Item 1. Business
GENERAL
Merit Behavioral Care Corporation ("MBC" or the "Company") is one of the leading behavioral health managed care companies in the United States, arranging for the provision of a full spectrum of behavioral healthcare services on a nationwide basis. 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. The Company provides behavioral health managed care services through a systematic clinical approach with the objective of diagnosing problems promptly and designing treatment plans to ensure that patients receive the appropriate level of care in an efficient and cost-effective manner. The Company manages behavioral healthcare programs for its payor customers across all segments of the healthcare industry, including health maintenance organizations ("HMOs"), Blue Cross/Blue Shield organizations and other insurance companies, corporations and labor unions, federal, state and local governmental agencies, and various state Medicaid programs. The Company's programs covered more than 20 million people as of September 30, 1997.
The Company's clinical care program includes the use of intake coordinators and professional case managers who coordinate and manage the delivery of treatment services. The Company offers a full continuum of behavioral healthcare services through contractual arrangements with approximately 37,000 third-party network providers and approximately 3,300 third-party treatment facilities, as well as approximately 160 "staff providers" employed by professional corporations (the "Professional Corporations") which provide treatment services principally on behalf of the Company. The Company's third-party network and staff providers include psychiatrists, psychologists, licensed clinical social workers, marriage, family and child therapists, licensed clinical professional counselors and nurses. Treatment services arranged for and managed by MBC include outpatient care 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).
On June 30, 1995, the Company and Medco Containment Services, Inc. ("Medco Containment"), the Company's previous owner, entered into an Agreement and Plan of Merger (as amended, the "1995 Merger Agreement") with MDC Acquisition Corp. ("MDC"), a company formed by Kohlberg Kravis Roberts & Co., L.P. ("KKR"). Pursuant to the 1995 Merger Agreement, on October 6, 1995, MDC was merged with and into the Company (the "1995 Merger"), with the Company continuing as the surviving corporation. Upon completion of the 1995 Merger, which was accounted for as a recapitalization, Medco Containment, a subsidiary of Merck & Co., Inc. ("Merck"), retained 15.0% of the Common Stock of the post-merger Company, and affiliates of KKR and members of MBC management (together with related entities) owned approximately 73.9% and 11.1%, respectively, of the post-merger Common Stock. On September 12, 1997, the Company acquired CMG Health, Inc. ("CMG"), a national managed behavioral healthcare company providing services to over 2.5 million people.
The principal executive offices of the Company are located at One Maynard Drive, Park Ridge, New Jersey 07656 and the Company's telephone number at that address is (201) 391-8700. Unless the context indicates otherwise, all references to the "Company" or "MBC" shall mean Merit Behavioral Care Corporation and its consolidated subsidiaries.
PROPOSED MERGER WITH MAGELLAN HEALTH SERVICES, INC.
On October 24, 1997, the Company and Magellan Health Services, Inc. ("Magellan") entered into an Agreement and Plan of Merger (the "Magellan Merger Agreement"), which provides that, subject to the fulfillment of certain conditions, a subsidiary of Magellan will merge (the "Magellan Merger") with and into the Company. As a result of the Magellan Merger, the Company will become a wholly owned subsidiary of Magellan. Under the terms of the Magellan Merger Agreement, Magellan will acquire all of the Company's outstanding stock and other equity interests for approximately $458.3 million in cash, subject to certain adjustments. In addition, all options outstanding under the Company's stock option plans will fully vest or otherwise become exercisable and be converted into cash upon closing of the transaction. Completion of the Magellan Merger is subject to a number of conditions, including Magellan's receipt of sufficient financing for the transaction, the receipt of certain healthcare and insurance regulatory approvals, and other conditions. One such condition, the expiration of the waiting period under the Hart- Scott-Rodino Antitrust Improvements Act of 1974, has been satisfied. In connection with the execution of the Magellan Merger Agreement, holders of more than 90% of the outstanding Common Stock of MBC have agreed to vote in favor of the Magellan Merger pursuant to Stockholder Support Agreements entered into with Magellan. The combined company will be the nation's largest provider of managed behavioral healthcare services, with an estimated 52.8 million covered lives under contract, and will manage behavioral healthcare programs for over 4,000 customers. It is expected that the Magellan Merger will close in the first calender quarter of 1998.
Consummation of the Magellan Merger and the related financing arrangements would result in events of default under the Indenture, dated as of November 22, 1995, as supplemented (the "Indenture"), by and between the Company and Marine Midland Bank, as trustee, under which the Company's outstanding 11 1/2 Senior Subordinated Notes due 2005 (the "Notes") were issued. In connection with the Magellan Merger and as a condition for Magellan to obtain the financing for the Magellan Merger, the Company intends to refinance the Notes. No assurance can be given that such refinancing will occur or that the Magellan Merger will be consummated.
BEHAVIORAL HEALTH MANAGED CARE INDUSTRY
Overview
Behavioral healthcare costs have increased significantly in the United States in recent years. According to industry sources, the 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 billion in 1990. In addition, according to industry sources, direct behavioral healthcare treatment costs in 1995 amounted to approximately $80 billion, or 8% of total healthcare industry spending. In response to these escalating costs, behavioral health managed care companies, such as MBC, have been formed. These companies focus on care management techniques with the goal of improving early access to care, assuring an effective match between the patient and the behavioral healthcare provider's specialty, and arranging for the provision of an appropriate level of care in a cost-efficient and effective manner. As behavioral health managed care companies have expanded access to a full continuum
of care, the result has been a significant decrease in occupancy rates and average lengths of stay for inpatient facilities and an increase in outpatient treatment and alternative care services.
According to Open Minds, a leading behavioral healthcare industry publication, as of January 1997, approximately 149 million beneficiaries were covered by some form of specialty behavioral health managed care plan (i.e., a program typically operated by a vendor specializing in behavioral health managed care services). This figure has grown from approximately 78 million beneficiaries in 1992, representing an approximate 14% compound annual growth rate.
Segmentation
Open Minds divides the behavioral healthcare industry into the following categories of care, based on services provided, extent of care management and level of risk assumption:
These categories of care are described briefly below:
Utilization Review/Case Management Programs. Under utilization review/case management programs, a behavioral health managed care company manages and often arranges for treatment, but does not assume any of the responsibility for the cost of providing treatment services. These programs are typically categorized as administrative services only ("ASO") programs.
Non-Risk-Based Network Programs. Under non-risk-based network programs, which also are typically categorized as ASO programs, the behavioral health managed care company provides a full array of managed care services, including selecting, credentialling and managing a network of providers (such as psychologists, psychiatric hospitals, substance abuse clinics, etc.), and performs utilization review, claims administration and case management functions; however, the third-party payor remains responsible for the cost of providing the treatment services rendered.
Risk-Based Network Programs. Under risk-based network programs, the behavioral health managed care company assumes all or a portion of the responsibility for the cost of providing a full or specified range of treatment services. Most of these programs have payment arrangements in which the behavioral health managed care company agrees to provide services in exchange for a fixed fee per
covered member per month (a "capitated" program) 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 programs, the behavioral health managed care 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 thereof).
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.
Integrated Programs. 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 behavioral health managed care programs through "integrated" product offerings. Integrated programs offer employers comprehensive management and treatment of all aspects of behavioral healthcare by consolidating EAP and managed care services into a single program.
Areas of Growth
Management believes that the behavioral health managed care industry is growing across all customer segments as payors of behavioral healthcare benefits are seeking to reduce the costs of treatment and shift the responsibility for such costs to other entities while maintaining high quality care. Management believes that a number of opportunities exist in the behavioral health managed care industry for future growth, primarily for risk-based products, but also for Medicaid and Medicare recipients and uninsured individuals.
Risk-Based Products. According to Open Minds, industry enrollment in risk-based (capitated) products has grown from approximately 14 million covered lives in 1993 to approximately 38.9 million covered lives in 1997, a compound annual growth rate of over 29%. Despite this growth, according to Open Minds, only approximately 26% of total managed behavioral healthcare covered lives are enrolled in risk-based products. 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.
Medicaid Recipients. Medicaid is a joint state and federally funded program to provide healthcare benefits to an estimated 36 million low income individuals, including welfare recipients. According to the Health Care Financing Administration ("HCFA") of the United States Department of Health and Human Services (the "Department"), federal and state Medicaid spending increased from $65 billion in 1990 to $165 billion in 1996, at an average annual rate of approximately 16%, 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 has grown at a compound annual rate of approximately 38% per year. The Balanced Budget Act of 1997 (the "Budget Act"), passed by Congress in August 1997, is expected to 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 percentage increase in managed care enrollment of Medicaid beneficiaries, Medicaid managed care enrollment as a percentage of all Medicaid beneficiaries remains small. As of June 1996, according to the National Institute for Health Care Management, only approximately 35% of all Medicaid beneficiaries were enrolled in some form of managed care program, and less than 7% were enrolled in risk-based programs. The Company expects the number of Medicaid recipients enrolled in managed behavioral healthcare programs to increase through two avenues: (i) subcontracts with HMOs and (ii) direct contracts with state agencies. As HMOs increase their penetration of the Medicaid market, the Company expects that many HMOs will continue to (or begin to) subcontract with 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 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 provisions of the Budget Act related to Medicaid give the states broad flexibility to require most Medicaid beneficiaries to enroll in managed care organizations that only do business with the Medicaid program, without obtaining a waiver from the Secretary of the Department that was required under former law.
Medicare Beneficiaries. 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 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 provisions of the Budget Act related to Medicare would achieve the projected savings in Medicare expenditures by, among other things, changes in managed care programs designed to increase enrollment in managed care plans. The increase in Medicare enrollment would be achieved, in part, by allowing provider-sponsored organizations and PPOs to compete with Medicare HMOs for Medicare enrollees.
Uninsured Individuals. Approximately 42 million people, or 16% of the nation's total population, are not covered by any form of health insurance. Recently, certain states have enacted mandatory health insurance programs that automatically enroll all uninsured persons in managed care plans. To the extent that managed care plans increase their penetration among this large uninsured population, the Company believes that uninsured individuals will continue to represent an opportunity for growth among behavioral health managed care companies.
GROWTH STRATEGY
The Company's objective is to expand its presence in both existing and new behavioral health managed care programs by building on MBC's (i) proven clinical care methodology, (ii) leading position and experience in managing capitated programs, (iii) diverse and expanding customer base, particularly with respect to HMOs and corporations, and (iv) experienced and clinically-oriented management team. As part of its strategy, the Company intends to:
Continue to Pursue Capitated Contracts. Management believes MBC is the leading provider of capitated managed care programs. As of January 1997, according to Open Minds, only 27% of all beneficiaries covered by specialty behavioral health managed care programs were enrolled in risk-based or capitated programs. The Company believes that the market for capitated managed care services will continue to increase at a more rapid rate than the overall market for behavioral health managed care services because capitated compensation arrangements allow payors to reduce their risk with respect to the cost of providing behavioral healthcare services while continuing to provide access to high quality care. Management believes that MBC's past experience and success in managing capitated contracts for HMOs, corporations and other payors, as well as its status as the leading provider of capitated products, will enable MBC to benefit from the expected growth in capitated programs.
Increase Penetration of Medicaid Sector. The Company believes that the Medicaid sector offers a significant opportunity for growth in the behavioral health managed care industry over the near term. Management believes that as more state governmental agencies turn to managed care organizations to administer their Medicaid programs, MBC's expertise in managing capitated programs, its experience in managing Medicaid populations and its existing business relationships with HMOs, place the Company in a position to capitalize on this potential growth opportunity. MBC currently manages care for Medicaid beneficiaries in connection with, among other programs, the State of Iowa's Mental Health Access Program (the "Iowa Medicaid Program"), the State of Tennessee's TennCare Partners Program ("TennCare") and the State of Montana's Mental Health Access Plan.
PROGRAMS AND SERVICES
The following table sets forth the number of beneficiaries covered by MBC for each type of program offered as of September 30, 1997, and the revenue attributable to each such program in fiscal 1997:
Risk-Based Programs. Under the Company's risk-based or "capitated" programs, 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 fee arrangements in which MBC assumes all or a portion of the responsibility for the cost of providing such services. The Company arranges for the provision of treatment services pursuant to a managed network model, under which care is delivered by third-party network providers and, where appropriate, the Company's staff providers. Management believes that the Company's mix of third-party network and staff providers, as well as its experience in pricing capitated contracts and managing the provision of care, allows it to structure programs to meet a customer's specific healthcare benefits requirements.
Employee Assistance Programs. The Company's EAPs typically provide assessment and referral services to employees of MBC's customers in an effort to assist in the early identification and resolution of productivity problems associated with employees who are impaired by behavioral conditions or other personal concerns. For many EAP customers, MBC 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. A substantial majority of the Company's existing customer contracts are EAP contracts. Management believes that MBC is the leading provider (based on the number of beneficiaries covered) of EAPs in the behavioral healthcare industry.
Integrated Programs. Under its integrated programs, the Company typically establishes an EAP to function as the "front end" of a managed care program that provides a full range of services, including more intensive treatment services not covered by the EAP. The Company usually 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 MBC's case management and clinical care techniques to manage the provision of care.
ASO Programs. Under its ASO programs, 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.
CUSTOMERS, CONTRACTS AND MARKETING
Customers
The following table sets forth the number of beneficiaries covered by MBC in each of its market segments as of September 30, 1997 and the revenue attributable to each such segment for fiscal 1997:
--------------- (1) For purposes of this table, the HMO segment excludes HMOs that focus on Medicaid, Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS") or state employee plan beneficiary populations.
Contracts
The Company's contracts with customers typically have terms of one to five 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, including the Company's agreement with the State of Iowa for the Iowa Medicaid Program (the "Iowa Mental Health Contract"), the Company's contract relating to the TennCare program, the Company's contract relating to the State of Montana's Mental Health Access Plan and the Company's contracts in connection with the Empire Joint Venture (as described below), are terminable without cause by the customer either 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 other specified events. In addition, the Company's contracts with federal, state and local governmental agencies, under both direct contracts and subcontract arrangements with HMOs, generally are conditioned upon financial appropriations by one or more governmental agencies. These contracts generally can be terminated or modified by the agency or HMO, as applicable, if such appropriations are not made. In the ordinary course of business, the Company's business arrangements with certain customers may continue beyond expiration of the stated term of the
applicable contracts while the terms of new or renewed contracts are being negotiated. In such cases, the customer may terminate the arrangements at any time.
Marketing and Sales
The Company markets its services through its three operating divisions: (i) the Employer and Union Division; (ii) the HMO/Insurance Division; and (iii) the Public Sector Division (including Medicaid and Medicare). Each of these three operating divisions, organized by the type of customer to be served, is overseen by a President who reports to MBC's President and Chief Operating Officer. For each specific industry segment, the Company employs integrated teams of Sales Managers and Account Managers who work under the supervision of the operating division President for that market. The Sales Managers and the Account Managers, together with the Company's clinical management organization, work closely to ensure that new customer programs are implemented successfully, services delivered meet contract specifications and customer and member concerns are promptly and effectively addressed.
The Company's sales and account management activities are supported by the Company's Market Services staff, who assist in generating sales leads; prepare proposals and responses to formal Requests for Proposals ("RFPs"); provide product development support; perform competitive analyses; and train personnel for program implementation. Marketing personnel also support the delivery of services to existing accounts through assistance with program implementation and development of customer communications materials such as program brochures, summary plan descriptions and orientation documentation.
RECENT ACQUISITION OF CMG HEALTH, INC.
In September 1997, the Company acquired all of the capital stock of CMG Health, Inc. ("CMG"), a national behavioral health managed care company. The acquisition was effected through the merger of a subsidiary of the Company with CMG, as a result of which CMG became a wholly owned subsidiary of the Company. The holders of CMG's common stock received approximately $48.7 million in cash, 739,358 shares of Common stock and rights to receive certain additional cash and stock consideration based upon future events and the post-closing financial performance of CMG. The Company financed the acquisition by executing an extension of its existing credit facility. CMG was founded in 1986, and prior to its acquisition by the Company, served over 2.5 million lives on behalf of more than 20 clients through a network consisting of approximately 7,600 providers in 34 states. The acquisition of CMG expands MBC's presence in the provision of behavioral health services to three key behavioral healthcare sectors: Medicaid carve-out programs, CHAMPUS programs and HMO products. CMG arranges for the provision of mental health services for Medicaid-eligible and other lower income residents in the State of Montana under that state's Mental Health Access Plan. In addition, CMG is also a provider of mental health benefits to CHAMPUS beneficiaries in CHAMPUS Regions 3 and 4 through Choice Behavioral Healthcare
Partnership, in which CMG is a 50% partner. CMG also provides behavioral healthcare services to more than 20 HMOs, including Humana Inc., in various regions of the United States.
OTHER RECENT ACQUISITIONS, JOINT VENTURES AND SIGNIFICANT TRANSACTIONS
Empire. In September 1995, the Company invested $12.0 million to acquire an 80% interest in a five-year joint venture (the "Empire Joint Venture") with Empire Blue Cross and Blue Shield ("Empire") to provide behavioral health managed care services in 28 counties in the State of New York to approximately 750,000 enrollees as of September 30, 1995. After the repayment of the Company's initial investment and the direct payment by Empire to the Company of certain administrative fees, risk charges and other amounts, the profits of the Empire Joint Venture will be distributed 80% to MBC and 20% to Empire. In connection with the Empire Joint Venture, Empire has the right at any time to require the Company to purchase Empire's interest therein at a cash price equal to the fair market value of such interest. In addition, Empire may terminate the Empire Joint Venture at any time for convenience on written notice to the Company and upon payment to the Company of a specified portion of the Company's $12.0 million investment (which portion declines over time and as repayments of such investment are made to MBC during the life of the venture), together with up to $2.0 million of expenses incurred by the Company in connection with the termination of the venture. In March 1997, the term of the Empire Joint Venture was extended to eight years, subject to the termination rights described above.
Choate. In October 1995, the Company acquired Choate Health Management, Inc. and certain related entities (collectively, "Choate"), a Massachusetts-based integrated behavioral healthcare organization, for $8.7 million in cash at closing plus $1.3 million paid in July 1997. In September 1997, the Company sold Choate to UHSMS, Inc., an affiliate of Universal Health Services, Inc., for approximately $4.8 million. The Company recognized a pre-tax loss of approximately $6.9 million in connection with the transaction.
ProPsych. In December 1995, the Company acquired ProPsych, Inc. ("ProPsych"), a Florida-based behavioral health managed care company. The Company acquired ProPsych for an initial payment of $0.1 million, a payment of $2.9 million in January 1996 and a final payment of $0.4 million in November 1996.
Royal Health Care. In January 1996, the Company formed a joint venture with the hospital sponsors of Neighborhood Health Providers LLC ("NHP") under the name "Royal Health Care LLC" ("Royal"), in which each of the Company and NHP holds 50% of the equity interests. In addition, MBC, NHP and Empire have formed a second joint venture company, Empire Community Delivery Systems LLC ("ECDS"), in which MBC, NHP and Empire hold 16 2/3%, 16 2/3% and 66 2/3%, respectively, of the equity interests. Empire and ECDS have entered into an agreement under which ECDS will exclusively manage and
operate, on behalf of Empire, healthcare 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, MBC and NHP 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 (80% of which is owned by the Company, as described above) to exclusively provide 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 the behavioral health agreement also contains customary termination provisions.
Prudential. In June 1996, the Company entered into an Alliance Agreement (the "Alliance Agreement") with The Prudential Insurance Company of America ("Prudential"), under which Prudential selected the Company to provide behavioral health managed care services to enrollees in specified Prudential health benefit plans in certain areas of the country. The Alliance Agreement contemplates that Prudential, from time to time, will designate geographic areas in which the Company will provide such services. Pursuant to the Alliance Agreement, to date the Company has been selected to service Prudential enrollees in New York State, Connecticut and New Jersey (the "TriState Area"), North Texas, Oklahoma City, Oklahoma, St. Louis and Southern Illinois (the "St. Louis Area"), and Delaware and Pennsylvania (the "Delaware Valley Area"). The Company commenced providing services under the program for North Texas August 1, 1996, the TriState Area September 5, 1996, Oklahoma City on July 1, 1997, the St. Louis Area on September 1, 1997, and the Delaware Valley Area on November 1, 1997. The Alliance Agreement has an initial term of three years and six months (expiring December 31, 1999), and will be automatically renewed for a period of two years unless either party notifies the other that it does not intend to renew. The Alliance Agreement is subject to certain rights of termination in favor of Prudential, including the right to terminate upon certain change of control transactions (including the Magellan Merger). Pursuant to a separate agreement with Prudential, the Company assumed the responsibility for providing services to those Prudential members currently serviced through Prudential's service center operations in Houston, Texas. The Houston program commenced August 1, 1996.
TennCare. In July 1996, the State of Tennessee implemented the TennCare program, a mental health and substance abuse benefits program servicing principally Medicaid eligibles and uninsured individuals residing in the State. Two behavioral health organizations ("BHOs") were selected to provide services in connection with such program. One such BHO is comprised of the Company and Tennessee Behavioral Health, Inc. ("TBH"), a behavioral health company located in Knoxville, Tennessee (the "TBH-MBC BHO"), and served approximately 500,000 members as of September 30, 1997. The Company and TBH are
parties to an agreement (the "BHO Agreement") under which they operate a joint program to service TennCare beneficiaries through such BHO. Under the BHO Agreement, the Company shares in 51%, and TBH shares in 49%, of the profits and losses from their joint operation of the program, and each of the Company and TBH holds one-half of the voting power on all program decisions. The BHO Agreement provides that the TBH-MBC BHO will remain in effect until the earlier of (i) the termination of the TennCare program or (ii) the fourth anniversary of the BHO Agreement. The TennCare program commenced July 1, 1996. The current term of the TennCare program is 18 months commencing July 1, 1997 and automatically renews for successive 12-month periods unless either party gives notice of its intention not to renew. The contract between the State and TBH, however, is subject to certain rights of termination in favor of the State, including the right to terminate for convenience.
CHAMPUS Regions 7 and 8. In August 1996, TriWest Healthcare Alliance Corp. ("TriWest"), with which the Company previously entered into a Services Agreement (the "Services Agreement") to provide behavioral health managed care services as TriWest's subcontractor, entered into a prime contract with the Office of CHAMPUS ("OCHAMPUS") to provide services to CHAMPUS beneficiaries in certain geographic areas, principally in the southwest and midwestern United States, designated as CHAMPUS Regions 7 and 8. This CHAMPUS program commenced April 1, 1997 and services approximately 740,000 beneficiaries in such regions. The Services Agreement has a term which is coterminous with that of TriWest's prime contract, which has a term of one year with four option periods exercisable by OCHAMPUS. The prime contract, however, is subject to certain rights of termination in favor of OCHAMPUS, including the right of OCHAMPUS to terminate such contract for convenience.
OPERATIONS
Administrative Structure
Divisional, Regional and Area Operations. The Company's behavioral health managed care programs and EAPs are operated through an integrated service system consisting of three divisions, which are organized into a national region and a number of geographic regions (collectively, the "Regions"). These Regions are divided into a number of separate area operations ("Areas"), with each Area having independent administrative and management capabilities. All of the Regions are supported by the Company's National Service Center, located in St. Louis, Missouri (the "National Service Center"). MBC's National Region is primarily responsible for servicing national corporate accounts. Particular programs (such as state employee plans or Medicaid programs), however, require local implementation due to the nature of the services provided or customer requirements. Thus, each of the Areas delivers services to its local or regional customers in a manner similar to the National Region's delivery of services on a wider geographic scale to the Company's national accounts.
National Service Center. The National Service Center is an integral component of MBC's administrative and clinical operations, serving as the headquarters of the National Region and the center for policy decisions on key clinical and operations matters nationwide. The National Service Center also is responsible for providing back-up to the other Regions for certain aspects of Regional administration, oversight and service delivery. Functions provided by the National Service Center's 500-plus member support staff include:
Centralized Client Services. The National Service Center provides a 24-hour call center that performs after-hours crisis intervention. During business hours, operators at the call center also serve as customer service representatives, providing basic benefit and provider network information, supporting claims payment activities and responding to customer inquiries.
Network Administration Services. The National Service Center supports and coordinates provider network administration needs, including credentialling and recredentialling functions, while Region and Area personnel design and plan the Region's network, recruit and interview candidates, negotiate contracts with providers and perform on-site examinations of potential facility providers.
Claims Administration Services. The National Service Center provides centralized claims processing and payment services for most of the Company's clients and programs. Processing claims includes verifying eligibility and third party liability and coordinating payments with other third party payors.
Management Information Services. The National Service Center is responsible for the operation, development and implementation of the Company's management information systems, including the AMISYS(R) system described below.
Clinical Oversight. The Company's clinical management team is located at the National Service Center and sets standards for all Region and Area network personnel, including guidelines regarding contractual terms, credentialling criteria and provider oversight procedures. In addition, the National Service Center supports other clinical operations, including monitoring of Area utilization performance, personnel training and quality management.
Clinical Care Operations
The Company manages care through a systematic, clinical approach with the objective of diagnosing problems promptly and designing treatment plans to ensure that patients receive the appropriate level of care in an effective and cost-efficient manner. The fundamental principle of MBC's methodology in managing care is that the efficacy, quality and cost-effectiveness of care are enhanced by an accurate diagnosis and a targeted clinical
assessment early in the therapeutic process that is followed by appropriate treatment.
In order to access the Company's provider network, a beneficiary in need of behavioral healthcare services typically initiates contact with the Company by calling the appropriate toll-free telephone number, whereupon a specially trained intake coordinator will assess the patient's eligibility and arrange for inpatient admission or referral to an appropriate provider. Beneficiaries in crisis will call the toll-free number or present themselves at an inpatient facility, whereupon a clinician will assess the patient's needs and, if indicated, arrange for an inpatient admission or a referral to an appropriate provider. In both cases, the provider, in consultation with a clinical case manager employed by the Company, will develop and implement a treatment plan designed to meet the patient's needs. The designated provider and case manager remain in contact throughout the course of the patient's treatment in an effort to achieve an effective and efficient outcome. The provider's efficiency and the quality of the treatment outcome are monitored by Company personnel, with a view to determining which providers and treatment programs produce the highest quality outcomes in the most efficient manner. As part of MBC's case management, the Company's clinical services personnel prepare and review utilization reports on a daily basis and monitor on a regular basis key clinical statistics, such as referrals and facility admissions, average lengths of stay and recidivism.
The Company's clinical care program includes the following components:
Intake. Upon responding to a call to the Company's toll-free telephone number, the intake coordinator asks a series of questions designed to assess whether the beneficiary requires crisis intervention, verifies eligibility and refers the caller to an appropriate provider. By having one individual verify eligibility and arrange for referral to a provider, the process is streamlined for the beneficiary and made cost-effective for MBC.
Crisis Intervention. The Company provides crisis intervention on a 24-hour basis. As part of these services, clinicians attempt to stabilize the patient's condition, assess the patient's particular needs and, if indicated, make a referral for services or authorize reimbursement for admission to an inpatient facility.
Case Management. Typically, within 24 hours of a crisis inpatient admission or after initial assessment by an outpatient provider, the provider and MBC's case manager agree on a treatment plan for the patient. Throughout a patient's full course of assessment and treatment, an MBC case manager coordinates all aspects of the delivery of services with network providers and facilities by consulting with the providers regarding a course of treatment. The Company's case management procedures are based on comprehensive and flexible clinical guidelines and treatment protocols that are developed internally and are consistent with established industry standards. Intake coordinators and case managers are supervised by the Company's senior clinical staff, who are available for consultation and review the work of case managers and offer advice and suggestions for improvement. Where required, standardized
inpatient case management procedures and protocols of the Company have been accredited by the Utilization Review Accreditation Committee ("URAC"), an independent organization based in Washington, D.C.
Quality Management. MBC has procedures in place to monitor quality assurance (including the recruitment, credentialling, recredentialling, hiring and orientation of providers and facilities), quality assessment (including continuous audits of clinical utilization data, telephonic response times and claims accuracy) and quality improvement (such as provider profiling and problem identification and resolution). The Company's quality management program begins with the initial selection of network and staff providers. Candidates for these positions must satisfy an extensive set of professional and experience requirements. In addition, many of the Company's providers also complete an interview process designed to evaluate the practitioner's knowledge of clinical principles and standards of ethical behavior. Staff providers typically are required to complete orientation training in the Company's treatment philosophy and administrative practices and are expected to participate in periodic continuing education sessions. Network providers typically must participate in periodic case conferences and accrue accredited continuing education credits to enhance their skills in a behavioral health managed care delivery system. The Company's continuing education programs are accredited by the American Psychological Association for continuing education credit and by the Institute of Behavioral Healthcare for continuing education units.
National Committee for Quality Assurance. The National Committee for Quality Assurance ("NCQA"), an independent national managed care accreditation organization, has established operating standards for independent evaluation of the quality of care and services provided to enrolled members in managed care insurance plans (primarily HMOs). Currently, MBC participates in NCQA audits in connection with certain HMO customers. Although NCQA has yet to release its standards for managed care arrangements with managed care plans other than HMOs, the Company's non-HMO clients are increasingly expecting MBC to demonstrate compliance with existing NCQA standards.
MBC has initiated the process to become accredited as a managed behavioral healthcare organization ("MBHO") under NCQA standards by filing the requisite corporate application and undergoing an NCQA corporate audit. The corporate survey focused on policy, standards and corporate oversight processes. NCQA's 1998 regional surveys will focus on direct care and service processes. While the corporate audit does not generate an independent accreditation score, MBC's corporate compliance assessment will be integrated with regional compliance to determine regional accreditation.
A regional pre-assessment audit is anticipated to be conducted for MBC's New York metropolitan area operation in the late spring of 1998, with the accreditation survey scheduled for fall of 1998. The regional pre-assessment audit will not yield a score, but will provide MBC with NCQA's assessment of the Company's readiness for the actual survey. The accreditation survey is generally conducted 4-6 months following the pre-assessment audit.
Due to contractual requirements, the Company has also applied for accreditation surveys in Florida and Kentucky. Expected surveys for both states are scheduled for September 1998, with results expected approximately 90 days thereafter. Failure by MBC to obtain NCQA MBHO accreditation could have a material adverse effect on the Company.
NETWORK AND STAFF PROVIDERS; FACILITIES
The Company's behavioral health managed care and EAP treatment services are provided by a combination of third-party network providers and treatment facilities as well as staff providers. Network and staff providers include a variety of specialized behavioral healthcare personnel such as psychiatrists, psychologists, licensed clinical social workers, substance abuse counselors and other professionals.
Network Providers. As of September 30, 1997, MBC had contractual arrangements with approximately 37,000 third-party network providers. MBC's network providers are independent contractors located throughout the local areas in which MBC's customers' beneficiary populations reside. Network providers work out of their own offices, although staff providers and other resources of the Company are available to assist them with consultation and other needs. Network providers include both individual practitioners, as well as 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.
Staff Providers. Staff providers are behavioral healthcare practitioners employed by the Professional Corporations to provide behavioral treatment services principally to covered beneficiaries of certain MBC customers under contracts between the Professional Corporations and the Company. As of September 30, 1997, the Professional Corporations employed approximately 160 staff providers. Certain staff providers are also responsible for the supervision of network providers, crisis assessment and monitoring compliance with the Company's quality management procedures. The Company pays the Professional Corporations a professional service fee under a participating provider agreement; individual staff providers are paid by their respective Professional Corporations on a salary basis. In addition, the Company provides certain administrative and management services to each Professional Corporation under separate administrative services agreements. These agreements between the Company and each Professional Corporation typically have a one-year term that automatically renews for successive one-year terms and generally may be terminated by the Company upon 30 days notice following a substantial decrease in enrollment of beneficiaries of plans to which the Professional Corporation provides services.
Facilities. As of September 30, 1997, MBC had contractual arrangements with approximately 3,300 third-party treatment facilities, including inpatient psychiatric and substance abuse facilities, intensive outpatient programs, partial hospitalization facilities, community health centers and other community-based programs, rehabilitative and support programs, and other intermediate care and alternative care facilities or programs. This variety of facilities and programs enables the Company to offer patients a full continuum of care and 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 upon 30 to 120 days notice.
INFORMATION SYSTEMS
The Company has dedicated substantial resources to implementing and utilizing information systems required to manage the delivery of care in a cost-effective manner. AMISYS(R), a centralized system operating on a Hewlett-Packard HP/3000 platform which is intended to more fully integrate the Company's operations and achieve additional efficiencies in the overall management of care, is the Company's primary system. In addition to AMISYS(R), because MBC has grown in part through recent acquisitions, the Company utilizes four other operating systems to enable the Company to track program enrollee membership and verify beneficiaries' eligibility for coverage, access program benefits, record and monitor authorizations for treatment and cost of care, and process and pay claims. The four other primary information systems utilized by MBC, in addition to AMISYS (R), are: (i) servers, supporting the delivery of services to certain of the Company's HMOs, federal, state and local governmental agencies and Blue Cross/Blue Shield organization and insurance company customers; (ii) a system operating on a Hewlett-Packard HP/9000 platform, supporting the delivery of services principally to certain of the Company's HMO and insurance company customers; (iii) an IBM AS/400 system, supporting the delivery of services principally to the Company's EAP and integrated/EAP managed care customers; and (iv) a DEC VAX 4500 system, supporting the delivery of services principally to customers in the State of Texas.
The Company believes that AMISYS(R), in conjunction with various client-server applications, will enable the Company's intake coordinators, clinical case managers and claims reviewers to efficiently determine eligibility for coverage, authorize and manage treatment and adjudicate and process claims. The Company also believes AMISYS(R) will enhance the services provided to both its customers and beneficiaries while creating cost efficiencies for the Company by, among other things, measuring the effectiveness of providers and treatment programs, monitoring outcomes and enabling the Company to customize networks and rate structures. It is MBC's intention to utilize AMISYS(R) to support most significant programs implemented by MBC in the foreseeable future. The Company licenses AMISYS(R) from
Amisys, Inc.; however, the Company has made approximately $10.5 million of custom enhancements to AMISYS(R) in order to adapt AMISYS(R) for use in the Company's business.
To assist in the implementation of, and transition of its other four systems to, AMISYS(R), MBC entered into an AMISYS Implementation and Systems Integration Services Agreement with Perot Systems Corporation ("Perot") in January 1996 (the "Perot Agreement"). As contemplated by the Perot Agreement, the Company, utilizing both MBC and Perot personnel, has discontinued its use of most of the servers formerly operating in its Area offices and replaced such systems with AMISYS(R). In addition, the Company also intends to discontinue use of its Hewlett-Packard HP/9000 platform and replace it with AMISYS(R) over the next few years. The Company, with Perot's assistance, also began to utilize AMISYS(R) to support certain of MBC's current programs during calendar 1996, and implemented AMISYS(R) in a number of additional locations during fiscal 1997 to service new business, including Texas, Oklahoma, Colorado, Arizona, Florida and selected new accounts.
COMPETITION
The industry in which the Company conducts its business is highly competitive. The Company competes with large insurance companies, HMOs, preferred provider organizations ("PPOs"), third-party administrators ("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 MBC's competitors provide a broader range of services. The Company may also encounter substantial competition in the future from new market entrants. Many of the Company's customers that are managed care companies may, in the future, seek to provide behavioral health managed care and EAP services to their employees or subscribers directly or through affiliated organizations, rather than contracting with the Company for such services. In addition, the Company competes with a wide range of large and established providers of behavioral healthcare treatment services, most of which have greater experience in the delivery of care, and many of which have greater financial and other resources. 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.
EMPLOYEES
As of September 30, 1997, the Company employed approximately 3,600 persons who perform executive and administrative functions and engage in marketing and sales, clinical, development, customer service and other activities. The Professional Corporations employed approximately 372 additional persons, approximately 160 of whom are staff providers, on such date. None of the employees of the Company or the Professional Corporations is covered by a collective bargaining agreement. The Company considers its relationships with its employees to be good.
INSURANCE
The Company currently maintains professional liability insurance with per claim and aggregate coverage limits per annual term of the policy. The policy is subject to self-insured retentions on a per claim basis and on an aggregate basis and must be renewed annually. The policy is a "claims made" policy, meaning that if a person were to file suit against the Company after the term of the policy with respect to an alleged injury that occurred while the policy was in force, the policy would not cover any costs or judgments arising therefrom. The Company renewed the policy effective October 6, 1997 for a one-year term. The Company's professional liability policy also covers the Professional Corporations and certain of the Company's administrative staff that provide services to the Company. The current coverage terms have been in effect since January 1, 1994.
With the exception of certain EAP providers, as described below, it is the Company's policy to require each network and staff provider to carry professional liability insurance in a minimum amount per claim and in a minimum aggregate amount per year for physicians and doctoral level psychologists, as well as all other providers. Historically, the Company has provided professional liability insurance for its EAP providers. The Company has, however, begun to phase out such coverage and to require its EAP providers to carry their own professional liability insurance in the same amounts as the Company requires its staff providers to carry.
All of the insurance coverage described above is subject to various coverage limits, self-insured retentions and other conditions and limitations. There can be no assurance that any such insurance will be sufficient to cover any judgments, settlements or costs relating to any actions or claims, or that any such insurance will be available to the Company or its network or staff providers in the future on favorable terms, if at all. If the Company or its providers are unable to secure adequate insurance in the future, or if the insurance carried by the Company or its providers is not sufficient to cover any judgments, settlements or costs relating to any present or future actions or claims, there is no assurance that the Company or its providers will not be subject to other liabilities which might have a material adverse effect on the Company.
The Company also maintains general liability, property, automobile, workers compensation and other insurance. The Company believes that it maintains insurance coverage customary in the behavioral healthcare services industry, and that such insurance is adequate as to the risks covered and the amounts of coverage.
REGULATION
The managed healthcare industry and the provision of behavioral healthcare treatment 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; (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; and (iii) the establishment and operation of behavioral healthcare programs, clinics and facilities. 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 state and federal laws by virtue of its relationships with its staff and network providers and with certain customers, such as governmental agencies and HMOs maintaining health benefits programs for Medicaid and Medicare beneficiaries, and as a result of the role the Company assumes in connection with managing its customers' employee benefit plans.
The Company believes its operations are structured to materially comply with applicable laws and regulations, 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 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 will likely result in the adoption of a model NAIC regulation in the areas of health plan standards and financial solvency standards for such entities, which could be adopted by individual states in whole or in part. Individual states have also recently adopted their own regulatory initiatives that generally subject entities such as the Company to additional regulation in the area of insurance or HMO standards, including but not limited to requiring licensure, and greater financial solvency protections. These laws and regulations may also 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 the state 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 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 therewith 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 the Employee Retirement Income Security Act of 1974, as amended ("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 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, 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. The Company is not subject to such laws in any states in which it currently does business, although it has undertaken to comply with any willing provider contracting requirements at the request of certain customers. In addition, the Company could become subject to such laws in the future if they are adopted by states in which the Company is licensed as an insurance company, HMO or similar entity, or if the Company's customers become subject to such laws. 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.
Professional Services. The provision of behavioral healthcare treatment services by psychiatrists, psychologists and other providers is subject to state regulation with respect to the practice of licensed healthcare professionals, limitations on the ability of business corporations to directly provide, control or exercise excessive influence over the services of licensed healthcare professionals, and limitations on fee-splitting and payments for referrals. Although under the Company's programs all direct clinical services other than brief counseling services typically are provided by licensed professionals who are either staff providers employed by or under contract with one of the Professional Corporations, or are network providers under independent contractor arrangements with the Company, state regulatory authorities or courts may in certain instances determine that these relationships between the Company and the Professional Corporations are unenforceable. With respect to the Company's crisis intervention program, additional licensure of clinicians who provide telephonic assessment or stabilization services to beneficiaries 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 beneficiary's state. 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 Professional Corporations or 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 a Professional Corporation or IPA. The Company does not expect this method of contracting to have a material adverse effect on its operations.
Other Regulation of Healthcare Providers. The Company's business is affected indirectly by regulations imposed upon healthcare providers. Regulations imposed upon healthcare providers include provisions relating to the conduct of, and ethical considerations
involved in, the practice of psychiatry, psychology, social work and related behavioral healthcare professions and, in certain cases, the common law duty to warn others of danger or to prevent patient self-injury. Confidentiality and patient privacy requirements are particularly strict in the field of behavioral healthcare services, and additional legislative initiatives relating to confidentiality are expected. The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") included a provision that prohibits the wrongful disclosure of certain "individually identifiable health information." HIPAA requires the Secretary of the Department of Health and Human Services 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 regulations 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.
Healthcare Programs, Clinics and Facilities. The Company is also generally affected directly by regulations applicable to the operation of healthcare programs, clinics and facilities. Regulations governing the operation of behavioral health programs, clinics and facilities include provisions relating to program, clinic or facility design, ownership, operation, treatment procedures and medical records. In some instances, state laws require ownership of clinics or facilities by licensed practitioners or individuals (rather than corporations). In such cases, the Company maintains its relationship with the clinic or facility other than through direct shareholder status, such as through management services agreements between the Company and the Professional Corporations. If the Company's contractual relationships with the licensed clinics or facilities are deemed to convey an improper ownership interest in, or improper control of, the clinic or facility, changes in the Company's operations in the affected states could be required, and such contracts could potentially be unenforceable. The existence of such restrictions in a given state may present greater risks and may limit business opportunities as the Company endeavors to expands its relationships with providers. Such restrictions could have a material adverse effect on the Company.
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. The Company believes that it complies with ERISA requirements in all material respects, and that continuing ERISA compliance efforts will not have a material adverse effect on the Company.
Medicaid and Medicare. The Company provides and may in the future provide services to some program beneficiaries who are also beneficiaries of the Medicaid program, the Medicare program, other government sponsored healthcare programs, such as CHAMPUS, or the Federal Employees Health Benefits Program. The Company's compensation for services provided to such beneficiaries has historically been governed by the contracts with its customers having government program recipients, as applicable, enrolled in their healthcare benefits plans. Such customers typically have been either governmental agencies or HMOs. The Company must also comply with any cost reporting or other reporting requirements imposed by such government sponsored programs, as well as any reimbursement limitations on what it may charge the program or program beneficiaries. Such requirements may limit the amount of reimbursements that MBC may receive from these programs or subject the Company to periodic audits. The compensation received by the Company for such services under its private customer contracts generally has not been affected by Medicaid or Medicaid fee schedules or similar cost containment measures; however, the Company's provision of services to Medicaid beneficiaries, or beneficiaries of other government sponsored healthcare plans, through direct contracts with federal, state or local government agencies, is affected by such measures, and there can be no assurance that future legislation will not materially adversely affect the Company's compensation for services provided to beneficiaries of government sponsored healthcare programs under contracts with either government agencies or HMOs or other similar entities.
The provision of services to beneficiaries of federally funded healthcare programs may also subject the Company to various federal "fraud and abuse" laws, including "anti-kickback" and "physician self-referral" laws. Similar state laws could also govern the provision of services to beneficiaries of state funded healthcare programs such as Medicaid. The federal anti-kickback laws prohibit the knowing and willful solicitation, receipt or offering of any remuneration or consideration, directly or indirectly, to induce or in exchange for referrals of patients or for the ordering of services covered by federally funded healthcare programs (excluding the Federal Employees Health Benefits Program) and state funded healthcare programs, including Medicaid. The federal physician self-referral laws impose restrictions on physician referrals of patients for certain designated healthcare services to certain entities with which the physician or any immediate family member has a compensation or investment or ownership interest, and prevents the entity in question from lawfully being reimbursed under the Medicaid and Medicare program for patients improperly referred to it. Thus, these laws could impair the Company's ability to enter into certain types of arrangements with physicians or other healthcare providers. Certain state self-referral laws might apply to other types of providers as well as a broader class of payors. With respect to its non-governmental
operations, the Company may be subject to similar laws and regulations in a number of states, and proposed federal legislation would expand the scope of some or all of the fraud and abuse restrictions to cover many private payors of healthcare benefits. Penalties for violating existing fraud and abuse laws include civil monetary penalties, criminal sanctions and exclusion from participation in the Medicaid and Medicare programs. The Company believes that its existing operations comply with such state and federal laws and regulations based on their current interpretation and enforcement; however, because the fraud and abuse laws, particularly anti-kickback provisions, have been broadly construed to prohibit transactions in which any purpose of the transaction violates the law, many transactions potentially could be held to be improper. Uncertainty as to the scope and application of such laws continues; therefore, there can be no assurance that future regulatory and enforcement actions will not result in an interpretation of these laws and regulations that would require the Company to materially change its operations or contractual relationships in order to remain in compliance therewith.
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.
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 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 Medicare deductibles and coinsurance requirements for low-income Medicare 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. These changes may have an adverse effect on the Company if they result in reduced payment levels for providers of managed behavioral healthcare services.
The Medicaid-related provisions of the Budget Act also give states broad flexibility to require most Medicaid to enroll in managed care products that only cover Medicaid recipients without obtaining a waiver from the Secretary of the Department of Health and Human Services. 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.
MBC cannot predict the effect of the Budget Act, or other healthcare reform measures that may be adopted by Congress or state legislatures, on its 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.
CAUTIONARY STATEMENTS
This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Although the Company believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved. Important factors that could cause actual results to differ materially from the Company's forward-looking statements are set forth below and elsewhere in this Form 10-K. All forward-looking statements attributable to the Company or persons acting on behalf of the Company are expressly qualified in their entirety by the cautionary statements set forth below.
Risk-Based Programs. In order for the Company's risk-based contracts to be profitable, MBC must accurately estimate the rate of service utilization by beneficiaries enrolled in its programs. The Company's assumptions as to service utilization rates and costs may not accurately and adequately reflect actual utilization rates and costs, and increases in behavioral healthcare costs and higher than anticipated utilization rates, significant aspects of which are outside the Company's control, could cause expenses associated with such contracts to exceed the Company's revenue for such contracts. Furthermore, certain of such contracts
require the Company to reserve a specified amount of cash as financial assurance that it can meet its obligations thereunder. Such amounts are not available to the Company for general corporate purposes.
Customer Contracts. Substantially all of the Company's customer contracts are immediately terminable for cause, and many, including some of MBC's most significant contracts, are terminable without cause by the customer or upon the occurrence of certain other specified events. The Company is aware of several contracts expiring in fiscal 1997 that will not be renewed; however, the Company does not believe the loss of such contracts will result in a material adverse effect on its results of operations. The Company's ten largest behavioral health managed care customers had 37 contracts with MBC which accounted for approximately 54% of the Company's revenue for fiscal 1997. Such contracts may not be extended or successfully renegotiated, and the terms of any new or renegotiated contracts (particularly financial terms) may not be comparable to those of existing contracts. The loss of certain of these contracts could have a material adverse effect on the Company.
Competition. The industry in which the Company conducts its 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 MBC's competitors provide a broader range of services. The Company may also encounter substantial competition in the future from new market entrants. Many of the Company's customers that are managed care companies may, in the future, seek to provide behavioral health managed care and EAP services to their employees or subscribers directly or through affiliated organizations, rather than 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.
Key Management. The Company's growth depends largely upon the abilities and experience of certain key management personnel. The loss of the services of one or more of such key personnel could have a material adverse effect on the Company.
Information Systems. The Company's operation of its programs, as well as the implementation of its growth strategy, is dependent on its ability to store, retrieve, process and manage data. Interruption of data processing capabilities for any extended period of time, loss of stored data, programming errors or other system-related problems could have a material adverse effect on the Company. An integral part of the Company's strategy to improve its operating efficiency and management of care involves its investment in AMISYS(R), which is expected to provide advantages over the Company's other current information systems. The Company has implemented of AMISYS(R) into certain of its operations, transitioned certain programs supported by its other existing systems to AMISYS(R) and is continuing to migrate its other operating systems to AMISYS(R). The installation and implementation of AMISYS(R) involves the risk of unanticipated delay and expense. Failure to complete the modifications to AMISYS(R) required to adapt such system to the Company's business or to successfully implement AMISYS(R) into its operations could adversely impact MBC's operating efficiency and management of care and could result in the loss of existing customers, difficulties in attracting new customers, increases in operating expenses and other adverse consequences.
Control by KKR. KKR Associates and its General Partners control the Company, having the power to elect its directors and appoint management. The interests of KKR and its General Partners may not always be consistent with those of the Company's equity and debt holders and other constituencies.
Dependence on Government Spending for Managed Healthcare; New Legislation. A significant portion of the market for the Company's services is funded directly or indirectly by governmental agencies, including Medicaid programs. Any reduction in government spending for such programs could have a material adverse effect on the Company. In addition, the Company's contracts with governmental agencies generally are conditioned upon financial appropriations, especially with respect to Medicaid programs. These contracts generally can be terminated or modified by the customer if such appropriations are not made. The Company's strategy for growth depends in part on the engagement of managed care organizations to provide services to governmental agencies, especially with respect to Medicaid programs. If such engagements do not occur or if such contracts do not provide adequate pricing terms, the Company could be materially adversely affected. In addition, 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. The Company is unable to predict the impact on the Company's operations of future regulations or legislation affecting government healthcare programs, or the healthcare industry in general.
Regulation. The Company's business is subject to extensive state and federal regulation. State laws and regulations vary considerably, and the Company may be subject to different types of laws and regulations depending on the specific regulatory approach adopted by each state. State and federal laws regulate the Company's relationships with its providers and with certain customers, such as governmental agencies and HMOs servicing Medicaid and Medicare beneficiaries, and its management of its customers' employee benefit plans. Because regulation of the Company's business is evolving, new laws or regulations applicable to the Company may be enacted, and existing laws and regulations may be interpreted to apply to the Company's operations in a different manner than previously thought. Any such development may require the Company to secure additional licenses or restructure its operations to comply with such laws and regulations. Any delay or failure to secure or maintain licenses or otherwise comply with applicable laws and regulations or to so restructure operations could lead to lost business opportunities and have a material adverse effect on the Company.
Professional Liability; Insurance. 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 may also be subject to claims of professional liability for alleged negligence in performing utilization management activities, as well as for acts and omissions of the Company's staff and network providers. The Company could also become subject to claims for the costs of healthcare 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. While the Company carries professional liability insurance, it is subject to certain self-insured retentions, may not apply in certain circumstances and may not be sufficient to cover all damages or costs relating to present or future claims. Upon expiration thereof, sufficient insurance may not be available to the Company or its providers on favorable terms, if at all. If the Company or its providers are unable to secure adequate insurance in the future, or if the insurance carried by the Company or its providers is not applicable or is not sufficient to cover any damages or costs relating to any present or future claims, the Company and its providers could be subject to a liability that could have a material adverse effect on the Company.
Substantial Leverage and Related Considerations. The Company incurred substantial indebtedness in connection with the 1995 Merger, and is highly leveraged. Such indebtedness included borrowings under a $205.0 million senior credit facility (the "Senior Credit Facility") provided under the Credit Agreement dated
as of October 6, 1995, as amended, among the Company, the lending institutions listed therein and The Chase Manhattan Bank, N.A., as Agent (the "Credit Agreement") entered into in connection with the 1995 Merger and the Notes. Further, the Company borrowed an additional $80 million in connection with its acquisition of CMG in September 1997. The Company's ability to make scheduled payments of principal of, or to pay interest on, or to refinance its indebtedness (including the Notes), depends on its future performance, which, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors beyond its control. There can be no assurance that the Company's business will generate sufficient cash flow from operations or that future working capital borrowings will be available in an amount sufficient to enable MBC to service its indebtedness, including the Notes, or make necessary capital expenditures. The Notes are general unsecured obligations of the Company and are subordinated in right of payment to all Senior Indebtedness (as defined in the Indenture), of the Company (which includes all indebtedness under the Senior Credit Facility).
Item 2.
Item 2. Properties
The Company's principal executive offices, with approximately 37,500 square feet in the aggregate, are located in Park Ridge, New Jersey; the lease for the Company's headquarters expires in 2006. The Company leases approximately 195,500 square feet in the aggregate for the National Service Center in St. Louis, Missouri, under three leases expiring between 2001 and 2003. In addition, the Company leases approximately 64,000 square feet in the aggregate in New York City relating to the Empire Joint Venture and other business; the lease for the New York City space expires in 2008. The Company also maintains an office with approximately 24,800 square feet in the aggregate in San Francisco, California; the lease for the San Francisco office expires in 2003. As of September 30, 1997, the Company also maintained approximately 150 other offices in 32 states under leases which have terms of up to 10 years and range in size up to 30,000 square feet. Management believes that the Company's offices and other properties are adequate for its current needs and that suitable additional space will be available as required.
Item 3.
Item 3. Legal Proceedings
The management and administration of the delivery of behavioral health managed care and EAP services, and the direct provision of behavioral health treatment services, entail significant risks of liability. In recent years, the Company and its network and staff 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 Company to incur significant fees and costs related to their defense.
From time to time, the Company is subject to various actions and claims arising from the acts or omissions of its staff providers, its employees, its network providers or other parties. In the normal course of its business, the Company receives reports relating to suicides and other serious incidents involving patients enrolled in the Company's programs. Such incidents may give rise to
malpractice, professional negligence and other related actions and claims against the Company, its employees and its network and staff providers. As the number of beneficiaries covered by the Company grows, the number of providers employed by the Professional Corporations or under contract with the Company increases and the nature and scope of services provided by the Company in its managed care and EAP business expands, actions and claims against the Company (and, in turn, possible legal liability) predicated on malpractice, professional negligence or other related legal theories can be expected to increase. In addition, the Company may become subject to additional actions and claims alleging malpractice, professional negligence and other related theories arising from the behavioral health treatment services rendered directly to patients by the Company.
The Company carries insurance in respect of liabilities arising from actions and claims based on alleged malpractice, professional negligence and other related theories. The Company's staff providers are also required to maintain professional liability insurance on a per claim and aggregate basis. All such insurance is subject to various coverage limits, self-insured retentions and other limitations and conditions. To the extent the Company's customers are entitled to indemnification under their contracts with the Company relating to liabilities they incur arising from the operation of the Company's programs, such indemnification may not be covered under the Company's insurance policies. In addition, to the extent that certain actions and claims seek punitive and compensatory damages arising from alleged intentional misconduct by the Company, such damages, if awarded, may not be covered, in whole or in part, by the Company's insurance policies. In the ordinary course of business, the Company is also subject to actions and claims with respect to its employees, staff providers, network providers and suppliers of services. The Company does not believe that any pending action against the Company alleging malpractice, professional negligence or other related theories will have a material adverse effect on the Company. To date, claims and actions against the Company alleging professional negligence have not resulted in material liabilities to the Company; however, there can be no assurance that pending or future actions or claims for professional liability will not have a material adverse effect on the Company.
From time to time, the Company receives notifications from and engages in discussions with various governmental agencies concerning its business and operations. As a response to these contacts with regulators, the Company in many instances implements changes to its operations, revises its filings with such agencies and/or seeks additional licenses to conduct its business. In recent years, in response to governmental agency inquiries or discussions with regulators, the Company has determined to seek licensure as a single service HMO, TPA or utilization review agent in one or more jurisdictions.
In October 1996, a group of eight plaintiffs purporting to represent an uncertified class of psychiatrists, psychologists and clinical social workers brought an action under the federal antitrust laws in the United States District Court for the Southern District of New York against nine behavioral health managed care organizations, including the Company (collectively,
"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 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 Defendants' 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. However, there can be no assurance that the outcome of this litigation will be favorable to the Company. An unfavorable outcome could have a material adverse effect on the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
The Company did not submit any matters to a vote of its security holders during the fourth quarter of the fiscal year covered by this report.
PART II - -------------------------------------------------------------------------
Item 5.
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters
There is no established public trading market for the Common Stock. There were approximately 70 holders of the Common Stock at December 1, 1997. The Company has not paid dividends on the Common Stock to date and does not currently intend to pay dividends on the Common Stock in the foreseeable future. The payment of dividends is restricted by the Senior Credit Facility and the Indenture. See Note 6 to the Company's consolidated financial statements set forth in Part IV below.
Item 6.
Item 6. Selected Financial Data
The following audited selected historical financial data were derived from, and should be read in conjunction with, the historical consolidated financial statements of the Company and of MBC prior to the acquisition of Medco Containment by Merck (referred to herein as the "Predecessor"), including the respective notes thereto, included elsewhere herein. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Notes to Selected Financial Data:
(1) Represents the sum of direct service costs and selling, general and administrative expenses.
(2) Operating income equals income before income taxes, cumulative effect of accounting change, interest expense, other income and expense and merger costs and special charges.
(3) Represents primarily interest income.
(4) "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 and MBC 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 MBC'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 MBC's operating performance or as a measure of MBC'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.
(5) Includes restricted cash and short-term marketable securities classified as a long-term asset. See "Management'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 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 financial statements. The historical cost basis of the Predecessor differs from that of the Company due to the allocation of a portion of the total purchase price of Medco Containment to the Company's assets and liabilities.
(7) For purposes of this computation, earnings consist of income before taxes plus fixed charges. Fixed charges consist of interest expense (including amortization of deferred financing fees) and one-third of rental expense, representing that portion of rental expense deemed by MBC to be attributable to interest. For the period presented, earnings were insufficient to cover fixed charges and, therefore, such deficiency is presented above. The ratios of earnings to fixed charges for the periods prior to October 6, 1995 are not presented because the Company did not have interest expense prior to consummation of the 1995 Merger.
(8) "Adjusted EBITDA margin" represents Adjusted EBITDA as a percentage of revenue. As noted in footnote (4) above, Adjusted EBITDA is presented because MBC believes it is a
widely accepted financial indicator of a company's ability to service debt. However, Adjusted EBITDA margin should not be construed as an alternative to MBC's operating income as a percentage of revenue or net income as a percentage of revenue (as derived from operating income and net income determined in accordance with generally accepted accounting principles). Adjusted EBITDA margin should not be construed as an indication of MBC's operating performance or as a measure of MBC's liquidity.
(9) Excludes amortization of deferred financing costs.
(10) 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 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.
The Company recorded a pre-tax charge of $1.8 million ($1.0 million after taxes) in its fiscal 1996 first quarter results of operations as a cumulative effect of the change in accounting. Had the Company 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 for fiscal years prior to 1995.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
Revenue
Typically, the Company 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 MBC 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 monthly as it is received; inpatient revenue is recognized monthly and in most cases is (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.
Direct Service Costs and Margins
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 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.
The Company 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 MBC's revenue attributable to capitated managed care programs has continuously been increasing. Because capitated managed care programs require the Company 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 the Company's EAP and ASO programs. The Company 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 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 MBC to improve the productivity and efficiency of its operations; and (v) increasing the overall efficiency of MBC'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 Company's senior management. The Company 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(R) as well as increases in regional administration and sales and marketing operations necessary to support the growth of the Company's business; however, the Company 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 acquisition of Medco Containment in November 1993, the Company'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 the Company'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. The Company's total goodwill also includes goodwill associated with the Company'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 in connection with the Empire Joint Venture, the acquisition of 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.
The Company also capitalizes certain start-up expenses related to new contracts and amortizes these amounts over the life of the contracts. When the Company enters into a new contract or significantly expands services for an existing customer, the Company 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, the Company's balance sheet reflected $9.0 million of deferred start-up costs, net of amortization, categorized under long-term assets.
Liquidity
The Company's liquidity is affected by the one-to-four-month lag between the time the Company receives cash from capitation payments under new contracts and the time when the Company 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, the Company 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 the Company'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 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.
RESULTS OF OPERATIONS
Selected Operating Results
The following table sets forth certain statement of operations items of MBC expressed as a percentage of revenue:
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 the Company 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 the Company's contract relating to CHAMPUS Regions 7 and 8, under which services commenced on April 1, 1997. In addition, the Company'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 the Company'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 the Company 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 the Company's overall average direct profit margins. Excluding the effect of the TennCare Partners and the Delaware County contracts, however, the Company 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 the Company's continued development and deployment of alternative treatment programs designed to achieve more cost-effective treatment and the Company'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 MBC 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 the Company's National Service Center located in St. Louis, Missouri and the Company's headquarters located in Park Ridge, New Jersey, (iii) expenses related to the planned deployment of the Company'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 Company 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 in October 1995, (ii) interest and other income of $3.5 million relating primarily to investment earnings on the Company'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, (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 the Company 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 the Company in connection with the 1995 Merger; (ii) the full period impact of the Notes, which bore interest at a higher rate than the bridge financing facility that the 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. The Company recorded a benefit for income taxes during fiscal 1997, based upon the Company's pre-tax loss in such period.
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 the Company 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, the Company'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, the Company started to realize the benefits in fiscal 1996 of a nationwide recontracting program with providers which began in the second quarter of such year. The Company 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, the Company 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, the Company 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 the Company'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 MBC's current needs, and (iii) expenses related to the planned deployment of the Company'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 the Company, 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 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. The Company 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 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 its provider 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.
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 the Company's short-term investments and restricted cash balances.
Income Taxes. The Company recorded a benefit for income taxes during fiscal 1996 based upon the Company'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, 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 incurred prior to the commencement of services 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 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.
The Company 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 $26.9 million, investing activities used cash of $62.1 million and financing activities provided cash of $75.2 million, resulting in a net increase in cash and cash equivalents of $40.0 million. Investing activities in fiscal 1997 consisted principally of (i) capital expenditures of $24.0 million related primarily to the continued development of the Company's new information systems and expansion of the National Service Center, (ii) payments totaling $35.2 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 the Company.
Acquisition. On September 12, 1997, the Company acquired all of the outstanding capital stock of CMG for $48.7 million in cash and 739,358 shares of the Company's common stock valued at $5.5 million. In addition, the Company 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, the Company 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 the Company'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 Company's Credit Agreement with The Chase Manhattan Bank, N.A. (the "Senior Credit Facility"), and approximately $46.7 million was available for future borrowing.
Adjusted EBITDA. Adjusted EBITDA, a financial measure used in the Senior Credit
Facility and the Indenture, 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, the Company had total cash, cash equivalents 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 the Company's balance sheet. Under certain contracts, the Company 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 the Company for purposes other than the payment of claims. In addition, California and Illinois state regulatory requirements restrict access to cash held by the Company's subsidiaries in such states. As of September 30, 1997, the Company also held surplus cash balances, classified as cash and cash equivalents and short-term marketable securities, as required by the contracts held by the Company 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, the Company 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. The Company currently and in the future expects to finance is capital requirements through existing cash balances, cash generated from operations and borrowings under the revolving credit facility of the Senior Credit Facility. Based upon the current level of cash flow from operations and anticipated growth, the Company believes that available cash, together with available borrowings under the revolving credit facility and other sources of liquidity, will be adequate to meet the Company's anticipated future requirements for working capital, capital expenditures and scheduled payments of principal and interest on its indebtedness for the foreseeable future.
Pending Acquisition of MBC. On October 24, 1997, the Company and Magellan signed the Magellan Merger Agreement, under which a subsidiary of Magellan will merge into the Company. As a result of the Magellan Merger, the Company will become a wholly owned subsidiary of Magellan. Under the terms of the Magellan Merger Agreement, Magellan will purchase all of the Company's outstanding stock and other equity interests for approximately $460 million in cash and refinance the Company's existing debt. Completion of the Magellan Merger is subject to a number of conditions, including Magellan's receipt of financing for the transaction, the receipt of certain healthcare and insurance regulatory approvals, and other conditions.
Item 8.
Item 8. Financial Statements and Supplementary Data
The financial statements of the Company set forth on pages through hereof are incorporated herein by reference.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
None
PART III - ---------------------------------------------------------------------------
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Directors and Executive Officers
The following table sets forth certain information regarding MBC's directors and executive officers:
Albert S. Waxman, Ph.D. has served as Chief Executive Officer and as a Director of MBC since its incorporation in March 1993. Dr. Waxman has served as Chairman of the
Board of Directors of MBC since December 1994 and served as Co-Chairman of the Board of Directors of MBC from March 1993 until December 1994. Dr. Waxman also served as President of MBC from March 1993 through December 1993. Dr. Waxman was a co-founder of American Biodyne, Inc. ("American Biodyne"), which was acquired by Medco Containment in 1992, and has served as its Chairman or Co-Chairman since 1985, its Chief Executive Officer since December 1990, and also served as its President from May 1990 until April 1993. Since January 1990, Dr. Waxman has served as Chief Executive Officer of both Novatech Management Corporation and Waxman Enterprises, private venture capital firms. Since June 1990, Dr. Waxman has served as a member of the Board of Directors of Norland Corporation, a medical device company in the osteoporosis field, and Oestech Inc., a medical device company. Dr. Waxman founded Diasonics, Inc., a medical imaging company, where he served as Chairman of the Board, Chief Executive Officer and President from 1977 through 1987. Dr. Waxman holds Ph.D. and M.S. degrees in electrical engineering from Princeton University, where he is a member of the advisory council of the School of Engineering and Applied Sciences, and a B.S. degree in electrical engineering from City College of New York.
Arthur H. Halper has served as a Director of MBC since May 1996 and as President and Chief Operating Officer of MBC since August 1997. Mr. Halper served as Executive Vice President and Chief Financial Officer of MBC from December 1994 to August 1997, Executive Vice President, Mergers and Acquisitions, of MBC from November 1993 to December 1994 and Senior Vice President of Finance and Treasurer of MBC from its incorporation in March 1993 through November 1993. Mr. Halper has also served as Chief Financial Officer, Executive Vice President and Treasurer of American Biodyne since December 1994, and served as a Senior Vice President of American Biodyne from January 1994 to December 1994, as a Vice President of American Biodyne from March 1993 to January 1994 and as Regional Vice President of American Biodyne for the Mid-Atlantic Region from January 1992 through March 1993. Mr. Halper also has served as Chief Operating Officer of AGCA, Inc. (acquired by American Biodyne in 1992) since November 1990. Mr. Halper, a Certified Public Accountant, holds a B.A. degree in Business Administration from Rutgers University.
Henry R. Kravis became a Director of MBC in October 1995. Mr. Kravis is a Founding Partner of KKR and KKR Associates and is a managing member of the Executive Committee of the limited liability company which serves as the General Partner of KKR. Mr. Kravis is also a director of Amphenol Corporation, AutoZone, Inc., Borden, Inc., Bruno's, Inc., Evenflo & Spalding Holdings Corp., The Gillette Company, IDEX Corporation, KinderCare Learning Center, Inc., KSL Recreation Group, Inc., Newsquest Capital PLC, Owens-Illinois, Inc., Owens-Illinois Group, Inc., Primedia Inc., Safeway Inc., Sotheby's Holdings Inc., Union Texas Petroleum Holdings, Inc. and World Color Press, Inc.
George R. Roberts became a Director of MBC in October 1995. Mr. Roberts is a Founding Partner of KKR and KKR Associates and is a managing member of the Executive
Committee of the limited liability company which serves as the General Partner of KKR. Mr. Roberts is also a director of Amphenol Corporation, AutoZone, Inc., Borden, Inc., Bruno's, Inc., Evenflo & Spalding Holdings Corp., IDEX Corporation, KinderCare Learning Center, Inc., KSL Recreation Group, Inc., Newsquest Capital PLC, Owens-Illinois, Inc., Owens-Illinois Group, Inc., Primedia Inc., Safeway Inc., Union Texas Petroleum Holdings, Inc. and World Color Press, Inc.
Edward A. Gilhuly became a Director of MBC in October 1995. Mr. Gilhuly was a General Partner of KKR from January 1995 until January 1996, when he became a member of the limited liability company which serves as the General Partner of KKR. Mr. Gilhuly is also a General Partner of KKR Associates and, prior to 1995, was an Executive of KKR. Mr. Gilhuly is also a director of Doubletree Corporation, Layne Christensen Company, Owens-Illinois, Inc., Owens-Illinois Group, Inc. and Union Texas Petroleum Holdings, Inc.
Todd A. Fisher became a Director of MBC in October 1995. Mr. Fisher has been an Executive of KKR since June 1993 and a Limited Partner of KKR Associates since December 1993. From 1992 to June 1993, Mr. Fisher was an associate at Goldman, Sachs & Co. Mr. Fisher is also a director of Layne Christensen Company.
John A. Budnick, III has served as Executive Vice President and Chief Financial Officer of MBC since August 1997. Mr. Budnick served as Executive Vice President, Finance from January 1997 to August 1997, Senior Vice President of Finance from January 1995 to January 1997 and Vice President of Finance from April 1994 to January 1995. Prior to joining MBC, Mr. Budnick worked in the finance department of Medco Containment from September 1991 to April 1994. Mr. Budnick, a Certified Public Accountant, holds a B.S.degree in Business Administration from Georgetown University.
John P. Docherty, M.D. has served as Executive Vice President and Chief Medical Officer of MBC since March 1997. Dr. Docherty previously served as the Chief of the Psychosocial Treatments Research Branch of the National Institute of Mental Health, and has held faculty positions with Yale University, Tufts University, Harvard University and the University of California at Los Angeles. Dr. Docherty founded Northeast Psychiatric Associates, P.C., a private psychiatric practice, where he held the position of President and Executive Medical Director. He is currently on the faculty of Cornell University Medical College and chairs the National Institute on Drug Abuse (NIDA), Treatment Development and Review Committee. Dr. Docherty holds an M.D. degree from the University of Pennsylvania School of Medicine.
Ronald D. Geraty, M.D. has served as a Director of MBC since May 1996 and an Executive Vice President of MBC since its incorporation in March 1993. Dr. Geraty has also served as Senior Vice President, New Business Development of American Biodyne since May 1992 and as Vice President of American Biodyne from December 1991 to May 1992. He
served as President of Assured Health Systems, Inc. (acquired by American Biodyne in 1991) from September 1989 through May 1992. In addition, he is currently an Instructor in Psychiatry at the Harvard Medical School. Dr. Geraty holds an M.D. from the Loma Linda University School of Medicine, Loma Linda, California and attended Columbia Union College in Washington, D.C.
Michael G. Lenahan, Esq. has served as Executive Vice President, Mergers & Acquisitions of MBC since January 1996, Executive Vice President, General Counsel and Secretary of MBC since November 1993, and General Counsel or Executive Vice President, Legal of American Biodyne and each of MBC's other subsidiaries (other than CMG and its subsidiaries) since January 1994. Mr. Lenahan held the position of Vice President-Legal of Medco Containment from March 1993 until August 1995. Prior thereto, Mr. Lenahan was an associate with the New York law firm of Shearman & Sterling. Mr. Lenahan holds a J.D. degree from New York University School of Law and a B.A. degree in Political Science from the State University of New York at Binghamton.
David B. Stone has served as President, Employer and Union Division, of MBC since August 1997, as Executive Vice President and Chief Marketing Officer of MBC from June 1994 to August 1997 and as Senior Vice President of MBC from January 1994 to June 1994. Mr. Stone also served as Vice President of MBC from its incorporation in March 1993 to January 1994. Mr. Stone has served as President of Personal Performance Consultants, Inc. ("PPC"), a subsidiary of MBC, since August 1994 and served as Senior Vice President of Managed Care Services and Chief Marketing Officer of PPC from June 1993 to August 1994. From August 1988 to April 1992, Mr. Stone was Vice President of Sales and Marketing for Preferred Health Care, Ltd. and Chief Marketing Officer of Empire Mental Health Choice, a joint venture between Preferred Health Care Ltd. and Empire. Mr. Stone holds an M.S.W. degree from the Columbia School of Social Work and an M.B.A. degree from Pace University.
Richard C. Surles, Ph.D. has served as President, Advanced Clinical Delivery, of MBC since August 1997 and Executive Vice President of MBC from November 1994 to August 1997. Dr. Surles assumed the position of Executive Vice President, Service System Development, of MBC in October 1995 and, from January 1996 to August 1997, was Executive Vice President, Operations of MBC. Dr. Surles served as the New York State Commissioner of Mental Health from October 1987 to November 1994. Dr. Surles holds a Ph.D. degree in Administration and Organizational Behavior from the University of North Carolina.
Terry R. Thompson served as a Director of MBC from October 1996 to October 1997 and as Executive Vice President, Business Operations of MBC from September 1996 to November 1997. Effective November 18, 1997, Mr. Thompson resigned all of his positions and directorships with MBC and its subsidiaries.
Messrs. Kravis and Roberts are first cousins.
Item 11.
Item 11. Executive Compensation
The following table sets forth in summary form all compensation for all services rendered in all capacities to the Company paid or accrued during the three fiscal years ended September 30, 1997 to the Chief Executive Officer of the Company and the four other most highly compensated executive officers of the Company (collectively, with the Chief Executive Officer, the "Named Executive Officers"). Such table represents historical compensation and is not indicative of future compensation to be received by the Named Executive Officers.
Historical Summary Compensation Table
(1) Represents the Company's matching contribution under the Merit Behavioral Care Corporation 401(k) Plan.
Options/SAR Grants in Fiscal 1997
The following table summarizes options to acquire shares of Common Stock granted in fiscal 1997 to the Named Executive Officers.
The following table sets forth the number of shares covered by both exercisable and unexercisable options to acquire shares of Common Stock held by the Named Executive Officers as of September 30, 1997.
- -------------- (1) Until such time there is a public market in which the Common Stock may be traded, the value of such options is determined under a formula delineated under the 1995 Option Plan. As of September 30, 1997, based on such formula, no value was associated with such options.
The following table sets forth the number of shares covered by both exercisable and unexercisable options to acquire shares of common stock of Merck held by the Named Executive Officers as of September 30, 1997.
(1) Values for "in-the-money" options represent the positive spread between the respective exercise prices of outstanding options and $99.938, the value of the common stock of Merck as of September 30, 1997, as reported on the New York Stock Exchange Composite Tape.
Compensation Committee Interlocks and Insider Participation
The Compensation Committee of MBC's Board of Directors is comprised of Messrs. Gilhuly and Fisher. Mr. Gilhuly is a member of the limited liability company which serves as the General Partner of KKR and is also a General Partner of KKR Associates. Mr. Fisher is an Executive of KKR and a Limited Partner of KKR Associates. KKR Associates beneficially owned 71.4% of MBC's outstanding Common Stock as of December 1, 1997. As a General Partner of KKR Associates, Mr. Gilhuly may be deemed to share beneficial ownership of the Common Stock beneficially owned by KKR Associates; however, Mr. Gilhuly disclaims any such beneficial ownership.
Compensation of Directors
Each director who is not an employee of the Company receives an aggregate annual fee of $25,000, payable in quarterly installments. Directors who are also employees of the Company receive no remuneration for serving as directors.
Management Incentive Plan
The Board of Directors of MBC has adopted an Annual Incentive Plan for Key Employees of MBC (the "Incentive Plan"). The Incentive Plan provides that each fiscal year MBC senior management will designate as participants ("Participants") in the Incentive Plan those employees of MBC who are in a position to significantly impact the performance of the Company. Participants will be eligible to receive payments under the Incentive Plan equal to a specified percentage of their base salaries if the Company attains certain performance goals set by the Compensation Committee.
1995 Merit Stock Option Plan
In October 1995, MBC adopted the 1995 Stock Purchase and Option Plan for Employees of Merit Behavioral Care Corporation and Subsidiaries (the "1995 Option Plan") providing for the issuance of up to
8,561,000 shares of authorized but unissued or reacquired shares of Common Stock, subject to adjustment to reflect certain events such as stock dividends, stock splits, recapitalization, mergers or reorganizations of or by the Company. The 1995 Option Plan is intended to assist the Company in attracting and retaining employees of outstanding ability and to promote the identification of their interests with those of the stockholders of the Company. The 1995 Option Plan permits the issuance of Common Stock (the "Purchase Stock") and the grant of Non-Qualified Stock Options (the "1995 Options") to purchase shares of Common Stock (the issuance of Purchase Stock and the grant of Options pursuant to the Plan being a "1995 Grant"). Unless sooner terminated by MBC's Board of Directors, the 1995 Option Plan will expire on October 6, 2005. Such termination will not affect the validity of any 1995 Grant outstanding on the date of termination.
Each individual 1995 Option agreement provides that, upon certain events (each, an "Acceleration Event"), the 1995 Options will become immediately exercisable. The 1995 Option agreements provide that an Acceleration Event occurs if the participant's employment with the Company is terminated by such participant for "good reason" or by the Company without "cause" (each as defined in the MBC Management Stockholder's Agreements (as defined)) within one year following certain change in control events. The Magellan Merger Agreement provides that the vesting of all 1995 Options will become accelerated upon consummation of the Magellan Merger.
The 1995 Option Plan provides generally that the exercise price of 1995 Options and the purchase price of any Common Stock granted for consideration will not be less than 50% of the fair market value per share of Common Stock on the date of such 1995 Grant. Each participant in the 1995 Option Plan is required to enter into a stockholder's agreement with MBC substantially similar to the MBC Management Stockholder's Agreements described below.
The Compensation Committee of MBC's Board of Directors administers the 1995 Option Plan, including, without limitation, the determination of the employees to whom 1995 Grants will be made, the number of shares of Common Stock subject to each 1995 Grant, and the various terms of such 1995 Grants. The Compensation Committee of MBC's Board of Directors may from time to time amend the terms of any 1995 Grant, but, except for adjustments made upon a change in the Common Stock of the Company by reason of a stock split, spin-off, stock dividend, stock combination or reclassification, recapitalization, reorganization, consolidation, change of control, or similar event, such action shall not adversely affect the rights of any participant under the 1995 Option Plan with respect to the Purchase Stock and the 1995 Options without such participant's consent. MBC's Board of Directors retains the right to amend, suspend or terminate the 1995 Option Plan.
1996 Merit Stock Option Plan
In January 1996, MBC adopted the Merit Behavioral Care Corporation Employee Stock Option Plan (the "1996 Option Plan") providing for the issuance of up to 1,000,000 shares of authorized but unissued or reacquired shares of Common Stock, subject to adjustment to reflect certain events such as stock dividends, stock splits, recapitalization, mergers or reorganizations of or by the Company. The 1996 Option Plan is intended to provide incentive to employees of MBC to remain in the employ of the Company and to increase their interest in the success of the Company through the grant of stock options. Substantially all full-time employees of MBC (other than those receiving 1995 Options) who commenced employment with MBC prior to January 1, 1997 are eligible to participate in the 1996 Option Plan. The 1996 Option Plan permits the grant of Non-Qualified Stock Options (the "1996 Options") to purchase shares of Common Stock (each such grant of 1996 Options being a "1996 Grant"). Unless sooner terminated by the MBC Board of Directors, the 1996 Option Plan will expire on January 1, 2006. Such termination will not affect the validity of any 1996 Grant outstanding as the date of termination.
The Compensation Committee of the MBC Board of Directors administers the 1996 Plan, including, without limitation, the determination of employees to whom 1996 Grants will be made, the number of shares of Common Stock subject to each 1996 Grant, and the terms of such 1996 Grant. 1996 Grants to participants under the 1996 Option Plan are determined based on their length of service with the Company, with reference to the following service categories: (a) less than one year; (b) one to two years; (c) two to three years; and (d) greater than three years. Each participant will be required to execute an agreement with MBC (a "1996 Option Agreement") containing the following terms, among others: the number of 1996 Options; the exercise price therefor; and the vesting schedule for the 1996 Options. The MBC Board of Directors has reserved the right to amend or terminate the 1996 Option Plan, provided that no such amendment or termination may adversely affect the rights of participants in their 1996 Options.
The 1996 Option Agreements prohibit the participants from transferring 1996 Options, subject to enumerated exceptions. The 1996 Options are not exercisable until after the date when at least 25% of the then outstanding shares of Common Stock (on a fully diluted basis) have been sold in underwritten public offerings under the Securities Act (the "Public Company Date") and, thereafter, only when the shares of Common Stock underlying such 1996 Options have been registered under the Securities Act and qualified under applicable state "blue sky" laws, or MBC has determined that an exemption from such registration and "blue sky" qualification is available. In addition, upon termination of the participant's employment with MBC at any time, all unvested 1996 Options will be canceled and, if such termination is for Cause (as defined in the 1996 Option Agreements), all vested Options also will be canceled. If such employment is terminated prior to the Public Company Date without Cause, MBC will have the right for three years after such termination to require the participant to surrender for cancellation all vested 1996 Options in exchange for a payment determined under the 1996 Option Plan. If such employment is terminated without Cause after the Public Company Date, the participant's vested 1996 Options will remain exercisable for 90 days following such termination.
The Magellan Merger Agreement provides that the Board of Directors of MBC will take such actions as are necessary to enable holders of 1996 Options to exercise all of their outstanding 1996 Options upon consummation of the Magellan Merger.
Employment Agreements
Albert S. Waxman. American Biodyne has entered into an amended and restated employment agreement, dated as of August 17, 1992 and amended as of October 1, 1993, with Albert S. Waxman. The agreement provides that Dr. Waxman will be employed by American Biodyne for a period of five years and will receive a base salary of $400,000 plus a yearly discretionary bonus. Such annual base salary has been subsequently increased. American Biodyne may terminate the agreement for cause or by mutual agreement with Dr. Waxman. Dr. Waxman may terminate the agreement for good reason. If American Biodyne terminates the agreement for reasons other than cause or if Dr. Waxman terminates the agreement for good reason, Dr. Waxman will be entitled to (i) receive his base salary until the earliest of five years, death or the occurrence of a circumstance that constitutes cause or (ii) elect the employment status of Chairman Emeritus of American Biodyne. Dr. Waxman has agreed that, subject to and upon consummation of the Magellan Merger, he will become Chairman Emeritus of American Biodyne.
Michael G. Lenahan. The Company and Medco Containment have entered into an employment agreement, dated as of February 1, 1995, with Michael G. Lenahan. The agreement provides that Mr. Lenahan will be employed by the Company for a period of three years and receive a base salary of $200,000 per year, plus a yearly discretionary bonus and certain other fringe benefits. Such annual base salary has been subsequently increased. Mr. Lenahan may terminate the agreement for cause or upon a
change of control of MBC. The Company may terminate the agreement for cause, without cause upon 30 days' written notice or if Mr. Lenahan becomes disabled. If Mr. Lenahan terminates the agreement or if the Company terminates the agreement without cause, he is entitled to work for the Company as a consultant for a period of one year and to be paid at the base compensation rate in effect at the time of termination or, at his election, to assume a senior level position in the legal department of Medco Containment. Mr. Lenahan's employment agreement will terminate upon consummation of the Magellan Merger.
Richard C. Surles. The Company has entered into an employment agreement, effective January 16, 1995, with Richard C. Surles. The agreement provides that Dr. Surles will be employed by the Company for the period ending January 16, 1998 and receive (i) a minimum base salary of $250,000 per year, plus a yearly discretionary bonus, (ii) loans in connection with his relocation and (iii) an advance on his salary in the form of a loan of $25,000. The Company may terminate the agreement for cause, if Dr. Surles becomes disabled or without cause. Dr. Surles may terminate the agreement upon not less than six months' written notice. If the Company terminates the agreement without cause, Dr. Surles will be entitled to receive (i) his base compensation for the balance of the term of the agreement (but in no event less than one year) and (ii) insurance and medical benefits for the same term as base compensation is paid.
David B. Stone. The Company, American Biodyne and PPC have entered into a management agreement, dated April 27, 1992 and amended as of April 30, 1993, with David B. Stone. The agreement provides for an initial employment period that ended on March 31, 1995, and has been automatically renewed according to its terms until March 31, 1999. The agreement provides that Mr. Stone shall receive a minimum base annual salary of $176,000, plus a discretionary bonus based on targeted performance objectives, and certain other benefits. Such annual base salary has been subsequently increased. Mr. Stone may terminate the agreement for good reason and the Company may terminate the agreement for cause or if Mr. Stone becomes disabled. If Mr. Stone terminates the agreement for good reason or if the Company terminates the agreement for reasons other than for cause, Mr. Stone will be entitled to compensation equal to the greater of (i) his then current salary at the time of entering into the agreement for the remainder of the term (up to two years) or (ii) his then current salary for a period of one year.
John P. Docherty, M.D. The Company has entered into an employment agreement, effective March 1, 1997, with John P. Docherty, M.D. The agreement provides that during Dr. Docherty's employment with the Company he shall receive a minimum base salary of $250,000 per year, plus a yearly discretionary bonus. The Company may terminate the agreement for cause, if Dr. Docherty becomes disabled or without cause. Dr. Docherty may terminate the agreement upon not less than thirty days' written notice. If the Company terminates the agreement without cause prior to March 1, 2000, Dr. Docherty will be entitled to receive his base compensation for a defined period of time that is not less two years. If the Company terminates the agreement without cause after March 1, 2000, Dr. Docherty will be entitled to receive his base compensation for a defined period of time that is not less one year. In either case, Dr. Docherty will be entitled to receive insurance and medical benefits for the same term as base compensation is paid.
Terry R. Thompson. The Company entered into an employment agreement, effective as of September 3, 1996, with Terry R. Thompson. The agreement provided that Mr. Thompson would receive a base salary of $350,000 per year during his employment with the Company, plus a yearly discretionary bonus and certain other fringe benefits. The Company and Mr. Thompson executed a separation agreement, dated November 18, 1997, whereby Mr. Thompson resigned all officer and director positions with the Company. Under the separation agreement, Mr. Thompson will be paid, as severance compensation, his annual base salary through December 31, 1998. In
addition, Mr. Thompson will retain the 100,000 shares of Common Stock he purchased in 1996 and 140,000 of the 1995 Options granted to Mr. Thompson.
Severance Agreements
On October 6, 1995, the Company entered into severance agreements (collectively, the "Severance Agreements") with Dr. Waxman, Dr. Geraty, Mr. Halper, Mr. Lenahan, Mr. Stone and Dr. Surles. Each Severance Agreement provides that if, prior to October 6, 2000, (i) the Company terminates employment of the applicable officer for reasons other than for "cause" (as defined therein) or (ii) the officer terminates employment on his own initiative for "good reason" (as defined therein), such officer will be entitled, for a period of twelve months, to be paid the excess, if any, of his base salary at the time of such termination over any other payments made by the Company to such officer under other employment or consulting agreements then in effect. In addition, Mr. Budnick has a severance agreement with the Company that provides that he will be entitled to one year of base compensation if his employment is terminated by the Company other than for "cause".
Non-Competition Agreements
In connection with the execution of the Magellan Merger Agreement, each of Dr. Waxman and Messrs. Halper, Lenahan and Budnick entered into a non-competition agreements with Magellan and the Company (the "Non-Competition Agreements"). The Non-Competition Agreements provide that, effective upon the consummation of the Magellan Merger, the applicable executive will not compete against the Company in the behavioral health managed care and EAP business for a period of three years after the closing of the Magellan Merger. In consideration of entering into such Non-Competition Agreement, each executive will receive payments totaling two times his current base compensation, which payments will be in lieu of any other severance consideration otherwise payable to such executive under any employment, severance or other agreement to which the Company and such executive are parties.
MBC Management Stockholder's Agreements
In connection with the 1995 Merger and from time to time thereafter, the Company has entered into stockholder's agreements (each, an "MBC Management Stockholder's Agreement") with all management employees and others that are stockholders of MBC or holders of any 1995 Options (each, an "MBC Management Stockholder"). Pursuant to each MBC Management Stockholder's Agreement, the MBC Management Stockholder may not transfer any shares of Common Stock acquired thereby or upon exercise of vested 1995 Options (collectively, the "Plan Shares") within five years after the purchase date thereof, except as described below and except (a) for certain transfers to family members, similar transfers in the nature of estate planning and in connection with the loans described under "Certain Relationships and Related Transactions," (b) pursuant to a Qualified Public Offering (as defined therein), in which event only a stated percentage of his Plan Shares becomes transferable or (c) pursuant to certain sales of Common Stock by MBC Associates, L.P., an affiliate of KKR ("MBC Associates"), in which event the MBC Management Stockholder is entitled to sell a stated percentage of his Plan Shares. Each MBC Management Stockholder's Agreement provides the MBC Management Stockholder with the right to (a) require the Company to repurchase all of his Plan Shares and pay him a stated price for cancellation of 1995 Options upon a Permitted Retirement (as defined therein), death or disability, (b) until the later of
five years after the purchase date or the first Qualified Public Offering, have the Company register a stated percentage of his Plan Shares under the Securities Act in connection with certain public offerings, and (c) prior to the fifth anniversary of the first Public Offering (as defined therein), include a stated percentage of his Plan Shares in any sale of Common Stock by MBC Associates or an affiliate to any non-affiliated person (other than a Public Offering). Each MBC Management Stockholder's Agreement also provides the Company with (a) prior to a Public Offering, the right of first refusal to buy Plan Shares owned by each MBC Management Stockholder on essentially the same terms and conditions as such MBC Management Stockholder proposes in a sale of his Plan Shares to another purchaser, (b) the right to repurchase all of the MBC Management Stockholder's Plan Shares and pay him a stated price for cancellation of his 1995 Options upon certain events, including termination of employment (with or without cause) or an unpermitted transfer of Plan Shares and (c) prior to the fifth anniversary of the first Public Offering, the right to require the MBC Management Stockholder to sell a stated percentage of his Plan Shares in any sale of Common Stock by MBC Associates or an affiliate to any non-affiliated person (other than a Public Offering). Upon a "change of control" (as defined therein) of the Company, the transfer restrictions, right of first refusal, and certain other rights with respect to sale and repurchase of the Plan Shares and cancellation of 1995 Options as described above will lapse.
The repurchase price of the Plan Shares under the MBC Management Stockholder's Agreements depends upon the nature of the event that triggers the repurchase and whether such repurchase occurs at the election of the MBC Management Stockholder or the Company. Generally, if the repurchase is at the participant's election, the repurchase price per share will be the greater of the purchase price paid by the MBC Management Stockholder (the "Plan Share Purchase Price") and the market price; if the Common Stock is not then publicly traded, the repurchase price per share will be the Plan Share Purchase Price plus the increase, if any, in book value per share since the date of purchase of the Plan Shares.
Generally, if the repurchase is at the Company's election, the repurchase price per share will be the lesser of (a) the market price and (b) the Plan Share Purchase Price plus a stated percentage (the "Percentage") of the amount by which the market price exceeds the Plan Share Purchase Price; if the Common Stock is not then publicly traded, the repurchase price per share will be the lesser of (a) the Base Value Per Share (as defined below) and (b) the Plan Share Purchase Price, plus the Percentage multiplied by the increase, if any, in book value per share since the date of the purchase of the Plan Shares. The Percentage is 0% during the first year following the MBC Management Stockholder's purchase of Plan Shares, and increases annually thereafter (up to 100%) in increments of 20%. The "Base Value Per Share" equals the Plan Share Purchase Price per share plus the change (positive or negative) in book value per share since the date of the purchase.
If the Company repurchases Plan Shares as described above, it also must pay the MBC Management Stockholder the excess, if any, of the repurchase price applied to the repurchase of Plan Shares, over the exercise prices of the applicable 1995 Options, multiplied by the number of Exercisable Option Shares. Each MBC Management Stockholder's Agreement defines Exercisable Option Shares as shares of Common Stock which, at the time of determination, could be purchased by the MBC Management Stockholder upon exercise of his outstanding exercisable 1995 Options.
Certain MBC Management Stockholder's Agreements also contain noncompete provisions, pursuant to which each MBC Management Stockholder has agreed, for the term of his employment and one year thereafter, not to produce, sell or distribute, directly or indirectly, any product or service sold or distributed by the Company or its affiliated entities. The Company may extend the noncompete period for one additional year by giving notice thereof and paying the MBC Management Stockholder an amount equal to his annual base salary, calculated as of the time of termination of employment (the "Noncompete Amount"). If the MBC Management Stockholder's employment with the Company is terminated without
"cause" or for "good reason" (each as defined therein), the noncompete requirements will apply to the first year following termination of employment only if the Company pays the MBC Management Stockholder the Noncompete Amount.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth certain information known to MBC as of December 1, 1997 regarding the beneficial ownership of Common Stock by (i) all persons who own beneficially more than 5% of the Common Stock, (ii) each director of MBC, (iii) the Chief Executive Officer of MBC and each of the Named Executive Officers and (iv) all directors and executive officers as a group.
(1) Shares of Common Stock shown as beneficially owned by KKR Associates are held by MBC Associates and KKR Partners II, L.P. ("KKR Partners II"); KKR Associates is the sole general partner of both MBC Associates and KKR Partners II and possesses sole voting and investment power with respect to such shares. KKR Associates is a limited partnership, the general partners of which are Henry R. Kravis, George R. Roberts, Robert I. MacDonnell, Paul E. Raether, Michael W. Michelson, Michael T. Tokarz, James H. Greene, Jr., Perry Golkin, Clifton S. Robbins, Scott M. Stuart and Edward A. Gilhuly. Messrs. Kravis, Roberts and Gilhuly are also directors of the Company. Such individuals may be deemed to share beneficial ownership of the shares shown as beneficially owned by KKR Associates. Such individuals disclaim beneficial ownership of any such shares.
(2) Represents shares held by Medco Holdings Corp., a subsidiary of Medco Containment, which is a wholly owned subsidiary of Merck.
(3) Represents shares held by The Albert S. Waxman Family Charitable Remainder Unitrust, of which Albert S. Waxman is trustee. As trustee, Dr. Waxman may be deemed to have beneficial ownership of the shares shown as beneficially owned by such trust. Dr. Waxman disclaims beneficial ownership of any such shares.
(4) Does not include options to acquire 1,120,000 shares of Common Stock that are exercisable within 60 days of the date hereof.
(5) Does not include options to acquire 120,000 shares of Common Stock that are exercisable within 60 days of the date hereof.
(6) Does not include options to acquire 140,000 shares of Common Stock that are exercisable within 60 days of the date hereof.
(7) Does not include options to acquire 120,000 shares of Common Stock that are exercisable within 60 days of the date hereof.
(8) Does not include options to acquire 60,000 shares of Common Stock that are exercisable within 60 days of the date hereof.
(9) Does not include options to acquire 1,707,200 shares of Common Stock in the aggregate that are exercisable within 60 days of the date hereof.
Item 13.
Item 13. Certain Relationships and Related Transactions
Transactions with KKR. KKR Associates beneficially owned 71.4% of MBC's outstanding Common Stock as of December 1, 1997. Messrs. Kravis, Roberts and Gilhuly, directors of the Company, are members of the limited liability company which serves as the General Partner of KKR and also are General Partners of KKR Associates. Mr. Fisher, also a director of the Company, is an executive of KKR and a Limited Partner of KKR Associates. KKR, an affiliate of KKR Associates, received a fee of $5.5 million for negotiating the 1995 Merger and arranging the financing therefor and, from time to time in the future, KKR may receive customary investment banking fees for services rendered to the Company in connection with divestitures, acquisitions and certain other transactions. In addition, KKR renders management, consulting and financial services to the Company. During fiscal 1997 and 1996, KKR received $500,000 and $400,000, respectively, in fees for such services. Executives of KKR who also serve as directors of the Company receive customary directors' fees. Upon consummation of the Magellan Merger, KKR will receive a financial advisory fee from MBC of $5.0 million.
In connection with the 1995 Merger, the Company incurred $75.0 million of subordinated indebtedness under the Bridge Loan provided by MBC Associates, the general partner of which is KKR Associates. A portion of the net proceeds from the offering of the Private Notes in November 1995 (which were subsequently exchanged for the Notes) was applied to repay all indebtedness outstanding under the Bridge Loan (including accrued interest).
MBC Associates and KKR Partners II (collectively, the "KKR Investors") have the right, under certain circumstances and subject to certain conditions, to require the Company to register under the Securities Act shares of Common Stock held by them pursuant to a registration rights agreement entered into in connection with the 1995 Merger and certain stockholders' agreements. Such registration rights will generally be available to the KKR Investors until registration under the Securities Act is no longer required to enable them to resell the Common Stock owned by them. Such registration rights agreement provides, among other things, that the Company will pay all expenses in connection with the first six registrations requested by the KKR Investors and in connection with any registration commenced by the Company as a primary offering. In addition, other stockholders besides the KKR Investors, including the MBC Management Stockholders and Medco Containment, will be allowed to participate in any registration process, subject to certain conditions and exceptions.
Transactions with Management. In connection with the 1995 Merger, certain MBC Management Stockholders borrowed all or a portion of the purchase price for the Plan Shares acquired by them pursuant to
their respective MBC Management Stockholder's Agreements. Dr. Waxman borrowed $5.0 million; Dr. Surles borrowed $200,000; Dr. Geraty borrowed $250,000; Mr. Stone borrowed $250,000; and Mr. Morlan, the Company's former Executive Vice President and Chief Information Officer, borrowed $100,000. In addition, in connection with their purchases of Common Stock, Mr. Thompson, Mr. Halper, Mr. Budnick, Mr. Lenahan and Dr. Docherty borrowed $500,000, $250,000, $375,000, $375,000 and $80,000, respectively. All such borrowings are evidenced by promissory notes from the applicable MBC Management Stockholder and are secured by a pledge of such MBC Management Stockholder's Plan Shares. Each promissory note provides for the payment of interest at a rate of 6.5% per annum. The promissory notes of Dr. Waxman, Dr. Surles, Mr. Thompson, Mr. Halper, Mr. Budnick and Dr. Docherty mature on December 31, 2000. In connection with Mr. Morlan's separation from the Company, the Company acquired Mr. Morlan's shares of Common Stock. As part of such transaction, the Company cancelled Mr. Morlan's promissory note. Mr. Stone repaid his loan in November 1995, Dr. Geraty repaid his loan in October 1996 and Mr. Lenahan repaid his loan in October 1997. Upon consummation of the Magellan Merger, all such outstanding loans will be repaid in full.
Dr. Waxman owns all of the shares of LNY Corp., a limited partner of 38 Newbury Ventures/MBC Limited Partnership ("38 Newbury"). In connection with the 1995 Merger, the Company entered into a Stock Purchase and Stockholder's Agreement (the "38 Newbury Stockholder's Agreement"), dated as of October 6, 1995, with 38 Newbury and MBC Associates. Pursuant to the 38 Newbury Stockholder's Agreement, 38 Newbury purchased 600,000 shares of Common Stock for $3.0 million. The 38 Newbury Stockholder's Agreement provides the Company with the right of first refusal to purchase shares of Common Stock on the same terms and conditions as are proposed by a third party offer at any time prior to a Public Offering (as defined therein). Also under the 38 Newbury Stockholder's Agreement, at any time prior to the fifth anniversary of the first Public Offering, (i) MBC Associates may require 38 Newbury to include a pro rata portion of its shares of Common Stock in any sale by MBC Associates of its holdings of Common Stock and (ii) 38 Newbury has the option to include a pro rata portion of its shares in any sale by MBC Associates of its holdings of Common Stock. The 38 Newbury Stockholder's Agreement further provides that, upon the later of the first Public Offering and the fifth anniversary of the Stock Closing (as defined therein), the parties will be bound by certain provisions of the registration rights agreement discussed above between the Company and the KKR Investors.
Transactions with Merck and Medco Containment. In connection with the 1995 Merger, the Company entered into a stockholders' agreement (the "Medco Stockholders' Agreement") with the KKR Investors and Medco Containment (together with the KKR Investors, the "Stockholders").
Pursuant to the Medco Stockholders' Agreement, Medco Containment has the right to include a pro rata portion of its shares of Common Stock in any proposed transfer of KKR Investors' Common Stock (other than to affiliates of the KKR Investors) at the same price per share and upon the same terms and conditions as such shares of KKR Investors' Common Stock would be sold to the proposed transferee. The Medco Stockholders' Agreement also provides the KKR Investors with the right to require Medco Containment to sell all of its shares of Common Stock in a proposed transfer by the KKR Investors of 100% of the KKR Investors' Common Stock.
Medco Containment will have the right, on two occasions following the earlier to occur of (i) 180 days after the initial public offering of Common Stock and (ii) five years from the closing date of the 1995 Merger, to cause the Company to file a registration statement in connection with the sale of shares of Common Stock held by Medco Containment. The Company has agreed to pay certain expenses of such offerings. The Stockholders will, upon request, execute 180 day market stand-off agreements in connection with the initial public offering of Common Stock, if so requested by the underwriters for such an initial public offering.
After the Company's initial public offering, each time the Company files a registration statement (other than on Form S-4 or S-8) in connection with a sale of shares of Common Stock by the Company, the KKR Investors or any of their respective Affiliates (as defined therein), the Company, at the request of Medco Containment, will use its reasonable efforts to effect the registration of all shares of Common Stock owned by Medco Containment that the Company has been so requested to register by Medco Containment. In the event that the managing underwriter or underwriters determines that a proposed offering including shares of Medco Containment and the KKR Investors exceeds the number of shares of Common Stock that can be sold without having a significant adverse effect on such offering or that inclusion of such Stockholders' shares would significantly and adversely affect the offering, the number of shares held by the KKR Investors and Medco Containment, if any, to be registered shall be in proportion to the relative sizes of their holdings of Common Stock.
In certain circumstances, including the issuance of Common Stock by the Company to Affiliates of the KKR Investors, Medco Containment will have the right to subscribe for and purchase additional shares of Common Stock at the same price and upon the same terms and conditions so as to enable Medco Containment to maintain its percentage of ownership of shares of Common Stock as of the time of the Company's proposal to issue shares of Common Stock. In addition, Medco Containment has the right to designate a person to observe all Board of Directors' meetings and to approve certain transactions with affiliates (other than transactions as to which no approval of institutional lenders is required).
Pursuant to the 1995 Merger Agreement, Medco Containment agreed to abide by a confidentiality provision relating to all information it possesses regarding the Company. A portion of the purchase price for the Company was allocated to the consideration paid to Merck in connection with the 1995 Merger.
In the ordinary course of business, the Company provides EAP services to certain divisions of Merck and behavioral health managed care services to Medco Containment.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
MERIT BEHAVIORAL CARE CORPORATION
By: /s/ Albert S. Waxman, Ph.D. Albert S. Waxman, Ph.D. Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report on Form 10-K has been signed by the following persons in the capacities and on the dates indicated.
Financial Statement Schedules
All schedules for which provision is made in the applicable regulations of the Securities and Exchange Commission are omitted because they are not required under the related instructions or are not applicable or the required information is shown in the Consolidated Financial Statements or the notes thereto.
To the Board of Directors
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 require 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.
/s/ Deloitte & Touche Deloitte & Touche
November 12, 1997
New York, New York
MERIT BEHAVIORAL CARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
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.
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.
Certain prior year amounts have been reclassified to conform to the current year 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.
Included in cash and cash equivalents at September 30, 1997 and 1996 is $11,020 and $11,713, 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 until such reconciliation process has been completed. The amount of cash held under such arrangements in excess of anticipated customer claims at September 30, 1997 and 1996 was $6,197 and $4,267, respectively.
The Company held surplus cash balances of $29,325 and $13,715 as of September 30, 1997 and 1996, respectively, as required by contracts with various state and local governmental entities. In addition, at September 30, 1997 and 1996, the Company held surplus cash balances of $3,137 and $1,214, 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 cash and cash equivalents at September 30, 1997 and 1996 is $0 and $900, respectively, under such requirements.
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
Short-Term Marketable Securities
Short-term marketable securities consist 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
At September 30, 1997 and 1996, $6,623 and $7,168, 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 $3,559 and $5,510 at September 30, 1997 and 1996, 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:
Expenditures for maintenance, repairs and renewals of minor items are charged to operations as incurred. Major betterments are capitalized.
The integrated managed care information system (the "System") represents costs incurred in the development and adaptation of AMISYS(R) 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.
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
Goodwill and intangible assets consisted of the following at September 30, 1997 and 1996:
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, 1997 and 1996 of 4.3 and 3.3 years, respectively. Amortization of deferred contract start-up costs was $3,096, $2,848, and $1,315 for the periods ended September 30, 1997, 1996, and 1995, respectively. During the periods ended September 30, 1997, 1996, and 1995, the Company deferred contract start-up costs of $6,067, $4,816, and $6,231, respectively. Other non-current assets include $9,036 and $6,077 of unamortized deferred contract start-up costs at September 30, 1997 and 1996, 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
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
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 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 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.
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
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 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:
6. LONG TERM DEBT
Long-term debt consisted of the following at September 30:
6. LONG-TERM DEBT--(Continued)
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"), 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 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.
6. LONG-TERM DEBT-- (Continued)
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 $250 and $265 were repaid during the periods ended September 30, 1997 and 1996, 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, 1997 and 1996 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 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.
8. ACQUISITIONS--(Continued)
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.
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:
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.
9. JOINT VENTURES--(Continued)
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, 1997 and 1996, the Company had net advances to CHN outstanding of $1,732 and $2,079, 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, 1997 and 1996, 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.
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 made capital contributions to ECDS in 1997 and 1996 of $667 and $458, respectively. Also, in 1997 and 1996 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.
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:
The differences between the U.S. federal statutory tax rate and the Company's effective tax rate are as follows:
At September 30, 1997 and 1996, the Company had $46,733 and $23,707, respectively, of deferred income tax assets and $55,505 and $52,080, respectively, of deferred income tax liabilities which have been netted for presentation purposes. The significant components of these amounts are shown on the balance sheet as follows:
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:
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, 1997, 1996 and 1995 amounted to $15,842, $13,059 and $10,115, respectively.
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.
11. COMMITMENTS AND CONTINGENCIES--(Continued)
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.
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.
12. RELATED PARTY TRANSACTIONS--(Continued)
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:
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 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 1996 and 1995, 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, 1997, 1996 and 1995 was $1,289, $542 and $330, 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, 1997 and 1996 would have increased to the pro forma amounts indicated below:
The resulting compensation expense may not be representative of compensation expense to be incurred on a pro forma basis in future years.
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, 1997 and 1996:
16. STOCK OPTIONS AND AWARDS--(Continued)
Information regarding the Company's stock option plans is summarized below:
The weighted-average fair values of options granted during fiscal 1997 and 1996 for the 1995 Option Plan were $1.42 and $1.72, respectively. The weighted-average fair values of options granted during fiscal 1997 and 1996 for the 1996 Employee Option Plan were $0.87 and $0.01, respectively.
The following table summarizes information about stock options outstanding as of September 30, 1997:
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 1997 and 1996, the Company recorded tax benefits of $11,630 and $1,505, respectively, from the exercise of Merck options. Information regarding the options outstanding under these plans held by employees of the Company at September 30, 1997 and 1996 is as follows:
16. STOCK OPTIONS AND AWARDS--(Continued)
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.
19. SUPPLEMENTAL INFORMATION
Supplemental cash flow information and noncash investing and financing activities are as follows:
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 October 24, 1997, the Company signed a definitive merger agreement under which a subsidiary of Magellan Health Services, Inc. ("Magellan") will merge into the Company. As a result of this merger, the Company will become a wholly owned subsidiary of Magellan. Under the terms of the merger agreement, Magellan will purchase all of the Company's outstanding stock and other equity interests for approximately $460 million in cash and refinance the Company's existing debt. In addition, all options outstanding under the 1995 Option Plan and the 1996 Employee Option Plan will fully vest upon closing of the transaction. Completion of the merger transaction is subject to a number of conditions, including Magellan's receipt of sufficient financing for the transaction, the expiration or early termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1974, the receipt of certain healthcare and insurance regulatory approvals, and other conditions.