. Holders of the options from the second offering period as of July 31, 1995 were given the choice of (i) canceling their options to purchase shares of Common Stock, (ii) exercising the option to purchase shares of Common Stock at a purchase price of $15.831 or (iii) keeping their options. A total of 11,870 options were exercised on July 31, 1995. The third offering period began August 1, 1995 and ended December 31, 1995. A total of 29,217 options were exercised at a purchase price of $16.681 at the end of the third offering period. The fourth offering period began January 1, 1996 and ended on June 30, 1996. A total of 68,146 options were exercised at a purchase price of $18.275 at the end of the fourth offering period. The fifth offering period began July 1, 1996 and ended on December 31, 1996. A total of 80,018 options were exercised at a purchase price of $17.85 at the end of the fifth and final offering period. 1997 EMPLOYEE STOCK PURCHASE PLAN The 1997 Employee Stock Purchase Plan (the "1997 ESPP") covers 600,000 shares of Common Stock that can be purchased by eligible employees of the Company. The 1997 ESPP offering periods will have a term not less than three months and not more than 12 months. The first offering period under the 1997 ESPP began January 1, 1997 and the last offering period will end on or before December 31, 1999. The option price of each offering period will be the lesser of (i) 85% of the fair value of a share of Common Stock on the first day of the offering period or (ii) 85% of the fair value of a share of Common Stock on the last day of the offering period. F-32 A summary of the 1997 ESPP is as follows:
OFFERING OPTIONS EXERCISE PERIOD BEGAN ENDED EXERCISED PRICE - --------------- ------------------- ----------------------- ----------- ----------- 1 January 2, 1997 June 30, 1997 73,410 $ 19.125 2 August 1, 1997 December 31, 1997 26,774 $ 19.125 3 January 1, 1998 June 30, 1998 43,800 $ 18.4875 4 July 1, 1998 December 31, 1998 -- --
The number of options granted and the option price for the fourth offering period will be determined on December 31, 1998 when the option price is known. 1992 DIRECTORS' STOCK OPTION PLAN AND DIRECTORS' UNIT AWARD PLAN The 1992 Directors' Stock Option Plan provides for the grant of options to non-employee members of the Company's Board of Directors to purchase up to 175,000 shares of the Company's Common Stock, subject to adjustments to reflect certain changes in capitalization. The options have an exercise price which approximates the fair market value of the Common Stock on the date of grant. During fiscal 1996, 1997 and 1998, no options were granted. As of September 30, 1998, 125,000 options were outstanding at exercise prices ranging from $14.56 to $22.875. No options were exercised during fiscal 1996, 1997 and 1998. Options granted can be exercised from the date of vesting until February 1, 2003. No options can be granted after December 31, 1995. Options vest 20% when granted and an additional 20% on each successive February 1 for a period of four years, if the optionee continues to serve as a non-employee director on the applicable February 1. Unvested options vest in full in certain instances of termination. As of September 30, 1998, 96.0% of the options outstanding were vested. In addition, during fiscal 1994, the Company approved the Directors' Unit Award Plan (the "Unit Plan") which provides for the award of a maximum of 15,000 units (the "Units") that, upon vesting under the terms of the Unit Plan, would result in the issuance of an aggregate of 15,000 shares of Common Stock in settlement of Units. The Unit Plan provides for the award to each director who is not an employee of the Company of 2,500 Units. Upon vesting of the Units awarded to a director, the Company will settle the Units by issuing to the director, with no exercise price, a number of shares of the Company's Common Stock equal to the number of vested Units. 1996 DIRECTORS' STOCK OPTION PLAN The 1996 Directors' Stock Option Plan provides for the grant of options to non-employee members of the Company's Board of Directors to purchase up to 250,000 shares of the Company's Common Stock, subject to adjustments to reflect certain changes in capitalization. The options have an exercise price which approximates the fair market value of a share of the Common Stock on the date of grant. During fiscal 1996, 175,000 options were granted at exercise prices ranging from $18.25 to $23.375. During fiscal 1997, 25,000 options were granted at an exercise price of $30.812. During fiscal 1998, 50,000 options were granted at an exercise prices ranging from $20.25 to $22.4375. As of September 30, 1998, 250,000 options were outstanding at exercise prices ranging from $18.25 to $30.812. No options were exercised during fiscal 1996, 1997 or 1998. Options granted can be exercised from the date of vesting until November 30, 2005. No options can be granted after December 31, 1999. Options vest at the rate of 25% of the shares covered on each of the four anniversary dates of the grant of the option if the optionee continues to serve as a non-employee director on such dates. Options vest in full in certain instances of termination. As of September 30, 1998, 41.7% of the options outstanding were vested. F-33 RIGHTS PLAN The Company adopted a Share Purchase Rights Plan in fiscal 1992 (the "Rights Plan"). Pursuant to the Rights Plan, each share of Common Stock also represents one Share Purchase Right (collectively, the "Rights"). The Rights trade automatically with the underlying shares of Common Stock. Upon becoming exercisable, but prior to the occurrence of certain events, each Right initially entitles its holder to buy one share of Common Stock from the Company at an exercise price of $60.00. The Rights will be distributed and become exercisable only if a person or group acquires, or announces its intention to acquire, Common Stock exceeding certain levels, as specified in the Rights Plan. Upon the occurrence of such events, the exercise price of each Right reduces to one-half of the then current market price. The Rights also give the holder certain rights in an acquiring company's common stock. The Company is entitled to redeem the Rights at a price of $.01 per Right at any time prior to the distribution of the Rights. The Rights have no voting power until exercised. COMMON STOCK WARRANTS The Company issued 114,690 warrants in fiscal 1992 which expire on June 30, 2002 (the "2002 Warrants") to purchase one share each of the Company's Common Stock. The 2002 Warrants have an exercise price of $5.24 per share. During fiscal 1996, 1997 and 1998, 4,320, 1,397 and 1,553 shares were issued, respectively, upon the exercise of 2002 Warrants. At September 30, 1998, 18,920 of the 2002 Warrants were outstanding. The 2006 Warrants, which expire on September 1, 2006, were subject to certain adjustments, and accordingly, 146,791 of such warrants are currently outstanding with an exercise price of $38.70 per share. Crescent and COI each have the right to purchase 1,283,311 shares of Common Stock (2,566,622 shares in aggregate) at a warrant exercise price of $30 per share (subject to adjustment pursuant to antidilution provisions). The Crescent Warrants will be exercisable at the following times and in the following amounts:
NUMBER OF SHARES OF DATE FIRST COMMON STOCK END OF EXERCISABLE ISSUABLE UPON EXERCISE EXERCISE PERIOD JUNE 17, OF WARRANTS JUNE 17, - ------------------------------ ------------------------------ ------------------------------ 1998 30,000 2001 1999 62,325 2002 2000 97,114 2003 2001 134,513 2004 2002 174,678 2005 2003 217,770 2006 2004 263,961 2007 2005 313,433 2008 2006 366,376 2009 2007 422,961 2009 2008 483,491 2009
Crescent's and COI's rights with respect to the Crescent Warrants are not contingent on or subject to the satisfaction or completion of any obligation that Crescent or COI may have to CBHS, or that CBHS may have to the Company, or by any subordination of fees otherwise payable to the Company by CBHS. The Crescent Warrants contain provisions relating to adjustments in the number of shares covered by the Crescent Warrants and the warrant exercise price in the event of stock splits, stock dividends, mergers, reorganizations and similar transactions. F-34 The Crescent Warrants were recorded at $25 million upon issuance, or their approximate fair value upon execution of the Warrant Purchase Agreement in January 1997. PRIVATE PLACEMENT TRANSACTION On January 25, 1996, the Company issued 4 million shares of Common Stock (the "Shares") along with a warrant to purchase an additional 2 million shares of Common Stock (the "Warrant") pursuant to a Stock and Warrant Purchase Agreement. The Warrant entitles the holders to purchase such additional shares of Common Stock at a per share price of $26.15, subject to adjustment for certain dilutive events, and provides registration rights for the shares of Common Stock underlying the Warrant. The aggregate purchase price for the Shares and the Warrant was approximately $69.73 million. The Warrant became exercisable on January 25, 1997 and expires on January 25, 2000. Approximately $68.0 million of the proceeds were used to repay outstanding borrowings under the then existing credit agreement. TREASURY STOCK TRANSACTIONS On August 15, 1996, the Company commenced a "Dutch Auction" self-tender offer to stockholders for the repurchase of 1,891,891 shares of its own Common Stock. On September 5, 1996, the Company increased the self-tender offer to 3,300,000 shares. Under the terms of the offer, stockholders were invited to tender their shares by September 18, 1996 at prices ranging from $16.50 to $18.50 per share as specified by each stockholder. At the conclusion of the offer, the Company repurchased 3,961,505 shares on September 27, 1996 at $18.375 per share for a total cost of approximately $73.5 million, including transaction costs. The total shares repurchased represent approximately 12.0% of the outstanding Common Stock at such date. The transaction was financed through cash on hand and borrowings under the then existing credit agreement. During fiscal 1998, the Company repurchased an aggregate of 696,600 shares of its common stock in the open market for approximately $14.4 million. Those transactions were funded with cash on hand. In January 1998, the Company issued an aggregate of 2,831,516 shares of treasury stock to the then existing minority stockholders of Green Spring to effect the Green Spring Minority Stockholder Conversion. See Note 2, "Acquisitions." INCOME (LOSS) PER COMMON SHARE The Company adopted Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("FAS 128"), effective October 1, 1997. Income per common share for fiscal 1996 and 1997 have been restated to conform to FAS 128 as required. The effect of adopting FAS 128 was not material. The following table presents the components of weighted average common shares outstanding-- diluted:
YEAR ENDED SEPTEMBER 30, ------------------------------- 1996 1997 1998 --------- --------- --------- Weighted average common shares outstanding--basic.................................. 31,014 28,781 30,784 Common stock equivalents--stock options............................................ 563 676 399 Common stock equivalents--warrants................................................. 19 17 15 --------- --------- --------- Weighted average common shares outstanding--diluted................................ 31,596 29,474 31,198 --------- --------- --------- --------- --------- ---------
Options to purchase approximately 2,051,000 shares of common stock at $23.00-$31.0625 per share were outstanding during fiscal 1998 but were not included in the computation of diluted EPS F-35 because the options exercise price was greater than the average market price of the common shares. Approximately 1,341,000 of these options, which expire between fiscal 2001 and 2009, were still outstanding at September 30, 1998. Warrants to purchase approximately 4,713,000 shares of common stock at $26.15 to $38.70 per share were outstanding during fiscal 1998 but were not included in the computation of diluted EPS because the warrants exercise price was greater than the average market price of the common shares. The warrants, which expire between fiscal 2000 and 2009, were still outstanding at September 30, 1998. The Company owned a 61% equity interest in Green Spring Health Services, Inc. ("Green Spring") during the periods presented above. The four minority stockholders of Green Spring had the options to exchange their ownership interests in Green Spring for 2,831,516 shares of the Company's common stock or $65.1 million of subordinated notes (the "Exchange Option"). The Exchange Option was considered a potentially dilutive security since the Company acquired Green Spring in December 1995 for the purpose of computing diluted income per common share. The Exchange Option was anti-dilutive for all periods presented and, therefore, was excluded from the respective diluted income per common share calculations. Each of the minority stockholders of Green Spring exercised the Exchange Option in January 1998, which resulted in the issuance of 2,831,516 shares of the Company's common stock. See Note 2-- "Acquisitions and Joint Ventures--Green Spring." On November 17, 1998, the Company's Board of Directors approved the repricing of stock options outstanding under the Company's existing stock option plans (the "Stock Option Repricing"). Each holder of 10,000 or more stock options that was eligible to participate in the Stock Option Repricing was required to forfeit a percentage of outstanding stock options as follows: Directors, including the Chief Executive 40% - - Officer.................................... - - Named Executive Officers................... 30% - - Holders of 50,000 or more stock options.... 25% - - Holders of 10,000-49,999 stock options..... 15%
The Stock Option Repricing was consummated on December 8, 1998 based on the fair value of the Company's Common Stock on such date. Approximately 1.7 million outstanding stock options were repriced to $8.41 and approximately 0.5 million outstanding stock options were forfeited as a result of the Stock Option Repricing. Each participant in the Stock Option Repricing is precluded from exercising repriced stock options until June 8, 1999. STOCK-BASED COMPENSATION Effective October 1, 1996, the Company adopted the disclosure requirements of FAS 123. FAS 123 requires disclosure of pro forma net income and pro forma net income per share as if the fair value-based method of accounting for stock options had been applied in measuring compensation cost for stock-based awards granted in fiscal 1996, 1997 and 1998. Pro forma amounts are not representative of the effects of stock-based awards on future pro forma net income and pro forma net income per share because those pro forma amounts exclude the pro forma compensation expense related to unvested stock options granted before fiscal 1996. F-36 Reported and pro forma net income and net income per share amounts are set forth below (in thousands, except per share data):
1996 1997 1998 --------- --------- ---------- Reported: Income before extraordinary items....................... $ 32,383 $ 4,755 $ 13,732 Net income (loss)....................................... 32,383 (498) (19,283) Income (loss) per common share--basic: Income before extraordinary items....................... 1.04 0.17 0.45 Net income (loss)....................................... 1.04 (0.02) (0.63) Income (loss) per common share--diluted: Income before extraordinary items....................... 1.02 0.16 0.44 Net income (loss)....................................... 1.02 (0.02) (0.62) Pro Forma: Income (loss) before extraordinary items................ 28,835 (3,721) 9,787 Net income (loss)....................................... 28,835 (8,974) (23,228) Income (loss) per common share--basic: Income (loss) before extraordinary items................ 0.93 (0.13) 0.32 Net income (loss)....................................... 0.93 (0.31) (0.76) Income (loss) per common share--diluted: Income (loss) before extraordinary items................ 0.91 (0.13) 0.31 Net income (loss)....................................... 0.91 (0.31) (0.75)
The fair values of the stock options and ESPP options granted were estimated on the date of their grant using the Black-Scholes option pricing model based on the following weighted average assumptions:
1996 1997 1998 --------- ----------- ----------- Risk-free interest rate................................. 6% 6% 4.5% Expected life........................................... 5 years 5.5 years 4 years Expected volatility..................................... 35% 30% 50% Expected dividend yield................................. 0% 0% 0%
The weighted average fair value of options granted during fiscal 1996, 1997 and 1998 was $6.85, $9.67 and $9.53, respectively. Stock option activity for all plans for 1996, 1997 and 1998 was as follows:
YEAR ENDED SEPTEMBER 30, ----------------------------------------------------------------------------- 1996 1997 1998 ------------------------ ------------------------ ------------------------- WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE ----------- ----------- ----------- ----------- ------------ ----------- Balance, beginning of period........ 2,002,847 $ 15.32 2,916,159 $ 17.92 4,122,109 $ 20.13 Granted............................. 1,749,000 19.05 1,665,166 24.24 1,386,500 24.22 Canceled............................ (444,662) 21.20 (183,623) 20.84 (1,082,331) 23.66 Exercised........................... (391,026) 6.37 (275,593) 20.26 (590,366) 9.90 ----------- ----------- ------------ Balance, end of period.............. 2,916,159 17.92 4,122,109 20.13 3,835,912 22.23 ----------- ----------- ------------ ----------- ----------- ------------ Exercisable, end of period.......... 926,195 14.75 2,419,711 17.65 2,375,919 20.89 ----------- ----------- ------------ ----------- ----------- ------------
F-37 8. STOCKHOLDERS' EQUITY (CONTINUED) Stock options outstanding on September 30, 1998:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE - ---------------------------------------------------------------------------- ------------------------ WEIGHTED AVERAGE WEIGHTED WEIGHTED RANGE OF REMAINING AVERAGE AVERAGE EXERCISE CONTRACTUAL EXERCISE EXERCISE PRICE OPTIONS LIFE PRICE OPTIONS PRICE - --------------------------------- ----------- --------------- ----------- ----------- ----------- $14.56-$20.44 1,288,579 6.70 $ 18.21 1,181,081 $ 18.15 $20.50-$23.00 1,265,722 7.61 22.32 635,557 22.34 $23.06-$31.06 1,281,611 8.51 26.24 559,281 25.04 ----------- ----------- $14.56-$31.06 3,835,912 7.60 22.23 2,375,919 20.89 ----------- ----------- ----------- -----------
9. INCOME TAXES The provision for income taxes consisted of the following (in thousands):
YEAR ENDED SEPTEMBER 30, -------------------------------- 1996 1997 1998 ---------- --------- --------- Income taxes currently payable: Federal................................................. $ 6,900 $ 11,148 $ 3,462 State................................................... (1,139) 3,959 1,794 Foreign................................................. 3,779 3,678 2,340 Deferred income taxes: Federal................................................. 15,313 (6,670) 11,117 State................................................... 807 (2,569) 1,320 Foreign................................................. 35 (308) -- ---------- --------- --------- $ 25,695 $ 9,238 $ 20,033 ---------- --------- --------- ---------- --------- ---------
A reconciliation of the Company's income tax provision to that computed by applying the statutory federal income tax rate is as follows (in thousands):
YEAR ENDED SEPTEMBER 30, ------------------------------- 1996 1997 1998 --------- --------- --------- Income tax provision at federal statutory income tax rate..................................................... $ 22,483 $ 8,083 $ 13,671 State income taxes, net of federal income tax benefit...... (216) 904 2,024 Foreign income taxes, net of federal income tax benefit.... 2,479 2,190 1,521 Merit goodwill amortization................................ -- -- 4,410 Other--net................................................. 949 (1,939) (1,593) --------- --------- --------- Income tax provision....................................... $ 25,695 $ 9,238 $ 20,033 --------- --------- --------- --------- --------- ---------
As of September 30, 1998, the Company has estimated tax net operating loss ("NOL") carryforwards of approximately $476 million available to reduce future federal taxable income. These NOL carryforwards expire in 2006 through 2018 and are subject to examination by the Internal Revenue Service. In addition, the Company also has estimated tax NOL carryforwards of approximately $151 F-38 million available to reduce the federal taxable income of Merit and its subsidiaries. These NOL carryforwards expire in 2010 through 2018 and are subject to examination by the Internal Revenue Service. Further, these NOL carryforwards are subject to limitations on the taxable income of Merit and its subsidiaries. The Company has recorded a valuation allowance against the portion of the total NOL deferred tax asset and certain other deferred tax assets, that in management's opinion, are not likely to be recovered. Components of the net deferred income tax (assets) liabilities at September 30, 1997 and 1998 are as follows (in thousands):
SEPTEMBER 30, -------------------------- 1997 1998 ------------ ------------ Deferred tax liabilities: Insurance settlements........................................... $ 8,460 $ -- Property and depreciation....................................... -- 8,670 Long-term debt and interest..................................... 54,820 20,388 ESOP............................................................ 11,112 12,777 Other........................................................... 17,449 9,556 ------------ ------------ Total deferred tax liabilities................................ 91,841 51,391 ------------ ------------ Deferred tax assets: Property and depreciation....................................... (7,123) -- Intangible Assets............................................... (6,785) (8,992) Operating loss carryforwards.................................... (111,251) (250,512) Self-insurance reserves......................................... (30,918) (9,534) Restructuring costs............................................. (22,990) (4,071) Other........................................................... (38,924) (39,561) ------------ ------------ Total deferred tax assets....................................... (217,991) (312,670) ------------ ------------ Valuation allowance............................................. 124,992 163,893 ------------ ------------ Deferred tax assets after valuation allowance................... (92,999) (148,777) ------------ ------------ Net deferred tax assets......................................... $ (1,158) $ 97,386 ------------ ------------ ------------ ------------
The Internal Revenue Service is currently examining the Company's income tax returns for fiscal 1992 and 1993 and expects a report to be issued during fiscal 1999. In management's opinion, adequate provisions have been made for any adjustments which may result from these examinations, including a potential reduction in the amount of NOL carryforwards. The Company believes the examinations could result in a reduction in NOL carryforwards available to offset future taxable income. F-39 10. ACCRUED LIABILITIES Accrued liabilities consist of the following (in thousands):
SEPTEMBER 30, ------------------------ 1997 1998 ----------- ----------- Salaries, wages and other benefits...................................................... $ 21,647 $ 23,893 Amounts due health insurance programs................................................... 14,126 9,392 Interest................................................................................ 19,739 9,271 Crescent Transactions................................................................... 14,648 3,972 CHAMPUS Adjustments..................................................................... -- 25,484 Other................................................................................... 63,761 121,518 ----------- ----------- $ 133,921 $ 193,530 ----------- ----------- ----------- -----------
11. MANAGED CARE INTEGRATION PLAN AND COSTS INTEGRATION PLAN The Company owns three behavioral managed care organizations ("BMCOs"), Green Spring, HAI and Merit, as a result of acquisitions consummated in fiscal 1996 (Green Spring) and fiscal 1998 (HAI and Merit). The Company also owns two specialty managed care organizations, Allied and Care Management Resources, Inc. ("CMR"). Management has approved and committed the Company to a plan to combine and integrate the operations of its BMCOs and specialty managed care organizations (the "Integration Plan") that will result in the elimination of duplicative functions and will standardize business practices and information technology platforms. The Integration Plan will result in the elimination of approximately 1,000 positions during fiscal 1998 and fiscal 1999. Approximately 350 employees had been involuntarily terminated pursuant to the Integration Plan as of September 30, 1998, and approximately 280 positions had been eliminated by normal attrition through September 30, 1998. The remaining positions to be eliminated have been identified, and will be eliminated through a combination of normal attrition and involuntary termination. The employee groups of the BMCOs that are primarily affected include executive management, finance, human resources, information systems and legal personnel at the various BMCOs corporate headquarters and regional offices and credentialing, claims processing, contracting and marketing personnel at various operating locations. The Company expects to complete the specific identification of all personnel who will be involuntarily terminated by March 31, 1999 and will complete its involuntary terminations by the end of fiscal 1999. The Integration Plan has resulted in the closure and identified closure of approximately 20 leased facilities at the BMCOs, Allied and CMR during fiscal 1998 and 1999. The Company expects the remaining office closures, if any, to be insignificant. The Company has recorded approximately $21.3 million of liabilities related to the Integration Plan, of which $12.4 million was recorded as part of the Merit purchase price allocation and $8.9 million was recorded in the statement of operations under "Managed Care integration costs". The Company may record additional liabilities as a result of the Integration Plan in fiscal 1999 as final decisions regarding office closures and other contractual obligation terminations are made. F-40 11. MANAGED CARE INTEGRATION PLAN AND COSTS (CONTINUED) The following table provides a rollforward of liabilities resulting from the Integration Plan (in thousands):
BALANCE BALANCE SEPTEMBER 30, SEPTEMBER 30, TYPE OF COST 1997 ADDITIONS PAYMENTS 1998 - ------------------------------------------- ----------------- ----------- ------------- -------------- Employee termination benefits.............. $ -- $ 13,009 $ (6,819) $ 6,190 Facility closing costs..................... -- 8,008 (533) 7,475 Other...................................... -- 244 (75) 169 ----- ----------- ------------- -------------- $ -- $ 21,261 $ (7,427) $ 13,834 ----- ----------- ------------- -------------- ----- ----------- ------------- --------------
OTHER INTEGRATION COSTS The Integration Plan will result in additional incremental costs that must be expensed as incurred in accordance with Emerging Issues Task Force Consensus 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)" that are not described above and certain other charges. Other integration costs include, but are not limited to, outside consultants, costs to relocate closed office contents and long-lived asset impairments. Other integration costs are reflected in the statement of operations under "Managed Care integration costs". During the year ended September 30, 1998, the Company incurred approximately $8.1 million, in other integration costs, including long-lived asset impairments of approximately $2.4 million, and outside consulting costs of approximately $4.1 million. The asset impairments relate primarily to identifiable intangible assets and leasehold improvements that no longer have value and have been written off as a result of the Integration Plan. 12. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information is as follows (in thousands):
YEAR ENDED SEPTEMBER 30, ---------------------------------- 1996 1997 1998 --------- --------- ------------ (UNAUDITED) Income taxes paid, net of refunds received.................................. $ 9,299 $ 18,406 $ 11,116 Interest paid, net of amounts capitalized................................... 56,248 54,378 95,153 Long-term debt assumed in connection with acquisitions...................... 12,100 -- -- Non-cash Transactions: Initial capital contribution to CBHS, primarily property and equipment, less assumed liabilities....................................................... -- 5,281 -- Common Stock in Treasury issued in connection with the purchase of the remaining 39% interest in Green Spring Health Services, Inc............... -- -- 63,496
13. COMMITMENTS AND CONTINGENCIES The Company is self-insured for a substantial portion of its general and professional liability risks. The reserves for self-insured general and professional liability losses, including loss adjustment expenses, are included in reserve for unpaid claims in the Company's balance sheet and are based on actuarial estimates that are discounted at an average rate of 6% to their present value based on the F-41 13. COMMITMENTS AND CONTINGENCIES (CONTINUED) Company's historical claims experience adjusted for current industry trends. The undiscounted amount of the reserve for unpaid claims at September 30, 1997 and 1998 was approximately $56.1 million and $34.6 million, respectively. The carrying amount of accrued medical malpractice claims was $47.7 million and $26.2 million at September 30, 1997 and 1998, respectively. The reserve for unpaid claims is adjusted periodically as such claims mature, to reflect changes in actuarial estimates based on actual experience. During fiscal 1996, 1997 and 1998, the Company recorded reductions in malpractice claim reserves of approximately $15.3 million, $7.5 million and $4.1 million, respectively, as a result of updated actuarial estimates. These reductions resulted primarily from updates to actuarial assumptions regarding the Company's expected losses for more recent policy years. These revisions are based on changes in expected values of ultimate losses resulting from the Company's claim experience, and increased reliance on such claim experience. While management and its actuaries believe that the present reserve is reasonable, ultimate settlement of losses may vary from the amount recorded. The healthcare industry is subject to numerous laws and regulations. The subjects of such laws and regulations include but are not limited to, matters such as licensure, accreditation, government healthcare program participation requirements, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Recently, government activity has increased with respect to investigations and/or allegations concerning possible violations of fraud and abuse and false claims statutes and/or regulations by healthcare providers. Entities that are found to have violated these laws and regulations may be excluded from participating in government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed patient services. The Office of the Inspector General of the Department of Health and Human Services and the United States Department of Justice and certain other governmental agencies are currently conducting inquiries and/ or investigations regarding the compliance by the Company and certain of its subsidiaries and the compliance by CBHS and certain of its subsidiaries with such laws and regulations. Certain of the inquiries relate to the operations and business practices of the Psychiatric Hospital Facilities prior to the consummation of the Crescent Transactions. In addition, the Company is also subject to or party to litigation, claims and civil suits relating to its operations and business practices. In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company arising out of such litigation, civil suits and governmental inquiries. Furthermore, management believes that the resolution of such litigation, civil suits and governmental inquiries will not have a material adverse effect on the Company's financial position or results of operations; however, there can be no assurance in this regard. In January 1996, the Company settled an ongoing dispute with the Resolution Trust Corporation ("RTC"), for itself or in its capacity as conservator or receiver for 12 financial institutions, which formerly held certain debt securities that were issued by the Company in 1988. In connection with the settlement, the Company, denying any liability or fault, paid $2.7 million to the RTC in exchange for a release of all claims. On August 1, 1996, the United States Department of Justice, Civil Division, filed an Amended Complaint in a civil QUI TAM action initiated in November 1994 against the Company and its Orlando South hospital subsidiary ("Charter Orlando") by two former employees. The First Amended Complaint alleges that Charter Orlando violated the federal False Claims Act (the "Act") in billing for inpatient treatment provided to elderly patients. The Court granted the Company's motion to dismiss the government's First Amended Complaint yet granted the government leave to amend its First Amended Complaint. The government filed a Second Amended Complaint on December 12, 1996 which, similar to the First Amended Complaint, alleges that the Company and its subsidiary violated the Act in billing for the treatment of geriatric patients. Like the First Amended Complaint, the Second Amended Complaint was based on disputed clinical and factual issues which the Company believes do not constitute a violation F-42 13. COMMITMENTS AND CONTINGENCIES (CONTINUED) of the Act. On the Company's motion, the Court ordered the parties to participate in mediation of the matter. As a result of the mediation, the parties reached a settlement. Pursuant to the settlement, the Company paid approximately $4.8 million in August 1998. Furthermore, Charter Orlando (now operated by CBHS) will not seek reimbursement for services provided to patients covered under the Medicare program for a period of up to fifteen months. The Company has agreed to reimburse CBHS for the resulting loss of revenues during such period. The Company has an accrued liability of approximately $2.3 million as of September 30, 1998 for this reimbursement. In October 1996, a group of eight plaintiffs purporting to represent an uncertified class of psychiatrists, psychologists and social workers brought an action under the federal antitrust laws in the United States District Court for the Southern District of New York against nine behavioral health managed care organizations, including Merit, CMG, Green Spring and HAI (collectively, the "Defendants"). The complaint (the "Stephens Case") alleges that the Defendants violated Section I of the Sherman Act by engaging in a conspiracy to fix the prices at which the defendants purchase services from mental healthcare providers such as the plaintiffs. The complaint further alleges that the Defendants engaged in a group boycott to exclude mental healthcare providers from the Defendants' networks in order to further the goals of the alleged conspiracy. The complaint also challenges the propriety of the Defendants' capitation arrangements with their respective customers, although it is unclear from the complaint whether the plaintiffs allege that the Defendants unlawfully conspired to enter into capitation arrangements with their respective customers. The complaint seeks treble damages against the Defendants in an unspecified amount and a permanent injunction prohibiting the Defendants from engaging in the alleged conduct which forms the basis of the complaint, plus costs and attorneys' fees. On May 12, 1998, the District Court granted the Defendants' motion to dismiss the complaint with prejudice. On May 27, 1998, the plaintiffs filed a notice of appeal of the District Court's dismissal of their complaint with the United States Second Circuit Court of Appeals. On November 16, 1998, the Second Circuit court issued a Summary Order affirming the District Court's decision. The plaintiffs have not filed a petition for rehearing, and the time allotted for doing so has expired. The plaintiffs have 90 days from the date of judgment to file a petition for certiorari with the United States Supreme Court. The plaintiffs have not indicated whether they will file such a petition. If no petition is filed, or if a filed petition is denied, this matter will have been concluded. The Company does not believe this matter will have a material adverse effect on its financial position or results of operations. On May 26, 1998, the counsel representing the plaintiffs in the Stephens Case filed an action in the United States District Court for the District of New Jersey on behalf of a group of thirteen plaintiffs who also purport to represent an uncertified class of psychiatrists, psychologists and clinical social workers. This complaint alleges substantially the same violations of federal antitrust laws by the same nine managed behavorial healthcare organizations that are the defendants in the Stephens Case. The Defendants believe the factual and legal issues involved in this case are substantially similar to those involved in the Stephens Case. The Defendants intend to vigorously defend themselves in this litigation. On August 28, 1998, the defendants filed a joint motion requesting that the case be: (1) transferred to the Southern District of New York; (2) alternatively, that all proceedings be stayed pending the Second Circuit's determination of the Stephens Case appeal, given the RES JUDICATA effect of the Stephens Case dismissal; and (3) if the Court proceeds with the case, that the complaint be dismissed for failure to state a claim for substantially the same reasons as in the Stephens Case. The plaintiffs have opposed this motion, which was argued on November 23, 1998. At the conclusion of the November 23 hearing, the Court ruled that the case should be transferred to the Southern District of New York. The Defendants' motion to dismiss was deemed withdrawn without prejudice to its resubmission in the Southern District. The plaintiffs have stated that they intend to appeal the Court's transfer order to the United States District F-43 13. COMMITMENTS AND CONTINGENCIES (CONTINUED) Court for the District of New Jersey. The Company does not believe this matter will have a material adverse effect on its financial position or results of operations. The Company provides mental health and substance abuse services, as a subcontractor, to beneficiaries of CHAMPUS. The fixed monthly amounts that the Company receives for medical costs under CHAMPUS contracts are subject to retroactive adjustment ("CHAMPUS Adjustments") based upon actual healthcare utilization during the period known as the "data collection period". The Company has recorded reserves of approximately $25.5 million as of September 30, 1998 for CHAMPUS Adjustments. While management believes that the present reserve for CHAMPUS Adjustments is reasonable, ultimate settlement resulting from the adjustment and available appeal process may vary from the amount provided. 14. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Gerald L. McManis, a director of the Company, is the President of McManis Associates, Inc. ("MAI"), a healthcare development and management consulting firm. During fiscal 1996, 1997 and 1998, MAI provided consulting services to the Company with respect to the development of strategic plans and a review of the Company's business processes. The Company incurred approximately $287,000, $865,000 and $85,000 in fees for such services and related expenses during fiscal 1996, 1997 and 1998, respectively. G. Fred DiBona, Jr., a director of the Company, is a Director and the President and Chief Executive Officer of Independence Blue Cross ("IBC"), a health insurance company. IBC owned 16.67% of Green Spring prior to December 13, 1995. On December 13, 1995, IBC sold 4.42% of its ownership interest in Green Spring to the Company for $5,376,000 in cash. IBC had a cost basis of $3,288,000 in the 4.42% ownership interest sold to the Company. The Exchange Option described previously gave IBC the right to exchange its ownership interest in Green Spring for a maximum of 889,456 shares of Common Stock or $20,460,000 in subordinated notes through December 13, 1998. IBC exercised its Exchange Option in January 29, 1998 for Magellan Common Stock valued at approximately $17.9 million. IBC and its affiliated entities contract with Green Spring for provider network, care management and medical review services pursuant to contractual relationships entered into on July 7, 1994 with terms of up to five years. During the period from December 14, 1995 through September 30, 1996, fiscal 1997 and fiscal 1998, IBC and its affiliated entities made payments to Green Spring of approximately $29.2 million, $48.0 million and $54.7 and owed Green Spring approximately $13.6 million and $13.5 at September 30, 1997 and 1998, respectively. Green Spring recorded revenue of approximately $32.8 million, $47.4 million and $54.6 million from IBC during fiscal 1996, 1997 and 1998, respectively. On July 7, 1994, IBC sold a subsidiary to Green Spring in exchange for a $15 million promissory note. As of September 30, 1998, $3 million remained outstanding under such promissory note and is due and payable on July 7, 1999. Darla D. Moore, a director of the Company since February 1996, is the spouse of Richard E. Rainwater, Chairman of the Board of Crescent and the largest stockholder of the Company (13.1% beneficial ownership as of September 30, 1998). Because of her relationship to Mr. Rainwater, Ms. Moore did not participate in any Board action taken with respect to the Crescent Transactions. Daniel S. Messina, a director of the Company, is the Chief Financial Officer of Aetna. Mr. Messina became a director of the Company in December 1997. On December 4, 1997, the Company consummated the purchase of HAI, formerly a unit of Aetna, for approximately $122.1 million. F-44 14. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED) The Company may be required to make additional contingent payment of up to $60.0 million annually to Aetna over the five-year period subsequent to closing. The amount and timing of the payments will be contingent upon net increases in the HAI's covered lives in specified products. The consideration paid for HAI was determined through arm's length negotiations that considered, among other factors, the historical and projected income of HAI. The consideration paid by the Company was determined by the Board with the advice of management and the Company's investment bankers. Aetna and its affiliated entities contract with the Company for various behavioral managed care services pursuant to contractual relationships, the most material of which is the Master Service Agreement, which was entered into on December 4, 1997. During fiscal 1998, Aetna and its affiliated entities paid the Company approximately $72.3 million for such services. As of September 30, 1998. Aetna and its affiliated entities owed the Company approximately $0.8 million. The Company recorded revenue of approximately $69.2 million from Aetna during fiscal 1998. 15. BUSINESS SEGMENT INFORMATION The Company operates through five reportable segments engaging in (i) the behavioral managed healthcare business, (ii) the human services business, (iii) the specialty managed healthcare business, (iv) the healthcare franchising business and (v) the healthcare provider business. The behavorial managed healthcare segment provides behavioral managed care services to health plans, insurance companies, corporations, labor unions and various governmental agencies. The human services segment provides therapeutic foster care services and residential and day services to individuals with acquired brain injuries and for individuals with mental retardation and developmental disabilities. The speciality managed healthcare segment provides managed care services to health plans and insurance companies for chronic medical conditions. The healthcare franchising segment "franchises" the CHARTER system of behavioral healthcare, which includes call center management, clinical outcomes monitoring and advertising and marketing services. The healthcare provider segment provides behavioral healthcare services to people in the U.S., United Kingdom and Switzerland. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance of its segments based on profit or loss from operations before depreciation, amortization, interest, stock option expense (credit), managed care integration costs, gain or loss on asset sales, other unusual items, income taxes and minority interest ("Segment Profit"). Intersegment sales and transfers are not significant. The Company's reportable segments are strategic business units that offer different services. They are managed separately because each business has (i) different marketing strategies due to differences in types of customers and (ii) different capital resource needs. F-45 15. BUSINESS SEGMENT INFORMATION (CONTINUED) The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in thousands):
BEHAVIORAL SPECIALTY MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED ----------- ----------- ----------- ------------ ------------- ----------- ------------- 1996 Net revenue................ $ 230,755 $ 69,813 $ -- $ -- $ 1,044,711 $ -- $ 1,345,279 Segment profit (loss)...... 25,589 9,910 -- -- 198,651 (34,786) 199,364 Equity in loss of unconsolidated subsidiary................ (2,005) -- -- -- -- -- (2,005) Capital expenditures....... 6,018 1,964 -- -- 21,737 9,082 38,801
BEHAVIORAL SPECIALTY MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED ----------- --------- ----------- ------------ ----------- ----------- ------------- 1997 Net revenue................... $ 369,974 $ 88,331 $ -- $ 22,739 $ 729,652 $ -- $ 1,210,696 Segment profit (loss)......... 37,019 10,695 (2,303) 10,964 147,053 (25,578) 177,850 Equity in loss of unconsolidated subsidiaries................ (5,567) -- -- (8,122) -- -- (13,689) Total assets.................. 231,543 39,454 2,366 19,134 271,555 331,568 895,620 Investment in unconsolidated subsidiaries................ (658) -- -- 16,878 -- -- 16,220 Capital expenditures.......... 9,548 1,880 567 195 18,172 2,986 33,348
BEHAVIORAL SPECIALTY MANAGED HUMAN MANAGED HEALTHCARE HEALTHCARE CORPORATE HEALTHCARE SERVICES HEALTHCARE FRANCHISING PROVIDER OVERHEAD CONSOLIDATED ------------- ----------- ----------- ------------ ----------- ----------- ------------- 1998 Net revenue................ $ 1,039,038 $ 141,032 $ 143,503 $ 55,625 $ 133,256 $ -- $ 1,512,454 Segment profit (loss)...... 137,192 15,493 3,128 14,676 26,379 (15,750) 181,118 Equity in income (loss) of unconsolidated subsidiaries.............. 12,859 -- -- (31,878) -- -- (19,019) Total assets............... 1,356,259 119,356 106,184 1,941 150,095 182,455 1,916,290 Investment in unconsolidated subsidiaries.............. 10,125 -- -- -- -- -- 10,125 Capital expenditures....... 27,535 8,391 3,937 1,483 2,219 648 44,213
F-46 15. BUSINESS SEGMENT INFORMATION (CONTINUED) The following tables reconcile segment profit to consolidated income before provision for income taxes, minority interest and extraordinary items: 1996 Segment profit................................................................... $ 199,364 Depreciation and amortization.................................................... (48,924) Interest, net.................................................................... (48,017) Stock option expense............................................................. (914) Unusual items.................................................................... (37,271) --------- Income before provision for income taxes, minority interest and extraordinary items.................................... $ 64,238 --------- ---------
1997 Segment profit................................................................... $ 177,850 Depreciation and amortization.................................................... (44,861) Interest, net.................................................................... (45,377) Stock option expense............................................................. (4,292) Loss on Crescent Transactions.................................................... (59,868) Unusual items.................................................................... (357) --------- Income before provision for income taxes, minority interest and extraordinary items........................................................................ $ 23,095 --------- ---------
1998 Segment profit................................................................... $ 181,118 Depreciation and amortization.................................................... (54,885) Interest, net.................................................................... (75,375) Stock option credit.............................................................. 5,623 Managed care integration costs................................................... (16,962) Unusual items.................................................................... (458) --------- Income before provision for income taxes, minority interest and extraordinary items........................................................................ $ 39,061 --------- ---------
Revenue generated and long-lived assets located in foreign countries are not material. Revenues from one customer of the Company's behavioral managed healthcare segment represented 10.1% of the Company's consolidated revenues for fiscal 1998. 16. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The following is a summary of the quarterly results of operations for the years ended September 30, 1997 and 1998. The second quarter and third quarter of fiscal 1997 include unusual items of approximately $1.4 million and ($1.0) million, respectively. The third quarter of fiscal 1997 also includes a $59.9 million loss on the Crescent Transactions. See Notes 3 and 5 for an explanation of these items. The fourth quarter of 1997 includes increases to income before income taxes and minority interest for revenue and bad debt expense adjustments of approximately $6.4 million relating to a change in estimate for contractual allowances and allowance for doubtful accounts in the Company's provider business. The third and fourth quarters of fiscal 1998 include unusual items of $(3.0) million and $3.5 million, respectively. See Note 5 for an explanation of these items. The second, third, and fourth quarters of fiscal 1998 included managed care integrations cost of $11.0 million, $1.3 million and $4.7 million, respectively. See Note 11 for an explanation of these costs. Net revenue and cost of care were both reduced from amounts previously reported in the first, second and third quarters of fiscal 1998 by $4.4 million, $0.1 million and $4.1 million, respectively. F-47 16. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED)
FISCAL QUARTERS -------------------------------------------------- FIRST SECOND THIRD FOURTH ----------- ----------- ----------- ----------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1997 Net revenue.................................................. $ 346,819 $ 349,922 $ 324,921 $ 189,034 Income (loss) before extraordinary items..................... 7,141 11,892 (24,441) 10,163 Net income (loss)............................................ 4,191 11,892 (26,744) 10,163 Income (loss) per common share--basic: Income (loss) before extraordinary items................... 0.25 0.41 (0.85) 0.35 Net income (loss).......................................... 0.15 0.41 (0.93) 0.35 Income (loss) per common share--diluted: Income (loss) before extraordinary items................... 0.25 0.41 (0.85) 0.33 Net income (loss).......................................... 0.14 0.41 (0.93) 0.33 1998 Net revenue.................................................. $ 211,737 $ 372,153 $ 470,679 $ 457,885 Income (loss) before extraordinary items..................... 7,628 (2,292) 7,410 986 Net income (loss)............................................ 7,628 (35,307) 7,410 986 Income (loss) per common share--basic: Income (loss) before extraordinary items................... 0.26 (0.07) 0.24 0.03 Net income (loss).......................................... 0.26 (1.14) 0.24 0.03 Income (loss) per common share--diluted: Income (loss) before extraordinary items................... 0.26 (0.07) 0.23 0.03 Net Income (loss).......................................... 0.26 (1.14) 0.23 0.03
F-48 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE MEMBERS OF CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC: We have audited the accompanying consolidated balance sheets of Charter Behavioral Health Systems, LLC (a Delaware limited liability corporation) and subsidiaries as of September 30, 1997 and 1998, and the related consolidated statements of operations, changes in members' capital (deficit) and cash flows for the period June 17, 1997 to September 30, 1997 and for the year ended September 30, 1998. These consolidated financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Charter Behavioral Health Systems, LLC and subsidiaries as of September 30, 1997 and 1998, and the results of their operations and their cash flows for the period June 17, 1997 to September 30, 1997 and for the year ended September 30, 1998, in conformity with generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has incurred recurring losses from operations and has a net capital deficiency that raises substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index to the consolidated financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. The schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states, in all material respects, the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP ATLANTA, GEORGIA DECEMBER 3, 1998 F-49 CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
SEPTEMBER 30, ------------------------ 1997 1998 ----------- ----------- ASSETS Current Assets: Cash, including cash equivalents of $15,477 in 1997 and $9,117 in 1998, at cost, which approximates market value............................................ $ 23,443 $ 13,493 Accounts receivable, less allowance for doubtful accounts of $17,605 in 1997 and $33,548 in 1998......................................................... 107,961 120,187 Accounts receivable from Magellan..................................................... 5,090 -- Supplies.............................................................................. 2,313 2,665 Prepaid expenses...................................................................... 9,385 10,538 Other current assets.................................................................. 345 236 ----------- ----------- Total Current Assets.............................................................. 148,537 147,119 Property and Equipment: Buildings and improvements............................................................ 11,879 9,616 Equipment............................................................................. 7,121 11,924 ----------- ----------- 19,000 21,540 Accumulated depreciation.............................................................. (662) (2,916) ----------- ----------- 18,338 18,624 Construction in progress.............................................................. 86 2,524 ----------- ----------- Total Property and Equipment...................................................... 18,424 21,148 Other Long-Term Assets.................................................................. 6,471 6,699 Goodwill, net of accumulated amortization of $3 in 1997 and $17 in 1998................. 286 294 Deferred Financing Fees, net of accumulated amortization of $115 in 1997 and $513 in 1998.................................................................................. 1,876 1,878 ----------- ----------- $ 175,594 $ 177,138 ----------- ----------- ----------- -----------
The accompanying Notes to Consolidated Financial Statements are an integral part of these consolidated balance sheets. F-50 CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
SEPTEMBER 30, ------------------------- 1997 1998 ----------- ------------ LIABILITIES AND MEMBERS' CAPITAL (DEFICIT) Current Liabilities: Accounts payable..................................................................... $ 34,864 $ 54,443 Accounts payable to Magellan......................................................... -- 36,857 Accrued liabilities.................................................................. 33,578 47,279 Current maturities of long-term debt and capital lease obligations................... 55 2,800 ----------- ------------ Total Current Liabilities.......................................................... 68,497 141,379 Long-Term Debt and Capital Lease Obligations........................................... 65,860 67,200 Reserve for Unpaid Claims.............................................................. 2,686 10,812 Deferred Rent.......................................................................... 3,956 17,054 Long-Term Obligations to Lessor........................................................ 803 3,803 Minority Interest and Other Long-Term Liabilities...................................... 36 3,768 Members' Capital (Deficit): Preferred interests.................................................................. 35,000 35,000 Common interests..................................................................... 15,000 15,000 Accumulated deficit.................................................................. (16,244) (116,878) ----------- ------------ Total Members' Capital (Deficit)................................................... 33,756 (66,878) ----------- ------------ $ 175,594 $ 177,138 ----------- ------------ ----------- ------------
The accompanying Notes to Consolidated Financial Statements are an integral part of these consolidated balance sheets. F-51 CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS)
106 DAYS ENDED YEAR ENDED SEPTEMBER 30, SEPTEMBER 30, 1997 1998 ---------------- -------------- Net revenue.................................................................... $ 213,730 $ 730,447 ---------------- -------------- Costs and expenses: Salaries, supplies and other operating expenses.............................. 170,619 606,628 Franchise fees--Magellan..................................................... 22,739 78,584 Crescent Lease expense....................................................... 16,919 56,133 Bad debt expense............................................................. 17,437 63,895 Depreciation and amortization................................................ 668 5,693 Interest, net................................................................ 1,592 5,263 Unusual items................................................................ -- 11,125 ---------------- -------------- 229,974 827,321 ---------------- -------------- Loss before minority interest.................................................. (16,244) (96,874) Minority interest.............................................................. -- 41 ---------------- -------------- Net loss....................................................................... (16,244) (96,915) Preferred dividend requirement................................................. -- 3,719 ---------------- -------------- Net loss applicable to common members.......................................... $ (16,244) $ (100,634) ---------------- -------------- ---------------- --------------
The accompanying Notes to Consolidated Financial Statements are an integral part of these consolidated statements. F-52 CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC CONSOLIDATED STATEMENTS OF CHANGES IN MEMBERS' CAPITAL (DEFICIT) (IN THOUSANDS)
106 DAYS ENDED YEAR ENDED SEPTEMBER 30, SEPTEMBER 30, 1997 1998 ---------------- -------------- Preferred Interests: Balance, beginning of period................................................. $ -- $ 35,000 Issuance of cumulative redeemable preferred interests--Magellan........................................................ 17,500 -- Issuance of cumulative redeemable preferred interests--COI............................................................. 17,500 -- -------- -------------- Balance, end of period....................................................... 35,000 35,000 -------- -------------- Common Interests: Balance, beginning of period................................................. -- 15,000 Capital contribution--Magellan............................................... 7,500 -- Capital contribution--COI.................................................... 7,500 -- -------- -------------- Balance, end of period....................................................... 15,000 15,000 -------- -------------- Accumulated Deficit: Balance, beginning of period................................................. -- (16,244) Net loss applicable to common members........................................ (16,244) (100,634) -------- -------------- Balance, end of period....................................................... (16,244) (116,878) -------- -------------- Total Members' Capital (Deficit)............................................... $ 33,756 $ (66,878) -------- -------------- -------- --------------
The accompanying Notes to Consolidated Financial Statements are an integral part of these consolidated statements. F-53 CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
106 DAYS ENDED YEAR ENDED SEPTEMBER 30, SEPTEMBER 30, 1997 1998 ---------------- -------------- Cash Flows From Operating Activities Net loss..................................................................... $ (16,244) $ (96,915) -------- -------------- Adjustments to reconcile net loss to net cash used in operating activities: (Gain) loss on sale of businesses.......................................... (355) 2,688 Depreciation and amortization.............................................. 668 5,693 Non-cash interest expense.................................................. 115 398 Cash flows from changes in assets and liabilities, net of effects from sales and acquisitions of businesses: Accounts receivable, net................................................. (98,504) (5,318) Accounts receivable/payable to Magellan.................................. (5,090) 41,947 Other current assets..................................................... (5,089) (1,096) Other long-term assets................................................... (4,565) (275) Accounts payable and accrued liabilities................................. 53,791 30,848 Reserve for unpaid claims................................................ 2,686 8,126 Deferred rent............................................................ 3,956 13,098 Minority interest, net of dividends paid................................. -- (25) Other liabilities........................................................ 800 43 -------- -------------- Total adjustments........................................................ (51,587) 96,127 -------- -------------- Net cash used in operating activities.................................. (67,831) (788) -------- -------------- Cash Flows From Investing Activities Capital expenditures......................................................... (149) (9,549) Purchase of information systems equipment from Magellan...................... (5,000) -- Purchase of net assets from Magellan......................................... (11,288) -- Proceeds from sale of businesses, net of transaction costs................... -- 1,160 Acquisition of businesses, net of cash acquired.............................. -- (5,327) -------- -------------- Net cash used in investing activities.................................. (16,437) (13,716) -------- -------------- Cash Flows From Financing Activities Payments on debt and capital lease obligations............................... (16) (46) Proceeds from issuance of debt, net of issuance costs........................ 98,009 4,600 Proceeds from capital contributions--Magellan................................ 2,218 -- Proceeds from capital contributions--COI..................................... 7,500 -- -------- -------------- Net cash provided by financing activities.............................. 107,711 4,554 -------- -------------- Net increase(decrease) in cash and cash equivalents............................ 23,443 (9,950) Cash and cash equivalents at beginning of period............................... -- 23,443 -------- -------------- Cash and cash equivalents at end of period..................................... $ 23,443 $ 13,493 -------- -------------- -------- --------------
The accompanying Notes to Consolidated Financial Statements are an integral part of these consolidated statements. F-54 CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1997 AND 1998 1. ORGANIZATION AND BASIS OF PRESENTATION The consolidated financial statements of Charter Behavioral Health Systems, LLC ("CBHS" or the "Company"), a Delaware limited liability corporation, include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company provides behavioral healthcare services in the United States. The Company's principal services include group and individual inpatient treatment, day and partial hospitalization services, group and individual outpatient treatment and residential services. On June 17, 1997 the Company began operations pursuant to a series of transactions (the "Crescent Transactions") between Magellan Health Services, Inc. ("Magellan"), Crescent Real Estate Equities Limited Partnership ("Crescent") and Crescent Operating, Inc. ("COI"). The Crescent Transactions provided for the following: - -- Magellan sold to Crescent 80 behavioral healthcare facilities (76 operating and four held for sale) ("Purchased Facilities") and related medical office buildings formerly operated by Magellan. - -- The Company operates the Purchased Facilities and the Contributed Facilities (defined below) (together the "Facilities"). The Company is owned equally by Magellan and COI. - -- Magellan contributed to the Company certain property and intangible rights used in connection with the Facilities with a net book value of approximately $5.0 million in exchange for its equity interest in CBHS. The property that was contributed by Magellan included five acute care psychiatric hospitals and other ancillary facilities that Magellan leased from third parties (together the "Contributed Facilities"). The Company also purchased certain assets from Magellan relating to Magellan's information systems subsidiary for $5.0 million. - -- COI contributed $5.0 million of cash as its initial equity investment in the Company. - -- CBHS entered into a service agreement with Magellan pursuant to which the Company manages Magellan's interest in certain joint ventures with unaffiliated third parties, including joint ventures that operate or manage ten behavioral healthcare facilities. Magellan is the general partner or managing entity of such joint ventures. - -- CBHS leased the Purchased Facilities from Crescent under an initial 12-year lease term with four renewal terms of five years each ("Crescent Lease"). CBHS pays annual base rent to Crescent, which was initially $41.7 million and increases at 5% compounded annually (See Note 5). - -- CBHS and certain of its subsidiaries entered into franchise agreements with Magellan (the "Franchise Agreements") pursuant to which CBHS and such subsidiaries operate using the "CHARTER" name, services and protocols and pay Magellan annual franchise fees, subject to increase, of approximately $78.3 million (See Note 6). The franchise fees due Magellan are subordinate to the payment of rent due Crescent. - -- Both Magellan and COI contributed an additional $2.5 million in cash to the capital of CBHS. In addition, each made a commitment to loan CBHS up to $17.5 million each, for a period of five years. Such loans were made to CBHS by each for $17.5 million ("Member Loans") and, effective September 30, 1997, were converted to cumulative redeemable preferred interests (See Note 8). F-55 CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 1. ORGANIZATION AND BASIS OF PRESENTATION (CONTINUED) The Company's financial statements have been prepared assuming that the Company will continue as a going concern. As shown in the financial statements during the 106 days ended September 30, 1997 and the year ended September 30, 1998, the Company has incurred losses from operations, and therefore, the Company has a significant accumulated deficit at September 30, 1998. The financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company's continuation as a going concern is dependent upon its ability to generate sufficient cash flows to meet its obligations on a timely basis. The Company believes its cash flows and profitability are influenced by the cyclical nature of the behavioral healthcare provider business, with a reduced demand for certain services generally occurring during the first fiscal quarter around major holidays and during the summer months comprising the fourth fiscal quarter. Management has formulated and implemented a business plan to reduce overhead and add new lines of business to improve the cash flows and the profitability of the Company. Additionally, the Company is actively pursuing additional sources of capital and/or borrowings. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. NET REVENUE Net revenue is based on established billing rates, less estimated allowances for patients covered by Medicare and other contractual reimbursement programs, and discounts from established billing rates. Amounts received by the Company for treatment of patients covered by Medicare and other contractual reimbursement programs, which may be based on cost of services provided or predetermined rates, are generally less than the established billing rates of the Company's hospitals. Final determination of amounts earned under contractual reimbursement programs is subject to review and audit by the applicable agencies. Net revenue in fiscal 1998 included a charge of $0.7 million for the settlement and adjustment of reimbursement issues related to the previous fiscal period. Management believes that adequate provision has been made for any adjustments that may result from such reviews. ADVERTISING COSTS The production costs of advertising are expensed as incurred. The Company does not consider any of its advertising costs to be direct-response and, accordingly, does not capitalize such costs. Advertising costs consist primarily of radio and television air time, which is amortized as utilized, and printed media services. Advertising expense was approximately $6.4 million and $20.3 million for the 106 days ended September 30,1997 and for the year ended September 30, 1998, respectively. F-56 CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CHARITY CARE The Company provides healthcare services without charge or at amounts less than its established rates to patients who meet certain criteria under its charity care policies. Because the Company does not pursue collection of amounts determined to be charity care, they are not reported as revenue. For the 106 days ended September 30, 1997 and for the year ended September 30, 1998, the Company provided, at its established billing rates, approximately $5.3 million and $28.4 million, respectively, of such care. INTEREST, NET The Company records interest expense net of interest income. Interest income for the 106 days ended September 30, 1997 and for the year ended September 30, 1998 was approximately $0.2 million and $0.3 million, respectively. CASH AND CASH EQUIVALENTS Cash equivalents are short-term, highly liquid interest-bearing investments with a maturity of three months or less when purchased, consisting primarily of money market instruments. CONCENTRATION OF CREDIT RISK Accounts receivable from patient revenue subject the Company to a concentration of credit risk with third-party payors that include insurance companies, managed healthcare organizations and governmental entities. The Company establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific payors, historical trends and other information. Management believes the allowance for doubtful accounts is adequate to provide for normal credit losses. PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Expenditures for renewals and improvements are charged to the property accounts. Replacements and maintenance and repairs that do not improve or extend the lives of the respective assets are expensed as incurred. Amortization of capital lease assets is included in depreciation expense. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets, which is generally three to ten years for equipment. Leasehold improvements are amortized over the useful lives of the related assets or the terms of the leases, whichever is shorter. Depreciation and amortization expense was $0.7 million and $5.7 million for the 106 days ended September 30, 1997 and for the year ended September 30, 1998, respectively. INTANGIBLE ASSETS Intangible assets are composed principally of goodwill and deferred financing costs. Goodwill represents the excess of the cost of businesses acquired over the fair value of the net identifiable assets at the date of acquisition and is amortized using the straight-line method over 25 years. Deferred financing costs are the costs incurred by the Company to obtain and amend its credit agreement (See Note 5) and are amortized over the term of the related agreement (five years). F-57 CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The Company continually monitors events and changes in circumstances which could indicate that carrying amounts of intangible assets may not be recoverable. When events or changes in circumstances are present that indicate that the carrying amount of intangible assets may not be recoverable, the Company assesses the recoverability of intangible assets by determining whether the carrying value of such intangible assets will be recovered through the future cash flows expected from the use of the asset and its eventual disposition. No impairment losses on intangible assets were recorded by the Company for the 106 days ended September 30, 1997 or for the year ended September 30, 1998. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company estimates that the carrying amounts of financial instruments including cash and cash equivalents, accounts receivable and accounts payable approximated their fair values as of the date of the balance sheets due to the relatively short maturity of these instruments. 3. ACQUISITIONS, JOINT VENTURES AND DIVESTITURES ACQUISITIONS On September 28, 1998, the Company acquired four inpatient behavioral healthcare facilities, two related transitional care businesses and a behavioral healthcare contract management business (collectively "Acquired Hospitals") from Ramsay Health Care, Inc. The purchase price for the Acquired Hospitals was approximately $5.3 million. The Company accounted for the acquisition using the purchase method of accounting. The operating results of the Acquired Hospitals are included in the Company's Consolidated Statements of Operations since the date of acquisition. JOINT VENTURES Effective September 2, 1998, the Company entered into a hospital-based behavioral healthcare joint venture ("Brentwood JV") with Brentwood Behavioral Healthcare, LLC. The Company contributed certain assets from an existing behavioral healthcare facility in Shreveport, Louisiana, to the joint venture in exchange for its 50% interest in the Brentwood JV. The Company subsequently closed its Shreveport, Louisiana, facility. The Company accounts for its investment in the Brentwood JV using the equity method. DIVESTITURES On September 30, 1997, the Company sold the operations of a 60-bed behavioral healthcare hospital in Sioux Falls, South Dakota, for $422,000. Proceeds from the sale were not received until October 2, 1997. The transaction resulted in a gain of $355,000. F-58 CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 4. UNUSUAL ITEMS The following table summarizes the unusual items recorded during the year ended September 30, 1998 (in thousands):
YEAR ENDED SEPTEMBER 30, 1998 -------------- Purchase Terminations......................................................... $ 4,450 Severance..................................................................... 3,002 Divestitures.................................................................. 2,688 Other......................................................................... 985 -------------- $ 11,125 -------------- --------------
PURCHASE TERMINATIONS In the first quarter of fiscal 1998, the Company recorded a charge of approximately $2.1 million related to expenses incurred in connection with a terminated acquisition of an unrelated entity. In the fourth quarter of fiscal 1998, the Company recorded a charge of approximately $2.3 million related to expenses incurred in connection with terminated transactions with Magellan and COI that included (i) the purchase of Magellan's franchise operations relating to the "CHARTER" system and certain other assets, (ii) termination of the Franchise Agreements, (iii) the sale of Magellan's equity interest in CBHS to COI and (iv) review of the potential to obtain new capital for the Company (collectively the "Magellan Buyout"). See Note 12. SEVERANCE The Company recorded charges of approximately $3.0 million during fiscal 1998 related to severance and related benefits for employees who were terminated during fiscal 1998 pursuant to planned overhead reductions. DIVESTITURES In June 1998, the Company sold a 77-bed behavioral healthcare facility in Virginia for approximately $0.8 million which resulted in a loss of approximately $2.7 million. OTHER In the fourth quarter of fiscal 1998, the Company accrued approximately $0.8 million for estimated expenses incurred in connection with the settlement of various litigation matters. Also in the fourth quarter of fiscal 1998, the Company closed and consolidated one behavioral health care operation in Texas and recorded charges of approximately $0.2 million related to severance and related benefits and closure costs. F-59 CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 5. LONG-TERM DEBT AND LEASE OBLIGATIONS Information with regard to the Company's long-term debt and capital lease obligations at September 30, 1997 and 1998 is as follows (in thousands):
SEPTEMBER 30, -------------------- 1997 1998 --------- --------- Revolving Credit Agreement due through 2002 (6.90234% to 7.59375%)......................... $ 65,000 $ 70,000 10.5% Capital lease obligations............................................................ 915 -- --------- --------- 65,915 70,000 Less amounts due within one year......................................................... 55 2,800 --------- --------- $ 65,860 $ 67,200 --------- --------- --------- ---------
The aggregate scheduled maturities of long-term debt during the five years subsequent to September 30, 1998 are as follows (in thousands): 1999--$2,800; 2000--$0; 2001--$0, 2002--$67,200; 2003--$0. The Company's debt is carried at cost which approximates fair market value. REVOLVING CREDIT AGREEMENTS On June 17, 1997, the Company entered into a credit agreement (the "Revolving Credit Agreement") with certain financial institutions for a five-year senior secured revolving credit facility in an aggregate committed amount of $100 million. Effective September 30, 1998, the Revolving Credit Agreement was amended to provide for, among other things, modification of financial covenant levels and increases in interest rates. The maximum amount allowed to be borrowed under the Revolving Credit Agreement is based on a working capital calculation. At September 30, 1998, the Company did not have any amounts available for borrowing under the Revolving Credit Agreement. The Revolving Credit Agreement is secured by the tangible and intangible personal property, including accounts receivable, owned by the Company. The loans outstanding under the Revolving Credit Agreement bear interest (subject to certain potential adjustments) at a rate per annum equal to one, two, three or six-month LIBOR plus 2.75% or the Alternative Base Rate ("ABR"), as defined, plus 1.75%. Interest on ABR loans is payable at the end of each fiscal quarter. Interest on LIBOR-based loans is payable at the end of their respective terms, but at a minimum of every three months. COVENANTS The Revolving Credit Agreement contains a number of restrictive covenants which, among other things, limit the ability of the Company and certain of its subsidiaries to incur other indebtedness, engage in transactions with affiliates, incur liens, make certain restricted payments, and enter into certain business combinations. The Revolving Credit Agreement also requires the Company to maintain certain specified financial ratios. The Company was in compliance with all debt covenants under the Revolving Credit Agreement, as amended, at September 30, 1998. Budget projections prepared by management for the fiscal year ending September 30, 1999 estimate that the Company will be in F-60 CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 5. LONG-TERM DEBT AND LEASE OBLIGATIONS (CONTINUED) compliance with all debt covenants under the Revolving Credit Agreement, as amended, during fiscal 1999. Management believes that its budget projections for fiscal 1999 are reasonable and achievable, however, there can be no assurances that such projections will be achieved. If the Company were to fail to achieve such budget projections during fiscal 1999, the Company could become in noncompliance with certain debt covenants resulting in an event of default under the Revolving Credit Agreement. CRESCENT LEASE Effective June 17, 1997, the Company entered into an agreement to lease the Purchased Facilities from Crescent under an initial 12-year lease term with four renewal terms of five years each. The Crescent Lease requires the Company to pay all maintenance, property tax and insurance costs. The base rent for the first year of the initial term was $41.7 million and increases at 5% compounded annually. The Company accounts for the Crescent Lease as an operating lease and accordingly, records base rent expense on a straight-line basis over the lease term. Effective December 1, 1997, Crescent and the Company amended the Crescent Lease to delete the requirement for the Company to pay an additional annual rent of $20.0 million. This amendment has no impact on future commitments for the Company as it remains directly liable for the capital expenditures and other obligations under the Crescent Lease which were to be funded by the additional annual rent. OTHER LEASES The Company also leases certain of its operating facilities other than the Purchased Facilities. The leases, which expire at various dates through 2027, generally require the Company to pay all maintenance, property tax and insurance costs. In connection with the purchase of the Acquired Hospitals, CBHS entered into an agreement to lease a behavioral healthcare facility under an initial eight-year lease term with two renewal terms of four years each. The lease requires the Company to pay all maintenance, property tax and insurance costs. The base rent is $270,000, subject to increases for inflation. The Company accounts for the lease as an operating lease. At September 30, 1998, aggregate amounts of future minimum payments under operating leases were as follows (in thousands): 1999--$49,225; 2000--$49,719; 2001--$50,562; 2002--$52,597; 2003--$54,972; subsequent to 2003--$367,948. Rent expense for the 106 days ended September 30, 1997 and for the year ended September 30, 1998 was $20.0 million and $67.4 million, respectively. 6. FRANCHISE FEES--MAGELLAN Effective June 17, 1997, the Company and certain of its subsidiaries entered into franchise agreements with Magellan, pursuant to which CBHS and such subsidiaries operate using the "CHARTER" name, services and protocols. The franchise agreements provide, among other things, that: - Magellan agrees to use its commercially reasonable best efforts, subject to applicable law, to cause CBHS and such subsidiaries to have "preferred provider" status in connection with F-61 CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 6. FRANCHISE FEES--MAGELLAN (CONTINUED) Magellan's managed behavioral healthcare business on a basis substantially consistent with existing agreements for such business. - Magellan agrees to operate or provide a toll free "800" telephone number and call center as a means of assisting customers to locate the places of business of franchisees. - Franchisees were granted a right to a defined territory to engage in the business of providing behavioral healthcare business, as defined. - Magellan will provide franchisees with the following assistance: (i) advertising and marketing assistance including consultation, access to media buying programs and access to broadcast and other advertising materials produced by Magellan from time to time for franchisees; (ii) risk management services, including risk financial planning, loss control and claims management; (iii) outcomes monitoring; (iv) national and regional contracting services; and (v) consultation by telephone or at the Magellan offices with respect to matters relating to the franchisee's business in which Magellan has expertise, including reimbursement, government relations, clinical strategies, regulatory matters, strategic planning and business development. Franchise fees payable by the Company are the greater of (i) $78.3 million, subject to increases for inflation; or (ii) $78.3 million, plus 3% of gross revenues over $1 billion and not exceeding $1.2 billion and 5% of gross revenues over $1.2 billion. Pursuant to a subordination agreement, franchise fees generally are subordinated to base rent under the Crescent lease and the 5% annual increase. The initial term of the franchise agreements is 12 years with four renewal terms of five years each. Pursuant to the provisions of the franchise agreement, the Company must pay additional franchise fees to Magellan on management contract agreements entered into during the term of the Franchise Agreement ("Managed Business"). Managed Business franchise fees payable by the Company are 15% or 30% of the Managed Business total fees less total direct costs for contract locations within or outside of the Company's existing franchise territories, respectively. Managed Business franchise fees expense was $0 and $0.3 million for the 106 days ended September 30, 1997 and for the year ended September 30, 1998, respectively. On December 22, 1997, Magellan and the Company entered into a management agreement relating to the operation of the "call centers" formerly operated by Magellan. The Company received $5.9 million as consideration for performing the various obligations relating to the "call centers" for the 18-month period ended June 21, 1999. The Company has not made total monthly franchise fee payments to Magellan since February 1998, and, as a result, is in default under the franchise agreements. Franchise fee arrearages are approximately $38.0 million at September 30, 1998. In addition to other remedies, whenever franchise fees are past due for any reason in the amount of $6.0 million or more, Magellan has the right to prohibit any incentive compensation to CBHS management and prohibit any vesting of CBHS management equity. Whenever fees are past due in the amount of $18.0 million or more, Magellan has the right to prohibit any salary increases for key personnel of CBHS, prohibit any additional hiring by CBHS, and prohibit any new direct or indirect hospital acquisitions or joint ventures participation. If franchise fees are past due in an amount greater than $24.0 million, Magellan has the right to require a 5% cutback on budgeted F-62 CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 6. FRANCHISE FEES--MAGELLAN (CONTINUED) expenses under the then-current approved CBHS annual budget, require monthly approval of expenditures of CBHS, including capital and operating expenditures, and require the transfer of control and management of CBHS and CBHS franchisees to Magellan. During the fourth quarter of fiscal 1998, due to the franchise fee arrearages, Magellan exercised its limited management rights under the franchise agreements and, with CBHS's board of directors' support, made operational and management changes at CBHS. Subsequent to September 30, 1998, Magellan notified the CBHS board of directors that it was relinquishing its exercise of limited management rights of CBHS. 7. BENEFIT PLAN The Company has a defined contribution retirement plan (the "401(k) Plan"). Employee participants can elect to voluntarily contribute up to 15% of their compensation to the 401(k) Plan. The Company makes contributions to the 401(k) Plan based on employee compensation and contributions. The Company makes a discretionary contribution of 2% of each employee's compensation and matches 50% of each employee's contribution up to 3% of their compensation. During the year ended September 30, 1998, the Company made contributions of approximately $2.7 million to the 401(k) Plan. 8. CUMULATIVE REDEEMABLE PREFERRED INTERESTS Effective September 30, 1997, Magellan and COI each agreed to exchange their respective Member Loans for cumulative redeemable preferred interest ("Preferred Interests") in the Company. The Preferred Interests are callable in whole at the Company's option on or after April 1, 1998, at an amount equal to the initial amount plus all accrued dividends thereon. Each holder of Preferred Interests receives preferential allocation of the Company's profits computed at 10% per annum on a cumulative basis, compounded monthly. In addition, each Preferred Interests has a similar preferred position in the event of dissolution of the Company. The Company recorded approximately $3.7 million in fiscal 1998 relating to this dividend requirement, which is all unpaid and included in Other Long-Term Liabilities at September 30, 1998. 9. ACCRUED LIABILITIES Accrued liabilities consist of the following (in thousands):
SEPTEMBER 30, -------------------- 1997 1998 --------- --------- Salaries and wages..................................................... $ 18,220 $ 20,334 Property taxes......................................................... 4,874 5,157 Interest............................................................... 333 105 Other.................................................................. 10,151 21,683 --------- --------- $ 33,578 $ 47,279 --------- --------- --------- ---------
F-63 CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 10. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information for the 106 days ended September 30, 1997 and for the year ended September 30, 1998 is as follows (in thousands):
106 DAYS ENDED YEAR ENDED SEPTEMBER 30, SEPTEMBER 30, 1997 1998 ---------------- -------------- Interest paid.................................................................. $ 1,291 $ 5,561 Exchange of debt for cumulative preferred interest--COI........................ 17,500 -- Exchange of debt for cumulative preferred interest--Magellan................... 17,500 -- Initial capital contribution from Magellan, primarily property and equipment less assumed liabilities..................................................... 5,282 -- Account receivable for the sale of facility.................................... 386 -- Accrued dividend requirement on cummulative redeemable preferred interests..... -- 3,719 Capital lease obligation assigned with sale of facility........................ -- 874
11. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS As part of the Crescent Transactions, (i) certain items of working capital were purchased from Magellan, (ii) the Company agreed to collect Magellan's patient accounts receivable outstanding as of the closing date for a fee of 5% of cash collections and (iii) the Company agreed to manage Magellan's interest in certain joint ventures for a management fee. Included in net revenues for the 106 days ended September 30, 1997 and for the year ended September 30, 1998 are approximately $5.0 million and $2.0 million, respectively, of these collection fee revenues and approximately $2.1 million and $5.5 million, respectively, of these joint venture management fees. The Company had a net receivable from Magellan as of September 30, 1997 of approximately $5.1 million and a net payable to Magellan as of September 30, 1998 of approximately $36.9 million. This receivable/payable results from (i) amounts due for the management of Magellan's joint ventures as of September 30, 1997 and 1998, (ii) amounts due for the collection fees on Magellan's patient accounts receivable as of September 30, 1997 and 1998, (iii) receivable for the settlement of working capital related matters as of September 30, 1997 and 1998, (iv) receivable for the reimbursement effect associated with the collection fees as of September 30, 1997 and 1998 and (v) payable for the franchise fees as of September 30, 1998. Effective April 1, 1998, the Company entered into an agreement with Green Spring Health Services, Inc. ("Green Spring"), a wholly-owned subsidiary of Magellan, for managed mental health, substance abuse and employee assistance plan services for the Company's employees. During fiscal 1998, the Company paid approximately $0.1 million to Green Spring for these services. John C. Goff was the Chairman of CBHS and the Vice Chairman of both Crescent and COI. During fiscal 1998, the Company paid approximately $0.4 million to John Goff for salary and related benefits. In November 1998, Mr. Goff resigned his position on the CBHS board. Richard P. Knight, the Chief Financial Officer of COI, was appointed to fill the vacancy on the CBHS board left by Mr. Goff's resignation. Jeffrey L. Stevens of COI was subsequently elected Chairman of CBHS. F-64 CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 12. COMMITMENTS AND CONTINGENCIES The Company carries general and professional liability insurance from an unrelated commercial insurance carrier with a self insured retention of $1.5 million per occurrence and $8.0 million in the aggregate, on a claim made basis. In addition, the Company has an umbrella policy with coverage up to $75.0 million per occurrence and in the aggregate. Magellan and the predecessor to the Company's Orlando, Florida facility (the "Orlando Facility") were named as defendants in a complaint entitled United States of America ex rel. Francine M. Mettevis and Rhea Rowan v. Charter Hospital of St. Louis, Inc. et al. The action was filed on November 6, 1994 as a qui tam action in the United States District court for the Middle District of Florida. Magellan, the Department of Justice, and the Company entered into a settlement of the action in August 1998. Pursuant to the settlement agreement, Magellan paid the government $4.75 million and the Company entered into a Corporate Integrity Agreement for the Orlando Facility whereby the Orlando Facility will be monitored for five years by the Department of Health and Human Services ("HHS) and the Office of the Inspector General ("OIG") as well as a concurrent reviewer. In the settlement agreement, the Company also agreed that the Orlando Facility would not bill Medicare for the treatment of Medicare patients for a period of 12 to 15 months beginning August 1, 1998 (the "Non-Billing Period"). The Company intends to seek indemnification from Magellan under the Crescent Transactions for all of the fees, costs, expenses and losses it incurs in connection with the settlement agreement and the Corporate Integrity Agreement. The Company has been reimbursed by Magellan for losses and costs it has incurred through October 1998 which relate to the services provided by the Orlando Facility to Medicare beneficiaries. In connection with the Magellan Buyout, Magellan and COI entered into a Support Agreement pursuant to which COI agreed, under certain conditions, to assist the Company in obtaining the funds required to consummate the contemplated transactions and to pay expenses incurred in obtaining such funds. On August 19, 1998, Magellan and COI each announced the termination of negotiations regarding the Magellan Buyout. On November 5, 1998, Magellan notified COI that Magellan believes COI owes CBHS $2.3 million for the reimbursement of expenses incurred by the Company in connection with attempts to obtain financing for the contemplated transactions. COI disputes this matter which will be sent to arbitration. See Note 4. In April 1998, following the death of a patient at the Company's Greensboro, North Carolina facility ("Greensboro Facility"), the North Carolina Department of Health and Human Services ("NC HHS") conducted a survey of that facility. On April 14, 1998, the Greensboro Facility received notice that as a result of the survey, NC HHS was recommending to the Health Care Financing Administration ("HCFA") that the Greensboro Facility be excluded from participation in Medicare within 23 days. Similarly, on April 14, 1998, the Greensboro Facility received notice that as a result of the survey, NC HHS intended to revoke the Greensboro Facility's state license. In response to such notices, the Company submitted a plan of correction and refutation of deficiencies with HCFA and NC HHS, and NC HHS conducted a subsequent visit on May 4 through May 6, 1998. On May 7, 1998, the Greensboro Facility received notice from HCFA that based on the findings in the second visit, the date scheduled for involuntary termination was extended to July 7, 1998. On June 5, 1998, the Greensboro Facility entered into a settlement agreement with NCHHS which resolved all outstanding regulatory and operational issues with NCHHS and HCFA arising from the patient's death. The local District Attorney's office and the North Carolina Board of Nursing ("NCBN") have continued their separate investigations into this incident. An indictment F-65 CHARTER BEHAVORIAL HEALTH SYSTEMS, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SEPTEMBER 30, 1997 AND 1998 12. COMMITMENTS AND CONTINGENCIES (CONTINUED) of one of the Greensboro Facility's employees has been returned while the NCBN continues its investigation. At this stage, it is not possible to predict whether any future action will be taken against the Greensboro Facility or any of its other employees involved in the patient's death, the likelihood of an unfavorable outcome, or the amount of any potential loss associated with any such action. The healthcare industry is subject to numerous laws and regulations. The subjects of such laws and regulations include, but are not limited to, matters such as licensure, accreditation, government healthcare program participation requirements, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Recently, government activity has increased with respect to investigations and/or allegations concerning possible violations of fraud and abuse and false claims statutes and regulations by healthcare providers. Entities that are found to have violated these laws and regulations may be excluded from participating in government healthcare programs, subjected to fines or penalties or required to repay amounts received from the government for previously billed patient services. The Office of the Inspector General of the Department of Health and Human Services and the United States Department of Justice and certain other governmental agencies are currently conducting inquiries and/ or investigations regarding the compliance by the Company and certain of its subsidiaries with such laws and regulations. In addition, the Company is also subject to or party to litigation, claims and civil suits relating to its operations and business practices. In the opinion of management, the Company has recorded reserves that are adequate to cover litigation, claims or assessments that have been or may be asserted against the Company arising out of such litigation, civil suits and governmental inquiries. Furthermore, management believes that the resolution of such litigation, civil suits and governmental inquiries will not have a material adverse effect on the Company's financial position or results of operations; however, there can be no assurance in this regard. F-66 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS--MAGELLAN (IN THOUSANDS)
CHARGED TO BALANCE AT CHARGED TO OTHER BALANCE AT BEGINNING COSTS AND ACCOUNTS-- DEDUCTIONS-- END OF CLASSIFICATION OF PERIOD EXPENSES DESCRIBE DESCRIBE PERIOD - ---------------------------------------------------- ----------- ------------ ------------ ------------- ----------- Year ended September30, 1996: Allowance for doubtful accounts................... $ 48,741 $ 81,470(D) $ 22,761(A) $ 103,236(B) $ 50,548 812(C) ----------- ------------ ------------ ------------- ----------- $ 48,741 $ 81,470 $ 23,573 $ 103,236 $ 50,548 ----------- ------------ ------------ ------------- ----------- ----------- ------------ ------------ ------------- ----------- Year ended September30, 1997: Allowance for doubtful accounts................... $ 50,548 $ 46,211(D) $ 19,373(A) $ 89,114(B) $ 40,311 $ 21,400(E) 5,164(F) 2,943(G) ----------- ------------ ------------ ------------- ----------- $ 50,548 $ 67,611 $ 19,373 $ 97,221 $ 40,311 ----------- ------------ ------------ ------------- ----------- ----------- ------------ ------------ ------------- ----------- Year ended September30, 1998: Allowance for doubtful accounts................... $ 40,311 $ 4,977(D) $ 15,031(A) $ 24,440(B) $ 34,867 4,376(C) 5,388(F) ----------- ------------ ------------ ------------- ----------- $ 40,311 $ 4,977 $ 19,407 $ 29,828 $ 34,867 ----------- ------------ ------------ ------------- ----------- ----------- ------------ ------------ ------------- -----------
- ------------------------ (A) Recoveries of accounts receivable previously written off. (B) Accounts written off. (C) Allowance for doubtful accounts assumed in acquisitions. (D) Bad debt expense. (E) Accounts receivable collection fees included in loss on Crescent Transactions. (F) Accounts receivable collection fees payable to CBHS and outside vendors. (G) Amounts reclassified to contractual allowances. S-1 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS-CBHS (IN THOUSANDS)
ADDITIONS ------------------------ CHARGED TO BALANCE AT CHARGED TO OTHER BALANCE AT BEGINNING COSTS AND ACCOUNTS- DEDUCTIONS- END CLASSIFICATION OF PERIOD EXPENSE DESCRIBE DESCRIBE OF PERIOD - ------------------------------------------------------ ----------- ----------- ----------- ------------ ----------- 106 days ended September 30, 1997: Allowance for doubtful accounts..................... $ -- $ 17,437 $ 39(A) $ 843(B) $ 17,605 972(C) ----------- ----------- ----------- ------------ ----------- $ -- $ 17,437 $ 1,011 $ 843 $ 17,605 ----------- ----------- ----------- ------------ ----------- ----------- ----------- ----------- ------------ ----------- Year ended September 30, 1998: Allowance for doubtful accounts..................... $ 17,605 $ 63,895 $ 4,035(A) $ 51,987(B) $ 33,548 ----------- ----------- ----------- ------------ ----------- $ 17,605 $ 63,895 $ 4,035 $ 51,987 $ 33,548 ----------- ----------- ----------- ------------ ----------- ----------- ----------- ----------- ------------ -----------
- ------------------------ (A) Recoveries of amounts previously charged to income. (B) Accounts written off. (C) Allowance for doubtful accounts assumed in purchase of net assets from Magellan. S-2 EX-2.M 2 EXHIBIT 2(M) Exhibit 2(m) SECOND AMENDMENT TO ASSET PURCHASE AGREEMENT THIS SECOND AMENDMENT TO ASSET PURCHASE AGREEMENT (this "Amendment") is made and entered into as of the 18th day of November, 1998, by and among Allied Specialty Care Services, Inc., a Florida corporation formerly known as CMSF, Inc. (the "Buyer"), Allied Health Group, Inc., a Florida corporation ("AHG"), Gut Management, Inc., a Florida corporation ("Gut"), Sky Management Co., a Florida corporation ("Sky"), Florida Specialty Network, Ltd., a Florida limited partnership ("FSN"), Surgical Associates of South Florida, Inc., a Florida corporation ("SASF"), Surginet, Inc., a Florida corporation ("Surginet" and, together with AHG, Gut, Sky, FSN and SASF, the "Sellers" and individually, a "Seller"), Jacob Nudel, M.D. ("Nudel"), David Russin, M.D. ("Russin"), Lawrence Schimmel, M.D. ("Schimmel" and, together with Nudel and Russin, the "Executive Shareholders") and Magellan Health Services, Inc., a Delaware corporation and the ultimate corporate Parent of the Buyer (the "Parent"). RECITALS A. The parties entered into that certain Asset Purchase Agreement dated as of October 16, 1997, as amended on December 5, 1997 (the "Asset Purchase Agreement"). Capitalized terms used herein and not otherwise defined shall have the meanings ascribed to them in the Asset Purchase Agreement. B. The parties desire to further amend the Asset Purchase Agreement, on the terms and subject to the conditions set forth hereinbelow. NOW, THEREFORE, in consideration of the foregoing and the mutual promises of the parties, and in consideration of the representations, warranties and covenants herein contained, and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto, intending to be legally bound, hereby agree as follows: 1. Amendments. 1.1 Buy-Out. In exchange for the payment by the Buyer to AHG of the aggregate sum of $4,000,000 (the "Buyout Price"), payable in cash at Closing (defined below) by wire transfer of immediately available funds, (a) the Buyer shall be entitled to receive, and the Sellers shall release all claims to, $18,906,746 of the Escrow Deposit, and any interest or earnings thereon (the "Released Clawback"), and (b) the Buyer shall purchase, and the Sellers shall sell, 87 1/2% of the Year 1 Earn-Out, the Year 2 Earn-Out and the Year 3 Earn-Out (collectively, the "Purchased Earn-Out"). In addition, effective on the Effective Date, all Executive Shareholders and Sellers other than AHG shall cease to be entitled to any amounts payable by the Buyer under the Asset Purchase Agreement and the representations and warranties set forth in Sections 5.5, 5.6, 5.8, 5.9, 5.10, 5.11, 5.12, 5.13, 5.16, 5.17(e)-(h), 5.18, 5.20, 5.21, 5.22 and 5.25 of the Asset Purchase Agreement shall terminate. The parties to this Amendment acknowledge and agree that the Buyout Price is payable in consideration for the Purchased Earn-Out, and the restructuring of Sections 3.3 and 3.4 of the Asset Purchase Agreement as set forth herein, and that there is no perceived value of future claims to the Released Clawback. 1.2 Ongoing Arrangement with AHG. Effective on the Effective Date, AHG shall remain entitled to the amounts payable by the Buyer pursuant to Section 3 of the Asset Purchase Agreement, subject to the terms and conditions described below. (a) Modification of Earn-Out Provisions. Effective on the Effective Date (except as set forth in Section 1.2(b) of this Amendment, which sets forth certain amendments to the Remaining Earn-Out (defined below) and the Remaining Clawback (defined below), and restates said provisions as Sections 3.3A and 3.4A of the Asset Purchase Agreement), Sections 3.3 and 3.4 of the Asset Purchase Agreement shall be amended and restated in their entirety to read as follows: Section 3.3 Earn-Out. The Purchase Price shall be subject to adjustment after the Closing as set forth in this Section 3.3: (a) Earn-Out Definitions. Unless the context otherwise requires, as used in this Section 3.3 and in Section 3.4, the following terms shall have the following meanings: (1) "Accountants" shall mean the independent public accountants of the Buyer. (2) "Earn-Out Period" shall mean each of the Year 2 Earn-Out Period and the Year 3 Earn-Out Period. (3) "EBITDA" shall mean the aggregate Net Revenue from the operations of the Businesses, minus all expenses incurred in operating the Businesses but before interest, income taxes, depreciation and amortization, prepared in accordance with GAAP, consistently applied, and adjusted as follows: (1) Introduced Business will be deemed to have been conducted at the Businesses' cost of providing services for such Introduced Business plus the applicable IB Profit Margin. (2) As long as the Businesses are operated as a separate subsidiary or division, administrative services provided to the Businesses will be actual corporate overhead, including services provided by Parent or Parent's Affiliates, on a cost basis, and will only include administrative services that are reasonably and directly related to the Businesses. In the event the Businesses are integrated into Parent or an Affiliate of Parent to the extent that the corporate overhead attributable to the Businesses cannot be readily determined, then, in lieu of actual overhead, an amount equal to a percentage of Net Revenue of the Businesses shall be allocated to the Businesses as deemed overhead, which percentage will be established by dividing (A) the amount of actual overhead incurred with respect to the Businesses for the six month period immediately preceding such 2 integration by (B) the Net Revenue of the Businesses for said six-month period. Said fixed percentage shall thereafter be applied to the Net Revenue of the Businesses for purposes of determining the deemed overhead to be allocated to the Businesses. (3) Net proceeds from dispositions of assets of the Businesses shall be reinvested in the Businesses. (4) With respect to acquisitions made from and after the Closing, in lieu of including Net Revenue and expenses related to such acquisition in the calculation of EBITDA, net income, determined in accordance with GAAP, from such acquisition shall be included in EBITDA. (5) Expenses and capital expenditures with respect to the items set forth in the Information Technologies Budget will be allocated and treated as set forth in the Information Technologies Budget regardless of their treatment under GAAP. (4) "EBITDA Run Rate" shall mean an amount equal to the sum of (i) the product of (x) two and (y) the aggregate "Per Contract EBITDA" (as defined below) for the period from July 1, 2001 through December 31, 2001 resulting from each contract which constitutes New Business commencing on or before June 30, 2001, and (ii) the product of (x) two and (y) the aggregate "Per Contract EBITDA" for the first six months of operations resulting from each contract which constitutes New Business commencing on or after July 1, 2001. For purposes of this definition, the term "Per Contract EBITDA" shall mean an amount equal to (i) revenue from each contract constituting New Business, minus (ii) the direct costs and expenses related to each contract constituting New Business, minus (iii) an allocated portion of all other expenses taken into account in calculating EBITDA (other than direct costs and expenses related to contracts not constituting New Business), which allocation shall be based upon the number of claims processed under each such contract constituting New Business as compared to the number of claims processed under all contracts, including both contracts which constitute New Business and contracts which do not constitute New Business. (5) "IB Profit Margin" shall mean a profit margin equal to fifty percent (50%) or such other agreed upon percentage (the "IB Profit Margin Percentage") of the average profit margin of the Businesses for services similar to the applicable Introduced Business provided during the fiscal quarter immediately preceding the fiscal quarter in which the Businesses are to begin to provide services for the Introduced Business. The proposed IB Profit Margin Percentage and the proposed calculation of the IB Profit Margin (collectively, the "IB Profit Margin Calculation") will be made by the Buyer in good faith and presented in writing to the Executive Shareholders as soon as practicable prior to the date on which services relating to the Introduced Business are to be rendered. The Executive Shareholders shall, not later that five Business 3 Days after receipt of the IB Profit Margin Calculation, notify the Buyer in writing of any objections thereto. Absent delivery of a written objection as provided above, the IB Profit Margin Calculation will be conclusive and binding upon the parties to this Agreement. If written objection is delivered to the Buyer and the Buyer and the Executive Shareholders are unable, within 5 Business Days after the receipt by the Buyer of such written objection, to resolve the dispute, the Buyer, in its sole discretion, may elect either (i) to not make the Introduced Business available to the Buyer or (ii) to submit the IB Profit Margin Calculation to an Independent Accounting Firm mutually acceptable to the Executive Shareholders and the Buyer whose determination shall be conclusive and binding on the parties. In the event the Buyer elects to submit the matter to an Independent Accounting Firm, the Businesses shall provide services for the Introduced Business pending determination of the IB Profit Margin Calculation. (6) "Independent Accounting Firm" shall mean one of the "big-five" certified public accounting firms that does not have a conflict of interest with respect to the preparation or review of the EBITDA Statements. (7) "Introduced Business" shall mean business introduced to the Buyer by Parent or Parent's Affiliates (i) as part of a contract with Parent or its Affiliates, or (ii) by reason of introductions to the Buyer made by Parent or Parent's Affiliates. Neither Parent nor any Parent Affiliate shall be obligated to introduce any business to the Buyer or to otherwise cause any business that could be conducted by the Buyer as Introduced Business to be referred to or conducted by the Buyer. (8) "New Business" shall mean contracts for services to be provided by the Businesses (and additional services to be provided under existing contracts by the Businesses) commencing between October 1, 1998 and October 1, 2001, inclusive, and for which no notice of cancellation or nonrenewal has been given on or before October 1, 2001, but excluding (i) renewals (including amendments, restatements or replacements) of contracts in force as of October 1, 1998 and (ii) contracts which will expire by their terms absent notice of intent to renew on or before October 1, 2001 (and with respect to which no notice of intent to renew has been given). (9) "Net Revenue" shall be defined as the combined revenues of the Businesses (including income on operating cash and monies held on behalf of third parties remaining after Buyer distributes cash in excess of working capital requirements to Parent) (after elimination of all inter-Business transactions and balances) which are capitation fees (net of physician services expenses for AHG only, and net of any retroactive adjustments under the terms of any managed care 4 plans), service bureau billing fees, administrative fees, facility fees, and fee for service billings (less contractual adjustments, bad debt expense, charity adjustments, refunds, NSF checks, collection agency fees and other adjustments to gross revenues), all as computed in accordance with GAAP. (10) "Year 2 Earn-Out" shall mean the amount, if any, payable by the Buyer to AHG in accordance with the provisions of Section 3.3(d) and Section 3.4. (11) "Year 3 Earn-Out" shall mean the amount, if any, payable by the Buyer to AHG in accordance with the provisions of Section 3.3(e) and Section 3.4. (12) "Year 3 Run Rate Earn-Out" shall mean the amount, if any, payable by the Buyer to AHG in accordance with the provisions of Section 3.3(f) and Section 3.4. (13) "Year 2 EBITDA" shall have the meaning set forth in Section 3.3(d). (14) "Year 3 EBITDA" shall have the meaning set forth in Section 3.3(e). (15) "Year 2 Earn-Out Period" shall mean the 12-month period ending on November 30, 1999. (16) "Year 3 Earn-Out Period" shall mean the 12-month period ending on November 30, 2000. (17) "Year 2 Threshold" shall mean $11,000,000. (18) "Year 3 Threshold" shall mean the greater of (i) $11,000,000 or (ii) Year 2 EBITDA. (b) EBITDA Statement. Within 75 calendar days after the last day of each of the Year 2 Earn-Out Period and the Year 3 Earn-Out Period, the Buyer shall prepare, the Accountants shall review, and the Buyer shall deliver to AHG a statement reflecting the EBITDA from the consolidated operations of the Businesses during such Earn-Out Period (each, an "EBITDA Statement"), which statement will be determined in accordance with GAAP, applied on a basis consistent with the financial statements of the Buyer and the Parent for such period. The parties shall ensure that the Accountants have full access to the books, records, facilities and employees of the Businesses for purposes of reviewing the EBITDA Statement and shall cooperate with the Accountants to the extent reasonably requested to review the EBITDA Statement. The EBITDA Statement will be examined by AHG (and, if AHG so chooses, by a 5 firm of independent certified public accountants), who shall, not later than 45 calendar days after receipt of the EBITDA Statement, raise any objections it has to the EBITDA Statement by notifying the Buyer in writing within such time period in a statement indicating the item or items disputed, AHG's proposed adjustments and an adjusted EBITDA Statement reflecting such adjustments (an "Objection Notice"). During such 45 day period, AHG and any such independent certified public accountants shall have full access to the books and records, other financial information (including the working papers of the Accountants) and appropriate financial personnel of the Buyer reasonably necessary for the preparation of an Objection Notice. Absent delivery of an Objection Notice as provided above, the EBITDA Statement will be conclusive and binding upon the parties to this Agreement for the purposes of any purchase price adjustment under this Section 3.3(b). In the event that an Objection Notice is delivered by AHG as provided above, and if the Buyer and AHG are unable, within 15 calendar days after receipt by the Buyer of such Objection Notice, to resolve the disputed exceptions, such disputed exceptions will be referred to an Independent Accounting Firm mutually acceptable to AHG and the Buyer. The Independent Accounting Firm shall, within 60 days following its engagement by the Buyer and AHG for this purpose, deliver to AHG and the Buyer a written report determining such disputed exceptions (the "IAF EBITDA Statement"). During such 60 day period, the Independent Accounting Firm shall have full access to the books and records, other financial information (including the working papers of the Accountants and AHG's accountants, if any) and appropriate financial personnel of the Buyer which the Independent Accounting Firm reasonably deems necessary or advisable for the preparation of the IAF EBITDA Statement. The EBITDA reflected in the IAF EBITDA Statement will be conclusive and binding upon the parties to this Agreement for the purposes of any purchase price adjustment under this Section 3.3(b), subject to application of the following provisions: (i) if the IAF EBITDA Statement reflects EBITDA in excess of $300,000 over the amount of the EBITDA reflected in the EBITDA Statement for the Earn-Out Period at issue, then EBITDA for such Earn-Out Period shall be deemed to be equal to the EBITDA reflected in the IAF EBITDA Statement, and the Buyer shall bear all the fees and disbursements of the Independent Accounting Firm in respect of its services under this Section 3.3(b) for such Earn-Out Period, (ii) if the IAF EBITDA Statement reflects EBITDA that is equal to or less than $300,000 over the amount of the EBITDA reflected in the EBITDA Statement for such Earn-Out Period, but greater than the amount of the EBITDA reflected in such EBITDA Statement, then EBITDA for such Earn-Out Period shall be deemed to be equal to (A) the sum of (1) the EBITDA reflected in the EBITDA Statement and (2) the EBITDA reflected in the IAF EBITDA Statement divided by (B) two, and AHG shall bear all the fees and disbursements of the Independent Accounting Firm in respect of its services under this Section 3.3(b) for the Earn-Out Period at issue; and (iii) if the IAF EBITDA Statement reflects EBITDA that is equal to or less than the amount of the EBITDA reflected in the EBITDA Statement for such Earn-Out Period, then EBITDA for such Earn-Out Period shall be deemed to be equal to the EBITDA reflected in the IAF EEITDA Statement, and AHG shall 6 bear all the fees and disbursements of the Independent Accounting Firm in respect of its services under this Section 3.3(b) for the Earn-Out Period at issue. (c) Run Rate Statement. Within 75 calendar days after April 1, 2002, the Buyer shall prepare, the Accountants shall review, and the Buyer shall deliver to AHG a statement reflecting the EBITDA Run Rate (the "Run Rate Statement"), which statement will be determined on a basis consistent with the financial statements of the Buyer and the Parent for the fiscal years ending September 30, 1999, 2000 and 2001. The parties shall ensure that the Accountants have full access to the books, records, facilities and employees of the Businesses for purposes of reviewing the Run Rate Statement and shall cooperate with the Accountants to the extent reasonably requested to review the Run Rate Statement. The Run Rate Statement will be examined by AHG (and, if AHG so chooses, by a firm of independent certified public accountants), who shall, not later than 45 calendar days after receipt of the Run Rate Statement, raise any objections it has to the Run Rate Statement by notifying the Buyer in writing within such time period in a statement indicating the item or items disputed, AHG's proposed adjustments and an adjusted Run Rate Statement reflecting such adjustments (a "Run Rate Objection Notice"). During such 45 day period, AHG and any such independent certified public accountants shall have full access to the books and records, other financial information (including the working papers of the Accountants) and appropriate financial personnel of the Buyer reasonably necessary for the preparation of a Run Rate Objection Notice. Absent delivery of a Run Rate Objection Notice as provided above, the Run Rate Statement will be conclusive and binding upon the parties to this Agreement for the purposes of any purchase price adjustment under this Section 3.3(c). In the event that a Run Rate Objection Notice is delivered by AHG as provided above, and if the Buyer and AHG are unable, within 15 calendar days after receipt by the Buyer of such Run Rate Objection Notice, to resolve the disputed exceptions, such disputed exceptions will be referred to an Independent Accounting Firm mutually acceptable to AHG and the Buyer. The Independent Accounting Firm shall, within 60 days following its engagement by the Buyer and AHG for this purpose, deliver to AHG and the Buyer a written report determining such disputed exceptions (the "IAF Run Rate Statement"). During such 60 day period, the Independent Accounting Firm shall have full access to the books and records, other financial information (including the working papers of the Accountants and AHG's accountants, if any) and appropriate financial personnel of the Buyer which the Independent Accounting Firm reasonably deems necessary or advisable for the preparation of the IAF Run Rate Statement. The Run Rate reflected in the IAF Run Rate Statement will be conclusive and binding upon the parties to this Agreement for the purposes of any purchase price adjustment under this Section 3.3(c) subject to application of the following provisions: (i) if the IAF Run Rate Statement reflects an EBITDA Run Rate in excess of $300,000 over the amount of the EBITDA Run Rate reflected in the Run Rate Statement, then the EBITDA Run Rate shall be deemed to be equal to the EBITDA Run Rate reflected in the IAF Run Rate Statement, and the Buyer shall bear all the fees and disbursements 7 of the Independent Accounting Firm in respect of its services under this Section 3.3(c), (ii) if the IAF Run Rate Statement reflects an EBITDA Run Rate that is equal to or less than $300,000 over the amount of the EBITDA Run Rate reflected in the Run Rate Statement, but greater than the amount of the EBITDA Run Rate reflected in such Run Rate Statement, then the EBITDA Run Rate shall be deemed to be equal to (A) the sum of (1) the EBITDA Run Rate reflected in the Run Rate Statement and (2) the EBITDA Run Rate reflected in the IAF Run Rate Statement divided by (B) two, and AHG shall bear all the fees and disbursements of the Independent Accounting Firm in respect of its services under this Section 3.3(c); and (iii) if the IAF Run Rate Statement reflects an EBITDA Run Rate that is equal to or less than the amount of the EBITDA Run Rate reflected in the Run Rate Statement, then the EBITDA Run Rate shall be deemed to be equal to the EBITDA Run Rate reflected in the IAF Run Rate Statement, and AHG shall bear all the fees and disbursements of the Independent Accounting Firm in respect of its services under this Section 3.3(c). (d) Year 2 Earn-Out Calculation. In the event EBITDA for the Year 2 Earn-Out Period (the "Year 2 EBIDTA") is greater than the Year 2 Threshold, then the Year 2 Earn-Out is the amount equal to the product of (1) six multiplied by the difference between the Year 2 EBITDA and the Year 2 Threshold and (2) 0.075. (e) Year 3 Earn-Out Calculation. In the event EBITDA for the Year 3 Earn-Out Period (the "Year 3 EBIDTA") is greater than the Year 3 Threshold, then the Year 3 Earn-Out is the amount equal to the product of (1) four multiplied by the difference between the Year 3 EBITDA and the Year 3 Threshold and (2) 0.075. (f) Year 3 Run Rate Earn-Out Calculation. (1) In the event the EBITDA Run Rate is less than $15,000,000, then the Year 3 Run Rate Earn-Out is $0. (2) In the event the EBITDA Run Rate is equal to or greater than $15,000,000 but less than $20,000,000, then the Year 3 Run Rate Earn-Out is the amount equal to a quotient (the numerator of which is the EBITDA Run Rate less $14,999,999.99 and the denominator of which is $20,000,000 less $14,999,999.99) multiplied by $1,500,000. (3) In the event the EBITDA Run Rate is equal to or greater than $20,000,000, then the Year 3 Run Rate Earn-Out is $1,500,000. Section 3.4 Payment of Earn-Outs; Limitation on Earn-Outs. The Year 2 Earn-Out and the Year 3 Earn-Out, if any, shall be paid within 5 Business Days of final determination of EBITDA for the applicable Earn-Out Period pursuant to Section 3.3(b) and shall be paid to AHG, in cash by wire transfer of immediately 8 available funds. The Year 3 Run Rate Earn-Out, if any, shall be paid within 5 Business Days of final determination of the EBITDA Run Rate pursuant to Section 3.3(c) and shall be paid to AHG, in cash by wire transfer of immediately available funds. Notwithstanding anything to the contrary contained in this Section 3, in no event shall the Year 2 Earn-Out and the Year 3 Earn-Out exceed $1,500,000 in the aggregate, and in no event shall the Year 3 Run Rate Earn-Out exceed $1,500,000. (b) Agreement Between AHG and GHS, Inc. AHG and the Executive Shareholders, on a joint and several basis, represent and warrant that, pursuant to the terms and conditions of a letter agreement dated October 8, 1997 by and among the Sellers, the Executive Shareholders and GHS, Inc. (the "Letter Agreement"), GHS, Inc. is entitled to receive a portion of the Escrow Deposit (the "Clawback"), if and when released to the Sellers, and of the Year 1 Earn-Out, the Year 2 Earn-Out and the Year 3 Earn-Out, if any (collectively, the "Earn-Out"). A total of $1,093,254 of the Escrow Deposit (the "Remaining Clawback") is being held pursuant to the terms and conditions of the Escrow Agreement for and on behalf of AHG for further payment to GHS, Inc. under the terms of the Letter Agreement. In addition, GHS, Inc. is entitled under the Letter Agreement to 12 1/2% of the Earn-Out (the "Remaining Earn-Out"). The Remaining Clawback will not be released to the Buyer and the Remaining Earn-Out will not be purchased by the Buyer pursuant to this Amendment. Notwithstanding any provision of this Amendment to the contrary, effective on the Effective Date, the Buyer agrees to continue to pay to AHG, for further payment to GHS, Inc. pursuant to the terms and conditions of the Letter Agreement, sums payable with respect to the Remaining Earn-Out pursuant to Sections 3.3 and 3.4 of the Asset Purchase Agreement, as amended and restated in their entirety as Sections 3.3A and 3.4A of the Asset Purchase Agreement as follows: Section 3.3A Earn-Out. The Purchase Price shall be subject to adjustment after the Closing as set forth in this Section 3.3A: (a) Earn-Out Definitions. Unless the context otherwise requires, as used in this Agreement (other than with respect to Sections 3.3 and 3.4), the following terms shall have the following meanings: (1) "Accountants" shall mean the independent public accountants of the Buyer. (2) "Earn-Out Period" shall mean each of the Year 1 Earn-Out Period, the Year 2 Earn-Out Period and the Year 3 Earn-out Period. (3) "EBITDA" shall mean the aggregate Net Revenue from the operations of the Businesses, minus all expenses incurred in operating the Businesses but before interest, income taxes, depreciation and amortization, prepared in accordance with GAAP, consistently applied, and adjusted as follows: (1) Introduced Business will be deemed to have been conducted at the Businesses' cost of providing services for such Introduced Business plus the applicable IB Profit Margin. (2) Any increase in EBITDA earned by the Businesses through the 9 restructuring of the Farrell Consulting Agreement that requires one-time cash payments by Buyer or Buyer's Affiliates shall be deducted from EBITDA. (3) As long as the Businesses are operated as a separate subsidiary or division, administrative services provided to the Businesses will be actual corporate overhead, including services provided by Parent or Parent's Affiliates, on a cost basis, and will only include administrative services that are reasonably and directly related to the Businesses. In the event the Businesses are integrated into Parent or an Affiliate of Parent to the extent that the corporate-overhead attributable to the Businesses cannot be readily determined, then, in lieu of actual overhead, an amount equal to a percentage of Net Revenue of the Businesses shall be allocated to the Businesses as deemed overhead, which percentage will be established by dividing (A) the amount of actual overhead incurred with respect to the Businesses for the six month period immediately preceding such integration by (B) the Net Revenue of the Businesses for said six-month period. Said fixed percentage shall thereafter be applied to the Net Revenue of the Businesses for purposes of determining the deemed overhead to be allocated to the Businesses. (4) Net proceeds from dispositions of assets of the Businesses shall be reinvested in the Businesses. (5) With respect to acquisitions made from and after the Closing, in lieu of including Net Revenue and expenses related to such acquisition in the calculation of EBITDA, net income, determined in accordance with GAAP, from such acquisition shall be included in EBITDA. (6) Expenses and capital expenditures with respect to the items set forth in the Information Technologies Budget will be allocated and treated as set forth in the Information Technologies Budget regardless of their treatment under GAAP. (7) Any and all amounts payable under, or in connection with the termination of, any Leases which are assumed by the Buyer as part of the Contracts for Leased Real Property which is no longer used in any of the Businesses shall be treated as current expenses for purposes of calculating EBITDA regardless of their treatment under GAAP. (4) "IB Profit Margin" shall mean a profit margin equal to fifty percent (50%) or such other agreed upon percentage (the "IB Profit Margin Percentage") of the average profit margin of the Businesses for services similar to the applicable Introduced Business provided during the fiscal quarter immediately preceding the fiscal quarter in which the Businesses are to begin to provide services for the Introduced Business. The proposed IB Profit Margin Percentage and the proposed calculation of the IB Profit Margin (collectively, the "IB Profit Margin Calculation") will be made by the Buyer in good faith and presented in writing to the Executive Shareholders as soon as practicable prior to the date on which services relating to the Introduced Business are to be rendered. The Executive Shareholders shall, not later that five Business Days after receipt of the IB Profit Margin Calculation, notify the Buyer in writing of any objections thereto. Absent delivery of a written objection as provided above, the IB Profit Margin Calculation will be conclusive and binding upon the parties to this Agreement. If written objection is delivered to the Buyer and the Buyer and the Executive Shareholders are unable, within 5 Business Days after the receipt by the Buyer of such written objection, to resolve the dispute, the Buyer, in its sole 10 discretion, may elect either (i) to not make the Introduced Business available to the Buyer or (ii) to submit the IB Profit Margin Calculation to an Independent Accounting Firm mutually acceptable to the Executive Shareholders and the Buyer whose determination shall be conclusive and binding on the parties. In the event the Buyer elects to submit the matter to an Independent Accounting Firm, the Businesses shall provide services for the Introduced Business pending determination of the IB Profit Margin Calculation. (5) "Independent Accounting Firm" the "big-five" certified public accounting firms that does not a conflict of interest with respect to the preparation or review of the EBITDA Statements. (6) "Introduced Business" shall mean business introduced to the Buyer by Parent or Parent's Affiliates (i) as part of a contract with Parent or its Affiliates, or (ii) by reason of introductions to the Buyer made by Parent or Parent's Affiliates. The Executive Shareholders acknowledge and agree that neither Parent nor any Parent Affiliate shall be obligated to introduce any business to the Buyer or to otherwise cause any business that could be conducted by the Buyer as Introduced Business to be referred to or conducted by the Buyer. (7) "Net Revenue" shall be defined as the combined revenues of the Businesses (including income on operating cash and monies held on behalf of third parties remaining after Buyer distributes cash in excess of working capital requirements to Parent) (after elimination of all inter-Business transactions and balances) which are capitation fees (net of physician services expenses for AHG only, and net of any retroactive adjustments under the terms of any managed care plans), service bureau billing fees, administrative fees, facility fees, and fee for service billings (less contractual adjustments, bad debt expense, charity adjustments, refunds, NSF checks, collection agency fees and other adjustments to gross revenues), all as computed in accordance with GAAP. (8) "Year 1 Adjustment" shall mean the amount, if any, payable to the Buyer from the Escrow Funds in accordance with the provisions of Section 3.3A(c) and Section 3.4A(a). (9) "Year 2 Adjustment" shall mean the amount, if any, payable to the Buyer from the Escrow Funds in accordance with the provisions of Section 3.3A(d) and Section 3.4A(b). (10) "Year 3 Adjustment" shall mean the amount, if any, payable to the Buyer from the Escrow Funds in accordance with the provisions of Section 3.3A(e) and Section 3.4A(c). 11 (11) "Year 1 Earn-Out" shall mean the amount, if any, payable by the Buyer to the Escrow Agent in accordance with the provisions of Section 3.3A(c) and Section 3.4A(a). (12) "Year 2 Earn-Out" shall mean the amount, if any, payable by the Buyer to the Escrow Agent in accordance with the provisions of Section 3.3A(d) and Section 3.4A(b). (13) "Year 3 Earn-Out" shall mean the amount, if any, payable by the Buyer to the Escrow Agent in accordance with the provisions of Section 3.3A(e) and Section 3.4A(c). (14) "Year 1 EBITDA" shall have the meaning set forth in Section 3.3A(c)(1). (15) "Year 2 EBITDA" shall have the meaning set forth in Section 3.3A(d)(1). (16) "Year 3 EBITDA" shall have the meaning set forth in Section 3.3A(e)(1). (17) "Year 1 Earn-Out Period" shall mean the 12-month period ending on November 30, 1998. (18) "Year 2 Earn-Out Period" shall mean the 12-month period ending on November 30, 1999. (19) "Year 3 Earn-Out Period" shall mean the 12-month period ending on November 30, 2000. (20) "Year 1 Threshold" shall mean $11,000,000. (21) "Year 2 Threshold" shall mean the greater of (i) $11,000,000 or (ii) Year 1 EBITDA. (22) "Year 3 Threshold" shall mean the greater of (i) $11,000,000, (ii) Year 1 EBITDA, or (iii) Year 2 EBITDA. (b) EBITDA Statement. Within 75 calendar days after the last day of each of the Year 1 Earn-Out Period, the Year 2 Earn-Out Period and the Year 3 Earn-Out Period, the Buyer shall prepare, the Accountants shall review, and the Buyer shall deliver to AHG a statement reflecting the EBITDA from the consolidated operations of the Businesses during such Earn-Out Period (each, an "EBITDA Statement"), which statement will be determined in accordance with GAAP, applied on a basis consistent with the financial statements of the Buyer and Parent for such period. The parties shall ensure that the Accountants have full 12 access to the books, records, facilities and employees of the Businesses for purposes of reviewing the EBITDA Statement and shall cooperate with the Accountants to the extent reasonably requested to review the EBITDA Statement. The EBITDA Statement will be examined by AHG (and, if AHG so chooses, by a firm of independent certified public accountants), who shall, not later than 45 calendar days after receipt of the EBITDA Statement, raise any objections it has to the EBITDA Statement by notifying the Buyer in writing within such time period in a statement indicating the item or items disputed, AHG's proposed adjustments and an adjusted EBITDA Statement reflecting such adjustments (an "Objection Notice"). During such 45 day period, AHG and any such independent certified public accountants shall have full access to the books and records, other financial information (including the working papers of the Accountants) and appropriate financial personnel of the Buyer reasonably necessary for the preparation of an Objection Notice. Absent delivery of an Objection Notice as provided above, the EBITDA Statement will be conclusive and binding upon the parties to this Agreement for the purposes of any purchase price adjustment under this Section 3.3A(b). In the event that an Objection Notice is delivered by AHG as provided above, and if the Buyer and AHG are unable, within 15 calendar days after receipt by the Buyer of such Objection Notice, to resolve the disputed exceptions, such disputed exceptions will be referred to an Independent Accounting Firm mutually acceptable to AHG and the Buyer. The Independent Accounting Firm shall, within 60 days following its engagement by the Buyer and AHG for this purpose, deliver to AHG and the Buyer a written report determining such disputed exceptions (the "IAF EBITDA Statement"). During such 60 day period, the Independent Accounting Firm shall have full access to the books and records, other financial information (including the working papers of the Accountants and AHG's accountants, if any) and appropriate financial personnel of the Buyer which the Independent Accounting Firm reasonably deems necessary or advisable for the preparation of the IAF EBITDA Statement. The EBITDA reflected in the IAF EBITDA Statement will be conclusive and binding upon the parties to this Agreement for the purposes of any purchase price adjustment under this Section 3.3A(b), subject to application of the following provisions: (i) if the IAF EBITDA Statement reflects EBITDA in excess of $300,000 over the amount of the EBITDA reflected in the EBITDA Statement for the Earn-Out Period at issue, then EBITDA for such Earn-Out Period shall be deemed to be equal to the EBITDA reflected in the IAF EBITDA Statement, and the Buyer shall bear all the fees and disbursements of the Independent Accounting Firm in respect of its services under this Section 3.3A(b) for such Earn-Out Period, (ii) if the IAF EBITDA Statement reflects EBITDA that is equal to or less than $300,000 over the amount of the EBITDA reflected in the EBITDA Statement for such Earn-Out Period, but greater than the amount of the EBITDA reflected in such EBITDA Statement, then EBITDA for such Earn-Out Period shall be deemed to be equal to (A) the sum of (1) the EBITDA reflected in the EBITDA Statement and (2) the EEITDA reflected in the IAF EBITDA Statement divided by (B) two, and AHG and the Executive Shareholders, on a joint and several basis, shall bear all the fees and disbursements of the Independent Accounting Firm in respect of its services 13 under this Section 3.3A(b) for the Earn-Out Period at issue; and (iii) if the IAF EBITDA Statement reflects EBITDA that is equal to or less than the amount of the EBITDA reflected in the EBITDA Statement for such Earn-Out Period, then EBITDA for such Earn-Out Period shall be deemed to be equal to the EBITDA reflected in the IAF EEITDA Statement, and AHG and the Executive Shareholders, on a joint and several basis, shall bear all the fees and disbursements of the Independent Accounting Firm in respect of its services under this Section 3.3A(b) for the Earn-Out Period at issue. (c) Year 1 Adjustment/Year 1 Earn-Out Calculation. (1) In the event the EBITDA for the Year 1 Earn-Out Period calculated pursuant to Section 3.3A(b) above (the "Year 1 EBITDA") is less than $10,000,000, then the Year 1 Adjustment is the amount equal to the product of (i) seven multiplied by the difference between the Year 1 EBITDA and $10,000,000 and (ii) 0.125. (2) In the event the Year 1 EBITDA is equal to or less than the Year 1 Threshold and equal to or greater than $10,000,000, then the Year 1 Adjustment is $0.00. (3) In the event the Year 1 EBITDA is greater than the Year 1 Threshold, then the Year I Earn-Out is the amount equal to the product of (i) six multiplied by the difference between the Year 1 EBITDA and the Year 1 Threshold and (ii) 0.125. (d) Year 2 Adjustment/Year 2 Earn-Out Calculation. (1) In the event the EBITDA for the Year 2 Earn-Out Period calculated pursuant to Section 3.3A(b) above (the "Year 2 EBITDA") is equal to or less than the Year 2 Threshold, then the Year 2 Adjustment is the amount equal to the sum of (i) the product of (x) six multiplied by the difference between the Year 2 Threshold and the greater of (a) $11,000,000 or (b) the Year 2 EBITDA and (y) 0.125; plus (ii) the amount equal to the product of (x) seven multiplied by the amount, if any, by which the Year 2 EBITDA is less than $10,000,000 and (y) 0.125; provided, however, that the Year 2 Adjustment will be $0.00 if the Year 2 EBITDA is equal to or greater than $10,000,000 but less than or equal to $11,000,000. (2) In the event the Year 2 EBITDA is greater than the Year 2 Threshold, then the Year 2 Earn-Out is the amount equal to the product of (i) six multiplied by the difference between the Year 2 EBITDA and the Year 2 Threshold and (ii) 0.125; provided, however, that the Year 2 Earn-Out will be $0.00 if the Year 2 EBITDA is equal to or greater than $10,000,000 but less than or equal to $11,000,000. 14 (e) Year 3 Adjustment/Year 3 Earn-Out Calculation. (1) In the event the EBITDA for the Year 3 Earn-Out Period calculated pursuant to Section 3.3A(b) above (the "Year 3 EBITDA") is equal to or less than the Year 3 Threshold, then the Year 3 Adjustment is the amount equal to the sum of (i) the product of (x) four multiplied by the difference between Year 3 Threshold and the greater of (a) $11,000,000 or (b) the Year 3 EBITDA and (y) 0.125, plus (ii) the amount equal to the product of (x) seven multiplied by the amount, if any, by which the Year 3 EBITDA is less than $10,000,000 and (y) 0.125; provided, however, that the Year 3 Adjustment will be $0.00 if the Year 3 EBITDA is equal to or greater than $10,000,000 but less than or equal to $11,000,000. (2) In the event the Year 3 EBITDA is greater than the Year 3 Threshold, then the Year 3 Earn-Out is the amount equal to the product of (i) four multiplied by the difference between the Year 3 EBITDA and the Year 3 Threshold and (ii) 0.125; provided, however, that the Year 3 Earn-Out will be $0.00 if the Year 3 EBITDA is equal to or greater than $10,000,000 but less than or equal to $11,000,000. Section 3.4A Payment of Adjustment and Earn-Out; Distribution of Escrow. The Year 1 Adjustment or Year 1 Earn-Out, Year 2 Adjustment or Year 2 Earn-Out and Year 3 Adjustment or Year 3 Earn-Out, if any, shall be paid within 5 Business Days of final determination of EBITDA for the applicable Earn-Out Period pursuant to Section 3.3A(b) and shall be paid to the Buyer or the Escrow Agent, as the case may be, in the following manner: (a) Year 1 Adjustment/Year 1 Earn-Out. (1) In the event the Year 1 Adjustment is calculated pursuant to Section 3.3A(c)(1) above, then the Escrow Agent shall deliver to Buyer from the Escrow Funds an amount equal to the Year 1 Adjustment, together with the interest or earnings thereon as set forth in Section 3.4A(d). (2) In the event the Year 1 Earn-Out is calculated pursuant to Section 3.3A(c)(3) above, the Buyer shall pay to the Escrow Agent the Year I Earn-Out in cash by wire transfer of immediately available funds, which shall be held by the Escrow Agent as part of the Escrow Funds. Upon receipt by the Escrow Agent of the Year 1 Earn-Out, the Escrow Agent shall then deliver to AHG an amount equal to one-third of the principal of the Escrow Funds, together with the interest or earnings thereon as set forth in Section 3.4A(d). 15 (b) Year 2 Adjustment/Year 2 Earn-Out. (1) In the event the Year 2 Adjustment is calculated pursuant to Section 3.3A(d)(1) above, then the Escrow Agent shall deliver to the Buyer from the Escrow Funds an amount equal to the Year 2 Adjustment, together with the interest or earnings thereon as set forth in Section 3.4A(d). (2) In the event the Year 2 Earn-Out is calculated pursuant to Section 3.3A(d)(2) above, then the Buyer shall pay to the Escrow Agent the Year 2 Earn-Out in cash by wire transfer of immediately available funds, which shall be held by the Escrow Agent as part of the Escrow Funds. Upon receipt by the Escrow Agent of the Year 2 Earn-Out, the Escrow Agent shall then deliver to AHG an amount equal to one-half of the principal of the Escrow Funds, together with the interest or earnings thereon as set forth in Section 3.4A(d). (c) Year 3 Adjustment/Year 3 Earn-Out. (1) In the event the Year 3 Adjustment is calculated pursuant to Section 3.3A(e)(1) above, then the Escrow Agent shall deliver to the Buyer from the Escrow Funds an amount equal to the Year 3 Adjustment, together with the interest or earnings thereon as set forth in Section 3.4A(d). Any Escrow Funds remaining after distribution of the Year 3 Adjustment to the Buyer shall be disbursed to AHG, promptly after disbursement of the Year 3 Adjustment, together with interest or earnings thereon, to the Buyer. (2) In the event the Year 3 Earn-Out is calculated pursuant to Section 3.3A(e)(2) above, then the Buyer shall pay to AHG the Year 3 Earn-Out in cash by wire transfer of immediately available funds, and the Escrow Agent shall transfer the Escrow Funds to AHG. (d) Distributions of Interest or Earnings on the Escrow Funds. Interest or other earnings on the Escrow Deposit and additional amounts paid by the Buyer to the Escrow Agent pursuant to this Section 3.4A shall be disbursed prorata to the recipient of principal held in the Escrow Funds. For income tax purposes, it shall be assumed that AHG will be entitled to receive all interest and other earnings on the principal amounts held in the Escrow Fund and the Buyer and AHG agree to direct the Escrow Agent pursuant to joint instructions to disburse to AHG an amount from the Escrow Funds necessary for AHG or its assigns to pay their federal income tax liability on said interest and earnings, assuming for purposes hereof an effective tax rate of 31%. The amount of any previous distributions for taxes made to AHG shall be taken into account in the event that disbursements from the Escrow Funds are later made to the Buyer and appropriate adjustments will be made in accordance with joint instructions from the Buyer and AHG to the Escrow Agent. 16 (e) Limitations on Distributions to AHG. Notwithstanding anything to the contrary contained in Sections 3.3A and 3.4A, in no event shall distributions to AHG pursuant to this Section 3.4A exceed $6,093,254 in the aggregate (exclusive of interest or earnings thereon). (f) Adjustments in Excess of Escrow Funds. In the event that the Adjustment for any Earn-Out Period should exceed the amount of the remaining Escrow Funds, the amount of such excess, shall be applied as a credit in favor of the Buyer and shall be deducted from the amount otherwise payable by the Buyer as the Year 2 Earn-Out and Year 3 Earn-Out, as applicable. 2. Closing and Termination. The closing of the transactions contemplated by this Amendment (the "Closing") shall take place no later than two (2) business days after the fulfillment of all conditions precedent to Closing set forth in Sections 3 and 4 to this Amendment, or such other date as the Buyer and AHG shall mutually agree (the "Closing Date"). The Closing shall take place by the delivery of documents by facsimile, overnight courier or other means on or before the Closing Date. Notwithstanding the actual time of the Closing, the parties hereto agree that the Closing shall be effective and deemed for all purposes to have occurred as of 12:01 a.m. local time on October 1, 1998 (the "Effective Date"). This Amendment may be terminated and the transactions contemplated hereby may be abandoned at any time before the Closing: 2.1 By Consent. By the mutual written consent of all of the parties hereto; 2.2 By the Buyer and the Parent. By the Buyer and the Parent, upon written notice to the Sellers and the Executive Shareholders, if all the conditions set forth in Section 4 of this Amendment shall not have been satisfied or waived on or before November 30, 1998, unless such satisfaction has been frustrated or made impossible by any act or failure to act of the Buyer or the Parent; or 2.3 By the Sellers and the Executive Shareholders. By the Sellers and the Executive Shareholders, upon written notice to the Buyer and the Parent, if all of the conditions set forth in Section 3 of this Amendment shall not have been satisfied or waived on or before November 30, 1998, unless satisfaction has been frustrated or made impossible by any act or failure to act of any of the Sellers or the Executive Shareholders. 3. Conditions Precedent to the Sellers' and the Executive Shareholders' Obligations to Close. The obligations of the Seller and the Executive Shareholders to consummate the transactions contemplated by this Amendment are subject to the fulfillment, on or before the Closing Date, of the following conditions, any one or more of which may be waived by the Sellers and the Executive Shareholders hereto in their sole discretion. 3.1 Delivery of Buy-Out Price. The Buyer shall cause the Buyout Price to be delivered by federal funds wire transfer to the Broad and Cassel Trust Account, in accordance with wire transfer instructions furnished in writing by AHG, for further credit to AHG in accordance with the agreement of the Sellers. 17 3.2 Escrow Agreement. The Sellers and the Buyer shall deliver joint written instructions to the Escrow Agent authorizing and directing the Escrow Agent to disburse to the Buyer the Released Clawback and any interest or earnings thereon. In addition, the Escrow Agreement shall be amended to reflect that the Remaining Clawback and any interest or earnings thereon shall continue to be held in escrow for the sole benefit of AHG (for further distribution to GHS, Inc.) and the Buyer, and to reflect that all of the Sellers other than AHG shall cease to be parties to the Escrow Agreement. 3.3 Management Agreement. The Management Agreement dated as of December 5, 1997 by and among the Buyer, the Parent, RNSF Management, Inc., a Florida corporation, and the Executive Shareholders shall be terminated. 3.4 Schimmel Employment Agreement. Schimmel and the Buyer shall enter into an employment agreement (the "Schimmel Employment Agreement"), in form and substance reasonably acceptable to the Buyer and Schimmel. The Schimmel Employment Agreement will be for a term of two years commencing October 1, 1998 (each, an "Annual Period"). Schimmel will be entitled to an annual salary of $50,000 during each Annual Period, during which time the Schimmel Employment Agreement cannot be terminated by the Buyer without "cause", as defined therein. If Schimmel terminates the Schimmel Employment Agreement on or before the end of the first Annual Period or the second Annual Period other than for cause or "good cause", as defined therein, he will be required to repay to the Buyer $400,000 or $250,000, respectively, of his allocable portion of the Buyout Price. Schimmel shall provide services to the Buyer on a part-time basis for up to 20 hours per week in each Annual Period. The Schimmel Employment Agreement will contain a reasonable non-compete provision. 3.5 Farrell Employment Agreement. Farrell and the Buyer shall enter into an employment agreement, in form and substance reasonably acceptable to Farrell and the Buyer (the "Farrell Employment Agreement"). The Farrell Employment Agreement will be for a term of two Annual Periods. Farrell will be entitled to an annual salary of $450,000 during the first two Annual Periods, during which time the Farrell Employment Agreement cannot be terminated by the Buyer without "cause", as defined therein. If Farrell terminates the Farrell Employment Agreement on or before the end of the first Annual Period or the second Annual Period other than for cause or "good cause", as defined therein, he will be required to repay to the Buyer $500,000 or $300,000, respectively, of his allocable portion of the Buyout Price. The Farrell Employment Agreement will automatically renew for a third year (the "Renewal Period"), with an annual salary of $450,000, if the Buyer has a "run rate" resulting from new business (and additional services under existing contracts) commencing between October 1, 1998 and October 1, 2000, inclusive, and for which no notice of cancellation or non-renewal has been given on or before October 1, 2000, but excluding (i) renewals (including amendments, restatements or replacements) of contracts in force as of October 1, 1998 and (ii) contracts which will expire by their terms absent notice of intent to renew on or before October 1, 2000 (and with respect to which no notice of intent to renew has been given) (the "Two Year New Business"), of $15,000,000 or more projected for the fiscal year ending September 30, 2001. The "run rate" is to be computed by projecting, on or about October 1, 2000, EBITDA of the Buyer resulting from the Two Year New Business for the fiscal year ending September 30, 2001. The "run rate" will 18 be determined by the Buyer in good faith and consistent with the methodology used for computing the EBITDA Run Rate. There will be a provision for resolving disputes as to the computation of the "run rate", consistent with the provisions of Section 3.3(c) of the Asset Purchase Agreement, as amended by this Amendment. If the Buyer does not achieve the requisite "run rate", then the Buyer will have the option of renewing the Farrell Employment Agreement for the Renewal Period, at an annual salary to be determined by Farrell and the Buyer in good faith. The Farrell Employment Agreement will contain a reasonable non-compete provision. 3.6 Jones Release. J.R. Jones, M.D. shall execute and deliver a release in favor of AHG and the Executive Shareholders, in form and substance reasonably acceptable to AHG, releasing any and all claims under the Bonus Agreement, dated December 1, 1997, by and between AHG and Jones (the "Bonus Agreement"), in exchange for receipt at Closing of a portion AHG's Applicable Percentage of the Buyout Price. 3.7 Kanter and Young Releases. Steven Kanter, M.D. and Andrea Kanter (collectively, the "Kanters") and Jerrold Young, M.D. and Jo-Ann Young (collectively, the "Youngs") each shall execute and deliver a release in favor of Schimmel, in form and substance reasonably acceptable to Schimmel, acknowledging the release to the Buyer of the Released Clawback and releasing and any all claims to payment of a portion of the Released Clawback under the Purchase and Indemnification Agreement, dated December 5, 1997, by and among the Kanters, the Youngs and Schimmel (the "Purchase and Indemnification Agreement"). 3.8 Farrell Buy-Out Agreement. In consideration for the receipt of an allocable portion of the Buyout Price, the Buy-Out Agreement, dated December 1, 1997, by and among FSN, Morgan Chase Company, Stephen Wulf and Farrell (collectively, the "Farrell Parties"), AHG and FSN (the "Farrell Buy-Out Agreement") shall be amended (a) to terminate all rights of the Farrell Parties to receive a portion of the Escrow Funds and (b) to provide for payment of the Year 3 Run Rate Earn-Out and of the Year 2 Earn-Out and the Year 3 Earn-Out (as determined pursuant to Section 1.2(a) of this Amendment) in lieu of the Earn-Out Payments (as such term is defined in the Farrell Buy-Out Agreement). 3.9 Authorization of the Sellers. Execution, delivery and performance of this Amendment, and all other agreements entered into in connection with the transactions contemplated hereby, shall have been authorized by all necessary action on the part of each of the Sellers. 4. Conditions Precedent to the Buyer's and the Parent's Obligations to Close. The obligations of the Buyer and the Parent to consummate the transactions contemplated by this Amendment are subject to the fulfillment, on or before the Closing Date, of the following conditions, any one or more of which may be waived by the Buyer and the Parent hereto in their sole discretion: 4.1 Escrow Agreement. The Sellers and the Buyer shall deliver joint written instructions to the Escrow Agent authorizing and directing the Escrow Agent to disburse to the Buyer the Released Clawback and any interest or earnings thereon. In addition, the Escrow Agreement shall be amended to reflect that the Remaining Clawback and any interest or earnings 19 thereon shall continue to be held in escrow for the sole benefit of AHG (for further distribution to GHS, Inc.) and the Buyer, and to reflect that all of the Sellers other than AHG shall cease to be parties to the Escrow Agreement. 4.2 Management Agreement. The Management Agreement dated as of December 5, 1997 by and among the Buyer, the Parent, RNSF Management, Inc., a Florida corporation, and the Executive Shareholders shall be terminated. 4.3 Schimmel Employment Agreement. Schimmel and the Buyer shall enter into the Schimmel Employment Agreement on the terms and conditions set forth in Section 3.4 of this Amendment. 4.4 Farrell Employment Agreement. Farrell and the Buyer shall enter into the Farrell Employment Agreement on the terms and conditions set forth in Section 3.5 of this Amendment. 4.5 Farrell Buy-Out Agreement. The Farrell Buy-Out Agreement shall be amended as set forth in Section 3.8 of this Amendment. 4.6 Authorization. Each of the Sellers shall deliver an officer's certificate dated as of the Closing Date and certifying that execution, delivery and performance of this Amendment, and all other agreements entered into in connection with the transactions contemplated hereby, have been authorized by all necessary action on the part of each Seller. 5. Representations and Warranties. 5.1 Representations and Warranties of the Buyer and the Parent. In order to induce the Seller and the Executive Shareholders to enter into this Amendment, and to consummate the transactions contemplated hereby, the Buyer and the Parent, on a joint and several basis, represent and warrant as follows: (a) Corporate Status. The Buyer and the Parent are corporations duly organized and validly existing under the laws of the State of Florida and Delaware, respectively. The Buyer's status is active under the laws of the State of Florida and the Parent is in good standing under the laws of the State of Delaware. The Buyer and the Parent have all requisite corporate power and authority to own their respective properties and assets and to carry on their respective businesses as they are presently being conducted. (b) Power and Authority. The Buyer and the Parent have the full right, power and authority to enter into, and to perform their respective obligations under, this Amendment. (c) Binding Agreement. The execution and delivery by the Buyer and the Parent of this Amendment and the performance of their respective obligations hereunder have been duly authorized by all necessary corporate action and no other proceedings on the part of the Buyer or the Parent are necessary to authorize the execution of this Amendment and the performance of transactions contemplated hereby. This Amendment has been duly and validly 20 executed and delivered by the Buyer and the Parent and constitutes the legal, valid and binding obligation of the Buyer and of the Parent enforceable against the Buyer and the Parent in accordance with its terms, except as enforcement may be limited by bankruptcy, insolvency, moratorium or other laws affecting creditors' rights generally, or equitable principles, whether applied in a proceeding in equity or law. (d) Absence of Conflicting Agreements. Neither the execution or delivery of this Amendment by the Buyer and the Parent, nor the performance by the Buyer and the Parent of the transactions contemplated hereby, conflicts with, or constitutes a breach of or a default under (a) the respective Articles of Incorporation or Bylaws of the Buyer and the Parent (b) any applicable law, or any applicable rule, judgment, order, writ, injunction or decree of any court, (c) any applicable rule or regulation of any administrative agency or other governmental authority, or (d) any agreement, lease, indenture, instrument or contract to which the Buyer or the Parent is now a party or by which the Buyer or the Parent or any of their respective properties or assets are bound, which breach or default would have a material adverse effect on the business or operations of the Buyer or the Parent. 5.2 Representations and Warranties of the Sellers and of the Executive Shareholders. In order to induce the Buyer and the Parent to enter into this Amendment, and to consummate the transactions contemplated hereby, each of the Sellers and of the Executive Shareholders, on a joint and several basis, represent and warrant as follows; provided, however, that the representations and the warranties of each Executive Shareholder are made only as to himself and to each Seller in which such Executive Shareholder owns any shares or partnership interests, as the case may be: (a) Corporate and Partnership Status. Each Seller (other than FSN) is a corporation duly organized and validly existing under the laws of the State of Florida and its status is active. FSN is a limited partnership duly organized and validly existing under the laws of the State of Florida and its status is active. Each Seller has all requisite corporate or partnership power and authority to own its property and assets and to carry on its business as it is presently being conducted. (b) Power and Authority. On or before the Closing Date, each Seller will have the full right, power and authority to enter into, and to perform its obligations under, this Amendment and the consent of no other party will be necessary or required in order to permit or allow each such Seller to enter into and perform its obligations hereunder. Other than as provided in the Farrell Buy-Out Agreement, the Bonus Agreement, the Letter Agreement and the Purchase and Indemnification Agreement, no Seller has assigned or will have assigned on or before the Closing Date any rights to any portion of the Clawback or the Earn-Out under the Asset Purchase Agreement. (c) Binding Agreement. On or before the Closing Date, the execution and delivery by each Seller of this Amendment and the performance of its obligations hereunder will have been duly authorized by all necessary corporate or partnership action, as applicable, and no other proceedings on the part of such Seller will be necessary to authorize the execution of this Amendment and the performance of transactions contemplated hereby. On or before the Closing Date, this Amendment will have been duly and validly executed and delivered by each 21 Seller and will constitute the legal, valid and binding obligation of such Seller enforceable against such Seller in accordance with its terms, except as enforcement may be limited by bankruptcy, insolvency, moratorium or other laws affecting creditors' rights generally, or equitable principles, whether applied in a proceeding in equity or law. This Amendment has been duly and validly executed and delivered by each Executive Shareholder and constitutes the legal, valid and binding obligation of such Executive Shareholder enforceable against such Executive Shareholder in accordance with its terms, except as enforcement may be limited by bankruptcy, insolvency, moratorium or other laws affecting creditors' rights generally, or equitable principles, whether applied in a proceeding in equity or law. (d) Absence of Conflicting Amendments. Neither the execution or delivery of this Amendment by each Seller and each Executive Shareholder, nor the performance by each Seller and each Executive Shareholder of the transactions contemplated hereby, conflicts with, or constitutes a breach of or a default under (a) the Articles of Incorporation or Bylaws (or, in the case of FSN, the Certificate of Limited Partnership or the FSN Limited Partnership Agreement) of such Seller, (b) any applicable law, or any applicable rule, judgment, order, writ, injunction or decree of any court, (c) any applicable rule or regulation of any administrative agency or other governmental authority, or (d) any agreement, lease, indenture, instrument or contract to which such Seller or Executive Shareholder is now a party or by which such Seller or Executive Shareholder or any of their respective properties or assets are bound, which breach or default would have a material adverse effect on the business or operations of such Seller or the assets of such Executive Shareholder. 6. Ratification. Except as modified by this Amendment, the Asset Purchase Amendment is and shall continue to be in full force and effect and is hereby in all respects confirmed, approved and ratified. 7. Miscellaneous. 7.1 Further Assurances. At any time, and from time to time, each party will execute such additional instruments and take such action as may be reasonably requested by the other party to confirm or perfect title to any property transferred hereunder or otherwise to carry out the intent and purposes of this Amendment. 7.2 Costs and Expenses. Each party hereto agrees to pay its own costs and expenses incurred in negotiating this Amendment and consummating the transactions described herein. 7.3 Time. Time is of the essence. 7.4 Entire Amendment. This Amendment and the transactions contemplated hereby constitute the entire Amendment among the parties hereto with respect to the subject matter hereof, and supersede all prior negotiations, letters and understandings relating to the subject matter hereof. 22 7.5 Amendment. This Amendment may not be amended, supplemented or modified in whole or in part except by an instrument in writing signed by the party or parties against whom enforcement of any such amendment, supplement or modification is sought. 7.6 Assignment. Except as otherwise provided in Section 12.1 the Asset Purchase Agreement, this Amendment may not be assigned by any party hereto without the prior written consent of the other parties. 7.7 Choice of Law. This Amendment will be interpreted, construed and enforced in accordance with the laws of the State of Florida. 7.8 Headings. The section and subsection headings in this Amendment are inserted for convenience only and shall not affect in any way the meaning or interpretation of this Amendment. 7.9 Pronouns. All pronouns and any variations thereof shall be deemed to refer to the masculine, feminine, neuter, singular or plural as the context may require. 7.10 Number and Gender. Words used in this Amendment, regardless of the number and gender specifically used, shall be deemed and construed to include any other number, singular or plural, and any other gender, masculine, feminine or neuter, as the context indicates is appropriate. 7.11 Construction. The parties hereto and their respective legal counsel participated in the preparation of this Amendment; therefore, this Amendment shall be construed neither against nor in favor of any of the parties hereto, but rather in accordance with the fair meaning thereof. 7.12 Effect of Waiver. The failure of any party at any time or times to require performance of any provision of this Amendment will in no manner affect the right to enforce the same. The waiver by any party of any breach of any provision of this Amendment will not be construed to be a waiver by any such party of any succeeding breach of that provision or a waiver by such party of any breach of any other provision. 7.13 Severability. The invalidity, illegality or unenforceability of any provision or provisions of this Amendment will not affect any other provision of this Amendment, which will remain in full force and effect, nor will the invalidity, illegality or unenforceability of a portion of any provision of this Amendment affect the balance of such provision. In the event that any one or more of the provisions contained in this Amendment or any portion thereof shall for any reason be held to be invalid, illegal or unenforceable in any respect, this Amendment shall be reformed, construed and enforced as if such invalid, illegal or unenforceable provision had never been contained herein. 7.14 Binding Nature. This Amendment will be binding upon and will inure to the benefit of any successor or successors of the parties hereto. 23 7.15 No Third-Party Beneficiaries. Notwithstanding anything in this Amendment to the contrary, no person (including, without limitation, GHS, Inc.) shall be deemed to possess any third-party beneficiary right pursuant to this Amendment. It is the intent of the parties hereto that no direct benefit to any third party is intended or implied by the execution of this Amendment. 7.16 Counterparts. This Amendment may be executed in one or more counterparts, each of which will be deemed an original and all of which together will constitute one and the same instrument. [SIGNATURES BEGIN ON THE FOLLOWING PAGE] 24 IN WITNESS WHEREOF, the parties hereto have executed this Amendment as of the date first above written. ALLIED SPECIALTY CARE SERVICES, INC. By: ---------------------------------- Name: -------------------------------- Title: ------------------------------- ALLIED HEALTH GROUP, INC. By: ---------------------------------- Lawrence Schimmel, M.D., President GUT MANAGEMENT, INC. By: ---------------------------------- Jacob Nudel, M.D., President SKY MANAGEMENT CO. By: ---------------------------------- Lawrence Schimmel, M.D., President FLORIDA SPECIALTY NETWORK, LTD. By:Florida Specialty Network, Inc., General Partner By: ---------------------------------- Lawrence Schimmel, M.D., President 25 SURGICAL ASSOCIATES OF SOUTH FLORIDA, INC. By: ---------------------------------- David Russin, M.D., President SURGINET, INC. By: ---------------------------------- Lawrence Schimmel, M.D., President -------------------------------------- JACOB NUDEL, M.D. -------------------------------------- DAVID RUSSIN, M.D. -------------------------------------- LAWRENCE SCHIMMEL, M.D. MAGELLAN HEALTH SERVICES, INC. By: ----------------------------------- Name: --------------------------------- Title: -------------------------------- 26 EX-3.B 3 EXHIBIT 3(B) Exhibit 3(b) BYLAWS OF MAGELLAN HEALTH SERVICES, INC. BYLAWS OF MAGELLAN HEALTH SERVICES, INC. ARTICLE I. OFFICES..............................................................- 1 - Section 1. Registered Office....................................................- 1 - Section 2. Other Offices........................................................- 1 - ARTICLE II. MEETINGS OF STOCKHOLDERS............................................- 1 - Section 1. Place of Meetings....................................................- 1 - Section 2. Date of Meetings.....................................................- 1 - Section 3. Notice of Meetings...................................................- 1 - Section 4. List of Stockholders.................................................- 1 - Section 5. Special Meetings.....................................................- 2 - Section 6. Notice of Special Meetings...........................................- 2 - Section 7. Limitations on Special Meetings......................................- 2 - Section 8. Quorum and Adjournment...............................................- 2 - Section 9. Stockholder Action...................................................- 2 - Section 10. Voting Rights.......................................................- 2 - Section 11. Proxies and Voting Rights...........................................- 3 - Section 12. Action by Consent...................................................- 3 - Section 13. Inspector of Elections..............................................- 3 - Section 14. Presiding Officer...................................................- 3 - ARTICLE III. DIRECTORS..........................................................- 3 - Section 1. Number, Election and Term of Office..................................- 3 - Section 2. Vacancies............................................................- 4 - Section 3. Removal..............................................................- 4 - Section 4. Powers of Directors..................................................- 4 - Section 5. Place of Meetings....................................................- 4 - Section 6. Time of Meetings.....................................................- 4 - Section 7. Regular Meetings.....................................................- 4 - Section 8. Special Meetings.....................................................- 4 - Section 9. Quorum...............................................................- 5 - Section 10. Action by Consent...................................................- 5 - Section 11. Telephone Conference Call...........................................- 5 - Section 12. Executive and Other Committees......................................- 5 - Section 13 . Minutes of Committee Meetings......................................- 6 - Section 14. Compensation........................................................- 6 -
i ARTICLE IV. NOTICES.............................................................- 6 - Section 1. Procedure............................................................- 6 - Section 2. Waiver and Consent...................................................- 6 - ARTICLE V. OFFICERS.............................................................- 6 - Section 1. General..............................................................- 6 - Section 2. Election of Officers.................................................- 7 - Section 3. Additional Officers..................................................- 7 - Section 4. Compensation.........................................................- 7 - Section 5. Tenure...............................................................- 7 - Section 6. President - Powers and Duties........................................- 7 - Section 7. President - Execution of Documents...................................- 7 - Section 8. Vice Presidents - Powers and Duties..................................- 7 - Section 9. Secretary - Powers and Duties........................................- 7 - Section 10. Assistant Secretary.................................................- 8 - Section 11. Treasurer - Powers and Duties.......................................- 8 - Section 12. Treasurer - Disbursements and Accounting............................- 8 - Section 13. Assistant Treasurer.................................................- 8 - Section 14. Bonds...............................................................- 8 - ARTICLE VI. CERTIFICATES FOR SHARES OF STOCK....................................- 8 - Section 1. Rights to Certificate................................................- 8 - Section 2. Classes of Stock - Rights............................................- 9 - Section 3. Officers' Signatures.................................................- 9 - Section 4. Lost Certificates....................................................- 9 - Section 5. Transfers of Stock...................................................- 9 - Section 6. Fixing of Record Date................................................- 9 - Section 7. Registered Stockholders.............................................- 10 - ARTICLE VII. INDEMNIFICATION....................................................- 10 - Section 1. Actions Not By or In the Right of the Corporation...................- 10 - Section 2. Actions By or In the Right of the Corporation.......................- 10 - Section 3. Indemnification Where Director or Officer Successfully Defends Action.....................................................- 11 - Section 4. Determinations Required Prior to Indemnification....................- 11 - Section 5. Advances............................................................- 11 - Section 6. General.............................................................- 11 - Section 7. Insurance...........................................................- 11 - Section 8. The Corporation.....................................................- 11 - Section 9. Employee Benefit Plans..............................................- 12 - Section 10. Continuation.......................................................- 12 - Section 11. Future Amendments..................................................- 12 - ARTICLE VIII. GENERAL PROVISIONS...............................................- 12 - Section 1. Dividends...........................................................- 12 - Section 2. Reserves............................................................- 13 - Section 3. Annual Statement....................................................- 13 -
ii Section 4. Checks..............................................................- 13 - Section 5. Fiscal Year.........................................................- 13 - Section 6. Seal................................................................- 13 - Section 7. Miscellaneous.......................................................- 13 - ARTICLE IX. AMENDMENTS.........................................................- 13 -
iii iv v BYLAWS OF MAGELLAN HEALTH SERVICES, INC. ARTICLE I. OFFICES Section 1. Registered Office. The registered office shall be in the City of Wilmington, County of New Castle, State of Delaware. Section 2. Other Offices. The corporation may also have offices at such other places both within and without the State of Delaware as the board of directors may from time to time determine or the business of the corporation may require. ARTICLE II. MEETINGS OF STOCKHOLDERS Section 1. Place of Meetings. All meetings of the stockholders for the election of directors shall be held in the City of Atlanta, State of Georgia, at such place as may be fixed from time to time by the Board of Directors, or at such other place either within or without the State of Delaware as shall be designated from time to time by the Board of Directors and stated in the notice of the meeting. Meetings of stockholders for any other purpose may be held at such time and place, within or without the State of Delaware, as shall be stated in the notice of the meeting or in a duly executed waiver of notice thereof. Section 2. Date of Meetings. Annual meetings of stockholders shall be held on a date and at a time as shall be designated from time to time by the Board of Directors and stated in the notice of the meeting, at which the stockholders shall elect members of the Board of Directors and transact such other business as may properly be brought before the meeting. Election of directors need not be by written ballot. Section 3. Notice of Meetings. Written notice of the annual meeting stating the place, date and hour of the meeting shall be given to each stockholder entitled to vote at such meeting not less than ten nor more than sixty days before the date of the meeting. Section 4. List of Stockholders. The officer who has charge of the stock ledger of the corporation shall prepare and make, or cause to be prepared and made, at least ten days before every meeting of stockholders, a complete list of the stockholders entitled to vote at the meeting, arranged in alphabetical order, and showing the address of each stockholder and the number of shares registered in the name of each stockholder. Such list shall be open to the examination of any stockholder, for any purpose germane to the meeting, during ordinary business hours, for a period of at least ten days prior to the meeting, either at a place within the city where the meeting is to be held, which place shall be specified in the notice of the meeting, or, if not so specified, at the place where the meeting is to be held. The list shall also be produced and kept at the time and place of the meeting during the whole time thereof, and may be inspected by any stockholder who is present. Section 5. Special Meetings. Special meetings of the stockholders, for any purpose or purposes, unless otherwise prescribed by statute or by the certificate of incorporation, may be called only by the affirmative vote of a majority of the Board of Directors. Section 6. Notice of Special Meetings. Written notice of a special meeting stating the place, date and hour of the meeting and the purpose or purposes for which the meeting is called, shall be given not less than ten nor more than sixty days before the date of the meeting, to each stockholder entitled to vote at such meeting. Section 7. Limitations on Special Meetings. Business transacted at any special meeting of stockholders shall be limited to the purposes stated in the notice. Section 8. Quorum and Adjournment. The holders of a majority of the shares of all classes of stock issued and outstanding and entitled to vote thereat, present in person or represented by proxy, shall constitute a quorum at all meetings of the stockholders for the transaction of business, except as otherwise provided by statute or by the certificate of incorporation. If, however, such quorum shall not be present or represented at any meeting of the stockholders, the stockholders entitled to vote thereat, present in person or represented by proxy, shall have power to adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum shall be present or represented. At such adjourned meeting at which a quorum shall be present or represented any business may be transacted which might have been transacted at the meeting as originally notified. If the adjournment is for more than thirty days, or if after the adjournment a new record date is fixed for the adjourned meeting, a notice of the adjourned meeting shall be given to each stockholder of record entitled to vote at the meeting. Section 9. Stockholder Action. Except as provided in Section 3 of Article III of these Bylaws, or unless the question is one upon which, by express provision of statute or the certificate of incorporation, a different vote is required, in which case such express provision shall govern and control the decision of such question: (1) in all matters other than the election of directors, the affirmative vote of the majority of shares present in person or represented by proxy at the meeting and entitled to vote on the subject matter shall be the act of the stockholders; (2) directors shall be elected by a plurality of the votes of the shares present in person or represented by proxy at the meeting and entitled to vote on the election of directors; and (3) in voting on such questions, every stockholder of record who is entitled to vote shall be entitled to one vote for each share of stock held by him on the record date for such meeting. Section 10. Voting Rights. Except as otherwise provided by law or by the certificate of incorporation, the holders of shares of all classes of stock shall have the right to vote, in person or by proxy, together on all matters to come before a meeting of the stockholders. 2 Section 11. Proxies and Voting Rights. No proxy shall be voted on after three years from its date, unless the proxy provides for a longer period. A duly executed proxy shall be irrevocable if it states that it is irrevocable and if, and only as long as, it is coupled with an interest sufficient in law to support an irrevocable power. A proxy may be made irrevocable regardless of whether the interest with which it is coupled is an interest in the stock itself or an interest in the corporation generally. In the event that any proxy shall designate two or more persons to act as proxies, a majority of such persons present at the meeting, or if only one be present that one, shall have all of the powers conferred by the proxy upon all of the persons so designated unless the proxy shall otherwise provide. Section 12. Action by Consent. The stockholders may not take any actions required to be taken at an annual or special meeting of the stockholders, or any actions which may be taken at an annual meeting or special meeting of the stockholders, by written consent in lieu of a meeting. Section 13. Inspector of Elections. The Board of Directors, in advance of any meeting of the stockholders of the Corporation, shall appoint one or more inspectors of elections to act at such meeting, and any adjournment thereof. In case any person who has been designated as an inspector of elections fails to appear or act, the vacancy may be filled by an alternate appointed by the Board, in advance of the meeting, or at the meeting by the person presiding thereat. An inspector, before entering upon discharge of his duties, shall take and sign an oath faithfully to execute the duties of inspector with strict impartiality and according to the best of his ability. The inspector or inspectors so appointed shall perform the duties required by Section 231 of the Delaware General Corporation Law. Section 14. Presiding Officer. The Chairman of the Board of Directors, or in his absence the President, shall serve as Chairman of every stockholders' meeting unless some other person is elected to serve as Chairman by a majority vote of the voting power of the shares represented at the meeting. The Chairman shall appoint the Secretary of the corporation, or in his absence an Assistant Secretary, as Secretary of every stockholders' meeting and such other persons as he deems required to assist with the meeting. ARTICLE III. DIRECTORS Section 1. Number, Election and Term of Office. The number of directors which shall constitute the whole Board shall be eight. A change in the number of directors shall only occur by an affirmative vote of at least seventy-five percent (75%) of the issued and outstanding shares of the corporation entitled to vote thereon cast at a meeting of the stockholders called for such purpose. The Board of Directors shall be divided into three classes, as nearly equal in numbers as the then total number of directors constituting the whole Board permits, with the term of office of one class expiring each year. The directors shall be elected at the annual meeting of the stockholders, except as provided in Sections 2 and 3 of this Article, and each director elected shall hold office until his successor is elected and qualifies. Directors need not be stockholders or a resident of the State of Delaware. 3 Section 2. Vacancies. Any vacancies in the Board of Directors for any reason, and any newly created directorships resulting from any increase in the authorized number of directors, may be filled by a majority of the directors then in office, though less than a quorum, or by a sole remaining director, and the directors so chosen shall hold office until the next election of the respective class or classes for which such directors shall have been chosen and until their successors are duly elected and shall qualify, unless sooner displaced. If there are no directors in office, then an election of directors may be held in the manner provided by statute. Section 3. Removal. Notwithstanding any other provision of these Bylaws (and notwithstanding the fact that some lesser percentage may be specified by law), any director or the entire Board of Directors of the corporation may be removed from office at any time, but only (i) for cause by the affirmative vote of the holders of a majority of the issued and outstanding shares of the capital stock of the corporation entitled to vote thereon cast at a meeting of the stockholders called for that purpose, or (ii) without cause by the affirmative vote of the holders of at least seventy-five percent (75%) of the issued and outstanding shares of capital stock of the corporation entitled to vote thereon cast at a meeting of the stockholders called for that purpose. Section 4. Powers of Directors. The business of the corporation shall be managed by its Board of Directors which may exercise all such powers of the corporation and do all such lawful acts and things as are not by statute or by the certificate of incorporation or by these Bylaws directed or required to be exercised or done by the stockholders. Section 5. Place of Meetings. The Board of Directors of the corporation may hold meetings, both regular and special, either within or without the State of Delaware. The Board of Directors shall appoint from its members a Chairman of the Board of Directors who shall preside at all meetings of the stockholders and the Board of Directors. In the absence of the Chairman of the Board of Directors from a meeting of the Board of Directors, the Board of Directors shall appoint from its members, by a majority vote of all directors constituting a quorum, another director who shall preside at such meeting. The Chairman of the Board of Directors may but need not be an officer of or employed in an executive or any other capacity by the corporation. Section 6. Time of Meetings. A meeting of the Board of Directors shall be held immediately following the annual meeting of stockholders at the same place as such annual meeting or, in the alternative, at such time and place as shall be fixed by the vote of the stockholders at the annual meeting. No notice of such meeting shall be necessary, provided a quorum shall be present. In the event such meeting is not held at the time and place determined under the preceding sentence, the meeting may be held at such time and place as shall be specified in a notice given as hereinafter provided for special meetings of the Board of Directors, or as shall be specified in a written waiver signed by all of the directors. Section 7. Regular Meetings. Regular meetings of the Board of Directors may be held without notice at such time and at such place as shall from time to time be determined by the Board of Directors. Section 8. Special Meetings. Special meetings of the Board of Directors may be called by the Chairman of the Board of Directors, the President, or a majority of the directors then in office 4 (a) by written notice mailed to each director first class postage prepaid, not later than the fifth day before the meeting, or (b) by either written or oral notice given personally or by telephone or other means of electronic communication, in which case the meeting may be held as soon after such notice is given as a quorum shall be assembled at the place of the meeting or by telephone conference call, unless another time shall be specified in the notice. Section 9. Quorum. At all meetings of the Board of Directors, a majority of the directors then in office shall constitute a quorum for the transaction of business and the act of a majority of the directors present at any meeting at which there is a quorum shall be the act of the Board of Directors, except as may be otherwise specifically provided by statute, by the certificate of incorporation or by these Bylaws. If a quorum shall not be present at any meeting of the Board of Directors, the directors present thereat may adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum shall be present. Section 10. Action by Consent. Unless otherwise restricted by the certificate of incorporation or these Bylaws, any action required or permitted to be taken at any meeting of the Board of Directors or of any committee thereof may be taken without a meeting, if all members of the Board or committee, as the case may be, consent thereto in writing, and the writing or writings are filed with the minutes of proceedings of the Board or committee. Section 11. Telephone Conference Call. Unless otherwise restricted by the Certificate of Incorporation or these Bylaws, members of the board of directors, or any committee designated by the board of directors, may participate in a meeting of the board of directors, or any committee, by means of conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other, and such participation in a meeting shall constitute presence in person at the meeting. Section 12. Executive and Other Committees. The Board of Directors may, by resolution adopted by a majority of the whole Board of Directors, appoint three or more of its members to constitute an Executive Committee which to the extent provided by the Board of Directors shall have and exercise all of the authority of the Board of Directors, except as otherwise provided by law, in the management of the business and affairs of the corporation, and may authorize the seal of the corporation to be affixed to all papers which may require it. All action taken by the Executive Committee shall be reported to the Board of Directors at its first meeting thereafter. The Board of Directors may also from time to time by resolution passed by a majority of the whole Board appoint other committees, consisting of one or more members, from among its members; and such committee or committees shall have such powers and duties as the Board of Directors may from time to time prescribe. Unless otherwise provided by the Board of Directors, a majority of the members of any committee appointed by the Board of Directors pursuant to this Section 12 shall constitute a quorum at any meeting thereof and the act of a majority of the members present at a meeting at which a quorum is present shall be the act of such committee. Action may be taken by any such committee without a meeting by a writing as provided in Section 10 of this Article III. Any such committee shall, subject to any rules prescribed by the Board of Directors, prescribe its own rules for calling, giving notice of and holding meetings and its method of procedure at such meetings and shall keep a written record of all action taken by it. 5 Section 13. Minutes of Committee Meetings. Each committee shall keep regular minutes of its meetings and periodically report the same to the Board of Directors. Section 14. Compensation. The directors may be paid their expenses, if any, of attendance at each meeting of the Board of Directors and may be paid a fixed sum for attendance at each meeting of the Board of Directors or a stated salary as director or a combination thereof. No such payment shall preclude any director from serving the corporation in any other capacity and receiving compensation therefor. Members of special or standing committees may be allowed like compensation for attending committee meetings. ARTICLE IV. NOTICES Section 1. Procedure. Whenever, under the provisions of the statutes or of the certificate of incorporation or of these Bylaws, notice is required to be given to any director or stockholder, it shall not be construed to mean personal notice, but such notice may be given in writing, by mail, addressed to such director or stockholder, at his address as it appears on the records of the corporation, with postage thereon prepaid, and such notice shall be deemed to be given at the time when the same shall be deposited in the United States mail. Notice to directors may also be given as provided in Section 8 of Article III. Section 2. Waiver and Consent. Whenever any notice is required to be given under the provisions of the statutes or of the certificate of incorporation or of these Bylaws, a waiver thereof in writing, signed by the person or persons entitled to said notice, whether before or after the time stated therein, shall be deemed equivalent thereto. Notice of all stockholders' meetings, whether annual or special, shall be given in writing and may be given by the Chairman of the Board of Directors or the Secretary (or in case of their refusal, by the person or persons entitled to call meetings under the provisions of these Bylaws). The notice shall state the general nature of the business to be transacted at the meeting and the place, day and hour thereof. If such notice is mailed or telegraphed, it shall be deemed to have been given when deposited in the United States mail or with a telegraph office for transmission, as the case may be. If any meeting is adjourned to another time or place, no notice as to such adjourned meeting or of the business to be transacted thereat need be given other than by announcement at the meeting at which such adjournment is given, except as otherwise expressly provided in Section 8 of Article II. ARTICLE V. OFFICERS Section 1. General. The officers of the corporation shall be chosen by the Board of Directors and shall be a President, a Vice President, a Secretary and a Treasurer. The Board of Directors may also choose additional Vice Presidents, and one or more Assistant Secretaries and Assistant Treasurers. 6 Section 2. Election of Officers. The Board of Directors at its first meeting after each annual meeting of stockholders shall choose a President, one or more Vice Presidents, a Secretary and a Treasurer, or shall continue the incumbents in office. Section 3. Additional Officers. The Board of Directors may appoint such other officers and agents as it shall deem necessary who shall hold their offices for such terms and shall exercise such powers and perform such duties as shall be determined from time to time by the Board of Directors. Section 4. Compensation. The salaries of all officers and agents of the corporation shall be fixed by the Board of Directors or by a duly authorized committee. Section 5. Tenure. Each officer of the Corporation shall hold office until the earliest to occur of (a) his successor is elected and qualifies, (b) death or retirement of such officer, (c) resignation of such officer or (d) removal of such officer in the manner provided by these bylaws. Any officer elected or appointed by the Board of Directors may be removed at any time by the affirmative vote of a majority of the Board of Directors or, in the case of all officers except the President, by the President. Any vacancy occurring in any office of the Corporation and all newly created officer positions shall be filled by the Board of Directors. Section 6. President - Powers and Duties. The President shall be and perform the duties and responsibilities of the Chief Executive Officer of the corporation and as such shall have general supervision and control over all the affairs of the corporation, its officers and employees. The President may, but need not, be designated the Chief Operating Officer of the corporation. The President shall report to the Board of Directors regarding the affairs of the corporation and shall have such other duties and powers as may be assigned to or vested in him from time to time by the Board of Directors or by the Executive Committee and as prescribed by these Bylaws. Section 7. President - Execution of Documents. The President shall execute bonds, mortgages and other contracts requiring a seal, under the seal of the corporation, except where required or permitted by law to be otherwise signed and executed and except where the signing and execution thereof shall be delegated by the Board of Directors or the Executive Committee to some other officer or agent of the corporation. Section 8. Vice Presidents - Powers and Duties. The Vice President, or if there shall be more than one the Vice Presidents, shall perform such duties and have such powers as the Board of Directors may from time to time prescribe. Section 9. Secretary - Powers and Duties. The Secretary shall attend all meetings of the Board of Directors and all meetings of the stockholders and record or cause to be recorded all the proceedings of the meetings of the corporation and of the Board of Directors in a book to be kept for that purpose and shall perform like duties for the standing committees when required. He shall give, or cause to be given, notice of all meetings of the stockholders and special meetings of the Board of Directors, and shall perform such other duties as may be prescribed by the Board of Directors or Chairman of the Board of Directors, under whose supervision he shall be. He shall have custody of the corporate seal of the corporation, and he, or an Assistant Secretary, shall have authority to affix the same to any instrument requiring it; when so affixed, it may be attested by his signature or by 7 the signature of such Assistant Secretary. The Board of Directors may give general authority to any other officer to affix the seal of the corporation and to attest the affixing by his signature. Section 10. Assistant Secretary. The Assistant Secretary, or if there be more than one the Assistant Secretaries in the order determined by the Board of Directors, shall, in the absence or disability of the Secretary, perform the duties and exercise the powers of the Secretary and shall perform such other duties and have such other powers as the Board of Directors may from time to time prescribe. Section 11. Treasurer - Powers and Duties. The Treasurer shall have custody of the corporate funds and securities, shall together with the Controller keep full and accurate accounts of receipts and disbursements in books belonging to the corporation and shall deposit all moneys and other valuable effects in the name and to the credit of the corporation in such depositories as may be designated by the Board of Directors. Section 12. Treasurer - Disbursements and Accounting. The Treasurer and Controller shall disburse the funds of the corporation as may be ordered by the Board of Directors, and shall render to the Board of Directors, at its regular meetings, or when the Board of Directors so requires, an account of the financial condition of the corporation. Section 13. Assistant Treasurer. The Assistant Treasurer, or if there shall be more than one the Assistant Treasurers in the order determined by the Board of Directors, shall, in the absence or disability of the Treasurer, perform the duties and exercise the powers of the Treasurer and shall perform such other duties and have such other powers as the Board of Directors may from time to time prescribe. Any one or more of the duties of the Treasurer may be delegated by the Board of Directors to the Controller, an Assistant Treasurer or any other officer of the corporation. Section 14. Bonds. If required by the Board of Directors, any officer shall give the corporation a bond in such sum and with such surety or sureties as shall be satisfactory to the Board of Directors for the faithful performance of the duties of his office and for the restoration to the corporation, in case of his death, resignation, retirement or removal from office, of all books, papers, vouchers, money and other property of whatever kind in his possession or under his control belonging to the corporation. ARTICLE VI. CERTIFICATES FOR SHARES OF STOCK Section 1. Rights to Certificate. Every holder of stock in the corporation shall be entitled to have a certificate, signed by, or in the name of the corporation, by the Chairman of the Board of Directors, the President or a Vice President and the Treasurer or an Assistant Treasurer, or the Secretary or an Assistant Secretary of the corporation, certifying the number of shares of capital stock of the corporation owned by him in the corporation. Section 2. Classes of Stock - Rights. If the corporation shall be authorized to issue more than one class of stock, or more than one series of any class, the powers, designations, preferences 8 and relative, participating, optional or other special rights of each class of stock or series thereof and the qualifications, limitations or restrictions of such preferences and/or rights shall be set forth in full or summarized on the face or back of the certificate which the corporation shall issue to represent such class of stock; provided, however, that, except as otherwise provided in Section 202 of the General Corporation Law of Delaware, in lieu of the foregoing requirements there may be set forth on the face or back of the certificate which the corporation shall issue to represent such class or series of stock, a statement that the corporation will furnish without charge to each stockholder who so requests, the powers, designations, preferences and relative, participating, optional or other special rights of each class of stock or series thereof and the qualifications, limitations or restrictions of such preferences and/or rights. Section 3. Officers' Signatures. Where a certificate is signed (1) by a transfer agent or an assistant transfer agent or (2) a registrar, the signature of any such officer may be facsimile. In case any officer or officers who have signed, or whose facsimile signature or signatures have been used on, any such certificate or certificates shall cease to be such officer or officers of the corporation, whether because of death, resignation or otherwise, before such certificate or certificates have been delivered by the corporation, such certificate or certificates may nevertheless be adopted by the corporation and be issued and delivered as though the person or persons who signed such certificate or certificates or whose facsimile signature or signatures have been used thereon had not ceased to be such officer or officers of the corporation. Section 4. Lost Certificates. The Board of Directors may direct a new certificate or certificates to be issued in place of any certificate or certificates theretofore issued by the corporation alleged to have been lost or destroyed, upon the making of an affidavit of that fact by the person claiming the certificate of stock to be lost or destroyed. When authorizing such issue of a new certificate or certificates, the Board of Directors may, in its discretion and as a condition precedent to the issuance thereof, require the owner of such lost or destroyed certificate or certificates, or his legal representative, to advertise the same in such manner as it shall require and/or to give the corporation a bond in such sum as it may direct as indemnity against any claim that may be made against the corporation with respect to the certificate alleged to have been lost or destroyed. Section 5. Transfers of Stock. Upon surrender to the corporation or the transfer agent of the corporation of a certificate for shares duly endorsed or accompanied by proper evidence of succession, assignment or authority to transfer, in each case with signatures guaranteed, it shall be the duty of the corporation to issue a new certificate to the person entitled thereto, cancel the old certificate and record the transaction upon its books. Section 6. Fixing of Record Date. The Board of Directors shall fix in advance a date, not less than ten nor more than sixty days preceding the date of any meeting of stockholders, or the date for the payment of any dividend, or the date for the allotment of rights, or the date when any change or conversion or exchange of capital stock shall go into effect, or a date in connection with obtaining a consent, as a record date for the determination of the stockholders entitled to notice of, and to vote at, any such meeting, and any adjournment thereof, or entitled to receive payment of any such dividend, or to any such allotment of rights, or to exercise the rights in respect of any such change, conversion or exchange of capital stock, or to give such consent, and in such case such stockholders as shall be stockholders of record on the date so fixed shall be entitled to such notice of, and to vote 9 at, such meeting and any adjournment thereof, or to receive payment of such dividend, or to receive such allotment of rights, or to exercise such rights, or to give such consent, as the case may be, notwithstanding any transfer of any stock on the books of the corporation after any such record date fixed as aforesaid. Section 7. Registered Stockholders. The corporation shall be entitled to recognize the exclusive right of a person registered on its books as the owner of shares to receive dividends, and to vote as such owner, and to hold liable for calls and assessments a person registered on its books as the owner of shares, and shall not be bound to recognize any equitable or other claim to or interest in such share or shares on the part of any other person, whether or not it shall have express or other notice thereof, except as otherwise provided by the laws of Delaware. ARTICLE VII. INDEMNIFICATION Section 1. Actions Not By or In the Right of the Corporation. The corporation shall indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (other than an action by or in the right of the corporation) by reason of the fact that he is or was a director, officer or employee of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him in connection with such action, suit or proceeding if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful. The termination of any action, suit or proceeding by judgment, order, settlement, conviction, or upon a plea of nolo contendere or its equivalent, shall not, of itself, create a presumption that the person did not act in good faith and in a manner which he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had reasonable cause to believe that his conduct was unlawful. Section 2. Actions By or In the Right of the Corporation. The corporation shall indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action or suit by or in the right of the corporation to procure a judgment in its favor by reason of the fact that he is or was a director, officer or employee of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including attorneys' fees) actually and reasonably incurred by him in connection with the defense or settlement of such action or suit if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation and except that no indemnification shall be made in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable to the corporation unless and only to the extent that the Court of Chancery or the court in which such action or suit was brought shall determine upon application that, despite the adjudication of liability 10 but in view of all the circumstances of the case, such person is fairly and reasonably entitled to indemnity for such expenses which the Court of Chancery or such other court shall deem proper. Section 3. Indemnification Where Director or Officer Successfully Defends Action. To the extent that a director, officer or employee of the corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding referred to in Sections 1 and 2 of this Article VII, or in defense of any claim, issue or matter therein, he shall be indemnified against expenses (including attorneys' fees) actually and reasonably incurred by him in connection therewith. Section 4. Determinations Required Prior to Indemnification. Except as provided in Section 3 of this Article VII and except as may be ordered by a court, any indemnification under Sections 1 and 2 of this Article VII shall be made by the corporation only as authorized in the specific case upon a determination that indemnification of the director, officer or employee is proper in the circumstances because he has met the applicable standard of conduct set forth in Sections 1 and 2 of this Article VII, as the case may be. Such determination shall be made (1) by a majority vote of the directors who were not parties to such action, suit or proceeding, even though less than a quorum; or (2) if there are no such directors, or if such directors so direct, by independent legal counsel in a written opinion; or (3) by the stockholders. Section 5. Advances. Expenses (including attorney's fees) incurred by an officer or director in defending any civil, criminal, administrative, or investigative action, suit or proceeding shall be paid by the corporation in advance of the final disposition of such action, suit or proceeding upon receipt of an undertaking by or on behalf of the director or officer to repay such amount if it shall ultimately be determined that he is not entitled to be indemnified by the corporation as authorized in this Article. Such expenses (including attorney's fees) incurred by other employees may be so paid upon such terms and conditions, if any, as the Board of Directors deems appropriate. Section 6. General. The indemnification and advancement of expenses provided by or granted pursuant to these Bylaws shall not be deemed exclusive of any other rights to which those seeking indemnification or advancement of expenses may be or shall become entitled under any agreement, vote of stockholders or disinterested directors or otherwise, both as to actions in an official capacity and as to actions in another capacity while holding such office. Section 7. Insurance. The corporation may purchase and maintain insurance on behalf of any person who is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise against any liability asserted against him and incurred by him in any such capacity, or arising out of his status as such, whether or not the corporation would have the power to indemnify him against such liabilities under the certificate of incorporation, the provisions of these Bylaws or under the provisions of the General Corporation Law of the State of Delaware. Section 8. The Corporation. For purposes of this Article VII, references to "the corporation" shall include, in addition to the resulting corporation, any constituent corporation (including any constituent of a constituent) absorbed in a consolidation or merger which, if its separate existence had continued, would have had the power and authority to indemnify its directors, officers and 11 employees, so that any person who is or was a director, officer or employee of such constituent corporation, or is or was serving at the request of such constituent corporation as a director, officer or employee of another corporation, partnership, joint venture, trust or other enterprise, shall stand in the same position under the provisions of this Article VII with respect to the resulting or surviving corporation as he would have with respect to such constituent corporation if its separate existence had continued. Section 9. Employee Benefit Plans. For purposes of this Article VII, references to "other enterprises" shall include employee benefit plans; the reference to "fines" shall include any excise taxes assessed on a person with respect to an employee benefit plan; and references to "serving at the request of the corporation" shall include any service as a director, officer, employee or agent of the corporation which imposes duties on, or involves services by, such director, officer or employee with respect to an employee benefit plan, its participants or beneficiaries; and a person who acted in good faith and in a manner he reasonably believed to be in the interest of the participants and beneficiaries of an employee benefit plan shall be deemed to have acted in a manner "not opposed to the best interests of the corporation" as referred to in this Article VII. Section 10. Continuation. The indemnification and advancement of expenses provided by, or granted pursuant to, these Bylaws shall continue as to a person who has ceased to be a director, officer or employee and shall inure to the benefit of the heirs, executors and administrators of such a person. Section 11. Future Amendments. In the event of any amendment or addition to ss. 145 of the General Corporation Law of the State of Delaware or the addition of any other section of such law with regard to indemnification, the corporation shall indemnify to the fullest extent authorized or permitted by such then-existing General Corporation Law of the State of Delaware, as amended, any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (including an action by or in the right of the corporation), by reason of the fact that he is or was a director, officer or employee of the corporation or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust, or other enterprise against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him in connection with such action, suit or proceeding. ARTICLE VIII. GENERAL PROVISIONS Section 1. Dividends. Dividends upon the capital stock of the corporation, subject to the provisions of the certificate of incorporation, if any, may be declared by the Board of Directors at any regular or special meeting, pursuant to law. Dividends may be paid in cash, in property, or in shares of the capital stock, subject to the provisions of the certificate of incorporation. Section 2. Reserves. Before payment of any dividend, there may be set aside out of any funds of the corporation available for dividends such sum or sums as the Board of Directors from 12 time to time, in their absolute discretion, think proper as a reserve or reserves to meet contingencies, or for equalizing dividends, or for repairing or maintaining any property of the corporation, or for such other purpose as the Board of Directors shall think conducive to the interest of the corporation, and the Board of Directors may modify or abolish any such reserve in the manner in which it was created. Section 3. Annual Statement. The Board of Directors shall present at each annual meeting, and at any special meeting, of the stockholders when called for by vote of the stockholders a concise statement of the business and condition of the corporation. Section 4. Checks. All checks or demands for money and notes of the corporation shall be signed by such officer or officers or such other person or persons as the Board of Directors may from time to time designate. Section 5. Fiscal Year. The fiscal year of the corporation shall be determined by the Board of Directors, and shall be from October 1 through September 30, unless otherwise determined by the Board of Directors. Section 6. Seal. The corporate seal shall be in the form prescribed by the Board of Directors. The seal may be used by causing it or a facsimile thereof to be impressed or affixed or reproduced or otherwise. Section 7. Miscellaneous. Unless otherwise ordered by the Board of Directors, the President, any Vice President, the Secretary, any Assistant Secretary or the Treasurer in person or by proxy appointed by any of them shall have full power and authority on behalf of the corporation to vote, act and consent with respect to any shares of stock issued by other corporations which the corporation may own or as to which the corporation has the right to vote, act or consent. ARTICLE IX. AMENDMENTS These Bylaws may be altered or repealed at any regular meeting of the stockholders or of the Board of Directors or at any special meeting of the stockholders or of the Board of Directors if such notice of such alteration or repeal be contained in the notice of such special meeting. No Bylaw adopted by vote of the stockholders shall be subject to amendment by the Board of Directors if such Bylaw so provides. Notwithstanding the foregoing, neither Sections 5 nor 12 of Article II may be amended, altered, changed or repealed except by the affirmative vote of the holders of at least seventy-five percent (75%) of the issued and outstanding shares of capital stock of the Corporation entitled to vote thereon cast at a meeting of the stockholders called for that purpose. 13 EX-10.S 4 EXHIBIT 10(S) Exhibit 10(s) PLAN OBJECTIVES The primary objective of the Green Spring annual incentive program is to foster our overall compensation philosophy of paying for performance. The Plan helps prioritize and focus employees' efforts on the accomplishment of various goals established through the annual planning and budget process. This is achieved by linking a significant element of variable cash compensation to the accomplishment of these specified goals. While base salaries are targeted to be merely at 50% of market, at targeted performance levels, the Plan provides incentive compensative opportunities which, in combination with base salary, will yield total annual compensation that is very competitive.. ELIGIBILITY CRITERIA All regular non-clinical employees, except commissioned sales, Maryland clinical and temporary employees are eligible. While employees will be immediately eligible upon employment, it will be up to senior management to determine whether employees hired after June 30th have contributed enough to merit an annual incentive. In order to receive an incentive award, an employee must be employed by the company at the time of pay out. The one exception to this is an employee who is separated from employment due to the eliminated of his/her position and had worked at least nine months during the calendar year for which incentives are being paid. PERFORMANCE GOALS Incentive award pay outs will be tied to the accomplishment of goals and objectives. These goals will be established and communicated to employees at the beginning of each year. Each goal should be weighted according to its relative importance and priority, and the degree to which the employee can influence its accomplishment. Each goal will have performance standards tied to target (100%) and maximum (150%) award levels. FUNDING Funds for the pay-out of incentives shall be accrued for each unit based upon financial performance. The national pool shall be established based upon National's financial results [Earning Before Taxes - EBT] versus target. Individual state pools shall be established based 50% upon their financial performance versus targeted contribution margin and 50% based upon National's financial results [Earnings Before Taxes - EBT] versus target. The rate the pools shall increase will be 2% for every 1% above target. The funding pools may grow up to 150% of target. No funding will be established unless at least 80% of the goal is met (threshold funding). TARGET INCENTIVE LEVELS The following are the target incentive levels assuming target performance and target funding:
GRADE PERCENTAGE - ----- ---------- 1- 9 2% 11 - 16 3% 17 8% 18 10% 19 12% 20 15% 21-23* 20% 23* 25 - 30% 24* 30% 24 30% 25 30% 26+ 35%
The amounts are established as a percentage of midpoint for the grade and not the employee's actual salary. Individual pay outs may increase by 50% based upon performance versus established goals (see Performance Goals) and increase by 50% again based upon financial results (see Funding). PLAN ADMINISTRATION, MODIFICATION AND ADJUSTMENT The Plan will be administered by Green Spring's CEO and Board of Directors. The CEO and Board will approve award levels for Plan participants, as recommended by managers, and be responsible for changes in plan design, participation, and other aspects of Plan administration. OTHER CONDITIONS This Plan and the applicable Incentive Schedules do not constitute either an express or implied contract of employment. At their discretion, the CEO and Board reserves the right to amend, change, interpret, replace and/or terminate this Plan and the individual incentive opportunities at any time. EX-10.AH 5 EXHIBIT 10(AH) Exhibit 10(ah) AGREEMENT AND PLAN OF MERGER THIS AGREEMENT AND PLAN OF MERGER (this "Agreement") is entered into as of July 14, 1997, by and among Merit Behavioral Care Corporation, a Delaware corporation ("Parent"), Merit Merger Corp., a Delaware corporation and a wholly owned subsidiary of Parent ("Merger Sub"), and CMG Health, Inc., a Maryland corporation (the "Company"). W I T N E S S E T H: WHEREAS, the respective Boards of Directors of Parent, Merger Sub and the Company each have determined that it is in the best interests of their respective stockholders for Merger Sub to merge with and into the Company upon the terms and subject to the conditions of this Agreement (the "Merger"), and such Boards of Directors have approved such Merger, pursuant to which each share of common stock, par value $.00333 per share, of the Company ("Company Common Stock") issued and outstanding immediately prior to the Effective Time of the Merger, and each share of preferred stock, par value $.00333 per share, of the Company ("Company Preferred Stock") issued and outstanding immediately prior to the Effective Time, will be converted into the right to receive the consideration set forth in Article III hereof; WHEREAS, concurrently with the execution of this Agreement, and as an inducement to Parent to enter into this Agreement, certain stockholders of the Company have entered into Stockholder Support Agreements (the "Stockholder Support Agreements") with the Company and Parent, pursuant to which such stockholders have, among other things, represented that they will vote all voting securities of the Company beneficially owned by them in favor of approval and adoption of this Agreement and the transactions contemplated hereby and, further, that they agree, among other things, to take any further actions as stockholders as may be required to approve this Agreement and the transactions contemplated hereby; and WHEREAS, each of Parent, Merger Sub and the Company desires to make certain representations, warranties, covenants and agreements in connection with the Merger and to prescribe various conditions to the Merger. NOW, THEREFORE, in consideration of the foregoing, and the mutual representations, warranties, covenants and agreements contained herein, the parties hereto do hereby agree as follows: ARTICLE I. THE MERGER 1.1. The Merger. Subject to the terms and conditions set forth in this Agreement, and in accordance with the Maryland General Corporation Law (the "MGCL") and the General Corporation Law of the State of Delaware (the "DGCL"), Merger Sub shall be merged with and into the Company at the Effective Time. As provided in and subject to Section 1.4 hereof, following the Effective Time, the separate corporate existence of Merger Sub shall cease and the Company shall continue as the surviving corporation (the "Surviving Corporation") and shall succeed to and assume all the rights and obligations of Merger Sub and the Company in accordance with the MGCL. The Merger shall have the effect set forth in Section 3-114 of the MGCL and Section 252 of the DGCL. 1.2. The Closing. (a) The closing of the Merger (the "Closing") will take place at 10:00 a.m. Eastern Time as soon as practicable following the satisfaction or waiver of all of the conditions set forth in Article XII hereof (the "Closing Date"), at the offices of Latham & Watkins, New York, New York, unless another date or place is agreed to in writing by the parties hereto. (b) At the Closing, the Company shall deliver or cause to be delivered to Parent the following: (i) Officers' Certificate. (A) The certificate required to be delivered by the Chief Executive Officer of the Company pursuant to Section 12.2(q) and (B) the certificate required to be delivered by the Chief Financial Officer of the Company pursuant to Section 12.2(r). (ii) Certificates of Good Standing. (A) A certificate of good standing for the Company from the State Department of Assessments and Taxation of the State of Maryland; and (B) certificates of good standing (or equivalent certification) for each of the entities listed in Sections 4.2(a) and 4.2(b) of the Company Disclosure Schedule from their respective states of formation. (iii) Secretary's Certificate. A certificate, executed by the Secretary of the Company, dated as of the Closing Date, which certifies the continued effectiveness without modification since the date hereof of resolutions adopted by the members of the Board of Directors of the Company duly authorizing the execution, delivery and performance of this Agreement, the other agreements referred to herein and the transactions contemplated hereby and thereby, the continued effectiveness without modification since the date hereof of resolutions adopted by the stockholders of the Company duly approving the Merger, and such other matters as may be reasonably requested by Parent. (iv) Opinions of Counsel. (A) Opinions of Skadden, Arps, Slate, Meagher & Flom (Illinois), counsel to the Company, dated the Closing Date, addressing the matters set forth on Exhibit 1.2(b)(iv)(A). (B) An opinion of Jill B. Reamer, Esq., Vice President of Mergers and Acquisitions and General Counsel of the Company, dated the Closing Date, addressing the matters set forth on Exhibit 1.2(b)(iv)(B). (v) Director Resignations. Resignations of all members of the Board of Directors of the Company and each Company Subsidiary, effective as of the Closing. (vi) Stockholders Agreement. An agreement entered into by and among the ACR Beneficiaries, certain stockholders of Parent and Parent, effective as of the Closing Date (the "Stockholders Agreement"), which Stockholders Agreement shall be substantially in the form attached as Exhibit 1.2(b)(vi) hereto, fully executed by such holders. (vii) Escrow Agreement. An escrow agreement, dated as the Closing Date (the "Escrow Agreement"), by and between the ACR Representative and NationsBank, N.A., as escrow agent (the "Escrow Agent"), which Escrow Agreement shall be substantially in the form of Exhibit 1.2(d)(vii) hereto, fully executed by the parties thereto. (c) At the Closing, Parent shall deliver or cause to be delivered to those holders of the Exchanging Company Shares who have complied with Section 3.3 the Merger Consideration set forth in clause (i) of Section 3.1(b) in immediately available funds. (d) At the Closing, Parent shall deliver or caused to be delivered to the Company the following: (i) Officers' Certificates. The certificates required to be delivered by the Chief Executive Officers of Parent and Merger Sub pursuant to Section 12.3(f). (ii) Certificate of Good Standing. Certificates of good standing for Parent and Merger Sub from the Secretary of State of the State of Delaware. (iii) Secretaries' Certificates. Certificates, executed by the Secretaries of Parent and Merger Sub, dated as of the Closing Date, which certify the continued effectiveness without modification since the date hereof of the resolutions adopted by the directors of Parent and Merger Sub, respectively, duly authorizing the execution, delivery and performance of this Agreement, the other agreements referred to herein and the transactions contemplated hereby and thereby, and such other matters as may be reasonably requested by the Company. (iv) Stockholders Agreement. The Stockholders Agreement, fully executed by Parent and those stockholders of Parent that are a party thereto. (v) Opinion of Counsel. An opinion of Richards, Layton & Finger, special Delaware counsel to Parent, dated the Closing Date, addressing the matters set forth on Exhibit 1.2(d)(v). (vi) Opinion of General Counsel. An opinion of Michael G. Lenahan, Esq., Executive Vice President -- Mergers & Acquisitions and General Counsel of Parent, dated the Closing Date, addressing the matters set forth on Exhibit 1.2(d)(vi). 1.3. Effective Time. Subject to the provisions of this Agreement, the parties shall file (i) articles of merger (the "Maryland Articles of Merger") executed in accordance with the relevant provisions of the MGCL and (ii) a certificate of merger (the "Delaware Certificate of Merger") executed in accordance with the relevant provisions of the DGCL and shall make all other filings or recordings required under the MGCL and the DGCL on the Closing Date. The Merger shall become effective at the latest of such time as (i) the Maryland Articles of Merger are duly filed with the State Department of Assessments and Taxation of the State of Maryland, (ii) the Delaware Certificate of Merger is filed with the Secretary of State of the State of Delaware, or (iii) at such other time as the Company and Parent shall agree should be specified in the Maryland Articles of Merger and the Delaware Certificate of Merger (the "Effective Time"). 1.4. Effect of the Merger. When the Merger has been effected, the separate existence of Merger Sub shall cease, the Surviving Corporation shall have all of the rights, privileges, immunities and powers and shall be subject to all the duties and liabilities of a corporation organized under Maryland law, the Surviving Corporation shall thereupon and thereafter possess all the rights, privileges, immunities and franchises of a public as well as of a private nature of Merger Sub and the Company (together, the "Constituent Corporations"); all property, real, personal and mixed, and all debts due on whatever account, including subscriptions to shares and all other choses in action, and all and every other interest, of or belonging to or due each of the Constituent Corporations, shall be taken and deemed to be transferred to and vested in the Surviving Corporation without further act or deed. The Surviving Corporation shall thenceforth be responsible and liable for all liabilities and obligations of each of the Constituent Corporations so merged; and any claim existing or action or proceeding pending by or against either of the Constituent Corporations may be prosecuted as if the Merger had not taken place, or the Surviving Corporation may be substituted in its place. Neither the rights of creditors nor any liens upon the respective properties of the Constituent Corporations and the Surviving Corporation shall be impaired by the Merger, all with the effect set forth in the MGCL and the DGCL. ARTICLE II. CHARTER, BYLAWS, DIRECTORS AND OFFICERS OF THE SURVIVING CORPORATION 2.1. Charter of the Surviving Corporation. The charter of the Company, as in effect immediately prior to the Effective Time, shall be the charter of the Surviving Corporation from and after the Effective Time and until thereafter amended as provided by law. 2.2. Bylaws of the Surviving Corporation. The Bylaws of the Company as in effect immediately prior to the Effective Time, shall be the Bylaws of the Surviving Corporation from and after the Effective Time and until thereafter altered, amended or repealed in accordance with the laws of the State of Maryland, the charter of the Company and the said Bylaws. 2.3. Directors of the Surviving Corporation. The Board of Directors of the Surviving Corporation shall be comprised of the directors of Merger Sub immediately prior to the Effective Time until their respective successors are duly elected and qualified. The Company shall cause each member of its Board of Directors and of its subsidiaries, and each other member of the Board of Directors of a Group Entity which is identified by Parent in writing prior to the Effective Time, to tender his or her resignation prior to the Effective Time, each such resignation to be effective as of the Effective Time. 2.4. Officers of the Surviving Corporation. The officers of the Company immediately prior to the Effective Time shall be the officers of the Surviving Corporation until their respective successors are duly elected and qualified. ARTICLE III. EFFECT OF THE MERGER ON CAPITAL STOCK 3.1. Effect on Capital Stock. As of the Effective Time, by virtue of the Merger and without any action on the part of any holder of any shares of Company Common Stock or Company Preferred Stock or any holder of shares of capital stock of Merger Sub: (a) Capital Stock of Merger Sub. Each issued and outstanding share of capital stock of Merger Sub shall be converted into and become one fully paid and nonassessable share of common stock, par value $.00333 per share, of the Surviving Corporation. (b) Conversion of the Company Common Stock. Each issued and outstanding share of Company Common Stock shall be converted into the right to receive, subject to any applicable withholding taxes, the following (collectively, the "Merger Consideration"): (i) a cash amount equal to the Cash Price (as calculated below, subject to recalculation pursuant to the terms of Section 3.3.1); and (ii) provided that the holder of such share of Company Common Stock is a party to the Stockholders Agreement, one (1) right to the additional consideration set forth in Section 3.7 (each, an "Additional Consideration Right"); each holder of an Additional Consideration Right being deemed herein an "ACR Beneficiary." As used herein, the "Cash Price" shall be calculated as follows: Cash Price = [$51,500,000 +.5 (AEPUO) + AEPFO + AEPVO - .5 (ADJ) - EA - EX] M246 [.5 (UO) + CS + VO + FO] The abbreviations used in the formula above shall have the following meanings: ADJ shall be the amount designated as the "Adjustment Amount" on Exhibit 3.1(b). AEPFO shall be an amount equal to the aggregate exercise prices of all Frozen Options. AEPUO shall be an amount equal to the aggregate exercise prices of all Unvested Options. AEPVO shall be an amount equal to the aggregate exercise prices of all Vested Options. CS shall be the number of outstanding shares of Company Common Stock immediately prior to the Effective Time, deeming the Company Preferred Stock to have been converted into Company Common Stock at a conversion rate of one share of Company Common Stock for each share of Company Preferred Stock. EA shall be an amount equal to $60,000 (the "Escrow Amount"), which shall represent the amount deposited into the Escrow Account pursuant to Section 10.6 hereof. EX shall be the amount designated as the "Excess Amount" on Exhibit 3.1(b). FO shall be the number of shares of Company Common Stock for which Stock Options issued under the 1996 Option Plan which are not vested immediately prior to or at the Effective Time but which, for a period of twelve months after the Effective Time, are subject to vesting upon the happening of certain events in accordance with the terms of the agreements and instruments governing such Stock Options (each, a "Frozen Option"). UO shall be the number of shares of Company Common Stock for which Stock Options were granted in 1995 under the 1994 Option Plan which are not vested immediately prior to the Effective Time but which, upon the Effective Time, consistent with the terms of the agreements and instruments governing such Stock Options, have been vested by action of the Board of Directors of the Company and, in accordance with Section 3.2 hereof, converted into the right to receive the Merger Consideration (each, an "Unvested Option"). VO shall be the number of shares of Company Common Stock for which Stock Options which are either (i) vested immediately prior to the Effective Time (without giving effect to the Merger or the Stockholder Support Agreements) or (ii) vested at the Effective Time pursuant to the terms of the 1996 Option Plan (each, a "Vested Option"). (c) Conversion of the Company Preferred Stock. Each issued and outstanding share of Company Preferred Stock shall be converted into the right to receive the Merger Consideration such holder would have received if such holder had converted its shares of Company Preferred Stock into Company Common Stock immediately prior to the Effective Time. The conversion rate of the Company Preferred Stock is and shall be one share of Company Common Stock for each share of Company Preferred Stock. (d) Status of the Shares. As of the Effective Time, all shares of Company Common Stock and Company Preferred Stock shall no longer be outstanding and shall automatically be canceled and retired and shall cease to exist, and each holder of a certificate representing any Company Common Stock or Company Preferred Stock (collectively, "Exchanging Company Shares") shall cease to have any rights with respect thereto, except the right to receive the Merger Consideration to be paid in consideration therefor upon surrender of such certificate in accordance with Section 3.3, without interest. (e) Dissenters' Rights. Notwithstanding any provision of this Agreement to the contrary, and subject to the provisions of the Stockholder Support Agreements, any Exchanging Company Shares outstanding immediately prior to the Effective Time held by a holder who has complied with the provisions of Sections 3-203(a)(1)(ii) and 3-203(a)(2) of the MGCL and as of the Effective Time has not withdrawn or forfeited such right to such appraisal shall not be converted into or represent a right to receive the Merger Consideration, but the holder thereof shall only be entitled to such rights as are granted by the MGCL. If a holder of Exchanging Company Shares who demands appraisal of those Exchanging Company Shares under the MGCL shall effectively withdraw or forfeit (through failure to perfect or otherwise) the right to appraisal, then, as of the Effective Time or the occurrence of such event, whichever last occurs, those Exchanging Company Shares shall be converted into and represent only the right to receive the Merger Consideration as provided in Section 3.1(b)(i), without interest, upon the surrender of the certificate or certificates representing those Exchanging Company Shares. The Company shall give Parent (i) prompt notice of any written demands for appraisal of any Exchanging Company Shares, attempted withdrawals of such demands, and any other instruments served pursuant to the MGCL received by the Company relating to stockholders' rights of appraisal and (ii) the opportunity to direct all negotiations and proceedings with respect to demands for appraisal under the MGCL. The Company shall not, except with the prior written consent of Parent, voluntarily make any payment with respect to any demands for appraisals of capital stock of the Company, offer to settle or settle any such demands or approve any withdrawal of any such demands. (f) Calculation of Cash Price. On the business day immediately preceding the Closing Date, the Company's Chief Financial Officer shall deliver to Parent a true, correct and complete statement of each of the items set forth in the definition of Cash Price. (g) Equity Rights. As used in this Agreement, "Equity Rights" shall mean any options, warrants, rights of conversion (including under the Company Preferred Stock) or agreements, arrangements or commitments (whether or not in writing) obligating the Company (with or without consideration and whether or not presently exercisable or convertible) to issue or sell shares of its capital stock. 3.2. Stock Options. (a) The Board of Directors of the Company (or the proper committee thereof), by amendment of the appropriate Stock Option plan or by resolution of the Board of Directors, as may be appropriate, shall cause, immediately prior to the Effective Time, each unvested Stock Option (other than Frozen Options), which is outstanding immediately prior to the Effective Time, without any action on the part of the holder thereof, to become fully vested (in the case of all outstanding Stock Options granted under the 1992 Option Plan, the 1994 Option Plan and the 1995 Option Plan and those Stock Options granted under the 1996 Option Plan and listed in Attachment 4.4(2) of the Company Disclosure Schedule in the columns headed "1996 Options" - "10%" or "COC") or canceled (in the case of Stock Options granted under the 1996 Option Plan, which are not Frozen Options and which are not referred to in the immediately preceding parenthetical) pursuant to the terms thereof, and if vested, converted (along with each otherwise Vested Option outstanding immediately prior to the Effective Time) into the right to receive, less applicable withholding taxes and without interest, (A) cash in an amount equal to the difference (if positive) between (x) the Cash Price and (y) the exercise price of such option, provided, if the difference between (x) the Cash Price and (y) the exercise price of such option is zero or less, such option shall, immediately prior to the Effective Time, and without any action on the part of the holder thereof, be canceled and no consideration shall be issued in exchange therefor; and (B) if the holder of such Stock Option becomes a party to the Stockholders Agreement, in respect of each share of Company Common Stock which such holder had the right to acquire at an exercise price per share of Company Common Stock which is less than the Cash Price, one Additional Consideration Right. The Company shall pay amounts due to the holders of Stock Options under this Section 3.2(a) immediately prior to the Effective Time. As used herein, "Stock Option" shall mean stock options issued pursuant to the CMG Health, Inc. Stock Option Plan, dated July 1, 1992 (the "1992 Option Plan"), the CMG Health, Inc. Non-Qualified Stock Option Plan, dated July 1, 1994 (the "1994 Option Plan"), the CMG Health, Inc. Non-Qualified Non-Employee Director's Stock Option Plan, dated February 1, 1995 (the "1995 Option Plan"), and the Performance Equity Incentive Plan, amended and restated as of November 1, 1996 (the "1996 Option Plan"). (b) If at any time during the twelve month period beginning at the Effective Time, a Frozen Option shall have its vesting accelerated pursuant to the terms of the 1996 Option Plan, such Frozen Option shall be converted, as of the date of the event effecting such acceleration, into the right to receive, less applicable withholding taxes and without interest, (A) cash in an amount equal to the difference (if positive) between (x) the Cash Price and (y) the exercise price of such Frozen Option, provided, if the difference between (x) the Cash Price and (y) the exercise price of such Frozen Option is zero or less, such Frozen Option shall, without any action on the part of the holder thereof, be canceled and no consideration shall be issued in exchange therefor; and (B) if the holder of such Frozen Option becomes a party to the Stockholders Agreement, in respect of each share of Company Common Stock which such holder had the right to acquire at an exercise price per share of Company Common Stock which is less than the Cash Price, one Additional Consideration Right. The Surviving Corporation shall pay amounts due to the each holder of Frozen Options under this Section 3.2(b) within five (5) business days following the receipt by the Surviving Corporation of an agreement, fully executed by such holder, releasing the Surviving Corporation from any and all liabilities and obligations to such holder arising under the 1996 Option Plan and providing that the consideration to be paid such holder pursuant to this Section 3.2(b) constitutes full and complete payment in respect of such holder's Frozen Options. 3.3. Exchange of Certificates; Procedures. (a) Immediately following the Effective Time, each record holder of any certificate or certificates which, immediately prior to the Effective Time, represented outstanding Exchanging Company Shares (the "Certificates") whose Exchanging Company Shares were converted into the right to receive a portion of the Merger Consideration shall be entitled to surrender its Certificates to Parent for cancellation in exchange for the Merger Consideration and, subject to receipt of such certifications as Parent may reasonably request, Parent hereby agrees to cause such Merger Consideration to be paid to such person at such time; provided, however, the rights represented by the Additional Consideration Rights shall be uncertificated and be evidenced only by Section 3.7 hereof. The Litigation Shares shall be issued to the ACR Beneficiaries at the Effective Time, in the amounts and subject to the provisions set forth in Section 3.7(c) hereof, and shall be delivered at the time and in the manner set forth in the preceding sentence with respect to the right to receive Merger Consideration generally. If any stockholder shall fail to surrender its Certificates promptly following the Effective Time, Parent shall send to such stockholder notice of the Merger and instructions for use in effecting the surrender of the Certificates in exchange for the stockholder's pro rata share of the Merger Consideration and the holder of such Certificates shall be entitled to receive in exchange therefor solely the stockholder's pro rata share of the Merger Consideration less any applicable stock transfer taxes (whether imposed on such stockholder or on Parent) and such Certificates shall forthwith be canceled. No interest shall be paid or accrued for the benefit of holders of the Certificates on the consideration payable upon the surrender of the Certificates. It shall be a condition of payment that the Certificate so surrendered shall be properly endorsed or otherwise be in proper form for transfer. Notwithstanding the foregoing, no party hereto shall be liable to a holder of Exchanging Company Shares for any cash or interest delivered to a public official pursuant to applicable abandoned property, escheat or similar laws. If any Certificates shall not have been surrendered prior to two years after the Effective Time (or immediately prior to such earlier date on which any payment in respect hereof would otherwise escheat to or become the property of any governmental unit or agency), the payment in respect of such Certificates shall, to the extent permitted by applicable Law, become the property of the Surviving Corporation, free and clear of all claims of interest of any person previously entitled thereto and any holders of Certificates who have not theretofore complied with this Article III shall thereafter look only to the Surviving Corporation for the Merger Consideration with respect to the Exchanging Company Shares formerly represented thereby to which such holders are entitled pursuant to this Article III. (b) From and after the Effective Time, there shall be no transfers on the share transfer books of the Surviving Corporation of the Exchanging Company Shares which were outstanding immediately prior to the Effective Time. If, after the Effective Time, Certificates are presented to the Surviving Corporation for payment, they shall be canceled and exchanged for the Merger Consideration in accordance with the procedures set forth in this Section 3.3 and Section 3.1. 3.3.1. Recalculation of Cash Price. Upon the twelve month anniversary of the Effective Time, the Cash Price shall be recalculated, treating as never having been outstanding each Frozen Option that has subsequently been terminated or cancelled without consideration in accordance with its terms, and any portion of the Cash Price not previously distributed by the Surviving Corporation which would, based upon such recalculation, have been originally due in respect of Vested Options and Unvested Options (pursuant to Section 3.2) and Exchanging Company Shares (pursuant to Section 3.3), shall be distributed (without interest and subject to applicable withholding taxes) promptly by the Surviving Corporation in respect of (i) each such Stock Option and (ii) each Exchanging Company Share entitled to receive Merger Consideration pursuant to the terms hereof. 3.4. No Further Rights in Exchanging Company Shares. All Merger Consideration received by any stockholder pursuant to this Agreement shall be deemed to have been delivered and received in full satisfaction of all rights pertaining to such stockholder's Exchanging Company Shares. At the Effective Time, the holders of Certificates shall cease to have any rights with respect to such shares (other than such rights as they may have as dissenting stockholders under the MGCL), and their sole right shall be to receive the Merger Consideration. Dissenting stockholders shall have the rights accorded by the MGCL. 3.5. Lost Certificates. Notwithstanding the provisions of Section 3.3, in the event any Certificate which immediately prior to the Effective Time represented outstanding Exchanging Company Shares has been lost, stolen or destroyed (a "Lost Certificate"), upon the making of an affidavit of that fact by the person claiming such Lost Certificate to be lost, stolen or destroyed and an agreement to indemnify Parent against any claim that may be made against it with respect to such Certificate, Parent will deliver the Merger Consideration to which the Exchanging Company Shares were entitled in respect of such Lost Certificate. 3.6. Withholding Rights. Parent shall be entitled to deduct and withhold from the Merger Consideration or Additional Consideration Rights otherwise payable pursuant to this Agreement to any holder of Exchanging Company Shares or any Stock Options such amounts as Parent is required to deduct and withhold with respect to the making of such payment under the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder (the "IRC"), or any provisions of state, local or foreign tax law. To the extent that amounts are so withheld by Parent, such withheld amounts shall be treated for all purposes of this Agreement as having been paid to the holder of the Exchanging Company Shares in respect of which such deduction and withholding was made. 3.7. Additional Consideration Rights. (a) General. Each Additional Consideration Right shall represent only a right to receive: (i) a cash payment (the "CHAMPUS Earn-Out Payment") from Parent, as provided and subject to the terms set forth in Section 3.7(b). (ii) a pro rata portion of 750,000 shares (the "Litigation Condition Shares") of common stock, par value $.01 per share, of Parent ("Parent Common Stock"), as provided and subject to the terms set forth in Section 3.7(c); (iii) a pro rata portion of up to 750,000 shares of Parent Common Stock (the "CHAMPUS Condition Shares" and together with the Litigation Condition Shares, the "Parent Shares"), as provided and subject to the terms set forth in Section 3.7(d); (iv) a cash payment (the "State Earn-Out Payment") from Parent, as provided and subject to the terms set forth in Section 3.7(e); (v) the pro rata right to receive amounts on deposit in the Escrow Account, pursuant to the terms of the Escrow Agreement; and (vi) a cash payment, as provided and subject to the terms set forth in Section 3.7(k). (b) CHAMPUS Earn-Out Payment. (i) The amount of any CHAMPUS Earn-Out Payment payable with respect to each Additional Consideration Right shall be equal to the aggregate CHAMPUS Earn-Out Payment payable, calculated as provided on Exhibit 3.7(b), divided by the total number of Additional Consideration Rights outstanding (the "ACR Denominator") as of the third business day prior to the date an Earn-Out Statement is first sent to the ACR Beneficiaries; provided, however, that if the Earn-Out Payment Date occurs prior to the twelve month anniversary of the Effective Time, (A) the ACR Denominator shall be adjusted for purposes of calculating the amount of the CHAMPUS Earn-Out Payment payable to each ACR Beneficiary pursuant to this Section 3.7(b) by adding an amount equal to "FO" (as used in the definition of Cash Price) to the ACR Denominator, and (B) if at any time from and after the Earn-Out Payment Date, a Frozen Option shall have its vesting accelerated pursuant to the terms of the 1996 Option Plan, such Frozen Option shall be converted into the right to receive, if the holder of such Frozen Option is an ACR Beneficiary, the amount payable with respect to each Additional Consideration Right as calculated hereinabove, which shall be payable at the time, and only if, a payment is due to such holder pursuant to Section 3.2(b). Upon the twelve month anniversary of the Effective Time, any CHAMPUS Earn-Out Payment not previously paid pursuant to the terms of this Section 3.7(b) shall be paid to all ACR Beneficiaries, pro rata in accordance with the number of Additional Consideration Rights held by each ACR Beneficiary. (ii) Not later than the latest of (x) thirty (30) days following the date of final resolution with respect to the bid price adjustment provisions of the CHAMPUS Regions 3 and 4 request for proposals of claims paid during the data collection period (i.e., the twelve (12) month period ended June 30, 1996) under the CHAMPUS Regions 3 and 4 program (such final resolution being deemed to occur upon (A) the acceptance by Choice Behavioral Health Partnership ("Choice") of the bid price adjustment of the Office of CHAMPUS ("OCHAMPUS") either by (1) the settlement of such bid price adjustment by Humana Military Healthcare Services, Inc. ("Humana MHS") and OCHAMPUS, or (2) Humana MHS's decision not to, or failure to timely, appeal such final bid price adjustment determination by OCHAMPUS (which settlement or decision is accepted by Choice) or (B) Humana MHS's proposal to limit the impact of such bid price adjustment determination upon Choice (which proposal is accepted by Choice)), (y) the date Humana MHS and Choice complete all risk sharing and other calculations required for Choice to determine its profit generated from the CHAMPUS 3/4 Subcontract for the first year of service delivery thereunder and reflecting the results to the bid price adjustment described above and (z) April 30, 1998, Parent shall prepare and deliver to the ACR Beneficiaries a statement (the "Earn-Out Statement") setting forth the calculation of the CHAMPUS Earn-Out Payment calculated in accordance with Exhibit 3.7(b). The amount of the CHAMPUS Earn-Out Payment reflected on the Earn-Out Statement shall be paid by Parent to the ACR Beneficiaries not later than the tenth business day following the date the Earn-Out Statement becomes final under Section 3.7(b)(iii) (the "Earn-Out Payment Date"). As used in this Agreement, "CHAMPUS 3/4 Subcontract" means that certain Subcontract for the Comprehensive Management of the Delivery of Mental Health and Substance Abuse Services dated July 28, 1995, among Humana MHS, the Company and FHC Options, Inc. relating to that certain Request For Proposals MDA 906-94-R-002, under which Choice operates. (iii) The Surviving Corporation shall provide the ACR Representative and its agents access, upon reasonable notice and during normal business hours, to the books and records of the Surviving Corporation pertaining solely to the Earn-Out Statement, provided that the ACR Representative and its agents execute confidentiality agreements as may reasonably be requested by the Surviving Corporation. If the ACR Representative shall have any objections to the Earn-Out Statement, the ACR Representative shall deliver a complete and detailed written statement describing its objections to Parent within 60 days after receiving the Earn-Out Statement in question. The ACR Representative and Parent will use reasonable efforts to resolve any objections to the Earn-Out Statement which are timely raised by the ACR Representative as set forth herein. If any such objections are resolved, they shall be confirmed in a writing signed by Parent and the ACR Representative. If the parties do not obtain a final and complete written, signed resolution within 30 days (which time period may be extended but only by a writing signed by Parent and the ACR Representative) after Parent's receipt of a written statement of objections, the ACR Representative and Parent will select within 30 days thereafter an accounting firm mutually acceptable to them to resolve by binding arbitration, with the aforesaid accounting firm acting (as a firm) as the sole arbitrator, any remaining objections not previously resolved in a writing signed by Parent and the ACR Representative. The aforesaid accounting firm shall determine the procedures to be utilized by it in resolving the remaining objections. If the ACR Representative and Parent are unable to timely agree on the choice of an accounting firm, such accounting firm will be selected by lot from a list of the six largest national accounting firms remaining after excluding the regular outside accounting firms of Parent, the Company (on the date hereof), each holder of more than 10% of the Additional Consideration Rights and the ACR Representative. The determination of the accounting firm as to the remaining objections will be set forth in writing and when set forth in writing, designated as a "Final Determination" and signed by the accounting firm. If such accounting firm thus determines that the ACR Beneficiaries are entitled, under this Section 3.7(b), to a CHAMPUS Earn-Out Payment in excess of that set forth in the Earn-Out Statement, Parent shall promptly pay such amount, but Parent shall not be required to pay any interest except as provided below in this clause (iii). In the event that the parties submit any unresolved objections to an accounting firm for resolution as provided in this clause (iii), the fees, charges and expenses of the accounting firm shall (A) be borne by the ACR Beneficiaries (pro rata based upon the number of such rights held) as a set-off to the CHAMPUS Earn-Out Payment if such accounting firm determines that no amount in excess of the CHAMPUS Earn-Out Payment set forth in the Earn-Out Statement is due to the ACR Beneficiaries, (B) be borne equally by Parent and the ACR Beneficiaries if the CHAMPUS Earn-Out Payment which such accounting firm determines to be due to the ACR Beneficiaries does not exceed the CHAMPUS Earn-Out Payment reflected on the Earn-Out Statement by more than 7.5%, or (C) be borne by Parent if the CHAMPUS Earn-Out Payment which such accounting firm determines to be due to the holders exceeds the CHAMPUS Earn-Out Payment reflected on such Earn-Out Statement by more than 7.5%. For purposes of this Agreement, the Earn-Out Statement shall become final upon the earliest to occur of (X) the expiration of the 60-day period described in the second sentence of this Section 3.7(b)(iii) if the ACR Representative shall not have delivered any written statement of objections to the Earn-Out Statement to Parent within such period (or the date prior to such expiration on which the ACR Representative accepts the Earn-Out Statement in writing), (Y) the date on which the ACR Representative and Parent resolve in writing all objections, if any, of the ACR Representative to the Earn-Out Statement timely delivered to Parent, and (Z) the date on which the accounting firm determines and delivers to Parent and the ACR Representative in a writing designated as a "Final Determination" and signed by the accounting firm its resolution of all objections not otherwise previously resolved in writing by the ACR Representative and Parent. In the event the Final Determination results in an amount due to the ACR Beneficiaries as the CHAMPUS Earn-Out Payment in excess of that reflected on the Earn-Out Statement first delivered, the amount of the CHAMPUS Earn-Out Payment shall be increased by an amount equal to the amount of interest on the CHAMPUS Earn-Out Payment accruing from the 60th day after the Earn-Out Statement was first delivered to the ACR Beneficiaries through the date of payment, at a rate of interest equal to LIBOR (one month maturity) plus 1.875% per annum. Upon the Earn-Out Statement becoming final as aforesaid, such Earn-Out Statement, including but not limited to the amount to be paid to each ACR Beneficiary and the non-existence of any other ACR Beneficiaries entitled to an Earn-Out Payment, shall be conclusive and binding on the ACR Representative, Parent and each ACR Beneficiary, whether or not said ACR Beneficiary is identified therein as being entitled to an Earn-Out Payment. Notwithstanding any other provision of this Agreement, including but not limited to any provision stating that remedies shall be cumulative and not exclusive, and as a condition of the receipt of Additional Consideration Rights and the consideration which may arise in respect thereof, this Section 3.7(b)(iii) provides the sole and exclusive method for resolving any and all disputes of each and every nature whatever that may arise between or among the parties, the ACR Beneficiaries, or their representatives (including the ACR Representative) with respect to any CHAMPUS Earn-Out Payment or the Earn-Out Statement. All parties hereto, the ACR Beneficiaries and their representatives (including the ACR Representative) hereby irrevocably waive, relinquish and surrender all rights to, and agree that they will not attempt to, resolve any such dispute or disputes in any manner other than as set forth in this Section 3.7(b)(iii), including but not limited to through litigation. All parties hereto, the ACR Beneficiaries and their representatives (including the ACR Representative) further agree that if one or more of them should initiate any attempt to resolve any such dispute or disputes in any manner other than the sole and exclusive manner set forth in this Section 3.7(b)(iii), said initiators shall pay and reimburse all fees, costs and expenses incurred by anyone else as a result of, in connection with or related to said attempt or attempts. (iv) Payment of the CHAMPUS Earn-Out Payment shall be made by cashier's or certified check or, if requested by a person entitled to receive payment, by wire transfer of immediately available funds to an account specified by such person. (c) Litigation Condition Payment. At the Effective Time, each holder of an Additional Consideration Right shall be entitled to receive, in respect of each such Additional Consideration Right so held, a number of shares of Parent Common Stock equal to (i) 750,000 (as adjusted pursuant to Section 3.7(g)) divided by (ii) the ACR Denominator as of such date plus the number of Frozen Options; provided, that any holder of aggregate Stock Options to acquire less than 20,000 shares of Company Common Stock immediately prior to the Effective Time shall, in respect of the Additional Consideration Rights issuable in respect of such Stock Options, be issued the Equivalent Cash Amount (as defined in Section 3.7(h) below) in respect of each Litigation Condition Share which was to be issued to such holder in respect of an Additional Consideration Right pursuant to Section 3.2 hereof. Such Litigation Condition Shares and any Equivalent Cash Amount shall be issued or paid to the ACR Beneficiaries at the Effective Time in respect of the Additional Conditional Rights. If at any time from and after the Effective Time, a Frozen Option shall have its vesting accelerated pursuant to the terms of the 1996 Option Plan, such Frozen Option shall be converted into the right to receive, if the holder of such Frozen Option is an ACR Beneficiary, the number of Litigation Condition Shares allocable to each Additional Consideration Right as calculated hereinabove, which shall be issuable at the time, and only if, a payment is due to such holder pursuant to Section 3.2(b). Upon the twelve month anniversary of the Effective Time, any Litigation Condition Shares not previously issued pursuant to the terms of this Section 3.7(c) shall be issued to all ACR Beneficiaries, pro rata in accordance with the number of Additional Consideration Rights held by each ACR Beneficiary. To the extent any Parent Share to be issued under Sections 3.7(c) or (d) is a fractional share, at Parent's option, Parent shall either (i) issue such fractional share, (ii) issue a whole Parent Share in lieu thereof or (iii) issue cash in lieu thereof based upon the Equivalent Cash Amount. (d) CHAMPUS 2/5 Condition Payment. (i) Upon satisfaction of the CHAMPUS 2/5 Condition, each holder of an Additional Consideration Right shall be entitled to receive, in respect of each such Additional Consideration Right so held, a number of shares of Parent Common Stock equal to (i) 750,000 (as adjusted pursuant to Section 3.7(g) or reduced pursuant to Exhibit 3.7(d)) divided by (ii) the ACR Denominator; provided, that any holder of aggregate Stock Options to acquire less than 20,000 shares of Company Common Stock immediately prior to the Effective Time shall, in respect of the Additional Consideration Rights issuable in respect of such Stock Options, be issued the Equivalent Cash Amount in respect of each CHAMPUS Condition Share which was to be issued to such holder pursuant to this subsection. Such CHAMPUS Condition Shares and any Equivalent Cash Amount shall be issued or paid to the ACR Beneficiaries (A) subject to clause (B), upon the latest of (1) thirty (30) days following satisfaction of the CHAMPUS 2/5 Condition, (2) ten business days following the date on which the Share Adjustment becomes final pursuant to Section 3.7(g)(ii) hereof with respect to any pending Share Adjustment, upon the terms and subject to the restrictions set forth in the Stockholders Agreement, or (3) ten business days following the date on which the CHAMPUS 2/5 Statement becomes final, or (B) in the event the CHAMPUS 2/5 Condition is satisfied prior to the Effective Time, such CHAMPUS Condition Shares and any Equivalent Cash Amount shall be issued or paid to the ACR Beneficiaries at the Effective Time in respect of the Additional Conditional Rights if the parties are then in agreement as to the CHAMPUS 2/5 Statement; provided, however, that if the CHAMPUS Condition Shares are issued prior to the twelve month anniversary of the Effective Time, (A) the ACR Denominator shall be adjusted for purposes of calculating the number of CHAMPUS Condition Shares issuable to each ACR Beneficiary pursuant to this Section 3.7(d) by adding an amount equal to "FO" (as used in the definition of Cash Price) to the ACR Denominator, and (B) if at any time from and after the issuance of the CHAMPUS Condition Shares, a Frozen Option shall have its vesting accelerated pursuant to the terms of the 1996 Option Plan, such Frozen Option shall be converted into the right to receive, if the holder of such Frozen Option is an ACR Beneficiary, the number of CHAMPUS Condition Shares allocable to each Additional Consideration Right as calculated hereinabove, which shall be at the time, and only if, a payment is due to such holder pursuant to Section 3.2(b). Upon the twelve month anniversary of the Effective Time, any CHAMPUS Condition Shares not previously issued pursuant to the terms of this Section 3.7(d) shall be issued to all ACR Beneficiaries pro rata in accordance with the number of Additional Consideration Rights held by each ACR Beneficiary. As used herein, the "CHAMPUS 2/5 Condition" shall have the meaning set forth on Exhibit 3.7(d). (ii) The Surviving Corporation shall provide the ACR Representative and its agents access, upon reasonable notice and during normal business hours, to the books and records of the Surviving Corporation pertaining solely to any adjustments (the "CHAMPUS 2/5 Adjustments") made to the number of CHAMPUS Condition Shares to be issued pursuant to the calculations set forth on Exhibit 3.7(d), provided that the ACR Representative and its agents execute confidentiality agreements as may reasonably be requested by the Surviving Corporation. If the ACR Representative shall have any objections to the CHAMPUS 2/5 Adjustments, the ACR Representative shall deliver a complete and detailed written statement describing its objections to Parent within 60 days after receiving written notice from Parent of the CHAMPUS 2/5 Adjustments in question. The ACR Representative and Parent will use reasonable efforts to resolve any objections to the CHAMPUS 2/5 Adjustments which are timely raised by the ACR Representative as set forth herein. If any such objections are resolved, they shall be confirmed in a writing signed by Parent and the ACR Representative. If the parties do not obtain a final and complete written, signed resolution within 30 days (which time period may be extended but only by a writing signed by Parent and the ACR Representative) after Parent's receipt of a written statement of objections, the ACR Representative and Parent will select within 30 days thereafter an accounting firm mutually acceptable to them to resolve by binding arbitration, with the aforesaid accounting firm acting (as a firm) as the sole arbitrator, any remaining objections not previously resolved in a writing signed by Parent and the ACR Representative. The aforesaid accounting firm shall determine the procedures to be utilized by it in resolving the remaining objections. If the ACR Representative and Parent are unable to timely agree on the choice of an accounting firm, such accounting firm will be selected by lot from a list of the six largest national accounting firms remaining after excluding the regular outside accounting firms of Parent, the Company (on the date hereof), each holder of more than 10% of the Additional Consideration Rights and the ACR Representative. The determination of the accounting firm as to the remaining objections will be set forth in writing and when set forth in writing, designated as a "Final Determination" and signed by the accounting firm. If such accounting firm thus determines that the ACR Beneficiaries are entitled, under this Section 3.7(d), to a number of CHAMPUS Condition Shares in excess of that set forth in Parent's written notice of CHAMPUS 2/5 Adjustments, Parent shall promptly pay such amount. In the event that the parties submit any unresolved objections to an accounting firm for resolution as provided in this clause (ii), the fees, charges and expenses of the accounting firm shall (A) be borne by the ACR Beneficiaries (pro rata based upon the number of such rights held) as a set-off to the number of CHAMPUS Condition Shares issuable if such accounting firm determines that no amount in excess of the number of CHAMPUS Condition Shares set forth in Parent's written notice of CHAMPUS 2/5 Adjustments is due to the ACR Beneficiaries, (B) be borne equally by Parent and the ACR Beneficiaries if the number of CHAMPUS Condition Shares which such accounting firm determines to be due to the ACR Beneficiaries does not exceed the number reflected on Parent's written notice of CHAMPUS 2/5 Adjustments by more than 7.5%, or (C) be borne by Parent if the number of CHAMPUS Condition Shares which such accounting firm determines to be due to the holders exceeds the number reflected on Parent's written notice of CHAMPUS 2/5 Adjustments by more than 7.5%. For purposes of this Agreement, the CHAMPUS 2/5 Adjustments shall become final upon the earliest to occur of (X) the expiration of the 60-day period described in the second sentence of this Section 3.7(d)(ii) if the ACR Representative shall not have delivered any written statement of objections to the CHAMPUS 2/5 Adjustments to Parent within such period (or the date prior to such expiration on which the ACR Representative accepts the CHAMPUS 2/5 Adjustments in writing), (Y) the date on which the ACR Representative and Parent resolve in writing all objections, if any, of the ACR Representative to the CHAMPUS 2/5 Adjustments timely delivered to Parent, and (Z) the date on which the accounting firm determines and delivers to Parent and the ACR Representative in a writing designated as a "Final Determination" and signed by the accounting firm its resolution of all objections not otherwise previously resolved in writing by the ACR Representative and Parent. In the event the Final Determination results in a number of CHAMPUS Condition Shares issuable to the ACR Beneficiaries as a result of the satisfaction of the CHAMPUS 2/5 Condition in excess of that reflected on the written notice of CHAMPUS 2/5 Adjustments first delivered by Parent, the amount of CHAMPUS Condition Shares issuable to the ACR Beneficiaries shall be increased by an amount equal to the difference between (1) the number set forth in the Final Determination and (2) the number set forth on Parent's written notice of CHAMPUS 2/5 Adjustments, in both cases, with respect to the aggregate number of CHAMPUS Condition Shares issuable. Upon the number of CHAMPUS Condition Shares issuable and any CHAMPUS 2/5 Adjustments becoming final as aforesaid, such number of CHAMPUS Condition Shares issuable and any CHAMPUS 2/5 Adjustments, including but not limited to the number of CHAMPUS Condition Shares to be issued to each ACR Beneficiary and the non-existence of any other ACR Beneficiaries entitled to receive CHAMPUS Condition Shares, shall be conclusive and binding on the ACR Representative, Parent and each ACR Beneficiary, whether or not said ACR Beneficiary is identified therein as being entitled to receive CHAMPUS Condition Shares. Notwithstanding any other provision of this Agreement, including but not limited to any provision stating that remedies shall be cumulative and not exclusive, and as a condition of the receipt of Additional Consideration Rights and the consideration which may arise in respect thereof, this Section 3.7(d)(ii) provides the sole and exclusive method for resolving any and all disputes of each and every nature whatever that may arise between or among the parties, the ACR Beneficiaries, or their representatives (including the ACR Representative) with respect to any CHAMPUS Condition Shares or CHAMPUS 2/5 Adjustments. All parties hereto, the ACR Beneficiaries and their representatives (including the ACR Representative) hereby irrevocably waive, relinquish and surrender all rights to, and agree that they will not attempt to, resolve any such dispute or disputes in any manner other than as set forth in this Section 3.7(d)(ii), including but not limited to through litigation. All parties hereto, the ACR Beneficiaries and their representatives (including the ACR Representative) further agree that if one or more of them should initiate any attempt to resolve any such dispute or disputes in any manner other than the sole and exclusive manner set forth in this Section 3.7(d)(ii), said initiators shall pay and reimburse all fees, costs and expenses incurred by anyone else as a result of, in connection with or related to said attempt or attempts. (e) State Contract Earn-Out Payment. (i) The amount of any State Earn-Out Payment payable with respect to each Additional Consideration Right shall be equal to the aggregate State Earn-Out Payment payable, calculated as provided on Exhibit 3.7(e), divided by the total number of Additional Consideration Rights outstanding as of the third business day prior to the date a State Earn-Out Statement is first sent to the ACR Beneficiaries. (ii) Not later than December 31, 1998, Parent shall prepare and deliver to the ACR Beneficiaries a statement (the "State Earn-Out Statement") setting forth the calculation of the State Earn-Out Payment calculated in accordance with Exhibit 3.7(e). The amount of the State Earn-Out Payment reflected on the State Earn-Out Statement shall be paid by Parent to the ACR Beneficiaries not later than the tenth business day following the date the State Earn-Out Statement becomes final under Section 3.7(e)(iii) (the "State Payment Date"). As used in this Agreement, "State Contract" means Contract No. 97-331-74069-0 between the Montana State Department of Public Health and Human Services and Montana Community Partners, Inc. and CMG Health, Inc. and Care Coalition of Montana, Inc. for managed mental health care, dated as of December 23, 1996. (iii) The Surviving Corporation shall provide the ACR Representative and its agents access, upon reasonable notice and during normal business hours, to the books and records of the Surviving Corporation pertaining solely to the State Earn-Out Statement, provided that the ACR Representative and its agents execute confidentiality agreements as may reasonably be requested by the Surviving Corporation. If the ACR Representative shall have any objections to the State Earn-Out Statement, the ACR Representative shall deliver a complete and detailed written statement describing its objections to Parent within 60 days after receiving the State Earn-Out Statement in question. The ACR Representative and Parent will use reasonable efforts to resolve any objections to the State Earn-Out Statement which are timely raised by the ACR Representative as set forth herein. If any such objections are resolved, they shall be confirmed in a writing signed by Parent and the ACR Representative. If the parties do not obtain a final and complete written, signed resolution within 30 days (which time period may be extended but only by a writing signed by Parent and the ACR Representative) after Parent's receipt of a written statement of objections, the ACR Representative and Parent will select within 30 days thereafter an accounting firm mutually acceptable to them to resolve by binding arbitration, with the aforesaid accounting firm acting (as a firm) as the sole arbitrator, any remaining objections not previously resolved in a writing signed by Parent and the ACR Representative. The aforesaid accounting firm shall determine the procedures to be utilized by it in resolving the remaining objections. If the ACR Representative and Parent are unable to timely agree on the choice of an accounting firm, such accounting firm will be selected by lot from a list of the six largest national accounting firms remaining after excluding the regular outside accounting firms of Parent, the Company (on the date hereof), each holder of more than 10% of the Additional Consideration Rights and the ACR Representative. The determination of the accounting firm as to the remaining objections will be set forth in writing and when set forth in writing, designated as a "Final Determination" and signed by the accounting firm. If such accounting firm thus determines that the ACR Beneficiaries are entitled, under this Section 3.7(e), to a State Earn-Out Payment in excess of that set forth in the State Earn-Out Statement, Parent shall promptly pay such amount, but Parent shall not be required to pay any interest except as provided below in this clause (iii). In the event that the parties submit any unresolved objections to an accounting firm for resolution as provided in this clause (iii), the fees, charges and expenses of the accounting firm shall (A) be borne by the ACR Beneficiaries (pro rata based upon the number of such rights held) as a set-off to the State Earn-Out Payment if such accounting firm determines that no amount in excess of the State Earn-Out Payment set forth in the State Earn-Out Statement is due to the ACR Beneficiaries, (B) be borne equally by Parent and the ACR Beneficiaries if the State Earn-Out Payment which such accounting firm determines to be due to the ACR Beneficiaries does not exceed the State Earn-Out Payment reflected on the State Earn-Out Statement by more than 7.5%, or (C) be borne by Parent if the State Earn-Out Payment which such accounting firm determines to be due to the holders exceeds the State Earn-Out Payment reflected on such State Earn-Out Statement by more than 7.5%. For purposes of this Agreement, the State Earn-Out Statement shall become final upon the earliest to occur of (X) the expiration of the 60-day period described in the second sentence of this Section 3.7(e)(iii) if the ACR Representative shall not have delivered any written statement of objections to the State Earn-Out Statement to Parent within such period (or the date prior to such expiration on which the ACR Representative accepts the State Earn-Out Statement in writing), (Y) the date on which the ACR Representative and Parent resolve in writing all objections, if any, of the ACR Representative to the State Earn-Out Statement timely delivered to Parent, and (Z) the date on which the accounting firm determines and delivers to Parent and the ACR Representative in a writing designated as a "Final Determination" and signed by the accounting firm its resolution of all objections not otherwise previously resolved in writing by the ACR Representative and Parent. In the event the Final Determination results in an amount due to the ACR Beneficiaries as the State Earn-Out Payment in excess of that reflected on the State Earn-Out Statement first delivered, the amount of the State Earn-Out Payment shall be increased by an amount equal to the amount of interest on the State Earn-Out Payment accruing from the 60th day after the State Earn-Out Statement was first delivered to the ACR Beneficiaries through the date of payment, at a rate of interest equal to LIBOR (one month maturity) plus 1.875% per annum. Upon the State Earn-Out Statement becoming final as aforesaid, such State Earn-Out Statement, including but not limited to the amount to be paid to each ACR Beneficiary and the non-existence of any other ACR Beneficiaries entitled to a State Earn-Out Payment, shall be conclusive and binding on the ACR Representative, Parent and each ACR Beneficiary, whether or not said ACR Beneficiary is identified therein as being entitled to a State Earn-Out Payment. Notwithstanding any other provision of this Agreement, including but not limited to any provision stating that remedies shall be cumulative and not exclusive, and as a condition of the receipt of Additional Consideration Rights and the consideration which may arise in respect thereof, this Section 3.7(e)(iii) provides the sole and exclusive method for resolving any and all disputes of each and every nature whatever that may arise between or among the parties, the ACR Beneficiaries, or their representatives (including the ACR Representative) with respect to any State Earn-Out Payment or the State Earn-Out Statement. All parties hereto, the ACR Beneficiaries and their representatives (including the ACR Representative) hereby irrevocably waive, relinquish and surrender all rights to, and agree that they will not attempt to, resolve any such dispute or disputes in any manner other than as set forth in this Section 3.7(e)(iii), including but not limited to through litigation. All parties hereto, the ACR Beneficiaries and their representatives (including the ACR Representative) further agree that if one or more of them should initiate any attempt to resolve any such dispute or disputes in any manner other than the sole and exclusive manner set forth in this Section 3.7(e)(iii), said initiators shall pay and reimburse all fees, costs and expenses incurred by anyone else as a result of, in connection with or related to said attempt or attempts. (iv) Payment of the State Earn-Out Payment shall be made by cashier's or certified check or, if requested by a person entitled to receive payment, by wire transfer of immediately available funds to an account specified by such person. (f) Additional Consideration Rights Generally. (i) The Additional Consideration Rights are personal to each initial holder thereof and shall not be transferable for any reason other than (A) to an Affiliate of such holder, (B) to another holder of Additional Consideration Rights or (C) by operation of law or by will or the laws of descent and distribution. Any attempted transfer of an Additional Consideration Right by any holder thereof (other than as permitted by the immediately preceding sentence) shall be null and void. Additional Consideration Rights shall not possess any attributes of common stock or other security and shall not entitle the holders of the Additional Consideration Rights to any rights of any kind other than as specifically set forth in this Agreement. (ii) As a condition to the receipt of any Additional Consideration Rights, each ACR Beneficiary has duly appointed Alan J. Shusterman as its designated representative (together with any designee of Alan J. Shusterman (or his properly designated successor), acceptable to Parent in its reasonable discretion (provided that any representative of Humana Inc. shall be deemed acceptable to Parent), the "ACR Representative") and as such ACR Beneficiary's attorney-in-fact, to act on such ACR Beneficiary's behalf and to take any and all actions required or permitted to be taken by the ACR Representative under this Agreement. Parent and the Company shall be entitled to rely upon as being binding upon each ACR Beneficiary any document or other paper believed by Parent or the Company, respectively, to be genuine and correct and to have been signed or sent by the ACR Representative, and neither Parent or the Company shall be liable to any of ACR Beneficiaries for any action taken or omitted to be taken by Parent or the Company, respectively, in such reliance. All fees and expenses of the ACR Representative and its agents shall be paid by the ACR Beneficiaries. Neither Parent nor the Company shall in any event incur any liability for (i) any such fees or expenses or (ii) any losses, damages or expenses incurred by any ACR Beneficiary arising from or related to any action (or failure to act) by the ACR Representative. (g) Adjustment of Share Amounts. (i) In the event that, prior to the issuance of the Parent Shares under Sections 3.7(c) or 3.7(d), the outstanding shares of Parent Common Stock are hereafter changed into or exchanged for a different number or kind of shares or other securities of Parent or of another corporation, by reason of reorganization, merger, consolidation, recapitalization, reclassification, stock split-up, stock dividend or combination of shares, appropriate and equitable adjustments (each, a "Share Adjustment") shall be made by the Board of Directors of Parent to the number and kind of the Parent Shares issuable to the ACR Beneficiaries, prior to the issuance thereof, pursuant to Sections 3.7(c) and 3.7(d). Parent shall give the ACR Representative prompt notice of the number and kind of adjustments which have been made. (ii) Parent shall provide the ACR Representative and its agents access upon reasonable notice and during normal business hours to the books and records of Parent pertaining solely to the Share Adjustment. If the ACR Representative shall have any objections to any Share Adjustment, the ACR Representative shall deliver a complete and detailed written statement describing its objections to Parent within 60 days after receiving the notice of the Share Adjustment required pursuant to Section 3.7(g)(i), above. The ACR Representative and Parent will use reasonable efforts to resolve any objections to the Share Adjustment which are timely raised by the ACR Representative as set forth herein. If any such objections are resolved, they shall be confirmed in a writing signed by Parent and the ACR Representative. If the parties do not obtain a final and complete written, signed resolution within 30 days (which time period may be extended but only by a writing signed by Parent and the ACR Representative) after Parent's receipt of a written statement of objections, the ACR Representative and Parent will select within 45 days thereafter an accounting firm mutually acceptable to them to resolve by binding arbitration, with the aforesaid accounting firm acting (as a firm) as the sole arbitrator, any remaining objections not previously resolved in a writing signed by Parent and the ACR Representative. The aforesaid accounting firm shall determine the procedures to be utilized by it in resolving the remaining objections. If the ACR Representative and Parent are unable to timely agree on the choice of an accounting firm, such accounting firm will be selected by lot from a list of the six largest national accounting firms remaining after excluding the regular outside accounting firms of Parent, the Company (on the date hereof), each holder of more than 10% of the Additional Consideration Rights and the ACR Representative. The determination of the accounting firm as to the remaining objections will be set forth in writing and when set forth in writing, designated as a "Final Determination," and signed by the accounting firm. If such accounting firm thus determines that the ACR Beneficiaries are entitled, under this Section 3.7(g), to a number or kind of shares or other securities of Parent other than as contemplated by the Share Adjustment, Parent shall promptly authorize and issue or authorize for future issuance the number and kind of shares or securities to which the ACR Beneficiaries are entitled. In the event that the parties submit any unresolved objections to an accounting firm for resolution as provided in this clause (ii), the fees, charges and expenses of the accounting firm shall (A) be borne by the ACR Beneficiaries (pro rata based upon the number of Additional Consideration Rights held) as a set-off to the number of Parent Shares issued or issuable to the ACR Beneficiaries (based upon the Equivalent Cash Amount at the time of the issuance of Parent Shares) in the event such accounting firm determines that the Share Adjustment, as determined by Parent pursuant to Section 3.7(g)(i), is appropriate, (B) be borne equally by Parent and the ACR Beneficiaries (by the same method of set-off) if such accounting firm determines that the Share Adjustment requires modification so as to increase the number of shares or other securities of Parent to be issued or issuable to the ACR Beneficiaries by less than or equal to 7.5% (calculated as a percentage of the number of shares of Parent Common Stock comprising the Share Adjustment), or (C) be borne by Parent if such accounting firm determines that the Share Adjustment requires modification so as to increase the number of shares or other securities of Parent to be issued or issuable to the ACR Beneficiaries by more than 7.5% (calculated as a percentage of the number of shares of Parent Common Stock comprising the Share Adjustment). For purposes of this Agreement, the Share Adjustment shall become final upon the earliest to occur of (X) the expiration of the 60-day period described in the second sentence of this Section 3.7(g)(ii) if the ACR Representative shall not have delivered any written statement of objections to the Share Adjustment to Parent within such period (or the date prior to such expiration on which the ACR Representative accepts the Share Adjustment in writing), (Y) the date on which the ACR Representative and Parent resolve in writing all objections, if any, of the ACR Representative to the Share Adjustment timely delivered to Parent, and (Z) the date on which the accounting firm determines and delivers to Parent and the ACR Representative in a writing designated as a "Final Determination" and signed by the accounting firm its resolution of all objections not otherwise previously resolved in writing by the ACR Representative and Parent. Upon the Share Adjustment becoming final as aforesaid, such Share Adjustment, including but not limited to the amount to be paid to each ACR Beneficiary and the non-existence of any other ACR Beneficiaries entitled to a Share Adjustment, shall be conclusive and binding on the ACR Representative, Parent and each ACR Beneficiary, whether or not said ACR Beneficiary is identified therein as being entitled to a Share Adjustment. Notwithstanding any other provision of this Agreement, including but not limited to any provision stating that remedies shall be cumulative and not exclusive, and as a condition of the receipt of Parent Shares and the consideration which may arise in respect thereof, any dispute that may arise between or among the parties, the ACR Beneficiaries, or their representatives (including the ACR Representative) with respect to any Share Adjustment shall be governed and resolved solely and exclusively by this Section 3.7(g)(ii). All parties hereto, the ACR Beneficiaries and their representatives hereby irrevocably waive, relinquish and surrender all rights to, and agree that they will not attempt to, resolve any such dispute or disputes in any manner other than as set forth in this Section 3.7(g)(ii), including but not limited to through litigation. All parties hereto, the ACR Beneficiaries and their representatives further agree that if one or more of them should initiate any attempt to resolve any such dispute or disputes in any manner other than the sole and exclusive manner set forth in this Section 3.7(g)(ii), said initiators shall pay and reimburse all fees, costs and expenses incurred by anyone else as a result of, in connection with or related to said attempt or attempts. Upon the Share Adjustment becoming final as aforesaid, such determination with respect to the Share Adjustment, including but not limited to the number and kind of shares of Parent Common Stock issued or issuable to each ACR Beneficiary, shall be conclusive and binding on the ACR Representative, Parent and each ACR Beneficiary, whether or not said ACR Beneficiary is identified therein as being entitled to a Share Adjustment. (h) Determination of Equivalent Cash Amount. The "Equivalent Cash Amount" with respect to each Parent Share shall be an amount established by the Board of Directors of Parent, in good faith, as the fair market value of a Parent Share as of the date of its issuance to the ACR Beneficiaries. (i) Escrow Arrangement. The ACR Representative shall be entitled to withdraw funds necessary to perform his duties on behalf of the ACR Beneficiaries hereunder from the Escrow Account, in the amounts set forth in and subject to the provisions of the Escrow Agreement. (j) Parent's Acceleration Rights. On any date subsequent to the Effective Time, upon not less than five (5) business days' notice and notwithstanding the occurrence of any event or fulfillment of any condition (or failure thereof to occur or be fulfilled), Parent may elect to (i) issue any or all of the shares of Parent Common Stock constituting the CHAMPUS Condition Shares to the ACR Beneficiaries (to the extent such shares have not, as of such date, been issued to the ACR Beneficiaries), and (ii) pay an amount equal to the maximum amount that could then be paid out under Section 3.7(l), were a payment to then be made under Sections 3.7(b) and 3.7(e), in full satisfaction of the CHAMPUS Earn-Out Payment and the State Earn-Out Payment (to the extent such amounts have not, as of such date, been paid to the ACR Beneficiaries). (k) Unpaid Severance Amount. Each Additional Consideration Right shall also represent the right to receive an amount, if any, equal to one-half (.5) multiplied by the aggregate Unpaid Severance Amount, divided by the total number of Additional Consideration Rights outstanding as of the third business day prior to the Unpaid Severance Amount Payment Date. The "Unpaid Severance Amount" shall mean that portion of the payments described under clause (v) of Exhibit 3.1(b) which, on the first anniversary of the Effective Time, has not yet been paid and is not then payable (unless the obligation to pay such amount is then being contested, in which case such amount shall be deemed to have been paid as severance until it is thereafter finally determined that such amount is not payable as severance, at which time (or within 10 business days thereafter) such amount shall be deemed to be an Unpaid Severance Amount, and shall be paid as provided in this Section 3.7(k)). The "Unpaid Severance Amount Payment Date" shall mean the 15th day (or, if such day is not a business day, the next succeeding business day) following the first anniversary of the Effective Time. (l) Payment Limitation. Notwithstanding anything to the contrary in this Agreement, in no event shall Parent be required to pay to the ACR Beneficiaries more than $23,500,000 in total under Sections 3.7(b) and 3.7(e). Accordingly, if at any time the payment of an amount to the ACR Beneficiaries under Section 3.7(b) or 3.7(e) hereof would, when added to the aggregate amounts previously paid under either of said Sections, exceed $23,500,000, then any such excess amount shall be retained by Parent (such reduction being applied to the ACR Beneficiaries pro rata based upon the number of Additional Consideration Rights held by each ACR Beneficiary) and not paid to the ACR Beneficiaries. ARTICLE IV. REPRESENTATIONS AND WARRANTIES OF THE COMPANY The Company hereby represents and warrants to Parent and Merger Sub as follows, subject to qualification by the specific disclosures set forth in the written statement signed by the Chief Executive Officer of the Company and delivered by the Company to Parent at least three (3) business days prior to the date hereof (the "Company Disclosure Schedule"), which disclosure shall expressly reference the representations and warranties so qualified: 4.1. Organization, Existence and Good Standing. The Company is a corporation duly organized, validly existing and in good standing under the laws of the State of Maryland and has all necessary corporate power to own, operate or lease the properties and assets owned, operated or leased by it and to carry on its business as presently conducted, except where failure to so qualify or be in good standing would not have a Material Adverse Effect (as defined in Section 13.7 hereof) with respect to the Company. The Company is duly qualified as a foreign corporation to do business, and is in good standing, in each jurisdiction in which the character of its properties and assets owned, operated or leased by it or the nature of its activities makes such qualification necessary, except for such failures which, when taken together with all other such failures, would not have a Material Adverse Effect on the Company. The Company has heretofore made available to Parent complete and correct copies of its charter and Bylaws, each of the foregoing as amended to the date of this Agreement. 4.2. Subsidiaries and Affiliated Partnerships. (a) Section 4.2(a) of the Company Disclosure Schedule lists all Subsidiaries of the Company (individually, a "Company Subsidiary," and collectively, the "Company Subsidiaries"). As used herein, "Subsidiary" shall mean any corporation in which the Company, directly or indirectly, beneficially owns any Equity Interest. (b) Set forth in Section 4.2(b) of the Company Disclosure Schedule is a list of all general partnerships in which a general partner is the Company, a Company Subsidiary or another Company Partnership (individually, a "Company Partnership" and collectively, the "Company Partnerships"), and any limited liability company in which the Company, a Company Subsidiary or a Company Partnership is a member or manager (a "Company LLC"). The Company Partnerships and the Company LLCs are collectively referred to herein as the "Company Other Entities" and the Company, the Company Subsidiaries and the Company Other Entities are collectively referred to herein as "Group Entities." Company Other Entities which are not Affiliates of the Company are referred to herein as "Unaffiliated Entities." (c) Other than the Group Entities, there are no corporations, partnerships, joint ventures, associations or other entities in which any Group Entity owns, of record or beneficially, any direct or indirect equity or other interest or any right (contingent or otherwise) to acquire the same. Except as set forth in Section 4.2(d) of the Company Disclosure Schedule, no Group Entity is a member of (nor is any part of its business of any Group Entity collectively conducted through) any partnership, joint venture or similar arrangement. (d) Section 4.2(d) of the Company Disclosure Schedule sets forth the jurisdiction of incorporation, organization or formation of each Group Entity; its authorized capital stock or other equity interests; the number and type of its issued and outstanding shares of capital stock, partnership interests or limited liability company interests ("Equity Interest"); and the current ownership by each Group Entity of any Equity Interests (collectively, the "Company Equity Interests"). Except as set forth in Section 4.2(d) of the Company Disclosure Schedule, the Company Equity Interests are owned free and clear of all security interests, pledges, mortgages, liens, charges, adverse claims of ownership, voting restrictions, limitations on transfer or proxies or use or other encumbrances of any kind (collectively, "Encumbrances"). All of the Company Equity Interests have been duly authorized and validly issued and are fully paid and non-assessable and were not issued in violation of any preemptive rights; except as set forth in Section 4.2(d) of the Company Disclosure Schedule, there are no options, warrants or rights of conversion or other rights, agreements, arrangements or commitments relating to the Equity Interests of any Group Entity obligating any Group Entity, as applicable, to issue or sell any of its Equity Interests. 4.3. Organization, Existence and Good Standing of the Company Subsidiaries and the Company Other Entities. (a) Each Company Subsidiary is a corporation duly organized, validly existing and in good standing under the laws of its respective state of incorporation. Each Company Subsidiary has all necessary corporate power to own, lease or operate its properties and assets owned, leased or operated by it and to carry on its business as presently conducted. Each Company Subsidiary is duly qualified as a foreign corporation to do business, and is in good standing, in each jurisdiction in which the character of properties and assets owned, operated or leased by it or the nature of its activities makes such qualification necessary, except for such failures which, when taken together with all other such failures, would not have a Material Adverse Effect with respect to the Company. True and complete copies of the certificate of incorporation or by-laws of each Company Subsidiary, each as amended to the date of this Agreement, have been heretofore made available to Parent. (b) Each Company Partnership has been duly formed, is validly existing and is in good standing under the laws of its respective state of organization and has all necessary power to own, lease or operate its property and assets owned, leased or operated by it and to carry on its business as presently conducted. Each Company Partnership is duly qualified as a foreign partnership to do business in each jurisdiction in which the character of properties and assets owned, operated or leased by it or the nature of its activities makes such qualification necessary, except for such failures which, when taken together with all other such failures, would not have a Material Adverse Effect with respect to the Company. True and complete copies of the partnership agreement and other organizational documents of each Company Partnership, each as amended to the date of this Agreement, have been heretofore made available to Parent. (c) Each Company LLC is a limited liability company duly formed, validly existing and in good standing under the laws of its respective state of organization. Each Company LLC has all necessary power to own, lease or operate its property and assets owned, leased or operated by it and to carry on its business as presently conducted. Each Company LLC is duly qualified as a foreign limited liability company to do business in each jurisdiction in which the character of properties and assets owned, operated or leased by it or the nature of its activities makes such qualification necessary, except for such failures which, when taken together with all other such failures, would not have a Material Adverse Effect with respect to the Company. True and complete copies of the articles of organization, operating agreement and other organizational documents of each Company LLC, each as amended to the date of this Agreement, have been heretofore made available to Parent. 4.4. Company Capital Stock. The Company's authorized capital stock consists of 57,000,000 shares of capital stock, comprised of 36,000,000 shares of Class A Voting Common Stock, par value $.00333 per share, and 12,000,000 shares of Class B Non-Voting Common Stock, par value $.00333 per share, of which 9,000,000 and 5,266,122 shares, respectively, are issued and outstanding on the date hereof, and 9,000,000 shares Company Preferred Stock, comprised of 6,000,000 shares designated as Class A Convertible Preferred Stock, par value $.00333 per share, and 3,000,000 shares designated as Class B Convertible Preferred Stock, par value $.00333 per share, of which 4,537,815 and 2,632,152 shares, respectively, are issued and outstanding on the date hereof. All of the issued and outstanding shares of Company Common Stock and Company Preferred Stock are duly and validly issued, fully paid and nonassessable and were not issued in violation of any preemptive rights. The owners of all issued and outstanding shares of Company Common Stock and Company Preferred Stock, together with number, class and series of such stock held by such stockholder as of the date hereof, are set forth in Section 4.4 of the Company Disclosure Schedule. The holders of all outstanding Equity Rights, and number of such Equity Rights so held as of the date hereof, are set forth in Section 4.4 of the Company Disclosure Schedule. Except as set forth in Section 4.4 of the Company Disclosure Schedule, there are no voting trusts, stockholders agreements, proxies or other similar agreements in effect with respect to the voting or transfer of the Company Common Stock or Company Preferred Stock. There is no liability for dividends declared or accumulated but unpaid with respect to any of the shares of Company Common Stock or Company Preferred Stock. Set forth in Section 4.4 of the Company Disclosure Schedule is a true and complete listing of each Vested Option, each Unvested Option, and each Frozen Option, and the holders thereof, the terms of vesting with respect to each such Unvested Option, the exercise price of each Stock Option listed, and the Stock Option plan under which each Stock Option listed was issued (and any restatements, amendments or supplements to any such plans prior to the date hereof). 4.5. Power and Authority. (a) The Company has all necessary corporate power and authority to execute, deliver and perform this Agreement and to consummate the transactions contemplated hereby, and has taken all action required by Law, its charter, Bylaws or otherwise, to authorize the execution, delivery and performance of this Agreement and the consummation of the transactions contemplated hereby (other than the Stockholder Approvals, as defined in Section 4.5(b)). This Agreement has been duly executed and delivered by the Company and, assuming this Agreement constitutes a valid and binding obligation of Parent and Merger Sub, as the case may be, constitutes a valid and binding obligation of the Company, enforceable against the Company in accordance with its terms except that the enforcement hereof may be limited by (i) bankruptcy, insolvency, reorganization, moratorium or other similar laws now or hereafter in effect relating to creditors' rights generally and (ii) general principles of equity (regardless of whether enforceability is considered in a proceeding in equity or at law). (b) The Company has duly noticed a meeting of holders of all outstanding shares of the Company Common Stock and Company Preferred Stock, pursuant to Section 2-504 of the MGCL, which meeting is scheduled to take place on or about July 29, 1997, for the purpose of obtaining the approval and adoption of (i) with respect to the Company Common Stock and Company Preferred Stock, holders of not less than a majority of the Company Class A Common Stock and the Company Preferred Stock, voting together as a single class, and (ii) with respect to the Company Preferred Stock, holders of not less than sixty percent (60%) of such shares voting together as a class, in each case, with respect to this Agreement, the Merger and the transactions contemplated hereby and thereby (the approval and adoption described in this Section 4.5(b) being herein referred to as the "Stockholder Approvals"). 4.6. Legal Proceedings. (a) Except as set forth in Section 4.6(a) of the Company Disclosure Schedule, there is no claim, action, suit, arbitration, litigation, governmental investigation or other proceeding (each, an "Action") pending against any Group Entity or its properties or business, or the transactions contemplated by this Agreement. To the knowledge of the Company, except as set forth in Section 4.6(a) of the Company Disclosure Schedule, there is no Action threatened against any Group Entity or its properties or business, or the transactions contemplated by this Agreement, which is reasonably likely to have a Material Adverse Effect on the Group Entities, taken as a whole. None of the Group Entities or their respective assets or properties is subject to any material order, judgment, injunction, decree, stipulation or determination entered by or with any government, governmental or regulatory authority, board, agency or other entity, or any court, tribunal or judicial body, whether federal, state or local (each, a "Governmental Authority"). No Group Entity has received any opinion or memorandum from internal or outside legal counsel to the effect that it is exposed, from a legal standpoint, to any liability that is reasonably likely to have a Material Adverse Effect on such Group Entity. Section 4.6(a) of the Company Disclosure Schedule sets forth all closed litigation matters involving amounts in dispute in excess of $100,000 to which any Group Entity was a party during the three years preceding the Closing, the date such litigation was commenced and concluded, and the nature of the resolution thereof (including amounts paid in settlement or judgment). (b) The Company has provided outside counsel to Parent complete and candid access to all members of the Board of Directors, officers, employees and agents of the Company with knowledge pertaining to the matters in connection with the litigation which is the subject of the complaint as previously filed of Vista of Montana, Inc. filed in the action captioned Vista of Montana, Inc. v. Department of Administration of the State of Montana and the Department of Public Health and Human Services of the State of Montana and Montana Community Partners, Inc., (Case No.: BDV97-192), and complete access to all Company documentation material thereto. The Company has not failed and will not fail to disclose any information or documentation which is known to the Company and which is material to such counsel's analysis of the claims in such litigation and the Company has caused the members of its Board of Directors, officers, employees and agents to cooperate fully in such analysis and to make full disclosure of all facts and information which is known to the Company and which is material to such analysis. (c) The Company has retained the firm of Piper & Marbury, L.L.P. ("Piper & Marbury") as its legal counsel in the litigation pending in the United States District Court for the Southern District of New York captioned: Edward M. Stephens, M.D., et al. v. CMG Health, et al., 96 Cir. 198 (KMW) ("Stephens"). The Company has provided Piper & Marbury complete and candid access to all members of the Board of Directors, officers, employees and agents of the Company with knowledge pertaining to the matters which are the subject of the Stephens litigation and complete access to all Company documentation pertinent to the Stephens litigation. The Company has not failed and will not fail to disclose any information or documentation which is known to the Company and which is material to Piper & Marbury's analysis of the claims in Stephens and it has caused and will cause the members of its Board of Directors, officers, employees and agents to cooperate fully in such analysis and to make full disclosure of all facts and information which is known to the Company and which is material to such analysis. 4.7. Financial Statements. The Company has heretofore furnished to Parent copies of the following financial statements: (a) the audited Consolidated Balance Sheets of the Company as of December 31, 1995 and 1996, and the audited Consolidated Statements of Operations, Stockholders' Equity, and Cash Flows for each of the years in the three year period ended December 31, 1996 (the "Latest Statement Date"), together with the notes thereto (the "Latest Company Financial Statements"), and the unqualified opinion of Ernst & Young LLP, the Company's independent auditors, and (b) the Consolidated Balance Sheet of the Company and the Consolidated Statement of Operations for each month ended between the Latest Statement Date and May 31, 1997 (collectively with the Latest Company Financial Statements, the "Company Financial Statements"). The Company Financial Statements fairly present the consolidated financial position, consolidated results of operations and consolidated cash flows of the Company as of the dates and for the periods indicated therein. Each of the Company Financial Statements has been prepared in accordance with generally accepted accounting principles ("GAAP") (applied on a consistent basis except as disclosed in the footnotes thereto) and, with respect to financial statements referred to in clause (b) of the first sentence of this Section 4.7, subject to normal year-end adjustments and the absence of footnotes. The "Supplemental Schedules" set forth in Section 4.7 of the Company Disclosure Schedule fairly present, in accordance with GAAP, the results of operations and variances in revenue for each of the items described therein, for each month during the period from January 1, 1996 through May 31, 1997. The Subsequent Company Financial Statements, delivered pursuant to Section 8.1(h), will fairly present the consolidated financial position, consolidated results of operations and consolidated cash flows of the Company as of the dates and for the periods indicated therein, and the Subsequent Supplemental Schedules, also delivered pursuant to Section 8.1(h), will fairly present, in accordance with GAAP, the results of operations and variances in revenue for each of the items described therein, for each month during the period covered by the Subsequent Company Financial Statements. Each of the Subsequent Company Financial Statements will be prepared in accordance with GAAP (applied on a consistent basis except as disclosed in the footnotes thereto), subject to normal year-end adjustments and the absence of footnotes. 4.8. No Undisclosed Liabilities. Neither the Company nor any other Group Entity has any liabilities or obligations of any nature, whether accrued, absolute, fixed or contingent, except (i) to the extent reflected and accrued for or fully reserved against in the Company Financial Statements, (ii) for liabilities disclosed in Section 4.8 of the Company Disclosure Schedule, (iii) for liabilities and obligations not required under GAAP to be disclosed on the balance sheets included in the Company Financial Statements or in the financial footnotes thereto, or (iv) for liabilities and obligations which have arisen after the Latest Statement Date in the ordinary course of business consistent with past custom and practice (in each case of this clause (iv), none of which is a liability resulting from breach of contract, breach of warranty, tort, infringement claim or lawsuit). 4.9. No Violation. Except as set forth in Section 4.9 of the Company Disclosure Schedule, neither the execution and delivery of this Agreement nor the consummation by the Company of the transactions contemplated hereby will (a) violate, conflict with or result in any breach of any provision of the respective organizational documents of any Group Entity, (b) violate any order, decree, injunction, judgment, ruling, law, statute, regulation, rule or other determination of any Governmental Authority (collectively, "Laws") applicable to any Group Entity, (c) require the giving of notice to any party to a Material Contract or accord any such party the right to modify a Material Contract, or (d) conflict with or result in a breach of any provision of, or constitute a material default (or an event which, with notice or lapse of time or both, would constitute a material default) under or give to others any rights of termination, amendment, acceleration, suspension, revocation or cancellation of, or result in any Encumbrance on the shares of Company Common Stock or Company Preferred Stock or the properties or assets of the Company, the Company Subsidiaries or the Company Other Entities pursuant to (i) any material agreement, contract or other instrument binding upon any Group Entity or (ii) any material License (as defined in Section 4.15) held by any Group Entity. 4.10. Material Contracts. (a) Section 4.10(a) of the Company Disclosure Schedule sets forth (grouped by each clause of this Section 4.10(a)) the following contracts (collectively, along with each Lease and each other contract which is material to the Group Entities, taken as a whole, or the conduct of its business or the absence of which would have a Material Adverse Effect on the Company, "Material Contracts") in effect as of the date of this Agreement to which any Group Entity is a party: (i) any contract (excluding any customer, provider or employment contract) that the Company reasonably anticipates will, in accordance with its terms, involve aggregate annual payments after the date hereof by any Group Entity of more than $100,000 and that is not cancelable without liability within 60 days; (ii) any contract, note or other instrument with any customer of the Company; (iii) each provider contract or other contract with an individual, facility, program or entity rendering professional health care services as a contractor to any Group Entity under which $100,000 has been paid in calendar year 1996 or is reasonably likely to be paid in calendar year 1997 and that is not cancelable without payment to a third party or liability within 90 days; (iv) any employment or consulting contracts (including without limitation any arrangements or obligations with respect to severance, change in control or termination pay) with any member of the Board of Directors, officer or employee of any Group Entity; (v) all partnership, joint venture or similar contracts of any Group Entity; (vi) any note, loan, letter of credit, contract relating to indebtedness for borrowed money or capitalized leases, or other contract in respect of which any Group Entity is obligated in any way to provide funds in respect of, or to guarantee or assume, any debt, obligation or dividend of any person or entity involving aggregate obligations of the Group Entities of more than $50,000; (vii) any indemnity arrangement arising in connection with any sale or disposition of assets (other than sales of assets in the ordinary course of business); (viii) any acquisition or disposition contracts of any Group Entity under which a party thereto remains obliged to pay monies or perform; (ix) all contracts with any Governmental Authority or with any labor union; (x) contracts for capital expenditures requiring payments by any Group Entity after the date hereof in excess of $100,000 for any single project; (xi) all patent, trademark, service mark, trade name, copyright and franchise licenses, royalty agreements or similar contracts; (xii) any material contracts relating to the licensure or ownership of the hardware or software utilized in any Group Entity's information systems; and (xiii) each contract to which any Group Entity is a party (i) limiting the right of any Group Entity prior to or after the Closing Date, or Parent or any of its subsidiaries or Affiliates at or after the Closing Date, (A) to engage in, or to compete with any person in, any business, including each contract or agreement containing exclusivity provisions restricting the geographical area in which, or the method by which, any business may be conducted by any Group Entity prior to or after the Closing Date, or Parent or any of its subsidiaries or Affiliates after the Closing Date or (B) to solicit any customer, client or patient or (ii) containing "most favored nations" or similar provisions affecting the pricing terms of contracts to which it is a party. The Company has made available to Parent true and complete copies of all written Material Contracts (including all amendments thereto). Without limiting the generality of the foregoing, the Company has provided to Parent a true and complete copy of the amendment to its existing contract with Physician Health Services ("PHS") relating to the Connecticut Medicaid business, extending the terms of such existing contract through December 31, 1998. Set forth in Section 4.10(a)(xiv) of the Company Disclosure Schedule is a true and complete list of base compensation as reported on Form W-2 for each person disclosed as being the beneficiary of a contract or obligation pursuant to Section 4.10(a)(iv) hereof, since and including calendar year 1991, or with respect to any person whose employment with the Company commenced subsequent to 1991, since and including the first calendar year of such person's employment. (b) Each Material Contract which is a customer contract, and each other material contract of any Group Entity which is a customer contract which would have been required to be disclosed in Section 4.10(a) of the Company Disclosure Schedule had such contract been entered into prior to the date of this Agreement, is in full force and effect and is a legal, valid and binding obligation, and there is not (i) any material default (or any event which, with the giving of notice or lapse of time or both, would be a material default) by any Group Entity or, to the knowledge of the Company, any other party, in the timely performance of any obligation to be performed or paid under any such Material Contract or any such other material contract, (ii) to the Company's knowledge, any threat of cancellation or termination of any such Material Contract or other such material contract, (iii) any contract that has been canceled or otherwise terminated within the last 12 months which would have been such a Material Contract had such contract not been canceled or terminated, or (iv) to the Company's knowledge, any material amendment to any such Material Contract, which amendment has been entered into or became effective in the last twelve months, except, in each case, as specifically described in Section 4.10(b) of the Company Disclosure Schedule. (c) Each Material Contract which is not a customer contract, and each other material contract of any Group Entity which is not a customer contract and which would have been required to be disclosed in Section 4.10(a) of the Company Disclosure Schedule had such contract been entered into prior to the date of this Agreement, is in full force and effect and is a legal, valid and binding obligation, and there is (i) no material default (or any event which, with the giving of notice or lapse of time or both, would be a material default) by any Group Entity or, to the knowledge of the Company, any other party, in the timely performance of any obligation to be performed or paid under any such Material Contract or any such other material contract, or (ii) to the knowledge of the Company, no threat of cancellation or termination of any such Material Contract or other such material contract, except, in each case, as specifically described in Section 4.10(c) of the Company Disclosure Schedule. (d) As used herein, (1) "contract" means any written agreement and any legally binding oral agreement, commitment or arrangement and (2) "customer contract" means a contract with a customer of any Group Entity. 4.11. Compliance With Law; Consents and Authorizations. (a) Except as set forth in Section 4.11(a) of the Company Disclosure Schedule, each Group Entity has, in all material respects, operated its business in compliance with applicable Law and it and its business are not in material violation of any Law applicable to such Group Entity. (b) No consent, authorization, license, approval, order or permit of, or declaration, filing or registration with, or notification to, any Governmental Authority or any other third party, is required to be made or obtained by any Group Entity or any stockholder thereof in connection with the execution, delivery and performance of this Agreement and the consummation of the transactions contemplated hereby, except (i) as set forth in Section 4.11(b) of the Company Disclosure Schedule; (ii) pursuant to applicable requirements, if any, of the MGCL, the DGCL and the Hart-Scott-Rodino Antitrust Improvements Act of 1974, as amended (the "HSR Act"); (iii) the Stockholder Approvals; or (iv) as would not, if not so obtained, (A) have a Material Adverse Effect upon the Group Entities, taken as a whole or (B) prevent or materially interfere with the consummation of the transactions contemplated hereby. (c) The representations and warranties in this Section 4.11 shall be deemed not to cover matters which are expressly subject to the representations and warranties set forth in Section 4.15 hereof. 4.12. Insurance. (a) Section 4.12(a) of the Company Disclosure Schedule lists all of the Group Entities' insurance policies or binders covering the assets, employees and operations of the Group Entities as of the date hereof, showing the insurers, limits, type of coverage, annual premiums, deductibles and expiration dates. All such policies or binders are in full force and effect. In the case of professional liability, medical malpractice and errors and omissions, Section 4.12(a) of the Company Disclosure Schedule sets forth such information for each policy or binder held by any Group Entity since January 1, 1991. Section 4.12(a) of the Company Disclosure Schedule also describes each pending claim under the professional liability, medical malpractice or errors and omissions policies. To the Company's knowledge, no Group Entity that is not an Unaffiliated Entity is in default with respect to any provision contained in any such policy or binder, which default would compromise the coverage under any such policy or binder. Attached to Section 4.12(a) of the Company Disclosure Schedule are copies of all letters from each Group Entity's insurance providers concerning the provider's acceptance, denial or qualification of coverage for any pending claims which may be subject to such provider's insurance coverage. (b) The business policy of the Group Entities with respect to the requirements for each individual or entity rendering professional health care services as an employee of or contractor to any Group Entity for professional liability or medical malpractice insurance is set forth in Section 4.12(b) of the Company Disclosure Schedule. 4.13. Tax Matters. The Group Entities have timely filed with the appropriate tax authorities all tax returns required to be filed by or on behalf of the Group Entities, and such tax returns are true, complete and correct in all material respects, and the Group Entities have paid all material Taxes and any other charges, whether or not shown to be due and owing on such tax returns. The Group Entities have withheld and paid in full on a timely basis or accrued as a liability on the balance sheet of the Group Entities as of the Closing Date all material Taxes required to be withheld and paid in connection with amounts paid or owing to any employee, independent contractor, creditor, stockholder or other third party. The Group Entities have not received written notice of, and the Company has no knowledge of, any action, suit, proceeding, audit, claim, deficiency or assessment pending with respect to any Taxes. There are no outstanding waivers of statute of limitations with respect to any tax return or report of the Group Entities and no request for such waiver is pending. No claim has been made by an authority in a jurisdiction where a Group Entity does not file tax returns that the Group Entity may be subject to taxation by the jurisdiction. The Group Entities have not made, are not obligated to make and will not become obligated under any contract entered into prior to or contemporaneously with the Closing to make any payments, separately or in the aggregate, that will be nondeductible under Section 280G of the IRC or subject to excise tax to the recipient under Section 4999 of the IRC. Except for the group of which Company and its Subsidiaries are presently members, none of Company or any of its Subsidiaries have ever been a member of an affiliated group of corporations, within the meaning of Section 1504 of the IRC. The Company has not filed a consent pursuant to Section 341(f) of the IRC or agreed to have Section 341(f)(2) of the IRC apply to any disposition of any asset owned by it or any of its Subsidiaries. The Company and its Subsidiaries have no deferred intercompany transactions or other deferred items of income or gain. The Company is not a personal holding company within the meaning of Section 542 of the IRC. Neither the Company nor any of its Subsidiaries is a party to or is bound by any tax-indemnity, tax-sharing, or tax-allocation agreement. The Company Financial Statements include all reserves for matters concerning Taxes as are required under GAAP. Since December 31, 1995, no Group Entity has made or rescinded any express or deemed election relating to Taxes, settlement or compromise of any claim, action, suit, litigation, proceeding, arbitration, investigation, audit or controversy relating to Taxes, or made any change in any methods of reporting income or deductions for federal income Tax purposes from those employed in the preparation of the federal income Tax returns, as amended, for the taxable year ending December 31, 1995, except as may be required by applicable Law. 4.14. Employee Benefit Plans. (a) Except as set forth in Section 4.14(a) of the Company Disclosure Schedule, no Group Entity has established or maintains, is obligated to make contributions to or under, or otherwise to participate in, or has any liability or obligations with respect to (i) any bonus, stock option, stock purchase, stock appreciation, phantom stock or other type of incentive compensation plan, program, agreement, policy, commitment, contract or arrangement (whether or not set forth in a written document), (ii) any pension, profit-sharing, retirement or other plan, program or arrangement, or (iii) any other employee benefit plan, fund or program, including, but not limited to, those described in Section 3(3) of the Employee Retirement Income Security Act of 1974, as amended, and the rules and regulations promulgated thereunder ("ERISA"). All such plans (individually, a "Plan" and, collectively, the "Plans") have been operated and administered, in all material respects, in accordance with, as applicable, ERISA, the IRC, Title VII of the Civil Rights Act of 1964, as amended, the Equal Pay Act of 1967, as amended, the Age Discrimination in Employment Act of 1967, as amended, and the related rules and regulations adopted by those federal agencies responsible for the administration of such laws. No act or failure to act by any Group Entity has resulted in a "prohibited transaction" (as defined in ERISA and in Section 4975 of the IRC) with respect to the Plans that is not subject to a statutory or regulatory exception or in any breach of fiduciary duty under Title I of ERISA. No Group Entity has previously made, is currently making, or is obligated in any way to make, any contributions to, or has any liability or obligations with respect to, any multiemployer plan within the meaning of Section 3(37) or Section 4001(a)(3) of ERISA or any pension plan which is subject to Section 412 of the IRC or Title IV of ERISA. Other than as set forth in Section 4.14(a) of the Company Disclosure Schedule, no Group Entity has any obligation, under any Plan or otherwise, to provide any employee or former employee with any postretirement, medical, life or other welfare benefit, except as required by Section 4980B of the IRC. The Internal Revenue Service has issued, with respect to each Plan and each related trust agreement, annuity contractor other funding instrument which is intended to be qualified and tax-exempt under the provisions of Sections 401(a) and 501(a) of the IRC, respectively, a favorable determination letter with respect to such qualification and tax-exempt status for all periods from the effective date of each Plan to date. The Company has no knowledge of any facts which exist or any events which have occurred that would adversely effect such qualification and tax-exempt status. All contributions required to be made to any Plan by any Group Entity have been made when due on a timely basis. No Group Entity is or at any time has been a member of a "controlled group of corporations" with or under "common control" with any corporation or any trades or businesses other than with one or more Group Entities. With the exception of the Employee Assistance Service, Inc. Employee Assistance Program, all Plans set forth in Section 4.14(a)(6) of the Company Disclosure Schedule are terminable on not more than 60 days' notice without liability. (b) True and complete copies of each of the following documents have been made available by the Company with respect to each Plan: (i) each Plan document (and, if applicable, related trust agreements) and all amendments thereto, all written interpretations thereof and written descriptions thereof which have been distributed to the employees of any Group Entity, (ii) for the three (3) most recent Plan years, Annual Reports on Form 5500 Series filed with any governmental agency for each Plan which is subject to such filing requirement and (iii) the most recent determination letter issued by the Internal Revenue Service for each Plan which is intended to be qualified under Section 401(a) of the IRC. (c) Section 4.14(c) of the Company Disclosure Schedule sets forth, opposite the name of each employee of the Company who may be eligible to receive severance payments under the Company's severance policy, an agreement (whether oral or written) with the Company or otherwise, the amount of such severance to which the applicable employee may be entitled. 4.15. Licenses; Accreditation and Regulatory Approvals. To the Company's knowledge, the Group Entities hold all material licenses, permits, franchises, certificates of need and other governmental or regulatory authorizations and approvals which are needed or required by Law with respect to their businesses, operations and facilities as they are currently owned or presently conducted (collectively, the "Licenses"). All such material Licenses are in full force and effect and each Group Entity is in compliance in all material respects with all conditions and requirements of the Licenses and with all rules and regulations relating thereto, except as set forth in Section 4.15 of the Company Disclosure Schedule. No such License has been revoked, conditioned or restricted except as for customary conditions or restrictions or as can be cured by a Group Entity within the period allowed by the applicable Governmental Authority for such cure without having a Material Adverse Effect upon the Company or its business, and no Action is pending, or to the Company's knowledge, threatened which in any way challenges the validity of, or seeks to revoke, condition or restrict any such License. Except as set forth in Section 4.15 of the Company Disclosure Schedule, no transfer of any material License is necessary to allow the Surviving Corporation to continue after the Effective Time to operate the Company's facilities as presently operated. 4.16. Absence of Certain Changes or Events. Except as set forth in Section 4.16 of the Company Disclosure Schedule, since the Latest Statement Date to the date of this Agreement there has not been: (a) any material damage, destruction or loss (whether or not covered by insurance) with respect to any material assets of any Group Entity; (b) any change by any Group Entity in its accounting methods, principles or practices, other than such changes required by GAAP; (c) any (i) increase in the compensation payable or to become payable to any member of the Board of Directors, officer or employee, except for increases in salary or wages payable or to become payable in the ordinary course of business and consistent with past practice to employees of such Group Entity who are not members of the Board of Directors or officers of such Group Entity; (ii) grant of any severance or termination pay (other than pursuant to the normal severance policy of such Group Entity as in effect on the date of this Agreement) to, or entry into any employment or severance agreement with, any member of the Board of Directors, officer or employee; or (iii) promise of an increase in the benefits under, or the establishment or amendment of, any bonus, insurance, severance, deferred compensation, pension, retirement, profit sharing, stock option (including, without limitation, the granting of stock options, stock appreciation rights, performance awards or restricted stock awards), stock purchase or other employee benefit plan (except as may be contractually required under Law), or promise of any other increase in the compensation payable or to become payable to members of the Board of Directors, officers or employees of any Group Entity, except for increases in salaries or wages payable or to become payable in the ordinary course of business and consistent with past practice to employees of any Group Entity who are not members of the Board of Directors or officers of any Group Entity and that in the aggregate have not resulted in or will not result in a material increase in the benefits or compensation expense of any Group Entity; (d) any transaction or contract material to the Group Entities taken as a whole, or any commitment to do the same, entered into by any Group Entity (other than in the ordinary course of business and consistent with past practice) or any material changes in the customary method of operations of any Group Entity, including, without limitation, practices and policies relating to marketing, selling and pricing; (e) any transfer, Encumbrance, lease, sublease, license or other disposition by any Group Entity of any of its assets and any action described in Section 8.2(f) hereof, other than in the ordinary course of business and consistent with past practice and not material in the aggregate; (f) any writing down, in accordance with GAAP and consistent with past practice, of the value of any inventories or accounts receivable or any revaluation by any Group Entity of any of its assets or any cancellation or writing off as worthless and uncollectable of any debt, note or account receivable by any Group Entity, or any waiver by any Group Entity of a right of substantial value; (g) to the Company's knowledge, any cancellation, termination, waiver, modification, release or relinquishment by any party (including a Group Entity) to a Material Contract (excluding customer contracts), or, to the Company's knowledge, any receipt by any Group Entity of notice that any such Material Contract to which any Group Entity is a party has been or will be canceled, or that any services provided or to be provided thereunder by any Group Entity will be discontinued; (h) any individual capital expenditure by any Group Entity or commitment to make such capital expenditure in excess of $25,000, except in the ordinary course of business and consistent with past practice; (i) any payment or incurring of liability to pay any Taxes, assessments, fees, penalties, interest or other governmental charges other than those arising and discharged or to be discharged in the ordinary course of business and consistent with past practice; (j) any loans, advances or capital contributions made by any Group Entity to, or investments by any such party in, any person or entity (other than another wholly-owned Group Entity, as to which the uses of the transferred cash or property are not subject to restrictions greater than those imposed prior to such transfer), including, without limitation, to any employee, officer or member of the Board of Directors of any Group Entity; (k) any incurring or guarantee of indebtedness by any Group Entity or commitment to incur or guarantee indebtedness, or of liabilities (except in the ordinary course of business), by any Group Entity exceeding $50,000 in the aggregate, other than as described in Section 4.16(h), above, and other than as may be incurred in the ordinary course of business under the revolving credit agreement for working capital purposes; (l) any failure to maintain the Group Entity plant, property and equipment in good repair and operating condition, ordinary wear and tear excepted; (m) any failure to pay any creditor any material amount owed to such creditor, or to discharge any material obligation, when such payment or discharge is due or within 30 days of such date, except where such obligation is contested in good faith by a Group Entity; (n) any declaration, setting aside or payment of dividends or distributions in respect of any Equity Interests of any Group Entity (other than to a wholly-owned Group Entity, as to which the uses of the transferred cash or property are not subject to restrictions greater than those imposed prior to such transfer) or any redemption, purchase or other acquisition of any Equity Interests or other securities of any Group Entity; (o) any issuance by any Group Entity of any share of capital stock, bond, note, option, warrant or other corporate security (other than option exercises for Company Common Stock), or other action described in Section 8.2(d) hereof; (p) any acquisition of assets by any Group Entity of any corporation, partnership or other business organization or division thereof, or any other action described in Section 8.2(e) hereof; (q) any (i) reorganization or recapitalization of any Group Entity other than the Company; or (ii) split, combination or reclassification of any of the capital stock or issue or authorize or propose the issuance of any other securities in respect of, in lieu of or in substitution for, shares of capital stock, of any Group Entity other than the Company; (r) a Material Adverse Change with respect to the Company; or (s) any authorization, approval, agreement or commitment by any Group Entity to take any action described in clauses (a) through (q) above. 4.17. Personal Property; Information Systems. (a) The Group Entities collectively own, have a valid leasehold interest in, or have legal right to use, all of the tangible personal property necessary to carry on the business of the Group Entities as presently conducted, free and clear of all Encumbrances except for (i) Encumbrances for inchoate mechanics' and materialmens' liens for construction in progress and workmens', repairmens', warehousemens' and carriers' liens arising in the ordinary course of business, (ii) Encumbrances for Taxes not yet payable, (iii) Encumbrances arising out of, under, or in connection with, this Agreement and (iv) Encumbrances set forth in Section 4.17 of the Company Disclosure Schedule arising in connection with the Company's revolving credit agreement (collectively, "Permitted Encumbrances"). (b) The operating and applications computer programs and data bases ("Software") which the Group Entities currently use or have available for use are adequate and sufficient to service their existing customers on the date hereof through the end of the current term of the contracts with such customers. All such Software is owned outright by a Group Entity or, if not owned by a Group Entity, a Group Entity has the right to use the same pursuant to valid licenses therefor. None of the Software owned by a Group Entity and, to the Company's knowledge, none of the Software licensed by a Group Entity, infringes upon or violates any patent, copyright, trade secret or other property right of any other Person. (c) The central processing units, monitors, printers and other computer-related hardware ("Hardware") which the Group Entities currently use or have available for use are adequate and sufficient to service their existing customers on the date hereof through the end of the current term of the contracts with such customers. All such Hardware is owned outright by a Group Entity or, if not owned by a Group Entity, a Group Entity has the right to use the same pursuant to valid licenses therefor. 4.18. Real Property. (a) No Group Entity owns any real property. (b) Section 4.18(b) of the Company Disclosure Schedule lists each parcel of real property leased by each Group Entity, as tenant (collectively, "Leased Real Property"), together with a description of the approximate square footage of each parcel of Leased Real Property and the initial and renewal terms under the applicable Lease with respect to each parcel of Leased Real Property. Except as set forth in Section 4.18(b) of the Company Disclosure Schedule, each Group Entity party to the respective leases for the Leased Real Property (the "Leases") (i) has a valid and subsisting leasehold interest in each Lease, (ii) has not subleased or assigned any interest in any such Lease and (iii) has not received any written notice of material default under any such Lease which is still in effect. 4.19. Customers. Section 4.10(a)(ii) of the Company Disclosure Schedule contains a complete and accurate list, as of the date of this Agreement, of each customer of each Group Entity, and the amount of revenue generated for each such customer during the twelve month period ended December 31, 1996 and during the four-month period ended April 30, 1997. No Group Entity has received any notice, and the Company has no knowledge, that any customer of any Group Entity has ceased, or will cease, to use the services of such Group Entity, or that any customer of any Group Entity has reduced, or will reduce, the use of such services at any time or has threatened to do so. Except as set forth in Sections 4.10(a) and (b) of the Company Disclosure Schedule, no Group Entity has received notice from any existing customer of any Group Entity requesting, nor does the Company have knowledge of an intention by any existing customer to request, that any Group Entity grant price concessions, rebates or reductions on products or services provided by such Group Entity, or any other modification of any contract with a Group Entity that has had, or could reasonably be expected to have, a Material Adverse Effect upon the economic benefits of the relationship with such customer (collectively, "Customer Modifications"). Section 4.19 of the Company Disclosure Schedules sets forth the Company's treatment (i.e., deferral, expensing and amortization) during the fiscal years 1995 and 1996 and the period ending April 30, 1997 of start-up costs for each customer contract listed in Section 4.10(a)(ii) of the Company Disclosure Schedule. 4.20. Receivables; IBNR Claims. The accounts receivable of any Group Entity reflected on the Consolidated Balance Sheet as of May 31, 1997 have arisen in the ordinary course of business and represent bona fide claims of a Group Entity against debtors for sales made, services performed or other charges arising on or before the date hereof, are not subject to valid claims of set-off or other defenses or counterclaims, and, subject to the reserves therefor set forth on such balance sheet (which have been recorded on a consistent basis in a manner consistent with GAAP), will be collectible in the ordinary course of business, without resort to litigation or extraordinary collection activity. All items which are required by GAAP to be reflected as accounts receivable on the Latest Company Financial Statements and the Consolidated Balance Sheet as of May 31, 1997 and the books and records of any Group Entity are so reflected. The reserves for "incurred but not reported" claims ("IBNR Claims") reflected on the Company Financial Statements for the fiscal year ended December 31, 1996 and the month ended immediately preceding the Closing Date are and will be adequate and sufficient, and were determined in accordance with the Company's customary internal accounting practices with respect to reserves for IBNR Claims. Set forth in Section 4.20 of the Company Disclosure Schedule is the Company's IBNR "cushion" as of May 31, 1997, as well as changes in such IBNR "cushion" during the period commencing on January 1, 1997 and ending on May 31, 1997. 4.21. Transactions with Affiliates. Except as disclosed in Section 4.21 of the Company Disclosure Schedule, from the Latest Statement Date to the date of this Agreement, there have been no material transactions, contracts or arrangements between any Group Entity, on the one hand, and (i) the Company or any of its Affiliates (other than a wholly-owned Group Entity, except any transaction which will result in any cash or property transferred in any such transaction becoming more restricted as to use or disposition than it was prior to such transaction), (ii) any member of the Board of Directors or officer of the Company or any of its Affiliates, (iii) any holder of Company Equity Interests or (iv) any member of the immediate family of any individual described in (i), (ii) or (iii), on the other hand. As used in this Agreement, "Affiliate" means, when used with respect to a specified party, another party that, either directly or indirectly through one or more intermediaries, controls or is controlled by or is under common control with the party specified. 4.22. Restricted Cash. Except as set forth in Section 4.22 of the Company Disclosure Schedule, there are no regulatory or contractual restrictions on the ability of any Group Entity to freely transfer its cash and cash equivalents. 4.23. Commissions and Fees. The Company has not employed any investment banker, broker, finder, consultant or intermediary in connection with the transactions contemplated by this Agreement which would be entitled to any investment banking, brokerage, finder's or similar fees or commissions in connection with this Agreement or the transactions contemplated hereby payable by the Company, except for the fees of Merrill Lynch & Co. as set forth on Exhibit 3.1(b) hereto. 4.24. Environmental Matters. No Group Entity is currently Handling, nor in the past has Handled, any Materials of Environmental Concern in any material quantity at, on or from any property or facility owned, leased, operated or occupied by any of them, including any previously owned, leased, operated or occupied property or facility. To the Company's knowledge, no Group Entity is the subject of any federal, state, local or foreign investigation, and no Group Entity has received any written notice or claim, or entered into any negotiations or agreements with any third party, relating to any liability or remedial action or potential liability or remedial action under Environmental Laws, and there are no pending or, to the Company's knowledge, threatened actions, suits or proceedings against or affecting the Group Entities, or their properties, assets or operations, in connection with any such Environmental Laws that if adversely determined, might result in any Material Adverse Change in the Group Entities. There are no past or present Environmental Conditions that are, to the Company's knowledge, likely to form the basis of any claim under existing law against them which might result in any Material Adverse Change of the Group Entities. The term "Handling" or "Handled" means the production, use, generation, storage, treatment, recycling, disposal, discharge, release, processing, distribution, transport or other handling or disposition of any kind. The term "Environmental Laws" means all federal, state, local or foreign statutes, ordinances, regulations, rules, judgments, orders, notice requirements, court decisions, agency guidelines or principles of law, as they may be hereinafter amended from time to time, that (i) regulate or relate to the protection, investigation, remediation or clean-up of the environment or the Handling of any Material of Environmental Concern, the preservation or protection of waterways, groundwater, drinking water, air, wildlife, plants or other natural resource, or the health and safety of persons or property (including without limitation occupational safety and health), or (ii) impose or create liability or responsibility with respect to any of the foregoing. The term "Environmental Condition" means any occurrence, fact or other condition at any location in, on, about or beneath any property owned, leased, operated or otherwise occupied by any Group Entity, including any previously owned, leased or occupied property, resulting from, relating to or arising out of the presence, emission, exposure, migration, dispersal or threatened release, spill, leak, escape into the environment, or Handling of any Material of Environmental Concern. The term "Material of Environmental Concern" means any substance that is regulated by or forms the basis for liability under any applicable Environmental Laws. 4.25. Labor Matters. No Group Entity is a party to any labor agreement with respect to its employees with any labor organization, group or association nor, to the knowledge of the Company, within the last year, have there been attempts to organize. Except as set forth in Section 4.25 of the Company Disclosure Schedule, there is no complaint, charge or claim pending or, to the knowledge of the Company, threatened against any Group Entity with any Governmental Authority, arising out of, in connection with, or otherwise relating to the employment by any Group Entity of any individual. 4.26. Disclosure. None of the representations, warranties or statements by the Company in this Agreement contains or will contain any untrue statement of a material fact, or omits or will omit to state any material fact necessary to make the statements or facts contained herein not misleading. To the Company's knowledge, there is no fact in existence which has, or is reasonably likely to have, a Material Adverse Effect on the Company or the due performance by the Company of its obligations hereunder, which has not been expressly set forth in this Agreement, or in the other documents described herein. ARTICLE V. REPRESENTATIONS AND WARRANTIES OF MERGER SUB AND PARENT Merger Sub and Parent, jointly and severally, hereby represent and warrant to the Company as follows: 5.1. Organization. Existence and Capital Stock. Merger Sub is a corporation duly organized and validly existing and is in good standing under the laws of the State of Delaware. The authorized capital of Merger Sub consists of l,000 shares of common stock, par value $.01 per share ("Merger Sub Common Stock"), all of which shares are issued and registered in the name of Parent. 5.2. Power and Authority. Merger Sub has all necessary corporate power and authority to execute, deliver and perform this Agreement and to consummate the transactions contemplated hereby, and has taken all action required by Law, its charter, Bylaws or otherwise, to authorize the execution, delivery and performance of this Agreement and the consummation of the transactions contemplated hereby. The execution and delivery of this Agreement by Merger Sub, performance of its obligations hereunder and consummation of the transactions contemplated hereby have been duly authorized by all necessary corporate action on the part of Merger Sub and Parent. This Agreement has been duly executed and delivered by Merger Sub and, assuming this Agreement constitutes a valid and binding obligation of the Company, constitutes a valid and binding obligation of Merger Sub, enforceable against Merger Sub in accordance with its terms except that the enforcement hereof may be limited by (a) bankruptcy, insolvency, reorganization, moratorium or other similar laws now or hereafter in effect relating to creditors' rights generally and (b) general principles of equity (regardless of whether enforceability is considered in a proceeding in equity or at law). 5.3. Consents and Approvals; No Violation. Neither the execution and delivery of this Agreement nor the consummation by Merger Sub of the transactions contemplated hereby will (a) violate, conflict with or result in any breach of any provision of the charter or Bylaws of Merger Sub, (b) violate any Laws applicable to Merger Sub, (c) conflict with or result in a breach of any provision of, or constitute a default (or an event which, with notice or lapse of time or both, would constitute a default) under or give to others any rights of termination, amendment, acceleration, suspension, revocation or cancellation of, or result in any Encumbrance on the properties or assets of Merger Sub pursuant to, (i) any material agreement, contract or other instrument binding upon Merger Sub or (ii) any material license, franchise, permit or other similar authorization held by Merger Sub or (d) require any consent, approval or authorization of, notice or declaration to, or filing or registration with, any Governmental Authority, except (1) pursuant to applicable requirements, if any, of the MGCL, the DGCL and the HSR Act, or (2) as would not, if not so obtained, (A) have a Material Adverse Effect upon Merger Sub or (B) prevent or materially interfere with the consummation of the transactions contemplated hereby. 5.4. Legal Proceedings. On the date hereof, there are no Actions pending or, to Merger Sub's knowledge, threatened against, Merger Sub, at law or in equity, relating to the Merger. 5.5. No Prior Activities. Merger Sub is not a party to any material agreements and has not conducted any activities other than in connection with the organization of Merger Sub, the negotiation and execution of this Agreement and the consummation of the transactions contemplated hereby. Merger Sub has no subsidiaries. ARTICLE VI. REPRESENTATIONS AND WARRANTIES OF PARENT Parent hereby represents and warrants to the Company as follows: 6.1. Organization. Existence and Good Standing. Parent is a corporation duly organized and validly existing and is in good standing under the laws of the State of Delaware. Parent has all necessary corporate power to own its properties and assets and to carry on its business as presently conducted and is duly qualified to do business and is in good standing in all jurisdictions in which the character of the property owned, leased or operated or the nature of the business transacted by it makes qualification necessary, except where the failure to be in good standing or qualify would not have a Material Adverse Effect on Parent. 6.2. Power and Authority. Parent has all necessary corporate power and authority to execute, deliver and perform this Agreement and to consummate the transactions contemplated hereby and has taken all corporate actions required to authorize the execution, delivery and performance of this Agreement and the consummation of the transactions contemplated hereby. The execution and delivery of this Agreement has been approved by the Board of Directors of Parent. This Agreement has been duly executed and delivered by Parent and Merger Sub and, assuming this Agreement constitutes a valid and binding obligation of the Company, constitutes a valid and binding obligation of Parent and Merger Sub, enforceable against Parent and Merger Sub in accordance with its terms except that the enforcement hereof may be limited by (a) bankruptcy, insolvency, reorganization, moratorium or other similar laws now or hereafter in effect relating to creditors' rights generally and (b) general principles of equity (regardless of whether enforceability is considered in a proceeding in equity or at law). 6.3. Financing. Parent has provided true and complete copies of all commitment letters for the benefit of Parent (the "Commitment Letters") relating to the Merger and the transactions contemplated thereby. The financing outlined in the Commitment Letters is sufficient, assuming funding of such amounts, to pay the portion of the Merger Consideration payable under Section 3.1(b)(i) in connection with the transactions contemplated hereby. 6.4. Legal Proceedings. On the date hereof, there are no Actions pending or, to Parent's knowledge, threatened against Parent, at law or in equity, relating to the Merger. 6.5. Consents and Approvals; No Violation. Neither the execution and delivery of this Agreement nor the consummation by Parent of the transactions contemplated hereby will (a) violate, conflict with or result in any breach of any provision of the respective organizational documents of Parent, (b) violate any Law applicable to Parent, (c) conflict with or result in a breach of any provision of, or constitute a default (or an event which, with notice or lapse of time or both, would constitute a default) under, or give to others any rights of termination, amendment, acceleration, suspension, revocation or cancellation of, or result in any Encumbrance on the shares of Parent's capital stock or the properties or assets of Parent pursuant to, (i) any material agreement, contract or other instrument binding upon Parent or (ii) any material license, franchise, permit or other similar authorization held by Parent, or (d) require any consent, approval or authorization of, notice or declaration to, or filing or registration with, any Governmental Authority, except (1) pursuant to applicable requirements, if any, of the MGCL, the DGCL and the HSR Act, or (2) as would not, if not so obtained, (A) have a Material Adverse Effect upon Parent or (B) prevent or materially interfere with the consummation of the transactions contemplated hereby. 6.6. Parent Capital Stock. Parent's authorized capital stock consists of 40,000,000 shares of Parent Common Stock, of which 28,559,800 shares are issued and outstanding on the date hereof, and 1,000,000 shares of preferred stock, par value $.01 per share ("Parent Preferred Stock"), of which no shares are issued and outstanding on the date hereof. Such shares constitute all of the issued and outstanding shares of capital stock of Parent. All of the issued and outstanding shares of Parent Common Stock are duly and validly issued, fully paid and nonassessable and were not issued in violation of any preemptive rights. All of the Parent Shares, if and when issued in accordance with Section 3.7 hereof, will be duly and validly issued, fully paid and nonassessable, and will not be issued in violation of any preemptive rights. Parent has authorized options to acquire 9,561,000 shares of Parent Common Stock under its 1995 Stock Purchase and Option Plan for Employees of Merit Behavioral Care Corporation and Subsidiaries and its 1996 Employee Stock Option Plan of Merit Behavioral Care Corporation, of which options to acquire not more than 7,000,000 shares of Parent Common Stock are issued and outstanding on the date hereof. 6.7. SEC Documents; No Material Adverse Change. The Parent has filed all forms, reports, statements and other documents required to be filed by it with the Securities and Exchange Commission ("SEC") since March 20, 1996 (such forms, reports, statements and other documents are referred to herein as the "Parent SEC Documents"). The Parent SEC Documents filed by Parent with the SEC prior to and after the date of this Agreement (i) complied, or will comply, when filed, in all material respects with the applicable requirements of GAAP, the Securities Act of 1933, as amended, the Securities Exchange Act of 1934, as amended, and the rules and regulations thereunder, and (ii) did not, or will not, when filed, contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading. Since December 31, 1996, there has been no Material Adverse Change with respect to Parent not disclosed in the Parent SEC Documents. ARTICLE VII. ACCESS TO INFORMATION AND DOCUMENTS 7.1. Access to Information. Between the date hereof and the Closing Date, the Company will, and will cause each Group Entity (other than an Unaffiliated Entity) and their respective officers, stockholders, employees, accountants, counsel, financial advisors and other representatives (collectively, the "Company Parties") to provide Parent and its Affiliates, officers, employees, stockholders, subsidiaries, counsel, accountants, financing sources, financial advisors and other representatives (collectively, the "Parent Representatives") full access, at reasonable times, to all the properties, documents, contracts, personnel files and other records of the Company Parties and shall furnish the Parent Representatives with access to the employees of such Company Parties and copies of such documents and with such information with respect to the affairs of such Company Parties as the Parent Representatives may from time to time reasonably request. Each Company Party will disclose and make available to the Parent Representatives all books, contracts, accounts, personnel records, letters of intent, papers, records, communications with Governmental Authorities and other documents relating to the business and operations of such Company Party. All information disclosed by any Company Party shall be deemed to be "Confidential Information" under the terms of the Confidentiality Agreement dated March 28, 1997, between the Company and Parent (the "Confidentiality Agreement"). No investigation pursuant to this Section 7.1 shall affect any representations or warranties of the parties herein or the conditions to the obligations of the parties hereto. ARTICLE VIII. COVENANTS OF THE COMPANY 8.1. Affirmative Covenants. Unless otherwise expressly contemplated by this Agreement, or consented to in writing by Parent, the Company hereby covenants and agrees to, the Company hereby covenants and agrees to cause each Group Entity other than an Unaffiliated Entity to, and the Company hereby covenants and agrees to use its best efforts to cause each Unaffiliated Entity to, between the date hereof and the Effective Time: (a) operate the business of such Group Entity only in the usual, regular and ordinary course consistent with past practice; (b) use reasonable efforts to preserve intact the business organization and assets, maintain the rights and franchises, retain the services of the respective officers, key employees and consultants, and maintain the relationships with the respective customers and suppliers of the business of such Group Entity; (c) maintain and keep the properties and assets of such Group Entity in as good repair and condition as at present in all material respects, ordinary wear and tear excepted; (d) keep in full force and effect insurance and bonds comparable in amount and scope of coverage to that currently maintained by such Group Entity; (e) perform in all material respects all obligations required to be performed under all Material Contracts, leases, contracts and documents relating to or affecting the assets, properties or operations of such Group Entity; (f) comply with and perform in all material respects all obligations and duties imposed by all applicable Laws; (g) maintain the books, accounts and records of such Group Entity in the usual, regular and ordinary manner on a basis consistent with past practice; (h) deliver to Parent, within fifteen (15) business days after the end of each calendar month, an unaudited, consolidated balance sheet, statement of operations, statement of stockholders' equity and cash flow statement for the Company for such month just ended (the "Subsequent Company Financial Statements"), schedules showing the results of operations and variances in revenue for each of the items set forth therein (the "Subsequent Supplemental Schedules"), and within 45 days after the end of each fiscal quarter, an unaudited, condensed balance sheet, statement of operations, statement of stockholders' equity and cash flow statement for the Company for such fiscal quarter just ended; (i) notify Parent of any material Action commenced by or against such Group Entity or any Actions commenced or threatened which relate to the transactions contemplated by this Agreement; (j) consult with Parent as to additional expenditures with respect to any Group Entity's information systems exceeding $100,000 in the aggregate; (k) through its Board of Directors, recommend to the holders of Company Common Stock at the meeting noticed as described in Section 4.5(b) hereof and scheduled to occur on or about July 29, 1997, approval of the Merger, this Agreement and the transactions contemplated thereby and hereby, and take all other necessary and appropriate action to properly notice and convene such meeting and obtain the Stockholder Approvals. In connection with such meeting, the Company shall provide to Parent and its counsel drafts of, and accept (pursuant to the reasonable requests of Parent), Parent's comments on and revisions to, the disclosure materials to be provided to the holders of Company Common Stock and Company Preferred Stock in connection with such meeting; (l) obtain the approval described in Section 12.2(m), at the meeting noticed as described in Section 4.5(b) hereof and scheduled to occur on or about July 29, 1997; and (m) use reasonable efforts, in connection with the payment described in Section 9.2, to arrange for evidence of the full and complete satisfaction of the debt owed to NationsBank, N.A. and the release of any related guarantees (the "Existing Debt"), which satisfaction and release shall occur at the Effective Time. 8.2. Negative Covenants. Unless otherwise expressly contemplated by this Agreement, consented to in writing by Parent or disclosed in Section 8.2 of the Company Disclosure Schedule, the Company hereby covenants and agrees not to, the Company hereby covenants and agrees not to permit any Group Entity other than an Unaffiliated Entity to, and the Company hereby covenants and agrees to use its best efforts to cause each Unaffiliated Entity not to, do any of the following between the date hereof and the Effective Time: (a) (i) increase the compensation payable or to become payable to any member of the Board of Directors or Board of Managers, officer or employee, except for increases in salary or wages payable or to become payable in the ordinary course of business and consistent with past practice to employees of such Group Entity who are not members of the Board of Directors or Board of Managers or officers of such Group Entity; (ii) grant any severance or termination pay (other than pursuant to the normal severance policy of such Group Entity as in effect on the date of this Agreement) to, or enter into any employment or severance agreement with, any member of the Board of Directors or Board of Managers, officer or employee; or (iii) grant, promise an increase in benefits under, establish or amend, or pay any bonus, insurance, deferred compensation, pension, retirement, profit sharing, stock option (including, without limitation, the granting of stock options, stock appreciation rights, performance awards or restricted stock awards), stock purchase or other similar employee benefit plans or arrangements in respect of members of the Board of Directors or Board of Managers, officers or employees of such Group Entity, except to the extent that such Group Entities are, on the date hereof, contractually obligated or required by Law to do so; (b) declare, set aside or pay any dividend on, or make or incur any obligation to make any other distribution in respect of, outstanding Equity Interests of such Group Entity or effect any other payment or distribution to the holders of Company Equity Interests, except any dividend or distribution to a wholly-owned Group Entity of the respective Group Entity which will result in the cash or other property so transferred becoming more restricted as to use or disposition than it was prior to such dividend or distribution; (c) (i) redeem, purchase or otherwise acquire any shares of capital stock or other equity interests or any securities or obligations convertible or exchangeable for any shares of capital stock or other equity interests, or any options, warrants or conversion or other rights to acquire any shares of the capital stock, equity interests or any such securities or obligations, in each case of such Group Entity; (ii) effect any reorganization or recapitalization; or (iii) split, combine or reclassify any of the capital stock or issue or authorize or propose the issuance of any other securities in respect of, in lieu of or in substitution for, shares of capital stock, in each case of such Group Entity; (d) issue, deliver, award, grant or sell, or authorize or propose the issuance, delivery, award, grant or sale (including the grant of any Encumbrances, limitations on voting rights or other encumbrances) of, any shares of any class of capital stock or other equity interests (including shares held in treasury), any securities convertible into or exercisable or exchangeable for any such shares or other equity interests, or any rights, warrants or options to acquire, any such shares or other equity interests, of such Group Entity (except for the issuance of shares of Company Common Stock upon exercise of options outstanding on the date hereof) or amend or otherwise modify the terms of any such rights, warrants or options, the effect of which shall be favorable to the holders thereof; (e) acquire or agree to acquire, by merging or consolidating with, by purchasing an equity interest in or a portion of the assets of, or by any other manner, any business or any corporation, partnership, association or other business organization or division thereof, or otherwise acquire or agree to acquire any assets of any other person (other than the purchase of assets from suppliers or vendors in the ordinary course of business and consistent with past practice); (f) sell, lease, exchange, mortgage, pledge, transfer or otherwise dispose of, or agree (or solicit any inquiries or proposals or enter into any discussions or negotiations) to sell, lease, exchange, mortgage, pledge, transfer or otherwise dispose of, any of the properties or assets of such Group Entity (including, without limitation, any Equity Interest in a Group Entity) or cancel, release or assign any indebtedness owed to or any claims held by such Group Entity, except for dispositions of immaterial assets in the ordinary course of business and consistent with past practice; (g) propose or adopt any amendments to the articles of organization or bylaws or equivalent organizational documents of such Group Entity, other than as contemplated by Article II hereof; (h) (i) change any methods of accounting in effect at December 31, 1996, (ii) make or rescind any express or deemed election relating to Taxes, settle or compromise any claim, action, suit, litigation, proceeding, arbitration, investigation, audit or controversy relating to Taxes, or change any methods of reporting income or deductions for federal income Tax purposes from those employed in the preparation of the federal income Tax returns for the taxable year ending December 31, 1995, except as may be required by applicable Law or (iii) file any income or franchise tax returns without first submitting such returns to Parent for its review, and unless Parent provides its prior written consent, which consent shall not be unreasonably withheld, file its 1996 federal and state income tax returns prior to the fifth business day before the due date of such returns, with extensions; (i) incur any indebtedness for borrowed money or purchase money indebtedness (other than in connection with the acquisition of fixed assets in the ordinary course of business which do not exceed $100,000 in the aggregate), or assume, guarantee, endorse or otherwise become responsible for indebtedness of any other person, or make any loans or advances to any person; (j) enter into any contract material to the Company; (k) terminate, modify or amend any Material Contract, Lease, License, or other contract or commitment, except in the ordinary course of business and not involving a material increase in liability or reduction in revenue, settle or otherwise resolve any financial issue, claim or adjustment under any such Material Contract, Lease, License, or other contract or commitment (including, without limitation, any resolution or settlement of the bid price adjustment of OCHAMPUS described in Section 3.7(b)(ii) hereof), or make any payment or effect any modification to any Material Contract, Lease or License in connection with obtaining any consent or approval necessitated by the transactions contemplated hereby (other than payments and modifications which, individually, and in the aggregate, are immaterial); (l) enter into any material transactions, agreements, or arrangements between such Group Entity, on the one hand, and (i) the Company or any of its Affiliates (other than wholly-owned Group Entities, except any transaction which will result in any cash or property transferred in any such transaction becoming more restricted as to use or disposition than it was prior to such transaction), (ii) any member of the Board of Directors or Board of Managers or officer of the Company or any of its Affiliates (other than wholly-owned Group Entities, except any transaction which will result in any cash or property transferred in any such transaction becoming more restricted as to use or disposition than it was prior to such transaction), (iii) any holder of Company Equity Interests or (iv) any member of the immediate family of any individual described in (i), (ii) or (iii) on the other hand; (m) settle or compromise any Action (i) for any amount in excess of $100,000 or (ii) that involves any commitment or arrangement which has, or is reasonably likely to have, a material effect on the prospects, operations, results of operations, assets or condition (financial or otherwise) of the Group Entities, taken as a whole; (n) make any payment in respect of any component of the Adjustment Amount described on Exhibit 3.1(b) in excess of the amount specified for such component on such Exhibit; or (o) agree, authorize, approve or commit in writing or otherwise to do any of the foregoing. Notwithstanding the foregoing, the Company's actions and payments required under Section 3.2 and the payment of the amounts set forth on Exhibit 3.1(b) shall not be prohibited by the terms of this Section 8.2. 8.3. CHAMPUS 2/5 Subcontract. The Company covenants that the definitive subcontract between Humana MHS and the Company, dated June 26, 1997, relating to the provision of behavioral health managed care services by the Company on behalf of Humana MHS with respect to CHAMPUS Regions 2 and 5 (the "CHAMPUS 2/5 Subcontract"), attached hereto as Exhibit 8.3, represents a legal, valid and binding agreement of the Company and is in full force and effect as of the date hereof. 8.4. No Solicitations. From the date hereof until the earlier of the Effective Time or the termination of this Agreement in accordance with its terms (the "Acquisition Exclusivity Period"), the Company hereby covenants and agrees not to, and agrees to cause each other Group Entity other than an Unaffiliated Entity not to, permit any of the members of their respective Boards of Directors or Board of Managers, or any of their respective stockholders, officers, members, agents, advisors, counsel or representatives (collectively, "Representatives") to, directly or indirectly, (a) solicit or entertain any inquiries or proposals or enter into or continue any discussion, negotiations or agreements relating to the sale or other disposition of the Company (whether through a merger, reorganization, stock purchase or otherwise) or its assets, properties, business or operations (a "Proposed Acquisition") to or with any person or entity other than Parent or (b) provide any assistance or any information to any person or entity other than Parent relating to any Proposed Acquisition. The Company agrees that it will immediately cease and cause to be terminated any existing activities, discussions or negotiations with any parties (other than Parent) heretofore conducted, or the provision by the Company or any Group Entity (other than an Unaffiliated Entity) or their respective Representatives of information to any party (other than Parent) to which information heretofore has been provided. If, after the date hereof, the Company or any Group Entity (other than an Unaffiliated Entity) receives any such inquiry or proposal or request for information, or offer to discuss or negotiate any Proposed Acquisition, the Company will immediately provide notice thereof to Parent. ARTICLE IX. COVENANTS OF THE PARENT AND MERGER SUB 9.1. Financing. Parent will use its reasonable efforts to obtain the financing necessary for the consummation of the transactions contemplated hereby from a bank or banks or other institutional lenders. The Company shall cooperate with, and provide all necessary assistance to, Parent in connection with Parent's financing contemplated under the Commitment Letters. 9.2. Existing Debt. Parent shall, subject to the provisions of Section 9.1 and the Company's fulfillment of its covenant in Section 8.1(m), at the Effective Time pay to NationsBank, N.A. an amount required to fully and completely satisfy, retire and release the Existing Debt. ARTICLE X. COVENANTS OF THE COMPANY, PARENT AND MERGER SUB 10.1. Public Disclosures. Parent and the Company will consult with each other before issuing any press release or otherwise making any public statement with respect to the transactions contemplated by this Agreement, and shall not issue any such press release or make any such public statement prior to such consultation, including as may be required by applicable Law or requirements of the SEC. 10.2. Notification of Certain Matters. The Company shall give prompt notice to Parent, and Parent shall give prompt notice to the Company, of (i) the occurrence, or failure to occur, of any event which occurrence or failure would be likely to cause any representation or warranty contained in this Agreement to be untrue or inaccurate in any material respect at any time from the date hereof to the Effective Time and (ii) any material failure of the Company or Parent, as the case may be, or of any Affiliate thereof, to comply with or satisfy any covenant, condition or agreement to be complied with or satisfied by it hereunder; provided, however, that no such notification shall affect the representations or warranties of the parties or the conditions to the obligations of the parties hereunder. 10.3. Other Actions. None of the Company, Parent and Merger Sub shall knowingly or intentionally take any action, or omit to take any action, if such action or omission would, or reasonably might be expected to, result in any of its representations and warranties set forth herein being or becoming untrue in any material respect, or in any of the conditions to the Merger set forth in this Agreement not being satisfied, or (unless such action or omission is required by applicable Law) which would materially and negatively affect the ability of the Company or Parent to obtain any consents or approvals required for the consummation of the Merger or which would otherwise materially impair the ability of the Company or Parent to consummate the Merger in accordance with the terms of this Agreement or materially delay such consummation, in each case without consent of the other party. 10.4. Regulatory and Other Authorizations; Consents. Each party hereto shall use its commercially reasonable efforts to (a) take, or cause to be taken, all appropriate action, and do, or cause to be done, all things necessary, proper or advisable under applicable Law or otherwise to promptly consummate and make effective the transactions contemplated by this Agreement and (b) obtain all authorizations, consents, orders and approvals of, and to give all notices to and make all filings with, all Governmental Authorities and other third parties that may be or become necessary for its execution and delivery of, and the performance of its obligations pursuant to, this Agreement including, without limitation, those consents set forth in Section 4.11(b) of the Company Disclosure Schedule. Each party will cooperate fully with the other party in promptly seeking to obtain all such authorizations, consents, orders and approvals, giving such notices, and making such filings. In connection with obtaining such consents from third parties, neither party shall be required to make payments, commence litigation or agree to modifications of the terms thereof (other than payments and modifications which individually, and in the aggregate, are immaterial), and no material modification shall be made to any contract, agreement or other commitment of any Group Entity without the prior written consent of Parent. Each party hereto agrees to make an appropriate filing of a Notification and Report Form pursuant to the HSR Act with respect to the transactions contemplated hereby as soon as practicable following the date hereof and to supply promptly any additional information and documentary material that may be requested pursuant to the HSR Act. The parties hereto agree not to take any action that will have the effect of unreasonably delaying, impairing or impeding the receipt of any required authorizations, consents, orders or approvals. Prior to making any application or filing with any Governmental Authority or other person or entity in connection with this Agreement, the Company, on the one hand, and Parent, on the other hand, shall provide the other with drafts thereof and afford the other a reasonable opportunity to comment on such drafts. Without limiting the generality of the preceding sentences, each of Parent and the Company agrees to cooperate and use all commercially reasonable efforts to vigorously contest and resist any action, suit, proceeding or claim, and to have vacated, lifted, reversed or overturned any injunction, order, judgment or decree (whether temporary, preliminary or permanent), that delays, prevents or otherwise restricts the consummation of the Merger or any other transaction contemplated by this Agreement, and to take any and all actions as may be required by Governmental Authorities as a condition to the granting of any such necessary approvals or as may be required to avoid, vacate, lift, reverse or overturn any injunction, order, judgment, decree or regulatory action (provided, however, that in no event shall any party hereto take, or be required to take, any action that would have a Material Adverse Effect on Parent or the Group Entities). Notwithstanding the foregoing, in no event shall Parent be required at any time from the date hereof through and following the Effective Time to dispose of the assets, or divest the businesses, of Parent, any Group Entity or any of their respective Affiliates. 10.5. Employee Transition Matters. The parties hereto shall address certain matters concerning employees of Group Entities as provided on Exhibit 10.5. 10.6. Escrow Agreement. Pursuant to the terms of the Escrow Agreement, Parent shall have deposited an amount equal to the Escrow Amount into the Escrow Account (as defined in the Escrow Agreement). ARTICLE XI. TERMINATION, AMENDMENT AND WAIVER 11.1. Termination. This Agreement may be terminated at any time prior to the Effective Time: (a) by mutual written consent of Parent and the Company; (b) by either Parent or the Company: (i) if the Merger shall not have been consummated on or before the 75th day after the date hereof , unless the failure to consummate the Merger is the result of a willful and material breach of this Agreement by the party seeking to terminate this Agreement or further, in the case of the Company, any breach of a Stockholder Support Agreement by any stockholder which is a party thereto; (ii) if any Governmental Authority shall have issued an order, decree or ruling or taken any other action permanently enjoining, restraining or otherwise prohibiting the Merger and such order, decree, ruling or other action shall have become final and nonappealable; (iii) in the event of a breach by the other party of any representation, warranty, covenant or other agreement contained in this Agreement which (A) would give rise to the failure of a condition set forth in Article XII and (B) has not been cured within 30 days after the giving of written notice to the breaching party of such breach (a "Material Breach") (provided that the terminating party is not then in Material Breach of any representation, warranty, covenant or other agreement contained in this Agreement); or (iv) in the event that (A) all of the conditions to the obligation of such party to effect the Merger set forth in Section 12.1 shall have been satisfied and (B) any condition to the obligation of such party to effect the Merger set forth in Section 12.2 (in the case of Parent) or Section 12.3 (in the case of the Company) is not capable of being satisfied prior to the end of the period referred to in Section 11.1(b)(i); or (c) by Parent, in the event of a breach by a stockholder of any representation, warranty, covenant or other agreement contained in a Stockholder Support Agreement which cannot be or has not been cured within 30 days after the giving of written notice to the breaching stockholder of such breach. 11.2. Effect of Termination. In the event of termination of this Agreement as provided in Section 11.1, this Agreement shall forthwith become void and have no effect, without any liability or obligation on the part of any party, other than the provisions of Sections 7.1 and 11.3 and this Section 11.2, and except to the extent that such termination results from the willful and material breach by a party of any of its representations, warranties, covenants or other agreements set forth in this Agreement. 11.3. Expenses and Fees. With the exception of the expenses and fees set forth on Exhibit 3.1(b) hereto to be paid by the Company, all costs and expenses incurred in connection with this Agreement and the transactions contemplated hereby shall be paid by the party incurring such expense. ARTICLE XII. CONDITIONS TO CLOSING 12.1. Mutual Conditions. The respective obligations of each party to effect the Merger shall be subject to the satisfaction, at or prior to the Closing Date, of the following conditions (any of which may be waived in writing by Parent and the Company): (a) None of Parent, Merger Sub or the Company nor any of their respective subsidiaries shall be subject to any order, decree or injunction by a Governmental Authority which prevents or materially delays the consummation of the Merger. (b) No statute, rule, regulation, order, decree, judgment, injunction, stipulation or determination shall have been enacted by any Governmental Authority that makes the consummation of the Merger and any other transaction contemplated hereby illegal. 12.2. Conditions to Obligations of Parent and Merger Sub. The obligations of Parent and Merger Sub to consummate the Merger and the other transactions contemplated hereby shall be subject to the satisfaction, at or prior to the Closing Date, of the following conditions (any of which may be waived by Parent or Merger Sub): (a) Each of the agreements of the Company to be performed at or prior to the Closing Date pursuant to the terms hereof shall have been duly performed in all material respects, and the Company shall have performed, in all material respects, all of the acts required to be performed by it at or prior to the Closing Date by the terms hereof. (b) The representations and warranties of the Company set forth in this Agreement that are qualified as to materiality shall be true and correct, and those that are not so qualified shall be true and correct in all material respects, as of the date of this Agreement and as of the Closing as though made at and as of such time, except to the extent such representations and warranties expressly relate to an earlier date (in which case such representations and warranties that are qualified as to materiality shall be true and correct, and those that are not so qualified shall be true and correct in all material respects, as of such earlier date). (c) The applicable waiting period under the HSR Act shall have expired or been terminated; and, except as set forth in Section 4.11(b) of the Company Disclosure Schedule, all consents and approvals of Governmental Authorities necessary for consummation of the transactions contemplated hereby and all consents and approvals set forth on Section 4.11(b) of the Company Disclosure Schedule shall have been obtained. (d) Neither Parent nor Merger Sub nor any of their respective Affiliates shall be subject to any (i) Action brought by any third party challenging the transactions contemplated hereby which would, if decided adversely to Parent or any Group Entity, have a Material Adverse Effect on Parent or the Group Entities, in either case, taken as a whole, on or after the Effective Time, or (ii) order, decree or injunction by a Governmental Authority which would impose any material limitation on the ability of Parent effectively to exercise full rights of ownership of, or control over, the common stock of the Surviving Corporation or any material portion of the assets or business of the Group Entities, taken as a whole. (e) Parent and/or Merger Sub shall have obtained the financing set forth in the Commitment Letters on the terms set forth in such Commitment Letters and other terms reasonably acceptable to Parent, and such financing has been funded on such terms. (f) The Stockholder Support Agreements shall be in full force and effect in accordance with their terms. The parties to the Stockholder Support Agreements shall have performed and complied with all covenants and agreements required to be performed or complied with therein by such parties. (g) Holders of not more than 5% (excluding outstanding shares of Company Common Stock and Company Preferred Stock held by Ronald E. Cann, M.D.) of the outstanding shares of Company Common Stock and Company Preferred Stock shall have filed with the Company a written objection to the Merger meeting the requirements of Section 3-203(a)(1) of the MGCL with respect to their shares of Company Common Stock or Company Preferred Stock. (h) From the date of this Agreement until the Effective Time, there shall not have occurred any Material Adverse Change with respect to the Company. (i) (1) Each of the agreements listed in Exhibit 12.2(i)(1) shall have been terminated without cost or liability to Parent, Merger Sub or any Group Entity, and shall be of no further force or legal effect; and (2) the agreements listed in Exhibit 12.2(i)(2) shall remain in full force and effect, without any assertion by Humana Inc. of any breach or default thereunder. (j) The CHAMPUS 2/5 Subcontract shall not have been terminated by Humana. (k) [intentionally omitted]. (l) Parent or one of its subsidiaries shall have been provided reasonable access to each of the customers of the Company set forth on Exhibit 12.2(l) hereto, and Parent shall have received verbal or written confirmation reasonably satisfactory to Parent from each such customer that such customer will not terminate or modify in any material respect its business relationship with the Company as a result of the consummation of the transactions contemplated by this Agreement. (m) The Stockholder Approvals shall have been obtained. (n) Parent shall have received, for the months of June 1997 and July 1997, each of the Subsequent Company Financial Statements and the Subsequent Supplemental Schedules for such months. (o) The payment of the amounts set forth in clause (iv) of the definition of "Adjustment Amount" in Exhibit 3.1(b) hereto shall have been approved by the Company's stockholders in accordance with Section 280G of the IRC. (p) The Employment and Consulting Agreement, dated as of the date hereof, between the Company and Dr. Alan J. Shusterman shall have become and shall remain effective as of the Closing Date, and the Letter Agreement, dated as of the date hereof, between the Company and Dr. Douglass Kay shall have become and shall remain effective as of the Closing Date. (q) Parent and Merger Sub shall have been furnished with a certificate, executed by the Chief Executive Officer of the Company, dated the Closing Date, certifying in such detail as Parent and Merger Sub may reasonably request as to the fulfillment of the conditions set forth in Sections 12.2(a), (b), (g), (h), (i), (j), (k), (m), (n) and (o). (r) Parent and Merger Sub shall have been furnished with a certificate, executed by the Chief Financial Officer of the Company, dated the Closing Date, certifying in such detail as Parent and Merger Sub may reasonably request as to the fulfillment of the conditions set forth in paragraphs 1, 2(D) and 2(F) of Exhibit 13.7. (s) The holders of Stock Options identified on Exhibit 12.2(s) shall have delivered to Parent and the Company consents to the treatment of their Stock Options in accordance with Section 3.2. 12.3. Conditions to Obligations of the Company. The obligations of the Company to consummate the Merger and the other transactions contemplated hereby shall be subject to the satisfaction, at or prior to the Closing Date, of the following conditions (any of which may be waived by the Company): (a) Each of the agreements of Parent and Merger Sub to be performed at or prior to the Closing Date pursuant to the terms hereof shall have been duly performed, in all material respects, and Parent and Merger Sub shall have performed, in all material respects, all of the acts required to be performed by them at or prior to the Closing Date by the terms hereof. (b) The representations and warranties of Parent and Merger Sub set forth in Article V shall be true and correct in all material respects as of the date of this Agreement and as of the Closing Date. The representations and warranties of Parent set forth in Article VI of this Agreement that are qualified as to materiality shall be true and correct, and those that are not so qualified shall be true and correct in all material respects, as of the date of this Agreement and as of the Closing Date as though made at and as of such time, except to the extent such representations and warranties expressly relate to an earlier date (in which case such representations and warranties that are qualified as to materiality shall be true and correct, and those that are not so qualified shall be true and correct in all material respects, as of such earlier date). (c) From the date of this Agreement until the Effective Time, there shall not have occurred any Material Adverse Change with respect to Parent and its Affiliated subsidiaries, taken as a whole. (d) The Stockholder Approvals shall have been obtained. (e) The applicable waiting period under the HSR Act shall have expired or been terminated. (f) The Company shall have been furnished with certificates, executed by the Chief Executive Officers of Parent and Merger Sub, dated the Closing Date, certifying in such detail as the Company may reasonably request as to the fulfillment of the conditions set forth in Sections 12.3(a), (b) and (c). ARTICLE XIII. MISCELLANEOUS 13.1. Nonsurvival of Representations and Warranties. None of the representations and warranties in this Agreement or in any instrument delivered pursuant to this Agreement shall survive the Effective Time. 13.2. Scope of Representations and Warranties. The Company shall not be deemed to have made to Parent any representation or warranty other than as expressly made by the Company in Article IV hereof. Without limiting the generality of the foregoing, and notwithstanding any otherwise express representations and warranties made by the Company in Article IV hereof, the Company makes no representation or warranty to Parent with respect to (a) any projections, estimates or budgets heretofore delivered or made available to Parent of future revenues, expenses or expenditures, future results of operations and other similar projections or estimates or (b) any other information or documents made available to Parent or its counsel, accountants, or advisors with respect to the Group Entities, except as expressly covered by a representation and warranty contained in Article IV hereof. 13.3. Notices. Any communications required or desired to be given hereunder shall be deemed to have been properly given if sent by hand delivery or by facsimile and overnight courier to the parties hereto at the following addresses, or at such other address as either party may advise the other in writing from time to time: If to the Company: CMG Health, Inc. 25 Crossroads Drive Owings Mills, Maryland 21117 Attention: Alan J. Shusterman, Ph.D. Facsimile: (410) 654-2655 with a copy to: CMG Health, Inc. 25 Crossroads Drive Owings Mills, Maryland 211117 Attention: Jill B. Reamer, Esq. Vice President of Mergers and Acquisitions and General Counsel Facsimile: (410) 654-2655 and William R. Kunkel, Esq. Skadden, Arps, Slate, Meagher & Flom (Illinois) 333 West Wacker Drive, Suite 2100 Chicago, Illinois 60606 Facsimile: (312) 407-0411 If to Parent or Merger Sub: Merit Behavioral Care Corporation One Maynard Drive Park Ridge, New Jersey 07446 Attention: Michael G. Lenahan, Esq. Executive Vice President -- Mergers & Acquisitions and General Counsel Facsimile: (201) 573-1324 with a copy to: Mark D. Gerstein, Esq. Latham & Watkins Sears Tower, Suite 5800 Chicago, Illinois 60606 Facsimile: (312) 993-9767 All such communications shall be deemed to have been delivered on the date of hand delivery or facsimile transmission, or on the next business day following the deposit of such communications with the overnight courier. 13.4. Further Assurances. Each party hereby agrees to perform any further acts and to execute and deliver any documents which may be reasonably necessary to carry out the provisions of this Agreement. 13.5. Governing Law. The Laws of the State of Delaware shall govern the interpretation, validity and performance of the terms of this Agreement, regardless of the law that might be applied under principles of conflicts of law. Any suit, action or proceeding by a party hereto with respect to this Agreement, or any judgment entered by any court in respect of any thereof, may be brought in any state or federal court of competent jurisdiction in the State of Delaware, and each party hereto hereby submits to the exclusive jurisdiction of such courts for the purpose of any such suit, action, proceeding or judgment. By the execution and delivery of this Agreement, (i) Parent and Merger Sub each appoints The Corporation Trust Company, at its office in Wilmington, Delaware, as its agent upon which process may be served in any such suit, action or proceeding and (ii) the Company appoints Skadden, Arps, Slate, Meagher & Flom LLP, at its office at One Rodney Square, P.O. Box 636, Wilmington, Delaware 19899-0636, as its agent upon which process may be served in any such suit, action or proceeding. Service of process upon such agent, together with notice of such service given to a party hereto in the manner provided in Section 13.3 hereof, shall be deemed in every respect effective service of process upon it in any suit, action or proceeding. Nothing herein shall in any way be deemed to limit the ability of a party hereto to serve any such writs, process or summonses in any other manner permitted by applicable Law. Each party hereto hereby irrevocably waives any objections which it may now or hereafter have to the laying of the venue of any suit, action or proceeding arising out of or relating to this Agreement brought in any state or federal court of competent jurisdiction in the State of Delaware, and hereby further irrevocably waives any claim that any such suit, action or proceeding brought in any such court has been brought in any inconvenient forum. No suit, action or proceeding against a party hereto with respect to this Agreement may be brought in any court, domestic or foreign, or before any similar domestic or foreign authority other than in a court of competent jurisdiction in the State of Delaware, and each party hereto hereby irrevocably waives any right which it may otherwise have had to bring such an action in any other court, domestic or foreign, or before any similar domestic or foreign authority. 13.6. Knowledge. As used herein, "knowledge," "to the knowledge," "to the best knowledge," or any similar phrase shall be deemed to refer to the actual knowledge of the Chief Executive Officer, Chief Operating Officer, Chief Financial Officer and General Counsel of that party and all persons reporting directly to any such officer, after due inquiry by each such officer and person reporting directly to such officer regarding the business of the Group Entities or of Parent, as applicable. 13.7 "Material Adverse Effect" or "Material Adverse Change". "Material Adverse Change" or "Material Adverse Effect" means, when used in connection with a party, any change, effect, event or occurrence that has, or is reasonably likely to have, individually or in the aggregate, a material adverse impact on the business, prospects, operations, results of operations, assets or condition (financial or otherwise) of such party and its subsidiaries taken as a whole. As used in this Section 13.7, "subsidiary" means any entity which is a Significant Subsidiary of such party as such term is defined in Regulation S-X of the SEC. Without limiting the generality of the foregoing, and notwithstanding anything else to the contrary in this Agreement, a Material Adverse Change will be deemed to have occurred, and a Material Adverse Effect shall be deemed to exist, with respect to the Company, in the event that any of the events or circumstances set forth on Exhibit 13.7 shall have occurred or be deemed to have occurred, or any Group Entity or Parent receives notice, or otherwise has knowledge, that any of the events or circumstances set forth on Exhibit 13.7 shall exist or have occurred (subject to the exceptions set forth on Exhibit 13.7). For purposes of this Agreement, the term "tax" or "taxes" (whether or not capitalized) shall mean all taxes, charges, fees, stamp taxes and duties, levies, penalties or other assessment, together with any interest and any penalties, additions to tax or additional amounts imposed by any United States federal, state, local or foreign taxing authority, including, but not limited to, income, gross receipts, use, employment, profits, capital stock, premium, minimum and alternative minimum, excise, property, sales, transfer, franchise, payroll, withholding, Social Security or other taxes, including any interest, penalties or additions attributable thereto. For purposes of this Agreement, the term "tax return" shall mean any return, report, information return or other document (including any related or supporting information) with respect to Taxes. 13.8. Captions. The captions or headings in this Agreement are made for convenience and general reference only and shall not be construed to describe, define or limit the scope or intent of the provisions of this Agreement. 13.9. Integration of Company Disclosure Schedule and Exhibits. The Exhibits and the Company Disclosure Schedule attached to this Agreement are integral parts of this Agreement as if fully set forth herein. 13.10. Entire Agreement; No Third-Party Beneficiaries. This instrument, including the Company Disclosure Schedule and all Exhibits attached hereto, together with the Confidentiality Agreement, contains the entire agreement of the parties and supersedes any and all prior or contemporaneous agreements between the parties, written or oral, with respect to the transactions contemplated hereby. This Agreement is for the sole benefit of the parties hereto, their permitted assigns and the ACR Beneficiaries, and nothing herein, express or implied, is intended to or shall confer upon any other person or entity any legal or equitable right, benefit or remedy of any nature whatsoever under or by reason of this Agreement. 13.11. Counterparts. This Agreement may be executed in several counterparts, each of which, when so executed, shall be deemed to be any original, and such counterparts shall, together, constitute and be one and the same instrument. 13.12. Binding Effect. This Agreement shall be binding on, and shall inure to the benefit of, the parties hereto, and their respective successors and assigns, and no other person shall acquire or have any right under or by virtue of this Agreement. No party may assign any right or obligation hereunder without the prior written consent of the other parties. 13.13. Severability. If any term or other provision of this Agreement is invalid, illegal or incapable of being enforced by any rule or law or public policy, all other conditions and provisions of this Agreement shall nevertheless remain in full force and effect so long as the economic or legal substance of the transactions contemplated hereby is not affected in any manner adverse to any party. Upon such determination that any term or other provision is invalid, illegal or incapable of being enforced, the parties hereto shall negotiate in good faith to modify this Agreement so as to effect the original intent of the parties as closely as possible in a mutually acceptable manner in order that the transactions contemplated hereby be consummated as originally contemplated to the greatest extent possible. 13.14. Waivers and Amendments. This Agreement may be amended or modified, and the terms and conditions hereby may be waived, only by a written instrument signed by the parties hereto or, in the case of a waiver, by the party waiving compliance; provided, however, that there shall be no amendment or change to the provisions hereof which by Law requires further approval by the stockholders of the Company, without such further approval. No delay on the part of any party in exercising any right, power or privilege hereunder shall operate as a waiver thereof, nor shall any waiver on the part of any party of any right, power or privilege hereunder, nor any single or partial exercise of any other right, power or privilege hereunder, preclude any other or further exercise thereof or the exercise of any other right, power or privilege hereunder. The rights and remedies herein provided are cumulative and are not exclusive of any rights or remedies which any party may otherwise have at Law or in equity. 13.15. Specific Performance. The parties hereto agree that irreparable damage would occur in the event any provision of this Agreement required to be performed prior to the Closing was not performed in accordance with the terms hereof and that, prior to the Closing, the parties shall be entitled to specific performance of the terms hereof, in addition to any other remedy at Law or in equity. IN WITNESS WHEREOF, Parent, Merger Sub and the Company have caused this Agreement and Plan of Merger to be executed by their respective duly authorized officers, and have caused their respective corporate seals to be hereunto affixed, all as of the day and year first above written. CMG HEALTH, INC. /s/ Alan J. Shusterman By ---------------------------------------- a duly authorized signatory MERIT BEHAVIORAL CARE CORPORATION /s/ Michael G. Lenahan By ---------------------------------------- a duly authorized signatory MERIT MERGER CORP. /s/ Michael G. Lenahan By ---------------------------------------- a duly authorized signatory EX-21 6 EXHIBIT 21 Exhibit 21 MAGELLAN HEALTH SERVICES, INC. SUBSIDIARIES September 30, 1998 The following corporations are all of the direct or indirect subsidiary corporations of Magellan Health Services, Inc., a Delaware corporation. Magellan Health Services, Inc. directly or indirectly owns all of the outstanding voting securities of such subsidiaries except where noted.
Name of Corporation: State/Jurisdiction of Incorporation: Allied Specialty Care Services, Inc. Florida Care Management Resources, Inc.(1) Florida Charter Advantage, LLC Delaware Subsidiaries: Charter Call Center, Inc. Delaware Charter Call Center of Texas, Inc. Delaware Charter Managed Care Services, LLC Delaware Charter Behavioral Corporation Delaware Subsidiary: Charter System, LLC Delaware Green Spring Health Services, Inc. Delaware Subsidiaries: Advantage Behavioral Systems, Inc. Pennsylvania Subsidiary: Resource Day Treatment Center Pennsylvania AdvoCare of Tennessee, Inc. Tennessee Subsidiary: Premier Holdings, Inc. Tennessee Subsidiary: Premier Behavioral Systems of Tennessee, LLC(2) Tennessee Ceres Behavioral Healthcare System, LLC(3) Oregon Green Spring Canadian Holding, Inc. Delaware
- ---------------------------------- (1) 85% owned by Magellan Health Services, Inc. (2) approximately 50% owned by Premier Holdings, Inc. (3) 95% owned by Green Spring Health Services, Inc.
Name of Corporation: State/Jurisdiction of Incorporation: Subsidiary: Green Spring Health Services of Canada Co.(4) Nova Scotia Green Spring Health Services of Michigan, Inc. Michigan Green Spring of Pennsylvania, Inc. Pennsylvania Group Practice Affiliates, Inc. Delaware Subsidiaries: GMV, LLC(5) Virginia Capital Area PsySystems, Inc.(6) Texas Subsidiaries: Capital Area Psych Services Texas Integrated Mental Health, LLC(7) Texas Subsidiary: Integrated Mental Health Texas GPA Arizona, Inc. Arizona GPA Pennsylvania, Inc. Pennsylvania Integrated Behavioral Care, Inc.(8) Virginia Novapsy Clinic, LLC(9) Virginia Pacific Behavioral Management, LLC(10) California Managed Care Services Mainstay of Central Pennsylvania, Inc. Pennsylvania Maryland Health Partners, LLC(11) Maryland Maschhoff, Barr & Associates, Inc. Washington Vista Behavioral Health Plans, Inc. California
- ---------------------------------- (4) 80% owned by Green Spring Canadian Holding, Inc. (5) 50% owned by Group Practice Affiliates, Inc. (6) 50% owned by Group Practice Affiliates, Inc. (7) 50% owned by Capital Area PsySystems, Inc. (8) 50% owned by Group Practice Affiliates, Inc. (9) 50% owned by Group Practice Affiliates, Inc. (10) 70% owned by Group Practice Affiliates, Inc. (11) 50% owned by Green Spring Health Services, Inc.; 50% owned by CMG Health, Inc., a direct subsidiary of Merit Behavioral Care Corporation. 2
Name of Corporation: State/Jurisdiction of Incorporation: Human Affairs International, Incorporated Utah Subsidiaries: Behavioral Healthcare Solutions, Inc. Delaware Human Affairs of Alaska, Inc. Alaska Human Affairs Global Services, Inc. Delaware Human Affairs International of California California Human Affairs International IPA, Inc. New York Human Affairs International of Pennsylvania, Inc. Pennsylvania Human Affairs International of Texas, Inc. Texas Magellan Behavioral Health, Inc. Delaware Magellan Capital, Inc. Delaware Magellan CBHS Holdings, Inc. Delaware Subsidiaries: Behavioral Health Systems of Indiana, Inc. Indiana Subsidiaries: The Charter Arbor Indy Behavioral Health System, Delaware LLC(12) The Charter Behavioral Health System of Evansville, Delaware LLC(13) The Charter Behavioral Health System of Michigan Delaware City, LLC(14) The Charter Behavioral Health System of Northwest Delaware Indiana, LLC(15) Blue Grass Physician Management Services, Inc. Kentucky C.A.C.O. Services, Inc. Ohio CCM, Inc.(16) Nevada Charter Alvarado Behavioral Health System, Inc. California
- ---------------------------------- (12) 5% owned by Behavioral Health Systems of Indiana, Inc.; 95% owned by Charter Indiana BHS Holding, Inc. (13) 5% owned by Behavioral Health Systems of Indiana, Inc.; 95% owned by Charter Indiana BHS Holding, Inc. (14) 5% owned by Behavioral Health Systems of Indiana, Inc.; 95% owned by Charter Indiana BHS Holding, Inc. (15) 5% owned by Behavioral Health Systems of Indiana, Inc.; 95% owned by Charter Indiana BHS Holding, Inc. (16) 50% owned by Magellan CBHS Holdings, Inc.; 50% owned by CMCI, Inc. 3
Name of Corporation: State/Jurisdiction of Incorporation: Charter Asheville Behavioral Health System, Inc. North Carolina Charter Bay Harbor Behavioral Health System, Inc. Florida Charter Behavioral Health System of Athens, Inc. Georgia Subsidiary: Charter Behavioral Health System of Northern California California, Inc. Charter Behavioral Health System of Baywood, Inc. Texas Charter Behavioral Health System of Bradenton, Inc. Florida Subsidiary: Charter Behavioral Health System at Manatee Florida Adolescent Treatment Services, Inc. Charter Behavioral Health System of Central Georgia, Inc. Georgia Charter Behavioral Health System of Central Virginia, Inc. Virginia Subsidiary: Mental Healthsource, L.L.C.(17) Charter Behavioral Health System of Charleston, Inc. South Carolina Charter Behavioral Health System of Charlottesville, Inc. Virginia Charter Behavioral Health System of Chicago, Inc. Illinois Charter Behavioral Health System of Chula Vista, Inc. California Charter Behavioral Health System of Columbia, Inc. Missouri Charter Behavioral Health System of Corpus Christi, Inc. Texas Charter Behavioral Health System of Dallas, Inc. Texas Charter Behavioral Health System of Delmarva, Inc. Maryland Charter Behavioral Health System at Fair Oaks, Inc. New Jersey Charter Behavioral Health System of Fort Worth, Inc. Texas Charter Behavioral Health System at Hidden Brook, Inc. Maryland Charter Behavioral Health System of Jackson, Inc. Mississippi Charter Behavioral Health System of Jacksonville, Inc. Florida Charter Behavioral Health System of Kansas City, Inc. Kansas
- ---------------------------------- (17) 50% owned by Charter Behavioral Health System of Central Virginia, Inc. 4
Name of Corporation: State/Jurisdiction of Incorporation: Charter Behavioral Health System of Lafayette, Inc. Louisiana Subsidiary: The Charter Cypress Behavioral Health System, L.L.C.(18) Tennessee Charter Behavioral Health System of Lake Charles, Inc. Louisiana Charter Behavioral Health System at Los Altos, Inc. California Charter Behavioral Health System of Massachusetts, Inc. Massachusetts Subsidiary: Westwood/Pembroke Health System Limited Massachusetts Partnership(19) Charter Behavioral Health System of Mississippi, Inc. Mississippi Charter Behavioral Health System of Nashua, Inc. New Hampshire Charter Behavioral Health System of Nevada, Inc. Nevada Charter Behavioral Health System of New Mexico, Inc. New Mexico Subsidiary: The Charter Heights Behavioral Health System Limited Delaware Partnership(20) Charter Behavioral Health System of Northwest Arkansas, Inc. Arkansas Charter Behavioral Health System of Paducah, Inc. Kentucky Charter Behavioral Health System at Potomac Ridge, Inc. Maryland Charter Behavioral Health of Puerto Rico, Inc. Georgia Charter Behavioral Health System of San Jose, Inc. California Charter Behavioral Health System of Texarkana, Inc. Arkansas Charter Behavioral Health System of Toledo, Inc. Ohio Charter Behavioral Health System of Tucson, Inc. Arizona Charter Behavioral Health System of Visalia, Inc. California Charter Behavioral Health System of Waverly, Inc. Minnesota Charter Behavioral Health System of Winston-Salem, Inc. North Carolina Charter Behavioral Health System of Yorba Linda, Inc. California
- ---------------------------------- (18) 50% owned by Charter Behavioral Health System of Lafayette, Inc. (19) 95% owned by Charter Behavioral Health System of Massachusetts, Inc. (20) 67% owned by Charter Behavioral Health System of New Mexico, Inc. 5
Name of Corporation: State/Jurisdiction of Incorporation: Charter Behavioral Health Systems, LLC(21) Delaware Charter-By-The-Sea Behavioral Health System, Inc. Georgia Charter Canyon Behavioral Health System, Inc. Utah Charter Canyon Springs Behavioral Health System, Inc. California Charter Centennial Peaks Behavioral Health System, Inc. Colorado Charter Community Hospital, Inc. California Charter Cove Forge Behavioral Health System, Inc. Pennsylvania Charter Fairmount Behavioral Health System, Inc. Pennsylvania Charter Fenwick Hall Behavioral Health System, Inc. South Carolina Charter Financial Offices, Inc. Georgia Charter Forest Behavioral Health System, Inc. Louisiana Charter Grapevine Behavioral Health System, Inc. Texas Subsidiary: Metroplex Behavioral Healthcare Services, Inc. Texas Charter Greensboro Behavioral Health System, Inc. North Carolina Charter Hospital of Columbus, Inc. Ohio Charter Hospital of Mobile, Inc. Alabama Charter Hospital of Santa Teresa, Inc. New Mexico Charter Hospital of St. Louis, Inc. Missouri Charter Hospital of Torrance, Inc. California Charter Indiana BHS Holding, Inc. Indiana Subsidiaries: The Charter Arbor Indy Behavioral Health System, Delaware LLC(22) The Charter Behavioral Health System of Evansville, Delaware LLC(23)
- ---------------------------------- (21) 50% owned by Magellan CBHS Holdings, Inc.; subsidiaries of Charter Behavioral Health Systems, LLC are not reflected on this list (22) 95% owned by Charter Indiana BHS Holding, Inc.; 5% owned by Behavioral Health Systems of Indiana, Inc. (23) 95% owned by Charter Indiana BHS Holding, Inc.; 5% owned by Behavioral Health Systems of Indiana, Inc. 6
Name of Corporation: State/Jurisdiction of Incorporation: The Charter Behavioral Health System of Michigan Delaware City, LLC(24) The Charter Behavioral Health System of Northwest Delaware Indiana, LLC(25) Charter Lakehurst Behavioral Health System, Inc. New Jersey Charter Lakeside Behavioral Health System, Inc. Tennessee Subsidiary: Charter Lakeside Behavioral Health Network, Inc. Tennessee Charter Laurel Heights Behavioral Health System, Inc. Georgia Charter Linden Oaks Behavioral Health System, Inc. Illinois Subsidiary: Naperville Psychiatric Ventures (26) Illinois Charter Little Rock Behavioral Health System, Inc. Arkansas Charter Louisiana Behavioral Health System, Inc. Louisiana Charter Louisville Behavioral Health System, Inc. Kentucky Charter Meadows Behavioral Health System, Inc. Maryland Charter Medical (Cayman Islands) Ltd. Cayman Islands Charter Medical - Clayton County, Inc. Georgia Charter Medical - Cleveland, Inc. Texas Charter Medical of East Valley, Inc. Arizona Charter Medical International, Inc. Cayman Islands Charter Medical International, S.A., Inc. Nevada Subsidiaries: Charter Medical of England Limited United Kingdom Societe Anonyme De La Metairie Switzerland Charter Medical International Services, Inc. Cayman Islands Charter Medical Leasing Limited United Kingdom Charter Medical - Long Beach, Inc. California
- ---------------------------------- (24) 95% owned by Charter Indiana BHS Holding, Inc.; 5% owned by Behavioral Health Systems of Indiana, Inc. (25) 95% owned by Charter Indiana BHS Holding, Inc.; 5% owned by Behavioral Health Systems of Indiana, Inc. (26) 75% owned by Charter Linden Oaks Behavioral Health System, Inc. 7
Name of Corporation: State/Jurisdiction of Incorporation: Charter Medical - New York, Inc. New York Charter Medical of North Phoenix, Inc. Arizona Charter Medical of Puerto Rico, Inc. Commonwealth of Puerto Rico Charter Milwaukee Behavioral Health System, Inc. Wisconsin Charter Mission Viejo Behavioral Health System, Inc. California Charter MOB of Charlottesville, Inc. Virginia Charter North Behavioral Health System, Inc. Alaska Charter North Counseling Center, Inc. Alaska Charter North Star Behavioral Health System, L.L.C.(27) Tennessee Charter Northridge Behavioral Health System, Inc. North Carolina Subsidiary: Holly Hill/Charter Behavioral Health System, L.L.C.(28) Tennessee Charter Oak Behavioral Health System, Inc. California Charter Palms Behavioral Health System, Inc. Texas Charter Park Hospital Limited United Kingdom Charter Peachford Behavioral Health System, Inc. Georgia Charter Pines Behavioral Health System, Inc. North Carolina Charter Plains Behavioral Health System, Inc. Texas Charter - Provo School, Inc. Utah Charter Real Behavioral Health System, Inc. Texas Charter Ridge Behavioral Health System, Inc. Kentucky Charter Rivers Behavioral Health System, Inc. South Carolina Charter Rockford Behavioral Health System, Inc. Delaware Charter San Diego Behavioral Health System, Inc. California Charter Sioux Falls Behavioral Health System, Inc. South Dakota Charter Springs Behavioral Health System, Inc. Florida Charter Springwood Behavioral Health System, Inc. Virginia
- ---------------------------------- (27) 57% owned by Magellan CBHS Holdings, Inc. (28) 50% owned by Charter Northridge Behavioral Health System, Inc. 8
Name of Corporation: State/Jurisdiction of Incorporation: Charter Suburban Hospital of Mesquite, Inc. Texas Charter Talbott Behavioral Health System, Inc. Georgia Subsidiary: Charter Behavioral Health System of Savannah, Inc. Georgia Charter Thousand Oaks Behavioral Health System, Inc. California Charter Westbrook Behavioral Health System, Inc. Virginia Subsidiary: CPS Associates, Inc. Virginia Charter White Oak Behavioral Health System, Inc. Maryland Charter Wichita Behavioral Health System, Inc. Kansas Charter Woods Behavioral Health System, Inc. Alabama Desert Springs Hospital, Inc. Nevada Subsidiaries: CMCI, Inc. Nevada Subsidiary: CCM, Inc.(29) Nevada CMFC, Inc. Nevada Employee Assistance Services, Inc. Georgia Florida Health Facilities, Inc. Florida Golden Isle Assurance Company Ltd. Bermuda NEPA - Massachusetts, Inc. Massachusetts NEPA - New Hampshire, Inc. New Hampshire New Allied, Inc. Florida Pacific - Charter Medical, Inc. California Subsidiary: Charter Behavioral Health System of the Inland Empire, California Inc. Plymouth Insurance Company, Ltd. Bermuda Sistemas De Terapia Respiratoria S.A., Inc. Georgia
- ---------------------------------- (29) 50% owned by CMCI, Inc.; 50% owned by Magellan CBHS Holdings, Inc. 9
Name of Corporation: State/Jurisdiction of Incorporation: Strategic Advantage, Inc. Minnesota Western Behavioral Systems, Inc. California Magellan Executive Corporation Delaware Magellan Public Solutions, Inc. Delaware Subsidiaries: KidsCareNet of Milwaukee, LLC(30) Wisconsin Magellan Public Network, Inc. Delaware Subsidiaries: Correctional Behavioral Solutions, Inc. Delaware Subsidiaries: Correctional Behavioral Solutions of Indiana, Inc. Indiana Correctional Behavioral Solutions of New Jersey, New Jersey Inc. Correctional Behavioral Solutions of Ohio, Inc. Ohio National Mentor, Inc. Delaware Subsidiaries: Center for Comprehensive Services, Inc. Illinois First Step Independent Living Program, Inc. California Horrigan Cole Enterprises, Inc. California Illinois Mentor, Inc. Illinois Subsidiary: Rehabilitation Achievement Center, Inc. Illinois Massachusetts Mentor, Inc. Massachusetts National Mentor Healthcare, Inc. Massachusetts Subsidiaries: Carolina Behavioral Services, LLC Delaware Loyd's Liberty Homes, Inc. California Ohio Mentor, Inc. Ohio South Carolina Mentor, Inc. South Carolina
- ---------------------------------- (30) 70% owned by Magellan Public Solutions, Inc. 10
Name of Corporation: State/Jurisdiction of Incorporation: Magellan Public Solutions of Ohio, Inc. Ohio Solutions For Care, Inc. Delaware Magellan Specialty Medical Care Holdings, Inc. Delaware Subsidiaries: CAI Holdings, Inc. Delaware Subsidiary: CAI Merger Corporation Delaware MBCH, Inc. Delaware Subsidiary: Merit Behavioral Care Corporation Delaware Subsidiaries: American Biodyne, Inc. Delaware Subsidiaries: AGCA Acquisition Corporation-New York Delaware AGCA, Inc. Pennsylvania Subsidiaries: AGCA Headquarters Limited Pennsylvania Partnership(31) AGCA New York, Inc. New York Subsidiaries: Achievement and Guidance New York Centers of New York, Inc. AGCA IPA of New York, Inc. New York AGCA/Better Health Plan, Inc. New York AGCA/Chubb Health Plan, Inc. New York MBC Behavioral Care of New New York York, Inc., a New York Independent Practice Association MBC Behavioral Health Services New York of New York, Inc., a New York Independent Practice Association
- ---------------------------------- (31) 15% owned by AGCA, Inc. 11
Name of Corporation: State/Jurisdiction of Incorporation: MBC Health Care of New York, New York Inc., a New York Independent Practice Association MBC Health Services of New New York York, Inc., a New York Independent Practice Association MBC of New York, Inc., a New New York York Independent Practice Association MBC Providers of New York, Inc., New York a New York Independent Practice Association U.S. IPA Providers, Inc. New York Quality Healthcare Solutions, Inc. Pennsylvania Subsidiary: AGCA/Net Recovery Systems(32) Pennsylvania Alliance Health Systems, Inc.(33) Indiana Arizona Biodyne, Inc. Arizona California Biodyne Health Services, Inc. California Colorado Biodyne, Inc. Colorado Hawaii Biodyne, Inc. Hawaii Indiana Biodyne, Inc. Indiana Louisiana Biodyne, Inc. Louisiana Maine Biodyne, Inc. Maine MBC Federal Programs, Inc. Delaware MBC of New Mexico, Inc. New Mexico Merit Behavioral Care of Florida, Inc. Florida Merit Behavioral Care of Illinois, Inc. Illinois Merit Behavioral Care of Massachusetts, Inc. Massachusetts Merit Behavioral Care of Montana, Inc. Montana Merit Behavioral Care of Pennsylvania, Inc. Pennsylvania
- ---------------------------------- (32) 50% owned by Quality Healthcare Solutions, Inc. (33) 80% owned by American Biodyne, Inc. 12
Name of Corporation: State/Jurisdiction of Incorporation: Merit Behavioral Care of Texas, Inc. Texas Michigan Biodyne, Inc. Michigan Nevada Biodyne, Inc. Nevada Ohio Biodyne, Inc. Ohio Tennessee Biodyne, Inc. Tennessee Vermont Biodyne, Inc. Vermont BCOV-GP, Inc.(34) Delaware Benesys, Inc. Delaware CMG Health, Inc. Maryland Subsidiaries: ARD Properties, Inc. Delaware Choice Behavioral Health Partnership(35) Virginia CMG Behavioral Health of California, Inc. California CMG Behavioral Healthcare of New York, Inc. New York CMG Choice Independent Practice Association New York of New York, Inc. CMG Health of New York, Inc. New York CMG Independent Practice Association of New New York York, Inc. CMG Plus Independent Practice Association of New York New York, Inc. Group Practice Management, Inc. Maryland Inpsych, Inc. Maryland Inpsych Kentucky, Inc. Kentucky Inpsych Midwest, Inc. Missouri Maryland Health Partners, LLC(36) Maryland Montana Community Partners, Inc.(37) Montana
- ---------------------------------- (34) 50% owned by Merit Behavioral Care Corporation (35) 50% owned by CMG Health, Inc. (36) 50% owned by CMG Health, Inc.; 50% owned by Green Spring Health Services, Inc. (37) 55% owned by CMG Health, Inc. 13
Name of Corporation: State/Jurisdiction of Incorporation: Continuum Behavioral Care, LLC(38) Rhode Island Continuum Behavioral Healthcare Corporation Delaware Subsidiary: Spectrum-Continuum Management Services of Delaware New York, LLC(39) Subsidiary: Spectrum-Continuum IPA Providers of Delaware New York, LLC EMHC-MBC of New York, LLC(40) New York EMHC/MBC IPA Providers of New York, LLC(41) New York EMHC-MBC Services of New York, LLC(42) New York Group Plan Clinic, Inc. Texas MBC Health Providers of Texas, Inc. Texas MBC of America, Inc. Delaware Subsidiaries: EMHC/MBC IPA Providers of New York, LLC(43) New York EMHC-MBC Services of New York, LLC(44) New York Empire Community Delivery Systems, LLC(45) New York MBC Management Services of New York, LLC(46) New York MBC of Nebraska, L.L.C.(47) Nebraska MBC of Tennessee, Inc. Tennessee
- ---------------------------------- (38) 50% owned by Merit Behavioral Care Corporation (39) 50% owned by Continuum Behavioral Healthcare Corporation (40) 79.8% owned by Merit Behavioral Care Corporation (41) 99% owned by EMHC-MBC of New York, LLC; 1% owned by MBC of America, Inc. (42) 99% owned by EMHC-MBC of New York, LLC; 1% owned by MBC of America, Inc. (43) 1% owned by MBC of America, Inc.; 99% owned by EMHC-MBC of New York, LLC (44) 1% owned by MBC of America, Inc.; 99% owned by EMHC-MBC of New York, LLC (45) 16.667% owned by MBC of America, Inc. (46) 80.2 % owned by MBC of America, Inc. (47) 50% owned by MBC of America, Inc. 14
Name of Corporation: State/Jurisdiction of Incorporation: MBC of Tennessee, LLC(48) Tennessee MBC/IPA Providers of New York, LLC(49) New York Royal Health Care, LLC(50) New York MBC of North Carolina, LLC North Carolina MBC of Tennessee, LLC(51) Tennessee MBC Washington Systems, Inc. Washington Subsidiary: Community Sector Systems, Inc.(52) Washington Merit Behavioral Care Corporation of Iowa Iowa Merit Behavioral Care of Colorado, Inc. Colorado Merit Behavioral Care of Georgia, Inc. Georgia Merit Behavioral Care Systems Corporation Ohio Subsidiaries: INROADS Behavioral Health Services of Texas, Texas L.P.(53) MBCS of Florida, Inc. Florida MBCS of North Carolina, Inc. North Carolina Merit INROADS Behavioral Health Services of Illinois Illinois, LLC(54) Merit Health Insurance Company Illinois Subsidiary: Orion Life Insurance Company Delaware Merit Holdings Corp. Delaware
- ---------------------------------- (48) MBC of America, Inc and Merit Behavioral Care Corporation serve as sole members (49) 80.2% owned by MBC of America, Inc. (50) 50% owned by MBC of America, Inc. (51) Merit Behavioral Care Corporation and MBC of America, Inc. serve as sole members (52) 19.9 % owned by MBC Washington Systems, Inc. (53) 1% owned by Merit Behavioral Care Systems Corporation; 99% owned by Merit INROADS Behavioral Health Services, LLC (54) 1% owned by Merit Behavioral Care Systems Corporation; 99% owned by Merit INROADS Behavioral Health Services, LLC 15
Name of Corporation: State/Jurisdiction of Incorporation: Subsidiaries: MBC National Service Corporation Delaware MBC of Louisiana, Inc. Louisiana Merit Behavioral Care of Arkansas, Inc. Arkansas Merit Behavioral Care of Maryland, Inc. Maryland Merit INROADS Behavioral Health Services, Delaware LLC(55) Subsidiaries: Merit INROADS Behavioral Health Illinois Services of Illinois, LLC(56) INROADS Behavioral Health Services of Texas Texas, L.P.(57) MeritChoice, Inc.(58) Delaware MeritChoice, Ltd.(59) Pennsylvania ProPsych, Inc. Florida PPC Group, Inc. Delaware Subsidiaries: Merit Behavioral Care of California, Inc. Missouri P.P.C., Inc. Missouri Subsidiary: Personal Performance Consultants of New New York York, Inc.
- ---------------------------------- (55) 99% owned by Merit Holdings Corp.; 1% owned by Merit Behavioral Care of Illinois, Inc. (56) 99% owned by Merit INROADS Behavioral Health Services, LLC; 1% owned by Merit Behavioral Care Systems Corporation (57) 99% owned by Merit INROADS Behavioral Health Services, LLC; 1% owned by Merit Behavioral Care Systems Corporation (58) 50% owned by Merit Holdings Corp. (59) 50% owned by Merit Holdings Corp. 16 EX-23 7 EXHIBIT 23 EXHIBIT 23 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference of our reports dated December 3, 1998 and to all references to our firm, included in this Form 10-K, into the Company's previously filed Registration Statements on Form S-3 (File Nos. 333-53353, 333-20371, 333-01217, and 333-50423). Atlanta, Georgia December 28, 1998 EX-27 8 EX-27
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEETS AND CONSOLIDATED STATEMENTS OF OPERATIONS FOUND ON PAGES F-3 AND F-4 OF THE COMPANY'S FORM 10-K FOR THE YEAR-TO-DATE, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 12-MOS SEP-30-1998 SEP-30-1998 92,050,000 0 174,846,000 0 0 399,724,000 237,269,000 60,100,000 1,916,290,000 454,766,000 1,202,613,000 0 0 8,476,000 179,159,000 1,916,290,000 1,512,454,000 1,512,454,000 0 1,294,481,000 98,560,000 4,977,000 75,375,000 39,061,000 20,033,000 13,732,000 0 (33,015,000) 0 (19,283,000) (0.63) (0.62)
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