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PROSPECTUS
$625,000,000 [LOGO]
MAGELLAN HEALTH SERVICES, INC.
OFFER TO EXCHANGE ITS
9% SERIES A SENIOR SUBORDINATED NOTES DUE 2008
FOR ANY AND ALL OF ITS OUTSTANDING
9% SENIOR SUBORDINATED NOTES DUE 2008
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THE EXCHANGE OFFER WILL EXPIRE AT 5:00 P.M., NEW YORK CITY TIME, ON NOVEMBER 9,
1998, UNLESS EXTENDED.
Magellan Health Services, Inc., a Delaware corporation (the "Company"),
hereby offers (the "Exchange Offer"), upon the terms and subject to the
conditions set forth in this Prospectus (this "Prospectus") and the accompanying
Letter of Transmittal (the "Letter of Transmittal"), to exchange $1,000
principal amount of its 9% Series A Senior Subordinated Notes due 2008 (the "New
Notes"), which have been registered under the Securities Act of 1933, as amended
(the "Securities Act"), pursuant to a Registration Statement of which this
Prospectus is a part, for each $1,000 principal amount of its outstanding 9%
Senior Subordinated Notes due 2008 (the "Old Notes"), which have not been
registered under the Securities Act. The aggregate principal amount of the Old
Notes currently outstanding is $625,000,000. The form and terms of the New Notes
are the same as the form and terms of the Old Notes except that (i) the New
Notes have been registered under the Securities Act and, therefore, will not
bear legends restricting their transfer, (ii) holders of New Notes will not be
entitled to certain rights under the Registration Rights Agreement (as defined),
which rights will terminate when the Exchange Offer is consummated, and (iii)
the New Notes have been given a series designation to distinguish them from the
Old Notes. The New Notes will evidence the same debt as the Old Notes (which
they will replace) and will be issued under and be entitled to the benefits of
the indenture governing the Old Notes dated as of February 12, 1998 (the
"Indenture"). The Old Notes and the New Notes are sometimes referred to herein
collectively as the "Notes." See "The Exchange Offer" and "Description of the
New Notes." The Company will accept for exchange and exchange any and all Old
Notes validly tendered and not withdrawn prior to 5:00 p.m., New York City time,
on November 9, 1998, unless extended by the Company in its sole discretion (the
"Expiration Date"). Tenders of Old Notes may be withdrawn at any time prior to
5:00 p.m. on the Expiration Date. The Exchange Offer is subject to certain
customary conditions. See "The Exchange Offer." Old Notes may be tendered only
in integral multiples of $1,000.
The New Notes will be unsecured and will be subordinated in right of payment
to all existing and future Senior Indebtedness (as defined) of the Company. The
New Notes will rank PARI PASSU with all future Senior Subordinated Indebtedness
(as defined) of the Company and will rank senior to all future Subordinated
Obligations (as defined) of the Company. The Company conducts substantially all
of its operations through its subsidiaries. Therefore, the New Notes will be
effectively subordinated to all liabilities of the Company's subsidiaries. The
Indenture permits the Company and its subsidiaries to incur additional
indebtedness, including Senior Indebtedness, subject to certain restrictions. As
of June 30, 1998, (i) the aggregate amount of the Company's outstanding Senior
Indebtedness was $580.7 million (exclusive of unused commitments), substantially
all of which would have been Secured Indebtedness (as defined) and would have
been guaranteed by substantially all of the Company's subsidiaries, (ii) the
Company would have had no Senior Subordinated Indebtedness other than the New
Notes and no Indebtedness that is subordinate or junior in right of payment to
the New Notes and (iii) the outstanding indebtedness of the Company's
subsidiaries (excluding guarantees of the Company's indebtedness) was $342.8
million, substantially all of which would have been Secured Indebtedness.
The Company sold the Old Notes on February 12, 1998, in transactions that
were not registered under the Securities Act in reliance upon the exemption
provided in Section 4(2) of the Securities Act. The initial purchaser of the Old
Notes subsequently resold the Old Notes to "qualified institutional buyers" in
reliance upon Rule 144A under the Securities Act or pursuant to offers and sales
that occurred outside the United States within the meaning of Regulation S under
the Securities Act. Accordingly, the Old Notes may not be reoffered, resold or
otherwise transferred unless so registered or unless an applicable exemption
from the registration requirements of the Securities Act is available. See "The
Exchange Offer--Purpose and Effect of the Exchange Offer." The New Notes are
being offered for exchange hereby to satisfy certain obligations of the Company
under the Exchange and Registration Rights Agreement, dated February 12, 1998,
among the Company and the initial purchaser of the Old Notes (the "Registration
Rights Agreement"). Based on existing interpretations of the staff of the
Division of Corporation Finance (the "Staff") of the Securities and Exchange
Commission (the "Commission") with respect to similar transactions, the Company
believes that New Notes issued pursuant to the Exchange Offer in exchange for
Old Notes may be offered for resale, resold and otherwise transferred by holders
thereof (other than any such holder which is an "affiliate" of the Company
within the meaning of Rule 405 under the Securities Act ) without compliance
with the registration and prospectus delivery requirements of the Securities
Act, provided that such New Notes are acquired in the ordinary course of such
holders' business and such holders are not engaged in, have no arrangement with
any person to participate in, and do not intend to engage in any public
distribution of the New Notes. Each broker-dealer that receives New Notes for
its own account pursuant to the Exchange Offer in exchange for Old Notes
acquired by the broker-dealer for its own account in market-making or other
trading activities must acknowledge that it will deliver a resale prospectus in
connection with any resale of such New Notes. The Letter of Transmittal which
accompanies this Prospectus states that by so acknowledging and by delivering a
resale prospectus, such a broker-dealer will not be deemed to admit to be acting
in the capacity of an "underwriter" (within the meaning of Section 2(11) of the
Securities Act). This Prospectus, as it may be amended or supplemented from time
to time, may be used by such a broker-dealer in connection with resales of New
Notes received in exchange for Old Notes where such Old Notes were acquired by
such broker-dealer as a result of market-making or other trading activities. Any
broker-dealer that receives New Notes for its own account in exchange for Old
Notes acquired directly from the Company may not rely on the interpretations of
the Staff of the Commission referred to above and, in connection with the resale
of any such New Notes, must comply with the registration and prospectus delivery
requirements of the Securities Act, including the requirement that such
broker-dealer be named as a selling Noteholder in the resale prospectus. The
Company has agreed that, for a period of 180 days after the date on which the
Registration Statement of which this Prospectus is a part is first declared
effective, it will make this Prospectus available to any broker-dealer for use
in connection with any such resale. See "Plan of Distribution."
SEE "RISK FACTORS" BEGINNING ON PAGE 22 FOR A DESCRIPTION OF CERTAIN RISKS
TO BE CONSIDERED BY HOLDERS WHO TENDER THEIR OLD NOTES IN THE EXCHANGE OFFER.
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THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL
OFFENSE.
THE DATE OF THIS PROSPECTUS IS OCTOBER 6, 1998.
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(CONTINUED FROM FRONT COVER)
Holders of Old Notes whose Old Notes are not tendered and accepted in the
Exchange Offer will continue to hold such Old Notes and will be entitled to all
the rights and preferences and will be subject to the limitations applicable
thereto under the Indenture, and with respect to transfer, under the Securities
Act. The Company will not receive any proceeds from the Exchange Offer and will
pay all the expenses incurred by it incident to the Exchange Offer. Any Old
Notes not accepted for exchange for any reason will be returned without expense
to the tendering holders thereof as promptly as practicable after the expiration
or termination of the Exchange Offer. See "The Exchange Offer." Prior to the
Exchange Offer, there is no public market for the Old Notes. The New Notes will
not be listed on any securities exchange, but the Old Notes are included in the
Private Offerings, Resales and Trading through Automated Linkages ("PORTAL")
Market for trading among "qualified institutional buyers." There can be no
assurance that an active trading market for the New Notes will develop. To the
extent that a market for the New Notes does develop, the market value of the New
Notes will depend on market conditions (such as yields on alternative
investments), general economic conditions, the Company's financial condition and
certain other factors. Such conditions might cause the New Notes, to the extent
that they are traded, to trade at a significant discount from face value. See
"Risk Factors--Absence of Trading Markets."
NEW HAMPSHIRE RESIDENTS ONLY
Neither the fact that a registration statement or an application for a
license has been filed under Chapter 421-B of the New Hampshire Revised Statutes
with the State of New Hampshire nor the fact that a security is effectively
registered or a person is licensed in the State of New Hampshire constitutes a
finding by the Secretary of State that any document filed under Chapter 421-B of
the New Hampshire Revised Statutes is true, complete and not misleading. Neither
any such fact nor the fact that an exemption or exception is available for a
security or a transaction means that the Secretary of State has passed in any
way upon the merits or qualifications of, or recommended or given approval to,
any person, security or transaction. It is unlawful to make, or cause to be
made, to any prospective purchaser, customer or client any representation
inconsistent with the provisions of this paragraph.
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SUMMARY
THE FOLLOWING SUMMARY IS QUALIFIED IN ITS ENTIRETY BY THE MORE DETAILED
INFORMATION AND FINANCIAL STATEMENTS, INCLUDING THE NOTES THERETO, APPEARING
ELSEWHERE IN THIS PROSPECTUS. UNLESS THE CONTEXT OTHERWISE REQUIRES, ALL
REFERENCES HEREIN TO THE "COMPANY" REFER TO MAGELLAN HEALTH SERVICES, INC. AND
ITS CONSOLIDATED SUBSIDIARIES. ALL REFERENCES TO FISCAL YEARS IN THIS PROSPECTUS
REFER TO YEARS ENDED SEPTEMBER 30. DATA PRESENTED IN THIS PROSPECTUS ON A PRO
FORMA BASIS FOR THE YEAR ENDED SEPTEMBER 30, 1997, AND FOR THE NINE MONTHS ENDED
JUNE 30, 1998, GIVE EFFECT TO: (I) THE COMPANY'S SALE OF SUBSTANTIALLY ALL OF
ITS DOMESTIC ACUTE CARE PSYCHIATRIC HOSPITALS (COLLECTIVELY, THE "PSYCHIATRIC
HOSPITAL FACILITIES") AND RESIDENTIAL TREATMENT FACILITIES TO CRESCENT REAL
ESTATE EQUITIES ("CRESCENT"), THE FORMATION BY THE COMPANY AND CRESCENT
OPERATING, INC. ("COI"), AN AFFILIATE OF CRESCENT, OF CHARTER BEHAVIORAL HEALTH
SYSTEMS, LLC ("CBHS"), A JOINT VENTURE, TO OPERATE THE PSYCHIATRIC HOSPITAL
FACILITIES AND CERTAIN OTHER FACILITIES TRANSFERRED TO CBHS BY THE COMPANY, AND
CERTAIN RELATED TRANSACTIONS (COLLECTIVELY, THE "CRESCENT TRANSACTIONS")
(SEE"--HISTORY"); (II) THE COMPANY'S ACQUISITION (THE "ACQUISITION") OF MERIT
BEHAVIORAL CARE CORPORATION ("MERIT"), WHICH WAS CONSUMMATED ON FEBRUARY 12,
1998; (III) THE COMPANY'S ACQUISITION OF HUMAN AFFAIRS INTERNATIONAL,
INCORPORATED ("HAI"), WHICH WAS CONSUMMATED ON DECEMBER 4, 1997; (IV) THE
COMPANY'S ACQUISITION OF ALLIED HEALTH GROUP, INC. AND CERTAIN OF ITS AFFILIATES
("ALLIED"), WHICH WAS CONSUMMATED ON DECEMBER 5, 1997; (V) MERIT'S ACQUISITION
OF CMG HEALTH, INC. ("CMG"), WHICH WAS CONSUMMATED ON SEPTEMBER 12, 1997 AND
(VI) EACH OF THE OTHER TRANSACTIONS (AS DEFINED). PRO FORMA STATEMENT OF
OPERATIONS DATA GIVE EFFECT TO THE EVENTS DESCRIBED IN THE PRECEEDING SENTENCE
AS IF THEY OCCURRED ON OCTOBER 1, 1996. SEE "UNAUDITED PRO FORMA CONSOLIDATED
FINANCIAL INFORMATION." UNLESS OTHERWISE INDICATED, ALL INDUSTRY DATA SET FORTH
IN THIS PROSPECTUS HAVE BEEN DERIVED FROM "MANAGED BEHAVIORAL HEALTH MARKET
SHARE IN THE UNITED STATES 1997-1998" PUBLISHED BY OPEN MINDS, GETTYSBURG,
PENNSYLVANIA (HEREINAFTER REFERRED TO AS "OPEN MINDS").
THE COMPANY
OVERVIEW
According to enrollment data reported in OPEN MINDS, the Company is the
nation's largest provider of managed behavioral healthcare services, offering a
broad array of cost-effective managed behavioral healthcare products. As of June
30, 1998, the Company had approximately 61.3 million covered lives under managed
behavioral healthcare contracts and managed behavioral healthcare programs for
over 4,000 customers. Through its current network of over 34,000 providers and
2,000 treatment facilities, the Company manages behavioral healthcare programs
for Blue Cross/Blue Shield organizations, health maintenance organizations
("HMOs") and other insurance companies, corporations, federal, state and local
governmental agencies, labor unions and various state Medicaid programs. The
Company believes it has the largest and most comprehensive behavioral healthcare
provider network in the United States as a result of the Acquisition. In
addition to the Company's managed behavioral healthcare products, the Company
offers specialty managed care products related to the management of certain
chronic conditions. The Company also offers a broad continuum of behavioral
healthcare services to approximately 3,270 individuals who receive healthcare
benefits funded by state and local governmental agencies through National
Mentor, Inc., its wholly-owned public-sector provider ("Mentor"). Furthermore,
the Company franchises the "CHARTER" System of behavioral healthcare to the
acute-care psychiatric hospitals and other behavioral care facilities operated
by CBHS, an entity in which the Company owns a 50% equity interest. On a pro
forma basis, the Company had revenues of $1.6 billion, Adjusted EBITDA (as
defined) of $263.7 million and net income of $18.5 million in fiscal 1997.
The Company's professional care managers coordinate and manage the delivery
of behavioral healthcare treatment services through the Company's network of
providers, which includes psychiatrists, psychologists, licensed clinical social
workers, marriage and family therapists and licensed clinical
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professional counselors. The treatment services provided by the Company's
extensive behavioral provider network include outpatient programs (such as
counseling and therapy), intermediate care programs (such as sub-acute emergency
care, intensive outpatient programs and partial hospitalization services),
inpatient treatment services and alternative care services (such as residential
treatment, home and community-based programs and rehabilitative and support
services). The Company provides these services through: (i) risk-based products,
(ii) employee assistance programs ("EAPs"), (iii) administrative services-only
products ("ASO products") and (iv) products that combine features of some or all
of these products. Under risk-based products, the Company arranges for the
provision of a full range of behavioral healthcare services for beneficiaries of
its customers' healthcare benefit plans through fee arrangements under which the
Company assumes all or a portion of the responsibility for the cost of providing
such services in exchange for a fixed per member per month fee. Under EAPs, the
Company provides assessment services to employees and dependents of its
customers, and if required, referral services to the appropriate behavioral
healthcare service provider. Under ASO products, the Company provides services
such as utilization review, claims administration and provider network
management. The Company does not assume the responsibility for the cost of
providing healthcare services pursuant to its ASO products. As a result of the
Acquisition, based on total covered lives, the Company is the industry leader
with respect to risk-based, ASO, EAP and integrated products, according to the
enrollment data reported in OPEN MINDS. For its fiscal year ended September 30,
1997, on a pro forma basis, risk-based, ASO, EAP and integrated products would
have accounted for 73%, 12%, 9% and 5%, respectively, of the Company's managed
behavioral healthcare net revenues. The Company was incorporated in 1969 under
the laws of the State of Delaware. The Company's principal executive offices are
located at 3414 Peachtree Road, N.E., Suite 1400, Atlanta, Georgia 30326, and
its telephone number is (404) 841-9200.
INDUSTRY OVERVIEW
According to industry sources, in 1994 (the most recent year for which such
information was available), direct behavioral healthcare services treatment
costs amounted to approximately $81.0 billion, or approximately 8% of total
healthcare industry spending. In response to increasing healthcare costs, payors
of behavioral healthcare services have increasingly turned to managed care in an
effort to control costs. As a result, the managed behavioral healthcare industry
has experienced significant growth over the past several years. According to
OPEN MINDS, the total number of Americans enrolled in managed behavioral
healthcare plans increased from approximately 86.0 million in 1993 to
approximately 149.0 million in 1997, a compound annual growth rate of
approximately 15%. In an effort to control costs, payors are increasingly
utilizing risk-based products, and the number of risk-based covered lives has
increased from approximately 13.6 million, or approximately 16% of the total, in
1993 to approximately 38.9 million, or approximately 26% of the total, in 1997,
representing a compound annual growth rate of over 30%. Risk-based products
typically generate higher revenues per member per month than other managed
behavioral healthcare products. According to OPEN MINDS, although only 26% of
total managed behavioral healthcare covered lives were enrolled in risk-based
products in 1997, such products accounted for approximately two-thirds of the
total managed behavioral healthcare premiums during the survey period. In
addition to the trend toward the increased use of risk-based products, the
Company believes that payors are increasingly seeking to contract with larger
managed behavioral healthcare providers that are able to: (i) provide a
consistent quality of service on a nationwide basis, (ii) control costs through
economies of scale in administrative operations, and (iii) enter into
cost-effective provider contracts. As a result, the industry has consolidated,
and the three largest providers (including the Company after the Acquisition)
currently account for approximately 60% of all covered lives, an increase from
1992 when the top three providers accounted for approximately 37% of all covered
lives.
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COMPETITIVE STRENGTHS
The Company believes it benefits from the competitive strengths described
below with respect to its managed behavioral healthcare business, which should
allow it to increase its revenues and cash flow. Furthermore, the Company
believes it can leverage its competitive strengths to expand its service
offerings into other specialty managed care products.
INDUSTRY LEADERSHIP. As a result of the Acquisition, the Company became the
largest provider of managed behavioral healthcare services in the United States,
according to enrollment data reported in OPEN MINDS. The Company believes, based
on data reported in OPEN MINDS, that it also now has the number one market
position in each of the major product markets in which it competes. The Company
believes its industry leading position will enhance its ability to: (i) provide
a consistent level of high quality service on a nationwide basis; (ii) enter
into favorable agreements with behavioral healthcare providers that allow it to
effectively control healthcare costs for its customers; and (iii) effectively
market its managed care products to large corporate, HMO and insurance
customers, which, the Company believes, increasingly prefer to be serviced by a
single-source provider on a national basis. See "Risk Factors--Highly
Competitive Industry" and "--Reliance on Customer Contracts" for a discussion of
the risks associated with the highly competitive nature of the managed
behavioral healthcare industry and the Company's reliance on contracts with
payors of behavioral healthcare benefits, respectively.
BROAD PRODUCT OFFERING AND NATIONWIDE PROVIDER NETWORK. The Company offers
a full spectrum of behavioral managed care products that can be designed to meet
specific customer needs, including risk-based and partial risk-based products,
integrated EAPs, stand-alone EAPs and ASO products. The Company's nationwide
provider network encompasses over 34,000 providers and 2,000 treatment
facilities in all 50 states. The Company believes that the combination of broad
product offerings and its nationwide provider network allows the Company to meet
virtually any customer need for managed behavioral healthcare on a nationwide
basis, and positions the Company to capture incremental revenue opportunities
resulting from the continued growth of the managed behavioral healthcare
industry and the continued migration of its customers from ASO and EAP products
to higher revenue risk-based products. See "Risk Factors--Risk-Based Products"
for a discussion of the risks associated with risk-based products which are the
Company's primary source of revenue.
BROAD BASE OF STRONG CUSTOMER RELATIONSHIPS. The Company enjoys strong
customer relationships across all its markets, as evidenced by a contract
renewal rate of over 90% during the last three fiscal years. Management believes
that its strong customer relationships are attributable to the Company's broad
product offering, nationwide provider network, commitment to quality care and
ability to manage behavioral healthcare costs effectively. The Company's
customers include: (i) Blue Cross/Blue Shield organizations; (ii) national HMOs
and other large insurers, such as Aetna/US Healthcare, Humana and Prudential;
(iii) large corporations, such as IBM, Federal Express and AT&T; (iv) state and
local governmental agencies through commercial, Medicaid and other programs; and
(v) the federal government through contracts pursuant to the Civilian Health and
Medical Program for the Uniformed Services ("CHAMPUS") and with the U.S. Postal
Service. This broad base of strong customer relationships provides the Company
with stable and diverse sources of revenue and cash flow and an established base
from which to continue to increase covered lives and revenue. See "Risk
Factors--Reliance on Customer Contracts" for a discussion of the risks
associated with the Company's reliance on certain contracts with payors of
behavioral healthcare benefits.
PROVEN RISK MANAGEMENT EXPERIENCE. As of June 30, 1998, the Company had
approximately 18.7 million covered lives under risk-based contracts, making it
the nation's industry leader in at-risk managed behavioral healthcare products,
based on enrollment data reported in OPEN MINDS. The Company's experience with
risk-based products covering a large number of lives (including the experience
of Green Spring, HAI and Merit) has given it a broad base of data from which to
analyze utilization rates. The Company believes that this broad database permits
it to estimate utilization trends and costs
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more accurately than many of its competitors, which allows it to bid
effectively. The Company believes that its experience has also allowed it to
develop effective measures for controlling the cost of providing a unit of care
to its covered lives. Among other cost control measures, the Company has
developed or acquired clinical protocols, which permit the Company to assist its
network providers to administer effective treatment in a cost efficient manner,
and claims management technology, which permits the Company to reduce the cost
of processing claims. As the Company integrates the managed care operations it
acquired in the Acquisition with its pre-existing managed care operations, it
will be able to select from the best practices of its subsidiaries to further
enhance its utilization and cost control methodologies. See "Risk
Factors--Integration of Operations" for a discussion of the risks associated
with integrating the Company's recently acquired businesses, including the
managed care operations it acquired in the Acquisition, with its existing
operations.
BUSINESS STRATEGY
INCREASE ENROLLMENT IN BEHAVIORAL MANAGED CARE PRODUCTS. The Company
believes it has a significant opportunity to increase covered lives in all its
behavioral managed care products. The Company believes its increased market
presence following the Acquisition will further enhance its ability to increase
ASO and EAP covered lives with large corporate, HMO and insurance customers. The
Company further believes that it has a significant opportunity to increase
revenues and cash flow by increasing lives covered by its risk-based products.
As a result of the Acquisition, the Company became the industry's leading
provider of risk-based products, according to enrollment data reported in OPEN
MINDS, and believes that it is well positioned to benefit from the continuing
shift to risk-based products. According to OPEN MINDS, industry enrollment in
risk-based products has grown from approximately 13.6 million in 1993 to
approximately 38.9 million in 1997, representing a compound annual growth rate
of over 30%. Despite this growth, only approximately 26% of total managed
behavioral healthcare enrollees were in risk-based products in 1997. The Company
believes that the market for risk-based products has grown and will continue to
grow as payors attempt to reduce their cost of providing behavioral healthcare
while ensuring a high quality of care and an appropriate level of access to
care. The Company believes enrollment in its risk-based products will increase
through growth in new covered lives and through the transition of covered lives
in ASO and EAP products to higher revenue risk-based products. On a pro forma
basis for fiscal 1997, risk-based products accounted for 30% of the Company's
covered lives but accounted for 73% of its total managed behavioral healthcare
revenues. There are certain risks associated with increased enrollment in
risk-based products. See "Risk Factors-- Risk-Based Products."
ACHIEVE SIGNIFICANT INTEGRATION EFFICIENCIES. The Company believes that the
Acquisition has created opportunities for the Company to achieve significant
cost savings. Management believes that cost saving opportunities will result
from leveraging fixed overhead over a larger revenue base and an increased
number of covered lives and from reducing duplicative corporate and regional
selling, general and administrative expenses. As a result, the Company expects
to achieve approximately $60.0 million of cost savings on an annual basis within
eighteen months following the consummation of the Acquisition. There can be no
assurance that the Company will be able to integrate its operations according to
its plan. See "Risk Factors--Integration of Operations."
PURSUE ADDITIONAL SPECIALTY MANAGED CARE OPPORTUNITIES. The Company
believes that significant demand exists for specialty managed care products
related to the management of certain chronic conditions. The Company believes
its large number of covered lives, information systems infrastructure and
demonstrated expertise in managing behavioral healthcare programs position the
Company to provide customers with specialty managed care products. As a first
major step in implementing this strategy, the Company acquired Allied, a
provider of specialty managed care products for cardiology, oncology and
diabetes patients, on December 5, 1997. See "--Recent Developments". The
Company's
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highly leveraged financial position may prevent it from acquiring additional
speciality managed care providers. See "Risk Factors--Substantial Leverage and
Debt Service Obligations."
HISTORY
The Company has historically derived the majority of its revenue as a
provider of healthcare services in an inpatient setting. Payments from third
party payors are the principal source of revenue for most healthcare providers.
In the early 1990's, many third party payors sought to control the cost of
providing care to their patients by instituting managed care programs or seeking
the assistance of managed care companies. Providers participating in managed
care programs agree to provide services to patients for a discount from
established rates, which generally results in pricing concessions by the
providers and lower margins. Additionally, managed care programs generally
encourage alternatives to inpatient treatment settings and the reduced
utilization of inpatient services. As a result, third party payors established
managed care programs or engaged managed care companies in many areas of
healthcare, including behavioral healthcare. The Company, which until June 1997
was the largest operator of psychiatric hospitals in the United States, was
adversely affected by the adoption of managed care programs by third party
payors.
Prior to the first quarter of fiscal 1996, the Company was not a provider of
behavioral managed care services. During the first quarter of fiscal 1996, the
Company acquired a 61% ownership interest in Green Spring Health Services, Inc.,
a managed care company specializing in mental health and substance
abuse/dependence services ("Green Spring"). At that time, the Company intended
to become a fully integrated behavioral healthcare provider by combining the
managed behavioral healthcare products offered by Green Spring with the direct
treatment services offered by the Company's psychiatric hospitals. The Company
believed that an entity that participated in both the managed care and provider
segments of the behavioral healthcare industry could more efficiently provide
and manage behavioral healthcare for insured populations than an entity that was
solely a managed care company. The Company also believed that earnings from its
managed care business would offset, in part, the negative impact on the
financial performance of its psychiatric hospitals caused by managed care. Green
Spring was the Company's first significant involvement in managed behavioral
healthcare.
Subsequent to the Company's acquisition of Green Spring, the growth of the
managed behavioral healthcare industry accelerated. Under the Company's majority
ownership, Green Spring increased its base of covered lives from 12.0 million as
of the end of calendar year 1995 to 21.1 million as of the end of calendar year
1997, a compound annual growth rate of over 32%. Green Spring's revenue
increased from $205.0 million in fiscal 1995 to $364.0 million in fiscal 1997, a
compound annual growth rate of over 33%. While growth in the industry was
accelerating, the managed behavioral healthcare industry also began to
consolidate. The Company concluded that consolidation presented an opportunity
for the Company to enhance its stockholder value by increasing its participation
in the managed behavioral healthcare industry, which the Company believed
offered growth and earnings prospects superior to those of the psychiatric
hospital industry. Therefore, the Company decided to sell its domestic
psychiatric facilities to obtain capital for expansion in the managed behavioral
healthcare business.
The Company took a significant step toward implementing this strategy during
the third quarter of fiscal 1997 with the Crescent Transactions when it sold the
Psychiatric Hospital Facilities to Crescent for $417.2 million in cash (before
costs of approximately $16.0 million) and certain other consideration.
Simultaneously with the sale of the Psychiatric Hospital Facilities, the Company
and COI, an affiliate of Crescent, formed CBHS, a joint venture, to operate the
Psychiatric Hospital Facilities and certain other facilities transferred to CBHS
by the Company. The Company retained a 50% ownership of CBHS; the other 50% of
the equity of CBHS is owned by COI.
In related transactions, (i) Crescent leased the Psychiatric Hospital
Facilities to CBHS and (ii) the Company entered into a master franchise
agreement (the "Master Franchise Agreement") with CBHS
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and a franchise agreement with each of the Psychiatric Hospital Facilities and
the other facilities operated by CBHS (collectively, the "Franchise
Agreements"). The Company's sale of the Psychiatric Hospital Facilities and the
related transactions described above, collectively, constitute the Crescent
Transactions. Pursuant to the Franchise Agreements, the Company franchises the
"CHARTER" System of behavioral healthcare to each of the Psychiatric Hospital
Facilities and other facilities operated by CBHS. In exchange, CBHS agreed to
pay the Company, pursuant to the Master Franchise Agreement, annual franchise
fees (the "Franchise Fees") of approximately $78.3 million. However, CBHS's
obligation to pay the Franchise Fees is subordinate to its obligation to pay
rent for the Psychiatric Hospital Facilities to Crescent.
The sale of the Psychiatric Hospital Facilities provided the Company with
approximately $200 million of net cash proceeds after debt repayment for use in
implementing its business strategy. The Company used the net cash proceeds to
finance the acquisition of additional managed care companies, as described
below. See "--Recent Developments." The Company continues to pursue a strategy
of expanding its managed care operations and of reducing the extent to which its
earnings are derived from the psychiatric hospital business. In this regard, the
Company has further implemented its business strategy through the Acquisition.
RECENT DEVELOPMENTS
THE ACQUISITION. On February 12, 1998, the Company consummated its
acquisition of Merit for cash consideration of approximately $448.9 million plus
the repayment of Merit's debt. Merit manages behavioral healthcare programs for
approximately 800 customers across all segments of the healthcare industry,
including HMOs, Blue Cross/Blue Shield organizations and other insurance
companies, corporations and labor unions, federal, state and local governmental
agencies and various state Medicaid programs, and had approximately 21.0 million
covered lives at the time of the Acquisition, including approximately 10.6
million risk-based lives. On September 12, 1997, Merit completed the acquisition
of CMG. CMG is a national managed behavioral healthcare company with over two
million covered lives, including over 1.9 million risk-based lives. Merit paid
approximately $48.7 million in cash and issued approximately 739,000 shares of
Merit common stock as consideration for CMG. The former owners of CMG may be
entitled to additional consideration, depending on CMG's future performance. See
"Merit's Management's Discussion and Analysis of Financial Condition and Results
of Operations--Liquidity and Capital Resources."
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED ACQUISITION. On December 4, 1997,
the Company consummated the purchase of HAI, formerly a unit of Aetna/U.S.
Healthcare ("Aetna"), for approximately $122.1 million, which the Company funded
from cash on hand. HAI manages the care of approximately 16.3 million covered
lives, primarily through EAPs and other managed behavioral healthcare plans. The
Company may be required to make additional contingent payments of up to $60.0
million annually to Aetna over the five year period subsequent to closing. The
amount and timing of the payments will be contingent upon net increases in the
number of HAI's covered lives in specified products. See "Magellan's
Management's Discussion and Analysis of Financial Condition and Results of
Operations-- Pro Forma Liquidity and Capital Resources."
ALLIED HEALTH GROUP, INC. ACQUISITION. On December 5, 1997, as part of the
Company's strategy to expand its specialty managed care business, the Company
purchased the assets of Allied. Allied provides specialty risk-based products
and administrative services to a variety of insurance companies and other
customers, including Blue Cross of New Jersey, CIGNA and NYLCare, for its 5.0
million members. Allied has over 80 physician networks across the eastern United
States. Allied's networks include physicians specializing in cardiology,
oncology and diabetes. The Company paid approximately $70.0 million for Allied,
of which $50.0 million was paid to the seller at closing with the remaining
$20.0 million placed in escrow. The escrowed amount is payable in one-third
increments if Allied achieves
8
<PAGE>
specified earnings targets during each of the three years following the closing.
Additionally, the purchase price may be increased during the three year period
by up to $40.0 million if Allied's performance exceeds specified earnings
targets. The maximum purchase price payable is $110.0 million. See "Magellan's
Management's Discussion and Analysis of Financial Condition and Results of
Operations-- Pro Forma Liquidity and Capital Resources."
GREEN SPRING MINORITY SHAREHOLDER CONVERSION. The minority shareholders of
Green Spring have converted their interests in Green Spring into an aggregate of
2,831,516 shares of Company Common Stock. Such conversion is referred to as the
"Green Spring Minority Shareholder Conversion." As a result of the Green Spring
Minority Shareholder Conversion, the Company owns 100% of Green Spring.
PUBLIC SECTOR ACQUISITIONS. During fiscal 1998, the Company has acquired
six businesses in its public sector segment for an aggregate purchase price of
approximately $53.0 million (collectively, the "Public Sector Acquisitions").
The Public Sector Acquisitions provide various residential and day services for
individuals with acquired brain injuries and for individuals with mental
retardation and developmental disabilities.
CBHS TRANSACTIONS. On March 3, 1998, the Company and certain of its wholly
owned subsidiaries entered into definitive agreements with COI and CBHS pursuant
to which the Company would have, among other things, sold the Company's
franchise operations, certain domestic provider operations and certain other
assets and operations. On August 19, 1998, the Company announced that it had
terminated discussions with COI for the sale of its interest in CBHS.
Furthermore, the Company has exercised certain of its rights pursuant to the
Master Franchise Agreement and is assisting CBHS management in improving
profitability. See "Risk Factors--Subordination of Franchise Fees." The Company
will continue to seek opportunities to divest its ownership interest in CBHS at
a later date.
THE TRANSACTIONS
On February 12, 1998, in connection with the consummation of the
Acquisition, the Company consummated certain related transactions (together with
the Acquisition, collectively, the "Transactions"), as follows: (i) the Company
terminated its existing credit agreement (the "Magellan Existing Credit
Agreement"); (ii) the Company repaid all loans outstanding pursuant to and
terminated Merit's existing credit agreement (the "Merit Existing Credit
Agreement") (the Magellan Existing Credit Agreement and the Merit Existing
Credit Agreement are hereinafter referred to as the "Existing Credit
Agreements"); (iii) the Company consummated a tender offer for its 11 1/4%
Series A Senior Subordinated Notes due 2004 (the "Magellan Outstanding Notes");
(iv) Merit consummated a tender offer for its 11 1/2% Senior Subordinated Notes
due 2005 (the "Merit Outstanding Notes") (the Magellan Outstanding Notes and the
Merit Outstanding Notes are hereinafter referred to collectively as the
"Outstanding Notes" and such tender offers are hereinafter referred to
collectively as the "Debt Tender Offers"); (v) the Company entered into a new
senior secured bank credit agreement (the "New Credit Agreement") with The Chase
Manhattan Bank ("Chase"), an affiliate of Chase Securities Inc., the Initial
Purchaser, and a syndicate of financial institutions, providing for credit
facilities of $700 million; and (vi) the Company issued the Old Notes. See "The
Transactions" and "Summary of New Credit Agreement."
9
<PAGE>
The following table sets forth the sources and uses of funds for the
Transactions (in millions):
<TABLE>
<S> <C>
SOURCES:
Cash and cash equivalents......................................... $ 59.3
New Credit Agreement:
Revolving Facility(1)........................................... 20.0
Term Loan Facility.............................................. 550.0
The Old Notes..................................................... 625.0
--------
Total sources................................................. $ 1,254.3
--------
--------
USES:
Direct Cash Merger Consideration.................................. $ 448.9
Repayment of Merit Existing Credit Agreement(2)................... 196.4
Purchase of Magellan Outstanding Notes(3)......................... 432.1
Purchase of Merit Outstanding Notes(4)............................ 121.6
Transaction costs(5).............................................. 55.3
--------
Total uses.................................................... $ 1,254.3
--------
--------
</TABLE>
-------------------------------
(1) The Revolving Facility provides for borrowings of up to $150.0
million. As of February 12, 1998, the Company had approximately $112.5
million available for borrowing pursuant to the Revolving Facility,
excluding approximately $17.5 million of availability reserved for
certain letters of credit.
(2) Includes principal amount of $193.6 million and accrued interest of
$2.7 million.
(3) Includes principal amount of $375.0 million, tender premium of $43.4
million and accrued interest of $13.7 million.
(4) Includes principal amount of $100.0 million, tender premium of $18.9
million and accrued interest of $2.8 million.
(5) Transaction costs include, among other things, costs paid at closing
associated with the Debt Tender Offers, the Old Notes offering, the
Acquisition and the New Credit Agreement.
All but $105,000 of the $375.0 million of Magellan Outstanding Notes and all
but $35,000 of the $100.0 million of Merit Outstanding Notes were tendered in
response to the Debt Tender Offers. Upon consummation of the Debt Tender Offers,
the Company paid $1,115.69 plus accrued interest per $1,000 principal amount of
Magellan Outstanding Notes tendered and $1,189.14 plus accrued interest per
$1,000 principal amount of Merit Outstanding Notes tendered.
RAINWATER, INC.
During the second quarter of fiscal 1996, Rainwater-Magellan Holding, L.P.,
an affiliate of Richard Rainwater ("Rainwater-Magellan"), purchased four million
shares of the Company's Common Stock and a warrant to purchase an additional two
million shares at an exercise price of $26.15 per share (the "Rainwater-Magellan
Warrant") from the Company for aggregate cash consideration of $69.7 million in
a private placement (the "Private Placement"). Mr. Rainwater currently
beneficially owns approximately 13.3% of the Company's Common Stock. Mr.
Rainwater and certain affiliates have the right to designate a nominee
acceptable to the Company for election as a director of the Company. See
"Management-- Certain Relationships and Related Transactions."
10
<PAGE>
THE OLD NOTES OFFERING
<TABLE>
<S> <C>
The Old Notes................. The Old Notes were sold by the Company on February 12, 1998
in a private placement (the "Offering") to Chase Securities
Inc. (the "Initial Purchaser") pursuant to a Purchase
Agreement dated February 5, 1998 (the "Purchase Agreement").
The Initial Purchaser subsequently resold the Old Notes to
either "qualified institutional buyers" pursuant to Rule
144A under the Securities Act or pursuant to sales that
occurred outside the United States within the meaning of
Regulation S of the Securities Act. As of the date of this
Prospectus, all $625,000,000 outstanding principal amount of
the Old Notes were evidenced by global securities,
registered in the name of CEDE & Co., as nominee for The
Depositary Trust Company ("DTC"), and held by Marine Midland
Bank as securities custodian for CEDE & Co. As indicated
elsewhere in this Prospectus, the Old Notes have been
included in the PORTAL Market for trading among "qualified
institutional buyers" pursuant to Rule 144A under the
Securities Act.
Registration Rights
Agreement................... Pursuant to the Purchase Agreement, the Company and the
Initial Purchaser entered into the Registration Rights
Agreement, which, among other things, grants the holders of
the Old Notes certain exchange and registration rights. The
Exchange Offer is intended to satisfy such exchange rights,
which rights will terminate upon consummation of the
Exchange Offer. Pursuant to the Registration Rights
Agreement, the Company agreed that, in the event that the
Exchange Offer is not consummated on or prior to September
10, 1998, the Company will be obligated to pay liquidated
damages to each holder of the Old Notes in an amount equal
to $0.192 per week per $1,000 principal amount of the Old
Notes held by such holder until the Exchange Offer is
consummated. See "The Exchange Offer--Purpose and Effect of
the Exchange Offer."
Use of Proceeds............... Simultaneously with the sale of the Old Notes, the Company
entered into the New Credit Agreement. The Company used the
net proceeds from the sale of the Old Notes and the initial
borrowings pursuant to the New Credit Agreement to finance
the Acquisition, repay all loans outstanding pursuant to the
Merit Existing Credit Agreement and purchase the Outstanding
Notes tendered in response to the Debt Tender Offers. See
"Use of Proceeds."
THE EXCHANGE OFFER
Securities Offered............ $625,000,000 aggregate principal amount of 9% Series A
Senior Subordinated Notes due February 15, 2008 that have
been registered pursuant to the Securities Act (the "New
Notes").
The Exchange Offer............ $1,000 principal amount of the New Notes in exchange for
each $1,000 principal amount of 9% Senior Subordinated Notes
due February 15, 2008 that have not been registered pursuant
to the Securities Act (the "Old Notes"). As of the date
hereof, $625,000,000 aggregate principal amount of Old Notes
is outstanding. The Company will issue the New Notes to
holders on or promptly after the Expiration Date.
</TABLE>
11
<PAGE>
<TABLE>
<S> <C>
The New Notes are being offered for exchange hereby to
satisfy certain obligations of the Company under the
Registration Rights Agreement. Based on existing
interpretations of the Staff with respect to similar
transactions, the Company believes that New Notes issued
pursuant to the Exchange Offer in exchange for Old Notes may
be offered for resale, resold and otherwise transferred by
holders thereof (other than any such holder which is an
"affiliate" of the Company within the meaning of Rule 405
under the Securities Act), without compliance with the
registration and prospectus delivery requirements of the
Securities Act, provided that such New Notes are acquired in
the ordinary course of such holders' business and such
holders are not engaged in, have no arrangement with any
person to participate in, and do not intend to engage in,
any public distribution of the New Notes. Each broker-dealer
that receives New Notes for its own account pursuant to the
Exchange Offer in exchange for Old Notes acquired by the
broker-dealer for its own account in market-making or other
trading activities must acknowledge that it will deliver a
resale prospectus in connection with any resale of such New
Notes. The Letter of Transmittal which accompanies this
Prospectus states that by so acknowledging and by delivering
a resale prospectus, such a broker-dealer will not be deemed
to admit to be acting in the capacity of an "underwriter"
(within the meaning of Section 2(11) of the Securities Act).
This Prospectus, as it may be amended or supplemented from
time to time, may be used by such a broker-dealer in
connection with resales of New Notes received in exchange
for Old Notes where such Old Notes were acquired by such
broker-dealer as a result of market-making or other trading
activities. Any broker-dealer that receives New Notes for
its own account in exchange for Old Notes acquired directly
from the Company may not rely on the interpretations of the
Staff referred to above and, in connection with the resale
of any such New Notes, must comply with the registration and
prospectus delivery requirements of the Securities Act,
including the requirement that such broker-dealer be named
as a selling Noteholder in the resale prospectus. The
Company has agreed that, for a period of 180 days after the
date on which the Registration Statement of which this
Prospectus is a part is first declared effective it will
make this Prospectus available to any broker-dealer for use
in connection with any such resale. See "Plan of
Distribution."
Expiration Date............... 5:00 p.m., New York City time, on November 9, 1998 unless
the Exchange Offer is extended, in which case the term
"Expiration Date" means the latest date and time to which
the Exchange Offer is extended.
Accrued Interest on the New
Notes and Old Notes......... Each New Note will bear interest from its date of original
issuance. Holders of Old Notes that are accepted for
exchange and exchanged for New Notes will receive, in cash,
accrued interest thereon to, but not including, the original
issuance date of the New Notes. Such interest will be paid
on the first interest payment date for the New Notes.
Interest on the Old Notes accepted for exchange
</TABLE>
12
<PAGE>
<TABLE>
<S> <C>
and exchanged in the Exchange Offer will cease to accrue on
the date preceding the date of original issuance of the New
Notes.
Conditions to the Exchange
Offer....................... The Exchange Offer is subject to certain customary
conditions, which may be waived by the Company. See "The
Exchange Offer-- Conditions."
Procedures for Tendering Old
Notes....................... Each holder of Old Notes wishing to accept the Exchange
Offer must complete, sign and date the accompanying Letter
of Transmittal, or a facsimile thereof, in accordance with
the instructions contained herein and therein, and deliver
such Letter of Transmittal, or such facsimile, together with
any other required documentation to the Exchange Agent (as
defined) at the address set forth herein on or prior to the
Expiration Date. By executing the Letter of Transmittal,
each holder of the Old Notes who wishes to exchange its
Notes for New Notes in the Exchange Offer will make certain
representations to the Company, including that (i) any New
Notes to be received by it will be acquired in the ordinary
course of its business, (ii) it is not participating in,
does not intend to participate in and has no arrangement
with any person to participate in a public distribution
(within the meaning of the Securities Act) of the New Notes,
and (iii) it is not an "affiliate," as defined in Rule 405
of the Securities Act of the Company, or if it is such an
affiliate, that it will comply with the registration and
prospectus delivery requirements of the Securities Act to
the extent applicable to it. In addition, each holder who is
not a broker-dealer will be required to represent that it is
not engaged in, and does not intend to engage in, a public
distribution of the New Notes. Each holder who is a
broker-dealer and who receives New Notes for its own account
in exchange for Old Notes that were acquired by it as a
result of market-making activities or other trading
activities, will be required to acknowledge that it will
deliver a prospectus in connection with any resale by it of
such New Notes. The Company has agreed that, for a period of
180 days after the date on which the Registration Statement
of which this Prospectus is a part is first declared
effective, it will make this Prospectus available to any
broker-dealer for use in connection with any such resales.
For a description of the procedures for certain resales by
broker-dealers, see "Plan of Distribution." See "The
Exchange Offer--Procedures for Tendering."
Untendered Old Notes.......... Following the consummation of the Exchange Offer, holders of
Old Notes eligible to participate and to receive freely
transferrable New Notes (based on existing interpretations
of the Staff described elsewhere in this Prospectus) but who
do not tender their Old Notes will not have any further
registration rights and such Old Notes will continue to be
subject to certain restrictions on transfer under the
Securities Act. Accordingly, the liquidity of the market for
such Old Notes could be adversely affected.
Shelf Registration
Statement................... Pursuant to the Registration Rights Agreement, if (i)
because of any change in law or applicable interpretations
thereof by the Staff of the Commission, the Company is not
permitted to effect the
</TABLE>
13
<PAGE>
<TABLE>
<S> <C>
Exchange Offer as contemplated hereby, (ii) any Old Notes
validly tendered pursuant to the Exchange Offer are not
exchanged for New Notes by September 10, 1998, (iii) the
Initial Purchaser so requests with respect to Old Notes not
eligible to be exchanged for New Notes in the Exchange
Offer, (iv) any applicable law or interpretations do not
permit any holder of Old Notes to participate in the
Exchange Offer, (v) any holder of Old Notes that
participates in the Exchange Offer does not receive freely
transferable New Notes in exchange for tendered Old Notes,
or (vi) the Company so elects, then the Company will file
with the Commission a shelf registration statement (the
"Shelf Registration Statement") to cover resales of Transfer
Restricted Securities (as defined) by such holders who
satisfy certain conditions relating to the provision of
information in connection with the Shelf Registration
Statement. For purposes of the foregoing, "Transfer
Restricted Securities" means each Old Note until (i) the
date on which such Old Note has been exchanged for a freely
transferable New Note in the Exchange Offer; (ii) the date
on which such Old Note has been effectively registered under
the Securities Act and disposed of in accordance with the
Shelf Registration Statement or (iii) the date on which such
Old Note is distributed to the public pursuant to Rule 144
under the Securities Act or is saleable pursuant to Rule
144(k) under the Securities Act. The Company will use its
reasonable best efforts to have the Shelf Registration
Statement declared effective by the Commission as promptly
as practicable after the filing thereof and to keep the
Shelf Registration Statement continuously effective until
February 12, 2000. The Company, at its expense, will provide
to each holder of the Old Notes copies of the prospectus
that is a part of the Shelf Registration Statement, notify
each such holder when the Shelf Registration Statement has
become effective and take certain other actions as are
required to permit unrestricted resales of the Old Notes
from time to time. A holder of Old Notes who sells such Old
Notes pursuant to the Shelf Registration Statement generally
will be required to be named as a selling security holder in
the related prospectus and to deliver a prospectus to
purchasers, will be subject to certain of the civil
liability provisions under the Securities Act in connection
with such sales and will be bound by the provisions of the
Registration Rights Agreement which are applicable to such
holder (including certain indemnification obligations).
Special Procedures for
Beneficial Owners........... Any beneficial owner whose Old Notes are registered in the
name of a broker, dealer, commercial bank, trust company or
other nominee and who wishes to tender its Old Notes for
exchange in the Exchange Offer should contact such
registered holder promptly and instruct such registered
holder to tender on such beneficial owner's behalf. If such
beneficial owner wishes to tender on such beneficial owner's
behalf, such owner must, prior to completing and executing
the Letter of Transmittal, either make appropriate
arrangements to register ownership of the Old Notes in such
owner's name or obtain a properly completed bond power from
the
</TABLE>
14
<PAGE>
<TABLE>
<S> <C>
registered holder. The transfer of registered ownership may
take considerable time.
Guaranteed Delivery
Procedures.................. Holders of Old Notes who wish to tender their Old Notes and
who cannot deliver the Letter of Transmittal or any other
documents required by the Letter of Transmittal to the
Exchange Agent (or comply with the procedures for book-entry
transfer) prior to the Expiration Date must tender their Old
Notes according to the guaranteed delivery procedures set
forth in "The Exchange Offer-- Guaranteed Delivery
Procedures."
Withdrawal Rights............. Tenders may be withdrawn at any time prior to 5:00 p.m., New
York City time, on the Expiration Date.
Acceptance of Old Notes and
Delivery of New Notes....... The Company will accept for exchange and exchange any and
all Old Notes which are properly tendered in the Exchange
Offer and not withdrawn prior to 5:00 p.m., New York City
time, on the Expiration Date. The New Notes issued pursuant
to the Exchange Offer will be delivered promptly following
the Expiration Date. See "The Exchange Offer--Terms of the
Exchange Offer."
Federal Income Tax
Consequences................ The exchange pursuant to the Exchange Offer will not be a
taxable event for federal income tax purposes. See "Federal
Income Tax Consequences of the Exchange Offer."
Use of Proceeds............... There will be no cash proceeds to the Company from the
exchange pursuant to the Exchange Offer. See "Use of
Proceeds."
Exchange Agent................ Marine Midland Bank.
</TABLE>
SUMMARY OF TERMS OF THE NEW NOTES
The form and terms of the New Notes are identical to the form and terms of
the Old Notes except that the New Notes have been registered under the
Securities Act and, therefore, will not bear legends restricting the transfer
thereof and except for the series designation. The New Notes will evidence the
same debt as the Old Notes and will be entitled to the benefits of the
Indenture. See "Description of the New Notes."
<TABLE>
<S> <C>
Maturity Date................ February 15, 2008
Interest Payment Dates....... February 15 and August 15, commencing August 15, 1998.
Optional Redemption.......... Except as described below, the Company may not redeem the
New Notes prior to February 15, 2003. On or after such date,
the Company may redeem the New Notes, in whole or in part,
at any time at the redemption prices set forth herein,
together with accrued and unpaid interest, if any, to the
date of redemption. In addition, at any time and from time
to time prior to February 15, 2001, the Company may, subject
to certain requirements, redeem up to 35% of the original
aggregate principal amount of the New Notes with the net
cash proceeds of one or more Equity Offerings (as defined),
at a redemption price equal to 109% of the principal amount
thereof, together with accrued and unpaid interest, if any,
to the date of redemption, provided that at least 65% of the
original aggregate principal amount of the New Notes remains
outstanding immediately
</TABLE>
15
<PAGE>
<TABLE>
<S> <C>
after each such redemption. See "Description of the New
Notes-- Optional Redemption."
Change of Control............ Upon the occurrence of a Change of Control, each holder of
the New Notes will have the right to require the Company to
make an offer to repurchase such holder's New Notes at a
price equal to 101% of the principal amount thereof,
together with accrued and unpaid interest, if any, to the
repurchase date. See "Description of the New Notes-- Change
of Control."
Ranking...................... The New Notes will be unsecured and will be subordinated in
right of payment to all existing and future Senior
Indebtedness of the Company. The New Notes will rank PARI
PASSU with all future Senior Subordinated Indebtedness of
the Company and will rank senior to all future Subordinated
Obligations of the Company. The New Notes will be PARI PASSU
in right of payment with all Old Notes that are not
exchanged for New Notes pursuant to the Exchange Offer. As
of June 30, 1998, (i) the aggregate amount of the Company's
outstanding Senior Indebtedness would have been
approximately $580.7 million (exclusive of unused
commitments), substantially all of which would have been
Secured Indebtedness and would have been guaranteed by
substantially all of the Company's subsidiaries, (ii) the
Company would have had no Senior Subordinated Indebtedness
(other than the Notes) and no indebtedness that is
subordinate or junior in right of payment to the Notes and
(iii) the outstanding indebtedness of the Company's
subsidiaries (excluding guarantees of the Company's
indebtedness) would have been approximately $342.8 million,
substantially all of which would have been Secured
Indebtedness. See "Description of the New Notes" and
"Summary of New Credit Agreement."
Restrictive Covenants........ The Indenture governing the Notes limits, among other
things: (i) the incurrence of additional indebtedness by the
Company and its Restricted Subsidiaries (as defined); (ii)
the payment of dividends on, and redemption or repurchase
of, capital stock of the Company and its Restricted
Subsidiaries and the redemption of certain Subordinated
Obligations of the Company; (iii) certain other restricted
payments, including investments; (iv) sales of assets; (v)
certain transactions with affiliates; (vi) the creation of
liens; and (vii) consolidations, mergers and transfers of
all or substantially all the Company's assets. The Indenture
also prohibits certain restrictions on distributions from
Restricted Subsidiaries. However, all these limitations and
prohibitions are subject to a number of important
qualifications and exceptions. See "Description of the New
Notes--Certain Covenants."
Risk Factors................. In evaluating the Exchange Offer, holders of Old Notes
should carefully consider the factors set forth under the
caption "Risk Factors" prior to determining whether to
participate in the Exchange Offer. Holders of the Old Notes
should also consider that such factors are also generally
applicable to the Old Notes.
</TABLE>
16
<PAGE>
SUMMARY HISTORICAL AND UNAUDITED PRO FORMA FINANCIAL DATA
The following tables set forth: (i) summary consolidated financial data for
Magellan for and as of each of the three fiscal years in the period ended
September 30, 1997 and for the nine months ended June 30, 1997 and 1998; (ii)
summary consolidated financial data for Merit for and as of the three fiscal
years in the period ended September 30, 1997, for the three months ended
December 31, 1996 and 1997 and as of December 31, 1997; and (iii) summary
unaudited pro forma consolidated financial information for the fiscal year ended
September 30, 1997 and for the nine months ended June 30, 1998, giving effect to
the Transactions as if they had occurred on October 1, 1996. The summary
unaudited pro forma consolidated financial information also gives effect to the
Crescent Transactions, the HAI acquisition, the Allied acquisition, Merit's
acquisition of CMG, and the Green Spring Minority Shareholder Conversion. The
summary historical consolidated financial information of Magellan for each of
the three years in the period ended September 30, 1997 has been derived from the
audited historical consolidated financial statements and the selected historical
consolidated financial information of Magellan included elsewhere herein. The
summary historical consolidated financial information of Merit for each of the
three years in the period ended September 30, 1997 has been derived from the
audited historical consolidated financial statements and the selected historical
consolidated financial information of Merit included elsewhere herein.
The summary historical consolidated financial information of Magellan for
the nine months ended June 30, 1997 and 1998 has been derived from unaudited
consolidated financial statements of Magellan appearing elsewhere herein. The
summary historical consolidated financial information of Merit for the three
months ended December 31, 1996 and 1997 and as of December 31, 1997 has been
derived from unaudited consolidated financial statements of Merit appearing
elsewhere herein. In the opinion of management, it includes all adjustments
(consisting only of normal recurring adjustments) that are necessary for a fair
presentation of the operating results for such interim periods. Results for the
interim periods are not necessarily indicative of the results for the full year
or for any future periods. The summary historical financial data set forth below
should be read in conjunction with the consolidated financial statements of
Magellan and Merit and the notes thereto and Management's Discussion and
Analysis of Financial Condition and Results of Operations of Magellan and Merit
appearing elsewhere herein.
The summary unaudited pro forma consolidated financial information set forth
herein is provided for informational purposes only and is not necessarily
indicative of actual results or future results that would have been or will be
achieved had the Transactions, the Crescent Transactions, the HAI, Allied and
CMG acquisitions and the Green Spring Minority Shareholder Conversion been
consummated on the assumed dates. The summary unaudited pro forma consolidated
financial information is derived from the Unaudited Pro Forma Consolidated
Financial Information appearing elsewhere herein. The information set forth
below should be read in conjunction with: (i) the audited consolidated financial
statements of Magellan, Merit, CBHS and HAI and notes thereto appearing
elsewhere herein; (ii) the Unaudited Pro Forma Consolidated Financial
Information appearing elsewhere herein; and (iii) Management's Discussion and
Analysis of Financial Condition and Results of Operations of Magellan and Merit
appearing elsewhere herein.
17
<PAGE>
MAGELLAN HISTORICAL AND PRO FORMA FINANCIAL DATA
<TABLE>
<CAPTION>
HISTORICAL
----------------------------------------------------------
NINE MONTHS ENDED
YEAR ENDED SEPTEMBER 30, JUNE 30,
---------------------------------- ----------------------
1995 1996 1997 1997 1998
---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
STATEMENT OF OPERATIONS DATA:
Net revenue.............................. $1,151,736 $1,345,279 $1,210,696 $1,021,662 $1,063,099
Salaries, cost of care and other
operating expenses..................... 863,598 1,064,445 978,513 830,248 909,353
Bad debt expense......................... 92,022 81,470 46,211 47,456 2,972
Depreciation and amortization............ 38,087 48,924 44,861 38,231 37,649
Interest, net............................ 55,237 48,017 45,377 39,324 49,336
Income (loss) before extraordinary
items.................................. (42,963) 32,383 4,755 (5,408) 12,746
Net income (loss)........................ (42,963) 32,383 (498) (10,661) (20,269)
OTHER FINANCIAL DATA:
EBITDA(1)................................
Adjusted EBITDA(2).......................
Cash interest expense(3).................
Ratio of Adjusted EBITDA to cash interest
expense(3).............................
Ratio of total debt to Adjusted
EBITDA(4)..............................
Net cash provided by (used in) operating
activities............................. $ 95,620 $ 101,866 $ 73,599 $ 5,216 $ (5,401)
Net cash provided by (used in) investing
activities............................. (96,981) (102,203) 331,680 355,102 (1,001,132)
Net cash provided by (used in) financing
activities............................. (22,728) 15,768 (153,346) (155,020) 723,501
Ratio (deficiency) of earnings to fixed
charges................................ (53,518) 1.98 1.41 1.46
BALANCE SHEET DATA (END OF PERIOD):
Working capital (deficiency)............. $ 91,413 $ 63,834 $ 287,662 $ (51,021)
Total assets............................. 983,558 1,140,137 895,620 1,902,211
Total debt and capital lease
obligations............................ 541,569 572,058 395,294 1,205,716
Stockholders' equity..................... 88,560 121,817 158,250 190,795
<CAPTION>
PRO FORMA
----------------------------
NINE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, JUNE 30,
1997 1998
------------- ------------
<S> <C> <C>
STATEMENT OF OPERATIONS DATA:
Net revenue.............................. $ 1,601,606 $1,374,059
Salaries, cost of care and other
operating expenses..................... 1,361,165 1,193,251
Bad debt expense......................... 3,491 2,972
Depreciation and amortization............ 68,116 52,511
Interest, net............................ 95,092 73,986
Income (loss) before extraordinary
items.................................. 18,467 10,975
Net income (loss)........................ 18,467 10,975
OTHER FINANCIAL DATA:
EBITDA(1)................................ $ 250,647 $ 186,154
Adjusted EBITDA(2)....................... 263,740 180,840
Cash interest expense(3)................. 104,389 79,004
Ratio of Adjusted EBITDA to cash interest
expense(3)............................. 2.5x 2.3x
Ratio of total debt to Adjusted
EBITDA(4).............................. 4.6x
Net cash provided by (used in) operating
activities.............................
Net cash provided by (used in) investing
activities.............................
Net cash provided by (used in) financing
activities.............................
Ratio (deficiency) of earnings to fixed
charges................................ 1.31 1.31
BALANCE SHEET DATA (END OF PERIOD):
Working capital (deficiency).............
Total assets.............................
Total debt and capital lease
obligations............................
Stockholders' equity.....................
</TABLE>
See Notes to Magellan Historical and Pro Forma Financial Data
18
<PAGE>
NOTES TO MAGELLAN HISTORICAL AND PRO FORMA FINANCIAL DATA
(1) EBITDA is defined as earnings before interest, taxes, depreciation and
amortization plus interest income, stock option expense and unusual items.
The calculation of EBITDA is as follows (in thousands):
<TABLE>
<CAPTION>
PRO FORMA
-------------------
YEAR ENDED
SEPTEMBER 30, 1997
-------------------
<S> <C>
Net income..................................................................................................... $ 18,467
Minority interest.............................................................................................. 2,267
Equity in loss of CBHS......................................................................................... 20,150
Provision for income taxes..................................................................................... 24,121
Interest, net.................................................................................................. 95,092
Depreciation and amortization.................................................................................. 68,116
----------
Earnings before interest, taxes, depreciation and amortization............................................... 228,213
Interest income................................................................................................ 13,697
Stock option expense (credit).................................................................................. 4,292
Unusual items.................................................................................................. 4,445
----------
EBITDA....................................................................................................... $ 250,647
----------
----------
<CAPTION>
NINE MONTHS ENDED
JUNE 30, 1998
-------------------
<S> <C>
Net income..................................................................................................... $ 10,975
Minority interest.............................................................................................. 2,457
Equity in loss of CBHS......................................................................................... 24,221
Provision for income taxes..................................................................................... 17,213
Interest, net.................................................................................................. 73,986
Depreciation and amortization.................................................................................. 52,511
----------
Earnings before interest, taxes, depreciation and amortization............................................... 181,363
Interest income................................................................................................ 8,318
Stock option expense (credit).................................................................................. (3,527)
Unusual items.................................................................................................. --
----------
EBITDA....................................................................................................... $ 186,154
----------
----------
</TABLE>
EBITDA is presented because management believes that EBITDA provides
additional indications of the financial performance of the Company and
provides useful information regarding the Company's ability to service debt
and meet certain debt covenants under the Indenture. Accordingly, EBITDA
includes interest income, which can be utilized to service debt, and
excludes non-cash expenses such as depreciation and amortization and stock
option expense (credit). The Company's definition of EBITDA used in this
Prospectus is consistent with the definition of EBITDA in the New Credit
Agreement and the Indenture. EBITDA does not represent cash flows from
operations or investing and financing activities as defined by generally
accepted accounting principles. EBITDA does not measure whether cash flows
will be sufficient to fund all cash flow needs, including principal and
interest payments on debt and capital lease obligations, capital
expenditures or other investing and financing activities. EBITDA should not
be construed as an alternative to the Company's operating income, net
income or cash flows from operating activities (as determined in accordance
with generally accepted accounting principles) and should not be construed
as an indication of the Company's operating performance or as a measure of
the Company's liquidity. In addition, items excluded from EBITDA, such as
depreciation and amortization, interest, net and provision for income
taxes, are significant components in understanding and assessing the
Company's financial performance. EBITDA is not presented for historical
purposes as management does not believe historical EBITDA is indicative of
the Company's prospects after consummation of the Transactions. The
Company's definition of EBITDA may be different from the definition of
EBITDA used by other companies. For a complete discussion of the Company's
future prospects related to net income, cash flows from operations and
investing and financing activities, see "Magellan's Management's Discussion
and Analysis of Financial Condition and Results of Operations."
19
<PAGE>
(2) Adjusted EBITDA is defined as EBITDA adjusted to eliminate expenses that the
Company expects to eliminate as a result of the Integration Plan and to
eliminate certain revenues and expenses that the Company does not believe
will have significant continuing impact. Adjusted EBITDA represents EBITDA
adjusted as follows (in thousands):
<TABLE>
<CAPTION>
PRO FORMA
--------------------------------------
<S> <C> <C>
YEAR ENDED NINE MONTHS ENDED
SEPTEMBER 30, 1997 JUNE 30, 1998
------------------ -----------------
EBITDA................................... $250,647 $186,154
Elimination of duplicative executive
management, finance, human resource and
legal positions and related overhead
expenses, including the closure of
Merit's corporate headquarters.......... 11,800 8,850
Elimination of duplicative regional
management positions and related
overhead expenses....................... 8,900 6,675
Elimination of duplicative
credentialling, contracting and other
administrative expenses in connection
with the consolidation of the Company's
existing and acquired provider
networks................................ 7,500 5,625
Elimination of expenses associated with
the closure of field offices located in
overlapping service areas............... 7,200 5,400
Elimination of duplicative personnel,
development and maintenance expenses in
connection with the consolidation of the
Company's existing and acquired
information systems operations.......... 5,900 4,425
Elimination of duplicative personnel and
related administrative expenses in
connection with the consolidation of the
Company's existing and acquired claims
processing operations................... 4,900 3,675
Elimination of duplicative sales and
marketing positions..................... 4,600 3,450
Less estimated cost savings reflected in
the Company's historical financial
statements.............................. -- (11,142)
Elimination of revenue from settlements
of reimbursement issues related to
provider operations sold as part of the
Crescent Transactions. The Company
expects to continue to record such
settlements in future periods, but such
amounts are expected to decline
significantly from fiscal 1997 levels... (20,594) (2,349)
Elimination of EBITDA associated with the
Company's six hospital-based joint
ventures. The Company pays a management
fee to CBHS that equals the Company's
portion of the joint ventures' net
income pursuant to a management
agreement with CBHS..................... (9,613) (5,323)
Franchise Fees receivable from CBHS...... -- (20,500)
Elimination of favorable adjustments to
medical malpractice reserves. The
Company does not expect that such
adjustments will have a significant
impact on the Company's future operating
performance............................. (7,500) (4,100)
---------- -----------------
Adjusted EBITDA.......................... $263,740 $180,840
---------- -----------------
---------- -----------------
</TABLE>
The foregoing $50.8 million and $38.1 million of positive adjustments
represent the full year and the nine month impact of cost savings,
respectively, that are expected to be achieved within one year following the
consummation of the Acquisition. The Company expects to achieve a total of
approximately $60.0 million of annual cost savings within eighteen months
following the consummation of the Acquisition. Cost savings are measured
relative to the combined budgeted amounts for the Company, Merit and HAI for
the current fiscal year prior to the cost savings initiatives. The Company
expects to spend approximately $30.0 million in the year following the
consummation of the Acquisition in connection with achieving such cost
savings. Cost savings will be effected in all of the Company's existing and
acquired managed behavioral healthcare operations. Adjusted EBITDA is
presented because management believes that Adjusted EBITDA provides useful
information regarding the Company's ability to service debt and meet certain
debt covenants under the Indenture following the consummation of the
Transactions. Adjusted EBITDA does not represent cash flows from operations
or investing and financing activities as defined by generally accepted
accounting principles. Adjusted EBITDA does not measure whether cash flows
will be sufficient to fund all cash flow needs, including principal and
interest payments on debt and capital lease obligations, capital
expenditures or other investing and financing activities. Adjusted EBITDA
should not be construed as an alternative to the Company's operating income,
net income or cash flows from operating activities (as determined in
accordance with generally accepted accounting principles) and should not be
construed as an indication of the Company's operating performance or as a
measure of the Company's liquidity. Adjusted EBITDA is not presented for
historical purposes as management does not believe historical Adjusted
EBITDA is indicative of the Company's prospects after consummation of the
Transactions. The Company's definition of Adjusted EBITDA may be different
from the definition of Adjusted EBITDA used by other companies. For a
complete discussion of the Company's future prospects related to net income,
cash flows from operations and investing and financing activities, see
"Magellan's Management's Discussion and Analysis of Financial Condition and
Results of Operations."
(3) Represents the ratio of Adjusted EBITDA to cash interest expense. Cash
interest expense represents total interest expense as reduced for interest
expense related to the amortization of deferred financing costs.
(4) Represents the ratio of total debt and capital lease obligations as of June
30, 1998 to Adjusted EBITDA for the year ended September 30, 1997.
20
<PAGE>
MERIT HISTORICAL FINANCIAL DATA
<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEAR ENDED SEPTEMBER 30, DECEMBER 31,
------------------------------------- ------------------------
<S> <C> <C> <C> <C> <C>
1995 1996 1997 1996 1997
----------- ----------- ----------- ----------- -----------
<CAPTION>
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue......................................... $ 361,549 $ 457,830 $ 555,717 $ 128,625 $ 177,217
Direct service costs............................ 286,001 361,684 449,563 102,932 145,997
----------- ----------- ----------- ----------- -----------
Direct profit................................. 75,548 96,146 106,154 25,693 31,220
Selling, general and administrative expenses.... 49,823 64,523 67,450 16,579 22,091
Amortization of intangibles..................... 21,373 25,869 26,897 6,799 7,231
Restructuring charge............................ -- 2,995 -- -- --
Income from joint ventures...................... -- -- -- -- (1,649)
----------- ----------- ----------- ----------- -----------
Operating income.............................. 4,352 2,759 11,807 2,315 3,547
Other (income)(1)............................... (1,498) (2,838) (3,497) (780) (1,074)
Interest expense................................ -- 23,826 25,063 6,186 7,216
Loss on disposal of subsidiary.................. -- -- 6,925 -- --
Merger costs and special charges................ -- 3,972 1,314 -- 545
----------- ----------- ----------- ----------- -----------
Income (loss) before income taxes and
cumulative effect of accounting change...... 5,850 (22,201) (17,998) (3,091) (3,140)
Provision (benefit) for income taxes............ 4,521 (5,332) (4,126) (219) (468)
----------- ----------- ----------- ----------- -----------
Income (loss) before cumulative effect of
accounting change............................. 1,329 (16,869) (13,872) (2,872) (2,672)
Cumulative effect of accounting change.......... -- (1,012) -- -- --
----------- ----------- ----------- ----------- -----------
Net income (loss)............................. $ 1,329 $ (17,881) $ (13,872) $ (2,872) $ (2,672)
----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- -----------
OTHER FINANCIAL DATA:
Capital expenditures............................ $ 31,529 $ 23,808 $ 23,951 $ 5,554 $ 3,073
Depreciation and amortization................... 28,150 36,527 39,400 9,907 11,028
BALANCE SHEET DATA (END OF PERIOD):
Cash and cash equivalents, short-term marketable
securities and restricted cash and
investments................................... $ 34,159 $ 53,043 $ 95,206 $ 83,816
Total assets.................................... 305,420 344,801 468,745 451,471
Due to parent (noninterest bearing)............. 70,813 -- -- --
Total debt...................................... -- 254,000 329,500 319,265
Stockholders' equity (deficit)(2)............... 122,333 (29,482) (25,864) (26,917)
</TABLE>
- ------------------------
(1) Represents primarily interest income.
(2) The reduction in stockholders' equity in fiscal 1996 resulted from the
acquisition of Merit's common stock by Merit's management and an investor
group, which was accounted for as a recapitalization. See Note 2 to the
audited historical consolidated financial statements of Merit included
elsewhere herein.
21
<PAGE>
RISK FACTORS
IN EVALUATING THE EXCHANGE OFFER, HOLDERS OF THE OLD NOTES SHOULD CAREFULLY
CONSIDER THE FOLLOWING FACTORS IN ADDITION TO THOSE DISCUSSED ELSEWHERE IN THIS
PROSPECTUS PRIOR TO ACCEPTING THE EXCHANGE OFFER. HOLDERS OF OLD NOTES SHOULD
ALSO CONSIDER THAT SUCH FACTORS ARE ALSO GENERALLY APPLICABLE TO THE OLD NOTES.
THE OLD NOTES AND THE NEW NOTES ARE COLLECTIVELY REFERRED TO HEREIN AS THE
"NOTES."
SUBSTANTIAL LEVERAGE AND DEBT SERVICE OBLIGATIONS
As a result of the Transactions, the Company is currently highly leveraged,
with indebtedness that is substantial in relation to its stockholders' equity.
As of June 30, 1998, the Company's aggregate outstanding indebtedness was
approximately $1.2 billion and the Company's stockholders' equity was
approximately $190.8 million as of the same date. The New Credit Agreement and
the Indenture permit the Company to incur or guarantee certain additional
indebtedness, subject to certain limitations. See "Unaudited Pro Forma
Consolidated Financial Information," "Description of the New Notes" and "Summary
of New Credit Agreement."
The Company's high degree of leverage could have important consequences to
holders of the Notes, including, but not limited to, the following: (i) the
Company's ability to obtain additional financing for working capital, capital
expenditures, acquisitions, general corporate purposes or other purposes may be
impaired in the future; (ii) a substantial portion of the Company's cash flow
from operations must be dedicated to the payment of principal and interest on
its indebtedness; (iii) the Company is substantially more leveraged than certain
of its competitors, which might place the Company at a competitive disadvantage;
(iv) the Company may be hindered in its ability to adjust rapidly to changing
market conditions; and (v) the Company's high degree of leverage could make it
more vulnerable in the event of a downturn in general economic conditions or its
business or in the event of adverse changes in the regulatory environment
applicable to the Company.
The Company's ability to repay or to refinance its indebtedness and to pay
interest on its indebtedness will depend on its financial and operating
performance, which, in turn, is subject to prevailing economic and competitive
conditions and to certain financial, business and other factors, many of which
are beyond the Company's control. These factors could include operating
difficulties, increased operating costs, the actions of competitors, regulatory
developments and delays in implementing strategic projects. The Company's
ability to meet its debt service and other obligations may depend in significant
part on the extent to which the Company can successfully implement its business
strategy. There can be no assurance that the Company will be able to implement
its strategy fully or that the anticipated results of its strategy will be
realized. See "Business--Business Strategy."
If the Company's cash flow and capital resources are insufficient to fund
its debt service obligations, the Company may be forced to reduce or delay
capital expenditures, sell assets or seek to obtain additional equity capital or
to restructure its debt. There can be no assurance that the Company's cash flow
and capital resources will be sufficient for payment of principal of and
interest on its indebtedness in the future, or that any such alternative
measures would be successful or would permit the Company to meet its scheduled
debt service obligations.
The indebtedness outstanding pursuant to the New Credit Agreement matures
prior to the maturity of the Notes. If the Company is unable to refinance the
indebtedness outstanding pursuant to the New Credit Agreement at maturity or
repay such indebtedness with cash on hand, through asset sales, equity sales or
otherwise, its ability to repay the principal and interest on the Notes could be
adversely affected.
In addition, because the Company's obligations under the New Credit
Agreement bear interest at floating rates, an increase in interest rates could
adversely affect, among other things, the Company's ability to meet its debt
service obligations.
22
<PAGE>
SUBORDINATION
The payment of principal of and interest on, and any premium or other
amounts owing in respect of, the Notes is subordinated to the prior payment in
full of all existing and future Senior Indebtedness of the Company, including
all amounts owing under the New Credit Agreement. Consequently, in the event of
a bankruptcy, liquidation, dissolution, reorganization or similar proceeding
with respect to the Company, assets of the Company will be available to pay
obligations on the Notes only after all Senior Indebtedness of the Company has
been paid in full, and there can be no assurance that there will be sufficient
assets to pay amounts due on any or all of the Notes. In addition, the Company
may not pay principal, premium, interest or other amounts on account of the
Notes in the event of a payment default or certain other defaults in respect of
Specified Senior Indebtedness (as defined) unless such indebtedness has been
paid in full or the default has been cured or waived. In addition, in the event
of certain other defaults with respect to Specified Senior Indebtedness, the
Company may not be permitted to make any payment on account of the Notes for a
designated period of time. See "Description of the New Notes-- Subordination."
As of June 30, 1998, the aggregate amount of the Company's outstanding Senior
Indebtedness was approximately $580.7 million (exclusive of unused commitments)
substantially all of which would have been Secured Indebtedness and would have
been guaranteed by substantially all of the Company's subsidiaries.
The Notes are unsecured and thus, in effect, rank junior to any Secured
Indebtedness of the Company or its subsidiaries. The indebtedness outstanding
pursuant to the New Credit Agreement (including the guarantees thereof by the
Company's wholly owned domestic subsidiaries) is secured by substantially all of
the assets of the Company and its wholly owned domestic subsidiaries, including
pledges of all or a portion of the capital stock of substantially all of the
Company's operating subsidiaries. See "Summary of New Credit Agreement."
HOLDING COMPANY STRUCTURE
The Company conducts substantially all of its operations through its
subsidiaries. As a result, the Company is required to rely upon payments from
its subsidiaries for the funds necessary to meet its obligations, including the
payment of interest on and principal of the Notes. The ability of the
subsidiaries to make such payments is subject to, among other things, applicable
state laws. Claims of creditors of the Company's subsidiaries generally have
priority as to the assets of such subsidiaries over claims of the Company.
Therefore, the Notes are effectively subordinated to all liabilities of the
Company's subsidiaries, including trade payables of the subsidiaries. In
addition, the payment of dividends to the Company by its subsidiaries is
contingent upon the earnings of those subsidiaries and subject to various
business considerations. The Indenture permits restrictions, in certain
circumstances, on the payment of dividends and distributions and the transfer of
assets to the Company. See "Summary of New Credit Agreement," and "Description
of the New Notes--Certain Covenants--Limitation on Payment Restrictions
Affecting Restricted Subsidiaries."
The indebtedness outstanding pursuant to the New Credit Agreement is fully
guaranteed by substantially all of the Company's direct and indirect domestic
wholly owned subsidiaries on the issue date of the Old Notes and substantially
all future direct and indirect domestic wholly owned subsidiaries (collectively,
the "Subsidiary Guarantors"). The obligations of the Subsidiary Guarantors are
secured by security interests in, or liens on, substantially all tangible and
intangible assets of the Subsidiary Guarantors (excluding real property). The
Notes are not guaranteed by the subsidiaries of the Company. Therefore, the
lenders pursuant to the New Credit Agreement have a direct claim against the
assets of the Subsidiary Guarantors but the holders of the Notes have no such
claims.
23
<PAGE>
HISTORY OF UNPROFITABLE OPERATIONS
The Company experienced losses from continuing operations before
extraordinary items in each fiscal year from 1993 through 1995. Such losses
amounted to $39.6 million, $47.0 million and $43.0 million for the fiscal years
ended September 30, 1993, 1994 and 1995, respectively. Merit experienced losses
before cumulative effects of accounting changes in fiscal 1996 and 1997 of $16.9
million and $13.9 million, respectively. The Company reported net revenue and
net income of approximately $1.35 billion and $32.4 million, respectively, for
fiscal 1996 and net revenue and income before extraordinary items of
approximately $1.2 billion and $4.8 million, respectively, for fiscal 1997. The
Company's fiscal 1997 net income included a loss on the Crescent Transactions of
$35.9 million, net of taxes. There can be no assurance that the Company's
profitability will continue in future periods.
RESTRICTIVE FINANCING COVENANTS
The New Credit Agreement and the Indenture contain a number of covenants
that restrict the operations of the Company and its subsidiaries. In addition,
the New Credit Agreement requires the Company to comply with specified financial
ratios and tests, including a minimum interest coverage ratio, a maximum
leverage ratio, a minimum net worth test, a maximum senior debt ratio and a
minimum "EBITDA" (as defined in the New Credit Agreement). There can be no
assurance that the Company will be able to comply with such covenants, ratios
and tests in the future. The Company's ability to comply with such covenants,
ratios and tests may be affected by events beyond its control, including
prevailing economic, financial and industry conditions. The breach of any such
covenants, ratios or tests could result in a default under the New Credit
Agreement that would permit the lenders thereunder to declare all amounts
outstanding thereunder to be immediately due and payable, together with accrued
and unpaid interest, and to prevent the Company from paying principal, premium,
interest or other amounts due on any or all of the Notes until the default is
cured or all Senior Indebtedness is paid or satisfied in full. See "Description
of the Notes--Subordination." Furthermore, the commitments of the lenders under
the New Credit Agreement to make further extensions of credit thereunder could
be terminated. If the Company were unable to repay all amounts accelerated, the
lenders could proceed against the Subsidiary Guarantors and the collateral
securing the Company's and the Subsidiary Guarantors' obligations pursuant to
the New Credit Agreement. If the indebtedness outstanding pursuant to the New
Credit Agreement were to be accelerated, there can be no assurance that the
assets of the Company would be sufficient to repay such indebtedness and the
other indebtedness of the Company, including the Notes. See "Description of the
New Notes" and "Summary of New Credit Agreement."
CHANGE OF CONTROL
The occurrence of a Change of Control may result in a default, or otherwise
require repayment of indebtedness, under both the Indenture and the New Credit
Agreement. In addition, the New Credit Agreement prohibits the repayment of the
Notes by the Company upon the occurrence of a Change of Control, unless and
until such time as the indebtedness under the New Credit Agreement is repaid in
full. The Company's failure to make such repayments in such instances would
result in a default under both the Indenture and the New Credit Agreement.
Future indebtedness of the Company may also contain restrictions or repayment
requirements with respect to certain events or transactions that could
constitute a Change of Control. In the event of a Change of Control, there can
be no assurance that the Company would have sufficient assets to satisfy all of
its obligations under the Notes or the New Credit Agreement. See "Description of
the New Notes--Change of Control."
The provisions of the Indenture and the New Credit Agreement imposing
restrictions or repayment requirements with respect to a Change of Control, as
well as certain provisions of the Delaware General Corporation Law and the
Company's Amended and Restated Certificate of Incorporation and Amended and
Restated Bylaws, could have the effect of making it more difficult for a third
party to acquire, or of discouraging a third party from attempting to acquire,
control of the Company. Such provisions could
24
<PAGE>
limit the price that investors might be willing to pay in the future for Common
Stock which could in turn adversely affect the ability of the Company to sell
additional Common Stock.
RISK-BASED PRODUCTS
As a result of the Acquisition, revenues under risk-based contracts are the
primary source of the Company's revenue from its managed behavioral care
business. On a pro forma basis, such revenues would have accounted for
approximately 50% of the Company's total revenue and 73% of its managed
behavioral healthcare revenue in fiscal 1997. Under a risk-based contract, the
Company assumes all or a portion of the responsibility for the cost of providing
a full or specified range of behavioral healthcare treatment services to a
specified beneficiary population in exchange, generally, for a fixed fee per
member per month. In order for such contracts to be profitable, the Company must
accurately estimate the rate of service utilization by beneficiaries enrolled in
programs managed by the Company and control the unit cost of such services. If
the aggregate cost of behavioral healthcare treatment services provided to a
given beneficiary population in a given period exceeds the aggregate of the per
member per month fees received by the Company with respect to the beneficiary
population in such period, the Company will incur a loss with respect to such
beneficiary population during such period. Furthermore, the Company may be
required to pay during any period amounts with respect to behavioral healthcare
treatment services provided to a given beneficiary population that exceed per
member per month fees received with respect to such beneficiary population
during the same period. There can be no assurance that the Company's assumptions
as to service utilization rates and costs will accurately and adequately reflect
actual utilization rates and costs, nor can there be any assurance that
increases in behavioral healthcare costs or higher-than-anticipated utilization
rates, significant aspects of which are outside the Company's control, will not
cause expenses associated with such contracts to exceed the Company's revenue
for such contracts. In addition, there can be no assurance that adjustments will
not be required to the estimates, particularly those regarding cost of care,
made in reporting historical financial results. See Note 1 to the audited
historical consolidated financial statements of the Company included herein,
Note 4 to the audited historical consolidated financial statements of Merit
included herein and Note 1 to the audited historical consolidated financial
statements of HAI included herein. The Company will attempt to increase
membership in its risk-based products following the Acquisition. If the Company
is successful in this regard, the Company's exposure to potential losses from
its risk-based products will also be increased. Furthermore, certain of such
contracts and certain state regulations limit the profits that may be earned by
the Company on risk-based business and may require refunds if the loss
experience is more favorable than that originally anticipated. Such contracts
and regulations may also require the Company or certain of its subsidiaries to
reserve a specified amount of cash as financial assurance that it can meet its
obligations under such contracts. As of June 30, 1998, the Company had
restricted cash reserves of $60.5 million pursuant to such contracts and
regulations. Such amounts will not be available to the Company for general
corporate purposes. Furthermore, certain state regulations restrict the ability
of subsidiaries that offer risk-based products to pay dividends to the Company.
See "Business" and "Merit's Management's Discussion and Analysis of Financial
Condition and Results of Operations." Certain state regulations relating to the
licensing of insurance companies may also adversely affect the Company's
risk-based business. See "--Regulation." Although experience varies on a
contract-by-contract basis, historically, the Company's and Merit's risk-based
contracts have been profitable. However, the degree of profitability varies
significantly from contract to contract. For example, Medicaid contracts with
governmental entities tend to have direct profit margins that are lower than the
Company's other contracts. The most significant factor affecting the
profitability of risk-based contracts is the ability to control direct service
costs. The Company believes that it will be in a better position to control
direct service costs as a result of the HAI, Allied and Merit acquisitions.
25
<PAGE>
RELIANCE ON CUSTOMER CONTRACTS
On a pro forma basis, approximately 69% of the Company's revenue in fiscal
1997 would have been derived from contracts with payors of behavioral healthcare
benefits. The Company's managed care contracts typically have terms of one to
three years, and in certain cases contain renewal provisions providing for
successive terms of between one and two years (unless terminated earlier).
Substantially all of these contracts are immediately terminable with cause and
many, including some of the Company's most significant contracts, are terminable
without cause by the customer upon the provision of requisite notice and the
passage of a specified period of time (typically between 60 and 180 days), or
upon the occurrence of certain other specified events. See "Business." On a pro
forma basis, following the Company's acquisitions of Merit, HAI and Allied, the
Company's ten largest managed behavioral healthcare customers would have
accounted for approximately 47% of the Company's managed behavioral healthcare
revenue for fiscal 1997. One of such contracts, an agreement between HAI and
Aetna, represents 21% of the Company's pro forma covered lives and would have
represented 5% of its pro forma managed behavioral healthcare revenues for
fiscal 1997. The contract expires on December 3, 2003. There can be no assurance
that such contracts will be extended or successfully renegotiated or that the
terms of any new contracts will be comparable to those of existing contracts.
Loss of all of these contracts or customers would, and loss of any one of these
customers could, have a material adverse effect on the Company. In addition,
price competition in bidding for contracts can significantly affect the
financial terms of any new or renegotiated contract. The Company's customers may
reevaluate their contractual arrangements with the Company as a result of the
consummation of the Transactions.
DEPENDENCE ON GOVERNMENT SPENDING FOR MANAGED HEALTHCARE; POSSIBLE IMPACT OF
HEALTHCARE REFORM
A significant portion of the Company's managed care revenue is derived,
directly or indirectly, from federal, state and local governmental agencies,
including state Medicaid programs. Reimbursement rates vary from state to state,
are subject to periodic negotiation and may limit the Company's ability to
maintain or increase rates. The Company is unable to predict the impact on the
Company's operations of future regulations or legislation affecting Medicaid or
Medicare programs, or the healthcare industry in general, and there can be no
assurance that future regulations or legislation will not have a material
adverse effect on the Company. Moreover, any reduction in government spending
for such programs could also have a material adverse effect on the Company. In
addition, the Company's contracts with federal, state and local governmental
agencies, under both direct contract and subcontract arrangements, generally are
conditioned upon financial appropriations by one or more governmental agencies,
especially with respect to state Medicaid programs. These contracts generally
can be terminated or modified by the customer if such appropriations are not
made. Finally, some of the Company's contracts with federal, state and local
governmental agencies, under both direct contract and subcontract arrangements,
require the Company to perform additional services if federal, state or local
laws or regulations imposed after the contract is signed so require, in exchange
for additional compensation to be negotiated by the parties in good faith.
Government and other third-party payors are generally seeking to impose lower
reimbursement rates and to renegotiate reduced contract rates with service
providers in a trend toward cost control. See "Industry--Areas of Growth" and
"Business--Business Strategy."
In August 1997, Congress enacted the Balanced Budget Act of 1997 (the
"Budget Act"). The Medicare-related provisions of the Budget Act are designed to
reduce Medicare expenditures over the next five years by $115 billion, compared
to projected Medicare expenditures before adoption of the Budget Act. The
Congressional Budget Office projected in July 1997 that $43.8 billion of the
reductions would come from reduced payments to hospitals, $21.8 billion from
increased enrollment in managed care plans and $11.7 billion from reduced
payments to physicians and ambulatory care providers. The five-year savings in
projected Medicare payments to physicians and hospitals would be achieved under
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the Budget Act by reduced fee-for-service reimbursement and by changes in
managed care programs designed to increase enrollment of Medicare beneficiaries
in managed care plans. The increase in Medicare enrollment in managed care plans
would be achieved in part by allowing provider-sponsored organizations and
preferred provider organizations to compete with Medicare HMOs for Medicare
enrollees.
The Medicaid-related provisions of the Budget Act are designed to achieve
net federal Medicaid savings of $14.6 billion over the next five years and $56.4
billion over the next ten years. The Budget Act achieves federal Medicaid
savings in three areas. First, two-thirds of the savings over the next ten years
are attributable to limitations on federal matching payments to states for
reimbursements to "disproportionate share" hospitals. The next largest source of
federal savings is a provision allowing states to shift the cost of Medicaid
deductibles and coinsurance requirements for low-income Medicaid beneficiaries
from their Medicaid programs to physicians and other providers. Most of the
remaining savings derive from the repeal of the "Boren Amendment" and other
minimum payment guarantees for hospitals, nursing homes and community health
centers that serve Medicaid patients. These changes may have an adverse effect
on the Company if they result in reduced payment levels for providers of managed
behavioral healthcare services.
Prior to adoption of the Budget Act, the states were prohibited from
requiring Medicaid recipients to enroll in managed care products that covered
only Medicaid recipients. The Medicaid laws required that the states enroll
Medicaid recipients in products that also covered a specific number of
commercial enrollees. This requirement of the Medicaid laws was intended to
limit the ability of the states to reduce coverage levels for Medicaid
recipients below those offered to commercial enrollees. Under prior law, the
Secretary of the United States Department of Health and Human Services (the
"Department") could waive the prohibition. The Medicaid-related provisions of
the Budget Act give states broad flexibility to require most Medicaid recipients
to enroll in managed care products that only cover Medicaid recipients, without
obtaining a waiver from the Secretary of the Department that was required under
prior law. The Budget Act also allows states to limit the number of managed care
organizations with which the state will contract to deliver care to Medicaid
beneficiaries. These changes could have a positive impact on the Company's
business, if they result in increased enrollment of Medicaid beneficiaries in
managed care organizations and increased Medicaid spending on managed care.
However, these changes also may have an adverse effect on the Company if a
number of states decide to limit the number of managed care organizations with
which they will contract and to select the organization solely on the basis of
the cost of care, which could result in increased cost competition for state
contracts.
The Company cannot predict the effect of the Budget Act, or other healthcare
reform measures that may be adopted by Congress or state legislatures, on its
managed care operations and no assurance can be given that either the Budget Act
or other healthcare reform measures will not have an adverse effect on the
Company.
REGULATION
The managed healthcare industry and the provision of behavioral healthcare
services are subject to extensive and evolving state and federal regulation. The
Company is subject to certain state laws and regulations, including those
governing: (i) the licensing of insurance companies, HMOs, preferred provider
organizations ("PPOs"), third-party administrators ("TPAs") and companies
engaged in utilization review and (ii) the licensing of healthcare
professionals, including restrictions on business corporations from practicing,
controlling or exercising excessive influence over behavioral healthcare
services through the direct employment of psychiatrists or, in a few states,
psychologists and other behavioral healthcare professionals. In addition, the
Company is subject to certain federal laws as a result of the role the Company
assumes in connection with managing its customers' employee benefit plans. The
Company's managed care operations are also indirectly affected by regulations
applicable to the establishment and operation of behavioral healthcare clinics
and facilities.
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In many states, entities that assume risk under contracts with licensed
insurance companies or HMOs have not been considered by state regulators to be
conducting an insurance or HMO business. As a result, the Company has not sought
licensure as either an insurer or HMO in certain states. Regulators in some
states, however, have determined that risk assuming activity by entities that
are not themselves providers of care is an activity that requires some form of
licensure. There can be no assurance that other states in which the Company
operates will not adopt a similar view, thus requiring the Company to obtain
additional licenses. Such additional licensure might require the Company to
maintain minimum levels of deposits, net worth, capital, surplus or reserves, or
limit the Company's ability to pay dividends, make investments or repay
indebtedness. The imposition of these additional licensure requirements could
increase the Company's cost of doing business or delay the Company's conduct or
expansion of its business.
Regulators may impose operational restrictions on entities granted licenses
to operate as insurance companies or HMOs. For example, the DOC imposed certain
restrictions on the Company in connection with its issuance of an approval of
the Company's acquisition of HAI, including restrictions on the ability of the
California subsidiaries of HAI to fund the Company's operations in other states
and on the ability of the Company to make certain operational changes with
respect to HAI's California subsidiaries. The DOC imposed substantially
identical restrictions on the Company in connection with the Company's
acquisition of Merit. The Company does not believe such restrictions will
materially impact its integration plan.
In addition, utilization review and TPA activities conducted by the Company
are regulated by many states, which states impose requirements upon the Company
that increase its business costs. The Company believes that its TPA activities
performed for its self-insured employee benefit plan customers are exempt from
otherwise applicable state licensing or registration requirements based upon
federal preemption under the Employee Retirement Income Security Act of 1974, as
amended ("ERISA"), and has relied on this general principle in determining not
to seek licensure for certain of its activities in many states. Existing case
law is not uniform on the applicability of ERISA preemption with respect to
state regulation of utilization review or TPA activities. There can be no
assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states. See "Business--
Regulation--Insurance, HMO, and PPO Activities" and "--Utilization Review and
Third-Party Administrator Activities."
State regulatory agencies responsible for the administration and enforcement
of the laws and regulations to which the Company's operations are subject have
broad discretionary powers. A regulatory agency or a court in a state in which
the Company operates could take a position under existing or future laws or
regulations, or change its interpretation or enforcement practices with respect
thereto, that such laws or regulations apply to the Company differently than the
Company believes such laws and regulations apply or should be enforced. The
resultant compliance with, or revocation of, or failure to obtain, required
licenses and governmental approvals could result in significant alteration to
the Company's business operations, delays in the expansion of the Company's
business and lost business opportunities, any of which, under certain
circumstances, could have a material adverse effect on the Company. See
"Business--Regulation--General," "--Licensure," "--Insurance, HMO and PPO
Activities" and "--Utilization Review and Third-Party Administrator Activities."
The laws of some states limit the ability of a business corporation to
directly provide, control or exercise excessive influence over behavioral
healthcare services through the direct employment of psychiatrists,
psychologists, or other behavioral healthcare professionals. In addition, the
laws of some states prohibit psychiatrists, psychologists, or other healthcare
professionals from splitting fees with other persons or entities. These laws and
their interpretations vary from state to state and enforcement by the courts and
regulatory authorities may vary from state to state and may change over time.
The Company believes that its operations as currently conducted are in material
compliance with the applicable laws, however there can be no assurance that the
Company's existing operations and its
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contractual arrangements with psychiatrists, psychologists and other healthcare
professionals will not be successfully challenged under state laws prohibiting
fee splitting or the practice of a profession by an unlicensed entity, or that
the enforceability of such contractual arrangements will not be limited. The
Company believes that it could, if necessary, restructure its operations to
comply with changes in the interpretation or enforcement of such laws and
regulations, and that such restructuring would not have a material adverse
effect on its operations.
Several states in which the Company does business have adopted, or are
expected to adopt, "any willing provider" laws. Such laws typically impose upon
insurance companies, PPOs, HMOs or other types of third-party payors an
obligation to contract with, or pay for the services of, any healthcare provider
willing to meet the terms of the payor's contracts with similar providers.
Compliance with any willing provider laws could increase the Company's costs of
assembling and administering provider networks and could, therefore, have a
material adverse effect on its operations.
The Company's managed care operations are also generally affected by
regulations applicable to the operations of healthcare clinics and facilities.
See "Charter Advantage--Regulation."
INTEGRATION OF OPERATIONS
As a result of the Company's acquisition of Merit and HAI, the Company is
the largest provider of managed behavioral healthcare services in the United
States, according to the enrollment data reported in OPEN MINDS. The Company's
ability to operate its acquired managed care businesses successfully depends on
how well and how quickly it integrates the acquired businesses with its existing
operations. The Company expects to achieve approximately $60.0 million of cost
savings on an annual basis within eighteen months following the consummation of
the Acquisition. See "Magellan's Management's Discussion and Analysis of
Financial Condition and Results of Operations--Pro Forma Liquidity and Capital
Resources." However, as the Company implements the integration process, it may
need to implement enhanced operational, financial and information systems and
may require additional employees and management, operational and financial
resources. There can be no assurance that the Company will be able to implement
and maintain such operational, financial and information systems successfully or
successfully obtain, integrate and utilize the required employees and
management, operational and financial resources to achieve the successful
integration of the acquired businesses with its existing operations. Failure to
implement such systems successfully and to use such resources effectively could
have a material adverse effect on the Company. Furthermore, implementing such
operational, financial and information systems or obtaining such employees and
management could reduce the cost savings the Company expects to achieve. See
"Business--Business Strategy."
HIGHLY COMPETITIVE INDUSTRY
The industry in which the Company conducts its managed care business is
highly competitive. The Company competes with large insurance companies, HMOs,
PPOs, TPAs, provider groups and other managed care companies. Many of the
Company's competitors are significantly larger and have greater financial,
marketing and other resources than the Company, and some of the Company's
competitors provide a broader range of services. The Company may also encounter
substantial competition in the future from new market entrants. Many of the
Company's customers that are managed care companies may, in the future, seek to
provide managed behavioral healthcare services to their employees or subscribers
directly, rather than contracting with the Company for such services. See
"Business-- Competition."
RISKS RELATED TO AMORTIZATION OF INTANGIBLE ASSETS
The Company's total assets at June 30, 1998 reflect intangible assets of
approximately $1.18 billion. At June 30, 1998, net intangible assets were 61.9%
of total assets and 616.9% of total stockholders'
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equity. Intangible assets include goodwill of approximately $934.7 million,
which is amortized over 25 to 40 years, and other identifiable intangible assets
(primarily customer lists, provider networks and treatment protocols) of
approximately $242.4 million that are amortized over 5 to 25 years. The
amortization periods used by the Company may differ from those used by other
registrants. In addition, the Company may be required to shorten the
amortization period for intangible assets in future periods based on the
prospects of acquired companies. There can be no assurance that the value of
such assets will ever be realized by the Company. The Company evaluates, on a
regular basis, whether events and circumstances have occurred that indicate that
all or a portion of the carrying value of intangible assets may no longer be
recoverable, in which case a charge to earnings for impairment losses could
become necessary. Any determination requiring the write-off of a significant
portion of unamortized intangible assets would adversely affect the Company's
results of operations. A write-off of intangible assets could become necessary
if the anticipated undiscounted cash flows of an acquired company do not support
the carrying value of long-lived assets, including intangible assets. At
present, no evidence exists that would indicate impairment losses may be
necessary in future periods.
SUBORDINATION OF FRANCHISE FEES
The Company owns a 50% equity interest in CBHS, from which it receives the
Franchise Fees. The Franchise Fees represent a significant portion of the
Company's earnings and cash flows. The Franchise Fees payable to the Company by
CBHS are subordinated in right of payment to the $41.7 million annual base rent,
5% minimum escalator rent and, in certain circumstances, certain additional rent
due to Crescent. The Company is required to provide certain services to CBHS
under the Master Franchise Agreement whether or not CBHS pays the Franchise
Fees. However, the Company has no obligation to contribute additional capital or
make advances to CBHS . See "Charter Advantage -- Franchise Operations." If CBHS
encounters a decline in earnings or financial difficulties, such amounts due to
Crescent will be paid before any Franchise Fees are paid. The remainder of
CBHS's available cash will then be applied in such order of priority as CBHS may
determine, in the reasonable discretion of the CBHS governing board or, under
certain circumstances, the Company's representatives on such board, to all other
operating expenses of CBHS, including the current and accumulated Franchise
Fees. The Company will be entitled to pursue all available remedies for breach
of the Master Franchise Agreement, except that the Company does not have the
right to take any action that could reasonably be expected to force CBHS into
bankruptcy or receivership.
As a result of the Crescent Transactions, the Company no longer controls the
operations of the Psychiatric Hospital Facilities and other facilities operated
by CBHS. Accordingly, factors that the Company does not control will likely
influence the amount of the equity in the earnings of CBHS and the amount of
Franchise Fees that the Company will realize in the future. For example, CBHS
may pursue acquisitions in markets where it does not currently have a presence
and in markets where it has existing hospital operations. Furthermore, CBHS may
consolidate services in selected markets by closing additional facilities
depending on market conditions and evolving business strategies. If CBHS closes
additional psychiatric hospitals, it could result in charges to income for the
costs attributable to the closure, which would result in lower equity in
earnings of CBHS for the Company and receipt by the Company of less than the
agreed to amount of Franchise Fees.
Based on operational projections prepared by CBHS management for the quarter
ended September 30, 1998, and for the fiscal year ended September 30, 1999, and
on CBHS' results of operations through June 30, 1998, the Company believes that
CBHS will be unable to pay the full amount of the Franchise Fees it is
contractually obligated to pay the Company during fiscal 1998 and fiscal 1999.
CBHS has paid $30.6 million of Franchise Fees to the Company during the nine
months ended June 30, 1998. As of June 30, 1998, the Company had Franchise Fees
receivable from CBHS, net of equity in loss of CBHS in excess of the Company's
investment in CBHS, of approximately $13.2 million reflected in the consolidated
balance sheet. The Company expects to receive additional Franchise Fee payments
from
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CBHS of $9.4 million to $14.4 million during the quarter ended September 30,
1998, in the form of cash payments and settlements of other amounts due to CBHS.
The Company also estimates that CBHS will be able to pay $15.0 million to $25.0
million of Franchise Fees in fiscal 1999. Accordingly, the Company believes the
Franchise Fees receivable from CBHS, net of equity in loss of CBHS in excess of
the Company's investment in CBHS, at June 30, 1998, is fully collectible.
However, the Company may reflect Franchise Fee revenue in its statements of
operations for future periods which is lower in amount than that specified in
the Master Franchise Agreement if CBHS does not generate sufficient cash flows
to allow for payment of future Franchise Fees. Based on the amount of unpaid
Franchise Fees to date, the Company has exercised certain rights available to it
under the Master Franchise Agreement and is assisting CBHS management in
improving profitability. See "Charter Advantage--Franchise Operations."
On August 19, 1998, the Company announced that it had terminated discussions
with COI for the sale of its interests in CBHS. The Company will record a charge
against earnings in the fourth quarter of fiscal 1998 of approximately $1.5
million to $2.0 million for transaction costs incurred to date in connection
with the proposed sale of the Company's interests in CBHS to COI. In addition,
actions taken by CBHS in the fourth quarter of fiscal 1998 to improve long-term
profitability will result in immediate charges to CBHS income, which will result
in additional losses in the equity in loss of CBHS for the Company in the fourth
quarter of fiscal 1998. See "Magellan's Management's Discussion and Analysis of
Financial Condition and Results of Operations--Results of Operations--Impact of
Crescent Transactions."
The Company's relationship with CBHS and the business of CBHS are described
elsewhere in this Prospectus. Such information is relevant to an understanding
of the factors having a bearing on the Company's continued receipt of Franchise
Fees from CBHS.
PROFESSIONAL LIABILITY; INSURANCE
The management and administration of the delivery of managed behavioral
healthcare services, like other healthcare services, entail significant risks of
liability. The Company is regularly subject to lawsuits alleging malpractice and
related legal theories, some of which involve situations in which participants
in the Company's programs have committed suicide. The Company is also subject to
claims of professional liability for alleged negligence in performing
utilization review activities, as well as for acts and omissions of independent
contractors participating in the Company's third-party provider networks. The
Company is subject to claims for the costs of services denied. There can be no
assurance that the Company's procedures for limiting liability have been or will
be effective, or that one or more lawsuits will not have a material adverse
effect on the Company in the future. See "Business --Legal Proceedings."
The Company carries professional liability insurance, subject to certain
deductibles. There can be no assurance that such insurance will be sufficient to
cover any judgments, settlements or costs relating to present or future claims,
suits or complaints or that, upon expiration thereof, sufficient insurance will
be available on favorable terms, if at all. If the Company is unable to secure
adequate insurance in the future, or if the insurance carried by the Company is
not sufficient to cover any judgments, settlements or costs relating to any
present or future actions or claims, there can be no assurance that the Company
will not be subject to a liability that could have a material adverse effect on
the Company. See "Business-Insurance."
The Company has certain liabilities relating to the self-insurance program
it maintained with respect to its provider business prior to the Crescent
Transactions. See Note 13 to the Company's audited historical consolidated
financial statements included elsewhere herein.
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FRAUDULENT TRANSFER CONSIDERATIONS
If, in a bankruptcy or reorganization case or a lawsuit by or on behalf of
unpaid creditors of the Company, a court were to find that, at the time the
Company incurred indebtedness under the Notes, (i) the Company incurred such
indebtedness with the intent of hindering, delaying or defrauding current or
future creditors or (ii) (a) the Company received less than reasonably
equivalent value or fair consideration for incurring such indebtedness and (b)
the Company (1) was insolvent or was rendered insolvent by reason of such
incurrence, (2) was engaged, or about to engage, in a business or transaction
for which its assets constituted unreasonably small capital, (3) intended to
incur, or believed that it would incur, debts beyond its ability to pay such
debts as they matured (as all of the foregoing terms are defined in or
interpreted under the relevant fraudulent transfer or conveyance statutes) or
(4) was a defendant in an action for money damages, or had a judgment for money
damages docketed against it (if, in either case, after final judgment, the
judgment is unsatisfied), then such court could avoid or subordinate the
Company's obligations under the Notes to presently existing and future
indebtedness of the Company and take other actions detrimental to the holders of
the Notes.
The measures of insolvency for purposes of the foregoing considerations will
vary depending upon the law of the jurisdiction that is being applied in any
such proceeding. Generally, however, the Company would be considered insolvent
if, at the time it incurred the indebtedness, either (i) the sum of its debts
(including contingent liabilities) is greater than its assets, at a fair
valuation, or (ii) the present fair saleable value of its assets is less than
the amount required to pay the probable liability on its total existing debts
and liabilities (including contingent liabilities) as they become absolute and
matured. There can be no assurance as to what standards a court would use to
determine whether the Company was solvent at the relevant time, or whether,
whatever standard was used, the Company's obligations with respect to the Notes
would not be avoided or further subordinated on the grounds set forth above.
Counsel for the Company and counsel for the Initial Purchaser will not express
any opinion as to the applicability of federal or state fraudulent transfer and
conveyance laws.
The Company believes that at the time the Old Notes were issued, the Company
(i) was (a) neither insolvent nor rendered insolvent thereby, (b) in possession
of sufficient capital to run its businesses effectively and (c) incurring debts
within its ability to pay as the same mature or become due and (ii) had
sufficient assets to satisfy any probable money judgment against it in any
pending action. There can be no assurance, however, that a court passing on such
question would reach the same conclusions.
Additionally, under federal bankruptcy or applicable state insolvency law,
if certain bankruptcy or insolvency proceedings were initiated by or against the
Company within 90 days after any payment by the Company with respect to the
Notes or if the Company anticipated becoming insolvent at the time of such
payment or incurrence, all or a portion of such payment could be avoided as a
preferential transfer and the recipient of such payment could be required to
return such payment.
ABSENCE OF TRADING MARKETS
The Old Notes are currently owned by a relatively small number of
institutional investors. The Company believes that none of such holders is an
affiliate (as defined in Rule 405 under the Securities Act) of the Company.
Prior to the Exchange Offer, no public market for the Old Notes will exist,
although the Old Notes are eligible for trading in the PORTAL Market among
"qualified institutional buyers." The New Notes will not be listed on any
securities exchange. There can be no assurance that an active trading market for
the Notes will develop. Future trading prices of the Notes will depend on many
factors, including, among other things, prevailing interest rates, the Company's
results of operations and the market for similar securities. Depending on
prevailing interest rates, the markets for similar securities and other factors,
including the financial condition of the Company, the Notes may trade at a
discount from their principal amount.
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RESTRICTIONS ON TRANSFER OF THE NOTES
The Old Notes have not been registered under the Securities Act and will
remain subject to restrictions on transferability to the extent they are not
exchanged for New Notes by holders who are entitled to participate in the
Exchange Offer. The holders of Old Notes who are not eligible to participate in
the Exchange Offer are entitled to certain registration rights, and the Company
is required to file the Shelf Registration Statement with respect to resales
from time to time of any such Old Notes.
EXCHANGE OFFER PROCEDURES
Issuance of the New Notes in exchange for the Old Notes pursuant to the
Exchange Offer will be made only after timely receipt by the Exchange Agent of
such Old Notes, a properly completed and duly executed Letter of Transmittal and
all other required documents. Therefore, holders of the Old Notes desiring to
tender such Old Notes in exchange for New Notes should allow sufficient time to
ensure timely delivery. The Company is under no duty to give notification of
defects or irregularities with respect to tenders of Old Notes for exchange. Old
Notes that are not tendered or that are tendered but not accepted by the Company
for exchange will, following consummation of the Exchange Offer, continue to be
subject to the existing restrictions upon transfer thereof under the Securities
Act and, upon consummation of the Exchange Offer, certain registration rights
under the Registration Rights Agreement will terminate. In addition, any holder
of Old Notes who tenders in the Exchange Offer for the purpose of participating
in a public distribution of the New Notes may be deemed to be an "underwriter"
(within the meaning of Section 2(11) of the Securities Act) of the New Notes
and, if so, will be required to comply with the registration and prospectus
delivery requirements in the Securities Act in connection with any resale
transaction. Each broker-dealer that receives New Notes for its own account in
exchange for Old Notes, where such Old Notes were acquired by such broker-dealer
as result of market-making activities or other trading activities, must
acknowledge in the Letter of Transmittal that accompanies this Prospectus that
it will deliver a prospectus in connection with any resale of such New Notes.
See "Plan of Distribution." To the extent that Old Notes are tendered and
accepted in the Exchange Offer, the trading market for untendered and tendered
but unaccepted Old Notes could be adversely affected. See "The Exchange Offer."
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THE TRANSACTIONS
GENERAL
The Transactions, all of which were consummated on February 12, 1998,
consist of the following: (i) the Acquisition; (ii) the repayment of all amounts
outstanding pursuant to, and the termination of, the Existing Credit Agreements;
(iii) the consummation of the Debt Tender Offers; (iv) the execution and
delivery of, and initial borrowings under, the New Credit Agreement; and (v) the
issuance of the Old Notes. The Transactions are described in more detail below.
THE ACQUISITION
On February 12, 1998, the Company consummated the Acquisition of Merit
pursuant to an Agreement and Plan of Merger, dated October 24, 1997 (the "Merger
Agreement"), between the Company and Merit. Under the Merger Agreement, Merit
became a wholly-owned subsidiary of the Company and the Company paid an amount
of cash equal to approximately $448.9 million at the closing (the "Direct Cash
Merger Consideration"). Upon consumation of the Acquisition, pursuant to the
Merger Agreement, the Company caused Merit to repay all amounts outstanding
under the Merit Existing Credit Agreement and to perform Merit's obligations
under the indenture governing the Merit Outstanding Notes to offer to purchase
the Merit Outstanding Notes following the consummation of the Acquisition.
Pursuant to the Merger Agreement, the Company provided sufficient funds to
permit Merit to take such actions. The Company estimates that the total
consideration it paid to acquire Merit and to retire Merit's outstanding
indebtedness (net of cash) was approximately $750 million, excluding transaction
costs.
Pursuant to the Merger Agreement, Merit made representations and warranties
customary for transactions of this type. None of Merit's representations and
warranties and agreements survived the consummation of the Acquisition.
Therefore, if any of the representations and warranties prove to be inaccurate,
the Company will not be able to recover from Merit's former owners the amount of
any damage resulting from the inaccuracy.
TERMINATION OF EXISTING CREDIT AGREEMENTS
It was a condition to Chase's obligation to advance loans pursuant to the
New Credit Agreement that the Magellan Existing Credit Agreement be terminated.
Furthermore, Magellan agreed, in connection with the Acquisition, to repay all
amounts outstanding pursuant to the Merit Existing Credit Agreement. Such
transactions were consummated simultaneously with the Offering.
DESCRIPTION OF MAGELLAN EXISTING CREDIT AGREEMENT. The Magellan Existing
Credit Agreement was that certain Amended and Restated Credit Agreement, dated
as of June 16, 1997, among the Company, Charter Behavioral Health System of New
Mexico, Inc., the lenders named therein, Chase, as administrative agent, and
First Union National Bank, as syndication agent. Simultaneously with the
consummation of the offering of the Old Notes, the Magellan Existing Credit
Agreement was terminated. The Magellan Existing Credit Agreement provided for a
five-year senior secured revolving credit facility in an aggregate committed
amount of $200 million and also provided for the support of letters of credit
for general corporate purposes. At December 31, 1997, there were no loans
outstanding under the Magellan Existing Credit Agreement other than one letter
of credit issued in the amount of approximately $6.6 million. Loans outstanding
under the Magellan Existing Credit Agreement bore interest (subject to certain
potential adjustments) at a rate per annum equal to one, two, three or six-month
LIBOR plus 1.25% or a specified "alternate base rate", plus 0.25%.
DESCRIPTION OF MERIT EXISTING CREDIT AGREEMENT. The Merit Existing Credit
Agreement was that certain Credit Agreement, dated as of October 6, 1995, among
Merit, the lenders named therein and Chase, as agent. Simultaneously with the
consummation of the Offering, the Merit Existing Credit Agreement was
terminated. The Merit Existing Credit Agreement provided for: (i) a six and
one-half year senior secured revolving credit facility in an aggregate committed
amount of $85 million and also provided for the support of letters of credit for
general corporate purposes; (ii) a six and one-half year
34
<PAGE>
senior term loan facility in the amount of $70.0 million; and (iii) a nine and
one-half year senior term loan facility in the amount of $130.0 million. At
September 30, 1997, $30.0 million of revolving loans and three letters of credit
totaling approximately $8.0 million were outstanding under the revolving credit
faciliity and an aggregate of approximately $200.0 million was outstanding under
the term loan facilities. Loans outstanding under the Merit Existing Credit
Agreement bore interest at floating rates, which were, at Merit's option based
upon (i) the higher of the Federal Funds rate plus 0.5%, or bank prime rates, or
(ii) Eurodollar rates, subject to certain adjustments.
DEBT TENDER OFFERS
The Company agreed, in connection with the Acquisition, to pay on behalf of
Merit an amount sufficient to permit Merit to repurchase the Merit Outstanding
Notes. Furthermore, borrowings pursuant to the New Credit Agreement and the Old
Notes required to effect the Transactions would have resulted in events of
default with respect to the Outstanding Notes. Accordingly, the Company and
Merit conducted tender offers for the Outstanding Notes. All but $105,000 of the
$375.0 million of Magellan Outstanding Notes and all but $35,000 of the $100.0
million of Merit Outstanding Notes were tendered in response to the Debt Tender
Offers. Upon consummation of the Debt Tender Offers, the Company paid $1,115.69
plus accrued interest per $1,000 principal amount of Magellan Outstanding Notes
tendered and $1,189.14 plus accrued interest per $1,000 principal amount of
Merit Outstanding Notes tendered. Outstanding Notes that were not tendered
remain outstanding and are general unsecured obligations of the Company or
Merit, as the case may be.
THE NEW CREDIT AGREEMENT
On February 12, 1998 the Company entered into the New Credit Agreement with
Chase pursuant to which Chase made available to the Company credit facilities of
$700.0 million. See "Summary of New Credit Agreement."
The following table sets forth the sources and uses of funds for the
Transactions (in millions):
<TABLE>
<S> <C>
SOURCES:
Cash and cash equivalents........................................ $ 59.3
New Credit Agreement:
Revolving Facility(1).......................................... 20.0
Term Loan Facility............................................. 550.0
Notes offered hereby............................................. 625.0
--------
Total sources................................................ $ 1,254.3
--------
--------
USES:
Direct Cash Merger Consideration................................. $ 448.9
Repayment of Merit Existing Credit Agreement(2).................. 196.4
Purchase of Magellan Outstanding Notes(3)........................ 432.1
Purchase of Merit Outstanding Notes(4)........................... 121.6
Transaction costs(5)............................................. 55.3
--------
Total uses................................................... $ 1,254.3
--------
--------
</TABLE>
-------------------------------
(1) The Revolving Facility provides for borrowings of up to $150 million.
As of February 12, 1998, the Company had approximately $112.5 million
available for borrowing pursuant to the Revolving Facility, excluding
approximately $17.5 million of availability reserved for certain
letters of credit.
(2) Includes principal amount of $193.6 million and accrued interest of
$2.7 million.
(3) Includes principal amount of $375.0 million, tender premium of $43.4
million and accrued interest of $13.7 million.
(4) Includes principal amount of $100.0 million, tender premium of $18.9
million and accrued interest of $2.8 million.
(5) Transaction costs include, among other things, costs paid at closing
associated with the Debt Tender Offers, the Old Notes offering, the
Acquisition and the New Credit Agreement.
35
<PAGE>
USE OF PROCEEDS
The Exchange Offer is intended to satisfy certain of the Company's
obligations under the Registration Rights Agreement. The Company will not
receive any cash proceeds from the issuance of the New Notes offered hereby. In
consideration for issuing the New Notes contemplated in this Prospectus, the
Company will receive in exchange Old Notes in like principal amount, the form
and terms of which are the same as the form and terms of the New Notes, except
as otherwise described herein. The Old Notes surrendered in exchange for New
Notes will be retired and cancelled and cannot be reissued. Accordingly,
issuance of the New Notes will not result in any increase or decrease in the
indebtedness of the Company.
The proceeds from the sale of the Old Notes, net of transaction costs, were
approximately $606.8 million. The net proceeds were used as a portion of the
cash consideration paid by the Company to consummate the other Transactions.
36
<PAGE>
CAPITALIZATION
The following table sets forth the capitalization of the Company at June 30,
1998. The information in this table should be read in conjunction with
"Unaudited Pro Forma Consolidated Financial Information," "The Transactions,"
"Summary of New Credit Agreement," "Magellan's Management's Discussion and
Analysis of Financial Condition and Results of Operations" and the financial
statements and the notes thereto appearing elsewhere in this Prospectus.
<TABLE>
<S> <C>
Total debt (including current maturities):
New Credit Agreement:
Revolving Facility(1).............................................. $ 20,000
Term Loan Facility(2).............................................. 550,000
Notes offered hereby................................................. 625,000
Other(3)............................................................. 10,716
----------
Total debt......................................................... 1,205,716
Stockholders' equity(4).............................................. 190,795
----------
Total capitalization............................................... $1,396,511
----------
----------
</TABLE>
-------------------------------
(1) The Revolving Facility provides for borrowings of up to $150.0
million. As of June 30, 1998, the Company would have had approximately
$112.5 million available under the Revolving Facility, excluding
approximately $17.5 million of availability reserved for certain
letters of credit. The Company borrowed $20.0 million pursuant to the
Revolving Facility upon consummation of the Transactions.
(2) The Term Loan Facility consists of: (i) a 6 year term loan facility
(the "Tranche A Term Loan"); (ii) a 7 year term loan facility (the
"Tranche B Term Loan"); and (iii) an 8 year term loan facility (the
"Tranche C Term Loan"), each in an aggregate principal amount of
approximately $183.3 million.
(3) Other debt consists primarily of: $4.3 million of mortgages and other
notes payable through 2005, bearing interest at 6.7% to 11.5%; and
(ii) $6.4 million in 3.9% capital lease obligations due in 2014.
(4) Represents the historical book value of the Company's stockholders'
equity. The Company's Common Stock is publicly traded on The New York
Stock Exchange. As of October 2, 1998, the market value of the
Company's Common Stock was approximately $324.0 million.
37
<PAGE>
MAGELLAN SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
The following table sets forth selected historical consolidated financial
information of the Company for each of the five years in the period ended
September 30, 1997 and for the nine months ended June 30, 1997 and 1998. In
1993, the Company restated its consolidated financial statements to reflect the
sale of certain subsidiaries as discontinued operations. The summary of
operations and balance sheet data for the five years ended and as of September
30, 1997, presented below, have been derived from, and should be read in
conjunction with, the Company's audited consolidated financial statements and
the notes thereto. Selected consolidated financial information for the nine
months ended June 30, 1997 and 1998 has been derived from unaudited consolidated
financial statements and, in the opinion of management, includes all adjustments
(consisting only of normal recurring adjustments) that are necessary for a fair
presentation of the operating results for such interim periods. Results for the
interim periods are not necessarily indicative of the results for the full year
or for any future periods. The selected financial data set forth below should be
read in conjunction with the Company's consolidated financial statements and the
notes thereto and "Magellan's Management's Discussion and Analysis of Financial
Condition and Results of Operations" appearing elsewhere herein.
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEAR ENDED SEPTEMBER 30, JUNE 30,
-------------------------------------------------------- ----------------------
1993 1994 1995 1996 1997 1997 1998
--------- --------- ---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
STATEMENT OF OPERATIONS DATA:
Net revenue....................... $ 897,907 $ 904,646 $1,151,736 $1,345,279 $1,210,696 $1,021,662 $1,063,099
Salaries, cost of care and other
operating expenses.............. 640,847 661,436 863,598 1,064,445 978,513 830,248 909,353
Bad debt expense.................. 67,300 70,623 92,022 81,470 46,211 47,456 2,972
Depreciation and amortization..... 26,382 28,354 38,087 48,924 44,861 38,231 37,649
Amortization of reorganization
value in excess of amounts
allocable to identifiable
assets.......................... 42,678 31,200 26,000 -- -- -- --
Interest, net..................... 74,156 39,394 55,237 48,017 45,377 39,324 49,336
ESOP expense...................... 45,874 49,197 73,527 -- -- -- --
Stock option expense (credit)..... 38,416 10,614 (467) 914 4,292 3,214 (3,527)
Managed Care integration costs.... -- -- -- -- -- -- 12,314
Equity in loss of CBHS............ -- -- -- -- 8,122 399 24,221
Loss on Crescent Transactions..... -- -- -- -- 59,868 59,868 --
Unusual items, net................ -- 71,287 57,437 37,271 357 357 (3,000)
Income (loss) from continuing
operations before income taxes,
minority interest and
extraordinary items............. (37,746) (57,459) (53,705) 64,238 23,095 2,565 33,781
Provision for (benefit from)
income taxes.................... 1,874 (10,504) (11,082) 25,695 9,238 1,025 15,972
Income (loss) from continuing
operations before minority
interest and extraordinary
items........................... (39,620) (46,955) (42,623) 38,543 13,857 1,540 17,809
Minority interest................. -- 48 340 6,160 9,102 6,948 5,063
Income (loss) before discontinued
operations and extraordinary
items........................... (39,620) (47,003) (42,963) 32,383 4,755 (5,408) 12,746
Discontinued operations:
Loss from discontinued
operations...................... (14,703) -- -- -- -- -- --
Gain on disposal of discontinued
operations.................... 10,657 -- -- -- -- -- --
Income (loss) before extraordinary
items........................... (43,666) (47,003) (42,963) 32,383 4,755 (5,408) 12,746
Extraordinary items-losses on
early extinguishments or
discharge of debt............... (8,561) (12,616) -- -- (5,253) (5,253) (33,015)
Net income (loss)................. $ (52,227) $ (59,619) $ (42,963) $ 32,383 $ (498) $ (10,661) $ (20,269)
</TABLE>
38
<PAGE>
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEAR ENDED SEPTEMBER 30, JUNE 30,
-------------------------------------------------------- ----------------------
1993 1994 1995 1996 1997 1997 1998
--------- --------- ---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
INCOME (LOSS) PER COMMON
SHARE--BASIC:
Income (loss) from continuing
operations before extraordinary
items........................... $ (1.59) $ (1.78) $ (1.54) $ 1.04 $ 0.17 $ (0.19) $ 0.42
Loss from discontinued operations
and disposal of discontinued
operations...................... (0.16) -- -- -- -- -- --
Income (loss) before extraordinary
items........................... (1.75) (1.78) (1.54) 1.04 0.17 (0.19) 0.42
Net Income (loss)................. $ (2.10) $ (2.26) $ (1.54) $ 1.04 $ (0.02) $ (0.37) $ (0.66)
INCOME (LOSS) PER COMMON
SHARE--DILUTED:
Income (loss) from continuing
operations before extraordinary
items........................... $ (1.59) $ (1.78) $ (1.54) $ 1.02 $ 0.16 $ (0.19) $ 0.41
Loss from discontinued operations
and disposal of discontinued
operations...................... (0.16) -- -- -- -- -- --
Income (loss) before extraordinary
items........................... (1.75) (1.78) (1.54) 1.02 0.16 (0.19) 0.41
Net income (loss)................. $ (2.10) $ (2.26) $ (1.54) $ 1.02 $ (0.02) $ (0.37) $ (0.65)
Ratio (deficiency) of earnings to
fixed charges................... $ (37,746) $ (57,459) $ (53,518) 1.98 1.41
BALANCE SHEET DATA (END OF
PERIOD):
Current assets.................... $ 231,915 $ 324,627 $ 305,575 $ 338,150 $ 507,038 $ 389,378
Current liabilities............... 272,598 215,048 214,162 274,316 219,376 440,399
Property and equipment, net....... 444,786 494,345 488,767 495,390 109,214 177,716
Total assets...................... 838,186 961,480 983,558 1,140,137 895,620 1,902,211
Total debt and capital lease
obligations..................... 421,162 536,129 541,569 572,058 395,294 1,205,716
Stockholders' equity.............. 57,298 56,221 88,560 121,817 158,250 190,795
</TABLE>
39
<PAGE>
MERIT SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
The following selected historical financial data were derived from, and
should be read in conjunction with, the historical consolidated financial
statements of Merit, including the notes thereto. The historical consolidated
financial statements of the Predecessor for the fiscal year ended September 30,
1993 and the period from October 1, 1993 through November 17, 1993 and of Merit
for the period from November 18, 1993 through September 30, 1994 and for the
fiscal years ended September 30, 1995, 1996 and 1997 are audited. The historical
consolidated financial statements for the three months ended December 31, 1996
and 1997 and as of December 31, 1997 are unaudited. In the opinion of
management, all necessary adjustments (consisting only of normal recurring
adjustments) have been made to present fairly the consolidated financial
position and results of operations and cash flows for these periods. The results
of operations for the period ended December 31, 1997 are not necessarily
indicative of the expected results for the year ending September 30, 1998. See
"Merit's Management's Discussion and Analysis of Financial Condition and Results
of Operations."
<TABLE>
<CAPTION>
PREDECESSOR(6) MERIT
------------------------------ -------------------------------------------------------
FISCAL YEAR NOV. 18, 1993 FISCAL YEAR FISCAL YEAR
ENDED OCT. 1-NOV. TO ENDED ENDED
SEPT. 30, 1993 17, 1993 SEPT. 30, 1994 SEPT. 30, 1995 SEPT. 30, 1996
--------------- ------------- ----------------- ----------------- -----------------
(DOLLARS IN MILLIONS)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue....................... $ 197.4 $ 31.0 $ 245.9 $ 361.5 $ 457.8
Operating expenses(1)......... 180.5 29.3 225.4 335.8 426.2
Amortization of intangibles... 1.8 0.3 17.1 21.4 25.8
Restructuring charge.......... 1.7 -- -- -- 3.0
Income from joint ventures.... -- -- -- -- --
------- ------ ------- ------- -------
Operating income(2)........... 13.4 1.4 3.4 4.3 2.8
Other (income) (3)............ (0.6) (0.1) (0.8) (1.5) (2.8)
Interest expense.............. 23.8
Loss on disposal of
subsidiary..................
Merger costs and special
charges..................... 2.4 -- -- -- 4.0
------- ------ ------- ------- -------
Income (loss) before income
taxes and cumulative effect
of accounting change........ 11.6 1.5 4.2 5.8 (22.2)
Provision (benefit) for income
taxes....................... 6.1 0.6 2.1 4.5 (5.3)
------- ------ ------- ------- -------
Income (loss) before
cumulative effect of
accounting change........... 5.5 0.9 2.1 1.3 (16.9)
Cumulative effect of
accounting change(4)........ -- -- -- -- (1.0)
------- ------ ------- ------- -------
Net income (loss)............. $ 5.5 $ 0.9 $ 2.1 $ 1.3 $ (17.9)
------- ------ ------- ------- -------
------- ------ ------- ------- -------
BALANCE SHEET DATA (END OF PERIOD):
Cash and cash equivalents,
short-term marketable
securities and restricted
cash and investments(5)..... $ 21.9 $ 32.7 $ 34.1 $ 53.0
Total assets.................. 91.9 259.3 305.4 344.8
Due to parent (non-interest
bearing).................... 5.9 37.9 70.8 --
Total debt.................... -- -- -- 254.0
Stockholders' equity
(deficit)................... 47.0 121.0 122.3 (29.5)
<CAPTION>
THREE MONTHS ENDED
DECEMBER 31,
--------------------
FISCAL YEAR
ENDED
SEPT. 30, 1997 1996 1997
----------------- --------- ---------
<S> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue....................... $ 555.7 $ 128.6 $ 177.2
Operating expenses(1)......... 517.0 119.5 168.1
Amortization of intangibles... 26.9 6.8 7.2
Restructuring charge.......... -- -- --
Income from joint ventures.... -- -- (1.6)
------- --------- ---------
Operating income(2)........... 11.8 2.3 3.5
Other (income) (3)............ (3.5) (0.8) (1.1)
Interest expense.............. 25.1 6.2 7.2
Loss on disposal of
subsidiary.................. 6.9 -- --
Merger costs and special
charges..................... 1.3 -- 0.5
------- --------- ---------
Income (loss) before income
taxes and cumulative effect
of accounting change........ (18.0) (3.1) (3.1)
Provision (benefit) for income
taxes....................... (4.1) (0.2) (0.4)
------- --------- ---------
Income (loss) before
cumulative effect of
accounting change........... (13.9) (2.9) (2.7)
Cumulative effect of
accounting change(4)........ -- -- --
------- --------- ---------
Net income (loss)............. $ (13.9) $ (2.9) $ (2.7)
------- --------- ---------
------- --------- ---------
BALANCE SHEET DATA (END OF PER
Cash and cash equivalents,
short-term marketable
securities and restricted
cash and investments(5)..... $ 95.2 $ 83.8
Total assets.................. 468.7 451.5
Due to parent (non-interest
bearing).................... -- --
Total debt.................... 329.5 319.3
Stockholders' equity
(deficit)................... (25.9) (26.9)
</TABLE>
- ----------------------------------
(1) Represents the sum of direct service costs and selling, general and
administrative expenses.
(2) Operating income equals income before income taxes, the cumulative effect of
accounting changes, interest expense, other income and expense and merger
costs and special charges and loss on disposal of subsidiary.
(3) Represents primarily interest income.
(4) Effective October 1, 1995, Merit changed its method of accounting for
deferred start-up costs related to new contracts or expansion of existing
contracts: (i) to expense costs relating to start-up activities incurred
after commencement of services under the contract, and (ii) to limit the
amortization period for deferred start-up costs to the initial contract
period. Prior to October 1, 1995, Merit capitalized start-up costs related
to the completion of the provider networks and reporting systems beyond
commencement of contracts and, in limited instances, amortized the start-up
costs over a period that included the initial renewal term associated with
the contract. Under the new policy, Merit does not defer contract start-up
costs after contract commencement. The change was made to increase the focus
on controlling costs associated with contract start-ups. Merit recorded a
pre-tax charge of $1.8 million ($1.0 million after taxes) in its fiscal 1996
results of operations as a cumulative effect of the change in accounting.
Had Merit adopted this accounting principle in the prior year, fiscal 1995
net income would have been $0.3 million. There was no pro forma effect of
this change on Merit's fiscal years prior to 1995.
(5) Includes restricted cash and short-term marketable securities classified as
a long-term asset. See "Merit's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources--Cash
in Claims Funds and Restricted Cash."
(6) On November 18, 1993, Merck & Co., Inc. acquired all of the outstanding
shares of Medco Containment in a transaction accounted for by the purchase
method. The amounts related to periods prior to November 18, 1993, were
derived from predecessor company financial statements. The historical cost
basis of the predecessor company differs from that of Merit due to the
allocation of a portion of the total purchase price of Medco Containment to
Merit's assets and liabilities.
40
<PAGE>
UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
The Unaudited Pro Forma Consolidated Financial Information set forth below
is based on the historical presentation of the consolidated financial statements
of Magellan, and the historical operating results of HAI, Allied, Merit, CMG,
and CBHS. The Unaudited Pro Forma Consolidated Statements of Operations for the
year ended September 30, 1997 and the nine months ended June 30, 1998 give
effect to the Crescent Transactions (1997 only), the HAI acquisition, the Allied
acquisition, the Green Spring Minority Shareholder Conversion, Merit's
acquisition of CMG and the Transactions as if they had been consummated on
October 1, 1996.
The Unaudited Pro Forma Consolidated Statements of Operations do not give
effect to hospital acquisitions and closures during the year ended September 30,
1997 as such transactions and events are not considered material to the pro
forma presentation. The Unaudited Pro Forma Consolidated Statements of
Operations presentation assumes that the net proceeds from the Crescent
Transactions, after debt repayment of approximately $200 million, were fully
utilized to fund the HAI acquisition and the Allied acquisition. The Unaudited
Pro Forma Consolidated Statement of Operations for the year ended September 30,
1997 excludes the non-recurring losses incurred by the Company as a result of
the Crescent Transactions.
The Unaudited Pro Forma Consolidated Financial Information does not purport
to be indicative of the results that actually would have been obtained if the
operations had been conducted as presented and they are not necessarily
indicative of operating results to be expected in future periods. The business
of CBHS is seasonal in nature with a reduced demand for certain services
generally occurring in the first fiscal quarter around major holidays, such as
Thanksgiving and Christmas, and during the summer months comprising the fourth
fiscal quarter. Accordingly, the Unaudited Pro Forma Statement of Operations for
the nine months ended June 30, 1998 is not necessarily indicative of the pro
forma results expected for a full year. The Unaudited Pro Forma Statements of
Operations excludes approximately $60.0 million of cost savings on an annual
basis that the Company expects to achieve within eighteen months following
consummation of the Acquisition. The Unaudited Pro Forma Consolidated Statement
of Operations for the nine months ended June 30, 1998 also excludes managed care
integration costs of $12.3 million that were directly attributable to the
acquisitions described herein. The Unaudited Pro Forma Consolidated Financial
Information and notes thereto should be read in conjunction with the historical
consolidated financial statements and notes thereto of Magellan, Merit, CBHS and
HAI, which appear elsewhere herein, and Management's Discussion and Analysis of
Financial Condition and Results of Operations of Magellan and Merit, which
appear elsewhere herein.
The following is a description of each of the transactions (other than the
Transactions, which are described elsewhere herein) reflected in the pro forma
presentation:
CRESCENT TRANSACTIONS. The Crescent Transactions, which were consummated on
June 17, 1997, resulted in, among other things: (i) the sale of the Psychiatric
Hospital Facilities to Crescent for $417.2 million (before costs of
approximately $16.0 million); (ii) the creation of CBHS, which is 50% owned by
the Company and engages in the behavioral healthcare provider business; (iii)
the Company's entry into the healthcare franchising business; and (iv) the
issuance by Magellan of 2,566,622 warrants to Crescent and COI (1,283,311
warrants each) with an exercise price of $30 per share. CBHS leases the
Psychiatric Hospital Facilities from Crescent under a twelve-year operating
lease (the "Facilities Lease") (subject to renewal) for $41.7 million annually,
subject to adjustment, with a 5% escalator, compounded annually plus certain
additional rent. The warrants issued to Crescent and COI have been valued at
$25.0 million in the Company's balance sheet. See "Charter Advantage." The
Company accounts for its 50% investment in CBHS under the equity method of
accounting, which significantly reduces the revenues and related operating
expenses presented in the Unaudited Pro Forma Consolidated Statements of
Operations. "Divested Operations--Crescent Transactions" in the Unaudited Pro
Forma
41
<PAGE>
Consolidated Statement of Operations represents the results of operations of the
businesses that are operated by CBHS.
The Company incurred a loss before income taxes, minority interest and
extraordinary items of approximately $59.9 million as a result of the Crescent
Transactions, which was recorded during fiscal 1997.
HAI ACQUISITION. On December 4, 1997, the Company consummated the purchase
of HAI, formerly a unit of Aetna, for approximately $122.1 million. HAI manages
the care of over 16.3 million covered lives, primarily through EAPs and other
managed behavioral healthcare plans. The Company funded the acquisition of HAI
with cash on hand and accounted for the acquisition of HAI using the purchase
method of accounting. The Company may be required to make additional contingent
payments of up to $60.0 million annually to Aetna over the five-year period
subsequent to closing. The maximum contingent payments are $300.0 million. The
amount and timing of the payments will be contingent upon net increases in the
number of HAI's covered lives in specified products. The Company is obligated to
make contingent payments under two separate calculations. Under the first
calculation, the amount and timing of the contingent payments will be based on
growth in the number of lives covered by certain HAI products during the next
five years. The Company may be required to make contingent payments of up to
$25.0 million per year for each of the five years following the HAI acquisition
depending on the net annual growth in the number of lives covered by such
products. The amount to be paid per incremental covered life decreases during
the five-year term of the Company's contingent payment obligation. Under the
second calculation, the Company may be required to make contingent payments of
up to $35.0 million per year for each of five years based on the net cumulative
growth in the number of lives covered by certain other HAI products. Aetna will
receive a specified amount per net incremental life covered by such products.
The amount to be paid per incremental covered life increases with the number of
incremental covered lives. The Company will account for the additions to the
purchase price for HAI under the purchase method. See "Magellan's Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Outlook-Liquidity and Capital Resources."
ALLIED ACQUISITION. On December 5, 1997, the Company purchased the assets
of Allied for approximately $70.0 million, of which $50.0 million was paid to
the seller at closing with the remaining $20.0 million placed in escrow. Allied
provides specialty risk-based products and administrative services to a variety
of insurance companies and other customers, including Blue Cross of New Jersey,
CIGNA and NYLCare, for its 5.0 million members. Allied has over 80 physician
networks across the eastern United States. Allied's networks include physicians
specializing in cardiology, oncology and diabetes. The Company funded the Allied
acquisition with cash on hand. The Company accounted for the Allied acquisition
using the purchase method of accounting. The escrowed amount of the purchase
price is payable in one-third increments if Allied achieves specified earnings
targets during each of the three years following the closing. Additionally, the
purchase price may be increased during the three-year period by up to $40.0
million, if Allied's performance exceeds specified earnings targets, or
decreased by up to $20.0 million, if Allied's performance does not meet
specified earnings targets. The purchase price adjustments will be computed
based on the amount of "EBITDA" (as defined in the Allied Purchase Agreement)
earned by Allied during each of the three 12-month periods ending on November
30, 1998, 1999 and 2000. The seller will be paid an amount that is a specified
multiple of the excess of Allied's "EBITDA" during such periods over specified
"EBITDA" targets for such periods. The maximum purchase price payable is $110.0
million. The Company will account for the additions to the purchase price for
Allied under the purchase method. The Company will be paid an amount that is a
specified multiple of the amount by which Allied's "EBITDA" during such periods
is less than the specified "EBITDA" targets for such periods. See "Magellan's
Management's Discussion and Analysis of Financial Conditions and Results of
Operations--Outlook-Liquidity and Capital Resources."
42
<PAGE>
GREEN SPRING MINORITY SHAREHOLDER CONVERSION. The minority shareholders of
Green Spring converted their interests in Green Spring into an aggregate of
2,831,516 shares of Company Common Stock. As a result of the Green Spring
Minority Shareholder Conversion, the Company owns 100% of Green Spring. The
Company accounted for the Green Spring Minority Shareholder Conversion as a
purchase of minority interest at the fair value of the consideration paid.
MERIT ACQUISITION OF CMG. On September 12, 1997, Merit acquired all of the
outstanding capital stock of CMG for approximately $48.7 million in cash and
approximately 739,000 shares of Merit common stock. In connection with Merit's
acquisition of CMG, the Company may be required to make contingent payments to
the former shareholders of CMG if the financial results of certain contracts
exceed specified base-line amounts. Such contingent payments are subject to an
aggregate maximum of $23.5 million.
43
<PAGE>
UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE YEAR ENDED SEPTEMBER 30, 1997
(IN THOUSANDS, EXCEPT RATIOS AND PER SHARE DATA)
<TABLE>
<CAPTION>
DIVESTED
OPERATIONS-- MERIT/CMG MERIT/CMG
MAGELLAN CRESCENT PRO FORMA PRO FORMA PRO FORMA PRO FORMA
AS REPORTED TRANSACTIONS HAI ALLIED ADJUSTMENTS COMBINED MERIT CMG ADJUSTMENTS COMBINED
----------- ------------ -------- -------- ----------- --------- -------- -------- ----------- ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Net
revenue... $1,210,696 $(555,324) $116,736 $143,889 $41,578(1) $957,575 $555,717 $101,356 $(13,042)(9) $644,031
----------- ------------ -------- -------- ----------- --------- -------- -------- ----------- ----------
Salaries,
cost of
care and
other
operating
expenses... 978,513 (426,862) 88,002 137,873 (7,797)(2) 769,729 504,510 99,434 (18,075)(10) 585,869
Bad debt
expense... 46,211 (42,720) 0 0 0 3,491 0 0 0 0
Depreciation
and
amortization... 44,861 (20,073) 312 362 6,164(3) 31,626 39,400 1,987 2,365(11) 43,752
Interest,
net..... 45,377 (3,233) (1,604) (725) (6,833)(4) 32,982 21,566 (516) 4,390(12) 25,440
Stock
option
expense... 4,292 0 0 0 0 4,292 0 0 0 0
Equity in
loss of
CBHS.... 8,122 0 0 0 12,028(5) 20,150 0 0 0 0
Loss on
Crescent
Transactions... 59,868 0 0 0 (59,868)(6) 0 0 0 0 0
Unusual
items... 357 (2,500) 0 0 5,388(7) 3,245 8,239 1,200 (6,925)(13) 2,514
----------- ------------ -------- -------- ----------- --------- -------- -------- ----------- ----------
1,187,601 (495,388) 86,710 137,510 (50,918) 865,515 573,715 102,105 (18,245) 657,575
----------- ------------ -------- -------- ----------- --------- -------- -------- ----------- ----------
Income
(loss)
before
income
taxes
and
minority
interest... 23,095 (59,936) 30,026 6,379 92,496 92,060 (17,998) (749) 5,203 (13,544)
Provision
for
(benefit
from)
income
taxes... 9,238 (23,974) 11,480 0 39,550(8) 36,294 (4,126) (443) 2,095(14) (2,474)
----------- ------------ -------- -------- ----------- --------- -------- -------- ----------- ----------
Income
(loss)
before
minority
interest... 13,857 (35,962) 18,546 6,379 52,946 55,766 (13,872) (306) 3,108 (11,070)
Minority
interest... 9,102 0 0 0 0 9,102 0 0 0 0
----------- ------------ -------- -------- ----------- --------- -------- -------- ----------- ----------
Net income
(loss)... $ 4,755 $ (35,962) $ 18,546 $ 6,379 $52,946 $ 46,664 $(13,872) $ (306) $ 3,108 $(11,070)
----------- ------------ -------- -------- ----------- --------- -------- -------- ----------- ----------
----------- ------------ -------- -------- ----------- --------- -------- -------- ----------- ----------
Average
number
of
common
shares
outstanding--basic... 28,781 28,781
----------- ---------
----------- ---------
Average
number
of
common
shares
outstanding--diluted... 29,474 29,474
----------- ---------
----------- ---------
Net income
(loss)
per
common
share--basic... $ 0.17 $ 1.62
----------- ---------
----------- ---------
Net income
(loss)
per
common
share--diluted... $ 0.16 $ 1.58
----------- ---------
----------- ---------
Ratio of
earnings
to fixed
charges... 1.41
-----------
-----------
<CAPTION>
THE
TRANSACTIONS
PRO FORMA PRO FORMA
ADJUSTMENTS CONSOLIDATED
------------ ------------
<S> <C> <C>
Net
revenue... $ 0 $1,601,606
------------ ------------
Salaries,
cost of
care and
other
operating
expenses. 5,567(15) 1,361,165
Bad debt
expense... 0 3,491
Depreciati
and
amortiza (7,262)(16) 68,116
Interest,
net..... 36,670(17) 95,092
Stock
option
expense... 0 4,292
Equity in
loss of
CBHS.... 0 20,150
Loss on
Crescent
Transact 0 0
Unusual
items... (1,314)(19) 4,445
------------ ------------
33,661 1,556,751
------------ ------------
Income
(loss)
before
income
taxes
and
minority
interest (33,661) $ 44,855
Provision
for
(benefit
from)
income
taxes... (9,699)(20) 24,121
------------ ------------
Income
(loss)
before
minority
interest (23,962) 20,734
Minority
interest.. (6,835)(21) 2,267
------------ ------------
Net income
(loss)... $(17,127) $ 18,467
------------ ------------
------------ ------------
Average
number
of
common
shares
outstand 2,832(21) 31,613
------------ ------------
------------ ------------
Average
number
of
common
shares
outstand 2,832(21) 32,306
------------ ------------
------------ ------------
Net income
(loss)
per
common
share--b $ 0.58
------------
------------
Net income
(loss)
per
common
share--d $ 0.57
------------
------------
Ratio of
earnings
to fixed
charges... 1.31
------------
------------
</TABLE>
See Notes to Unaudited Pro Forma Consolidated Statements of Operations
44
<PAGE>
UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE NINE MONTHS ENDED JUNE 30, 1998
(IN THOUSANDS, EXCEPT RATIOS AND PER SHARE DATA)
<TABLE>
<CAPTION>
THE TRANSACTIONS
MAGELLAN PRO FORMA PRO FORMA PRO FORMA PRO FORMA
AS REPORTED HAI ALLIED ADJUSTMENTS COMBINED MERIT ADJUSTMENTS CONSOLIDATED
------------- ------- ------- ----------- ----------- -------- ---------------- --------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net revenue............. $1,063,099 $19,528 $30,945 $(2,143)(1) $1,111,429 $262,630 $ 0 $1,374,059
------------- ------- ------- ----------- ----------- -------- ------- --------------
Salaries, cost of care
and other operating
expenses.............. 909,353 15,031 31,068 (1,392)(2) 954,060 241,084 (1,893)(15) 1,193,251
Bad debt expense........ 2,972 0 0 0 2,972 0 0 2,972
Depreciation and
amortization.......... 37,649 34 100 1,075(3) 38,858 16,159 (2,506)(16) 52,511
Interest, net........... 49,336 (256) (92) 1,816(4) 50,804 8,870 14,312(17) 73,986
Stock option expense.... (3,527) 0 0 0 (3,527) 0 0 (3,527)
Managed Care integration
costs................. 12,314 0 0 (2,729)(18) 9,585 0 (9,585)(18) 0
Equity in loss of
CBHS.................. 24,221 0 0 0 24,221 0 0 24,221
Unusual items........... (3,000) 0 0 3,000(7) 0 1,318 (1,318)(19) 0
------------- ------- ------- ----------- ----------- -------- ------- --------------
1,029,318 14,809 31,076 1,770 1,076,973 267,431 (990) 1,343,414
------------- ------- ------- ----------- ----------- -------- ------- --------------
Income (loss) before
income taxes and
minority interest..... 33,781 4,719 (131) (3,913) 34,456 (4,801) 990 30,645
Provision for (benefit
from) income taxes.... 15,972 1,879 0 (1,617)(8) 16,234 (786) 1,765(20) 17,213
------------- ------- ------- ----------- ----------- -------- ------- --------------
Income (loss) before
minority interest..... 17,809 2,840 (131) (2,296) 18,222 (4,015) (775) 13,432
Minority interest....... 5,063 0 0 0 5,063 0 (2,606)(21) 2,457
------------- ------- ------- ----------- ----------- -------- ------- --------------
Net income (loss)....... $ 12,746 $ 2,840 $ (131) $(2,296) $ 13,159 $ (4,015) $ 1,831 $ 10,975
------------- ------- ------- ----------- ----------- -------- ------- --------------
------------- ------- ------- ----------- ----------- -------- ------- --------------
Average number of common
shares
outstanding--basic.... 30,505 30,505 1,090(21) 31,595
------------- ----------- ------- --------------
------------- ----------- ------- --------------
Average number of common
shares
outstanding--diluted... 31,099 31,099 1,090(21) 32,189
------------- ----------- ------- --------------
------------- ----------- ------- --------------
Net income per common
share--basic.......... $ 0.42 $ 0.43 $ 0.35
------------- ----------- --------------
------------- ----------- --------------
Net income per common
share--diluted........ $ 0.41 $ 0.42 $ 0.34
------------- ----------- --------------
------------- ----------- --------------
Ratio of earnings to
fixed charges......... 1.46 1.31
------------- --------------
------------- --------------
</TABLE>
See Notes to Unaudited Pro Forma Consolidated Statements of Operations
45
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS
(1) Adjustments to net revenue for the year ended September 30, 1997 represent
Franchise Fees of $55.5 million for the 259 days ended June 16, 1997 (prior
to consummation of the Crescent Transactions) less a $13.9 million decrease
in HAI revenue resulting from renegotiated contractual rates with Aetna as a
direct result of the acquisition of HAI by the Company. Adjustment to net
revenue for the nine months ended June 30, 1998 represents the effect of
renegotiated contractual rates with Aetna for the two months prior to
consummation of the HAI acquisition.
The pro forma presentation assumes that all Franchise Fees due from CBHS are
collectible. Based on projections of fiscal 1998 and fiscal 1999 operations
prepared by management of CBHS and results of operations through June 30,
1998, the Company believes that CBHS will be unable to pay the full amount
of the Franchise Fees it is contractually obligated to pay during fiscal
1998 and fiscal 1999. The Company currently estimates that CBHS will be able
to pay approximately $40.0 million to $45.0 million of the Franchise Fees in
fiscal 1998, a $33.3 million to $38.3 million shortfall relative to amounts
payable under the Master Franchise Agreement. The Company also estimates
that CBHS will be able to pay $15.0 million to $25.0 million of the
Franchise Fees in fiscal 1999, a $53.3 million to $63.3 million shortfall
relative to amounts payable under the Master Franchise Agreement. The
Company may be required to record bad debt expense related to Franchise Fees
receivable from CBHS in fiscal 1999 or future periods if CBHS does not
generate sufficient cash flows to allow for payment of Franchise Fees. As a
result of CBHS's failure to pay Franchise Fees due in fiscal 1998, the
Company has exercised certain of its rights pursuant to the Master Franchise
Agreement and is assisting CBHS management in improving profitability. See
"Risk Factors--Subordination of Franchise Fees."
(2) Adjustments to salaries, cost of care and other operating expenses represent
the following (in thousands):
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, JUNE 30,
TRANSACTION DESCRIPTION 1997 1998
- ----------- --------------------------------------------- -------------------- -----------
<S> <C> <C> <C>
Crescent Fees payable to CBHS by the Company for the
management of less than wholly-owned
hospital-based joint ventures controlled by
the Company for the 259 days ended June 16,
1997......................................... $ 7,564 $ --
Crescent Reduction of corporate overhead that was
transferred to CBHS for the 259 days ended
June 16, 1997................................ (2,845) --
HAI Elimination of Aetna overhead allocations.... (17,162) (2,044)
HAI Bonus expense previously reflected in Aetna's
financial statements......................... 1,138 200
HAI Costs absorbed by HAI previously incurred by
Aetna including information technology, human
resources and legal.......................... 5,110 852
Allied Reduction of shareholders'/executives'
compensation to revised contractual level
pursuant to the Allied purchase agreement.... (648) (197)
Allied Reduction of certain consulting agreement
costs to revised contractual level pursuant
to the Allied purchase agreement............. (954) (203)
---------- -----------
$ (7,797) $ (1,392)
---------- -----------
---------- -----------
</TABLE>
46
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(3) Adjustments to depreciation and amortization represent the following (in
thousands):
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, JUNE 30,
TRANSACTION DESCRIPTION 1997 1998
- ------------- --------------------------------------------- -------------------- -----------
<S> <C> <C> <C>
Crescent Elimination of amortization related to
impaired intangible assets................... $ (177) $ --
HAI Purchase price allocation (i)................ 3,948 676
Allied Purchase price allocation (ii)............... 2,393 399
------- -----------
$ 6,164 $ 1,075
------- -----------
------- -----------
</TABLE>
---------------------------------
(i) Represents $4.0 million estimated fair value of property and
equipment depreciated over an estimated useful life of 5 years, $83.3
million of goodwill amortized over an estimated useful life of 40
years and $20.7 million estimated fair value of other intangible
assets (primarily client lists) amortized over an estimated useful
life of 15 years less historical depreciation and amortization.
(ii) Represents $50.7 million of goodwill amortized over an estimated
useful life of 40 years and $16.9 million estimated fair value of
other intangible assets (primarily client lists and treatment
protocols) amortized over an estimated useful life of 15 years.
The allocation of the HAI and Allied purchase prices to goodwill and
identifiable intangible assets and estimated useful lives are based on the
Company's preliminary valuations, which are subject to change upon receiving
independent appraisals for such assets.
Subsequent to the consummation of the HAI acquisition, the Company may be
required to make additional contingent payments of up to $60 million
annually during the five years following the consummation of the HAI
acquisition to Aetna for aggregate potential contingent payments of $300
million. These contingent payments, if any, would be recorded as goodwill
and identifiable intangible assets, which would result in estimated
additional annual amortization of $11 million to $13 million in future
periods if all the contingent payments are made.
The Company may also be required to make contingent payments to the former
owners of Allied of up to $60 million during the three years subsequent to
consummation of the Allied acquisition, of which $20 million is in escrow.
These contingent payments, if any, would be recorded as goodwill, which
would result in estimated additional annual amortization of $1.5 million.
(4) Adjustments to interest, net, represent reductions in interest expense as a
result of the repayment of outstanding borrowings under the Magellan
Existing Credit Agreement with the proceeds from the Crescent Transactions
offset by forgone interest income as a result of using cash on hand to fund
the HAI and Allied acquisitions. The Magellan Existing Credit Agreement had
an outstanding balance of approximately $131.0 million at May 31, 1997
(prior to consummation of the Crescent Transactions). The pro forma interest
expense reduction in fiscal 1997 of approximately $6.8 million represents
actual interest expense related to Magellan's Credit Agreements in effect
during fiscal 1997, or an effective interest rate of 7.3%
(5) Adjustment to equity in loss of CBHS represents the Company's 50% interest
in CBHS' pro forma loss for the 259 day period ended June 16, 1997. The
Company's investment in CBHS is accounted for under the equity method of
accounting. The Condensed Pro Forma Statement of Operations of CBHS for the
year ended September 30, 1997 is as follows (in thousands):
47
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
<TABLE>
<CAPTION>
CBHS
OPERATIONS--
DIVESTED 106 DAYS ENDED PRO FORMA PRO FORMA
OPERATIONS SEPTEMBER 30, 1997 ADJUSTMENTS CONSOLIDATED
----------- -------------------- ------------ -------------
<S> <C> <C> <C> <C>
Net revenue.............. $ 555,324 $ 213,730 $ 2,565(i) $ 771,619
----------- ---------- ------------ -------------
Salaries, supplies and
other operating
expenses............... 426,862 210,277 103,723 (ii 740,862
Bad debt expense......... 42,720 17,437 0 60,157
Depreciation and
amortization........... 20,073 668 (17,333) ii) 3,408
Interest, net............ 3,233 1,592 167 (iv 4,992
Unusual items............ 2,500 0 0 2,500
----------- ---------- ------------ -------------
495,388 229,974 86,557 811,919
----------- ---------- ------------ -------------
Income (loss) before
income taxes........... 59,936 (16,244) (83,992) (40,300)
Provision for income
taxes.................. 23,974 0 (23,974)(v) 0
----------- ---------- ------------ -------------
Net income (loss)...... $ 35,962 $ (16,244) $ (60,018) $ (40,300)
----------- ---------- ------------ -------------
----------- ---------- ------------ -------------
</TABLE>
----------------------------------------
(i) Fees from the Company for the management of less than
wholly-owned hospital-based joint ventures controlled by the
Company (see note 2) less non-recurring accounts receivable
collection fees receivable from the Company (see note 6) of
approximately $5.0 million during the 106 days ended September
30, 1997.
(ii) Adjustments to salaries, supplies and other operating
expenses represent the following (in thousands):
<TABLE>
<CAPTION>
259 DAYS
ENDED
JUNE 16, 1997
--------------
<S> <C>
Franchise Fees (see note 1)................................................ $ 55,463
Rent expense under the Facilities Lease.................................... 44,665
Additional corporate overhead.............................................. 3,595
--------------
$ 103,723
--------------
--------------
</TABLE>
(iii) Adjustment to depreciation and amortization represents the
decrease in depreciation expense as a result of the sale of
property and equipment to Crescent by the Company and the
elimination of amortization expense related to impaired
intangible assets.
(iv) Adjustment to interest, net, represents the following (in
thousands):
<TABLE>
<CAPTION>
259 DAYS
ENDED
JUNE 16, 1997
--------------
<S> <C>
Interest expense on debt repaid by the Company............................. $ (3,233)
Interest expense for the 259 days ended June 16, 1997 for estimated average
borrowings of $60 million at an assumed interest rate of 8% per annum...... 3,400
--------------
$ 167
--------------
--------------
</TABLE>
(v) CBHS is a limited liability company. Accordingly, provision
for income taxes is eliminated as the tax consequences of CBHS
ownership will pass through to the Company and COI.
48
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(6) Adjustment to loss on Crescent Transactions represents the elimination of
the non-recurring losses incurred by the Company as a result of the Crescent
Transactions as follows (in thousands):
<TABLE>
<S> <C>
Accounts receivable collection fees(i).................................... $ 21,400
Impairment losses on intangible assets(ii)................................ 14,408
Exit costs and construction obligation(iii)............................... 12,549
Loss on the sale of property and equipment................................ 11,511
---------
$ 59,868
---------
---------
</TABLE>
----------------------------------------
(i) Accounts receivable collection fees represent the reduction
in the net realizable value of accounts receivable for
estimated collection fees on hospital-based receivables
retained by the Company. The Company paid CBHS a fee equal to
5% of collections for the first 120 days after consummation of
the Crescent Transactions and estimated bad debt agency fees of
40% for receivables collected subsequent to 120 days after the
consummation of the Crescent Transactions.
(ii) The impairment loss on intangible assets resulted from
reducing the book value of the Company's investment in CBHS to
its approximate fair value at the consummation date of the
Crescent Transactions. The impairment losses represent the
reductions in the carrying amount of goodwill and other
intangible assets related to the divested or contributed CBHS
operations.
(iii) Represents approximately $5.0 million of incremental costs
to perform finance and accounting functions transferred to CBHS
and approximately $7.5 million for the Company's obligation to
replace CBHS' Philadelphia hospital.
(7) Adjustments to unusual items represent the elimination of non-recurring
gains on the sale of psychiatric hospitals.
(8) Adjustments to provision for income taxes represent the tax expense related
to the pro forma adjustments at the Company's historic effective tax rate of
40% and the imputed income tax expense on the operating results of Allied,
which was an S-corporation for income tax purposes and historically did not
provide for income taxes.
(9) Adjustment to net revenue represents the elimination of the fiscal 1997
revenues of Choate Health Management, Inc. ("Choate"), which was sold by
Merit in fiscal 1997.
(10) Adjustment to salaries, cost of care and other operating expenses
represents the elimination of salaries, benefits and other costs of $5.5
million for duplicate CMG personnel and facilities that were eliminated as a
direct result of Merit's acquisition of CMG and the elimination of fiscal
1997 expenses of $12.6 million for Choate, which was sold by Merit in fiscal
1997.
(11) Adjustment to depreciation and amortization represents the effect of
Merit's purchase price allocation related to the CMG acquisition.
(12) Adjustment to interest, net, represents the effect of increased borrowing
by Merit related to the CMG acquisition.
(13) Adjustments to unusual items, net, represents the elimination of
non-recurring losses on Merit's sale of Choate.
(14) Adjustment to provision for income taxes represents the tax effect of the
Merit/CMG pro forma adjustments.
(15) Adjustment to salaries, cost of care and other operating expenses
represents (i) the elimination of fees paid by Merit to its former owner,
(ii) the presentation of Merit's capitalized start-up costs of $6.1 million
and $0.5 million for the fiscal year ended September 30, 1997 and the nine
months ended June 30, 1998, respectively, as other operating expenses to
conform to the Company's accounting policies and (iii) the elimination of
salaries, benefits and other costs of $2.2 million for the nine
49
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
months ended June 30, 1998 for duplicate CMG personnel and facilities that
have been announced as a direct result of Merit's acquisition of CMG. The
adjustment excludes approximately $60.0 million of cost savings on an annual
basis that the Company expects to achieve within eighteen months following
consummation of the Merit acquisition.
(16) Adjustments to depreciation and amortization represent the effect of the
Merit purchase price allocation and the Green Spring Minority Shareholder
Conversion as follows (in thousands):
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, JUNE 30,
1997 1998
-------------- -----------
<S> <C> <C>
Estimated fair value of property and equipment of $51.9 million
depreciated over an estimated useful life of 5 years........... $ 10,384 $ 3,894
Estimated goodwill of $641.2 million amortized over an estimated
useful life of 40 years........................................ 16,029 6,011
Estimated fair value of other intangible assets (primarily client
lists and provider networks) of $140.0 million amortized over
an estimated useful life of 15 years........................... 9,333 3,500
-------------- -----------
Total estimated depreciation and amortization.................... 35,746 13,405
Elimination of Merit and CMG historical and pro forma
depreciation and amortization.................................. (43,752) (16,157)
Effect of Green Spring Minority Shareholder Conversion(i)........ 744 246
-------------- -----------
$ (7,262) $ (2,506)
-------------- -----------
-------------- -----------
</TABLE>
----------------------------------------
(i) The Green Spring Minority Shareholder Conversion resulted in
approximately $20.5 million of additional intangible assets
(Goodwill of $6.9 million; Client lists of $13.6 million) with
a weighted average useful life of 27.5 years. The additional
intangible assets resulted from the excess of the fair value of
the consideration paid for the Green Spring Minority
Shareholder Conversion ($63.5 million) over the book value of
minority interests purchased.
The allocation of the Merit purchase price to property and
equipment, goodwill and identifiable intangible assets and estimated
useful lives was based on the Company's preliminary valuations,
which are subject to change upon receiving independent appraisals
for such assets.
(17) Adjustments to interest, net, represent the following (in thousands):
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, JUNE 30,
DESCRIPTION 1997 1998
- ------------------------------------------------------- -------------------- ---------------
<S> <C> <C>
Elimination of Merit and CMG historical and pro forma
interest expense..................................... $ (29,959) $ (10,536)
Elimination of historical interest expense for the
Magellan Outstanding Notes........................... (42,188) (15,820)
Elimination of the Company's historical deferred
financing cost amortization.......................... (1,214) (914)
Tranche A Term Loan interest expense (i)............... 14,393 5,500
Tranche B Term Loan interest expense (i)............... 14,850 5,672
Tranche C Term Loan interest expense (i)............... 15,308 5,844
Revolving Facility interest expense (i)................ 1,570 600
Foregone interest income--cash proceeds utilized in the
Merit acquisition at 5.5% per annum.................. 3,261 1,223
The Notes at an interest rate of 9.0%.................. 56,250 21,094
</TABLE>
50
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, JUNE 30,
DESCRIPTION 1997 1998
- ------------------------------------------------------- -------------------- ---------------
<S> <C> <C>
Amortization of deferred financing costs of $35.6
million over a weighted average life of approximately
8.1 years............................................ 4,399 1,649
---------- ---------------
$ 36,670 $ 14,312
---------- ---------------
---------- ---------------
</TABLE>
----------------------------------------
(i) Assumes borrowings are one-month LIBOR-based, which is
consistent with the Company's past borrowing practices. Average
one-month LIBOR was approximately 5.60% and 5.75% during the
year ended September 30, 1997 and the six months ended March
31, 1998, respectively. Each tranche of the Term Loan Facility
is approximately $183.3 million and the Revolving Facility
borrowing is $20.0 million. Interest rates utilized to compute
pro forma adjustments are as follows:
<TABLE>
<CAPTION>
YEAR ENDED SIX MONTHS ENDED
SEPTEMBER 30, MARCH 31,
1997 1998
----------------------- -------------------
<S> <C> <C>
Tranche A Term Loan and Revolving Facility
(LIBOR plus 2.25%).......................... 7.85% 8.00%
Tranche B Term Loan (LIBOR plus 2.50%)........ 8.10% 8.25%
Tranche C Term Loan (LIBOR plus 2.75%)........ 8.35% 8.50%
</TABLE>
(18) Adjustments to managed care integration costs represent the elimination of
the expenses incurred by the Company as a direct result of the Merit
Acquisition and the Allied Acquisition. The Company owns three behavioral
managed care organizations ("BMCOs"), Green Spring, HAI and Merit, as a
result of acquisitions consummated in fiscal 1996 (Green Spring) and fiscal
1998 (HAI and Merit). The Company also owns two other specialty managed care
organizations, Allied and Care Management Resources, Inc. ("CMR").
Management has approved and committed the Company to a plan to combine and
integrate the operations of its BMCOs and other specialty managed care
organizations (the "Integration Plan") that will result in the elimination
of duplicative functions and will standardize business practices and
information technology platforms. The Company expects to achieve
approximately $60 million of cost savings on an annual basis by August 1999
at its BMCOS and approximately $3 million of cost savings on an annual basis
at CMR as a result of the Integration Plan.
The Integration Plan will result in the elimination of approximately 1,000
positions during fiscal 1998 and fiscal 1999. Approximately 200 employees
had been involuntarily terminated pursuant to the Integration Plan as of
June 30, 1998 and approximately 250 positions have been eliminated by normal
attrition through June 30, 1998. The remaining positions to be eliminated
have been identified, and will be eliminated through a combination of normal
attrition and involuntary termination.
The employee groups of the BMCOs that are primarily affected include
executive management, finance, human resources, information systems and
legal personnel at the various BMCOs corporate headquarters and regional
offices and credentialing, claims processing, contracting and marketing
personnel at various operating locations. The Company expects to complete
the specific identification of all personnel who will be involuntarily
terminated by December 31, 1998 and will complete its involuntary
terminations by April 1999.
The Integration Plan will also result in the closure of approximately 40 to
45 leased facilities at the BMCOs during fiscal 1998 and fiscal 1999. As of
June 30, 1998, 20 offices had been specifically identified for closure and
20 to 25 additional offices are under consideration for closure. The
51
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
Company expects to complete the specific identification of remaining office
closures by December 31, 1998.
The Company has recorded approximately $18.3 million of liabilities related
to the Integration Plan, as of June 30, 1998 of which $11.7 million was
recorded as part of the Merit purchase price allocation and $6.6 million was
recorded in the statement of operations under "Managed Care integration
costs". These amounts represent those portions of the Integration Plan
obligations that were measurable as of June 30, 1998. The Company expects to
record additional liabilities as a result of the Integration Plan in fiscal
1998 and fiscal 1999 as final decisions regarding office closures and other
contractual obligation terminations are made. The Integration Plan will
result in additional incremental costs that must be expensed as incurred in
accordance with Emerging Issues Task Force Consensus 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to
Exit an Activity (Including Certain Costs Incurred in a Restructuring)" that
are not described above and certain other charges. Other integration costs
include, but are not limited to, outside consultants, costs to relocate
closed office contents and long-lived asset impairments. Other integration
costs are reflected in the statement of operations under "Managed Care
integration costs."
During the nine months ended June 30, 1998, the Company incurred
approximately $5.7 million in other integration costs, including long-lived
asset impairments of approximately $2.2 million and outside consulting costs
of approximately $3.1 million. The asset impairments relate primarily to
identifiable intangible assets that no longer have value and have been
written off as a result of the Integration Plan.
(19) Adjustments to unusual items represent the following (in thousands):
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
DESCRIPTION SEPTEMBER 30, 1997 JUNE 30, 1998
- ------------------------------------------------------- -------------------- ---------------
<S> <C> <C>
Elimination of Merit's transaction costs related to
Merit's attempt to acquire HAI....................... $ (733) $ --
Elimination of non-recurring employee benefit costs
related to stock options which were eliminated upon
the consummation of the Acquisition.................. (581) (57)
Elimination of Merit's transaction costs related
primarily to the Transactions........................ -- (1,261)
-------- ---------------
$ (1,314) $ (1,318)
-------- ---------------
-------- ---------------
</TABLE>
(20) Adjustment to provision for income taxes represents the tax benefit related
to Merit/CMG combined and the pro forma adjustments, excluding annual
non-deductible goodwill amortization of $16.1 million related to the
Acquisition, at the Company's historic effective tax rate of 40%.
(21) Adjustments to minority interest and average number of common shares
outstanding (basic and diluted) represents the effect of the Green Spring
Minority Shareholder Conversion.
52
<PAGE>
MAGELLAN'S MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion relates to the historical consolidated results of
operations and financial condition of the Company and should be read in
conjunction with the consolidated financial statements of the Company included
elsewhere in this Prospectus.
OVERVIEW
The Company has historically derived the majority of its revenue from
providing healthcare services in an inpatient setting. Payments from third party
payors are the principal source of revenue for most healthcare providers. In the
early 1990's, many third party payors sought to control the cost of providing
care to their patients by instituting managed care programs or seeking the
assistance of managed care companies. Providers participating in managed care
programs agree to provide services to patients for a discount from established
rates, which generally results in pricing concessions by the providers and lower
margins. Additionally, managed care programs generally encourage alternatives to
inpatient treatment settings and reduce utilization of inpatient services. As a
result, third party payors established managed care programs or engaged managed
care companies in many areas of healthcare, including behavioral healthcare. The
Company, which until June 1997 was the largest operator of psychiatric hospitals
in the United States, was adversely affected by the adoption of managed care
programs by third-party payors.
Prior to the first quarter of fiscal 1996, the Company was not a provider of
behavioral managed care services. During the first quarter of fiscal 1996, the
Company acquired a 61% ownership interest in Green Spring. At that time, the
Company intended to become a fully integrated behavioral healthcare provider by
combining the managed behavioral healthcare products offered by Green Spring
with the direct treatment services offered by the Company's psychiatric
hospitals. The Company believed that an entity that participated in both the
managed care and provider segments of the behavioral healthcare industry could
more efficiently provide and manage behavioral healthcare for insured
populations than an entity that was solely a managed care company. The Company
also believed that earnings from its managed care business would offset, in
part, the negative impact on the financial performance of its psychiatric
hospitals caused by managed care. Green Spring was the Company's first
significant involvement in managed behavioral healthcare. During the first
quarter of fiscal 1998 pursuant to the Green Spring Minority Shareholder
Conversion, the minority shareholders of Green Spring converted their interests
in Green Spring into an aggregate of 2,831,516 shares of Company Common Stock.
Subsequent to the Company's acquisition of Green Spring, the growth of the
managed behavioral healthcare industry accelerated. Under the Company's majority
ownership, Green Spring increased its base of covered lives from 12.0 million as
of the end of calendar year 1995 to 21.1 million as of the end of calendar year
1997, a compound annual growth rate of over 32%. While growth in the industry
was accelerating, the managed behavioral healthcare industry also began to
consolidate. The Company concluded that consolidation presented an opportunity
for the Company to enhance its stockholder value by increasing its participation
in the managed behavioral healthcare industry, which the Company believed
offered growth and earnings prospects superior to those of the psychiatric
hospital industry. Therefore, the Company decided to sell its domestic
psychiatric facilities to obtain capital for expansion in the managed behavioral
healthcare business.
During the third quarter of fiscal 1997, the Company sold the Psychiatric
Hospital Facilities, which comprised substantially all of its domestic acute
care psychiatric hospitals and residential treatment facilities, to Crescent for
$417.2 million in cash (before costs of approximately $16.0 million) and certain
other consideration. The sale of the Psychiatric Hospital Facilities provided
the Company with approximately $200.0 million of net cash proceeds, after debt
repayment, for use in implementing its business strategy. The Company used the
net cash proceeds to finance the acquisitions of HAI and Allied in December
1997.
53
<PAGE>
The Company further implemented its business strategy through the
Acquisition, which increased the Company's revenue attributable to managed care
operations to 78% of the Company's total fiscal 1997 revenue on a pro forma
basis.
The following table sets forth, on a pro forma basis, for the year ended
September 30, 1997, the Company's net revenue and EBITDA from its business
segments (in thousands):
<TABLE>
<CAPTION>
% OF % OF
NET REVENUE CONSOLIDATED EBITDA(3) CONSOLIDATED
------------- --------------- ----------- ---------------
<S> <C> <C> <C> <C>
Existing managed care business (1)..................... $ 610,623 38.1% $ 73,258 29.2%
Merit managed care business............................ 644,031 40.2 52,595 21.0
------------- ----- ----------- -----
Total managed care business.......................... 1,254,654 78.3 125,853 50.2
Public sector business................................. 94,422 5.9 7,839 3.1
Healthcare franchising business........................ 78,300 4.9 66,148 26.4
Provider business (2) 174,230 10.9 50,385 20.1
Corporate overhead..................................... -- -- (13,275) (5.3)
Interest income........................................ -- -- 13,697 5.5
------------- ----- ----------- -----
Consolidated......................................... $ 1,601,606 100.0% $ 250,647 100.0%
------------- ----- ----------- -----
------------- ----- ----------- -----
</TABLE>
- ------------------------
(1) Includes HAI and Allied pro forma results.
(2) The provider business segment includes the Company's joint venture hospital
operations, three European psychiatric hospitals, a general hospital that
was closed in January 1997 and certain other operations. EBITDA includes
revenue associated with settlements of reimbursement issues and reductions
of operating expenses associated with medical malpractice adjustments. Pro
Forma Adjusted EBITDA as presented in "Summary-- Summary Historical and
Unaudited Pro Forma Financial Data--Magellan Historical and Pro Forma
Financial Data" excludes EBITDA associated with the settlements of
reimbursement issues and reductions of operating expenses associated with
medical malpractice adjustments.
(3) EBITDA is defined as earnings before interest, taxes, depreciation and
amortization plus interest income, stock option expense and unusual items.
The calculation of EBITDA on a consolidated basis is as follows (in
thousands):
<TABLE>
<CAPTION>
PRO FORMA
--------------------
YEAR ENDED
SEPTEMBER 30, 1997
--------------------
<S> <C>
Net income......................................................................... $ 18,467
Minority interest.................................................................. 2,267
Equity in loss of CBHS............................................................. 20,150
Provision for income taxes......................................................... 24,121
Interest, net...................................................................... 95,092
Depreciation and amortization...................................................... 68,116
----------
Earnings before interest, taxes, depreciation and amortization................... 228,213
Interest income.................................................................... 13,697
Stock option expense (credit)...................................................... 4,292
Unusual items...................................................................... 4,445
----------
EBITDA........................................................................... $ 250,647
----------
----------
</TABLE>
EBITDA is presented because management believes that EBITDA provides
additional indications of the financial performance of the Company and
provides useful information regarding the Company's ability to service debt
and meet certain debt covenants under the Indenture. Accordingly, EBITDA
includes interest income, which can be utilized to service debt, and
excludes non-cash expenses such as depreciation and amortization and stock
option expense (credit). The Company's definition of EBITDA used in this
Prospectus is consistent with the definition of EBITDA in the New Credit
Agreement and the Indenture. EBITDA does not represent cash flows from
operations or investing and financing activities as defined by generally
accepted accounting principles. EBITDA does not measure whether cash flows
will be sufficient to fund all cash flow needs, including principal and
interest payments on debt and capital lease obligations, capital
expenditures or
54
<PAGE>
other investing and financing activities. EBITDA should not be construed as
an alternative to the Company's operating income, net income or cash flows
from operating activities (as determined in accordance with generally
accepted accounting principles) and should not be construed as an indication
of the Company's operating performance or as a measure of the Company's
liquidity. In addition, items excluded from EBITDA, such as depreciation and
amortization, interest, net and provision for income taxes, are significant
components in understanding and assessing the Company's financial
performance. EBITDA is not presented for historical purposes as management
does not believe historical EBITDA is indicative of the Company's prospects
after consummation of the Transactions. The Company's definition of EBITDA
may be different from the definition of EBITDA used by other companies. For
a complete discussion of the Company's future prospects related to net
income, cash flows from operations and investing and financing activities,
see, "-- Result of Operations," "-- Historical Liquidity and Capital
Resources" and "-- Outlook -- Liquidity and Capital Resources."
For further information regarding pro forma operating results, see "Unaudited
Pro Forma Consolidated Financial Information" appearing elsewhere herein.
The Company undertook the transformation into a managed behavioral
healthcare company because it believed that the managed behavioral healthcare
industry offers growth and earnings prospects superior to those available to the
psychiatric hospital industry because, among other things, third party payors
for healthcare services are continuing to seek to control the cost of providing
care to their patients by instituting managed care programs or seeking the
assistance of managed care companies. Furthermore, government payors are
continuing to reduce reimbursement rates or coverage in an effort to control
costs.
As a result of the Acquisition, the Company generates a significant portion
of its revenue and earnings from its managed care business, including risk-based
products. The Company believes enrollment in risk-based products will continue
to grow through new covered lives and the transition of covered lives in ASO and
EAP products to higher revenue risk-based products. Risk-based products
typically generate significantly higher amounts of revenue than other managed
behavioral healthcare products. Because the Company is responsible for the cost
of care, risk-based products typically have lower margins than non-risk-based
products. Furthermore, under risk-based contracts, the Company assumes all or a
portion of the responsibility for the cost of providing a full or specified
range of behavioral healthcare treatment services to a specified beneficiary
population. In order for such contracts to be profitable, the Company must
accurately estimate the rate of service utilization by beneficiaries enrolled in
programs managed by the Company and control the unit cost of such services. If
the Company is unable to either estimate the rate of service utilization or
control the cost of such services, its risk-based contracts may be unprofitable.
55
<PAGE>
RESULTS OF OPERATIONS
GENERAL
For fiscal years prior to 1996, the Company did not have any material
operations other than the provider business. The following table summarizes, for
the periods indicated, operating results by business segment (in thousands):
<TABLE>
<CAPTION>
MANAGED PUBLIC HEALTHCARE
CARE SECTOR FRANCHISING PROVIDER CORPORATE
1996 BUSINESS BUSINESS BUSINESS BUSINESS OVERHEAD CONSOLIDATED
- ------------------------------- ----------- --------- ------------ ------------- ---------- -------------
<S> <C> <C> <C> <C> <C> <C>
Net revenue.................... $ 229,859 $ 70,709 $ -- $ 1,044,711 $ -- $ 1,345,279
----------- --------- ------------ ------------- ---------- -------------
Salaries, cost of care and
other operating expenses..... 202,690 60,840 -- 766,129 34,786 1,064,445
Bad debt expense............... 1,192 347 -- 79,931 -- 81,470
Depreciation and
amortization................. 9,111 2,580 -- 34,201 3,032 48,924
Stock option expense........... -- -- -- -- 914 914
Unusual items (1).............. -- -- -- 36,050 1,221 37,271
----------- --------- ------------ ------------- ---------- -------------
212,993 63,767 -- 916,311 39,953 1,233,024
----------- --------- ------------ ------------- ---------- -------------
Operating profit........... $ 16,866 $ 6,942 $ -- $ 128,400 $ (39,953) $ 112,255
----------- --------- ------------ ------------- ---------- -------------
----------- --------- ------------ ------------- ---------- -------------
</TABLE>
<TABLE>
<CAPTION>
1997
- -------------------------------
<S> <C> <C> <C> <C> <C> <C>
Net revenue.................... $ 363,883 $ 94,422 $ 22,739 $ 729,652 $ -- $ 1,210,696
----------- --------- ------------ ------------- ---------- -------------
Salaries, cost of care and
other operating expenses..... 323,814 86,709 3,652 538,760 25,578 978,513
Bad debt expense............... 192 (126) -- 46,145 -- 46,211
Depreciation and
amortization................. 13,016 2,904 160 24,528 4,253 44,861
Stock option expense........... -- -- -- -- 4,292 4,292
Unusual items (1).............. -- -- -- 5,745 -- 5,745
----------- --------- ------------ ------------- ---------- -------------
337,022 89,487 3,812 615,178 34,123 1,079,622
----------- --------- ------------ ------------- ---------- -------------
Operating profit........... $ 26,861 $ 4,935 $ 18,927 $ 114,474 $ (34,123) $ 131,074
----------- --------- ------------ ------------- ---------- -------------
----------- --------- ------------ ------------- ---------- -------------
</TABLE>
- ------------------------
(1) Includes charges for insurance settlements, facility closures, asset
impairments and other amounts.
56
<PAGE>
NINE MONTHS ENDED JUNE 30, 1997 COMPARED TO THE NINE MONTHS ENDED JUNE 30, 1998.
REVENUE. Managed care revenue increased 198.7% to $816.1 million for the
nine months ended June 30, 1998 from $273.2 million the same period in fiscal
1997. The increase resulted primarily from the acquisition of HAI, Allied and
Merit in fiscal 1998 and revenue growth at Green Spring. The aggregate revenues
of HAI, Allied and Merit's were approximately $462.9 million for the nine months
ended June 30, 1998. Green Spring revenues were positively impacted by the award
of several new contracts and acquisitions in fiscal 1997 and fiscal 1998 and
significant improvements in negotiated rates in its TennCare contract in fiscal
1998.
Public sector revenue increased 49.8% to $96.5 million for the nine months
ended June 30, 1998 from $64.4 million in the same period in fiscal 1997. The
increase was primarily attributable to a 22.9% increase in placements in Mentor
homes since June 30, 1997 to 3,270 individuals and revenue from fiscal 1998
acquisitions.
Healthcare franchising revenue was $51.1 million for the nine months ended
June 30, 1998, compared to $3.2 million for the nine months ended June 30, 1997.
The increase resulted from the effect of the consummation of the Crescent
Transactions on June 17, 1997, resulting in only 14 days of franchising revenue
in the fiscal 1997 period.
Provider business revenue decreased 85.4% to $99.4 million for the nine
months ended June 30, 1998 from $680.9 million in the same period in fiscal
1997. The decrease resulted primarily from the effect of the consummation of the
Crescent Transactions on June 17, 1997, following which revenue from the
Psychiatric Hospital Facilities and other facilities transferred to CBHS was no
longer recorded as part of the Company's revenue. During the nine months ended
June 30, 1997 and 1998, the Company recorded revenue of $16.2 million and $2.7
million, respectively, for settlements and adjustments related to reimbursement
issues with respect to psychiatric hospitals owned or formerly owned by the
Company. During fiscal 1997, the Company recorded $27.4 million for such
settlements. Management anticipates that revenue related to such settlements
will decline significantly for fiscal 1998.
SALARIES, COST OF CARE AND OTHER OPERATING EXPENSES. Salaries, cost of care
and other operating expenses attributable to the managed care business increased
193.9% to $725.4 million for the nine months ended June 30, 1998 from $246.8
million in the same period in fiscal 1997. The increase resulted primarily from
the acquisitions of HAI, Allied and Merit, which had aggregate expenses of
$414.9 million for the nine months ended June 30, 1998, and from continued
growth at Green Spring.
Public sector salaries, cost of care and other operating expenses increased
54.1% to $86.7 million for the nine months ended June 30, 1998 from $56.3
million in the same period in fiscal 1997. The increase was due primarily to
internal growth, increases in costs related to expansion and new product
development and expenses from fiscal 1998 acquisitions.
Healthcare franchising operating expenses were $6.7 million for the nine
months ended June 30, 1998. The Company recorded $0.5 million of expenses with
respect to the healthcare franchising business during the nine months ended June
30, 1997 after the consummation of the Crescent Transactions.
Salaries, cost of care and other operating expenses attributable to the
provider business decreased 84.7% to $77.3 million for the nine months ended
June 30, 1998 from $504.2 million in the same period in fiscal 1997. The
decrease resulted primarily from the effect of the consummation of the Crescent
Transactions, following which operating expenses of the Psychiatric Hospital
Facilities and other facilities transferred to CBHS were no longer accounted for
as part of the Company's operating expenses. During the nine months ended June
30, 1997, the Company recorded reductions of expenses of approximately $7.5
million compared to reductions of $4.1 million for the nine months ended June
30, 1998, as a result of updated actuarial estimates related to malpractice
claim reserves. These reductions resulted primarily from updates to actuarial
assumptions regarding the Company's expected losses for
57
<PAGE>
more recent policy years. These revisions are based on changes in expected
values of ultimate losses resulting from the Company's claim experience, and
increased reliance on such claim experience. While management and its actuaries
believe that the present reserve is reasonable, ultimate settlement of losses
may vary from the amount recorded and result in additional fluctuations in
income in future periods.
BAD DEBT EXPENSE. Bad debt expense, which is primarily attributable to the
provider business, decreased 93.7% or $44.5 million for the nine months ended
June 30, 1998 compared to the same period in fiscal 1997. The decrease was
primarily attributable to the effect of the consummation of the Crescent
Transactions, following which the bad debt expense incurred by the Psychiatric
Hospital Facilities and other facilities transferred to CBHS was no longer
accounted for as part of the Company's bad debt expense.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased 1.5%
or $0.6 million for the nine months ended June 30, 1998 compared to the same
period in fiscal 1997. The decrease was primarily attributable to the effect of
the consummation of the Crescent Transactions, whereby the Psychiatric Hospital
Facilities were sold to Crescent, offset by increases in depreciation and
amortization resulting from the HAI, Allied and Merit acquisitions of $16.7
million, in aggregate, for the nine months ended June 30, 1998, respectively.
INTEREST, NET. Interest expense, net, increased 25.5% or $10.0 million for
the nine months ended June 30, 1998 compared to the same period in fiscal 1997.
The increase was primarily the result of interest expense incurred on borrowings
used to fund the Merit acquisition and related transactions offset by lower
interest expense due to lower average borrowings and higher interest income due
to temporary investments of the cash received in the Crescent Transactions
through February 12, 1998.
OTHER ITEMS. Stock option expense for the nine months ended June 30, 1998
decreased $6.7 million, from the prior year period primarily due to fluctuations
in the market price of the Company's common stock.
The Company recorded Managed Care integration costs of $12.3 million for the
nine months ended June 30, 1998. See Note 18--"Subsequent Events--Integration
Plan" to the Company's audited financial statements for fiscal 1997, set forth
elsewhere herein.
The Company recorded equity in the loss of CBHS of $24.2 million for the
nine months ended June 30, 1998, representing the Company's proportionate (50%)
loss in CBHS. See Note 5--"Investment in CBHS" to the Company's audited
financial statements for fiscal 1997, set forth elsewhere herein.
The Company recorded unusual items, net, of $0.4 million, during the nine
months ended June 30, 1997, which consisted of a $5.4 million pre-tax gain on
the sale of previously closed psychiatric hospitals offset by a $4.2 million
charge for the closure of three psychiatric hospitals and one general hospital
and a $1.6 million charge related to the termination of an agreement to sell the
Company's European Hospitals. The Company recorded unusual items, net, of $(3.0)
million, during the nine months ended June 30, 1998 for the net gain on the sale
of hospitals that were previously closed.
The Company's effective income tax rate increased to 47.3% for the nine
months ended June 30, 1998, respectively, compared to 40% in the fiscal 1997
period. The increase was primarily attributable to non-deductible goodwill
amortization of approximately $6.2 million resulting from the Merit acquisition
in fiscal 1998.
Minority interest decreased $1.9 million during the nine months ended June
30, 1998, compared to the same period in fiscal 1997. The decrease was primarily
attributable to the Green Spring Minority Shareholder Conversion in January 1998
offset by Green Spring's net income growth in fiscal 1998 through January 1998.
58
<PAGE>
The Company recorded extraordinary losses on early extinguishment of debt,
net of tax, of $5.3 million and $33.0 million during the nine months ended June
30, 1997 and 1998, respectively, related primarily to the termination of its
then existing credit agreements in fiscal 1997 and the termination of the Credit
Agreement and extinguishment of the Old Notes in fiscal 1998. See Note
18--"Subsequent Events--Effect of the Merit Acquisition on Long-Term Debt" to
the Company's audited financial statements for fiscal 1997, set forth elsewhere
herein.
FISCAL 1996 COMPARED TO FISCAL 1997.
REVENUE. Managed care business revenue increased 58.3%, or $134.0 million,
in fiscal 1997 compared to fiscal 1996. The increase resulted primarily from the
inclusion of a full year of Green Spring operations in fiscal 1997 results.
Managed care business revenue was also positively impacted by the award of
several new contracts to Green Spring in the fourth quarter of fiscal 1996 and
in fiscal 1997, resulting in a 22% increase in covered lives on September 30,
1997 as compared to September 30, 1996.
Public sector business revenue increased 33.5%, or $23.7 million, in fiscal
1997 compared to fiscal 1996. The increase was primarily attributable to a 23%
increase in placements in Mentor homes and $5.2 million in additional revenues
from correctional contracts awarded in fiscal 1996 and fiscal 1997.
Healthcare franchising business revenue was $22.7 million for fiscal 1997.
The healthcare franchising business revenue consisted of Franchise Fees paid by
CBHS pursuant to the Master Franchise Agreement since the consummation of the
Crescent Transactions.
Provider business revenue decreased 30.2%, or $315.1 million, in fiscal 1997
compared to fiscal 1996. The decrease resulted primarily from: (i) the effect of
the consummation of the Crescent Transactions on June 17, 1997, following which
revenue from the Psychiatric Hospital Facilities and other facilities
transferred to CBHS was no longer recorded as part of the Company's revenue;
(ii) the closure of hospitals in fiscal 1996 and 1997; and (iii) reduced
equivalent patient days at the Company's operating hospitals as a result of
reduced average length of stay. During fiscal 1996 and 1997, the Company
recorded revenue of $28.3 million and $27.4 million, respectively, for
settlements and adjustments related to reimbursement issues with respect to
psychiatric hospital facilities owned by the Company. The settlements and
adjustments related primarily to certain reimbursement issues associated with
the Company's financial reorganization in fiscal 1992 and early extinguishment
of long-term debt in fiscal 1994. Management anticipates that revenue related to
such settlements will decline significantly for fiscal 1998.
SALARIES, COST OF CARE AND OTHER OPERATING EXPENSES. Salaries, cost of care
and other operating expenses attributable to the managed care business increased
59.8%, or $121.1 million, in fiscal 1997 compared to fiscal 1996 as a result of
the acquisition of Green Spring and its growth during the period.
With respect to the public sector business, salaries, cost of care and other
operating expenses increased 42.5%, or $25.9 million, in fiscal 1997 compared to
fiscal 1996 due to internal growth, increases in costs related to expansion and
approximately $1.2 million of expenditures related to new product development.
The Company recorded no expenses with respect to the healthcare franchising
business during fiscal 1996 because the Crescent Transactions were not
consummated until the third quarter of fiscal 1997.
Salaries, cost of care and other operating expenses attributable to the
provider business decreased 29.7%, or $227.4 million, in fiscal 1997 compared to
fiscal 1996. The decrease resulted primarily from: (i) the effect of the
consummation of the Crescent Transactions, following which operating expenses of
the Psychiatric Hospital Facilities and other facilities transferred to CBHS
were no longer accounted for as part of the Company's operating expenses and
(ii) the closure of hospitals during fiscal 1996 and 1997. During fiscal 1996
and 1997, the Company recorded reductions of expenses of approximately $15.3
59
<PAGE>
million and $7.5 million, respectively, as a result of updated actuarial
estimates related to malpractice claim reserves. These reductions resulted
primarily from updates to actuarial assumptions regarding the Company's expected
losses for more recent policy years. These revisions are based on changes in
expected values of ultimate losses resulting from the Company's claim
experience, and increased reliance on such claim experience. While management
and its actuaries believe that the present reserve is reasonable, ultimate
settlement of losses may vary from the amount recorded and result in additional
fluctuations in income in future periods.
Salaries and other operating expenses attributable to the Company's
headquarters decreased 26.5%, or $9.2 million, due primarily to the transfer of
personnel and overhead to CBHS and the healthcare franchising business as a
result of the Crescent Transactions.
BAD DEBT EXPENSE. Bad debt expense, which is primarily attributable to the
provider business, decreased 43.3%, or $35.3 million, in fiscal 1997 compared to
fiscal 1996. The decrease was primarily attributable to: (i) the effect of the
consummation of the Crescent Transactions, following which the bad debt expense
of the Psychiatric Hospital Facilities and other facilities transferred to CBHS
was no longer accounted for as part of the Company's bad debt expense; (ii)
improved accounts receivable aging and turnover compared to prior periods; and
(iii) a shift towards governmental and managed care payors, which reduced the
Company's credit risk associated with individual patients.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased
8.3%, or $4.1 million, in fiscal 1997 compared to fiscal 1996. The decrease was
primarily attributable to the effect of the consummation of the Crescent
Transactions, whereby the Psychiatric Hospital Facilities were sold to Crescent,
offset by increases in depreciation and amortization resulting from the Green
Spring acquisition.
INTEREST, NET. Interest, net, decreased 5.5%, or $2.6 million, in fiscal
1997 compared to fiscal 1996. The decrease was primarily the result of lower
interest expense due to lower average borrowings and higher interest income due
to temporary investments of the cash received in the Crescent Transactions.
Fiscal 1996 included approximately $5.0 million of interest income related to
income tax refunds from the State of California for the Company's income tax
returns for fiscal 1982 through 1989.
OTHER ITEMS. Stock option expense for fiscal 1997 increased $3.4 million
from fiscal 1996 primarily due to fluctuations in the market price of the
Company's Common Stock.
The Company recorded equity in the loss of CBHS of $8.1 million in fiscal
1997, representing the Company's proportionate (50%) loss in CBHS for the 106
days ended September 30, 1997.
The Company recorded a loss on the Crescent Transactions of approximately
$59.9 million during fiscal 1997.
The Company recorded unusual items, net, of $0.4 million during fiscal 1997,
which consisted of: (i) a $5.4 million net pre-tax gain on the sales of
previously closed psychiatric hospitals; (ii) a $4.2 million charge for the
closure of three psychiatric hospitals and one general hospital; and (iii) a
$1.6 million charge related to the termination of an agreement to sell the
Company's European hospitals.
Minority interest increased $2.9 million during fiscal 1997 compared to
fiscal 1996. The increase was primarily due to: (i) the Company acquiring a
controlling interest in Green Spring in December 1995; (ii) Green Spring's
internal growth subsequent to the acquisition date; and (iii) increased net
income from hospital-based joint ventures.
The Company recorded extraordinary losses on early extinguishment of debt,
net of tax, of $5.3 million during fiscal 1997.
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The fourth quarter of fiscal 1997 included increases to income before income
taxes and minority interest of approximately $6.4 million for revenue and bad
debt adjustments related to accounts receivable retained by the Company that
were generated by the hospitals operated by CBHS. Such adjustments reflect a
change in estimates of contractual allowances and allowance for doubtful
accounts of such receivables based on the collection activity subsequent to the
completion of the Crescent Transactions.
FISCAL 1995 COMPARED TO FISCAL 1996.
REVENUE. The Company's net revenue for fiscal 1996 increased 16.8%, or
$193.5 million, compared to fiscal 1995. The increase resulted primarily from
the acquisitions of Green Spring and Mentor offset in part by: (i) the effect of
hospitals closed during fiscal 1995 and 1996 and (ii) the decrease in revenue
per equivalent patient day in fiscal 1996. Net revenue per equivalent patient
day at the Company's psychiatric hospitals decreased in 1996 by 4.5% compared to
fiscal 1995. The decreases were primarily due to: (i) continued shift in payor
mix from private payor sources to managed care payors and governmental payors;
(ii) pricing pressure from certain payors, primarily related to the denial of
claims payable to the hospitals; (iii) lower settlements of reimbursement
issues; (iv) shifts in program mix to residential treatment settings from acute
care settings; and (v) the elimination of ESOP expense in fiscal 1996, which
resulted in lower Medicare reimbursement levels.
Managed care business revenue was $229.9 million in 1996, as a result of the
acquisition of Green Spring during the first quarter of fiscal 1996.
Public sector business revenue increased from $44.8 million in fiscal 1995
to $70.7 million in fiscal 1996 as a result of the inclusion of a full year of
operations of Mentor, which was acquired in January 1995.
During fiscal 1995 and 1996, the Company recorded revenue of $35.6 million
and $28.3 million, respectively, for settlements and adjustments related to
reimbursement issues with respect to psychiatric hospital facilities owned by
the Company. The settlements in fiscal 1995 and 1996 related primarily to
certain reimbursable costs associated with the Company's financial
reorganization in fiscal 1992 and costs related to the early extinguishment of
long-term debt in fiscal 1994.
SALARIES, COST OF CARE AND OTHER OPERATING EXPENSES. The Company's
salaries, cost of care and other operating expenses increased 23.3%, or $200.8
million, in fiscal 1996 compared to fiscal 1995. The increase resulted primarily
from the acquisitions of Green Spring and Mentor, offset in part by: (i) the
effect of hospitals closed in fiscal 1995 and 1996 and (ii) adjustments, as a
result of updated actuarial estimates to malpractice claim reserves, which
resulted in a reduction of expenses of approximately $15.3 million during fiscal
1996.
Managed care business salaries, cost of care and other operating expenses
were $202.7 million during fiscal 1996 as a result of the Green Spring
acquisition.
Public sector business salaries, cost of care and other operating expenses
increased from $38.1 million in fiscal 1995 to $60.8 million during fiscal 1996
as a result of the Mentor acquisition.
BAD DEBT EXPENSE. The Company's bad debt expense decreased 11.5%, or $10.6
million, during fiscal 1996 compared to fiscal 1995. The decrease was primarily
due to: (i) the shift in the provider business to managed care payors, which
reduces the Company's credit risk associated with individual patients, and (ii)
the number of reduced days of net revenue in its hospital receivables at
September 30, 1996.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
28.5%, or $10.8 million, during fiscal 1996 compared to fiscal 1995. The
increase resulted primarily from depreciation and amortization related to the
acquisition of Green Spring.
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Reorganization value in excess of amounts allocable to identifiable assets
("Reorganization Value") and ESOP expense were not recorded in fiscal 1996 as a
result of the completion of the amortization of Reorganization Value in fiscal
1995 and the Company's decision to allocate all existing shares held by the ESOP
to the participants as of September 30, 1995.
INTEREST, NET. Interest, net, decreased 13.1%, or $7.2 million, during
fiscal 1996 compared to fiscal 1995. The decrease resulted primarily from
approximately $5.0 million of interest income recorded during fiscal 1996
related to income tax refunds due from the State of California for the Company's
income tax returns for fiscal 1982 through 1989.
OTHER ITEMS. Stock option expense for fiscal 1996 increased $1.4 million
from the previous year due to fluctuations in the market price of the Company's
Common Stock.
During fiscal 1996, the Company recorded unusual items of $37.3 million.
Included in the unusual charges was the resolution of a billing dispute in
August 1996 between the Company and a group of insurance carriers that arose in
fiscal 1996 related to matters originating in the 1980's. As part of the
settlement of these claims, certain related payor matters and associated legal
fees, the Company recorded a charge of approximately $30.0 million. The Company
is paying the insurance settlement in twelve installments over a three-year
period. The Company's obligation to make the settlement payments is supported by
a cash collateralized letter of credit. Other unusual items included: (i)
charges of approximately $4.1 million during fiscal 1996 related to the closure
of psychiatric hospitals; (ii) a charge of approximately $1.2 million related to
impairment losses; and (iii) charges of approximately $2.0 million related to
severance costs for personnel reductions.
During fiscal 1995, the Company recorded unusual items of $57.4 million. The
unusual charges include the resolution in March 1995 of disputes between the
Company and a group of insurance carriers that arose in fiscal 1995 related to
claims paid predominantly in the 1980's. As part of the resolution, the Company
agreed to pay the insurance carriers approximately $29.8 million in five
installments over a three-year period. Other unusual items included: (i) a
charge of approximately $3.6 million related to the closure of five psychiatric
hospitals; (ii) a charge of approximately $27.0 million related to the adoption
and implementation of Statement of Financial Accounting Standards No. 121; and
(iii) a gain of approximately $3.0 million on the sale of three psychiatric
hospitals.
In fiscal 1995, the Company recorded an income tax benefit because it had a
net operating loss during the period. The Company's effective tax rate was 40.0%
during fiscal 1996. The change in the effective tax rate was primarily
attributable to: (i) the elimination of non-deductible amortization of
Reorganization Value in fiscal 1996 and (ii) the reduction in the Company's
effective tax rate as a result of the favorable resolution of the Company's
California income tax returns for fiscal 1982 through 1989, partially offset by
the increase in non-deductible intangible amortization in fiscal 1996 as a
result of the acquisitions of Mentor and Green Spring.
Minority interest increased $5.8 million during fiscal 1996 compared to
fiscal 1995. The increase was primarily due to the Company acquiring a
controlling interest in Green Spring in December 1995 and obtaining a
controlling interest in other businesses during fiscal 1995 and 1996.
IMPACT OF CRESCENT TRANSACTIONS ON RESULTS OF OPERATIONS.
The Company owns a 50% equity interest in CBHS, from which it receives the
Franchise Fees. The Franchise Fees represent a significant portion of the
Company's earnings and cash flows. The following is a discussion of certain
matters related to the Company's ownership of CBHS that may have a bearing on
the Company's future results of operations.
CBHS may consolidate services in selected markets by closing facilities
depending on market conditions and evolving business strategies. For example,
during fiscal 1995 and 1996, the Company
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consolidated, closed or sold 15 and 9 psychiatric hospitals, respectively.
During fiscal 1997, the Company consolidated or closed three psychiatric
hospitals, prior to the Crescent Transactions. If CBHS closes additional
psychiatric hospitals, it could result in charges to income for the costs
attributable to the closures, which would result in additional losses in the
equity in loss of CBHS for the Company.
The Company's joint venture hospitals and CBHS' hospitals continue to
experience a shift in payor mix to managed care payors from other payors, which
contributed to a reduction in revenue per equivalent patient day in fiscal 1996
and a decline in average length of stay in fiscal 1995, 1996 and 1997.
Management anticipates a continued shift in hospital payor mix towards managed
care payors as a result of changes in the healthcare marketplace. Future shifts
in hospital payor mix to managed care payors could result in lower revenue per
equivalent patient day and lower average length of stay in future periods for
the Company's joint venture hospitals and CBHS' hospitals, which could result in
lower equity in earnings from CBHS for the Company and cash flows to pay the
Franchise Fees. The hospitals currently managed or operated by CBHS, including
hospitals closed or sold in 1997, reported a 10% reduction in equivalent patient
days, a 7% reduction in average length of stay and a 4% decrease in admissions
as compared to the same period in 1996.
The Budget Act, which was enacted in August 1997, includes provisions that
eliminated the TEFRA bonus payment and reduced reimbursement of certain costs
previously paid by Medicare and eliminated the Medicaid "disproportionate share"
program. These provisions, along with other provisions in the Budget Act, will
reduce the amount of revenue and earnings that CBHS hospitals will receive for
the treatment of Medicare patients. CBHS management estimates that such
reductions will approximate $10 million in fiscal 1998, and due to the phase-in
effects of the Budget Act, approximately $15 million annually in subsequent
fiscal years.
Based on operational projections prepared by CBHS management for the quarter
ended September 30, 1998, and for the fiscal year ended September 30, 1999, and
on CBHS' results of operations through June 30, 1998, the Company believes that
CBHS will be unable to pay the full amount of the Franchise Fees it is
contractually obligated to pay the Company during fiscal 1998 and fiscal 1999.
CBHS has paid $30.6 million of Franchise Fees to the Company during the nine
months ended June 30, 1998. As of June 30, 1998, the Company had Franchise Fees
receivable from CBHS, net of equity in loss of CBHS in excess of the Company's
investment in CBHS, of approximately $13.2 million reflected in the consolidated
balance sheet. The Company expects to receive additional Franchise Fee payments
from CBHS of $9.4 million to $14.4 million during the quarter ended September
30, 1998, in the form of cash payments and settlements of other amounts due to
CBHS. The Company also estimates that CBHS will be able to pay $15.0 million to
$25.0 million of Franchise Fees in fiscal 1999. Accordingly, the Company
believes the Franchise Fees receivable from CBHS, net of equity in loss of CBHS
in excess of the Company's investment in CBHS, at June 30, 1998, is fully
collectible. However, the Company may reflect Franchise Fee revenue in its
statements of operations for future periods which is lower in amount than that
specified in the Master Franchise Agreement if CBHS does not generate sufficient
cash flows to allow for payment of future Franchise Fees. Based on the amount of
unpaid Franchise Fees to date, the Company has exercised certain rights
available to it under the Master Franchise Agreement and is assisting CBHS
management in improving profitability. See "Charter Advantage--Franchise
Operations."
On August 19, 1998, the Company announced that it had terminated discussions
with COI for the sale of its interest in CBHS. The Company will record a charge
against earnings in the fourth quarter of fiscal 1998 of approximately $1.5
million to $2.0 million for CBHS Transaction costs incurred to date. In
addition, actions taken by CBHS in the fourth quarter of fiscal 1998 to improve
long-term profitability will result in immediate charges to CBHS income, which
will result in additional losses in the equity in loss of CBHS for the Company
in the fourth quarter of fiscal 1998.
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IMPACT OF THE ACQUISITION ON RESULTS OF OPERATIONS.
As of June 30, 1998, the Company had approximately 61.3 million covered
lives under managed behavioral healthcare contracts and manages behavioral
healthcare programs for over 4,000 customers. The Company believes it also now
has the number one market position in each of the major product markets in which
it competes, according to enrollment data reported in OPEN MINDS. The Company
believes that the Acquisition creates opportunities for the Company to achieve
significant cost savings in its managed behavioral healthcare business.
Management believes that cost saving opportunities will result from leveraging
fixed overhead over a larger revenue base and an increased number of covered
lives and from reducing duplicative corporate and regional selling, general and
administrative expenses. As a result, the Company expects to achieve
approximately $60.0 million of cost savings in its managed behavioral healthcare
business on an annual basis within eighteen months following the consummation of
the Acquisition. The Company expects to spend approximately $30.0 million during
the eighteen months following the consummation of the Acquisition in connection
with achieving such costs.
The Company expects to record additional managed care integration costs
during future quarters to the extent the Integration Plan results in additional
facility closures at HAI and Green Spring and for integration plan costs
incurred that benefit future periods.
The full implementation of the Integration Plan is expected to take eighteen
months. The Acquisition and related transactions are expected to be dilutive to
earnings until the Integration Plan is complete.
HISTORICAL LIQUIDITY AND CAPITAL RESOURCES
OPERATING ACTIVITIES. The Company's net cash provided by operating
activities was $101.9 million and $73.6 million for fiscal 1996 and fiscal 1997,
respectively. The decrease in net cash provided by operating activities in
fiscal 1997 compared to fiscal 1996 was primarily the result of: (i) higher
income tax payments ($9.3 million and $18.4 million in fiscal 1996 and fiscal
1997, respectively); (ii) $5.0 million of interest income related to income tax
refunds from the State of California in fiscal 1996; (iii) higher insurance
settlement payments ($24.6 million in fiscal 1996 and $28.5 million in fiscal
1997); and (iv) reduced cash flows from the provider business, net of franchise
fees received.
The Company's net cash provided by (used in) operating activities was
approximately $5.2 million and $(5.4) million for the nine months ended June 30,
1997 and 1998, respectively. Operating cash flows for the nine months ended June
30, 1998 were adversely affected by unpaid Franchise Fees of $20.5 million, the
prepayment of CHARTER call center management fees to CBHS of $3.9 million,
insurance settlement payments of $10.8 million and payments of unpaid claims of
$11.4 million.
INVESTING ACTIVITIES. The Company acquired a 61% ownership interest in
Green Spring during the first quarter of fiscal 1996. The consideration paid for
Green Spring and related acquisition costs resulted in the use of cash of
approximately $87.2 million compared to approximately $50.9 million for
acquisitions and investments in businesses, including CBHS, during fiscal 1997.
The Crescent Transactions have resulted in net proceeds of $374.4 million,
during fiscal 1997 and 1998, consisting of $393.7 million related to the sale of
property and equipment to Crescent and CBHS less $19.3 million in costs and
construction obligations incurred to date.
The Company made $20.0 million of cash capital contributions to CBHS during
fiscal 1997. The Company has no present intention of making any additional
capital contributions to CBHS.
The Company utilized $1.0 billion in funds, net of cash acquired, for
acquisitions and investments in businesses, including the Allied, HAI and Merit
acquisitions during the nine months ended June 30, 1998.
FINANCING ACTIVITIES. The Company borrowed approximately $104.8 million and
$203.6 million during fiscal 1996 and 1997, respectively. The fiscal 1996
borrowings primarily funded the Green Spring
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acquisition and $35.0 million of treasury stock purchases. The fiscal 1997
borrowings primarily funded the repayment of variable rate secured notes and
other long-term debt (including the refinancing of a previous revolving credit
agreement), acquisitions and working capital needs.
The Company repaid approximately $85.8 million and $390.3 million of debt
and capital lease obligations during fiscal 1996 and 1997, respectively. The
fiscal 1997 repayments related primarily to a previous revolving credit
agreement and repaying other indebtedness as a result of the Crescent
Transactions.
On January 25, 1996, the Company sold 4.0 million shares of Common Stock
along with the Rainwater-Magellan Warrant pursuant to the Private Placement. The
Rainwater-Magellan Warrant, which expires in January, 2000, entitles the holder
to purchase 2.0 million shares of Common Stock at a per share price of $26.15,
subject to adjustment for certain dilutive events, and provides registration
rights for the shares of Common Stock underlying the warrant. The warrant became
exercisable on January 25, 1997. The Company received proceeds of approximately
$68.6 million, net of issuance costs, from the Private Placement. Approximately
$68.0 million of the proceeds were used to repay outstanding borrowings related
to the Green Spring acquisition.
The Company issued approximately 2.6 million warrants to Crescent and COI
for $25.0 million in cash as part of the Crescent Transactions during fiscal
1997.
On September 27, 1996, the Company repurchased approximately 4.0 million
shares of its Common Stock for approximately $73.5 million, including
transaction costs, pursuant to a "Dutch Auction" self-tender offer to its
stockholders. On November 1, 1996, the Company announced that its board of
directors approved the repurchase of an additional 3.0 million shares of its
Common Stock from time to time subject to the terms of the Magellan Existing
Credit Agreement.
The Company borrowed approximately $126.8 million, net of issuance costs, in
the first quarter of fiscal 1997, primarily to refinance its then existing
credit agreement. The Company borrowed approximately $1.2 billion during the
nine months ended June 30, 1998 primarily to fund the Transactions. Also, the
Company extinguished the Old Notes for approximately $418.4 million during the
nine months ended June 30, 1998. The Company repurchased approximately 545,000
shares of its common stock for approximately $12.5 million during the nine
months ended June 30, 1998.
As of June 30, 1998, the Company had approximately $112.5 million of
availability under the Revolving Facility of the Credit Agreement. The Company
was in compliance with all debt covenants as of June 30, 1998.
OUTLOOK--LIQUIDITY AND CAPITAL RESOURCES
The interest payments on the New Notes and interest and principal payments
on indebtedness outstanding pursuant to the New Credit Agreement will represent
significant liquidity requirements for the Company. Borrowings under the New
Credit Agreement will bear interest at floating rates and will require interest
payments on varying dates depending on the interest rate option selected by the
Company. Borrowings pursuant to the New Credit Agreement include $550 million
under the Term Loan Facility and up to $150 million under the Revolving
Facility. Commencing in the second quarter of fiscal 1999, the Company will be
required to make principal payments with respect to the Term Loan Facility. The
Company will be required to repay the principal amount of borrowings outstanding
under the Term
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Loan Facility provided for in the New Credit Agreement and the principal amount
of the New Notes in the years and amounts set forth in the following table:
<TABLE>
<CAPTION>
FISCAL YEAR PRINCIPAL AMOUNT
- ------------- -----------------
<S> <C>
1999...... $ 19.8
2000...... 32.4
2001...... 38.9
2002...... 49.4
2003...... 92.0
2004...... 156.5
2005...... 131.8
2006...... 29.2
2007...... --
2008...... 625.0
</TABLE>
In addition, any amounts outstanding under the Revolving Credit Facility created
by the New Credit Agreement mature in 2004.
The Company has finalized its plans for the integration of the businesses of
Green Spring, HAI and Merit. The Company expects to achieve approximately $60.0
million of cost savings on an annual basis within eighteen months following the
consummation of the Acquisition. Such cost savings are measured relative to the
combined budgeted amounts of the Company, Merit and HAI for the current fiscal
year prior to the cost savings initiatives. The Company expects to spend
approximately $30.0 million during the eighteen months following the
consummation of the Merit acquisition in connection with achieving such cost
savings, including expenses related to reducing duplicative personnel in its
managed care organizations, contractual terminations for eliminating excess real
estate (primarily locations under operating leases) and other related costs in
connection with the integration plan. Certain of such costs will be capital
expenditures.
POTENTIAL PURCHASE PRICE ADJUSTMENTS. During December 1997, the Company
purchased HAI and Allied for approximately $122.1 million and $70.0 million,
respectively, excluding transaction costs. In addition, the Company incurred the
obligation to make contingent payments to the former owners of HAI and Allied.
With respect to HAI, the Company may be required to make additional contingent
payments of up to $60.0 million annually to Aetna over the five-year period
subsequent to closing. The Company is obligated to make contingent payments
under two separate calculations as follows: In respect of each Contract Year (as
defined), the Company may be required to pay to Aetna the "Tranche 1 Payments"
(as defined) and the "Tranche 2 Payments" (as defined). "Contract Year" means
each of the twelve-month periods ending on the last day of December in 1998,
1999, 2000, 2001, and 2002.
Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest
with respect to such Contract Year in an amount equal to the product of (i) the
Tranche 1 Cumulative Incremental Members (as defined) for such Contract Year and
(ii) the Tranche 1 Multiplier (as defined) for such Contract Year. The vested
amount of Tranche 1 Payment shall be zero with respect to any Contract Year in
which the Tranche 1 Cumulative Incremental Members is a negative number.
Furthermore, in the event that the number of Tranche 1 Cumulative Incremental
Members with respect to any Contract Year is a negative number due to a decrease
in the number of Tranche 1 Cumulative Incremental Members for such Contract Year
(as compared to the immediately preceding Contract Year), Aetna will forfeit the
right to receive a certain portion (which may be none or all) of the vested and
unpaid amounts of the Tranche 1 Payment relating to preceding Contract Years.
"Tranche 1 Cumulative Incremental Members" means, with respect to any
Contract Year, (i) the number of Equivalent Members (as defined) serviced by the
Company during such Contract Year for Tranche 1 Members, minus (ii) (A) for each
Contract Year other than the initial Contract Year, the number of Equivalent
Members serviced by the Company for Tranche 1 Members during the immediately
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preceding Contract Year or (B) for the initial Contract Year, the number of
Tranche 1 Members as of September 30, 1997, subject to certain upward
adjustments. There were 3,761,253 Tranche 1 Members for the initial Contract
Year, prior to such upward adjustments. "Tranche 1 Members" are members of
managed behavioral healthcare plans for whom the Company provides services in
any of specified categories of products or services. "Equivalent Members" for
any Contract Year equals the aggregate Member Months for which the Company
provides services to a designated category or categories of members during the
applicable Contract Year divided by 12. "Member Months" means, for each member,
the number of months for which the Company provides services and is compensated.
The "Tranche 1 Multiplier" is $80, $50, $40, $25, and $20 for the Contract Years
1998, 1999, 2000, 2001, and 2002, respectively.
For each Contract Year, the Company is obligated to pay to Aetna the lesser
of (i) the vested portion of the Tranche 1 Payment for such Contract Year and
the vested and unpaid amount relating to prior Contract Years as of the end of
the immediately preceding Contract Year and (ii) $25.0 million. To the extent
that the vested and unpaid portion of the Tranche 1 Payment exceeds $25.0
million, the Tranche 1 Payment remitted to Aetna shall be deemed to have been
paid first from any vested but unpaid amounts from previous Contract Years in
order from the earliest Contract Year for which vested amounts remain unpaid to
the most recent Contract Year at the time of such calculation. Except with
respect to the Contract Year ending in 2002, any vested but unpaid portion of
the Tranche 1 Payment shall be available for payment to Aetna in future Contract
Years, subject to certain exceptions. All vested but unpaid amounts of Tranche 1
Payments shall expire following the payment of the Tranche 1 Payment in respect
to the Contract Year ending in 2002, subject to certain exceptions. In no event
shall the aggregate Tranche 1 Payments to Aetna exceed $125.0 million.
Upon the expiration of each Contract Year, the Tranche 2 Payment shall be an
amount equal to the lesser of: (a)(I) the product of (A) the Tranche 2
Cumulative Members (as defined) for such Contract Year and (B) the Tranche 2
Multiplier (as defined) applicable to such number of Tranche 2 Cumulative
Members, minus (II) the aggregate of the Tranche 2 Payments paid to Aetna for
all previous Contract Years and (b) $35.0 million. The amount shall be zero with
respect to any Contract Year in which the Tranche 2 Cumulative Members is a
negative number.
"Tranche 2 Cumulative Members" means, with respect to any Contract Year, (i)
the Equivalent Members serviced by the Company during such Contract Year for
Tranche 2 Members, minus (ii) the Tranche 2 Members as of September 30, 1997,
subject to certain upward adjustments. There were 936,391 Tranche 2 Members
prior to such upward adjustments. "Tranche 2 Members" means Members for whom the
Company provides products or services in the HMO category. The "Tranche 2
Multiplier" with respect to each Contract Year is $65 in the event that the
Tranche 2 Cumulative Members are less than 2,100,000, and $70 if more than or
equal to 2,100,000.
For each Contract Year, the Company shall pay to Aetna the amount of Tranche
2 Payment payable for such Contract Year. All rights to receive Tranche 2
Payment shall expire following the payment of the Tranche 2 Payment in respect
to the Contract Year ending in 2002, subject to certain exceptions.
Notwithstanding anything herein to the contrary, in no event shall the aggregate
Tranche 2 Payment to Aetna exceed $175.0 million, subject to certain exceptions.
The purchase price the Company paid for Allied is subject to increase or
decrease based on the operating performance of Allied during the three year
period following the closing. The Company may be required to pay up to $40.0
million during the three years following the closing of the Allied acquisition
based on Allied's performance relative to certain earnings targets. The
adjustments will be computed based on EBITDA (as defined in the Allied Purchase
Agreement) from the consolidated operations of Allied during each of the Year 1
Earn-Out Period, the Year 2 Earn-Out Period and the Year 3 Earn-Out Period
(each, as defined). "EBITDA," as defined in the Allied Purchase Agreement, means
the aggregate net revenue from the operations of Allied, minus all expenses
incurred in operating the business of
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Allied but before interest, income taxes, depreciation and amortization,
prepared in accordance with generally accepted accounting principles,
consistently applied, subject to specified adjustments. "Year 1 Earn-Out Period"
means the 12-month period ending on November 30, 1998. "Year 2 Earn-Out Period"
means the 12-month period ending on November 30, 1999. "Year 3 Earn-Out Period"
means the 12-month period ending on November 30, 2000.
With respect to the Year 1 Earn-Out Period, in the event the EBITDA for the
Year 1 Earn-Out Period (the "Year 1 EBITDA") is less than $10.0 million, then
the adjustment to the purchase price with respect to such period is an amount
equal to seven multiplied by the difference between the Year 1 EBITDA and $10.0
million. Such amount shall be paid to the Company from the portion of the
purchase price paid for Allied that was placed in escrow. In the event the Year
1 EBITDA is equal to or less than $11.0 million and equal to or greater than
$10.0 million, then there will be no adjustment to the purchase price with
respect to such period. In the event the Year 1 EBITDA is greater than $11.0
million, then the adjustment to the purchase price with respect to such period
is an amount equal to six multiplied by the difference between the Year 1 EBITDA
and $11.0 million. Such amount shall be paid in escrow for the benefit of the
sellers.
With respect to the Year 2 Earn-Out Period, in the event the EBITDA for the
Year 2 Earn-Out Period (the "Year 2 EBITDA") is equal to or less than the
greater of (i) $11.0 million or (ii) the Year 1 EBITDA (the greater of which
being the "Year 2 Threshold"), then the adjustment to the purchase price with
respect to such period is an amount equal to the sum of (i) six multiplied by
the difference between the Year 2 Threshold and the greater of (x) $11.0 million
or (y) the Year 2 EBITDA, plus (ii) an amount equal to seven multiplied by the
amount, if any, by which the Year 2 EBITDA is less than $10.0 million. Such
amount shall be paid to the Company from the portion of the purchase price paid
for Allied that was placed in escrow. In the event the Year 2 EBITDA is greater
than the Year 2 Threshold, then the adjustment to the purchase price with
respect to such period is the amount equal to six multiplied by the difference
between the Year 2 EBITDA and the Year 2 Threshold. Such amount shall be paid in
escrow for the benefit of the sellers. If the Year 2 EBITDA is equal to or
greater than $10.0 million but less than or equal to $11.0 million, there will
be no adjustment to the purchase price with respect to such period.
With respect to the Year 3 Earn-Out Period, in the event the EBITDA for the
Year 3 Earn-Out Period (the "Year 3 EBITDA") is equal to or less than the
greater of (i) $11.0 million, (ii) the Year 1 EBITDA, or (iii) the Year 2 EBITDA
(the greatest of which being the "Year 3 Threshold"), then the adjustment to the
purchase price with respect to such period is an amount equal to the sum of (i)
four multiplied by the difference between the Year 3 Threshold and the greater
of (x) $11.0 million or (y) the Year 3 EBITDA, plus (ii) an amount equal to
seven multiplied by the amount, if any, by which the Year 3 EBITDA is less than
$10.0 million. Such amount shall be paid to the Company from the portion of the
purchase price paid for Allied that was placed in escrow. In the event the Year
3 EBITDA is greater than the Year 3 Threshold, then the adjustment to the
purchase price with respect to such period is the amount equal to four
multiplied by the difference between the Year 3 EBITDA and the Year 3 Threshold.
Such amount shall be paid to the sellers. If the Year 3 EBITDA is equal to or
greater than $10.0 million but less than or equal to $11.0 million, there will
be no adjustment to the purchase price with respect to such period.
In connection with Merit's acquisition of CMG, the Company, by acquiring
Merit, may be required to make certain future contingent cash payments over the
next two years to the former shareholders of CMG based upon the performance of
certain CMG customer contracts. Such contingent payments are subject to an
aggregate maximum of $23.5 million.
The Revolving Facility will provide the Company with revolving loans and
letters of credit in an aggregate principal amount at any time not to exceed
$150.0 million. At June 30, 1998, the Company had approximately $112.5 million
of availability under the Revolving Facility. The Company currently estimates
that it will spend approximately $50.0 million for capital expenditures in
fiscal 1999. The majority of the Company's anticipated capital expenditures
relate to management information systems
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and related equipment. The Company believes that the cash flow generated from
its operations together with amounts available for borrowing under the New
Credit Agreement, and its ability to raise capital through the issuance of
additional debt and equity securities, which the Company believes it could issue
under appropriate market conditions, should be sufficient to fund its debt
service requirements, anticipated capital expenditures, contingent payments, if
any, with respect to HAI, Allied and CMG and other investing and financing
activities. The Company's future operating performance and ability to service or
refinance the Notes or to extend or refinance the indebtedness outstanding
pursuant to the New Credit Agreement will be subject to future economic
conditions and to financial, business and other factors, many of which are
beyond the Company's control.
The New Credit Agreement imposes restrictions on the Company's ability to
make capital expenditures and both the New Credit Agreement and the Indenture
governing the Notes limit the Company's ability to incur additional
indebtedness. Such restrictions, together with the highly leveraged financial
condition of the Company subsequent to the Transactions, limit the Company's
ability to respond to market opportunities. The covenants contained in the New
Credit Agreement also, among other things, restrict the ability of the Company
to dispose of assets, repay other indebtedness, amend other debt instruments
(including the Indenture), pay dividends, create liens on assets, enter into
sale and leaseback transactions, make investments, loans or advances, redeem or
repurchase common stock and make acquisitions. See "Risk Factors--Substantial
Leverage and Debt Service Obligations," "Description of the New Notes" and
"Summary of New Credit Agreement."
RECENT ACCOUNTING PRONOUNCEMENTS
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants ("AICPA") issued Statement of Position
98-1, "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" ("SOP 98-1"). SOP 98-1 establishes accounting guidance for
internal-use software. SOP 98-1 requires the following:
- Computer software costs that are incurred in the preliminary project state
(as described in SOP 98-1) should be expensed as incurred. Once the
capitalization criteria of SOP 98-1 have been met, external direct costs
of materials and services consumed in developing or obtaining internal-use
computer software; payroll and payroll-related costs for employees who are
directly associated with and who devote time to the internal-use computer
software project (to the extent of the time spent directly on the
project); and interest costs incurred when developing computer software
for internal use should be capitalized. Training costs and data conversion
costs should generally be expensed as incurred.
- Internal costs incurred for upgrades and enhancements should be expensed
or capitalized in accordance with SOP 98-1. Internal costs incurred for
maintenance should be expensed as incurred. Entities that cannot separate
internal costs on a reasonably cost-effective basis between maintenance
and relatively minor upgrades and enhancements should expense such costs
as incurred.
- External costs incurred under agreements related to specified upgrades and
enhancements should be expensed or capitalized in accordance with SOP
98-1. However, external costs related to maintenance, unspecified upgrades
and enhancements, and costs under agreements that combine the costs of
maintenance and unspecified upgrades and enhancements should be recognized
in expense over the contract period on a straight-line basis unless
another systematic and rational basis is more representative of the
services received.
- Impairment should be recognized and measured in accordance with the
provisions of FASB Statement No. 121, ACCOUNTING FOR THE IMPAIRMENT OF
LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF.
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- The capitalized costs of computer software developed or obtained for
internal use should be amortized on a straight-line basis unless another
systematic and rational basis is more representative of the software's
use.
SOP 98-1 becomes effective for financial statements for fiscal years
beginning after December 15, 1998. The provisions of SOP 98-1 should be applied
to internal-use software costs incurred in those fiscal years for all projects,
including those projects in progress upon initial application of SOP 98-1. Costs
incurred prior to the initial application of SOP 98-1, whether capitalized or
not, should not be adjusted to the amounts that would have been capitalized had
SOP 98-1 been in effect when those costs were incurred.
The Company must adopt SOP 98-1 no later than October 1, 1999. Each of the
Company's operating units maintains its own information systems, which includes
internal-use software as defined by SOP 98-1. The care management and claims
processing systems used in the managed care segment are the Company's most
significant internal-use software applications. The Company is in the process of
evaluating the requirements of SOP 98-1 versus its internal-use software
capitalization policies. The Company does not believe SOP 98-1 will have a
material impact on its financial position or results of operations.
In April 1998, the AICPA issued Statement of Position 98-5, "Reporting on
the Costs of Start-up Activities" ("SOP 98-5"). SOP 98-5 requires all
nongovernmental entities to expense costs of start-up activities as those costs
are incurred. Start-up costs, as defined by SOP 98-5, include pre-operating
costs, pre-opening costs and organization costs.
SOP 98-5 becomes effective for financial statements for fiscal years
beginning after December 31, 1998. At adoption, a company must record a
cumulative effect of a change in accounting principle to write off any
unamortized start-up costs remaining on the balance sheet when SOP 98-5 is
adopted. Prior year financial statements cannot be restated. The Company must
adopt SOP 98-5 no later than October 1, 1999. The Company does not believe SOP
98-5 will have a material impact on its financial position or results of
operations.
MODIFICATION OF COMPUTER SOFTWARE FOR THE YEAR 2000
The Company and its subsidiaries have internally developed computer software
systems that process transactions based on storing two digits for the year of a
transaction (i.e., "97 " for 1997) rather than four digits, which will be
required for year 2000 transaction processing. CBHS expects to spend $1.0
million in the aggregate during fiscal 1998 and fiscal 1999 to modify internal
use software. The Company expects to spend approximately $1.6 million in the
aggregate during fiscal 1998 and fiscal 1999 to modify internal use software.
The Company does not anticipate incurring any other significant costs for year
2000 software modification. The cost of modifying internal use software for the
year 2000 is charged to expense as incurred.
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MERIT'S MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
THE FOLLOWING IS AN EXCERPT FROM MERIT'S ANNUAL REPORT ON FORM 10-K FOR ITS
FISCAL YEAR ENDED SEPTEMBER 30, 1997. THE EXCERPT IS PRESENTED TO ASSIST HOLDERS
OF THE OLD NOTES IN EVALUATING THE EXCHANGE OFFER. THE EXCERPT HAS BEEN REVISED
TO PERMIT CONSISTENT USE OF TERMS DEFINED ELSEWHERE IN THIS PROSPECTUS.
FURTHERMORE, THE COMPANY ADDED THE TEXT THAT APPEARS IN ITALICS AND PARENTHESIS
TO PROVIDE (I) AN EXPLANATION OF CERTAIN TERMS THAT ARE DEFINED ELSEWHERE IN
MERIT'S ANNUAL REPORT ON FORM 10-K AND (II) A CROSS REFERENCE FROM MERIT'S
DEFINITIONS OF ADJUSTED EBITDA AND ADJUSTED EBITDA MARGIN TO ITS DISCUSSION OF
LIQUIDITY AND CAPITAL RESOURCES. THE FOLLOWING ALSO INCLUDES DISCUSSION AND
ANALYSIS OF MERIT'S RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED DECEMBER
31, 1996 AND 1997.
OVERVIEW
REVENUE
Typically, Merit charges each of its HMO, Blue Cross/Blue Shield
organization, insurance company, corporate, union, governmental and other
customers a flat monthly capitation fee for each beneficiary enrolled in such
customer's behavioral health managed care plan or EAP. This capitation fee is
generally paid to Merit in the current month. Contract revenue billed in advance
of performing related services is deferred and recognized ratably over the
period to which it applies. For a number of Merit's behavioral health managed
care programs, the capitation fee is divided into outpatient and inpatient fees,
which are recognized separately. Outpatient revenue is recognized monthly as it
is received; inpatient revenue is recognized monthly and in most cases is (i)
paid to Merit monthly (in cases where Merit is responsible for the payment of
inpatient claims) or in certain cases (ii) retained by the customer for payment
of inpatient claims. When the customer retains the inpatient revenue, actual
inpatient costs are periodically reconciled to amounts retained and Merit
receives the excess of the amounts retained over the cost of services, or
reimburses the customer if the cost of services exceeds the amounts retained. In
certain instances, such excess or deficiency is shared between Merit and the
customer.
DIRECT SERVICE COSTS AND MARGINS
Direct service costs are comprised principally of expenses associated with
managing, supervising and providing Merit's services, including third-party
network provider charges, various charges associated with Merit's staff offices,
inpatient facility charges, costs associated with members of management
principally engaged in Merit's clinical operations and their support staff, and
rent for certain offices maintained by Merit in connection with the delivery of
services. Direct service costs are recognized in the month in which services are
expected to be rendered. Network provider and facility charges for authorized
services that have not been reported and billed to Merit (known as incurred but
not reported expenses, or "IBNR") are estimated and accrued based on historical
experience, current enrollment statistics, patient census data, adjudication
decisions, and other information.
Merit has experienced an increase in direct service costs as a percentage of
revenue (which have been offset to varying degrees by various initiatives
described below) primarily as a result of changing product mix and pricing
pressure associated with both the competitive bid process for new contracts and
negotiations to extend existing contracts. The portion of Merit's revenue
attributable to capitated managed care programs has continuously been
increasing. Because capitated managed care programs require Merit to incur
greater direct service costs than EAP and ASO managed care programs, the direct
profit margins attributable to such programs are lower than the direct profit
margins attributable to Merit's EAP and ASO programs. Merit is continuing to
focus on reducing direct service costs. Efforts intended to reduce these costs
include: (i) negotiating better rates and/or different compensation arrangements
(such as retainer arrangements, volume discounts, case rates and capitation of
fees) with third-party network providers and treatment facilities; (ii)
contracting with treatment facilities that provide
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a broader spectrum of treatment programs in an effort to expand beneficiary
access to a broader continuum of care, thereby achieving more cost-effective
treatment; (iii) focusing management and clinical care techniques on patients
requiring more intensive treatment services to assure that such patients receive
the appropriate level of care in a cost-efficient and effective manner; (iv)
implementing a new information system intended to enable Merit to improve the
productivity and efficiency of its operations; and (v) increasing the overall
efficiency of Merit's staff provider system by closing or consolidating less
efficient staff offices, streamlining operations and increasing the efficiency
of remaining staff offices.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses are comprised principally of
corporate and regional overhead expenses, such as marketing and sales, legal,
finance, information systems and administrative expenses, as well as
professional and consulting fees, and the compensation of members of the Merit's
senior management. Merit expects selling, general and administrative expenses to
grow over the near term, primarily due to growth in information systems expenses
related to the implementation of AMISYS-Registered Trademark- (A CENTRALIZED
INFORMATION SYSTEM THAT IS MERIT'S PRIMARY SYSTEM) as well as increases in
regional administration and sales and marketing operations necessary to support
the growth of Merit's business; however, Merit expects selling, general and
administrative expenses to grow at a rate less than that of anticipated revenue
growth in the future. There can be no assurance, however, that anticipated
revenue growth will occur or that any such revenue growth will occur at a rate
greater than the rate of growth in selling, general and administrative expenses.
AMORTIZATION OF INTANGIBLES
As a result of Merck's (MERCK & CO., INC.) acquisition of Medco Containment
Services, Inc. (MERIT'S PREVIOUS OWNER) in November 1993, Merit's financial
statements include an allocation by Merck of the excess of its cost over fair
market value of the net assets acquired. Accordingly, goodwill and other
acquisition-related intangibles in the amount of $160.0 million were recorded on
Merit's balance sheet as of November 1993 and are being amortized over various
periods. A noncurrent deferred tax liability of $47.8 million was established to
reflect the tax consequences of the difference between the financial and tax
reporting bases of the identified intangibles. Merit's total goodwill also
includes goodwill associated with Merit's acquisitions of Group Plan Clinic,
Inc., and of BenesYs, Inc. (collectively, "BenesYs"), a Houston-based behavioral
health managed care organization, and CMG. In addition, the payment made to
Empire (EMPIRE BLUE CROSS AND BLUE SHIELD ("EMPIRE")) in connection with the
Empire Joint Venture (MERIT'S JOINT VENTURE WITH EMPIRE IN SEPTEMBER 1995 (THE
"EMPIRE JOINT VENTURE")), the acquisition of ProPsych, Inc. ("ProPsych") in
December 1995, and various contingent consideration payments, together with the
goodwill recognized from the BenesYs and CMG transactions, resulted in the
incurrence of additional goodwill of approximately $117.8 million. Amortization
of acquisition-related intangibles was $20.1 million in fiscal 1995, $23.0
million in fiscal 1996, and $23.8 million in fiscal 1997.
Merit also capitalizes certain start-up expenses related to new contracts
and amortizes these amounts over the life of the contracts. When Merit enters
into a new contract or significantly expands services for an existing customer,
Merit typically incurs up-front start-up costs that historically have ranged
from $50,000 to $2.5 million per program. These start-up costs include, among
other things, the costs of recruiting, interviewing and training providers and
support staff, establishing offices and other facilities, acquiring furniture,
computers and other equipment, and implementing information systems. As of
September 30, 1997, Merit's balance sheet reflected $9.0 million of deferred
start-up costs, net of amortization, categorized under long-term assets.
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LIQUIDITY
Merit's liquidity is affected by the one-to-four-month lag between the time
Merit receives cash from capitation payments under new contracts and the time
when Merit pays the claims for services rendered by third-party network
providers and treatment facilities relating to such capitation payments. During
the first few months of a new contract, Merit builds cash balances as capitation
payments are received and also builds a payables balance as direct service costs
are accrued based on expected levels of service. After the first several months
of a contract, monthly claims payments typically increase to normal levels and
the contract generates cash commensurate with the expected profit margin for
that contract. When a contract is terminated, monthly capitation payments cease
on contract termination, but claims for services rendered prior to termination
continue to be received and paid for several months. This post contract
termination period is often referred to as the "run-off" period. To date,
contract terminations have not had a material impact on Merit's liquidity.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, which will
be effective for Merit beginning October 1, 1998. SFAS No. 131 redefines how
operating segments are determined and requires disclosure of certain financial
and descriptive information about a company's operating segments. Merit has not
yet completed its analysis with respect to which operating segments of its
business it will provide such information.
RESULTS OF OPERATIONS
SELECTED OPERATING RESULTS
The following table sets forth certain statement of operations items of
Merit expressed as a percentage of revenue:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
FISCAL YEAR ENDED SEPTEMBER 30, DECEMBER 31,
<S> <C> <C> <C> <C> <C>
1995 1996 1997 1996 1997
--------- --------- --------- --------- ---------
Revenue............................................. 100.0% 100.0% 100.0% 100.0% 100.0%
Direct service costs................................ 79.1 79.0 80.9 80.0 82.4
--------- --------- --------- --------- ---------
Direct profit margin.............................. 20.9 21.0 19.1 20.0 17.6
Selling, general and administrative expenses........ 13.8 14.1 12.2 12.9 12.4
Amortization of intangibles......................... 5.9 5.7 4.8 5.3 4.1
Restructuring charge................................ -- 0.6 -- -- --
Income from joint ventures.......................... -- -- -- -- (0.9)
--------- --------- --------- --------- ---------
Operating Income.................................. 1.2 0.6 2.1 1.8 2.0
Other income........................................ 0.4 0.6 0.6 0.6 0.6
Interest expense.................................... -- (5.2) (4.5) (4.8) (4.1)
Loss on disposal of subsidiary...................... -- -- (1.2) -- --
Merger costs and special charges.................... -- (0.8) (0.2) -- (0.3)
--------- --------- --------- --------- ---------
Income (loss) before income taxes and cumulative
effect of accounting change....................... 1.6 (4.8) (3.2) (2.4) (1.8)
Provision (benefit) for income taxes................ 1.2 (1.1) (0.7) (0.2) (0.3)
--------- --------- --------- --------- ---------
Income (loss) before cumulative effect of accounting
change............................................ 0.4% (3.7)% (2.5)% 2.2% 1.5%
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Adjusted EBITDA margin.............................. 9.4% 9.9% 9.8% 10.1% 9.8%
</TABLE>
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(MERIT'S FORM 10-K ELSEWHERE INCLUDED THE FOLLOWING DEFINITIONS: "ADJUSTED
EBITDA" REPRESENTS THE SUM OF OPERATING INCOME, DEPRECIATION AND
AMORTIZATION, AND OTHER INCOME AND EXPENSE, EXCLUDING RESTRUCTURING CHARGES
IN 1993 AND 1996. ADJUSTED EBITDA IS PRESENTED BECAUSE A SIMILAR MEASURE IS
USED IN THE COVENANTS CONTAINED IN THE INDENTURE (FOR THE MERIT OUTSTANDING
NOTES) AND MERIT BELIEVES THAT ADJUSTED EBITDA IS A WIDELY ACCEPTED
FINANCIAL INDICATOR OF A COMPANY'S ABILITY TO SERVICE DEBT. HOWEVER,
ADJUSTED EBITDA SHOULD NOT BE CONSTRUED AS AN ALTERNATIVE TO MERIT'S
OPERATING INCOME, NET INCOME OR CASH FLOW FROM OPERATING ACTIVITIES (AS
DETERMINED IN ACCORDANCE WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES) AND
SHOULD NOT BE CONSTRUED AS AN INDICATION OF MERIT'S OPERATING PERFORMANCE OR
AS A MEASURE OF MERIT'S LIQUIDITY. IN ADDITION, ITEMS EXCLUDED FROM EBITDA,
SUCH AS RESTRUCTURING CHARGES AND DEPRECIATION AND AMORTIZATION, ARE
SIGNIFICANT COMPONENTS IN UNDERSTANDING AND ASSESSING THE COMPANY'S
FINANCIAL PERFORMANCE.
"ADJUSTED EBITDA MARGIN" REPRESENTS ADJUSTED EBITDA AS A PERCENTAGE OF
REVENUE.
SEE "-- LIQUIDITY AND CAPITAL RESOURCES" FOR A COMPLETE DISCUSSION OF MERIT'S
PROSPECTS RELATED TO NET INCOME, CASH FLOWS FROM OPERATIONS AND INVESTING
AND FINANCING ACTIVITIES.)
THREE MONTHS ENDED DECEMBER 31, 1997 COMPARED TO THREE MONTHS ENDED DECEMBER 31,
1996
REVENUE. Revenue increased by $48.6 million, or 37.8%, to $177.2 million
for the three months ended December 31, 1997 from $128.6 million for the three
months ended December 31, 1996. Of this increase, $30.4 million was attributable
to the inclusion of revenue from certain contracts that commenced during the
prior fiscal year as well as additional revenue from existing customers
generated by an increase in both the number of programs managed by Merit on
behalf of such customers and an increase in the number of beneficiaries enrolled
in such customers' programs; and $0.5 million was attributable to new customers
commencing service in the current quarter. Also, Merit's acquisition of CMG on
September 12, 1997 contributed an additional $32.6 million in revenue for the
fiscal 1998 period. These revenue increases were partially offset by an $11.2
million decrease in revenue as a result of the termination of certain contracts,
$11.0 million of which was due to terminations that occurred in various periods
of the prior fiscal year. Also, Merit's disposition of Choate Health Management,
Inc. and certain related companies (collectively "Choate") in September 1997
resulted in a revenue decrease of $3.7 million for the fiscal 1998 period.
Contract price increases were not a material factor in the increase in revenue.
DIRECT SERVICE COSTS. Direct service costs increased by $43.1 million, or
41.9% , to $146.0 million for the three months ended December 31, 1997 from
$102.9 million for the three months ended December 31, 1996. As a percentage of
revenue, direct service costs increased from 80.0% in the prior year period to
82.4% in the current year period. The increase in cost as a percentage of
revenue was due primarily to the lower than average direct profit margins earned
on contracts for the State of Montana and for the Delaware County Medicaid
programs. In general, Merit's Medicaid contracts with governmental entities tend
to have significant revenue levels, with direct profit margins which are lower
than Merit's other contracts. The State of Montana contract was obtained through
the CMG acquisition in September 1997. The Delaware County contract started in
February 1997.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased by $5.5 million, or 33.1%, to $22.1 million
for the three months ended December 31, 1997 from $16.6 million for the three
months ended December 31, 1996. The increase in total selling, general and
administrative expenses was primarily attributable to (i) growth in marketing
and sales administrative staff, corporate and regional management and support
systems associated with the higher sales volume; (ii) inclusion of CMG's results
of operation since the acquisition date; and (iii) expenses related to the
planned deployment of Merit's new information systems. As a percentage of
revenue, selling, general and administrative expenses decreased from 12.9% in
the prior year period to 12.5% in the
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current year period. This decline is due to Merit's efforts to contain such
expenses as well as an allocation of such expenses over a larger revenue base.
AMORTIZATION OF INTANGIBLES. Amortization of intangibles increased $0.4
million, or 6.4%, to $7.2 million for the three months ended December 31, 1997
from $6.8 million for the three months ended December 31, 1996. The increase was
primarily due to an increase in amortization of goodwill and other intangibles
recognized in connection with the acquisition of CMG.
INCOME FROM JOINT VENTURES. For the three months ended December 31, 1997,
Merit had income from joint ventures of $1.6 million. The majority of such
income is from Merit's 50% interest in the CHOICE Behavioral Health Partnership,
which Merit obtained in connection with the CMG acquisition.
OTHER INCOME (EXPENSE). For the three months ended December 31, 1997, other
income and expense consisted of (i) interest expense of $7.2 million related to
debt incurred as a result of the merger of Merit and an affiliate of Kohlberg
Kravis Roberts & Co. ("KKR") in October 1995 (the "1995 Merger"), and debt
incurred in connection with the acquisition of CMG; (ii) interest and other
income of $1.1 million relating primarily to investment earnings on Merit's
short-term investments and restricted cash balances; and (iii) merger costs and
special charges of $0.5 million relating primarily to expenses incurred for the
Transactions. The year over year increase in interest expense of $1.0 million
was primarily attributable to the interest expense incurred on the additional
debt issued in September 1997 in order to finance the acquisition of CMG. The
year over year increase in interest income of $0.3 million was primarily
attributable to both an increase in average invested cash balances as compared
to the prior year period and interest earned on advances to certain joint
ventures.
INCOME TAXES. Merit recorded a benefit for income taxes during the three
months ended December 31, 1996 and 1997 based upon Merit's pre-tax loss for such
periods.
FISCAL 1997 COMPARED TO FISCAL 1996
REVENUE. Revenue increased by $97.9 million, or 21.4%, to $555.7 million
for fiscal 1997 from $457.8 million for fiscal 1996. Of this increase, $71.3
million was attributable to the inclusion of revenue from certain contracts that
commenced during the prior fiscal year as well as additional revenue from
existing customers generated by an increase in both the number of programs
managed by Merit on behalf of such customers and an increase in the number of
beneficiaries enrolled in such customers' programs; and $65.8 million was
attributable to new customers commencing service in the current year, a
significant portion of which was derived from Merit's contract relating to
CHAMPUS Regions 7 and 8, under which services commenced on April 1, 1997. In
addition, Merit's acquisition of CMG on September 12, 1997 contributed an
additional $7.0 million in revenue for fiscal 1997. These revenue increases were
partially offset by a $46.2 million decrease in revenue as a result of the
termination of certain contracts, $29.1 million of which was due to contract
terminations that occurred in various periods of the prior fiscal year. Contract
price increases were not a material factor in the increase in revenue.
DIRECT SERVICE COSTS. Direct service costs increased by $87.9 million, or
24.3%, to $449.6 million for fiscal 1997 from $361.7 million for fiscal 1996. As
a percentage of revenue, direct service costs increased from 79.0% in the prior
year period to 80.9% in the current year period. The increase in cost as a
percentage of revenue was due primarily to the lower than average direct profit
margin earned on the TennCare Partners and the Delaware County Medicaid
programs, partially offset by a year over year decline in healthcare treatment
services utilization in Merit's overall business. In addition, the Delaware
County carve-out program replaced a program under which beneficiaries previously
received their mental health benefit through membership in various HMOs
servicing this area. Direct profit margins under contracts that Merit held with
certain of these HMOs, which terminated or membership in which decreased
substantially as a result of the Delaware County program, were higher than the
direct profit margins for the Delaware County program and Merit's overall
average direct profit margins. Excluding
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the effect of the TennCare Partners and the Delaware County contracts, however,
Merit experienced a decline in the direct service cost percentage as a result of
overall lower healthcare utilization in the current year period as compared to
the prior year period, due to Merit's continued development and deployment of
alternative treatment programs designed to achieve more cost-effective treatment
and Merit's increased focus on clinical care techniques directed at patients
requiring more intensive treatment services. Also positively impacting the
direct cost percentage were the effect of (i) a nationwide recontracting program
with providers which began in the second quarter of fiscal 1996, and (ii) the
closing of certain underperforming staff offices pursuant to a plan implemented
by Merit in the fourth quarter of 1996.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased by $2.9 million, or 4.5%, to $67.4 million for
fiscal 1997 from $64.5 million for fiscal 1996. The increase in total selling,
general and administrative expenses was primarily attributable to (i) growth in
marketing and sales administrative staff, corporate and regional management and
support systems associated with the higher sales volume, (ii) expenses
associated with the expansion of both Merit's National Service Center located in
St. Louis, Missouri and Merit's headquarters located in Park Ridge, New Jersey,
(iii) expenses related to the planned deployment of Merit's new information
systems, and (iv) inclusion of CMG's results of operations since the acquisition
date. As a percentage of revenue, selling, general and administrative expenses
decreased from 14.1% in the prior year period to 12.2% in the current year
period primarily as a result of these expenses being allocated over a larger
revenue base. Contributing significantly to this decrease were the TennCare
Partners and the Delaware County programs, which are large, self-contained
programs requiring minimal selling, general and administrative expenses or Merit
operational support, thereby mitigating, in large part, the effects of their
lower than average direct service cost margins described above.
AMORTIZATION OF INTANGIBLES. Amortization of intangibles increased by $1.0
million, or 4.0%, to $26.9 million for fiscal 1997 from $25.9 million for fiscal
1996. The increase was primarily due to an increase in amortization of goodwill
recognized in connection with the acquisitions of ProPsych and CMG as well as to
increases in the amortization of deferred contract start-up costs related to new
contracts.
OTHER INCOME (EXPENSE). For fiscal 1997, other income and expense consisted
of (i) interest expense of $25.1 million related to debt incurred as a result of
the 1995 Merger (OF MERIT AND AN AFFILIATE OF KOHLBERG KRAVIS ROBERTS & CO.
("KKR")) in October 1995 (THE "1995 MERGER"), (ii) interest and other income of
$3.5 million relating primarily to investment earnings on Merit's short-term
marketable securities and restricted cash and investment balances, (iii) a loss
of $6.9 million recognized in September 1997 on the disposal of Choate (CHOATE
HEALTH MANAGEMENT, INC. AND CERTAIN RELATED COMPANIES (COLLECTIVELY, "CHOATE")),
(iv) $0.7 million of expenses associated with uncompleted acquisition
transactions, and (v) $0.6 million of nonrecurring employee benefit costs
associated with the exercise of stock options by employees of Merit under plans
administered by Merck. The year over year increase in interest expense of $1.2
million was primarily attributable to (i) the full period impact of the
indebtedness incurred in October 6, 1995 by Merit in connection with the 1995
Merger; (ii) the full period impact of (THE MERIT OUTSTANDING) Notes, which bore
interest at a higher rate than the bridge financing facility that the (MERIT
OUTSTANDING) Notes replaced, and (iii) the increase in the senior credit
facility as a result of the acquisition of CMG. The year over year increase in
interest income of $0.7 million was primarily attributable to both an increase
in average invested cash balances as compared to the prior year period and
interest earned on advances to certain joint ventures.
INCOME TAXES. Merit recorded a benefit for income taxes during fiscal 1997,
based upon Merit's pre-tax loss in such period.
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FISCAL 1996 COMPARED TO FISCAL 1995
REVENUE. Revenue increased by $96.3 million, or 26.6%, to $457.8 million
for fiscal 1996 from $361.5 million for fiscal 1995. Of this increase, $87.7
million was attributable to the inclusion of revenue for the entire period from
certain contracts that commenced during the prior fiscal year as well as
additional revenue from existing customers generated by an increase in both the
number of programs managed by Merit on behalf of such customers and an increase
in the number of beneficiaries enrolled in such customers' programs; and $26.4
million was attributable to new customers commencing service in the current
year, the majority of which was derived from two contracts totaling $20.9
million. In addition, Merit's acquisitions of Choate and ProPsych contributed an
additional $18.4 million in revenue for fiscal 1996. These revenue increases
were partially offset by a $36.2 million decrease in revenue as a result of the
termination of certain contracts, five of which accounted for $21.1 million of
such decrease. Certain of these contracts had terminated in various periods of
the prior fiscal year. Contract price increases were not a material factor in
the increase in revenue.
DIRECT SERVICE COSTS. Direct service costs increased by $75.7 million, or
26.5%, to $361.7 million for fiscal 1996 from $286.0 million for fiscal 1995. As
a percentage of revenue, direct service costs decreased from 79.1% for fiscal
1995 to 79.0% for fiscal 1996. This net decrease in the direct service cost
percentage was due to a variety of largely offsetting factors. The direct
service cost percentage was positively impacted by lower inpatient utilization
in fiscal 1996 as compared to the prior year related to a significant contract
with an HMO focused on the Medicaid beneficiary population. Such decrease
resulted from the implementation of changes in program management and
modification of the clinical treatment protocols applicable to such contract. In
addition, Merit started to realize the benefits in fiscal 1996 of a nationwide
recontracting program with providers which began in the second quarter of such
year. Merit is continuing its efforts to reduce direct service costs to mitigate
the effects of pricing pressure, which is expected to continue in fiscal 1997,
associated with the competitive bid process for new contracts and negotiations
to extend existing contracts. The direct service cost percentage was adversely
impacted by the loss in the fourth quarter of fiscal 1995 of two contracts with
higher than average direct profit margins and a renewal of a significant
contract on lower pricing terms. In addition, Merit earned a lower than average
direct profit margin on a significant state Medicaid program which was not in
effect for the entire twelve month period in the prior year. Furthermore, in the
fourth quarter of fiscal 1996, Merit commenced providing services under the
TennCare Partners program. Due to the unusual structure of the TennCare Partners
program, the direct profit margin under such contract was lower than Merit's
average direct profit margin for fiscal 1996 and is expected to continue to be
lower in future periods.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased by $14.7 million, or 29.5%, to $64.5 million
for fiscal 1996 from $49.8 million for fiscal 1995. The increase in total
selling, general and administrative expenses was primarily attributable to (i)
growth in marketing and sales administrative staff, corporate and regional
management and support systems associated with the higher sales volume, (ii)
expenses associated with the expansion of the National Service Center, which
will allow for growth beyond Merit's current needs, and (iii) expenses related
to the planned deployment of Merit's new information systems. As a percentage of
revenue, selling, general and administrative expenses increased to 14.1% for
fiscal 1996 from 13.8% for fiscal 1995. The increase in such expenses, coupled
with unanticipated delays in the planned start dates of significant new
contracts (including the TennCare Partners program) secured by Merit,
contributed to the increase in selling, general and administrative expenses as a
percentage of revenue.
AMORTIZATION OF INTANGIBLES. Amortization of intangibles increased by $4.5
million, or 21.0%, to $25.9 million for fiscal 1996 from $21.4 million for
fiscal 1995. The increase was primarily due to an increase in amortization of
goodwill recognized in connection with the acquisitions of Choate and
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ProPsych and the Empire Joint Venture, as well as to increases in the
amortization of deferred contract start-up costs related to new contracts.
RESTRUCTURING CHARGE. Merit recorded a pre-tax restructuring charge of $3.0
million related to a plan, adopted and approved in the fourth quarter of 1996,
to restructure its staff offices by exiting certain geographic markets and
streamlining the field and administrative management organization of Continuum
Behavioral Healthcare Corporation, a subsidiary of Merit. This decision was in
response to the results of underperforming locations affected by the lack of
sufficient patient flow in the geographic areas serviced by these offices and
Merit's ability to purchase healthcare services at lower rates from its provider
network. In addition, it was determined that Merit would be able to expand
beneficiary access to specialists and other providers thereby achieving more
cost-effective treatment and to favorably shift a portion of the economic risk,
in some cases, of providing outpatient healthcare to the provider through the
use of case rates and other alternative reimbursement methods. The restructuring
charge was comprised primarily of accruals for employee severance, real property
lease terminations and write-off of certain assets in geographic markets which
were being exited. The restructuring plan was substantially completed during
fiscal 1997.
OTHER INCOME (EXPENSE). For fiscal 1996, other income and expense consisted
of (i) interest expense of $23.8 million incurred as a result of the increase in
long-term debt resulting from the 1995 Merger; (ii) merger expenses of $4.0
million consisting primarily of professional and advisory fees; and (iii)
interest and other income of $2.8 million relating primarily from investment
earnings on Merit's short-term investments and restricted cash balances.
INCOME TAXES. Merit recorded a benefit for income taxes during fiscal 1996
based upon Merit's pre-tax loss in such period. The resulting income tax benefit
has been partially offset by the nondeductible nature of certain merger costs.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE
Effective October 1, 1995, Merit changed its method of accounting for
deferred start-up costs related to new contracts or expansion of existing
contracts (i) to expense costs relating to start-up activities incurred after
commencement of services under the contract, and (ii) to limit the amortization
period for deferred start-up costs incurred prior to the commencement of
services to the initial contract period. Prior to October 1, 1995, Merit
capitalized start-up costs related to the completion of the provider networks
and reporting systems beyond commencement of contracts and, in limited
instances, amortized the start-up costs over a period that included the initial
renewal term associated with the contract. Under the new policy, Merit does not
defer contract start-up costs after contract commencement or include the initial
renewal term in the amortization period. The change was made to increase the
focus on controlling costs associated with contract start-ups.
Merit recorded a pre-tax charge of $1.8 million ($1.0 million after taxes)
in the first quarter of fiscal 1996 as a cumulative effect of a change in
accounting. The pro forma impact of this change for the year ended September 30,
1995 would be to increase costs and expenses by $1.8 million ($1.0 after taxes).
There was no pro forma effect on periods prior to fiscal 1995. The effect of the
change on fiscal 1996 cannot be reasonably estimated.
LIQUIDITY AND CAPITAL RESOURCES
GENERAL. For fiscal 1997, operating activities provided cash of $19.5
million, investing activities used cash of $70.7 million and financing
activities provided cash of $75.2 million, resulting in a net increase in cash
and cash equivalents of $24.1 million. Investing activities in fiscal 1997
consisted principally of (i) capital expenditures of $24.0 million related
primarily to the continued development of Merit's new information systems and
expansion of the National Service Center, (ii) payments totaling
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$42.2 million (net of cash acquired) for the acquisition of CMG, (iii) payments
totaling $2.6 million for funding under joint venture agreements, primarily with
Empire Community Delivery Systems, LLC and Community Sector Systems, Inc., and
(iv) expenditures of $4.1 million for the purchase of short-term investments
made to satisfy obligations under contracts held by Merit.
ACQUISITION (OF CMG). On September 12, 1997, Merit acquired all of the
outstanding capital stock of CMG for $48.7 million in cash and 739,358 shares of
Merit's common stock valued at $5.5 million. In addition, Merit agreed to absorb
certain expenses and other obligations of CMG totaling up to $5.4 million. CMG
is a Maryland-based national managed care company serving over 30 customers
through a network consisting of approximately 7,600 providers in 34 states. CMG
currently provides behavioral health managed care services to 2.5 million people
under full risk capitation, ASO and other funding arrangements. The clients
include state and local governments, Blue Cross /Blue Shield organizations, HMOs
and insurance companies. As additional consideration for the acquisition, Merit
may be required to make certain future contingent cash and stock payments over
the next two years to the former shareholders of CMG based upon the performance
of certain CMG customer contracts. Such contingent cash payments are subject to
an aggregate maximum of $23.5 million. The acquisition was accounted for using
the purchase method. Accordingly, the purchase price was allocated to assets
acquired based on their estimated fair values. This treatment resulted in
approximately $64.7 million of cost in excess of net tangible assets acquired as
of September 30, 1997. Such excess is being amortized on a straight line basis
over periods ranging up to 40 years. The inclusion of CMG from the date of
acquisition did not have a significant impact on Merit's results of operations.
SENIOR INDEBTEDNESS. As of September 30, 1997, $30.0 million of revolving
loans and $8.3 million of letters of credit were outstanding under the revolving
credit facility of the (MERIT EXISTING) Credit Agreement with The Chase
Manhattan Bank, N.A. (the "(MERIT) Senior Credit Facility"), and approximately
$46.7 million was available for future borrowing.
ADJUSTED EBITDA. Adjusted EBITDA, a financial measure used in the (MERIT)
Senior Credit Facility and the indenture (FOR THE MERIT OUTSTANDING NOTES),
increased by $9.6 million, or 21.3%, to $54.7 million for fiscal 1997 from $45.1
million for 1996.
CASH IN CLAIMS FUNDS AND RESTRICTED CASH. As of September 30, 1997, Merit
had total cash, cash equivalents, restricted cash and investment balances of
$95.2 million, of which $51.3 million was restricted under certain contractual,
fiduciary and regulatory requirements; moreover, of such amount, $3.7 million
was classified as a long-term asset on Merit's balance sheet. Under certain
contracts, Merit is required to establish segregated claims funds into which a
portion of its capitation fee is held until a reconciliation date (which
reconciliation typically occurs annually). Until that time, cash funded under
these arrangements is unavailable to Merit for purposes other than the payment
of claims. In addition, California and Illinois state regulatory requirements
restrict access to cash held by Merit's subsidiaries in such states. As of
September 30, 1997, Merit also held surplus cash balances, classified as
restricted cash and investments--current, as required by the contracts held by
Merit relating to Medicaid programs for the States of Iowa and Montana and the
TennCare Partners and Delaware County Medicaid programs described above.
AVAILABILITY OF CASH. Prior to the 1995 Merger, Merit funded its operations
primarily with cash generated from operations and through the funding of certain
acquisitions, investments and other transactions by its former parent, Merck.
Merit currently and in the future expects to finance its capital requirements
through existing cash balances, cash generated from operations and borrowings
under the revolving credit facility of the (MERIT) Senior Credit Facility. Based
upon the current level of cash flow from operations and anticipated growth,
Merit believes that available cash, together with available borrowings under the
revolving credit facility and other sources of liquidity, will be adequate to
meet Merit's anticipated future requirements for working capital, capital
expenditures and scheduled payments of principal and interest on its
indebtedness for the foreseeable future.
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INDUSTRY
OVERVIEW
Behavioral healthcare costs have increased significantly in the United
States in recent years. According to industry sources, direct medical costs of
behavioral health problems, combined with the indirect costs, such as lost
productivity due to mental illness and alcohol and drug abuse, were estimated at
more than $300.0 billion in 1990, the latest year for which statistics are
available. In addition, according to industry sources, in 1994 (the most recent
year for which such information was available), direct behavioral healthcare
services treatment costs amounted to approximately $81.0 billion, or
approximately 8% of total healthcare industry spending. These direct costs have
grown, in part, as society has begun to recognize and address behavioral health
concerns and employers have realized that rehabilitation of employees suffering
from substance abuse and relatively mild mental health problems can reduce
losses due to absenteeism and decreased productivity.
In response to these escalating costs, managed behavioral healthcare
companies such as Green Spring, HAI and Merit have been formed. These companies
focus on care management techniques with the goal of arranging for the provision
of an appropriate level of care in a cost-efficient and effective manner by
improving early access to care and assuring an effective match between the
patient and the behavioral healthcare provider's specialty. As the growth of
managed behavioral healthcare has increased, there has been a significant
decrease in occupancy rates and average lengths of stay for inpatient
psychiatric facilities and an increase in outpatient treatment and alternative
care services.
According to OPEN MINDS, as of January 1997, approximately 149.0 million
beneficiaries were covered by some form of specialty managed behavioral
healthcare plan and an additional 19.5 million beneficiaries were enrolled in
internally-managed behavioral healthcare programs within HMOs. The number of
covered beneficiaries has grown from approximately 86.0 million beneficiaries in
1993 to approximately 149.0 million in 1997, representing an approximate 15%
compound annual growth rate since 1993. In addition, according to OPEN MINDS,
beneficiaries covered under risk-based programs are growing even more rapidly,
from approximately 13.6 million as of January 1993 to approximately 38.9 million
as of January 1997, representing a compound annual growth rate of over 30%. OPEN
MINDS estimates that the revenues of managed behavioral healthcare companies
totaled approximately $3.5 billion in 1996.
SEGMENTATION
OPEN MINDS divides the managed behavioral healthcare industry as of January
1997 into the following categories of care, based on services provided, extent
of care management and level of risk assumption:
<TABLE>
<CAPTION>
BENEFICIARIES PERCENT
CATEGORY OF CARE (IN MILLIONS) OF TOTAL
- ----------------------------------------------------------------------------------------- --------------- -----------
<S> <C> <C>
Utilization Review/Care Management Programs.............................................. 39.2 26.3%
Risk-Based Network Products.............................................................. 38.9 26.1
Non-Risk-Based Network Products.......................................................... 31.9 21.4
EAPs..................................................................................... 28.3 19.0
Integrated Programs...................................................................... 10.7 7.2
----- -----
Total............................................................................ 149.0 100.0%
----- -----
----- -----
</TABLE>
Management believes the current trends in the behavioral healthcare industry
include increased utilization of risk-based network managed care products and
the integration of EAPs with such managed care products. Management believes
that these trends have developed in response to the attempt by payors to reduce
rapidly escalating behavioral healthcare costs and to limit their risk
associated with
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such costs while continuing to provide access to high quality care. According to
OPEN MINDS, risk-based network products, integrated programs and EAPs are the
most rapidly growing segments of the managed behavioral healthcare industry.
UTILIZATION REVIEW/CARE MANAGEMENT PRODUCTS. Under utilization review/care
management products, a managed behavioral healthcare company manages and often
arranges for treatment, but does not maintain a network of providers or assume
any of the responsibility for the cost of providing treatment services. The
Company categorizes its products within this segment of the managed behavioral
healthcare industry (as it is defined by OPEN MINDS) as ASO products. The
Company does not expect this segment of the industry to experience significant
growth, given the growth of risk-based products.
NON-RISK-BASED NETWORK PRODUCTS. Under non-risk-based network products, the
managed behavioral healthcare company provides a full array of managed care
services, including selecting, credentialing and managing a network of providers
(such as psychiatrists, psychologists, social workers and hospitals), and
performs utilization review, claims administration and care management
functions. The third-party payor remains responsible for the cost of providing
the treatment services rendered. The Company categorizes its products within
this segment of the managed behavioral healthcare industry (as it is defined by
OPEN MINDS) as ASO products.
RISK-BASED NETWORK PRODUCTS. Under risk-based network products, the managed
behavioral healthcare company assumes all or a portion of the responsibility for
the cost of providing a full or specified range of behavioral healthcare
treatment services. Most of these programs have payment arrangements in which
the managed care company agrees to provide services in exchange for a fixed fee
per member per month that varies depending on the profile of the beneficiary
population or otherwise shares the responsibility for providing all or some
portion of the treatment services at a specific cost per person. Under these
products, the managed behavioral healthcare company not only approves and
monitors a course of treatment, but also arranges and pays for the provision of
patient care (either through its third-party network providers or staff
providers or some combination of network and staff providers). Therefore, the
managed behavioral healthcare company must be proficient in contracting with,
credentialing and managing a network of specialized providers and facilities
that covers the complete continuum of care. The managed behavioral healthcare
company must also ensure that the appropriate level of care is delivered in the
appropriate setting. Given the ability of payors of behavioral healthcare
benefits to reduce their risk with respect to the cost of treatment services
through risk-based network products while continuing to provide access to high
quality care, this market segment has grown rapidly in recent years. In addition
to the expected growth in total beneficiaries covered under managed behavioral
healthcare products, this shift of beneficiaries into risk-based network
products should further contribute to revenue growth for the managed behavioral
healthcare industry because such contracts generate significantly higher revenue
than ASO contracts. The higher revenue is intended to compensate the managed
behavioral healthcare company for bearing the financial responsibility for the
cost of delivering care. The Company's risk-based products are risk-based
network products as defined by OPEN MINDS.
EMPLOYEE ASSISTANCE PROGRAMS. An EAP is a worksite-based program designed
to assist in the early identification and resolution of productivity problems
associated with behavioral conditions or other personal concerns of employees.
Under an EAP, staff or network providers or other affiliated clinicians provide
assessment and referral services to employee beneficiaries. These services
consist of evaluating a patient's needs and, if indicated, providing limited
counseling and/or identifying an appropriate provider, treatment facility or
other resource for more intensive treatment services. The EAP industry developed
largely out of employers' efforts to combat alcoholism and substance abuse
problems afflicting workers. A 1990 industry survey estimated the total costs of
this dependency at approximately $98.6 billion per year. Many businesses have
implemented alcoholism and drug abuse
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treatment programs in the workplace, and in some cases have expanded those
services to cover a wider spectrum of personal problems experienced by workers
and their families. As a result, EAP products now typically include consultation
services, evaluation and referral services, employee education and outreach
services. The Company believes that federal and state "drug-free workplace"
measures and Federal Occupational Health and Safety Act requirements, taken
together with the growing public perception of increased violence in the
workplace, have prompted many companies to implement EAPs. Although EAPs
originated as a support tool to assist managers in dealing with troubled
employees, payors increasingly regard EAPs as an important component in the
continuum of behavioral healthcare services.
INTEGRATED EAP/MANAGED BEHAVIORAL HEALTHCARE PRODUCTS. EAPs are utilized in
a preventive role and in facilitating early intervention and brief treatment of
behavioral healthcare problems before more extensive treatment is required.
Consequently, EAPs often are marketed and sold in tandem with managed behavioral
healthcare programs through "integrated" product offerings. Integrated products
offer employers comprehensive management and treatment of all aspects of
behavioral healthcare. In an effort to both reduce costs and increase
accessibility and ease of treatment, employers are increasingly attempting to
consolidate EAP and managed behavioral healthcare services into a single
product. Although integrated EAP/managed behavioral healthcare products are
currently only a small component of the overall industry, the Company expects
this market segment to grow.
AREAS OF GROWTH
Management believes that the growth of the managed behavioral healthcare
industry will continue, as payors of behavioral healthcare benefits attempt to
reduce the costs of behavioral healthcare while maintaining high quality care.
Management also believes that a number of opportunities exist in the managed
behavioral healthcare industry for continued growth, primarily for risk-based
products. The following paragraphs discuss factors contributing to the growth of
risk-based products and the increase in the number of covered lives in certain
markets.
RISK-BASED PRODUCTS. According to OPEN MINDS, industry enrollment in
risk-based products has grown from approximately 13.6 million covered lives in
1993 to approximately 38.9 million covered lives in 1997, a compound annual
growth rate of over 30%. Despite this growth, only approximately 26% of total
managed behavioral healthcare covered lives were enrolled in risk-based products
in 1997. The Company believes that the market for risk-based products has grown
and will continue to grow as payors attempt to reduce their responsibility for
the cost of providing behavioral healthcare while ensuring an appropriate level
of access to care. Risk-based products can generate significantly greater
revenue per covered life than other non-risk product types. According to the
OPEN MINDS survey, risk-based products account for approximately two-thirds of
total managed behavioral healthcare industry premiums, but, as stated above,
accounted for only approximately 26% of total covered lives in 1997.
MEDICAID. Medicaid is a joint state and federal program to provide
healthcare benefits to approximately 33.0 million low income individuals,
including welfare recipients. According to the Health Care Financing
Administration of the United States Department of Health and Human Services
("HCFA"), federal and state Medicaid spending increased from $69.0 billion in
1990 to an estimated $160.0 billion in 1996, at an average annual rate almost
twice as fast as the annual increase in overall healthcare spending.
Furthermore, according to HCFA, from 1991 to 1996 the number of Medicaid
beneficiaries covered under full managed contracts grew at a compound annual
rate of approximately 40% per year. The Company expects that the Budget Act will
slow the growth of Medicaid spending by accelerating the trend of state Medicaid
programs toward shifting beneficiaries into managed care programs in order to
control rising costs.
Despite the recent increase in managed care enrollment of Medicaid
beneficiaries, Medicaid managed care enrollment as a percentage of all Medicaid
beneficiaries remains small. As of June 1996,
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according to the National Institute for Health Care Management, only
approximately 35% of all Medicaid beneficiaries were enrolled in some form of
managed care program, and less than 7% were enrolled in risk-based programs. The
Company expects the number of Medicaid recipients enrolled in managed behavioral
healthcare programs to increase through two avenues: (i) subcontracts with HMOs
and (ii) direct contracts with state agencies. As HMOs increase their
penetration of the Medicaid market, the Company expects that many HMOs will
continue to (or begin to) subcontract with managed behavioral healthcare
companies to provide services for Medicaid beneficiaries. State agencies have
also begun to contract directly with managed behavioral healthcare companies to
provide behavioral healthcare services to their Medicaid beneficiaries. Iowa,
Massachusetts, Nebraska, Maryland, Tennessee and Montana have decided to "carve
out" behavioral healthcare from their overall Medicaid managed care programs and
have contracted or are expected to contract directly with managed behavioral
healthcare companies to provide such services. The Company expects that the
Budget Act will accelerate the trend of states contracting directly with managed
behavioral healthcare companies. See "Risk Factors-- Dependence on Government
Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and
"Business--Regulation--Budget Act."
MEDICARE. Medicare is a federally funded healthcare program for the
elderly. Medicare has experienced an increase in its beneficiary population over
the past several years, as well as rapidly escalating healthcare costs.
According to HCFA, as of January 1, 1997, only approximately 4.9 million, or
13%, of the approximately 38.0 million eligible Medicare beneficiaries were
enrolled in managed care programs. Although enrollment has increased from
approximately 7% of the eligible Medicare beneficiaries in 1993, it is still
considerably below that of the commercial population. The Budget Act contains
provisions designed to increase enrollment of Medicare beneficiaries in managed
care plans as a means of achieving projected savings in Medicare expenditures.
Management believes that in response to increased healthcare costs and the
Budget Act, the Medicare market will shift into managed care programs in the
future, representing an opportunity for growth among managed behavioral
healthcare companies. See "Business--Regulation--Budget Act."
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BUSINESS
OVERVIEW
According to enrollment data reported in OPEN MINDS, the Company is the
nation's largest provider of managed behavioral healthcare services, offering a
broad array of cost-effective managed behavioral healthcare products. As of June
30, 1998, the Company had approximately 61.3 million covered lives under managed
behavioral healthcare contracts and manages behavioral healthcare programs for
over 4,000 customers. Through its current network of over 34,000 providers and
2,000 treatment facilities, the Company manages behavioral healthcare programs
for Blue Cross/Blue Shield organizations, HMOs and other insurance companies,
corporations, federal, state and local governmental agencies, labor unions and
various state Medicaid programs. The Company believes it has the largest and
most comprehensive behavioral healthcare provider network in the United States
as a result of the Acquisition. In addition to the Company's managed behavioral
healthcare products, the Company offers specialty managed care products related
to the management of certain chronic conditions. The Company also offers a broad
continuum of behavioral healthcare services to approximately 3,270 individuals
who receive healthcare benefits funded by state and local governmental agencies
through Mentor, its wholly-owned public-sector provider. Furthermore, the
Company franchises the "CHARTER" System of behavioral healthcare to the
Psychiatric Hospital Facilities and other facilities operated by CBHS, an entity
in which the Company owns a 50% equity interest.
The Company's professional care managers coordinate and manage the delivery
of behavioral healthcare treatment services through the Company's network of
providers, which includes psychiatrists, psychologists, licensed clinical social
workers, marriage and family therapists and licensed clinical professional
counselors. The treatment services provided by the Company's extensive
behavioral provider network include outpatient programs (such as counseling and
therapy), intermediate care programs (such as sub-acute emergency care,
intensive outpatient programs and partial hospitalization services), inpatient
treatment services and alternative care services (such as residential treatment,
home and community-based programs and rehabilitative and support services). The
Company provides these services through: (i) risk-based products, (ii) EAPs,
(iii) ASO products and (iv) products that combine features of some or all of
these products. Under risk-based products, the Company arranges for the
provision of a full range of behavioral healthcare services for beneficiaries of
its customers' healthcare benefit plans through fee arrangements under which the
Company assumes all or a portion of the responsibility for the cost of providing
such services in exchange for a fixed per member per month fee. Under EAPs, the
Company provides assessment services to employees and dependents of its
customers, and if required, referral services to the appropriate behavioral
healthcare service provider. Under ASO products, the Company provides services
such as utilization review, claims administration and provider network
management. The Company does not assume the responsibility for the cost of
providing healthcare services pursuant to its ASO products. As a result of the
Acquisition, based on total covered lives, the Company believes it is the
industry leader with respect to risk-based, ASO, EAP and integrated products.
For its fiscal year ended September 30, 1997, on a pro forma basis, risk-based,
ASO, EAP and integrated products would have accounted for 73%, 12%, 9% and 5%,
respectively, of the Company's managed behavioral healthcare net revenues.
The Company conducts operations in four segments: managed care operations,
public sector operations, franchise operations and provider operations. The
following describes the Company's business segments:
MANAGED CARE OPERATIONS. The managed care segment is the Company's primary
operating segment. The Company's managed care subsidiaries are Green Spring,
HAI, Allied and Merit. On a pro forma basis for fiscal 1997, revenue of the
Company's managed care operations would have been $1.25 billion and salaries,
cost of care and other operating expenses from its managed care operations would
have been $1.13 billion.
Green Spring is one of the largest companies in the managed behavioral
healthcare industry and is the largest managed behavioral healthcare provider to
the Blue Cross/Blue Shield networks. It currently covers approximately 23.4
million lives (29% of them pursuant to risk-based products) through a network
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of more than 34,000 providers. Green Spring's client base includes 25 Blue
Cross/Blue Shield plans, major HMOs and PPOs, state employee programs, Fortune
1000 corporations, labor unions and a growing number of state Medicaid programs.
Merit is one of the leading managed behavioral healthcare providers in the
nation, arranging for the provision of managed behavioral healthcare services to
approximately 21.6 million people, including approximately 10.6 million
risk-based lives. Merit manages behavioral healthcare programs for approximately
800 clients across all segments of the healthcare industry, with particularly
strong positions in the corporate and HMO segment. Merit is also a leading
provider to Blue Cross/Blue Shield organizations and other insurance companies,
corporations and labor unions, federal, state and local governmental agencies
and various state Medicaid programs.
HAI was one of the first and is one of the largest providers of EAP
products. It currently provides managed behavioral healthcare services to
approximately 16.3 million lives. HAI has providers in all 50 states, operating
through nine regional service centers. It serves many of the nation's largest
companies, including Aetna, Avis, Exxon, JP Morgan, MCI, Northwest Airlines and
Sears.
The Company recently acquired Allied to establish its presence in the
management of specialty healthcare services. Allied provides specialty
risk-based products and administrative services to a variety of insurance
companies and other customers, including Blue Cross of New Jersey, CIGNA and
NYLCare, for its 5.0 million members. Allied has over 80 physician networks
across the eastern United States. Allied's networks include physicians
specializing in cardiology, oncology and diabetes.
The Company's managed care operations also include certain physician
practice management businesses and certain behavioral staff model operations. In
fiscal 1997, the Company derived less than 2% of the pro forma revenues and
expenses from its managed care operations from physician practice management and
behavioral staff model operations. Therefore, the Company believes that such
business and operations are not material to its managed care business.
The Company's managed care operations are operated through two wholly owned
subsidiaries of the Company: Magellan Behavioral Healthcare Organization, Inc.
("Magellan BHO") and Magellan Specialty Medical Care Holdings, Inc. ("Magellan
Specialty Medical"). Magellan BHO is organized around three customer segments to
manage the products offered by Green Spring, Merit, HAI and Magellan Public
Solutions, as follows: (i) the HMO/Insurance Division, focusing on the needs of
health insurance plans and their members; (ii) the Corporate Employer/Union
Division, focusing on self-insured employers and unions and their employees and
dependents; and (iii) the Public Sector Division, focusing on the needs of
public purchasers of behavioral healthcare services and their constituents.
Magellan Specialty Medical focuses on the needs of health plans to manage their
specialty care networks and disease management programs in areas such as
diabetes, asthma, oncology and cardiology. Magellan Specialty Medical manages
the products offered by Allied and Care Management Resources, Inc.
PUBLIC SECTOR OPERATIONS. The Company's public sector business provides
specialty home-based behavioral healthcare services through Mentor to over 3,270
individuals in 95 programs in 20 states from 65 branches as of June 30, 1998.
Mentor was founded in 1983 and was acquired by the Company in January 1995.
Mentor's services include specialty home-based behavioral healthcare services,
which feature individualized home and community-based health and human services
delivered in highly structured and professionally monitored family environments
or "mentor" homes. The mentor homes serve clients with chronic behavioral
disorders and disabilities requiring long-term care, including children and
adolescents with behavioral problems, individuals with mental retardation or
developmental disabilities, and individuals with neurological impairment or
other medical and behavioral frailties.
FRANCHISE OPERATIONS. The Company's wholly-owned subsidiary Charter
Advantage, LLC ("Charter Advantage") franchises the "CHARTER" System of
behavioral healthcare to the Psychiatric Hospital Facilities and other
facilities operated by CBHS. See "Charter Advantage."
PROVIDER OPERATIONS. The Company's provider operations include the
ownership and operation of two psychiatric hospitals in London, England (a
45-bed hospital and a 78-bed hospital) and a 69-bed
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psychiatric hospital in Nyon, Switzerland (collectively, the "European
Facilities"). The Company's provider operations also include its interest in the
Joint Ventures and the 50% ownership of CBHS. The Company's Joint Venture
partner in four of the Joint Ventures is Columbia/HCA Healthcare Corporation.
Although the Company is the managing member of each Joint Venture, it has
delegated its management responsibilities to CBHS. The Company pays CBHS a fee
for managing the Joint Ventures equal to the Company's share of the earnings of
the Joint Ventures. The Company's provider operations also include a Puerto
Rican provider management business.
COMPETITIVE STRENGTHS
The Company believes it benefits from the competitive strengths described
below with respect to its managed behavioral healthcare business, which should
allow it to increase its revenues and cash flow. Furthermore, the Company
believes it can leverage its competitive strengths to expand its service
offerings into other specialty managed care products.
INDUSTRY LEADERSHIP. As a result of the Acquisition, the Company is the
nation's largest provider of managed behavioral healthcare services in the
United States, according to enrollment data reported in OPEN MINDS. The Company
believes, based on data reported in OPEN MINDS, that it also now has the number
one market position in each of the major product markets in which it competes.
The Company believes its industry leading position will enhance its ability to:
(i) provide a consistent level of high quality service on a nationwide basis;
(ii) enter into favorable agreements with behavioral healthcare providers that
allow it to effectively control healthcare costs for its customers; and (iii)
effectively market its managed-care products to large corporate, HMO and
insurance customers, which, the Company believes, increasingly prefer to be
serviced by a single-source provider on a national basis. See "Risk
Factors--Highly Competitive Industry" and "--Reliance on Customer Contracts" for
a discussion of the risks associated with the highly competitive nature of the
managed behavioral healthcare industry and the Company's reliance on contracts
with payors of behavioral healthcare benefits, respectively.
BROAD PRODUCT OFFERING AND NATIONWIDE PROVIDER NETWORK. The Company offers
a full spectrum of behavioral managed care products that can be designed to meet
specific customer needs, including risk-based and partial risk-based products,
integrated EAPs, stand-alone EAPs and ASO products. The Company's nationwide
provider network encompasses over 34,000 providers and 2,000 treatment
facilities in all 50 states. The Company believes that the combination of broad
product offerings and its nationwide provider network allows the Company to meet
virtually any customer need for managed behavioral healthcare on a nationwide
basis, and positions the Company to capture incremental revenue opportunities
resulting from the continued growth of the managed behavioral healthcare
industry and the continued migration of its customers from ASO and EAP products
to higher revenue risk-based products. See "Risk Factors--Risk-Based Products"
for a discussion of the risks associated with risk-based products, which are the
Company's primary source of revenue.
BROAD BASE OF STRONG CUSTOMER RELATIONSHIPS. The Company enjoys strong
customer relationships across all its markets, as evidenced by a contract
renewal rate of over 90% during the last three fiscal years. Management believes
that its strong customer relationships are attributable to the Company's broad
product offering, nationwide provider network, commitment to quality care and
ability to manage behavioral healthcare costs effectively. The Company's
customers include: (i) Blue Cross/Blue Shield organizations; (ii) national HMOs
and other large insurers, such as Aetna/US Healthcare, Humana and Prudential;
(iii) large corporations, such as IBM, Federal Express and AT&T; (iv) state and
local governmental agencies through commercial, Medicaid and other programs; and
(v) the federal government through contracts pursuant to CHAMPUS and with the
U.S. Postal Service. This broad base of strong customer relationships provides
the Company with stable and diverse sources of revenue and cash flow and an
established base from which to continue to increase covered lives and revenue.
See "Risk Factors--Reliance on Customer Contracts" for a discussion of the risks
associated with the Company's reliance on certain contracts with payors of
behavioral healthcare benefits.
PROVEN RISK MANAGEMENT EXPERIENCE. As a result of the Acquisition, the
Company has approximately 18.7 million covered lives under risk-based contracts,
making it the nation's industry leader in at-
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risk managed behavioral healthcare products, based on data reported in OPEN
MINDS. The Company's experience with risk-based products covering a large number
of lives (including the experience of Green Spring, HAI and Merit) has given it
a broad base of data from which to analyze utilization rates. The Company
believes that this broad database permits it to estimate utilization trends and
costs more accurately than many of its competitors, which allows it to bid
effectively. The Company believes that its experience has also allowed it to
develop effective measures for controlling the cost of providing a unit of care
to its covered lives. Among other cost control measures, the Company has
developed or acquired clinical protocols, which permit the Company to assist its
network providers to administer effective treatment in a cost efficient manner,
and claims management technology, which permits the Company to reduce the cost
of processing claims. As the Company integrates the managed care operations it
acquired in the Acquisition with its pre-existing managed care operations, it
will be able to select from the best practices of its subsidiaries to further
enhance its utilization and cost control methodologies. See "Risk
Factors--Integration of Operations" for a discussion of the risks associated
with integrating the Company's recently acquired businesses, including the
managed care operations it acquired in the Acquisition, with its existing
operations.
BUSINESS STRATEGY
INCREASE ENROLLMENT IN BEHAVIORAL MANAGED CARE PRODUCTS. The Company
believes it has a significant opportunity to increase covered lives in all its
behavioral managed care products. The Company believes its increased market
presence following the Acquisition will further enhance its ability to increase
ASO and EAP covered lives with large corporate, HMO and insurance customers. The
Company further believes that it has a significant opportunity to increase
revenues and cash flow by increasing lives covered by its risk-based products.
As a result of the Acquisition, the Company became the industry's leading
provider of risk-based products, according to data reported by OPEN MINDS, and
believes that it is well positioned to benefit from the continuing shift to
risk-based products. According to OPEN MINDS, industry enrollment in risk-based
products has grown from approximately 13.6 million in 1993 to approximately 38.9
million in 1997, representing a compound annual growth rate of over 30%. Despite
this growth, only approximately 26% of total managed behavioral healthcare
enrollees were in risk-based products in 1997. The Company believes that the
market for risk-based products has grown and will continue to grow as payors
attempt to reduce their cost of providing behavioral healthcare while ensuring a
high quality of care and an appropriate level of access to care. The Company
believes enrollment in its risk-based products will increase through growth in
new covered lives and through the transition of covered lives in ASO and EAP
products to higher revenue risk-based products. On a pro forma basis for fiscal
1997, risk-based products accounted for 30% of the Company's covered lives but
accounted for 73% of its total managed behavioral healthcare revenues. There are
certain risks associated with increased enrollment in risk-based products. See
"Risk Factors--Risk-Based Products."
ACHIEVE SIGNIFICANT INTEGRATION EFFICIENCIES. The Company believes that the
Acquisition has created opportunities for the Company to achieve significant
cost savings. Management believes that cost saving opportunities will result
from leveraging fixed overhead over a larger revenue base and an increased
number of covered lives and from reducing duplicative corporate and regional
selling, general and administrative expenses. As a result, the Company expects
to achieve approximately $60.0 million of costs savings on an annual basis
within eighteen months following the consummation of the Acquisition. There can
be no assurance that the Company will be able to integrate its operations
according to its plan. See "Risk Factors--Integration of Operations."
PURSUE ADDITIONAL SPECIALTY MANAGED CARE OPPORTUNITIES. The Company
believes that significant demand exists for specialty managed care products
related to the management of certain chronic conditions. The Company believes
its large number of covered lives, information systems infrastructure and
demonstrated expertise in managing behavioral healthcare programs position the
Company to provide customers with specialty managed care products. As a first
major step in implementing this strategy, the Company acquired Allied, a
provider of specialty managed care products for cardiology, oncology and
diabetes patients, on December 5, 1997. See "Summary--Recent Developments." The
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Company's highly leveraged financial position may prevent it from acquiring
additional specialty managed care providers. See "Risk Factors--Substantial
Leverage and Debt Service Obligations."
MANAGED BEHAVIORAL HEALTHCARE PRODUCTS AND SERVICES
GENERAL. The following table sets forth the approximate number of covered
lives as of June 30, 1998 and pro forma revenue for fiscal 1997 for each type of
managed behavioral healthcare program offered by the Company:
<TABLE>
<CAPTION>
PROGRAMS COVERED LIVES PERCENT REVENUE PERCENT
- ----------------------------------------------------------------- ----------------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
(IN MILLIONS, EXCEPT PERCENTAGES)
Risk-Based Products.............................................. 18.7 30.5% $ 808.1 72.8%
EAPs............................................................. 11.5 18.8 99.7 9.0
Integrated Products.............................................. 3.5 5.7 54.2 4.9
ASO Products..................................................... 24.4 39.8 134.6 12.1
Other............................................................ 3.2 5.2 14.2 1.2
--- ----- ---------- -----
Total........................................................ 61.3 100.0% $ 1,110.8 100.0%
--- ----- ---------- -----
--- ----- ---------- -----
</TABLE>
The number of the Company's covered lives fluctuates based on the number of the
Company's customer contracts and as employee, HMO and insurance company
subscriber and government program enrollee populations change from time to time.
On a pro forma basis, the number of lives covered by the Company's managed
behavorial healthcare products at September 30, 1995, 1996 and 1997 would have
been 43.7 million, 45.7 million, and 51.7 million, respectively.
RISK-BASED PRODUCTS. Under the Company's risk-based products, the Company
typically arranges for the provision of a full range of outpatient, intermediate
and inpatient treatment services to beneficiaries of its customers' healthcare
benefit plans, primarily through arrangements in which the Company assumes all
or a portion of the responsibility for the cost of providing such services in
exchange for a per member per month fee. The Company's experience with
risk-based contracts (including the experience of Green Spring, HAI and Merit)
covering a large number of lives has given it a broad base of data from which to
analyze utilization rates. The Company believes that this broad database permits
it to estimate utilization trends and costs more accurately than many of its
competitors, which allows it to bid effectively. The Company believes that its
experience has also allowed it to develop effective measures for controlling the
cost of providing a unit of care to its covered lives. Among other cost control
measures, the Company has developed or acquired clinical protocols, which permit
the Company to assist its network providers to administer effective treatment in
a cost efficient manner, and claims management technology, which permits the
Company to reduce the cost of processing claims. The Company's care managers are
an essential element in its provision of cost-effective care. Except in
emergencies, treatment is required to be authorized by a Company care manager.
Care managers, in consultation with treating professionals, and using the
Company's clinical protocols, authorize an appropriate level and intensity of
services that can be delivered in a cost-efficient manner. See
"Industry--Segmentation-- Risk-Based Network Products."
EMPLOYEE ASSISTANCE PROGRAMS. The Company's EAP products typically provide
assessment and referral services to employees and dependents of the Company's
customers in an effort to assist in the early identification and resolution of
productivity problems associated with the employees who are impaired by
behavioral conditions or other personal concerns. For many EAP customers, the
Company also provides limited outpatient therapy (typically limited to eight or
fewer sessions) to patients requiring such services. For these services, the
Company typically is paid a fixed fee per member per month; however, the Company
is usually not responsible for the cost of providing care beyond these services.
If further services are necessary beyond limited outpatient therapy, the Company
will refer the beneficiary to an appropriate provider or treatment facility.
INTEGRATED PRODUCTS. Under its integrated products, the Company typically
establishes an EAP to function as the "front end" of a managed care program that
provides a full range of services, including
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more intensive treatment services not covered by the EAP. The Company typically
manages the EAP and accepts all or some of the responsibility for the cost of
any additional treatment required upon referral out of the EAP, thus integrating
the two products and using both the Company's care management and clinical care
techniques to manage the provision of care. See
"Industry--Segmentation--Integrated EAP/Managed Behavioral Healthcare Products."
ASO PRODUCTS. Under its ASO products, the Company provides services ranging
from utilization review and claims administration to the arrangement for and
management of a full range of patient treatment services, but does not assume
any of the responsibility for the cost of providing treatment services. Services
include member assistance, management reporting and claims processing in
addition to utilization review and care management. See
"Industry--Segmentation--Utilization Review/Care Management Products" and
"--Non-Risk-Based Network Products."
MANAGED BEHAVIORAL HEALTHCARE CUSTOMERS
GENERAL. The following table sets forth the approximate number of covered
lives as of June 30, 1998 and pro forma revenue for fiscal 1997 in each of the
Company's market segments described below:
<TABLE>
<CAPTION>
MARKET COVERED LIVES PERCENT REVENUE PERCENT
- ----------------------------------------------------------------- ----------------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
(IN MILLIONS, EXCEPT PERCENTAGES)
Corporations and Labor Unions.................................... 18.9 30.8% $ 197.7 17.8%
HMOs............................................................. 7.1 11.6 226.4 20.3
Blue Cross/Blue Shield and Insurance Companies................... 23.8 38.8 323.0 29.2
Medicaid Programs................................................ 4.0 6.5 265.4 23.9
Governmental Agencies (including CHAMPUS)........................ 4.4 7.2 84.7 7.6
Other............................................................ 3.1 5.1 13.6 1.2
--- ----- ---------- -----
Total........................................................ 61.3 100.0% $ 1,110.8 100.0%
--- ----- ---------- -----
--- ----- ---------- -----
</TABLE>
CORPORATIONS AND LABOR UNIONS. Corporations and, to a lesser extent, labor
unions, account for a large number of the Company's contracts to provide managed
behavioral healthcare services and, in particular, EAP and integrated
EAP/managed care services. The Company has structured a variety of fee
arrangements with corporate customers to cover all or a portion of the
responsibility of the cost of providing treatment services. In addition, the
Company operates a number of programs for corporate customers on an ASO basis.
Management believes the corporate market is an area of potential growth for the
Company, as corporations are anticipated to increase their utilization of
managed behavioral healthcare services. In an effort to increase penetration of
the corporate market, the Company intends to build upon Merit's experience in
managing programs for large corporate customers (such as IBM, Federal Express
and AT&T) and to market integrated programs to Merit's existing EAP customers
and other prospective corporate clients.
HMOS. The Company is a leader in the HMO market, providing managed
behavioral healthcare services to HMO beneficiaries. HMO contracts are full,
limited or shared risk contracts in which the Company accepts a fixed fee per
member per month from the HMO in exchange for providing a full or specified
range of behavioral healthcare services for a specific portion of the HMO's
beneficiaries. Although certain large HMOs provide their own managed behavioral
healthcare services, many HMOs "carve out" behavioral healthcare from their
general healthcare services and subcontract such services to managed behavioral
healthcare companies such as the Company. The Company anticipates that its
business with HMOs will continue to grow.
BLUE CROSS/BLUE SHIELD ORGANIZATIONS AND INSURANCE COMPANIES. The Company
is the nation's leading provider of managed behavioral healthcare services to
Blue Cross/Blue Shield organizations. Green Spring derived approximately $194.0
million, or 53%, of its revenue in fiscal 1997 from contracts with Blue
Cross/Blue Shield organizations. The Company recently expanded its Blue
Cross/Blue Shield
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relationships by entering into a contract with Blue Cross/Blue Shield of
Michigan relating to 2.3 million covered lives.
HAI has contracts with its former owner, Aetna, pursuant to which HAI
provides managed behavioral healthcare products to Aetna, including focused
psychiatric review (a type of utilization review product), risk-based HMO
products, administrative services for Aetna's "Managed Choice" product and
provider network management services. For the twelve months ended September 30,
1997, HAI would have derived approximately $58.9 million of revenue, or
approximately 58% of its total revenue, from its contracts with Aetna, on a pro
forma basis. Approximately 71% of HAI's covered lives are attributable to its
contracts with Aetna.
MEDICAID PROGRAMS. The Company provides managed behavioral healthcare
services to Medicaid recipients through both direct contracts with state and
local governmental agencies and through subcontracts with HMOs focused on
Medicaid beneficiary populations. In addition to the Medicaid population, other
public entitlement programs, such as Medicare and state insurance programs for
the uninsured, offer the Company areas of potential future growth. The Company
expects that governmental agencies will continue to implement a significant
number of managed care Medicaid programs through contracts with HMOs and that
many HMOs will subcontract with managed behavioral healthcare organizations,
such as the Company, for behavioral healthcare services. The Company also
expects that other states will continue the trend of "carving-out" behavioral
healthcare services from their general healthcare benefit plans and contracting
directly with managed behavioral healthcare companies such as the Company. See
"Industry--Areas of Growth," "Risk Factors--Dependence on Government Spending
for Managed Healthcare; Possible Impact of Healthcare Reform" and
"--Regulation--Other Proposed Legislation."
GOVERNMENTAL AGENCIES. The Company provides EAPs and other managed care
products for employees and their dependents who are beneficiaries of federal,
state and local governmental agencies' healthcare benefit plans. Governmental
agencies' healthcare benefit plans have historically contracted for managed
behavioral healthcare services as part of their general healthcare contracts
with HMOs or indemnity insurers. In turn, HMOs or indemnity insurers have either
provided managed behavioral healthcare services directly or subcontracted such
services to managed behavioral healthcare companies such as the Company. The
Company currently provides services to a number of government employees either
directly pursuant to a contract with the government agency or as a subcontractor
to HMOs. More recently, governmental agencies have begun to contract directly
with managed behavioral healthcare companies to provide these services. In
addition, the Company currently manages contracts for CHAMPUS beneficiaries and
is actively pursuing new contracts and subcontracts under the CHAMPUS program.
In this market, the Company often bids for such contracts together with HMOs to
provide the behavioral healthcare services portion of the overall CHAMPUS
healthcare contract.
MANAGED BEHAVIORAL HEALTHCARE CONTRACTS
The Company's contracts with customers typically have terms of one to three
years, and in certain cases contain renewal provisions (at the customer's
option) for successive terms of between one and two years (unless terminated
earlier). Substantially all of these contracts are immediately terminable with
cause and many are terminable without cause by the customer or the Company
either upon the giving of requisite notice and the passage of a specified period
of time (typically between 60 and 180 days) or upon the occurrence of other
specified events. In addition, the Company's contracts with federal, state and
local governmental agencies, under both direct contract and subcontract
arrangements with HMOs, generally are conditioned on legislative appropriations.
These contracts, notwithstanding terms to the contrary, generally can be
terminated or modified by the customer if such appropriations are not made. See
"Risk Factors--Risk Based Programs" and "--Reliance on Customer Contracts."
The specific terms of the Company's contracts are determined by whether the
contracts are for risk-based, EAP, integrated or ASO products. Risk-based and
EAP contracts provide for payment of a fixed
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per member per month fee to the Company. The customer remits this fee to the
Company monthly. With respect to ASO products, the Company is generally paid on
a per member per month basis. The Company bills its customer for such services
on a monthly basis. The Company's billing arrangements for integrated products
vary on a case by case basis.
MANAGED BEHAVIORAL HEALTHCARE NETWORK
The Company's managed behavioral healthcare and EAP treatment services are
provided by a network of third-party providers. The number and type of providers
in a particular area depend upon customer preference, site, geographic
concentration and demographic make-up of the beneficiary population in that
area. Network providers include a variety of specialized behavioral healthcare
personnel, such as psychiatrists, psychologists, licensed clinical social
workers, substance abuse counselors and other professionals.
As of June 30, 1998, the Company had contractual arrangements covering over
34,000 individual third-party network providers. The Company's network providers
are independent contractors located throughout the local areas in which the
Company's customer's beneficiary population resides. Network providers work out
of their own offices, although the Company's personnel are available to assist
them with consultation and other needs. Network providers include both
individual practitioners, as well as individuals who are members of group
practices or other licensed centers or programs. Network providers typically
execute standard contracts with the Company for which they are typically paid by
the Company on a fee-for-service basis. In some cases, network providers are
paid on a "case rate" basis, whereby the provider is paid a set rate for an
entire course of treatment, or through other risk sharing arrangements. A
network provider's contract with the Company typically has a one-year term, with
automatic renewal at the Company's option for successive one-year terms, and
generally may be terminated without cause by the Company or the provider upon 30
to 90 days notice.
As of June 30, 1998, the Company's managed behavorial healthcare network
included contractual arrangements with approximately 2,000 third-party treatment
facilities, including inpatient psychiatric and substance abuse hospitals,
intensive outpatient facilities, partial hospitalization facilities, community
health centers and other community-based facilities, rehabilitative and support
facilities, and other intermediate care and alternative care facilities or
programs. This variety of facilities enables the Company to offer patients a
full continuum of care and to refer patients to the most appropriate facility or
program within that continuum. Typically, the Company contracts with facilities
on a per diem or fee-for-service basis and, in some cases, on a "case rate" or
capitated basis. The contracts between the Company and inpatient and other
facilities typically are for one year terms and, in some cases, are
automatically renewable at the Company's option. Facility contracts are usually
terminable by the Company or the facility owner upon 30 to 120 days notice. The
Psychiatric Hospital Facilities and other facilities operated by CBHS are
members of the Company's hospital provider network on the same terms as are
generally applicable to unaffiliated third-party treatment facilities.
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COMPETITION
Each segment of the Company's business is highly competitive. With respect
to its managed care business, the Company competes with large insurance
companies, HMOs, PPOs, TPAs, IPAs, multi-disciplinary medical groups and other
managed care companies. Many of the Company's competitors are significantly
larger and have greater financial, marketing and other resources than the
Company, and some of the Company's competitors provide a broader range of
services. The Company may also encounter substantial competition in the future
from new market entrants. Many of the Company's customers that are managed care
companies may, in the future, seek to provide managed behavioral healthcare and
EAP services to their employees or subscribers directly, rather than by
contracting with the Company for such services. Because of competition, the
Company does not expect to be able to rely on price increases to achieve revenue
growth and expects to continue experiencing pressure on direct operating
margins. See "Risk Factors--Highly Competitive Industry."
The Company's public sector operations compete with various for profit and
not-for-profit entities, including, but not limited to: (i) managed behavioral
healthcare companies that have started managing human services for governmental
agencies; (ii) home health care organizations; (iii) proprietary nursing home
companies; and (iv) proprietary corrections companies. The Company believes that
the most significant factors in a customer's selection of services include price
and quality of services and outcomes. The pricing aspect of such services is
especially important to attract public sector agencies looking to outsource
public services to the private sector as demand for quality services escalates
while budgeted dollars for healthcare services are reduced. The Company's
management believes that it competes effectively with respect to these factors.
The competitive environment affecting the Company's franchise and provider
operations are discussed elsewhere. See "Charter Advantage--Competition."
INSURANCE
The Company maintains a general and professional liability insurance policy
with an unaffiliated insurer. The policy is written on a "claims made or
circumstances reported" basis, subject to a $500,000 deductible per occurrence
and an aggregate deductible of $1.5 million.
PROPERTIES
MAGELLAN. The Company's principal executive offices are located in Atlanta,
Georgia; the lease for the Company's headquarters expires in 1999. Green Spring
leases its 83 offices with terms expiring between 1997 and 2020. Green Spring's
headquarters are leased and are located in Columbia, Maryland with lease terms
expiring between 1998 and 2002. Mentor and Public Solutions lease their 68
offices with terms expiring between 1998 and 2002. Mentor and Public Solutions'
headquarters are leased and are located in Boston, Massachusetts with a lease
term expiring in 2002. The Company owns two behavioral healthcare facilities in
the United Kingdom, one of which is subject to a land-lease that expires in
2069, and a behavorial healthcare facility in Nyon, Switzerland. The Company has
a controlling interest in six hospital-based Joint Ventures that operate or
manage 10 behavioral healthcare facilities ("JV Hospitals"). The Joint Ventures
own six of the JV Hospitals and lease two of the JV Hospitals from the
respective Joint Venture owners. The remaining two JV Hospitals are owned by the
respective Joint Venture owners.
MERIT. Merit's principal executive offices were located in Park Ridge, New
Jersey; the lease for Merit's headquarters expires in 2006. Merit leases a
facility that comprises its National Service Center in St. Louis, Missouri,
under three leases expiring between 2001 and 2003. In addition, Merit leases
significant amounts of office space in New York City and San Francisco,
California pursuant to leases that expire in 2008 and 2003, respectively. Merit
also maintained at September 30, 1997, approximately 150 other offices in 32
states under leases that have terms of up to 10 years.
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HAI. HAI's principal executive offices are located in Sandy, Utah; the
lease expires in 2005. HAI maintains 29 other offices in 17 states under leases
that have terms of up to 4 years.
INTELLECTUAL PROPERTY
The Company has developed and is marketing applications and systems for
managing the delivery of care and measuring the outcome of treatment, including
an integrated suite of applications that includes a "Speciality Care Management"
component and an "Advanced Call Center" component. The Speciality Care
Management component includes a suite of proprietary clinical protocols called
"Specifications for Acceptable Care."
These protocols were developed and are supported by recognized physician
experts in the relevant specialities. Clinical protocols are detailed treatment
plans for specific medical conditions. The Advanced Call Center component
includes a nurse advice line application, which permits nurses to answer calls
from managed care beneficiaries and to provide health information and care
decision counseling. It also includes an application that initiates calls to
managed care beneficiaries requiring information on care of chronic conditions,
other information or screening. Finally, the Advanced Call Center component
includes an application that facilitates precertification of beneficiaries,
program referral or enrollment and after-hours back-up of the Speciality Care
Management component. The Advanced Call Center assists the Company and other
users to control costs by reducing unnecessary emergency room visits and by
assisting network providers to monitor compliance with treatment plans. Green
Spring, HAI and Merit have also developed or licensed clinical protocols and
proprietary software applications for use in providing managed behavorial
healthcare products.
EMPLOYEES
At September 30, 1997, the Company had approximately 5,000 full-time and
part-time employees. The Company believes it has satisfactory relations with its
employees.
MANAGEMENT INFORMATION SYSTEMS
Currently, each of the Company's operating units maintains its own
information systems. The systems maintained and the applications software used
varies depending on the business processes performed by the operating unit.
Green Spring processes all claims on a centralized system using its proprietary
"Claims Adjudication and Tracking System" software and two Compaq Proliant
servers. Green Spring conducts utilization review functions on a decentralized
client/server system, using proprietary "Care Utilization and Review Expediter"
software. Each regional Green Spring office maintains its own complement of data
base servers. Green Spring's information systems are relatively new and
management believes that they have sufficient remaining capacity to accommodate
Green Spring's foreseeable needs.
The Company's information technology strategy is to establish and implement
a common company-wide infrastructure in an attempt to facilitate the integration
of future acquisitions, reduce information technology costs and enhance the
Company's ability to share information internally and with its customers and
business partners. The Company will also attempt to standardize software,
equipment, training and support. An enterprise architecture standards working
group has been formed to implement the strategy. The working group is currently
developing the architecture and migration approach toward a Microsoft Windows NT
environment and standards and implementation plans for hardware and software
platforms and a wide-area network. Management believes that it could achieve
significant cost savings by implementing common system architectures, shared
applications systems and common business operating procedures throughout the
Company, by consolidating back-office functions and by minimizing redundant
systems.
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The Company's integration plan for the Acquisition includes an IT Department
working group consisting of senior information technology executives from the
Company, Green Spring, Merit and HAI. The Company's strategy for integrating the
Company, Green Spring, Merit and HAI is being coordinated with the Company's
ongoing efforts to establish and implement a common company-wide information
technology infrastructure.
The Company expects to be able to implement its company-wide information
technology infrastructure, including the integration of Merit, by the end of
calendar year 1999, without incurring material expenditures in excess of
historical capital requirements.
LEGAL PROCEEDINGS
The management and administration of the delivery of managed behavioral
healthcare services, and the direct provision of behavioral health treatment
services, entail significant risks of liability. In recent years, the Company,
Merit, HAI and Allied and their respective network providers have been subject
to a number of actions and claims alleging malpractice, professional negligence
and other related legal theories. Many of these actions and claims seek
substantial damages and therefore require the defendant to incur significant
fees and costs related to their defense.
From time to time, the Company, Merit, HAI and Allied are subject to various
actions and claims arising from the acts or omissions of their respective
employees, network providers or other parties. In the normal course of business,
the Company, Merit, HAI and Allied receive reports relating to suicides and
other serious incidents involving patients enrolled in their respective
programs. Such incidents may give rise to malpractice, professional negligence
and other related actions and claims against the Company, Merit, HAI or Allied
or their respective employees and network providers. As the number of lives
covered by the Company and such other entities grows, the number of providers
under contract with them increases and the nature and scope of services provided
by them in their respective managed care and EAP businesses expands, actions and
claims against such entities (and, in turn, possible legal liability) predicated
on malpractice, professional negligence or other related legal theories can be
expected to increase. See "Risk Factors--Professional Liability; Insurance."
To the extent customers of the Company, HAI, Allied or Merit are entitled to
indemnification under their contracts with the relevant entity relating to
liabilities they incur arising from the operation of the relevant entity's
programs, such indemnification may not be covered under the relevant entity's
insurance policies. In addition, to the extent that certain actions and claims
seek punitive and compensatory damages arising from alleged intentional
misconduct by the Company, HAI, Allied or Merit such damages, if awarded, may
not be covered, in whole or in part, by the relevant entity's insurance
policies. In the ordinary course of business, such entities are also subject to
actions and claims with respect to their respective employees, network providers
and suppliers of services. The Company does not believe that any pending action
against the Company, Merit, HAI or Allied will have a material adverse effect on
the Company. To date, claims and actions against the Company, Merit, HAI or
Allied alleging professional negligence have not resulted in material
liabilities to the Company, Merit, HAI or Allied; however, there can be no
assurance that pending or future actions or claims for professional liability
(including any judgments, settlements or costs associated therewith) will not
have a material adverse effect on the Company. See "--Insurance" and "Risk
Factors--Professional Liability; Insurance."
From time to time, the Company, HAI, Allied and Merit receive notifications
from and engage in discussions with various governmental agencies concerning
their respective businesses and operations. As a result of these contacts with
regulators, the relevant entity in many instances implements changes to its
operations, revises its filings with such agencies and/or seeks additional
licenses to conduct its business. In recent years, in response to governmental
agency inquiries or discussions with regulators, Merit has determined to seek
licensure as a single service HMO, TPA or utilization review agent in one or
more jurisdictions.
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In October 1996, a group of eight plaintiffs purporting to represent an
uncertified class of psychiatrists, psychologists and clinical social workers
brought an action under the federal antitrust laws in the United States District
Court for the Southern District of New York against nine behavioral health
managed care organizations, including Merit, CMG, Green Spring and HAI
(collectively, the "Defendants"), entitled Edward M. Stephens, Jose A.
Yaryura-Tobias, Judith Green, Ph.D., Fugen Neziroglu Ph.D., Ona Robinson, Ph.D.,
Laurie A. Baum, C.S.W., Agnes Wohl, C.S.W., and The On-Step Institute For Mental
Health Research Inc., individually and on behalf of all others similarly
situated v. CMG Health, FHC Options, Inc., Foundation Health PsychCare Services,
Inc., Green Spring Health Services, Inc., Human Affairs International, Inc.,
Merit Behavioral Care Corp., MCC Behavioral Care Inc., United Behavioral
Systems, Inc., and Value Behavioral Health, Inc., 96 Civ. 7798 (KMW) (the
"Stephens Case"). The complaint alleges that the Defendants violated Section 1
of the Sherman Act by engaging in a conspiracy to fix the prices at which the
Defendants purchase services from mental healthcare providers such as the
plaintiffs. The complaint further alleges that the Defendants engaged in a group
boycott to exclude mental healthcare providers from the Defendants' networks in
order to further the goals of the alleged conspiracy. The complaint also
challenges the propriety of the Defendants' capitation arrangements with their
respective customers, although it is unclear from the complaint whether the
plaintiffs allege that the Defendants unlawfully conspired to enter into
capitation arrangements with their respective customers. The complaint seeks
treble damages against the Defendants in an unspecified amount and a permanent
injunction prohibiting the Defendants from engaging in the alleged conduct which
forms the basis of the complaint, plus costs and attorneys' fees. On May 12,
1998, the District Court granted the Defendants' motion to dismiss the complaint
with prejudice. On May 27, 1998, the plaintiffs filed a notice of appeal of the
District Court's dismissal of their complaint with the United States Second
Circuit Court of Appeals. The Defendants intend to vigorously contest this
appeal and to further defend themselves in this litigation. However, there can
be no assurance that the ultimate outcome of this litigation will be favorable
to the Defendants. An unfavorable outcome could have a material adverse effect
on the Company.
On May 26, 1998, the counsel representing the plaintiffs in the Stephens
Case filed an action in the United States District Court for the District of New
Jersey on behalf of a group of thirteen plaintiffs who also purport to represent
an uncertified class of psychiatrists, psychologists and clinical social
workers. This complaint alleges substantially the same violations of federal
antitrust laws by the same nine managed behavioral healthcare organizations that
are the defendants in the Stephens Case. This claim is entitled Russell M.
Holstein, Ph.D., Barbara I. Holstein, Ed.D., Tijen B. Eron, Ph.D., Roger Swift,
C.S.W., Chuck Stannard, C.S.W., R. Anthony Moore, M.D., Maria T. Lymberis, M.D.,
the American Association of Private Practice Psychiatrists, Inc., the Black
Psychiatrists of America, Inc. and the New Jersey Society for Clinical Social
Work, Inc., individually and on behalf of their members and all others similarly
situated, v. Green Spring Health Services, Inc., Human Affairs International,
Inc., Merit Behavioral Care Corp., CMG Health, Inc., Options Healthcare, Inc.,
Value Behavioral Health, Inc., United Behavioral Health, Inc., Foundation Health
Systems, Inc., and MCC Behavioral Care, Inc. The Defendants believe the factual
and legal issues involved in this case are substantially similar to those
involved in the Stephens Case. The Defendants intend to vigorously defend
themselves in this litigation. However, there can be no assurance that the
outcome of this litigation will be favorable to the Defendants. An unfavorable
outcome could have a material adverse effect on the Company.
REGULATION
GENERAL. The managed behavioral healthcare industry and the provision of
behavioral healthcare services are subject to extensive and evolving state and
federal regulation. The Company is subject to certain state laws and
regulations, including those governing: (i) the licensing of insurance
companies, HMOs, PPOs, TPAs and companies engaged in utilization review and (ii)
the licensing of healthcare professionals, including restrictions on business
corporations from practicing, controlling or exercising excessive influence over
behavioral healthcare services through the direct employment of psychiatrists
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or, in a few states, psychologists and other behavioral healthcare
professionals. These laws and regulations vary considerably among states and the
Company may be subject to different types of laws and regulations depending on
the specific regulatory approach adopted by each state to regulate the managed
care business and the provision of behavioral healthcare treatment services. In
addition, the Company is subject to certain federal laws as a result of the role
the Company assumes in connection with managing its customers' employee benefit
plans. The regulatory scheme generally applicable to the Company's managed care
operations is described in this section. The Company's managed care operations
are also indirectly affected by regulations applicable to the operations of
behavioral healthcare clinics and facilities. See "Charter
Advantage--Regulation."
The Company believes its operations are structured to comply with applicable
laws and regulations in all material respects and that it has received, or is in
the process of applying for, all licenses and approvals that are material to the
operation of its business. However, regulation of the managed healthcare
industry is evolving, with new legislative enactments and regulatory initiatives
at the state and federal levels being implemented on a regular basis.
Consequently, it is possible that a court or regulatory agency may take a
position under existing or future laws or regulations, or as a result of a
change in the interpretation thereof, that such laws or regulations apply to the
Company in a different manner than the Company believes such laws or regulations
apply. Moreover, any such position may require significant alterations to the
Company's business operations in order to comply with such laws or regulations,
or interpretations thereof. Expansion of the Company's business to cover
additional geographic areas, to serve different types of customers, to provide
new services or to commence new operations could also subject the Company to
additional licensure requirements and/or regulation.
LICENSURE. Certain regulatory agencies having jurisdiction over the Company
possess discretionary powers when issuing or renewing licenses or granting
approval of proposed actions such as mergers, a change in ownership, transfer or
assignment of licenses and certain intracorporate transactions. One or multiple
agencies may require as a condition of such licensure or approval that the
Company cease or modify certain of its operations in order to comply with
applicable regulatory requirements or policies. In addition, the time necessary
to obtain licensure or approval varies from state to state, and difficulties in
obtaining a necessary license or approval may result in delays in the Company's
plans to expand operations in a particular state and, in some cases, lost
business opportunities. Compliance activities, mandated changes in the Company's
operations, delays in the expansion of the Company's business or lost business
opportunities as a result of regulatory requirements or policies could have a
material adverse effect on the Company.
INSURANCE, HMO AND PPO ACTIVITIES. To the extent that the Company operates
or is deemed to operate in one or more states as an insurance company, HMO, PPO
or similar entity, it may be required to comply with certain laws and
regulations that, among other things, may require the Company to maintain
certain types of assets and minimum levels of deposits, capital, surplus,
reserves or net worth. In many states, entities that assume risk under contracts
with licensed insurance companies or HMOs have not been considered by state
regulators to be conducting an insurance or HMO business. As a result, the
Company has not sought licensure as either an insurer or HMO in certain states.
The National Association of Insurance Commissioners (the "NAIC") has undertaken
a comprehensive review of the regulatory status of entities arranging for the
provision of healthcare services through a network of providers that, like the
Company, may assume risk for the cost and quality of healthcare services, but
that are not currently licensed as an HMO or similar entity. As a result of this
review, the NAIC developed a "health organizations risk-based capital" formula,
designed specifically for managed care organizations, that establishes a minimum
amount of capital necessary for a managed care organization to support its
overall operations, allowing consideration for the organization's size and risk
profile. The NAIC initiative also may result in the adoption of a model NAIC
regulation in the area of health plan standards, which could be adopted by
individual states in whole or in part, and could result in the Company being
required to meet additional or new standards in connection with its existing
operations.
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Individual states have also recently adopted their own regulatory initiatives
that subject entities such as the Company to regulation under state insurance
laws. This includes, but is not limited to, requiring licensure as an insurance
company or HMO and requiring adherence to specific financial solvency standards.
State insurance laws and regulations may limit the ability of the Company to pay
dividends, make certain investments and repay certain indebtedness. Licensure as
an insurance company, HMO or similar entity could also subject the Company to
regulations governing reporting and disclosure, mandated benefits, and other
traditional insurance regulatory requirements. PPO regulations to which the
Company may be subject may require the Company to register with a state
authority and provide information concerning its operations, particularly
relating to provider and payor contracting. Based on the information presently
available to it, the Company does not believe that the imposition of
requirements related to maintaining certain types of assets, prescribed levels
of deposits, capital, surplus, reserves or net worth, or complying with other
regulatory requirements applicable to its insurance company, HMO, PPO or similar
operations, would have a material adverse effect on the Company. Notwithstanding
the foregoing, the imposition of such requirements could increase the Company's
cost of doing business and could delay the Company's conduct or expansion of its
business in some areas. The licensure process under state insurance laws can be
lengthy and, unless the applicable state regulatory agency allows the Company to
continue to operate while the licensure process is ongoing, the Company could
experience a material adverse effect on its operating results and financial
condition while its licensure application is pending. In addition, failure by
the Company to obtain and maintain required licenses typically also constitutes
an event of default under the Company's contracts with its customers. The loss
of business from one or more of the Company's major customers as a result of
such an event of default or otherwise could have a material adverse effect on
the Company.
UTILIZATION REVIEW AND THIRD-PARTY ADMINISTRATOR ACTIVITIES. Numerous
states in which the Company does business have adopted, or are expected to
adopt, regulations governing entities engaging in utilization review and TPA
activities. Utilization review regulations typically impose requirements with
respect to the qualifications of personnel reviewing proposed treatment,
timeliness and notice of the review of proposed treatment, and other matters.
TPA regulations typically impose requirements regarding claims processing and
payments and the handling of customer funds. Utilization review and TPA
regulations may increase the Company's cost of doing business in the event that
compliance requires the Company to retain additional personnel to meet the
regulatory requirements and to take other required actions and make necessary
filings. Although compliance with utilization review regulations has not had a
material adverse effect on the Company, there can be no assurance that specific
regulations adopted in the future would not have such a result, particularly
since the nature, scope and specific requirements of such provisions vary
considerably among states that have adopted regulations of this type.
There is a trend among states to require licensure or certification of
entities performing utilization review or TPA activities; however, certain
federal courts have held that such licensure requirements are preempted by
ERISA. ERISA preempts state laws that mandate employee benefit structures or
their administration, as well as those that provide alternative enforcement
mechanisms. The Company believes that its TPA activities performed for its
self-insured employee benefit plan customers are exempt from otherwise
applicable state licensing or registration requirements based upon federal
preemption under ERISA and has relied on this general principle in determining
not to seek licensure for certain of its activities in many states. Existing
case law is not uniform on the applicability of ERISA preemption with respect to
state regulation of utilization review or TPA activities. There can be no
assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states.
"ANY WILLING PROVIDER" LAWS. Several states in which the Company does
business have adopted, or are expected to adopt, "any willing provider" laws.
Such laws typically impose upon insurance companies, PPOs, HMOs or other types
of third-party payors an obligation to contract with, or pay for the services
of, any healthcare provider willing to meet the terms of the payor's contracts
with similar
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providers. Compliance with any willing provider laws could increase the
Company's costs of assembling and administering provider networks and could,
therefore, have a material adverse effect on its operations.
LICENSING OF HEALTHCARE PROFESSIONALS. The provision of behavioral
healthcare treatment services by psychiatrists, psychologists and other
providers is subject to state regulation with respect to the licensing of
healthcare professionals. The Company believes that the healthcare professionals
who provide behavioral healthcare treatment on behalf of or under contracts with
the Company are in compliance with the applicable state licensing requirements
and current interpretations thereof; however, there can be no assurance that
changes in such state licensing requirements or interpretations thereof will not
adversely affect the Company's existing operations or limit expansion. With
respect to the Company's crisis intervention program, additional licensure of
clinicians who provide telephonic assessment or stabilization services to
individuals who are calling from out-of-state may be required if such assessment
or stabilization services are deemed by regulatory agencies to be treatment
provided in the state of such individual's residence. The Company believes that
any such additional licensure could be obtained; however, there can be no
assurance that such licensing requirements will not adversely affect the
Company's existing operations or limit expansion.
PROHIBITION ON FEE SPLITTING AND CORPORATE PRACTICE OF PROFESSIONS. The
laws of some states limit the ability of a business corporation to directly
provide, control or exercise excessive influence over behavioral healthcare
services through the direct employment of psychiatrists, psychologists, or other
behavioral healthcare professionals. In addition, the laws of some states
prohibit psychiatrists, psychologists, or other healthcare professionals from
splitting fees with other persons or entities. These laws and their
interpretations vary from state to state and enforcement by the courts and
regulatory authorities may vary from state to state and may change over time.
The Company believes that its operations as currently conducted are in material
compliance with the applicable laws, however, there can be no assurance that the
Company's existing operations and its contractual arrangements with
psychiatrists, psychologists and other healthcare professionals will not be
successfully challenged under state laws prohibiting fee splitting or the
practice of a profession by an unlicensed entity, or that the enforceability of
such contractual arrangements will not be limited. The Company believes that it
could, if necessary, restructure its operations to comply with changes in the
interpretation or enforcement of such laws and regulations, and that such
restructuring would not have a material adverse effect on its operations.
DIRECT CONTRACTING WITH LICENSED INSURERS. Regulators in several states in
which the Company does business have adopted policies that require HMOs or, in
some instances, insurance companies, to contract directly with licensed
healthcare providers, entities or provider groups, such as IPAs, for the
provision of treatment services, rather than with unlicensed intermediary
companies. In such states, the Company's customary model of contracting directly
with its customers may need to be modified so that, for example, the IPAs
(rather than the Company) contract directly with the HMO or insurance company,
as appropriate, for the provision of treatment services. The Company intends to
work with a number of these HMO customers to restructure existing contractual
arrangements, upon contract renewal or in renegotiations, so that the entity
which contracts with the HMO directly is an IPA. The Company does not expect
this method of contracting to have a material adverse effect on its operations.
OTHER REGULATION OF HEALTHCARE PROVIDERS. The Company's business is
affected indirectly by regulations imposed upon healthcare providers.
Regulations imposed upon healthcare providers include provisions relating to the
conduct of, and ethical considerations involved in, the practice of psychiatry,
psychology, social work and related behavioral healthcare professions and, in
certain cases, the common law duty to warn others of danger or to prevent
patient self-injury. Confidentiality and patient privacy requirements are
particularly strict in the field of behavioral healthcare services, and
additional legislative initiatives relating to confidentiality are expected. The
Health Insurance Portability and Accountability Act of 1996 ("HIPAA") included a
provision that prohibits the wrongful disclosure of certain "individually
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identifiable health information." HIPAA requires the Secretary of the Department
to adopt standards relating to the transmission of such health information by
healthcare providers and healthcare plans. Although the Company believes that
such regulations do not at present materially impair the Company's operations,
there can be no assurance that such indirect regulation will not have a material
adverse effect on the Company in the future.
REGULATION OF CUSTOMERS. Regulations imposed upon the Company's customers
include, among other things, benefits mandated by statute, exclusions from
coverages prohibited by statute, procedures governing the payment and processing
of claims, record keeping and reporting requirements, requirements for and
payment rates applicable to coverage of Medicaid and Medicare beneficiaries,
provider contracting and enrollee rights, and confidentiality requirements.
Although the Company believes that such regulations do not at present materially
impair the Company's operations, there can be no assurance that such indirect
regulation will not have a material adverse effect on the Company in the future.
ERISA. Certain of the Company's services are subject to the provisions of
ERISA. ERISA governs certain aspects of the relationship between
employer-sponsored healthcare benefit plans and certain providers of services to
such plans through a series of complex laws and regulations that are subject to
periodic interpretation by the Internal Revenue Service and the Department of
Labor. In some circumstances, and under certain customer contracts, the Company
may be expressly named as a "fiduciary" under ERISA, or be deemed to have
assumed duties that make it an ERISA fiduciary, and thus be required to carry
out its operations in a manner that complies with ERISA requirements in all
material respects. Although the Company believes that it is in material
compliance with the applicable ERISA requirements and that such compliance does
not currently have a material adverse effect on the Company's operations, there
can be no assurance that continuing ERISA compliance efforts or any future
changes to the applicable ERISA requirements will not have a material adverse
effect on the Company.
THE BUDGET ACT. In August 1997, Congress enacted the Budget Act. The
Medicare-related provisions of the Budget Act are designed to reduce Medicare
expenditures over the next five years by $115 billion, compared to projected
Medicare expenditures before adoption of the Budget Act. The Congressional
Budget Office projected in July 1997 that $43.8 billion of the reductions would
come from reduced payments to hospitals, $21.8 billion from increased enrollment
in managed care plans and $11.7 billion from reduced payments to physicians and
ambulatory care providers. The five-year savings in projected Medicare payments
to physicians and hospitals would be achieved under the Budget Act by reduced
fee-for-service reimbursement and by changes in managed care programs designed
to increase enrollment of Medicare beneficiaries in managed care plans. The
increase in Medicare enrollment in managed care plans would be achieved in part
by allowing provider-sponsored organizations and preferred provider
organizations to compete with Medicare health maintenance organizations for
Medicare enrollees.
Prior to adoption of the Budget Act, the states were prohibited from
requiring Medicaid recipients to enroll in managed care products that covered
only Medicaid recipients. The Medicaid laws required that the states enroll
Medicaid recipients in products that also covered a specific number of
commercial enrollees. This requirement of the Medicaid laws was intended to
limit the ability of states to reduce coverage levels for Medicaid recipients
below those offered to commercial enrollees. Under prior law, the Secretary of
the Department could waive the prohibition. The Medicaid-related provisions of
the Budget Act give states broad flexibility to require most Medicaid recipients
to enroll in managed care products that only cover Medicaid recipients, without
obtaining a waiver from the Secretary of the Department. The Budget Act also
allows states to limit the number of managed care organizations with which the
state will contract to deliver care to Medicaid beneficiaries. These changes
could have a
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positive impact on the Company's business, if they result in increased
enrollment of Medicaid beneficiaries in managed care organizations and increased
Medicaid spending on managed care. However, these changes also may have an
adverse effect on the Company if a number of states decide to limit the number
of managed care organizations with which they will contract and to select the
organization solely on the basis of the cost of care, which could result in
increased cost competition for state contracts.
The Company cannot predict the effect of the Budget Act, or other healthcare
reform measures that may be adopted by Congress or state legislatures, on its
managed care operations and no assurance can be given that either the Budget Act
or other healthcare reform measures will not have an adverse effect on the
Company.
OTHER PROPOSED LEGISLATION. In the last five years, legislation has
periodically been introduced at the state and federal level providing for new
regulatory programs and materially revising existing regulatory programs. Any
such legislation, if enacted, could materially adversely affect the Company's
business, financial condition or results of operations. Such legislation could
include both federal and state bills affecting the Medicaid programs which may
be pending in or recently passed by state legislatures and which are not yet
available for review and analysis. Such legislation could also include proposals
for national health insurance and other forms of federal regulation of health
insurance and healthcare delivery. It is not possible at this time to predict
whether any such legislation will be adopted at the federal or state level, or
the nature, scope or applicability to the Company's business of any such
legislation, or when any particular legislation might be implemented. No
assurance can be given that any such federal or state legislation will not have
a material adverse effect on the Company.
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CHARTER ADVANTAGE
OVERVIEW
On June 17, 1997, the Company consummated the Crescent Transactions,
pursuant to which, among other things, it sold the Psychiatric Hospital
Facilities to Crescent. In addition, the Company and COI, an affiliate of
Crescent, formed a joint venture known as CBHS to operate the Psychiatric
Hospital Facilities and certain other facilities transferred by the Company to
CBHS. The Company and COI each own 50% of the equity interest of CBHS. The
Company obtained its equity interest by contributing approximately $5 million of
net assets, including five leased psychiatric hospitals, to CBHS. In fiscal
1997, subsequent to the initial capitalization of CBHS, the Company and COI each
contributed an additional $17.5 million to the capital of CBHS. The Company has
no obligation to make additional contributions to the capital of CBHS. The
Company accounts for its 50% investment in CBHS under the equity method of
accounting. In connection with the Crescent Transactions, the Company received
approximately $417.2 million in cash (before costs of approximately $16.0
million) and warrants for the purchase of 2.5% of COI's common stock,
exercisable over 12 years. The Company also issued 1,283,311 warrants to
purchase shares of the Company's Common Stock to each of Crescent and COI at an
exercise price of $30 per share. In related agreements, Crescent and CBHS
entered into the facilities lease described below and the Company, CBHS and the
Psychiatric Hospital Facilities and other facilities transferred by the Company
to CBHS entered into the franchise agreements described below. Following the
consummation of the Crescent Transactions, the Company formed a new business
unit, "Charter Advantage," to franchise the "CHARTER" system of behavioral
healthcare to operators of behavioral healthcare facilities. Currently, its
primary customer is CBHS.
The following discussion of Charter Advantage's operations, CBHS's
facilities and the psychiatric hospital industry in general is relevant to an
assessment of the factors having a bearing on CBHS's ability to pay Franchise
Fees to the Company, the value of the Company's interest in the equity of CBHS
and the future business prospects of CBHS.
FRANCHISE OPERATIONS
FRANCHISE AGREEMENTS. Charter Advantage franchises the "CHARTER" System of
behavioral healthcare to the Psychiatric Hospital Facilities and other
facilities operated by CBHS. See "-- CBHS." Each facility has entered into a
separate Franchise Agreement with Charter Advantage. Each franchisee is granted
the right to engage in the business of providing behavioral healthcare utilizing
the "CHARTER" System in a defined territory. Each franchisee is authorized to
conduct a "Hospital/RTC Based Behavioral Healthcare Business," which is defined
as the business of the operation of an acute care psychiatric hospital, part of
an acute care general hospital operating an acute care psychiatric unit, a
behavioral healthcare residential treatment center, a part of a facility
operating a behavioral healthcare residential treatment center, or other similar
facility providing 24-hour behavioral healthcare and the delivery of behavioral
healthcare from such facility or other affiliated facilities; such behavioral
healthcare to include inpatient hospitalization, partial hospitalization
programs, outpatient therapy, intensive outpatient therapy, residential
treatment, ambulatory detoxification, behavioral modification programs and
related services. The "CHARTER" System is a system for the operation of
Hospital/RTC Based Behavioral Healthcare Businesses under the "CHARTER" names
and marks, and includes the right to use computer software, treatment programs
and procedures, quality standards, quality assessment methods, performance
improvement and monitoring programs, as well as advertising and marketing
assistance, promotional materials, consultation and other matters relating to
the operation of Hospital/RTC Based Behavioral Healthcare Businesses.
The rights granted under each franchise agreement relate solely to a defined
territory. The rights are non-exclusive except that Charter Advantage may not
grant a franchise for, or itself operate, a facility located within a
franchisee's territory using the "CHARTER" System. Charter Advantage, however,
may
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grant franchises or licenses to individual physicians, psychologists or other
mental healthcare professionals, to operate businesses for the delivery of
behavioral healthcare utilizing the "CHARTER" System at facilities in the
franchisee's territory other than at an in-patient facility. Charter Advantage
also reserves the right to grant franchises to others to operate behavioral
healthcare businesses utilizing the "CHARTER" System other than in the
franchisee's territory and to otherwise use and grant to others the right to use
the "CHARTER" name or any other name for other businesses. In addition, Charter
Advantage reserves the right to: (i) provide behavioral healthcare services
incidental to the managed behavioral healthcare businesses or any other business
the principal purpose of which is not the operation of a Hospital/RTC Based
Behavioral Healthcare Business and (ii) pursuant to contracts with federal,
state and local governmental agencies, provide health and human services,
including behavioral healthcare services, to the mentally retarded, the
developmental disabled, the elderly, persons under the control or supervision of
criminal/juvenile systems and other designated populations.
During the term of each franchise agreement, Charter Advantage provides
franchisees with: (i) advertising and marketing assistance, including
consultation, access to media buying programs and access to broadcast and other
advertising materials produced by Charter Advantage; (ii) risk management
services, including risk financial planning, loss control and claims management;
(iii) outcomes monitoring; (iv) national and regional contracting services; and
(v) consultation by telephone or at Charter Advantage's offices with respect to
matters relating to the franchisee's business in which Charter Advantage has
expertise, including reimbursement, government relations, clinical strategies,
regulatory matters, strategic planning and business development.
FRANCHISE FEES; SUBORDINATION. The Company and CBHS are parties to a Master
Franchise Agreement pursuant to which CBHS pays the Company annual Franchise
Fees for granting the right to utilize the "CHARTER" System to the facilities
operated by CBHS. CBHS is required by the Master Franchise Agreement to pay
annual Franchise Fees equal to the greater of (i) $78.3 million, subject to
increases for inflation, and (ii) $78.3 million, plus 3% of CBHS's gross
revenues over $1 billion and not in excess of $1.2 billion and 5% of CBHS' gross
revenues over $1.2 billion. The Company, CBHS and Crescent have entered into a
Subordination Agreement pursuant to which the Franchise Fees are subordinated to
base rent, minimum escalator rent and the first $10.0 million of additional rent
under the Facilities Lease between Crescent and CBHS with respect to the
facilities operated by CBHS. If CBHS (with the consent of the Company) informs
Crescent that capital expenditures in excess of $10.0 million are required and
Crescent funds or makes an irrevocable commitment to fund capital expenditures
in excess of $10.0 million, then Franchise Fees are also subordinated to such
expenditures or commitments in excess of $10.0 million.
Based on operational projections prepared by CBHS management for the quarter
ended September 30, 1998, and for the fiscal year ended September 30, 1999, and
on CBHS' results of operations through June 30, 1998, the Company believes that
CBHS will be unable to pay the full amount of the Franchise Fees it is
contractually obligated to pay the Company during fiscal 1998 and fiscal 1999.
CBHS has paid $30.6 million of Franchise Fees to the Company during the nine
months ended June 30, 1998. As of June 30, 1998, the Company had Franchise Fees
receivable from CBHS, net of equity in loss of CBHS in excess of the Company's
investment in CBHS, of approximately $13.2 million reflected in the consolidated
balance sheet. The Company expects to receive additional Franchise Fee payments
from CBHS of $9.4 million to $14.4 million during the quarter ended September
30, 1998, in the form of cash payments and settlements of other amounts due to
CBHS. The Company also estimates that CBHS will be able to pay $15.0 million to
$25.0 million of Franchise Fees in fiscal 1999. If the amount of Franchise Fees
not paid exceeds $6.0 million, but is less than $18.0 million, the Company has
the right to prohibit CBHS from paying any incentive compensation to CBHS's
management and may prohibit the vesting of any equity in CBHS to which
management of CBHS may be entitled during the period when Franchise Fees remain
unpaid. If the amount of Franchise Fees not paid exceeds $18.0 million, but is
less than $24.0 million, the Company has the right to prohibit any salary
increases for key personnel of CBHS, to
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prohibit any additional hiring by CBHS and to prohibit CBHS from making any
hospital acquisitions or entering into any hospital joint ventures directly or
indirectly during such period. If the amount of Franchise Fees not paid exceeds
$24.0 million, the Company may require CBHS to reduce by 5% the expenses
approved in its current budget, to seek approval of expenditures, including
capital and operating expenditures, on a monthly basis, and to transfer control
and management of CBHS and the Psychiatric Hospital Facilities to the Company.
Notwithstanding the foregoing, the Company does not have the right to take any
action, in connection with the exercise of remedies against CBHS, that could
reasonably be expected to force CBHS into bankruptcy or receivership, or similar
proceedings, with respect to any dispute that may arise among the parties with
respect to payment or nonpayment of the Franchise Fees. Based on the amount of
unpaid Franchise Fees to date, the Company has exercised certain of the rights
available to it under the Master Franchise Agreement and is assisting CBHS
management in improving profitability.
The initial term of the Facilities Lease is twelve years. CBHS has the right
to renew the lease for four additional terms of five years each. The base rent
for the first year of the initial term is $41.7 million, which increases each
year during the initial term by five percent compounded annually. CBHS is
required by the Facilities Lease to pay Crescent in each lease year additional
rent in the amount of $20.0 million. Crescent is obligated to use at least $10.0
million of the additional rent to pay for capital expenditures with respect to
the Psychiatric Hospital Facilities in the time and manner directed by CBHS.
Furthermore, CBHS has the right to require Crescent to use up to $10.0 million
of additional rent to pay property taxes, insurance premiums and Franchise Fees.
CBHS's failure to pay additional rent pursuant to the Facilities Lease is not a
default with respect to the Facilities Lease, except to the extent that Crescent
has made capital expenditures or advanced sums to pay taxes, insurance premiums,
assessments or Franchise Fees that have not been reimbursed by additional rent
payments.
Notwithstanding the foregoing, if the accrued and unpaid Franchise Fees,
including interest thereon, if any, equal or exceed $15.0 million, then CBHS's
available cash would thereafter first be applied to base rent and minimum
escalator rent, but not to additional rent, under the Facilities Lease. The
remainder of CBHS's available cash would then be applied in such order of
priority as CBHS may determine, in the reasonable discretion of its Board of
Directors (half the members of which are appointed by the Company), to all other
operating expenses of CBHS, including, without limitation, the current and
accumulated Franchise Fees, additional rent due under the Facilities Lease and
any other operating expenses. If CBHS (with the consent of the Company) informs
Crescent that capital expenditures are required and Crescent funds or makes an
irrevocable commitment to fund such capital expenditures, then CBHS's available
cash will first be applied to base rent, minimum escalator rent and the amount
of additional rent necessary to fund such capital expenditures; provided that
Crescent will have no obligation to refund any amounts paid by CBHS as
additional rent.
CBHS
OVERVIEW. CBHS is the nation's largest operator of acute-care psychiatric
hospitals and other behavioral care treatment facilities. CBHS's psychiatric
hospitals are located in well-populated urban and suburban locations in 32
states. Seven of CBHS's hospitals are affiliated with medical schools for
residency and other post-graduate teaching programs. Most of CBHS's hospitals
offer a full continuum of behavioral care in their service area. The continuum
includes inpatient hospitalization, partial hospitalization, intensive
outpatient services and, in some markets, residential treatment services.
CBHS's hospitals provide structured and intensive treatment programs for
mental health and alcohol and drug dependency disorders in children, adolescents
and adults. The specialization of programs enables the clinical staff to provide
care that is specific to the patient's needs and facilitates monitoring of the
patient's progress. A typical treatment program at a CBHS facility integrates
physicians and other patient-care professionals with structured activities,
providing patients with testing, adjunctive therapies (occupational,
recreational and other), group therapy, individual therapy and educational
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programs. A treatment program includes one or more of the types of treatment
settings provided by CBHS's continuum of care. For those patients who do not
have a personal psychiatrist or other specialist, the hospital refers the
patient to a member of its medical staff.
A significant portion of hospital admissions are provided by referrals from
former patients, local marketplace advertising, managed care organizations and
physicians. Professional relationships are an important aspect of the ongoing
business of a behavioral care facility. Management believes the quality of
CBHS's treatment programs, staff employees and physical facilities are important
factors in maintaining good professional relationships.
CBHS's hospitals work closely with mental health professionals,
non-psychiatric physicians, emergency rooms and community agencies that come in
contact with individuals who may need treatment for mental illness or substance
abuse. A portion of the Company's marketing efforts is directed at increasing
general awareness of mental health and addictive disease and the services
offered by the Company's franchisees.
INDUSTRY TRENDS. CBHS's hospitals have been adversely affected by factors
influencing the entire psychiatric hospital industry. Such factors include: (i)
the imposition of more stringent length of stay and admission criteria and other
cost containment measures by payors; (ii) the failure of reimbursement rate
increases from certain payors that reimburse on a per diem or other discounted
basis to offset increases in the cost of providing services; (iii) an increase
in the percentage of business that CBHS derives from payors that reimburse on
per diem or other discounted basis; (iv) a trend toward higher deductibles and
co-insurance for individual patients; (v) a trend toward limited employee
behavioral health benefits, such as reductions in annual and lifetime limits on
behavioral health coverage; and (vi) pricing pressure related to an increasing
rate of claims denials by third party payors. In response to these conditions,
the Company believes that CBHS will (i) strengthen controls to minimize costs
and capital expenditures; (ii) review its portfolio of hospitals and sell, close
or lease hospitals or consolidate operations in certain locations; (iii) develop
strategies to increase outpatient services and partial hospitalization programs
to meet the demands of the marketplace; (iv) implement programs to contest third
party denials relating to valid pre-certified treatment and admissions; and (v)
renegotiate contracts with managed care organizations at increased rates.
SOURCES OF REVENUE. Payments are made to CBHS by patients, by insurance
companies and self-insured employers, by the federal and state governments under
Medicare, Medicaid, CHAMPUS and other programs and by HMOs, PPOs and other
managed care programs. Amounts received from most payors are less than the
hospital's established charges. The approximate percentages of gross patient
revenue (which is revenue before deducting contractual allowances and discounts
from established charges) derived by CBHS and the Company from various payment
sources for the last three fiscal years were as follows:
<TABLE>
<CAPTION>
PERCENTAGE OF HOSPITAL GROSS
PATIENT
REVENUE FOR THE YEAR ENDED
SEPTEMBER 30,
-------------------------------
<S> <C> <C> <C>
1995 1996 1997
--------- --------- ---------
Medicare........................................................................... 26% 28% 27%
Medicaid........................................................................... 17 17 18
--- --- ---
43 45 45
HMOs and PPOs...................................................................... 17 21 24
CHAMPUS............................................................................ 4 3 2
Other Government Programs.......................................................... 6 6 7
Other (primarily Blue Cross and other commercial insurance)........................ 30 25 22
--- --- ---
Total............................................................................ 100% 100% 100%
--- --- ---
--- --- ---
</TABLE>
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Most private insurance carriers reimburse their policyholders or make direct
payments to the hospitals for charges at rates specified in their policies. The
patient remains responsible to the hospital for any difference between the
insurance proceeds and the total charges. Certain Blue Cross programs have
negotiated reimbursement rates with certain of CBHS's hospitals which are less
than the hospital's established charges.
Most of CBHS's facilities have entered into contracts with HMOs, PPOs,
certain self-insured employers and other managed care plans which provide for
reimbursement at rates less than the hospital's normal charges. In addition to
contracts entered into by individual hospitals with such managed care plans,
CBHS has entered into regional and national contracts with HMOs, PPOs,
self-insured employers and other managed care plans that apply to all of such
franchisees in the geographic areas covered by a contract. CBHS is seeking to
obtain additional regional and national contracts. The Company expects the
percentage of revenue obtained by CBHS from these payor sources to increase in
the future.
Under the Medicare provisions of the Tax Equity and Fiscal Responsibility
Act of 1982 ("TEFRA"), costs per Medicare case are determined for each of the
Company's franchisees. A target cost per case is established for each year (the
"Target Rate"). If a hospital's costs per case are less than the Target Rate,
the hospital receives a bonus of 50% of the difference between its actual costs
per case and the Target Rate (limited to 5% of the Target Rate). Hospitals with
costs which exceed the Target Rate are paid an additional amount equal to 50% of
the excess, up to 10% of the Target Rate. These limits apply only to operating
costs and do not apply to capital costs, including lease expense, depreciation
and interest associated with capital expenditures. The Target Rate for each
hospital is increased annually by the application of an "update factor." The
Budget Act establishes caps on a hospital's Target Rate for cost reporting
periods beginning on or after October 1, 1997 and before October 1, 2002 equal
to no more than the 75th percentile of the Target Rate of such hospital for cost
reporting periods ending during fiscal year 1996, subject to certain subsequent
updates.
Most of CBHS's hospitals participate in state-operated Medicaid programs.
Current federal law prohibits Medicaid funding for inpatient services in
freestanding psychiatric hospitals for patients between the ages of 21 and 64.
Each state is responsible for establishing the Medicaid eligibility and coverage
criteria, payment methodology and funding mechanisms which apply in that state,
subject to federal guidelines. Accordingly, the level of Medicaid payments
received by CBHS's hospitals varies from state to state. In addition to the
basic payment level for patient care, several state programs include a financial
benefit for hospitals which treat a disproportionately large volume of Medicaid
patients as a percentage of the total patient population. The Company received
approximately $11.0 million, $9.0 million and $5.0 million in Medicaid
disproportionate share payments in fiscal 1994, 1995 and 1996, respectively,
when it owned the facilities now operated by CBHS. The Company and CBHS received
approximately $3.0 million in such payments in fiscal 1997. Disproportionate
share payments will not apply to services rendered in fiscal 1998 and
thereafter. See "--Risk Factors--Governmental Budgetary Constraints and
Healthcare Reform."
Within the statutory framework of the Medicare and Medicaid programs, there
are substantial areas subject to administrative rulings and interpretations
which may affect payments made under either or both of such programs. In
addition, federal or state governments could reduce the future funds available
under such programs or adopt additional restrictions on admissions and more
stringent requirements for utilization of services. These types of measures
could adversely affect CBHS's operations. Final determination of amounts payable
under Medicare and certain Medicaid programs are subject to review and audit.
Most of CBHS's hospitals receive revenues from the CHAMPUS program. Under
various CHAMPUS programs, payments can either be based on contractually agreed
upon rates or rates determined by regulatory formulas. CHAMPUS patients are
subject to annual limits on the number of psychiatric days covered by CHAMPUS.
Covered inpatient services are generally limited to 30 days for adult acute
patients, 45 days for child and adolescent acute patients, and 150 days for
residential treatment center patients.
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MEDICAL STAFFS. At September 30, 1997, approximately 1,300 licensed
physicians were active members of the medical staffs of CBHS's hospitals. Many
of these physicians also serve on the medical staffs of other hospitals. A
number of physicians are independent contractors who have private practices in
addition to their duties for CBHS, while certain of these physicians are
employees of CBHS. The medical and professional affairs of each hospital are
supervised by the medical staff of the hospital, under the control of its board
of trustees. CBHS recruits physicians to serve in administrative capacities at
its hospitals and to engage in private practice in communities where CBHS's
hospitals are located. Registered nurses and certain other hospital employees
are required to be licensed under the professional licensing laws of most
states. CBHS's hospital subsidiaries require such employees to maintain such
professional licenses as a condition of employment.
COMPETITION
Each of CBHS's hospitals competes with other hospitals, some of which are
larger and have greater financial resources. Some competing hospitals are owned
and operated by governmental agencies, others by nonprofit organizations
supported by endowments and charitable contributions and others by proprietary
hospital corporations. The hospitals frequently draw patients from areas outside
their immediate locale and, therefore, CBHS's hospitals may, in certain markets,
compete with both local and distant hospitals. In addition, CBHS's hospitals
compete not only with other psychiatric hospitals, but also with psychiatric
units in general hospitals, and outpatient services provided by CBHS compete
with private practicing mental health professionals, publicly funded mental
health centers and partial hospitalization and other intensive outpatient
services programs and facilities. The competitive position of a hospital is, to
a significant degree, dependent upon the number and quality of physicians who
practice at the hospital and who are members of its medical staff. The Company
believes that CBHS competes effectively with respect to the aforementioned
factors. However, there can be no assurance that CBHS will be able to compete
successfully in the provider business in the future.
Competition among hospitals and other healthcare providers for patients has
intensified in recent years. During this period, hospital occupancy rates for
inpatient behavioral care patients in the United States have declined as a
result of cost containment pressures, changing technology, changes in
reimbursement, changes in practice patterns from inpatient to outpatient
treatment and other factors. In recent years, the competitive position of
hospitals has been affected by the ability of such hospitals to obtain contracts
with PPO's, HMO's and other managed care programs to provide inpatient and other
services. Such contracts normally involve a discount from the hospital's
established charges, but provide a base of patient referrals. These contracts
also frequently provide for pre-admission certification and for concurrent
length of stay reviews. The importance of obtaining contracts with HMO's, PPO's
and other managed care companies varies from market to market, depending on the
individual market strength of the managed care companies. In certain states,
certificate of need laws place limitations on CBHS's and its competitors'
ability to build new hospitals and to expand existing hospitals and services. As
of September 30, 1997, the Company had joint ventures, which are managed by
CBHS, that operated three hospitals in two states (Louisiana and New Mexico) and
CBHS operated 34 hospitals in ten states (Arizona, Arkansas, California,
Colorado, Indiana, Kansas, Louisiana, Nevada, Texas and Utah) that do not have
certificate of need laws applicable to hospitals.
REGULATION
The operation of psychiatric hospitals and other behavioral healthcare
facilities and the provision of behavioral healthcare services are subject to
extensive federal, state and local laws and regulations. These laws and
regulations provide for periodic inspections or other reviews by state agencies,
the Department and CHAMPUS to determine compliance with their respective
standards of medical care, staffing, equipment and cleanliness necessary for
continued licensing or participation in the Medicare, Medicaid or CHAMPUS
programs. The admission and treatment of patients at psychiatric hospitals is
also subject to substantial state regulation relating to involuntary admissions,
confidentiality of patient
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medical information, patients' rights and federal regulation relating to
confidentiality of medical records of substance abuse patients. Although CBHS
believes that its facilities are currently in compliance with these federal,
state, and local requirements, there can be no assurance that all facilities
will continuously be operated in full compliance with the applicable
requirements. The failure to obtain or renew any required regulatory approvals,
the failure to satisfy the requirements for continued participation in the
Medicare, Medicaid or CHAMPUS programs, or the failure to satisfy other state
and federal regulatory requirements relating to the operation of psychiatric
hospitals and other behavioral healthcare facilities and the provision of
behavioral healthcare services could have a material adverse effect on the
operations of CBHS.
A number of states have adopted hospital rate review legislation, which
generally provides for state regulation of rates charged for various hospital
services. Such laws are in effect in the State of Florida, in which CBHS
operates seven hospitals. In Florida, the Health Care Board approves a budget
for each hospital, which establishes a permitted level of revenues per
discharge. If this level of permitted revenues per discharge is exceeded by a
hospital in a particular year by more than a specified amount, certain
penalties, including cash penalties, can be imposed. Although the Company
believes that CBHS's facilities in Florida currently are in compliance with the
state hospital rate review laws, there can be no assurance that such facilities
will not be subject to penalties under the hospital rate review laws in the
future.
CBHS is also subject to state certificate of need laws that regulate the
construction of new hospitals and the expansion of existing hospital facilities
and services. These laws require that the approval of a state agency be obtained
prior to the construction of a new hospital or the expansion of the facilities
or services of an existing hospital. Such approvals may require a finding of
community need for the additional hospital facilities and services. In recent
years, many states have repealed certificate of need laws or limited the scope
of the facilities and services to which such certificate of need laws apply.
There can be no assurance that state certificate of need laws will not limit
CBHS's future expansion, or that increased competition as a result of the repeal
or limitation in scope of existing certificate of need laws will not have a
materially adverse effect on the existing operations of CBHS.
Federal law contains numerous provisions designed to insure that services
rendered by hospitals to Medicare and Medicaid patients are medically necessary
and are of a quality that meets professionally recognized standards, and to
insure that claims for reimbursement under the Medicare and Medicaid programs
are properly filed. Among other things, services provided at CBHS's psychiatric
hospitals are subject to periodic review by Peer Review Organizations ("PROs").
All hospitals which participate in the Medicare program are subject to review by
PROs. PRO activities include review of certain admissions and services to
determine medical necessity and to determine whether quality of care meets
professionally recognized standards. PROs have the authority to recommend to the
Department that a provider who is in substantial noncompliance with the medical
necessity and quality of care standards of a PRO or who has grossly and
flagrantly violated an obligation to render care be excluded from participation
in the Medicare program or be required to reimburse the federal government for
certain payments previously made to the provider under the Medicare program. The
Company believes that CBHS's facilities are in material compliance with the
applicable medical necessity and quality of care standards for Medicare and
Medicaid patients, however, there can be no assurance that all CBHS facilities
will continuously remain in material compliance with such standards.
CBHS is subject to federal and state laws that govern financial and other
arrangements between healthcare providers. Such laws include the illegal
remuneration provisions of the Social Security Act (the "Anti-Kickback Statute")
and the physician self-referral provisions of the Omnibus Budget Reconciliation
Act of 1993 ("Stark II").
The Anti-Kickback Statute prohibits, among other things, the offer, payment,
solicitation or receipt of any form of remuneration, in exchange for or which is
intended to induce the referral of patients for services that will be paid for
in whole or in part under any federal healthcare program, including Medicare
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and Medicaid. A violation of the Anti-Kickback Statute is a felony, punishable
by a fine of up to $25,000, a term of imprisonment for up to five years, or
both. In addition, an individual or entity convicted of a violation of the
Anti-Kickback Statute may be subject to civil monetary penalties in an amount
equal to $50,000 for each prohibited act, plus damages up to three times the
total amount of remuneration offered, paid, solicited or received, and may be
subject to exclusion from participation in any federal healthcare program.
In order to provide guidance with respect to the Anti-Kickback Statute,
Congress required the Department to issue regulations outlining business
arrangements that would not be subject to prosecution under the Anti-Kickback
Statute. These regulations include "safe harbors" for certain investment
interests, leases of space and equipment, personal service arrangements,
employment arrangements, personal services and management contracts, sale of
physician practices, discounts, and waiver of beneficiary copayments and
deductibles. Certain transactions and agreements of CBHS do not satisfy all of
the applicable criteria contained in the safe harbor regulations that relate to
such transactions and agreements. The Company believes that such transactions
and agreements do not violate the Anti-Kickback Statute; however, there can be
no assurance that (i) government enforcement agencies will not assert that
certain of these arrangements are in violation of the Anti-Kickback Statute, or
(ii) the Anti-Kickback Statute and safe harbor regulations will not ultimately
be interpreted by the courts in a manner inconsistent with CBHS's business
practices.
In 1989, Congress passed legislation, commonly referred to as the "Stark
Law," which prohibits physicians who have a financial relationship with entities
that furnish clinical laboratory services from referring patients to such
entities for Medicare-reimbursed clinical laboratory services and which
prohibits the entities for billing for services provided pursuant to such
prohibited referrals. The Stark Law, which contains a number of exceptions to
its general referral prohibition, became effective January 1, 1992. Proposed
regulations implementing the Stark Law were first issued in March 1992, however,
the final Stark regulations were issued on August 14, 1995.
In 1993, Congress passed legislation commonly referred to as "Stark II,"
which expanded the prohibitions of the Stark Law to include referrals from
physicians for a wide variety of designated health services, including
inpatient/outpatient hospital services, and extended the referral prohibition to
include services reimbursed under Medicaid. The limitations on referrals
outlined in Stark II became effective January 1, 1995. A violation of Stark II
may result in the imposition of civil monetary penalties of up to $15,000 for
each service billed in violation of the statute and exclusion from participation
in any federal healthcare program. Although the regulations implementing Stark
II have not been issued it is anticipated that they will be similar to the
original Stark regulations. The Company believes that the financial
relationships between CBHS's hospitals and physicians do not violate the Stark
Law and regulations. There can be no assurance however that (i) government
enforcement agencies will not contend that certain of these financial
relationships are in violation of the Stark legislation; (ii) that the Stark
legislation will not ultimately be interpreted by the courts in a manner
inconsistent with CBHS's practices; or (iii) regulations will be issued in the
future that will result in an interpretation of the Stark Law or Stark II that
is inconsistent with CBHS's practices.
CBHS is also subject to state illegal remuneration and self-referral
statutes and regulations that prohibit payments in exchange for referrals and
referrals by physicians or other healthcare providers to persons or entities
with which the physician or healthcare provider has a financial relationship.
These state statutes generally apply to services reimbursed under both
government programs and private health insurance plans. Violations of these laws
may result in payment not being made for the items or services rendered, loss of
the healthcare provider's license, fines, or criminal penalties. These statutes
and regulations vary widely from state to state, are often vague and, in many
states, have not been interpreted by courts or regulatory agencies. Although the
Company has no reason to believe that CBHS is in violation of any such state
statutes, there can be no assurance that CBHS's existing business arrangements
will not be subject to challenge under these types of laws in one or more
states.
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The Medicare and Medicaid Patient and Program Protection Act of 1987
expanded the authority of the Department to exclude from participation in the
Medicare and Medicaid programs those individuals and entities that engage in
defined prohibited activities. The Department is required under this Act to
exclude from participation in the Medicare and Medicaid programs any individual
or entity that has been convicted of a criminal offense relating to the delivery
of services under Medicare and Medicaid or to the neglect or abuse of patients.
In addition, the Department may exclude from participation in the Medicare and
Medicaid programs individuals and entities under certain other circumstances.
These include engaging in illegal remuneration arrangements with physicians and
other healthcare providers, license revocation, exclusion from other government
programs (such as CHAMPUS), filing claims for excessive charges or for
unnecessary services, failure to comply with the Medicare conditions of
participation and failure to disclose certain required information or to grant
proper access to hospital books and records.
The Department's exclusion authority was recently expanded under HIPAA and
the Budget Act, which added additional grounds for exclusion, established
minimum exclusion periods for certain offenses, and expanded the scope of the
exclusion to include exclusion for all other federal and state healthcare
programs, other than the Federal Employees Health Benefit Program.
The Department also has the authority to impose civil monetary penalties for
certain listed prohibited activities, including filing claims that are false or
fraudulent or are for services that were not rendered as claimed. HIPAA
increased the amount of authorized penalties from $2,000 per item or service
claimed to $10,000 per item or service claimed and increased the assessment to
which a person may be subject in lieu of damages from two times the amount
claimed for each item or service to three times the amount claimed. Both HIPAA
and the Budget Act also expanded the Department's authority to impose civil
monetary penalties. Among other things, the new legislation prohibits the
knowing submission of a claim for reimbursement that will result in a greater
payment than is applicable to the item or service actually provided, and
prohibits submitting claims to Medicare or Medicaid for a pattern of medical or
other items or services that a person knows or should know are not medically
necessary. The legislation also prohibits offering any inducements to
beneficiaries in order to influence them to order or receive Medicare or
Medicaid covered items or services from a particular provider or practitioner.
Provisions contained in HIPAA and the Budget Act also created new criminal
healthcare fraud offenses that are applicable to both government programs and
private health insurance plans and added new programs and increased funding for
fraud and abuse detection and enforcement activities. The new offenses created
by HIPAA and the Budget Act, as well as the greater spending on healthcare fraud
and abuse enforcement which will result from this legislation, may significantly
increase the likelihood that any particular healthcare company will be
scrutinized by federal, state and/or local law enforcement officials. In
addition, the increased penalties will strengthen the ability of enforcement
agencies to effect more numerous and larger monetary settlements with healthcare
providers and businesses than was previously the case. Although the Company
believes that CBHS's billing practices are consistent with the applicable
Medicare and Medicaid requirements, those requirements are often vague and
subject to interpretation. The Company also believes that CBHS is in compliance
with the applicable federal laws described above, however, there can be no
assurance that aggressive anti-fraud enforcement activities will not adversely
affect the business of CBHS.
Finally, CHAMPUS regulations authorize CHAMPUS to exclude from the CHAMPUS
program any provider that has committed fraud or engaged in abusive practices.
The regulations permit CHAMPUS to make its own determination of abusive
practices without reliance on any actions of the Department. The term "abusive
practices" is defined broadly to include, among other things, the provision of
medically unnecessary services, the provision of care of inferior quality and
the failure to maintain adequate medical or financial records. Although the
Company believes that CBHS is in compliance with the applicable CHAMPUS
regulations, exclusion from the CHAMPUS program could have a material adverse
effect on the operations and financial condition of CBHS.
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GENERAL AND PROFESSIONAL LIABILITY
CBHS maintains a general and hospital professional liability insurance
policy with an unaffiliated insurer. The policy is written on a "claims made or
circumstances reported" basis, subject to a $1.5 million retention limit per
occurrence and an aggregate retention limit of $8.8 million. The amount of
expense relating to CBHS's malpractice insurance is based on estimated ultimate
losses incurred during the year and may materially increase or decrease from
year to year depending, among other things, on the nature and number of new
reported claims against CBHS and amounts of settlements of previously reported
claims. To date, CBHS has not experienced a loss in excess of policy limits.
Management believes that its coverage limits are adequate. However, losses in
excess of the limits described above or for which insurance is otherwise
unavailable could have a material adverse effect upon the Company.
RISK FACTORS
The following factors are relevant to an understanding of the risks
associated with CBHS's business and the ability of CBHS to pay Franchise Fees to
the Company.
POTENTIAL REDUCTIONS IN REIMBURSEMENT BY THIRD-PARTY PAYORS AND CHANGES IN
HOSPITAL PAYOR MIX. CBHS's hospitals have been adversely affected by factors
influencing the entire psychiatric hospital industry. Such factors include: (i)
the imposition of more stringent length of stay and admission criteria and other
cost containment measures by payors; (ii) the failure of reimbursement rate
increases from certain payors that reimburse on a per diem or other discounted
basis to offset increases in the cost of providing services; (iii) an increase
in the percentage of business that CBHS derives from payors that reimburse on a
per diem or other discounted basis; (iv) a trend toward higher deductibles and
co-insurance for individual patients; (v) a trend toward limiting employee
behavorial health benefits, such as reductions in annual and lifetime limits on
behavioral health coverage; and (vi) pricing pressure related to an increasing
rate of claims denials by third party payors. Any of these factors may result in
reductions in the amounts that CBHS's hospitals can expect to collect per
patient day for services provided or the number of equivalent patient days.
For the fiscal year ended September 30, 1997, CBHS derived approximately 24%
of its gross psychiatric patient service revenue from managed care organizations
(primarily HMOs and PPOs), 22% from other private payors (primarily commercial
insurance and Blue Cross), 27% from Medicare, 18% from Medicaid, 2% from CHAMPUS
and 7% from other government programs. Changes in the mix of CBHS's patients
among the private-pay, Medicare and Medicaid categories, and among different
types of private-pay sources, could significantly affect the profitability of
CBHS's hospital operations. Moreover, there can be no assurance that payments
under governmental and private third-party payor programs will remain at levels
comparable to present levels or will, in the future, be sufficient to cover the
costs of providing care to patients covered by such programs.
GOVERNMENTAL BUDGETARY CONSTRAINTS AND HEALTHCARE REFORM. In the 1995 and
1996 sessions of the United States Congress, the focus of healthcare legislation
was on budgetary and related funding mechanism issues. Both the Congress and the
Clinton Administration have made proposals to reduce the rate of increase in
projected Medicare and Medicaid expenditures and to change funding mechanisms
and other aspects of both programs. The Budget Act, which was signed into law by
President Clinton in August 1997, reduces federal spending by an estimated $140
billion. The majority of the spending reduction will come from Medicare cuts of
$115.0 billion. The Congressional Budget Office projected in July 1997 that
$43.8 billion of the reductions would come from reduced payments to hospitals,
$21.8 billion from increased enrollment in managed care plans and $11.7 billion
from reduced payments to physicians and ambulatory care providers. The five-year
savings in projected Medicare payments to physicians and hospitals would be
achieved under the Budget Act by reduced fee-for-service reimbursement and by
changes in managed care programs designed to increase enrollment of Medicare
beneficiaries in managed care plans. The increase in Medicare enrollment in
managed care
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plans would be achieved in part by allowing provider-sponsored organizations and
preferred provider organizations to compete with Medicare HMOs for Medicare
enrollees.
The Medicaid-related provisions of the Budget Act are designed to achieve
net federal Medicaid savings of $14.6 billion over the next five years and $56.4
billion over the next ten years. The Budget Act achieves Federal Medicaid
savings in three areas. First, two-thirds of the savings over the next ten years
are attributable to limitations on federal matching payments to states for
reimbursements to "disproportionate share" hospitals. The next largest source of
federal savings is a provision allowing states to shift the cost of Medicaid
deductibles and coinsurance requirements for low-income Medicaid beneficiaries
from their Medicaid programs to physicians and other providers. Most of the
remaining savings derive from the repeal of the "Boren Amendment" and other
minimum payment guarantees for hospitals, nursing homes and community health
centers that service Medicaid patients.
CBHS management estimates that the Budget Act will reduce the amount of
revenue and earnings that CBHS will receive for the treatment of Medicare and
Medicaid patients. CBHS management estimates that such reductions will
approximate $10.0 million in fiscal 1998, and due to the phase in effects of the
bill, approximately $15.0 million in subsequent fiscal years.
A number of states in which CBHS has operations have either adopted or are
considering the adoption of healthcare reform proposals of general applicability
or Medicaid reform proposals. Where adopted, these state reform laws have often
not yet been fully implemented. The Company cannot predict the effect of these
state healthcare reform proposals on CBHS's operations. The Company cannot
predict the effect of other healthcare reform measures that may be adopted by
Congress on the operations of CBHS and no assurance can be given that other
federal healthcare reform measures will not have an adverse effect on CBHS.
DEPENDENCE ON HEALTHCARE PROFESSIONALS. Physicians traditionally have been
the source of a significant portion of the patients treated at CBHS's hospitals.
Therefore, the success of CBHS's hospitals is dependent in part on the number
and quality of the physicians on the medical staffs of the hospitals and their
admission practices. A small number of physicians account for a significant
portion of patient admissions at some of CBHS's hospitals. There can be no
assurance that CBHS can retain its current physicians on staff or that
additional physician relationships will be developed in the future. Furthermore,
hospital physicians generally are not employees of CBHS and, in general, CBHS
does not have contractual arrangements with hospital physicians restricting the
ability of such physicians to practice elsewhere.
POTENTIAL GENERAL AND PROFESSIONAL LIABILITY. In recent years, physicians,
hospitals, and other healthcare professionals and providers have become subject
to an increasing number of lawsuits alleging medical malpractice and related
legal theories. Many of these lawsuits involve large claims and substantial
defense costs. CBHS maintains a general and hospital professional liability
insurance policy with an unaffiliated insurer. In addition, CBHS' hospitals
require all physicians on each hospital's medical staff to maintain professional
liability coverage. Management believes that its coverage limits are adequate,
however, there can be no assurance that a future claim or claims will not exceed
the limits of these existing insurance policies or that a loss or losses for
which insurance is unavailable will not have a material adverse effect on CBHS.
GOVERNMENT REGULATION. The operation of psychiatric hospitals and other
behavioral healthcare facilities and the provision of behavioral healthcare
services are subject to extensive federal, state and local laws and regulations.
These laws and regulations provide for periodic inspections or other reviews by
state agencies, the Department and CHAMPUS to determine compliance with their
respective standards of medical care, staffing, equipment and cleanliness
necessary for continued licensing or participation in the Medicare, Medicaid or
CHAMPUS programs. The admission and treatment of patients at psychiatric
hospitals is also subject to substantial state regulation relating to
involuntary admissions, confidentiality of patient medical information,
patients' rights and federal regulation relating
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<PAGE>
to confidentiality of medical records of substance abuse patients. CBHS is also
subject to state certificate of need laws that regulate the construction of new
hospitals and the expansion of existing hospital facilities and services.
CBHS also is subject to federal and state laws that govern financial and
other arrangements between healthcare providers. Such laws include the
Anti-Kickback Statute, Stark II and state illegal remuneration and self-referral
statutes and regulations that prohibit payments in exchange for referrals and
referrals by physicians or other healthcare providers to persons or entities
with which the physician or other healthcare provider has a financial
relationship.
The Medicare and Medicaid Patient and Program Protection Act of 1987
expanded the authority of the Department to exclude from participation in the
Medicare and Medicaid programs those individuals and entities that engage in
defined prohibited activities. The Department's exclusion authority was recently
expanded under HIPAA and the Budget Act, which added additional grounds for
exclusion, established minimum exclusion periods for certain offenses and
expanded the scope of the exclusion to include all federal health care programs.
The Department also has the authority to impose civil monetary penalties for
certain prohibited activities. HIPAA increased the amount of authorized
penalties from $2,000 per item or service claimed to $10,000 per item or service
claimed, and increased the assessment to which a person may be subject in lieu
of damages from two times the amount claimed for each item or service to three
times the amount claimed. Both HIPAA and the Budget Act expanded the
Department's authority to impose civil monetary penalties by adding additional
activities for which civil monetary penalties may be imposed.
Provisions contained in HIPAA and the Budget Act also created new criminal
healthcare fraud offenses that are applicable to both government programs and
private health insurance plans and added new programs and increased funding for
fraud and abuse detection and prevention.
CHAMPUS regulations also authorize the exclusion of providers from the
CHAMPUS program, if the provider has committed fraud or engaged in certain
"abusive practices," which are defined broadly to include, among other things,
the provision of medically unnecessary services, the provision of care of
inferior quality and the failure to maintain adequate medical or financial
records.
State regulatory agencies responsible for the administration and enforcement
of the laws and regulations to which CBHS' operations are subject have broad
discretionary powers. A regulatory agency or a court in a state in which CBHS
operates could take a position under existing or future laws or regulations, or
change its interpretation or enforcement practices with respect thereto, that
such laws or regulations apply to CBHS differently than CBHS believes such laws
and regulations apply or should be enforced. The resultant compliance with, or
revocation of, or failure to obtain, required licences and governmental
approvals could result in significant alteration to CBHS' business operations,
delays in the expansion of CBHS' business and lost business opportunities, any
of which, under certain circumstances, could have a material adverse effect on
CBHS. See "--Regulation."
INTELLECTUAL PROPERTY
The Company owns certain intellectual property which is important to its
franchise operation. The Company has registered as trademarks both the "CHARTER"
name and "800-CHARTER." The Company also owns the "Charter System," which is a
system for the operation of businesses specializing in the delivery of
behavioral healthcare under the "CHARTER" names and marks. The Charter System
includes treatment programs and procedures, quality standards, quality
assessment methods, performance improvement and monitoring programs, advertising
and marketing assistance, promotional materials, consultation and other matters
related to the operation of businesses specializing in the delivery of
behavioral healthcare.
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<PAGE>
MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The following table sets forth the name and certain other information about
each director and executive officer of the Company:
<TABLE>
<CAPTION>
NAME AGE POSITION
- --------------------------------------- --- ------------------------------------------------------------------
<S> <C> <C>
Henry T. Harbin M.D.................... 51 President, Chief Executive Officer and Director
Craig L. McKnight...................... 46 Executive Vice President and Chief Financial Officer
John J. Wider, Jr...................... 50 President and Chief Operating Officer of Magellan BHO
Clarissa C. Marques, Ph.D.............. 46 Executive Vice President of Clinical and Quality Management of
Magellan BHO and Magellan Specialty Medical
Gregory T. Torres...................... 48 President and Chief Executive Officer of Mentor
Raymond H. Kiefer...................... 70 Director
Gerald L. McManis...................... 61 Director
Andre C. Dimitriadis................... 57 Director
A.D. Frazier, Jr....................... 53 Director
G. Fred DiBona, Jr..................... 46 Director
Edwin M. Banks......................... 35 Director
Daniel S. Messina...................... 42 Director
Robert W. Miller....................... 56 Chairman of the Board of Directors
Darla D. Moore......................... 43 Director
Jeffrey A. Sonnenfeld Ph.D............. 43 Director
</TABLE>
HENRY T. HARBIN, M.D. became President, Chief Executive Officer and a
Director of the Company on March 18, 1998. Dr. Harbin served as President and
Chief Executive Officer of Green Spring from 1994 to 1998. Dr. Harbin served as
Executive Vice President of the Company from 1995 until becoming President and
Chief Executive Officer of the Company. Dr. Harbin served as Executive Vice
President and Chief Clinical Officer of Green Spring during 1993 and 1994.
CRAIG L. MCKNIGHT became Executive Vice President and Chief Financial
Officer of the Company in October 1995. From March 1995 through September 1995,
he served as Executive Vice President-- Office of the President and Chairman.
Mr. McKnight practiced public accounting with Coopers & Lybrand L.L.P. from 1985
through 1995. Coopers & Lybrand L.L.P. is an international accounting firm that
provides accounting and auditing services, tax services and consulting services.
As an audit partner at Coopers & Lybrand L.L.P., from 1985 to 1995, Mr. McKnight
had responsibility for a wide range of hospital and managed-care engagements, as
well as assisting clients with formulating financing options, financial
restructurings and the purchase and sale of health plans and facilities.
JOHN J. WIDER, JR. has served as President and Chief Operating Officer of
Magellan BHO since March 1998. Mr. Wider served as Executive Vice President and
Chief Operating Officer of Green Spring from 1997 to 1998. Mr. Wider was
President and General Manager for Cigna Healthcare Corporation's ("Cigna")
Mid-Atlantic region from 1996 to 1997. Mr. Wider served as Area Operations
Officer for Cigna during 1995 and 1996 and as Vice President of Sales of Cigna's
Midwest region from 1993 to 1995.
CLARISSA C. MARQUES, PH.D. has served as Executive Vice President of
Clinical and Quality Management of both Magellan BHO and Magellan Specialty
Medical since March 1998. Dr. Marques served as Executive Vice President and
Chief Clinical Officer of Green Spring during 1997 and 1998. Dr. Marques served
as Senior Vice President of Green Spring from 1992 to 1997. Dr. Marques also
serves as a director of Community Sector Systems.
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<PAGE>
GREGORY T. TORRES is President and Chief Executive Officer of Mentor,
positions he has held since 1996. Mr. Torres served as Senior Vice President for
Public Affairs of Mentor from 1992 until 1996.
RAYMOND H. KIEFER has been a Director of the Company since July 1992. Mr.
Kiefer was President of Allstate Insurance Company from 1989 until he retired in
1992.
GERALD L. MCMANIS has been a Director of the Company since February 1994.
Mr. McManis is President of McManis Associates, Inc., a strategy development and
management consulting firm for healthcare and healthcare related companies, a
position he has occupied since 1965. Mr. McManis serves on the board of
directors of MMI Companies, Inc.
ANDRE C. DIMITRIADIS has been a Director since July 1992. Mr. Dimitriadis
has been Chairman and Chief Executive Officer of LTC Properties, Inc., a
healthcare real estate investment trust, since 1992. Mr. Dimitriadis is a
director of Health Management, Inc. and Assisted Living Concepts, Inc.
A.D. FRAZIER, JR. has been a Director since May 1995. He is currently
President and Chief Executive Officer of Invesco, Inc., a registered investment
advisor, a position he has held since 1996. Prior to joining Invesco, Mr.
Frazier was Senior Executive Vice President and Chief Operating Officer for the
Atlanta Committee for the Olympic Games, Inc., a position he occupied from 1991
through 1996. Mr. Frazier also serves on the board of directors of Invesco PLC
and three registered investment companies of which Invesco PLC is the registered
investment advisor.
G. FRED DIBONA, JR. has been a Director since January 1996. Mr. DiBona has
been President and Chief Executive Officer of and a director of Independence
Blue Cross, a health insurance company, since 1990. Mr. DiBona serves on the
board of directors of Philadelphia Savings Bank and Philadelphia Suburban Water
Company.
EDWIN M. BANKS has been a Director since July 1992. Mr. Banks has been a
securities analyst with W.R. Huff Asset Management Co., LLC, a registered
investment advisor, since 1988. Mr. Banks also serves on the board of directors
of American Communications Services, Inc. and Del Monte Corporation.
DANIEL S. MESSINA has been a Director since December 1997. Mr. Messina
currently is Chief Financial Officer of Aetna U.S. Healthcare. Mr. Messina was
Vice President-Business Strategy of Aetna U.S. Healthcare in 1997 and served as
Deputy Chief Financial Officer of Aetna in 1996 and 1997. During 1995 and 1996,
Mr. Messina served as Vice President Financial Relations and Chief of Staff to
the Vice Chairman for Strategy, Finance and Administration of Aetna, Inc. Mr.
Messina also was the Vice President and Controller of Aetna Health Plans from
1991 to 1995.
ROBERT W. MILLER has been the Chairman of the Board since March 1998 and a
Director since February 1998. Mr. Miller practiced law with the law firm King &
Spalding in Atlanta from 1985 to 1997. In his practice, Mr. Miller specialized
in representing health care clients in a variety of different capacities,
including representations in mergers and acquisitions involving more than 75
hospitals, debt and equity restructurings and other corporate finance
transactions.
DARLA D. MOORE has been a Director since February 1996. Ms. Moore has been a
private investor of Rainwater, Inc., a private investment firm, since 1994. From
1982 through 1994 she was a Managing Director of The Chase Manhattan Bank, N.A.
JEFFREY A. SONNENFELD, PH.D. has been a Director since September 1997. Dr.
Sonnenfeld has been President of The Chief Executive Institute (education) since
December 1997. Dr. Sonnenfeld is a professor of organization and management and
director of the Center for Leadership & Career Studies of the Goizueta Business
School at Emory University. Dr. Sonnenfeld received his AB, MBA and doctorate
degrees from Harvard University. Dr. Sonnenfeld also serves on the board of
directors of Klaster Cruise Limited, Masely Securities Corporations,
Transmedia-CBS, Inc. and U.S. Franchise Systems.
114
<PAGE>
EXECUTIVE COMPENSATION
The following table sets forth the compensation paid by the Company to the
Company's Chief Executive Officer and the Company's four next most highly
compensated executive officers (the "Named Executive Officers"), for the three
fiscal years ended September 30, 1997:
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
ALL OTHER
COMPENSATION (3)
------------------
ANNUAL COMPENSATION LONG-TERM
---------------------------------------------- COMPENSATION
NAME AND PRINCIPAL FISCAL OTHER ANNUAL --------------
POSITIONS YEAR SALARY BONUS COMPENSATION (1) OPTIONS(#) (2)
- ----------------------------- ----------- ----------- ------------- ------------------ --------------
<S> <C> <C> <C> <C> <C> <C>
E. Mac Crawford (4).......... 1997 $ 806,250 $ 2,475,000 $ -- 933,666 $ 166,575
Chairman of the Board, 1996 712,500 153,500 -- 300,000 181,936
President and Chief 1995 600,000 -- 177,236 -- 204,095
Executive Officer
Craig L. McKnight (5)........ 1997 378,688 150,000 59,743 65,000 45,158
Executive Vice President 1996 361,250 50,000 -- 25,000 73,891
and Chief Financial Officer 1995 204,167 -- 45,668 100,000 11,218
Steve J. Davis (6)........... 1997 337,500 150,000 -- 167,500 43,750
Executive Vice President- 1996 256,667 50,000 -- 40,000 50,449
Administrative Services and 1995 182,083 -- 21,121 -- 91,972
General Counsel
Henry T. Harbin M.D. (7)..... 1997 338,069 161,707 -- 125,000 10,750
Executive Vice President 1996 236,705 167,195 -- 100,000 10,750
and President and Chief
Executive Officer of Green
Spring
Danna Mauch Ph.D. (8)........ 1997 304,500 -- -- -- 33,660
Executive Vice President 1996 125,000 10,000 -- 50,000 23,452
and President and Chief
Operating Officer of
Magellan Public Solutions,
Inc.
</TABLE>
- ------------------------
(1) Other Annual Compensation for fiscal 1997 includes country club initiation
fees and dues of $42,004 for Mr. McKnight. Other Annual Compensation for
fiscal 1995 includes: (a) reimbursement of relocation expenses of $157,558
and $38,289 for Messrs. Crawford and McKnight, respectively, and (b) a car
allowance of $12,000 for Mr. Davis.
(2) Represents the number of stock options granted under the Company's 1994
Stock Option Plan, 1996 Stock Option Plan and 1997 Stock Option Plan.
(3) All Other Compensation for fiscal 1997 includes: (a) contributions to the
Company's 401(k) Plan of $5,250 for Messrs. Crawford and Davis, $3,000 for
Mr. McKnight and contributions to the Green Spring 401(k) plan of $10,750
for Dr. Harbin; (b) amounts deposited in trust pursuant to the Company's
Executive Benefits Plan ("EBP") of $151,816, $42,158, $38,500 and $33,660
for Messrs. Crawford, McKnight, Davis and Dr. Mauch, respectively and (c)
premiums paid for disability insurance of $9,509 for Mr. Crawford. All Other
Compensation for fiscal 1996 includes: (a) contributions to the ESOP of
$18,050, $22,795 and $22,795 for Messrs. Crawford,
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<PAGE>
McKnight and Davis, respectively, which represents the Company's expense
(the fair value of the ESOP shares on the date earned was $699, $883 and
$883 for Messrs. Crawford, McKnight and Davis, respectively); (b)
contributions to the Company's 401(k) Plan of $5,250 for Mr. Crawford and
contributions to the Green Spring 401(k) Plan of $10,750 for Dr. Harbin; (c)
amounts deposited in trust pursuant to the EBP of $137,191, $40,150, $23,375
and $23,452 for Messrs. Crawford, McKnight, Davis and Dr. Mauch,
respectively; (d) premiums paid for life and disability insurance of
$19,840, $10,260 and $3,595 for Messrs. Crawford, McKnight and Davis,
respectively; and (e) term life insurance premiums of $1,605, $686 and $684
for Messrs. Crawford, McKnight and Davis, respectively. All Other
Compensation for fiscal 1995 includes: (a) contributions to the ESOP of
$20,408 and $18,560 for Messrs. Crawford and Davis, respectively, which
represents the Company's expense (the fair value of the ESOP shares on the
date earned was $465 and $424 for Messrs. Crawford, and Davis,
respectively); (b) contributions to the Company's 401(k) Plan of $5,250 for
Mr. Crawford; (c) amounts deposited in trust pursuant to the EBP of $104,877
and $25,897 for Messrs. Crawford and Davis, respectively; (d) premiums paid
for life and disability insurance of $72,954, $11,010 and $4,410 for Messrs.
Crawford, McKnight and Davis, respectively; (e) term life insurance premiums
of $606, $208 and $685 for Messrs. Crawford, McKnight and Davis,
respectively; and (f) amounts paid to Mr. Davis of $42,420 pursuant to Mr.
Davis achieving performance goals set relating to his employment with the
Company.
(4) Mr. Crawford resigned his position with the Company on March 18, 1998.
(5) Mr. McKnight became an employee of the Company effective March 1, 1995.
(6) In November, 1997, Mr. Davis resigned his position with the Company to
become President and Chief Executive Officer of CBHS.
(7) Dr. Harbin became an executive officer of the Company effective December 13,
1995.
(8) Dr. Mauch became an employee of the Company effective May 1, 1996.
OPTION GRANTS IN FISCAL 1997
The following table sets forth certain information with respect to grants of
options to the Named Executive Officers who were granted options during fiscal
1997 and the potential realizable value of such options on September 30, 1997:
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
-----------------------------------------------------------------------------------------------
POTENTIAL REALIZABLE
VALUE AT ASSUMED
NUMBER OF PERCENTAGE OF ANNUAL RATES OF STOCK
SECURITIES TOTAL OPTIONS PRICE APPRECIATION
UNDERLYING GRANTED TO FOR OPTION TERM
OPTIONS GRANTED EMPLOYEES IN PRICE EXERCISE ------------------------------
NAME (#) FISCAL 1997 PER SHARE EXPIRATION DATE 5% 10%
- ------------------------- ---------------- --------------- ----------- --------------- -------------- --------------
<S> <C> <C> <C> <C> <C> <C>
E. Mac Crawford (1)...... 183,666(2) 11.2% $ 20.875 12/17/06 $ 2,411,199 $ 6,110,453
750,000(4) 45.7 24.375 2/28/07 11,496,980 29,135,604
Craig L. McKnight........ 15,000(2) 0.9 20.875 12/17/06 196,923 499,041
50,000(3) 3.0 23.438 11/30/05 631,648 1,570,244
Steve J. Davis........... 67,500(2) 4.1 20.875 12/17/06 886,152 2,245,683
100,000(3) 6.1 23.438 11/30/05 1,263,296 3,140,488
Henry T. Harbin M.D...... 25,000(2) 1.5 20.875 12/17/06 328,204 831,734
100,000(4) 6.1 30.438 2/28/07 1,796,152 4,492,103
</TABLE>
- ------------------------
(1) Mr. Crawford resigned his position with the Company on March 18, 1998.
(2) Options granted under the 1994 Stock Option Plan which become exercisable
over three years at the rate of 33 1/3% of the total number of options per
year.
(3) Options granted under the 1996 Stock Option Plan which became exercisable on
June 17, 1997.
(4) Options granted under the 1997 Stock Option Plan, which become exercisable
over three years at the rate of 33 1/3% of the total number of options per
year.
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<PAGE>
AGGREGATED OPTION EXERCISES IN FISCAL 1997
AND OPTION VALUES AT SEPTEMBER 30,1997
The following table sets forth certain information with respect to options
exercised by the Named Executive Officers during fiscal 1997, and the number and
value of options held on September 30, 1997:
<TABLE>
<CAPTION>
VALUE OF UNEXERCISED
NUMBER OF LN-THE-MONEY
UNEXERCISED OPTIONS OPTIONS AT
SHARES VALUE AT SEPTEMBER 30, 1997 SEPTEMBER 30, 1997($)(1)
ACQUIRED ON REALIZED ---------------------------- ------------------------------
NAME EXERCISE (#) ($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ------------------------- ------------ ----------- ------------ -------------- -------------- --------------
<S> <C> <C> <C> <C> <C> <C>
E. Mac Crawford (2)...... -- $ -- 755,440 933,666 $ 14,791,046 $ 7,528,618
Craig L. McKnight........ -- -- 141,667 48,333 1,648,996 611,054
Steve J. Davis........... -- -- 157,500 67,500 1,526,563 734,063
Henry T. Harbin M.D...... -- -- 100,000 125,000 1,287,500 403,125
Danna Mauch Ph.D......... -- -- 50,000 -- 437,500 --
</TABLE>
- ------------------------
(1) The closing price for the Common Stock as reported on September 30, 1997 was
$31.75. The value of unexercised in-the-money options is the difference
between the per share option exercise price and $31.75, multiplied by the
number of shares of Common Stock underlying in-the-money options.
(2) Mr. Crawford resigned his position with the Company on March 18, 1998.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. The following table sets
forth certain information as of April 15, 1998 (except as otherwise noted) with
respect to any person known by the Company to be the beneficial owner of more
than five percent of the Company's outstanding Common Stock:
<TABLE>
<CAPTION>
AMOUNT AND NATURE PERCENT OF
NAME AND ADDRESS OF BENEFICIAL OWNERSHIP CLASS
- ---------------------------------------------------------------------------- ----------------------- -------------
<S> <C> <C>
Richard E. Rainwater(1)..................................................... 4,440,431 13.3%
777 Main Street
Suite 2700
Ft. Worth, TX 76102
Rainwater-Magellan Holdings, L.P.(2)........................................ 1,970,653 5.9%
777 Main Street
Suite 2700
Ft. Worth, TX 76102
Wellington Management Company, LLP(3)....................................... 3,205,850 10.2%
75 State Street
Boston, MA 02109
Lazard Freres & Co., LLC(4)................................................. 2,422,575 7.7%
30 Rockefeller Plaza
New York, NY 10020
First Pacific Advisors, Inc.(5)............................................. 1,592,500 5.1%
11400 West Olympic Blvd.
Suite 1200
Los Angeles, CA 90064
</TABLE>
- ------------------------
(1) Includes 1,970,653 shares of Common Stock that Rainwater-Magellan has the
right to acquire pursuant to the Rainwater-Magellan Warrant and 12,500
shares that Darla D. Moore, a director of the Company and spouse of Richard
E. Rainwater, has the right to acquire upon the exercise of options.
Information concerning beneficial ownership of securities by Richard E.
Rainwater is based on his Form 13 D/A dated April 20, 1998.
(2) Includes 1,970,653 shares of Common Stock that Rainwater-Magellan has the
right to acquire pursuant to the Rainwater-Magellan Warrant. Under the rules
of the SEC, Rainwater, Inc., the general partner of Rainwater-Magellan and
Richard E. Rainwater, the sole owner and sole director of Rainwater, Inc.,
are also deemed to be
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<PAGE>
beneficial owners of the shares owned by Rainwater-Magellan. Information
concerning beneficial ownership of securities by Rainwater-Magellan is based
on its Form 13 D/A, dated April 20, 1997.
(3) Information concerning beneficial ownership of securities by Wellington
Management Company, LLP is based on its Form 13F, dated May 12, 1998.
(4) Information concerning beneficial ownership of securities by Lazard Freres &
Co., LLC is based on its Form 13F, dated May 13, 1998.
(5) Information concerning beneficial ownership of securities by First Pacific
Advisors, Inc. is based on its Form 13F, dated April 1, 1998.
Wellington Management Company, LLP is an institutional investment manager
and possesses sole dispositive power over 3,149,100 shares of Common Stock and
shares dispositive power over 56,750 shares of Common Stock owned by it.
Wellington Management Company, LLP possesses sole voting authority over
2,101,700 shares of Common Stock, shared voting power over 56,750 shares of
Common Stock and no voting power over 1,047,400 shares of Common Stock.
Lazard Freres & Co., LLC is an institutional money manager and possesses
sole dispositive power and sole voting authority over all shares of Common Stock
owned by it.
First Pacific Advisors, Inc. is an institutional money manager and possesses
sole dispositive power over 1,200,000 of the shares of Common Stock owned by it
and shares dispositive power over 392,500 of such shares. It possesses no voting
power over 1,200,000 of such shares and shares voting power over 392,500 of such
shares.
SECURITY OWNERSHIP OF MANAGEMENT. The following table sets forth certain
information concerning the beneficial ownership of Common Stock by (i)
directors, (ii) the Named Executive Officers and other executive officers and
(iii) directors and executive officers as a group, as of March 1, 1998:
<TABLE>
<CAPTION>
AMOUNT AND NATURE
OF BENEFICIAL PERCENT OF
NAME OWNERSHIP (1)(2) TOTAL OUTSTANDING
- ------------------------------------------------------------------------- ------------------- -------------------
<S> <C> <C>
E. Mac Crawford(3)....................................................... 1,067,016 3.3%
Craig L. McKnight........................................................ 180,037 *
Henry T. Harbin M.D...................................................... 108,333 *
John J. Wider, Jr........................................................ -- *
Clarissa C. Marques, Ph.D. .............................................. 20,168 *
Gregory T. Torres........................................................ 60,915 *
Edwin M. Banks(4)........................................................ 39,500 *
G. Fred DiBona, Jr.(5)................................................... 901,956 2.8
Andre C. Dimitriadis..................................................... 39,000 *
A.D. Frazier, Jr......................................................... 28,500 *
Raymond H. Kiefer........................................................ 40,000 *
Gerald L. McManis........................................................ 39,000 *
Darla D. Moore(6)........................................................ 5,841,328 17.5
Robert W. Miller......................................................... -- *
Jeffrey A. Sonnenfeld Ph.D............................................... -- *
Daniel S. Messina........................................................ --(7) *
All directors and executive officers as a group (16 persons)............. 8,365,753(8) 23.2
</TABLE>
- ------------------------
* Less than 1% of total outstanding.
(1) Includes 1,066,662, 180,000, 108,333, 35,000 and 20,000 shares that Messrs.
Crawford, McKnight, Harbin, Torres and Ms. Marques, respectively, have the
right to acquire upon the exercise of options and warrants within 60 days of
March 1, 1998.
(2) Includes 39,000 shares that each of Messrs. Dimitriadis, Kiefer, Banks and
McManis have the right to acquire, 28,500 shares that Mr. Frazier has the
right to acquire, and 12,500 shares that each of Mr. DiBona and Ms. Moore
have the right to acquire within 60 days of March 1, 1998.
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<PAGE>
(3) Mr. Crawford resigned his position with the Company on March 18, 1998.
(4) Does not include shares owned by W.R. Huff Asset Management Co., LLC, a
registered investment advisor ("Huff"), of which Mr. Banks disclaims
beneficial ownership. Mr. Banks is a securities analyst with Huff.
(5) Includes 889,456 shares that Independence Blue Cross owns. See "Certain
Relationships and Related Transactions." Mr. DiBona is a director and the
President and Chief Executive Officer of Independence Blue Cross and
disclaims beneficial ownership of all securities attributed to him because
of his positions with Independence Blue Cross.
(6) Includes 3,885,832 shares owned by Rainwater-Magellan and 1,942,966 shares
that Rainwater-Magellan had the right to acquire as of March 1, 1988
pursuant to the Rainwater-Magellan Warrant. Ms. Moore is the spouse of
Richard F. Rainwater, the sole stockholder and sole director of Rainwater,
Inc., which is the sole general partner of Rainwater-Magellan.
(7) In accordance with Aetna U.S. Healthcare's policy, Mr. Messina will not
accept any option grants for serving as a director.
(8) Includes 1,556,162 shares that the directors and executive officers have the
right to acquire upon the exercise of options, 889,456 shares that
Independence Blue Cross owns and 1,942,996 shares that Rainwater-Magellan,
L.P. has the right to acquire upon the exercise of the Rainwater-Magellan
Warrant, all of which are exercisable within 60 days of March 1, 1998.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Gerald L. McManis, a director of the Company, is the President of McManis
Associates, Inc. ("MAI"), a strategy development and management consulting firm
for healthcare and health-related companies. During fiscal 1997, MAI provided
consulting services to the Company with respect to the development of strategic
plans and a review of the Company's business processes. The Company paid
approximately $825,000 in fees for such services during fiscal 1997 and
reimbursed MAI approximately $60,000 for expenses.
G. Fred DiBona, Jr., a director of the Company, is a director and the
President and Chief Executive Officer of Independence Blue Cross. As of November
30, 1997, Independence Blue Cross had a 12.25% equity interest in Green Spring.
The Company acquired a 51% equity interest in Green Spring on December 13,
1995 for approximately $68.9 million in cash, the issuance of Common Stock
valued at approximately $4.3 million and the contribution of Group Practice
Affiliates, Inc., a wholly-owned subsidiary of the Company ("GPA"), to Green
Spring. The Exchange Agreement provided that the minority stockholders of Green
Spring, including Independence Blue Cross, had the option (the "Exchange
Option") under certain circumstances, to exchange their equity interests in
Green Spring for 2,831,516 shares of Common Stock or $65.1 million in
subordinated notes. In the event of an exchange, the Company could have elected
to pay cash in lieu of issuing subordinated notes. Each of the Exchange Options
has been exercised. The consideration paid and terms of the Exchange Option were
determined through arm's length negotiations that considered, among other
factors, the historical and projected income of Green Spring and the value of
GPA. The consideration paid by the Company was determined by the Board with the
advice of management and the Company's investment bankers. On December 20, 1995,
the Company acquired an additional 10% equity interest in Green Spring for $16.7
million in cash as a result of the exercise of the Exchange Option by a minority
stockholder of Green Spring. The Company had a 61% equity interest in Green
Spring as of November 30, 1997.
On December 13, 1995, as part of the Company's initial investment in Green
Spring, Independence Blue Cross sold a 4.42% equity interest in Green Spring, in
which it had a cost basis of $3.2 million, to the Company for $5.4 million in
cash. The Exchange Option gave Independence Blue Cross the right, until December
13, 1998, to exchange its remaining equity interest in Green Spring for a
maximum of 889,565 shares of Common Stock or $20.5 million in subordinated
notes. Independence Blue Cross converted
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its equity interest in Green Spring into 889,456 shares of Common Stock during
January 1998 in connection with the Company's announced acquisition of Merit and
related transactions.
Independence Blue Cross and its affiliated entities contract with Green
Spring for provider network, care management and medical review services
pursuant to contractual relationships entered into on July 7, 1994, with terms
of up to five years. During fiscal 1997, Independence Blue Cross and its
affiliated entities paid Green Spring approximately $48.0 million for such
services. As of September 30, 1997, Independence Blue Cross and its affiliated
entities owed Green Spring approximately $13.6 million. Green Spring recorded
revenue of approximately $47.4 million from Independence Blue Cross during
fiscal 1997.
On July 7, 1994, Independence Blue Cross sold a subsidiary to Green Spring
in exchange for a $15.0 million promissory note. As of November 30, 1997, $6.0
million remained outstanding under such promissory note and is due and payable
in equal installments on July 7, 1998 and 1999.
Daniel S. Messina, a director of the Company, is the Chief Financial Officer
of Aetna. On December 4, 1997, the Company consummated the purchase of HAI,
formerly a unit of Aetna, for approximately $122.1 million, which the Company
funded from cash on hand. HAI manages the care of 16.3 million covered lives,
primarily through EAPs and other non-risk-based managed behavioral healthcare
plans. The Company may be required to make additional contingent payments of up
to $60.0 million annually to Aetna over the five-year period subsequent to
closing. The amount and timing of the payments will be contingent upon net
increases in the number of HAI's covered lives in specified products. For the
twelve months ended September 30, 1997, HAI had revenue of $117.0 million. The
consideration paid was determined through arm's length negotiations that
considered, among other factors, the historical and projected income of HAI. The
consideration paid by the Company was determined by the Board with the advice of
management and the Company's investment bankers. A contract between HAI and
Aetna represents 21% of the Company's pro forma covered lives and would
represent 5% of its pro forma managed behavioral healthcare revenues for fiscal
1997.
Richard E. Rainwater and certain of his affiliates have a significant
interest in Crescent and the Company. Set forth below is a summary of the
interests of such persons.
On June 17, 1997, the Company sold the Psychiatric Hospital Facilities to
Crescent for $417.2 million in cash (before costs of approximately $16 million)
and warrants for the purchase of 2.5% of the common stock of COI. Simultaneously
with the sale of the Psychiatric Hospital Facilities to Crescent, the Company
and COI formed CBHS to conduct the operations of the Psychiatric Hospital
Facilities and certain other facilities transferred to CBHS by the Company. The
Company owns a 50% interest in CBHS, which it obtained by contributing
approximately $5 million of certain net assets to CBHS. The Company franchises
the "CHARTER" System of behavioral healthcare to each of the Psychiatric
Hospital Facilities and other facilities operated by CBHS. In exchange, CBHS
pays certain franchise fees to the Company.
Crescent is the operating partnership of Crescent Real Estate Equities
("CEI"). Mr. Rainwater is the Chairman of the Board of Directors of CEI. The
sole general partner of Crescent is Crescent Real Estate Equities ("Crescent
GP"), which is a wholly-owned subsidiary of CEI. Mr. Rainwater owns beneficially
12.5% of Crescent, which interests consist of common stock in CEI (including
common stock of CEI that may be acquired pursuant to the exercise of options)
and units of ownership in Crescent. Mr. Rainwater is an affiliate of Crescent,
Crescent GP, COI and CEI.
A total of 4,000,000 shares of Common Stock and warrants for an additional
2,000,000 shares of Common Stock were acquired by Rainwater-Magellan from the
Company in a Private Placement pursuant to a Stock and Warrant Purchase
Agreement and certain related agreements (the "Private Placement Agreements").
Rainwater-Magellan owns 27,657 shares of Common Stock and holds a portion of
the Rainwater-Magellan Warrant, which gives Rainwater-Magellan the right to
purchase an additional 1,942,996 shares
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of Common Stock. Rainwater, Inc. is the sole general partner of
Rainwater-Magellan. Richard E. Rainwater is the sole stockholder and a director
of Rainwater, Inc. Mr. Rainwater has sole voting and dispositive power over the
shares of Common Stock owned by Rainwater-Magellan and the shares of Common
Stock underlying the Rainwater-Magellan Warrant. As a result of such
relationships, Mr. Rainwater is deemed to be the beneficial owner of the shares
of Common Stock held by Rainwater-Magellan, including the shares of Common Stock
which can be purchased under the Rainwater-Magellan Warrant.
Mr. Rainwater owns beneficially approximately 62.8% of Rainwater-Magellan.
Mr. Rainwater's three children own beneficially an additional 4.8% of
Rainwater-Magellan through a limited partnership of which Mr. Rainwater is
general partner and an additional 1.2% each through trusts which are managed by
an unaffiliated trustee.
The Rainwater-Magellan Warrant entitles the holders to purchase in the
aggregate, at any time prior to its January 25, 2000 expiration date, up to
2,000,000 shares of Common Stock at a purchase price of $26.15 per share. The
Private Placement Agreements provide, among other things, for the adjustment of
the number of shares of Common Stock that can be purchased under the
Rainwater-Magellan Warrant and the purchase price, respectively, for certain
dilutive events, for registration rights for the shares of Common Stock owned by
Rainwater-Magellan, including those underlying the Rainwater-Magellan Warrant
(which registration rights, as mentioned below, have been exercised), and for a
variety of other customary provisions, including, without limitation, certain
restrictions on Rainwater-Magellan's private sale of such shares, certain
preemptive rights of Rainwater-Magellan to acquire additional securities issued
by the Company for cash in a private placement transaction and standstill
covenants restricting the purchase of additional shares of Common Stock by
Rainwater-Magellan and its affiliates in certain circumstances.
Darla D. Moore, a director of the Company, is the spouse of Richard E.
Rainwater. Under the terms of the Private Placement Agreements,
Rainwater-Magellan has the right to designate a nominee acceptable to the
Company for election as a director of the Company for so long as the Rainwater
Group continues to own beneficially a specified minimum number of shares of
Common Stock. Rainwater-Magellan proposed Ms. Moore as its nominee for director,
and Ms. Moore was elected a director by the Board in February 1996. For purposes
of this Prospectus, any reference to the "Rainwater Group" includes Rainwater
Magellan, Rainwater, Inc., Richard E. Rainwater, Darla D. Moore and their
affiliates and associates.
As of April 15, 1998, Rainwater-Magellan beneficially owned 1,970,653 shares
of Common Stock (including the 1,942,996 shares which can be purchased under the
Rainwater-Magellan Warrant), which represents in the aggregate 5.9% of the
Common Stock.
Under the terms of the Private Placement Agreements, the Company agreed (i)
to pay a transaction fee of $150,000; (ii) to reimburse certain expenses of
Rainwater, Inc. in connection with the Private Placement; (iii) to pay the
Rainwater Group an annual monitoring fee of $75,000 commencing on March 31,
1996; and (iv) to reimburse the Rainwater Group for reasonable fees and expenses
(up to a maximum of $25,000 annually) incurred in connection with its ownership
of the Common Stock and the Rainwater-Magellan Warrant. The Company also agreed
under the Private Placement Agreements to reimburse the Rainwater Group in the
future for one additional filing under the Hart-Scott-Rodino Antitrust
Improvements Act of 1976, as amended, if a filing under such act is required in
connection with an exercise of the Rainwater-Magellan Warrant.
Rainwater-Magellan purchased the Common Stock and the Rainwater-Magellan
Warrant on January 25, 1996. During fiscal 1997, the Company paid an aggregate
of $77,019 for the annual monitoring fee and fees and expenses incurred in
connection with Rainwater-Magellan's ownership of the Common Stock and
Rainwater-Magellan Warrant. Excluded from these amounts are directors' fees and
expense reimbursement paid to Ms. Moore in her capacity as a director of the
Company. The Company has incurred costs to date of approximately $55,000 in
connection with its registration of the shares and approximately $40,000 in
costs to register the shares of Common Stock underlying the Rainwater-Magellan
Warrant.
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THE EXCHANGE OFFER
PURPOSE AND EFFECT OF THE EXCHANGE OFFER
The Company sold the Old Notes to the Initial Purchaser on February 12, 1998
pursuant to the Purchase Agreement. The Initial Purchaser subsequently resold
the Old Notes to "qualified institutional buyers" in reliance on Rule 144A under
the Securities Act or pursuant to offers and sales that occurred outside the
United States within the meaning of Regulation S under the Securities Act. As a
condition to the Purchase Agreement, the Company entered into the Registration
Rights Agreement, pursuant to which the Company agreed, for the benefit of all
holders of the Old Notes, that it would, at its expense, (i) prepare, and not
later than 60 days following the date of the original issuance of the Old Notes,
file a registration statement with the Commission with respect to a registered
offer to exchange the Old Notes for the New Notes and (ii) use its reasonable
best efforts to cause such registration statement to be declared effective under
the Securities Act by July 10, 1998. The Company also agreed that upon
effectiveness of the Registration Statement, it would offer to all holders of
the Old Notes an opportunity to exchange their securities for an equal principal
amount of the New Notes. Further, the Company agreed that it would keep the
Exchange Offer open for acceptance for not less than 30 days (subject to any
extensions required by applicable law) after the date on which notice of the
Exchange Offer is mailed to the holders of the Old Notes. A copy of the
Registration Rights Agreement has been filed as an exhibit to the Registration
Statement of which this Prospectus is a part. The term "Holder" with respect to
the Exchange Offer means any person in whose name Old Notes are registered on
the books of the Company or any other person who has obtained a properly
completed bond power from the registered holder. The Exchange Offer is intended
to satisfy certain of the Company's obligations under the Registration Rights
Agreement.
Based on existing interpretations of the Staff with respect to similar
transactions, the Company believes that the New Notes issued pursuant to the
Exchange Offer in exchange for Old Notes may be offered for resale, resold and
otherwise transferred by holders thereof (other than any such holder which is an
"affiliate" of the Company within the meaning of Rule 405 under the Securities
Act) without compliance with the registration and prospectus delivery
requirements of the Securities Act; provided that such New Notes are acquired in
the ordinary course of such holders' business and such holders are not engaged
in, have no arrangement with any person to participate in, and do not intend to
engage in, any public distribution of the New Notes. Each broker or dealer
receiving New Notes in the Exchange Offer in exchange for Old Notes acquired by
the broker-dealer for its own account in market-making or other trading
activities ("Participating Broker-Dealers") will be subject to a prospectus
delivery requirement with respect to resales of such New Notes. Each
Participating Broker-Dealer must acknowledge that it will deliver a resale
prospectus in connection with any resale of such New Notes. The Letter of
Transmittal which accompanies this Prospectus states that by so acknowledging
and by delivering a resale prospectus, a Participating Broker-Dealer will not be
deemed to admit to be acting in the capacity of an "underwriter" (within the
meaning of Section 2(11) of the Securities Act). This Prospectus, as it may be
amended or supplemented from time to time, may be used by a Participating
Broker-Dealer in connection with resales of New Notes received in exchange for
Old Notes where such Old Notes were acquired by such Participating Broker-Dealer
as result of market-making or other trading activities. Any broker-dealer that
receives New Notes for its own account in exchange for Old Notes acquired
directly from the Company may not rely on the interpretations of the Staff of
the Commission referred to above and, in connection with the resale of any such
New Notes, must comply with the registration and prospectus delivery
requirements of the Securities Act, including the requirement that such broker-
dealer be named as a selling Noteholder in the resale prospectus. Pursuant to
the Registration Rights Agreement, the Company has agreed to permit
Participating Broker-Dealers to use this Prospectus in connection with the
resale of such New Notes for a period of 180 days from the date on which the
Registration Statement of which this Prospectus is a part is first declared
effective.
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Each holder of the Old Notes who wishes to exchange its Old Notes for New
Notes in the Exchange Offer will be required to make certain representations to
the Company in the accompanying Letter of Transmittal, including that (i) any
New Notes to be received by it will be acquired in the ordinary course of its
business, (ii) it is not participating in, does not intend to participate in and
has no arrangement with any person to participate in a public distribution
(within the meaning of the Securities Act) of the New Notes, and (iii) it is not
an "affiliate," as defined in Rule 405 of the Securities Act of the Company, or
if it is such an affiliate, that it will comply with the registration and
prospectus delivery requirements of the Securities Act to the extent applicable
to it. In addition, each holder who is not a broker-dealer will be required to
represent that it is not engaged in, and does not intend to engage in, a public
distribution of the New Notes. Each Participating Broker-Dealer who receives New
Notes for its own account in exchange for Old Notes that were acquired by it as
a result of market-making or other trading activities, will be required to
acknowledge that it will deliver this Prospectus in connection with any resale
by it of such New Notes.
Accordingly, subject to the aforementioned interpretations of the Staff with
respect to the free transferability of the New Notes received by holders in
exchange for their Old Notes pursuant to the Exchange Offer and, as set forth in
such interpretations, the ability of certain holders to participate in the
Exchange Offer, holders of Old Notes otherwise eligible to participate in the
Exchange Offer and receive pursuant thereto freely tradeable New Notes but who
elect not to tender their Old Notes for exchange, will not have any further
registration rights under the Registration Rights Agreement and the Old Notes
not so exchanged will remain "restricted securities" (within the meaning of the
Securities Act) and subject to restrictions on transfer under the Securities
Act.
TERMS OF THE EXCHANGE OFFER
Upon the terms and subject to the conditions set forth in this Prospectus
and in the accompanying Letter of Transmittal (together, the "Exchange Offer"),
the Company will accept for exchange and exchange any and all Old Notes validly
tendered and not withdrawn prior to 5:00 p.m., New York City time, on the
Expiration Date. The Company will issue $1,000 principal amount of New Notes in
exchange for each $1,000 principal amount of outstanding Old Notes accepted in
the Exchange Offer. Holders may tender some or all of their Old Notes pursuant
to the Exchange Offer. However, Old Notes may be tendered only in integral
multiples of $1,000.
The form and terms of the New Notes are the same as the form and terms of
the Old Notes except that (i) the New Notes have been registered under the
Securities Act and will not bear legends restricting the transfer thereof, (ii)
the holders of the New Notes will not be entitled to certain rights under the
Registration Rights Agreement, which rights will terminate when the Exchange
Offer is terminated and (iii) the New Notes have been given a series designation
to distinguish the New Notes from the Old Notes. The New Notes will evidence the
same debt as the Old Notes and will be entitled to the benefits of the
Indenture.
As of the date of this Prospectus, all $625,000,000 outstanding principal
amount of the Old Notes were evidenced by global securities, registered in the
name of CEDE & Co., as nominee for DTC, and held by Marine Midland Bank as
securities custodian for CEDE & Co. As indicated elsewhere in this Prospectus,
the Old Notes have been included in the PORTAL Market for trading among
"qualified institutional buyers" pursuant to Rule 144A under the Securities Act.
For purposes of administration, the Company has fixed the close of business
on October 7, 1998 as the record date for the Exchange Offer for purposes of
determining the persons to whom this Prospectus and the accompanying Letter of
Transmittal will be mailed initially. There will be no fixed record date for
determining generally registered holders of Old Notes entitled to participate in
the Exchange Offer.
Holders of Old Notes do not have any appraisal or dissenters' rights under
the General Corporation Law of Delaware or the Indenture in connection with the
Exchange Offer. The Company intends to
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conduct the Exchange Offer in accordance with Regulation 14E and Rule 13e-4
under the Exchange Act (other than the filing requirements of Rule 13e-4).
The Company shall be deemed to have accepted validly tendered Old Notes
when, as and if the Company has given oral or written notice thereof to the
Exchange Agent. The Exchange Agent will act as agent for the tendering Holders
for the purpose of receiving the New Notes from the Company.
If any tendered Old Notes are not accepted for exchange because of an
invalid tender, the occurrence of certain other events set forth herein under
"--Conditions" or otherwise, the certificates for any such unaccepted Old Notes
will be returned, without expense, to the tendering Holder thereof as promptly
as practicable after the Expiration Date. See "--Procedures for Tendering."
Holders who tender Old Notes in the Exchange Offer will not be required to
pay brokerage commissions or fees or, subject to the instructions in the Letter
of Transmittal, transfer taxes with respect to the exchange of Old Notes
pursuant to the Exchange Offer. The Company will pay all charges and expenses,
other than transfer taxes in certain circumstances, in connection with the
Exchange Offer. See "--Fees and Expenses."
EXPIRATION DATE; EXTENSIONS; AMENDMENTS
The term "Expiration Date" shall mean 5:00 p.m., New York City time, on
November 9, 1998, unless the Company, in its sole discretion, extends the
Exchange Offer, in which case the term "Expiration Date" shall mean the latest
date and time to which the Exchange Offer is extended.
In order to extend the Exchange Offer, the Company will notify the Exchange
Agent of any extension by oral or written notice and will notify the registered
Holders as promptly as practicable by public announcement thereof, the
announcement in the case of an extension to be issued no later than 9:00 a.m.,
New York City time, on the next business day after the previously scheduled
expiration date.
The Company reserves the right, in its sole discretion, (i) to delay
accepting any Old Notes, to extend the Exchange Offer or to terminate the
Exchange Offer if any of the conditions set forth below under "--Conditions"
shall not have been satisfied, by giving oral or written notice of such delay,
extension or termination to the Exchange Agent or (ii) to amend the terms of the
Exchange Offer in any manner. Any such delay in acceptance, extension,
termination or amendment will be followed as promptly as practicable by oral or
written notice thereof to the registered Holders. If the Exchange Offer is
amended in a manner determined by the Company to constitute a material change,
the Company will promptly disclose such amendment by means of (a) an amendment
to the Registration Statement of which this Prospectus is a part and (b) a
prospectus supplement that will be distributed to the registered Holders, and
the Company will extend the Exchange Offer, in accordance with applicable rules
of the Commission and published interpretations of the Staff, for a period of
five to ten business days, depending upon the significance of the amendment and
the manner of disclosure to the registered Holders, if the Exchange Offer would
otherwise expire during such five to ten business day period.
Without limiting the manner in which the Company may choose to make public
announcement of any delay, extension, amendment or termination of the Exchange
Offer, the Company shall have no obligation to publish, advertise or otherwise
communicate any such public announcement, other than by making a timely release
to the Dow Jones News Service.
INTEREST ON THE NEW NOTES
Each New Note will bear interest from its date of original issuance. Holders
of Old Notes that are accepted for exchange and exchanged for New Notes will
receive, in cash, accrued interest thereon to, but not including, the original
issuance date of the New Notes. The Old Notes will bear interest at a rate per
annum of 9% through the date next preceding the date of the original issuance of
the New Notes. Such interest will be paid on the first interest payment date for
the New Notes. Interest on the Old Notes
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accepted for exchange and exchanged in the Exchange Offer will cease to accrue
on the date next preceding the date of original issuance of the New Notes. The
New Notes will bear interest (as do the Old Notes) at a rate per annum of 9%,
which interest will be payable semi-annually on each February 15 and August 15,
commencing on August 15, 1998.
PROCEDURES FOR TENDERING
Only a Holder of Old Notes may participate in the Exchange Offer. The tender
to the Exchange Agent of Old Notes by a Holder thereof as set forth below and
the acceptance thereof by the Company will constitute a binding agreement
between the tendering Holder and the Company upon the terms and subject to the
conditions set forth in this Prospectus and in the accompanying Letter of
Transmittal. Except as set forth below, a Holder who wishes to tender Old Notes
for exchange pursuant to the Exchange Offer must transmit a properly completed
and duly executed Letter of Transmittal, including all other documents required
by such Letter of Transmittal, to the Exchange Agent at one of the addresses set
forth below under "Exchange Agent" on or prior to the Expiration Date. In
addition, either (i) a timely Book-Entry Confirmation (as hereinafter defined)
of such Old Notes into the Exchange Agent's account at the Depositary (the "Book
Entry Transfer Facility") pursuant to the procedure for book-entry transfer
described below must be received by the Exchange Agent prior to the Expiration
Date or (ii) the Holder must comply with the guaranteed delivery procedures
described below.
By executing the accompanying Letter of Transmittal, each Holder will
thereby make to the Company the representations set forth above in the third
paragraph under the heading "--Purpose and Effect of the Exchange Offer."
The tender by a Holder and the acceptance thereof by the Company will
constitute an agreement between such Holder and the Company in accordance with
the terms and subject to the conditions set forth herein and in the accompanying
Letter of Transmittal.
THE METHOD OF DELIVERY OF THE LETTER OF TRANSMITTAL AND ALL OTHER REQUIRED
DOCUMENTS TO THE EXCHANGE AGENT IS AT THE ELECTION AND RISK OF THE HOLDER.
INSTEAD OF DELIVERY BY MAIL, IT IS RECOMMENDED THAT HOLDERS USE AN OVERNIGHT OR
HAND DELIVERY SERVICE. IN ALL CASES, SUFFICIENT TIME SHOULD BE ALLOWED TO ASSURE
DELIVERY TO THE EXCHANGE AGENT BEFORE THE EXPIRATION DATE. NO LETTER OF
TRANSMITTAL SHOULD BE SENT TO THE COMPANY. HOLDERS MAY REQUEST THEIR RESPECTIVE
BROKERS, DEALERS, COMMERCIAL BANKS, TRUST COMPANIES OR NOMINEES TO EFFECT THE
ABOVE TRANSACTIONS FOR SUCH HOLDERS.
Any beneficial owner whose Old Notes are registered in the name of a broker,
dealer, commercial bank, trust company or other nominee and who wishes to tender
should contact the registered Holder promptly and instruct such registered
Holder to tender on such beneficial owner's behalf. See "Instruction to
Registered Holder and/or Book-Entry Transfer Facility Participant from Owner"
included with the Letter of Transmittal.
Signatures on a Letter of Transmittal or a notice of withdrawal, as the case
may be, must be guaranteed by an Eligible Institution (as defined below) unless
the Old Notes tendered pursuant thereto are tendered (i) by a registered Holder
who has not completed the box entitled "Special Registration Instructions" or
"Special Delivery Instructions" on the Letter of Transmittal or (ii) for the
account of an Eligible Institution. In the event that signatures on a Letter of
Transmittal or a notice of withdrawal, as the case may be, are required to be
guaranteed, such guarantee must be by a member firm of a registered national
securities exchange or of the National Association of Securities Dealers, Inc.,
a commercial bank or trust company having an office or correspondent in the
United States or an "eligible guarantor institution" within the meaning of Rule
17Ad-15 under the Exchange Act (an "Eligible Institution").
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If the Letter of Transmittal is signed by a person other than the registered
Holder of any Old Notes listed therein, such person must submit a properly
completed bond power, signed by such registered Holder as such registered
Holder's name appears on such Old Notes with the signature thereon guaranteed by
an Eligible Institution.
If the Letter of Transmittal or any bond powers are signed by trustees,
executors, administrators, guardians, attorneys-in-fact, officers of
corporations or others acting in a fiduciary or representative capacity, such
persons should so indicate when signing, and unless waived by the Company,
evidence satisfactory to the Company of their authority to so act must be
submitted with the Letter of Transmittal.
The Exchange Agent and DTC have confirmed to the Company that any financial
institution that maintains a direct account with DTC (a "Participant") may
utilize DTC's Automated Tender Offer Program ("ATOP") to tender Old Notes for
exchange in the Exchange Offer. The Exchange Agent will request that DTC
establish an account with respect to the Old Notes for purposes of the Exchange
Offer within two business days after the date of this Prospectus. Any
Participant may effect book-entry delivery of Old Notes by causing DTC to record
the transfer of the tendering Participant's beneficial interests in the global
Old Notes into the Exchange Agent's account in accordance with DTC's ATOP
procedures for such transfer. However, the exchange of New Notes for Old Notes
so tendered only will be made after timely confirmation (a "Book-Entry
Confirmation") of such book-entry transfer of Old Notes into the Exchange
Agent's account, and timely receipt by the Exchange Agent of an Agent's Message
(as defined below) and any other documents required by the Letter of
Transmittal. The term "Agent's Message" as used herein means a message,
transmitted by DTC and received by the Exchange Agent and forming part of a
Book-Entry Confirmation, which states that DTC has received an express
acknowledgment from a Participant tendering Old Notes for exchange which are the
subject of such Book-Entry Confirmation that such Participant has received and
agrees to be bound by the terms and conditions of the Letter of Transmittal, and
that the Company may enforce such agreement against such Participant.
All questions as to the validity, form, eligibility (including time of
receipt), acceptance of tendered Old Notes and withdrawal of tendered Old Notes
will be determined by the Company in its sole discretion, which determination
will be final and binding. The Company reserves the absolute right to reject any
and all Old Notes not properly tendered or any Old Notes the Company's
acceptance of which would, in the opinion of counsel for the Company, be
unlawful. The Company also reserves the right to waive any defects,
irregularities or conditions of tender as to particular Old Notes. The Company's
interpretation of the terms and conditions of the Exchange Offer (including the
instructions in the Letter of Transmittal) will be final and binding on all
parties. Unless waived, any defects or irregularities in connection with tenders
of Old Notes must be cured within such time as the Company shall determine.
Although the Company intends to notify Holders of defects or irregularities with
respect to tenders of Old Notes, neither the Company, the Exchange Agent nor any
other person shall incur any liability for failure to give such notification.
Tenders of Old Notes will not be deemed to have been made until such defects or
irregularities have been cured or waived. Any Old Notes received by the Exchange
Agent that are not properly tendered and as to which the defects or
irregularities have not been cured or waived will be returned by the Exchange
Agent to the tendering Holders, unless otherwise provided in the Letter of
Transmittal, as soon as practicable following the Expiration Date.
GUARANTEED DELIVERY PROCEDURES
Holders who wish to tender their Old Notes and (i) who cannot deliver the
Letter of Transmittal or any other required documents to the Exchange Agent or
(ii) who cannot complete the procedures for book-entry transfer, prior to the
Expiration Date, may effect a tender if:
(a) the tender is made through an Eligible Institution;
(b) prior to the Expiration Date, the Exchange Agent receives from such
Holder and such Eligible Institution a properly completed and duly executed
Notice of Guaranteed Delivery (by
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facsimile transmission, mail or hand delivery) setting forth the name and
address of the Holder and the principal amount of Old Notes tendered,
stating that the tender is being made thereby and guaranteeing that, within
three New York Stock Exchange trading days after the Expiration Date, the
Letter of Transmittal (or facsimile thereof) together with a confirmation of
book-entry transfer of such Old Notes into the Exchange Agent's account at
the Book-Entry Transfer Facility, and any other documents required by the
Letter of Transmittal will be deposited by the Eligible Institution with the
Exchange Agent; and
(c) such properly completed and executed Letter of Transmittal (or
facsimile thereof), as well as a confirmation of book-entry transfer of such
Old Notes into the Exchange Agent's account at the Book-Entry Transfer
Facility, and all other documents required by the Letter of Transmittal are
received by the Exchange Agent within three New York Stock Exchange trading
days after the Expiration Date.
Upon request to the Exchange Agent, a Notice of Guaranteed Delivery will be
sent to Holders who wish to tender their Old Notes according to the guaranteed
delivery procedures set forth above.
WITHDRAWAL OF TENDERS
Except as otherwise provided herein, tenders of Old Notes may be withdrawn
at any time prior to 5:00 p.m., New York City time, on the Expiration Date. To
withdraw a tender of Old Notes in the Exchange Offer, a written or facsimile
transmission notice of withdrawal must be received by the Exchange Agent at its
address set forth herein prior to 5:00 p.m., New York City time, on the
Expiration Date. Any such notice of withdrawal must (i) specify the name of the
person having deposited the Old Notes to be withdrawn (the "Depositor"), (ii)
identify the Old Notes to be withdrawn (including the certificate number(s) and
principal amount of such Old Notes, or, in the case of Old Notes transferred by
book-entry transfer, the name and number of the account at the Book-Entry
Transfer Facility to be credited), (iii) be signed by the Holder in the same
manner as the original signature on the Letter of Transmittal by which such Old
Notes were tendered (including any required signature guarantees) or be
accompanied by documents of transfer sufficient to have the Trustee with respect
to the Old Notes register the transfer of such Old Notes into the name of the
person withdrawing the tender and (iv) specify the name in which any such Old
Notes are to be registered, if different from that of the Depositor. All
questions as to the validity, form and eligibility (including time of receipt)
of such notices will be determined by the Company, whose determination shall be
final and binding on all parties. Any Old Notes so withdrawn will be deemed not
to have been validly tendered for purposes of the Exchange Offer and no New
Notes will be issued with respect thereto unless the Old Notes so withdrawn are
validly retendered. Any Old Notes which have been tendered but which are not
accepted for exchange, will be returned to the Holder thereof without cost to
such Holder as soon as practicable after withdrawal, rejection of tender or
termination of the Exchange Offer. Properly withdrawn Old Notes may be
retendered by following one of the procedures described above under
"--Procedures for Tendering" at any time prior to the Expiration Date.
CONDITIONS
Notwithstanding any other term of the Exchange Offer, the Company shall not
be required to accept for exchange, or exchange New Notes for, any Old Notes,
and may terminate or amend the Exchange Offer as provided herein before the
acceptance of such Old Notes, if:
(a) any action or proceeding is instituted or threatened in any court or
by or before any governmental agency with respect to the Exchange Offer
which, in the reasonable judgment of the Company, might materially impair
the ability of the Company to proceed with the Exchange Offer or any
material adverse development has occurred in any existing action or
proceeding with respect to the Company or any of its subsidiaries; or
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(b) any change, or any development involving a prospective change, in
the business or financial affairs of the Company or any of its subsidiaries
has occurred which, in the reasonable judgment of the Company, might
materially impair the ability of the Company to proceed with the Exchange
Offer; or
(c) any law, statute, rule, regulation or interpretation by the Staff is
proposed, adopted or enacted, which, in the reasonable judgment of the
Company, might materially impair the ability of the Company to proceed with
the Exchange Offer or materially impair the contemplated benefits of the
Exchange Offer to the Company; or
(d) any governmental approval has not been obtained, which approval the
Company shall, in its reasonable discretion, deem necessary for the
consummation of the Exchange Offer as contemplated hereby.
If the Company determines in its reasonable discretion that any of the
conditions are not satisfied, the Company may (i) refuse to accept any Old Notes
and return all tendered Old Notes to the tendering Holders, (ii) extend the
Exchange Offer and retain all Old Notes tendered prior to the expiration of the
Exchange Offer, subject, however, to the rights of Holders to withdraw such Old
Notes (see "--Withdrawal of Tenders") or (iii) waive such unsatisfied conditions
with respect to the Exchange Offer and accept all properly tendered Old Notes
which have not been withdrawn. If such waiver constitutes a material change to
the Exchange Offer, the Company will promptly disclose such waiver by means of
(a) an amendment to the Registration Statement of which this Prospectus is a
part and (b) a prospectus supplement that will be distributed to the registered
Holders, and the Company will extend the Exchange Offer, in accordance with
applicable rules of the Commission and published interpretation of the Staff,
for a period of five to ten business days, depending upon the significance of
the waiver and the manner of disclosure to the registered Holders, if the
Exchange Offer would otherwise expire during such five to ten business day
period.
EXCHANGE AGENT
Marine Midland Bank has been appointed as Exchange Agent for the Exchange
Offer. Questions and requests for assistance, requests for additional copies of
this Prospectus or of the Letter of Transmittal and requests for Notices of
Guaranteed Delivery should be directed to the Exchange Agent addressed as
follows:
Marine Midland Bank
140 Broadway, Level A
New York, New York 10005-1180
Attention: Corporate Trust Operations
Telephone: (212) 658-6433
Facsimile: (212) 658-6425
FEES AND EXPENSES
The expenses of soliciting tenders will be borne by the Company. The
principal solicitation is being made by mail; however, additional solicitation
may be made by telegraph, telephone or in person by officers and regular
employees of the Company and its affiliates.
The Company has not retained any dealer-manager in connection with the
Exchange Offer and will not make any payments to brokers or others soliciting
acceptances of the Exchange Offer. The Company, however, will pay the Exchange
Agent reasonable and customary fees for its services and will reimburse it for
its reasonable out-of-pocket expenses in connection therewith and will reimburse
the Holders of the Old Notes for the reasonable fees and expenses of not more
than one firm of counsel designated by the holders of a majority in principal
amount of the Old Notes outstanding within the
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meaning of the Indenture to act as counsel for all Holders of Old Notes in
connection therewith and will reimburse the Holders of the Old Notes for the
reasonable fees and expenses of not more than one firm of counsel designated by
the holders of a majority in principal amount of the Old Notes outstanding
within the meaning of the Indenture to act as counsel for all Holders of Old
Notes in connection therewith.
The cash expenses to be incurred in connection with the Exchange Offer will
be paid by the Company. Such expenses include fees and expenses of the Exchange
Agent and Trustee, accounting and legal fees and printing costs, among others.
The Company will pay all transfer taxes, if any, applicable to the exchange
of Old Notes pursuant to the Exchange Offer. If, however, certificates
representing New Notes or Old Notes for principal amounts not tendered or
accepted for exchange are to be delivered to, or are to be issued in the name
of, any person other than the registered Holder of the Old Notes tendered, or if
tendered Old Notes are registered in the name of any person other than the
person signing the Letter of Transmittal, or if a transfer tax is imposed for
any reason other than the exchange of Old Notes pursuant to the Exchange Offer,
then the amount of any such transfer taxes (whether imposed on the registered
Holder or any other persons) will be payable by the tendering Holder. If
satisfactory evidence of payment of such taxes or exemption therefrom is not
submitted with the Letter of Transmittal, the amount of such transfer taxes will
be billed directly to such tendering Holder.
ACCOUNTING TREATMENT
The New Notes will be recorded at the same carrying value as the Old Notes,
which is face value, as reflected in the Company's accounting records on the
date of the exchange. Accordingly, no gain or loss for accounting purposes will
be be recognized.
TERMINATION OF CERTAIN RIGHTS
Holders of the New Notes will not be entitled to the benefits of the
Registration Rights Agreement, pursuant to which the Company agreed, for the
benefit of holders of the Old Notes, that it would, at its expense, (i) prepare,
and not later than 60 days following the date of the original issuance of the
Old Notes, file a registration statement with the Commission with respect to a
registered offer to exchange the Old Notes for the New Notes and (ii) use its
reasonable best efforts to cause such registration statement to be declared
effective under the Securities Act by July 10, 1998.
In addition, pursuant to the Registration Rights Agreement, if (i) because
of any change in law or applicable interpretations thereof by the staff of the
Commission, the Company is not permitted to effect the Exchange Offer as
contemplated hereby, (ii) any Old Notes validly tendered pursuant to the
Exchange Offer are not exchanged for New Notes by September 10, 1998, (iii) the
Initial Purchaser so requests with respect to Old Notes not eligible to be
exchanged for New Notes in the Exchange Offer, (iv) any applicable law or
interpretations do not permit any holder of Old Notes to participate in the
Exchange Offer, (v) any holder of Old Notes that participates in the Exchange
Offer does not receive freely transferable New Notes in exchange for tendered
Old Notes, or (vi) the Company so elects, then the Company will file with the
Commission a shelf registration statement (the "Shelf Registration Statement")
to cover resales of Transfer Restricted Securities by such holders who satisfy
certain conditions relating to the provision of information in connection with
the Shelf Registration Statement. For purposes of the foregoing, "Transfer
Restricted Securities" means each Old Note until (i) the date on which such Old
Note has been exchanged for a freely transferable New Note in the Exchange
Offer; (ii) the date on which such Old Note has been effectively registered
under the Securities Act and disposed of in accordance with the Shelf
Registration Statement or (iii) the date on which such Old Note is distributed
to the public pursuant to Rule 144 under the Securities Act or is saleable
pursuant to Rule 144(k) under the Securities Act. The Company will use its
reasonable best efforts to have the Shelf Registration Statement
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declared effective by the Commission as promptly as practicable after the filing
thereof and to keep the Shelf Registration Statement continuously effective
until February 12, 2000. The Company, at its expense, will provide to each
holder of the Old Notes copies of the prospectus that is a part of the Shelf
Registration Statement, notify each such holder when the Shelf Registration
Statement has become effective and take certain other actions as are required to
permit unrestricted resales of the Old Notes from time to time. A holder of Old
Notes who sells such Old Notes pursuant to the Shelf Registration Statement
generally will be required to be named as a selling security holder in the
related prospectus and to deliver a prospectus to purchasers, will be subject to
certain of the civil liability provisions under the Securities Act in connection
with such sales and will be bound by the provisions of the Registration Rights
Agreement which are applicable to such holder (including certain indemnification
obligations).
Pursuant to the Registration Rights Agreement, the Company agreed that, in
the event that the Exchange Offer is not consummated on or prior to September
10, 1998, the Company will be obligated to pay liquidated damages to each holder
of the Old Notes in an amount equal to $0.192 per week per $1,000 principal
amount of the Old Notes held by such holder until the Exchange Offer is
consummated. See "--Purpose and Effect of the Exchange Offer."
CONSEQUENCES OF FAILURE TO EXCHANGE
The Old Notes that are not exchanged for New Notes pursuant to the Exchange
Offer will remain "restricted securities" (within the meaning of the Securities
Act). Accordingly, prior to the date that is two years after the later of the
date of the original issue thereof and the last date on which the Company or any
affiliate of the Company was the owner of such Old Notes (the "Resale
Restriction Termination Date"), such Old Notes may be resold only (i) to the
Company, (ii) to a person whom the seller reasonably believes is a "qualified
institutional buyer" purchasing for its own account or for the account of
another "qualified institutional buyer" in compliance with the resale
limitations of Rule 144A, (iii) to an "accredited investor" (as defined in Rule
501(a)(1), (2), (3) or (7) of Regulation D under the Securities Act) that is an
institution (an "Institutional Accredited Investor") that, prior to such
transfer, furnishes to the Trustee a written certification containing certain
representations and agreements relating to the restrictions on transfer of the
Notes (the form of which letter can be obtained from the Trustee), (iv) pursuant
to the limitations on resale provided by Rule 144 under the Securities Act (if
available), (v) pursuant to the resale provisions of Rule 904 of Regulation S
under the Securities Act, (vi) pursuant to an effective registration statement
under the Securities Act or (vii) pursuant to any other available exemption from
the registration requirements of the Securities Act, subject in each of the
foregoing cases to any requirement of law that the disposition of its property
or the property of such account be at all times within its control and to
compliance with applicable state securities laws. The foregoing restrictions on
resale will not apply subsequent to the Resale Restriction Termination Date.
RESALES OF THE NEW NOTES
With respect to resales of New Notes, based on existing interpretations of
the Staff, the Company believes that the New Notes issued pursuant to the
Exchange Offer in exchange for Old Notes may be offered for resale, resold and
otherwise transferred by holders thereof (other than any such holder which is an
"affiliate" of the Company within the meaning of Rule 405 under the Securities
Act) without compliance with the registration and prospectus delivery
requirements of the Securities Act; provided such New Notes are acquired in the
ordinary course of such holders' business and such holders are not engaged in,
have no arrangement with any person to participate in, and do not intend to
engage in any public distribution of the New Notes. Each Participating
Broker-Dealer receiving New Notes in the Exchange Offer will be subject to a
prospectus delivery requirement with respect to resales of such New Notes. Each
Participating Broker-Dealer must acknowledge that it will deliver a resale
prospectus in connection with any resale of such New Notes. The Letter of
Transmittal which accompanies this Prospectus states that by so acknowledging
and by delivering a resale prospectus, a Participating
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Broker-Dealer will be deemed not to be acting in the capacity of an
"underwriter" (within the meaning of Section 2(11) of the Securities Act). This
Prospectus, as it may be amended or supplemented from time to time, may be used
by a Participating Broker-Dealer in connection with resales of New Notes
received in exchange for Old Notes where such Old Notes were acquired by such
Participating Broker-Dealer as result of market-making or other trading
activities. Pursuant to the Registration Rights Agreement, the Company has
agreed to permit Participating Broker-Dealers and other persons, if any, subject
to similar prospectus delivery requirements to use this Prospectus in connection
with the resale of such New Notes for a period of 180 days from the date on
which the Registration Statement of which this Prospectus is a part is first
declared effective.
Each holder of the Old Notes who wishes to exchange its Old Notes for New
Notes in the Exchange Offer will be required to make certain representations to
the Company in the accompanying Letter of Transmittal, including that (i) any
New Notes to be received by it will be acquired in the ordinary course of its
business, (ii) it has no arrangement with any person to participate in a public
distribution (within the meaning of the Securities Act) of the New Notes, and
(iii) it is not an "affiliate," as defined in Rule 405 of the Securities Act of
the Company, or if it is such an affiliate, that it will comply with the
registration and prospectus delivery requirements of the Securities Act to the
extent applicable to it. In addition, each holder who is not a broker-dealer
will be required to represent that it is not engaged in, and does not intend to
engage in, a public distribution of the New Notes. Each Participating
Broker-Dealer who receives New Notes for its own account in exchange for Old
Notes that were acquired by it as a result of market-making or other trading
activities, will be required to acknowledge that it will deliver a Prospectus in
connection with any resale by it of such Old Notes. For a description of the
procedures for certain resales by broker-dealers, see "Plan of Distribution."
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PLAN OF DISTRIBUTION
Each Participating Broker-Dealer that holds Old Notes that were acquired for
its own account as a result of market-making or other trading activities (other
than Old Notes acquired directly from the Company), may exchange such Old Notes
for New Notes pursuant to the Exchange Offer. However, a Participating
Broker-Dealer may be deemed to be an "underwriter" within the meaning of the
Securities Act and, therefore, will be required to deliver a prospectus
satisfying the requirements of the Act in connection with any resales by it of
such New Notes. This Prospectus, as it may be amended or supplemented from time
to time, may be used by a Participating Broker-Dealer in connection with resales
of New Notes received in exchange for Old Notes in satisfaction of such
prospectus-delivery requirement. The delivery by a Participating Broker-Dealer
of this Prospectus in connection with resales of New Notes shall not be deemed
to be an admission by such Participating Broker-Dealer that it is an
"underwriter" within the meaning of the Act. The Company has agreed that it
shall cause the Registration Statement of which this Prospectus is a part to
remain current and continuously effective for a period of 180 days from the date
on which such Registration Statement was first declared effective and that it
shall supplement or amend from time to time this Prospectus to the extent
necessary to permit this Prospectus (as so supplemented or amended) to be
delivered by Participating Broker-Dealers in connection with their resales of
New Notes.
The Company will not receive any proceeds from any sale of New Notes by
Participating Broker-Dealers or otherwise. New Notes received by Participating
Broker-Dealers for their own account pursuant to the Exchange Offer may be sold
from time to time in one or more transactions in the over-the-counter market, in
negotiated transactions, through the writing of options on the New Notes or a
combination of such methods of resale, at market prices prevailing at the time
of resale, at prices related to such prevailing market prices or at negotiated
prices. Any such resale may be made directly to purchasers or to or through
dealers who may receive compensation in the form of commissions, concessions or
allowances from any such Participating Broker-Dealer and/or the purchasers of
any such New Notes. Any Broker-Dealer that resells New Notes that were received
by it for its own account pursuant to the Exchange Offer and any broker or
dealer that participates in a distribution of such New Notes may be deemed to be
an "underwriter" within the meaning of the Securities Act and any profit on any
such resale of New Notes and any commissions, concessions or allowances received
by any such persons may be deemed to be underwriting compensation under the
Securities Act. The accompanying Letter of Transmittal states that by
acknowledging that it will deliver and by delivering a prospectus, a
broker-dealer will not be deemed to admit that it is an "underwriter" within the
meaning of the Securities Act.
For a period 180 days from the date on which the Registration Statement of
which this Prospectus is a part is first declared effective, the Company will
deliver to each holder of New Notes, without charge, as many copies of this
Prospectus and any amendment or supplement to this Prospectus as such person may
reasonably request. The Company has agreed to pay all expenses incident to the
Exchange Offer other than commissions, concessions or allowances of any brokers
or dealers and certain transfer taxes and will indemnify the holders of the New
Notes (including any Participating Broker-Dealers) against certain liabilities,
including liabilities under the Securities Act, or to the extent such
indemnification is unavailable or insufficient, to contribute to any payments
that such Participating Broker-Dealers may be required to make in respect
thereof.
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DESCRIPTION OF THE NEW NOTES
GENERAL
The New Notes will be issued under the Indenture, dated February 12, 1998,
between the Company and Marine Midland Bank, as trustee (the "Trustee"),
pursuant to which the Old Notes were issued. For purposes of the following
summary, the Old Notes and the New Notes shall be collectively referred to as
the "Notes." The terms of the Notes include those stated in the Indenture and
those made part of the Indenture by reference to the Trust Indenture Act of
1939, as amended (the "Trust Indenture Act"). The Notes are subject to all such
terms, and holders of the Notes are referred to the Indenture and the Trust
Indenture Act for a statement thereof. The following summary of certain
provisions of the Indenture does not purport to be complete and is qualified in
its entirety by reference to the Indenture, including the definitions therein of
certain terms used below and those terms made a part thereof by the Trust
Indenture Act. The definitions of certain terms used in the following summary
are set forth below under "--Certain Definitions." Copies of the Indenture will
be made available to holders of Notes upon request.
The Notes will be general unsecured senior subordinated obligations of the
Company. The Notes are limited in aggregate principal amount to $625 million and
will mature on February 15, 2008. Interest on the Notes will accrue at the rate
of 9% per annum and will be payable semi-annually on each February 15 and August
15, commencing on August 15, 1998, to the holders of record on the immediately
preceding February 1 and August 1, whether or not a business day. Interest on
the Notes will accrue from the most recent date to which interest has been paid
or, if no interest has been paid, from the date of issuance. Interest will be
computed on the basis of a 360-day year, comprised of twelve 30-day months.
Interest and principal on the Notes will be payable at the office or agency of
the Company maintained for such purpose within the City of New York, Borough of
Manhattan or, at the option of the Company, payment of interest may be made by
check mailed to the holders of the Notes at their respective addresses set forth
in the register of holders of Notes. Unless otherwise designated by the Company,
the Company's office or agency maintained for such purpose in the City of New
York, Borough of Manhattan will be the office of the Trustee located at 140
Broadway, New York, New York 10005. The Notes will be issued only in fully
registered form, without coupons in denominations of $1,000 and integral
multiples thereof.
OPTIONAL REDEMPTION
The Notes are not redeemable at the option of the Company prior to February
15, 2003. The Notes will be redeemable at the option of the Company on or after
such date, in whole or in part, upon not less than 30 nor more than 60 days
prior notice mailed by first-class mail to each holder's registered address, at
the redemption prices (expressed as a percentage of the principal amount) set
forth below, plus accrued and unpaid interest thereon to the applicable
redemption date (subject to the right of holders of record on the relevant
record date to receive interest due on the relevant interest payment date), if
redeemed during the twelve-month period beginning on February 15 of the years
indicated below:
<TABLE>
<CAPTION>
REDEMPTION
YEAR PRICES
- -------------------------------------------------------------------------------- ------------
<S> <C>
2003............................................................................ 104.500%
2004............................................................................ 103.000%
2005............................................................................ 101.500%
2006 and thereafter............................................................. 100.000%
</TABLE>
In addition, at any time and from time to time prior to February 15, 2001,
the Company may, at its option, redeem up to 35% of the original aggregate
principal amount of Notes at a redemption price (expressed as a percentage of
the principal amount) of 109%, plus accrued and unpaid interest thereon, if any,
to the redemption date (subject to the right of holders of record on the
relevant record date to receive interest due on the relevant interest payment
date), with the net cash proceeds of one or more
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Equity Offerings; PROVIDED that at least 65% of such original aggregate
principal amount of Notes remains outstanding immediately after the occurrence
of such redemption; and PROVIDED, FURTHER, that such redemption shall occur
within 60 days of the date of the closing of any such Equity Offering.
SINKING FUND
The Notes are not subject to the benefit of any sinking fund.
SELECTION AND NOTICE
If less than all of the Notes are to be redeemed at any time, selection of
the Notes for redemption will be made by the Trustee in compliance with the
requirements of the principal national securities exchange, if any, on which the
Notes are listed or, if the Notes are not listed on a national securities
exchange, on a pro rata basis, provided that Notes shall be redeemed in
principal amounts of $1,000 or integral multiples thereof. Notice of redemption
shall be mailed by first-class mail at least 30 but not more than 60 days before
the redemption date to each holder of Notes to be redeemed at its registered
address. If any Note is to be redeemed in part only, the notice of redemption
that relates to such Note shall state the portion of the principal amount
thereof to be redeemed. A new Note in principal amount equal to the unredeemed
portion thereof will be issued in the name of the holder thereof upon
cancellation of the original Note. On and after the redemption date, interest
ceases to accrue on Notes or portions of them called for redemption.
CHANGE OF CONTROL
Upon the occurrence of a Change of Control, each holder of Notes shall have
the right to require the repurchase of such holder's Notes in whole or in part
pursuant to the offer described below (the "Change of Control Offer") at a
purchase price equal to 101% of the aggregate principal amount thereof plus
accrued and unpaid interest, if any, to the date of purchase (subject to the
right of holders of record on the relevant record date to receive interest due
on the relevant interest payment date). Within 10 days following any Change of
Control, the Company shall mail a notice (along with any other instructions
determined by the Company, consistent with this covenant, that a holder must
follow in order to have its Notes purchased) to the Trustee and to each holder
stating: (i) that the Change of Control Offer is being made pursuant to the
"Change of Control" provision of the Indenture and that all Notes tendered and
not subsequently withdrawn will be accepted for payment and paid for by the
Company; (ii) the purchase price and the purchase date (which shall not be less
than 30 days nor more than 60 days after the date such notice is mailed) (the
"Change of Control Payment Date"); (iii) that any Note not tendered will
continue to accrue interest and shall continue to be governed by the terms of
the Indenture in all respects; (iv) that, unless the Company defaults in the
payment thereof, all Notes accepted for payment pursuant to the Change of
Control Offer shall cease to accrue interest on and after the Change of Control
Payment Date; (v) that holders electing to have any Notes purchased pursuant to
a Change of Control Offer will be required to surrender the Notes to be
purchased to the Paying Agent at the address specified in the notice prior to
the close of business on the business day next preceding the Change of Control
Payment Date; (vi) that holders will be entitled to withdraw their election on
the terms and conditions set forth in such notice; and (vii) that holders whose
Notes are being purchased only in part will be issued new Notes equal in
principal amount to the unpurchased portion of the Notes surrendered; provided
that each Note purchased and each such new Note issued shall be in a principal
amount of $1,000 or integral multiples thereof.
On (or, in the case of clause (ii) of this paragraph, at the Company's
election, before) the Change of Control Payment Date, the Company shall (i)
accept for payment all Notes or portions thereof tendered and not theretofore
withdrawn, pursuant to the Change of Control Offer, (ii) deposit with the Paying
Agent immediately available funds sufficient to pay the purchase price of all
Notes or portions thereof accepted for payment, and (iii) deliver or cause to be
delivered to the Trustee all Notes so tendered, together with
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an officer's certificate specifying the Notes or portions thereof tendered to
the Company. The Paying Agent shall promptly mail to each holder of Notes so
tendered payment in an amount equal to the purchase price for such Notes, and
the Trustee shall promptly authenticate and mail to such holder one or more
certificates evidencing new Notes equal in principal amount to any unpurchased
portion of the Notes surrendered; provided that each such new Note shall be in a
principal amount of $1,000 or integral multiples thereof. The Company will
publicly announce the results of the Change of Control Offer on or as soon as
practicable after the Change of Control Payment Date.
If at the time of such Change of Control the terms of the Bank Indebtedness
restrict or prohibit the repurchase of Notes pursuant to this covenant, then
prior to the mailing of the notice to holders provided for in the second
preceding paragraph, the Company shall (i) repay in full all Bank Indebtedness
or offer to repay in full all Bank Indebtedness and repay the Bank Indebtedness
of each lender who has accepted such offer or (ii) (x) obtain any requisite
consent under the agreements governing the Bank Indebtedness to permit the
repurchase of Notes as provided for in this covenant or (y) deliver to the
Trustee an officer's certificate signed by a responsible financial officer of
the Company that no such consent is required.
The Company will comply with the requirements of Regulation 14E and Rule
13e-4 (other than the filing requirements of such rule) under the Exchange Act,
and any other securities laws and regulations thereunder that are applicable in
connection with the repurchase of the Notes resulting from a Change of Control.
The Change of Control purchase feature is a result of negotiations between
the Company and the Initial Purchaser. Management has no present intention to
engage in a transaction involving a Change of Control, although it is possible
that the Company would decide to do so in the future. Subject to the limitations
discussed below, the Company could, in the future, enter into certain
transactions, including acquisitions, refinancings or other recapitalizations,
that would not constitute a Change of Control under the Indenture, but that
could increase the amount of indebtedness outstanding at such time or otherwise
affect the Company's capital structure or credit ratings.
One of the events that constitutes a Change of Control under the Indenture
is the disposition of "all or substantially all" of the Company's assets under
certain circumstances. This phrase has no clearly established meaning under New
York law (which governs the Indenture), has been the subject of limited judicial
interpretations, and will be interpreted based upon the particular facts and
circumstances of each case in which it arises. As a result, in the event holders
of the Notes elect to require the Company to purchase the Notes and the Company
elects to contest such election, there can be no assurance as to how a court
interpreting New York law would interpret the phrase and, therefore, whether
such court would deem a Change of Control to have occurred.
The occurrence of certain of the events which would constitute a Change of
Control would constitute a default under the New Credit Agreement. Future Senior
Indebtedness of the Company may contain prohibitions of certain events which
would constitute a Change of Control or require such Senior Indebtedness to be
repurchased upon a Change of Control. Moreover, the exercise by the holders of
their right to require the Company to repurchase the Notes could cause a default
under such Senior Indebtedness, even if the Change of Control itself does not,
due to the financial effect of such repurchase on the Company. Finally, the
Company's ability to pay cash to the holders upon a repurchase may be limited by
the Company's then existing financial resources. There can be no assurance that
sufficient funds will be available when necessary to make any required
repurchases.
SUBORDINATION
The indebtedness evidenced by the Notes will be unsecured Senior
Subordinated Indebtedness of the Company, will be subordinated in right of
payment, as set forth in the Indenture, to all existing and future Senior
Indebtedness of the Company, will rank PARI PASSU in right of payment with all
existing and
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future Senior Subordinated Indebtedness of the Company and will be senior in
right of payment to all existing and future Subordinated Obligations of the
Company. The Notes will also be effectively subordinated to any Secured
Indebtedness of the Company and its subsidiaries to the extent of the value of
the assets securing such Indebtedness. However, payment from the money or the
proceeds of U.S. Government Obligations (as defined in the Indenture) held in
any defeasance trust described under "Defeasance and Discharge of the Indenture
and the Notes" below is not subordinated to any Senior Indebtedness or subject
to the restrictions described herein.
Currently, substantially all of the operations of the Company are conducted
through its subsidiaries. Claims of creditors of such subsidiaries, including
trade creditors, and claims of preferred stockholders (if any) of such
subsidiaries generally will have priority with respect to the assets and
earnings of such subsidiaries over the claims of creditors of the Company,
including holders of the Notes. The Notes, therefore, will be effectively
subordinated to creditors (including trade creditors) and preferred stockholders
(if any) of subsidiaries of the Company. At June 30, 1998, the total liabilities
(including indebtedness but excluding subsidiary guarantees of amounts
outstanding under the New Credit Agreement) of the Company's subsidiaries were
approximately $393.2 million, plus trade payables. Although the Indenture limits
the incurrence of indebtedness and preferred stock of certain of the Company's
subsidiaries, such limitation is subject to a number of significant
qualifications.
As of June 30, 1998, (i) the aggregate amount of the Company's outstanding
Senior Indebtedness was $580.7 million (exclusive of unused commitments),
substantially all of which would have been Secured Indebtedness and would have
been guaranteed by substantially all of the Company's subsidiaries, (ii) the
Company would have had no Senior Subordinated Indebtedness other than the Notes
and no Indebtedness that is subordinate or junior in right of payment to the
Notes and (iii) the outstanding indebtedness of the Company's subsidiaries
(excluding guarantees of the Company's indebtedness) would have been $342.8
million, substantially all of which would have been Secured Indebtedness.
Only Indebtedness of the Company that is Senior Indebtedness will rank
senior to the Notes. The Notes will in all respects rank PARI PASSU with all
other Senior Subordinated Indebtedness of the Company. The Company has agreed in
the Indenture that it will not incur, directly or indirectly, any Indebtedness
which is subordinate or junior in ranking in any respect to Senior Indebtedness
unless such Indebtedness is Senior Subordinated Indebtedness or is expressly
subordinated in right of payment to Senior Subordinated Indebtedness. Unsecured
Indebtedness is not deemed to be subordinate or junior to Secured Indebtedness
merely because it is unsecured.
Upon any distribution to creditors upon any liquidation, dissolution,
winding up, bankruptcy, reorganization, assignment for the benefit of creditors,
marshaling of assets and liabilities, insolvency, receivership or similar
proceedings relating to the Company, the holders of Senior Indebtedness will be
entitled to receive payment in full of all obligations with respect to Senior
Indebtedness before the holders of Notes receive any direct or indirect payment
(excluding certain permitted equity or subordinated securities) on account of
principal of, premium, if any, or interest on the Notes.
The Company may not pay principal of, premium (if any) or interest on, the
Notes or make any deposit pursuant to the provisions described under "Defeasance
and Discharge of the Indenture and the Notes" below and may not otherwise
purchase, redeem or otherwise retire any Notes (collectively, "pay the Notes")
if (i) any Specified Senior Indebtedness is not paid when due or (ii) any other
default on Specified Senior Indebtedness occurs which results in the maturity of
such Specified Senior Indebtedness being accelerated in accordance with its
terms unless, in either case, the default has been cured or waived or any such
acceleration has been rescinded or such Specified Senior Indebtedness has been
paid in full. However, the Company may pay the Notes without regard to the
foregoing if the Company and the Trustee receive written notice approving such
payment from the Representative of the Specified Senior Indebtedness with
respect to which either of the events set forth in clause (i) or (ii) of the
immediately preceding sentence has occurred and is continuing. During the
continuance of any default
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(other than a default described in clause (i) or (ii) of the second preceding
sentence) with respect to any Specified Senior Indebtedness pursuant to which
the maturity thereof may be accelerated immediately without further notice
(except such notice as may be required to effect such acceleration) or the
expiration of any applicable grace periods, the Company may not pay the Notes
for a period (a "Payment Blockage Period") commencing upon the receipt by the
Trustee (with a copy to the Company) of written notice (a "Blockage Notice") of
such default from the Representative of the Specified Senior Indebtedness
specifying an election to effect a Payment Blockage Period and ending 179 days
thereafter (or earlier if such Payment Blockage Period is terminated (i) by
written notice to the Trustee and the Company from the Person or Persons who
gave such Blockage Notice, (ii) by repayment in full of such Specified Senior
Indebtedness or (iii) because the default giving rise to such Blockage Notice is
no longer continuing). Notwithstanding the provisions described in the
immediately preceding sentence (but subject to the provisions contained in the
first sentence of this paragraph), unless the holders of such Specified Senior
Indebtedness or the Representative of such holders have accelerated the maturity
of such Specified Senior Indebtedness, the Company may resume payments on the
Notes after the end of such Payment Blockage Period. Not more than one Blockage
Notice may be given in any consecutive 360-day period, irrespective of the
number of defaults that may exist or occur with respect to Specified Senior
Indebtedness during such period. However, subject to the following sentence, if
any Blockage Notice within such 360-day period is given by or on behalf of any
holders of Specified Senior Indebtedness other than the Bank Indebtedness, the
Representative of the Bank Indebtedness may give another Blockage Notice within
such period. In no event, however, may the total number of days during which any
Payment Blockage Period or Periods is in effect exceed 179 days in the aggregate
during any 360 consecutive day period. For purposes of this Section, no default
or event of default that existed or was continuing on the date of the
commencement of any Payment Blockage Period with respect to the Specified Senior
Indebtedness initiating such Payment Blockage Period shall be, or be made, the
basis of the commencement of a subsequent Payment Blockage Period by the
Representative of such Specified Senior Indebtedness, whether or not within a
period of 360 consecutive days, unless such default or event of default shall
have been cured or waived for a period of not less than 90 consecutive days.
CERTAIN COVENANTS
LIMITATION ON RESTRICTED PAYMENTS. The Company will not, and will not
permit any of its Restricted Subsidiaries to, directly or indirectly, (i)
declare or pay any dividend or make any distribution on or in respect of the
Company's or any of its Restricted Subsidiaries' Capital Stock or other Equity
Interests, including any such payment in connection with any merger or
consolidation (other than dividends or distributions payable to the Company or
any of its Restricted Subsidiaries or payable in shares of Capital Stock or
other Equity Interests of the Company other than Redeemable Stock), (ii)
purchase, repurchase, redeem or otherwise acquire or retire for value any Equity
Interests of the Company or any of its Subsidiaries from any Person (other than
from the Company or any of its Restricted Subsidiaries); (iii) purchase,
repurchase, redeem, prepay, defease, or otherwise acquire or retire for value
(A) any Subordinated Obligations prior to scheduled maturity, repayment or
sinking fund payment or (B) any Indebtedness of any Unrestricted Subsidiary or
(iv) make any Investment other than a Permitted Investment (the foregoing
actions set forth in clauses (i) through (iv) being referred to as "Restricted
Payments"), if at the time the Company or such Restricted Subsidiary makes such
Restricted Payment:
(a) a Default or Event of Default shall have occurred and be continuing
or shall occur as a consequence thereof; or
(b) such Restricted Payment (the amount so expended, if other than in
cash and if greater than $20 million, to be determined in good faith by the
Board of Directors, whose determination will be conclusive and evidenced by
a resolution of the Board of Directors), together with the aggregate of all
other Restricted Payments made on or after the Closing Date, exceeds the sum
of (A) $15 million,
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(B) 50% of the Consolidated Net Income of the Company accrued on a
cumulative basis for the period beginning on the first day of the first
month following the Closing Date and ending on the last day of the last
month immediately preceding the month in which such Restricted Payment
occurs (or, if aggregate cumulative Consolidated Net Income for such period
is a deficit, minus 100% of such deficit), (C) 100% of the aggregate net
cash proceeds received by the Company after the Closing Date from the
issuance or sale of Capital Stock or other Equity Interests of the Company
(other than such Capital Stock or other Equity Interests issued or sold to a
Subsidiary of the Company or an employee stock ownership plan or similar
trust established by the Company or any of its Subsidiaries and other than
Redeemable Stock), (D) the aggregate net cash proceeds received on or after
the Closing Date by the Company from the issuance or sale of debt securities
of the Company that have subsequently been converted into or exchanged for
Capital Stock or other Equity Interests of the Company (other than
Redeemable Stock) plus the aggregate net cash proceeds received by the
Company at the time of such conversion or exchange less the amount of any
cash or other property distributed by the Company or any Restricted
Subsidiary upon such conversion or exchange, (E) 100% of the aggregate net
cash proceeds received by the Company after the Closing Date upon the
exercise of options, warrants or similar instruments or rights (whether
issued prior to or after the Closing Date) to purchase the Company's Capital
Stock (other than Redeemable Stock) and (F) 100% of the aggregate net cash
proceeds received by the Company or any Restricted Subsidiary after the
Closing Date from (i) the sale or other disposition of Investments (other
than Permitted Investments) made by the Company and its Restricted
Subsidiaries in an Unrestricted Subsidiary or (ii) a dividend from, or the
sale of the stock of, an Unrestricted Subsidiary; or
(c) the Company would not be permitted to incur $1.00 of additional
Indebtedness pursuant to the first paragraph of "--Limitation on Additional
Indebtedness" below.
The foregoing provisions will not prohibit (i) so long as no Default or
Event of Default has occurred and is continuing or would result therefrom, the
payment of any dividend within 60 days after the date of declaration thereof, if
at said date of declaration such payment would have complied with the provisions
of the Indenture; (ii) to the extent required under applicable law, rule, order
or regulation or if the failure to do so would create a material risk of
disqualification of the ESOP under the Internal Revenue Code, the acquisition by
the Company of its common stock from the ESOP or from participants and
beneficiaries of the ESOP; (iii) the acquisition or retirement of Capital Stock
of the Company held by any future, present or former employee, director or
consultant of the Company or any Subsidiary of the Company pursuant to any
management or employee equity, stock option or other benefit plan or any other
agreement in an amount not to exceed $5 million in any fiscal year; (iv) the
acquisition by the Company or any of its Restricted Subsidiaries of Equity
Interests of the Company or such Restricted Subsidiary, if the exclusive
consideration for such acquisition is the issuance by the Company or such
Restricted Subsidiary of its Equity Interests (other than Redeemable Stock); (v)
the purchase, redemption or acquisition by the Company of rights under the
Rights Plan prior to such time as such rights have become exercisable not to
exceed $2 million in the aggregate; (vi) the redemption, repurchase, acquisition
or retirement of Indebtedness of the Company or its Restricted Subsidiaries
being concurrently refinanced by Refinancing Indebtedness permitted under
"--Limitation on Additional Indebtedness" below; (vii) the purchase, repayment,
redemption, prepayment, defeasance, acquisition or retirement of any
Indebtedness, if the exclusive consideration therefor is the issuance by the
Company of its Equity Interests (other than Redeemable Stock); (viii) the
redemption, repurchase, acquisition or retirement of Equity Interests in a
Permitted Joint Venture of the Company or of a Restricted Subsidiary, provided
that (A) if the Company or any of its Restricted Subsidiaries incurs
Indebtedness in connection with such redemption, repurchase, acquisition or
retirement, after giving effect to such incurrence and such redemption,
repurchase, acquisition or retirement, the Company could incur $1.00 of
additional Indebtedness pursuant to the first paragraph of "--Limitation on
Additional Indebtedness" below and (B) no Default or Event of Default has
occurred and is continuing or would result therefrom; (ix) dividend payments to
the holders of interests
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in Permitted Joint Ventures of the Company or of a Restricted Subsidiary,
ratably in accordance with their respective Equity Interests or, if not ratably,
then in accordance with the priorities set forth in the respective
organizational documents for, and agreements among holders of Equity Interests
in, such Permitted Joint Ventures; (x) the acquisition or retirement of options,
warrants and similar instruments and rights upon the exercise thereof; (xi) any
purchase, redemption or other acquisition of Equity Interests of a Healthcare
Service Business which is required by applicable law, regulation, rule, order,
approval, license, permit or similar restriction (in each case issued by a
governmental authority) to be purchased, redeemed or otherwise acquired by the
Company or one of its Restricted Subsidiaries; (xii) the acquisition or
retirement for value of any Equity Interests of the Company, or the making of
any Investments in Charter Behavioral Health Systems, LLC or any Subsidiaries of
Charter Behavioral Health Systems, LLC consisting of loans, advances, or other
extensions of credit, in any case as acquired, retired or made as part of the
consideration for the sale by the Company of Equity Interests in Charter
Behavioral Health Systems, LLC and certain Subsidiaries and joint ventures of
the Company and related transactions, where the aggregate value of such Equity
Interests of the Company and the aggregate amount of such Investments do not
collectively exceed a total of $40 million; or (xiii) other Restricted Payments
(excluding Investments that were Restricted Payments when made but are no longer
outstanding at the time of determination of Restricted Payments permitted by
this clause (xiii), but not excluding Investments made in accordance with this
clause (xiii) that are subsequently sold or otherwise disposed of, to the extent
such sale or other disposition increases the amount of Restricted Payments
permitted to be made in accordance with clause (F) of paragraph (b) above) made
after the Closing Date in an aggregate amount not to exceed $25 million.
The Company shall deliver to the Trustee within 60 days after the end of
each of the Company's first three fiscal quarters (and 120 days after the end of
the Company's fiscal year) in which a Restricted Payment is made under the first
paragraph of this covenant, an officer's certificate setting forth each
Restricted Payment made in such fiscal quarter, stating that each such
Restricted Payment is permitted and setting forth the basis upon which the
calculations required by the "Limitation on Restricted Payments" covenant were
computed, which calculations may be based on the Company's financial statements
included in filings required under the Exchange Act for such quarter or such
year. For purposes of calculating the aggregate amount of Restricted Payments
that are permitted under clause (b) of the first paragraph of "--Limitation on
Restricted Payments," the amounts expended for Restricted Payments permitted
under clauses (ii) through (xiii) above shall be excluded.
LIMITATION ON PAYMENT RESTRICTIONS AFFECTING RESTRICTED SUBSIDIARIES. The
Indenture provides that the Company shall not, and shall not permit any of its
Restricted Subsidiaries to, from and after the Closing Date, directly or
indirectly, create or otherwise cause or permit to exist or become effective or
enter into any consensual encumbrance or consensual restriction on the ability
of any Restricted Subsidiary to (A) pay dividends or make any other
distributions on its Equity Interests, the Equity Interests of any of its
Restricted Subsidiaries or on any other interest or participation in, or
measured by, its profits, which interest or participation is owned by the
Company or any of its Restricted Subsidiaries; (B) pay any Indebtedness owed to
the Company or any of its Restricted Subsidiaries; (C) make loans or advances to
the Company or any of its Restricted Subsidiaries; or (D) sell, lease or
transfer any of its properties or assets to the Company or any of its Restricted
Subsidiaries except, in each case, for such encumbrances or restrictions
existing under or by reason of (1) applicable law, regulation, rule, order,
approval, license, permit or similar restriction, in each case issued by a
governmental authority; (2) the Indenture and the Notes; (3) contractual
encumbrances or restrictions in effect on the Closing Date, including, without
limitation, pursuant to the New Credit Agreement and its related documentation;
(4) in the case of clause (D), by reason of customary non-assignment or
subletting provisions in leases entered into in the ordinary course of business;
(5) Prior Purchase Money Obligations; (6) Indebtedness or Capital Stock of
Restricted Subsidiaries that are acquired by or merged with or into the Company
or any of its Restricted Subsidiaries after the Closing Date; PROVIDED that such
Indebtedness or Capital Stock is in existence prior to the time of such
acquisition or merger and was not incurred, assumed or
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issued by the Person so acquired or merged in contemplation of such acquisition
or merger or to provide all or any portion of the funds or credit support
utilized to consummate such acquisition or merger; provided further that such
restrictions only apply to such Restricted Subsidiary and its Subsidiaries; (7)
contracts for the sale of assets not otherwise prohibited by the Indenture,
including without limitation customary restrictions with respect to a Subsidiary
pursuant to an agreement that has been entered into for the sale or disposition
of all or substantially all of the Capital Stock or assets of such Subsidiary;
(8) in the case of clause (D), secured Indebtedness otherwise permitted to be
incurred pursuant to the covenants described under "--Limitation on Additional
Indebtedness" and "--Limitation on Liens" that limit the right of the debtor to
sell, lease, transfer or otherwise dispose of the assets securing such
Indebtedness; (9) customary provisions contained in leases or other agreements
entered into in the ordinary course of business or in Indebtedness permitted to
be incurred subsequent to the Closing Date pursuant to the provisions of the
covenant described under "--Limitation on Additional Indebtedness", in each case
which do not limit the ability of any Restricted Subsidiary to take any of the
actions described in clauses (A) through (D) above with respect to a material
amount of dividends, distributions, Indebtedness, loans, advances or sales,
leases or transfers of properties or assets, as applicable; (10) provisions in
joint venture agreements and other similar agreements in each case related to
Permitted Joint Ventures of the Company or of a Restricted Subsidiary that are
materially similar to customary provisions entered into by parties to joint
ventures in the Healthcare Service Business at the time of such joint venture or
similar agreement; (11) restrictions on cash or other deposits or net worth or
similar type restrictions imposed by customers under contracts entered into in
the ordinary course of business; and (12) any encumbrances or restrictions
imposed by any amendments, modifications, restatements, renewals, increases,
supplements, refundings, replacements or refinancings of the contracts,
instruments or obligations referred to in clauses (1) through (11) above, in
whole or in part, PROVIDED that such amendments, modifications, restatements,
renewals, increases, supplements, refundings, replacements or refinancings are
not materially more restrictive with respect to such dividend and other payment
restrictions than those contained in the dividend or other payment restrictions
prior to such amendment, modification, restatement, renewal, increase,
supplement, refunding, replacement or refinancing.
LIMITATION ON ADDITIONAL INDEBTEDNESS. The Indenture provides that the
Company shall not, and shall not permit any of its Restricted Subsidiaries,
directly or indirectly, to create, incur, issue, assume, guarantee or otherwise
become directly or indirectly liable with respect to (collectively, "incur") any
Indebtedness; PROVIDED, HOWEVER, the Company may incur Indebtedness if, after
giving pro forma effect to the incurrence of such Indebtedness and the
application of any of the proceeds therefrom to repay Indebtedness, the
Consolidated Cash Interest Coverage Ratio of the Company for the four most
recent consecutive fiscal quarters for which financial statements are available
prior to the date such additional Indebtedness is incurred will be at least (i)
2.00 to 1.00x if such Indebtedness is incurred on or prior to the second
anniversary of the Closing Date and (ii) 2.25 to 1.00x if such Indebtedness is
incurred thereafter. Any Indebtedness or Capital Stock of a Person existing at
the time such person becomes a Subsidiary of the Company (whether by merger,
consolidation, acquisition or otherwise) shall be deemed to be incurred by such
person at the time it becomes a Subsidiary of the Company.
Notwithstanding the foregoing paragraph, the Company and its Restricted
Subsidiaries may incur the following Indebtedness: (i) Indebtedness under the
New Credit Agreement and any replacements, refundings, refinancings and
substitute facility or facilities thereof, in whole or in part, and additional
facility or facilities (provided that Indebtedness under the New Credit
Agreement and any such replacements, refundings, refinancings and substitute and
additional facility or facilities, including unused commitments, shall not at
any time exceed $700 million in aggregate outstanding principal amount
(including the available undrawn amount of any letters of credit issued under
the New Credit Agreement and any such replacements, refundings, refinancings,
and substitute and additional facility or facilities); (ii) Indebtedness of the
Company and its Restricted Subsidiaries, which Indebtedness is in existence on
the Closing Date (including any existing or future Guarantees of the Company's
11.25% Series A Senior
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Subordinated Notes due 2004, but excluding Indebtedness permitted by clause (i)
above); (iii) Indebtedness represented by the Notes; (iv) Indebtedness of the
Company and its Restricted Subsidiaries incurred in exchange for, or the
proceeds of which are used to extend, refinance, renew, replace, substitute or
refund, in whole or in part, Indebtedness (subject to the following proviso,
"Refinancing Indebtedness") permitted by clauses (ii) and (iii) of this
covenant; PROVIDED, HOWEVER, that (A) the principal amount of such Refinancing
Indebtedness shall not exceed the principal amount of Indebtedness (including
unused commitments) so extended, refinanced, renewed, replaced, substituted or
refunded (plus costs of issuance), (B) such Refinancing Indebtedness ranks,
relative to the Notes, no more senior than the Indebtedness being refinanced
thereby (excluding the effect of the granting of security for any Senior
Indebtedness), (C) such Refinancing Indebtedness bears interest at a market
rate, (D) such Refinancing Indebtedness (1) shall have an Average Life equal to
or greater than the Average Life of the Indebtedness being extended, refinanced,
renewed, replaced, substituted or refunded and (2) shall not have a Stated
Maturity prior to the Stated Maturity of the Indebtedness being extended,
refinanced, renewed, replaced, substituted or refunded, (E) such Refinancing
Indebtedness shall not include (x) Indebtedness of a Restricted Subsidiary
(other than Guarantees by a Restricted Subsidiary of (i) Senior Indebtedness or
(ii) Refinancing Indebtedness the proceeds of which are used to extend,
refinance, renew, replace, substitute or refund Indebtedness that was Guaranteed
by such Restricted Subsidiary) that refinances Indebtedness of the Company or
(y) Indebtedness of the Company or a Restricted Subsidiary that refinances
Indebtedness of an Unrestricted Subsidiary; (v) Indebtedness of the Company or
any Restricted Subsidiary to any Restricted Subsidiary or to the Company;
PROVIDED, HOWEVER, that any subsequent issuance or transfer of any Capital Stock
or any other event that results in any such Restricted Subsidiary ceasing to be
a Restricted Subsidiary or any subsequent transfer of any such Indebtedness
(except to the Company or a Restricted Subsidiary) will be deemed, in each case,
to constitute the incurrence of such Indebtedness by the issuer thereof; (vi)
Indebtedness arising from Guarantees, letters of credit, and bid, performance or
surety bonds or similar bonds or instruments securing any obligations of the
Company or any Restricted Subsidiary incurred in the ordinary course of
business, which Guarantees, letters of credit, bonds or similar instruments do
not secure other Indebtedness; (vii) Indebtedness (including Capitalized Lease
Obligations) incurred by the Company or any of its Restricted Subsidiaries to
finance the purchase, lease or improvement of property (real or personal)
(whether through the direct purchase, lease or improvement of assets or purchase
of the Equity Interests of any Person owning such assets) in an aggregate
principal amount outstanding not to exceed 5% of Total Assets of the Company at
the time of any incurrence thereof (including any Refinancing Indebtedness with
respect thereto); (viii) Non-Recourse Indebtedness incurred in connection with
the acquisition of real and/or personal property by the Company or its
Restricted Subsidiaries; provided that such Indebtedness was in existence prior
to the time of such acquisition and was not incurred by the Person from whom
such property was acquired in contemplation of such acquisition or in order to
provide all or any portion of the funds or credit support utilized to consummate
such acquisition; (ix) Guarantees of any Senior Indebtedness; (x) Indebtedness
under Hedging Obligations entered into for bona fide hedging purposes of the
Company and not for speculative purposes; PROVIDED, HOWEVER, that such Hedging
Obligations do not increase the Indebtedness of the Company outstanding at any
time other than as a result of fluctuations in foreign currency exchange rates
or interest rates, as applicable, or by reason of fees, indemnities and
compensation payable thereunder; and (xi) Indebtedness other than that permitted
pursuant to the foregoing clauses (i) through (x) provided that the aggregate
outstanding amount of such additional Indebtedness does not at any time exceed
$50 million, all or any portion of which Indebtedness, notwithstanding clause
(i) above, may be incurred pursuant to the New Credit Agreement and any
replacements, refinancings, refundings, and substitute facility or facilities
thereof, in whole or in part, and additional facility or facilities.
LIMITATION ON LIENS. The Indenture provides that the Company shall not, and
shall not permit any of its Restricted Subsidiaries to, directly or indirectly,
create, incur, assume or suffer to exist any Lien on any of their respective
assets, now owned or hereinafter acquired, securing any Indebtedness that is
PARI
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PASSU with or subordinated in right of payment to the Notes, unless the Notes
are equally and ratably secured; provided that, if such Indebtedness is by its
terms expressly subordinate or junior in right of payment to the Notes, the Lien
securing such subordinate or junior Indebtedness shall be subordinate and junior
to the Lien securing the Notes with the same relative priority as such
subordinated or junior Indebtedness shall have with respect to the Notes. The
Company and its Restricted Subsidiaries may at any time, directly or indirectly,
create, incur, assume or suffer to exist any Lien on any of their respective
assets, now owned or hereafter acquired, securing any Senior Indebtedness
permitted under the covenant described under "--Limitation on Additional
Indebtedness" above.
LIMITATION ON USE OF PROCEEDS FROM ASSET SALES. The Indenture provides that
the Company and its Restricted Subsidiaries shall not, directly or indirectly,
consummate any Asset Sale with or to any Person other than the Company or a
Restricted Subsidiary, unless (i) the Company or such Restricted Subsidiary, as
the case may be, receives consideration at the time of any such Asset Sale at
least equal to the fair market value of the asset sold or otherwise disposed of,
(ii) at least 70% of the net proceeds from such Asset Sale are received in Cash
at closing (unless (A) such Asset Sale is a lease, or (B) such Asset Sale is in
connection with the creation of, Investment in, or issuance or sale of Equity
Interests by, a Permitted Joint Venture of the Company or of a Restricted
Subsidiary or other Permitted Investment) and (iii) with respect to any Asset
Sale involving the Equity Interest of any Restricted Subsidiary (unless such
Restricted Subsidiary is, or as a result of such Asset Sale would be, a
Permitted Joint Venture of the Company or of a Restricted Subsidiary or other
Permitted Investment), the Company shall sell all of the Equity Interests of
such Restricted Subsidiary it owns. Within 365 days after the receipt of Net
Cash Proceeds in respect of any Asset Sale, the Company must use all such Net
Cash Proceeds either to invest in properties and assets used in a Healthcare
Service Business (including, without limitation, a capital investment in any
Person which becomes a Restricted Subsidiary) or to reduce Senior Indebtedness;
PROVIDED, that when any non-Cash proceeds are liquidated, such proceeds (to the
extent they are Net Cash Proceeds) will be deemed to be Net Cash Proceeds at
that time. When the aggregate amount of Excess Proceeds (as defined below)
exceeds $20 million, the Company shall make an offer (the "Excess Proceeds
Offer") to apply the Excess Proceeds to repurchase the Notes at a purchase price
equal to 100% of the principal amount of such Notes, plus accrued and unpaid
interest to the date of purchase. The Excess Proceeds Offer shall be made
substantially in accordance with the procedures for a Change of Control Offer
described under "--Change of Control" above. To the extent that the aggregate
principal amount of the Notes (plus accrued interest thereon) tendered pursuant
to the Excess Proceeds Offer is less than the Excess Proceeds, the Company may
use such deficiency, or a portion thereof, for general corporate purposes. If
the aggregate principal amount of the Notes surrendered by holders thereof
exceeds the amount of Excess Proceeds, the Company shall select the Notes to be
purchased in accordance with the procedures described above under "--Selection
and Notice." "Excess Proceeds" shall mean any Net Cash Proceeds from an Asset
Sale that is not invested or used to reduce Senior Indebtedness as provided in
the second sentence of this paragraph. Notwithstanding the foregoing, any Asset
Sale which results in Net Cash Proceeds of less than $5 million and all Asset
Sales (including any Asset Sale which results in Net Cash Proceeds of less than
$5 million) in any twelve consecutive-month period which result in Net Cash
Proceeds of less than $10 million in the aggregate shall not be subject to the
requirement of clause (ii) of the first sentence of this paragraph.
The Company will comply with the requirements of Regulation 14E and Rule
13e-4 (other than the filing requirements of such rule) under the Exchange Act
and any other securities laws and regulations thereunder to the extent such laws
and regulations are applicable in connection with the repurchase of the Notes
pursuant to an Excess Proceeds Offer.
LIMITATION ON TRANSACTIONS WITH AFFILIATES. (a) The Indenture provides that
the Company will not, and will not permit any of its Restricted Subsidiaries to,
directly or indirectly, enter into or conduct any transaction (including the
purchase, sale, lease or exchange of any property or the rendering of any
service) with any Affiliate of the Company (an "Affiliate Transaction") (i) on
terms that are materially less
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favorable to the Company or such Restricted Subsidiary, as the case may be, than
those that could be obtained at the time of such transaction in arm's-length
dealings with a Person who is not such an Affiliate and (ii) that, in the event
such Affiliate Transaction involves an aggregate amount in excess of $15
million, are not in writing and have not been approved by a majority of the
Disinterested Directors. In addition, if such Affiliate Transaction involves an
amount in excess of $30 million, a fairness opinion must be provided by a
nationally recognized appraisal or investment banking firm.
(b) The provisions of the foregoing paragraph (a) will not prohibit (i) any
Restricted Payment permitted to be paid pursuant to the covenant described under
"--Limitation on Restricted Payments," (ii) any issuance of securities, or other
payments, awards or grants in cash, securities or otherwise pursuant to, or the
funding of, employment arrangements, stock options and stock ownership plans
approved by the Board of Directors, (iii) loans or advances to employees in the
ordinary course of business in accordance with past practices of the Company,
but in any event not to exceed $7.5 million in the aggregate outstanding at any
one time, (iv) the payment of reasonable fees to directors of the Company and
its Subsidiaries who are not employees of the Company or its Subsidiaries, (v)
any transaction between the Company and a Restricted Subsidiary or between
Restricted Subsidiaries or (vi) arrangements in existence as of the date hereof
with Persons that employ staff providers and which provide service exclusively
on behalf of the Company and its Subsidiaries, which arrangements are not
material to the Company and its Subsidiaries taken as a whole.
MERGER, CONSOLIDATION OR SALE OF ASSETS. The Indenture provides that the
Company shall not consolidate with, merge with or into, or transfer all or
substantially all of its assets (in one transaction or a series of related
transactions) to, any Person or permit any party to merge with or into it
unless: (i) the Company shall be the continuing Person, or the Person (if other
than the Company) (the "Successor Company") formed by such consolidation or into
or with which the Company is merged or to which the properties and assets of the
Company are transferred shall be a corporation organized and existing under the
laws of the United States or any State thereof or the District of Columbia and
shall expressly assume, by a supplemental indenture, executed and delivered to
the Trustee, in form satisfactory to the Trustee, all of the obligations of the
Company under the Notes and the Indenture and the Indenture remains in full
force and effect; (ii) immediately before and immediately after giving effect to
such transaction (and treating any Indebtedness which becomes an obligation of
the Company, the Successor Company or any Restricted Subsidiary as a result of
such transaction as having been incurred by the Company, the Successor Company
or such Restricted Subsidiary at the time of such transaction), no Event of
Default or Default shall have occurred and be continuing; (iii) except in the
case of a merger of the Company with a wholly-owned subsidiary (which does not
have assets or liabilities in excess of $1 million) of a newly-formed holding
company for the sole purpose of forming a holding company structure, the Company
or the Successor Company, as applicable, could, after giving pro forma effect to
such transaction, incur $1.00 of Indebtedness pursuant to the first paragraph of
"--Limitation on Additional Indebtedness" and (iv) the Company shall have
delivered to the Trustee an officers' certificate and an opinion of counsel,
each stating that such consolidation, merger or transfer and such supplemental
indenture (if any) comply with the Indenture. Notwithstanding the foregoing
clauses (ii) and (iii), (a) any Restricted Subsidiary may consolidate with,
merge into or transfer all or part of its properties and assets to the Company
or another Restricted Subsidiary and (b) the Company may merge with an Affiliate
incorporated solely for the purpose of reincorporating the Company in another
jurisdiction.
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The Successor Company will succeed to, and be substituted for, and may
exercise every right and power of, the Company under the Indenture, and the
predecessor Company in the case of a conveyance, transfer or lease of all or
substantially all its assets will be released from all obligations under the
Indenture, including, without limitation, any obligation to pay the principal of
and interest on the Notes.
PAYMENT FOR CONSENT. The Indenture provides that neither the Company nor
any of its Subsidiaries shall, directly or indirectly, pay or cause to be paid
any consideration, whether by way of interest, fee or otherwise, to any holder
of any Notes for or as an inducement to obtaining any consent, waiver or
amendment of, or direction in respect of, any of the terms or provisions of the
Indenture or the Notes, unless such consideration is offered or agreed to be
paid, and paid, to all holders of the Notes which so consent, waive, agree or
direct to amend in the time frame set forth in solicitation documents relating
to such consent, waiver, agreement or direction.
PROVISIONS OF REPORTS AND OTHER INFORMATION. The Indenture provides that at
all times while any Note is outstanding, the Company shall timely file with the
Commission and furnish to each holder of Notes all such reports and other
information as required by Section 13 or 15(d) of the Exchange Act, including,
without limitation, Forms 10-K, 10-Q and 8-K. At such time as the Company is not
subject to the reporting requirements of the Exchange Act, promptly after the
same would be required to be filed with the Commission if the Company then were
subject to Section 13 or 15(d) of the Exchange Act, the Company will file with
the Trustee and supply to each holder of the Notes and, upon request, to any
prospective purchaser of Notes, without cost, copies of its financial statements
and certain other reports or information comparable to that which the Company
would have been required to report pursuant to Sections 13 and 15(d) of the
Exchange Act, including, without limitation, the information that would be
required by Forms 10-K, 10-Q and 8-K.
EVENTS OF DEFAULT AND REMEDIES
The Indenture provides that each of the following constitutes an Event of
Default: (i) default for 30 days in payment of interest on the Notes, whether or
not prohibited by provisions described under
"--Subordination" above; (ii) default in payment when due of principal of or
premium, if any, on the Notes, whether at maturity, or upon acceleration,
redemption or otherwise, whether or not prohibited by provisions described under
"--Subordination" above; (iii) failure by the Company to comply with its
obligations under the covenant described under "--Merger, Consolidation or Sale
of Assets" above, (iv) failure by the Company to comply in any respect with any
of its other agreements in the Indenture or the Notes which failure continues
for 30 days after receipt of a written notice from the Trustee or holders of at
least 25% of the aggregate principal amount of the Notes then outstanding,
specifying such Default and requiring that it be remedied; (v) default under any
mortgage, indenture or instrument under which there may be issued or by which
there may be secured or evidenced any Indebtedness of the Company or any of its
Restricted Subsidiaries (or the payment of which is guaranteed by the Company or
any of its Restricted Subsidiaries) whether such Indebtedness is now existing or
hereafter created, which default results from the failure to pay any such
Indebtedness at its stated final maturity or results in the acceleration of such
Indebtedness prior to its stated final maturity and the principal amount of such
Indebtedness is at least $20 million, or the principal amount of such
Indebtedness, together with the principal amount of any other such Indebtedness
the maturity of which has been accelerated, aggregates $35 million or more; (vi)
failure by the Company or any Restricted Subsidiary to pay final judgments
aggregating in excess of $20 million which judgments are not paid, discharged or
stayed within 60 days after their entry; and (vii) certain events of bankruptcy
or insolvency with respect to the Company and its Restricted Subsidiaries.
If an Event of Default occurs and is continuing and if it is known to the
Trustee, the Trustee shall mail to each holder of the Notes notice of the Event
of Default within 90 days after it becomes known to the Trustee, unless such
Event of Default has been cured or waived. Except in the case of an Event of
Default in the payment of principal of, premium, if any, or interest on any
Note, the Trustee may withhold the
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notice if and so long as a committee of its trust officers in good faith
determines that withholding the notice is in the interest of the holders of the
Notes.
If an Event of Default (other than an Event of Default resulting from
bankruptcy, insolvency or reorganization) occurs and is continuing, the Trustee
or the holders of at least 25% of the principal amount of the Notes then
outstanding, by written notice to the Company (and to the Trustee if such notice
is given by such holders) (the "Acceleration Notice"), may, and the Trustee at
the request of such holders shall, declare all unpaid principal of, premium, if
any, and accrued interest on such Notes to be due and payable immediately. Upon
a declaration of acceleration, such principal, premium, if any, and accrued
interest shall be due and payable. If an Event of Default resulting from certain
events of bankruptcy, insolvency or reorganization occurs, all unpaid principal
of, premium, if any, and accrued interest on the Notes then outstanding shall
IPSO FACTO become and be immediately due and payable without any declaration or
other act on the part of the Company, the Trustee or any holder. The holders of
a majority of the aggregate principal amount of the Notes outstanding by notice
to the Trustee may rescind an acceleration and its consequences, except an
acceleration due to default in payment of principal or interest on the Notes
upon conditions provided in the Indenture. Subject to certain restrictions set
forth in the Indenture, the holders of a majority of the aggregate principal
amount of the outstanding Notes by notice to the Trustee may waive an existing
Default or Event of Default and its consequences, except a Default in the
payment of principal of, premium, if any, or interest on, such Notes or a
Default under a provision which requires consent of all holders to amend. When a
Default or Event of Default is waived, it is cured and ceases to exist, but no
waiver shall extend to any subsequent or other Default or impair any consequent
right. A holder of Notes may not pursue any remedy with respect to the Indenture
or the Notes unless: (i) the holder gives to the Trustee written notice of a
continuing Event of Default; (ii) the holders of at least 25% in principal
amount of such Notes outstanding make a written request to the Trustee to pursue
the remedy; (iii) such holder or holders offer to the Trustee indemnity or
security satisfactory to the Trustee against any loss, liability or expense;
(iv) the Trustee does not comply with the request within 30 days after receipt
thereof and the offer of indemnity or security; and (v) during such 30-day
period the holders of a majority of the aggregate principal amount of the
outstanding Notes do not give the Trustee a direction which is inconsistent with
the request.
The Company is required to deliver to the Trustee annually a statement
regarding compliance with the Indenture, and the Company is required, upon
becoming aware of any Default or Event of Default, to deliver a statement to the
Trustee specifying such Default or Event of Default.
DEFEASANCE AND DISCHARGE OF THE INDENTURE AND THE NOTES
The Indenture provides that the Company may, at its option and at any time,
elect to have the obligations of the Company discharged with respect to the
outstanding Notes ("legal defeasance"). Such legal defeasance means that the
Company shall be deemed to have paid and discharged the entire indebtedness
represented by the outstanding Notes, except for (i) the rights of holders of
outstanding Notes to receive solely out of the trust described below payments in
respect of the principal of, premium, if any, and interest on such Notes when
such payments are due, (ii) the obligations of the Company with respect to the
Notes concerning issuing temporary Notes, registration of Notes, replacing
mutilated, destroyed, lost or stolen Notes and the maintenance of an office or
agency for payment and money for security payments held in trust, (iii) the
rights, powers, trusts, duties and immunities of the Trustee, and (iv) the
defeasance provisions of the Indenture.
The Company may, at its option and at any time, elect to have its
obligations under the provisions "Certain Covenants" and "Change of Control"
discharged with respect to the outstanding Notes ("covenant defeasance"). Such
covenant defeasance means that, with respect to the outstanding Notes, the
Company may omit to comply with and shall have no liability in respect of any
term, condition or limitation set forth in any such provisions and such omission
to comply shall not constitute a Default or an Event of Default.
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In order to exercise defeasance, (i) the Company must have irrevocably
deposited with the Trustee, in trust, for the benefit of the holders of the
Notes, cash in U.S. Dollars, U.S. Government Obligations (as defined in the
Indenture), or a combination thereof, in such amounts as will be sufficient, in
the opinion of a nationally recognized firm of independent public accountants,
to pay the principal of, premium, if any, and interest on the outstanding Notes
on the stated maturity of such principal (and premium, if any) or installment of
interest or upon redemption; (ii) the Company shall have delivered to the
Trustee an opinion of counsel stating that the holders of the outstanding Notes
will not recognize income, gain or loss for federal income tax purposes as a
result of such defeasance and will be subject to federal income tax on the same
amounts, in the same manner and at the same times as would have been the case if
such defeasance had not occurred, which such opinion, in the case of legal
defeasance, will also state that (A) the Company has received from, or there has
been published by, the Internal Revenue Service a ruling to such effect or (B)
since the Closing Date there has been a change in the applicable federal income
tax laws or regulations to such effect or (C) there exists controlling precedent
to such effect; (iii) no Default or Event of Default shall have occurred and be
continuing on the date of such deposit; (iv) such defeasance shall not result in
a breach or violation of or constitute a default under any material agreement or
instrument to which the Company is a party or by which it is bound; and (v) the
Company shall have delivered to the Trustee an officers' certificate and an
opinion of counsel, each stating that all conditions precedent to such
defeasance have been satisfied.
NO PERSONAL LIABILITY OF DIRECTORS, OFFICERS, EMPLOYEES AND STOCKHOLDERS
No director, officer, employee or stockholder of the Company shall have any
liability for any obligations of the Company under the Notes or the Indenture or
for any claim based on, in respect of, or by reason of such obligations or their
creation. Each holder of the Notes by accepting a Note waives and releases all
such liability. The waiver and release are part of the consideration for
issuance of the Notes. Such waiver may not be effective to waive liabilities
under the federal securities laws and it is the view of the Commission that such
a waiver is against public policy.
TRANSFER AND EXCHANGE
A holder may transfer or exchange Notes in accordance with the Indenture.
The Registrar may require a holder, among other things, to furnish appropriate
endorsements and transfer documents, and to pay any taxes and fees required by
law or permitted by the Indenture. The Registrar is not required to register a
transfer or exchange of any Note selected for redemption except for the
unredeemed portion of any Note being redeemed in part. Also, the Registrar is
not required to register a transfer or exchange of any Note for a period of 15
days before the mailing of a notice of redemption offer. The registered holder
of a Note will be treated as the owner of it for all purposes.
AMENDMENT, SUPPLEMENT AND WAIVER
Subject to certain exceptions, the Indenture or the Notes may be amended or
supplemented with the consent of the holders of a majority of the aggregate
principal amount of the Notes then outstanding, and any existing Default or
compliance with any provision may be waived (other than a continuing Default or
Event of Default in the payment of principal or interest on any Note) with the
consent of the holders of a majority of the aggregate principal amount of the
then outstanding Notes.
Without the consent of each holder affected, an amendment, supplement or
waiver may not (i) reduce the percentage of principal amount of the Notes whose
holders must consent to an amendment, supplement or waiver, (ii) change the
stated maturity or the time or currency of payment of the principal of, premium,
if any, or any interest on, or reduce the rate of interest on or principal of or
premium payable on any Note or alter the redemption provisions with respect
thereto, (iii) make any change in the subordination provisions of the Indenture
that adversely affects the rights of any holder of the Notes under the
subordination provisions of the Indenture, (iv) impair the right of any holder
to institute suit for
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the enforcement of any payment on or with respect to such holder's Notes, (v)
waive a default in the payment of the principal of, premium, if any, or interest
on, any Note, (vi) make any change to the provisions of the Indenture relating
to the Excess Proceeds Offer, (vii) make any change to the "--Payment for
Consent" covenant of the Indenture, or (viii) make any change in the provision
of the Indenture containing the terms described in this paragraph.
Notwithstanding the foregoing, without the consent of any holder of the
Notes, the Company and the Trustee may amend or supplement the Indenture or the
Notes to cure any ambiguity, defect or inconsistency, to provide for
certificated or uncertificated Notes (provided that the uncertificated Notes are
issued in registered form for purposes of Section 163(f) of the Code, or in a
manner such that the uncertificated Notes are described in Section 163(f)(2)(B)
of the Code) to provide for the assumption of the Company's obligations to
holders of the Notes in the case of a merger or consolidation, to make any
change that does not adversely affect the rights of any holder of the Notes or
to comply with any requirement of the Commission in connection with the
qualification of the Indenture or the Trustee under the Trust Indenture Act.
CONCERNING THE TRUSTEE
The Indenture contains certain limitations on the rights of the Trustee,
should it become a creditor of the Company, to obtain payment of claims in
certain cases, or to realize on certain property received in respect of any such
claim as security or otherwise. The Trustee will be permitted to engage in other
transactions; however, if it acquires any conflicting interest, it must
eliminate such conflict within 90 days or apply to the Commission for permission
to continue or resign.
The holders of a majority of the aggregate principal amount of the then
outstanding Notes will have the right to direct the time, method and place of
conducting any proceeding for exercising any remedy available to the Trustee,
subject to certain exceptions. The Indenture provides that in case an Event of
Default shall occur (which shall not be cured), the Trustee will be required, in
the exercise of its power, to use the degree of care and skill of a prudent
person under the circumstances in the conduct of such person's own affairs.
Subject to such provisions, the Trustee will be under no obligation to exercise
any of its rights or powers under the Indenture at the request of any of the
holders of the Notes, unless they shall have offered to the Trustee security or
indemnity satisfactory to it against any loss, liability or expense.
GOVERNING LAW
The Indenture provides that it and the Notes will be governed by, and
construed in accordance with, the laws of the State of New York without giving
effect to applicable principles of conflicts of law to the extent that the
application of the law of another jurisdiction would be required thereby.
CERTAIN DEFINITIONS
"Affiliate" of any specified Person means any other Person directly or
indirectly controlling or controlled by or under direct or indirect common
control with such specified Person. A Person shall be deemed to "control"
(including the correlative meanings, the terms "controlling," "controlled by,"
and "under common control with") another Person if the controlling Person (a)
possesses, directly or indirectly, the power to direct or cause the direction of
the management or policies of the controlled Person, whether through ownership
of voting securities, by agreement or otherwise, or (b) owns, directly or
indirectly, 10% or more of any class of the issued and outstanding equity
securities of the controlled Person.
"Asset Sale" means, with respect to any Person, the sale, lease, conveyance,
disposition or other transfer by such Person of any of its assets (including by
way of a sale-and-leaseback and including the sale or other transfer of any
Equity Interests in any Restricted Subsidiary) which results in proceeds with
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a fair market value of $1 million or more. However, the following shall not
constitute an Asset Sale: (i) unless part of a disposition including other
assets or operations, (A) dispositions of Cash, Cash Equivalents and Investment
Grade Securities, (B) payments on or in respect of non-Cash proceeds of Asset
Sales, and (C) dispositions of Investments by foreign subsidiaries of the
Company in Cash and instruments or securities or in certificates of deposit (or
comparable instruments) with banks or similar institutions; (ii) the lease of
space in the ordinary course of business and in a manner consistent with either
past practices or the healthcare industry generally; or (iii) the issuance or
sale by the Company of any Equity Interests in the Company.
"Average Life" means, as of the date of determination, with respect to any
Indebtedness or Preferred Stock, the quotient obtained by dividing (i) the sum
of the products of the numbers of years from the date of determination to the
dates of each successive scheduled principal payment (assuming the exercise by
the obligor of such Indebtedness of all unconditional (other than as to the
giving of notice) extension options of each such scheduled payment date) of such
Indebtedness or redemption or similar payment with respect to such Preferred
Stock multiplied by the amount of such principal payment by (ii) the sum of all
such principal payments.
"Bank Indebtedness" means any and all amounts payable under or in respect of
the New Credit Agreement (and any substitutes, refundings, refinancings and
replacements thereof, in whole or in part) and all related documentation, as
amended from time to time, including principal, premium (if any), interest
(including interest accruing on or after the filing of any petition in
bankruptcy or for reorganization relating to the Company whether or not a claim
for post-filing interest is allowed in such proceedings), fees, charges,
expenses, reimbursement obligations, Guarantees and all other amounts payable
thereunder or in respect thereof.
"Board of Directors" means the Board of Directors of the Company or any
committee thereof duly authorized to act on behalf of such Board.
"Capital Lease Obligation" means, at the time any determination thereof is
to be made, the amount of the liability in respect of a capital lease which
would at such time be so required to be capitalized on the balance sheet in
accordance with GAAP.
"Capital Stock" means any and all shares, interests, participations, rights
or other equivalents (however designated) of corporate stock (including, without
limitation, common and preferred stock), excluding warrants, options or similar
instruments or other rights to acquire Capital Stock.
"Cash" means money or currency or a credit balance in a Deposit Account.
"Cash Equivalents" means (i) securities issued or directly and fully
guaranteed or insured by the United States of America or any agency,
instrumentality or sponsored corporation thereof which are rated at least A or
the equivalent thereof by Standard and Poor's Ratings Services ("S&P") or at
least A-2 or the equivalent thereof by Moody's Investor Services, Inc.
("Moody's") (or if at such time neither is issuing ratings, then a comparable
rating of another nationally recognized rating agency), and in each case having
maturities of not more than one year from the date of acquisition, (ii) time
deposits, certificates of deposit, Eurodollar time deposits, and overnight bank
deposits with any commercial bank of recognized standing, having capital and
surplus in excess of $250 million and the commercial paper of the holding
company of which is rated at least A-2 or the equivalent thereof by S&P or at
least P-2 or the equivalent thereof by Moody's (or if at such time neither is
issuing ratings, then a comparable rating of another nationally recognized
rating agency), or, if no such commercial paper rating is available, a long-term
debt rating of at least A or the equivalent thereof by S&P or at least A-2 or
the equivalent thereof by Moody's (or if at such time neither is issuing
ratings, then a comparable rating of another nationally recognized rating
agency), (iii) repurchase obligations with a term of not more than ninety-two
days for underlying securities of the types described in clause (i) above
entered into with any commercial bank meeting the qualifications specified in
clause (ii) above, (iv) other investment instruments
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offered or sponsored by financial institutions having capital and surplus in
excess of $250 million and the commercial paper of the holding company of which
is rated at least A-2 or the equivalent thereof by S&P or at least P-2 or the
equivalent thereof by Moody's (or if at such time neither is issuing ratings,
then a comparable rating of another nationally recognized rating agency), or, if
no such commercial paper rating is available, a long-term debt rating of at
least A or the equivalent thereof by S&P or at least A-2 or the equivalent
thereof by Moody's (or if at such time neither is issuing ratings, then a
comparable rating of another nationally recognized rating agency), (v) readily
marketable direct obligations issued by any state of the United States of
America or any political subdivision thereof having one of the two highest
rating categories obtainable from either Moody's or S&P (or if at such time
neither is issuing ratings, then a comparable rating of another nationally
recognized rating agency), (vi) commercial paper rated at least A-2 or the
equivalent thereof by S&P or at least P-2 or the equivalent thereof by Moody's
(or if at such time neither is issuing ratings, then a comparable rating of
another nationally recognized rating agency), in each case maturing within one
year after the date of acquisition and (vii) other money market investments with
a weighted average maturity of less than one year in an aggregate amount not to
exceed $10 million at any time outstanding.
"Change of Control" means (a) the sale, lease, transfer or other disposition
in one or more related transactions of all or substantially all of the Company's
assets, or the sale of substantially all of the Capital Stock or assets of the
Company's Subsidiaries that constitutes a sale of substantially all of the
Company's assets, to any Person or group (as such term is used in Section
13(d)(3) of the Exchange Act), (b) the merger or consolidation of the Company
with or into another corporation, or the merger of another corporation into the
Company or any other transaction, with the effect, in any such case, that the
stockholders of the Company immediately prior to such transaction hold 50% or
less of the total voting power entitled to vote in the election of directors,
managers or trustees of the surviving corporation or, in the case of a
triangular merger, the parent corporation of the surviving corporation resulting
from such merger, consolidation or such other transaction, (c) any Person
(except for the parent corporation of the surviving corporation in a triangular
merger) or group acquires beneficial ownership of a majority in interest of the
voting power or voting Capital Stock of the Company, or (d) the liquidation or
dissolution of the Company; PROVIDED, HOWEVER, that in no event shall the sale
of any Equity Interests in, or assets of, Charter Behavioral Health Systems,
LLC, Charter Advantage, LLC, or Charter System, LLC, be deemed to constitute a
sale of all or substantially all of the Company's assets.
"Closing Date" means February 12, 1998.
"Code" means the Internal Revenue Code of 1986, as amended.
"Consolidated Cash Interest Coverage Ratio" means the ratio of (i)
Consolidated Net Income plus the sum of Consolidated Interest Expense, income
tax expense, depreciation expense, amortization expense and other non-cash
charges of the Company and its Restricted Subsidiaries (to the extent such items
were deducted in computing Consolidated Net Income of the Company)
(collectively, "EBITDA") for the preceding four fiscal quarters to (ii) the
Consolidated Cash Interest Expense of the Company and its Restricted
Subsidiaries for the preceding four fiscal quarters; PROVIDED that (without
duplication) (A) if the Company or any of its Restricted Subsidiaries incurs,
assumes, guarantees, repays or redeems any Indebtedness subsequent to the
commencement of the period for which the Consolidated Cash Interest Coverage
Ratio is being calculated but prior to the event for which the calculation of
the Consolidated Cash Interest Coverage Ratio is made or if the transaction
giving rise to the need to calculate the Consolidated Cash Interest Coverage
Ratio is an incurrence, assumption, Guarantee, repayment or redemption of
Indebtedness, then the Consolidated Cash Interest Coverage Ratio will be
calculated giving pro forma effect to any such incurrence, assumption,
Guarantee, repayment or redemption of Indebtedness, as if the same had occurred
at the beginning of the applicable period, (B) if the Company or any Restricted
Subsidiary shall have made any Material Asset Sale subsequent to the
commencement of the period for which the Consolidated Cash Interest Coverage
Ratio is being calculated but prior to the event for which the calculation of
the Consolidated Cash Interest Coverage Ratio is made, the
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EBITDA for such period shall be reduced by an amount equal to the EBITDA (if
positive) directly attributable to the assets that are the subject of such
Material Asset Sale for such period or increased by an amount equal to the
EBITDA (if negative) directly attributable thereto for such period and
Consolidated Interest Expense for such period shall be reduced by an amount
equal to the Consolidated Interest Expense for such period directly attributable
to any Indebtedness of the Company or any Restricted Subsidiary repaid,
repurchased, defeased or otherwise discharged with respect to the Company and
its continuing Restricted Subsidiaries in connection with such Material Asset
Sale (or, if the Equity Interests of any Restricted Subsidiary are sold, the
Consolidated Interest Expense for such period directly attributable to the
Indebtedness of such Restricted Subsidiary to the extent the Company and its
continuing Restricted Subsidiaries are no longer liable for such Indebtedness
after such sale), (C) if the Company or any Restricted Subsidiary (by merger or
otherwise) shall have made an Investment in any Restricted Subsidiary (or any
Person that becomes a Restricted Subsidiary) or an acquisition of assets,
including any acquisition of assets occurring in connection with a transaction
causing a calculation to be made hereunder, which Investment or acquisition of
assets constitutes all or substantially all an operating unit of a business
subsequent to the commencement of the period for which the Consolidated Cash
Interest Coverage Ratio is being calculated but prior to the event for which the
calculation of the Consolidated Cash Interest Coverage Ratio is made, EBITDA and
Consolidated Interest Expense for such period shall be calculated after giving
pro forma effect thereto (including the incurrence, assumption, Guarantee,
repayment or redemption of any Indebtedness and any pro forma expense and cost
reductions that are directly attributable to such transaction), as if such
Investment or acquisition occurred at the beginning of the applicable period and
(D) if subsequent to the commencement of the period for which the Consolidated
Cash Interest Coverage Ratio is being calculated but prior to the event for
which the calculation of the Consolidated Cash Interest Coverage Ratio is made
any Person (that subsequently became a Restricted Subsidiary or was merged with
or into the Company or any Restricted Subsidiary since the beginning of such
period) shall have made any Material Asset Sale or any Investment or acquisition
of assets that would have required an adjustment pursuant to clause (B) or (C)
above if made by the Company or a Restricted Subsidiary during such period,
EBITDA and Consolidated Interest Expense for such period shall be calculated
after giving pro forma effect thereto as if such Material Asset Sale, Investment
or acquisition of assets occurred on the first day of such period. For purposes
of this definition, whenever pro forma effect is given for a transaction, the
pro forma calculation shall be made in good faith by a responsible financial or
accounting officer of the Company. In making such calculations on a pro forma
basis, interest attributable to Indebtedness bearing a floating interest rate
shall be computed as if the rate in effect on the date of computation had been
the applicable rate for the entire period.
"Consolidated Cash Interest Expense" of any Person means, for any period for
which the determination thereof is to be made, the Consolidated Interest Expense
of such Person less, to the extent incurred, assumed or Guaranteed by such
Person and its Subsidiaries in such period and included in such Consolidated
Interest Expense (i) deferred financing costs and (ii) other noncash interest
expense; PROVIDED, HOWEVER, that amortization of original issue discount shall
be included in Consolidated Cash Interest Expense.
"Consolidated Interest Expense" of any Person means, for any period for
which the determination thereof is to be made, the total interest expense of
such Person and its consolidated Restricted Subsidiaries, plus, without
duplication, to the extent incurred, assumed or Guaranteed by such Person and
its Subsidiaries in such period but not included in such interest expense,
(A)(i) all commissions, discounts and other fees and charges owed with respect
to letters of credit and bankers' acceptance financing, (ii) all but the
principal component of rentals in respect of Capital Lease Obligations, paid,
accrued or scheduled to be paid or accrued by such Person during such period,
(iii) capitalized interest, (iv) amortization of original issue discount and
deferred financing costs, (v) noncash interest expense, (vi) interest accruing
on any Indebtedness of any other Person to the extent such Indebtedness is
Guaranteed by such Person or any of its Restricted Subsidiaries; PROVIDED that
payment of such
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amounts by the Company or any Restricted Subsidiary is being made to, or is
sought by, the holders of such Indebtedness pursuant to such guarantee, (vii)
net costs (benefits) associated with Hedging Obligations relating to interest
rate protection (including amortization of fees), (viii) Preferred Stock
dividends in respect of all Preferred Stock of the Subsidiaries of such Person
and Redeemable Stock of such Person held by Persons other than such Person or a
Wholly-owned Subsidiary of such Person, and (ix) the cash contributions to any
employee stock ownership plan or similar trust to the extent such contributions
are used by such plan or trust to pay interest or fees to any Person (other than
such Person) in connection with Indebtedness incurred, assumed or Guaranteed by
such plan or trust, all as determined in accordance with GAAP, less (B) interest
expense of the type described in clause (A) above attributable to Unrestricted
Subsidiaries of such Person to the extent the related Indebtedness is not
Guaranteed or paid by such Person or any Restricted Subsidiary of such Person.
"Consolidated Net Income" means, with respect to any Person for any period,
the aggregate of the Net Income of such Person and its Subsidiaries for such
period, on a consolidated basis, determined in accordance with GAAP, plus the
sum of the amount allocated to excess reorganization value, employee stock
ownership plan expense and consolidated stock option expense (to the extent such
items were taken into account in computing the Net Income of such Person and its
Subsidiaries); PROVIDED, HOWEVER, that (i) the Net Income of any Person that is
not a Restricted Subsidiary or that is accounted for by the equity method of
accounting shall be included only to the extent of the amount of dividends or
distributions actually paid in cash to the referent Person or its Restricted
Subsidiaries, (ii) the Net Income of any Person acquired in a pooling of
interests transaction for any period prior to the date of such acquisition shall
be excluded, (iii) the cumulative effect of a change in accounting principles
shall be excluded and (iv) any net income (loss) of any Restricted Subsidiary of
such Person if such Restricted Subsidiary of such Person is subject to
restrictions, directly or indirectly, on the payment of dividends or the making
of distributions by such Restricted Subsidiary, directly or indirectly, to such
Person that violate the covenant described under "--Limitation on Payment
Restrictions Affecting Restricted Subsidiaries" (without giving effect to clause
(6) thereof with respect to any Indebtedness) shall be excluded, except that (A)
such Persons's equity in the net income of any such Restricted Subsidiary for
such period shall be included in such Consolidated Net Income up to the
aggregate amount of cash that could have been distributed by such Restricted
Subsidiary during such period to the Company or another Restricted Subsidiary as
a dividend or otherwise (subject, in the case of a dividend or distribution that
could have been made to another Restricted Subsidiary, to the limitation
contained in this clause) and (B) the Company's equity in a net loss of any such
Restricted Subsidiary for such period shall be included in determining such
Consolidated Net Income.
Notwithstanding the foregoing, for the purpose of the covenant described
under "--Limitation on Restricted Payments" only, there shall be excluded from
Consolidated Net Income any dividends, repayments of loans or advances or other
transfers of assets or other amounts from or in respect of Unrestricted
Subsidiaries to such Person or a Restricted Subsidiary of such Person to the
extent such dividends, repayments or transfers or other amounts increase the
amount of Restricted Payments permitted under such covenant pursuant to clause
(F) of paragraph (b) thereof.
"Default" means any event which is, or after notice or passage of time or
both would be, an Event of Default.
"Deposit Account" means a demand, savings, passbook, money market or like
account with or sponsored by a commercial bank, financial institution,
investment bank or brokerage firm, savings and loan association or like
organization or a government securities dealer, other than an account evidenced
by a negotiable certificate of deposit.
"Disinterested Director" means, with respect to any specific transaction,
any director of the Company that does not have a direct or indirect interest
(other than any interest resulting solely from such director's ownership of
Equity Interests in the Company) in such transaction.
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"Equity Interests" means (a) Capital Stock, warrants, options or similar
instruments or other rights to acquire Capital Stock (but excluding any debt
security which is convertible into, or exchangeable for, Capital Stock), and (b)
limited and general partnership interests, interests in limited liability
companies, joint venture interests and other ownership interests in any Person.
"Equity Offering" means an underwritten primary public offering of common
stock of the Company pursuant to an effective registration statement under the
Securities Act or a private primary offering of common stock of the Company.
"ESOP" means the Employee Stock Ownership Plan of the Company as established
on September 1, 1988, and effective as of January 1, 1988, as from time to time
amended, and/or the trust created in accordance with such plan pursuant to the
Trust Agreement between the Company and the trustee named therein, executed as
of September 1, 1988, as amended, as the context in which the term "ESOP" is
used permits.
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"GAAP" means generally accepted accounting principles set forth in the
opinions and pronouncements of the Accounting Principles Board of the American
Institute of Certified Public Accountants and statements and pronouncements of
the Financial Accounting Standards Board or in such other statements by such
other entity as approved by a significant segment of the accounting profession,
as in effect on the Closing Date.
"Guarantee" means any obligation, contingent or otherwise, of any Person
directly or indirectly guaranteeing any Indebtedness of any other Person and any
obligation, direct or indirect, contingent or otherwise, of such Person (i) to
purchase or pay (or advance or supply funds for the purchase or payment of) such
Indebtedness of such other Person (whether arising by virtue of partnership
arrangements, or by arrangements to keep-well, to purchase assets, goods,
securities or services, to take-or-pay, or to maintain financial statement
conditions or otherwise) or (ii) entered into for purposes of assuring in any
other manner the obligee of such Indebtedness of the payment thereof or to
protect such obligee against loss in respect thereof (in whole or in part);
PROVIDED, HOWEVER, that the term "Guarantee" shall not include (i) endorsements
for collection or deposit in the ordinary course of business or (ii) obligations
under preferred provider arrangements with Charter Behavioral Health Systems,
LLC and its Affiliates related to the purchase of minimum amounts of behavioral
healthcare services at market rates. The term "Guarantee" used as a verb has a
corresponding meaning.
"Healthcare Service Business" means a business, the majority of whose
revenues are derived from providing or arranging to provide or administering,
managing or monitoring healthcare services or any business or activity that is
reasonably similar thereto or a reasonable extension, development or expansion
thereof or ancillary thereto.
"Hedging Obligations" means, with respect to any Person, the obligations of
such Person under (i) currency exchange or interest rate swap agreements,
currency exchange or interest rate cap agreements and currency exchange or
interest rate collar agreements and (ii) other agreements or arrangements
designed to protect such Person against fluctuations in currency exchange or
interest rates.
"Indebtedness" of any Person means, without duplication at the date of
determination thereof, (i) the principal of and premium (if any) in respect of
indebtedness of such Person for borrowed money (including in respect of
obligations of such Person evidenced by bonds, debentures, notes or other
similar instruments) or for the deferred purchase price of property or services
(other than (a) trade payables on terms of 365 days or less incurred in the
ordinary course of business, (b) deferred earn-out and other performance-based
payment obligations incurred in connection with acquisitions of Healthcare
Service Businesses and (c) obligations under preferred provider arrangements
with Charter Behavioral Health Systems, LLC and its Affiliates related to the
purchase of minimum amounts of behavioral healthcare services at market rates),
all as determined in accordance with GAAP, (ii) all Capital Lease
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Obligations of such Person, (iii) all Guarantees of such Person in respect of
Indebtedness of others, (iv) the aggregate amount of all unreimbursed drawings
in respect of letters of credit or other similar instruments issued for the
account of such Person (less the amount of Cash, Cash Equivalents or Investment
Grade Securities on deposit securing reimbursement obligations in respect of
such letters of credit or similar instruments), (v) all indebtedness,
obligations or other liabilities of such person or of others for borrowed money
secured by a Lien on any property of such Person, whether or not such
indebtedness, obligations or liabilities are assumed by such Person, (vi) the
amount of all obligations of such Person with respect to the redemption,
repayment or other repurchase of any Redeemable Stock and, with respect to any
Subsidiary of the Company, any Preferred Stock (but excluding, in each case, any
accrued dividends); and (vii) to the extent not otherwise included in this
definition actual (rather than notional) liabilities under Hedging Obligations
of such Person; PROVIDED, HOWEVER, that all or any portion of Indebtedness that
becomes the subject of a defeasance (whether a "legal" defeasance or a
"covenant" or "in substance" defeasance) shall, at all times that such
defeasance remains in effect, cease to be treated as Indebtedness for purposes
of the Indenture.
"Investment" means, when used with respect to any Person, any direct or
indirect advance, loan or other extension of credit (other than the creation of
receivables in the ordinary course of business) or capital contribution by such
Person (by means of transfers of cash or property (other than Equity Interests
in the Company) to others or payments for property or services for the account
or use of others, or otherwise) to any other Person, or any direct or indirect
purchase or other acquisition by such Person of a beneficial interest in capital
stock, bonds, notes, debentures or other securities issued by any other Person,
or any Guarantee by such Person of the Indebtedness of any other Person (in
which case such Guarantee shall be deemed an Investment in such other Person in
an amount equal to the aggregate amount of Indebtedness so guaranteed). For
purposes of the definition of "Unrestricted Subsidiary" and the covenant
described under "--Limitation on Restricted Payments," (i) "Investment" shall
include the portion (proportionate to the Company's equity interest in such
Subsidiary) of the fair market value of the net assets of any Subsidiary of the
Company at the time that such Subsidiary is designated an Unrestricted
Subsidiary; PROVIDED, HOWEVER, that upon a redesignation of such Subsidiary as a
Restricted Subsidiary, the Company shall be deemed to continue to have a
permanent "Investment" in an Unrestricted Subsidiary in an amount (if positive)
equal to (x) the Company's "Investment" in such Subsidiary at the time of such
redesignation less (y) the portion (proportionate to the Company's equity
interest in such Subsidiary) of the fair market value of the net assets of such
Subsidiary at the time of such redesignation; and (ii) any property transferred
to or from an Unrestricted Subsidiary shall be valued at its fair market value
at the time of such transfer, in the case of property with a fair market value
of up to $15 million, as determined in good faith by a responsible financial
officer of the Company, and in the case of property with a fair market value in
excess of $15 million, as determined in good faith by the Board of Directors.
"Investment Grade Securities" means (i) securities issued or directly and
fully guaranteed or insured by the United States government or any agency or
instrumentality thereof (other than Cash Equivalents), (ii) debt securities or
debt instruments with a rating of BBB- or higher by S&P, Baa3 or higher by
Moody's or Class (2) or higher by NAIC or the equivalent of such rating by such
rating organization, or, if no rating of S&P, Moody's or NAIC then exists, the
equivalent of such rating by any other nationally recognized securities rating
agency, but excluding any debt securities or instruments constituting loans or
advances among the Company and its Subsidiaries, and (iii) investments in any
fund that invests exclusively in investments of the type described in clauses
(i) and (ii) which fund may also hold immaterial amounts of Cash or Cash
Equivalents pending investment and/or distribution.
"Lien" means any mortgage, pledge, security interest, charge, hypothecation,
collateral assignment, deposit arrangement, encumbrance, lien (statutory or
otherwise), or security agreement of any kind or nature whatsoever (including,
without limitation, any conditional sale or other title retention agreement, any
financing lease having substantially the same economic effect as any of the
foregoing
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and the filing of any financing statement, other than notice or precautionary
filings not perfecting a security interest, under the Uniform Commercial Code or
comparable law of any jurisdiction, domestic or foreign, in respect of any of
the foregoing).
"Material Asset Sale" means any Asset Sale exceeding $25 million of all or
substantially all of an operating unit of a business.
"NAIC" means National Association of Insurance Commissioners.
"Net Cash Proceeds" means, with respect to any Asset Sale, the proceeds of
such Asset Sale in the form of Cash or Cash Equivalents, including payments in
respect of deferred payment obligations (to the extent corresponding to the
principal, but not the interest, component thereof) when received in the form of
Cash or Cash Equivalents (except to the extent such obligations are financed or
sold with recourse to the Company or any Restricted Subsidiary of the Company),
casualty loss insurance proceeds, condemnation awards and proceeds from the
conversion of other property received when converted to Cash or Cash
Equivalents, net of (i) brokerage commissions and other fees and expenses
related to such Asset Sale, (ii) provision for all taxes as a result of such
Asset Sale without regard to the consolidated results of operations of the
Company and its Subsidiaries, taken as a whole, (iii) payments made to repay
Indebtedness or any other obligation outstanding at the time of such Asset Sale
that either, (A) in the case of a sale of all of the Equity Interests in any
Restricted Subsidiary, is a direct obligation of such Restricted Subsidiary or
(B) is secured by the asset subject to such sale or was incurred to finance the
acquisition or construction of, improvements on, or operations related to, the
assets subject to such sale and (iv) appropriate amounts to be provided by the
Company or any Restricted Subsidiary of the Company as a reserve against any
liabilities associated with such Asset Sale, including, without limitation,
pension and other post-employment benefit liabilities, liabilities related to
environmental matters and liabilities under indemnification obligations
associated with such Asset Sale, all as determined in conformity with GAAP.
"Net Income" means, with respect to any Person, the net income (loss) of
such Person, determined in accordance with GAAP, excluding, however, any gain or
loss, together with any related provision for taxes on such gain or loss,
realized in connection with any Asset Sale (including, without limitation,
dispositions pursuant to Sale/Leaseback Transactions) not in the ordinary course
of business, and excluding any extraordinary, unusual, non-recurring or similar
type of gain or loss, together with any related provision for taxes.
"New Credit Agreement" means (a) the Credit Agreement, to be dated as of the
Closing Date, among the Company, the banks and other financial institutions
named therein and The Chase Manhattan Bank, as Administrative Agent, and (b)
each note, guaranty, mortgage, pledge agreement, security agreement, indemnity,
subrogation and contribution agreement, and other instruments and documents from
time to time entered into pursuant to or in respect of either such credit
agreement or any such guaranty, as each such credit agreement and other
documents may be amended, restated, supplemented, extended, renewed, increased,
replaced, substituted, refunded, refinanced or otherwise modified from time to
time, in whole or in part.
"Non-Recourse Indebtedness" shall mean any Indebtedness of the Company or
any of its Restricted Subsidiaries if the holder of such Indebtedness has no
recourse, direct or indirect, absolute or contingent, to the general assets of
the Company or any of its Restricted Subsidiaries.
"Permitted Asset Swap" means any one or more transactions in which the
Company or any of its Restricted Subsidiaries exchanges assets for consideration
consisting of Equity Interests in or assets of a Person engaged in a Healthcare
Service Business or assets of a Person the Company or any of its Restricted
Subsidiaries intends to use in a Healthcare Service Business, and, to the extent
necessary to equalize the value of the assets being exchanged, cash; PROVIDED
that cash does not exceed 30% of the
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sum of the amount of the cash and the fair market value of the Equity Interests
or assets received or given by the Company and its Restricted Subsidiaries in
such transaction.
"Permitted Investments" means (a) any Investment in the Company, any
Restricted Subsidiary or any Permitted Joint Venture of the Company or of a
Restricted Subsidiary that in each case is a Healthcare Service Business; (b)
any Investment in Cash and Cash Equivalents or Investment Grade Securities; (c)
any Investment by the Company or any Restricted Subsidiary of the Company in a
Person that is engaged in the Healthcare Service Business if as a result of such
Investment (i) such Person becomes a Restricted Subsidiary or a Permitted Joint
Venture of the Company or of a Restricted Subsidiary or (ii) such Person, in one
transaction or a series of related transactions, is merged, consolidated or
amalgamated with or into, or transfers or conveys substantially all of its
assets to, or is liquidated into, the Company or a Restricted Subsidiary or a
Permitted Joint Venture of the Company or of a Restricted Subsidiary; (d) any
Investment in securities or other assets not constituting Cash or Cash
Equivalents and received in connection with an Asset Sale made pursuant to the
provisions of "--Limitation on Use of Proceeds from Asset Sales" or any other
disposition of assets not constituting an Asset Sale; (e) any Investment
existing on the Closing Date; (f) any transaction to the extent it constitutes
an Investment that is permitted by and made in accordance with the provisions of
clause (ii) of paragraph (b) of the covenant described under "--Limitation on
Transactions with Affiliates"; (g) any Investment in Healthcare Service
Businesses having an aggregate fair market value, taken together with all other
Investments made pursuant to this clause (g) that are at that time outstanding
(and not including any Investments outstanding on the Closing Date), not to
exceed 5% of Total Assets of the Company at the time of such Investment (with
the fair market value of each Investment being measured at the time made and
without giving effect to subsequent changes in value); (h) any Investment by
Restricted Subsidiaries in other Restricted Subsidiaries and Investments by
Subsidiaries of the Company that are not Restricted Subsidiaries in Subsidiaries
of the Company that are not Restricted Subsidiaries; (i) advances to employees
in the ordinary course of business not in excess of $7.5 million outstanding at
any one time; (j) any Investment acquired by the Company or any of its
Restricted Subsidiaries (i) in exchange for any other Investment or accounts
receivable held by the Company or any such Restricted Subsidiary in connection
with or as a result of a bankruptcy, workout, reorganization or recapitalization
of the issuer of such other Investment or accounts receivable or (ii) as a
result of a foreclosure by the Company or any of its Restricted Subsidiaries
with respect to any secured Investment or other transfer of title with respect
to any secured Investment in default; (k) Hedging Obligations; (l) Investments
the payment for which consists exclusively of Equity Interests (other than
Redeemable Stock) of the Company; (m) Investments made in connection with
Permitted Asset Swaps; and (n) additional Investments having an aggregate fair
market value, taken together with all other Investments made pursuant to this
clause (n) that are at that time outstanding, not to exceed $30 million at the
time of such Investment (with fair market value of each Investment being
measured at the time made and without giving effect to subsequent changes in
value).
"Permitted Joint Venture" means, with respect to any Person, (i) any
corporation, association, limited liability company or other business entity
(other than a partnership) (A) of which 50% or more of the total voting power of
shares of Capital Stock or other Equity Interests entitled (without regard to
the occurrence of any contingency) to vote in the election of directors,
managers or trustees thereof is at the time of determination owned or
controlled, directly or indirectly, by such Person or one or more of the
Restricted Subsidiaries of that Person or a combination thereof and (B) which is
either managed or controlled by such Person or any of its Restricted
Subsidiaries and (ii) any partnership of which (x) 50% or more of the general or
limited partnership interests are owned or controlled, directly or indirectly,
by such Person or one or more of the Restricted Subsidiaries of that Person or a
combination thereof and (y) which is either managed or controlled by such Person
or any of its Restricted Subsidiaries, and which in the case of each of clauses
(i) and (ii) is engaged in a Healthcare Service Business; PROVIDED, HOWEVER,
that none of Charter Behavioral Health Systems, LLC or any of its Affiliates
shall in any event be deemed to be a Permitted Joint Venture of the Company or
of a Restricted Subsidiary (provided that for
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the purposes of this proviso the Company and its Subsidiaries shall not be
considered Affiliates of Charter Behavioral Health Systems, LLC).
"Person" means any individual, corporation, partnership, joint venture,
incorporated or unincorporated association, joint-stock company, limited
liability company, trust, unincorporated organization or government or other
agency or political subdivision thereof or other entity of any kind.
"Preferred Stock", as applied to the Capital Stock of any corporation, means
Capital Stock of any class or classes (however designated) which is preferred as
to the payment of dividends, or as to the distribution of assets upon any
voluntary or involuntary liquidation or dissolution of such corporation, over
shares of Capital Stock of any other class of such corporation.
"Prior Purchase Money Obligations" means purchase money obligations relating
to property acquired by the Company or any of its Restricted Subsidiaries in the
ordinary course of business that existed prior to the acquisition of such
property by the Company or any of its Restricted Subsidiaries and that impose
restrictions of the nature described under "--Limitation on Payment Restrictions
Affecting Restricted Subsidiaries" on the property so acquired.
"Redeemable Stock" means any Equity Interest which, by its terms (or by the
terms of any security into which it is convertible or for which it is
exchangeable or exercisable), or upon the happening of any event, (i) matures or
is mandatorily redeemable pursuant to a sinking fund obligation or otherwise,
(ii) is convertible or exchangeable for Indebtedness or Redeemable Stock or
(iii) is redeemable at the option of the holder thereof, in whole or in part, in
each case on or prior to four months after the stated maturity of the Notes.
"Representative" means the trustee, agent or representative (if any) for an
issue of Specified Senior Indebtedness.
"Restricted Subsidiary" means each of the Subsidiaries of the Company that
has not been designated an Unrestricted Subsidiary.
"Rights Plan" means the Company's Share Purchase Rights Plan, dated July 21,
1992, as amended, restated, supplemented or otherwise modified from time to
time.
"Sale/Leaseback Transaction" means an arrangement relating to property now
owned or hereafter acquired whereby the Company or a Restricted Subsidiary
transfers such property to a Person and the Company or a Restricted Subsidiary
leases it from such Person, other than leases between the Company and a
Wholly-owned Subsidiary or between Wholly-owned Subsidiaries.
"Secured Indebtedness" means any Indebtedness secured by a Lien.
"Senior Subordinated Indebtedness" means the Notes and any other
Indebtedness of the Company that specifically provides that such Indebtedness is
to rank PARI PASSU with the Notes and is not subordinated by its terms to any
Indebtedness or other obligation of the Company which is not Senior
Indebtedness.
"Senior Indebtedness" means the principal of and premium, if any, and
interest on (such interest on Senior Indebtedness, wherever referred to in the
Indenture, is deemed to include interest accruing after the filing of a petition
initiating any proceeding pursuant to any bankruptcy law in accordance with and
at the rate (including any rate applicable upon any default or event of default,
to the extent lawful) specified in any document evidencing the Senior
Indebtedness, whether or not the claim for such interest is allowed as a claim
after such filing in any proceeding under such bankruptcy law) and other amounts
(including, but not limited to, fees, expenses, reimbursement obligations in
respect of letters of credit and indemnities) due or payable from time to time
on or in connection with any Indebtedness of the Company incurred pursuant to
the first paragraph of the "Limitation on Additional Indebtedness" covenant
described above or permitted under clauses (i), (ii), (iv), (vi), (vii), (viii),
(ix), (x) and (xi) of the
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second paragraph under "--Limitation on Additional Indebtedness" described
above, in each case whether outstanding on the Closing Date or thereafter
created, incurred or assumed, unless, in the case of any particular
Indebtedness, the instrument creating or evidencing the same or pursuant to
which the same is outstanding expressly provides that such Indebtedness shall
not be senior in right of payment to the Notes. Notwithstanding anything to the
contrary in the foregoing, Senior Indebtedness shall not include (a) any
Indebtedness of the Company to any of its Subsidiaries or other Affiliates, (b)
any Indebtedness incurred after the Closing Date that is contractually
subordinated in right of payment to any Senior Indebtedness, (c) amounts owed
(except to banks and other financial institutions) for goods, materials or
services purchased in the ordinary course of business or for compensation to
employees, (d) any liability for Federal, state, local or other taxes owed or
owing by the Company, (e) any obligations with respect to any Capital Stock, or
(f) any Indebtedness incurred, assumed or Guaranteed in violation of the
Indenture, except where at the time of such incurrence, assumption or Guarantee,
a responsible financial officer of the Company has delivered a certification as
to its compliance at such time with the first paragraph of the covenant
described under "--Limitation on Additional Indebtedness" above, and the holder
of such Indebtedness or its trustee, agent or representative is not aware of
facts or circumstances such that such Person could not rely in good faith on
such certification.
"Specified Senior Indebtedness" means (i) Bank Indebtedness under the New
Credit Agreement and any replacements, refinancings, refundings, and substitute
facility or facilities thereof, and additional facility or facilities permitted
by clause (i) of the second paragraph of the covenant described under
"--Limitation on Additional Indebtedness" and (ii) each single issue of other
Senior Indebtedness having an outstanding principal balance of $50 million or
more and which is specifically designated by the Company in the instrument
evidencing or governing such Senior Indebtedness as "Specified Senior
Indebtedness" for purposes of the Indenture.
"Stated Maturity" means, with respect to any Indebtedness, the date or dates
specified in such Indebtedness as the fixed date or dates on which the payment
of principal of such Indebtedness is due and payable, including pursuant to any
mandatory redemption provision, it being understood that if an issue of
Indebtedness has more than one fixed date on which the payment of principal is
due and payable, each such fixed date shall be a separate Stated Maturity with
respect to the principal amount of Indebtedness due on such date.
"Subordinated Obligation" means any Indebtedness of the Company (whether
outstanding on the Closing Date or thereafter incurred, assumed or Guaranteed)
that is subordinate or junior in right of payment to the Notes pursuant to a
written agreement.
"Subsidiary" means with respect to any Person, (i) any corporation,
association, limited liability company or other business entity (other than a
partnership) of which more than 50% of the total voting power of the Equity
Interests entitled (without regard to the occurrence of any contingency) to vote
in the election of directors, managers or trustees thereof is at the time of
determination owned or controlled, directly or indirectly, by such Person or one
or more of the other Subsidiaries of that Person or a combination thereof, (ii)
any partnership of which more than 50% of the general or limited partnership
interests are owned or controlled, directly or indirectly, by such Person or one
or more of the other Subsidiaries of that Person or a combination thereof and
(iii) any Permitted Joint Venture of such Person.
"Total Assets" means, with respect to any Person, the total consolidated
assets of such Person and its Restricted Subsidiaries, as shown on the most
recent balance sheet of such Person.
"Unrestricted Subsidiary" means (i) any Subsidiary of the Company which at
the time of determination is an Unrestricted Subsidiary (as designated by the
Board of Directors of the Company, as provided below) and (ii) any Subsidiary of
an Unrestricted Subsidiary. The Board of Directors of the Company may designate
any Subsidiary of the Company (including any Subsidiary and any newly acquired
or newly formed Subsidiary) to be an Unrestricted Subsidiary unless such
subsidiary owns any Equity Interests or Indebtedness (other than any
Indebtedness incurred in connection with services performed in the
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ordinary course of business by such Subsidiary for the Company or any of its
Restricted Subsidiaries) of, or owns, or holds any Lien on, any property of, the
Company or any Restricted Subsidiary of the Company, provided that (a) any
Unrestricted Subsidiary must be an entity of which shares of the Capital Stock
or other Equity Interests (including partnership interests) entitled to cast at
least a majority of the votes that may be cast by all shares or Equity Interests
having ordinary voting power for the election of directors or other governing
body are owned, directly or indirectly, by the Company, (b) such designation
complies with the covenants described under "--Limitation on Restricted
Payments" and (c) each of (I) the Subsidiary to be designated and (II) its
Subsidiaries has not at the time of designation, and does not thereafter,
create, incur, issue, assume, guarantee or otherwise become directly or
indirectly liable with respect to any Indebtedness pursuant to which the lender
has recourse to any of the assets of the Company or any of its Restricted
Subsidiaries. The Board of Directors may designate any Unrestricted Subsidiary
to be a Restricted Subsidiary; PROVIDED, HOWEVER, that immediately after giving
effect to such designation (x) the Company could incur $1.00 of additional
Indebtedness under the first paragraph of the covenant described under
"--Limitation on Additional Indebtedness" and (y) no Default shall have occurred
and be continuing. Any such designation by the Board of Directors shall be
evidenced to the Trustee by promptly filing with the Trustee a copy of the
resolution of the Board of Directors giving effect to such designation and an
officers' certificate certifying that such designation complied with the
foregoing provisions.
"Voting Stock" means, with respect to any Person, any class or series of
Capital Stock of such Person that is ordinarily entitled to vote in the election
of directors thereof at a meeting of stockholders called for such purpose,
without the occurrence of any additional event or contingency.
"Wholly-owned Subsidiary" of any Person means any Restricted Subsidiary of
such Person of which 95% or more of the outstanding Equity Interests of such
Restricted Subsidiary are owned by such Person (either directly or indirectly
through Wholly-owned Subsidiaries).
158
<PAGE>
SUMMARY OF NEW CREDIT AGREEMENT
Concurrently with the sale of the Old Notes on February 12, 1998, the
Company paid all amounts outstanding pursuant to the Existing Credit Agreements
and entered into a $700 million Credit Agreement with the banks and other
financial institutions named therein and The Chase Manhattan Bank, as
administrative agent (the "New Credit Agreement"). The following is a summary of
the material terms of the New Credit Agreement. This summary is not a complete
description of the New Credit Agreement and is qualified in its entirety by
reference to the terms of the New Credit Agreement.
Pursuant to the terms of the New Credit Agreement, The Chase Manhattan Bank
and such other banks and financial institutions committed to provide to the
Company and certain of its wholly owned domestic subsidiaries, subject to
certain terms and conditions, the credit facilities described below in an
aggregate principal amount equal to $700.0 million. At the closing of the
Transactions, (a) $550.0 million was borrowed under the Term Loan Facility
described below and (b) $20.0 million was drawn under the Revolving Facility
described below and $17.5 million of availability was reserved for certain
letters of credit. The initial loans under the New Credit Agreement were made to
the Company and Merit to finance the Transactions.
THE FACILITIES
STRUCTURE. The New Credit Agreement provides for (a) a term loan facility
in an aggregate principal amount of $550 million (the "Term Loan Facility"),
consisting of an approximately $183.3 million Tranche A Term Loan (the "Tranche
A Term Loan"), an approximately $183.3 million Tranche B Term Loan (the "Tranche
B Term Loan") and an approximately $183.3 million Tranche C Term Loan (the
"Tranche C Term Loan") and (b) a revolving credit facility providing for
revolving loans to the Company and the "Subsidiary Borrowers" (as defined
therein) and the issuance of letters of credit for the account of the Company
and the Subsidiary Borrowers in an aggregate principal amount (including the
aggregate stated amount of letters of credit) of $150 million (the "Revolving
Facility").
AVAILABILITY. The availability of the credit facilities is subject to
various conditions precedent typical of bank loans. The full amount of the Term
Loan Facility was drawn at the closing of the Transactions and amounts repaid or
prepaid under the Term Loan Facility may not be reborrowed. The Company borrowed
$20.0 million under the Revolving Facility to finance, in part, the
Transactions. Amounts repaid under the Revolving Facility may be reborrowed. The
amount available pursuant to the Revolving Facility is available for general
corporate purposes.
COMMITMENT REDUCTIONS AND REPAYMENTS
The Tranche A Term Loan and the Revolving Facility matures on February 12,
2004. The Tranche B Term Loan matures on February 12, 2005 and the Tranche C
Term Loan matures on February 12, 2006. The Tranche A Term Loan amortizes in
installments in each fiscal year in amounts equal to $16.5 in 1999, $28.0
million in 2000, $34.5 million in 2001, $45.0 million in 2002, $48.0 million in
2003, and $11.3 million in 2004. The Tranche B Term Loan amortizes in
installments in each fiscal year in amounts equal to $1.7 in 1999, $2.2 million
in each of 2000 through 2002, $41.8 in 2003, $103.4 million in 2004, and $29.8
million in 2005. The Tranche C Term Loan amortizes in installments in each
fiscal year in amounts equal to $1.7 in 1999, $2.2 million in each of 2000
through 2003, $41.8 in 2004, $101.9 million in 2005, and $29.1 million in 2006.
In addition, the credit facilities are subject to mandatory prepayment and
reductions (to be applied first to the Term Loan Facility) in an amount equal to
(a) 100% of the net proceeds of certain offerings of equity securities by the
Company or any of its subsidiaries, (b) 100% of the net proceeds of certain debt
issuances of the Company or any of its subsidiaries, (c) 75% of the Company's
excess cash flow and (d) 100% of the net proceeds of certain asset sales or
other dispositions of property of the Company and its subsidiaries, in each case
subject to certain limited exceptions.
INTEREST
At the Company's election, the interest rates per annum applicable to the
loans under the New Credit Agreement are a fluctuating rate of interest measured
by reference to either (a) an adjusted
159
<PAGE>
London inter-bank offered rate ("LIBOR") plus a borrowing margin or (b) an
alternate base rate ("ABR") (equal to the highest of The Chase Manhattan Bank's
published prime rate and the Federal Funds effective rate plus 1/2 of 1%) plus a
borrowing margin. The borrowing margins applicable to the Tranche A Term Loan
and loans under the Revolving Facility are currently 1.25% for ABR loans and
2.25% for LIBOR loans, and are subject to reduction if the Company's financial
results satisfy certain leverage tests. The borrowing margins applicable to the
Tranche B Term Loan and the Tranche C Term Loan are 1.50% and 1.75%,
respectively, for ABR loans and 2.50% and 2.75%, respectively, for LIBOR loans,
and are not subject to reduction. Amounts outstanding under the credit
facilities not paid when due bear interest at a default rate equal to 2.00%
above the rates otherwise applicable to each of the loans under the Term Loan
Facility and the Revolving Facility.
FEES
The Company has agreed to pay certain fees with respect to the credit
facilities, including (i) fees on the unused commitments of the lenders equal to
3/8 to 1/2% on the undrawn portion of the commitments in respect of the
facilities; (ii) letter of credit fees on the aggregate face amount of
outstanding letters of credit equal to the then applicable borrowing margin for
LIBOR Revolving Loans plus a 1/8 of 1% per annum fronting bank fee for the
letter of credit issuing bank; (iii) annual administration fees; and (iv) agent,
arrangement and other similar fees.
SECURITY; GUARANTEES
The obligations of the Company and the Subsidiary Borrowers under the New
Credit Agreement are unconditionally and irrevocably guaranteed by, subject to
certain exceptions, each wholly owned domestic subsidiary and, to the extent no
adverse tax consequences would result, each foreign subsidiary of the Company
(excluding certain subsidiaries that are prohibited by law or any applicable
regulation, rule, order, approval, license or other restriction of any
governmental authority (collectively, "Regulations")). In addition, the Credit
Facilities and the guarantees thereunder are secured by security interests in
and pledges of or liens on substantially all the material tangible and
intangible assets of the Company and the guarantors (subject to certain
limitations to be agreed upon), including pledges of all the capital stock of,
or other equity interests in, each direct or indirect domestic subsidiary of the
Company (except to the extent any such pledge or lien would violate any
applicable Regulations) and, subject to limited exceptions, 65% of the capital
stock of, or other equity interests in, each foreign subsidiary of the Company.
AFFIRMATIVE, NEGATIVE AND FINANCIAL COVENANTS
The New Credit Agreement contains a number of covenants that, among other
things, restrict the ability of the Company and its subsidiaries to dispose of
assets, incur additional indebtedness, incur or guarantee obligations, prepay
other indebtedness or amend other debt instruments, pay dividends, create liens
on assets, make investments, loans or advances, make acquisitions, engage in
mergers or consolidations, change the business conducted by the Company and its
subsidiaries, make capital expenditures, or engage in certain transactions with
affiliates and otherwise restrict certain corporate activities. In addition, the
New Credit Agreement requires the Company to comply with specified financial
ratios and tests, including minimum interest coverage ratios, maximum leverage
ratios, maximum senior debt ratios, minimum "EBITDA" (as defined in the New
Credit Agreement) and minimum net worth tests.
EVENTS OF DEFAULT
The New Credit Agreement contains customary events of default, including
non-payment of principal, interest or fees, violation of covenants, inaccuracy
of representations or warranties in any material respect, cross default and
cross acceleration to certain other indebtedness, bankruptcy, material judgments
and liabilities and change of control.
160
<PAGE>
FEDERAL INCOME TAX CONSEQUENCES
OF THE EXCHANGE OFFER
In the opinion of the Company's counsel, King & Spalding, the exchange of
Old Notes for New Notes pursuant to the Exchange Offer will not constitute a
material modification of the Old Notes and, therefore, such exchange will not
constitute an exchange for federal income tax purposes. Accordingly, such
exchange will have no federal income tax consequences to holders of Old Notes,
either to those who exchange their Old Notes for New Notes or those who do not
so exchange their Old Notes.
LEGAL MATTERS
The legality of the New Notes offered hereby will be passed upon for the
Company by King & Spalding, 191 Peachtree Street, Atlanta, Georgia 30303-1763.
King & Spalding has also rendered an opinion regarding the federal income tax
consequences of the exchange of Old Notes for New Notes.
EXPERTS
The audited consolidated financial statements and schedule of the Company as
of September 30, 1996 and 1997 and for each of the three years in the period
ended September 30, 1997, included in this Prospectus and elsewhere in this
Registration Statement, have been audited by Arthur Andersen LLP, independent
public accountants, as stated in their report appearing herein, and are included
herein in reliance upon the authority of said firm, as experts in giving said
report.
The consolidated financial statements of Merit as of September 30, 1996 and
1997 and for each of the three years in the period ended September 30, 1997,
included in this Prospectus have been audited by Deloitte & Touche LLP,
independent auditors, as stated in their report appearing herein which report
expresses an unqualified opinion and includes an explanatory paragraph which
refers to the change in the method of accounting for deferred contract start-up
costs related to new contracts or expansion of existing contracts and are
included herein in reliance upon the authority of said firm, as experts in
accouning and auditing.
The audited consolidated financial statements and schedule of CBHS as of
September 30, 1997 and for the 106 days ended September 30, 1997, included in
this Prospectus and elsewhere in this Registration Statement, have been audited
by Arthur Andersen LLP, independent public accountants, as stated in their
report appearing herein, and are included herein in reliance upon the authority
of said firm, as experts in giving said report.
The audited consolidated financial statements of HAI as of December 31, 1995
and 1996 and for each of the years in the two year period ended December 31,
1996, have been included in this Prospectus in reliance on the report of KPMG
Peat Marwick LLP, certified public accountants, appearing elsewhere herein, and
upon the authority of said firm as experts in accounting and auditing.
AVAILABLE INFORMATION
The Company has filed with the Commission a Registration Statement on Form
S-4 under the Securities Act for the Registration of the New Notes offered
hereby. This Prospectus, which constitutes a part of the Registration Statement,
does not contain all of the information set forth in the Registration Statement,
certain items of which are contained in exhibits and schedules to the
Registration Statement as permitted by the rules and regulations of the
Commission. For further information with respect to the Company and the New
Notes offered hereby, reference is made to the Registration Statement, including
the exhibits thereto, and financial statements and notes filed as a part
thereof. Statements made in this Prospectus concerning the contents of any
document referred to herein are not necessarily complete. With respect to each
such document filed with the Commission as an exhibit to the Registration
161
<PAGE>
Statement, reference is made to the exhibit for a more complete description of
the matter involved, and each such statement shall be deemed qualified in its
entirety by such reference.
The Company is subject to the information requirements of the Exchange Act,
and, in accordance therewith, files reports, proxy statements and other
information with the Commission. Copies of such material can be obtained from
the Public Reference Section of the Commission, at Room 1024, Judiciary Plaza,
450 Fifth Street, NW, Washington, D.C. 20549 at prescribed rates. In addition,
such reports, proxy statements and other information can be inspected and copied
at the public reference facility referred to above and at Regional Offices of
the Commission located at Seven World Trade Center, Suite 1300, New York, New
York 10048 and at Citicorp Center, 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661. The Commission also maintains a Web site that contains reports,
proxy statements and other information regarding registrants that file
electronically with the SEC. The address of such site is
http://www.sec.gov. The Company's Common Stock is listed for trading on the New
York Stock Exchange and reports, proxy statements and other information
concerning the Company may be inspected at the office of the New York Stock
Exchange, 20 Broad Street, New York, New York. If, at any time, the Company is
not subject to the information requirements of the Exchange Act, the Company has
agreed to furnish to holders of New Notes and prospective purchasers of New
Notes designated by holders of New Notes, upon request of such holders or such
prospective purchasers financial statements, including notes thereto and with
respect to annual reports, an auditor's report by an accounting firm of
established national reputation and a "Management's Discussion and Analysis of
Financial Condition and Results of Operations," and any other information that
would be required by Form 10-K, Form 10-Q and Form 8-K.
162
<PAGE>
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
MAGELLAN HEALTH SERVICES, INC.
Report of independent public accountants.............................................................. F-2
Consolidated balance sheets as of September 30, 1996 and 1997 and June 30, 1998 (unaudited)........... F-3
Consolidated statements of operations for the years ended September 30, 1995, 1996 and 1997 and for
the nine months ended June 30, 1997 (unaudited) and 1998 (unaudited)................................. F-5
Consolidated statements of changes in stockholders' equity for the years ended September 30, 1995,
1996 and 1997........................................................................................ F-6
Consolidated statements of cash flows for the years ended September 30, 1995, 1996 and 1997 and for
the nine months ended June 30, 1997 (unaudited) and 1998 (unaudited)................................. F-7
Notes to consolidated financial statements............................................................ F-8
MERIT BEHAVIORAL CARE CORPORATION
Report of independent public accountants.............................................................. F-57
Consolidated balance sheets as of September 30, 1996 and 1997 and December 31, 1997 (unaudited)....... F-58
Consolidated statements of operations for the years ended September 30, 1995, 1996 and 1997 and for
the three months ended December 31, 1996 (unaudited) and 1997 (unaudited)............................ F-59
Consolidated statements of stockholders' equity for the years ended September 30, 1995, 1996 and
1997................................................................................................. F-60
Consolidated statements of cash flows for the years ended September 30, 1995, 1996 and 1997 and for
the three months ended December 31, 1996 (unaudited) and 1997 (unaudited)............................ F-61
Notes to consolidated financial statements............................................................ F-62
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
Report of independent public accountants.............................................................. F-82
Consolidated balance sheet as of September 30, 1997 and June 30, 1998 (unaudited)..................... F-83
Consolidated statement of operations for the 106 days ended September 30, 1997, for the nine months
ended June 30, 1998 (unaudited) and for the 14 days ended June 30, 1997 (unaudited).................. F-85
Consolidated statement of changes in members' capital for the 106 days ended September 30, 1997....... F-86
Consolidated statement of cash flows for the 106 days ended September 30, 1997 and for the nine months
ended June 30, 1998 (unaudited) and for the 14 days ended June 30, 1997 (unaudited).................. F-87
Notes to consolidated financial statements............................................................ F-88
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED
Independent Auditors' Report.......................................................................... F-96
Consolidated balance sheets as of December 31, 1995 and 1996 and as of September 30, 1997
(unaudited).......................................................................................... F-97
Consolidated statements of income for the years ended December 31, 1995 and 1996 and the nine months
ended September 30, 1996 (unaudited) and 1997 (unaudited)............................................ F-98
Consolidated statements of stockholders' equity for the years ended December 31, 1995 and 1996 and the
nine months ended September 30, 1997 (unaudited)..................................................... F-99
Consolidated statements of cash flows for the years ended December 31, 1995 and 1996 and the nine
months ended September 30, 1996 (unaudited) and 1997 (unaudited)..................................... F-100
Notes to consolidated financial statements............................................................ F-101
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Magellan Health Services, Inc:
We have audited the accompanying consolidated balance sheets of Magellan
Health Services, Inc. (a Delaware corporation) and subsidiaries as of September
30, 1996 and 1997, and the related consolidated statements of operations,
changes in stockholders' equity and cash flows for each of the three years in
the period ended September 30, 1997. These consolidated financial statements and
the schedule referred to below are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Magellan Health Services,
Inc. and subsidiaries as of September 30, 1996 and 1997, and the results of
their operations and their cash flows for each of the three years in the period
ended September 30, 1997 in conformity with generally accepted accounting
principles.
Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in the index to
financial statements is presented for purposes of complying with the Securities
and Exchange Commission's rules and is not part of the basic financial
statements. This schedule has been subjected to the auditing procedures applied
in the audits of the basic financial statements and, in our opinion, fairly
states, in all material respects, the financial data required to be set forth
therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Atlanta, Georgia
November 14, 1997
F-2
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30,
-------------------------- JUNE 30,
1996 1997 1998
------------- ----------- -------------
<S> <C> <C> <C>
(UNAUDITED)
ASSETS
Current Assets:
Cash, including cash equivalents of $54,631 at September 30, 1996 and
$319,823 at September 30, 1997 at cost, which approximates market
value.............................................................. $ 120,945 $ 372,878 $ 89,846
Accounts receivable, less allowance for doubtful accounts of $50,548
at September 30, 1996 and $40,311 at September 30, 1997............ 189,878 107,998 204,137
Restricted cash and investments...................................... -- -- 60,548
Refundable income taxes.............................................. 1,323 2,466 --
Other current assets................................................. 26,004 23,696 34,847
------------- ----------- -------------
Total Current Assets............................................. 338,150 507,038 389,378
Assets restricted for settlement of unpaid claims and other
long-term liabilities................................................. 105,303 87,532 40,253
Property and Equipment:
Land................................................................. 83,431 11,667 10,817
Buildings and improvements........................................... 388,821 70,174 75,425
Equipment............................................................ 146,915 63,719 144,448
------------- ----------- -------------
619,167 145,560 230,690
Accumulated depreciation............................................. (126,053) (37,038) (53,720)
------------- ----------- -------------
493,114 108,522 176,970
Construction in progress............................................. 2,276 692 746
------------- ----------- -------------
Total property and equipment..................................... 495,390 109,214 177,716
------------- ----------- -------------
Deferred income taxes.................................................. -- 1,158 68,614
Investment in CBHS..................................................... -- 16,878 --
Other long-term assets................................................. 30,755 20,893 49,194
Goodwill, net of accumulated amortization of $9,151 at September 30,
1996 and $14,006 at September 30, 1997................................ 128,012 114,234 934,651
Other intangible assets, net of accumulated amortization of $10,393 at
September 30, 1996 and $5,855 at September 30, 1997................... 42,527 38,673 242,405
------------- ----------- -------------
$ 1,140,137 $ 895,620 $ 1,902,211
------------- ----------- -------------
------------- ----------- -------------
</TABLE>
F-3
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
SEPTEMBER 30,
-------------------------- JUNE 30,
1996 1997 1998
------------- ----------- -------------
<S> <C> <C> <C>
(UNAUDITED)
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
<S> <C> <C> <C>
Current Liabilities:
Accounts payable..................................................... $ 78,966 $ 45,346 $ 42,148
Accrued liabilities.................................................. 189,599 170,429 381,666
Current maturities of long-term debt and capital lease obli-
gations............................................................ 5,751 3,601 16,585
------------- ----------- -------------
Total Current Liabilities........................................ 274,316 219,376 440,399
Long-term debt and capital lease obligations........................... 566,307 391,693 1,189,131
Deferred income tax liabilities........................................ 12,368 -- --
Reserve for unpaid claims.............................................. 73,040 49,113 33,374
Deferred credits and other long-term liabilities....................... 39,769 16,110 16,244
Minority Interest...................................................... 52,520 61,078 32,268
Commitments and Contingencies
Stockholders' Equity:
Preferred stock, without par value
Authorized--10,000 shares
Issued and outstanding--none....................................... -- -- --
Common Stock, par value $.25 per share
Authorized--80,000 shares
Issued and outstanding--33,007 shares at September 30, 1996
and 33,439 shares at September 30, 1997.......................... 8,252 8,361 8,423
Other Stockholders' Equity:
Additional paid-in capital........................................... 327,681 340,645 353,125
Accumulated deficit.................................................. (129,457) (129,955) (150,224)
Warrants outstanding................................................. 54 25,050 25,050
Common Stock in treasury, 4,424 shares at September 30, 1996 and at
September 30, 1997................................................. (82,731) (82,731) (42,413)
Cumulative foreign currency adjustments.............................. (1,982) (3,120) (3,166)
------------- ----------- -------------
Total stockholders' equity......................................... 121,817 158,250 190,795
------------- ----------- -------------
$ 1,140,137 $ 895,620 $ 1,902,211
------------- ----------- -------------
------------- ----------- -------------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these balance sheets.
F-4
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS
ENDED
YEAR ENDED SEPTEMBER 30, JUNE 30,
---------------------------------- ------------------------
1995 1996 1997 1997 1998
---------- ---------- ---------- ----------- -----------
<S> <C> <C> <C> <C> <C>
(UNAUDITED) (UNAUDITED)
Net revenue........................................... $1,151,736 $1,345,279 $1,210,696 $1,021,662 $1,063,099
---------- ---------- ---------- ----------- -----------
Costs and expenses:
Salaries, cost of care and other operating
expenses.......................................... 863,598 1,064,445 978,513 830,248 909,353
Bad debt expense.................................... 92,022 81,470 46,211 47,456 2,972
Depreciation and amortization....................... 38,087 48,924 44,861 38,231 37,649
Amortization of reorganization value in excess of
amounts allocable to identifiable assets.......... 26,000 -- -- -- --
Interest, net....................................... 55,237 48,017 45,377 39,324 49,336
ESOP expense........................................ 73,527 -- -- -- --
Stock option expense (credit)....................... (467) 914 4,292 3,214 (3,527)
Managed care integration costs...................... -- -- -- -- 12,314
Equity in loss of CBHS.............................. -- -- 8,122 399 24,221
Loss on Crescent Transactions....................... -- -- 59,868 59,868 --
Unusual items, net.................................. 57,437 37,271 357 357 (3,000)
---------- ---------- ---------- ----------- -----------
1,205,441 1,281,041 1,187,601 1,019,097 1,029,318
---------- ---------- ---------- ----------- -----------
Income (loss) before income taxes, minority interest
and extraordinary items............................. (53,705) 64,238 23,095 2,565 33,781
Provision for (benefit from) income taxes............. (11,082) 25,695 9,238 1,025 15,972
---------- ---------- ---------- ----------- -----------
Income (loss) before minority interest and
extraordinary items................................. (42,623) 38,543 13,857 1,540 17,809
Minority interest..................................... 340 6,160 9,102 6,948 5,063
---------- ---------- ---------- ----------- -----------
Income (loss) before extraordinary items.............. (42,963) 32,383 4,755 (5,408) 12,746
Extraordinary items--losses on early extinguishments
of debt (net of income tax benefit of $3,503) for
the year ended September 30, 1997................... -- -- (5,253) (5,253) (33,015)
---------- ---------- ---------- ----------- -----------
Net income (loss)..................................... $ (42,963) $ 32,383 $ (498) $ (10,661) $ (20,269)
---------- ---------- ---------- ----------- -----------
---------- ---------- ---------- ----------- -----------
Average number of common shares outstanding--basic.... 27,870 31,014 28,781 28,715 30,505
---------- ---------- ---------- ----------- -----------
---------- ---------- ---------- ----------- -----------
Average number of common shares outstanding--diluted.. 27,870 31,596 29,474 28,715 31,099
---------- ---------- ---------- ----------- -----------
---------- ---------- ---------- ----------- -----------
Income (loss) per common share--basic:
Income (loss) before extraordinary items............ $ (1.54) $ 1.04 $ 0.17 $ (0.19) $ 0.42
---------- ---------- ---------- ----------- -----------
---------- ---------- ---------- ----------- -----------
Extraordinary losses on early extinguishments of
debt.............................................. $ -- $ -- $ (0.18) $ (0.18) $ (1.08)
---------- ---------- ---------- ----------- -----------
---------- ---------- ---------- ----------- -----------
Net income (loss)................................... $ (1.54) $ 1.04 $ (0.02) $ (0.37) $ (0.66)
---------- ---------- ---------- ----------- -----------
---------- ---------- ---------- ----------- -----------
Income (loss) per common share--diluted:
Income (loss) before extraordinary items............ $ (1.54) $ 1.02 $ 0.16 $ (0.19) $ 0.41
---------- ---------- ---------- ----------- -----------
---------- ---------- ---------- ----------- -----------
Extraordinary losses on early extinguishments of
debt.............................................. $ -- $ -- $ (0.18) $ (0.18) $ (1.06)
---------- ---------- ---------- ----------- -----------
---------- ---------- ---------- ----------- -----------
Net income (loss)................................... $ (1.54) $ 1.02 $ (0.02) $ (0.37) $ (0.65)
---------- ---------- ---------- ----------- -----------
---------- ---------- ---------- ----------- -----------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-5
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-------------------------------
<S> <C> <C> <C>
1995 1996 1997
--------- --------- ---------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C>
Common Stock:
Balance, beginning of period................................................. $ 6,725 $ 7,101 $ 8,252
Exercise of options and warrants............................................. 24 97 109
Green Spring Health Services, Inc. acquisition............................... -- 54 --
Pooling of Mentor............................................................ 352 -- --
Issuance of Common Stock, net of issuance costs.............................. -- 1,000 --
--------- --------- ---------
Balance, end of period....................................................... 7,101 8,252 8,361
--------- --------- ---------
Additional Paid-in Capital:
Balance, beginning of period................................................. 244,339 253,295 327,681
Stock option expense (credit)................................................ (467) 914 4,292
Green Spring Health Services, Inc. acquisition............................... -- 4,263 --
Exercise of options and warrants............................................. 624 1,636 8,156
Issuance of Common Stock, net of issuance costs.............................. -- 67,573 --
Pooling of Mentor............................................................ 8,799 -- --
Other........................................................................ -- -- 516
--------- --------- ---------
Balance, end of period....................................................... 253,295 327,681 340,645
--------- --------- ---------
Accumulated Deficit:
Balance, beginning of period................................................. (119,042) (161,840) (129,457)
Net income (loss)............................................................ (42,963) 32,383 (498)
Pooling of Mentor............................................................ 165 -- --
--------- --------- ---------
Balance, end of period....................................................... (161,840) (129,457) (129,955)
--------- --------- ---------
Unearned Compensation under ESOP:
Balance, beginning of period................................................. (73,527) -- --
ESOP expense................................................................. 73,527 -- --
--------- --------- ---------
Balance, end of period....................................................... -- -- --
--------- --------- ---------
Warrants Outstanding:
Balance, beginning of period................................................. 180 64 54
Exercise of warrants......................................................... (116) (10) (4)
Issuance of warrants to Crescent and COI..................................... -- -- 25,000
--------- --------- ---------
Balance, end of period....................................................... 64 54 25,050
--------- --------- ---------
Common Stock in treasury:
Balance, beginning of period................................................. -- (9,238) (82,731)
Purchases of treasury stock.................................................. (5,349) (73,493) --
Reacquisition of shares under shareholder note............................... (3,889) -- --
--------- --------- ---------
Balance, end of period....................................................... (9,238) (82,731) (82,731)
--------- --------- ---------
Cumulative Foreign Currency Adjustments:
Balance, beginning of period................................................. (2,454) (822) (1,982)
Foreign currency translation gain (loss)..................................... 1,632 (1,160) (1,138)
--------- --------- ---------
Balance, end of period....................................................... (822) (1,982) (3,120)
--------- --------- ---------
Total Stockholders' Equity..................................................... $ 88,560 $ 121,817 $ 158,250
--------- --------- ---------
--------- --------- ---------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-6
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEAR ENDED SEPTEMBER 30, JUNE 30,
------------------------------- ------------------------
<S> <C> <C> <C> <C> <C>
1995 1996 1997 1997 1998
--------- --------- --------- ----------- -----------
<CAPTION>
(IN THOUSANDS) (UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C> <C>
Cash Flows From Operating Activities
Net income (loss).................................... $ (42,963) $ 32,383 $ (498) $ (10,661) $ (20,269)
--------- --------- --------- ----------- -----------
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Loss (gain) on sale of assets.................... (2,961) (2,062) (5,747) (5,747) (3,000)
Depreciation and amortization.................... 64,087 48,924 44,861 38,231 37,649
Non-cash portion of unusual items and Managed
Care integration costs......................... 45,773 31,206 -- -- 2,160
Equity in loss of CBHS........................... -- -- 8,122 399 24,221
Loss on Crescent Transactions.................... -- -- 59,868 59,868 --
ESOP expense..................................... 73,527 -- -- -- --
Stock option expense (credit).................... (467) 914 4,292 3,214 (3,527)
Non-cash interest expense........................ 2,735 2,424 1,710 1,297 1,984
Extraordinary losses on early extinguishments of
debt........................................... -- -- 8,756 8,756 55,025
Cash flows from changes in assets and liabilities,
net of effects from sales and acquisitions of
businesses:
Accounts receivable, net......................... 7,280 15,495 60,675 18,521 (28,360)
Other current assets............................. 9,533 129 4,708 5,978 3,341
Restricted cash and investments.................. -- -- -- -- (8,268)
Other long-term assets........................... (5,813) 6,569 3,156 2,431 (11,333)
Accounts payable and accrued liabilities......... (11,645) (7,516) (60,659) (67,540) (18,428)
Income taxes payable and deferred income taxes... (16,761) 14,925 (14,669) (17,985) (16,544)
Reserve for unpaid claims........................ (5,885) (29,985) (26,553) (20,679) (16,083)
Other liabilities................................ (21,127) (18,968) (23,038) (17,400) (7,239)
Minority interest, net of dividends paid......... 22 6,406 9,633 7,498 4,354
Other............................................ 285 1,022 (1,018) (965) (1,084)
--------- --------- --------- ----------- -----------
Total adjustments................................ 138,583 69,483 74,097 15,877 14,868
--------- --------- --------- ----------- -----------
Net cash provided by (used in) operating
activities................................... 95,620 101,866 73,599 5,216 (5,401)
--------- --------- --------- ----------- -----------
Cash Flows From Investing Activities:
Capital expenditures................................. (20,224) (38,801) (33,348) (28,113) (26,938)
Acquisitions and investments in businesses, net of
cash acquired...................................... (61,980) (50,918) (50,876) (28,840) (1,033,155)
Decrease (increase) in assets restricted for
settlement of unpaid claims and other
long-term liabilities.............................. (19,606) (17,732) 17,209 12,551 46,943
Proceeds from sale of assets......................... 5,879 5,248 18,270 15,463 18,088
Proceeds from sale of property and equipment to
Crescent and CBHS,
net of transaction costs........................... -- -- 380,425 384,041 (6,070)
Other................................................ (1,050) -- -- -- --
--------- --------- --------- ----------- -----------
Net cash provided by (used in) investing
activities................................... (96,981) (102,203) 331,680 355,102 (1,001,132)
--------- --------- --------- ----------- -----------
Cash Flows From Financing Activities:
Payments on debt and capital lease obligations....... (46,779) (85,835) (390,254) (389,406) (438,563)
Proceeds from issuance of debt, net of issuance
costs.............................................. 28,869 104,800 203,643 203,643 1,169,887
Proceeds from issuance of common stock............... -- 68,573 -- -- --
Proceeds from exercise of stock options and
warrants........................................... 531 3,401 8,265 5,743 4,633
Proceeds from issuance of warrants................... -- -- 25,000 25,000 --
Purchases of treasury stock.......................... (5,349) (73,493) -- -- (12,456)
Income tax payments made on behalf of stock
optionee........................................... -- (1,678) -- -- --
--------- --------- --------- ----------- -----------
Net cash provided by (used in) financing
activities................................... (22,728) 15,768 (153,346) (155,020) 723,501
--------- --------- --------- ----------- -----------
Net increase (decrease) in cash and cash equivalents... (24,089) 15,431 251,933 205,298 (283,032)
Cash and cash equivalents at beginning of period....... 129,603 105,514 120,945 120,945 372,878
--------- --------- --------- ----------- -----------
Cash and cash equivalents at end of period............. $ 105,514 $ 120,945 $ 372,878 $ 326,243 $ 89,846
--------- --------- --------- ----------- -----------
--------- --------- --------- ----------- -----------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
F-7
<PAGE>
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1997
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements of Magellan Health Services, Inc., a
Delaware corporation, ("Magellan" or the "Company") include the accounts of the
Company and its subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.
On June 2, 1992, the Company filed a voluntary petition under Chapter 11 of
the United States Bankruptcy Code. The prepackaged plan of reorganization (the
"Plan") effected a restructuring of the Company's debt and equity
capitalization. The Company's Plan was confirmed on July 8, 1992, and became
effective on July 21, 1992, (effective on July 31, 1992, for financial reporting
purposes). The consolidated financial statements for the three years in the
period ended September 30, 1997, are presented for the Company after the
consummation of the Plan. These financial statements were prepared under the
principles of fresh start accounting. (See Note 3.)
The Company's primary segment of operations, as of September 30, 1997, was
the provision of a broad array of managed behavioral healthcare services to Blue
Cross/Blue Shield organizations, health maintenance organizations and other
insurance companies, corporations, federal, state and local government agencies,
labor unions and various state Medicaid programs. The Company operates in three
other segments. Through its public-sector operations, the Company also provides
a broad continuum of behavioral healthcare services to individuals who receive
healthcare benefits funded by state and local government agencies. The Company's
franchise operations segment franchises the "CHARTER" system of behavioral
healthcare to psychiatric hospitals and other facilities operated by Charter
Behavioral Health Systems, LLC ("CBHS"). See Note 4. The Company's provider
segment includes the ownership and operation of two psychiatric hospitals in
London, England, a 69-bed psychiatric hospital in Switzerland, hospital-based
joint ventures (See Note 2) and the 50% ownership of CBHS.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Actual results could differ from those estimates.
The unaudited consolidated financial statements of the Company as of June
30, 1998 and for the nine month periods ended June 30, 1997 and 1998 have been
prepared in accordance with generally accepted accounting principles for interim
financial information. Accordingly, certain information and footnotes required
by generally accepted accounting principles for complete financial statements
have been condensed or omitted. In the opinion of management, all adjustments,
consisting of normal recurring adjustments considered necessary for a fair
presentation, have been included. The results of operations for the period ended
June 30, 1998 are not necessarily indicative of the expected results for the
year ended September 30, 1998.
MANAGED CARE REVENUE
Managed care revenue is recognized over the applicable coverage period on a
per member basis for covered members and as earned and estimable for performance
based revenues. Deferred revenue is recorded when premium payments are received
in advance of the applicable coverage period.
F-8
<PAGE>
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FRANCHISE REVENUE
Continuing annual franchise fees are recognized as the fees are earned and
become receivable from the franchisee. Costs relating to continuing franchise
fees are expensed as incurred. Individual franchise sales are recognized when
all material services or conditions relating to the sale have been substantially
performed or satisfied by the Company. Direct costs relating to franchise sales
are deferred until the related revenue is recognized up to the amount of
anticipated revenue less estimated additional related costs.
PROVIDER NET REVENUE
Provider net revenue is based on established billing rates, less estimated
allowances for patients covered by Medicare and other contractual reimbursement
programs, and discounts from established billing rates. Amounts received by the
Company for treatment of patients covered by Medicare and other contractual
reimbursement programs, which may be based on cost of services provided or
predetermined rates, are generally less than the established billing rates of
the Company's hospitals. Final determination of amounts earned under contractual
reimbursement programs is subject to review and audit by the applicable
agencies. The Company recorded net revenue in fiscal 1995, 1996 and 1997 of
$35.6 million, $28.3 million and $27.4 million, respectively, for the settlement
and adjustment of reimbursement issues related to earlier fiscal periods.
Management believes that adequate provision has been made for any adjustments
that may result from such reviews.
ADVERTISING COSTS
The production costs of advertising are expensed as incurred. The Company
does not consider any of its advertising costs to be direct-response and,
accordingly, does not capitalize such costs. Advertising costs consist primarily
of radio and television air time, which is amortized as utilized, and printed
media services. Advertising expense was approximately $33.5 million, $30.5
million and $19.2 million for the years ended September 30, 1995, 1996 and 1997,
respectively.
CHARITY CARE
The Company provides healthcare services without charge or at amounts less
than its established rates to patients who meet certain criteria under its
charity care policies. Because the Company does not pursue collection of amounts
determined to be charity care, they are not reported as revenue. For the years
ended September 30, 1995, 1996 and 1997, the Company provided, at its
established billing rates, approximately $41.2 million, $37.9 million and $19.5
million, respectively, of such care.
INTEREST, NET
The Company records interest expense net of interest income. Interest income
for the years ended September 30, 1995, 1996, and 1997 was approximately $3.7
million, $10.5 million and $10.1 million, respectively.
CASH AND CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid interest-bearing investments
with a maturity of three months or less when purchased, consisting primarily of
money market instruments.
F-9
<PAGE>
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RESTRICTED CASH AND INVESTMENTS
Restricted cash and investments at June 30, 1998 (unaudited) include
approximately $60.5 million that is held for the payment of claims under the
terms of certain behavioral managed care contracts and for regulatory purposes
related to the payment of claims in certain jurisdictions.
CONCENTRATION OF CREDIT RISK
Franchise fee revenue and related receivables subject the Company to a
concentration of credit risk with franchisees. The Company establishes an
allowance for doubtful accounts based upon current and projected financial
performance of franchisees. No franchise fee receivables existed as of September
30, 1997.
Accounts receivable from patient revenue subject the Company to a
concentration of credit risk with third party payors that include insurance
companies, managed healthcare organizations and governmental entities. The
Company establishes an allowance for doubtful accounts based upon factors
surrounding the credit risk of specific payors, historical trends and other
information. Management believes the allowance for doubtful accounts is adequate
to provide for normal credit losses.
ASSETS RESTRICTED FOR THE SETTLEMENT OF UNPAID CLAIMS AND OTHER LONG-TERM
LIABILITIES
Assets restricted for the settlement of unpaid claims and other long-term
liabilities include investments which are carried at fair market value. Transfer
of such investments from the Company's insurance subsidiaries to Magellan or any
of its other subsidiaries is subject to approval by certain regulatory
authorities.
The investments are classified into three categories: (i) held to maturity;
(ii) available for sale; and (iii) trading. Unrealized holding gains or losses
are recorded for trading and available for sale securities. The Company's
investments are classified as available for sale. The unrealized gain or loss on
investments available for sale was not material at September 30, 1996 and 1997.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, except for assets that have been
impaired, for which the carrying amount is reduced to estimated fair value.
Expenditures for renewals and improvements are charged to the property accounts.
Replacements and maintenance and repairs that do not improve or extend the life
of the respective assets are expensed as incurred. Amortization of capital lease
assets is included in depreciation expense. Depreciation is provided on a
straight-line basis over the estimated useful lives of the assets, which is
generally 10 to 40 years for buildings and improvements and three to ten years
for equipment. Depreciation expense was $35.1 million, $40.0 million and $34.1
million for the years ended September 30, 1995, 1996 and 1997, respectively.
INTANGIBLE ASSETS
Intangible assets are composed principally of (i) goodwill, (ii) customer
lists, (iii) non-compete agreements and (iv) deferred financing costs. Goodwill
represents the excess of the cost of businesses acquired over the fair value of
the net identifiable assets at the date of acquisition and is amortized using
the straight-line method over 25 to 40 years. Customer lists are amortized using
the straight-line method over their estimated useful lives of 5 to 25 years.
Non-compete agreements and deferred financing costs are amortized over the term
of the related agreements.
F-10
<PAGE>
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The Company continually monitors events and changes in circumstances that
could indicate carrying amounts of intangible assets may not be recoverable.
When events or changes in circumstances are present that indicate the carrying
amount of intangible assets may not be recoverable, the Company assesses the
recoverability of intangible assets by determining whether the carrying value of
such intangible assets will be recovered through the future cash flows expected
from the use of the asset and its eventual disposition. No impairment losses on
intangible assets were recorded by the Company in 1996. Impairment losses of
approximately $4.0 million and $14.4 million were recorded in fiscal 1995 and
fiscal 1997, respectively. (See Note 4 and 6)
MEDICAL CLAIMS PAYABLE
Medical claims payable represent the liability for healthcare services
authorized, incurred and not yet reported to the Company's managed care
business. Medical claims payable are estimated based upon authorized healthcare
services, past claim payment experience for member groups and other factors.
While Management believes the liability for medical claims payable is adequate,
actual results could differ from such estimates.
FOREIGN CURRENCY
Changes in the cumulative translation of foreign currency assets and
liabilities are presented as a separate component of stockholders' equity. Gains
and losses resulting from foreign currency transactions, which were not
material, are included in operations as incurred.
NET INCOME (LOSS) PER COMMON SHARE
Net income (loss) per common share is computed based on the weighted average
number of shares of common stock and common stock equivalents outstanding during
the period. Common stock equivalents, which include unexercised stock options
and warrants, were anti-dilutive in fiscal 1995 and not material in fiscal 1996.
Accordingly, they were excluded from the fiscal 1995 and fiscal 1996
calculations.
The Exchange Option, as hereinafter defined (see Note 2), is classified as a
potentially dilutive security for fiscal 1996 and 1997 and for the six month
periods ended March 31, 1997 and 1998 for the purpose of computing diluted
income per common share. The Exchange Option was anti-dilutive for fiscal 1996,
fiscal 1997 and for the nine month periods ended June 30, 1997 and 1998 and,
therefore, was excluded from the respective calculations.
STOCK-BASED COMPENSATION
In October 1995, the FASB issued Statement of Financial Accounting Standards
No. 123 ("FAS 123") "Accounting for Stock-Based Compensation," which became
effective for fiscal years beginning after December 15, 1995 (fiscal 1997 for
the Company). FAS 123 established new financial accounting and reporting
standards for stock-based compensation plans. Entities are allowed to measure
compensation cost for stock-based compensation under FAS 123 or APB Opinion No.
25, "Accounting for Stock Issued to Employees." Entities electing to remain with
the accounting in APB Opinion No. 25 are required to make pro forma disclosures
of net income and earnings per share as if the provisions of FAS 123 had been
applied. The Company has adopted FAS 123 on a pro forma disclosure basis (see
Note 9).
F-11
<PAGE>
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RECLASSIFICATIONS
Certain reclassifications have been made to fiscal 1996 amounts to conform
to fiscal 1997 presentation.
2. ACQUISITIONS AND JOINT VENTURES
ACQUISITIONS
On December 13, 1995, the Company acquired a 51% ownership interest in Green
Spring Health Services, Inc. ("Green Spring") for approximately $68.9 million in
cash, the issuance of 215,458 shares of Magellan Common Stock valued at
approximately $4.3 million and the contribution of Group Practice Affiliates,
Inc. ("GPA"), a wholly-owned subsidiary of the Company, which became a
wholly-owned subsidiary of Green Spring. On December 20, 1995, the Company
acquired an additional 10% ownership interest in Green Spring for approximately
$16.7 million in cash as a result of an exercise by a minority stockholder of
its Exchange Option (as hereinafter defined) for a portion of the stockholder's
interest in Green Spring. The Company has a 61% ownership interest in Green
Spring. As of September 30, 1997, Green Spring provided managed behavioral
healthcare services, which includes utilization management, care management and
employee assistance programs, through a 50-state provider network for
approximately 16.6 million people nationwide.
The minority stockholders of Green Spring consist of four Blue Cross/Blue
Shield organizations (the "Blues") that are key customers of Green Spring. In
addition, two other Blues organizations that formerly owned a portion of Green
Spring are customers of Green Spring. As of September 30, 1997 and December 31,
1997, the minority stockholders of Green Spring had the option, under certain
circumstances, to exchange their ownership interests ("Exchange Option") in
Green Spring for 2,831,516 shares of the Company's Common Stock or $65.1 million
in subordinated notes. The Company may elect to pay cash in lieu of issuing the
subordinated notes. The Exchange Option expires December 13, 1998. The Exchange
Option, if exercised by the minority stockholders of Green Spring, would be
recorded at the fair value of the consideration paid. See Note 18 for a
discussion regarding the Exchange Option conversion.
The Company recorded the investments in Green Spring using the purchase
method of accounting. Green Spring's results of operations have been included in
the consolidated financial statements since the acquisition date, less minority
interest.
The cost of the investments in Green Spring have been allocated to the
estimated fair value of assets acquired and liabilities assumed to the extent
acquired by the Company. The remaining portion of Green Spring's assets and
liabilities has been recorded at the historical cost basis of the minority
stockholders. The purchase price allocation for the investments in Green Spring
and the historical cost basis of the minority stockholders of Green Spring, in
aggregate, resulted in goodwill of approximately $89 million and identifiable
intangible assets of approximately $24 million.
At each reporting date, the Company must assess the fair value of the
Exchange Option in relation to the redemption price available to the minority
stockholders. In any period that the fair value of the Exchange Option is
determined to be less than the redemption price, the difference must be
recognized as an adjustment to minority interest. Subsequent increases in the
fair value of the Exchange Option can be recognized only to the extent of
previously recognized losses. No losses were recorded in fiscal 1996 and 1997 as
a result of changes in the fair value of the Exchange Option.
F-12
<PAGE>
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED)
In February 1995, the Company acquired Westwood Pembroke Health System,
which included two psychiatric hospitals and a professional group practice. The
Company accounted for the acquisition using the purchase method of accounting.
In January 1995, the Company acquired National Mentor, Inc. ("Mentor") by
issuing 1,409,978 shares of Common Stock. Mentor provides specialized health
services in mentor homes. The acquisition was accounted for as a pooling of
interests, effective January 1, 1995. The consolidated financial statements of
the Company were not restated for periods prior to January 1, 1995, as the
effect of restatement would not have been material to such periods.
During fiscal 1994, the Company agreed to acquire 40 psychiatric hospitals
(the "Acquired Hospitals") from Tenet Healthcare Corporation, formerly known as
National Medical Enterprises. The purchase price for the Acquired Hospitals was
approximately $120.4 million in cash plus an additional cash amount of
approximately $51 million, subject to adjustment, for the net working capital of
the Acquired Hospitals (the "Hospital Acquisition").
On June 30, 1994, the Company completed the purchase of 27 of the Acquired
Hospitals for a cash purchase price of approximately $129.6 million, which
included approximately $39.3 million, subject to adjustment, for the net working
capital of the facilities. On October 31, 1994, the Company completed the
purchase of three additional Acquired Hospitals for a cash purchase price of
approximately $5 million, which included approximately $2.2 million related to
the net working capital of the facilities. On November 30, 1994, the Company
completed the purchase of the remaining ten Acquired Hospitals for a cash
purchase price of approximately $36.8 million, including approximately $9.5
million related to the net working capital of ten Acquired Hospitals. The
Company accounted for the Hospital Acquisition using the purchase method of
accounting. The operating results of the Acquired Hospitals are included in the
Company's Consolidated Statements of Operations from the respective dates of
acquisition.
JOINT VENTURES
The Company has entered into four hospital-based joint ventures ("Columbia
JV's") with Columbia/ HCA Healthcare Corporation. Generally, each member of the
joint venture leased and/or contributed certain assets in each respective market
to the joint venture with the Company becoming the managing member.
The Columbia JV's results of operations have been included in the
consolidated financial statements since inception, less minority interest. A
summary of the Columbia JV's is as follows:
<TABLE>
<CAPTION>
OWNERSHIP
MARKET DATE PERCENTAGE
- ------------------------------------------ ---------------- -----------------
<S> <C> <C>
Albuquerque, NM........................... May 1995 67%
Raleigh, NC............................... June 1995 50%
Lafayette, LA............................. October 1995 50%
Anchorage, AK............................. August 1996 57%
</TABLE>
The Company's ownership interests in the Columbia JV's and other
hospital-based joint ventures have been managed by CBHS (as defined in Note 1)
for a fee equivalent to Magellan's portion of the joint ventures earnings since
June 17, 1997.
3. THE RESTRUCTURING AND FRESH START REPORTING
The consummation of the Plan discussed in Note 1 resulted in, among other
things, (i) a reduction of approximately $700 million in long-term debt, (ii)
elimination of $233 million of preferred stock and
F-13
<PAGE>
3. THE RESTRUCTURING AND FRESH START REPORTING (CONTINUED)
(iii) the issuance of approximately 24.8 million shares of Common Stock to
certain holders of debt securities, the preferred stockholders and common
stockholders.
As a result of the consummation of the Plan, the financing under the $880
Million Credit Agreement between the Company and certain banks dated September
1, 1988 was replaced by new facilities under the Amended and Restated Credit
Agreement, dated July 21, 1992, among the Company and certain banks (the "Credit
Agreement").
Upon consummation of the Plan, the Company recognized an extraordinary gain
on debt discharge of approximately $731 million which represented forgiveness of
debt, principal and interest, reduced by the estimated fair value of Common
Stock issued to certain debtholders of the Company. The Company's long-term debt
was stated at the present value of amounts to be paid, based on market interest
rates on July 31, 1992. This adjustment to present value resulted in an
aggregate carrying amount for the Company's long-term debt which was less than
the aggregate principal amount thereof, and resulted in the amortization of the
difference into interest expense over the terms of the debt instruments and,
upon extinguishment of the debt prior to scheduled maturity, resulted in a loss
on debt extinguishment.
Under the principles of fresh start accounting, the Company's total assets
were recorded at their assumed reorganization value, with the reorganization
value allocated to identifiable tangible assets on the basis of their estimated
fair value. Accordingly, the Company's property and equipment were reduced and
its intangible assets were written off. In addition, the Company's accumulated
deficit, common stock in treasury and cumulative foreign currency adjustments
were eliminated. The excess of the reorganization value over the value of
identifiable assets was reported as "reorganization value in excess of amounts
allocable to identifiable assets" (the "Excess Reorganization Value").
The total reorganization value assigned to the Company's assets was
estimated by calculating projected cash flows before debt service requirements,
for a five-year period, plus an estimated terminal value of the Company
(calculated using a multiple of approximately six (6) on projected EBDIT (which
is net revenue less operating and bad debt expenses)), each discounted back to
its present value using a discount rate of 12% (representing the estimated
after-tax weighted cost of capital). This amount was approximately $1.2 billion
and was increased by (i) the estimated net realizable value of assets to be sold
and (ii) estimated cash in excess of normal operating requirements. The above
calculations resulted in an estimated reorganization value of approximately $1.3
billion, of which the Excess Reorganization Value was $225 million, of which
$129 million related to continuing operations. The Excess Reorganization Value
was amortized over the three-year period ended July 31, 1995.
4. CRESCENT TRANSACTIONS
On June 17, 1997, the Company consummated a series of transactions including
the sale of substantially all of its domestic hospital real estate and related
personal property (the "Assets") to Crescent Real Estate Equities Limited
Partnership ("Crescent") and CBHS. In addition, CBHS was formed as a joint
venture to operate the domestic portion of the Company's provider business
segment. CBHS is owned equally by Magellan and Crescent Operating, Inc., an
affiliate of Crescent ("COI"). The Company accounts for its 50% investment in
CBHS under the equity method of accounting (See Note 5). The Company received
approximately $417.2 million in cash (before costs estimated to be $16.0
million) and warrants in COI for the purchase of 2.5% of COI's common stock at
$18.32, which are exercisable over 12 years. The Company also issued 1,283,311
warrants each to Crescent and COI (the "Crescent Warrants") for the purchase of
Magellan common stock at an exercise price of $30 per share. (See Note 9.)
F-14
<PAGE>
4. CRESCENT TRANSACTIONS (CONTINUED)
In related agreements, (i) Crescent leased the hospital real estate and
related assets to CBHS for annual rent beginning at approximately $41.7 million
with a 5% annual escalation clause compounded annually (the "Facilities Lease")
and (ii) CBHS will pay Magellan approximately $78.3 million in annual franchise
fees, subject to increase, for the use of assets retained by Magellan and for
support in certain areas. The franchise fees to be paid by CBHS to the Company
are subordinated to the lease obligations in favor of Crescent. The assets
retained by Magellan include, but are not limited to, the "CHARTER" name,
intellectual property, protocols and procedures, clinical quality management,
operating processes and the "1-800-CHARTER" telephone call center. Magellan
provides CBHS ongoing support in areas including advertising and marketing
assistance, risk management services, outcomes monitoring, and consultation on
matters relating to reimbursement, government relations, clinical strategies,
regulatory matters, strategic planning and business development.
The Company initially used a portion of the proceeds from the sale of the
Assets to reduce its long-term debt, including borrowings under its then
existing credit agreement (See Note 8.) In December 1997, the Company used the
remaining proceeds from the sale of the Assets to acquire additional managed
care businesses (See Note 18).
The Company recorded a loss before income taxes of approximately $59.9
million as a result of the Crescent Transactions, which consisted of the
following (in thousands):
<TABLE>
<S> <C>
Accounts receivable collection fees............................... $ 21,400
Impairment losses on intangible assets............................ 14,408
Exit costs and construction obligation............................ 12,549
Loss on the sale of property and equipment........................ 11,511
---------
$ 59,868
---------
---------
</TABLE>
Accounts receivable collection fees represent the reduction in the net
realizable value of accounts receivable for estimated collection fees on
retained hospital-based receivables for CBHS pursuant to a contractual
obligation with CBHS, whereby CBHS receives a fee equal to 5% of collections for
the first 120 days after consummation of the Crescent Transaction and estimated
bad debt agency fees of 40% for receivables collected subsequent to 120 days
after the consummation of the Crescent Transaction.
The Company disposed of a significant portion of its provider business
segment as part of the Crescent Transactions. The impairment loss on intangible
assets results from reducing the book value of the Company's investment in CBHS
to its approximate fair value at the consummation date. The fair value of CBHS
was determined by the Company's financial advisors using a discounted cash flows
analysis. The impairment losses represent the carrying amount of goodwill and
other intangible assets related to the divested or contributed CBHS operations.
The $5.0 million of exit costs accrued as a result of the Crescent
transactions include incremental staffing, consulting and related costs to
prepare and coordinate audits of terminating Medicare cost reports, prepare and
file income tax, property tax, sales and use tax and other tax returns and
perform accounting functions related to the divested businesses (CBHS). The
Company incurred approximately $0.6 million of such costs during the year ended
September 30, 1997.
The Company is constructing a hospital in Philadelphia as required by the
Crescent Real Estate Purchase Agreement to replace the existing Philadelphia
hospital operated by CBHS. The Company has incurred approximately $2.7 million
in construction costs as of September 30, 1997 and expects to incur up to $4.9
million in additional construction costs before completion.
F-15
<PAGE>
4. CRESCENT TRANSACTIONS (CONTINUED)
The Company's Consolidated Statement of Operations for the years ended
September 30, 1996 and 1997 include the operations of businesses divested as
part of the Crescent Transactions through June 16, 1997. The following unaudited
pro forma information for the years ended September 30, 1996 and 1997 has been
prepared assuming the Crescent Transactions were consummated on October 1, 1995.
The pro forma information does not purport to be indicative of the results which
would have actually been obtained had the Crescent Transactions been consummated
on October 1, 1995 or which may be attained in future periods (in thousands,
except per share data).
<TABLE>
<CAPTION>
PRO FORMA
FOR THE YEARS ENDED
SEPTEMBER 30,
------------------------
<S> <C> <C>
1996 1997
----------- -----------
Net revenue......................................................... $ 628,249 $ 710,835
Income before extraordinary items(1)................................ 20,481 32,149
Net income(1)....................................................... 20,481 26,896
Income per common share--basic:
Income before extraordinary items(1).............................. 0.72 1.12
Net income(1)..................................................... 0.72 0.93
Income per common share--diluted:
Income before extraordinary items(1).............................. 0.71 1.09
Net income(1)..................................................... 0.71 0.91
</TABLE>
- ------------------------
(1) Excludes the loss on the Crescent Transactions and assumes the excess
proceeds from the Crescent Transactions are not invested.
F-16
<PAGE>
5. INVESTMENT IN CBHS
The Company became a 50% owner of CBHS upon consummation of the Crescent
Transactions on June 17, 1997. The Company accounts for its investment in CBHS
using the equity method.
A summary of financial information for CBHS is as follows (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, 1997 JUNE 30, 1998
-------------------- ---------------
<S> <C> <C>
(UNAUDITED)
Current assets......................................... $ 148,537 $ 156,385
Property and equipment, net............................ 18,424 14,917
Other noncurrent assets................................ 8,633 10,211
---------- ---------------
Total Assets......................................... $ 175,594 $ 181,513
---------- ---------------
---------- ---------------
Current liabilities.................................... $ 68,497 $ 112,681
Long-term debt......................................... 65,860 65,000
Other noncurrent liabilities........................... 7,481 28,889
Members' capital (deficiency).......................... 33,756 (25,057)
---------- ---------------
Total Liabilities and Members' Capital............... $ 175,594 $ 181,513
---------- ---------------
---------- ---------------
</TABLE>
<TABLE>
<CAPTION>
NINE MONTHS
106 DAYS ENDED 14 DAYS ENDED ENDED
SEPTEMBER 30, 1997 JUNE 30, 1997 JUNE 30, 1998
-------------------- --------------- ---------------
<S> <C> <C> <C>
(UNAUDITED) (UNAUDITED)
Net revenue.......................... $ 213,730 $ 29,865 $ 553,370
---------- --------------- ---------------
Operating expenses................... 228,382 30,565 605,462
Interest, net........................ 1,592 98 3,975
---------- --------------- ---------------
Net loss before preferred member
distribution..................... $ (16,244) $ (798) $ (56,067)
---------- --------------- ---------------
---------- --------------- ---------------
Cash used in operating activities.... $ (67,831) $ (13,996) $ (4,553)
---------- --------------- ---------------
---------- --------------- ---------------
Magellan's portion of net loss....... $ (8,122) $ (399) $ (28,034)
Intercompany loss elimination........ -- -- 3,813(1)
---------- --------------- ---------------
Magellan equity loss................. $ (8,122) $ (399) $ (24,221)
---------- --------------- ---------------
---------- --------------- ---------------
</TABLE>
F-17
<PAGE>
5. INVESTMENT IN CBHS (CONTINUED)
The Company's transactions with CBHS and related balances are as follows (in
thousands):
<TABLE>
<CAPTION>
106 DAYS ENDED 14 DAYS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 1997 JUNE 30, 1997 JUNE 30, 1998
-------------------- -------------- --------------------------
<S> <C> <C> <C>
(UNAUDITED) (UNAUDITED)
Franchise Fee revenue...... $ 22,739 $ 3,164 $ 51,100(1)
-------- ------- --------
Costs:
Accounts receivable
collection fees........ 4,993 1,426 1,862
Hospital-based joint
venture management
fees................... 1,853 417 5,191
<CAPTION>
SEPTEMBER 30, 1997 JUNE 30, 1998
-------------------- --------------
(UNAUDITED)
<S> <C> <C> <C>
Due to CBHS, net............................ $ (5,090) $ (4,384)(2)
-------- --------
-------- --------
Franchise fees receivable................... $ -- $ 20,500 (3
-------- --------
-------- --------
Equity in loss of CBHS in excess of
investment................................ $ -- $ (7,344)
-------- --------
-------- --------
Prepaid CHARTER call center management
fees...................................... $ -- $ 3,937
-------- --------
-------- --------
</TABLE>
- ------------------------
(Unaudited)
(1) Based on the original terms of the CBHS Transactions (as defined), the
Franchise Fees were reduced to $5.0 million per month from approximately
$6.5 million per month, effective February 1, 1998, through the consummation
date of the CBHS Transactions. In the event that the CBHS Transactions are
not consummated, no adjustment will be made to the Franchise Fees. The
Company's Franchise Fee revenue for the nine months ended June 30, 1998,
reflects the reduced Franchise Fee revenue, since February 1, 1998, while
CBHS recorded Franchise Fee expense of approximately $6.5 million per month
in its financial statements. Accordingly, the Company has eliminated the
intercompany loss for the proportionate share of the difference between
Franchise Fee revenue and expense reflected in the Company's financial
statements and CBHS' financial statements.
(2) The nature of hospital accounts receivable billing and collection processes
have resulted in the Company and CBHS receiving remittances from payors
which belong to the other party. Additionally, the Company and CBHS have
established a settlement and allocation process for the accounts receivable
related to those patients who were not yet discharged from their treatment
on June 16, 1997. In an effort to settle these amounts on a timely basis,
and in light of CBHS start up operations and cash flow requirements, the
Company made advances to CBHS periodically during the nine months ending
June 30, 1998, which have been repaid by CBHS. Such advances, net of all
settlement activity and certain other amounts due to CBHS for certain shared
services and related matters, resulted in the amount shown above as due to
CBHS.
(3) CBHS did not pay all of its Franchise Fee obligation for February 1998
through June 1998.
F-18
<PAGE>
6. UNUSUAL ITEMS
GENERAL
The following table summarizes unusual items recorded during the three years
in the period ended September 30, 1997 (in thousands):
<TABLE>
<CAPTION>
1995 1996 1997
--------- --------- ---------
<S> <C> <C> <C>
Insurance Settlements........................................ $ 29,800 $ 30,000 $ --
Facility Closures............................................ 3,624 4,116 4,201
Asset impairments............................................ 26,973 1,207 --
Gains on the Sale of Psychiatric Hospitals, net.............. (2,960) -- (5,388)
Other........................................................ -- 1,948 1,544
--------- --------- ---------
$ 57,437 $ 37,271 $ 357
--------- --------- ---------
--------- --------- ---------
</TABLE>
INSURANCE SETTLEMENTS
Unusual items included the resolutions of disputes between the Company and
insurance carriers concerning certain billings for services.
In November 1994, the Company and a group of insurance carriers resolved a
billing dispute that arose in the fourth quarter of fiscal 1994 related to
claims paid predominantly in the 1980's. As part of the resolution, the Company
agreed to pay the insurance carriers approximately $31 million plus interest,
for a total of $37.5 million in four installments over a three year period. As
part of the settlement, the Company and the insurance carriers agreed to
continue to do business at the same or similar general levels as prior to the
settlement. Furthermore, the parties will seek additional business opportunities
that will serve to enhance their present relationships.
In March 1995, the Company and a group of insurance carriers resolved a
billing dispute which arose in fiscal 1995 related to matters arising
predominately in the 1980's. As part of the settlement, the Company agreed to
pay the insurance carriers $29.8 million payable in five installments over a
three year period. As part of the settlement, the Company and the insurance
carriers have agreed to continue to do business at the same or similar general
levels and to seek additional business opportunities that will serve to enhance
their present relationships.
In August 1996, the Company and a group of insurance carriers resolved a
billing dispute which arose in fiscal 1996 related to matters originating in the
1980's. As part of the settlement of these claims, certain related payer matters
and associated legal fees, the Company recorded a charge of approximately $30.0
million during the quarter ended June 30, 1996. The Company will pay the
insurance settlement amount in twelve installments over a three year period,
beginning August 1996. As part of the settlement, the Company and the insurance
carriers agreed that the dispute and settlement would not negatively impact any
present or pending business relationships nor would it prevent the parties from
negotiating in good faith concerning additional business opportunities available
to, and future relationships between, the parties.
Amounts payable in future periods for insurance settlements are as follows
(in thousands):
<TABLE>
<CAPTION>
<S> <C>
1998........................................................... $ 12,788
1999........................................................... 5,985
</TABLE>
F-19
<PAGE>
6. UNUSUAL ITEMS (CONTINUED)
FACILITY CLOSURES
During fiscal 1995, 1996 and 1997, the Company consolidated, closed or sold
fifteen, nine and three psychiatric facilities and its one general hospital (the
"Closed Facilities"), respectively, exclusive of the Crescent Transactions. The
three psychiatric facilities closed in 1997 were sold as part of the Crescent
Transactions. The Closed Facilities that are still owned by the Company will be
sold, leased or used for alternative purposes depending on the market conditions
in each geographic area and are recorded as other long-term assets in the
accompanying balance sheets.
The Company recorded charges of approximately $3.6 million, $4.1 million and
$4.2 million related to facility closures in fiscal 1995, 1996 and 1997,
respectively, as follows (in thousands):
<TABLE>
<CAPTION>
1995 1996 1997
--------- --------- ---------
<S> <C> <C> <C>
Severance and related benefits................................. $ 2,132 $ 2,334 $ 2,976
Contract terminations and other................................ 1,492 1,782 1,225
--------- --------- ---------
$ 3,624 $ 4,116 $ 4,201
--------- --------- ---------
--------- --------- ---------
</TABLE>
Approximately 500, 620 and 700 employees were terminated at the facilities
closed in fiscal 1995, 1996 and 1997, respectively. Severance and related
benefits have been substantially paid as of September 30, 1997. Other exit costs
paid and applied against the resulting liabilities were approximately $0.2
million, $1.4 million and $0.1 million in fiscal 1995, 1996 and 1997,
respectively.
The following table presents net revenue, salaries, cost of care and other
operating expenses and bad debt expenses and depreciation and amortization of
the Closed Facilities (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
---------------------------------
<S> <C> <C> <C>
1995 1996 1997
----------- --------- ---------
Net revenue.............................................. $ 149,428 $ 82,568 $ 19,582
Salaries, cost of care and other operating expense and
bad debt expenses...................................... 145,720 86,426 23,263
Depreciation and amortization............................ 3,509 2,015 349
</TABLE>
The Company also recorded a charge of approximately $2.0 million in fiscal
1996 related to severance and related benefits for approximately 275 employees
who were terminated pursuant to planned overhead reductions.
ASSET IMPAIRMENTS
During fiscal 1995, the Company recorded impairment losses on property and
equipment and intangible assets of approximately $23.0 million and $4.0 million,
respectively. During fiscal 1996, the Company recorded impairment losses on
property and equipment of approximately $1.2 million. Such losses resulted from
changes in the manner that certain of the Company's assets were to be used in
future periods and current period operating losses at certain of the Company's
operating facilities combined with projected future operating losses. Fair
values of the long-lived assets that have been written down were determined
using the best available information in each individual circumstance, which
included quoted market price, comparable sales prices for similar assets or
valuation techniques utilizing present value of estimated expected cash flows.
Most of the impaired assets were sold as part of the Crescent Transactions.
F-20
<PAGE>
6. UNUSUAL ITEMS (CONTINUED)
OTHER
During fiscal 1995 and 1997, the Company recorded gains of approximately
$3.0 million and $5.4 million, respectively, related to the sales of psychiatric
hospitals and other real estate. The Company also recorded a charge of
approximately $1.6 million during fiscal 1997 for costs incurred related
primarily to the expiration of its agreement to sell its three European
Hospitals.
7. BENEFIT PLANS
The Company maintains an Employee Stock Ownership Plan (the "ESOP"), a
noncontributory retirement plan that enables eligible employees to participate
in the ownership of the Company.
The Company had recorded unearned compensation to reflect the cost of Common
Stock purchased by the ESOP but not yet allocated to participants' accounts. In
the period that shares are allocated or projected to be allocated to
participants, ESOP expense is recorded and unearned compensation is reduced. All
shares had been allocated to the participants as of September 30, 1995. The ESOP
distributed 103,332 shares to participants who were transferred to CBHS as a
result of the Crescent Transactions in fiscal 1997.
The Internal Revenue Service has ruled that the ESOP qualifies under Section
401 of the Internal Revenue Code of 1986, as amended. Such determination allowed
the Company to deduct its contributions to the ESOP for federal income tax
purposes.
During fiscal 1992, the Company reinstated a defined contribution plan (the
"Magellan 401-K Plan"). Effective January 1, 1997, the plan was amended to allow
participants to contribute up to 15% of their compensation to the Magellan 401-K
Plan. The Company makes a discretionary contribution of 2% of each employee's
compensation and matches 50% of each employee's contribution up to 3% of their
compensation. During the years ended September 30, 1995, 1996 and 1997, the
Company made contributions of approximately $5.8 million, $5.3 million and $5.7
million, respectively, to the Magellan 401-K Plan.
Green Spring also maintains a defined contribution plan (the "Green Spring
401-K Plan"). Employee participants can elect to voluntarily contribute up to 6%
or 12% of their compensation, depending upon each employee's compensation level,
to the Green Spring 401-K Plan. Green Spring matches up to 3% of each employee's
compensation. Employees vest in employer contributions over five years. During
the years ended September 30, 1996 and 1997, Green Spring contributed
approximately $0.8 million and $1.3 million, respectively, to the Green Spring
401-K Plan.
F-21
<PAGE>
8. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
Information with regard to the Company's long-term debt and capital lease
obligations at September 30, 1996 and 1997 and June 30, 1998 is as follows (in
thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, SEPTEMBER 30, JUNE 30,
1996 1997 1998
-------------- -------------- --------------
<S> <C> <C> <C>
(UNAUDITED)
Magellan Existing Credit Agreement due
through 2002.............................. $ 105,593 $ -- $ --
11.25% Series A Senior Subordinated Notes
due 2004.................................. 375,000 375,000 --
New Credit Agreement (unaudited):
Revolving Facility (7.91% at June 30,
1998) due through 2004.................. -- -- 20,000
Term Loan Facility (7.91% to 8.41% at June
30, 1998) due through 2006.............. -- -- 550,000
9.0% Senior Subordinated Notes due 2008
(unaudited)............................... -- -- 625,000
6.71% to 11.5% Mortgage and other notes
payable through 2005...................... 12,163 7,721 4,278
Variable rate secured notes................. 60,875 -- --
7.5% Swiss Bonds............................ 6,443 6,443 --
3.9% Capital lease obligations due through
2014...................................... 12,333 6,438 6,438
-------------- -------------- --------------
572,407 395,602 1,205,716
Less amounts due within one year.......... 5,751 3,601 16,585
Less debt service funds................... 349 308 --
-------------- -------------- --------------
$ 566,307 $ 391,693 $ 1,189,131
-------------- -------------- --------------
-------------- -------------- --------------
</TABLE>
The aggregate scheduled maturities of long-term debt and capital lease
obligations during the five years subsequent to September 30, 1997 are as
follows (in thousands): 1998--$3,601; 1999--$3,252; 2000--$28; 2001--$6,165 and
2002--$28.
The 11.25% Series A Senior Subordinated Notes (the "Magellan Outstanding
Notes"), which are carried at cost, had a fair value of approximately $405
million and $417 million at September 30, 1996 and 1997, respectively, based on
market quotes. The Company's remaining debt is also carried at cost, which
approximates fair market value.
NEW REVOLVING CREDIT AGREEMENTS
On October 28, 1996, the Company entered into a credit agreement with
certain financial institutions for a five-year Senior Secured reducing revolving
credit facility in an aggregate committed amount of $400 million. The Company
borrowed approximately $121.0 million under such credit agreement in October
1996 to (i) repay the existing borrowings outstanding under their existing
credit agreement and (ii) pay for fees and expenses related to the credit
agreement.
The loans outstanding under the credit agreement bore interest (subject to
certain potential adjustments) at a rate per annum equal to one, two, three or
six-month LIBOR plus 1.25% or the Prime Lending Rate.
The Company recorded an extraordinary loss from the early extinguishment of
debt of approximately $3.0 million, net of tax, during the quarter ended
December 31, 1996 to write off unamortized deferred financing costs related to
the previous credit agreement.
F-22
<PAGE>
8. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS (CONTINUED)
On June 17, 1997, the Company entered into a new credit agreement with
certain financial institutions for a five-year senior secured revolving credit
facility in an aggregate committed amount of $200 million (the "Magellan
Existing Credit Agreement"). The Company repaid approximately $191.8 million of
borrowings outstanding under the previous credit agreement, which included
borrowings to retire approximately $66 million of variable rate secured notes
and other long-term debt, with proceeds from the Crescent Transactions.
The loans outstanding under the Magellan Existing Credit Agreement bear
interest (subject to certain potential adjustments) at a rate per annum equal to
one, two, three or six-month LIBOR plus 1.25% or the Alternative Base Rate
("ABR"), as defined, plus .25%. Interest on ABR loans is payable at the end of
each fiscal quarter. Interest on LIBOR-based loans is payable at the end of
their respective terms, but a minimum of every three months.
The Company recorded an extraordinary loss of approximately $2.3 million,
net of tax, during the quarter ended June 30, 1997 to write off unamortized
deferred financing costs related to the previous credit agreement and for costs
related to repaying the variable rate secured notes.
SENIOR SUBORDINATED NOTES
On May 2, 1994, the Company issued $375 million of 11.25% Series A Senior
Subordinated Notes which mature on April 15, 2004 and are general unsecured
obligations of the Company. Interest on the Magellan Outstanding Notes is
payable semi-annually on each April 15 and October 15. Proceeds of $181.8
million from the sale of the Magellan Outstanding Notes were used to decrease,
and, subsequently on June 9, 1994, to redeem the Company's outstanding 7.5%
Senior Subordinated Debentures due 2003. Certain remaining proceeds were used,
along with proceeds from the credit agreement, to finance the Hospital
Acquisition. The Magellan Outstanding Notes are guaranteed on an unsecured
senior subordinated basis by substantially all of the Company's existing
subsidiaries and certain subsidiaries created after the issuance of the Magellan
Outstanding Notes.
The Magellan Outstanding Notes are not redeemable at the option of the
Company prior to April 15, 1999. Thereafter, the Magellan Outstanding Notes will
be subject to redemption at the option of the Company, in whole or in part, at
the redemption prices (expressed as a percentage of the principal amount) set
forth below, plus accrued and unpaid interest thereon to the applicable
redemption date, if redeemed during the twelve-month period beginning April 15
of the years indicated below:
<TABLE>
<CAPTION>
REDEMPTION
YEAR PRICE
- ------------------------------------------------------------ ------------
<S> <C>
1999........................................................ 105.625%
2000........................................................ 103.750%
2001........................................................ 101.875%
2002 and thereafter......................................... 100.000%
</TABLE>
COVENANTS
The Magellan Existing Credit Agreement and the indenture for the Magellan
Outstanding Notes contain a number of restrictive covenants, which, among other
things, limit the ability of the Company and certain of its subsidiaries to
incur other indebtedness, engage in transactions with affiliates, repurchase
shares of the Company's common stock above specified levels, incur liens, make
certain restricted payments, and enter into certain business combination and
asset sale transactions. The Magellan Existing Credit Agreement also requires
the Company to maintain certain specified financial ratios. The Company was in
compliance with all debt covenants under the Magellan Existing Credit Agreement
and the Magellan Outstanding Notes at September 30, 1997.
F-23
<PAGE>
8. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS (CONTINUED)
LEASES
The Company leases certain of its operating facilities, some of which may be
purchased during the term or at expiration of the leases. The book value of
capital leased assets was approximately $3.5 million at September 30, 1997. The
leases, which expire at various dates through 2069, generally require the
Company to pay all maintenance, property tax and insurance costs.
At September 30, 1997, aggregate amounts of future minimum payments under
operating leases were as follows: 1998--$12.4 million; 1999--$10.8 million;
2000--$8.9 million; 2001--$7.1 million; 2002--$5.2 million; subsequent to
2002--$47.7 million.
Rent expense for the years ended September 30, 1995, 1996 and 1997 was $15.4
million, $18.7 million and $19.2 million, respectively.
See Note 18--"Subsequent Events--Effect of the Merit Acquisition on
Long-Term Debt."
F-24
<PAGE>
9. STOCKHOLDERS' EQUITY
Pursuant to the Company's Restated Certificate of Incorporation, the Company
is authorized to issue 80 million shares of common stock, $.25 par value per
share, and 10 million shares of preferred stock, without par value. No shares of
preferred stock have been issued as of September 30, 1997.
COMMON STOCK
The Company is prohibited from paying dividends on its Common Stock under
the terms of the New Revolving Credit Agreement except under certain limited
circumstances.
1992 STOCK OPTION PLAN
The 1992 Stock Option Plan provided for the issuance of approximately 3.4
million options to purchase shares of Common Stock. A summary of changes in
options outstanding and other related information is as follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
----------------------------------------------------
<S> <C> <C> <C>
1995 1996 1997
---------------- ---------------- ----------------
Balance, beginning of period.......... 772,516 715,516 368,990
Canceled............................ (10,500) -- --
Exercised........................... (46,500) (346,526) --
---------------- ---------------- ----------------
Balance, end of period................ 715,516 368,990 368,990
---------------- ---------------- ----------------
---------------- ---------------- ----------------
Option prices, end of period.......... $ 4.36-$22.75 $ 4.36-$22.75 $ 4.36-$22.75
Price range of exercised options...... $ 4.36-$14.19 $ 4.36-$16.875 --
Average exercise price................ $6.26 $4.59 --
</TABLE>
The exercise price of certain options would be reduced upon termination of
employment of a certain optionee without cause. The Company records compensation
expense for the difference between the exercise price of these options and the
fair value of the Company's common stock until the measurement date is known.
Such compensation expense is included in stock option expense (credit) in the
Company's statements of operations.
Options issued pursuant to the 1992 Stock Option Plan are exercisable upon
vesting and expire through October 2000. As of September 30, 1997, 100% of the
options outstanding were vested.
1994 STOCK OPTION PLAN
The 1994 Stock Option Plan provided for the issuance of approximately 1.3
million options to purchase shares of Common Stock. Officers and key employees
of the Company are eligible to participate. The options have an exercise price
which approximates fair market value of the Common
F-25
<PAGE>
9. STOCKHOLDERS' EQUITY (CONTINUED)
Stock at the date of grant. A summary of changes in options outstanding and
other related information is as follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-------------------------------------------------------------
<S> <C> <C> <C>
1995 1996 1997
------------------- ------------------- -------------------
Balance, beginning of
period...................... 876,500 1,162,331 948,669
Granted..................... 495,000 161,000 341,166
Canceled.................... (209,169) (330,162) (87,498)
Exercised................... -- (44,500) (173,843)
------------------- ------------------- -------------------
Balance, end of period........ 1,162,331 948,669 1,028,494
------------------- ------------------- -------------------
------------------- ------------------- -------------------
Option prices, end of
period...................... $ 15.625-$27.875 $ 15.687-$27.875 $ 15.687-$27.718
Price range of exercised
options................... -- $ 15.625-$22.875 $ 15.687-$27.875
Average exercise price...... -- $20.70 $22.20
</TABLE>
Options granted under the 1994 Stock Option Plan are exercisable to the
extent vested. An option vests at the rate of 33 1/3% of the shares covered by
the option on each of the first three anniversary dates of the grant of the
option if the optionee is an employee of the Company on such dates. Options must
be exercised no later than ten years after the date of grant. As of September
30, 1997, 50.6% of the options outstanding were vested.
1996 STOCK OPTION PLAN
The 1996 Stock Option Plan (the "1996 Plan") provides for the issuance of
1.75 million options to purchase shares of the Company's Common Stock. Options
must be granted on or before December 31, 1999. Officers and key employees of
the Company are eligible to participate. The options have an exercise price
which approximates fair market value of the Common Stock at the date of grant. A
summary of changes in options outstanding and other related information is as
follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30
----------------------------------------
<S> <C> <C>
1996 1997
------------------- -------------------
Balance, beginning of period....................... -- 1,298,500
Granted.......................................... 1,413,000 310,667
Canceled......................................... (114,500) (96,125)
Exercised........................................ -- (101,750)
------------------- -------------------
Balance, end of period............................. 1,298,500 1,411,292
------------------- -------------------
------------------- -------------------
Option prices, end of period....................... $ 15.75-$24.00 $ 15.75-$30.875
Price range of exercised options................... -- $ 18.125-$18.875
Average exercise price............................. -- $18.348
</TABLE>
Options granted under the 1996 Plan are exercisable to the extent vested. An
option vests at the rate of 25% of the shares covered by the option on each of
the four anniversary dates of the grant of the option if the optionee is an
employee of the Company on such dates. Options must be exercised no later than
November 30, 2005.
F-26
<PAGE>
9. STOCKHOLDERS' EQUITY (CONTINUED)
The 1996 Plan provides that the options granted thereunder, upon the
occurrence of certain events, vest and become fully exercisable upon the "sale,
lease, transfer of other disposition...of all or substantially all" of the
Company's assets. Based upon a review of relevant Delaware case law, the Company
believes that substantial uncertainty existed regarding whether the Crescent
Transactions, which are described in Note 4, constituted a "sale ... of all or
substantially all" of the Company's assets. Accordingly, the Company's Board of
Directors determined it should treat the Crescent Transactions as such an event
in order to eliminate the risk of a dispute. Options outstanding under the 1996
Plan immediately vested upon closing the Crescent Transactions. As of September
30, 1997, 96.5% of the options outstanding under the 1996 Plan were vested.
1997 STOCK OPTION PLAN
The 1997 Stock Option Plan provides for the issuance of 1.5 million options
to purchase shares of the Company's Common Stock. Options must be granted on or
before December 31, 2000. Officers and key employees of the Company are eligible
to participate. The options have an exercise price which approximates fair
market value of the Common Stock at the date of grant. A summary of changes in
options outstanding and other related information is as follows:
<TABLE>
<CAPTION>
YEAR ENDED
SEPTEMBER 30,
1997
------------------
<S> <C>
Balance, beginning of period.............................................. --
Granted................................................................... 988,333
Canceled.................................................................. --
------------------
Balance, end of period.................................................... 988,333
------------------
Option prices, end of period.............................................. $ 24.375-$31.00
</TABLE>
Options granted under the 1997 Stock Option Plan are exercisable to the
extent vested. An option vests at the rate of 33 1/3% of the shares covered by
the option on each of the three anniversary dates of the grant of the option if
the optionee is an employee of the Company on such dates. Options must be
exercised no later than February 28, 2007. As of September 30, 1997, none of the
options outstanding were vested. Certain of the options granted under the 1997
stock option plan were granted prior to the stockholder approval date. The
measurement date for purposes of measuring compensation expense for such grants
under the 1997 Stock Option Plan was the date of stockholder approval, which
resulted in compensation expense of approximately $0.5 million in fiscal 1997.
1994 EMPLOYEE STOCK PURCHASE PLAN
The 1994 Employee Stock Purchase Plan (the "1994 ESPP") covered 600,000
shares of Common Stock that could be purchased by eligible employees of the
Company.
The initial offering period began on April 1, 1994 and expired on March 31,
1995. The second offering period began on April 1, 1995 and ended March 31,
1996. On the first date of these offering periods, each participant was granted
an option to purchase shares of Common Stock at a purchase price equal to 85% of
the fair value of a share of Common Stock on such date. Total options granted on
April 1, 1994 and April 1, 1995 were 85,115 and 41,565, respectively, with
option prices of $21.144 and $15.831, respectively. A total of 4,872 and 22,065
options were exercised at the end of the first and second offering periods,
respectively.
Effective August 1, 1995, the Company amended the 1994 ESPP to change the
option price in subsequent offering periods to the lesser of (i) 85% of the fair
value of a share of Common Stock on the
F-27
<PAGE>
9. STOCKHOLDERS' EQUITY (CONTINUED)
first day of the offering period or (ii) 85% of the fair value of a share of
Common Stock on the last day of the offering period. Holders of the options from
the second offering period as of July 31, 1995 were given the choice of (i)
canceling their options to purchase shares of Common Stock, (ii) exercising the
option to purchase shares of Common Stock at a purchase price of $15.831 or
(iii) keeping their options. A total of 11,870 options were exercised on July
31, 1995. The third offering period began August 1, 1995 and ended December 31,
1995. A total of 29,217 options were exercised at a purchase price of $16.681 at
the end of the third offering period.
The fourth offering period began January 1, 1996 and ended on June 30, 1996.
A total of 68,146 options were exercised at a purchase price of $18.275 at the
end of the fourth offering period. The fifth offering period began July 1, 1996
and ended on December 31, 1996. A total of 80,018 options were exercised at a
purchase price of $17.85 at the end of the fifth and final offering period.
1997 EMPLOYEE STOCK PURCHASE PLAN
The 1997 Employee Stock Purchase Plan (the "1997 ESPP") covers 600,000
shares of Common Stock that can be purchased by eligible employees of the
Company. The 1997 ESPP offering periods will have a term not less than three
months and not more than 12 months. The first offering period under the 1997
ESPP began January 1, 1997 and the last offering period will end on or before
December 31, 1999. The option price of each offering period will be the lesser
of (i) 85% of the fair value of a share of Common Stock on the first day of the
offering period or (ii) 85% of the fair value of a share of Common Stock on the
last day of the offering period.
The first offering period began January 1, 1997 and ended on June 30, 1997.
A total of 73,410 options were exercised at a purchase price of $19.125. The
second offering period began August 1, 1997 and will end on December 31, 1997.
The number of options granted and the option price for the second offering
period will be determined on December 31, 1997 when the option price is known.
1992 DIRECTORS' STOCK OPTION PLAN AND DIRECTORS' UNIT AWARD PLAN
The 1992 Directors' Stock Option Plan provides for the grant of options to
non-employee members of the Company's Board of Directors to purchase up to
175,000 shares of the Company's Common Stock, subject to adjustments to reflect
certain changes in capitalization. The options have an exercise price which
approximates the fair market value of the Common Stock on the date of grant.
During fiscal 1995, 25,000 options were granted at an exercise price of $18.875
per share. During fiscal 1996 and 1997, no options were granted. As of September
30, 1997, 125,000 options were outstanding. No options were exercised during
fiscal 1995, 1996 and 1997.
Options granted can be exercised from the date of vesting until February 1,
2003. No options can be granted after December 31, 1995. Options vest 20% when
granted and an additional 20% on each successive February 1 for a period of four
years, if the optionee continues to serve as a non-employee director on the
applicable February 1. Unvested options vest in full in certain instances of
termination. As of September 30, 1997, 88.0% of the options outstanding were
vested.
In addition, during fiscal 1994, the Company approved the Directors' Unit
Award Plan (the "Unit Plan") which provides for the award of a maximum of 15,000
units (the "Units") that, upon vesting under the terms of the Unit Plan, would
result in the issuance of an aggregate of 15,000 shares of Common Stock in
settlement of Units.
The Unit Plan provides for the award to each director who is not an employee
of the Company of 2,500 Units. Upon vesting of the Units awarded to a director,
the Company will settle the Units by issuing
F-28
<PAGE>
9. STOCKHOLDERS' EQUITY (CONTINUED)
to the director, with no exercise price, a number of shares of the Company's
Common Stock equal to the number of vested Units.
1996 DIRECTORS' STOCK OPTION PLAN
The 1996 Directors' Stock Option Plan provides for the grant of options to
non-employee members of the Company's Board of Directors to purchase up to
250,000 shares of the Company's Common Stock, subject to adjustments to reflect
certain changes in capitalization. The options have an exercise price which
approximates the fair market value of a share of the Common Stock on the date of
grant. During fiscal 1996, 175,000 options were granted at exercise prices
ranging from $18.25 to $23.375. During fiscal 1997, 25,000 options were granted
at an exercise price of $30.812. No options were exercised during fiscal 1996 or
1997.
Options granted can be exercised from the date of vesting until November 30,
2005. No options can be granted after December 31, 1999. Options vest at the
rate of 25% of the shares covered on each of the four anniversary dates of the
grant of the option if the optionee continues to serve as a non-employee
director on such dates. Options vest in full in certain instances of
termination. As of September 30, 1997, 21.9% of the options outstanding were
vested.
RIGHTS PLAN
Also upon consummation of the Plan, the Company adopted a Share Purchase
Rights Plan (the "Rights Plan"). Pursuant to the Rights Plan, each share of
Common Stock also represents one Share Purchase Right (collectively, the
"Rights"). The Rights trade automatically with the underlying shares of Common
Stock. Upon becoming exercisable, but prior to the occurrence of certain events,
each Right initially entitles its holder to buy one share of Common Stock from
the Company at an exercise price of $60.00. The Rights will be distributed and
become exercisable only if a person or group acquires, or announces its
intention to acquire, Common Stock exceeding certain levels, as specified in the
Rights Plan. Upon the occurrence of such events, the exercise price of each
Right reduces to one-half of the then current market price. The Rights also give
the holder certain rights in an acquiring company's common stock. The Company is
entitled to redeem the Rights at a price of $.01 per Right at any time prior to
the distribution of the Rights. The Rights have no voting power until exercised.
COMMON STOCK WARRANTS
In connection with the Plan, the Company issued 114,690 warrants, which
expire on June 30, 2002 (the "2002 Warrants") to purchase one share each of the
Company's Common Stock. The 2002 Warrants have an exercise price of $5.24 per
share. During fiscal 1995, 1996 and 1997, 47,392, 4,320 and 1,397 shares were
issued, respectively, upon the exercise of 2002 Warrants.
The 2006 Warrants, which expire on September 1, 2006, were adjusted as a
result of the Plan, and accordingly, 146,791 of such warrants are currently
outstanding with an exercise price of $38.70 per share. The Company records
compensation expense related to warrants when the exercise price changes, which
results in a new measurement date. No compensation expense related to warrants
is included in the statement of operations.
Crescent and COI each have the right to purchase 1,283,311 shares of Common
Stock (2,566,622 shares in aggregate) at a warrant exercise price of $30 per
share (subject to adjustment pursuant to
F-29
<PAGE>
9. STOCKHOLDERS' EQUITY (CONTINUED)
antidilution provisions). The Crescent Warrants will be exercisable at the
following times and in the following amounts:
<TABLE>
<CAPTION>
NUMBER OF SHARES OF
COMMON STOCK
DATE FIRST ISSUABLE UPON END OF
EXERCISABLE EXERCISE EXERCISE PERIOD
JUNE 17 OF WARRANTS JUNE 17
- -------------------- -------------------- --------------------
<S> <C> <C>
1998 30,000 2001
1999 62,325 2002
2000 97,114 2003
2001 134,513 2004
2002 174,678 2005
2003 217,770 2006
2004 263,961 2007
2005 313,433 2008
2006 366,376 2009
2007 422,961 2009
2008 483,491 2009
</TABLE>
Crescent's and COI's rights with respect to the Crescent Warrants will not
be contingent on or subject to the satisfaction or completion of any obligation
that Crescent or COI may have to CBHS, or that CBHS may have to the Company, or
by any subordination of fees otherwise payable to the Company by CBHS.
The Crescent Warrants contain provisions relating to adjustments in the
number of shares covered by the Crescent Warrants and the warrant exercise price
in the event of stock splits, stock dividends, mergers, reorganizations and
similar transactions.
The Crescent Warrants were recorded at $25 million upon issuance, or their
approximate fair value upon execution of the Warrant Purchase Agreement in
January 1997.
PRIVATE PLACEMENT TRANSACTION
On January 25, 1996, the Company issued 4 million shares of Common Stock
(the "Shares") along with a warrant to purchase an additional 2 million shares
of Common Stock (the "Warrant") pursuant to a Stock and Warrant Purchase
Agreement. The Warrant entitles the holders to purchase such additional shares
of Common Stock at a per share price of $26.15 subject to adjustment for certain
dilutive events, and provides registration rights for the shares of Common Stock
underlying the Warrant. The aggregate purchase price for the Shares and the
Warrant was approximately $69.73 million. The Warrant became exercisable on
January 25, 1997 and expires on January 25, 2000.
Approximately $68.0 million of the proceeds were used to repay outstanding
borrowings under the then existing credit agreement.
TREASURY STOCK TRANSACTIONS
During fiscal 1995, the Company purchased approximately 327,000 shares of
its Common Stock in the open market for approximately $5.6 million.
Approximately 17,000 of such shares were reissued related to 1994 ESPP exercises
for approximately $291,000.
F-30
<PAGE>
9. STOCKHOLDERS' EQUITY (CONTINUED)
On August 15, 1996, the Company commenced a "Dutch Auction" self-tender
offer to stockholders for the repurchase of 1,891,891 shares of its own Common
Stock. On September 5, 1996, the Company increased the self-tender offer to
3,300,000 shares. Under the terms of the offer, stockholders were invited to
tender their shares by September 18, 1996 at prices ranging from $16.50 to
$18.50 per share as specified by each stockholder.
At the conclusion of the offer, the Company repurchased 3,961,505 shares on
September 27, 1996 at $18.375 per share for a total cost of approximately $73.5
million, including transaction costs. The total shares repurchased represent
approximately 12.0% of the outstanding Common Stock at such date.
The transaction was financed through cash on hand and borrowings under the
then existing credit agreement.
INCOME PER COMMON SHARE
The Company adopted Statement of Financial Accounting Standards No. 128,
"Earnings per Share" ("FAS 128"), effective October 1, 1997. Income per common
share for the years ended September 30, 1996 and 1997 and for the nine months
ended June 30, 1997 have been restated to conform to FAS 128 as required. Income
per common share for the year ended September 30, 1995 was not restated due to
the anti-dilutive nature of common stock equivalents due to the Company's net
loss. The effect of adopting FAS 128 was not material.
The following table presents the components of weighted average common
shares outstanding-- diluted:
<TABLE>
<CAPTION>
YEAR ENDED NINE MONTHS ENDED
SEPTEMBER 30, JUNE 30,
-------------------- ---------------------------
1996 1997 1997 1998
--------- --------- -------------- -----------
<S> <C> <C> <C> <C>
(UNAUDITED) (UNAUDITED)
Weighted average common shares outstanding-- basic.......... 31,014 28,781 28,715 30,505
Common stock equivalents--stock options..................... 563 676 -- 578
Common stock equivalents--warrants.......................... 19 17 -- 16
--------- --------- -------------- -----------
Weighted average common shares outstanding-- diluted........ 31,596 29,474 28,715 31,099
--------- --------- -------------- -----------
--------- --------- -------------- -----------
</TABLE>
Options to purchase approximately 112,000 shares of common stock at $25.44
to $31.00 per share were outstanding during fiscal 1997 but were not included in
the computation of diluted EPS because the options' exercise price was greater
than the average market price of the common shares. The options, which expire
between fiscal 2006 and 2007, were still outstanding at September 30, 1997.
Warrants to purchase approximately 4,713,000 shares of common stock at
$26.15 to $38.70 per share were outstanding during fiscal 1997 but were not
included in the computation of diluted EPS because the warrants' exercise price
was greater than the average market price of the common shares. The warrants,
which expire between fiscal 2000 and 2009, were still outstanding at September
30, 1997.
The Company owned a 61% equity interest in Green Spring Health Services,
Inc. ("Green Spring") during the periods presented above. The four minority
stockholders of Green Spring had the option to exchange their ownership
interests in Green Spring for 2,831,516 shares of the Company's common stock or
$65.1 million of subordinated notes (the "Exchange Option"). The Exchange Option
was considered a potentially dilutive security since the Company acquired Green
Spring in December 1995 for the purpose of computing diluted income per common
share. The Exchange Option was anti-dilutive
F-31
<PAGE>
9. STOCKHOLDERS' EQUITY (CONTINUED)
for all periods presented and, therefore, was excluded from the respective
diluted income per common share calculations.
Each of the minority stockholders of Green Spring exercised the Exchange
Option in January 1998, which resulted in the issuance of 2,831,516 shares of
the Company's common stock. See Note 18-- "Subsequent Events--Green Spring
Minority Shareholder Conversion".
Common stock equivalents of approximately 612,000 were excluded from the
diluted income per common share calculation for the year ended September 30,
1995 due to their anti-dilutive nature as a result of the Company's loss for
such period.
UNAUDITED
Options to purchase approximately 457,000 shares of common stock at $25.16
to $31.06 per share were outstanding during the nine months ended June 30, 1998,
but were not included in the computation of diluted EPS because the options'
exercise price was greater than the average market price of the common shares.
The options, which expire between fiscal 2006 and fiscal 2008, were still
outstanding at June 30, 1998.
Warrants to purchase approximately 4,713,000 shares of common stock at
$26.15 to $38.70 per share were outstanding during the nine months ended June
30, 1998 but were not included in the computation of diluted EPS because the
warrants' exercise price was greater than the average market price of the common
shares. The warrants, which expire between fiscal 2000 and fiscal 2009, were
still outstanding at June 30, 1998.
Common stock equivalents of approximately 582,000 were excluded from the
income per common share calculation for the nine months ended June 30, 1997, due
to their anti-dilutive nature as a result of the Company's losses for such
periods.
STOCK BASED COMPENSATION
Effective October 1, 1996, the Company adopted the disclosure requirements
of FAS 123. FAS 123 requires disclosure of pro forma net income and pro forma
net income per share as if the fair value-based method of accounting for stock
options had been applied in measuring compensation cost for stock-based awards
granted in fiscal 1996 and 1997. Pro forma amounts are not representative of the
effects of stock-based awards on future pro forma net income and pro forma net
income per share because those pro forma amounts exclude the pro forma
compensation expense related to unvested stock options granted before fiscal
1996.
F-32
<PAGE>
9. STOCKHOLDERS' EQUITY (CONTINUED)
Reported and pro forma net income and net income per share amounts are set
forth below (in thousands, except per share data):
<TABLE>
<CAPTION>
1996 1997
--------- ---------
<S> <C> <C>
Reported:
Income before extraordinary items.................................... $ 32,383 $ 4,755
Net income (loss).................................................... $ 32,383 $ (498)
Income (loss) per common share--basic:
Income before extraordinary items.................................... $ 1.04 $ 0.17
Net income........................................................... $ 1.04 $ (0.02)
Income (loss) per common share--diluted:
Income before extraordinary items.................................... $ 1.02 $ 0.16
Net income (loss).................................................... $ 1.02 $ (0.02)
Pro Forma:
Income (loss) before extraordinary items............................. $ 28,835 $ (3,721)
Net income (loss).................................................... $ 28,835 $ (8,974)
Income (loss) per common share--basic:
Income (loss) before extraordinary items............................. $ 0.93 $ (0.13)
Net income (loss).................................................... $ 0.93 $ (0.31)
Income (loss) per common share--diluted:
Income (loss) before extraordinary items............................. $ 0.91 $ (0.13)
Net income (loss).................................................... $ 0.91 $ (0.31)
</TABLE>
The fair values of the stock options and ESPP options granted were estimated
on the date of their grant using the Black-Scholes option pricing model based on
the following weighted average assumptions:
<TABLE>
<CAPTION>
1996 1997
--------- -----------
<S> <C> <C>
Risk-free interest rate........................................... 6% 6%
Expected life..................................................... 5 years 5.5 years
Expected volatility............................................... 35% 30%
Expected dividend yield........................................... 0% 0%
</TABLE>
The weighted average fair value of options granted during fiscal 1996 and
1997 was $6.85 and $9.67, respectively.
F-33
<PAGE>
9. STOCKHOLDERS' EQUITY (CONTINUED)
Stock option activity for all plans for 1995, 1996 and 1997 was as follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
----------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
1995 1996 1997
------------------------ ------------------------ ------------------------
<CAPTION>
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
----------- ----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Balance, beginning of period......... 1,749,016 $ 14.42 2,002,847 $ 15.32 2,916,159 $ 17.92
Granted.............................. 520,000 20.95 1,749,000 19.05 1,665,166 24.24
Canceled............................. (219,669) 23.55 (444,662) 21.20 (183,623) 20.84
Exercised............................ (46,500) 6.09 (391,026) 6.37 (275,593) 20.26
----------- ----------- -----------
Balance, end of period............... 2,002,847 15.32 2,916,159 17.92 4,122,109 20.13
----------- ----------- -----------
Exercisable, end of period........... 1,025,988 9.61 926,195 14.75 2,419,711 17.65
----------- ----------- -----------
----------- ----------- -----------
</TABLE>
Stock options outstanding on September 30, 1997:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- ---------------------------------------------------------------------------- ------------------------
<S> <C> <C> <C> <C> <C>
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
RANGE OF REMAINING AVERAGE AVERAGE
EXERCISE CONTRACTUAL EXERCISE EXERCISE
PRICE OPTIONS LIFE PRICE OPTIONS PRICE
- --------------------------------- ----------- --------------- ----------- ----------- -----------
$4.36-$18.25 1,377,444 7.81 $ 14.32 1,256,200 $ 13.97
$18.31-$22.88 1,378,166 7.68 $ 20.87 870,756 $ 20.84
$23.00-$31.00 1,366,499 9.18 $ 25.33 292,755 $ 23.94
----------- -----------
$4.36-$31.00 4,122,109 8.21 $ 20.13 2,419,711 $ 17.65
----------- -----------
----------- -----------
</TABLE>
10. INCOME TAXES
The provision (benefit) for income taxes consisted of the following (in
thousands):
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
--------------------------------
<S> <C> <C> <C>
1995 1996 1997
---------- --------- ---------
Income taxes currently payable:
Federal................................................. $ 658 $ 6,900 $ 11,148
State................................................... 1,851 (1,139) 3,959
Foreign................................................. 1,188 3,779 3,678
Deferred income taxes:
Federal................................................. (12,931) 15,313 (6,670)
State................................................... (1,848) 807 (2,569)
Foreign................................................. -- 35 (308)
---------- --------- ---------
$ (11,082) $ 25,695 $ 9,238
---------- --------- ---------
---------- --------- ---------
</TABLE>
F-34
<PAGE>
10. INCOME TAXES (CONTINUED)
A reconciliation of the Company's income tax provision (benefit) to that
computed by applying the statutory federal income tax rate is as follows (in
thousands):
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
--------------------------------
<S> <C> <C> <C>
1995 1996 1997
---------- --------- ---------
Income tax provision (benefit) at federal statutory income
tax rate................................................ $ (18,798) $ 22,483 $ 8,083
State income taxes, net of federal income tax benefit..... (16) (216) 904
Foreign income taxes, net of federal income tax benefit... 772 2,479 2,190
Amortization of excess reorganization value............... 9,100 -- --
Other--net................................................ (2,140) 949 (1,939)
---------- --------- ---------
Income tax provision (benefit)............................ $ (11,082) $ 25,695 $ 9,238
---------- --------- ---------
---------- --------- ---------
</TABLE>
As of September 30, 1997, the Company has estimated tax net operating loss
("NOL") carryforwards of approximately $278 million available to reduce future
federal taxable income. These NOL carryforwards expire in 2006 through 2011 and
are subject to examination by the Internal Revenue Service. The Company has
recorded a valuation allowance against the entire amount of the NOL deferred tax
asset and certain other deferred tax assets, that in management's opinion, are
not likely to be recovered.
Components of the net deferred income tax (assets) liabilities at September
30, 1996 and 1997 are as follows (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30,
--------------------------
<S> <C> <C>
1996 1997
------------ ------------
Deferred tax liabilities:
Insurance settlements........................................... $ -- $ 8,460
Property and depreciation....................................... 23,970 --
Long-term debt and interest..................................... 63,516 54,820
ESOP............................................................ 11,616 11,112
Other........................................................... 14,133 17,449
------------ ------------
Total deferred tax liabilities................................ 113,235 91,841
------------ ------------
Deferred tax assets:
Property and depreciation....................................... -- (7,123)
Operating loss carry forwards................................... (102,229) (111,251)
Insurance settlements........................................... (3,649) --
Self-insurance reserves......................................... (44,234) (30,918)
Restructuring costs............................................. (26,695) (22,990)
Other........................................................... (48,033) (45,709)
------------ ------------
Total deferred tax assets....................................... (224,840) (217,991)
------------ ------------
Valuation allowance............................................. 123,973 124,992
------------ ------------
Deferred tax assets after valuation allowance................... (100,867) (92,999)
------------ ------------
Net deferred tax (assets) liabilities........................... $ 12,368 $ (1,158)
------------ ------------
------------ ------------
</TABLE>
The Internal Revenue Service is currently examining the Company's income tax
returns for fiscal 1989 through 1992 and expects a report to be issued during
fiscal 1998. In management's opinion, adequate provisions have been made for any
adjustments which may result from these examinations,
F-35
<PAGE>
10. INCOME TAXES (CONTINUED)
including a potential reduction in the amount of NOL carryforwards. The Company
believes the examinations could result in a reduction in NOL carryforwards
available to offset future taxable income.
11. ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, JUNE 30,
------------------------ ------------
1996 1997 1998
----------- ----------- ------------
(UNAUDITED)
<S> <C> <C> <C>
Salaries, wages and other benefits....................................... $ 39,841 $ 21,647 $ 18,928
Amounts due health insurance programs.................................... 27,223 14,126 10,457
Medical claims payable................................................... 26,552 36,508 198,558
Interest................................................................. 20,348 19,739 22,915
Crescent Transactions.................................................... -- 14,648 4,385
Other.................................................................... 75,635 63,761 126,423
----------- ----------- ------------
$ 189,599 $ 170,429 $ 381,666
----------- ----------- ------------
----------- ----------- ------------
</TABLE>
12. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information is as follows (in thousands):
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEAR ENDED SEPTEMBER 30, JUNE 30,
------------------------------- --------------------------
1995 1996 1997 1997 1998
--------- --------- --------- ------------ ------------
<S> <C> <C> <C> <C> <C>
(UNAUDITED) (UNAUDITED)
Income taxes paid, net of refunds received........ $ 4,682 $ 9,299 $ 18,406 $ 14,419 $ 8,572
Interest paid, net of amounts capitalized......... 54,302 56,248 54,378 53,945 53,686
Long-term debt assumed in connection with
acquisitions.................................... -- 12,100 -- -- --
Non-cash Transactions:
Initial capital contribution to CBHS, primarily
property and equipment, less assumed
liabilities..................................... $ -- $ -- $ 5,281 $ 5,281 $ --
Common Stock in Treasury issued in connection with
the purchase of the remaining 39% interest in
Green Spring Health Services, Inc............... -- -- -- -- 63,496
</TABLE>
The non-cash portion of unusual items for fiscal 1995 and 1996 includes the
unpaid portion of the $29.8 million and $30.0 million insurance settlements that
were recorded during the quarters ended March 31, 1995 and June 30, 1996,
respectively. The payments of the insurance settlements are included in accounts
payable and other accrued liabilities in the statement of cash flows for fiscal
1995, 1996 and 1997.
13. COMMITMENTS AND CONTINGENCIES
The Company is self-insured for a substantial portion of its general and
professional liability risks. The reserves for self-insured general and
professional liability losses, including loss adjustment expenses, are included
in reserve for unpaid claims in the Company's balance sheet and are based on
actuarial estimates that are discounted at an average rate of 6% to their
present value based on the Company's historical claims experience adjusted for
current industry trends. The undiscounted amount of the reserve for unpaid
claims at September 30, 1996 and 1997 was approximately $84.3 million and
F-36
<PAGE>
13. COMMITMENTS AND CONTINGENCIES (CONTINUED)
$56.1 million, respectively. The carrying amount of accrued medical malpractice
claims was $70.6 million and $47.7 million at September 30, 1996 and 1997,
respectively. The reserve for unpaid claims is adjusted periodically as such
claims mature, to reflect changes in actuarial estimates based on actual
experience. During fiscal 1996 and 1997, and the nine months ended June 30, 1997
and 1998 (unaudited) the Company recorded reductions in malpractice claim
reserves of approximately $15.3 million, $7.5 million, $7.5 million and $4.1
million, respectively, as a result of updated actuarial estimates. These
reductions resulted primarily from updates to actuarial assumptions regarding
the Company's expected losses for more recent policy years. These revisions are
based on changes in expected values of ultimate losses resulting from the
Company's claim experience, and increased reliance on such claim experience.
While management and its actuaries believe that the present reserve is
reasonable, ultimate settlement of losses may vary from the amount recorded.
Certain of the Company's subsidiaries are subject to or parties to claims,
civil suits and governmental investigations and inquiries relating to their
operations and certain alleged business practices. In the opinion of management,
based on consultation with counsel, resolution of these matters will not have a
material adverse effect on the Company's financial position or results of
operations.
In January 1996, the Company settled an ongoing dispute with the Resolution
Trust Corporation ("RTC"), for itself or in its capacity as conservator or
receiver for 12 financial institutions, which formerly held certain debt
securities that were issued by the Company in 1988. In connection with the
settlement, the Company, denying any liability or fault, paid $2.7 million to
the RTC in exchange for a release of all claims.
On August 1, 1996, the United States Department of Justice, Civil Division,
filed an Amended Complaint in a civil QUI TAM action initiated in November 1994
against the Company and its Orlando South hospital subsidiary ("Charter
Orlando") by two former employees. The First Amended Complaint alleges that
Charter Orlando violated the federal False Claims Act (the "Act") in billing for
inpatient treatment provided to elderly patients. The Court granted the
Company's motion to dismiss the government's First Amended Complaint yet granted
the government leave to amend its First Amended Complaint. The government filed
a Second Amended Complaint on December 12, 1996 which, similar to the First
Amended Complaint, alleges that the Company and its subsidiary violated the Act
in billing for the treatment of geriatric patients. Like the First Amended
Complaint, the Second Amended Complaint is based on disputed clinical and
factual issues which the Company believes do not constitute a violation of the
Act. On the Company's motion, the Court has ordered the parties to participate
in mediation of the matter. As a result of the mediation, the parties are
engaged in settlement discussions which may lead to a resolution of the matter.
The Company has offered to settle for $3.5 million, which the Company has
accrued. The government has made a counter demand of $5.9 million plus
penalties. Nonetheless, the Company and its subsidiary deny the allegations made
in the Second Amended Complaint and will vigorously defend against its claims.
The Company does not believe this matter will have a material adverse effect on
its financial position or results of operations.
In October 1996, a group of eight plaintiffs purporting to represent an
uncertified class of psychiatrists, psychologists and social workers brought an
action under the federal antitrust laws in the United States District Court for
the Southern District of New York (the "District Court") against nine managed
behavioral healthcare organizations, including Green Spring (collectively,
"Defendants"). The complaint alleges that Defendants violated Section 1 of the
Sherman Act by engaging in a conspiracy to fix the prices at which Defendants
purchase services from managed behavioral healthcare providers such as
plaintiffs. The complaint further alleges that Defendants engaged in a group
boycott to exclude mental healthcare providers from Defendants' networks in
order to further the goals of the alleged conspiracy. The complaint also
challenges the propriety of Defendant's capitation arrangements with their
respective customers, although it is unclear from the complaint whether
plaintiffs allege that Defendants
F-37
<PAGE>
13. COMMITMENTS AND CONTINGENCIES (CONTINUED)
unlawfully conspired to enter into capitation arrangements with their respective
customers. The complaint seeks treble damages against Defendants in an
unspecified amount and a permanent injunction prohibiting defendants from
engaging in the alleged conduct which forms the basis of the complaint, plus
costs and attorneys' fees. In January 1997, Defendants filed a motion to dismiss
the complaint. On July 21, 1997, a court-appointed magistrate judge issued a
report and recommendation to the District Court recommending that Defendants'
motion to dismiss the complaint with prejudice be granted. On August 5, 1997,
plaintiffs filed objections to the magistrate judge's report and recommendation;
such objections have not yet been heard. Green Spring intends to vigorously
defend itself in this litigation. The Company does not believe this matter will
have a material adverse effect on its financial position or results of
operations. See Note 18--"Subsequent Events--Contingencies."
14. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Gerald L. McManis, a director of the Company, is the President of McManis
Associates, Inc. ("MAI"), a healthcare development and management consulting
firm. During fiscal 1995, 1996 and 1997, MAI provided consulting services to the
Company with respect to the development of strategic plans and a review of the
Company's business processes. The Company incurred approximately $158,000,
$274,000 and $825,000 in fees for such services during fiscal 1995, 1996 and
1997, respectively, and reimbursed MAI for approximately $21,000, $13,000 and
$60,000, respectively, for expenses.
G. Fred DiBona, Jr., a director of the Company, is a Director and the
President and Chief Executive Officer of Independence Blue Cross ("IBC"), a
health insurance company. As of September 30, 1997, IBC owned 12.25% of Green
Spring.
IBC owned 16.67% of Green Spring prior to December 13, 1995. On December 13,
1995, IBC sold 4.42% of its ownership interest in Green Spring to the Company
for $5,376,000 in cash. IBC had a cost basis of $3,288,000 in the 4.42%
ownership interest sold to the Company. The Exchange Option described previously
gives IBC the right to exchange its ownership interest in Green Spring for a
maximum of 889,456 shares of Common Stock or $20,460,000 in subordinated notes
through December 13, 1998.
IBC and its affiliated entities contract with Green Spring for provider
network, care management and medical review services pursuant to contractual
relationships entered into on July 7, 1994 with terms of up to five years.
During the period beginning December 14, 1995 through September 30, 1996 and
fiscal 1997, IBC and its affiliated entities made payments to Green Spring of
approximately $29.2 million and $48.0 million and owed Green Spring
approximately $13.6 million at September 30, 1997. Green Spring recorded revenue
of approximately $32.8 million and $47.4 million from IBC during fiscal 1996 and
1997, respectively.
On July 7, 1994, IBC sold a subsidiary to Green Spring in exchange for a $15
million promissory note. As of September 30, 1997, $6 million remained
outstanding under such promissory note and is due and payable in equal
installments on July 7, 1998 and 1999.
Darla D. Moore, a director of the Company since February 1996, is the spouse
of Richard E. Rainwater, Chairman of the Board of Crescent and the largest
stockholder of the Company (18.8% beneficial ownership as of October 31, 1997).
Because of her relationship to Mr. Rainwater, Ms. Moore did not participate in
any Board action taken with respect to the Crescent Transactions.
15. BUSINESS SEGMENT INFORMATION
The Company operates through four principal subsidiaries engaging in, (i)
the managed care business, (ii) the public sector business, (iii) the healthcare
franchising business and (iv) the provider business. Intersegment sales are not
material. Operating profit represents net revenue less salaries, cost of care
and other operating expenses, bad debt expense, depreciation, amortization,
stock option expense and unusual items (excluding gains on sale of closed
psychiatric hospitals) and excludes interest, net, equity in loss of CBHS, loss
on Crescent Transactions, income taxes, minority interest and
F-38
<PAGE>
15. BUSINESS SEGMENT INFORMATION (CONTINUED)
extraordinary items. Identifiable assets are those used in the Company's
operations in each segment, excluding goodwill. Depreciation and amortization
for the managed care business includes the amortization expense related to the
step-up in asset basis for the acquisition of Green Spring in December 1995.
Corporate assets consist primarily of cash and cash equivalents, investments and
assets not employed in operations.
Prior to fiscal 1996, the Company's managed care, public sector and
healthcare franchising businesses were not material. Accordingly, no comparable
segment information is presented for fiscal 1995. Operating profit for the
provider segment and corporate overhead include unusual items of $36.1 million
(facility closures, insurance settlement, severance, impairment loss) and $1.2
million (severance), respectively, for fiscal 1996. Operating profit for the
provider segment includes unusual items of $5.7 million (facility closures,
European sale termination) in fiscal 1997. See Note 6 for further information
regarding unusual items. The Company classified juvenile justice facilities
operations as public sector in its 1996 financial statements. Such amounts are
classified as provider business in the following presentation.
<TABLE>
<CAPTION>
MANAGED HEALTHCARE
CARE PUBLIC SECTOR FRANCHISING PROVIDER CORPORATE
BUSINESS BUSINESS BUSINESS BUSINESS OVERHEAD CONSOLIDATED
----------- ------------- ------------ ------------- ---------- -------------
<S> <C> <C> <C> <C> <C> <C>
1996
Net revenue......................... $ 229,859 $ 70,709 $ -- $ 1,044,711 $ -- $ 1,345,279
Operating profit.................... 16,866 6,942 -- 128,400 (39,953) 112,255
Depreciation and amortization....... 9,111 2,580 -- 34,201 3,032 48,924
Identifiable assets................. 116,501 15,487 -- 791,536 88,601 1,012,125
Capital expenditures................ 6,018 1,964 -- 21,737 9,082 38,801
1997
Net revenue......................... $ 363,883 $ 94,422 $ 22,739 $ 729,652 $ -- $ 1,210,696
Operating profit.................... 26,861 4,935 18,927 114,474 (34,123) 131,074
Depreciation and amortization....... 13,016 2,904 160 24,528 4,253 44,861
Identifiable assets................. 137,372 24,035 2,256 286,155 331,568 781,386
Capital expenditures................ 9,183 2,245 195 18,739 2,986 33,348
</TABLE>
16. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the quarterly results of operations for the
years ended September 30, 1996 and 1997. The third and fourth quarters of fiscal
1996 include unusual items of approximately $34.0 million and $3.3 million,
respectively. The second quarter and third quarter of fiscal 1997 include
unusual items of approximately $1.4 million and ($1.0) million, respectively.
The third quarter of fiscal 1997 also includes a $59.9 million loss on the
Crescent Transactions. See Notes 4 and 6 for an explanation of these charges.
The fourth quarter of 1997 includes increases to income before income taxes and
minority interest for revenue and bad debt expense adjustments of approximately
$6.4 million relating to a change in estimate for contractual allowances and
allowance for doubtful accounts in the Company's provider business.
F-39
<PAGE>
16. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED)
<TABLE>
<CAPTION>
FISCAL QUARTERS
--------------------------------------------------
<S> <C> <C> <C> <C>
FIRST SECOND THIRD FOURTH
----------- ----------- ----------- -----------
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
1996
Net revenue.................................................. $ 295,665 $ 354,953 $ 346,379 $ 348,282
Net income (loss)............................................ 9,748 20,069 (5,722) 8,288
Net income (loss) per common share:
Basic...................................................... 0.35 0.64 (0.18) 0.26
Diluted.................................................... 0.34 0.59 (0.18) 0.25
1997
Net revenue.................................................. $ 346,819 $ 349,922 $ 324,921 $ 189,034
Income (loss) before extraordinary items..................... 7,141 11,892 (24,441) 10,163
Net income (loss)............................................ 4,191 11,892 (26,744) 10,163
Income (loss) per common share--basic:
Income (loss) before extraordinary items................... 0.25 0.41 (0.85) 0.35
Net income (loss).......................................... 0.15 0.41 (0.93) 0.35
Income (loss) per common share--diluted:
Income (loss) before extraordinary items................... 0.25 0.41 (0.85) 0.33
Net income (loss).......................................... 0.14 0.41 (0.93) 0.33
</TABLE>
F-40
<PAGE>
17. GUARANTOR CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 30, 1996
-------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
MAGELLAN
HEALTH
SERVICES,
INC. CONSOLIDATED
GUARANTOR NONGUARANTOR (PARENT ELIMINATION CONSOLIDATED
SUBSIDIARIES SUBSIDIARIES CORPORATION) ENTRIES TOTAL
------------ -------------- ------------- ------------- -------------
<CAPTION>
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
<CAPTION>
ASSETS
<S> <C> <C> <C> <C> <C>
Current Assets
Cash and cash equivalents................... $ 29,751 $ 79,552 $ 11,642 $ -- $ 120,945
Accounts receivable, net.................... 139,523 44,904 5,451 -- 189,878
Other current assets........................ 12,470 515 14,342 -- 27,327
------------ -------------- ------------- ------------- -------------
Total Current Assets...................... 181,744 124,971 31,435 -- 338,150
Assets restricted for settlement of unpaid
claims and other long-term liabilities...... -- 78,542 26,761 -- 105,303
Property and Equipment
Land........................................ 74,790 6,657 1,984 -- 83,431
Buildings and improvements.................. 350,187 33,493 5,141 -- 388,821
Equipment................................... 112,748 25,206 8,961 -- 146,915
------------ -------------- ------------- ------------- -------------
537,725 65,356 16,086 -- 619,167
Accumulated depreciation.................... (111,556) (10,313) (4,184) -- (126,053)
Construction in progress.................... 1,586 621 69 -- 2,276
------------ -------------- ------------- ------------- -------------
427,755 55,664 11,971 -- 495,390
Other Long-Term Assets(1)..................... 98,191 (56,176) 1,187,042 (1,155,775) 73,282
Goodwill, net................................. 20,645 94,682 12,685 -- 128,012
------------ -------------- ------------- ------------- -------------
$ 728,335 $ 297,683 $ 1,269,894 $(1,155,775) $ 1,140,137
------------ -------------- ------------- ------------- -------------
------------ -------------- ------------- ------------- -------------
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
<S> <C> <C> <C> <C> <C>
Current Liabilities
Accounts payable............................ $ 32,644 $ 34,057 $ 12,265 $ -- $ 78,966
Accrued liabilities and income tax
payable................................... 57,948 55,208 76,443 -- 189,599
Current maturities of long-term debt and
capital lease obligations................. 2,620 3,131 -- -- 5,751
------------ -------------- ------------- ------------- -------------
Total Current Liabilities................. 93,212 92,396 88,708 -- 274,316
Long-Term Debt and Capital Lease
Obligations................................. (455,333) 8,815 1,012,825 -- 566,307
Deferred Income Tax Liabilities............... -- (4,252) 16,620 -- 12,368
Reserve for Unpaid Claims..................... -- 72,494 546 -- 73,040
Deferred Credits and Other Long-Term
Liabilities(1).............................. 352,044 43,565 29,378 (385,218) 39,769
Minority interest............................. -- -- -- 52,520 52,520
Stockholders' Equity
Common Stock, par value $0.25 per share;
Authorized--80,000 shares
Issued and outstanding--33,007 shares..... 2,764 (483) 8,252 (2,281) 8,252
Committments and contingencies
Other Stockholders' Equity
Additional paid-in capital.................. 609,627 30,237 327,681 (639,864) 327,681
Retained earnings (Accumulated deficit)..... 126,826 58,932 (129,457) (185,758) (129,457)
Warrants outstanding........................ -- -- 54 -- 54
Common Stock in treasury, 4,424 shares...... -- (4,736) (82,731) 4,736 (82,731)
Cumulative foreign currency adjustments..... (805) 715 (1,982) 90 (1,982)
------------ -------------- ------------- ------------- -------------
738,412 84,665 121,817 (823,077) 121,817
------------ -------------- ------------- ------------- -------------
$ 728,335 $ 297,683 $ 1,269,894 $(1,155,775) $ 1,140,137
------------ -------------- ------------- ------------- -------------
------------ -------------- ------------- ------------- -------------
</TABLE>
- ------------------------
(1) Elimination entry related to intercompany receivables and payables and
investment in consolidated subsidiaries.
The accompanying Notes to Condensed Consolidating Financial Statements
are an integral part of these balance sheets.
F-41
<PAGE>
17. GUARANTOR CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MAGELLAN HEALTH SERVICES INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 30, 1997
-------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
MAGELLAN
HEALTH
SERVICES,
INC. CONSOLIDATED
GUARANTOR NONGUARANTOR (PARENT ELIMINATION CONSOLIDATED
SUBSIDIARIES SUBSIDIARIES CORPORATION) ENTRIES TOTAL
------------ -------------- ------------- ------------- -------------
<CAPTION>
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
ASSETS
Current Assets
Cash and cash equivalents................. $ 102,419 $ 62,326 $ 208,133 $ -- $ 372,878
Accounts receivable, net.................. 46,652 60,185 1,161 -- 107,998
Other current assets...................... 2,346 10,215 13,601 -- 26,162
------------ -------------- ------------- ------------- -------------
Total Current Assets.................... 151,417 132,726 222,895 -- 507,038
Assets restricted for settlement of unpaid
claims and other long-term liabilites..... -- 71,501 16,031 -- 87,532
Property and Equipment
Land...................................... 5,406 5,389 872 -- 11,667
Buildings and improvements................ 35,789 31,517 2,868 -- 70,174
Equipment................................. 19,704 35,023 8,992 -- 63,719
------------ -------------- ------------- ------------- -------------
60,899 71,929 12,732 -- 145,560
Accumulated depreciation.................. (15,168) (17,288) (4,582) -- (37,038)
Construction in progress.................. 4 611 77 -- 692
------------ -------------- ------------- ------------- -------------
45,735 55,252 8,227 -- 109,214
Investment in CBHS.......................... 16,878 -- -- -- 16,878
Deferred Income Taxes....................... -- 4,428 (3,270) -- 1,158
Other Long-Term Assets (1).................. 114,642 (5,757) 978,588 (1,027,907) 59,566
Goodwill, net............................... 17,966 96,268 -- -- 114,234
------------ -------------- ------------- ------------- -------------
$ 346,638 $ 354,418 $ 1,222,471 $(1,027,907) $ 895,620
------------ -------------- ------------- ------------- -------------
------------ -------------- ------------- ------------- -------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable.......................... $ 23,057 $ 17,097 $ 5,192 $ -- $ 45,346
Accrued liabilities and income tax
payable................................. 27,800 73,586 69,043 -- 170,429
Current maturities of long-term debt and
capital lease obligations............... 466 3,135 -- -- 3,601
------------ -------------- ------------- ------------- -------------
Total Current Liabilities............... 51,323 93,818 74,235 -- 219,376
Long-Term Debt and Capital Lease
Obligations................................. (793,325) 3,913 1,181,105 -- 391,693
Reserve for Unpaid Claims................... -- 56,339 (7,226) -- 49,113
Deferred Credits and Other Long-Term
Liabilities (1)............................. 8,393 6,290 (183,893) 185,320 16,110
Minority interest........................... -- -- -- 61,078 61,078
Stockholders' Equity
Common Stock, par value $0.25 per share;
Authorized--80,000 shares Issued and
outstanding 33,439 shares............... 2,752 (483) 8,361 (2,269) 8,361
Commitments and contingencies
Other Stockholders' Equity
Additional paid-in capital................ 1,000,935 125,624 340,645 (1,126,559) 340,645
Retained earnings (Accumulated deficit)... 76,035 71,317 (129,955) (147,352) (129,955)
Warrants outstanding...................... -- -- 25,050 -- 25,050
Common Stock in treasury 4,424 shares..... -- -- (82,731) -- (82,731)
Cumulative foreign currency adjustments... 525 (2,400) (3,120) 1,875 (3,120)
------------ -------------- ------------- ------------- -------------
1,080,247 194,058 158,250 (1,274,305) 158,250
------------ -------------- ------------- ------------- -------------
$ 346,638 $ 354,418 $ 1,222,471 $(1,027,907) $ 895,620
------------ -------------- ------------- ------------- -------------
------------ -------------- ------------- ------------- -------------
</TABLE>
- ------------------------
(1) Elimination entry related to intercompany receivables and payables and
investment in consolidated subsidiaries.
The accompanying Notes to Condensed Consolidating Financial Statements
are an integral part of these balance sheets.
F-42
<PAGE>
17. GUARANTOR CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
SEPTEMBER 30, 1995
-------------------------------------------------------------------------
MAGELLAN
HEALTH
SERVICES,
INC. CONSOLIDATED
GUARANTOR NONGUARANTOR (PARENT ELIMINATION CONSOLIDATED
SUBSIDIARIES SUBSIDIARIES CORPORATION) ENTRIES TOTAL
------------ -------------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C>
(IN THOUSANDS)
Net revenue................................. $1,099,039 $ 79,702 $ (2,792) $ (24,213) $ 1,151,736
Costs and expenses
Salaries, cost of care and other operating
expenses................................ 789,850 74,449 22,934 (23,635) 863,598
Bad debt expense.......................... 91,945 2,088 (2,011) -- 92,022
Depreciation and amortization............. 35,769 2,073 823 (578) 38,087
Amortization of reorganization value in
excess of amounts allocable to
identifiable assets..................... -- -- 26,000 -- 26,000
Interest, net............................. (32,975) 32 88,180 -- 55,237
ESOP expense.............................. 55,497 70 17,960 -- 73,527
Stock option expense...................... -- -- (467) -- (467)
Unusual items............................. 26,640 3,957 26,840 -- 57,437
------------ -------------- ------------- ------------- -------------
966,726 82,669 180,259 (24,213) 1,205,441
------------ -------------- ------------- ------------- -------------
Income (loss) before income taxes and equity
in earnings (loss) of subsidiaries........ 132,313 (2,967) (183,051) -- (53,705)
Provision for (benefit from) income taxes... 6,139 (2,418) (14,803) -- (11,082)
------------ -------------- ------------- ------------- -------------
Income (loss) before equity in earnings
(loss) of subsidiaries.................... 126,174 (549) (168,248) -- (42,623)
Equity in earnings (loss) of continuing
subsidiaries.............................. 3,680 -- 125,285 (129,305) (340)
------------ -------------- ------------- ------------- -------------
Net income (loss)........................... $ 129,854 $ (549) $ (42,963) $ (129,305) $ (42,963)
------------ -------------- ------------- ------------- -------------
------------ -------------- ------------- ------------- -------------
<CAPTION>
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
<S> <C> <C> <C> <C> <C>
Cash provided by (used in) operating
activities................................ $ 82,863 $ 28,223 $ (15,466) $ -- $ 95,620
------------ -------------- ------------- ------------- -------------
Cash Flows from Investing Activities:
Capital expenditures...................... (17,729) (1,177) (1,318) -- (20,224)
Acquisition of businesses................. (57,882) (4,098) -- -- (61,980)
Increase in assets restricted for the
settlement of unpaid claims............. -- (16,713) (2,893) -- (19,606)
Proceeds from the sale of assets.......... -- -- 5,879 -- 5,879
Other..................................... (1,050) -- -- -- (1,050)
------------ -------------- ------------- ------------- -------------
Cash provided by (used in) investing
activities................................ (76,661) (21,988) 1,668 -- (96,981)
------------ -------------- ------------- ------------- -------------
Cash Flows from Financing Activities:
Proceeds from the issuance of debt........ 28,869 -- -- -- 28,869
Payments on debt and capital lease
obligations............................. (46,202) (31) (546) -- (46,779)
Purchases of treasury stock............... -- (4,531) (818) -- (5,349)
Cash flows from other financing
activities.............................. -- -- 531 -- 531
------------ -------------- ------------- ------------- -------------
Cash provided by (used in) financing
activities................................ (17,333) (4,562) (833) -- (22,728)
------------ -------------- ------------- ------------- -------------
Net increase (decrease) in cash and cash
equivalents............................... (11,131) 1,673 (14,631) -- (24,089)
Cash and cash equivalents at beginning of
period.................................... 71,850 8,606 49,147 -- 129,603
------------ -------------- ------------- ------------- -------------
Cash and cash equivalents at end of
period.................................... $ 60,719 $ 10,279 $ 34,516 $ -- $ 105,514
------------ -------------- ------------- ------------- -------------
------------ -------------- ------------- ------------- -------------
</TABLE>
The accompanying Notes to Condensed Consolidating Financial Statements
are an integral part of these statements.
F-43
<PAGE>
17. GUARANTOR CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
SEPTEMBER 30, 1996
-------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
MAGELLAN
HEALTH
SERVICES,
INC. CONSOLIDATED
GUARANTOR NONGUARANTOR (PARENT ELIMINATION CONSOLIDATED
SUBSIDIARIES SUBSIDIARIES CORPORATION) ENTRIES TOTAL
------------ -------------- ------------- ------------- -------------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Net revenue................................. $1,012,448 $ 349,910 $ 975 $ (18,054) $ 1,345,279
Costs and expenses
Salaries, cost of care and other operating
expenses................................ 767,317 300,919 14,263 (18,054) 1,064,445
Bad debt expense.......................... 76,784 5,379 (693) -- 81,470
Depreciation and amortization............. 35,801 11,969 1,154 -- 48,924
Interest, net............................. (42,935) (1,038) 91,990 -- 48,017
Stock option expense...................... -- -- 914 -- 914
Unusual items............................. 4,897 1,265 31,109 -- 37,271
------------ -------------- ------------- ------------- -------------
841,864 318,494 138,737 (18,054) 1,281,041
------------ -------------- ------------- ------------- -------------
Income (loss) before income taxes and equity
in earnings (loss) of subsidiaries........ 170,584 31,416 (137,762) -- 64,238
Provision for (benefit from) income taxes... (14,543) 9,317 30,921 -- 25,695
------------ -------------- ------------- ------------- -------------
Income (loss) before equity in earnings
(loss) of subsidiaries.................... 185,127 22,099 (168,683) -- 38,543
Equity in earnings (loss) of continuing
subsidiaries.............................. (997) (4,772) 201,066 (201,457) (6,160)
------------ -------------- ------------- ------------- -------------
Net income (loss)........................... $ 184,130 $ 17,327 $ 32,383 $ (201,457) $ 32,383
------------ -------------- ------------- ------------- -------------
------------ -------------- ------------- ------------- -------------
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
Cash provided byoperating activities........ $ 8,028 $ 67,865 $ 25,973 $ -- $ 101,866
------------ -------------- ------------- ------------- -------------
Cash Flows from Investing Activities:
Capital expenditures...................... (27,543) (5,687) (5,571) -- (38,801)
Acquisition of businessess................ (820) 35,792 (85,890) -- (50,918)
Increase in assets restricted for the
settlement of unpaid claims............. -- (28,543) 10,811 -- (17,732)
Proceeds from the sale of assets.......... 2,663 2,585 -- -- 5,248
------------ -------------- ------------- ------------- -------------
Cash provided by (used in) investing
activities................................ (25,700) 4,147 (80,650) -- (102,203)
------------ -------------- ------------- ------------- -------------
Cash Flows from Financing Activities:
Payments on debt and capital lease
obligations............................. (13,296) (4,539) (68,000) -- (85,835)
Proceeds from the issuance of debt........ -- 1,800 103,000 -- 104,800
Proceeds from the issuance of common
stock, net of issuance costs............ -- -- 68,573 -- 68,573
Purchase of treasury stock................ -- -- (73,493) -- (73,493)
Income tax payments made on behalf of
stock optionee.......................... -- -- (1,678) -- (1,678)
Proceeds from exercise of stock options &
warrants................................ -- -- 3,401 -- 3,401
------------ -------------- ------------- ------------- -------------
Cash provided by (used in) financing
activities................................ (13,296) (2,739) 31,803 -- 15,768
------------ -------------- ------------- ------------- -------------
Net increase (decrease) in cash and cash
equivalents............................... (30,968) 69,273 (22,874) -- 15,431
Cash and cash equivalents at beginning of
period.................................... 60,719 10,279 34,516 -- 105,514
------------ -------------- ------------- ------------- -------------
Cash and cash equivalents at end of
period.................................... $ 29,751 $ 79,552 $ 11,642 $ -- $ 120,945
------------ -------------- ------------- ------------- -------------
------------ -------------- ------------- ------------- -------------
</TABLE>
The accompanying Notes to Condensed Consolidating Financial Statements
are an integral part of these statements.
F-44
<PAGE>
17. GUARANTOR CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MAGELLAN HEALTH SERVICES, INC.
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
SEPTEMBER 30, 1997
-------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
MAGELLAN
HEALTH
SERVICES,
INC. CONSOLIDATED
GUARANTOR NONGUARANTOR (PARENT ELIMINATION CONSOLIDATED
SUBSIDIARIES SUBSIDIARIES CORPORATION) ENTRIES TOTAL
------------ -------------- ------------- ------------- -------------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Net revenue................................. $ 733,604 $ 477,186 $ 865 $ (959) $ 1,210,696
Costs and expenses
Salaries, cost of care and other
operating expenses.................... 543,297 399,726 36,449 (959) 978,513
Bad debt expense........................ 42,427 4,228 (444) -- 46,211
Depreciation and amortization........... 26,194 15,695 2,972 -- 44,861
Interest, net........................... (60,735) (2,372) 108,484 -- 45,377
Stock option expense.................... -- -- 4,292 -- 4,292
Equity in loss of CBHS.................. 8,122 -- -- -- 8,122
Loss on Crescent Transactions........... 13,684 14 46,170 -- 59,868
Unusual items........................... (1,188) -- 1,545 -- 357
------------ -------------- ------------- ------------- -------------
571,801 417,291 199,468 (959) 1,187,601
------------ -------------- ------------- ------------- -------------
Income (loss) before income taxes, equity in
earnings (loss) of subsidiaries and
extraordinary items....................... 161,803 59,895 (198,603) -- 23,095
Provision for (benefit from) income taxes... 8,424 8,929 (8,115) -- 9,238
------------ -------------- ------------- ------------- -------------
Income (loss) before equity in earnings
(loss) of subsidiaries and extraordinary
items..................................... 153,379 50,966 (190,488) -- 13,857
Equity in earnings (loss) of continuing
subsidiaries.............................. (930) (7,985) 195,243 (195,430) (9,102)
------------ -------------- ------------- ------------- -------------
Income (loss) before extraordinary item..... 152,449 42,981 4,755 (195,430) 4,755
Extraordinary item--loss on early
extinguishment of debt (net of income tax
benefit of $3,503)........................ (2,103) -- (5,253) 2,103 (5,253)
------------ -------------- ------------- ------------- -------------
Net income (loss)........................... $ 150,346 $ 42,981 $ (498) $ (193,327) $ (498)
------------ -------------- ------------- ------------- -------------
------------ -------------- ------------- ------------- -------------
<CAPTION>
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
<S> <C> <C> <C> <C> <C>
Cash provided by (used in) operating
activities................................ $ 58,324 $ 9,964 $ 5,311 $ -- $ 73,599
------------ -------------- ------------- ------------- -------------
Cash Flows from Investing Activities:
Capital expenditures.................... (18,300) (13,225) (1,823) -- (33,348)
Acquisitions and investments in
businesses, net of cash acquired...... (37,066) (13,186) (624) -- (50,876)
Decrease (increase) in assets restricted
for the settlement of unpaid claims... -- 4,652 12,557 -- 17,209
Proceeds from the sale of assets........ 18,270 -- -- -- 18,270
Proceeds from the sale of property and
equipment to Crescent and CBHS........ 196,066 -- 184,359 -- 380,425
------------ -------------- ------------- ------------- -------------
Cash provided by (used in) investing
activities................................ 158,970 (21,759) 194,469 -- 331,680
------------ -------------- ------------- ------------- -------------
Cash Flows from Financing Activities:
Payments on debt and capital lease
obligations........................... (273,060) (5,431) (111,763) -- (390,254)
Proceeds from the issuance of debt...... 128,434 -- 75,209 -- 203,643
Proceeds from the exercise of stock
options & warrants.................... -- -- 8,265 -- 8,265
Proceeds from the issuance of warrants
to Crescent and COI................... -- -- 25,000 -- 25,000
------------ -------------- ------------- ------------- -------------
Cash provided by (used in) financing
activities................................ (144,626) (5,431) (3,289) -- (153,346)
------------ -------------- ------------- ------------- -------------
Net increase (decrease) in cash and cash
equivalents............................... 72,668 (17,226) 196,491 -- 251,933
Cash and cash equivalents at beginning of
period.................................... 29,751 79,552 11,642 -- 120,945
------------ -------------- ------------- ------------- -------------
Cash and cash equivalents at end of
period.................................... $ 102,419 $ 62,326 $ 208,133 $ -- $ 372,878
------------ -------------- ------------- ------------- -------------
------------ -------------- ------------- ------------- -------------
</TABLE>
The accompanying Notes to Condensed Consolidating Financial Statements
are an integral part of these statements.
F-45
<PAGE>
17. GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (CONTINUED)
NOTES TO THE CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
General--These condensed consolidating financial statements reflect the
Guarantors under the Magellan Outstanding Notes as of 9/30/97 (the "Guarantor").
The direct and indirect Guarantors are wholly owned by the Company or a
Guarantor of the Company. Separate financial statements of the Guarantors are
not presented because the Guarantors are jointly, severally and unconditionally
liable under the guarantees, which are full, unconditional, joint and several
and the Company believes the condensed consolidating financial statements
presented are more meaningful in understanding the financial position of the
Guarantor, and the separate financial statements are deemed not material to
investors.
Distributions--There are no restrictions on the ability of the Guarantor to
make distributions to the Company.
Transfers from Guarantors to Nonguarantors--The Magellan Existing Credit
Agreement permits the Company to contribute certain assets to joint ventures
that conduct a healthcare business, provided that certain conditions are
satisfied and that the aggregate fair market value of all such assets
contributed to joint ventures with respect to which the Company and its
wholly-owned subsidiaries have less than 50% of the equity interests or do not
control such joint ventures does not exceed $35 million. Furthermore, the
Magellan Existing Credit Agreement permits the Company and its Subsidiaries to
make investments in controlled joint ventures up to $35 million plus the amount
permitted but not used for uncontrolled joint ventures. The indenture related to
the Magellan Outstanding Notes also contains provisions that permit the Company
and its Restricted Subsidiaries (as defined in the indenture for the Magellan
Outstanding Notes) to make investments in non-guarantors subject to limits.
The Company intends to make investments in Permitted Non-Control Investments
(as defined in the Magellan Existing Credit Agreement) and Permitted
Non-Guarantor Transactions (as defined in the Magellan Existing Credit
Agreement) to the extent it believes doing so will be consistent with its
business strategy. To the extent the Company or its Restricted Subsidiaries make
investments of the type described above, the assets available for debt payments
and guarantee obligations could be diminished.
F-46
<PAGE>
18. SUBSEQUENT EVENTS (UNAUDITED)
MERIT ACQUISITION. On February 12, 1998, the Company acquired all of the
outstanding stock of Merit Behavioral Care Corporation ("Merit") for
approximately $448.9 million in cash plus the repayment of Merit's debt. The
Company refinanced its $375 million 11.25% Senior Subordinated Notes as part of
the Merit acquisition. The Company accounted for the Merit acquisition using the
purchase method of accounting. Merit provides managed health care services for
approximately 21.6 million covered lives across all segments of the healthcare
industry, including HMOs, Blue Cross/Blue Shield organizations and other
insurance companies, corporations and labor unions, federal, state and local
government agencies, and various state Medicaid programs.
The following table sets forth the sources and uses of funds for the
Transactions at closing (in thousands):
<TABLE>
<S> <C>
SOURCES:
Cash and cash equivalents...................................... $ 59,290
New Credit Agreement:
Revolving Facility (1)....................................... 20,000
Term Loan Facility........................................... 550,000
The Notes...................................................... 625,000
----------
Total sources................................................ $1,254,290
----------
----------
USES:
Cash paid to Merit shareholders................................ $ 448,867
Repayment of Merit Existing Credit Agreement (2)............... 196,357
Purchase of Magellan Outstanding Notes (3)..................... 432,102
Purchase of Merit Outstanding Notes (4)........................ 121,651
Transaction costs (5).......................................... 55,313
----------
Total uses..................................................... $1,254,290
----------
----------
</TABLE>
- ------------------------
(1) The Revolving Facility provides for borrowings of up to $150.0 million. The
Company had approximately $112.5 million available for borrowing pursuant to
the Revolving Facility after consummating the Transactions, excluding
approximately $17.5 million of availability reserved for certain letters of
credit.
(2) Includes principal amount of $193.6 million and accrued interest of $2.7
million.
(3) Includes principal amount of $375.0 million, tender premium of $43.4 million
and accrued interest of $13.7 million.
(4) Includes principal amount of $100.0 million, tender premium of $18.9 million
and accrued interest of $2.8 million.
(5) Transaction costs include, among other things, expenses payable at closing
associated with the tender offers for the Magellan Outstanding Notes and the
Merit Outstanding Notes, the Notes, the Merit acquisition and the New Credit
Agreement.
The purchase price allocation for the Merit Acquisition reflected in the
June 30, 1998 balance sheet is tentative and subject to adjustment pending final
valuations on property and equipment and identifiable intangible assets,
determination of final valuation allowances on deferred tax assets, integration
plan matters and certain other matters. The Company expects the purchase price
allocation to be finalized by December 31, 1998.
F-47
<PAGE>
18. SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
EFFECT OF THE MERIT ACQUISITION ON LONG-TERM DEBT
In connection with the acquisition of Merit on February 12, 1998, the
Company (i) terminated the Magellan Existing Credit Agreement; (ii) repaid all
loans outstanding pursuant to Merit's existing credit agreement; (iii) completed
a tender offer for its 11.25% Series A Senior Subordinated Notes due 2004; (iv)
completed a tender offer for Merit's 11.50% Senior Subordinated Notes due 2005
(the "Merit Outstanding Notes"); (v) entered into a new senior secured bank
credit agreement (the "New Credit Agreement") with the Chase Manhattan Bank and
a syndicate of financial institutions, providing for Credit Facilities of up to
$700 million, and (vi) issued $625 million in 9.0% Senior Subordinated Notes due
2008 (the "New Notes").
The Company recognized a net extraordinary loss from the early
extinguishment of debt of approximately $33.0 million, net of income tax
benefit, during the nine months ended June 30, 1998 to write off unamortized
deferred financing costs related to terminating the Magellan Existing Credit
Agreement and extinguishing the Magellan Outstanding Notes, to record the tender
premium and related costs of extinguishing the Magellan Outstanding Notes and to
record the gain on extinguishment of the 7.5% Swiss Bonds.
The New Credit Agreement provides for a Term Loan Facility in an aggregate
principal amount of $550 million, consisting of an approximately $183.3 million
Tranche A Term Loan (the "Tranche A Term Loan"), an approximately $183.3 million
Tranche B Term Loan (the "Tranche B Term Loan") and an approximately $183.3
million Tranche C Term Loan (the "Tranche C Term Loan"), and a Revolving
Facility providing for revolving loans to the Company and the "Subsidiary
Borrowers" (as defined therein) and the issuance of letters of credit for the
account of the Company and the Subsidiary Borrowers in an aggregate principal
amount (including the aggregate stated amount of letters of credit) of $150
million.
The Tranche A Term Loan and the Revolving Facility matures on February 12,
2004. The Tranche B Term Loan matures on February 12, 2005 and the Tranche C
Term Loan matures on February 12, 2006. The Tranche A Term Loan amortizes in
installments in each fiscal year in amounts equal to $16.5 million in 1999,
$28.0 million in 2000, $34.5 million in 2001, $45.0 million in 2002, $48.0
million in 2003, and $11.3 million in 2004. The Tranche B Term Loan amortizes in
installments in amounts equal to $1.7 million in 1999, $2.2 million in each of
2000 through 2002, $41.8 million in 2003, $103.4 million in 2004, and $29.8
million in 2005. The Tranche C Term Loan amortizes in installments in amounts
equal to $1.7 million in 1999, $2.2 million in each of 2000 through 2003, $41.8
million in 2004, $101.9 million in 2005, and $29.1 million in 2006. In addition,
the credit facilities are subject to mandatory prepayment and reductions (to be
applied first to the Term Loan Facility) in an amount equal to (a) 100% of the
net proceeds of certain offerings of equity securities by the Company or any of
its subsidiaries, (b) 100% of the net proceeds of certain debt issuances of the
Company or any of its subsidiaries, (c) 75% of the Company's excess cash flow
and (d) 100% of the net proceeds of certain asset sales or other dispositions of
property of the Company and its subsidiaries, in each case subject to certain
limited exceptions.
The New Credit Agreement contains a number of covenants that, among other
things, restrict the ability of the Company and its subsidiaries to dispose of
assets, incur additional indebtedness, incur or guarantee obligations, prepay
other indebtedness or amend other debt instruments (including the Indenture for
the New Notes), pay dividends, create liens on assets, make investments, loans
or advances, redeem or repurchase common stock, make acquisitions, engage in
mergers or consolidations, change the business conducted by the Company and its
subsidiaries and make capital expenditures. In addition, the New Credit
Agreement requires the Company to comply with specified financial ratios and
tests, including minimum coverage ratios, maximum leverage ratios, maximum
senior debt ratios, minimum "EBITDA" (as defined in the New Credit Agreement)
and minimum net worth tests.
F-48
<PAGE>
18. SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
At the Company's election, the interest rates per annum applicable to the
loans under the New Credit Agreement are a fluctuating rate of interest measured
by reference to either (a) an adjusted London inter-bank offered rate ("LIBOR")
plus a borrowing margin or (b) an alternate base rate ("ABR") (equal to the
higher of the Chase Manhattan Bank's published prime rate and the Federal Funds
effective rate plus 1/2 of 1%) plus a borrowing margin. The borrowing margins
applicable to the Tranche A Term Loan and loans under the Revolving Facility are
currently 1.25% for ABR loans and 2.25% for LIBOR loans, and are subject to
reduction if the Company's financial results satisfy certain leverage tests. The
borrowing margins applicable to the Tranche B Term Loan and the Tranche C Term
Loan are 1.50% and 1.75%, respectively, for ABR loans and 2.50% and 2.75%,
respectively, for LIBOR loans, and are not subject to reduction. Amounts
outstanding under the credit facilities not paid when due bear interest at a
default rate equal to 2.00% above the rates otherwise applicable to each of the
loans under the Term Loan Facility and the Revolving Facility.
The obligations of the Company and the Subsidiary Borrowers under the New
Credit Agreement are unconditionally and irrevocably guaranteed by, subject to
certain exceptions, each wholly owned domestic subsidiary and, subject to
certain exceptions, each foreign subsidiary of the Company. In addition, the
Credit Facilities and the guarantees are secured by security interests in and
pledges of or liens on substantially all the tangible and intangible assets of
the guarantors, subject to certain exceptions.
The New Notes are general unsecured senior subordinated obligations of the
Company. The New Notes are limited in aggregate principal amount to $625 million
and will mature on February 15, 2008. Interest on the New Notes will accrue at
the rate of 9.0% per annum and will be payable semi-annually on each February 15
and August 15, commencing on August 15, 1998. The Company entered into an
Exchange and Registration Rights Agreement in connection with the issuance of
the New Notes. The Company agreed, pursuant to such agreement, to use its
reasonable best efforts to file with the Securities and Exchange Commission (the
"Commission") an exchange offer registration statement and to have this
registration statement declared effective as promptly as practicable after
filing it. Furthermore, the Company agreed to offer to the holders of the New
Notes the opportunity to exchange the New Notes for an issue of a second series
of notes that are identical in all material respects to the New Notes and that
would be registered under the Securities Act of 1933, as amended (the
"Securities Act"). Under the Commission's interpretations of the Securities Act,
holders of the New Notes who accept the exchange offer would receive, subject to
certain exceptions, securities that could be freely transferred. The Company
also agreed that, if the exchange offer were not consummated by July 13, 1998,
it would pay liquidated damages in an amount equal to $0.192 per week per $1,000
principal amount of the New Notes commencing on July 13, 1998, and continuing
until such exchange offer is consummated. The Company has not had its exchange
offer registration statement declared effective by the Commission and,
therefore, could not consummate the exchange offer on the scheduled date.
Therefore, the Company became obligated to pay the liquidated damages on the New
Notes on July 13, 1998 and will continue to be obligated to pay such liquidated
damages until the exchange offer is consummated.
The New Notes are not redeemable at the option of the Company prior to
February 15, 2003. The New Notes will be redeemable at the option of the Company
on or after such date, in whole or in part, at the redemption prices (expressed
as a percentage of the principal amount) set forth below, plus accrued
F-49
<PAGE>
18. SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
and unpaid interest, during the twelve-month period beginning on February 15 of
the years indicated below:
<TABLE>
<CAPTION>
REDEMPTION
YEAR PRICES
- ------------------------------------------------------------ -------------
<S> <C>
2003........................................................ 104.5%
2004........................................................ 103.0%
2005........................................................ 101.5%
2006 and thereafter......................................... 100.0%
</TABLE>
In addition, at any time and from time to time prior to February 15, 2001,
the Company may, at its option, redeem up to 35% of the original aggregate
principal amount of New Notes at a redemption price (expressed as a percentage
of the principal amount) of 109%, plus accrued and unpaid interest with the net
cash proceeds of one or more equity offerings; provided that at least 65% of the
original aggregate principal amount of New Notes remains outstanding immediately
after the occurrence of such redemption and that such redemption occurs within
60 days of the date of the closing of any such equity offering.
The Indenture for the New Notes limits, among other things: (i) the
incurrence of additional indebtedness by the Company and its Restricted
Subsidiaries (as defined); (ii) the payment of dividends on, and redemption or
repurchase of, capital stock of the Company and its Restricted Subsidiaries and
the redemption of certain Subordinated Obligations of the Company; (iii) certain
other restricted payments, including investments; (iv) sales of assets; (v)
certain transactions with affiliates; (vi) the creation of liens; and (vii)
consolidations, mergers and transfers of all or substantially all the Company's
assets. The Indenture for the New Notes also prohibits certain restrictions on
distributions from Restricted Subsidiaries. However, all such limitations and
prohibitions are subject to certain qualifications and exceptions.
GREEN SPRING MINORITY SHAREHOLDER CONVERSION. The four minority
shareholders of Green Spring converted their ownership interests into 2,831,516
shares of Magellan common stock in accordance with the terms in the Green Spring
Exchange Agreement at various dates during January 1998. The Company accounted
for the Green Spring Minority Shareholder Conversion as a purchase of the
minority interests in Green Spring at the fair value of the consideration paid
of approximately $63.5 million. The fair value of the consideration paid was
based on the closing price of the Company's Common Stock on the date each
minority shareholder formally elected to convert their interests in Green Spring
to the Company's Common Stock.
ALLIED HEALTH GROUP, INC. ACQUISITION. On December 5, 1997, the Company
purchased the assets of Allied Health Group, Inc. and certain affiliates
("Allied"). Allied provides specialty risk-based products and administrative
services to a variety of insurance companies and other customers for its 5.0
million members. Allied manages over 80 physician networks across the eastern
United States. Allied's networks include physicians specializing in cardiology,
oncology and diabetes. The Company paid $70 million for Allied, of which $50
million was paid to the sellers at closing with the remaining $20 million placed
in escrow.
The Company funded the acquisition of Allied with cash on hand and has
accounted for the acquisition of Allied using the purchase method of accounting.
The escrowed amount is payable if Allied achieves specified earnings targets
during the three years following the closing. Additionally, the purchase price
may be increased during the three year period by $40 million if Allied's
performance exceeds specified earnings targets. The maximum purchase price
payable is $110 million.
The purchase price the Company paid for Allied is subject to increase or
decrease based on the operating performance of Allied during the three year
period following the closing. The adjustments will be computed based on EBITDA
(as defined in the Allied Purchase Agreement) from the consolidated
F-50
<PAGE>
18. SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
operations of Allied during each of the Year 1 Earn-Out Period, the Year 2
Earn-Out Period and the Year 3 Earn-Out Period (each, as defined). "EBITDA," as
defined in the Allied Purchase Agreement, means the aggregate net revenue from
the operations of Allied, minus all expenses incurred in operating the business
of Allied but before interest, income taxes, depreciation and amortization,
prepared in accordance with generally accepted accounting principles,
consistently applied, subject to specified adjustments. "Year 1 Earn-Out Period"
means the 12-month period ending on November 30, 1998. "Year 2 Earn-Out Period"
means the 12-month period ending on November 30, 1999. "Year 3 Earn-Out Period"
means the 12-month period ending on November 30, 2000.
With respect to the Year 1 Earn-Out Period, in the event the EBITDA for the
Year 1 Earn-Out Period (the "Year 1 EBITDA") is less than $10.0 million, then
the adjustment to the purchase price with respect to such period is an amount
equal to seven multiplied by the difference between the Year 1 EBITDA and $10.0
million. Such amount shall be paid to the Company from the portion of the
purchase price paid for Allied that was placed in escrow. In the event the Year
1 EBITDA is equal to or less than $11.0 million and equal to or greater than
$10.0 million, then there will be no adjustment to the purchase price with
respect to such period. In the event the Year 1 EBITDA is greater than $11.0
million, then the adjustment to the purchase price with respect to such period
is an amount equal to six multiplied by the difference between the Year 1 EBITDA
and $11.0 million. Such amount shall be paid in escrow for the benefit of the
sellers.
With respect to the Year 2 Earn-Out Period, in the event the EBITDA for the
Year 2 Earn-Out Period (the "Year 2 EBITDA") is equal to or less than the
greater of (i) $11.0 million or (ii) the Year 1 EBITDA (the greater of which
being the "Year 2 Threshold"), then the adjustment to the purchase price with
respect to such period is an amount equal to the sum of (i) six multiplied by
the difference between the Year 2 Threshold and the greater of (x) $11.0 million
or (y) the Year 2 EBITDA, plus (ii) an amount equal to seven multiplied by the
amount, if any, by which the Year 2 EBITDA is less than $10.0 million. Such
amount shall be paid to the Company from the portion of the purchase price paid
for Allied that was placed in escrow. In the event the Year 2 EBITDA is greater
than the Year 2 Threshold, then the adjustment to the purchase price with
respect to such period is the amount equal to six multiplied by the difference
between the Year 2 EBITDA and the Year 2 Threshold. Such amount shall be paid in
escrow for the benefit of the Sellers. If the Year 2 EBITDA is equal to or
greater than $10.0 million but less than or equal to $11.0 million, there will
be no adjustment to the purchase price with respect to such period.
With respect to the Year 3 Earn-Out Period, in the event the EBITDA for the
Year 3 Earn-Out Period (the "Year 3 EBITDA") is equal to or less than the
greater of (i) $11.0 million, (ii) the Year 1 EBITDA, or (iii) the Year 2 EBITDA
(the greatest of which being the "Year 3 Threshold"), then the adjustment to the
purchase price with respect to such period is an amount equal to the sum of (i)
four multiplied by the difference between the Year 3 Threshold and the greater
of (x) $11.0 million or (y) the Year 3 EBITDA, plus (ii) an amount equal to
seven multiplied by the amount, if any, by which the Year 3 EBITDA is less than
$10.0 million. Such amount shall be paid to the Company from the portion of the
purchase price paid for Allied that was placed in escrow. In the event the Year
3 EBITDA is greater than the Year 3 Threshold, then the adjustment to the
purchase price with respect to such period is the amount equal to four
multiplied by the difference between the Year 3 EBITDA and the Year 3 Threshold.
Such amount shall be paid to the Seller. If the Year 3 EBITDA is equal to or
greater than $10.0 million but less than or equal to $11.0 million, there will
be no adjustment to the purchase price with respect to such period.
The Company would record contingent consideration payable, if any, as
additional goodwill.
The preliminary allocation of the Allied purchase price to goodwill and
identifiable intangible assets was based on the Company's preliminary
valuations, which are subject to change upon receiving independent appraisals of
identifiable intangible assets. The Company expects the Allied purchase price
allocation to be finalized by September 30, 1998.
F-51
<PAGE>
18. SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
HAI ACQUISITION. On December 4, 1997, the Company acquired the outstanding
common stock of Human Affairs International, Incorporated ("HAI"), a
wholly-owned subsidiary of Aetna Insurance Company of Connecticut and a unit of
Aetna U.S. Healthcare ("Aetna"), for approximately $122.1 million. HAI provides
managed care services to approximately 16.3 million covered lives, primarily
through employee assistance programs and other managed behavioral healthcare
plans. The Company funded the acquisition of HAI with cash on hand and has
accounted for the acquisition of HAI using the purchase method of accounting.
The Company may be required to make additional contingent payments of up to
$300 million to Aetna (the "Contingent Payments") over the five-year period
(each year a "Contract Year") subsequent to closing. The amount and timing of
the Contingent Payments will depend upon HAI's receipt of additional covered
lives as computed, under two separate calculations. Under the first calculation,
the Company may be required to pay up to $25 million per year for each of five
years following the acquisition based on the net annual growth in the number of
lives covered in specified HAI products. Under the second calculation, the
Company may be required to pay up to $35 million per Contract Year, based on the
net cumulative increase in lives covered by certain other HAI products.
The Company is obligated to make contingent payments under two separate
calculations (as previously described) as follows: In respect of each Contract
Year, the Company may be required to pay to Aetna the "Tranche 1 Payments" (as
defined) and the "Tranche 2 Payments" (as defined).
Upon the expiration of each Contract Year, the Tranche 1 Payment shall vest
with respect to such Contract Year in an amount equal to the produce of (i) the
Tranche 1 Cumulative Incremental Members (as defined) for such Contract Year and
(ii) the Tranche 1 Multiplier (as defined) for such Contract Year. The vested
amount of Tranche 1 Payment shall be zero with respect to any Contract Year in
which the Tranche 1 Cumulative Incremental Members is a negative number.
Furthermore, in the event that the number of Tranche 1 Cumulative Incremental
Members with respect to any Contract Year is a negative number due to a decrease
in the number of Tranche 1 Cumulative Incremental Members for such Contract Year
(as compared to the immediately preceding Contract Year), Aetna will forfeit the
right to receive a certain portion (which may be none or all) of the vested and
unpaid amounts of the Tranche 1 Payment relating to preceding Contract years.
"Tranche 1 Cumulative Incremental Members" means, with respect to any
Contract Year, (i) the number of Equivalent Members (as defined) serviced by the
Company during such Contract Year for Tranche 1 Members, minus (9)(A) for each
Contract Year other than the Initial Contract Year, the number of Equivalent
Members serviced by the Company for Tranche 1 Members during the Immediately
preceding Contract Year or (B) for the Initial Contract Year, the number of
Tranche 1 Members as of September 30, 1997, subject to certain upward
adjustments. There were 3,761,253 Tranche 1 Members for the initial Contract
Year, prior to such upward adjustments. "Tranche 1 Members" are members of
managed behavioral healthcare plans for whom the Company provides services in
any of specified categories of products or services. "Equivalent Members" for
any Contract Year equals the aggregate Member Months for which the Company
provides services to a designated category or categories of members during the
applicable Contract Year divided by 12. "Member Months" means, for each member,
the number of months for which the Company provides services and is compensated.
The "Tranche 1 Multiplier" is $80, $50, $40, $25, and $20 for the Contract Years
1998, 1999, 2000, 2001, and 2002, respectively.
For each Contract Year, the Company is obligated to pay to Aetna the lesser
of (i) the vested portion of the Tranche 1 Payment for such Contract Year and
the vested and unpaid amount relating to prior Contract Years as of the end of
the immediately preceding Contract Year and (ii) $25.0 million. To the extent
that the vested and unpaid portion of the Tranche 1 Payment exceeds $25.0
million, the Tranche 1 Payment remitted to Aetna shall be deemed to have been
paid first from any vested but unpaid amounts
F-52
<PAGE>
18. SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
from previous Contract Years in order from the earliest Contract Year for which
vested amounts remain unpaid to the most recent Contract Year at the time of
such calculation. Except with respect to the Contract Year ending in 2002, any
vested but unpaid portion of the Tranche 1 Payment shall be available for
payment to Aetna in future Contract Years, subject to certain exceptions. All
vested but unpaid amounts of Tranche 1 Payments shall expire following the
payment of the Tranche 1 Payment in respect to the Contract Year ending in 2002,
subject to certain exceptions. In no event shall the aggregate Tranche 1
Payments to Aetna exceed $125.0 million.
Upon the expiration of each Contract Year, the Tranche 2 Payment shall be an
amount equal to the lesser of: (a)(i) the product of (A) the Tranche 2
Cumulative Members (as defined) for such Contract Year and (B) the Tranche 2
Multiplier (as defined) applicable to such number of Tranche 2 Cumulative
Members, minus (ii) the aggregate of the Tranche 2 Payments paid to Aetna for
all previous Contract Years and (b) $35.0 million. the amount shall be zero with
respect to any Contract Year in which the Tranche 2 Cumulative Members is a
negative number.
"Tranche 2 Cumulative Members" means, with respect to any Contract Year; (I)
the Equivalent Members serviced by the Company during such Contract Year for
Tranche 2 Members, minus (II) the Tranche 2 Members as of September 30, 1997,
subject to certain upward adjustments. There were 936,391 Tranche 2 Members
prior to such upward adjustments. "Tranche 2 Members" means Members for whom the
Company provides products or services in the HMO category. the "Tranche 2
Multiplier" with respect to each Contract Year is $85 in the event that the
Tranche 2 Cumulative Members are less than 2,100,000, and $70 if more than of
equal to 2,100,000.
For each Contract Year, the Company shall pay to Aetna the amount of Tranche
2 Payment payable for such Contract Year. All rights to receive Tranche 2
Payment shall expire following the payment of the Tranche 2 Payment in respect
to the Contract Year ending in 2002, subject to certain exceptions.
Notwithstanding anything herein to the contrary, in no event shall the aggregate
Tranche 2 Payment to Aetna exceed $175.0 million, subject to certain exceptions.
The Company would record contingent consideration payable, if any, as
goodwill and identifiable intangible assets.
The preliminary allocation of the HAI purchase price to goodwill and
identifiable intangible assets was based on the Company's preliminary
valuations, which are subject to change upon receiving independent appraisals of
identifiable intangible assets. The Company expects the Allied purchase price
allocation to be finalized by September 30, 1998
The unaudited pro forma information for the nine months ended June 30, 1997
and 1998 has been prepared assuming the Crescent Transactions (as defined),
Allied acquisition, HAI acquisition, the Transactions and the Green Spring
Minority Shareholder Conversion were consummated on October 1, 1996. The
unaudited pro forma information does not purport to be indicative of the results
that would
F-53
<PAGE>
18. SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
have been obtained had such transactions been consummated, or which may be
attained in future periods (in thousands, except per share data):
<TABLE>
<CAPTION>
PRO FORMA
FOR THE NINE MONTHS ENDED
----------------------------
JUNE 30, JUNE 30,
1997 1998
------------- -------------
<S> <C> <C>
Net revenue.................................................. $ 1,158,515 $ 1,374,059
Income before extraordinary items(1)......................... 12,466 10,975
Net income(1)(2)............................................. 9,516 10,975
Income per common share--basic...............................
Income before extraordinary items.......................... 0.40 0.35
Net income................................................. 0.30 0.35
Income per common share--diluted:
Income before extraordinary items.......................... 0.39 0.34
Net income................................................. 0.30 0.34
</TABLE>
(1) Excludes expected unrealized cost savings related to the Integration
Plan, Managed Care integration costs and Loss on Crescent Transactions.
(2) Excludes the extraordinary loss on early extinguishment of debt for the
nine months ended June 30, 1998 that was directly attributable to the
consummation of the Transactions.
PUBLIC SECTOR ACQUISITIONS
During fiscal 1998, the Company has acquired six businesses in its public
sector segment for an aggregate purchase price of approximately $53.0 million
(collectively, the "Public Sector Acquisitions"). The Public Sector Acquisitions
have been accounted for using the purchase method of accounting. The Public
Sector Acquisitions provide various residential and day services for individuals
with acquired brain injuries and for individuals with mental retardation and
developmental disabilities.
INTEGRATION PLAN
The Company owns three behavioral managed care organizations ("BMCOs"),
Green Spring, HAI and Merit, as a result of acquisitions consummated in fiscal
1996 (Green Spring) and fiscal 1998 (HAI and Merit). The Company also owns two
other specialty managed care organizations, Allied and Care Management
Resources, Inc. ("CMR"). Management has approved and committed the Company to a
plan to combine and integrate the operations of its BMCOs and other specialty
managed care organizations (the "Integration Plan") that will result in the
elimination of duplicative functions and will standardize business practices and
information technology platforms. The Company expects to achieve approximately
$60 million of cost savings on an annual basis by August 1999 at its BMCOs and
approximately $3 million of cost savings on an annual basis at CMR as a result
of the Integration Plan.
The Integration Plan will result in the elimination of approximately 1,000
positions during fiscal 1998 and fiscal 1999. Approximately 200 employees had
been involuntarily terminated pursuant to the Integration Plan as of June 30,
1998 and approximately 250 positions have been eliminated by normal attrition
through June 30, 1998. The remaining positions to be eliminated have been
identified, and will be eliminated through a combination of normal attrition and
involuntary termination.
The employee groups of the BMCOs that are primarily affected include
executive management, finance, human resources, information systems and legal
personnel at the various BMCOs corporate headquarters and regional offices and
credentialing, claims processing, contracting and marketing personnel at various
operating locations. The Company expects to complete the specific identification
of
F-54
<PAGE>
18. SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
all personnel who will be involuntarily terminated by December 31, 1998 and will
complete its involuntary terminations by April 1999.
The Integration Plan will also result in the closure of approximately 40 to
45 leased facilities at the BMCOs during fiscal 1998 and fiscal 1999. As of June
30, 1998, 20 offices had been specifically identified for closure and 20 to 25
additional offices are under consideration for closure. The Company expects to
complete the specific identification of remaining office closures by December
31, 1998.
The Company has recorded approximately $18.3 million of liabilities related
to the Integration Plan, of which $11.7 million was recorded as part of the
Merit purchase price allocation and $6.6 million was recorded in the statement
of operations under "Managed Care integration costs". These amounts represent
portions of the Integration Plan obligations that were measurable as of June 30,
1998. The Company expects to record additional liabilities as a result of the
Integration Plan in fiscal 1998 and fiscal 1999 as final decisions regarding
office closures and other contractual obligation terminations are made.
The following table provides a rollforward of liabilities resulting from the
Integration Plan (in thousands):
<TABLE>
<CAPTION>
BALANCE BALANCE
SEPTEMBER 30, JUNE 30,
TYPE OF COST 1997 ADDITIONS PAYMENTS(1) 1998
- ----------------------------------------------------------- ------------------- ----------- ------------ ---------
<S> <C> <C> <C> <C>
Employee termination benefits.............................. $ -- $ 12,763 $ (3,520) $ 9,243
Facility closing costs..................................... -- 5,279 (188) 5,091
Other...................................................... -- 244 (75) 169
--- ----------- ------------ ---------
$ -- $ 18,286 $ (3,783) $ 14,503
--- ----------- ------------ ---------
--- ----------- ------------ ---------
</TABLE>
- ------------------------
(1) Includes $2.7 million in payments related to Merit
OTHER INTEGRATION COSTS
The Integration Plan will result in additional incremental costs that must
be expensed as incurred in accordance with Emerging Issues Task Force Consensus
94-3, "Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)"
that are not described above and certain other charges. Other integration costs
include, but are not limited to, outside consultants, costs to relocate closed
office contents and long-lived asset impairments. Other integration costs are
reflected in the statement of operations under "Managed Care integration costs".
During the nine months ended June 30, 1998, the Company incurred
approximately $5.7 million in other integration costs, including long-lived
asset impairments of approximately $2.2 million and outside consulting costs of
approximately $3.1 million. The asset impairments relate primarily to
identifiable intangible assets that no longer have value and have been written
off as a result of the Integration Plan.
CBHS TRANSACTIONS. On March 3, 1998, the Company and certain of its wholly
owned subsidiaries entered into definitive agreements with Crescent Operating,
Inc. ("COI") and CBHS pursuant to which the Company would have, among other
things, sold the Company's franchise operations, certain domestic provider
operations and certain other assets and operations. On August 19, 1998, the
Company announced that it had terminated discussions with COI for the sale of
its interest in CBHS. The Company will continue to seek opportunities to divest
its ownership interest in CBHS at a later date. The Company will record a charge
against earnings in the fourth quarter of fiscal 1998 of approximately $1.5
million to $2.0 million for CBHS Transaction costs incurred to date. In
addition, the Company's exercise of its rights under the Master Franchise
Agreement may result in charges to CBHS income, which would result in additional
losses in the equity in loss of CBHS for the Company.
F-55
<PAGE>
18. SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
CONTINGENCIES. The parties involved in the civil QUI TAM action referred to
in Note 13 have reached a tentative settlement. Pursuant to the tentative
settlement, the Company would pay approximately $4.8 million, which has been
accrued as of June 30, 1998. Furthermore, Charter Orlando (now operated by CBHS)
would agree not to seek reimbursement for services provided to patients covered
under the Medicare program for a period of up to fifteen months. The Company has
agreed to reimburse CBHS for the resulting loss of revenues during such period.
The Company has an accrued obligation of $2.2 million as of June 30, 1998 for
this reimbursement.
On May 12, 1998, the District Court granted the Defendants' motion to
dismiss with prejudice the complaint filed against the Defendants alleging
violations of Section 1 of the Sherman Act (the "Antitrust Case") (See Note 13).
On May 27, 1998 the plaintiffs filed a notice of appeal of the District Court's
dismissal of their complaint with the United States Second Circuit Court of
Appeals. The Defendants intend to vigorously contest this appeal and to further
defend themselves in this matter. The Company does not believe this matter will
have a material adverse effect on its financial position or results of
operations.
On May 26, 1998, the counsel representing the plaintiffs in the Antitrust
Case filed an action in the United States District Court for the District of New
Jersey on behalf of a group of thirteen plaintiffs who also purport to represent
an uncertified class of psychiatrists, psychologists and clinical social
workers. This complaint alleges substantially the same violations of federal
antitrust laws by the same nine managed behavioral healthcare organizations that
are the defendants in the Antitrust Case. The Defendants believe the factual and
legal issues involved in this case are substantially similar to those involved
in the Antitrust Case. The Defendants intend to vigorously defend themselves in
this litigation. The Company does not believe this matter will have a material
adverse effect on its financial position or results of operations.
F-56
<PAGE>
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Merit Behavioral Care Corporation
We have audited the accompanying consolidated balance sheets of Merit
Behavioral Care Corporation (the "Company") as of September 30, 1997 and 1996,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for each of the three years in the period ended September 30, 1997.
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 generally accepted auditing
standards. Those standards required that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Merit Behavioral Care
Corporation as of September 30, 1997 and 1996, and the results of its operations
and its cash flows for each of the three years in the period ended September 30,
1997, in conformity with generally accepted accounting principles.
As discussed in Note 4 to the financial statements, effective October 1,
1995, the Company changed its method of accounting for deferred contract
start-up costs related to new contracts or expansion of existing contracts.
Deloitte & Touche LLP
November 14, 1997
New York, New York
F-57
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30,
------------------------
<S> <C> <C> <C>
DECEMBER 31,
1996 1997 1997
----------- ----------- --------------
<CAPTION>
(UNAUDITED)
<S> <C> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents............................................... $ 19,833 $ 43,886 $ 26,153
Accounts receivable, net of allowance for doubtful accounts of $1,996
and $2,603 at September 30, 1996 and 1997 and $1,711 at December 31,
1997 (unaudited)...................................................... 28,383 41,884 49,917
Restricted cash and investments......................................... 27,542 47,593 53,783
Deferred income taxes................................................... 2,296 6,616 6,616
Other current assets.................................................... 2,481 13,129 7,300
----------- ----------- --------------
Total current assets................................................ 80,535 153,108 143,769
Property, plant and equipment, net...................................... 67,880 83,312 82,427
Goodwill and other intangibles, net of accumulated amortization of
$59,781 and $82,637 at September 30, 1996 and 1997 and $89,047 at
December 31, 1997 (unaudited)......................................... 162,849 195,192 187,597
Restricted cash and investments......................................... 5,668 3,727 3,880
Deferred financing costs, net of accumulated amortization of $1,142 and
$2,484 at September 30, 1996 and 1997 and $2,871 at December 31, 1997
(unaudited)........................................................... 11,362 10,634 10,246
Other assets............................................................ 16,507 22,772 23,552
----------- ----------- --------------
Total assets............................................................ $ 344,801 $ 468,745 $ 451,471
----------- ----------- --------------
----------- ----------- --------------
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable........................................................ $ 5,888 $ 11,347 7,217
Claims payable.......................................................... 57,611 102,834 106,957
Deferred revenue........................................................ 6,577 8,131 8,747
Accrued interest........................................................ 5,008 5,161 2,336
Current portion of long-term debt....................................... 500 6,498 1,263
Other current liabilities............................................... 13,079 18,386 15,307
----------- ----------- --------------
Total current liabilities........................................... 88,663 152,357 141,827
Long-term debt.......................................................... 253,500 323,002 318,002
Deferred income taxes................................................... 30,669 15,388 13,525
Other long-term liabilities............................................. 1,451 3,862 5,034
COMMITMENTS AND CONTINGENCIES (SEE NOTE 11)
STOCKHOLDERS' EQUITY:
Common stock (40,000,000 shares authorized, $0.01 par value, 28,398,800
and 29,396,158 shares issued at September 30, 1996 and 1997 and
29,396,158 shares issued at December 31, 1997 (unaudited))............ 284 294 294
Additional paid in capital.............................................. (9,756) 8,949 10,193
Accumulated deficit..................................................... (14,435) (28,307) (30,979)
Notes receivable from officers.......................................... (5,470) (6,800) (6,425)
----------- ----------- --------------
(29,377) (25,864) (26,917)
Less common stock in treasury (21,000 shares)........................... (105) -- --
----------- ----------- --------------
Total stockholders' equity............................................ (29,482) (25,864) (26,917)
----------- ----------- --------------
Total liabilities and stockholders' equity.............................. $ 344,801 $ 468,745 $ 451,471
----------- ----------- --------------
----------- ----------- --------------
</TABLE>
The accompanying notes are an integral part of these statements.
F-58
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEARS ENDED SEPTEMBER 30, DECEMBER 31,
------------------------------------- --------------------------
1995 1996 1997 1996 1997
----------- ----------- ----------- ------------ ------------
<S> <C> <C> <C> <C> <C>
(UNAUDITED) (UNAUDITED)
Revenue....................................... $ 361,549 $ 457,830 $ 555,717 $ 128,625 $ 177,217
Expenses:
Direct service costs........................ 286,001 361,684 449,563 102,932 145,997
Selling, general and administrative......... 49,823 64,523 67,450 16,579 22,091
Amortization of intangibles................. 21,373 25,869 26,897 6,799 7,231
Restructuring charge........................ -- 2,995 -- -- --
Income from joint ventures.................. -- -- -- -- (1,649)
----------- ----------- ----------- ------------ ------------
357,197 455,071 543,910 126,310 173,670
Operating income.............................. 4,352 2,759 11,807 2,315 3,547
Other income (expense):
Interest income and other................... 1,498 2,838 3,497 780 1,074
Interest expense............................ -- (23,826) (25,063) (6,186) (7,216)
Loss on disposal of subsidiary.............. -- -- (6,925) -- --
Merger costs and special charges............ -- (3,972) (1,314) -- (545)
----------- ----------- ----------- ------------ ------------
1,498 (24,960) (29,805) (5,406) (6,687)
(Loss) income before income taxes and
cumulative effect of accounting change...... 5,850 (22,201) (17,998) (3,091) (3,140)
(Benefit) provision for income taxes.......... 4,521 (5,332) (4,126) (219) (468)
----------- ----------- ----------- ------------ ------------
(Loss) income before cumulative effect of
accounting change........................... 1,329 (16,869) (13,872) (2,872) (2,672)
Cumulative effect of accounting change for
deferred contract start-up costs, net of tax
benefit of $757............................. -- (1,012) -- -- --
----------- ----------- ----------- ------------ ------------
Net (loss) income............................. $ 1,329 $ (17,881) $ (13,872) $ (2,872) $ (2,672)
----------- ----------- ----------- ------------ ------------
----------- ----------- ----------- ------------ ------------
Pro forma net (loss) income assuming the new
method of accounting for deferred contract
start-up costs was applied retroactively.... $ 317 $ (16,869) $ (13,872) $ (2,872) $ (2,672)
----------- ----------- ----------- ------------ ------------
----------- ----------- ----------- ------------ ------------
</TABLE>
The accompanying notes are an integral part of these statements.
F-59
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
RETAINED NOTES
COMMON STOCK ADDITIONAL EARNINGS RECEIVABLE COMMON
-------------------------- PAID IN (ACCUMULATED FROM STOCK IN
SHARES AMOUNT CAPITAL DEFICIT) OFFICERS TREASURY
------------- ----------- ------------ -------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
BALANCE SEPTEMBER 30, 1994.............. 1,000,000 $ 10 $ 118,877 $ 2,117 $ -- $ --
Net income.............................. -- -- -- 1,329 -- --
------------- ----- ------------ -------------- ----------- -----
BALANCE SEPTEMBER 30, 1995.............. 1,000,000 10 118,877 3,446 -- --
Recapitalization from merger:
Redemption of common stock............ (915,754) (9) (258,129) -- -- --
Merger with MDC Acquisition Corp...... 415,023 4 104,996 -- -- --
Stock dividend........................ 24,763,531 247 (247) -- -- --
Issuance of stock to management....... 3,156,000 32 15,748 -- (5,800) --
Deferred taxes associated with
merger.............................. -- -- 7,594 -- -- --
Tax benefit from exercise of Merck stock
options............................... -- -- 1,505 -- -- --
Repayment of notes receivable........... -- -- -- -- 265 --
Cancellation of note receivable......... (20,000) -- (100) -- 100 --
Repurchase of common stock.............. -- -- -- -- -- (600)
Sale of common stock.................... -- -- -- -- (35) 495
Net loss................................ -- -- -- (17,881) -- --
------------- ----- ------------ -------------- ----------- -----
BALANCE SEPTEMBER 30, 1996.............. 28,398,800 284 (9,756) (14,435) (5,470) (105)
Issuance of stock for CMG acquisition... 739,358 7 5,538 -- -- --
Tax benefit from exercise of Merck stock
options............................... -- -- 11,630 -- -- --
Repayment of notes receivable........... -- -- -- -- 250 --
Repurchase of common stock.............. -- -- -- -- -- (30)
Sale of common stock.................... 258,000 3 1,537 -- (1,580) 135
Net loss................................ -- -- -- (13,872) -- --
------------- ----- ------------ -------------- ----------- -----
BALANCE SEPTEMBER 30, 1997.............. 29,396,158 $ 294 $ 8,949 $ (28,307) $ (6,800) $ --
------------- ----- ------------ -------------- ----------- -----
------------- ----- ------------ -------------- ----------- -----
</TABLE>
The accompanying notes are an integral part of these statements.
F-60
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEARS ENDED SEPTEMBER 30, DECEMBER 31,
------------------------------- --------------------------
1995 1996 1997 1996 1997
--------- --------- --------- ------------ ------------
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income.................................. $ 1,329 $ (17,881) $ (13,872) $ (2,872) $ (2,672)
Adjustments to reconcile net (loss) income to net
cash provided by (used for) operating activities:
Income from joint ventures..................... -- -- -- -- (1,649)
Loss on sale of subsidiary..................... -- -- 6,925 -- --
Cumulative effect of accounting change......... -- 1,012 -- -- --
Depreciation and amortization.................. 28,150 36,527 39,400 9,907 11,028
Amortization of deferred financing costs....... -- 1,142 1,342 335 387
Deferred taxes and other....................... 379 (6,068) (4,409) (369) (619)
Restructuring charge........................... -- 2,995 -- -- --
Changes in operating assets and liabilities, net of
the effect of acquisitions:
Accounts receivable............................ (8,545) 265 (9,781) (6,492) (8,033)
Restricted cash and investments................ (7,357) (10,166) (13,051) (149) (6,190)
Other current assets........................... (4,528) (607) 1,257 (1,336) 1,092
Deferred contract start-up costs............... (6,231) (4,816) (6,067) (637) (335)
Accounts payable and accrued liabilities....... 11,982 14,864 16,224 (4,526) (5,295)
Change in non-current assets and other......... (1,503) (1,282) 1,558 773 1,454
--------- --------- --------- ------------ ------------
Net cash provided by (used for) operating
activities....................................... 13,676 15,985 19,526 (5,366) (10,832)
--------- --------- --------- ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment..... (31,529) (23,808) (23,951) (5,554) (3,073)
Cash used for acquisitions, net of cash
acquired..................................... (9,580) (12,676) (42,645) -- --
Investments in and advances to joint
ventures..................................... (14,860) (2,931) (2,595) (850) (541)
Repayments of advances from joint ventures..... -- 420 675 180 1,859
Sales (purchases) of marketable securities..... 3,533 1,143 (4,111) -- --
Long-term restrictions removed from (placed on)
cash......................................... (211) (2,183) 1,941 47 (153)
Proceeds from sale of subsidiary and property,
plant and equipment.......................... -- -- -- -- 4,867
--------- --------- --------- ------------ ------------
Net cash provided by (used for) investing
activities................................... (52,647) (40,035) (70,686) (6,177) 2,959
--------- --------- --------- ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from capital contribution............. -- 114,980 -- -- --
Borrowings from parent......................... 32,882 -- -- -- --
Proceeds from bridge loan...................... -- 75,000 -- -- --
Proceeds from revolving credit facility........ -- 163,500 187,500 40,000 25,000
Proceeds from senior term loans................ -- 120,000 80,000 -- --
Proceeds from sale of notes.................... -- 100,000 -- -- --
Redemption of common stock..................... -- (258,138) -- -- --
Repayment of due to parent..................... -- (67,878) -- -- --
Repayment of bridge loan....................... -- (75,000) -- -- --
Repayment of senior term loans................. -- -- (500) (500) (5,235)
Repayment of revolving credit facility......... -- (129,500) (191,500) (35,000) (30,000)
Payment of financing costs..................... -- (12,504) (602) -- --
Other.......................................... -- 125 315 250 375
--------- --------- --------- ------------ ------------
Net cash provided by (used for) financing
activities................................... 32,882 30,585 75,213 4,750 (9,860)
--------- --------- --------- ------------ ------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS... (6,089) 6,535 24,053 (6,793) (17,733)
Cash and cash equivalents at beginning of period... 19,387 13,298 19,833 19,833 43,886
--------- --------- --------- ------------ ------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD......... $ 13,298 $ 19,833 $ 43,886 $ 13,040 $ 26,153
--------- --------- --------- ------------ ------------
--------- --------- --------- ------------ ------------
</TABLE>
The accompanying notes are an integral part of these statements.
F-61
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1997, 1996 AND 1995
(DOLLARS IN THOUSANDS)
1. ORGANIZATION
Merit Behavioral Care Corporation (the "Company") was incorporated in the
State of Delaware in March 1993 as a wholly-owned subsidiary of Medco
Containment Services, Inc. ("Medco"). The Company manages behavioral healthcare
programs for payors across all segments of the healthcare industry, including
health maintenance organizations, Blue Cross/Blue Shield organizations and other
insurance companies, corporations and labor unions, federal, state and local
governmental agencies, and various state Medicaid programs. Behavioral
healthcare involves the treatment of a variety of behavioral health conditions
such as emotional and mental health problems, substance abuse and other personal
concerns that require counseling, outpatient therapy or more intensive treatment
services.
On November 18, 1993, Merck & Co., Inc. ("Merck") acquired all of the
outstanding shares of Medco (See Note 3).
On October 6, 1995, the Company completed a merger (the "Merger") with MDC
Acquisition Corp. ("MDC"), a company formed by Kohlberg Kravis Roberts & Co.,
L.P. ("KKR"), whereby MDC was merged with and into the Company. In connection
with the Merger, the Company changed its name from Medco Behavioral Care
Corporation to Merit Behavioral Care Corporation (See Note 2).
2. MERGER
Prior to the Merger, the Company was a wholly-owned subsidiary of Merck &
Co., Inc. ("Merck"). As a result of the Merger, KKR and Company management and
related entities obtained approximately 85% of the post-Merger common stock of
the Company. In connection with the Merger, Merck received $326,016 in cash
(which reflects various final purchase price adjustments) and retained
approximately 15% of the common stock of the post-Merger Company. The Merger was
accounted for as a recapitalization which resulted in a charge to equity of
$258,138 to reflect the redemption of common stock. In conjunction with the
Merger, the Company paid a stock dividend of approximately 49.6 shares for each
share of the Company's stock then outstanding.
The Merger was financed with $114,980 of new cash equity, consisting of
$105,000 from affiliates of KKR and $9,980 from Company management and related
entities ("Management"). Management acquired an additional $5,800 of equity
which was funded by loans from the Company. The balance of the transaction was
funded with a $75,000 bridge loan (the "Bridge Loan") provided by an affiliate
of KKR and $155,000 of initial borrowings under a $205,000 senior credit
facility among the Company, The Chase Manhattan Bank, N.A. and Bankers Trust
Company (the "Senior Credit Facility"). The aforementioned proceeds were
utilized to redeem common stock for $258,138, repay amounts due Merck of
$67,878, and pay certain fees and expenses related to the Merger. Of the total
fees and expenses, $5,500 was paid to KKR.
3. BASIS OF PRESENTATION
On November 18, 1993, Merck acquired all the outstanding shares of Medco in
a transaction accounted for by the purchase method. As a result of this
acquisition, a new basis of accounting was established and as such, the
appraised value of the Company's assets and liabilities was recognized as of
November 18, 1993.
F-62
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. BASIS OF PRESENTATION (CONTINUED)
The appraisal determined that identified intangible assets, consisting
principally of customer contracts, had an appraised value of $112,000 and
related deferred taxes of $47,800 at the acquisition date. These identified
intangible assets are being amortized on a straight line basis over a weighted
average life of 12 years. Based on the allocation of the purchase price to the
net tangible and identified intangible assets and liabilities of the Company, an
excess of the allocated purchase price over the fair value of net assets
acquired of approximately $47,988 was recorded as goodwill. Such goodwill is
being amortized on a straight line basis over 40 years.
The unaudited consolidated financial statements of the Company as of
December 31, 1997 and for the three-month periods ended December 31, 1996 and
1997, were prepared by the Company without audit. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted. In the opinion of management, all necessary adjustments (consisting
only of normal recurring adjustments) have been made to present fairly the
consolidated financial position and results of operations and cash flows for
these periods. The results of operations for the period ended December 31, 1997
are not necessarily indicative of the expected results for the year ending
September 30, 1998.
Certain prior period amounts have been reclassified to conform to the
current presentation.
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its majority-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated.
CASH AND CASH EQUIVALENTS
The Company considers all liquid investment instruments with an original
maturity of three months or less to be the equivalent of cash for purposes of
balance sheet presentation.
RESTRICTED CASH AND INVESTMENTS--CURRENT
Restricted cash and investments--current at September 30, 1996 and 1997
includes $11,713 and $11,020, respectively, of cash held under the terms of
certain customer contracts that require a claims fund to be established and
segregated for the purpose of paying customer behavioral healthcare claims.
Under these arrangements, a reconciliation process is typically conducted
annually between the customer and the Company to determine the amount of
unexpended funds, if any, accruing to the Company. This cash is unavailable to
the Company for purposes other than the payment of customer claims
F-63
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
until such reconciliation process has been completed. The amount of cash held
under such arrangements in excess of anticipated customer claims at September
30, 1996 and 1997 was $4,267 and $6,197, respectively.
The Company held surplus cash balances of $13,715 and $29,325 as of
September 30, 1996 and 1997, respectively, as required by contracts with various
state and local governmental entities. In addition, at September 30, 1996 and
1997, the Company held surplus cash balances of $1,214 and $3,137, respectively,
as required by various other contracts. These contracts require the segregation
of such cash as financial assurance that the Company can meet its obligations
thereunder.
The Company has a subsidiary organized in the State of Missouri that is
licensed to do business as a foreign corporation in the State of California and
is subject to regulation by the Department of Corporations of the State of
California. Pursuant to these regulatory requirements, certain amounts of cash
are required to be retained for the use of this subsidiary. Included in
restricted cash and investments--current at September 30, 1996 and 1997 is $900
and $0, respectively, under such requirements.
The Company has short-term marketable securities consisting of treasury
notes and certificates of deposit, carried at amortized cost which approximates
fair value. All of the Company's short-term marketable securities are classified
as held-to-maturity. The Company held short-term marketable securities in the
amount of $4,011 at September 30, 1997 as required by the Company's contract
with a governmental entity.
RESTRICTED CASH AND INVESTMENTS--NON-CURRENT
At September 30, 1996 and 1997, $7,168 and $6,623, respectively, of cash and
marketable securities were held by subsidiaries of the Company that are
organized and regulated under state law as insurance companies. Such insurance
companies are required to maintain certain minimum statutory deposits and
reserves with respect to the payment of future claims. The amount of cash in
excess of the liabilities of such subsidiaries and not available for dividend to
the Company without prior regulatory approval was $5,510 and $3,559 at September
30, 1996 and 1997, respectively. As a result, such amounts of cash held by these
subsidiaries have been classified as a long-term asset in the accompanying
consolidated balance sheets.
All of the Company's long-term marketable investments are classified as
held-to-maturity; in addition, such investments are carried at amortized cost
which approximates fair value.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at cost. For financial reporting
purposes, depreciation is provided principally on a straight line basis over the
estimated useful lives of the assets as follows:
<TABLE>
<S> <C>
Machinery and equipment....................................... 5 Years
Integrated managed care information system.................... 7 Years
Furniture and fixtures........................................ 15 Years
Life of
Leasehold improvements........................................ lease
</TABLE>
Expenditures for maintenance, repairs and renewals of minor items are
charged to operations as incurred. Major betterments are capitalized.
F-64
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The integrated managed care information system (the "System") represents
costs incurred in the development and adaptation of AMISYS software for use in
the Company's business. In addition to purchased hardware and software costs,
the payroll and related benefits of employees who are exclusively engaged in the
development and deployment of the System are capitalized. The System was
substantially complete in October 1995 at which time the Company began
installing the System in various area and regional offices in the Company's
service delivery system. As the System is installed in an office, the office is
allocated a ratable portion of the total cost of the System, at which time the
allocated cost is depreciated over an estimated useful life of 7 years.
GOODWILL AND OTHER INTANGIBLES
The Company amortizes costs in excess of the net assets of businesses
acquired on a straight line basis over periods not to exceed 40 years.
Contingent consideration is charged to goodwill when paid and is amortized over
the remaining life of such goodwill, not to exceed 40 years. The Company
periodically reviews the carrying value of goodwill to assess recoverability and
other than temporary impairments.
Goodwill and intangible assets consisted of the following at September 30,
1996 and 1997:
<TABLE>
<CAPTION>
1996 1997
----------- -----------
<S> <C> <C>
Customer Contracts.................................................. $ 80,000 $ 88,074
Provider Network.................................................... 12,000 12,000
Trade Names and other............................................... 20,000 20,000
Goodwill............................................................ 110,630 157,755
----------- -----------
$ 222,630 $ 277,829
----------- -----------
----------- -----------
</TABLE>
DEFERRED CONTRACT START-UP COSTS
The Company defers contract start-up costs related to new contracts or
expansion of existing contracts that require the implementation of separate,
dedicated service delivery teams, provider networks and delivery systems or the
establishment of a local clinical organization in a new geographic area to
service the new program. The Company defers only costs which (i) are separately
identified, incremental and segregated from ordinary operating expenses; (ii)
provide a direct, quantifiable benefit to future periods; and (iii) are fully
recoverable from contract revenues directly attributable to such benefit. The
incremental costs deferred by the Company include, among other things,
consulting fees, salary costs, travel costs, office costs and network and
reporting system development costs. Consulting fees deferred by the Company
relate primarily to the recruitment, credentialling and contracting of the
particular customer's provider network. The salary costs relate primarily to
employees of the Company dedicated to clinical protocol design, network
development activities and program reporting and information systems
customization for the specific customer. These contract start-up costs are
capitalized and amortized on a straight line basis over the initial term of the
related contract. The amortization periods range from one to five years, with a
weighted-average life at September 30, 1996 and 1997 of 3.3 and 4.3 years,
respectively. Amortization of deferred contract start-up costs was $1,315,
$2,848, and $3,096 for the periods ended September 30, 1995, 1996, and 1997,
respectively. During the periods ended September 30, 1995, 1996, and 1997, the
Company deferred contract start-up costs of $6,231,
F-65
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
$4,816, and $6,067, respectively. Other non-current assets include $6,077 and
$9,036 of unamortized deferred contract start-up costs at September 30, 1996 and
1997, respectively.
Effective October 1, 1995, the Company changed its method of accounting for
deferred start-up costs related to new contracts or expansion of existing
contracts (i) to expense costs relating to start-up activities incurred after
commencement of services under the contract, and (ii) to limit the amortization
period for deferred start-up costs to the initial contract period. Prior to
October 1, 1995, the Company capitalized start-up costs related to the
completion of the provider networks and reporting systems beyond commencement of
contracts and, in limited instances, amortized the start-up costs over a period
that included the initial renewal term associated with the contract. Under the
new policy, the Company does not defer contract start-up costs after contract
commencement, or amortize start-up costs beyond the initial contract period. The
change was made to increase the focus on controlling costs associated with
contract start-ups.
The pro forma effect of the change, had the Company adopted this new
accounting policy in prior years, is to decrease total assets by $1,769 and
decrease total liabilities by $757 as of September 30, 1995, and to increase
costs and expenses by $1,769 ($1,012 after taxes) for the year ended September
30, 1995. The effect of the change on fiscal 1996 and 1997 cannot be reasonably
estimated.
REVENUE RECOGNITION
Typically, the Company charges each of its customers a flat monthly
capitation fee for each beneficiary enrolled in such customer's behavioral
health managed care plan or Employee Assistance Program ("EAP"). This capitation
fee is generally paid to the Company in the current month. Contract revenue
billed in advance of performing related services is deferred and recognized
ratably over the period to which it applies. For a number of the Company's
behavioral health managed care programs, the capitation fee is divided into
outpatient and inpatient fees, which are recognized separately.
Outpatient revenue is recognized when earned; inpatient revenue is
recognized monthly and is in most cases (i) paid to the Company monthly (in
cases where the Company is responsible for the payment of inpatient claims) or
in certain cases (ii) retained by the customer for payment of inpatient claims.
When the customer retains the inpatient revenue, actual inpatient costs are
periodically reconciled to amounts retained and the Company receives the excess
of the amounts retained over the cost of services, or reimburses the customer if
the cost of services exceeds the amounts retained. In certain instances, such
excess or deficiency is shared between the Company and the customer. A
significant portion of the Company's revenue is derived from capitated
contracts.
DIRECT SERVICE COSTS
Direct service costs are comprised principally of expenses associated with
managing, supervising and providing the Company's services, including
third-party network provider charges, various charges associated with the
Company's staff offices, inpatient facility charges, costs associated with
members of management principally engaged in the Company's clinical operations
and their support staff, and rent for certain offices maintained by the Company
in connection with the delivery of services. Direct service costs are recognized
in the month in which services are expected to be rendered. Network provider and
facility charges for authorized services that have not been reported and billed
to the Company (known as
F-66
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
incurred but not reported expenses, or "IBNR") are estimated and accrued based
on historical experience, current enrollment statistics, patient census data,
adjudication decisions and other information. Such costs are included in the
caption "Claims payable" in the accompanying consolidated balance sheets.
INCOME TAXES
Deferred taxes are provided for the expected future income tax consequences
of events that have been recognized in the Company's financial statements.
Deferred tax assets and liabilities are determined based on the temporary
differences between the financial statement carrying amounts and the tax bases
of assets and liabilities using enacted tax rates in effect in the years in
which the temporary differences are expected to reverse.
LONG-LIVED ASSETS
The Financial Accounting Standards Board issued SFAS No. 121, ACCOUNTING FOR
THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF,
in March 1995. The general requirements of this statement are applicable to the
properties and intangible assets of the Company and require impairment to be
considered whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. If the sum of expected
future cash flows (undiscounted and without interest charges) is less than the
carrying amount of the asset, an impairment loss is recognized. The Company
adopted this standard on October 1, 1996. No impairment losses have been
identified by the Company.
STOCK-BASED COMPENSATION PLANS
During fiscal 1997, the Company adopted SFAS No. 123, ACCOUNTING FOR
STOCK-BASED COMPENSATION ("SFAS 123"). The new standard defines a fair value
method of accounting for stock options and similar equity instruments. Under the
fair value method, compensation cost is measured at the grant date based on the
fair value of the award and is recognized over the service period, which is
usually the vesting period. As permitted by SFAS 123, however, the Company has
elected to continue to recognize and measure compensation for its stock rights
and stock option plans in accordance with the existing provisions of Accounting
Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES ("APB
25"). See Note 16 for pro forma disclosures of net loss as if the fair
value-based method prescribed by SFAS No. 123 had been applied.
DISCLOSURE OF FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amount reported in the consolidated balance sheets for cash and
cash equivalents, accounts receivable, accounts payable and accrued liabilities
approximates fair value because of the immediate or short-term maturity of these
financial instruments. The Company's short-term marketable securities and
long-term marketable investments are carried at amortized cost which
approximates fair value. The carrying amount of loans made to certain joint
ventures engaged in the development of Medicaid programs (Note 9) approximates
fair value which was estimated by discounting future cash flows using rates at
which similar loans would be made to borrowers with similar credit ratings. The
carrying value for the variable rate debt outstanding under the Senior Credit
Facility (as described in Note 6) approximates the fair value. The fair value of
the Company's senior subordinated notes (see
F-67
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Note 6) is estimated to be $109,000 at September 30, 1997 (based on quoted
market prices) which compares to the carrying value of $100,000.
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to concentrations
of credit risk consist principally of trade receivables. Concentrations of
credit risk with respect to trade receivables are limited due to the large
number of customers comprising the Company's customer base and the dispersion of
such customers across different businesses and geographic regions.
5. PROPERTY, PLANT, AND EQUIPMENT
Property, plant and equipment consisted of the following at September 30:
<TABLE>
<CAPTION>
1996 1997
---------- -----------
<S> <C> <C>
Machinery and equipment............................................. $ 44,896 $ 58,988
Integrated managed care information system.......................... 28,349 38,914
Furniture and fixtures.............................................. 12,795 16,665
Leasehold improvements.............................................. 2,977 3,443
---------- -----------
89,017 118,010
Accumulated depreciation and amortization........................... (21,137) (34,698)
---------- -----------
$ 67,880 $ 83,312
---------- -----------
---------- -----------
</TABLE>
Depreciation and amortization related to property, plant and equipment was
$6,776, $10,658, and $12,503 for the periods ended September 30, 1995, 1996, and
1997, respectively.
6. LONG TERM DEBT
Long-term debt consisted of the following at September 30:
<TABLE>
<CAPTION>
1996 1997
----------- -----------
<S> <C> <C>
Revolving Loans..................................................... $ 34,000 $ 30,000
Senior Term Loan A.................................................. 70,000 70,000
Senior Term Loan B.................................................. 50,000 129,500
Notes............................................................... 100,000 100,000
----------- -----------
254,000 329,500
Less current portion................................................ (500) (6,498)
----------- -----------
$ 253,500 $ 323,002
----------- -----------
----------- -----------
</TABLE>
SENIOR CREDIT FACILITY--In October 1995, the Company entered into a credit
agreement (the "Credit Agreement"), which provided for secured borrowings from a
syndicate of lenders. The Senior Credit Facility consisted initially of (i) a
six and one-half year revolving credit facility (the "Revolving Credit
Facility") providing for up to $85,000 in revolving loans, which includes
borrowing capacity available for letters of credit of up to $20,000, and (ii) a
term loan facility providing for up to $120,000 in term loans, consisting of a
$70,000 senior term loan with a maturity of six and one-half years ("Senior Term
Loan A"),
F-68
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. LONG TERM DEBT (CONTINUED)
and a $50,000 senior term loan with a maturity of eight years ("Senior Term Loan
B"). On September 12, 1997, the Senior Term Loan B was increased by $80,000 to
$130,000 with the maturity extended one and one-half years. The additional
borrowings from Senior Term Loan B were primarily obtained to fund the
acquisition of CMG Health, Inc. ("CMG"), as discussed in Note 8. At September
30, 1997, $30,000 of revolving loans and five letters of credit totaling $8,313
were outstanding under the Revolving Credit Facility, and approximately $46,687
was available for future borrowing. At September 30, 1996, $34,000 of revolving
loans and three letters of credit totaling $425 were outstanding under the
Revolving Credit Facility, and approximately $50,575 was available for future
borrowings.
In October 1996, a scheduled repayment of $500 was made on Senior Term Loan
B. The annual amortization schedule of the Senior Term Loans is $6,498 in 1998,
$10,000 in 1999, $12,500 in 2000, $20,000 in 2001, $25,000 in 2002 and $125,502
thereafter. The Senior Term Loans are subject to mandatory prepayment (i) with
the proceeds of certain asset sales and (ii) on an annual basis with 50% of the
Company's Excess Cash Flow (as defined in the Credit Agreement) for so long as
the ratio of the Company's Total Debt (as defined in the Credit Agreement) to
annual Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA"
as defined in the Credit Agreement) is greater than 3.5 to 1.0. Proceeds in the
amount of $4,735 received in October 1997 as a result of the disposal of one of
the Company's subsidiaries (See Note 17) have been classified as current in
accordance with the mandatory prepayment loan provision. At September 30, 1997,
approximately $662 has been classified as current in accordance with mandatory
prepayment requirements for Excess Cash Flow.
The Company is charged a commitment fee calculated at an EBITDA-dependent
rate ranging from 0.250% to 0.500% per annum of the commitment under the
Revolving Credit Facility in effect on each day. The Company is charged a letter
of credit fee calculated at an EBITDA-dependent rate ranging from 0.375% to
1.750% per annum of the face amount of each letter of credit and a fronting fee
calculated at a rate equal to 0.250% per annum of the face amount of each letter
of credit. Loans under the Credit Agreement bear interest at EBITDA-dependent
floating rates, which are, at the Company's option, based upon (i) the higher of
the Federal funds rate plus 0.5%, or bank prime rates, or (ii) Eurodollar rates.
Rates on borrowing outstanding under the Senior Credit Facility averaged 8.1%
and 8.3% for the years ended September 30, 1997 and 1996, respectively.
NOTES--On November 22, 1995, the Company issued $100,000 aggregate principal
amount of 11 1/2% senior subordinated notes due 2005 (the "Private Notes"), the
net proceeds of which were applied to repay the Bridge Loan (including accrued
interest) and a portion of the Revolving Credit Facility. On March 20, 1996, the
Company exchanged the Private Notes for $100,000 aggregate principal amount of
11 1/2% Senior Subordinated Notes due 2005 that are registered under the
Securities Act of 1933 (the "Notes"). The Notes are senior subordinated,
unsecured obligations of the Company.
The Company may be obligated to purchase at the holders' option all or a
portion of the Notes upon a change of control or asset sale, as defined in the
indenture for the Notes (the "Notes Indenture"). The Notes are not redeemable at
the Company's option prior to November 15, 2000, except that at any time on or
prior to November 15, 1998, under certain conditions the Company may redeem up
to 35% of the initial principal amount of the Notes originally issued with the
net proceeds of a public offering of the common stock of the Company. The
redemption price is equal to 111.50% of the principal amount if the redemption
is on or prior to November 15, 1997, and 110.50% if the redemption is on or
prior to November 15, 1998. From and after November 15, 2000, the Notes will be
subject to redemption at the
F-69
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. LONG TERM DEBT (CONTINUED)
option of the Company, in whole or in part, at various redemption prices,
declining from 105.75% of the principal amount to par on and after November 15,
2004. The Notes mature on November 15, 2005.
The Credit Agreement and the Notes Indenture contain restrictive covenants
that, among other things and under certain conditions, limit the ability of the
Company to incur additional indebtedness, to acquire (including a limitation on
capital expenditures) or to dispose of assets or operations, to incur liens on
its property or assets, to make advances, investments and loans, and to pay any
dividends. The Company must also satisfy certain financial covenants and tests.
Borrowings under the Credit Agreement are secured by a first priority lien
on the capital stock of certain of the Company's subsidiaries.
7. NOTES RECEIVABLE FROM OFFICERS
In October 1995, the Company loaned several officers an aggregate of $5,800
for the purchase of common stock of the Company; subsequent to the Merger,
additional loans totaling $1,615 were made to officers for the purchase of
shares of common stock. Each loan is represented by a promissory note which
bears interest at a rate of 6.5% per annum.
These notes are full recourse obligations of the officers, are
collateralized by the pledge of common stock of the Company held by such
officers and may be prepaid in part or in full without notice or penalty. Notes
receivable totaling $265 and $250 were repaid during the periods ended September
30, 1996 and 1997, respectively. Also a note for $100 was canceled in January
1996 for receipt of shares of common stock. The remaining outstanding notes are
due as follows: $20 in 1998 and $6,780 in 2001. The notes are shown as a
reduction of stockholders' equity in the accompanying consolidated balance
sheets.
8. ACQUISITIONS
On September 12, 1997, the Company paid an initial $48,740 and issued
739,358 shares of Company common stock to acquire all of the capital stock of
CMG, a Maryland-based provider of managed behavioral healthcare services. The
acquisition was accounted for as a purchase transaction. The consolidated
financial statements of the Company include the operating results of CMG from
the date of the acquisition. The purchase price for CMG was allocated to the net
assets acquired based upon their estimated fair values. The Company common stock
issued in the acquisition was assigned a value of $7.50 per share based on a
valuation analysis performed by an independent third party. The excess of the
purchase price over the net tangible assets acquired amounted to $64,715 and is
being amortized over periods up to 40 years using the straight-line method. The
purchase price allocation was based on preliminary estimates and may be revised
upon final valuation. The Company is obligated to make contingent payments to
the former shareholders of CMG if the financial results of certain contracts
exceed specified base-line amounts. Such contingent payments are subject to an
aggregate maximum of $23,500. Any such additional payments will be recorded as
goodwill.
The following summary of the unaudited pro forma consolidated results of
operations of the Company for the years ended September 30, 1996 and 1997
assumes the CMG acquisition occurred as of the beginning of the respective
periods. The pro forma results include the combined historical results of the
Company and CMG, and pro forma adjustments to reflect (i) interest expense
associated with the debt incurred to finance the acquisition, (ii) changes to
depreciation and amortization related to the allocation of the cost of CMG to
the assets acquired and liabilities assumed and (iii) reductions of
F-70
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. ACQUISITIONS (CONTINUED)
salaries, benefits and certain other costs included in the historical results of
CMG which will be eliminated as a result of the acquisition. These pro forma
results have been prepared for comparative purposes only and do not purport to
be indicative of the results of operations which actually would have resulted
had the acquisition occurred at the beginning of the respective periods, or
which may result in the future.
<TABLE>
<CAPTION>
UNAUDITED
------------------------
<S> <C> <C>
1996 1997
----------- -----------
Revenue............................................................. $ 522,857 $ 653,477
Net loss............................................................ (16,939) (15,048)
</TABLE>
In August 1996, the Company paid approximately $340 to acquire Orion Life
Insurance Company ("Orion"), a Delaware life and health insurance company. Orion
holds insurance licenses in 17 states and provides the Company with the ability
to underwrite future business in those states should a customer require that a
licensed insurance entity underwrite its behavioral health program.
On December 19, 1995, the Company paid an initial $50 with a subsequent
payment of $2,950 in January 1996 to acquire ProPsych, Inc. ("ProPsych"), a
Florida-based behavioral health managed care company. As of September 30, 1996,
the Company recorded additional goodwill in the amount of $400 for a final
contingent payment made to the former shareholders of ProPsych in November 1996.
On October 5, 1995, the Company paid an initial $8,730 to acquire Choate
Health Management, Inc. and certain related entities ("Choate"), a
Massachusetts-based integrated behavioral healthcare organization. The Company
made a contingent consideration payment of $1,278 to the former shareholders of
Choate in July 1996; such payment was recorded as goodwill. In June 1997, the
Company and the former Choate shareholders signed an agreement which provided
for the settlement of the contingent consideration related to Choate. Such
agreement required no further payments by the Company. Choate was sold by the
Company in September 1997 (See Note 17).
In September 1995, a contingent payment of $8,550 was made to the former
shareholders of BenesYs, a subsidiary of the Company, in full settlement of any
and all contingent consideration due to such former shareholders. In April 1995,
a final payment of $650 was made related to the acquisition of the clinical
protocols of the Washton Institute.
9. JOINT VENTURES
CMG, which was acquired on September 12, 1997, is a 50% partner in CHOICE
Behavioral Health Partnership ("Choice"), a managed behavioral healthcare
company. The Company reports its investment in Choice using the equity method.
Although the Company reports its share of earnings from the joint venture, the
financial statements of Choice are not consolidated with those of the Company.
All revenue of the joint venture is from a contract for the Civilian Health and
Medical Program of the Uniformed Services ("CHAMPUS") with Humana, Inc.
F-71
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. JOINT VENTURES (CONTINUED)
Summarized financial information of the joint venture, representing 100% of
its business, as of September 30, 1997 and for the period from September 12,
1997 through September 30, 1997, is as follows:
<TABLE>
<S> <C> <C> <C>
Current Assets............. $ 38,286 Net Revenues............... $ 3,333
Cost of Providing
Non-Current Assets......... 700 Services................... 2,973
--------- ---------
Total Assets........... $ 38,986
---------
---------
Gross Profit............... 360
Total Liabilities.......... $ 37,141
Partners' Capital.......... 1,845 Other Expenses............. 106
--------- ---------
Total Liabilities & P.C.... $ 38,986 Net Income................. $ 254
--------- ---------
--------- ---------
</TABLE>
In March 1994, the Company entered into a joint venture partnership with
Community Sector Systems, Inc. ("CSS"), a software development company, to
market a proprietary clinical information, communications and case documentation
software package. The Company contributed $125 in capital, loaned $1,375 to CSS
in 1994 and made an additional loan of $300 to CSS in 1995. In December 1996,
the Company converted the $1,375 loan and the accrued interest receivable on the
loan of $369 into an equity interest in CSS, and made an additional capital
contribution of $500. Additionally, in February 1997 the Company contributed
capital of $350 and loaned CSS $150. As of September 30, 1997, the Company has a
net loan receivable from CSS of $450 and an equity investment in CSS of $2,719.
In April 1995, the Company entered into a contractual arrangement with
Community Health Network of Connecticut, Inc. ("CHN"), an organization
consisting of 11 not-for-profit health centers in Connecticut, under which the
Company has agreed to provide CHN with up to a total of $4,000 in unsecured debt
to help finance CHN's Medicaid program development costs. As of September 30,
1996 and 1997, the Company had net advances to CHN outstanding of $2,079 and
$1,732, respectively.
Also, in April 1995, the Company entered into a joint venture with
Neighborhood Health Providers, LLC ("NHP"), an organization consisting of five
hospitals located in Brooklyn and Queens, New York, under which the Company
agreed to fund a portion of NHP's Medicaid program development costs in the form
of $1,500 in unsecured debt. As of September 30, 1996 and 1997, the Company had
net advances of $1,500 to NHP.
In September 1995, the Company paid $12,010 to Empire Blue Cross and Blue
Shield ("Empire") for the right to provide behavioral health managed care
services to approximately 750,000 Empire enrollees in the State of New York for
a period of eight years. In connection therewith, the Company formed a limited
liability company (the "Empire Joint Venture") with the Company and Empire
receiving ownership interests of 80% and 20%, respectively. The payment was
charged to goodwill and is being amortized over the life of the underlying
contract.
In January 1996, the Company formed a joint venture with the hospital
sponsors of NHP under the name Royal Health Care LLC ("Royal"), in which the
Company and NHP each holds a 50% equity interest. Royal has management services
contracts with certain organizations including NHP and Empire Community Delivery
Systems LLC ("ECDS"). During fiscal 1996, the Company made an equity
contribution and an unsecured working capital loan to Royal in the amounts of
$200 and $228, respectively. During fiscal 1997, the Company made an additional
capital contribution of $100 to Royal.
F-72
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. JOINT VENTURES (CONTINUED)
ECDS, which was formed in fiscal 1996, is a joint venture company in which
the Company, NHP and Empire hold interests of approximately 16.7%, 16.7%, and
66.6%, respectively. The Company accounts for its investment in ECDS under the
cost method. The Company made capital contributions to ECDS in 1996 and 1997 of
$458 and $667, respectively. Also, in 1996 and 1997 the Company provided loans
to NHP, the proceeds of which were used to fund NHP's capital contributions to
ECDS, of $667 and $458, respectively. The loans to NHP are secured by NHP's
interest in ECDS. Empire and ECDS have entered into an agreement under which
ECDS will exclusively manage and operate, on behalf of Empire, health care
benefit programs (covering all services except behavioral healthcare and vision
care) in the five New York City boroughs for Medicaid beneficiaries enrolled in
Empire plans. Each of Empire and Royal will provide specified administrative and
management services to ECDS to support its delivery of services to Empire under
such agreement. Moreover, each of ECDS and Royal will hold specified equity
interests in certain independent practice associations (IPAs) providing
treatment services to the Empire Medicaid beneficiaries. In addition, Empire has
entered into an agreement with the Empire Joint Venture to exclusively provide,
on behalf of Empire, all behavioral healthcare services in New York City to such
Empire Medicaid enrollees. The Royal and ECDS joint ventures and related
agreements have five year terms, with up to three five-year renewals (subject to
applicable regulatory approvals). Each such venture and agreement also contains
customary termination provisions.
The receivables from, and the investments in, CSS, NHP, CHN, Royal and ECDS
are reflected in "other assets" in the accompanying balance sheets.
F-73
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES
Prior to the Merger, the Company filed a consolidated federal income tax
return with Merck. Though no formal tax sharing agreement existed between the
Company and Merck, the Company computed federal income taxes on a separate
return basis and recorded such taxes in the caption "Due to parent".
The components of income tax expense (benefit) for the periods ended
September 30, are as follows:
<TABLE>
<CAPTION>
1995 1996 1997
--------- --------- ---------
<S> <C> <C> <C>
Current:
Federal.................................................... $ 3,030 $ -- $ --
State...................................................... 1,112 736 283
--------- --------- ---------
4,142 736 283
--------- --------- ---------
Deferred:
Federal.................................................... 200 (5,495) (4,848)
State...................................................... 179 (573) 439
--------- --------- ---------
379 (6,068) (4,409)
--------- --------- ---------
Total........................................................ $ 4,521 $ (5,332) $ (4,126)
--------- --------- ---------
--------- --------- ---------
</TABLE>
The differences between the U.S. federal statutory tax rate and the
Company's effective tax rate are as follows:
<TABLE>
<CAPTION>
1995 1996 1997
--------- --------- ---------
<S> <C> <C> <C>
U.S. federal statutory tax rate.................................. 35.0% (35.0)% (35.0)%
State income taxes (net of federal benefit)...................... 14.4 0.4 0.6
Capital loss..................................................... -- -- 6.9
Merger expenses.................................................. -- 5.8 --
Goodwill......................................................... 13.1 2.3 3.1
Expenses without tax benefit..................................... 13.9 2.0 1.6
Other............................................................ 0.9 0.5 (0.1)
--- --------- ---------
Effective tax rate............................................... 77.3% (24.0)% (22.9)%
--- --------- ---------
--- --------- ---------
</TABLE>
At September 30, 1996 and 1997, the Company had $23,707 and $46,733,
respectively, of deferred income tax assets and $52,080 and $55,505,
respectively, of deferred income tax liabilities which have
F-74
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES (CONTINUED)
been netted for presentation purposes. The significant components of these
amounts are shown on the balance sheet as follows:
<TABLE>
<CAPTION>
1996 1997
----------------------- -----------------------
<S> <C> <C> <C> <C>
CURRENT NON CURRENT CURRENT NON CURRENT
ASSET LIABILITY ASSET LIABILITY
--------- ------------ --------- ------------
Provision for estimated expenses.................. $ 2,630 $ 2,161 $ 7,023 $ 507
Capitalized expenses.............................. (334) (1,436) (407) (1,224)
Net operating loss carryforwards.................. -- 9,170 -- 28,502
Accelerated depreciation.......................... -- (14,605) -- (20,194)
Intangible asset differences...................... -- (25,959) -- (22,979)
--------- ------------ --------- ------------
$ 2,296 $ (30,669) $ 6,616 $ (15,388)
--------- ------------ --------- ------------
--------- ------------ --------- ------------
</TABLE>
Management believes that the deferred tax assets will be fully realized
based on future reversals of existing taxable temporary differences and
projected operating results of the Company. As a result, no valuation allowance
has been provided. At September 30, 1997, the Company had U.S. federal net
operating loss carryforwards of approximately $76,630 for tax purposes.
Approximately $5,920 of the carryforwards expire in 2010, $21,460 expire in 2011
and $49,250 expire in 2012.
11. COMMITMENTS AND CONTINGENCIES
A. LEASES
The Company leases office facilities and equipment under various
noncancelable operating leases.
At September 30, 1997, the minimum aggregate rental commitments under
noncancelable leases, excluding renewal options, are as follows:
<TABLE>
<S> <C>
1998.............................................................. $ 13,469
1999.............................................................. 11,606
2000.............................................................. 9,892
2001.............................................................. 8,699
2002.............................................................. 6,382
Thereafter........................................................ 18,219
---------
Minimum lease payments............................................ 68,267
Less amounts representing sublease income......................... (2,060)
---------
$ 66,207
---------
---------
</TABLE>
Several of the leases contain escalation provisions due to increased
maintenance costs and taxes. Scheduled rent increases are amortized on a
straight-line basis over the lease term. Total rent expense for the periods
ended September 30, 1995, 1996 and 1997 amounted to $10,115, $13,059 and
$15,842, respectively.
F-75
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
B. EMPLOYMENT AGREEMENTS
The Company and certain of its subsidiaries have employment agreements with
various officers and certain other management personnel that provide for salary
continuation for a specified number of months under certain circumstances. The
aggregate commitment for future salaries at September 30, 1997, excluding
bonuses, was approximately $2,735.
C. LEGAL PROCEEDINGS
In October 1996, a group of eight plaintiffs purporting to represent an
uncertified class of psychiatrists and clinical social workers brought an action
under the federal antitrust laws in the United States District Court for the
Southern District of New York against nine behavioral health managed care
organizations, including the Company (collectively, "Defendants"). The complaint
alleges that Defendants violated section 1 of the Sherman Act by engaging in a
conspiracy to fix the prices at which Defendants purchase services from mental
healthcare providers such as plaintiffs. The complaint further alleges that
Defendants engaged in a group boycott to exclude mental healthcare providers
from Defendants' networks in order to further the goals of the alleged
conspiracy. The complaint also challenges the propriety of Defendents'
capitation arrangements with their respective customers, although it is unclear
from the complaint whether plaintiffs allege that Defendants unlawfully
conspired to enter into capitation arrangements with their respective customers.
The complaint seeks treble damages against Defendants in an unspecified amount
and a permanent injunction prohibiting Defendants from engaging in the alleged
conduct which forms the basis of the complaint, plus costs and attorneys' fees.
In January 1997, Defendants filed a motion to dismiss the complaint. On July 21,
1997, a court-appointed magistrate judge issued a report and recommendation to
the District Court recommending that Defendants' motion to dismiss the complaint
with prejudice be granted. On August 5, 1997, plaintiffs filed objections to the
magistrate judge's report and recommendation; such objections have not yet been
heard. The Company intends to vigorously defend itself in this litigation. No
amounts are recorded on the books of the Company in anticipation of a loss as a
result of this contingency.
The Company is engaged in various other legal proceedings that have arisen
in the ordinary course of its business. The Company believes that the ultimate
outcome of such proceedings will not have a material effect on the Company's
financial position, liquidity or results of operations.
D. INSURANCE
Under the Company's professional liability insurance policy, coverage is
limited to the period in which a claim is asserted, rather than when the
incident giving rise to such claim occurred. The Company has obtained
professional liability insurance through October 6, 1998; however, in the event
the Company was unable to obtain professional liability insurance at the
expiration of the current policy period, it is possible that the Company would
be uninsured for claims asserted after the expiration of the current policy
period. Historical experience of the Company does not indicate that losses, if
any, arising from claims asserted after the expiration of the current
professional liability policy period would have a material effect on the
Company's financial position, liquidity or results of operations.
F-76
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
E. CHAMPUS CONTRACT
On April 1, 1997, the Company began providing mental health and substance
abuse services, as a subcontractor, to beneficiaries of CHAMPUS in the
Southwestern and Midwestern United States, designated as CHAMPUS Regions 7 and
8. The fixed monthly amounts that the Company receives for medical costs and
records as revenue are subject to a one-time retroactive adjustment scheduled to
be determined in August 1998 based upon actual healthcare utilization during the
period known as the "data collection period". The data collection period is the
year ended March 31, 1997. Because of the inherent uncertainty surrounding
factors included in the determination of the final retroactive adjustment,
management has not been able to quantify a range of potential adjustment, and
accordingly no adjustments have been recorded as of September 30, 1997. As a
result, the amount of recorded revenue and income from the CHAMPUS contract may
differ significantly from the amount that would have been recorded had the
actual factors been known.
12. RELATED PARTY TRANSACTIONS
During the period ended September 30, 1997, the Company paid consulting fees
and board fees to KKR totaling approximately $500. During the period ended
September 30, 1996, the Company paid consulting fees and board fees to KKR
totaling approximately $5,900; of such amount, $5,500 related to the Merger and
associated financing transactions.
Prior to the merger, Medco disbursed funds on behalf of the Company for the
payment of certain of the Company's U.S. federal, state and local income taxes
and certain acquisition transactions described in Note 8.
Included in expense for the periods ended September 30, 1997, 1996 and 1995
are charges totaling $1,467, $1,218 and $703, respectively, related to a
prescription drug benefit program administered by Medco.
The average balance due to the parent (Medco) for fiscal 1995 was $40,996;
such balance was repaid in full on October 6, 1995 in connection with the
Merger. A summary of intercompany activity with the parent is as follows:
<TABLE>
<S> <C>
Due to parent, October 1, 1994................................... $ 37,931
Allocation of costs from parent.................................. 379
Intercompany purchases........................................... 659
Income taxes paid by parent...................................... 3,795
Cash transfer from parent........................................ 28,049
---------
Due to parent, September 30,1995................................. 70,813
Adjustment to income taxes paid by parent........................ (2,935)
Repayment made in connection with the Merger..................... (67,878)
---------
Due to parent, September 30,1996................................. $ --
---------
---------
</TABLE>
13. RESTRUCTURING CHARGE
The Company recorded a pre-tax restructuring charge of $2,995 related to a
plan, adopted and approved in the fourth quarter of 1996, to restructure its
staff offices by exiting certain geographic
F-77
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
13. RESTRUCTURING CHARGE (CONTINUED)
markets and streamlining the field and administrative management organization of
Continuum Behavioral Healthcare Corporation, a subsidiary of the Company. This
decision was in response to the results of underperforming locations affected by
the lack of sufficient patient flow in the geographic areas serviced by these
offices and the Company's ability to purchase healthcare services at lower rates
from the network. In addition, it was determined that the Company would be able
to expand beneficiary access to specialists and other providers, thereby
achieving more cost-effective treatment, and to favorably shift a portion of the
economic risk, in some cases, of providing outpatient healthcare to the provider
through the use of case rates and other alternative reimbursement methods. The
restructuring charge was comprised primarily of accruals for employee severance,
real property lease terminations and write-off of certain assets in geographic
markets which were being exited. The restructuring plan was substantially
completed during fiscal 1997.
14. MAJOR CUSTOMERS
For fiscal 1997, revenue derived from a state Medicaid contract accounted
for approximately 12% of the Company's operating revenues. For fiscal 1995 and
1996, no customer accounted for more than 10% of the Company's operating
revenues.
15. EMPLOYEE BENEFIT PLAN
The Company has a 401(k) savings plan covering substantially all employees
who have completed one year of active employment during which 1,000 hours of
service has been credited. Under the plan, an employee may elect to contribute
on a pre-tax basis to a retirement account up to 15% of the employee's
compensation up to the maximum annual contributions permitted by the Internal
Revenue Code. The Company matches employee contributions at the rate of 50% (25%
for periods prior to January 1, 1997) of the employee's contributions to the
401(k) savings plan, up to a maximum of 6% of an employee's annual compensation.
The Company's 401(k) savings plan contribution recognized as expense for the
periods ended September 30, 1995, 1996 and 1997 was $330, $542 and $1,289,
respectively.
16. STOCK OPTIONS AND AWARDS
Effective October 1, 1996, the Company adopted SFAS No. 123. As permitted by
the standard, the Company has elected to continue following the guidance of APB
25 for measurement and recognition of stock-based transactions with employees.
Accordingly, no compensation cost has been recognized for the Company's option
plans. Had the determination of compensation cost for these plans been based on
the fair value as of the grant dates for awards under these plans, the Company's
net loss for the years ending September 30, 1996 and 1997 would have increased
to the pro forma amounts indicated below:
<TABLE>
<CAPTION>
1996 1997
---------- ----------
<S> <C> <C>
Net loss:
As reported........................................................ $ (17,881) $ (13,872)
Pro forma (unaudited).............................................. (19,428) (15,729)
</TABLE>
The resulting compensation expense may not be representative of compensation
expense to be incurred on a pro forma basis in future years.
F-78
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
16. STOCK OPTIONS AND AWARDS (CONTINUED)
In October 1995, the Company adopted the 1995 Stock Purchase and Option Plan
for Employees of Merit Behavioral Care Corporation and Subsidiaries (the "1995
Option Plan"). The 1995 Option Plan permits the issuance of common stock and the
grant of up to 8,561,000 non-qualified stock options (the "1995 Options") to
purchase shares of common stock to key employees of the Company. The exercise
price of 1995 Options will not be less than 50% of the fair market value per
share of common stock on the date of such grant. Such options vest at the rate
of 20% per year over a period of five years. An option's maximum term is 10
years.
In January 1996, the Company adopted a second stock option plan, the Merit
Behavioral Care Corporation Employee Stock Option Plan ("1996 Employee Option
Plan"). The 1996 Employee Option Plan covers all employees not included in the
1995 Option Plan whose employment commenced prior to January 1, 1997. The 1996
Employee Option Plan permits the grant of up to 1,000,000 non-qualified stock
options (the "1996 Employee Options") to purchase shares of common stock. The
1996 Employee Options vest on the fourth anniversary of the date of grant,
provided that the employee remains employed with the Company on such date. The
1996 Employee Options are exercisable after an initial public offering of common
stock of the Company meeting certain requirements. An option's maximum term is
10 years.
The fair value of each option grant is estimated on the date of grant by
using the Black-Scholes option-pricing model. The following weighted-average
assumptions were used for grants in the years ending September 30, 1996 and
1997:
<TABLE>
<CAPTION>
1996 1997
--------- ---------
<S> <C> <C>
Expected dividend yield..................................................... 0.00% 0.00%
Expected volatility......................................................... 1.00% 1.00%
Risk-free interest rates.................................................... 6.08% 6.44%
Expected option lives (years)............................................... 7.0 7.0
</TABLE>
Information regarding the Company's stock option plans is summarized below:
<TABLE>
<CAPTION>
1995 OPTION PLAN 1996 EMPLOYEE OPTION PLAN
-------------------------------- -------------------------------
WEIGHTED AVERAGE WEIGHTED AVERAGE
SHARES EXERCISE PRICE SHARES EXERCISE PRICE
----------- ------------------- ---------- -------------------
<S> <C> <C> <C> <C>
Outstanding at October 1, 1995................. -- --
Granted........................................ 5,698,000 $ 5.00 835,175 $ 7.50
Canceled....................................... (585,000) $ 5.00 (119,625) $ 7.50
----------- ----------
Outstanding at September 30, 1996.............. 5,113,000 $ 5.00 715,550 $ 7.50
Granted........................................ 1,327,075 $ 7.22 254,400 $ 7.50
Exercised...................................... (3,000) $ 5.00 -- --
Canceled....................................... (202,000) $ 5.74 (212,300) $ 7.50
----------- ----------
Outstanding at September 30, 1997.............. 6,235,075 $ 5.45 757,650 $ 7.50
----------- ----------
----------- ----------
</TABLE>
The weighted-average fair values of options granted during fiscal 1996 and
1997 for the 1995 Option Plan were $1.72 and $1.42, respectively. The
weighted-average fair values of options granted during fiscal 1996 and 1997 for
the 1996 Employee Option Plan were $0.01 and $0.87, respectively.
F-79
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
16. STOCK OPTIONS AND AWARDS (CONTINUED)
The following table summarizes information about stock options outstanding
as of September 30, 1997:
<TABLE>
<CAPTION>
1995 OPTION PLAN 1996 EMPLOYEE OPTION PLAN
----------------- -----------------------------
<S> <C> <C>
Range of exercise price.......................................... $ 5.00-$7.50 $ 7.50
Weighted-average remaining contracted life (years)............... 8.38 8.51
</TABLE>
As of September 30, 1997, 993,600 shares pertaining to the 1995 Option Plan
were exercisable with an exercise price of $5.00. No shares were exercisable for
the 1996 Employee Option Plan as of September 30, 1997.
Prior to the Merger, employees of the Company participated in stock option
plans administered by Merck. Pursuant to these plans, options were granted at
the fair market value of Merck common stock on the date of grant and generally
vest over a period of five years. The Company realizes an income tax benefit
when Company employees exercise either (a) nonqualified Merck stock options; or
(b) Merck incentive stock options, assuming the underlying common stock is sold
within one year from the date that the incentive stock option was exercised.
This benefit results in a decrease in tax liabilities and an increase in
additional paid in capital. During 1996 and 1997, the Company recorded tax
benefits of $1,505 and $11,630, respectively, from the exercise of Merck
options. Information regarding the options outstanding under these plans held by
employees of the Company at September 30, 1996 and 1997 is as follows:
<TABLE>
<CAPTION>
SHARES OPTION PRICE PER SHARE
---------------------- ---------------------------------------
<S> <C> <C> <C> <C>
1996 1997 1996 1997
----------- --------- ------------------ -------------------
Vested........................................ 905,504 497,353 $ 3.78 to $35.75 $ 3.78 to $25.87
Unvested...................................... 391,169 127,472 $ 3.78 to $35.75 $ 21.93 to $22.24
----------- ---------
Total......................................... 1,296,673 624,825
----------- ---------
----------- ---------
</TABLE>
Through September 30, 1995, employees of the Company participated in an
Employee Stock Purchase Plan administered by Merck. The stock plan permitted
employees of the Company to purchase Merck common stock at the end of each
quarter at a price equal to 85% of the fair market value at that date.
17. DISPOSAL OF SUBSIDIARY
In September 1997, the Company sold Choate for approximately $4,775 ($4,735
of which was received in October 1997). The Company recognized a loss of
approximately $6,925 relating to the transaction.
18. MERGER COSTS AND SPECIAL CHARGES
In fiscal 1997, the Company recognized approximately $733 of expenses
associated with uncompleted acquisition transactions. Also, the Company incurred
other special charges of approximately $581 related to nonrecurring employee
benefit costs associated with the exercise of stock options by employees of the
Company under plans administered by Merck. A significant number of these stock
options, which were granted prior to the Merger, required exercise by September
30, 1997.
F-80
<PAGE>
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
19. SUPPLEMENTAL INFORMATION
Supplemental cash flow information and noncash investing and financing
activities are as follows:
<TABLE>
<CAPTION>
1995 1996 1997
--------- --------- -----------
<S> <C> <C> <C>
Supplemental Cash Flow Information:
Cash (received) paid for income taxes........................................ $ 2,167 $ 1,100 $ (596)
Cash paid for interest....................................................... -- 17,676 23,568
Supplemental Noncash Investing and Financing Activities:
Record deferred taxes associated with the Merger............................. -- 7,594 --
Exercise of Merck stock options.............................................. -- 1,505 11,630
Acquisitions:
Fair value of assets acquired, other than cash............................. -- 14,360 89,412
Liabilities assumed........................................................ -- (2,962) (41,622)
--------- --------- -----------
Total consideration paid................................................... -- 11,398 47,790
Stock consideration paid................................................... -- -- (5,545)
--------- --------- -----------
Cash consideration paid.................................................... -- 11,398 42,245
Contingent consideration................................................... 9,580 1,278 400
--------- --------- -----------
Cash used for acquisitions, net of cash acquired............................... $ 9,580 $ 12,676 $ 42,645
--------- --------- -----------
--------- --------- -----------
</TABLE>
20. RECENTLY ISSUED ACCOUNTING STANDARD
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, which will
be effective for the Company beginning October 1, 1998. SFAS No. 131 redefines
how operating segments are determined and requires disclosure of certain
financial and descriptive information about a company's operating segments. The
Company has not yet completed its analysis with respect to which operating
segments of its business it will provide such information
21. SUBSEQUENT EVENT
On February 12, 1998, the Company's outstanding stock was aquired by
Magellan Health Services, Inc. for approximately $448.9 million in cash plus the
repayment of the Company's existing debt. In addition, all options outstanding
under the 1995 Option Plan and the 1996 Employee Option Plan vested upon closing
of the transaction.
F-81
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
TO CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
We have audited the accompanying consolidated balance sheet of Charter
Behavioral Health Systems, LLC (a Delaware limited liability corporation) and
subsidiaries as of September 30, 1997 and the related consolidated statement of
operations, changes in members' capital and cash flows for the period June 17,
1997 to September 30, 1997. These consolidated financial statements and the
schedule referred to below are the responsibility of the Company's management.
Our responsibility is to express an opinion on these consolidated financial
statements and schedule based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Charter Behavioral Health
Systems, LLC and subsidiaries as of September 30, 1997 and the results of their
operations and their cash flows for the period June 17, 1997 to September 30,
1997 in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in the index to
financial statements is presented for purposes of complying with the Securities
and Exchange Commission's rules and is not part of the basic financial
statements. The schedule has been subjected to the auditing procedures applied
in the audit of the basic financial statements and, in our opinion, fairly
states, in all material respects, the financial data required to be set forth
therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
ATLANTA, GEORGIA
NOVEMBER 14, 1997
F-82
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
CONSOLIDATED BALANCE SHEET
(IN THOUSANDS)
ASSETS
<TABLE>
<CAPTION>
SEPTEMBER 30, JUNE 30,
1997 1998
-------------- -----------
<S> <C> <C>
(UNAUDITED)
Current Assets:
Cash and cash equivalents......................................................... $ 23,443 $ 17,098
Accounts receivable, less allowance for doubtful accounts of $17,605 at September
30, 1997........................................................................ 107,961 123,931
Due from Magellan, net............................................................ 5,090 --
Supplies.......................................................................... 2,313 2,442
Prepaid expenses and other current assets......................................... 9,730 12,914
-------------- -----------
Total Current Assets.......................................................... 148,537 156,385
Property and Equipment:
Buildings and improvements........................................................ 11,879 7,643
Equipment......................................................................... 7,121 9,524
-------------- -----------
19,000 17,167
Accumulated depreciation.......................................................... (662) (2,287)
-------------- -----------
18,338 14,880
Construction in progress.......................................................... 86 37
-------------- -----------
Total Property and Equipment.................................................. 18,424 14,917
Other long-term assets.............................................................. 6,471 8,356
Goodwill, net of accumulated amortization of $3 at September 30, 1997............... 286 277
Deferred financing fees, net of accumulated amortization of $115 at September 30,
1997.............................................................................. 1,876 1,578
-------------- -----------
$ 175,594 $ 181,513
-------------- -----------
-------------- -----------
</TABLE>
F-83
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
CONSOLIDATED BALANCE SHEET
(IN THOUSANDS)
LIABILITIES AND MEMBERS' CAPITAL
<TABLE>
<CAPTION>
SEPTEMBER 30, JUNE 30,
1997 1998
-------------- -----------
<S> <C> <C>
(UNAUDITED)
Current Liabilities:
Accounts payable.................................................................. $ 34,864 $ 47,939
Accrued liabilities............................................................... 33,578 41,489
Due to Magellan, net.............................................................. -- 23,253
Current maturities of long-term debt and capital lease obligations................ 55 --
-------------- -----------
Total Current Liabilities..................................................... 68,497 112,681
Long-Term Debt and Capital Lease Obligations........................................ 65,860 65,000
Deferred Rent....................................................................... 4,759 17,223
Reserve for Unpaid Claims........................................................... 2,686 8,918
Minority Interest and Other Long-Term Liabilities................................... 36 2,748
Members' Capital:
Preferred interests............................................................... 35,000 35,000
Common interests.................................................................. 15,000 15,000
Accumulated deficit............................................................... (16,244) (75,057)
-------------- -----------
Total Members' Capital........................................................ 33,756 (25,057)
-------------- -----------
$ 175,594 $ 181,513
-------------- -----------
-------------- -----------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of this balance sheet.
F-84
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
CONSOLIDATED STATEMENT OF OPERATIONS
(IN THOUSANDS)
<TABLE>
<CAPTION>
106 DAYS 14 DAYS NINE MONTHS
ENDED ENDED ENDED
SEPTEMBER 30, JUNE 30, JUNE 30,
1997 1997 1998
-------------- ----------- -----------
<S> <C> <C> <C>
(UNAUDITED) (UNAUDITED)
Net revenue........................................................... $ 213,730 $ 29,865 $ 553,370
-------------- ----------- -----------
Costs and expenses:
Salaries, supplies and other operating expenses..................... 170,619 22,538 449,207
Franchise fees--Magellan............................................ 22,739 3,164 58,725
Crescent lease expense.............................................. 16,919 2,262 42,033
Bad debt expense.................................................... 17,437 2,503 45,905
Depreciation and amortization....................................... 668 98 4,304
Interest, net....................................................... 1,592 98 3,975
Unusual items....................................................... -- -- 5,288
-------------- ----------- -----------
Total costs and expenses........................................ 229,974 30,663 609,437
-------------- ----------- -----------
Net loss.............................................................. (16,244) (798) (56,067)
Preferred member dividend............................................. -- -- 2,746
-------------- ----------- -----------
Net loss applicable to common member capital.......................... $ (16,244) $ (798) $ (58,813)
-------------- ----------- -----------
-------------- ----------- -----------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of this statement.
F-85
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
CONSOLIDATED STATEMENT OF CHANGES IN MEMBERS' CAPITAL
FOR THE 106 DAYS ENDED SEPTEMBER 30, 1997
(IN THOUSANDS)
<TABLE>
<CAPTION>
PREFERRED INTERESTS COMMON INTERESTS
TOTAL
----------------------- ----------------------- ACCUMULATED MEMBERS'
COI MAGELLAN COI MAGELLAN DEFICIT CAPITAL
--------- ------------ --------- ------------ ---------------- ------------
<S> <C> <C> <C> <C> <C> <C>
Additions (Deductions):
Issuance of cumulative redeemable
preferred interest.................. $ 17,500 $ 17,500 $ -- $ -- $ -- $ 35,000
Capital contributions................. -- -- 7,500 7,500 -- 15,000
Net loss.............................. -- -- -- -- (16,244) (16,244)
--------- ------------ --------- ------------ -------- ------------
Balances, September 30, 1997............ $ 17,500 $ 17,500 $ 7,500 $ 7,500 $ (16,244) $ 33,756
--------- ------------ --------- ------------ -------- ------------
--------- ------------ --------- ------------ -------- ------------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of this statement.
F-86
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
106 DAYS 14 DAYS NINE MONTHS
ENDED ENDED ENDED
SEPTEMBER 30, JUNE 30, JUNE 30,
1997 1997 1998
-------------- ----------- -------------
<S> <C> <C> <C>
(UNAUDITED) (UNAUDITED)
Cash Flows From Operating Activities
Net loss.......................................................... $ (16,244) $ (798) $ (56,067)
-------------- ----------- -------------
Adjustments to reconcile net loss to net cash used in operating
activities:
Loss (gain) on sale of assets................................... (355) -- 2,019
Depreciation and amortization................................... 668 98 4,304
Non-cash interest expense....................................... 115 15 299
Cash flows from changes in assets and liabilities, net of
effects from sales and acquisitions of businesses:
Accounts receivable, net...................................... (98,504) (28,296) (17,670)
Due to/from Magellan.......................................... (5,090) 3,728 29,657
Other current assets.......................................... (5,089) (17,321) (2,571)
Other long-term assets........................................ (4,565) (1,075) (1,886)
Accounts payable and accrued liabilities...................... 53,458 28,612 21,173
Accrued interest payable...................................... 333 59 (228)
Deferred rent................................................. 4,759 630 10,214
Reserve for unpaid claims..................................... 2,686 350 6,232
Other liabilities............................................. (3) 2 (29)
-------------- ----------- -------------
Total adjustments............................................. (51,587) (13,198) 51,514
-------------- ----------- -------------
Net cash used in operating activities..................... (67,831) (13,996) (4,553)
-------------- ----------- -------------
Cash Flows From Investing Activities
Capital expenditures............................................ (149) -- (2,706)
Purchase of information systems equipment from Magellan......... (5,000) (5,000) --
Purchase of net assets from Magellan............................ (11,288) -- --
Proceeds from sale of assets.................................... -- -- 960
-------------- ----------- -------------
Net cash used in investing activities..................... (16,437) (5,000) (1,746)
-------------- ----------- -------------
Cash Flows From Financing Activities
Payments on debt and capital lease obligations.................. (16) -- (46)
Proceeds from issuance of debt, net of issuance costs........... 98,009 23,009 --
Proceeds from capital contributions--COI........................ 7,500 7,500 --
Proceeds from capital contributions--Magellan................... 2,218 2,218 --
-------------- ----------- -------------
Net cash provided by (used in) financing activities....... 107,711 32,727 (46)
-------------- ----------- -------------
Net increase (decrease) in cash and cash equivalents................ 23,443 13,731 (6,345)
Cash and cash equivalents at beginning of period.................... -- -- 23,443
-------------- ----------- -------------
Cash and cash equivalents at end of period.......................... $ 23,443 $ 13,731 $ 17,098
-------------- ----------- -------------
-------------- ----------- -------------
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of this statement.
F-87
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1997
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements of Charter Behavioral Health Systems,
LLC, a Delaware limited liability corporation, ("CBHS" or the "Company") include
the accounts of the Company and its subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation.
The Company provides behavioral healthcare services in the United States.
The Company's principal services include inpatient treatment, day and partial
hospitalization services, group and individual outpatient treatment and
residential services.
On June 17, 1997, the Company began operations pursuant to a series of
transactions (the "Crescent Transactions") between Magellan Health Services,
Inc. ("Magellan"), Crescent Real Estate Equities Limited Partnership
("Crescent") and Crescent Operating, Inc., an affiliate of Crescent ("COI"). The
Crescent Transactions provided for the following:
- Magellan sold to Crescent 80 behavioral healthcare facilities (76
operating and four held for sale) ("Purchased Facilities") and related
medical office buildings formerly operated by Magellan.
- Magellan and COI formed the Company to operate the Purchased Facilities
and the Contributed Facilities (defined below) (together the
"Facilities"). The Company is owned equally by Magellan and COI.
- Magellan contributed to the Company certain property and intangible rights
used in connection with the Facilities in exchange for its equity interest
in CBHS. The property that was contributed by Magellan included five acute
care psychiatric hospitals and other ancillary facilities that Magellan
leased from third parties (together the "Contributed Facilities"). The
Company also purchased certain assets from Magellan relating to Magellan's
information systems subsidiary for $5 million.
- CBHS entered into a service agreement with Magellan pursuant to which the
Company manages Magellan's interest in certain joint ventures with
unaffiliated third parties, including joint ventures that operate or
manage ten behavioral healthcare facilities. Magellan is the general
partner or managing entity of such joint ventures.
- CBHS leased the Purchased Facilities from Crescent under a 12-year lease
(subject to renewal). CBHS pays annual base rent to Crescent, which is
initially $41.7 million and increases at 5% compounded annually (See Note
2).
- CBHS and certain of its subsidiaries entered into franchise agreements
with Magellan pursuant to which CBHS and such subsidiaries operate using
the "CHARTER" name, services and protocols and pay to Magellan annual
franchise fees, subject to increase, of approximately $78.3 million (See
Note 7). The franchise fees due Magellan are subordinate to the payment of
rent due Crescent.
- Both Magellan and COI contributed an additional $2.5 million in cash to
the capital of CBHS. In addition, each made a commitment to loan CBHS up
to $17.5 million each, for a period of 5 years. Such loans were made to
CBHS by each for $17.5 million ("Member Loans") and, effective September
30, 1997, were converted to cumulative redeemable preferred interests (See
Note 8).
F-88
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Actual results could differ from those estimates.
The unaudited consolidated financial statements of the Company as of June
30, 1998 and for the 14 day period ended June 30, 1997 and the nine month period
ended June 30, 1998 have been prepared in accordance with generally accepted
accounting principles for interim financial information. Accordingly, certain
information and footnotes required by generally accepted accounting principles
for complete financial statements have been condensed or omitted. In the opinion
of management, all adjustments, consisting of normal recurring adjustments
considered necessary for a fair presentation, have been included. The results of
operations for the nine months ended June 30, 1998 are not necessarily
indicative of the expected results for the year ended September 30, 1998.
NET REVENUE
Patient net revenue is based on established billing rates, less estimated
allowances for patients covered by Medicare and other contractual reimbursement
programs, and discounts from established billing rates. Amounts received by the
Company for treatment of patients covered by Medicare and other contractual
reimbursement programs, which may be based on cost of services provided or
predetermined rates, are generally less than the established billing rates of
the Company's hospitals. Final determination of amounts earned under contractual
reimbursement programs is subject to review and audit by the applicable
agencies. Management believes that adequate provision has been made for any
adjustments that may result from such reviews.
ADVERTISING COSTS
The production costs of advertising are expensed as incurred. The Company
does not consider any of its advertising costs to be direct-response and,
accordingly, does not capitalize such costs. Advertising costs consist primarily
of radio and television air time, which is amortized as utilized, and printed
media services. Advertising expense was approximately $6.4 million for the 106
days ended September 30, 1997.
CHARITY CARE
The Company provides healthcare services without charge or at amounts less
than its established rates to patients who meet certain criteria under its
charity care policies. Because the Company does not pursue collection of amounts
determined to be charity care, they are not reported as revenue. For the 106
days ended September 30, 1997, the Company provided, at its established billing
rates, approximately $5.3 million of such care.
INTEREST, NET
The Company records interest expense net of interest income. Interest income
for the 106 days ended September 30, 1997 was approximately $0.2 million.
F-89
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CASH AND CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid interest-bearing investments
with a maturity of three months or less when purchased, consisting primarily of
money market instruments.
CONCENTRATION OF CREDIT RISK
Accounts receivable from patient revenue subject the Company to a
concentration of credit risk with third party payors that include insurance
companies, managed healthcare organizations and governmental entities. The
Company establishes an allowance for doubtful accounts based upon factors
surrounding the credit risk of specific payors, historical trends and other
information. Management believes the allowance for doubtful accounts is adequate
to provide for normal credit losses.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Expenditures for renewals and
improvements are charged to the property accounts. Replacements and maintenance
and repairs that do not improve or extend the life of the respective assets are
expensed as incurred. Amortization of capital lease assets is included in
depreciation expense. Depreciation is provided on a straight-line basis over the
estimated useful lives of the assets, which is generally 10 to 30 years for
buildings and improvements and three to ten years for equipment. Depreciation
expense was $0.7 million for the 106 days ended September 30, 1997.
INTANGIBLE ASSETS
Intangible assets are composed principally of goodwill and deferred
financing costs. Goodwill represents the excess of the cost of businesses
acquired over the fair value of the net identifiable assets at the date of
acquisition and is amortized using the straight-line method over 25 years.
Deferred financing costs are the costs incurred by the Company to obtain its
revolving credit agreement (See Note 2), and are amortized over the term of the
related agreement (5 years).
The Company continually monitors events and changes in circumstances that
could indicate carrying amounts of intangible assets may not be recoverable.
When events or changes in circumstances are present that indicate the carrying
amount of intangible assets may not be recoverable, the Company assesses the
recoverability of intangible assets by determining whether the carrying value of
such intangible assets will be recovered through the future cash flows expected
from the use of the asset and its eventual disposition. No impairment losses on
intangible assets were recorded by the Company in during the 106 days ended
September 30, 1997.
F-90
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
2. LONG-TERM DEBT AND LEASE OBLIGATIONS
Information with regard to the Company's long-term debt and capital lease
obligations at September 30, 1997 is as follows (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30,
1997
--------------
<S> <C>
Revolving Credit Agreement due through 2002 (6.906% to 6.938%)................ $ 65,000
10.5% Capital lease obligations due through 2007.............................. 915
--------------
65,915
Less amounts due within one year............................................ 55
--------------
$ 65,860
--------------
--------------
</TABLE>
The aggregate scheduled maturities of long-term debt and capital lease
obligations during the five years subsequent to September 30, 1997 are as
follows (in thousands): 1998--$55; 1999--$62; 2000-- $68; 2001--$76 and
2002--$65,084.
REVOLVING CREDIT AGREEMENTS
On June 17, 1997, the Company entered into a Credit Agreement (the
"Revolving Credit Agreement") with certain financial institutions for a
five-year senior secured revolving credit facility in an aggregate committed
amount of $100 million.
The maximum amount allowed to be borrowed under the Revolving Credit
Agreement is based on a working capital calculation. At September 30, 1997, the
Company had approximately $4.3 million available for borrowing under the
Revolving Credit Agreement. The Revolving Credit Agreement is secured by the
tangible and intangible personal property, including accounts receivable, owned
by the Company.
The loans outstanding under the Revolving Credit Agreement bear interest
(subject to certain potential adjustments) at a rate per annum equal to one,
two, three or six-month LIBOR plus 1.25% or the Alternative Base Rate ("ABR"),
as defined, plus .25%. Interest on ABR loans is payable at the end of each
fiscal quarter. Interest on LIBOR-based loans is payable at the end of their
respective terms, but a minimum of every three months.
COVENANTS
The Revolving Credit Agreement contains a number of restrictive covenants,
which, among other things, limit the ability of the Company and certain of its
subsidiaries to incur other indebtedness, engage in transactions with
affiliates, incur liens, make certain restricted payments, and enter into
certain business combinations. The Revolving Credit Agreement also requires the
Company to maintain certain specified financial ratios. The Company was in
compliance with all debt covenants under the Revolving Credit Agreement at
September 30, 1997. Budget projections prepared by management for the fiscal
year ending September 30, 1998 estimate that the Company will be in compliance
with all debt covenants under the Revolving Credit Agreement during fiscal 1998.
Management believes that its budget projections for fiscal 1998 are reasonable
and achievable, however, there can be no assurances that such projections will
be achieved. If the Company were to fail to achieve such budget projections
F-91
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
2. LONG-TERM DEBT AND LEASE OBLIGATIONS (CONTINUED)
during fiscal 1998, the Company could become in noncompliance with certain debt
covenants resulting in an event of default under the Revolving Credit Agreement.
CRESCENT LEASE
The Company leases the Purchased Facilities from Crescent under an initial
twelve year lease term with four renewal terms of five years each. The lease
requires the Company to pay all maintenance, property tax and insurance costs.
The base rent for the first year of the initial term is $41.7 million and
increases at 5% compounded annually. The Company accounts for the Crescent Lease
as an operating lease and accordingly, records base rent expense on a
straight-line basis over the lease term. The Company is required to pay Crescent
in each lease year additional rent of $20.0 million, $10.0 million of which must
be used for capital expenditures each year and $10.0 million which can be used
to pay property taxes, insurance premiums and franchise fees. Such additional
rent amounts are included in the future minimum lease payments disclosed below.
OTHER LEASES
The Company also leases certain of its operating facilities, other than the
Purchased Facilities. The book value of capital leased assets was approximately
$4.5 million at September 30, 1997. The leases, which expire at various dates
through 2027, generally require the Company to pay all maintenance, property tax
and insurance costs.
At September 30, 1997, aggregate amounts of future minimum payments under
operating leases were as follows: 1998--$65.4 million; 1999--$66.4 million;
2000--$67.6 million; 2001--$69.5 million; 2002--$71.8 million; subsequent to
2002--$556.0 million.
Rent expense for the 106 days ended September 30, 1997 was $20.4 million.
3. ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30,
1997
--------------
<S> <C>
Salaries and wages............................................................ $ 18,220
Property taxes................................................................ 4,874
Interest...................................................................... 333
Other......................................................................... 10,151
--------------
$ 33,578
--------------
--------------
</TABLE>
F-92
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
4. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information for the 106 days ended September 30, 1997
is as follows (in thousands):
<TABLE>
<CAPTION>
106 DAYS ENDED
SEPTEMBER 30,
1997
-----------------
<S> <C>
Interest paid............................................................... $ 1,291
Non-cash transactions:
Exchange of debt for cumulative preferred interest--COI................... 17,500
Exchange of debt for cumulative preferred interest--Magellan.............. 17,500
Initial capital contribution from Magellan, primarily property and
equipment less assumed liabilities...................................... 5,282
Account receivable for the sale of facility............................... 386
</TABLE>
5. DIVESTITURES
On September 30, 1997 the Company sold the operations of a 60 bed behavioral
healthcare hospital for $422,000. Proceeds from the sale were not received until
October 2, 1997. The transaction resulted in a gain of $355,000.
6. BENEFITS PLANS
The Company has a defined contribution retirement plan (the "CBHS 401-K
Plan"). Employee participants can elect to voluntarily contribute up to 15% of
their compensation to the CBHS 401-K Plan. The Company will make contributions
to the CBHS 401-K Plan based on employee compensation and contributions. The
Company makes a discretionary contribution of 2% of each employee's compensation
and matches 50% of each employee's contribution up to 3% of their compensation.
7. FRANCHISE FEES--MAGELLAN
The Company and certain of its subsidiaries entered into franchise
agreements with Magellan pursuant to which CBHS and such subsidiaries operate
using the "CHARTER" name, services and protocols. The franchise agreements
provide, among other things, that:
- Magellan agrees to use its commercially reasonable best efforts, subject
to applicable law, to cause such subsidiaries to have "preferred provider"
status in connection with Magellan's managed behavioral healthcare
business on a basis substantially consistent with existing agreements for
such business.
- Magellan agrees to operate or provide a toll free "800" telephone number,
and call center as a means of assisting customers to locate the places of
business of franchisees.
- Franchisees were granted a right to a defined territory to engage in the
business of providing behavioral healthcare business, as defined.
- Magellan will provide franchisees with the following assistance: (i)
advertising and marketing assistance including consultation, access to
media buying programs and access to broadcast and other advertising
materials produced by Magellan from time to time for franchisees; (ii)
risk
F-93
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
7. FRANCHISE FEES--MAGELLAN (CONTINUED)
management services, including risk financial planning, loss control and
claims management; (iii) outcomes monitoring; (iv) national and regional
contracting services; and (v) consultation by telephone or at the Magellan
offices with respect to matters relating to the franchisee's business in
which Magellan has expertise, including reimbursement, government
relations, clinical strategies, regulatory matters, strategic planning and
business development.
Franchise fees payable by the Company are the greater of (i) $78.3
million, subject to increases for inflation; or (ii) $78.3 million, plus 3%
of gross revenues over $1 billion and not exceeding $1.2 billion and 5% of
gross revenues over $1.2 billion.
The initial term of the franchise agreements is 12 years with four
renewal terms of five years each.
8. CUMULATIVE REDEEMABLE PREFERRED INTEREST
Effective September 30, 1997, Magellan and COI each agreed to exchange their
respective Member Loans for cumulative redeemable preferred interest ("Preferred
Interest") in the Company. The Preferred Interest is callable in whole at the
Company's option on or after April 1, 1998, at an amount equal to the initial
amount plus all accrued dividends thereon. Each holder of Preferred Interest
receives preferential allocation of the Company's profits computed at 10% per
annum on a cumulative basis, compounded monthly. In addition, each Preferred
Interest has a similar preferred position in the event of dissolution of the
Company.
9. COMMITMENTS AND CONTINGENCIES
The Company carries general and professional liability insurance from an
unrelated commercial insurance carrier with a self insured retention of $1.5
million per occurrence and $8.8 million in the aggregate, on a claims made
basis. In addition, the Company has an umbrella policy with coverage up to $125
million per occurrence and in the aggregate.
Certain of the Company's subsidiaries are subject to or parties to claims,
civil suits and governmental investigations and inquiries relating to their
operations and certain alleged business practices. In the opinion of management,
based on consultation with counsel, resolution of these matters will not have a
material adverse effect on the Company's financial position or results of
operations.
10. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
John C. Goff is the Chairman of CBHS and the Vice Chairman of both Crescent
and COI.
As part of the Crescent Transactions, (i) certain items of working capital
were purchased from Magellan and (ii) the Company agreed to collect Magellan's
patient accounts receivable outstanding as of the closing date for a fee of 5%
of cash collections. Included in net revenues for the 106 days ended September
30, 1997 are approximately $5.0 million of collection fee revenues.
The Company has a receivable due from Magellan as of September 30, 1997 of
approximately $5.1 million. This receivable results from (i) amounts due for the
management of Magellan's joint ventures, (ii) amounts due for the collection fee
on Magellan's patient account receivable and (iii) a receivable for the
settlement of working capital related matters.
F-94
<PAGE>
CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1997
11. SUBSEQUENT EVENTS (UNAUDITED)
UNUSUAL ITEMS. Unusual items for the nine months ended June 30, 1998
include (i) costs incurred in connection with an unsuccessful acquisition
attempt of $2.0 million, (ii) severance, primarily related to the former
president and CEO, of $1.3 million and (iii) loss on the sale of a psychiatric
hospital of $2.0 million.
F-95
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholder of
Human Affairs International, Incorporated:
We have audited the accompanying consolidated balance sheets of Human
Affairs International, Incorporated and subsidiaries, (a wholly owned subsidiary
of Aetna Inc.), as of December 31, 1995 and 1996, and the related consolidated
statements of income, stockholder's equity, and cash flows for the years then
ended. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Human
Affairs International, Incorporated and subsidiaries as of December 31, 1995 and
1996, and the results of their operations and their cash flows for the years
then ended in conformity with generally accepted accounting principles.
/s/ KPMG Peat Marwick LLP
February 7, 1997, except as to
note 10 which is as of
February 27, 1997
F-96
<PAGE>
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AETNA INC.)
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
---------------------------- SEPTEMBER 30,
1995 1996 1997
------------- ------------- --------------
(UNAUDITED)
<S> <C> <C> <C>
Assets
Current assets:
Cash and cash equivalents........................................ $ 22,294,437 $ 33,446,435 $ 36,255,658
Receivables:
Contract service fees, less allowance for doubtful accounts of
$375,748 at December 31, 1995, $68,422 at December 31, 1996
and September 30, 1997....................................... 6,206,738 6,364,124 6,771,313
Related party (note 6)......................................... 2,250,953 2,957,865 5,547,515
Income taxes (note 3).......................................... -- 99,584 130,188
Other current assets........................................... 269,180 423,471 29,162
Deferred income taxes (note 3)................................. 419,309 364,629 364,629
------------- ------------- --------------
Total current assets......................................... 31,440,617 43,656,108 49,098,465
------------- ------------- --------------
Property, equipment, and leasehold improvements, less accumulated
depreciation and amortization (note 2)........................... 846,285 406,044 241,923
Cost in excess of net assets acquired of purchased subsidiaries,
less accumulated amortization of $61,502 at December 31, 1995,
$143,504 at December 31, 1996 and $205,006 at September 30, 1997
(note 8)......................................................... 758,520 676,518 615,016
Noncurrent deferred income taxes (note 3).......................... 808,821 364,498 56,751
Other assets....................................................... 62,995 63,006 21,033
------------- ------------- --------------
$ 33,917,238 $ 45,166,174 $ 50,033,188
------------- ------------- --------------
------------- ------------- --------------
Liabilities and Stockholder's Equity
Current liabilities:
Unearned contract service fees................................. $ 4,832,356 $ 4,591,431 $ 4,260,590
Accounts payable and accrued liabilities....................... 6,948,838 8,231,292 11,776,208
Related party (note 6)......................................... 6,793,418 2,454,957 9,441,603
Current installments of note payable (note 8).................. 333,333 333,333 --
Current installments of noncompete and salary continuation
agreements (note 7).......................................... 500,932 -- --
Current installments of obligations under capital leases (note
5)........................................................... 9,453 7,058 7,098
Income taxes payable (note 3).................................. 823,439 -- 1,328,814
------------- ------------- --------------
Total current liabilities.................................... 20,241,769 15,618,071 26,814,313
Note payable, less current installments (note 8)................... 333,333 -- --
Obligations under capital leases, less current installments (note
5)............................................................... 18,093 10,112 2,635
Other long-term liabilities........................................ 92,519 2,404 2,737
Stockholder's equity (notes 6 and 10):
Common stock, no par value. Authorized 50,000 shares; issued
and outstanding 10,000 shares................................ 1,000 1,000 1,000
Additional paid-in capital..................................... 11,092,000 11,092,000 --
Retained earnings.............................................. 2,138,524 18,442,587 23,212,503
------------- ------------- --------------
Total stockholder's equity................................... 13,231,524 29,535,587 23,213,503
Commitments and contingencies (notes 5, 9 and 10)
------------- ------------- --------------
$ 33,917,238 $ 45,166,174 $ 50,033,188
------------- ------------- --------------
------------- ------------- --------------
</TABLE>
See accompanying notes to consolidated financial statements.
F-97
<PAGE>
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AETNA INC.)
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEAR ENDED DECEMBER 31, SEPTEMBER 30,
-------------------------------- ------------------------------
<S> <C> <C> <C> <C>
1995 1996
-------------- ----------------
1996 1997
-------------- --------------
(UNAUDITED) (UNAUDITED)
Revenues:
Contract service fees (note 6)............ $ 94,148,402 $ 105,923,687 $ 78,033,338 $ 88,845,581
Interest.................................. 2,240,216 1,538,769 1,100,649 1,166,952
-------------- ---------------- -------------- --------------
Total revenues........................ 96,388,618 107,462,456 79,133,987 90,012,533
-------------- ---------------- -------------- --------------
Expenses (note 6):
Operating costs........................... 70,209,268 80,696,520 59,828,799 67,128,675
Interest.................................. 1,701 1,033 673 900
Depreciation and amortization............. 822,273 517,404 404,455 219,458
Noncompete employment agreement (note
7)...................................... 262,824 105,708 105,708 --
Minority interest......................... 71,524 -- -- --
-------------- ---------------- -------------- --------------
Total expenses........................ 71,367,590 81,320,665 60,339,635 67,349,033
-------------- ---------------- -------------- --------------
Income before income taxes............ 25,021,028 26,141,791 18,794,352 22,663,500
Income tax expense (note 3)................... 9,775,720 9,837,728 7,343,152 8,985,584
-------------- ---------------- -------------- --------------
Net income............................ $ 15,245,308 $ 16,304,063 $ 11,451,200 $ 13,677,916
-------------- ---------------- -------------- --------------
-------------- ---------------- -------------- --------------
</TABLE>
See accompanying notes to consolidated financial statements.
F-98
<PAGE>
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AETNA INC.)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1995 AND 1996 AND
NINE MONTHS ENDED SEPTEMBER 30, 1997 (UNAUDITED)
<TABLE>
<CAPTION>
RETAINED
ADDITIONAL EARNINGS TOTAL
COMMON PAID-IN (ACCUMULATED STOCKHOLDER'S
STOCK CAPITAL DEFICIT) EQUITY
----------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
----------- --------------- --------------- ---------------
Balances at December 31, 1994..................... $ 1,000 $ 18,692,000 $ (706,784) $ 17,986,216
Dividend to parent................................ -- -- (12,400,000) (12,400,000)
Return of capital to parent....................... -- (7,600,000) -- (7,600,000)
Net income........................................ -- -- 15,245,308 15,245,308
----------- --------------- --------------- ---------------
Balances at December 31, 1995..................... 1,000 11,092,000 2,138,524 13,231,524
Net income........................................ -- -- 16,304,063 16,304,063
----------- --------------- --------------- ---------------
Balances at December 31, 1996..................... 1,000 11,092,000 18,442,587 29,535,587
Dividend to parent (unaudited).................... -- -- (8,908,000) (8,908,000)
Return of capital to parent (unaudited)........... -- (11,092,000) -- (11,092,000)
Net income (unaudited)............................ -- -- 13,677,916 13,677,916
----------- --------------- --------------- ---------------
Balances at September 30, 1997 (unaudited)........ $ 1,000 $ -- $ 23,212,503 $ 23,213,503
----------- --------------- --------------- ---------------
----------- --------------- --------------- ---------------
</TABLE>
See accompanying notes to consolidated financial statements.
F-99
<PAGE>
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AETNA INC.)
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEARS ENDED DECEMBER 31, SEPTEMBER 30,
-------------------------- --------------------------
<S> <C> <C> <C> <C>
1995 1996
------------ ------------
1996 1997
------------ ------------
(UNAUDITED) (UNAUDITED)
Cash flows from operating activities:
Net income.......................................... $ 15,245,308 $ 16,304,063 $ 11,451,200 $ 13,677,916
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization..................... 822,273 517,404 404,455 219,458
Loss on disposal of assets........................ 77,260 32,066 10,378 41,776
Increase (decrease) in allowance for doubtful
accounts........................................ 314,733 (314,733) 150,000 7,407
(Increase) decrease in contract service fees
receivable...................................... 539,966 157,347 (2,127,925) (414,595)
Decrease (increase) in related party receivable... (196,706) (706,912) 1,069,259 (2,589,650)
Decrease (increase) in income tax receivable...... -- (99,584) (152,662) (30,604)
Decrease (increase) in other current assets....... 13,674 (154,291) 175,582 394,308
Decrease in deferred tax assets................... 167,190 499,003 470,598 307,747
Decrease (increase) in other assets............... 3,027 (11) (9) 41,971
Decrease in unearned contract service fees........ (234,116) (240,925) (557,382) (330,840)
Increase (decrease) in accounts payable and
accrued liabilities............................. (1,497,670) 1,282,454 820,325 3,544,916
Increase (decrease) in payable to related party... (1,396,534) (4,338,461) (3,931,504) 6,986,646
Increase (decrease) in noncompete and salary
continuation agreements payable................. 34,180 (500,932) (500,932) --
Increase (decrease) in income taxes payable....... (3,133,475) (823,439) 1,050,060 1,328,814
Increase (decrease) in other long-term
liabilities..................................... (331,729) (90,115) (72,764) 333
Increase in minority interest..................... 71,524 -- -- --
------------ ------------ ------------ ------------
Net cash provided by operating activities....... 10,498,905 11,522,934 8,258,679 23,185,603
------------ ------------ ------------ ------------
Cash flows from investing activities:
Capital expenditures................................ (209,328) (35,895) (44,698) (39,696)
Proceeds from disposal of fixed assets.............. 34,818 8,668 4,949 4,087
Distribution to minority interest................... (309,610) -- -- --
Payment for purchase of minority interest (note
8)................................................ (333,334) (333,333) (333,333) (333,333)
------------ ------------ ------------ ------------
Net cash used in investing activities........... (817,454) (360,560) (373,082) (368,942)
------------ ------------ ------------ ------------
Cash flows from financing activities:
Principal payments on capital lease obligations..... (16,839) (10,376) -- (7,438)
Return of capital to parent......................... (7,600,000) -- -- (11,092,000)
Dividends paid to parent............................ (12,400,000) -- -- (8,908,000)
------------ ------------ ------------ ------------
Net cash used in financing activities........... (20,016,839) (10,376) -- (20,007,438)
------------ ------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents.... (10,335,388) 11,151,998 7,885,597 2,809,223
Cash and cash equivalents, beginning of period.......... 32,629,825 22,294,437 22,294,437 33,446,435
------------ ------------ ------------ ------------
Cash and cash equivalents, end of period................ $ 22,294,437 $ 33,446,435 $ 30,180,034 $ 36,255,658
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
Supplemental Disclosures of Cash Flow Information
Interest paid........................................... $ 1,701 $ 1,033 $ 673 $ 900
Income taxes paid....................................... 12,742,005 11,647,990 5,559,681 7,138,190
Supplemental Disclosures of Noncash Investing and
Financing Activities
Capital lease obligations incurred for office
equipment............................................. $ 25,248 $ -- $ -- $ --
Note payable to a related party for acquisition of
minority interest..................................... 666,666 -- -- --
</TABLE>
See accompanying notes to consolidated financial statements.
F-100
<PAGE>
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AETNA INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1995 AND 1996
(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Description of Business
Human Affairs International, Incorporated is a provider of employee
behavioral health assistance programs and a managed behavioral health care
company. The employee assistance programs are provided for clients' employees
and their families and include the management of the delivery of behavioral
health services that deal with personal problems that can interfere with an
employee's well-being and job performance. These problems may include, among
other things, psychological disorders, family or marital issues, alcohol and/or
other drug abuse, stress, depression, and anxiety. The managed behavioral health
care program manages the clinical services delivered for the treatment of
psychiatric and/or substance abuse conditions through the process of negotiating
clinical quality at a reasonable price in order to achieve optimal care. The
Company provides services primarily throughout the Continental United States,
Alaska, and Hawaii.
(b) Basis of Presentation
The accompanying consolidated financial statements include the accounts of
Human Affairs International, Incorporated and its wholly owned subsidiaries,
Human Affairs International of California, Incorporated and Human Affairs of
Alaska which was an unincorporated joint venture in 1994 (collectively referred
to as the Company). All significant intercompany accounts and transactions have
been eliminated in consolidation. The Company is a wholly owned subsidiary of
Aetna Life Insurance Company (ALIC). The Company's ultimate parent is Aetna Inc.
(the Parent). During 1996, Aetna Life and Casualty Company, the Company's former
parent, merged with U.S. Healthcare, Inc. and each became a wholly owned
subsidiary of a new holding company, Aetna Inc.
The unaudited consolidated condensed financial statements of the Company as
of September 30, 1997, and for the nine-month periods ended September 30, 1996
and 1997, were prepared by the Company without audit. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted. In the opinion of management, all necessary adjustments (consisting
only of normal recurring adjustments) have been made to present fairly the
consolidated financial position and results of operations and cash flows for
these periods. The results of operations for the period ended September 30,
1997, are not necessarily indicative of the expected results for the year ending
December 31, 1997.
(c) Cash Equivalents
The Company considers all highly liquid debt instruments with original
maturities of three months or less to be cash equivalents. Cash equivalents
consisted of money market funds of $21,901,800 and $31,693,520 at December 31,
1995 and 1996, respectively. At December 31, 1995 and 1996, the book value of
cash equivalents approximates fair value.
(d) Cost in Excess of Net Assets Acquired of Purchased Subsidiaries
These costs represent the excess purchase price over the fair value of the
net assets of acquired companies and are amortized on a straight-line basis over
a period of ten years. During 1995, additional costs were incurred when the
Company acquired the remaining interest of the Alaska Joint Venture.
Amortization expense was $61,502 and $82,002 in 1995 and 1996, respectively.
F-101
<PAGE>
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AETNA INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1995 AND 1996
(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
(e) Property, Equipment, and Leasehold Improvements
Property, equipment, and leasehold improvements are recorded at cost.
Depreciation is calculated on a straight-line basis over the estimated useful
lives of the assets which range from three to ten years.
(f) Revenue Recognition
Contract services fees are primarily determined on a monthly per capita
amount and are recognized over the life of the contract. Unearned contract
service fees are billed or collected revenues that have not been recognized as
income pending the performance of contract service obligations. These fees
primarily represent 1 to 12 months of advance billings as specified in the
contracts.
(g) Contract Service Costs
The direct operating costs associated with servicing the contracts are
expensed as incurred and included in operating costs. These costs are directly
related to the level and timing of the services provided. These direct operating
costs are accrued as services are rendered and include estimates of the costs of
services rendered but not yet reported. The Company accrues for losses on
contracts when it is probable that the expected future service costs of a
contract will exceed the service fees expected on the contract.
(h) Income Taxes
The Company is included in the consolidated federal income tax return of the
Parent and the Parent's other subsidiaries. In accordance with a tax sharing
arrangement, the Company's current federal income tax provisions are generally
computed as if the Company were filing a separate federal income tax return;
current income tax benefits, including those resulting from carrybacks, are
recognized to the extent realized in the consolidated return.
Deferred income tax assets and liabilities are recognized for the expected
future tax consequences of temporary differences between the income tax and
financial statement reporting amounts of assets and liabilities.
(i) 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 amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates.
(j) Reclassifications
Certain amounts in 1995 have been reclassified to conform to the 1996
presentation.
F-102
<PAGE>
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AETNA INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(2) PROPERTY, EQUIPMENT, AND LEASEHOLD IMPROVEMENTS
The components of property, equipment, and leasehold improvements follow:
<TABLE>
<CAPTION>
1995 1996
------------- -------------
<S> <C> <C>
Property and equipment.......................................... $ $4,252,318 $ 3,785,868
Leasehold improvements.......................................... 186,111 180,693
------------- -------------
4,438,429 3,966,561
Less accumulated depreciation and amortization.................. 3,592,144 3,560,517
------------- -------------
$ 846,285 $ 406,044
------------- -------------
------------- -------------
</TABLE>
(3) INCOME TAXES
Income tax expense consists of the following:
<TABLE>
<CAPTION>
CURRENT DEFERRED TOTAL
------------- ----------- -------------
<S> <C> <C> <C>
Year ended December 31, 1995:
U.S. federal........................................................... $ 8,109,809 $ 145,335 $ 8,255,144
State and local........................................................ 1,498,721 21,855 1,520,576
------------- ----------- -------------
$ 9,608,530 $ 167,190 $ 9,775,720
------------- ----------- -------------
------------- ----------- -------------
Year ended December 31, 1996:
U.S. federal........................................................... $ 8,017,571 $ 192,764 $ 8,210,335
State and local........................................................ 1,598,406 28,987 1,627,393
------------- ----------- -------------
$ 9,615,977 $ 221,751 $ 9,837,728
------------- ----------- -------------
------------- ----------- -------------
</TABLE>
The following schedule reconciles the computed "expected" tax expense based
on a U.S. federal corporate tax rate of 35 percent in effect for the year, to
the tax expense reflected in the accompanying consolidated financial statements:
<TABLE>
<CAPTION>
1995 1996
------------- -------------
<S> <C> <C>
Computed "expected" tax expense................................. $ 8,757,360 $ 9,149,627
State tax (net of federal income tax benefit)................... 988,374 1,057,805
Change in beginning-of-year valuation allowance allocated to
income tax expense............................................ (18,984) (389,395)
Other........................................................... 48,970 19,691
------------- -------------
Total tax expense............................................... $ 9,775,720 $ 9,837,728
------------- -------------
------------- -------------
</TABLE>
F-103
<PAGE>
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AETNA INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(3) INCOME TAXES (CONTINUED)
The significant components of deferred income tax expense for the years
ended December 31, 1995 and 1996, are as follows:
<TABLE>
<CAPTION>
1995 1996
----------- -----------
<S> <C> <C>
Deferred tax expense (exclusive of the effects of other components
listed below)..................................................... $ 186,174 $ 611,146
Decrease in beginning-of-year balance of the valuation allowance for
deferred tax assets............................................... (18,984) (389,395)
----------- -----------
$ 167,190 $ 221,751
----------- -----------
----------- -----------
</TABLE>
The tax effects of temporary differences that give rise to deferred tax
assets and deferred tax liabilities at December 31, 1995 and 1996, are presented
below:
<TABLE>
<CAPTION>
1995 1996
------------- -----------
<S> <C> <C>
Deferred tax assets:
Accounts receivable, principally due to allowance for doubtful accounts............... $ 143,724 $ 23,338
Deferred compensation, due to accrual for financial reporting purposes................ 209,217 --
Accrued liabilities not deductible until paid for tax reporting purposes.............. 357,701 253,664
HMO claims accrued not yet reported................................................... 122,219 255,795
Rent payable on long-term lease forfeiture, due to accrual for financial reporting
purposes............................................................................ 93,407 32,558
Software expense...................................................................... 465,290 253,654
Amortization due to goodwill.......................................................... 7,842 18,278
Tax credit carryforwards.............................................................. 37,398 38,652
Net operating loss carryforward....................................................... 368,337 --
------------- -----------
Total gross deferred tax assets....................................................... 1,805,135 875,939
Less valuation allowance.............................................................. 526,352 136,957
------------- -----------
Total deferred tax assets............................................................. 1,278,783 738,982
------------- -----------
Deferred tax liabilities-fixed assets, due to differences in depreciation methods..... (50,653) (9,855)
------------- -----------
Net deferred tax assets............................................................... $ 1,228,130 $ 729,127
------------- -----------
------------- -----------
Net current deferred tax assets....................................................... $ 419,309 $ 364,629
Net noncurrent deferred tax assets.................................................... 808,821 364,498
------------- -----------
$ 1,228,130 $ 729,127
------------- -----------
------------- -----------
</TABLE>
The valuation allowance for deferred tax assets as of January 1, 1995 and
1996, was $545,336 and $526,352, respectively. The change in the total valuation
allowance for the years ended December 31, 1995 and 1996, was a decrease of
$18,984 and $389,395, respectively. Subsequently recognized tax benefits
relating to the valuation allowance for deferred tax assets will be recognized
as an income tax benefit in the consolidated statements of operations.
Management believes that it is more likely than not that the Company will
realize the benefit of the net deferred tax asset in the future. During 1996,
the Company utilized net operating loss carryforwards for tax return purposes of
approximately $1,052,000.
F-104
<PAGE>
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AETNA INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(4) EMPLOYEE RETIREMENT PLANS
The Company's employees are covered under the Parent's Employee Benefit
Plans and are entitled to benefits earned under the plan through December 31,
1996. Eligible employees receive pension incentive savings, post retirement
health care, and life insurance benefits. The aggregate charges to operations
for all benefit plans are allocated by the Parent based upon measures
appropriate for the nature of the service provided and are included in the
overall benefits allocation from the Parent which approximates 23 percent of the
Company's salaries and wages. The related liabilities are recorded on the
Parent's financial statements.
(5) LEASES
The Company is obligated under capital leases for equipment that expire at
various dates during the next five years. At December 31, 1995 and 1996,
equipment of $48,215 and $52,141 and related accumulated amortization of $33,258
and $34,971, respectively, were recorded under these capital leases.
Amortization of assets held under capital leases is included in depreciation
expense.
The Company leases office space and equipment under operating lease
agreements. Rent expense under these leases was $3,685,159 and $4,092,214 in
1995 and 1996, respectively.
Future minimum lease payments under noncancelable operating leases (with
initial or remaining lease terms in excess of one year) and future minimum
capital lease payments as of December 31, 1996 are as follows:
<TABLE>
<CAPTION>
OPERATING
OPERATING LEASES, NET
CAPITAL OPERATING SUBLEASE OF SUBLEASE
LEASES LEASES RENTALS RENTALS
--------- -------------- ---------- --------------
<S> <C> <C> <C> <C>
Year ending December 31:
1997................................................ $ 8,261 $ 2,909,298 $ (83,444) $ 2,825,854
1998................................................ 5,669 2,653,337 -- 2,653,337
1999................................................ 5,361 2,164,973 -- 2,164,973
2000................................................ -- 1,698,488 -- 1,698,488
2001................................................ -- 1,689,914 -- 1,689,914
Thereafter.......................................... -- 5,913,232 -- 5,913,232
--------- -------------- ---------- --------------
Total minimum lease payments.................... 19,291 $ 17,029,242 $ (83,444) $ 16,945,798
-------------- ---------- --------------
-------------- ---------- --------------
Less amount representing interest at 9%................. 2,121
---------
Present value of net minimum capital lease
payments...................................... 17,170
---------
Less current installments of obligations under capital
leases................................................ 7,058
---------
Obligations under capital leases, excluding
current installments.......................... $ 10,112
---------
---------
</TABLE>
(6) RELATED PARTY TRANSACTIONS
The Company utilizes its network of providers to service existing contracts
of the Parent in the area of focused psychiatric review (FPR), health
maintenance organizations (HMO), managed choice (MC), and network services (NS).
The Company provides behavioral health care and utilization management services
to the Parent's members at a capitated rate per member per month. The Company
recorded
F-105
<PAGE>
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF AETNA INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(6) RELATED PARTY TRANSACTIONS (CONTINUED)
FPR revenue of approximately $14.5 million and $14.1 million, HMO revenue of
approximately $9.5 million and $16.8 million, MC revenue of approximately $19.4
million and $27.8 million, and NS revenue of approximately $4.3 million and $4.5
million in 1995 and 1996, respectively, from Parent company agreements. Related
party receivables of $2,250,953 and $2,957,865 at December 31, 1995 and 1996,
respectively, are due from the Parent for balances paid to the Parent from
customers of the Company.
Certain administrative and support functions of the Company are provided by
the Parent and its affiliates. The consolidated financial statements reflect
allocated charges for these services based upon measures appropriate for the
type and nature of the services provided. The year ended December 31, 1996, was
the first full year following the Parent company sale of its property/casualty
division. As a result of this sale, the methodology of allocating the
administrative and support functions performed by the Parent changed
significantly. Accordingly, the amount allocated to the Company for the year
ending December 31, 1996 increased significantly over what it had been in prior
years. The Company was charged $8,399,540 and $15,159,017 during 1995 and 1996,
respectively, for these allocated charges.
The Company also rents furniture, fixtures, and equipment from the Parent.
The rental expense for these items totaled $782,691 and $1,062,068 for December
31, 1995 and 1996, respectively. Additionally, the Parent pays certain direct
costs on behalf of the Company such as payroll and office supplies which the
Company then reimburses the Parent. Balances of $6,793,418 and $2,454,957 were
payable to the Parent at December 31, 1995 and 1996, respectively, for these
allocated charges and direct costs.
(7) NON-COMPETE EMPLOYMENT AGREEMENT
During 1990, the Company terminated the employment of the officer and former
sole stockholder of the Company. Pursuant to the terms of employment and
noncompete agreements, the officer received annual compensation and benefits
through June 9, 1996, paid ratably over the period. During the year ended
December 31, 1996, the Company paid all remaining amounts due to this officer
which amounted to $500,932.
(8) ACQUISITION OF JOINT VENTURE
On April 1, 1995, the Company purchased the remaining minority interest of
Human Affairs of Alaska Joint Venture for $1,000,000. Of the total purchase
price $333,333 was paid in April 1997, $333,333 was paid during 1996, and the
remainder was paid at closing. The acquisition has been accounted for using the
purchase method of accounting and, accordingly, the acquired interest in assets
and liabilities is stated at estimated fair values. This transaction resulted in
costs in excess of net assets acquired of approximately $820,000. The Former
Joint Venture Partner entered into Personal Services and Bonus Agreements with
the Company wherein the Former Joint Venture Partner has agreed to serve as an
employee of the Company through March 2000.
(9) COMMITMENTS AND CONTINGENCIES
The Company is involved in certain legal actions arising in the normal
course of business. After taking into consideration legal counsel's evaluation
of such actions, management is of the opinion that their outcome will not have a
significant effect on the Company's consolidated financial statements.
(10) SUBSEQUENT EVENT
On February 27, 1997, $20,000,000 was paid to the Parent. This payment
represented a return of capital of $11,092,000 and a dividend of $8,908,000.
F-106
<PAGE>
NO DEALER, SALESPERSON OR OTHER INDIVIDUAL HAS BEEN AUTHORIZED TO GIVE ANY
INFORMATION OR TO MAKE ANY REPRESENTATION NOT CONTAINED IN THIS PROSPECTUS IN
CONNECTION WITH THE EXCHANGE OFFER. IF GIVEN OR MADE, SUCH INFORMATION OR
REPRESENTATION MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED. THIS
PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO
BUY THE NOTES IN ANY JURISDICTION WHERE, OR TO ANY PERSON TO WHOM, IT IS
UNLAWFUL TO MAKE SUCH OFFER OR SOLICITATION. NEITHER THE DELIVERY OF THIS
PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE
ANY IMPLICATION THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY DATE
SUBSEQUENT TO THE DATE HEREOF.
- ------------------------------------------------
TABLE OF CONTENTS
<TABLE>
<S> <C>
Summary.................................... 3
Risk Factors............................... 22
The Transactions........................... 34
Use of Proceeds............................ 36
Capitalization............................. 37
Magellan Selected Historical Consolidated
Financial Information.................... 38
Merit Selected Historical Consolidated
Financial Information.................... 40
Unaudited Pro Forma Consolidated Financial
Information.............................. 41
Magellan's Management's Discussion and
Analysis of Financial Condition and
Results of Operations.................... 53
Merit's Management's Discussion and
Analysis of Financial Condition and
Results of Operations.................... 71
Industry................................... 80
Business................................... 84
Charter Advantage.......................... 101
Management................................. 113
The Exchange Offer......................... 122
Plan of Distribution....................... 132
Description of the New Notes............... 133
Summary of New Credit Agreement............ 159
Federal Income Tax Consequences of the
Exchange Offer........................... 161
Legal Matters.............................. 161
Experts.................................... 161
Available Information...................... 161
Index to Financial Statements.............. F-1
</TABLE>
PROSPECTUS
$625,000,000
MAGELLAN HEALTH
SERVICES, INC.
OFFER TO EXCHANGE ITS
9% SERIES A SENIOR SUBORDINATED NOTES DUE 2008
FOR ANY AND ALL OF ITS OUTSTANDING
9% SENIOR SUBORDINATED NOTES DUE 2008
[LOGO]
[LOGO]
OCTOBER 6, 1998
