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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

For the fiscal year ended September 30, 2001

For the transition period from                to               

Commission File No. 1-6639

MAGELLAN HEALTH SERVICES, INC.
(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code: (410) 953-1000

Securities registered pursuant to Section 12(b) of the Act:

    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 December 21, 2001 was approximately $212.2 million.

    The number of shares of the registrant's common stock outstanding as of December 21, 2001 was 34,670,729.

    DOCUMENTS INCORPORATED BY REFERENCE: The registrant's definitive proxy materials on Schedule 14A relating to its annual meeting of stockholders to be held on               are incorporated by reference into Part III as set forth herein.

MAGELLAN HEALTH SERVICES, INC.
ANNUAL REPORT ON FORM 10-K
For the Fiscal Year Ended September 30, 2001

Table of Contents

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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 operates in the behavioral managed healthcare 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

    Sale of National Mentor, Inc.  On January 18, 2001, the Company's Board of Directors approved and the Company entered into a definitive agreement for the sale of National Mentor, Inc. ("Mentor"), which represented the business and interest that comprised the Company's human services segment. On March 9, 2001 the Company consummated the sale of the stock of Mentor for approximately $113 million in consideration, net of approximately $2 million in transaction costs. The Company's consideration consisted of $103 million in cash and $10 million in the form of an interest-bearing note. Additionally, the Company assumed liabilities of approximately $3.0 million. Approximately $50 million of the proceeds were used to retire loans under the Term Loan Facility as required by the Credit Agreement with the remainder used to reduce amounts outstanding under the Revolving Facility.

    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 the discontinuance of the human services segment of approximately $12.1 million in fiscal 2001. See Note 3—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

    Debt Issuance.  On May 31, 2001, the Company issued $250 million of 9.375% Senior Notes (the "Senior Notes") which mature on November 15, 2007 and are general senior unsecured obligations of the Company. Interest on the Senior Notes is payable semi-annually on each May 15 and November 15, commencing on November 15, 2001. The gross proceeds of $250 million from the issuance and sale of the Senior Notes, together with cash on hand, were used to pay the initial purchasers' fees and other expenses related to the offering and to repay indebtedness outstanding under the Company's Term Loan Facilities as follows: $99.6 million under Tranche A Term Loans, $75.2 million under Tranche B Term Loans, and $75.2 million under Tranche C Term Loans. In connection with the issuance of the Senior Notes, the Company also amended its Credit Agreement.

    Bank Amendments.  In an amendment to the Credit Agreement dated April 25, 2001, the Company provided for (1) the issuance of the Senior Notes; (2) elimination of the minimum EBITDA (earnings before interest, taxes, depreciation and amortization, but including interest income) and net worth covenants; (3) increased flexibility in making certain types of investments and asset sales and in incurring limited additional debt and liens; (4) increased flexibility for stock buy backs and subordinated debt repurchases based on leverage ratios; (5) reduction in the required amount of mandatory principal payments required for excess cash flow and equity issuance payments based on leverage ratios; (6) established same day borrowing ability under the Credit Agreement in the amount of $5 million; and (7) increased the letter of credit capacity under the Credit Agreement to $100 million.

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    In addition, the Company received an amendment to the Credit Agreement dated December 26, 2001 that, among other things: (1) defers from the third quarter of fiscal 2002 to the fourth quarter of fiscal 2002, the implementation of a more restrictive leverage ratio covenant (total debt divided by previous twelve months' EBITDA, as defined for financial covenants); and (2) excludes from the calculation of EBITDA certain contract settlement charges incurred in the fourth quarter of fiscal 2001 and certain restructuring charges expected to be incurred in fiscal 2002.

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. During the second quarter of fiscal year 1998, the minority stockholders of Green Spring converted their 39% ownership interest in Green Spring into an aggregate of 2,831,516 shares of the Company's common stock and Green Spring became a wholly owned subsidiary of the Company.

    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 million, net of approximately $16 million in costs (the "Crescent Transactions"), and used approximately $200 million of the proceeds to reduce long-term debt, including borrowings under the then existing credit agreements. 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"). See Note 3—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein.

    The CBHS Transaction, together with the formal plan of disposal authorized by the Company's Board of Directors on September 2, 1999 (the measurement date), represented the disposal of the Company's healthcare provider and healthcare franchising business segments under APB 30.

    On February 16, 2000, CBHS filed a voluntary petition for relief of indebtedness under Chapter 11 of the United States Bankruptcy Code. In connection with the bankruptcy proceedings, CBHS indicated

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that it believed that it had certain claims against the Company regarding certain previous transactions. During fiscal 2001, the Company entered into an agreement with CBHS that provided the Company with a full release of all claims. The agreement was approved by the bankruptcy court in April 2001. Under the agreement, (i) the Company was released from all obligations to CBHS, (ii) the Company obtained the economic value of the five Provider JVs that were previously conveyed to CBHS, and (iii) the Company agreed to pay CBHS approximately $26 million over a period of 270 days from the date on which the agreement was approved by the bankruptcy court. The amounts due under the agreement are anticipated being funded primarily through proceeds from the sale of the Company's interest in the Provider JVs and from amounts previously withheld from CBHS for services provided. As of September 30, 2001 the remaining amount due was $8.5 million.

    The Company's original plan of disposal contemplated that the disposition (to CBHS) of all Provider JV interests would take place within twelve months of the measurement date. The Company, with the cooperation of its joint venture partners and CBHS, closed two of the five hospital-based joint ventures during fiscal 2000. In fiscal 2001, the Company sold the assets and operations of two of the joint ventures and continued negotiating to sell its interest in the remaining joint venture. Subsequent to September 30, 2001, the Company and its joint venture partner sold the assets and operations of the remaining joint venture for $7.6 million, less selling costs of $0.1 million, resulting in an approximate gain to the Company of $1.5 million.

    The Crescent Transactions discussed above 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 Specialty Care Services, Inc. ("Allied") (which became part of the Company's specialty managed healthcare segment) 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 $180 million through September 30, 2001. The amount and timing of the payments are contingent upon the number of HAI's covered lives in specified products. The amount of these additional payments has been included in goodwill and future payments, if any, will be recorded as goodwill and identifiable intangible assets. 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 $448.9 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"), which provided for a revolving credit facility (the "Revolving Facility") and a term loan facility (the "Term Loan Facility") which provided for borrowings of up to $700 million, and the Company issued the 9% Series A Senior Subordinated Notes due 2008 (the "Subordinated Notes") pursuant to an indenture which governs the Subordinated Notes ("Indenture").

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    In connection with the Managed Care Acquisitions, the Company implemented the Managed Integration Plan starting in fiscal year 1998 to combine and integrate the Company's behavioral managed healthcare organizations and specialty managed care organizations. The plan included the elimination of duplicate staffing and facilities and the standardization of business practices and information technology platforms. See Note 10—"Managed Care Integration Costs and Special Charges" to the Company's audited consolidated financial statements set forth elsewhere herein.

    On October 4, 2000, the Company adopted a formal plan to exit from the businesses included in the Company's specialty managed healthcare segment through the sale and/or abandonment of these businesses and related assets. The specialty managed healthcare segment included the businesses acquired in conjunction with the purchase of Vivra, Inc. ("Vivra") which was consummated February 29, 2000 and Allied which was consummated on December 5, 1997. The purchase price for Vivra was $10.25 million. The Company paid approximately $54.5 million for Allied. The Company has exited the specialty managed healthcare business via sale and/or abandonment of businesses and related assets, certain of which activities had already occurred in the normal course prior to October 4, 2000. The Company has exited all contracts entered into by Allied and Vivra as of September 30, 2001. Further, the Company is obligated to satisfy lease agreements through 2008, for which the Company believes it has adequate reserves at September 30, 2001.

    On January 18, 2001, the Board of Directors approved, and the Company entered into a definitive agreement for, the sale of the stock of Mentor, which represented the business and interests that comprised the Company's human services segment. The human services the Company provided through Mentor included specialty home-based healthcare services provided through "mentor" homes, as well as residential and day treatment services for individuals with acquired brain injuries and for individuals with developmental disabilities.

    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 related to the healthcare provider and franchising, specialty managed healthcare and human services business segments. The Company recorded an after-tax loss on disposal of its healthcare provider and franchising business segments of approximately $47.4 million (primarily non-cash) in fiscal year 1999, an after-tax loss of $17.7 million on the disposal of its specialty managed healthcare segment in fiscal year 2000 and an after-tax loss on the discontinuance of its human services segment of approximately $12.1 million in fiscal year 2001. See Note 3—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein. Also, in conjunction with the settlement of the CBHS bankruptcy, the Company was released from certain liabilities, resulting in a change in estimate in the after-tax loss on disposal of the healthcare provider and franchising segments of $2.7 million.

    As of September 30, 2001 the Company has disposed of its human services segment in its entirety, and has taken the majority of the actions necessary to complete the disposal of or shutting down of its healthcare provider and franchising segments and its specialty managed healthcare segment but still has certain assets and liabilities of these two segments on its balance sheet. These remaining assets and liabilities are described in Note 3—"Discontinued Operations" to the Company's audited consolidated financial statements set forth elsewhere herein. As of September 30, 2001, the Company has recorded reserves on its balance sheet for estimates of all future losses and expenses of disposal or shutdown of these remaining operations, as well as for all operational losses expected to be incurred prior to the completion of disposal or shutdown. However, there can be no assurance that the reserves established will prove to be adequate. In the event that any future losses or expenses exceed the amount of reserves on the balance sheet, the Company will be required to record additional losses on disposal of discontinued operations or losses from discontinued operations in the income statement.

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    The Company is currently engaged in the behavioral managed healthcare business. The Company coordinates and manages the delivery of behavioral healthcare treatment services through its network of providers, which includes psychiatrists, psychologists and other medical professionals. The treatment services provided through these provider networks include outpatient programs (such as counseling or therapy), intermediate care programs (such as intensive outpatient programs and partial hospitalization services) inpatient treatment and crisis intervention services. The Company provides these services primarily through: (i) risk-based products, whereby the Company assumes all or a portion of the responsibility for the cost of providing treatment services in exchange for a fixed per member per month fee, (ii) Administrative Services Only ("ASO") products, whereby the Company provides services such as utilization review, claims administration or provider network management, but does not assume responsibility for the cost of services, (iii) EAPs and (iv) products which combine features of some or all of our risk-based, ASO, or EAP products.

    At September 30, 2001, the Company managed the behavioral healthcare benefits of approximately 69.6 million individuals.

Industry

    According to the Healthcare Handbook, 22 percent of American adults, or 45 million individuals, suffer from a diagnosable mental disorder in any given year. According to the Healthcare Handbook, in the United States during 1996, approximately $69 billion, or more than seven percent of total healthcare spending, was spent on mental health services. Further, direct costs associated with substance abuse were nearly $13 billion in 1996. 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, according to an estimate by the Healthcare Handbook, indirect costs associated with these issues approach $79 billion annually, reflecting the fact that four of the ten leading causes of disability for persons aged 5 and older 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 Yearbook 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 covered by some form of behavioral managed healthcare plan. According to Open Minds, 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 an approximate 15% growth rate in the year ended July 2000. In an effort to control costs, payors are increasingly utilizing risk-based products and, according to Open Minds, the number of risk-based covered lives has increased from approximately 13.6 million as of July 1993 to approximately 62.9 million as of July, 2000, representing a compound annual growth rate of 24% since July 1993 and growth of approximately 27% in the year ended July 2000.

    Management believes that the growth of the behavioral managed healthcare industry may continue, as there is wider public acceptance of treatment, as the benefits of treatment become more widely known and as payors of behavioral healthcare benefits attempt to further reduce the costs of behavioral healthcare while maintaining high quality care. Management also believes that a number of

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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 reduces or in some cases 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, 33 states have passed parity legislation that reduces and in some cases eliminates the difference in coverage limits for mental health coverage as compared to medical health coverage. Management believes that this trend will continue. All federal employees are covered by mental health parity effective January 1, 2001 due to an executive order signed by former President Clinton. The executive order resulted in the addition of approximately 600,000 lives to the Company's accounts and in significant rate increases in already existing EAP accounts. Additional federal legislation has been under consideration that could apply to all companies regardless of the exemptions provided under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). Management believes parity and other legislation may result in additional demands for its products due to the potential for: (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.

    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:

    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. 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 as defined by Open Minds:

    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 (excluding at present the cost of medication). 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

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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.

    According to Open Minds, industry enrollment in risk-based products has grown from approximately 13.6 million covered lives as of July 1993 to approximately 62.9 million covered lives as of July 2000, representing a compound annual growth rate of approximately 24% since July 1993 and growth of approximately 27% in the year ended July 2000. Despite this growth, according to Open Minds, only approximately 30% of total managed behavioral healthcare covered lives were enrolled in risk-based products as of July, 2000. Although certain market factors indicate that this portion of the industry may continue to grow, the Company believes there may also be a shift of certain third party payors from risk to non-risk products. See "Cautionary Statements—Risk—Related 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 beneficiary'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 portion of the market 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

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healthcare industry (as it is defined by Open Minds) as ASO products. The Company does not expect this portion 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. The Company expects this portion of the industry to grow as it may be impacted by potential shifts by certain third-party payors from risk to non-risk.

Company Overview

    The Company is currently engaged in the behavioral managed healthcare business. Within the behavioral managed healthcare business, the Company operates in the following four segments, based on the services it provides and the customers that it serves: (i) Workplace Group ("Workplace"); (ii) Health Plan Solutions Group ("Health Plans"); (iii) Public Solutions Group ("Public"); and (iv) Corporate and Other. Workplace provides, primarily to employers, EAP assessment and referral services and integrated products that combine EAP with risk-based or ASO managed behavioral healthcare services. Health Plans provides risk-based and ASO products to health plan beneficiaries through contracts with managed care companies, health insurance companies and other health plans. Public provides risk-based and ASO products to Medicaid beneficiaries through contracts with State or local government agencies. Corporate and Other mainly provides administrative support to the other segments.

    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, 2001, the Company had approximately 69.6 million covered lives under behavioral managed healthcare contracts and managed behavioral healthcare programs for approximately 2,100 customers. Through its current network of approximately 45,000 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.

    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.

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Business Strategy

    With the Company's exit from its non-core businesses substantially complete, the primary business strategy is focused on the following:

    Utilizing the Company's leadership position to continue to grow revenue and earnings.  As demand for behavioral managed healthcare services continues to grow, management believes the Company is well positioned to continue to grow membership and revenues as a result of the Company's economies of scale, proven experience in risk management and increased focus within the industry on the more complex products provided. As the industry leader, management believes the Company is also well positioned to benefit from any additional changes in federal and state parity legislation, legislation that reduces and in some cases eliminates the difference in coverage limits for mental health coverage as compared to medical health coverage.

    Continuing in focus on improving operating efficiency and margins.  In the past two years, the Company has consolidated its behavioral managed healthcare businesses, eliminating 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 the administrative burden on providers, customers and beneficiaries. Although these initiatives are at an early stage, the Company believes that they will reduce administrative costs and improve customer service. The Company expects to fund the costs for this next level of integration with internally generated funds. However, there can be no assurance that the Company will be able to implement these initiatives or realize the anticipated savings.

    Continuing to reduce debt and improve financial flexibility.  Although the Company has successfully reduced its indebtedness by approximately $221.5 million since April 1999, it intends to continue to reduce its indebtedness, primarily through the application of free cash flow. The total remaining scheduled amortization payments under the Term Loan Facility through 2003 were $16.3 million as of September 30, 2001.

Behavioral Managed Healthcare Products and Services

    General.  The following table sets forth the approximate number of covered lives as of September 30, 2000 and 2001 and revenue for fiscal 2000 and 2001 for the types of behavioral managed healthcare programs offered by the Company:

(1)

Includes Risk-Based Products, EAP's and Integrated Products.

(2)

Includes approximately 2.2 million covered lives that were associated with the Company's Canadian subsidiary, which was sold in fiscal 2001, and GPA, a subsidiary of the Company which ceased

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operations in fiscal 2001. See Note 10—"Managed Care Integration Costs and Special Charges" to the Company's audited consolidated financial statements set forth elsewhere herein.

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.

    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.

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Customers

    General.  The following table sets forth the approximate number of covered lives as of September 30, 2000 and 2001 and revenue for fiscal 2000 and 2001 in each of the Company's behavioral customer segments described below:

    Workplace.  The Company provides EAP services and integrated products that combine EAP and behavioral managed healthcare services primarily to corporations and, to a lesser extent, labor unions. The Company's contracts with corporate customers generally provide for a fee (per member per month) to be paid to the Company for which the Company provides all required consultation, assessment and referral services and, in certain cases, either arranges and pays for all or a portion of the costs of providing treatment services or arranges and manages the provision of treatment services 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 demand for employee assistance products and 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 and AT&T) and to market integrated programs to existing EAP customers and other prospective corporate clients.

    Health Plans.  The Company provides behavioral managed healthcare services to beneficiaries of managed care companies, health insurers and other health plans. Health Plans' contracts are Risk-Based or ASO contracts. Although certain large health plans provide their own behavioral managed healthcare services, many health plans "carve out" behavioral healthcare from their general healthcare services and subcontract such services to behavioral managed healthcare companies such as the Company. 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 34 such organizations as of September 30, 2001. The Company provides managed behavioral healthcare products to Aetna, including focused psychiatric review (a type of utilization review product), risk-related health plan products, administrative services for Aetna's "Managed Choice" product and provider network managed services. The Company also provides mental health and substance abuse services to the beneficiaries of TRICARE, formerly the Civilian Health and Medical Program of the Uniformed Services (CHAMPUS), under two separate subcontracts with health plans that contract with TRICARE. Choice Behavioral Health Partnership ("Choice"), in which the Company has a 50% interest, also is a subcontractor with respect to TRICARE. The Company believes there are opportunities to grow the health plan business by obtaining additional health plan customers and by expanding contracts with current customers to serve more of the customers' membership. (See "Joint Ventures" and Note 2—"Acquisitions and Joint Ventures" to the audited consolidated financial statements set forth elsewhere herein). See "Cautionary Statements—Dependence on Government

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Spending for Managed Healthcare; Possible Impact of Healthcare Reform", "—Regulation" and "Management's Discussion and Analysis of Financial Condition and Results of Operations".

    Public.  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 provides behavioral managed healthcare services to the State of Tennessee's TennCare program, both through a direct contract and through Premier Behavorial Systems of Tennessee ("Premier") a joint venture in which the Company owns a 50% interest. The Company expects that state governments will continue to implement managed care Medicaid programs and the Company will continue to evaluate, and pursue when appropriate, opportunities to provide the behavioral healthcare services portion of such programs. See "Cautionary Statements—Dependence on Government Spending for Managed Healthcare; Possible Impact of Healthcare Reform" and —Regulation".

Customer 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. The Company's contracts generally provide for payment of a per member per month fee to the Company. See "Cautionary Statements—Risk-Related Products" and —Reliance on Customer Contracts."

Provider 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.

    As of September 30, 2001, the Company had contractual arrangements covering approximately 45,000 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, 2001, the Company's behavorial managed healthcare network also included contractual arrangements with approximately 5,000 third-party treatment facilities, including inpatient

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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.

Joint Ventures

    The Company is a 50% partner with Value Options, Inc. in Choice, a managed behavioral healthcare company. Choice derives all of its revenues from a subcontract under which it provides behavioral managed healthcare services to TRICARE beneficiaries. The subcontract expires on June 30, 2003. The Company accounts for its investment in Choice using the equity method of accounting with the Company's share of net income or loss of Choice recognized in the statement of operations. The Company's investment in Choice at September 30, 2000 and 2001 was approximately $1.5 million and $(0.1) million, respectively. The Company's equity in income of Choice for fiscal years 1999, 2000 and 2001 was approximately $13.4 million, $12.1 million and $36.4 million, respectively. During the second quarter of fiscal 2001, Choice recognized revenues related to the settlement of certain contract appeals under its subcontract with respect to TRICARE. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations," Note 2—"Acquisitions and Joint Ventures" to the audited consolidated financial statements set forth elsewhere herein.

    The Company owns a 50% interest in Premier. Premier was formed to manage behavioral healthcare benefits for the State of Tennessee's TennCare program. The Company accounts for its investment in Premier using the equity method of accounting. The Company's investment in Premier at September 30, 2000 and 2001 was $8.1 million and $5.6 million, respectively. The Company's equity in income (loss) of Premier for fiscal years 1999, 2000 and 2001 was $6.3 million, $(4.0) million and $(2.5) million, respectively. The Company has not received a partnership distribution from nor has it made any further investments in Premier during fiscal years 1999, 2000 and 2001. See Note 2—"Acquisitions and Joint Ventures" to the audited consolidated financial statements set forth elsewhere herein.

Competition

    The Company's business is highly competitive. 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 subscribers, rather than by contracting with the Company for such services. Because of competition, the Company does not expect to be able to rely solely on price increases to achieve revenue growth and expects to continue experiencing pressure on direct operating margins. See "Cautionary Statements—Highly Competitive Industry".

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    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 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 45,000 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-Related 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 the U.S. Postal Service and indirectly through its subcontracts with respect to TRICARE. 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 36.5 million covered lives under risk-based contracts at September 30, 2001, 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. See "Cautionary Statements—Risk-Related Products."

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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.

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 subjects of these regulations include Medicare and Medicaid fraud and abuse.

    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. In recent years, in response to governmental agency inquiries and discussions with regulators, the Company has determined to seek licensing as a single service HMO, TPA or utilization review agent in or more jurisdictions. 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.

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    Insurance, HMO and PPO Activities.  To the extent that the Company operates or is deemed to operate in one or more states as an insurance company, HMO, PPO or similar entity, it may be required to comply with certain laws and regulations that, among other things, may require the Company to maintain certain types of assets and minimum levels of deposits, capital, surplus, reserves or net worth. In many states, entities that assume risk under contracts with licensed insurance companies or HMOs have not been considered by state regulators to be conducting an insurance or HMO business. As a result, the Company has not sought licensure as either an insurer or HMO in certain states. The National Association of Insurance Commissioners (the "NAIC") has undertaken a comprehensive review of the regulatory status of entities arranging for the provision of healthcare services through a network of providers that, like the Company, may assume risk for the cost and quality of healthcare services, but that are not currently licensed as an HMO or similar entity. As a result of this review, the NAIC developed a "health organizations risk-based capital" formula, designed specifically for managed care organizations, that establishes a minimum amount of capital necessary for a managed care organization to support its overall operations, allowing consideration for the organization's size and risk profile. The NAIC initiative also may result in the adoption of a model NAIC regulation in the area of health plan standards, which could be adopted by individual states in whole or in part, and could result in the Company being required to meet additional or new standards in connection with its existing operations. Certain states, for example, have adopted regulations based on the NAIC initiative, and as a result the Company has been subject to certain minimum capital requirements in those states. Certain other states, such as Maryland and New Jersey, have also recently adopted their own regulatory initiatives that subject entities such as the Company's subsidiaries to regulation under state insurance laws. This includes, but is not limited to 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.

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    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 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.

    Licensing of Healthcare Professionals.  The provision of behavioral healthcare treatment services by psychiatrists, psychologists and other providers is subject to state regulation with respect to the licensing of healthcare professionals. The Company believes that the healthcare professionals who provide behavioral healthcare treatment on behalf of or under contracts with the Company 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

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Company does not expect this method of contracting to have a material adverse effect on its operations.

    HIPAA.  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, privacy and security of health information by healthcare providers and healthcare plans. HIPAA calls for HHS to create regulations in several different areas to address the following areas: electronic transactions and code sets, privacy, security, provider IDs, employer IDs, health plan IDs and individual IDs. At present, only the regulation relating to electronic transactions and code sets and the regulation relating to privacy have been released in final form.

    The Transactions and Code Sets regulation is final and was scheduled to become effective on October 16, 2002. Congress recently passed HR 3323 which would delay this compliance date by one year. It is expected that President Bush will sign this bill into law. This rule establishes standard data content and formats for the submission of electronic claims and other administrative and health transactions. This regulation only applies to electronic transactions, and healthcare providers will still be able to submit paper documents without being subject to this regulation. In addition, health plans must be prepared to receive these various transactions.

    The final regulation on privacy was published on December 28, 2000 and accepted by Congress on February 16, 2001. This regulation, which became effective on April 14, 2001 with a compliance date of April 14, 2003, requires patient consent and authorization to release healthcare information, creates rules about how much and when information may be released and creates rights for patients to review and amend their health records. This regulation applies to both electronic and paper transactions.

    The draft version of the regulation on security was published on August 12, 1998. The final version of this rule is expected to be released in the next few months. This regulation creates safeguards for physical and electronic storage of, maintenance and transmission of, and access to, individual health information.

    The proposed provider ID and employer ID regulations are similar in concept. The provider ID regulation was published in draft form on May 7, 1998 and would create a unique number for healthcare providers that will be used by all health plans. The employer ID regulation was published in draft form on June 16, 1998 and calls for using the Employer Identification Number (the taxpayer identifying number for employers that is assigned by the Internal Revenue Service) as the identifying number for employers that will be used by all health plans. It is expected that the final versions of these regulations will be released a few months after the regulation on security. The health plan ID and individual ID regulations have not been released in draft form.

    Management is currently assessing and acting on the wide reaching implications of these regulations to ensure the Company's compliance by the implementation dates. Management has identified HIPAA as a major initiative impacting the Company's systems, business processes and business relationships. This issue extends beyond the Company's internal operations and requires active participation and coordination with the Company's customers, providers and business partners. Management has commissioned a dedicated HIPAA project team to develop, coordinate and implement our compliance plan. With respect to the proposed regulation on security and the final regulation on privacy, Management has hired a chief security officer, appointed an officer who will be responsible for privacy issues, commissioned separate security and privacy workgroups to identify and assess the potential impact of the regulations and reviewed current policies and drafted new policies to comply with the new requirements. Management believes that significant resources will be required over the next 2 years to ensure compliance with the new requirements. Management estimates that the Company will incur approximately $5 million to $7 million in additional operating expenditures and

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approximately $5 million to $8 million in additional capital expenditures related to these efforts during fiscal 2002.

    Other Significant Privacy Regulation.  Another initiative impacting the privacy of healthcare information is the Gramm-Leach-Bliley Act of 1999 ("GLB"). This federal legislation calls on the departments of insurance in the various states to enact regulations relating to a number of issues, including the privacy of health information, with an implementation date of July 1, 2001. The privacy regulation under HIPAA does not preempt state law, unless the state law is in conflict with HIPAA, so in many states the Company will be addressing privacy issues under not only HIPAA, but under GLB as well. A few states have recognized this as an issue and have stated that entities that comply with HIPAA by the effective date under GLB will be considered to be in compliance with GLB even though the laws are different.

    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 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.

    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, accreditation, government healthcare program participation requirements, reimbursements for patient services, Medicare and

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Medicaid fraud and abuse, 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.

    Substantial Leverage.  The Company is currently highly leveraged, wi