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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-KSB
ANNUAL REPORT UNDER SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999
COMMISSION FILE NUMBER _____________.
CORRECTIONAL SYSTEMS, INC.
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(Name of Small Business Issuer in Its Charter)
DELAWARE 33-0607766
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(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)
6910 "A" MIRAMAR ROAD, SAN DIEGO, CA 92121
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(Address of Principal Executive Offices) (Zip Code)
(858) 566-9816
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(Registrant's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH
TO BE SO REGISTERED EACH CLASS IS TO BE REGISTERED
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Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $0.001 PAR VALUE PER SHARE
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(Title of Class)
Check whether the issuer: (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such report(s), and (2) has been
subject to such filing requirements for the past 90 days.
Yes No X
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Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B is not contained in this form, and no disclosure will 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-KSB
or any amendment to this Form 10-KSB. X
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The aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the average bid and asked prices of the
common stock as of February 29, 2000, was .
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The number of shares of common stock outstanding as of February 29, 2000, was
3,644,400.
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PART I
ITEM 1. DESCRIPTION OF BUSINESS.
Correctional Systems, Inc. and its subsidiaries, Sentencing Concepts, Inc.
and Reality House, Inc. (collectively, the "Company" or "CSI"), provide
management services to federal, state and local jails and community correctional
facilities and offer non-imprisonment alternatives such as electronic home
monitoring, counseling and educational programs, community service, offender
intervention and treatment, and comprehensive drug and alcohol testing. We
formed the Company in 1994 and acquired our subsidiaries in 1998.
ACQUISITIONS
On August 1, 1998, the Company acquired 100 percent of the common stock of
RHI and the separately owned building in which RHI operates, in exchange for
approximately $1,411,508 in cash. The excess cost over the fair market value of
the net tangible assets acquired was allocated to goodwill in the amount of
$335,176 and to other intangibles in the amount of $610,000, which represents
authorization from the city that allows RHI to operate as a community
corrections facility.
On September 1, 1998, the Company acquired 100 percent of the common stock
of SCI in exchange for 1,150,000 shares of the Company's common stock. In
connection with the SCI acquisition, the Company entered into employment
agreements and non-qualified option agreements with the two principal owners of
SCI, Daniel Verwiel and Patricia Verwiel. See Item 10. Executive
Compensation--Employment Agreements--Verwiels.
October 4, 1999, the shareholders of the Company approved by written
consent a re-incorporation of the Company into Delaware. Of the 3,644,400 shares
of common stock of the Company outstanding, holders of 1,978,849, or 54.3% of
the total outstanding shares voted for the re-incorporation. The
re-incorporation was effective as of February 7, 2000.
A. CSI'S INSTITUTIONAL DIVISION
CSI SERVICES. Services provided in a CSI jail facility generally include
booking, processing, holding and programming.
CITY JAILS
We have entered into agreements with nine cities or counties to manage and
operate their city or county jail. With the exception of one of the agreements,
each provides for payment to Correctional Systems of an amount based upon
operating expenses incurred plus a fixed management fee or a management fee
based on a percentage of the operating expenses. One agreement provides for
payment to Correctional Systems of an amount based upon operating income; in the
event there is no operating income, the Company is responsible for one-half of
operating expenses.
JAIL POPULATION. The population of these jails are arrestees, self-pay
inmates, sentenced county work furlough inmates and sentenced federal inmates
serving short-term sentences. A facility that qualifies to handle arrestees
prior to arraignment (for not more than 96 hours) is a "Type I Facility." A
facility that qualifies to handle both arrestees prior to arraignment as well as
sentenced inmates is a "Type II Facility."
CSI SERVICES. Services provided in a CSI jail facility generally include
booking, processing, holding and programming. Programming can include, but is
not limited to GED preparation, literacy and education, counseling, etc. Other
services may include, depending upon the contract:
- Work Furlough. Inmates are allowed to leave the facility to work,
attend court-related programs and return to the facility.
- Electronic Monitoring. Inmates have an electronic monitoring device
attached at the jail facility.
- Detoxification. Arrestees under the influence are place in detox cells
up to the time prescribed by law.
- Revenue-Generation via Self-Pay and Contract Inmates. The City may
enter into intergovernmental agreements to house inmates from other
jurisdictions for a fee.
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With the approval of the court, some inmates choose to pay to serve
their sentence in City jails rather than at a County jail. An inmate
would pay to serve their sentence in a City Jail so that they would
not have to be housed in overcrowded county facilities, so that they
would be nearer to their home or for a variety of other reasons.
CURRENT OPERATIONS. Correctional Systems currently operates the following
nine jails:
1) The Seal Beach, California, City Jail. The Seal Beach Jail agreement has
been in effect since May 1, 1994. It is renewable each year for one-year
terms until April 2004. This Type II Facility also houses self-pay inmates,
work furlough inmates, Bureau of Prison inmates and arrestees from
surrounding cities. The Seal Beach Jail was awarded accreditation by the
American Correctional Association in August 1996.
2) The Baldwin Park, California, City Jail. The Baldwin Park City Jail
agreement has been in effect since March 1, 1996. Its term was three years
and is renewable for one-year terms. The agreement was renewed in February
2000.
3) The Montebello, California, City Jail. The Montebello City agreement has
been in effect since March 1996. It was a two-year agreement and is
renewable each year. It was renewed in January 1998, 1999 and 2000. This
Type II Facility also houses short-term city or county inmates and United
States Marshals Service inmates.
4) The Alhambra, California, City Jail. The City of Alhambra agreement has
been in effect since April 29, 1997. Its term is three years and is
renewable for two additional one-year terms. Correctional Systems also
manages Alhambra's contract to house detainees from the Immigration and
Naturalization Service.
5) The Downey, California, City Jail. The City of Downey agreement has been in
effect since May 1998 and is for a term of three years. The agreement is
renewable for two one-year terms.
6) The Bell, California, City Jail. The Bell City agreement has been in effect
since October 1998 and is for a term of three years. The agreement is
renewable for an additional three-year term.
7) The Hawthorne, California, City Jail. The City of Hawthorne agreement was
approved by the City Council on October 12, 1998. Correctional Systems
assumed complete responsibility for the Jail on November 1, 1998. The
agreement's three-year term is renewable for two one-year terms.
8) The Whittier, California, City Jail. The City of Whittier agreement was
approved by the City Council in September 1999. CSI assumed complete
responsibility for the Jail at the end of November 1999. The agreement's
three-year term is renewable for additional three-year terms unless
canceled by the City or the Company.
9) The Lincoln County, New Mexico, County Jail. Correctional Systems entered
into a memorandum of understanding with Lincoln County, New Mexico to
provide a Jail Commander to manage their 55 bed jail as of January 5, 1998,
and to provide the County Commissioners with an evaluation of their jail.
This initial agreement had been extended five times. The present agreement
with Lincoln County is a short-term agreement from July 1999 through June
30, 2000.
U.S. BUREAU OF PRISONS CONTRACTS
Correctional Systems operates three U.S. Bureau of Prisons community
correctional center halfway houses in Brownsville, Austin and McAllen, Texas.
The community correctional centers ("CCC") are half-way houses that house
inmates under authority of Bureau of Prisons who are within 18 months of being
released from prison. CCCs provide transitional housing for inmates still under
federal custody and guides them through a process of vocational evaluation,
obtaining and maintaining steady employment, alcohol and other drug counseling
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and testing, life skills development, anger management and family reunification.
These services are offered at each community corrections center. Each inmate is
evaluated upon entry and will be assigned services as required.
REALITY HOUSE, BROWNSVILLE, TEXAS. Correctional Systems acquired Reality
House, Inc., a wholly-owned subsidiary, in August 1998. Reality House has been
in operation for twenty-five years and has a capacity to house 54 inmates.
MID-VALLEY HOUSE, MCALLEN, TEXAS. In August 1998, the Federal Bureau of
Prisons awarded a Community Correctional Center contract to Correctional
Systems. Mid-Valley House is capable of housing 60 inmates and has been
operational since December, 1998.
MCCABE CENTER, AUSTIN, TEXAS. Correctional Systems, Inc. acquired certain
assets of the McCabe Comprehensive Sanctions Center in July 1999. McCabe Center
has been in operation for the past twenty-two years. With a capacity to house 55
inmates, McCabe Center also provides services to the U.S. Pretrial Service, the
U.S. Probation Department and the Texas Department of Corrections.
B. CSI'S ALTERNATIVE SENTENCING SUBSIDIARY
The Company's wholly-owned subsidiary, Sentencing Concepts, provides
alternatives to imprisonment for low-risk offenders. Sentencing Concepts'
programs combine punishment options and offender supervision with education and
counseling and utilize a combination of measures such as home detention via
electronic monitoring, rehabilitative counseling and education programs,
offender supervision and substance abuse testing.
Sentencing Concepts was established in 1994 and has California offices
in Anaheim, Lake Forest, Stockton, San Luis Obispo and Santa Barbara and a
Connecticut operation in Newington. There are currently more than 1,000
offenders per week receiving counseling, drug testing, electronic monitoring
or other Sentencing Concepts services. Sentencing Concepts provides
monitoring programs by contract or certification to the following counties:
a) San Luis Obispo County, California;
b) Santa Barbara County, California;
c) Orange County, California;
d) San Joaquin County, California;
e) Contra Costa County, California; and
f) Placer County, California.
Certification is a process in which a monitoring provider is evaluated and
approved by the governing body. The Company is placed on the list of approved
providers for that agency. When services are needed, the agency will select a
provider from the list.
In addition, Sentencing Concepts provides PharmChek-TM- Drugs of Abuse
Patch to over 30 Drug Courts nationwide and to over 75 county agencies and
health care providers.
SENTENCING CONCEPTS' SERVICES
- 24-hour electronic monitoring. Sentencing Concepts provides 24-hour
monitoring services by utilizing advanced electronic monitoring
equipment, such as ankle transmitters and receiving units, to monitor
individuals through a central station.
- Scheduled compliance monitoring. This program is designed to allow
offenders to perform only certain daily activities such as employment,
school, etc. The program includes the use of a tamperproof digital
electro-optical monitoring device that is worn by an offender like a
wristwatch.
- The Shield Program. The Shield Program is specifically designed for
use in cases of domestic violence or battery, and allows for the
effective monitoring of compliance with court imposed restraining
orders.
- Monitored community service. The goal of this program is to provide
the Court with a means of utilizing community service as a sentencing
option for low risk and first-time offenders.
- Video in-home breathalyzer. This program combines a Department of
Transportation approved breath analysis testing unit with an installed
video monitor which allows for the random testing of an offender's
breath alcohol level combined with visual verification.
- Voice verified telephone monitoring. This system is a computer-based
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voice verification device, which utilizes telephone transmission
and caller identification.
- Day reporting center. The Day Reporting Center is an alternative to
custody for low risk offenders. Offenders are required to attend
regular counseling and education sessions and must submit to random
drug and alcohol testing as required by the Court.
- Chemical dependency treatment program. Sentencing Concepts offers a
State of California certified outpatient treatment program designed
specifically for individuals who have acknowledged a drug and/or
alcohol dependency problem.
- Substance abuse counseling and education. This class is designed for
the individual who is in the early stages of drug use.
- Anger management program. This program focuses on those involved with
non-domestic (i.e. physical fights between employees in a work
environment) problems relating to anger control or management.
- Batterer's treatment program. This program was designed to meet the
1996 State of California legislation that mandates attendance in a
52-week course for any person charged or convicted of a domestic
battering offense.
- Drug and alcohol testing. Sentencing Concepts performs random drug and
alcohol testing of its clients. The offender pays for the tests. In
addition to the standard test by urinalysis, Sentencing Concepts is a
national distributor of the PharmChek-TM- Drugs of Abuse Patch that
detects the use of illicit drugs.
C. PRIVATE CORRECTIONAL INDUSTRY
OFFENDER MANAGEMENT INDUSTRY. Offender management describes the broad range
of activities related to maintaining a large group of arrested and convicted
people (adults and juveniles) during incarceration, probation and parole. It
includes prison management, jail management, inmate health care, food service,
education and training, and security monitoring. The industry has three
segments: adult secure corrections, juvenile corrections and community
corrections (work release, prerelease programs and alternative sentencing
practices such as electronic monitoring and counseling services in lieu of
incarceration).
The U.S. public expenditures on offender management are believed to exceed
$40 billion dollars annually. The U.S. adult secure prison population exceeded
1.8 million in 1998, according to a recent Bureau of Justice Statistics report.
In addition, the state prison population grew 4.1% to 1.06 million; federal
prison population grew 6.4% to 99,000; and the local jail population increased
9.4% to 567,000, according to the report. Significantly, local jails are now at
97% of capacity, up from 92% in 1996. With both federal and state prisons
operating 15% to 25% above design capacity, space is at a premium. Furthermore,
over the last ten years there has been an increase in the tendency of
politicians to demand that offenders serve more actual jail time. With prison
populations increasing and public agencies strapped for funds to build new
facilities, private companies have been moving to either manage adult and
juvenile facilities or to provide some form of alternative sentencing programs
for low risk, first-time offenders.
In addition to increasing demand for traditional correctional services,
there also appears to be a great demand for alternative sentencing practices.
According to a draft report of an Orange County, California, task force on jail
overcrowding, jail facilities should be saved for dangerous offenders, and low
risk offenders should be placed in some form of electronic monitoring or
counseling program (Los Angeles Times). The report suggests the following
alternatives:
- Greater use of electronic monitoring and house arrest
- Expansion of the County Drug Court
- Use of private jail facilities
- More work furlough and community service programs
Despite the increasing demand for traditional correctional services and
alternative sentencing practices, there is no assurance that CSI or SCI will be
successful in obtaining new revenue sources.
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COMPETITION. We face competition in two areas: Corrections Competition and
Alternative Sentencing Competition.
CORRECTIONAL COMPETITION
PRIVATE PRISONS: We believe there are currently approximately twelve major
private corrections firms providing correctional services to Government
Agencies. The largest of the publicly-held companies are Corrections Corporation
of America and Wackenhut Corporation who, combined, have captured the largest
share of the industry. The other large publicly-held companies include Cornell
Corrections and Correctional Services. Management Training Company (MTC) and
CiviGenics are the large privately-held companies that provide correctional
services. The following is a short list of the largest publicly-held and
privately-held companies with which CSI competes:
- Cornell Corrections (CRN)
- Wackenhut Corporation (WAK)
- Corrections Corporation of America (PZN)
- Community Correctional Services (CSCQ)
- CiviGenics - A Private Company
- Community Corrections Corporation - A Private Company
COMMUNITY PRE-RELEASE CENTERS: With respect to the community pre-release
centers, there are a variety of competitors in both the non-profit and
for-profit arenas. These include The Salvation Army and Volunteers of America
and many other smaller non-profit organizations, and Cornell Corrections,
Community Corrections, Inc. and Behavioral Systems Southwest, Inc., among
others, on the for-profit side. Typical Government contracts for pre-release
services are granted for two years with three one-year options.
SMALL CITY JAIL: In the small city jail market in California there appears
to be only one major competitor to Correctional Systems and that is the
Wackenhut Security Division. Other firms that have been known to bid on the
small jail business outside of California include G.R.W. Associates.
ALTERNATIVE SENTENCE COMPETITION
The Alternative Sentence industry includes electronic monitoring, drug and
alcohol counseling and testing and other related counseling services as referred
by the criminal courts. Sentencing Concepts combines the use of electronic
monitoring and counseling or case management services. Case management is the
tracking of sentenced offenders during monitoring, counseling and testing to
ensure compliance with the court's orders.
We are aware of only one electronic monitoring company that is
publicly-held (BI, Inc.); we believe that other electronic monitoring companies
are small, private companies or subsidiaries of larger companies, including
several security alarm companies. Sentencing Concepts leases equipment and
services as needed from several different vendors. Below is a short list of the
major companies with whom SCI competes:
- BI, Incorporated (BIAC)
- Sentinel Monitoring - A Private Company
- GSSC - A Private Company
- LCA - A Private Company
- EMS - A Private Company
- CSSS, Inc. - A Private Company
CORRECTIONAL SYSTEMS' POSITION IN THE INDUSTRY. There are approximately
twelve management firms that are presently operating secure, 24-hour, adult
correctional facilities. Correctional Systems is one of the smallest of these
twelve firms.
GOVERNMENT APPROVAL. For our jail projects, there is no outside
governmental approval required in order for the Company to provide its services
other than normal contract approval and the oversight of the governmental entity
with which we are contracting. CSI's halfway house projects (CCC's) do require
some outside governmental approval in order for us to operate, such as zoning
approval, fire and health department clearances. Several of the Alternative
Sentencing options are required to meet strict criteria. All equipment and
programs utilized by the Company meet or exceed the established criteria and
have been approved for use by the appropriate governmental agency.
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GOVERNMENTAL REGULATIONS. Certain states either do not allow privatization
of correctional facilities or limit the type of facilities that can be
privatized. For example, the State of California prohibits county correctional
facilities from privatizing, but allows for all other jurisdictions to
privatize.
ITEM 2. DESCRIPTION OF PROPERTY.
The following chart lists the principal locations and size of the Company's
facilities and indicates whether the property is owned or leased and, if leased,
the lease expiration.
<TABLE>
<CAPTION>
LEASED
LOCATION USE SIZE OR OWNED LEASE EXPIRATION
<S> <C> <C> <C> <C>
San Diego, CA Corporate and 1,200 sq. ft. Leased (Expires 06/03/2000)
Administration
Los Alamitos, CA Regional and 1,100 sq.ft. Leased (Expires 12/31/2001)
Accounting
Anaheim Administrative and 3,000 sq. ft. Leased (Expires 12/31/2000)
Program Monitoring
Lake Forest Program Monitoring 849 sq.ft. Leased (Expires 09/30/2000)
Stockton Program Monitoring 4,000 sq.ft. Leased (Expires 10/14/2001)
San Luis Obispo Program Monitoring 715 sq. ft. Month-to-Month Lease
Santa Barbara Program Monitoring 624 sq. ft. Leased (Expires 12/31/2000)
Edinburg, Texas Community 6,400 sq.ft. Leased (Expires 12/16/2008)
Corrections Center
Brownsville, Texas Community 8,338 sq.ft. Owned
Corrections Center
Austin, Texas Community 18,000 sq. ft Owned
Corrections Center
</TABLE>
The Company owns the real property and buildings located in Brownsville,
Texas, and Austin, Texas, at which it operates its Community Correctional
Centers for the Federal Bureau of Prisons. The real property and building in
Brownsville, Texas, is subject to a real estate lien note in the principal
amount of $788,400 which matures on March 15, 2006. The note is secured by the
real property, building and other personal property. The real property and
building in Austin, Texas, is subject to a promissory note in the principal
amount of $500,000 which matures on July 29, 2011. The note is secured by the
real property, building and other personal property.
The Company leases corporate and administrative offices in San Diego, Los
Alamitos, Anaheim, Lake Forest, Stockton, San Luis Obispo and Santa Barbara. As
of December 31, 1998, its minimum future lease payment commitment for the next
five years under operating leases of office space, facilities and equipment is
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as follows: 1999 - $208,613; 2000 - $199,328; 2001 - $140,599; 2002 - $135,535;
and 2003 - $135,850.
ITEM 3. LEGAL PROCEEDINGS.
The Company is not a party to any legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS.
There were no matters submitted during the fourth quarter of the fiscal
year ended December 31, 1999, to a vote of security holders, through the
solicitation of proxies or otherwise.
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Until October 21, 1999, our common stock was published on the National
Association of Securities Dealers' OTC Bulletin Board ("OTCBB") under the symbol
"CRXS." The OTCBB is a quotation service that displays real-time quotes,
last-sale prices, and volume information in domestic and certain foreign
securities. Although the OTCBB is operated by the National Association of
Securities Dealers ("NASD"), it is unlike Nasdaq-Registered Trademark- or other
listed markets where individual companies apply for listing and must meet and
maintain strict listing standards; instead, individual brokerage firms or Market
Makers initiate quotations for specific securities on the OTCBB.
In 1999, the U.S. Securities and Exchange Commission ("SEC") approved
amendments to the NASD's OTC Bulletin Board eligibility rules. The amendments
require a company with securities quoted on the OTCBB to make periodic filings
with the SEC. Prior to the eligibility rule amendments, there was no requirement
for a company quoted on the OTCBB to make publicly available reports with the
SEC or other regulator. In order to make periodic filings with the SEC, a
company must register its class of securities with the SEC under the Securities
Exchange Act of 1934 (the "1934 Act").
In November, 1999, the OTCBB removed the Company's symbol from the OTCBB,
as the Company had not yet registered its common stock under the 1934 Act. Until
the Company becomes eligible for quotation on the OTCBB, its securities will be
traded through the "Pink Sheets," which is a paper medium published daily but
not widely disseminated.
The following market quotations for the Company's common stock were
obtained from the OTC Bulletin Board. The quotations reflect inter-dealer
prices, without retail mark-up, mark-down or commission and may not represent
actual transactions. See "No Assurance of Public Market; Possible Volatility of
Market Price of common stock."
<TABLE>
<CAPTION>
1999 HIGH LOW
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<S> <C> <C>
Fourth Quarter 1.01 0.17
Third Quarter 0.9375 0.5625
Second Quarter 0.9375 0.3125
First Quarter 0.8125 0.3125
1998
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Fourth Quarter 1.03125 0.28125
</TABLE>
The approximate number of security holders is 75. The Board of Directors
has never declared any dividends and does not expect to do so in the foreseeable
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future.
The Company has authorized an employee stock option plan pursuant to which
it may issue options to acquire up to 1,500,000 shares of common stock. Of these
options, there are presently outstanding nonstatutory options to acquire
1,201,855 shares of common stock. Of these options outstanding, all except
473,980 are fully vested. The unvested options vest from time to time until
January 2003, at which time all presently outstanding options will be vested.
There are also outstanding 3,363,636 shares of Series A Preferred Stock
that are convertible on a share for share basis into common stock of the
Company.
Of the 3,644,400 shares of common stock outstanding, all except 150,000 may
be sold pursuant to Rule 144 of the Securities Act of 1933, as amended.
The sale of a significant number of the foregoing shares may cause
substantial fluctuations in the market price of our common stock. Moreover,
sales of substantial amounts of our common stock (including shares issuable upon
exercise of options) in the public market could materially and adversely affect
the market price of our common stock.
NO ASSURANCE OF PUBLIC MARKET; POSSIBLE VOLATILITY OF MARKET PRICE OF COMMON
STOCK.
Although we intend to have our common stock published on the OTCBB, there
can be no assurance that a regular trading market for our common stock will
develop. The OTCBB is an unorganized, inter-dealer, over-the-counter market
which provides significantly less liquidity than a national securities exchange
or the Nasdaq Stock Market, and quotes for securities included in the OTCBB are
not listed in the financial sections of newspapers as they are for securities
listed on a national securities exchange and the Nasdaq Stock Market. Therefore,
prices for securities traded solely on the OTCBB may be difficult to obtain and
our stockholders may be unable to resell our common stock at or near their
original offering price or at any price.
RISKS RELATING TO LOW-PRICED STOCKS; POSSIBLE ADVERSE EFFECTS OF "PENNY STOCK"
RULES ON LIQUIDITY FOR OUR COMMON STOCK.
The Securities and Exchange Commission (the "Commission") has adopted
regulations which generally define "penny stock" to be any equity security that
is not traded on a national securities exchange or the Nasdaq Stock Market and
that has a market price of less than $5.00 per share or an exercise price of
less than $5.00 per share, subject to certain exceptions. If our common stock is
included in the OTCBB and is trading at less than $5.00 per share at any time,
trading in our common stock will be subject to the requirements of "penny stock"
regulations.
These regulations require, among other things, prior to any penny stock
transaction, the delivery of a disclosure schedule explaining the penny stock
market and the associated risks, and which impose various sales practice
requirements on broker-dealers who sell penny stocks to persons other than
established customers and accredited investors (generally institutions or
individual investors with assets in excess of $1,000,000 or an individual annual
income exceeding $200,000 or, together with the investor's spouse, a joint
income of $300,000). For these types of transactions, the broker-dealer must
make a special suitability determination for the purchaser and have received the
purchaser's written consent to the transaction prior to sale. The broker-dealer
must also disclose the commission payable to both the broker-dealer and the
registered representative, current quotations for the securities and, if the
broker-dealer is the sole market-maker, the broker-dealer must disclose this
fact and the broker-dealer's presumed control over the market.
These additional regulations imposed upon broker-dealers that trade "penny
stocks" may discourage broker-dealers from effecting transactions in our
securities, which could severely limit the market price and liquidity of such
securities and the ability of holders of our common stock to sell their
securities in the secondary market.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
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The following financial analysis should be read in conjunction with the
Company's financial statements.
Statements in this section regarding our anticipated capital expenditures
and anticipated performance in future periods constitute forward looking
statements within the meaning of the Securities Exchange Act of 1934. These
statements are subject to certain risks and uncertainties that could cause
actual amounts to differ materially from those projected. We believe these
forward looking statements are reasonable; however, undue reliance should not be
placed on such forward looking statements, which are based on current
expectations.
With respect to anticipated capital expenditures, we have made certain
assumptions regarding, among other things, maintenance of existing facilities
and equipment, availability and desirability of new, technologically advanced
equipment, installation and start up times, cost estimates and continued
availability of financial resources. The estimated amount of capital
expenditures is subject to certain risks, including, among other things, the
risk that unexpected capital expenditures will be required and unexpected costs
and expenses will be incurred.
General
At present, the Company has contracts to manage nine city and one county
jail, three community pre-release centers and an alternative sentencing
division. During the majority of 1999 and 1998 the Company operated a tenth
city jail in Chino, California. In December 1999, Chino decided to bring the
jail management function back in house and terminated its contract with the
Company for reasons unrelated to the Company's performance of the contract.
The Company's largest customer is the Federal Bureau of Prisons (BOP)
which accounted for nearly 22% and 15% of the Company's total net revenue for
the years ended December 31, 1999 and 1998, respectively. This customer
accounted for approximately 30% and 14% of the Company's total accounts
receivable on December 31, 1999 and 1998, respectively. At December 31, 1999
the Company had three separate community pre-release center contracts with
BOP. If the Company were to experience difficulty in continuing to provide
services to this customer, or collecting these accounts receivable, it could
have a material adverse effect on the Company's business financial condition
and results of operations. In addition, a loss of this customer could
materially and adversely affect the Company's net revenue.
CITY/COUNTY JAIL OPERATIONS:
With the exception of the Seal Beach facility, each of the contracts
provides that the Company will be reimbursed for all of its direct operating
cost, and certain overhead expenses in addition to a management fee that is
either fixed or a percentage of the operating expenses. These contracts require
the Company to operate within certain annual budget restrictions. In the event
that the jail's operating costs exceed the budgeted amounts, the city is no
longer obligated to pay the management fee. In contrast to the other jails, the
Seal Beach facility primarily houses Bureau of Prisons and self-pay inmates on a
per diem basis. The Seal Beach agreement provides for payment to Correctional
Systems of an amount based upon operating income; in the event there is no
operating income, the Company is responsible for one-half of operating expenses.
The population of these jails is arrestees, self-pay inmates, sentenced
county work furlough inmates and federal inmates serving short-term sentences.
All of these jails are in Los Angeles/Orange County California, with the
exception of the Lincoln County New Mexico operation.
COMMUNITY PRE-RELEASE CENTERS:
At present the Company has three pre-release community correction centers.
Reality House ("RHI"), a wholly-owned subsidiary, is located in Brownsville
Texas and has a capacity to house 65 inmates. As its primary source of revenue,
the facility has a contract with the Bureau of Prisons that runs through the
year 2000. The Company has submitted a bid to renew this contract and management
believes that the contract will be re-awarded to the Company.
Mid-Valley House is located in McAllen, Texas and has the capacity to house
60 inmates. As its primary source of revenue the facility has a contract with
the Bureau of Prisons that runs thorough the year 2003.
McCabe Center, a Company owned facility, is located in Austin Texas and has
the capacity to house 55 inmates. In addition to a contract with the Bureau of
Prisons, that runs though the year 2000, the facility also has a contract with
the US Courts to house inmates during pre-trial arraignment in addition to group
and individual counseling. The Company has submitted a bid to renew the Bureau
of Prisons contract and management believes that the contract will be re-awarded
to the Company.
As part of the Bureau of Prisons contracts, the community pre-release
centers monitor low risk offenders that are on home confinement.
10
<PAGE>
ALTERNATIVE SENTENCING DIVISION:
The Company's wholly-owned subsidiary, Sentencing Concepts, Inc., ("SCI"),
provides alternatives to imprisonment for low risk offenders. SCI's programs
provide punishment options, i.e. home detention via electronic monitoring,
rehabilitative counseling, educational programs and substance abuse testing. SCI
has contracts with various judicial agencies to provide these services.
Currently SCI provides services to more than 1,000 offenders with
California offices in Anaheim, Lake Forest, Stockton, San Luis Obispo and
Santa Barbara. SCI provides monitoring programs in the following California
counties: San Luis Obispo, Santa Barbara, Orange, San Joaquin and Placer
County.
RESULTS OF OPERATIONS
Correctional Systems, Inc. revenues are recognized as services are provided
either on a fixed fee arrangement, percentage of expenses, per diem rate or fee
for service.
The Company's largest operating expense is salaries and related payroll
taxes. Substantially all other operating expenses consist of food, subsistence
items, medical services related items, insurance, equipment rental, cost
associated with the sale of drug testing patches and other general operating
expenses. The Company believes that as the inmate population increases at the
pre-release centers and the Seal Beach facility, and the clientele increases at
SCI, operating profits will improve. However, since a portion of the Company's
operations consist of effectively fixed fee contracts with cities/counties to
manage jails, increases in the inmate population at these facilities will have
little or no impact on the Company's operating margins.
The Company's general and administrative expenses consist of officers and
administrative personnel salaries as well as legal, accounting, other
professional fees and travel.
Year Ended December 31, 1999 Compared to Year Ended December 31, 1998
The following table sets forth the Company's revenue and expenses for the
years ended December 31:
<TABLE>
<CAPTION>
% %
1999 OF REVENUE 1998 OF REVENUE
----------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Revenue $ 6,731,006 100% $2,702,409 100%
Salaries & wages 2,923,939 43% 1,269,512 47%
Depreciation & amortization 147,790 2% 50,685 2%
Other operating expenses 2,052,935 30% 703,408 26%
General and administrative 1,406,471 20% 707,197 26%
Operating income (loss) 199,871 3% (28,392) -
Interest income (expense) (57,960) (1%) 2,377 -
Other income (expense) (4,799) - (2,393) -
Pre-tax income (loss) 137,112 2% (28,408) (1%)
Provision for income taxes 20,385 3% - -
Net income (loss) $ 116,727 2% $ (28,408) -
Basic net income (loss) per share $ .03 - $ (.01) -
Diluted net income (loss) per share $ .02 - $ (.01) -
</TABLE>
In 1999, the increase in revenues over 1998 of 124% is due primarily to the
inclusion of RHI and SCI operations for 12 months in 1999 as compared to 5 and 4
months respectively in 1998. On a proforma basis, had the operations of RHI and
SCI been annualized in 1998, the percentage increase for 1999 would have been
39%. This increase is due to the addition of Mid-Valley and McCabe pre-release
community corrections centers in 1999, the addition of the Hawthorn, Whittier
and Chino City jails, as well as the addition of new programs and services
within existing SCI operations.
In 1999, the increase in salaries and wages over 1998 of 130% is due
primarily to the Company's expansion mentioned above, i.e. the additions of the
Hawthorn, Whittier and Chino facilities, the additions of two pre-release
community correction centers (Mid-Valley and McCabe), and the effect of 12
months of salaries at SCI, included in the Company's 1999 operation compared to
5 months in 1998.
In 1999, the increase in depreciation and amortization expense over 1998 of
192% is due primarily to purchase of the McCabe community correction center
facility and the inclusion of RHI's depreciation and amortization in 1999 for 12
months as compared to 5 months in 1998.
11
<PAGE>
In 1999, the increase in other operating expenses over 1998 of 192% is due
to the additions of the Hawthorn, Whittier and Chino facilities, the additions
of two pre-release community correction centers (Mid-Valley and McCabe), and the
effect of 12 months of operating expenses at SCI included in the Company's 1999
operation compared to 5 months in 1998.
General and administrative expenses increased in 1999 over 1998 by 99% due
primarily to the additional staff and expenses required to keep pace with the
Company's expansion.
The increase in interest expense in 1999 of ($60,337) over 1998, is due
primarily to the financing ($500,000 at 8%) of the McCabe pre-release community
correction center acquisition in July 1999 and the financing of the RHI
pre-release community correction center in May 1999 for $788,400 at 9.288%.
Funds generated from the RHI financing were used to acquire the McCabe Center.
The Company also has entered into approximately $75,000 of equipment financing
transactions with several companies at various rates of interest.
The increase in the provision for income taxes in 1999 of $20,385, over
1998 was a result of the Company becoming profitable. The primary difference
between income taxes at the statutory rate, of 34% ($46,619), and the effective
rate, of 14.9% ($20,385), was the use of net operating loss carry forwards
generated in prior years, ($30,812), offset by other changes of $10,880.
PROPERTY AND EQUIPMENT:
On July 29, 1999 the Company acquired McCabe Pre-Release Community
Correction Center. The purchase included a building, certain equipment and
intangibles in exchange for cash of $525,000 and notes payable of $500,000.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
The following table sets forth the Company's revenue and expenses for
the years ended December 31:
<TABLE>
<CAPTION>
% of % of
1998 Revenue 1997 Revenue
----------- -------- ----------- ----------
<S> <C> <C> <C> <C>
Revenue $2,702,409 100% $1,051,806 100 %
Salaries and wages 1,269,512 47% 648,374 62 %
Depreciation & amortization 50,685 2% 6,415 1 %
Other operating expenses 703,408 26% 247,846 23 %
General and administrative 707,197 26% 620,247 59 %
Operating (loss) (28,392) - (471,076) (45)%
Interest income (expense) 2,377 - 11,120 1 %
Other income (expense) (2,393) - (631) -
Pre-tax (loss) (28,408) 1% (460,587) (44)%
Provision for income taxes - - - -
Net (loss) $ (28,408) - $(460,587) (44)%
Basic (loss) per share $ (.01) - $ (.19) -
Diluted net (loss) per share $ (.01) - $ (.19) -
</TABLE>
In 1998, the increase in revenues over 1997 of 157%, is due primarily to
the acquisition of SCI and RHI in August and September of 1998 respectively,
the addition of the Downey city jail and, the New Mexico county jail, the
inclusion of the Montebello, Baldwin Park and Alhambra city jails for the
entire year in 1998, as compared to a partial year in 1997 and an increase in
the Bureau of Prisons and self-pay, inmate populations at the Company's Seal
Beach facility.
In 1998, the increase in salaries and wages over 1997 of 96%, is due
primarily to the acquisition of SCI and RHI in 1998, the addition of the
Downey city jail and, the New Mexico county jail, the inclusion of the
Montebello, Baldwin Park and Alhambra city jails for the entire year in 1998,
as compared to a partial year in 1997.
In 1998, the increase in depreciation and amortization over 1997 of
690%, is due primarily to the increase in property and equipment and an
intangible asset associated with the Company's acquisition of RHI in 1998.
In 1998, the increase in other operating expenses over 1997 of 184% is
due primarily to the acquisition of SCI and RHI in 1998, the addition of the
Downey city jail and, the New Mexico county jail, the inclusion of the
Montebello, Baldwin Park and Alhambra city jails for the entire year in 1998,
as compared to a partial year in 1997.
In 1998, the increase in general and administrative expenses over 1997
of 14% is due primarily to the additional staff and expenses required to keep
pace with the Company's expansion and the additional costs associated with
the Security and Exchange Commission's reporting requirements.
In 1998 the decrease in interest income net of interest expense over
1997 of (79%) is due primarily to the uses of funds required to purchase RHI
and costs associated with the acquisition of SCI, in 1998.
Due to the net losses in 1998 and 1997, the Company did not accrue any
provision for income taxes. The accumulation of these losses over the years
have generated approximately $155,000 in net operating loss carryforwards.
These loss carryforwards are in accordance with federal tax laws that limited
their utilization, after the issuance of the Company's preferred stock to
First Analysis Corporation.
In 1998, cash used in operations decreased to $(276,074) from $(436,220)
in 1997 or 37%. This was primarily due to the reduction in net loss in 1998
offset by an increase in accounts receivable in 1998.
As part of its expansion policy, the Company acquired RHI for
approximately $1.4 million and SCI for common stock, valued at $575,000. In
connection with the SCI transaction, $500,000 of additional funds was
invested in SCI for future expansion. Additionally, $100,000 was loaned to
the previous owners of SCI.
Resources for these acquisitions were made possible by an infusion of
equity capital in the form of preferred stock by First Analysis Corporation
in the amount of approximately $2.2 million.
LIQUIDITY AND CAPITAL RESOURCES:
Although the Company reached profitability in 1999, cash generated by
operations will not be sufficient to provide growth because of the
capital-intensive nature of the Company's business. The Company is continuously
looking for new sources of funds to finance its growth. In the past these funds
have come from secured borrowing on Company owned property and equipment and an
infusion of equity capital by First Analysis Securities Corporation in July of
1998 in the amount of $2,200,000.
Cash generated from operations in 1999 was $157,629 as compared to cash
used from operations of $(499,948) for the same period in 1998. This improvement
is due primarily to the profitability the Company achieved in 1999 of $116,727
as compared to net loss of $(28,408) for the same period in 1998, an increase in
1999 in: accounts payable $58,450, accrued liabilities $33,253, accrued
compensation $116,438, offset in part by increase in accounts receivable of
$(279,518).
Our working capital requirements have increased due to our growth. We
believe cash flows from operations will be sufficient to enable us to meet our
working capital requirements for the next 12 months. However, in order to
implement future growth plans, future equity financing will be required.
Based on total assets and annual revenues, we are significantly smaller
than many of our competitors. These competitors include large privately-held and
publicly-held companies that have substantially greater financial, marketing and
other resources than we do. These companies offer services and operate in the
markets in which we compete. The services offered by these companies in some
cases are similar to the services that we offer. We expect that competition will
increase substantially as a result of industry consolidations and alliances, as
well as the emergence of new competitors. There can be no assurance that we will
be able to compete successfully with existing or new competitors or that
competitive pressures faced by us will not materially and adversely affect our
business, operating results and financial condition.
We anticipate that we will need to undertake private placements or a public
offering of our securities at a future date, depending upon market conditions,
in order to obtain sufficient capital for us to implement our intended growth
plan. No assurance can be given that we will be successful in raising additional
investment capital in the future, or that if we are successful, that the
financial resources obtained will be sufficient for us to successfully carry out
our intended growth plan.
YEAR 2000.
12
<PAGE>
CSI and its subsidiaries have not been affected by any Year 2000 issues and
we do not anticipate any. Between mid-1998 and the end of 1999, we identified
and modified any systems that were not Year 2000 compliant.
ITEM 7. FINANCIAL STATEMENTS.
Our consolidated financial statements, with notes thereto and the report of
Arthur Andersen, LLP, our independent auditors, are set forth as indicated in
Item 13.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS.
Not applicable.
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS.
EXECUTIVE OFFICERS AND DIRECTORS
The executive officers and directors of the Company, their ages as of
December 31, 1999 and their positions are set forth below.
<TABLE>
<CAPTION>
HELD OFFICE
NAME AGE POSITION SINCE
---- --- -------- -----------
<S> <C> <C> <C>
William L. Garrison 58 Chairman of the Board, Director 1998
John R. Forren 45 President, Chief Executive Officer, Director 1996
R. Andrew Gately 49 Chief Financial Officer 1998
Daniel J. Verwiel 37 Chief Executive Officer (SCI), Director 1998
Charles Turnbo 56 Vice President, Mid-West Regional Administrator 1996
Martin Rickler 54 Vice President, Planning & Research 1996
David S. Crouse 61 Vice President, Facility Activation 1994
Western Regional Administrator 1997
Gary Maynard 56 Director 1998
James Macdonald 42 Director 1998
</TABLE>
TERM OF OFFICE: The term of office for all directors is one year.
WILLIAM L. GARRISON. Mr. Garrison joined Correctional Systems after over 25
years of employment with the Federal Bureau of Prisons. He served as an
Assistant Regional Director of the South Central Region of the Federal Bureau of
Prisons (September 1982 through April 1985); Warden at five different prisons of
the Federal Bureau of Prisons (April 1976 to September 1982; May 1985 through
October 1988); Director of a Federal Bureau of Prisons Staff Training Center;
Correctional Programs Administrator, Case Management Supervisor and a
Correctional Officer. After leaving the Federal Bureau of Prisons, he served as
the administrator of a privately-owned prison (October 1988 through May 1989);
auditor for the American Correctional Association (1989 until the present); a
self-employed corrections consultant (October 1989 through January 1990);
Director of Operations for Detention Services, Inc. (January 1990 through
November 1990); a self-employed corrections consultant (December 1990 through
July 1993); and Actively involved in the development of Correctional Systems,
Inc. Served as Executive Vice President, CEO and presently Chairman of the Board
of Directors (1992 to Present).
JOHN R. FORREN, MHA. Mr. Forren has 18 years experience in the private
corrections industry. As Vice President and Chief Operating Officer of two other
large private correctional service providers, Eclectic Communications, Inc. and
Cornell Corrections, he has "started-up" more than 15 facilities, many of them a
first for the corrections field. Mr. Forren has worked closely with such
contracting agencies as: California Department of Corrections, North Carolina
Department of Corrections, U.S. Marshal Service, Federal Bureau of Prisons, U.S.
Department Of Justice, Immigrations and Naturalization Service, Virginia
Department of Corrections and the State of North Carolina. Mr. Forren holds a
Bachelor of Science and a Master of Hospital Administration degree from the
University of LaVerne. Mr. Forren served as Vice President of Operations for
Cornell Corrections, Inc., a private corrections management company, from 1994
to 1996; in 1996, as a Senior Partner in The Paladin Group, a criminal justice
systems, alcohol and other drug abuse and health care issues consulting firm;
and as of September, 1996, as the President and then the President and Chief
Executive Officer of the Company.
R. ANDREW GATELY. Mr. Gately's fiscal expertise is deeply rooted in the
financial supervision and oversight of public companies with annual revenues
from $20 million through $100 million. As Vice President and Controller of
Maxicare Health Plans, Mr. Gately was
13
<PAGE>
responsible for all corporate accounting, SEC reporting and fiscal management
for the company's $1 Billion in annual revenue. As a Partner in R. Andrew Gately
& Co. since 1992, Mr. Gately now specializes in financial management and audits
for small publicly traded companies an since 1998, devotes fifty percent of his
time to Correctional Systems, Inc. as Chief Financial Officer.
DANIEL J. VERWIEL. Mr. Verwiel manages the operations and development of
Sentencing Concepts since its inception in 1994. Mr. Verwiel has experience in
administering contracts with public agencies and working with state and federal
legislators on the development of legislature and prison alternatives. Prior to
the formation of Sentencing Concepts, he was a program manager for TRW
(1982-1994). Mr. Verwiel received his Bachelor of Science degree from the
University of Arizona and a Master of Business Administration degree from the
University of Southern California.
CHARLES A. TURNBO. As South Central Regional Director for the Federal
Bureau of Prisons, Mr. Turnbo was responsible for 20,000 inmates and 4,000 staff
in the states of Tennessee, Arkansas, Louisiana, Texas, Oklahoma and New Mexico.
He also served as Northeast Regional Director for the BOP. He has also been a
BOP Warden at two prisons; an Associate Warden at the FCI in Lompoc, CA, and an
instructor at the Federal Prison Staff Training Center in Dallas, Texas. Turnbo
began his 20+ year career with the BOP as the Chief of Classification and Parole
at the FCI in Seagoville, Texas. An adjunct college professor of Criminal
Justice at several different colleges, Mr. Turnbo also has a Masters Degree in
Social Work. Since retiring from the BOP in July 1996, Mr. Turnbo has been the
Company's Vice President and Midwest Regional Director. Mr. Turnbo has also been
the Director of Dispute Resolution Professionals, Inc., a professional mediation
corporation, since 1988; the President of Positive Solutions, Inc., a non-profit
family and individual crisis resolution agency, since 1997; and a Professor at
the School of Professional Studies and Colorado Christian University since 1999.
MARTIN RICKLER, PH.D. Dr. Rickler has devoted over 20 years to the
development of innovative programs in the areas of criminal justice, alcohol &
drug abuse treatment, and health care. Dr. Rickler was part of the team that
implemented the first privately-operated state prison in California; the first
private federal juvenile prison in the U.S.; the first psychiatric halfway house
for developmentally disabled Cuban aliens under federal detention; and the first
California Department of Corrections Return To Custody Facility. As a Programs
Designer and consultant, Dr. Rickler has created innovative treatment programs
that have garnered over $100 million in renewable government and foundation
awards. In addition to five years of counseling experience, Dr. Rickler has also
served on the faculty of the University of California, Antioch University and
the Pacifica Graduate Institute. Dr. Rickler was presented a lifetime
achievement award in 1988 by the Governor of California and the California State
Alcohol Advisory Board for his work in the substance abuse field. Dr. Rickler is
a consultant to the State of California Alcohol and Drug Programs and since
September 1996, serves Correctional Systems, Inc. as Vice President of Planning
and Research. Dr. Rickler has also been the Director and Senior Partner of the
Paladin Group, a criminal justice system, alcohol and other drug abuse and
health care issues consulting firm, since 1994.
DAVID S. CROUSE. As a third generation corrections professional, Mr. Crouse
brings 36 years of professional correctional experience to his current duties as
Correctional Systems' Vice President of Facility Activation and Western Regional
Administrator. Mr. Crouse has held this position since the Company's inception
in 1994. In his 27 years at the BOP, Mr. Crouse served as a Correctional
Treatment Specialist at a 1,000-bed jail facility that he managed from design,
through start-up and into operation; Manager of an 86-bed Youth Corrections Act
Unit; Shift Supervisor; and Transportation Supervisor. In addition to his
extensive corrections management experience, Mr. Crouse has training and
experience in correctional counseling and has been responsible for establishing
programs utilizing a variety of treatment modalities.
CARMINE R. LANZA--DIRECTOR OF LAW ENFORCEMENT LIAISON. Mr. Lanza joined
Correctional Systems, Inc. in 1998 as Director of Law Enforcement Liaison upon
retirement from a very successful 27 year law enforcement career . He served in
the ranks of Patrol Officer, Detective, Sergeant, Lieutenant, Captain and Chief
of Police. Chief Lanza headed a police department of 100 full-time employees and
managed an annual budget in excess of $8 million dollars. During Chief Lanza's 8
years as Police Chief, he brought many innovative programs to Baldwin Park,
California, including Community-Oriented Policing in which he became a
nationally recognized expert. Chief Lanza's duties at Correctional Systems
include networking with local, county, state and federal public safety
14
<PAGE>
organizations and working with these organizations and Correctional Systems
staff to develop and implement new project proposals.
GARY D. MAYNARD. Mr. Maynard received a Bachelor of Arts degree in 1966
from East Central State College in Oklahoma, a Master of Science degree in 1968
from Oklahoma State University at Stillwater and a Doctorate degree in
Counseling Psychology in 1973 from Oklahoma University at Norman. He commenced
service in the Oklahoma Army National Guard even before graduation and continued
this service until retirement at the rank of Brigadier General in 1995. His
service included positions of Adjutant General, Oklahoma Military Department
(June 1992 to June 1995) and Cabinet Secretary for Veterans Affairs for the
State of Oklahoma (July 1993 to January 1995). During his studies towards his
Masters degree, he was employed as a Rehabilitation Counselor (1968 to 1970) and
during his continuing studies toward his Doctorate degree, he was employed as a
Psychologist at the El Reno, Oklahoma, Federal Reformatory. Starting in 1973 and
concurrently with his service in the Oklahoma Army National Guard, he was
employed with the Oklahoma and Arkansas Department of Corrections as follows:
Chief Counselor, Lexington, Oklahoma, Regional Treatment Center (1973 to 1974);
Supervisor, Planning and Research. Oklahoma Department of Corrections (1974 to
1975); Deputy Warden, Oklahoma State Penitentiary (1975 to 1977); Assistant
Director, Arkansas Department of Corrections, Pine Bluff, Arkansas (1977 to
1980); Warden, Joseph Harp Correctional Center, Lexington, Oklahoma (May 1980 to
May 1982); Deputy Director of Institutions, Western Division, Oklahoma
Department of Corrections (May 1982 to July 1985); Warden, Oklahoma State
Penitentiary (July 1985 to July 1987); Associate Director, Oklahoma Department
of Corrections (July 1987 to December 1987); Director, Oklahoma Department of
Corrections (December 1987 to June 1992); and Director, Southwestern Region,
Oklahoma Department of Corrections (June 1995 to May 1997). Following retirement
from the Oklahoma Army National Guard, Mr. Maynard served as a consultant to the
University of Oklahoma Department of Juvenile Affairs (May 1997 to August 1997).
Mr. Maynard has been serving as the Director, Corrections and Public Safety
Programs, College of Continuing Education, University of Oklahoma since August
1997.
JAMES R. MACDONALD. Mr. Macdonald is employed by First Analysis
Corporation, an investment research firm which manages several venture capital
partnerships. He specializes in business services and outsourcing investments
with special focus on the offender management industry. He joined First Analysis
in 1997. From 1983 to 1997, he held a variety of general management and
marketing positions with Nalco Chemical Company. From 1980 to 1983, he was
employed by Ecolab, Inc. He received an MBA from Harvard Business School in 1980
and a Bachelor of Science degree in Civil Engineering from Cornell University in
1978.
ITEM 10. EXECUTIVE COMPENSATION.
The following table sets forth the cash compensation, as well as certain
other compensation paid or accrued, by the Company to the Company's President
and Chief Executive Officer, John R. Forren, and the Company's Vice President of
Planning and Research, Dr. Martin Rickler, for the period from January 1, 1997
to December 31, 1999. No other executive officer had a total annual salary and
bonus equal to or in excess of $100,000 during the reported periods.
MANAGEMENT COMPENSATION
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
ANNUAL COMPENSATION LONG-TERM COMPENSATION
- -----------------------------------------------------------------------------------------------------------------------------------
AWARDS PAYOUTS
- -----------------------------------------------------------------------------------------------------------------------------------
RESTRICTED SECURITIES
NAME AND STOCK UNDERLYING LTIP ALL OTHER
PRINCIPAL SALARY BONUS OTHER ANNUAL AWARD(S) OPTIONS/ PAYOUTS COMPENSATION
POSITION YEAR ($) ($) COMPENSATION ($) ($) SARS (#) ($) ($)
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
John Forren 1999 100,000 -- -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
President and Chief 1998 78,125 -- -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
Executive Officer 1997 46,875 -- -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------------
Martin Rickler 1999 100,000 -- -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
Vice-President, Planning 1998 78,125 -- -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
and Research 1997 64,375 -- -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
15
<PAGE>
OPTIONS/SAR GRANTS IN LAST FISCAL YEAR (Individual Grants)
The following table lists stock options (whether or not in tandem with
SARs) and freestanding SARs (including options and SARs that subsequently have
been transferred) made during the last completed fiscal year to each of the
named executive officers.
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
NUMBER OF SECURITIES PERCENT OF TOTAL
UNDERLYING OPTIONS/ OPTIONS/SARS
SARS GRANTED GRANTED TO EMPLOYEES EXERCISE OF BASE EXPIRATION
NAME # IN FISCAL YEAR PRICE ($/SH) DATE
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
John Forren 100,000 16% 0.94 3/16/08
- -----------------------------------------------------------------------------------------------------------------------------------
Martin Rickler 100,000 16% 0.94 3/16/08
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
NUMBER OF
UNEXERCISED VALUE OF
SECURITIES UNEXERCISED
UNDERLYING IN-THE-MONEY
OPTIONS/SARS AT OPTION/SARS AT
SHARES ACQUIRED FY-END (#) FY-END ($)
ON EXERCISE VALUE REALIZED EXERCISABLE/ EXERCISABLE/
NAME (#) ($) UNEXERCISABLE UNEXERCISABLE
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
John Forren -- -- -- -0-
-0- $100,000 $94,000
- -----------------------------------------------------------------------------------------------------------------------------------
Martin Rickler -- -- -- -0-
-0- $100,000 $94,000
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
DIRECTOR COMPENSATION
WILLIAM GARRISON. As of June 17, 1999, Mr. Garrison, Chairman of the Board
of Directors, receives the compensation listed below:
- Salary of $60,000 per year;
- Expense reimbursement related to business activities;
- $2,500 bonus for each project with profit contribution of
$30,000-$50,000; and
- $5,000 bonus for each completed community corrections acquisition or
new project with $200,000 to $400,000 profit contribution won with
substantive input from Mr. Garrison.
In addition to serving as Chairman of the Board of Directors, Mr. Garrison
acts as Regional Administrator for the current Texas projects and performs
development duties for the company.
GARY MAYNARD. Mr. Maynard receives $500.00 for each meeting attended in the
course of Company business.
EMPLOYMENT AGREEMENTS
MR. FORREN AND DR. RICKLER. Both Mr. Forren and Dr. Rickler have five year
employment agreements. The agreements, effective from September 15, 1996 through
September 14, 2001, provide that Mr. Forren shall serve at no position lower
than President and Chief of Operations, and that Dr. Rickler will serve at no
position lower than Vice President of Planning and Research. The agreements
provide further:
1. BASE SALARY. The first year of employment Mr. Forren received $25,000
and Dr. Rickler received $60,000 plus a signing bonus of $5,000. The
second year both Mr. Forren and Dr. Rickler received $75,000 and both
16
<PAGE>
are to receive $100,000 base salary each year thereafter.
2. EXECUTIVE BENEFITS. Standard executive health, sick leave and holiday
benefits were granted, including 30 days vacation leave annually.
3. PLACE OF EMPLOYMENT: SAN DIEGO, CALIFORNIA. It was agreed that both
Mr. Forren and Dr. Rickler would be employed within the Greater San
Diego area.
4. CONSTRUCTIVE TERMINATION. Except for standard malfeasance and such,
any termination of Mr. Forren and Dr. Rickler will be deemed a
"constructive termination" and will immediately grant the terminated
party all stock options due for the entire contract as well as one
year of the current base salary.
VERWIELS. Daniel Verwiel and Patricia Verwiel each have entered into
employment agreements with Sentencing Concepts providing for an initial annual
salary of $75,000 each, with any increase to be approved by the compensation
committees of the Boards of Sentencing Concepts and Correctional Systems. The
Verwiel's employment agreements also contain covenants not to compete that
extend for two years following any termination of employment and confidentiality
and non-disclosure provisions.
In addition, the Employment Agreement for Daniel Verwiel provides for (i) a
bonus of $10,950, provided Mr. Verwiel was employed by Sentencing Concepts,
Correctional Systems or its subsidiary through July 31, 1999; (ii) a two (2)
year nonstatutory stock option covering up to 30,000 shares of Correctional
Systems common stock (the "Longevity Options"); and (iii) a bonus in an amount
equal to certain tax liabilities that Daniel Verwiel may incur as a result of
exercising any Longevity Options.
The Employment Agreements provide for the grant of (i) a 5 year
nonstatutory stock option covering 600,000 shares of Correctional Systems common
stock (300,000 shares per person) (the "Employment Options"); (ii) a 2 year
nonstatutory stock option covering up to 100,000 shares of Correctional Systems
common stock (the "Earn-Out Options"); (iii) a bonus in an amount equal to
certain tax liabilities that the Verwiels may incur as a result of exercising
any Earn-Out Options; and (iv) a loan in an amount necessary for the exercise of
the Earn-Out Options.
The Earn-Out Option agreements grant to the Verwiels non-qualified options
to acquire up to an aggregate of 200,000 shares of Correctional Systems common
stock (100,000 shares per person) at an exercise price equal to $0.20 per share.
The Earn-Out Options vest as follows and shall be exercisable at any time after
they vest until August 1, 2000.
(i) if the Earn-Out Period Profit is equal to or greater than $50,000,
options to acquire an aggregate of 100,000 shares of Correctional
Systems common stock vest (50,000 shares for each person); and
(ii) if the Earn-Out Period Profit exceeds $50,000, then for each Dollar in
excess of $50,000, options to acquire 4 additional shares of
Correctional Systems common stock vest (2 shares for each Dollar for
each person) up to the maximum 200,000 shares. The Earn-Out Options,
however, automatically vest if there is a change in control during the
Earn-Out Period.
The Longevity Option agreement will grant to Daniel Verwiel non-qualified
options to acquire 30,000 shares of Correctional Systems common stock at an
exercise price of $0.20 per share (the "Longevity Options") exercisable on or
after July 31, 1999, provided he is still employed by Sentencing Concepts at
that time until August 1, 2000.
The Employment Option agreements will grant to the Verwiels non-qualified
options to acquire up to an additional 600,000 shares of Correctional Systems
common stock (300,000 per person).
The Employment Options vest as follows and are exercisable at any time
after they vest until the fifth anniversary of the grant:
(i) If each is, and has at all times prior to January 1, 2002, been
employed by Correctional Systems and/or Sentencing Concepts, then
options to acquire an aggregate of 50,000 shares of Correctional
17
<PAGE>
Systems common stock (25,000 Employment Options for each person) vest
on January 1, 2002; and
(ii) If each is, and has at all times prior to January 1, 2003, been
employed by Correctional Systems and/or Sentencing Concepts, then
options to acquire an additional 50,000 shares of Correctional Systems
common stock (25,000 Employment Options for each person) vest on
January 1, 2003.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table sets forth certain information regarding the beneficial
ownership of shares of common stock and Preferred Stock as of October 4, 1999
for (i) each director and director nominee of the Company; (ii) each executive
officer; (iii) each person known to the Company to be the beneficial owner of
more than 5% of the outstanding shares; and (iv) all directors and executive
officers as a group. Except pursuant to applicable community property laws or as
otherwise indicated, each shareholder has sole voting and investment power with
respect to the shares beneficially owned.
<TABLE>
<CAPTION>
TYPE OF VOTING NUMBER OF % VOTING
NAME AND ADDRESS OF OWNER SECURITY SHARES SECURITIES
------------------------- -------- ------ ----------
<S> <C> <C> <C>
William L. Garrison
7341 Clear Haven
Dallas, TX 75248 common stock 910,500 (1)(4) 24.0%
John Forren
6910-A Miramar Road
Suite 200
San Diego, CA 92121 195,000 (1)(5) 5.1%
Gary Maynard
2001 Priestley Ave.
North Base, Building 605
Norman, OK 73072 0 0%
Daniel J. Verwiel
1815 E. Center Street
Suite 201
Anaheim, CA 92805 common stock 525,269 (1)(6) 14.3%
Patricia Verwiel
1815 E. Center Street
Suite 201
Anaheim, CA 92805 common stock 523,580 (1) 14.4%
Estate of Lawrence G. Grossman
209 Camaro Way
San Marcos, TX 78666 common stock 760,500 (1) 20.9%
James R. Macdonald
233 S. Wacker Drive
Suite 9500
Chicago, IL 60606 A Preferred 3,363,636 (7) 48.0%
Apex Funds (2) A Preferred 884,351 19.5%
IEPEF Funds (3) A Preferred 1,632,657 30.9%
The Productivity Fund III, L.P. A Preferred 816,325 18.3%
Officers and Directors as a Group Common and
(12 persons) A Preferred 2,588,462 36.9%
Total Outstanding (1) common stock 3,644,400 (1) 52.0%
A Preferred 3,363,636 48.0%
Voting Securities 7,008,036 (1) 100.0%
</TABLE>
1) DOES NOT INCLUDE COMMON STOCK ISSUABLE UPON EXERCISE OF OUTSTANDING OPTIONS
(SEE OPTION TABLE. BELOW), EXCEPT COMMON STOCK THAT THE LISTED BENEFICIAL OWNER
HAS THE RIGHT TO ACQUIRE WITHIN SIXTY DAYS, FROM OPTIONS, WARRANTS, RIGHTS,
CONVERSION PRIVILEGE OR SIMILAR OBLIGATIONS.
2) INCLUDES 841,438 SHARES HELD BY APEX FUND III, L.P. AND 42,913 SHARES HELD
BY APEX STRATEGIC PARTNERS, LLC.
3) INCLUDES 1,306,126 SHARES HELD BY INFRA STRUCTURE AND ENVIRONMENTAL PRIVATE
EQUITY FUND III, L.P. AND 326,531 SHARES HELD BY ENVIRONMENTAL & INFORMATION
TECHNOLOGY PRIVATE EQUITY FUND III.
4) INCLUDES 150,000 SHARES OF COMMON STOCK UNDERLYING OUTSTANDING OPTIONS
EXCERCISABLE WITHIN 60 DAYS.
5) INLCUDES 195,000 SHARES OF COMMON STOCK UNDERLYING OUTSTANDING OPTIONS
EXERCISABLE WITHIN 60 DAYS.
6) INLCUDES 30,000 SHARES OF COMMON STOCK UNDERLYING OUTSTANDING OPTIONS
EXERCISABLE WITHIN 60 DAYS.
7) INCLUDES 3,333,333 OWNED BY AFFILIATES OF FIRST ANALYSIS CORPORATION OF WHICH
MR. MCDONALD IS AN OFFICER.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
ESCROW AGREEMENT
Pursuant to the Sentencing Concepts Merger Agreement, the Company deposited
18
<PAGE>
into escrow 270,000 shares of Correctional Systems common stock (the "Escrowed
Shares"), consisting of the following: 70,000 shares issuable to Daniel Verwiel
to provide incentive for Mr. Verwiel to remain in the employ of Correctional
Systems or Sentencing Concepts (the "Longevity Shares"); 100,000 shares issuable
to Patricia and Daniel Verwiel as security for the Verwiels' indemnity
obligations under the Sentencing Concepts Merger Agreement (the "Indemnification
Shares"); and 100,000 shares issuable to Patricia and Daniel Verwiel as security
for the repayment of loans by Correctional Systems to the Verwiels (described
below) contemplated by the Sentencing Concepts Merger Agreement (the "Pledged
Shares").
The Escrow Agreement provides for the release of the Escrowed Shares to the
Verwiels and/or the cancellation of such shares as follows:
Longevity Shares (70,000 shares):
(1) July 31, 1999. On July 31, 1999, 20,000 of the Longevity Shares
were released to Mr. Verwiel.
(2) July 31, 2000. If Mr. Verwiel is still employed by Sentencing
Concepts or Correctional Systems on July 31, 2000, then 50,000 of
the Longevity Shares shall be released to Mr. Verwiel. If his
employment is terminated on or before July 31, 2000, he forfeits
any right to the remaining Longevity Shares;
(3) Change of Control. If a Change of Control, as defined in the
Sentencing Concepts Merger Agreement, notwithstanding the
foregoing, any remaining Longevity Shares shall be released to
Mr. Verwiel. A "Change of Control" includes, among other
transactions, certain mergers of Correctional Systems with
another corporation or entity and any certain sales of
substantially all of the assets of Correctional Systems.
Indemnification Shares (100,000 shares):
Pursuant to the Sentencing Concepts Merger Agreement, the Verwiels
will jointly and severally indemnify the Company against damages that arise
arise out of any breach of or failure by Sentencing Concepts or any
Sentencing Concepts shareholder to perform any of their obligations under
theSentencing Concepts Merger Agreement. As security for these indemnities
by the Verwiels, 50,000 shares of the Correctional Systems common stock to
be issued and delivered to each of Daniel Verwiel and Patricia Verwiel
pursuant to the Sentencing Concepts Merger Agreement, an aggregate of
100,000 shares (the "Indemnification Shares"), shall be placed in escrow
and are subject to forfeiture and cancellation pursuant to escrow agreement
described above. If no claims under the indemnity (described below)
provided by the Verwiels to Correctional Systems have been made on or
before the first anniversary of the closing date of the Sentencing Concepts
Merger Agreement, all of the Indemnification Shares will be released from
the Escrow on such date and shall be delivered to Daniel and Patricia
Verwiel (50,000 shares each). If a claim or claims are made under the
indemnities before such first anniversary date, then the Indemnification
Shares shall remain in and subject to the Escrow Agreement until such time
as the amount of such claims made and the indemnification obligations of
the Verwiels with respect thereto have been finally determined. Once a
determination is made, a number of Indemnification Shares shall be canceled
to satisfy the indemnity obligation.
Pledged Shares (100,000 shares):
Upon repayment in full of all amounts outstanding under loans to the
Verwiels (described below) contemplated by the Sentencing Concepts Merger
Agreement, all of the Pledged Shares will be released from the Escrow on
such date and shall be delivered to Daniel and Patricia Verwiel (50,000
shares each).
LOANS
On August 18, 1998, pursuant to the Sentencing Concepts Merger Agreement,
Correctional Systems loaned Daniel and Patricia Verwiel $50,000 each, pursuant
to a promissory note and security agreement. The promissory notes (i) bear
interest at the rate of seven percent
19
<PAGE>
(7%) per annum or the rate necessary to avoid imputed interest under the
Internal Revenue Code of 1986, as amended, whichever rate is higher, (ii)
provide that interest and principal shall be due and payable on the fifth
anniversary of the issuance of such notes and (iii) are secured by a pledge of
an aggregate of 100,000 shares of the Correctional Systems common stock to be
issued to Patricia and Daniel Verwiel (50,000 shares each) pursuant to the
Sentencing Concepts Merger Agreement (the "Pledged Shares").
The loans to the Verwiels were negotiated in connection with the Company's
acquisition of SCI, and, as such, the terms of the loans may not be comparable
to loans that would be made independently to unaffiliated third parties.
STOCKHOLDERS' AGREEMENT AND REGISTRATION RIGHTS AGREEMENT
The Company, William Garrison, John Forren, Martin Rickler (the "Management
Parties") and the present holders of Series A Preferred Stock in the Company
(the "Preferred Holders") are parties to an Amended and Restated Registration
Rights Agreement dated August 31, 1998 (the "Registration Rights Agreement").
The Registration Rights Agreement granted the Preferred Holders rights to
require the Company to register the Common Stock underlying their Series A
Preferred Stock for public sale on SEC registration statement Form S-1. The
Registration Rights Agreement grants the Management Parties rights to require
the Company to register certain of their Common Stock for public sale on SEC
registration statement Form S-3 or any similar short-form registration if such
form is then available to the Company for registration of its securities.
The Company, the Management Parties and the Preferred Holders are parties
to an Amended and Restated Stockholders' Agreement dated August 31, 1998 (the
"Stockholders' Agreement"). The Stockholders' Agreement provides that the
Company's Board of Directors shall consist of 6 members, one of whom shall be
designated by a certain holder of the Series A Preferred Stock of the Company
(the "Preferred Designee" who is currently James Macdonald), and one of whom
shall be designated by a majority vote of the holders of Common Stock who are
parties to the Stockholders' Agreement (which parties are the Management
Parties) (the "Common Designee," who is currently Gary Maynard). The Preferred
Holders have the right to approve the Common Designee. The Management Parties
have no plans or proposals to change the current composition of the Board. The
Stockholders' Agreement also provides that the Board of any subsidiary of the
Company shall be the same as the Board of the Company.
The Stockholders' Agreement also restricts the transfer of Common Stock
owned by the Management Parties. The Preferred Holders have a right of first
refusal on any proposed transfer of Common Stock by the Management Parties, and
the Preferred Holders also have co-sale rights on any transfer of Common Stock
by a Management Party to a third party; provided that each Management Party
shall have the right to transfer in any twelve-month period up to 15,000 shares
of stock. Pursuant to the Stockholders' Agreement, the Preferred Parties have a
preemptive right to purchase a certain portion of any new securities offered for
sale by the Company.
Pursuant to the Sentencing Concepts Merger Agreement, the Verwiels became a
party to a Stockholders' Agreement and a Registration Rights Agreement, each by
and among Correctional Systems and certain of its shareholders, which agreements
constitute a portion of the Series A Preferred Agreements and set forth certain
restrictions on transfer of any of the Correctional Systems securities or
options issued to the Verwiels pursuant to the Sentencing Concepts Merger
Agreement and certain registration rights of the parties thereto.
RESTRICTED ACTS. As long as any shares of Series A Preferred are
outstanding, Correctional Systems shall not, with certain exceptions, without
the affirmative vote or written consent of the holders of at least a majority of
then outstanding Series A Preferred: (a) authorize, create or issue any shares
of any additional shares of common stock or securities convertible into common
stock; (b) issue any instrument or security exercisable for or convertible into
shares of Series A Preferred, or issue shares of Series A Preferred other than
the first 3,363,636 shares issued; (c) enter into, or permit any Subsidiary to
enter into, any agreement, indenture or other instrument which contains any
provisions restricting the payment of dividends on the Series A Preferred; (d)
redeem, purchase or otherwise acquire for value (or pay into or set aside for a
sinking fund for such purpose) any share or shares of Series A Preferred; (e)
redeem, purchase or otherwise acquire (or pay into or set aside for a sinking
fund for such purpose) any shares of common stock, provided, however, that this
restriction shall not apply to (i) the repurchase by resolution of the Board of
shares of Common from employees, officers, directors, consultants or other
persons performing services for the Correctional Systems or any Subsidiary
pursuant to agreements under which the Correctional Systems has the option to
repurchase such shares upon the occurrence of certain events, such as the
termination of employment or (ii) the cancellation of shares of Common subject
to forfeiture; (f) merge
20
<PAGE>
Correctional Systems with or into any other person or entity or other form of
corporate reorganization in which the Correctional Systems shall not be the
continuing or surviving entity (other than a reincorporation transaction) or
sell all or the majority of Correctional Systems' assets; (g) amend its Articles
of Incorporation or Bylaws; or (h) incur funded indebtedness, capitalized lease
obligations or guarantees of third party debt, in each case involving an amount
in excess of $3,000,000; (i) engage an investment bank, consultant, or other
advisor for the purpose of raising capital or refinancing securities or
indebtedness or for selling or merging Correctional Systems; (j) engage in any
transaction which could involve a conflict of interest or which involves
dealings between the Correctional Systems, insiders or affiliates; (k) declare
or pay any dividend other than pursuant to the terms of the Series A Preferred;
(l) enter into any agreement, commitment or plan of merger, reorganization or
consolidation that would result in the Correctional Systems acquiring any
business entity, or any division or segment of a business entity; or (m) file a
registration statement under the Securities Act.
ADDITIONAL APPROVALS. The Stockholders' Agreement provides that the
following actions require the prior approval of the Director designated by the
holders of the Series A Preferred:
(i) increasing the cash compensation of any executive by more than Five
Percent (5%) per year;
(ii) granting any stock options or entering into any phantom option
plans;
(iii) terminating or replacing any of the four most senior executives;
(iv) increasing the number of the directors composing the Board;
(v) causing Correctional Systems or any Subsidiary to enter into any
business other than the business presently conducted; and
(vi) forming any Subsidiary or causing it to issue any debt or equity
securities.
MANDATORY SALE. The Stockholder's Agreement provides that if Correctional
Systems has not been sold, merged with a public company or has not been the
subject of a Qualified Public Offering (as defined in the Stockholders'
Agreement) by July 21, 2003, or if Correctional Systems fails to report a profit
in any calendar year beginning with the calendar year ending December 31, 1999,
then the parties thereto will upon the request of the holders of Series A
Preferred take such action as is necessary or appropriate to cause Correctional
Systems or its outstanding securities to be sold within in six (6) months after
delivery of the sale request.
Item 13. EXHIBITS AND REPORTS ON FORM 8-K
2.1 Certificate of Incorporation*
2.2 By-laws*
6.1 City Detention Facility Operations and Management Agreement
(Correctional Services, Inc. and the City of Alhambra)*
6.2 Agreement Between the County of Orange and Sentencing
Concepts, Inc. for the Provision of Supervised Electronic
Confinement Services*
9.1 Amended and Restated Stockholders' Agreement, dated as of
August 31, 1998**
*Incorporated by reference to exhibits filed with Form 10-SB/A filed
January 11, 2000
**Incorporated by reference to Exhibit D filed with Schedule 13D filed
February 7, 2000, by Daniel J. Verwiel, John Forren, Martin Rickler, Patricia
A. Verwiel, Estate of Lawrence G. Grossman, and William L. Garrison.
21
<PAGE>
PART F/S
Annual Report on Form 10-SB
Correctional Systems, Inc. and Subsidiaries
<TABLE>
<CAPTION>
PAGE
<S> <C>
Report of Independent Public Accountants......................................................................F - 2
Consolidated Balance Sheets as of December 31, 1999 and 1998 .................................................F - 3
Consolidated Statements of Operations for the Years Ended December 31, 1999 and 1998 .........................F - 4
Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1999 and 1998 ...............F - 5
Consolidated Statements of Cash Flows for the Years Ended December 31, 1999 and 1998 .........................F - 6
Notes to Consolidated Financial Statements....................................................................F - 8
</TABLE>
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Correctional Systems, Inc.:
We have audited the accompanying consolidated balance sheets of CORRECTIONAL
SYSTEMS, INC. (a Delaware corporation) and subsidiaries as of December 31, 1999
and 1998, and the related consolidated statements of operations, shareholders'
equity and cash flows for the years then ended. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of
Correctional Systems, Inc. and subsidiaries as of December 31, 1999 and 1998,
and the results of their operations and their cash flows for the years then
ended, in conformity with accounting principles generally accepted in the
United States.
ARTHUR ANDERSEN LLP
San Diego, California
March 8, 2000
F-2
<PAGE>
<TABLE>
<CAPTION>
CORRECTIONAL SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Balance Sheets - December 31, 1999 and 1998
ASSETS
1999 1998
--------------- ---------------
<S> <C> <C>
Cash $ 472,488 $ 489,096
Accounts receivable, net of bad debt reserve of $5,000 and $10,000 792,746 513,228
Other current assets 63,075 (100)
--------------- ---------------
Total current assets 1,328,309 1,002,224
--------------- ---------------
Property and equipment:
Land 105,278 78,000
Building 1,314,336 262,000
Furniture and equipment 348,824 116,449
Less: accumulated depreciation (98,371) (32,145)
--------------- ---------------
Total property and equipment 1,670,067 424,304
--------------- ---------------
Related party notes and interest receivable 109,333 103,333
Goodwill, net of accumulated amortization of $90,004 and $25,565 1,231,971 1,295,766
Other intangibles, net of accumulated amortization of $27,151 and $6,818 582,849 603,182
Deposits and other assets 17,374 15,970
--------------- ---------------
$4,939,903 $3,444,779
=============== ===============
LIABILITIES AND SHAREHOLDERS' EQUITY
Line of credit $ - $ 40,887
Accounts payable 188,281 129,831
Accrued liabilities 140,802 107,549
Accrued compensation 217,254 100,816
Current portion of long-term debt 132,170 106,776
Deferred revenue 81,459 71,512
--------------- ---------------
Total current liabilities 759,966 557,371
--------------- ---------------
Long-term debt, net of current portion 1,156,681 -
Deferred income taxes 2,621 -
Commitments and Contingencies
Shareholders' equity:
Convertible preferred stock, $.001 par value, 10,000,000
shares authorized, 3,363,636 shares of Series A issued and
outstanding 3,364 3,364
Common stock, $.001 par value, 40,000,000 shares authorized,
3,644,400 shares issued and outstanding 3,644 3,644
Additional paid-in capital 3,691,317 3,674,817
Accumulated deficit (677,690) (794,417)
--------------- ---------------
3,020,635 2,887,400
--------------- ---------------
$4,939,903 $3,444,779
=============== ===============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
<PAGE>
CORRECTIONAL SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
For the Years Ended December 31, 1999 and 1998
<TABLE>
<CAPTION>
1999 1998
--------------- ---------------
<S> <C> <C>
Revenues $6,731,006 $2,702,409
--------------- ---------------
Expenses:
Salaries and wages 2,923,939 1,269,512
Depreciation and amortization 147,790 50,685
Other operating expenses 2,052,935 703,407
General and administrative expenses 1,406,471 707,197
--------------- ---------------
Total expenses 6,531,135 2,730,801
--------------- ---------------
Operating income (loss) 199,871 (28,392)
Other income (expense):
Interest income and expense, net (57,960) 2,377
Other expense (4,799) (2,393)
--------------- ---------------
Total other income (expense) (62,759) (16)
--------------- ---------------
Income (loss) before provision for income taxes 137,112 (28,408)
Provision for income taxes 20,385 -
--------------- ---------------
Net income (loss) $ 116,727 $ (28,408)
=============== ===============
Basic net income (loss) per share $ .03 $ (0.01)
Diluted net income (loss) per share $ .02 $ (0.01)
=============== ===============
Weighted average common shares outstanding - basic 3,424,400 2,861,067
Weighted average common shares outstanding - diluted 6,793,758 2,861,067
</TABLE>
F-4
<PAGE>
CORRECTIONAL SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
For the Years Ended December 31, 1999 and 1998
<TABLE>
<CAPTION>
PREFERRED COMMON ADDITIONAL
---------------------------------- ---------------------------------- PAID-IN
SHARES AMOUNT SHARES AMOUNT CAPITAL
-----------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1997 - $ - 2,494,400 $2,494 $ 936,726
Issuance of common
stock for
acquisition of
SCI - - 1,150,000 1,150 573,850
Issuance of
preferred stock,
net of offering
costs of $52,395 3,363,636 3,364 - - 2,164,241
Net loss - - - - -
------------- ---------- ------------- ---------- ---------------
BALANCE AT DECEMBER 31, 1998 3,363,636 3,364 3,644,400 3,644 3,674,817
Net income - - - - -
Issuance of stock
options for
compensation - - - - 16,500
------------- ---------- ------------- ---------- ---------------
BALANCE AT DECEMBER 31, 1999 3,363,636 $ 3,364 3,644,400 $ 3,644 $3,691,317
============= ========== ============= ========== ===============
</TABLE>
<TABLE>
<CAPTION>
ACCUMULATED
DEFICIT TOTAL
-----------------------------------
<S> <C> <C>
BALANCE AT DECEMBER 31, 1997 $(766,009) $ 173,211
Issuance of common
stock for
acquisition of
Sentencing Concepts, Inc. - 575,000
Issuance of
preferred stock,
net of offering
costs of $52,395 - 2,167,605
Net loss (28,408) (28,408)
------------- ---------------
BALANCE AT DECEMBER 31, 1998 (794,417) 2,887,408
Net income 116,727 116,727
Issuance of stock
options for
compensation - 16,500
------------- ---------------
Balance at December 31, 1999 $(677,690) $3,020,635
============= ===============
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL
STATEMENTS.
F-5
<PAGE>
CORRECTIONAL SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
For the Years Ended December 31, 1999 and 1998
<TABLE>
<CAPTION>
1999 1998
---------------- -----------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 116,727 $ (28,408)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization 147,790 50,685
Stock options issued as compensation 16,500 -
Increase in accounts receivable (279,518) (221,404)
Increase in other current assets (63,175) -
Increase in deposits and other assets (1,404) -
Increase (decrease) in accounts payable 58,450 (146,555)
Increase (decrease) in accrued liabilities 33,253 (203,242)
Increase in accrued compensation 116,438 18,633
Increase in deferred revenue 9,947 30,343
Increase in deferred income taxes 2,621 -
------------------------------------
Net cash provided by (used in) operating activities 157,629 (499,948)
------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Payments for acquired companies, net of cash acquired - (1,205,611)
Purchase of land and depreciable assets (738,631) (30,889)
Payments received from related parties - 30,000
Related party notes interest receivable (6,000) (4,326)
Loans to related parties - (100,000)
Proceeds from asset disposal 6,776 -
------------------------------------
Net cash used in investing activities (737,856) (1,310,826)
------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of preferred stock, net - 2,167,605
Borrowings on notes payable 788,576 -
Payments on notes payable (184,070) (6,959)
Borrowings on line of credit - 14,525
Payments on line of credit (40,887) -
------------------------------------
Net cash provided by financing activities 563,619 2,175,171
----------------- -----------------
INCREASE (DECREASE) IN CASH (16,608) 364,397
CASH, beginning of year 489,096 124,699
----------------- -----------------
CASH, end of year $ 472,488 $ 489,096
================= =================
(continued)
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL
STATEMENTS.
F-6
<PAGE>
CORRECTIONAL SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
For the Years Ended December 31, 1999 and 1998
(continued)
<TABLE>
<CAPTION>
1999 1998
---------------- -----------------
<S> <C> <C>
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING ACTIVATES:
Acquisition of Sentencing Concepts, Inc.:
Accounts receivable $ - $ 36,907
Furniture and equipment - 14,164
Other assets - 11,020
Accounts payable - (550,428)
Notes payable - (113,735)
------------ --------------
$ - $(602,072)
============ ==============
SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING AND INVESTING
ACTIVITIES:
Assets acquired under capital lease obligations $ 77,569 $ -
============ ==============
Austin Recovery Center assets acquired by issuance of note payable $500,000 $ -
============ ==============
SUPPLEMENTAL DISCLOSURE OF OTHER INFORMATION:
Interest paid $ 80,305 $ 7,058
============ ==============
Taxes paid $ - $ -
============ ==============
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL
STATEMENTS.
F-7
<PAGE>
CORRECTIONAL SYSTEMS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1999 and 1998
1. DESCRIPTION OF BUSINESS AND RISK FACTORS
DESCRIPTION OF BUSINESS
Correctional Systems, Inc. and subsidiaries ("CSI" individually or the
"Company" collectively) was incorporated in the state of California on
March 31, 1994. In October 1999, the Company reincorporated in the
state of Delaware. CSI operates correctional facilities on behalf of
cities and counties under the terms of multi-year contracts with local
governmental agencies. The population of the correctional facilities
typically consists of arrestees, self-pay inmates, sentenced county
work furlough inmates, sentenced federal inmates serving short-term
sentences and individuals requiring detoxification. As a result of an
acquisition in 1998 (see Note 3), the Company also operates a community
correction facility known as Reality House, Inc. (RHI). RHI primarily
provides work furlough programs and counseling, funded by the Bureau of
Prisons. The Company's subsidiary, Sentencing Concepts, Inc. (SCI),
also acquired in 1998 (see Note 3), provides non-imprisonment
alternatives to individuals who would have otherwise been subject to
standard judicial punishment. The services include electronic home
monitoring; drug, alcohol, and anger management counseling; and drug
use testing. The Company has contracts with various municipal judicial
systems to provide these services.
RISK FACTORS
Based on total assets and annual revenues, the Company is significantly
smaller than many of its competitors. These competitors include large
privately-held and publicly-held companies that have substantially
greater financial, marketing and other resources than the Company.
These companies offer services and operate in the markets in which the
Company competes. The services offered by these companies in some cases
are similar to the services that the Company offers. The Company
expects that competition will increase substantially as a result of
industry consolidations and alliances, as well as the emergence of new
competitors. There can be no assurance that the Company will be able to
compete successfully with existing or new competitors or that
competitive pressures faced by the Company will not materially and
adversely effect its business, operating results and financial
condition.
The Company has grown internally, by procuring agreements to operate
correctional facilities, and externally, by acquiring existing
operators of correctional facilities. The Company intends to continue
its development and growth in this manner. Its ability to manage this
development and intended growth will depend on the efforts of its key
management and employees. The Company plans to use incentives,
including competitive compensation and stock plans, to retain
well-qualified employees and attract new employees to accommodate any
expansion. There can be no assurance, however, that the Company will be
able to retain and attract personnel with the requisite capabilities
and experience. The loss of one or more current key management
personnel could also materially adversely effect the Company.
The Company anticipates that it will need to undertake private
placements or a public offering of its securities at a future date,
depending upon market conditions, in order to obtain sufficient capital
to implement its intended growth plan. No assurance can be given that
it will be successful in raising additional investment capital in the
future, or that, if it is successful, the financial resources obtained
will be sufficient to successfully carry out the Company's intended
growth plan. The company believes, based on its business plan that it
has sufficient capital on both the short and long-term to meet its
business objectives, using both the available cash and the Company's
positive working capital position. However, there is no assurance that
the Company will not need additional capital in the future.
The Company's largest customer is the Federal Bureau of Prisons
(BOP) which accounted for nearly 22% and 15% of the Company's total net
revenue for the years ended December 31, 1999 and 1998, respectively.
This customer accounted for approximately 30% and 14% of the Company's
total accounts receivable on December 31, 1999 and 1998, respectively.
At December 31, 1999 the Company had three separate community
pre-release center contracts with BOP. If the Company were to
experience difficulty in continuing to provide services to this
customer, or collecting these accounts receivable, it could have a
material adverse effect on the Company's business financial condition
and results of operations. In addition, a loss of this customer could
materially and adversely affect the Company's net revenue.
F-8
<PAGE>
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION
The consolidated financial statements include the accounts of CSI and
its wholly-owned subsidiaries, SCI and RHI. All significant
intercompany accounts and transactions have been eliminated.
CASH
Cash includes cash in readily available checking and money market
accounts.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost and depreciated over the
estimated useful lives of the assets using the straight-line method as
follows:
<TABLE>
<S> <C>
Building 40 years
Furniture and equipment 3 to 5 years
</TABLE>
GOODWILL AND INTANGIBLES
Goodwill is amortized on a straight-line basis over a period not to
exceed 20 years. Other intangibles, which represent certain operating
rights (see Note 3), are amortized on a straight-line basis over a
period not to exceed 40 years.
LONG-LIVED ASSETS
The Company accounts for long-lived assets in accordance with Statement
of Accounting Standards No. 121, "Accounting for the Impairment of
Long-Lived Assets" ("SFAS No. 121"). SFAS No. 121 requires that
long-lived assets and certain identifiable intangibles to be held by an
entity be reviewed for possible impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not
be fully recoverable. The Company periodically re-evaluates the
carrying value and estimated lives of its long-lived assets based on
expected undiscounted cash flows and recognizes impairments, if any.
REVENUE RECOGNITION
Revenue is generally recognized as services are provided under the
provisions of contracts entered into with governmental agencies, either
at a fixed monthly rate or at a net rate per day per inmate.
Under contracts entered into by SCI, the Company must provide services
to all clients referred by the judicial process, regardless of the
client's ability to pay. Further, the contracts allow for SCI to charge
its clients fees based on a prearranged sliding fee schedule. SCI
contracts do not guarantee a specified level of revenue nor do they
provide for reimbursement for losses relating to servicing clients who
are unable to pay. As a result, portions of SCI's clients receive
services for nominal or for no fees. Accordingly, losses for services
provided are recognized when identified. Fees received in advance of
services are recorded as deferred revenue until services are rendered.
NET INCOME (LOSS) PER SHARE
Basic and diluted net income (loss) per share for the years ended
December 31 1999 and 1998 have been computed using the weighted average
number of shares of common stock outstanding during the period pursuant
to Statement of Financial Accounting Standards No. 128, "Earnings Per
Share." For 1998, the weighted average number of shares does not
include the dilutive effect of any stock options or convertible
preferred stock, as the effect would be antidilutive. For 1999, the
reconciliation between the weighted average common shares outstanding
for basic earnings per share compared to diluted earnings per share
includes the assumed conversion of preferred stock of 3,363,636 shares
and the assumed exercise of 30,000 stock options. Shares held in escrow
until certain conditions are met are excluded from the weighted average
number of shares outstanding in 1999 and 1998.
F-9
<PAGE>
INCOME TAXES
The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standards No. 109 ("SFAS No. 109"), "Accounting
for Income Taxes." Under SFAS No. 109, deferred tax assets and
liabilities reflect the future tax consequences of the temporary
difference between the financial reporting and tax basis of assets and
liabilities using current enacted tax rates.
STOCK BASED COMPENSATION
Statement of Financial Accounting Standards No. 123 ("SFAS No. 123"),
"Accounting for Stock-Based Compensation," requires that the Company
either recognize compensation expense for grants of stock, stock
options, and other equity instruments to employees based on new fair
value accounting rules or using the intrinsic value method and provide
proforma disclosure as if the fair value method had been applied. The
Company has elected to use the intrinsic value method with proforma
disclosure of the fair value method (see Note 7).
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 revenues
and expenses during the reported period. Actual results could differ
from those estimates.
FAIR VALUE OF THE FINANCIAL INSTRUMENTS
The carrying value amounts of cash, accounts receivable, other current
assets, accounts payable, and accrued liabilities approximate fair
value because of the short-term nature of those instruments. Based on
borrowing rates currently available to the Company for credit
arrangements with similar terms, the carrying amounts of balances under
capital lease and notes payable obligations approximate fair value.
NEW ACCOUNTING STANDARDS
In 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 131 ("SFAS No. 131"),
"Disclosure About Segments Of An Enterprise and Related Information".
SFAS No. 131 requires that public business enterprises report financial
and descriptive information about its reportable segments. Operating
segments are components of an enterprise about which separate financial
information is available that is evaluated regularly by the chief
operating decision-maker in deciding how to allocate resources and in
assessing performance. The Company operates in one segment (privatized
correctional services).
In 1997, the FASB issued Statement of Financial Accounting Standards
No. 130 ("SFAS No. 130"), "Reporting Comprehensive Income." This
statement is effective for fiscal years beginning after December 15,
1997. This statement requires that all items that are required to be
recognized under accounting standards as components of comprehensive
income be reported in a financial statement that is displayed with the
same prominence as other financial statements. During the periods
presented, the Company had no items required to be disclosed as
components of comprehensive income.
In December 1999, the Securities and Exchange Commission (the "SEC")
issued Staff Accounting Bulletin No. 101, "Revenue Recognition" ("SAB
101"), which provides guidance on the recognition, presentation and
disclosure of revenue in financial statements. SAB 101 outlines the
basic criteria that must be met to recognize revenue and provides
guidance for disclosures related to revenue recognition policies.
Management believes that the Company's revenue recognition policies
comply with the applicable provisions of SAB 101.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform with the
current year presentation.
F-10
<PAGE>
3. ACQUISITIONS AND RELATED PRO FORMA INFORMATION
On August 1, 1998, the Company acquired 100% of the common stock of RHI
and the separately owned building in which RHI operates, in exchange
for approximately $1,411,500 in cash. The acquisition was accounted for
under the purchase method of accounting. Accordingly, the results of
operations of RHI have been included in these consolidated financial
statements from August 1, 1998. All acquired assets and liabilities of
RHI and the operating building have been recorded at estimated fair
market values on August 1, 1998, based on an independent appraisal.
The excess cost over the fair market value of the tangible net assets
and identified intangible assets acquired was allocated to goodwill in
the amount of $335,176, which is being amortized on a straight-line
basis over a 20 year period. Identified intangible assets in the
amount of $610,000, represent a special use permit that allows the
property to be operated as a community corrections facility. This
intangible asset is being amortized on a straight-line basis over a
40 year period, which equals the estimated economic useful life of the
operating building. In 1999, the Company entered into a debt agreement
under which RHI's assets were pledged as security (see Note 10).
On September 1, 1998 the Company acquired 100% of the common stock of
SCI in exchange for 1,150,000 shares of the Company's common stock with
an estimated fair market value of $575,000. This estimated fair value
was based on management's assessment of the relative value of the
Company's common stock compared to its preferred stock issued in July
1998 (see Note 4). The acquisition of SCI was accounted for under the
purchase method of accounting. Accordingly, the results of operations
of SCI have been included in these consolidated financial statements
from September 1, 1998. All acquired tangible and intangible assets and
liabilities of SCI have been recorded at estimated fair market value on
September 1, 1998, based on an independent appraisal. The excess cost
over the fair market value of the tangible net assets and identifiable
intangible assets acquired was allocated to goodwill in the amount of
$986,000, which is being amortized over 20 years using the
straight-line method. The SCI purchase agreement includes the following
provisions:
ESCROWED SHARES
A total of 270,000 shares issued to SCI principals were placed
in escrow to be released to the principals of SCI as follows:
i) 20,000 shares were released effective July 31, 1999, as a
result of continued employment at SCI by one of the
principals; ii) 100,000 shares were released effective July
31, 1999, as a result of no claims filed under the indemnity
clause of the agreement; iii) 50,000 shares will be released
on July 31, 2000 if the principal remains employed at SCI on
that date; and iv) 100,000 shares will be released upon
repayment in full of all amounts outstanding under notes
receivable from the SCI principals (see Note 6).
LONGEVITY AND PERFORMANCE PERIOD OPTIONS
600,000 stock options were granted to the previous owners of
SCI with the following vesting requirements: 50,000 options
will vest upon the principals' continued employment with the
Company, through January 1, 2002 and 50,000 options will vest
upon the principals' continued employment with the Company,
through January 1, 2003. The remaining 500,000 options shall
vest if profitability levels of SCI are achieved as defined
during a pre-determined performance period subsequent to the
acquisition. The preliminary unaudited earnings of SCI during
the performance period indicate that the required
profitability was not achieved. Consequently, the 500,000
options would be terminated immediately. However, a final
determination of the profitability is not expected to be made
until mid fiscal year 2000. If the required profitability was
achieved, the applicable vested options will be accounted for
as compensation expense, with the measurement being equal to
the difference between the exercise price ($.83) and the fair
market value of the stock on the measurement date.
LONGEVITY AND EARN-OUT PERIOD OPTIONS
The Company entered into employment agreements with the
principals of SCI through August 2000. The agreements included
base salaries and the
F-11
<PAGE>
issuance of 230,000 additional stock options with an exercise
price of $0.20 per share, of which 200,000 options will vest
if profitability levels of SCI are achieved as defined during
a pre-determined earn-out period subsequent to the
acquisition; and 30,000 options that vested on July 31, 1999
as a result of continued employment at SCI by one of the
principals, resulting in a compensation charge of $16,500 in
1999. The preliminary unaudited earnings of SCI during the
earn-out period indicate that the required profitability was
not achieved. Consequently, the 200,000 options would be
terminated immediately. However, a final determination of the
profitability is not expected to be made until mid fiscal year
2000. If achieved, the vested options will be accounted for as
compensation expense, with the measurement being equal to the
difference between the exercise price and the fair market
value of the stock on the measurement date.
Certain shares contingently issuable under these agreements were
previously reported as a component of goodwill. Upon further
review, the Company determined that such shares should not be
recorded until the contingency is resolved, and, accordingly,
previously reported goodwill and accrued liabilities were reduced
by approximately $230,000 in the accompanying balance sheet.
On a pro forma basis, had the SCI and the RHI acquisitions taken place
on January 1, 1998, and January 1, 1997, respectively, the Company
would have recorded revenue, net loss, and basic and diluted net loss
per share as follows:
<TABLE>
<CAPTION>
PRO FORMA (UNAUDITED)
YEAR ENDED DECEMBER 31, 1998
----------------------------
<S> <C>
Revenue $ 4,826,489
Net loss $ (163,633)
Basic and diluted net loss per share $ (0.05)
</TABLE>
In July 1999, the Company entered into an asset purchase agreement with
Austin Recovery Center, Inc. (ARC) under which certain assets of an
operating subdivision of ARC known as the McCabe Center were acquired
and certain contract rights were assumed by the Company with
purchase price allocated to the land and building acquired based on
independent appraisal. The consideration paid under the agreement was
$1,050,000, of which $550,000 was paid in cash and $500,000 is payable
under a secured promissory note with monthly payments due through
July 2011 (see Note 10). This transaction was accounted for as an asset
purchase.
4. SALE OF PREFERRED STOCK
On July 31, 1998, the Company entered into a stock purchase agreement
with First Analysis Securities Corporation (FASC), under which FASC
purchased 3,363,636 shares of Series A preferred stock for $2,220,000
in cash. In connection with this transaction, the Company incurred
$52,395 in direct costs, which are netted against the proceeds in the
statement of shareholders' equity. The agreement specified that
$500,000 of the $2,200,000 be allocated to fund expansion activities by
SCI.
Series A preferred stock is convertible at the option of the
shareholder, in whole or in part, at any time. The Series A preferred
stock is automatically converted into common stock upon a conversion
event, as defined by the agreement. Generally, a conversion event is a
public offering of the Company's common stock in which gross proceeds
are at least $20,000,000. The conversion rate initially is one share of
common stock for each share of Series A preferred stock. The number of
shares of common stock issuable upon conversion of the preferred stock
and the conversion price shall be adjusted from time to time, based
upon certain events as defined by the agreement. Additionally, if at
any time the Company issues additional shares of common stock, or
securities convertible into common stock, for a consideration per share
of common stock less than the conversion price in effect at the time of
such issuance, then the conversion price in effect immediately prior to
the issuance of such additional shares of common stock shall be reduced
to a price per share equal to the consideration per share received for
the additional shares of common stock.
The preferred stock has voting rights equal to the number of shares of
common stock issuable upon conversion. As long as the preferred stock
is outstanding, the Company is restricted from certain acts, as defined
by the agreement, without the affirmative vote of a majority of Series
A stockholders. Such restricted acts include, among other things,
certain merger activity, limitations on indebtedness and certain types
of equity transactions. If the Company is voluntarily or involuntarily
liquidated, the preferred stockholders shall be entitled to receive,
prior to distributions
F-12
<PAGE>
to any holder of common stock, a per share amount equal to the
preferred stock original issue price in addition to all accrued but
unpaid preferred dividends, if any. Upon distribution of the Series A
liquidation preference, the remaining assets would be distributed to
common and preferred stockholders on a pro rata basis.
The holders of the preferred stock are entitled to dividends or other
distributions entitled to holders of common stock in the same amount as
such holder would receive if preferred stock were converted to common
stock.
5. INCOME TAXES
Significant components of the 1999 income tax provision are as follows:
<TABLE>
<S> <C>
Federal income tax provision
Current $ 10,607
Deferred -
State income tax provision
Current 7,157
Deferred 2,621
-----------
$ 20,385
===========
</TABLE>
Income taxes at the statutory rate is reconciled to the Company's
actual provision as follows:
<TABLE>
<CAPTION>
AMOUNT PERCENT
---------- -----------
<S> <C> <C>
Tax at federal statutory rates $46,619 34.0%
State income tax, net of federal tax benefit 6,454 4.7%
Utilization of net operating loss (30,812) (22.5%)
Non-deductible expenses 1,275 1.0%
Benefit of graduated rates (3,151) (2.3%)
---------- -----------
Provision for income tax $20,385 14.9%
========== ===========
</TABLE>
Due to the change in ownership percentages as a result of the
issuance of preferred stock to First Analysis Securities Corporation
(see Note 4), in accordance with federal tax law, the utilization of
the net operating losses incurred prior to the change in ownership
will be limited to $6,400 per year. Subsequent to the preferred
stock transaction, the Company incurred $22,000 of additional net
operating losses during 1998, which are not limited. The NOL carry
forward for federal and state tax purposes is approximately $120,000
and $25,000, respectively. The Company's combined net operating
losses expire in 2018. At December 31, 1999, the only significant
deferred tax asset or liability is the asset related to the net
operating loss carryforward. Due to uncertainty of future
realization, the Company has recorded a full valuation allowance
against this deferred tax asset.
6. RELATED PARTY NOTES AND INTEREST RECEIVABLE
As of December 31, 1999, related party notes receivable consisted of
two $50,000 loans (plus accrued interest at 7%) due from officers (the
President and Chief Operating Officer) of SCI. The loans are secured by
CSI common stock owned by the officers and held in escrow (see Note 3).
Principal and interest are due on July 31, 2003.
7. EMPLOYEE STOCK OPTION PLAN
The Company has reserved 1,500,000 shares of common stock for future
issuance under an employee stock option plan. Options are generally
granted at fair
F-13
<PAGE>
market value at the date of grant, expire ten years after the date of
grant and fully vest within four years of the date of grant.
The following table summarizes stock option plan activity for the years
ended December 31, 1999 and 1998:
<TABLE>
<CAPTION>
PLAN WEIGHTED AVERAGE
OPTIONS EXERCISE PRICE
--------------- ----------------
<S> <C> <C>
Outstanding, December 31, 1997 1,114,625 $0.60
Granted 404,350 $0.89
Forfeited (317,175) $0.60
---------------
Outstanding, December 31, 1998 1,201,800 $0.70
Granted 51,805 $0.67
Forfeited (51,750) $0.61
---------------
Outstanding, December 31, 1999 1,201,855 $0.70
===============
Exercisable, December 31, 1999 473,980 $0.78
===============
</TABLE>
The following table summarizes stock option related to the SCI
acquisition for the years ended December 31, 1999 and 1998.
<TABLE>
<CAPTION>
SCI
STOCK WEIGHTED AVERAGE
OPTIONS EXERCISE PRICE
----------- ----------------
<S> <C> <C>
Outstanding, December 31, 1997 - $ -
Granted 830,000 $0.51
Forfeited - $ -
-----------
Outstanding, December 31, 1998 830,000 $0.51
Granted - $ -
Forfeited - $ -
-----------
Outstanding, December 31, 1999 830,000 $0.51
===========
Exercisable, December 31, 1999 30,000 $0.20
===========
</TABLE>
As permitted, the Company has adopted the disclosure only provisions of
SFAS No. 123. Accordingly, no compensation expense has been recognized
for options granted, except for certain options granted to an SCI
principal (see Note 3). Had compensation expense been determined based
on the fair value accounting rules under SFAS No. 123 at date of grant
for the 1999 and 1998 awards, the Company's net income (loss) would
have been the pro forma amounts as follows:
<TABLE>
<CAPTION>
1999 1998
--------------- ---------------
<S> <C> <C>
Net income (loss) - as reported $ 116,727 $ (28,408)
Net income (loss) - pro forma $ 90,320 $ (40,911)
Net income (loss) per basic share $ 0.03 $ (0.01)
Net income (loss) per diluted share $ 0.01 $ (0.01)
</TABLE>
F-14
<PAGE>
The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option-pricing model and using the following
weighted average assumptions for grants in 1999 and 1998:
<TABLE>
<CAPTION>
1999 1998
------- -------
<S> <C> <C>
Risk-free interest rate 6.04% 5.74%
Expected lives 4 Years 4 Years
Expected volatility 162.72% 115.06%
Expected dividend yield 0.00% 0.00%
</TABLE>
8. COMMITMENTS AND CONTINGENCIES
The Company leases certain office space, facilities, and equipment
under operating lease agreements. The Company is obligated to make
future minimum lease payments as of December 31, 1999 as follows:
<TABLE>
<S> <C>
2000 $ 239,506
2001 147,598
2002 135,534
2003 135,850
2004 132,300
Thereafter 460,800
---------------
Total $1,251,588
===============
</TABLE>
Total rent expense for 1999 and 1998 was $146,082 and $48,054,
respectively.
The Company is involved in various legal matters in the ordinary course
of its business activities. In the opinion of management, the outcome
of such matters is not expected to have a material adverse impact on
the Company's financial position or results of operations.
9. LINE OF CREDIT
During 1999 and 1998, the Company had a line of credit with a bank,
which provided for borrowings of up to $50,000 at an annual interest
rate of 11%. The line of credit was fully repaid on April 28, 1999 with
the account being closed on May 28, 1999.
On December 2, 1999, the Company opened a line of credit with a bank,
which provided for borrowings up to $500,000 at an annual rate of 1%
plus prime lending rate (7.25% APR as of December 31, 1999). At
December 31, 1999, the Company had not drawn on this line of credit.
10. LONG-TERM DEBT OBLIGATIONS
During 1999, the Company entered into two significant debt agreements.
The first agreement is a promissory note payable to ABN Amro for
$788,400 under which the real property used in the operations of RHI is
secured as collateral. The second agreement is a promissory note
payable to Austin Recovery Center, Inc. for $500,000 under which the
real property used in the operations of the McCabe Center is secured as
collateral.
The Company's long-term debt as of December 31, 1999 and 1998 consists
of the following:
<TABLE>
<CAPTION>
1999 1998
--------------- ---------------
<S> <C> <C>
ABN Amro, secured by real property with
interest at 9.288% and monthly principal
and interest payments of $12,800, maturing
July 2006 $733,343 $ -
Austin Recovery Center, Inc., secured by
real property with interest at 8% and
monthly principal and interest payments of
$5,412, maturing July 2011 489,466 -
Michael Criscell, former owner of RHI unsecured
with 8% interest and monthly interest payments
of $667 maturing May 20, 1999 - 100,000
</TABLE>
F-15
<PAGE>
<TABLE>
<S> <C> <C>
Other notes payable secured by equipment,
with interest rates ranging from 6% to 26%
and due at various dates through
September 2004 66,042 6,776
--------------- ---------------
Total 1,288,851 106,776
Less current portion 132,170 106,776
--------------- ---------------
Total long-term debt $1,156,681 $ -
============== ===============
</TABLE>
A schedule of maturities of long-term debt is as follows for the years
ended December 31:
<TABLE>
<CAPTION>
CAPITAL
NOTES PAYABLE LEASES TOTAL
------------- ------- ----------
<S> <C> <C> <C>
2000 $ 228,981 $16,452 $ 245,433
2001 228,981 14,239 243,220
2002 222,205 14,239 236,444
2003 222,205 14,239 236,444
2004 221,590 3,231 224,821
Thereafter 619,588 - 619,588
---------- ------- ----------
Total 1,743,550 62,400 $1,805,950
Less amount representing interest 493,648 23,453 517,101
---------- ------- ----------
Present value of payments 1,249,907 38,946 1,288,851
Less current portion 124,406 7,764 132,170
---------- ------- ----------
Long-term obligations, net $1,125,501 $31,182 $1,156,681
========== ======= ==========
</TABLE>
11. QUARTERLY FINANCIAL DATA (UNAUDITED)
<TABLE>
<CAPTION>
Quarter Ended
---------------------------------------------------
03/31/99 06/30/99 09/30/99 12/31/99
--------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
Revenue $1,517,737 $1,490,006 $2,010,843 $1,712,420
Operating expenses and other 1,473,549 1,467,026 1,984,066 1,689,638
--------------- --------------- --------------- ---------------
Net income $ 44,188 $ 22,980 $ 26,777 $ 22,782
=============== =============== =============== ===============
Weighted average common shares
outstanding 3,374,400 3,374,400 3,374,400 3,374,400
Basic net income per share $ 0.013 $ 0.007 $ 0.008 $ 0.007
=============== =============== =============== ===============
Weighted average common shares
outstanding 3,374,400 3,374,400 3,374,400 3,374,400
Preferred convertible shares 3,363,636 3,363,636 3,363,636 3,363,636
Incremental shares in longevity
options - - 12,848 10,039
--------------- --------------- --------------- -----------------
Diluted weighted average common
shares outstanding 6,738,036 6,738,036 6,830,884 6,868,075
Diluted net income per share $ 0.007 $ 0.003 $ 0.004 $ 0.003
=============== =============== =============== ===============
</TABLE>
F-16
<PAGE>
<TABLE>
<CAPTION>
Quarter Ended
---------------------------------------------------
03/31/98 06/30/98 09/30/98 12/31/98
--------------- --------------- --------------- -----------------
<S> <C> <C> <C> <C>
Revenue $ 381,849 $ 466,686 $ 818,359 $ 1,338,090
Operating expenses and other 397,369 499,044 749,738 1,387,241
--------------- --------------- --------------- -----------------
Net income (loss) $ (15,520) $ (32,358) $ 68,621 $ (49,151)
=============== =============== =============== ===============
Weighted average common shares
outstanding 2,494,400 2,494,400 3,081,067 3,374,400
Basic and diluted net income
(loss) per share $ (0.006) $ (0.013) $ 0.022 $ (0.015)
=============== =============== =============== ===============
</TABLE>
F-17
<PAGE>
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
CORRECTIONAL SYSTEMS, INC.
a California Corporation
Date: April 7, 2000
/s/ John R. Forren
--------------------------
By: John R. Forren
Its: President, Chief Executive Officer
and Director
In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the registrant and in the capacities and on
the dates indicated.
April 7, 2000 /s/ John R. Forren
----------------------------------------
John R. Forren, Director
April 7, 2000 /s/ William L. Garrison
----------------------------------------
William L. Garrison, Director
April 7, 2000 /s/ Daniel J. Verwiel
---------------------------------------
Daniel J. Verwiel, Director
April 7, 2000
---------------------------------------
James R. MacDonald, Director
April 7, 2000
---------------------------------------
Gary Maynard, Director
April 7, 2000 /s/ R. Andrew Gately
---------------------------------------
R. Andrew Gately, Chief Financial Officer
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM CORRECTIONAL
SYSTEMS, INC. FORM-KSB FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999 AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<CIK> 0001010032
<NAME> CORRECTIONAL SYSTEMS, INC.
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> DEC-31-1999
<CASH> 472,488
<SECURITIES> 0
<RECEIVABLES> 792,746
<ALLOWANCES> 5,000
<INVENTORY> 0
<CURRENT-ASSETS> 1,328,309
<PP&E> 1,670,067
<DEPRECIATION> 98,371
<TOTAL-ASSETS> 4,939,903
<CURRENT-LIABILITIES> 759,667
<BONDS> 0
0
3,364
<COMMON> 3,644
<OTHER-SE> 3,691,317
<TOTAL-LIABILITY-AND-EQUITY> 4,939,903
<SALES> 6,731,006
<TOTAL-REVENUES> 6,731,006
<CGS> 0
<TOTAL-COSTS> 6,531,135
<OTHER-EXPENSES> 62,759
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 57,960
<INCOME-PRETAX> 116,727
<INCOME-TAX> 20,385
<INCOME-CONTINUING> 137,112
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 116,727
<EPS-BASIC> .03
<EPS-DILUTED> .02
</TABLE>
