AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON APRIL 3, 1998
REGISTRATION NO.
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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM S-4
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
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MAGELLAN HEALTH SERVICES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 8060 58-1076937
(State or other jurisdiction of (Primary Standard Industrial (I.R.S. Employer
incorporation or organization) Classification Code Number) Identification No.)
3414 Peachtree Road, N.E.
Suite 1400
Atlanta, Georgia 30326
404-841-9200
(Address, including zip code, and telephone number,
including area code, of registrant's principal executive offices)
------------------------
DAVID J. HANSEN, ESQ.
Vice President and
General Counsel
Magellan Health Services, Inc.
3414 Peachtree Road, N.E.
Suite 1400
Atlanta, Georgia 30326
404-841-9200
(Name, address, including zip code, and telephone number,
including area code, of agent for service)
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COPY TO:
PHILIP A. THEODORE, ESQ.
King & Spalding
191 Peachtree Street
Atlanta, Georgia 30303-1763
(404) 572-4600
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APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC:
AS SOON AS PRACTICABLE AFTER THIS REGISTRATION STATEMENT BECOMES EFFECTIVE.
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If the securities being registered on this Form are being offered in
connection with the formation of a holding company and there is compliance with
General Instruction G, check the following box: / /
If this form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, check the following box and
list the Securities Act registration statement number of the earlier effective
registration statement for the same offering. / /
If this form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. / /
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CALCULATION OF REGISTRATION FEE
PROPOSED MAXIMUM PROPOSED MAXIMUM
TITLE OF EACH CLASS OF AMOUNT TO BE OFFERING PRICE AGGREGATE
SECURITIES TO BE REGISTERED REGISTERED PER NOTE OFFERING PRICE
9% Series A Senior Subordinated Notes due
2008..................................... $625,000,000 $1,000(1) $625,000,000
TITLE OF EACH CLASS OF AMOUNT OF
SECURITIES TO BE REGISTERED REGISTRATION FEE
9% Series A Senior Subordinated Notes due
2008..................................... $184,375(2)
(1) Estimated solely for purposes of calculating the registration fee.
(2) Pursuant to Rule 457(f), the registration fee was computed based on the
market value of the $625,000,000 aggregate principal amount of the
Registrant's 9% Senior Subordinated Notes due 2008 for which the Registrant
offers to exchange the securities to be registered.
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THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF
THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE SECURITIES AND EXCHANGE COMMISSION, ACTING
PURSUANT TO SAID SECTION 8(A), MAY DETERMINE.
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MAGELLAN HEALTH SERVICES, INC.
CROSS-REFERENCE SHEET
FOR REGISTRATION STATEMENT ON FORM S-4
AND INFORMATION STATEMENT/PROSPECTUS
ITEM CAPTION IN INFORMATION
NUMBER CAPTION STATEMENT/PROSPECTUS
- --------- -------------------------------------------------- ----------------------------------------------------
1. Forepart of Registration Statement and Outside
Front Cover Page of Prospectus.................. Facing Page of Registration Statement; Outside Front
Cover Page of Prospectus.
2. Inside Front and Outside Back Cover Pages of
Prospectus...................................... Inside Front and Outside Back Cover Pages of
Prospectus; Available Information.
3. Risk Factors, Ratio of Earnings to Fixed Charges
and Other Information........................... Summary; Risk Factors; Certain Federal Income Tax
Consequences of the Exchange Offer; The Exchange
Offer; Magellan Selected Historical Consolidated
Financial Information; Merit Consolidated
Financial Information; Magellan Unaudited Pro
Forma Financial Information.
4. Terms of the Transaction.......................... Summary; Risk Factors; The Exchange Offer; Certain
Federal Income Tax Consequences of the Exchange
Offer; Description of the New Notes; Plan of
Distribution.
5. Pro Forma Financial Information................... Summary; Capitalization; Magellan Selected
Historical Consolidated Financial Information;
Merit Selected Historical Consolidated Financial
Information; Unaudited Pro Forma Financial
Information.
6. Material Contacts with the Company Being
Acquired........................................ Not Applicable.
7. Additional Information Required for
Reoffering by Persons and Parties Deemed to be
Underwriters.................................... Not Applicable.
8. Interests of Named Experts and Counsel............ Legal Matters; Independent Auditors and Public
Accountants.
9. Disclosure of Commission Position on
Indemnification for Securities Act
Liabilities..................................... Not Applicable.
10. Information With Respect to S-3 Registrants....... Not Applicable.
11. Incorporation of Certain Information by
Reference....................................... Not Applicable.
12. Information With Respect to S-2 or
S-3 Registrants................................. Not Applicable.
13. Incorporation of Certain Information by
Reference....................................... Not Applicable.
ITEM CAPTION IN INFORMATION
NUMBER CAPTION STATEMENT/PROSPECTUS
- --------- -------------------------------------------------- ----------------------------------------------------
14. Information With Respect to Registrants Other than
S-3 or S-2 Registrants.......................... Summary; The Company; Risk Factors; The Acquisition;
Capitalization; Magellan Selected Historical
Consolidated Financial Information; Merit Selected
Historical Consolidated Financial Information;
Unaudited Pro Forma Financial Information;
Magellan's Management's Discussion and Analysis of
Financial Condition and Results of Operations;
Merit's Management's Discussion and Analysis of
Financial Condition and Results of Operations;
Business; Management; Executive Compensation;
Security Ownership of Certain Beneficial Owners
and Management; Certain Relationships and Related
Transactions; Index to Financial Statements;
Financial Statements.
15. Information With Respect to S-3 Companies......... Not Applicable.
16. Information With Respect to S-2 or S-3
Companies....................................... Not Applicable.
17. Information With Respect to Companies Other Than
S-2 or S-3 Companies............................ Not Applicable.
18. Information if Proxies, Consents or
Authorizations are to be Solicited.............. Not Applicable.
19. Information if Proxies, Consents or
Authorizations are not to be Solicited, or in an
Exchange Offer.................................. Summary; Management; Security Ownership of Certain
Beneficial Owners and Management.
PROSPECTUS
$625,000,000 [LOGO]
MAGELLAN HEALTH SERVICES, INC.
OFFER TO EXCHANGE ITS
9% SERIES A SENIOR SUBORDINATED NOTES DUE 2008
FOR ANY AND ALL OF ITS OUTSTANDING
9% SENIOR SUBORDINATED NOTES DUE 2008
THE EXCHANGE OFFER WILL EXPIRE AT 5:00 P.M., NEW YORK CITY TIME, ON [ ],
1998, UNLESS EXTENDED.
Magellan Health Services, Inc., a Delaware corporation (the "Company"),
hereby offers (the "Exchange Offer"), upon the terms and subject to the
conditions set forth in this Prospectus (this "Prospectus") and the accompanying
Letter of Transmittal (the "Letter of Transmittal"), to exchange $1,000
principal amount of its 9% Series A Senior Subordinated Notes due 2008 (the "New
Notes"), which have been registered under the Securities Act of 1933, as amended
(the "Securities Act"), pursuant to a Registration Statement of which this
Prospectus is a part, for each $1,000 principal amount of its outstanding 9%
Senior Subordinated Notes due 2008 (the "Old Notes"), which have not been
registered under the Securities Act. The aggregate principal amount of the Old
Notes currently outstanding is $625,000,000. The form and terms of the New Notes
are the same as the form and terms of the Old Notes except that (i) the New
Notes have been registered under the Securities Act and, therefore, will not
bear legends restricting their transfer, (ii) holders of New Notes will not be
entitled to certain rights under the Registration Rights Agreement (as defined),
which rights will terminate when the Exchange Offer is consummated, and (iii)
the New Notes have been given a series designation to distinguish them from the
Old Notes. The New Notes will evidence the same debt as the Old Notes (which
they will replace) and will be issued under and be entitled to the benefits of
the indenture governing the Old Notes dated as of February 12, 1998 (the
"Indenture"). The Old Notes and the New Notes are sometimes referred to herein
collectively as the "Notes." See "The Exchange Offer" and "Description of the
New Notes." The Company will accept for exchange and exchange any and all Old
Notes validly tendered and not withdrawn prior to 5:00 p.m., New York City time,
on [ ], 1998, unless extended by the Company in its sole discretion (the
"Expiration Date"). Tenders of Old Notes may be withdrawn at any time prior to
5:00 p.m. on the Expiration Date. The Exchange Offer is subject to certain
customary conditions. See "The Exchange Offer." Old Notes may be tendered only
in integral multiples of $1,000.
The New Notes will be unsecured and will be subordinated in right of payment
to all existing and future Senior Indebtedness (as defined) of the Company. The
New Notes will rank PARI PASSU with all future Senior Subordinated Indebtedness
(as defined) of the Company and will rank senior to all future Subordinated
Obligations (as defined) of the Company. The Company conducts substantially all
of its operations through its subsidiaries. Therefore, the New Notes will be
effectively subordinated to all liabilities of the Company's subsidiaries. The
Indenture permits the Company and its subsidiaries to incur additional
indebtedness, including Senior Indebtedness, subject to certain restrictions. As
of December 31, 1997, on a pro forma basis after giving effect to the
Transactions (as defined), (i) the aggregate amount of the Company's outstanding
Senior Indebtedness would have been $590.2 million (exclusive of unused
commitments), substantially all of which would have been Secured Indebtedness
(as defined) and would have been guaranteed by substantially all of the
Company's subsidiaries, (ii) the Company would have had no Senior Subordinated
Indebtedness other than the New Notes and no Indebtedness that is subordinate or
junior in right of payment to the New Notes and (iii) the outstanding
indebtedness of the Company's subsidiaries (excluding guarantees of the
Company's indebtedness) would have been $346.0 million, substantially all of
which would have been Secured Indebtedness.
The Company sold the Old Notes on February 12, 1998, in transactions that
were not registered under the Securities Act in reliance upon the exemption
provided in Section 4(2) of the Securities Act. The initial purchaser of the Old
Notes subsequently resold the Old Notes to "qualified institutional buyers" in
reliance upon Rule 144A under the Securities Act or pursuant to offers and sales
that occurred outside the United States within the meaning of Regulation S under
the Securities Act. Accordingly, the Old Notes may not be reoffered, resold or
otherwise transferred unless so registered or unless an applicable exemption
from the registration requirements of the Securities Act is available. See "The
Exchange Offer--Purpose and Effect of the Exchange Offer." The New Notes are
being offered for exchange hereby to satisfy certain obligations of the Company
under the Exchange and Registration Rights Agreement, dated February 12, 1998,
among the Company and the initial purchaser of the Old Notes (the "Registration
Rights Agreement"). Based on existing interpretations of the staff of the
Division of Corporation Finance (the "Staff") of the Securities and Exchange
Commission (the "Commission") with respect to similar transactions, the Company
believes that New Notes issued pursuant to the Exchange Offer in exchange for
Old Notes may be offered for resale, resold and otherwise transferred by holders
thereof (other than any such holder which is an "affiliate" of the Company
within the meaning of Rule 405 under the Securities Act ) without compliance
with the registration and prospectus delivery requirements of the Securities
Act, provided that such New Notes are acquired in the ordinary course of such
holders' business and such holders are not engaged in, have no arrangement with
any person to participate in, and do not intend to engage in any public
distribution of the New Notes. Each broker-dealer that receives New Notes for
its own account pursuant to the Exchange Offer must acknowledge that it will
deliver a resale prospectus in connection with any resale of such New Notes. The
Letter of Transmittal which accompanies this Prospectus states that by so
acknowledging and by delivering a resale prospectus, a broker-dealer will not be
deemed to admit to be acting in the capacity of an "underwriter" (within the
meaning of Section 2(11) of the Securities Act). This Prospectus, as it may be
amended or supplemented from time to time, may be used by a broker-dealer in
connection with resales of New Notes received in exchange for Old Notes where
such Old Notes were acquired by such broker-dealer as a result of market-making
or other trading activities. The Company has agreed that, for a period of 180
days after the date on which the Registration Statement of which this Prospectus
is a part is first declared effective, it will make this Prospectus available to
any broker-dealer for use in connection with any such resale. See "Plan of
Distribution."
SEE "RISK FACTORS" BEGINNING ON PAGE 23 FOR A DESCRIPTION OF CERTAIN RISKS
TO BE CONSIDERED BY HOLDERS WHO TENDER THEIR OLD NOTES IN THE EXCHANGE OFFER.
------------------------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL
OFFENSE.
THE DATE OF THIS PROSPECTUS IS [ ], 1998.
(CONTINUED FROM FRONT COVER)
Holders of Old Notes whose Old Notes are not tendered and accepted in the
Exchange Offer will continue to hold such Old Notes and will be entitled to all
the rights and preferences and will be subject to the limitations applicable
thereto under the Indenture, and with respect to transfer, under the Securities
Act. The Company will not receive any proceeds from the Exchange Offer and will
pay all the expenses incurred by it incident to the Exchange Offer. Any Old
Notes not accepted for exchange for any reason will be returned without expense
to the tendering holders thereof as promptly as practicable after the expiration
or termination of the Exchange Offer. See "The Exchange Offer." Prior to the
Exchange Offer, there is no public market for the Old Notes. The New Notes will
not be listed on any securities exchange, but the Old Notes are included in the
Private Offerings, Resales and Trading through Automated Linkages ("PORTAL")
Market for trading among "qualified institutional buyers." There can be no
assurance that an active trading market for the New Notes will develop. To the
extent that a market for the New Notes does develop, the market value of the New
Notes will depend on market conditions (such as yields on alternative
investments), general economic conditions, the Company's financial condition and
certain other factors. Such conditions might cause the New Notes, to the extent
that they are traded, to trade at a significant discount from face value. See
"Risk Factors--Absence of Trading Markets."
NEW HAMPSHIRE RESIDENTS ONLY
Neither the fact that a registration statement or an application for a
license has been filed under Chapter 421-B of the New Hampshire Revised Statutes
with the State of New Hampshire nor the fact that a security is effectively
registered or a person is licensed in the State of New Hampshire constitutes a
finding by the Secretary of State that any document filed under Chapter 421-B of
the New Hampshire Revised Statutes is true, complete and not misleading. Neither
any such fact nor the fact that an exemption or exception is available for a
security or a transaction means that the Secretary of State has passed in any
way upon the merits or qualifications of, or recommended or given approval to,
any person, security or transaction. It is unlawful to make, or cause to be
made, to any prospective purchaser, customer or client any representation
inconsistent with the provisions of this paragraph.
2
SUMMARY
THE FOLLOWING SUMMARY IS QUALIFIED IN ITS ENTIRETY BY THE MORE DETAILED
INFORMATION AND FINANCIAL STATEMENTS, INCLUDING THE NOTES THERETO, APPEARING
ELSEWHERE IN THIS PROSPECTUS. UNLESS THE CONTEXT OTHERWISE REQUIRES, ALL
REFERENCES HEREIN TO THE "COMPANY" REFER TO MAGELLAN HEALTH SERVICES, INC. AND
ITS CONSOLIDATED SUBSIDIARIES. ALL REFERENCES TO FISCAL YEARS IN THIS PROSPECTUS
REFER TO YEARS ENDED SEPTEMBER 30. DATA PRESENTED IN THIS PROSPECTUS ON A PRO
FORMA BASIS FOR THE YEAR ENDED SEPTEMBER 30, 1997, AND FOR THE QUARTER ENDED
DECEMBER 31, 1997, GIVE EFFECT TO: (I) THE CRESCENT TRANSACTIONS (AS DEFINED);
(II) THE COMPANY'S ACQUISITION (THE "ACQUISITION") OF MERIT BEHAVIORAL CARE
CORPORATION ("MERIT"), WHICH WAS CONSUMMATED ON FEBRUARY 12, 1998; (III) THE
COMPANY'S ACQUISITION OF HUMAN AFFAIRS INTERNATIONAL, INCORPORATED ("HAI"),
WHICH WAS CONSUMMATED ON DECEMBER 4, 1997; (IV) THE COMPANY'S ACQUISITION OF
ALLIED HEALTH GROUP, INC. AND CERTAIN OF ITS AFFILIATES ("ALLIED"), WHICH WAS
CONSUMMATED ON DECEMBER 5, 1997; (V) MERIT'S ACQUISITION OF CMG HEALTH, INC.
("CMG"), WHICH WAS CONSUMMATED ON SEPTEMBER 12, 1997; AND (VI) EACH OF THE OTHER
TRANSACTIONS (AS DEFINED). PRO FORMA STATEMENT OF OPERATIONS DATA GIVE EFFECT TO
THE EVENTS DESCRIBED IN THE PRECEEDING SENTENCE AS IF THEY OCCURRED ON OCTOBER
1, 1996; PRO FORMA BALANCE SHEET DATA GIVE EFFECT TO SUCH EVENTS AS IF THEY
OCCURRED ON DECEMBER 31, 1997. SEE "UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL
INFORMATION." UNLESS OTHERWISE INDICATED, ALL INDUSTRY DATA SET FORTH IN THIS
PROSPECTUS HAVE BEEN DERIVED FROM "MANAGED BEHAVIORAL HEALTH MARKET SHARE IN THE
UNITED STATES 1997-1998" PUBLISHED BY OPEN MINDS, GETTYSBURG, PENNSYLVANIA
(HEREINAFTER REFERRED TO AS "OPEN MINDS").
ON MARCH 3, 1998, THE COMPANY ENTERED INTO DEFINITIVE AGREEMENTS WITH
CRESCENT OPERATING, INC. ("COI") AND CHARTER BEHAVIORAL HEALTH SYSTEMS, LLC
("CBHS") TO, AMONG OTHER THINGS, SELL THE COMPANY'S FRANCHISE OPERATIONS,
CERTAIN DOMESTIC PROVIDER OPERATIONS AND CERTAIN OTHER ASSETS AND OPERATIONS FOR
$280.0 MILLION IN CASH AND THE NUMBER OF SHARES OF COI COMMON STOCK OBTAINED BY
DIVIDING $30.0 MILLION BY THE AVERAGE CLOSING PRICE OF A SHARE OF COI COMMON
STOCK FOR THE TEN TRADING DAYS PRECEDING CONSUMMATION OF THE TRANSACTIONS (THE
"CBHS TRANSACTIONS"). SEE "PENDING SALE OF PROVIDER BUSINESS." UNLESS OTHERWISE
INDICATED, DATA PROVIDED IN THIS OFFERING MEMORANDUM ON A PRO FORMA BASIS DO NOT
GIVE EFFECT TO THE CBHS TRANSACTIONS.
THE COMPANY
OVERVIEW
The Company is the nation's largest provider of managed behavioral
healthcare services, offering a broad array of cost-effective managed behavioral
healthcare products. As a result of the Acquisition, the Company has over 58.0
million covered lives under managed behavioral healthcare contracts and manages
behavioral healthcare programs for over 4,000 customers. Through its current
network of over 34,000 providers and 2,000 treatment facilities, the Company
manages behavioral healthcare programs for Blue Cross/Blue Shield organizations,
health maintenance organizations ("HMOs") and other insurance companies,
corporations, federal, state and local governmental agencies, labor unions and
various state Medicaid programs. The Company believes it has the largest and
most comprehensive behavioral healthcare provider network in the United States
as a result of the Acquisition. In addition to the Company's managed behavioral
healthcare products, the Company offers specialty managed care products related
to the management of certain chronic conditions. The Company also offers a broad
continuum of behavioral healthcare services to approximately 2,900 individuals
who receive healthcare benefits funded by state and local governmental agencies
through National Mentor, Inc., its wholly-owned public-sector provider
("Mentor"). Furthermore, the Company franchises the "CHARTER" System of
behavioral healthcare to the acute-care psychiatric hospitals and other
behavioral care facilities operated by CBHS, an entity in which the Company owns
a 50% equity interest. On a pro forma basis, the Company had revenues of $1.6
billion and Adjusted EBITDA (as defined) of $268.4 million in fiscal 1997. If
the CBHS Transactions are consummated, the Company will no longer have franchise
operations or an ownership interest in CBHS. On a pro forma basis and after
giving effect to the CBHS
3
Transactions, the Company would have had revenues of $1.4 billion and Adjusted
EBITDA of $204.9 million in fiscal 1997.
The Company's professional care managers coordinate and manage the delivery
of behavioral healthcare treatment services through the Company's network of
providers, which includes psychiatrists, psychologists, licensed clinical social
workers, marriage and family therapists and licensed clinical professional
counselors. The treatment services provided by the Company's extensive
behavioral provider network include outpatient programs (such as counseling and
therapy), intermediate care programs (such as sub-acute emergency care,
intensive outpatient programs and partial hospitalization services), inpatient
treatment services and alternative care services (such as residential treatment,
home and community-based programs and rehabilitative and support services). The
Company provides these services through: (i) risk-based products, (ii) employee
assistance programs ("EAPs"), (iii) administrative services-only products ("ASO
products") and (iv) products that combine features of some or all of these
products. Under risk-based products, the Company arranges for the provision of a
full range of behavioral healthcare services for beneficiaries of its customers'
healthcare benefit plans through fee arrangements under which the Company
assumes all or a portion of the responsibility for the cost of providing such
services in exchange for a fixed per member per month fee. Under EAPs, the
Company provides assessment services to employees and dependents of its
customers, and if required, referral services to the appropriate behavioral
healthcare service provider. Under ASO products, the Company provides services
such as utilization review, claims administration and provider network
management. The Company does not assume the responsibility for the cost of
providing healthcare services pursuant to its ASO products. As a result of the
Acquisition, based on total covered lives, the Company is the industry leader
with respect to risk-based, ASO, EAP and integrated products. For its fiscal
year ended September 30, 1997, on a pro forma basis, risk-based, ASO, EAP and
integrated products would have accounted for 73%, 12%, 9% and 5%, respectively,
of the Company's managed behavioral healthcare net revenues. The Company was
incorporated in 1969 under the laws of the State of Delaware. The Company's
principal executive offices are located at 3414 Peachtree Road, N.E., Suite
1400, Atlanta, Georgia 30326, and its telephone number is (404) 841-9200.
INDUSTRY OVERVIEW
According to industry sources, in 1994 (the most recent year for which such
information was available), direct behavioral healthcare services treatment
costs amounted to approximately $81.0 billion, or approximately 8% of total
healthcare industry spending. In response to increasing healthcare costs, payors
of behavioral healthcare services have increasingly turned to managed care in an
effort to control costs. As a result, the managed behavioral healthcare industry
has experienced significant growth over the past several years. According to
OPEN MINDS, the total number of Americans enrolled in managed behavioral
healthcare plans increased from approximately 86.0 million in 1993 to
approximately 149.0 million in 1997, a compound annual growth rate of
approximately 15%. In an effort to control costs, payors are increasingly
utilizing risk-based products, and the number of risk-based covered lives has
increased from approximately 13.6 million, or approximately 16% of the total, in
1993 to approximately 38.9 million, or approximately 26% of the total, in 1997,
representing a compound annual growth rate of over 30%. Risk-based products
typically generate higher revenues per member per month than other managed
behavioral healthcare products. According to OPEN MINDS, although only 26% of
total managed behavioral healthcare covered lives were enrolled in risk-based
products in 1997, such products accounted for approximately two-thirds of the
total managed behavioral healthcare premiums during the survey period. In
addition to the trend toward the increased use of risk-based products, the
Company believes that payors are increasingly seeking to contract with larger
managed behavioral healthcare providers that are able to: (i) provide a
consistent quality of service on a nationwide basis, (ii) control costs through
economies of scale in administrative operations, and (iii) enter into
cost-effective provider contracts. As a result, the industry has consolidated,
and the three largest providers (including the Company after the Acquisition)
currently account for approximately 60% of all
4
covered lives, an increase from 1992 when the top three providers accounted for
approximately 37% of all covered lives.
COMPETITIVE STRENGTHS
The Company believes it benefits from the competitive strengths described
below with respect to its managed behavioral healthcare business, which should
allow it to increase its revenues and cash flow. Furthermore, the Company
believes it can leverage its competitive strengths to expand its service
offerings into other specialty managed care products.
INDUSTRY LEADERSHIP. As a result of the Acquisition, the Company became the
nation's largest provider of managed behavioral healthcare services in the
United States with over 58.0 million covered lives. The Company believes it also
now has the number one market position in each of the major product markets in
which it competes. The Company believes its industry leading position will
enhance its ability to: (i) provide a consistent level of high quality service
on a nationwide basis; (ii) enter into favorable agreements with behavioral
healthcare providers that allow it to effectively control healthcare costs for
its customers; and (iii) effectively market its managed care products to large
corporate, HMO and insurance customers, which, the Company believes,
increasingly prefer to be serviced by a single-source provider on a national
basis.
BROAD PRODUCT OFFERING AND NATIONWIDE PROVIDER NETWORK. The Company offers
a full spectrum of behavioral managed care products that can be designed to meet
specific customer needs, including risk-based and partial risk-based products,
integrated EAPs, stand-alone EAPs and ASO products. The Company's nationwide
provider network encompasses over 34,000 providers and 2,000 treatment
facilities in all 50 states. The combination of broad product offerings and a
nationwide provider network allows the Company to meet virtually any customer
need for managed behavioral healthcare on a nationwide basis, and positions the
Company to capture incremental revenue opportunities resulting from the
continued growth of the managed behavioral healthcare industry and the continued
migration of its customers from ASO and EAP products to higher revenue
risk-based products.
BROAD BASE OF STRONG CUSTOMER RELATIONSHIPS. The Company enjoys strong
customer relationships across all its markets, as evidenced by a contract
renewal rate of over 90% during the last three fiscal years. Management believes
that its strong customer relationships are attributable to the Company's broad
product offering, nationwide provider network, commitment to quality care and
ability to manage behavioral healthcare costs effectively. Following the
Acquisition, the Company's leading customers include: (i) Blue Cross/Blue Shield
organizations; (ii) national HMOs and other large insurers, such as Aetna/US
Healthcare, Humana and Prudential; (iii) large corporations, such as IBM,
Federal Express and AT&T; (iv) state and local governmental agencies through
commercial, Medicaid and other programs; and (v) the federal government through
contracts pursuant to the Civilian Health and Medical Program for the Uniformed
Services ("CHAMPUS") and with the U.S. Postal Service. This broad base of strong
customer relationships provides the Company with stable and diverse sources of
revenue and cash flow and an established base from which to continue to increase
covered lives and revenue.
PROVEN RISK MANAGEMENT EXPERIENCE. As a result of the Acquisition, the
Company has approximately 18.0 million covered lives under risk-based contracts,
making it the nation's industry leader in at-risk managed behavioral healthcare
products. The Company's experience with risk-based products covering a large
number of lives has given it a broad base of data from which to analyze
utilization rates. The Company believes that this broad database permits it to
estimate utilization trends and costs more accurately than many of its
competitors, which allows it to bid effectively. The Company's experience has
also allowed it to develop effective measures for controlling the cost of
providing a unit of care to its covered lives. Among other cost control
measures, the Company has developed or acquired clinical protocols, which permit
the Company to assist its network providers to administer effective treatment in
a cost efficient manner, and claims management technology, which permits the
Company to reduce the cost of processing claims. As the Company integrates the
managed care operations it acquired in the
5
Acquisition with its pre-existing managed care operations, it will be able to
select from the best practices of its subsidiaries to further enhance its
utilization and cost control methodologies.
BUSINESS STRATEGY
INCREASE ENROLLMENT IN BEHAVIORAL MANAGED CARE PRODUCTS. The Company
believes it has a significant opportunity to increase covered lives in all its
behavioral managed care products. The Company believes its increased market
presence following the Acquisition will further enhance its ability to increase
ASO and EAP covered lives with large corporate, HMO and insurance customers. The
Company further believes that it has a significant opportunity to increase
revenues and cash flow by increasing lives covered by its risk-based products.
As a result of the Acquisition, the Company became the industry's leading
provider of risk-based products and is well positioned to benefit from the
continuing shift to risk-based products. According to OPEN MINDS, industry
enrollment in risk-based products has grown from approximately 13.6 million in
1993 to approximately 38.9 million in 1997, representing a compound annual
growth rate of over 30%. Despite this growth, only approximately 26% of total
managed behavioral healthcare enrollees were in risk-based products in 1997. The
Company believes that the market for risk-based products has grown and will
continue to grow as payors attempt to reduce their cost of providing behavioral
healthcare while ensuring a high quality of care and an appropriate level of
access to care. The Company believes enrollment in its risk-based products will
increase through growth in new covered lives and through the transition of
covered lives in ASO and EAP products to higher revenue risk-based products. On
a pro forma basis for fiscal 1997, risk-based products accounted for 32% of the
Company's covered lives but accounted for 73% of its total managed behavioral
healthcare revenues.
ACHIEVE SIGNIFICANT INTEGRATION EFFICIENCIES. The Company believes that the
Acquisition has created opportunities for the Company to achieve significant
cost savings. Management believes that cost saving opportunities will result
from leveraging fixed overhead over a larger revenue base and an increased
number of covered lives and from reducing duplicative corporate and regional
selling, general and administrative expenses. As a result, the Company expects
to achieve approximately $60.0 million of cost savings on an annual basis within
eighteen months following the consummation of the Acquisition.
PURSUE ADDITIONAL SPECIALTY MANAGED CARE OPPORTUNITIES. The Company
believes that significant demand exists for specialty managed care products
related to the management of certain chronic conditions. The Company believes
its large number of covered lives, information systems infrastructure and
demonstrated expertise in managing behavioral healthcare programs position the
Company to provide customers with specialty managed care products. As a first
major step in implementing this strategy, the Company acquired Allied, a
provider of specialty managed care products for cardiology, oncology and
diabetes patients, on December 5, 1997. See "--Recent Developments".
HISTORY
The Company has historically derived the majority of its revenue as a
provider of healthcare services in an inpatient setting. Payments from third
party payors are the principal source of revenue for most healthcare providers.
In the early 1990's, many third party payors sought to control the cost of
providing care to their patients by instituting managed care programs or seeking
the assistance of managed care companies. Providers participating in managed
care programs agree to provide services to patients for a discount from
established rates, which generally results in pricing concessions by the
providers and lower margins. Additionally, managed care programs generally
encourage alternatives to inpatient treatment settings and the reduced
utilization of inpatient services. As a result, third party payors established
managed care programs or engaged managed care companies in many areas of
healthcare, including behavioral healthcare. The Company, which until June 1997
was the largest operator of psychiatric hospitals in the United States, was
adversely affected by the adoption of managed care programs by third party
payors.
6
Prior to the first quarter of fiscal 1996, the Company was not a provider of
behavioral managed care services. During the first quarter of fiscal 1996, the
Company acquired a 61% ownership interest in Green Spring Health Services, Inc.,
a managed care company specializing in mental health and substance
abuse/dependence services ("Green Spring"). At that time, the Company intended
to become a fully integrated behavioral healthcare provider by combining the
managed behavioral healthcare products offered by Green Spring with the direct
treatment services offered by the Company's psychiatric hospitals. The Company
believed that an entity that participated in both the managed care and provider
segments of the behavioral healthcare industry could more efficiently provide
and manage behavioral healthcare for insured populations than an entity that was
solely a managed care company. The Company also believed that earnings from its
managed care business would offset, in part, the negative impact on the
financial performance of its psychiatric hospitals caused by managed care. Green
Spring was the Company's first significant involvement in managed behavioral
healthcare.
Subsequent to the Company's acquisition of Green Spring, the growth of the
managed behavioral healthcare industry accelerated. Under the Company's majority
ownership, Green Spring increased its base of covered lives from 12.0 million as
of the end of calendar year 1995 to 21.1 million as of the end of calendar year
1997, a compound annual growth rate of over 32%. Green Spring's revenue
increased from $205.0 million in fiscal 1995 to $364.0 million in fiscal 1997, a
compound annual growth rate of over 33%. While growth in the industry was
accelerating, the managed behavioral healthcare industry also began to
consolidate. The Company concluded that consolidation presented an opportunity
for the Company to enhance its stockholder value by increasing its participation
in the managed behavioral healthcare industry, which the Company believed
offered growth and earnings prospects superior to those of the psychiatric
hospital industry. Therefore, the Company decided to sell its domestic
psychiatric facilities to obtain capital for expansion in the managed behavioral
healthcare business.
The Company took a significant step toward implementing this strategy during
the third quarter of fiscal 1997, when it sold substantially all of its domestic
acute care psychiatric hospitals and residential treatment facilities
(collectively, the "Psychiatric Hospital Facilities") to Crescent Real Estate
Equities Limited Partnership ("Crescent") for $417.2 million in cash (before
costs of approximately $16.0 million) and certain other consideration.
Simultaneously with the sale of the Psychiatric Hospital Facilities, the Company
and COI, an affiliate of Crescent, formed CBHS, a joint venture, to operate the
Psychiatric Hospital Facilities and certain other facilities transferred to CBHS
by the Company. The Company retained a 50% ownership of CBHS; the other 50% of
the equity of CBHS is owned by COI.
In related transactions, (i) Crescent leased the Psychiatric Hospital
Facilities to CBHS and (ii) the Company entered into a master franchise
agreement (the "Master Franchise Agreement") with CBHS and a franchise agreement
with each of the Psychiatric Hospital Facilities and the other facilities
operated by CBHS (collectively, the "Franchise Agreements"). The Company's sale
of the Psychiatric Hospital Facilities and the related transactions described
above are referred to as the "Crescent Transactions." Pursuant to the Franchise
Agreements, the Company franchises the "CHARTER" System of behavioral healthcare
to each of the Psychiatric Hospital Facilities and other facilities operated by
CBHS. In exchange, CBHS agreed to pay the Company, pursuant to the Master
Franchise Agreement, annual franchise fees (the "Franchise Fees") of
approximately $78.3 million. However, CBHS's obligation to pay the Franchise
Fees is subordinate to its obligation to pay rent for the Psychiatric Hospital
Facilities to Crescent.
The sale of the Psychiatric Hospital Facilities provided the Company with
approximately $200 million of net cash proceeds after debt repayment for use in
implementing its business strategy. The Company used the net cash proceeds to
finance the acquisition of additional managed care companies, as described
below. See "--Recent Developments." The Company continues to pursue a strategy
of expanding its managed care operations and of reducing the extent to which its
earnings are derived from the psychiatric hospital business. In this regard, the
Company has further implemented its business strategy through the Acquisition.
7
On March 3, 1998, the Company entered into definitive agreements with COI
and CBHS to, among other things, sell the Company's franchise operations,
certain domestic provider operations and certain other assets and operations for
$280.0 million in cash, subject to certain adjustments, and the number of shares
of COI common stock obtained by dividing $30.0 million by the average closing
price of a share of COI common stock for the ten trading days preceding
consummation of the CBHS Transactions. If the CBHS Transactions are consummated,
the Company will have completed the divestiture of substantially all of its
domestic provider operations. See "--Recent Developments."
RECENT DEVELOPMENTS
THE ACQUISITION. On February 12, 1998, the Company consummated its
acquisition of Merit for cash consideration of approximately $448.9 million plus
the repayment of Merit's debt. Merit manages behavioral healthcare programs for
approximately 800 customers across all segments of the healthcare industry,
including HMOs, Blue Cross/Blue Shield organizations and other insurance
companies, corporations and labor unions, federal, state and local governmental
agencies and various state Medicaid programs, and had approximately 21.0 million
covered lives at the time of the Acquisition, including approximately 10.6
million risk-based lives. On September 12, 1997, Merit completed the acquisition
of CMG. CMG is a national managed behavioral healthcare company with over two
million covered lives, including over 1.9 million risk-based lives. Merit paid
approximately $48.7 million in cash and issued approximately 739,000 shares of
Merit common stock as consideration for CMG. The former owners of CMG may be
entitled to additional consideration, depending on CMG's future performance. See
"Merit's Management's Discussion and Analysis of Financial Condition and Results
of Operations--Liquidity and Capital Resources." In fiscal 1997, including CMG
on a pro forma basis, Merit had revenue of $644.0 million.
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED ACQUISITION. On December 4, 1997,
the Company consummated the purchase of HAI, formerly a unit of Aetna/U.S.
Healthcare ("Aetna"), for approximately $122.1 million, which the Company funded
from cash on hand. HAI manages the care of over 16.0 million covered lives,
primarily through EAPs and other managed behavioral healthcare plans. The
Company may be required to make additional contingent payments of up to $60.0
million annually to Aetna over the five year period subsequent to closing. The
amount and timing of the payments will be contingent upon net increases in the
number of HAI's covered lives in specified products. See "Magellan's
Management's Discussion and Analysis of Financial Condition and Results of
Operations-- Pro Forma Liquidity and Capital Resources." For the twelve months
ended September 30, 1997, HAI had revenue of $117.0 million.
ALLIED HEALTH GROUP, INC. ACQUISITION. On December 5, 1997, as part of the
Company's strategy to expand its specialty managed care business, the Company
purchased the assets of Allied. Allied provides specialty risk-based products
and administrative services to a variety of insurance companies and other
customers, including Blue Cross of New Jersey, CIGNA and NYLCare, for its 3.4
million members. Allied has over 80 physician networks across the eastern United
States. Allied's networks include physicians specializing in cardiology,
oncology and diabetes. The Company paid approximately $70.0 million for Allied,
of which $50.0 million was paid to the seller at closing with the remaining
$20.0 million placed in escrow. The escrowed amount is payable in one-third
increments if Allied achieves specified earnings targets during each of the
three years following the closing. Additionally, the purchase price may be
increased during the three year period by up to $40.0 million if Allied's
performance exceeds specified earnings targets. The maximum purchase price
payable is $110.0 million. See "Magellan's Management's Discussion and Analysis
of Financial Condition and Results of Operations-- Pro Forma Liquidity and
Capital Resources." For the twelve months ended September 30, 1997, Allied had
revenue of $144.0 million.
8
GREEN SPRING MINORITY SHAREHOLDER CONVERSION. The minority shareholders of
Green Spring have converted their interests in Green Spring into an aggregate of
2,831,516 shares of Company Common Stock. Such conversion is referred to as the
"Green Spring Minority Shareholder Conversion." As a result of the Green Spring
Minority Shareholder Conversion, the Company owns 100% of Green Spring.
CBHS TRANSACTIONS. On March 3, 1998, the Company and certain of its wholly
owned subsidiaries entered into definitive agreements with COI and CBHS pursuant
to which the Company will, among other things, sell the Company's franchise
operations, certain domestic provider operations and certain other assets and
operations. The definitive agreements include: (i) an equity purchase agreement
between the Company and COI (the "Equity Purchase Agreement"); (ii) a purchase
agreement between the Company, certain of its wholly owned subsidiaries and CBHS
(the "Purchase Agreement"); and (iii) a support agreement between the Company
and COI (the "Support Agreement"). Pursuant to the Equity Purchase Agreement,
the Company agreed to sell to COI the Company's common and preferred equity
interest in CBHS. Pursuant to the Purchase Agreement, the Company and certain of
its wholly owned subsidiaries agreed to sell to CBHS: (i) Charter Advantage, the
entity that conducts the Company's franchise operations; (ii) Charter System,
LLC, which owns the intellectual property comprising the "CHARTER" system of
behavioral healthcare; (iii) Group Practice Affiliates, Inc., the Company's
physician practice management business ("GPA"); (iv) certain behavioral staff
model operations; (v) the Company's Puerto Rican provider management business;
(vi) Golden Isle Assurance Company, Ltd., one of the Company's captive insurance
companies ("Golden Isle"); and (vii) Strategic Advantage, Inc., which owns
certain intellectual property used by the Company to monitor clinical results
("Strategic Advantage"). The obligations of CBHS and the Company to consummate
the transactions contemplated by the Purchase Agreement are also subject to,
among other things, the execution of either (i) a Joint Venture Purchase
Agreement pursuant to which the Company will sell to CBHS, for no additional
consideration, its interest in six hospital-based joint ventures that are
managed by CBHS on behalf of the Company (the "Joint Ventures") or (ii)
amendments to the services agreement between the Company and certain
subsidiaries of CBHS relating to the Joint Ventures pursuant to which the
Company will transfer to CBHS all rights to receive certain distributions with
respect to the Joint Ventures and pursuant to which CBHS would assume all
obligations of the Company with respect to the Joint Ventures arising after
consummation of the CBHS Transactions.
Among other things, the Support Agreement obligates COI to provide CBHS
assistance in obtaining financing for its payment obligation under the Purchase
Agreement, including its agreement to: (i) provide assistance in the preparation
of any offering documents required in connection with CBHS's efforts to obtain
financing, (ii) reimburse CBHS for all expenses incurred in connection with
obtaining financing, whether or not the CBHS Transactions are consummated, and
(iii) purchase up to $25.0 million of CBHS securities if necessary to permit
CBHS to obtain the required financing. The Support Agreement also obligates COI,
under certain circumstances, to pay the Company a termination fee equal to $2.5
million in cash and the number of shares of COI common stock obtained by
dividing $2.5 million by the average closing price of a share of COI common
stock for the five trading days prior to the termination of the Purchase
Agreement and for the five trading days after the termination of the Purchase
Agreement (the "Termination Fee"), if the CBHS Transactions are not consummated
as a result of the failure of CBHS to obtain sufficient financing for its
payment obligations under the Purchase Agreement.
Upon consummation of the CBHS Transactions, the Company will receive $280.0
million in cash, pursuant to the Purchase Agreement and, pursuant to the Equity
Purchase Agreement, the number of shares of COI common stock obtained by
dividing $30.0 million by the average closing price of a share of COI common
stock for the ten trading days preceding consummation of the CBHS Transactions.
The Company expects to use the cash proceeds, after transaction costs of
approximately $8.0 million, to repay indebtedness outstanding under the Term
Loan Facility. The CBHS Transactions are expected to
9
close in the third quarter of fiscal 1998. There can be no assurance that the
Company will consummate the CBHS Transactions.
The obligations of the Company and CBHS to consummate the transactions
contemplated by the Equity Purchase Agreement and the Support Agreement are
conditioned upon the execution and delivery of a services purchase agreement
(the "Services Purchase Agreement"). It is expected that the Services Purchase
Agreement would obligate the Company to purchase from CBHS a designated minimum
amount of behavioral healthcare services for gate-kept risk-based covered lives
if CBHS meets certain standards required of it pursuant to the Provider Services
Agreement (as defined). If the CBHS Transactions are consummated, the Company
also expects to enter into a provider services agreement (the "Provider Services
Agreement") with CBHS pursuant to which the Company would grant CBHS status as a
national preferred provider of behavioral healthcare services to the Company for
ten years provided that CBHS complies during the term of the Provider Services
Agreement with enhanced clinical, quality assurance, reporting and customer
service standards in addition to the standards currently required of other
providers of such services to the Company. See "Pending Sale of Provider
Business--Description of the Definitive Agreements."
THE TRANSACTIONS
On February 12, 1998, in connection with the consummation of the
Acquisition, the Company consummated certain related transactions (together with
the Acquisition, collectively, the "Transactions"), as follows: (i) the Company
terminated its existing credit agreement (the "Magellan Existing Credit
Agreement"); (ii) the Company repaid all loans outstanding pursuant to and
terminated Merit's existing credit agreement (the "Merit Existing Credit
Agreement") (the Magellan Existing Credit Agreement and the Merit Existing
Credit Agreement are hereinafter referred to as the "Existing Credit
Agreements"); (iii) the Company consummated a tender offer for its 11 1/4%
Series A Senior Subordinated Notes due 2004 (the "Magellan Outstanding Notes");
(iv) Merit consummated a tender offer for its 11 1/2% Senior Subordinated Notes
due 2005 (the "Merit Outstanding Notes") (the Magellan Outstanding Notes and the
Merit Outstanding Notes are hereinafter referred to collectively as the
"Outstanding Notes" and such tender offers are hereinafter referred to
collectively as the "Debt Tender Offers"); (v) the Company entered into a new
senior secured bank credit agreement (the "New Credit Agreement") with The Chase
Manhattan Bank ("Chase"), an affiliate of Chase Securities Inc., the Initial
Purchaser, and a syndicate of financial institutions, providing for credit
facilities of $700 million; and (vi) the Company issued the Old Notes. See "The
Transactions" and "Summary of New Credit Agreement."
10
The following table sets forth the sources and uses of funds for the
Transactions (in millions):
SOURCES:
Cash and cash equivalents......................................... $ 59.3
New Credit Agreement:
Revolving Facility(1)........................................... 20.0
Term Loan Facility(2)........................................... 550.0
The Old Notes..................................................... 625.0
--------
Total sources................................................. $ 1,254.3
--------
--------
USES:
Direct Cash Merger Consideration.................................. $ 448.9
Repayment of Merit Existing Credit Agreement(3)................... 196.4
Purchase of Magellan Outstanding Notes(4)......................... 432.1
Purchase of Merit Outstanding Notes(5)............................ 121.6
Transaction costs(6).............................................. 55.3
--------
Total uses.................................................... $ 1,254.3
--------
--------
-------------------------------
(1) The Revolving Facility provides for borrowings of up to $150.0
million. As of February 12, 1998, the Company had approximately $112.5
million available for borrowing pursuant to the Revolving Facility,
excluding approximately $17.5 million of availability reserved for
certain letters of credit.
(2) If the CBHS Transactions are consummated, the net proceeds of an
estimated $272.0 million will be used to repay a portion of the Term
Loan Facility under the New Credit Agreement. Additionally, upon the
sale of all or a portion of the COI common stock to be received upon
consummation of the CBHS Transactions, the Company is required to use
the net proceeds of such sale to reduce or repay amounts outstanding
under the Term Loan Facility.
(3) Includes principal amount of $193.6 million and accrued interest of
$2.7 million.
(4) Includes principal amount of $375.0 million, tender premium of $43.4
million and accrued interest of $13.7 million.
(5) Includes principal amount of $100.0 million, tender premium of $18.9
million and accrued interest of $2.8 million.
(6) Transaction costs include, among other things, costs paid at closing
associated with the Debt Tender Offers, the Old Notes offering, the
Acquisition and the New Credit Agreement.
All but $105,000 of the $375.0 million of Magellan Outstanding Notes and all
but $35,000 of the $100.0 million of Merit Outstanding Notes were tendered in
response to the Debt Tender Offers. Upon consummation of the Debt Tender Offers,
the Company paid $1,115.69 plus accrued interest per $1,000 principal amount of
Magellan Outstanding Notes tendered and $1,189.14 plus accrued interest per
$1,000 principal amount of Merit Outstanding Notes tendered.
RAINWATER, INC.
During the second quarter of fiscal 1996, Rainwater-Magellan Holding, L.P.,
an affiliate of Richard Rainwater ("Rainwater-Magellan"), purchased four million
shares of the Company's Common Stock and a warrant to purchase an additional two
million shares at an exercise price of $26.15 per share (the "Rainwater-Magellan
Warrant") from the Company for aggregate cash consideration of $69.7 million in
a private placement (the "Private Placement"). Rainwater-Magellan currently
beneficially owns approximately 19% of the Company's Common Stock and has the
right to designate a nominee acceptable to the Company for election as a
director of the Company. See "Management--Certain Relationships and Related
Transactions."
11
THE OLD NOTES OFFERING
The Old Notes................. The Old Notes were sold by the Company on February 12, 1998
in a private placement (the "Offering") to Chase Securities
Inc. (the "Initial Purchaser") pursuant to a Purchase
Agreement dated February 5, 1998 (the "Purchase Agreement").
The Initial Purchaser subsequently resold the Old Notes to
either "qualified institutional buyers" pursuant to Rule
144A under the Securities Act or pursuant to sales that
occurred outside the United States within the meaning of
Regulation S of the Securities Act. As of the date of this
Prospectus, all $625,000,000 outstanding principal amount of
the Old Notes were evidenced by global securities,
registered in the name of CEDE & Co., as nominee for The
Depositary Trust Company ("DTC"), and held by Marine Midland
Bank as securities custodian for CEDE & Co. As indicated
elsewhere in this Prospectus, the Old Notes have been
included in the PORTAL Market for trading among "qualified
institutional buyers" pursuant to Rule 144A under the
Securities Act.
Registration Rights
Agreement................... Pursuant to the Purchase Agreement, the Company and the
Initial Purchaser entered into the Registration Rights
Agreement, which, among other things, grants the holders of
the Old Notes certain exchange and registration rights. The
Exchange Offer is intended to satisfy such exchange rights,
which rights will terminate upon consummation of the
Exchange Offer. Pursuant to the Registration Rights
Agreement, the Company agreed that, in the event that the
Exchange Offer is not consummated on or prior to September
10, 1998, the Company will be obligated to pay liquidated
damages to each holder of the Old Notes in an amount equal
to $0.192 per week per $1,000 principal amount of the Old
Notes held by such holder until the Exchange Offer is
consummated. See "The Exchange Offer--Purpose and Effect of
the Exchange Offer."
Use of Proceeds............... Simultaneously with the sale of the Old Notes, the Company
entered into the New Credit Agreement. The Company used the
net proceeds from the sale of the Old Notes and the initial
borrowings pursuant to the New Credit Agreement to finance
the Acquisition, repay all loans outstanding pursuant to the
Merit Existing Credit Agreement and purchase the Outstanding
Notes tendered in response to the Debt Tender Offers. See
"Use of Proceeds."
THE EXCHANGE OFFER
Securities Offered............ $625,000,000 aggregate principal amount of 9% Series A
Senior Subordinated Notes due February 15, 2008 that have
been registered pursuant to the Securities Act (the "New
Notes").
The Exchange Offer............ $1,000 principal amount of the New Notes in exchange for
each $1,000 principal amount of 9% Senior Subordinated Notes
due February 15, 2008 that have not been registered pursuant
to the Securities Act (the "Old Notes"). As of the date
hereof, $625,000,000 aggregate principal amount of Old Notes
is
12
outstanding. The Company will issue the New Notes to holders
on or promptly after the Expiration Date.
The New Notes are being offered for exchange hereby to
satisfy certain obligations of the Company under the
Registration Rights Agreement. Based on existing
interpretations of the Staff with respect to similar
transactions, the Company believes that New Notes issued
pursuant to the Exchange Offer in exchange for Old Notes may
be offered for resale, resold and otherwise transferred by
holders thereof (other than any such holder which is an
"affiliate" of the Company within the meaning of Rule 405
under the Securities Act), without compliance with the
registration and prospectus delivery requirements of the
Securities Act, provided that such New Notes are acquired in
the ordinary course of such holders' business and such
holders are not engaged in, have no arrangement with any
person to participate in, and do not intend to engage in,
any public distribution of the New Notes. Each broker-dealer
that receives New Notes for its own account pursuant to the
Exchange Offer must acknowledge that it will deliver a
resale prospectus in connection with any resale of such New
Notes. The Letter of Transmittal which accompanies this
Prospectus states that by so acknowledging and by delivering
a resale prospectus, a broker-dealer will not be deemed to
admit to be acting in the capacity of an "underwriter"
(within the meaning of Section 2(11) of the Securities Act).
This Prospectus, as it may be amended or supplemented from
time to time, may be used by a broker-dealer in connection
with resales of New Notes received in exchange for Old Notes
where such Old Notes were acquired by such broker-dealer as
a result of market-making or other trading activities. The
Company has agreed that, for a period of 180 days after the
date on which the Registration Statement of which this
Prospectus is a part is first declared effective it will
make this Prospectus available to any broker-dealer for use
in connection with any such resale. See "Plan of
Distribution."
Expiration Date............... 5:00 p.m., New York City time, on [ ], 1998 unless
the Exchange Offer is extended, in which case the term
"Expiration Date" means the latest date and time to which
the Exchange Offer is extended.
Accrued Interest on the New
Notes and Old Notes......... Each New Note will bear interest from its date of original
issuance. Holders of Old Notes that are accepted for
exchange and exchanged for New Notes will receive, in cash,
accrued interest thereon to, but not including, the original
issuance date of the New Notes. Such interest will be paid
on the first interest payment date for the New Notes.
Interest on the Old Notes accepted for exchange and
exchanged in the Exchange Offer will cease to accrue on the
date preceding the date of original issuance of the New
Notes.
Conditions to the Exchange
Offer....................... The Exchange Offer is subject to certain customary
conditions,
13
which may be waived by the Company. See "The Exchange
Offer-- Conditions."
Procedures for Tendering Old
Notes....................... Each holder of Old Notes wishing to accept the Exchange
Offer must complete, sign and date the accompanying Letter
of Transmittal, or a facsimile thereof, in accordance with
the instructions contained herein and therein, and deliver
such Letter of Transmittal, or such facsimile, together with
any other required documentation to the Exchange Agent (as
defined) at the address set forth herein on or prior to the
Expiration Date. By executing the Letter of Transmittal,
each holder of the Old Notes who wishes to exchange its
Notes for New Notes in the Exchange Offer will make certain
representations to the Company, including that (i) any New
Notes to be received by it will be acquired in the ordinary
course of its business, (ii) it is not participating in,
does not intend to participate in and has no arrangement
with any person to participate in a public distribution
(within the meaning of the Securities Act) of the New Notes,
and (iii) it is not an "affiliate," as defined in Rule 405
of the Securities Act of the Company, or if it is such an
affiliate, that it will comply with the registration and
prospectus delivery requirements of the Securities Act to
the extent applicable to it. In addition, each holder who is
not a broker-dealer will be required to represent that it is
not engaged in, and does not intend to engage in, a public
distribution of the New Notes. Each holder who is a
broker-dealer and who receives New Notes for its own account
in exchange for Old Notes that were acquired by it as a
result of market-making activities or other trading
activities, will be required to acknowledge that it will
deliver a prospectus in connection with any resale by it of
such New Notes. The Company has agreed that, for a period of
180 days after the date on which the Registration Statement
of which this Prospectus is a part is first declared
effective, it will make this Prospectus available to any
broker-dealer for use in connection with any such resales.
For a description of the procedures for certain resales by
broker-dealers, see "Plan of Distribution." See "The
Exchange Offer--Procedures for Tendering."
Untendered Old Notes.......... Following the consummation of the Exchange Offer, holders of
Old Notes eligible to participate and to receive freely
transferrable New Notes (based on existing interpretations
of the staff described elsewhere in this Prospectus) but who
do not tender their Old Notes will not have any further
registration rights and such Old Notes will continue to be
subject to certain restrictions on transfer under the
Securities Act. Accordingly, the liquidity of the market for
such Old Notes could be adversely affected.
Shelf Registration
Statement................... Pursuant to the Registration Rights Agreement, if (i)
because of any change in law or applicable interpretations
thereof by the Staff of the Commission, the Company is not
permitted to effect the Exchange Offer as contemplated
hereby, (ii) any Old Notes validly tendered pursuant to the
Exchange Offer are not exchanged for
14
New Notes by September 10, 1998, (iii) the Initial Purchaser
so requests with respect to Old Notes not eligible to be
exchanged for New Notes in the Exchange Offer, (iv) any
applicable law or interpretations do not permit any holder
of Old Notes to participate in the Exchange Offer, (v) any
holder of Old Notes that participates in the Exchange Offer
does not receive freely transferable New Notes in exchange
for tendered Old Notes, or (vi) the Company so elects, then
the Company will file with the Commission a shelf
registration statement (the "Shelf Registration Statement")
to cover resales of Transfer Restricted Securities by such
holders who satisfy certain conditions relating to the
provision of information in connection with the Shelf
Registration Statement. For purposes of the foregoing,
"Transfer Restricted Securities" means each Old Note until
(i) the date on which such Old Note has been exchanged for a
freely transferable New Note in the Exchange Offer; (ii) the
date on which such Old Note has been effectively registered
under the Securities Act and disposed of in accordance with
the Shelf Registration Statement or (iii) the date on which
such Old Note is distributed to the public pursuant to Rule
144 under the Securities Act or is saleable pursuant to Rule
144(k) under the Securities Act. The Company will use its
reasonable best efforts to have the Shelf Registration
Statement declared effective by the Commission as promptly
as practicable after the filing thereof and to keep the
Shelf Registration Statement continuously effective until
February 12, 2000. The Company, at its expense, will provide
to each holder of the Old Notes copies of the prospectus
that is a part of the Shelf Registration Statement, notify
each such holder when the Shelf Registration Statement has
become effective and take certain other actions as are
required to permit unrestricted resales of the Old Notes
from time to time. A holder of Old Notes who sells such Old
Notes pursuant to the Shelf Registration Statement generally
will be required to be named as a selling security holder in
the related prospectus and to deliver a prospectus to
purchasers, will be subject to certain of the civil
liability provisions under the Securities Act in connection
with such sales and will be bound by the provisions of the
Registration Rights Agreement which are applicable to such
holder (including certain indemnification obligations).
Special Procedures for
Beneficial Owners........... Any beneficial owner whose Old Notes are registered in the
name of a broker, dealer, commercial bank, trust company or
other nominee and who wishes to tender its Old Notes for
exchange in the Exchange Offer should contact such
registered holder promptly and instruct such registered
holder to tender on such beneficial owner's behalf. If such
beneficial owner wishes to tender on such beneficial owner's
behalf, such owner must, prior to completing and executing
the Letter of Transmittal, either make appropriate
arrangements to register ownership of the Old Notes in such
owner's name or obtain a properly completed bond power from
the
15
registered holder. The transfer of registered ownership may
take considerable time.
Guaranteed Delivery
Procedures.................. Holders of Old Notes who wish to tender their Old Notes and
who cannot deliver the Letter of Transmittal or any other
documents required by the Letter of Transmittal to the
Exchange Agent (or comply with the procedures for book-entry
transfer) prior to the Expiration Date must tender their Old
Notes according to the guaranteed delivery procedures set
forth in "The Exchange Offer-- Guaranteed Delivery
Procedures."
Withdrawal Rights............. Tenders may be withdrawn at any time prior to 5:00 p.m., New
York City time, on the Expiration Date.
Acceptance of Old Notes and
Delivery of New Notes....... The Company will accept for exchange and exchange any and
all Old Notes which are properly tendered in the Exchange
Offer and not withdrawn prior to 5:00 p.m., New York City
time, on the Expiration Date. The New Notes issued pursuant
to the Exchange Offer will be delivered promptly following
the Expiration Date. See "The Exchange Offer--Terms of the
Exchange Offer."
Federal Income Tax
Consequences................ The exchange pursuant to the Exchange Offer should not be a
taxable event for federal income tax purposes. See "Federal
Income Tax Consequences of the Exchange Offer."
Use of Proceeds............... There will be no cash proceeds to the Company from the
exchange pursuant to the Exchange Offer. See "Use of
Proceeds."
Exchange Agent................ Marine Midland Bank.
SUMMARY OF TERMS OF THE NEW NOTES
The form and terms of the New Notes are identical to the form and terms of
the Old Notes except that the New Notes have been registered under the
Securities Act and, therefore, will not bear legends restricting the transfer
thereof and except for the series designation. The New Notes will evidence the
same debt as the Old Notes and will be entitled to the benefits of the
Indenture. See "Description of the New Notes."
Maturity Date................ February 15, 2008
Interest Payment Dates....... February 15 and August 15, commencing August 15, 1998.
Optional Redemption.......... Except as described below, the Company may not redeem the
New Notes prior to February 15, 2003. On or after such date,
the Company may redeem the New Notes, in whole or in part,
at any time at the redemption prices set forth herein,
together with accrued and unpaid interest, if any, to the
date of redemption. In addition, at any time and from time
to time prior to February 15, 2001, the Company may, subject
to certain requirements, redeem up to 35% of the original
aggregate principal amount of the New Notes with the net
cash proceeds of one or more Equity Offerings (as defined),
at a redemption price equal to 109% of the principal amount
thereof, together with accrued and unpaid interest, if any,
to the date of redemption, provided that at least 65% of the
original aggregate principal amount of the New Notes remains
outstanding immediately
16
after each such redemption. See "Description of the New
Notes-- Optional Redemption."
Change of Control............ Upon the occurrence of a Change of Control, each holder of
the New Notes will have the right to require the Company to
make an offer to repurchase such holder's New Notes at a
price equal to 101% of the principal amount thereof,
together with accrued and unpaid interest, if any, to the
repurchase date. See "Description of the New Notes-- Change
of Control."
Ranking...................... The New Notes will be unsecured and will be subordinated in
right of payment to all existing and future Senior
Indebtedness of the Company. The New Notes will rank PARI
PASSU with all future Senior Subordinated Indebtedness of
the Company and will rank senior to all future Subordinated
Obligations of the Company. The New Notes will be PARI PASSU
in right of payment with all Old Notes that are not
exchanged for New Notes pursuant to the Exchange Offer. As
of December 31, 1997, on a pro forma basis after giving
effect to the Transactions, (i) the aggregate amount of the
Company's outstanding Senior Indebtedness would have been
approximately $590.2 million (exclusive of unused
commitments), substantially all of which would have been
Secured Indebtedness and would have been guaranteed by
substantially all of the Company's subsidiaries, (ii) the
Company would have had no Senior Subordinated Indebtedness
(other than the Notes) and no indebtedness that is
subordinate or junior in right of payment to the Notes and
(iii) the outstanding indebtedness of the Company's
subsidiaries (excluding guarantees of the Company's
indebtedness) would have been approximately $346.0 million,
substantially all of which would have been Secured
Indebtedness. See "Description of the New Notes" and
"Summary of New Credit Agreement."
Restrictive Covenants........ The Indenture governing the Notes limits, among other
things: (i) the incurrence of additional indebtedness by the
Company and its Restricted Subsidiaries (as defined); (ii)
the payment of dividends on, and redemption or repurchase
of, capital stock of the Company and its Restricted
Subsidiaries and the redemption of certain Subordinated
Obligations of the Company; (iii) certain other restricted
payments, including investments; (iv) sales of assets; (v)
certain transactions with affiliates; (vi) the creation of
liens; and (vii) consolidations, mergers and transfers of
all or substantially all the Company's assets. The Indenture
also prohibits certain restrictions on distributions from
Restricted Subsidiaries. However, all these limitations and
prohibitions are subject to a number of important
qualifications and exceptions. See "Description of the New
Notes--Certain Covenants."
Risk Factors................. In evaluating the Exchange Offer, holders of Old Notes
should carefully consider the factors set forth under the
caption "Risk Factors" prior to determining whether to
participate in the Exchange Offer. Holders of the Old Notes
should also consider that such factors are also generally
applicable to the Old Notes.
17
SUMMARY HISTORICAL AND UNAUDITED PRO FORMA FINANCIAL DATA
The following tables set forth: (i) summary consolidated financial data for
Magellan for and as of each of the three fiscal years in the period ended
September 30, 1997, for the three months ended December 31, 1996 and 1997 and as
of December 31, 1997; (ii) summary consolidated financial data for Merit for and
as of the three fiscal years in the period ended September 30, 1997, for the
three months ended December 31, 1996 and 1997 and as of December 31, 1997; and
(iii) summary unaudited pro forma consolidated financial information for the
fiscal year ended September 30, 1997 and for and as of the three months ended
December 31, 1997, giving effect to the Transactions as if they had occurred on
October 1, 1996 in the case of the unaudited pro forma statements of operations
data and on December 31, 1997 in the case of the unaudited pro forma balance
sheet data. The summary unaudited pro forma consolidated financial information
also gives effect to the Crescent Transactions, the HAI acquisition, the Allied
acquisition, Merit's acquisition of CMG and the Green Spring Minority
Shareholder Conversion. Summary unaudited pro forma consolidated financial
information is also presented, in addition to giving effect to the transactions
discussed in the preceeding sentence, after giving effect to the CBHS
Transactions. The summary historical consolidated financial information of
Magellan for each of the three years in the period ended September 30, 1997 has
been derived from the audited historical consolidated financial statements and
the selected historical consolidated financial information of Magellan included
elsewhere herein. The summary historical consolidated financial information of
Merit for each of the three years in the period ended September 30, 1997 has
been derived from the audited historical consolidated financial statements and
the selected historical consolidated financial information of Merit included
elsewhere herein.
The summary historical consolidated financial information for the three
months ended December 31, 1996 and 1997 and as of December 31, 1997 has been
derived from unaudited consolidated financial statements of Magellan and Merit
appearing elsewhere herein and, in the opinion of management, includes all
adjustments (consisting only of normal recurring adjustments) that are necessary
for a fair presentation of the operating results for such interim periods.
Results for the interim periods are not necessarily indicative of the results
for the full year or for any future periods. The summary historical financial
data set forth below should be read in conjunction with the consolidated
financial statements of Magellan and Merit and the notes thereto and
Management's Discussion and Analysis of Financial Condition and Results of
Operations of Magellan and Merit appearing elsewhere herein.
The summary unaudited pro forma consolidated financial information set forth
herein is provided for informational purposes only and is not necessarily
indicative of actual results or future results that would have been or will be
achieved had the Transactions, the Crescent Transactions, the HAI, Allied and
CMG acquisitions, the CBHS Transactions and the Green Spring Minority
Shareholder Conversion been consummated on the assumed dates. The summary
unaudited pro forma consolidated financial information is derived from the
Unaudited Pro Forma Consolidated Financial Information appearing elsewhere
herein and the Unaudited Pro Forma Consolidated Financial Information--CBHS
Transactions appearing in "Pending Sale of Provider Business." The information
set forth below should be read in conjunction with: (i) the audited consolidated
financial statements of Magellan, Merit, CBHS and HAI and notes thereto
appearing elsewhere herein; (ii) the Unaudited Pro Forma Consolidated Financial
Information appearing elsewhere herein and the Unaudited Pro Forma Consolidated
Financial Information-- CBHS Transactions appearing in "Pending Sale of Provider
Business"; and (iii) Management's Discussion and Analysis of Financial Condition
and Results of Operations of Magellan and Merit appearing elsewhere herein.
18
MAGELLAN HISTORICAL AND PRO FORMA FINANCIAL DATA
HISTORICAL
--------------------------------------------------
THREE
MONTHS
ENDED
DECEMBER
YEAR ENDED SEPTEMBER 30, 31,
------------------------------------- -----------
1995 1996 1997 1996
----------- ----------- ----------- -----------
(DOLLARS IN THOUSANDS)
STATEMENT OF OPERATIONS DATA:
Net revenue............................................................. $ 1,151,736 $ 1,345,279 $ 1,210,696 $ 346,819
Salaries, cost of care and other operating expenses..................... 863,598 1,064,445 978,513 284,123
Bad debt expense........................................................ 92,022 81,470 46,211 20,235
Depreciation and amortization........................................... 38,087 48,924 44,861 13,099
Interest, net........................................................... 55,237 48,017 45,377 13,569
Income (loss) before extraordinary items................................ (42,963) 32,383 4,755 7,141
Net income (loss)....................................................... (42,963) 32,383 (498) 4,191
OTHER FINANCIAL DATA:
EBITDA(1)...............................................................
Adjusted EBITDA(2)......................................................
Cash interest expense(3)................................................
Ratio of Adjusted EBITDA to cash interest expense(3)....................
Ratio of total debt to Adjusted EBITDA(4)...............................
Net cash provided by (used in) operating activities..................... $ 95,620 $ 101,866 $ 73,599 $ (23,389)
Net cash provided by (used in) investing activities..................... (96,981) (102,203) 331,680 6,579
Net cash provided by (used in) financing activities..................... (22,728) 15,768 (153,346) 10,317
Ratio (deficiency) of earnings to fixed charges......................... (53,518) 1.98 1.41
BALANCE SHEET DATA (END OF PERIOD):
Working capital (deficiency)............................................ $ 91,413 $ 63,834 $ 287,662
Total assets............................................................ 983,558 1,140,137 895,620
Total debt and capital lease obligations................................ 541,569 572,058 395,294
Stockholders' equity.................................................... 88,560 121,817 158,250
PRO FORMA EXCLUDING THE CBHS
TRANSACTIONS
----------------------------------
THREE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, DECEMBER 31,
1997 1997 1997
----------- ---------------- ----------------
STATEMENT OF OPERATIONS DATA:
Net revenue............................................................. $ 216,097 $ 1,601,606 $ 443,293
Salaries, cost of care and other operating expenses..................... 175,621 1,355,098 382,704
Bad debt expense........................................................ 1,070 3,491 1,070
Depreciation and amortization........................................... 6,969 68,962 17,470
Interest, net........................................................... 7,401 96,389 24,685
Income (loss) before extraordinary items................................ 7,628 21,867 3,115
Net income (loss)....................................................... 7,628 21,867 3,115
OTHER FINANCIAL DATA:
EBITDA(1)............................................................... $ 255,263 $ 62,119
Adjusted EBITDA(2)...................................................... 268,356 68,229
Cash interest expense(3)................................................ 104,389 26,224
Ratio of Adjusted EBITDA to cash interest expense(3).................... 2.6x 2.6x
Ratio of total debt to Adjusted EBITDA(4)............................... 4.5x
Net cash provided by (used in) operating activities..................... $ (31,725)
Net cash provided by (used in) investing activities..................... (160,015)
Net cash provided by (used in) financing activities..................... (10,679)
Ratio (deficiency) of earnings to fixed charges......................... 2.04 1.38 1.27
BALANCE SHEET DATA (END OF PERIOD):
Working capital (deficiency)............................................ $ 111,423 $ 19,010
Total assets............................................................ 897,114 1,857,050
Total debt and capital lease obligations................................ 395,154 1,215,154
Stockholders' equity.................................................... 151,862 179,033
PRO FORMA INCLUDING THE CBHS
TRANSACTIONS
----------------------------------
THREE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, DECEMBER 31,
1997 1997
---------------- ----------------
STATEMENT OF OPERATIONS DATA:
Net revenue............................................................. $ 1,407,459 $ 394,143
Salaries, cost of care and other operating expenses..................... 1,237,938 353,343
Bad debt expense........................................................ (624) 50
Depreciation and amortization........................................... 64,831 16,394
Interest, net........................................................... 75,399 19,374
Income (loss) before extraordinary items................................ 7,707 3,096
Net income (loss)....................................................... 7,707 3,096
OTHER FINANCIAL DATA:
EBITDA(1)............................................................... $ 182,240 $ 43,335
Adjusted EBITDA(2)...................................................... 204,946 51,191
Cash interest expense(3)................................................ 83,248 20,898
Ratio of Adjusted EBITDA to cash interest expense(3).................... 2.5x 2.5x
Ratio of total debt to Adjusted EBITDA(4)............................... 4.6x
Net cash provided by (used in) operating activities.....................
Net cash provided by (used in) investing activities.....................
Net cash provided by (used in) financing activities.....................
Ratio (deficiency) of earnings to fixed charges......................... 1.26 1.35
BALANCE SHEET DATA (END OF PERIOD):
Working capital (deficiency)............................................ $ (25,604)
Total assets............................................................ 1,701,354
Total debt and capital lease obligations................................ 942,494
Stockholders' equity.................................................... 278,619
See Notes to Magellan Historical and Pro Forma Financial Data
19
NOTES TO MAGELLAN HISTORICAL AND PRO FORMA FINANCIAL DATA
(1) The calculation of EBITDA is as follows (in thousands):
PRO FORMA
EXCLUDING THE CBHS
TRANSACTIONS
---------------------
YEAR ENDED
SEPTEMBER 30, 1997
---------------------
Net income......................................................................................... $ 21,867
Minority interest.................................................................................. 2,267
Provision for income taxes......................................................................... 30,033
Interest, net...................................................................................... 96,389
Depreciation and amortization...................................................................... 68,962
----------
Earnings before interest, taxes, depreciation and amortization................................... 219,518
Interest income.................................................................................... 12,246
Stock option expense (credit)...................................................................... 4,292
Equity in loss of CBHS............................................................................. 20,150
Unusual items...................................................................................... (943)
----------
EBITDA........................................................................................... $ 255,263
----------
----------
THREE MONTHS ENDED
DECEMBER 31, 1997
---------------------
Net income......................................................................................... $ 3,115
Minority interest.................................................................................. 518
Provision for income taxes......................................................................... 6,202
Interest, net...................................................................................... 24,685
Depreciation and amortization...................................................................... 17,470
--------
Earnings before interest, taxes, depreciation and amortization................................... 51,990
Interest income.................................................................................... 2,600
Stock option expense (credit)...................................................................... (3,959)
Equity in loss of CBHS............................................................................. 11,488
Unusual items...................................................................................... 0
--------
EBITDA........................................................................................... $ 62,119
--------
--------
PRO FORMA
INCLUDING THE CBHS
TRANSACTIONS
---------------------
YEAR ENDED
SEPTEMBER 30, 1997
---------------------
Net income......................................................................................... $ 7,707
Minority interest.................................................................................. (133)
Provision for income taxes......................................................................... 18,992
Interest, net...................................................................................... 75,399
Depreciation and amortization...................................................................... 64,831
----------
Earnings before interest, taxes, depreciation and amortization................................... 166,796
Interest income.................................................................................... 12,095
Stock option expense (credit)...................................................................... 4,292
Equity in loss of CBHS............................................................................. 0
Unusual items...................................................................................... (943)
----------
EBITDA........................................................................................... $ 182,240
----------
----------
THREE MONTHS ENDED
DECEMBER 31, 1997
---------------------
Net income......................................................................................... $ 3,096
Minority interest.................................................................................. 1
Provision for income taxes......................................................................... 5,844
Interest, net...................................................................................... 19,374
Depreciation and amortization...................................................................... 16,394
--------
Earnings before interest, taxes, depreciation and amortization................................... 44,709
Interest income.................................................................................... 2,585
Stock option expense (credit)...................................................................... (3,959)
Equity in loss of CBHS............................................................................. 0
Unusual items...................................................................................... 0
--------
EBITDA........................................................................................... $ 43,335
--------
--------
Management believes that EBITDA provides additional indications of the
financial performance of the Company and provides useful information
regarding the Company's ability to service debt and meet certain debt
covenants under the Indenture. Accordingly, EBITDA includes interest
income, which can be utilized to service debt, and excludes non-cash
expenses such as depreciation and amortization, stock option expense
(credit) and equity in loss of CBHS. The Company's definition of EBITDA
used in this Prospectus is consistent with the definition of EBITDA in the
New Credit Agreement and the Indenture. EBITDA does not represent cash
flows from operations or investing and financing activities as defined by
generally accepted accounting principles. EBITDA does not measure whether
cash flows will be sufficient to fund all cash flow needs, including
principal and interest payments on debt and capital lease obligations,
capital expenditures or other investing and financing activities. EBITDA
should not be construed as an alternative to the Company's operating
income, net income or cash flows from operating activities (as determined
in accordance with generally accepted accounting principles) and should not
be construed as an indication of the Company's operating performance or as
a measure of the Company's liquidity. In addition, items excluded from
EBITDA, such as depreciation and amortization, provision for income taxes
and equity in loss of CBHS, are significant components in understanding and
assessing the Company's financial performance. EBITDA is not presented for
historical purposes as management does not believe historical EBITDA is
indicative of the Company's prospects after consummation of the
Transactions. The Company's definition of EBITDA may be different from the
definition of EBITDA used by other companies.
20
(2) Adjusted EBITDA represents EBITDA adjusted as follows (in thousands):
PRO FORMA
EXCLUDING THE CBHS TRANSACTIONS
-------------------------------------------
YEAR ENDED THREE MONTHS ENDED
SEPTEMBER 30, 1997 DECEMBER 31, 1997
-------------------- ---------------------
EBITDA...................................................................... $ 255,263 $ 62,119
Elimination of duplicative executive management, finance, human resource and
legal positions and related overhead expenses, including the closure of
Merit's corporate headquarters............................................. 11,800 2,950
Elimination of duplicative regional management positions and related
overhead expenses.......................................................... 8,900 2,225
Elimination of duplicative credentialling, contracting and other
administrative expenses in connection with the consolidation of the
Company's existing and acquired provider networks.......................... 7,500 1,875
Elimination of expenses associated with the closure of field offices located
in overlapping service areas............................................... 7,200 1,800
Elimination of duplicative personnel, development and maintenance expenses
in connection with the consolidation of the Company's existing and acquired
information systems operations............................................. 5,900 1,475
Elimination of duplicative personnel and related administrative expenses in
connection with the consolidation of the Company's existing and acquired
claims processing operations............................................... 4,900 1,225
Elimination of duplicative sales and marketing positions.................... 4,600 1,150
Elimination of revenue from settlements of reimbursement issues related to
provider operations sold as part of the Crescent Transactions. The Company
expects to continue to record such settlements in future periods, but such
amounts are expected to decline significantly from fiscal 1997 levels...... (20,594) (744)
Elimination of EBITDA associated with the Company's six hospital-based joint
ventures. The Company pays a management fee to CBHS that equals the
Company's portion of the joint ventures' net income pursuant to a
management agreement with CBHS............................................. (9,613) (1,746)
Elimination of favorable adjustments to medical malpractice reserves. The
Company does not expect that such adjustments will have a significant
impact on the Company's future operating performance....................... (7,500) (4,100)
-------------------- ----------
Adjusted EBITDA............................................................. $ 268,356 $ 68,229
-------------------- ----------
-------------------- ----------
PRO FORMA
INCLUDING THE CBHS TRANSACTIONS
-------------------------------------------
YEAR ENDED THREE MONTHS ENDED
SEPTEMBER 30, 1997 DECEMBER 31, 1997
-------------------- ---------------------
EBITDA...................................................................... $ 182,240 $ 43,335
Elimination of duplicative executive management, finance, human resource and
legal positions and related overhead expenses, including the closure of
Merit's corporate headquarters............................................. 11,800 2,950
Elimination of duplicative regional management positions and related
overhead expenses.......................................................... 8,900 2,225
Elimination of duplicative credentialling, contracting and other
administrative expenses in connection with the consolidation of the
Company's existing and acquired provider networks.......................... 7,500 1,875
Elimination of expenses associated with the closure of field offices located
in overlapping service areas............................................... 7,200 1,800
Elimination of duplicative personnel, development and maintenance expenses
in connection with the consolidation of the Company's existing and acquired
information systems operations............................................. 5,900 1,475
Elimination of duplicative personnel and related administrative expenses in
connection with the consolidation of the Company's existing and acquired
claims processing operations............................................... 4,900 1,225
Elimination of duplicative sales and marketing positions.................... 4,600 1,150
Elimination of revenue from settlements of reimbursement issues related to
provider operations sold as part of the Crescent Transactions. The Company
expects to continue to record such settlements in future periods, but such
amounts are expected to decline significantly from fiscal 1997 levels...... (20,594) (744)
Elimination of EBITDA associated with the Company's six hospital-based joint
ventures. The Company pays a management fee to CBHS that equals the
Company's portion of the joint ventures' net income pursuant to a
management agreement with CBHS............................................. 0 0
Elimination of favorable adjustments to medical malpractice reserves. The
Company does not expect that such adjustments will have a significant
impact on the Company's future operating performance....................... (7,500) (4,100)
-------------------- ----------
Adjusted EBITDA............................................................. $ 204,946 $ 51,191
-------------------- ----------
-------------------- ----------
The foregoing $50.8 and $12.7 million of positive adjustments represent the
full year and the three month impact of cost savings, respectively, that are
expected to be achieved within one year following the consummation of the
Acquisition. The Company expects to achieve a total of approximately $60.0
million of annual cost savings within eighteen months following the
consummation of the Acquisition. Cost savings are measured relative to the
combined budgeted amounts for the Company, Merit and HAI for the current
fiscal year prior to the cost savings initiatives. The Company expects to
spend approximately $26.0 million in the year following the consummation of
the Acquisition in connection with achieving such cost savings. Cost savings
will be effected in all of the Company's existing and acquired managed
behavioral healthcare operations.
(3) Represents the ratio of Adjusted EBITDA to cash interest expense. Cash
interest expense represents total interest expense as reduced for interest
expense related to the amortization of deferred financing costs.
(4) Represents the ratio of total pro forma debt and capital lease obligations
as of December 31, 1997 to Adjusted EBITDA for the year ended September 30,
1997.
21
MERIT HISTORICAL FINANCIAL DATA
THREE MONTHS ENDED
YEAR ENDED SEPTEMBER 30, DECEMBER 31,
------------------------------------- ------------------------
1995 1996 1997 1996 1997
----------- ----------- ----------- ----------- -----------
(DOLLARS IN THOUSANDS)
STATEMENT OF OPERATIONS DATA:
Revenue......................................... $ 361,549 $ 457,830 $ 555,717 $ 128,625 $ 177,217
Direct service costs............................ 286,001 361,684 449,563 102,932 145,997
----------- ----------- ----------- ----------- -----------
Direct profit................................. 75,548 96,146 106,154 25,693 31,220
Selling, general and administrative expenses.... 49,823 64,523 67,450 16,579 22,091
Amortization of intangibles..................... 21,373 25,869 26,897 6,799 7,231
Restructuring charge............................ -- 2,995 -- -- --
Income from joint ventures...................... -- -- -- -- (1,649)
----------- ----------- ----------- ----------- -----------
Operating income.............................. 4,352 2,759 11,807 2,315 3,547
Other (income)(1)............................... (1,498) (2,838) (3,497) (780) (1,074)
Interest expense................................ -- 23,826 25,063 6,186 7,216
Loss on disposal of subsidiary.................. -- -- 6,925 -- --
Merger costs and special charges................ -- 3,972 1,314 -- 545
----------- ----------- ----------- ----------- -----------
Income (loss) before income taxes and
cumulative effect of accounting change...... 5,850 (22,201) (17,998) (3,091) (3,140)
Provision (benefit) for income taxes............ 4,521 (5,332) (4,126) (219) (468)
----------- ----------- ----------- ----------- -----------
Income (loss) before cumulative effect of
accounting change............................. 1,329 (16,869) (13,872) (2,872) (2,672)
Cumulative effect of accounting change.......... -- (1,012) -- -- --
----------- ----------- ----------- ----------- -----------
Net income (loss)............................. $ 1,329 $ (17,881) $ (13,872) $ (2,872) $ (2,672)
----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- -----------
OTHER FINANCIAL DATA:
Capital expenditures............................ $ 31,529 $ 23,808 $ 23,951 $ 5,554 $ 3,073
Depreciation and amortization................... 28,150 36,527 39,400 9,907 11,028
BALANCE SHEET DATA (END OF PERIOD):
Cash and cash equivalents, short-term marketable
securities and restricted cash and
investments................................... $ 34,159 $ 53,043 $ 95,206 $ 83,816
Total assets.................................... 305,420 344,801 468,745 451,471
Due to parent (noninterest bearing)............. 70,813 -- -- --
Total debt...................................... -- 254,000 329,500 319,265
Stockholders' equity (deficit)(2)............... 122,333 (29,482) (25,864) (26,917)
- ------------------------
(1) Represents primarily interest income.
(2) The reduction in stockholders' equity in fiscal 1996 resulted from the
acquisition of Merit's common stock by Merit's management and an investor
group, which was accounted for as a recapitalization. See Note 2 to the
audited historical consolidated financial statements of Merit included
elsewhere herein.
22
RISK FACTORS
IN EVALUATING THE EXCHANGE OFFER, HOLDERS OF THE OLD NOTES SHOULD CAREFULLY
CONSIDER THE FOLLOWING FACTORS IN ADDITION TO THOSE DISCUSSED ELSEWHERE IN THIS
PROSPECTUS PRIOR TO ACCEPTING THE EXCHANGE OFFER. HOLDERS OF OLD NOTES SHOULD
ALSO CONSIDER THAT SUCH FACTORS ARE ALSO GENERALLY APPLICABLE TO THE OLD NOTES.
THE OLD NOTES AND THE NEW NOTES ARE COLLECTIVELY REFERRED TO HEREIN AS THE
"NOTES."
SUBSTANTIAL LEVERAGE AND DEBT SERVICE OBLIGATIONS
As a result of the Transactions, the Company is currently highly leveraged,
with indebtedness that is substantial in relation to its stockholders' equity.
As of December 31, 1997, on a pro forma basis, the Company's aggregate
outstanding indebtedness would have been approximately $1.2 billion and the
Company's stockholders' equity would have been approximately $179.0 million as
of the same date. The New Credit Agreement and the Indenture permit the Company
to incur or guarantee certain additional indebtedness, subject to certain
limitations. See "Unaudited Pro Forma Consolidated Financial Information,"
"Description of the New Notes" and "Summary of New Credit Agreement."
The Company's high degree of leverage could have important consequences to
holders of the Notes, including, but not limited to, the following: (i) the
Company's ability to obtain additional financing for working capital, capital
expenditures, acquisitions, general corporate purposes or other purposes may be
impaired in the future; (ii) a substantial portion of the Company's cash flow
from operations must be dedicated to the payment of principal and interest on
its indebtedness; (iii) the Company is substantially more leveraged than certain
of its competitors, which might place the Company at a competitive disadvantage;
(iv) the Company may be hindered in its ability to adjust rapidly to changing
market conditions; and (v) the Company's high degree of leverage could make it
more vulnerable in the event of a downturn in general economic conditions or its
business or in the event of adverse changes in the regulatory environment
applicable to the Company.
The Company's ability to repay or to refinance its indebtedness and to pay
interest on its indebtedness will depend on its financial and operating
performance, which, in turn, is subject to prevailing economic and competitive
conditions and to certain financial, business and other factors, many of which
are beyond the Company's control. These factors could include operating
difficulties, increased operating costs, the actions of competitors, regulatory
developments and delays in implementing strategic projects. The Company's
ability to meet its debt service and other obligations may depend in significant
part on the extent to which the Company can successfully implement its business
strategy. There can be no assurance that the Company will be able to implement
its strategy fully or that the anticipated results of its strategy will be
realized. See "Business--Business Strategy."
If the Company's cash flow and capital resources are insufficient to fund
its debt service obligations, the Company may be forced to reduce or delay
capital expenditures, sell assets or seek to obtain additional equity capital or
to restructure its debt. There can be no assurance that the Company's cash flow
and capital resources will be sufficient for payment of principal of and
interest on its indebtedness in the future, or that any such alternative
measures would be successful or would permit the Company to meet its scheduled
debt service obligations.
The indebtedness outstanding pursuant to the New Credit Agreement matures
prior to the maturity of the Notes. If the Company is unable to refinance the
indebtedness outstanding pursuant to the New Credit Agreement at maturity or
repay such indebtedness with cash on hand, through asset sales, equity sales or
otherwise, its ability to repay the principal and interest on the Notes could be
adversely affected.
In addition, because the Company's obligations under the New Credit
Agreement bear interest at floating rates, an increase in interest rates could
adversely affect, among other things, the Company's ability to meet its debt
service obligations.
23
SUBORDINATION
The payment of principal of and interest on, and any premium or other
amounts owing in respect of, the Notes is subordinated to the prior payment in
full of all existing and future Senior Indebtedness of the Company, including
all amounts owing under the New Credit Agreement. Consequently, in the event of
a bankruptcy, liquidation, dissolution, reorganization or similar proceeding
with respect to the Company, assets of the Company will be available to pay
obligations on the Notes only after all Senior Indebtedness of the Company has
been paid in full, and there can be no assurance that there will be sufficient
assets to pay amounts due on any or all of the Notes. In addition, the Company
may not pay principal, premium, interest or other amounts on account of the
Notes in the event of a payment default or certain other defaults in respect of
Specified Senior Indebtedness (as defined) unless such indebtedness has been
paid in full or the default has been cured or waived. In addition, in the event
of certain other defaults with respect to Specified Senior Indebtedness, the
Company may not be permitted to make any payment on account of the Notes for a
designated period of time. See "Description of the New Notes-- Subordination."
As of December 31, 1997, on a pro forma basis, the aggregate amount of the
Company's outstanding Senior Indebtedness would have been approximately $590.2
million (exclusive of unused commitments), substantially all of which would have
been Secured Indebtedness and would have been guaranteed by substantially all of
the Company's subsidiaries.
The Notes are unsecured and thus, in effect, rank junior to any Secured
Indebtedness of the Company or its subsidiaries. The indebtedness outstanding
pursuant to the New Credit Agreement (including the guarantees thereof by the
Company's wholly owned domestic subsidiaries) is secured by substantially all of
the assets of the Company and its wholly owned domestic subsidiaries, including
pledges of all or a portion of the capital stock of substantially all of the
Company's operating subsidiaries. See "Summary of New Credit Agreement."
HOLDING COMPANY STRUCTURE
The Company conducts substantially all of its operations through its
subsidiaries. As a result, the Company is required to rely upon payments from
its subsidiaries for the funds necessary to meet its obligations, including the
payment of interest on and principal of the Notes. The ability of the
subsidiaries to make such payments is subject to, among other things, applicable
state laws. Claims of creditors of the Company's subsidiaries generally have
priority as to the assets of such subsidiaries over claims of the Company.
Therefore, the Notes are effectively subordinated to all liabilities of the
Company's subsidiaries, including trade payables of the subsidiaries. In
addition, the payment of dividends to the Company by its subsidiaries is
contingent upon the earnings of those subsidiaries and subject to various
business considerations. The Indenture permits restrictions, in certain
circumstances, on the payment of dividends and distributions and the transfer of
assets to the Company. See "Summary of New Credit Agreement," and "Description
of the New Notes--Certain Covenants--Limitation on Payment Restrictions
Affecting Restricted Subsidiaries."
The indebtedness outstanding pursuant to the New Credit Agreement is fully
guaranteed by substantially all of the Company's direct and indirect domestic
wholly owned subsidiaries on the issue date of the Old Notes and substantially
all future direct and indirect domestic wholly owned subsidiaries (collectively,
the "Subsidiary Guarantors"). The obligations of the Subsidiary Guarantors are
secured by security interests in, or liens on, substantially all tangible and
intangible assets of the Subsidiary Guarantors (excluding real property). The
Notes are not guaranteed by the subsidiaries of the Company. Therefore, the
lenders pursuant to the New Credit Agreement have a direct claim against the
assets of the Subsidiary Guarantors but the holders of the Notes have no such
claims.
24
HISTORY OF UNPROFITABLE OPERATIONS
The Company experienced losses from continuing operations before
extraordinary items in each fiscal year from 1993 through 1995. Such losses
amounted to $39.6 million, $47.0 million and $43.0 million for the fiscal years
ended September 30, 1993, 1994 and 1995, respectively. Merit experienced losses
before cumulative effects of accounting changes in fiscal 1996 and 1997 of $16.9
million and $13.9 million, respectively. The Company reported net revenue and
net income of approximately $1.35 billion and $32.4 million, respectively, for
fiscal 1996 and net revenue and income before extraordinary items of
approximately $1.2 billion and $4.8 million, respectively, for fiscal 1997. The
Company's fiscal 1997 net income included a loss on the Crescent Transactions of
$35.9 million, net of taxes. There can be no assurance that the Company's
profitability will continue in future periods.
RESTRICTIVE FINANCING COVENANTS
The New Credit Agreement and the Indenture contain a number of covenants
that restrict the operations of the Company and its subsidiaries. In addition,
the New Credit Agreement requires the Company to comply with specified financial
ratios and tests, including a minimum interest coverage ratio, a maximum
leverage ratio, a minimum net worth test, a maximum senior debt ratio and a
minimum "EBITDA" (as defined in the New Credit Agreement). There can be no
assurance that the Company will be able to comply with such covenants, ratios
and tests in the future. The Company's ability to comply with such covenants,
ratios and tests may be affected by events beyond its control, including
prevailing economic, financial and industry conditions. The breach of any such
covenants, ratios or tests could result in a default under the New Credit
Agreement that would permit the lenders thereunder to declare all amounts
outstanding thereunder to be immediately due and payable, together with accrued
and unpaid interest, and to prevent the Company from paying principal, premium,
interest or other amounts due on any or all of the Notes until the default is
cured or all Senior Indebtedness is paid or satisfied in full. See "Description
of the Notes--Subordination." Furthermore, the commitments of the lenders under
the New Credit Agreement to make further extensions of credit thereunder could
be terminated. If the Company were unable to repay all amounts accelerated, the
lenders could proceed against the Subsidiary Guarantors and the collateral
securing the Company's and the Subsidiary Guarantors' obligations pursuant to
the New Credit Agreement. If the indebtedness outstanding pursuant to the New
Credit Agreement were to be accelerated, there can be no assurance that the
assets of the Company would be sufficient to repay such indebtedness and the
other indebtedness of the Company, including the Notes. See "Description of the
New Notes" and "Summary of New Credit Agreement."
CHANGE OF CONTROL
The occurrence of a Change of Control may result in a default, or otherwise
require repayment of indebtedness, under both the Indenture and the New Credit
Agreement. In addition, the New Credit Agreement prohibits the repayment of the
Notes by the Company upon the occurrence of a Change of Control, unless and
until such time as the indebtedness under the New Credit Agreement is repaid in
full. The Company's failure to make such repayments in such instances would
result in a default under both the Indenture and the New Credit Agreement.
Future indebtedness of the Company may also contain restrictions or repayment
requirements with respect to certain events or transactions that could
constitute a Change of Control. In the event of a Change of Control, there can
be no assurance that the Company would have sufficient assets to satisfy all of
its obligations under the Notes or the New Credit Agreement. See "Description of
the New Notes--Change of Control."
RISK-BASED PRODUCTS
As a result of the Acquisition, revenues under risk-based contracts are the
primary source of the Company's revenue from its managed behavioral care
business. On a pro forma basis, such revenues would have accounted for
approximately 50% of the Company's total revenue and 73% of its managed
25
behavioral healthcare revenue in fiscal 1997. On a pro forma basis, after giving
effect to the CBHS Transactions, such revenue would have accounted for
approximately 56% of the Company's total revenue and 73% of its managed
behavioral healthcare revenue in fiscal 1997. In order for such contracts to be
profitable, the Company must accurately estimate the rate of service utilization
by beneficiaries enrolled in programs managed by the Company and control the
unit cost of such services. There can be no assurance that the Company's
assumptions as to service utilization rates and costs will accurately and
adequately reflect actual utilization rates and costs, nor can there be any
assurance that increases in behavioral healthcare costs or
higher-than-anticipated utilization rates, significant aspects of which are
outside the Company's control, will not cause expenses associated with such
contracts to exceed the Company's revenue for such contracts. In addition, there
can be no assurance that adjustments will not be required to the estimates,
particularly those regarding cost of care, made in reporting historical
financial results. See Note 1 to the audited historical consolidated financial
statements of the Company included herein, Note 4 to the audited historical
consolidated financial statements of Merit included herein and Note 1 to the
audited historical consolidated financial statements of HAI included herein. The
Company will attempt to increase membership in its risk-based products following
the Acquisition. If the Company is successful in this regard, the Company's
exposure to potential losses from its risk-based products will also be
increased. Furthermore, certain of such contracts and certain state regulations
limit the profits that may be earned by the Company on risk-based business and
may require refunds if the loss experience is more favorable than that
originally anticipated. Such contracts and regulations may also require the
Company or certain of its subsidiaries to reserve a specified amount of cash as
financial assurance that it can meet its obligations under such contracts. As of
December 31, 1997, on a pro forma basis, the Company would have had cash
reserves of $52.1 million pursuant to such contracts and regulations. Such
amounts will not be available to the Company for general corporate purposes.
Furthermore, certain state regulations restrict the ability of subsidiaries that
offer risk-based products to pay dividends to the Company. See "Business" and
"Merit's Management's Discussion and Analysis of Financial Condition and Results
of Operations."
RELIANCE ON CUSTOMER CONTRACTS
On a pro forma basis, before and after giving effect to the CBHS
Transactions, and following the Company's acquisitions of Merit, HAI and Allied,
approximately 69% and 78%, respectively, of the Company's revenue in fiscal 1997
would have been derived from contracts with payors of behavioral healthcare
benefits. The Company's managed care contracts typically have terms of one to
three years, and in certain cases contain renewal provisions providing for
successive terms of between one and two years (unless terminated earlier).
Substantially all of these contracts are immediately terminable with cause and
many, including some of the Company's most significant contracts, are terminable
without cause by the customer upon the provision of requisite notice and the
passage of a specified period of time (typically between 60 and 180 days), or
upon the occurrence of certain other specified events. See "Business." On a pro
forma basis, following the Company's acquisitions of Merit, HAI and Allied, both
before and after giving effect to the CBHS Transactions, the Company's ten
largest managed behavioral healthcare customers would have accounted for
approximately 47% of the Company's managed behavioral healthcare revenue for
fiscal 1997. One of such contracts, an agreement between HAI and Aetna,
represents 21% of the Company's pro forma covered lives and would have
represented 5% of its pro forma managed behavioral healthcare revenues for
fiscal 1997. The contract expires on December 3, 2003. There can be no assurance
that such contracts will be extended or successfully renegotiated or that the
terms of any new contracts will be comparable to those of existing contracts.
Loss of all of these contracts or customers would, and loss of any one of these
customers could, have a material adverse effect on the Company. In addition,
price competition in bidding for contracts can significantly affect the
financial terms of any new or renegotiated contract. The Company's customers may
reevaluate their contractual arrangements with the Company as a result of the
consummation of the Transactions.
26
SERVICES PURCHASE AGREEMENT
The obligations of the Company and CBHS to consummate the transactions
contemplated by the Equity Purchase Agreement and the Support Agreement are
conditioned upon the execution and delivery of the Services Purchase Agreement.
It is expected that the Services Purchase Agreement would obligate the Company
to purchase from CBHS a designated minimum amount of behavioral healthcare
services for gate-kept risk-based covered lives, subject to certain conditions,
and to make certain payments to CBHS if it fails to do so. It is expected that
such payments could equal up to $59.4 million, subject to increases pursuant to
the terms of the Services Purchase Agreement. There can be no assurance that the
Company will not be required to make such payments. See "Pending Sale of
Provider Business--Description of the Definitive Agreements--The Services
Purchase Agreement."
DEPENDENCE ON GOVERNMENT SPENDING FOR MANAGED HEALTHCARE; POSSIBLE IMPACT OF
HEALTHCARE REFORM
A significant portion of the Company's managed care revenue is derived,
directly or indirectly, from federal, state and local governmental agencies,
including state Medicaid programs. Reimbursement rates vary from state to state,
are subject to periodic negotiation and may limit the Company's ability to
maintain or increase rates. The Company is unable to predict the impact on the
Company's operations of future regulations or legislation affecting Medicaid or
Medicare programs, or the healthcare industry in general, and there can be no
assurance that future regulations or legislation will not have a material
adverse effect on the Company. Moreover, any reduction in government spending
for such programs could also have a material adverse effect on the Company. In
addition, the Company's contracts with federal, state and local governmental
agencies, under both direct contract and subcontract arrangements, generally are
conditioned upon financial appropriations by one or more governmental agencies,
especially with respect to state Medicaid programs. These contracts generally
can be terminated or modified by the customer if such appropriations are not
made. Finally, some of the Company's contracts with federal, state and local
governmental agencies, under both direct contract and subcontract arrangements,
require the Company to perform additional services if federal, state or local
laws or regulations imposed after the contract is signed so require, in exchange
for additional compensation to be negotiated by the parties in good faith.
Government and other third-party payors are generally seeking to impose lower
reimbursement rates and to renegotiate reduced contract rates with service
providers in a trend toward cost control. See "Industry--Areas of Growth" and
"Business--Business Strategy."
In August 1997, Congress enacted the Balanced Budget Act of 1997 (the
"Budget Act"). The Medicare-related provisions of the Budget Act are designed to
reduce Medicare expenditures over the next five years by $115 billion, compared
to projected Medicare expenditures before adoption of the Budget Act. The
Congressional Budget Office projected in July 1997 that $43.8 billion of the
reductions would come from reduced payments to hospitals, $21.8 billion from
increased enrollment in managed care plans and $11.7 billion from reduced
payments to physicians and ambulatory care providers. The five-year savings in
projected Medicare payments to physicians and hospitals would be achieved under
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
27
the cost of Medicaid deductibles and coinsurance requirements for low-income
Medicaid beneficiaries from their Medicaid programs to physicians and other
providers. Most of the remaining savings derive from the repeal of the "Boren
Amendment" and other minimum payment guarantees for hospitals, nursing homes and
community health centers that serve Medicaid patients. These changes may have an
adverse effect on the Company if they result in reduced payment levels for
providers of managed behavioral healthcare services.
Prior to adoption of the Budget Act, the states were prohibited from
requiring Medicaid recipients to enroll in managed care products that covered
only Medicaid recipients. The Medicaid laws required that the states enroll
Medicaid recipients in products that also covered a specific number of
commercial enrollees. This requirement of the Medicaid laws was intended to
limit the ability of the states to reduce coverage levels for Medicaid
recipients below those offered to commercial enrollees. Under prior law, the
Secretary of the United States Department of Health and Human Services (the
"Department") could waive the prohibition. The Medicaid-related provisions of
the Budget Act give states broad flexibility to require most Medicaid recipients
to enroll in managed care products that only cover Medicaid recipients, without
obtaining a waiver from the Secretary of the Department that was required under
prior law. The Budget Act also allows states to limit the number of managed care
organizations with which the state will contract to deliver care to Medicaid
beneficiaries. These changes could have a positive impact on the Company's
business, if they result in increased enrollment of Medicaid beneficiaries in
managed care organizations and increased Medicaid spending on managed care.
However, these changes also may have an adverse effect on the Company if a
number of states decide to limit the number of managed care organizations with
which they will contract and to select the organization solely on the basis of
the cost of care, which could result in increased cost competition for state
contracts.
The Company cannot predict the effect of the Budget Act, or other healthcare
reform measures that may be adopted by Congress or state legislatures, on its
managed care operations and no assurance can be given that either the Budget Act
or other healthcare reform measures will not have an adverse effect on the
Company.
REGULATION
The managed healthcare industry and the provision of behavioral healthcare
services are subject to extensive and evolving state and federal regulation. The
Company is subject to certain state laws and regulations, including those
governing: (i) the licensing of insurance companies, HMOs, preferred provider
organizations ("PPOs"), third-party administrators ("TPAs") and companies
engaged in utilization review and (ii) the licensing of healthcare
professionals, including restrictions on business corporations from practicing,
controlling or exercising excessive influence over behavioral healthcare
services through the direct employment of psychiatrists or, in a few states,
psychologists and other behavioral healthcare professionals. In addition, the
Company is subject to certain federal laws as a result of the role the Company
assumes in connection with managing its customers' employee benefit plans. The
Company's managed care operations are also indirectly affected by regulations
applicable to the establishment and operation of behavioral healthcare clinics
and facilities.
The Company believes its operations are structured to comply with applicable
laws and regulations in all material respects and that it has received, or is in
the process of applying for, all licenses and approvals material to the
operation of its business. In many states, entities that assume risk under
contracts with licensed insurance companies or HMOs have not been considered by
state regulators to be conducting an insurance or HMO business. As a result, the
Company has not sought licensure as either an insurer or HMO in certain states.
Regulators in some states, however, have determined that risk assuming activity
by entities that are not themselves providers of care is an activity that
requires some form of licensure. There can be no assurance that other states in
which the Company operates will not adopt a similar view, thus requiring the
Company to obtain additional licenses. Such additional licensure might require
the Company to maintain minimum levels of deposits, net worth, capital, surplus
or
28
reserves, or limit the Company's ability to pay dividends, make investments or
repay indebtedness. The imposition of these additional licensure requirements
could increase the Company's cost of doing business or delay the Company's
conduct or expansion of its business.
Regulators may impose operational restrictions on entities granted licenses
to operate as insurance companies or HMOs. For example, the DOC imposed certain
restrictions on the Company in connection with its issuance of an approval of
the Company's acquisition of HAI, including restrictions on the ability of the
California subsidiaries of HAI to fund the Company's operations in other states
and on the ability of the Company to make certain operational changes with
respect to HAI's California subsidiaries. The DOC imposed substantially
identical restrictions on the Company in connection with the Company's
acquisition of Merit. The Company does not believe such restrictions will
materially impact its integration plan.
In addition, utilization review and TPA activities conducted by the Company
are regulated by many states, which states impose requirements upon the Company
that increase its business costs. The Company believes that its TPA activities
performed for its self-insured employee benefit plan customers are exempt from
otherwise applicable state licensing or registration requirements based upon
federal preemption under the Employee Retirement Income Security Act of 1974, as
amended ("ERISA"), and has relied on this general principle in determining not
to seek licensure for certain of its activities in many states. Existing case
law is not uniform on the applicability of ERISA preemption with respect to
state regulation of utilization review or TPA activities. There can be no
assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states. See "Business--
Regulation--Insurance, HMO, and PPO Activities" and "--Utilization Review and
Third-Party Administrator Activities."
State regulatory agencies responsible for the administration and enforcement
of the laws and regulations to which the Company's operations are subject have
broad discretionary powers. A regulatory agency or a court in a state in which
the Company operates could take a position under existing or future laws or
regulations, or change its interpretation or enforcement practices with respect
thereto, that such laws or regulations apply to the Company differently than the
Company believes such laws and regulations apply or should be enforced. The
resultant compliance with, or revocation of, or failure to obtain, required
licenses and governmental approvals could result in significant alteration to
the Company's business operations, delays in the expansion of the Company's
business and lost business opportunities, any of which, under certain
circumstances, could have a material adverse effect on the Company. See
"Business--Regulation--General," "--Licensure," "--Insurance, HMO and PPO
Activities" and "--Utilization Review and Third-Party Administrator Activities."
The laws of some states limit the ability of a business corporation to
directly provide, control or exercise excessive influence over behavioral
healthcare services through the direct employment of psychiatrists,
psychologists, or other behavioral healthcare professionals. In addition, the
laws of some states prohibit psychiatrists, psychologists, or other healthcare
professionals from splitting fees with other persons or entities. These laws and
their interpretations vary from state to state and enforcement by the courts and
regulatory authorities may vary from state to state and may change over time.
The Company believes that its operations as currently conducted are in material
compliance with the applicable laws, however there can be no assurance that the
Company's existing operations and its contractual arrangements with
psychiatrists, psychologists and other healthcare professionals will not be
successfully challenged under state laws prohibiting fee splitting or the
practice of a profession by an unlicensed entity, or that the enforceability of
such contractual arrangements will not be limited. The Company believes that it
could, if necessary, restructure its operations to comply with changes in the
interpretation or enforcement of such laws and regulations, and that such
restructuring would not have a material adverse effect on its operations.
29
Several states in which the Company does business have adopted, or are
expected to adopt, "any willing provider" laws. Such laws typically impose upon
insurance companies, PPOs, HMOs or other types of third-party payors an
obligation to contract with, or pay for the services of, any healthcare provider
willing to meet the terms of the payor's contracts with similar providers.
Compliance with any willing provider laws could increase the Company's costs of
assembling and administering provider networks and could, therefore, have a
material adverse effect on its operations.
The Company's managed care operations are also generally affected by
regulations applicable to the operations of healthcare clinics and facilities.
See "Charter Advantage--Regulation."
INTEGRATION OF OPERATIONS
As a result of the Company's acquisition of Merit and HAI, the Company is
the largest provider of managed behavioral healthcare services in the United
States. The Company's ability to operate its acquired managed care businesses
successfully depends on how well and how quickly it integrates the acquired
businesses with its existing operations. The Company expects to achieve
approximately $60.0 million of cost savings on an annual basis within eighteen
months following the consummation of the Acquisition. See "Magellan's
Management's Discussion and Analysis of Financial Condition and Results of
Operations--Pro Forma Liquidity and Capital Resources." However, as the Company
implements the integration process, it may need to implement enhanced
operational, financial and information systems and may require additional
employees and management, operational and financial resources. There can be no
assurance that the Company will be able to implement and maintain such
operational, financial and information systems successfully or successfully
obtain, integrate and utilize the required employees and management, operational
and financial resources to achieve the successful integration of the acquired
businesses with its existing operations. Failure to implement such systems
successfully and to use such resources effectively could have a material adverse
effect on the Company. Furthermore, implementing such operational, financial and
information systems or obtaining such employees and management could reduce the
cost savings the Company expects to achieve. See "Business-- Business Strategy."
HIGHLY COMPETITIVE INDUSTRY
The industry in which the Company conducts its managed care business is
highly competitive. The Company competes with large insurance companies, HMOs,
PPOs, TPAs, provider groups and other managed care companies. Many of the
Company's competitors are significantly larger and have greater financial,
marketing and other resources than the Company, and some of the Company's
competitors provide a broader range of services. The Company may also encounter
substantial competition in the future from new market entrants. Many of the
Company's customers that are managed care companies may, in the future, seek to
provide managed behavioral healthcare services to their employees or subscribers
directly, rather than contracting with the Company for such services. See
"Business-- Competition."
SUBORDINATION OF FRANCHISE FEES
The Company owns a 50% equity interest in CBHS, from which it receives the
Franchise Fees. The Franchise Fees represent a significant portion of the
Company's earnings and cash flows. The Franchise Fees payable to the Company by
CBHS are subordinated in right of payment to the $41.7 million annual base rent,
5% minimum escalator rent and, in certain circumstances, certain additional rent
due to Crescent. See "Charter Advantage -- Franchise Operations -- Franchise
Fees; Subordination." If CBHS encounters a decline in earnings or financial
difficulties, such amounts due to Crescent will be paid before any Franchise
Fees are paid. The remainder of CBHS's available cash will then be applied in
such order of priority as CBHS may determine, in the reasonable discretion of
the CBHS governing board, to all other operating expenses of CBHS, including the
current and accumulated Franchise Fees. The
30
Company will be entitled to pursue all available remedies for breach of the
Master Franchise Agreement, except that the Company does not have the right to
take any action that could reasonably be expected to force CBHS into bankruptcy
or receivership.
As a result of the Crescent Transactions, the Company no longer controls the
operations of the Psychiatric Hospital Facilities and other facilities operated
by CBHS. Accordingly, factors that the Company does not control will likely
influence the amount of the equity in the earnings of CBHS and the amount of
Franchise Fees that the Company will realize in the future. For example, CBHS
may pursue acquisitions in markets where it does not currently have a presence
and in markets where it has existing hospital operations. Furthermore, CBHS may
consolidate services in selected markets by closing additional facilities
depending on market conditions and evolving business strategies. If CBHS closes
additional psychiatric hospitals, it could result in charges to income for the
costs attributable to the closure, which would result in lower equity in
earnings of CBHS for the Company and receipt by the Company of less than the
agreed to amount of Franchise Fees.
Based on projections of fiscal 1998 operations prepared by management of
CBHS, the Company believes that CBHS will be unable to pay the full amount of
the Franchise Fees it is contractually obligated to pay the Company during
fiscal 1998. The Company currently estimates that CBHS will be able to pay
approximately $58.0 million to $68.0 million of the Franchise Fees in fiscal
1998, a $10.0 million to $20.0 million shortfall relative to amounts payable
under the Master Franchise Agreement. See "Magellan's Management's Discussion
and Analysis of Financial Condition and Results of Operations-- Results of
Operations--Impact of Crescent Transactions."
The Company's relationship with CBHS and the business of CBHS are described
elsewhere in this Prospectus. Such information is relevant to an understanding
of the factors having a bearing on the Company's continued receipt of Franchise
Fees from CBHS. The Company has signed definitive agreements with COI and CBHS
to, among other things, sell to such entities the Company's franchise
operations, certain domestic provider operations and certain other assets and
operations and the Company's ownership interest in CBHS. If the CBHS
Transactions are consummated, the Company would no longer receive the Franchise
Fees. The cash proceeds received by the Company upon the consummation of the
CBHS Transactions would be used to repay amounts outstanding under the Term Loan
Facility. There can be no assurance that the CBHS Transactions will be
consummated. See "Charter Advantage" and "Pending Sale of Provider Business."
PROFESSIONAL LIABILITY; INSURANCE
The management and administration of the delivery of managed behavioral
healthcare services, like other healthcare services, entail significant risks of
liability. The Company is regularly subject to lawsuits alleging malpractice and
related legal theories, some of which involve situations in which participants
in the Company's programs have committed suicide. The Company is also subject to
claims of professional liability for alleged negligence in performing
utilization review activities, as well as for acts and omissions of independent
contractors participating in the Company's third-party provider networks. The
Company is subject to claims for the costs of services denied. There can be no
assurance that the Company's procedures for limiting liability have been or will
be effective, or that one or more lawsuits will not have a material adverse
effect on the Company in the future. See "Business --Legal Proceedings."
The Company carries professional liability insurance, subject to certain
deductibles. There can be no assurance that such insurance will be sufficient to
cover any judgments, settlements or costs relating to present or future claims,
suits or complaints or that, upon expiration thereof, sufficient insurance will
be available on favorable terms, if at all. If the Company is unable to secure
adequate insurance in the future, or if the insurance carried by the Company is
not sufficient to cover any judgments, settlements or costs relating to any
present or future actions or claims, there can be no assurance that the Company
will
31
not be subject to a liability that could have a material adverse effect on the
Company. See "Business-Insurance."
The Company has certain liabilities relating to the self-insurance program
it maintained with respect to its provider business prior to the Crescent
Transactions. See Note 13 to the Company's audited historical consolidated
financial statements included elsewhere herein.
FRAUDULENT TRANSFER CONSIDERATIONS
If, in a bankruptcy or reorganization case or a lawsuit by or on behalf of
unpaid creditors of the Company, a court were to find that, at the time the
Company incurred indebtedness under the Notes, (i) the Company incurred such
indebtedness with the intent of hindering, delaying or defrauding current or
future creditors or (ii) (a) the Company received less than reasonably
equivalent value or fair consideration for incurring such indebtedness and (b)
the Company (1) was insolvent or was rendered insolvent by reason of such
incurrence, (2) was engaged, or about to engage, in a business or transaction
for which its assets constituted unreasonably small capital, (3) intended to
incur, or believed that it would incur, debts beyond its ability to pay such
debts as they matured (as all of the foregoing terms are defined in or
interpreted under the relevant fraudulent transfer or conveyance statutes) or
(4) was a defendant in an action for money damages, or had a judgment for money
damages docketed against it (if, in either case, after final judgment, the
judgment is unsatisfied), then such court could avoid or subordinate the
Company's obligations under the Notes to presently existing and future
indebtedness of the Company and take other actions detrimental to the holders of
the Notes.
The measures of insolvency for purposes of the foregoing considerations will
vary depending upon the law of the jurisdiction that is being applied in any
such proceeding. Generally, however, the Company would be considered insolvent
if, at the time it incurred the indebtedness, either (i) the sum of its debts
(including contingent liabilities) is greater than its assets, at a fair
valuation, or (ii) the present fair saleable value of its assets is less than
the amount required to pay the probable liability on its total existing debts
and liabilities (including contingent liabilities) as they become absolute and
matured. There can be no assurance as to what standards a court would use to
determine whether the Company was solvent at the relevant time, or whether,
whatever standard was used, the Company's obligations with respect to the Notes
would not be avoided or further subordinated on the grounds set forth above.
Counsel for the Company and counsel for the Initial Purchaser will not express
any opinion as to the applicability of federal or state fraudulent transfer and
conveyance laws.
The Company believes that at the time the Old Notes were issued, the Company
(i) was (a) neither insolvent nor rendered insolvent thereby, (b) in possession
of sufficient capital to run its businesses effectively and (c) incurring debts
within its ability to pay as the same mature or become due and (ii) had
sufficient assets to satisfy any probable money judgment against it in any
pending action. There can be no assurance, however, that a court passing on such
question would reach the same conclusions.
Additionally, under federal bankruptcy or applicable state insolvency law,
if certain bankruptcy or insolvency proceedings were initiated by or against the
Company within 90 days after any payment by the Company with respect to the
Notes or if the Company anticipated becoming insolvent at the time of such
payment or incurrence, all or a portion of such payment could be avoided as a
preferential transfer and the recipient of such payment could be required to
return such payment.
ABSENCE OF TRADING MARKETS
The Old Notes are currently owned by a relatively small number of
institutional investors. The Company believes that none of such holders is an
affiliate (as defined in Rule 405 under the Securities Act) of the Company.
Prior to the Exchange Offer, no public market for the Old Notes will exist,
although the Old Notes are eligible for trading in the PORTAL Market among
"qualified institutional buyers." The New Notes will not be listed on any
securities exchange. There can be no assurance that an active
32
trading market for the Notes will develop. Future trading prices of the Notes
will depend on many factors, including, among other things, prevailing interest
rates, the Company's results of operations and the market for similar
securities. Depending on prevailing interest rates, the markets for similar
securities and other factors, including the financial condition of the Company,
the Notes may trade at a discount from their principal amount.
RESTRICTIONS ON TRANSFER OF THE NOTES
The Old Notes have not been registered under the Securities Act and will
remain subject to restrictions on transferability to the extent they are not
exchanged for New Notes by holders who are entitled to participate in the
Exchange Offer. The holders of Old Notes who are not eligible to participate in
the Exchange Offer are entitled to certain registration rights, and the Company
is required to file the Shelf Registration Statement with respect to resales
from time to time of any such Old Notes.
EXCHANGE OFFER PROCEDURES
Issuance of the New Notes in exchange for the Old Notes pursuant to the
Exchange Offer will be made only after timely receipt by the Exchange Agent of
such Old Notes, a properly completed and duly executed Letter of Transmittal and
all other required documents. Therefore, holders of the Old Notes desiring to
tender such Old Notes in exchange for New Notes should allow sufficient time to
ensure timely delivery. The Company is under no duty to give notification of
defects or irregularities with respect to tenders of Old Notes for exchange. Old
Notes that are not tendered or that are tendered but not accepted by the Company
for exchange will, following consummation of the Exchange Offer, continue to be
subject to the existing restrictions upon transfer thereof under the Securities
Act and, upon consummation of the Exchange Offer, certain registration rights
under the Registration Rights Agreement will terminate. In addition, any holder
of Old Notes who tenders in the Exchange Offer for the purpose of participating
in a public distribution of the New Notes may be deemed to be an "underwriter"
(within the meaning of Section 2(11) of the Securities Act) of the New Notes
and, if so, will be required to comply with the registration and prospectus
delivery requirements in the Securities Act in connection with any resale
transaction. Each broker-dealer that receives New Notes for its own account in
exchange for Old Notes, where such Old Notes were acquired by such broker-dealer
as result of market-making activities or other trading activities, must
acknowledge in the Letter of Transmittal that accompanies this Prospectus that
it will deliver a prospectus in connection with any resale of such New Notes.
See "Plan of Distribution." To the extent that Old Notes are tendered and
accepted in the Exchange Offer, the trading market for untendered and tendered
but unaccepted Old Notes could be adversely affected. See "The Exchange Offer."
33
THE TRANSACTIONS
GENERAL
The Transactions, all of which were consummated on February 12, 1998,
consist of the following: (i) the Acquisition; (ii) the repayment of all amounts
outstanding pursuant to, and the termination of, the Existing Credit Agreements;
(iii) the consummation of the Debt Tender Offers; (iv) the execution and
delivery of, and initial borrowings under, the New Credit Agreement; and (v) the
issuance of the Old Notes. The Transactions are described in more detail below.
THE ACQUISITION
On February 12, 1998, the Company consummated the Acquisition of Merit
pursuant to an Agreement and Plan of Merger, dated October 24, 1997 (the "Merger
Agreement"), between the Company and Merit. Under the Merger Agreement, Merit
became a wholly-owned subsidiary of the Company and the Company paid an amount
of cash equal to approximately $448.9 million at the closing (the "Direct Cash
Merger Consideration"). Upon consumation of the Acquisition, pursuant to the
Merger Agreement, the Company caused Merit to repay all amounts outstanding
under the Merit Existing Credit Agreement and to perform Merit's obligations
under the indenture governing the Merit Outstanding Notes to offer to purchase
the Merit Outstanding Notes following the consummation of the Acquisition.
Pursuant to the Merger Agreement, the Company provided sufficient funds to
permit Merit to take such actions. The Company estimates that the total
consideration it paid to acquire Merit and to retire Merit's outstanding
indebtedness (net of cash) was approximately $750 million, excluding transaction
costs.
Pursuant to the Merger Agreement, Merit made representations and warranties
customary for transactions of this type. None of Merit's representations and
warranties and agreements survived the consummation of the Acquisition.
Therefore, if any of the representations and warranties prove to be inaccurate,
the Company will not be able to recover from Merit's former owners the amount of
any damage resulting from the inaccuracy.
TERMINATION OF EXISTING CREDIT AGREEMENTS
It was a condition to Chase's obligation to advance loans pursuant to the
New Credit Agreement that the Magellan Existing Credit Agreement be terminated.
Furthermore, Magellan agreed, in connection with the Acquisition, to repay all
amounts outstanding pursuant to the Merit Existing Credit Agreement. Such
transactions were consummated simultaneously with the Offering.
DESCRIPTION OF MAGELLAN EXISTING CREDIT AGREEMENT. The Magellan Existing
Credit Agreement was that certain Amended and Restated Credit Agreement, dated
as of June 16, 1997, among the Company, Charter Behavioral Health System of New
Mexico, Inc., the lenders named therein, Chase, as administrative agent, and
First Union National Bank, as syndication agent. Simultaneously with the
consummation of the offering of the Old Notes, the Magellan Existing Credit
Agreement was terminated. The Magellan Existing Credit Agreement provided for a
five-year senior secured revolving credit facility in an aggregate committed
amount of $200 million and also provided for the support of letters of credit
for general corporate purposes. At December 31, 1997, there were no loans
outstanding under the Magellan Existing Credit Agreement other than one letter
of credit issued in the amount of approximately $6.6 million. Loans outstanding
under the Magellan Existing Credit Agreement bore interest (subject to certain
potential adjustments) at a rate per annum equal to one, two, three or six-month
LIBOR plus 1.25% or a specified "alternate base rate", plus 0.25%.
DESCRIPTION OF MERIT EXISTING CREDIT AGREEMENT. The Merit Existing Credit
Agreement was that certain Credit Agreement, dated as of October 6, 1995, among
Merit, the lenders named therein and Chase, as agent. Simultaneously with the
consummation of the Offering, the Merit Existing Credit Agreement was
terminated. The Merit Existing Credit Agreement provided for: (i) a six and
one-half year senior secured revolving credit facility in an aggregate committed
amount of $85 million and also provided for the support of letters of credit for
general corporate purposes; (ii) a six and one-half year
34
senior term loan facility in the amount of $70.0 million; and (iii) a nine and
one-half year senior term loan facility in the amount of $130.0 million. At
September 30, 1997, $30.0 million of revolving loans and three letters of credit
totaling approximately $8.0 million were outstanding under the revolving credit
faciliity and an aggregate of approximately $200.0 million was outstanding under
the term loan facilities. Loans outstanding under the Merit Existing Credit
Agreement bore interest at floating rates, which were, at Merit's option based
upon (i) the higher of the Federal Funds rate plus 0.5%, or bank prime rates, or
(ii) Eurodollar rates, subject to certain adjustments.
DEBT TENDER OFFERS
The Company agreed, in connection with the Acquisition, to pay on behalf of
Merit an amount sufficient to permit Merit to repurchase the Merit Outstanding
Notes. Furthermore, borrowings pursuant to the New Credit Agreement and the Old
Notes required to effect the Transactions would have resulted in events of
default with respect to the Outstanding Notes. Accordingly, the Company and
Merit conducted tender offers for the Outstanding Notes. All but $105,000 of the
$375.0 million of Magellan Outstanding Notes and all but $35,000 of the $100.0
million of Merit Outstanding Notes were tendered in response to the Debt Tender
Offers. Upon consummation of the Debt Tender Offers, the Company paid $1,115.69
plus accrued interest per $1,000 principal amount of Magellan Outstanding Notes
tendered and $1,189.14 plus accrued interest per $1,000 principal amount of
Merit Outstanding Notes tendered. Outstanding Notes that were not tendered
remain outstanding and are general unsecured obligations of the Company or
Merit, as the case may be.
THE NEW CREDIT AGREEMENT
On February 12, 1998 the Company entered into the New Credit Agreement with
Chase pursuant to which Chase made available to the Company credit facilities of
$700.0 million. See "Summary of New Credit Agreement."
The following table sets forth the sources and uses of funds for the
Transactions (in millions):
SOURCES:
Cash and cash equivalents........................................ $ 59.3
New Credit Agreement:
Revolving Facility(1).......................................... 20.0
Term Loan Facility(2).......................................... 550.0
Notes offered hereby............................................. 625.0
--------
Total sources................................................ $ 1,254.3
--------
--------
USES:
Direct Cash Merger Consideration................................. $ 448.9
Repayment of Merit Existing Credit Agreement(3).................. 196.4
Purchase of Magellan Outstanding Notes(4)........................ 432.1
Purchase of Merit Outstanding Notes(5)........................... 121.6
Transaction costs(6)............................................. 55.3
--------
Total uses................................................... $ 1,254.3
--------
--------
-------------------------------
(1) The Revolving Facility provides for borrowings of up to $150 million.
As of February 12, 1998, the Company had approximately $112.5 million
available for borrowing pursuant to the Revolving Facility, excluding
approximately $17.5 million of availability reserved for certain
letters of credit.
(2) If the CBHS Transactions are consummated, the net proceeds of an
estimated $272.0 million will be used to repay a portion of the Term
Loan Facility under the New Credit Agreement. Additionally, upon the
sale of all or a portion of the COI common stock to be received upon
consummation of the CBHS Transactions, the Company is required to use
the net proceeds of such sale to reduce or repay amounts outstanding
under the Term Loan Facility.
(3) Includes principal amount of $193.6 million and accrued interest of
$2.7 million.
(4) Includes principal amount of $375.0 million, tender premium of $43.4
million and accrued interest of $13.7 million.
(5) Includes principal amount of $100.0 million, tender premium of $18.9
million and accrued interest of $2.8 million.
(6) Transaction costs include, among other things, costs paid at closing
associated with the Debt Tender Offers, the Old Notes offering, the
Acquisition and the New Credit Agreement.
35
USE OF PROCEEDS
The Exchange Offer is intended to satisfy certain of the Company's
obligations under the Registration Rights Agreement. The Company will not
receive any cash proceeds from the issuance of the New Notes offered hereby. In
consideration for issuing the New Notes contemplated in this Prospectus, the
Company will receive in exchange Old Notes in like principal amount, the form
and terms of which are the same as the form and terms of the New Notes, except
as otherwise described herein. The Old Notes surrendered in exchange for New
Notes will be retired and cancelled and cannot be reissued. Accordingly,
issuance of the New Notes will not result in any increase or decrease in the
indebtedness of the Company.
The proceeds from the sale of the Old Notes, net of transaction costs, were
approximately $606.8 million. The net proceeds were used as a portion of the
cash consideration paid by the Company to consummate the other Transactions.
36
CAPITALIZATION
The following table sets forth the capitalization of the Company on a pro
forma basis at December 31, 1997. The information in this table should be read
in conjunction with "Unaudited Pro Forma Consolidated Financial Information,"
"The Transactions," "Summary of New Credit Agreement," "Magellan's Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the financial statements and the notes thereto appearing elsewhere in this
Prospectus.
DECEMBER 31, 1997
----------------------
(DOLLARS IN THOUSANDS)
Cash and cash equivalents(1).................................................... $ 160,609
-----------
-----------
Total debt (including current maturities):
New Credit Agreement:
Revolving Facility(2)....................................................... $ 20,000
Term Loan Facility(3)....................................................... 550,000
Notes offered hereby.......................................................... 625,000
Other(4)...................................................................... 20,154
-----------
Total debt.................................................................. 1,215,154
Stockholders' equity(5)....................................................... 179,033
-----------
Total capitalization........................................................ $ 1,394,187
-----------
-----------
-------------------------------
(1) Includes restricted cash of $52.1 million. See "Risk Factors--Risk
Based Products" and "Merit's Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital
Resources."
(2) The Revolving Facility provides for borrowings of up to $150.0
million. On a pro forma basis as of December 31, 1997, the Company
would have had approximately $112.5 million available under the
Revolving Facility, excluding approximately $17.5 million of
availability reserved for certain letters of credit. The Company
borrowed $20.0 million pursuant to the Revolving Facility upon
consummation of the Transactions.
(3) The Term Loan Facility consists of: (i) a 6 year term loan facility
(the "Tranche A Term Loan"); (ii) a 7 year term loan facility (the
"Tranche B Term Loan"); and (iii) an 8 year term loan facility (the
"Tranche C Term Loan"), each in an aggregate principal amount of
approximately $183.3 million. If the CBHS Transactions are
consummated, the net proceeds of an estimated $272.0 million will be
used to repay approximately $90.7 million of each tranche of the Term
Loan Facility.
(4) Other debt consists primarily of: (i) $7.6 million of mortgages and
other notes payable through 1999, bearing interest at 6.8% to 8.0%;
(ii) $6.1 million of 7.5% Swiss Bonds due 2001, which were redeemed in
March, 1998; and (iii) $6.4 million in 3.95% capital lease obligations
due in 2014.
(5) Represents the pro forma book value of the Company's stockholders'
equity. Pro forma stockholders' equity, after giving effect to the
CBHS Transactions, would be approximately $278.6 million. The
Company's Common Stock is publicly traded on The New York Stock
Exchange. As of March 31, 1998, the market value of the Company's
Common Stock was approximately $818.7 million.
37
MAGELLAN SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
The following table sets forth selected historical consolidated financial
information of the Company for each of the five years in the period ended
September 30, 1997 and for the three months ended December 31, 1996 and 1997. In
1993, the Company restated its consolidated financial statements to reflect the
sale of certain subsidiaries as discontinued operations. The summary of
operations and balance sheet data for the five years ended and as of September
30, 1997, presented below, have been derived from, and should be read in
conjunction with, the Company's audited consolidated financial statements and
the notes thereto. Selected consolidated financial information for the quarters
ended December 31, 1996 and 1997 has been derived from unaudited consolidated
financial statements and, in the opinion of management, includes all adjustments
(consisting only of normal recurring adjustments) that are necessary for a fair
presentation of the operating results for such interim periods. Results for the
interim periods are not necessarily indicative of the results for the full year
or for any future periods. The selected financial data set forth below should be
read in conjunction with the Company's consolidated financial statements and the
notes thereto and "Magellan's Management's Discussion and Analysis of Financial
Condition and Results of Operations" appearing elsewhere herein.
THREE MONTHS ENDED
YEAR ENDED SEPTEMBER 30, DECEMBER 31,
-------------------------------------------------------- --------------------
1993 1994 1995 1996 1997 1996 1997
--------- --------- ---------- ---------- ---------- --------- ---------
(DOLLARS IN THOUSANDS)
STATEMENT OF OPERATIONS DATA:
Net revenue.......................... $ 897,907 $ 904,646 $1,151,736 $1,345,279 $1,210,696 $ 346,819 $ 216,097
Salaries, cost of care and other
operating expenses................. 640,847 661,436 863,598 1,064,445 978,513 284,123 175,621
Bad debt expense..................... 67,300 70,623 92,022 81,470 46,211 20,235 1,070
Depreciation and amortization........ 26,382 28,354 38,087 48,924 44,861 13,099 6,969
Amortization of reorganization value
in excess of amounts allocable to
identifiable assets................ 42,678 31,200 26,000 -- -- --
Interest, net........................ 74,156 39,394 55,237 48,017 45,377 13,569 7,401
ESOP expense......................... 45,874 49,197 73,527 -- -- --
Stock option expense (credit)........ 38,416 10,614 (467) 914 4,292 604 (3,959)
Equity in loss of CBHS............... -- -- -- -- 8,122 -- 11,488
Loss on Crescent Transactions........ -- -- -- -- 59,868 -- --
Unusual items, net................... -- 71,287 57,437 37,271 357 -- --
Income (loss) from continuing
operations before income taxes,
minority interest and extraordinary
items.............................. (37,746) (57,459) (53,705) 64,238 23,095 15,189 17,507
Provision for (benefit from) income
taxes.............................. 1,874 (10,504) (11,082) 25,695 9,238 6,075 7,003
Income (loss) from continuing
operations before minority interest
and extraordinary items............ (39,620) (46,955) (42,623) 38,543 13,857 9,114 10,504
Minority interest.................... -- 48 340 6,160 9,102 1,973 2,876
Income (loss) before discontinued
operations and extraordinary
items.............................. (39,620) (47,003) (42,963) 32,383 4,755 7,141 7,628
Discontinued operations:
Loss from discontinued
operations......................... (14,703) -- -- -- -- -- --
Gain on disposal of discontinued
operations....................... 10,657 -- -- -- -- -- --
Income (loss) before extraordinary
items.............................. (43,666) (47,003) (42,963) 32,383 4,755 7,141 7,628
Extraordinary items-losses on early
extinguishments or discharge of
debt............................... (8,561) (12,616) -- -- (5,253) (2,950) --
Net income (loss).................... $ (52,227) $ (59,619) $ (42,963) $ 32,383 $ (498) $ 4,191 $ 7,628
38
THREE MONTHS ENDED
YEAR ENDED SEPTEMBER 30, DECEMBER 31,
-------------------------------------------------------- --------------------
1993 1994 1995 1996 1997 1996 1997
--------- --------- ---------- ---------- ---------- --------- ---------
(DOLLARS IN THOUSANDS)
INCOME (LOSS) PER COMMON SHARE--
BASIC:
Income (loss) from continuing
operations before extraordinary
items.............................. $ (1.59) $ (1.78) $ (1.54) $ 1.04 $ 0.17 $ 0.25 $ 0.26
Loss from discontinued operations and
disposal of discontinued
operations......................... (0.16) -- -- -- -- -- --
Income (loss) before extraordinary
items.............................. (1.75) (1.78) (1.54) 1.04 0.17 0.25 0.26
Net Income (loss).................... $ (2.10) $ (2.26) $ (1.54) $ 1.04 $ (0.02) $ 0.15 $ 0.26
INCOME (LOSS) PER COMMON SHARE--
DILUTED:
Income (loss) from continuing
operations before extraordinary
items.............................. $ (1.59) $ (1.78) $ (1.54) $ 1.02 $ 0.16 $ 0.25 $ 0.26
Loss from discontinued operations and
disposal of discontinued
operations......................... (0.16) -- -- -- -- -- --
Income (loss) before extraordinary
items.............................. (1.75) (1.78) (1.54) 1.02 0.16 0.25 0.26
Net income (loss).................... $ (2.10) $ (2.26) $ (1.54) $ 1.02 $ (0.02) $ 0.14 $ 0.26
Ratio (deficiency) of earnings to
fixed charges...................... $ (37,746) $ (57,459) $ (53,518) 1.98 1.41 2.04
BALANCE SHEET DATA (END OF PERIOD):
Current assets....................... $ 231,915 $ 324,627 $ 305,575 $ 338,150 $ 507,038 $ 345,116
Current liabilities.................. 272,598 215,048 214,162 274,316 219,376 233,693
Property and equipment, net.......... 444,786 494,345 488,767 495,390 109,214 117,934
Total assets......................... 838,186 961,480 983,558 1,140,137 895,620 897,114
Total debt and capital lease
obligations........................ 421,162 536,129 541,569 572,058 395,294 395,154
Stockholders' equity................. 57,298 56,221 88,560 121,817 158,250 151,862
39
MERIT SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
The following selected historical financial data were derived from, and
should be read in conjunction with, the historical consolidated financial
statements of Merit, including the notes thereto. The historical consolidated
financial statements of the Predecessor for the fiscal year ended September 30,
1993 and the period from October 1, 1993 through November 17, 1993 and of Merit
for the period from November 18, 1993 through September 30, 1994 and for the
fiscal years ended September 30, 1995, 1996 and 1997 are audited. The historical
consolidated financial statements for the three months ended December 31, 1996
and 1997 and as of December 31, 1997 are unaudited. In the opinion of
management, all necessary adjustments (consisting only of normal recurring
adjustments) have been made to present fairly the consolidated financial
position and results of operations and cash flows for these periods. The results
of operations for the period ended December 31, 1997 are not necessarily
indicative of the expected results for the year ending September 30, 1998. See
"Merit's Management's Discussion and Analysis of Financial Condition and Results
of Operations."
PREDECESSOR(6) MERIT
------------------------------ -------------------------------------------------------
FISCAL YEAR NOV. 18, 1993 FISCAL YEAR FISCAL YEAR
ENDED OCT. 1-NOV. TO ENDED ENDED
SEPT. 30, 1993 17, 1993 SEPT. 30, 1994 SEPT. 30, 1995 SEPT. 30, 1996
--------------- ------------- ----------------- ----------------- -----------------
(DOLLARS IN MILLIONS)
STATEMENT OF OPERATIONS DATA:
Revenue....................... $ 197.4 $ 31.0 $ 245.9 $ 361.5 $ 457.8
Operating expenses(1)......... 180.5 29.3 225.4 335.8 426.2
Amortization of intangibles... 1.8 0.3 17.1 21.4 25.8
Restructuring charge.......... 1.7 -- -- -- 3.0
Income from joint ventures.... -- -- -- -- --
------- ------ ------- ------- -------
Operating income(2)........... 13.4 1.4 3.4 4.3 2.8
Other (income) (3)............ (0.6) (0.1) (0.8) (1.5) (2.8)
Interest expense.............. 23.8
Loss on disposal of
subsidiary..................
Merger costs and special
charges..................... 2.4 -- -- -- 4.0
------- ------ ------- ------- -------
Income (loss) before income
taxes and cumulative effect
of accounting change........ 11.6 1.5 4.2 5.8 (22.2)
Provision (benefit) for income
taxes....................... 6.1 0.6 2.1 4.5 (5.3)
------- ------ ------- ------- -------
Income (loss) before
cumulative effect of
accounting change........... 5.5 0.9 2.1 1.3 (16.9)
Cumulative effect of
accounting change(4)........ -- -- -- -- (1.0)
------- ------ ------- ------- -------
Net income (loss)............. $ 5.5 $ 0.9 $ 2.1 $ 1.3 $ (17.9)
------- ------ ------- ------- -------
------- ------ ------- ------- -------
BALANCE SHEET DATA (END OF PERIOD):
Cash and cash equivalents,
short-term marketable
securities and restricted
cash and investments(5)..... $ 21.9 $ 32.7 $ 34.1 $ 53.0
Total assets.................. 91.9 259.3 305.4 344.8
Due to parent (non-interest
bearing).................... 5.9 37.9 70.8 --
Total debt.................... -- -- -- 254.0
Stockholders' equity
(deficit)................... 47.0 121.0 122.3 (29.5)
THREE MONTHS ENDED
DECEMBER 31,
--------------------
FISCAL YEAR
ENDED
SEPT. 30, 1997 1996 1997
----------------- --------- ---------
STATEMENT OF OPERATIONS DATA:
Revenue....................... $ 555.7 $ 128.6 $ 177.2
Operating expenses(1)......... 517.0 119.5 168.1
Amortization of intangibles... 26.9 6.8 7.2
Restructuring charge.......... -- -- --
Income from joint ventures.... -- -- (1.6)
------- --------- ---------
Operating income(2)........... 11.8 2.3 3.5
Other (income) (3)............ (3.5) (0.8) (1.1)
Interest expense.............. 25.1 6.2 7.2
Loss on disposal of
subsidiary.................. 6.9 -- --
Merger costs and special
charges..................... 1.3 -- 0.5
------- --------- ---------
Income (loss) before income
taxes and cumulative effect
of accounting change........ (18.0) (3.1) (3.1)
Provision (benefit) for income
taxes....................... (4.1) (0.2) (0.4)
------- --------- ---------
Income (loss) before
cumulative effect of
accounting change........... (13.9) (2.9) (2.7)
Cumulative effect of
accounting change(4)........ -- -- --
------- --------- ---------
Net income (loss)............. $ (13.9) $ (2.9) $ (2.7)
------- --------- ---------
------- --------- ---------
BALANCE SHEET DATA (END OF PER
Cash and cash equivalents,
short-term marketable
securities and restricted
cash and investments(5)..... $ 95.2 $ 83.8
Total assets.................. 468.7 451.5
Due to parent (non-interest
bearing).................... -- --
Total debt.................... 329.5 319.3
Stockholders' equity
(deficit)................... (25.9) (26.9)
- ----------------------------------
(1) Represents the sum of direct service costs and selling, general and
administrative expenses.
(2) Operating income equals income before income taxes, the cumulative effect of
accounting changes, interest expense, other income and expense and merger
costs and special charges and loss on disposal of subsidiary.
(3) Represents primarily interest income.
(4) Effective October 1, 1995, Merit changed its method of accounting for
deferred start-up costs related to new contracts or expansion of existing
contracts: (i) to expense costs relating to start-up activities incurred
after commencement of services under the contract, and (ii) to limit the
amortization period for deferred start-up costs to the initial contract
period. Prior to October 1, 1995, Merit capitalized start-up costs related
to the completion of the provider networks and reporting systems beyond
commencement of contracts and, in limited instances, amortized the start-up
costs over a period that included the initial renewal term associated with
the contract. Under the new policy, Merit does not defer contract start-up
costs after contract commencement. The change was made to increase the focus
on controlling costs associated with contract start-ups. Merit recorded a
pre-tax charge of $1.8 million ($1.0 million after taxes) in its fiscal 1996
results of operations as a cumulative
40
effect of the change in accounting. Had Merit adopted this accounting
principle in the prior year, fiscal 1995 net income would have been $0.3
million. There was no pro forma effect of this change on Merit's fiscal
years prior to 1995.
(5) Includes restricted cash and short-term marketable securities classified as
a long-term asset. See "Merit's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources--Cash
in Claims Funds and Restricted Cash."
(6) On November 18, 1993, Merck & Co., Inc. acquired all of the outstanding
shares of Medco Containment in a transaction accounted for by the purchase
method. The amounts related to periods prior to November 18, 1993, were
derived from predecessor company financial statements. The historical cost
basis of the predecessor company differs from that of Merit due to the
allocation of a portion of the total purchase price of Medco Containment to
Merit's assets and liabilities.
41
UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION
The Unaudited Pro Forma Consolidated Financial Information set forth below
is based on the historical presentation of the consolidated financial statements
of Magellan, and the historical operating results of HAI, Allied, Merit and CMG
and the historical financial position of Merit. The Unaudited Pro Forma
Consolidated Statements of Operations for the year ended September 30, 1997 and
the three months ended December 31, 1997 give effect to the Crescent
Transactions, the HAI acquisition, the Allied acquisition, the Green Spring
Minority Shareholder Conversion, Merit's acquisition of CMG and the Transactions
as if they had been consummated on October 1, 1996. The Unaudited Pro Forma
Consolidated Balance Sheet as of December 31, 1997 gives effect to the Green
Spring Minority Shareholder Conversion and the Transactions as if they had been
consummated on December 31, 1997. The Unaudited Pro Forma Consolidated Financial
Information does not give effect to the CBHS Transactions. See "Pending Sale of
Provider Business--Unaudited Pro Forma Financial Information--CBHS
Transactions."
The Unaudited Pro Forma Consolidated Statements of Operations do not give
effect to hospital acquisitions and closures during the year ended September 30,
1997 as such transactions and events are not considered material to the pro
forma presentation. The Unaudited Pro Forma Consolidated Statements of
Operations presentation assumes that the net proceeds from the Crescent
Transactions, after debt repayment of approximately $200 million, were fully
utilized to fund the HAI acquisition and the Allied acquisition. The Unaudited
Pro Forma Consolidated Statement of Operations for the year ended September 30,
1997 excludes the non-recurring losses incurred by the Company as a result of
the Crescent Transactions.
The Unaudited Pro Forma Consolidated Financial Information does not purport
to be indicative of the results that actually would have been obtained if the
operations had been conducted as presented and they are not necessarily
indicative of operating results to be expected in future periods. The business
of CBHS is seasonal in nature with a reduced demand for certain services
generally occurring in the first fiscal quarter around major holidays, such as
Thanksgiving and Christmas, and during the summer months comprising the fourth
fiscal quarter. Accordingly, the Unaudited Pro Forma Statement of Operations for
the three months ended December 31, 1997 is not necessarily indicative of the
pro forma results expected for a full year. The Unaudited Pro Forma Statements
of Operations excludes approximately $60.0 million of cost savings on an annual
basis that the Company expects to achieve within eighteen months following
consummation of the Acquisition. The Unaudited Pro Forma Consolidated Financial
Information and notes thereto should be read in conjunction with the historical
consolidated financial statements and notes thereto of Magellan, Merit, CBHS and
HAI, which appear elsewhere herein, and Management's Discussion and Analysis of
Financial Condition and Results of Operations of Magellan and Merit, which
appear elsewhere herein.
The following is a description of each of the transactions (other than the
Transactions, which are described elsewhere herein) reflected in the pro forma
presentation:
CRESCENT TRANSACTIONS. The Crescent Transactions, which were consummated on
June 17, 1997, resulted in, among other things: (i) the sale of the Psychiatric
Hospital Facilities to Crescent for $417.2 million (before costs of
approximately $16.0 million); (ii) the creation of CBHS, which is 50% owned by
the Company and engages in the behavioral healthcare provider business; (iii)
the Company's entry into the healthcare franchising business; and (iv) the
issuance by Magellan of 2,566,622 warrants to Crescent and COI (1,283,311
warrants each) with an exercise price of $30 per share. CBHS leases the
Psychiatric Hospital Facilities from Crescent under a twelve-year operating
lease (the "Facilities Lease") (subject to renewal) for $41.7 million annually,
subject to adjustment, with a 5% escalator, compounded annually plus certain
additional rent. The warrants issued to Crescent and COI have been valued at
$25.0 million in the Company's balance sheet. See "Charter Advantage." The
Company accounts for its 50% investment in CBHS under the equity method of
accounting, which significantly reduces the
42
revenues and related operating expenses presented in the Unaudited Pro Forma
Consolidated Statements of Operations. "Divested Operations--Crescent
Transactions" in the Unaudited Pro Forma Consolidated Statement of Operations
represents the results of operations of the businesses that are operated by
CBHS.
The Company incurred a loss before income taxes, minority interest and
extraordinary items of approximately $59.9 million as a result of the Crescent
Transactions, which was recorded during fiscal 1997.
HAI ACQUISITION. On December 4, 1997, the Company consummated the purchase
of HAI, formerly a unit of Aetna, for approximately $122.1 million. HAI manages
the care of over 16.0 million covered lives, primarily through EAPs and other
managed behavioral healthcare plans. The Company funded the acquisition of HAI
with cash on hand and accounted for the acquisition of HAI using the purchase
method of accounting. The Company may be required to make additional contingent
payments of up to $60.0 million annually to Aetna over the five-year period
subsequent to closing. The amount and timing of the payments will be contingent
upon net increases in the number of HAI's covered lives in specified products.
The maximum contingent payments are $300.0 million.
ALLIED ACQUISITION. On December 5, 1997, the Company purchased the assets
of Allied for approximately $70.0 million, of which $50.0 million was paid to
the seller at closing with the remaining $20.0 million placed in escrow. Allied
provides specialty risk-based products and administrative services to a variety
of insurance companies and other customers, including Blue Cross of New Jersey,
CIGNA and NYLCare, for its 3.4 million members. Allied has over 80 physician
networks across the eastern United States. Allied's networks include physicians
specializing in cardiology, oncology and diabetes. The Company funded the Allied
acquisition with cash on hand. The Company accounted for the Allied acquisition
using the purchase method of accounting. The escrowed amount of the purchase
price is payable in one-third increments if Allied achieves specified earnings
targets during each of the three years following the closing. Additionally, the
purchase price may be increased during the three-year period by up to $40.0
million, if Allied's performance exceeds specified earnings targets. The maximum
purchase price payable is $110.0 million.
GREEN SPRING MINORITY SHAREHOLDER CONVERSION. The minority shareholders of
Green Spring converted their interests in Green Spring into an aggregate of
2,831,516 shares of Company Common Stock. As a result of the Green Spring
Minority Shareholder Conversion, the Company owns 100% of Green Spring. The
Company accounted for the Green Spring Minority Shareholder Conversion as a
purchase of minority interest at the fair value of the consideration paid.
MERIT ACQUISITION OF CMG. On September 12, 1997, Merit acquired all of the
outstanding capital stock of CMG for approximately $48.7 million in cash and
approximately 739,000 shares of Merit common stock. In connection with Merit's
acquisition of CMG, the Company may be required to make contingent payments to
the former shareholders of CMG if the financial results of certain contracts
exceed specified base-line amounts. Such contingent payments are subject to an
aggregate maximum of $23.5 million.
43
UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE YEAR ENDED SEPTEMBER 30, 1997
(IN THOUSANDS, EXCEPT RATIOS AND PER SHARE DATA)
DIVESTED
OPERATIONS--
MAGELLAN CRESCENT PRO FORMA PRO FORMA
AS REPORTED TRANSACTIONS HAI ALLIED ADJUSTMENTS COMBINED MERIT CMG
----------- ------------ -------- -------- ----------- --------- -------- --------
Net revenue............... $1,210,696 $(555,324) $116,736 $143,889 $41,578(1) $957,575 $555,717 $101,356
----------- ------------ -------- -------- ----------- --------- -------- --------
Salaries, cost of care and
other operating
expenses................ 978,513 (426,862) 88,002 137,873 (7,797)(2) 769,729 504,510 99,434
Bad debt expense.......... 46,211 (42,720) 0 0 0 3,491 0 0
Depreciation and
amortization............ 44,861 (20,073) 312 362 6,164(3) 31,626 39,400 1,987
Interest, net............. 45,377 (3,233) (1,604) (725) (6,833)(4) 32,982 21,566 (516)
Stock option expense...... 4,292 0 0 0 0 4,292 0 0
Equity in loss of CBHS.... 8,122 0 0 0 12,028(5) 20,150 0 0
Loss on Crescent
Transactions............ 59,868 0 0 0 (59,868)(6) 0 0 0
Unusual items............. 357 (2,500) 0 0 0 (2,143) 8,239 1,200
----------- ------------ -------- -------- ----------- --------- -------- --------
1,187,601 (495,388) 86,710 137,510 (56,306) 860,127 573,715 102,105
----------- ------------ -------- -------- ----------- --------- -------- --------
Income (loss) before
income taxes and
minority interest....... 23,095 (59,936) 30,026 6,379 97,884 97,448 (17,998) (749)
Provision for (benefit
from) income taxes...... 9,238 (23,974) 11,480 0 41,705(7) 38,449 (4,126) (443)
----------- ------------ -------- -------- ----------- --------- -------- --------
Income (loss) before
minority interest....... 13,857 (35,962) 18,546 6,379 56,179 58,999 (13,872) (306)
Minority interest......... 9,102 0 0 0 0 9,102 0 0
----------- ------------ -------- -------- ----------- --------- -------- --------
Net income (loss)......... $ 4,755 $ (35,962) $ 18,546 $ 6,379 $56,179 $ 49,897 $(13,872) $ (306)
----------- ------------ -------- -------- ----------- --------- -------- --------
----------- ------------ -------- -------- ----------- --------- -------- --------
Average number of common
shares
outstanding--basic...... 28,781 28,781
----------- ---------
----------- ---------
Average number of common
shares
outstanding--diluted.... 29,474 29,474
----------- ---------
----------- ---------
Net income per common
share--basic............ $ 0.17 $ 1.73
----------- ---------
----------- ---------
Net income per common
share--diluted.......... $ 0.16 $ 1.69
----------- ---------
----------- ---------
Ratio of earnings to fixed
charges................. 1.41
-----------
-----------
THE
MERIT/CMG MERIT/CMG TRANSACTIONS
PRO FORMA PRO FORMA PRO FORMA PRO FORMA
ADJUSTMENTS COMBINED ADJUSTMENTS CONSOLIDATED
----------- ---------- ------------ ------------
Net revenue............... $(13,042)(8) $644,031 $ 0 $1,601,606
----------- ---------- ------------ ------------
Salaries, cost of care and
other operating
expenses................ (18,075)(9) 585,869 (500)(14) 1,355,098
Bad debt expense.......... 0 0 0 3,491
Depreciation and
amortization............ 2,365(10) 43,752 (6,416)(15) 68,962
Interest, net............. 4,390(11) 25,440 37,967(16) 96,389
Stock option expense...... 0 0 0 4,292
Equity in loss of CBHS.... 0 0 0 20,150
Loss on Crescent
Transactions............ 0 0 0 0
Unusual items............. (6,925)(12) 2,514 (1,314)(17) (943)
----------- ---------- ------------ ------------
(18,245) 657,575 29,737 1,547,439
----------- ---------- ------------ ------------
Income (loss) before
income taxes and
minority interest....... 5,203 (13,544) (29,737) $ 54,167
Provision for (benefit
from) income taxes...... 2,095(13) (2,474) (5,942)(18) 30,033
----------- ---------- ------------ ------------
Income (loss) before
minority interest....... 3,108 (11,070) (23,795) 24,134
Minority interest......... 0 0 (6,835)(19) 2,267
----------- ---------- ------------ ------------
Net income (loss)......... $ 3,108 $(11,070) $(16,960) $ 21,867
----------- ---------- ------------ ------------
----------- ---------- ------------ ------------
Average number of common
shares
outstanding--basic...... 2,832(19) 31,613
------------ ------------
------------ ------------
Average number of common
shares
outstanding--diluted.... 2,832(19) 32,306
------------ ------------
------------ ------------
Net income per common
share--basic............ $ 0.69
------------
------------
Net income per common
share--diluted.......... $ 0.68
------------
------------
Ratio of earnings to fixed
charges................. 1.38
------------
------------
See Notes to Unaudited Pro Forma Consolidated Statements of Operations
44
UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE THREE MONTHS ENDED DECEMBER 31, 1997
(IN THOUSANDS, EXCEPT RATIOS AND PER SHARE DATA)
MAGELLAN PRO FORMA
AS REPORTED HAI ALLIED ADJUSTMENTS
----------- ------- ------- -----------
Net revenue................................................. $216,097 $19,528 $30,945 $(2,143)(1)
----------- ------- ------- -----------
Salaries, cost of care and other operating expenses......... 175,621 15,031 31,068 (1,392)(2)
Bad debt expense............................................ 1,070 0 0 0
Depreciation and amortization............................... 6,969 34 100 1,075(3)
Interest, net............................................... 7,401 (256) (92) 1,816(4)
Stock option expense........................................ (3,959) 0 0 0
Equity in loss of CBHS...................................... 11,488 0 0 0
Unusual items............................................... 0 0 0 0
----------- ------- ------- -----------
198,590 14,809 31,076 1,499
----------- ------- ------- -----------
Income (loss) before income taxes and minority interest..... 17,507 4,719 (131) (3,642)
Provision for (benefit from) income taxes................... 7,003 1,879 0 (1,509)(7)
----------- ------- ------- -----------
Income (loss) before minority interest...................... 10,504 2,840 (131) (2,133)
Minority interest........................................... 2,876 0 0 0
----------- ------- ------- -----------
Net income (loss)........................................... $ 7,628 $ 2,840 $ (131) $(2,133)
----------- ------- ------- -----------
----------- ------- ------- -----------
Average number of common shares outstanding--basic.......... 28,969
-----------
-----------
Average number of common shares outstanding--diluted........ 29,784
-----------
-----------
Net income per common share--basic.......................... $ 0.26
-----------
-----------
Net income per common share--diluted........................ $ 0.26
-----------
-----------
Ratio of earnings to fixed charges.......................... 2.04
-----------
-----------
THE TRANSACTIONS
PRO FORMA PRO FORMA PRO FORMA
COMBINED MERIT ADJUSTMENTS CONSOLIDATED
--------- -------- ---------------- ------------
Net revenue................................................. $264,427 $178,866 $ 0 $443,293
--------- -------- ------- ------------
Salaries, cost of care and other operating expenses......... 220,328 164,291 (1,915)(14) 382,704
Bad debt expense............................................ 1,070 0 0 1,070
Depreciation and amortization............................... 8,178 11,028 (1,736)(15) 17,470
Interest, net............................................... 8,869 6,142 9,674(16) 24,685
Stock option expense........................................ (3,959) 0 0 (3,959)
Equity in loss of CBHS...................................... 11,488 0 0 11,488
Unusual items............................................... 0 545 (545)(17) 0
--------- -------- ------- ------------
245,974 182,006 5,478 433,458
--------- -------- ------- ------------
Income (loss) before income taxes and minority interest..... 18,453 (3,140) (5,478) 9,835
Provision for (benefit from) income taxes................... 7,373 (468) (703)(18) 6,202
--------- -------- ------- ------------
Income (loss) before minority interest...................... 11,080 (2,672) (4,775) 3,633
Minority interest........................................... 2,876 0 (2,358)(19) 518
--------- -------- ------- ------------
Net income (loss)........................................... $ 8,204 $ (2,672) $(2,417) $ 3,115
--------- -------- ------- ------------
--------- -------- ------- ------------
Average number of common shares outstanding--basic.......... 28,969 2,832(19) 31,801
--------- ------- ------------
--------- ------- ------------
Average number of common shares outstanding--diluted........ 29,784 2,832(19) 32,616
--------- ------- ------------
--------- ------- ------------
Net income per common share--basic.......................... $ 0.28 $ 0.10
--------- ------------
--------- ------------
Net income per common share--diluted........................ $ 0.28 $ 0.10
--------- ------------
--------- ------------
Ratio of earnings to fixed charges.......................... 1.27
------------
------------
See Notes to Unaudited Pro Forma Consolidated Statements of Operations
45
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS
(1) Adjustments to net revenue for the year ended September 30, 1997 represent
Franchise Fees of $55.5 million for the 259 days ended June 16, 1997 (prior
to consummation of the Crescent Transactions) less a $13.9 million decrease
in HAI revenue resulting from renegotiated contractual rates with Aetna as a
direct result of the acquisition of HAI by the Company. Adjustment to net
revenue for the three months ended December 31, 1997 represents the effect
of renegotiated contractual rates with Aetna for the two months prior to
consummation of the HAI acquisition.
The pro forma presentation assumes that all Franchise Fees due from CBHS
were paid when due. Based on projections of fiscal 1998 operations prepared
by management of CBHS, the Company believes that CBHS will be unable to pay
the full amount of the Franchise Fees it is contractually obligated to pay
during fiscal 1998. The Company currently estimates that CBHS will be able
to pay approximately $58.0 million to $68.0 million of the Franchise Fees in
fiscal 1998, a $10.0 million to $20.0 million shortfall relative to amounts
payable under the Master Franchise Agreement. The Company may be required to
record bad debt expense related to Franchise Fees receivable from CBHS, if
any, in fiscal 1998 or future periods if CBHS's operating performance does
not improve to levels achieved prior to the consummation of the Crescent
Transactions. If CBHS defaults in payment of the Franchise Fees, the Company
will pursue all remedies available to it under the Master Franchise
Agreement. See "Charter Advantage--Franchise Operations."
(2) Adjustments to salaries, cost of care and other operating expenses represent
the following (in thousands):
THREE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, DECEMBER 31,
TRANSACTION DESCRIPTION 1997 1997
- ----------- ------------------------------------ -------------------- ---------------------
Crescent Fees payable to CBHS by the Company
for the management of less than
wholly-owned hospital-based joint
ventures controlled by the Company
for the 259 days ended June 16,
1997................................ $ 7,564 $ --
Crescent Reduction of corporate overhead that
was transferred to CBHS for the 259
days ended June 16, 1997............ (2,845) --
HAI Elimination of Aetna overhead
allocations......................... (17,162) (2,044)
HAI Bonus expense previously reflected
in Aetna's financial statements..... 1,138 200
HAI Costs absorbed by HAI previously
incurred by Aetna including
information technology, human
resources and legal................. 5,110 852
Allied Reduction of shareholders'/
executives' compensation to revised
contractual level pursuant to the
Allied purchase agreement........... (648) (197)
Allied Reduction of certain consulting
agreement costs to revised
contractual level pursuant to the
Allied purchase agreement........... (954) (203)
---------- --------
$ (7,797) $ (1,392)
---------- --------
---------- --------
46
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(3) Adjustments to depreciation and amortization represent the following (in
thousands):
THREE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, DECEMBER 31,
TRANSACTION DESCRIPTION 1997 1997
- ------------- ------------------------------------ -------------------- ---------------------
Crescent Elimination of amortization related
to impaired intangible assets....... $ (177) $ --
HAI Purchase price allocation (i)....... 3,948 676
Allied Purchase price allocation (ii)...... 2,393 399
------- -------
$ 6,164 $ 1,075
------- -------
------- -------
---------------------------------
(i) Represents $4.0 million estimated fair value of property and
equipment depreciated over an estimated useful life of 5 years, $83.3
million of goodwill amortized over an estimated useful life of 40
years and $20.7 million estimated fair value of other intangible
assets (primarily client lists) amortized over an estimated useful
life of 15 years less historical depreciation and amortization.
(ii) Represents $50.7 million of goodwill amortized over an estimated
useful life of 40 years and $16.9 million estimated fair value of
other intangible assets (primarily client lists and treatment
protocols) amortized over an estimated useful life of 15 years.
The allocation of the HAI and Allied purchase prices to equipment, goodwill
and identifiable intangible assets and estimated useful lives are based on
the Company's preliminary valuations, which are subject to change upon
receiving independent appraisals for such assets.
Subsequent to the consummation of the HAI acquisition, the Company may be
required to make additional contingent payments of up to $60 million
annually during the five years following the consummation of the HAI
acquisition to Aetna for aggregate potential contingent payments of $300
million. These contingent payments, if any, would be recorded as goodwill
and identifiable intangible assets, which would result in estimated
additional annual amortization of $11 million to $13 million in future
periods if all the contingent payments are made.
The Company may also be required to make contingent payments to the former
owners of Allied of up to $60 million during the three years subsequent to
consummation of the Allied acquisition, of which $20 million is in escrow.
These contingent payments, if any, would be recorded as goodwill, which
would result in estimated additional annual amortization of $1.5 million.
(4) Adjustments to interest, net, represent reductions in interest expense as a
result of the repayment of outstanding borrowings under the Magellan
Existing Credit Agreement with the proceeds from the Crescent Transactions
offset by forgone interest income as a result of using cash on hand to fund
the HAI and Allied acquisitions.
(5) Adjustment to equity in loss of CBHS represents the Company's 50% interest
in CBHS' pro forma loss for the 259 day period ended June 16, 1997. The
Company's investment in CBHS is accounted for under the equity method of
accounting. The Condensed Pro Forma Statement of Operations of CBHS for the
year ended September 30, 1997 is as follows (in thousands):
47
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
CBHS
OPERATIONS--
DIVESTED 106 DAYS ENDED PRO FORMA PRO FORMA
OPERATIONS SEPTEMBER 30, 1997 ADJUSTMENTS CONSOLIDATED
----------- -------------------- ------------ -------------
Net revenue.............. $ 555,324 $ 213,730 $ 2,565(i) $ 771,619
----------- ---------- ------------ -------------
Salaries, supplies and
other operating
expenses............... 426,862 210,277 103,723 (ii 740,862
Bad debt expense......... 42,720 17,437 0 60,157
Depreciation and
amortization........... 20,073 668 (17,333) ii) 3,408
Interest, net............ 3,233 1,592 167 (iv 4,992
Unusual items............ 2,500 0 0 2,500
----------- ---------- ------------ -------------
495,388 229,974 86,557 811,919
----------- ---------- ------------ -------------
Income (loss) before
income taxes........... 59,936 (16,244) (83,992) (40,300)
Provision for income
taxes.................. 23,974 0 (23,974)(v) 0
----------- ---------- ------------ -------------
Net income (loss)...... $ 35,962 $ (16,244) $ (60,018) $ (40,300)
----------- ---------- ------------ -------------
----------- ---------- ------------ -------------
----------------------------------------
(i) Fees from the Company for the management of less than
wholly-owned hospital-based joint ventures controlled by the
Company (see note 2) less non-recurring accounts receivable
collection fees receivable from the Company (see note 6) of
approximately $5.0 million during the 106 days ended September
30, 1997.
(ii) Adjustments to salaries, supplies and other operating
expenses represent the following (in thousands):
259 DAYS
ENDED
JUNE 16, 1997
--------------
Franchise Fees (see note 1)................................................ $ 55,463
Rent expense under the Facilities Lease.................................... 44,665
Additional corporate overhead.............................................. 3,595
--------------
$ 103,723
--------------
--------------
(iii) Adjustment to depreciation and amortization represents the
decrease in depreciation expense as a result of the sale of
property and equipment to Crescent by the Company and the
elimination of amortization expense related to impaired
intangible assets.
(iv) Adjustment to interest, net, represents the following (in
thousands):
259 DAYS
ENDED
JUNE 16, 1997
--------------
Interest expense on debt repaid by the Company............................. $ (3,233)
Interest expense for the 259 days ended June 16, 1997 for estimated average
borrowings of $60 million at an assumed interest rate of 8% per annum...... 3,400
--------------
$ 167
--------------
--------------
(v) CBHS is a limited liability company. Accordingly, provision
for income taxes is eliminated as the tax consequences of CBHS
ownership will pass through to the Company and COI.
48
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(6) Adjustment to loss on Crescent Transactions represents the elimination of
the non-recurring losses incurred by the Company as a result of the Crescent
Transactions as follows (in thousands):
Accounts receivable collection fees(i).................................... $ 21,400
Impairment losses on intangible assets(ii)................................ 14,408
Exit costs and construction obligation(iii)............................... 12,549
Loss on the sale of property and equipment................................ 11,511
---------
$ 59,868
---------
---------
----------------------------------------
(i) Accounts receivable collection fees represent the reduction
in the net realizable value of accounts receivable for
estimated collection fees on hospital-based receivables
retained by the Company. The Company paid CBHS a fee equal to
5% of collections for the first 120 days after consummation of
the Crescent Transactions and estimated bad debt agency fees of
40% for receivables collected subsequent to 120 days after the
consummation of the Crescent Transaction.
(ii) The impairment loss on intangible assets resulted from
reducing the book value of the Company's investment in CBHS to
its approximate fair value at the consummation date of the
Crescent Transactions. The impairment losses represent the
reductions in the carrying amount of goodwill and other
intangible assets related to the divested or contributed CBHS
operations.
(iii) Represents approximately $5.0 million of incremental costs
to perform finance and accounting functions transferred to CBHS
and approximately $7.5 million for the Company's obligation to
replace CBHS' Philadelphia hospital.
(7) Adjustments to provision for income taxes represent the tax expense related
to the pro forma adjustments at the Company's historic effective tax rate of
40% and the imputed income tax expense on the operating results of Allied,
which was an S-corporation for income tax purposes and historically did not
provide for income taxes.
(8) Adjustment to net revenue represents the elimination of the fiscal 1997
revenues of Choate Health Management, Inc. ("Choate"), which was sold by
Merit in fiscal 1997.
(9) Adjustment to salaries, cost of care and other operating expenses represents
the elimination of salaries, benefits and other costs of $5.5 million for
duplicate CMG personnel and facilities that were eliminated as a direct
result of Merit's acquisition of CMG and the elimination of fiscal 1997
expenses of $12.6 million for Choate, which was sold by Merit in fiscal
1997.
(10) Adjustment to depreciation and amortization represents the effect of
Merit's purchase price allocation related to the CMG acquisition.
(11) Adjustment to interest, net, represents the effect of increased borrowing
by Merit related to the CMG acquisition.
(12) Adjustments to unusual items, net, represents the elimination of
non-recurring losses on Merit's sale of Choate.
(13) Adjustment to provision for income taxes represents the tax effect of the
Merit/CMG pro forma adjustments.
(14) Adjustment to salaries, cost of care and other operating expenses
represents the elimination of fees paid by Merit to its former owner and the
elimination of salaries, benefits and other costs of $1.7 million for the
three months ended December 31, 1997 for duplicate CMG personnel and
facilities that have been announced as a direct result of Merit's
acquisition of CMG. The adjustment excludes approximately $60.0 million of
cost savings on an annual basis that the Company expects to achieve within
eighteen months following consummation of the Merit acquisition.
49
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(15) Adjustments to depreciation and amortization represent the effect of the
Merit purchase price allocation and the Green Spring Minority Shareholder
Conversion as follows (in thousands):
THREE MONTHS
YEAR ENDED ENDED
SEPTEMBER 30, DECEMBER 31,
1997 1997
-------------- --------------
Estimated fair value of property and equipment of $52.4
million depreciated over an estimated useful life of 5
years....................................................... $ 10,485 $ 2,622
Estimated goodwill of $599.5 million amortized over an
estimated useful life of 40 years........................... 14,989 3,746
Estimated fair value of other intangible assets (primarily
client lists and provider networks) of $121.3 million
amortized over an estimated useful life of 15 years......... 8,084 2,021
-------------- --------------
Total estimated depreciation and amortization................. 33,558 8,389
Elimination of Merit and CMG historical and pro forma
depreciation and amortization (i)........................... (40,655) (10,296)
Effect of Green Spring Minority Shareholder Conversion........ 681 171
-------------- --------------
$ (6,416) $ (1,736)
-------------- --------------
-------------- --------------
----------------------------------------
(i) Excludes amortization of deferred start-up costs of
approximately $3.1 million and $0.7 million for the year ended
September 31, 1997 and the three moths ended December 31, 1997,
respectively, which will be a continuing cost of the Company
after the Merit acquisition.
The allocation of the Merit purchase price to property and equipment,
goodwill and identifiable intangible assets and estimated useful lives was
based on the Company's preliminary valuations, which are subject to change
upon receiving independent appraisals for such assets.
(16) Adjustments to interest, net, represent the following (in thousands):
YEAR ENDED THREE MONTHS ENDED
SEPTEMBER 30, DECEMBER 31,
DESCRIPTION 1997 1997
- --------------------------------------------------- -------------------- -------------------
Elimination of Merit and CMG historical and pro
forma interest expense........................... $ (29,959) $ (7,216)
Elimination of historical interest expense for the
Magellan Outstanding Notes....................... (42,188) (10,547)
Elimination of the Company's historical deferred
financing cost amortization...................... (1,214) (610)
Tranche A Term Loan interest expense (i)........... 14,393 3,667
Tranche B Term Loan interest expense (i)........... 14,850 3,781
Tranche C Term Loan interest expense (i)........... 15,308 3,896
Revolving Facility interest expense (i)............ 1,570 400
Foregone interest income--cash proceeds utilized in
the Merit acquisition at 5.5% per annum.......... 4,712 1,178
The Notes at an interest rate of 9.0%.............. 56,250 14,063
Amortization of deferred financing costs of $34.2
million over a weighted average life of
approximately 8.1 years.......................... 4,245 1,062
---------- ----------
$ 37,967 $ 9,674
---------- ----------
---------- ----------
----------------------------------------
(i) Assumes borrowings are one-month LIBOR-based, which is
consistent with the Company's past borrowing practices. Average
one-month LIBOR was approximately 5.60% and 5.75%
50
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
during the year ended September 30, 1997 and the three months
ended December 31, 1997, respectively. Each tranche of the Term
Loan Facility is approximately $183.3 million and the Revolving
Facility borrowing is $20.0 million. Interest rates utilized to
compute pro forma adjustments are as follows:
YEAR ENDED THREE MONTHS ENDED
SEPTEMBER 30, DECEMBER 31,
1997 1997
----------------------- ---------------------
Tranche A Term Loan and Revolving Facility
(LIBOR plus 2.25%)...................... 7.85% 8.00%
Tranche B Term Loan (LIBOR plus 2.50%).... 8.10% 8.25%
Tranche C Term Loan (LIBOR plus 2.75%).... 8.35% 8.50%
(17) Adjustments to unusual items represent the following (in thousands):
THREE MONTHS
YEAR ENDED ENDED
DESCRIPTION SEPTEMBER 30, 1997 DECEMBER 31, 1997
- --------------------------------------------------- -------------------- ---------------------
Elimination of Merit's transaction costs related to
Merit's attempt to acquire HAI................... $ (733) $ --
Elimination of non-recurring employee benefit costs
related to stock options which were eliminated
upon the consummation of the Acquisition......... (581) (57)
Elimination of Merit's transaction costs related
primarily to the Transactions.................... -- (488)
-------- ------
$ (1,314) $ (545)
-------- ------
-------- ------
(18) Adjustment to provision for income taxes represents the tax benefit related
to the pro forma adjustments, excluding annual non-deductible goodwill
amortization of $14.9 million related to the Acquisition and the Green
Spring Minority Shareholder Conversion, at the Company's historic effective
tax rate of 40%.
(19) Adjustments to minority interest and average number of common shares
outstanding (primary and fully diluted) represents the effect of the Green
Spring Minority Shareholder Conversion.
51
UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET
DECEMBER 31, 1997
(DOLLARS IN THOUSANDS)
THE
TRANSACTIONS
MAGELLAN PRO FORMA PRO FORMA
ASSETS AS REPORTED MERIT ADJUSTMENTS CONSOLIDATED
------------ ----------- ------------- -------------
Current assets:
Cash and cash equivalents........................... $ 170,459 $ 75,827 $ (85,677)(1) $ 160,609
Accounts receivable, net............................ 140,219 49,917 0 190,136
Deferred income taxes............................... 0 6,616 0 6,616
Other current assets................................ 34,438 11,409 0 45,847
------------ ----------- ------------- -------------
Total current assets.............................. 345,116 143,769 (85,677) 403,208
Assets restricted for settlement of unpaid claims and
other long-term liabilities......................... 73,020 0 0 73,020
Property and equipment:
Land................................................ 11,687 0 0 11,687
Buildings and improvements.......................... 72,102 3,596 0 75,698
Equipment........................................... 74,319 117,151 (68,320)(2) 123,150
------------ ----------- ------------- -------------
158,108 120,747 (68,320) 210,535
Accumulated depreciation............................ (41,169) (38,320) 38,320(2) (41,169)
------------ ----------- ------------- -------------
116,939 82,427 (30,000) 169,366
Construction in progress............................ 995 0 0 995
------------ ----------- ------------- -------------
Total property and equipment...................... 117,934 82,427 (30,000) 170,361
Other long-term assets................................ 42,932 27,432 (8,624)(3) 61,740
Deferred income taxes................................. 2,178 0 69,351(4) 71,529
Investments in CBHS................................... 5,390 0 0 5,390
Goodwill, net......................................... 242,968 141,787 462,227(5) 846,982
Other intangible assets, net.......................... 67,576 56,056 101,188(5) 224,820
------------ ----------- ------------- -------------
$ 897,114 $ 451,471 $ 508,465 $ 1,857,050
------------ ----------- ------------- -------------
------------ ----------- ------------- -------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.................................... $ 37,663 $ 7,217 $ 0 $ 44,880
Accrued liabilities................................. 192,426 133,347 9,941(6) 335,714
Current maturities of long-term debt and capital
lease obligations................................. 3,604 1,263 (1,263)(7) 3,604
------------ ----------- ------------- -------------
Total current liabilities....................... 233,693 141,827 8,678 384,198
Long-term debt and capital lease obligations.......... 391,550 318,002 501,998(7) 1,211,550
Reserve for unpaid claims............................. 40,201 0 0 40,201
Deferred tax liabilities.............................. 0 13,525 (13,525)(4) 0
Deferred credits and other long-term liabilities...... 15,023 5,034 (3,262)(8) 16,795
Minority interest..................................... 64,785 0 (39,512)(8) 25,273
Commitments and contingencies
Stockholders' equity:
Common stock........................................ 8,387 294 414(9) 9,095
Additional paid-in capital.......................... 338,961 3,768 56,412(9) 399,141
Retained earnings (accumulated deficit)............. (122,327) (30,979) (2,738)(9) (156,044)
Warrants outstanding................................ 25,050 0 0 25,050
Common stock in treasury............................ (95,187) 0 0 (95,187)
Cumulative foreign currency adjustments............. (3,022) 0 0 (3,022)
------------ ----------- ------------- -------------
Total stockholders' equity........................ 151,862 (26,917) 54,088 179,033
------------ ----------- ------------- -------------
$ 897,114 $ 451,471 $ 508,465 $ 1,857,050
------------ ----------- ------------- -------------
------------ ----------- ------------- -------------
See Notes to Unaudited Pro Forma Consolidated Balance Sheet
52
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET
(1) Adjustments to cash and cash equivalents represent the following (in
thousands):
DESCRIPTION AMOUNT
- -------------------------------------------------------------------------------- ------------
Term Loan Facility borrowings................................................... $ 550,000
Revolving Facility borrowings................................................... 20,000
Proceeds from the Notes......................................................... 625,000
Repayment of Existing Merit Credit Agreement.................................... (219,265)
Repayment of Merit Outstanding Notes............................................ (100,000)
Repayment of Magellan Outstanding Notes......................................... (375,000)
Cash paid to Merit shareholders................................................. (448,867)
Transaction costs and accrued interest payments................................. (137,545)
------------
$ (85,677)
------------
------------
(2) Adjustments to equipment and accumulated depreciation accounts represent the
changes necessary to adjust Merit's property and equipment to fair value.
See note 15 to Unaudited Pro Forma Consolidated Statement of Operations.
(3) Adjustment to other long-term assets represents the reclassification of
deferred start-up costs to identifiable intangible assets.
(4) Adjustments to deferred income tax assets and liabilities represent the tax
consequences of the Transactions related primarily to basis differences and
recognition of net operating loss carry forwards.
(5) Adjustments to goodwill and other intangible assets represent the following
(in thousands):
DESCRIPTION AMOUNT
- --------------------------------------------------------------------------------- -----------
Merit purchase price allocation.................................................. $ 457,715
Green Spring Minority Shareholder Conversion..................................... 4,512
-----------
Goodwill pro forma adjustment................................................ $ 462,227
-----------
-----------
Merit purchase price allocation.................................................. $ 75,455
Write-off of Merit deferred financing costs...................................... (10,246)
Write-off of the Company's deferred financing costs.............................. (11,811)
Deferred financing costs related to the Transactions............................. 34,188
Green Spring Minority Shareholder Conversion..................................... 13,602
-----------
Other intangible asset pro forma adjustment.................................. $ 101,188
-----------
-----------
See note 15 to the Unaudited Pro Forma Consolidated Statements of
Operations.
(6) Adjustments to accrued liabilities represent the following (in thousands):
DESCRIPTION AMOUNT
- --------------------------------------------------------------------------------- -----------
Payment of Merit accrued interest................................................ $ (2,338)
Payment of the Company's accrued interest........................................ (8,721)
Accrued severance and related costs (i).......................................... 21,000
-----------
$ 9,941
-----------
-----------
- ------------------------
(i) Includes the initial estimates of costs of severance, lease
terminations, relocation and other related costs for the integration
of Merit into the Company's existing managed care operations. This
amount is subject to change based on finalization of the Company's
integration plan.
53
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET (CONTINUED)
(7) Adjustments to long-term debt and capital lease obligations (including the
current portion) represent the following (in thousands):
DESCRIPTION AMOUNT
- --------------------------------------------------------------------------------- -----------
Term Loan Facility borrowings.................................................... $ 550,000
Revolving Facility borrowings.................................................... 20,000
The Notes........................................................................ 625,000
Repayment of Existing Merit Credit Agreement..................................... (219,265)
Repayment of Merit Outstanding Notes............................................. (100,000)
Repayment of Magellan Outstanding Notes.......................................... (375,000)
-----------
$ 500,735
-----------
-----------
(8) Adjustments to deferred credits and other long-term liabilities and minority
interest represent the effect of the Green Spring Minority Shareholder
Conversion.
(9) Adjustments to the stockholders' equity accounts represent the elimination
of Merit's historical stockholders' equity accounts, the increase in
accumulated deficit related to the $33.7 million extraordinary loss on the
early extinguishment of the Magellan Existing Credit Agreement and the
Magellan Outstanding Notes and the effect of issuing 2,831,516 shares of
Company Common Stock in the Green Spring Minority Shareholder Conversion,
which was valued using the closing price of Company Common Stock on December
31, 1997, of $21.50.
54
MAGELLAN'S MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion relates to the historical consolidated results of
operations and financial condition of the Company and should be read in
conjunction with the consolidated financial statements of the Company included
elsewhere in this Prospectus.
OVERVIEW
The Company has historically derived the majority of its revenue from
providing healthcare services in an inpatient setting. Payments from third party
payors are the principal source of revenue for most healthcare providers. In the
early 1990's, many third party payors sought to control the cost of providing
care to their patients by instituting managed care programs or seeking the
assistance of managed care companies. Providers participating in managed care
programs agree to provide services to patients for a discount from established
rates, which generally results in pricing concessions by the providers and lower
margins. Additionally, managed care programs generally encourage alternatives to
inpatient treatment settings and reduce utilization of inpatient services. As a
result, third party payors established managed care programs or engaged managed
care companies in many areas of healthcare, including behavioral healthcare. The
Company, which until June 1997 was the largest operator of psychiatric hospitals
in the United States, was adversely affected by the adoption of managed care
programs by third-party payors.
Prior to the first quarter of fiscal 1996, the Company was not a provider of
behavioral managed care services. During the first quarter of fiscal 1996, the
Company acquired a 61% ownership interest in Green Spring. At that time, the
Company intended to become a fully integrated behavioral healthcare provider by
combining the managed behavioral healthcare products offered by Green Spring
with the direct treatment services offered by the Company's psychiatric
hospitals. The Company believed that an entity that participated in both the
managed care and provider segments of the behavioral healthcare industry could
more efficiently provide and manage behavioral healthcare for insured
populations than an entity that was solely a managed care company. The Company
also believed that earnings from its managed care business would offset, in
part, the negative impact on the financial performance of its psychiatric
hospitals caused by managed care. Green Spring was the Company's first
significant involvement in managed behavioral healthcare.
Subsequent to the Company's acquisition of Green Spring, the growth of the
managed behavioral healthcare industry accelerated. Under the Company's majority
ownership, Green Spring increased its base of covered lives from 12.0 million as
of the end of calendar year 1995 to 21.1 million as of the end of calendar year
1997, a compound annual growth rate of over 32%. While growth in the industry
was accelerating, the managed behavioral healthcare industry also began to
consolidate. The Company concluded that consolidation presented an opportunity
for the Company to enhance its stockholder value by increasing its participation
in the managed behavioral healthcare industry, which the Company believed
offered growth and earnings prospects superior to those of the psychiatric
hospital industry. Therefore, the Company decided to sell its domestic
psychiatric facilities to obtain capital for expansion in the managed behavioral
healthcare business.
During the third quarter of fiscal 1997, the Company sold the Psychiatric
Hospital Facilities, which comprised substantially all of its domestic acute
care psychiatric hospitals and residential treatment facilities, to Crescent for
$417.2 million in cash (before costs of approximately $16.0 million) and certain
other consideration. The sale of the Psychiatric Hospital Facilities provided
the Company with approximately $200.0 million of net cash proceeds, after debt
repayment, for use in implementing its business strategy. The Company used the
net cash proceeds to finance the acquisitions of HAI and Allied in December
1997.
The Company further implemented its business strategy through the
Acquisition, which increased the Company's revenue attributable to managed care
operations to 78% of the Company's total fiscal 1997 revenue on a pro forma
basis. The following table sets forth, on a pro forma basis for the year
55
ended September 30, 1997, the Company's net revenue and EBITDA from its business
segments (in thousands):
NET % OF % OF
REVENUE CONSOLIDATED EBITDA(3) CONSOLIDATED
------------- --------------- ----------- ---------------
Existing managed care business (1)..................... $ 610,623 38.1% $ 73,258 28.7%
Merit managed care business............................ 644,031 40.2 58,662 23.0
------------- ----- ----------- -----
Total managed care business.......................... 1,254,654 78.3 131,920 51.7
Public sector business................................. 94,422 5.9 7,839 3.1
Healthcare franchising business........................ 78,300 4.9 66,148 25.9
Provider business (2).................................. 174,230 10.9 50,385 19.7
Corporate overhead..................................... -- -- (13,275) (5.2)
Interest income........................................ -- -- 12,246 4.8
------------- ----- ----------- -----
Consolidated......................................... $ 1,601,606 100.0% $ 255,263 100.0%
------------- ----- ----------- -----
------------- ----- ----------- -----
- --------------------------
(1) Includes HAI and Allied pro forma results.
(2) The provider business segment includes the Company's joint venture hospital
operations, three European psychiatric hospitals, a general hospital that
was closed in January 1997 and certain other operations. EBITDA includes
revenue associated with settlements of reimbursement issues and reductions
of operating expenses associated with medical malpractice adjustments. Pro
Forma Adjusted EBITDA as presented in "Summary-- Summary Historical and
Unaudited Pro Forma Financial Data--Magellan Historical and Pro Forma
Financial Data" excludes EBITDA associated with the joint venture
operations, settlements of reimbursement issues and reductions of operating
expenses associated with medical malpractice adjustments.
(3) EBITDA is defined under the caption "Summary--Summary Historical and
Unaudited Pro Forma Financial Data--Magellan Historical and Pro Forma
Financial Data."
For further information regarding pro forma operating results, see "Unaudited
Pro Forma Consolidated Financial Information" appearing elsewhere herein.
On March 3, 1998, the Company entered into definitive agreements with COI
and CBHS to, among other things, sell the Company's franchise operations,
certain domestic provider operations and certain other assets and operations for
$280.0 million, subject to certain adjustments, in cash and $30.0 million in COI
common stock.
The following table sets forth, on a pro forma basis after giving effect to
the CBHS Transactions for the year ended September 30, 1997, the Company's net
revenue and EBITDA from its business segments (in thousands):
% OF % OF
NET REVENUE CONSOLIDATED EBITDA(3) CONSOLIDATED
------------- --------------- ----------- ---------------
Existing managed care business (1)..................... $ 594,156 42.2% $ 72,221 39.6%
Merit managed care business............................ 644,031 45.8 58,662 32.2
------------- ----- ----------- -----
Total managed care business.......................... 1,238,187 88.0 130,883 71.8
Public sector business................................. 94,422 6.7 7,839 4.3
Healthcare franchising business........................ -- -- -- --
Provider business (2) 74,850 5.3 44,698 24.5
Corporate overhead..................................... -- -- (13,275) (7.3)
Interest income........................................ -- -- 12,095 6.7%
------------- ----- ----------- -----
Consolidated......................................... $ 1,407,459 100.0% $ 182,240 100.0%
------------- ----- ----------- -----
------------- ----- ----------- -----
- ------------------------
(1) Includes HAI and Allied pro forma results.
(2) The provider business segment includes the Company's three European
psychiatric hospitals, a general hospital that was closed in January 1997
and certain other operations. EBITDA includes revenue associated with
settlements of reimbursement issues and reductions of operating expenses
associated with medical malpractice adjustments. Pro Forma Adjusted EBITDA
as presented in "Summary--Summary Historical and
(FOOTNOTES CONTINUED ON FOLLOWING PAGE)
56
(FOOTNOTES CONTINUED FROM PRECEDING PAGE)
Unaudited Pro Forma Financial Data--Magellan Historical and Pro Forma
Financial Data" excludes EBITDA associated with the settlements of
reimbursement issues and reductions of operating expenses associated with
medical malpractice adjustments.
(3) EBITDA is defined under the caption "Summary--Summary Historical and
Unaudited Pro Forma Financial Data--Magellan Historical and Pro Forma
Financial Data."
For further information regarding pro forma operating results, see "Unaudited
Pro Forma Consolidated Financial Information" and "Pending Sale of Provider
Business--Unaudited Pro Forma Consolidated Financial Information--CBHS
Transactions" appearing elsewhere herein.
The Company generates a significant portion of its revenue and earnings from
its managed care business. A significant portion of the Company's managed care
revenue and earnings are generated from risk-based products, and such portion
will increase following the Acquisition. The Company believes enrollment in
risk-based products will continue to grow through new covered lives and the
transition of covered lives in ASO and EAP products to higher revenue risk-based
products. Risk-based products typically generate significantly higher amounts of
revenue than other managed behavioral healthcare products. Because the Company
is responsible for the cost of care, risk-based products typically have lower
margins than non-risk-based products.
RESULTS OF OPERATIONS
GENERAL
For fiscal years prior to 1996, the Company did not have any material
operations other than the provider business. The following table summarizes, for
the periods indicated, operating results by business segment (in thousands):
MANAGED PUBLIC HEALTHCARE
CARE SECTOR FRANCHISING PROVIDER CORPORATE
1996 BUSINESS BUSINESS BUSINESS BUSINESS OVERHEAD CONSOLIDATED
- ------------------------------- ----------- --------- ------------ ------------- ---------- -------------
Net revenue.................... $ 229,859 $ 70,709 $ -- $ 1,044,711 $ -- $ 1,345,279
----------- --------- ------------ ------------- ---------- -------------
Salaries, cost of care and
other operating expenses..... 202,690 60,840 -- 766,129 34,786 1,064,445
Bad debt expense............... 1,192 347 -- 79,931 -- 81,470
Depreciation and
amortization................. 9,111 2,580 -- 34,201 3,032 48,924
Stock option expense........... -- -- -- -- 914 914
Unusual items (1).............. -- -- -- 36,050 1,221 37,271
----------- --------- ------------ ------------- ---------- -------------
212,993 63,767 -- 916,311 39,953 1,233,024
----------- --------- ------------ ------------- ---------- -------------
Operating profit........... $ 16,866 $ 6,942 $ -- $ 128,400 $ (39,953) $ 112,255
----------- --------- ------------ ------------- ---------- -------------
----------- --------- ------------ ------------- ---------- -------------
1997
- -------------------------------
Net revenue.................... $ 363,883 $ 94,422 $ 22,739 $ 729,652 $ -- $ 1,210,696
----------- --------- ------------ ------------- ---------- -------------
Salaries, cost of care and
other operating expenses..... 323,814 86,709 3,652 538,760 25,578 978,513
Bad debt expense............... 192 (126) -- 46,145 -- 46,211
Depreciation and
amortization................. 13,016 2,904 160 24,528 4,253 44,861
Stock option expense........... -- -- -- -- 4,292 4,292
Unusual items (1).............. -- -- -- 5,745 -- 5,745
----------- --------- ------------ ------------- ---------- -------------
337,022 89,487 3,812 615,178 34,123 1,079,622
----------- --------- ------------ ------------- ---------- -------------
Operating profit........... $ 26,861 $ 4,935 $ 18,927 $ 114,474 $ (34,123) $ 131,074
----------- --------- ------------ ------------- ---------- -------------
----------- --------- ------------ ------------- ---------- -------------
- ------------------------
(1) Includes charges for insurance settlements, facility closures, asset
impairments and other amounts.
57
QUARTER ENDED DECEMBER 31, 1996 COMPARED TO THE QUARTER ENDED DECEMBER 31, 1997.
REVENUE. Managed care revenue increased 61.8% to $134.1 million for the
quarter ended December 31, 1997 from $82.9 million in the same period in fiscal
1997. The increase resulted primarily from the acquisition of HAI and Allied in
December 1997 and continued revenue growth at Green Spring. HAI and Allied
revenues were approximately $9.2 million and $18.5 million, respectively, for
the quarter ended December 31, 1997. Green Spring revenues were positively
impacted by the award of several new contracts and acquisitions since December
31, 1996, resulting in a 54% increase in covered lives to 21.1 million as of
December 31, 1997 as compared to December 31, 1996.
Public sector revenue increased 36.1% to $29.3 million for the quarter ended
December 31, 1997 from $21.5 million in the same period in fiscal 1997. The
increase was primarily attributable to a 26% increase in placements in Mentor
homes and $1.7 million in additional revenues from correctional contracts.
Healthcare franchising revenue was $19.6 million for the quarter ended
December 31, 1997. The healthcare franchising revenue consisted of Franchise
Fees payable by CBHS pursuant to the master franchising agreement entered into
as part of the Crescent Transactions.
Provider business revenue decreased 86.3% to $33.1 million for the quarter
ended December 31, 1997 from $242.4 million in the same period in fiscal 1997.
The decrease resulted primarily from the effect of the consummation of the
Crescent Transactions on June 17, 1997, following which revenue from the
Psychiatric Hospital Facilities and other facilities transferred to CBHS was no
longer recorded as part of the Company's revenue. During the quarters ended
December 31, 1996 and 1997, the Company recorded revenue of $11.0 million and
$0.7 million, respectively, for settlements and adjustments related to
reimbursement issues with respect to psychiatric hospitals owned or formerly
owned by the Company. During fiscal 1997, the Company recorded $27.4 million for
such settlements. Management anticipates that revenue related to such
settlements will decline significantly for fiscal 1998.
SALARIES, COST OF CARE AND OTHER OPERATING EXPENSES. Salaries, cost of care
and other operating expenses attributable to the managed care business increased
61.7% to $119.6 million for the quarter ended December 31, 1997 from $73.9
million in the same period in fiscal 1997. The increase resulted primarily from
the acquisition of HAI and Allied, which had expenses of $6.8 million and $17.6
million, respectively, for the quarter ended December 31, 1997, and from
continued growth at Green Spring.
Public sector salaries, cost of care and other operating expenses increased
39.0% to $27.4 million for the quarter ended December 31, 1997 from $19.7
million in the same period in fiscal 1997. The increase was due primarily to
internal growth and increases in costs related to expansion and new product
development.
Healthcare franchising operating expenses were $2.2 million for the quarter
ended December 31, 1997. The Company recorded no expenses with respect to the
healthcare franchising business during the quarter ended December 31, 1996
because the Crescent Transactions were not consummated until the third quarter
of fiscal 1997.
Salaries, cost of care and other operating expenses attributable to the
provider business decreased 88.0% to $22.1 million for the quarter ended
December 31, 1997 from $184.7 million in the same period in fiscal 1997. The
decrease resulted primarily from the effect of the consummation of the Crescent
Transactions, following which operating expenses of the Psychiatric Hospital
Facilities and other facilities transferred to CBHS were no longer accounted for
as part of the Company's operating expenses. During the quarter ended December
31, 1997, the Company recorded reductions of expenses of approximately $4.1
million as a result of updated actuarial estimates related to malpractice claim
reserves. These reductions resulted primarily from updates to actuarial
assumptions regarding the Company's expected losses for more recent policy
years. These revisions are based on changes in expected values of ultimate
losses resulting from the Company's claim experience, and increased
58
reliance on such claim experience. While management and its actuaries believe
that the present reserve is reasonable, ultimate settlement of losses may vary
from the amount recorded and result in additional fluctuations in income in
future periods.
BAD DEBT EXPENSE. Bad debt expense, which is primarily attributable to the
provider business, decreased 94.7%, or $19.2 million, for the quarter ended
December 31, 1997 compared to the same period in fiscal 1997. The decrease was
primarily attributable to the effect of the consummation of the Crescent
Transactions, following which the bad debt expense incurred by the Psychiatric
Hospital Facilities and other facilities transferred to CBHS was no longer
accounted for as part of the Company's bad debt expense.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased
46.8%, or $6.1 million, for the quarter ended December 31, 1997 compared to the
same period in fiscal 1997. The decrease was primarily attributable to the
effect of the consummation of the Crescent Transactions, whereby the Psychiatric
Hospital Facilities were sold to Crescent, offset by increases in depreciation
and amortization resulting from the HAI and Allied acquisitions.
INTEREST, NET. Interest expense, net, decreased 45.5%, or $6.2 million, for
the quarter ended December 31, 1997 compared to the same period in fiscal 1997.
The decrease was primarily the result of lower interest expense due to lower
average borrowings and higher interest income due to temporary investments of
the cash received in the Crescent Transactions.
OTHER ITEMS. Stock option expense (credit) for the quarter ended December
31, 1997 decreased $4.6 million from the quarter ended December 31, 1996
primarily due to fluctuations in the market price of the Company's common stock.
The Company recorded equity in the loss of CBHS of $11.5 million for the
quarter ended December 31, 1997, representing the Company's proportionate (50%)
loss in CBHS for the quarter ended December 31, 1997.
Minority interest increased $0.9 million during the quarter ended December
31, 1997 compared to the same period in fiscal 1997. The increase was primarily
due to Green Spring's net income growth in fiscal 1998.
The Company recorded an extraordinary loss on early extinguishment of debt,
net of tax, of $3.0 million during the quarter ended December 31, 1996 related
to the termination of its then existing credit agreement.
FISCAL 1996 COMPARED TO FISCAL 1997.
REVENUE. Managed care business revenue increased 58.3%, or $134.0 million,
in fiscal 1997 compared to fiscal 1996. The increase resulted primarily from the
inclusion of a full year of Green Spring operations in fiscal 1997 results.
Managed care business revenue was also positively impacted by the award of
several new contracts to Green Spring in the fourth quarter of fiscal 1996 and
in fiscal 1997, resulting in a 22% increase in covered lives on September 30,
1997 as compared to September 30, 1996.
Public sector business revenue increased 33.5%, or $23.7 million, in fiscal
1997 compared to fiscal 1996. The increase was primarily attributable to a 23%
increase in placements in Mentor homes and $5.2 million in additional revenues
from correctional contracts awarded in fiscal 1996 and fiscal 1997.
Healthcare franchising business revenue was $22.7 million for fiscal 1997.
The healthcare franchising business revenue consisted of Franchise Fees paid by
CBHS pursuant to the Master Franchise Agreement since the consummation of the
Crescent Transactions.
Provider business revenue decreased 30.2%, or $315.1 million, in fiscal 1997
compared to fiscal 1996. The decrease resulted primarily from: (i) the effect of
the consummation of the Crescent Transactions on June 17, 1997, following which
revenue from the Psychiatric Hospital Facilities and other
59
facilities transferred to CBHS was no longer recorded as part of the Company's
revenue; (ii) the closure of hospitals in fiscal 1996 and 1997; and (iii)
reduced equivalent patient days at the Company's operating hospitals as a result
of reduced average length of stay. During fiscal 1996 and 1997, the Company
recorded revenue of $28.3 million and $27.4 million, respectively, for
settlements and adjustments related to reimbursement issues with respect to
psychiatric hospital facilities owned by the Company. The settlements and
adjustments related primarily to certain reimbursement issues associated with
the Company's financial reorganization in fiscal 1992 and early extinguishment
of long-term debt in fiscal 1994. Management anticipates that revenue related to
such settlements will decline significantly for fiscal 1998.
SALARIES, COST OF CARE AND OTHER OPERATING EXPENSES. Salaries, cost of care
and other operating expenses attributable to the managed care business increased
59.8%, or $121.1 million, in fiscal 1997 compared to fiscal 1996 as a result of
the acquisition of Green Spring and its growth during the period.
With respect to the public sector business, salaries, cost of care and other
operating expenses increased 42.5%, or $25.9 million, in fiscal 1997 compared to
fiscal 1996 due to internal growth, increases in costs related to expansion and
approximately $1.2 million of expenditures related to new product development.
The Company recorded no expenses with respect to the healthcare franchising
business during fiscal 1996 because the Crescent Transactions were not
consummated until the third quarter of fiscal 1997.
Salaries, cost of care and other operating expenses attributable to the
provider business decreased 29.7%, or $227.4 million, in fiscal 1997 compared to
fiscal 1996. The decrease resulted primarily from: (i) the effect of the
consummation of the Crescent Transactions, following which operating expenses of
the Psychiatric Hospital Facilities and other facilities transferred to CBHS
were no longer accounted for as part of the Company's operating expenses and
(ii) the closure of hospitals during fiscal 1996 and 1997. During fiscal 1996
and 1997, the Company recorded reductions of expenses of approximately $15.3
million and $7.5 million, respectively, as a result of updated actuarial
estimates related to malpractice claim reserves. These reductions resulted
primarily from updates to actuarial assumptions regarding the Company's expected
losses for more recent policy years. These revisions are based on changes in
expected values of ultimate losses resulting from the Company's claim
experience, and increased reliance on such claim experience. While management
and its actuaries believe that the present reserve is reasonable, ultimate
settlement of losses may vary from the amount recorded and result in additional
fluctuations in income in future periods.
Salaries and other operating expenses attributable to the Company's
headquarters decreased 26.5%, or $9.2 million, due primarily to the transfer of
personnel and overhead to CBHS and the healthcare franchising business as a
result of the Crescent Transactions.
BAD DEBT EXPENSE. Bad debt expense, which is primarily attributable to the
provider business, decreased 43.3%, or $35.3 million, in fiscal 1997 compared to
fiscal 1996. The decrease was primarily attributable to: (i) the effect of the
consummation of the Crescent Transactions, following which the bad debt expense
of the Psychiatric Hospital Facilities and other facilities transferred to CBHS
was no longer accounted for as part of the Company's bad debt expense; (ii)
improved accounts receivable aging and turnover compared to prior periods; and
(iii) a shift towards governmental and managed care payors, which reduced the
Company's credit risk associated with individual patients.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased
8.3%, or $4.1 million, in fiscal 1997 compared to fiscal 1996. The decrease was
primarily attributable to the effect of the consummation of the Crescent
Transactions, whereby the Psychiatric Hospital Facilities were sold to Crescent,
offset by increases in depreciation and amortization resulting from the Green
Spring acquisition.
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INTEREST, NET. Interest, net, decreased 5.5%, or $2.6 million, in fiscal
1997 compared to fiscal 1996. The decrease was primarily the result of lower
interest expense due to lower average borrowings and higher interest income due
to temporary investments of the cash received in the Crescent Transactions.
Fiscal 1996 included approximately $5.0 million of interest income related to
income tax refunds from the State of California for the Company's income tax
returns for fiscal 1982 through 1989.
OTHER ITEMS. Stock option expense for fiscal 1997 increased $3.4 million
from fiscal 1996 primarily due to fluctuations in the market price of the
Company's Common Stock.
The Company recorded equity in the loss of CBHS of $8.1 million in fiscal
1997, representing the Company's proportionate (50%) loss in CBHS for the 106
days ended September 30, 1997.
The Company recorded a loss on the Crescent Transactions of approximately
$59.9 million during fiscal 1997.
The Company recorded unusual items, net, of $0.4 million during fiscal 1997,
which consisted of: (i) a $5.4 million net pre-tax gain on the sales of
previously closed psychiatric hospitals; (ii) a $4.2 million charge for the
closure of three psychiatric hospitals and one general hospital; and (iii) a
$1.6 million charge related to the termination of an agreement to sell the
Company's European hospitals.
Minority interest increased $2.9 million during fiscal 1997 compared to
fiscal 1996. The increase was primarily due to: (i) the Company acquiring a
controlling interest in Green Spring in December 1995; (ii) Green Spring's
internal growth subsequent to the acquisition date; and (iii) increased net
income from hospital-based joint ventures.
The Company recorded extraordinary losses on early extinguishment of debt,
net of tax, of $5.3 million during fiscal 1997.
The fourth quarter of fiscal 1997 included increases to income before income
taxes and minority interest of approximately $6.4 million for revenue and bad
debt adjustments related to accounts receivable retained by the Company that
were generated by the hospitals operated by CBHS. Such adjustments reflect a
change in estimates of contractual allowances and allowance for doubtful
accounts of such receivables based on the collection activity subsequent to the
completion of the Crescent Transactions.
FISCAL 1995 COMPARED TO FISCAL 1996.
REVENUE. The Company's net revenue for fiscal 1996 increased 16.8%, or
$193.5 million, compared to fiscal 1995. The increase resulted primarily from
the acquisitions of Green Spring and Mentor offset in part by: (i) the effect of
hospitals closed during fiscal 1995 and 1996 and (ii) the decrease in revenue
per equivalent patient day in fiscal 1996. Net revenue per equivalent patient
day at the Company's psychiatric hospitals decreased in 1996 by 4.5% compared to
fiscal 1995. The decreases were primarily due to: (i) continued shift in payor
mix from private payor sources to managed care payors and governmental payors;
(ii) pricing pressure from certain payors, primarily related to the denial of
claims payable to the hospitals; (iii) lower settlements of reimbursement
issues; (iv) shifts in program mix to residential treatment settings from acute
care settings; and (v) the elimination of ESOP expense in fiscal 1996, which
resulted in lower Medicare reimbursement levels.
Managed care business revenue was $229.9 million in 1996, as a result of the
acquisition of Green Spring during the first quarter of fiscal 1996.
Public sector business revenue increased from $44.8 million in fiscal 1995
to $70.7 million in fiscal 1996 as a result of the inclusion of a full year of
operations of Mentor, which was acquired in January 1995.
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During fiscal 1995 and 1996, the Company recorded revenue of $35.6 million
and $28.3 million, respectively, for settlements and adjustments related to
reimbursement issues with respect to psychiatric hospital facilities owned by
the Company. The settlements in fiscal 1995 and 1996 related primarily to
certain reimbursable costs associated with the Company's financial
reorganization in fiscal 1992 and costs related to the early extinguishment of
long-term debt in fiscal 1994.
SALARIES, COST OF CARE AND OTHER OPERATING EXPENSES. The Company's
salaries, cost of care and other operating expenses increased 23.3%, or $200.8
million, in fiscal 1996 compared to fiscal 1995. The increase resulted primarily
from the acquisitions of Green Spring and Mentor, offset in part by: (i) the
effect of hospitals closed in fiscal 1995 and 1996 and (ii) adjustments, as a
result of updated actuarial estimates to malpractice claim reserves, which
resulted in a reduction of expenses of approximately $15.3 million during fiscal
1996.
Managed care business salaries, cost of care and other operating expenses
were $202.7 million during fiscal 1996 as a result of the Green Spring
acquisition.
Public sector business salaries, cost of care and other operating expenses
increased from $38.1 million in fiscal 1995 to $60.8 million during fiscal 1996
as a result of the Mentor acquisition.
BAD DEBT EXPENSE. The Company's bad debt expense decreased 11.5%, or $10.6
million, during fiscal 1996 compared to fiscal 1995. The decrease was primarily
due to: (i) the shift in the provider business to managed care payors, which
reduces the Company's credit risk associated with individual patients, and (ii)
the number of reduced days of net revenue in its hospital receivables at
September 30, 1996.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
28.5%, or $10.8 million, during fiscal 1996 compared to fiscal 1995. The
increase resulted primarily from depreciation and amortization related to the
acquisition of Green Spring.
Reorganization value in excess of amounts allocable to identifiable assets
("Reorganization Value") and ESOP expense were not recorded in fiscal 1996 as a
result of the completion of the amortization of Reorganization Value in fiscal
1995 and the Company's decision to allocate all existing shares held by the ESOP
to the participants as of September 30, 1995.
INTEREST, NET. Interest, net, decreased 13.1%, or $7.2 million, during
fiscal 1996 compared to fiscal 1995. The decrease resulted primarily from
approximately $5.0 million of interest income recorded during fiscal 1996
related to income tax refunds due from the State of California for the Company's
income tax returns for fiscal 1982 through 1989.
OTHER ITEMS. Stock option expense for fiscal 1996 increased $1.4 million
from the previous year due to fluctuations in the market price of the Company's
Common Stock.
During fiscal 1996, the Company recorded unusual items of $37.3 million.
Included in the unusual charges was the resolution of a billing dispute in
August 1996 between the Company and a group of insurance carriers that arose in
fiscal 1996 related to matters originating in the 1980's. As part of the
settlement of these claims, certain related payor matters and associated legal
fees, the Company recorded a charge of approximately $30.0 million. The Company
is paying the insurance settlement in twelve installments over a three-year
period. The Company's obligation to make the settlement payments is supported by
a cash collateralized letter of credit. Other unusual items included: (i)
charges of approximately $4.1 million during fiscal 1996 related to the closure
of psychiatric hospitals; (ii) a charge of approximately $1.2 million related to
impairment losses; and (iii) charges of approximately $2.0 million related to
severance costs for personnel reductions.
During fiscal 1995, the Company recorded unusual items of $57.4 million. The
unusual charges include the resolution in March 1995 of disputes between the
Company and a group of insurance carriers that arose in fiscal 1995 related to
claims paid predominantly in the 1980's. As part of the
62
resolution, the Company agreed to pay the insurance carriers approximately $29.8
million in five installments over a three-year period. Other unusual items
included: (i) a charge of approximately $3.6 million related to the closure of
five psychiatric hospitals; (ii) a charge of approximately $27.0 million related
to the adoption and implementation of Statement of Financial Accounting
Standards No. 121; and (iii) a gain of approximately $3.0 million on the sale of
three psychiatric hospitals.
In fiscal 1995, the Company recorded an income tax benefit because it had a
net operating loss during the period. The Company's effective tax rate was 40.0%
during fiscal 1996. The change in the effective tax rate was primarily
attributable to: (i) the elimination of non-deductible amortization of
Reorganization Value in fiscal 1996 and (ii) the reduction in the Company's
effective tax rate as a result of the favorable resolution of the Company's
California income tax returns for fiscal 1982 through 1989, partially offset by
the increase in non-deductible intangible amortization in fiscal 1996 as a
result of the acquisitions of Mentor and Green Spring.
Minority interest increased $5.8 million during fiscal 1996 compared to
fiscal 1995. The increase was primarily due to the Company acquiring a
controlling interest in Green Spring in December 1995 and obtaining a
controlling interest in other businesses during fiscal 1995 and 1996.
IMPACT OF CRESCENT TRANSACTIONS.
The Company owns a 50% equity interest in CBHS, from which it receives the
Franchise Fees. The Franchise Fees represent a significant portion of the
Company's earnings and cash flows. The following is a discussion of certain
matters related to the Company's ownership of CBHS that may have a bearing on
the Company's future results of operations.
CBHS may consolidate services in selected markets by closing facilities
depending on market conditions and evolving business strategies. For example,
during fiscal 1995 and 1996, the Company consolidated, closed or sold 15 and 9
psychiatric hospitals, respectively. During fiscal 1997, the Company
consolidated or closed three psychiatric hospitals, prior to the Crescent
Transactions. If CBHS closes additional psychiatric hospitals, it could result
in charges to income for the costs attributable to the closures, which would
result in lower equity in earnings of CBHS for the Company.
The Company's joint venture hospitals and CBHS' hospitals continue to
experience a shift in payor mix to managed care payors from other payors, which
contributed to a reduction in revenue per equivalent patient day in fiscal 1996
and a decline in average length of stay in fiscal 1995, 1996 and 1997.
Management anticipates a continued shift in hospital payor mix towards managed
care payors as a result of changes in the healthcare marketplace. Future shifts
in hospital payor mix to managed care payors could result in lower revenue per
equivalent patient day and lower average length of stay in future periods for
the Company's joint venture hospitals and CBHS' hospitals, which could result in
lower equity in earnings from CBHS for the Company and cash flows to pay the
Franchise Fees. The hospitals currently managed or operated by CBHS, including
hospitals closed or sold in 1997, reported a 10% reduction in equivalent patient
days, a 7% reduction in average length of stay and a 4% decrease in admissions
as compared to the same period in 1996.
The Budget Act, which was enacted in August 1997, includes provisions that
eliminated the TEFRA bonus payment and reduced reimbursement of certain costs
previously paid by Medicare and eliminated the Medicaid "disproportionate share"
program. These provisions, along with other provisions in the Budget Act, will
reduce the amount of revenue and earnings that CBHS hospitals will receive for
the treatment of Medicare patients. CBHS management estimates that such
reductions will approximate $10 million in fiscal 1998, and due to the phase-in
effects of the Budget Act, approximately $15 million annually in subsequent
fiscal years.
Based on projections of fiscal 1998 operations prepared by management of
CBHS, the Company believes that CBHS will be unable to pay the full amount of
the Franchise Fees it is contractually obligated to pay the Company during
fiscal 1998. The Company currently estimates that CBHS will be
63
able to pay approximately $58.0 to $68.0 million of the Franchise Fees in fiscal
1998, a $10.0 to $20.0 million shortfall relative to amounts payable under the
Master Franchise Agreement. The Company may be required to record bad debt
expense related to Franchise Fees receivable from CBHS, if any, in fiscal 1998
or future periods if CBHS's operating performance does not improve to levels
achieved prior to the consummation of the Crescent Transactions. If CBHS
defaults in payment of the Franchise Fees, the Company will pursue all remedies
available to it under the Master Franchise Agreement. See "Charter
Advantage--Franchise Operations."
IMPACT OF THE ACQUISITION.
As a result of the Acquisition, the Company has over 58.0 million covered
lives under managed behavioral healthcare contracts and manages behavioral
healthcare programs for over 4,000 customers. The Company believes it also now
has the number one market position in each of the major product markets in which
it competes. The Company believes its industry leading position will enhance its
ability to: (i) provide a consistent level of high quality service on a
nationwide basis; (ii) enter into favorable agreements with behavioral
healthcare providers that allow it to effectively control healthcare costs for
its customers; and (iii) effectively market its managed care products to large
corporate, HMO and insurance customers, which, the Company believes,
increasingly prefer to be serviced by a single-source provider on a national
basis.
The Company believes that the Acquisition has created opportunities for the
Company to achieve significant cost savings in its managed behavioral healthcare
business. Management believes that cost savings opportunities will result from
leveraging fixed overhead over a larger revenue base and an increased number of
covered lives and from reducing duplicative corporate and regional selling,
general and administrative expenses. As a result, the Company expects to achieve
approximately $60.0 million of cost savings in its managed behavioral healthcare
business on an annual basis within eighteen months following the consummation of
the Acquisition. The Company expects to spend approximately $26.0 million during
the eighteen months following the consummation of the Acquisition in connection
with achieving such costs.
The Company expects to finalize its plans for the integration of the
businesses of Green Spring, HAI and Merit by March 31, 1998. The Company expects
to record charges to operations during the quarter ended March 31, 1998 to the
extent the integration plan results in the elimination of personnel and facility
closures at HAI and Green Spring and for integration plan costs incurred that
benefit future periods.
The full implementation of the integration plan is expected to take eighteen
months. The Acquisition and related transactions are expected to be dilutive to
earnings during the remaining quarters of fiscal 1998.
The Company expects to record an extraordinary loss of approximately $30.0
million to $35.0 million, net of tax benefits, in connection with the
termination of its Credit Agreement and extinguishing the Magellan Outstanding
Notes as part of the Transactions.
IMPACT OF THE CBHS TRANSACTIONS.
If the CBHS Transactions are consummated, the Company will no longer conduct
its franchising operations. Accordingly, the Company will no longer receive
Franchise Fees or incur expenses related to the Franchise Fees. In addition, if
the CBHS Transactions are consummated, the Company will sell substantially all
of its domestic provider operations. The net proceeds from the CBHS Transactions
will be used to reduce debt. The CBHS Transactions, if consummated, would reduce
the Company's future earnings as the earnings of the Company attributable to the
franchise operations and the domestic provider operations which would be sold in
the CBHS Transactions would exceed the decrease in interest expense as a result
of reduced debt.
64
HISTORICAL LIQUIDITY AND CAPITAL RESOURCES
OPERATING ACTIVITIES. The Company's net cash provided by operating
activities was $101.9 million and $73.6 million for fiscal 1996 and fiscal 1997,
respectively. The decrease in net cash provided by operating activities in
fiscal 1997 compared to fiscal 1996 was primarily the result of: (i) higher
income tax payments ($9.3 million and $18.4 million in fiscal 1996 and fiscal
1997, respectively); (ii) $5.0 million of interest income related to income tax
refunds from the State of California in fiscal 1996; (iii) higher insurance
settlement payments ($24.6 million in fiscal 1996 and $28.5 million in fiscal
1997); and (iv) reduced cash flows from the provider business, net of franchise
fees received.
The Company's net cash used in operating activities was approximately $23.4
million and $31.7 million for the quarters ended December 31, 1996 and 1997,
respectively. The Company typically had negative operating cash flows in the
December quarter each year due to the interest payment previously due in October
each year for the Magellan Outstanding Notes and annual employee incentive
payments. Operating cash flows for the quarter ended December 31, 1997 were also
adversely affected by the change in due to/from CBHS, primarily due to working
capital advances, of $11.3 million, the prepayment of CHARTER call center
management fees to CBHS of $5.9 million and insurance settlement payments of
$6.8 million.
INVESTING ACTIVITIES. The Company acquired a 61% ownership interest in
Green Spring during the first quarter of fiscal 1996. The consideration paid for
Green Spring and related acquisition costs resulted in the use of cash of
approximately $87.2 million compared to approximately $50.9 million for
acquisitions and investments in businesses, including CBHS, during fiscal 1997.
The Crescent Transactions resulted in net proceeds of $380.4 million, during
fiscal 1997, consisting of $393.7 million related to the sale of property and
equipment to Crescent and CBHS, less $13.3 million in costs and construction
obligations incurred to date.
The Company made $20.0 million of cash capital contributions to CBHS during
fiscal 1997. The Company has no present intention of making any additional
capital contributions to CBHS.
The Company utilized $165.5 million in funds, net of cash acquired, for
acquisitions and investments in businesses, including Allied and HAI, during the
quarter ended December 31, 1997. In addition, the Company paid approximately
$4.3 million for Crescent Transaction costs during the quarter ended December
31, 1997. The Company expects to fund an additional $6.6 million in transaction
costs and construction costs during the remainder of fiscal 1998 related to the
Crescent Transactions.
FINANCING ACTIVITIES. The Company borrowed approximately $104.8 million and
$203.6 million during fiscal 1996 and 1997, respectively. The fiscal 1996
borrowings primarily funded the Green Spring acquisition and $35.0 million of
treasury stock purchases. The fiscal 1997 borrowings primarily funded the
repayment of variable rate secured notes and other long-term debt (including the
refinancing of a previous revolving credit agreement), acquisitions and working
capital needs.
The Company repaid approximately $85.8 million and $390.3 million of debt
and capital lease obligations during fiscal 1996 and 1997, respectively. The
fiscal 1997 repayments related primarily to a previous revolving credit
agreement and repaying other indebtedness as a result of the Crescent
Transactions.
On January 25, 1996, the Company sold 4.0 million shares of Common Stock
along with the Rainwater-Magellan Warrant pursuant to the Private Placement. The
Rainwater-Magellan Warrant, which expires in January, 2000, entitles the holder
to purchase 2.0 million shares of Common Stock at a per share price of $26.15,
subject to adjustment for certain dilutive events, and provides registration
rights for the shares of Common Stock underlying the warrant. The warrant became
exercisable on January 25, 1997. The Company received proceeds of approximately
$68.6 million, net of issuance costs, from the Private Placement. Approximately
$68.0 million of the proceeds were used to repay outstanding borrowings related
to the Green Spring acquisition.
65
The Company issued approximately 2.6 million warrants to Crescent and COI
for $25.0 million in cash as part of the Crescent Transactions during fiscal
1997.
On September 27, 1996, the Company repurchased approximately 4.0 million
shares of its Common Stock for approximately $73.5 million, including
transaction costs, pursuant to a "Dutch Auction" self-tender offer to its
stockholders. On November 1, 1996, the Company announced that its board of
directors approved the repurchase of an additional 3.0 million shares of its
Common Stock from time to time subject to the terms of the Magellan Existing
Credit Agreement.
The Company borrowed approximately $126.8 million, net of issuance costs, in
the first quarter of fiscal 1997, primarily to refinance its then existing
credit agreement. The Company repurchased approximately 545,000 shares of its
common stock for approximately $12.5 million during the quarter ended December
31, 1997.
As of February 12, 1998, the Company had approximately $112.5 million of
availability under the Revolving Facility of the Credit Agreement. The Company
was in compliance with all debt covenants as of February 12, 1998.
OUTLOOK--LIQUIDITY AND CAPITAL RESOURCES
Following the consummation of the Transactions, interest payments on the
Notes and interest and principal payments on indebtedness outstanding pursuant
to the New Credit Agreement represent significant liquidity requirements for the
Company. Borrowings under the New Credit Agreement bear interest at floating
rates and require interest payments on varying dates depending on the interest
rate option selected by the Company. Borrowings pursuant to the New Credit
Agreement include $550 million in term loans and up to $150 million under the
Revolving Facility. Commencing in the second quarter of fiscal 1999, the Company
will be required to make principal payments with respect to the term loans.
The Company is in the process of finalizing its plans for the integration of
the businesses of Green Spring, HAI and Merit. The Company expects to achieve
approximately $60.0 million of cost savings on an annual basis within eighteen
months following the consummation of the Acquisition. Such cost savings are
measured relative to the combined budgeted amounts of the Company, Merit and HAI
for the current fiscal year prior to the cost savings initiatives. The Company
expects to spend approximately $26.0 million during the eighteen months
following the consummation of the Acquisition in connection with achieving such
cost savings, including expenses related to reducing duplicative personnel in
its managed care organizations, contractual terminations for eliminating excess
real estate (primarily locations under operating leases) and other related costs
in connection with the integration plan. Certain of such costs will be capital
expenditures.
During December 1997, the Company purchased HAI and Allied for approximately
$122.1 million and $70.0 million, respectively, excluding transaction costs. In
addition, the Company incurred the obligation to make contingent payments to the
former owners of HAI and Allied. With respect to HAI, the Company may be
required to make additional contingent payments of up to $60.0 million annually
to Aetna over the five-year period subsequent to closing. The Company is
obligated to make contingent payments under two separate calculations. Under the
first calculation, the amount and timing of the contingent payments will be
based on growth in the number of lives covered by certain HAI products during
the next five years. The Company may be required to make contingent payments of
up to $25.0 million per year for each of the five years following the HAI
acquisition depending on the net annual growth in the number of lives covered by
such HAI products. Aetna will receive a specified amount per net incremental
life covered by such products. The amount to be paid per incremental covered
life decreases during the five-year term of the Company's contingent payment
obligation. Under the second calculation, the Company may be required to make
contingent payments of up to $35.0 million per year for each of five years based
on the net cumulative growth in the number of lives covered by certain other HAI
products. Aetna will receive a specified amount per net incremental life covered
by such products.
66
The amount to be paid per incremental covered life increases with the number of
incremental covered lives.
The Company may be required to pay up to $40.0 million during the three
years following the closing of the Allied acquisition based on Allied's
performance relative to certain earnings targets. In connection with Merit's
acquisition of CMG, the Company, by acquiring Merit, may be required to make
certain future contingent cash payments over the next two years to the former
shareholders of CMG based upon the performance of certain CMG customer
contracts. Such contingent payments are subject to an aggregate maximum of $23.5
million.
The Company believes that the cash flow generated from its operations
together with amounts available for borrowing under the New Credit Agreement,
should be sufficient to fund its debt service requirements, anticipated capital
expenditures, contingent payments, if any, with respect to HAI, Allied and CMG
and other investing and financing activities. The CBHS Transactions, if
consummated, would result in an estimated annual reduction in cash flows from
operations of $25.0 million to $35.0 million. The Company currently estimates
that it will spend approximately $50.0 million to $60.0 million for capital
expenditures in fiscal 1998. On a combined basis, the Company (excluding its
provider business), Merit and HAI spent approximately $40 million for capital
expenditures during fiscal 1997. The majority of the Company's budgeted capital
expenditures relate to management information systems and related equipment. The
Revolving Facility will provide the Company with revolving loans and letters of
credit in an aggregate principal amount at any time not to exceed $150.0
million. Immediately after the consummation of the Transactions, approximately
$112.5 million was available to the Company for borrowing pursuant to the
Revolving Facility. The Company's future operating performance and ability to
service or refinance the Notes or to extend or refinance the indebtedness
outstanding pursuant to the New Credit Agreement will be subject to future
economic conditions and to financial, business and other factors, many of which
are beyond the Company's control.
The New Credit Agreement imposes restrictions on the Company's ability to
make capital expenditures and both the New Credit Agreement and the Indenture
governing the Notes limit the Company's ability to incur additional
indebtedness. Such restrictions, together with the highly leveraged financial
condition of the Company subsequent to the Transactions, limit the Company's
ability to respond to market opportunities. The covenants contained in the New
Credit Agreement also, among other things, restrict the ability of the Company
to dispose of assets, repay other indebtedness, amend other debt instruments
(including the Indenture), pay dividends, create liens on assets, enter into
sale and leaseback transactions, make investments, loans or advances, redeem or
repurchase common stock and make acquisitions. See "Risk Factors--Substantial
Leverage and Debt Service Obligations," "Description of the New Notes" and
"Summary of New Credit Agreement."
MODIFICATION OF COMPUTER SOFTWARE FOR THE YEAR 2000
The Company and its subsidiaries have internally developed computer software
systems that process transactions based on storing two digits for the year of a
transaction (i.e., "97 " for 1997) rather than four digits, which will be
required for year 2000 transaction processing. CBHS expects to spend $1.0
million in the aggregate during fiscal 1998 and fiscal 1999 to modify internal
use software. The Company expects to spend approximately $1.6 million in the
aggregate during fiscal 1998 and fiscal 1999 to modify internal use software.
The Company does not anticipate incurring any other significant costs for year
2000 software modification. The cost of modifying internal use software for the
year 2000 is charged to expense as incurred.
67
MERIT'S MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
THE FOLLOWING IS AN EXCERPT FROM MERIT'S ANNUAL REPORT ON FORM 10-K FOR ITS
FISCAL YEAR ENDED SEPTEMBER 30, 1997. THE EXCERPT IS PRESENTED TO ASSIST HOLDERS
OF THE OLD NOTES IN EVALUATING THE EXCHANGE OFFER. THE EXCERPT HAS BEEN REVISED
TO PERMIT CONSISTENT USE OF TERMS DEFINED ELSEWHERE IN THIS PROSPECTUS.
FURTHERMORE, THE COMPANY ADDED THE TEXT THAT APPEARS IN ITALICS AND PARENTHESIS
TO PROVIDE AN EXPLANATION OF CERTAIN TERMS THAT ARE DEFINED ELSEWHERE IN MERIT'S
ANNUAL REPORT ON FORM 10-K. THE FOLLOWING ALSO INCLUDES DISCUSSION AND ANALYSIS
OF MERIT'S RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED DECEMBER 31, 1996
AND 1997.
OVERVIEW
REVENUE
Typically, Merit charges each of its HMO, Blue Cross/Blue Shield
organization, insurance company, corporate, union, governmental and other
customers a flat monthly capitation fee for each beneficiary enrolled in such
customer's behavioral health managed care plan or EAP. This capitation fee is
generally paid to Merit in the current month. Contract revenue billed in advance
of performing related services is deferred and recognized ratably over the
period to which it applies. For a number of Merit's behavioral health managed
care programs, the capitation fee is divided into outpatient and inpatient fees,
which are recognized separately. Outpatient revenue is recognized monthly as it
is received; inpatient revenue is recognized monthly and in most cases is (i)
paid to Merit monthly (in cases where Merit is responsible for the payment of
inpatient claims) or in certain cases (ii) retained by the customer for payment
of inpatient claims. When the customer retains the inpatient revenue, actual
inpatient costs are periodically reconciled to amounts retained and Merit
receives the excess of the amounts retained over the cost of services, or
reimburses the customer if the cost of services exceeds the amounts retained. In
certain instances, such excess or deficiency is shared between Merit and the
customer.
DIRECT SERVICE COSTS AND MARGINS
Direct service costs are comprised principally of expenses associated with
managing, supervising and providing Merit's services, including third-party
network provider charges, various charges associated with Merit's staff offices,
inpatient facility charges, costs associated with members of management
principally engaged in Merit's clinical operations and their support staff, and
rent for certain offices maintained by Merit in connection with the delivery of
services. Direct service costs are recognized in the month in which services are
expected to be rendered. Network provider and facility charges for authorized
services that have not been reported and billed to Merit (known as incurred but
not reported expenses, or "IBNR") are estimated and accrued based on historical
experience, current enrollment statistics, patient census data, adjudication
decisions, and other information.
Merit has experienced an increase in direct service costs as a percentage of
revenue (which have been offset to varying degrees by various initiatives
described below) primarily as a result of changing product mix and pricing
pressure associated with both the competitive bid process for new contracts and
negotiations to extend existing contracts. The portion of Merit's revenue
attributable to capitated managed care programs has continuously been
increasing. Because capitated managed care programs require Merit to incur
greater direct service costs than EAP and ASO managed care programs, the direct
profit margins attributable to such programs are lower than the direct profit
margins attributable to Merit's EAP and ASO programs. Merit is continuing to
focus on reducing direct service costs. Efforts intended to reduce these costs
include: (i) negotiating better rates and/or different compensation arrangements
(such as retainer arrangements, volume discounts, case rates and capitation of
fees) with third-party network providers and treatment facilities; (ii)
contracting with treatment facilities that provide a broader spectrum of
treatment programs in an effort to expand beneficiary access to a broader
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continuum of care, thereby achieving more cost-effective treatment; (iii)
focusing management and clinical care techniques on patients requiring more
intensive treatment services to assure that such patients receive the
appropriate level of care in a cost-efficient and effective manner; (iv)
implementing a new information system intended to enable Merit to improve the
productivity and efficiency of its operations; and (v) increasing the overall
efficiency of Merit's staff provider system by closing or consolidating less
efficient staff offices, streamlining operations and increasing the efficiency
of remaining staff offices.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses are comprised principally of
corporate and regional overhead expenses, such as marketing and sales, legal,
finance, information systems and administrative expenses, as well as
professional and consulting fees, and the compensation of members of the Merit's
senior management. Merit expects selling, general and administrative expenses to
grow over the near term, primarily due to growth in information systems expenses
related to the implementation of AMISYS-Registered Trademark- (A CENTRALIZED
INFORMATION SYSTEM THAT IS MERIT'S PRIMARY SYSTEM) as well as increases in
regional administration and sales and marketing operations necessary to support
the growth of Merit's business; however, Merit expects selling, general and
administrative expenses to grow at a rate less than that of anticipated revenue
growth in the future. There can be no assurance, however, that anticipated
revenue growth will occur or that any such revenue growth will occur at a rate
greater than the rate of growth in selling, general and administrative expenses.
AMORTIZATION OF INTANGIBLES
As a result of Merck's (MERCK & CO., INC.) acquisition of Medco Containment
Services, Inc. (MERIT'S PREVIOUS OWNER) in November 1993, Merit's financial
statements include an allocation by Merck of the excess of its cost over fair
market value of the net assets acquired. Accordingly, goodwill and other
acquisition-related intangibles in the amount of $160.0 million were recorded on
Merit's balance sheet as of November 1993 and are being amortized over various
periods. A noncurrent deferred tax liability of $47.8 million was established to
reflect the tax consequences of the difference between the financial and tax
reporting bases of the identified intangibles. Merit's total goodwill also
includes goodwill associated with Merit's acquisitions of Group Plan Clinic,
Inc., and of BenesYs, Inc. (collectively, "BenesYs"), a Houston-based behavioral
health managed care organization, and CMG. In addition, the payment made to
Empire (EMPIRE BLUE CROSS AND BLUE SHIELD ("EMPIRE")) in connection with the
Empire Joint Venture (MERIT'S JOINT VENTURE WITH EMPIRE IN SEPTEMBER 1995 (THE
"EMPIRE JOINT VENTURE")), the acquisition of ProPsych, Inc. ("ProPsych") in
December 1995, and various contingent consideration payments, together with the
goodwill recognized from the BenesYs and CMG transactions, resulted in the
incurrence of additional goodwill of approximately $117.8 million. Amortization
of acquisition-related intangibles was $20.1 million in fiscal 1995, $23.0
million in fiscal 1996, and $23.8 million in fiscal 1997.
Merit also capitalizes certain start-up expenses related to new contracts
and amortizes these amounts over the life of the contracts. When Merit enters
into a new contract or significantly expands services for an existing customer,
Merit typically incurs up-front start-up costs that historically have ranged
from $50,000 to $2.5 million per program. These start-up costs include, among
other things, the costs of recruiting, interviewing and training providers and
support staff, establishing offices and other facilities, acquiring furniture,
computers and other equipment, and implementing information systems. As of
September 30, 1997, Merit's balance sheet reflected $9.0 million of deferred
start-up costs, net of amortization, categorized under long-term assets.
LIQUIDITY
Merit's liquidity is affected by the one-to-four-month lag between the time
Merit receives cash from capitation payments under new contracts and the time
when Merit pays the claims for services rendered
69
by third-party network providers and treatment facilities relating to such
capitation payments. During the first few months of a new contract, Merit builds
cash balances as capitation payments are received and also builds a payables
balance as direct service costs are accrued based on expected levels of service.
After the first several months of a contract, monthly claims payments typically
increase to normal levels and the contract generates cash commensurate with the
expected profit margin for that contract. When a contract is terminated, monthly
capitation payments cease on contract termination, but claims for services
rendered prior to termination continue to be received and paid for several
months. This post contract termination period is often referred to as the
"run-off" period. To date, contract terminations have not had a material impact
on Merit's liquidity.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, which will
be effective for Merit beginning October 1, 1998. SFAS No. 131 redefines how
operating segments are determined and requires disclosure of certain financial
and descriptive information about a company's operating segments. Merit has not
yet completed its analysis with respect to which operating segments of its
business it will provide such information.
RESULTS OF OPERATIONS
SELECTED OPERATING RESULTS
The following table sets forth certain statement of operations items of
Merit expressed as a percentage of revenue:
FISCAL YEAR ENDED SEPTEMBER 30, THREE MONTHS ENDED
DECEMBER 31,
1995 1996 1997 1996 1997
--------- --------- --------- --------- ---------
Revenue................................................ 100.0% 100.0% 100.0% 100.0% 100.0%
Direct service costs................................... 79.1 79.0 80.9 80.0 82.4
--------- --------- --------- --------- ---------
Direct profit margin................................. 20.9 21.0 19.1 20.0 17.6
Selling, general and administrative expenses........... 13.8 14.1 12.2 12.9 12.4
Amortization of intangibles............................ 5.9 5.7 4.8 5.3 4.1
Restructuring charge................................... -- 0.6 -- -- --
Income from joint ventures............................. -- -- -- -- (0.9)
--------- --------- --------- --------- ---------
Operating Income..................................... 1.2 0.6 2.1 1.8 2.0
Other income........................................... 0.4 0.6 0.6 0.6 0.6
Interest expense....................................... -- (5.2) (4.5) (4.8) (4.1)
Loss on disposal of subsidiary......................... -- -- (1.2) -- --
Merger costs and special charges....................... -- (0.8) (0.2) -- (0.3)
--------- --------- --------- --------- ---------
Income (loss) before income taxes and cumulative effect
of accounting change................................. 1.6 (4.8) (3.2) (2.4) (1.8)
Provision (benefit) for income taxes................... 1.2 (1.1) (0.7) (0.2) (0.3)
--------- --------- --------- --------- ---------
Income (loss) before cumulative effect of accounting
change............................................... 0.4% (3.7% (2.5% 2.2% 1.5%
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Adjusted EBITDA margin................................. 9.4% 9.9% 9.8% 10.1% 9.8%
70
THREE MONTHS ENDED DECEMBER 31, 1997 COMPARED TO THREE MONTHS ENDED DECEMBER 31,
1996
REVENUE. Revenue increased by $48.6 million, or 37.8%, to $177.2 million
for the three months ended December 31, 1997 from $128.6 million for the three
months ended December 31, 1996. Of this increase, $30.4 million was attributable
to the inclusion of revenue from certain contracts that commenced during the
prior fiscal year as well as additional revenue from existing customers
generated by an increase in both the number of programs managed by Merit on
behalf of such customers and an increase in the number of beneficiaries enrolled
in such customers' programs; and $0.5 million was attributable to new customers
commencing service in the current quarter. Also, Merit's acquisition of CMG on
September 12, 1997 contributed an additional $32.6 million in revenue for the
fiscal 1998 period. These revenue increases were partially offset by an $11.2
million decrease in revenue as a result of the termination of certain contracts,
$11.0 million of which was due to terminations that occurred in various periods
of the prior fiscal year. Also, Merit's disposition of Choate Health Management,
Inc. and certain related companies (collectively "Choate") in September 1997
resulted in a revenue decrease of $3.7 million for the fiscal 1998 period.
Contract price increases were not a material factor in the increase in revenue.
DIRECT SERVICE COSTS. Direct service costs increased by $43.1 million, or
41.9% , to $146.0 million for the three months ended December 31, 1997 from
$102.9 million for the three months ended December 31, 1996. As a percentage of
revenue, direct service costs increased from 80.0% in the prior year period to
82.4% in the current year period. The increase in cost as a percentage of
revenue was due primarily to the lower than average direct profit margins earned
on contracts for the State of Montana and for the Delaware County Medicaid
programs. In general, Merit's Medicaid contracts with governmental entities tend
to have significant revenue levels, with direct profit margins which are lower
than Merit's other contracts. The State of Montana contract was obtained through
the CMG acquisition in September 1997. The Delaware County contract started in
February 1997.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased by $5.5 million, or 33.1%, to $22.1 million
for the three months ended December 31, 1997 from $16.6 million for the three
months ended December 31, 1996. The increase in total selling, general and
administrative expenses was primarily attributable to (i) growth in marketing
and sales administrative staff, corporate and regional management and support
systems associated with the higher sales volume; (ii) inclusion of CMG's results
of operation since the acquisition date; and (iii) expenses related to the
planned deployment of Merit's new information systems. As a percentage of
revenue, selling, general and administrative expenses decreased from 12.9% in
the prior year period to 12.5% in the current year period. This decline is due
to Merit's efforts to contain such expenses as well as an allocation of such
expenses over a larger revenue base.
AMORTIZATION OF INTANGIBLES. Amortization of intangibles increased $0.4
million, or 6.4%, to $7.2 million for the three months ended December 31, 1997
from $6.8 million for the three months ended December 31, 1996. The increase was
primarily due to an increase in amortization of goodwill and other intangibles
recognized in connection with the acquisition of CMG.
INCOME FROM JOINT VENTURES. For the three months ended December 31, 1997,
Merit had income from joint ventures of $1.6 million. The majority of such
income is from Merit's 50% interest in the CHOICE Behavioral Health Partnership,
which Merit obtained in connection with the CMG acquisition.
OTHER INCOME (EXPENSE). For the three months ended December 31, 1997, other
income and expense consisted of (i) interest expense of $7.2 million related to
debt incurred as a result of the merger of Merit and an affiliate of Kohlberg
Kravis Roberts & Co. ("KKR") in October 1995 (the "1995 Merger"), and debt
incurred in connection with the acquisition of CMG; (ii) interest and other
income of $1.1 million relating primarily to investment earnings on Merit's
short-term investments and restricted cash balances; and (iii) merger costs and
special charges of $0.5 million relating primarily to expenses incurred for the
71
Transactions. The year over year increase in interest expense of $1.0 million
was primarily attributable to the interest expense incurred on the additional
debt issued in September 1997 in order to finance the acquisition of CMG. The
year over year increase in interest income of $0.3 million was primarily
attributable to both an increase in average invested cash balances as compared
to the prior year period and interest earned on advances to certain joint
ventures.
INCOME TAXES. Merit recorded a benefit for income taxes during the three
months ended December 31, 1996 and 1997 based upon Merit's pre-tax loss for such
periods.
FISCAL 1997 COMPARED TO FISCAL 1996
REVENUE. Revenue increased by $97.9 million, or 21.4%, to $555.7 million
for fiscal 1997 from $457.8 million for fiscal 1996. Of this increase, $71.3
million was attributable to the inclusion of revenue from certain contracts that
commenced during the prior fiscal year as well as additional revenue from
existing customers generated by an increase in both the number of programs
managed by Merit on behalf of such customers and an increase in the number of
beneficiaries enrolled in such customers' programs; and $65.8 million was
attributable to new customers commencing service in the current year, a
significant portion of which was derived from Merit's contract relating to
CHAMPUS Regions 7 and 8, under which services commenced on April 1, 1997. In
addition, Merit's acquisition of CMG on September 12, 1997 contributed an
additional $7.0 million in revenue for fiscal 1997. These revenue increases were
partially offset by a $46.2 million decrease in revenue as a result of the
termination of certain contracts, $29.1 million of which was due to contract
terminations that occurred in various periods of the prior fiscal year. Contract
price increases were not a material factor in the increase in revenue.
DIRECT SERVICE COSTS. Direct service costs increased by $87.9 million, or
24.3%, to $449.6 million for fiscal 1997 from $361.7 million for fiscal 1996. As
a percentage of revenue, direct service costs increased from 79.0% in the prior
year period to 80.9% in the current year period. The increase in cost as a
percentage of revenue was due primarily to the lower than average direct profit
margin earned on the TennCare Partners and the Delaware County Medicaid
programs, partially offset by a year over year decline in healthcare treatment
services utilization in Merit's overall business. In addition, the Delaware
County carve-out program replaced a program under which beneficiaries previously
received their mental health benefit through membership in various HMOs
servicing this area. Direct profit margins under contracts that Merit held with
certain of these HMOs, which terminated or membership in which decreased
substantially as a result of the Delaware County program, were higher than the
direct profit margins for the Delaware County program and Merit's overall
average direct profit margins. Excluding the effect of the TennCare Partners and
the Delaware County contracts, however, Merit experienced a decline in the
direct service cost percentage as a result of overall lower healthcare
utilization in the current year period as compared to the prior year period, due
to Merit's continued development and deployment of alternative treatment
programs designed to achieve more cost-effective treatment and Merit's increased
focus on clinical care techniques directed at patients requiring more intensive
treatment services. Also positively impacting the direct cost percentage were
the effect of (i) a nationwide recontracting program with providers which began
in the second quarter of fiscal 1996, and (ii) the closing of certain
underperforming staff offices pursuant to a plan implemented by Merit in the
fourth quarter of 1996.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased by $2.9 million, or 4.5%, to $67.4 million for
fiscal 1997 from $64.5 million for fiscal 1996. The increase in total selling,
general and administrative expenses was primarily attributable to (i) growth in
marketing and sales administrative staff, corporate and regional management and
support systems associated with the higher sales volume, (ii) expenses
associated with the expansion of both Merit's National Service Center located in
St. Louis, Missouri and Merit's headquarters located in Park Ridge, New Jersey,
(iii) expenses related to the planned deployment of Merit's new information
systems, and
72
(iv) inclusion of CMG's results of operations since the acquisition date. As a
percentage of revenue, selling, general and administrative expenses decreased
from 14.1% in the prior year period to 12.2% in the current year period
primarily as a result of these expenses being allocated over a larger revenue
base. Contributing significantly to this decrease were the TennCare Partners and
the Delaware County programs, which are large, self-contained programs requiring
minimal selling, general and administrative expenses or Merit operational
support, thereby mitigating, in large part, the effects of their lower than
average direct service cost margins described above.
AMORTIZATION OF INTANGIBLES. Amortization of intangibles increased by $1.0
million, or 4.0%, to $26.9 million for fiscal 1997 from $25.9 million for fiscal
1996. The increase was primarily due to an increase in amortization of goodwill
recognized in connection with the acquisitions of ProPsych and CMG as well as to
increases in the amortization of deferred contract start-up costs related to new
contracts.
OTHER INCOME (EXPENSE). For fiscal 1997, other income and expense consisted
of (i) interest expense of $25.1 million related to debt incurred as a result of
the 1995 Merger (OF MERIT AND AN AFFILIATE OF KOHLBERG KRAVIS ROBERTS & CO.
("KKR")) in October 1995 (THE "1995 MERGER"), (ii) interest and other income of
$3.5 million relating primarily to investment earnings on Merit's short-term
marketable securities and restricted cash and investment balances, (iii) a loss
of $6.9 million recognized in September 1997 on the disposal of Choate (CHOATE
HEALTH MANAGEMENT, INC. AND CERTAIN RELATED COMPANIES (COLLECTIVELY, "CHOATE")),
(iv) $0.7 million of expenses associated with uncompleted acquisition
transactions, and (v) $0.6 million of nonrecurring employee benefit costs
associated with the exercise of stock options by employees of Merit under plans
administered by Merck. The year over year increase in interest expense of $1.2
million was primarily attributable to (i) the full period impact of the
indebtedness incurred in October 6, 1995 by Merit in connection with the 1995
Merger; (ii) the full period impact of (THE MERIT OUTSTANDING) Notes, which bore
interest at a higher rate than the bridge financing facility that the (MERIT
OUTSTANDING) Notes replaced, and (iii) the increase in the senior credit
facility as a result of the acquisition of CMG. The year over year increase in
interest income of $0.7 million was primarily attributable to both an increase
in average invested cash balances as compared to the prior year period and
interest earned on advances to certain joint ventures.
INCOME TAXES. Merit recorded a benefit for income taxes during fiscal 1997,
based upon Merit's pre-tax loss in such period.
FISCAL 1996 COMPARED TO FISCAL 1995
REVENUE. Revenue increased by $96.3 million, or 26.6%, to $457.8 million
for fiscal 1996 from $361.5 million for fiscal 1995. Of this increase, $87.7
million was attributable to the inclusion of revenue for the entire period from
certain contracts that commenced during the prior fiscal year as well as
additional revenue from existing customers generated by an increase in both the
number of programs managed by Merit on behalf of such customers and an increase
in the number of beneficiaries enrolled in such customers' programs; and $26.4
million was attributable to new customers commencing service in the current
year, the majority of which was derived from two contracts totaling $20.9
million. In addition, Merit's acquisitions of Choate and ProPsych contributed an
additional $18.4 million in revenue for fiscal 1996. These revenue increases
were partially offset by a $36.2 million decrease in revenue as a result of the
termination of certain contracts, five of which accounted for $21.1 million of
such decrease. Certain of these contracts had terminated in various periods of
the prior fiscal year. Contract price increases were not a material factor in
the increase in revenue.
DIRECT SERVICE COSTS. Direct service costs increased by $75.7 million, or
26.5%, to $361.7 million for fiscal 1996 from $286.0 million for fiscal 1995. As
a percentage of revenue, direct service costs decreased from 79.1% for fiscal
1995 to 79.0% for fiscal 1996. This net decrease in the direct service cost
percentage was due to a variety of largely offsetting factors. The direct
service cost percentage was
73
positively impacted by lower inpatient utilization in fiscal 1996 as compared to
the prior year related to a significant contract with an HMO focused on the
Medicaid beneficiary population. Such decrease resulted from the implementation
of changes in program management and modification of the clinical treatment
protocols applicable to such contract. In addition, Merit started to realize the
benefits in fiscal 1996 of a nationwide recontracting program with providers
which began in the second quarter of such year. Merit is continuing its efforts
to reduce direct service costs to mitigate the effects of pricing pressure,
which is expected to continue in fiscal 1997, associated with the competitive
bid process for new contracts and negotiations to extend existing contracts. The
direct service cost percentage was adversely impacted by the loss in the fourth
quarter of fiscal 1995 of two contracts with higher than average direct profit
margins and a renewal of a significant contract on lower pricing terms. In
addition, Merit earned a lower than average direct profit margin on a
significant state Medicaid program which was not in effect for the entire twelve
month period in the prior year. Furthermore, in the fourth quarter of fiscal
1996, Merit commenced providing services under the TennCare Partners program.
Due to the unusual structure of the TennCare Partners program, the direct profit
margin under such contract was lower than Merit's average direct profit margin
for fiscal 1996 and is expected to continue to be lower in future periods.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased by $14.7 million, or 29.5%, to $64.5 million
for fiscal 1996 from $49.8 million for fiscal 1995. The increase in total
selling, general and administrative expenses was primarily attributable to (i)
growth in marketing and sales administrative staff, corporate and regional
management and support systems associated with the higher sales volume, (ii)
expenses associated with the expansion of the National Service Center, which
will allow for growth beyond Merit's current needs, and (iii) expenses related
to the planned deployment of Merit's new information systems. As a percentage of
revenue, selling, general and administrative expenses increased to 14.1% for
fiscal 1996 from 13.8% for fiscal 1995. The increase in such expenses, coupled
with unanticipated delays in the planned start dates of significant new
contracts (including the TennCare Partners program) secured by Merit,
contributed to the increase in selling, general and administrative expenses as a
percentage of revenue.
AMORTIZATION OF INTANGIBLES. Amortization of intangibles increased by $4.5
million, or 21.0%, to $25.9 million for fiscal 1996 from $21.4 million for
fiscal 1995. The increase was primarily due to an increase in amortization of
goodwill recognized in connection with the acquisitions of Choate and ProPsych
and the Empire Joint Venture, as well as to increases in the amortization of
deferred contract start-up costs related to new contracts.
RESTRUCTURING CHARGE. Merit recorded a pre-tax restructuring charge of $3.0
million related to a plan, adopted and approved in the fourth quarter of 1996,
to restructure its staff offices by exiting certain geographic markets and
streamlining the field and administrative management organization of Continuum
Behavioral Healthcare Corporation, a subsidiary of Merit. This decision was in
response to the results of underperforming locations affected by the lack of
sufficient patient flow in the geographic areas serviced by these offices and
Merit's ability to purchase healthcare services at lower rates from its provider
network. In addition, it was determined that Merit would be able to expand
beneficiary access to specialists and other providers thereby achieving more
cost-effective treatment and to favorably shift a portion of the economic risk,
in some cases, of providing outpatient healthcare to the provider through the
use of case rates and other alternative reimbursement methods. The restructuring
charge was comprised primarily of accruals for employee severance, real property
lease terminations and write-off of certain assets in geographic markets which
were being exited. The restructuring plan was substantially completed during
fiscal 1997.
OTHER INCOME (EXPENSE). For fiscal 1996, other income and expense consisted
of (i) interest expense of $23.8 million incurred as a result of the increase in
long-term debt resulting from the 1995 Merger; (ii) merger expenses of $4.0
million consisting primarily of professional and advisory fees; and
74
(iii) interest and other income of $2.8 million relating primarily from
investment earnings on Merit's short-term investments and restricted cash
balances.
INCOME TAXES. Merit recorded a benefit for income taxes during fiscal 1996
based upon Merit's pre-tax loss in such period. The resulting income tax benefit
has been partially offset by the nondeductible nature of certain merger costs.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE
Effective October 1, 1995, Merit changed its method of accounting for
deferred start-up costs related to new contracts or expansion of existing
contracts (i) to expense costs relating to start-up activities incurred after
commencement of services under the contract, and (ii) to limit the amortization
period for deferred start-up costs incurred prior to the commencement of
services to the initial contract period. Prior to October 1, 1995, Merit
capitalized start-up costs related to the completion of the provider networks
and reporting systems beyond commencement of contracts and, in limited
instances, amortized the start-up costs over a period that included the initial
renewal term associated with the contract. Under the new policy, Merit does not
defer contract start-up costs after contract commencement or include the initial
renewal term in the amortization period. The change was made to increase the
focus on controlling costs associated with contract start-ups.
Merit recorded a pre-tax charge of $1.8 million ($1.0 million after taxes)
in the first quarter of fiscal 1996 as a cumulative effect of a change in
accounting. The pro forma impact of this change for the year ended September 30,
1995 would be to increase costs and expenses by $1.8 million ($1.0 after taxes).
There was no pro forma effect on periods prior to fiscal 1995. The effect of the
change on fiscal 1996 cannot be reasonably estimated.
LIQUIDITY AND CAPITAL RESOURCES
GENERAL. For fiscal 1997, operating activities provided cash of $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 Merit'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 Merit.
ACQUISITION (OF CMG). On September 12, 1997, Merit acquired all of the
outstanding capital stock of CMG for $48.7 million in cash and 739,358 shares of
Merit's common stock valued at $5.5 million. In addition, Merit agreed to absorb
certain expenses and other obligations of CMG totaling up to $5.4 million. CMG
is a Maryland-based national managed care company serving over 30 customers
through a network consisting of approximately 7,600 providers in 34 states. CMG
currently provides behavioral health managed care services to 2.5 million people
under full risk capitation, ASO and other funding arrangements. The clients
include state and local governments, Blue Cross /Blue Shield organizations, HMOs
and insurance companies. As additional consideration for the acquisition, Merit
may be required to make certain future contingent cash and stock payments over
the next two years to the former shareholders of CMG based upon the performance
of certain CMG customer contracts. Such contingent cash payments are subject to
an aggregate maximum of $23.5 million. The acquisition was accounted for using
the purchase method. Accordingly, the purchase price was allocated to assets
acquired based on their estimated fair values. This treatment resulted in
approximately $64.7 million of cost in excess of net tangible assets acquired as
of September 30, 1997. Such excess is being amortized on a straight line
75
basis over periods ranging up to 40 years. The inclusion of CMG from the date of
acquisition did not have a significant impact on Merit's results of operations.
SENIOR INDEBTEDNESS. As of September 30, 1997, $30.0 million of revolving
loans and $8.3 million of letters of credit were outstanding under the revolving
credit facility of the (MERIT EXISTING) Credit Agreement with The Chase
Manhattan Bank, N.A. (the "(MERIT) Senior Credit Facility"), and approximately
$46.7 million was available for future borrowing.
ADJUSTED EBITDA. Adjusted EBITDA, a financial measure used in the (MERIT)
Senior Credit Facility and the indenture (FOR THE MERIT OUTSTANDING NOTES),
increased by $9.6 million, or 21.3%, to $54.7 million for fiscal 1997 from $45.1
million for 1996.
CASH IN CLAIMS FUNDS AND RESTRICTED CASH. As of September 30, 1997, Merit
had total cash, cash equivalents and investment balances of $95.2 million, of
which $51.3 million was restricted under certain contractual, fiduciary and
regulatory requirements; moreover, of such amount, $3.7 million was classified
as a long-term asset on Merit's balance sheet. Under certain contracts, Merit is
required to establish segregated claims funds into which a portion of its
capitation fee is held until a reconciliation date (which reconciliation
typically occurs annually). Until that time, cash funded under these
arrangements is unavailable to Merit for purposes other than the payment of
claims. In addition, California and Illinois state regulatory requirements
restrict access to cash held by Merit's subsidiaries in such states. As of
September 30, 1997, Merit also held surplus cash balances, classified as cash
and cash equivalents and short-term marketable securities, as required by the
contracts held by Merit relating to Medicaid programs for the States of Iowa and
Montana and the TennCare Partners and Delaware County Medicaid programs
described above.
AVAILABILITY OF CASH. Prior to the 1995 Merger, Merit funded its operations
primarily with cash generated from operations and through the funding of certain
acquisitions, investments and other transactions by its former parent, Merck.
Merit currently and in the future expects to finance its capital requirements
through existing cash balances, cash generated from operations and borrowings
under the revolving credit facility of the (MERIT) Senior Credit Facility. Based
upon the current level of cash flow from operations and anticipated growth,
Merit believes that available cash, together with available borrowings under the
revolving credit facility and other sources of liquidity, will be adequate to
meet Merit's anticipated future requirements for working capital, capital
expenditures and scheduled payments of principal and interest on its
indebtedness for the foreseeable future.
76
INDUSTRY
OVERVIEW
Behavioral healthcare costs have increased significantly in the United
States in recent years. According to industry sources, direct medical costs of
behavioral health problems, combined with the indirect costs, such as lost
productivity due to mental illness and alcohol and drug abuse, were estimated at
more than $300.0 billion in 1990, the latest year for which statistics are
available. In addition, according to industry sources, in 1994 (the most recent
year for which such information was available), direct behavioral healthcare
services treatment costs amounted to approximately $81.0 billion, or
approximately 8% of total healthcare industry spending. These direct costs have
grown, in part, as society has begun to recognize and address behavioral health
concerns and employers have realized that rehabilitation of employees suffering
from substance abuse and relatively mild mental health problems can reduce
losses due to absenteeism and decreased productivity.
In response to these escalating costs, managed behavioral healthcare
companies such as Green Spring, HAI and Merit have been formed. These companies
focus on care management techniques with the goal of arranging for the provision
of an appropriate level of care in a cost-efficient and effective manner by
improving early access to care and assuring an effective match between the
patient and the behavioral healthcare provider's specialty. As the growth of
managed behavioral healthcare has increased, there has been a significant
decrease in occupancy rates and average lengths of stay for inpatient
psychiatric facilities and an increase in outpatient treatment and alternative
care services.
According to OPEN MINDS, as of January 1997, approximately 149.0 million
beneficiaries were covered by some form of specialty managed behavioral
healthcare plan and an additional 19.5 million beneficiaries were enrolled in
internally-managed behavioral healthcare programs within HMOs. The number of
covered beneficiaries has grown from approximately 86.0 million beneficiaries in
1993 to approximately 149.0 million in 1997, representing an approximate 15%
compound annual growth rate since 1993. In addition, according to OPEN MINDS,
beneficiaries covered under risk-based programs are growing even more rapidly,
from approximately 13.6 million as of January 1993 to approximately 38.9 million
as of January 1997, representing a compound annual growth rate of over 30%. OPEN
MINDS estimates that the revenues of managed behavioral healthcare companies
totaled approximately $3.5 billion in 1996.
SEGMENTATION
OPEN MINDS divides the managed behavioral healthcare industry as of January
1997 into the following categories of care, based on services provided, extent
of care management and level of risk assumption:
BENEFICIARIES PERCENT
CATEGORY OF CARE (IN MILLIONS) OF TOTAL
- ----------------------------------------------------------------------------------------- --------------- -----------
Utilization Review/Care Management Programs.............................................. 39.2 26.3%
Risk-Based Network Products.............................................................. 38.9 26.1
Non-Risk-Based Network Products.......................................................... 31.9 21.4
EAPs..................................................................................... 28.3 19.0
Integrated Programs...................................................................... 10.7 7.2
----- -----
Total............................................................................ 149.0 100.0%
----- -----
----- -----
Management believes the current trends in the behavioral healthcare industry
include increased utilization of risk-based network managed care products and
the integration of EAPs with such managed care products. Management believes
that these trends have developed in response to the attempt by payors to reduce
rapidly escalating behavioral healthcare costs and to limit their risk
associated with
77
such costs while continuing to provide access to high quality care. According to
OPEN MINDS, risk-based network products, integrated programs and EAPs are the
most rapidly growing segments of the managed behavioral healthcare industry.
UTILIZATION REVIEW/CARE MANAGEMENT PRODUCTS. Under utilization review/care
management products, a managed behavioral healthcare company manages and often
arranges for treatment, but does not maintain a network of providers or assume
any of the responsibility for the cost of providing treatment services. The
Company categorizes its products within this segment of the managed behavioral
healthcare industry (as it is defined by OPEN MINDS) as ASO products. The
Company does not expect this segment of the industry to experience significant
growth, given the growth of risk-based products.
NON-RISK-BASED NETWORK PRODUCTS. Under non-risk-based network products, the
managed behavioral healthcare company provides a full array of managed care
services, including selecting, credentialing and managing a network of providers
(such as psychiatrists, psychologists, social workers and hospitals), and
performs utilization review, claims administration and care management
functions. The third-party payor remains responsible for the cost of providing
the treatment services rendered. The Company categorizes its products within
this segment of the managed behavioral healthcare industry (as it is defined by
OPEN MINDS) as ASO products.
RISK-BASED NETWORK PRODUCTS. Under risk-based network products, the managed
behavioral healthcare company assumes all or a portion of the responsibility for
the cost of providing a full or specified range of behavioral healthcare
treatment services. Most of these programs have payment arrangements in which
the managed care company agrees to provide services in exchange for a fixed fee
per member per month that varies depending on the profile of the beneficiary
population or otherwise shares the responsibility for providing all or some
portion of the treatment services at a specific cost per person. Under these
products, the managed behavioral healthcare company not only approves and
monitors a course of treatment, but also arranges and pays for the provision of
patient care (either through its third-party network providers or staff
providers or some combination of network and staff providers). Therefore, the
managed behavioral healthcare company must be proficient in contracting with,
credentialing and managing a network of specialized providers and facilities
that covers the complete continuum of care. The managed behavioral healthcare
company must also ensure that the appropriate level of care is delivered in the
appropriate setting. Given the ability of payors of behavioral healthcare
benefits to reduce their risk with respect to the cost of treatment services
through risk-based network products while continuing to provide access to high
quality care, this market segment has grown rapidly in recent years. In addition
to the expected growth in total beneficiaries covered under managed behavioral
healthcare products, this shift of beneficiaries into risk-based network
products should further contribute to revenue growth for the managed behavioral
healthcare industry because such contracts generate significantly higher revenue
than ASO contracts. The higher revenue is intended to compensate the managed
behavioral healthcare company for bearing the financial responsibility for the
cost of delivering care. The Company's risk-based products are risk-based
network products as defined by OPEN MINDS.
EMPLOYEE ASSISTANCE PROGRAMS. An EAP is a worksite-based program designed
to assist in the early identification and resolution of productivity problems
associated with behavioral conditions or other personal concerns of employees.
Under an EAP, staff or network providers or other affiliated clinicians provide
assessment and referral services to employee beneficiaries. These services
consist of evaluating a patient's needs and, if indicated, providing limited
counseling and/or identifying an appropriate provider, treatment facility or
other resource for more intensive treatment services. The EAP industry developed
largely out of employers' efforts to combat alcoholism and substance abuse
problems afflicting workers. A 1990 industry survey estimated the total costs of
this dependency at approximately $98.6 billion per year. Many businesses have
implemented alcoholism and drug abuse
78
treatment programs in the workplace, and in some cases have expanded those
services to cover a wider spectrum of personal problems experienced by workers
and their families. As a result, EAP products now typically include consultation
services, evaluation and referral services, employee education and outreach
services. The Company believes that federal and state "drug-free workplace"
measures and Federal Occupational Health and Safety Act requirements, taken
together with the growing public perception of increased violence in the
workplace, have prompted many companies to implement EAPs. Although EAPs
originated as a support tool to assist managers in dealing with troubled
employees, payors increasingly regard EAPs as an important component in the
continuum of behavioral healthcare services.
INTEGRATED EAP/MANAGED BEHAVIORAL HEALTHCARE PRODUCTS. EAPs are utilized in
a preventive role and in facilitating early intervention and brief treatment of
behavioral healthcare problems before more extensive treatment is required.
Consequently, EAPs often are marketed and sold in tandem with managed behavioral
healthcare programs through "integrated" product offerings. Integrated products
offer employers comprehensive management and treatment of all aspects of
behavioral healthcare. In an effort to both reduce costs and increase
accessibility and ease of treatment, employers are increasingly attempting to
consolidate EAP and managed behavioral healthcare services into a single
product. Although integrated EAP/managed behavioral healthcare products are
currently only a small component of the overall industry, the Company expects
this market segment to grow.
AREAS OF GROWTH
Management believes that the growth of the managed behavioral healthcare
industry will continue, as payors of behavioral healthcare benefits attempt to
reduce the costs of behavioral healthcare while maintaining high quality care.
Management also believes that a number of opportunities exist in the managed
behavioral healthcare industry for continued growth, primarily for risk-based
products. The following paragraphs discuss factors contributing to the growth of
risk-based products and the increase in the number of covered lives in certain
markets.
RISK-BASED PRODUCTS. According to OPEN MINDS, industry enrollment in
risk-based products has grown from approximately 13.6 million covered lives in
1993 to approximately 38.9 million covered lives in 1997, a compound annual
growth rate of over 30%. Despite this growth, only approximately 26% of total
managed behavioral healthcare covered lives were enrolled in risk-based products
in 1997. The Company believes that the market for risk-based products has grown
and will continue to grow as payors attempt to reduce their responsibility for
the cost of providing behavioral healthcare while ensuring an appropriate level
of access to care. Risk-based products can generate significantly greater
revenue per covered life than other non-risk product types. According to the
OPEN MINDS survey, risk-based products account for approximately two-thirds of
total managed behavioral healthcare industry premiums, but, as stated above,
accounted for only approximately 26% of total covered lives in 1997.
MEDICAID. Medicaid is a joint state and federal program to provide
healthcare benefits to approximately 33.0 million low income individuals,
including welfare recipients. According to the Health Care Financing
Administration of the United States Department of Health and Human Services
("HCFA"), federal and state Medicaid spending increased from $69.0 billion in
1990 to an estimated $160.0 billion in 1996, at an average annual rate almost
twice as fast as the annual increase in overall healthcare spending.
Furthermore, according to HCFA, from 1991 to 1996 the number of Medicaid
beneficiaries covered under full managed contracts grew at a compound annual
rate of approximately 40% per year. The Company expects that the Budget Act will
slow the growth of Medicaid spending by accelerating the trend of state Medicaid
programs toward shifting beneficiaries into managed care programs in order to
control rising costs.
Despite the recent increase in managed care enrollment of Medicaid
beneficiaries, Medicaid managed care enrollment as a percentage of all Medicaid
beneficiaries remains small. As of June 1996,
79
according to the National Institute for Health Care Management, only
approximately 35% of all Medicaid beneficiaries were enrolled in some form of
managed care program, and less than 7% were enrolled in risk-based programs. The
Company expects the number of Medicaid recipients enrolled in managed behavioral
healthcare programs to increase through two avenues: (i) subcontracts with HMOs
and (ii) direct contracts with state agencies. As HMOs increase their
penetration of the Medicaid market, the Company expects that many HMOs will
continue to (or begin to) subcontract with managed behavioral healthcare
companies to provide services for Medicaid beneficiaries. State agencies have
also begun to contract directly with managed behavioral healthcare companies to
provide behavioral healthcare services to their Medicaid beneficiaries. Iowa,
Massachusetts, Nebraska, Maryland, Tennessee and Montana have decided to "carve
out" behavioral healthcare from their overall Medicaid managed care programs and
have contracted or are expected to contract directly with managed behavioral
healthcare companies to provide such services. The Company expects that the
Budget Act will accelerate the trend of states contracting directly with managed
behavioral healthcare companies. See "Risk Factors-- Dependence on Government
Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and
"Business--Regulation--Budget Act."
MEDICARE. Medicare is a federally funded healthcare program for the
elderly. Medicare has experienced an increase in its beneficiary population over
the past several years, as well as rapidly escalating healthcare costs.
According to HCFA, as of January 1, 1997, only approximately 4.9 million, or
13%, of the approximately 38.0 million eligible Medicare beneficiaries were
enrolled in managed care programs. Although enrollment has increased from
approximately 7% of the eligible Medicare beneficiaries in 1993, it is still
considerably below that of the commercial population. The Budget Act contains
provisions designed to increase enrollment of Medicare beneficiaries in managed
care plans as a means of achieving projected savings in Medicare expenditures.
Management believes that in response to increased healthcare costs and the
Budget Act, the Medicare market will shift into managed care programs in the
future, representing an opportunity for growth among managed behavioral
healthcare companies. See "Business--Regulation--Budget Act."
80
BUSINESS
OVERVIEW
The Company is the nation's largest provider of managed behavioral
healthcare services, offering a broad array of cost-effective managed behavioral
healthcare products. As a result of the Acquisition, the Company has over 58.0
million covered lives under managed behavioral healthcare contracts and manages
behavioral healthcare programs for over 4,000 customers. Through its current
network of over 34,000 providers and 2,000 treatment facilities, the Company
manages behavioral healthcare programs for Blue Cross/Blue Shield organizations,
HMOs and other insurance companies, corporations, federal, state and local
governmental agencies, labor unions and various state Medicaid programs. The
Company believes it has the largest and most comprehensive behavioral healthcare
provider network in the United States as a result of the Acquisition. In
addition to the Company's managed behavioral healthcare products, the Company
offers specialty managed care products related to the management of certain
chronic conditions. The Company also offers a broad continuum of behavioral
healthcare services to approximately 2,900 individuals who receive healthcare
benefits funded by state and local governmental agencies through Mentor, its
wholly-owned public-sector provider. Furthermore, the Company franchises the
"CHARTER" System of behavioral healthcare to the Psychiatric Hospital Facilities
and other facilities operated by CBHS, an entity in which the Company owns a 50%
equity interest. If the CBHS Transactions are consummated, the Company will no
longer have franchise operations or an ownership interest in CBHS.
The Company's professional care managers coordinate and manage the delivery
of behavioral healthcare treatment services through the Company's network of
providers, which includes psychiatrists, psychologists, licensed clinical social
workers, marriage and family therapists and licensed clinical professional
counselors. The treatment services provided by the Company's extensive
behavioral provider network include outpatient programs (such as counseling and
therapy), intermediate care programs (such as sub-acute emergency care,
intensive outpatient programs and partial hospitalization services), inpatient
treatment services and alternative care services (such as residential treatment,
home and community-based programs and rehabilitative and support services). The
Company provides these services through: (i) risk-based products, (ii) EAPs,
(iii) ASO products and (iv) products that combine features of some or all of
these products. Under risk-based products, the Company arranges for the
provision of a full range of behavioral healthcare services for beneficiaries of
its customers' healthcare benefit plans through fee arrangements under which the
Company assumes all or a portion of the responsibility for the cost of providing
such services in exchange for a fixed per member per month fee. Under EAPs, the
Company provides assessment services to employees and dependents of its
customers, and if required, referral services to the appropriate behavioral
healthcare service provider. Under ASO products, the Company provides services
such as utilization review, claims administration and provider network
management. The Company does not assume the responsibility for the cost of
providing healthcare services pursuant to its ASO products. As a result of the
Acquisition, based on total covered lives, the Company is the industry leader
with respect to risk-based, ASO, EAP and integrated products. For its fiscal
year ended September 30, 1997, on a pro forma basis, risk-based, ASO, EAP and
integrated products would have accounted for 73%, 12%, 9% and 5%, respectively,
of the Company's managed behavioral healthcare net revenues.
The Company conducts operations in four segments: managed care operations,
public sector operations, franchise operations and provider operations. The
following describes the Company's business segments:
MANAGED CARE OPERATIONS. The managed care segment is the Company's primary
operating segment. The Company's managed care subsidiaries are Green Spring,
HAI, Allied and Merit. On a pro forma basis for fiscal 1997, revenue of the
Company's managed care operations would have been $1.25 billion.
81
Green Spring is one of the largest companies in the managed behavioral
healthcare industry and is the largest managed behavioral healthcare provider to
the Blue Cross/Blue Shield networks. It currently covers over 21.0 million lives
(30% of them pursuant to risk-based products) through a network of more than
34,000 providers. Green Spring's client base includes 25 Blue Cross/Blue Shield
plans, major HMOs and PPOs, state employee programs, Fortune 1000 corporations,
labor unions and a growing number of state Medicaid programs.
Merit is one of the leading managed behavioral healthcare providers in the
nation, arranging for the provision of managed behavioral healthcare services to
more than 21.0 million people, including approximately 10.6 million risk-based
lives. Merit manages behavioral healthcare programs for approximately 800
clients across all segments of the healthcare industry, with particularly strong
positions in the corporate and HMO segment. Merit is also a leading provider to
Blue Cross/Blue Shield organizations and other insurance companies, corporations
and labor unions, federal, state and local governmental agencies and various
state Medicaid programs.
HAI was one of the first and is one of the largest providers of EAP
products. It currently provides managed behavioral healthcare services to over
16.0 million lives. HAI has providers in all 50 states, operating through nine
regional service centers. It serves many of the nation's largest companies,
including Aetna, Avis, Exxon, JP Morgan, MCI, Northwest Airlines and Sears.
The Company recently acquired Allied to establish its presence in the
management of specialty healthcare services. Allied provides specialty
risk-based products and administrative services to a variety of insurance
companies and other customers, including Blue Cross of New Jersey, CIGNA and
NYLCare, for its 3.4 million members. Allied has over 80 physician networks
across the eastern United States. Allied's networks include physicians
specializing in cardiology, oncology and diabetes.
The Company's managed care operations also include certain physician
practice management businesses and certain behavioral staff model operations.
The Company's managed care operations are operated through two wholly owned
subsidiaries of the Company: Magellan Behavioral Healthcare Organization, Inc.
("Magellan BHO") and Magellan Specialty Medical Care Holdings, Inc. ("Magellan
Specialty Medical"). Magellan BHO is organized around three customer segments to
manage the products offered by Green Spring, Merit, HAI and Magellan Public
Solutions, as follows: (i) the HMO/Insurance Division, focusing on the needs of
health insurance plans and their members; (ii) the Corporate Employer/Union
Division, focusing on self-insured employers and unions and their employees and
dependents; and (iii) the Public Sector Division, focusing on the needs of
public purchasers of behavioral healthcare services and their constituents.
Magellan Specialty Medical focuses on the needs of health plans to manage their
specialty care networks and disease management programs in areas such as
diabetes, asthma, oncology and cardiology. Magellan Specialty Medical manages
the products offered by Allied and Care Management Resources, Inc.
PUBLIC SECTOR OPERATIONS. The Company's public sector business provides
specialty home-based behavioral healthcare services through Mentor to over 2,900
individuals in 84 programs in 20 states from 58 branches as of December 31,
1997. Mentor was founded in 1983 and was acquired by the Company in January
1995. Mentor's services include specialty home-based behavioral healthcare
services, which feature individualized home and community-based health and human
services delivered in highly structured and professionally monitored family
environments or "mentor" homes. The mentor homes serve clients with chronic
behavioral disorders and disabilities requiring long-term care, including
children and adolescents with behavioral problems, individuals with mental
retardation or developmental disabilities, and individuals with neurological
impairment or other medical and behavioral frailties. Public sector operations
include correctional behavioral healthcare services, which feature the
management and provisions of behavioral healthcare to the prison population of
government-run correctional facilities in Ohio and New Jersey. For fiscal 1997,
public sector revenue was $94.4 million.
82
FRANCHISE OPERATIONS. The Company's wholly-owned subsidiary Charter
Advantage, LLC ("Charter Advantage") franchises the "CHARTER" System of
behavioral healthcare to the Psychiatric Hospital Facilities and other
facilities operated by CBHS. See "Charter Advantage." For fiscal 1997, Charter
Advantage had revenues of $22.7 million. The Company has entered a definitive
agreement to sell Charter Advantage to CBHS. See "Pending Sale of Provider
Business."
PROVIDER OPERATIONS. The Company's provider operations include the
ownership and operation of two psychiatric hospitals in London, England (a
45-bed hospital and a 78-bed hospital) and a 69-bed psychiatric hospital in
Nyon, Switzerland. Revenue for the Company's foreign psychiatric hospitals was
$29.2 million in fiscal 1997. The Company's provider operations also include its
interest in the Joint Ventures and the 50% ownership of CBHS. The Company's
Joint Venture partner in four of the Joint Ventures is Columbia/HCA Healthcare
Corporation. Although the Company is the managing member of each Joint Venture,
it has delegated its management responsibilities to CBHS. The Company pays CBHS
a fee for managing the Joint Ventures equal to the Company's share of the
earnings of the Joint Ventures. The Company's provider operations also include a
Puerto Rican provider management business. The Company has entered into
definitive agreements to sell its ownership interest in CBHS to COI and its
Puerto Rican provider management business to CBHS. The Company has also entered
into a definitive agreement to either sell its interest in the Joint Ventures or
transfer its rights and obligations with respect to the Joint Ventures to CBHS.
See "Pending Sale of Provider Business."
COMPETITIVE STRENGTHS
The Company believes it benefits from the competitive strengths described
below with respect to its managed behavioral healthcare business, which should
allow it to increase its revenues and cash flow. Furthermore, the Company
believes it can leverage its competitive strengths to expand its service
offerings into other specialty managed care products.
INDUSTRY LEADERSHIP. As a result of the Acquisition, the Company became the
nation's largest provider of managed behavioral healthcare services in the
United States with over 58.0 million covered lives. The Company believes it also
now has the number one market position in each of the major product markets in
which it competes. The Company believes its industry leading position will
enhance its ability to: (i) provide a consistent level of high quality service
on a nationwide basis; (ii) enter into favorable agreements with behavioral
healthcare providers that allow it to effectively control healthcare costs for
its customers; and (iii) effectively market its managed-care products to large
corporate, HMO and insurance customers, which, the Company believes,
increasingly prefer to be serviced by a single-source provider on a national
basis.
BROAD PRODUCT OFFERING AND NATIONWIDE PROVIDER NETWORK. The Company offers
a full spectrum of behavioral managed care products that can be designed to meet
specific customer needs, including risk-based and partial risk-based products,
integrated EAPs, stand-alone EAPs and ASO products. The Company's nationwide
provider network encompasses over 34,000 providers and 2,000 treatment
facilities in all 50 states. The combination of broad product offerings and a
nationwide provider network allows the Company to meet virtually any customer
need for managed behavioral healthcare on a nationwide basis, and positions the
Company to capture incremental revenue opportunities resulting from the
continued growth of the managed behavioral healthcare industry and the continued
migration of its customers from ASO and EAP products to higher revenue
risk-based products.
BROAD BASE OF STRONG CUSTOMER RELATIONSHIPS. The Company enjoys strong
customer relationships across all its markets, as evidenced by a contract
renewal rate of over 90% during the last three fiscal years. Management believes
that its strong customer relationships are attributable to the Company's broad
product offering, nationwide provider network, commitment to quality care and
ability to manage behavioral healthcare costs effectively. Following the
Acquisition, the Company's leading customers include: (i) Blue Cross/Blue Shield
organizations; (ii) national HMOs and other large insurers, such as Aetna/US
Healthcare, Humana and Prudential; (iii) large corporations, such as IBM,
Federal Express and AT&T; (iv) state and local governmental agencies through
commercial, Medicaid and other
83
programs; and (v) the federal government through contracts pursuant to CHAMPUS
and with the U.S. Postal Service. This broad base of strong customer
relationships provides the Company with stable and diverse sources of revenue
and cash flow and an established base from which to continue to increase covered
lives and revenue.
PROVEN RISK MANAGEMENT EXPERIENCE. As a result of the Acquisition, the
Company has approximately 18.0 million covered lives under risk-based contracts,
making it the nation's industry leader in at-risk managed behavioral healthcare
products. The Company's experience with risk-based products covering a large
number of lives has given it a broad base of data from which to analyze
utilization rates. The Company believes that this broad database permits it to
estimate utilization trends and costs more accurately than many of its
competitors, which allows it to bid effectively. The Company's experience has
also allowed it to develop effective measures for controlling the cost of
providing a unit of care to its covered lives. Among other cost control
measures, the Company has developed or acquired clinical protocols, which permit
the Company to assist its network providers to administer effective treatment in
a cost efficient manner, and claims management technology, which permits the
Company to reduce the cost of processing claims. As the Company integrates the
managed care operations it acquired in the Acquisition with its pre-existing
managed care operations, it will be able to select from the best practices of
its subsidiaries to further enhance its utilization and cost control
methodologies.
BUSINESS STRATEGY
INCREASE ENROLLMENT IN BEHAVIORAL MANAGED CARE PRODUCTS. The Company
believes it has a significant opportunity to increase covered lives in all its
behavioral managed care products. The Company believes its increased market
presence following the Acquisition will further enhance its ability to increase
ASO and EAP covered lives with large corporate, HMO and insurance customers. The
Company further believes that it has a significant opportunity to increase
revenues and cash flow by increasing lives covered by its risk-based products.
As a result of the Acquisition, the Company became the industry's leading
provider of risk-based products and is well positioned to benefit from the
continuing shift to risk-based products. According to OPEN MINDS, industry
enrollment in risk-based products has grown from approximately 13.6 million in
1993 to approximately 38.9 million in 1997, representing a compound annual
growth rate of over 30%. Despite this growth, only approximately 26% of total
managed behavioral healthcare enrollees were in risk-based products in 1997. The
Company believes that the market for risk-based products has grown and will
continue to grow as payors attempt to reduce their cost of providing behavioral
healthcare while ensuring a high quality of care and an appropriate level of
access to care. The Company believes enrollment in its risk-based products will
increase through growth in new covered lives and through the transition of
covered lives in ASO and EAP products to higher revenue risk-based products. On
a pro forma basis for fiscal 1997, risk-based products accounted for 32% of the
Company's covered lives but accounted for 73% of its total managed behavioral
healthcare revenues.
ACHIEVE SIGNIFICANT INTEGRATION EFFICIENCIES. The Company believes that the
Acquisition has created opportunities for the Company to achieve significant
cost savings. Management believes that cost saving opportunities will result
from leveraging fixed overhead over a larger revenue base and an increased
number of covered lives and from reducing duplicative corporate and regional
selling, general and administrative expenses. As a result, the Company expects
to achieve approximately $60.0 million of costs savings on an annual basis
within eighteen months following the consummation of the Acquisition.
PURSUE ADDITIONAL SPECIALTY MANAGED CARE OPPORTUNITIES. The Company
believes that significant demand exists for specialty managed care products
related to the management of certain chronic conditions. The Company believes
its large number of covered lives, information systems infrastructure and
demonstrated expertise in managing behavioral healthcare programs position the
Company to provide customers with specialty managed care products. As a first
major step in implementing this strategy, the Company acquired Allied, a
provider of specialty managed care products for cardiology,
84
oncology and diabetes patients, on December 5, 1997. For the twelve months ended
September 30, 1997, Allied had revenue of $144.0 million. See "Summary--Recent
Developments."
MANAGED BEHAVIORAL HEALTHCARE PRODUCTS AND SERVICES
GENERAL. The following table sets forth on a pro forma basis the
approximate number of covered lives as of December 31, 1997 and revenue for
fiscal 1997 for each type of managed behavioral healthcare program offered by
the Company:
PROGRAMS COVERED LIVES PERCENT REVENUE PERCENT
- ----------------------------------------------------------------- ----------------- ----------- ---------- -----------
(IN MILLIONS, EXCEPT PERCENTAGES)
Risk-Based Products.............................................. 18.0 30.7% $ 808.1 72.8%
EAPs............................................................. 10.5 18.0 99.7 9.0
Integrated Products.............................................. 3.1 5.3 54.2 4.9
ASO Products..................................................... 23.4 40.1 134.6 12.1
Other............................................................ 3.3 5.9 14.2 1.2
--- ----- ---------- -----
Total........................................................ 58.3 100.0% $ 1,110.8 100.0%
--- ----- ---------- -----
--- ----- ---------- -----
The number of the Company's covered lives fluctuates based on the number of the
Company's customer contracts and as employee, HMO and insurance company
subscriber and government program enrollee populations change from time to time.
On a pro forma basis, the number of lives covered by the Company's managed
behavorial healthcare products at September 30, 1995, 1996 and 1997 would have
been 43.7 million, 46.5 million, and 52.8 million, respectively. On November 8,
1997, the Company announced that Green Spring had been selected by Blue
Cross/Blue Shield of Michigan to manage behavioral healthcare services for over
2.3 million covered lives. This contract, which became effective as of December
1, 1997, primarily relates to utilization review services.
If the CBHS Transactions are consummated, the Company's total number of
covered lives would decrease by approximately 1.1 million due to the sale of GPA
and the Company's pro forma managed care revenue for fiscal 1997 would decrease
by $16.5 million. See "Pending Sale of Provider Business."
RISK-BASED PRODUCTS. Under the Company's risk-based products, the Company
typically arranges for the provision of a full range of outpatient, intermediate
and inpatient treatment services to beneficiaries of its customers' healthcare
benefit plans, primarily through arrangements in which the Company assumes all
or a portion of the responsibility for the cost of providing such services in
exchange for a per member per month fee. The Company's experience with
risk-based contracts (including the experience of Green Spring, HAI and Merit)
covering a large number of lives has given it a broad base of data from which to
analyze utilization rates. The Company believes that this broad database permits
it to estimate utilization trends and costs more accurately than many of its
competitors, which allows it to bid effectively. The Company's experience has
also allowed it to develop effective measures for controlling the cost of
providing a unit of care to its covered lives. Among other cost control
measures, the Company has developed or acquired clinical protocols, which permit
the Company to assist its network providers to administer effective treatment in
a cost efficient manner, and claims management technology, which permits the
Company to reduce the cost of processing claims. The Company's care managers are
an essential element in its provision of cost-effective care. Except in
emergencies, treatment is required to be authorized by a Company care manager.
Care managers, in consultation with treating professionals, and using the
Company's clinical protocols, authorize an appropriate level and intensity of
services that can be delivered in a cost-efficient manner. See
"Industry--Segmentation--Risk-Based Network Products."
EMPLOYEE ASSISTANCE PROGRAMS. The Company's EAP products typically provide
assessment and referral services to employees and dependents of the Company's
customers in an effort to assist in the early identification and resolution of
productivity problems associated with the employees who are impaired by
behavioral conditions or other personal concerns. For many EAP customers, the
Company also provides limited outpatient therapy (typically limited to eight or
fewer sessions) to patients requiring
85
such services. For these services, the Company typically is paid a fixed fee per
member per month; however, the Company is usually not responsible for the cost
of providing care beyond these services. If further services are necessary
beyond limited outpatient therapy, the Company will refer the beneficiary to an
appropriate provider or treatment facility.
INTEGRATED PRODUCTS. Under its integrated products, the Company typically
establishes an EAP to function as the "front end" of a managed care program that
provides a full range of services, including more intensive treatment services
not covered by the EAP. The Company typically manages the EAP and accepts all or
some of the responsibility for the cost of any additional treatment required
upon referral out of the EAP, thus integrating the two products and using both
the Company's care management and clinical care techniques to manage the
provision of care. See "Industry--Segmentation--Integrated EAP/Managed
Behavioral Healthcare Products."
ASO PRODUCTS. Under its ASO products, the Company provides services ranging
from utilization review and claims administration to the arrangement for and
management of a full range of patient treatment services, but does not assume
any of the responsibility for the cost of providing treatment services. Services
include member assistance, management reporting and claims processing in
addition to utilization review and care management. See
"Industry--Segmentation--Utilization Review/Care Management Products" and
"--Non-Risk-Based Network Products."
MANAGED BEHAVIORAL HEALTHCARE CUSTOMERS
GENERAL. The following table sets forth on a pro forma basis the
approximate number of covered lives as of December 31, 1997 and revenue for
fiscal 1997 in each of the Company's market segments described below:
MARKET COVERED LIVES PERCENT REVENUE PERCENT
- ----------------------------------------------------------------- ----------------- ----------- ---------- -----------
(IN MILLIONS, EXCEPT PERCENTAGES)
Corporations and Labor Unions.................................... 20.7 35.6% $ 197.7 17.8%
HMOs............................................................. 7.6 13.1 226.4 20.3
Blue Cross/Blue Shield and Insurance Companies................... 19.4 33.2 323.0 29.2
Medicaid Programs................................................ 2.5 4.3 265.4 23.9
Governmental Agencies (including CHAMPUS)........................ 4.7 8.0 84.7 7.6
Other............................................................ 3.4 5.8 13.6 1.2
--- ----- ---------- -----
Total........................................................ 58.3 100.0% $ 1,110.8 100.0%
--- ----- ---------- -----
--- ----- ---------- -----
If the CBHS Transactions are consummated, the Company's total number of
covered lives would decrease by approximately 1.1 million due to the sale of GPA
and the Company's pro forma managed care revenue for fiscal 1997 would decrease
by $16.5 million. See "Pending Sale of Provider Business."
CORPORATIONS AND LABOR UNIONS. Corporations and, to a lesser extent, labor
unions, account for a large number of the Company's contracts to provide managed
behavioral healthcare services and, in particular, EAP and integrated
EAP/managed care services. The Company has structured a variety of fee
arrangements with corporate customers to cover all or a portion of the
responsibility of the cost of providing treatment services. In addition, the
Company operates a number of programs for corporate customers on an ASO basis.
Management believes the corporate market is an area of potential growth for the
Company, as corporations are anticipated to increase their utilization of
managed behavioral healthcare services. In an effort to increase penetration of
the corporate market, the Company intends to build upon Merit's experience in
managing programs for large corporate customers (such as IBM, Federal Express
and AT&T) and to market integrated programs to Merit's existing EAP customers
and other prospective corporate clients.
HMOS. The Company is a leader in the HMO market, providing managed
behavioral healthcare services to HMO beneficiaries. HMO contracts are full,
limited or shared risk contracts in which the Company accepts a fixed fee per
member per month from the HMO in exchange for providing a full or
86
specified range of behavioral healthcare services for a specific portion of the
HMO's beneficiaries. Although certain large HMOs provide their own managed
behavioral healthcare services, many HMOs "carve out" behavioral healthcare from
their general healthcare services and subcontract such services to managed
behavioral healthcare companies such as the Company. The Company anticipates
that its business with HMOs will continue to grow.
BLUE CROSS/BLUE SHIELD ORGANIZATIONS AND INSURANCE COMPANIES. The Company
is the nation's leading provider of managed behavioral healthcare services to
Blue Cross/Blue Shield organizations. Green Spring derived approximately $194.0
million, or 53%, of its revenue in fiscal 1997 from contracts with Blue
Cross/Blue Shield organizations. The Company recently expanded its Blue
Cross/Blue Shield relationships by entering into a contract with Blue Cross/Blue
Shield of Michigan relating to 2.3 million covered lives.
HAI has contracts with its former owner, Aetna, pursuant to which HAI
provides managed behavioral healthcare products to Aetna, including focused
psychiatric review (a type of utilization review product), risk-based HMO
products, administrative services for Aetna's "Managed Choice" product and
provider network management services. For the twelve months ended September 30,
1997, HAI would have derived approximately $58.9 million of revenue, or
approximately 58% of its total revenue, from its contracts with Aetna, on a pro
forma basis. Approximately 71% of HAI's covered lives are attributable to its
contracts with Aetna.
MEDICAID PROGRAMS. The Company provides managed behavioral healthcare
services to Medicaid recipients through both direct contracts with state and
local governmental agencies and through subcontracts with HMOs focused on
Medicaid beneficiary populations. In addition to the Medicaid population, other
public entitlement programs, such as Medicare and state insurance programs for
the uninsured, offer the Company areas of potential future growth. The Company
expects that governmental agencies will continue to implement a significant
number of managed care Medicaid programs through contracts with HMOs and that
many HMOs will subcontract with managed behavioral healthcare organizations,
such as the Company, for behavioral healthcare services. The Company also
expects that other states will continue the trend of "carving-out" behavioral
healthcare services from their general healthcare benefit plans and contracting
directly with managed behavioral healthcare companies such as the Company. See
"Industry--Areas of Growth," "Risk Factors--Dependence on Government Spending
for Managed Healthcare; Possible Impact of Healthcare Reform" and
"--Regulation--Other Proposed Legislation."
GOVERNMENTAL AGENCIES. The Company provides EAPs and other managed care
products for employees and their dependents who are beneficiaries of federal,
state and local governmental agencies' healthcare benefit plans. Governmental
agencies' healthcare benefit plans have historically contracted for managed
behavioral healthcare services as part of their general healthcare contracts
with HMOs or indemnity insurers. In turn, HMOs or indemnity insurers have either
provided managed behavioral healthcare services directly or subcontracted such
services to managed behavioral healthcare companies such as the Company. The
Company currently provides services to a number of government employees either
directly pursuant to a contract with the government agency or as a subcontractor
to HMOs. More recently, governmental agencies have begun to contract directly
with managed behavioral healthcare companies to provide these services. In
addition, the Company currently manages contracts for CHAMPUS beneficiaries and
is actively pursuing new contracts and subcontracts under the CHAMPUS program.
In this market, the Company often bids for such contracts together with HMOs to
provide the behavioral healthcare services portion of the overall CHAMPUS
healthcare contract.
MANAGED BEHAVIORAL HEALTHCARE CONTRACTS
Green Spring's contracts with customers typically have terms of one to three
years, and in certain cases contain renewal provisions (at the customer's
option) for successive terms of between one and
87
two years (unless terminated earlier). Substantially all of these contracts are
immediately terminable with cause and many are terminable without cause by the
customer or Green Spring either upon the giving of requisite notice and the
passage of a specified period of time (typically between 60 and 180 days) or
upon the occurrence of other specified events. In addition, Green Spring's
contracts with federal, state and local governmental agencies, under both direct
contract and subcontract arrangements with HMOs, generally are conditioned on
legislative appropriations. These contracts, notwithstanding terms to the
contrary, generally can be terminated or modified by the customer if such
appropriations are not made. See "Risk Factors--Risk Based Programs" and
"--Reliance on Customer Contracts." Merit's and HAI's customer contracts have
substantially similar terms to those described above.
MANAGED BEHAVIORAL HEALTHCARE NETWORK
The Company's managed behavioral healthcare and EAP treatment services are
provided by a network of third-party providers. The number and type of providers
in a particular area depend upon customer preference, site, geographic
concentration and demographic make-up of the beneficiary population in that
area. Network providers include a variety of specialized behavioral healthcare
personnel, such as psychiatrists, psychologists, licensed clinical social
workers, substance abuse counselors and other professionals.
As of December 31, 1997, the Company had contractual arrangements covering
over 34,000 individual third-party network providers. The Company's network
providers are independent contractors located throughout the local areas in
which the Company's customer's beneficiary population resides. Network providers
work out of their own offices, although the Company's personnel are available to
assist them with consultation and other needs. Network providers include both
individual practitioners, as well as individuals who are members of group
practices or other licensed centers or programs. Network providers typically
execute standard contracts with the Company for which they are typically paid by
the Company on a fee-for-service basis. In some cases, network providers are
paid on a "case rate" basis, whereby the provider is paid a set rate for an
entire course of treatment, or through other risk sharing arrangements. A
network provider's contract with the Company typically has a one-year term, with
automatic renewal at the Company's option for successive one-year terms, and
generally may be terminated without cause by the Company or the provider upon 30
to 90 days notice.
As of December 31, 1997, the Company's managed behavorial healthcare network
included contractual arrangements with approximately 2,000 third-party treatment
facilities, including inpatient psychiatric and substance abuse hospitals,
intensive outpatient facilities, partial hospitalization facilities, community
health centers and other community-based facilities, rehabilitative and support
facilities, and other intermediate care and alternative care facilities or
programs. This variety of facilities enables the Company to offer patients a
full continuum of care and to refer patients to the most appropriate facility or
program within that continuum. Typically, the Company contracts with facilities
on a per diem or fee-for-service basis and, in some cases, on a "case rate" or
capitated basis. The contracts between the Company and inpatient and other
facilities typically are for one year terms and, in some cases, are
automatically renewable at the Company's option. Facility contracts are usually
terminable by the Company or the facility owner upon 30 to 120 days notice. The
Psychiatric Hospital Facilities and other facilities operated by CBHS are
members of the Company's hospital provider network on the same terms as are
generally applicable to unaffiliated third-party treatment facilities.
88
COMPETITION
Each segment of the Company's business is highly competitive. With respect
to its managed care business, the Company competes with large insurance
companies, HMOs, PPOs, TPAs, IPAs, multi-disciplinary medical groups and other
managed care companies. Many of the Company's competitors are significantly
larger and have greater financial, marketing and other resources than the
Company, and some of the Company's competitors provide a broader range of
services. The Company may also encounter substantial competition in the future
from new market entrants. Many of the Company's customers that are managed care
companies may, in the future, seek to provide managed behavioral healthcare and
EAP services to their employees or subscribers directly, rather than by
contracting with the Company for such services. Because of competition, the
Company does not expect to be able to rely on price increases to achieve revenue
growth and expects to continue experiencing pressure on direct operating
margins. See "Risk Factors--Highly Competitive Industry."
The Company's public sector operations compete with various for profit and
not-for-profit entities, including, but not limited to: (i) managed behavioral
healthcare companies that have started managing human services for governmental
agencies; (ii) home health care organizations; (iii) proprietary nursing home
companies; and (iv) proprietary corrections companies. The Company believes that
the most significant factors in a customer's selection of services include price
and quality of services and outcomes. The pricing aspect of such services is
especially important to attract public sector agencies looking to outsource
public services to the private sector as demand for quality services escalates
while budgeted dollars for healthcare services are reduced. The Company's
management believes that it competes effectively with respect to these factors.
The competitive environment affecting the Company's franchise and provider
operations are discussed elsewhere. See "Charter Advantage--Competition."
INSURANCE
The Company maintains a general and professional liability insurance policy
with an unaffiliated insurer. The policy is written on a "claims made or
circumstances reported" basis, subject to a $500,000 deductible per occurrence
and an aggregate deductible of $1.5 million.
PROPERTIES
MAGELLAN. The Company's principal executive offices are located in Atlanta,
Georgia; the lease for the Company's headquarters expires in 1999. Green Spring
leases its 83 offices with terms expiring between 1997 and 2020. Green Spring's
headquarters are leased and are located in Columbia, Maryland with lease terms
expiring between 1998 and 2002. Mentor and Public Solutions lease their 68
offices with terms expiring between 1998 and 2002. Mentor and Public Solutions'
headquarters are leased and are located in Boston, Massachusetts with a lease
term expiring in 2002. The Company owns two behavioral healthcare facilities in
the United Kingdom, one of which is subject to a land-lease that expires in
2069, and a behavorial healthcare facility in Nyon, Switzerland. The Company has
a controlling interest in six hospital-based Joint Ventures that operate or
manage 10 behavioral healthcare facilities ("JV Hospitals"). The Joint Ventures
own six of the JV Hospitals and lease two of the JV Hospitals from the
respective Joint Venture owners. The remaining two JV Hospitals are owned by the
respective Joint Venture owners.
MERIT. Merit's principal executive offices are located in Park Ridge, New
Jersey; the lease for Merit's headquarters expires in 2006. Merit leases a
facility that comprises its National Service Center in St. Louis, Missouri,
under three leases expiring between 2001 and 2003. In addition, Merit leases
significant amounts of office space in New York City and San Francisco,
California pursuant to leases that expire in 2008 and 2003, respectively. Merit
also maintained at September 30, 1997, approximately 150 other offices in 32
states under leases that have terms of up to 10 years.
89
HAI. HAI's principal executive offices are located in Sandy, Utah; the
lease expires in 2005. HAI maintains 29 other offices in 17 states under leases
that have terms of up to 4 years.
INTELLECTUAL PROPERTY
The Company has developed and is marketing applications and systems for
managing the delivery of care and measuring the outcome of treatment, including
an integrated suite of applications that includes a "Speciality Care Management"
component and an "Advanced Call Center" component. The Speciality Care
Management component includes a suite of proprietary clinical protocols called
"Specifications for Acceptable Care."
These protocols were developed and are supported by recognized physician
experts in the relevant specialities. Clinical protocols are detailed treatment
plans for specific medical conditions. The Advanced Call Center component
includes a nurse advice line application, which permits nurses to answer calls
from managed care beneficiaries and to provide health information and care
decision counseling. It also includes an application that initiates calls to
managed care beneficiaries requiring information on care of chronic conditions,
other information or screening. Finally, the Advanced Call Center component
includes an application that facilitates precertification of beneficiaries,
program referral or enrollment and after-hours back-up of the Speciality Care
Management component. The Advanced Call Center assists the Company and other
users to control costs by reducing unnecessary emergency room visits and by
assisting network providers to monitor compliance with treatment plans. Green
Spring, HAI and Merit have also developed or licensed clinical protocols and
proprietary software applications for use in providing managed behavorial
healthcare products.
EMPLOYEES
At September 30, 1997, the Company had approximately 5,000 full-time and
part-time employees. The Company believes it has satisfactory relations with its
employees.
MANAGEMENT INFORMATION SYSTEMS
In March 1997, the Company hired a Chief Information Officer and established
the Corporate Information Technology Department (the "IT Department"). The Chief
Information Officer reports to the Chief Executive Officer of the Company. Each
operating unit of the Company also has a chief information officer who reports
to the chief executive officer of the operating unit. The IT Department provides
strategic technical direction, consultation and implementation coordination to
each of the operating units.
Currently, each of the Company's operating units maintains its own
information systems. The systems maintained and the applications software used
varies depending on the business processes performed by the operating unit.
Green Spring processes all claims on a centralized system using its proprietary
"Claims Adjudication and Tracking System" software and two Compaq Proliant
servers. Green Spring conducts utilization review functions on a decentralized
client/server system, using proprietary "Care Utilization and Review Expediter"
software. Each regional Green Spring office maintains its own complement of data
base servers. Green Spring's information systems are relatively new and
management believes that they have sufficient remaining capacity to accommodate
Green Spring's foreseeable needs.
The Company's information technology strategy is to establish and implement
a common company-wide infrastructure in an attempt to facilitate the integration
of future acquisitions, reduce information technology costs and enhance the
Company's ability to share information internally and with its customers and
business partners. The Company will also attempt to standardize software,
equipment, training and support. An enterprise architecture standards working
group has been formed to implement the strategy. The working group is currently
developing the architecture and migration approach toward a Microsoft Windows NT
environment and standards and implementation plans for hardware and software
platforms and a wide-area network. Management believes that it could achieve
significant cost
90
savings by implementing common system architectures, shared applications systems
and common business operating procedures throughout the Company, by
consolidating back-office functions and by minimizing redundant systems.
The Company's integration plan for the Acquisition includes an IT Department
working group consisting of senior information technology executives from the
Company, Green Spring, Merit and HAI. The Company's strategy for integrating the
Company, Green Spring, Merit and HAI is being coordinated with the Company's
ongoing efforts to establish and implement a common company-wide information
technology infrastructure.
The Company expects to be able to implement its company-wide information
technology infrastructure, including the integration of Merit, by the end of
calendar year 1999, without incurring material expenditures in excess of
historical capital requirements.
LEGAL PROCEEDINGS
The management and administration of the delivery of managed behavioral
healthcare services, and the direct provision of behavioral health treatment
services, entail significant risks of liability. In recent years, the Company,
Merit, HAI and Allied and their respective network providers have been subject
to a number of actions and claims alleging malpractice, professional negligence
and other related legal theories. Many of these actions and claims seek
substantial damages and therefore require the defendant to incur significant
fees and costs related to their defense.
From time to time, the Company, Merit, HAI and Allied are subject to various
actions and claims arising from the acts or omissions of their respective
employees, network providers or other parties. In the normal course of business,
the Company, Merit, HAI and Allied receive reports relating to suicides and
other serious incidents involving patients enrolled in their respective
programs. Such incidents may give rise to malpractice, professional negligence
and other related actions and claims against the Company, Merit, HAI or Allied
or their respective employees and network providers. As the number of lives
covered by the Company and such other entities grows, the number of providers
under contract with them increases and the nature and scope of services provided
by them in their respective managed care and EAP businesses expands, actions and
claims against such entities (and, in turn, possible legal liability) predicated
on malpractice, professional negligence or other related legal theories can be
expected to increase. See "Risk Factors--Professional Liability; Insurance."
To the extent customers of the Company, HAI, Allied or Merit are entitled to
indemnification under their contracts with the relevant entity relating to
liabilities they incur arising from the operation of the relevant entity's
programs, such indemnification may not be covered under the relevant entity's
insurance policies. In addition, to the extent that certain actions and claims
seek punitive and compensatory damages arising from alleged intentional
misconduct by the Company, HAI, Allied or Merit such damages, if awarded, may
not be covered, in whole or in part, by the relevant entity's insurance
policies. In the ordinary course of business, such entities are also subject to
actions and claims with respect to their respective employees, network providers
and suppliers of services. The Company does not believe that any pending action
against the Company, Merit, HAI or Allied will have a material adverse effect on
the Company. To date, claims and actions against the Company, Merit, HAI or
Allied alleging professional negligence have not resulted in material
liabilities to the Company, Merit, HAI or Allied; however, there can be no
assurance that pending or future actions or claims for professional liability
(including any judgments, settlements or costs associated therewith) will not
have a material adverse effect on the Company. See "--Insurance" and "Risk
Factors--Professional Liability; Insurance."
From time to time, the Company, HAI, Allied and Merit receive notifications
from and engage in discussions with various governmental agencies concerning
their respective businesses and operations. As a result of these contacts with
regulators, the relevant entity in many instances implements changes to its
operations, revises its filings with such agencies and/or seeks additional
licenses to conduct its business. In recent years, in response to governmental
agency inquiries or discussions with
91
regulators, Merit has determined to seek licensure as a single service HMO, TPA
or utilization review agent in one or more jurisdictions.
In October 1996, a group of eight plaintiffs purporting to represent an
uncertified class of psychiatrists, psychologists and clinical social workers
brought an action under the federal antitrust laws in the United States District
Court for the Southern District of New York against nine behavioral health
managed care organizations, including Merit, CMG, Green Spring and HAI
(collectively, the "Defendants"), entitled Edward M. Stephens, Jose A.
Yaryura-Tobias, Judith Green, Ph.D., Fugen Neziroglu Ph.D., Ona Robinson, Ph.D.,
Laurie A. Baum, C.S.W., Agnes Wohl, C.S.W., and The On-Step Institute For Mental
Health Research Inc., individually and on behalf of all others similarly
situated v. CMG Health, FHC Options, Inc., Foundation Health PsychCare Services,
Inc., Green Spring Health Services, Inc., Human Affairs International, Inc.,
Merit Behavioral Care Corp., MCC Behavioral Care Inc., United Behavioral
Systems, Inc., and Value Behavioral Health, Inc., 96 Civ. 7798 (KMW). The
complaint alleges that the Defendants violated Section 1 of the Sherman Act by
engaging in a conspiracy to fix the prices at which the Defendants purchase
services from mental healthcare providers such as the plaintiffs. The complaint
further alleges that the Defendants engaged in a group boycott to exclude mental
healthcare providers from the Defendants' networks in order to further the goals
of the alleged conspiracy. The complaint also challenges the propriety of the
Defendants' capitation arrangements with their respective customers, although it
is unclear from the complaint whether the plaintiffs allege that the Defendants
unlawfully conspired to enter into capitation arrangements with their respective
customers. The complaint seeks treble damages against the Defendants in an
unspecified amount and a permanent injunction prohibiting the Defendants from
engaging in the alleged conduct which forms the basis of the complaint, plus
costs and attorneys' fees. In January 1997, the 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 the
Defendants' motion to dismiss the complaint with prejudice be granted. On August
5, 1997, the plaintiffs filed objections to the magistrate judge's report and
recommendation; such objections have not yet been heard. The Defendants intend
to vigorously defend themselves in this litigation. However, there can be no
assurance that the outcome of this litigation will be favorable to the
Defendants. An unfavorable outcome could have a material adverse effect on the
Company.
REGULATION
GENERAL. The managed behavioral healthcare industry and the provision of
behavioral healthcare services are subject to extensive and evolving state and
federal regulation. The Company is subject to certain state laws and
regulations, including those governing: (i) the licensing of insurance
companies, HMOs, PPOs, TPAs and companies engaged in utilization review and (ii)
the licensing of healthcare professionals, including restrictions on business
corporations from practicing, controlling or exercising excessive influence over
behavioral healthcare services through the direct employment of psychiatrists
or, in a few states, psychologists and other behavioral healthcare
professionals. These laws and regulations vary considerably among states and the
Company may be subject to different types of laws and regulations depending on
the specific regulatory approach adopted by each state to regulate the managed
care business and the provision of behavioral healthcare treatment services. In
addition, the Company is subject to certain federal laws as a result of the role
the Company assumes in connection with managing its customers' employee benefit
plans. The regulatory scheme generally applicable to the Company's managed care
operations is described in this section. The Company's managed care operations
are also indirectly affected by regulations applicable to the operations of
behavioral healthcare clinics and facilities. See "Charter
Advantage--Regulation."
The Company believes its operations are structured to comply with applicable
laws and regulations in all material respects and that it has received, or is in
the process of applying for, all licenses and approvals that are material to the
operation of its business. However, regulation of the managed healthcare
industry is evolving, with new legislative enactments and regulatory initiatives
at the state and federal levels being implemented on a regular basis.
Consequently, it is possible that a court or
92
regulatory agency may take a position under existing or future laws or
regulations, or as a result of a change in the interpretation thereof, that such
laws or regulations apply to the Company in a different manner than the Company
believes such laws or regulations apply. Moreover, any such position may require
significant alterations to the Company's business operations in order to comply
with such laws or regulations, or interpretations thereof. Expansion of the
Company's business to cover additional geographic areas, to serve different
types of customers, to provide new services or to commence new operations could
also subject the Company to additional licensure requirements and/or regulation.
LICENSURE. Certain regulatory agencies having jurisdiction over the Company
possess discretionary powers when issuing or renewing licenses or granting
approval of proposed actions such as mergers, a change in ownership, transfer or
assignment of licenses and certain intracorporate transactions. One or multiple
agencies may require as a condition of such licensure or approval that the
Company cease or modify certain of its operations in order to comply with
applicable regulatory requirements or policies. In addition, the time necessary
to obtain licensure or approval varies from state to state, and difficulties in
obtaining a necessary license or approval may result in delays in the Company's
plans to expand operations in a particular state and, in some cases, lost
business opportunities. Compliance activities, mandated changes in the Company's
operations, delays in the expansion of the Company's business or lost business
opportunities as a result of regulatory requirements or policies could have a
material adverse effect on the Company.
INSURANCE, HMO AND PPO ACTIVITIES. To the extent that the Company operates
or is deemed to operate in one or more states as an insurance company, HMO, PPO
or similar entity, it may be required to comply with certain laws and
regulations that, among other things, may require the Company to maintain
certain types of assets and minimum levels of deposits, capital, surplus,
reserves or net worth. In many states, entities that assume risk under contracts
with licensed insurance companies or HMOs have not been considered by state
regulators to be conducting an insurance or HMO business. As a result, the
Company has not sought licensure as either an insurer or HMO in certain states.
The National Association of Insurance Commissioners (the "NAIC") has undertaken
a comprehensive review of the regulatory status of entities arranging for the
provision of healthcare services through a network of providers that, like the
Company, may assume risk for the cost and quality of healthcare services, but
that are not currently licensed as an HMO or similar entity. As a result of this
review, the NAIC developed a "health organizations risk-based capital" formula,
designed specifically for managed care organizations, that establishes a minimum
amount of capital necessary for a managed care organization to support its
overall operations, allowing consideration for the organization's size and risk
profile. The NAIC initiative also may result in the adoption of a model NAIC
regulation in the area of health plan standards, which could be adopted by
individual states in whole or in part, and could result in the Company being
required to meet additional or new standards in connection with its existing
operations. Individual states have also recently adopted their own regulatory
initiatives that subject entities such as the Company to regulation under state
insurance laws. This includes, but is not limited to, requiring licensure as an
insurance company or HMO and requiring adherence to specific financial solvency
standards. State insurance laws and regulations may limit the ability of the
Company to pay dividends, make certain investments and repay certain
indebtedness. Licensure as an insurance company, HMO or similar entity could
also subject the Company to regulations governing reporting and disclosure,
mandated benefits, and other traditional insurance regulatory requirements. PPO
regulations to which the Company may be subject may require the Company to
register with a state authority and provide information concerning its
operations, particularly relating to provider and payor contracting. Based on
the information presently available to it, the Company does not believe that the
imposition of requirements related to maintaining certain types of assets,
prescribed levels of deposits, capital, surplus, reserves or net worth, or
complying with other regulatory requirements applicable to its insurance
company, HMO, PPO or similar operations, would have a material adverse effect on
the Company. Notwithstanding the foregoing, the imposition of such requirements
could increase the Company's cost of doing business and could delay the
Company's conduct or expansion of its business in some areas.
93
The licensure process under state insurance laws can be lengthy and, unless the
applicable state regulatory agency allows the Company to continue to operate
while the licensure process is ongoing, the Company could experience a material
adverse effect on its operating results and financial condition while its
licensure application is pending. In addition, failure by the Company to obtain
and maintain required licenses typically also constitutes an event of default
under the Company's contracts with its customers. The loss of business from one
or more of the Company's major customers as a result of such an event of default
or otherwise could have a material adverse effect on the Company.
UTILIZATION REVIEW AND THIRD-PARTY ADMINISTRATOR ACTIVITIES. Numerous
states in which the Company does business have adopted, or are expected to
adopt, regulations governing entities engaging in utilization review and TPA
activities. Utilization review regulations typically impose requirements with
respect to the qualifications of personnel reviewing proposed treatment,
timeliness and notice of the review of proposed treatment, and other matters.
TPA regulations typically impose requirements regarding claims processing and
payments and the handling of customer funds. Utilization review and TPA
regulations may increase the Company's cost of doing business in the event that
compliance requires the Company to retain additional personnel to meet the
regulatory requirements and to take other required actions and make necessary
filings. Although compliance with utilization review regulations has not had a
material adverse effect on the Company, there can be no assurance that specific
regulations adopted in the future would not have such a result, particularly
since the nature, scope and specific requirements of such provisions vary
considerably among states that have adopted regulations of this type.
There is a trend among states to require licensure or certification of
entities performing utilization review or TPA activities; however, certain
federal courts have held that such licensure requirements are preempted by
ERISA. ERISA preempts state laws that mandate employee benefit structures or
their administration, as well as those that provide alternative enforcement
mechanisms. The Company believes that its TPA activities performed for its
self-insured employee benefit plan customers are exempt from otherwise
applicable state licensing or registration requirements based upon federal
preemption under ERISA and has relied on this general principle in determining
not to seek licensure for certain of its activities in many states. Existing
case law is not uniform on the applicability of ERISA preemption with respect to
state regulation of utilization review or TPA activities. There can be no
assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states.
"ANY WILLING PROVIDER" LAWS. Several states in which the Company does
business have adopted, or are expected to adopt, "any willing provider" laws.
Such laws typically impose upon insurance companies, PPOs, HMOs or other types
of third-party payors an obligation to contract with, or pay for the services
of, any healthcare provider willing to meet the terms of the payor's contracts
with similar providers. Compliance with any willing provider laws could increase
the Company's costs of assembling and administering provider networks and could,
therefore, have a material adverse effect on its operations.
LICENSING OF HEALTHCARE PROFESSIONALS. The provision of behavioral
healthcare treatment services by psychiatrists, psychologists and other
providers is subject to state regulation with respect to the licensing of
healthcare professionals. The Company believes that the healthcare professionals
who provide behavioral healthcare treatment on behalf of or under contracts with
the Company are in compliance with the applicable state licensing requirements
and current interpretations thereof; however, there can be no assurance that
changes in such state licensing requirements or interpretations thereof will not
adversely affect the Company's existing operations or limit expansion. With
respect to the Company's crisis intervention program, additional licensure of
clinicians who provide telephonic assessment or stabilization services to
individuals who are calling from out-of-state may be required if such assessment
or stabilization services are deemed by regulatory agencies to be treatment
provided in the state of such individual's residence. The Company believes that
any such additional licensure could be
94
obtained; however, there can be no assurance that such licensing requirements
will not adversely affect the Company's existing operations or limit expansion.
PROHIBITION ON FEE SPLITTING AND CORPORATE PRACTICE OF PROFESSIONS. The
laws of some states limit the ability of a business corporation to directly
provide, control or exercise excessive influence over behavioral healthcare
services through the direct employment of psychiatrists, psychologists, or other
behavioral healthcare professionals. In addition, the laws of some states
prohibit psychiatrists, psychologists, or other healthcare professionals from
splitting fees with other persons or entities. These laws and their
interpretations vary from state to state and enforcement by the courts and
regulatory authorities may vary from state to state and may change over time.
The Company believes that its operations as currently conducted are in material
compliance with the applicable laws, however, there can be no assurance that the
Company's existing operations and its contractual arrangements with
psychiatrists, psychologists and other healthcare professionals will not be
successfully challenged under state laws prohibiting fee splitting or the
practice of a profession by an unlicensed entity, or that the enforceability of
such contractual arrangements will not be limited. The Company believes that it
could, if necessary, restructure its operations to comply with changes in the
interpretation or enforcement of such laws and regulations, and that such
restructuring would not have a material adverse effect on its operations.
DIRECT CONTRACTING WITH LICENSED INSURERS. Regulators in several states in
which the Company does business have adopted policies that require HMOs or, in
some instances, insurance companies, to contract directly with licensed
healthcare providers, entities or provider groups, such as IPAs, for the
provision of treatment services, rather than with unlicensed intermediary
companies. In such states, the Company's customary model of contracting directly
with its customers may need to be modified so that, for example, the IPAs
(rather than the Company) contract directly with the HMO or insurance company,
as appropriate, for the provision of treatment services. The Company intends to
work with a number of these HMO customers to restructure existing contractual
arrangements, upon contract renewal or in renegotiations, so that the entity
which contracts with the HMO directly is an IPA. The Company does not expect
this method of contracting to have a material adverse effect on its operations.
OTHER REGULATION OF HEALTHCARE PROVIDERS. The Company's business is
affected indirectly by regulations imposed upon healthcare providers.
Regulations imposed upon healthcare providers include provisions relating to the
conduct of, and ethical considerations involved in, the practice of psychiatry,
psychology, social work and related behavioral healthcare professions and, in
certain cases, the common law duty to warn others of danger or to prevent
patient self-injury. Confidentiality and patient privacy requirements are
particularly strict in the field of behavioral healthcare services, and
additional legislative initiatives relating to confidentiality are expected. The
Health Insurance Portability and Accountability Act of 1996 ("HIPAA") included a
provision that prohibits the wrongful disclosure of certain "individually
identifiable health information." HIPAA requires the Secretary of the Department
to adopt standards relating to the transmission of such health information by
healthcare providers and healthcare plans. Although the Company believes that
such regulations do not at present materially impair the Company's operations,
there can be no assurance that such indirect regulation will not have a material
adverse effect on the Company in the future.
REGULATION OF CUSTOMERS. Regulations imposed upon the Company's customers
include, among other things, benefits mandated by statute, exclusions from
coverages prohibited by statute, procedures governing the payment and processing
of claims, record keeping and reporting requirements, requirements for and
payment rates applicable to coverage of Medicaid and Medicare beneficiaries,
provider contracting and enrollee rights, and confidentiality requirements.
Although the Company believes that such regulations do not at present materially
impair the Company's operations, there can be no assurance that such indirect
regulation will not have a material adverse effect on the Company in the future.
ERISA. Certain of the Company's services are subject to the provisions of
ERISA. ERISA governs certain aspects of the relationship between
employer-sponsored healthcare benefit plans and certain
95
providers of services to such plans through a series of complex laws and
regulations that are subject to periodic interpretation by the Internal Revenue
Service and the Department of Labor. In some circumstances, and under certain
customer contracts, the Company may be expressly named as a "fiduciary" under
ERISA, or be deemed to have assumed duties that make it an ERISA fiduciary, and
thus be required to carry out its operations in a manner that complies with
ERISA requirements in all material respects. Although the Company believes that
it is in material compliance with the applicable ERISA requirements and that
such compliance does not currently have a material adverse effect on the
Company's operations, there can be no assurance that continuing ERISA compliance
efforts or any future changes to the applicable ERISA requirements will not have
a material adverse effect on the Company.
THE BUDGET ACT. In August 1997, Congress enacted the Budget Act. The
Medicare-related provisions of the Budget Act are designed to reduce Medicare
expenditures over the next five years by $115 billion, compared to projected
Medicare expenditures before adoption of the Budget Act. The Congressional
Budget Office projected in July 1997 that $43.8 billion of the reductions would
come from reduced payments to hospitals, $21.8 billion from increased enrollment
in managed care plans and $11.7 billion from reduced payments to physicians and
ambulatory care providers. The five-year savings in projected Medicare payments
to physicians and hospitals would be achieved under the Budget Act by reduced
fee-for-service reimbursement and by changes in managed care programs designed
to increase enrollment of Medicare beneficiaries in managed care plans. The
increase in Medicare enrollment in managed care plans would be achieved in part
by allowing provider-sponsored organizations and preferred provider
organizations to compete with Medicare health maintenance organizations for
Medicare enrollees.
Prior to adoption of the Budget Act, the states were prohibited from
requiring Medicaid recipients to enroll in managed care products that covered
only Medicaid recipients. The Medicaid laws required that the states enroll
Medicaid recipients in products that also covered a specific number of
commercial enrollees. This requirement of the Medicaid laws was intended to
limit the ability of states to reduce coverage levels for Medicaid recipients
below those offered to commercial enrollees. Under prior law, the Secretary of
the Department could waive the prohibition. The Medicaid-related provisions of
the Budget Act give states broad flexibility to require most Medicaid recipients
to enroll in managed care products that only cover Medicaid recipients, without
obtaining a waiver from the Secretary of the Department. The Budget Act also
allows states to limit the number of managed care organizations with which the
state will contract to deliver care to Medicaid beneficiaries. These changes
could have a positive impact on the Company's business, if they result in
increased enrollment of Medicaid beneficiaries in managed care organizations and
increased Medicaid spending on managed care. However, these changes also may
have an adverse effect on the Company if a number of states decide to limit the
number of managed care organizations with which they will contract and to select
the organization solely on the basis of the cost of care, which could result in
increased cost competition for state contracts.
The Company cannot predict the effect of the Budget Act, or other healthcare
reform measures that may be adopted by Congress or state legislatures, on its
managed care operations and no assurance can be given that either the Budget Act
or other healthcare reform measures will not have an adverse effect on the
Company.
OTHER PROPOSED LEGISLATION. In the last five years, legislation has
periodically been introduced at the state and federal level providing for new
regulatory programs and materially revising existing regulatory programs. Any
such legislation, if enacted, could materially adversely affect the Company's
business, financial condition or results of operations. Such legislation could
include both federal and state bills affecting the Medicaid programs which may
be pending in or recently passed by state legislatures and which are not yet
available for review and analysis. Such legislation could also include proposals
for national health insurance and other forms of federal regulation of health
insurance and healthcare delivery. It is not possible at this time to predict
whether any such legislation will be adopted at the federal or state level, or
the nature, scope or applicability to the Company's business of any such
legislation, or when any particular legislation might be implemented. No
assurance can be given that any such federal or state legislation will not have
a material adverse effect on the Company.
96
CHARTER ADVANTAGE
OVERVIEW
On June 17, 1997, the Company consummated the Crescent Transactions,
pursuant to which, among other things, it sold the Psychiatric Hospital
Facilities to Crescent. In addition, the Company and COI, an affiliate of
Crescent, formed a joint venture known as CBHS to operate the Psychiatric
Hospital Facilities and certain other facilities transferred by the Company to
CBHS. The Company and COI each own 50% of the equity interest of CBHS. The
Company obtained its equity interest by contributing approximately $5 million of
net assets, including five leased psychiatric hospitals, to CBHS. In fiscal
1997, subsequent to the initial capitalization of CBHS, the Company and COI each
contributed an additional $17.5 million to the capital of CBHS. The Company has
no obligation to make additional contributions to the capital of CBHS. The
Company accounts for its 50% investment in CBHS under the equity method of
accounting. In connection with the Crescent Transactions, the Company received
approximately $417.2 million in cash (before costs of approximately $16.0
million) and warrants for the purchase of 2.5% of COI's common stock,
exercisable over 12 years. The Company also issued 1,283,311 warrants to
purchase shares of the Company's Common Stock to each of Crescent and COI at an
exercise price of $30 per share. In related agreements, Crescent and CBHS
entered into the facilities lease described below and the Company, CBHS and the
Psychiatric Hospital Facilities and other facilities transferred by the Company
to CBHS entered into the franchise agreements described below. Following the
consummation of the Crescent Transactions, the Company formed a new business
unit, "Charter Advantage," to franchise the "CHARTER" system of behavioral
healthcare to operators of behavioral healthcare facilities. Currently, its sole
customer is CBHS.
On March 3, 1998, the Company and certain of its wholly owned subsidiaries
entered into definitive agreements with COI and CBHS pursuant to which it will,
among other things, sell the Company's franchise operations. See "Pending Sale
of Provider Business."
The following discussion of Charter Advantage's operations, CBHS's
facilities and the psychiatric hospital industry in general is relevant to an
assessment of the factors having a bearing on CBHS's ability to pay Franchise
Fees to the Company, the value of the Company's interest in the equity of CBHS
and the future business prospects of CBHS. If the CBHS Transactions are
consumated, the Master Franchise Agreement will be canceled and the Company will
no longer receive the Franchise Fees. Furthermore, the future business prospects
of CBHS will no longer be relevant to the Company's future financial
performance.
FRANCHISE OPERATIONS
FRANCHISE AGREEMENTS. Charter Advantage franchises the "CHARTER" System of
behavioral healthcare to the Psychiatric Hospital Facilities and other
facilities operated by CBHS. See "-- CBHS." Each facility has entered into a
separate Franchise Agreement with Charter Advantage. Each franchisee is granted
the right to engage in the business of providing behavioral healthcare utilizing
the "CHARTER" System in a defined territory. Each franchisee is authorized to
conduct a "Hospital/RTC Based Behavioral Healthcare Business," which is defined
as the business of the operation of an acute care psychiatric hospital, part of
an acute care general hospital operating an acute care psychiatric unit, a
behavioral healthcare residential treatment center, a part of a facility
operating a behavioral healthcare residential treatment center, or other similar
facility providing 24-hour behavioral healthcare and the delivery of behavioral
healthcare from such facility or other affiliated facilities; such behavioral
healthcare to include inpatient hospitalization, partial hospitalization
programs, outpatient therapy, intensive outpatient therapy, residential
treatment, ambulatory detoxification, behavioral modification programs and
related services. The "CHARTER" System is a system for the operation of
Hospital/RTC Based Behavioral Healthcare Businesses under the "CHARTER" names
and marks, and includes the right to use
97
computer software, treatment programs and procedures, quality standards, quality
assessment methods, performance improvement and monitoring programs, as well as
advertising and marketing assistance, promotional materials, consultation and
other matters relating to the operation of Hospital/RTC Based Behavioral
Healthcare Businesses.
The rights granted under each franchise agreement relate solely to a defined
territory. The rights are non-exclusive except that Charter Advantage may not
grant a franchise for, or itself operate, a facility located within a
franchisee's territory using the "CHARTER" System. Charter Advantage, however,
may grant franchises or licenses to individual physicians, psychologists or
other mental healthcare professionals, to operate businesses for the delivery of
behavioral healthcare utilizing the "CHARTER" System at facilities in the
franchisee's territory other than at an in-patient facility. Charter Advantage
also reserves the right to grant franchises to others to operate behavioral
healthcare businesses utilizing the "CHARTER" System other than in the
franchisee's territory and to otherwise use and grant to others the right to use
the "CHARTER" name or any other name for other businesses. In addition, Charter
Advantage reserves the right to: (i) provide behavioral healthcare services
incidental to the managed behavioral healthcare businesses or any other business
the principal purpose of which is not the operation of a Hospital/RTC Based
Behavioral Healthcare Business and (ii) pursuant to contracts with federal,
state and local governmental agencies, provide health and human services,
including behavioral healthcare services, to the mentally retarded, the
developmental disabled, the elderly, persons under the control or supervision of
criminal/juvenile systems and other designated populations.
During the term of each franchise agreement, Charter Advantage provides
franchisees with: (i) advertising and marketing assistance, including
consultation, access to media buying programs and access to broadcast and other
advertising materials produced by Charter Advantage; (ii) risk management
services, including risk financial planning, loss control and claims management;
(iii) outcomes monitoring; (iv) national and regional contracting services; and
(v) consultation by telephone or at Charter Advantage's offices with respect to
matters relating to the franchisee's business in which Charter Advantage has
expertise, including reimbursement, government relations, clinical strategies,
regulatory matters, strategic planning and business development.
FRANCHISE FEES; SUBORDINATION. The Company and CBHS are parties to a Master
Franchise Agreement pursuant to which CBHS pays the Company annual Franchise
Fees for granting the right to utilize the "CHARTER" System to the facilities
operated by CBHS. CBHS is required by the Master Franchise Agreement to pay
annual Franchise Fees equal to the greater of (i) $78.3 million, subject to
increases for inflation, and (ii) $78.3 million, plus 3% of CBHS's gross
revenues over $1 billion and not in excess of $1.2 billion and 5% of CBHS' gross
revenues over $1.2 billion. The Company, CBHS and Crescent have entered into a
Subordination Agreement pursuant to which the Franchise Fees are subordinated to
base rent, minimum escalator rent and the first $10.0 million of additional rent
under the Facilities Lease between Crescent and CBHS with respect to the
facilities operated by CBHS. If CBHS (with the consent of the Company) informs
Crescent that capital expenditures in excess of $10.0 million are required and
Crescent funds or makes an irrevocable commitment to fund capital expenditures
in excess of $10.0 million, then Franchise Fees are also subordinated to such
expenditures or commitments in excess of $10.0 million.
Based on projections of fiscal 1998 operations prepared by management of
CBHS, the Company believes that CBHS will be unable to pay the full amount of
the Franchise Fees it is contractually obligated to pay the Company during
fiscal 1998. The Company currently estimates that CBHS will be able to pay
approximately $58.0 million to $68.0 million of the Franchise Fees in fiscal
1998, a $10.0 million to $20.0 million shortfall relative to amounts payable
under the Master Franchise Agreement. If CBHS defaults in payment of the
Franchise Fees, the Company has the following remedies available to it under the
Master Franchise Agreement. If the amount of Franchise Fees not paid exceeds
$6.0 million, but is less than $18.0 million, the Company will have the right to
prohibit CBHS from paying any incentive compensation to CBHS's management and
may prohibit the vesting of any equity in CBHS to which
98
management of CBHS may be entitled during the period when Franchise Fees remain
unpaid. If the amount of Franchise Fees not paid exceeds $18.0 million, but is
less than $24.0 million, the Company will have the right to prohibit any salary
increases for key personnel of CBHS, to prohibit any additional hiring by CBHS
and to prohibit CBHS from making any hospital acquisitions or entering into any
hospital joint ventures directly or indirectly during such period. If the amount
of Franchise Fees not paid exceeds $24.0 million, the Company may require CBHS
to reduce by 5% the expenses approved in its current budget, to seek approval of
expenditures, including capital and operating expenditures, on a monthly basis,
and to transfer control and management of CBHS and the Psychiatric Hospital
Facilities to the Company. Notwithstanding the foregoing, the Company does not
have the right to take any action, in connection with the exercise of remedies
against CBHS, that could reasonably be expected to force CBHS into bankruptcy or
receivership, or similar proceedings, with respect to any dispute that may arise
among the parties with respect to payment or nonpayment of the Franchise Fees.
The initial term of the Facilities Lease is twelve years. CBHS has the right
to renew the lease for four additional terms of five years each. The base rent
for the first year of the initial term is $41.7 million, which increases each
year during the initial term by five percent compounded annually. CBHS is
required by the Facilities Lease to pay Crescent in each lease year additional
rent in the amount of $20.0 million. Crescent is obligated to use at least $10.0
million of the additional rent to pay for capital expenditures with respect to
the Psychiatric Hospital Facilities in the time and manner directed by CBHS.
Furthermore, CBHS has the right to require Crescent to use up to $10.0 million
of additional rent to pay property taxes, insurance premiums and Franchise Fees.
CBHS's failure to pay additional rent pursuant to the Facilities Lease is not a
default with respect to the Facilities Lease, except to the extent that Crescent
has made capital expenditures or advanced sums to pay taxes, insurance premiums,
assessments or Franchise Fees that have not been reimbursed by additional rent
payments.
Notwithstanding the foregoing, if the accrued and unpaid Franchise Fees,
including interest thereon, if any, equal or exceed $15.0 million, then CBHS's
available cash would thereafter first be applied to base rent and minimum
escalator rent, but not to additional rent, under the Facilities Lease. The
remainder of CBHS's available cash would then be applied in such order of
priority as CBHS may determine, in the reasonable discretion of its Board of
Directors (half the members of which are appointed by the Company), to all other
operating expenses of CBHS, including, without limitation, the current and
accumulated Franchise Fees, additional rent due under the Facilities Lease and
any other operating expenses. If CBHS (with the consent of the Company) informs
Crescent that capital expenditures are required and Crescent funds or makes an
irrevocable commitment to fund such capital expenditures, then CBHS's available
cash will first be applied to base rent, minimum escalator rent and the amount
of additional rent necessary to fund such capital expenditures; provided that
Crescent will have no obligation to refund any amounts paid by CBHS as
additional rent.
CBHS
OVERVIEW. CBHS is the nation's largest operator of acute-care psychiatric
hospitals and other behavioral care treatment facilities. CBHS's psychiatric
hospitals are located in well-populated urban and suburban locations in 32
states. Seven of CBHS's hospitals are affiliated with medical schools for
residency and other post-graduate teaching programs. Most of CBHS's hospitals
offer a full continuum of behavioral care in their service area. The continuum
includes inpatient hospitalization, partial hospitalization, intensive
outpatient services and, in some markets, residential treatment services.
CBHS's hospitals provide structured and intensive treatment programs for
mental health and alcohol and drug dependency disorders in children, adolescents
and adults. The specialization of programs enables the clinical staff to provide
care that is specific to the patient's needs and facilitates monitoring of the
patient's progress. A typical treatment program at a CBHS facility integrates
physicians and other patient-care professionals with structured activities,
providing patients with testing, adjunctive therapies (occupational,
recreational and other), group therapy, individual therapy and educational
99
programs. A treatment program includes one or more of the types of treatment
settings provided by CBHS's continuum of care. For those patients who do not
have a personal psychiatrist or other specialist, the hospital refers the
patient to a member of its medical staff.
A significant portion of hospital admissions are provided by referrals from
former patients, local marketplace advertising, managed care organizations and
physicians. Professional relationships are an important aspect of the ongoing
business of a behavioral care facility. Management believes the quality of
CBHS's treatment programs, staff employees and physical facilities are important
factors in maintaining good professional relationships.
CBHS's hospitals work closely with mental health professionals,
non-psychiatric physicians, emergency rooms and community agencies that come in
contact with individuals who may need treatment for mental illness or substance
abuse. A portion of the Company's marketing efforts is directed at increasing
general awareness of mental health and addictive disease and the services
offered by the Company's franchisees.
INDUSTRY TRENDS. CBHS's hospitals have been adversely affected by factors
influencing the entire psychiatric hospital industry. Such factors include: (i)
the imposition of more stringent length of stay and admission criteria and other
cost containment measures by payors; (ii) the failure of reimbursement rate
increases from certain payors that reimburse on a per diem or other discounted
basis to offset increases in the cost of providing services; (iii) an increase
in the percentage of business that CBHS derives from payors that reimburse on
per diem or other discounted basis; (iv) a trend toward higher deductibles and
co-insurance for individual patients; (v) a trend toward limited employee
behavioral health benefits, such as reductions in annual and lifetime limits on
behavioral health coverage; and (vi) pricing pressure related to an increasing
rate of claims denials by third party payors. In response to these conditions,
the Company believes that CBHS will (i) strengthen controls to minimize costs
and capital expenditures; (ii) review its portfolio of hospitals and sell, close
or lease hospitals or consolidate operations in certain locations; (iii) develop
strategies to increase outpatient services and partial hospitalization programs
to meet the demands of the marketplace; (iv) implement programs to contest third
party denials relating to valid pre-certified treatment and admissions; and (v)
renegotiate contracts with managed care organizations at increased rates.
SOURCES OF REVENUE. Payments are made to CBHS by patients, by insurance
companies and self-insured employers, by the federal and state governments under
Medicare, Medicaid, CHAMPUS and other programs and by HMOs, PPOs and other
managed care programs. Amounts received from most payors are less than the
hospital's established charges. The approximate percentages of gross patient
revenue (which is revenue before deducting contractual allowances and discounts
from established charges) derived by CBHS and the Company from various payment
sources for the last three fiscal years were as follows:
PERCENTAGE OF HOSPITAL GROSS
PATIENT
REVENUE FOR THE YEAR ENDED
SEPTEMBER 30,
-------------------------------
1995 1996 1997
--------- --------- ---------
Medicare........................................................................... 26% 28% 27%
Medicaid........................................................................... 17 17 18
--- --- ---
43 45 45
HMOs and PPOs...................................................................... 17 21 24
CHAMPUS............................................................................ 4 3 2
Other Government Programs.......................................................... 6 6 7
Other (primarily Blue Cross and other commercial insurance)........................ 30 25 22
--- --- ---
Total............................................................................ 100% 100% 100%
--- --- ---
--- --- ---
100
Most private insurance carriers reimburse their policyholders or make direct
payments to the hospitals for charges at rates specified in their policies. The
patient remains responsible to the hospital for any difference between the
insurance proceeds and the total charges. Certain Blue Cross programs have
negotiated reimbursement rates with certain of CBHS's hospitals which are less
than the hospital's established charges.
Most of CBHS's facilities have entered into contracts with HMOs, PPOs,
certain self-insured employers and other managed care plans which provide for
reimbursement at rates less than the hospital's normal charges. In addition to
contracts entered into by individual hospitals with such managed care plans,
CBHS has entered into regional and national contracts with HMOs, PPOs,
self-insured employers and other managed care plans that apply to all of such
franchisees in the geographic areas covered by a contract. CBHS is seeking to
obtain additional regional and national contracts. The Company expects the
percentage of revenue obtained by CBHS from these payor sources to increase in
the future.
Under the Medicare provisions of the Tax Equity and Fiscal Responsibility
Act of 1982 ("TEFRA"), costs per Medicare case are determined for each of the
Company's franchisees. A target cost per case is established for each year (the
"Target Rate"). If a hospital's costs per case are less than the Target Rate,
the hospital receives a bonus of 50% of the difference between its actual costs
per case and the Target Rate (limited to 5% of the Target Rate). Hospitals with
costs which exceed the Target Rate are paid an additional amount equal to 50% of
the excess, up to 10% of the Target Rate. These limits apply only to operating
costs and do not apply to capital costs, including lease expense, depreciation
and interest associated with capital expenditures. The Target Rate for each
hospital is increased annually by the application of an "update factor." The
Budget Act establishes caps on a hospital's Target Rate for cost reporting
periods beginning on or after October 1, 1997 and before October 1, 2002 equal
to no more than the 75th percentile of the Target Rate of such hospital for cost
reporting periods ending during fiscal year 1996, subject to certain subsequent
updates.
Most of CBHS's hospitals participate in state-operated Medicaid programs.
Current federal law prohibits Medicaid funding for inpatient services in
freestanding psychiatric hospitals for patients between the ages of 21 and 64.
Each state is responsible for establishing the Medicaid eligibility and coverage
criteria, payment methodology and funding mechanisms which apply in that state,
subject to federal guidelines. Accordingly, the level of Medicaid payments
received by CBHS's hospitals varies from state to state. In addition to the
basic payment level for patient care, several state programs include a financial
benefit for hospitals which treat a disproportionately large volume of Medicaid
patients as a percentage of the total patient population. The Company received
approximately $11.0 million, $9.0 million and $5.0 million in Medicaid
disproportionate share payments in fiscal 1994, 1995 and 1996, respectively,
when it owned the facilities now operated by CBHS. The Company and CBHS received
approximately $3.0 million in such payments in fiscal 1997. Disproportionate
share payments will not apply to services rendered in fiscal 1998 and
thereafter. See "--Risk Factors--Governmental Budgetary Constraints and
Healthcare Reform."
101
Within the statutory framework of the Medicare and Medicaid programs, there
are substantial areas subject to administrative rulings and interpretations
which may affect payments made under either or both of such programs. In
addition, federal or state governments could reduce the future funds available
under such programs or adopt additional restrictions on admissions and more
stringent requirements for utilization of services. These types of measures
could adversely affect CBHS's operations. Final determination of amounts payable
under Medicare and certain Medicaid programs are subject to review and audit.
Most of CBHS's hospitals receive revenues from the CHAMPUS program. Under
various CHAMPUS programs, payments can either be based on contractually agreed
upon rates or rates determined by regulatory formulas. CHAMPUS patients are
subject to annual limits on the number of psychiatric days covered by CHAMPUS.
Covered inpatient services are generally limited to 30 days for adult acute
patients, 45 days for child and adolescent acute patients, and 150 days for
residential treatment center patients.
MEDICAL STAFFS. At September 30, 1997, approximately 1,300 licensed
physicians were active members of the medical staffs of CBHS's hospitals. Many
of these physicians also serve on the medical staffs of other hospitals. A
number of physicians are independent contractors who have private practices in
addition to their duties for CBHS, while certain of these physicians are
employees of CBHS. The medical and professional affairs of each hospital are
supervised by the medical staff of the hospital, under the control of its board
of trustees. CBHS recruits physicians to serve in administrative capacities at
its hospitals and to engage in private practice in communities where CBHS's
hospitals are located. Registered nurses and certain other hospital employees
are required to be licensed under the professional licensing laws of most
states. CBHS's hospital subsidiaries require such employees to maintain such
professional licenses as a condition of employment.
COMPETITION
Each of CBHS's hospitals competes with other hospitals, some of which are
larger and have greater financial resources. Some competing hospitals are owned
and operated by governmental agencies, others by nonprofit organizations
supported by endowments and charitable contributions and others by proprietary
hospital corporations. The hospitals frequently draw patients from areas outside
their immediate locale and, therefore, CBHS's hospitals may, in certain markets,
compete with both local and distant hospitals. In addition, CBHS's hospitals
compete not only with other psychiatric hospitals, but also with psychiatric
units in general hospitals, and outpatient services provided by CBHS compete
with private practicing mental health professionals, publicly funded mental
health centers and partial hospitalization and other intensive outpatient
services programs and facilities. The competitive position of a hospital is, to
a significant degree, dependent upon the number and quality of physicians who
practice at the hospital and who are members of its medical staff. The Company
believes that CBHS competes effectively with respect to the aforementioned
factors. However, there can be no assurance that CBHS will be able to compete
successfully in the provider business in the future.
Competition among hospitals and other healthcare providers for patients has
intensified in recent years. During this period, hospital occupancy rates for
inpatient behavioral care patients in the United States have declined as a
result of cost containment pressures, changing technology, changes in
reimbursement, changes in practice patterns from inpatient to outpatient
treatment and other factors. In recent years, the competitive position of
hospitals has been affected by the ability of such hospitals to obtain contracts
with PPO's, HMO's and other managed care programs to provide inpatient and other
services. Such contracts normally involve a discount from the hospital's
established charges, but provide a base of patient referrals. These contracts
also frequently provide for pre-admission certification and for concurrent
length of stay reviews. The importance of obtaining contracts with HMO's, PPO's
and other managed care companies varies from market to market, depending on the
individual market strength of the managed care companies. In certain states,
certificate of need laws place limitations on
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CBHS's and its competitors' ability to build new hospitals and to expand
existing hospitals and services. As of September 30, 1997, the Company had joint
ventures, which are managed by CBHS, that operated three hospitals in two states
(Louisiana and New Mexico) and CBHS operated 34 hospitals in ten states
(Arizona, Arkansas, California, Colorado, Indiana, Kansas, Louisiana, Nevada,
Texas and Utah) that do not have certificate of need laws applicable to
hospitals.
REGULATION
The operation of psychiatric hospitals and other behavioral healthcare
facilities and the provision of behavioral healthcare services are subject to
extensive federal, state and local laws and regulations. These laws and
regulations provide for periodic inspections or other reviews by state agencies,
the Department and CHAMPUS to determine compliance with their respective
standards of medical care, staffing, equipment and cleanliness necessary for
continued licensing or participation in the Medicare, Medicaid or CHAMPUS
programs. The admission and treatment of patients at psychiatric hospitals is
also subject to substantial state regulation relating to involuntary admissions,
confidentiality of patient medical information, patients' rights and federal
regulation relating to confidentiality of medical records of substance abuse
patients. Although CBHS believes that its facilities are currently in compliance
with these federal, state, and local requirements, there can be no assurance
that all facilities will continuously be operated in full compliance with the
applicable requirements. The failure to obtain or renew any required regulatory
approvals, the failure to satisfy the requirements for continued participation
in the Medicare, Medicaid or CHAMPUS programs, or the failure to satisfy other
state and federal regulatory requirements relating to the operation of
psychiatric hospitals and other behavioral healthcare facilities and the
provision of behavioral healthcare services could have a material adverse effect
on the operations of CBHS.
A number of states have adopted hospital rate review legislation, which
generally provides for state regulation of rates charged for various hospital
services. Such laws are in effect in the State of Florida, in which CBHS
operates seven hospitals. In Florida, the Health Care Board approves a budget
for each hospital, which establishes a permitted level of revenues per
discharge. If this level of permitted revenues per discharge is exceeded by a
hospital in a particular year by more than a specified amount, certain
penalties, including cash penalties, can be imposed. Although the Company
believes that CBHS's facilities in Florida currently are in compliance with the
state hospital rate review laws, there can be no assurance that such facilities
will not be subject to penalties under the hospital rate review laws in the
future.
CBHS is also subject to state certificate of need laws that regulate the
construction of new hospitals and the expansion of existing hospital facilities
and services. These laws require that the approval of a state agency be obtained
prior to the construction of a new hospital or the expansion of the facilities
or services of an existing hospital. Such approvals may require a finding of
community need for the additional hospital facilities and services. In recent
years, many states have repealed certificate of need laws or limited the scope
of the facilities and services to which such certificate of need laws apply.
There can be no assurance that state certificate of need laws will not limit
CBHS's future expansion, or that increased competition as a result of the repeal
or limitation in scope of existing certificate of need laws will not have a
materially adverse effect on the existing operations of CBHS.
Federal law contains numerous provisions designed to insure that services
rendered by hospitals to Medicare and Medicaid patients are medically necessary
and are of a quality that meets professionally recognized standards, and to
insure that claims for reimbursement under the Medicare and Medicaid programs
are properly filed. Among other things, services provided at CBHS's psychiatric
hospitals are subject to periodic review by Peer Review Organizations ("PROs").
All hospitals which participate in the Medicare program are subject to review by
PROs. PRO activities include review of certain admissions and services to
determine medical necessity and to determine whether quality of care meets
professionally recognized standards. PROs have the authority to recommend to the
Department that a provider
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who is in substantial noncompliance with the medical necessity and quality of
care standards of a PRO or who has grossly and flagrantly violated an obligation
to render care be excluded from participation in the Medicare program or be
required to reimburse the federal government for certain payments previously
made to the provider under the Medicare program. The Company believes that
CBHS's facilities are in material compliance with the applicable medical
necessity and quality of care standards for Medicare and Medicaid patients,
however, there can be no assurance that all CBHS facilities will continuously
remain in material compliance with such standards.
CBHS is subject to federal and state laws that govern financial and other
arrangements between healthcare providers. Such laws include the illegal
remuneration provisions of the Social Security Act (the "Anti-Kickback Statute")
and the physician self-referral provisions of the Omnibus Budget Reconciliation
Act of 1993 ("Stark II").
The Anti-Kickback Statute prohibits, among other things, the offer, payment,
solicitation or receipt of any form of remuneration, in exchange for or which is
intended to induce the referral of patients for services that will be paid for
in whole or in part under any federal healthcare program, including Medicare and
Medicaid. A violation of the Anti-Kickback Statute is a felony, punishable by a
fine of up to $25,000, a term of imprisonment for up to five years, or both. In
addition, an individual or entity convicted of a violation of the Anti-Kickback
Statute may be subject to civil monetary penalties in an amount equal to $50,000
for each prohibited act, plus damages up to three times the total amount of
remuneration offered, paid, solicited or received, and may be subject to
exclusion from participation in any federal healthcare program.
In order to provide guidance with respect to the Anti-Kickback Statute,
Congress required the Department to issue regulations outlining business
arrangements that would not be subject to prosecution under the Anti-Kickback
Statute. These regulations include "safe harbors" for certain investment
interests, leases of space and equipment, personal service arrangements,
employment arrangements, personal services and management contracts, sale of
physician practices, discounts, and waiver of beneficiary copayments and
deductibles. Certain transactions and agreements of CBHS do not satisfy all of
the applicable criteria contained in the safe harbor regulations that relate to
such transactions and agreements. The Company believes that such transactions
and agreements do not violate the Anti-Kickback Statute; however, there can be
no assurance that (i) government enforcement agencies will not assert that
certain of these arrangements are in violation of the Anti-Kickback Statute, or
(ii) the Anti-Kickback Statute and safe harbor regulations will not ultimately
be interpreted by the courts in a manner inconsistent with CBHS's business
practices.
In 1989, Congress passed legislation, commonly referred to as the "Stark
Law," which prohibits physicians who have a financial relationship with entities
that furnish clinical laboratory services from referring patients to such
entities for Medicare-reimbursed clinical laboratory services and which
prohibits the entities for billing for services provided pursuant to such
prohibited referrals. The Stark Law, which contains a number of exceptions to
its general referral prohibition, became effective January 1, 1992. Proposed
regulations implementing the Stark Law were first issued in March 1992, however,
the final Stark regulations were issued on August 14, 1995.
In 1993, Congress passed legislation commonly referred to as "Stark II,"
which expanded the prohibitions of the Stark Law to include referrals from
physicians for a wide variety of designated health services, including
inpatient/outpatient hospital services, and extended the referral prohibition to
include services reimbursed under Medicaid. The limitations on referrals
outlined in Stark II became effective January 1, 1995. A violation of Stark II
may result in the imposition of civil monetary penalties of up to $15,000 for
each service billed in violation of the statute and exclusion from participation
in any federal healthcare program. Although the regulations implementing Stark
II have not been issued it is anticipated that they will be similar to the
original Stark regulations. The Company believes that the financial
relationships between CBHS's hospitals and physicians do not violate the Stark
Law and regulations.
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There can be no assurance however that (i) government enforcement agencies will
not contend that certain of these financial relationships are in violation of
the Stark legislation; (ii) that the Stark legislation will not ultimately be
interpreted by the courts in a manner inconsistent with CBHS's practices; or
(iii) regulations will be issued in the future that will result in an
interpretation of the Stark Law or Stark II that is inconsistent with CBHS's
practices.
CBHS is also subject to state illegal remuneration and self-referral
statutes and regulations that prohibit payments in exchange for referrals and
referrals by physicians or other healthcare providers to persons or entities
with which the physician or healthcare provider has a financial relationship.
These state statutes generally apply to services reimbursed under both
government programs and private health insurance plans. Violations of these laws
may result in payment not being made for the items or services rendered, loss of
the healthcare provider's license, fines, or criminal penalties. These statutes
and regulations vary widely from state to state, are often vague and, in many
states, have not been interpreted by courts or regulatory agencies. Although the
Company has no reason to believe that CBHS is in violation of any such state
statutes, there can be no assurance that CBHS's existing business arrangements
will not be subject to challenge under these types of laws in one or more
states.
The Medicare and Medicaid Patient and Program Protection Act of 1987
expanded the authority of the Department to exclude from participation in the
Medicare and Medicaid programs those individuals and entities that engage in
defined prohibited activities. The Department is required under this Act to
exclude from participation in the Medicare and Medicaid programs any individual
or entity that has been convicted of a criminal offense relating to the delivery
of services under Medicare and Medicaid or to the neglect or abuse of patients.
In addition, the Department may exclude from participation in the Medicare and
Medicaid programs individuals and entities under certain other circumstances.
These include engaging in illegal remuneration arrangements with physicians and
other healthcare providers, license revocation, exclusion from other government
programs (such as CHAMPUS), filing claims for excessive charges or for
unnecessary services, failure to comply with the Medicare conditions of
participation and failure to disclose certain required information or to grant
proper access to hospital books and records.
The Department's exclusion authority was recently expanded under HIPAA and
the Budget Act, which added additional grounds for exclusion, established
minimum exclusion periods for certain offenses, and expanded the scope of the
exclusion to include exclusion for all other federal and state healthcare
programs, other than the Federal Employees Health Benefit Program.
The Department also has the authority to impose civil monetary penalties for
certain listed prohibited activities, including filing claims that are false or
fraudulent or are for services that were not rendered as claimed. HIPAA
increased the amount of authorized penalties from $2,000 per item or service
claimed to $10,000 per item or service claimed and increased the assessment to
which a person may be subject in lieu of damages from two times the amount
claimed for each item or service to three times the amount claimed. Both HIPAA
and the Budget Act also expanded the Department's authority to impose civil
monetary penalties. Among other things, the new legislation prohibits the
knowing submission of a claim for reimbursement that will result in a greater
payment than is applicable to the item or service actually provided, and
prohibits submitting claims to Medicare or Medicaid for a pattern of medical or
other items or services that a person knows or should know are not medically
necessary. The legislation also prohibits offering any inducements to
beneficiaries in order to influence them to order or receive Medicare or
Medicaid covered items or services from a particular provider or practitioner.
Provisions contained in HIPAA and the Budget Act also created new criminal
healthcare fraud offenses that are applicable to both government programs and
private health insurance plans and added new programs and increased funding for
fraud and abuse detection and enforcement activities. The new offenses created
by HIPAA and the Budget Act, as well as the greater spending on healthcare fraud
and abuse enforcement which will result from this legislation, may significantly
increase the likelihood that any particular healthcare company will be
scrutinized by federal, state and/or local law
105
enforcement officials. In addition, the increased penalties will strengthen the
ability of enforcement agencies to effect more numerous and larger monetary
settlements with healthcare providers and businesses than was previously the
case. Although the Company believes that CBHS's billing practices are consistent
with the applicable Medicare and Medicaid requirements, those requirements are
often vague and subject to interpretation. The Company also believes that CBHS
is in compliance with the applicable federal laws described above, however,
there can be no assurance that aggressive anti-fraud enforcement activities will
not adversely affect the business of CBHS.
Finally, CHAMPUS regulations authorize CHAMPUS to exclude from the CHAMPUS
program any provider that has committed fraud or engaged in abusive practices.
The regulations permit CHAMPUS to make its own determination of abusive
practices without reliance on any actions of the Department. The term "abusive
practices" is defined broadly to include, among other things, the provision of
medically unnecessary services, the provision of care of inferior quality and
the failure to maintain adequate medical or financial records. Although the
Company believes that CBHS is in compliance with the applicable CHAMPUS
regulations, exclusion from the CHAMPUS program could have a material adverse
effect on the operations and financial condition of CBHS.
GENERAL AND PROFESSIONAL LIABILITY
CBHS maintains a general and hospital professional liability insurance
policy with an unaffiliated insurer. The policy is written on a "claims made or
circumstances reported" basis, subject to a $1.5 million retention limit per
occurrence and an aggregate retention limit of $8.8 million. The amount of
expense relating to CBHS's malpractice insurance is based on estimated ultimate
losses incurred during the year and may materially increase or decrease from
year to year depending, among other things, on the nature and number of new
reported claims against CBHS and amounts of settlements of previously reported
claims. To date, CBHS has not experienced a loss in excess of policy limits.
Management believes that its coverage limits are adequate. However, losses in
excess of the limits described above or for which insurance is otherwise
unavailable could have a material adverse effect upon the Company.
RISK FACTORS
The following factors are relevant to an understanding of the risks
associated with CBHS's business and the ability of CBHS to pay Franchise Fees to
the Company.
POTENTIAL REDUCTIONS IN REIMBURSEMENT BY THIRD-PARTY PAYORS AND CHANGES IN
HOSPITAL PAYOR MIX. CBHS's hospitals have been adversely affected by factors
influencing the entire psychiatric hospital industry. Such factors include: (i)
the imposition of more stringent length of stay and admission criteria and other
cost containment measures by payors; (ii) the failure of reimbursement rate
increases from certain payors that reimburse on a per diem or other discounted
basis to offset increases in the cost of providing services; (iii) an increase
in the percentage of business that CBHS derives from payors that reimburse on a
per diem or other discounted basis; (iv) a trend toward higher deductibles and
co-insurance for individual patients; (v) a trend toward limiting employee
behavorial health benefits, such as reductions in annual and lifetime limits on
behavioral health coverage; and (vi) pricing pressure related to an increasing
rate of claims denials by third party payors. Any of these factors may result in
reductions in the amounts that CBHS's hospitals can expect to collect per
patient day for services provided or the number of equivalent patient days.
For the fiscal year ended September 30, 1997, CBHS derived approximately 24%
of its gross psychiatric patient service revenue from managed care organizations
(primarily HMOs and PPOs), 22% from other private payors (primarily commercial
insurance and Blue Cross), 27% from Medicare, 18% from Medicaid, 2% from CHAMPUS
and 7% from other government programs. Changes in the mix of CBHS's patients
among the private-pay, Medicare and Medicaid categories, and among different
types
106
of private-pay sources, could significantly affect the profitability of CBHS's
hospital operations. Moreover, there can be no assurance that payments under
governmental and private third-party payor programs will remain at levels
comparable to present levels or will, in the future, be sufficient to cover the
costs of providing care to patients covered by such programs.
GOVERNMENTAL BUDGETARY CONSTRAINTS AND HEALTHCARE REFORM. In the 1995 and
1996 sessions of the United States Congress, the focus of healthcare legislation
was on budgetary and related funding mechanism issues. Both the Congress and the
Clinton Administration have made proposals to reduce the rate of increase in
projected Medicare and Medicaid expenditures and to change funding mechanisms
and other aspects of both programs. The Budget Act, which was signed into law by
President Clinton in August 1997, reduces federal spending by an estimated $140
billion. The majority of the spending reduction will come from Medicare cuts of
$115.0 billion. The Congressional Budget Office projected in July 1997 that
$43.8 billion of the reductions would come from reduced payments to hospitals,
$21.8 billion from increased enrollment in managed care plans and $11.7 billion
from reduced payments to physicians and ambulatory care providers. The five-year
savings in projected Medicare payments to physicians and hospitals would be
achieved under the Budget Act by reduced fee-for-service reimbursement and by
changes in managed care programs designed to increase enrollment of Medicare
beneficiaries in managed care plans. The increase in Medicare enrollment in
managed care plans would be achieved in part by allowing provider-sponsored
organizations and preferred provider organizations to compete with Medicare HMOs
for Medicare enrollees.
The Medicaid-related provisions of the Budget Act are designed to achieve
net federal Medicaid savings of $14.6 billion over the next five years and $56.4
billion over the next ten years. The Budget Act achieves Federal Medicaid
savings in three areas. First, two-thirds of the savings over the next ten years
are attributable to limitations on federal matching payments to states for
reimbursements to "disproportionate share" hospitals. The next largest source of
federal savings is a provision allowing states to shift the cost of Medicaid
deductibles and coinsurance requirements for low-income Medicaid beneficiaries
from their Medicaid programs to physicians and other providers. Most of the
remaining savings derive from the repeal of the "Boren Amendment" and other
minimum payment guarantees for hospitals, nursing homes and community health
centers that service Medicaid patients.
CBHS management estimates that the Budget Act will reduce the amount of
revenue and earnings that CBHS will receive for the treatment of Medicare and
Medicaid patients. CBHS management estimates that such reductions will
approximate $10.0 million in fiscal 1998, and due to the phase in effects of the
bill, approximately $15.0 million in subsequent fiscal years.
A number of states in which CBHS has operations have either adopted or are
considering the adoption of healthcare reform proposals of general applicability
or Medicaid reform proposals. Where adopted, these state reform laws have often
not yet been fully implemented. The Company cannot predict the effect of these
state healthcare reform proposals on CBHS's operations. The Company cannot
predict the effect of other healthcare reform measures that may be adopted by
Congress on the operations of CBHS and no assurance can be given that other
federal healthcare reform measures will not have an adverse effect on CBHS.
DEPENDENCE ON HEALTHCARE PROFESSIONALS. Physicians traditionally have been
the source of a significant portion of the patients treated at CBHS's hospitals.
Therefore, the success of CBHS's hospitals is dependent in part on the number
and quality of the physicians on the medical staffs of the hospitals and their
admission practices. A small number of physicians account for a significant
portion of patient admissions at some of CBHS's hospitals. There can be no
assurance that CBHS can retain its current physicians on staff or that
additional physician relationships will be developed in the future. Furthermore,
hospital physicians generally are not employees of CBHS and, in general, CBHS
does not have contractual arrangements with hospital physicians restricting the
ability of such physicians to practice elsewhere.
107
POTENTIAL GENERAL AND PROFESSIONAL LIABILITY. In recent years, physicians,
hospitals, and other healthcare professionals and providers have become subject
to an increasing number of lawsuits alleging medical malpractice and related
legal theories. Many of these lawsuits involve large claims and substantial
defense costs. CBHS maintains a general and hospital professional liability
insurance policy with an unaffiliated insurer. In addition, CBHS' hospitals
require all physicians on each hospital's medical staff to maintain professional
liability coverage. Management believes that its coverage limits are adequate,
however, there can be no assurance that a future claim or claims will not exceed
the limits of these existing insurance policies or that a loss or losses for
which insurance is unavailable will not have a material adverse effect on CBHS.
GOVERNMENT REGULATION. The operation of psychiatric hospitals and other
behavioral healthcare facilities and the provision of behavioral healthcare
services are subject to extensive federal, state and local laws and regulations.
These laws and regulations provide for periodic inspections or other reviews by
state agencies, the Department and CHAMPUS to determine compliance with their
respective standards of medical care, staffing, equipment and cleanliness
necessary for continued licensing or participation in the Medicare, Medicaid or
CHAMPUS programs. The admission and treatment of patients at psychiatric
hospitals is also subject to substantial state regulation relating to
involuntary admissions, confidentiality of patient medical information,
patients' rights and federal regulation relating to confidentiality of medical
records of substance abuse patients. CBHS is also subject to state certificate
of need laws that regulate the construction of new hospitals and the expansion
of existing hospital facilities and services.
CBHS also is subject to federal and state laws that govern financial and
other arrangements between healthcare providers. Such laws include the
Anti-Kickback Statute, Stark II and state illegal remuneration and self-referral
statutes and regulations that prohibit payments in exchange for referrals and
referrals by physicians or other healthcare providers to persons or entities
with which the physician or other healthcare provider has a financial
relationship.
The Medicare and Medicaid Patient and Program Protection Act of 1987
expanded the authority of the Department to exclude from participation in the
Medicare and Medicaid programs those individuals and entities that engage in
defined prohibited activities. The Department's exclusion authority was recently
expanded under HIPAA and the Budget Act, which added additional grounds for
exclusion, established minimum exclusion periods for certain offenses and
expanded the scope of the exclusion to include all federal health care programs.
The Department also has the authority to impose civil monetary penalties for
certain prohibited activities. HIPAA increased the amount of authorized
penalties from $2,000 per item or service claimed to $10,000 per item or service
claimed, and increased the assessment to which a person may be subject in lieu
of damages from two times the amount claimed for each item or service to three
times the amount claimed. Both HIPAA and the Budget Act expanded the
Department's authority to impose civil monetary penalties by adding additional
activities for which civil monetary penalties may be imposed.
Provisions contained in HIPAA and the Budget Act also created new criminal
healthcare fraud offenses that are applicable to both government programs and
private health insurance plans and added new programs and increased funding for
fraud and abuse detection and prevention.
CHAMPUS regulations also authorize the exclusion of providers from the
CHAMPUS program, if the provider has committed fraud or engaged in certain
"abusive practices," which are defined broadly to include, among other things,
the provision of medically unnecessary services, the provision of care of
inferior quality and the failure to maintain adequate medical or financial
records.
State regulatory agencies responsible for the administration and enforcement
of the laws and regulations to which CBHS' operations are subject have broad
discretionary powers. A regulatory agency or a court in a state in which CBHS
operates could take a position under existing or future laws or regulations, or
change its interpretation or enforcement practices with respect thereto, that
such laws or
108
regulations apply to CBHS differently than CBHS believes such laws and
regulations apply or should be enforced. The resultant compliance with, or
revocation of, or failure to obtain, required licences and governmental
approvals could result in significant alteration to CBHS' business operations,
delays in the expansion of CBHS' business and lost business opportunities, any
of which, under certain circumstances, could have a material adverse effect on
CBHS. See "--Regulation."
INTELLECTUAL PROPERTY
The Company owns certain intellectual property which is important to its
franchise operation. The Company has registered as trademarks both the "CHARTER"
name and "800-CHARTER." The Company also owns the "Charter System," which is a
system for the operation of businesses specializing in the delivery of
behavioral healthcare under the "CHARTER" names and marks. The Charter System
includes treatment programs and procedures, quality standards, quality
assessment methods, performance improvement and monitoring programs, advertising
and marketing assistance, promotional materials, consultation and other matters
related to the operation of businesses specializing in the delivery of
behavioral healthcare.
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PENDING SALE OF PROVIDER BUSINESS
OVERVIEW
On March 3, 1998, the Company entered into the Equity Purchase Agreement,
pursuant to which it agreed to sell to COI the Company's common and preferred
equity interest in CBHS. In addition, the Company and certain of its
wholly-owned subsidiaries entered into the Purchase Agreement, pursuant to which
the Company and such subsidiaries agreed to sell to CBHS: (i) Charter Advantage,
the entity that conducts the Company's franchise operations; (ii) Charter
System, LLC, which owns the intellectual property comprising the "CHARTER"
system of behavioral healthcare; (iii) GPA, the Company's physician practice
management business; (iv) certain behavioral staff model operations; (v) the
Company's Puerto Rican provider management business; (vi) Golden Isle, one of
the Company's captive insurance companies; and (vii) Strategic Advantage, which
owns certain intellectual property used by the Company to monitor clinical
results. The Company and COI also entered into the Support Agreement which,
among other things, obligates COI to provide CBHS assistance to obtain financing
for its payment obligation under the Purchase Agreement. The following summary
of certain provisions of the Equity Purchase Agreement, the Purchase Agreement
and the Support Agreement does not purport to be complete and is qualified in
its entirety by reference to the copies of such documents filed as exhibits to
the Registration Statement of which this Prospectus is a part. The obligations
of CBHS and the Company to consummate the transactions contemplated by the
Purchase Agreement are also subject to, among other things, the execution of
either (i) a Joint Venture Purchase Agreement pursuant to which the Company will
sell to CBHS, for no additional consideration, its interest in the Joint
Ventures or (ii) amendments to the services agreement between the Company and
certain subsidiaries of CBHS relating to the Joint Ventures pursuant to which
the Company will transfer to CBHS all rights to receive certain distributions
with respect to the Joint Ventures and pursuant to which CBHS would assume all
obligations of the Company with respect to the Joint Ventures arising after
consummation of the CBHS Transactions.
Upon consummation of the CBHS Transactions, the Company will receive $280.0
million in cash, pursuant to the Purchase Agreement and, pursuant to the Equity
Purchase Agreement, the number of shares of COI Common Stock obtained by
dividing $30.0 million by the average closing price of a share of COI Common
Stock for the ten trading days preceding consummation of the CBHS Transactions.
The Company expects to use the cash proceeds, after transaction costs of
approximately $8.0 million, to repay indebtedness outstanding under the Term
Loan Facility. The CBHS Transactions are expected to close in the third quarter
of fiscal 1998. There can be no assurance that the Company will consummate the
CBHS Transactions.
The obligations of the Company and CBHS to consummate the transactions
contemplated by the Equity Purchase Agreement and the Support Agreement are
conditioned upon the execution and delivery of the Services Purchase Agreement.
It is expected that the Services Purchase Agreement would obligate the Company
to purchase from CBHS a designated minimum amount of behavioral healthcare
services for gate-kept risk-based covered lives if it meets certain standards
required of it pursuant to the Provider Services Agreement. If the CBHS
Transactions are consummated, the Company also expects to enter into the
Provider Services Agreement with CBHS, pursuant to which the Company would grant
CBHS status as a national preferred provider of behavioral healthcare services
to the Company for ten years provided that CBHS complies during the term of the
Provider Services Agreement with enhanced clinical, quality assurance, reporting
and customer service standards in addition to the standards currently required
of other providers of such services to the Company. See "-- Description of the
Definitive Agreements."
110
DESCRIPTION OF THE DEFINITIVE AGREEMENTS
THE EQUITY PURCHASE AGREEMENT. The Company has agreed, pursuant to the
Equity Purchase Agreement, to sell to COI the Company's common and preferred
equity interest in CBHS for the number of shares of COI common stock obtained by
dividing $30.0 million by the average closing price of a share of COI common
stock for the ten trading days preceding consummation of the CBHS Transactions.
The obligation of COI to consummate the transactions contemplated by the Equity
Purchase Agreement is conditioned, among other things, upon the consummation of
the transactions contemplated by the Purchase Agreement. The obligations of COI
and the Company to consummate the transactions contemplated by the Equity
Purchase Agreement are also subject to, among other things, the interim final
rule relating to the existing statutory shared risk safe harbor of the
Anti-Kickback Statute shall have become effective (the "Final Rule"). If the
Final Rule becomes effective in the form proposed on the date of execution of
the Equity Purchase Agreement, the obligations of COI and the Company to
consummate the transactions contemplated by the Equity Purchase Agreement are
also subject to execution and delivery of the Services Purchase Agreement
substantially in the form agreed to by the parties. If the Final Rule does not
become effective in the form proposed on the date of execution of the Equity
Purchase Agreement, it is a condition of the obligation of COI and the Company
to consummate the transactions contemplated by the Equity Purchase Agreement
that the Company and CBHS shall have executed the Services Purchase Agreement in
a form that complies with the Final Rule without any material loss of the
proposed benefits to be provided to the parties under the Services Purchase
Agreement.
THE PURCHASE AGREEMENT. The Company and certain of its wholly-owned
subsidiaries have agreed, pursuant to a Purchase Agreement, to sell to CBHS: (i)
Charter Advantage; (ii) Charter System, LLC; (iii) GPA; (iv) certain behavioral
staff model operations; (v) the Company's Puerto Rican provider management
business; (vi) Golden Isle and (vii) Strategic Advantage. The Purchase Agreement
also grants CBHS the right to purchase any or all of certain staff model
operations of Merit for no additional consideration. The obligation of CBHS to
consummate the transactions contemplated by the Purchase Agreement is
conditioned, among other things, upon the occurrence of the following: (i)
consummation of the transactions contemplated by the Equity Purchase Agreement
and (ii) consummation by CBHS of financing arrangements sufficient to permit it
to consummate the transactions contemplated by the Purchase Agreement. The
obligations of CBHS and the Company to consummate the transactions contemplated
by the Purchase Agreement are also subject to, among other things, the execution
of either (i) a Joint Venture Purchase Agreement pursuant to which the Company
will sell to CBHS, for no additional consideration, its interest in the Joint
Ventures or (ii) amendments to the services agreement between the Company and
certain subsidiaries of CBHS relating to the Joint Ventures pursuant to which
the Company will transfer to CBHS all rights to receive certain distributions
with respect to the Joint Ventures and pursuant to which CBHS would assume all
obligations of the Company with respect to the Joint Ventures arising after
consummation of the CBHS Transactions.
Pursuant to the Purchase Agreement, CBHS will be obligated to repay to the
Company, within 180 days after the consummation of the CBHS Transactions, all
amounts owed under any working capital loan and other loans, advances and
prepaid items from the Company existing on the date of the execution of the
Purchase Agreement and thereafter made by the Company. The Purchase Agreement
also provides that the Company and CBHS will execute an amendment to the Master
Franchise Agreement upon the closing of the Purchase Agreement which will reduce
the Franchise Fees from the current amount of approximately $6.5 million per
month to $5.0 million per month from February 1, 1998 until the closing of the
Purchase Agreement. If, however, the transactions contemplated by the Purchase
Agreement are not consummated, CBHS will be obligated to pay the full amount of
the Franchise Fees during the period between February 1, 1998 and the
termination of the Purchase Agreement. Any amount of accrued and unpaid
Franchise Fees on the date of the execution of the Purchase Agreement and the
amount of the Franchise Fees accrued but not paid following the execution of the
Purchase
111
Agreement must be paid by CBHS no later than 180 days following the consummation
of the CBHS Transactions.
THE SUPPORT AGREEMENT. The Company and COI also entered into the Support
Agreement. Pursuant to the Support Agreement, COI agreed to cooperate with and
provide assistance to CBHS in the preparation of any offering documents or other
material required in connection with CBHS's efforts to obtain financing for its
payment obligation under the Purchase Agreement. COI further agreed to reimburse
CBHS for all expenses incurred in connection with obtaining such financing,
whether or not the CBHS Transactions are consummated. In addition, COI agreed to
purchase up to $25.0 million of CBHS securities if necessary to permit CBHS to
obtain the required financing. Pursuant to the Support Agreement, the Company
agreed to cooperate with CBHS in obtaining the financing by providing any
information required in connection with the financing.
The Support Agreement also provides that if, as a result of the failure of
CBHS to obtain sufficient financing for its payment obligations under the
Purchase Agreement, the transactions contemplated by the Purchase Agreement are
not consummated or the Purchase Agreement is terminated, then COI will pay the
Company the Termination Fee which is comprised of $2.5 million in cash and the
number of shares of COI Common Stock obtained by dividing $2.5 million by the
average closing price of a share of COI Common Stock for the five trading days
prior to the date of termination of the Purchase Agreement and for the five
trading days after the termination of the Purchase Agreement. COI shall not be
obligated to pay the Termination Fee until the later to occur of (i) 30 days
after the date of the execution of the Support Agreement or (ii) the date on
which the Company and CBHS agree on a schedule defining CBHS's obligation to
open additional psychiatric facilities and implement services at such
facilities. Furthermore, COI may terminate either the Equity Purchase Agreement
or the Support Agreement for any reason within 30 days of the signing of the
agreements without incurring the Termination Fee.
All of COI's obligations under the Support Agreement described above are
also subject to the Final Rule becoming effective. If the Final Rule becomes
effective in the form proposed on the date of execution of the Support
Agreement, COI's obligations under the Support Agreement are also subject to
execution and delivery of the Services Purchase Agreement substantially in the
form agreed to by the parties. If the Final Rule does not become effective in
the form proposed on the date of the Support Agreement, it is a condition of
COI's obligations under the Support Agreement that the Company and CBHS shall
have executed the Services Purchase Agreement in a form that complies with the
Final Rule without any material loss of the proposed benefits to be provided
under the Services Purchase Agreement.
THE SERVICES PURCHASE AGREEMENT. The obligations of the Company and CBHS to
consumate the transactions contemplated by the Equity Purchase Agreement and the
Support Agreement are conditioned upon the execution and delivery of the
Services Purchase Agreement upon consummation of the CBHS Transactions. The
Company now contemplates that, pursuant to the Services Purchase Agreement, CBHS
would agree to comply with certain standards required of it pursuant to the
Provider Services Agreement to maintain existing inpatient facilities and
service capabilities and to develop and implement (i) a buildout of outpatient
facilities within a 20-mile radius of certain existing CBHS facilities providing
inpatient services and (ii) a comprehensive, nationwide buildout of additional
services and facilities to service the Company's gate-kept risk-based covered
lives. In exchange, the Company would agree to purchase a designated amount of
behavioral healthcare services for the Company's gate-kept risk-based covered
lives from CBHS and the entities managed by CBHS (collectively, the "CBHS
Entities") for the five year term of the Services Purchase Agreement.
The Services Purchase Agreement would obligate the Company to purchase
during each year of the term of the agreement not less than $18 million of
inpatient services (the "Designated Inpatient Amount") and not less than $20
million of outpatient services, each subject to certain reductions under certain
circumstances (the "Designated Outpatient Amount," and together with the
Designated Inpatient
112
Amount, the "Designated Amounts"). A liason committee made up of representatives
of the Company and CBHS (the "Committee") would adjust the Designated Amounts,
either up or down, subject to certain minimum Designated Amounts to be mutually
agreed on by the parties. The Committee would make the following adjustments to
the Designated Amounts, as applicable: (i) an upward adjustment due to the CBHS
Entities' build out of additional services and facilities, (ii) a downward
adjustment due to CBHS Facilities (as defined) being closed or (iii) a downward
adjustment due to reductions in the number of the Company's risk based lives due
to expired or terminated customer contracts.
To the extent that the Company purchases less than the Designated Amounts
during any of the years of the term of the Services Purchase Agreement, (each
year a "Contract Year") the Company is required to pay service fees to CBHS as
calculated by the Committee pursuant to a formula to be set forth in the
Services Purchase Agreement ("Service Fees"). The maximum potential Service Fees
payable to CBHS by the Company for the five-year term of the Service Purchase
Agreement is expected to be approximately $59.4 million, assuming no changes to
the Designated Amounts. To determine the amount of the Service Fees, the
Committee will first determine the Purchased Inpatient and Purchased Outpatient
Amounts (collectively, the "Purchased Amounts") by adding (i) the amount of
certain defined inpatient and outpatient services, respectively, which the
Company refers to CBHS Entities but which the CBHS Entities do not actually
provide to (ii) the amounts of inpatient and outpatient services actually
purchased by the Company.
Next, the Committee will determine the amounts of shortfalls and/or excess
purchases made by the Company based on the Purchased Amounts as compared to the
Designated Amounts. If the Purchased Inpatient Amount is less than the
Designated Inpatient Amount, then there is deemed to be an Inpatient Shortfall
which is equal to 33% of the difference between the Purchased Inpatient Amount
and the Designated Inpatient Amount. Likewise, if the Purchased Outpatient
Amount is less than the Designated Outpatient Amount, then there is deemed to be
an Outpatient Shortfall which is equal to 17% of the difference in the Purchased
Outpatient Amount and the Designated Outpatient Amount. On the other hand, if
either of the Purchased Amounts exceeds its respective Designated Amount, then
there is an Excess Purchase. If the Purchased Inpatient Amount exceeds the
Designated Inpatient Amount, then the Inpatient Excess Purchase is equal to 33%
of the difference in the Purchased Inpatient Amount and the Designated Inpatient
Amount. Similarly, if the Purchased Outpatient Amount exceeds the Designated
Outpatient Amount, then the Outpatient Excess Purchase is equal to 17% of the
difference in the Purchased Outpatient Amount and the Designated Outpatient
Amount. The resulting Inpatient Shortfall or Inpatient Excess Purchase and
Outpatient Shortfall or Outpatient Excess Purchase will then be netted against
one another to determine the Net Shortfall or Net Excess Purchase.
In the event of a Net Excess Purchase, no Services Fees are due and 50% of
the Net Excess Purchase (the "Carryforward Amount") will be carried forward to
reduce any Net Shortfall in future years. In the event of a Net Shortfall, the
Committee will determine the Final Shortfall by subtracting the Carryforward
Amount from previous years, if any, from the Net Shortfall. The Final Shortfall,
if any, will then be divided into a Final Inpatient Shortfall and Final
Outpatient Shortfall by reducing the Inpatient and/or Outpatient Shortfalls by
the Carryforward Amount allocated on a pro rata basis in percentages equal to
the proportions in which the Inpatient and Outpatient Shortfalls comprise the
Net Shortfall. The Service Fee is then calculated by multiplying the Final
Inpatient and Outpatient Shortfalls by the appropriate factors for each Contract
Year, as set forth below:
CONTRACT YEAR OUTPATIENT SHORTFALL FACTORS INPATIENT SHORTFALL FACTORS
- --------------------------------------------------------- ----------------------------- ---------------------------
First.................................................... 1 50/33
Second................................................... 50/17 50/33
Third.................................................... 1 1
Fourth................................................... 1 1
Fifth.................................................... 1 1
113
THE PROVIDER SERVICES AGREEMENT. The Company and CBHS expect to enter into
a Provider Services Agreement upon the consummation of the CBHS Transactions.
The Company will grant "national preferred provider" status to CBHS and the
entities managed by CBHS (collectively, the "CBHS Entities") for a period of ten
years, pursuant to the Provider Services Agreement. The Provider Services
Agreement would replace, amend or supercede all existing provider agreements
between the Company and the CBHS Entities. If one of the CBHS Entities'
facilities ("CBHS Facilities") is qualified to provide behavioral health
services required by an individual patient and if permitted by the patient's
benefit agreement, the Company's customer and applicable law, a CBHS Facility
meeting the patient's needs will be the first provider recommended by the
Company to a patient at the time the patient is provided with a list of
potential providers. Pursuant to the Provider Services Agreement, in order to
retain their national preferred provider status, the CBHS Entities are required
to: (i) provide services to the Company and its customers at market rates
comparable to those charged by comparable facilities in the geographic area of a
particular facility; (ii) comply with terms and conditions for participation in
the provider networks of the Company and its customers; (iii) have available
certain required behavioral health services at each of the CBHS Facilities, (iv)
have facilities geographically located such that they are accessable to patients
within the Company's provider networks; (v) comply with certain service
standards and requirements of the Company and its customers; and (vi) comply
with enhanced clinical, quality assurance, reporting and customer service
standards in addition to the standards currently required of other providers of
such services to the Company which will be mutually agreed on by the Company and
CBHS. The Provider Services Agreement would also standardize the provider
arrangements between the Company and CBHS to include additional representations,
covenants and agreements customarily present in contracts with similar providers
of behavioral healthcare.
IMPACT ON THE COMPANY
REDUCTION IN NUMBER OF COVERED LIVES. Consummation of the CBHS Transactions
will result in a reduction in the number of covered lives in the Company's
behavioral managed care products by the approximately 1.1 million lives enrolled
in behavioral managed care products offered by GPA. The following table sets
forth, on a pro forma basis after giving effect to the CBHS Transactions, the
approximate number of covered lives as of December 31, 1997 and revenue for
fiscal 1997 for each type of managed behavioral healthcare program offered by
the Company:
PROGRAMS COVERED LIVES PERCENT REVENUE PERCENT
- ----------------------------------------------------------- ----------------- ----------- ---------- -----------
(IN MILLIONS, EXCEPT PERCENTAGES)
Risk-Based Products........................................ 17.2 30.1% $ 795.1 72.7%
EAPs....................................................... 10.5 18.4 99.7 9.1
Integrated Products........................................ 3.1 5.4 54.2 5.0
ASO Products............................................... 23.0 40.2 131.1 11.9
Other...................................................... 3.4 5.9 14.2 1.3
----- ----------- ---------- -----------
Total.................................................. 57.2 100.0% $ 1,094.3 100.0%
----- ----------- ---------- -----------
----- ----------- ---------- -----------
114
The following table sets forth, on a pro forma basis after giving effect to
the CBHS Transactions, the approximate number of covered lives as of December
31, 1997, and revenue for fiscal 1997 in each of the Company's market segments
described below:
MARKET COVERED LIVES PERCENT REVENUE PERCENT
- ------------------------------------------------------------ ----------------- ----------- --------- -----------
(IN MILLIONS, EXCEPT PERCENTAGES)
Corporations and Labor Unions............................... 20.6 36.1% $ 193.2 17.7%
HMOs........................................................ 7.6 13.3 226.4 20.7
Blue Cross/Blue Shield and Insurance Companies.............. 18.4 32.1 311.0 28.4
Medicaid Programs........................................... 2.5 4.4 265.4 24.3
Governmental Agencies (including CHAMPUS)................... 4.7 8.2 84.7 7.7
Other....................................................... 3.4 5.9 13.6 1.2
--- ----- --------- -----
Total................................................... 57.2 100.0% $ 1,094.3 100.0%
--- ----- --------- -----
--- ----- --------- -----
REDUCTION IN INDEBTEDNESS. If the CBHS Transactions are consummated, the
Company will use the estimated net proceeds of $272.0 million received from the
CBHS Transactions to reduce indebtedness outstanding under the Term Loan
Facility. The following table sets forth the capitalization of the Company on a
pro forma basis, before and after giving effect to the consummation of the CBHS
Transactions, at December 31, 1997. The information in this table should be read
in conjunction with "Unaudited Pro Forma Consolidated Financial Information,"
"The Transactions," "--Unaudited Pro Forma Consolidated Financial
Information--CBHS Transactions" and the financial statements and notes thereto
appearing elsewhere in this Prospectus.
DECEMBER 31, 1997
----------------------------------
BEFORE THE CBHS AFTER THE CBHS
TRANSACTIONS TRANSACTIONS
----------------- ---------------
(DOLLARS IN THOUSANDS)
Cash and cash equivalents(1)............................... $ 160,609 $ 128,393
----------------- ---------------
----------------- ---------------
Total debt (including current maturities):
New Credit Agreement:
Revolving Facility(2).................................. $ 20,000 $ 20,000
Term Loan Facility(3).................................. 550,000 278,000
New Notes................................................ 625,000 625,000
Other(4)................................................. 20,154 19,494
----------------- ---------------
Total debt............................................. 1,215,154 942,494
Stockholders' equity(5).................................. 179,033 278,619
----------------- ---------------
Total capitalization................................... $ 1,394,187 $ 1,221,113
----------------- ---------------
----------------- ---------------
-------------------------------
(1) Includes restricted cash of $52.1 million. See "Risk Factors--Risk
Based Products" and "Merit's Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital
Resources."
(2) The Revolving Facility provides for borrowings of up to $150.0
million. As of February 12, 1998, the Company had $112.5 million
available under the Revolving Facility, excluding approximately $17.5
million of availability reserved for certain letters of credit.
(3) The Term Loan Facility consists of: (i) a 6 year Tranche A Term Loan;
(ii) a 7 year Tranche B Term Loan; and (iii) an 8 year Tranche C Term
Loan each in an aggregate principal amount of $183.3 million. If the
CBHS Transactions are consummated, the net proceeds of an estimated
$272.0 million will be used to repay approximately $90.7 million of
each tranche of the Term Loan Facility.
(4) Other debt consists primarily of: (i) $7.6 million of mortgages and
other notes payable through 1999, bearing interest at 6.8% to 8.0%;
(ii) $6.1 million of 7.5% Swiss Bonds due 2001, which were redeemed in
March, 1998; and (iii) $6.4 million in 3.95% capital lease obligations
due in 2014.
(5) Represents the pro forma book value of the Company's stockholders'
equity. The Company's Common Stock is publicly traded on The New York
Stock Exchange. As of March 31, 1998 the market value of the Company's
Common Stock was approximately $818.7 million.
115
UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION--CBHS TRANSACTIONS
The Unaudited Pro Forma Consolidated Financial Information--CBHS
Transactions is based on the pro forma presentation included in Unaudited Pro
Forma Consolidated Financial Information appearing elsewhere herein. The
Unaudited Pro Forma Consolidated Statements of Operations--CBHS Transactions for
the year ended September 30, 1997 and the three months ended December 31, 1997
give effect to the CBHS Transactions as if they had been consummated on October
1, 1996. The Unaudited Pro Forma Consolidated Balance Sheet--CBHS Transactions
as of December 31, 1997 gives effect to the CBHS Transactions as if they had
been consummated on December 31, 1997. "Pro Forma Combined" in the Unaudited Pro
Forma Consolidated Statements of Operations--CBHS Transactions and Unaudited Pro
Forma Consolidated Balance Sheet--CBHS Transactions gives effect to all the
transactions described in "Unaudited Pro Forma Consolidated Financial
Information."
The Unaudited Pro Forma Consolidated Financial Information--CBHS
Transactions does not purport to be indicative of the results that actually
would have been obtained if the operations had been conducted as presented and
they are not necessarily indicative of operating results to be expected in
future periods. The Unaudited Pro Forma Consolidated Financial Information--CBHS
Transactions and notes thereto should be read in conjunction with the historical
consolidated financial statements and notes thereto of Magellan, Merit, CBHS and
HAI, which appear elsewhere herein, the Unaudited Pro Forma Consolidated
Financial Information which appear elsewhere herein and Management's Discussion
and Analysis of Financial Condition and Results of Operations of Magellan and
Merit, which appear elsewhere herein.
116
UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS--CBHS TRANSACTIONS
FOR THE YEAR ENDED SEPTEMBER 30, 1997
(IN THOUSANDS, EXCEPT RATIOS AND PER SHARE DATA)
DIVESTED
PRO FORMA OPERATIONS--CBHS PRO FORMA PRO FORMA
COMBINED TRANSACTIONS(1) ADJUSTMENTS CONSOLIDATED
------------- ------------------- ------------- -------------
Net revenue......................... $ 1,601,606 $ (138,684) $ (55,463)(2) $ 1,407,459
------------- ---------- ------------- -------------
Salaries, cost of care and other
operating expenses................ 1,355,098 (101,096) (16,064)(3) 1,237,938
Bad debt expense.................... 3,491 (4,115) 0 (624)
Depreciation and amortization....... 68,962 (4,131) 0 64,831
Interest, net....................... 96,389 1,042 (22,032)(4) 75,399
Stock option expense................ 4,292 0 0 4,292
Equity in loss of CBHS.............. 20,150 0 (20,150)(5) 0
Unusual items....................... (943) 0 0 (943)
------------- ---------- ------------- -------------
1,547,439 (108,300) (58,246) 1,380,893
------------- ---------- ------------- -------------
Income (loss) before income taxes
and minority interest............. 54,167 (30,384) 2,783 26,566
Provision for (benefit from) income
taxes............................. 30,033 (12,154) 1,113(6) 18,992
------------- ---------- ------------- -------------
Income (loss) before minority
interest.......................... 24,134 (18,230) 1,670 7,574
Minority interest................... 2,267 (2,400) 0 (133)
------------- ---------- ------------- -------------
Net income (loss)................... $ 21,867 $ (15,830) $ 1,670 $ 7,707
------------- ---------- ------------- -------------
------------- ---------- ------------- -------------
Average number of common shares
outstanding--basic................ 31,613 31,613
------------- -------------
------------- -------------
Average number of common shares
outstanding--diluted.............. 32,306 32,306
------------- -------------
------------- -------------
Net income per common share--basic.. $ 0.69 $ 0.24
------------- -------------
------------- -------------
Net income per common share--
diluted........................... $ 0.68 $ 0.24
------------- -------------
------------- -------------
Ratio of earnings to fixed
charges........................... 1.38 1.26
------------- -------------
------------- -------------
See Notes to Unaudited Pro Forma Consolidated Statements of Operations--CBHS
Transactions
117
UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE THREE MONTHS ENDED DECEMBER 31, 1997
(IN THOUSANDS, EXCEPT RATIOS AND PER SHARE DATA)
DIVESTED
PRO FORMA OPERATIONS--CBHS PRO FORMA PRO FORMA
COMBINED TRANSACTIONS ADJUSTMENTS CONSOLIDATED
----------- ------------------- ------------- -------------
Net revenue........................... $ 443,293 $ (49,150) $ 0 $ 394,143
----------- ---------- ------------- -------------
Salaries, cost of care and other
operating expenses.................. 382,704 (29,361) 0 353,343
Bad debt expense...................... 1,070 (1,020) 0 50
Depreciation and amortization......... 17,470 (1,076) 0 16,394
Interest, net......................... 24,685 299 (5,610)(4) 19,374
Stock option expense (credit)......... (3,959) 0 0 (3,959)
Equity in loss of CBHS................ 11,488 0 (11,488)(5) 0
----------- ---------- ------------- -------------
433,458 (31,158) (17,098) 385,202
----------- ---------- ------------- -------------
Income (loss) before income taxes and
minority interest................... 9,835 (17,992) 17,098 8,941
Provision for (benefit from) income
taxes............................... 6,202 (7,197) 6,839(6) 5,844
----------- ---------- ------------- -------------
Income (loss) before minority
interest............................ 3,633 (10,795) 10,259 3,097
Minority interest..................... 518 (517) 0 1
----------- ---------- ------------- -------------
Net income (loss)..................... $ 3,115 $ (10,278) $ 10,259 $ 3,096
----------- ---------- ------------- -------------
----------- ---------- ------------- -------------
Average number of common shares
outstanding--basic.................. 31,801 31,801
----------- -------------
----------- -------------
Average number of common shares
outstanding--diluted................ 32,616 32,616
----------- -------------
----------- -------------
Net income per common share--basic.... $ 0.10 $ 0.10
----------- -------------
----------- -------------
Net income per common share--diluted.. $ 0.10 $ 0.09
----------- -------------
----------- -------------
Ratio of earnings to fixed charges.... 1.27 1.35
----------- -------------
----------- -------------
See Notes to Unaudited Pro Forma Consolidated Statements of Operations--CBHS
Transactions
118
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS--CBHS
TRANSACTIONS
(1) Represents the elimination of historical operations as a result of the CBHS
Transactions, including franchise operations from June 17, 1997 through
December 31, 1997, and the operations of GPA, the Puerto Rican provider
business, the Joint Ventures and other operations.
(2) Adjustment to net revenue represents the elimination of pro forma Franchise
Fees for the 259 days ended June 16, 1997.
(3) Adjustments to salaries, cost of care and other operating expenses represent
the elimination of fees payable to CBHS by Magellan for the management of
less than wholly-owned hospital based joint ventures controlled by Magellan
for the 259 days ended June 16, 1997 and the elimination of estimated
franchise overhead and personnel.
(4) Adjustment to interest, net, represents the reductions in interest expense
as a result of the repayment of pro forma outstanding borrowings under the
New Credit Agreement with the net proceeds from the CBHS Transactions. The
net proceeds would be applied ratably to repay each tranche of the Term Loan
Facility upon consummation of the CBHS Transactions.
(5) Adjustment to equity in loss of CBHS represents the elimination of
Magellan's pro forma equity in loss of CBHS.
(6) Adjustment to provision for income taxes represents the tax expense related
to the pro forma adjustments at the Company's historic effective tax rate of
40%.
119
UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET--CBHS TRANSACTIONS
DECEMBER 31, 1997
(DOLLARS IN THOUSANDS)
PRO FORMA DIVESTED OPERATIONS-- PRO FORMA PRO FORMA
ASSETS COMBINED CBHS TRANSACTIONS ADJUSTMENTS CONSOLIDATED
-------- ------------- ---------------------- ------------ -------------
Current assets:
Cash and cash equivalents........ $ 160,609 $ (32,216) $ 0 $ 128,393
Accounts receivable, net......... 190,136 (14,468) 0 175,668
Deferred income taxes............ 6,616 0 0 6,616
Other current assets............. 45,847 (3,206) 0 42,641
------------- ---------- ------------ -------------
Total current assets........... 403,208 (49,890) 0 353,318
Assets restricted for settlement of
unpaid claims and other long-term
liabilities...................... 73,020 0 0 73,020
Property and equipment:
Land............................. 11,687 (2,018) 0 9,669
Buildings and improvements....... 75,698 (47,196) 0 28,502
Equipment........................ 123,150 (14,317) 0 108,833
------------- ---------- ------------ -------------
210,535 (63,531) 0 147,004
Accumulated depreciation......... (41,169) 12,806 0 (28,363)
------------- ---------- ------------ -------------
169,366 (50,725) 0 118,641
Construction in progress......... 995 (83) 0 912
------------- ---------- ------------ -------------
Total property and equipment... 170,361 (50,808) 0 119,553
Other long-term assets............. 61,740 (687) 0 61,053
Deferred income taxes.............. 71,529 0 (66,390)(1) 5,139
Investment in CBHS................. 5,390 0 (5,390)(2) 0
Investment in COI.................. 0 0 30,000(3) 30,000
Goodwill, net...................... 846,982 (10,272) 0 836,710
Other intangible assets, net....... 224,820 (2,259) 0 222,561
------------- ---------- ------------ -------------
$ 1,857,050 $ (113,916) $ (41,780) $ 1,701,354
------------- ---------- ------------ -------------
------------- ---------- ------------ -------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable................. $ 44,880 $ (6,661) $ 0 $ 38,219
Accrued liabilities.............. 335,714 (10,438) 12,400(4) 337,676
Current maturities of long-term
debt and capital lease
obligations...................... 3,604 (577) 0 3,027
------------- ---------- ------------ -------------
Total current liabilities.... 384,198 (17,676) 12,400 378,922
Long-term debt and capital lease
obligations...................... 1,211,550 (83) (272,000)(5) 939,467
Reserve for unpaid claims.......... 40,201 0 0 40,201
Deferred tax liabilities........... 0 0 0 0
Deferred credits and other
long-term liabilities............ 16,795 0 47,020(4) 63,815
Minority interest.................. 25,273 (24,943) 0 330
Commitments and contingencies
Stockholders' equity:
Common stock..................... 9,095 0 0 9,095
Additional paid-in capital....... 399,141 0 0 399,141
Retained earnings (accumulated
deficit)......................... (156,044) 0 99,586(6) (56,458)
Warrants outstanding............. 25,050 0 0 25,050
Common stock in treasury......... (95,187) 0 0 (95,187)
Cumulative foreign currency
adjustments...................... (3,022) 0 0 (3,022)
------------- ---------- ------------ -------------
Total stockholders' equity..... 179,033 0 99,586 278,619
------------- ---------- ------------ -------------
$ 1,857,050 $ (42,702) $ (112,994) $ 1,701,354
------------- ---------- ------------ -------------
------------- ---------- ------------ -------------
See Notes to Unaudited Pro Forma Consolidated Balance Sheet--CBHS Transactions
120
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET--CBHS TRANSACTIONS
(1) Adjustment to deferred income tax assets represents the tax consequences of
the gains related to the CBHS Transactions which relate primarily to the
utilization of historical and pro forma net operating loss carryforwards.
(2) Adjustment to Investment in CBHS represents the elimination of the Company's
investment.
(3) Adjustment to Investment in COI represents the Company's basis in COI common
stock received as consideration in the CBHS Transactions. The Company's
investment in COI would have represented approximately % of COI's
outstanding common stock based on the closing price of COI's common stock on
March , 1998. The Company expects to account for its investment in COI as
an available-for-sale security.
(4) Adjustment to accrued liabilities and deferred credits and other long-term
liabilities represents the current and long-term portion of the net deferred
gain recorded on the CBHS Transaction equal to the maximum potential
obligation payable under the Services Purchase Agreement. Such amounts, or
portions thereof, would be payable to CBHS to the extent that shortfalls
exist under the Services Purchase Agreement. The Company will recognize a
gain from the CBHS Transactions in future periods for that portion of
services purchased from CBHS.
(5) Adjustment to long-term debt and capital lease obligations represents the
repayment of long-term debt under the New Credit Agreement with the
estimated net proceeds of approximately $280.0 million less approximately
$8.0 million of transaction costs from the CBHS Transactions.
(6) Adjustment to accumulated deficit represents the net gain on the CBHS
Transactions, computed as follows (in thousands):
Net consideration--CBHS Transactions............................. $ 302,000
Net assets sold to COI and CBHS.................................. (71,214)
Basis of CBHS Investment Sold.................................... (5,390)
Obligations under the Services Purchase Agreement................ (59,420)
---------
Gain on sale before income taxes............................. 165,976
Provision for income taxes................................... 66,390
---------
$ 99,586
---------
---------
121
MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The following table sets forth the name and certain other information about
each director and
executive officer of the Company:
NAME AGE POSITION
- --------------------------------------- --- ------------------------------------------------------------------
Henry T. Harbin M.D.................... 51 President, Chief Executive Officer and Director
Craig L. McKnight...................... 46 Executive Vice President and Chief Financial Officer
John J. Wider, Jr...................... 50 President and Chief Operating Officer of Magellan BHO
Clarissa C. Marques, Ph.D.............. 46 Executive Vice President of Clinical and Quality Management of
Magellan BHO and Magellan Specialty Medical
Gregory T. Torres...................... 48 President and Chief Executive Officer of Mentor
Raymond H. Kiefer...................... 70 Director
Gerald L. McManis...................... 61 Director
Andre C. Dimitriadis................... 57 Director
A.D. Frazier, Jr....................... 53 Director
G. Fred DiBona, Jr..................... 46 Director
Edwin M. Banks......................... 35 Director
Daniel S. Messina...................... 42 Director
Robert W. Miller....................... 56 Chairman of the Board of Directors
Darla D. Moore......................... 43 Director
Jeffrey A. Sonnenfeld Ph.D............. 43 Director
HENRY T. HARBIN, M.D. became President, Chief Executive Officer and a
Director of the Company on March 18, 1998. Dr. Harbin served as President and
Chief Executive Officer of Green Spring from 1994 to 1998. Dr. Harbin served as
Executive Vice President of the Company from 1995 until becoming President and
Chief Executive Officer of the Company. Dr. Harbin served as Executive Vice
President and Chief Clinical Officer of Green Spring during 1993 and 1994.
CRAIG L. MCKNIGHT became Executive Vice President and Chief Financial
Officer of the Company in October 1995. From March 1995 through September 1995,
he served as Executive Vice President-- Office of the President and Chairman.
Mr. McKnight practiced public accounting with Coopers & Lybrand L.L.P. from 1985
through 1995. Coopers & Lybrand L.L.P. is an international accounting firm that
provides accounting and auditing services, tax services and consulting services.
As an audit partner at Coopers & Lybrand L.L.P., from 1985 to 1995, Mr. McKnight
had responsibility for a wide range of hospital and managed-care engagements, as
well as assisting clients with formulating financing options, financial
restructurings and the purchase and sale of health plans and facilities.
JOHN J. WIDER, JR. has served as President and Chief Operating Officer of
Magellan BHO since March 1998. Mr. Wider served as Executive Vice President and
Chief Operating Officer of Green Spring from 1997 to 1998. Mr. Wider was
President and General Manager for Cigna Healthcare Corporation's ("Cigna")
Mid-Atlantic region from 1996 to 1997. Mr. Wider served as Area Operations
Officer for Cigna during 1995 and 1996 and as Vice President of Sales of Cigna's
Midwest region from 1993 to 1995.
CLARISSA C. MARQUES, PH.D. has served as Executive Vice President of
Clinical and Quality Management of both Magellan BHO and Magellan Specialty
Medical since March 1998. Dr. Marques served as Executive Vice President and
Chief Clinical Officer of Green Spring during 1997 and 1998. Dr. Marques served
as Senior Vice President of Green Spring from 1992 to 1997. Dr. Marques also
serves as a director of Community Sector Systems.
122
GREGORY T. TORRES is President and Chief Executive Officer of Mentor,
positions he has held since 1996. Mr. Torres served as Senior Vice President for
Public Affairs of Mentor from 1992 until 1996.
RAYMOND H. KIEFER has been a Director of the Company since July 1992. Mr.
Kiefer was President of Allstate Insurance Company from 1989 until he retired in
1992.
GERALD L. MCMANIS has been a Director of the Company since February 1994.
Mr. McManis is President of McManis Associates, Inc., a strategy development and
management consulting firm for healthcare and healthcare related companies, a
position he has occupied since 1965. Mr. McManis serves on the board of
directors of MMI Companies, Inc.
ANDRE C. DIMITRIADIS has been a Director since July 1992. Mr. Dimitriadis
has been Chairman and Chief Executive Officer of LTC Properties, Inc., a
healthcare real estate investment trust, since 1992. Mr. Dimitriadis is a
director of Health Management, Inc. and Assisted Living Concepts, Inc.
A.D. FRAZIER, JR. has been a Director since May 1995. He is currently
President and Chief Executive Officer of Invesco, Inc., a registered investment
advisor, a position he has held since 1996. Prior to joining Invesco, Mr.
Frazier was Senior Executive Vice President and Chief Operating Officer for the
Atlanta Committee for the Olympic Games, Inc., a position he occupied from 1991
through 1996. Mr. Frazier also serves on the board of directors of Invesco PLC
and three registered investment companies of which Invesco PLC is the registered
investment advisor.
G. FRED DIBONA, JR. has been a Director since January 1996. Mr. DiBona has
been President and Chief Executive Officer of and a director of Independence
Blue Cross, a health insurance company, since 1990. Mr. DiBona serves on the
board of directors of Philadelphia Savings Bank and Philadelphia Suburban Water
Company.
EDWIN M. BANKS has been a Director since July 1992. Mr. Banks has been a
securities analyst with W.R. Huff Asset Management Co., LLC, a registered
investment advisor, since 1988. Mr. Banks also serves on the board of directors
of American Communications Services, Inc. and Del Monte Corporation.
DANIEL S. MESSINA has been a Director since December 1997. Mr. Messina
currently is Chief Financial Officer of Aetna U.S. Healthcare. Mr. Messina was
Vice President-Business Strategy of Aetna U.S. Healthcare in 1997 and served as
Deputy Chief Financial Officer of Aetna in 1996 and 1997. During 1995 and 1996,
Mr. Messina served as Vice President Financial Relations and Chief of Staff to
the Vice Chairman for Strategy, Finance and Administration of Aetna, Inc. Mr.
Messina also was the Vice President and Controller of Aetna Health Plans from
1991 to 1995.
ROBERT W. MILLER has been the Chairman of the Board since March 1998 and a
Director since February 1998. Mr. Miller practiced law with the law firm King &
Spalding in Atlanta from 1985 to 1997. In his practice, Mr. Miller specialized
in representing health care clients in a variety of different capacities,
including representations in mergers and acquisitions involving more than 75
hospitals, debt and equity restructurings and other corporate finance
transactions.
DARLA D. MOORE has been a Director since February 1996. Ms. Moore has been a
private investor of Rainwater, Inc., a private investment firm, since 1994. From
1982 through 1994 she was a Managing Director of The Chase Manhattan Bank, N.A.
JEFFREY A. SONNENFELD, PH.D. has been a Director since September 1997. Dr.
Sonnenfeld has been President of The Chief Executive Institute (education) since
December 1997. Dr. Sonnenfeld is a professor of organization and management and
director of the Center for Leadership & Career Studies of the Goizueta Business
School at Emory University. Dr. Sonnenfeld received his AB, MBA and doctorate
degrees from Harvard University. Dr. Sonnenfeld also serves on the board of
directors of Klaster Cruise Limited, Masely Securities Corporations,
Transmedia-CBS, Inc. and U.S. Franchise Systems.
123
EXECUTIVE COMPENSATION
The following table sets forth the compensation paid by the Company to the
Company's Chief Executive Officer and the Company's four next most highly
compensated executive officers (the "Named Executive Officers"), for the three
fiscal years ended September 30, 1997:
SUMMARY COMPENSATION TABLE
ALL OTHER
COMPENSATION (3)
------------------
ANNUAL COMPENSATION LONG-TERM
---------------------------------------------- COMPENSATION
NAME AND PRINCIPAL FISCAL OTHER ANNUAL --------------
POSITIONS YEAR SALARY BONUS COMPENSATION (1) OPTIONS(#) (2)
- ----------------------------- ----------- ----------- ------------- ------------------ --------------
E. Mac Crawford (4).......... 1997 $ 806,250 $ 2,475,000 $ -- 933,666 $ 166,575
Chairman of the Board, 1996 712,500 153,500 -- 300,000 181,936
President and Chief 1995 600,000 -- 177,236 -- 204,095
Executive Officer
Craig L. McKnight (5)........ 1997 378,688 150,000 59,743 65,000 45,158
Executive Vice President 1996 361,250 50,000 -- 25,000 73,891
and Chief Financial Officer 1995 204,167 -- 45,668 100,000 11,218
Steve J. Davis (6)........... 1997 337,500 150,000 -- 167,500 43,750
Executive Vice President- 1996 256,667 50,000 -- 40,000 50,449
Administrative Services and 1995 182,083 -- 21,121 -- 91,972
General Counsel
Henry T. Harbin M.D. (7)..... 1997 338,069 161,707 -- 125,000 10,750
Executive Vice President 1996 236,705 167,195 -- 100,000 10,750
and President and Chief
Executive Officer of Green
Spring
Danna Mauch Ph.D. (8)........ 1997 304,500 -- -- -- 33,660
Executive Vice President 1996 125,000 10,000 -- 50,000 23,452
and President and Chief
Operating Officer of
Magellan Public Solutions,
Inc.
- ------------------------
(1) Other Annual Compensation for fiscal 1997 includes country club initiation
fees and dues of $42,004 for Mr. McKnight. Other Annual Compensation for
fiscal 1995 includes: (a) reimbursement of relocation expenses of $157,558
and $38,289 for Messrs. Crawford and McKnight, respectively, and (b) a car
allowance of $12,000 for Mr. Davis.
(2) Represents the number of stock options granted under the Company's 1994
Stock Option Plan, 1996 Stock Option Plan and 1997 Stock Option Plan.
(3) All Other Compensation for fiscal 1997 includes: (a) contributions to the
Company's 401(k) Plan of $5,250 for Messrs. Crawford and Davis, $3,000 for
Mr. McKnight and contributions to the Green Spring 401(k) plan of $10,750
for Dr. Harbin; (b) amounts deposited in trust pursuant to the Company's
Executive Benefits Plan ("EBP") of $151,816, $42,158, $38,500 and $33,660
for Messrs. Crawford, McKnight, Davis and Dr. Mauch, respectively and (c)
premiums paid for disability insurance of $9,509 for Mr. Crawford. All Other
Compensation for fiscal 1996 includes: (a) contributions to the ESOP of
$18,050, $22,795 and $22,795 for Messrs. Crawford,
124
McKnight and Davis, respectively, which represents the Company's expense
(the fair value of the ESOP shares on the date earned was $699, $883 and
$883 for Messrs. Crawford, McKnight and Davis, respectively); (b)
contributions to the Company's 401(k) Plan of $5,250 for Mr. Crawford and
contributions to the Green Spring 401(k) Plan of $10,750 for Dr. Harbin; (c)
amounts deposited in trust pursuant to the EBP of $137,191, $40,150, $23,375
and $23,452 for Messrs. Crawford, McKnight, Davis and Dr. Mauch,
respectively; (d) premiums paid for life and disability insurance of
$19,840, $10,260 and $3,595 for Messrs. Crawford, McKnight and Davis,
respectively; and (e) term life insurance premiums of $1,605, $686 and $684
for Messrs. Crawford, McKnight and Davis, respectively. All Other
Compensation for fiscal 1995 includes: (a) contributions to the ESOP of
$20,408 and $18,560 for Messrs. Crawford and Davis, respectively, which
represents the Company's expense (the fair value of the ESOP shares on the
date earned was $465 and $424 for Messrs. Crawford, and Davis,
respectively); (b) contributions to the Company's 401(k) Plan of $5,250 for
Mr. Crawford; (c) amounts deposited in trust pursuant to the EBP of $104,877
and $25,897 for Messrs. Crawford and Davis, respectively; (d) premiums paid
for life and disability insurance of $72,954, $11,010 and $4,410 for Messrs.
Crawford, McKnight and Davis, respectively; (e) term life insurance premiums
of $606, $208 and $685 for Messrs. Crawford, McKnight and Davis,
respectively; and (f) amounts paid to Mr. Davis of $42,420 pursuant to Mr.
Davis achieving performance goals set relating to his employment with the
Company.
(4) Mr. Crawford resigned his position with the Company on March 18, 1998.
(5) Mr. McKnight became an employee of the Company effective March 1, 1995.
(6) In November, 1997, Mr. Davis resigned his position with the Company to
become President and Chief Executive Officer of CBHS.
(7) Dr. Harbin became an executive officer of the Company effective December 13,
1995.
(8) Dr. Mauch became an employee of the Company effective May 1, 1996.
OPTION GRANTS IN FISCAL 1997
The following table sets forth certain information with respect to grants of
options to the Named Executive Officers who were granted options during fiscal
1997 and the potential realizable value of such options on September 30, 1997:
INDIVIDUAL GRANTS
-----------------------------------------------------------------------------------------------
POTENTIAL REALIZABLE
VALUE AT ASSUMED
NUMBER OF PERCENTAGE OF ANNUAL RATES OF STOCK
SECURITIES TOTAL OPTIONS PRICE APPRECIATION
UNDERLYING GRANTED TO FOR OPTION TERM
OPTIONS GRANTED EMPLOYEES IN PRICE EXERCISE ------------------------------
NAME (#) FISCAL 1997 PER SHARE EXPIRATION DATE 5% 10%
- ------------------------- ---------------- --------------- ----------- --------------- -------------- --------------
E. Mac Crawford (1)...... 183,666(2) 11.2% $ 20.875 12/17/06 $ 2,411,199 $ 6,110,453
750,000(4) 45.7 24.375 2/28/07 11,496,980 29,135,604
Craig L. McKnight........ 15,000(2) 0.9 20.875 12/17/06 196,923 499,041
50,000(3) 3.0 23.438 11/30/05 631,648 1,570,244
Steve J. Davis........... 67,500(2) 4.1 20.875 12/17/06 886,152 2,245,683
100,000(3) 6.1 23.438 11/30/05 1,263,296 3,140,488
Henry T. Harbin M.D...... 25,000(2) 1.5 20.875 12/17/06 328,204 831,734
100,000(4) 6.1 30.438 2/28/07 1,796,152 4,492,103
- ------------------------
(1) Mr. Crawford resigned his position with the Company on March 18, 1998.
(2) Options granted under the 1994 Stock Option Plan which become exercisable
over three years at the rate of 33 1/3% of the total number of options per
year.
(3) Options granted under the 1996 Stock Option Plan which became exercisable on
June 17, 1997.
(4) Options granted under the 1997 Stock Option Plan, which become exercisable
over three years at the rate of 33 1/3% of the total number of options per
year.
125
AGGREGATED OPTION EXERCISES IN FISCAL 1997
AND OPTION VALUES AT SEPTEMBER 30,1997
The following table sets forth certain information with respect to options
exercised by the Named Executive Officers during fiscal 1997, and the number and
value of options held on September 30, 1997:
VALUE OF UNEXERCISED
NUMBER OF LN-THE-MONEY
UNEXERCISED OPTIONS OPTIONS AT
SHARES VALUE AT SEPTEMBER 30, 1997 SEPTEMBER 30, 1997($)(1)
ACQUIRED ON REALIZED ---------------------------- ------------------------------
NAME EXERCISE (#) ($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ------------------------- ------------ ----------- ------------ -------------- -------------- --------------
E. Mac Crawford (2)...... -- $ -- 755,440 933,666 $ 14,791,046 $ 7,528,618
Craig L. McKnight........ -- -- 141,667 48,333 1,648,996 611,054
Steve J. Davis........... -- -- 157,500 67,500 1,526,563 734,063
Henry T. Harbin M.D...... -- -- 100,000 125,000 1,287,500 403,125
Danna Mauch Ph.D......... -- -- 50,000 -- 437,500 --
- ------------------------
(1) The closing price for the Common Stock as reported on September 30, 1997 was
$31.75. The value of unexercised in-the-money options is the difference
between the per share option exercise price and $31.75, multiplied by the
number of shares of Common Stock underlying in-the-money options.
(2) Mr. Crawford resigned his position with the Company on March 18, 1998.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. The following table sets
forth certain information as of November 30, 1997 (except as otherwise noted)
with respect to any person known by the Company to be the beneficial owner of
more than five percent of the Company's outstanding Common Stock:
AMOUNT AND NATURE PERCENT OF
NAME AND ADDRESS OF BENEFICIAL OWNERSHIP CLASS
- ---------------------------------------------------------------------------- ----------------------- -------------
Rainwater-Magellan Holdings, L.P.(1)........................................ 5,835,078 18.8%
777 Main Street
Suite 2700
Ft. Worth, TX 76102
Albert O. Nicholas.......................................................... 2,736,000 9.4%
Nicholas Company, Inc.(2)
700 North Water Street
Suite 1010
Milwaukee, WI 53202
Wellington Management Company, LLP(3)....................................... 2,337,300 8.0%
75 State Street
Boston, MA 02109
Lazard Freres & Co., LLC(4)................................................. 2,101,895 7.2%
30 Rockefeller Plaza
New York, NY 10020
First Pacific Advisors, Inc.(5)............................................. 1,592,500 5.5%
11400 West Olympic Blvd.
Suite 1200
Los Angeles, CA 90064
- ------------------------
(1) Includes 1,942,996 shares of Common Stock that Rainwater-Magellan has the
right to acquire pursuant to the Rainwater-Magellan Warrant and 6,250 shares
that Darla D. Moore, a director of the Company and spouse of Richard E.
Rainwater, has the right to acquire upon the exercise of options. Under the
rules of the SEC, Rainwater, Inc., the general partner of Rainwater-Magellan
and Richard E. Rainwater, the sole owner and sole director of Rainwater,
Inc., are also deemed to be beneficial owners of the shares owned by
Rainwater-
126
Magellan. Information concerning beneficial ownership of securities by
Rainwater-Magellan is based on its Form 4, dated April 4, 1997.
(2) Information concerning beneficial ownership of securities by Nicholas
Company, Inc. is based on its Form 13F, dated October 21, 1997.
(3) Information concerning beneficial ownership of securities by Wellington
Management Company, LLP is based on its Form 13F, dated November 7, 1997.
(4) Information concerning beneficial ownership of securities by Lazard Freres &
Co., LLC is based on its Form 13F, dated November 12, 1997.
(5) Information concerning beneficial ownership of securities by First Pacific
Advisors, Inc. is based on its Form 13F, dated November 13, 1997.
Nicholas Company, Inc. is a registered investment advisor and possesses sole
dispositive power over the 2,736,000 shares of Common Stock owned by it.
Nicholas Fund, Inc. is a registered investment company managed by Nicholas
Company, Inc. and possesses sole voting power over 166,000 shares of the
2,736,000 shares owned by Nicholas Company, Inc. and no voting power over
2,570,000 of such shares. Albert O. Nicholas may be deemed to be a beneficial
owner of the shares held by Nicholas Company, Inc. under SEC rules because of
his control of Nicholas Company, Inc. Mr. Nicholas is the President, a director
and majority stockholder of Nicholas Company, Inc. and disclaims beneficial
ownership of all securities reported as beneficially owned by Nicholas Company,
Inc.
Wellington Management Company, LLP is an institutional investment manager
and possesses sole dispositive power over 2,299,300 shares of Common Stock and
shares dispositive power over 38,000 shares of Common Stock owned by it.
Wellington Management Company, LLP possesses sole voting authority over
1,416,200 shares of Common Stock, shared voting power over 38,000 shares of
Common Stock and no voting power over 883,100 shares of Common Stock.
Lazard Freres & Co., LLC is an institutional money manager and possesses
sole dispositive power and sole voting authority over all shares of Common Stock
owned by it.
First Pacific Advisors, Inc. is an institutional money manager and possesses
sole dispositive power over 1,200,000 of the shares of Common Stock owned by it
and shares dispositive power over 392,500 of such shares. It possesses no voting
power over 1,200,000 of such shares and shares voting power over 392,500 of such
shares.
127
SECURITY OWNERSHIP OF MANAGEMENT. The following table sets forth certain
information concerning the beneficial ownership of Common Stock by (i)
directors, (ii) the Named Executive Officers and other executive officers and
(iii) directors and executive officers as a group, as of March 1, 1998:
AMOUNT AND NATURE
OF BENEFICIAL PERCENT OF
NAME OWNERSHIP (1)(2) TOTAL OUTSTANDING
- ------------------------------------------------------------------------- ------------------- -------------------
E. Mac Crawford(2)....................................................... 1,067,016 3.3%
Craig L. McKnight........................................................ 180,037 *
Henry T. Harbin M.D...................................................... 108,333 *
John J. Wider, Jr........................................................ -- *
Clarissa C. Marques, Ph.D. .............................................. 20,000 *
Gregory T. Torres........................................................ 35,000 *
Edwin M. Banks(4)........................................................ 39,500 *
G. Fred DiBona, Jr.(5)................................................... 901,956 2.8
Andre C. Dimitriadis..................................................... 39,000 *
A.D. Frazier, Jr......................................................... 28,500 *
Raymond H. Kiefer........................................................ 40,000 *
Gerald L. McManis........................................................ 39,000 *
Darla D. Moore(6)........................................................ 5,841,328 17.5
Robert W. Miller......................................................... -- *
Jeffrey A. Sonnenfeld Ph.D............................................... -- *
Daniel S. Messina........................................................ --(7) *
All directors and executive officers as a group (16 persons)............. 8,339,670(8) 23.2
- ------------------------
* Less than 1% of total outstanding.
(1) Includes 1,066,662, 180,000, 108,333, 35,000 and 20,000 shares that Messrs.
Crawford, McKnight, Harbin, Torres and Ms. Marques, respectively, have the
right to acquire upon the exercise of options and warrants within 60 days of
March 1, 1998.
(2) Includes 39,000 shares that each of Messrs. Dimitriadis, Kiefer, Banks and
McManis have the right to acquire, 28,500 shares that Mr. Frazier has the
right to acquire, and 12,500 shares that each of Mr. DiBona and Ms. Moore
have the right to acquire within 60 days of March 1, 1998.
(3) Mr. Crawford resigned his position with the Company on March 18, 1998.
(4) Does not include shares owned by W.R. Huff Asset Management Co., LLC, a
registered investment advisor ("Huff"), of which Mr. Banks disclaims
beneficial ownership. Mr. Banks is a securities analyst with Huff.
(5) Includes 889,456 shares that Independence Blue Cross owns. See "Certain
Relationships and Related Transactions." Mr. DiBona is a director and the
President and Chief Executive Officer of Independence Blue Cross and
disclaims beneficial ownership of all securities attributed to him because
of his positions with Independence Blue Cross.
(6) Includes 3,885,832 shares owned by Rainwater-Magellan and 1,942,996 shares
that Rainwater-Magellan has the right to acquire pursuant to the
Rainwater-Magellan Warrant. Ms. Moore is the spouse of Richard F. Rainwater,
the sole stockholder and sole director of Rainwater, Inc., which is the sole
general partner of Rainwater-Magellan.
(7) In accordance with Aetna U.S. Healthcare's policy, Mr. Messina will not
accept any option grants for serving as a director.
(8) Includes 1,556,162 shares that the directors and executive officers have the
right to acquire upon the exercise of options, 889,456 shares that
Independence Blue Cross owns and 1,942,996 shares that Rainwater-Magellan,
L.P. has the right to acquire upon the exercise of the Rainwater-Magellan
Warrant, all of which are exercisable within 60 days of March 1, 1998.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Gerald L. McManis, a director of the Company, is the President of McManis
Associates, Inc. ("MAI"), a strategy development and management consulting firm
for healthcare and health-related companies.
128
During fiscal 1997, MAI provided consulting services to the Company with respect
to the development of strategic plans and a review of the Company's business
processes. The Company paid approximately $825,000 in fees for such services
during fiscal 1997 and reimbursed MAI approximately $60,000 for expenses.
G. Fred DiBona, Jr., a director of the Company, is a director and the
President and Chief Executive Officer of Independence Blue Cross. As of November
30, 1997, Independence Blue Cross had a 12.25% equity interest in Green Spring.
The Company acquired a 51% equity interest in Green Spring on December 13,
1995 for approximately $68.9 million in cash, the issuance of Common Stock
valued at approximately $4.3 million and the contribution of Group Practice
Affiliates, Inc., a wholly-owned subsidiary of the Company ("GPA"), to Green
Spring. The Exchange Agreement provided that the minority stockholders of Green
Spring, including Independence Blue Cross, had the option (the "Exchange
Option") under certain circumstances, to exchange their equity interests in
Green Spring for 2,831,516 shares of Common Stock or $65.1 million in
subordinated notes. In the event of an exchange, the Company could have elected
to pay cash in lieu of issuing subordinated notes. Each of the Exchange Options
has been exercised. The consideration paid and terms of the Exchange Option were
determined through arm's length negotiations that considered, among other
factors, the historical and projected income of Green Spring and the value of
GPA. The consideration paid by the Company was determined by the Board with the
advice of management and the Company's investment bankers. On December 20, 1995,
the Company acquired an additional 10% equity interest in Green Spring for $16.7
million in cash as a result of the exercise of the Exchange Option by a minority
stockholder of Green Spring. The Company had a 61% equity interest in Green
Spring as of November 30, 1997.
On December 13, 1995, as part of the Company's initial investment in Green
Spring, Independence Blue Cross sold a 4.42% equity interest in Green Spring, in
which it had a cost basis of $3.2 million, to the Company for $5.4 million in
cash. The Exchange Option gave Independence Blue Cross the right, until December
13, 1998, to exchange its remaining equity interest in Green Spring for a
maximum of 889,565 shares of Common Stock or $20.5 million in subordinated
notes. Independence Blue Cross converted its equity interest in Green Spring
into 889,456 shares of Common Stock during January 1998 in connection with the
Company's announced acquisition of Merit and related transactions.
Independence Blue Cross and its affiliated entities contract with Green
Spring for provider network, care management and medical review services
pursuant to contractual relationships entered into on July 7, 1994, with terms
of up to five years. During fiscal 1997, Independence Blue Cross and its
affiliated entities paid Green Spring approximately $48.0 million for such
services. As of September 30, 1997, Independence Blue Cross and its affiliated
entities owed Green Spring approximately $13.6 million. Green Spring recorded
revenue of approximately $47.4 million from Independence Blue Cross during
fiscal 1997.
On July 7, 1994, Independence Blue Cross sold a subsidiary to Green Spring
in exchange for a $15.0 million promissory note. As of November 30, 1997, $6.0
million remained outstanding under such promissory note and is due and payable
in equal installments on July 7, 1998 and 1999.
Daniel S. Messina, a director of the Company, is the Chief Financial Officer
of Aetna. On December 4, 1997, the Company consummated the purchase of HAI,
formerly a unit of Aetna, for approximately $122.1 million, which the Company
funded from cash on hand. HAI manages the care of over 16.0 million covered
lives, primarily through EAPs and other non-risk-based managed behavioral
healthcare plans. The Company may be required to make additional contingent
payments of up to $60.0 million annually to Aetna over the five-year period
subsequent to closing. The amount and timing of the payments will be contingent
upon net increases in the number of HAI's covered lives in specified products.
For the twelve months ended September 30, 1997, HAI had revenue of $117.0
million. The consideration paid was determined through arm's length negotiations
that considered, among other
129
factors, the historical and projected income of HAI. The consideration paid by
the Company was determined by the Board with the advice of management and the
Company's investment bankers. A contract between HAI and Aetna represents 21% of
the Company's pro forma covered lives and would represent 5% of its pro forma
managed behavioral healthcare revenues for fiscal 1997.
Richard E. Rainwater and certain of his affiliates have a significant
interest in Crescent and the Company. Set forth below is a summary of the
interests of such persons.
On June 17, 1997, the Company sold the Psychiatric Hospital Facilities to
Crescent for $417.2 million in cash (before costs of approximately $16 million)
and warrants for the purchase of 2.5% of the common stock of COI. Simultaneously
with the sale of the Psychiatric Hospital Facilities to Crescent, the Company
and COI formed CBHS to conduct the operations of the Psychiatric Hospital
Facilities and certain other facilities transferred to CBHS by the Company. The
Company owns a 50% interest in CBHS, which it obtained by contributing
approximately $5 million of certain net assets to CBHS. The Company franchises
the "CHARTER" System of behavioral healthcare to each of the Psychiatric
Hospital Facilities and other facilities operated by CBHS. In exchange, CBHS
pays certain franchise fees to the Company.
Crescent is the operating partnership of Crescent Real Estate Equities
("CEI"). Mr. Rainwater is the Chairman of the Board of Directors of CEI. The
sole general partner of Crescent is Crescent Real Estate Equities ("Crescent
GP"), which is a wholly-owned subsidiary of CEI. Mr. Rainwater owns beneficially
12.5% of Crescent, which interests consist of common stock in CEI (including
common stock of CEI that may be acquired pursuant to the exercise of options)
and units of ownership in Crescent. Mr. Rainwater is an affiliate of Crescent,
Crescent GP, COI and CEI.
A total of 4,000,000 shares of Common Stock and warrants for an additional
2,000,000 shares of Common Stock were acquired by Rainwater-Magellan from the
Company in a Private Placement pursuant to a Stock and Warrant Purchase
Agreement and certain related agreements (the "Private Placement Agreements").
Rainwater-Magellan owns 3,885,832 shares of Common Stock and holds a portion
of the Rainwater-Magellan Warrant, which gives Rainwater-Magellan the right to
purchase an additional 1,942,996 shares of Common Stock. Rainwater, Inc. is the
sole general partner of Rainwater-Magellan. Richard E. Rainwater is the sole
stockholder and a director of Rainwater, Inc. Mr. Rainwater has sole voting and
dispositive power over the shares of Common Stock owned by Rainwater-Magellan
and the shares of Common Stock underlying the Rainwater-Magellan Warrant. As a
result of such relationships, Mr. Rainwater is deemed to be the beneficial owner
of the shares of Common Stock held by Rainwater-Magellan, including the shares
of Common Stock which can be purchased under the Rainwater-Magellan Warrant.
Mr. Rainwater owns beneficially approximately 62.8% of Rainwater-Magellan.
Mr. Rainwater's three children own beneficially an additional 4.8% of
Rainwater-Magellan through a limited partnership of which Mr. Rainwater is
general partner and an additional 1.2% each through trusts which are managed by
an unaffiliated trustee.
The Rainwater-Magellan Warrant entitles the holders to purchase in the
aggregate, at any time prior to its January 25, 2000 expiration date, up to
2,000,000 shares of Common Stock at a purchase price of $26.15 per share. The
Private Placement Agreements provide, among other things, for the adjustment of
the number of shares of Common Stock that can be purchased under the
Rainwater-Magellan Warrant and the purchase price, respectively, for certain
dilutive events, for registration rights for the shares of Common Stock owned by
Rainwater-Magellan, including those underlying the Rainwater-Magellan Warrant
(which registration rights, as mentioned below, have been exercised), and for a
variety of other customary provisions, including, without limitation, certain
restrictions on Rainwater-Magellan's private sale of such shares, certain
preemptive rights of Rainwater-Magellan to acquire additional securities issued
by the Company for cash in a private placement transaction and standstill
covenants restricting
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the purchase of additional shares of Common Stock by Rainwater-Magellan and its
affiliates in certain circumstances.
Darla D. Moore, a director of the Company, is the spouse of Richard E.
Rainwater. Under the terms of the Private Placement Agreements,
Rainwater-Magellan has the right to designate a nominee acceptable to the
Company for election as a director of the Company for so long as the Rainwater
Group continues to own beneficially a specified minimum number of shares of
Common Stock. Rainwater-Magellan proposed Ms. Moore as its nominee for director,
and Ms. Moore was elected a director by the Board in February 1996. For purposes
of this Prospectus, any reference to the "Rainwater Group" includes Rainwater
Magellan, Rainwater, Inc., Richard E. Rainwater, Darla D. Moore and their
affiliates and associates.
As of November 30, 1997, Rainwater-Magellan beneficially owned 5,835,078
shares of Common Stock (including the 1,942,996 shares which can be purchased
under the Rainwater-Magellan Warrant), which represented in the aggregate 18.8%
of the Common Stock.
Under the terms of the Private Placement Agreements, the Company agreed (i)
to pay a transaction fee of $150,000; (ii) to reimburse certain expenses of
Rainwater, Inc. in connection with the Private Placement; (iii) to pay the
Rainwater Group an annual monitoring fee of $75,000 commencing on March 31,
1996; and (iv) to reimburse the Rainwater Group for reasonable fees and expenses
(up to a maximum of $25,000 annually) incurred in connection with its ownership
of the Common Stock and the Rainwater-Magellan Warrant. The Company also agreed
under the Private Placement Agreements to reimburse the Rainwater Group in the
future for one additional filing under the Hart-Scott-Rodino Antitrust
Improvements Act of 1976, as amended, if a filing under such act is required in
connection with an exercise of the Rainwater-Magellan Warrant.
Rainwater-Magellan purchased the Common Stock and the Rainwater-Magellan
Warrant on January 25, 1996. During fiscal 1997, the Company paid an aggregate
of $77,019 for the annual monitoring fee and fees and expenses incurred in
connection with Rainwater-Magellan's ownership of the Common Stock and
Rainwater-Magellan Warrant. Excluded from these amounts are directors' fees and
expense reimbursement paid to Ms. Moore in her capacity as a director of the
Company. The Company has incurred costs to date of approximately $55,000 in
connection with its registration of the shares and approximately $40,000 in
costs to register the shares of Common Stock underlying the Rainwater-Magellan
Warrant.
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THE EXCHANGE OFFER
PURPOSE AND EFFECT OF THE EXCHANGE OFFER
The Company sold the Old Notes to the Initial Purchaser on February 12, 1998
pursuant to the Purchase Agreement. The Initial Purchaser subsequently resold
the Old Notes to "qualified institutional buyers" in reliance on Rule 144A under
the Securities Act or pursuant to offers and sales that occurred outside the
United States within the meaning of Regulation S under the Securities Act. As a
condition to the Purchase Agreement, the Company entered into the Registration
Rights Agreement, pursuant to which the Company agreed, for the benefit of all
holders of the Old Notes, that it would, at its expense, (i) as soon as
practicable after the initial issuance of the Old Notes, file a registration
statement with the Commission with respect to a registered offer to exchange the
Old Notes for the New Notes and (ii) use its best efforts to cause such
registration statement to be declared effective under the Securities Act by July
10, 1998. The Company also agreed that upon effectiveness of the Registration
Statement, it would offer to all holders of the Old Notes an opportunity to
exchange their securities for an equal principal amount of the New Notes.
Further, the Company agreed that it would keep the Exchange Offer open for
acceptance for not less than 30 business days (subject to any extensions
required by applicable law) after the date such Registration Statement was
declared effective and would comply with Regulation 14E and Rule 13e-4 under the
Securities Exchange Act of 1934, as amended (the "Exchange Act") (other than the
filing requirements of Rule 13e-4). A copy of the Registration Rights Agreement
has been filed as an exhibit to the Registration Statement of which this
Prospectus is a part. The term "Holder" with respect to the Exchange Offer means
any person in whose name Old Notes are registered on the books of the Company or
any other person who has obtained a properly completed bond power from the
registered holder. The Exchange Offer is intended to satisfy certain of the
Company's obligations under the Registration Rights Agreement.
Based on existing interpretations of the Staff with respect to similar
transactions, the Company believes that the New Notes issued pursuant to the
Exchange Offer in exchange for Old Notes may be offered for resale, resold and
otherwise transferred by holders thereof (other than any such holder which is an
"affiliate" of the Company within the meaning of Rule 405 under the Securities
Act) without compliance with the registration and prospectus delivery
requirements of the Securities Act; provided that such New Notes are acquired in
the ordinary course of such holders' business and such holders are not engaged
in, have no arrangement with any person to participate in, and do not intend to
engage in, any public distribution of the New Notes. Each broker or dealer
registered as such under Section 15 of the Exchange Act receiving New Notes in
the Exchange Offer ("Participating Broker-Dealers") will be subject to a
prospectus delivery requirement with respect to resales of such New Notes. Each
Participating Broker-Dealer must acknowledge that it will deliver a resale
prospectus in connection with any resale of such New Notes. The Letter of
Transmittal which accompanies this Prospectus states that by so acknowledging
and by delivering a resale prospectus, a Participating Broker-Dealer will not be
deemed to admit to be acting in the capacity of an "underwriter" (within the
meaning of Section 2(11) of the Securities Act). This Prospectus, as it may be
amended or supplemented from time to time, may be used by a Participating
Broker-Dealer in connection with resales of New Notes received in exchange for
Old Notes where such Old Notes were acquired by such Participating Broker-Dealer
as result of market-making or other trading activities. Pursuant to the
Registration Rights Agreement, the Company has agreed to permit Participating
Broker-Dealers and other persons, if any, subject to similar prospectus delivery
requirements to use this Prospectus in connection with the resale of such New
Notes for a period of 180 days from the date on which the Registration Statement
of which this Prospectus is a part is first declared effective.
Each holder of the Old Notes who wishes to exchange its Old Notes for New
Notes in the Exchange Offer will be required to make certain representations to
the Company in the accompanying Letter of Transmittal, including that (i) any
New Notes to be received by it will be acquired in the ordinary course of its
business, (ii) it is not participating in, does not intend to participate in and
has no arrangement with
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any person to participate in a public distribution (within the meaning of the
Securities Act) of the New Notes, and (iii) it is not an "affiliate," as defined
in Rule 405 of the Securities Act of the Company, or if it is such an affiliate,
that it will comply with the registration and prospectus delivery requirements
of the Securities Act to the extent applicable to it. In addition, each holder
who is not a broker-dealer will be required to represent that it is not engaged
in, and does not intend to engage in, a public distribution of the New Notes.
Each Participating Broker-Dealer who receives New Notes for its own account in
exchange for Old Notes that were acquired by it as a result of market-making or
other trading activities, will be required to acknowledge that it will deliver
this Prospectus in connection with any resale by it of such New Notes.
Accordingly, subject to the aforementioned interpretations of the Staff with
respect to the free transferability of the New Notes received by holders in
exchange for their Old Notes pursuant to the Exchange Offer and, as set forth in
such interpretations, the ability of certain holders to participate in the
Exchange Offer, holders of Old Notes otherwise eligible to participate in the
Exchange Offer and receive pursuant thereto freely tradeable New Notes but who
elect not to tender their Old Notes for exchange, will not have any further
registration rights under the Registration Rights Agreement and the Old Notes
not so exchanged will remain "restricted securities" (within the meaning of the
Securities Act) and subject to restrictions on transfer under the Securities
Act.
TERMS OF THE EXCHANGE OFFER
Upon the terms and subject to the conditions set forth in this Prospectus
and in the accompanying Letter of Transmittal (together, the "Exchange Offer"),
the Company will accept for exchange and exchange any and all Old Notes validly
tendered and not withdrawn prior to 5:00 p.m., New York City time, on the
Expiration Date. The Company will issue $1,000 principal amount of New Notes in
exchange for each $1,000 principal amount of outstanding Old Notes accepted in
the Exchange Offer. Holders may tender some or all of their Old Notes pursuant
to the Exchange Offer. However, Old Notes may be tendered only in integral
multiples of $1,000.
The form and terms of the New Notes are the same as the form and terms of
the Old Notes except that (i) the New Notes have been registered under the
Securities Act and will not bear legends restricting the transfer thereof, (ii)
the holders of the New Notes will not be entitled to certain rights under the
Registration Rights Agreement, which rights will terminate when the Exchange
Offer is terminated and (iii) the New Notes have been given a series designation
to distinguish the New Notes from the Old Notes. The New Notes will evidence the
same debt as the Old Notes and will be entitled to the benefits of the
Indenture.
As of the date of this Prospectus, all $625,000,000 outstanding principal
amount of the Old Notes were evidenced by global securities, registered in the
name of CEDE & Co., as nominee for DTC, and held by Marine Midland Bank as
securities custodian for CEDE & Co. As indicated elsewhere in this Prospectus,
the Old Notes have been included in the PORTAL Market for trading among
"qualified institutional buyers" pursuant to Rule 144A under the Securities Act.
For purposes of administration, the Company has fixed the close of business
on [ ], 1998 as the record date for the Exchange Offer for purposes of
determining the persons to whom this Prospectus and the accompanying Letter of
Transmittal will be mailed initially. There will be no fixed record date for
determining generally registered holders of Old Notes entitled to participate in
the Exchange Offer.
Holders of Old Notes do not have any appraisal or dissenters' rights under
the General Corporation Law of Delaware or the Indenture in connection with the
Exchange Offer. The Company intends to conduct the Exchange Offer in accordance
with Regulation 14E and Rule 13e-4 under the Exchange Act (other than the filing
requirements of Rule 13e-4).
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The Company shall be deemed to have accepted validly tendered Old Notes
when, as and if the Company has given oral or written notice thereof to the
Exchange Agent. The Exchange Agent will act as agent for the tendering Holders
for the purpose of receiving the New Notes from the Company.
If any tendered Old Notes are not accepted for exchange because of an
invalid tender, the occurrence of certain other events set forth herein under
"--Conditions" or otherwise, the certificates for any such unaccepted Old Notes
will be returned, without expense, to the tendering Holder thereof as promptly
as practicable after the Expiration Date. See "--Procedures for Tendering."
Holders who tender Old Notes in the Exchange Offer will not be required to
pay brokerage commissions or fees or, subject to the instructions in the Letter
of Transmittal, transfer taxes with respect to the exchange of Old Notes
pursuant to the Exchange Offer. The Company will pay all charges and expenses,
other than transfer taxes in certain circumstances, in connection with the
Exchange Offer. See "--Fees and Expenses."
EXPIRATION DATE; EXTENSIONS; AMENDMENTS
The term "Expiration Date" shall mean 5:00 p.m., New York City time, on
[ ], 1998, unless the Company, in its sole discretion, extends the
Exchange Offer, in which case the term "Expiration Date" shall mean the latest
date and time to which the Exchange Offer is extended.
In order to extend the Exchange Offer, the Company will notify the Exchange
Agent of any extension by oral or written notice and will notify the registered
Holders as promptly as practicable by public announcement thereof, the
announcement in the case of an extension to be issued no later than 9:00 a.m.,
New York City time, on the next business day after the previously scheduled
expiration date.
The Company reserves the right, in its sole discretion, (i) to delay
accepting any Old Notes, to extend the Exchange Offer or to terminate the
Exchange Offer if any of the conditions set forth below under "--Conditions"
shall not have been satisfied, by giving oral or written notice of such delay,
extension or termination to the Exchange Agent or (ii) to amend the terms of the
Exchange Offer in any manner. Any such delay in acceptance, extension,
termination or amendment will be followed as promptly as practicable by oral or
written notice thereof to the registered Holders. If the Exchange Offer is
amended in a manner determined by the Company to constitute a material change,
the Company will promptly disclose such amendment by means of a prospectus
supplement that will be distributed to the registered Holders, and the Company
will extend the Exchange Offer, in accordance with applicable rules of the
Commission and published interpretations of the Staff, for a period of five to
ten business days, depending upon the significance of the amendment and the
manner of disclosure to the registered Holders, if the Exchange Offer would
otherwise expire during such five to ten business day period.
Without limiting the manner in which the Company may choose to make public
announcement of any delay, extension, amendment or termination of the Exchange
Offer, the Company shall have no obligation to publish, advertise or otherwise
communicate any such public announcement, other than by making a timely release
to the Dow Jones News Service.
INTEREST ON THE NEW NOTES
Each New Note will bear interest from its date of original issuance. Holders
of Old Notes that are accepted for exchange and exchanged for New Notes will
receive, in cash, accrued interest thereon to, but not including, the original
issuance date of the New Notes. The Old Notes will bear interest at a rate per
annum of 9% through the date next preceding the date of the original issuance of
the New Notes. Such interest will be paid on the first interest payment date for
the New Notes. Interest on the Old Notes accepted for exchange and exchanged in
the Exchange Offer will cease to accrue on the date next preceding the date of
original issuance of the New Notes. The New Notes will bear interest (as do the
Old
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Notes) at a rate per annum of 9%, which interest will be payable semi-annually
on each February 15 and August 15, commencing on August 15, 1998.
PROCEDURES FOR TENDERING
Only a Holder of Old Notes may participate in the Exchange Offer. The tender
to the Exchange Agent of Old Notes by a Holder thereof as set forth below and
the acceptance thereof by the Company will constitute a binding agreement
between the tendering Holder and the Company upon the terms and subject to the
conditions set forth in this Prospectus and in the accompanying Letter of
Transmittal. Except as set forth below, a Holder who wishes to tender Old Notes
for exchange pursuant to the Exchange Offer must transmit a properly completed
and duly executed Letter of Transmittal, including all other documents required
by such Letter of Transmittal, to the Exchange Agent at one of the addresses set
forth below under "Exchange Agent" on or prior to the Expiration Date. In
addition, either (i) a timely Book-Entry Confirmation (as hereinafter defined)
of such Old Notes into the Exchange Agent's account at the Depositary (the "Book
Entry Transfer Facility") pursuant to the procedure for book-entry transfer
described below must be received by the Exchange Agent prior to the Expiration
Date or (ii) the Holder must comply with the guaranteed delivery procedures
described below.
By executing the accompanying Letter of Transmittal, each Holder will
thereby make to the Company the representations set forth above in the third
paragraph under the heading "--Purpose and Effect of the Exchange Offer."
The tender by a Holder and the acceptance thereof by the Company will
constitute an agreement between such Holder and the Company in accordance with
the terms and subject to the conditions set forth herein and in the accompanying
Letter of Transmittal.
THE METHOD OF DELIVERY OF THE LETTER OF TRANSMITTAL AND ALL OTHER REQUIRED
DOCUMENTS TO THE EXCHANGE AGENT IS AT THE ELECTION AND RISK OF THE HOLDER.
INSTEAD OF DELIVERY BY MAIL, IT IS RECOMMENDED THAT HOLDERS USE AN OVERNIGHT OR
HAND DELIVERY SERVICE. IN ALL CASES, SUFFICIENT TIME SHOULD BE ALLOWED TO ASSURE
DELIVERY TO THE EXCHANGE AGENT BEFORE THE EXPIRATION DATE. NO LETTER OF
TRANSMITTAL SHOULD BE SENT TO THE COMPANY. HOLDERS MAY REQUEST THEIR RESPECTIVE
BROKERS, DEALERS, COMMERCIAL BANKS, TRUST COMPANIES OR NOMINEES TO EFFECT THE
ABOVE TRANSACTIONS FOR SUCH HOLDERS.
Any beneficial owner whose Old Notes are registered in the name of a broker,
dealer, commercial bank, trust company or other nominee and who wishes to tender
should contact the registered Holder promptly and instruct such registered
Holder to tender on such beneficial owner's behalf. See "Instruction to
Registered Holder and/or Book-Entry Transfer Facility Participant from Owner"
included with the Letter of Transmittal.
Signatures on a Letter of Transmittal or a notice of withdrawal, as the case
may be, must be guaranteed by an Eligible Institution (as defined below) unless
the Old Notes tendered pursuant thereto are tendered (i) by a registered Holder
who has not completed the box entitled "Special Registration Instructions" or
"Special Delivery Instructions" on the Letter of Transmittal or (ii) for the
account of an Eligible Institution. In the event that signatures on a Letter of
Transmittal or a notice of withdrawal, as the case may be, are required to be
guaranteed, such guarantee must be by a member firm of a registered national
securities exchange or of the National Association of Securities Dealers, Inc.,
a commercial bank or trust company having an office or correspondent in the
United States or an "eligible guarantor institution" within the meaning of Rule
17Ad-15 under the Exchange Act (an "Eligible Institution").
If the Letter of Transmittal is signed by a person other than the registered
Holder of any Old Notes listed therein, such person must submit a properly
completed bond power, signed by such registered
135
Holder as such registered Holder's name appears on such Old Notes with the
signature thereon guaranteed by an Eligible Institution.
If the Letter of Transmittal or any bond powers are signed by trustees,
executors, administrators, guardians, attorneys-in-fact, officers of
corporations or others acting in a fiduciary or representative capacity, such
persons should so indicate when signing, and unless waived by the Company,
evidence satisfactory to the Company of their authority to so act must be
submitted with the Letter of Transmittal.
The Exchange Agent and DTC have confirmed to the Company that any financial
institution that maintains a direct account with DTC (a "Participant") may
utilize DTC's Automated Tender Offer Program ("ATOP") to tender Old Notes for
exchange in the Exchange Offer. The Exchange Agent will request that DTC
establish an account with respect to the Old Notes for purposes of the Exchange
Offer within two business days after the date of this Prospectus. Any
Participant may effect book-entry delivery of Old Notes by causing DTC to record
the transfer of the tendering Participant's beneficial interests in the global
Old Notes into the Exchange Agent's account in accordance with DTC's ATOP
procedures for such transfer. However, the exchange of New Notes for Old Notes
so tendered only will be made after timely confirmation (a "Book-Entry
Confirmation") of such book-entry transfer of Old Notes into the Exchange
Agent's account, and timely receipt by the Exchange Agent of an Agent's Message
(as defined below) and any other documents required by the Letter of
Transmittal. The term "Agent's Message" as used herein means a message,
transmitted by DTC and received by the Exchange Agent and forming part of a
Book-Entry Confirmation, which states that DTC has received an express
acknowledgment from a Participant tendering Old Notes for exchange which are the
subject of such Book-Entry Confirmation that such Participant has received and
agrees to be bound by the terms and conditions of the Letter of Transmittal, and
that the Company may enforce such agreement against such Participant.
All questions as to the validity, form, eligibility (including time of
receipt), acceptance of tendered Old Notes and withdrawal of tendered Old Notes
will be determined by the Company in its sole discretion, which determination
will be final and binding. The Company reserves the absolute right to reject any
and all Old Notes not properly tendered or any Old Notes the Company's
acceptance of which would, in the opinion of counsel for the Company, be
unlawful. The Company also reserves the right to waive any defects,
irregularities or conditions of tender as to particular Old Notes. The Company's
interpretation of the terms and conditions of the Exchange Offer (including the
instructions in the Letter of Transmittal) will be final and binding on all
parties. Unless waived, any defects or irregularities in connection with tenders
of Old Notes must be cured within such time as the Company shall determine.
Although the Company intends to notify Holders of defects or irregularities with
respect to tenders of Old Notes, neither the Company, the Exchange Agent nor any
other person shall incur any liability for failure to give such notification.
Tenders of Old Notes will not be deemed to have been made until such defects or
irregularities have been cured or waived. Any Old Notes received by the Exchange
Agent that are not properly tendered and as to which the defects or
irregularities have not been cured or waived will be returned by the Exchange
Agent to the tendering Holders, unless otherwise provided in the Letter of
Transmittal, as soon as practicable following the Expiration Date.
GUARANTEED DELIVERY PROCEDURES
Holders who wish to tender their Old Notes and (i) who cannot deliver the
Letter of Transmittal or any other required documents to the Exchange Agent or
(ii) who cannot complete the procedures for book-entry transfer, prior to the
Expiration Date, may effect a tender if:
(a) the tender is made through an Eligible Institution;
(b) prior to the Expiration Date, the Exchange Agent receives from such
Holder and such Eligible Institution a properly completed and duly executed
Notice of Guaranteed Delivery (by facsimile transmission, mail or hand
delivery) setting forth the name and address of the Holder and the principal
amount of Old Notes tendered, stating that the tender is being made thereby
and
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guaranteeing that, within three New York Stock Exchange trading days after
the Expiration Date, the Letter of Transmittal (or facsimile thereof)
together with a confirmation of book-entry transfer of such Old Notes into
the Exchange Agent's account at the Book-Entry Transfer Facility, and any
other documents required by the Letter of Transmittal will be deposited by
the Eligible Institution with the Exchange Agent; and
(c) such properly completed and executed Letter of Transmittal (or
facsimile thereof), as well as a confirmation of book-entry transfer of such
Old Notes into the Exchange Agent's account at the Book-Entry Transfer
Facility, and all other documents required by the Letter of Transmittal are
received by the Exchange Agent within three New York Stock Exchange trading
days after the Expiration Date.
Upon request to the Exchange Agent, a Notice of Guaranteed Delivery will be
sent to Holders who wish to tender their Old Notes according to the guaranteed
delivery procedures set forth above.
WITHDRAWAL OF TENDERS
Except as otherwise provided herein, tenders of Old Notes may be withdrawn
at any time prior to 5:00 p.m., New York City time, on the Expiration Date. To
withdraw a tender of Old Notes in the Exchange Offer, a written or facsimile
transmission notice of withdrawal must be received by the Exchange Agent at its
address set forth herein prior to 5:00 p.m., New York City time, on the
Expiration Date. Any such notice of withdrawal must (i) specify the name of the
person having deposited the Old Notes to be withdrawn (the "Depositor"), (ii)
identify the Old Notes to be withdrawn (including the certificate number(s) and
principal amount of such Old Notes, or, in the case of Old Notes transferred by
book-entry transfer, the name and number of the account at the Book-Entry
Transfer Facility to be credited), (iii) be signed by the Holder in the same
manner as the original signature on the Letter of Transmittal by which such Old
Notes were tendered (including any required signature guarantees) or be
accompanied by documents of transfer sufficient to have the Trustee with respect
to the Old Notes register the transfer of such Old Notes into the name of the
person withdrawing the tender and (iv) specify the name in which any such Old
Notes are to be registered, if different from that of the Depositor. All
questions as to the validity, form and eligibility (including time of receipt)
of such notices will be determined by the Company, whose determination shall be
final and binding on all parties. Any Old Notes so withdrawn will be deemed not
to have been validly tendered for purposes of the Exchange Offer and no New
Notes will be issued with respect thereto unless the Old Notes so withdrawn are
validly retendered. Any Old Notes which have been tendered but which are not
accepted for exchange, will be returned to the Holder thereof without cost to
such Holder as soon as practicable after withdrawal, rejection of tender or
termination of the Exchange Offer. Properly withdrawn Old Notes may be
retendered by following one of the procedures described above under
"--Procedures for Tendering" at any time prior to the Expiration Date.
CONDITIONS
Notwithstanding any other term of the Exchange Offer, the Company shall not
be required to accept for exchange, or exchange New Notes for, any Old Notes,
and may terminate or amend the Exchange Offer as provided herein before the
acceptance of such Old Notes, if:
(a) any action or proceeding is instituted or threatened in any court or
by or before any governmental agency with respect to the Exchange Offer
which, in the sole judgment of the Company, might materially impair the
ability of the Company to proceed with the Exchange Offer or any material
adverse development has occurred in any existing action or proceeding with
respect to the Company or any of its subsidiaries; or
(b) any change, or any development involving a prospective change, in
the business or financial affairs of the Company or any of its subsidiaries
has occurred which, in the sole judgment
137
of the Company, might materially impair the ability of the Company to
proceed with the Exchange Offer; or
(c) any law, statute, rule, regulation or interpretation by the Staff is
proposed, adopted or enacted, which, in the sole judgment of the Company,
might materially impair the ability of the Company to proceed with the
Exchange Offer or materially impair the contemplated benefits of the
Exchange Offer to the Company; or
(d) any governmental approval has not been obtained, which approval the
Company shall, in its sole discretion, deem necessary for the consummation
of the Exchange Offer as contemplated hereby.
If the Company determines in its sole discretion that any of the conditions
are not satisfied, the Company may (i) refuse to accept any Old Notes and return
all tendered Old Notes to the tendering Holders, (ii) extend the Exchange Offer
and retain all Old Notes tendered prior to the expiration of the Exchange Offer,
subject, however, to the rights of Holders to withdraw such Old Notes (see
"--Withdrawal of Tenders") or (iii) waive such unsatisfied conditions with
respect to the Exchange Offer and accept all properly tendered Old Notes which
have not been withdrawn. If such waiver constitutes a material change to the
Exchange Offer, the Company will promptly disclose such waiver by means of a
prospectus supplement that will be distributed to the registered Holders, and
the Company will extend the Exchange Offer, in accordance with applicable rules
of the Commission and published interpretation of the Staff, for a period of
five to ten business days, depending upon the significance of the waiver and the
manner of disclosure to the registered Holders, if the Exchange Offer would
otherwise expire during such five to ten business day period.
EXCHANGE AGENT
Marine Midland Bank has been appointed as Exchange Agent for the Exchange
Offer. Questions and requests for assistance, requests for additional copies of
this Prospectus or of the Letter of Transmittal and requests for Notices of
Guaranteed Delivery should be directed to the Exchange Agent addressed as
follows:
Marine Midland Bank
140 Broadway, Level A
New York, New York 10005-1180
Attention: Corporate Trust Operations
Telephone: (212) 658-6433
Facsimile: (212) 658-6425
FEES AND EXPENSES
The expenses of soliciting tenders will be borne by the Company. The
principal solicitation is being made by mail; however, additional solicitation
may be made by telegraph, telephone or in person by officers and regular
employees of the Company and its affiliates.
The Company has not retained any dealer-manager in connection with the
Exchange Offer and will not make any payments to brokers or others soliciting
acceptances of the Exchange Offer. The Company, however, will pay the Exchange
Agent reasonable and customary fees for its services and will reimburse it for
its reasonable out-of-pocket expenses in connection therewith and will reimburse
the Holders of the Old Notes for the reasonable fees and expenses of not more
than one firm of counsel designated by the holders of a majority in principal
amount of the Old Notes outstanding within the meaning of the Indenture to act
as counsel for all Holders of Old Notes in connection therewith and will
reimburse the Holders of the Old Notes for the reasonable fees and expenses of
not more than one firm of counsel designated by the holders of a majority in
principal amount of the Old Notes outstanding
138
within the meaning of the Indenture to act as counsel for all Holders of Old
Notes in connection therewith.
The cash expenses to be incurred in connection with the Exchange Offer will
be paid by the Company. Such expenses include fees and expenses of the Exchange
Agent and Trustee, accounting and legal fees and printing costs, among others.
The Company will pay all transfer taxes, if any, applicable to the exchange
of Old Notes pursuant to the Exchange Offer. If, however, certificates
representing New Notes or Old Notes for principal amounts not tendered or
accepted for exchange are to be delivered to, or are to be issued in the name
of, any person other than the registered Holder of the Old Notes tendered, or if
tendered Old Notes are registered in the name of any person other than the
person signing the Letter of Transmittal, or if a transfer tax is imposed for
any reason other than the exchange of Old Notes pursuant to the Exchange Offer,
then the amount of any such transfer taxes (whether imposed on the registered
Holder or any other persons) will be payable by the tendering Holder. If
satisfactory evidence of payment of such taxes or exemption therefrom is not
submitted with the Letter of Transmittal, the amount of such transfer taxes will
be billed directly to such tendering Holder.
ACCOUNTING TREATMENT
The New Notes will be recorded at the same carrying value as the Old Notes,
which is face value, as reflected in the Company's accounting records on the
date of the exchange. Accordingly, no gain or loss for accounting purposes will
be be recognized.
TERMINATION OF CERTAIN RIGHTS
Holders of the New Notes will not be entitled to the benefits of the
Registration Rights Agreement, pursuant to which the Company agreed, for the
benefit of holders of the Old Notes, that it would, at its expense, (i) as soon
as practicable after the initial issuance of the Old Notes, file a registration
statement with the Commission with respect to a registered offer to exchange the
Old Notes for the New Notes and (ii) use its best efforts to cause such
registration statement to be declared effective under the Securities Act by July
10, 1998.
In addition, pursuant to the Registration Rights Agreement, if (i) because
of any change in law or applicable interpretations thereof by the staff of the
Commission, the Company is not permitted to effect the Exchange Offer as
contemplated hereby, (ii) any Old Notes validly tendered pursuant to the
Exchange Offer are not exchanged for New Notes by September 10, 1998, (iii) the
Initial Purchaser so requests with respect to Old Notes not eligible to be
exchanged for New Notes in the Exchange Offer, (iv) any applicable law or
interpretations do not permit any holder of Old Notes to participate in the
Exchange Offer, (v) any holder of Old Notes that participates in the Exchange
Offer does not receive freely transferable New Notes in exchange for tendered
Old Notes, or (vi) the Company so elects, then the Company will file with the
Commission a shelf registration statement (the "Shelf Registration Statement")
to cover resales of Transfer Restricted Securities by such holders who satisfy
certain conditions relating to the provision of information in connection with
the Shelf Registration Statement. For purposes of the foregoing, "Transfer
Restricted Securities" means each Old Note until (i) the date on which such Old
Note has been exchanged for a freely transferable New Note in the Exchange
Offer; (ii) the date on which such Old Note has been effectively registered
under the Securities Act and disposed of in accordance with the Shelf
Registration Statement or (iii) the date on which such Old Note is distributed
to the public pursuant to Rule 144 under the Securities Act or is saleable
pursuant to Rule 144(k) under the Securities Act. The Company will use its
reasonable best efforts to have the Shelf Registration Statement declared
effective by the Commission as promptly as practicable after the filing thereof
and to keep the Shelf Registration Statement continuously effective until
February 12, 2000. The Company, at its expense, will provide to each holder of
the Old Notes copies of the prospectus that is a part of the Shelf
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Registration Statement, notify each such holder when the Shelf Registration
Statement has become effective and take certain other actions as are required to
permit unrestricted resales of the Old Notes from time to time. A holder of Old
Notes who sells such Old Notes pursuant to the Shelf Registration Statement
generally will be required to be named as a selling security holder in the
related prospectus and to deliver a prospectus to purchasers, will be subject to
certain of the civil liability provisions under the Securities Act in connection
with such sales and will be bound by the provisions of the Registration Rights
Agreement which are applicable to such holder (including certain indemnification
obligations).
Pursuant to the Registration Rights Agreement, the Company agreed that, in
the event that the Exchange Offer is not consummated on or prior to September
10, 1998, the Company will be obligated to pay liquidated damages to each holder
of the Old Notes in an amount equal to $0.192 per week per $1,000 principal
amount of the Old Notes held by such holder until the Exchange Offer is
consummated. See "--Purpose and Effect of the Exchange Offer."
CONSEQUENCES OF FAILURE TO EXCHANGE
The Old Notes that are not exchanged for New Notes pursuant to the Exchange
Offer will remain "restricted securities" (within the meaning of the Securities
Act). Accordingly, prior to the date that is two years after the later of the
date of the original issue thereof and the last date on which the Company or any
affiliate of the Company was the owner of such Old Notes (the "Resale
Restriction Termination Date"), such Old Notes may be resold only (i) to the
Company, (ii) to a person whom the seller reasonably believes is a "qualified
institutional buyer" purchasing for its own account or for the account of
another "qualified institutional buyer" in compliance with the resale
limitations of Rule 144A, (iii) to an "accredited investor" (as defined in Rule
501(a)(1), (2), (3) or (7) of Regulation D under the Securities Act) that is an
institution (an "Institutional Accredited Investor") that, prior to such
transfer, furnishes to the Trustee a written certification containing certain
representations and agreements relating to the restrictions on transfer of the
Notes (the form of which letter can be obtained from the Trustee), (iv) pursuant
to the limitations on resale provided by Rule 144 under the Securities Act (if
available), (v) pursuant to the resale provisions of Rule 904 of Regulation S
under the Securities Act, (vi) pursuant to an effective registration statement
under the Securities Act or (vii) pursuant to any other available exemption from
the registration requirements of the Securities Act, subject in each of the
foregoing cases to any requirement of law that the disposition of its property
or the property of such account be at all times within its control and to
compliance with applicable state securities laws. The foregoing restrictions on
resale will not apply subsequent to the Resale Restriction Termination Date.
RESALES OF THE NEW NOTES
With respect to resales of New Notes, based on existing interpretations of
the Staff, the Company believes that the New Notes issued pursuant to the
Exchange Offer in exchange for Old Notes may be offered for resale, resold and
otherwise transferred by holders thereof (other than any such holder which is an
"affiliate" of the Company within the meaning of Rule 405 under the Securities
Act) without compliance with the registration and prospectus delivery
requirements of the Securities Act; provided such New Notes are acquired in the
ordinary course of such holders' business and such holders are not engaged in,
have no arrangement with any person to participate in, and do not intend to
engage in any public distribution of the New Notes. Each Participating
Broker-Dealer receiving New Notes in the Exchange Offer will be subject to a
prospectus delivery requirement with respect to resales of such New Notes. Each
Participating Broker-Dealer must acknowledge that it will deliver a resale
prospectus in connection with any resale of such New Notes. The Letter of
Transmittal which accompanies this Prospectus states that by so acknowledging
and by delivering a resale prospectus, a Participating Broker-Dealer will be
deemed not to be acting in the capacity of an "underwriter" (within the meaning
of Section 2(11) of the Securities Act). This Prospectus, as it may be amended
or supplemented from time to time, may be used by a Participating Broker-Dealer
in connection with resales of New Notes received
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in exchange for Old Notes where such Old Notes were acquired by such
Participating Broker-Dealer as result of market-making or other trading
activities. Pursuant to the Registration Rights Agreement, the Company has
agreed to permit Participating Broker-Dealers and other persons, if any, subject
to similar prospectus delivery requirements to use this Prospectus in connection
with the resale of such New Notes for a period of 180 days from the date on
which the Registration Statement of which this Prospectus is a part is first
declared effective.
Each holder of the Old Notes who wishes to exchange its Old Notes for New
Notes in the Exchange Offer will be required to make certain representations to
the Company in the accompanying Letter of Transmittal, including that (i) any
New Notes to be received by it will be acquired in the ordinary course of its
business, (ii) it has no arrangement with any person to participate in a public
distribution (within the meaning of the Securities Act) of the New Notes, and
(iii) it is not an "affiliate," as defined in Rule 405 of the Securities Act of
the Company, or if it is such an affiliate, that it will comply with the
registration and prospectus delivery requirements of the Securities Act to the
extent applicable to it. In addition, each holder who is not a broker-dealer
will be required to represent that it is not engaged in, and does not intend to
engage in, a public distribution of the New Notes. Each Participating
Broker-Dealer who receives New Notes for its own account in exchange for Old
Notes that were acquired by it as a result of market-making or other trading
activities, will be required to acknowledge that it will deliver a Prospectus in
connection with any resale by it of such Old Notes. For a description of the
procedures for certain resales by broker-dealers, see "Plan of Distribution."
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PLAN OF DISTRIBUTION
Each Participating Broker-Dealer that holds Old Notes that were acquired for
its own account as a result of market-making or other trading activities (other
than Old Notes acquired directly from the Company), may exchange such Old Notes
for New Notes pursuant to the Exchange Offer. However, a Participating
Broker-Dealer may be deemed to be an "underwriter" within the meaning of the
Securities Act and, therefore, will be required to deliver a prospectus
satisfying the requirements of the Act in connection with any resales by it of
such New Notes. This Prospectus, as it may be amended or supplemented from time
to time, may be used by a Participating Broker-Dealer in connection with resales
of New Notes received in exchange for Old Notes in satisfaction of such
prospectus-delivery requirement. The delivery by a Participating Broker-Dealer
of this Prospectus in connection with resales of New Notes shall not be deemed
to be an admission by such Participating Broker-Dealer that it is an
"underwriter" within the meaning of the Act. The Company has agreed that it
shall cause the Registration Statement of which this Prospectus is a part to
remain current and continuously effective for a period of 180 days from the date
on which such Registration Statement was first declared effective and that it
shall supplement or amend from time to time this Prospectus to the extent
necessary to permit this Prospectus (as so supplemented or amended) to be
delivered by Participating Broker-Dealers in connection with their resales of
New Notes.
The Company will not receive any proceeds from any sale of New Notes by
Participating Broker-Dealers or otherwise. New Notes received by Participating
Broker-Dealers for their own account pursuant to the Exchange Offer may be sold
from time to time in one or more transactions in the over-the-counter market, in
negotiated transactions, through the writing of options on the New Notes or a
combination of such methods of resale, at market prices prevailing at the time
of resale, at prices related to such prevailing market prices or at negotiated
prices. Any such resale may be made directly to purchasers or to or through
dealers who may receive compensation in the form of commissions, concessions or
allowances from any such Participating Broker-Dealer and/or the purchasers of
any such New Notes. Any Broker-Dealer that resells New Notes that were received
by it for its own account pursuant to the Exchange Offer and any broker or
dealer that participates in a distribution of such New Notes may be deemed to be
an "underwriter" within the meaning of the Securities Act and any profit on any
such resale of New Notes and any commissions, concessions or allowances received
by any such persons may be deemed to be underwriting compensation under the
Securities Act. The accompanying Letter of Transmittal states that by
acknowledging that it will deliver and by delivering a prospectus, a
broker-dealer will not be deemed to admit that it is an "underwriter" within the
meaning of the Securities Act.
For a period 180 days from the date on which the Registration Statement of
which this Prospectus is a part is first declared effective, the Company will
deliver to each holder of New Notes, without charge, as many copies of this
Prospectus and any amendment or supplement to this Prospectus as such person may
reasonably request. The Company has agreed to pay all expenses incident to the
Exchange Offer other than commissions, concessions or allowances of any brokers
or dealers and certain transfer taxes and will indemnify the holders of the New
Notes (including any Participating Broker-Dealers) against certain liabilities,
including liabilities under the Securities Act, or to the extent such
indemnification is unavailable or insufficient, to contribute to any payments
that such Participating Broker-Dealers may be required to make in respect
thereof.
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DESCRIPTION OF THE NEW NOTES
GENERAL
The New Notes will be issued under the Indenture, dated February 12, 1998,
between the Company and Marine Midland Bank, as trustee (the "Trustee"),
pursuant to which the Old Notes were issued. For purposes of the following
summary, the Old Notes and the New Notes shall be collectively referred to as
the "Notes." The terms of the Notes include those stated in the Indenture and
those made part of the Indenture by reference to the Trust Indenture Act of
1939, as amended (the "Trust Indenture Act"). The Notes are subject to all such
terms, and holders of the Notes are referred to the Indenture and the Trust
Indenture Act for a statement thereof. The following summary of certain
provisions of the Indenture does not purport to be complete and is qualified in
its entirety by reference to the Indenture, including the definitions therein of
certain terms used below and those terms made a part thereof by the Trust
Indenture Act. The definitions of certain terms used in the following summary
are set forth below under "--Certain Definitions." Copies of the Indenture will
be made available to holders of Notes upon request.
The Notes will be general unsecured senior subordinated obligations of the
Company. The Notes are limited in aggregate principal amount to $625 million and
will mature on February 15, 2008. Interest on the Notes will accrue at the rate
of 9% per annum and will be payable semi-annually on each February 15 and August
15, commencing on August 15, 1998, to the holders of record on the immediately
preceding February 1 and August 1, whether or not a business day. Interest on
the Notes will accrue from the most recent date to which interest has been paid
or, if no interest has been paid, from the date of issuance. Interest will be
computed on the basis of a 360-day year, comprised of twelve 30-day months.
Interest and principal on the Notes will be payable at the office or agency of
the Company maintained for such purpose within the City of New York, Borough of
Manhattan or, at the option of the Company, payment of interest may be made by
check mailed to the holders of the Notes at their respective addresses set forth
in the register of holders of Notes. Unless otherwise designated by the Company,
the Company's office or agency maintained for such purpose in the City of New
York, Borough of Manhattan will be the office of the Trustee located at 140
Broadway, New York, New York 10005. The Notes will be issued only in fully
registered form, without coupons in denominations of $1,000 and integral
multiples thereof.
OPTIONAL REDEMPTION
The Notes are not redeemable at the option of the Company prior to February
15, 2003. The Notes will be redeemable at the option of the Company on or after
such date, in whole or in part, upon not less than 30 nor more than 60 days
prior notice mailed by first-class mail to each holder's registered address, at
the redemption prices (expressed as a percentage of the principal amount) set
forth below, plus accrued and unpaid interest thereon to the applicable
redemption date (subject to the right of holders of record on the relevant
record date to receive interest due on the relevant interest payment date), if
redeemed during the twelve-month period beginning on February 15 of the years
indicated below:
REDEMPTION
YEAR PRICES
- -------------------------------------------------------------------------------- ------------
2003............................................................................ 104.500%
2004............................................................................ 103.000%
2005............................................................................ 101.500%
2006 and thereafter............................................................. 100.000%
In addition, at any time and from time to time prior to February 15, 2001,
the Company may, at its option, redeem up to 35% of the original aggregate
principal amount of Notes at a redemption price (expressed as a percentage of
the principal amount) of 109%, plus accrued and unpaid interest thereon, if any,
to the redemption date (subject to the right of holders of record on the
relevant record date to receive interest due on the relevant interest payment
date), with the net cash proceeds of one or more
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Equity Offerings; PROVIDED that at least 65% of such original aggregate
principal amount of Notes remains outstanding immediately after the occurrence
of such redemption; and PROVIDED, FURTHER, that such redemption shall occur
within 60 days of the date of the closing of any such Equity Offering.
SINKING FUND
The Notes are not subject to the benefit of any sinking fund.
SELECTION AND NOTICE
If less than all of the Notes are to be redeemed at any time, selection of
the Notes for redemption will be made by the Trustee in compliance with the
requirements of the principal national securities exchange, if any, on which the
Notes are listed or, if the Notes are not listed on a national securities
exchange, on a pro rata basis, provided that Notes shall be redeemed in
principal amounts of $1,000 or integral multiples thereof. Notice of redemption
shall be mailed by first-class mail at least 30 but not more than 60 days before
the redemption date to each holder of Notes to be redeemed at its registered
address. If any Note is to be redeemed in part only, the notice of redemption
that relates to such Note shall state the portion of the principal amount
thereof to be redeemed. A new Note in principal amount equal to the unredeemed
portion thereof will be issued in the name of the holder thereof upon
cancellation of the original Note. On and after the redemption date, interest
ceases to accrue on Notes or portions of them called for redemption.
CHANGE OF CONTROL
Upon the occurrence of a Change of Control, each holder of Notes shall have
the right to require the repurchase of such holder's Notes in whole or in part
pursuant to the offer described below (the "Change of Control Offer") at a
purchase price equal to 101% of the aggregate principal amount thereof plus
accrued and unpaid interest, if any, to the date of purchase (subject to the
right of holders of record on the relevant record date to receive interest due
on the relevant interest payment date). Within 10 days following any Change of
Control, the Company shall mail a notice (along with any other instructions
determined by the Company, consistent with this covenant, that a holder must
follow in order to have its Notes purchased) to the Trustee and to each holder
stating: (i) that the Change of Control Offer is being made pursuant to the
"Change of Control" provision of the Indenture and that all Notes tendered and
not subsequently withdrawn will be accepted for payment and paid for by the
Company; (ii) the purchase price and the purchase date (which shall not be less
than 30 days nor more than 60 days after the date such notice is mailed) (the
"Change of Control Payment Date"); (iii) that any Note not tendered will
continue to accrue interest and shall continue to be governed by the terms of
the Indenture in all respects; (iv) that, unless the Company defaults in the
payment thereof, all Notes accepted for payment pursuant to the Change of
Control Offer shall cease to accrue interest on and after the Change of Control
Payment Date; (v) that holders electing to have any Notes purchased pursuant to
a Change of Control Offer will be required to surrender the Notes to be
purchased to the Paying Agent at the address specified in the notice prior to
the close of business on the business day next preceding the Change of Control
Payment Date; (vi) that holders will be entitled to withdraw their election on
the terms and conditions set forth in such notice; and (vii) that holders whose
Notes are being purchased only in part will be issued new Notes equal in
principal amount to the unpurchased portion of the Notes surrendered; provided
that each Note purchased and each such new Note issued shall be in a principal
amount of $1,000 or integral multiples thereof.
On (or, in the case of clause (ii) of this paragraph, at the Company's
election, before) the Change of Control Payment Date, the Company shall (i)
accept for payment all Notes or portions thereof tendered and not theretofore
withdrawn, pursuant to the Change of Control Offer, (ii) deposit with the Paying
Agent immediately available funds sufficient to pay the purchase price of all
Notes or portions thereof accepted for payment, and (iii) deliver or cause to be
delivered to the Trustee all Notes so tendered, together with
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an officer's certificate specifying the Notes or portions thereof tendered to
the Company. The Paying Agent shall promptly mail to each holder of Notes so
tendered payment in an amount equal to the purchase price for such Notes, and
the Trustee shall promptly authenticate and mail to such holder one or more
certificates evidencing new Notes equal in principal amount to any unpurchased
portion of the Notes surrendered; provided that each such new Note shall be in a
principal amount of $1,000 or integral multiples thereof. The Company will
publicly announce the results of the Change of Control Offer on or as soon as
practicable after the Change of Control Payment Date.
If at the time of such Change of Control the terms of the Bank Indebtedness
restrict or prohibit the repurchase of Notes pursuant to this covenant, then
prior to the mailing of the notice to holders provided for in the second
preceding paragraph, the Company shall (i) repay in full all Bank Indebtedness
or offer to repay in full all Bank Indebtedness and repay the Bank Indebtedness
of each lender who has accepted such offer or (ii) (x) obtain any requisite
consent under the agreements governing the Bank Indebtedness to permit the
repurchase of Notes as provided for in this covenant or (y) deliver to the
Trustee an officer's certificate signed by a responsible financial officer of
the Company that no such consent is required.
The Company will comply with the requirements of Regulation 14E and Rule
13e-4 (other than the filing requirements of such rule) under the Exchange Act,
and any other securities laws and regulations thereunder that are applicable in
connection with the repurchase of the Notes resulting from a Change of Control.
The Change of Control purchase feature is a result of negotiations between
the Company and the Initial Purchaser. Management has no present intention to
engage in a transaction involving a Change of Control, although it is possible
that the Company would decide to do so in the future. Subject to the limitations
discussed below, the Company could, in the future, enter into certain
transactions, including acquisitions, refinancings or other recapitalizations,
that would not constitute a Change of Control under the Indenture, but that
could increase the amount of indebtedness outstanding at such time or otherwise
affect the Company's capital structure or credit ratings.
The occurrence of certain of the events which would constitute a Change of
Control would constitute a default under the New Credit Agreement. Future Senior
Indebtedness of the Company may contain prohibitions of certain events which
would constitute a Change of Control or require such Senior Indebtedness to be
repurchased upon a Change of Control. Moreover, the exercise by the holders of
their right to require the Company to repurchase the Notes could cause a default
under such Senior Indebtedness, even if the Change of Control itself does not,
due to the financial effect of such repurchase on the Company. Finally, the
Company's ability to pay cash to the holders upon a repurchase may be limited by
the Company's then existing financial resources. There can be no assurance that
sufficient funds will be available when necessary to make any required
repurchases.
SUBORDINATION
The indebtedness evidenced by the Notes will be unsecured Senior
Subordinated Indebtedness of the Company, will be subordinated in right of
payment, as set forth in the Indenture, to all existing and future Senior
Indebtedness of the Company, will rank PARI PASSU in right of payment with all
existing and future Senior Subordinated Indebtedness of the Company and will be
senior in right of payment to all existing and future Subordinated Obligations
of the Company. The Notes will also be effectively subordinated to any Secured
Indebtedness of the Company and its subsidiaries to the extent of the value of
the assets securing such Indebtedness. However, payment from the money or the
proceeds of U.S. Government Obligations (as defined in the Indenture) held in
any defeasance trust described under "Defeasance and Discharge of the Indenture
and the Notes" below is not subordinated to any Senior Indebtedness or subject
to the restrictions described herein.
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Currently, substantially all of the operations of the Company are conducted
through its subsidiaries. Claims of creditors of such subsidiaries, including
trade creditors, and claims of preferred stockholders (if any) of such
subsidiaries generally will have priority with respect to the assets and
earnings of such subsidiaries over the claims of creditors of the Company,
including holders of the Notes. The Notes, therefore, will be effectively
subordinated to creditors (including trade creditors) and preferred stockholders
(if any) of subsidiaries of the Company. At December 31, 1997, after giving pro
forma effect to the Transactions, the total liabilities (including indebtedness
but excluding subsidiary guarantees of amounts outstanding under the New Credit
Agreement) of the Company's subsidiaries were approximately $746.5 million,
including trade payables. Although the Indenture limits the incurrence of
indebtedness and preferred stock of certain of the Company's subsidiaries, such
limitation is subject to a number of significant qualifications.
As of December 31, 1997, on a pro forma basis after giving effect to the
Transactions, (i) the aggregate amount of the Company's outstanding Senior
Indebtedness would have been $590.2 million (exclusive of unused commitments),
substantially all of which would have been Secured Indebtedness and would have
been guaranteed by substantially all of the Company's subsidiaries, (ii) the
Company would have had no Senior Subordinated Indebtedness other than the Notes
and no Indebtedness that is subordinate or junior in right of payment to the
Notes and (iii) the outstanding indebtedness of the Company's subsidiaries
(excluding guarantees of the Company's indebtedness) would have been $363.1
million, substantially all of which would have been Secured Indebtedness.
Only Indebtedness of the Company that is Senior Indebtedness will rank
senior to the Notes. The Notes will in all respects rank PARI PASSU with all
other Senior Subordinated Indebtedness of the Company. The Company has agreed in
the Indenture that it will not incur, directly or indirectly, any Indebtedness
which is subordinate or junior in ranking in any respect to Senior Indebtedness
unless such Indebtedness is Senior Subordinated Indebtedness or is expressly
subordinated in right of payment to Senior Subordinated Indebtedness. Unsecured
Indebtedness is not deemed to be subordinate or junior to Secured Indebtedness
merely because it is unsecured.
Upon any distribution to creditors upon any liquidation, dissolution,
winding up, bankruptcy, reorganization, assignment for the benefit of creditors,
marshaling of assets and liabilities, insolvency, receivership or similar
proceedings relating to the Company, the holders of Senior Indebtedness will be
entitled to receive payment in full of all obligations with respect to Senior
Indebtedness before the holders of Notes receive any direct or indirect payment
(excluding certain permitted equity or subordinated securities) on account of
principal of, premium, if any, or interest on the Notes.
The Company may not pay principal of, premium (if any) or interest on, the
Notes or make any deposit pursuant to the provisions described under "Defeasance
and Discharge of the Indenture and the Notes" below and may not otherwise
purchase, redeem or otherwise retire any Notes (collectively, "pay the Notes")
if (i) any Specified Senior Indebtedness is not paid when due or (ii) any other
default on Specified Senior Indebtedness occurs which results in the maturity of
such Specified Senior Indebtedness being accelerated in accordance with its
terms unless, in either case, the default has been cured or waived or any such
acceleration has been rescinded or such Specified Senior Indebtedness has been
paid in full. However, the Company may pay the Notes without regard to the
foregoing if the Company and the Trustee receive written notice approving such
payment from the Representative of the Specified Senior Indebtedness with
respect to which either of the events set forth in clause (i) or (ii) of the
immediately preceding sentence has occurred and is continuing. During the
continuance of any default (other than a default described in clause (i) or (ii)
of the second preceding sentence) with respect to any Specified Senior
Indebtedness pursuant to which the maturity thereof may be accelerated
immediately without further notice (except such notice as may be required to
effect such acceleration) or the expiration of any applicable grace periods, the
Company may not pay the Notes for a period (a "Payment Blockage Period")
commencing upon the receipt by the Trustee (with a copy to the Company) of
written notice (a "Blockage Notice") of such default from the Representative of
the Specified Senior
146
Indebtedness specifying an election to effect a Payment Blockage Period and
ending 179 days thereafter (or earlier if such Payment Blockage Period is
terminated (i) by written notice to the Trustee and the Company from the Person
or Persons who gave such Blockage Notice, (ii) by repayment in full of such
Specified Senior Indebtedness or (iii) because the default giving rise to such
Blockage Notice is no longer continuing). Notwithstanding the provisions
described in the immediately preceding sentence (but subject to the provisions
contained in the first sentence of this paragraph), unless the holders of such
Specified Senior Indebtedness or the Representative of such holders have
accelerated the maturity of such Specified Senior Indebtedness, the Company may
resume payments on the Notes after the end of such Payment Blockage Period. Not
more than one Blockage Notice may be given in any consecutive 360-day period,
irrespective of the number of defaults that may exist or occur with respect to
Specified Senior Indebtedness during such period. However, subject to the
following sentence, if any Blockage Notice within such 360-day period is given
by or on behalf of any holders of Specified Senior Indebtedness other than the
Bank Indebtedness, the Representative of the Bank Indebtedness may give another
Blockage Notice within such period. In no event, however, may the total number
of days during which any Payment Blockage Period or Periods is in effect exceed
179 days in the aggregate during any 360 consecutive day period. For purposes of
this Section, no default or event of default that existed or was continuing on
the date of the commencement of any Payment Blockage Period with respect to the
Specified Senior Indebtedness initiating such Payment Blockage Period shall be,
or be made, the basis of the commencement of a subsequent Payment Blockage
Period by the Representative of such Specified Senior Indebtedness, whether or
not within a period of 360 consecutive days, unless such default or event of
default shall have been cured or waived for a period of not less than 90
consecutive days.
CERTAIN COVENANTS
LIMITATION ON RESTRICTED PAYMENTS. The Company will not, and will not
permit any of its Restricted Subsidiaries to, directly or indirectly, (i)
declare or pay any dividend or make any distribution on or in respect of the
Company's or any of its Restricted Subsidiaries' Capital Stock or other Equity
Interests, including any such payment in connection with any merger or
consolidation (other than dividends or distributions payable to the Company or
any of its Restricted Subsidiaries or payable in shares of Capital Stock or
other Equity Interests of the Company other than Redeemable Stock), (ii)
purchase, repurchase, redeem or otherwise acquire or retire for value any Equity
Interests of the Company or any of its Subsidiaries from any Person (other than
from the Company or any of its Restricted Subsidiaries); (iii) purchase,
repurchase, redeem, prepay, defease, or otherwise acquire or retire for value
(A) any Subordinated Obligations prior to scheduled maturity, repayment or
sinking fund payment or (B) any Indebtedness of any Unrestricted Subsidiary or
(iv) make any Investment other than a Permitted Investment (the foregoing
actions set forth in clauses (i) through (iv) being referred to as "Restricted
Payments"), if at the time the Company or such Restricted Subsidiary makes such
Restricted Payment:
(a) a Default or Event of Default shall have occurred and be continuing
or shall occur as a consequence thereof; or
(b) such Restricted Payment (the amount so expended, if other than in
cash and if greater than $20 million, to be determined in good faith by the
Board of Directors, whose determination will be conclusive and evidenced by
a resolution of the Board of Directors), together with the aggregate of all
other Restricted Payments made on or after the Closing Date, exceeds the sum
of (A) $15 million, (B) 50% of the Consolidated Net Income of the Company
accrued on a cumulative basis for the period beginning on the first day of
the first month following the Closing Date and ending on the last day of the
last month immediately preceding the month in which such Restricted Payment
occurs (or, if aggregate cumulative Consolidated Net Income for such period
is a deficit, minus 100% of such deficit), (C) 100% of the aggregate net
cash proceeds received by the Company after the Closing Date from the
issuance or sale of Capital Stock or other Equity Interests of the Company
147
(other than such Capital Stock or other Equity Interests issued or sold to a
Subsidiary of the Company or an employee stock ownership plan or similar
trust established by the Company or any of its Subsidiaries and other than
Redeemable Stock), (D) the aggregate net cash proceeds received on or after
the Closing Date by the Company from the issuance or sale of debt securities
of the Company that have subsequently been converted into or exchanged for
Capital Stock or other Equity Interests of the Company (other than
Redeemable Stock) plus the aggregate net cash proceeds received by the
Company at the time of such conversion or exchange less the amount of any
cash or other property distributed by the Company or any Restricted
Subsidiary upon such conversion or exchange, (E) 100% of the aggregate net
cash proceeds received by the Company after the Closing Date upon the
exercise of options, warrants or similar instruments or rights (whether
issued prior to or after the Closing Date) to purchase the Company's Capital
Stock (other than Redeemable Stock) and (F) 100% of the aggregate net cash
proceeds received by the Company or any Restricted Subsidiary after the
Closing Date from (i) the sale or other disposition of Investments (other
than Permitted Investments) made by the Company and its Restricted
Subsidiaries in an Unrestricted Subsidiary or (ii) a dividend from, or the
sale of the stock of, an Unrestricted Subsidiary; or
(c) the Company would not be permitted to incur $1.00 of additional
Indebtedness pursuant to the first paragraph of "--Limitation on Additional
Indebtedness" below.
The foregoing provisions will not prohibit (i) so long as no Default or
Event of Default has occurred and is continuing or would result therefrom, the
payment of any dividend within 60 days after the date of declaration thereof, if
at said date of declaration such payment would have complied with the provisions
of the Indenture; (ii) to the extent required under applicable law, rule, order
or regulation or if the failure to do so would create a material risk of
disqualification of the ESOP under the Internal Revenue Code, the acquisition by
the Company of its common stock from the ESOP or from participants and
beneficiaries of the ESOP; (iii) the acquisition or retirement of Capital Stock
of the Company held by any future, present or former employee, director or
consultant of the Company or any Subsidiary of the Company pursuant to any
management or employee equity, stock option or other benefit plan or any other
agreement in an amount not to exceed $5 million in any fiscal year; (iv) the
acquisition by the Company or any of its Restricted Subsidiaries of Equity
Interests of the Company or such Restricted Subsidiary, if the exclusive
consideration for such acquisition is the issuance by the Company or such
Restricted Subsidiary of its Equity Interests (other than Redeemable Stock); (v)
the purchase, redemption or acquisition by the Company of rights under the
Rights Plan prior to such time as such rights have become exercisable not to
exceed $2 million in the aggregate; (vi) the redemption, repurchase, acquisition
or retirement of Indebtedness of the Company or its Restricted Subsidiaries
being concurrently refinanced by Refinancing Indebtedness permitted under
"--Limitation on Additional Indebtedness" below; (vii) the purchase, repayment,
redemption, prepayment, defeasance, acquisition or retirement of any
Indebtedness, if the exclusive consideration therefor is the issuance by the
Company of its Equity Interests (other than Redeemable Stock); (viii) the
redemption, repurchase, acquisition or retirement of Equity Interests in a
Permitted Joint Venture of the Company or of a Restricted Subsidiary, provided
that (A) if the Company or any of its Restricted Subsidiaries incurs
Indebtedness in connection with such redemption, repurchase, acquisition or
retirement, after giving effect to such incurrence and such redemption,
repurchase, acquisition or retirement, the Company could incur $1.00 of
additional Indebtedness pursuant to the first paragraph of "--Limitation on
Additional Indebtedness" below and (B) no Default or Event of Default has
occurred and is continuing or would result therefrom; (ix) dividend payments to
the holders of interests in Permitted Joint Ventures of the Company or of a
Restricted Subsidiary, ratably in accordance with their respective Equity
Interests or, if not ratably, then in accordance with the priorities set forth
in the respective organizational documents for, and agreements among holders of
Equity Interests in, such Permitted Joint Ventures; (x) the acquisition or
retirement of options, warrants and similar instruments and rights upon the
exercise thereof; (xi) any purchase, redemption or other acquisition of Equity
Interests of a Healthcare Service Business which is required by applicable law,
regulation, rule, order,
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approval, license, permit or similar restriction (in each case issued by a
governmental authority) to be purchased, redeemed or otherwise acquired by the
Company or one of its Restricted Subsidiaries; (xii) the acquisition or
retirement for value of any Equity Interests of the Company, or the making of
any Investments in Charter Behavioral Health Systems, LLC or any Subsidiaries of
Charter Behavioral Health Systems, LLC consisting of loans, advances, or other
extensions of credit, in any case as acquired, retired or made as part of the
consideration for the sale by the Company of Equity Interests in Charter
Behavioral Health Systems, LLC and certain Subsidiaries and joint ventures of
the Company and related transactions, where the aggregate value of such Equity
Interests of the Company and the aggregate amount of such Investments do not
collectively exceed a total of $40 million; or (xiii) other Restricted Payments
(excluding Investments that were Restricted Payments when made but are no longer
outstanding at the time of determination of Restricted Payments permitted by
this clause (xiii), but not excluding Investments made in accordance with this
clause (xiii) that are subsequently sold or otherwise disposed of, to the extent
such sale or other disposition increases the amount of Restricted Payments
permitted to be made in accordance with clause (F) of paragraph (b) above) made
after the Closing Date in an aggregate amount not to exceed $25 million.
The Company shall deliver to the Trustee within 60 days after the end of
each of the Company's first three fiscal quarters (and 120 days after the end of
the Company's fiscal year) in which a Restricted Payment is made under the first
paragraph of this covenant, an officer's certificate setting forth each
Restricted Payment made in such fiscal quarter, stating that each such
Restricted Payment is permitted and setting forth the basis upon which the
calculations required by the "Limitation on Restricted Payments" covenant were
computed, which calculations may be based on the Company's financial statements
included in filings required under the Exchange Act for such quarter or such
year. For purposes of calculating the aggregate amount of Restricted Payments
that are permitted under clause (b) of the first paragraph of "--Limitation on
Restricted Payments," the amounts expended for Restricted Payments permitted
under clauses (ii) through (xiii) above shall be excluded.
LIMITATION ON PAYMENT RESTRICTIONS AFFECTING RESTRICTED SUBSIDIARIES. The
Indenture provides that the Company shall not, and shall not permit any of its
Restricted Subsidiaries to, from and after the Closing Date, directly or
indirectly, create or otherwise cause or permit to exist or become effective or
enter into any consensual encumbrance or consensual restriction on the ability
of any Restricted Subsidiary to (A) pay dividends or make any other
distributions on its Equity Interests, the Equity Interests of any of its
Restricted Subsidiaries or on any other interest or participation in, or
measured by, its profits, which interest or participation is owned by the
Company or any of its Restricted Subsidiaries; (B) pay any Indebtedness owed to
the Company or any of its Restricted Subsidiaries; (C) make loans or advances to
the Company or any of its Restricted Subsidiaries; or (D) sell, lease or
transfer any of its properties or assets to the Company or any of its Restricted
Subsidiaries except, in each case, for such encumbrances or restrictions
existing under or by reason of (1) applicable law, regulation, rule, order,
approval, license, permit or similar restriction, in each case issued by a
governmental authority; (2) the Indenture and the Notes; (3) contractual
encumbrances or restrictions in effect on the Closing Date, including, without
limitation, pursuant to the New Credit Agreement and its related documentation;
(4) in the case of clause (D), by reason of customary non-assignment or
subletting provisions in leases entered into in the ordinary course of business;
(5) Prior Purchase Money Obligations; (6) Indebtedness or Capital Stock of
Restricted Subsidiaries that are acquired by or merged with or into the Company
or any of its Restricted Subsidiaries after the Closing Date; PROVIDED that such
Indebtedness or Capital Stock is in existence prior to the time of such
acquisition or merger and was not incurred, assumed or issued by the Person so
acquired or merged in contemplation of such acquisition or merger or to provide
all or any portion of the funds or credit support utilized to consummate such
acquisition or merger; provided further that such restrictions only apply to
such Restricted Subsidiary and its Subsidiaries; (7) contracts for the sale of
assets not otherwise prohibited by the Indenture, including without limitation
customary restrictions with respect to a Subsidiary pursuant to an agreement
that has been entered into for the sale or disposition of all or substantially
all of the Capital Stock or assets of such Subsidiary; (8) in
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the case of clause (D), secured Indebtedness otherwise permitted to be incurred
pursuant to the covenants described under "--Limitation on Additional
Indebtedness" and "--Limitation on Liens" that limit the right of the debtor to
sell, lease, transfer or otherwise dispose of the assets securing such
Indebtedness; (9) customary provisions contained in leases or other agreements
entered into in the ordinary course of business or in Indebtedness permitted to
be incurred subsequent to the Closing Date pursuant to the provisions of the
covenant described under "--Limitation on Additional Indebtedness", in each case
which do not limit the ability of any Restricted Subsidiary to take any of the
actions described in clauses (A) through (D) above with respect to a material
amount of dividends, distributions, Indebtedness, loans, advances or sales,
leases or transfers of properties or assets, as applicable; (10) provisions in
joint venture agreements and other similar agreements in each case related to
Permitted Joint Ventures of the Company or of a Restricted Subsidiary that are
materially similar to customary provisions entered into by parties to joint
ventures in the Healthcare Service Business at the time of such joint venture or
similar agreement; (11) restrictions on cash or other deposits or net worth or
similar type restrictions imposed by customers under contracts entered into in
the ordinary course of business; and (12) any encumbrances or restrictions
imposed by any amendments, modifications, restatements, renewals, increases,
supplements, refundings, replacements or refinancings of the contracts,
instruments or obligations referred to in clauses (1) through (11) above, in
whole or in part, PROVIDED that such amendments, modifications, restatements,
renewals, increases, supplements, refundings, replacements or refinancings are
not materially more restrictive with respect to such dividend and other payment
restrictions than those contained in the dividend or other payment restrictions
prior to such amendment, modification, restatement, renewal, increase,
supplement, refunding, replacement or refinancing.
LIMITATION ON ADDITIONAL INDEBTEDNESS. The Indenture provides that the
Company shall not, and shall not permit any of its Restricted Subsidiaries,
directly or indirectly, to create, incur, issue, assume, guarantee or otherwise
become directly or indirectly liable with respect to (collectively, "incur") any
Indebtedness; PROVIDED, HOWEVER, the Company may incur Indebtedness if, after
giving pro forma effect to the incurrence of such Indebtedness and the
application of any of the proceeds therefrom to repay Indebtedness, the
Consolidated Cash Interest Coverage Ratio of the Company for the four most
recent consecutive fiscal quarters for which financial statements are available
prior to the date such additional Indebtedness is incurred will be at least (i)
2.00 to 1.00x if such Indebtedness is incurred on or prior to the second
anniversary of the Closing Date and (ii) 2.25 to 1.00x if such Indebtedness is
incurred thereafter. Any Indebtedness or Capital Stock of a Person existing at
the time such person becomes a Subsidiary of the Company (whether by merger,
consolidation, acquisition or otherwise) shall be deemed to be incurred by such
person at the time it becomes a Subsidiary of the Company.
Notwithstanding the foregoing paragraph, the Company and its Restricted
Subsidiaries may incur the following Indebtedness: (i) Indebtedness under the
New Credit Agreement and any replacements, refundings, refinancings and
substitute facility or facilities thereof, in whole or in part, and additional
facility or facilities (provided that Indebtedness under the New Credit
Agreement and any such replacements, refundings, refinancings and substitute and
additional facility or facilities, including unused commitments, shall not at
any time exceed $700 million in aggregate outstanding principal amount
(including the available undrawn amount of any letters of credit issued under
the New Credit Agreement and any such replacements, refundings, refinancings,
and substitute and additional facility or facilities); (ii) Indebtedness of the
Company and its Restricted Subsidiaries, which Indebtedness is in existence on
the Closing Date (including any existing or future Guarantees of the Company's
11.25% Series A Senior Subordinated Notes due 2004, but excluding Indebtedness
permitted by clause (i) above); (iii) Indebtedness represented by the Notes;
(iv) Indebtedness of the Company and its Restricted Subsidiaries incurred in
exchange for, or the proceeds of which are used to extend, refinance, renew,
replace, substitute or refund, in whole or in part, Indebtedness (subject to the
following proviso, "Refinancing Indebtedness") permitted by clauses (ii) and
(iii) of this covenant; PROVIDED, HOWEVER, that (A) the
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principal amount of such Refinancing Indebtedness shall not exceed the principal
amount of Indebtedness (including unused commitments) so extended, refinanced,
renewed, replaced, substituted or refunded (plus costs of issuance), (B) such
Refinancing Indebtedness ranks, relative to the Notes, no more senior than the
Indebtedness being refinanced thereby (excluding the effect of the granting of
security for any Senior Indebtedness), (C) such Refinancing Indebtedness bears
interest at a market rate, (D) such Refinancing Indebtedness (1) shall have an
Average Life equal to or greater than the Average Life of the Indebtedness being
extended, refinanced, renewed, replaced, substituted or refunded and (2) shall
not have a Stated Maturity prior to the Stated Maturity of the Indebtedness
being extended, refinanced, renewed, replaced, substituted or refunded, (E) such
Refinancing Indebtedness shall not include (x) Indebtedness of a Restricted
Subsidiary (other than Guarantees by a Restricted Subsidiary of (i) Senior
Indebtedness or (ii) Refinancing Indebtedness the proceeds of which are used to
extend, refinance, renew, replace, substitute or refund Indebtedness that was
Guaranteed by such Restricted Subsidiary) that refinances Indebtedness of the
Company or (y) Indebtedness of the Company or a Restricted Subsidiary that
refinances Indebtedness of an Unrestricted Subsidiary; (v) Indebtedness of the
Company or any Restricted Subsidiary to any Restricted Subsidiary or to the
Company; PROVIDED, HOWEVER, that any subsequent issuance or transfer of any
Capital Stock or any other event that results in any such Restricted Subsidiary
ceasing to be a Restricted Subsidiary or any subsequent transfer of any such
Indebtedness (except to the Company or a Restricted Subsidiary) will be deemed,
in each case, to constitute the incurrence of such Indebtedness by the issuer
thereof; (vi) Indebtedness arising from Guarantees, letters of credit, and bid,
performance or surety bonds or similar bonds or instruments securing any
obligations of the Company or any Restricted Subsidiary incurred in the ordinary
course of business, which Guarantees, letters of credit, bonds or similar
instruments do not secure other Indebtedness; (vii) Indebtedness (including
Capitalized Lease Obligations) incurred by the Company or any of its Restricted
Subsidiaries to finance the purchase, lease or improvement of property (real or
personal) (whether through the direct purchase, lease or improvement of assets
or purchase of the Equity Interests of any Person owning such assets) in an
aggregate principal amount outstanding not to exceed 5% of Total Assets of the
Company at the time of any incurrence thereof (including any Refinancing
Indebtedness with respect thereto); (viii) Non-Recourse Indebtedness incurred in
connection with the acquisition of real and/or personal property by the Company
or its Restricted Subsidiaries; provided that such Indebtedness was in existence
prior to the time of such acquisition and was not incurred by the Person from
whom such property was acquired in contemplation of such acquisition or in order
to provide all or any portion of the funds or credit support utilized to
consummate such acquisition; (ix) Guarantees of any Senior Indebtedness; (x)
Indebtedness under Hedging Obligations entered into for bona fide hedging
purposes of the Company and not for speculative purposes; PROVIDED, HOWEVER,
that such Hedging Obligations do not increase the Indebtedness of the Company
outstanding at any time other than as a result of fluctuations in foreign
currency exchange rates or interest rates, as applicable, or by reason of fees,
indemnities and compensation payable thereunder; and (xi) Indebtedness other
than that permitted pursuant to the foregoing clauses (i) through (x) provided
that the aggregate outstanding amount of such additional Indebtedness does not
at any time exceed $50 million, all or any portion of which Indebtedness,
notwithstanding clause (i) above, may be incurred pursuant to the New Credit
Agreement and any replacements, refinancings, refundings, and substitute
facility or facilities thereof, in whole or in part, and additional facility or
facilities.
LIMITATION ON LIENS. The Indenture provides that the Company shall not, and
shall not permit any of its Restricted Subsidiaries to, directly or indirectly,
create, incur, assume or suffer to exist any Lien on any of their respective
assets, now owned or hereinafter acquired, securing any Indebtedness that is
PARI PASSU with or subordinated in right of payment to the Notes, unless the
Notes are equally and ratably secured; provided that, if such Indebtedness is by
its terms expressly subordinate or junior in right of payment to the Notes, the
Lien securing such subordinate or junior Indebtedness shall be subordinate and
junior to the Lien securing the Notes with the same relative priority as such
subordinated or junior Indebtedness shall have with respect to the Notes. The
Company and its Restricted Subsidiaries may at
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any time, directly or indirectly, create, incur, assume or suffer to exist any
Lien on any of their respective assets, now owned or hereafter acquired,
securing any Senior Indebtedness permitted under the covenant described under
"--Limitation on Additional Indebtedness" above.
LIMITATION ON USE OF PROCEEDS FROM ASSET SALES. The Indenture provides that
the Company and its Restricted Subsidiaries shall not, directly or indirectly,
consummate any Asset Sale with or to any Person other than the Company or a
Restricted Subsidiary, unless (i) the Company or such Restricted Subsidiary, as
the case may be, receives consideration at the time of any such Asset Sale at
least equal to the fair market value of the asset sold or otherwise disposed of,
(ii) at least 70% of the net proceeds from such Asset Sale are received in Cash
at closing (unless (A) such Asset Sale is a lease, or (B) such Asset Sale is in
connection with the creation of, Investment in, or issuance or sale of Equity
Interests by, a Permitted Joint Venture of the Company or of a Restricted
Subsidiary or other Permitted Investment) and (iii) with respect to any Asset
Sale involving the Equity Interest of any Restricted Subsidiary (unless such
Restricted Subsidiary is, or as a result of such Asset Sale would be, a
Permitted Joint Venture of the Company or of a Restricted Subsidiary or other
Permitted Investment), the Company shall sell all of the Equity Interests of
such Restricted Subsidiary it owns. Within 365 days after the receipt of Net
Cash Proceeds in respect of any Asset Sale, the Company must use all such Net
Cash Proceeds either to invest in properties and assets used in a Healthcare
Service Business (including, without limitation, a capital investment in any
Person which becomes a Restricted Subsidiary) or to reduce Senior Indebtedness;
PROVIDED, that when any non-Cash proceeds are liquidated, such proceeds (to the
extent they are Net Cash Proceeds) will be deemed to be Net Cash Proceeds at
that time. When the aggregate amount of Excess Proceeds (as defined below)
exceeds $20 million, the Company shall make an offer (the "Excess Proceeds
Offer") to apply the Excess Proceeds to repurchase the Notes at a purchase price
equal to 100% of the principal amount of such Notes, plus accrued and unpaid
interest to the date of purchase. The Excess Proceeds Offer shall be made
substantially in accordance with the procedures for a Change of Control Offer
described under "--Change of Control" above. To the extent that the aggregate
principal amount of the Notes (plus accrued interest thereon) tendered pursuant
to the Excess Proceeds Offer is less than the Excess Proceeds, the Company may
use such deficiency, or a portion thereof, for general corporate purposes. If
the aggregate principal amount of the Notes surrendered by holders thereof
exceeds the amount of Excess Proceeds, the Company shall select the Notes to be
purchased in accordance with the procedures described above under "--Selection
and Notice." "Excess Proceeds" shall mean any Net Cash Proceeds from an Asset
Sale that is not invested or used to reduce Senior Indebtedness as provided in
the second sentence of this paragraph. Notwithstanding the foregoing, any Asset
Sale which results in Net Cash Proceeds of less than $5 million and all Asset
Sales (including any Asset Sale which results in Net Cash Proceeds of less than
$5 million) in any twelve consecutive-month period which result in Net Cash
Proceeds of less than $10 million in the aggregate shall not be subject to the
requirement of clause (ii) of the first sentence of this paragraph.
The Company will comply with the requirements of Regulation 14E and Rule
13e-4 (other than the filing requirements of such rule) under the Exchange Act
and any other securities laws and regulations thereunder to the extent such laws
and regulations are applicable in connection with the repurchase of the Notes
pursuant to an Excess Proceeds Offer.
LIMITATION ON TRANSACTIONS WITH AFFILIATES. (a) The Indenture provides that
the Company will not, and will not permit any of its Restricted Subsidiaries to,
directly or indirectly, enter into or conduct any transaction (including the
purchase, sale, lease or exchange of any property or the rendering of any
service) with any Affiliate of the Company (an "Affiliate Transaction") (i) on
terms that are materially less favorable to the Company or such Restricted
Subsidiary, as the case may be, than those that could be obtained at the time of
such transaction in arm's-length dealings with a Person who is not such an
Affiliate and (ii) that, in the event such Affiliate Transaction involves an
aggregate amount in excess of $15 million, are not in writing and have not been
approved by a majority of the Disinterested Directors. In
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addition, if such Affiliate Transaction involves an amount in excess of $30
million, a fairness opinion must be provided by a nationally recognized
appraisal or investment banking firm.
(b) The provisions of the foregoing paragraph (a) will not prohibit (i) any
Restricted Payment permitted to be paid pursuant to the covenant described under
"--Limitation on Restricted Payments," (ii) any issuance of securities, or other
payments, awards or grants in cash, securities or otherwise pursuant to, or the
funding of, employment arrangements, stock options and stock ownership plans
approved by the Board of Directors, (iii) loans or advances to employees in the
ordinary course of business in accordance with past practices of the Company,
but in any event not to exceed $7.5 million in the aggregate outstanding at any
one time, (iv) the payment of reasonable fees to directors of the Company and
its Subsidiaries who are not employees of the Company or its Subsidiaries, (v)
any transaction between the Company and a Restricted Subsidiary or between
Restricted Subsidiaries or (vi) arrangements in existence as of the date hereof
with Persons that employ staff providers and which provide service exclusively
on behalf of the Company and its Subsidiaries, which arrangements are not
material to the Company and its Subsidiaries taken as a whole.
MERGER, CONSOLIDATION OR SALE OF ASSETS. The Indenture provides that the
Company shall not consolidate with, merge with or into, or transfer all or
substantially all of its assets (in one transaction or a series of related
transactions) to, any Person or permit any party to merge with or into it
unless: (i) the Company shall be the continuing Person, or the Person (if other
than the Company) (the "Successor Company") formed by such consolidation or into
or with which the Company is merged or to which the properties and assets of the
Company are transferred shall be a corporation organized and existing under the
laws of the United States or any State thereof or the District of Columbia and
shall expressly assume, by a supplemental indenture, executed and delivered to
the Trustee, in form satisfactory to the Trustee, all of the obligations of the
Company under the Notes and the Indenture and the Indenture remains in full
force and effect; (ii) immediately before and immediately after giving effect to
such transaction (and treating any Indebtedness which becomes an obligation of
the Company, the Successor Company or any Restricted Subsidiary as a result of
such transaction as having been incurred by the Company, the Successor Company
or such Restricted Subsidiary at the time of such transaction), no Event of
Default or Default shall have occurred and be continuing; (iii) except in the
case of a merger of the Company with a wholly-owned subsidiary (which does not
have assets or liabilities in excess of $1 million) of a newly-formed holding
company for the sole purpose of forming a holding company structure, the Company
or the Successor Company, as applicable, could, after giving pro forma effect to
such transaction, incur $1.00 of Indebtedness pursuant to the first paragraph of
"--Limitation on Additional Indebtedness" and (iv) the Company shall have
delivered to the Trustee an officers' certificate and an opinion of counsel,
each stating that such consolidation, merger or transfer and such supplemental
indenture (if any) comply with the Indenture. Notwithstanding the foregoing
clauses (ii) and (iii), (a) any Restricted Subsidiary may consolidate with,
merge into or transfer all or part of its properties and assets to the Company
or another Restricted Subsidiary and (b) the Company may merge with an Affiliate
incorporated solely for the purpose of reincorporating the Company in another
jurisdiction.
The Successor Company will succeed to, and be substituted for, and may
exercise every right and power of, the Company under the Indenture, and the
predecessor Company in the case of a conveyance, transfer or lease of all or
substantially all its assets will be released from all obligations under the
Indenture, including, without limitation, any obligation to pay the principal of
and interest on the Notes.
PAYMENT FOR CONSENT. The Indenture provides that neither the Company nor
any of its Subsidiaries shall, directly or indirectly, pay or cause to be paid
any consideration, whether by way of interest, fee or otherwise, to any holder
of any Notes for or as an inducement to obtaining any consent, waiver or
amendment of, or direction in respect of, any of the terms or provisions of the
Indenture or the Notes, unless such consideration is offered or agreed to be
paid, and paid, to all holders of the Notes which so consent, waive, agree or
direct to amend in the time frame set forth in solicitation documents relating
to such consent, waiver, agreement or direction.
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PROVISIONS OF REPORTS AND OTHER INFORMATION. The Indenture provides that at
all times while any Note is outstanding, the Company shall timely file with the
Commission and furnish to each holder of Notes all such reports and other
information as required by Section 13 or 15(d) of the Exchange Act, including,
without limitation, Forms 10-K, 10-Q and 8-K. At such time as the Company is not
subject to the reporting requirements of the Exchange Act, promptly after the
same would be required to be filed with the Commission if the Company then were
subject to Section 13 or 15(d) of the Exchange Act, the Company will file with
the Trustee and supply to each holder of the Notes and, upon request, to any
prospective purchaser of Notes, without cost, copies of its financial statements
and certain other reports or information comparable to that which the Company
would have been required to report pursuant to Sections 13 and 15(d) of the
Exchange Act, including, without limitation, the information that would be
required by Forms 10-K, 10-Q and 8-K.
EVENTS OF DEFAULT AND REMEDIES
The Indenture provides that each of the following constitutes an Event of
Default: (i) default for 30 days in payment of interest on the Notes, whether or
not prohibited by provisions described under
"--Subordination" above; (ii) default in payment when due of principal of or
premium, if any, on the Notes, whether at maturity, or upon acceleration,
redemption or otherwise, whether or not prohibited by provisions described under
"--Subordination" above; (iii) failure by the Company to comply with its
obligations under the covenant described under "--Merger, Consolidation or Sale
of Assets" above, (iv) failure by the Company to comply in any respect with any
of its other agreements in the Indenture or the Notes which failure continues
for 30 days after receipt of a written notice from the Trustee or holders of at
least 25% of the aggregate principal amount of the Notes then outstanding,
specifying such Default and requiring that it be remedied; (v) default under any
mortgage, indenture or instrument under which there may be issued or by which
there may be secured or evidenced any Indebtedness of the Company or any of its
Restricted Subsidiaries (or the payment of which is guaranteed by the Company or
any of its Restricted Subsidiaries) whether such Indebtedness is now existing or
hereafter created, which default results from the failure to pay any such
Indebtedness at its stated final maturity or results in the acceleration of such
Indebtedness prior to its stated final maturity and the principal amount of such
Indebtedness is at least $20 million, or the principal amount of such
Indebtedness, together with the principal amount of any other such Indebtedness
the maturity of which has been accelerated, aggregates $35 million or more; (vi)
failure by the Company or any Restricted Subsidiary to pay final judgments
aggregating in excess of $20 million which judgments are not paid, discharged or
stayed within 60 days after their entry; and (vii) certain events of bankruptcy
or insolvency with respect to the Company and its Restricted Subsidiaries.
If an Event of Default occurs and is continuing and if it is known to the
Trustee, the Trustee shall mail to each holder of the Notes notice of the Event
of Default within 90 days after it becomes known to the Trustee, unless such
Event of Default has been cured or waived. Except in the case of an Event of
Default in the payment of principal of, premium, if any, or interest on any
Note, the Trustee may withhold the notice if and so long as a committee of its
trust officers in good faith determines that withholding the notice is in the
interest of the holders of the Notes.
If an Event of Default (other than an Event of Default resulting from
bankruptcy, insolvency or reorganization) occurs and is continuing, the Trustee
or the holders of at least 25% of the principal amount of the Notes then
outstanding, by written notice to the Company (and to the Trustee if such notice
is given by such holders) (the "Acceleration Notice"), may, and the Trustee at
the request of such holders shall, declare all unpaid principal of, premium, if
any, and accrued interest on such Notes to be due and payable immediately. Upon
a declaration of acceleration, such principal, premium, if any, and accrued
interest shall be due and payable. If an Event of Default resulting from certain
events of bankruptcy, insolvency or reorganization occurs, all unpaid principal
of, premium, if any, and accrued interest on the Notes then outstanding shall
IPSO FACTO become and be immediately due and payable
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without any declaration or other act on the part of the Company, the Trustee or
any holder. The holders of a majority of the aggregate principal amount of the
Notes outstanding by notice to the Trustee may rescind an acceleration and its
consequences, except an acceleration due to default in payment of principal or
interest on the Notes upon conditions provided in the Indenture. Subject to
certain restrictions set forth in the Indenture, the holders of a majority of
the aggregate principal amount of the outstanding Notes by notice to the Trustee
may waive an existing Default or Event of Default and its consequences, except a
Default in the payment of principal of, premium, if any, or interest on, such
Notes or a Default under a provision which requires consent of all holders to
amend. When a Default or Event of Default is waived, it is cured and ceases to
exist, but no waiver shall extend to any subsequent or other Default or impair
any consequent right. A holder of Notes may not pursue any remedy with respect
to the Indenture or the Notes unless: (i) the holder gives to the Trustee
written notice of a continuing Event of Default; (ii) the holders of at least
25% in principal amount of such Notes outstanding make a written request to the
Trustee to pursue the remedy; (iii) such holder or holders offer to the Trustee
indemnity or security satisfactory to the Trustee against any loss, liability or
expense; (iv) the Trustee does not comply with the request within 30 days after
receipt thereof and the offer of indemnity or security; and (v) during such
30-day period the holders of a majority of the aggregate principal amount of the
outstanding Notes do not give the Trustee a direction which is inconsistent with
the request.
The Company is required to deliver to the Trustee annually a statement
regarding compliance with the Indenture, and the Company is required, upon
becoming aware of any Default or Event of Default, to deliver a statement to the
Trustee specifying such Default or Event of Default.
DEFEASANCE AND DISCHARGE OF THE INDENTURE AND THE NOTES
The Indenture provides that the Company may, at its option and at any time,
elect to have the obligations of the Company discharged with respect to the
outstanding Notes ("legal defeasance"). Such legal defeasance means that the
Company shall be deemed to have paid and discharged the entire indebtedness
represented by the outstanding Notes, except for (i) the rights of holders of
outstanding Notes to receive solely out of the trust described below payments in
respect of the principal of, premium, if any, and interest on such Notes when
such payments are due, (ii) the obligations of the Company with respect to the
Notes concerning issuing temporary Notes, registration of Notes, replacing
mutilated, destroyed, lost or stolen Notes and the maintenance of an office or
agency for payment and money for security payments held in trust, (iii) the
rights, powers, trusts, duties and immunities of the Trustee, and (iv) the
defeasance provisions of the Indenture.
The Company may, at its option and at any time, elect to have its
obligations under the provisions "Certain Covenants" and "Change of Control"
discharged with respect to the outstanding Notes ("covenant defeasance"). Such
covenant defeasance means that, with respect to the outstanding Notes, the
Company may omit to comply with and shall have no liability in respect of any
term, condition or limitation set forth in any such provisions and such omission
to comply shall not constitute a Default or an Event of Default.
In order to exercise defeasance, (i) the Company must have irrevocably
deposited with the Trustee, in trust, for the benefit of the holders of the
Notes, cash in U.S. Dollars, U.S. Government Obligations (as defined in the
Indenture), or a combination thereof, in such amounts as will be sufficient, in
the opinion of a nationally recognized firm of independent public accountants,
to pay the principal of, premium, if any, and interest on the outstanding Notes
on the stated maturity of such principal (and premium, if any) or installment of
interest or upon redemption; (ii) the Company shall have delivered to the
Trustee an opinion of counsel stating that the holders of the outstanding Notes
will not recognize income, gain or loss for federal income tax purposes as a
result of such defeasance and will be subject to federal income tax on the same
amounts, in the same manner and at the same times as would have been the case if
such defeasance had not occurred, which such opinion, in the case of legal
defeasance, will also state that (A) the Company has received from, or there has
been published by, the Internal Revenue Service a
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ruling to such effect or (B) since the Closing Date there has been a change in
the applicable federal income tax laws or regulations to such effect or (C)
there exists controlling precedent to such effect; (iii) no Default or Event of
Default shall have occurred and be continuing on the date of such deposit; (iv)
such defeasance shall not result in a breach or violation of or constitute a
default under any material agreement or instrument to which the Company is a
party or by which it is bound; and (v) the Company shall have delivered to the
Trustee an officers' certificate and an opinion of counsel, each stating that
all conditions precedent to such defeasance have been satisfied.
NO PERSONAL LIABILITY OF DIRECTORS, OFFICERS, EMPLOYEES AND STOCKHOLDERS
No director, officer, employee or stockholder of the Company shall have any
liability for any obligations of the Company under the Notes or the Indenture or
for any claim based on, in respect of, or by reason of such obligations or their
creation. Each holder of the Notes by accepting a Note waives and releases all
such liability. The waiver and release are part of the consideration for
issuance of the Notes. Such waiver may not be effective to waive liabilities
under the federal securities laws and it is the view of the Commission that such
a waiver is against public policy.
TRANSFER AND EXCHANGE
A holder may transfer or exchange Notes in accordance with the Indenture.
The Registrar may require a holder, among other things, to furnish appropriate
endorsements and transfer documents, and to pay any taxes and fees required by
law or permitted by the Indenture. The Registrar is not required to register a
transfer or exchange of any Note selected for redemption except for the
unredeemed portion of any Note being redeemed in part. Also, the Registrar is
not required to register a transfer or exchange of any Note for a period of 15
days before the mailing of a notice of redemption offer. The registered holder
of a Note will be treated as the owner of it for all purposes.
AMENDMENT, SUPPLEMENT AND WAIVER
Subject to certain exceptions, the Indenture or the Notes may be amended or
supplemented with the consent of the holders of a majority of the aggregate
principal amount of the Notes then outstanding, and any existing Default or
compliance with any provision may be waived (other than a continuing Default or
Event of Default in the payment of principal or interest on any Note) with the
consent of the holders of a majority of the aggregate principal amount of the
then outstanding Notes.
Without the consent of each holder affected, an amendment, supplement or
waiver may not (i) reduce the percentage of principal amount of the Notes whose
holders must consent to an amendment, supplement or waiver, (ii) change the
stated maturity or the time or currency of payment of the principal of, premium,
if any, or any interest on, or reduce the rate of interest on or principal of or
premium payable on any Note or alter the redemption provisions with respect
thereto, (iii) make any change in the subordination provisions of the Indenture
that adversely affects the rights of any holder of the Notes under the
subordination provisions of the Indenture, (iv) impair the right of any holder
to institute suit for the enforcement of any payment on or with respect to such
holder's Notes, (v) waive a default in the payment of the principal of, premium,
if any, or interest on, any Note, (vi) make any change to the provisions of the
Indenture relating to the Excess Proceeds Offer, (vii) make any change to the
"--Payment for Consent" covenant of the Indenture, or (viii) make any change in
the provision of the Indenture containing the terms described in this paragraph.
Notwithstanding the foregoing, without the consent of any holder of the
Notes, the Company and the Trustee may amend or supplement the Indenture or the
Notes to cure any ambiguity, defect or inconsistency, to provide for
certificated or uncertificated Notes (provided that the uncertificated Notes are
issued in registered form for purposes of Section 163(f) of the Code, or in a
manner such that the uncertificated Notes are described in Section 163(f)(2)(B)
of the Code) to provide for the assumption of
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the Company's obligations to holders of the Notes in the case of a merger or
consolidation, to make any change that does not adversely affect the rights of
any holder of the Notes or to comply with any requirement of the Commission in
connection with the qualification of the Indenture or the Trustee under the
Trust Indenture Act.
CONCERNING THE TRUSTEE
The Indenture contains certain limitations on the rights of the Trustee,
should it become a creditor of the Company, to obtain payment of claims in
certain cases, or to realize on certain property received in respect of any such
claim as security or otherwise. The Trustee will be permitted to engage in other
transactions; however, if it acquires any conflicting interest, it must
eliminate such conflict within 90 days or apply to the Commission for permission
to continue or resign.
The holders of a majority of the aggregate principal amount of the then
outstanding Notes will have the right to direct the time, method and place of
conducting any proceeding for exercising any remedy available to the Trustee,
subject to certain exceptions. The Indenture provides that in case an Event of
Default shall occur (which shall not be cured), the Trustee will be required, in
the exercise of its power, to use the degree of care and skill of a prudent
person under the circumstances in the conduct of such person's own affairs.
Subject to such provisions, the Trustee will be under no obligation to exercise
any of its rights or powers under the Indenture at the request of any of the
holders of the Notes, unless they shall have offered to the Trustee security or
indemnity satisfactory to it against any loss, liability or expense.
GOVERNING LAW
The Indenture provides that it and the Notes will be governed by, and
construed in accordance with, the laws of the State of New York without giving
effect to applicable principles of conflicts of law to the extent that the
application of the law of another jurisdiction would be required thereby.
CERTAIN DEFINITIONS
"Affiliate" of any specified Person means any other Person directly or
indirectly controlling or controlled by or under direct or indirect common
control with such specified Person. A Person shall be deemed to "control"
(including the correlative meanings, the terms "controlling," "controlled by,"
and "under common control with") another Person if the controlling Person (a)
possesses, directly or indirectly, the power to direct or cause the direction of
the management or policies of the controlled Person, whether through ownership
of voting securities, by agreement or otherwise, or (b) owns, directly or
indirectly, 10% or more of any class of the issued and outstanding equity
securities of the controlled Person.
"Asset Sale" means, with respect to any Person, the sale, lease, conveyance,
disposition or other transfer by such Person of any of its assets (including by
way of a sale-and-leaseback and including the sale or other transfer of any
Equity Interests in any Restricted Subsidiary) which results in proceeds with a
fair market value of $1 million or more. However, the following shall not
constitute an Asset Sale: (i) unless part of a disposition including other
assets or operations, (A) dispositions of Cash, Cash Equivalents and Investment
Grade Securities, (B) payments on or in respect of non-Cash proceeds of Asset
Sales, and (C) dispositions of Investments by foreign subsidiaries of the
Company in Cash and instruments or securities or in certificates of deposit (or
comparable instruments) with banks or similar institutions; (ii) the lease of
space in the ordinary course of business and in a manner consistent with either
past practices or the healthcare industry generally; or (iii) the issuance or
sale by the Company of any Equity Interests in the Company.
"Average Life" means, as of the date of determination, with respect to any
Indebtedness or Preferred Stock, the quotient obtained by dividing (i) the sum
of the products of the numbers of years
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from the date of determination to the dates of each successive scheduled
principal payment (assuming the exercise by the obligor of such Indebtedness of
all unconditional (other than as to the giving of notice) extension options of
each such scheduled payment date) of such Indebtedness or redemption or similar
payment with respect to such Preferred Stock multiplied by the amount of such
principal payment by (ii) the sum of all such principal payments.
"Bank Indebtedness" means any and all amounts payable under or in respect of
the New Credit Agreement (and any substitutes, refundings, refinancings and
replacements thereof, in whole or in part) and all related documentation, as
amended from time to time, including principal, premium (if any), interest
(including interest accruing on or after the filing of any petition in
bankruptcy or for reorganization relating to the Company whether or not a claim
for post-filing interest is allowed in such proceedings), fees, charges,
expenses, reimbursement obligations, Guarantees and all other amounts payable
thereunder or in respect thereof.
"Board of Directors" means the Board of Directors of the Company or any
committee thereof duly authorized to act on behalf of such Board.
"Capital Lease Obligation" means, at the time any determination thereof is
to be made, the amount of the liability in respect of a capital lease which
would at such time be so required to be capitalized on the balance sheet in
accordance with GAAP.
"Capital Stock" means any and all shares, interests, participations, rights
or other equivalents (however designated) of corporate stock (including, without
limitation, common and preferred stock), excluding warrants, options or similar
instruments or other rights to acquire Capital Stock.
"Cash" means money or currency or a credit balance in a Deposit Account.
"Cash Equivalents" means (i) securities issued or directly and fully
guaranteed or insured by the United States of America or any agency,
instrumentality or sponsored corporation thereof which are rated at least A or
the equivalent thereof by Standard and Poor's Ratings Services ("S&P") or at
least A-2 or the equivalent thereof by Moody's Investor Services, Inc.
("Moody's") (or if at such time neither is issuing ratings, then a comparable
rating of another nationally recognized rating agency), and in each case having
maturities of not more than one year from the date of acquisition, (ii) time
deposits, certificates of deposit, Eurodollar time deposits, and overnight bank
deposits with any commercial bank of recognized standing, having capital and
surplus in excess of $250 million and the commercial paper of the holding
company of which is rated at least A-2 or the equivalent thereof by S&P or at
least P-2 or the equivalent thereof by Moody's (or if at such time neither is
issuing ratings, then a comparable rating of another nationally recognized
rating agency), or, if no such commercial paper rating is available, a long-term
debt rating of at least A or the equivalent thereof by S&P or at least A-2 or
the equivalent thereof by Moody's (or if at such time neither is issuing
ratings, then a comparable rating of another nationally recognized rating
agency), (iii) repurchase obligations with a term of not more than ninety-two
days for underlying securities of the types described in clause (i) above
entered into with any commercial bank meeting the qualifications specified in
clause (ii) above, (iv) other investment instruments offered or sponsored by
financial institutions having capital and surplus in excess of $250 million and
the commercial paper of the holding company of which is rated at least A-2 or
the equivalent thereof by S&P or at least P-2 or the equivalent thereof by
Moody's (or if at such time neither is issuing ratings, then a comparable rating
of another nationally recognized rating agency), or, if no such commercial paper
rating is available, a long-term debt rating of at least A or the equivalent
thereof by S&P or at least A-2 or the equivalent thereof by Moody's (or if at
such time neither is issuing ratings, then a comparable rating of another
nationally recognized rating agency), (v) readily marketable direct obligations
issued by any state of the United States of America or any political subdivision
thereof having one of the two highest rating categories obtainable from either
Moody's or S&P (or if at such time neither is issuing ratings, then a comparable
rating of another nationally recognized rating agency), (vi) commercial paper
rated at least A-2 or the equivalent thereof by S&P or at least P-2 or the
equivalent thereof by Moody's (or if at
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such time neither is issuing ratings, then a comparable rating of another
nationally recognized rating agency), in each case maturing within one year
after the date of acquisition and (vii) other money market investments with a
weighted average maturity of less than one year in an aggregate amount not to
exceed $10 million at any time outstanding.
"Change of Control" means (a) the sale, lease, transfer or other disposition
in one or more related transactions of all or substantially all of the Company's
assets, or the sale of substantially all of the Capital Stock or assets of the
Company's Subsidiaries that constitutes a sale of substantially all of the
Company's assets, to any Person or group (as such term is used in Section
13(d)(3) of the Exchange Act), (b) the merger or consolidation of the Company
with or into another corporation, or the merger of another corporation into the
Company or any other transaction, with the effect, in any such case, that the
stockholders of the Company immediately prior to such transaction hold 50% or
less of the total voting power entitled to vote in the election of directors,
managers or trustees of the surviving corporation or, in the case of a
triangular merger, the parent corporation of the surviving corporation resulting
from such merger, consolidation or such other transaction, (c) any Person
(except for the parent corporation of the surviving corporation in a triangular
merger) or group acquires beneficial ownership of a majority in interest of the
voting power or voting Capital Stock of the Company, or (d) the liquidation or
dissolution of the Company; PROVIDED, HOWEVER, that in no event shall the sale
of any Equity Interests in, or assets of, Charter Behavioral Health Systems,
LLC, Charter Advantage, LLC, or Charter System, LLC, be deemed to constitute a
sale of all or substantially all of the Company's assets.
"Closing Date" means February 12, 1998.
"Code" means the Internal Revenue Code of 1986, as amended.
"Consolidated Cash Interest Coverage Ratio" means the ratio of (i)
Consolidated Net Income plus the sum of Consolidated Interest Expense, income
tax expense, depreciation expense, amortization expense and other non-cash
charges of the Company and its Restricted Subsidiaries (to the extent such items
were deducted in computing Consolidated Net Income of the Company)
(collectively, "EBITDA") for the preceding four fiscal quarters to (ii) the
Consolidated Cash Interest Expense of the Company and its Restricted
Subsidiaries for the preceding four fiscal quarters; PROVIDED that (without
duplication) (A) if the Company or any of its Restricted Subsidiaries incurs,
assumes, guarantees, repays or redeems any Indebtedness subsequent to the
commencement of the period for which the Consolidated Cash Interest Coverage
Ratio is being calculated but prior to the event for which the calculation of
the Consolidated Cash Interest Coverage Ratio is made or if the transaction
giving rise to the need to calculate the Consolidated Cash Interest Coverage
Ratio is an incurrence, assumption, Guarantee, repayment or redemption of
Indebtedness, then the Consolidated Cash Interest Coverage Ratio will be
calculated giving pro forma effect to any such incurrence, assumption,
Guarantee, repayment or redemption of Indebtedness, as if the same had occurred
at the beginning of the applicable period, (B) if the Company or any Restricted
Subsidiary shall have made any Material Asset Sale subsequent to the
commencement of the period for which the Consolidated Cash Interest Coverage
Ratio is being calculated but prior to the event for which the calculation of
the Consolidated Cash Interest Coverage Ratio is made, the EBITDA for such
period shall be reduced by an amount equal to the EBITDA (if positive) directly
attributable to the assets that are the subject of such Material Asset Sale for
such period or increased by an amount equal to the EBITDA (if negative) directly
attributable thereto for such period and Consolidated Interest Expense for such
period shall be reduced by an amount equal to the Consolidated Interest Expense
for such period directly attributable to any Indebtedness of the Company or any
Restricted Subsidiary repaid, repurchased, defeased or otherwise discharged with
respect to the Company and its continuing Restricted Subsidiaries in connection
with such Material Asset Sale (or, if the Equity Interests of any Restricted
Subsidiary are sold, the Consolidated Interest Expense for such period directly
attributable to the Indebtedness of such Restricted Subsidiary to the extent the
Company and its continuing Restricted Subsidiaries are no longer liable for such
Indebtedness after such sale), (C) if the Company or any Restricted Subsidiary
(by merger or otherwise) shall have made an Investment in any
159
Restricted Subsidiary (or any Person that becomes a Restricted Subsidiary) or an
acquisition of assets, including any acquisition of assets occurring in
connection with a transaction causing a calculation to be made hereunder, which
Investment or acquisition of assets constitutes all or substantially all an
operating unit of a business subsequent to the commencement of the period for
which the Consolidated Cash Interest Coverage Ratio is being calculated but
prior to the event for which the calculation of the Consolidated Cash Interest
Coverage Ratio is made, EBITDA and Consolidated Interest Expense for such period
shall be calculated after giving pro forma effect thereto (including the
incurrence, assumption, Guarantee, repayment or redemption of any Indebtedness
and any pro forma expense and cost reductions that are directly attributable to
such transaction), as if such Investment or acquisition occurred at the
beginning of the applicable period and (D) if subsequent to the commencement of
the period for which the Consolidated Cash Interest Coverage Ratio is being
calculated but prior to the event for which the calculation of the Consolidated
Cash Interest Coverage Ratio is made any Person (that subsequently became a
Restricted Subsidiary or was merged with or into the Company or any Restricted
Subsidiary since the beginning of such period) shall have made any Material
Asset Sale or any Investment or acquisition of assets that would have required
an adjustment pursuant to clause (B) or (C) above if made by the Company or a
Restricted Subsidiary during such period, EBITDA and Consolidated Interest
Expense for such period shall be calculated after giving pro forma effect
thereto as if such Material Asset Sale, Investment or acquisition of assets
occurred on the first day of such period. For purposes of this definition,
whenever pro forma effect is given for a transaction, the pro forma calculation
shall be made in good faith by a responsible financial or accounting officer of
the Company. In making such calculations on a pro forma basis, interest
attributable to Indebtedness bearing a floating interest rate shall be computed
as if the rate in effect on the date of computation had been the applicable rate
for the entire period.
"Consolidated Cash Interest Expense" of any Person means, for any period for
which the determination thereof is to be made, the Consolidated Interest Expense
of such Person less, to the extent incurred, assumed or Guaranteed by such
Person and its Subsidiaries in such period and included in such Consolidated
Interest Expense (i) deferred financing costs and (ii) other noncash interest
expense; PROVIDED, HOWEVER, that amortization of original issue discount shall
be included in Consolidated Cash Interest Expense.
"Consolidated Interest Expense" of any Person means, for any period for
which the determination thereof is to be made, the total interest expense of
such Person and its consolidated Restricted Subsidiaries, plus, without
duplication, to the extent incurred, assumed or Guaranteed by such Person and
its Subsidiaries in such period but not included in such interest expense,
(A)(i) all commissions, discounts and other fees and charges owed with respect
to letters of credit and bankers' acceptance financing, (ii) all but the
principal component of rentals in respect of Capital Lease Obligations, paid,
accrued or scheduled to be paid or accrued by such Person during such period,
(iii) capitalized interest, (iv) amortization of original issue discount and
deferred financing costs, (v) noncash interest expense, (vi) interest accruing
on any Indebtedness of any other Person to the extent such Indebtedness is
Guaranteed by such Person or any of its Restricted Subsidiaries; PROVIDED that
payment of such amounts by the Company or any Restricted Subsidiary is being
made to, or is sought by, the holders of such Indebtedness pursuant to such
guarantee, (vii) net costs (benefits) associated with Hedging Obligations
relating to interest rate protection (including amortization of fees), (viii)
Preferred Stock dividends in respect of all Preferred Stock of the Subsidiaries
of such Person and Redeemable Stock of such Person held by Persons other than
such Person or a Wholly-owned Subsidiary of such Person, and (ix) the cash
contributions to any employee stock ownership plan or similar trust to the
extent such contributions are used by such plan or trust to pay interest or fees
to any Person (other than such Person) in connection with Indebtedness incurred,
assumed or Guaranteed by such plan or trust, all as determined in accordance
with GAAP, less (B) interest expense of the type described in clause (A) above
attributable to Unrestricted Subsidiaries of such Person to the extent the
related Indebtedness is not Guaranteed or paid by such Person or any Restricted
Subsidiary of such Person.
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"Consolidated Net Income" means, with respect to any Person for any period,
the aggregate of the Net Income of such Person and its Subsidiaries for such
period, on a consolidated basis, determined in accordance with GAAP, plus the
sum of the amount allocated to excess reorganization value, employee stock
ownership plan expense and consolidated stock option expense (to the extent such
items were taken into account in computing the Net Income of such Person and its
Subsidiaries); PROVIDED, HOWEVER, that (i) the Net Income of any Person that is
not a Restricted Subsidiary or that is accounted for by the equity method of
accounting shall be included only to the extent of the amount of dividends or
distributions actually paid in cash to the referent Person or its Restricted
Subsidiaries, (ii) the Net Income of any Person acquired in a pooling of
interests transaction for any period prior to the date of such acquisition shall
be excluded, (iii) the cumulative effect of a change in accounting principles
shall be excluded and (iv) any net income (loss) of any Restricted Subsidiary of
such Person if such Restricted Subsidiary of such Person is subject to
restrictions, directly or indirectly, on the payment of dividends or the making
of distributions by such Restricted Subsidiary, directly or indirectly, to such
Person that violate the covenant described under "--Limitation on Payment
Restrictions Affecting Restricted Subsidiaries" (without giving effect to clause
(6) thereof with respect to any Indebtedness) shall be excluded, except that (A)
such Persons's equity in the net income of any such Restricted Subsidiary for
such period shall be included in such Consolidated Net Income up to the
aggregate amount of cash that could have been distributed by such Restricted
Subsidiary during such period to the Company or another Restricted Subsidiary as
a dividend or otherwise (subject, in the case of a dividend or distribution that
could have been made to another Restricted Subsidiary, to the limitation
contained in this clause) and (B) the Company's equity in a net loss of any such
Restricted Subsidiary for such period shall be included in determining such
Consolidated Net Income.
Notwithstanding the foregoing, for the purpose of the covenant described
under "--Limitation on Restricted Payments" only, there shall be excluded from
Consolidated Net Income any dividends, repayments of loans or advances or other
transfers of assets or other amounts from or in respect of Unrestricted
Subsidiaries to such Person or a Restricted Subsidiary of such Person to the
extent such dividends, repayments or transfers or other amounts increase the
amount of Restricted Payments permitted under such covenant pursuant to clause
(F) of paragraph (b) thereof.
"Default" means any event which is, or after notice or passage of time or
both would be, an Event of Default.
"Deposit Account" means a demand, savings, passbook, money market or like
account with or sponsored by a commercial bank, financial institution,
investment bank or brokerage firm, savings and loan association or like
organization or a government securities dealer, other than an account evidenced
by a negotiable certificate of deposit.
"Disinterested Director" means, with respect to any specific transaction,
any director of the Company that does not have a direct or indirect interest
(other than any interest resulting solely from such director's ownership of
Equity Interests in the Company) in such transaction.
"Equity Interests" means (a) Capital Stock, warrants, options or similar
instruments or other rights to acquire Capital Stock (but excluding any debt
security which is convertible into, or exchangeable for, Capital Stock), and (b)
limited and general partnership interests, interests in limited liability
companies, joint venture interests and other ownership interests in any Person.
"Equity Offering" means an underwritten primary public offering of common
stock of the Company pursuant to an effective registration statement under the
Securities Act or a private primary offering of common stock of the Company.
"ESOP" means the Employee Stock Ownership Plan of the Company as established
on September 1, 1988, and effective as of January 1, 1988, as from time to time
amended, and/or the trust created in accordance with such plan pursuant to the
Trust Agreement between the Company and the trustee
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named therein, executed as of September 1, 1988, as amended, as the context in
which the term "ESOP" is used permits.
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"GAAP" means generally accepted accounting principles set forth in the
opinions and pronouncements of the Accounting Principles Board of the American
Institute of Certified Public Accountants and statements and pronouncements of
the Financial Accounting Standards Board or in such other statements by such
other entity as approved by a significant segment of the accounting profession,
as in effect on the Closing Date.
"Guarantee" means any obligation, contingent or otherwise, of any Person
directly or indirectly guaranteeing any Indebtedness of any other Person and any
obligation, direct or indirect, contingent or otherwise, of such Person (i) to
purchase or pay (or advance or supply funds for the purchase or payment of) such
Indebtedness of such other Person (whether arising by virtue of partnership
arrangements, or by arrangements to keep-well, to purchase assets, goods,
securities or services, to take-or-pay, or to maintain financial statement
conditions or otherwise) or (ii) entered into for purposes of assuring in any
other manner the obligee of such Indebtedness of the payment thereof or to
protect such obligee against loss in respect thereof (in whole or in part);
PROVIDED, HOWEVER, that the term "Guarantee" shall not include (i) endorsements
for collection or deposit in the ordinary course of business or (ii) obligations
under preferred provider arrangements with Charter Behavioral Health Systems,
LLC and its Affiliates related to the purchase of minimum amounts of behavioral
healthcare services at market rates. The term "Guarantee" used as a verb has a
corresponding meaning.
"Healthcare Service Business" means a business, the majority of whose
revenues are derived from providing or arranging to provide or administering,
managing or monitoring healthcare services or any business or activity that is
reasonably similar thereto or a reasonable extension, development or expansion
thereof or ancillary thereto.
"Hedging Obligations" means, with respect to any Person, the obligations of
such Person under (i) currency exchange or interest rate swap agreements,
currency exchange or interest rate cap agreements and currency exchange or
interest rate collar agreements and (ii) other agreements or arrangements
designed to protect such Person against fluctuations in currency exchange or
interest rates.
"Indebtedness" of any Person means, without duplication at the date of
determination thereof, (i) the principal of and premium (if any) in respect of
indebtedness of such Person for borrowed money (including in respect of
obligations of such Person evidenced by bonds, debentures, notes or other
similar instruments) or for the deferred purchase price of property or services
(other than (a) trade payables on terms of 365 days or less incurred in the
ordinary course of business, (b) deferred earn-out and other performance-based
payment obligations incurred in connection with acquisitions of Healthcare
Service Businesses and (c) obligations under preferred provider arrangements
with Charter Behavioral Health Systems, LLC and its Affiliates related to the
purchase of minimum amounts of behavioral healthcare services at market rates),
all as determined in accordance with GAAP, (ii) all Capital Lease Obligations of
such Person, (iii) all Guarantees of such Person in respect of Indebtedness of
others, (iv) the aggregate amount of all unreimbursed drawings in respect of
letters of credit or other similar instruments issued for the account of such
Person (less the amount of Cash, Cash Equivalents or Investment Grade Securities
on deposit securing reimbursement obligations in respect of such letters of
credit or similar instruments), (v) all indebtedness, obligations or other
liabilities of such person or of others for borrowed money secured by a Lien on
any property of such Person, whether or not such indebtedness, obligations or
liabilities are assumed by such Person, (vi) the amount of all obligations of
such Person with respect to the redemption, repayment or other repurchase of any
Redeemable Stock and, with respect to any Subsidiary of the Company, any
Preferred Stock (but excluding, in each case, any accrued dividends); and (vii)
to the extent not otherwise included in this definition actual (rather than
notional) liabilities under Hedging Obligations of such Person; PROVIDED,
HOWEVER, that all or any portion
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of Indebtedness that becomes the subject of a defeasance (whether a "legal"
defeasance or a "covenant" or "in substance" defeasance) shall, at all times
that such defeasance remains in effect, cease to be treated as Indebtedness for
purposes of the Indenture.
"Investment" means, when used with respect to any Person, any direct or
indirect advance, loan or other extension of credit (other than the creation of
receivables in the ordinary course of business) or capital contribution by such
Person (by means of transfers of cash or property (other than Equity Interests
in the Company) to others or payments for property or services for the account
or use of others, or otherwise) to any other Person, or any direct or indirect
purchase or other acquisition by such Person of a beneficial interest in capital
stock, bonds, notes, debentures or other securities issued by any other Person,
or any Guarantee by such Person of the Indebtedness of any other Person (in
which case such Guarantee shall be deemed an Investment in such other Person in
an amount equal to the aggregate amount of Indebtedness so guaranteed). For
purposes of the definition of "Unrestricted Subsidiary" and the covenant
described under "--Limitation on Restricted Payments," (i) "Investment" shall
include the portion (proportionate to the Company's equity interest in such
Subsidiary) of the fair market value of the net assets of any Subsidiary of the
Company at the time that such Subsidiary is designated an Unrestricted
Subsidiary; PROVIDED, HOWEVER, that upon a redesignation of such Subsidiary as a
Restricted Subsidiary, the Company shall be deemed to continue to have a
permanent "Investment" in an Unrestricted Subsidiary in an amount (if positive)
equal to (x) the Company's "Investment" in such Subsidiary at the time of such
redesignation less (y) the portion (proportionate to the Company's equity
interest in such Subsidiary) of the fair market value of the net assets of such
Subsidiary at the time of such redesignation; and (ii) any property transferred
to or from an Unrestricted Subsidiary shall be valued at its fair market value
at the time of such transfer, in the case of property with a fair market value
of up to $15 million, as determined in good faith by a responsible financial
officer of the Company, and in the case of property with a fair market value in
excess of $15 million, as determined in good faith by the Board of Directors.
"Investment Grade Securities" means (i) securities issued or directly and
fully guaranteed or insured by the United States government or any agency or
instrumentality thereof (other than Cash Equivalents), (ii) debt securities or
debt instruments with a rating of BBB- or higher by S&P, Baa3 or higher by
Moody's or Class (2) or higher by NAIC or the equivalent of such rating by such
rating organization, or, if no rating of S&P, Moody's or NAIC then exists, the
equivalent of such rating by any other nationally recognized securities rating
agency, but excluding any debt securities or instruments constituting loans or
advances among the Company and its Subsidiaries, and (iii) investments in any
fund that invests exclusively in investments of the type described in clauses
(i) and (ii) which fund may also hold immaterial amounts of Cash or Cash
Equivalents pending investment and/or distribution.
"Lien" means any mortgage, pledge, security interest, charge, hypothecation,
collateral assignment, deposit arrangement, encumbrance, lien (statutory or
otherwise), or security agreement of any kind or nature whatsoever (including,
without limitation, any conditional sale or other title retention agreement, any
financing lease having substantially the same economic effect as any of the
foregoing and the filing of any financing statement, other than notice or
precautionary filings not perfecting a security interest, under the Uniform
Commercial Code or comparable law of any jurisdiction, domestic or foreign, in
respect of any of the foregoing).
"Material Asset Sale" means any Asset Sale exceeding $25 million of all or
substantially all of an operating unit of a business.
"NAIC" means National Association of Insurance Commissioners.
"Net Cash Proceeds" means, with respect to any Asset Sale, the proceeds of
such Asset Sale in the form of Cash or Cash Equivalents, including payments in
respect of deferred payment obligations (to the extent corresponding to the
principal, but not the interest, component thereof) when received in the form of
Cash or Cash Equivalents (except to the extent such obligations are financed or
sold with recourse to
163
the Company or any Restricted Subsidiary of the Company), casualty loss
insurance proceeds, condemnation awards and proceeds from the conversion of
other property received when converted to Cash or Cash Equivalents, net of (i)
brokerage commissions and other fees and expenses related to such Asset Sale,
(ii) provision for all taxes as a result of such Asset Sale without regard to
the consolidated results of operations of the Company and its Subsidiaries,
taken as a whole, (iii) payments made to repay Indebtedness or any other
obligation outstanding at the time of such Asset Sale that either, (A) in the
case of a sale of all of the Equity Interests in any Restricted Subsidiary, is a
direct obligation of such Restricted Subsidiary or (B) is secured by the asset
subject to such sale or was incurred to finance the acquisition or construction
of, improvements on, or operations related to, the assets subject to such sale
and (iv) appropriate amounts to be provided by the Company or any Restricted
Subsidiary of the Company as a reserve against any liabilities associated with
such Asset Sale, including, without limitation, pension and other
post-employment benefit liabilities, liabilities related to environmental
matters and liabilities under indemnification obligations associated with such
Asset Sale, all as determined in conformity with GAAP.
"Net Income" means, with respect to any Person, the net income (loss) of
such Person, determined in accordance with GAAP, excluding, however, any gain or
loss, together with any related provision for taxes on such gain or loss,
realized in connection with any Asset Sale (including, without limitation,
dispositions pursuant to Sale/Leaseback Transactions) not in the ordinary course
of business, and excluding any extraordinary, unusual, non-recurring or similar
type of gain or loss, together with any related provision for taxes.
"New Credit Agreement" means (a) the Credit Agreement, to be dated as of the
Closing Date, among the Company, the banks and other financial institutions
named therein and The Chase Manhattan Bank, as Administrative Agent, and (b)
each note, guaranty, mortgage, pledge agreement, security agreement, indemnity,
subrogation and contribution agreement, and other instruments and documents from
time to time entered into pursuant to or in respect of either such credit
agreement or any such guaranty, as each such credit agreement and other
documents may be amended, restated, supplemented, extended, renewed, increased,
replaced, substituted, refunded, refinanced or otherwise modified from time to
time, in whole or in part.
"Non-Recourse Indebtedness" shall mean any Indebtedness of the Company or
any of its Restricted Subsidiaries if the holder of such Indebtedness has no
recourse, direct or indirect, absolute or contingent, to the general assets of
the Company or any of its Restricted Subsidiaries.
"Permitted Asset Swap" means any one or more transactions in which the
Company or any of its Restricted Subsidiaries exchanges assets for consideration
consisting of Equity Interests in or assets of a Person engaged in a Healthcare
Service Business or assets of a Person the Company or any of its Restricted
Subsidiaries intends to use in a Healthcare Service Business, and, to the extent
necessary to equalize the value of the assets being exchanged, cash; PROVIDED
that cash does not exceed 30% of the sum of the amount of the cash and the fair
market value of the Equity Interests or assets received or given by the Company
and its Restricted Subsidiaries in such transaction.
"Permitted Investments" means (a) any Investment in the Company, any
Restricted Subsidiary or any Permitted Joint Venture of the Company or of a
Restricted Subsidiary that in each case is a Healthcare Service Business; (b)
any Investment in Cash and Cash Equivalents or Investment Grade Securities; (c)
any Investment by the Company or any Restricted Subsidiary of the Company in a
Person that is engaged in the Healthcare Service Business if as a result of such
Investment (i) such Person becomes a Restricted Subsidiary or a Permitted Joint
Venture of the Company or of a Restricted Subsidiary or (ii) such Person, in one
transaction or a series of related transactions, is merged, consolidated or
amalgamated with or into, or transfers or conveys substantially all of its
assets to, or is liquidated into, the Company or a Restricted Subsidiary or a
Permitted Joint Venture of the Company or of a Restricted Subsidiary; (d) any
Investment in securities or other assets not constituting Cash or Cash
164
Equivalents and received in connection with an Asset Sale made pursuant to the
provisions of "--Limitation on Use of Proceeds from Asset Sales" or any other
disposition of assets not constituting an Asset Sale; (e) any Investment
existing on the Closing Date; (f) any transaction to the extent it constitutes
an Investment that is permitted by and made in accordance with the provisions of
clause (ii) of paragraph (b) of the covenant described under "--Limitation on
Transactions with Affiliates"; (g) any Investment in Healthcare Service
Businesses having an aggregate fair market value, taken together with all other
Investments made pursuant to this clause (g) that are at that time outstanding
(and not including any Investments outstanding on the Closing Date), not to
exceed 5% of Total Assets of the Company at the time of such Investment (with
the fair market value of each Investment being measured at the time made and
without giving effect to subsequent changes in value); (h) any Investment by
Restricted Subsidiaries in other Restricted Subsidiaries and Investments by
Subsidiaries of the Company that are not Restricted Subsidiaries in Subsidiaries
of the Company that are not Restricted Subsidiaries; (i) advances to employees
in the ordinary course of business not in excess of $7.5 million outstanding at
any one time; (j) any Investment acquired by the Company or any of its
Restricted Subsidiaries (i) in exchange for any other Investment or accounts
receivable held by the Company or any such Restricted Subsidiary in connection
with or as a result of a bankruptcy, workout, reorganization or recapitalization
of the issuer of such other Investment or accounts receivable or (ii) as a
result of a foreclosure by the Company or any of its Restricted Subsidiaries
with respect to any secured Investment or other transfer of title with respect
to any secured Investment in default; (k) Hedging Obligations; (l) Investments
the payment for which consists exclusively of Equity Interests (other than
Redeemable Stock) of the Company; (m) Investments made in connection with
Permitted Asset Swaps; and (n) additional Investments having an aggregate fair
market value, taken together with all other Investments made pursuant to this
clause (n) that are at that time outstanding, not to exceed $30 million at the
time of such Investment (with fair market value of each Investment being
measured at the time made and without giving effect to subsequent changes in
value).
"Permitted Joint Venture" means, with respect to any Person, (i) any
corporation, association, limited liability company or other business entity
(other than a partnership) (A) of which 50% or more of the total voting power of
shares of Capital Stock or other Equity Interests entitled (without regard to
the occurrence of any contingency) to vote in the election of directors,
managers or trustees thereof is at the time of determination owned or
controlled, directly or indirectly, by such Person or one or more of the
Restricted Subsidiaries of that Person or a combination thereof and (B) which is
either managed or controlled by such Person or any of its Restricted
Subsidiaries and (ii) any partnership of which (x) 50% or more of the general or
limited partnership interests are owned or controlled, directly or indirectly,
by such Person or one or more of the Restricted Subsidiaries of that Person or a
combination thereof and (y) which is either managed or controlled by such Person
or any of its Restricted Subsidiaries, and which in the case of each of clauses
(i) and (ii) is engaged in a Healthcare Service Business; PROVIDED, HOWEVER,
that none of Charter Behavioral Health Systems, LLC or any of its Affiliates
shall in any event be deemed to be a Permitted Joint Venture of the Company or
of a Restricted Subsidiary (provided that for the purposes of this proviso the
Company and its Subsidiaries shall not be considered Affiliates of Charter
Behavioral Health Systems, LLC).
"Person" means any individual, corporation, partnership, joint venture,
incorporated or unincorporated association, joint-stock company, limited
liability company, trust, unincorporated organization or government or other
agency or political subdivision thereof or other entity of any kind.
"Preferred Stock", as applied to the Capital Stock of any corporation, means
Capital Stock of any class or classes (however designated) which is preferred as
to the payment of dividends, or as to the distribution of assets upon any
voluntary or involuntary liquidation or dissolution of such corporation, over
shares of Capital Stock of any other class of such corporation.
"Prior Purchase Money Obligations" means purchase money obligations relating
to property acquired by the Company or any of its Restricted Subsidiaries in the
ordinary course of business that
165
existed prior to the acquisition of such property by the Company or any of its
Restricted Subsidiaries and that impose restrictions of the nature described
under "--Limitation on Payment Restrictions Affecting Restricted Subsidiaries"
on the property so acquired.
"Redeemable Stock" means any Equity Interest which, by its terms (or by the
terms of any security into which it is convertible or for which it is
exchangeable or exercisable), or upon the happening of any event, (i) matures or
is mandatorily redeemable pursuant to a sinking fund obligation or otherwise,
(ii) is convertible or exchangeable for Indebtedness or Redeemable Stock or
(iii) is redeemable at the option of the holder thereof, in whole or in part, in
each case on or prior to four months after the stated maturity of the Notes.
"Representative" means the trustee, agent or representative (if any) for an
issue of Specified Senior Indebtedness.
"Restricted Subsidiary" means each of the Subsidiaries of the Company that
has not been designated an Unrestricted Subsidiary.
"Rights Plan" means the Company's Share Purchase Rights Plan, dated July 21,
1992, as amended, restated, supplemented or otherwise modified from time to
time.
"Sale/Leaseback Transaction" means an arrangement relating to property now
owned or hereafter acquired whereby the Company or a Restricted Subsidiary
transfers such property to a Person and the Company or a Restricted Subsidiary
leases it from such Person, other than leases between the Company and a
Wholly-owned Subsidiary or between Wholly-owned Subsidiaries.
"Secured Indebtedness" means any Indebtedness secured by a Lien.
"Senior Subordinated Indebtedness" means the Notes and any other
Indebtedness of the Company that specifically provides that such Indebtedness is
to rank PARI PASSU with the Notes and is not subordinated by its terms to any
Indebtedness or other obligation of the Company which is not Senior
Indebtedness.
"Senior Indebtedness" means the principal of and premium, if any, and
interest on (such interest on Senior Indebtedness, wherever referred to in the
Indenture, is deemed to include interest accruing after the filing of a petition
initiating any proceeding pursuant to any bankruptcy law in accordance with and
at the rate (including any rate applicable upon any default or event of default,
to the extent lawful) specified in any document evidencing the Senior
Indebtedness, whether or not the claim for such interest is allowed as a claim
after such filing in any proceeding under such bankruptcy law) and other amounts
(including, but not limited to, fees, expenses, reimbursement obligations in
respect of letters of credit and indemnities) due or payable from time to time
on or in connection with any Indebtedness of the Company incurred pursuant to
the first paragraph of the "Limitation on Additional Indebtedness" covenant
described above or permitted under clauses (i), (ii), (iv), (vi), (vii), (viii),
(ix), (x) and (xi) of the second paragraph under "--Limitation on Additional
Indebtedness" described above, in each case whether outstanding on the Closing
Date or thereafter created, incurred or assumed, unless, in the case of any
particular Indebtedness, the instrument creating or evidencing the same or
pursuant to which the same is outstanding expressly provides that such
Indebtedness shall not be senior in right of payment to the Notes.
Notwithstanding anything to the contrary in the foregoing, Senior Indebtedness
shall not include (a) any Indebtedness of the Company to any of its Subsidiaries
or other Affiliates, (b) any Indebtedness incurred after the Closing Date that
is contractually subordinated in right of payment to any Senior Indebtedness,
(c) amounts owed (except to banks and other financial institutions) for goods,
materials or services purchased in the ordinary course of business or for
compensation to employees, (d) any liability for Federal, state, local or other
taxes owed or owing by the Company, (e) any obligations with respect to any
Capital Stock, or (f) any Indebtedness incurred, assumed or Guaranteed in
violation of the Indenture, except where at the time of such incurrence,
assumption or Guarantee, a responsible financial officer of the Company has
delivered a certification as to its compliance at such time with the
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first paragraph of the covenant described under "--Limitation on Additional
Indebtedness" above, and the holder of such Indebtedness or its trustee, agent
or representative is not aware of facts or circumstances such that such Person
could not rely in good faith on such certification.
"Specified Senior Indebtedness" means (i) Bank Indebtedness under the New
Credit Agreement and any replacements, refinancings, refundings, and substitute
facility or facilities thereof, and additional facility or facilities permitted
by clause (i) of the second paragraph of the covenant described under
"--Limitation on Additional Indebtedness" and (ii) each single issue of other
Senior Indebtedness having an outstanding principal balance of $50 million or
more and which is specifically designated by the Company in the instrument
evidencing or governing such Senior Indebtedness as "Specified Senior
Indebtedness" for purposes of the Indenture.
"Stated Maturity" means, with respect to any Indebtedness, the date or dates
specified in such Indebtedness as the fixed date or dates on which the payment
of principal of such Indebtedness is due and payable, including pursuant to any
mandatory redemption provision, it being understood that if an issue of
Indebtedness has more than one fixed date on which the payment of principal is
due and payable, each such fixed date shall be a separate Stated Maturity with
respect to the principal amount of Indebtedness due on such date.
"Subordinated Obligation" means any Indebtedness of the Company (whether
outstanding on the Closing Date or thereafter incurred, assumed or Guaranteed)
that is subordinate or junior in right of payment to the Notes pursuant to a
written agreement.
"Subsidiary" means with respect to any Person, (i) any corporation,
association, limited liability company or other business entity (other than a
partnership) of which more than 50% of the total voting power of the Equity
Interests entitled (without regard to the occurrence of any contingency) to vote
in the election of directors, managers or trustees thereof is at the time of
determination owned or controlled, directly or indirectly, by such Person or one
or more of the other Subsidiaries of that Person or a combination thereof, (ii)
any partnership of which more than 50% of the general or limited partnership
interests are owned or controlled, directly or indirectly, by such Person or one
or more of the other Subsidiaries of that Person or a combination thereof and
(iii) any Permitted Joint Venture of such Person.
"Total Assets" means, with respect to any Person, the total consolidated
assets of such Person and its Restricted Subsidiaries, as shown on the most
recent balance sheet of such Person.
"Unrestricted Subsidiary" means (i) any Subsidiary of the Company which at
the time of determination is an Unrestricted Subsidiary (as designated by the
Board of Directors of the Company, as provided below) and (ii) any Subsidiary of
an Unrestricted Subsidiary. The Board of Directors of the Company may designate
any Subsidiary of the Company (including any Subsidiary and any newly acquired
or newly formed Subsidiary) to be an Unrestricted Subsidiary unless such
subsidiary owns any Equity Interests or Indebtedness (other than any
Indebtedness incurred in connection with services performed in the ordinary
course of business by such Subsidiary for the Company or any of its Restricted
Subsidiaries) of, or owns, or holds any Lien on, any property of, the Company or
any Restricted Subsidiary of the Company, provided that (a) any Unrestricted
Subsidiary must be an entity of which shares of the Capital Stock or other
Equity Interests (including partnership interests) entitled to cast at least a
majority of the votes that may be cast by all shares or Equity Interests having
ordinary voting power for the election of directors or other governing body are
owned, directly or indirectly, by the Company, (b) such designation complies
with the covenants described under "--Limitation on Restricted Payments" and (c)
each of (I) the Subsidiary to be designated and (II) its Subsidiaries has not at
the time of designation, and does not thereafter, create, incur, issue, assume,
guarantee or otherwise become directly or indirectly liable with respect to any
Indebtedness pursuant to which the lender has recourse to any of the assets of
the Company or any of its Restricted Subsidiaries. The Board of Directors may
designate any Unrestricted Subsidiary to be a Restricted Subsidiary; PROVIDED,
HOWEVER, that immediately after giving effect to such designation (x) the
Company could incur $1.00 of additional Indebtedness under the first paragraph
of
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the covenant described under "--Limitation on Additional Indebtedness" and (y)
no Default shall have occurred and be continuing. Any such designation by the
Board of Directors shall be evidenced to the Trustee by promptly filing with the
Trustee a copy of the resolution of the Board of Directors giving effect to such
designation and an officers' certificate certifying that such designation
complied with the foregoing provisions.
"Voting Stock" means, with respect to any Person, any class or series of
Capital Stock of such Person that is ordinarily entitled to vote in the election
of directors thereof at a meeting of stockholders called for such purpose,
without the occurrence of any additional event or contingency.
"Wholly-owned Subsidiary" of any Person means any Restricted Subsidiary of
such Person of which 95% or more of the outstanding Equity Interests of such
Restricted Subsidiary are owned by such Person (either directly or indirectly
through Wholly-owned Subsidiaries).
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SUMMARY OF NEW CREDIT AGREEMENT
Concurrently with the sale of the Old Notes on February 12, 1998, the
Company paid all amounts outstanding pursuant to the Existing Credit Agreements
and entered into a $700 million Credit Agreement with the banks and other
financial institutions named therein and The Chase Manhattan Bank, as
administrative agent (the "New Credit Agreement"). The following is a summary of
the material terms of the New Credit Agreement. This summary is not a complete
description of the New Credit Agreement and is qualified in its entirety by
reference to the terms of the New Credit Agreement.
Pursuant to the terms of the New Credit Agreement, The Chase Manhattan Bank
and such other banks and financial institutions committed to provide to the
Company and certain of its wholly owned domestic subsidiaries, subject to
certain terms and conditions, the credit facilities described below in an
aggregate principal amount equal to $700.0 million. At the closing of the
Transactions, (a) $550.0 million was borrowed under the Term Loan Facility
described below and (b) $20.0 million was drawn under the Revolving Facility
described below and $17.5 million of availability was reserved for certain
letters of credit. The initial loans under the New Credit Agreement were made to
the Company and Merit to finance the Transactions.
THE FACILITIES
STRUCTURE. The New Credit Agreement provides for (a) a term loan facility
in an aggregate principal amount of $550 million (the "Term Loan Facility"),
consisting of an approximately $183.3 million Tranche A Term Loan (the "Tranche
A Term Loan"), an approximately $183.3 million Tranche B Term Loan (the "Tranche
B Term Loan") and an approximately $183.3 million Tranche C Term Loan (the
"Tranche C Term Loan") and (b) a revolving credit facility providing for
revolving loans to the Company and the "Subsidiary Borrowers" (as defined
therein) and the issuance of letters of credit for the account of the Company
and the Subsidiary Borrowers in an aggregate principal amount (including the
aggregate stated amount of letters of credit) of $150 million (the "Revolving
Facility").
AVAILABILITY. The availability of the credit facilities is subject to
various conditions precedent typical of bank loans. The full amount of the Term
Loan Facility was drawn at the closing of the Transactions and amounts repaid or
prepaid under the Term Loan Facility may not be reborrowed. The Company borrowed
$20.0 million under the Revolving Facility to finance, in part, the
Transactions. Amounts repaid under the Revolving Facility may be reborrowed. The
amount available pursuant to the Revolving Facility is available for general
corporate purposes.
COMMITMENT REDUCTIONS AND REPAYMENTS
The Tranche A Term Loan and the Revolving Facility matures on February 12,
2004. The Tranche B Term Loan matures on February 12, 2005 and the Tranche C
Term Loan matures on February 12, 2006. The Tranche A Term Loan amortizes in
installments in each fiscal year in amounts equal to $16.5 in 1999, $28.0
million in 2000, $34.5 million in 2001, $45.0 million in 2002, $48.0 million in
2003, and $11.3 million in 2004. The Tranche B Term Loan amortizes in
installments in each fiscal year in amounts equal to $1.7 in 1999, $2.2 million
in each of 2000 through 2002, $41.8 in 2003, $103.4 million in 2004, and $29.8
million in 2005. The Tranche C Term Loan amortizes in installments in each
fiscal year in amounts equal to $1.7 in 1999, $2.2 million in each of 2000
through 2003, $41.8 in 2004, $101.9 million in 2005, and $29.1 million in 2006.
In addition, the credit facilities are subject to mandatory prepayment and
reductions (to be applied first to the Term Loan Facility) in an amount equal to
(a) 100% of the net proceeds of certain offerings of equity securities by the
Company or any of its subsidiaries, (b) 100% of the net proceeds of certain debt
issuances of the Company or any of its subsidiaries, (c) 75% of the Company's
excess cash flow and (d) 100% of the net proceeds of certain asset sales or
other dispositions of property of the Company and its subsidiaries, in each case
subject to certain limited exceptions.
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INTEREST
At the Company's election, the interest rates per annum applicable to the
loans under the New Credit Agreement are a fluctuating rate of interest measured
by reference to either (a) an adjusted London inter-bank offered rate ("LIBOR")
plus a borrowing margin or (b) an alternate base rate ("ABR") (equal to the
highest of The Chase Manhattan Bank's published prime rate and the Federal Funds
effective rate plus 1/2 of 1%) plus a borrowing margin. The borrowing margins
applicable to the Tranche A Term Loan and loans under the Revolving Facility are
currently 1.25% for ABR loans and 2.25% for LIBOR loans, and are subject to
reduction if the Company's financial results satisfy certain leverage tests. The
borrowing margins applicable to the Tranche B Term Loan and the Tranche C Term
Loan are 1.50% and 1.75%, respectively, for ABR loans and 2.50% and 2.75%,
respectively, for LIBOR loans, and are not subject to reduction. Amounts
outstanding under the credit facilities not paid when due bear interest at a
default rate equal to 2.00% above the rates otherwise applicable to each of the
loans under the Term Loan Facility and the Revolving Facility.
FEES
The Company has agreed to pay certain fees with respect to the credit
facilities, including (i) fees on the unused commitments of the lenders equal to
3/8 to 1/2% on the undrawn portion of the commitments in respect of the
facilities; (ii) letter of credit fees on the aggregate face amount of
outstanding letters of credit equal to the then applicable borrowing margin for
LIBOR Revolving Loans plus a 1/8 of 1% per annum fronting bank fee for the
letter of credit issuing bank; (iii) annual administration fees; and (iv) agent,
arrangement and other similar fees.
SECURITY; GUARANTEES
The obligations of the Company and the Subsidiary Borrowers under the New
Credit Agreement are unconditionally and irrevocably guaranteed by, subject to
certain exceptions, each wholly owned domestic subsidiary and, to the extent no
adverse tax consequences would result, each foreign subsidiary of the Company
(excluding certain subsidiaries that are prohibited by law or any applicable
regulation, rule, order, approval, license or other restriction of any
governmental authority (collectively, "Regulations")). In addition, the Credit
Facilities and the guarantees thereunder are secured by security interests in
and pledges of or liens on substantially all the material tangible and
intangible assets of the Company and the guarantors (subject to certain
limitations to be agreed upon), including pledges of all the capital stock of,
or other equity interests in, each direct or indirect domestic subsidiary of the
Company (except to the extent any such pledge or lien would violate any
applicable Regulations) and, subject to limited exceptions, 65% of the capital
stock of, or other equity interests in, each foreign subsidiary of the Company.
AFFIRMATIVE, NEGATIVE AND FINANCIAL COVENANTS
The New Credit Agreement contains a number of covenants that, among other
things, restrict the ability of the Company and its subsidiaries to dispose of
assets, incur additional indebtedness, incur or guarantee obligations, prepay
other indebtedness or amend other debt instruments, pay dividends, create liens
on assets, make investments, loans or advances, make acquisitions, engage in
mergers or consolidations, change the business conducted by the Company and its
subsidiaries, make capital expenditures, or engage in certain transactions with
affiliates and otherwise restrict certain corporate activities. In addition, the
New Credit Agreement requires the Company to comply with specified financial
ratios and tests, including minimum interest coverage ratios, maximum leverage
ratios, maximum senior debt ratios, minimum "EBITDA" (as defined in the New
Credit Agreement) and minimum net worth tests.
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EVENTS OF DEFAULT
The New Credit Agreement contains customary events of default, including
non-payment of principal, interest or fees, violation of covenants, inaccuracy
of representations or warranties in any material respect, cross default and
cross acceleration to certain other indebtedness, bankruptcy, material judgments
and liabilities and change of control.
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FEDERAL INCOME TAX CONSEQUENCES
OF THE EXCHANGE OFFER
The following is a description of the material federal income tax
consequences of the Exchange Offer to the holders of the Old Notes and the
Company. The Company's counsel, King & Spalding, has issued an opinion to the
Company, which opinion was filed as an exhibit to the Registration Statement of
which this Prospectus is a part, stating that, in the opinion of such counsel,
the material federal income tax consequences of the Exchange Offer to the
holders of the Old Notes and to the Company are fairly and accurately set forth
below.
The exchange of Old Notes for New Notes pursuant to the Exchange Offer
should not constitute a material modification of the Old Notes and, accordingly,
such exchange should not constitute an exchange for federal income tax purposes.
Accordingly, such exchange should have no federal income tax consequences to
holders of Old Notes, either to those who exchange their Old Notes for New Notes
or those who do not so exchange their Old Notes, and each holder of Old Notes
would continue to be required to include interest on the Old Notes in its gross
income in accordance with its method of accounting for federal income tax
purposes.
LEGAL MATTERS
The legality of the New Notes offered hereby will be passed upon for the
Company by King & Spalding, 191 Peachtree Street, Atlanta, Georgia 30303-1763.
EXPERTS
The audited consolidated financial statements and schedule of the Company as
of September 30, 1996 and 1997 and for each of the three years in the period
ended September 30, 1997, included in this Prospectus and elsewhere in this
Registration Statement, have been audited by Arthur Andersen LLP, independent
public accountants, as stated in their report appearing herein, and are included
herein in reliance upon the authority of said firm, as experts in giving said
report.
The consolidated financial statements of Merit as of September 30, 1996 and
1997 and for each of the three years in the period ended September 30, 1997,
included in this Prospectus have been audited by Deloitte & Touche LLP,
independent auditors, as stated in their report appearing herein which report
expresses an unqualified opinion and includes an explanatory paragraph which
refers to the change in the method of accounting for deferred contract start-up
costs related to new contracts or expansion of existing contracts and are
included herein in reliance upon the authority of said firm, as experts in
accouning and auditing.
The audited consolidated financial statements and schedule of CBHS as of
September 30, 1997 and for the 106 days ended September 30, 1997, included in
this Prospectus and elsewhere in this Registration Statement, have been audited
by Arthur Andersen LLP, independent public accountants, as stated in their
report appearing herein, and are included herein in reliance upon the authority
of said firm, as experts in giving said report.
The audited consolidated financial statements of HAI as of December 31, 1995
and 1996 and for each of the years in the two year period ended December 31,
1996, have been included in this Prospectus in reliance on the report of KPMG
Peat Marwick LLP, certified public accountants, appearing elsewhere herein, and
upon the authority of said firm as experts in accounting and auditing.
AVAILABLE INFORMATION
The Company has filed with the Commission a Registration Statement on Form
S-4 under the Securities Act for the Registration of the New Notes offered
hereby. This Prospectus, which constitutes a part of the Registration Statement,
does not contain all of the information set forth in the Registration
172
Statement, certain items of which are contained in exhibits and schedules to the
Registration Statement as permitted by the rules and regulations of the
Commission. For further information with respect to the Company and the New
Notes offered hereby, reference is made to the Registration Statement, including
the exhibits thereto, and financial statements and notes filed as a part
thereof. Statements made in this Prospectus concerning the contents of any
document referred to herein are not necessarily complete. With respect to each
such document filed with the Commission as an exhibit to the Registration
Statement, reference is made to the exhibit for a more complete description of
the matter involved, and each such statement shall be deemed qualified in its
entirety by such reference.
The Company is subject to the information requirements of the Exchange Act,
and, in accordance therewith, files reports, proxy statements and other
information with the Commission. Copies of such material can be obtained from
the Public Reference Section of the Commission, at Room 1024, Judiciary Plaza,
450 Fifth Street, NW, Washington, D.C. 20549 at prescribed rates. In addition,
such reports, proxy statements and other information can be inspected and copied
at the public reference facility referred to above and at Regional Offices of
the Commission located at Seven World Trade Center, Suite 1300, New York, New
York 10048 and at Citicorp Center, 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661. The Commission also maintains a Web site that contains reports,
proxy statements and other information regarding registrants that file
electronically with the SEC. The address of such site is
http://www.sec.gov. The Company's Common Stock is listed for trading on the New
York Stock Exchange and reports, proxy statements and other information
concerning the Company may be inspected at the office of the New York Stock
Exchange, 20 Broad Street, New York, New York. If, at any time, the Company is
not subject to the information requirements of the Exchange Act, the Company has
agreed to furnish to holders of New Notes and prospective purchasers of New
Notes designated by holders of New Notes, upon request of such holders or such
prospective purchasers financial statements, including notes thereto and with
respect to annual reports, an auditor's report by an accounting firm of
established national reputation and a "Management's Discussion and Analysis of
Financial Condition and Results of Operations," and any other information that
would be required by Form 10-K, Form 10-Q and Form 8-K.
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PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 20. INDEMNIFICATION OF DIRECTORS AND OFFICERS.
The Company is a Delaware corporation. Section 145 of the Delaware General
Corporation Law (the "DGCL") provides that a Delaware corporation has the power
to indemnify its officers and directors in certain circumstances.
Subsection (a) of Section 145 of the DGCL empowers a corporation to
indemnify any director or officer, or former director or officer, who was or is
a party or is threatened to be made a party to any threatened, pending or
completed action, suit or proceeding, whether civil, criminal, administrative or
investigative (other than an action by or in the right of the corporation) by
reason of his service as director, officer, employee or agent of the
corporation, or his service, at the corporation's request, as a director,
officer, employee or agent of another corporation or enterprise, against
expenses (including attorneys' fees), judgments, fines and amounts paid in
settlement actually and reasonably incurred in connection with such action, suit
or proceeding provided that such director or officer acted in good faith and in
a manner reasonably believed to be in or not opposed to the best interests of
the corporation, and, with respect to any criminal action or proceeding,
provided that such director or officer had no reasonable cause to believe his
conduct was unlawful.
Subsection (b) of Section 145 empowers a corporation to indemnify any
director or officer, or former director or officer, who was or is a party or is
threatened to be made a party to any threatened, pending or completed action or
suit by or in the right of the corporation to procure a judgment in its favor by
reason of the fact that such person acted in any of the capacities set forth
above, against expenses (including attorneys' fees) actually and reasonably
incurred in connection with the defense or settlement of such action or suit
provided that such director or officer acted in good faith and in a manner he
reasonably believed to be in or not opposed to the best interests of the
corporation, except that no indemnification may be made in respect of any claim,
issue or matter as to which such director or officer shall have been adjudged to
be liable to the corporation unless and only to the extent that the Court of
Chancery or the court in which such action or suit was brought shall determine
upon application that, despite the adjudication of liability but in view of all
the circumstances of the case, such director or officer is fairly and reasonably
entitled to indemnity for such expenses which the court shall deem proper.
Section 145 further provides that to the extent a director or officer of a
corporation has been successful in the defense of any action, suit or proceeding
referred to in subsections (a) or (b) or in the defense of any claim, issue or
matter therein, he shall be indemnified against expenses (including attorneys'
fees) actually and reasonably incurred by him in connection therewith; provided
that indemnification provided for by Section 145 or granted pursuant thereto
shall not be deemed exclusive of any other rights to which the indemnified party
may be entitled; and empowers the corporation to purchase and maintain insurance
on behalf of a director or officer of the corporation against any liability
asserted against him or incurred by him in any such capacity or arising out of
his status as such whether or not the corporation would have the power to
indemnify him against such liabilities under Section 145.
Article VII of the By-laws of the Company provide in substance that the
Company shall indemnify directors and officers against all liability and related
expenses incurred in connection with the affairs of the Company if: (a), in the
case of action not by or in the right of the Company, the director or officer
acted in good faith and in a manner he reasonably believed to be in or not
opposed to the best interests of the Company, and (with respect to a criminal
proceeding) had no reasonable cause to believe his conduct was unlawful; and
(b), in the case of actions by or in the right of the Company, the director or
officer acted in good faith and in a manner he reasonably believed to be in or
not opposed to the best interests of the Company, provided that no
indemnification shall be made for a claim as to which the
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director or officer is adjudged liable for negligence or misconduct unless (and
only to the extent that) an appropriate court determines that, in view of all
the circumstances, such person is fairly and reasonably entitled to indemnity.
In addition, Section 102(b)(7) of the DGCL permits Delaware corporations to
include a provision in their certificates of incorporation eliminating or
limiting the personal liability of a director to the corporation or its
stockholders for monetary damages for breach of fiduciary duty as a director,
provided that such provisions shall not eliminate or limit the liability of a
director (i) for any breach of the director's duty of loyalty to the corporation
or its stockholders, (ii) for acts or omissions not in good faith or that
involve intentional misconduct or a knowing violation of law, (iii) for unlawful
payment of dividends or other unlawful distributions, or (iv) for any
transactions from which the director derived an improper personal benefit.
Article Twelfth of the Company's Certificate of Incorporation sets forth such a
provision.
Magellan maintains directors' and officers' liability insurance with various
providers in the aggregate amount of $80 million.
The foregoing summaries are necessarily subject to the complete text of the
statutes, Certificate of Incorporation, Bylaws, insurance policies and
agreements referred to above and are qualified in their entirety by reference
thereto.
For the undertaking with respect to indemnification, see Item 22 herein.
ITEM 21. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a) Exhibits
2(a) Stock Purchase Agreement, dated August 5, 1997, between the Company and
Aetna Insurance Company of Connecticut, which was filed as Exhibit 2(a) to
the Company's Current Report on Form 8-K, which was filed on December 17,
1997, and is incorporated herein by reference.
2(b) Amendment to Stock Purchase Agreement, dated December 4, 1997, between the
Company and Aetna Insurance Company of Connecticut, which was filed as
Exhibit 2(c) to the Company's Current Report on Form 8-K, which was filed on
December 17, 1997, and is incorporated herein by reference.
2(c) Asset Purchase Agreement, dated October 16, 1997, among the Company; Allied
Health Group, Inc.; Gut Management, Inc.; Sky Management Co.; Florida
Specialty Network, LTD; Surgical Associates of South Florida, Inc.;
Surginet, Inc.; Jacob Nudel, M.D.; David Russin, M.D. and Lawrence Schimmel,
M.D., which was filed as Exhibit 2(e) to the Company's Quarterly Report on
Form 10-Q for the quarterly period ended December 31, 1997, and is
incorporated herein by reference.
2(d) First Amendment to Asset Purchase Agreement, dated December 5, 1997, among
the Company; Allied Health Group, Inc.; Gut Management, Inc.; Sky Management
Co.; Florida Specialty Network, LTD; Surgical Associates of South Florida,
Inc.; Surginet, Inc.; Jacob Nudel, M.D.; David Russin M.D.; and Lawrence
Schimmel, M.D., which was filed as Exhibit 2(f) to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended December 31, 1997, and is
incorporated herein by reference.
2(e) Agreement and Plan of Merger, dated October 24, 1997, among the Company,
Merit Behavioral Care Corporation and MBC Merger Corporation which was filed
as Exhibit 2(g) to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended December 31, 1997, and is incorporated herein by
reference.
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2(f) Purchase Agreement, dated March 3, 1998, between the Company, Charter Behav-
ioral Corporation, Charter Behavioral Health Systems,Inc., Green Spring
Health Services, Inc., Advantage Behavioral Systems, Inc. and Charter
Behavioral Health Systems, LLC.
2(g) Equity Purchase Agreement, dated March 3, 1998, between the Company, Charter
Behavioral Health Systems, Inc. and Crescent Operating, Inc.
2(h) Support Agreement, dated March 3, 1998, between the Company and Crescent
Operating, Inc.
2(i) Master Service Agreement, dated August 5, 1997, between the Company, Aetna
U.S. Healthcare, Inc. and Human Affairs International, Incorporated, which
was filed as Exhibit 2(b) to the Company's Current Report on Form 8-K, which
was filed on December 17, 1997, and is incorporated herein by reference.
2(j) First Amendment to Master Services Agreement, dated December 4, 1997,
between the Company, Aetna U.S. Healthcare, Inc. and Human Affairs
International, Incorporated, which was filed as Exhibit 2(d) to the
Company's Current Report on Form 8-K, which was filed on December 17, 1997,
and is incorporated herein by reference.
2(k) Real Estate Purchase and Sale Agreement, dated January 29, 1997, between the
Company and Crescent Real Estate Equities Limited Partnership, which was
filed as Exhibit 2(a) to the Company's Current Report on Form 8-K which was
filed on April 23, 1997, and is incorporated herein by reference.
2(l) Amendment No. 1, dated February 28, 1997, to the Real Estate Purchase and
Sale Agreement, dated January 29, 1997, between the Company and Crescent
Real Estate Equities Limited Partnership, which was filed as Exhibit 2(b) to
the Company's Current Report on Form 8-K filed on April 23, 1997, and is
incorporated herein by reference.
2(m) Amendment No. 2, dated May 29, 1997, to the Real Estate Purchase and Sale
Agreement, dated January 29, 1997, between the Company and Crescent Real
Estate Equities Limited Partnership, which was filed as Exhibit 2(c) to the
Company's Current Report on Form 8-K filed on June 30, 1997, and is
incorporated herein by reference.
2(n) Contribution Agreement, dated June 16, 1997, between the Company and
Crescent Operating, Inc., which was filed as Exhibit 2(d) to the Company's
Current Report on Form 8-K which was filed on June 30, 1997, and is
incorporated herein by reference.
2(o) Stockholders' Agreement, dated December 13, 1995, among Green Spring Health
Services, Inc., Blue Cross and Blue Shield of New Jersey, Inc., Health Care
Service Corporation, Independence Blue Cross, Pierce County Medical Bureau,
Inc. and the Company, which was filed as Exhibit 4(d) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended December 31,
1995, and is incorporated herein by reference.
2(p) First Amendment to Stockholders' Agreement, dated February 28, 1997, among
Green Spring Health Services, Inc., Blue Cross and Blue Shield of New
Jersey, Inc., Health Care Service Corporation, Independence Blue Cross,
Pierce County Medical Bureau, Inc. and the Company, which was filed as
Exhibit 10(af) to the Company's Annual Report on Form 10-K for the year
ended September 30, 1997, and is incorporated herein by reference.
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2(q) Exchange Agreement, dated December 13, 1995, among Blue Cross and Blue
Shield of New Jersey, Inc., Health Care Service Corporation, Independence
Blue Cross, Pierce County Medical Bureau, Inc. and the Company, which was
filed as Exhibit 4(e) to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended December 31, 1995, and is incorporated herein by
reference.
3(a) Restated Certificate of Incorporation of the Company, as filed in Delaware
on October 16, 1992, which was filed as Exhibit 3(a) to the Company's Annual
Report on Form 10-K for the year ended September 30, 1992, and is
incorporated herein by reference.
3(b) Bylaws of the Company, as amended, effective May 19, 1995, which was filed
as Exhibit 3(a) to the Company's Quarterly Report on Form 10-Q for the
quarterly period ended June 30, 1995, and is incorporated herein by
reference.
3(c) Certificate of Ownership and Merger merging Magellan Health Services, Inc.
(a Delaware corporation) into Charter Medical Corproation (a Delaware
corporation), as filed in Delaware on December 21, 1995, which was filed as
Exhibit 3(c) to the Company's Annual Report on Form 10-K for the year ended
September 30, 1995, and is incorporated herein by reference.
4(a) Indenture, dated as of February 12, 1998, between the Company and Marine
Midland Bank, as Trustee, relating to the 9% Senior Subordinated Notes due
February 15, 2008 of the Company, which was filed as Exhibit 4(a) to the
Company's Current Report on Form 8-K, which was filed April 3, 1998, and is
incorporated herein by reference.
4(b) Purchase Agreement, dated February 5, 1998, between the Company and Chase
Securities Inc., which was filed as Exhibit 4(b) to the Company's Current
Report on Form 8-K, which was filed April 3, 1998, and is incorporated
herein by reference.
4(c) Exchange and Registration Rights Agreement, dated February 12, 1998 between
the Company and Chase Securities Inc., which was filed as Exhibit 4(c) to
the Company's Current Report on Form 8-K, which was filed April 3, 1998, and
is incorporated herein by reference.
4(d) Credit Agreement, dated as of February 12, 1998, among the Company, certain
of the Company's subsidiaries listed therein and The Chase Manhattan Bank,
as administrative agent, which was filed as Exhibit 4(d) to the Company's
Current Report on Form 8-K, which was filed April 3, 1998, and is
incorporated herein by reference.
5 Opinion of King & Spalding as to the legality of the securities being
registered.
8 Opinion of King & Spalding as to tax matters.
*10(a) Written description of Corporate Annual Incentive Plan for the year ended
September 30, 1996, which was filed as Exhibit 10(a) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended December 31,
1995, and is incorporated herein by reference.
*10(b) 1989 Non-Qualified Deferred Compensation Plan of the Company, adopted Janu-
ary 1, 1989, as amended, which was filed as Exhibit 10(f) to the Company's
Annual Report on Form 10-K dated as of September 30, 1989 and is
incorporated herein by reference.
*10(c) 1992 Stock Option Plan of the Company, as amended, which was filed as
Exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended
September 30, 1994, and is incorporated herein by reference.
*10(d) Directors' Stock Option Plan of the Company, as amended, which was filed as
Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended
September 30, 1994, and is incorporated herein by reference.
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*10(e) 1994 Stock Option Plan of the Company, as amended, which was filed as
Exhibit 10(e) to the Company's Annual Report on Form 10-K for the year ended
September 30, 1994, and is incorporated herein by reference.
*10(f) Directors' Unit Award Plan of the Company, which was filed as Exhibit 10(i)
to the Company's Registration Statement on Form S-4 (No. 33-53701) filed May
18, 1994, and is incorporated herein by reference.
*10(g) Description of Flexible Benefits Plan, which was filed as Exhibit 10(g) to
the Company's Annual Report on Form 10-K for the year ended September 30,
1994, and is incorporated herein by reference.
*10(h) 1996 Stock Option Plan of the Company, which was filed as Exhibit 10(a) to
the Company's Quarterly Report on Form 10-Q for the quarterly period ended
March 31, 1996 and is incorporated herein by reference.
*10(i) 1996 Directors' Stock Option Plan of the Company, which was filed as Exhibit
10(b) to the Company's Quarterly Report on Form 10-Q for the quarterly
period ended March 31, 1996 and is incorporated herein by reference.
*10(j) 1997 Stock Option Plan of the Company, which was filed as Exhibit 10(i) to
the Company's Quarterly Report on Form 10-Q for the quarterly period ended
June 30, 1997, and is incorporated herein by reference.
*10(k) Employment Agreement, dated February 28, 1995, between the Company and John
Cook Barlett, Executive Vice President--Quality Improvement, which was filed
as Exhibit 10(k) to the Company's Annual Report on Form 10-K for the year
ended September 30, 1995, and is incorporated herein by reference.
*10(l) Employment Agreement, dated March 31, 1995, between the Company and Craig L.
McKnight, Executive Vice President and Chief Financial Officer, which was
filed as Exhibit 10(l) to the Company's Annual Report on Form 10-K for the
year ended September 30, 1995, and is incorporated herein by reference.
*10(m) Employment Agreement, dated October 1, 1995, between the Company and E. Mac
Crawford, Chairman of the Board of Directors, President and Chief Executive
Officer, which was filed as Exhibit 10(m) to the Company's Annual Report on
Form 10-K for the year ended September 30, 1995, and is incorporated herein
by reference.
*10(n) Employment Agreement, dated March 1, 1997, between the Company and E. Mac
Crawford, which was filed as Exhibit 10(g) to the Company's Quarterly Report
on Form 10-Q for the quarterly period ended June 30, 1997, and is
incorporated by reference.
*10(o) Letter Agreement, dated November 9, 1993, between Green Spring Health
Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the
Company and President and Chief Executive Officer of Green Spring Health
Services, Inc., which was filed as Exhibit 10(c) to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended December 31, 1995 and is
incorporated herein by reference.
*10(p) Letter Agreement, dated September 19, 1994, between Green Spring Health
Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the
Company and President and Chief Executive Officer of Green Spring Health
Services, Inc., which was filed as Exhibit 10(d) to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended December 31, 1995 and is
incorporated herein by reference.
*10(q) Employment Agreement, dated May 1, 1996, between the Company and Dr. Danna
Mauch, President and Chief Operating Officer of Magellan Public Solutions,
Inc. and Executive Vice President of the Company, which was filed as Exhibit
10(a) to the Company's Quarterly Report on Form 10-Q for the quarterly
period ended June 30, 1996 and is incorporated herein by reference.
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*10(r) Employment Agreement dated April 15, 1996, between the Company and John M.
DeStefanis, President and Chief Operating Officer of Charter Behavioral
Health Systems, Inc. and Executive Vice President of the Company, which was
filed as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for
the quarterly period ended June 30, 1996 and is incorporated herein by
reference.
*10(s) Employment Agreement dated May 7, 1996, between the Company and Steve J.
Davis, Executive Vice President, Administrative Services and General
Counsel, which was filed as Exhibit 10(c) to the Company's Quarterly Report
on Form 10-Q for the quarterly period ended June 30, 1996 and is
incorporated herein by reference.
*10(t) Employment Agreement dated February 28, 1996, between Green Spring Health
Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the
Company and President and Chief Executive Officer of Green Spring Health
Services, Inc., which was filed as Exhibit 10(t) to the Company's annual
report on Form 10-K for the year ended September 30, 1996, and is
incorporated herein by reference.
*10(u) Compensation Agreement dated September 30, 1996, between Magellan Health
Services, Inc. and Henry T. Harbin, M.D., Executive Vice President of the
Company and President and Chief Executive Officer of Green Spring Health
Services, Inc., which was filed as Exhibit 10(u) to the Company's annual
report on Form 10-K for the year ended September 30, 1996, and is
incorporated herein by reference.
*10(v) Written description of the Green Spring Health Services, Inc. Annual
Incentive Plan for the period ended September 30, 1996, which was filed as
Exhibit 10(v) to the Company's Annual Report on Form 10-K for the year ended
September 30, 1996, and is incorporated herein by reference.
*10(w) Written description of the Green Spring Health Services, Inc. Annual
Incentive Plan for the year ended September 30, 1997, which was filed as
Exhibit 10(w) to the Company's Annual Report on Form 10-K for the year ended
September 30, 1997, and is incorporated herein by reference.
10(x) Master Lease Agreement, dated June 16, 1997, between Crescent Real Estate
Funding VII, L.P., as Landlord, and Charter Behavioral Health Systems, LLC,
as Tenant, which was filed as Exhibit 99(b) to the Company's Current Report
on Form 8-K, which was filed on June 30, 1997, and is incorporated herein by
reference.
10(y) Master Franchise Agreement, dated June 17, 1997, between the Company and
Charter Behavioral Health Systems, LLC, which was filed as Exhibit 99(c) to
the Company's Current Report on Form 8-K, which was filed on June 30, 1997,
and is incorporated herein by reference.
10(z) Form of Franchise Agreement, dated June 17, 1997, between the Company, as
Franchisor, and Franchise Owners, which was filed as Exhibit 99(d) to the
Company's Current Report on Form 8-K, which was filed on June 30, 1997, and
is incorporated herein by reference.
10(aa) Subordination Agreement, dated June 16, 1997, between the Company, Charter
Behavioral Health Systems, LLC and Crescent Real Estate Equities Limited
Partnership, which was filed as Exhibit 99(e) to the Company's Current
Report on Form 8-K, which was filed on June 30, 1997, and is incorporated
herein by reference.
10(ab) Operating Agreement of Charter Behavioral Health Systems, LLC, dated June
16, 1997, between the Company and Crescent Operating, Inc., which was filed
as Exhibit 99(f) to the Company's Current Report on Form 8-K, which was
filed on June 30, 1997, and is incorporated herein by reference.
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10(ac) Warrant Purchase Agreement, dated June 16, 1997, between the Company and
Crescent Operating, Inc., which was filed as Exhibit 99(g) to the Company's
Current Report on Form 8-K, which was filed on June 30, 1997, and is
incorporated herein by reference.
10(ad) Offer to Purchase and Consent Solicitation Statement, dated January 12,
1998, by the Company for all of its 11 1/4% Series A Senior Subordinated
Notes due 2008.
10(ae) Offer to Purchase and Consent Solicitation Statement, dated January 12,
1998, by Merit Behavioral Care Corporation for all of its 11 1/2% Senior
Subordinated Notes due 2005.
10(af) Second Amended and Restated Credit Agreement, dated as of May 2, 1994, among
the Company, the financial institutions listed therein, Bankers Trust
Company, as Agent, and First Union National Bank of North Carolina, as
Co-Agent, which was filed as Exhibit 4(e) to the Company's Registration
Statement on Form S-4 (No. 33-53701) filed May 18, 1994, and is incorporated
herein by reference.
10(ag) Amendment No. 1, dated as of June 9, 1994, to Second Amended and Restated
Credit Agreement, dated as of May 2, 1994, among the Company, the financial
institutions listed therein, Bankers Trust Company, as Agent, and First
Union National Bank of North Carolina, as Co-Agent, which was filed as
Exhibit 4(w) to the Company's Amendment No. 1 to Registration Statement on
Form S-4 (No. 33-53701) filed July 1, 1994, and is incorporated herein by
reference.
10(ah) Amendment No. 2, dated September 30, 1994, to Second Amended and Restated
Credit Agreement, dated as of May 2, 1994, among the Company, the financial
institutions listed therein, Bankers Trust Company, as Agent, and First
Union National Bank of North Carolina, as Co-Agent, which was filed as
Exhibit 4(s) to the Company's Annual Report on Form 10-K for the year ended
September 30, 1994, and is incorporated herein by reference.
10(ai) Amendment No. 3, dated as of December 12, 1994, to Second Amended and
Restated Credit Agreement, dated as of May 2, 1994, among the Company, the
financial institutions listed herein, Bankers Trust Company, as Agent, and
First Union National Bank of North Carolina, as Co-Agent, which was filed as
Exhibit 4(a) to the Company's Quarterly Report on Form 10-Q for the
Quarterly Period ended December 31, 1994, and is incorporated herein by
reference.
10(aj) Amendment No. 4, dated as of January 11, 1995, to Second Amended and
Restated Credit Agreement, dated as of May 2, 1994, among the Company, the
financial institutions listed therein, Bankers Trust Company, as Agent, and
First Union National Bank of North Carolina, as Co-Agent, which was filed as
Exhibit 4(b) to the Company's Quarterly Report on Form 10-Q for the
Quarterly Period ended December 31, 1994, and is incorporated herein by
reference.
10(ak) Amendment No. 5, dated as of March 17, 1995, to Second Amended and Restated
Credit Agreement, dated as of May 2, 1994, among the Company, Bankers Trust
Company, as Agent, First Union National Bank of North Carolina, as Co-Agent,
and the lenders listed on Annex I, which was filed as Exhibit 4(a) to the
Company's Quarterly Report on Form 10-Q for the Quarterly Period ended March
31, 1995, and is incorporated herein by reference.
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10(al) Amendment No. 6, dated as of October 17, 1995, to Second Amended and
Restated Credit Agreement, dated as of May 2, 1994, among the Company,
Bankers Trust Company, as Agent and First Union National Bank of North
Carolina, as Co-Agent, which was filed as Exhibit 4(a) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended December 31,
1995, and is incorporated herein by reference.
10(am) Amendment No. 7, dated as of November 30, 1995, to Second Amended and
Restated Credit Agreement, dated as of May 2, 1994, among the Company,
Bankers Trust Company, as Agent, First Union National Bank of North
Carolina, as Co-Agent, which was filed as exhibit 4(b) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended December 31,
1995, and is incorporated herein by reference.
10(an) Amendment No. 8, dated as of January 24,, 1996, to Second Amended and
Restated Credit Agreement, dated as of May 2, 1994, among the Company,
Bankers Trust Company, as Agent, First Union National Bank of North
Carolina, as Co-Agent, which was filed as exhibit 4(c) to the Company's
Quarterly Report on Form 10-Q for the quarterly period ended December 31,
1995, and is incorporated herein by reference.
10(ao) Amendment No. 9, dated as of June 30, 1996, to Second Amended and Restated
Credit Agreement, dated as of May 2, 1994, among the Company, Bankers Trust
Company, as Agent, First Union National Bank of North Carolina, as Co-Agent,
which was filed as exhibit 4(a) to the Company's Quarterly Report on Form
10-Q for the quarterly period ended June 30, 1996, and is incorporated
herein by reference.
10(ap) Amendment No. 10, dated as of July 31, 1996, to Second Amended and Restated
Credit Agreement, dated as of May 2, 1994, among the Company, Bankers Trust
Company, as Agent, First Union National Bank of North Carolina, as Co-Agent,
which was filed as exhibit 4(b) to the Company's Quarterly Report on Form
10-Q for the quarterly period ended June 30, 1996, and is incorporated
herein by reference.
10(aq) Amendment No. 11, dated as of September 3, 1996, to Second Amended and
Restated Credit Agreement, dated as of May 2, 1994, among the Company,
Bankers Trust Company, as Agent, First Union National Bank of North
Carolina, as Co-Agent, which was filed as Exhibit (b) 12 to the Company's
Amendment No. 2 to Schedule 13 E-4 dated September 5, 1996 and is
incorporated herein by reference.
10(ar) Credit Agreement, dated as of October 16, 1996, among the Company, the
lenders named therein, The Chase Manhattan Bank as Administrative Agent and
Collateral Agent and First Union National Bank of North Carolina as
Syndication Agent, which was filed as Exhibit 4(ai) to the Company's Annual
Report on Form 10-K for the year ended September 30, 1996, and is
incorporated by reference.
10(as) Amended and Restated Credit Agreement, dated June 16, 1997, among the Com-
pany and Chase Manhattan Bank, as Administrative Agent, and First Union Bank
of North Carolina as Syndication Agent, which was filed as Exhibit 10(h) to
the Company's Quarterly Report on Form 10-Q for the quarterly period ended
June 30, 1997, and is incorporated herein by reference.
10(at) Amendment No 1. to Amended and Restated Credit Agreement, dated September
10, 1997, among the Company and Chase Manhattan Bank, as Administrative
Agent, and First Union National Bank of North Carolina as Syndication Agent,
which was filed as Exhibit 10(al) to the Company's Annual Report on Form
10-K for the year ended September 30, 1997, and is incorporated herein by
reference.
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10(au) Amendment No 2. to Amended and Restated Credit Agreement, dated October 9,
1997, among the Company and Chase Manhattan Bank, as Administrative Agent,
and First Union National Bank of North Carolina as Syndication Agent, which
was filed as Exhibit 4(am) to the Company's Annual Report on Form 10-K for
the year ended September 30, 1997, and is incorporated herein by reference.
10(av) Stock and Warrant Purchase Agreement, dated December 22, 1995, between the
Company and Richard E. Rainwater, which was filed as Exhibit 4(f) to the
Company's Quarterly Report on Form 10-Q for the quarterly period ended
December 31, 1995, and is incorporated herein by reference.
10(aw) Warrant Purchase Agreement, dated January 29, 1997, between the Company and
Crescent Real Estate Equities Limited Partnership, which was filed as
Exhibit 4(a) to the Company's Current Report on Form 8-K, which was filed on
April 23, 1997, and is incorporated herein by reference.
10(ax) Amendment No. 1, dated June 17, 1997, to the Warrant Purchase Agreement,
dated January 29, 1997, between the Company and Crescent Real Estate
Equities Limited Partnership, which was filed as Exhibit 4(b) to the
Company's Current Report on Form 8-K, which was filed on June 30, 1997, and
is incorporated herein by reference.
10(ay) 1998 Stock Option Plan of the Company.
10(az) Letter Agreement, dated May 7, 1997, between Green Spring Health Services,
Inc. and John J. Wider, Jr., Executive Vice President and Chief Operating
Officer of Green Spring Health Services, Inc.
10(ba) Employment Agreement, dated March 12, 1997, between Green Spring Health Ser-
vices, Inc. and Clarissa C. Marques, Chief Clinical Officer of Green Spring
Health Services, Inc.
10(bb) Letter Agreement, dated February 2, 1995, between Green Spring Health
Services, Inc. and Clarissa C. Marques, Senior Vice President of Green
Spring Health Services, Inc.
10(bc) Indenture, dated May 2, 1994, among the Company, the Guarantors listed
therein and Marine Midland Bank, as Trustee, relating to the 11 1/4% Senior
Subordinated Notes due April 15, 2004 of the Company, which was filed as
Exhibit 4(a) to the Company's Registration Statement on Form S-4 (No.
33-53701) filed May 18, 1994, and is incorporated herein by reference.
10(bd) Indenture Supplement No. 1, dated June 3, 1994, among the Company, the
Guarantors listed therein and Marine Midland Bank, as Trustee, relating to
the 11 1/4% Senior Subordinated Notes due April 15, 2004 of the Company,
together with a schedule identifying substantially similar documents,
pursuant to Instruction 2 to Item 601 of Regulation S-K, which was filed as
Exhibit 4(t) to the Company's Annual Report on Form 10-K for the year ended
September 30, 1994, and is incorporated herein by reference.
10(be) Indenture Supplement No. 3, dated August 30, 1994, among the Company, the
Guarantors listed therein and Marine Midland Bank, as Trustee, relating to
the 11 1/4% Senior Subordinated Notes due April 15, 2004 of the Company,
which was filed as Exhibit 4(v) to the Company's Annual Report on Form 10-K
for the year ended September 30, 1994, and is incorporated herein by
reference.
10(bf) Indenture Supplement No. 20, dated January 26, 1998, among the Company, the
Guarantors listed therein and Marine Midland Bank, as Trustee, relating to
the 11 1/4% Senior Subordinated Notes due April 15, 2004 of the Company.
12 Statement regarding computation of ratios.
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21 List of subsidiaries of the Registrant, which was filed as Exhibit 21 to the
Company's Annual Report on Form 10-K for the year ended September 30, 1997,
and is incorporated herein by reference.
23(a) Consent of Arthur Andersen LLP for the Company.
23(b) Consent of Deloitte & Touche.
23(c) Consent of KPMG Peat Marwick LLP.
23(d) Consent of Arthur Andersen LLP for CBHS.
23(e) Consent of King & Spalding (included in opinion filed as Exhibit 5).
24 Powers of Attorney (see signature pages).
25 Statement of Eligibility and Qualification on Form T-1 of Marine Midland
Bank, as Trustee, under the Indenture relating to the Senior Subordinated
Notes due February 15, 2008.
99(a) Form of Letter of Transmittal (Proof of March 31, 1998).
99(b) Form of Notice of Guaranteed Delivery (Proof of March 31, 1998)
99(c) Form of Instruction to Registered Holder and/or Book-Entry Transfer Facility
Participant from Owner (Proof of March 31, 1998)
99(d) Form of Exchange Agent Agreement between the Company and Marine Midland Bank
(Proof of March 31, 1998)
- ------------------------
* Constitutes a management contract of compensatory plan arrangement.
(b) Financial Statement Schedules
The following financial statement schedules are set forth on pages S-1
through S-2 hereof.
Report of Arthur Andersen LLP regarding financial statement schedules (included in the
Report set forth on page F-2 and F-72).
II -- Valuation and Qualifying Accounts
All other schedules are omitted as the required information is presented in
the Company's consolidated financial statements or related notes or such
schedules are not applicable.
ITEM 22. UNDERTAKINGS.
(a) The Registrant hereby undertakes:
(1) To file, during any period in which offers or sales are being made,
a post-effective admendment to this Registration Statement:
(i) To include any prospectus required by Section 10(a)(3) of the
Securities Act of 1933;
(ii) To reflect in the prospectus any facts or events arising after
the effective date of the Registration Statement (or the most recent
post-effective amendment thereof) which, individually or in the
aggregate, represent a fundamental change in the information set forth in
the Registration Statement; and
(iii) To include any material information with respect to the plan of
distribution not previously disclosed in the Registration Statement or
any material change to such information in the Registration Statement.
(2) That, for the purpose of determining any liability under the
Securities Act of 1933, each such post-effective amendment shall be deemed
to be a new registration statement relating to the
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securities offered therein, and the offering of such securities at that time
shall be deemed to be the initial BONA FIDE offering thereof.
(3) To remove from registration by means of a post-effective amendment
any of the securities being registered which remain unsold at the
termination of the offering.
(d) The Registrant hereby undertakes to respond to requests for information
that is incorporated by reference into the prospectus pursuant to Items 4,
10(b), 11 or 13 of this Form within one business day of receipt of such request,
and to send the incorporated documents by first class mail or other equally
prompt means. This includes information contained in documents filed subsequent
to the effective date of this Registration Statement through the date of
responding to the request.
(e) The Registrant hereby undertakes to supply by means of a post-effective
amendment all information concerning a transaction, and the company being
acquired involved therein, that was not the subject of and included in this
Registration Statement when it became effective.
(f) Insofar as indemnification for liabilities arising under the Securities
Act of 1933 may be permitted to directors, officers and controlling persons of
the Registrant pursuant to the foregoing provisions, or otherwise, the
Registrant has been advised that in the opinion of the Securities and Exchange
Commission such indemnification is against public policy as expressed in the
Securities Act of 1933 and is, therefore, unenforceable. In the event that a
claim for indemnification against such liabilities (other than the payment by
the Registrant of expenses incurred or paid by a director, officer or
controlling person of the Registrant in the successful defense of any action,
suit or proceeding) is asserted by such director, officer or controlling person
in connection with the securities being registered, the Registrant will, unless
in the opinion of its counsel the matter has been settled by controlling
precedent, submit to a court of appropriate jurisdiction the question whether
such indemnification by it is against public policy as expressed in the
Securities Act of 1933 and will be governed by the final adjudication of such
issue.
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SIGNATURES
Pursuant to the requirements of the Securities Act, the registrant has duly
caused this registration statement to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Atlanta, State of
Georgia, on April 2, 1998.
MAGELLAN HEALTH SERVICES, INC.
By: /s/ CRAIG L. MCKNIGHT
-----------------------------------------
Craig L. McKnight
Executive Vice President and
Chief Financial Officer
Pursuant to the requirements of the Securities Act of 1933, this
Registration Statement has been signed by the following persons in the
capacities and on the dates indicated. KNOW ALL MEN BY THESE PRESENTS, that each
person whose signature appears below constitutes and appoints Craig L. McKnight
and Howard A. McClure and each of them, his true and lawful attorneys-in-fact
and agents, with full power of substitution and resubstitution, for him and in
his name, place and stead, in any and all capacities, to sign any and all
amendments to this Registration Statement, and to file the same, with all
exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and
agents full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully to all
intents and purposes as he might or could do in person, hereby ratifying and
confirming all that said attorneys-in-fact and agents, or their substitute or
substitutes, may lawfully do or cause to be done by virtue hereof.
NAME TITLE DATE
- ------------------------------ -------------------------- -------------------
/s/ HENRY T. HARBIN
- ------------------------------ President, Chief Executive April 2, 1998
Henry T. Harbin Officer and Director
/s/ CRAIG L. MCKNIGHT Executive Vice President
- ------------------------------ and Chief Financial April 2, 1998
Craig L. McKnight Officer
/s/ HOWARD A. MCLURE Senior Vice President and
- ------------------------------ Controller April 2, 1998
Howard A. McLure (Chief Accounting Officer)
/s/ EDWIN M. BANKS
- ------------------------------ Director April 2, 1998
Edwin M. Banks
/s/ G. FRED DIBONA, JR.
- ------------------------------ Director April 2, 1998
G. Fred DiBona, Jr.
/s/ ANDRE C. DIMITRIADIS
- ------------------------------ Director April 2, 1998
Andre C. Dimitriadis
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NAME TITLE DATE
- ------------------------------ -------------------------- -------------------
/s/ A.D. FRAZIER, JR.
- ------------------------------ Director April 2, 1998
A.D. Frazier, Jr.
/s/ RAYMOND H. KIEFER
- ------------------------------ Director March 11, 1998
Raymond H. Kiefer
/s/ GERALD L. MCMANIS
- ------------------------------ Director March 10, 1998
Gerald L. McManis
/s/ DANIEL S. MESSINA
- ------------------------------ Director April 2, 1998
Daniel S. Messina
/s/ ROBERT W. MILLER
- ------------------------------ Chairman of the Board April 2, 1998
Robert W. Miller of Directors
/s/ DARLA D. MOORE
- ------------------------------ Director March 10, 1998
Darla D. Moore
/s/ JEFFREY A. SONNENFELD
- ------------------------------ Director March 11, 1998
Jeffrey A. Sonnenfeld
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