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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended September 30, 2000
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______________ to ______________
COMMISSION FILE NO. 1-6639
MAGELLAN HEALTH SERVICES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 58-1076937
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6950 COLUMBIA GATEWAY DRIVE
SUITE 400
COLUMBIA, MARYLAND 21046
(Address of principal executive (Zip Code)
offices)
Registrant's telephone number, including area code: (410) 953-1000
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Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
Common Stock ($0.25 par value) New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. / /
The aggregate market value of the common stock held by non-affiliates of the
registrant at November 30, 2000 was approximately $93,939,264.
The number of shares of the registrant's common stock outstanding as of
November 30, 2000 was 34,921,746.
DOCUMENTS INCORPORATED BY REFERENCE: The registrant's definitive proxy
materials on Schedule 14A relating to its annual meeting of stockholders to be
held on February 21, 2001 are incorporated by reference into Part III as set
forth herein.
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MAGELLAN HEALTH SERVICES, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2000
TABLE OF CONTENTS
PAGE
--------
PART I
ITEM 1. Business.................................................... 3
ITEM 2. Properties.................................................. 26
ITEM 3. Legal Proceedings........................................... 27
ITEM 4. Submission of Matters to a Vote of Security Holders......... 29
PART II
ITEM 5. Market Price for Registrant's Common Equity and Related
Stockholder Matters....................................... 29
ITEM 6. Selected Financial Data..................................... 29
ITEM 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 31
ITEM 7A. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 42
ITEM 8. Financial Statements and Supplementary Data................. 42
ITEM 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................. 42
PART III
ITEM 10. Directors and Executive Officers of the Registrant.......... 43
ITEM 11. Executive Compensation...................................... 43
ITEM 12. Security Ownership of Certain Beneficial Owners and
Management................................................ 43
ITEM 13. Certain Relationships and Related Transactions.............. 43
PART IV
ITEM 14. Exhibits, Financial Statement Schedule and Reports on
Form 8-K.................................................. 43
2
PART I
ITEM 1. BUSINESS
Magellan Health Services, Inc. (the "Company"), which was incorporated in
1969 under the laws of the State of Delaware, is a national healthcare company.
The Company primarily operates through two principal segments and engages in the
behavioral managed healthcare business and the human services business The
Company's executive offices are located at Suite 400, 6950 Columbia Gateway
Drive, Columbia, Maryland 21046, and its telephone number at that location is
(410) 953-1000.
RECENT DEVELOPMENTS
DIVESTITURE OF SPECIALTY MANAGED HEALTHCARE BUSINESS. On October 4, 2000
the Board of Directors of the Company, adopted a formal plan of disposal of the
specialty managed healthcare business segment. This action represents a disposal
of a business segment under Accounting Principles Board Opinion No. 30,
"Reporting the Results of Operations--Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions" ("APB 30"). APB 30 requires that the results of
continuing operations be reported separately from those of discontinued
operations for all periods presented and that any gain or loss from disposal of
a segment of a business be reported in conjunction with the related results of
discontinued operations. Accordingly, the Company has restated its results of
operations for all prior periods. The Company recorded an after-tax loss on
disposal of its specialty managed healthcare segment of approximately
$17.7 million (primarily non-cash), in the fourth quarter of fiscal 2000. See
Note 3--"Discontinued Operations" to the Company's audited consolidated
financial statements set forth elsewhere herein.
The specialty managed healthcare segment includes the businesses acquired in
conjunction with the purchase of Vivra, Inc. ("Vivra") on February 29, 2000 and
Allied Health Group, Inc. ("Allied") on December 5, 1997. The initial purchase
price of Vivra was $10.25 million and additional consideration of $10.0 million
may be payable based upon future results. Approximately 30% of the voting
interest in Vivra was owned by the investment firm Texas Pacific Group ("TPG")
at the time of the Company's acquisition. Three of the Company's twelve board
members are affiliated with TPG; however, these three Board members did not
participate in the Board's approval of the Vivra acquisition. TPG is the holder
of 59,063 shares of the Company's redeemable preferred stock, representing
approximately 16% of the outstanding voting securities of the Company at
September 30, 2000. See Note 7--"Redeemable Preferred Stock" to the Company's
audited consolidated financial statements set forth elsewhere herein. The
Company paid approximately $54.5 million for Allied.
BANK AMENDMENT. On August 11, 2000, the Company was successful in amending
certain financial covenants and terms of the Credit Agreement (as defined). The
Company believes the amended Credit Agreement will enable the Company to comply
with all future financial covenants based on the Company's projected operating
performance. The Company incurred approximately $3.1 million in fees to obtain
this amendment and the Company's borrowing rate on its term debt was increased
by 1.25%, resulting in increased interest cost in future periods.
TPG INVESTMENT. On December 15, 1999, the Company entered into an amended
and restated definitive agreement with TPG Magellan, LLC, an affiliate of the
investment firm Texas Pacific Group ("TPG"), pursuant to which TPG purchased
approximately $59.1 million of the Company's Series A Cumulative Convertible
Preferred Stock (the "Series A Preferred Stock") and an Option (the "Option") to
purchase an additional approximately $21.0 million of Series A Preferred Stock.
Net proceeds from issuance of the Series A Preferred Stock were $54.0 million.
Approximately 50% of the net proceeds received from the issuance of the
Series A Preferred Stock was used to reduce debt outstanding under the Term Loan
Facility (as defined) with the remaining 50% of the proceeds being used for
general corporate purposes. The Series A Preferred Stock carries a dividend of
6.5% per annum, payable in quarterly installments in cash or common stock,
subject to certain conditions. Dividends not paid in cash or common
3
stock will accumulate. The Series A Preferred Stock is convertible at any time
into the Company's common stock at a conversion price of $9.375 per share (which
would result in approximately 6.3 million shares of common stock if all of the
currently issued Series A Preferred Stock were to convert) and carries "as
converted" voting rights. The Company may, under certain circumstances, require
the holders of the Series A Preferred Stock to convert such stock into common
stock. The Series A Preferred Stock, plus accrued and unpaid dividends thereon,
must be redeemed by the Company on December 15, 2009. The Option may be
exercised in whole or in part at any time on or prior to June 15, 2002. The
terms of the shares of Series A Preferred Stock issuable pursuant to the Option
are identical to the terms of the shares of Series A Preferred Stock issued to
TPG at the closing of the TPG Investment. See Note 7--"Redeemable Preferred
Stock" to the Company's audited consolidated financial statements set forth
elsehwere herein.
TPG has three representatives on the Company's twelve-member Board of
Directors.
HISTORY
Prior to June 1997, the Company's primary business was the operation of
psychiatric hospitals. During the first quarter of fiscal 1996, the Company
acquired a 61% ownership interest in Green Spring Health Services, Inc. ("Green
Spring"), a managed care company specializing in mental health and substance
abuse/dependence services. At that time, the Company intended to become a fully
integrated behavioral healthcare provider by combining the behavioral managed
healthcare products offered by Green Spring with the direct treatment services
offered by the Company's psychiatric hospitals. Subsequent to the Company's
acquisition of Green Spring, the growth of the behavioral managed healthcare
industry accelerated. The Company concluded that the behavioral managed
healthcare industry offered growth and earnings prospects superior to those of
the psychiatric hospital industry. Therefore, the Company decided to sell its
domestic psychiatric facilities to obtain capital for expansion of its managed
healthcare business.
In June 1997, the Company sold substantially all of its domestic acute-care
psychiatric hospitals and residential treatment facilities (collectively, the
"Psychiatric Hospital Facilities") to Crescent Real Estate ("Crescent") for
approximately $400.0 million (the "Crescent Transactions"). Simultaneously with
the sale of the Psychiatric Hospital Facilities, the Company and Crescent
Operating, Inc. ("COI"), an affiliate of Crescent, formed Charter Behavioral
Health Systems, LLC ("CBHS") to conduct the operations of the Psychiatric
Hospital Facilities and certain other facilities transferred to CBHS by the
Company. The Company retained a 50% ownership of CBHS; the other 50% of the
ownership interest of CBHS was owned by COI.
During fiscal 1999, the Company completed its exit from the healthcare
provider and franchising businesses. In April 1999, the Company sold its
European psychiatric provider operations to Investment AB Bure of Sweden for
approximately $57.0 million. On September 10, 1999, the Company consummated the
transfer of certain assets and other interests pursuant to a Letter Agreement
dated August 10, 1999 with Crescent, COI and CBHS. Under the Letter Agreement,
the Company redeemed 80% of its common interest and all of its preferred
interest in CBHS, agreed to transfer to CBHS its interests in five of its six
hospital-based joint ventures ("Provider JVs") and related real estate as soon
as practicable, transferred certain assets to CBHS, agreed to pay $2.0 million
to CBHS in 12 equal monthly installments beginning on the first anniversary of
the closing date, transferred its healthcare franchising interest to CBHS and
forgave unpaid franchise fees of approximately $115 million (the "CBHS
Transaction").
The CBHS Transaction, together with the formal plan of disposal authorized
by the Company's Board of Directors on September 2, 1999, represents the
disposal of the Company's healthcare provider and healthcare franchising
business segments under APB 30. Pursuant to APB 30, the Company has restated its
results of operations for all prior periods. The Company recorded an after-tax
loss on disposal of its healthcare provider and healthcare franchising business
segments of approximately $47.4 million (primarily non-cash), in the fourth
quarter of fiscal 1999.
4
The Crescent Transactions provided the Company with approximately
$200 million of net cash proceeds, after debt repayment, for use in implementing
its business strategy of expanding its managed care operations. The Company used
the proceeds to finance the acquisition of Allied as well as two important
acquisitions in managed behavioral healthcare (collectively, the "Managed Care
Acquisitions"). A summary of the Managed Care Acquisitions and related
transactions are as follows:
HUMAN AFFAIRS INTERNATIONAL, INCORPORATED ACQUISITION. On December 4, 1997,
the Company consummated the purchase of Human Affairs International,
Incorporated ("HAI"), formerly a unit of Aetna/U.S. Healthcare ("Aetna"), for
approximately $122.1 million, which the Company funded from cash on hand. HAI
managed behavioral healthcare programs primarily through employee assistance
programs ("EAPs") and other behavioral managed healthcare plans. The Company may
be required to make additional contingent payments of up to $60.0 million
annually to Aetna through 2003. The Company has made additional purchase price
payments totaling $120 million through September 30, 2000. The amount and timing
of the payments will be contingent upon the number of HAI's covered lives in
specified products. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Outlook--Liquidity and Capital Resources."
MERIT ACQUISITION. On February 12, 1998, the Company consummated the
acquisition of Merit Behavioral Care Corporation ("Merit") for cash
consideration of approximately $450 million plus the repayment of Merit's debt.
Merit managed behavioral healthcare programs across all segments of the
healthcare industry, including health maintenance organizations ("HMO's"), Blue
Cross/Blue Shield organizations and other insurance companies, corporations and
labor unions, federal, state and local governmental agencies and various state
Medicaid programs. In connection with the consummation of the Merit acquisition,
the Company entered into a new senior secured bank credit agreement (the "Credit
Agreement"), providing for a revolving credit facility (the "Revolving
Facility") and a term loan facility (the "Term Loan Facility") which provides
for borrowings of up to $700 million and the Company issued the 9% Series A
Senior Subordinated Notes due 2008 (the "Notes") pursuant to an indenture which
governs the Notes ("Indenture").
INDUSTRY
According to industry sources, 22.1 percent of American adults suffer from a
diagnosable mental disorder in any given year. Applied to recent population
census, this would translate to approximately 44 million individuals. In the
United States during 1996, approximately $69 billion was spent or more than
seven percent of total health spending, was on mental health services. Further,
direct costs associated with substance abuse were nearly $13 billion. These
direct costs have grown, in part, as society has begun to recognize and address
behavioral health concerns and employers have realized that rehabilitation of
employees suffering from substance abuse and relatively mild mental health
problems can reduce losses due to absenteeism and decreased productivity. In
addition, estimation of indirect costs associated with these issues approach
$79 billion annually, reflecting the fact that four of the ten leading causes of
disability in the United States are mental disorders.
In response to these escalating costs, behavioral managed healthcare
companies such as Green Spring, HAI and Merit were formed. Behavorial managed
healthcare companies focus on matching an appropriate level of specialist and
treatment setting with the patient to provide care in a cost-efficient manner
while improving early access to care and utilizing the most modern and effective
treatments. As the growth of behavioral managed healthcare has increased, there
has been a significant decrease in occupancy rates and average lengths of stay
for inpatient psychiatric facilities and an increase in outpatient treatment and
alternative care services.
According to an industry trade publication entitled "Open Minds Year Book of
Managed Behavioral Health Market Share in the United States 2000-2001" published
by Open Minds, Gettysburg, Pennsylvania (hereinafter referred to as "OPEN
MINDS"), as of July 2000, approximately 209.2 million beneficiaries were
5
covered by some form of behavioral managed healthcare plan. The number of
covered beneficiaries has grown from approximately 86.3 million beneficiaries in
1993 to approximately 209.2 million as of July 2000, representing a 13% compound
annual growth rate since 1993 and 15% growth just in the last year. In addition,
according to OPEN MINDS, beneficiaries covered under risk-based programs, see
below, are growing even more rapidly, from approximately 13.6 million as of
January 1993 to approximately 62.9 million as of July, 2000, representing a
compound annual growth rate of 24% and growth of over 27% since last year.
OPEN MINDS divides the managed behavioral healthcare industry as of
July 2000 into the following categories of care, based on services provided,
extent of care management and level of risk assumption:
BENEFICIARIES PERCENT OF
CATEGORY OF CARE (IN MILLIONS) TOTAL
- ---------------- ------------- ----------
Risk-Based Network Products................................. 62.9 30.1%
EAPs........................................................ 51.0 24.3
Integrated Products......................................... 15.5 7.4
Utilization Review/Care Management Products................. 37.4 17.9
Non-Risk-Based Network Products............................. 42.4 20.3
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Total................................................. 209.2 100.0%
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Management believes the current trends in the behavioral healthcare industry
include increased risk-based network managed care products and significant
expansion of EAP services offered to employees. Management believes that these
trends have developed in response to the attempt by payors to reduce rapidly
escalating behavioral healthcare costs and to limit their risk associated with
such costs while continuing to provide access to high quality care. Expansion of
EAP services is a reflection of the tight labor market and represents a
relatively inexpensive way to help retain workers and reduce turnover. According
to OPEN MINDS, risk-based network products and EAPs are the most rapidly growing
segments of the behavioral managed healthcare industry.
The following is a summary of each of these categories of care.
RISK-BASED NETWORK PRODUCTS. Under risk-based network products, the
behavioral managed healthcare company assumes all or a portion of the
responsibility for the cost of providing a full or specified range of behavioral
healthcare treatment services. Most of these programs have payment arrangements
in which the managed care company agrees to arrange for services in exchange for
a fixed fee per member per month that varies depending on the profile of the
beneficiary population or otherwise shares the responsibility for arranging for
all or some portion of the treatment services at a specific cost per member.
Under these products, the behavioral managed healthcare company not only reviews
and monitors a course of treatment, but also arranges and pays for the provision
of patient care. Therefore, the behavioral managed healthcare company must
contract with, credential and manage a network of specialized providers and
facilities that covers the complete continuum of care. The behavioral managed
healthcare company must also see that the appropriate level of care is delivered
in the appropriate setting. Given the ability of payors of behavioral healthcare
benefits to reduce their risk with respect to the cost of treatment services
through risk-based network products while continuing to provide access to high
quality care, this market segment has grown rapidly in recent years. In addition
to the expected growth in total beneficiaries covered under behavioral managed
healthcare products, this shift of beneficiaries into risk-based network
products should further contribute to revenue growth for the behavioral managed
healthcare industry because such contracts generate significantly higher revenue
than non-risk based contracts. The higher revenue is intended to compensate the
behavioral managed healthcare company for bearing the financial responsibility
for the cost of delivering care. The Company's risk-based products are
risk-based network products as defined by OPEN MINDS.
6
According to OPEN MINDS, industry enrollment in risk-based products has
grown from approximately 13.6 million covered lives in 1993 to approximately
62.9 million covered lives in 2000, a compound annual growth rate of over 24%.
Despite this growth, only approximately 30% of total managed behavioral
healthcare covered lives were enrolled in risk-based products as of July, 2000.
The Company believes that the market for risk-based products has grown and will
continue to grow as payors attempt to reduce their responsibility for the cost
of providing behavioral healthcare while ensuring an appropriate level of access
to care. Risk-based products can generate significantly greater revenue per
covered life than other non-risk product types. See "Cautionary
Statements--Risk--Based Products."
EMPLOYEE ASSISTANCE PROGRAMS. An EAP is a worksite-based program designed
to assist in the early identification and resolution of productivity problems
associated with behavioral conditions or other personal concerns of employees
and their dependants. Under an EAP, staff or network providers or other
affiliated clinicians provide assessment and referral services to employee
beneficiaries and their dependants. These services consist of evaluating a
patient's needs and, if indicated, providing limited counseling and/or
identifying an appropriate provider, treatment facility or other resource for
more intensive treatment services. The EAP industry developed largely out of
employers' efforts to combat alcoholism and substance abuse problems afflicting
workers. A recent industry survey estimated the total cost of this dependency at
approximately $98.6 billion per year. Many businesses have implemented
alcoholism and drug abuse treatment programs in the workplace, and in some cases
have expanded those services to cover a wider spectrum of personal problems
experienced by workers and their families. As a result, EAP products now
typically include consultation services, evaluation and referral services,
employee education and outreach services. The Company believes that federal and
state "drug-free workplace" measures and Federal Occupational Safety and Health
Act requirements, taken together with the growing public perception of increased
violence in the workplace, have prompted many companies to implement EAPs.
Although EAPs originated as a support tool to assist managers in dealing with
troubled employees, payors increasingly regard EAPs as an important component in
the continuum of behavioral healthcare services.
INTEGRATED EAP/MANAGED BEHAVIORAL HEALTHCARE PRODUCTS. EAPs are utilized in
a preventive role and in facilitating early intervention and brief treatment of
behavioral healthcare problems before more extensive treatment is required.
Consequently, EAPs often are marketed and sold in tandem with managed behavioral
healthcare programs through "integrated" product offerings. Integrated products
offer employers comprehensive management and treatment of all aspects of
behavioral healthcare. In an effort to reduce costs, increase accessibility and
ease of treatment, employers are increasingly attempting to consolidate EAP and
managed behavioral healthcare services into a single product. Although
integrated EAP/managed behavioral healthcare products are currently only a small
component of the overall industry, the Company expects this market segment to
grow.
UTILIZATION REVIEW/CARE MANAGEMENT PRODUCTS. Under utilization review/care
management products, a managed behavioral healthcare company manages and often
arranges for treatment, but does not maintain a network of providers or assume
any of the responsibility for the cost of providing treatment services. The
Company categorizes its products within this segment of the managed behavioral
healthcare industry (as it is defined by OPEN MINDS) as administrative services
only ("ASO") products. The Company does not expect this segment of the industry
to experience significant growth.
NON-RISK-BASED NETWORK PRODUCTS. Under non-risk-based network products, the
behavioral managed healthcare company provides a full array of managed care
services, including selecting, credentialing and managing a network of providers
(such as psychiatrists, psychologists, social workers and hospitals), and
performs utilization review, claims administration and care management
functions. The third-party payor remains responsible for the cost of providing
the treatment services rendered. The Company categorizes its products within
this segment of the behavioral managed healthcare industry (as it is defined by
OPEN MINDS) as ASO products.
7
Management believes that the growth of the behavioral managed healthcare
industry will continue, as payors of behavioral healthcare benefits attempt to
reduce the costs of behavioral healthcare while maintaining high quality care.
Management also believes that a number of opportunities exist in the behavioral
managed healthcare industry for continued growth, primarily for risk-based
products, including state and federal parity legislation.
State and federal legislation that eliminates the difference in coverage
limits for medical health coverage as compared to mental health coverage is
referred to as parity legislation or anti-discrimination legislation.
Historically, copayments and deductibles have been higher for mental health
treatment than for traditional medical coverage. This has served as an
artificial barrier to utilization in some cases. Currently, 29 states have
passed legislation that requires insurance companies to provide the same levels
of coverage between medical and mental health coverage. The Company believes
that this trend will continue, and perhaps accelerate. All federal employees
will be covered by mental health parity effective January 1, 2001 due to an
executive order signed by President Clinton. Additional federal legislation is
under consideration that could apply to all companies regardless of the
exemptions provided under the Employee Retirement Income Security Act of 1974
("ERISA"). The Company believes parity and other legislation may result in
additional demands for its products due to: (1) increased need for managed
behavioral healthcare services to mitigate increased cost and (2) current
customers of ASO products switching to risk arrangements due to the higher
coverage requirements associated with parity.
HUMAN SERVICES. The Company's human services business (see below) is
conducted in three markets, the mental retardation/developmental disability
community-based ("MR/DD") market, the at-risk youth market and the acquired
brain injury market. It is estimated that in 1998, approximately $25 billion was
spent for MR/DD services for approximately 400,000 persons, which is believed to
represent only 10% of the estimated potential market of persons with some level
of developmental disability. Over the past twenty years, the preferred care for
these persons has been shifting from institutional to community-based care and
the demand continues to outpace capacity. State Medicaid programs are the
primary source of funding for MR/DD services. The at-risk youth market, which
includes children with severe emotional, developmental and behavioral disorders
and youth under the auspices of the juvenile justice system, is expected to grow
from $22 billion in 1998 to approximately $29.3 billion in 2003. Program models
utilized to treat at-risk youth include residential treatment facilities,
alternative schools and community-based programs. The acquired brain injury
market ("ABI") serves the more than 2 million individuals who suffer traumatic
brain injuries each year. Improvements in medicine result in more persons
surviving ABI but often with a resulting substantial disability, often for
extended periods of time. The Company believes the improvements in medicine,
pressures of managed care, and other factors will result in increasing need for
community-based, post-acute long-term care options.
COMPANY OVERVIEW
The Company conducts operations in two business segments: behavioral managed
healthcare and human services.
BEHAVIORAL MANAGED HEALTHCARE. According to enrollment data reported in
OPEN MINDS, the Company is the nation's largest provider of behavioral managed
healthcare services. As of September 30, 2000, the Company had approximately
71.0 million covered lives under behavioral managed healthcare contracts and
managed behavioral healthcare programs for approximately 3,300 customers.
Through its current network of over 40,000 providers and 5,000 treatment
facilities, the Company manages behavioral healthcare programs for HMOs, Blue
Cross/Blue Shield organizations and other insurance companies, corporations,
federal, state and local governmental agencies, labor unions and various state
Medicaid programs. The Company believes it has the largest and most
comprehensive behavioral healthcare provider network in the United States.
8
The Company's professional care managers coordinate and manage the delivery
of behavioral healthcare treatment services through the Company's network of
providers, which includes psychiatrists, psychologists, licensed clinical social
workers, marriage and family therapists and licensed clinical professional
counselors. The treatment services provided by the Company's behavioral provider
network include outpatient programs (such as counseling and therapy),
intermediate care programs (such as sub-acute emergency care, intensive
outpatient programs and partial hospitalization services), inpatient treatment
services and alternative care services (such as residential treatment, home and
community-based programs and rehabilitative and support services). The Company
provides these services through: (i) risk-based products; (ii) EAPs; (iii) ASO
products and (iv) products that combine features of some or all of these
products. Under risk-based products, the Company arranges for the provision of a
full range of behavioral healthcare services for beneficiaries of its customers'
healthcare benefit plans through fee arrangements under which the Company
assumes all or a portion of the responsibility for the cost of providing such
services in exchange for a fixed per member per month fee. Under EAPs, the
Company provides assessment services to employees and dependents of its
customers, and if required, referral services to the appropriate behavioral
healthcare service provider. Under ASO products, the Company provides services
such as utilization review, claims administration and provider network
management. The Company does not assume the responsibility for the cost of
providing behavioral healthcare services pursuant to its ASO products.
HUMAN SERVICES. The Company's human services business provided specialty
home-based behavioral healthcare services through its wholly-owned subsidiary
National Mentor, Inc. ("Mentor"), to approximately 7,800 individuals in 21
states as of September 30, 2000. Mentor was founded in 1983 and was acquired by
the Company in January 1995. Mentor's services include specialty home-based
behavioral healthcare services, which feature individualized home and
community-based health and human services delivered in highly structured and
professionally monitored family environments or "mentor" homes. The mentor homes
serve clients with chronic behavioral disorders and disabilities requiring
long-term care, including children and adolescents with behavioral problems,
individuals with mental retardation or developmental disabilities, and
individuals with neurological impairment or other medical and behavioral
frailties. Mentor also provides various residential and day services for
individuals with acquired brain injuries and for individuals with mental
retardation and developmental disabilities.
For financial information regarding the business segments see
Note 14--"Business Segment Information" to the Company's audited consolidated
financial statements set forth elsewhere herein.
BUSINESS STRATEGY
The Company's business strategy is comprised of two primary objectives:
(i) evaluate the potential to sell or exit non-core and/or under performing
assets and (ii) take advantage of our market leadership position and economies
of scale to improve cost structure and overall efficiency in providing service
in the behavioral managed healthcare arena.
The Company has taken aggressive action recently to dispose of those assets
that are not generating cash for debt reduction or are not part of its ongoing
strategy. These activities include: (i) the exit from its specialty managed
healthcare segment; (ii) the exit from its psychiatric practice management
business; and (iii) the sale of its Canadian operations. The Company is
currently evaluating the potential to divest on acceptable terms certain other
assets and businesses, including Mentor, and is currently involved in
discussions with various parties. There can be no assurance that the Company
will be able to divest any asset or businesses or that such divestiture would
result in significant reductions of long-term debt or improvements in liquidity.
9
The second part of the Company's strategy centers on improving the
efficiencies of its business. In the past two years, Magellan consolidated its
behavioral managed healthcare businesses, elminating duplicate staffing and
facilities. The Company is now focusing on the next level of integration that
includes reduction in computer system platforms, best practices analysis,
standardization of provider contracting and utilization of the internet to
reduce administrative burden to both providers, customers and beneficiaries. The
Company believes that it will reduce administrative costs and improve customer
service through these measures; however, there can be no assurance that the
Company will be able to implement these initiatives or realize the anticipated
savings.
The Company believes this strategy will position the Company to take
advantage of favorable macro-economic trends that support continued growth in
the behavioral managed healthcare industry.
BEHAVIORAL MANAGED HEALTHCARE PRODUCTS AND SERVICES
GENERAL. The following table sets forth the approximate number of covered
lives as of September 30, 1999 and 2000 and revenue for fiscal 1999 and 2000 for
the types of behavioral managed healthcare programs offered by the Company:
PROGRAMS COVERED LIVES PERCENT REVENUE PERCENT
- -------- ------------- -------- -------- --------
(IN MILLIONS, EXCEPT PERCENTAGES)
1999
Risk-Based Products(1)................................ 35.8 53.9% $1,282.8 86.5%
ASO products.......................................... 30.6 46.1 200.4 13.5
---- ----- -------- -----
Total............................................. 66.4 100.0% $1,483.2 100.0%
==== ===== ======== =====
2000
Risk-Based Products(1)................................ 39.1 55.1% $1,453.4 87.8%
ASO products.......................................... 31.9 44.9 201.7 12.2
---- ----- -------- -----
Total............................................. 71.0 100.0% $1,655.1 100.0%
==== ===== ======== =====
- ------------------------
(1) Includes Risk-Based Products, Employee Assistance Programs and Integrated
Products.
The number of covered lives fluctuates based on several factors, including the
number of contracts entered into by the Company and changes in the number of
employees, subscribers or enrollees of the Company's customers covered by such
contracts.
RISK-BASED PRODUCTS. Under the Company's risk-based products, the Company
typically arranges for the provision of a full range of outpatient, intermediate
and inpatient treatment services to beneficiaries of its customers' healthcare
benefit plans, primarily through arrangements in which the Company assumes all
of the responsibility for the cost of providing such services in exchange for a
per member per month fee. The Company's experience with risk-based contracts
covering a large number of lives has given it a broad base of data from which to
analyze utilization rates. The Company believes that this broad database permits
it to estimate utilization trends and costs more accurately than many of its
competitors, which allows it to bid effectively. The Company believes that its
experience has also allowed it to develop effective measures for managing the
cost of providing a unit of care to its covered lives. The Company has developed
or acquired clinical protocols, which permit it to assist its network providers
to administer effective treatment in a cost efficient manner, and claims
management technology, which permits the Company to reduce the cost of
processing claims. The Company's care managers are an essential element in its
provision of cost-effective care. Care managers, in consultation with treating
professionals, and using the Company's clinical protocols, authorize an
appropriate level and intensity of services that can be delivered in a
cost-efficient manner.
10
EMPLOYEE ASSISTANCE PROGRAMS. The Company's EAP products typically provide
assessment and referral services to employees and dependents of the Company's
customers in an effort to assist in the early identification and resolution of
productivity problems associated with the employees who are impaired by
behavioral conditions or other personal concerns. For many EAP customers, the
Company also provides limited outpatient therapy (typically limited to eight or
fewer sessions) to patients requiring such services. For these services, the
Company typically is paid a fixed fee per member per month; however, the Company
is usually not responsible for the cost of providing care beyond these services.
If further services are necessary beyond limited outpatient therapy, the Company
will refer the beneficiary to an appropriate provider or treatment facility.
INTEGRATED PRODUCTS. Under its integrated products, the Company typically
establishes an EAP to function as the "front end" of a managed care program that
provides a full range of services, including more intensive treatment services
not covered by the EAP. The Company typically manages the EAP and accepts all or
some of the responsibility for the cost of any additional treatment required
upon referral out of the EAP, thus integrating the two products and using both
the Company's care management and clinical care techniques to manage the
provision of care.
ASO PRODUCTS. Under its ASO products, the Company provides services ranging
from utilization review and claims administration to the arrangement for and
management of a full range of patient treatment services, but does not assume
any of the responsibility for the cost of providing treatment services. Services
include member assistance, management reporting and claims processing in
addition to utilization review and care management. The Company is paid a fee
for such services.
BEHAVIORAL MANAGED HEALTHCARE CUSTOMERS
GENERAL. The following table sets forth the approximate number of covered
lives as of September 30, 1999 and 2000 and revenue for fiscal 1999 and 2000 in
each of the Company's behavioral customer groups described below:
MARKET COVERED LIVES PERCENT REVENUE PERCENT
- ------ ------------- -------- -------- --------
(IN MILLIONS, EXCEPT PERCENTAGES)
1999
Workplace (Corporations and Labor Unions)............ 27.0 40.7% $ 230.6 15.5%
Health Plans......................................... 36.5 54.9 846.9 57.1
Public Sector (Primarily Medicaid)................... 2.9 4.4 405.9 27.4
---- ------ -------- ------
Total............................................ 66.4 100.0% $1,483.2 100.0%
==== ====== ======== ======
2000
Workplace (Corporations and Labor Unions)............ 27.9 39.3% $ 234.4 14.1%
Health Plans......................................... 40.1 56.5 951.1 57.5
Public Sector (Primarily Medicaid)................... 3.0 4.2 469.6 28.4
---- ------ -------- ------
Total............................................ 71.0 100.0% $1,655.1 100.0%
==== ====== ======== ======
CORPORATIONS AND LABOR UNIONS. Corporations and, to a lesser extent, labor
unions, account for a large number of the Company's contracts to provide
behavioral managed healthcare services and, in particular, EAP and integrated
EAP/managed care services. The Company has structured a variety of fee
arrangements with corporate customers to cover all or a portion of the
responsibility of the cost of providing treatment services. In addition, the
Company operates a number of programs for corporate customers on an ASO basis.
Management believes the corporate market is an area of potential growth for the
Company, as corporations are anticipated to increase their utilization of
behavioral managed healthcare services. In an effort to increase penetration of
the corporate market, the Company intends to build upon its experience in
managing programs for large corporate customers (such as IBM, Federal Express
11
and AT&T) and to market integrated programs to existing EAP customers and other
prospective corporate clients.
HEALTH PLANS. The Company is a leader in providing behavioral managed
healthcare services to HMO beneficiaries. HMO contracts are Risk-Based or ASO
contracts. Although certain large HMOs provide their own behavioral managed
healthcare services, many HMOs "carve out" behavioral healthcare from their
general healthcare services and subcontract such services to behavioral managed
healthcare companies such as the Company. The Company anticipates that its
business with HMOs will continue to grow. The Company believes that it is one of
the nation's leading providers of behavioral managed healthcare services to Blue
Cross/Blue Shield organizations, serving 33 such organizations as of
September 30, 2000.
PUBLIC SECTOR. The Company provides behavioral managed healthcare services
to Medicaid recipients through both direct contracts with state and local
governmental agencies and through subcontracts with HMOs focused on Medicaid
beneficiary populations. In addition to the Medicaid population, other public
entitlement programs, such as Medicare and state insurance programs for the
uninsured, offer the Company areas of potential future growth. The Company
expects that governmental agencies will continue to implement a significant
number of managed care Medicaid programs through contracts with HMOs and that
many HMOs will subcontract with behavioral managed healthcare organizations,
such as the Company, for behavioral healthcare services. The Company also
expects that other states will continue the trend of "carving-out" behavioral
healthcare services from their general healthcare benefit plans and contracting
directly with behavioral managed healthcare companies such as the Company. See
"Cautionary Statements--Dependence on Government Spending for Managed
Healthcare; Possible Impact of Healthcare Reform" and "Cautionary
Statements--Regulation".
BEHAVIORAL MANAGED HEALTHCARE CONTRACTS
The Company's contracts with customers typically have terms of one to three
years, and in certain cases contain renewal provisions (at the customer's
option) for successive terms of between one and two years (unless terminated
earlier). Substantially all of these contracts may be immediately terminated
with cause and many are terminable without cause by the customer or the Company
either upon the giving of requisite notice and the passage of a specified period
of time (typically between 60 and 180 days) or upon the occurrence of other
specified events. In addition, the Company's contracts with federal, state and
local governmental agencies, under both direct contract and subcontract
arrangements with HMOs, generally are conditioned on legislative appropriations.
These contracts, notwithstanding terms to the contrary, generally can be
terminated or modified by the customer if such appropriations are not made. See
"Cautionary Statements--Risk-Based Products" and "Cautionary
Statements--Reliance on Customer Contracts."
The specific terms of the Company's contracts are determined by whether the
contracts are for risk-based, EAP, integrated or ASO products. Risk-based, EAP
and ASO contracts generally provide for payment of a per member per month fee to
the Company. The Company's billing arrangements for integrated products vary on
a case by case basis.
BEHAVIORAL MANAGED HEALTHCARE NETWORK
The Company's behavioral managed healthcare and EAP treatment services are
provided by a network of third-party providers. The number and type of providers
in a particular area depend upon customer preference, site, geographic
concentration and demographic make-up of the beneficiary population in that
area. Network providers include a variety of specialized behavioral healthcare
personnel, such as psychiatrists, psychologists, licensed clinical social
workers, substance abuse counselors and other professionals.
12
As of September 30, 2000, the Company had contractual arrangements covering
over 40,000 individual third-party network providers. The Company's network
providers are independent contractors located throughout the local areas in
which the Company's customers' beneficiary populations reside. Network providers
work out of their own offices, although the Company's personnel are available to
assist them with consultation and other needs. Network providers include both
individual practitioners, as well as individuals who are members of group
practices or other licensed centers or programs. Network providers typically
execute standard contracts with the Company for which they are typically paid by
the Company on a fee-for-service basis. In some cases, network providers are
paid on a "case rate" basis, whereby, the provider is paid a set rate for an
entire course of treatment, or through other risk sharing arrangements.
As of September 30, 2000, the Company's behavorial managed healthcare
network also included contractual arrangements with approximately 5,000
third-party treatment facilities, including inpatient psychiatric and substance
abuse hospitals, intensive outpatient facilities, partial hospitalization
facilities, community health centers and other community-based facilities,
rehabilitative and support facilities, and other intermediate care and
alternative care facilities or programs. This variety of facilities enables the
Company to offer patients a full continuum of care and to refer patients to the
most appropriate facility or program within that continuum. Typically, the
Company contracts with facilities on a per diem or fee-for-service basis and, in
some cases, on a "case rate" or capitated basis. The contracts between the
Company and inpatient and other facilities typically are for one year terms and,
in some cases, are automatically renewable at the Company's option. Facility
contracts are usually terminable by the Company or the facility owner upon 30 to
120 days' notice.
COMPETITION
Each segment of the Company's business is highly competitive. With respect
to its behavioral managed healthcare business, the Company competes with large
insurance companies, HMOs, PPOs, third-party administrators ("TPAs"),
independent practitioner associations ("IPAs"), multi-disciplinary medical
groups and other managed care companies. Many of the Company's competitors are
significantly larger and have greater financial, marketing and other resources
than the Company, and some of the Company's competitors provide a broader range
of services. The Company may also encounter substantial competition in the
future from new market entrants. Many of the Company's customers that are
managed care companies may, in the future, seek to provide behavioral managed
healthcare services directly to their employees or subscribers directly, rather
than by contracting with the Company for such services. Because of competition,
the Company does not expect to be able to rely on price increases to achieve
revenue growth and expects to continue experiencing pressure on direct operating
margins. See "Cautionary Statements--Highly Competitive Industry."
The Company's human services operations compete with various for profit and
not-for-profit entities, including, but not limited to: (i) behavioral managed
healthcare companies that have started managing human services for governmental
agencies; (ii) home health care organizations; (iii) proprietary nursing home
companies; and (iv) proprietary human services companies. The Company believes
that the most significant factors in a customer's selection of services include
price, quality of services and outcomes. The pricing aspect of such services is
especially important to attract public sector agencies looking to outsource
public services to the private sector as demand for quality services escalates
while budgeted dollars for healthcare services are reduced. The Company's
management believes that it competes effectively with respect to these factors.
The Company believes it benefits from the competitive strengths described
below:
INDUSTRY LEADERSHIP. The Company is the largest provider of behavioral
managed healthcare services in the United States, according to enrollment data
reported in OPEN MINDS. The Company believes, based on data reported in OPEN
MINDS, that it also now has the number one market position in each of the major
behavioral managed healthcare product markets in which it competes. The Company
believes its position
13
will enhance its ability to: (i) provide a consistent level of high quality
service on a nationwide basis; (ii) enter into agreements with behavioral
healthcare providers that allow it to control healthcare costs for its
customers; and (iii) market its behavioral managed care products to large
corporate, HMO and health insurance customers, which, the Company believes,
increasingly prefer to be serviced by a single-source provider on a national
basis. See "Cautionary Statements--Highly Competitive Industry" and "--Reliance
on Customer Contracts" for a discussion of the risks associated with the highly
competitive nature of the behavioral managed healthcare industry and the
Company's reliance on contracts with payors of behavioral healthcare benefits,
respectively.
BROAD PRODUCT OFFERING AND NATIONWIDE PROVIDER NETWORK. The Company offers
behavioral managed care products that can be designed to meet specific customer
needs, including risk-based and partial risk-based products, integrated EAPs,
stand-alone EAPs and ASO products. The Company's provider network encompasses
approximately 40,000 providers and 5,000 treatment facilities in all 50 states.
The Company believes that the combination of its product offerings and its
provider network allows the Company to meet its customers needs for behavioral
managed healthcare on a nationwide basis, and positions the Company to capture
incremental revenue opportunities resulting from the continued growth of the
behavioral managed healthcare industry and the continued migration of its
customers from ASO and EAP products to higher revenue risk-based products. See
"Cautionary Statements--Risk-Based Products" for a discussion of the risks
associated with risk-based products, which are the Company's primary source of
revenue.
BROAD BASE OF CUSTOMER RELATIONSHIPS. The Company believes that the breadth
of its customer relationships are attributable to the Company's broad product
offerings, nationwide provider network, commitment to quality care and ability
to manage behavioral healthcare costs effectively. The Company's customers
include: (i) Blue Cross/Blue Shield organizations; (ii) national HMOs and other
large insurers, such as Aetna and Humana; (iii) large corporations, such as IBM,
Federal Express and AT&T; (iv) state and local governmental agencies through
commercial, Medicaid and other programs; and (v) the federal government through
contracts with CHAMPUS, as defined, and the U.S. Postal Service. This broad base
of customer relationships provides the Company with stable and diverse sources
of revenue, earnings and cash flows and an established base from which to
continue to increase covered lives and revenue. See "Cautionary
Statements--Reliance on Customer Contracts" for a discussion of the risks
associated with the Company's reliance on certain contracts with payors of
behavioral healthcare benefits.
PROVEN RISK MANAGEMENT EXPERIENCE. The Company had approximately
39.1 million covered lives under risk-based contracts at September 30, 2000,
making it the nation's industry leader in at-risk behavioral managed healthcare
products, based on data reported in OPEN MINDS. The Company's experience with
risk-based products covering a large number of lives has given it a broad base
of data from which to analyze utilization rates. The Company believes that this
broad database permits it to estimate utilization trends and costs more
accurately than many of its competitors, which allows it to bid effectively. The
Company believes that its experience has also allowed it to develop effective
measures for controlling the cost of providing a unit of care to its covered
lives. Among other cost control measures, the Company has developed or acquired
clinical protocols, which permit the Company to assist its network providers to
administer effective treatment in a cost efficient manner, and claims management
technology, which permits the Company to reduce the cost of processing claims.
INSURANCE
The Company maintains a general, professional and managed care liability
insurance policy with an unaffiliated insurer. The policy is written on a
"claims-made" basis, subject to a $250,000 per claim and $1.0 million annual
aggregate self-insured retention for general and professional liability, and
also subject to a $500,000 per claim and $2.5 million annual aggregate
self-insured retention for managed care liability, for a two-year policy period
ending June 17, 2002.
14
REGULATION
GENERAL. The behavioral managed healthcare industry and the provision of
behavioral healthcare services are subject to extensive and evolving state and
federal regulation. The Company is subject to certain state laws and
regulations, including those governing: (i) the licensing of insurance
companies, HMOs, PPOs, TPAs and companies engaged in utilization review and
(ii) the licensing of healthcare professionals, including restrictions on
business corporations from practicing, controlling or exercising excessive
influence over behavioral healthcare services through the direct employment of
psychiatrists or, in a few states, psychologists and other behavioral healthcare
professionals. These laws and regulations vary considerably among states and the
Company may be subject to different types of laws and regulations depending on
the specific regulatory approach adopted by each state to regulate the managed
care business and the provision of behavioral healthcare treatment services. In
addition, the Company is subject to certain federal laws as a result of the role
the Company assumes in connection with managing its customers' employee benefit
plans. The regulatory scheme generally applicable to the Company's behavioral
managed healthcare operations is described in this section.
The Company believes its operations are structured to comply with applicable
laws and regulations in all material respects and that it has received all
licenses and approvals that are material to the operation of its business.
However, regulation of the managed healthcare industry is evolving, with new
legislative enactments and regulatory initiatives at the state and federal
levels being implemented on a regular basis. Consequently, it is possible that a
court or regulatory agency may take a position under existing or future laws or
regulations, or as a result of a change in the interpretation thereof, that such
laws or regulations apply to the Company in a different manner than the Company
believes such laws or regulations apply. Moreover, any such position may require
significant alterations to the Company's business operations in order to comply
with such laws or regulations, or interpretations thereof. Expansion of the
Company's business to cover additional geographic areas, to serve different
types of customers, to provide new services or to commence new operations could
also subject the Company to additional licensure requirements and/or regulation.
LICENSURE. Certain regulatory agencies having jurisdiction over the Company
possess discretionary powers when issuing or renewing licenses or granting
approval of proposed actions such as mergers, a change in ownership, transfer or
assignment of licenses and certain intracorporate transactions. One or multiple
agencies may require as a condition of such licensure or approval that the
Company cease or modify certain of its operations in order to comply with
applicable regulatory requirements or policies. In addition, the time necessary
to obtain licensure or approval varies from state to state, and difficulties in
obtaining a necessary license or approval may result in delays in the Company's
plans to expand operations in a particular state and, in some cases, lost
business opportunities. Compliance activities, mandated changes in the Company's
operations, delays in the expansion of the Company's business or lost business
opportunities as a result of regulatory requirements or policies could have a
material adverse effect on the Company.
INSURANCE, HMO AND PPO ACTIVITIES. To the extent that the Company operates
or is deemed to operate in one or more states as an insurance company, HMO, PPO
or similar entity, it may be required to comply with certain laws and
regulations that, among other things, may require the Company to maintain
certain types of assets and minimum levels of deposits, capital, surplus,
reserves or net worth. In many states, entities that assume risk under contracts
with licensed insurance companies or HMOs have not been considered by state
regulators to be conducting an insurance or HMO business. As a result, the
Company has not sought licensure as either an insurer or HMO in certain states.
The National Association of Insurance Commissioners (the "NAIC") has undertaken
a comprehensive review of the regulatory status of entities arranging for the
provision of healthcare services through a network of providers that, like the
Company, may assume risk for the cost and quality of healthcare services, but
that are not currently licensed as an HMO or similar entity. As a result of this
review, the NAIC developed a "health organizations risk-based capital" formula,
designed specifically for managed care organizations, that
15
establishes a minimum amount of capital necessary for a managed care
organization to support its overall operations, allowing consideration for the
organization's size and risk profile. The NAIC initiative also may result in the
adoption of a model NAIC regulation in the area of health plan standards, which
could be adopted by individual states in whole or in part, and could result in
the Company being required to meet additional or new standards in connection
with its existing operations. Individual states have also recently adopted their
own regulatory initiatives that subject entities such as the Company to
regulation under state insurance laws. This includes, but is not limited to,
requiring licensure as an insurance company or HMO and requiring adherence to
specific financial solvency standards. State insurance laws and regulations may
limit the ability of the Company to pay dividends, make certain investments and
repay certain indebtedness. Licensure as an insurance company, HMO or similar
entity could also subject the Company to regulations governing reporting and
disclosure, mandated benefits, rate setting, and other traditional insurance
regulatory requirements. PPO regulations to which the Company may be subject may
require the Company to register with a state authority and provide information
concerning its operations, particularly relating to provider and payor
contracting. The imposition of such requirements could increase the Company's
cost of doing business and could delay the Company's conduct or expansion of its
business in some areas. The licensure process under state insurance laws can be
lengthy and, unless the applicable state regulatory agency allows the Company to
continue to operate while the licensure process is ongoing, the Company could
experience a material adverse effect on its operating results and financial
condition while its licensure application is pending. In addition, failure by
the Company to obtain and maintain required licenses typically also constitutes
an event of default under the Company's contracts with its customers. The loss
of business from one or more of the Company's major customers as a result of
such an event of default or otherwise could have a material adverse effect on
the Company.
UTILIZATION REVIEW AND THIRD-PARTY ADMINISTRATOR ACTIVITIES. Numerous
states in which the Company does business have adopted, or are expected to
adopt, regulations governing entities engaging in utilization review and TPA
activities. Utilization review regulations typically impose requirements with
respect to the qualifications of personnel reviewing proposed treatment,
timeliness and notice of the review of proposed treatment, and other matters.
TPA regulations typically impose requirements regarding claims processing and
payments and the handling of customer funds. Utilization review and TPA
regulations may increase the Company's cost of doing business in the event that
compliance requires the Company to retain additional personnel to meet the
regulatory requirements and to take other required actions and make necessary
filings. Although compliance with utilization review regulations has not had a
material adverse effect on the Company, there can be no assurance that specific
regulations adopted in the future would not have such a result, particularly
since the nature, scope and specific requirements of such provisions vary
considerably among states that have adopted regulations of this type.
There is a trend among states to require licensure or certification of
entities performing utilization review or TPA activities; however, certain
federal courts have held that such licensure requirements are preempted by the
Employee Retirement Income Security Act of 1974, as amended, ("ERISA"). ERISA
preempts state laws that mandate employee benefit structures or their
administration, as well as those that provide alternative enforcement
mechanisms. The Company believes that its TPA activities performed for its
self-insured employee benefit plan customers are exempt from otherwise
applicable state licensing or registration requirements based upon federal
preemption under ERISA and has relied on this general principle in determining
not to seek licensure for certain of its activities in many states. Existing
case law is not uniform on the applicability of ERISA preemption with respect to
state regulation of utilization review or TPA activities. There can be no
assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states.
"ANY WILLING PROVIDER" LAWS. Several states in which the Company does
business have adopted, or are expected to adopt, "any willing provider" laws.
Such laws typically impose upon insurance companies, PPOs, HMOs or other types
of third-party payors an obligation to contract with, or pay for the services
of, any healthcare provider willing to meet the terms of the payor's contracts
with similar providers.
16
Compliance with any willing provider laws could increase the Company's costs of
assembling and administering provider networks and could, therefore, have a
material adverse effect on its operations.
LICENSING OF HEALTHCARE PROFESSIONALS. The provision of behavioral
healthcare treatment services by psychiatrists, psychologists and other
providers is subject to state regulation with respect to the licensing of
healthcare professionals. In addition, the oversight supervision and case
management of the human services business is subject to similar regulation
requiring licensure or accreditation of personnel performing such functions. The
Company believes that the healthcare professionals who provide behavioral
healthcare treatment on behalf of or under contracts with the Company and the
case managers and other personnel of the health services business are in
compliance with the applicable state licensing requirements and current
interpretations thereof; however, there can be no assurance that changes in such
state licensing requirements or interpretations thereof will not adversely
affect the Company's existing operations or limit expansion. With respect to the
Company's crisis intervention program, additional licensure of clinicians who
provide telephonic assessment or stabilization services to individuals who are
calling from out-of-state may be required if such assessment or stabilization
services are deemed by regulatory agencies to be treatment provided in the state
of such individual's residence. The Company believes that any such additional
licensure could be obtained; however, there can be no assurance that such
licensing requirements will not adversely affect the Company's existing
operations or limit expansion.
PROHIBITION ON FEE SPLITTING AND CORPORATE PRACTICE OF PROFESSIONS. The
laws of some states limit the ability of a business corporation to directly
provide, control or exercise excessive influence over behavioral healthcare
services through the direct employment of psychiatrists, psychologists, or other
behavioral healthcare professionals, who are providing direct clinical services.
In addition, the laws of some states prohibit psychiatrists, psychologists, or
other healthcare professionals from splitting fees with other persons or
entities. These laws and their interpretations vary from state to state and
enforcement by the courts and regulatory authorities may vary from state to
state and may change over time. The Company believes that its operations as
currently conducted are in material compliance with the applicable laws,
however, there can be no assurance that the Company's existing operations and
its contractual arrangements with psychiatrists, psychologists and other
healthcare professionals will not be successfully challenged under state laws
prohibiting fee splitting or the practice of a profession by an unlicensed
entity, or that the enforceability of such contractual arrangements will not be
limited. The Company believes that it could, if necessary, restructure its
operations to comply with changes in the interpretation or enforcement of such
laws and regulations, and that such restructuring would not have a material
adverse effect on its operations.
DIRECT CONTRACTING WITH LICENSED INSURERS. Regulators in several states in
which the Company does business have adopted policies that require HMOs or, in
some instances, insurance companies, to contract directly with licensed
healthcare providers, entities or provider groups, such as IPAs, for the
provision of treatment services, rather than with unlicensed intermediary
companies. In such states, the Company's customary model of contracting directly
with its customers may need to be modified so that, for example, the IPAs
(rather than the Company) contract directly with the HMO or insurance company,
as appropriate, for the provision of treatment services. The Company intends to
work with a number of these HMO customers to restructure existing contractual
arrangements, upon contract renewal or in renegotiations, so that the entity
which contracts with the HMO directly is an IPA. The Company does not expect
this method of contracting to have a material adverse effect on its operations.
CONFIDENTIALITY AND PATIENT PRIVACY. Confidentiality and patient privacy
requirements are particularly strict in the field of behavioral healthcare
services, and additional legislative initiatives relating to confidentiality and
privacy are expected. The Health Insurance Portability and Accountability Act of
1996 ("HIPAA") requires the Secretary of the Department of Health and Human
Services ("HHS") to adopt standards relating to the transmission of health
information by healthcare providers and healthcare plans. HIPAA calls for HHS to
create regulations in several different areas to address security, privacy and
17
administrative simplification. The regulations specifically relate to electronic
transactions and code sets, security and electronic signatures, privacy,
provider and employer IDs as well as health plan and individual IDs. While only
the regulations relating to electronic transactions and code sets section are
final, other areas of the regulations are expected to be finalized in the next
few months. The regulations go into effect 26 months after they are released,
with a deadline to implement the regulations governing electronic transaction
and code sets by October 16, 2002. On November 3, 1999, the Secretary
promulgated proposed regulations to protect the privacy of such health
information that is electronically transmitted or maintained. In addition, on
August 17, 2000, HHS published a final rule establishing standard data content
and formats for the submission of electronic claims and other administrative and
health transactions. The wide reaching implications of these regulations are
beginning to be addressed now to ensure the Company's compliance with the
regulations by the implementation dates. These regulations, while creating a
need for some software changes, present more business and policy issues rather
than technology issues. The regulations will require changes to the Company's
provider contracts, as well as the creation of new policies for transmitting
patient information to ensure that the new privacy and electronic security
measures are satisfied. In some cases, these changes will mean executing chain
of trust agreements with business partners and ensuring that encryption
technology is used when transmitting electronic files. In addition, the
Company's systems must be equipped to handle both the electronic transactions
governed by the regulations, as well as paper transactions, which are not
affected by the regulations and to manage different sets of data depending on
whether the transaction is electronic or paper in nature. While the Company
believes it has existing systems and policies in place in many instances that
will assist in the Company's compliance, the Company expects that significant
resources will be required over the next two years to ensure compliance.
REGULATION OF CUSTOMERS. Regulations imposed upon the Company's customers
include, among other things, benefits mandated by statute, exclusions from
coverages prohibited by statute, procedures governing the payment and processing
of claims, record keeping and reporting requirements, requirements for and
payment rates applicable to coverage of Medicaid and Medicare beneficiaries,
provider contracting and enrollee rights, and confidentiality requirements.
Although the Company believes that such regulations do not at present materially
impair the Company's operations, there can be no assurance that such indirect
regulation will not have a material adverse effect on the Company in the future.
ERISA. Certain of the Company's services are subject to the provisions of
ERISA. ERISA governs certain aspects of the relationship between
employer-sponsored healthcare benefit plans and certain providers of services to
such plans through a series of complex laws and regulations that are subject to
periodic interpretation by the Internal Revenue Service and the Department of
Labor. In some circumstances, and under certain customer contracts, the Company
may be expressly named as a "fiduciary" under ERISA, or be deemed to have
assumed duties that make it an ERISA fiduciary, and thus be required to carry
out its operations in a manner that complies with ERISA requirements in all
material respects. Although the Company believes that it is in material
compliance with the applicable ERISA requirements and that such compliance does
not currently have a material adverse effect on the Company's operations, there
can be no assurance that continuing ERISA compliance efforts or any future
changes to the applicable ERISA requirements will not have a material adverse
effect on the Company.
OTHER PROPOSED LEGISLATION. In the last five years, legislation has
periodically been introduced at the state and federal level providing for new
healthcare regulatory programs and materially revising existing healthcare
regulatory programs. Any such legislation, if enacted, could materially
adversely affect the Company's business, financial condition or results of
operations. Such legislation could include both federal and state bills
affecting the Medicaid programs which may be pending in or recently passed by
state legislatures and which are not yet available for review and analysis. Such
legislation could also include proposals for national health insurance and other
forms of federal regulation of health insurance and healthcare delivery. It is
not possible at this time to predict whether any such legislation will be
adopted at the federal or state level, or the nature, scope or applicability to
the Company's business of any such
18
legislation, or when any particular legislation might be implemented. No
assurance can be given that any such federal or state legislation will not have
a material adverse effect on the Company.
REGULATION OF HUMAN SERVICES. The human services business is subject to
certain state laws, regulations, and/or requirements with respect to its
services, including those governing: (i) the licensing of child placement
agencies; (ii) the registration or certification of Medicaid participating
providers; and (iii) a state's authorization or recognition of a provider's
capacity to deliver services to adults with developmental disabilities and/or
mental retardation. These laws and regulations vary considerably among states
and the Company may be subject to different types of laws and regulations
depending on the specific regulatory approach adopted by each state to regulate
the provision of these services.
OTHER REGULATION OF HEALTHCARE PROVIDERS. The Company's business is
affected indirectly by regulations imposed upon healthcare providers.
Regulations imposed upon healthcare providers include provisions relating to the
conduct of, and ethical considerations involved in, the practice of psychiatry,
psychology, social work and related behavioral healthcare professions and, in
certain cases, the common law duty to warn others of danger or to prevent
patient self-injury.
CAUTIONARY STATEMENTS
This Form 10-K includes "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). Although the Company believes that its plans, intentions and expectations
reflected in such forward-looking statements are reasonable, it can give no
assurance that such plans, intentions or expectations will be achieved.
Important factors that could cause actual results to differ materially from the
Company's forward-looking statements are set forth below and elsewhere in this
Form 10-K. All forward-looking statements attributable to the Company or persons
acting on behalf of the Company are expressly qualified in their entirety by the
cautionary statements set forth below.
LEVERAGE AND DEBT SERVICE OBLIGATIONS. The Company is currently highly
leveraged, with indebtedness that is substantial in relation to its
stockholders' equity. As of September 30, 2000, the Company's aggregate
outstanding indebtedness was approximately $1.1 billion and the Company's
stockholders' equity was approximately $128.5 million. The Credit Agreement and
the Indenture permit the Company to incur or guarantee certain additional
indebtedness, subject to certain limitations.
The Company's high degree of leverage could have important consequences to
the Company, including, but not limited to, the following: (i) the Company's
ability to obtain additional financing for working capital, capital
expenditures, acquisitions, general corporate purposes or other purposes may be
impaired in the future; (ii) a substantial portion of the Company's cash flows
from operations must be dedicated to the payment of principal and interest on
its indebtedness; (iii) the Company is substantially more leveraged than certain
of its competitors, which might place the Company at a competitive disadvantage;
(iv) the Company may be hindered in its ability to adjust rapidly to changing
market conditions and (v) the Company's high degree of leverage could make it
more vulnerable in the event of a downturn in general economic conditions or its
business or in the event of adverse changes in the regulatory environment or
other adverse circumstances applicable to the Company.
The Company's ability to repay or to refinance its indebtedness and to pay
interest on its indebtedness will depend on its financial and operating
performance, which, in turn, is subject to prevailing economic and competitive
conditions and to certain financial, business and other factors, many of which
are beyond the Company's control. These factors could include operating
difficulties, increased operating costs, the actions of competitors, regulatory
developments and delays in implementing strategic projects. The Company's
ability to meet its debt service and other obligations may depend in significant
part on the extent to which the Company can successfully implement its business
strategy. There can be no assurance
19
that the Company will be able to implement its strategy fully or that the
anticipated results of its strategy will be realized. See "Business--Business
Strategy."
If the Company's cash flows and capital resources are insufficient to fund
its debt service obligations, the Company may be forced to reduce or delay
capital expenditures, sell assets or seek to obtain additional equity capital or
to restructure its debt. There can be no assurance that the Company's cash flows
and capital resources will be sufficient for payment of principal of and
interest on its indebtedness in the future, or that any such alternative
measures would be successful or would permit the Company to meet its scheduled
debt service obligations.
In addition, because the Company's obligations under the Credit Agreement
bear interest at floating rates, an increase in interest rates could adversely
affect, among other things, the Company's ability to meet its debt service
obligations. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Outlook--Results of Operations."
RESTRICTIVE FINANCING COVENANTS. The Credit Agreement and the Indenture
contain a number of covenants that restrict the operations of the Company and
its subsidiaries. In addition, the Credit Agreement, as amended, requires the
Company to comply with specified financial ratios and tests, including a minimum
interest coverage ratio, a maximum leverage ratio, a minimum net worth test, a
maximum senior debt ratio and a minimum "EBITDA" test (as defined in the Credit
Agreement, as amended). There can be no assurance that the Company will be able
to comply with such covenants, ratios and tests in the future. The Company's
ability to comply with such covenants, ratios and tests may be affected by
events beyond its control, including prevailing economic, financial and industry
conditions. The breach of any such covenants, ratios or tests could result in a
default under the Credit Agreement that would permit the lenders to declare all
amounts outstanding thereunder to be immediately due and payable, together with
accrued and unpaid interest, and to prevent the Company from paying principal,
premium, interest or other amounts due on any or all of the Notes until the
default is cured or all senior indebtedness is paid or satisfied in full.
Furthermore, the commitments of the lenders under the Credit Agreement to make
further extensions of credit thereunder could be terminated. If the Company were
unable to repay all amounts accelerated, the lenders could proceed against the
subsidiary guarantors and the collateral securing the Company's and the
subsidiary guarantors' obligations pursuant to the Credit Agreement. If the
indebtedness outstanding pursuant to the Credit Agreement were to be
accelerated, there can be no assurance that the assets of the Company would be
sufficient to repay such indebtedness and the other indebtedness of the Company.
The value of the Company's common stock would be adversely affected if the
Company were unable to repay such indebtedness.
RISK-BASED PRODUCTS. Revenues under risk-based contracts are the primary
source of the Company's revenue from its behavioral managed healthcare business.
Such revenues accounted for approximately 77.6% of the Company's total revenue
and approximately 87.8% of its behavioral managed healthcare revenue in fiscal
2000. Under a risk-based contract, the Company assumes all or a portion of the
responsibility for the cost of providing a full or specified range of behavioral
healthcare treatment services to a specified beneficiary population in exchange,
generally, for a fixed fee per member per month. In order for such contracts to
be profitable, the Company must accurately estimate the rate of service
utilization by beneficiaries enrolled in programs managed by the Company and
control the unit cost of such services. If the aggregate cost of behavioral
healthcare treatment services provided to a given beneficiary population in a
given period exceeds the aggregate of the per member per month fees received by
the Company with respect to the beneficiary population in such period, the
Company will incur a loss with respect to such beneficiary population during
such period. Furthermore, the Company may be required to pay during any period
amounts with respect to behavioral healthcare treatment services provided to a
given beneficiary population that exceed per member per month fees received with
respect to such beneficiary population during the same period. There can be no
assurance that the Company's assumptions as to service utilization rates and
costs will accurately and adequately reflect actual utilization rates and costs,
nor can there be any assurance that increases in behavioral healthcare costs or
20
higher-than-anticipated utilization rates, significant aspects of which are
outside the Company's control, will not cause expenses associated with such
contracts to exceed the Company's revenue for such contracts. In addition, there
can be no assurance that adjustments will not be required to the estimates,
particularly those regarding cost of care, made in reporting historical
financial results. See Note 1 to the audited consolidated financial statements
of the Company included elsewhere herein. The Company expects to attempt to
increase membership in its risk-based products. If the Company is successful in
this regard, the Company's exposure to potential losses from its risk-based
products will also be increased. Furthermore, certain of such contracts and
certain state regulations limit the profits that may be earned by the Company on
risk-based business and may require refunds if the loss experience is more
favorable than that originally anticipated. Such contracts and regulations may
also require the Company or certain of its subsidiaries to reserve a specified
amount of cash as financial assurance that it can meet its obligations under
such contracts. As of September 30, 2000, the Company had restricted cash and
investments of $117.7 million pursuant to such contracts and regulations. Such
amounts will not be available to the Company for general corporate purposes.
Furthermore, certain state regulations restrict the ability of subsidiaries that
offer risk-based products to pay dividends to the Company. Certain state
regulations relating to the licensing of insurance companies may also adversely
affect the Company's risk-based business. See "Business Regulation." Although
experience varies on a contract-by-contract basis, historically, the Company's
risk-based contracts have been profitable. However, the degree of profitability
varies significantly from contract to contract. For example, the Company's
Medicaid contracts with governmental entities generally tend to have direct
profit margins that are lower than the Company's other contracts. The most
significant factor affecting the profitability of risk-based contracts is the
ability to control direct service costs in relation to contract pricing.
RELIANCE ON CUSTOMER CONTRACTS. Approximately 88.3% of the Company's
revenue in fiscal 2000 was derived from contracts with payors of behavioral
healthcare benefits. The Company's behavioral managed healthcare contracts
typically have terms of one to three years, and in certain cases contain renewal
provisions providing for successive terms of between one and two years (unless
terminated earlier). Substantially all of these contracts are immediately
terminable with cause and many, including some of the Company's most significant
contracts, are terminable without cause by the customer upon the provision of
requisite notice and the passage of a specified period of time (typically
between 60 and 180 days), or upon the occurrence of certain other specified
events. The Company's ten largest behavioral managed healthcare customers
accounted for approximately 56.6% of the Company's behavioral managed healthcare
revenue for fiscal 2000. Both the Company and Premier Behavioral Systems of
Tennessee, LLC ("Premier"), in which the Company has a fifty percent interest,
separately contract with the State of Tennessee to manage the behavioral
healthcare benefits for the State's TennCare program. The Company's direct
Contract (exclusive of Premier) represented approximately 13.7% of the Company's
behavioral managed healthcare revenue and approximately 12.1% of the Company's
consolidated revenue in fiscal 2000. The Company's managed behavioral contracts
with Aetna, including Nylcare and Prudential, which were acquired by Aetna in
July 1998 and August 1999, respectively, represented approximately 17.2% of the
Company's behavioral managed healthcare revenue and approximately 15.2% of the
Company's consolidated revenue in fiscal 2000. The current TennCare and Aetna
contracts extend through December 31, 2000 and December 31, 2003, respectively.
The Company is in the process of renegotiating its TennCare contract. There can
be no assurance that such contracts will be extended or successfully
renegotiated or that the terms of any new contracts will be comparable to those
of existing contracts. Loss of all of these contracts or customers would, and
loss of any one of these customers could, have a material adverse effect on the
Company. In addition, price competition in bidding for contracts can
significantly affect the financial terms of any new or renegotiated contract.
DEPENDENCE ON GOVERNMENT SPENDING FOR HEALTHCARE; POSSIBLE IMPACT OF
HEALTHCARE REFORM. A significant portion of the Company's revenue is derived,
directly or indirectly, from federal, state and local governmental agencies,
including state Medicaid programs. Reimbursement rates vary from state to state,
are subject to periodic negotiation and may limit the Company's ability to
maintain or increase rates. The
21
Company is unable to predict the impact on the Company's operations of future
regulations or legislation affecting Medicaid or Medicare programs, or the
healthcare industry in general, and there can be no assurance that future
regulations or legislation will not have a material adverse effect on the
Company. Moreover, any reduction in government spending for such programs could
also have a material adverse effect on the Company. In addition, the Company's
contracts with federal, state and local governmental agencies, under both direct
contract and subcontract arrangements, generally are conditioned upon financial
appropriations by one or more governmental agencies, especially with respect to
state Medicaid programs. These contracts generally can be terminated or modified
by the customer if such appropriations are not made. Finally, some of the
Company's contracts with federal, state and local governmental agencies, under
both direct contract and subcontract arrangements, require the Company to
perform additional services if federal, state or local laws or regulations
imposed after the contract is signed so require, in exchange for additional
compensation to be negotiated by the parties in good faith. Government and other
third-party payors are generally seeking to impose lower reimbursement rates and
to renegotiate reduced contract rates with service providers in a trend toward
cost control. See "Business--Industry--Areas of Growth" and "Business--Business
Strategy."
The House of Representatives of the U.S. Congress recently passed the
Norwood-Dingell bill which would (if it or similar legislation became law),
among other things, place limits on healthcare plans, methods of operations,
limit employers' and health care plans' ability to define medical necessity and
permit employers and health care plans to be sued in state courts for coverage
determinations. It is uncertain whether the Company could recoup, through higher
premiums or other measures, the increased costs of federally mandated benefits
or other increased costs caused by such legislation or similar legislation. The
Company cannot predict the effect of this legislation, nor other legislation
that may be adopted by Congress, and no assurance can be given that such
legislation will not have an adverse effect on the Company.
REGULATION. The healthcare industry and the provision of behavioral
healthcare and human services are subject to extensive and evolving state and
federal regulation. The Company is subject to certain state laws and
regulations, including those governing: (i) the licensing of insurance
companies, HMOs, PPOs, TPAs and companies engaged in utilization review and
(ii) the licensing of healthcare professionals, including restrictions on
business corporations from practicing, controlling or exercising excessive
influence over behavioral healthcare services through the direct employment of
psychiatrists or, in a few states, psychologists and other behavioral healthcare
professionals. In addition, the Company is subject to certain federal laws as a
result of the role the Company assumes in connection with managing its
customers' employee benefit plans. The Company's managed care operations are
also indirectly affected by regulations applicable to the establishment and
operation of behavioral healthcare clinics and facilities.
In many states, entities that assume risk under contracts with licensed
insurance companies or HMOs have not been considered by state regulators to be
conducting an insurance or HMO business. As a result, the Company has not sought
licensure as either an insurer or HMO in certain states. Regulators in some
states, however, have determined that risk assuming activity by entities that
are not themselves providers of care is an activity that requires some form of
licensure. There can be no assurance that other states in which the Company
operates will not adopt a similar view, thus requiring the Company to obtain
additional licenses. Such additional licensure might require the Company to
maintain minimum levels of deposits, net worth, capital, surplus or reserves, or
limit the Company's ability to pay dividends, make investments or repay
indebtedness. The imposition of these additional licensure requirements could
increase the Company's cost of doing business or delay the Company's conduct or
expansion of its business.
Regulators may impose operational restrictions on entities granted licenses
to operate as insurance companies or HMOs. For example, the California
Department of Corporations ("DOC") imposed certain restrictions on the Company
in connection with its issuance of an approval of the Company's acquisitions of
HAI and Merit, including restrictions on the ability of the California
subsidiaries of HAI and Merit to
22
fund the Company's operations in other states and on the ability of the Company
to make certain operational changes with respect to HAI and Merit California
subsidiaries.
In addition, utilization review and TPA activities conducted by the Company
are regulated by many states, which states impose requirements upon the Company
that increase its business costs. The Company believes that its TPA activities
performed for its self-insured employee benefit plan customers are exempt from
otherwise applicable state licensing or registration requirements based upon
federal preemption under ERISA, and has relied on this general principle in
determining not to seek licensure for certain of its activities in many states.
Existing case law is not uniform on the applicability of ERISA preemption with
respect to state regulation of utilization review or TPA activities. There can
be no assurance that additional licensure will not be required with respect to
utilization review or TPA activities in certain states. See
"Business--Regulation--Insurance, HMO, and PPO Activities" and "--Utilization
Review and Third-Party Administrator Activities."
State regulatory agencies responsible for the administration and enforcement
of the laws and regulations to which the Company's operations are subject have
broad discretionary powers. A regulatory agency or a court in a state in which
the Company operates could take a position under existing or future laws or
regulations, or change its interpretation or enforcement practices with respect
thereto, that such laws or regulations apply to the Company differently than the
Company believes such laws and regulations apply or should be enforced. The
resultant compliance with, or revocation of, or failure to obtain, required
licenses and governmental approvals could result in significant alteration to
the Company's business operations, delays in the expansion of the Company's
business and lost business opportunities, any of which, under certain
circumstances, could have a material adverse effect on the Company.
The laws of some states limit the ability of a business corporation to
directly provide, control or exercise excessive influence over behavioral
healthcare services through the direct employment of psychiatrists,
psychologists, or other behavioral healthcare professionals. In addition, the
laws of some states prohibit psychiatrists, psychologists, or other healthcare
professionals from splitting fees with other persons or entities. These laws and
their interpretations vary from state to state and enforcement by the courts and
regulatory authorities may vary from state to state and may change over time.
The Company believes that its operations as currently conducted are in material
compliance with the applicable laws, however there can be no assurance that the
Company's existing operations and its contractual arrangements with
psychiatrists, psychologists and other healthcare professionals will not be
successfully challenged under state laws prohibiting fee splitting or the
practice of a profession by an unlicensed entity, or that the enforceability of
such contractual arrangements will not be limited. The Company believes that it
could, if necessary, restructure its operations to comply with changes in the
interpretation or enforcement of such laws and regulations, and that such
restructuring would not have a material adverse effect on its operations.
Confidentiality and patient privacy requirements are particularly strict in
the field of behavioral healthcare services, and additional legislative
initiatives relating to confidentiality and privacy are expected. HIPAA requires
the HHS to adopt standards relating to the transmission of health information by
healthcare providers and healthcare plans. HIPAA calls for HHS to create
regulations in several different areas to address security, privacy and
administrative simplification. The regulations specifically relate to electronic
transactions and code sets, security and electronic signatures, privacy,
provider and employer IDs as well as health plan and individual IDs. While only
the regulations relating to electronic transactions and code sets section are
final, other areas of the regulations are expected to be finalized in the next
few months. The regulations go into effect 26 months after they are released,
with a deadline to implement the regulations governing electronic transaction
and code sets by October 16, 2002. On November 3, 1999, the Secretary
promulgated proposed regulations to protect the privacy of such health
information that is electronically transmitted or maintained. In addition, on
August 17, 2000, HHS published a final rule establishing standard data content
and formats for the submission of electronic claims and other administrative and
health transactions. The wide reaching implications of these regulations are
beginning to be
23
addressed now to ensure the Company's compliance with the regulations by the
implementation dates. These regulations, while creating a need for some software
changes, present more business and policy issues rather than technology issues.
The regulations will require changes to the Company's provider contracts, as
well as the creation of new policies for transmitting patient information to
ensure that the new privacy and electronic security measures are satisfied. In
some cases, these changes will mean executing chain of trust agreements with
business partners and ensuring that encryption technology is used when
transmitting electronic files. In addition, the Company's systems must be
equipped to handle both the electronic transactions governed by the regulations,
as well as paper transactions, which are not affected by the regulations and to
manage different sets of data depending on whether the transaction is electronic
or paper in nature. While the Company believes it has existing systems and
policies in place in many instances that will assist in the Company's
compliance, the Company expects that significant resources will be required over
the next two years to ensure compliance.
Several states in which the Company does business have adopted, or are
expected to adopt, "any willing provider" laws. Such laws typically impose upon
insurance companies, PPOs, HMOs or other types of third-party payors an
obligation to contract with, or pay for the services of, any healthcare provider
willing to meet the terms of the payor's contracts with similar providers.
Compliance with any willing provider laws could increase the Company's costs of
assembling and administering provider networks and could, therefore, have a
material adverse effect on its operations.
HIGHLY COMPETITIVE INDUSTRY. The industry in which the Company conducts its
managed care businesses is highly competitive. The Company competes with large
insurance companies, HMOs, PPOs, TPAs, provider groups and other managed care
companies. Many of the Company's competitors are significantly larger and have
greater financial, marketing and other resources than the Company, and some of
the Company's competitors provide a broader range of services. The Company may
also encounter substantial competition in the future from new market entrants.
Many of the Company's customers that are managed care companies may, in the
future, seek to provide behavioral managed healthcare services to their
employees or subscribers directly, rather than contracting with the Company for
such services. See "Business--Competition."
RISKS RELATED TO AMORTIZATION OF INTANGIBLE ASSETS. The Company's total
assets at September 30, 2000 reflect goodwill of approximately $1.1 billion,
which is amortized over 25 to 40 years, and other identifiable intangible assets
(primarily customer lists, provider networks and treatment protocols) of
approximately $152.0 million that are amortized over 4 to 30 years. At
September 30, 2000, net intangible assets were 68.0% of total assets of
$1.8 billion. The amortization periods used by the Company may differ from those
used by other entities. In addition, the Company may be required to shorten the
amortization period for intangible assets in future periods based on the
prospects of acquired companies. There can be no assurance that the value of
such assets will ever be realized by the Company. The Company evaluates, on a
regular basis, whether events and circumstances have occurred that indicate that
all or a portion of the carrying value of intangible assets may no longer be
recoverable, in which case a charge to earnings for impairment losses could
become necessary. During fiscal 2000 the Company recorded a $91.0 million
impairment charge. This charge related to the write-down of certain long-lived
assets of the Company's specialty managed healthcare segment and the Company's
Group Practice Affiliates subsidiary (GPA). See Note 3--"Discontinued
Operations" and Note 10--"Managed Care Integration Plan and Costs and Special
Charges", to the Company's audited consolidated financial statements included
elsewhere herein. Any determination requiring additional write-offs of a
significant portion of unamortized intangible assets would adversely affect the
Company's results of operations. A write-off of intangible assets could become
necessary if the anticipated undiscounted cash flows of an acquired company do
not support the carrying value of long-lived assets, including intangible
assets.
PROFESSIONAL LIABILITY; INSURANCE. The management and administration of the
delivery of behavioral and specialty managed healthcare services and human
services, like other healthcare services, entail
24
significant risks of liability. The Company is regularly subject to lawsuits
alleging malpractice and related legal theories, some of which involve
situations in which participants in the Company's behavioral programs have
committed suicide. The Company is also subject to claims of professional
liability for alleged negligence in performing utilization review activities, as
well as for acts and omissions of independent contractors participating in the
Company's third-party provider networks. The Company is subject to claims for
the costs of services for which payment was denied. There can be no assurance
that the Company's procedures for limiting liability have been or will be
effective, or that one or more lawsuits will not have a material adverse effect
on the Company in the future.
Recently, certain managed healthcare companies, including the Company, have
been targeted as defendants in several national class action lawsuits regarding
their business practices. These class action complaints include (i) inadequate
disclosure of provider compensation arrangements to members,
(ii) misrepresentation and omissions in advertising and health plan materials
and (iii) concealment of information from health plan members used to determine
what claims will be paid, procedures to determine medical necessity and
procedures to determine the extent and type of coverage. The Company believes
that these national class action lawsuits are part of a trend targeting the
healthcare industry, particularly managed care companies. There can be no
assurance that such lawsuits, which are generally uninsured, won't have a
material adverse effect on the Company.
The Company carries professional liability insurance, subject to certain
deductibles. There can be no assurance that such insurance will be sufficient to
cover any judgments, settlements or costs relating to present or future claims,
suits or complaints or that, upon expiration thereof, sufficient insurance will
be available on favorable terms, if at all. If the Company is unable to secure
adequate insurance in the future, or if the insurance carried by the Company is
not sufficient to cover any judgments, settlements or costs relating to any
present or future actions or claims, there can be no assurance that the Company
will not be subject to a liability that could have a material adverse effect on
the Company. See "Business--Insurance" and "Legal Proceedings."
The Company has certain potential liabilities relating to the self-insurance
program it maintained with respect to its provider business prior to the
Crescent Transactions. In addition, the Company continues to be subject to
governmental investigations and inquiries, civil suits and other claims and
assessments with respect to the provider business. See "Legal Proceedings" and
Note 12--"Commitments and Contingencies", to the Company's audited consolidated
financial statements included elsewhere herein.
25
EXECUTIVE OFFICERS OF THE REGISTRANT
NAME AGE POSITION
- ---- -------- --------
Henry T. Harbin, M.D................... 53 President, Chief Executive Officer and Director
Daniel S. Messina...................... 45 Executive Vice President, Chief Operating Officer and
Director
Mark S. Demilio........................ 45 Executive Vice President, Finance and Legal
Clarissa C. Marques, Ph.D.............. 48 Executive Vice President and Chief Administrative
Officer
Dennis P. Moody........................ 43 Executive Vice President, Business Operations
HENRY T. HARBIN, M.D. became President, Chief Executive Officer and a
Director of the Company on March 18, 1998. Dr. Harbin served as President and
Chief Executive Officer of Green Spring from 1994 to 1998. Dr. Harbin served as
Executive Vice President of the Company from 1995 until becoming President and
Chief Executive Officer of the Company.
DANIEL S. MESSINA became Executive Vice President and Chief Operating
Officer in September 2000. Prior to joining the Company, Mr. Messina was chief
financial officer and head of business strategy for Aetna U.S. Healthcare in
Hartford, Connecticut from February 1990 to September 2000. Mr. Messina has also
served on the Board of Directors of the Company since 1998.
MARK S. DEMILIO became Executive Vice President, Finance and Legal of the
Company in November 2000. Mr. Demilio served as Executive Vice President and
General Counsel from July 1999. Prior thereto, Mr. Demilio was with Youth
Services International, Inc., a publicly traded company that managed facilities
for adjudicated youth, serving as Executive Vice President Business Development
and General Counsel from March 1997 and Acting Chief Financial Officer from
June 1998. Mr. Demilio was a partner with Miles & Stockbridge, a Baltimore,
Maryland-based law firm, from 1994 to March 1997 and served as an associate with
that firm from 1989.
CLARISSA C. MARQUES, PH.D. became Executive Vice President and Chief
Adminsitrative Officer in June 2000. Prior thereto, Dr. Marques served as the
Executive Vice President and Clinical and Quality Management since March 1998.
Dr. Marques serviced as the Executive Vice President and Chief Clinical Officer
of Green Spring during 1997 and 1998 and Senior Vice President of Green Spring
from 1992 to 1997.
DENNIS P. MOODY became Executive Vice President of Business Operations in
October 2000. Prior thereto, Mr. Moody served as President and Chief Operating
Officer of the Health Plan Solutions Group since February 1998. Mr. Moody
previously held the following positions with Merit from 1991 through 1997:
Executive Vice President, National Business (1997), Executive Vice President,
National Services (1995 - 1996), Executive Vice President, Regional Operations
(1994 - 1995), and Regional Vice President (1991 - 1994).
EMPLOYEES OF THE REGISTRANT
At September 30, 2000, the Company had approximately 12,800 full-time and
part-time employees. The Company believes it has satisfactory relations with its
employees.
ITEM 2. PROPERTIES
The Company's principal executive offices are located in Columbia, Maryland;
the lease for the Company's headquarters expires in 2003. Additionally, the
Company leases 158 offices with terms expiring between 2000 and 2008.
26
ITEM 3. LEGAL PROCEEDINGS
The management and administration of the delivery of behavioral managed
healthcare services, and the direct provision of behavioral healthcare treatment
services, entail significant risks of liability. From time to time, the Company
is subject to various actions and claims arising from the acts or omissions of
its employees, network providers or other parties. In the normal course of
business, the Company receives reports relating to suicides and other serious
incidents involving patients enrolled in its programs. Such incidents
occasionally give rise to malpractice, professional negligence and other related
actions and claims against the Company or its network providers. As the number
of lives covered by the Company grows and the number of providers under contract
increases, actions and claims against the Company (and, in turn, possible legal
liability) predicated on malpractice, professional negligence or other related
legal theories can be expected to increase. See "Business Cautionary
Statements--Professional Liability; Insurance." Many of these actions and claims
received by the Company seek substantial damages and therefore require the
defendant to incur significant fees and costs related to their defense. To date,
claims and actions against the Company alleging professional negligence have not
resulted in material liabilities and the Company does not believe that any
pending action against it will have a material adverse effect on the Company.
However, there can be no assurance that pending or future actions or claims for
professional liability (including any judgments, settlements or costs associated
therewith) will not have a material adverse effect on the Company. See
"--Insurance" and "Cautionary Statements--Professional Liability; Insurance."
From time to time, the Company receives notifications from and engages in
discussions with various governmental agencies concerning its respective managed
care businesses and operations. As a result of these contacts with regulators,
the Company in many instances implements changes to its operations, revises its
filings with such agencies and/or seeks additional licenses to conduct its
business. In recent years, in response to governmental agency inquiries or
discussions with regulators, the Company has determined to seek licensure as a
single service HMO, TPA or utilization review agent in one or more
jurisdictions.
The healthcare industry is subject to numerous laws and regulations. The
subjects of such laws and regulations include, but are not limited to, matters
such as licensure, accreditation, government healthcare program participation
requirements, reimbursement for patient services, and Medicare and Medicaid
fraud and abuse. Recently, government activity has increased with respect to
investigations and/or allegations concerning possible violations of fraud and
abuse and false claims statutes and/or regulations by healthcare providers.
Entities that are found to have violated these laws and regulations may be
excluded from participating in government healthcare programs, subjected to
fines or penalties or required to repay amounts received from the government for
previously billed patient services. The Office of the Inspector General of the
Department of Health and Human Services and the United States Department of
Justice ("Department of Justice") and certain other governmental agencies are
currently conducting inquiries and/or investigations regarding the compliance by
the Company and certain of its subsidiaries with such laws and regulations.
Certain of the inquiries relate to the operations and business practices of the
Psychiatric Hospital Facilities prior to the consummation of the Crescent
Transactions in June 1997. The Department of Justice has indicated that its
inquiries are based on its belief that the federal government has certain civil
and administrative causes of action under the Civil False Claims Act, the Civil
Monetary Penalties Law, other federal statutes and the common law arising from
the participation in federal health benefit programs of The Psychiatric Hospital
Facilities nationwide. The Department of Justice inquiries relate to the
following matters: (i) Medicare cost reports; (ii) Medicaid cost statements;
(iii) supplemental applications to CHAMPUS (as defined) based on Medicare cost
reports; (iv) medical necessity of services to patients and admissions;
(v) failure to provide medically necessary treatment or admissions; and
(vi) submission of claims to government payors for inpatient and outpatient
psychiatric services. No amounts related to such proposed causes of action have
yet been specified. The Company cannot reasonably estimate the settlement
amount, if any, associated with the Department of Justice inquiries.
Accordingly, no reserve has been recorded related to this matter.
27
Five affiliated outpatient clinic providers that are participating providers
in the TennCare program asserted claims against Green Spring Health
Services, Inc., a wholly-owned subsidiary of the Company ("Green Spring") and
Premier, the joint venture that contracts with the State of Tennessee to manage
services under the TennCare program and in which the Company holds a 50%
interest, alleging that Premier and Green Spring failed to pay the providers in<