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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934
For the Fiscal Year ended December 31, 1996
Commission file number 1-12215
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QUEST DIAGNOSTICS INCORPORATED
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(formerly known as Corning Clinical Laboratories Inc.)
One Malcolm Avenue
Teterboro, NJ 07608
(201) 393-5000
DELAWARE 16-1387862
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(State of Incorporation) (I.R.S. Employer Identification Number)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which
Registered
Common Stock with attached New York Stock Exchange
Preferred Share Purchase Right
10.75% Senior Subordinated Notes due 2006 New York Stock Exchange
Securities registered pursuant to None
Section 12(g) of the Act:
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 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. [ X ]
As of March 17, 1997, the aggregate market value of the voting stock held by
non-affiliates of the registrant was approximately $466 million, based on the
closing price on such date of the Company's Common Stock on the New York Stock
Exchange.
As of March 17, 1997, there were outstanding 29,362,998 shares of Common Stock,
$.01 par value.
Documents Incorporated by Reference: None
PART I
Item 1. Business
Overview
Quest Diagnostics Incorporated, a Delaware corporation formerly known as
Corning Clinical Laboratories Inc., is one of the largest clinical laboratory
testing companies in the United States. Quest Diagnostics Incorporated and its
subsidiaries are collectively referred to as "Quest Diagnostics" or the
"Company." The Company offers a broad range of routine and esoteric testing
services used by the medical profession in the diagnosis, monitoring and
treatment of disease and other medical conditions. The Company currently
processes approximately 60 million requisitions each year.
The Company is the successor by merger to MetPath Inc. ("MetPath"), a New
York corporation organized in 1967. Corning Incorporated ("Corning") acquired
MetPath in 1982 and in 1992 merged MetPath into the Company, which had been
organized in 1990 as a holding company. On December 31, 1996, Corning
distributed all of the outstanding shares of common stock of the Company to the
stockholders of Corning, with one share of the Company's common stock being
distributed for each eight shares of common stock of Corning outstanding on
December 31, 1996. This distribution was followed immediately by the
distribution to the stockholders of the Company of all of the outstanding common
stock of Covance Inc. ("Covance") (a contract research organization previously
known as Corning Pharmaceutical Services Inc.) with one share of Covance's
common stock being distributed for each four shares of common stock of Corning
outstanding on December 31, 1996. These two distributions are collectively
referred to as the "Spin-Off Distribution."
Since its founding in 1967, the Company's clinical laboratory testing
business has grown into a network of 17 regional laboratories across the United
States and an esoteric testing laboratory (previously known as Nichols
Institute)("Nichols") located in San Juan Capistrano, California. In addition,
the Company has 15 smaller branch laboratories, including one located in Mexico
City, Mexico; approximately 200 STAT laboratories; and approximately 850 patient
service centers located throughout the United States. A substantial portion of
this growth has resulted from acquisitions. See "Acquisitions and Dispositions."
The principal executive offices of the Company are located at One Malcolm
Avenue, Teterboro, New Jersey 07608, telephone number: (201) 393-5000.
Recent Organizational Changes
Between 1990 and 1995, Corning tripled the size of its clinical laboratory
testing business, principally through acquisitions. Prior management pursued a
strategy of growth through acquisitions, including diversification outside of
the clinical laboratory testing business. As a result of difficult integrations
and increased pricing pressures and regulatory complexity in the clinical
testing industry, a new strategy was needed. In May 1995, Corning responded by
appointing Kenneth Freeman, then an Executive Vice President of Corning, as
President and Chief Executive Officer of the Company, who was charged with the
responsibility to formulate a new strategy. Mr. Freeman has over 24 years of key
financial and managerial experience at Corning, including serving as the general
manager of Corning's science products division and the President and Chief
Executive Officer of Corning Asahi Video Products Company. Under Mr. Freeman's
leadership, profitability of these operations increased.
Mr. Freeman immediately suspended the Company's acquisition program. Under
his direction, the Company began to refocus on its core clinical laboratory
testing business and reorganize its senior management team. As a result, the
Company is in the process of implementing its best practices in each region
throughout the Company; standardizing processes and systems; analyzing the cost
of serving various customers; intensifying efforts to correct persistent billing
errors to both enhance customer satisfaction and reduce the cost of billing
operations; enhancing its compliance program to audit and correct system
defaults and to better train employees in the laws and rules governing the
industry; and improving communications with employees by improving systems and
the type and amount of current information available to employees.
1
Mr. Freeman revamped the senior management team by appointing four new
senior executives and changing the responsibilities of five other senior
executives. Additionally, approximately one-half of the existing laboratory
facility general managers were replaced.
Mr. Freeman also changed the management structure, appointing three of the
senior executives to newly created key positions--Douglas VanOort, who focuses
exclusively on laboratory operations, Don Hardison, who focuses on commercial
activities, and Dr. Gregory Critchfield, who leads the efforts in the areas of
science and medicine and pursues innovations. All three report directly to Mr.
Freeman. The Company believes that this new management structure has greatly
enhanced the Company's ability to pursue its business strategy. Mr. VanOort and
the regional and local operations leaders who report to him focus their primary
attention on laboratory operations, efficiencies and standardization. Mr.
Hardison and the regional and local commercial leaders who report to him develop
and coordinate national, regional and local sales and marketing efforts, and
cultivate national and regional client relationships and provider alliances. Dr.
Critchfield pursues scientific excellence in the laboratory as well as seeks
out, develops and assimilates those new tests and technologies that will
differentiate the Company and help propel its growth in the future.
This three-prong management structure is designed to implement the
Company's business strategy to make the Company the best supplier (i.e.,
lowest-cost, highest quality) of quality testing services; the preferred partner
to large health care purchasers of fairly priced and useful health care services
and information; and the industry's leading innovator of new clinical tests,
methodologies and services.
Business Strategy
The Company's overall goal is to be recognized by its customers, employees
and competitors as the best provider of comprehensive and innovative diagnostic
testing, information and services. To achieve this, the Company has set several
strategic goals and put in place organizational structures to implement them.
Best Supplier. The Company seeks to be the best supplier of the highest
quality and the lowest-cost testing services. Health care providers and patients
expect accurate, timely and consistent laboratory test results at a fair price.
[bullet] Lowest Cost Provider. Currently, approximately 28% of the Company's
net revenues are from laboratories that the Company believes are the
lowest-cost providers in their respective markets. Management believes that
these laboratories are the lowest cost providers in their respective
markets based on its knowledge of such markets and information obtained in
acquiring other laboratories. The Company currently receives approximately
60 million requisitions for testing each year. Currently, the Company's
average cost per requisition varies significantly among its regional
laboratories: an approximately $8.00 difference in cost per requisition
between the most efficient regional laboratory and the average and an
approximately $13.00 difference in cost per requisition between the most
and the least efficient regional laboratories. In many cases, these
variations do not relate to testing volumes or mixes, space costs, service
requirements or regional labor cost differences. To reduce costs, the
Company has begun to replicate the best practices from each region
throughout its national network. Standardization of processes, equipment
and supplies, as well as leveraging of the Company's purchasing power, is
part of this strategy. While the Company's overall program of
standardization is in a preliminary stage, the Company has already selected
its standard clinical instruments and has selected its national vendors for
laboratory supplies, temporary services and personal computers. Management
expects to achieve significant cost savings within the next three years as
these programs are fully implemented, the majority of which are expected to
be achieved by the end of 1998.*
[bullet] Highest Quality Provider. The Company is dedicated to providing
accurate and timely testing results and to being viewed by its customers as
the highest quality provider of clinical testing services. The Company
believes that implementation of best practices already developed in certain
regions will permit the Company to be viewed by its customers as the
highest quality provider of clinical testing services. For example, as part
of its best practices policy, the Company is identifying the most common
service failures in each regional laboratory and establishing procedures to
substantially reduce these service failures. Management
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* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "Cautionary
Statement for Purposes of the 'Safe Harbor' Provisions of the Private
Securities Litigation Reform Act of 1995." In particular see factors (c),
(d), (g) and (j).
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believes that implementing these best practices will increase the level of
quality while lowering costs.* Historically, the Company's experience has
been that the regions with the highest quality of services have also had
the lowest costs.
Preferred Partner. The Company seeks to be the preferred provider of
laboratory testing services to existing and new health care networks on a
selective basis determined by profitability of accounts. The Company believes
that it will become the preferred partner to these networks as (1) large
networks typically prefer to utilize large independent clinical laboratories
that can service them on a national or regional basis and (2) the Company
continues to pursue its primary strategy of becoming the highest quality, lowest
cost provider. To achieve this, the Company will employ a rigorous national and
regional process to identify prospective customers and to efficiently allocate
resources to support these efforts. The Company will also pursue innovative
alliances and seek to assist its partners in achieving their business
objectives.
[bullet] Account Profitability. The Company intends to refocus its sales
efforts on pursuing and keeping profitable accounts. The Company is
engaging in an active program with current accounts, including those with
managed care organizations, to evaluate their profitability and either
increase pricing or eliminate accounts that cannot be serviced profitably.
Throughout the independent clinical laboratory industry, there are
substantial differences in pricing among, as well as the cost of serving,
various categories of payors and health care providers. The Company is
beginning to provide clear pricing guidelines to its sales force and is
changing its commission structure so that compensation is tied to the
profitability of (rather than revenues from) business. Management expects
to achieve significant benefits from these programs within the next three
years, the majority of which are expected to be achieved by the end of
1998.**
[bullet] Regional Profitability. The Company presently believes that it has
the leading market share among independent clinical laboratories in most
routine testing markets of the northeast, mid-Atlantic and midwest regions.
Approximately 68% of the Company's revenues and almost all of its earnings
before net interest, taxes, depreciation and amortization ("EBITDA") are
generated from these markets. In most of these markets, the Company
believes that it also is the lowest cost provider. The Company is
evaluating its strategic alternatives relative to units whose profitability
does not meet its internal goals. These alternatives may include asset
swaps, joint ventures, alliances, or dispositions. In the interim, the
Company will continue to drive its core strategy in these regions. The
Company may also make selected local acquisitions where appropriate.
Leading Innovator. The Company intends to remain a leading innovator in the
clinical laboratory industry by continuing to introduce new tests, technology
and services. Through its relationship with the academic community and
pharmaceutical and biotechnology firms and its own internal research and
development the Company believes it is one of the leaders in transferring
innovation from academic biotechnology laboratories to the market. For example,
the Company has been informed by its licensors that it is currently the only
independent clinical laboratory that is using both molecular signal
amplification (branched DNA) and polymerase chain reaction (PCR) technologies
for HIV testing. These technologies permit the detection of lower levels of HIV
than can be achieved using other technologies, which in turn permits health care
providers to better tailor drug therapies for HIV-infected patients. The
Company's esoteric laboratory located in San Juan Capistrano continues to be one
of the leading esoteric testing laboratories in the world. This esoteric
laboratory serves approximately 2,000 of the country's estimated 6,400 hospitals
and counts among its largest customers other independent clinical laboratory
companies. The Company hopes to leverage its existing relationships with
hospitals into increased routine testing for hospitals, which continue to
perform over half of the clinical laboratory testing in the United States.
The Clinical Laboratory Testing Industry
Clinical testing is a critical component in the delivery of quality health
care service to patients. Currently, clinical laboratory testing is the first
step in determining how a significant amount of all health care dollars are
spent.
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* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "Cautionary
Statement for Purposes of the 'Safe Harbor' Provisions of the Private
Securities Litigation Reform Act of 1995." In particular see factors (b),
(c), (d), (f) and (j).
** This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "Cautionary
Statement for Purposes of the 'Safe Harbor' Provisions of the Private
Securities Litigation Reform Act of 1995." In particular see factors (a),
(b), (c), (d), (f) and (i).
3
Laboratory tests and procedures are used generally by physicians and other
health care providers to assist in the diagnosis, evaluation, detection,
monitoring and treatment of diseases and other medical conditions through the
measurement and analysis of chemical and cellular components in blood, tissues
and other specimens. Clinical laboratory testing is generally categorized as
either clinical testing, which is performed on body fluids such as blood and
urine, or anatomical pathology testing, which is performed on tissue and other
samples, including human cells. Clinical and anatomical pathology procedures are
frequently ordered as part of regular physician office visits and hospital
admissions. Most clinical laboratory tests ordered by health care providers are
considered "routine" and can be performed by most independent clinical
laboratories, while "esoteric" tests (which generally require more sophisticated
equipment, materials and personnel) are generally referred to laboratories, such
as the Company's facility in San Juan Capistrano, that specialize in such tests.
The Company believes that in 1995 the entire United States clinical
laboratory industry had revenues exceeding $30 billion. The clinical laboratory
industry consists primarily of three types of providers: hospital-affiliated
laboratories, independent clinical laboratories, such as those owned by the
Company, and physician-office laboratories. The Company believes that in 1995
approximately 56% of the clinical testing revenues in the United States were
attributable to hospital-affiliated laboratories, approximately 36% were
attributable to independent clinical laboratories and approximately 8% were
attributable to physicians in their offices and laboratories.
The Company believes that a number of factors are likely to positively
influence the volume of clinical laboratory testing performed in the United
States in the future, including (1) the general aging of the population in the
United States; (2) an expanded base of scientific knowledge which has led to the
development of more sophisticated specialized tests and an increase in the
awareness of physicians of the value of clinical laboratory testing as a
cost-effective means of early detection of disease and monitoring of treatment;
(3) an increase in the number and types of tests which are, due to advances in
technology and increased cost efficiencies, readily available on a more
affordable basis to physicians; (4) expanded substance-abuse testing by
corporations and governmental agencies; and (5) increased testing for sexually
transmitted diseases such as AIDS. The impact of these factors is expected to be
offset in part by increased controls over the utilization of clinical laboratory
tests by Medicare and other third party payors. In addition, as a result of its
focus on account profitability, the Company expects to eliminate certain
accounts that cannot be serviced profitably, which will negatively affect
volume. See "Business Strategy-Preferred Partner-Account Profitability."
The Company believes that the clinical laboratory industry will continue to
be subject to pricing pressures as a result of (1) continued growth of the
managed care sector; (2) a shift toward capitated payment contracts within the
managed care sector; and (3) decreases in Medicare reimbursement rates. In
addition, increased regulatory requirements in the billing of tests to Medicare
are expected to result in reimbursement reductions and additional costs to
clinical laboratory testing companies in the United States. The Company has
formulated strategies to address these challenges. See "Business Strategy."
Services
The Company's laboratory business is comprised of routine testing, which
the Company's management estimates currently generates approximately 88% of the
Company's net laboratory revenues; and esoteric testing, which is performed at
the esoteric testing facility in San Juan Capistrano and which the Company's
management estimates generates approximately 10% of the Company's net laboratory
revenues. The balance of the Company's net revenues is derived principally from
the manufacture of clinical laboratory test kits.
Routine Testing Services and Operations. Routine tests, which are
performed at the Company's regional laboratories, include procedures in the area
of blood chemistry, hematology, urine chemistry, virology, tissue pathology and
cytology. Commonly ordered individual tests include red and white blood cell
counts, Pap smears, blood cholesterol level tests, HIV-related tests,
urinalyses, pregnancy tests, and alcohol and other substance-abuse tests.
Routine test groups include tests to determine the function of the kidney,
heart, liver and thyroid, as well as other organs, and several health screens
that measure various important bodily health parameters.
The Company provides services through 17 regional laboratories located in
major metropolitan areas throughout the United States, as well as 14 branch
laboratories, approximately 200 STAT laboratories and 850
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patient service centers. The Company also operates a branch laboratory in
Mexico. Regional laboratories offer a full line of routine clinical testing
procedures. "STAT" laboratories are local laboratory facilities where the
Company can quickly perform and report results of certain routine tests for
customers that require such emergency testing services. "Branch laboratories"
have a test menu that is smaller than that of regional laboratories but larger
than that of STAT laboratories. A "patient service center" is a facility
maintained by the Company, typically in or near a medical professional building,
to which patients can be referred by physicians for specimen collection.
The Company operates 24 hours a day, 365 days a year, utilizing a fully
integrated collection and processing system. The Company generally performs and
reports most routine procedures within 24 hours, employing a variety of
sophisticated and computerized laboratory testing instruments. On an average
work day, the Company processes approximately 220,000 requisitions. The Company
provides daily pickup of specimens from most customers principally through an
in-house courier system. The specimens are sent to one of the Company's
laboratories (generally a regional or branch laboratory) where one or more tests
are performed.
Each patient specimen is accompanied by a test requisition form, which is
completed by the customer, that indicates the tests to be performed and provides
the necessary billing information. Each specimen and related requisition form is
checked for completeness and then given a unique bar-coded identification
number. The unique identification number assigned to each specimen helps to
assure that the results are attributed to the correct patient. The requisition
form is sent to a data entry department where a file is established for each
patient and the necessary testing and billing information is entered. Once this
information is entered into the computer system, the tests are performed and the
results are entered, primarily through computer interface or manually, depending
upon the type of testing equipment involved. Most of the Company's automated
testing equipment is directly linked with the Company's information systems.
Most routine testing is performed and completed during the evening and test
results are readied for distribution the following morning either electronically
or by service representatives. Many customers have local printer capabilities
enabling laboratory medical reports to be printed in their offices. Customers
who request that they be called with a result are so notified in the morning. It
is the Company's policy to notify the customer immediately if a life-threatening
result is found at any point during the course of the testing process.
Esoteric Testing Services and Operations. As a result of the acquisition of
Nichols in 1994, the Company operates one of the leading esoteric clinical
testing laboratories in the world. Esoteric tests are performed in cases where
the information provided by routine tests is not specific enough or is
inconclusive as to the existence or absence of disease or when a physician
requires more information. Typically, unlike routine testing, only one test is
ordered and performed per requisition. The logistics for esoteric testing are
similar to that for routine testing except that, due to the complexity of the
testing, approximately 60% of the tests are performed within 24 hours, with
almost all of the rest being performed within one week.
Esoteric tests generally require more sophisticated equipment and materials
as well as more highly skilled personnel to perform test procedures and analyze
results than what are required for routine testing. Consequently, esoteric tests
are generally priced substantially higher than routine tests. New medical
discoveries lead to the development of new esoteric tests. However, over time
esoteric tests may become routine tests as a result of improved technology or
increased volume. The volume of esoteric tests required by most health care
providers, including hospitals, is relatively low compared to the volume of
routine tests. Because it is generally not cost effective for such health care
providers to perform the low volume of esoteric tests in-house, a significant
portion of esoteric tests are referred to clinical laboratories like the
Company's esoteric laboratory in San Juan Capistrano that specialize in such
tests. Some examples of esoteric testing procedures include capillary
electrophoresis, cell culture technology, certain chemiluminescent immunoassays,
certain enzyme immunoassays, flow cytometry, fluorescent in situ hybridization
(FISH), inductively coupled plasma mass spectroscopy (ICPMS), molecular tissue
pathology, molecular signal amplification (branched DNA), and polymerase chain
reaction (PCR) technologies.
The Company's esoteric testing laboratory is comprised of 18 individual
laboratory departments, which offer tests or "assays" in such fields as
endocrinology, genetics, immunology, microbiology, molecular biology, oncology,
serology, special chemistry and toxicology. The Company believes that it has
been one of the leaders in transferring technological innovation from academic
biotechnology laboratories to the marketplace. Nichols was the first to
introduce a number of esoteric tests, including immunoassay methods for
measurement of circulating hormone levels and sensitive tests to predict breast
cancer prognosis. Among more recent developments have been tests to detect a
variety of tumor types, a common form of mental retardation, leukemia, cystic
fibrosis, osteoporosis, hepatitis and neurological disorders and to monitor the
success of therapy for cancer and AIDS. The branched DNA
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and PCR technologies permit the detection of lower levels of HIV than can be
achieved under other technologies. The ability to measure the amount of HIV
permits health care providers to better tailor drug therapies for HIV-infected
patients. These techniques can be applied to a variety of infectious agents. The
Company has also expanded its capabilities in molecular diagnostics by offering
important gene sequencing testing for an inherited cancer disorder in
endocrinology (the Ret gene). As part of its research and development efforts,
the Company maintains a relationship with the academic community through its
Academic Associates program, under which approximately sixty scientists from
academia and biotechnology firms work directly with the Company's staff
scientists to monitor and consult on existing test procedures and develop new
esoteric test methods. In addition, the Company relies on internal resources for
the development of new tests as well as on license arrangements and
co-development agreements with biotechnology companies and academic medical
centers.
The Company also provides clinical laboratory testing in connection with
pre-marketing clinical trials of pharmaceutical drugs. Net revenues from such
testing accounted for less than 1% of the Company's net revenues in 1996.
Diagnostics. Through its Nichols Institute Diagnostics ("NID")
subsidiaries, which were acquired as a result of the acquisition of Nichols in
August 1994, the Company manufactures and markets clinical laboratory kits
primarily for esoteric testing. Test kits are sold principally to hospital and
clinical laboratories.
Customers and Payors
The Company provides testing services to a broad range of health care
providers. The primary types of customers served by the Company are as follows:
Independent Physicians and Physician Groups. Physicians requesting testing
for their patients who are unaffiliated with a managed care plan remain the
principal source of the Company's clinical laboratory business. Fees for
clinical laboratory testing services rendered for these physicians are billed
either to the physician, to the patient, or to the patient's third-party payor
such as insurance companies, Medicare and Medicaid. In four states, including
New York and Michigan, the Company is required to bill patients directly. The
clinical laboratory industry is supporting legislative efforts to expand direct
patient billing. Billings are typically on a fee-for-service basis. If the
billings are to the physician, they are based on the laboratory's wholesale or
customer fee schedule and are typically subject to negotiation. Otherwise, the
billings are based on the laboratory's retail or patient fee schedule, subject
to limitations on fees imposed by third parties and to negotiation by physicians
on behalf of their patients. Reimbursement from Medicare and Medicaid billings
is based on fee schedules set by governmental authorities. See "Regulation and
Reimbursement."
HMOs and Other Managed Care Groups. HMOs and other managed care
organizations typically contract with a limited number of clinical laboratories
and then designate the laboratory or laboratories to be used for tests ordered
by their participating physicians. In an effort to control costs, the managed
care groups generally negotiate discounts to the fees usually charged by such
laboratories or negotiate capitated payment contracts, whereby the clinical
laboratory receives a monthly fee per individual. The fixed monthly payment
generally covers all laboratory tests performed during the month, regardless of
the number or cost of tests actually performed. Such contracts shift the risks
of additional routine testing beyond that covered by the capitated payment to
the clinical laboratory. In certain cases, however, the monthly payment may be
subject to prospective or retroactive adjustment if the number of tests
performed exceeds (or is less than) certain thresholds. The types of tests
covered by capitated contracts are negotiated for each contract, with esoteric
tests and anatomic pathology services generally not being covered under the
capitation rate. Large regional and national HMOs and preferred provider
organization networks typically prefer to utilize large independent clinical
laboratories such as the Company that can service the managed care groups on a
national or regional basis. See "Effect of the Growth of the Managed Care Sector
on the Clinical Laboratory Business."
Hospitals. The Company serves approximately 3,000 hospitals with services
that vary from providing esoteric testing to management contracts, where the
Company manages the hospital's laboratory for a fee. Hospitals generally
maintain an on-site laboratory to perform testing on patients receiving care and
refer less frequently needed procedures and highly specialized procedures to
outside laboratories. Hospitals are typically charged for such tests on a
negotiated fee-for-service basis which is based on the laboratory's customer fee
schedule. Some hospitals actively encourage community physicians to send their
testing to the hospital's laboratory. In addition, some
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hospitals have been purchasing physician practices and requiring that the
physicians/employees send their testing to the hospital's affiliated laboratory.
As a result, hospital-affiliated laboratories can be both a customer and a
competitor for independent clinical laboratories such as the Company.
Other Institutions. The Company also serves other institutions, including
governmental agencies, such as the Department of Defense and prison systems,
large employers and independent clinical laboratories that do not have the full
range of the Company's testing capabilities. These institutions are typically
charged on a negotiated or bid fee-for-service basis. The Company's services to
employers principally involve the provision of substance abuse testing services.
In 1996, no single customer or affiliated group of customers accounted for
more than 2% of the Company's net revenues. The Company believes that the loss
of any one of its customers would not have a material adverse effect on the
Company's results of operations or cash flows.
Payors. Most clinical laboratory testing is billed to a party other than
the "customer" that ordered the test. Tests performed for various patients of a
single physician may be billed to different payors besides the ordering
physician, including third-party payors (generally an insurance company or
managed care organization), Medicare, Medicaid or the patient.
The following table sets forth current estimates of the breakdown by payor
of the Company's total volume of requisitions and average approximate revenues
per requisition:
Requisition Volume as
% of Total Revenue Per Requisition
----------------------- -------------------------
Patient ............................................ 5%-10% $60-$80
Medicare & Medicaid ................................ 20%-25% $20-$30
Monthly Bill (Physician, Hospital, Employer, Other). 35%-40% $15-$35
Third Party Fee-For-Service ........................ 15%-20% $30-$40
Managed Care-Capitated ............................. 15%-20% $ 5-$15
For a discussion of the mix shift and the impact of the managed care sector
on volume and price trends, see "Effect of the Growth of the Managed Care Sector
on the Clinical Laboratory Business."
Average Revenue per Requisition Trends. The Company-wide average revenue
per requisition remained relatively stable during 1996 but was lower than in
1995. Average revenue per requisition for the quarters ended September 30, 1996
and December 31, 1996 were approximately 1.7% and 1.6%, respectively, below the
comparable periods in 1995. These declines in revenue per requisition were
smaller than the approximate 4.8% and 3.6% decline experienced in the first and
second quarters of 1996, respectively.
Sales and Marketing
The Company markets and services its customers through its direct sales
force, as well as through its account representatives and couriers. At February
28, 1997 the Company had approximately 320 sales representatives, 230 account
representatives and 2,100 couriers.
Most sales representatives market the mainstream or traditional routine
laboratory services primarily to physicians, while others concentrate on
individual market segments, such as hospitals or managed care organizations, or
on testing niches, such as substance abuse testing. The Company's sales
representatives are compensated through a combination of salaries, commissions
and bonuses, at levels commensurate with each individual's qualifications and
responsibilities. Commissions are based primarily upon the individual's results
in generating new business for the Company. The Company is currently changing
its commission structure so that compensation is tied to the profitability of
(rather than revenues from) business. See "Business Strategy-Preferred Partner."
The Company's account representatives interact with customers on an ongoing
basis. Account representatives monitor the status of services being provided to
customers, act as problem-solvers, provide information on new testing
developments and serve as the customer's regular point of contact with the
Company. Account representatives are compensated with a combination of salaries
and bonuses commensurate with each individual's qualifications and
responsibilities.
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The Company believes that the clinical laboratory service business is
shifting away from the traditional direct sales structure and into one in which
the purchasing decisions for laboratory services are increasingly made by
managed care organizations, integrated health delivery systems, insurance plans,
employers and by patients themselves. In view of these changes, the Company has
completed a rigorous regional market strategy and has reorganized its sales and
marketing organization structure to support these strategies and emerging
customers.
The Company believes that, given the increasing regulation and complexity
of the clinical laboratory marketplace, training of its sales force is of
paramount importance. With this goal in mind, since 1995 the Company has
enhanced its comprehensive sales training program and compliance training. See
"Compliance Program."
Effect of the Growth of the Managed Care Sector on the Clinical Laboratory
Business
The managed care industry is growing as well as undergoing rapid
consolidation which has created large managed care companies that control the
delivery of health care services for millions of people, and have significant
bargaining power in negotiating fees with health care providers, including
clinical laboratories. The Company believes that there are opportunities for
large, low-cost, clinical laboratories such as the Company to capture additional
testing volume from managed care organizations. The larger regional and national
managed care organizations typically prefer to utilize large independent
clinical laboratories, like the Company, that can service their organizations on
a national or a regional basis. In addition, smaller laboratories are unlikely
to be able to achieve the low cost structures necessary to profitably service
managed care organizations.
The growth of the managed care sector presents various challenges to
independent clinical laboratories, including the Company. Managed care
organizations frequently negotiate capitated payment contracts, whereby the
clinical laboratory receives a monthly fee per covered individual. The fixed
monthly payment generally covers all laboratory tests (excluding certain tests,
such as esoteric tests and anatomic pathology services) performed during the
month, regardless of the number or cost of the tests performed. Unlike
fee-for-service indemnity insurance, such contracts shift the risks of
additional routine testing beyond that covered by the capitated payment to the
clinical laboratory. In certain cases, however, the monthly payment may be
subject to prospective or retroactive adjustment if the number of tests
performed exceeds (or is less than) certain thresholds. The Company expects the
amount of clinical laboratory testing performed for managed care organizations
under capitated rate agreements to continue to grow.
Laboratory services agreements with managed care organizations have
historically been priced aggressively due to competitive pressures and the
expectation that a laboratory would capture not only the volume of testing
covered under the contract, but also additional fee-for-service business from
patients of participating physicians who are not covered under the managed care
plan. However, as the number of patients covered under managed care plans
continues to increase, there is less such fee-for-service business and,
accordingly, less high margin business to offset the low margin (and often
unprofitable) managed care business. Furthermore, increasingly, physicians are
affiliated with more than one managed care organization and as a result may be
required to refer clinical laboratory tests to different clinical laboratories,
depending on the coverage of their patients. As a result, a clinical laboratory
might not receive any fee-for-service testing from such physicians. The level of
pricing charged to managed care organizations, including under capitated payment
contracts, if continued, may adversely affect the clinical laboratory industry.
During 1996, services to managed care organizations under capitated rate
agreements accounted for approximately 6% of the Company's net revenues from
clinical laboratory testing and approximately 15% of the number of tests
performed by the Company. The Company believes that the prices charged by the
independent clinical laboratory testing companies to managed care organizations
must be increased. The Company is currently reviewing its pricing structures for
agreements with managed care organizations and intends to ensure that all such
agreements are profitably priced. However, there can be no assurance that the
Company will be able to increase the prices charged to managed care
organizations or that the Company will not lose market share in the managed care
market to other clinical laboratories who continue to aggressively price
laboratory services agreements with managed care organizations. The Company
believes that the growth of the managed care sector presents both challenges and
opportunities. The Company, as part of its preferred partner strategy, will seek
to capitalize on the opportunity and meet the challenge by seeking to secure
large-volume, profitable managed care contracts through providing low cost, high
quality testing services at rational prices.
8
Expansion Opportunities
The Company believes that there are several expansion opportunities which
it can take advantage of without incurring significant capital expenditures or
deploying significant resources.
Hospital Alliances. In response to the growth of the managed care sector
and the developments described under "Effect of the Growth of the Managed Care
Sector on the Clinical Laboratory Business," many health care providers have
established new alliances. Hospital-physician networks are emerging in many
markets in order to offer comprehensive, integrated service capabilities, either
to managed care plans or directly to employers.
Since the Company has traditionally derived a substantial portion of its
esoteric testing revenues from referrals from hospitals, which perform
approximately half of all clinical laboratory tests in the United States, the
Company established a hospital business venture group whose primary goal is to
develop additional nontraditional hospital arrangements, including management
and consulting agreements, shared service and outsourcing arrangements and joint
ventures.
Under federal cost containment legislation enacted in 1985, treatment
provided to hospital inpatients covered by Medicare is classified into
diagnosis-related groups ("DRGs") which prescribe the maximum reimbursable
payments for all services, including laboratory testing services, provided on
behalf of an inpatient under each DRG. As a result of this payment structure,
and similar price constraints from managed care organizations and other
third-party payors, hospitals have an economic incentive to seek the most
cost-effective laboratory testing services for their patients. The Company
believes that in many cases, by entering into arrangements such as those
described in the preceding paragraph, the Company can improve a hospital
laboratory's economic structure and preserve hospital capital that would be
required for needed laboratory improvements while providing accurate and timely
testing services due to greater economies of scale, increased utilization of
expensive testing and data processing equipment through optimization of the mix
between on-site and off-site testing and more efficient use of laboratory
employees. The Company has several such arrangements with hospitals, including a
joint venture with approximately twenty hospitals in northwestern Pennsylvania
and southwestern New York and a management agreement with a group of
approximately 25 hospitals in eastern Nebraska and Sioux City, Iowa. These two
laboratory arrangements, which provide testing for the hospitals as well as
unaffiliated physicians and other health care providers in their geographical
areas, serve as two of the Company's laboratory facilities. The Company also
manages the laboratories at several hospitals in the eastern United States.
However, despite the potential cost savings and additional revenues available to
hospitals through such arrangements, the Company believes that only a small
percentage of the hospitals in the United States have entered into such
arrangements with independent clinical laboratories. Nonetheless, the Company
expects to enter into alliances with various hospitals in the future and
believes that this market has potential.* The Company recently signed a letter
of intent with the University of Pittsburgh Medical Center to explore a
potential relationship, including the possibility of a partnership. As an
alternative service for hospitals that are entering into integrated delivery
systems, the Company is beginning to market consulting support and technical
solutions for integrating diverse laboratory infrastructures, systems and data.
Employer Market. The Company is considering expanding its business in the
employer market to include the provision of laboratory services to large
employers on a basis comparable to that offered to managed care organizations,
whereby laboratory services paid under self-insured indemnity plans may be
relatively fixed (rather than on a fee-for-service basis). These services could
be offered in alliance with other service providers, including pharmaceutical
benefits and diagnostic imaging services. In 1996, the Company organized
National Imaging Associates Inc. ("NIA"), a company offering diagnostic imaging
benefit management services to employers, payors and managed care organizations.
NIA seeks to carve out the imaging component of a health care plan service
offering and manage it at lower cost through utilization controls and provider
price concessions. The Company currently owns approximately 27% of the
outstanding capital stock of NIA.
Medical Information. The market need for medical information, particularly
disease-specific information about provider practices and patient care, is
growing rapidly. Large customers of clinical laboratories are
- --------------
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "Cautionary
Statement for Purposes of the 'Safe Harbor' Provisions of the Private
Securities Litigation Reform Act of 1995."
9
increasingly interested in using information from clinical laboratory data on
their covered population to answer financial, marketing and quality related
questions. Integrated data from clinical laboratories and other health
encounters provides additional insights to these questions. To meet these
emerging needs, the Company created the Quest Informatics Division ("Quest
Informatics"), which focuses solely on the medical information needs of managed
care organizations, integrated healthcare delivery networks and other large
customers. Through internal development, the Company now has a portfolio of
information products, based primarily upon the Company's extensive database,
that assist large customers in delivering more effective health care to their
patients. A combination of advanced information technology and experienced
analytical and data integration skills provides the platform for delivery of
these products.
As market interest has increased, Quest Informatics has devoted experienced
account executives to work with customers to meet their information needs.
Current information products include provider profiles and benchmarks, high-risk
patient registries based on customer disease management initiatives, normative
comparisons with other populations, and quantitative clinical outcomes based on
laboratory measures. The Company believes that health care customers will
increasingly see value in the information obtained from clinical laboratory
results.
Information Systems
The need for information systems to support laboratory, billing, customer
service, logistics, medical data, and other business requirements is significant
and will continue to place high demands on the Company's information systems
staff. The Company has historically not standardized the billing, laboratory and
other information systems at laboratories that it has acquired. As a result, the
Company has numerous different information systems to handle billing, test
result reporting and financial data and transactions. The Company believes that
the efficient handling of information involving customers, patients, payors, and
other parties will be critical to the Company's future success.
To this end, the Company has chosen standard billing and laboratory
systems. During the third quarter of 1996, the Company recorded a charge of
$13.7 million to write off capitalized software as a result of its decision to
abandon the billing system which had been intended as its company-wide billing
system. Management now plans to standardize using a SYS billing system which has
already been implemented in seven of its billing sites, which seven sites
account for approximately 34% of the Company's net revenues. The standard
laboratory system is already operational in nine of its sites, which account for
approximately 30% of the Company's net revenues. Such sites are not necessarily
the same sites as those with standard billing systems. The Company is beginning
to convert the remaining nonstandard billing and laboratory systems to the
standard systems, prioritized on an impact basis. The most critical conversions
will be completed within three years. The New York/New Jersey (Teterboro) and
Long Island laboratories are the first priority and are expected to be converted
during 1998. The conversion costs are expected to average approximately $3
million per billing system and $1 million to $3 million per laboratory system.
As more billing sites are converted to the standard billing system,
consolidation of billing sites is expected to occur, which will reduce overall
conversion costs and improve billing efficiencies. The Company anticipates that
the cost of converting all billing and laboratory systems to the standard
systems over the next several years will cost between approximately $55 million
and $85 million, depending on the number of billing consolidations that occur.*
The Company does not anticipate that the conversion costs will result in a
significant increase in capital expenditures over the levels spent during the
last several years.
The Company is developing systems that will permit managed care
organizations and other providers to have electronic access to test orders and
results for participating physicians, which will permit managed care
organizations to better monitor and control the utilization of testing services.
Billing
Billing for laboratory services is a complicated process. Laboratories must
bill different payors such as doctors, patients, insurance companies, Medicare,
Medicaid and employer groups, all of whom have different billing
- --------------
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "Cautionary
Statement for Purposes of the 'Safe Harbor' Provisions of the Private
Securities Litigation Reform Act of 1995." In particular see factors (d), (j)
and (k).
10
requirements. The Company believes that less than 30% of its bad debt expense is
attributable to specific credit or payment issues affecting its customers. The
remainder of the bad debt expense is the result of many non-credit related
issues which slow the billing process, create backlogs of unbilled requisitions
and generally increase the aging of accounts receivable. A primary cause of bad
debt expense is missing or incorrect billing information on requisitions.
Typically, approximately one-third of the requisitions that the Company receives
either do not provide all the necessary data or provide incorrect data. The
Company believes that this experience is similar to that of its primary
competitors. The Company performs the requested tests and reports back the test
results regardless of whether billing information has been provided at all or
has been provided incorrectly. The Company subsequently attempts to obtain any
missing information and rectify any incorrect billing information received from
the health care provider. Among the many other factors complicating the billing
process are pricing differences between the fee schedules of the Company and the
payor, disputes between payors as to the party responsible for payment of the
bill and auditing for specific compliance issues. Ultimately, if all issues are
not resolved in a timely manner, the related receivables are written off to bad
debt expense.
The Company's bad debt expense increased each year from 1993 to 1995 due
principally to three developments that have further complicated the billing
process: (1) increased complexity in the health care system; (2) increased
requirements in complying with fraud and abuse regulations; and (3) changes in
Medicare reimbursement policies. These factors have placed additional
requirements on the billing process, including the need for specific test
coding, additional research on processing rejected claims, increased audits for
compliance, and management of a large number of contracts which have very
different information requirements for pricing and reimbursement. The Company is
improving its management of these requirements and bad debt expense was reduced
substantially in 1996 from 1995 levels. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations." The Company's
billing has also been hampered by the existence of multiple billing information
systems. In 1995 the Company had severe billing problems at its largest
laboratory site in Teterboro, New Jersey. A new billing information system
developed with outside consultants experienced significant implementation
problems, including excessive downtime, which severely impacted the Company's
ability to efficiently bill for its services from the Teterboro location. The
problem was compounded by a lack of experienced staff as the result of work
force reductions made to meet cost reduction initiatives undertaken in
anticipation of greater efficiencies from the new billing information system. As
a result of all of these factors, the Company recorded a charge to bad debt
expense of $62 million in the third quarter of 1995. Of this amount,
approximately $35 million was attributable to the Teterboro location. At the
time of this charge, the backlog of unbilled requisitions was estimated at over
2 million requisitions and days sales outstanding ("DSOs") for the clinical
testing business were approximately 90 days. In addition, significant backlogs
existed in (1) reconciling cash received to payment of specific bills, (2)
rejected claims that needed to be researched and (3) correspondence from
customers attempting to resolve billing problems.
Integration of a standardized billing system is a priority of the Company
and the Company is in the process of implementing the SYS billing system, which
has proven reliable, throughout its network. Its reliability is evidenced by
both the improvement in the laboratories' bad debt experience after SYS was
implemented and the improved capability to handle new billing requirements as
compared with non-SYS laboratories, such as Teterboro. The use of a standard
system will also provide for operational efficiencies as redundant programming
efforts are eliminated and the ability to consolidate billing sites will become
more feasible. See "Information Systems." Standardizing billing systems presents
conversion risk to the Company as key databases and masterfiles are transferred
to the SYS system and because the billing workflow is interrupted during the
conversion, which may cause backlogs. In 1997 and 1998, efforts will be focused
on converting the Company's New York and New Jersey laboratories to the SYS
system. The Company has already completed seven conversions to this system and
has retained key people who have been involved in those conversions.
The Company has concentrated on improving its billing operations in the
last year. Over the last fifteen months, the backlog of unbilled requisitions
has been reduced by approximately 40%, DSOs for the clinical testing business
have been reduced to 72 days, bad debt expense as a percentage of net revenues
has decreased, the percentage of requisitions received with missing billing
information has been reduced by approximately 30% and backlogs in rejected
claims, unapplied cash and customer correspondence have been significantly
reduced. These improvements were achieved in spite of a higher level of
information requirements necessary for correct billing, especially those bills
relating to Medicare. However, additional requirements to provide documentation
of the "medical necessity" of testing have added to the backlog of unbilled
receivables and caused bad debt expense as a percentage of revenues
11
in the last two quarters of 1996 to increase above the rate the Company had
experienced during the first two quarters of 1996. See "Regulation and
Reimbursement-Regulation of Reimbursement for Clinical Laboratory Services."
Acquisitions and Dispositions
MetPath, the Company's predecessor, originally commenced operations in 1967
with a laboratory only in the New York metropolitan area. Most of the Company's
other regional laboratories have been added through acquisitions. Principally as
the result of acquisitions that were completed in 1993 and 1994, the Company's
revenues have almost tripled since 1991. However, this increase in revenues is
not reflected in the Selected Historical Financial Data because several of the
major acquisitions are accounted for as poolings of interests and have been
restated on a combined basis. Acquisition activity has diminished significantly
since May 1995, in part so that the Company could concentrate on the integration
of the laboratory networks that had been acquired in 1993 and 1994. The Company
may resume making acquisitions in the future, most likely focusing on
acquisitions of smaller laboratories that can be folded into existing
laboratories where the Company can expect to achieve significant cost savings
and other benefits resulting from the elimination of redundant facilities and
equipment and reductions in personnel. The Company is evaluating its strategic
alternatives relative to units whose profitability does not meet its internal
goals. These alternatives may include joint ventures, alliances, asset swaps or
dispositions.
Competition
The clinical laboratory testing business is intensely competitive. As
recently as 1993, there were seven independent clinical laboratories that
provided clinical laboratory testing services on a national basis: the Company,
SmithKline Beecham Clinical Laboratories Inc. ("SmithKline"), National Health
Laboratories Inc. ("NHL"), Roche Biomedical Laboratories Inc. ("Roche"), Damon
Corporation ("Damon"), Allied Clinical Laboratories Inc. ("Allied") and Nichols.
In April 1995 Roche merged into NHL (under the name Laboratory Corporation of
America Holdings ("LabCorp")), which had acquired Allied in June 1994. The
Company acquired Nichols in August 1994 and Damon in August 1993. In addition,
in the last several years a number of large regional laboratories have been
acquired by national clinical laboratories. There are presently three national
independent clinical laboratories: the Company, which had approximately $1.6
billion in revenues from clinical laboratory testing in 1996; LabCorp, which had
approximately $1.6 billion in revenues from clinical laboratory testing in 1996;
and SmithKline, which had approximately $1.3 billion in revenues from clinical
laboratory testing in 1996. Both LabCorp and SmithKline are affiliated with
large corporations that have greater financial resources than the Company.
SmithKline is wholly owned by SmithKline Beecham Ltd.; F. Hoffman La Roche Ltd.
beneficially owns approximately 49.9% of the outstanding capital stock of
LabCorp.
In addition to the three national clinical laboratories, the Company
competes on a regional basis with many smaller regional independent clinical
laboratories as well as laboratories owned by hospitals and physicians. The
Company has the leading market share in most of the northeast, mid-Atlantic and
midwest routine testing markets, while its market share is much lower in the
routine testing market in the rest of the country. The Company does not
generally compete in the California routine testing market other than in the San
Diego metropolitan area.
The independent clinical laboratory industry has experienced intense price
competition over the past several years, which has negatively impacted the
Company's profitability. However, pricing remained relatively stable during
1996. See "Customers and Payors-Average Revenue per Requisition Trends."
The Company believes that the following factors, among others, are often
used by health care providers in selecting a laboratory: (i) pricing of the
laboratory's testing services; (ii) accuracy, timeliness and consistency in
reporting test results; (iii) number and type of tests performed; (iv) service
capability and convenience offered by the laboratory; and (v) its reputation in
the medical community. The Company believes that it competes favorably with its
principal competitors in each of these areas and is currently implementing
strategies to improve its competitive position. See "Business Strategy."
The Company believes that consolidation will continue in the clinical
laboratory testing business. In addition, the Company believes that it and the
other large independent clinical laboratory testing companies will be able to
increase their share of the overall clinical laboratory testing market due to a
number of external factors including cost efficiencies afforded by large-scale
automated testing, Medicare reimbursement reductions and the growth of
12
managed health care entities which require low-cost testing services and large
service networks.* In addition, legal restrictions on physician referrals and
the ownership of laboratories as well as increased regulation of laboratories
are expected to contribute to the continuing consolidation of the industry.
Quality Assurance
The Company maintains a comprehensive quality assurance program for all of
its laboratories and patient service centers. The goal is to ensure optimal
patient care by continually improving the processes used for collection, storage
and transportation of patient specimens, as well as the precision and accuracy
of analysis and result reporting.
The Company's quality assurance efforts focus on proficiency testing,
process audits, statistical process control, credentialing and personnel
training.
Internal Quality Control and Audits. Quality control samples are processed
in parallel with the analysis of patient specimens. The results of tests on such
samples are then monitored to identify drift, shift or imprecision in the
analytical processes. In addition, the Company administers an extensive internal
program of "blind" proficiency testing. These samples are processed and reported
through the Company's systems as routine patient samples, unknown to the
laboratory as quality control samples. This provides a system to assure accuracy
of the entire pre- and post-analytical testing process. Another element of the
Company's comprehensive quality assurance program includes performance of
internal process audits.
External Proficiency Testing and Accreditation. All of the Company's
laboratories participate in numerous externally conducted, blind sample quality
surveillance programs. These include proficiency testing programs administered
by the College of American Pathologists ("CAP"), as well as many state agencies.
These programs supplement all other quality assurance procedures.
All of the Company's laboratories are accredited by CAP. Accreditation
includes on-site inspections and participation in the CAP Proficiency Test
Program. CAP is an independent nongovernmental organization of board certified
pathologists that offers an accreditation program to which laboratories may
voluntarily subscribe. CAP is approved by the Health Care Financing
Administration ("HCFA") to inspect clinical laboratories to determine compliance
with the standards required by the Clinical Laboratory Improvement Amendments of
1988 ("CLIA").
Regulation and Reimbursement
Overview. The clinical laboratory industry is subject to significant
governmental regulation at the federal and state levels. All of the Company's
laboratories and patient service centers are appropriately licensed and
accredited by various state and federal agencies.
The health care industry is undergoing significant change as third-party
payors, such as Medicare (which principally serves patients 65 and older),
Medicaid (which principally serves indigent patients), private insurers and
large employers increase their efforts to control the cost, utilization and
delivery of health care services. In an effort to address the problem of
increasing health care costs, legislation has been proposed or enacted at both
the federal and state levels to regulate health care delivery in general and
clinical laboratories in particular. Some of the proposals include managed
competition, global budgeting and price controls. Although the Clinton
Administration's health care reform proposal, initially advanced in 1994, was
not enacted, such proposal or other proposals may be considered in the future.
In particular, the Company believes that reductions in reimbursement for
Medicare services may continue to be implemented from time to time. Reductions
in the reimbursement rates of other third-party payors are likely to occur as
well. The Company cannot predict the effect health care reform, if enacted,
would have on its business, and there can be no assurance that such reforms, if
enacted, would not have a material adverse effect on the Company's business and
operations.
Regulation of Clinical Laboratory Operations. CLIA extends federal
oversight to virtually all clinical laboratories by requiring that laboratories
be certified by the government. Many clinical laboratories must also meet
- --------------
* This is a forward looking statement and is based on current expectations.
Actual results may vary materially from those projected. See "Cautionary
Statement for Purposes of the 'Safe Harbor' Provisions of the Private
Securities Litigation Reform Act of 1995." In particular see factors (j) and
(k).
13
governmental quality and personnel standards, undergo proficiency testing and be
subject to biennial inspection. Rather than focusing on location, size or type
of laboratory, this extended oversight is based on the complexity of the tests
performed by the laboratory.
The CLIA standards were designed to ensure that all clinical laboratory
testing services are uniformly accurate and of high quality by using a single
set of requirements. The final rules implementing CLIA generally became
effective in 1992. These regulations extended federal oversight, with few
exceptions, to virtually all clinical laboratories regardless of size, type,
location or ownership of the laboratory. The standards for laboratory personnel,
quality control, quality assurance and patient test management are based on
complexity and risk factors. Laboratories categorized as "high" complexity are
required to meet more stringent requirements than either "moderate" or "waived"
(performing only tests regarded as having a low potential for error and
requiring little or no oversight) laboratories.
All of the Company's regional and branch laboratories and most of the
Company's STAT laboratories are categorized as high complexity and these
laboratories are in compliance with the more stringent standards for personnel,
quality control, quality assurance and patient test management. A few of the
Company's laboratories are categorized as moderate complexity (some STAT
laboratories) or waived (only patient service centers). The sanction for failure
to comply with these regulations may be suspension, revocation or limitation of
a laboratory's CLIA certificate necessary to conduct business, significant fines
or criminal penalties. The loss of a license, imposition of a fine or future
changes in such federal, state and local laws and regulations (or in the
interpretation of current laws and regulations) could have a material adverse
effect on the Company.
The Company is also subject to state regulation. CLIA permits states to
adopt regulations that are more stringent than federal law. For example, state
law may require that laboratory personnel meet certain more stringent
qualifications, specify certain quality control standards, maintain certain
records and undergo additional proficiency testing. For example, certain of the
Company's laboratories are subject to the State of New York's clinical
laboratory regulations, which contain certain provisions that are significantly
more stringent than federal law on the same matters.
The Company believes it is in material compliance with the foregoing
standards. See "Compliance Program."
Drug Testing. Drug testing for public sector employees is regulated by the
Substance Abuse and Mental Health Services Administration ("SAMHSA") (formerly
the National Institute on Drug Abuse), which has established detailed
performance and quality standards that laboratories must meet in order to be
approved to perform drug testing on employees of federal government contractors
and certain other entities. To the extent that the Company's laboratories
perform such testing, each must be certified by the Department of Health and
Human Services ("HHS") as meeting SAMHSA standards. Seven of the Company's
laboratories are SAMHSA certified.
Controlled Substances. The use of controlled substances in testing for drug
abuse is regulated by the federal Drug Enforcement Administration ("DEA"). All
of the Company's laboratories using controlled substances for testing purposes
are licensed by the DEA.
Medical Wastes and Radioactive Materials. The Company is subject to
licensing and regulation under federal, state and local laws relating to the
handling and disposal of medical specimens and hazardous waste and radioactive
materials as well as to the safety and health of laboratory employees. All of
the Company's laboratories are operated in material compliance with applicable
federal and state laws and regulations relating to disposal of all laboratory
specimens. The Company utilizes outside vendors for disposal of specimens.
Although the Company believes that it is currently in compliance in all material
respects with such federal, state and local laws, failure to comply could
subject the Company to denial of the right to conduct business, fines, criminal
penalties and other enforcement actions.
Occupational Safety. In addition to its comprehensive regulation of safety
in the workplace, the federal Occupational Safety and Health Administration
("OSHA") has established extensive requirements relating to workplace safety for
health care employers, including clinical laboratories, whose workers may be
exposed to blood- borne pathogens such as HIV and the hepatitis B virus. These
regulations, among other things, require work practice controls, protective
clothing and equipment, training, medical follow-up, vaccinations and other
measures designed to minimize exposure to chemicals and transmission of
blood-borne and airborne pathogens.
Specimen Transportation. Regulations of the Department of Transportation,
the Public Health Service and the Postal Service apply to the surface and air
transportation of clinical laboratory specimens.
14
Regulation of Reimbursement for Clinical Laboratory Services. Containment
of health care costs, including reimbursement for clinical laboratory services,
has been a focus of ongoing governmental activity. In 1984, Congress established
a Medicare fee schedule for clinical laboratory services performed for patients
covered under Part B of the Medicare program. Subsequently, Congress imposed a
national ceiling on the amount that would be paid under the Medicare fee
schedule. Laboratories must bill the program directly and must accept the
scheduled amount as payment in full for most tests performed on behalf of
Medicare beneficiaries. In addition, state Medicaid programs are prohibited from
paying more (and in most instances, pay significantly less) than the Medicare
fee schedule for clinical laboratory testing services furnished to Medicaid
recipients. In 1996, the Company derived approximately 18% and 3% of its net
revenues from tests performed for beneficiaries of Medicare and Medicaid
programs, respectively. In addition, the Company's other business depends
significantly on continued participation in these programs because clients often
want a single laboratory to perform all of their clinical laboratory testing
services. Since 1984, Congress has periodically reduced the ceilings on Medicare
reimbursement to clinical laboratories from previously authorized levels. In
1993, pursuant to the Omnibus Budget and Reconciliation Act of 1993 ("OBRA
'93"), Congress reduced, effective January 1, 1994, the Medicare national fee
schedule limitations from 88% of the 1984 national median to 76% of the 1984
national median, which reductions were phased in from 1994 through 1996 (to 84%
on January 1, 1994, to 80% on January 1, 1995 and to 76% on January 1, 1996, in
each case as a percentage of the 1984 national median). OBRA '93 also eliminated
the provision for annual fee schedule increases based upon the consumer price
index for 1994 and 1995 (but not for 1996 and 1997). Medicare reimbursement
reductions have a direct adverse effect on the Company's net earnings and cash
flows. The Company cannot predict if additional Medicare reductions will be
implemented. The Senate and House Medicare proposal (the Medicare Preservation
Act of 1995) passed in October 1995 would have reduced the national limitation
to 65% beginning in 1997 and would have eliminated all annual consumer price
index adjustments through 2002. This reduction in laboratory reimbursement rates
was retained in the House-Senate conference report agreed upon in November 1995.
The President vetoed this bill in December 1995. The President's budget proposal
for fiscal 1998 does not provide for any changes in the national fee schedule
limitations or any change in the annual fee schedule increases based on the
consumer price index.
Effective January 1, 1996, HCFA adopted a new policy on reimbursement for
chemistry panel tests. As of January 1, 1996, 22 automated tests (rather than 19
tests) became reimbursable by Medicare as part of an automated chemistry
profile. An additional allowance of $0.50 per test is authorized when more than
19 tests are billed in a panel. HCFA retains the authority to expand in the
future the list of tests included in automated chemistry profile. The
President's budget proposal for fiscal 1998 proposes an increase (above the
current 22) in the number of tests that would be included in the automated
chemistry profile. Effective as of March 1, 1996, HCFA eliminated its prior
policy of permitting payment for all tests contained in an automated chemistry
panel when at least one of the tests in the panel is medically necessary. Under
the new policy, Medicare payment will not exceed the amount that would be
payable if only the tests that are "medically necessary" had been ordered. In
addition, since 1995 most Medicare carriers have begun to require clinical
laboratories to submit documentation supporting the medical necessity, as judged
by ordering physicians, for many commonly ordered tests. The Company expects to
incur additional reimbursement reductions and additional costs associated with
the implementation of these requirements of HCFA and Medicare carriers. The
amount of the reductions in reimbursements and additional costs cannot be
determined at this time. See "Billing." These and other proposed changes
affecting the reimbursement policy of Medicare and Medicaid programs could have
a material adverse effect on the Company.
Major clinical laboratories, including the Company, use dual fee schedules:
"client" fees charged to physicians, hospitals, and institutions with which a
laboratory deals on a wholesale basis, which fees are generally subject to
negotiation or discount, and "patient" fees charged to individual patients and
third-party payors, including Medicare and Medicaid, who generally require
separate bills or claims for each requisition. Medicare and other third party
payors also set maximum fees that they will pay which are substantially lower
than the patient fees otherwise charged by the Company, but are generally higher
than the Company's fees actually charged to clients. Federal and some state
regulatory programs prohibit clinical laboratories from charging government
programs more than certain charges to other customers. During 1992, in issuing
final regulations implementing the federal statutory prohibition against
charging Medicare substantially in excess of a provider's usual charge, the OIG
declined to provide any guidance concerning the interpretation of this
legislation, including whether or not discounting or the dual fee structure
employed by clinical laboratories might be inconsistent with the provision.
Medicare budget proposals developed by the Clinton Administration in 1993
and 1994, along with proposals incorporated in many major health reform bills
considered by Congress in 1994, called for the reinstatement of
15
20% Medicare clinical laboratory co-insurance (which was last in effect in
1984). While co-insurance was in effect, clinical laboratories received from
Medicare carriers only 80% of their Medicare reimbursement rates and were
required to bill Medicare beneficiaries for the balance of the charges. A
co-insurance proposal was not included in any of the Congressional Medicare
reform packages considered in the 1995 and 1996 legislative sessions. However,
it is still possible a co-insurance provision will be proposed in the future
and, if enacted, such a proposal could materially adversely affect the revenues
and costs of the clinical laboratory industry, including the Company, by
exposing the testing laboratory to the credit of individuals and by increasing
the number of bills. In addition, a laboratory could be subject to potential
fraud and abuse violations if adequate procedures to bill and collect the
co-insurance payments are not established and followed.
Proposals have also been developed to procure Medicare and Medicaid
laboratory testing services through competitive bidding mechanisms. To date,
none of the Congressional Medicare reform packages introduced in the 1995 or
1996 legislative sessions have included a competitive bidding provision for
clinical laboratory tests. However, President Clinton's budget for fiscal 1998
(as did his prior Medicare reform proposal) proposed the establishment of
competitive bidding for clinical laboratory services. If competitive bidding
were implemented, such action could materially adversely affect the clinical
laboratory industry, including the Company. HCFA is currently conducting a
demonstration project to determine whether competitive bidding can be used to
provide quality laboratory services at prices below current Medicare
reimbursement rates. The bidding phase of the demonstration is expected to begin
in 1997.
Future changes in federal, state and local regulations (or in the
interpretation of current regulations) affecting governmental reimbursement for
clinical laboratory testing could have a material adverse effect on the Company.
The Company is unable to predict, however, whether and what type of legislation
will be enacted into law.
Fraud and Abuse Regulations. The Medicare and Medicaid anti-kickback laws
prohibit clinical laboratories from, among other things, making payments or
furnishing other benefits to influence the referral of tests billed to Medicare,
Medicaid or other federal programs. Penalties for violations of these federal
laws include exclusion from participation in the Medicare/Medicaid programs,
assets forfeitures, and civil and criminal penalties and fines. Under the Health
Insurance Portability and Accountability Act of 1996 (the "Health Insurance
Act"), on January 1, 1997 civil administrative penalties for a wide range of
offenses were increased to up to $10,000 per item plus three times the amount
claimed. In the case of certain criminal offenses, exclusion from participation
in Medicare and Medicaid is a mandatory penalty.
The fraud and abuse provisions are interpreted liberally and enforced
aggressively by various enforcing agencies of the federal government, including
the Federal Bureau of Investigation ("FBI") and the Office of the Inspector
General of HHS ("OIG"). According to public statements by the Department of
Justice ("DOJ"), health care fraud has been elevated to the second-highest
priority of the DOJ, and FBI agents have been transferred from investigating
counterintelligence activities to health care provider fraud. The OIG also is
involved in such investigations and has, according to recent workplans, targeted
certain laboratory practices for study, investigation and prosecution. The
federal government's involvement in curtailing fraud and abuse is likely to
increase as a result of the enactment in August 1996 of the Health Insurance Act
which requires the U.S. Attorney General and the OIG to jointly establish a
program to (a) coordinate federal, state and local enforcement programs to
control fraud and abuse with respect to health care, (b) conduct investigations,
audits, evaluations and inspections relating to the delivery and payment for
health care, (c) facilitate the enforcement of the health care fraud and abuse
laws, (d) provide for the modification and establishment of safe harbors and to
issue advisory opinions and Special Fraud Alerts and (e) provide for a data
collection system for the reporting and disclosure of adverse actions taken
against health care providers. The Health Insurance Act also authorizes the
establishment of an anti-fraud and abuse account funded through the collection
of penalties and fines for violations of the health care anti-fraud laws as well
as amounts authorized therefor by Congress. The Health Insurance Act also
requires HHS to establish a program to encourage Medicare beneficiaries and
others to report violations of the health care anti-fraud laws, including paying
to the reporting person a portion of any fines and penalties collected.
In October 1994, the OIG issued a Special Fraud Alert, which set forth a
number of practices allegedly engaged in by clinical laboratories and health
care providers that the OIG believes violate the anti-kickback laws. These
practices include providing employees to collect patient samples at physician
offices if the employees perform additional services for physicians that are
typically the responsibility of the physicians' staff; selling laboratory
services to renal dialysis centers at prices that are below fair market value in
return for referrals of Medicare tests
16
which are billed to Medicare at higher rates; providing free testing to a
physician's HMO patients in situations where the referring physicians benefit
from lower utilization; providing free pickup and disposal of bio-hazardous
waste for physicians for items unrelated to a laboratory's testing services;
providing facsimile machines or computers to physicians that are not exclusively
used in connection with the laboratory services performed; and providing free
testing for health care providers, their families and their employees
(professional courtesy testing). The OIG stressed in the Special Fraud Alert
that when one purpose of an arrangement is to induce referral of
program-reimbursed laboratory testing, both the clinical laboratory and the
health care provider or physician may be liable under the anti-kickback laws and
may be subject to criminal prosecution and exclusion from participation in the
Medicare and Medicaid programs. The Special Fraud Alert was issued in part at
the request of the American Clinical Laboratory Association ("ACLA"), which
sought clarification of certain of these rules. The Company does not believe
that it has been negatively affected by the issuance of the Special Fraud Alert.
Many of these statutes and regulations, including those relating to joint
ventures and alliances, are vague or indefinite and have not been interpreted by
the courts. In addition, regulators have generally offered little guidance to
the clinical laboratory industry. Despite several requests from ACLA for
clarification of the anti-fraud and abuse rules, since 1992, OIG has issued only
two fraud alerts specifically with regard to clinical laboratory practices and
has insisted that it lacked statutory authority to issue advisory opinions.
Legislation requiring OIG to issue fraud alerts and advisory opinions was
enacted in August 1996, and as a result the Company is hopeful that additional
regulatory guidance will be given to the clinical laboratory industry.
A federal anti- "self-referral" law commonly known as the "Stark" law has,
since 1992, generally prohibited (with certain exceptions) Medicare payments for
laboratory tests referred by physicians who have (personally or through a family
member) an investment interest in, or a compensation arrangement with, the
testing laboratory. Since January 1995, these restrictions apply to
Medicaid-covered services as well. Physicians may, however, be reimbursed by
Medicare and Medicaid for testing performed by or under the supervision of the
physician or the group practice to which the physician belongs. In addition, a
physician may refer specimens to a laboratory owned by a company, such as the
Company, whose stock is traded on a public exchange and which has stockholders'
equity exceeding $75 million even if the physician owns stock of that company.
An amendment to the Stark law in August 1993 makes it clear that ordinary
day-to-day transactions between laboratories and their customers, including, but
not limited to, discounts granted by laboratories to their customers, are not
covered by the compensation arrangement provisions of the Medicare statute.
Sanctions for laboratory violations of the prohibition include denial of
Medicare payments, refunds, civil money penalties of up to $15,000 for each
service billed in violation of the prohibition and exclusion from the Medicare
and Medicaid programs.
The 1995 House Medicare reform proposal contained, and the House-Senate
report adopted, provisions that would significantly narrow the scope of the
Stark anti-referral laws. That proposal would, among other changes, have ended
the ban on physician referrals to laboratories based on any "compensation
arrangement" between the laboratory and the physician. The President vetoed this
bill on December 6, 1995.
Government Investigations and Related Claims
The Company has settled various government and private claims (i.e.,
nongovernmental claims such as those by private insurers) totaling approximately
$192 million relating primarily to industry-wide billing and marketing practices
that had been substantially discontinued by early 1993. Specifically, the
Company has entered into, (i) for an aggregate of approximately $180 million,
five settlements with the OIG and the DOJ (including the MetPath and Damon
settlements discussed below) and two settlements with state governments with
respect to Medicare and Medicaid marketing and billing practices of the Company
and certain companies acquired by the Company prior to their acquisition and
(ii) thirteen settlements relating to private claims totaling approximately $12
million. In addition, there are pending investigations by the OIG and DOJ into
billing and marketing practices at three regional laboratories operated by
Nichols prior to its acquisition by the Company. There are no other material
private claims presently pending.
Government Settlements
The MetPath Settlement. In September 1993, the Company (under the name
MetPath Inc.) entered into an agreement with the DOJ and the OIG pursuant to
which the Company paid a total of approximately $36 million in settlement of
civil claims by the United States that the Company had wrongfully induced
physicians to order
17
certain laboratory tests without their realizing that such tests would be billed
to Medicare at rates higher than those the physicians believed were applicable.
The Damon Settlement. By issuance of a civil subpoena in August 1993, the
government began a formal investigation of Damon, an independent clinical
laboratory company acquired by Corning in August 1993. Subsequent to September
1993, several additional subpoenas were issued. By a plea agreement and civil
settlement agreement and release dated October 9, 1996, between the DOJ and
Damon, all federal criminal matters within the scope of the various federal
investigations against Damon, and all claims included in the civil qui tam cases
underlying the civil investigations, were settled for an aggregate of $119
million, which sum was reimbursed to the Company by Corning. The settlement
included base recoupments of approximately $40 million and total criminal and
civil payments in excess of base recoupments of approximately $79 million. At
the time the Company began its settlement negotiations with DOJ in April 1996,
it believed it had meritorious defenses to a number of charges and claims made
by the government. Reserves established for such settlements in the second
quarter of 1996 were based on the Company's and its counsel's belief that the
merits of its factual and legal arguments would be given more weight by the
government. Certain of these positions were ultimately rejected by criminal and
civil prosecutors in the final rounds of negotiations which occurred in late
September 1996, resulting in a total settlement substantially in excess of what
had earlier been anticipated. The Damon settlement does not exclude the Company
from future participation in any federal health care programs on account of
Damon's practices. For further information regarding the Damon settlement, see
Note 15 to the Consolidated Financial Statements.
Other Governmental Settlements. In addition to the MetPath settlement and
the Damon settlement, since 1992 the Company has settled five other federal and
state billing-related claims for a total of approximately $25 million.
Ongoing Government Investigations
The Nichols Investigation. By issuance of a civil subpoena in August 1993,
the government began a formal investigation of Nichols, a company acquired by
Corning in August 1994. The investigation of Nichols remains open. While the
Company has established reserves in respect of the Nichols investigations, at
present there are no settlement discussions pending between the DOJ and the
Company regarding Nichols, and it is too early to predict the outcome of this
investigation. Remedies available to the government include exclusion from
participation in the Medicare and Medicaid programs, criminal fines, civil
recoveries plus civil penalties and asset forfeitures. However, in light of the
Corporate Integrity Agreement referred to below entered into between the Company
and the OIG in connection with the Damon settlement, the fact that the matters
being investigated were corrected with or before the Company's acquisition of
Nichols and the Company's cooperation in this investigation, the Company
believes the prospect of such exclusion on account of the investigation is
remote. Additionally, while application of such remedies and penalties could
materially and adversely affect the Company's business, financial condition,
results of operations and prospects, management believes that the possibility of
such effects is remote. As discussed below, Corning has agreed to indemnify the
Company against any monetary penalties, fines or settlements for any
governmental claims that may arise as a result of the Nichols investigations.
The Damon Officer Investigations. The Company understands that the Boston
United States Attorney's Office has designated several former officers and
employees of Damon as targets of its criminal investigation, and will seek
indictments against them. Under the agreement and plan of merger under which
Damon was acquired by Corning, the Company is obligated to indemnify former
officers and directors of Damon to the fullest extent permitted by Delaware law
with respect to this investigation. These obligations (which relate primarily to
fees and expenses of counsel) will not be indemnified by Corning. In addition,
as part of the Damon settlement, Corning agreed to cooperate with DOJ in its
continuing investigation of individuals formerly associated with Damon and, in
connection therewith, the Company is providing additional information pursuant
to several subpoenas.
Other Government Investigations. In December 1995 and December 1996, the
Company received subpoenas from the OIG seeking information as to the Company's
policies in instances in which specimens were received and tested by a
laboratory without first receiving or verifying specific test requisitions.
While compliance with the latter subpoena is ongoing, the Company has concluded
the occurrence of this practice was relatively rare and was engaged in primarily
to preserve the integrity of test results from specimens subject to rapid
deterioration. During 1996, the Company voluntarily self-reported to the
government a few isolated events, involving billings of approximately $16
million, that may have resulted in overpayment by Medicare and Medicaid to the
Company. It is the Company's policy to internally investigate all such incidents
and to self-report and reimburse payors as
18
appropriate. Although the Company has commenced internal investigations to
quantify the amounts that may be recouped by the government and corrective
action has been taken as to each such event, it is too early to predict the
outcome of these disclosures to the government. As discussed below, Corning has
agreed to indemnify the Company against any monetary penalties, fines or
settlements for any governmental claims that may arise as a result of the
investigations described in this paragraph.
Outlook for Future Government Investigations
The Damon settlement involved, and a settlement regarding Nichols is
expected to involve, only matters predating Corning's acquisition of both such
companies, and turned on, or will turn on, facts unique to those companies and
other factors individual government enforcement personnel may take into account.
However, recent experience in the Company's settlement of the Damon case and
public announcements by various government officials indicate that the
government's position on health care fraud is still hardening and collections of
amounts greatly in excess of mere recoupment of overcharges from laboratories
and other providers will be more prevalent. In addition, the newly adopted
Health Insurance Act includes provisions relating to health care fraud and abuse
that will give federal enforcement personnel substantially increased funding,
powers and remedies to pursue suspected fraud and abuse. In connection with the
Damon settlement, the Company signed a Corporate Integrity Agreement pursuant to
which the Company will maintain its corporate compliance program, modify certain
of its marketing materials, make periodic reports to the OIG and take certain
other steps to demonstrate the Company's integrity as a provider of services to
federally sponsored health care programs. This agreement also includes an
obligation to self-report instances of noncompliance that are uncovered by the
Company, but also gives the Company the opportunity to obtain clearer guidance
on matters of compliance and to resolve compliance issues directly with OIG.
Importantly, the agreement gives the Company the opportunity to cure any
asserted breaches and to otherwise initiate corrective actions, which the
Company believes should help to avoid enforcement actions outside of the process
provided in the agreement. See "Compliance Program."
Private Settlements and Claims
Since 1992 the Company has settled thirteen private actions relating to the
governmental settlements described above for an aggregate of approximately $12
million.
Corning Indemnity
In connection with the Spin-Off Distribution, Corning has agreed to
indemnify the Company against all monetary penalties, fines or settlements for
any governmental claims arising out of alleged violations of applicable federal
fraud and health care statutes and relating to billing practices of the Company
and its predecessors that have been settled or are pending on December 31, 1996,
when the Spin-Off Distribution was completed. This includes the settlements
described under "Government Settlements" above and the claims described under
"Ongoing Government Investigations-The Nichols Investigation" and "-Other
Government Investigations." Corning has also agreed to indemnify the Company for
50% of the aggregate of all judgment or settlement payments made by the Company
that are in excess of $42 million in respect of claims by private parties (i.e.,
nongovernmental parties such as private insurers) that relate to indemnified or
previously settled governmental claims (such as the Damon settlement) and that
alleged overbillings by the Company or any existing subsidiaries of the Company,
for services provided prior to January 1, 1997; provided, however, such
indemnification will not exceed $25 million in the aggregate and that all
amounts indemnified against by Corning for the benefit of the Company will be
calculated on a net after-tax basis by taking into account any deductions and
other tax benefits realized by the Company (or a consolidated group of which the
Company is a member after Spin-Off Distribution ("the Company Group")) in
respect of the underlying settlement, judgment payment, or other loss (or
portion thereof) indemnified against by Corning generally to the extent such
deductions or tax benefits are deemed to reduce the tax liability of the Company
or the Company Group.
Corning will not indemnify the Company against (i) any governmental claims
that arise after December 31, 1996 pursuant to service of subpoena or other
notice of such investigation after December 31, 1996, (ii) any nongovernmental
claims unrelated to the indemnified governmental claims or investigations, (iii)
any nongovernmental claims not settled prior to December 31, 2001, (iv) any
consequential or incidental damages relating to the billing claims, including
losses of revenues and profits as a consequence of exclusion for participation
19
in federal or state health care programs or (v) the fees and expenses of
litigation. The Company will control the defense of any governmental claim or
investigation unless Corning elects to assume such defense. However, in the case
of all nongovernmental claims related to indemnified governmental claims related
to alleged overbillings, the Company will control the defense. All disputes
relating to the Corning indemnification agreement are subject to binding
arbitration.
The Company's Reserves
The Company's aggregate reserve with respect to all governmental and
private claims, including litigation costs of approximately $4.3 million, was
approximately $81 million at December 31, 1996. This reserve represents amounts
for future government and private settlements of matters which are either
presently pending or anticipated as a consequence of the government and private
settlements and self-reported matters described above. Based on information
available to management and the Company's experience with past settlements,
especially the Damon settlement, and the fact that the aggregate amount of such
settlement was significantly in excess of established reserves, management has
reassessed its reserve levels and believes that its current level of reserves is
adequate. However, it is possible that additional information may become
available (such as the indication by the government of criminal activity,
additional tests being questioned or other changes in the government's theories
of wrongdoing) which may cause the final resolution of these matters to be in
excess of established reserves by an amount which could be material to the
Company's results of operations and, for non-indemnified claims, the Company's
cash flows in the period in which such claims are settled. While none of the
current governmental or nongovernmental investigations or claims is covered by
insurance, the Company does not believe that these matters will have a material
adverse effect on the Company's overall financial condition.
Compliance Program
Because of evolving interpretations of regulations and the national debate
over health care, compliance with all Medicare, Medicaid and other
government-established rules and regulations has become a significant concern
throughout the clinical laboratory industry. The Company began the
implementation of a compliance program early in 1993. The objective of the
program is to develop aggressive and reliable compliance safeguards. Emphasis is
placed on developing training programs for personnel intended to assure the
strict implementation and observance of all applicable rules and regulations.
Further, in-depth reviews of procedures, personnel and facilities are conducted
to assure regulatory compliance throughout the Company. The Company's current
compliance plan establishes a Compliance Committee of the Board of Directors and
requires periodic reporting of compliance operations by management to the
Compliance Committee. Such sharpened focus on regulatory standards and
procedures will continue to be a priority for the Company in the future.
The Company's current comprehensive program is designed to ensure that it
is in compliance in all material respects with all statutes, regulations and
other requirements applicable to its clinical laboratory operations. This
program has been publicly cited by government officials as a "model" for the
industry. In addition, the government advised the Company's representatives that
the Company's compliance program, coupled with corrective action taken by the
Company after its acquisition of Damon, greatly reduced the amounts of fines and
penalties, and was influential in causing the OIG not to seek exclusion of the
Company from future participation in governmental health care programs. Pursuant
to the Damon settlement, the Company signed a five year Corporate Integrity
Agreement with the OIG pursuant to which the Company will, among other things,
maintain its corporate compliance program, make certain changes to its test
order forms, provide certain additional notices to ordering physicians, provide
to the OIG data on certain test ordering patterns, adopt certain pricing
guidelines, audit laboratory operations, deliver annual reports on compliance
activities, and investigate and report instances of noncompliance, including any
corrective actions and disciplinary steps. Importantly, the agreement gives the
Company the opportunity to cure any asserted breaches and to otherwise initiate
corrective actions, which the Company believes should help to avoid enforcement
actions outside of the process provided in the agreement. The agreement gives
the Company the opportunity to obtain clearer guidance on matters of compliance
and to resolve compliance issues directly with the OIG. LabCorp and SmithKline
have executed similar agreements with the OIG. The OIG recently published a
guideline on the essential elements of a satisfactory compliance program for the
entire clinical laboratory industry, including hospital laboratories. This
guideline is similar to the Company's compliance program, and it is believed
that this development may help create a fairer competitive environment for the
Company.
None of the undertakings included in the Company's Corporate Integrity
Agreement or in the recently published guideline is expected to have any
material adverse affect on the Company's business, financial condition,
20
results of operations and prospects. The clinical laboratory testing industry
is, however, subject to extensive regulation. The Company believes that, in all
material respects, it is in compliance with all applicable statutes and
regulations. However, there can be no assurance that any statutes or regulations
might not be interpreted or applied by a prosecutorial, regulatory or judicial
authority in a manner that would adversely affect the Company. Potential
sanctions for violation of these statutes and regulations include significant
fines and the loss of various licenses, certificates and authorizations.
Insurance
The Company maintains liability insurance (subject to maximum limits and
self-insured retentions) for claims, which may be substantial, that could result
from providing or failing to provide clinical laboratory testing services,
including inaccurate testing results. While there can be no assurance that
coverage will be adequate to cover all future exposure, management believes that
the present levels of insurance coverage and reserves are adequate to cover
currently estimated exposures. Although the Company believes that it will be
able to obtain adequate insurance coverage in the future at acceptable costs,
there can be no assurance that the Company will be able to obtain such coverage
or will be able to do so at an acceptable cost or that the Company will not
incur significant liabilities in excess of policy limits.
Employees
At February 28, 1997, the Company employed approximately 17,800 people.
These include approximately 15,600 full-time employees and approximately 2,200
part-time employees. The Company has no collective bargaining agreements with
any unions and believes that its overall relations with its employees are good.
Seasonality
During the summer months, year-end holiday periods and other major
holidays, volume of testing declines, reducing net revenues and resulting cash
flows below annual averages during such periods. Winter months are also subject
to declines in testing volume due to inclement weather. As a result, comparisons
of the results of successive quarters may not accurately reflect trends or
results for the full year. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations-Overview."
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995
The Private Securities Litigation Reform Act of 1995 ("Litigation Reform
Act") provides a new "safe harbor" for forward-looking statements to encourage
companies to provide prospective information about their companies without fear
of litigation so long as those statements are identified as forward-looking and
are accompanied by meaningful cautionary statements identifying important
factors that could cause actual results to differ materially from those
projected in the statement. The Company desires to take advantage of the new
"safe harbor" provisions of the Litigation Reform Act in connection with the
information included herein and is including this section in order to do so.
Accordingly, the Company hereby identifies the following important factors that
could cause the Company's actual financial results to differ materially from
those projected, forecast or estimated by the Company in forward-looking
statements.
The Company wishes to caution investors that the following factors are
hereby identified as potentially important factors that could cause the
Company's actual financial results to differ materially from those projected,
forecast or estimated by the Company in forward-looking statements.
(a) Heightened competition, including the intensification of price
competition. See "Competition."
(b) Impact of changes in payor mix, including the shift from traditional,
fee-for-service medicine to managed-cost health care. See "Role of
Managed Care."
(c) Adverse actions by governmental or other third-party payors, including
unilateral reduction of fee schedules payable to the Company. See
"Regulation and Reimbursement-Regulation of Reimbursement for Clinical
Laboratory Services."
21
(d) The impact upon the Company's collection rates or general or
administrative expenses resulting from compliance with Medicare
administrative policies, including specifically the recent requirements
of Medicare carriers to provide diagnosis codes for commonly ordered
tests and the policy of HCFA to limit Medicare reimbursement for tests
contained in automated chemistry panels to the amount that would have
been paid if only the covered tests, determined on the basis of
demonstrable "medical necessity," had been ordered. See "Regulation and
Reimbursement-Regulation of Reimbursement for Clinical Laboratory
Services."
(e) Adverse results from pending governmental investigations, including in
particular significant monetary damages and/or exclusion from the
Medicare and Medicaid programs and/or other significant litigation
matters. Also, the absence of indemnification from Corning for private
claims unrelated to the indemnified governmental claims or investigations
and for private claims that are not settled within five years of the
Distribution Date. See "Government Investigations and Related Claims."
(f) Failure to obtain new customers at profitable pricing, failure to retain
existing customers or reduction in tests ordered or specimens submitted
by existing customers.
(g) Inability to obtain professional liability insurance coverage or a
material increase in premiums for such coverage. See "Insurance."
(h) Denial of CLIA certification or other licensure of any of the Company's
clinical laboratories under CLIA, by HCFA for Medicare and Medicaid
programs or other federal, state and local agencies. See "Regulation and
Reimbursement".
(i) Adverse publicity and news coverage about the Company or the clinical
laboratory industry.
(j) Computer or other system failures that affect the ability of the Company
to perform tests, report test results or properly bill customers. See
"Billing."
(k) Development of technologies that substantially alter the practice of
laboratory medicine.
(l) Changes in interest rates causing a substantial increase in the Company's
effective borrowing rate.
Item 2. Properties
The Company's principal laboratories (listed alphabetically by state) are
located in the following metropolitan areas:
Location Type of Laboratory Leased or Owned
- ------------------------------------------------ ---------------------- ------------------------
Phoenix, Arizona ............................ Regional Leased
San Diego, California ......................... Regional Leased
San Juan Capistrano, California ............. Esoteric Owned
Denver, Colorado ............................ Regional Leased
New Haven, Connecticut ...................... Regional Owned
Miami, Florida ............................... Branch Leased
Tampa, Florida ............................... Regional Leased
Atlanta, Georgia ............................ Regional Leased
Chicago, Illinois ............................ Regional Leased
Indianapolis, Indiana ......................... Branch Leased
Baltimore, Maryland ......................... Regional Owned
Boston, Massachusetts ......................... Regional Owned subject to put/call
with option to lease
Detroit, Michigan ............................ Regional Leased
Grand Rapids, Michigan ...................... Branch Leased
Kansas City, Missouri ......................... Branch Leased
St. Louis, Missouri ......................... Regional Leased
Billings, Montana ............................ Branch Leased
Lincoln, Nebraska ............................ Regional Managed (hospital)
Teterboro, New Jersey(near New York City) .... Regional Owned
22
Location Type of Laboratory Leased or Owned
- ----------------------------------------------- ------------------------ --------------------------
Albuquerque, New Mexico ..................... Branch Leased
Buffalo, New York ........................... Branch Owned
Long Island, New York ........................ Branch Leased
Cleveland, Ohio .............................. Branch Owned
Columbus, Ohio .............................. Branch Leased
Portland, Oregon ........................... Regional Leased
Erie, Pennsylvania ........................... Branch Leased by joint venture
Philadelphia, Pennsylvania .................. Regional Leased
Pittsburgh, Pennsylvania ..................... Regional Leased
Nashville, Tennessee ........................ Branch Owned
Dallas, Texas .............................. Regional Leased
El Paso, Texas .............................. Branch Leased
Salt Lake City, Utah ........................ Branch Leased
The Company's executive offices are located in Teterboro, New Jersey in the
building that serves as the Company's regional laboratory in the New York City
metropolitan area. The Company owns its branch laboratory facility in Mexico
City. The Company believes that, in general, its laboratory facilities are
suitable and adequate for its current and anticipated future levels of
operation. The Company believes that if it were unable to renew the lease on any
of its testing facilities, it could find alternative space at competitive market
rates and relocate its operations to such new locations.
Item 3. Legal Proceedings
In addition to the investigations described in "Government Investigations
and Related Claims," the Company is involved in various legal proceedings
arising in the ordinary course of business. Some of the proceedings against the
Company involve claims that are substantial in amount. Although it is not
feasible to predict the outcome of such proceedings or any claims made against
the Company, it does not anticipate that the ultimate liability of such
proceedings or claims will have a material adverse effect on the Company's
financial position or results of operations as they primarily relate to
professional liability for which the Company believes it has adequate insurance
coverage. See "Business-Insurance."
Item 4. Submission of Matters to a Vote of Security Holders
On December 31, 1996, prior to the consummation of the Spin-Off
Distribution, an annual meeting of stockholders was held at which Corning, the
then sole stockholder of the Company, was present. The record date for the
meeting was December 20, 1996, at which time there were issued and outstanding
400,000 shares of common sto