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Securities and Exchange Commission Washington, DC 20549
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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, 1997
Commission file number 1-12215
QUEST DIAGNOSTICS INCORPORATED
One Malcolm Avenue. Teterboro, New Jersey 07608
201.393.5000
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Delaware 16-1387862
(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
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Common Stock
with attached Preferred Share Purchase Right New York Stock Exchange
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10.75% Senior Subordinated Notes due
2006 New York Stock Exchange
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Securities registered pursuant to
Section 12(g) of the Act: None
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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. _X_ Yes ___ No
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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 February 24, 1998, the aggregate market value of the voting and
non-voting common equity held by non-affiliates of the registrant was
approximately $464 million, based on the closing price on such date of the
Company's Common Stock on the New York Stock Exchange.
As of February 24, 1998, there were outstanding 30,130,081 shares of Common
Stock, $.01 par value.
Documents Incorporated by Reference
Part of Form 10-K
Document into which incorporated
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Portions of the Registrant's
Proxy Statement to be filed by
April 30, 1998 ............... Part III
Such Proxy Statement, except for portions thereof which have been specifically
incorporated by reference, shall not be deemed "filed" as part of this report
on Form 10-K.
[LOGO OF QUEST DIAGNOSTICS]
PART I
Item 1. Business
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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 54 million requisitions for testing 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. that was previously a
subsidiary of the Company), 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 15 regional laboratories across the United States
and an esoteric testing laboratory and research and development facility
(Nichols Institute) located in San Juan Capistrano, California. In addition,
the Company has several smaller branch laboratories, including one located in
Mexico City, Mexico; approximately 150 stat laboratories; and approximately 800
patient service centers located throughout the United States. A substantial
portion of this growth has resulted from acquisitions. During the fourth
quarter of 1997, the Company decided to downsize several of its laboratories
and transfer testing currently performed at these laboratories to other
laboratories of the Company. These consolidation activities are expected to be
complete by the end of 1998. See "Acquisitions and Consolidations."
The principal executive offices of the Company are located at One Malcolm
Avenue, Teterboro, New Jersey 07608, telephone number: (201) 393-5000.
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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.
o Highest Quality Provider. The Company strives to achieve superior customer
satisfaction by being viewed as the highest quality provider of accurate and
timely test results and related services. Customer perceptions are measured
by means of extensive quarterly satisfaction surveys. A comprehensive Total
Quality Management System operates within each regional laboratory and is led
by the business unit leader. All Company employees attend quality awareness
training where they are taught quality principles. Programs aimed at ensuring
quality control and quality assurance are augmented by efforts to identify
and eliminate errors. Error rates are generally reported in parts per million
with aggressive goals set and progress monitored. Results are improved
primarily through the use of process improvement techniques, training and the
implementation of identified best practices. The Company believes that these
initiatives will allow the Company to improve the overall quality of its
clinical testing services while at the same time lowering costs.
Historically, the Company's experience verifies this relationship between
quality and costs. All of the Company's laboratories are accredited by the
College of American Pathologists.
o Lowest Cost Provider. Currently, approximately 39% of the Company's net
revenues are from laboratories that the Company believes are among the
lowest-cost providers in their respective markets. Management believes that
these laboratories are among the lowest-cost providers in their respective
markets based on
Quest Diagnostics Incorporated: 1997 Form 10-K
1
its knowledge of such markets and information obtained in acquiring other
laboratories. Currently, the Company's average cost per requisition varies
significantly among its 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, are
part of this strategy. The Company estimates that it reduced clinical
operating costs by approximately $60 million during 1997 principally due to
these efforts (approximately 25% of such $60 million reduction was due to
reduced volume). The Company expects to achieve significant additional cost
savings during 1998 and 1999 as these programs are fully implemented.*
Despite these efforts, the average cost per requisition increased during
1997 due to the impact of fixed costs on a lower number of requisitions.
However, during 1998 the Company expects that these programs, together with
consolidations of several of the Company's facilities, will result in cost
reductions that exceed the revenue losses associated with any reduced
volume.*
Preferred Partner with Large Buyers. 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 market position and fit between the
Company and the prospective partners. 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 employs a national and regional process to identify
prospective customers and to efficiently allocate resources to support these
efforts. The Company also pursues innovative alliances and seeks to assist its
partners in achieving their business objectives.
o Account Profitability. The Company is refocusing its sales efforts on
pursuing and keeping only those accounts that generate an acceptable profit.
The Company is engaging in an active account management process with current
customers, including those who are providers for managed care organizations,
to evaluate their profitability and, where appropriate, to take action by
increasing pricing, changing the service levels or deselecting accounts that
cannot be serviced profitably. During 1997, the Company provided clear
pricing and service offering guidelines to its sales force and is working to
change the compensation structure of its sales staff so that compensation is
tied more closely to the profitability of (rather than revenues from) its
accounts. The first phase of the account management process, which was
targeted at the Company's smallest accounts, was completed during 1997. The
Company expects to implement the balance of the program, which is targeted at
the Company's entire base of larger accounts, by the end of 1998. Management
expects to achieve significant benefits from these programs within the next
two years, the majority of which are expected to be achieved by the end of
1998.**
o 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 two-thirds 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 regions, the Company
believes that it also is among the lowest cost providers. During the last
several years, the Company has incurred operating losses in six regional
laboratories located principally in the south and southwest. During 1997 the
Company took several steps to eliminate excess capacity in four of these
regional laboratories. See "Acquisitions and Consolidations." 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 develop and introduce new tests,
technology and services. Through its relationship with the academic community
and pharmaceutical and biotech-
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* These are forward looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 27E of the Securities Act of
1934, as amended, and are based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and
uncertainties include the impact upon the Company's revenues and expenses
resulting from compliance with Medicare administrative policies; failure to
retain existing customers including by reason of consolidation of certain
laboratories; computer or other system failures; and development of technologies
that substantially alter the practice of medicine. 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), (f), (g), (j) and (l).
** This is a forward looking statement within the meaning of Section 27A of
Securities Act of 1933, as amended, and Section 27E of the Securities Act of
1934, as amended, and is based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and
uncertainties include heightened competition; changes in payor mix; failure to
retain existing customers including by reason of consolidation of certain
laboratories; and computer or other system failures. 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 (g).
Quest Diagnostics Incorporated : 1997 Form 10-K
2
nology 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 national independent
clinical laboratory that is using molecular signal amplification (branched
DNA), polymerase chain reaction (PCR) and nucleic acid sequence-based
amplification (NASBA[TM]) 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
at San Juan Capistrano is one of the leading esoteric testing laboratories in
the world. This esoteric laboratory serves hospitals throughout the country 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.
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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 one of the first
steps in determining how a significant portion of all health care dollars are
spent. 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 the entire United States clinical laboratory industry
has revenues of approximately $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 over half
of the clinical testing in the United States is performed by
hospital-affiliated laboratories, approximately one-third is performed by
independent clinical laboratories and the balance is performed by physicians in
their offices and laboratories.
During 1997, the Company's base clinical testing volume, measured by the number
of test requisitions, declined 7% from 1996. The decline is due largely to
three factors: changes in government and private payor reimbursement policies
intended to reduce costs which have altered physician ordering patterns for
testing; intensified competition, including from hospital outreach laboratories
in several regions; and the Company's strategy of refusing to accept business
that does not meet minimum profitability objectives. The Company believes that
during 1998 clinical testing volume will continue to be negatively impacted by
these factors as well as by the Company's consolidation of several laboratories
during 1998. See "Regulation and Reimbursement-Regulation of Reimbursement for
Clinical Laboratory Services" and "Acquisitions and Consolidations."
On a long term basis, 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 and specialized tests;
(3) an increase in the awareness of physicians as well as patients of the value
of clinical laboratory testing as a cost-effective means of early detection of
disease and monitoring of treatment; (4) 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; (5) expanded
substance-abuse testing by corporations and governmental agencies; and (6)
increased testing for sexually transmitted diseases such as AIDS.
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 decreased testing volume to
clinical laboratory testing companies in the United States, although in many
cases patients are willing to pay for screening tests that are not paid for by
Medicare. Notwithstanding these factors, as a result of increased focus on
profitability of accounts (See "Busi-
Quest Diagnostics Incorporated : 1997 Form 10-K
3
ness Strategy") the Company's prices for clinical laboratory tests rose 3%
during 1997 from 1996 levels, representing the first average price increases
since 1992.
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Services
The Company's laboratory business is comprised of routine testing, which the
Company's management estimates currently generates approximately 89% of the
Company's net laboratory revenues; and esoteric testing, which is performed at
the esoteric testing facility in San Juan Capistrano, which generates
approximately 9% of the Company's net laboratory revenues. The balance of the
Company's net revenues is derived from the manufacture and sale of clinical
laboratory test kits and from its clinical trials and informatics businesses.
Routine Testing Services and Operations. Routine tests, which are performed at
the Company's regional laboratories, include procedures in the areas 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 15 regional laboratories located in major
metropolitan areas throughout the United States, as well as several branch
laboratories, approximately 150 stat laboratories and approximately 800 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 is
in the process of consolidating certain of its branch and regional
laboratories. See "Acquisitions and Consolidations."
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
week day, the Company processes approximately 200,000 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 generally accompanied by a test requisition form,
which is completed by a physician, 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 specimen processing and billing
departments 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 Institute 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. Unlike routine testing, only one test is typically
ordered and performed per requisition. The logistics for esoteric testing are
similar to those 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.
Quest Diagnostics Incorporated : 1997 Form 10-K
4
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 at 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 offers tests or "assays" in such
fields as endocrinology, genetics, immunology, microbiology, molecular biology,
oncology, serology, special chemistry and toxicology. The Company believes that
it is one of the leaders in transferring technological innovation from academic
biotechnology laboratories to the marketplace. The Company's Nichols Institute
was the first to introduce a number of 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 use of technologies such as
branched DNA, PCR and nucleic acid sequence-based amplification 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) and
resistance to drug therapy in HIV infection. 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 1997.
Diagnostic Test Kits. Through its Nichols Institute Diagnostics subsidiaries,
which were acquired as a result of the acquisition of Nichols Institute 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. Nichols Institute Diagnostics is currently awaiting
approval from the Food and Drug Administration for its first cancer diagnostic
products, which will be featured on its recently launched Nichols Advantage[TM]
automated assay system.
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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 an insurance company, Medicare or Medicaid. In several states,
including New York, New Jersey 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 client fee schedule and are typically subject to negotiation.
Otherwise, the billings are based on the laboratory's 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
Quest Diagnostics Incorporated : 1997 Form 10-K
5
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 enrolled 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 frequently being billed on
a fee-for-service basis rather than being covered under the capitation rate.
Large regional and national HMOs and preferred provider organization networks
typically prefer to use 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 provides to approximately half of the hospitals in the
country 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. Many hospitals actively encourage community
physicians to send their testing to the hospital's laboratory. In addition,
many hospitals have been purchasing physician practices and requiring that
their employed physicians send their testing to the hospital's affiliated
laboratory. Hospitals have also been seeking to expand their commercial
outreach business. As a result, hospital-affiliated laboratories can be both a
customer and a competitor for independent clinical laboratories such as the
Company. Hospitals perform over half of the clinical laboratory testing
performed in the United States.
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
and occupational medicine. The Company is expanding its capabilities so that it
can serve a broader range of employer customers.
In 1997, 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
patient or the physician "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
insurance companies and managed care organizations), 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 Revenue
as % of Total 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."
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Sales and Marketing
The Company markets and services its customers through its direct sales force,
as well as through its account representatives and 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. The Company is cur-
Quest Diagnostics Incorporated : 1997 Form 10-K
6
rently changing the compensation structure of its sales force so that
compensation is tied more closely to the profitability of (rather than revenues
from) its accounts. See "Business Strategy-Preferred Partner with Large
Buyers."
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.
The Company believes that the clinical laboratory service business is shifting
away from the traditional direct to physician sales structure and into one in
which the purchasing decisions for laboratory services are increasingly made by
physician groups and networks, managed care organizations, integrated health
delivery systems, insurance plans, hospitals or hospital groups, employers and
by patients themselves. In view of these changes, the Company has developed
regional market strategies 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."
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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 tens of 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, high quality, 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 use 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 enrolled 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 profitable 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 receive little if any fee-for-service testing from such physicians. The
level of pricing charged to managed care organizations, including those under
capitated payment contracts, if continued, may adversely affect the clinical
laboratory industry.
The Company believes that the prices charged by the independent clinical
laboratory testing companies to managed care organizations must be increased.
The Company continues to review its pricing structures for agreements with
managed care organizations and intends to continue to negotiate price increases
for those agreements that are not profitably priced. Further, to obtain a wider
market presence, the Company has developed a centralized organization to ensure
consistent standards of practice and uniform approaches and to better respond
to and address the needs of national managed care plans. 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 ser-
Quest Diagnostics Incorporated : 1997 Form 10-K
7
vices agreements with managed care organizations. The Company, as part of its
preferred partner strategy, will seek to secure large-volume, profitable
managed care contracts through providing low cost, high quality testing
services at rational prices.
- --------------------------------------------------------------------------------
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 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 over
half of all clinical laboratory tests in the United States, the Company has
established a hospital alliance 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 established during July 1997 with
Samaritan Health System, a leading integrated health care delivery network in
Arizona; and a joint venture with approximately twenty hospitals in northwestern
Pennsylvania and southwestern New York. These 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 has outsource agreements with a group of
approximately 25 hospitals in eastern Nebraska and manages the laboratories of
those hospitals. In addition, 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
and outsource arrangements with a number of hospitals in the future.* The
Company has signed a letter of intent with UPMC (University of Pittsburgh
Medical Center) Health System to operate through a joint venture a clinical
laboratory utilizing the Company's existing laboratory facility in Pittsburgh.
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 increasingly
interested in using information from clinical laboratory data on their covered
populations 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 Quest Informatics, a division which focuses on the medical
information needs of managed care organizations, integrated health care
delivery networks, pharmaceutical companies, 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.
- --------------------------------------------------------------------------------
* This is a forward looking statement within the meaning of Section 27A of
the Securities Act of 1933, as amended, and Section 27E of the Securities Act
of 1934, as amended, and is based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and uncer-
tainties include increased competition from hospitals in the commercial out-
reach market. See "Cautionary Statement for Purposes of the 'Safe Harbor'
Provisions of the Private Securities Litigation Reform Act of 1995". In par-
ticular see factor (a).
Quest Diagnostics Incorporated : 1997 Form 10-K
8
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. Pharmaceutical customers have interest
in clinical data to expand sales and marketing efforts as well as to promote
disease management initiatives. 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. The Company is committed to building a standardized
company-wide infrastructure, including an information technology environment
that is Year 2000 compliant. To lead this effort, in November 1997 the Company
hired Gerald Marrone as its Senior Vice President and Chief Information
Officer. Mr. Marrone previously was with Citibank, N.A. for 12 years, most
recently serving as Vice President, Division Executive for Citibank's global
production support division. Mr. Marrone was also the Chief Information Officer
for Citibank's global cash management business. Prior to joining Citibank, Mr.
Marrone was the Chief Information Officer at Memorial Sloan-Kettering Cancer
Center for five years.
The Company has chosen its SYS billing system as its standard billing system and
its QuestLab system (which is licensed from a third party) as its standard
laboratory information system. The Company believes that both of these systems
are substantially Year 2000 compliant. The SYS billing system, which in March
1998 will become operational in the New York/New Jersey (Teterboro) regional
laboratory, has already been implemented in sites that, after giving effect to
the closing of certain facilities (see "Acquisitions and Consolidations") and
the conversion of the Teterboro laboratory, account for approximately 57% of
the Company's net revenues. The QuestLab laboratory information system is
already operational in sites that, after giving effect to the closing of certain
facilities, account for approximately 35% of the Company's net revenues. Five of
these sites also have the standard SYS billing system. The Company is continuing
to convert the remaining nonstandard billing and laboratory systems to the
standard systems, prioritized on a basis intended to minimize the cost of making
non-standardized systems Year 2000 compliant. The Company expects that by June
30, 1999, as a result of additional conversions, billing sites representing 71%
of its 1997 net revenues will be utilizing its SYS system; and laboratory sites
accounting for 61% of its 1997 net revenues will be utilizing its QuestLab
system; and the Company's remaining non-standard billing and laboratory systems
will have been made Year 2000 compliant.* 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
expects that its total capital expenditures during 1998 and 1999, including
spending on its information systems, will be between approximately $60 million
and $70 million per year.* In addition, the Company expects to incur during 1998
and 1999 an additional $25 million to $35 million in non-capitalized expenses in
making its systems Year 2000 compliant.*
The Company is developing systems that will permit managed care organizations
and other providers to have electronic access to place test orders and receive
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 patients, insurance companies, Medicare,
Medicaid, doctors, and employer groups, all of whom have different billing
requirements. A significant portion of the Company's bad debt expense is the
result of many non-credit
- --------------------------------------------------------------------------------
* These are forward looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 27E of the Securities Act of
1934, as amended, and are based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and
uncertainties include computer or other system failures, including failure
resulting from the Year 2000 problem, the impact of compliance with Medicare
administrative policies, and development of technologies that substantially
alter the practice of medicine. 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), (k), and (l).
Quest Diagnostics Incorporated : 1997 Form 10-K
9
related issues, primarily missing or incorrect billing information on
requisitions which slow the billing process, create backlogs of unbilled
requisitions and generally increase the aging of accounts receivable.
Approximately 10% 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 charged to the
allowance for doubtful accounts.
The Company's bad debt expense increased from 1993 to 1995 due principally to
increased complexity in the health care system, including changes in
reimbursement policies of Medicare carriers and third party payors, that further
complicated the billing process. This increased complexity has 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
has improved its management of these requirements and bad debt expense was
reduced substantially in 1996 and 1997 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 (but subsequently
abandoned) 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. During the third quarter of 1996 the Company decided to
abandon the new billing system and recorded a charge of $13.7 million to write
off capitalized software.
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
generally proven reliable, throughout its network. 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. The Company has retained key people who
have been involved in prior conversions.
The Company has concentrated on improving its billing operations in the last two
years. Since the third quarter of 1995, the Company has achieved significant
reductions in unbilled requisitions; days sales outstanding; bad debt expense as
a percentage of net revenues; the percentage of requisitions received with
missing billing information; and backlogs in rejected claims, unapplied cash and
customer correspondence. These improvements were achieved in spite of a higher
level of information requirements necessary for correct billing, especially
those bills relating to Medicare. See "Regulation and Reimbursement-Regulation
of Reimbursement for Clinical Laboratory Services."
- --------------------------------------------------------------------------------
Acquisitions and Consolidations
MetPath, the Company's predecessor, originally commenced operations 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 historical financial data because several of the major
acquisitions are accounted for as poolings of interests and accordingly prior
financial statements have been restated on a combined basis. Acquisition
activity has diminished significantly since the end of 1994, in part so that the
Company could concentrate on the integration of the laboratory networks that had
been acquired in 1993 and 1994. Future acquisition efforts are expected to focus
on smaller laboratories that can be integrated 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.
Quest Diagnostics Incorporated : 1997 Form 10-K
10
During 1997 the Company completed one such acquisition, Diagnostic Medical
Laboratory, a laboratory based in Connecticut that had duplicate operations
that have since been merged into the Company's operations.
The Company believes that it and the clinical laboratory industry at large
operate significantly below available capacity. During 1997 the Company took
several steps to eliminate excess capacity. In July the Company formed a joint
venture with Samaritan Health System ("Samaritan"), a leading integrated health
care delivery network in Arizona. The Company and Samaritan contributed their
existing laboratory assets in Arizona to the joint venture (known as Sonora
Quest Laboratories), which is now the leading clinical laboratory in the
Arizona market. Integration of the two systems is expected to be complete by
the end of 1998, thereby eliminating duplicative costs and improving financial
results. The joint venture is accounted for as an equity investment. During the
fourth quarter of 1997, the Company decided to convert two of its regional
laboratories (Atlanta and Tampa) into stat laboratories and local customer
centers, downsize one other regional laboratory (St. Louis) and several branch
laboratories (Indianapolis, Buffalo, Columbus and Cleveland), and transfer
testing currently performed at these laboratories to other of the Company's
laboratories. The total cash outlays associated with these consolidations is
expected to be approximately $40 million before taxes. By the beginning of
1999, when the consolidations are fully implemented, net annual benefits are
expected to be in excess of $20 million before taxes, although volume and
revenue are expected to be affected negatively by these consolidations.*
- --------------------------------------------------------------------------------
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
Institute. 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 Damon in August 1993 and Nichols Institute in August
1994. 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 $1.5 billion in revenues from clinical laboratory testing in
1997; LabCorp, which had approximately $1.5 billion in revenues from clinical
laboratory testing in 1997; and SmithKline, which had approximately $1.4 billion
in revenues from clinical laboratory testing in 1997. Both LabCorp and
SmithKline are affiliated with large corporations that have greater financial
resources than the Company. F. Hoffman La Roche Ltd. beneficially owns
approximately 49.9% of the outstanding capital stock of LabCorp; SmithKline is
wholly owned by SmithKline Beecham Ltd.
In addition to the three national clinical laboratories, the Company competes
on a regional basis with many smaller regional and local 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 (measured by the average revenue per
requisition) remained relatively stable during 1996 and in 1997 increased by 3%
from 1996 levels. See "Customers and Payors."
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."
- --------------------------------------------------------------------------------
* This is a forward looking statement within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 27E of the Securities Act of
1934, as amended, and is based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and
uncertainties include the impact upon the Company's revenues and expenses
resulting from compliance with Medicare administrative policies; failure to
retain existing customers including by reason of consolidation of certain
laboratories; computer or other system failures; and development of
technologies that substantially alter the practice of medicine. 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),(f),(j) and (k).
Quest Diagnostics Incorporated : 1997 Form 10-K
11
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 may be able to increase their
share of the overall clinical laboratory testing business due to a number of
external factors, including cost efficiencies afforded by large- scale automated
testing, Medicare reimbursement reductions and the growth of 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 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 through the
Company's systems as routine patient samples, unknown to the laboratory as
quality control samples and reported. 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 federal and state agencies.
The health care industry is undergoing significant change as third-party
payors, such as Medicare (which principally serves patients aged 65 years 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 laborato-
- --------------------------------------------------------------------------------
* This is a forward looking statement within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 27E of the Securities Act of
1934, as amended, and is based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and
uncertainties include heightened competition; impact of changes in payor mix;
adverse actions by Medicare and other third party payors; computer or other
system failures; and development of technologies that substantially alter the
practice of medicine. 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), (j) and (l).
Quest Diagnostics Incorporated : 1997 Form 10-K
12
ries by requiring that laboratories be certified by the government. Many
clinical laboratories must also meet 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. Eight 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 Waste 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 and air-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
United States Public Health Service and the Postal Service apply to the surface
and air transportation of clinical laboratory specimens.
Regulation of Reimbursement for Clinical Laboratory Services. Containment of
health care costs, including
Quest Diagnostics Incorporated : 1997 Form 10-K
13
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 1997, the Company derived
approximately 17% 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 many clients 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 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 or 1997). Under the 1997 Balanced Budget Act,
effective January 1, 1998, the Medicare national fee schedule limitations were
further reduced to 74% of the 1984 national median, and consumer price index
adjustments are eliminated through 2002. 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.
During the last several years HCFA has taken several measures to reduce
utilization of clinical laboratory testing and to ensure that except for
certain limited exceptions Medicare does not pay for tests that are ordered for
screening purposes. 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. 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 will
only pay for those individual tests in a chemistry panel that are medically
necessary. During 1996, in conjunction with HCFA, the American Medical
Association ("AMA") designed four new panels of "clinically relevant" automated
chemistry panels (each consisting of between 4 and 12 tests) to replace the
previous automated chemistry test panels consisting of 19 to 22 tests.
Effective January 1, 1998, HCFA began implementation of these new panels but
granted clinical laboratories a grace period through April 1, 1998 during which
laboratories can choose to use either the old or new panel codes. The Company
believes that HCFA is encouraging its carriers to focus any future limited
coverage applications to the panel level (and not to the test component level).
In response to these developments, the Company is implementing a
Medicare/Medicaid only requisition form that incorporates the new AMA panels
and highlights "limited coverage" tests for which Medicare/
Medicaid will pay only if an approved diagnosis has been provided by the
ordering physician. The Company has field tested the requisition form in two
regional laboratories, where implementation of the new panels resulted in a net
reduction of approximately 10% of the Company's Medicare revenues (or
approximately 2% of the Company's aggregate net revenues) in these regional
laboratories. The Company is generally permitted to bill patients for certain
statutorily excluded clinical laboratory services. The Company is also
generally permitted to bill patients for clinical laboratory tests that
Medicare does not pay for due to "medical necessity" limitations (e.g., limited
coverage tests for which an approved diagnosis code is not provided by the
ordering physician) if the patient signs an advance beneficiary notice ("ABN"),
which is included on the Company's new Medicare/Medicaid-only requisition form.
However, since the majority of the Company's requisitions are filled out by
physician clients, the Company cannot mandate the proper use of the ABN. If the
ABN is not signed by the patient, the Company may perform tests which are not
covered by Medicare but cannot subsequently bill the patient for them.
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." While these
changes could have a material adverse affect on the Company's results of
operations, management does
Quest Diagnostics Incorporated : 1997 Form 10-K
14
not believe that these changes will have a material adverse effect on the
Company's financial condition.*
Currently Medicare is administered by over 20 local carriers, which have had
inconsistent policies on such matters as test coverage, automated chemistry
panels, diagnostics coding and claims documentation. Inconsistent regulation
has increased the complexity of the billing process for national clinical
laboratories such as the Company. As part of the 1997 Balanced Budget Act, HHS
is required to adopt uniform policies regarding such matters by January 1, 1999
and replace the current local carriers with no more than five regional
carriers. In addition, the 1997 Balanced Budget Act requires carriers to
include a representative of the laboratory industry on any advisory committee
that may be established to consider laboratory coverage, payment and claims
policies.
Major clinical laboratories, including the Company, typically 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 to non-governmental clients
and payors or the dual fee structure employed by clinical laboratories might be
inconsistent with the provision. A proposed rule released in September 1997
would authorize the OIG to exclude from Medicare providers, including clinical
laboratories, who charge Medicare and other programs fees that are
"substantially in excess of . . . .usual charges. . . . to any of the
[laboratories'] customers, clients or patients." If the rule is adopted as
proposed, the Company and other clinical laboratories would have to pass on to
Medicare discounts that they pass on to other clients charged on the "client"
fee schedule. The proposed rule, if adopted in such form, could have a material
adverse effect on the Company's net earnings and cash flows.
The 1997 Balanced Budget Act permits HCFA to adjust the statutorily prescribed
fees for certain medical services, including clinical laboratory services, if
such fees are "grossly excessive." In January 1998 HCFA issued an interim final
rule setting forth the criteria used by HCFA in determining whether or not to
exercise this adjustment power. Among the factors listed in the rule are
whether the statutorily prescribed fees are "grossly higher or lower than the
payment made for the. . . . services by other purchasers in the same locality."
Medicare reimbursement reductions effected pursuant to this rule would have a
direct adverse effect on the Company's net earnings and cash flows. The Company
cannot predict if and the extent to which such Medicare reductions will be
implemented.
HCFA is currently planning a demonstration project to determine whether
competitive bidding can be used to provide quality laboratory and other medical
services at prices below current Medicare reimbursement rates. The project is
expected to take place in Tennessee and begin by early 1999. If competitive
bidding were implemented on a regional or national basis for clinical
laboratory testing, such action could materially adversely affect the clinical
laboratory industry, including the Company. The 1997 Balanced Budget Act
requires HCFA to conduct five other Medicare bidding demonstrations involving
various types of medical services and complete them by 2002.
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, asset forfeitures, and civil and criminal penalties and
fines. Under the Health Insur-
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* This is a forward looking statement within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 27E of the Securities Act of
1934, as amended, and is based on current expectations. Forward looking
statements involve risks and uncertainties that could cause actual results to
differ materially from the forward looking statement. These risks and
uncertainties include the impact upon the Company's revenues and expenses
resulting from compliance with Medicare administrative policies; computer or
other system failures; and development of technologies that substantially alter
the practice of medicine. 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), (j) and (l).
Quest Diagnostics Incorporated : 1997 Form 10-K
15
ance Portability and Accountability Act of 1996 ("HIPAA"), 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 enforcement 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 HIPAA
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. HIPAA 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. HIPAA 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 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 several advisory opinions on health care matters
have been issued. As a result, the Company is hopeful that additional regulatory
guidance will be given to the clinical laboratory industry in the future.
Many states have anti-kickback, anti-rebate, anti-fee splitting and other laws
which also impact the Company's relationships with clients who refer other than
government reimbursed laboratory testing to the Company.
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
Quest Diagnostics Incorporated : 1997 Form 10-K
16
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.
Many states have similar anti-"self-referral" and other laws which also impact
investment and compensation arrangements with physicians who refer other than
government reimbursed laboratory testing to the Company.
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Government Investigations and Related Claims
The Company has settled various government and private claims (such as those by
private insurers) 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) fourteen settlements relating to private claims totaling
approximately $12 million. In addition, there are several pending
investigations by the OIG and DOJ, including one into billing and marketing
practices at three regional laboratories operated by Nichols Institute prior to
its acquisition by the Company and one into billing and marketing practices at
a former joint venture of Damon.
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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 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 earlier the same month. 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. 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 14
to the Consolidated Financial Statements.
Other Government 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.
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Ongoing Government Investigations
The Nichols Investigation. By issuance of a civil subpoena in August 1993, the
government began a formal investigation of Nichols Institute, a company
acquired by Corning in August 1994. The investigation of Nichols Institute
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 Institute, 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
Quest Diagnostics Incorporated : 1997 Form 10-K
17
referred to below entered into between the Company and the OIG in connection
with the Damon settlement, the fact that the matters apparently being
investigated were corrected with or before the Company's acquisition of Nichols
Institute 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,
and prospects, management believes that the possibility of such effects are
likewise 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.
Damon Joint Venture Investigation. In connection with the investigation that
resulted in the Damon settlement discussed above, the government began an
investigation into a joint venture between Damon and Vivra Inc. (which
dissolved in May 1996) and a predecessor joint venture between Damon and
Vivra's former parent. These joint ventures operated Damon's Atlanta regional
laboratory and furnished testing services to Vivra's dialysis centers, which
provided dialysis treatment to end stage renal dialysis ("ESRD") patients. As
discussed in the following paragraph, several former officers of Damon have
been indicted in part on account of their involvement with the organization and
operation of the joint venture. The terms of the Damon settlement releases the
Company of further criminal liability on account of the partnership; however,
civil recovery of overcharges remained a possibility after that settlement. The
government asserts that the joint ventures were formed and operated as a scheme
to generate referrals for medically unnecessary testing for ESRD patients by
providing unlawful kickbacks to Damon's joint venture partners in the form of
partnership profits. The Company has established reserves regarding this
investigation. 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 this investigation.
The Damon Officer Indictments. In January 1998, four former officers of Damon
Corporation were indicted by the United States of America for alleged health
care fraud committed during their employment by Damon. The indictment relates
to matters that were the subject of the Damon settlement and, in the case of
three of the officers, to the investigation of the former Damon joint venture
discussed in the preceding paragraph. Under the agreement and plan of merger
under which Damon was acquired by Corning, the Company is obligated to
indemnify these former officers of Damon to the fullest extent permitted by
Delaware law. The Company's obligations (primarily advancing fees and expenses
of counsel in connection with the defense by these former officers of Damon)
will not be indemnified by Corning. As part of the Damon settlement, Corning
agreed to cooperate with the DOJ in its continuing investigation of individuals
formerly associated with Damon and, in connection therewith, the Company
provided 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. 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. The Company has reached a tentative
settlement with the DOJ to settle this investigation for $6.8 million. The
Company has voluntarily self-reported to the government several isolated events
that may have resulted in overpayments 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 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 under "Corning Indemnity," Corning has agreed to indemnify
the Company against any monetary penalties, fines or settlements for certain
governmental claims that may arise as a result of the investigations commenced
prior to January 1, 1997.
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Outlook for Future Government Investigations
The Damon settlement involved, and a settlement regarding Nichols Institute 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, HIPAA
includes provisions relating to health care fraud and abuse that gives federal
Quest Diagnostics Incorporated : 1997 Form 10-K
18
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."
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Private Settlements and Claims
Since 1992 the Company has settled fourteen private actions relating to the
governmental settlements described above for an aggregate of approximately $12
million. The Company has received notices of claims from a number of private
payors relating to billing issues similar to those that were the subject of the
government settlements with MetPath and Damon. The outcome of these claims
cannot presently be predicted.
In March 1997, a former subsidiary of Damon, together with SmithKline and
LabCorp, was served with a complaint in a purported class action. The complaint
asserts claims under the federal civil RICO statute relating to private
reimbursement of billings by Damon that are similar to those that were part of
the government settlement. The ultimate outcome of the claim cannot be presently
predicted.
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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 above under "Government Settlements" and the claims pending at
December 31, 1996 that are described above under "Ongoing Government
Investigations-The Nichols Investigation", "-Damon Joint Venture 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
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.
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The Company's Reserves
The Company's aggregate reserve with respect to all governmental and private
claims was approximately $76 million at December 31, 1997. The 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.
The Company believes that its reserves are adequate. The reserves are based on
the
Quest Diagnostics Incorporated : 1997 Form 10-K
19
Company's experience with prior settlements and other information available to
the Company on potentially disputed billings. 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 or private claimant'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 cash flows in the period in which such claims are settled. The
Damon settlement was significantly in excess of the reserves existing in 1996
prior to the settlement. While it is likely that 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.
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Compliance Program
Because of evolving interpretations of regulations and the national debate over
health care, compliance with all Medicare, Medicaid and other legal 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 standards and 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, in October 1996 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 reduce the occurrence of 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. In 1997 the OIG 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, 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.
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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 and
anatomic pathology 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
Quest Diagnostics Incorporated : 1997 Form 10-K
20
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.
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Employees
At December 31, 1997, the Company employed approximately 16,300 people, as
compared to 18,300 employees at December 31, 1996. Approximately 14,400 of the
Company's employees at December 31, 1997 are full-time employees and
approximately 1,900 are part-