ITEM 1. BUSINESS
GENERAL
Magellan Health Services, Inc. ("Magellan" or the "Company"), which was incorporated in 1969, is an integrated, national behavioral healthcare company. The Company operates through three principal subsidiaries engaging in (i) the provider business, (ii) the managed care business and (iii) the public sector business.
Charter Behavioral Health Systems, Inc. ("Charter" or the "provider business"), the Company's wholly-owned subsidiary that engages in the provider business, operated 90 acute care psychiatric hospitals and 4 residential psychiatric treatment centers with an aggregate capacity of 8,429 licensed beds as of September 30, 1996. Charter also manages one acute care psychiatric hospital with 34 licensed beds. Eighty-eight of Charter's hospitals operate partial hospitalization programs and the Company operates approximately 150 outpatient centers, staffed by mental health professionals.
Green Spring Health Services, Inc. ("Green Spring" or the "managed care business"), the Company's 61% owned subsidiary that engages in the managed care business, provides managed behavioral healthcare services, which include (i) Enhanced Utilization Management, a utilization review process that employs clinical criteria designed to provide each patient with accessible, appropriate and affordable treatment across the entire continuum of care and services; (ii) Care Management, a fully integrated healthcare model that offers utilization review services and provides care to patients through the management of a national network of contract providers and Green Spring-owned staff model clinics; and (iii) Comprehensive Administrative Services, including member assistance, management reporting, claims processing, clinical management information and provider referral systems that are adaptable to customer circumstances and requirements through a network of more than 30,000 providers nationwide covering approximately 13.6 million people as of September 30, 1996.
Magellan Public Solutions, Inc. ("Public Solutions" or the "public sector business"), the Company's wholly-owned subsidiary that engages in the public sector business, provides specialty home-based behavioral healthcare services, behavioral services in correctional facilities and troubled and delinquent adolescent facilities services pursuant to contractual arrangements with governmental agencies.
The Company's business strategy is to provide access to a full continuum of behavioral healthcare and managed care services and to perform such services in a cost effective manner with monitored results. The Company's integrated national behavioral healthcare company has the capability to deliver and to manage the delivery of behavioral healthcare services for large public and private payers who need assistance in managing the risk of behavioral healthcare costs.
RECENT DEVELOPMENTS
GREEN SPRING ACQUISITION
On December 13, 1995, the Company acquired a 51% ownership interest in Green Spring for approximately $68.9 million in cash, the issuance of 215,438 shares of Magellan Common Stock valued at approximately $4.3 million and the contribution of Group Practice Affiliates, Inc. ("GPA"), a wholly-owned subsidiary of the Company, which became a wholly-owned subsidiary of Green Spring. GPA was organized by the Company for the purpose of acquiring and managing professional group practices and has acquired seven group practices through September 30, 1996. On December 20, 1995, the Company acquired an additional 10% ownership interest in Green Spring for approximately $16.7 million in cash as a result of an exercise by a minority stockholder of its Exchange Option (as hereinafter defined) for a portion of the stockholder's interest in Green Spring. The Company has a 61% ownership interest in Green Spring.
Green Spring is a leading provider of managed behavioral healthcare services, which includes utilization management, care management and employee assistance programs through a 50-state provider network covering approximately 13.6 million people nationwide.
The Green Spring acquisition and the creation of Public Solutions combined with the existing provider business created the first integrated national behavioral healthcare system and gives the Company the capability to provide case management and delivery services to large private organizations and a public sector marketplace seeking increased privatization of services. The Company changed its name to Magellan Health Services, Inc. on December 21, 1995 to reflect the broader range of services it provides as a result of the Green Spring acquisition.
The minority shareholders of Green Spring consist of four Blue Cross/Blue Shield organizations (the "Blues") that are key customers of Green Spring. In addition, two other Blues organizations that formerly owned a portion of Green Spring continue to be customers of Green Spring. The minority stockholders of Green Spring have the option, under certain circumstances, to exchange their ownership interests ("Exchange Option") in Green Spring for 2,831,739 shares of Magellan Common Stock or $65.1 million in subordinated notes. The Company may elect to pay cash in lieu of issuing the subordinated notes. The Exchange Option expires December 13, 1998.
NEW REVOLVING CREDIT AGREEMENT
On October 28, 1996, the Company entered into a new Credit Agreement with certain financial institutions for a five-year Senior Secured reducing revolving credit facility in an aggregate committed amount of $400 million (the "New Revolving Credit Agreement"). The Company borrowed approximately $121.0 million under the New Revolving Credit Agreement in October 1996 to (i) pay-off the existing borrowings under the Revolving Credit Agreement (as hereinafter defined) and (ii) pay for fees and expenses related to the New Revolving Credit Agreement.
The loans outstanding under the New Revolving Credit Agreement bear interest (subject to certain potential adjustments) at a rate per annum equal to one, two, three or six-month LIBOR plus 1.25% or the Prime Lending Rate. Interest on Prime Lending Rate loans is payable at the end of each fiscal quarter and upon conversion to a LIBOR-based loan. Interest on LIBOR-based loans is payable at the end of their respective one, two, three or six-month terms.
PRIOR DEVELOPMENTS
NME ACQUISITION
During fiscal 1994, the Company agreed to acquire 40 psychiatric hospitals (the "Acquired Hospitals") from Tenet Healthcare Corporation (formerly known as National Medical Enterprises, Inc. ("NME")). The purchase price for the Acquired Hospitals was approximately $120.4 million in cash plus an additional cash amount of approximately $51 million, subject to adjustment, for the net working capital of the Acquired Hospitals (the "Hospital Acquisition"). The Acquired Hospitals had an aggregate capacity of 2,873 licensed beds when acquired and were located in 19 states.
On June 30, 1994, the Company completed the purchase of 27 of the Acquired Hospitals for a cash purchase price of approximately $129.6 million, which included approximately $39.3 million, subject to adjustment, for the net working capital of the facilities. On October 31, 1994, the Company completed the purchase of three additional Acquired Hospitals for a cash purchase price of approximately $5 million, which included approximately $2.2 million related to the net working capital of the facilities. On November 30, 1994, the Company completed the purchase of the remaining ten Acquired Hospitals for a cash purchase price of approximately $36.8 million, including approximately $9.5 million related to the net working capital of the ten Acquired Hospitals. During the year ended September 30, 1995, the Company received approximately $3.5 million from NME as a partial payment related to the settlement of the
working capital portion of the purchase price. The Company accounted for the Hospital Acquisition using the purchase method of accounting.
DEBT REFINANCING
In order to finance the Hospital Acquisition and to refinance substantially all of the Company's outstanding long-term debt, on May 2, 1994, the Company entered into a Second Amended and Restated Credit Agreement with certain financial institutions for a five-year reducing, revolving credit facility in an aggregate committed amount of $300 million (the "Revolving Credit Agreement") and issued $375 million of 11 1/4% Series A Senior Subordinated Notes which mature on April 15, 2004 (the "Notes") and are general unsecured obligations of the Company. (See Note 6 of the Company's Consolidated Financial Statements.)
SALE OF GENERAL HOSPITALS
On September 30, 1993, the Company sold its general hospitals and related assets to Quorum, Inc. for approximately $338 million. The Company retained the assets and liabilities relating to these hospitals for professional liability claims incurred and cost report settlements for periods prior to September 30, 1993.
For fiscal 1993, the general hospitals had net revenue of approximately $347 million, a net loss of approximately $15 million, and admissions and patient days of 39,669 and 205,843, respectively. In 1993, the Company restated its consolidated financial statements to reflect the sales of the general hospitals and its interest in a non-hospital subsidiary as discontinued operations.
FINANCIAL RESTRUCTURING
In its 1992 fiscal year, the Company completed a restructuring of its debt and equity capitalization (the "Restructuring") pursuant to a prepackaged plan of reorganization filed under Chapter 11 of the United States Bankruptcy Code (the "Plan"), which became effective on July 21, 1992. As a result of the Restructuring, the Company's long-term debt was reduced by approximately $700 million and its redeemable preferred stock of $233 million was eliminated. The holders of the debt and preferred stock that were reduced or eliminated received approximately 97% of the Company's Common Stock outstanding on July 21, 1992.
PROVIDER BUSINESS
OVERVIEW
The Company's psychiatric hospitals in operation on September 30, 1996 are located in well-populated urban and suburban locations in 33 states and two foreign countries. Seven of the Company's hospitals are affiliated with medical schools for residency and other post-graduate teaching programs.
Most of the Company'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.
The Company'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 of the Company 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 programs. A treatment program includes one or more of the types of treatment settings provided by the Company'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 Company's ongoing business. Management believes the quality of the Company's treatment programs, staff employees and physical facilities are important factors in maintaining good professional relationships.
The Company'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 hospitals.
SEASONALITY
The Company's provider business 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.
COMPETITION
Each of the Company'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, the Company's hospitals may, in certain markets, compete with both local and distant hospitals. In addition, the Company's hospitals compete not only with other psychiatric hospitals, but also with psychiatric units in general hospitals, and outpatient services provided by the Company may compete with private practicing mental health professionals. 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 has entered into joint venture arrangements with other healthcare providers in certain markets to achieve more efficiency in the local delivery system.
In recent years, the competitive position of hospitals has been affected by the ability of such hospitals to obtain contracts with Preferred Provider Organizations ("PPO's"), Health Maintenance Organizations ("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. The Company's acquisition of Green Spring creates opportunities to increase its revenues through managed care contracts utilizing the continuum of care described above and through information systems that support care management and at-risk pricing mechanisms.
State certificate of need laws regulate the Company and its competitors' ability to build new hospitals and to expand existing hospital facilities and services. These laws do provide some protection from competition, as their intent is to prevent duplication of services. In most cases, these state laws do not restrict the ability of the Company or its competitors to offer new outpatient services. The Company operates 39 hospitals in 12 states (Arizona, Arkansas, California, Colorado, Indiana, Kansas, Louisiana, Nevada, New Mexico, South Dakota, Texas and Utah) which do not have certificate of need laws applicable to hospitals.
INDUSTRY TRENDS
The Company's hospitals have been adversely affected by factors influencing the entire psychiatric hospital industry. Factors which affect the Company include (i) the imposition of more stringent length of stay and admission criteria by payors; (ii) the failure of reimbursement rates received from certain payers 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 its business that the Company derives from payers 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 mental health benefits, such as reductions in annual and lifetime limits on mental health coverage and (vi) pricing pressure related to an increasing rate of claims denials by third party payers. In response to these conditions, the Company has (i) strengthened controls to minimize costs and capital expenditures; (ii) reviewed its portfolio of hospitals and sold, closed or leased hospitals or consolidated operations in certain locations; (iii) developed strategies to increase outpatient services and partial hospitalization programs to meet the demands of the marketplace; (iv) implemented programs to contest third party denials relating to valid pre-certified medical procedures; (v) renegotiated contracts with managed care organizations at increased rates; and (vi) created an integrated national behavioral healthcare system thereby improving Charter's ability to obtain contracts with large private and public payers.
GOVERNMENTAL BUDGETARY CONSTRAINTS AND HEALTHCARE REFORM
In the 1995 and 1996 sessions of the United States Congress, the focus of healthcare legislation has been 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. If enacted, these proposals would generally reduce Medicare and Medicaid expenditures. The Company cannot predict the effect of any such legislation, if adopted, on its operations; but the Company anticipates that, although overall Medicare and Medicaid funding may be reduced from projected levels, the changes in such programs may provide opportunities to the Company to obtain increased Medicare and Medicaid business through risk-sharing or partial risk-sharing contracts with managed care plans and state Medicaid programs.
A number of states in which the Company has operations have either adopted or are considering the adoption of healthcare reform proposals of general applicability or Medicaid reform proposals, partly in response to possible changes in Medicaid law. Where adopted, these state reform laws have often not yet been fully implemented. The Company cannot predict the effect of these state healthcare reform and Medicaid reform laws on its operations.
The Health Insurance Portability Act (H.R. 3103, also known as the Kassebaum-Kennedy Bill) was signed into law by President Clinton in August, 1996. Under this law, nongovernment health plans covering two or more employees are subject to new rules intended to make health insurance more accessible and avoid individual losses of coverage. Among other things, the law requires insurers to offer individual coverage to persons who lose their employer-sponsored insurance, and limits the ability of insurers to deny coverage because of pre-existing medical conditions, mental or physical. The law also prohibits group health plans (and insurers that offer them) from discriminating in enrollment or premiums based upon medical conditions, including both physical and mental illnesses, but does not require plans to offer particular benefits or restrictions. The law also establishes a four-year trial program to encourage the use of medical savings accounts by giving tax incentives to individuals and employers who contribute to such accounts. Anyone participating in a medical savings account must also maintain a high-deductible catastrophic health insurance policy, and the program is generally limited to 750,000 catastrophic policies. The law may have a minimal, though positive, impact on the Company's operations. The law effectively allows people with insurance coverage to retain that coverage, and while it does not mandate coverage for the uninsured, the law creates tax incentives for purchasing catastrophic health insurance coverage in
connection with a medical spending account. Accordingly, enactment of the law may result in an increase in the insurance coverage available for the types of services offered by the Company.
SOURCES OF REVENUE
Payments are made to the Company's hospitals by patients, by insurance companies and self-insured employers, by the federal and state governments under Medicare, Medicaid, CHAMPUS (as hereinafter defined) and other programs and by HMO's, PPO's and other managed care programs. Amounts received under government programs, HMO, PPO and other managed health care arrangements, certain self- insured employers and certain Blue Cross plans are generally 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 billing rates) derived by the Company's hospitals from various payment sources for the last three fiscal years were as follows:
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 the Company's hospitals which are less than the hospital's established charges.
Most of the Company's hospitals have entered into contracts with HMO's, PPO's, 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, the Company has entered into regional and national contracts with HMO's, PPO's, self-insured employers and other managed care plans that apply to all of the Company's hospitals in the geographic areas covered by a contract. The Company is seeking to obtain additional regional and national contracts. The Company expects its percentage of revenue 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 hospitals. 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."
Most of the Company'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 the Company'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. These "disproportionate share" benefits are subject to annual review and revision by the related state governments and could be substantially reduced or eliminated at any point in the future. The Omnibus Budget Reconciliation Act of 1993 ("OBRA 93") prohibits disproportionate share payments to hospitals which have a Medicaid utilization rate of less than 1%. The amount of disproportionate share payments each hospital can receive is limited through the use of formulas based generally on the cost of providing services to Medicaid and uninsured patients. The Company received approximately $11 million, $9 million and $5 million in Medicaid disproportionate share payments in fiscal 1994, 1995 and 1996, respectively.
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 the Company's operations. Final determination of amounts payable under Medicare and certain Medicaid programs are subject to review and audit. The Company's management believes that adequate provisions have been made for any adjustments that might result from such reviews or audits.
Most of the Company'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.
REGULATION AND OTHER FACTORS
Operations of psychiatric hospitals are subject to substantial federal, state and local government regulation. Such regulations provide for periodic inspections or other reviews by state agencies, the United States Department of Health and Human Services (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 the Company's hospitals are also subject to substantial state regulation relating to involuntary admissions, confidentiality and patients' rights and to federal regulation relating to confidentiality of medical records of substance abuse patients.
Obtaining approvals for construction of new hospitals and for renovation of and additions to existing hospitals is subject to various governmental requirements, such as approval of sites and findings of community need for additional hospital facilities and services. In addition, in certain states, as a practical matter, it is necessary to pledge to provide various amounts of uncompensated care to indigent persons in order to obtain a certificate of need.
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 which 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 the Company's hospitals are subject
to periodic review by Peer Review Organizations ("PRO's"). All hospitals which participate in the Medicare program are subject to review by PRO's. PRO activities include reviews of certain admissions and services to determine medical necessity and to determine whether quality of care meets professionally recognized standards. PRO's have the authority to recommend to the Department that a provider who is in substantial noncompliance with the medical necessity and quality of care standards of a PRO or who has grossly and flagrantly violated an obligation to render quality 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's hospitals have been subject to and have complied with various forms of utilization review since 1970. The Company has implemented a quality assurance program in each of its hospitals, which includes procedures for utilization review and retrospective patient care evaluation. Approximately 20% of the Company's hospitals have received accreditation with commendation from the Joint Commission on Accreditation of Healthcare Organizations (the "Joint Commission").
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 hospitals which 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 has authority to exclude from participation in the Medicare program individuals or hospitals under certain other circumstances. These include engaging in illegal remuneration arrangements with physicians and other healthcare providers, license revocation, exclusion from some other government programs (such as CHAMPUS), filing claims for excess charges or for unnecessary services, failure to comply with conditions of participation and failure to disclose certain required information or to grant proper access to hospital books and records.
The Department has authority to impose civil monetary penalties against any participant in the Medicare program which makes claims for payment for services which were not rendered or were rendered by a person or entity not properly licensed under state law. The Department also has authority to impose a penalty of not more than $2,000 for each improperly claimed service and an assessment equal to not more than twice the amount claimed for each service not rendered.
In 1989, Congress passed the so-called Stark I legislation ("Stark I") which prohibits physicians who have a financial relationship with entities that furnish clinical laboratory services from referring to such entities for Medicare-reimbursed clinical laboratory services and prohibits the entities for billing for services provided pursuant to such prohibited referrals. Stark I, which contains a number of exceptions from its general referral prohibition, became effective January 1, 1992. Proposed regulations implementing Stark I were first issued in March 1992, however, the final Stark I regulations were issued on August 14, 1995.
In 1993, Congress passed Stark II legislation ("Stark II") which expanded the prohibitions of Stark I to include referrals from physicians for a wide variety of medical services, including inpatient/outpatient hospital services, and extended the referral prohibition to include services reimbursed under Medicaid in addition to Medicare. The limitations on referrals outlined in Stark II became effective January 1, 1995. Although the regulations implementing Stark II have not been issued it is anticipated that they will be similar to the Stark I regulations. A number of states in which the Company has operations have adopted legislation similar to the Stark legislation. The Company believes that its financial relationships with physicians do not violate the applicable statutes and regulations. There can be no assurance however that (i) government enforcement agencies will not contend that certain of these financial relationships are in violation of the Stark legislation, (ii) that the Stark legislation will not ultimately be interpreted by the courts in a manner inconsistent with the Company's practices or (iii) regulations will be issued in the future that will result in an interpretation by the courts in the manner inconsistent with the Company's practices.
Federal law makes it a felony, subject to certain exceptions, for a hospital to make false statements relating to claims for payments under the Medicare program, to engage in illegal remuneration arrangements with physicians and other healthcare providers, to make false statements relating to compliance with the Medicare conditions of participation, or to make false claims for Medicare or Medicaid payments. A number of states have adopted laws that also make illegal under state law certain remuneration and referral arrangements with physicians and other healthcare providers.
In order to provide guidance to healthcare providers with respect to the statute that makes certain remuneration arrangements between hospitals and physicians and other healthcare providers illegal, the Department has issued regulations outlining certain "safe harbor" practices, which, although potentially capable of inducing prohibited referrals of business, would not be subject to enforcement action under the illegal remuneration statute. The practices covered by the regulations include, among others, certain investment transactions, leases of space and equipment, personal services and management contracts, sales of physician practices, payments to employees and waivers of beneficiary deductibles and co-payments. Additional proposed safe harbors were published in 1993 by the Department. Certain transactions and agreements of the Company do not satisfy all the applicable criteria contained in the final and proposed safe harbor regulations that relate to such transactions and agreements. However, the Company believes that such leases and contracts do not violate the statute that makes certain remuneration arrangements illegal. There can be no assurance that (i) government enforcement agencies will not assert that certain of these arrangements are in violation of the illegal remuneration statute or (ii) the statute and the regulations will ultimately be interpreted by the courts in a manner consistent with the Company's practices.
Recent legislation, which becomes effective January 1, 1997, strengthens federal health care fraud and abuse law enforcement efforts. Among other things, the new legislation (i) adds several new offenses, (ii) expands the scope of certain existing laws by including private health insurance plans as well as the Medicare and Medicaid programs, (iii) increases penalties for certain existing offenses and (iv) significantly increases funding for health care fraud and abuse detection and prosecution efforts, including authorizing informants to share in recoveries and establishing a national health care fraud and abuse data bank.
Among other things, the new legislation prohibits submitting a claim for reimbursement based on a code that the person knows or "should know" will result in a greater payment than the code "the person knows or should know" 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.
The new offenses created by this legislation, as well as the greater spending on health care fraud and abuse enforcement which will result from this legislation, may significantly increase the likelihood that any particular health care company will be scrutinized by federal, state and/or local law envorcement officials. In addition, the increased penalties will strengthen the ability of enforcement agencies to effect more numerous and larger monetary settlements with health care providers and businesses than was previously the case.
CHAMPUS regulations authorize CHAMPUS to exclude from the CHAMPUS program any provider who 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.
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 the Company 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.
GPA, a subsidiary of Green Spring that owns or manages professional group practices, is subject to the federal and state illegal remuneration statutes described above. In addition, in some states, practice of medicine and certain other health professions' laws prohibit the subsidiary from owning, but not from managing, professional practices.
MEDICAL STAFFS
At September 30, 1996, approximately 1,400 licensed physicians were active members of the medical staffs of the Company's hospitals. Many of these physicians also serve on the medical staffs of other hospitals. A number of these physicians serve in administrative capacities in the Company's hospitals. Most of these physicians are independent contractors who have private practices in addition to their duties for the Company, while certain of these physicians are employees of the Company. 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. The Company recruits physicians to serve in administrative capacities at its hospitals and to engage in private practice in communities where the Company's hospitals are located.
Registered nurses and certain other hospital employees are required to be licensed under the professional licensing laws of most states. The Company's hospital subsidiaries require such employees to maintain such professional licenses as a condition of employment.
GENERAL AND PROFESSIONAL LIABILITY
Effective June 1, 1995, Plymouth Insurance Company, Ltd. ("Plymouth"), a wholly-owned Bermuda subsidiary of the Company, provides general and hospital professional liability insurance up to $25 million per occurrence for the Company's hospitals. All of the risk of losses from $1.5 million to $25 million per occurrence has been reinsured with unaffiliated insurers. The Company also insures with an unaffiliated insurer 100% of the risk of losses between $25 million and $100 million per occurrence, subject to an annual aggregate limit of $75 million. The Company's general and professional liability coverage is written on a "claims made or circumstances reported" basis. For reinsured claims between $10 and $25 million per occurrence, the Company has an annual aggregate limit of coverage of $30 million. For reinsured claims between $1.5 million and $10 million per occurrence, the Company has no limits on the aggregate dollar amounts of coverage.
For the six years from June 1, 1989 through May 31, 1995, the Company had a similar general and hospital professional liability insurance program. For those years, the per occurrence deductible (with respect to which the Company was self-insured) was $2.5 million for the years ended May 31, 1990 and 1991, $2 million for the years ended May 31, 1992 and 1993 and $1.5 million (relating to the Company's general hospitals sold on September 30, 1993) for the year ended May 31, 1994. For psychiatric hospitals, Plymouth's coverage did not contain a per occurrence deductible for the years ended May 31, 1994 and 1995. In December 1994, the per occurrence deductible for the years ended May 31, 1989 and 1990 was eliminated. Plymouth provides coverage with no per occurrence deductible for hospital system claims which had not been paid prior to December 31, 1994. Plymouth does not underwrite any insurance policies with any parties other than the Company or its affiliates and subsidiaries.
The amount of expense relating to Magellan's malpractice insurance based on estimated ultimate losses incurred during the year may materially increase or decrease from year to year depending, among other things, on the nature and number of new reported claims against Magellan and amounts of
settlements of previously reported claims. To date, Magellan 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.
MANAGED CARE BUSINESS
OVERVIEW
Green Spring is the nation's third largest managed behavioral healthcare organization specializing in mental health and substance abuse/dependency services through a network of more than 30,000 providers nationwide, serving approximately 13.6 million people at September 30, 1996.
Green Spring was founded in 1989 by a group of clinicians who utilized a clinical model that emphasizes the treatment needs of individuals. Green Spring attempts to match each patient with an appropriate provider, focusing on the quality of care and cost effectiveness from both the clinical and service aspects.
Green Spring's services include:
ENHANCED UTILIZATION MANAGEMENT, a utilization review process that employs clinical criteria designed to provide each patient with accessible, appropriate and affordable treatment across the entire continuum of care and services;
CARE MANAGEMENT, a fully integrated healthcare model that offers utilization review services and provides care to patients through the management of a national network of providers and Green Spring-owned staff model clinics;
COMPREHENSIVE ADMINISTRATIVE SERVICES, including member assistance, management reporting, claims processing, clinical management information and provider referral systems that are adaptable to customer circumstances and requirements.
Green Spring has several contractual funding arrangements with its customers ranging from full risk capitated contracts to non-risk administrative services only (ASO) arrangements. The primary funding arrangements for risk business include full capitation and partial capitation. Under full capitation arrangements, Green Spring assumes full risk for care under the contract and is paid a monthly fee for each at-risk member regardless of the actual utilization of services by the member. Partial capitation arrangements are similar to full capitation arrangements except that the underwriting gain or loss is split between the customer and Green Spring based on a pre-determined formula. Non-risk funding arrangement include administrative service fees, and incentive-based administrative service fees. ASO funding arrangements call for the payment of a fee to Green Spring for providing varying levels of administrative support and management. Incentive-based administrative service fees are similar to incentive-based ASO arrangements except the ASO fee is subject to adjustment based on the level of performance achieved by Green Spring compared to a mutually agreed target level of performance.
At September 30, 1996, Green Spring's risk and non-risk membership was approximately 4.4 million and 9.2 million, respectively. During fiscal 1996, risk and non-risk business comprised approximately 70% and 30%, respectively, of Green Spring revenues.
Green Spring's customers include Fortune 1000 companies, Blue Cross/Blue Shield organizations, major HMO's/PPOs, several state employee programs, labor unions and several state Medicaid programs. During fiscal 1996, approximately 70% of Green Spring's revenues were generated from Blue Cross/Blue Shield organizations.
GOVERNMENT REGULATION
Green Spring operations, in some states, are subject to utilization review, licensure and related state regulatory procedures. Green Spring provides managed behavioral healthcare services to various Blue Cross/Blue Shield plans that operate Medicare and Medicaid health maintenance organizations or other at-risk managed care programs and that participate in the Blue Cross Federal Employees health program. As a contractor to these Blue Cross/Blue Shield plans, Green Spring is indirectly subject to federal and, with respect to the Medicaid program, state monitoring and regulation of performance and financial reporting requirements. However, Green Spring must comply with all reporting and monitoring requirements of the Health Care Financial Administration ("HCFA") communicated to it from the prime contractor, Blue Cross/Blue Shield plans, for the behavioral healthcare portion for the Medicare risk business. The Office of Inspector General of the United States monitors and reviews financial healthcare benefits through several Blue Cross plans. Medicaid business is also subject to the financial reporting and performance monitoring requirements of the applicable state governments as well as HCFA as noted above.
The management of Green Spring believes that it is in compliance, in all material respects, with all current state and federal regulatory requirements applicable to the business it conducts.
COMPETITION
The managed healthcare industry is being affected by various external factors including rising healthcare costs, intense price competition, market consolidation by major managed care companies and proposed healthcare reform legislation.
Green Spring faces competition from a number of sources, including other behavioral health managed care companies and traditional full service managed care companies that contract to provide behavioral healthcare benefits. Also, to a lesser extent, competition exists from fully capitated multi-specialty medical groups and individual practice associations that directly contract with managed care companies and other customers to provide and manage all components of healthcare for the members including the behavioral healthcare component.
Green Spring believes that the most significant factors in a customer's selection of a managed behavioral healthcare company include price, the extent and depth of provider networks and flexibility and quality of services. The management of Green Spring believes that Green Spring competes effectively with respect to these factors.
PUBLIC SECTOR BUSINESS
OVERVIEW
The Company's public sector business provides specialty home-based behavioral healthcare services ("mentor homes") through its National Mentor, Inc. subsidiary ("Mentor") to over 2,200 clients in 16 states as of September 30, 1996. The public sector business also includes three facilities in Florida for troubled and delinquent adolescents and two contracts for behavioral services in correctional facilities in Ohio and New Jersey.
Mentor was founded in 1983 and was acquired by the Company in January 1995. Public Solutions was established as a separate business unit of the Company during fiscal 1996 to meet the growing demand among public sector agencies for privatized behavioral healthcare services.
Public Solutions' services include:
SPECIALTY HOME-BASED BEHAVIORAL HEALTHCARE SERVICES, which features 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;
TROUBLED AND DELINQUENT ADOLESCENT FACILITY SERVICES, which features contracts with governmental entities for correctional facilities for youth with emotional and substance abuse problems that have led to convictions;
CORRECTIONAL FACILITY BEHAVIORAL HEALTHCARE SERVICES, which features the management and provision of behavioral healthcare to the prison population of government-run correctional facilities.
COMPETITION AND GOVERNMENT REGULATION
Public Solutions competes 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.
Public Solutions 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 management of Public Solutions believes it competes effectively with respect to these factors.
The public sector market place is extremely complex and therefore includes some unique issues regarding competition and government regulation. States normally purchase human services through various agencies utilizing a procurement process whereby one to seven program solicitations may be going on at the same time with little procurement coordination between agencies. County or municipal solicitations may also occur simultaneously. This situation may be changing as some states now have central procurement or purchasing divisions with standard proposal kits, and others are developing coordinated purchasing of blended services/funding.
Public sector purchasing methods have evolved to include a number of controls designed to maintain an open and competitive bidding process. Bids are typically solicitated through a variety of Request-for-Proposal formats ranging from vague to exhaustive in detail. Bids are generally sought on a price-basis only, although "two-envelope" price quality competitors are becoming more commonplace.
Several legal and regulatory barriers are found, depending on the state or governmental entity. For example, some entities have statutes which prevent contracts with for-profit or out-of-state organizations for delivery of services. Others require contractors to meet specific residency or business performance requirements.
Many governmental entities have specific statutes affecting the ability of public officials to privatize services. These include requirements to meet prior cost-effectiveness tests, requirements to give first priority to competitive bids submitted by public sector employee unions, or outright bars on privatization of specific services.
MENTAL HEALTH PARITY LEGISLATION
In October 1996, President Clinton signed a bill submitted by the U.S. Congress that prohibits health plans from setting annual or lifetime caps on mental health coverage ("parity") at levels below those set for general medical/surgical healthcare services. The bill does not require a health plan to offer or provide mental health services and does not affect other terms and conditions of health plans, such as inpatient day or outpatient visit limits or scope of benefits, nor does this bill prohibit health plans from utilizing other forms of cost containment. The definition of mental health services in the bill excludes substance abuse
and chemical dependency. The effective date for the parity legislation is January 1, 1998. Other key components of the parity legislation are as follows:
1) Employers with 50 or fewer employees are exempt from the parity legislation.
2) Health plans that incur increased costs of 1% or more as a result of the parity legislation will be exempt.
3) The parity legislation expires on September 30, 2001 unless extended by Congress.
The Company views the parity legislation as an acknowledgement by the Federal government of the importance of effective treatment of mental health disorders for society in general. However, at this time, the Company cannot predict or measure the effect the parity legislation will have on each of its businesses.
INTELLECTUAL PROPERTY
The Company owns certain intellectual property which is important to its provider business. 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.
EMPLOYEES OF THE REGISTRANT
At September 30, 1996, the Company had approximately 19,000 full-time and part-time employees. The Company believes it has satisfactory relations with its employees.
EXECUTIVE OFFICERS OF THE REGISTRANT
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., Mr. McKnight had responsibility for a wide range of hospital and managed care engagements, as well as assisting clients with formulating financing options, financial restructuring and the purchase/sale of health plans and facilities.
MCC Behavioral Care, Inc. is a managed mental health and substance abuse provider. As Corporate Medical Director, Dr. Bartlett coordinated and managed the professional and clinical activities of the organization, including quality management, risk management and outcomes evaluation.
Dow, Lohnes & Albertson is a law firm with offices in Washington, D.C. and Atlanta, Georgia. As a partner, Mr. Davis performed legal services for clients relating to commercial litigation, health care and general corporate matters, including representation of the Company. Following his employment by the Company, Mr. Davis has continued to provide consulting services to the firm on non-Company matters pursuant to an "Of Counsel" arrangement. Phears & Davis was a law firm in Norcross, Georgia, in which Mr. Davis was a Senior Partner.
Quantum Health Resources, Inc. is a provider of therapy and support services to individuals with chronic health disorders. Norrell Healthcare Corporation is a provider of healthcare and supplemental staffing services. Caremark International, Inc. is a provider of various healthcare-related services including home healthcare and intervenous therapy.
As a consultant to Green Spring, Dr. Harbin provided management services related to precertification and concurrent/retrospective review for Green Spring enrollees considered for or admitted for psychiatric or substance abuse treatment.
Integrated Health Strategies, Inc. ("IHS") was a consulting firm for health and human services organizations. As president of IHS, Dr. Mauch assisted health and human services executives, boards of directors and clinical leaders with strategic planning, policy analysis and program development.
Unilab Southern California Clinical Laboratory is California's largest clinical laboratory. Qualmed and Preferred Health Network are both managed healthcare companies.
INTERNATIONAL OPERATIONS
The Company owns and operates two psychiatric hospitals in London, England (a 45-bed hospital and a 78-bed hospital) and a 69-bed psychiatric hospital in Nyon, Switzerland. The Company's international hospital operations are not material to the Company's overall operations. The Company's international operations also include the Bermuda insurance company that provides the coverages described under "Liability Insurance."
ITEM 2.

ITEM 2. PROPERTIES
PROVIDER BUSINESS
The following table provides information relating to the 91 psychiatric hospitals and 4 residential psychiatric treatment centers operated or managed by the Company as of September 30, 1996.
All of the Company's hospitals located in the United States have been accredited by the Joint Commission. The Joint Commission is a national commission which establishes standards relating to the physical plant, administration, quality of patient care, governing body and medical staffs of hospitals.
The Company operates 10 leased hospitals, including one 150-bed general hospital not listed above, which is managed by an unaffiliated third party. The leases for such hospitals have terms expiring between 1997 and 2069. The leases for two hospitals contain options to purchase these hospitals for nominal consideration at the end of their respective lease terms.
Fifty-nine of the Company's hospitals previously listed are subject to mortgages at September 30, 1996, which were subsequently released in October 1996 pursuant to the terms of the New Revolving Credit Agreement.
The Company owns 15 medical office buildings and leases an additional 9 such buildings. Five of the Company's medical office buildings are subject to mortgages.
The Company leases office space for its outpatient centers. The leases generally have terms of less than five years.
In addition, the Company leases to third parties, with options to purchase by the lessees, three facilities which it previously operated prior to fiscal 1991. The Company is also attempting to sell or lease 16 other previously operated hospitals and related medical office buildings and certain unimproved real estate.
The Company's corporate headquarters in Atlanta, Georgia also serves as headquarters for the provider business with a lease term expiring in 1999.
MANAGED CARE BUSINESS
Green Spring leases all of its 50 operating facilities with terms expiring between 1996 and 2009. Green Spring's headquarters facilities are leased and are located in Columbia, Maryland with lease terms expiring between 1998 and 2001.
PUBLIC SECTOR BUSINESS
Public Solutions owns three juvenile facilities in Florida. The remaining 58 operating facilities are leased with terms expiring between 1997 and 2001. Public Solutions' headquarters is leased and is located in Boston, Massachusetts with a lease term expiring in 2002.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
Certain of the company's subsidiaries are subject to or parties to claims, civil suits and governmental investigations and inquiries relating to their operations and certain alleged business practices. In the opinion of management, based on consultation with counsel, resolution of these matters will not have a material adverse effect on the Company's financial position or results of operations.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.

ITEM 5. MARKET PRICE FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company has one class of Common Stock, which is listed for trading on the American Stock Exchange (ticker symbol "MGL"). As of November 25, 1996, there were 11,186 holders of record of the Company's $0.25 par value Common Stock. The following table sets forth the high and low sales prices of the Company's Common Stock from October 1, 1994 through the fiscal year ended September 30, 1996 as reported by the American Stock Exchange:
The Company has not declared any cash dividends during fiscal 1995 or 1996. As of November 30, 1996, the Company was prohibited from paying dividends on its Common Stock under the terms of its New Revolving Credit Agreement.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected historical financial information of the Company for each of the five years in the period ended September 30, 1996. The information prior to August 1992 is not comparable because of the consummation of the Company's Restructuring and the implementation of fresh start accounting in fiscal 1992, which included the revaluation of the Company's assets and liabilities and resulted in, among other things, significant reductions in long-term debt and interest expense and elimination of preferred stock and preferred stock dividend requirements. 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 September 30, 1996, presented below, have been derived from, and should be read in conjunction with, the Company's audited consolidated financial statements and the related notes thereto. The following financial information should be read in conjunction with "Item 1.--Business" and "Item 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This document contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 including, without limitation, statements regarding the sufficiency of the Company's liquidity and sources of capital and the statements under the heading "Outlook". These forward-looking statements are subject to certain risks, uncertainties and other factors which could cause actual results to differ materially from those anticipated, including, without limitation, potential reductions in reimbursement by third-party payers and changes in hospital payer mix, governmental budgetary constraints and healthcare reform, the impact of potential hospital closures, competition in the provider business and the managed care business, and the regulatory environment for the Company's businesses, as well as the other factors discussed in Exhibit 99 hereto, which is hereby incorporated by reference.
GREEN SPRING ACQUISITION
On December 13, 1995, the Company acquired a 51% ownership interest in Green Spring for approximately $68.9 million in cash, the issuance of 215,458 shares of Magellan Common Stock valued at approximately $4.3 million and the contribution of GPA, a wholly-owned subsidiary of the Company, which became a wholly-owned subsidiary of Green Spring. On December 20, 1995, the Company acquired an additional 10% ownership interest in Green Spring for approximately $16.7 million in cash as a result of an exercise by a minority stockholder of its Exchange Option for a portion of the stockholder's interest in Green Spring. The Company has a 61% ownership interest in Green Spring. Green Spring provides managed behavioral healthcare services, which includes utilization management, care management and employee assistance programs through a 50-state provider network covering approximately 13.6 million people nationwide. The Company has accounted for the acquisition of Green Spring using the purchase method of accounting, which resulted in additional intangible assets of approximately $113 million.
The minority stockholders of Green Spring consist of four Blues organizations that are key customers of Green Spring. In addition, two other Blues organizations that formerly owned a portion of Green Spring have continued as customers of Green Spring. As of September 30, 1996, the minority stockholders of Green Spring have the Exchange Option, under certain circumstances, to exchange their ownership interest in Green Spring for 2,831,739 shares of the Company's Common Stock or $65.1 million in subordinated notes. The Company may elect to pay cash in lieu of issuing the subordinated notes. The Exchange Option expires December 13, 1998.
OVERVIEW
For the fiscal years ended September 30, 1994, 1995 and 1996, the Company's provider business derived approximately 14%, 17% and 21%, respectively, of its gross patient revenue from managed care
payors (primarily HMO's and PPO's); 35%, 30% and 25%, respectively, from other private payor sources (primarily Blue Cross and commercial insurance); and 51%, 53% and 54%, respectively, from governmental payers (primarily Medicare, Medicaid and CHAMPUS). The Company believes that its provider revenue from private payers, as a percentage of total gross patient revenue, has declined because of a shift by purchasers of health care coverage to managed care plans that generally authorize shorter lengths of stay than traditional insurance plans and authorize more outpatient treatment plans. Services to Medicare and Medicaid patients have increased due to increased recognition and treatment of behavioral illnesses of the elderly and disabled and, in some states, improved coverage of behavioral services in psychiatric hospitals for Medicaid beneficiaries. These shifts in the Company's payer mix and a shift in program mix to residential treatment settings have resulted in lower net revenue per equivalent patient day. The psychiatric hospital industry has been adversely affected by the trends described under "Item 1. Provider Business--Industry Trends."
The Company's operating margins have declined to 14.8% in fiscal 1996 from 17.0% and 19.1% in fiscal 1995 and 1994, respectively. These declines are primarily attributable to the adverse business trends described above and the increasing significance of the Company's managed care business and public sector business in fiscal 1995 and 1996, which have historically had lower operating margins than the provider business. See Note 13 to the Consolidated Financial Statements. Operating income (net revenue less salaries, supplies and other operating expenses and bad debt expenses) was $199.4 million for fiscal 1996, compared with $196.1 million and $172.6 million in fiscal 1995 and 1994, respectively. The Company expects a reduction in operating margins as a percentage of net revenue in future periods due to continued pricing pressure in the provider business and the anticipated growth of its managed care and public sector businesses. The Company has broadened the scope of services it provides by offering alternatives to traditional inpatient treatment settings, such as partial hospitalization, intensive outpatient and residential treatment programs, the utilization of mentor homes and by entering the behavioral managed care business through the acquisition of Green Spring in December 1995.
The Company's ability to increase the rates it charges in its provider business to offset cost increases is limited because the Company derives a significant portion of its revenues from patients covered by governmental and managed care programs. With respect to governmental programs, the amount the Company is paid for its provider business services is established by law and regulation. With respect to managed care programs, the amount is established by the managed care contracts. Although inflation has not been a significant factor in the Company's results of operations in recent years, a resurgence of inflation could adversely affect the Company's results of operations because of such limitations on the Company's ability to increase its rates. It is unlikely that federal and state governments will increase reimbursement rates under their programs in amounts sufficient to offset future price increases that result from general inflationary pressures.
The Company's provider business is seasonal in nature, with a reduced demand for certain services generally occurring during the first fiscal quarter around major holidays such as Thanksgiving and Christmas and during the summer months comprising the fourth fiscal quarter.
A summary of the Company's psychiatric hospitals operated or managed during each fiscal year is as follows:
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(1) Includes Northstar Hospital in Anchorage, Alaska that is managed pursuant to an August 1996 joint venture agreement.
The Company leases one general hospital, which is managed by an unrelated third party. The lease and management agreement expire in January 1997.
During fiscal 1992, the Company filed a voluntary petition for relief pursuant to Chapter 11 of the U.S. Bankruptcy Code. The prepackaged plan of reorganization effected a restructuring of the Company's debt and equity capitalization. The Restructuring, which became effective on July 21, 1992, resulted in a reduction of approximately $700 million principal amount of long-term debt and the elimination of redeemable preferred stock having an aggregate liquidation preference of $233 million. The Company accounted for the Restructuring by using the principles of fresh start accounting. Accordingly, the Company's total assets were recorded at their assumed reorganization value, with the reorganization value allocated to identified tangible assets on the basis of their estimated fair value at July 31, 1992. The excess of the reorganization value over the value of identifiable assets is reported as "reorganization value in excess of amounts allocable to identifiable assets."
The following table summarizes, for the periods indicated, changes in selected operating indicators.
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(1) Hospitals operated or managed on September 30th.
PSYCHIATRIC HOSPITAL RESULTS
Following are financial and statistical results from operations of hospitals which are included in the Company's consolidated financial statements:
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(1) Hospitals operated or managed on September 30th.
(2) Includes inpatient and outpatient revenue.
(3) Provision of care to one patient for one day.
(4) Represents inpatient days adjusted to reflect outpatient utilization, computed by dividing patient charges by inpatient charges per day.
(5) Gross revenue is revenue before deducting contractual allowances and discounts from established billing rates. Gross Revenue is not separately identified in the Company's Consolidated Statements of Operations; instead, Net Revenue in the Consolidated Statements of Operations reflects gross revenue after deductions for contractual allowances and discounts from established billing rates.
(6) Government programs include Medicare, Medicaid and the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS"), which provides payment for medical services to military dependents and retired military personnel.
Note: Includes Northstar Hospital in Anchorage, Alaska that is managed pursuant to a joint venture agreement.
FISCAL 1995 COMPARED TO FISCAL 1996. Patient days at the Company's hospitals decreased 0.3% in fiscal 1996 compared to fiscal 1995. The decrease resulted primarily from the closure of hospitals during fiscal 1995 and 1996 offset by increases in patient days resulting from (i) admission growth at same store hospitals and (ii) hospital acquisitions and joint ventures during fiscal 1995 and 1996. Admissions at the Company's hospitals increased 6.3% in fiscal 1996 compared to fiscal 1995. The increase resulted from continued admissions growth at the Company's same store hospitals and admissions attributable to hospital acquisitions and joint ventures in fiscal 1995 and 1996 offset by reductions resulting from hospitals closed in fiscal 1995 and 1996.
The Company's net revenue for fiscal 1996 increased 16.8% compared to fiscal 1995. The increase resulted primarily from acquisitions less (i) the effect of hospitals closed during fiscal 1995 and 1996 and (ii) the decrease in revenue per equivalent patient day in fiscal 1996. Mentor, which was acquired in January 1995, had revenue of $69.8 million during fiscal 1996 compared to $44.8 million for fiscal 1995. Green Spring (excluding GPA), which was acquired on December 13, 1995, had revenues of approximately $215.0 million . Net revenue for fiscal 1995 and 1996 included $35.6 million and $28.3 million , respectively, for the normal settlement and adjustments of reimbursement issues related to earlier fiscal periods ("reimbursement issues"). 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 payer mix from private payer sources to managed care payers and governmental payers, (ii) pricing pressure from certain payers, 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.
The Company's salaries, supplies and other operating expenses increased 23.3% in fiscal 1996 compared to fiscal 1995. The increase resulted primarily from acquisitions less (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 1996. Expenses incurred by Mentor increased to $59.7 million during fiscal 1996 compared to $38.1 million for fiscal 1995. Green Spring expenses (excluding GPA) were approximately $188.2 million during fiscal 1996.
The Company's bad debt expense decreased 11.5% during fiscal 1996 compared to fiscal 1995. The decrease was primarily due to (i) the shift in the provider business to managed care payers, 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. Bad debt expense for Mentor and Green Spring was less than 1% of net revenue for their respective businesses in fiscal 1996.
Depreciation and amortization increased 28.5% during fiscal 1996 compared to fiscal 1995. The increase resulted primarily from depreciation and amortization related to the Green Spring Acquisition.
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 commitment to allocate all existing shares held by the ESOP to the participants as of September 30, 1995.
Interest expense, net, decreased 13.1% 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.
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 payer matters and associated legal fees, the Company recorded a charge of approximately $30.0 million. The Company will pay the insurance settlement in twelve installments over a three-year period. The Company and the insurance carriers have agreed that the dispute and settlement will not negatively impact any present or pending business relationships nor will it prevent the parties from negotiating in good faith concerning additional business opportunities available to, and future relationships between, the parties.
During fiscal 1996, the Company consolidated, closed or sold nine psychiatric facilities. The Company recorded charges of approximately $4.1 million during fiscal 1996 related to the closure of psychiatric hospitals.
The Company also recorded a charge of approximately $1.2 million related to impairment losses and $2.0 million related to severance costs for personnel reductions.
See Note 4 to the Company's Consolidated Financial Statements for further information regarding unusual items.
The Company's effective tax rate was 40.0% during fiscal 1996. The change in the effective tax rate from the prior year periods is primarily attributable to (i) the elimination of non-deductible amortization of reorganization value in excess of amounts allocable to identifiable assets 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 offset by the increase in non-deductible intangible amortization in the fiscal 1996 periods as a result of the Mentor and Green Spring acquisitions.
As of September 30, 1996, the Company had estimated tax net operating loss (NOL) carryforwards of approximately $250 million available to reduce future federal taxable income. These NOL carryforwards expire in 2006 through 2010 and are subject to examination by the Internal Revenue Service. The Internal Revenue Service is currently examining the Company's income tax returns for fiscal 1989 through 1992. Adjustments arising from such examination could reduce or eliminate the NOL carryforwards. In management's opinion, adequate provisions have been made for any adjustments which may result from such examinations.
Minority interest increased $5.8 million during fiscal 1996 compared to fiscal 1995. The increase is 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.
OUTLOOK
Management continually assesses events and changes in circumstances that could effect its business strategy and the viability of its provider facilities. During fiscal 1995, the Company consolidated, closed or sold 15 psychiatric hospitals. During fiscal 1996, the Company consolidated, closed or sold nine psychiatric hospitals. See Note 4 of the Company's Consolidated Financial Statements for further information regarding facility closures. The Company plans to pursue acquisitions in its provider segment during fiscal 1997 in markets where it does not currently have a presence and in markets where it has existing hospital operations. Management expects to consolidate services in selected markets as a result of acquisitions or overcapacity and to close or sell additional facilities in future periods depending on market conditions and evolving business strategies. If the Company closes additional psychiatric hospitals in future periods, it could result in additional charges to income for the costs necessary to exit the hospital operations.
During fiscal 1995 and fiscal 1996, the Company recorded impairment losses on property and equipment and intangible assets of approximately $27.0 million and $1.2 million, respectively. Such impairment losses resulted from changes in the manner that certain of the Company's assets will be used in future periods and from historical operating losses at certain of the Company's operating facilities combined with projected future operating losses. The affected businesses that were operating as of September 30, 1996 had operating income of less than $100,000 (net revenue less salaries, supplies and other operating expenses and bad debt expense) in aggregate during fiscal 1996, excluding the normal settlement of reimbursement issues. When events or changes in circumstances are present that indicate the carrying amount of long-lived assets may not be recoverable, the Company assesses the recoverability of long-lived assets by determining whether the carrying value of such assets will be recovered through future cash flows expected from the use of the asset and its eventual disposition. The Company may record additional impairment losses in future periods as circumstances warrant.
The Company's hospitals continue to experience a shift in payer mix to managed care payers from other payers, which contributed to a reduction in revenue per equivalent patient day in fiscal 1996 compared to prior periods. Management anticipates continued shifting in its hospitals' payer mix towards managed care payers as a result of changes in the healthcare marketplace and the synergies created by the Green Spring acquisition. Future shifts in the Company's hospital payer mix to managed care payers could result in lower revenue per equivalent patient day in future periods for the Company's hospital operations. In addition, the Company's hospitals have experienced pricing pressure related to an increasing rate of claim denials by third party payers, which contributed to a reduction in revenue per equivalent day compared to prior periods. Management expects the pricing pressure to continue into fiscal 1997, which could result in lower revenue per equivalent patient day in future periods. Management intends to vigorously contest third party denials that relate to valid pre-certified medical procedures and review or renegotiate contractual relationships with certain third party payers.
During fiscal 1994, 1995 and 1996, the Company recorded revenue of $32.1 million, $35.6 million and $28.3 million, respectively, for settlements and adjustments related to reimbursement issues. The settlements in fiscal 1994, 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. Management anticipates that revenue related to such settlements will decline in fiscal 1997, and that the decline will be comparable to the reduction experienced in fiscal 1996.
During fiscal 1996, the Company recorded reductions of expenses of approximately $15.3 million as a result of updated actuarial estimates related to malpractice claim reserves. 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.
On October 28, 1996, the Company terminated its Revolving Credit Agreement. The Company will record an extraordinary loss from the early extinguishment of debt of approximately $3.0 million, net of tax, in the first quarter of fiscal 1997 to write off deferred financing costs related to the Revolving Credit Agreement.
FISCAL 1994 COMPARED TO FISCAL 1995. Patient days at the Company's hospitals increased 27.1% in fiscal 1995. The increase resulted primarily from the Acquired Hospitals. Total admissions increased 28.6% in fiscal 1995 as compared to fiscal 1994. The increase resulted primarily from the Acquired Hospitals.
The Company's net revenue increased 27.3% from $904.6 million in fiscal 1994 to $1.15 billion in fiscal 1995. The increase resulted primarily from acquisitions. Net revenue for fiscal 1995 included $35.6 million related to reimbursement issues, compared to $32.1 million in fiscal 1994. Net revenue at the Company's non-psychiatric hospital operations increased $59.1 million, including $56.5 million provided by companies acquired or developed in the Company's expansion of services pursuant to its business strategy. The Company derived net revenue in fiscal 1995 of $249.2 million from the Acquired Hospitals compared to $52.1 million in fiscal 1994. Net revenue per equivalent patient day decreased 4.5% to $532 in fiscal 1995 from $557 in fiscal 1994. This decrease resulted primarily from lower net revenue per equivalent patient day for the Acquired Hospitals compared to the Company's other hospitals and a continued shift in payor mix from private payer sources to managed care payors and governmental payors.
The Company's salaries, supplies and other operating expenses increased 30.6% in fiscal 1995 compared to fiscal 1994, due primarily to expenses incurred by the Acquired Hospitals of $194.1 million in fiscal 1995 compared to $40.2 million in fiscal 1994. The same store psychiatric hospitals of the Company decreased their salaries, supplies and other expenses primarily by reducing advertising expenses, purchased services, salaries and benefits and medical professional fees.
The Company's bad debt expense increased 30.3% in fiscal 1995 compared to fiscal 1994. The increase resulted primarily from additional bad debt expense of $12.9 million during fiscal 1995 at the Acquired Hospitals and increased bad debt expense at the Company's other hospitals.
Depreciation and amortization increased 34.3% in fiscal 1995 compared to fiscal 1994. The increase resulted primarily from the depreciation related to the Acquired Hospitals and other acquisitions and the amortization of the related covenant not to compete and goodwill.
Reorganization value in excess of amounts allocable to identifiable assets (the "Excess Reorganization Value") was amortized over the three-year period ended July 31, 1995. The related amortization expense decreased $5.2 million in fiscal 1995 as compared to fiscal 1994 due to the completion of the amortization period in fiscal 1995.
Net interest expense for fiscal 1995 increased 40.2% from the previous fiscal year due to the issuance of the Notes and to borrowings under the Revolving Credit Agreement for acquisitions.
ESOP expense for fiscal 1995 increased 49.5% to $73.5 million from $49.2 million for fiscal 1994. The increase resulted primarily from an increase in shares allocated to the ESOP participants.
Stock option expense for fiscal 1995 decreased $11.1 million from the previous year due to a charge during the first quarter of fiscal 1994 of $3.9 million related to the manner of exercise of certain options held by a former employee and director (see Note 7 of the Company's Consolidated Financial Statements) and changes in the market price of the Company's Common Stock.
During fiscal 1995, the Company recorded unusual items of $57.4 million. Included in the unusual charges was the resolution in March 1995 of disputes between the Company and a group of insurance carriers that arose in fiscal 1995 related to claims paid predominantly in the 1980's. As part of the resolution, the Company agreed to pay the insurance carriers approximately $29.8 million in five installments over a three-year period. The Company and the insurance carriers will continue to do business at the same or similar general levels. Furthermore, the parties will seek additional business opportunities that will serve to enhance their present relationships.
During fiscal 1995, the Company consolidated, closed or sold 15 psychiatric facilities. The Company recorded a charge of approximately $3.6 million in the fourth quarter of fiscal 1995 related to the five psychiatric hospitals closed in the fourth quarter.
The Company also recorded a charge of approximately $27.0 million in fiscal 1995 related to the adoption and implementation of Statement of Financial Accounting Standards No. 121. See "Recent Accounting Pronouncements" on page 30 for further detail.
The Company also recorded an unusual item of approximately $3.0 million in fiscal 1995 for the gain on the sale of three psychiatric hospitals.
During fiscal 1994, the Company recorded unusual items of approximately $71.3 million. Included in the unusual charges was the resolution in November 1994 between the Company and a group of insurance carriers of disputes that arose in the fourth quarter related to claims paid predominantly in the 1980's. As part of the resolution, the Company agreed to pay the insurance carriers approximately $31 million plus interest, for a total of $37.5 million in four installments over a three-year period. The Company and the insurance carriers will continue to do business at the same or similar general levels. Furthermore, the parties will seek additional business opportunities that will serve to enhance their present relationships.
As a result of the Hospital Acquisition, the Company reassessed its business strategy in certain markets. The Company established a plan to consolidate services in selected markets and close or sell certain facilities owned prior to the Hospital Acquisition. Accordingly, the Company recorded a charge of $23.0 million in fiscal 1994 primarily to write down the assets of those facilities to their net realizable value. The Company also recorded as an unusual charge during fiscal 1994 of approximately $4.5 million of expenses related to the relocation of the Company's executive offices. See Note 4 to the Company's Consolidated Financial Statements for further information regarding unusual items.
During fiscal 1994, the Company recorded an extraordinary loss of approximately $12.6 million (net of income tax benefit of approximately $8.4 million) related to the defeasance of the Company's 7 1/2% Senior Subordinated Debentures due 2003 and the pay-off of certain subsidiary mortgages. The extraordinary loss includes the difference between the redemption price and the carrying value of the debentures and prepayment penalties related to such subsidiary mortgages.
See "Item 1 - -Business" for additional information on trends that may affect operations.
LIQUIDITY AND CAPITAL RESOURCES
OPERATIONAL ACTIVITIES. The Company's net cash provided by operating activities was $95.6 million and $101.9 million for fiscal 1995 and fiscal 1996, respectively. The increase in net cash provided by operating activities is primarily attributable to (i) Green Spring operating cash flows since acquisition and (ii) state income tax refunds of $8.6 million from the State of California offset by (a) the increased payments related to the insurance settlements ($22.3 million in fiscal 1995 and $24.6 million in fiscal 1996), and (b) reduced operating cash flows from the provider business. As of September 30, 1995 and 1996, the Company had working capital of $91.4 million and $63.8 million, respectively, including cash and cash equivalents of $105.5 million and $120.9 million, respectively. The decrease in working capital is due primarily to the partial funding ($38.5 million) of treasury stock purchases described below with cash on hand during September 1996. Management believes that the Company will have adequate cash flow from operations in fiscal 1997 to fund its operations, capital expenditures and debt service obligations.
INVESTING ACTIVITIES. The Company acquired a 61% ownership interest in Green Spring during 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 $62.0 million in acquisition expenditures during fiscal 1995. The Company plans to pursue acquisitions in each of its business segments during fiscal 1997. Management believes that its cash on hand, future cash flows from operations, borrowing capacity under the New Revolving Credit Agreement and its ability to issue debt and equity securities from time to time will provide adequate capital resources to support the Company's anticipated investing strategies.
FINANCING ACTIVITIES. The Company borrowed approximately $28.9 million and $104.8 million, respectively, during fiscal 1995 and 1996, primarily to fund the acquisition of 13 hospitals in fiscal 1995 and to (i) fund the Green Spring acquisition and to (ii) partially fund ($35.0 million) treasury stock purchases during September 1996. The Company believes that its businesses will generate sufficient cash flows from operations to meet its future debt service requirements.
On January 25, 1996, the Company issued 4,000,000 shares of Common Stock (the "Shares") along with a warrant to purchase an additional 2,000,000 shares of Common Stock (the "Warrant") pursuant to a Stock and Warrant Purchase Agreement. The Warrant, which expires in January, 2000 entitles the holder to purchase such additional shares of Common Stock at a per share price of $26.15, subject to adjustment for certain dilutive events, and provides registration rights for the shares of Common Stock underlying the Warrant. The aggregate purchase price for the Shares and the Warrant was $69,732,000. The Warrant becomes exercisable on January 25, 1997 and expires on January 25, 2000.
The Company received proceeds of approximately $68.6 million, net of issuance costs, from the issuance of the Shares and the Warrant. Approximately $68.0 million of the proceeds were used to repay outstanding borrowings under the Revolving Credit Agreement.
On September 27, 1996, the Company repurchased approximately 4.0 million shares 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 New Revolving Credit Agreement. The Company expects to use cash on hand, future cash flows from
operations and borrowings under its New Revolving Credit Facility to fund any future treasury stock purchases.
As of November 30, 1996, the Company had approximately $209 million of availability under the New Revolving Credit Agreement. The Company was in compliance with all debt covenants at September 30, 1996.
RECENT ACCOUNTING PRONOUNCEMENTS
In March 1995, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 121 ("FAS 121") "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of ", which becomes effective for fiscal years beginning after December 15, 1995. FAS 121 establishes standards for determining when impairment losses on long-lived assets have occurred and how impairment losses should be measured. The Company adopted FAS 121 effective October 1, 1994. The financial statement impact of adopting FAS 121 was not material.
In October 1995, the FASB issued Statement of Financial Accounting Standards No. 123 ("FAS 123") "Accounting for Stock-Based Compensation," which becomes effective for fiscal years beginning after December 15, 1995. FAS 123 establishes new financial accounting and reporting standards for stock-based compensation plans. Entities will be allowed to measure compensation expense for stock-based compensation under FAS 123 or APB Opinion No. 25, "Accounting for Stock Issued to Employees." Entities electing to remain with the accounting in APB Opinion No. 25 will be required to make pro forma disclosures of net income and earnings per share as if the provisions of FAS 123 had been applied. The Company plans to adopt FAS 123 in fiscal 1997 on a proforma disclosure basis.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information with respect to this item is contained in the Company's Consolidated Financial Statements and financial statement schedule indicated in the Index on Page of this Annual Report on Form 10-K and is incorporated herein by reference.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to the Company's executive officers is contained under "Item 1. Business-- Executive Officers of the Registrant." Pursuant to General Instruction G(3) to Form 10-K, the information required by this item with respect to directors has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
Pursuant to General Instruction G(3) to Form 10-K, the information required with respect to this item has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Pursuant to General Instruction G(3) to Form 10-K, the information required with respect to this item has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Pursuant to General Instruction G(3) to Form 10-K, the information required with respect to this item has been omitted inasmuch as the Company files with the Securities and Exchange Commission a definitive proxy statement not later than 120 days subsequent to the end of its fiscal year. Such information is incorporated herein by reference.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(A) DOCUMENTS FILED AS PART OF THE REPORT:
1. FINANCIAL STATEMENTS
Information with respect to this item is contained on Pages to of this Annual Report on Form 10-K.
2. FINANCIAL STATEMENT SCHEDULE
Information with respect to this item is contained on page S-1 of this Annual Report on Form 10-K.
3. EXHIBITS
- ------------------------
* Constitutes a management contract or compensatory plan arrangement.
(B) REPORTS ON FORM 8-K:
There were no current reports on Form 8-K filed by the Registrant with the Securities and Exchange Commission during the quarter ended September 30, 1996.
(C) EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K:
Exhibits required to be filed by the Company pursuant to Item 601 of Regulation S-K are contained in a separate volume.
(D) FINANCIAL STATEMENT SCHEDULES REQUIRED BY REGULATION S-X:
Separate financial statements and schedules of Magellan Health Services, Inc. ("Parent Company") have been omitted since the restricted net assets as defined by Rule 4-08(e)(3) of Regulation S-X of the Parent Company's consolidated subsidiaries do not exceed 25% of the consolidated net assets of the Company as of September 30, 1996.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
MAGELLAN HEALTH SERVICES, INC. (Registrant)
Date: December 20, 1996 /S/ CRAIG L. MCKNIGHT ------------------------------------------ Craig L. McKnight Executive Vice President and Chief Financial Officer
Date: December 20, 1996 /S/ HOWARD A. MCLURE ------------------------------------------ Howard A. McLure Vice President and Controller (Chief Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE - ------------------------------ --------------------------- ------------------- /s/ E. MAC CRAWFORD Chairman of the Board of - ------------------------------ Directors, President and December 20, 1996 E. Mac Crawford Chief Executive Officer
/s/ EDWIN M. BANKS Director - ------------------------------ December 20, 1996 Edwin M. Banks
/s/ G. FRED DIBONA, JR. Director - ------------------------------ December 20, 1996 G. Fred DiBona, Jr.
/s/ ANDRE C. DIMITRIADIS Director - ------------------------------ December 20, 1996 Andre C. Dimitriadis
/s/ A.D. FRAZIER, JR. Director - ------------------------------ December 20, 1996 A.d. Frazier, Jr.
/s/ RAYMOND H. KIEFER Director - ------------------------------ December 20, 1996 Raymond H. Kiefer
/s/ GERALD L. MCMANIS Director - ------------------------------ December 20, 1996 Gerald L. McManis
/s/ DARLA D. MOORE Director - ------------------------------ December 20, 1996 Darla D. Moore
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
The following Consolidated Financial Statements of the Registrant and its subsidiaries are submitted herewith in response to Item 8 and Item 14(a)1:
The following financial statement schedule of the Registrant and its subsidiaries is submitted herewith in response to Item 14(a)2:
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of Magellan Health Services, Inc:
We have audited the accompanying consolidated balance sheets of Magellan Health Services, Inc. (a Delaware corporation) and subsidiaries as of September 30, 1995 and 1996, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the three years in the period ended September 30, 1996. These consolidated financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Magellan Health Services, Inc. and subsidiaries as of September 30, 1995 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1996 in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index to financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Atlanta, Georgia November 7, 1996
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) ASSETS
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) LIABILITIES AND STOCKHOLDERS' EQUITY
The accompanying Notes to Consolidated Financial Statements
are an integral part of these balance sheets.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1996
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements of Magellan Health Services, Inc. ("Magellan" or the "Company") include the accounts of the Company and its subsidiaries except where control is temporary or does not rest with the Company. All significant intercompany accounts and transactions have been eliminated in consolidation.
On June 2, 1992, the Company filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code. The prepackaged plan of reorganization (the "Plan") effected a restructuring of the Company's debt and equity capitalization. The Company's Plan was confirmed on July 8, 1992, and became effective on July 21, 1992 (effective on July 31, 1992 for financial reporting purposes). The consolidated financial statements for the three years in the period ended September 30, 1996 are presented for the Company after the consummation of the Plan. These financial statements were prepared under the principles of fresh start accounting. (See Note 3.)
The Company is an integrated behavioral healthcare company providing behavioral healthcare services in the United States, the United Kingdom and Switzerland. The Company operates through three principal subsidiaries engaging in (i) the provider business, (ii) the managed care business and (iii) the public sector business.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
PROVIDER NET REVENUE
Provider net revenue is based on established billing rates, less estimated allowances for patients covered by Medicare and other contractual reimbursement programs and discounts from established billing rates. Amounts received by the Company for treatment of patients covered by Medicare and other contractual reimbursement programs, which may be based on cost of services provided or predetermined rates, are generally less than the established billing rates of the Company's hospitals. Final determination of amounts earned under contractual reimbursement programs is subject to review and audit by the applicable agencies. Net revenue for fiscal 1994, 1995 and 1996 included $32.1 million, $35.6 million and $28.3 million, respectively, for the settlement and adjustment of reimbursement issues related to earlier fiscal periods. Management believes that adequate provision has been made for any adjustments that may result from such reviews.
MANAGED CARE REVENUE
Managed care revenue is recognized over the applicable coverage period on a per member basis for covered members and as earned and estimable for performance based revenues. Deferred revenue is recorded when premium payments are received in advance of the applicable coverage period.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) ADVERTISING COSTS
The production costs of advertising are expensed as incurred. The Company does not consider any of its advertising costs to be direct-response and, accordingly, does not capitalize such costs. Advertising costs consist primarily of radio and television air time, which is amortized as utilized, and printed media services. Advertising expense was approximately $35.6 million, $33.5 million and $30.5 million for the years ended September 30, 1994, 1995 and 1996, respectively.
CHARITY CARE
The Company provides healthcare services without charge or at amounts less than its established rates to patients who meet certain criteria under its charity care policies. Because the Company does not pursue collection of amounts determined to be charity care, they are not reported as revenue. For the years ended September 30, 1994, 1995 and 1996, the Company provided, at its established billing rates, approximately $29.3 million, $41.2 million and $37.9 million, respectively, of such care.
INTEREST, NET
The Company records interest expense net of capitalized interest and interest income. Interest income for the years ended September 30, 1994, 1995, and 1996 was approximately $4.4 million, $3.7 million and $10.5 million, respectively.
CASH AND CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid interest-bearing investments with a maturity of three months or less when purchased, consisting primarily of money market instruments.
CONCENTRATION OF CREDIT RISK
Accounts receivable from patient revenue subject the Company to a concentration of credit risk with third party payors that include insurance companies, managed healthcare organizations and governmental entities. The Company establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific payors, historical trends and other information. Management believes the allowance for doubtful accounts is adequate to provide for normal credit losses.
ASSETS RESTRICTED FOR THE SETTLEMENT OF UNPAID CLAIMS AND OTHER LONG-TERM LIABILITIES
Assets restricted for the settlement of unpaid claims and other long-term liabilities include marketable securities which are carried at fair market value. Transfer of such investments from the insurance subsidiaries to the Company or any of its other subsidiaries is subject to approval by certain regulatory authorities.
During fiscal 1994, the Company adopted Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities ("FAS 115"). Under FAS 115, investments are classified into three categories: (i) held to maturity; (ii) available for sale; and (iii) trading. Unrealized holding gains or losses are recorded for trading and available for sale securities. The Company's investments are classified as available for sale and the adoption of FAS 115 did not have a
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) material effect on the Company's financial statements, financial condition and liquidity or results of operations. The unrealized gain or loss on investments available for sale was not material at September 30, 1995 and 1996.
PROPERTY AND EQUIPMENT
As a result of the adoption of fresh start accounting, property and equipment were adjusted to their estimated fair value as of July 31, 1992 and historical accumulated depreciation was eliminated. Expenditures for renewals and improvements are charged to the property accounts. Replacements and maintenance and repairs that do not improve or extend the life of the respective assets are expensed as incurred. The Company removes the cost and related accumulated depreciation from the accounts for property sold or retired, and any resulting gain or loss is included in operations. Amortization of capital lease assets is included in depreciation expense. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets, which is generally 10 to 40 years for buildings and improvements and three to ten years for equipment. Depreciation expense was $27.4 million, $35.1 million and $40.0 million for the years ended September 30, 1994, 1995 and 1996, respectively.
INTANGIBLE ASSETS
Intangible assets are composed principally of (i) goodwill, (ii) customer lists, (iii) non-compete agreements and (iv) deferred financing costs. Goodwill represents the excess of the cost of businesses acquired over the fair value of the net identifiable assets at the date of acquisition and is amortized using the straight-line method over 25 to 40 years. Customer lists are amortized using the straight line method over their estimated useful lives of 5 to 25 years. Non-compete agreements and deferred financing costs are amortized over the term of the related agreements.
The Company continually monitors events and changes in circumstances that could indicate carrying amounts of intangible assets may not be recoverable. When events or changes in circumstances are present that indicate the carrying amount of intangible assets may not be recoverable, the Company assesses the recoverability of intangible assets by determining whether the carrying value of such intangible assets will be recovered through the future cash flows expected from the use of the asset and its eventual disposition. No impairment losses on intangible assets were recorded by the Company in fiscal 1994 and 1996. Impairment losses of approximately $4.0 million were recorded in fiscal 1995. (See Note 4)
MEDICAL CLAIMS PAYABLE
Medical claims payable represents the liability for healthcare services authorized, incurred and not yet reported to the Company's managed care business. Medical claims payable are estimated based upon authorized healthcare services, past claim payment experience for member groups and other factors. While Management believes the liability for medical claims payable is adequate, actual results could differ from such estimates.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) FOREIGN CURRENCY
Changes in the cumulative translation of foreign currency assets and liabilities are presented as a separate component of stockholders' equity. Gains and losses resulting from foreign currency transactions, which were not material, are included in operations as incurred.
NET INCOME (LOSS) PER COMMON SHARE
Net income (loss) per common share is computed based on the weighted average number of shares of common stock outstanding during the period. Common stock equivalents were anti-dilutive or not material for the periods presented and therefore were excluded from the calculations.
The Exchange Option, as hereinafter defined (see Note 2), is classified as a potentially dilutive security for fiscal 1996 for the purpose of computing fully diluted earnings per common share. The Exchange Option was anti-dilutive for fiscal 1996 and therefore was excluded from the 1996 calculation.
RECENT ACCOUNTING PRONOUNCEMENTS
In March 1995, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 121 ("FAS 121") "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," which became effective for fiscal years beginning after December 15, 1995. FAS 121 established standards for determining when impairment losses on long-lived assets have occurred and how impairment losses should be measured. The Company adopted FAS 121 effective October 1, 1994. The initial financial statement impact of adopting FAS 121 was not material.
In October 1995, the FASB issued Statement of Financial Accounting Standards No. 123 ("FAS 123") "Accounting for Stock-Based Compensation," which becomes effective for fiscal years beginning after December 15, 1995. FAS 123 establishes new financial accounting and reporting standards for stock-based compensation plans. Entities will be allowed to measure compensation cost for stock-based compensation under FAS 123 or APB Opinion No. 25, "Accounting for Stock Issued to Employees." Entities electing to remain with the accounting in APB Opinion No. 25 will be required to make pro forma disclosures of net income and earnings per share as if the provisions of FAS 123 had been applied. The Company plans to adopt FAS 123 in the fiscal year ended September 30, 1997 on a pro forma disclosure basis.
RECLASSIFICATIONS
Certain reclassifications have been made to fiscal 1994 and fiscal 1995 amounts to conform to fiscal 1996 presentation.
2. ACQUISITIONS AND JOINT VENTURES
ACQUISITIONS
On December 13, 1995, the Company acquired a 51% ownership interest in Green Spring Health Services, Inc. ("Green Spring") for approximately $68.9 million in cash, the issuance of 215,458 shares of Magellan Common Stock valued at approximately $4.3 million and the contribution of Group Practice Affiliates, Inc. ("GPA"), a wholly-owned subsidiary of the Company, which became a wholly-owned
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) subsidiary of Green Spring. On December 20, 1995, the Company acquired an additional 10% ownership interest in Green Spring for approximately $16.7 million in cash as a result of an exercise by a minority stockholder of its Exchange Option (as hereinafter defined) for a portion of the stockholder's interest in Green Spring. The Company has a 61% ownership interest in Green Spring. As of September 30, 1996, Green Spring provided managed behavioral healthcare services, which includes utilization management, care management and employee assistance programs through a 50-state provider network for approximately 13.6 million people nationwide.
The minority stockholders of Green Spring consist of four Blue Cross/Blue Shield organizations (the "Blues") that are key customers of Green Spring. In addition, two other Blues organizations that formerly owned a portion of Green Spring have continued as customers of Green Spring. As of September 30, 1996, the minority stockholders of Green Spring have the option, under certain circumstances, to exchange their ownership interests ("Exchange Option") in Green Spring for 2,831,739 shares of the Company's Common Stock or $65.1 million in subordinated notes. The Company may elect to pay cash in lieu of issuing the subordinated notes. The Exchange Option expires December 13, 1998. The Exchange Option, if exercised by the minority stockholders of Green Spring, would be recorded at the fair value of the consideration paid.
The Company recorded the investments in Green Spring using the purchase method of accounting. Green Spring's results of operations have been included in the consolidated financial statements since the acquisition date, less minority interest.
The cost of the investments in Green Spring have been allocated to the estimated fair value of assets acquired and liabilities assumed to the extent acquired by the Company. The remaining portion of Green Spring's assets and liabilities has been recorded at the historical cost basis of the minority stockholders. The purchase price allocation for the investments in Green Spring and the historical cost basis of the minority stockholders of Green Spring, in aggregate, resulted in goodwill of approximately $89 million and identifiable intangible assets of approximately $24 million.
At each reporting date, the Company must assess the fair value of the Exchange Option in relation to the redemption price available to the minority stockholders. In any period that the fair value of the Exchange Option is determined to be less than the redemption price, the difference must be recognized as an adjustment to minority interest. Subsequent increases in the fair value of the Exchange Option can be recognized only to the extent of previously recognized losses. No losses were recorded in fiscal 1996 as a result of changes in the fair value of the Exchange Option.
In February 1995, the Company acquired Westwood Pembroke Health System, which includes two psychiatric hospitals and a professional group practice. The Company accounted for the acquisition using the purchase method of accounting.
In January 1995, the Company acquired National Mentor, Inc. ("Mentor") by issuing 1,409,978 shares of Common Stock. Mentor provides specialized health services in mentor homes. The acquisition was accounted for as a pooling of interests, effective January 1, 1995. The consolidated financial statements of the Company were not restated for periods prior to January 1, 1995, as the effect of restatement would not have been material to such periods.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
2. ACQUISITIONS AND JOINT VENTURES (CONTINUED) During fiscal 1994, the Company agreed to acquire 40 psychiatric hospitals (the "Acquired Hospitals") from National Medical Enterprises. The purchase price for the Acquired Hospitals was approximately $120.4 million in cash plus an additional cash amount of approximately $51 million, subject to adjustment, for the net working capital of the Acquired Hospitals (the "Hospital Acquisition").
On June 30, 1994, the Company completed the purchase of 27 of the Acquired Hospitals for a cash purchase price of approximately $129.6 million, which included approximately $39.3 million, subject to adjustment, for the net working capital of the facilities. On October 31, 1994, the Company completed the purchase of three additional Acquired Hospitals for a cash purchase price of approximately $5 million, which included approximately $2.2 million related to the net working capital of the facilities. On November 30, 1994, the Company completed the purchase of the remaining ten Acquired Hospitals for a cash purchase price of approximately $36.8 million, including approximately $9.5 million related to the net working capital of ten Acquired Hospitals. The Company accounted for the Hospital Acquisition using the purchase method of accounting. The operating results of the Acquired Hospitals are included in the Company's Consolidated Statements of Operations from the respective dates of acquisition.
JOINT VENTURES
The Company has entered into four hospital-based joint ventures with Columbia/HCA Healthcare Corporation through September 30, 1996. Generally, each member of the joint venture leases and/or contributes certain assets in each respective market to the joint venture with the Company becoming the managing member.
The joint ventures' results of operations have been included in the consolidated financial statements since inception, less minority interest. A summary of the joint ventures is as follows:
3. THE RESTRUCTURING AND FRESH START REPORTING
The consummation of the Plan discussed in Note 1 resulted in, among other things, (i) a reduction of approximately $700 million in long-term debt, (ii) elimination of $233 million of preferred stock and (iii) the issuance of approximately 24.8 million shares of Common Stock to certain holders of debt securities, the preferred stockholders and common stockholders.
As a result of the consummation of the Plan, the financing under the $880 Million Credit Agreement between the Company and certain banks dated September 1, 1988 was replaced by new facilities under the Amended and Restated Credit Agreement, dated July 21, 1992, among the Company and certain banks (the "Credit Agreement").
Upon consummation of the Plan, the Company recognized an extraordinary gain on debt discharge of approximately $731 million which represented forgiveness of debt, principal and interest, reduced by the estimated fair value of Common Stock issued to certain debtholders of the Company. The Company's
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
3. THE RESTRUCTURING AND FRESH START REPORTING (CONTINUED) long-term debt was stated at the present value of amounts to be paid, based on market interest rates on July 31, 1992. This adjustment to present value resulted in an aggregate carrying amount for the Company's long-term debt which was less than the aggregate principal amount thereof, and resulted in the amortization of the difference into interest expense over the terms of the debt instruments and, upon extinguishment of the debt prior to scheduled maturity, resulted in a loss on debt extinguishment.
Under the principles of fresh start accounting, the Company's total assets were recorded at their assumed reorganization value, with the reorganization value allocated to identifiable tangible assets on the basis of their estimated fair value. Accordingly, the Company's property and equipment were reduced and its intangible assets were written off. In addition, the Company's accumulated deficit, common stock in treasury and cumulative foreign currency adjustments were eliminated. The excess of the reorganization value over the value of identifiable assets was reported as "reorganization value in excess of amounts allocable to identifiable assets" (the "Excess Reorganization Value").
The total reorganization value assigned to the Company's assets was estimated by calculating projected cash flows before debt service requirements, for a five-year period, plus an estimated terminal value of the Company (calculated using a multiple of approximately six (6) on projected EBDIT (which is net revenue less operating and bad debt expenses)), each discounted back to its present value using a discount rate of 12% (representing the estimated after-tax weighted cost of capital). This amount was approximately $1.2 billion and was increased by (i) the estimated net realizable value of assets to be sold and (ii) estimated cash in excess of normal operating requirements. The above calculations resulted in an estimated reorganization value of approximately $1.3 billion, of which the Excess Reorganization Value was $225 million, of which $129 million related to continuing operations. The Excess Reorganization Value was amortized over the three-year period ended July 31, 1995.
4. UNUSUAL ITEMS
INSURANCE SETTLEMENTS
Unusual items included the resolutions of disputes between the Company and insurance carriers concerning certain billings for services.
In November 1994, the Company and a group of insurance carriers resolved a billing dispute that arose in the fourth quarter of fiscal 1994 related to claims paid predominantly in the 1980's. As part of the resolution, the Company agreed to pay the insurance carriers approximately $31 million plus interest, for a total of $37.5 million in four installments over a three year period. The Company and the insurance carriers will continue to do business at the same or similar general levels. Furthermore, the parties will seek additional business opportunities that will serve to enhance their present relationships.
In March 1995, the Company and a group of insurance carriers resolved a billing dispute which arose in fiscal 1995 related to matters arising predominately in the 1980's. As part of the settlement, the Company agreed to pay the insurance carriers $29.8 million payable in five installments over a three year period. The Company and the insurance carriers have agreed to continue to do business at the same or similar general levels and to seek additional business opportunities that will serve to enhance their present relationships.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
4. UNUSUAL ITEMS (CONTINUED) In August 1996, the Company and a group of insurance carriers resolved a billing dispute which arose in fiscal 1996 related to matters originating in the 1980's. As part of the settlement of these claims, certain related payer matters and associated legal fees, the Company recorded a charge of approximately $30.0 million during the quarter ended June 30, 1996. The Company will pay the insurance settlement amount in twelve installments over a three year period, beginning August 1996. The Company and the insurance carriers have agreed that the dispute and settlement will not negatively impact any present or pending business relationships nor will it prevent the parties from negotiating in good faith concerning additional business opportunities available to, and future relationships between, the parties.
Amounts payable in future periods under the insurance settlements are as follows (in thousands):
FACILITY CLOSURES
During fiscal 1995 and fiscal 1996, the Company consolidated, closed or sold fifteen and nine psychiatric facilities (the "Closed Facilities"), respectively. The Closed Facilities that are still owned by the Company will be sold, leased or used for alternative purposes depending on the market conditions in each geographic area.
The Company recorded charges of approximately $3.6 million and $4.1 million related to facility closures in fiscal 1995 and fiscal 1996, respectively, as follows (in thousands):
Approximately 500 and 620 employees were terminated at the facilities closed in the fourth quarter of fiscal 1995 and during fiscal 1996, respectively. Severance and related benefits paid and charged against the resulting liability were approximately $1.3 million and $2.9 million in fiscal 1995 and fiscal 1996, respectively. Other exit costs paid and applied against the resulting liabilities were approximately $212,000 and $1.4 million in fiscal 1995 and fiscal 1996, respectively.
The following table presents net revenue, salaries, supplies and other operating expenses and bad debt expenses and loss before income taxes, excluding unusual items, of the Closed Facilities (in thousands):
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
The Company also recorded a charge of approximately $2.0 million in fiscal 1996 related to severance and related benefits for approximately 275 employees who were terminated pursuant to planned overhead reductions.
ASSET IMPAIRMENTS
As a result of the Hospital Acquisition, the Company reassessed its business strategy in certain markets at the end of fiscal 1994. The Company established a plan to consolidate services in selected markets and to close or sell certain facilities owned prior to the Hospital Acquisition. The Company recorded a charge of $23 million in fiscal 1994 primarily to write down the property and equipment at these facilities to their net realizable value.
As discussed in Note 1, the Company adopted FAS 121 effective October 1, 1994. During fiscal 1995, the Company recorded impairment losses on property and equipment and intangible assets of approximately $23.0 million and $4.0 million, respectively. During fiscal 1996, the Company recorded impairment losses on property and equipment of approximately $1.2 million. Such losses resulted from changes in the manner that certain of the Company's assets will be used in future periods and current period operating losses at certain of the Company's operating facilities combined with projected future operating losses. Fair values of the long-lived assets that have been written down were determined using the best available information in each individual circumstance, which included quoted market price, comparable sales prices for similar assets or valuation techniques utilizing present value of estimated expected cash flows.
OTHER
During fiscal 1994, the Company recorded a charge of approximately $4.5 million related to the relocation of the Company's executive offices. During fiscal 1995, the Company recorded a gain of approximately $3.0 million related to the sale of three psychiatric hospitals.
5. BENEFIT PLANS
The Company maintains an Employee Stock Ownership Plan (the "ESOP"), a noncontributory retirement plan that enables eligible employees to participate in the ownership of the Company.
The Company had recorded unearned compensation to reflect the cost of Common Stock purchased by the ESOP but not yet allocated to participants' accounts. In the period that shares are allocated or projected to be allocated to participants, ESOP expense is recorded and unearned compensation is reduced. All shares had been allocated to the participants as of September 30, 1995. Interest expense on the remaining portion of the debt incurred to finance the ESOP transaction amounted to approximately $6.2 million for fiscal 1994 and is included in interest expense in the statements of operations.
The Internal Revenue Service has ruled that the ESOP qualifies under Section 401 of the Internal Revenue Code of 1986, as amended. Such determination allows the Company to deduct its contributions to the ESOP for federal income tax purposes.
During fiscal 1992, the Company reinstated a defined contribution plan (the "Magellan 401-K Plan"). Employee participants can elect to voluntarily contribute up to 6% of their compensation to the Magellan 401-K Plan. Effective October 1, 1992, the Company began making contributions to the Magellan 401-K Plan based on employee compensation and contributions. The Company makes a discretionary contribution of 2% of each employee's compensation and matches 50% of each employee's contribution up to 3% of their compensation. During the years ended September 30, 1994, 1995 and 1996, the Company made
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
5. BENEFIT PLANS (CONTINUED) contributions of approximately $4.9 million, $5.8 million and $5.3 million, respectively, to the Magellan 401-K Plan.
Green Spring also maintains a defined contribution plan (the "Green Spring 401-K Plan"). Employee participants can elect to voluntarily contribute up to 6% or 12% of their compensation, depending upon each employee's compensation level, to the Green Spring 401-K Plan. Green Spring matches up to 3% of each employee's compensation. Employees vest in employer contributions over five years. During the year ended September 30, 1996, Green Spring contributed approximately $760,000 to the Green Spring 401-K Plan.
6. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
Information with regard to the Company's long-term debt and capital lease obligations at September 30, 1995 and 1996 is as follows (in thousands):
The aggregate scheduled maturities of long-term debt and capital lease obligations during the five years subsequent to September 30, 1996 are as follows (in thousands): 1997--$5,751; 1998--$5,273; 1999-- $5,103; 2000--$1,991 and 2001--$16,802.
The Senior Subordinated Notes, which are carried at cost, had a fair value of approximately $402 million and $405 million at September 30, 1995 and 1996, respectively, based on market quotes. The Company's remaining debt is also carried at cost, which approximates fair market value.
REVOLVING CREDIT AGREEMENT
On May 2, 1994, the Company entered into a Second Amended and Restated Credit Agreement with certain financial institutions for a five-year reducing, revolving credit facility in an aggregate committed amount of $300 million (the "Revolving Credit Agreement"). Proceeds from the Revolving Credit Agreement were used (i) to refinance certain mortgage indebtedness of certain subsidiaries of the Company in the principal amount of approximately $14.7 million and the loans to certain subsidiaries of
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
6. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS (CONTINUED) the Company outstanding under the Credit Agreement in the principal amount of approximately $46.8 million, (ii) for continued credit enhancement of certain currently outstanding variable rate demand notes issued by or for the benefit of certain subsidiaries of the Company and (iii) for working capital and other general corporate purposes, including to finance, in part, the Hospital Acquisition and to finance other permitted acquisitions and investments.
The loans outstanding under the Revolving Credit Agreement bore interest (subject to certain potential adjustments) at a rate per annum equal to (a) the sum of the Base Lending Rate plus 3/4 of 1%, or (b) at the option of the Company, the sum of the maximum reserve-adjusted one, two, three or six-month LIBOR plus 1 3/4%. The Base Lending Rate was the higher of (x) the rate announced from time to time as Bankers Trust Company's prime lending rate, (y) the Federal Reserve's reported weekly average dealer offering rate for three-month certificates of deposit, adjusted for maximum reserves, plus 1/2 of 1%, and (z) the Federal Funds Rate plus 1/2 of 1%.
NEW REVOLVING CREDIT AGREEMENT
On October 28, 1996, the Company entered into a new Credit Agreement with certain financial institutions for a five-year Senior Secured reducing revolving credit facility in an aggregate committed amount of $400 million (the "New Revolving Credit Agreement"). The Company borrowed approximately $121.0 million under the New Revolving Credit Agreement in October 1996 to (i) pay-off the existing borrowings outstanding under the Revolving Credit Agreement and (ii) pay for fees and expenses related to the New Revolving Credit Agreement.
The loans outstanding under the New Revolving Credit Agreement bear interest (subject to certain potential adjustments) at a rate per annum equal to one, two, three or six-month LIBOR plus 1.25% or the Prime Lending Rate. Interest on Prime Lending Rate Loans is payable at the end of each fiscal quarter and upon conversion to a LIBOR based loan. Interest on LIBOR based loans is payable at the end of their respective one, two, three or six-month terms.
SENIOR SUBORDINATED NOTES
Also on May 2, 1994, the Company issued $375 million of 11.25% Senior Subordinated Notes which mature on April 15, 2004 (the "Notes") and are general unsecured obligations of the Company. Interest on the Notes is payable semi-annually on each April 15 and October 15. Proceeds of $181.8 million from the sale of the Notes were used to defease, and, subsequently on June 9, 1994, to redeem the Company's outstanding 7.5% Senior Subordinated Debentures due 2003 (the "Debentures"). Certain remaining proceeds were used, along with proceeds from the Revolving Credit Agreement, to finance the Hospital Acquisition. The Notes are guaranteed on an unsecured senior subordinated basis by substantially all of the Company's existing subsidiaries and certain subsidiaries created after the issuance of the Notes.
The Notes are not redeemable at the option of the Company prior to April 15, 1999. Thereafter, the Notes will be subject to redemption at the option of the Company, in whole or in part, at the redemption prices (expressed as a percentage of the principal amount) set forth below, plus accrued and unpaid
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
6. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS (CONTINUED) interest thereon to the applicable redemption date, if redeemed during the twelve-month period beginning April 15 of the years indicated below:
COVENANTS
The New Revolving Credit Agreement and the indenture for the Notes contain a number of restrictive covenants, which, among other things, limit the ability of the Company and certain of its subsidiaries to incur other indebtedness, engage in transactions with affiliates, repurchase shares of the Company's common stock above specified levels, incur liens, make certain restricted payments, and enter into certain business combination and asset sale transactions. The New Revolving Credit Agreement also requires the Company to maintain certain specified financial ratios. The Company was in compliance with all debt covenants under the Revolving Credit Agreement and the Notes at September 30, 1996.
EXTRAORDINARY LOSSES
The consolidated statements of operations for the year ended September 30, 1994 includes an extraordinary after-tax loss of approximately $12.6 million, resulting from the early extinguishment of debt. The extraordinary loss in fiscal 1994 was related to the defeasance of the Debentures and the pay-off of certain subsidiary mortgages and includes the difference between the redemption price and the carrying value of the Debentures and prepayment penalties related to the subsidiary mortgages.
On October 28, 1996, the Company paid off all obligations under its Revolving Credit Agreement. The Company will record an extraordinary loss from the early extinguishment of debt of approximately $3.0 million, net of tax, in fiscal 1997 to write off deferred financing costs related to the Revolving Credit Agreement.
LEASES
The Company leases certain of its operating facilities, some of which may be purchased during the term or at expiration of the leases. The book value of capital leased assets was approximately $8.4 million at September 30, 1996. The leases, which expire at various dates through 2069, generally require the Company to pay all maintenance, property tax and insurance costs.
At September 30, 1996, aggregate amounts of future minimum payments under operating leases were as follows: 1997--$9.5 million; 1998--$7.0 million; 1999--$5.1 million; 2000--$3.3 million; 2001--$2.4 million; subsequent to 2001--$48.6 million.
Rent expense for the years ended September 1994, 1995 and 1996 was $11.4 million, $15.4 million and $18.7 million, respectively.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
7. STOCKHOLDERS' EQUITY
Pursuant to the Company's Restated Certificate of Incorporation, the Company is authorized to issue 80 million shares of common stock, $.25 par value per share, and 10 million shares of preferred stock, without par value. Under the terms of the Plan, approximately 24.8 million shares of Common Stock were issued to certain holders of debt securities, the preferred stockholders, and common stockholders. No shares of preferred stock have been issued as of September 30, 1996.
COMMON STOCK
The Company is prohibited from paying dividends on its Common Stock under the terms of the New Revolving Credit Agreement except under certain limited circumstances.
1992 STOCK OPTION PLAN
The 1992 Stock Option Plan provides for the issuance of approximately 3.4 million options to purchase shares of Common Stock. A summary of changes in options outstanding and other related information is as follows:
The exercise price of certain options will be reduced upon termination of employment of a certain optionee without cause.
Options issued pursuant to the 1992 Stock Option Plan are exercisable upon vesting and expire through October 2000. As of September 30, 1996, 100% of the options outstanding were vested.
Upon the termination of the employment of the Company's former Chairman of the Board on March 4, 1993, and under the provisions of the 1992 Stock Option Plan, all of the former employee's options vested and the option prices were reduced to $.25 per share. Such options totaled 2,220,336 at September 30, 1993. As a result, the Company recognized approximately $21.3 million in additional stock option expense during fiscal 1993. On December 3 and December 29, 1993, all of the options under the 1992 Stock Option Plan held by the former employee were exercised. On December 3, 1993, 326,000 options were exercised and the option exercise price was paid by reducing the number of shares issuable by the number of shares having a fair market value equal to the option exercise price (3,326 shares). This exercise triggered a new measurement date for the options exercised and, since the stock price had increased since March 4, 1993, additional stock option expense of $3.9 million was recognized in fiscal 1994. The option exercise price for the 1,894,336 options exercised on December 29, 1993, was paid in
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
7. STOCKHOLDERS' EQUITY (CONTINUED) cash; accordingly, no additional stock option expense was triggered. For both of the exercises, the former employee elected to surrender optioned shares (approximately 570,000 shares) as consideration for the payment of required withholding taxes of approximately $14.2 million. These withholdings represent the minimum required tax withholding amounts required in order to avoid triggering a new measurement date and additional compensation expense. The Company was required to make withholding tax payments on behalf of the former employee of approximately $14.2 million which was charged against additional paid-in capital. This charge was offset by a tax benefit recorded of approximately $9.4 million related to additional stock option expense allowable for income tax purposes.
1994 STOCK OPTION PLAN
The 1994 Stock Option Plan provides for the issuance of approximately 1.3 million options to purchase shares of Common Stock. Options must be granted on or before December 31, 1996. Officers and key employees of the Company are eligible to participate. The options have an exercise price which approximates fair market value of the Common Stock at the date of grant. A summary of changes in options outstanding and other related information is as follows:
Options granted under the 1994 Stock Option Plan are exercisable to the extent vested. An option vests at the rate of 33 1/3% of the shares covered by the option on each of the first three anniversary dates of the grant of the option if the optionee is an employee of the Company on such dates. Options must be exercised no later than ten years after the date of grant. As of September 30, 1996, 48.4% of the options outstanding were vested.
1996 STOCK OPTION PLAN
The 1996 Stock Option Plan provides for the issuance of 1.75 million options to purchase shares of Company Common Stock. Options must be granted on or before December 31, 1999. Officers and key
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
7. STOCKHOLDERS' EQUITY (CONTINUED) employees of the Company are eligible to participate. The options have an exercise price which approximates fair market value of the Common Stock at the date of grant. A summary of changes in options outstanding and other related information is as follows:
Options granted under the 1996 Stock Option Plan are exercisable to the extent vested. An option vests at the rate of 25% of the shares covered by the option on each of the four anniversary dates of the grant of the option if the optionee is an employee of the Company on such dates. Options must be exercised no later than November 30, 2005. As of September 30, 1996, none of the options outstanding were vested.
1994 EMPLOYEE STOCK PURCHASE PLAN
The 1994 Employee Stock Purchase Plan (the "1994 ESPP") covers 600,000 shares of Common Stock that can be purchased by eligible employees of the Company.
The initial offering period began on April 1, 1994 and expired on March 31, 1995. The second offering period began on April 1, 1995 and ended March 31, 1996. On the first date of these offering periods, each participant was granted an option to purchase shares of Common Stock at a purchase price equal to 85% of the fair value of the Company's Common Stock on such date. Total options granted on April 1, 1994 and April 1, 1995 were 85,115 and 41,565, respectively, with option prices of $21.144 and $15.831, respectively. A total of 4,872 and 22,065 options were exercised at the end of the first and second offering periods, respectively.
Effective August 1, 1995, the Company amended the 1994 ESPP to change the option price in subsequent offering periods to the lesser of (i) 85% of the fair value of Company Common Stock on the first day of the offering period or (ii) 85% of the fair value of the Company's Common Stock on the last day of the offering period. Holders of the options from the second offering period as of July 31, 1995 were given the choice of (i) canceling their options to purchase shares of Common Stock, (ii) exercising the option to purchase shares of Common Stock at a purchase price of $15.831 or (iii) keeping their options. A total of 11,870 options were exercised on July 31, 1995. The third offering period began August 1, 1995 and ended December 31, 1995. A total of 29,217 options were exercised at a purchase price of $16.681 at the end of the third offering period.
The fourth offering period began January 1, 1996 and ended on June 30, 1996. A total of 68,146 options were exercised at a purchase price of $18.275 at the end of the fourth offering period. The fifth offering period began July 1, 1996 and will end on December 31, 1996. The number of options granted and
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
7. STOCKHOLDERS' EQUITY (CONTINUED) the option price for the fifth offering period will be determined on December 31, 1996 when the option price is known.
1997 EMPLOYEE STOCK PURCHASE PLAN
The 1997 Employee Stock Purchase Plan (the "1997 ESPP") covers 600,000 shares of Common Stock that can be purchased by eligible employees of the Company. The 1997 ESPP offering periods will have a term not less than three months and not more than 12 months. The first offering period under the 1997 ESPP will not begin prior to January 1, 1997 and the last offering period will end on or before December 31, 1999. The option price of each offering period will be the lesser of (i) 85% of the fair value of the Company's Common Stock on the first day of the offering period or (ii) 85% of the fair value of the Company's Common Stock on the last day of the offering period.
1992 DIRECTORS' STOCK OPTION PLAN AND DIRECTORS' UNIT AWARD PLAN
The 1992 Directors' Stock Option Plan provides for the grant of options to non-employee members of the Company's Board of Directors to purchase up to 175,000 shares of the Company's Common Stock, subject to adjustments to reflect certain changes in capitalization. The options have an exercise price which approximates the fair market value of the Common Stock on the date of grant. During fiscal 1994, 25,000 of these options were exercised and an additional 25,000 options were granted at an exercise price of $23.163 per share. During fiscal 1995, 25,000 options were granted at an exercise price of $18.875 per share. During fiscal 1996, no options were granted.
Options granted can be exercised from the date of vesting until February 1, 2003. No options can be granted after December 31, 1995. Options vest 20% when granted and an additional 20% on each successive February 1 for a period of four years, if the optionee continues to serve as a non-employee director on the applicable February 1. Unvested options vest in full in certain instances of termination. As of September 30, 1996, 68.0% of the options outstanding were vested.
In addition, during 1994, the Company approved the Directors' Unit Award Plan (the "Unit Plan") which provides for the award of a maximum of 15,000 units (the "Units") that, upon vesting under the terms of the Unit Plan, would result in the issuance of an aggregate of 15,000 shares of Common Stock in settlement of Units.
The Unit Plan provides for the award to each director who is not an employee of the Company of 2,500 Units. Upon vesting of the Units awarded to a director, the Company will settle the Units by issuing to the director, with no exercise price, a number of shares of the Company's Common Stock equal to the number of vested Units.
1996 DIRECTORS' STOCK OPTION PLAN
The 1996 Directors' Stock Option Plan provides for the grant of options to non-employee members of the Company's Board of Directors to purchase up to 250,000 shares of the Company's Common Stock, subject to adjustments to reflect certain changes in capitalization. The options have an exercise price which approximates the fair market value of the Common Stock on the date of grant. During fiscal 1996, 175,000 options were granted at exercise prices ranging from $18.25 to $23.375.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
7. STOCKHOLDERS' EQUITY (CONTINUED) Options granted can be exercised from the date of vesting until November 30, 2005. No options can be granted after December 31, 1999. Options vest at the rate of 25% of the shares covered on each of the four anniversary dates of the grant of the option if the optionee continues to serve as a non-employee director on such dates. Options vest in full in certain instances of termination. As of September 30, 1996, none of the options outstanding were vested.
RIGHTS PLAN
Also upon consummation of the Plan, the Company adopted a Share Purchase Rights Plan (the "Rights Plan"). Pursuant to the Rights Plan, each share of Common Stock also represents one Share Purchase Right (collectively, the "Rights"). The Rights trade automatically with the underlying shares of Common Stock. Upon becoming exercisable, but prior to the occurrence of certain events, each Right initially entitles its holder to buy one share of Common Stock from the Company at an exercise price of $60.00. The Rights will be distributed and become exercisable only if a person or group acquires, or announces its intention to acquire, Common Stock exceeding certain levels, as specified in the Rights Plan. Upon the occurrence of such events, the exercise price of each Right reduces to one-half of the then current market price. The Rights also give the holder certain rights in an acquiring company's Common Stock. The Company is entitled to redeem the Rights at a price of $.01 per Right at any time prior to the distribution of the Rights. The Rights have no voting power until exercised.
COMMON STOCK WARRANTS
The Company has two series of warrants outstanding, the 2002 Warrants and the 2006 Warrants.
In connection with the Plan, the Company issued 114,690 of the 2002 Warrants to purchase one share each of the Company's Common Stock. These warrants, which expire on June 30, 2002, have an exercise price of $5.24 per share. During fiscal 1994, 1995 and 1996, 37,395, 47,392, and 4,320 shares were issued, respectively, upon the exercise of these warrants.
The 2006 Warrants, which expire on September 1, 2006, were subject to certain adjustments as a result of the Plan, and accordingly, 146,791 of such warrants are currently outstanding with an exercise price of $38.70 per share.
PRIVATE PLACEMENT TRANSACTION
On January 25, 1996, the Company issued 4,000,000 shares of Common Stock (the "Shares") along with a warrant to purchase an additional 2,000,000 shares of Common Stock (the "Warrant") pursuant to a Stock and Warrant Purchase Agreement. The Warrant, which expires in January 2000 entitles the holder to purchase such additional shares of Common Stock at per share price of $26.15 subject to adjustment for certain dilutive events, and provides registration rights for the shares of Common Stock underlying the Warrant. The aggregate purchase price for the Shares and the Warrant was $69,732,000. The Warrant becomes exercisable on January 25, 1997 and expires on January 25, 2000.
Approximately $68.0 million of the proceeds were used to repay outstanding borrowings under the Revolving Credit Agreement.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
7. STOCKHOLDERS' EQUITY (CONTINUED) TREASURY STOCK TRANSACTIONS
During fiscal 1995, the Company purchased approximately 327,000 shares of its Common Stock in the open market for approximately $5.6 million. Approximately 17,000 of such shares were reissued related to 1994 ESPP exercises for approximately $291,000.
On August 15, 1996, the Company commenced a "Dutch Auction" self-tender offer to stockholders for the repurchase of 1,891,891 shares of its own Common Stock. On September 5, 1996, the Company increased the self-tender offer to 3,300,000 shares. Under the terms of the offer, stockholders were invited to tender their shares by September 18, 1996 at prices ranging from $16.50 to $18.50 per share as specified by each stockholder.
At the conclusion of the offer, the Company repurchased 3,961,505 shares on September 27, 1996 at $18.375 per share for a total cost of approximately $73.5 million, including transaction costs. The total shares repurchased represent approximately 12.0% of the outstanding Common Stock at such date.
The transaction was financed through cash on hand and borrowings under the Revolving Credit Agreement.
8. INCOME TAXES
The provision (benefit) for income taxes consisted of the following (in thousands):
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
8. INCOME TAXES (CONTINUED) A reconciliation of the Company's income tax provision (benefit) to that computed by applying the statutory federal income tax rate is as follows (in thousands):
As of September 30, 1996, the Company has estimated tax net operating loss ("NOL") carryforwards of approximately $250 million available to reduce future federal taxable income. These NOL carryforwards expire in 2006 through 2010 and are subject to examination by the Internal Revenue Service. The Company has recorded a valuation allowance against the entire amount of the NOL deferred tax asset and certain other deferred tax assets, that in management's opinion, are not likely to be recovered.
Components of the net deferred income tax (assets) liabilities at September 30, 1995 and 1996 are as follows (in thousands):
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996
8. INCOME TAXES (CONTINUED)
The Internal Revenue Service is currently examining the Company's income tax returns for fiscal 1989 through 1992. In management's opinion, adequate provisions have been made for any adjustments which may result from these examinations.
9. ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
10. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information for the years ended September 30, 1994, 1995 and 1996 is as follows (in thousands):
The non-cash portion of unusual items for fiscal 1995 and 1996 includes the unpaid portion of the $29.8 million and $30.0 million insurance settlements that were recorded during the quarters ended March 31, 1995 and June 30, 1996, respectively. The payments of the insurance settlements are included in accounts payable and other accrued liabilities in the statement of cash flows for the years ended September 30, 1995 and 1996.
11. COMMITMENTS AND CONTINGENCIES
The Company is self-insured for a substantial portion of its general and professional liability risks. The reserves for self-insured general and professional liability losses, including loss adjustment expenses, are based on actuarial estimates that are discounted at an average rate of 6% to their present value based on the Company's historical claims experience adjusted for current industry trends. The undiscounted amount of the reserve for unpaid claims at September 30, 1995 and 1996 was approximately $113.1 million and $84.3 million, respectively. The reserve for unpaid claims is adjusted periodically as such claims mature, to reflect changes in actuarial estimates based on actual experience. During fiscal 1996, the Company recorded a reduction in malpractice claim reserves of approximately $15.3 million as a result of updated
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (CONTINUED)
SEPTEMBER 30, 1996
11. COMMITMENTS AND CONTINGENCIES (CONTINUED) actuarial estimates. While management and its actuaries believe that the present reserve is reasonable, ultimate settlement of losses may vary from the amount recorded.
Certain of the Company's subsidiaries are subject to or parties to claims, civil suits and governmental investigations and inquiries relating to their operations and certain alleged business practices. In the opinion of management, based on consultation with counsel, resolution of these matters will not have a material adverse effect on the Company's financial position or results of operations.
In January 1996, the Company settled an ongoing dispute with the Resolution Trust Corporation ("RTC"), for itself or in its capacity as conservator or receiver for 12 financial institutions, which formerly held certain debt securities that were issued by the Company in 1988. In connection with the settlement, the Company, denying any liability or fault, paid $2.7 million to the RTC in exchange for a release of all claims.
On August 1, 1996, the United States Department of Justice, Civil Division, filed an Amended Complaint in a civil QUI TAM action initiated in November of 1994 against the Company and its Orlando South hospital subsidiary by two former employees. The Amended Complaint alleges that the hospital violated the federal False Claims Act ("the Act") in billing for inpatient treatment provided to elderly patients. The Amended Complaint is based on disputed clinical and factual issues which the Company believes do not constitute a violation of the Act. The Company and its subsidiary deny any liability in this matter and will continue to vigorously defend themselves against the suit. As is its policy, the Company will continue to cooperate with the government in this matter. The Company does not believe this matter will have a material adverse effect on its financial position or results of operations.
12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The Company owns 50% of the Charter Medical Building in Macon, Georgia, and leases space in such building for certain corporate offices. Through September 30, 1994, the Company's corporate headquarters were located in the building and the lease, which expired September 30, 1994, provided for an average annual rent of approximately $1.2 million. Currently the Company is paying approximately $45,000 per month in rent on the building. Mr. William A. Fickling, Jr., a former Director and former Chairman of the Board of Directors of the Company, and his father's estate own 25% of the building. In the opinion of management, such office space was leased on terms as favorable as could be obtained from an unaffiliated party. The Company received distributions of approximately $280,000 in 1994.
On September 15, 1993, the Company sold its ownership interest in Beech Street to the children of Mr. Fickling for approximately $5.5 million, plus the right to receive additional consideration if certain events (e.g. a public offering of Beech Street stock or if Beech Street sells 50% or more of its assets) occur within two years. The Company obtained a fairness opinion by an independent appraisal firm stating that the financial consideration was fair. The Company acquired its ownership interest in a series of related transactions beginning in May 1989, for a total purchase price of $2,956,000. During the period of its ownership, the Company received $1,242,000 in dividend distributions from Beech Street.
Beech Street was, prior to May 1989, a wholly owned subsidiary of Beech Street, Inc., in which Mr. Fickling beneficially owns a majority of the outstanding stock.
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (CONTINUED)
SEPTEMBER 30, 1996
12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED) The Company also has agreements with Beech Street where certain of the Company's hospitals provide services to employers (and their related employee and covered dependent groups) who have entered into agreements with Beech Street to utilize a Beech Street Preferred Provider Organization ("PPO") for hospital and other healthcare services. Such agreements provide for covered services to be rendered under terms (including discounts from the hospital's normal charges) which management of the Company believes are customary for hospital PPO agreements. The Beech Street PPO reviews claims and serves as an intermediary between the Company's hospitals and the contracting employers. The Company derived approximately $5.2 million in revenue from these agreements during fiscal 1994. The aggregate discount from customary charges was 19% in 1994.
Gerald L. McManis, who was elected director in February 1994, is the President of McManis Associates, Inc. ("MAI"), a healthcare development and management consulting firm and a subsidiary of MMI Companies, Inc. ("MMI"). Mr. McManis also serves on the Board of Directors of MMI. During fiscal 1994, 1995 and 1996, MAI provided consulting services for the Company related to the development of strategic plans and a review of the Company's business processes. The Company incurred approximately $1.3 million, $158,000 and $274,000 in fees for such services during fiscal 1994, 1995 and 1996, respectively, and reimbursed MAI for approximately $244,000, $21,000 and $13,000, respectively, for expenses.
G. Fred DiBona, Jr., who was appointed as a director of the Company in January 1996, is a Director and the President and Chief Executive Officer of Independence Blue Cross ("IBC"), a health insurance company. As of September 30, 1996, IBC owned 12.25% of Green Spring, a majority-owned subsidiary of the Company.
IBC owned 16.67% of Green Spring prior to December 13, 1995. On December 13, 1995, IBC sold 4.42% of its ownership interest in Green Spring to the Company for $5,376,000 in cash. IBC had a cost basis of $3,288,000 in the 4.42% ownership interest sold to the Company. The Exchange Option described previously gives IBC the right to exchange its ownership interest in Green Spring for a maximum of 889,565 shares of Common Stock or $20,460,000 in subordinated notes through December 13, 1998.
IBC and its affiliated entities contract with Green Spring for provider network, case management and medical review services pursuant to contractual relationships entered into on July 7, 1994 with terms of up to five years. During the period beginning December 14, 1995 through September 30, 1996, IBC and its affiliated entities made payments to Green Spring of approximately $29.2 million and owed Green Spring approximately $9.6 million at September 30, 1996. Green Spring recorded revenue of approximately $32.8 million from IBC during fiscal 1996.
On July 7, 1994, IBC sold a subsidiary to Green Spring in exchange for a $15 million promissory note. As of September 30, 1996, $9 million remains outstanding under such promissory note and is due and payable in equal installments on July 7, 1997, 1998 and 1999.
13. BUSINESS SEGMENT INFORMATION
The Company operates through three principal subsidiaries engaging in (i) the provider business, (ii) the managed care business and (iii) the public sector business. Intersegment sales are not material. Operating income represents net revenue less salaries, supplies and other operating expenses and bad debt expense, and excludes depreciation, amortization, interest (net), unusual items, income taxes and minority interest. Identifiable assets are those used in the Company's operations in each segment. Depreciation and
MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (CONTINUED)
SEPTEMBER 30, 1996
13. BUSINESS SEGMENT INFORMATION (CONTINUED) amortization for the managed care business includes the amortization expense related to the step-up in asset basis for the acquisition of Green Spring in December 1995. Corporate assets consist primarily of cash and cash equivalents, investments and assets not employed in operations.
Prior to fiscal 1996, the Company's managed care and public sector businesses were not material. Accordingly, no comparable segment information is presented for fiscal 1994 and 1995.
14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the quarterly results of operations for the years ended September 30, 1995 and 1996. The first quarter, second quarter and fourth quarter of fiscal 1995 contained unusual charges (income) of approximately ($3.0) million, $29.8 million and $30.6 million, respectively. The third and fourth quarter of fiscal 1996 include unusual charges of approximately $34.0 million and $3.3 million, respectively. See Note 4 for an explanation of these charges.
15. GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
MAGELLAN HEALTH SERVICES INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
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(1) Elimination entry related to intercompany receivables and payables and investment in consolidated subsidiaries.
The accompanying Notes to Condensed Consolidating Financial Statements are an integral part of these balance sheets.
15. GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (CONTINUED) MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
- ------------------------ (1) Elimination entry related to intercompany receivables and payables and investment in consolidated subsidiaries.
The accompanying Notes to Condensed Consolidating Financial Statements are an integral part of these balance sheets.
15. GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (CONTINUED) MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS (IN THOUSANDS)
The accompanying Notes to Condensed Consolidating Financial Statements are an integral part of these statements.
15. GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (CONTINUED) MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS (IN THOUSANDS)
The accompanying Notes to Condensed Consolidating Financial Statements are an integral part of these statements.
15. GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (CONTINUED) MAGELLAN HEALTH SERVICES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS (IN THOUSANDS)
The accompanying Notes to Condensed Consolidating Financial Statements are an integral part of these statements.
15. GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (CONTINUED)
NOTES TO THE CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
General--These condensed consolidating financial statements reflect the Guarantors under the Notes and the Revolving Credit Agreement consummated in May 1994. The direct and indirect Guarantors are wholly owned by the Company or a Guarantor Subsidiary of the Company. Separate financial statements of the Guarantors are not presented because the Guarantors are jointly, severally and unconditionally liable under the guarantee, and the Company believes the condensed consolidating financial statements presented are more meaningful in understanding the financial position of the Guarantor Subsidiaries, and the separate financial statements are deemed not material to investors.
Distributions--There are no restrictions on the ability of the Guarantor Subsidiaries to make distributions to the Company.
Transfers from Guarantors to Nonguarantors--The New Revolving Credit Agreement permits the Company to contribute the assets of hospitals and related medical facilities to joint ventures that conduct a healthcare business, provided that certain conditions are satisfied and that the aggregate fair market value of all such facilities contributed to joint ventures with respect to which the Company and its wholly-owned subsidiaries have less than 50% of the equity interests or do not control such joint ventures does not exceed $100 million. Furthermore, the New Revolving Credit Agreement permits the Company and its Subsidiaries to make investments in controlled joint ventures up to $100 million plus the amount permitted but not used for uncontrolled joint ventures. The indenture related to the Notes also contains provisions that permit the Company and its Restricted Subsidiaries (as defined in the indenture for the Notes) to make investments in non-guarantors.
The Company intends to make investments in Permitted Non-Control Investments (as defined in the New Revolving Credit Agreement) and Permitted Non Guarantor Transactions (as defined in the New Revolving Credit Agreement) to the extent it believes doing so will be consistent with its business strategy. To the extent the Company or its Restricted Subsidiaries make investments of the type described above, the assets available for debt payments and guarantee obligations could be diminished.
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
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(A) Recoveries of amounts previously charged to income.
(B) Included in provision for restructuring for operations.
(C) Accounts written off.
(D) Allowance for doubtful accounts assumed in acquisitions.
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