UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (mark one) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1996 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ....... to ....... Commission file number 0-19360 MERIS LABORATORIES, INC. - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) California 77-0274078 - -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2890 Zanker Road, San Jose, California 95134 - -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) 408-434-9200 - -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X . No . The number of shares outstanding of the issuer's common stock is 8,010,535 shares as of November 8, 1996. 1 MERIS LABORATORIES, INC. INDEX PAGE PART I. FINANCIAL INFORMATION NO. Item 1. Financial Statements (Unaudited, except for the Condensed Consolidated Balance Sheet at December 31, 1995): Condensed Consolidated Balance Sheets at September 30, 1996 and December 31, 1995................... 3 Condensed Consolidated Statements of Operations for the Three and Nine Month Periods ended September 30, 1996 and 1995. 4 Condensed Consolidated Statements of Cash Flows for the Nine Month Periods ended September 30, 1996 and 1995............... 5 Notes to Condensed Consolidated Financial Statements.......... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................................... 12 PART II. OTHER INFORMATION Item 1. Legal Proceedings............................................. 23 Item 3. Defaults Upon Senior Securities............................... 30 Item 5. Other Information............................................. 31 Item 6. Exhibits and Reports on Form 8-K.............................. 32 SIGNATURES .............................................................. 33 2 Item 1. MERIS LABORATORIES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands) Sept.30, Dec.31, 1996 1995 --------- --------- (Unaudited) ASSETS Current assets: Cash and cash equivalents ............................... $ 26 $ 1,490 Restricted cash ......................................... 1,964 1,585 Accounts receivable, net ................................ 7,968 11,270 Income tax refund receivable ............................ - 384 Supplies inventory ...................................... 475 749 Prepaid expenses and other current assets ............... 634 548 -------- -------- Total current assets .................................. 11,067 16,026 Property and equipment, net ................................ 1,798 2,283 Intangible and other assets, net ........................... 23,308 25,165 -------- -------- Total assets ........................................ $ 36,173 $ 43,474 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Bank borrowings ......................................... $ - $ 7,657 Notes Payable ........................................... 8,300 - Convertible subordinated debt ........................... 10,894 - Current portion of long-term obligations ................ 615 544 Accounts payable ........................................ 6,064 3,767 Accrued expenses ........................................ 3,129 3,115 Note payable to Former Executive ........................ 1,526 1,526 Accrued litigation and investigation charges ............ 5,721 3,940 -------- -------- Total current liabilities ............................. 36,249 20,549 -------- -------- Convertible subordinated debt .............................. - 10,824 Long-term obligations, less current portion ................ 224 469 -------- -------- Commitments and contingencies (Notes 6 and 7) .............. -- -- -------- -------- Shareholders' equity: Common stock ............................................ 37,157 37,136 Additional paid-in capital .............................. 826 826 Accumulated deficit ..................................... (38,283) (26,330) -------- -------- Total shareholders' equity ............................ (300) 11,632 -------- -------- Total liabilities and shareholders' equity .......... $ 36,173 $ 43,474 ======== ======== See accompanying notes to Condensed Consolidated Financial Statements 3 MERIS LABORATORIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) Three Months Nine Months Ended Ended September 30, September 30, --------------------- --------------------- 1996 1995 1996 1995 ---------- --------- --------- ---------- (Unaudited) Net revenues $ 8,344 $ 9,853 $27,728 $32,240 ---------- --------- --------- ---------- Cost of services: Salaries, wages and benefits 3,016 3,399 9,142 10,036 Supplies 1,172 1,314 3,938 3,797 Depreciation and amortization 785 1,057 2,537 3,412 Other cost of services 1,869 2,030 5,519 6,065 --------- --------- --------- ---------- Total cost of services 6,842 7,800 21,136 23,310 Selling, general and administrative expenses 3,093 2,825 8,662 8,734 Provision for doubtful accounts 1,215 653 4,789 3,227 Litigation and investigation charges 2,500 - 2,750 700 Write-down of intangible assets 115 - 665 - --------- --------- --------- ---------- Operating loss (5,421) (1,425) (10,274) (3,731) Interest expense (655) (513) (1,815) (1,518) Interest and other income, net 90 15 136 36 --------- --------- --------- ---------- Loss before income taxes (5,986) (1,923) (11,953) (5,213) Provision for income taxes - - - 36 --------- --------- --------- ---------- Net loss $(5,986) $ (1,923) $(11,953) $ (5,249) ========= ========= ========= ========== Net loss per share $ (0.75) $ (0.24) $ (1.49) $ (0.66) ========= ========= ========= ========== Weighted average shares outstanding 8,011 7,961 7,998 7,944 ========= ========= ========= ========== See accompanying notes to Condensed Consolidated Financial Statements 4 MERIS LABORATORIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Nine Months Ended September 30, --------------------- 1996 1995 ---------- --------- (Unaudited) Net cash used in operating activities $(1,087) $ (289) ---------- --------- Cash flows from investing activities: Cash expenditure for customer lists and other assets related to acquisitions (348) (2,258) Purchase of property and equipment,net (199) (427) ---------- --------- Net cash used in investing activities (547) (2,685) ---------- --------- Cash flows from financing activities: Issuance of common stock for option exercises 21 132 Proceeds from bank borrowings 2,429 5,000 Payments on bank borrowings (10,086) (3,131) Proceeds from notes payable 8,200 - Payments on long-term obligations (394) (530) Payment of distribution payable to related parties - (267) ---------- --------- Net cash provided by financing activities 170 1,204 ---------- --------- Net decrease in cash and cash equivalents (1,464) (1,770) Cash and cash equivalents at beginning of period 1,490 3,115 ---------- --------- Cash and cash equivalents at end of period $ 26 $1,345 ========== ========= See accompanying notes to Condensed Consolidated Financial Statements 5 MERIS LABORATORIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 1 - BASIS OF PRESENTATION: The accompanying condensed consolidated balance sheet of Meris Laboratories, Inc. (the "Company") at September 30, 1996 and the condensed consolidated statements of operations and of cash flows for the three and nine months ended September 30, 1996 and 1995, are unaudited. In the opinion of management, these statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of the interim information. The data disclosed in these notes to condensed consolidated financial statements for these periods are unaudited. The condensed consolidated financial statements for the periods ended September 30, 1996 have been prepared assuming that the Company will continue as a going concern. Management recognizes that the Company will have to improve its operating results and generate additional cash from operations. The Company continues its efforts to increase revenues and decrease costs. NOTE 2 - NET LOSS PER SHARE: Net loss per share is computed using the weighted average common shares and common stock equivalents when dilutive. Common stock equivalents consist of the Company's common stock issuable upon exercise of stock options (using the treasury stock method, except when antidilutive). The convertible subordinated debentures were not considered in the calculation of net loss per share because their effect is antidilutive. NOTE 3 - RESTRICTED CASH: During 1994, in accordance with the terms of the unsecured convertible senior subordinated debentures, the Company purchased a certificate of deposit in the amount of $1,585,000 representing the full amount to satisfy the Company's obligations owing to a former executive (the "Former Executive") pursuant to and in connection with a promissory note dated October 28, 1992 (see Note 5). Since the Company believes the Former Executive is indebted to the Company in an amount in excess of the amount of the final payment in the promissory note, the Company continues to hold the balance in a separate account pending the outcome of the litigation. On February 21, 1996, the Company deposited $379,000 (150% of the amount of the $253,000 judgement as required by the court) to an account with a bank to perfect its appeal in connection with a wrongful termination suit. See Part II. Other Information - Item 1. Legal Proceedings. Since both deposits are assets of the Company, they are also subject to any applicable security interests of the Company's creditors. NOTE 4 - BANK BORROWINGS/NOTES PAYABLE: On November 14, 1994, the Company obtained a $6.0 million accounts receivable line of credit (the "Line of Credit") with a bank. In April 1995, the 6 MERIS LABORATORIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Company entered into a one-year agreement to increase the Line of Credit from $6.0 million to the lesser of $10.0 million or the borrowing base calculated based upon eligible accounts receivable. On July 27, 1995, the Company entered into a loan modification agreement in which the bank agreed to issue letters of credit in an aggregate amount not to exceed (i) the lesser of the total Line of Credit or the qualifying borrowing base minus (ii) any amounts outstanding under the Line of Credit, provided that the amount of outstanding letters of credit should not in any case exceed $2.0 million. On December 8, 1995, the Company obtained a revision of certain covenants consisting of a minimum quick ratio, a minimum tangible net worth, a maximum senior liabilities to annualized earnings before interest, taxes, depreciation and amortization (EBITDA) ratio, and a restricted amount of loss for the fiscal year end of 1995. Borrowings under the Line of Credit were secured by substantially all of the Company's assets. The interest rate increased or decreased based upon the Company's quarterly operating results. The Line of Credit expired on April 20, 1996 and on June 4, 1996, the Company entered into an amendment to the Line of Credit agreement (the "Amended Agreement"). Subject to the terms of the Amended Agreement and in accordance with the terms of the debenture agreement (the "Debenture Agreement") (see Note 5), the Company is prohibited from making any further payments of accrued interest or principal on account of the convertible subordinated debt. The Amended Agreement further stated that the bank would forbear from exercising its remedies under the Line of Credit agreement until August 15, 1996, notwithstanding the Company's existing defaults. On August 14, 1996, the Company entered into a forbearance agreement with the bank which included an extension of the forbearance period to September 15, 1996. As of September 20, 1996, the Company's borrowings under the Line of Credit, including unpaid interest and costs, were $8.2 million. Such amount was substantially in excess of its available Line of Credit. Additionally, the Company was in default of all the financial covenants under the Line of Credit. Interest on borrowings under the Line of Credit was charged at the bank's prime rate plus 3% (11.25% as of September 20, 1996). On September 20, 1996, pursuant to a privately negotiated transaction, the bank assigned the Company's entire debt outstanding as of such date of $8.2 million to a private lender (the "Lender"). The Lender acquired from the bank any and all rights, claims and causes of action under the Amended Agreement. In conjunction with discussions with the Lender regarding a proposed financing and the assignment of the Bank borrowings, the Company issued a promissory note to the lender for $100,000 representing a commitment fee relating to such financing. SUBSEQUENT EVENTS: On October 4, 1996, the Lender advanced additional operating funds to the Company, and the Company issued a promissory note (the "Note") to the Lender in the amount of $575,000 payable on demand. The Note bears interest at 24% per annum. 7 MERIS LABORATORIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) The Company and the Lender are in the process of negotiating amendments to the terms of the Amended Agreement, however, under the terms of the existing Amended Agreement, the Lender may, without notice to the Company, exercise any of the remedies available to it under such agreement. There can be no assurance that such negotiation will be concluded or, if concluded, will be on terms acceptable to the Company. NOTE 5 - CONVERTIBLE SUBORDINATED DEBT: On November 14 and December 5, 1994, the Company completed a private placement consisting of the sale of $11,000,000 of unsecured convertible senior subordinated debentures (the "Debentures"). The Debentures carry a 10% interest rate and require interest to be paid monthly. In addition, the Debentures mature three years from the date of issue and are convertible sixty days from the date of issuance, at the option of the holders, into approximately 3,188,000 shares of the Company's common stock at a conversion price based on certain antidilution provisions in the Debenture Agreement. The Board of Directors have reserved an aggregate of 3,188,000 shares of the Company's common stock for issuance upon conversion of the Debentures, provided that the number of shares reserved for issuance may be subject to change in the event of any further adjustment in the conversion price of the Debentures. If the Debentures are repaid at maturity and have not been converted into common stock, the Company is required to issue warrants to purchase shares of common stock equal to the number of shares into which the Debentures outstanding would have been converted upon maturity. The warrants would be exercisable immediately, generally expire four years following the maturity date and have an exercise price equal to the conversion price at maturity. Subject to the prior payment of certain senior indebtedness, the Company may call the Debentures at any time. However, if the Debentures are called within 30 months of the date of issue, or if the Company's common stock trades below 200% of the conversion price for 20 days within a period of 30 consecutive trading days immediately prior to the Company giving notice to call the Debentures, the Company must issue warrants to purchase shares of common stock equal to the number of shares into which the Debentures outstanding could have been converted. The warrants would be exercisable immediately, expire on November 1, 1999 and have an exercise price equal to the conversion price in effect on the date of the call. The Company ascribed a value of $280,000 to the warrants issuable upon the payment of the Debentures at maturity. The value ascribed to the warrants was computed based upon an estimated spread between the cost of funds associated with the Company's senior and subordinated borrowings, recognizing the overall higher level of risk assumed by the Debenture holders. This amount was recorded as a debt discount and is reflected as an offset to the proceeds from the sale of the Debentures and is being amortized as interest expense over three years. 8 MERIS LABORATORIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Upon a change of control of the Company, the Debenture holders have a right to "put" the Debentures back to the Company at a price that will achieve a 30% internal rate of return, including interest. To the extent any warrants have been issued as a result of previous calls, the warrant holders may "put" all or part of the warrants to the Company at a price that will result in a 30% internal rate of return, including interest. However, in either instance, the premium shall not exceed 150% of the original principal amount of the Debentures. The Debentures also require that certain criteria be met, including a minimum earnings before income taxes to interest expense ratio, limitations on minimum consolidated net worth and maximum senior indebtedness, limitations on payment of other indebtedness junior to the Debentures, limitations on merging or selling all, or substantially all, of the property or business of the Company and a restriction on the repurchase of the Company's common stock. At December 31, 1995, the Company was in default of the minimum consolidated net worth covenant for which the Company obtained a waiver of the default effective through January 1, 1997 from the Debenture holders provided the Company's minimum consolidated net worth remained greater than $9 million. As of September 30, 1996, the Company was in default of the amended minimum consolidated net worth criteria. Additionally, as of September 30, 1996, the Company was in default of all the financial covenants under the Line of Credit. Such Line of Credit arrangement was assigned by the bank to a Lender on September 20, 1996 (see Note 4). The Lender acquired from the bank any and all rights, claims and causes of action under the Line of Credit including the terms of the Amended Agreement entered into by the Company and its bank on June 4, 1996 (see Note 4). Subject to the terms of the Amended Agreement and in accordance with the terms of the Debenture Agreement, the Company ceased making any further payments of accrued interest or principal on accounts of the Debentures effective May 1, 1996. Such nonpayment is an event of default under the Debenture Agreement resulting in assessment of interest on any unpaid interest and a decrease in the conversion price of the debentures by 1% per month until the overdue amounts have been paid in full. As a result, at September 30, 1996, the Debentures are convertible into 3,188,000 shares of the Company's common stock. The Company is attempting to obtain waivers of default from the Debenture holders. In the event that such waivers are not received, the convertible subordinated debt becomes due and payable and adjustments to the conversion price of the Debenture become effective. The Company has recognized the Debenture as a current liability as of September 30, 1996. Interest expense has been recorded and is included in accrued expenses at September 30, 1996. As long as an original investor or certain transferee holds any Debentures, any warrants issued in connection therewith or any shares of common stock issued on conversion of the Debentures, the Company will have, as a member of its Board 9 MERIS LABORATORIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) of Directors, a director designated by such holders. The Debenture Agreement provides for certain registration rights with respect to the Debentures, the warrants issuable in connection therewith and the common stock issuable upon the conversion of the Debentures. The Debenture Agreement also requires the Company to place in escrow all remaining amounts due to the Former Executive of the Company under a promissory note issued to him. Such amount has been recorded as restricted cash at September 30, 1996. See Note 3 and Part II. Other Information - - Item 1. Legal Proceedings. NOTE 6 - LITIGATION AND INVESTIGATION CHARGES: On May 6, 1994, the Company was subpoenaed to furnish certain documents to the Department of Health and Human Services ("HHS") with respect to the Company's Medicare and Medicaid billing practices. On July 18, 1994, the Company was subpoenaed to furnish certain documents to the Department of Defense with respect to the Company's Civilian Health and Medical Program of Uniformed Services ("CHAMPUS") billing practices. The Company believes these matters relate to the investigations of such practices being conducted with respect to other laboratories. On August 28, 1995, the Company was notified that a Qui Tam action had been filed by two former employees under the False Claims Act. The Company believes the Qui Tam action and billing investigations are related. The investigations relate to billing certain panels and profiles, adding tests to recognized panels and profiles, billing for tests deemed not to be medically necessary, improper coding, billing for tests not performed, double billing and other alleged improper practices. Through the fourth quarter of 1995, as a result of the initial and continuing correspondence and discussions with government agencies relating to certain issues under investigation, the Company recorded an aggregate charge of approximately $2,250,000. The Company has produced the documents subpoenaed by the government agencies. The Company and the government agencies have discussed a proposed settlement agreement. While the actual agreement has not been finalized, the Company recorded a charge during the third quarter of 1996 of $2,000,000 based on preliminary estimates. Such amount, when aggregated with previously recorded accruals, bring the total estimated accrual to $4,250,000. However, based on the ultimate outcome of the proposed settlement agreement, additional charges may be recorded in the future. Additionally, subsequent to the finalization of an agreement, noncompliance with any terms of such an agreement could result in the acceleration of any unpaid amounts or imposition of additional payments, fines and penalties. As a consequence of the Company's review of the reimbursements it has received from Medicare with respect to chemistry panels and certain questions raised during the investigation, the Company determined that Medicare overpaid the Company approximately $960,000 with respect to matters that were not the subject of the original investigations. This amount was charged against net revenues during September 1995. The Company repaid $350,000 of this amount in 1995 and is repaying the remaining balance in monthly installments of $50,000 commencing January 2, 1996. 10 MERIS LABORATORIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 7 - CONTINGENCIES: The Company is involved in various other lawsuits which are described in detail under Part II - Other Information - Item 1. Legal Proceedings. NOTE 8 - CURRENT ACCOUNTING PRONOUNCEMENTS: In June 1995, the American Institute of Certified Public Accountants (the "AICPA") issued the AICPA Audit and Accounting Guide for Health Care Organizations (the "Guide") to assist providers of health care services in accounting and preparation of financial statements. The provisions of the Guide are effective for financial statement periods beginning after June 15, 1996. The Company expects to adopt the provisions of the Guide effective January 1, 1997. The Company has not evaluated the financial statement impact of adopting the Guide. 11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations General The Company's principal objective is to be a leading provider of high-quality, low-cost clinical laboratory testing services in California. To achieve this objective, the Company has focused its efforts on (i) continuing implementation of technological improvements in its San Jose laboratory, which the Company hopes will further reduce operating costs per test and enhance levels of service, and (ii) increasing its volume of testing (accessions) through the acquisition of laboratories and customer lists as well as through internal growth. However, notwithstanding these efforts, the Company has incurred substantial losses during the first nine months of 1996 and in each of its last three fiscal years. Increases in net revenues and/or reductions in operating costs continue to be necessary for the Company to achieve profitability. The Company must experience growth in testing volume through acquisitions and/or internal growth. The Company's growth through acquisitions has been severely curtailed as a result of difficulties in securing acquisition financing and, despite its marketing efforts, accessions (volume of business) are decreasing. In addition, net revenues per test may continue to decrease and be lower than the Company's historical net revenues per test. Finally, the Company may also, from time to time, record charges relating to the write-down of intangible assets should the revenue stream related to acquisitions be below the carrying value of such intangible assets. Unless revenues can be increased and operating costs reduced, the Company may not remain financially viable. Given the increasing importance of managed care and other cost containment arrangements in the health care industry in California, the Company must strategically pursue laboratory service contracts with managed care providers such as health maintenance organizations. The Company anticipates that an increasing portion of its business will be attributable to these contracts. Such contracts typically provide for payment on the basis of capitated fees rather than fees for actual tests performed. Such contracts result in lower net revenues per test, however, the Company believes that these contracts could also result in identifiable referrals on a fee-for-service basis from the clients participating in the managed care contracts, thereby improving the overall performance of the arrangements. The Company's business mix has changed with a shift away from patient billing and fee-for-service. An increasing percentage of the Company's business is expected to be in managed care contracts and with third party payors where reimbursements are less than at patient prices resulting in an increasing portion of the Company's business being subject to contractual discounts. In addition, third party payor reimbursement rates have and will continue to decrease. Throughout the first nine months of 1996, certain of the HMOs previously contracted with the Company chose to utilize other laboratory service providers. Conversely, the Company was successful in obtaining additional HMO 12 contracts. The Company believes it will continue to face increasing competition with respect to obtaining and retaining managed care contracts. To the extent that reimbursement rates continue to decrease, contractual discounts continue to increase and utilization under managed care arrangements increases (or the identifiable fee-for-service revenues decrease), net revenues per test and profitability will be adversely impacted. As stated above, if these trends continue, and the Company fails to meet its objectives in increasing the volume of accessions and/or decreasing costs, management believes the viability of the Company would be adversely impacted. Additionally, as a result of the requirement that effective January 1, 1997, the Company adopt the AICPA's Audit and Accounting Guide for Health Care Organizations, (see Note 8 of Notes to Condensed Consolidated Financial Statements), which precludes the grouping of identifiable fee-for-service revenue with capitation premiums for purpose of assessing the overall profitability under capitated arrangements, the Company may, in the future, record loss acruals for existing and/or new contracts, adversely impacting its results of operations. The Company's net revenues and results of operations are impacted in large part by statutes and regulations governing Medicare and Medi-Cal and the reimbursement policies of insurance companies and other third-party payors. Pursuant to the Stark Bill, which became effective in early 1992, as amended by the Omnibus Budget and Reconciliation Act of 1993, clinical laboratories are generally prohibited from billing the Medicare program or, effective as of January 1, 1995, Medi-Cal programs or the patient or any other payor, for testing performed for Medicare or Medi-Cal patients when the physician ordering the test (or a relative of such physician) has an investment interest or compensation arrangement with the laboratory. Legislation was also enacted in California which made it unlawful, as of January 1, 1995, for a physician to refer a patient or specimen to a clinical laboratory in which the physician has an ownership interest or from which the physician receives compensation, regardless of the source of payment for such testing. Although it is difficult to quantify, the Company believes these statutes and regulations have resulted in less referrals to the Company. Acquisition Program A major element of the Company's business strategy has been to acquire clinical laboratories and customer lists. Future acquisitions, internal sales growth and retention of existing business are necessary to achieve growth in net revenues, attain profitability in the future and to leverage the Company's technological improvements. However, as a result of difficulties in securing adequate financing and other impediments resulting from the litigation and investigations (see Part II. Other Information - Item 1. Legal Proceedings), the Company's acquisition program has been severely curtailed. Furthermore, the supply of potential acquisition candidates could be adversely affected by changes in the regulatory environment in which the Company operates. 13 Statement of Operations Data The following represents selected Statement of Operations data as a percentage of net revenues: Three Months Nine Months Ended Ended September 30, September 30, ------------------ ------------------- 1996 1995 1996 1995 -------- ------- -------- --------- (Unaudited) Net revenues 100.0% 100.0% 100.0% 100.0% -------- -------- -------- -------- Cost of services: Salaries, wages and benefits 36.1 34.5 33.0 31.1 Supplies 14.0 13.3 14.2 11.8 Depreciation and amortization 9.4 10.7 9.1 10.6 Other cost of services 22.4 20.6 19.9 18.8 -------- --------- -------- -------- Total cost of services 81.9 79.1 76.2 72.3 Selling, general and administrative 37.1 28.7 31.2 27.1 Provision for doubtful accounts 14.6 6.6 17.3 10.0 Litigation and investigation charges 30.0 - 9.9 2.2 Write-down of intangible assets 1.4 - 2.4 - -------- --------- -------- -------- Operating loss (65.0)% (14.4)% (37.0)% (11.6)% ======== ========= ======== ======== Three Months Ended September 30, 1996 Compared to Three Months Ended September 30, 1995 Net Revenues. Net revenues decreased 15.3% to $8.34 million for the three months ended September 30, 1996 from $9.85 million for the same period in 1995. During the three months ended September 30, 1995, the Company recorded a charge of approximately $780,000 associated with certain overpayments received from Medicare during 1994 and 1995. Excluding the effect of the 1995 Medicare adjustment, net revenues decreased 21.5% from $10.63 million for the three months ended September 30, 1995. The decrease in net revenues reflects a 15.8% decrease in testing volume resulting partly from increased competition and decreased utilization of the Company's laboratory services by patients and clients. The general trend toward increased contractual discounts, including a reduction in the composite Medicare reimbursement rate in 1996 of approximately 4% and an increase in discounts associated with a shift to more contract payors, also contributed to the decrease in net revenues per accession. Cost of Services. Cost of services decreased 12.3% to $6.84 million for the three months ended September 30, 1996 from $7.80 million for the same period in 1995. The decrease in cost of services, including reference laboratory fees, courier costs and operating expenses for PSCs and STAT laboratories, is 14 attributable to the decrease in overall costs in relation to testing volume as well as the cost containment programs put in place in the latter part of 1995 through September 30, 1996. Salaries, wages and benefits decreased as a result of a 17.8% reduction in the number of employees. The decrease in supplies expense, primarily for reagents and testing consumables, is the net effect of an increase in supplies expense as a result of the Company bringing in-house approximately 17 tests throughout 1995 and 1996 offset by a decrease directly resulting from a decrease in testing volume. The decrease in depreciation and amortization expense is a result of the full depreciation of certain fixed assets and the write-down of certain intangible assets during the year ended December 31, 1995 and through the period ended June 30, 1996. Excluding the effect of the 1995 Medicare adjustment to net revenues, cost of services as a percent of net revenues increased to 81.9% for the three months ended September 30, 1996 from 73.4% for the same period during 1995. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by 9.5% to $3.09 million for the three months ended September 30, 1996 from $2.83 million for the same period in 1995. The increase in selling, general and administrative expenses is the net result of a reduction in commission expense as a direct result of the modification of the Company's commission structure as well as decreased net revenues offset by an increase in facility rent, utility and property costs. Excluding the effect of the 1995 Medicare adjustment, selling, general and administrative expenses as a percentage of net revenues increased to 37.1% for the three months ended September 30, 1996 from 26.6% for the corresponding period in 1995. Provision for Doubtful Accounts. The provision for doubtful accounts increased 86.1% to $1.22 million for the three months ended September 30, 1996 from $653,000 for the same period in 1995. Excluding the effect of the 1995 Medicare adjustment, the provision for doubtful accounts, as a percentage of net revenues, increased to 14.6% of net revenues for the three months ended September 30, 1996 from 6.1% of net revenues for the three months ended September 30, 1995. Of the increase in bad debt expense in the third quarter of 1996 over the same period in 1995, approximately $500,000 reflects an increase in management's estimate, resulting from modification of the estimation basis, in determining amounts which may not be ultimately collected. The increase is also attributable to the Company's efforts, commencing in early 1996, to reduce its investment in accounts receivable and increase cash flow by identifying accounts with inaccurate billing or incomplete information. The Company's initial efforts resulted in the resubmission of certain accounts to third party payors for payment and obtaining more accurate data for patient and client accounts. As a result of the resubmissions and the Company's continuing efforts in pursuing the collection of outstanding receivable balances, the Company continues to identify accounts receivable deemed to be uncollectible due to the application of payor time constraints and the Company's current limitations in financial and personnel resources to pursue collection of such accounts. Litigation and Investigation Charges. The Company recorded litigation and investigation charges during the three months ended September 30, 1996 aggregating $2,500,000. Of the total amount, $500,000 reflects accruals for estimated professional fees and other costs to be incurred in relation to existing litigation and investigations. The estimated costs are determined based 15 on actual costs incurred to date and management's best estimates as to amounts to be incurred in the foreseeable future. The remaining $2,000,000, when aggregated with an existing accrual of $2,250,000, represents the Company's estimate of the total potential liability related to the Department of Health and Human Services investigation. (See Note 6 of notes to Condensed Consolidated Financial Statements). Write-Down of Intangible Assets. During the three months ended September 30, 1996, the Company recorded a write-down for the impairment of certain customer lists, covenants not-to-compete, and goodwill aggregating approximately $115,000. Recognition of such impairment is in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," which requires that long-lived assets and certain identifiable intangibles held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Relating to acquired customers lists to the extent that assessing volume decreases, the Company may , in future periods, record additional write-downs of intangible assets. Interest Expense. Interest expense increased 27.7% to $655,000 for the three months ended September 30, 1996 from $513,000 for the same period in 1995. The increase is primarily the result of increased borrowings resulting from decreased cash collections coupled with higher interest rates. Nine Months Ended September 30, 1996 Compared to Nine Months Ended September 30, 1995 Net Revenues. Net revenues decreased 14.0% to $27.73 million for the nine months ended September 30, 1996 from $32.24 million for the same period in 1995. The decrease in net revenues reflects a 12.6% decrease in testing volume resulting partly from increased competition and decreased utilization of the Company's laboratory services by patients and clients. The general trend toward increased contractual discounts, including a reduction in the composite Medicare reimbursement rates in 1996 of approximately 4% and an increase in discounts associated with a shift to more contract payors, also contributed to the decrease in net revenues per accession. Cost of Services. Cost of services decreased 9.3% to $21.14 million for the nine months ended September 30, 1996 from $23.31 million for the same period in 1995. The decrease in cost of services, including reference laboratory fees, courier costs and operating expenses for PSCs and STAT laboratories, is attributable to the decrease in overall costs in relation to testing volume as well as the cost containment programs put in place in the latter part of 1995 through September 30, 1996. Salaries, wages and benefits decreased as a result of a 17.8% reduction in the number of employees. The increase in supplies expense, primarily for reagents and testing consumables, is the net effect of an increase in supplies expense as a result of the Company bringing in-house approximately 17 tests throughout 1995 and 1996 offset by a decrease directly resulting from a decrease in testing volume. The decrease in depreciation and amortization expense is a result of the full depreciation of certain fixed assets and the write-down of certain intangible assets during the year ended December 31, 1995 and through the period ended June 30, 1996. 16 Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased by 0.8% to $8.66 million for the nine months ended September 30, 1996 from $8.73 million for the same period in 1995. The decrease in selling, general and administrative expenses is the net result of a reduction in labor costs as a result of a $200,000 severance charge in the nine months ended September 30, 1995, and a reduction in commission expense as a direct result of the modification of the Company's commission structure as well as decreased net revenues offset by an increase in facility rent, utility and property costs. Provision for Doubtful Accounts. The provision for doubtful accounts increased 48.4% to $4.79 million for the nine months ended September 30, 1996 from $3.28 million for the same period in 1995. Of the increase in bad debt expense in the third quarter of 1996 over the same period in 1995, approximately $500,000 reflects an increase in management's estimate, resulting from modification of the estimation basis, in determining amounts which may not be ultimately collected. For the nine months ended September 30, 1996, approximately $2.83 million represents estimated uncollectible accounts due to the payor's inability to pay. The remaining $1.96 million is largely attributable to the Company's efforts, commencing in early 1996, to reduce its investment in accounts receivable and increase cash flow by identifying accounts with inaccurate billing information. The Company's initial efforts resulted in the resubmission of certain accounts to third party payors for payment and obtaining more accurate data for patient and client accounts. As a result of the resubmissions and the Company's continuing efforts in pursuing the collection of outstanding receivable balances, the Company identified, and accordingly recorded a provision for, accounts receivable deemed to be uncollectible due to the application of payor time constraints and administration problems due in part to financial and personnel constraints. Litigation and Investigation Charges. During the nine months ended September 30, 1996 and 1995, the Company recorded $750,000 and $700,000, respectively, for estimated professional fees and other costs to be incurred in relation to existing litigation and investigations. The estimated costs are determined based on actual costs incurred to date and management's best estimates as to amounts to be incurred in the foreseeable future. Also during the nine months ended September 30, 1996, the Company recorded an additional $2,000,000 which, when aggregated with an existing accrual of $2,250,000, represents the Company's estimate of the total potential liability related to the Department of Health and Human Services investigation. (See Note 6 of notes to Condensed Consolidated Financial Statements). Write-Down of Intangible Assets. During the nine months ended September 30, 1996, the Company recorded a write-down for the impairment of certain customer lists, covenants not-to-compete, and goodwill aggregating approximately $665,000. Recognition of such impairment is in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," which requires that long-lived assets and certain identifiable intangibles held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. 17 Interest Expense. Interest expense increased 19.6% to $1.82 million for the nine months ended September 30, 1996 from $1.52 million for the same period in 1995. The increase is primarily the result of increased borrowings for working capital purposes resulting from decreased cash collections coupled with higher interest rates. Income Taxes Income taxes are provided in accordance with Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes." The effective income tax rate for the nine months ended September 30, 1995 was lower than the federal statutory rate due primarily to less than full benefit from operating losses due to limited carryback opportunities and non-recognition of loss carryforwards due to uncertainty regarding realization. Variability of Quarterly Results In the past, the Company's net revenues and results of operations have fluctuated from quarter to quarter, and the Company anticipates that such fluctuations will continue in the future. Variations in payor mix, and the frequency, timing and size of recent and future acquisitions, if any, contribute to the quarterly variability of net revenues and operating results. Inherent in the clinical laboratory industry are challenges in billing and collecting accounts receivable balances. Consequently, interim results of operations are from time to time subject to fluctuations resulting from the Company's recognition of certain identified uncollectible accounts. Additionally, the Company may experience further fluctuations in quarterly net revenues and results of operations, should charges relating to the write-down of intangible assets and loss accruals for capitated contracts be recognized. Costs of continuing litigation and management participation in ongoing litigation and investigations are significant and have had, and may continue to have, a material adverse effect on the quarterly variability of the Company's operations. The Company's operations also experience seasonal trends that the Company believes affect all clinical laboratory companies. In addition, regulatory changes, reimbursement policies of governmental agencies, insurance companies and other third-party payors, and actions by the Company or its competitors, may cause fluctuations in, and adversely affect, the Company's net revenues and results of operations. Managed care contracts are generally executed for periods of at least one year. The execution of new, or the loss of existing, managed care contracts could also result in significant fluctuations in the Company's operations. 18 Liquidity and Capital Resources The Company's primary source of short-term financing for working capital purposes has been operating cash flow and the liquidation of accounts receivable. The Company, however, is currently negotiating financing arrangements with an outside lender for additional funds which would help to alleviate short-time cash constraints. Net cash used in operating activities totaled $1,087,000 for the nine months ended September 30, 1996. As of September 30, 1996, the Company had $26,000 in cash and cash equivalents, $1.96 million in restricted cash and $8.30 million of current borrowings under the loan agreement. Management believes that cash to be generated from operations, together with existing cash balances, will not be sufficient to satisfy the Company's cash requirements for the foreseeable future. The Company's cash position may be further adversely impacted by an unfavorable outcome of any of the existing litigation and/or billing investigations. The Company will require additional financing from outside sources during 1996 to remain viable. Capital expenditures during the nine months ended September 30, 1996 totaled $547,000. Of the total, the Company paid an aggregate of approximately $348,000 with respect to payments made on customer lists acquired prior to January 1, 1996. In addition, the Company purchased approximately $199,000 of computer and laboratory equipment. The Company is currently involved in a number of lawsuits including two derivative suits, one class action suit, litigation involving its former Chairman, President, and Chief Executive Officer (the "Former Executive") and other matters. Certain of the Company's billing practices are under investigation by the U.S. Department of Health and Human Services, the Department of Defense and the Department of Justice. These investigations relate to practices of laboratories in the billing of groups of tests (i.e., panels and profiles) and billing tests that have been added to recognized panels and profiles, billing for tests deemed not to be medically necessary, billing for tests not performed, double billing and other matters. As of September 30, 1996, the Company was in discussion with the government agencies regarding a proposed settlement agreement. While an actual agreement has not been finalized, the Company has accrued to date $4.25 million of estimated potential liability. In connection with these investigations and the Company's review of its Medicare reimbursements, the Company identified certain Medicare overpayments aggregating approximately $960,000 with respect to matters that were not the subject of the original investigation. The Company paid Medicare $350,000 on December 18, 1995, and is repaying the remaining balance of the overpayment in monthly installments of $50,000 commencing January 2, 1996. Costs of continuing litigation and management participation in ongoing litigation and investigations are significant and have had a material adverse effect on the Company's operations, both financially and with respect to diversion of management's attention from operations of the Company. An unfavorable outcome in any of these lawsuits or investigations would have a material adverse effect on the Company's results of 19 operations and cash flow. The ultimate outcome of these litigation matters and investigations is uncertain. In October 1992, the Company and the Former Executive entered into an agreement (the "Settlement Agreement") for the purpose of resolving certain disputes between them. The Settlement Agreement is further described in Part II. Other Information - Item 1. Legal Proceedings. The Company paid cash in the amount of $9.0 million for the repurchase of all of the Company's common stock held by the Former Executive. Additionally, the Company issued a three-year secured promissory note (the "Promissory Note") in the principal amount of $4.4 million which required installment payments on April 15, 1993 and October 28, 1993, 1994 and 1995, of which $1.41 million and $1.47 million in principal were paid during 1993 and 1994, respectively. On August 11, 1994, the Superior Court of the State of California for the County of Santa Clara entered an order in relation to the Brown action (see Part II. Other Information - Item 1. Legal Proceedings) directing the Company to, within 10 days, (i) deposit with a bank escrow, to be held in trust, the balance of approximately $3.17 million (including $1.47 million in principal paid in 1994 as described above) owing to the Former Executive under the Promissory Note and (ii) indemnify the Former Executive for legal fees and expenses incurred in the amount of approximately $364,000, and to continue to indemnify him for legal fees and expenses, as he contends is required by and subject to the provisions of the Settlement Agreement. The decision was appealed. To perfect the appeal, the Company deposited with the Superior Court the sum of $546,000 as security for the payment of the legal fees portion of the order. In connection with and using the proceeds from a bank line of credit, the Company paid the October 28, 1994 installment under the Promissory Note and deposited in an account with a bank the remaining principal and interest balance of $1,585,000 provided for thereunder as restricted cash available to satisfy future payment obligations and may be required to be paid under the Promissory Note. Since the Company believes the Former Executive is indebted to the Company in an amount in excess of the amount of the final payment on the Promissory Note, and the Company, as well as the plaintiffs in the Mills and Brown actions, are seeking rescission of the Settlement Agreement (see Part II. Other Information - Item 1. Legal Proceedings), the Company has not made the final payment under the Promissory Note. On September 26, 1995, the appellate court entered an order reversing the lower court's decision and sustaining the Company's position. On December 26, 1995, the sum deposited as security for the appeal of $546,000 was returned to the Company. The court has also held that the deposit made by the Company of $1,585,000 with the bank satisfies the earlier injunction insofar as it relates to the Promissory Note payment. In April 1995, the jury in a wrongful termination suit brought by a former employee (see Part II. Other Information - Item 1. Legal Proceedings) returned awards against the Company and in favor of such former employee in an amount aggregating $300,000. Subsequently, the judge consolidated certain of the awards and entered judgment for $253,000. Both parties have appealed. Unless modified or set aside on appeal, the judgement will have to be satisfied from existing cash resources, if available. Approximately $300,000 has been accrued for this matter at September 30, 1996. On July 27, 1995, the Company entered into an amendment of its Line of Credit agreement in which the bank agreed to issue letters of credit in an 20 aggregate amount not to exceed (i) the lesser of the total Line of Credit or the qualifying borrowing base minus (ii) any amounts outstanding under the Line of Credit, provided that the amount of outstanding letters of credit should not in any case exceed $2.0 million. The Line of Credit agreement contained certain financial covenants including a minimum quick ratio, a maximum debt to net worth ratio, a minimum tangible net worth and profitability on a monthly basis. As of September 30, 1995, the Company was in default of the quarterly profitability covenant as well as certain other ratio covenants under the Line of Credit. In addition, the failure by the Company to make the final payment on a Promissory Note (see Part II. Other Information - Item 1. Legal Proceedings) is a default under the Line of Credit. The Company obtained a waiver from the bank of all defaults. In conjunction with obtaining such waiver, on December 8, 1995, the covenants were amended to require a minimum quick ratio, minimum tangible net worth, maximum loss for the year ended December 31, 1995, and a maximum senior liabilities to earnings before interest expense, income taxes, depreciation and amortization (EBITDA) ratio. As of December 31, 1995, the Company was in default of all financial covenants under the Line of Credit and unsecured senior subordinated Debentures. The Company obtained a waiver of such default from the holders of the Debentures effective through January 1, 1997 provided that the Company's net worth remains greater than $9 million. The Company also obtained a waiver of such default from the bank as of December 31, 1995. See Notes 4 and 5 of Notes to Condensed Consolidated Financial Statements. Prior to September 20, 1996, the Company's outstanding borrowings under its line of credit arrangement (the "Line of Credit") with a bank, including unpaid interest and costs were $8.2 million (see Note 4 of Notes to Condensed Consolidated Financial Statements) which was substantially in excess of its available Line of Credit. Additionally, the Company was in default of all the financial covenants under the Line of Credit. The Line of Credit expired on April 20, 1996 and on June 4, 1996, the Company and its bank entered into an amendment to the Line of Credit Agreement (the "Amended Agreement"). Subject to the terms of the Amended Agreement and in accordance with the terms of the debenture agreement ("the Debenture Agreement") (see Note 5 of Notes to Condensed Consolidated Financial Statements), the Company is prohibited from making any further payments of accrued interest or principal on account of the convertible subordinated debentures (the "Debentures"). Such nonpayment is an event of default under the Debenture Agreement and resulted in the assessment of interest on any unpaid interest and reductions to the conversion price of the Debentures by 1% per month until the overdue amounts have been paid in full. The Amended Agreement further stated that the bank would forbear from exercising its remedies under the Line of Credit agreement until August 15, 1996, notwithstanding the Company's existing defaults. On August 14, 1996, the Company entered into a forbearance agreement with the bank which included an extension of the forbearance period to September 15, 1996. On September 20, 1996, the bank assigned the entire $8.2 million of the Company's borrowings to a private lender (the "Lender") under a privately negotiated transaction. The Lender acquired from the bank any and all rights, claims and causes of action under the Amended Agreement. On October 4, 1996, the Lender advanced additional operating funds to the Company and the Company issued a promissory note to the Lender in the amount of $575,000 payable on demand. The Company and the Lender are in the process of negotiating amendments to the terms 21 of the Amended Agreement, however, under the terms of the existing Amended Agreement, the Lender may, without notice to the Company, exercise any of the remedies available to it under such agreement. There can be no assurance that such negotiation will be concluded or, if concluded, will be on terms acceptable to the Company. As of September 30, 1996, the Company was in default of the minimum consolidated net worth criteria under the Debenture Agreement. Additionally, compliance with the terms of the Amended Agreement with respect to nonpayment of accrued interest or principal on account of the Debentures constituted an event of default under the Debenture Agreement. The Company is attempting to obtain waivers of default from the Debenture holders. In the event that such waivers are not received, the convertible subordinated debt becomes due and payable and adjustments to the conversion price of the Debenture become effective. The Company has recognized the Debenture as a current liability as of September 30, 1996. Interest expense has been recorded and is included in accrued expenses at September 30, 1996. The Company currently has no material commitments for capital expenditures. The Company anticipates making expenditures to improve its financial and billing systems and facilities in the foreseeable future subject to cash availability. If financing for other than working capital and other opportunities become available, the Company also plans to continue increasing testing volume through its acquisition program (see Acquisition Program). The Company believes that in addition to internal sales efforts, acquisitions will continue to be necessary to achieve growth in net revenues and achieve operating income in the future. There can be no assurance, however, that the Company will be successful in implementing improvements to its financial and billing systems and facilities, or that, if implemented, would have a positive impact on the Company's results of operations. There can also be no assurance that the Company will effect any future acquisitions, or if effected, such acquisitions would have a positive impact on the Company's results of operations. The Management's Discussion and Analysis of Financial Condition and Results of Operations section above and other sections of this Quarterly Report on Form 10-Q may contain certain forward-looking statements that involve risks and uncertainties. Potential risks and uncertainties relating to such forward-looking statements and the Company in general include, without limitation, that the Lender will demand payment of all outstanding borrowings and interest related thereto the Company's inability to generate cash from operations or to secure additional financing from outside sources sufficient to satisfy the Company's cash requirements in the foreseeable future, continued competitive pressures for clients and acquisition targets, continued decrease in reimbursement rates and increased promulgation of government regulation which negatively impact the Company's results of operations. Furthermore, there can be no assurance that the Company will be successful in decreasing costs, or that there will be an increase in the number of accessions performed, or that the Company will return to profitability. These risks and other risks are discussed in more detail in the Company's Securities and Exchange Act filings. 22 PART II. OTHER INFORMATION Item 1. Legal Proceedings Settlement Agreement with Former Executive On October 28, 1992, the Company entered into an agreement (the "Settlement Agreement") with its former Chairman, President and Chief Executive Officer (the "Former Executive") for the purpose of resolving certain disputes between the Former Executive and the Company. The Settlement Agreement provided for the Former Executive's resignation from the Company's Board of Directors and the Company's purchase of all of the Former Executive's 1,176,440 shares of common stock of the Company. The Settlement Agreement also provided that for a ten-year period, the Former Executive will refrain from competing with the Company in certain areas or from taking certain actions, such as the purchase of any voting securities of the Company, to influence the Company's management. The Settlement Agreement also contains mutual general releases among the Former Executive, the Company and certain of the Company's officers and directors. The purchase of the Former Executive's shares and the effectiveness of the other terms of the Agreement were conditioned upon the closing price of the Company's common stock (as quoted on the Nasdaq National Market System) reaching at least $7-5/8 per share, which occurred on November 2, 1992. The transaction closed on November 3, 1992. Of the total consideration, the Company allocated $10,315,908 to the repurchase of common stock based upon an evaluation by an independent third party. A total of $2,984,000 was initially allocated to the covenant not-to-compete. During the fourth quarter of 1993, the Company wrote off the unamortized balance of the intangible asset relating to the Settlement Agreement. Pursuant to the Settlement Agreement, the Company paid the Former Executive cash in the amount of $9,000,000 and issued the three-year secured Promissory Note in the principal amount of $4,400,000 bearing interest at a rate of 3.85% per year. The Promissory Note requires installment payments on April 15, 1993 and on October 28, 1993, 1994 and 1995. On August 11, 1994, the Company was directed by a court order to deposit with a bank escrow, to be held in trust, the outstanding balance under the Promissory Note. See discussion of the Brown action below for additional information with respect to the final payment under the Promissory Note. In consideration of the non-competition agreement, the Company also agreed to make certain additional payments to the Former Executive (the "Contingent Payments") computed by a formula based upon the trading price of the Company's common stock on certain future dates, or on the sale of all or substantially all of the Company's assets or a merger, consolidation or other transaction in which more than 50% of the Company's voting stock is transferred, upon the consideration per share paid in such transaction. The maximum amount the Former Executive could have received pursuant to the Contingent Payments provision was $4,700,000. Under the Settlement Agreement, the Company's obligation to make Contingent Payments expired on October 28, 1995. No Contingent Payments were 23 made and the Company believes none were payable, however, the Contingent Payments are part of the Former Executive's cross-complaint in the Brown action (see below). The Settlement Agreement is the subject of the derivative suits discussed below and of the cross-complaints filed therein. The plaintiffs in such derivative suits are seeking rescission of the Settlement Agreement as does the Company as an alternative remedy in its cross complaint against the Former Executive for damages in the Brown action. In addition, the Former Executive is seeking payment of the amount of the Contingent Payments in his cross complaint filed in the Brown action. Wrongful Termination Suit On August 27, 1992, a former employee of the Company filed suit against the Company in the Superior Court of Santa Clara County, California, alleging breach of contract, wrongful constructive termination in violation of public policy and defamation. The case was tried and, in April 1995, the jury returned awards aggregating $300,000 against the Company and in favor of the former employee. Subsequently, the judge consolidated certain of the awards and entered judgment for $253,000. The plaintiff and the Company have appealed the judgement. As of December 31, 1995, the Company perfected its appeal through a $379,000 surety bond (150% of the amount of the $253,000 judgement as required by the court rules). On February 21, 1996, the Company deposited in an account with a bank $379,000 provided for thereunder as restricted cash. The Company accrued approximately $300,000 at June 30, 1996 in connection with this matter. Derivative Suits On September 14, 1992, four shareholders filed a lawsuit in the Superior Court of the County of San Mateo, California, seeking to pursue various claims on a derivative basis (the "Mills action"). The suit has been transferred to the Superior Court of Santa Clara County, California. It is now in its Third Amended Complaint, and two of the original plaintiffs have withdrawn. The defendants are the Company and certain current and former directors of the Company, including the Former Executive. The Third Amended Complaint alleges various breaches of fiduciary duty by the Company's directors and seeks a declaration that the Settlement Agreement is invalid, a constructive trust for commissions paid under an agreement between the Company and Harmet Associates, an injunction prohibiting the Company in any securities offering from coupling the offering to the survival, as directors, of members of its Board of Directors (the "Board"), the reformation of the Board, an investigation by independent Board members of the Company's quality assurance procedures, compensatory and exemplary damages in an unspecified amount, an order requiring all damages to be placed in a trust fund for the benefit of the Company's shareholders so long as any defendant remains an officer or director of the Company, and compensation to the plaintiffs and attorneys fees in unspecified amounts. The Company believes that the Third Amended Complaint is without merit and is defending the lawsuit. Answers have been filed by all defendants. 24 In May 1994, a cross-complaint was filed in the Mills action by the Former Executive which named certain current and former directors, officers and employees as cross-defendants. The cross-complaint seeks indemnity for the claims made against the Former Executive in the Third Amended Complaint referred to above, and for legal fees and expenses allegedly incurred in defending such claims. The defendants believe such claims to be without merit and are defending the cross-complaint. An answer has been filed on behalf of the defendants. On July 1, 1993, a demand was made on the Board to pursue the allegations contained in a derivative lawsuit filed in the Superior Court of the State of California for the County of Santa Clara against the Company and certain of its current and former directors including the Former Executive (the "Brown action"). On July 12, 1993, the Board appointed a special committee (the "Special Committee") comprised of outside directors to investigate the allegations and to evaluate whether the Company should pursue the lawsuit. On September 30, 1993, the Special Committee determined that the allegations in the Complaint were unfounded, that the claims alleged thereon lack merit, and that it is not in the best interest of the Company for the litigation to proceed, either in the name of the plaintiffs derivatively on behalf of the Company or through the substitution of the Company as plaintiff. On that basis, the Special Committee determined that the Company should take appropriate steps to seek dismissal of the action. The Company and the individual defendants moved for summary judgment dismissing the action. The motion was denied. The Company's attempt for writ review by an appellate court of the order denying summary judgment was also denied. The Brown action is now in its Second Amended Complaint. The defendants are the Company, certain current and former directors of the Company, including the Former Executive, the Company's independent accountants and a principal of such accounting firm. The Second Amended Complaint alleges certain breaches of fiduciary duty by the Company's directors, negligence, conspiracy, breach of contract and negligent misrepresentation and seeks an order that the Settlement Agreement be rescinded and the Former Executive to return all money received under the Settlement Agreement to the Company, compensatory damages against certain defendants in the amount of $35,000,000, exemplary damages in an unspecified amount against the same defendants, an order requiring all damages be placed in trust for the benefit of the Company's shareholders so long as any defendant remains an officer or director of the Company, a declaration that the individual defendants did not act in good faith and are not entitled to indemnification, an injunction prohibiting the Company from indemnifying individual defendants and compensation to the plaintiffs and attorneys fees in unspecified amounts. The Company believes that the Second Amended Complaint is without merit and is defending the lawsuit. Answers have been filed by all defendants. On October 29, 1993, the Former Executive filed an answer and a cross-complaint in the Brown action naming as cross-defendants the Company and certain of its present and former officers, directors and employees. The cross-complaint has subsequently been amended and has added the Company's independent accountants, another director and another former employee of the Company as additional cross-defendants. As amended, the cross-complaint seeks indemnification for expenses allegedly incurred by the Former Executive in 25 connection with various legal proceedings and for such future damages as may be incurred by the Former Executive, compensatory and other damages for defamation allegedly committed by the Company and one of its officers, compensatory and other damages and injunctive relief for various unfair business practices alleged to have been committed by the defendants, damages for breach of contract, breach of the implied covenant of good faith and fair dealing, conspiracy and intentional interference with contract, the gravamen of which is that the cross-defendants deprived the Former Executive of his potential stock appreciation rights (i.e. the Contingent Payments) under the Settlement Agreement by allegedly operating the Company in such a way as to decrease the value of the Company's common stock and damages for violation of and conspiracy to violate the Racketeer Influenced and Corrupt Organization Act ("RICO"). All damage claims are for unspecified amounts to be determined by the proof or the Court. RICO damages are requested to be trebled. The Company is defending the cross-complaint. On August 11, 1994, the Superior Court of the State of California for the County of Santa Clara entered an order in relation to the Brown action directing the Company to, within 10 days, (i) deposit with a bank escrow, to be held in trust, the balance of approximately $3.17 million (to be paid to the Former Executive in two installments of $1,585,000 each on October 28, 1994 and 1995) under the Promissory Note and (ii) indemnify the Former Executive for legal fees and expenses allegedly incurred in the amount of approximately $364,000, and to continue to indemnify him for legal fees and expenses, as he contends is required by and subject to the provisions of the Settlement Agreement. In connection with and using the proceeds from a bank line of credit and the private placement of convertible subordinated debentures, the Company paid the October 28, 1994 installment under the Promissory Note and deposited in an account with a bank the remaining principal and interest balance of $1,585,000 provided for thereunder as restricted cash available to satisfy future payment obligations as may be required to be paid under the Promissory Note. Since the Company believes the Former Executive is indebted to the Company in an amount in excess of the amount of the final payment on the Promissory Note, and the Company, as well as the plaintiffs in the Mills and Brown actions, are seeking rescission of the Settlement Agreement, in lieu of making the final note payment, the Company continues to hold the balance in a separate account pending the outcome of the litigation. The Company appealed the indemnification for legal fees and expense portion of the decision, and, on September 26, 1995, the appellate court entered an order reversing the lower court's decision and sustaining the Company's position. On December 26, 1995, pursuant to court order, the sum deposited as security for the appeal of $546,000 was returned to the Company. Company's Claim Against Former Officer and Others On October 6, 1993, the Company filed in the United States District Court for the Northern District of California, a complaint against the Former Executive and certain other defendants, including certain of the plaintiffs in the Mills and Brown actions. The Court granted defendants' motion to dismiss various portions of the complaint, and, on May 25, 1994, at the Company's request, dismissed the action without prejudice. On June 10, 1994, the Company 26 filed a similar suit as a cross-complaint in the Brown action against the Former Executive and certain of the defendants in the Federal action. The Company's cross-complaint is in its third amendment as the result of the defendants' successful demurrer to certain causes of action alleged by the Company, including those based on violation of, and conspiracy to violate, RICO and civil conspiracy. The Company's most recently filed cross-complaint alleges breach of contract, promissory fraud, constructive fraud, defamation, conspiracy, breach of fiduciary duty, abuse of process, interference with contract, interference with prospective economic advantage, and violation of California Corporation Code Section 15402. It seeks compensatory and punitive damages, trebling of certain damages, indemnification, rescission of the Settlement Agreement, rescission of a consulting agreement between the Company and another former employee and defendant and certain injunctive relief. The cross-defendants have answered the cross-complaint. SEC Investigation Commencing in July 1993 the Company became involved in an investigation by the Commission relating to certain accounting, public reporting and other matters. As a result of this investigation, in August 1994, the Company elected to make certain revisions in its 1992 and 1993 financial statements. On September 26, 1994, pursuant to settlement offers by the Company and two of its officers, in which neither it nor they admitted or denied any wrongdoing, the Commission issued an order (the "Order") finding that the Company had violated certain provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 and certain rules thereunder and that the two officers, by virtue of their positions in the Company and consequent responsibility for certain matters underlying the investigation, were a cause of certain of the Company's violations. The Order contained no finding that the Company or any of its officers or directors or employees, including the two officers, knowingly or intentionally committed any violations of laws, and the Commission imposed no fines or penalties on the Company or any individuals. The settlement was entered into without any admission or denial of wrongdoing. The Company believes that the Order resolves the Commission's investigation; however, there is no assurance that the Company will not be subject to further investigations or litigation related to this matter (see Class Action Suit below). Class Action Suit On February 23, 1995, two shareholders of the Company owning an alleged aggregate of 3,161 shares of the Company's common stock filed a suit in the United States District Court for the Northern District of California. The suit seeks to proceed as a class action suit and purports to be based on the Order issued by the Commission on September 26, 1994. The Company, certain current and former officers and directors and certain of its investment bankers, attorneys and independent accountants were named defendants. The complaint alleges violations of Federal and state securities laws and seeks monetary damages in an unspecified amount and equitable relief based on alleged misrepresentations contained in a registration statement and a prospectus filed with the Commission and alleged fraudulent acts and practices of the defendants. A motion to dismiss the complaint was filed by the defendants. Motions to dismiss the complaint have been granted with respect to certain claims, granted with leave to amend with 27 respect to other claims and denied with respect to the scienter based securities laws claims against the Company and two of its officers. Plaintiffs have filed an amended complaint against the Company, four of its former and current officers and its independent accountants. A motion to dismiss the amended complaint with respect to the independent accountant has been granted, and a motion to dismiss with respect to other defendants was denied. The Company believes the amended complaint is without merit and is defending the law suit. In response to cross-motions to certify and decertify the class action, the court orally stated recently that it would certify the suit as a class action suit. No written opinion has been received from the court ordering the certification. Investigations of Billing Practices; Qui Tam Suit On May 6, 1994, the Company was subpoenaed to furnish certain documents to the Department of Health and Human Services ("HHS") with respect to the Company's Medicare and Medicaid billing practices. On July 18, 1994, the Company was subpoenaed to furnish certain documents to the Department of Defense with respect to the Company's Civilian Health and Medical Program of Uniformed Services ("CHAMPUS") billing practices. The Company believes these matters relate to the investigations of such practices being conducted with respect to other laboratories. On August 28, 1995, the Company was notified that a Qui Tam action had been filed by two former employees under the False Claims Act. The Company believes the Qui Tam action and billing investigations are related. The investigations relate to billing certain panels and profiles, adding tests to recognized panels and profiles, billing for tests deemed not to be medically necessary, improper coding, billing for tests not performed, double billing and other alleged improper practices. During the fourth quarter of 1995, as a result of correspondence and discussions with government agencies relating to certain issues under investigation, the Company recorded a charge of approximately $2,000,000. The Company has produced the documents subpoenaed by the government agencies and both the Company and the government agencies have discussed a proposed settlement. While the actual agreement has not been finalized, the Company recorded a charge during the third quarter of 1996 of $2,000,000 based on preliminary estimates. Such amounts, when aggregated with previously recorded accruals, bring the total estimated accrual to $4,250,000. However, based on the ultimate outcome of the proposed settlement agreement, additional charges may be recorded in the future. Additionally, subsequent to the finalization of an agreement, noncompliance with any terms of such an agreement could result in the acceleration of any unpaid amounts or imposition of additional payments, fines and penalties. As a consequence of the Company's review of the reimbursements it has received from Medicare with respect to chemistry panels and certain questions raised during the investigation, the Company determined that Medicare overpaid the Company approximately $960,000 with respect to matters that were not the subject of the original investigations. This amount was charged against net revenues for the three months ended September 30, 1995. The Company repaid $350,000 of this amount during 1995 and is repaying the remaining balance in monthly installments of $50,000 commencing January 2, 1996. 28 Other Suits Members of the Company's current management are defendants in certain legal actions, including the actions described above, that have been brought by former employees and shareholders of the Company. These actions are believed to be without merit and are being defended with the Company's assistance. Additionally, the Company is involved in various other lawsuits and legal matters in the ordinary course of business. It is the opinion of management that the ultimate resolution of these lawsuits and legal matters will not have a material adverse effect on the Company's consolidated financial position or results of operations. 29 Item 3. Defaults Upon Senior Securities Prior to September 20, 1996, the Company's outstanding borrowings under its line of credit arrangement (the "Line of Credit") with a bank, including unpaid interest and costs were $8.2 million (see Note 4 of Notes to Condensed Consolidated Financial Statements) which was substantially in excess of its available Line of Credit. Additionally, the Company was in default of all the financial covenants under the Line of Credit. The Line of Credit expired on April 20, 1996 and on June 4, 1996, the Company and its bank entered into an amendment to the Line of Credit Agreement (the "Amended Agreement"). Subject to the terms of the Amended Agreement and in accordance with the terms of the debenture agreement ("the Debenture Agreement") (see Note 5 of Notes to Condensed Consolidated Financial Statements), the Company is prohibited from making any further payments of accrued interest or principal on account of the convertible subordinated debentures (the "Debentures"). Such nonpayment is an event of default under the Debenture Agreement and resulted in the assessment of interest on any unpaid interest and reductions to the conversion price of the Debentures by 1% per month until the overdue amounts have been paid in full. The Amended Agreement further stated that the bank would forbear from exercising its remedies under the Line of Credit agreement until August 15, 1996, notwithstanding the Company's existing defaults. On August 14, 1996, the Company entered into a forbearance agreement with the bank which included an extension of the forbearance period to September 15, 1996. On September 20, 1996, the bank assigned the entire $8.2 million of the Company's borrowings to a private lender (the "Lender") under a privately negotiated transaction. The Lender acquired from the bank any and all rights, claims and causes of action under the Amended Agreement. On October 4, 1996, the Lender advanced additional operating funds to the Company and the Company issued a promissory note to the Lender in the amount of $575,000 payable on demand. The Company and the Lender are in the process of negotiating amendments to the terms of the Amended Agreement, however, under the terms of the existing Amended Agreement, the Lender may, without notice to the Company, exercise any of the remedies available to it under such agreement. There can be no assurance that such negotiation will be concluded or, if concluded, will be on terms acceptable to the Company. As of September 30, 1996, the Company was in default of the minimum consolidated net worth criteria under the Debenture Agreement. Additionally, compliance with the terms of the Amended Agreement with respect to nonpayment of accrued interest or principal on account of the Debentures constituted an event of default under the Debenture Agreement. The Company is attempting to obtain waivers of default from the Debenture holders. In the event that such waivers are not received, the convertible subordinated debt becomes due and payable and adjustments to the conversion price of the Debenture become effective. The Company has recognized the Debenture as a current liability as of September 30, 1996. Interest expense has been recorded and is included in accrued expenses at September 30, 1996. 30 Item 5. Other Information On October 28, 1996, the Company announced the resignation of William E. Neeley, M.D. from the position of President of Meris Laboratories, Inc. In addition, effective November 1, 1996, Dr. Neeley also resigned as a member of the Board of Directors. Henry E. Bose, most recently the Company's General Counsel, has been appointed as the acting President and Chief Executive Officer pending the hiring of a permanent replacement. 31 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 10.1 Consulting Agreement, dated as of August 9, 1996, entered into between the Registrant and Stephen P. Monticelli Exhibit 10.2 Consulting Agreement, dated as of August 9, 1996, entered into between the Registrant and Henry W. Poett III Exhibit 10.3 Consulting Agreement, dated as of October 1, 1996, entered into between the Registrant and Henry E. Bose Exhibit 10.4 Letter dated October 1, 1996 to confirm the further understandings with respect to the Consulting Agreement between the Registrant and Henry E. Bose dated October 1, 1996 Exhibit 10.5 Term Promissory Note, dated as of September 6, 1996, entered into between the Registrant and Madeleine L.L.C. Exhibit 11 Computation of earnings per common shares Exhibit 27 Financial Data Schedule (b) Reports on Form 8-K None. 32 SIGNATURES Pursuant to the requirements 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. MERIS LABORATORIES, INC. By: /s/ Thurman Jordan -------------------------------------- Thurman Jordan Senior Vice President - Finance (Duly authorized Officer and Principal Financial and Accounting Officer) Date: November 14, 1996 33 EXHIBIT INDEX Exhibit Number Document - ------- -------- 10.1 Consulting Agreement, dated as of August 9, 1996, entered into between the Registrant and Stephen P. Monticelli 10.2 Consulting Agreement, dated as of August 9, 1996, entered into between the Registrant and Henry W. Poett III 10.3 Consulting Agreement, dated as of October 1, 1996, entered into between the Registrant and Henry E. Bose 10.4 Letter dated October 1, 1996 to confirm the further understandings with respect to the Consulting Agreement between the Registrant and Henry E. Bose dated October 1, 1996 10.5 Term Promissory Note, dated as of September 6, 1996, entered into between the Registrant and Madeleine L.L.C. 11 Computation of earnings per common shares 27 Financial Data Schedule 34